Summary Today’s wealthy investors and Wall Street have always had it so good. With credit expansionary schemes near exhaustion, what is the next bubble to bust? The next great financial crisis has already begun and the global currency war is your first clue. A traditional portfolio asset allocation won’t necessarily help your wealth survive what’s ahead. “What we learn from history is that people don’t learn from history.” Warren Buffett said it best. We are now late in 2015 and approaching the 8-year marker since the onset of the Great Recession of 2008. In a cyclical world of boom-to-bust economic and market history, we find the global financial markets of the developed world economies (ex-China) are all still trading near record highs. Private equity and pre-public venture capital valuations are fully valued across most historical metrics, and both commercial and residential real estate are also priced near the higher end of their historical valuation and price range. The Great Recession of 2008-9 is long forgotten by most investors and the Internet Bust of 2001-2 is now ancient history. Further back, the Bond Market Bust of 1994, the Stock Market Crash of 1987, and the Great Stagflationary Recession of early 1980s are buried within the digital archives of Wikipedia. Although our 7-year boom-to bust cycles are quickly dismissed from our collective investor memory banks, they have been quietly building in their financial intensity and devastating effects on our wealth. Thanks To A Lifetime Of Credit Expansionary Policies And ‘Easier Money’, The Wealthy And Wall Street Have Always Had It So Good For nearly 35 years, US monetary and fiscal policies have been the greatest ally to investors looking to build significant wealth and stay ‘long risk’ through the years. The buy & hold mentality is still deeply ingrained into both institutional and individual investor DNA. Through financial crises, bear markets and economic recessions, investors have been rewarded by not panicking and simply holding on. After all, the Federal Reserve and central banks had your back. Since 1980, through most investors’ professional lifetimes, the secular decline in interest rates tells the story of how this relatively complacent behavior of today’s investor psyche was born. (click to enlarge) To be sure, this has not only been a US interest rate phenomenon, but a global story among the world’s developed economies too. In fact, for the first time in history, short term government bond yield curves are now negative in both Germany and France, and near negative in the U.S. and Japan as well. (click to enlarge) The bad news for the global economy, however, is that record low interest rates have been excruciatingly painful for retirees, income investors, and the ‘savers’ class in general. Millions of people have watched their annual retirement income stream cut by nearly 2/3rds in just the last few years. Worse yet, there is also a huge problem looming for global public sector and private sector pensions that are growing increasingly underfunded with perpetual low rates destroying their ability to meet longer-term liabilities. Sovereign nations, cities, states, and municipalities will be unable to meet their unfunded liability obligations putting even more pressure on an aging world population and government safety-net programs. That said, long-term interest rates won’t stay low forever, particularly given how late we are in the current global economic cycle. If only human nature would let our minds look out just a bit further than our noses. (click to enlarge) Beyond decades of accommodating monetary policies, global fiscal policies have also been exceedingly generous to the wealthy. Endless government deficit spending and bailout programs have reached unprecedented and unsustainable levels. Skyrocketing debt-to-GDP ratios with no political consensus in Washington and around the world has fiscal credit limits near exhaustion. We will soon approach an inconceivable $10 Trillion of additional government debt load in the US alone since the onset of the Great Recession of 2008. (click to enlarge) To put this recent $10 Trillion government deficit spending binge into perspective, it took the United States 231 years to accumulate the first $9 Trillion of government debt and only 9 years to more than double it. With Credit Expansionary Schemes Near Exhaustion, What Is The Next Great Bubble To Bust? When the risk-free lending rate is near 0% (free money), one could argue that everything and every asset is being mispriced in one way or another. That’s right, everything. According to the Austrian Economic business cycle theory, free money also creates an investment environment that encourages dangerous ‘malinvestment’. Malinvestment can best easily be understood as essentially ‘bad money chasing good money’ into mispriced and often overpriced assets based on misleading price signals and a low lending rate. We now know the Dotcom Bubble of the 1990s and Housing Bubble of the 2000s were classic periods of ‘private sector’ malinvestment – whereby the laws for Supply & Demand clearly defied any logic. Until they went bust. History is cluttered with ‘public sector’ malinvestment periods too, whereby government bonds and risk-free assets themselves became the overpriced asset bubble. What transpired during those historic economic periods was a combination of government bond defaults and restructurings – with rising interest rates and high inflation across the globe. High inflation attributable to significant credit quality deterioration in the underlying sovereign debt issuer (bad inflation) as opposed to the higher inflation of a growing and prosperous global economic environment (good inflation). Today’s investors have long forgotten the long history of government bond default crises both here and abroad. (click to enlarge) Fast forward to the Global Government Bond Bubble here in the 2010s – whereby in just the last 7 years, the massive bond market ‘supply’ has grown at an exponential rate over the slowing global economy’s financial ability to service and support it. Global bonds, by any historical measurement, are screaming ‘global recession’ at best, or ‘global depression’ at worse. On the other hand, global stocks, ex-China, are screaming that growth prospects looking ahead are strong, asset inflation is rising and market ‘risks’ are minimal. Which market is now telling us the truth about the global economy – is it the world’s bond markets ( record deflation ) or the world’s stock markets ( record asset inflation )? The answer is that neither market is telling us the truth – as the world’s central banks have now suspended the free market’s price discovery mechanism of both markets through the monetization of the world’s debt markets (also known as quantitative easing, money printing, or ‘Ponzi’ economics). The big buyers of last resort are the global central banks with their perpetual backstopping of bond markets and free money policies. As a result, the world’s stock markets have gotten a free pass too. (click to enlarge) By extending zero interest rate policies (ZIRP) for 7 years and running, the world’s central banks have attempted to orchestrate an ‘indirect’ stimulus program of their own, forcing savers and fixed income investors out of cash and/or cash equivalents and into the riskier dividend stocks and equity markets. Creating a ‘wealth effect’ among businesses and consumers can be beneficial in the short run, as it was in the Internet Bust of 2001-2 and the Great Recession of 2008-9. At the same time, central banks have conveniently, and quietly, kept the cost of funds for many of the overextended, nearly insolvent developed nations at artificially ‘low-to-no’ interest rate borrowing levels. Many nations on the brink of sovereign default now require a perpetual ultra low cost of borrowing in order to maintain solvency. In the end, financial markets trade on perception as much as reality, and market perception that a perpetual central banking ‘put’ (a bid) on financial assets has greatly contributed to our multi-year bull market in stocks, bonds, real estate and risk assets in general. The Next Great Financial Crisis Has Already Begun And The Global Currency War Is Your First Clue “There is no means of avoiding the final collapse of a boom brought about by credit expansion . The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion or later as the final and total collapse of the currency itself .” Ludwig von Mises Founder of Austrian School of Economics (click to enlarge) For 35 years and counting, our global policymakers have done virtually everything in the credit expansionary playbook. Their Keynesian schemes are getting thin with little economic impact, and the free markets are now calling their bluff in the world’s major currency markets. Ludwig von Mises’s forthright plea for ‘voluntary abandonment’ of easy money policies has been repeatedly scorned by the Keynesian economists within the world’s central banks. With most advanced economies’ fiscal ‘credit card’ nearly fully spent up, and with no rational real economy buyers willing to support such lofty bond prices and low interest rates – the dangerous end of an era is precariously close. Nations around the world are aggressively devaluing their currencies in order to make their economies more competitive. There have been a record number of currency devaluations in 2015, with multiple rate cuts in the major economies of the Eurozone, China, India, and South Korea. Despite the rhetoric that US monetary authorities are soon looking to raise interest rates for the first time in over 9 years, a major global currency war is well underway. Welcome To The First Government Debt Crisis In The World’s Core Economy Of The 21st Century (click to enlarge) Global economic growth, particularly across the advanced economies of the U.S., the Eurozone, and Japan has been slowing for the last 20 years despite creating two major ‘private sector’ financial asset bubbles (2000, 2008) whose ultimate ‘bust’ nearly took the world’s economy into a global depression. With global growth now approaching ‘stall speed’, the emerging market ‘BRIC’ nations are now in steep decline for the first time in many decades. China, most notably, as the second largest economy in the world, has witnessed a near 40% crash in its stock market with real economic consequences just beginning to surface. Many market participants are skeptical of the Chinese economy and official economic reporting going forward, with some predicting a severe recession ahead for the country. (click to enlarge) We are entering the first public sector, global government bond bust in the world’s core economy of the 21st Century. The catalyst or series of catalysts to the next investment cycle change can be anything now – from economic, financial, non-financial, political or geopolitical. Arguably, geopolitical risks are now higher than at any point since World War II. We strongly believe the short years ahead will present the most challenging investment period for the great majority of investors in our lifetime. A Traditional Portfolio Asset Allocation Won’t Necessarily Help Your Wealth Survive What’s Ahead “The next crisis could be a very different type of crisis…we’re talking the 1930s where you could have a chain-link of government defaults.” Jeremy Grantham Founder and Chief Investment Strategist of $118B GMO Advisors Managing wealth and advising wealthy clients over our collective lifetime has been relatively simplistic. The primary ‘old school’ mantra can best be summed up by the following common financial advisory cliches: #1 – Diversify your portfolio holdings (stock, bond, cash, real estate) # 2 – Stay the course and don’t panic Pretty easy, right? Truth be told, as simple as #1 and #2 above seem to be, most investors have had trouble over the prior decades and boom & bust markets sticking to this modern day wisdom. After all, human nature and behavior economics have tended to work against the masses. The proof in that statement is the plethora of professional investor services that closely monitor investor sentiment and behavior across time, geography, volatility, and asset classes. The major challenge for global investors going forward is that no investor alive today has ever had to manage wealth through a major public sector debt crisis in the world’s core economy – a crisis that will soon lead to a major secular uptrend in global interest rates as a result of credit quality deterioration (insolvency) in public sector debt including federal, state, local, and municipality paper. Every financial crisis since WWII has been essentially a private sector crisis (industrial, oil, tech stocks, real estate, etc.) or a public sector problem in the peripheral economy (Russia, East Asia, Argentina, etc.). If our deep dive into global economic history and market cycle research proves to be correct, our lifetime of virtuous risk market ‘tailwinds’ are about to turn into vicious risk market ‘headwinds’. According to a recent report from Deutsche Bank, there is an estimated $225 Trillion of total debt in the world today, which is over three times the total world stock market capitalization of $69 Trillion. In the end, the global central banking cartel is powerless to maintain record high debt prices by suppressing low interest rates forever. Investing is simply a confidence game, and sooner or later, investors will lose confidence in the authorities’ futile attempt to control the global economy and free markets. The longstanding risk-free interest rates of our global government debt markets are about to begin rising around the world – likely starting in Europe and onto Japan and Asia, and eventually working its way back to the world’s deepest safe haven U.S. Treasury bond market. Make no mistake, at some point down the road, even the United States of America as the world’s ‘least dirty shirt’ and world’s reserve currency is not immune from major financial market upheaval. As a result, the long-standing ‘old school’ cliches bear two important challenges going forward: #1 – Diversification of assets as opposed to diversification of ‘risk’ will not prevent widespread wealth destruction for most investors. Where will investors hide to protect their wealth when traditional ‘safe haven’ investments are no longer safe? Realized and unrealized losses commensurate to the Great Recession of 2008-9 will likely unfold once again. #2 – Staying the course and ‘waiting out’ the next crisis will likely prove to be a costly approach for most investors. Our global policymakers will not be in a position to execute a quick fix to the economy and your portfolio. Over the last century, there have been multiple periods of extended stock market recovery times in the US lasting from 10 years (1973-1983) to 25 years (1929-1983). In fact, both Japan (1989-today) and Germany (1913-1948) have incurred 26 years (and counting) and 35 years break-even return periods respectively. Again, investor memories are short, and today’s investors have been fortunate to live in a 35-year period of credit expansionary schemes, which has artificially compressed economic recovery times. A Non-Traditional Portfolio Allocation Is Warranted Given The Major Public Sector Financial Crisis Ahead As traditional safe haven investments disappear, investors will look to non-traditional investment opportunities to protect and preserve their wealth and purchasing power. History has provided a road map of how international capital moves through public sector government debt crises. In 2011-2012, for example, European investors experienced first-hand a sovereign debt crisis across southern Europe. Greek government debt, as well as Spain, Portugal, and Italian sovereign paper all sold off dramatically in a very short period of time. Capital flight to other ‘blue chip’ countries including Germany and the US took place in rapid order. Although a short-term fix was put in place by the International Monetary Fund (IMF) and European Central bank (ECB) in 2012, safe haven investors were stunned at the time with huge paper losses in the billions of euros in perceived ‘risk-free’ investments. Investors should intuitively recognize that negative interest rates in Europe, or potentially soon here in the US, are major signals of an impending crisis. Near negative interest rates on long-term Japanese government bonds are further signs of major crisis in the making, particularly as Japan’s fiscal nightmare now widely surpasses Greece’s dangerously high debt-to-GDP and debt-to-revenue solvency ratios. Non-traditional portfolio strategies should consider tail risk and bear market strategies, tangible asset allocations, precious metals, commodities and inversely correlated assets – a combination of both long market and short market strategies – over the years ahead. Major crises never happen ‘all-at-once’, and the coming financial crisis ahead should prove to be no different. Kirk D. Bostrom Chief Portfolio Manager Strategic Preservation Partners LP For more information, please contact Mr. Bostrom and Strategic Preservation Partners LP. Disclaimer: The views expressed are the views of Kirk Bostrom and are subject to change at any time based on market and other conditions. This material is for informational purposes only, and is not an offer or solicitation for the purchase or sale of any security and should not be construed as such. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. The opinions expressed herein represent the current, good faith views of the author at the time of publication and are provided for limited purposes, are not definitive investment advice, and should not be relied on as such. The information presented in this article has been developed internally and/or obtained from sources believed to be reliable; however, the author does not guarantee the accuracy, adequacy or completeness of such information.