Matthew Erskine, principal of The Erskine Company, a strategic advisory firm located in Worcester, MA, discusses the effects on the investment climate of high government debt, and why specialized planning may be necessary.

Matthew Erskine, principal of The Erskine Company, a strategic advisory firm located in Worcester, MA, discusses the effects on the investment climate of high government debt, and why specialized planning may be necessary. Views are the author's own but this website is grateful for permission to publish them. As always, responses are welcome.

A recent edition of Barclays Wealth Insight reports that the proportion of wealth held by taxable individual investors in art, jewelry, precious metals and other “treasure” has dramatically increased to nearly 20 per cent of net worth, especially in areas of the world where there is political and economic turmoil, as they increase their holdings of “flight capital.” In the US, that proportion is now nearly 10 per cent of net worth and rising.

Although part of this increase in holdings of tangible assets may reflect the relative decline in the value other forms of wealth, including a nearly 40 per cent decline in residential real estate and price declines in many stocks, another part of this increase may reflect purposeful reallocation of resources. Indeed, we have seen some clients allocate as much as 40 per cent of their net worth to treasure.

Since year 2000, stock market investors have suffered high volatility and low returns. With relatively high unemployment in the US and a stubborn ongoing financial crisis abroad, some worry about a repeat of the Great Depression of the 1930s, and they have been moving out of stocks. Low yields on bonds and money markets are not attractive, but reflect security in an uncertain world.

In the 1930s, cash and sovereign debt were safe havens, made more attractive by the Federal Reserve, which reduced the supply of money in the economy by 25 per cent after 1929. Cash is king when there is deflation and low interest rates. In the Depression, collectable treasures were bartered away at a fraction of their original purchase prices a few years earlier, just to pay for a meal, a place to stay or for cash. That is not happening today and is unlikely to happen again.

“This time is different”

An important difference between the 1930s and now is the level of government debt. Governments had high levels of debt when the financial crisis hit in 2008. The crisis moved governments to issue much more debt in an effort to prevent the complete collapse of their financial systems. The crisis, which continues to this day, has been blamed on the easy monetary policy of the Federal Reserve and other central banks, as well as governments' runaway deficit spending fiscal policies. For decades, central banks adopted easy monetary policies to keep credit flowing with low interest rates.

Governments and central banks seemed to assume that the normal business cycle could be replaced by a new era where everyone could have a decent income, every child could go to college, everyone could own a big new home, and everyone could consume more and more on credit.

The "new era" overextended and had to end when the bills came due. In order to save the banks from drowning in nonperforming loans, governments massively increased their debt as they took on large amounts of private debt, such as mortgages and student loans, which governments had guaranteed during the boom years. In addition, governments continue to run large and growing budget deficits as they attempt to maintain popular social programs that politicians promised voters in order to get elected. In some nations, we are seeing that high levels of government spending are no longer sustainable and existing debts cannot be paid.

In contrast to governments, private companies have cut costs and strengthened their balance sheets, leading to increased profits even in a sluggish economy. So, the main risk today may not be in the private sector, as was the case in 1929, but rather the risk is in the public sector. Thus, today’s economy is the antithesis of the Great Depression.

Carmen Reinhart and Kenneth Rogoff, in their recent book, This Time is Different, make a case that because of high levels of debt, it is far more likely that a crash will occur in the currency and bond markets than in the equity markets. The US bond market is in a bubble, extremely overbought and overvalued, and may be venerable to a collapse. A collapse of currency and bond markets could occur just as quickly as the stock market crash of 1929 or the real estate meltdown of 2008, and many investors would be devastated.

In addition, Reinhart and Rogoff point out that, over the past eight centuries, when nations are confronted with the high levels of debt currently maintained by developed countries, nations resolve the problem by monetizing the debt. That means central banks "print" new money out of thin air (thereby debasing the currency) in order to buy bonds that can never be repaid. Historically, that is the only way out of such a debt crisis. Sooner or later, massive debt monetization (money printing) results in high and rising inflation and a mass exodus of investors out of bond markets.

A collapse of the Eurozone, a default by Greece, Spain or any other large debt-ridden sovereign entity could spread the financial crisis globally through interconnected finance, banking and trade channels. Precise timing is uncertain, but there can be no doubt that global currencies and bond markets will eventually come crashing down.

As inflation accelerates, many assets denominated in dollars increase in value. These include a few equities (though many will go down as they did in the 1970s), art, numismatics, real estate and commodities. Although not all are investments in the conventional meaning, specific considerations include:

·        Selected equities: if you decide to buy equities, focus on large-cap, blue-chip stocks with pristine balance sheets and business models that have no reliance on government contracts or government spending.

·        Art: if you decide to buy art, focus on moderately priced works of established artists that have critical recognition and that have a personal appeal to the investor.

·        Gemstones: if you decide to by gemstones, focus on the highest quality mid-priced gemstones.

·        Numismatics: if you decide to buy numismatics, focus on specific dates and types of coins that have both a metallic value and a numismatic value.

·        Real estate: if you choose to buy real estate, invest in properties that can be purchased with cash or paid off quickly and are not dependent on the public sector, but rather are dependent on private markets that will grow regardless of the economy, such as medical office buildings, warehouses, timber and food industries.

·        Commodities: focus on food commodities that are always in demand and precious metals that have industrial uses (e.g. platinum, palladium) and will not lose value in an inflationary environment.

Over the next decade, therefore, expect to see individuals and their families acquiring and holding treasures, both as flight capital in places of turmoil, and as a hedge against inflation in places of relative security such as the US. These treasures will be specific, tangible assets owned directly by individuals, and taxable to the owners. Much of the current financial and investment planning, which is based on the rational analysis of risk/benefit returns of a portfolio of liquid and intangible assets held by institutional nontaxable investors, will be useless. This is because planning for individual taxable investors in tangible investments is quite different from the planning for institutional nontaxable investors in liquid intangible assets.

Planning for treasure owners is different for several reasons. First, in addition to the obvious investment purpose, ownership of unique treasures can offer personal enjoyment and appreciation of heritage and culture. Indeed, these benefits can become the primary motivators  or individuals as their occasional purchase develops into a collection.

Second, once acquired, individuals are often very reluctant to part with their unique assets, even when prices rise excessively from a rational investment perspective.

Third, the goal of each individual is wholly dependent on the unique personality of the individual, which evolves over time. What at first may have been a purchase purely for decorative or investment diversity purposes, over time could evolve into a collection that has great personal significance. Success for these collector clients becomes outcome driven, not results driven.

Individual owners of treasures need more than just investment and financial planning: they need specialized guidance in building an object-oriented strategic plan. This must “overlay” their other planning to work at a high level of comprehensiveness and outcome oriented processes, while integrating into their investment, financial and legal processes.

Conclusion

A high level of government debt creates a different and challenging environment for investors. Historically, to resolve such debt, governments monetize debts and debase currencies, and that eventually leads to hyperinflation and collapse of currencies and bond markets. More individual taxable investors recognize this risk and are investing more of their wealth in treasures – tangible assets, such as art, gems, coins and other flight capital – even here in the US.

Ownership of treasures, however, is complicated by the emotional enjoyment and cultural significance of the treasure to investors. Traditional financial, legal and investment planning is not up to the task of handing the acquisition and ownership of treasure, so an overlay of specialized planning best serves collectors of treasures.