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Holon Global Investments - Active Fund Manager


Sovereign debt: 5 hard truths for investors, who should prepare for central banks to walk back on tough inflation action

Published 14 Jul 2022

In 2021, nothing could go wrong. Equities were flying, inflation was ‘transient’, governments were handing out money for free, Bitcoin was going to $500,000 and debt no longer mattered.

Fast forward to 2022, and it’s hard to find a single financial commentator not singing the story of double-digit inflation, rising interest rates, collapsing asset markets, digital asset as a Ponzi-scheme (again!) and an impending sovereign debt crisis.

Source: Adobe Stock

But if we look closely into the actual data that is driving markets’ emotional fear, we see a key ingredient missing from almost every conclusion that assumes central banks will continue to raise interest rates – unmanageable global sovereign debt.

If investors fail to account for this vital ingredient, they could make the serious mistake of positioning their portfolio for massively higher rates that are unlikely to occur, and in doing so damage their prospects of reaching their important financial goals, particularly in retirement.

Therefore, hype and hyperbole aside, here are five hard truths for investors.

1. Inflation is worse than you’re being told

Let’s begin by addressing the elephant in the room. Inflation has certainly taken off over the past 12 months and is creating fear amongst consumers who are now struggling to pay their energy and food bills. The US just released its ‘official’ June CPI which hit 8.6%, the highest since December 1981.

According to John Williams from Shadow Stats, the preeminent global expert on inflation, the original basket of 400 consumer goods that the US Bureau of Labour Statistics (BLS) used to measure the rise in the cost-of-living index (which we today refer to as inflation) circa 1980, shows that inflation has been over 10% per annum for most of the past 20 years (blue line, Figure 1, below1).

Figure 1: Consumer inflation, official vs ShadowStats (1980 – 2022)


This consistently underreported inflation (successfully sold each year by governments as running at 1-2% per year) has led to the slow death of the global middle-class over the past few decades, with annual wage growth failing to maintain the same pace as our cost-of-living. The recent June 2022 data in the chart above of 17% inflation has even surpassed the previous peak of 15% in 1981.

To prove this point further, the chart below shows the rising cost of a standard can of Campbell’s Tomato Soup from 1898 to 2020 (Figure 2, below). This staple food item sold for roughly $0.10 per can until the early 1970’s, before rocketing higher to US$0.85 in 2020. It has now risen to US$1.17 at US Walmart stores as of June 2022.

Figure 2: Campbell’s tomato soup unit price per can, Jan 1898 – Jan 2022

Source: Political Calculations

So, what changed to drive this price and the broader rise in inflation? The cost of producing the can of soup has risen slightly, as food, wages and manufacturing costs have increased. But what really drove the shift in price was the US leaving the gold standard in 1971, which began a 50-year journey of reckless debt accumulation funded by printed money.

2. Sovereign debt means no major central bank can hike rates higher than 3-4%

Market commentators are now suggesting global central banks solve the inflation problem by implementing a ‘Volker-type response’ (Paul Volker was the inflation-busting Chairman of the US Federal Reserve Bank from 1979 to 1987), which would see a return of double-digit interest rates until inflation fell back down again.

But this would almost certainly send the world into a global recession (declining economic conditions that last for many months) or possibly even a depression (a fall in economic activity over many years that leads to high unemployment).

In theory this approach makes sense, but in practice, because governments and consumers are drowning in debt, the cost of interest rate rises look substantially worse than the possible cure of lower inflation.

We believe that no central bank has the ability to raise interest rates above 3-4%.

Figure 3 below lists five important economic metrics for ten individual countries, plus the EU as a whole. The first column shows total national government debt in 2022 (this excludes corporate or personal debt held by local citizens or businesses), while the second column shows this as a share of the countries’ expected GDP in 2022. The third column shows the rise in the 10-year government bond rates (in percentage terms) over the past 12 months, while the fourth column shows how much additional interest (in US Dollars) would need to be paid by each country to reflect the rise in bond yields2. Finally, the fifth column reflects the amount of annual GDP (gross domestic product) that would need to pay down higher interest expenses rather than drive new growth opportunities.

Figure 3: Economic metrics, selected countries plus the EU

Source: Holon

Rising bond yields have already made a big impact on interest payments as a share of annual GDP over the past 12 months. With little to show in the way of improvements in inflation, the ability to raise interest rates much further to cut inflation looks very limited without tipping the world into a severe global recession by 2023.

The OECD Economic outlook, released in June 20223, has recently cut its 2022 GDP growth forecasts by 2-3% across most of the Western world economies since its last report in December 2021. The OECD now expects global growth will likely fall below 3% for 2022, against 5.7% in 2021.

Rising sovereign debt yields are also crossing over into higher mortgage lending rates, with the average US 30-yr US rate rising to 6.05% on June 15th, up from just 2.83% 12 months ago4. This will dramatically impact the borrowing capacity for new home buyers and those needing to refinance loans, likely further limiting global growth in H2 2022 and pressuring asset prices if some homeowners are forced to sell.

Every country included in the table above is also still struggling from the after-effects of the Covid-19 shutdown and the emergency spending measures, which the IMF (International Monetary Fund) estimates in 2020 alone increased total outstanding global debt by 28% to US$256 trillion5.

Regarding the last column, the impact of higher rates on GDP seems relatively small when we add in expected annual current account deficits (government’s borrowing to fund their own revenue shortfall) that will likely be beyond 7% in 2022 for most western economies, things are looking extremely vulnerable. Commodity exporters, including Russia, look to be the biggest beneficiaries from a likely prolonged period of elevated inflation.

Rising sovereign yields, especially over the past 3 months, are the proverbial canary in the coalmine, and suggest that investors are rapidly waking up to the fact that lending their savings to governments at current rates will destroy their purchasing power over the next decade. This leaves governments, as has occurred over much of the past decade, as the buyer of last resort.

So how are they likely to proceed?

3. Japan debt risk also will force central banks to intervene and hold down bond rates

There is another powerful factor that will keep global rates from rising – that is Japan, which is the scariest global risk by a mile.

Saddled with a 285% debt-to-GDP ratio, the Bank of Japan is desperately trying to stabilize its 10-year bond rate below 0.25% to meet its stated monetary policy goal of buying an unlimited amount of its own outstanding bonds (Quantitative Easing) to maintain a maximum 0.25% yield cap6.

As seen in Figure 4 below7 ,bond volatility has exploded in Japan throughout June, forcing the Bank of Japan to print massive quantities of Yen (estimated at US$80 billion in the 3rd week of June alone8).

Figure 4: Japan 10-year bond yield, May 2022


Back in 2011, the 10-Yr bond interest rate for the European PIGS nations (Portugal, Ireland, Greece, and Spain) traded as high as 25-30% to reflect sovereign debt burdens surpassing 150% GDP. With almost double this level of debt of these nations, and effectively zero GDP growth for the past 20 years, Japan’s horrible financial conditions, if accurately reflected in markets, could see interest rates surpass 10%, making the world’s third-largest economy effectively bankrupt in a matter of months.

But a collapse in Japan bonds could set a dangerous mark for global investors to reprice the sovereign debt of the US, Europe, and Australia so prices more accurately reflect their debt burden and annual deficits, as outlined above.

No central bank in the world can afford to let Japan fail, so all roads lead back to the resumption of co-ordinated central bank intervention to stabilise bond rates. We believe this will occur much sooner than almost all financial market commentators are considering.

4. Yes, Australia is highly indebted too

While Australia appears to be in a strong position with just a 45% ratio of federal debt to GDP, if you add in state government, corporate and household debt, total Australian borrowing surges towards US$6 trillion, or 400% of GDP9.

Supporting much of this credit balance are overinflated asset prices, particularly residential housing. As rising sovereign interest rates begin to impact mortgage rates at home, buying demand will likely retreat while tighter refinancing requirements could see forced sellers enter the market, further dampening housing prices, possibly triggering falls as high as 25%.

With the weighting of Australia’s big four banks’ lending books to Australian property approaching 80%, a steep fall in prices would place enormous pressure on bank balance sheets and the Australian dollar given the federal government’s depositor guarantee scheme.

The Reserve Bank of Australia (RBA) will be acutely aware of this potential risk given the 2.6% spike in government bond rates over the past 12 months. This includes the negative impact on its own QE bond buying portfolio that saw the RBA buy 40% of Australian government bonds on issue over the period from November 2020 to February 202210, tripling its balance sheet to A$650 billion in less than 20 months11.

A speech delivered by RBA Assistant Governor Christopher Kent on May 23rd this year, announcing its intention to begin selling down a portion of its bond portfolio12, looks exceedingly unlikely given the 0.8% spike in bond yields over the past three weeks.

Adding to these issues is the estimate from the Australian Treasury Department in May that our 2022-23 current account deficit will exceed 6%13, requiring Australia to borrow north of A$100 billion to fund it. Time will tell if the RBA can sell bonds while needing to raise more debt.

5. Central banks will begin ‘walking back’ on tough action soon

So given this picture, central banks will begin to walk back their talk of doing “whatever it takes” to solve inflation, because a global recession, rising bond prices and falling asset markets will become a much larger problem than high consumer prices. It’s clear to Holon that the US Federal Reserve Bank’s brief attempt at Quantitative Tightening (central banks selling down their balance sheet assets accumulated from past QE buying) is over, while our contrarian belief remains even more certain that QE will return to Europe, the US and Australia in the third quarter of 2022, possibly within the next 4-6 weeks. The money to fund ballooning interest bills alongside current account deficits must come from somewhere, and central banks again look to be the only buyer in town. Further falls in asset prices and global growth will make the problem substantially worse.

The shape of this QE will likely be different to what we have witnessed over the past decade, however.

Rather than buying aggressively in markets to drive interest rates towards 0%, a more likely outcome appears to be central banks adopting a ‘pegged interest rate’ approach where they commit to hold sovereign borrowing costs. This will mirror the current approach of Japan, but at more realistic levels.

If it adopts this approach, Holon expects the US Federal Reserve will likely maintain its 10-year bond at ~3.5%, close to current levels, which should stabilize global sovereign debt market nervousness.

Global central bank co-ordination, whereby the largest banks all agree to peg interest rates at reasonable interest rate levels, should also eventually calm equity, cryptocurrency, and property markets. How quickly this happens will be the key determinant of how much more asset price destruction occurs from here.

The bad news is that this will likely need to happen for a very long-period of time, possibly 5-10 years, until a solution to global sovereign debt burdens is found. Inflation will also remain stubbornly high for several years until critical issues like supply chains, particularly for goods exported out of China, and energy and food costs can stabilize.

This last point will almost certainly require a diplomatic solution in the Russia/Ukraine conflict. Leaving the politics aside, getting critical gas and oil flowing back into Europe, plus food and fertilizer exports to global customers from both Russia and the Ukraine must resume immediately if the world has a chance of bringing consumer price inflation back down to more manageable levels. We are slowly starting to see some movement around finding an end to this conflict.

What should investors do?

Global equity markets continue to sell off aggressively in response to rising economic concerns. Companies are beginning to lay off workers because they expect an impending recession. They are also planning to invest less due to rising borrowing costs and falling consumer demand. While this should have an eventual knock-on effect on reducing inflation in some areas, rising food and energy prices currently moving through the global economy continue to provide inflationary upside and confuse the mid-term outlook for investors.

As discussed briefly above, financial markets go through frantic periods of ups and downs every few years as investors react to negative news flows, leading them to panic-in or panic-out of their investment positions, usually at the worst time.
Taking your time to calmly address the situation, know your investments with a 5 to 10-year time frame, weigh each of these investment opportunities according to your own personal risk profile, and then discuss things with your adviser if you have one. This approach should give you a much better chance of achieving your long-term investment returns. It should also help you sleep better.

Here are three specific things to do.

a) Look for bullet-proof oversold tech companies

Indiscriminate selling from panicking investors, likely in reaction to market commentary (“the end is near”) has led to heavy losses, particularly in the global technology sector. This sector in particular offers substantial opportunities for long-term investors willing to do the work to identify companies with bullet-proof balance sheets who are best placed to dominate what just 12 months ago was a certain technology-centric future ahead. US examples include Amazon and Google along with the major Chinese names Alibaba and Tencent.

b) Focus on the huge value in digital assets

The selloff in digital assets has been particularly sharp, with most down 50-80% since late 2021. This fall is in line with previous crypto-crashes that have occurred over their short 10-year history. Financial commentators are once again claiming “they are all a Ponzi scheme,” but it’s clear to experienced technology investors that most fail to grasp the full user case for digital assets. Like any investment class, understanding the user case or value proposition of each digital asset, your own personal risk profile, and how big your asset allocation weighting should be to digital assets, is essential to ensure every investor remains focused on the long-term potential over short-term volatility.

Payment networks like Strike, through using the Bitcoin network, have dramatically lowered the cost and friction of sending money across the world. Total fees on the transfer of US$700 billion of remittance payments, mostly to support families in other countries, surpassed US$50 billion in 2021 alone. The adoption of smart contracts, which are being developed across the Ethereum blockchain, will also be widely adopted to lower operating costs, and improve trust across every industry. A return to QE (see below) sooner than most investors realise could also see traditional Bitcoin investors return.

Finally, the massive growth in data as the internet of things (IoT), autonomous vehicles, and over a dozen new technology platforms that are expected to be commercialised over the next five years will see an explosion in data generation. The limiting factor on their speed of development and eventual widespread adoption, however, requires cheaper and more efficient data storage. The Filecoin network offers enormous promise of assisting with this requirement.

c) Avoid government bonds

Perhaps the most important message of all to retain is that investing into government (and most likely corporate) bonds over the next few decades looks set to deliver extremely poor investment returns once adjusting for a true cost-of-living rate. With bloated balance sheets, governments simply cannot afford to borrow at interest rates that reflect the true nature of their own worsening risk profile. With few buyers, this means governments are being forced to decide to substantially cut back on spending programs including defence, social security and healthcare (and risk getting voted out), or peg interest rates, continue with quantitative easing and finance rising deficits until better economic conditions return. This can then generate higher income to begin paying down debts.

The first option remains firmly in the too hard basket, given the rapidly approaching ageing population across the western workforce and the impact of sustained inflation on retirement savings (will I have enough to retire on now?).

The second option, a return of quantitative easing through interest-rate pegging, is therefore the only viable option left on the table. Once governments begin the process of walking back from recent statements of “whatever it takes to address inflation”, asset markets should respond with a return to positive gains, particularly in inflation sensitive assets like Bitcoin and gold, and heavily oversold sectors like global technology.

Holon believes this could happen as early as July, particularly if bond and equity market prices volatility remains high. This will eventually force central banks to act to stabilise asset prices before the problem becomes unfixable. While we wait, it’s therefore time to do your homework and put together your shopping list of the best investments for your portfolio.

2    This is for illustrative purposes as it assumes that all of the outstanding debt is variable. The actual rise in interest payments will depend on each country’s term structure of their outstanding debt, as well as when new or existing debt needs to be financed at these higher interest rates.
12  Note 13.

Disclaimer: This publication has been prepared by Holon Investments Australia Limited (ABN: 45 648 884 164, AFS Licence No: 532669) (“Holon”). The information provided in this publication is general in nature and does not constitute investment advice or personal financial product advice. This information has not taken into account your investment objectives, particular needs or financial situation. Before acting on any information contained in this publication, each person should obtain independent taxation, financial and legal advice relating to this information and consider it carefully before making any decision on recommendations. Holon Digital Asset Funds: Holon Investments Australia Limited (ABN: 45 648 884 164, AFS Licence No: 532669) is the responsible entity for the Holon Bitcoin Fund (ARSN: 659 090 294), the Holon Ethereum Fund (ARSN: 659 090 516) and the Holon Filecoin Fund (ARSN 659 090 614) (the Funds). Holon is the investment manager of the Funds. The content of this publication does not constitute an offer or solicitation to subscribe for units in the Funds or an offer to buy or sell any financial product. Accordingly, reliance should not be placed on this publication as the basis for making an investment, financial or other decision. You should also consult a licensed financial adviser before making an investment decision in relation to the Funds. Any investment needs to be made in accordance with the relevant Product Disclosure Statement (PDS) and Reference Guide, and investors should consider the PDS and Reference Guide before deciding whether to invest in the Funds or continue to hold units in the Funds. Applications for units in the Funds can only be made pursuant to the application form relevant to the Fund. Distributors of our products must consider our Target Market Determination (TMD). You can access the relevant PDS, Reference Guide and TMD at holon.investmentsHolon Photon Fund: The responsible entity for the Holon Photon Fund (ARSN 633 803 497) (the Fund) is One Managed Investment Funds Limited (ACN 117 400 987) (AFSL 297042) (OMIFL). Holon Global Asset Management Pty Ltd (ACN 629 590 585) (HGAM) is the investment manager for the Holon Photon Fund. HGAM is an Australian Financial Services Representative (No. 1276082) of Atlas Funds Management Pty Ltd (ACN 612 499 528) which holds an Australian Financial Services Licence (No. 491395). The content of this publication does not constitute an offer or solicitation to subscribe for units in the Funds or an offer to buy or sell any financial product. Accordingly, reliance should not be placed on this publication as the basis for making an investment, financial or other decision. You should also consult a licensed financial adviser before making an investment decision in relation to the Fund. Any investment in OMIFL products need to be made in accordance with and after reading the Product Disclosure Statement (PDS), Additional Information Booklet (AIB) and Target Market Determination (TMD). Investors should consider the PDS, AIB and TMD before deciding whether to invest in the Fund or continue to hold units in the Fund. Applications for units in the Fund can only be made pursuant to the application form relevant to the Fund. The PDS, AIB and TMD can be obtained by visiting Investing involves risk including the risk of loss of principal. Past performance is not indicative of future performance. Holon, its officers, employees and agents believe that the information in this material and the sources on which the information is based (which may be sourced from third parties) are correct as at the date of publication. While every care has been taken in the preparation of this material, no warranty of accuracy or reliability is given and no responsibility for this information is accepted by Holon, its officers, employees or agents. Except where contrary to law, Holon excludes all liability for this information.

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