14th November 2013
John Beck, co-director of the Franklin Templeton Fixed Income Group, argues there are no safe havens below.
By nature, bond managers tend to be a suspicious breed. We are always on the look-out for factors that could undermine our strategies. Our business is to offer ‘fixed income’ investments, but we know that the value of the assets underlying such investments is anything but fixed.
In this age of quantitative easing, it has been said that capital is no longer sacrosanct, but history suggests it never has been. Examples of devaluation and default abound, from kings clipping their coinage in the Middle Ages through to the more recent prime ministers and presidents taking their currencies off the gold standard for expedient political reasons. Historically, states used to issue large amounts of debt to pay for wars and many – though with the important exceptions of the US and UK – would then default on their resulting obligations.
Rules of the Game
The reason for using gold to back a currency is therefore to fix its value. Gold was widely seen as the safest form of money, a store of value that could not be debased or printed excessively by bankers or politicians. George Bernard Shaw famously said that “you have to choose as a voter between trusting to the natural stability of gold and the natural stability and intelligence of the members of the (British) government. And with respect to these gentlemen, I advise you, as long as the capitalist system exists, to vote for gold.”
The Bank of England was founded in 1694 as a private company to finance the rebuilding of the Royal Navy, and in return was given the exclusive right to print bank notes. Soon afterwards, Britain effectively regulated the supply of money in circulation by fixing the price of sterling in terms of a specified amount of gold – a commitment that came to be known as the gold standard. The move was formalised when Britain tied the issue of money to its gold reserves in 1844.
However, a fixed value can become a problem when governments lose control of their budgets. Faced with such problems, the politicians’ answer has sometimes been to change the rules of the game and even renege on their debts. The US ‘greenback,’ or the paper dollar, was introduced as a way to contain the ruinous cost of fighting the war against the Confederates in the American Civil War. The paper dollar was not backed by gold but by the credibility of the US government. Inevitably, the dollar’s value fluctuated according to the army’s fortunes in the field.
With or without fiat currencies, gold has remained a store of value. In the 1930s, faced with mounting financial difficulties, investors turned to gold as a way to protect their wealth. In response, on April 1933, US President Franklin D Roosevelt issued Executive Order 6102, forbidding “the hoarding of gold coin, gold bullion or gold certificates within the continental United States.” All gold (beyond an allowance of $100) was surrendered to the government at the rate of $20.67 per troy ounce; with the transfer completed, the dollar peg against gold was reduced to $35, a devaluation of 75% that netted huge profits for the government at the expense of law-abiding citizens. Four months later, Decree 6102 was repealed.
“The UK Treasury recently issued a 60-year bond, with a 0.125% coupon and a maturity of 2068. The joke is that this bond requires a microscope to see the coupon and a telescope to see the maturity.”
Default or Devalue?
It has been said that countries don’t default, they just devalue. Germany has benefited from a reputation for fiscal prudence, which in part explains why it is the anchor for the euro currency project. But appearances can deceive, as Germany has defaulted more than once. The UK, too, has a reputation for never having defaulted, but coming off the gold standard in 1931 resulted in a devaluation of the currency similar in its effect to a default. And Richard Nixon took the US off the gold standard in 1971, in response to severe political and financial pressures resulting from, among other things, the Vietnam War. This is how presidents walk away from their debts.
As bond managers, we have to be suspicious. Governments can perfectly legally discuss ways of delaying payments, rearrange payment terms or even, as we have seen, arrange for legal expropriation of assets. Despite this, many investors continue to believe there is such a thing as a risk-free investment. This is just lazy thinking. Inflation will affect even the allegedly super-safe ‘inflation-linked’ bonds, as both real and nominal value are bound to be affected over time.
This is why I currently do not hold UK gilts, and am significantly under-represented in all “risk-free” assets, such as those issued by Germany, Japan and possibly even the US Treasury. The UK Treasury recently issued a 60-year bond, with a 0.125% coupon and a maturity of 2068. The joke is that this bond requires a microscope to see the coupon and a telescope to see the maturity. But, seriously, this is not an investment that offers me prospects of a return in my lifetime.