Unconventional wisdom: Navigating an age of economic disorder
The return of the bond vigilantes and the implications on your investment strategy.
Conventional wisdom is a byproduct of groupthink that presents solutions good enough for the average person while simultaneously not being right for any individual. You follow it at your peril. Each Monday I will challenge the investing norms that just may be holding you back from living the life you want.
Unconventional wisdom: Navigating an age of economic disorder
“I used to think that if there was reincarnation, I wanted to come back as the President or the Pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.”
- James Carville
In a literal sense it was the oblique-edged blade of the guillotine that ended the life of Louis XVI. But figuratively the demise of the corpulent monarch can be traced back to debt – the grim reaper of the financial world.
France was in a perilous fiscal position after waging the Seven Years War and helping the American colonists in their revolt against the British.
Running out of options Louis XVI called for the Estates General to meet for the first time in nearly 175 years. The goal was to push through financial reforms to placate the bankers enough so they would extend additional loans.
From there things spiralled out of control for Louis XVI. The tennis court oath morphed into the revolution. The revolution turned into the terror. The terror led to Louis XVI on the guillotine in the Place de la Concorde.
Amidst the frivolity of Versailles, the French aristocracy didn’t realise that the fate of their charmed life didn’t rest with the king. Instead, it was the staid Calvinist bankers in the Netherlands and Switzerland who were calling the shots. Nameless. Faceless. And in complete control.
Louis XVI learned that certain universal truths apply to the most powerful kings as well as the lowly peasant - debt demolishes options and true power lies with those who lend and not those who borrow. In the fall of the Bourbon dynasty that power rested with the bond vigilantes of the 18th century.
Return of the bond vigilantes
The term bond vigilantes was coined by Israeli American economist Ed Yardeni in the 1980s. It was the decade of the supply siders and the Laffer curve. Taxes were cut, defence spending rose, and deficits exploded.
With politicians unable to show fiscal restraint it was the bond vigilantes who would impose discipline. As Yardeni put it in 1983, “If the fiscal and monetary authorities won’t regulate the economy, the bond investors will. The economy will be run by vigilantes in the credit markets.”
The bond vigilantes receded into the background as fiscal health improved in the late 1990s. But they are back. In the UK they sprung up in 2022 when Prime Minister Liz Truss introduced 45 billion pounds of unfunded tax cuts. 10-year gilt interest rates surged 1.40% in one week. Truss resigned after only 45 days in office.
Last week the vigilantes struck again causing the Labor government in the UK to reverse welfare reforms in response to rising gilt yields. In April it was the bond vigilantes who reportedly helped to convince Trump to reverse course on his tariffs.
The bond vigilantes are not an organised group. There are no rules that define what is an acceptable level of debt and what isn’t. It is individuals acting in their own financial interest who are deciding when to say enough is enough. Markets tend to coalesce into a herd mentality which enhances the power of our contemporary nameless, faceless crowd.
In the 1980s when the bond vigilantes first appeared debt as a percent of GDP peaked at 51% in the US. Now the figure stands at over 100% for every member of the G7 except for Germany.
Things will likely get worse. Trump’s ‘big, beautiful bill’ will add $3 trillion to US national debt. The Europeans are rearming.
Recently the bond vigilantes have influenced specific policy proposals but haven’t caused a shift in political mindset. That wasn’t always the case.
It was the bond vigilantes that drove interest rates up on 10-year US Treasuries from 5.19% to 8.05% between October 1993 and November 1994.
Alarmed, the Clinton Administration and Congress cut spending and the US budget reached a surplus by the end of the decade. There are few signs a similar consensus is forming anywhere in the debt ridden world.
Investing in the new age of debt
It seems obvious – at least to me - that political leaders should grow a backbone and regain agency over their respective national policies by paying down debt. But this is not a public policy column.
The question for the Morningstar community is what each of us should do with our finances and portfolio in a world awash with debt. I’ve outlined three steps to consider.
Step one: Stop thinking a return to a low rates / low inflation environment is around the corner
We’ve gone through a long run of relatively low interest rates and mild inflation. It seems difficult to imagine the post-pandemic inflation and interest rate spike will be transient.
The actions of the bond vigilantes show that there is little appetite to continue to endlessly fund mounting piles of debt.
Each of the yield spikes so far have been temporary as governments have backed down. Maybe the status quo will hold but it seems unlikely that interest rates will meaningfully drop. There is just too much debt being issued and too little effort at addressing long-term fiscal challenges.
Higher interest rates further hamstring governments as servicing existing debt becomes more costly. Interest payments on US debt already exceeds US military spending. Trump’s criticism of Federal Reserve Chair Jerome Powell for not lowering interest rates is indicative of this predicament.
While it is delivered in a more civil tone our government is also criticising the RBA. Australia is in much better fiscal shape than the US. But Australian consumers are heavily indebted and more sensitive to interest rates. Another challenging predicament.
While there may be nuances between the views of Powell and RBA chair Michelle Bullock the underlying concern with inflation is consistent. The deflationary effect of globalisation is gone and many view tariffs and the ‘big, beautiful bill’ as inflationary.
There is a reason that inflationary periods often result from excessive debt. Inflation is one way to lessen the impact of debt. As Louis XVI was making his acquittance with Madame Guillotine, France was experiencing runaway inflation as the revolutionary government printed money to try and deal with the debt they inherited.
My own observation is too many people believe the good old days are right around the corner. One manifestation was the incredulous reaction to the RBA decision to hold on the 8th of July. I think it is more helpful to mentally prepare for a challenging time while hoping for the best.
Step two: Get back to basics with your portfolio
Getting back to basics with investing is focusing on what you are trying to achieve and what influences a successful outcome. It is surprising how easy it is to get caught up in the superfluous swirl of noise.
The purpose of investing is to earn a return that exceeds inflation. How much you should target above inflation is determined by the goal you want to achieve.
The first thing to do is to focus on real – or inflation adjusted - returns. I went back and looked at real returns on different US asset classes between 1928 and 2024.
I used US returns because the data is easier to find but the lessons are applicable to Australia. The following chart shows the overall real returns and the differences in high and low inflationary environments. A high inflationary environment is any year where inflation exceeds the average inflation over the entire 1928 to 2024 period. A low inflationary environment is less than average inflation.
Data source: NYU Stern School of Business
There are some obvious conclusions to draw. Across every asset class returns in high inflation years (38 of 97 years) are lower than both average returns and those in low inflation years.
If we are in a higher inflation environment focus on savings levels, minimising taxes and low fee investments. The beauty is that all of this happens to work well in any environment.
Cash and bonds are not the place to be in a high inflation environment. The safety of cash and bonds is largely illusionary and investors often trade the perceived safety of low volatility for poor (or negative) long-term outcomes in the only measure that matters – real returns.
Bonds will also do poorly if interest rates periodically spike because of the bond vigilantes or it they just stay high given all the debt issuance.
There is one further asset class that is getting a lot of attention lately. That is gold. I created a separate chart for gold as the price was distorted before 1971 when the gold standard was in place.
Gold has a different pattern of returns from the other asset classes. Real returns in the high inflationary environment were higher than average and low inflation years.
My issue with gold is that if historic patterns hold true it is more of a directional bet than other asset classes. I personally don’t like directional bets on a specific outcome because I’m humble enough to know I could be wrong. That is why I don’t invest in gold.
A proponent of gold would counter that it is hedge and not a directional bet. Your goals and timeframe will shape your view on gold. Either way it is an interesting contrast to most asset classes.
Remember that by far the largest contributor to investment returns is asset allocation. If you don’t get that right you won’t be successful.
When picking investments remember that quality is beneficial in any environment but especially challenging ones with a higher cost of capital. Strong balance sheets, sustainable competitive advantages and robust cash flow are an investor’s best friend.
Step three: Keep focused on financial freedom
We should feel lucky that Australian national debt is a relatively mild 32% of GDP. Yet as I wrote in a previous column on housing we are world leaders in personal debt.
Writing about debt is hard. It is too easy to become overly moralistic. Those that preach about debt often skew older and own a disproportionate share of assets. I would put myself in that category.
I understand why debt is tempting. The best way to increase your net worth is to lever up. And the more leverage you employ the higher the upside. The maths alone makes it easy to see why people get in trouble. Especially with housing at such shockingly high levels.
Some people who find themselves crippled by debt are frivolous spenders and woefully naïve of the consequences of their actions. But most people are just trying to get ahead and follow the pathway they believe will result in success. It is this ‘pathway’ that deserves scrutiny and not the people on it.
As a society we’ve come to accept that each subsequent generation will take on even more debt to fund the prosperity of the previous generation. To do this is an act of faith that the cycle will continue. It is time to break the cycle.
The lesson to take from Louis XVI and countless other episodes throughout history is clear. Debt is the antithesis of freedom. Take on too much and you’ve lost agency over your life. Where the line is often isn’t evident until it is too late. Prudence pays.
Final thoughts
It shouldn’t come as a surprise to frequent readers that I haven’t recommended anything extreme. Investors get in trouble when portfolios are constantly adjusted in anticipation of a future outcome - no matter how likely it seems.
Following these three steps may mean forsaking the positive tail in wealth outcomes. It might mean missing the top of every cycle. But it also likely means avoiding the lows which is a far better outcome than most investors achieve. It might just pay to be sensible in the age of economic disorder.
Comments? Email me at [email protected]
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What i’ve been eating
It has been about 15 years since I’ve been to Xi’an but i still think about the wonderful food in the Muslim Quarter. The city is the capital of Shaanxi Province in central China and home to the famous terracotta warriors. Due to the geographic isolation of the region the cuisine in Xi’an differs significantly from what is popularly thought of as Chinese food. There is no rice and pork and instead lamb and wheat are the central ingredients. Biang Biang Noodles is a chain started in Sydney which has since spread to Canberra, Melbourne and Auckland. I went to the location on Dixon Street in Haymarket last weekend and loved the Xi’an hand pulled noodles with spicy lamb topping.
