Forever and a day, the rule of thumb has been that you should not use IRA funds to purchase an annuity – primarily because traditional annuities had the primary feature of tax deferral. Since an IRA is already tax-deferred, it’s duplication of effort plus a not insignificant additional cost to include an annuity in an IRA. This hasn’t stopped enthusiastic sales approaches by annuity companies – plus new features may make it a more realistic approach. Changes in the annuity landscape have made some inroads against this rule of thumb – including guaranteed living benefit riders, death benefits, and other options. Recently the IRS made a change to its rules regarding IRAs and annuities that will likely make the use of annuities even more popular in IRAs: The use of the lesser of 25% or $125,000 of the IRA balance (also applies to 401(k) and other qualified retirement plans) for […]
Gavyn Davies wrote in the FT on July 10, 2014 about artificially high asset prices judged by an unknownable Wicksellian natural rate. My opinion is that the answer is that when debt service is too high it acts as a brake on demand and thus lowers the natural real rate (the NR rate) of interest. The NR rate is a form of rationing of resources which goes up when resources are scarce. Thus the current era of low rates are not too low. The verification of this is that one must ask what would happen if a debtor has too much debt and has to default and seek a haircut. The alternative to a cut in principal balance would be to cut the interest rate and make the loan interest-only. But the key here is to understand that debtors are over-indebted and further didn’t have a good reason for the parabolic increase in debt. Thus debtors need a haircut and the Invisible Hand of the marketplace lowering the NR rate (or the Fed) is a natural response. It is a way of saying to the market, go ahead and consume more resources. Deflation is the risk, and it needs to be offset by lowering rates so as to stimulate demand. There are huge labor surpluses for unskilled labor and a huge potential setup to failure as the truth comes out that demand from EM countries such as China was partly inflated by massive unsustainable debt bubbles and will subside. Eventually the world will learn that creating low tech make-work jobs with government sponsored unsound bank loans issued by “policy banks” doesn’t create sustainable, genuine prosperity or demand. Instead future demand will come from people learning new skills and developing new tech as needed by the market. The current global system is actually adding to deflationary pressures to the extent that people are fooled into spending from policy bank loans that ultimately leave people poorer off as these loans encourage a waste of resources that could have been used elsewhere; further such waste may cause the market to be fearful of an eventual pull back once the stimulus is withdrawn. If so then the debt induced stimulus did nothing to stimulate the economy except to encourage speculative bubbles that encourage a few winners to consume a few luxuries. In addition to bogus Keynesian debt stimulus there is bogus Central Bank monetary manipulation where the market sees through it and refuses to respect the Fed’s price setting out of fear that the price will change suddenly; this fear paralyses development, thee result if which is deflationary. Of course there are many inflationary forces at work but it is important to note that deflationary cross currents are at work. The Central Bank stimulus is only accepted by short term overnight speculators who are ruthless traders who are “stopped out” of trading positions at the slightest downtick thus creating a more volatile capital market which ultimately raises the costs of capital and thus defeats any benefit from Central Bank stimulus.
Low interest rates and the increase in the money supply from Quantitative Easing helped fuel a bubble in asset prices for just about every asset. However part of the reason why assets went up to excessively high prices is because the world’s governments and Central Banks have responded to the great recession of 2007-09 with a Too Big Too Fail attitude (TBTF) which has corrupted investors into thinking there is no downside risk, so why not buy on the dip. This asymmetric viewpoint by investors is supported by the tremendous growth in all types of debt since about 1988 or 1994. Before then U.S. debt was under 190% of GDP, now it has gone parabolic and is twice that level. When a consumer gets a credit card with six months interest free use he may be tempted to buy stocks and then will also buy the stocks on margin. If a consumer sells his house to a buyer who used a large loan the seller may decide to park the money in stocks and then later take a margin loan to buy a house. By offering ever increasing amounts of debt banks have created a situation where some of this new money has leaked into the hands of speculators. Some corporations have used debt to buy back shares to force the price higher so that executives get huge stock option bonuses.
The only logical explanation for both what happened to the huge increase in debt and why did stocks go up so much is that these issues are two sides of the same coin.
Low rates do not justify high asset prices. The proper way to use interest rates to discount the value of future cash flows would be to use a lifetime average forecasted rate, not today’s low rates. What is happening is that wishful thinking by investors makes them assume that they should simply use low rates as part of a discounting valuation formula. The idea that low rates justify high PE ratios was falsely accepted in Japan during their record shattering massive debt bubble of the 1980’s when their rates were very low. The result was a devastating crash in 1990 that hasn’t been fully fixed in 24 years.
If you buy rental real estate today you need to ask yourself what if you seek to sell it in ten years and the going rate then is 8% for a loan. Then ask yourself how can the future buyer buy your property if he has to pay double what your interest rate is? The proper answer is that the seller would need to cut his price in ten years.
Even if the Fed could somehow prevent future crashes it seems unlikely that PE ratios can go significantly higher. Thus a new buyer may find the best he could hope for is to own stocks in a stagnant market. But even stagnant markets have the risk of repeating crashes like 2002 and 2009 when stocks went down 50% to 57%.
Investors need to avoid bubbles and crashes by seeking independent financial advice.
I wrote an article “Why ZIRP doesn’t help the economy”.
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Thanks to Cheryl J. Sherrard, CFP®, NAPFA Registered Advisor and Director of Planning for Clearview Wealth Management in Charlotte, NC for contributing this post. This post is a follow-up to my recent post Family Financial Conversations and to the post previously contributed by Cheryl’s colleague Megan Rindskopf Meaningful Family Conversations for the Holidays. We all know that when we […]
The Federal Reserve’s zero rate policy (ZIRP) is designed to fool long term investors, particularly businesses into expanding a business, etc. yet it mainly is used by short term speculators who are afraid to commit to long term ownership and instead seek short term speculation. If Fed policy was that rates would be guaranteed to be low for decades then businesses would react differently. Even though low short term rates can act to pull down long term rates and thus give some people a fixed rate loan, the problem is that not every one or every project can qualify for a long term fixed rate loan. Further a project such as buying rental real estate is contingent upon selling it a decade in the future to a new buyer who will also need a low rate fixed rate loan. If today’s buyer worries that rates will rise then he may fear that future buyers who buy from him in the next cycle will not be able to afford it and that today’s low rates act as teaser to make asset prices artificially and temporarily high and are thus a setup to failure.
Thus ZIRP doesn’t really help the physical economy. Instead it encourages very volatile unreliable speculation as investors load up on marginable liquid assets which they plan on instantly selling when trouble hits. Thus the market becomes more prone to Flash Crashes, popped bubbles than it would have if no ZIRP had existed. Thus due to uncertainty a lesser amount of good investments in plant and equipment are made and instead undesirable non-productive speculative investments are done, so as a result society is no better off and may actually be worse off due to damage from burst bubbles such as people stuck in negative equity houses who can’t move to a new job. Also low rates impoverish moderate income retirees who depend on bonds because they dislike stocks; low rates hurt these people’s consumer confidence yet the benefit of low rates encouraging working age consumers to take on more debt may be asymmetric where workers may fear that even if rates are low that taking on more principal payments is a risk, or in the case of businesses debt the risk is great that amortizing the payment of the principal will be bigger than the benefits from buying new equipment. One symptom of current cycle is lack of capital deepening (lack of buying of new equipment). If business fears that low rates are a temporary teaser then they won’t take the bait.
The result of making the economy more bubbly and prone to crashes is that the physical economy or the GDP’s Sharpe ratio has been lowered due to increased risk and thus investing in GDP is less desirable on a risk adjusted basis. This can be seen where employers offload risk onto workers forcing them to work as independent contractors or forcing them to accept contingent pay such as constantly changing number of work hours, etc. Then these workers react by reducing their consumer confidence and buying smaller houses, etc. A lower Sharpe ratio for the owner of physical plant equipment is the result of constant boom and bust cycles where the owner seeing that he may be hit with a steep crash will try to get by without capital deepening during the expansion cycle because the downside risk of being stranded after buying expensive capital goods during a brief artificial boom is too great of a risk. Ultimately only smart wise people get to make major economic decisions and they are choosing to not believe manipulative actions by the Fed such as artificially low interest rates.
Ultimately the worst thing about ZIRP is that it may be a setup to failure where it starts to stimulate the economy just enough to fool people into taking on too much risk and then it loses credibility and then people are stuck owning bubby assets or unneeded expansion of a business.
Investors need independent advice about the risks of Federal Reserve created stock market bubbles.
I wrote an article “Fed’s zero rate policies are deflationary”.
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