Over the past decade, financial repression has enabled governments to increase debt, while attempting to control their interest expense. (by keeping interest rates artificially low). The combination of low interest rates and inflation has diluted consumers' spending power. Consumers are not happy!
With the more recent runup in both interest rates and inflation, the strategy of financial repression continues, but under a different form.
If investors receive over 10 times the interest on short-term cash reserves than was credited to them in 2021, how so?
But are investors any better off? Has financial Repression morphed into a new shape?
In high tax jurisdiction locations (think Canada, New York City, California) the combination of taxes and inflation takes a devastating toll on growing one's capital.
This might not be obvious over the shorter term, as the headwinds to growing capital have been less noticeable (reflected by the S&P 500 recent positive performance after inflation).
Â
The S&P 500 has produced a 12.0% nominal rate of return over the past four years, which inflation adjusts to 7.7%.
A successful equity investment strategy may generate a positive real return after inflation, but what about after-tax and inflation?
As detailed by the Tax Foundation in 2024........
One major shortcoming of current policy, however, is that when calculating the capital gain from the sale of an asset, the original purchase price (tax basis) is expressed in nominal terms when subtracted from the selling price. Because no inflation adjustment is made to the original purchase price, capital gains taxes are applied to nominal, not real, increases in wealth.
Peering into the future, what real, after-tax/after-inflation return, might wealthy investors achieve under the commonly held 60/40 asset allocation?
Possible future factors:
·      Inflation remains sticky and moderates at 3%
·      Short-term (cash) pays 3%
·      Longer term bonds generate interest of 4%
·      Equities continue to produce a long-term average annual return of 8%
·      Investors invest their portfolio; 60% in equities, 30% in bonds and 10% in cash
·      Top marginal taxes on interest income average 45%
·      Top marginal tax on capital gains average 35%
Marginal tax rates differ widely by Country, state/ province, location, form of income, and the hold period. These data points are just a sample of the many possible outcomes.
Under the above scenario, an investor would generate a real return (after tax and inflation) of 0.84% on average, per year. To develop this expected return, you take capital and substantial volatility risks. Given the potential results, it is hardly a satisfactory outlook.
How might one improve the outcome?
·      Increase your equity weighting if you are comfortable with the additional risk
·      Increase potential return on the equity portion of your portfolio, by adding greater weight to mid-capitalization stocks (anticipating that this will produce a higher return)
·      Focus more of your portfolio on a limited number of securities. Own the Apples and Nvidia’s of the future (very few investors, professional or amateur have experienced success with this strategy, over longer periods). This strategy reduces diversification and increases your risk of very unsatisfactory returns.
·      Where possible invest in non-taxable interest-bearing securities (U.S. taxpayers)
In Canada, take advantage of principal residence non-taxable status
·      Invest in insurance policies that may offer significant tax sheltering
·      Consider private debt/equity, alternative asset classes
     Or disappointingly accept that an attractive rate of return after tax and after inflation is a demanding goal.
A punitive level of taxation, combined with inflation, creates a challenging environment to grow your assets. There is no magic bullet or easy solution. Such is the goal of financial repression.
regards, Tim
Tim Morton, CFA is a retired portfolio manager with 45 years of experience working with private clients. For the past two years, the editor of mortonir.com and a contributor to Barron's. My comments are not to be taken as investment recommendations. They are purely for discussion purposes. Please see your advisor for investment advice.
Comments