The Collins St Global Fund is an unhedged, long-only portfolio comprising high-quality businesses trading at significantly mispriced valuations. It also holds thematic baskets of stocks on the cusp of a cyclical industry upturn.

Well known strands of financial literature (notably Froot 1993) have found that fully hedging currency exposure over long time horizons often fails to improve, and can indeed worsen, risk-adjusted outcomes.

However, there remain times where glaring macroeconomic developments translate to a more obvious medium-to-long term forward outlook for a currency. 

In these moments, we prioritise building a margin of safety into our portfolio because preservation of investor capital is a central hallmark of our investment philosophy.

Although rarely discussed by global equity managers, our view at Collins St is that today’s macroeconomic environment represents one of these rare, idiosyncratic set-ups.

The United States undoubtedly has a spending problem.

Ultimately, this problem is compounded by a pernicious permission structure across the American political divide which optimises for short-term sugar hits like unfunded tax cuts, expanded entitlements and one-off transfers as band-aid workarounds to paper over the long-term cracks of the country’s significantly deteriorating fiscal outlook.

Since the turn of the 21^st century, U.S. Debt-to-GDP has skyrocketed. Entitlement payments are today at peacetime highs in absolute dollars and as a percentage of GDP, while these future unfunded claims sit largely off the federal balance sheet. Net interest today is 3.3% of GDP, matching the early 1990s high and triple the mid-2010s trough.

We believe any attempt at true austerity would significantly hurt U.S. equity markets whilst defaulting on debt would have a similar effect on the U.S. bond market. Given the mass citizen wealth tied up in U.S. equities and the widespread perception of U.S. paper as risk-free, we believe both options are, at their core, politically impermissible.

This perfect storm affords the U.S. only one real avenue to veer from its disastrous fiscal trajectory. That is financial repression and sustained negative real yields by pinning nominal rates below inflation.

Given today’s floating U.S. dollar regime, the currency must be the valve to print their way out of this impending crisis.

U.S. Fiscal Disaster

Below is a graph showcasing the historic U.S. Debt-to-GDP ratio across time.

Source: LongTermTrends

Today, sitting at ~$40T of gross debt, the U.S. Debt-to-GDP ratio sits at ~123.5%, approaching COVID-era all-time highs.

Clearly, Debt-to-GDP can be lowered by:

1. Reducing debt through austerity measures and printing annual surpluses without collapsing GDP by as much as the debt.
2. Increasing GDP by more than nominal debt increases.

A third path, financial repression, can occur even as the dollar amount of debt keeps rising, so long as the rates paid on this debt are pinned below inflation and nominal GDP growth.

Can the U.S. start printing an annual surplus?

Source: Federal Reserve Economic Data (FRED)

Today, annual deficits to GDP sit at ~6%.

Understanding the composition of these deficits is crucial.

On a cash basis, social security, federal health programmes, veterans’ benefits and interest payments already consume 98.4% of annual federal tax receipts.

These payments also comprise 67% of all annual federal spending and are expected to grow at a ~5.7% Compound Annual Growth Rate (CAGR) over the next 10 years.
Source: Congressional Budget Office (CBO).  

Attempts to downplay the surging debt pile relative to GDP through half-baked statements like “the U.S. owes debt in its own currency” imply that it can simply print its way out. However, this conveniently ignores the salient reality that this gargantuan bill of entrenched entitlements are obligations which must be fulfilled with real resources such as hip and knee replacements, doctors’ time and prescriptions.

The critical readthrough is that these entitlements represent a stress on the system in real terms rather than nominal and that this seemingly ever-increasing chunk of U.S. annual spending cannot simply be inflated away and dismissed.

We believe these entitlements to pensioners, retirees and social security beneficiaries are firmly politically entrenched.

Given entrenched entitlements and interest repayments already comprise 98.4% of annual tax receipts and have a 5.7% expected 10-year forward CAGR, the debt pile cannot be shrunk in nominal terms to a level that will relieve the United States’ growing fiscal crisis without politically forbidden entitlement cuts.

Can U.S. GDP outgrow the debt?

The Congressional Budget Office’s (CBO) expected 10-year CAGR for U.S. nominal GDP is 3.9%.
Source: CBO.

Crucially, this is far below the 5.7% 10-year forward CAGR for U.S. entrenched entitlements and interest repayments.

This also doesn’t consider the growth in the remaining third of today’s U.S. fiscal outflows.

Two logical statements therefore follow:

1. The U.S. will keep printing annual deficits as the debt stock in dollars continues to rise, fuelled by growing entrenched entitlements and interest repayments.
2. Absent any astronomical surprise to the upside, nominal GDP growth will be unable to offset the faster growth in debt. As a result, Debt-to-GDP will continue to rise barring any coordinated treasury/central bank bond market intervention.

 


History rhymes – the only way out of a fiscal crisis

“Past experience, to the extent that it is part of memory at all, is dismissed as the primitive refuge of those who do not have the insight to appreciate the incredible wonders of the present.” John Kenneth Galbraith – A Short History of Financial Euphoria (1994)

At Collins St, a fundamental tenet of our investment philosophy has always centred around a focussed study of history. In today’s world of short attention spans dictated by never-ending clicks and soundbites, we believe this principle is more important than ever.

Barring COVID, the last regime where U.S. Debt-to-GDP stood at today’s levels was in 1946, peaking at ~122%. By 1974, this had miraculously fallen to 31%.

A careful study of what happened in between is critical for investors. Financial repression.

In the decade post-World War II, the United States pinned T-bills (3 month) at 0.375% and the long bond at 2.5%. The Fed stood ready to buy and absorb any quantity of paper required to pin these yields at levels structurally below growth and runaway inflation which peaked at 14.4% in 1947 as the country’s manufacturing base transitioned away from a predominantly wartime configuration.

Real rates on U.S. debt were held negative in roughly one year in four from 1945 to 1980. In these years, the transfer of value from bondholders to the treasury averaged approximately 3-4% of annual GDP.

Spending cuts, primary surpluses and growth were other contributing factors in lowering Debt-to-GDP throughout this period.

The high likelihood of a full-scale sovereign debt crisis is clearly backed by historic data. Our extensive analysis of the IMF Historical Public Debt Database and Reinhart and Rogoff’s crisis chronologies shows that since 1825, roughly 80% of net-debtor countries with gross government debt exceeding 120% of GDP had either a sovereign default or restructuring, an inflation crisis (>20% p.a.) or a currency crash (≥15% depreciation) within the following decade.

The United States today is the largest net debtor in history.

Crucially, it’s gross Debt-to-GDP has surpassed this pivotal 120% threshold.

In 2016, J.P. Morgan CEO Jamie Dimon publicly warned that U.S. entitlements are a “tragedy that we can see coming,” with his full comments below:

“I do not believe that these issues will cause a crisis in the next five to 10 years, and, unfortunately, this may lull us into a false sense of security. But after 10 years, it will become clear that action will need to be taken. The problem is not that the US economy won’t be able to take care of its citizens — it is that taking away benefits, creating intergenerational warfare and scapegoating will make for very difficult and bad politics. This is a tragedy that we can see coming. Early action would be relatively painless.”
Source: Business Insider

Crucially, we are now ten and a half years post this statement. The United States’ most recent Producer Price Index (PPI) inflation reading was 5.4% as President Trump prepares potential US$5000 dividends for every U.S. adult citizen, for a potential cash outflow of $1.2T. With Debt-to-GDP greater than 120%, this would represent the largest stimulus injection since the COVID pandemic as the 10-year yield sits at 5.11%, its highest level since 2007.

How this relates to today

It’s important to highlight the key differences in the monetary regime between the Bretton Woods era and today.

The Bretton Woods system, set up in 1944, meant the dollar was pegged to gold up until 1971. By March 1973, the U.S. dollar was floating.

Because the dollar could not be freely sold under Bretton Woods, domestic bondholders were largely taxed through inflation.

However, in today’s regime, the dollar floats.

This means that if private buyers are unwilling to lock in a 2.5% nominal return in a 5-6% inflation world then the Fed must indirectly monetize these bonds by printing new dollars out of thin air.

This scenario results in a rapid increase of circulating cash and structurally higher inflation against the same fixed set of goods and foreign assets.

The holders of this newfound cash circulating the economy can either spend it, continue to hold a rapidly depreciating U.S. dollar, or sell it for other assets or currencies.

Crucially, under Bretton Woods, the exit door of selling the U.S. dollar was largely closed. However, under the floating U.S. dollar regime of today, this is not the case.

In this environment, we believe a large chunk of foreigners and asset holders will diversify away from U.S. Dollars as the weakening U.S. fiscal outlook and its effect on the medium-to-long term trajectory of the U.S. dollar becomes increasingly clear.

How we’re navigating this

At Collins St, we are bottom-up, fundamentals-based investors.

We do not directly hedge currencies, and we do not invest in anything other than long-only equities.

However, from a portfolio management perspective, we cannot ignore this rapidly deteriorating U.S. fiscal outlook and the impact we believe inevitable intervention will have on weakening the U.S. dollar.

To hedge against this risk, we have built a highly conservative margin of safety into our investment process.

We apply a 10% per annum currency discount to our view of a business’s future earnings power and free cash flow generation whereby the bulk of these earnings are denominated within the United States.

To be clear, this haircut is not a view that these businesses will earn 10% less in U.S. dollar terms. Instead, it is a translation adjustment whereby we mark down the base-currency value of these U.S. dollar earnings by 10% per annum to reflect the risk that repression under a floating dollar regime will leak into a structurally weaker exchange rate.

Crucially, this 10% is not a forecast. Instead, it is a deliberately conservative margin of safety that we believe is large enough to offer considerable downside protection for our portfolio.

After this currency adjustment, we may still invest if a business meets our stringent qualitative filters and passes our valuation hurdle of having 75-100% upside over a 2-3 year horizon. Our investment in Intuit a few months ago, a stock swept up in the SaaSpocalypse narrative, is a fruitful example of this.

We recognize that the nature of holding a directional view specific to the trajectory of a foreign currency is riddled with uncertainty regarding how things definitively play out. To some, this applied currency discount may therefore seem overly punitive.

However, in the face of obvious U.S. fiscal deterioration, we’d much prefer to have a conservative margin of safety and be wrong than be overly exposed to U.S. dollar earnings that, over the medium-to-long term, may materially hurt portfolio returns.