September Mailbag: Questions and Autumnal Answers

Happy fall y’all, or so the lawn decorations say! Time to open the first mailbag on this side of the autumnal equinox.

What are your thoughts on hydrogen electricity?

We enjoy following the research and experiments, but more as fans of cool technology than anything else. For now, despite all the money poured into “green” hydrogen, which would use electrolyzers to produce hydrogen energy from water, the technology isn’t yet cost-effective or energy-efficient enough to power the world at scale, and the whole industry has been in a bit of a reset lately. If other technologies (computing power, battery storage, etc.) are a guide, then it is entirely feasible that hydrogen eventually becomes efficient and scalable, but the reports we read indicate it is a ways off.

From an investment standpoint, this likely presents a problem. Markets tend to look about 3 – 30 months out, with a big focus on expected earnings. Stocks move most on probabilities, not possibilities. The far future has a lot of possibilities—so many, it is impossible to assign probabilities to potential outcomes. Maybe something supplants hydrogen as the next big thing, something not on people’s radar today. If green hydrogen does become the future of global electricity, it is impossible to know which companies will be the long-term winners. Early technological pioneers don’t always reap the long-term rewards. Sometimes, the biggest winners from a market standpoint aren’t companies creating or producing the technology, but the creative users that apply it to create something new or provide existing things in a cheaper, better way. So for investors, we doubt there is a “there” there with hydrogen at the moment, to paraphrase Gertrude Stein.

If US government debt is downgraded, how does that affect interest rates?

There is a lot of evidence that it doesn’t. After S&P broke the ice by downgrading US Treasurys in August 2011, 10-year US Treasury yields went down. When Fitch followed suit in August 2023, yields rose initially, but it was a global move—and 10-year yields were back at pre-downgrade levels in four and a half months. And since Moody’s downgraded US debt in mid-May, 10-year yields are down.

Which doesn’t surprise when you think through how ratings agencies work. They tend to be very late to the party, basing their downgrades on things investors have been discussing for months, if not years. Bond markets are forward-looking and efficient, just like stock markets. So when a ratings agency issues its opinion—and ratings are indeed just opinions—it is based on things markets have already priced in.

Would it be better if we didn’t have debt?

We tried that once as a country, and it didn’t go well. Andrew Jackson eliminated the national debt in 1835. Coupled with the revocation of the national bank’s charter, this led to a massive monetary bubble as banks issued fiat private currency hand over fist. It culminated in the Panic of 1837—effectively a run on worthless banknotes—and a nasty economic depression that lasted for years.

We doubt it would go well this time. Treasury bills are a key cash-equivalent security, so ceasing their issuance would mean a high likelihood of monetary contraction. More broadly, US Treasurys are the backbone of the global financial system. They play an important role in bank and foreign exchange reserves. They are by far the world’s deepest, most liquid Treasury market. They are a vital tool for pension funds and other institutional investors, not to mention the millions of everyday investors who rely on them to cushion their portfolio’s expected short-term volatility.

Think of it this way. If you own US government bonds, for you, US debt is an asset. Would your financial life be better if the US had no debt and Treasury bonds didn’t exist? Alternatively, consider: We would have to totally rethink the mechanics of monetary policy in this scenario, as the Fed buys and sells government debt to effectuate its policy. History tells us that kind of rethink is fraught with peril.

Or think of it from the standpoint of a business. Most businesses carry some debt. Even cash-rich businesses will often choose to keep that liquidity and borrow to fund expansion. It is considered good business sense to do this because the expected return on those investments exceeds borrowing costs. Government debt is no different. We can all quibble over how Uncle Sam spends money, but as a country, the return on all of our assets exceeds the cost of borrowing. So from a pure mathematical standpoint, debt remains a net benefit.

Are short-term swings in the market always emotional?

Yes and no. Sometimes a pullback or correction (sharp, sudden drop of -10% to -20%) starts because of rampant fear over some seemingly scary thing hyped in headlines. But sometimes it is more of an operational thing, like 2010’s “Flash Crash” or, more recently, hedge funds’ forced selling in late 2018. Yet even when the initial cause is more technical or operational, we find the volatility tends to cause fear, leading to an emotional pile on. This is all hard to measure—feelings always are—but these are our observations.

In terms of daily movement, sometimes seemingly big drops are emotional, sometimes they are the fruit of very unemotional short-term traders and algorithms, and sometimes they are a little of both. This is why we frequently say daily moves are mostly noise. Sometimes headlines will attribute them to one thing, but that is more a case of markets reporters having deadlines and space to fill than actual, provable causality.