October 15, 2014; Russell Napier: A Dearth of Dollars

The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

Kevin: David, last week, you were talking about moving to cash, and cash, in our terms here, is a little bit of greenbacks, and a lot of gold. Talking to Russell Napier today, I am wondering if that is going to be the same conclusion.

David: Except he would probably say a lot of greenbacks and a little bit of gold, but he does like cash, and setting aside that bias, I think what you are really looking at is a scenario where you need to be lowering your risk, and be aware of the major structural changes which are afoot, which can lead to severe, steep, and swift changes in asset prices.

Kevin: Just as a reminder, last week we were talking about how you can’t judge one side or the other as the only outcome – inflation or deflation. You have authors out there who are saying, “Oh my gosh, we’re going to have deflation, it is the worst thing ever.” You have others saying we are going to have inflation. But actually, the reality of the matter is, you have deflation, and you have inflation, in various areas. You have to be able to hedge in the form of cash.

David: And this is the importance of Russell Napier’s contribution in his book, The Anatomy of the Bear. He looks at these various periods of major shifts, structural, tectonic shifts, in the world economy, and in the U.S. economy, and he says, “Listen, we saw this in the 1920s, we saw this in the 1930s, we saw this in the 1940s, we saw this in the 1980s, and in various iterations we have inflation and deflation in play,” and what emerged was major buying opportunities, significant wealth-building opportunities for those who are engaged in, number one, risk recognition and mitigation, and number two, the willingness to then put their capital to work when everyone else was operating at a high level of fear.

What we are about, in our conversation with Russell, going back six years, is this exploration of, “Where are we going? What are the risks? What are the major structural changes?” Russell has been a consultant with CLSA out of Asia for years and years. He has just started a new consultancy and research arm. If you go online and look for Eric and Russell Napier, any search engine will take you to his new resource, available primarily for institutions and professional money managers.

Kevin: He has the Library of Mistakes, too, Dave. And you have been there in Edinburgh with him. Tell me a little bit about his library.

David: The Library of Mistakes is 2500-3000 books which capture all of the various elements of what makes a market work. It is a study of people. It is a study of math. It is a study of psychology. It is a study of politics. It is a study of all of the things that make the world work, and ultimately, the way the world works is the way the market works, too.

Kevin: One of the things Russell has pointed out is that we have lived with a model, over the last few decades, where the emerging markets from China, all the way around to the other countries, have had a surplus of dollars.

David: And that is because here in the United States, consumers have spent more than we needed to. In fact, we have bought more goods and imported more goods than we have exported, and that is where that current account surplus and deficit comes from. We are running a deficit, and that means just that we are importing more than we are exporting. And they are running a surplus. They are exporting more than they are importing.

Kevin: And the problem is, like you said, that is a deficit that may have been without tears in the past, but it is a deficit with tears at this point. You have talked about the deficit without tears many times.

David: That is right. It was referenced in Jacques Rueff’s book Monetary Sin of the West, as he is talking about the instability of the 1960s and 1970s in U.S. monetary policy, and the fact that, even then, we were getting away with things, given the Bretton Woods monetary system, that no one else in the world could get away with. Russell will also contrast this current account deficit and its shrinkage, with a capital account, and that capital account is simply who owns what; we are talking about the assets of a nation – equity capital, debt capital. Again, it reflects the change in ownership of national assets.

Kevin: For the person who is not an economist, I think the basic thing is to say, “Look, America cannot continue to go into debt forever. The dollar, as it strengthens, will affect the liquidity of all these other countries that have enjoyed the surplus. Now that surplus is going away. I think that is the bottom line of what he is saying.

David: That’s right, and that is where the instability, he believes, will come from.

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David: Six years later, we are still checking in with you, Russell, and for very good reason. Studying market dynamics with the full scope of human history inspired you, last year, to add to your list of commitments, the opening of the Library of Mistakes. You have organized, probably the best concentration of books crossing disciplines, from economic and financial to psychological, to sociological; really, just the tip of the iceberg. This is what I like about you. You are always thinking, you are always learning, you are always synthesizing, and at least for the last six years, for the benefit of our listeners, that has trickled down to us. The uninitiated listener to this program should start by ordering your book The Anatomy of the Bear, and I would suggest they do that before the day ends. But perhaps you can tell us what you are up to. Let’s begin with the importance of your “error-ist cell” in Edinburgh, Scotland.

Russell: Thanks, David, for that introduction. The importance of what I call the “error-ist cell,” it has one aim, and the aim is to reduce the role of the equation in the study and practice of finance; not to destroy the role of equation, but to reduce it. I am sure many of your listeners will be aware of just how important these equations have become in pricing financial assets, but I think you really hit the nail on the head in the introduction. Finance is part sociology, part philosophy, part psychology, and part equation, but only part equation.

What we have done to create an equation is to distill, and when you distill you throw away a lot of things. What the small errorist cell is about is putting all those things back in the game. We have one in Edinburgh; it is a real physical library. People often ask me, “Does it really exist?” And yes, it does really exist. Thanks to our friends at Amazon, secondhand books are getting cheaper and cheaper, so the investment is not huge, and in an ideal world we would begin to put these small errorist cells close to other major seats of learning, and provide a resource for the finance students, who are told that the equation has the answers, but actually, there are some more things they need to put back into those equations. It is a soft science, it is not a hard science, and we are trying to do that. So, if there is anybody listening who would like to finance another library of mistakes somewhere else in the world and continue this revolt against the equations, then we would be very happy to speak to them.

David: In some of your recent research you were demonstrating the interconnectedness of the global economy, and the interdependent growth models. Explain how emerging markets are coming under pressure because of a shrinking current account deficit here in the United States.

Russell: It is always easy when you look around the rest of the world to take a model for the U.S. and then apply it to that economy. That is not true for emerging markets. But the most important difference of all is that they don’t truly have an independent monetary policy. The Federal Reserve clearly does that. And where they surrender that independent monetary policy is through an exchange rate link. These links, in many jurisdictions, are not as steady, not as hard as they used to be, but they remain, they are there, and there is massive intervention in the currency markets to manage their currencies, the exchange rates, relative to the United States dollar. Any central banker anywhere in the world who gets into that business is giving up his flexibility to run domestic monetary policy.

It is often said, and it is correct, certainly in a world of free capital movement, that a central bank can only target one monetary variable at a time, so the Federal Reserve, for some time now, has been targeting inflation. Prior to that, if you remember, back to the 1970s, into the early 1980s, it was targeting money supply growth. But they often pick a target. Once you pick the target of an exchange rate, then you lose the flexibility to run your domestic monetary policy. And when you link yourself to a strong currency, and this is the most important thing that is happening in the world today, in terms of the next six months, 12 months, 18 months, I tend to have a long-term view, but it is something which is really having an impact even as we are having this conversation, when you link yourself to a strong dollar, and the dollar is going up fairly significantly against just about everything, then monetary policy begins to tighten, so there is a very simple lesson from that.

Everybody in the markets is looking to Janet Yellen to raise interest rates and tighten monetary policy, and the tightening has already begun. And it has begun in emerging markets, because the dollar is going up, forcing them to take action to make sure that their exchange rates go up. And at the margin, that means tightening monetary policy. So, if you are going to wait for Janet Yellen to raise interest rates for the tightening of global monetary policy, you are going to wait too long.

David: This export of dollar liquidity, that is, running a current account deficit, which means that, essentially, the U.S. is importing and consuming more goods than we produce in export. That has been a reality, as you note, from 1991 up until 2007. Now, either because the U.S. consumer is exhausted, or U.S. energy productivity has increased, perhaps U.S. manufacturing is marginally improving in competitiveness, there could be a whole host of reasons the current account deficit is shrinking. Let’s talk about the Asian crisis in the late ’90s, and contrast the equity capital outflows then, versus the debt capital outflows you anticipate today, leading to an emerging market shock, deflation, and potentially, decline in emerging market equities.

Russell: It is important to draw this distinction. I think when most of us think about emerging markets and their external accounts, we just think about current account, and we think of it as the P&L. But where we look at the history of EM shocks, they are not driven by the P&L; they are driven by changes in the capital account, or let’s call them balance sheet changes. So, as you rightly said, in 1997-1998, it was a huge amount of equity funding coming from the developed world into emerging markets, and particularly Asia, which stopped forcing countries with large current account deficits into financial crisis.

By this time, the finance which has come pouring into emerging markets is in the form of debt, not in the form of bank debt, and that is something that has been very common in emerging markets in the past. You can remember what happened with the collapse of Mexico in 1982, and the impact that had on the U.S. banking system. This is a whole new way of financing emerging markets, and it is through the issuance of bonds, foreign currency bonds, but now for the first time, in real size local currency bonds. This is driven by the demand in the West, particularly by pensioners, for yield.

So, we have two terrible things happening at the same time. We have the local companies and the local governments funding in local currencies, but they are funding from foreign pensioners, and I think this is a particularly bad mix, because it is mainly held in open-ended funds. If you have ever tried to trade emerging market debt, you realize it is relatively illiquid, and I think that is an understatement, and it is held in open-ended funds, and these are huge open-ended funds which have developed over the past number of years.

So this time, I think what is going to happen is that when we get redemptions from those funds, and show me a fund that never had a redemption, when this asset class begins to lose favor, I think the strong dollar is a catalyst for losing favor, it is going to be extremely difficult for investors, I believe, to get the full liquidity to get redemptions on the underlying within the funds. That will cause a headache for the fund managers, but for the countries themselves it causes a real headache, because they are simply not going to have the capital coming in that they have had pouring in since, really, March 2009.

Back to our analogy with the dollar. If the pressure on their currencies is down because capital isn’t pouring in, at a time when the dollar is going up, well then domestic monetary policy can tighten very quickly, indeed.

David: So, has the Fed’s zero interest rate policy exaggerated this move to borrow in U.S. dollar terms?

Russell: Absolutely, because you can only have a bargain if you have a buyer and a seller, and the EMs have always been buyers. But the seller turned up, and that was people who really could not get a yield anywhere else, couldn’t get a yield, traditionally, around that 5% level, which is a magic number, actually, in the history of finance. You often find people, particularly getting to retirement age, who just look for the safe 5%. And financial history is littered with the disasters of people who could not get the safe 5% in genuinely safe investments, and therefore went searching overseas, and inadvertently, or perhaps fooling themselves, lent money at 5% to somebody else who ultimately wasn’t going to pay them back. So, the Fed’s very low interest rate in the United States of America triggered that scramble for yield, and it has triggered hundreds of billions of dollars’ worth. In fact, I think the number, since 2009, is close to 1.5 trillion dollars’ worth of inflows into emerging market debt, and that directly relates to the policy of the Federal Reserve.

David: So the demand for EM, emerging market, debt, has been on the increase, at the same time we have had an increase in demand for junk bonds. I guess they prefer not to call them junk bonds anymore, but high-yield bonds, and we have seen a move, similarly, toward 5%, in terms of your index yield for junk bonds. We hear tales of Chinese rebalancing. We see a 3x increase in Chinese wages in recent years, which is a factor in our trade balance with China. In essence, we have now two of the largest economies on the planet experiencing structural change, and I am wondering if this is causal or coincidental, both of us going through these structural changes at the same time. But it also seems that it may be an environment for conflict of national interests. What are your thoughts?

Russell: Yes, I think one of the important things to do as investors, is try to separate cyclical phenomena from structural phenomena, and often, the beauty of the structural phenomenon is that it is much easier to forecast than cyclical. The whole stock market seems to be absolutely obsessed with the next-quarter results. But let me give you three big structural things that are happening in the United States of America, which really should drive anybody’s investment portfolio allocation going forward, and as you say, have a profound effect on China. The first one is the move toward energy independence, which is reducing that large current account deficit with the impact we have already discussed in terms of the impact on the dollar and those managing their currency against the dollar.

The second one is America’s industrial competitiveness, and I speak mainly to investors who invest in emerging markets, and I say to them, “If you are looking for a jurisdiction where you have cheap property, cheap land, cheap people, cheap transport and cheap energy, you should be going to Pittsburgh, not to the emerging markets.” So, it is an old story, but, “Go west, young man.” That is, I think, structural in nature, and a lot of it is driven, not just by the energy, but by the fact that Chinese wages have gone up so much and simply in RMB [renminbi] terms, aren’t coming back down again.

And the third one is potentially the most important of all, but the one that is most neglected, which is the aging of the baby boom generation. On the 31st of December this year, the very last baby boomer will leave their 40s, and all baby boomers will be aged over 50. Most of them are in the business of repaying debt, between the ages of 50 and 65, if they are going to retire. As you know, we live in a world where many people have to work well above 65 to reach retirement, and we, basically, have a whole generation repaying debt. It is incredibly difficult. You have a higher level of growth in the United States, or more importantly, bank credit growth and money growth in a world where there is dominant demographic bulge, is now repaying debt.

And that creates a problem for China because China’s business model has entirely been based upon running larger and larger surpluses against America and it stopped relative to their GDP, and even if we measured it relative to American GDP, China’s surpluses with America are coming down. That hasn’t happened since 1991. That is the crucial structural change in the world and I think it brings many more changes to China than it does, necessarily, to the United States of America.

David: For August, we have consumer credit which is in decline. What you just described is something similar in terms of a contraction, a de-leveraging, if you will, of an entire generation, the baby boomer generation. To what degree do you think this de-leveraging, whether it is of financial assets or of baby boomers just trying to fix their balance sheet and get things paid off, pay off the debts and be in a position to retire and enjoy those years. To what degree have investors put faith in central bankers’ ability to prevent deflation? And as a side note, is that priced into equities?

Russell: I think they have put virtually 100% degree of faith, because of if you we just step back to March 2009, and in my day job I was visiting investors and suggesting that they buy equities, suggesting that the central bank had plenty of firepower, it was coming to use that firepower. On the balance of probabilities, it would probably succeed, it would probably create inflation, and exactly as we were pricing in deflation, they were a buy. Now, the index, and I’m sure your listeners will remember this, the S&P 500 was at the famous number of 666 in March, 2009, and it is right a long way from there.

If we got deflation anyway, so I’ll not forecast it, my forecast is that we are going to have deflation, but let’s just assume it happened. Well, the investors I was speaking to in March 2000 who were convinced that the Fed couldn’t generate inflation, would be on much firmer ground to make that call going forward because they would have seen five-and-a-half years of quantitative easing fail to deliver inflation. And that is my fear, that the safety net which investors believe is under equities is entirely based upon the Fed’s ability to generate inflation, and they are failing. And the best forward-looking market for this is the TIPS market, Treasury Inflation Protected Securities, and while that is forecasting for future inflation it is falling pretty rapidly now over the last three months, and nobody believes that the Fed can keep all the balls in the air by reducing nominal interest rates; they are already basically at zero.

So, you have to believe that the strength of the Fed is to keep real rates negative, and therefore spare economic activity or asset prices through negative real rates. But of course, the more the inflation rate comes down the more it is clear that the Fed is not in control of real rates, and therefore, it will sound alarmist, but the valuations of March 2009 seem reasonable numbers in a world where you lose faith in the ability of the Fed to generate this inflation. And just to be clear here, I think this is coming from outside of the United States of America. The key deflationary forces now are coming from emerging markets, in particular, and from Europe, and they eventually get to America, and that is when people begin to lose faith in the Fed because it is all based on one thing, given that nominal rates are zero – inflation. As inflation comes down, people lose faith in the Fed’s ability to generate it.

David: So it is not out of the realm of possibility to retrace the growth that we have seen since 2009. If we have put faith in the central banks, what we are really talking about is a crisis of faith where there are consequences in the global market. U.S. investors and global investors realize that the central banks don’t actually hold the universe together. Is the risk today greater, or is it even fair to say, one or the other, greater in the emerging markets, or in the U.S. markets?

Russell: I think at this stage the risk is greater in the emerging markets, and I wrote about this a while ago in a piece called “How the Yield Bubble Bursts,” and everybody knows that yields are too low and that is driven by Fed monetary policy, but all we have to do when we see a bubble is to try to find the weak bit of the bubble. Observing a bubble is not enough. The weakest bit of a bubble is people who borrow in somebody else’s currency. So the Federal Reserve is quite capable of manipulating interest rates to bail out American debtors, but it is not so clear that it is capable of bailing out foreign debtors who choose to speculate in the United States dollar. So, for instance, five-and-a-half years of quantitative easing has not stopped the rise in the dollar.

The key thing for emerging markets and their ability to pay back dollars is actually their exchange rates, not the interest rate on dollars. So, I think the weakest bit here is the emerging markets, so I see them going first, if you like, and it is worth stressing that the peak for emerging market equities is in April 2011, so I have been concerned about deflation, really, since then, and if you live in an emerging market, certainly in terms of your asset prices, that is something that you have been living with now since the middle of 2011, so it comes to America later.

I speak to a lot of professional investors in America on a regular basis. It is going to take a lot of convincing for them that the Federal Reserve has failed, because, like Pavlov’s dogs, they have been heavily rewarded. Every time the Fed rings the bell they make money, and it is going to take a long time before they realize that just because you ring a bell, it doesn’t mean there is any meat. And the meat of the Fed’s success is inflation. So, emerging markets first, but I think eventually, when we realize the impact that has on the United States, then the lower equities come to the United States, as well.

David: The IMF and World Bank don’t necessarily have a sterling reputation for growth projections but expectations for global growth, nonetheless, are in decline. If emerging markets are not, as we have just discussed, going to receive enough liquidity from the U.S. to promote their desired growth rates, how else will those emerging markets promote growth?

Russell: I think it is inevitable that key ones – and I would definitely include China on this, so this is the important one, but there are others – will devalue their exchange rates, because the problem here is that we need to generate more money, more credit, and more growth, and as I said at the outset, the restrictions on this are really the current monetary policy and the link to the dollar. If you give up the link to the dollar, you can print as much money as you like. Some countries have this flexibility, some countries don’t. The ones who don’t have that flexibility are countries where their foreign currency debt levels are so high already that a major devaluation of the currency basically bankrupts lots of domestic players, whether they be banks, whether they be corporations, or whether they be property companies.

Now, the good news, if you live in the emerging markets, is that unlike 1998, most countries have low levels of foreign currency debt, and can devalue. So, I would say that, basically, everybody in Asia can allow their currencies to take the pressure. I would say that is also true for Latin America, but crucially, it is not true for Eastern Europe, Turkey, and South Africa. So we could have an EM debt crunch, defaults, but I think it would fall clearly in that spectrum. But in a world where emerging markets begin to devalue their currencies, at least initially, you will find a decline in dollar-selling prices of globally traded goods, so you will see a major deflationary episode associated with emerging markets selling goods more cheaply.

The second deflationary episode is on the European banks. If we have serial bankruptcies in Eastern Europe, that once again is a huge hit on the capital base of the commercial central banking system of Europe. So, that is how I think they will attempt to get back to growth. Devaluing your exchange rate is always the easy way out. For most politicians, that is the way they will go. The ones who are really between a rock and a hard place in that are in Eastern Europe, and geopolitically, I would say it is between a rock and a hard place, as well. If you look entirely objectively at the country with the worst P&L, i.e. current account, and the worst balance sheet, I think you go straight to Turkey, geopolitically a member of NATO, I think economically incredibly weak, and now with severe issues on its borders with Syria, Iraq, and effectively, with the Kurds.

David: Maybe you could explain how the current dynamics of a shrinking current account deficit. That seems to be one of the big plugs that is being pulled out and a major difference from the last 20-30 years in terms of the global economy, but certainly driven from a U.S. perspective. How are the current dynamics of a shrinking current account deficit similar to the 1920s in which a global deflation was the result?

Russell: Yes, that is a great question because it is a period of financial history which I think is somewhat misunderstood. I think the best analysis of that period is in a book by Barry Eichengreen called Golden Fetters. He points out that the rest of the world was deflating prior to the collapse of the American stock market in October 1929. The reason for that, obviously, this was a world of the gold standard, and particularly, a reconstructed gold standard, following World War I. For various reasons, America was running such large surpluses that gold was not leaving America’s shores, partially due to the slowness in reconstructing industrial capacity across the world, but absolutely crucially, also the fact that Germany was paying reparations back to the British and the French, and the British and the French were using that money to pay off loans back to America, so America ran this surplus. It hoarded gold, if you like.

And because there wasn’t enough gold to create money supply elsewhere, then across the world you saw other economies getting into trouble before, the two years running up to, October 1929. Now, we are in a very different situation today, particularly in terms of the capital account. We don’t have this forced repatriation of capital to the United States of America, but as you have pointed out in terms of the current account, something really, really important is happening there for America, it is getting smaller and smaller. So, because we have reconstructed Bretton Woods, it is often called Bretton Woods II, it is an ad hoc reconstruction of that system where people link to the dollar, the inability of the United States to run large current account deficits, those have similarities with the late 1920s. I think in emerging markets we see Poland, you are probably aware, cut interest rates today because they are already deflating, and that is just one example of where emerging markets are being forced into this lower growth and I think there are actually going to be recessions at some stage if they don’t devalue. So, I see parallels with the late 1920s.

Now, obviously, it is easy to be a scaremonger about that and say that means the U.S. equity market reacts the same as it did in October 1929. It might, it might not, I don’t know, but I am pointing out that the economic dynamics are deflationary dynamics, and although it started somewhere else, it did eventually come back to the United States. So, I think cause and effect, in terms of 1929, 1930, 1931, 1932, I think we have probably got them wrong, they weren’t caused by the stock market crash, they were breaking out anyway, because we had a monetary system which was unfit for purpose, and in my opinion, this monetary system we have today is completely unfit for purpose. It relied 100% on America running bigger and bigger current account deficits and that has stopped.

David: But a careful study of the past and learning from the past also requires a careful appraisal of the present and the things which have changed in that time. It appears that central banks are not prudes when it comes to printing money. We have five years to look back on to see credit expansion, balance sheet expansion, at a variety of central banks around the world as evidence. Do you see concerted money-printing on the increase to try to keep the forces of deflation at bay, and does this suggest that some assets will reflect this reflationary attempt while others reflect the decidedly deflationary trend.

Russell: I think the fascinating thing about monetary policy since March 2009, since the launch of quantitative easing, is actually where money growth has come from. So, if we take all the money in the world in 2009, and all the money in the world today, and by money I have got just the broadest possible definition that a layman would understand, just something you can take into a shop, buy something, or something you can buy an asset with, that definition of money, which is clearly much, much broader than bank reserves, which is the type of money a central bank has direct control of. At least 80% of all the growth in global money since 2009 came in the emerging markets, not in the United States of America, not in Europe, not in Japan, not in the developed world, but in the emerging markets.

Now, the mechanism for that we have discussed already. We have capital flow to these jurisdictions, forcing them to create more money to stop their exchange rates going up as the capital came in. So, it was a direct result of Federal Reserve policy, but ultimately, the money that has stopped the deflation globally is not the increase in dollars, it has been the increase in emerging markets. The problem today, I think, is that given the current exchange rates, we are going to have tighter monetary policy there. So, the only way forward is for them to abandon those exchange rates and go for much more aggressive money supply growth without the fetter to the dollar. Barry Eichengreen’s book calls it the golden fetter; this is the dollar fetter. Shedding that dollar fetter is monetary policy.

So, I strongly believe, David, and I believe we have discussed this before, that ultimately we do get inflation, but if we are sitting here in ten years talking about the rampant global inflation, that will not have been generated by the monetary policy of the Federal Reserve. That will have been generated by the monetary policy of the People’s Bank of China, perhaps the Reserve Bank of India, but for China in particular, a devaluation has to come first to give them that freedom, but the Fed isn’t going to reflate the world, for the demographic reasons I have mentioned, and for other reasons to do with their competitiveness, they are not going to reflate the world. We are going to be relying on China to reflate the world, and that is where we get to, eventually, after this fairly disagreeable, and I think, particularly painful, deflationary episode.

David: If a rising dollar has the same impact in many emerging markets as monetary tightening, does that accelerate further fracturing of the global monetary system, with de-linkage, and as we just suggested, devaluation, a more popular political choice, really what we can expect the next few years?

Russell: Yes, the crucial bet going forward is politics; it is not economics. There are, effectively, no economic answers to any of our problems. They are all ultimately political answers. If emerging markets, and China, in particular, go for a major devaluation, the question is, does the West politically accept that, or does the West take political action against that? I am very aware of the huge damage which an undervalued RMB has done for people who work in industry all over the world, but I would strongly suggest no action against China. Now, that is because I ultimately think that the competitive advantage they would gain would be fairly short-lived, but I think devaluing your exchange rate does not give you competitiveness. If you print too much money it generates domestic inflation, but I think, after a very difficult adjustment period, that is exactly what would happen.

But of course, we can’t say that politicians under huge pressure would actually react to this in the right way. For those of us old enough to remember the 1998 Asian crisis, President Clinton put together a body after that to work out a new Bretton Woods system. The idea was we wouldn’t be running on these ad hoc systems anymore, we would sit down, we would put something together which worked. And if we do get to these devaluations, I think the first risk is a pretty negative political reaction, and the second one is that we are forced to put together a new global economic monetary system in a room with politicians, and when that happens, you don’t necessarily get the optimum outcome.

And I think we have raised this maybe every time we have discussed it in the last six years, if the politicians sit down in a room to devise, rather than an ad hoc system, a new global monetary system, severe restrictions on the free movement of capital, particularly, short-term capital, I think are extremely likely to be part and parcel of any new monetary regime. So, the fear going forward is, actually, for me, not the deflation, because I do think China can get us out of that. It is the political dislocation during the deflation, and what exactly might come from that, and it is very difficult to forecast, but we have to be aware that these things don’t happen in a political vacuum; they didn’t when the Bretton Woods system ended in the early 1970s, they didn’t when the gold standard ended in 1932. They all came with major political shifts. And I suspect this one would be very similar.

David: Back to equities, let’s look at valuations. It has been argued that emerging markets are a better value than U.S. equities, but I guess we could conclude from our conversation, you would suggest that maybe they are pricing in some of the long-term structural changes and they are selling at a discount for a reason, and could possibly sell at an even greater discount, so in this regard, fundamental valuations are not going to be your friend in choosing where to allocate capital.

Russell: Yes, emerging markets have never really lived up to the billing, which was, “Here are emerging economies with higher growth prospects. Simply buy the equities, tuck them away, leave them, and watch them grow.” And instead, what we have witnessed in emerging markets is extreme volatility in asset prices, and extreme volatility in the economies, as well. In my opinion, the reason for that is because of their exchange rate policies, and I would argue that you buy emerging market equities, in fact, you can buy any emerging market asset, generally, if their exchange rate is grossly undervalued, and if they manipulate it and hold it at an undervaluation, that forces them simply to print too much money, they are linking to the dollar, so you are getting a dollar return, they print too much money, and you get great asset inflation.

And sadly, therefore, that means that valuations have got very little to do with your returns from emerging market equities, at least over three to five years, and potentially, even over much longer periods, while they have such an infantile monetary policy, and therefore they can become incredibly cheap.

So, let’s take Greece, for example, not an emerging market, but worth looking at, because it is an economy which linked itself to the euro, and therefore lost its ability to have an independent monetary policy. As you know, one of my favorite measures of value is the cyclically adjusted PE and in the United States, the lows for that has been 6-9 times, but Greek equities went significantly below that, because they forced themselves into a monetary policy where there could be no deflation and no monetary release by the Greek authority, so valuations could go lower and lower because the threat of bankruptcy rose higher and higher and higher.

So, in terms of emerging market equity valuations, I think you would have to take an incredibly long-term view, to say that just because they are cheap they are a buy today. The traditional pattern now would be a major devaluation, stop the currencies going up, and print lots of money. That’s when they would be a buy. That is not because they would be cheap, but because the currencies would be cheap. So, it is a very different cycle, and as I said at the very beginning of this, the crucial thing is not to apply U.S. rules to other people’s equity markets. These have been very volatile equity markets for a very simple reason; they run an incredibly different monetary policy. In an ideal world, all of that will change, we are running a more adult monetary policy, but the ideal world will require the politicians within the next two to three years to make the right decisions, and on that, I do not have a high degree of confidence.

David: We have covered rate policies, exchange rate policies. There is also the issue of pressure on commodity-producing countries associated with a rising dollar. You have Brazil and Australia, which don’t make your short list of most vulnerable emerging markets, but South Africa is squarely there, from a balance sheet perspective, and also from commodity exposure. In some respects, doesn’t a rising dollar bring us closer to a credit crisis in these types of countries, and if not contained, a global credit crisis?

Russell: The simple answer is yes, that is exactly what the rising dollar does and that is exactly what it has done in the past. And the first order impact is clearly with those who use commodities, and the reason that South Africa stands out is just that it has a much higher foreign currency debt-to GDP ratio than the others, and therefore it stands out as perhaps debt worth as debt currency arbitrized than perhaps can be underway in Australia, or elsewhere. So, yes, a credit crunch, but I think there is one metric you have to look at to see who has the credit crunch, and to see who, perhaps, can go via a devaluing exchange rate, and that is that foreign currency debt-to-GDP ratio, and all this debt is freely available.

It is worthwhile to your listeners having a look at that, because Eastern Europe screams off the page as the bit of the complex which is really incredibly vulnerable. And in the commentary you hear about emerging markets, people rarely talk about it, but for the equity investor they are quite small. But what people have missed out is that for the debt investor, these are quite big, and a lot of the debt money has been flowing into Eastern Europe. So, when your listeners are worrying, or thinking about the emerging market complex, the rising dollar, I think, ultimately, the burden will fall – in terms of credit and the credit crunch you mention – yes, perhaps on South Africa, but very rapidly, I think, getting into Eastern Europe and Turkey, in particular.

David: Earlier this year, Kevin and I, my colleague, were discussing the three canaries in the coal mine warning signs of deflation: Copper prices breaking below $3, a steep deterioration in the Canadian dollar, deterioration in the Australian dollar. Are there any other birds we need to be listening for?

Russell: Yes, I think there are a couple. TIPS. There is no such thing as an unmanipulated market these days, so we have to be very careful in everything we look at, but the TIPS market is still there, and it is still giving us some indication on where the market thinks inflation will be further out. My work suggests that if TIPS-indicated inflation on the five-year falls below 150 basis points, then there would be a significant negative reaction for U.S. equities. Any decline in TIPS and expected inflation has a negative impact on EM equities, but it is only when it gets down to about that 150 level that you see the equity market in the United States reacting negatively. So the reason that we touched upon earlier, the faith in the Fed isn’t faith in the ability to create inflation, and at below 150 I think the word deflation, 150 on expected inflation, the word deflation crops back up again.

So, I would definitely be looking at the TIPS, and corporate bonds, as well. In my work in my book The Anatomy of the Bear, I looked at the indicators that the powers of deflation were winning, and one of the lead indicators was a decline in the spread of corporate bond yields above the risk-free rate. And I think as that pops up again it is indicating that deflation is rising up the agenda, because if you are looking at lower quality debt, which is what I do in the book, if the cash flows of those companies are undermined by deflation or an economic contraction, falling prices, then that is reflected in the debt markets pretty quickly.

So, at this stage I think there is not a lot going on in the U.S. corporate bond market to get you too worried, but that gives me more belief that actually this deflation is coming from outside the U.S. and gets to the U.S. at a later stage. So, I would fully agree with your list, by the way. I would add to that, the dollar, which we have discussed, the TIPS market, and just keep an eye on U.S., [unclear], corporate bond yields, and the spread there, as well, and if that starts moving quickly, then I think it just tells you it is coming to the U.S., perhaps quicker than we probably thought.

David: Two more questions for you. You are suggesting that these are structural shifts, and it appears that the real historical significance is their contribution to unhinging the current global monetary system. Is it fair to say for an investor that this is a period of time where caution is warranted?

Russell: Yes. That is the whole thing about structural changes. You tend to get big movements in financial markets, and big movements in prices. It tends not to be incremental, if you like. The world ignores the structural changes until one day they realize what these structural changes are, and prices can catch up really very rapidly. And I could be completely wrong in every forecast I have given you about the directions of these prices. But I can say this: These structural changes are real. When the market catches up with them, there is going to be significant dislocation in pricing, and it may be best for investors at the minute to sit on the sidelines to see how that is going to shake up and shake out.

It is always seen as dangerous to sit in cash, but only if you think these structural changes are going to generate inflation is it, indeed, dangerous to sit in cash. Now, I could be wrong on that, but when I look at how I line these things up, it seems to me that, actually, the least likely thing is going to be inflation, so I don’t consider it particularly dangerous to be waiting in cash, waiting to see how these prices finally catch up with these structural changes, and hopefully, creating opportunities for all of us, so cash is not as dangerous as it looks in this type of world.

David: Your recent research concludes this way: You say at some stage, as the deflationary shock turns to a new wave of inflation, equities should become a wonderful investment. So, number one, what you have just said, in terms of there not being an inflationary concern, is that really just a question of timing and sequencing where inflation becomes a real issue down the line? And then number two, your comment on equities. I guess that assumes as we just suggested a moment ago, big movements in light of structural change, and big price moves, which would imply a pretty steep decline in equities, globally.

Russell: Yes, the world is over-indebted. Most nations in the world are over-indebted, whether at the government level or whether at the private level, and some countries, actually, both. Sociologically, the acceptable political answer to that has always been inflation. It is much better than the alternatives, which are default or austerity. So, I think, from a sociological perspective, we have to expect that somehow this is how the democracies, and even the non-democracies, will seek to solve this problem. It brings its own issues, but that is where we start, sociologically. That is where we are already in terms of our attempt is failing. I don’t doubt that in the long run the attempt will succeed, and as I said, probably led by inflation out of China.

So, if we lose faith in the Fed’s ability to create inflation, equity valuations fall a long way, then I am hoping, David, to write a new bit of the book, The Anatomy of the Bear: Lessons from Wall Street’s Five Great Bottoms. And if the first four were anything to go by, equities will become very cheap as we witness deflation and contraction. But the wonderful time to buy them is as the world moves back into the inflation which, frankly, is something that is really going to be the only acceptable political and sociological way to reduce our debt burden in the long term. Now, as to the timing of all of that, it is anyone’s guess, but I think the best thing to do is to be in cash, watch, and wait, and buy the next edition of The Anatomy of the Bear: Lessons from Wall Street’s Five Great Bottoms. It should be soon.

David: Well, we look forward to seeing it, and that was my final question. If you are placing money for three, five, ten years, and that might be a bit of a stretch, getting out to the decade mark, but cash, equity, debt, real estate, gold, books, and I think you have just answered the question for us. Your book is coming out. (laughs) It is where you should be putting your money.

Russell: If I can get time away from being a librarian, I will get back on the time to write it.

David: We look forward to that. Thank you for joining us again. As always, we look forward to seeing you, whether it is here in the states, or there in Edinburgh. For any of our listeners who are traipsing through Europe, number one, stopping in Edinburgh; number two, making sure that the Library of Mistakes is on the list of places to go and things to see. That is a must.

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