The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
“Longer term, my concern is, if the government sucks in more and more of America’s savings, there are less savings to go around for the purchase of equities or property or something else. That’s something I wrote several years ago that I called The Great Reset, about what happens when foreign central bankers aren’t there to fund the U.S. government. It will be funded. It doesn’t have to be a particularly high interest rate, but it shouldn’t come at the expense of the valuation of other assets.”
– Russell Napier
Kevin: Finally, we have Russell Napier back. We talked about that last week and sure enough, today is the interview.
David: I enjoy reading his research, and have learned a lot. Going back to a number of years ago when he put together probably one of the most important books in my financial library, which is, The Anatomy of the Bear: Lessons from Wall Street’s Four Great Bottoms – that that is a must read. And I think, if anyone is interested in financial history, without knowing it, you owe Russell Napier a great debt of gratitude because of the time, energy and effort that he put into the research and compilation of facts and figures and insights in The Anatomy of the Bear.
Kevin: He does not idly call himself a financial historian. This is a man who put in hours and hours, weeks, months, years, of study to write that single book. In fact, you could save half a lifetime of study just simply reading the book. I don’t say that about many books, but this was one of the books that did that.
David: On a routine basis, The Solid Ground, his quarterly newsletter, comes out. I like to read it, and it is not one that is going to be accessible to many, mainly because of the price tag.
Kevin: Are you sure we couldn’t get a discount from him? I know it’s $15,000 a year to read Solid Ground, his quarterly report.
David: Well, multiply that 15,000 times 1.21, because that is the current exchange rate for the pound. It’s 15,000 pounds, not dollars. But an invaluable resource, all the same. The insights he brings, and the courses that he teaches at the Edinburgh Business School, which I’ve taken the time to attend, and the things that he writes periodically – I’m hoping that he writes another book. I don’t know what the encore performance is, actually, for The Anatomy of the Bear, but you can order that online, and I would encourage you to. If you are interested in financial history, it is a must read.
Kevin: David, his charity, The Library of Mistakes, that he has there in Edinburgh, I love the title, because the older I get the more I realize, I’m accumulating a library of mistakes. I’m learning.
David: (laughs) From your own life experience, let alone what sits on the shelves, reminding you that these are the lessons that need to be learned, and relearned.
Kevin: This is an interview that I would recommend people listen to twice because I know I have to listen two or three times, even after I listen to the interview live. Russell is just a wealth of information.
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David: Russell, some would argue that we have a tectonic shift which is occurring, and that would be away from the deflationary trends that we have had for nearly a decade, and toward inflation. You convincingly argue that structural shifts are occurring in the global economy which are unlikely to be reversed by the Trump administration’s fiscal reflation efforts. To start with, you write that global debt-to-GDP is now at a record high. We have global debt north of 217 trillion dollars, and the economic engine expected to keep up with that number is about a third its size. While equity investors are celebrating this sort of Trump turnaround, what do you think could go wrong?
Russell: There is a very long answer to a very simple question, but I’ll just headline the four great big deflationary flaws in the system. And when I put them like that, the listeners need to think about what the U.S. president can do to fix these, because none of them rest inside the United States of America. That’s the first thing to point out.
But they are the monetary policy of Japan, which I think will lead to a collapse of the yen – I’ll come back to all of these, but when you have an export nation that, when we use the word collapse on its exchange rate, that’s a powerful deflationary wave sent around the world, and they have adopted this monetary policy in Japan which is the most extreme monetary policy by any developed world country, at least since the 1930s.
The second one would be an emerging market default, and Turkey – I don’t know to what extent your listeners keep up with what is going on in Turkey, but we could be on the verge of another one of those, in other words, another shock to the financial system because somebody doesn’t pay back money that they owe. We have been through that in recent history and we know the implications that has for a system. Turkey, actually, is a pretty big creditor. It is just shy of 400 billion U.S. dollars it owes to the rest of the world. We have the European political situation, which, if there is a political upset in Europe akin to the election of President Trump or akin to Brexit, that is, effectively, the death of the euro, and I think we know the scale and negative impact of that.
We have a Chinese monetary policy which isn’t working. It’s not fit for purpose to keep trying to manage the currency against the dollar, and I think that will be abandoned, and relatively soon, and they will try to devalue the currency.
And your listeners have already worked out that this gives you the world’s strongest currency in the form of the dollar, and when was a very, very strong dollar reflationary, at least for the rest of the world? So here’s the question: What can President Trump do about that? (laughs) The President of America is a powerful man, but these are problems that exist way beyond the control of the United States president.
David: So, looking at those headlines, from Japan to the emerging markets, to the European political arena, and China, all of which are fairly significant, you could tie this into stresses and strains created within the global monetary system. Arguably the U.S. dollar should correct in the short term. It has had a great run since 2014. But should it continue to strengthen back to, say, the 120 level where we were, say, 15 years ago, at what point would you expect, say, China to float their currency and devalue, or Japan to devalue, in earnest? We’re really talking about a domino effect being started off by actions taken here in the United States, which ultimately affect the global monetary system.
Russell: I think we have to put these into three groups. One is a decision by a politician to do this, as a policy choice. That is the most difficult to forecast, because it is a political choice. That’s where China is. China is making that big political decision and the timing on that is notoriously difficult. The other two, actually, particularly in Japan, I think it has already happened. The Japanese voted some time ago for a man who promised them inflation, and he is delivering on that. The reason that I single out Japanese monetary policy as being the extreme one, and your listeners may say, “Well, how could it be more extreme than what we’ve already seen?”
Well, here it is. The Fed increased the size of its balance sheet at a rate like torture. They should be still increasing its balance sheet at a rate that I told you, but the Japanese have decided that it is entirely up to the private sector savers of Japan to keep pace and expansion of the balance sheet. They’ve given a put to all owners of JJBs to sell them as many JJBs as they like, at a yield of zero out to ten years. So the control of the size of that balance sheet is in the hands of the private sector.
Now, I think that is the step you need to code a massive devaluation. Now, the yen has fallen somewhat since that decision was taken in September, but I think it has much, much further to go. So the timing – for Japan, we’re living through it already. It is already underway. For timing in China – very difficult, not sure, but obviously, the more the yen falls, the more that comes to pass.
In the emerging markets, it is actually much easier, again, because it is when there is a fall in the currency undermine the ability of local corporations to pay back the debt? In other words, when do we get a credit event in the emerging markets? In other words, when do we get a credit event in the emerging markets? Nothing to do with the political choices, it is quite literally that someone borrows dollars and can’t pay them back. In Turkey, it seems like it could be any day that that is going to happen, and there are some other emerging markets under extreme strain.
You asked me the question, and I’m not a trader, “Is the dollar going to correct for a bit?” Perhaps. But in terms of the timing of these things, I think it has started in emerging markets and it started in Japan. In China, the currency is clearly falling. So I really think we’re going to have a very strong dollar, and any correction, I would think, would be fairly minimal.
Just one final, final point on that, because the reason the dollar gets momentum is that it is heavily borrowed by people to finance, and finance with cash in other currencies. So the thing that makes the dollar different because of that, is when it starts to rise it can produce compulsory purchases. You and I take a view on the dollar and the yen and we’re just using our savings and we get it wrong, no one forces us to change our minds. But if we have borrowed to do it, then we get forced to change our minds because our solvency is questioned. And a dollar bill rally can get a real emphasis and life of its own once you get people compelled to try to pay back the dollar debt. And I think that has begun.
David: Now, that’s happening in the context of a contraction in global trade. That’s the backdrop that the Trump administration inherits. So you have the dollar rising, global economic growth which is struggling. Is there a connection between these two, where we will actually see, as the dollar rises, further pressure put on global trade and global economic activity?
Russell: You’re right, it is the absolute root cause of all of this. America, from 1991 to 2007 – basically when America grew up it used a bigger current account deficit. In other words, it transferred dollars into the hands of people offshore. And that is not a dangerous situation in which to borrow dollars when they are moving from America offshore. But really, since this current expansion began, which is June 2009, America has failed to produce a larger current account deficit. Shale, oil and gas is part of that. But I think there is something more fundamental, which is the shift in the consumption patterns of the baby boom generation. They are still consuming, but they tend to shift more to services than goods, and the great current account deficit was built on a baby boom consumption of goods.
So there are some structural forces there which mean that America is simply not running these current account deficits. And that takes us to the policies of President Trump. The market is taking this fairly simplistic view that more fiscal stimulus in America means more economic growth, means more imports, means a bigger current account deficit. Well, possibly, but President Trump has other policies which may not produce a bigger current account deficit, and one could obviously think of the oil drilling policy, which could produce a smaller current account deficit for America who drills more oil, the tax policy which would encourage more domestic production and less foreign production, outright protectionism which may or may not form part of the new president’s policy settings.
So global trade is not growing. Your listeners can look up the NPP, which is the Dutch statistics board, and they have a wonderful chart of trade volume. The trade numbers get distorted by prices, and price is all over the place, but trade volumes are flat on their back, already. These policies may or may not flow from the new president. So that’s what is strengthening the dollar. Certainly, if there is any slowdown in economic growth in America that would not come as a surprise. You could be back at a current account surplus.
The world hasn’t had to live with an American current account surplus since 1991, and the stock markets were a lot lower in 1991. So America has to find a new way of growing. The conundrum is, to what extent it can be good for America and bad for everybody else, and we can maybe talk about that, but it is certainly bad for everybody else.
David: That is the point. As the U.S. dollar is appreciating on a relative basis, you are seeing a decline in a number of currencies around the world. So, how does that translate? Real goods and services, you could argue, are going up. So we have a strong dollar here, which may be reflationary in our context, but deflationary on a global basis.
Russell: Obviously, I think about that a lot. Can America decouple? And one thing, since 1927 – that’s what I think of instantly when I think of this scenario. In 1927 the rest of the world was not slowing down, it was actually contracting. Prices were falling outside of America. Commodity prices were coming down. Places like Argentina were in trouble. United Kingdom got itself into trouble.
Your listeners will know that the United States was absolute boom time from 1927 to 1929, and it was kind of for the same reasons, a slightly different mechanism, but all the capital in the world wanted to be in America. And it did go to America, whether it was directly participating in equities or actually lending money to people at very high interest rates to buy equities on margin. And that drained capital from elsewhere. It produced a tightening of liquidity elsewhere, but a loosening of liquidity in America.
Now, one could say that could happen again, but I think there is a difference this time. When that happened in 1927 the currencies were linked together, so a capital flow to the United States created more money in the United States. It didn’t push up the dollar, the dollar was linked to gold. This time, however, it does clearly affect the dollar exchange rate. So when I sit down and try to weigh all this up, I think it is unlikely, given what is happening with the dollar, that the rest of the world could stay stable as you have a great big American reflation and a boom, before that would come back to the United States in some form of crisis outside of the U.S.
So it’s certainly not impossible that you get a 1927 to 1929 blow-off in U.S. equities. I’m not betting my money on that because I look at a highly over-leveraged world with deflationary forces outside and think could the U.S. equity market just buck that trend if this really begins to roll over badly? My answer to that would be, no. But I do have an open mind that it is possible.
David: Let’s go back and talk a little bit more about the current account deficit, because as you say, 1991 is in the rearview a bit and would be interested in figuring out who gets hurt when the current account shrinks.
Russell: Well, 43% of China’s current account surplus is with the United States of America, so you don’t have to go much further, I think, than China. You’ve already had a capital account deficit which is a very new thing for it during the last two or three decades. So a country with a shrinking current account surplus and a growing capital account deficit, despite capital controls, is right in the front line of that. And also, a country that is managing its currency, Japan responds to that by just devaluing as much as it possibly can. But China has this vestigial link to the dollar, so it’s China. There would be lots of small countries I could mention, but they’re not that important. China is the crux of the issue.
David: So Xi Jinping has some pretty critical policy choices to make, and a part of that is, are we prepared to re-engineer our growth plan moving forward? We have operated on a mercantilist basis for some time, to our benefit, keeping something akin to a peg with the dollar, and now the question is, is it even worth it? Do U.S. demographics keep it interesting for us to remain mercantilist in our orientation? Or do we change completely? And – big question mark – can we?
Russell: That is right. I think we have to put it in that stark of a term. If you’re a fairly small economy you link yourself to the dollar and you grow, that can work. But when you become the second biggest economy in the world, as they now are, linking your currency to somebody else’s is not as sensible. Just how much market share are you going to take, number one? Number two, global trade is already not growing. And now number three, you have, potentially, a protectionist president. The policy just doesn’t make any sense anymore.
So the interesting thing is, the very obvious policy, and one that no one will talk about despite how obvious it is, is a free float for the renminbi, because when you’re the world’s second biggest economy, it is very hard to have anything but a free float, and you have to move toward that. People will talk about a devaluation and a re-pegging, and they just won’t talk about a free float. But that’s ultimately where China has to end up anyway. A free float with exchange controls, I hasten to add, but a free float nonetheless.
Now, if that is the policy that China goes to, the beauty of a free float is it means you just determine your own interest rates based on your own economic conditions. There is no fetter, no restriction, on your ability to put interest rates where you want them to be, so you could use them to engineer a great big consumer boom if you wanted and there would be no restriction on that. That is where China will go to, but that won’t be the biggest shock of all. But it’s a very nice thing to do for China because they’re clearly not currency manipulators.
They’re clearly not manipulating their currency, because you’re just following. You’re growing up and you’re following the same monetary policy that the United States of America follows, which is to set interest rates for domestic economic conditions and let the exchange rate find its own level. Now, I’m not naïve enough to think that there wouldn’t be political problems if the renminbi collapses, but you can genuinely say you’re not a currency manipulator if that is the business you’re in and you’re not really doing anything much different than what the United States did from 2007 to 2009.
So, as I said, very difficult to get the timing right on a political decision, particularly when it’s effectively the political decision of one individual. But that decision is getting closer and closer and putting more elements in the basket, widening the band, these are all steps in the same direction, and the direction is a free float for the renminbi. I think it was down a lot and that is deflationary once again, initially, at least, and not inflationary.
David: Do you think perhaps one of the things that keeps them from moving to a free float is sort of an insecurity relating to losing control, and being in charge of determining a course? Borrowing from the command and control dynamics which have existed there for a long time, have been lessened to a certain degree, but still, it’s almost like a security blanket. Do we let go? Do we really move toward a more free market? Is that a concern, or is it, again, maybe perhaps in the realm of politics?
Russell: That is absolutely correct. What does the Chinese Communist Party believe in? That’s a great question. It certainly doesn’t believe in communism, that’s for sure. But it believes in control. That’s what it believes in. It believes in political control and to have political control they have to have these other controls. So that is the delaying factor. But I would just stress again, this is not a free float without exchange control, this is a free float with exchange controls. So there is still some form of control.
But you’re right, the thing that holds us back is that the Communist Party – it’s a bizarre thing, but how can you have a market economy run by a party that likes to control? (laughs) People who talk about China as a free market – how can it be a free market run by a party that likes to control? So we’ll see. It can be forced upon them. A very weak yen could force it upon them. A spike in domestic interest rates forced by a large capital outflow could force it upon them.
But you really hit the nail on the head. And also, why it is so difficult to forecast the timing for this. This is a party that likes to control, and you’re asking it to give up at least some control, and that’s a difficult step for them to take. Particularly this president, I should say. Other presidents of China have been prepared to move a little bit quicker. I think this one is much more control-oriented.
David: The other party significant to a budget deficit – if we’re running a deficit here and it shows up as a surplus there – if we should diminish our budget deficit, what does that mean in terms of being able to finance our current spending deficit? We are still needing to borrow a pretty significant amount of money each year, between half a trillion and a trillion dollars, depending on the year, and it seems like the budget deficit is something that still has to be addressed if we allow the trade deficit to go away.
Russell: Yes, funding the budget deficit, the advantage you have is you have a very large domestic savings system, and a large domestic savings system is not heavily committed to your own treasury market. You might ask why. It is the reason that you have pointed out, that all of your treasury markets are owned by foreigners, and foreign central bankers have already disappeared as a buyer, and up until about two years ago you could have said, “Well, actually, it’s only because the Fed is the buyer that yields are staying relatively low.”
But then the Fed went away as a buyer of treasuries. The foreign central bankers went away as a buyer of treasuries. In fact, they have turned into a net seller of treasuries. Well, treasury yields didn’t go spiking up because your domestic savings system was capable, I think, aided quite a bit by the Japanese savings system, a private sector choice, not a central bank choice. It should come to the detriment of other assets, of course, that savings system should be liquidating other assets to buy these treasuries, and that has long been my fear that if the American people had to fund their own government then there is a lot less capital around to fund everything else.
Maybe we’re beginning to see that now in the last two months, but at least in the early stages of this the American government has been adequately funded by its own domestic saver in the absence of foreigners. Longer term, my concern is if the government sucks in more and more of America’s savings, there are less savings to go around for the purchase of equities or property or something else. That is something I wrote several years ago that I called The Great Reset, about what happens when foreign central bankers aren’t there to fund the U.S. government. It will be funded. It doesn’t have to be a particularly high interest rate, but it shouldn’t come at the expense of the valuation of other assets.
David: Two things come to mind. One is a conversation with Carmen Reinhart a few months ago where she described the corralling of assets and the creating of captive audiences. And last year, of course, we had a change in rules that affects money market funds where you have a free float for the shares of money market funds that are not treasury-backed, and a guaranteed one-dollar per-share valuation for those that are treasury-backed.
So of course, we had a massive flow out of money market funds that were in corporate paper and commercial paper and things like that, into treasuries, a classic example of creating a captive audience (laughs) and there are plenty of treasury buyers. Just change the incentive structure and, whether with carrot or stick, you can move people in the direction of treasuries.
But this is the second point, and perhaps the critical and dangerous one. Bill Gross, this last week, suggested if the ten-year treasury breaks above 2.6%, to him, it signals the end of a bull market in treasuries, which goes back over 30 years, and the beginning of a bear market. Is the domestic savings pool here in the United States, our domestic savings system, really that inclined to be buying treasuries as we head into a bear market, or would they justify it just on the basis of chasing yield? Not looking at capital losses but saying, “Hey, it’s not 2.5% anymore, it’s 3%, or it’s 4%. I just want more income.” How do you think that gets sussed out by the average investor?
Russell: Carmen Reinhart is now the world’s expert on financial repression and you and I have talked about that in the past. Now you say, what is financial repression? If the savers of America won’t fund the government at the price the government wants to be funded at, the government can force savers to do that. That is what financial repression is, and it ran from most of the post World War II period. So it’s not a new thing, it’s been done before. It wasn’t as aggressive in America as it was in the United Kingdom because we started with much higher debt after World War II, but that’s a policy which has been done before and it will be a policy which is being done again.
You have pointed out one way in which it is already being done. There are others, of course. Under the Basel rules the banks have to hold more liquid high-quality assets – guess what? Treasuries. The new Basel liability modeling for insurance companies also forces them to hold – guess what? More treasuries. This is not accidental. I say this over and over again, but you’ll never hear a government announce a policy of financial repression. It’s a bit like a burglar breaking into your house playing a trumpet. But it’s there, it’s coordinated, it’s for a reason. And I know this because I’ve done speeches on it and I’ve had central bankers come up to me afterward and say, “Well, if you don’t believe in financial repression, have you got any other bright ideas? How else are we going to do it?”
So you’re right, the yield is going up, it go up further. I’m someone who can see these great deflationary forces breaking out globally. I don’t think it’s going to go up that much, but short term rates in America could go up, the yield could go up. If there was a so-called buyer strike. And briefly, here in the United Kingdom in 1976 we had what was known as the buyer’s strike on government debt. You can force it. It can be forced upon the savings system of America, and I think it absolutely will. It already is. So the kind of a noose around private capital’s neck would tighten pretty significantly if there was a big spike in yields and those yields would be brought down.
Remember, the ultimate aim of financial repression is to keep a yield curve below inflation for a very prolonged period of time. And no free marketed government paper is going to keep a yield below inflation for a prolonged period of time so it’s going to have to be government enforced, and it has not been necessary to be too aggressive yet, but if it has to be aggressive then they will certainly do it. I’m sure you will be delighted to hear the number one go-to asset when that happens is gold because that’s your protection in an environment like that. So, it’s going to happen, it’s happening, it could ratchet up pretty aggressively if there was a big spike in yield that you’ve discussed.
David: Well, we have some time on the U.S. side, but we’re running out of time if we can pivot to Europe and say that, actually, the same kind of thing has to be done in Europe. We have political stress which is increasing, and really, the lynchpin is the German Central Bank, and they’ve got to be able to make some sacrifices, some compromises, which may go against sort of deep held philosophical views, in order to keep things together. Maybe it’s not the central bank. Is it Angela Merkel and political sacrifice that is on the table? Which of the two is more important to sustaining the Euro Project?
Russell: I think the central bank in Germany has kind of gone by. The ECB has done so many things. I know the Constitutional Court says it is not in breach of its mandate, but look, lawyers are lawyers, they will always find a reason why you haven’t broken something. But in terms of most of the safeguards that effectively the German Central Bank put in the Constitution of the European Central Bank, they’ve busted through those already, so that’s gone. The sacrifice now is a political sacrifice by Mrs. Merkel and by the German establishment, because they are going to have to live with much, much higher inflation in Germany if they’re going to help inflate away the debts of the whole of Europe.
Now, we will see. We know the historical reasons why the people of Germany are particular afraid of that particular dynamic and we’ll just see to what extent there is a revolt against that. Inflation is 1.7% in Germany, it’s not yet a live issue. But inflation is probably going to go up in Germany and it might become a live issue. So the person who has to make the sacrifice now is Mrs. Merkel. She’ll get elected, it seems dangerous to say that anybody will get elected. She’ll get elected and then maybe she’ll make that sacrifice, because to hold the euro together they’re going to have to endorse higher inflation, and maybe elected with another long term in front of her, she simply endorses that. Because without it, I think, the risk is there won’t be a euro.
It may not work anyway. We may already be too late, given the popular revolt against the federalization of Europe that the euro imposes, not the European Union, but that the euro imposes. It may be too late anyway. So, it’s difficult to see her making that sacrifice before the election, but maybe she gets elected and maybe that is what Germany can do that, in German political terms, is a great sacrifice.
David: So, correct me here. The likely European step-sequence is something like this. Tightening monetary policy leads to slowing growth, causing socioeconomic strain and pressure on the EMU, stirring the political will to abandon the monetary experiment, which would exaggerate disinflation as sort of monetary dissolution of the eurozone moves into play, leading to sort of the final stage, which would be independence amongst the member countries, and the latitude gained to inflate away the debt. Or Germany can make the decision to inflate away.
But one way or the other, you’re talking about the necessary step forward is inflating away the debt. They have already said no to austerity in one way or another, or at least the people are beginning to say, “No more.” You could risk ruining the financial markets through default of one sort or another, but it really leaves your options limited. It’s either inflate on an individual country basis, or inflate driven by Germany.
Russell: Yes, I think that’s a very accurate summary of the situation. There are other ways to bring down your debt, but they’re not politically acceptable. Default, austerity – not politically acceptable. In any democracy inflation has always been the one. Either Germany provides it, or everyone is going to have to go and create it themselves outside the eurozone. And there is a bigger issue in the eurozone, as well. The eurozone is enforcing a Federated States of Europe as destruction of the sovereign state. People within Europe kind of like the sovereign state. They like the European Union, but they like the sovereign state, as well. So that means a nice compromise is to say, “Yes, we want to stay in the European Union but we don’t want to be in the euro. And that way you can kind of go back a little bit more toward a common market. You and I look at it, because of what we do for a living, as a financial conundrum.
But there is actually a bigger layer on top of that, and it’s not one you’re unfamiliar with in the United States of America, in attempting to create a federated states. And it didn’t work, obviously, in America. It shattered pretty horrifically in the mid 19th century. I’m not suggesting that it will be that form of shattering in Europe, but trying to subsume the states into a federal system is never easy, and I would argue that your states were significantly more homogeneous than the states of Europe. So above the mere financial and the inflation and all that stuff, there is actually a bigger issue. I don’t think the sovereign states of Europe are finished yet. I think the federated states of Europe will never come to pass.
David: Well, if you’re right, and we have, because of a number of potential triggers, whether it is China, Japan, the eurozone, price deflation, and if that is to be expected, scared money tends to flow to places it views as a safe haven, whether that is the U.S. dollar, U.S. treasuries, even to gold. I guess it depends on why it is scared, of course. For most people, the idea of an appreciating dollar is antithetical to a rise in the price of gold, yet you seem to think that dollars, treasuries and gold work in the timeframe ahead. I wonder if you could look at that and say, “Well, what are some of the assumptions which ordinarily would cast a pall on gold in a rising dollar environment?”
Russell: Absolutely. Gold is a function – nothing is a perfect correlation, but it is kind of related to real interest rates. Now, I’m telling you that we’re going to have deflation. Real interest rates are going up, which has been bad for gold. So, how can I sit here and say that this time it’s different, this time it’s going to be good for gold? I find it easier to say because of where we are with policy settings. I think anybody listening to this will know that the mistake to be made in the last seven years was looking at the economy and not looking at the reaction to the economy. And that’s the thing that you had to get right to make some money. It was the reaction of policy makers.
Now, if we look at the move to deflation or a recession, or whatever, where does policy go next? The ball is firmly in the court of the government and not the central bank. The central bank has done an awful lot, and it’s fairly limited now in what we can do from here. I just think the more you move toward more and more action by government, the more people begin to move to gold.
Now, if I put that in historical terms, it can sound over-dramatic, but there is a rule of man, and there is a rule of law. And with the rule of law, you can kind of invest in anything. All assets are safe, there are no government diktats that dictate the returns in those assets, or dictate the necessary ownership of those assets. But as you begin to shift toward the rule of man, there is more capriciousness in the system. Capriciousness is uncertainty, and uncertainty – all these things play into the hand of gold.
Now, I’m not one of those people who is throwing my hands up in horror about the election of the president and getting upset about all these things. You have a very, very strong constitution, and we have a very strong constitution in the United Kingdom, and everything is going to be fine. But there are plenty of places in the world, whether it is Turkey or China, where the rule of man is shooting up, and the rule of law is collapsing. It may be Poland or Hungary, the rule of man is going up and the rule of law is coming down.
And when that happens, that is when people, whether they are Chinese or Turks or Poles or Hungarians, will start to move to gold. Maybe I’m wrong about the U.S. and Britain, and we’ll get more of the rule of man, and not ruled by law, but if that happens, then gold does even better. So the more you have the capricious will of government dictating the returns on capital, the more that will be to the benefit of gold.
David: It’s interesting, you took that in a direction I did not anticipate, because I would have probably replayed something of a 2008, 2009 market reaction, which was, “Wait a minute, we’ve got way too much counter-party exposure in the context of deflating asset values. We don’t know who survives, and we want to have a financial asset that is outside of the financial system.” I like that contrast between the rule of man and the rule of law.
Russell: First of all, that’s true, and that obviously helps gold. But there is an even bigger level now coming in, which is central bankers could try to do all the hard work for the last time. This time it has to be government. The impact for gold is even bigger this time because there is this new layer involved, as well as the one you’ve just mentioned.
David: So, it’s driven not only by concerns of counter-party, but ultimately, concerns of the larger context, not just the institution financial, but the institution, as you say, political. Are we safe, according to the rule of law, or are we safe according to what we see in terms of the capricious nature of government?
Russell: Yes, and any society where you don’t have great faith in ownership rights tends to hold a lot of gold.
David: Well, we look at that as an issue in India today, one of the largest consumers of gold, and you have moves this year by the government to contain the cash in the system, take out dirty money, try to clean up the system, etc. Some reports, even of a move against, or a limitation of, how much gold you can own. How does the individual suss that out? I’m not asking you to be in Mumbai and speculate what are your choices moving forward, but we exist in the West where, yes, we have a constitution in the United States, you do in the U.K., which we’ve been able to rely upon for a good long time.
But there are lots of places in the world that don’t have that same kind of social construct and instinctively respond to gold, or just getting out of the system, or at least out of the way of government, because there is more of an existential threat. Is that just a second or third world problem, or could that ever migrate into a first world problem?
Russell: I don’t think it will migrate into a first world problem. Financial repression, of course, is a way of stealing money kind of surreptitiously. So I’m sure anybody who is listening to this will say, “Well, financial repression is just a surreptitious way of doing it,” and to some extent that is right. But the really bad ones are the overt ways of doing it. I’m not so worried about India. I think that was a move that they made, they have a reasonably strong constitution, as well. It will go in the right direction.
But here is the crux of the issue. What we saw in 2016 was certain systems – and I pick the United Kingdom and the United States – bending. That’s positive, it’s not negative. We’ve just had this massive constitutional bending in the United Kingdom. You’re going to get a new president in America, working within the constitution. That’s a system that bends.
I think you’re absolutely right to look around the rest of the world and say that these forces that we see now, extant and working, whatever you call them, whether anti-globalization or anti-elite or anti-capitalist, whatever they are – who can’t bend? Who breaks? Who shatters? Now, Turkey, as far as I’m concerned, has already shattered. Hungary has already shattered.
What I mean by shattering is, the democratic institutions, or whatever level they were at, are sliding back toward less democratic institutions. And capitalists need those institutions. They need, in my opinion, I’ve agreed, and not everybody agrees with this, but the fundamental basis of capitalism is property rights, and the more you have a rule by man and not rule by law, the more capricious those property rights get, the more difficult it is to want to get involved in that.
So systems are breaking. They are already broken all around the world, and more of them will break. And we shouldn’t be getting pessimistic about the United States and the United Kingdom because they’re bending. And the euro is the biggest one of all that might break, because what is it? It is a new constitution imposed upon the sovereign states. It is nascent, but it’s brittle, and it might break. And you should be much more worried about the things that break than the things that bend.
You raised the issue of the breakup of the euro and what would happen. It cannot be forecasted. We don’t know. But I would say this. The idea that they have to move toward that because the people demand it, and they would permit the free movement of capital as they move to a breakup of the euro, seems to me highly unlikely, indeed. One of the fundamental laws that could break would be the free movement of capital if Europe ever gets to the dissolution of the insoluble currency union. And that is not going to happen in the United Kingdom or the United States. Years from now in an extreme situation, it could. So let’s look at the fragile systems in the world and be more worried about them than the systems that can bend and adjust.
David: So, returning to the credit markets, what do you think the odds are of major credit events occurring in the next 12, 24, 36 months? Significant credit events.
Russell: People will say that Turkey isn’t significant, but, from memory, they have borrowed 380 billion U.S. dollars’ worth of foreign currency, so some of that is euro and some of that is dollars, basically, but 380 billion – try to put that in context. The on-balance sheet liabilities of Lehman’s the day it went bust was 600 billion. It obviously had a lot of off-balance sheet liabilities, as well. So 380 billion is not an insignificant amount of money, but it is clearly not the scale of Lehman Brothers.
But I think it does spread round the emerging markets. There are other emerging markets that are vulnerable, as well, so the chances of a Turkish one – it does seem imminent, given how far the exchange rate has moved. The ability to pay back that foreign currency debt is collapsing. So that one is imminent, but not within 18 months, it could be within 18 days.
David: But you’re talking about, again, who has that exposure. There is a lot of that 380 billion that is sitting in European banks which are not exactly healthy to begin with. So when you see one domino fall it’s not in isolation, it’s how that relates to everything else that it’s connected to in an interconnected financial world. So you can say, “Well Turkey – who cares?” But the bigger issue is, that may be the straw that breaks the camel’s back in terms of the eurozone because you have tremendous pressure already building in their banking sector.
Russell: Yes, you’re right on that. I think one of the interesting things about this emerging market debt crisis, if and when it comes, is for the first time in modern history the American banks wouldn’t be at the front of it. In fact, it’s always dubious, the data you get, but from the data you get it does seem that the American banks aren’t exposed.
This may sound ridiculous, calling them prudent, but it does appear that they may have been prudent on this occasion. It falls upon the European banks, and it falls upon the bond-holders, because post 2009 it’s a whole new level of bond-holders, and now those bond-holders are savers. Maybe it is actually some of your listeners who have been juicing up their yield in these emerging market bond funds, and they pay a price.
But in terms of banks, it is the European banks, and I think it spreads to other emerging markets. So I have this problem with emerging markets. I sit down all the time with people who buy emerging market debt and they tell me about the ability to pay, that they have spreadsheets that show there is an ability to pay. Now, that spreadsheet goes the wrong way, obviously, as their domestic exchange rate falls. And I say to them, “What about the willingness to pay?” And you kind of get a blank stare because anybody who has been to business school knows the spreadsheets don’t lie (laughs). But spreadsheets do lie, because sometimes people decide not to pay you. And that’s the history of emerging markets.
The Reinhart and Rogoff book, This Time It’s Different, the number one indicator for a company that is going to default on its foreign currency debt is a country that has defaulted on its foreign currency debt. They’ve decided the socio-economic pain of paying back, i.e., running a large current account surplus that may be liquidating local assets and passing them into the hands of foreigners – these two things, they conclude, are too painful, cannot be borne, and it is easier just not to pay back your foreign currency debt. It’s not in the spreadsheet. The spreadsheets show an ability to pay. They don’t focus on the willingness to pay.
So if Turkey, for instance, does this, I think people will sit down and they will reassess the whole emerging market risk. The book, This Time It’s Different, does focus on all these great EM booms, and the ironic thing is, it was published just as a whole new one began, for the same reason. The business school educated analyst says, “These guys can pay us back, therefore they will pay us back.”
So there is a big shock coming when even one of them, particularly a big one, in terms of the amount of money it owes, suddenly says it can’t pay you back. I may be a corporation in Turkey who is currently capable of paying back my U.S. dollar debt, but I’m incapable of doing that the day they produce exchange controls, which is, I think, where Turkey is going to. So a big reassessment of what an emerging market risk is does have impacts beyond that 380 billion U.S. dollars, and as you say, dollars have very direct impacts upon the European banking system.
David: So we look at 2017 and there are some positive things, as you say, developing in the U.S. and the U.K. The systems are bending, they’re not breaking, they’re not in the context of shattering. There are heightened risks elsewhere highlighted in your most recent report, looking at China, Japan, the eurozone. I recall a conversation with Andrew Smithers, actually in Edinburgh, and I had seen you just the day before. Mr. Smithers said, “I’m happy to be in cash right now. I don’t need to take risks. A part of that is a function of my age, but a part of that also is a function of my analysis which says that things are priced for perfection and I don’t know that that is what we’re going to have over the next few years – valuations are getting rich.”
Now, the interesting thing is that, Russell, since then, of course, prices have gone up, valuations have moved to greater extremes, and being in cash, if you’re measuring success by opportunity cost, this was an utter failure. How would you view cash as an allocation today, and what is sort of the ideal – I realize, not taking into account individual investor needs and profiles, but just as I asked Mr. Smithers, for Russell Napier, what is kind of the ideal allocation, looking at both a mix of crisis and opportunity in the 2017-2018 timeframe?
Russell: Well, David, I’ve got some news for you. I don’t about Andrew, but I know that I’ve been sitting in cash, and I’ve made a fortune by sitting in cash because I’m sitting in your cash. I’m sitting in the mighty dollar. But actually, my return as an investor has been pretty spectacular owning cash, albeit that I choose the right cash. Now, I realize most of your listeners are in the United States and that maybe isn’t so germane, but to say that cash, per se, is not a good return has not been correct, if you chose the right one. So, if the mighty dollar is going to continue to rise, it’s making all those other assets that are getting cheaper and cheaper for your listeners. And one day, if the dollar does continue to rise, they will be able to buy them particularly cheaply.
I think I agree with Andrew very much on the issue of cash. I think cash is a very important asset for investors. Why is it constantly played down? Because obviously, in the very long run, it is a dreadful asset to own, because we live in a modern world, a democratic world where inflation is inevitably going to get you eventually, and clearly cash is not good asset to own. That’s the first reason it’s a bad one.
But I’ll tell you the second reason it’s a bad one, and people don’t like to talk about this. When you go to see a professional fund manager he can’t charge you for managing cash so of course he is going to tell you that you have to be in all these other things. He’s never going to tell you 30% cash because you’re going to say, “Why should I pay you a fee for managing cash?” So I think there is an institutional bias against cash, number one.
It is correct to say its long-term return characteristics are dreadful compared to equities, but the word that is used with it, and I think accurately, is optionality. It is there to buy stuff when it is cheap. So I’m a financial historian. I spend a lot of time reading about people who have made a lot of money in markets, and certainly if you go back to the 19th century, into the area of the 20th century, and look at the great success stories in the United States of America, whether it’s John D. Rockefeller, or Andrew Mellon, or Carnegie, or J.P. Morgan, not the secret of all of their success, but a significant portion of it was either having cash when things were cheap, or having the credit quality to borrow when things were cheap.
Now, we haven’t really been so much rewarded for that post World War II in a world of inflation. We haven’t had really crushing recessions. But 1982 was crushing recession and if you were able to access cash and put it to work – fantastic! What a huge amount of money you made. So, cash, I think, is unfairly maligned. You haven’t lost a lot of money from owning it because inflation has been somewhat subdued, maybe not as low as reported, but somewhat subdued. You have been losing money, but not a huge amount, and I think it is worth holding onto it for that optionality.
The bad news I have for American listeners is that it is very hard for me to recommend a currency that you could hold it in that I think would go up against the dollar because I think the dollar is in such a strong position. So for me, I’m a bit younger than Andrew, but I also like to own cash because I think it gives me optionality to buy things when they’re cheap, and it is very, very hard to argue that equities or bonds are cheap. That’s the bottom line. One reason for holding cash is because you could argue that both equities are bonds are over-valued, and that’s the reason for owning cash, and that’s why I continue to own it.
David: As a value investor, you made a play a number of years ago, perhaps one of the greatest plays that can be made, and that is, in knowledge. You invested in The Library of Mistakes, and that is a 3500-volume – maybe more now – library which looks at the history of the markets, the things that have gone right, the things that have gone wrong. I would venture to say that there are treasures within that library of incalculable value. And interestingly enough, you built that library for pennies – pennies on the dollar. So from a value perspective, what you put in, and what you ultimately gain – I look at that as one of your greatest investments over the last 15 years, and I’m very intrigued by what you’ve done with that. May, in fact, have to start one of those ourselves, so, with your permission.
Russell: Absolutely. I think I stole that one from Charlie Munger. I think it was Charlie Munger who said, “The best investment you can make is to read a book.” So, if it’s good enough for the world’s smartest lawyer, it’s certainly good enough for me.
David: Great to have you on the program again. It has been a little while. I look forward to being in the U.K., perhaps late this summer, and our paths crossing again. Thanks so much for your time today.
Russell: Thanks a lot. Cheers.