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About this week’s show:
- Emerging markets: trigger for next crises
- Government favoritism: rationing of credit
- Gold benefits from deflation and inflation
About the guest: Russell Napier is a consultant with CLSA Asia-Pacific Markets writing on issues affecting global equity markets. After studying law, he began his investment career sixteen years ago at Baillie Gifford in Edinburgh managing funds in the Japanese then the US and finally the Asian markets. Moving to Foreign & Colonial Emerging Markets in London he was responsible for managing Asian portfolios. In May 1995, Russell relocated to Hong Kong to become Asian equity strategist for CLSA, a leading Asian equity brokerage.
The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
Kevin: Russell Napier is one of our favorite, most cherished guests. We treat his interviews like a jewel. In the crisis back in June, Dave, 2008, we wanted Russell Napier on, the author of Anatomy of the Bear, and in November we brought him back on because we were right there in 2008, in the crisis. Then we waited a couple of years, brought him back in March of 2010 and April of 2012. Here we are on the cusp of what seems to be a crisis. Granted, people are falling asleep, but it’s a cusp of a crisis. It’s time to have Russell back.
David: The conversation is always intriguing and it is certainly a time to put your thinking cap on and schedule the time to go through and listen twice. But more than that, I would say, make sure you order Anatomy of the Bear. This is a book that he wrote some years ago, but it is just as relevant to the long-term trends and where you want your family to be in those long-term trends, on the right side of them.
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And so, without further ado, Russell, our conversations beginning in June 2008, when Lehman was getting their first downgrade, have been critical in content and, I think, in time. If our listening audience had, at any time over the last five years paid careful attention, and learned from your insights, Russell, the debt owed to the Napier family would be great, indeed.
It’s great to have you back again. We still live in fascinating times. I’d like to circle back around to a few big picture issues and mention how some of your analysis has panned out in the time we have been talking, but before that, what captures your attention right now?
Russell Napier: What’s really capturing my attention is the emerging markets. I’m sure people listening will realize there was quite a reaction to the word “tapering” in emerging markets. I don’t think the word tapering was actually as important as people think, but I think it was showing an underlying fragility in the emerging markets. I’m particularly concerned about ones in Eastern Europe, even in our last couple of decades. We have had a few emerging market crises, and I’m afraid there’s another one brewing, particularly in Eastern Europe, so as you know, there are many, many things to talk about in the global economic outlook, but that one concerns me because it’s vague, and also because nobody else is talking about it, or a very few people seem to be talking about it.
David: Well, you have the balance of payment surpluses which drove the purchase of treasuries, and as we continue the course of economic rebalancing on a global basis, I guess you would contend that emerging markets are impacted, and in turn, I guess, we here in the United States would be impacted, as well. Do you want to look at that for us?
Russell: Yes, absolutely. It’s been my great concern when we have spoken before that it is inevitable that this rebalancing takes place. Economically, that sounds wonderful. We go slightly faster, they go slightly slower, rebalancing. Rebalancing, intuitively, just sounds like a good term, but I think there is a monetary flaw at the core of this which is the one that you have alluded to, which is the emerging markets have been pouring a lot of money into treasuries because they have been manipulating their exchange rates and running very large surpluses. Part of that, when you do that, you also create lots of domestic currency, and what we saw in the summer with these problems in emerging markets, is that we got to a stage where they are not running the surpluses.
If you think about the reverse of this it becomes quite frightening as to what can actually happen if we truly go into the reverse of the situation. And the reverse of the situation, if the emerging markets decided to defend their exchange rates, they would be selling treasuries, and they would also be running tighter monetary policy at home, in other words, selling dollars, buying back their domestic currency, and tightening monetary policy.
Now that is anti-growth. It’s anti-growth, clearly, for the emerging markets themselves, but to the extent that it pushes up U.S. treasury yields, it’s anti-growth in the U.S. and I think we’ve already seen the role that treasury yields have played, particularly in mortgage refinancings, but clearly, the very low level of interest rates is already playing a role in slowing some economic activity in America, so I think that was the beginning, I don’t think it was the end of this process. I think it was a tremor of the earthquake which is to come. And it’s very clearly a deflationary earthquake, rather than an inflationary earthquake, if it’s pushing treasury yields higher in the states and producing lower growth in emerging markets. So it’s been my concern for a couple of years now that the next shock we would have would be a deflationary crisis coming out of emerging markets, and I think the events of the summer showed that we are perilously close to that.
David: The treasury yields, when you have concerns with deflation it seems treasuries are the go-to for anyone with concerns about deflation and deleveraging. This is a little bit different in the context of rising interest rates in a deflationary environment. How would you respond to that knee-jerk reaction to go to treasuries and potential risks there?
Russell: You are very right, and it’s a very extreme forecast I’ve just made, and the extreme forecast has been that U.S. treasury yields are going to go up as growth comes down and inflation expectations come down, and potentially even they would go up even if America avoided deflation. I always used to rightly say, that would be a very, very unusual situation for that to happen, but I think we live in very unusual times. The Fed owns about 20% of the treasury market, 34% of the treasury market is owned by other central bankers, so we have over half that market owned by central bankers. Clearly over the last two decades the marginal buyer, the central bankers being over half the marginal buyer, if you know he owns half the outstanding stock. And the crucial thing here is that that central banker, or those central bankers, in those days decided they wanted to buy treasuries but if they liked the price, they liked the yield, if they thought it fit in with the economic outlook for the United States of America, they bought it, simply to affect the monetary policy of the Fed, to affect quantitative easing, the emerging markets, to affect currency manipulation.
So we always assume, don’t we, that the treasury market will respond to economic fundamentals, and that may well be a reasonable forecast, it certainly has been for many decades now. But we are in a fairly perilous and dangerous situation where half of the treasury market is owned by people who are paying no attention to the fundamentals and the economic fundamentals.
So it may sound a rather outlandish forecast that treasury yields, let’s just say they can be sticky on the way down, or they go up a little bit, even as U.S. economic growth falls, but I don’t think it is as outlandish as it initially seemed, so it is difficult to foresee someone losing a lot of money in treasuries as the economy slows and inflation comes down. But I still think you’re not going to make a lot of money in treasuries and I prefer to own cash as a safer way of keeping the optionality of buying equities when they are cheap. All your listeners will know that in the long-run we all want to be able to invest in equities, we want to buy them when they are cheap, and cash will give us that optionality, and I am a little bit concerned that bonds will not perform the way they normally have done in the post war period.
David: In November of 2008 you and I discussed the future tense bypassing of the commercial banking system and the Fed directly purchasing assets, quantitative easing. You were right, it has happened. If that was a final solution for preventing deflation, how have they done? You see M2, MZM, the annualized numbers, they’re looking a bit inflationary, but there is really not much inflation if you look at the total amount of easy credit, easy money, monetization that has been put in place, from a policy perspective, directed by the Fed.
Russell: Yes, I think that’s a very good summary. It seems to have been good for money, but not good for credit. It is interesting that quantitative easing, really, we have to attribute to Irving Fisher. In his 1933 paper he said this policy was important because it would keep money growing, he never actually mentioned credit, but that it would keep money growing. And then in the process of a deleveraging, that would mean just like putting oil into a machine of a deleveraging, it would stop the friction building up, and it would stop bankruptcies. I won’t go into all the details of that, but basically, that seems to work.
But what doesn’t happen is what the Fed has really claimed for quantitative easing, that it would encourage people to re-lever, perhaps encourage people to save less and spend more, and if the Fed really thinks that will happen, and Fisher certainly didn’t say that would happen, but the Fed seems to think that will be part of the process, I think there is not much evidence that is actually working. And one of the potential reasons for that is just the demographics of America and the baby boom generation, and I think it may be true to say that there is no price of interest at which the baby boom generation would borrow more and save less, given the precarious situation of their personal finances, and just their age, and they are moving into an age where they have to change.
So I don’t think deflation, despite relatively high money supply growth… The last time I looked at our reconstituted M3 it was running just over 5%. It’s worth saying that’s a very low number by the average of the last 20 or 30 years, but obviously, it’s a number significantly better than where we were in early 2009. But in a world where the private sector, and particularly the household sector, continues to de-gear, and as I said, I think, particularly, emerging markets push deflation into America through lower commodity prices, and manufactured goods prices, and where the Japanese are aggressively cutting prices through depreciating the yen, I think the combination of those things, not really a collapse in America, but just a stagnation in credit, a lack of growth in America, at a time when American markets are slowing and the Japanese are exporting deflation, I think putting those things together, we’d probably get an America heading toward deflation despite quantitative easing.
David: Russell, the idea that there is a natural deleveraging embedded in our demographics, that age bracket of 55 and above who are now moving toward retirement and want to reduce their cash outflows to interest payments, and be more or less debt-free. That does fly in the face of credit growth and credit growth has been one of the key drivers of U.S. economic growth. What do you think the policies will be of the Fed? Have we exhausted our options? Or will we see even more and unique creativity coming from the new Fed president?
Russell: I think you will see more unique creativity. That’s a wonderful euphemism for what central bankers get up to. I wish I’d thought of that. Unique creativity – that’s one of the nicer things you could say about them. If you want to see unique creativity in action come to the United Kingdom. I think we have the template here for where you will be in the not-too-distant future, and that is really the government and the central bank working together. What we have going on here through a policy called Funding for Lending, and also a separate policy called Help For Homes, is the state, effectively, putting its stamp of state credit on loans flowing from the commercial banking system to the private sector, to the small corporations, and also the households, for the purchases of homes.
I realize in the United States you started that process in 1932. In fact, for farm mortgages, you started it well before 1932, but it’s new here, and it’s working. But you can see how in America, it can’t really go into mortgages because it’s already there, but the Funding for Lending, which is a bit premature on loans to small companies. You have some of that in America, but that could get more aggressive. You can see the conjunction of the two.
Now that can work here in the United Kingdom. In my opinion, it is effectively turning our central banker into a commercial bank. He is providing the funds for the commercial banker, who then passes those funds out into the private sector, with a state guarantee.
But it will come to America, I think, in a different way, because it is very difficult at the minute to foresee how Congress would endorse such a combination. The British government is a government that can get things done, and you have a certain stagnation inside the beltway in which maybe that form of cooperation is not available. Now, whether you politically like that form of cooperation or not, I think it is inevitably where we get to.
I could name one policy that we might end up with from the Federal Reserve, but clearly not a Federal Reserve acting alone, a Federal Reserve acting in conjunction with the government. It would be the forgiveness of student debt. We have this generational issue where I think the older generation simply has to de-gear, in terms of reflating America, reflating the United Kingdom, it’s getting credit flowing to young people, and one of the major impediments to that in the United States is the level of student debt. So there you have it, “Unique Creativity,” it’s needed for politicians as well. Like TARP, you don’t get it until you get it, and you don’t get it until you get a crisis, but if quantitative easing isn’t working I think this is the shape of things to come.
David: Central banks looking more like commercial banks. While that has a ring of a market dynamic to it, in the backdrop you are really talking about state-directed capital like what we have had for several decades in China and other economies that you could describe as command economies. Is that the inevitable future? Certainly, that was a part of our conversation in 2010 and in 2012, the potential for command economy characteristics emerging in the U.S., perhaps the U.K. as well. Is that the state of the future, where we can just expect more involvement from government in the economy?
Russell: Yes, I’m glad you mentioned it, because obviously it’s good to mention a forecast, but so that was 2010, we’ve just got to look at the United Kingdom again and for any of your listeners, if they want to go to the Bank of England website and look up the Financial Policy Committee, which has been established this year, you will see exactly how this works. Now the role of the FPC is separate from the monetary policy committee, which is our equivalent of the FOMC, and it is going to attempt to control credit with other tools. Now, those tools, without going into the details of them, mean, effectively, adjusting risk rating of capital within the banking system, to steer credit to, or away from, certain forms of lending. Now that is, in my opinion, state-directed credit. Of course, the central bank is not a direct arm of state, it is theoretically independent, but it is certainly not allocating credit by price. It is not allocating credit by its price, it’s not making loans based on the price, it’s having another tool out there which says, “No, even at this price we think this is the wrong place for credit to flow to.” So it was a 2010 forecast, but it has come true in 2013 for the United Kingdom. We are directing credit to bits of the economy where the central bank won’t. I do think that eventually something similar to that will come to the United States of America. I would call it a central bank activism. It’s not a good thing in terms of the efficient allocation of credit, it’s not an efficient allocation of capital, but that is the way forward, and that is the future, and it’s come to the United Kingdom already.
David: So we’re really not talking about the unseen hand, but we’re talking about the seen hand, central bank activism. It seems to me that the danger lies in loans and credit flowing to the politically connected and the potential for corruption increasing, not decreasing.
Russell: I agree with that. The government doesn’t like the unseen hand, and rationing by price, when something is not being delivered in terms of economic growth for a prolonged period of time, and apparently it’s not. The initial reaction of the government when it doesn’t is to abolish it rather than say, “Well, let’s let it work and let it sort itself out.” So they’ve come into this business to try to, as you say, bring in the seen hand.
I did a speech at the University last night and the punch line was, “He who seeks to control credit with something other than price, ultimately rations it.” If we had a list of the people who are most likely to benefit from that rationing, then clearly it would be the government, itself, or people who vote for the government, who are connected to the government. If we say that the long-run outlook for the United States must be to de-gear, and it must be, in some way, to keep credit growth below normal GDP growth over the long-term, and there is going to be a lot lower credit growth than we’ve had for the past three decades.
For the past three decades, anybody who wanted credit could get it, you just simply paid the price. Now, if paying the price is no longer sufficient because the government or the central bank deems that credit should not be flowing to that part of the economy, then it is going to be rationed to those who need it most, and believe me, in the world of politicians, the people who need credit the most are politicians. So they’re going to be at the top of the list, the voters were going to second, and everybody else is going to be behind them.
We have had policies like this before. They have not been very successful, but here we go again. At least when a politician makes the same mistake twice he has the good grace to give it a different name. This time credit controls are masquerading under the title of macro-credential regulation. But in my opinion, it will ultimately amount to the same thing.
David: We have many changes in the financial markets, and obviously, if you are changing these structural relationships, pricing of capital being one of them, and now we’ve been having prices controlled, manipulated by the Fed now for several years, with interest rates kept extraordinarily low, and through the asset purchases, the programs that we have had in place here, as well, where are we at, where are we going? Just a quick snapshot, gold, treasuries, U.S. equities, emerging market equities. Could you say pros and cons for each? How do you think the chips fall?
Russell: Okay. It’s very difficult to do quickly, but I think equities are straightforward to avoid, particularly U.S. equities. I think the so-called Shiller PE, which many of your listeners will know well, I think is a good guide to long-term returns, and it certainly is suggesting that for U.S. equities, long-term returns will be poor, and short-term returns could be very poor. We tend to get a couple of bad years with the long-term, when you have valuations at this level.
David: Let’s look at that. We have what you call the cyclically adjusted PE, or the Shiller PE. It’s north of 23 at present.
Russell: Yes, that’s correct.
David: Could it be on its way to 40 before it hits 10?
Russell: Well, for your listeners, they can look that up on Shiller’s website, and what you see is that 23 has been a very high level. It’s not that far away from where we were in 1929. There is only one period in history where you could buy at 23 times and actually make a lot of money in the short-term, and that was from 1995 to 2000, so it’s not unheard of that it could go from 23 to 40, because that is what it did from 1995 to 2000. But that was the only time in the historical record, beginning in 1881, that it did so, so I think it’s a high-risk strategy to say to invest on that basis, but it’s clear that it’s not out of the question.
What you would normally expect with a cyclically adjusted PE or a Shiller PE at 23 is over a 10-15 year period is probably about 2 to 2.5% real per annum, but of course that tells you the long-run average return, but not the distribution of returns, and as I suggested, somewhere in that record you are likely to get a couple of very bad years. So it’s only 2.5% real, perhaps, for a 10-15 year holder.
Treasuries, I think, will become certificates of confiscation, it’s just a matter of when that happens, and what I mean by that is the real returns on those will be dreadful. That’s always been the way that democracies have shifted their debt. Ultimately, it has been through inflation, and although I’m not an inflationist, clearly in the short-run, the next year, the next two years, ultimately, for the long-run investor, there is no value in government debt.
Gold is the most interesting one. However fundamental, it’s very difficult to get right. It clearly benefits from that long-run inflation, so I think it is a very good long-run investment. But even in the short-run, I think what we are about to see is such a significant economic dislocation, in my opinion, driven by deflation, that you might even see gold start to go up as we get bad economic news coming out, as we get worries about deflation. At that stage, I think it becomes a buy almost instantly, because what it is telling you, is that if it starts to react positively to bad economic news and deflationary news, it is telling you that here is an asset class which can actually benefit from deflation and inflation, and therefore it is going to be the go-to asset class. Cash is much more valuable than people think.
I think that will be a key take-away from this, and I assume we’ve had this conversation before, and it’s just clearly not been a good investment. At the minute, over the last couple of years it is deteriorating, and its real value is deteriorating every day, but that small incremental deterioration in its real value is nothing compared to the significant loss of capital one could undergo in developed world equities or U.S. equities today. So keeping that cash for the optionality to buy equities when they are cheap I still think has value despite the real losses you make every day.
Emerging markets, just finally, I think are a very straight avoid. There are a lot of dangerous things happening in emerging markets. I actually think it is mainly an Eastern European phenomenon, rather than a Latin American or an Asian phenomenon, but the whole asset class tends to get dragged down when we have one of these particular regions in trouble, and therefore I would stay clear of emerging markets, and particularly, emerging market debt. This is an entirely illiquid asset class crammed into very large, open-ended mutual funds sold to the world’s pensioners, and frankly, I think it’s one of the most dangerous asset classes out there because this is one you simply won’t be able to extract your capital from. At least emerging market equities, over many years, have had their ups and their downs, but it has been possible to get your money out.
Actually, there is one final thing to add on that, because it is hard to cover so many asset classes so quickly, your listeners really need to go and listen, or read, the speech of Christine Lagarde at Jackson Hole, because in that she stated, categorically, that one of the answers for this problem that emerging markets have in coping with a tighter U.S. monetary policy would be exchange controls, would be the restrictions on people removing their capital from emerging markets. I think that is something which is so important that it is good reason to be cautious in putting any more money into emerging markets and that is one of the potential responses that is going to be endorsed by the IMF next time we have an emerging market problem.
David: Let’s go back and contrast the balance sheet differences between the Asian emerging markets, obviously having benefitted tremendously from trade with the West, and having sat on surpluses for a long time, maybe you could say balance sheet strong, but declining on the income side of the equation in terms of an income statement. Your concern is Eastern European countries who maybe have a different balance sheet composition altogether.
Russell: Yes, there are flows in stocks. What I mean by a flow is the current account. That is, in any given year, in any country, how much it exports and how much it imports, at any given point in time. What makes us worried is balance sheet items. If you think of it from a corporate perspective it’s when you combine a poor PNL with a very bad balance sheet. You can get away with a poor PNL and a reasonable balance sheet.
The key indicator for all the emerging markets, as far as I am concerned, is not necessarily the current account, which is the one people tend to focus on, but it’s the scale of their external debt, which is the external debt to GDP ratio. Just how much has been borrowed from offshore? A lot of it they borrow offshore, they borrow, actually, in foreign currencies, which is very dangerous. They borrow in a foreign currency, use that to finance investment in domestic currency assets, and they are also now borrowing in their local currency from foreigners.
But in Eastern Europe, these are the highest numbers we’ve seen since the Asian economic crisis, and they are basically at levels where you wouldn’t expect these countries to be able to pay it back. Many of your listeners will have heard of some of these countries, they are very small, or they sound very small, but they still borrowed tens of billions of dollars. There are two big ones in Eastern Europe, and they have borrowed well over 300 billion dollars each, and they are important. They are Poland and Turkey. So even adding in some of the small ones, we find nearly 2 trillion dollars’ worth, in my opinion, of money which Eastern European emerging markets have borrowed. I think there’s a real question mark as to whether they will pay it back, and 2 trillion dollars, even today, is still quite a lot of money.
David: Just to come full circle to our conversation in 2008, we were talking about 600 billion dollars in exposure with Lehman, and they needed to raise a few billion dollars to keep themselves afloat, and obviously, that came to an end. We’re talking about 2 trillion. That dwarfs Lehman.
Russell: Absolutely, it does, and there are basically two sets of people who lent the money, so the risk obviously is to who has lent this money to Eastern Europe, because that is where the burden will fall. And unfortunately, it is the European banking system. They are one of the big funders of what has been going on in Eastern Europe, and I’m sure you are aware that the last thing these banks need is another hit to their capital base from defaults in Eastern Europe.
The sad thing is, and I think it is very sad, that also, Western pensioners have now got involved in this emerging market debt trade, which I think is fundamentally dangerous. That’s really been underway since about 2009. The banks of Western Europe have been pretty busy since 2009 sorting out their own mess, so what we find is that the loans that they have to Eastern Europe are pretty much the legacy loans that have been made before 2009, loans that they haven’t been able to get back. But the new level of debt which has kept the Eastern European party going since 2009 has predominantly come in the form of a bond issuance, which is now resting securely on the balance sheet of the developed world’s pensioners who are chasing it for the 5-6% yield which it promises, but that’s a yield which is taken, I think, at great risk. So, I think we know the transmission mechanism here. It’s a transmission mechanism which hurts European banks and therefore slows European growth, but also hurts the West’s pensioners and hurts their savings, which is not going to be good, ultimately, for economic activity in the West.
David: We have TIC data that does indicate a marginal loss of faith in U.S. government debt. Do we see that as a short-term aberration, a long-term trend? You received some mention in the Financial Times in recent weeks and the outside number for the S&P, you put at 400. That was mentioned again. Have you revised your estimates any? If not, what is the step-sequence that leads us, here in the U.S., to those kinds of numbers? What variables are at work in the market today?
Russell: Okay, well, just the justification for the number and where it comes from, it’s not a number plucked from the air, it’s not a number that was chosen to worry people or frighten people, it’s simply looking at the cyclically adjusted PE, the Shiller PE and the previous lows, and there is quite a range in the previous lows, so it’s just looking at an average of the previous lows and saying that if the Shiller PE has value because it mean reverts, then there is some valuable information provided to us by the previous lows. Not many people refute that it will continue to mean revert.
They say the mean reversion we have witnessed so far has come to an end, the 1881 to let’s say 2000 mean reversion is all going to come to an end and it’s irrelevant. But if you believe in it, as I do, and we simply take the previous four lows, and that indicates a number which is actually now somewhere between 400 and 500 for the S&P, the question is how on earth could we ever see the conditions in place that would drive equity valuations to those levels? Well, I could think of many of them. They have to be big things. Clearly, we only had four of these lows in the last 130 years. They are going to have to be very major things that are happening.
But let me give you some potential ones. I don’t think by any means that all of these will happen, but here are some of them. We begin to realize that the Federal Reserve is not a safety net for asset prices, but the printing of money does not necessarily create higher levels of economic growth, higher levels of corporate profits, and higher levels of asset prices. In other words, unlike 2009, when we had a deflationary disease, and we had administered a seeming cure, today, if we get that disease coming back despite the cure, there could be a huge loss of faith, to say, “Well, actually, this stuff doesn’t work, it doesn’t actually underwrite our downside.” That could be number one.
Number two, I have great fears, as we have slightly discussed, what will happen with foreign central bank ownership of treasuries. If China had to become an aggressive defender of the exchange rate, which is inevitable, I mean, it will happen, you can’t undervaluate an exchange rate forever, that would involve a significant selling of treasuries, and I think a significant upward movement in U.S. interest rates at a time when the economy may already be struggling. I would say that wouldn’t go on for long, but the alternative, which is a Chinese devaluation, would also have major negative issues for global growth, in terms of China exporting major deflation, so that adjustment in China, when it comes, I think is the sort of deflationary thing that can bring equity prices extremely low.
And finally, as we have discussed, the slow, gradual shift away from markets to government, we do live in a bizarre world where nearly every investor I meet thinks they are going to benefit from this, and they have benefitted from it. The initial few years of this attempt to print money has driven up asset price. Corporate profits are at an all-time high relative to GDP. But ultimately, in a world where the government wants to get involved and take over from the markets, do we really think that we are going to be paying higher prices for private sector assets in a world of public sector interference?
So the other thing that can bring equity valuations below levels is a gradual, gradual, gradual rise in the role of government in the marketplaces. That famous citation, it’s like boiling a frog in water. The water is getting nice and warm at this minute and everyone is pretty contented, but there is some degree of temperature of that water at which we want to pay significantly less for equities, rather than significantly more, which is what we have decided to do in the first five years of this great 20-30 year shift away from markets and back to government.
David: That was the same air we were breathing during the war, and then post World War II era, and that air didn’t clear until 1949 when the market can perceive the receding of government from the marketplace, and re-emergence of private interests.
One last thing, just on mean reversion in valuation, because if the Shiller PE is of value, and yet it is criticized for its mean reversion, if it does or doesn’t, what about Tobin’s Q? The mean reversion there, I think, it probably even more reliable, and yet, it’s two times its average. Those two would indicate that we are in, not necessarily nosebleed sections, but if you are looking at value, you are paying a very high price for it today, and probably not getting a very good value.
Russell: I run a course in finance called The Practical History of Financial Markets, and we have a whole section on value that is taught by Andrew Smithers. Andrew Smithers and Stephen Wright have written a book on Tobin’s Q. I would agree with you, Tobin’s Q is probably a better measure of value. I simply use the Shiller kit, because while they are both good, Shiller is simply better known. But ultimately, the Q ratio is probably an even better measure of value. And you are right, they both show extreme over-valuation of U.S. equities. They have, to date, both shown mean reversion, and when I talk about both measures of value, both showing over-valuation, the constant refrain is, “Well, this time they won’t mean revert.” Well, I just think it’s a big bet. Maybe there is some brand new paradigm in the world where for the first time this isn’t going to happen, but if that’s the bet you’re making, I think it’s quite a dangerous bet, and of course, it could be that the world has changed, and that’s not going to happen again, but that’s a dangerous, dangerous thing to do.
I would just say, why I think the Q is such an important measure of value, at its bottom it shows equities trading at a 70% discount to the replacement value of their assets, quite remarkable. I cover this in my book, it’s always exactly the same number every time, 70% discount to replacement value off their assets. Why that’s important is it stops companies investing. And this is why the world is in a mess, it stops companies investing. Companies simply won’t take a dollar of cash flow, invest it in a dollar of assets, if the market values them at 30 cents, and that’s where China comes in. China is not getting the signal. China is never getting a signal to stop investing, and because China never gets the signal to stop investing, then it just keeps over-producing, and we keep getting these deflationary threats.
So, I think a fall in the Q ratio, and something that is similar, getting a signal to China, is what we need to try to stop capital investment, stop over-capacity, and that’s when you want to be buying assets. So, it’s not just a measure of value, which I think tells you when equities are cheap, it also sends the signal to stop producing capital, and that’s a great time to buy existing capital, and a great time to buy it at a discount, and those signals have not been thrown yet.
David: So you say it’s a big bet that it won’t mean revert. Let’s take a timeframe, and I’m just pulling it out of the hat, 2014-2016. We talked about some of the potential structural negatives. Those would be the Federal Reserve not serving as an actual safety net, their policy is being ineffective, and being found that way in the market, hypothetically, China defending its exchange rate, de-valuing the yuan, some major things that could happen. Anything else that you would throw into the mix, that could bring 2014-2016 into frame, given that, as you pointed out in your book, The Anatomy of the Bear, the average bear market lasts about 14 years. We’re coming up on that kind of a time frame where you could assume the worst is behind us, and yet, I think what I’m hearing you say is, actually, we’ve got a long row to hoe, still in front of us.
Russell: In terms of the timing, it’s incredibly difficult. I would say the average is 14 years, but of course, in terms of the bear markets I look at, and what I’m looking at is peak valuations to low valuations, we haven’t got very many of them. The first one, I would say, lasted from 1900-1920, so that’s a 20-year one, but when you have such few observations, I think taking the average is potentially dangerous. So what I’ve tried to do in my book is try to look at the mechanisms that drive a mean reversion, and for me, rightly or wrongly, I’ve decided that it’s actually inflation or deflation, a breakout in inflation above 4%, or a deflation. If it’s inflation, it tends to bring these valuations down relatively slowly. That was the case, let’s just say, from 1968 to 1982. That was primarily an inflationary effect, bringing down valuations. So if we are looking at valuations falling to the sort of numbers we’ve just mentioned in that 2014 to 2016 time rise, that’s clearly going to be a very rapid decline in valuations, and that, I think, would have to be deflation, so I do see that deflation on the horizon, and that’s why I think valuations can fall quickly. They fell quickly in 1929 to 1932, which was a deflationary shock. Even 2000-2003 there was a real risk of deflation, post Lehman Brothers deflation.
This is when equity valuations adjust very rapidly, indeed, and I think that’s what we have on the cards, so I’m fairly convinced that we’ll get the mean reversions. If it’s going to be by inflation, it could take 20 years, in total, from the year 2000, as it did from the year 1900. But if it is going to be deflation, it will be much more quickly. So this inflation/deflation debate is very important for timing, apart from anything else, and as I’ve made clear, I’m on the deflation side of it, so it could happen quite quickly.
David: One of the last four major bear markets was deflationary, the other three were inflationary, and the overtones you see, contraction in bank lending, is supportive to the case that this is, still, after five years, a deflationary environment.
Russell: Yes, I think so, and particularly, outside of the United States of America. It is worth stressing, even the losses you make in an inflation, you get a long fall, a slow fall, in the valuation, it ultimately ends with some form of deflation or deflationary fear. I think even 1982 was a year when, as you have pointed out, that the money central banks looked like they were bust, and if the money central banks were bust, then most of the banks were bust, and we were going to get a major credit contraction. It turned out that Volcker changed his monetary policy and the banks were saved and everything was okay, but for a terrible moment it looked like we could be heading for a major banking crisis in 1982.
So even the ones where your valuation falls for a long time because of inflation, they ultimately end with some form of deflation, as was the same in 1921, as the Fed tried to squeeze out the World War I inflation. The deflation I see out there is just a very rapid slowdown in growth in emerging markets, Japan exporting products much more cheaply, and believe me, the yen has got an awful lot further to fall, and the price of Japanese exports has got a lot further to fall. And this comes at a time when the baby boom generation is de-gearing. Those things, combined, I think, raise that specter of deflation. I was much more optimistic on growth and inflation and up until 2011, that’s when it began to become clear to me that the lack of credit was a demand issue rather than a supply issue. I had expected that when the banks were fixed, they would supply credit and credit would grow, and it comes clearer to me every day that the problem with credit is a demand issue and not a supply issue, and fixing that is significantly more difficult than fixing the supply side.
David: I’m going to suggest that all of our listeners take about three months off and come to Edinburgh, go to the Edinburgh Business School, and attend your class, benefit from the expertise and insight that you bring, and also maybe spend a little time in Adam Smith’s home. As I understand, the Edinburgh Business School owns the home that he lived in for a good 10-12 years.
Russell: Yes, I’ve got an even better idea, you don’t have to come for three months, because we are 1 unit of an MBA program, we can teach it all in two days, so come for two days and I will personally take you down to see Adam Smith’s house, which the Edinburgh Business School has bought, and they are looking for some money to renovate it, so if you were feeling particularly charitable, you could actually make a contribution and be one of the few people who has contributed to refurbishing that house. That’s where we hope to keep alive the ideas of Adam Smith and his views on the invisible hand, in what will be difficult days to come.
David: Russ, we appreciate your time, and I’m going to take you up on that. That would be two days well spent, and I look forward to it. We just have to figure out where to put it on the calendar.
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Kevin: Dave, there’s something I don’t think a lot of people understand about the author, Russell Napier. We’ve heard the interviewee, Russell Napier, these numerous times, but the author Russell Napier goes back and reads everything, and takes himself through a historic narrative of what he is trying to study. When he was talking about the actions of 1982, this is somebody who actually read every article in the Wall Street Journal during that time, because as he was writing Anatomy of the Bear, he went through, virtually, a century of Wall Street Journals to understand how the markets actually work. I love the way he can bring the perspective, as if he is a man who travels through time.
David: And I think there are two things that he has left us with, his homework assignment. I started the conversation by saying, make sure you not only have his book on the shelf, but that it is well-read and well-worn. Over the next few years you will need to refer to it. The things that he referred to in a conversation today, Christine Lagarde’s comments at Jackson Hole, and the increase of capital controls, or exchange controls, and the diminishment of, if that were to take place, it’s a major sea-change in terms of globalization and the trend of international trade. You find that countries in that space and time, with those policies, are thinking more of themselves, uniquely, not just the collective global citizenry.
Kevin: Dave, I’m imagining the second part of the assignment you’re thinking of is this command economy that is being revealed to us, right on the internet. These guys are not keeping it secret, they are telling us, they will be the seen hand.
David: Exactly. The Bank of England, as Russell mentioned, going and looking at their Financial Policy Committee notes, and this is really important, just like Ben Bernanke gave us insight in 2002 into what extraordinary measures would be in place in the context of the crisis we have walked through over the last five years, we have the playbook in terms of government playing a larger role in the world of allocating finance, becoming, as he mentioned, more of a commercial entity, and of course, that comes with great dangers in terms of rationing capital.
Who gets it? Yes, it’s government, itself. Yes, it’s those connected to government. And yes, it’s those who vote for those in power. That is inherently corrupt. That is the nature of what we face over the next several years, structural issues, which, again, we need to better understand, to be making wise decisions.