Stocks will be worth buying eventually, says CLSA analyst and bear market expert Russell Napier. But we face a nasty deflationary shock first.
For all its problems and excesses, the credit-boom era was still better than the current nightmare of having asset prices effectively set by governments. According to economic theory, the power of governments to do this should be limited by the unwillingness of lenders to finance anything so unproductive. The price of government credit (what it costs the government to borrow) should be the one powerful truth that prevents the manufacture of all the other lies of price.
However, with the magic wand of government regulation – and the help of its lovely assistant, the central banker – the government has turned that one truth into a big lie, which in turn has given rise to many little lies.
If you play a game against the referee, the referee will be the likely victor. By manipulating the price at which it can borrow, a government gives itself the ability to change the rules and set prices as it wants. So now investors have to assess three factors when they invest: the usual two – supply and demand – plus government. Based on supply and demand, what should this price be? Does the government like that price? If not, what price would it like? And what are the unintended consequences of the government trying to get to that price? Just answering the first question is hard enough. Answering them all may be nigh on impossible.
Inflation is the only solution
This we know for sure: in the long run, governments must inflate away their debts. This is politically the easiest answer to a difficult economic problem. Holding interest rates below inflation will prove harder to achieve than they believe, but they will get us there in the end. This is known as ‘financial repression’. A more honest label is ‘stealing money from old people slowly’.
The key point? Bonds today are a form of government-licensed theft, offering returns that in no way reflect the obvious risk that their real value is being inflated away. It follows that no one should chose to hold them. In time we may all end up being forced to buy them one way or another – desperate governments can resort to whatever policies they feel will help – but we aren’t there yet. So don’t buy them.
In a world where the one big lie now permits all the other lies, how are savers to protect and grow their savings? You could always leave. In a world of the free movement of capital, we still have a choice about just how many little lies we choose to live with. Not all governments are over indebted and set on inflating away their debts. Not all governments are burdened with the major social commitments that prevent them from running sound finances. Some governments will be able to cope with market prices better than others.
I have long considered that the peculiar economic system of Singapore is unlikely to move the needle any further towards price unreality in the years and decades to come. That might be one place it is still worth buying sovereign bonds.
Much of the rest of Asia is similar. Domestic debt burdens and social entitlements are so limited that it should be unnecessary for governments to inflate away their debts. That means they can avoid the big lie, and that their currencies should provide sound returns for sterling investors in the longer run. That said, these countries still have to weather a nasty foreign-currency debt crisis – the strong dollar is a nightmare for them. So until that is over, you would, I think, be unwise to stray far from the Singapore dollar.
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Stocks aren’t cheap enough yet
What about other assets? At some stage, equities will become a wonderful way to preserve and grow your capital. The managements of these companies will be subject to all the same pricing unrealities as savers themselves.
However, while bonds have their cash flows fixed at birth, the equity dividend is not predestined. History shows that the best management can insure dividend growth through the most challenging of circumstances. Better still, it is possible for equity valuations to get so low that they can discount almost anything. When equities are very cheap, they are a buy, almost regardless of what the future holds. Short of sequestration of private-sector assets, destruction of the capital stock by enemy bombing, or major deflationary adjustments bankrupting almost all geared entities, then cheap equities must provide great returns.
Right now, most global equity markets remain too expensive. However, that’s not the case in southern Europe. Cheap equities there are already discounting a high risk of bankruptcy and the economic unrealities to come. That might be because southern Europe has embarked upon the third road to destruction noted above – death by deflation. But the point is that it won’t take it all the way. In the end, there can be no such thing as a deflated Italian. Italian society simply won’t put up with it.
One way or another – either by forcing the European Central Bank to print money, or by simply leaving the euro – Italy will get a central bank that is willing to make it more competitive via the traditional route of currency devaluation and inflation, rather than the more painful path of deflation.
So you should keep your powder dry, and await the central-bank policy that will produce reflation before you buy. Reflation, when it comes, will at least lift the risks of bankruptcy and, as a result, equity valuations and prices will rise. Capital controls are a likely part of the nightmare to come, but at least profits from Italian equities – even if they can’t be taken out of the country – can be spent in the sunshine on the dolce vita.
The bad news is that this dolce vita is in the future. Before that – and before equities in more developed markets become cheap enough to buy – investors need to prepare for a deflation shock.
A history of failure
The history of central banking is the history of failure. This is not because central bankers are stupid, but because we have given them an impossible job. In 1810, a committee was formed by the British government. Its task was to report on whether Britain should return to the gold standard, or have an independent central banker to determine monetary policy. The conclusion of these wise men should never be forgotten by investors.
“The most detailed knowledge of the actual trade of a country, combined with the profound Science in all the principles of Money and circulation, would not enable any man or set of men to adjust, and keep always adjusted, the right proportion of circulating medium in a country to the wants of trade.” This sums up why you must always be prepared for central-bank failure. If central banking was difficult in 1810, the massive increase in the complexity of our current economy surely makes it impossible today.
As central-bank success today is judged by ‘price stability’, then investors who are looking to protect themselves from the inevitable failure of central bankers need to prepare for either inflation or deflation. While the necessity to inflate away debts assures what kind of failure we will ultimately get – inflation – the near-term outlook is for a deflationary failure.
The emerging-market demand shock
Federal Reserve chief Ben Bernanke very kindly defined central-bank failure for us in his so-called ‘helicopter speech’ of November 2002. In that speech, he explains why central bankers must not let inflation fall below 1%, as demand shocks (a sudden fall in demand) could then easily create deflation. Such deflation would be particularly difficult to reverse if interest rates were at zero. Today, Bernanke’s chosen measure of inflation is at 0.7%, interest rates are at zero, and a demand shock seems to be brewing in the emerging markets.
As final demand growth in emerging markets has been the only driver of inflation in the world, problems in emerging markets can quickly take us to deflation. QE did little to boost final demand in the developed world, but it was very successful, through exchange rate linkages (ie, by forcing Asia to boost the supply of money, and hence economic growth, to prevent exchange rate appreciation), in boosting demand in emerging markets.
Emerging-market growth resulted in a boom in commodity prices, which lifted the US from deflation to inflation of 3.9% in September 2011. However, the external surpluses that forced emerging markets to adopt easy money policies (to try to cap the strength of their currencies) and also resulted in high growth, have been waning for almost two years. Now surpluses have been eradicated, and attempts to keep exchange rates steady will result in tighter monetary policy (now needed to prop up currencies that are tumbling against the dollar) and a resulting hit to the demand outlook.
The policy choice facing these jurisdictions is to deflate or devalue – neither of which is good for global demand. So Bernanke’s demand shock is hurtling towards him. If China is among the casualties, it will be a very large shock indeed.
Already, rising short-term interest rates in China raise the alarming prospect that China may be forced to choose to deflate or devalue sooner rather than later. This dynamic in emerging markets suggests that the next central bank failure is likely to result in deflation. If that’s the case, then investors should be in cash or in the government bonds of countries that really don’t have very many government bonds (in other words, they’re not particularly indebted).
My view is that it’s best to wait in cash, awaiting opportunities to buy equities at a price that more than discounts the economic nonsense that is to come. It’s painful to own cash, but it will be less painful as inflation falls. And it is ultimately less painful than lending money at high yields to people who won’t pay you back. And it’s a lot less painful than giving your capital away in risky ventures in the pursuit of income. In short, it’s time to do not very much at all, and to heed the greatest advice ever provided by a French man: “All of humanity’s problems stem from man’s inability to sit quietly in a room alone” – Blaise Pascal (1623-1662).
• Russell’s book, Anatomy of the Bear: Lessons from Wall Street’s Four Great Bottoms, is published by Harriman House, price £15.99 (via Amazon).