Financial historian Russell Napier talks to Merryn Somerset Webb about the next deflationary bust – why it’s coming, what it means for you, and how you can survive it.
Merryn Somerset Webb: Hi. I’m Merryn Somerset Webb and I am here today with Russell Napier. Russell used to be a strategist at CLSA – or should I say the strategist at CSLA – but he’s recently launched his own business. So, first we’re going to talk about that and then we’re going to talk quite a bit about the markets.
So, Russell, tell me about your new business.
Russell Napier: Well, my new business is a continuation of the old, which is me writing independent research and marketing that to institutional investors. The bit that’s very new is almost a second business, which is where that research is distributed. It’s distributed through a platform called ERIC. So, most of the people watching this will know the FCA is very keen that we unbundle research from commissions.
Merryn Somerset Webb: Explain what that means to a retail viewer.
Russell Napier: Sure. So, most of the institutions that your viewers have their money with receive research for free. But it’s not for free because in return they deal with their stock broker. They’re paying a higher commission because that research is coming in than they would do if they weren’t getting any commission. So, in the opinion of the FCA, the stock broker is really using his client’s money to get the research. So, they’re very keen that we split it up. In the future, your fund manager will pay for the research, not you indirectly through your commission.
So, ERIC the website is there to offer unbundled, individually-priced research where fund managers can buy it with their own money and not with their client’s money through bundled commission.
Merryn Somerset Webb: Do they buy things with their own money?
Russell Napier: Well, it’s funny you say that. First of all, some of them do. There are some of them who think it’s a very good idea because they’re not enamoured with the quality of research which comes through the broking community and they think they’re paying for a huge bundle of stuff and only using a small percentage of it. But of course, perhaps the most important thing is the regulator thinks that you should pay with their own money. The regulator seems dogmatically to keep going on this issue. So, they may not have a choice anyway.
Merryn Somerset Webb: OK. So, will the result of this be that we, as a market, get less research and better research?
Russell Napier: The institutions will get less research for sure. They should get better research.
Merryn Somerset Webb: But if they’re going to pay for it, they’re going to make sure that they get better research. The bad analysts will vanish from the market.
Russell Napier: Yeah. The only reason I paused is my estimate is that the market research will fall by 85 percent. I think 15 percent of it is good anyway. Whether we can improve the quality of it-I think we can improve the independence of it for sure. I think most people watching this will know there are certain conflicts of interest for stock analysts working with inside broking companies, which should be significantly diminished for stock analysts working outside broking companies. So, independence is potentially at least as important as quality. That, I think, will very clearly go up.
Merryn Somerset Webb: OK. Now, your research has been very clearly watched for years. Your institutional clients, your old institutional clients, can now get it on ERIC but I think the problem here is that retail investors, non-professional investors can’t use ERIC. Am I right?
Russell Napier: That’s right. According to the legal advice we have, ERIC is a platform for regulated investors. Of course, any analysts who’s writing will also have to be regulated as well. So, unfortunately, it can’t be open to members of the public. We will keep investigating that, but I don’t suspect there will be any change in that.
Merryn Somerset Webb: But luckily, for MoneyWeek readers, we have him here today to tell us what you’re thinking about at the moment.
Russell Napier: Yes. How long have you got?
Merryn Somerset Webb: We have quite a long time. So, let’s start at the beginning. You are a firm believer, as I understand it, in the idea that we live in a deflationary environment and there’s almost nothing that central banks can do to change that. So, maybe talk a little bit about why you think that is.
Russell Napier: OK.
Merryn Somerset Webb: First why we’re in a deflationary environment.
Russell Napier: Sure. There are some very, very big building blocks of this. Just before I go into those, the reason why we in recent times have deflation is not because supply is bigger than demand. That’s not the dangerous deflation. You might actually say that might be a good deflation. It’s because at some stage in that transition process from inflation downwards, we have a credit event which creates a shock for the financial system. Of course, that’s famously what happened in 2008-2009. But that also happened in 1998 with Russia and LTCM and it happened in 1982 with Mexico and their banking system.
So, when we talk about deflation, people say, “What’s so wrong with falling prices?” The answer is that usually that undermines somebody’s corporate cash flow. Somebody goes bankrupt and we get a credit event. That’s the likely way it goes forward. If it happens to be a big one, a country, a very large financial institution-we could name a few. So, that’s why it’s important. That’s why it’s likely to happen.
In terms of the big deflationary forces, there’s a significant overproduction in China. It’s very well-documented. I think potentially the biggest one is the aging of the Baby Boom generation and their move away from consumption to saving and perhaps even more important, they’re de-gearing and what that means for the efficacy of monetary policy going forward. And just in the short run, a strong dollar-a strong dollar has always been bad for people who link to the dollar. It forces them to run a tighter monetary policy.
I could go on about the forces of deflation. Technology in particular we could talk about for a whole hour and the deflationary impacts of technology. But there are many, many of them.
Merryn Somerset Webb: Let’s go back briefly to demographics. You are partially blaming the deflationary impulse in the global economy on Baby Boomers in America de-gearing.
Russell Napier: Yes, not just America. The Baby Boomer phenomenon is everywhere. If you look at the balance sheet of the Baby Boomers, something important happens this Christmas. As of the 31st of December at midnight, there will not be a Baby Boomer in the world who is less than 50. The last Baby Boomer turns 50. So, people always think they’re retiring. They’re not retiring. They’re 69-50. They’re preparing to retire. They’re hoping to retire. The simple rule of retirement is retire your debt or don’t retire.
Now, it turns out, not only are they a demographic bulge, they are a big dominant customer of the banking system. Now, if we go back to monetary economics 101, money is created by banks extending credit, and in the process they create deposits. And if their biggest customer is de-gearing for structural, demographic reasons, then it’s going to be incredibly difficult for monetary policy to generate all this money that we need to inflate away our debt.
So, five or six years ago, the general view was, “Look at this monetary policy that the central banks are running. There will be lots of money.” It hasn’t worked. Why? Because the banks haven’t lent the money. Common diagnosis of that is that the banks don’t want to lend the money. But I think people are forgetting there’s a very strong headwind of that Baby Boomer generation who want to repay their debts.
Merryn Somerset Webb: OK. Now, we’ve been here before with demographics and deflation in Japan. Is this similar to that experience?
Russell Napier: It’s similar. You’ve got to remember that Japan’s got 15 years ahead in terms of the demographics. So, our demographics don’t look dissimilar to Japan in the mid-1990s. So, this could be one of the reasons why monetary policy is not as powerful as it used to be.
I think the way you should look at a quantitative easing which is the way it was looked at by the man who invented it, Irving Fisher, is that it’s the oil in the machine, but not the accelerator. So, what Fisher said is that there are sometimes when a society has to de-gear. I would say that’s where we are with the Baby Boomer generation. If you don’t create money as you de-gear, then you get a 1929-1932 experience. Fisher said the central banker has to be in there creating money as the credit comes down. That way we don’t get the high-friction and the high dislocations that we did during the ’29-’32 period.
In that extent, I think quantitative easing has succeeded to the extent that some private sectors, not all of them but some, particularly American private sector, has fairly smoothly de-geared as the success of quantitative easing, but it hasn’t forced anybody to re-gear. It hasn’t generated more growth. It’s done what Fisher said it would do, but it hasn’t done what the current Fed said it would do, which pushes back into high levels of nominal GDP growth. Will that GDP ratio start to decline? It certainly hasn’t done it in Europe.
Merryn Somerset Webb: So, in this interpretation, QE can prevent disaster but it can’t improve the underlying economy and it can’t create inflation.
Russell Napier: It was designed to stop a debt deflation. It seems to have succeeded. Everything else has a new and modern claim for it and it doesn’t seem to be succeeding in that.
Merryn Somerset Webb: Is there anything else that the central banks can do to create inflation or are we at a dead end?
Russell Napier: If we’re sitting here in ten years, I’m fairly sure we’ll have inflation. I’m fairly sure nominal GDP growth with be above the growth of debt and all the democracies will be getting rid of debt in their tried and traditional methodology and way. I think we’ll attribute it, though, to the People’s Bank of China and not to the Federal Reserve.
We need a monetary policy which can generate-well, a central bank policy which can generate money and final demand. It seems to be the obvious place for that where that can happen is China, where you have a younger generation who are, let’s say, pro-consumption. That’s my euphemism for the younger generation of China. If we can get consumer debt flowing to them in a better way, then I think they would go out and consume a lot. It would be very, very easy for China to have 30-40 percent money supply growth within a year or year and a half if they chose to do it. I think that’s why China can potentially reflate the world.
But here’s the catch: it’s highly unlikely they do that without devaluing the currency in the process. So, that’s something we’re going to have to live through, I believe-a major devaluation of the Chinese currency. But the good news is that can set the field for true independent monetary policy in China, an end to their mercantilist pro-export system, a move towards consumerism. But we can’t get that move until we change the monetary policy, the focus on the dollar.
Merryn Somerset Webb: When you say we’ll have to live through devaluation of the currency, what do you mean? What is the impact?
Russell Napier: Well, I’m old enough to have lived through the last one. So, I witnessed what the last one meant. When the last one happened, China was a much smaller economy. But the implications of that are China became dramatically competitive. It undermined all its competitors and was directly responsible for the Asian Economic Crisis. They were directly responsible for the bankruptcy in Russia, directly responsible for problems in Latin America.
So, in the initial drop in the Chinese exchange rate, we get a huge deflationary pulse heading through the world for all goods priced in dollars, presumably even in euros and potentially even in yen when it happens. But we’ve got to weather that. We’ve got to weather it politically. We’ve got to weather it economically. I think we should try to do that because it’s going to be very painful.
But if the repercussions of that are a China which can produce a genuine expansion based upon demand and not supply-remember the history, really, of their last few business cycles has been creating more supply-if we can shift it through this, the supply, we’ve got to hold on and get through a difficult bit. But the difficult bit will be very difficult. If we have six years of quantitative easing and get deflation anyway, that might get some people quite concerned.
Merryn Somerset Webb: Apart from that, would you expect more quantitative easing from the US or do you think the Fed realizes at this point that it’s not working and they’re done?
Russell Napier: No. I think back to that initial point on quantitative easing, you have to keep doing it because you have to keep broad money growing. That doesn’t mean it’s necessary but not sufficient. You asked is there anything else that monetary policy could do if we picked on China. There are things that policy could do elsewhere.
So, if I had to pick the most likely thing to happen to reflate the United States of America, it would be the forgiveness of student debt. That isn’t a monetary policy. That’s a fiscal policy. The Federal Reserve can’t do that. They need the government to do that. When America has a government, maybe we’ll find out whether it can do that. But I think the time is coming when given a simple choice, do we extend the central bank balance sheet by one trillion dollars’ worth of wealthy people’s assets or do we move one trillion dollars’ worth of student debt from the student onto the state. That will take the second decision and not the first decision.
Now, the first thing students will do if you forgive them a trillion dollars of debt is borrow a trillion dollars. That’s a recovery. Now, when that becomes politically acceptable, who knows? But I suspect the time is not far away when the focus falls on that for reflation and not monetary policy. So, all the investors believe that the only thing that can happen from here on in is more monetary policy, more buying of their assets-everybody who owns assets as welfare. There are other ways, but they’re fiscal. They’re government policy rather than monetary.
Merryn Somerset Webb: Well, look, people say that QE is affecting fiscal policy anyway because of the way it transfers wealth.
Russell Napier: Well, yeah. We have certainly moved into a world where the true independence of the central bankers has to be questioned. As soon as you question their independence, you question whether they’re part of fiscal policy.
Merryn Somerset Webb: OK. Back to China, then, when do you think this happens? How does this happen? What makes China decide to reflate and save the world?
Russell Napier: Well, China has had an incredibly strange financial system in that they have retained the command economy banking system. They’ve changed many things in China but held onto that. They’ve had an economy which has grown where money supply wealth has grown at double nominal GDP. So, it’s an economy with a command economy banking system which has needed a huge amount of money to grow.
At this stage, their only supply growth is done at a very low level. Now, that suggests when we see this historically that the financial system may begin to creak at the edges. It may not be that stable. It may be unstable. Whether it’s the formal system or the informal system, things might start to go wrong.
Now, there’s a very simple playbook for that. We’ve seen it in 2008-2009. We’ve seen it over and over again. What do you do when your financial system starts to creak, when it looks like it might crack and capital might decline? You print money. If you’re going to print money and you have an exchange rate target, you’re going to massively increase the supply of currency. It’s most likely, not inevitably, most likely that the exchange rate will come down.
So, I think they’ll go to America and they’re probably go to Tim Geithner. They’ll probably hire him as an advisor. “What do we do now?” Tim will say, “Well, you can print money.” “OK. Let’s try that.” And then they can go to America and say, “The currency came down. We had to let that happen because if we didn’t let that happen, our financial system would be in trouble and that’s exactly what you did.”
That’s the playbook for China when the time is necessary. They’ve undervalued the currency since 1994. Obviously that let it go up a little bit. If it was this easy, we’d all do it, all paying to the currency of the dollar at a lower level and just sit back forever and have high export growth forever and it would be a wonderful policy. But it doesn’t’ work that way because eventually you get internal inflation which makes you uncompetitive. That’s where China is today. So, it is only a matter of time until the currency has to come down.
Merryn Somerset Webb: OK. When you wrote your book all that time ago, “Anatomy of the Bear,” you talked about how the next great bear market would play out. How does what we just talked about translate into your view on markets?
Russell Napier: Well, fortunately in the 2009 edition, I actually put in a bit in the preface saying they’re going to go up a lot first.
Merryn Somerset Webb: Phew.
Russell Napier: Indeed. So, there were signs that the deflationary expectations were undone, that inflation was coming back. I said we were in for a huge rally in the bear market. Well, it’s been a bigger rally than I thought for sure. I thought that was probably coming to an end by the middle of 2011.
Since the middle of 2011, I’ve been writing about deflation and why that would inevitably bring the market down again. Of course, it hasn’t. But it is worth pointing out what has come down since the middle of 2011. So, emerging market equities peak in April of 2011. Commodity prices peak in September, 2011. So, some things have been in bear market since 2011, but clearly not developed world equities.
So, someone said to me once, “Well, you got everything right except the market.” Well, given that my job is to get the market right, that’s not a great consolation. So, I’ve been wrong on the market for three years. So, what I note from financial history is the thing that can bring markets down quickly is deflation. Runaway inflation tends to bring them down more slowly. I just see so much evidence of the deflation out there that that’s what brings them down. I’ve been saying it for three years. So, maybe one day it will be right.
Merryn Somerset Webb: What will be the turning point that makes it right? You say you see deflation all around you. You expect more deflation. So, why haven’t the markets down already? It presumably is down to the constant money printing.
Russell Napier: The dollar, I think, is key to this. I’ve got a little chart of the dollar in my brain. It’s only in the last three or four months that it’s really become strong and really become a very strong propellant on the upward side. I think that’s the catalyst. I can analyse all these factors. But until the dollar starts to go up, that’s when you say, “Well, this could be the time.”
So, people will ask, “Why, what’s so important about the dollar?” There are so many people who link their currencies to the dollar. So, if you link yourself to a strong currency and you have to force your currency up in line with the dollar, that, on the whole, forces you to a tighter monetary policy. But worse than that, it’s highly borrowed across border. So, the world is full of people who borrow dollars, take the money and invest it in RMB, invest it in Indian currency, invest it in the Brazilian real and they use it to fund assets or purchases in those currencies. When the dollar starts going up, you effectively short the dollar.
There’s an old quote in financial history from Daniel Drew, one of the first great speculators. It goes like this. It says, “He who sells what isn’t his’n, buys it back or goes to prison.” If you’ve borrowed dollars, put it in RMB and the dollar starts going up, your board is going to say, “Cover it.” Don’t cover 100 percent of it because it may not continue, but cover a little bit of it.
So, there are these very rare periods of financial history where you get forced buying of the dollar as people seek to cover it. If you look at the chart of the dollar, it looks like we’re there. Forecasting currencies is incredibly difficult until you get forced buyers. It’s beginning to look like that. There’s nothing in the historical record that suggests emerging markets will ride that out smoothly. This has always been the time where they’ve gotten into trouble. So, the forecast was there three years ago. Deflation-well, we certainly haven’t had inflation. But the thing that might mean this is the time is the strong dollar.
Merryn Somerset Webb: So, how do we invest, assuming you’re right, which I’m sure you are at some point, how do we invest to deal with that really extraordinary environment?
Russell Napier: Well, I believe that the beauty of being a private investor is that you can do nothing. I know people watching this would not agree with that. But believe me, your options to do nothing are significantly stronger than the ability of a professional investor.
Merryn Somerset Webb: But there’s no such thing as nothing. Nothing is holding cash, right? This is not a nothing.
Russell Napier: That’s what I mean by doing nothing. Unless you think I’m completely wrong and we’re heading to rampant inflation-and of course, I could be and if that’s your view, you don’t own cash-but we’re at least in a period of low inflation. I think most people would agree with that. In a period of low inflation, you’re losing something on cash, but perhaps not a lot on cash.
I’ve often tried to find where I read this by Adam Smith, but he once said that, “The greatest of cause of distress amongst men of wealth is feeling that they have to do something.” Apparently Winnie the Pooh said something very similar. So, if Adam Smith and Winnie the Pooh thought it was good advice, I think it remains good advice. You have to wait for the right opportunity.
If I look back in financial history, certainly before World War II, the great financial success stories, the great wealth accumulators were people that had cash at the bottom to buy, whether it was Rockefeller, JP Morgan, Mellon. That all ended post-World War II because we never had deflation. Having all that money to buy assets, cheap assets from distress sellers hasn’t really been much of a policy in the post-World War II era but we’ve never lived through a period of deflation.
So, if you’re like me and you genuinely believe that that deflation is coming, then you take from the playbook of Melon, Rockefeller, Morgan, Carnegie and you’re ready to buy. So, it’s not doing nothing, as you say, being in cash. But in a period of low inflation, it’s as close as you get. You wait for what Buffett calls the fat pitch. There are very, very few fat pitches out there. In the world of deflation, there will be quite a few.
Merryn Somerset Webb: Is your own money in cash, Russell?
Russell Napier: It is, largely. It has some Japanese equities hedged back into the dollar. Apart from that, it’s pretty much cash.
Merryn Somerset Webb: Chinese equities, they seem cheap?
Russell Napier: I’ve never owned Chinese equities. I can’t say I never will. I think my problem is that I started out as a lawyer, not as a stock market forecaster, speculator, whatever people want to call me. As a lawyer, I look at things in a slightly different view. A lawyer says, “Is this entity that I own for my benefit?” The answer in a Chinese equity, in many cases but not all, is no. If I am buying, putting my savings to own an entity which isn’t generating profits for my benefit, why would I bother? I’m sure there are very good fund managers out there who can pick the ones that do. There are some that clearly do. But on the whole, they don’t. Therefore, I don’t want to be involved in it.
Merryn Somerset Webb: I’m guessing there are not Russian equities in your portfolio as well?
Russell Napier: That is the correct answer.
Merryn Somerset Webb: Is there any market at all that you would dabble in apart from Japan?
Russell Napier: No.
Merryn Somerset Webb: No. OK.
Russell Napier: People should know that I still have money in old equity markets because I might be long. I won’t say what it is. It’s not a huge percentage. But it’s public knowledge because I’m on the board of two investment trusts and they are global investment trusts. Because I’m a director, my shareholding is disclosed. So, I have money invested across the global stock market, but it’s not a high percentage. I think even the most bearish person in the world would probably have 20-30 percent of their money in equities because you might be wrong.
Merryn Somerset Webb: What about gold? Are you looking at gold just in case?
Russell Napier: Just a little bit but not very much. As a deflationist for three years, I have not been that keen on gold, but-and it’s a very big but-at some stage, if monetary policy doesn’t work, we get something else. That’s going to be government activism of some form. That’s what we discussed. We discussed it in context of forgiveness of student debt, but it could be something else. It could be exchange controls. It’s very hard to know what it could be.
Now, when you move from monetary policy to government activism, then I think there’s a chance that reinvigorates gold because it’s a confiscatory issue. If people believe that the state is in the business of confiscating their assets-I meet people every day who believe that already. They don’t have to see it in action for them to believe it. But if that becomes a prevalent view, then even in the world of deflation, it’s likely that the gold price would go up.
People would legitimately say, “Are you a bull or a bear? What are you actually saying?” What I’m saying is this-as a deflationist, you should have known it. If it starts to trade up on bad news, then it’s in a very prolonged bull market. The tinkering that the government does is bullish for it. When the government finally gets us back to a world flowing with milk and inflation, that’s very good for it. So, I think as someone who’s seeing a very long-term historical view, watch it trade. If it trades up on bad news, then that’s the time. But it doesn’t look like it’s doing that at the moment.
Merryn Somerset Webb: Russell, the other thing you’ve done recently which is very interesting is set up a new library in Edinburgh called the Library of Mistakes, which is jam full with books on financial disasters. Now, if you were to imagine what the next group of shelves would be filled with, what’s going to be their subject?
Russell Napier: OK. Well, one thing I’ve learned in the Library of Mistakes is that one of the most dangerous times in financial history is when people need an income and they choose yield. Particularly, there’s something magic about five percent. You see this in the novels and works of Jane Austen, that it’s the people when interest rates go well below five percent, it’s the people who choose the five percent who end up with financial ruin.
I believe we have an exact model equivalent of that, which is pensioners who are chasing yield in emerging market debt. They’ve been sold this as a fairly safe, low-risk investment where they can get the magical five percent that everybody needs to live on. There are many, many reasons why that isn’t the case. Financial history is just littered with companies and corporations who borrow one currency and invest in another currency. They get into trouble.
In fact, in Benjamin Graham’s post-war publication, “The Intelligent Investor,” if you look at that, basically, he said the first rule is never lend money to a foreign government. Well, this isn’t worse than foreign government. These are foreign corporations. So, with a strong dollar coming along as well, I think that’s bringing that home to roost.
Particularly worrisome is the way we’ve packaged it. This debt rests in open-ended funds. The history of lending to emerging markets was really bank debt. If one country went bad, the bankers didn’t necessarily pull their money from the other countries. But when you put this stuff into an open-ended fund and lets’ pick a country like the Ukraine, for instance, that couldn’t necessarily pay you back. It may not be possible to liquidate the Ukrainian debt. There simply may not be a market for that debt. So, the man who runs the fund or the woman who runs the fund, when the redemption comes finds himself liquidating something else.
So, the word is contagion. When you package something like this, it can be inherently contagious as to how this spreads. I believe that’s what we’ve done. I think that will clearly have a role to play in the Library of Mistakes going forward, which is how come the world’s developed world pensioners thought it was safe to lend money to some of the most dangerous and risky governments and corporates in the world. They were dangerous and risky for one simple reason – they borrow in one currency and they invest in another. It’s always been dangerous. It’s coming home to roost. Maybe we should have an annual prize and induct them into the Library of Mistakes.
Merryn Somerset Webb: The Library of Mistakes is never ever going to have enough shelves.
Thank you, Russell. I think we can summarize that by saying there is deflation. There will be more deflation. Hold lots of cash. Have some equities in case you’re wrong and never take your eye off gold.
Russell Napier: Yeah. And there’s nothing wrong in doing nothing.
Merryn Somerset Webb: Thank you.