China and America’s changing relationship could derail economic growth. Merryn Somerset Webb asks global strategist Russell Napier how to protect your wealth.
There is no better place in the UK to interview a global strategist (particularly one of a contrarian bent) than Edinburgh’s Library of Mistakes (LOM) – two small rooms in the Georgian New Town jammed with books and papers on the many, many financial disasters of the past. Russell Napier is also the keeper of the LOM – making it even more perfect. We start with China and the US – the link between their currencies is “the cornerstone of the global monetary system”. Give me “any asset price in the world for the last 25 years, and I can relate it to the link between China and America”, says Napier. Change the nature of that link, and you change the way the world works.
So how exactly does it work now? China has effectively been managing its currency (the renminbi – RMB) against the US dollar since 1994. That’s worked out well in some ways, but now that growth has slowed, the RMB may be overvalued, stymying all government efforts to stimulate the economy since last April. If an eventual trade deal with the US involves keeping the RMB at current levels (as rumours suggest), the Chinese economy will get worse, not better. Yet only a couple of years ago, I say, everyone was worrying about the RMB being massively undervalued (which made China’s exports too cheap). What changed?
Look at the current account and you can see, says Russell. China used to have a huge surplus (it exported more than it imported). It still has a fairly significant one with the US, but elsewhere “in aggregate, it is really very small”. That suggests the RMB is fairly valued or overvalued, but also that if China tries to hold it up artificially and also to buy more from the US (as President Donald Trump is demanding) it will end up in current-account deficit. That could leave China in a “bit of a pickle”. Why would China agree to this? Perhaps it won’t. But “some sort of deal is probably being cooked up” and it will almost inevitably be one that suggests lower growth for China from here.
What a slowdown in China means for the world
That means lower commodity prices (particularly bad for emerging markets); “credit events” in China (high levels of debt require high levels of growth if they are to be repaid); and a return to the world that all central bankers fear most – one “tipping back over to deflation”. This becomes a genuine risk if (when?) the China/US monetary link breaks. At that point, China won’t be able simply to devalue to another fixed rate, as in 1994. Then, its economy made up just 5% of global GDP. Today, at 19%, it “would be completely politically unacceptable. It would be banned from every goods market in the world”. Instead, China would have to adopt a fully flexible exchange rate. The RMB would fall “precipitously”, which would be deflationary for the rest of us. Then what? Every deflationary threat for the last few decades has been met with low interest rates and/or quantitative easing. But what if central bankers can’t solve the deflation that results from a huge Chinese devaluation? And what if the China/US spat is more than a spat? Take US vice-president Mike Pence: he is on record as lambasting China on everything from human rights to religious persecution, interference in American politics and trade. This could end up as a cold war.
This all implies a lot of losers. In a deflationary environment, debt becomes very hard to service. In a cold-war environment, emerging markets that rely on both the US and China for investment and markets have unpleasant choices to make. In a low-growth environment, corporate earnings growth suffers. And in all these scenarios, stockmarkets surely suffer. Equities outside the US may not be overly expensive, but they can still fall – there’s a big gap between fair value and cheap. As for the US, equities could “fall significantly, because they are grotesquely overvalued by any measure”. High levels of global debt and falling asset prices would make for a very nasty mix, given that “we have the most highly geared world economy… in our entire history”. Usually, says Napier, investors can ignore geopolitics. But the resetting of global monetary policy and of the relationship between China and the US? “This is a big one. This is important.”
Why the dollar is still top dog
Given that, I say, if you could hold just one fiat currency (ie, not gold) for a 20-year period, which would it be? “The dollar,” says Napier. Trump or no Trump, the US constitution is strong, as is the rule of law. The latter is the “number-one ingredient that attracts capital. I can see it crumbling elsewhere… I couldn’t put a single emerging market up and say to you – ‘I believe this emerging market will always back the rule of law’”. The same goes for China. As for Japan, it might back the rule of law, but one day the Bank of Japan’s efforts to inflate away its debt will work. “And you certainly don’t want to be holding the yen when it works.”
What’s left? Not the euro – the only way for the single currency to survive is for the superstate that the UK has been trying to avoid being part of, to exist – only a single fiscal and much closer political union can make it possible. But a look at the polls in advance of the European Parliament elections in May shows that most European Union citizens don’t want this level of integration. And “the rule of law in Europe is not the same as… in other countries”. Spain just had “12 democratically-elected politicians (from Catalonia) incarcerated for organising a vote… whatever happens in the UK or the US, I don’t think we would ever do that”. Let’s also not forget the one thing that is most unattractive to the global flow of capital: capital controls. The EU has twice used them to defend its monetary system (making a complete mockery of the idea of the inviolate four freedoms). “The idea that capital controls are legitimate is something that every investor should worry about.”
I wonder how he reckons Brexit is going. “Disappointingly.” For him it isn’t about an economic land of “milk and honey” outside the EU. It is about making “some really concerted moves to re-establish a representative democracy”. The loss of democratic accountability is not all the EU’s fault: power has been passed all over the place in the last few decades – to multinationals that don’t pay tax, for example. But we vote for people to go to Westminster, and we must make sure they have the power and authority to act as we would like them to when they get there. Erode that for too long and “you get yourself into a deep, deep hole”.
Leaving the EU “is one major step towards” changing things back. People like power to be as local as possible. Those who voted “remain” might want to think about the fact that on almost every occasion when we ask people if they want to devolve power rather than concentrate it, they say “yes”. So why would they want to be part of an organisation that “is absolutely committed to the centralisation of power that had to happen as soon as they put in a single currency?” When we leave, says Napier, “we will have the most decentralised, democratic system that we have ever had”. Our democracy at least will “flourish”. People think they want certainty out of the future – but certainty isn’t ever possible. Better, surely, then to have a flexible democratic system such as the UK’s – one that can cope with change – than an authoritarian and rigid one such as China’s?
If he was allowed to hold a second currency for his 20 years, would it be sterling? It would. And the UK stockmarket? “I am very tempted.” Any other cheap markets? This brings us back to the rule of law and to corporate governance. China and Russia are cheap, but “I want to be able to vote for the board. I want to be able to change the board”. You might say that these things are hypothetical for the small investor, but they are “the very core of what investing in equities is all about… So, I have never invested in Russia… I have never invested in China either, for similar reasons. I don’t believe that the management of Chinese corporations, with very few exceptions, is actually there with the power, ability and willingness to get me good returns. That is also true of quite a few Western managers… But at least there are other ones out there who are looking after and stewarding my capital with that aim. And those assets are legally protected”.
What to buy when governments get intrusive
What about gold? Napier isn’t a gold bug – someone for whom the answer to every question is “gold”. But he would hold it now. Why? First, we are facing a period of “more active government”. Governments want to redistribute wealth, usually via inflation, in which case you want gold. But it is not just inflation itself that makes gold attractive. It’s the fact that the government is looking at your assets and suggesting where they should be invested (which could also be sparked by the deflationary adjustment mentioned above). Everything in a wrapper of any kind (a Sipp or an Isa, say) can be pushed around by governments in the name of, say, macro-prudential regulation. Regulators could demand that we all hold government bonds in our Sipps, for example. Gold is less easy to manipulate. So more government is thus good for gold.
So there you have it. There is likely to be both deflation and inflation ahead. The UK hosts just about the only attractive stockmarket in the world. And if you want to protect your wealth from government, this is one of those times when you should probably hold gold (and not in your Isa).
• Hear the full interview at moneyweek.com/podcast
Who is Russell Napier?
Russell Napier is the co-founder of ERIC, an online platform for the sale of investment research (eri-c.com). He started his career as an investment manager at Baillie Gifford in Edinburgh in 1989 after studying law at Queen’s University, Belfast, and Magdalene College, Cambridge. In 1994 he moved to F&C Emerging Markets in London, then joined Hong Kong-based stockbroker CLSA as a strategist a year later. In 2005, he published the acclaimed Anatomy of the Bear: Lessons from Wall Street’s Four Great Bottoms (reissued by Harriman House in 2016), in which he provided a blow-by-blow analysis of how the bear markets ending in 1921, 1932, 1949 and 1982 played out. Since 2004 he has run a course for financial professionals – A Practical History of Financial Markets – at Edinburgh Business School. In 2014 he opened the Library of Mistakes, a library dedicated to financial disasters, in Edinburgh.