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Merryn Somerset Webb: Hello, and welcome to the MoneyWeek Magazine Podcast. I am Merryn Somerset Webb, editor-in-chief of the magazine, and with me today I have Sandy Nairn, or if you’re looking up his books online, Alasdair Nairn. For those of you who aren’t Scottish, Sandy is often short for Alasdair. Do you know, Sandy? I didn’t know that until I moved to Scotland.
Actually, that’s not true. When I met my husband, who’s also called Sandy, and then turned out to be called Alasdair, I was like, how does that work? And then I moved to Scotland and found that you’re all called Alasdair and Sandy.
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Anyway, Sandy is one of the founders of Edinburgh Partners. We have interviewed him in the magazine before. I’m sure that lots of you will have money invested with Edinburgh Partners, or you will have read one of my interviews with Sandy, so you know him well already.
And I also know that lots of you will have read his last book, Engines That Move Markets, but we are here today in the main to talk about his new book, The End of the Everything Bubble. So, hello, Sandy, and thank you for joining us.
Sandy Nairn: My pleasure. Good morning.
Merryn: The subtitle to your book is Why $75 Trillion of Investor Wealth is in Mortal Jeopardy, and I have a horrible feeling that some of that wealth is mine, and some of it is our readers’ wealth. So, can we start by, let’s have an overview of what on earth it is that you mean by everything bubble?
Sandy: I think the starting point here is to go back to the last period of financial crisis, the Global Financial Crisis, when the banking system nearly fell in on itself, and there were genuine and dire predictions of a potential return to the 1930s. And the central bankers at the time, they believed they’d learned the lessons of the 1930s, when you had a huge contraction in available liquidity, and they went the opposite direction, pushing liquidity out.
And without going into any detail, they proved very successful in the sense that the financial system did not implode, the banks did get refinanced. Partly to the surprise of everybody, inflation did not pick up, but one of the reasons for that was simultaneously forms of lending were curtailed, and then a bunch of other reasons. So, what we’ve had since 2007…
Merryn: Actually, Sandy, sorry, I’m going to interrupt you right there, because I think it’s really important, because I suspect we’re going to come on to inflation later.
I think it’s really important to be clear about why it is that we believe that inflation didn’t pick up after the financial crisis, because certainly as soon as the money printing began, we all believed that there was inflation coming, and it was going to come fast.
But what we hadn’t taken into account, and I think this is what you think, but correct me if I’m wrong, because the banks were deleveraging, the money went straight into the banks and got stuck there. So, it saved the banks, but it didn’t feed into ordinary spending.
Sandy: Absolutely, yes. And then, on top of that, the labour market structure was somewhat different, migration helped to suppress wages. There were a few other things, but the primary reason that the incremental impact of the central banks did not translate into inflation, I think, in my view, was the lending restrictions.
Merryn: All right, thank you. Sorry to interrupt you. I just wanted to get that nailed down at the beginning.
Sandy: Absolutely. I think just in addition to that, we’ve had secular trends for 30 or 40 years that have helped suppress inflation. And something we’ll come on to later is that all those secular trends are now either in reverse or about to reverse, whether it’s demographics, migration, single sourcing of supply chains, and the climate issues.
All of those are now in reverse, but that’s something maybe to come on to in a minute.
Merryn: We’ll come on to those in a minute, yes.
Sandy: But basically, we’ve had a period where the cost of money has been artificially suppressed, and if you want an explanation of why it’s an everything bubble, you can actually just go to the Bank of England website, and they explain what’s the reasoning. And the basically say, we’re suppressing the cost of money to make people take on riskier assets, to inflate assets, to make them feel welfare and make them spend. And they’ve been highly successful.
The issue and, in my mind, why we’ve got to where we’ve got to, is that the absence of inflation left policymakers, and central banks, with a view that you could continue on the same policy, indefinitely, without any inflationary impact. And when you say to a government policymaker, you can spend what you like and you can continue to finance at a zero real cost or close to zero real cost, it’s incredibly hard to stop them doing that, naturally so.
So, as a consequence, in previous asset market bubbles, what you’ve typically found is that there’s been a segment of the market, it might be the NIFTY 50, it might be Japan, it might be Asia, it might be bonds, it might be convertibles, but there are others that have not been inflated. But the difference this time is, in my mind, we have never seen an environment where we’ve had global suppression of the cost of money for over a decade.
And so, as a consequence, there are almost no assets that are cheaper, and there is a wide array of assets that are demonstrably, if you define expensive as relative to history, and you can come on to all sorts of definitions, are at levels that have never been sustained before. And when you add all that up and you say, I’ll just take it back to historic-type valuations, that’s how you get to that number.
Merryn: That’s how you get to the $75 trillion?
Sandy: Yes.
Merryn: OK, what we’ve had here over the last decade is an environment in which interest rates have been very low, inflation has been very low, obviously, and at the same time, we’ve been seeing reasonable GDP growth and very fast corporate profits growth. And if you were to assume that that would continue indefinitely, fast profit growth, very low interest rates, then a lot of these very high prices would make sense, right? It’s just that that assumption doesn’t hold.
Sandy: Yes.
Merryn: Let’s say that we could assume fast GDP growth, expansion of corporate margins, and very low interest rates forever, then you could say these prices do make sense. It’s just that that is not what’s going to happen, and not what is happening.
Sandy: Yes, but even on those assumptions, it’s not just fast GDP growth, it’s GDP growth that’s never been recorded since the industrial revolution. The implications of what’s required to get the profit growth, to bring this back into line, have not been seen before. And then you get to the internal contradictions of those kinds of levels of growth.
And I think the critical thing here, Merryn, for me, is to get those levels of growth, you need productivity growth at levels we’ve never seen before, and have not seen recently either. There’s not been a productivity miracle now.
It’s certainly true that there are lots of things going on that can lead to a lag of productivity growth, but it’s not at all clear that you can actually get above-trend productivity growth, to me, from where we are. And you need much more than that, so I struggle to see how, leaving aside even the internal contradictions, that that’s what could unfold.
Merryn: It’s interesting, though. A lot of people think, a lot of people who’ve come on this podcast have told me that the pandemic, and everyone’s actions during the pandemic, is one of the things that’s going to kickstart a productivity revolution. That we’ve seen a speeding up of digitalisation, a speeding up of automation, roboticization, etc, and a shift in the way people manage their supply chains, a shift in the way they manage their employees.
And all this is going to give us a massive productivity boom over the next five or six years. I’m not really hearing that from what you’re saying.
Sandy: No, I’m not. I guess I’ve got to be careful and not being dismissive. I think there are elements of that that are true, but there’re elements that are the exact opposite.
One of the things that both Covid and how geopolitics are unfolding on the supply chain, which we’re seeing in inflation, is the exact opposite, that single-source supply chain makes you highly vulnerable to a whole range of potential mishaps, and if any of those happen, you’ve got a real issue.
I think that there are a range of industries where that probably is true, but it’s only true to a degree. So, if you think about how some of the delivery mechanisms have changed, actually a lot, or a proportion of what you see, is heavily reliant on low-cost labour.
Those poor souls that are out on their bicycles on a cold evening in Edinburgh delivering food, there’s a limit to what you can gain from that. The logistics of delivery, and the things that go with it, enable the profitability at the centre, but there is a question of how sustainable that is in a labour market that may be tightening.
The sector that I work in, the general sector of the financial sector, is probably I would argue one of the least efficient sectors of the world, and has been least affected by digitalisation. And given that money’s a digital product, it seems odd to me that it has not been rationalised more than it has.
And I think there’s huge productivity gains potential in the financial sector, so I wouldn’t wish to be seen scoffing at the commentary that says that the pandemic has accelerated things. I’ve seen areas where I’m invested, both personally and professionally, where I’ve seen that, but it’s not enough to get you to the productivity levels that make the debt overhang go away. It’s just too big.
Merryn: OK, so when you wrote the book, what was it that you thought might bring the end of the bubble? For years now, the likes of you, the likes of me have been saying, this stuff is expensive. Goodness me, I can’t really see the US market getting any more expensive. Look at that CAPE ratio. Goodness me, the Q ratio, etc.
And it’s just kept going. So, obviously we’ll come on to this here and your take, because we’re just seeing a significant change in people’s expectations, but when you sat down to write The End of the Everything Bubble, what was it you thought would bring this to an end?
Sandy: I thought it was coming to an end before the pandemic began, and I thought you could see signs of the types of things that would’ve caused it. The thing that obviously causes it is sustained inflation, because it’s all very well having a negative real bond yield if inflation is 2%, but if it’s 5% and the nominal yield is close to 0%, then that really can’t be sustainable. So, that’s an obvious thing.
And then of course the pandemic hit, the Fed doubled the debt on its balance sheet, again for perfectly understandable reasons, so you had another deluge of liquidity, which I think gave it the final leg up, but I’m only guessing.
It’s not a very good analogy, but to me, the camel is bow legged at the moment. It’s got a huge burden on its back, and a feather could drift down on it and cause the legs to finally go.
So, it could be anything. It could be a policy issue in Europe. It could be the Ukraine, where people seem to be fairly sanguine about what might happen there. It could be geopolitics elsewhere. It could be US elections. It could be anything.
And I go back to fairly early on in my career, when the Bundesbank put up rates in Germany in 87 by a quarter point, and that was deemed to be what caused the 87 Crash. But obviously, quarter point in an economic sense is neither here nor there. It was the bursting of psychology that does it.
And it could be anything that bursts the psychology. It could be any feather floating down onto that camel. I just struggle to see, how do you make good returns in most asset classes from the valuations that we currently see?
So, I’m really not so concerned about, as I say, which feather floats down. I just want to make sure that when it does happen, we’re prepared for it and we have the reserves to take advantage of the opportunities that will subsequently appear.
Merryn: OK, but do you think it might be happening now?
January’s been a month where I think that the investment industry as a whole has had a bit of an inflation shock. I think an awful lot of fund managers and strategists allowed themselves to believe the transitory argument last year, that inflation will be transitory, that it will go very quickly, that the central banks, and the Fed in particular, wouldn’t have to put up interest rates.
And now suddenly, they don’t believe that anymore. Now they believe, or appear to believe, that inflation of 6%, 7% is something that one should expect for a good year, maybe two years, maybe three years. I’m hearing people begin to talk about permanently higher levels of inflation.
And so, it feels like there’s been that psychological shift already, which is how we might explain the extreme volatility in the stock market in the first month of this year. Is that the feather? Has it fallen?
Sandy: It could well be. The reason I wrote the book is, I find writing a very painful process. And part of the pain comes because it forces you to get your logic chains correct, and it forces you to make sure your data are accurate and properly processed. But I think of it a little bit like a pyramid. You start with the data, which are factual, then you put together an analysis which should be accurate, and then you come to make projections and thoughts off it. At which point, I’m not sure I have any greater insights than anybody else on that.
So, with that caveat in mind. And I don’t really feel it matters whether inflation is whether 2%, 3%, 4%, or 5%. If inflation is even just 2%, and bond investors demand 1% more, so you’re at 3% yield on the US ten-year, for example, how do you hold up valuations under that?
There’s no legitimacy, in my mind. The central banks, it’s not their job to pump up asset prices. It’s their job to protect the stability of the financial system, which they have done.
So, you’re going to get money rates returning to being market-determined, in my mind, one way or another. And the psychological bit may go before or after. I just don’t know. You did ask me my opinion, and I share your opinion. I think it is. I think the façade is dropping, and the repeated rallies, but I fear that as liquidity drains, the tide goes out with it. So, I share your views, but I am biased for all the reasons you know.
Merryn: Yes, but let’s get back to what we were talking about earlier, about the big structural trends that are shifting, that I suspect we might agree, you and I, are the drivers of this slightly higher level of inflation going forward. What are those big trends? I think I know what you’re going to say, but what are the things that are turning?
Sandy: As they say, in no particular order, you start with demographics. Outside of Africa, we have an aging population, more or less, so the dependency ratios are worsening, which means the supply of labour is tightening.
And we’ve had the opposite for 30 or 40 years, with incrementally the freeing up of the former, the countries behind the Iron Curtain, and then China and so forth. So, we’ve not only had positive demographics, we’ve had a political wave that’s been very supportive. That’s now in reverse, and secularly in reverse.
Secondly, for whatever reasons, migration, that used to be welcomed because of its positive economic impacts, where the evidence is pretty clear, is now not welcomed. Although, at some point, that is one that can reverse. I think when countries find they don’t have sufficient labour, that particular view tends to switch back around on itself.
But the migration flows are not helpful, so that’s more a short-term, but nevertheless tightening, impact. I’ve heard a lot of arguments that the drive towards cleaner energy will be lower cost and productivity enhancing, and I just don’t believe it, and I don’t think there’s evidence to support it.
And that’s not to say that we won’t get a situation where the cost of alternative energy comes down. I think the evidence of that is pretty clear, that it will, but nevertheless, there’s going to be an incremental cost, and it’s going to have to be added to by taxation to help causing the shift. Incentives alone I don’t think are going to be enough. So, that’s the third one.
I think the supply chains, and that is being discussed a lot more, but I think if you were in a corporate boardroom and you had these dreaded risk matrices and you said, my entire supply chain is single sourced and in a particular region of the world, that’s just not going to be…
And I don’t carry inventory. Those days are now over. So, the inventory channel will rise, there’ll be dual or triple sourcing, and I think there’ll be onshoring.
It’s interesting to me, that if you looked at the economics of the 20s and 30s, which is partly because where I come from, one of the issues for Clydeside and ships was every nation in the world said we have to build our own ships for military/strategic regions. And the Clyde, having had 40% of the world’s tonnage, everybody knows what happened.
It seems surprising to me, and everybody’s woken up to it now, that it’s not ships, it’s microprocessors and where they’re manufactured. So, exactly what happens, I don’t know, but it doesn’t lead to lower costs, it leads to higher costs. I think those are the four or five major trends that are not supportive.
I think the one other, and I don’t really know how this pans out, but it’s interesting that social media in terms of wage bargaining has entirely been supportive of the employers. So, you’ve got people working in jobs where they basically have a GPS in their back, and they’re monitored for productivity. It’s like Taylor’s efficient manufacturing taken to the nth degree. But the ability of labour to organise has gone nowhere, yet social media, you would have thought would have been supportive.
And as labour markets tighten, you might see the pendulum in the labour market just swing back a bit. I don’t think it goes back to the 70s, for a whole range of reasons, but I think the pendulum does swing back a bit.
Merryn: Yes, I wonder about that as well. I wonder, looking at it, have people got things the wrong way round? People say that wage inflation has fallen because the unions have lost power, but I wonder if the unions lost power because inflation was low – ie, when inflation is low, people don’t feel a desperate need, although I think they should, but they don’t feel a desperate need to go out and fight for higher wages, because they’re not seeing their purchasing power fall. So, they don’t need the unions, or they don’t feel they need the unions in the way they used to.
But possibly as inflation rises, organised labour will gain power again from the inflation itself, as people want to organise. So, I wonder if people are looking at the history of the interconnection between wage inflation and unions, and actually got the causation the wrong way round.
Sandy: Yes, I think there’s something to that, and I think the causation can flip back and forward, depending upon circumstances. And I think also, although the productivity gains that we had did not flow to labour, they flowed to the companies, which is why margins went up, I think I would anticipate seeing a reversal of that.
I think also that although wages were largely stagnant in significant parts of the labour market, the falling cost of a range of consumer goods, even if the cost didn’t fall that much, the utility of what you were getting for your money went up, meant that the cost-of-living increases weren’t as bad as might have been suggested in some of the numbers.
But that’s not what’s happening now, so there’re plenty of reasons. And it’s still anecdotal, but in many places the anecdotal is overwhelming, even though it’s anecdotal, in terms of what’s been needed to be paid for the attraction of labour.
And then you get into skilled versus unskilled, and the segmentation between them, but I just think there’s very little evidence to the contrary. So, the evidence is, this is rising, and the only question is, for how long? But as I said before, if you think inflation’s 2%-plus, as a bond investor, why do I want to take a real loss year after year? And if there’s upside inflation, I definitely don’t.
And as I say, that’s the large part of the reversal, because the central banks, there’s no justification. I don’t think there’s a central bank justification for continuing to flood the world with liquidity, to keep asset prices up in and of itself. There has to be another reason for it.
Merryn: So far, so depressing-sounding.
Sandy: Thanks very much.
Merryn: No problem. You’re not the first on this podcast.
So, good news, the wages might go up. I’m pleased with that. I’d love to see wages go up in real terms. Although obviously this podcast is mainly going out to investors, I think we might all be pleased to see a slight realignment of the proceeds of growth between capital and labour.
But here we are, possibly coming to The End of the Everything Bubble. But we want to have DC pensions. We’re all desperately trying to save enough and grow our assets enough to be able to retire one day.
If markets everywhere and every asset is massively overvalued, and inflation is running at 5%, 6%, and we can get almost nothing on our deposit accounts, so we lose money and we lose purchasing power, so we leave our money in cash, we’re go to lose a lot more potentially if we leave it in the markets. What on earth do we do? Do we accept that there is no way to not be poorer in five years, or is there something we can do?
Sandy: It’s something we see a lot, and you’ll have experienced it a lot in investment, and that is that people start with the outcome. It’s a bit like being a lawyer, an advocate, a barrister. You start with the outcome, and then you work back the logic that gets you to the outcome. And if the outcome you want is continuing rising assets, then you come up with a scenario that can potentially get you that.
But obviously, the chain of logic goes from where you’re valued, to what returns you can expect. And to me, it’s slightly inexorable. So, the answer is, we are poorer than we think we are.
Merryn: Already.
Sandy: Already. And some of the wealth that we see is an illusion, and one needs to think about that. The one bit where there’s potentially a little bit of solace, but many would argue potentially rightly that it’s dangerous, is cash. Because obviously, inflation eats away at cash, but it depends how long you’re in cash for.
So, it’s a bit of a footrace between, what do markets do? How long do markets stay where they are before they come down? Assuming the arguments for them coming down are correct, and the cash reserve that allows you to buy when they do, and the clock resets itself. And I think there’s not enough knowledge or insight or foresight to say, you go 100% one or the other.
Merryn: I was going to say, in your professional life, you can’t be sitting around having all your funds in cash. Apart from anything else, we’re not going to pay for that.
Sandy: True. Although, obviously what people should be paying for is, asset growth and preservation of wealth, however achieved. But there are different amounts you pay for it. That’s fair enough. To me, I would say why cash levels are at a historic high is because asset markets are at historic highs.
There’re still significant investments, but the investments are hopefully in areas that will be the most resilient to what’s happening. And there are some potential vehicles which would operate in the opposite direction.
For example, I put some assets in a long/short fund, because one of the things you’re going to find is, in a frothy environment there’re going to be lots of companies where probably the business model is long-term fundamentally flawed, that there are evaluations that can’t be sustained, irrespective of what markets do.
But their decline would be accelerated by a market fall, so as a consequence, in a market fall you might find some upside there, but these are at the margins. If pretty much all asset markets are expensive, it’s hard to find things that will make you returns.
But I think also my return expectations are a lot lower, so there’s a universe of stocks that I think it’s very small, but there are potentially some positive returns.
Merryn: OK, can you tell us about any of those? Give us a high to go out on?
Sandy: There’s just a number of stocks that are significantly out of favour, with decent yields. They’re not cheap, but they’re not ridiculously expensive, and therefore, sure, they’ll go down a bit when the market does, but they’ll go back up. And interestingly, telecoms are coming back into favour again a little bit. They probably, as a utility, have some pricing power.
Merryn: Telecoms in the UK? Are we talking about the UK market here?
Sandy: Globally. Not all of them, because obviously there’re company specifics. But most of them carry a bit of debt, which you would say would be difficult, other than the fact that a lot of the debt is long structured. So, inflation slightly erodes it, and they have pricing power, and telecoms are a utility.
Now, growth is mediocre at best, but you probably get a decent cash flow and yield, but nothing to get particularly excited about. I think that human ingenuity is a wonderful thing. I’m not depressed at all about the world. I just think we’re at a stage in history that we haven’t seen before, that the returns we’ve seen in equities and bonds are illusory.
And if you step back and try and protect yourself, you’ve got… People talk about there’s so much liquidity, this can’t happen. I think the liquidity is an illusion, and will be shown to be so. And if I have liquidity when it all happens, we’re going to be able to do well for investors.
Merryn: And why is liquidity an illusion?
Sandy: Because it’s debt. It’s just the other side of the balance sheet. If the Fed is $8 trillion or 9$ trillion, which is 40%-plus of GDP and debt, and that gets drained out, then there’s an impact with that. There’re a lot of assets that are also in a bit of a merry-go-round, passing from hand to hand with ever-higher valuations, and then that merry-go-round stops, and they need to be funded.
We didn’t create the wealth. We just printed some more money. And there are only two ways it goes, it drains or inflates, eventually.
Merryn: But there is a view, Sandy, that the UK market is not overpriced.
It’s not that far from its historical average levels. And it also plays into what you were talking about earlier, the extra costs that will be added because of the transition to net zero, and we have a lot of the oil companies, mining companies, etc, that will help mitigate that along the way. Is it possible, let’s say, the FTSE 100, which interestingly, it appears to be actually outperforming other markets in the first month of the year, a possibility that the UK might be maybe not a safe haven as such, but slightly more resilient than possibly the US market?
Sandy: Yes, I think that’s fair. I think that’s definitely fair. Obviously, it gets a bit boring when you start going into the different market structure and what companies are listed there and so forth, but as a general rule, I think that’s not an unfair comment.
Merryn: OK, good. I’m going to stop right there then, because that was almost positive. I didn’t feel huge positivity, but I felt a little low level of it’s all going to blow, so let’s leave it there.
Sandy: OK.
Merryn: Thank you so much.
Sandy: My pleasure.
Merryn: And everybody, you must go out immediately and buy The End of the Everything Bubble by Alasdair Nairn, Why $75 Trillion of Investor Wealth is in Mortal Jeopardy, some of it, I’m afraid, likely to be yours. While you’re on Amazon buying Sandy’s book, please do also look for mine, Share Power, which is about the renaissance of shareholder democracy and how important it is.
John and I will be doing a podcast on that next week, so if you want to ask me questions about it, get it now, read it now, and send those questions in, and we will make the discussion about things that you want to talk about.
Otherwise, if you’d like to hear more from MoneyWeek, you know where we are, MoneyWeek.com. Sign up there for Money Morning, our daily newsletter, which is mostly written by John, and absolutely excellent. Otherwise, what else can you do? You can follow us on Twitter @MoneyWeek. You can follow me on Twitter @MerrynSW. Sandy, are you on Twitter?
Sandy: No.
Merryn: Do you use any social media?
Sandy: No.
Merryn: Is there anywhere, apart from your books, that the readers can learn what you’re thinking?
Sandy: No.
Merryn: OK, that’s that, then. You’d better go out and buy the book, everybody. Sandy, thank you so much.
Sandy: My pleasure. Thank you. Bye bye.
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