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- Opportunity Is Coming: Equity Prices Will Be Much Cheaper
The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
Russell Napier: Cold War Between China & US – Prepare For Paradigm Shift
June 5, 2019
“There has never been a better time to be alive despite this. And this is a very simple fact. It has nothing to do with China. This is the problem. It’s the financiers who have gotten the world into this mess. But the world outside of China is looking pretty good, isn’t it? The world is in a much better place since 1968. Just because we are somewhat upset about the word finance and the valuation of assets and the distortion of those assets [unclear] doesn’t mean we have to be pessimistic about the future for humanity.”
– Russell Napier
Kevin:I always get excited with our next guest, Russell Napier. We have had him on a number of times, but David, before I had ever met Russell Napier or knew of him, you had me read a book called The Anatomy of the Bear. It was one of the more amazing books of a man who curiously went back and looked at history to fully understand when a market is undervalued or overvalued. Actually, it was more of a social commentary than it was a financial commentary.
David:As you know, one of the things that I love about any book is the bibliography, and the bibliography for The Anatomy of the Bearwas one of the richest resources I have ever come across in terms of financial and economic history. And as it turns out, Russell’s interest in all things economic and financial and historical is profound, curating the Library of Mistakes there in Edinburgh, Scotland, teaching courses on the subject matter all over the world. There is a reason why that bibliography is so rich. There were many significant financial investments that I made to that part of my library after going through that bibliography.
Kevin:Yes, Russell is a fascinating guy. One of his goals in life is to surround himself with curious people. Of course, like you mentioned, he started the Library of Mistakes there in Edinburgh, Scotland, and I know that has actually, David, been a dream of yours, to have an extension here in the United States of the Library of Mistakes.
David:I think within the next two or three years that will happen – building space, and having not only our Wealth Management offices in that new space, but also accommodating the 3-, 4-, even 5,000-volume library, which like that at Edinburgh, looks at the chronicling of corporate governance, economic history, financial market gyrations going back to the beginning of recorded time. It’s something I am very passionate about getting done here in the next few years.
Kevin:As far as Russell’s current writing and the things he is thinking on, we are about to experience, or we are experiencing, something that, really, we haven’t had since the 1960s, and that is a major structural change to the way the world works – in particular, a cold war that is developing between the United States and China.
David:When you think about the monetary system and what was Bretton Woods, and what is now a free floating system, we have been operating in a certain way, and that is one of the things that we will discuss with Russell today, the change in the structure of the global monetary system.
Kevin:That, and I hope you also cover Deutsche Bank, as well, with what is going on in Europe.
* * *
David:With us, again, on the Weekly Commentary is Russell Napier. Many of you know him as the author of The Anatomy of the Bear. Some of you may not know him as the curator of the Library of Mistakes, but also teacher of an excellent series of courses there in Edinburgh and around the world relating to market financial history. I was in one of those classes in Edinburgh just a few years ago and fully intend to join him again at some point when my time allows and his offerings are accessible.
Russell, thanks so much for joining us again.
Russell:Delighted to be with you.
David:There are two things that I would love to cover with you and I tried to organize some questions around. First, the European parliamentary elections and some of the things that are important for us to keep in mind in terms of the structure and viability of the euro project. And then secondly, I would also like to look at some structural changes in Asia, particularly in China. For several years we have seen the increase in populism across Europe and around the globe and you have had centralization in the eurozone. That theme has now, and in recent elections, been under pressure. We have the recent parliamentary elections behind us. What are the markets telling us about the short-term prospects of growth in Europe, and the long-term prospects for the euro project as a whole?
Russell:We have some very clear signals from the markets. Sometimes the markets don’t give you clear signals in the middle, but on this subject they are very clear, indeed. The German ten-year bond yield is at an all-time low. That all-time low, by the way, is -20 basis points per annum for the holder of a ten-year. So that is very low, indeed. The [unclear] ten-year has gone to an all-time low. That is also a negative number. The Dutch ten-year is very, very close to an all-time low. The Swedish one is very close, as well. So categorically, they are not building in growth in inflation.
Another market which I think is fascinating is what you call in the United States the Pips market. We have those instruments for Europe, as well. We have them for various countries around the world. And according to the implied inflation rate in Pips the country in the whole world with the second-lowest level of inflation for the next five years will be Italy. Japan will be number one, Italy will be number two, and Germany will be number three. So those markets are very clearly saying that there will be no inflation in Europe. I think that means probably there is not going to be very much growth in Europe.
It is also interesting that the Italian bond yield, ten-year bond yield, is nearly 2.5, so quite a gap has opened up between that and the Germans, so there is clearly a question mark for some people over the stability of the euro project where it relates to Italy.
And just a final thing before we go on to what I think in terms of what the markets are telling us, the share price of Deutsche Bank, which is one of the world’s largest commercial banks, I can [unclear] the share price back to 1992, but it is below its 1992 level. What does that mean? Well, I think it is impossible for anybody in the modern era to accurately divine the difference between the assets and liabilities of a global bank, it is so complicated. But the share price of Deutsche Bank is certainly telling us that that bank has some very, very significant problems given where it is.
And there are many banks in Europe, very large commercial banks, that are also looking at share prices at new lows, at least for the past 20 years. At least we haven’t seen the share prices at current levels in this millennium, and that includes French banks such as Soc Gen. So the first point is, what are the markets telling us? They are telling us something very dire, indeed, because we’re now looking at numbers below March 2009. We’re looking at bond yields below March 2009, we’re looking at bank share prices below March 2009. So we’re clearly not looking at a land flowing with milk and honey in terms of Europe.
I will just quickly add on top of that the European Parliament elections. There has been a fracturing there. There was a moderate left and a moderate right, and there has been a fracture, they are declining, and they are being replaced by a more extreme right, but also a more extreme left, which is the untold story because the Green party, whatever one thinks of its ends, the means to those ends are pretty far to the left. So, your listeners will know that Europe is trying to create a single currency. I think when something runs for 19 years you tend to believe that it has actually been achieved, but it hasn’t been achieved because the essential ingredients of a single currency would be a much closer single fiscal policy and a much closer political situation if there is to be no taxation without representation.
So the fracturing of politics within Europe makes that centralization much, much, much less likely. And it is interesting the schisms that have opened up. There is always a schism between the centrists, those who believe in the United States of Europe, and the sovereigntists, those who believe in the independent nation status of Europe. But this new schism that is opening up is between, I think, young people who believe in green issues and older people who believe in sovereignty, and that is all mixed up into the Constitution.
I know people will say, “Well, that’s just the world. The whole world is like that,” and they are prepared to accept that. But the whole world isn’t trying to create a single currency. So if you are looking at where all these schisms are opening up in the world, where they have they have the greatest financial implications, the greatest financial implications are in Europe because it makes the single currency much more dysfunctional than it has been for some time.
David:We had, at one point, the discussion about blending the companies, but Deutsche Bank and Commerce Bank, and to me it had the ring of something from the past – a past bank merger, Credit Anstalt – which did not end well. Do you see particular weak spots in Europe? Is it the German banks, is it the Italian banks, or are we really talking about the markets in general which could come under pressure?
Russell:I think it is a good question and I will just expand it to financial systems rather than just banks, and then talk about Northern Europe. Because the last question was about banking we tend to think that banks are the key thing. There are clearly problems for banks, but let’s discuss the problem. We used to have a thing in the United Kingdom when we had fairly old-style banking, retail banking. We used to call it the 3-6-3 model which was borrow at 3, lend at 6, on the golf course by 3. This is if you were a banker. So you took deposits at 3%, you lent them at 6%, and you got to the golf course at 3 in the afternoon.
In Germany – and I’m not particularly picking on Germany, it’s most of Northern Europe – short rates were zero, long rates were zero. So you would take deposits at zero, you would lend at zero and you spend zero time on the golf course. It sounds a bit flippant, but we, in the history of banking and banking really dates in its modern forms from the late 17thcentury. It’s based upon borrowing short and lending long, and we really haven’t been in a period where you haven’t been able to borrow short and lend long. When that comes along for the first time in history, and this is the first time in history when it has been zero to zero, there is no banking system that is profitable.
And to expand it is also incredibly difficult for insurance companies. Now, insurance companies have a guaranteed payout, and they have guaranteed, if you like, liabilities. Then it’s not so difficult. But the history of Germany is that there is a big legacy, in particular for insurance companies, where they have a guaranteed payout, or a guaranteed yield. And of course, delivering any yield in a world where your risk premium has gone to zero is incredibly difficult.
This is a well-known story, and it’s a well-known story that the financial system of Northern Europe is being completely undermined by this yield curve. Why is a well-known story not having more global prominence? Why are people not talking about it? Because none of us really know when that time bomb that ticks finally hits that horrible moment when it goes off. Nominal yields are on ten, and ten years have been below zero, were below zero for about four years, being below 1% for about eight years. And we just don’t know when the first institution basically gives up the ghost. Moody’s, for what it’s worth, are forecasting insolvencies in the German insurance companies this year. These could be small ones that will be bailed out by the government.
But frankly, although we always focus on Europe, on the failures, and the Italian banks – it used to be the Irish banks – we now have to focus at the very core, and if one is looking at the worst bank share prices in Europe, one is now looking at the very core of Europe. And it is because they have this attempt to create a single currency, it has created the wrong interest rates at the very core of Europe, and that is the price whereby [unclear] is really important because solving a problem at the fringes – we have done that. We have solved problems in Greece, Ireland, Portugal and Spain by bringing interest rates down at the fringes. But what happens if the core problem is that interest rates are too low at the core?
So I think markets are beginning to tell us that we have this great problem right at the very core and right at the very heart of the financial system of Europe. And whether it is life insurance companies that get into trouble first, or banks, I am not so sure. We don’t have a lot of visibility into some of these German life insurance companies. They’re not listed. They are state-owned, or local state owned. The banks, we just happen to have visibility through the share prices, but something is rotten at the core of the European financial system.
David:So when we think about what has worked at the periphery – the lowering of rates and keeping them at an unnatural level for quite a few years now, are you suggesting that there is a problem, ultimately, whether it is with particular companies within that system, or to the financial system as a whole, that the financial system cannot sustain unnaturally low rates on an indefinite basis? Tell us how it is that the world’s central bankers have grown so accustomed to this idea. This is a normal mindset now, that we just lower rates even below the zero-bound, and because there have not been any negative implications there are not likely to be. At least, that seems to be their view.
Russell:Yes, I would definitely set Europe apart from other countries. Obviously, we know the interest rate structure of the United States. And it’s not necessarily about central bankers having a short-rated zero. It’s about the yield curve. The U.S. yield curve may be nothing to write home about, but all the evidence is that U.S. bankers are able to lend money profitably, probably taking on commercial risk, as well. So whatever we think of the yield curve as outside observers, American bankers seem to say, “Well, we can make money on this.” They are reporting profits on this and I think [unclear] consensus on this, I don’t think they are taking [unclear] risks to do it.
The yield curve that is completely destructive is that Northern European yield curve because there is nothing at the long end for the bankers to go to. So obviously, there are other problems associated with very, very low short-term interest rates. There are massive distortions in that. But in terms of which set of interest rates and yield curves are destroying financial systems, the American one has problems, but I think the Northern European one – structurally, you can’t run a bank – and that is the difference. American ten-years are not at zero, but they have been at zero in Northern Europe for many, many years now.
David:We have within Brussels the presumption of control which has included policies and politics designed to influence the market, and now it seems that you have market realities swinging back and are redefining politics in some small irony in which the conflict over centralization continues. If that conflict continues are European equities still vulnerable from here?
Russell:I think they are very vulnerable and this is why I’m saying they are a lot cheaper than U.S. equities. There is a stunning statistic when you look at that special U.S. special European Index, MSDI, Europe index in dollar terms. It is obviously now below where it was in 1999. Now, that is not as bad as it sounds because obviously one has gotten dividends over that period, and one could have reinvested the dividends.
But it is still pretty dramatic when we say that the capital index for Europe, and that is not the case for America, so American equities have done spectacularly well. Clearly, the dividend volatility in 2008-2009, but they have not done spectacularly well in Europe. They have been dreadful. In fact, the whole history of the euro has been a history where the equities have gone absolutely nowhere in Europe.
So to some extent you might say, “Well, it must be [unclear] in the price. Now, after 20 years of a crushing of the European economy by this attempt to create a single currency, a crushing of asset prices by this single currency, surely now they are cheap. Now the headline numbers, I think they genuinely are cheap. But it isn’t over yet, and it wouldn’t be over if Europe had created a functioning single currency with a functioning fiscal policy, and a functioning political system to back up and legitimize the fiscal policy.
But I don’t think anybody thinks that is where Europe is, and I think most people would concede that we have been going backwards now for several years based on the [unclear] on politics. So it can absolutely get much worse. Absolutely, because remember, we have not had a recession since 2009 in the U.S., and we haven’t had that crisis in Europe since 2011/2012. What happens if we have a recession from here? I’m sure you have seen it, and most people. The manufacturing numbers and the growth numbers for Europe are very, very poor.
How do we get out of it this time, given where interest rates are, given how extended the central bank balance sheet is? How much lower can they take interest rates to drive growth? The answer is, not very far, indeed. If there has to be an answer to the next recession in Europe, which could be upon us, that will rely on fiscal policy. No doubt it means agreements, and it means agreement amongst the more and more diverse political parties of Europe.
So it’s not always about diseases, David. Sometimes it is about the remedies, as well. And Europe, given its fractured governmental and political system, doesn’t have the fiscal response. America, whether you agree with President Trump’s fiscal response or not, the country is capable of delivering one. Europe is not capable of delivering one and its monetary policy increasingly seems to have failed. So putting any political system, never mind economic and financial system, into recession can cause all sorts of unpredictable woes, and I think that is the risk now for Europe. The lack of response just makes the political situation even worse.
David:Part of the financial market vulnerability that we see revealed by the European parliamentary elections here is that you don’t have unification in Europe, and if the next round of crisis requires fiscal policy unification, Exhibit A is the green agenda, which doesn’t really complement centralization or unification. We have generational issues, which you pointed to, but also a fracturing of the old political system and just creates a little bit of concern for the investor in Europe.
Frankly, of greater long-term importance than the parliamentary elections in Europe is the percolating conflict between the U.S. and China. So we could pivot to that. Here in the U.S. the conflict has been scripted as a trade issue, with trade deficits playing a lead role in that story. Give us your thesis on why this misses the bigger concerns. You say it is not often that there is a change in structure. We tend to focus on changes in cycles as asset managers. Tell us what is in play, in your view.
Russell:This is the biggest structural change of all because I think it is a cold war that we have between these two countries. Now, a cold war is fundamentally different from a credit war, because it involves things that are way beyond credit and particularly in terms of savers, and that is really who is listening to us today. It involves restrictions of the free movement of capital, as well as in the free movement of goods. And I think if one just steps back a little bit and looks at the Huawei dispute, for instance, this is more than about goods and services, it’s about free movement of capital. The last cold war I’m certainly old enough to remember, David. You’re a bit younger than I am. But it is inconceivable, not just that countries trade with each other in a cold war, but that we invest in China and that China invests in us. These are not conceivable things in a cold war. So it is very hard for me to give you all the evidence that it is going to be a cold war, but I would like to quote from Vice President Mike Pence’s speech just a few days ago to the graduating class at West Point, which might give you some idea of this, and this is what he said. “It is a virtual certainty that you will fight on a battlefield for America at some point in your life. You will lead soldiers in combat. It will happen. Some of you will join the fight on the Korean Peninsula and in the Indo-Pacific when North Korea continues to threaten the peace,” and this is the bit that sort of jumps off the page, “and an increasingly militarized China challenges our presence in the region.” Those of you listening who want a more in depth analysis of Mike Pence, October 8thlast year he gave a very major speech at the Hudson Institute. Mike Pompeo has spoken today about Tiananmen Square and the legacy of Tiananmen Square. It is a full frontal attack on modern China, not the China of 1989. I could go on and on.
One tangible thing beyond the speeches – there are people in the world who don’t believe anything the Trump administration says, and I think that is incredibly dangerous. I think we should take this incredibly seriously. And for people listening to this who tend not to like the president that is not a good reason to not listen to the administration, and there is a lot of that going on. The tangible manifestation of this could be missiles because America is fully on course to leave in August the missile treaty with Russia. This will allow it to build more missiles, and it is almost certain that these intermediate missiles will be heading to Asia.
So for those of you who think this is saber-rattling on the fence, saber-rattling on ideological differences, purely for trade purposes, for trade leverage, I think the big minute when we realize this is really a cold war is if the intermediate U.S. missiles begin to head to Asia. So I would say, if you’re going to call a cold war, that’s a three-hour talk rather than a five-minute talk. But I hope some of those direct quotes from the administration make it pretty clear that this is something much, much, much bigger than trade.
David:In the U.S. we have a history of regime destabilization where we find competing national agendas to our own. How do you see the weaponization of finance occurring in this particular chapter? I think of Juan Zarate’s book, Treasuries War, the way that we conduct a lot of our foreign policy through the U.S. Treasury.
But again, coming back to the weaponization of finance, how might that apply to China?
Russell:I think that the fear that the markets have – and I’m just talking finance here and I don’t want to put this out of context. Obviously, there are much more important things than finance in a cold war. But the fear market [unclear] have on finance is Chinese dumping of treasuries. Now the ownership of treasuries by the Chinese is at least a trillion, arguably 1.4 trillion. There are certain different ways you can measure it. It sounds like a lot of money, it is a lot of money, but it is now less than 10% of the entire treasury market. The Fed, by the way, owns 2.1 trillion of treasuries. That balance sheet has shrunk. It was much bigger.
I think, ultimately, if the Fed wanted to step into the market and buy these treasuries it could buy them. We would all be throwing our hands up in horror expecting runaway inflation, but once again recent history suggests that may not happen. In terms of the weaponization of the treasury market by the Chinese, it may sound naïve, but I’m not that worried about it in terms of a 17-trillion U.S. dollar market, and not just the ability of the Federal Reserve to buy, but we have, particularly in recent weeks, seen very significant demand from the private sector to own treasuries yielding about 2% in a world where other government bonds yield zero.
And then there is the Chinese impact on America is terms of the weaponization of finance, and I actually think it is relatively limited. America’s impact on China is much, much, much bigger, because China has a managed exchange rate regime [unclear] capital. We couldn’t necessarily have said six, seven, eight years ago that America had a huge leverage over China because China had a very large current account surplus which is a buffer to protect it. But that buffer has gone. The president is obviously keen to make it even lower, given his tariffs. But actually, it is capital more than accounts. For those of you professional investors who listen to this will know that there has been a change in index weighting recently for equity of bonds, and that should have capital flowing into China to support it. But I think the more we get these cold war style speeches, the more foreign capital will be wary about putting money into China. And I wonder in a cold war how conceivable it is that American savings would be allowed to fund the Chinese Communist Party in a cold war? And there may be calls of hypocrisy because clearly the Chinese government previously has funded a lot American finance. But I think hypocrisy counts in a cold war. And China needs capital if it is to maintain its exchange rate and growth. These levers, I think are very significant, that America has. And I don’t that that China’s levers are quite as powerful.
The unknown and known are a difficult bit as to how the rest of the world reacts, which side the rest of the world finds itself on. I may be naïve but I think the rest of the world finds itself on the side of America, but obviously there is room for considerable surprise if we find other nations of the world deciding that they side with China in this cold war. So that is the unpredictable bit of the war of finance, I think, is estimating who is on which side of the fence and can anybody straddle the fence and be friends with both nations simultaneously?
David:We have had 30 years of disinflationary growth if we’re looking in the rear-view mirror, and you could attribute that, perhaps, to the fall of the Berlin Wall, or very constructive engagement with China over that period. You would say that the next 30 years looks quite a bit different, no?
Russell:Yes, I think the next 30 years we have to bet on inflation. I don’t think that means the next 30 months, which we could come back to, but over the next 30 years, I think so. You mentioned the fall of the Berlin Wall. The mobilization of Chinese resources, particularly post 1994, which was its last revaluation, has been truly immense. That exchange rate fell a long way in 1994 and what we didn’t realize is just how big the excess resources of China were and probably more importantly, they were mobilized in a much more rapid fashion – I wouldn’t say than any economy in history, but certainly any major economy in history never mobilized resources that quickly. It was hugely deflationary.
And the last major economy to mobilize resources that quickly was the United States. I can’t remember how long it took to build the Erie Canal but China was able to produce its infrastructure even quicker than the United States and even quicker than the Transcontinental Railway. So mobilizing these resources was far and away the biggest deflationary impact on the world in the modern era, much bigger than Amazon, much bigger than the fall of the Berlin Wall.
If we begin to ostracize China from the global trading regime, then over the long haul you have to be talking about more inflation, you have to be talking about particularly for just about anything that is produced in China the prices are almost certainly bound to go up. Supply responds. That is the wonderful thing about a capitalist system, it does respond. But ultimately, we’re the second biggest economy in the world. It takes a long time to replicate that supply.
So in the long-term it’s going to be inflationary, and that fits with a need anyway to inflate away debt globally. I have long argued for many years that the next move will be disinflationary to deflationary and I stick with that. But if you take a 30-year view I think there is no doubt that the stars are now aligned in terms of the need of the democracies to inflate away their debts. But also, the second impact of this cold war in the long-term is inflationary. So not yet, but over that long term it is a change in the way the world works which is a change to more inflation.
David:So a change to more inflation, a change in the trade relationship with the U.S. and China. The RMB is here in the middle, and you mentioned it earlier, but is the RMB likely to remain linked to the U.S. dollar? It seems unnatural in the context of a “cold war.”
Russell:I think the answer is that is no, it will not be. Even without the cold war it would be strange for it do so, just on a cyclical basis, as I mentioned, it tends to be overvalued at the minute, and from a political choice perspective, not many people choose to run with an overvalued exchange rate. It tends to have negative implications for your economic cycle and your growth, and therefore it is typically probably not a good time to be linking it to the United States dollar. Structurally for the second biggest economy in the world, it really is making less and less sense to be linking its monetary policy to the largest economy in the world.
For much, much smaller countries – one thinks of the United Kingdom, but one can go to Canada, or one can go to Australia, and these are independent countries with independent exchange rates, and we should, of course, expect a country that buys from China to move to an independent monetary policy, as well. And then third, you have this cold war, and in that situation it makes even less sense for this link to continue.
I think it will be very difficult for us to explain to our children or grandchildren why these two economies linked their exchange rates, or why China linked its exchange rate to America because they will live in an era where it will seem really quite strange for that to happen. But it did happen. And that period of time is coming to an end. There are many reasons why I think the initial end of this relation or this cold war is deflation. One of them would be a major devaluation of the Chinese exchange rate. I would call it a float, a move to a free float of the exchange rate to accommodate an independent monetary policy but a major decline in that exchange rate is initially very deflationary and I think that is what we face.
David:On this structural shift in the monetary system, if the RMB were to float, devaluation is a reasonable assumption. What impact does that have on China’s trade partners? What impact does that have on commodities? Are we talking about all of these being sucked into a deflationary vortex on the front end of that?
Russell:It depends on the reaction of the United States and its partners to the devaluation. Is it a move in the exchange rate in which we sit back and say, “This is acceptable, this is something that had to happen, it’s a reflection of a country moving to an independent monetary policy?” Or do we respond by saying, “This didn’t have to happen, this is aggressive, it’s cheating on trade,” and then we try to further sanction China because of the movement in the exchange rate. You will get different implications from those two different things.
So if there is no kickback, if there is no feedback, if there are no consequences from the movement in the exchange rate, it is much more deflationary than it otherwise would be, and things just come pouring out of China at ever cheaper prices. The last time that happened in 1994 it bankrupted quite a few of its competitors. The Asian economic crisis took a few years but it was directly caused by that move in the Chinese exchange rate.
Given where we are in terms of global relationships, it does seem unlikely that China would be allowed to flood the world with products at an ever lower exchange rate, and we should expect after the initial dislocation, some feedback and pushback with tariffs, quotas, restrictions, or whatever. And that is likely the point at which we turn what has been a naturally deflationary movement, a fall in the Chinese exchange rate, into something that ultimately becomes more inflationary. So commodity prices, I specifically mentioned, and they are absolutely in the firing line for this, completely in the firing line, because imagine you live in a country like Australia, your defense is entirely reliant on the United States of America. You have just opened and you are planning a new joint military base in Papua, New Guinea, and yet your entire economic cycle is aligned with China because of your resource base.
In a world where we trade less with China, and that is a two-way thing, then you are incredibly invulnerable to a world where you have to side with the U.S. for defense against China for trade. So I think commodity prices are particularly vulnerable if we are going to get a schism between the U.S. and China. But that is the initial deflationary impact and the inflationary impact is really just how quickly they respond to [unclear] exchange rate with more tariffs, quotas, etc.
David:If we’re finishing an extended bull market here in the United States, I think back to a period of time like the late 1960s where you had, not only a change in the world monetary system, but you had also gone, as you highlight in your book, from 1949 to about 1968 with a great stretch of growth in the equities markets, that kind of a parallel with there being a change in the global monetary system, and being at the tail end of an extended bull market in equities, we talked about potential devaluation in China, but you are also talking about an underlying currency system shifting. Do you see a dramatic impact looking at the dollar and dollar-based assets, as well?
Russell:Yes. In the longer term that is fairly easy to point to. In the shorter term, as we all know, things are significantly more difficult. And I think the late 1960s is a very good period to look at, and go back to that period and see what a fund manager would have been doing then. It is worth remembering that most people did see high inflation coming in the late 1960s, but they were confined by traditional thinking to say that we are bond and equities, equities and bonds, and if you are really negative you put more money on [unclear]. If you are really negative on inflation you think it is going higher, you put more money into equities and less in bonds, and that was the conventional thinking.
And then you had a handful of extremists who said, “No what we really need is gold.” And they were so extreme that the boss probably gave them the exclusion, “Well, go and put 10% in gold,” an incredibly extreme thing to do, but you think you’re right about inflation. And I think what history tells you at these major turning points, and what we’re having is a turning point because the global monetary system is breaking down, is that you don’t own radical assets, you own them in radical quantities. And the radical assets that you owned then were probably Swiss government bonds. They made it pretty well from 1968 before you got to the 1982 low, at clearly gold and clearly commodities.
So I’m not suggesting the same assets, I just think you need to own them in radical amounts and get beyond the bonds with equities and equities with bonds, and as long as we hold them as a balance between those two we’re going to do very well. Because you did shockingly badly with equities and bonds back from 1968 to 1982. Arguably, it was a better opportunity in 1974 in equities, but certainly not in bonds. So I’m very wary about people who just say, “As long as you get bond equity [unclear] and hold on to U.S. assets you will be absolutely fine.
Gold, in particular, needs to be more widely considered. Equity valuations by any historical standard are very high. I think the stock market is roughly just a little bit below where it was in January last year. The valuation of U.S. equities has come down from 33½ to 30. Is that the beginning of the spread, [unclear] and mean reversion of valuations? Well, perhaps. But when I go to a monetary system and link the radical with the quantity of assets, but not necessarily radical with the nature, and it’s hard to see how equities could be, over the longer term, a beneficiary of that massive shift.
David:We have debt, whether it is in the U.S. or globally, debt is an ever-growing issue, and it is one that politicians seem to appreciate for at least its contribution to GDP growth statistics. But it seems to be growing in the developed world without any real level of concern, and I wonder if policy-makers look at the easy use of inflation and the likely use of financial repression as the maneuvers that take away the pressure of increasing quantities of debt. For the investor or the saver, if that is the likely direction for policymakers, inflation and financial repression, does that circle back around to what you were just saying, that actually having an asset like gold outside of the financial system, somewhat inflation proof, is that a better way to approach it? Or could you maybe add to that list a little bit?
Russell:Yes, I think it is pretty straightforward to save gold and not bonds, and governments are fairly relaxed about the size of total government debt, and they obviously get advice from very [unclear] economists who say that debt is irrelevant, don’t worry about it, and borrow more. And ultimately, that is correct because they can inflate it away. So obviously, that is theft from savers, it is theft from people who lent money to government, and governments are perfectly, perfectly willing to steal that money. You have to demonize the people who have lent money to the government, and you demonize them by calling them capitalists, rentiers, or whatever.
There is a long, long, long, long history of this. In the United Kingdom if you held government debt from 1945 to 1978 you [unclear] about 90% of your purchasing power. Nobody was shedding any tears about it. For the people who financed World War II and financed the British government no tears were shed at all, they were seen as public enemies and they were treated accordingly, and that is what is already happening. You can see it in society, a movement building up that these are the people with the wealth, and these people and the government’s wealth in some way are supposed to be illegitimate and therefore, absolutely, that money has to be moved from them and redistribution of wealth by inflation is the number one way to do it.
It was Friedman, I think, who used to say that inflation was the only form of taxation that could be imposed without legislation. And so it remains, and that is obviously the way out. So you don’t own government bonds, and gold is a much better way of protecting your wealth in this environment. So I think it is one of the most predictable things we can say is that form of taxation without legislation is clearly the way forward. I’m sure on your show you have discussed modern monetary theory many times, [unclear] overt exhortation to that form of taxation, explicitly on savers, explicitly in the redistribution of wealth. And I don’t think anybody advocates, they just kind of hide that. It’s very open and very in public view.
We may not have the combination to get us there apparently. It may not be there just at the moment, but another recession and I think people will be clamoring for it. It is worth saying that for many people life gets better, but it is savers who pay the price in this situation. For many members of the public who don’t have any savings, wages could probably rise in line with inflation and their mortgage rates could be suppressed, and there is money illusion if you get high wage rises, even if inflation goes up. But there are clear benefits as well if you are getting significant wage rises and your mortgage rate doesn’t go up.
So for the section of society who isn’t a saver and who is a borrower, this is relief, and I think we both know the long-term implications. It might come back to that, not relief at all. But anyway, there is relief there, and we just need a political shift that wants to provide that relief, but be in no doubt that the people who lose out are savers, particularly those who owe government debt.
David:Yes, it is a tricky thing because you contrasted the next 30 years of inflation with the next 30 months, which may include some deflationary shock, and maybe that is limited to particular asset classes or what have you, but ordinarily people would choose U.S. bonds as a place to hold out and hang out certificates of confiscation, they once have been called, but maybe a better bet than corporate credit or junk. You have this time continuum of short-term, U.S. bonds could be fine. But very much longer and they are in the crosshairs, most certainly.
Russell:Yes, I wouldn’t recommend anybody to be trading assets. It’s not what I would do. I don’t recommend it for anybody to do that, but we are at one of those rare moments in history where profound structural change is coming, and personally, I own U.S. government bonds and I find them to be attractive, and I want to hold them, and I want to hold onto them because of deflation. And at the same time, everything I have just said about them [unclear] confiscation over the long-term is, I believe, also true.
So it is difficult. We have to be very careful of the timing, but I do think that owning these bonds at the minute is [unclear] should be a reasonable investment and over the long-term I don’t think that government bonds, really, anywhere on the planet, are going to be a good long-term investment.
David:Well, and as you say, there are many things that you can own today even if tomorrow’s prognosis is not positive, if you hedge accordingly. So here we are on a fine Wednesday morning considering a cold war, a new global monetary system, an imminent financial repression. Is there anything positive you would like to throw into the mix. I think of your quote from the Duke of Wellington – “All the business of war, and indeed, all the business of life, is to endeavor to find out what you don’t know, by what you do.” And that’s what he called, guessing what’s on the other side of the hill. There is good news in the sense of if you’re right about guessing what’s on the other side of the hill, it can be very good news.
Russell:Yes, there has never been a better time to be alive, despite this. And this is a very simple fact. But it has nothing to do with finance. This is the problem. The financiers have got the world into this mess. Admittedly, it has been assisted by the central bankers and some pretty stupid policymakers, but the world outside of finance is looking pretty good, isn’t it? Our technologists, our scientists, our industrialists are achieving things, it appears, that have never been achieved before, and I say that as a financial historian looking at America in the 19thcentury and what was achieved. But we are achieving things that are good for human beings, good for life expectancy, and generally good things all around for human beings, and we have a climate issue that we need to solve, but our ingenuity is doing wonderful things on that, as well.
So outside of the world of finance there is a lot to be buoyant, happy and excited about as a human being. It’s just a pity that we have got to one of those periods like the 1960s, and the world is in a much better place since 1968, but we just had to go through that period for people of finance, anyone particularly with savings, that was a pretty horrid period from 1968 to 1982, and then there was a new dawn and we moved on. So just because we are somewhat upset about the world of finance and the valuation of assets and the distortion of those assets by the theft of central bankers doesn’t mean doesn’t mean that you have to be pessimistic about the future for humanity.
David:It is increasingly clear to you what is on the other side of the hill. Is there a set of marching orders appropriate to the global investor seeking to de-risk a portfolio and position it for longer-term benefit? We’re talking about an environment which is unique. It carries with it the likelihood of structural, as well as cyclical change. Maybe if you could think about that question in terms of sitting down with one of your sons and saying, “This is what I’m going to recommend,” a little bit of a pep talk in terms of, “The world is not coming to an end, there are actually a lot of good things happening, and you could position for them this way and this way. And by the way, if you’re saving any money (laughs) it’s the saver who is really at risk here.”
Russell:So they need expert advice from someone, not like me, in terms of picking the right science, the right scientific breakthrough at the right price, finding someone like that who would obviously direct them to that. However, there is an easier way to do it than that, and I think it is holding a lot of low-risk assets and cash and waiting for opportunities. The negative point of what we are talking about here, David, is the things that will go wrong, but asset prices will be misplaced in this great schism that is coming along and some things will probably get too cheap.
Everybody who is listening to this knows that ultimately, in the long run, you want to own equities. You want to buy the cheap and you want to sell them when they are expensive, and that opportunity may be not too far away now. It may sound impossible because U.S. equity valuations are still high, but looking across the world, equity valuations in Europe are not high, equity valuations in emerging markets are arguably toward the lower end of the range. I don’t recommend buying any of them at the minute, by the way. But to have cash as equities are getting cheaper in the world is not a bad thing, it’s a good thing.
Opportunities now become apparent and ultimately getting wealthy, there is really only one way to do that, which is buying equities and holding them for a long time when you can buy them at a cheap price. So having some cash and waiting to do that and finding somebody who has some decent insight into the implications of technological breakthrough, not easy – very, very difficult. But that is the way forward, and particularly for young people that is the way forward. So opportunity is coming. Opportunity is ultimately always in equities and they are going to get cheaper and you want to have plenty of cash to buy them when they are cheaper.
David:And just to end on a question, more on a personal note, anything interesting that you are reading these days sitting on the bed stand that you would recommend to our listeners who might be interested in financial history? As the curator of the Library of Mistakes, I’m sure there are always a dozen books on your bed stand, but tell us what Russell is reading these days.
Russell:There is so much good stuff about. I’m about halfway through Alan Greenspan’s history, Capitalism in America, which for those of you who want a great span of economic history, more than financial history, but it is wonderful. I can’t think of the name of his co-author but it is very well-written, it’s a great romp, and for the layman I think it is as good a financial and economic history of America as you can possibly get. I know that Preet Bharara is not a name that everybody in America appreciates, but his book, Doing Justice, I think is a wonderful book. Not really about him, it’s about how to think, how to make decisions, how to make judgments. I think that is another great book that I’ve just read.
I’m looking on my bookshelf here. What else have I got? Basically there are too many. There are too many wonderful books right at the minute. There is a wonderful book on John Law. This is really a bit more esoteric, but [unclear] John Law. John Law was a man who physically, single-handedly, in 1720 bankrupted the whole of France. He was a Scot from Edinburgh, was expelled from this country because he killed a man in a duel, and then bankrupted France. Now, if that’s not a great rip-roaring view of financial history, I don’t know what is.
David:(laughs) Is that the one by Murphy?
Russell:No, this one is just by Buchan.
David:Okay. Well good. Loved seeing you in New York recently and I hope our paths cross again soon. Thank you for joining us on the Commentary today, and when are you going to write the sequel to Anatomy of the Bear?
Russell:(laughs) When I have time, and I don’t know when that is going to be. It’s in my head, but it’s not on a piece of paper. That one took two years, so it might have to wait a while.
David:Well, I can strongly recommend to any of our readers, if you have not read The Anatomy of the Bear, it is a must because although Russell mentions casually that it is best to buy when things are cheap and sell when they are expensive, the history of investors in general is that they have a much harder time dealing with that because they typically have a hard time dealing with themselves. The psychology involved in doing that is not so easy, and you can see this played out in grand scale in his book where there are epic opportunities to sit still, sit quiet, do little, so that you can put capital to work for you, and have it do a lot of good for you and for your heirs. So I would strongly recommend ordering a copy of The Anatomy of the Bear.
Again, Russell, thank you for joining us on the Commentary again.
Russell:Not at all. Thank you. And to everyone who is listening, most importantly, good luck.
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Kevin:David, one of the things that I enjoyed hearing from Russell is that opportunity is coming. Equities will be cheaper. He makes a great point that we live in a fascinating age of technology. It’s the financiers that have gotten us into trouble, and prices are so distorted at this point, it is very hard to make a decision as to what to buy, but there will be a time, if we’re liquid, and if we stay safe during this period of time, that we will be buying things for pennies on the dollar.
David:Many times you and I have talked about transitions being tricky, and there is not all musicians that can handle transitions. You happen to be a jazz musician, and jazz is all about the transitions. Investors struggle, too, with transitions, whether cyclical or secular, and in this case, structural transitions, a monetary system which may look very different. The financial market looked very different in light of those changes. So to be able to wrap your minds around those things and capture the transition, work through the transition, eliminate some of the risk that emerges in the context of that transition is absolutely vital for the investor. Not many will participate, but some will, and again, the opportunity is immense, whether it is that basic issue of buying things when they are cheap, selling them when they are expensive, being patient with assets that seem somewhat boring until things are cheap, sitting in low-risk assets and things that provide protection from the machinations of policymakers, the twin barrage of financial repression and inflation. It is very critical that an investor stay engaged and handle those transitions well.
Kevin:Dave, in jazz when you make a transition you don’t drown, and so many of the listeners may know this, but this weekend you are going to be swimming from Alcatraz to the mainland, jumping on a bike, after a transition, of course, riding 56 miles, and then jumping off the bike and running another 13. So I’m hoping that you have safe transitions.
David:Thank you, I appreciate that. The main one I hope to make is the first one.
