This is an edited version of Russell’s interview with Merryn, which was published in MoneyWeek magazine issue no 598. To read the full version of this interview, click here
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I think Russell Napier might be my favourite financial guru. He always has an opinion; his opinions make sense; he is more often right than wrong; his reports are actually readable; and when I interview him he usually comes to me. Given that it has not stopped raining in Edinburgh for nearly three months, this last bit is more vital than you might think.
We start with Russell’s recent trip to visit fund managers in America and across Europe. How did he find them? “Flummoxed.” Usually, says Russell, fund managers have pretty strong views (mostly wrong, sometimes right) about something. But at the moment they just don’t. Why? He suspects it is because they just haven’t been trained to operate in this kind of environment. The average fund manager will have an MBA of some sort. It will have been based on the idea that all you need to work out is the supply of something and the demand for something. Then you’ll know the right price for it.
But today they are limited by the fact that “the government doesn’t like the price”. So they have to look at supply, demand, policy, central banks, political personalities, central bank behaviour, regulation and the rest. And, not being trained in sociology, “they can’t cope with it”. We have effectively “transcended finance”: after a long stage in which markets have been more powerful than governments, we are now seeing “a structural change in the other direction”.
But where do we end up? I ask. Hard to say, says Russell, but we’ve been here before. Post-World War II “it was all about government, not markets”. Then from 1978 on it swung in the other direction – probably too far. Now we are looking at “a long swing” back again. The good news is that while this makes life very hard for fund managers in the short and the medium term, it doesn’t make much difference to the likes of us for investment purposes: when equities are cheap, says Russell, “you buy them anyway”.
The ‘buy’ signal for Europe
So are they cheap? In Europe the answer is yes – “decidedly cheap”. Does that mean now is the time to buy? It could be – history tells us that if we buy at these prices we should make double-digit returns over time. But Russell also thinks that there will be a better opportunity – when we see a change in Europe’s monetary policy. Right now, as he sees it, Europe is working with a “monetary system that would in the end eradicate all corporate equity”. If you force a society that is over-geared in every possible way to deflate, you reduce wages, revenues and asset prices along the way: “you effectively wipe it out”. It is a kind of equity “doomsday machine”.
So the buy trigger is not just the current price (as the MBAs might think), but the change in monetary policy – from deflationary austerity to large-scale money-printing. What if that change doesn’t come? It is almost inevitable, says Russell. There are almost no examples of democracies that have worked their way out of a debt crisis via deflating: populations and hence politicians won’t put up with it. “No society would ever opt to live with the consequences of this.” We can’t say for sure how or when it will happen (so if you buy now be prepared to lose money before you make it). But the change will come either via the European Central Bank (if the euro holds) or via the independent central banks (if it does not).
Is there anything Europe can do in the meantime to encourage growth? Possibly, says Russell. The strong countries could borrow at today’s very low rates and expand their fiscal policy. Hmmm. He doesn’t sound very convinced on this one. I point out that we could borrow at very low rates here to do the same. Would he approve of that? No. “I’m kind of old fashioned. I would insist that we take some pain… we shouldn’t be burdening the next generation with our own public debts.” It would be better to “focus on getting our banking system working”.
However we do this – be it by relaxing liquidity requirements or by forcing bank lending command-economy style – we have to do it. The secret to getting things moving in this country is “the banks, the banks and the banks”. So, much as it pains us all – and it really does – we need to understand just “how important banks are at creating money” and following on from that we need to grasp that “a society where there isn’t enough money has historically been a very bad place to live”. Over time we have to work to create the kind of bankers we want (ethically and structurally). But we can’t destroy our credit system by trying to do it too fast.
Fixing Britain’s banking system
So what is the perfect banking system? There is no such thing. But the obvious first step is the separation of commercial and investment banking. The British government’s biggest contingent liability is not, as most people think, the coming costs of the baby-boomer generation. It is its deposit insurance. Given that, we have to make sure that the bit we insure is as safe as possible. So we have to be clear that only certain things can be done with deposits.
That means a split. This is entirely obvious to Russell. It is also obvious to me and I suspect to all MoneyWeek readers. So why hasn’t it happened? “Capture,” says Russell. There has long been “a certain degree of capture of the political process by financial services” both in America and Britain. However, the Libor scandal might mark the beginning of the end for this. Just look at the way the politicians are “ditching bankers left, right and centre”.
Libor is different to all the other banking scandals for the simple reason that the population doesn’t see it as a victimless crime committed between various groups of the greedy, but as one committed against the public. Now it’s about newspaper readers and their mortgages. That’s brought about “a very rapid change in the political tone” and might mean that we do get some real change.
Encouraging long-term thinking
I wonder how we might do that in the rest of the corporate world. I’ve written endlessly over the last few years about the problems brought to us by short-term shareholder capitalism. How do we get back to a world where shareholders buy for the long term and so take responsibility for the businesses in which they are invested?
It turns out that if I had only asked Russell earlier I could have saved myself a whole load of bother. The answer, he says, is stepped dividends. The longer you hold the shares, the more of the dividend you get. If you have held the shares for under a year, you get a third of the dividend; hold for two years and you get two-thirds; hold for three years and you’ll get the lot. This, says Russell, is the perfect carrot. Returns over the next decade or so are going to be very dividend-orientated. So unless fund managers do all they can to get the dividends, “they haven’t a hope in hell of beating their benchmark”. That means that when things go wrong they are more likely to put pressure on corporates to perform better than to sell.
“It’s brilliant,” I say, possibly a little fawningly. Russell agrees. Sadly, he thinks that a transaction tax is going to end up being the way that friction is introduced to the market – it’s easier, it’s popular with politicians and thus is “all but inevitable”.
How China could derail America
On that sad note we move on to China. We are bears on China. Russell is too. But the really interesting thing there, he says, is the currency. Most investors, to the extent that they have an opinion on anything, firmly believe that the RMB is undervalued. But look at the bands the exchange rate trades in: they were widened on 16 April and since then the currency has not hit the top end once.
The RMB is linked to the US dollar and in the past, to stop it from rising, the Chinese have constantly had to buy Treasuries. But if the RMB is no longer pushing against the top of the band and they are playing by the rules, then “that means they haven’t bought a single Treasury since 16 April”. What would be really scary, however, would be if the RMB started hitting the bottom of the band. Then the Chinese would have to be very publicly selling Treasuries, which would mark a huge structural shift (and not a good one from the point of view of the cash-strapped American government).
Will that happen? Russell reckons it will. When currencies “move precipitously”, they do so because of capital shifts. “And there is evidence of very significant capital outflow from China.” That could easily accelerate. The Bank of International Settlements (BIS) notes that $498bn has been borrowed offshore by China. In the past, people will have borrowed dollars and used them to finance projects in RMB on the basis that the latter always rises 5% a year. But what if it is actually slowly drifting down? All that money leaves.
We’ll wake up one morning and find the RMB at the bottom of the range and the People’s Bank of China – the biggest owner of US Treasuries there is – a forced and guaranteed seller. It might sound like the “stuff of cheap novels”, but it is inevitable that one day the Chinese sell in volume – with thoroughly unpleasant implications for Treasury yields, for inflation (as the Fed prints oodles of money to mop up the supply) and for the American economy.
Buy gold and Singapore dollars
I ask about Russell’s own portfolio. I’m guessing he isn’t invested in Chinese equities, despite their apparent cheapness. He isn’t. Most of the market is “part of the state and as part of the state I don’t know how you can put a value on it”. Instead, his money is “very conservatively invested in a couple of investment trusts and it is pretty easy to work out which ones they are”. (Russell is a non-executive director of the Scottish Investment Trust and the Mid-Wynd International Investment Trust, so that is that worked out for you.)
After that, it is in cash – with a preference for the Singapore dollar – and in gold. Russell’s time is nearly up so we’ll come back to gold another time. But before he heads back into the council-created chaos of Edinburgh I ask him for a piece of good news. It turns out that he has quite a lot of it. Markets are “adaptable”. Society “won’t put up with a doomsday machine”. And “equities are a lot cheaper than they were in 2000”.
Who is Russell Napier?
Russell Napier is the author of Anatomy of the Bear, the definitive guide to how real bear markets work. He is also a consultant to Asia-based stockbroker CLSA, where he writes about the issues facing the global markets; and he is the creator of ‘A Practical History of Financial Markets’ – a particularly brilliant course on offer at Edinburgh Business School.