Merryn Somerset Webb interviews Paul Hodges about the global economy’s ‘Great Unwinding’, and how Britain’s house prices could halve.
• If you missed any of Merryn’s past interviews, see them all here.
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Transcript
Merryn: I’m here today with Paul Hodges, Chairman of IeC and an expert in the economic impact of demographics. I’ve interviewed Paul before; last time I did, he was absolutely right on everything. We’ll talk more about that in a minute, but I want to start by talking a little bit about the oil price.
Paul, when we last spoke you predicted a fall in oil price –you said that you thought the oil price would fall from $80 to $50 by the end of last year, and at the end of last year you were saying you thought it would be down at $50 in the first half of this year, so you’ve already been proven very, very right. Can we just talk briefly about what the basis was for that forecast?
Paul Hodges: Yes, it’s what we call the ‘great unwinding’ of policymaker stimulus that if you look at where we’ve been since our last interview here two years ago, central banks have pumped more and more money into the economy. As a result, we’ve had a sugar high, really, where financial markets just go up in a straight line. In China, people got the idea that somehow suddenly China had become middle class, and so there was this enormous demand and there was free money from the Fed and the Bank of England, so everything looked wonderful.
When we spotted – and this, I suppose, is because of history that I used to work with President Xi’s father in days gone by, and I knew immediately that he became president that he wasn’t going to continue the policies of the previous leadership – he was very definitely going to take things back to what he is now calling a ‘new normal’. Whether he’s taken it from the title of our book I don’t know, but he’s all the time talking about new normal.
This is critical because lending in China from 2009 to last year went up from $1trn to $10trn, so it was worth more than all the rest of the stimulus. If you get a new leadership coming in who say, “That’s it, we’re going back to normal, we’re not bothered about property wealth effects anymore and lending bubbles, we’re going back to income,” suddenly the bubble is burst.
Merryn: Okay, so the new normal is what?
Paul Hodges: The new normal is based on the fact – which, personally, I think everybody watching this interview will welcome – that life expectancy has grown by 20 to 25 years over the last century and as a result we now have nearly one in two of adult population over the age of 55.
The corollary of that, as you and I have discussed many times, is that people over the age of 55 already have everything they need and they’re moving, therefore, into a world where their needs are lowering and also their incomes are going down, so you cannot possibly get growth. It’s a very simple argument; it seems to be very obvious to me. Therefore, that is the new normal.
I don’t think it’s a bad thing if you go through life. My life, personally: born after the war, vast numbers of baby boomers born in the UK; 900,000 babies are born a year, on average, for 25 years. You came into London; most of it was bombed out – literally bomb sites and everything else – and so you had a tremendous supply problem just to catch up, because factories had been bombed and everything after the war, but all this demand from us babies coming through.
Then, from 1983 or so onwards, what you found was that gradually we began to get jobs, and we began to earn some money and, yes, our demand was very steady because there were so many of us, but also we were creating supply, and so you went into this second normal of disinflation. We peaked at 20% or so and now we came down.
Now we’re in the third normal, which is the new normal, where we now have this older generation who are going to live for 20 or 30 years, and we are going to go into deflation because we’ve got all the supply left over from when we were consuming like mad, but we don’t have the demand anymore.
Merryn: To bring that back to the oil price, the oil price up at $100 was a function not of real demand but of stimulated demand?
Paul Hodges: It was a complete and utter charade from beginning to end. There has never been, since 2009, a single moment anywhere in the world where there was a supply shortage, a customer didn’t get the oil, the petrol, or anything else that they wanted, but it was all built on wishful thinking from the central banks. They were saying, “We can create demand by printing money.”
The problem is, if you look at the markets, the futures market, where the financial players took the money from the central banks and they went into the… They wanted a store of value, because every pension fund in the world knew that Ben Bernanke and Janet Yellen wanted to devalue the dollar. As a result of wanting to devalue the dollar, pension funds looked for a store of value. That, of course, was oil, because everybody uses it, very large market, and it’s priced in dollars.
What you saw, instead of financial players and physical players – the oil companies, people like us who buy to use for transport and for heating and so on – instead of a balance of one-to-one, you’ve suddenly got six times as many financial players going into the market. What happens? Of course, the price rises and goes from $30 at the end of 2008 up to $120, because you can’t print oil in the way that you print money.
Merryn: Effectively, the press discovery mechanism for physical players just disappeared, during that period disappeared?
Paul Hodges: Absolutely, absolutely destroyed, entirely by the action of the central banks.
Merryn: What then is the trigger for the change, the end of QE in America?
“China realised that if they carried on with this stimulus programme, the economy could well implode”
Paul Hodges: No, I think that people have got this wrong. We’ve been very, very Fed-centric. I think there are two reasons why it has happened. One is that people have lost the power which they used to have of looking at things with their own eyes. If you read the financial papers today, we read any kind of discussion, it’s all about what Janet Yellen had for breakfast or what is it that she’s going to do with interest rates? “Will she raise them in June? Will she raise them in March? Will it be a quarter of a per cent?” or whatever.
It’s not about the real world and people got into this habit, but if you look at China, China is different. China has realised that if they carried on with this stimulus programme, the economy could well implode – implode – so they stopped. Not only did they stop, but they began to go backwards. We wrote a research paper a year ago saying, “From $1trn to $10trn and back again.”
Once you start deflating a bubble, it doesn’t go slowly, it bursts. This is what you saw happening in July and August. That was why we made the call in the middle of August, we said, “The oil price is now going to collapse, and the obvious logical corollary of that is the dollar is going to go very high indeed,” and we’ve seen that – the oil price down 50%, the dollar up over 10%.
The dollar going up 10% may not immediately, if you’re thinking in pounds and so on, become very important, but it’s absolutely critical because you’ve got $6trn or $7trn of debt in the emerging economies all tied to the dollar, all thinking, “We borrowed at 1%. Aren’t we clever?”
It was 1% then, but now it’s 1% plus 12% increased value of the dollar, so you’re going to see bankruptcies all over the emerging economies – and, of course, you’re going to see bankruptcies all over the States because people have spent $1trn. It’s terrible, this word ‘trillion’. Before 2009 I didn’t know what the word ‘trillion’ was.
Merryn: I suspect most people still don’t – or can’t picture it, anyway, a trillion.
Paul Hodges: No, it’s mind-boggling what has happened here. I used to think billions were rather a lot.
Merryn: So, bankruptcies in the US connected to the huge infrastructure spending in the energy sector?
Paul Hodges: Yes. The US economy is now riding for a fall. We don’t know how big it is, but if you look at jobs growth since 2009, it’s all – and I mean ALL, with capital letters – being tied into the oil and gas exploration bubble, so all the rest has not moved at all.
If you look at the housing recovery, such as it’s been – it’s been 600,000 to one million, which sounds good, but when you’re coming down from two million it’s not so good – that 400,000, most of that new house building has been in Texas in the oil belt, because I was in Houston summer last year; 10,000 people a month were coming into Houston, so you’re building a lot of houses.
Merryn: So, the USA economic recovery has been very heavily leveraged to the shale boom, which in turn was caused by very low interest rates in QE.
Paul Hodges: Yes.
Merryn: So, as that reverses, we can only expect the US economic recovery to just disappear?
Paul Hodges: My view of it all is the Fed is actually irrelevant here, that the real action is over in China, that the Fed could do maybe a $10trn final blast, but would the new Congress actually allow that to happen? It’s an interesting question. I don’t know the answer, I just raise the question, but if you look at what’s happening in China, you see that the property market taxes… Property taxes paid last year in China fell 30%. That’s a pretty big downturn in one year.
If you look at what’s happening in the car market, all the growth in the world car market from 2009 to today has been in China. The rest of the world – ourselves, Europe, the States, India, Japan, the other big countries and so on – overall we’ve been flat, so the growth has only been in China. Now you’re seeing dealers arguing like mad, in public, with companies like BMW saying “Look, we’ve got 55 days of inventory. We can’t sell this stuff; you have to give us some money” – and some very large sums of money.
Merryn: BMW has had their money in China, hasn’t it, to keep the dealers on the go?
Paul Hodges: Absolutely, yes.
Merryn: Yes.
Paul Hodges: Yes, so you can see that the bubble that was China is being reversed and there are some very sensible policies about future growth going on. President Xi and Premier Li are moving forward on what they call the ‘New Silk Road’ – very, very ambitious growth, but targeted much more to income levels and the real world.
Merryn: Let me ask you a question about the Silk Road. When you say they’re trying to create a “New Silk Road,” what exactly do you mean?
“We will see this ‘great unwinding’ continue, and the Fed will end up being very, very surprised one morning to find that the US recovery has disappeared.”
Paul Hodges: You’re looking at trying to stimulate… What China is worried about is employment, and it’s also worried about the half of the country where incomes in the rural areas are still only about $1,000 a year – not a day, $1,000 a year. Most people in China, the average income is still only £4,000 or £5,000 a year; it’s very, very low.
What Xi is looking at is to say, “Let’s do a railway link; let’s improve the railway link,” so he’s looking at very ambitious railway links all the way from China to Europe, and companies like Hewlett-Packard are already using this. Then he’s got a marine route, which is again, obviously, moving out around Asia in particular and over to Africa, and then he’s got his trains and his high-speed trains route.
As opposed to the previous leadership, who were focused entirely on property bubbles and, “Let’s get property bubbles as high as possible because that will mean people spend,” he’s saying, “Let’s actually build for the future. Let’s recreate the position of China as the Middle Kingdom.” It’s very ambitious; we don’t know, of course, whether it will work, but it’s a far better use of what cash you have than building more and more empty skyscrapers that nobody lives in and nobody can afford.
China is the place to watch and as long as China doesn’t change policy, which I think is very, very unlikely – as I say, if you know somebody’s father, you often know their children, so I think President Xi will stay the course here – what I think will happen, therefore, is that we will see what we call this ‘great unwinding’ continue and the Fed will end up being very, very surprised one morning to find that actually its US recovery has disappeared. That’s not surprising, because the Fed was very surprised when the financial crisis happened in 2008.
Merryn: So it would be a surprise if they were surprised again.
Paul Hodges: Yes.
Merryn: That rather suggests that you don’t think the fall in the oil price and other commodity prices – iron ore, copper, etc – is over yet.
Paul Hodges: No. No, I think that what we’re seeing is the other phrase that we have, and I have to say I am now more concerned than I was two years ago. Then one could come out with ideas and the downside from the wider world seemed less. Today, because of what the central banks have done, we’ve created massive debt – really massive debt now.
What worries me, keeps me awake at night, is this sense of we’ve got an unwinding starting in China, we see already that Russia and other Opec countries – not the ones in the Gulf but the others – are in major economic crisis. We see that affecting in turn our own companies: the terrible story about farmers and the collapse in the milk market, for example. This is a real disaster there.
Now we’re looking at a return of the eurozone debt crisis and Greece – and, of course, we’ve got mounting political risk here in the UK. Nobody believes that one party can get a majority in the May elections at the moment. Nobody actually believes that two parties… If you put Labour and the Scottish Nationalists together, and the Tories and Ukip, they probably can’t get a majority either.
Merryn: You know, Paul, I tend to think of myself as being quite depressing, but you’re really stealing my thunder here (Laughter). Can you think of anything, any good news in your scenario?
Let’s go back to demographics, for example: if 55 was the age of retirement or the age that you would say people move in for replacement, stop spending, etc., very few people really retire and stop life, effectively, at 55 anymore, do they? Seventy-five is really the new 55; people work that long. Even if they’re not going to keep a spending and consuming lifestyle going, they tend to pass money and the ability to consume down to their children, so is there any way out of this demographic disaster in that sense, or could it be delayed maybe by couple of decades?
Paul Hodges: I am actually quite happy. It may not appear so, but I’m actually quite happy, because I believe that we are now going to have to confront the issues that we should have confronted ten and 15 years ago.
I absolutely agree with you and it is a wonderful bonus that we are all living 20 or 25 years longer, so why have we got a lower pension age than 100 years ago when Lloyd George brought it in? Why are some countries, like France and Germany, actually reducing the pension age?
Merryn: This seems crazy, right?
Paul Hodges: Absolutely.
Merryn: Why is this happening?
Paul Hodges: It’s because – and this really comes to the question of the general election: why are people so apathetic about political parties? – because they know they are not talking about the key issue. The key issue is you have an older population, you have to keep people in work; if you put people in work, you can also train up young people. Older people have actually trained up their kids; they can train up other people’s kids.
You can create growth, you can create incomes, you can change the structure of the economy, but you cannot run an economy where nearly one in two adults is over the age of 55 as if it was full of children. It’s ridiculous and yet the politicians, because they are living on sound-bites, will not have this honest conversation with people that says, “Look, it may be depressing that you’re not going to be able to live on your pension for 30 years. I’m very sorry about that, but it’s one of those things. You are going to live for 30 years, with a bit of luck. Therefore, on the bright side, wouldn’t you like to keep your mind active? Wouldn’t you like to carry on doing this wonderful work that you’re doing here?” You have that conversation.
Of course, some people are going to get upset; that’s understandable because they’ve been treated like children – for 10 years they’ve been told, “No, go away; it’s a small number.” We used to have, in the UK, we used to have 900,000 babies a year born, for 25 years. Then, for the next 25 years, we only had 750,000. It’s most unfair to ask those 750,000 to subsidise the 900,000; it is most unfair and we shouldn’t be doing it.
Merryn: Why do you think the young don’t engage more on this? There’s always a much lower turnout – voter turnout – among the young than among the old. Why are they so apathetic? Why don’t your children do something about this?
Paul Hodges: I think my children are like the adults. I talk to a lot of groups, [I got] very lucky to be invited to talk to groups all over the country, and what you find is people feel they have no voice – that they say these things, and they go and they may talk to their MPs and so on, but nobody listens. It’s all American slick jingles and sound-bites.
Merryn: But we’re going to be forced to confront it by, effectively, a Minsky moment of some kind.
Paul Hodges: I think we are now seeing the Minsky moment. As I say, I think this is not at all a bad thing, the collapse of the oil price. You’ve got a lot of people around who a year ago were telling us that a high oil price showed that we had a strong economy.
Merryn: It showed nothing of the sort.
Paul Hodges: Those same people are now telling us that a low price… I said, “For goodness sake, could we get somebody who actually talks sense here and is consistent?”
Merryn: On the matter of talking sense, when I last spoke to you in 2013 you told me that gilts would be the absolutely best thing for the retail investor to buy, and you were right.
Paul Hodges: I did.
Merryn: Absolutely right. Should they be holding those gilts?
Paul Hodges: I have to say I am not an investment advisor, as you know, so I can only tell you what we are doing as a family, and I’ve sold my gilts.
Merryn: You’ve sold your gilts. Why have you done that?
Paul Hodges: Because I am worried about the concept of are we actually going to be able to pay our bills? Return of capital. We have such vast debt in this country and we are clearly… Inflation now down at 0.5% and we will have deflation within another couple of months because of the oil prices – absolutely inevitable. We’re going to go into deflation, and deflation itself is fine, but not if people have created vast debt that now can’t be repaid.
Merryn: You’re now genuinely concerned about a default of some kind on UK government debt?
Paul Hodges: Yes, I am. Yes, I am.
Merryn: That’s quite a leap.
Paul Hodges: It is. I’m not saying it’s my base case, but I don’t like the idea, which may only be a 10% chance at this moment, but yes, for 30 years I can tell you that it was in 1991 I thought, “Gilts are the right thing to do,” and we’ve held them in our portfolio all the way through. Of course, there have been ups and downs, but it’s been a very good investment. We’ve stopped; we’ve sold the lot.
Merryn: Interesting. The other thing you were absolutely right on was you said not to buy Tesco, not to hold shares in Tesco. You said “We don’t need superstores like that anymore because the over 55 don’t need stuff, so they’re not going to shop in superstores.” You were right there too (Laughter). Is there any case for buying Tesco at these levels, or have you got another brilliant tip for us?
Paul Hodges: I’m not against Tesco at all; I want Tesco to succeed. What I was against at that time was Phil Clarke’s policy of trying to, just like the central banks, trying to pretend that we still have the population and the demand levels of five and ten years ago when Tesco was very successful, and so he was building more and more supermarkets, more and more hypermarkets. I’m a great fan, I gave two positive ideas last time; I said, “Unilever,” which is up 10%, and “P&G,” which is up 30%.
Merryn: Thank you very much for those.
Paul Hodges: Probably people who listened – as I say, I was not giving advice – people who listened might have thought about those. I’m very positive about Unilever.
Merryn: But you see a business going in the right direction?
“In the early ‘90s house prices went down 50%. I think that we’re at the start of that kind of decline now”
Paul Hodges: I think the fact that he’s closed 40-odd stores, and he’s stopped building another 40 or so odd, and he’s now putting more people into the store, because what is it? The difference in a phrase is that when you’re younger, and you’re rushing off to work and the kids are screaming and everything else, you are probably cash rich, with a bit of luck, and time poor. When you’re older, you’re time rich and cash poor.
That’s just the way it is and so you want to be able to go down to your local store, and you want to have a chat about something, and you’re only going to buy what you need for that day. It’s much more of a social thing, so you need more people, you don’t need automatic tills and everything else; that’s not what I want.
Merryn: Small stores with checkout people.
Paul Hodges: That’s right; we want to go back to the local grocery (Laughter). That’s expensive, but if you want to be successful… This is the part of the great unwinding – that companies are going to have to go back, not to stripping out costs but to focusing on, “What does my customer want?”
Merryn: One last question on demographics and the great unwinding: when will this demographic change mean UK house prices fall?
Paul Hodges: I think they’re already falling, sad to say. I just wish they’d never got to these levels, but I think you’re going to see… You were saying recently that at the top end prices would be under 15 or 20%.
Merryn: Yes, completely.
Paul Hodges: We’ve seen price falls in the housing market in the past in the early ‘90s and they went down 50%, and I think that we’re at the start of that kind of decline now – as I think, indeed, fairly soon we will be at the start of that in the stock market as well. As I say, I’m not depressed about this, because it’s just something that we have to go through to get to reality.
Merryn: You’re not depressed, but in the short term, from an investor’s point of view, no commodities, no equities.
Paul Hodges: No.
Merryn: House prices will fall.
Paul Hodges: Yes.
Merryn: Do we hold cash?
Paul Hodges: Yes.
Merryn: We don’t hold cash when…
Paul Hodges: Absolutely, because cash is actually going to be a very good investment because under deflation the value of cash goes up every day. The other thing about this, what we’re looking at today, people who remember 1973 and the oil price shock of the Arab oil boycott, that was the day almost, those few weeks, where people suddenly got the idea: “What I ought to do is I ought to borrow as much as possible and I ought to buy as quickly as possible, because the borrowing will go down because of inflation and it will be more expensive if I buy it in a week’s time.” You brought forward consumption.
We are now – and it’s already happening, so we don’t have to talk about this as theory, this is already happening now – over the next few weeks we’re going through the deflation shock. The deflation shock means that by the summer people will say, “I don’t really need… It’s a lovely sofa, actually; I don’t think I need a new sofa just yet. Anyway, if I do, I could get it in another three or six months; there’s no great urgency about this. It will be cheaper then.”
Merryn: And the same with houses, so the fact that mortgage rates are now at their lowest ever, pretty much, and you can get a ten-year fixed-rate mortgage for the cheapest price since records began doesn’t mean that we should rush out and buy houses?
Paul Hodges: The cost of a house is relative to earnings. At the end of the day, the interest… You were mentioning Minsky and the thing that Minsky highlighted was that you have to be able to repay the capital. It’s all very well repaying the interest, keeping going all that, interest-only mortgages and so on, but can you actually afford, if you’re in London, a £300,000 or £400,000 flat, a one-bedroom flat – lots of them around at that kind of price – when the average earnings in London are about £30,000?
Merryn: I don’t think you’ve included the oligarchs in that average.
Paul Hodges: No, I’m leaving the oligarchs out. Sad to say, the poor oligarchs are suffering already and we’ll all have a collection for them, I’m sure, sometime in the year. No, I’m more worried about ordinary people, like my sons, who have been priced out of this market.
Yes, it’s all very well saying, “They can afford the interest.” They could, but they can’t afford the capital repayment, so for their good, for the good of this younger generation, I’m afraid us older generation have to say, “We did pretty well out of this. We’ve got to hand something back.”
Merryn: Final question: is it possible for a deflationary environment to persist when central banks can print as much money as they like and shovel it into the economy in a variety of different ways?
“Cash is going to be a very good investment – because under deflation the value of cash goes up every day.”
Paul Hodges: People have to want to spend, and if you don’t need to buy anything and if you are fairly cautious about knowing exactly how long you might live, then it’s quite difficult, I think, to encourage people to spend.
The central banks, the economists, work on this theory, which was fine at the time – Modigliani’s theory – which said that we all know how long we’re going to live and therefore we consciously make a decision to hold back on consumption today so that we have something left for the future.
That was fine if we were all dying at 50 because you weren’t holding back very much, you were just getting more money as you got… But if you’re living to 80 or 90, say, how long are we – you and I – going to live? We don’t know, so probably, if we’re sensible, we’re going to err on the side of caution.
Sixty per cent of our economy is personal consumption, so if people are not wanting to spend in that way… What the central banks could do, and I do worry about this: they could create hyperinflation.
Merryn: Yes.
Paul Hodges: They could because they…
Merryn: This is our worry – that they could. They have the ability to do so; anyone can create inflation if they really want to.
Paul Hodges: Yes, but what I hope is that common sense prevails and that we abandon these out-dated economic theories. Milton Friedman came along and he said that inflation was “Always and everywhere” – and monetary – but he’s wrong, of course; he’s completely wrong.
It’s understandable for Friedman to be wrong, because he was working during the baby boom in the States. The States had a 50% increase in the number of babies being born over an 18-year period. Of course there was massive demand, of course there was no supply, because the US hadn’t been bombed on the mainland; all its factories were making tanks and everything. It takes a long time to start making fridges and consumer products and so on, so of course there was inflation, but Friedman confused cause and effect.
We’ve had six years, let’s face it, six years of central banks believing that Friedman was right and saying, “If we put out enough money, then we will end up with inflation. Sorry about that.” Could we have some common sense on this which says, “If you’ve got an older population, you’re not going to want to spend,” and could we please, instead of being negative about all these older people, could we not celebrate this and say, “Isn’t it wonderful that our society has achieved this?”
Does it really matter if we have GDP? Let’s face it, before 1929, which isn’t very long ago, nobody measured GDP, so for thousands of years people were pretty happy and getting by without thinking about…
Merryn: Without knowing what growth was, yes.
Paul Hodges: Yes, and so they were having kids, and going out, and doing all these things, and so I don’t see why we should worry about GDP at all.
Merryn: I think that’s going to be a hard sell to politicians.
Paul Hodges: I think that the politician who has this debate with people in the main election will get a surprisingly large number of votes, and I also absolutely know that politicians who don’t have this will be punished by the electorate.
We see this: that the middle ground of politics is disappearing because people no longer trust these platitudes. They’re saying – they say it to me when I talk – “They’re treating us like children. Why should I vote for somebody who treats me like a child?” Let’s have a serious adult conversation. If there is bad news, can we have the bad news, because once we have the bad news we can decide what to do about it? You can pretend it’s alright – useless.
Merryn: I think we’ll have to leave it there.
Paul Hodges: Lovely to talk to you.
Merryn: Paul, thank you very, very much.