Monetary policy has reached its limits, Russell Napier tells Merryn Somerset Webb. Perhaps China or greedy baby-boomers will save us…
• Watch the full interview with Russell here
When I interviewed Russell Napier back in November 2014, he told me that monetary policy was going to stop working – and that as it stopped working central banks would do more and more of it. That’s pretty much what has happened, negative interest rates being the most obvious and bizarre manifestation of the trend. Even then – a mere four months ago – negative rates seemed pretty out there. Now central bankers appear to consider them to be a perfectly normal policy tool. They shouldn’t, says Napier.
The first thing to note is that they don’t appear to work. The idea is that negative base rates should push interest rates down across the board, something that then encourages people to borrow and to spend. But look to Sweden where rates have been negative for the longest and you will see that it just isn’t happening. Why? Because “there is a lack of demand for money” borrowed from the banks – at any price, says Napier. Our ageing populations are “gearing down” as they retire: they don’t want to borrow and they don’t want to spend, regardless of how low rates get. Rates are “irrelevant”.
The effect of negative rates
The second thing to understand is that our financial system simply isn’t structured to deal with negative rates. One obvious risk is that people begin to prefer cash to bank deposits, and so withdraw their funds from the system: that’s a bank run. And what about insurance companies? If insurers can’t make any returns in the bond markets how can they meet their long-term obligations? In October 2014 the Bundesbank wrote a paper forecasting that by 2023 “there would be solvency issues for 14% of the German insurance industry, given the yield curve in October 2014”. That’s a respectable analyst suggesting severe solvency issues for one of the safest insurance industries in the world.
It’s not just that negative rates do nothing for demand, it’s that the policy is “actually undermining insurance companies’ and banks’ business models”, something confirmed, says Napier, by the way that major bank share prices fell 50% from last October into the first quarter of this year. This didn’t come out of nowhere – it reflected the dawning understanding in the market that negative rates do bad things; that demand just isn’t there; and finally, that a piece of legislation called the Bank Recovery and Resolution Directive is real. This makes it clear that if a bank has to be “resolved” now, large-scale depositors will “pay a price”.
This matters because, according to Napier, “it means a structural repricing of bank capital, which means bank capital is more expensive for banks, which means in some way they have to feed it on to the consumer. Now we’re trying to get interest rates down. But the repricing of bank capital is putting the cost that a bank has to charge you and I up.” It all “massively changes the risk” of holding bank shares and bonds, structurally changing the price you should pay for them – and at the same time “it is running entirely counter to monetary policy” (which is trying to cut rates). No bank shares in your portfolio then? I ask. “No.”
What comes next?
One thing we do know is that governments are determined to create inflation. Another is that they aren’t doing a particularly good job. But if negative rates don’t work, what comes next? It is perfectly easy to get inflation into a system, says Napier: “I think we could do it tomorrow morning. But it wouldn’t be the policy of the central bank; it would have to be the policy of a government.” The most obvious starting point is debt forgiveness – student debt could come first, as US presidential candidate Bernie Sanders has suggested. US graduates have some $1.1trn of debt. If that just went away, they would borrow from the banking system to buy houses and cars, etc. That would drive demand and hence inflation. “I think that will happen,” says Napier. And so will many other things we consider extreme, such as direct monetary financing of government and “QE for the people”. The question is simply how big a crisis we need to have now for states to have the political capital to do it. Outright deflation could do it, so could a recession with deflation. If central banks are seen to have failed, all bets are off: “all the things that were seen as extreme five years ago are now just below the surface”.
China to the rescue
I wonder if there is any way out – one that doesn’t involve endless money printing. Could be, says Napier. It’s unlikely, but “China could, tomorrow morning, launch a major reflation based on consumer credit”. Consumer debt to GDP in China is low, so if everyone were to get a credit card in the post and use it, things would improve quickly – we’d be talking about inflation, not deflation. However, getting demand going this way would involve opening the financial system, shutting down lots of state-owned enterprises, and “the communist party giving up a lot of control”. That isn’t the direction President Xi Jinping has gone in since he took office: for him it has been “more control and more control”.
The other thing that might save the situation is unusual demographic behaviour. “Nobody ever got rich underestimating the greed and stupidity of the baby-boom generation,” says Napier. “If they ignore their debts and start shopping again things could change. This isn’t likely: the evidence suggests they have been hoarding not spending the savings from the low oil price.” But this baby-boom generation has been capable of things that no other generation contemplated, so we have to keep an open mind!
If you are relying on consumption to save the current economic model, it is also worth looking at the evidence suggesting that consumption patterns for both retirees and millennials “are moving towardsservices and experiences rather than goods”. If so, there are “huge implications for China”. They don’t benefit from us going to restaurants at home in the same way they do from us buying flat-screen TVs. This shift could, says Napier, perhaps explain the weakness of the global trade figures.
How to invest in difficult times
This moves us on to how we might invest in such difficult and complicated times. Napier is interested in miners for the same reasons we are: it’s hard to be bullish on demand, but as mines begin to shut down it might be a good idea to be bullish on supply (when it contracts, prices rise). He is interested in gold. Napier has always said that gold would “come into its own in deflation”. Why? Because he figured that when inflation turned to deflation, “we would begin to have these conversations about outright monetary finance” – and people would realise that “the actions of the government would be so strong and robust” that they should hold gold. And that – alongside all the geopolitical tension out there – is why gold is going up. It is, says Napier, “entering a 20- to 30-year bull market. I think that’s just started… because these policies will succeed in generating inflation.”
Where else would he invest? Emerging markets (EM)? No. There is a view that the EM bear market is coming to an end, but “I disagree with that”. He worries about emerging-market debt “and just what a high percentage of that is owned by foreigners. This is a brand-new thing.” The conditions for a bull market aren’t yet in place – he wouldn’t buy into EMs “regardless of the value”. But he still “quite likes” Japan. Unlike in America and Europe, the fiscal and monetary authorities there are “already entirely aligned”, so “I believe they’ll win this game of depreciation”. Hedge the currency and you should do well. Finally, he points to an investing style rather than a market: value. And equity markets are “generally overvalued”. Anyone invested needs to look where they can find some value.
Finally, I ask him what he’ll be voting in the EU referendum. Out, he says. Why? There are things “that are more important than money” and he believes in the “sovereignty of the individual state”. You can listen to his other thoughts on the EU on our website. Then, while you’re online, you might want to top up your gold holdings!
Factfile: Russell Napier
Russell Napier is co-founder of ERIC, an online platform for the sale of investment research (Eri-c.com). In 1989, he started his career as an investment manager at Baillie Gifford in Edinburgh, after studying law at Queen’s University, Belfast, and Magdalene College, Cambridge. In 1994 he moved to F&C Emerging Markets in London, then joined Hong Kong-based stockbroker CLSA as a strategist a year later.
In 2005 he published the critically acclaimed Anatomy of the Bear: Lessons from Wall Street’s Four Great Bottoms (reissued earlier this year), in which he provided a blow-by-blow analysis of how the bear markets ending in 1921, 1932, 1949 and 1982 played out. Since 2004 he has run a course for financial professionals – A Practical History of Financial Markets – at Edinburgh Business School. In 2014 he opened the Library of Mistakes – a library dedicated to financial history – in Edinburgh.
• Watch the full interview with Russell here