Russell Napier predicted we’d see a deflationary bust in 2011. So where is it? Our favourite guru warns us to brace ourselves…
Russell Napier has long been one of MoneyWeek’s favourite strategists.
We read his research religiously and take every opportunity we can to talk to him about his views on the market. We’ve all read his fabulous book analysing four of the biggest bear markets in history, Anatomy of the Bear (available on Amazon), and we are all fascinated by his latest career move.
Russell used to be the top strategist at broker CLSA. But a few months ago he broke the news that he has left them to set up on his own. ERIC (www.eri-c.com), his new business, will publish his own research and that of other independent analysts. Fund managers will then be able to go to the site and buy it directly.
Why has he done it? Because this is the future of research. The UK financial regulator, the FCA, is keen to prevent the cost of stock research done by analysts at brokerages from being bundled into the cost of trading. They think – rightly – that the system would be more honest if the two things were handled, and paid for, separately. Russell agrees. Hence ERIC. The bad news is that ERIC is only for professional investors. The good news is that I will continue to stalk Russell and bring his views to those of you who are not professional investors.
We’re still mired in deflation
Deflation is coming – hold on to your cash
We start in the only place any conversation about economies or markets can start these days – with prices. Russell has long said that we live in a firmly deflationary environment. Any change to that view?
No. There are still several “big deflationary forces”. The main ones are significant overproduction in China; fast-moving technological advances (which push down prices); and the “ageing of the baby-boom generation” across the West. The latter is the most important.
This Christmas, says Russell, something important happens: on 31 December the last baby boomer will turn 50. Most of them haven’t actually retired yet (they are 50-69 at the moment), but they are now “preparing to retire”. And what do you do before you retire? You “retire your debt”. So the boomers are moving away from consumption to saving and, crucially, deleveraging.
Go back to “monetary economics 101” and you will see why this matters so much. Money is created when banks lend money to people – in the process creating deposits. But if their biggest customer is, “for structural, demographic reasons”, paying back debt rather than borrowing more, then money is destroyed, not created. That makes it incredibly hard for politicians to use monetary policy to create new money. Right now the banks are being blamed for not lending. But how can they lend into the “very strong headwind of that baby-boomer generation who want to repay their debts”? They can’t. That’s why monetary policy is “not as powerful as it used to be” and why we can’t create the inflation we need to inflate our debt away.
QE worked – as much as it ever can
So quantitative easing (QE) hasn’t worked? Can’t ever work? In fact, Russell thinks “QE has succeeded” in the only way it can. You should look at it “the way it was looked at by the man who invented it, Irving Fisher”. He saw it as “the oil in the machine, but not the accelerator”. Creating credit during a period of deleveraging can stop a debt deflation – a “1929-1932 experience”. What is can’t do is live up to the “new and modern claims” current central bankers make for it: QE can’t actually create growth or inflation.
So we have hit a dead end, I say – but I’m wrong on that one too. Russell is “fairly sure” that in ten years we will have the kind of debt-busting inflation we need. How? “We will attribute it to the People’s Bank of China and not to the Federal Reserve.” If we want to generate debt and demand, we need to go somewhere with a pro-consumption, younger generation. If China chose to have a go at reflating the world, it would be “very easy for China to have 30%-40% money supply growth within a year or year-and-a-half”.
There’s a catch, of course. China couldn’t do that without devaluing the currency. So we would all have to “live through a major devaluation of the Chinese currency”, something that would make China super competitive and, as a result, send a temporary “deflationary impulse” throughout the world and undermine most other economies (as the price of China’s goods became ultra-cheap).
It’s worth noting that we’ve seen this before – the last time that China devalued, in the 1990s, it was “directly responsible for the Asian economic crisis… directly responsible for the bankruptcy in Russia, directly responsible for problems in Latin America”, says Russell. However, that said, if a huge Chinese money-printing programme can produce growth based upon genuine rising demand from its newly consumerist population, it would be worth doing: after all, we are currently getting deflation anyway.
Ditch the debt
I wonder if there is anything else the US might do to shake off deflation itself. There is. More QE might be needed – it is “necessary, if not sufficient”. But there are other policies the Americans can think about. “If I had to pick the most likely thing to happen to reflate the US,” says Russell, “it would be the forgiveness of student debt.”
This makes sense. If the US has a simple choice to either “extend the central-bank balance sheet by one trillion dollars’ worth of wealthy people’s assets, or to move one trillion dollars’ worth of student debt from the student onto the state”, most people would take the second. And the first thing former students will do if you forgive them a trillion dollars of debt? Borrow a trillion dollars. “That’s a recovery.” It is impossible to say when this becomes politically acceptable, but “I suspect the time is not far away when the focus falls on fiscal reflation and not just monetary policy”.
The trigger for the next crash
We move on to the markets. How does this view on deflation translate into a view on investing in them? In the 2009 edition of his book, Russell noted that markets were likely to rise fast (“a huge rally”) before deflation (which is terrible for businesses) pushed them back down again. However, he also expected the latter to happen “by the middle of 2011”. Some things did peak in 2011 (emerging markets and commodities, for example), but not developed markets. Russell isn’t thrilled by this (no one likes being wrong for three years), but he still notes that “judging from financial history, the thing that can bring markets down quickly is deflation [and] I just see so much evidence of deflation out there”.
So what will the catalyst be for the great bear market finally to begin, I ask? “The dollar.” And now that it has been rising strongly for the last three to four months, it could be the trigger. There are two main reasons.
Firstly, many countries link their currencies to the dollar. So as the dollar rises, they are all forced into adopting a tighter monetary policy. But the worst effects will come from the second factor – the way that the dollar is “highly borrowed across borders”.
If you’ve borrowed in dollars to invest in something in an asset denominated in another currency (like a government bond, say), then a rising dollar is going to make you nervous. You are going to want to cover it (by buying dollars back). And that’s when the move becomes self-fulfilling. “Forecasting currencies is incredibly difficult until you get forced buyers.” But judging by the way the dollar has surged recently, it’s “beginning to look like we’re there”.
There’s “nothing in the historical record that suggests emerging markets will ride that out smoothly… this has always been the time where they’ve got into trouble”. So while Russell forecasted a deflation-driven bear market three years ago, “the thing that might mean this is the time is the strong dollar”.
How to invest now
Yikes. So, I ask, if we really are entering yet another extraordinary environment – this time one in which a strong dollar destabilises emerging markets – how do we invest? We don’t, says Russell.
The “beauty of being a private investor is that you can do nothing”. Professional investors have to take action. But we can just hold cash. And at least in the current environment of low inflation we aren’t losing much on that cash. Then we wait. Does that sound dull? Well, just look back to financial history – the great financial success stories are all about “people who had cash at the bottom to buy”. Think “Rockefeller, JP Morgan, Mellon”.
Having cash is an active decision, of course, so it isn’t completely doing nothing. “But if, like me, you genuinely believe that deflation is coming, you take from the playbook of Mellon, Rockefeller, Morgan, Carnegie, and you’re ready to buy… you wait for what Buffett calls ‘the fat pitch’.” There are usually very few fat pitches out there. “In the world of deflation, there will be quite a few.”
I ask Russell if his own money is in cash. Mostly it is. He is on the board of some investment trusts and so holds shares in them. He also “has some Japanese equities hedged back into the dollar”. Overall, his equity holdings don’t make up a “high percentage” of his assets – but he notes that “even the most bearish person in the world would probably have 20%-30% of their money in equities”. Why? Because he “might be wrong”.
The most dangerous market of all
I wonder if he holds any Chinese equities, given that they seem cheap and that he sees China as the great reflator. He does not: he has no interest in putting his savings in “an entity that isn’t generating profits for my benefit”. I guess that goes for Russian equities too.
“That is the correct answer,” says Russell.
Any other markets at all that he likes? “No.” Any he particularly hates?
Yes. Emerging-market debt. The “most dangerous times in financial history” come when people need an income and can’t get it from safe assets. Right now investors have been sold emerging-market debt as “a fairly safe, low-risk investment where they can get the magical 5% everybody needs to live on”. But history is “littered with companies and corporations who borrow one currency and invest in another currency… they get into trouble”.
Benjamin Graham said that the first rule of investing should be “never lend money to a foreign government”. But, says Russell, lending to foreign corporations who are likely to have borrowed in dollars at a time when a strong dollar is on the way might well be even more dangerous.
We leave it there. But if you are looking for clear advice, you now have it. If you have emerging-market debt funds, you might want to sell them.
Then hold a reasonable selection of equities (particularly Japanese), just in case Russell is wrong – and a lot of cash, just in case he is right.
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Who is Russell Napier?
Russell Napier studied law at Queen’s University, Belfast, and Magdalene College, Cambridge. He began his career as an investment manager at Edinburgh-based Baillie Gifford in 1989. He moved to Foreign and Colonial Emerging Markets in London in 1994, before joining stockbrokers CLSA as an equity strategist in Hong Kong in 1995. From 1997 to 1999 he was ranked top Asian equity strategist by Asiamoney and Institutional Investor. He continued to work as a consultant global macro strategist for CLSA until this year, when he left to set up his own independent research business.
In 2005 Napier published the critically acclaimed book Anatomy of the Bear: Lessons from Wall Street’s Four Great Bottoms (reissued in 2009), 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 also run a course for financial professionals called A Practical History of Financial Markets at Edinburgh Business School.