Vivek Kaul
Copper prices have fallen by a little over 12.1%(in dollar terms) since the beginning of this year. Interestingly, a substantial portion of this fall has come since the beginning of this month. Analysts often refer to copper as Dr Copper, given that the demand for copper is often a reliable indicator of economic health.
How is that? Copper is widely used across different sectors of the economy. It has uses in sectors as varied as electronics, homes, factories and even power generation and transmission. Given this, demand for copper is often a very good lead indicator of the economic health of the global economy. This demand is reflected in the market price of copper.
Hence, rising copper prices indicate strong demand for copper, which in turn indicates a growing global economy. Vice versa, falling copper prices indicate low demand for the metal and hence, an imminent economic slowdown.
As Albert Edwards of Societe Generale writes in a note dated March 13, 2014, titled We are repeating 2008- just backwards? Ignore copper meltdown at your peril “Copper and iron ore prices have slumped almost 10% over the last week. Interpreting this move may prove crucial for global investors who traditionally have looked to Dr Copper specifically, and industrial commodity prices in general, to give an early warning to any changing direction of the global economy.”
In fact, there has been a lot of talk in the recent past about a worldwide economic recovery. But that doesn’t seem to be reflected in the price of copper, or other industrial metals for that matter. As a recent column in The Economist points out “It is not just copper this time; the aluminium price is down 10% over the last 12 months, nickel 7.9% and lead 6.3%. Compared with a year ago, metals prices are down 10.2 per cent. With the important exception of oil, commodity prices in general have been weak over the past year.”
What this tells us is that all the talk about a global economic recovery should not to be taken very seriously. In fact, other data suggests the same. The core personal consumption expenditure deflator, a measure of inflation closely tracked by the Federal Reserve of United States, the American central bank, rose by just 1.1% in January 2014. This is well below the Federal Reserve’s benchmark of 2%.
In fact, if housing is excluded from this index, the inflation comes in at 0.7%. Housing prices in the United States have been rising at a fast pace because of the low interest rates maintained by the Federal Reserve.
What this tells us is that consumer demand is rising at a very slow pace in the United States. And there can be no economic recovery without an up-tick in consumer demand. And how are things in Europe? The inflation in the Euro Zone (18 countries which use euro as their currency) fell to the lowest level of 0.7% in February 2014. It was at 0.8% in January 2014.
What these numbers clearly tell us is that most of the Western world is close to deflation. Deflation is the opposite of inflation and is a scenario where prices are falling. In a scenario where prices are falling (or even in a prospective scenario where people start to believe that prices will fall) people tend to postpone consumption in the hope of getting a better deal. And this lack of consumer demand essentially ends up killing the possibility of economic growth.
In fact, the inflation numbers in China are not looking good either. As Edwards writes “Indeed the widely ignored RPI (retail price index)…is rising by only 0.8% year on year, confirming that China is closer to outright deflation than widely appreciated.”
What is interesting is that falling copper prices also tell us clearly that the demand for the base metal is falling in China. Estimates suggest that Chinese demand comprises 40% of the world’s demand for copper. Nevertheless, the thing is that all the demand for copper in China is not genuine industrial demand.
A lot of copper demand is due to a practice known as “cash for copper”. The way this works is as follows. A Chinese speculator manages to raise money in dollars. These dollars he then uses to buy copper. He then sells the copper and gets Chinese yuan in return. He then invests the Chinese yuan in wealth management products, which promise huge returns. The money invested in wealth management products is typically lent to borrowers like property developers to whom the banks are reluctant to lend.
As Lucy Hornby and Paul J Davies point out in The Financial Times “The trick works best for copper because of the red metal’s liquidity and easy storage. Importers have also tried zinc, rubber, plastics and – least successfully – palm oil, which turned out to be bulky, difficult to store and perishable.”
The cash for copper scheme works as long as the the Chinese yuan remains stable against the dollar or appreciates. As on March 19, 2013, one dollar was worth around 6.21 Chinese yuan. Since then the yuan has gradually appreciated against the dollar and by January 13, 2014, one dollar was worth 6.04 yuan.
But since January 13, 2014, the yuan has started depreciating against the dollar, and one dollar is now worth around 6.15 Chinese yuan. A depreciating yuan makes the cash for copper scheme unviable simply because the speculators need more yuan in order to repay their dollar loan. Given this, as things stand currently, the cash for copper scheme doesn’t really work.
What this means is that a huge section of the Chinese economy which was borrowing through this route has effectively been cut off. As Horny and Davies write “Import financing is one of the few sources of cash flow left for companies that are already cut off from loans by state banks at official interest rates. Many have already exhausted their ability to fund themselves through high interest rate trust products.”
Also, an important part of this trick is that borrowers to whom yuan loans are given return the money. In the second week of March the solar equipment producer Chaori Solar missed a $14.7 million interest payment. This was first case of a Chinese company defaulting on a bond payment. What is interesting here is whether China will allow the yuan to continue to depreciate against the dollar. If it does that then the cash for copper scheme will automatically get killed. Also, it will be a recognition of the fact that the government is taking the deflationary fears in China seriously.
By allowing the yuan to depreciate it will make Chinese exporters more competitive internationally. A Chinese exporter will make much more money when one dollar is worth 6.5 yuan vis a vis when one dollar is worth 6.15 yuan, as it currently is. If this were to happen, Chinese exporters will get more competitive internationally and cut the prices of their products. In order to stay competitive manufacturers from other countries will also have to cut their prices (or source their products from China) and in the process, China can effectively end up exporting deflation to large parts of the world.
The article originally appeared on www.FirstBiz.com on March 20, 2014
(Vivek Kaul is a writer. He tweets @kaul_vivek)
Deflation
How deflation can spoil the global stock market rally
Vivek Kaul
There are stock market rallies that are currently on across various parts of the world. The stock market rally in the United States is now nearly 5 years old, having started in March 2009. But there is a small factor that investors who are driving up these markets are not taking into account. And that is the current low inflation scenario as well as the prospect of deflation.
As Gavyn Davies writes in The Financial Times “The vast majority of developed countries are currently reporting a headline inflation rate of below 1.5 per cent, with the trend in virtually all of them headed downward.”
Inflation in the Euro area (17 countries in Europe which use the euro as their currency) for the month of December 2013 stood at 0.8%. In December 2012 it had stood at 2.2%. The inflation in the European Union (which includes the euro area countries plus 11 more European countries) was at 1% in December 2013. It was at 2.3% in December 2012.
A similar trend seems to be playing out in the United States. For the month of November 2013, the consumer prices, as measured by the personal consumption expenditures deflator, rose by 0.9%. This number was at 1.7% in November 2012. The personal consumption expenditures deflator is a measure of inflation favoured by the Federal Reserve of United States, the American central bank. The Federal Reserve has an inflation target of 2%. Hence, to that extent consumer prices in the United States are rising at a much slower pace than the target favoured by the Federal Reserve.
As Davies writes “It is hard to remember a period, other than in the months immediately following the financial crash in 2008, when…headline inflation has been so low in so many different economies.”
And why is that a worry? Lets look at the European Union inflation data in a little more detail. Countries like Greece, Cyprus, Latvia and Bulgaria are facing deflation. This means that prices in these countries are falling. In other countries like Sweden, Spain, Italy, France and Portugal, the rates of inflation are less than 1%. In fact, in case of Spain and Portugal these rates are close to 0%.
When prices are falling or it looks like that they will soon start falling, consumers tend to postpone their consumption decisions in the hope of getting a better deal in the future. This has an impact on businesses, and, in turn, the economy in general.
When consumers postpone their buying, businesses try to attract them by cutting prices of their products. This means a loss of revenue and a further fall in the rate of inflation. And this might lead to consumers postponing their consumption even further. So the loop works.
Once countries get into what is known as a deflationary spiral, it is very difficult for them to get out. Japan is an excellent example of the same. The country has been trying to come out of a low inflation/deflation kind of scenario for close to two decades now, without much success.
Investors across the world have chosen to ignore this threat which has been lurking around the corner for a while now. As Albert Edwards of Society Generale writes in a research note titled Markets still refuse to price in deflation threat….. for now dated January 15, 2014, “Investors have yet to react to the deflationary threat however. They do not seem to care that they are sitting on the edge of a cliff. Markets remain stoic about the risks of outright deflation in the US and eurozone for one very simple reason – they simply do not believe a recession that would trigger outright deflation is on the horizon. Quite the reverse – they believe with all their heart that we are at the start of a self-sustained recovery. That is despite the fact that the US recovery is already noticeably longer than average, and that the classic signs of old age, such as rapidly slowing productivity growth and stagnant corporate profits, can clearly be seen.”
A reason for the confidence of the stock market investors is the fact that over the last few years, at the slightest sign of trouble, central banks around the world have printed money (or what they like to call quantitative easing or QE) to keep interest rates low. This has allowed investors to borrow at rock bottom interest rates and invest in financial markets throughout the world. And that will keep the stock market rallies going. As Edwards puts it “Because the market has firmly got it into its head that QE will always be good news for equities. So if the economy swoons, equities will look through any short-term disappointment as more QE will save the day. Investors see bad economic news as good news for equities.”
Hence, investors expect central banks to print more money once they start feeling that deflation is a serious threat to their economies. And the logic is that a lot of this money fill find its way into the stock market and drive prices higher. But there is a problem with this logic.
Until 2012, every time central banks cranked up the printing press, prices of commodities like gold rallied. But that hasn’t happened in the recent past, even though central banks continue to print money. Hence, the proposition that central banks printing money will lead to stock markets rallying, may not always hold true.
As Edwards puts it “I do believe this to be utter nonsense. For in the same way as investors believe, axiomatically that QE will drive up equity prices, they believed exactly the same thing of commodities until 2012. Commodities are a risk asset and benefited massively from QE1 and QE2, so why has QE3 had absolutely no effect on commodity prices? Exactly the same thing could happen to equities if a recession unfolds and profits plunge at the same time as the printing presses are running full pelt. Do not assume equities MUST benefit from QE.”
And this can really spoil the global stock market party. I had asked the well respected financial historian Russell Napier, who works for CLSA, in an October 2012 interview I did for the Daily News and Analysis, that by what level does he see the stock markets falling in the coming deflationary shock. And he had replied “I will just go back to my book Anatomy of the Bear, which was published in 2005 and in the book I forecasted that the equity market, the S&P 500 (an American stock market index constructed from the stock prices of the top 500 publicly traded companies) will fall to 400 points [On Thursday, January 16, 2014, the S&P 500 closed at 1,845.89]. As you know, in March 2009 it got to 666 points. It got somewhere there but it did not get to 400. So I am happy to stick with the number of 400.”
And once the S&P 500 starts to crash, the rest of the world will follow. Of course, till that happens, there is money to be made.
The article originally appeared on www.firstpost.com on January 17, 2014
(Vivek Kaul is a writer. He tweets @kaul_vivek)
Europe and US may have caught the Japanese disease
Vivek Kaul
Before things get better, they get worse.
The Federal Reserve of United States has been on a money printing spree over the last few years. Currently it prints $85 billion every month. This money it uses to buy bonds from banks and financial institutions and thus puts ‘new’ money into the financial system.
The hope and the economic theory behind this is that banks will lend this new money to ‘prospective’ borrowers, who will spend it to buy things ranging from homes to cars to consumer goods. This in turn will revive the stagnating American economy.
The money that the Federal Reserve puts into the financial system every month also ensures that there is enough money floating around, and thus interest rates continue to remain low. People are more likely to borrow and spend money at low interest rates than high.
The money printing will also create some inflation, the hope is. As this ‘new’ money chases the same amount of goods and services, prices will start to rise at a reasonably fast rate. In a scenario where prices are rising or are expected to rise, people are more likely to buy goods and services, rather than postpone their purchases.
All this buying will give a fillip to businesses and that in turn will help the overall economy grow faster. And this is how things will get better.
As things stand as of now, this economic theory doesn’t seem to be working, dashing all hopes. In fact, inflation instead of going up, has been falling in the United States. The Federal Reserve’s preferred measure of inflation is the personal consumption expenditure (PCE) deflater. This for the month of March stood at 1.1%, having fallen from 1.3% in February. The number stood 1.92% in March 2012.
What this tells is that the rate at which the personal consumption expenditure is growing has been coming down over the last one year.
A similar situation seems to be prevailing in Europe as well. As Ambrose Evans Pritchard recently wrote in a column in The Daily Telegraph “The region’s core inflation rate – which strips out food and energy – fell to 1% in March. This is far below expectations and leaves monetary union with a diminishing safety buffer.”
What this tells us is that attempts by the Federal Reserve and the European Central Bank, to get inflation and consumption going by keeping interest rates low, haven’t yielded the results that had been hoped for. People are not interested in borrowing and buying things even though interest rates are at very low levels.
In fact now there is an inherent danger of inflation getting into negative territory or what economists calls deflation. “Over the last 15 years most investors have refused to contemplate that events in the West are playing out in a similar fashion to Japan in the 1990s. But the latest inflation data out of both the US and eurozone should ram home the fact that we are now only one short recession away from Japanese-style outright deflation,” writes Albert Edwards of Societe Generale in a report released on May 2, 2013.
“The eurozone is tracking the experience in Japan in mid-1990s. there is a very high risk of a slide into deflation,” said Lars Christensen, a monetary theorist at Danske Bank, told Evans Pritchard.
Japan had experienced a huge real estate bubble and a stock market bubble in the mid to late 1980s. After these bubbles cracked, the country experienced a deflationary scenario, where prices were falling. The falling prices had a huge impact on economic growth. When prices are falling, or expected to fall, people tend to postpone purchase of goods and services, in the hope of getting a better deal. This means lower revenues and hence lower profits for businesses. It also leads to slower economic growth.
Such an economic scenario is now expected to hit both the United States as well as Europe.
In fact some of this has already started to play out. As a newsreport in the USA Today points out “The reports also show evidence of an economy weakening — a hiring pullback, a drop in construction spending and slowing manufacturing growth, among others.” So the American economy already seems to be entering the slowdown mode.
Suggestions have been made in the recent past that the Federal Reserve will wind down its money printing in the days to come. As Patrick Legland and Dr Michael Haigh of Societe Generale pointed out in a report titled The End of the Gold Era released around one month back “the Fed’s balance sheet will continue to expand at $85bn/month through September, at which point purchases may be tapered modestly to $65bn/month until being fully terminated at the end of the year.”
But with a deflationary scenario looming that doesn’t seem to be a distinct possibility. The Federal Reserve hinted at this in a statement released on May 1 where it said “To support a stronger economic recovery and to help ensure that inflation, over time…the Committee decided to continue purchasing additional agency mortgage-backed securities at a pace of $40 billion per month and longer-term Treasury securities at a pace of $45 billion per month.”
What this tells us is that the Federal Reserve plans to continue printing money and use it to buy $85 billion worth of bonds (mortgage bonds worth $40 billion and American government bonds worth $45 billion) every month. As Edwards puts it “With inflation now massively undershooting the Feds own 2-2½% target range there is nothing to stop the Fed keeping their foot pressed down hard on the gas pedal.”
As pointed out earlier the hope is that money printing will lead to some inflation and that in turn will get people to start consuming and drive economic growth. If it doesn’t there will be trouble. As the USA Today points out “if consumers and businesses are convinced prices of goods and services are falling, they tend to delay spending if possible. They want to wait and get the lowest price they can. That sentiment would snuff out the bull market, likely in an alarming sell-off.” And once deflation sets in, it becomes very difficult to break out of it, as has been proved in Japan’s case.
The trouble of course is that like has been the case in the past, this new money may not reach the people it is intended for, simply because they are no longer interested in borrowing and consuming.
Instead this money will be used for speculation. As economist Bill Bonner wrote in a recent column “The Fed creates new money (not more wealth… just new money). This new money goes into the banking system, pretending to have the same value as the money that people worked for. And people with good connections to the banks take advantage of the cheap credit this new money creates to aid financial speculation.”
The difference will be that instead of the money going into the stock market this time around it will go into bonds. As Edwards puts it “Quantitative easing (a sophisticated name for money printing) seems, in large part, to be bypassing the real economy, liquidity will evaporate from equities if we dive into a deflationary recession. Where will all the liquidity then go as quantitative easing is ramped up still further? It will go into ridiculously expensive bonds.”
But that doesn’t make bonds a safe investment bet. The American government is largely broke and not in a position to repay these bonds. “We remain of the view that on a 3-5 year time horizon bonds will prove to be a toxic investment and rapid inflation is the likely longer term outcome,” writes Edwards.
As the old Chinese curse goes “may you live in interesting times”. These surely are interesting times.
The article originally appeared on www.firstpost.com
Vivek Kaul is a writer. He tweets @kaul_vivek
Napier sees all equity markets falling
Stock markets and economies do not always go together. Take the case with India right now. The stock markets have done reasonably well this year. The economy clearly hasn’t with economic growth slowing down to around 5.5%.
As Russell Napier a consultant with CLSA and a financial historian of repute puts it “I maintain a very positive long term view on India and the Indian economy and how it develops. But, and it’s a big but, that financial history tells you that economic growth and return from equities are not linked at all.” Napier is also the author of the bestselling Anatomy of the Bear – Lessons from Wall Street’s Four Great Bottoms.
The most important thing is to buy equities when they are cheap because when they are cheap that’s when you make good return, feels Napier.
So how cheap are Indian stocks? “Indian equities haven’t been cheap for a very very long period. And the best measure of cheapness that I look at is the cyclically adjusted price to earnings (PE) ratio because it has been a good guide in America for future returns. In India the cyclically adjusted PE is now at 24. If you look at the history of America that is right at the top end of the range. And suggests that we are going to have pretty poor lowish returns from India over a prolonged period of time,” says Napier. Cyclically adjusted PE is calculated by using ten year rolling average earnings. India is now on 24 times cyclically adjusted PE.
This number has to fall if Indian stocks are to become attractive investment propositions. “The volatility of the market though is great, and I think and I hope we will get a chance to buy Indian equities cheaper, and get them cheaper sometime soon,” feels Napier. “Certainly if they ever get below 15 times cyclically adjusted PE you should be looking to buy some of them. And there is every reason to think that they will go lower than that, and then you should be buying a lot of them,” he adds.
Napier is looking at a global deflation shock and the stock markets falling all over the world. As he says “I see all the markets global equity markets coming down to the extent of this global shock.”
Despite the fact Napier feels that Indian stocks are expensive he would rather buy Indian stocks than Chinese. “Chinese are stocks probably at very viable sort of valuation levels. But I wouldn’t buy any of them because I don’t consider them to be corporations. I don’t consider the management to wake up in the morning and seek to push up the return on capital to the benefit of shareholders. And therefore those equities are cheap I don’t fundamentally want to buy,” explains Napier.
And how is India different? “Not every Indian company as you are also aware is going to do the best for all its shareholders. But because Indian companies come from the private sector so it is more likely you are going to find companies in India who work to benefit there shareholders and not just the small family unit in the company,” says Napier. “Hence when it comes to buying stocks cheaply I want to do that in India and not in China. But in India at the minute they remain still very expensive,” he concludes.
The article originally appeared in the Daily News and Analysis (DNA) on October 15, 2012. http://www.dnaindia.com/money/report_russell-napier-sees-all-equity-markets-falling_1752478
Vivek Kaul is a writer. He can be reached at [email protected]
“We are in for another deflation shock…So actually it’s time to own cash”
Russell Napier a consultant with CLSA and one of the finest financial minds in the world, sees another deflationary shock coming. “Yes I am looking at a global deflation shock. So I see all the markets global equity markets coming down,” he says. When asked to predict a level he adds “I will just go back to my book the Anatomy of the Bear which was published in 2005 and in the book I forecast that the equity market, the S&P 500(an American stock market index constructed from the stock prices of the top 500 publicly traded companies) will fall to 400 points (On Friday the S&P 500 closed at 1,428.5 points)….So I am happy to stick with the number of 400 and then just tell everybody else who sort of reads this interview to work out what that means for the rest of the world,” he told Vivek Kaul in an exhaustive free wheeling interview.
How do you see thing in Europe right now?
My focus of the way I try to look at these economies is really to look at the financial conditions, the banking systems, credit availability etc. Those numbers are about bad for Europe. If you look at bank lending in Europe it is contracting to the private sector. The money they are lending is going to the governments. The key issue really is that is lack of credit going to the European private sector due to lack of supply or demand? There is more and more evidence that it is actually demand, and that just makes it just a more difficult problem to solve.
Why is that?
When your banking system is incapable of providing credit there are lots of things you can do to help it. But when people fundamentally don’t want to borrow and corporates don’t want to borrow then it’s a different situation. What would normally happen is quantitative easing and trying to keep money growing at a time when bank credit is contracting. But for political reasons that is difficult in Europe. So Europe is facing a very difficult and nasty economic downturn, and things are going to get significantly worse. It’s worth adding on Europe as well that there is a chance that somebody is going to have to leave the Euro as early as next year. All seventeen members have to ratify the fiscal compact which is a major constitutional change. Still quite a few of them haven’t ratified it and maybe that early as first quarter next year some country may be unable to ratify that fiscal compact. And at that stage we would have a crisis for the euro because the country that fails to ratify wouldn’t be able to stay in the euro. So we are all rolling into a European crisis next year.
So what can keep the euro going?
Ultimately the only thing that can keep Europe going is can they become a Federal States of Europe?
Can they?
No. that is highly unlikely. There are seventeen members of the euro zone and all of them have to make the same constitutional changes and the same surrenders of sovereignty. And this is not an economic call. This is a political and social call. And it is highly unlikely that all sovereign states will end up surrendering their sovereignty to a Federal government of Europe.
How do you see the things in the United States?
There is a much more mixed picture coming out of the United States of America. Bank credit is expanding and the private sector is borrowing. What is interesting is that small and medium enterprises have been borrowing and we have been seeing a growth there for over a year now. That is normally a very good sign of thing because those are normally the people who create jobs.
What about other borrowing?
Banks balance sheets have premium components to them in terms of credit. And one is credit to small and medium enterprises. The other is mortgage credit. There is no sign of growth of mortgage credit. The other is consumer credit. There is no sign of growth in consumer credit either. At this stage one can be more optimistic about the United States simply because small and medium enterprises are borrowing.
But what about the long term view?
I have a longer term problem with the United States which isn’t going to show up quarter to quarter in the growth numbers but it is structurally the most important thing that is going on there. The rate at which foreign central bankers particularly the Chinese are accumulating treasuries has dropped very dramatically. The Chinese are not buying and actually seem to be selling United States treasuries. Along with the Federal Reserve of United States they are the biggest owners of treasuries. They are neck and neck. When the biggest owner of treasuries is effectively a forced seller, it has to make you cautious on America despite the shorter term positive data coming out.
What will be the impact of this?
If the Chinese are not going to be funding the American government it’s more of an onus on the American savers to fund the American government. With savings being a reasonably finite number then there is less to lend to the private sector. I see us already in a larger picture trend of America where the savings of America will be increasingly be funding the American government and not the private sector. At the minute that is not having any negative impact or particularly negative impact on private sector credit availability. But ultimately it will.
That being the case are Americans saving enough to bankroll the American treasury?
The answer to that is no. They are not saving enough to bankroll the American treasury and the private sector. You have to put them both together. If you look at a country like Italy in Europe the government always gets funded. The governments always get funded someway. Likewise, the American government will always be funded. And if has to force the American people to buy treasuries it will force the American people to buy the treasuries. The question is are they saving enough to fund the government and also fund the demand of the private sector for capital as well. My answer to that is definitely no. But if it comes to push whether the government is funded or the private is sector funded, even in America which is ideologically more to the right, more free market than elsewhere, even there you will find the savings are forced towards the government and away from the private sector.
That being the case how do you expect the US government to finance its unfunded liabilities over like social security, mediclaim etc, over the years? One estimate even puts the unfunded liabilities at $222trillion.
In the short term as long as they can keep borrowing at this level they will probably keep borrowing at this level. There is a basic rule. A government that can borrow at 2% will borrow at 2%. That’s an entirely and completely unsustainable path for the American government. But it is just so easy to borrow at 2% that they will continue to do that. So that reality for America will not dawn for unfunded liabilities until it has to borrow at a more realistic interest rate, which is inevitable. The numbers you point out are absolutely huge but it’s becoming incredibly difficult to say when that will happen, when they will have to live with proper real interest rates. It could be several years. It could be several days. But eventually of course they will have to do that. And there is a whole host of solutions for the United States government.
Like what?
There is a thing called financial repression which is effectively forcing people to lend money to the US government or forcing financial institutions to lend money to the US government. That is the path to travel for all the developed world countries. But there will have to be a renegotiation of benefits to the baby boom generation. Every society has to choose where the burden has to fall. Does it fall on tax payers? Does it fall on savers? Or does it fall on people who are recipients of this dole of money from the government. It will be a mix of all of these. So at some stage we will have to see a major renegotiation of the obligations that were signed for the baby boom generation in the 1960s. But it could be many years away. I have to stress that this will be political dynamite. No society wants to withdraw benefits from its retired or elderly population. But the entire western world faces the reality that is exactly what it will have to do.
Do you see what they call the American dream changing?
It has massively changed over the last two decades already. American people sustained by going from one person working to two persons working and then adding significant leverage to it. So the dream has been extended through those two mechanisms and clearly it is not going to go much further from here. It’s a much harder slog from here given excessive levels of debt on the starting position. It’s not only an American phenomenon but it’s a developed world phenomenon. It’s easy to be negative but the only possible positive way out of this is some technological innovation which gives us some very high levels of no inflationary growth and very high levels of productivity.
Could you elaborate on that?
If you read financial history sometimes these things just come along. They surprise everybody. One thing that is that could do it is cheap energy. Shale oil and shale gas are the main places we would be looking at for cheap energy. But it is worth stressing that we are going to need a very high level of real economic growth. So in America it will have to be in excess of 4% or maybe as high a 4.5%. That’s the sort of real economic growth that would help countries grow their way out of the debt problem and meet most of the potential liabilities going forward. One shouldn’t rule out that we have that wonderful outcome but it still does seem like very unlikely.
Talking about technological innovation can you give me some examples from the past?
Yeah absolutely. They have really been energy related. In United Kingdom the canals were such a revolution that the transportation cost collapsed. The price of coal in some major cities came down by 60-70% due to the introduction of canals. Obviously when energy prices fall by that much you get a productivity revolution. The railways had several impacts. Electricity which we didn’t really get going into the industrial process until the start of the last century, had a major impact. The automobile had a major impact. These are the types of major technological innovations which can change the world. When you can give the world cheap energy then that’s when you can begin to talk about much higher levels of growth. It is almost impossible to tell where these things come from but one that is sort on the horizon is shale oil and shale gas and potentially what that can do. But I want to stress it is going to have to produce levels of real economic activity in America, which haven’t seen for a very very long period of time, perhaps ever.
Do you the American government defaulting on all the debt it has accumulated?
They will not default in the technical term of the word default which obviously means refusing to pay back in dollars the debt in principle. That would be definition of default. That seems unlikely. But we are already in a situation where the Federal Reserve of the United States has intervened in the treasury market to hold the treasury yield below the level of inflation. Now that is not a default. But if you own treasuries and the yield is below the rate of inflation then the real value of your investment is declining in dollar terms. In terms of you and I investing in that treasury market it means that we are losing capital and therefore I would call this a democratic default. The second democratic default which I will come to America and the whole developed world will eventually be restrictions of free movement of capital. We are heading towards a world of controls and capital restrictions, which was a norm from 1945 to 1980-81.
Do you see them printing money to repay all the accumulated debt?
The answer is that partially they are already doing it. Quantitative easing is a form of printing money. Therefore you can say that is a process that is underway. So I have no doubts whatsoever that the Americans will be printing money to satisfy their foreign creditors.
Do you see that leading to a hyperinflation kind of scenario?
No. It is always assumed that if there is a dramatic sale of the treasuries by the Chinese, the Federal Reserve will simply buy all those treasuries and simply create lots of money in the process. If that mechanism happened you would end up with hyperinflation. But it’s worth remembering that there is a technical definition of hyperinflation and that is a rate of inflation of 50% per month or more. So it’s a very high number. Sometime people think that 20% per annum is hyperinflation but its 50% per month technically. The Federal Reserve is not stupid enough to do that. It would not simply print all the money it could to do to repay its creditors.
So what will happen?
What will happen is that there will be some money printing and as I stressed inflation will be higher than yield of treasuries. But Plan B is financial repression which is to effectively force the financial institutions and the people of America to buy the treasuries. Now this does not involve printing of money. I am sure that if the Federal Reserve sees inflation climbing to anywhere near 10% it would go to the government and say that we cannot continue to print money to buy these treasuries and we need to force financial institutions and people to buy these treasuries. In India you must be aware that banks have to compulsorily buy government debt. We can force banks and government companies to have a minimum amount of their assets in government debt. The road to hyperinflation is well known by central bankers. It has never ended well even though it can wipe out your debt very very rapidly indeed. Nevertheless, the political and social implications of that are truly dire. It tends to throw up despots and destroy democracies. Financial repression if you are a saver is a terrible but is much less painful than hyperinflation.
But what about the Western world practicing austerity to repay its debt?
True austerity is when you if you simply closed down on the government spending and accepted the economic consequences of that and still kept taking in the tax revenues. But that’s apolitically painful way of doing it. True austerity is highly unlikely. What Europe has nothing like sufficient austerity to take them to a situation where they can repay the government debt. So the only way out is repression, which is simply funding the government by forcing the people and financial institutions to buy government securities. That’s a very painful thing if you are a saver, but so much better than austerity, default and hyperinflation. It is ultimately the most acceptable form of getting out of this problem. Even with repression we are talking about a couple of decades before we could gain levels of gearing in the developed world drawn towards normal levels.
Do you see the paper money system surviving?
Yes I do see the paper money system surviving. To say that it doesn’t survive means we replace it with something that is based or anchored on metal. But the history of the paper currency system or the fiat currency system is really the history of democracy. Within the metal currency there was very limited ability for the elected governments to manipulate that currency. And I know this is why people with savings and people with money like the gold standard. They like it because it reduces the ability of politicians to play around with the quantity of money. But we have to remember that most people don’t have savings. They don’t have capital. And that’s why we got the paper currency in the first place. It was to allow the democracies. Democracy will always turn towards paper currency and unless you see the destruction of democracy in the developed world and I do not see that we will stay with paper currencies and not return to metallic currencies or metallic based currencies.
What about gold?
Gold is never easy to predict and it is particularly difficult at the moment. In the long run view which I have just run through that repression is ultimately the best choice for democracies, gold is the best asset class. It is the standout asset class. In a world of negative real interest rates prolonged for some decades gold does really well. And secondly in a world where tax rates are going up where the government needs to get more private wealth under its own control then gold is small, portable and hidable and therefore becomes an asset of choice. So my long term prognosis for gold remains very good. In the short run I am concerned that if we get another economic setback from here and we see growth coming down from here, the price of gold may come down. But I would say any declines in the price of gold are wonderful opportunities to buy some more and for the long term holder gold remains essential.
What are the other asset classes you would bullish is on?
I tend to believe that we are in for another deflation shock. The Asian crisis of 1998 was a deflation shock and we had one in 2002 when the American economy slowed and Mr Bernanke had to make his helicopter speech. We had another one post Lehman Brothers. So what you would want to look at is what asset classes did well during those periods? And really very little does well when we have deflation shocks. Whether deflation turns up or not the shock is very bad for pro-growth assets. So actually it’s time to own cash. Cash has historically been a good preserver of health during periods of deflation. It is worth buying debt of some of the governments that don’t have very much debt. There are some countries out there with small amount of government debts and they are small such as Singapore and Norway. So I would recommend cash and very small holding in government debt in markets where the governments don’t have very much debt. Also when markets have come down a bit we are looking to buy equities and we are looking to buy gold.
By when do you see this deflationary shock coming?
Well its coming. It is very rare for these things to erupt in the morning. Lehman Brothers was the exception a bank with $600billion of liabilities going bust suddenly threatens the stability of the entire financial system. Sometimes it happens like that but rarely. It happened like that in the 1930s with the bankruptcy of Creditanstalt (An Austrian bank which went bankrupt in 1931 and started a chain of bankruptcies). Occasionally it can be a major event. But it can be just like it was in 2003 just slower and slower growth. The only sort of one red flag which could suddenly jump and signal deflation is if someone leaves the euro because clearly if it’s a major currency leaving the euro they will be re-denominating their debts in their domestic currency which is tantamount to a large default on the global banking system. That is a small chance of that early next year.
What if the country is Greece?
Frankly Greece defaulting on its debts isn’t going to make much difference to a banking system but makes a big difference to the IMF and the government. But more likely it’s just going to be slower and slower growth coming forward particularly in China. The world has bet a lot on Chinese growth. The more the growth slows in China and capital flows out of China, the more the world begins to realise that its China which has been the source of global growth and global inflation, and if that’s not there we are more likely to get deflation. So that’s the more likely scenario rather than a Lehman Brothers style event.
So you are basically saying that the high Chinese growth rates will now be a thing of the past?
Yes unless they do some major reforms. And in my opinion that they need to do is reforms which will encourage private Chinese capital to remain in China and invest in China. And at the minute where is very limited reason for the Chinese private capital to remain in China because the returns are so poor. So anything they could do to open up the financial system for private sector investment and private sector competition would be good. And more importantly allow the private sector to take over some state owned enterprises and restructure them. If they are prepared to make that giant leap in terms of reforms then there is every prospect that keep they will keep capital in China. The good thing is we are getting a new administration. The bad thing is it is very difficult to predict what a new Chinese administration stands for. But soon enough we will know and if they come up with some policies like this, then there are many reasons to be more optimistic about the outlook for global growth.
By what levels do you see the stock markets falling in the coming deflationary shock?
I will just go back to my book the Anatomy of the Bear which was published in 2005 and in the book I forecasted that the equity market, the S&P 500(an American stock market index constructed from the stock prices of the top 500 publicly traded companies) will fall to 400 points (On Friday the S&P 500 closed at 1,428.5 points). As you know in March 2009 it got to 666points. It got somewhere there but it did not get to 400. So I am happy to stick with the number of 400 and then just tell everybody else who sort of reads this interview to work out what that means for the rest of the world.
The interview originally appeared in the Daily News and Analysis on October 15, 2012. http://www.dnaindia.com/money/interview_we-are-in-for-another-deflation-shock-so-actually-its-time-to-own-cash_1752471
(Interviewer Kaul is a writer. He can be reached at [email protected])