Russell Napier: Growing Wealth in an Inflation Avalanche (w/Russell Napier and Stephen Clapham)

Russell Napier: Growing Wealth in an Inflation Avalanche (w/Russell Napier and Stephen Clapham)

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STEVE CLAPHAM: Hi. I'm Steve Clapham. I'm really  excited and looking forward to my discussion with   Russell Napier. Russell, welcome. What I would like to start off by   doing is just painting the scene. Russell,  you've explained to me in the past your views,   which are quite radical, I think, about the  forthcoming denouement of inflation, how equities   will develop, how bonds will develop. Could  you briefly just paint a picture of your views.  RUSSELL NAPIER: Yeah. I'll try to get it into  a very short period of time so we can get   to discussing what it means for investment. But  the simple way to explain this is that there have  

always been two ways of creating money. One  is by a central bank. But most importantly,   the other is by commercial banks. And  the vast majority of all the money in the   world has been created by commercial banks. Now, sometimes that astounds people. But of   course the idea is the central banks  kind of control of commercial banks.  

And therefore they are in control at the rate  at which the commercial banks create money.  My entire thesis is that that changed in May. It  changed April, May. And it changed through the   use of what we call government bank guarantee  schemes or bank credit guarantee schemes. And   it sounds like a very technocratic,  not-very-interesting, not-very-important   shift, but actually it's fundamental. And last week, the European Central Bank  

recognized this. And they called it the  sovereign-bank- corporate nexus, which   is a classic euphemism for the fact that money is  now created by governments, not by central banks.  Now, I can't persuade anybody of that, even though  the ECB has now come out and said it as well.   Because once a government is then  offering that guarantee to the bank,   the bank begins to lend money. And we've  seen spectacular growth in bank credit in   this biggest recession in this country-- this  country being the United Kingdom-- since 1708,   fastest bank credit growth probably we've  ever seen, or certainly one of the highest   we've ever seen in peacetime. How on earth do you  reconcile those? The government guarantees it.  So when those bank loans are made, money is  created. And that has been the failure of  

central banking for 12 years, that they absolutely  failed to do that. They created a lot of their   type of money, which is technically called a  bank reserve and sits in the banking system.   But they didn't create a lot of what I call our  type of money. And by what I mean our type of   money, I mean citizens, people who spend it, the  stuff that we pick up in GDP and measure in GDP.   And my goodness, the governments are  doing a spectacular job at creating that. 

So to give you some numbers, the growth  in the total number of dollars in the   world is up 25% year on year. For the yen,  we're looking at about 9% year on year.   For the euro even we're getting to 10% year on  year. And these numbers, these growth rates,   have all doubled or tripled during COVID-19. So the first point is that it's a new mechanism.   It is working. Historically, that level of money  supply growth would normally create inflation.   And there's a bit of people who doubt that. But at  a very high level, it's almost certainly the case. 

And then the second part, Steve, which we will  no doubt talk a great deal about, is that that   leads us to a time when bond yields are capped,  when the state central bank regulator does not   allow the bond yields to reflect the inflation  outlook. And that is something called financial   repression. And it leads us down a rabbit hole  for a generation of government control mechanisms   to try and force savers to own an asset they  don't want to own. And if I started to talk about  

that in detail, it would take me 90 minutes. But that is the outline of two things. One,   inflation is coming because the control of  money is coming. But it takes us to a world   where we have to control the yield curve. And that  takes us to a thing called financial repression.   And then we're definitely not in Kansas anymore. STEVE CLAPHAM: Before we go down there, I mean,   the way I look at this, very simply, is  that the governments have got a lot of debt.   They need to keep --- RAOUL PAL: Hi, I’m Raoul Pal.  

Sorry to interrupt your video - I know it’s a  pain in the ass, but look, I want to tell you   something important because I can tell that  you really want to learn about what’s going   in financial markets and understand the global  economy in these complicated times. That’s what   we do at Real Vision. So this YouTube channel  is a small fraction of what we actually do.   You should really come over to and see the 20   or so videos a week that we produce  of this kind of quality of content,   the deep analysis and understanding of the  world around us. So, if you click on the link  

below or go to, it costs you $1.  I don’t think you can afford to be without it. STEVE CLAPHAM: Before we go down there, I  mean, the way I look at this, very simply,   is that the governments have got a lot of debt.  They need to keep interest rates very low. And   therefore, if we do get inflation, we're  going to be in a period in which there's   negative real interest rates, and large.  And that means that anybody that's trying  

to protect their wealth will have to seek to  borrow money, which means that there will be   a huge demand for credit. And that's why the  rationing will have to take place. Is that--  RUSSELL NAPIER: That's absolutely right.  And that's a brilliant word. Rationing is   a brilliant word, and a word that most people  watching this will never have had to live with.   And people will think it's an alarmist word  as well. But let's be clear what rationing is.  

Rationing is the allocating of resource by  a mechanism other than price. So don't think   of World War II. Don't think of queuing up to get  two eggs. Think of a means of allocating anything   by a mechanism other than price. So you're absolutely right. When you  

get negative real yields, we'll all want to borrow  really. I mean, if my wages were going up at 6%,   why wouldn't I want to borrow at 2%? And if I  was a corporation and my revenues were rising   at 7% or 8% because I was getting price rises  or 6%, of course I'd want to borrow at 2%.  So we have to put in place administrative  restrictions on this. And of all of the many, many   things we could discuss, this is probably one of  the most important. Because we've lived in an era   where anybody could get credit. Dogs got credit.  At least they were mailed credit card application  

forms. At a right price, anybody could get credit. And the world is geared for that reason. And   just one thing I'd correct you on  is, yes, it is about government   debt-to-GDP being high. But actually the  private sector debt-to-GDP is at a record high.   At least government debt to GDP may be slightly  lower than World War II in some countries.   But the private sector is at a record high. So just imagine a situation where we have to  

unstitch the past 30 years to get debt where we  need it or want it to be. How much debt will flow   to private equity? How much debt would flow to allow you and I, if we ran a corporation,   to buy back our own equity? How much debt  would flow to gear up commercial property?  In fact, what you might argue is that the  government divides rationing, good credit and   bad credit. The bad credit would be gearing up an  existing income stream. And the good credit would   be building an existing income stream. Because  in building an existing income stream, we have   the prospect that we're going to employ people. So you've absolutely hit the nail on the head.  

And as a stock selector, of course, that has huge  ramifications. Because if you can find the stocks   that get that really cheap credit, there is  potentially extremely good benefits for the   equity. But if you are in the stock already, which  has all this credit, and basically can't renew it,   and has to go for equity funding, then we're  going through a very prolonged re-equitization,   which I would argue is probably not  good for the price of that equity. 

But you're the micro specialist.  So what do you think?  STEVE CLAPHAM: Well, that is an interesting  question. I'm going to come back to that in   a minute. Because this idea, if we've  got inflation, well, theoretically,  

if governments are trying to inflate away the  debt, it might be a good idea to form leveraged   companies. But if they can't refinance the  credit, that's going to be a real problem.  But before we get onto that, there is one  sort of pushback I think people will have   to this idea we're going to have inflation.  And that pushback is, well, governments have   wanted the inflation for the last decade--  more. And they haven't been able to get it.  

So why are you so convinced that now is the time? RUSSELL NAPIER: Well, I need to give you a little   bit of my own history here. So when we got  to 2009, when I became a bill of equities,   I said, this is going to create inflation,  this quantitative easing. And you should own   equities and commodities. And of course they  both went up. And inflation actually went   down. So inflation did get quite close to 4%. But in 2012, I completely changed my mind,  

and said, we're not going to get inflation, we're  going to get deflation. Well, it took a while,   but as early as 2015, America was  actually again reporting deflation.  So why, as you say, given that  governments have wanted it for so long,   given that central-bank balance sheets have  gone like this, why didn't they get it? Because   they didn't create the sort of money that  circulates in the things that we call GDP.  

What that activity by the central bank  acting alone did is it was buying,   effectively, bonds from savings institutions and  crediting the savings institutions with cash.  You and I have both worked for savings  institutions. So we know that the only thing   that a savings institution can do with that is buy  more assets. It can't buy a Lamborghini. Despite  

what you read in the press, the fund manager  can't take the money and buy a Lamborghini.  So the money we're creating today is of an  entirely different sort. And if we look at   these loan programs, they've all really gone  to small companies rather than big companies.  

This is the ones that have come through  the banks rather than the bond market.  And I mean, very small companies, you know, taco  stands, Uber drivers, these are the sort of people   who are getting this. And these guys spend the  money. They have to spend the money to survive.   And they're going to spend this money. So to me, the fundamental difference   is that-- and it shows up in the data. So the  crucial data-- let's take Japan, the infamous   Japan, where there's been no inflation back  since the early 1990s. I think it's about 2%  

that broad money growth has averaged in Japan  over that period. And all the incredible things   the Bank of Japan has done, it's been 2%. Well, depending whether you go for M2 or M3,   we're up close to 10% today. Now, you can  either say that's irrelevant and it doesn't  

make a difference, or you can say, that's  it, the world has just changed. And to me,   that is what changed and who has that  money. And it will be spent in GDP.  And that's why, after many, many years, I'm  looking at a thing I wrote. I have it on the   wall. Because I wrote it in 1996. It was called  Dealing with Deflation. So I mean, it's something   I've been aware of since 1996. And every recession  we've had since 1996, it has tipped us towards--   either into deflation or a fear of deflation. So here I am, sitting here, after writing  

about that now for over 20 years, to  say that it won't happen again, that   this has fundamentally changed because of how  money is created and whose hands it is in.  STEVE CLAPHAM: OK, so our working assumption is  that you're right and there will be inflation.   We don't want to risk everything by betting 100%  that you're right, and just going and buying gold,   putting all our assets into gold and into gold  miners, which would be the simple solution. 

So let's just explore, OK, let's put some of our  assets into gold and gold miners, but what do we   do with the rest? So the first thing was to think  about companies that are heavily indebted. And   that's risky, because obviously companies with a  lot of debt will have to refinance at some point.  Your theory is that they'll just come up against  a roadblock and they won't be able to borrow the   money, either because the central banks will  ration the credit or because the credit markets   will charge them a heinously price because of  the risk that they won't pay and because they   want real interest rates. Is that fair enough? RUSSELL NAPIER: Well, I think the first one is   fair enough. And the second  one I'm going to differ on.  So on the first one, absolutely. But remember,  the world is being divided into good and bad. So  

we can find the corporate that's allowed to access  that credit because it's considered that credit is  for a socially-useful purpose. Then  things may be fine. I think it's very   clear that green lending is going to be  one of those socially-useful purposes.  Another one is definitely building residential  real estate. That is the American dream. it's   not just the American dream, it's a dream for  most people in the world to own their own homes.   That's going to be good credit. There's lots of  reasons why you might look to invest in companies  

like that get access to the good credit. The second point was corporates are going   to be starved because the yield they'll have  to pay to go into the non-bank market will be   excessively high. I think that's really  interesting. Because in my book, I looked at 1949   as one of the great bear market bottoms. And of  course that's a period of yield-curve control,  

when the central bank is actually keeping yields  at a certain level. The necessary arbitrage,   if you were a savings institution, actually  kept corporate bond yields pretty close to that   yield. That worked as an anchor. It worked as an  effective anchor. Now, it has to be said that most   corporate balance sheets in 1949 were in a hell  of a lot better condition than they are today. 

But on that second bit, the fundamental way we  did this after World War II was not via market   system at all. So the United Kingdom had a  thing called the Capital Issues Committee.   And the Capital Issues Committee, if you  and I wanted to issue a bond of debenture,   as it was called, to raise this money, let's say  to build office properties in London, it had to   be approved by a committee. And if the committee  didn't approve it, there wasn't any price that we   could issue at. We didn't get a license to  raise capital. So it didn't really matter. 

And I think most people will think that's  extreme. But in November last year,   the Bank of England, Her Majesty's Treasury,  and the FCA, announced a committee that is   going to work out what productive investment is.  Now, we'll just have to wait and see what that   means. But when the government starts drawing a  line between productive and non-productive, we   could well be morphing back into that committee. So you're absolutely right. If you and I run   a company which is just not getting at any  price, then it's a forced re-equitization.  

And that is not going to be good  for the return from investing in   the equity. Probably not going to be good for it. STEVE CLAPHAM: But the post-war period, which was   characterized by a limited amount of trade- - I  mean, we're in a much more global world today. So   the Bank of England can say, to all the  banks, you're not issuing loans to real estate   developers. A real estate developer is just going  to go to a Cayman Islands entity and issue a bond.   I mean, how can the government-- I mean, even  if the governments collude, can they stop global   finance? I mean, I don't see how that's possible. RUSSELL NAPIER: So it is possible. And in  

recent times, lots of people have  done it. Of course the Chinese   do it. I mean, they don't do it with 100%  success, but they do it with significant   success. And that's not just significant  success in stopping capital coming out,   it's also significant success in stopping Chinese  corporates borrowing overseas and bringing it in.   I mean, that got out of control up until about  2014. And they brought it back under control. 

Of course, the ultimate control is capital  controls themselves. And people say, well,   that can't happen. The technology's so wonderful.  We have Bitcoin. It'll never happen. Well,   then someone better explain to me how Iceland,  Greece, and Cyprus have all had capital controls   within the last 10 years. They've had them and  they've removed them. They're quite common in   emerging markets, where they work to a certain  degree. But even three of the-- well, you can't   call them major countries, but three developed  world countries have run these capital controls.  It is very difficult to do if one country was kind  of-- if you're bankrupt or over-leveraged and had   to do all this in isolation. But when you look at  the data, everybody's in the same boat. I mean,  

China is the only emerging market that's really  geared. All the developed world is really geared.   So there is a reason why they will cooperate. And just some evidence of that which existed   before COVID, the OECD has been forming a  group couple of years to try and work out   what they call base erosion profit sharing  taxation, which is stuff we all know about,   that every company-- Starbucks has a Belgian  or a Dutch subsidiary. They pay a license   for marketing and all that stuff. We-- I say "we" as a developed-world   group of companies-- were working on that  even before COVID came along. The secret   of taxation is to extract the maximum amount  of feathers with the least amount of hissing.  

And when governments can collaborate-- because  they all need the tax revenue-- then I think   these things become much more possible. So it may not be as strict as the post-World   War II situation. But that's not the point. The  point is it's going to be radically different from   the system that you and I spent our careers in. STEVE CLAPHAM: Well, I think this is an important   point you make. Because we've had, what,  nearly 40 years of falling interest rates.   And now they can't fall any further unless you  believe that they can go to negative 5%, which   I suppose is a potential-- I mean, you can't say  it's impossible. But it's probably less likely.  So I think everybody that's operating in  markets today has to look with a very different   lens. Because you can't look back at history and  necessarily conclude that this is what's going to  

happen in the future. And I think you've actually  really got to think a lot more radically, and   start with a blank sheet of paper, and think, OK,  so we're going into an inflationary environment.  Let's say there are capital controls. How  does that work? I'm sitting with Apple shares.   Apple buys its products from China. It pays  huge amounts of money to Foxconn. It sells  

huge numbers of iPhones in China. It's got a  service platform operating all around the world.   Well, does the cash have to stay in China  or wherever? I mean, how will it work?  RUSSELL NAPIER: Yeah, so where  you'd begin with is you'd stop   capital outflow. And you'd try to divide this  between capital outflow and outflow associated   with trade. So I'm not saying that it works, but  this is where you'd begin. So you don't want to   disrupt trade. Trade keeps people employed.  So somehow you can say, to a corporation,   if you're Apple, and you're moving $6 billion  offshore to buy something in Europe, that's   not allowed. We want to at least have a look at  that. But if you're Apple, and you need to move   some working capital to China to do some trade,  that's a different thing. I think we both know how  

difficult that will be. But that's how it works. All the money that Apple has offshore, of course,   it can bring back to America at any given point  in time. Capital controls are like a lobster pot.   You can always bring money in always. It's just  that you can't take it out. But there may be a   few companies that are really just struggling  with far too much capital coming in. Switzerland  

is already in that situation. I suspect Singapore  could be there. So there might be a few companies   that will try and stop you taking your  money out. And we can talk about how you   do that. But for most countries, it's not allowing  you to take money out for the purposes of capital   investment. And that's where it begins. But it becomes a giant game of whack-a-mole.   Because everybody finds ways of arbitraging that,  as the Chinese do. And then the government chases  

everybody around, trying to make sure that it's  not transfer pricing or whatever else. So that's   the mechanism where you worked on. So you start  with this sort of-- you target a tier. But,   by definition, you spread down through the system. And you probably know that, in the 1960s,  

I think the maximum amount of money you could  take out of the United Kingdom was 30 sterling.   Now, I'm not saying we're  going to get to that level. But   I keep recommending that everybody goes and reads  Graeme Green's Travels with my Aunt, which is a   novel. And I don't really want to give too much  away, because I'll ruin the entire novel. But it  

tells you something about capital arbitrage and  the world of exchange controls. That's all I will   say. But he's a great novelist. So worth a read. STEVE CLAPHAM: Well, you weren't allowed to take   out more than a certain amount in cash. But if  you were going for a long holiday, it wasn't  

enough to finance your holiday. So everybody  took more, right? And I mean, they didn't search   you at the airport-- or maybe they did. RUSSELL NAPIER: That's what I mean about   arbitrage. It turns out that your  grandmother becomes an arbitrager   in such a system. The Bank of England had a  huge department, Steve. So if you and I wanted   to move money out of the country, we filled in  a huge form. It went to the Bank of England.  I mean, I can't remember the numbers, but there  was something like 800 people in that department.  

And it basically closed down overnight.  Sir Jeffrey Hodge stood up-- I think it   was 1979-- said, there won't be any exchange  controls tomorrow morning. And all 800 of   them had to go home. So it was a really big  industry, approving our movements and capital.  And the other interesting thing about that is--  because when the capital controls came down,   and they came down here in 1939 for obvious  reasons-- what happened is that, your foreign   assets, they went to a big premium. Because if I  was in London and I owned some shares in New York,  

and you wanted to invest in New York, and  I'd say, Steve, if you want to have this   dollar- denominated asset, you've got to pay me a  premium. So that's a simplified way of doing it.  But a thing called dollar premium developed,  which you could get your money out of the   country if you like. But it certainly wasn't  at the prevailing exchange rate. It was at a   significant premium to that exchange rate. STEVE CLAPHAM: So that presumably is what   we should be doing right now, is to  protect ourselves if we believe the   capital controls are coming. We're sitting  in the UK. Where should we put our money?   Singapore? Switzerland? RUSSELL NAPIER: So the definition of who will not   have to put in financial repression are countries  with low debt-to-GDP ratios. So that's where we   start. And we say, are there any of those? But the  only ones in the developed world would actually be  

Germany and Austria. But they are not irrelevant,  given that they are part of the European Union.   So it's not Germany and Austria. But Switzerland  is all right. Singapore is probably very good.  The fascinating thing, however, is if you look at  countries with low debt-to-GDP, with the exception   of China, they're all in the emerging markets.  Now, if I said to you that we need to put our   money into Mumbai to avoid financial repression,  I think there would be deep, deep skepticism.  

And policymakers in India are-- let's  just say they can be unpredictable.  So I'm not suggesting-- as you said, you  don't want all your eggs in one basket.   But there are reasons, I think, where we  should be looking to emerging markets. Now,   for me, that's not yet investing in the  equities. There's a changing relationship  

between the West and China coming, which will  be deeply dislocative for emerging markets.  But there is a prospect that emerging markets can  do. Well, let me give you two historical examples.   Switzerland, after the war, was a brilliant  place to avoid financial repression   for very obvious reasons. Switzerland didn't  have a lot of debt at the end of World War   II. It was a nonbelligerent. Therefore, even  just putting money in the Swiss bond market,  

you made money from your bonds in Swiss Franc  terms. But actually you made a lot more on your   exchange rate. So that was a good place to be. But I think the really peculiar one is Hong Kong,   another colony that didn't have a lot of  debt after World War II for obvious reasons,   given that they'd been occupied by the  Japanese. They did not endorse financial   repression. It was famously run by a British  civil servant called Sir John Cowperthwaite,   who shunned financial repression and pursued a  kind of more free-market approach. That turned   out to be a wonderful place to make money in  the kind of 40, 50 years after World War II. 

So we're looking for-- but so I raise Hong Kong  because who would have thought of it? If I'd said   to you, in '45, Steve, you know what, London--  and, now, London had been the financial capital   of the world, really, until 1914-- get your money  out of London, put it into Hong Kong. You'd say,   you must be nuts. And not only that, it's got  all these communists just north of the border.  So when you said, let's start  with a blank sheet of paper,   when it comes to a world like this, we do need to  start with a blank piece of paper. So personally,   although, it's not a huge amount, I think investing in India is probably one of the better   things to do. And that will sound radical to  many people. And to be sure, not a huge percent,  

but it seems to me that there are-- Indonesia,  I've just made an investment in Indonesia.   Seems to me, for all the trials and  tribulations that Indonesia faces, a need   to financially repress will not be one of them. STEVE CLAPHAM: Well, I'm glad you said that,   because India is actually one of my biggest  country exposures in my equities portfolio. So   I believe in it, not because of what we're talking  about, because of fundamentals of the country.  One thing I'd like to explore on the subject  of inflation-- and you know, many of the people   watching this will almost have no idea what  inflation is. I mean, I can remember, as a child,   not as an operator in the stock market, I can  remember inflation. What do you think about what  

sort of investment people should be looking for?  And one of the things I wanted to talk about was,   if you look at what will work in a period of  inflation, it should be pricing power. But when   we talked about this before, you said that in an  inflation world, everybody's got pricing power.   And what you need to have is cost control. And I thought it was--  

it was quite a funny comment to me. I  mean, what do you think about this? I mean,   obviously, if you've got real pricing power,  that's the best protection against inflation.   How do we look for companies with cost control?  Because it's something that people have paid much   less emphasis on in the last 10, 20 years. RUSSELL NAPIER: Yeah, so, well, my personal   experience of the '70s was my father  was a butcher. So I used to work with  

him in his shop. And the first thing we did every  Monday morning was wipe down last week's prices   and put up this week's prices. I think UK  inflation peaked at 22%. But meat inflation   was running at a much higher rate. So I remember, very well, going into   a fish-and-chips shop about five years ago, and  noticing, for the first time, that the guy who   owned the fish-and-chips shop had bought a pricing  board where you couldn't change the prices.   All the prices were kind of-- he paid up, so  it was all done nicely. And I thought, well,  

that tells you, in my lifetime, how we've  gone from wiping them down every day to a   complete belief that prices could never go again  because you'd paid for permanent prices there.  This is the issue with stock markets, isn't it?  They [INAUDIBLE]. So you're absolutely right to   say pricing power is a good thing to have in  a period of rising inflation. That's obvious. 

But what we've got in the market today is an  entirely bifurcated market. You just mentioned   40 years of disinflation. So you have very high  valuations for companies with pricing power. Moats   is another word that the Sage of Omaha calls them.  Everybody knows that. You pay up for the moat,   you pay up for the pricing power. In other words,  I think it's in the capitalization of the price. 

And then we have this other class of stocks. And  let's just call them value stocks. Because I think   everybody can kind of close their eyes and see  the price chart. And we know that the value stocks  are languishing down here with one  of the worst-ever performances ever   relative to the so-called growth  stocks or pricing-power stocks.  And then we wake up one morning, and let's pick  a number-- I don't think this is coming that   quickly, but let's say we wake up and inflation  is 5%. Well, what that kind of means is everybody  

gets to put their prices up by 5%, and some people  get to put their prices up by more. But all these   stocks down here, which have been hit because  they've been price takers are still price takers,   but they just had to take a lower price  or virtually no price rise for 40 years.   Suddenly they're price takers at 5% higher up. A, what does that mean for their valuation, just   that they're suddenly enfranchised to get a higher  price? Not because they're brilliant businessmen,   that's just what happens in inflation. I  think that is positive for the earnings.  But now the second thing is the thing you raised  about cost control. There are some people who just   get cost control naturally. They don't have to  be geniuses either. And that's because so much  

of their costs are fixed. And we've discussed  this in the past. Depreciation's an obvious   one. There's these operating leases,  which is another obvious one. There is   interest if you have sort of borrowed  far into the future on a fixed coupon.   That's also a fixed cost. So I am fishing at the bottom for   those types of stocks. I.e. they have natural cost  control because they've got a lot of fixed cost.   But also, and crucially, the valuation's  right down because everybody thinks,   these guys will never put their prices up ever  again. Therefore they're worth x. This guy has  

been putting his prices up at 4% per annum for 20  years. Therefore I pay a premium on a valuation   up here. And all I'm saying is it will narrow.  And it will narrow. And therefore there's more   risk in these guys than there is in these ones. STEVE CLAPHAM: I mean, this is what makes it so   fascinating, isn't it? Because people will be  conditioned for years and years and years to   look for those stocks with the economic bolt, to  look for stocks with high returns in investment   capital. And if we're going into a period  in which there's consistent high inflation,  

those stocks-- perversely, those stocks with  very low returns on capital may actually do   quite well. Because if you need to have a  lot of assets, whether it's fixed assets--  I remember, in the 1980s, there  was current-cost accounting. And   what they did with current-cost accounting  was that, there being such high inflation,   they looked at the assets on the balance  sheet at their replacement cost value.   Because assets that were very old were generating  extremely high returns on capital. So perversely,   those heavy, capital-intensive industries which  have very low returns could end up seeing their   returns grow much faster than the ones with very  high returns. Is that something you agree with?  RUSSELL NAPIER: Yeah, it's something I agree with.  And then when I agree with that, people say, oh,  

but there's the reinvestment rate. There's the  money they have to put back into the asset.  So I want to tell you a story about my  visit to Santiago de Cuba, in Cuba. And   I think I went in 1992. And that is  where the old Bacardi distillery is.  

And it's still making rum. I don't think they're allowed to go in-- I don't know what the Cubans   call it. Obviously the Bacardi family and the  Cubans have got a few disagreements. But it's   still there and it's still producing. And  Cuba's most famous for those old automobiles   that are still managing to trundle along the  roads, whatever it is, more than 50 years ago.  Well, the distillery's still working. So it has  been possible, with virtually no reinvestment,   to keep a distillery running from whenever  the revolution was, right up until today,   producing rum. So I understand that that's not  the ideal way that one would produce rum. One  

would put some reinvestment back into  that distillery. But still, it is possible   to run a large fixed asset with a minimal level of  reinvestment. So the price of reinvestment, which   is obviously going up in an era of inflation,  isn't really massively undermining your returns. 

China plays into this a lot. The people  that we're talking about who have those big,   fixed assets, many of them have suffered  from Chinese competition. And one thinks   of shipbuilding or steel, things like that. Now, this is a different conversation really.   But if we believe that China is being increasingly  ostracized from the global trading regime,   this also lifts pressure from that type of  company. And when I look at where all of   these things cross, I keep looking at Japan.  Now, I get a lot of kickback on that. People   aren't so keen on the idea. But if you say to  me, who's really got cost control? I think the  

people who've really got cost control to the  people who've been under the cosh for 30 years.   And they've learned how to do it. And they will  now be rewarded for it in an era of inflation.  So I think we should be looking up at Japan. You  are the expert on valuations. The valuations look   reasonable. I mean, when you look around  the world, you see a lot of unreasonable   valuations. I think you can find some reasonable  valuations up there. And I think that is more  

likely to be the benefit from inflation. And  it's been heavily hit by trying to compete with   China. We attribute the deflation to many, many  things. But I don't think we pay enough attention   to just how much damage has been done  to Japan through competition with China.  STEVE CLAPHAM: Absolutely. And there's lots  of cheap stocks there. And I mean, I agree  

with you. There's lots of roads pointing there. The other thing I think is quite interesting,   just talking about low returns on capital  which may rise in an inflationary environment,   is companies with very high stocks.  Because one of the things that people   won't necessarily remember is that  if you've got very large inventory,   as you reprice the meat each week, as  you reprice the products each week,   you end up getting a gain on holding inventory. So again, perversely, the low-return stocks,   because they've got high inventory, will see  the greatest benefit in their earnings in an   inflationary environment, which I think is  something that people may not necessarily--   it's not an obvious conclusion. And what  this tells me is that maybe we need to   throw a lot of our existing rules. Because  everybody's doing screens for a "high return 

on investment" stocks. And maybe  they should be starting to think   about screens for low-return stocks. RUSSELL NAPIER: Well, you will the name   of it-- and it's in this library somewhere,  this is my library-- the British government   published a report on inflation accounting in  the '70s somewhere which will be available now   on eBay. And I think we should watch the price  of that on eBay. And I think you're going to   see it's going to start inflating quite quickly.  Because it mentions things like that. But actually  

there's a host of things where you just have to  start rethinking how you value a corporation.  I would add, however, that, I mean, a lot of those  profits were fake profits. And you were taxed on   them anyway. So in the early 1970s, things were  out of control here. I think headline inflation   was 22%. The corporate tax rate was very high. And  as you reported fake-inflation profits, they were   all taxed actual cash flow. And this doesn't apply  to all companies but, for some companies cash flow  

was getting sucked out of these companies. And  that process was called the doomsday machine, and   was run by a man that you and I both remember very  well, called Tony [? Benn, ?] who was quite keen   to run a doomsday machine, given that it would  catapult British enterprise into public control.  So I don't think either of us are talking about  a level of inflation at that. So let's be clear   about this. So what we are talking about has  some of these marginal effects. But if you   get up to that sort of level of inflation,  then it's very difficult for any company.  

Because your cash gets sucked out by taxation. STEVE CLAPHAM: I mean, if you talk to anybody   that was an industrialist in the 1970s, they  always shake their heads, obviously particularly   in the UK, because it was a disastrous period in  the UK, up until-- was it 1976 we went to the IMF?  And I had a call very recently with a very  well-known industrialist. And I talked about this   idea of inflation. And I could hear him, on the  other end of line, shaking his head. Because he   remembered how difficult it was. When I was on the  sales side, I used to follow P&O. And the chairman   of P&O, Lord Sterling, told me about the 1970s,  when he used to go around collecting the rent on   a Friday because they had their senior management  making sure that the rent was in. Because  

it was hand-to-mouth, week to week, day  to day. And so it's kind of frightening.  RUSSELL NAPIER: This is the really important  thing. We shouldn't pretend that inflation   is good for equities. We're talking an  element of equity asset class and which   element could have see more protection. But for  equities as a whole, this is not a good thing.   And obviously if it's 3%, 4%, not so bad.  But if it starts getting to 7%, 8%, 9%,   there isn't evidence that equities protect you  from inflation as a whole asset class. And of  

course, the best example of that is the '70s. And I'm sure it'll be online somewhere-- and   everybody who's watching this should read it--  an article that Warren Buffett wrote in 1977   for Fortune magazine, called High Inflation  Swindles the Equity Investor. So that's very   much a bottom-up view. But it's really worth  looking at in terms of what happened to margins,   what happened to effective tax rates,  and why equities didn't perform  during that period. It wasn't just that  interest rates went up and valuations came down.   But some of the reasons we've touched  on, it actually became very difficult   to retain cash and grow cash and reinvest. So the early stages of inflation are pretty   reassuring. But in the long run, equities are not  the place to be. Equities in the whole are not the  

place to be. So what we are talking about,  maybe heavy- asset companies, maybe Japan.   We're looking at a subset of equities. So I'm very  bullish on equities, because I think we're in the   early stage of inflation. And that's working on  all right at the minute. But this depends where   we're going to and how high it's going to get. STEVE CLAPHAM: Well, of course, if we are in for a  

period like that, then you can't put your money in  bonds. So you've got to put your money somewhere.  And it's funny you mentioned Buffett. Because  I read that I read the article this week,   preparing for this. And I also read his 1980  letter. And he said, well, if you look at  

not the book value but their adjusted book value  of Berkshire, including the market value of the   quartered holdings, we've done quite well  because we've increased at 20.5% per annum   from 1964 to 1979. So this is that 1980 letter. He said, we would pat ourself on the back, but   in 1964, a share of Berkshire bought you half an  ounce of gold. And today it buys you half an ounce   of gold. And you think about that as one of the  best-performing companies, it's quite remarkable. 

But the other thing I just wanted to touch on was,  if we're in a high-inflation environment-- I mean,   it doesn't need to be 8%-- presumably we need to  avoid companies that have a lot of labor cost.   There are two reasons for that. One is that labor  costs will be rising quite rapidly, because we'll   get, I assume-- and tell me if this is wrong--  but I assume we'll get that labor push inflation.  But the other thing is-- and I think it's  really relevant today-- is pension deficits.   Because if you start to increase the inflation  assumptions in the calculation of the pension   liability, those pension liabilities  are going to go through the roof.   And of course this kind of rates aren't going  to go up. So is it possible that is a ticking  

time bomb in those companies with big workforces  and ticking time bomb in the pension deficit?  RUSSELL NAPIER: So as you know, I run this course  called The Practical History of Financial Markets.   Both of these are issues we cover in that.  And I think the fascinating one in the post-   World War period, you ask anybody, certainly in  the United Kingdom, why do we have inflation,   certainly, if you go down to the city of  London, they'll say, oh, it was unions.   It was unions. It was all to do with the  unions. The unions caused the inflation.  There's quite a lot of statistical evidence that  actually what happened is the inflation caused   the unions. It was kind of the other way around.  I mean, all of us want protection from inflation.   And if we lived in a world where there isn't  inflation, we don't need to unionize to protect   ourselves. But when inflation  comes, that's when people go back to  

unionization. So Steve, one day, you and I will be forming the analysts   union. So I look forward to discussing that  somewhere appropriate when the time comes.  And that the second point is, I think, an  absolutely essential point for all of us to   think about in the Practical History  course. When we look at the things that  

make corporate mean revert, you would point  towards rising labor that we're discussing,   rising interest expense which we're discussing,  rising corporation tax which we're discussing,   rising cost of goods sold which we're discussing. But historically, we kind of never thought   about the pension scheme. Because in the long  sweep that we look at, in terms of that data   for mean reversion, the pension schemes, they only  come along really aggressively after World War   II. And of course, really, they're building  up into quite a big liability just as interest   rates start to decline from '78 to today. So for those people who are not familiar with  

pensions and accounting, that's how you value  your liabilities. And suddenly the liabilities are   going up as the interest rates are going down. As  we now cap interest rates as inflation goes up--   and remember, quite a few of these pension  liabilities are linked to inflation. They're  

usually capped about 4%, not 12% or 13%. Then, suddenly, one of the reasons we might   see corporate profits mean revert is because  such a large percentage of cash flow has to   go into the pension fund. If you look at the  assumed returns that pension funds put in,   some of them are putting in 7% or 8%. There is  nothing in the price of bonds-- nor equities for  

that matter-- which would give you any inkling  of hope that you're going to get a blended 7%.  So if we begin to force people to take a realistic  look in that-- and crucially, the interest rate   isn't allowed to go up, so the liabilities don't  come down-- tons of corporate cash could be   pouring into these pension schemes. I used to be  a pension fund trustee. So I used to say, to our   actuary-- because every actuary in the country  spends most of the time in the meeting saying,   to the trustees, don't worry, interest rates are  going up, liabilities are coming down. And I would   say to them, well, what happens if interest  rates don't go up but inflation does go up?   And the most normal answer you get from  an actuary is, well, that's not possible.  And of course, in a market system, in  an economic textbook, it isn't possible.  

But in real life it's absolutely been possible.  And it's going to happen again. So I'm glad you   raised the pension issue. But particularly for  a lot of European companies, I think there are   big pension legacy issues which the market  is not really paying enough attention to. 

And we could also-- and I will be, in  the next report I'm writing for clients,   looking at the life insurance industry,  particularly of northern Europe,   which on these numbers-- I mean, it's been in  deep, deep trouble for many years because of   where interest rates are. But in a world where  interest rates stay low and inflation goes up,   we are looking at a crisis for the  savings system slash pension system,   particularly for Northern Europe. STEVE CLAPHAM: So this doesn't sound like a very   pretty picture all round. I  mean, it sounds pretty awful.  RUSSELL NAPIER: I just watched an  interview with Evelyn Waugh from 1960. And   we're kind of saying this is kind of  a repeat of the post-World War II.  

And he claimed to be broke, claimed that he  didn't have any money. For those of you who   don't know, he's another famous English author. And the interviewer said to him, but Mr. Waugh,   you made a fortune selling books before the war,  before it was taxed away, to which he replied,   that's true, but I spent it all. And no honest  man has been able to save money since 1945.  In a world where the government is  telling you what to do with your savings,   it is incredibly difficult. So that's why the  top recommendation is find jurisdictions where   the government isn't going to tell you what  to do with your savings. And that isn't easy,   but that is the type of world that we now live in. STEVE CLAPHAM: I mean, one place you can go would  

be commodities. Another place would be energy,  because you own real assets. I mean, to what   extent do you think that will be hampered by the  whole move to ESG? I mean, interestingly, I listen   to a podcast with Peter Harrison, the CEO of  Schroders. I'm a bit behind in my podcast queue.   The interview was recorded last March. And  I just listened to it a couple of weeks ago.  But he said something quite remarkable. He  said, in five years, the term, ESG, won't exist.  

And by that he meant that it'll be so ingrained in  every investment manager, every institution will   have that as an integral part of the process. If  that's the case, I mean, is that the opportunity   for the little guy, the private investor? Because  no professional fund manager will want to be seen   owning big oil or, indeed, oil stocks.  And oil demand will continue. And there's   an opportunity for the little  guy to actually profit from the   fads and the fashion by buying real assets. RUSSELL NAPIER: Yeah. So just when we're   talking about real assets, I mean, I'll just do  10 seconds on residential real estate. That is,  

to me, the key real asset, which is easier than  this. We're going to have a discussion which is   really quite complicated and has a lot of moving  parts. I think the case for residential real   estate in a world where wages were maybe going  to be growing at 4% or 5%. Bond yields were 2%,   3%. I think it's probably even clearer in America,  where outside of the homes of the plutocrats,  

I think property is very cheap. So that's 10  seconds. And maybe we'll come back to that.  In terms of commodities, there's lots of  commodities which we need and lots of commodities   which we need for the Green Revolution. That's the  kind of irony of this. We're about to through a   huge investment boom-- a series of investment  booms, actually, one associated with getting   us green, one associated with us buying more  stuff from somewhere else other than China,   and I think another one associated with shorter  distribution chains, which is linked to China   but actually is supplementary to China. So three  investment booms are very good for commodities   and ultimately will be good for the planet.  I mean, ultimately not bad for the planet.  One of the things that's been going on for years  now is people have been moving their polluting   industry to China because there's no real control.  So if we are bringing stuff back from China,  

I don't think we're going to go easier on the  pollution regulation. So that is an investment in  commodities to save the planet, despite the fact  that extraction is inherently and necessarily not   that green. So I don't to what extent we'll really  want to come down on that in the first instance.  And just one thing-- there's one obvious  thing that we shouldn't be taking out of   the ground anymore. And that's gold. I mean,  I do realize it has its practical uses. And   you can't have a wedding in India without it.  That's a crucially practical use for gold. But on   the whole, I think ESG means it's going to be more  difficult to get gold out of the ground, which   makes it incredibly bullish for the gold that is  out of the ground. And I say out of the ground,  

because as you know, it comes out of the ground  very briefly and then goes back under the ground.  So the whole ESG thing, I think, will not  be as bad for commodities as we expect,   number one. And number two, it could be  particularly bullish for the price of gold.   And when we're talking to commodities, I almost  hate to mention this, but the history of inflation   is really the history of commodity inflation,  including food inflation. And the reason I don't  

want to mention it is disastrous if the savings  of the world flock into food because a lot of   people go hungry. But that is what's going  to happen and arguably is already happening.  Now, it may be that the governments have  to ultimately try and stop people's savings   going into food. But it's a very good example  of what can happen when you get to a tipping   point in inflation, when people consider that  their savings are better off in consumables   than in a savings asset. And that's  called the velocity of money. And that's   when the velocity of money starts going up. So food is a good one. If you think back to  

the Weimar Republic, who made all the money in the  Weimar Republic? Farmers. Not just because they   were selling food prices that were going up like  this. It's because they had quite a lot of debt,   long-term debt, over their farmland. So they  did spectacularly well. So let's not forget   what might happen to food prices. So rather than  saying you should go out and buy a lot of food,   which is obviously not going to happen, there are  lots of countries in the world who might benefit   from somewhat higher food prices going forward. STEVE CLAPHAM: So we should find some land in  

the right country, agricultural land in the right  country. But just going back to residential real   estate, I was trying to recall-- you wrote  this very good piece, Solid Ground, in 2016,   talking about financial repression. And you talked  about capital controls. Wasn't one of the issues,   in the past, when we had financial  repression, didn't we have rent controls?  RUSSELL NAPIER: Yeah, so that is definitely  an issue. And they have come in in Berlin,   they've come in in Vancouver, and they've come in  in Toronto. So you can't rule them out. So you've   got to be very careful about this. I think that's  one of the reasons I favor American residential   real estate, because I think, while it can  happen in America and it has happened in America,   if you've read that report, you'll know that  Mia Farrow is still paying something ridiculous,   like $2,000 a month to rent her rent-controlled  apartment up on the Upper East Side.  

But I think, in some countries, it's much less  likely than others. So I'm prepared to do that.  I started my career as a lawyer in Belfast. And I  remember traveling up to a place called Coleraine.   And there we were doing a rent-control review  for a very old lady who'd got her rent controlled   in 1948. And in 1987, she was still alive,  still there, and still paying her 1947 rent. 

So for people who don't know what rent control  means, begin to think of the consequences of   that for the capital value. In fact, there  were some-- and I've just been speaking to   one-- there were some people who were putting so  much money into the renovation of the property   that it cost more than the lease. Let me give you another example of why property   isn't necessarily the way to go. Continental  Can owned a building on Wall Street in the '70s.  

New York was not in a good place in the '70s. But  property taxes were very high. And it couldn't   be rented. So they knocked it down. It was  cheaper to destroy a building on Wall Street   than it was to keep it open. You couldn't  get any income of it, and you were paying  

property taxes. So you knocked it down. So it's back to this-- where we keep coming back   to, Steve, we have to think very differently. So  I'm happy to invest in US residential real estate   on the basis that we won't have rent controls  for the average citizen. And that could be wrong.   But I wouldn't be so keen to  do that in Paris, for instance.  STEVE CLAPHAM: Do you think governments will  introduce price controls? In that article,   you talked about that-- was it called the Office  of Price Control under Nixon? It seems almost   unimaginable. But then I wasn't aware-- I mean,  it's not that long ago, 50 years ago, that we did   have that. Do you think that will happen again? RUSSELL NAPIER: Do you think anybody who voted  

for Richard Nixon thought he would introduce  price controls? I mean, that's the point. I mean,   as you know, he sat with McCarthy on the  anti-communist trials. He was thought   to be extremely to the right of politics. So why on Earth did he bring in price controls?   You do what you have to do. Or as a certain  gentleman has famously said, "whatever it takes."   So I there's a lot of speculation about  what the Democratic party might do   in America. I don't think it really  matters that much. You know, politicians,   under extreme pressure, do extreme things. I wrote in that article that the first man to head  

the Office of Price Control was another famous  communist called Donald Rumsfeld. And Donald   was so busy in his first few months, he needed  help. So he hired another famous communist called   Dick Cheney. So the idea that Nixon, Cheney,  and Rumsfeld got together to control prices   tells you, in a crisis, anything is possible. So I'm not saying we're going to price controls   in the next two, three, four, five years. Highly,  highly unlikely, I think-- highly unlikely. But   at some stage in an inflationary movement, is it  possible? Of course it's possible. And most people  

have never heard of it. They'll say, well, why  on Earth didn't they just raise interest rates?  And the answer is they thought it would be too  painful-- pretty simple. I mean, Nixon knew that,   by raising interest rates or persuading Arthur  Burns to raise interest rates, he could tackle   inflation. But he knew what it would do to  the average American. So instead he went for  

price controls. So I guess the answer to  this is, never underestimate the ability   of politicians to make the same mistake all over  again, but usually giving it a different name.  STEVE CLAPHAM: But I suppose the justification  this time will be that we've all got so much debt,   every country in the world, government  debt and, as you say, private-sector debt,   that you can can't really afford for  interest rates to go up by much. And   therefore-- well, I mean, what else can they do  other than introduce some form of price controls?  RUSSELL NAPIER: So there isn't anything you  can do, which is called credit controls,   instead. So back to kind of my opening  statement here, that most of the money  

in the world is created by banks. So if you  and I, as the government, control the banks,   and we said, look, guys, this year you're only  growing credit by 6%, and therefore the growth   in money supply was close to 6%, inflation should  be pretty low. So that's another way of doing it.  The history suggests that we end up getting  a mixture of both of those. But it is worth   remembering that the way inflation was controlled  post-World War II, particularly in somewhere   like France, was not by using interest  rates or not so much by price controls.   But by controlling the banking system, the  governments managed to control the growth of money   and keep inflation somewhat in abeyance. That's it, I think, in terms of how you  

can control inflation without using interest  rates. Rationing is another one. But I don't   think we'll get to rationing. STEVE CLAPHAM: But presumably,   controlling the banks, would that work  for multinational companies? Because   wouldn't companies just borrow overseas? RUSSELL NAPIER: So you obviously have to   stop that. I mean, if we're doing it in the  United Kingdom, we're only interested in   sterling lending. Because only sterling  lending really contributes to our GDP.   So controlling the sterling lending would be easy. If they started borrowing euros, selling euros,  

and bringing it in, well, as long as we control  the supply of sterling, it really wouldn't make   any difference. So I think it's possible  unless you've got banks prepared to take huge   kind of currency risks to run a  sterling book borrowing it in Europe.  So there are commercial limits on that,  usually. But ultimately you can stop them  

from doing that. And obviously we  had capital controls after the war.   So that was not an option, not an option at all.  But normal commercial procedure makes that quite   a risky venture. Not that our banks are averse  to a bit of risk, of course, every now and then.  STEVE CLAPHAM: You've said this isn't going to  happen tomorrow, obviously. It's going to take   quite a long time for it to unwind. What's your  best guess on the sort of timescale for this? And  what should we be looking out for? I  mean, what are the signals? What are   the milestones that we'll need to pass that  will tell us, OK, now's the time to panic?  RUSSELL NAPIER: So the only thing to me that  really matters are bond yields. And that's what  

you should be looking at. So it'd be nice for me  to give you a detailed time frame and a detailed   endpoint. And that's just a hostage to fortune.  But there is probably more value in me saying,   here's a level of long-term bond yields  at which these things, these extreme   measures, are going to have to be taken. So I have done a very large report on that.   And I won't go through all of the details in it.  But the conclusions are pretty straightforward,   that on the-- and I'm looking at the five-year  rate, because it's the five-year government   bond yield that probably has more of an effect  on the price of bank credit, particularly for   corporations. And the kind of argument is, at  what level of interest rates would we trigger   debt defaults because interest are so expensive? So the answer, in America, is roughly 200 basis   points above today. That's quite a bit to  go. We're going quickly though, but that's  

quite a bit to go. For the United Kingdom, it's  still 200 basis points. For the European Union,   it's about 100 basis points. For Japan,  actually, it's probably about 100 basis   points. But obviously their rates are very low. And the fascinating one is China. It's only   100 basis points for China. I mean, I think, in  sort of the mess that we&

2021-04-03 00:55

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