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“The shares have reached what appears to be a permanent plateau.” – Irving Fisher, October 15, 1929
As the author and co-founder of Electronic Research Exchange (ERIC)Russell Napier studies financial market data over extended periods of time to assess the valuation of stocks and gain insight into where the markets are heading next.
“Most people tell me that long-term stock valuation data doesn’t make sense, that something has changed if you look at the data from 1994, and that stock valuations are no longer meant to reverse,” Napier explained in the CFA Institute Stock Research and Valuation Conference. 2018. “I think they are wrong.”
New technology is the key reason for today’s high stock valuations, he said: “It has created this vision of a world for all of us where we can have high growth and no inflation forever.” But the United States has had many periods of technological change since the late 1800s, and none have ever produced permanent high growth and low inflation.
A structural change in the global monetary system has also transformed stock markets: China devalued the renminbi (RMB) in 1994 and pegged it to the US dollar just as hundreds of millions of its workers were migrating from farms to cities. “Devaluing the currency and mobilizing resources at the same time was absolutely phenomenal,” Napier said.
The result was a huge capital and current account surplus in China that some believe are permanent. But countries never have permanent current account surpluses. “The problem with China is that the devaluation was so great that it has taken them a long, long time to go through the last stage of the cycle and go into a current account deficit,” he said.
Many other emerging market countries started targeting their exchange rates and reserves increased. Unlike in the Bretton Woods era, when the world had a sealed monetary system in which deficits and surpluses were balanced, we now have a rigged monetary system. “Today you can have massive imbalances with sudden and huge swings in reserves, especially in emerging markets, because of their peg to the US dollar,” Napier observed.
The end of the guaranteed buyer of US Treasuries.
To peg emerging market currencies to the US dollar, China and other nations had to buy US Treasuries and print money. The People’s Bank of China (PBOC) was a guaranteed buyer of US debt regardless of price. “The only price these rates were interested in was the exchange rate and that artificially depressed the global risk-free rate. [of US Treasuries],” he said.
This huge guaranteed inflow of capital from the People’s Bank of China and other foreign central banks is coming to an end, according to Napier, who cited the significant decline in the percentage of official foreign central bank holdings of US Treasuries. It is now 23.5% and he expects it to continue falling. Unfortunately for the United States, this comes at a time when US debt has increased fivefold, from $ 3.4 trillion in 2000 to $ 17 trillion in the second quarter of 2018.
“The period from 1995 to today was the product of an abnormal monetary system,” Napier said. “And it will end.”
A deflationary perspective
As central banks recede, Napier said, savers in the United States and around the world will have to step in to support the Treasury market, with deflationary consequences.
If it’s foreign savers, predict a scenario from the late 1990s, when U.S. equity markets rallied as emerging markets crashed, or a replay of markets from 1927 to 1929, which ended wrong.
The evidence suggests that foreign savers are stepping in, Napier said, especially given the attractive yield on two-year Treasuries. But Urjit Patel, Governor of the Reserve Bank of India (RBI), warned that if the US Federal Reserve continues to increase the supply of Treasuries, adding about $ 1.4 trillion for 2019 of tax cuts and reduction of the balance sheet, “it will absorb such a large part of the dollar liquidity that a crisis in the rest of the dollar bond markets is inevitable.” Given the recent volatility in emerging market currency and bond markets, this may already be happening.
But Napier bases his general deflationary outlook on another major force: world debt.
Combined data for public and private debt, as tracked by the Bank for International Settlements (BIS) since 2000, show that the ratio of non-financial debt to world GDP increased by 207% during the last financial crisis in late 2007 at 243% today. .
“It is the growth rate of this index that matters most as the BIS’s warning indicator of an upcoming credit crisis,” Napier said. “A highly adapted system is a vulnerable system, especially if you borrow in someone else’s currency.”
What happens next?
As the Federal Reserve shrinks its balance sheet, by all indications, the People’s Bank of China is expanding its balance by cutting interest rates and lending more to its commercial banking sector. This incompatibility in monetary policies is not sustainable unless China has a massive current account surplus. But it’s not like that. In fact, China’s current account surplus peaked at 10% of GDP in 2007 and has decreased to less than 2% of GDP today.
Therefore, China will abandon its link with the dollar. “It’s just not conceivable that the world’s second-largest economy would take its monetary policy from Washington, DC,” Napier said. He expects an initial devaluation, then a free-floating RMB that allows China to inflate its debt. And when the money relationship ends, so will the nirvana of high American growth, low inflation, and high equity valuations.
What does this mean for the stock markets? Napier pointed to CAPE and Q ratio data from 1881 as long-term guides to where stock valuations might go in the future.
“Sometimes it is not the business cycle that matters, but the structure of the system,” he said. A structural change in 1994 led to apparently new higher valuations. We now face a different structural change in the global monetary system that will have profound effects on the stock markets. “CAPE will ultimately mean reversing as the old monetary system collapses,” Napier said.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of the CFA Institute or the author’s employer.
Image courtesy of Paul McCaffrey