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“Stocks have reached what looks like a permanently high plateau.” — Irving Fisher, 15 October 1929
As an author and co-founder of Electronic Research Interchange (ERIC), Russell Napier studies financial market data across extended time frames to assess equity valuation and gain insight into where markets are going next.
“Most people tell me that long-run equity valuation data is meaningless, that something has changed if you look at the data since 1994, and that equity valuations have ceased to mean revert,” Napier explained at the CFA Institute Equity Research and Valuation Conference 2018. “I think they’re wrong.”
New technology is the key reason for today’s high equity valuations, he said: “It’s 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 ever produced permanent high growth and low inflation.
A structural change in the global monetary system has also transformed equity 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. “To devalue the currency and mobilize resources at the same time was absolutely phenomenal,” Napier said.
The result was huge current and capital account surpluses in China that some believe are permanent. But countries never have permanent current account surpluses. “The issue with China is that the devaluation was so large, that it has just taken a very, very long time for them to get through the later stage of the cycle and move into a current account deficit,” he said.
Many other emerging market countries began targeting their exchange rates and reserves went up. Unlike in the Bretton Woods era when the world had a sealed monetary system in which deficits and surpluses balanced out, we now have a jerry-rigged monetary system. “Today you can have massive imbalances with sudden and huge swings in reserves, especially in emerging markets, because of their link 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 purchase US Treasuries and print money. The People’s Bank of China (PBOC) was a guaranteed buyer of US debt without regard to price. “The only price these guys 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 PBOC 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 to fall. Unfortunately for the United States, this comes at a time when US debt has quintupled, from $3.4 trillion in 2000 to $17 trillion as of 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 Outlook
As central banks step back, 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, he predicts a late-1990s scenario, when the US equity markets rose as emerging markets went bust, or a rerun of the 1927 to 1929 markets, which ended badly.
Evidence suggests that foreign savers are stepping in, Napier said, especially given the attractive yield on the two-year Treasury notes. 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 by 2019 from tax cuts and balance sheet reduction, it will “absorb such a large share of dollar liquidity that a crisis in the rest of the dollar bond markets is inevitable.” Given recent volatility in emerging market currency and bond markets, this may already be happening.
But Napier bases his overall deflationary outlook on another major force: worldwide debt.
Combined public and private debt data as tracked by the Bank for International Settlements (BIS) since 2000 shows that the world-non-financial-debt-to-GDP ratio rose from 207% during the last financial crisis in late 2007 to 243% today.
“It’s the growth rate of this ratio that matters most as a BIS warning indicator of a forthcoming credit crisis,” Napier said. “A highly geared system is a vulnerable system — especially if you borrow in someone else’s currency.”
What Happens Next?
While the Fed is contracting its balance sheet, by every indication the PBOC is expanding its own 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 doesn’t. In fact, China’s current account surplus peaked at 10% of GDP in 2007 and has declined to less than 2% of GDP today.
So China will abandon its link to the dollar. “It’s just not conceivable that the second-biggest economy in the world 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 away its debt. And when the currency relationship ends, so will the nirvana of high US growth, low inflation, and high equity valuations.
What does this mean for equity markets? Napier pointed to CAPE and Q ratio data since 1881 as long-term guides to where equity valuations could go in the future.
“Sometimes it’s not the business cycle that matters, but rather it’s the structure of the system,” he said. A structural change in 1994 led to seemingly new higher valuations. Now we face a different structural change in the global monetary system that will have profound effects on equity markets. “The CAPE will finally mean revert as the old monetary system breaks down,” 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 CFA Institute or the author’s employer.
Image courtesy of Paul McCaffrey