by David Robertson, CFA
August 2020
One of the interesting aspects about investing is that many of the momentous changes that can make a big difference to portfolio performance only come around once in a great while. As a result, some of the trickiest aspects of investing are recognizing those big turning points and then having the courage to act decisively when the time comes.
It takes a unique set of skills and a unique mindset to pull this off; it is all too easy to find oneself incapacitated by indecision right when it matters most. Fortunately, there is straightforward way to hack this natural weakness: The answer is to bone up on financial history. With the winds of inflation blowing again, there may be no better time to do it.
One of the people uniquely suited to help with this endeavor is Russell Napier. He has worked in the investment business for 30 years and wrote a book on the historical lessons of bear markets entitled, Anatomy of The Bear: Lessons From Wall Street’s Four Great Bottoms. He also founded a course in The Practical History of Financial Markets. He is always quick to explain why he founded the course too: "Because the business schools don't teach it".
In the aftermath of the GFC, Napier recognized the condition of exploding levels of government debt differed from the experience in World War II. In a 2010 presentation to the CFA Society of Baltimore he noted that "Through WWII the US only borrowed money to 'kill people'". In other words, debt was drawn in extreme circumstances of existential necessity.
After the GFC, however, the rationale changed: "Now the US is borrowing money to keep people alive - which is more expensive". The ongoing and nonproductive (at least in economic terms) nature of the borrowing did not provide the necessary ingredients for inflation.
At the time, Napier's prognosis of disinflation competed with calls for increasing inflation and for a "beautiful deleveraging". His forecast was at least partly predicated on the faulty transmission mechanism of monetary policy.
As he noted in an interview with The Market/NZZ, "QE was a fiasco. All that central banks have achieved over the past ten years is creating a lot of non-bank debt." Looking back over the last ten years, Napier got the big points right.
His book, Anatomy of the Bear, also provides helpful lessons for investors. Napier describes the book as a "field guide for the financial bear" and he analyzed 70,000 articles from the Wall Street Journal to capture the contemporaneous sentiment of bear market bottoms. He also distinguishes factors that have "proven to be good markers to the future, and those that have been misleading."
The key strategic conclusion from the book is that "swings in equity valuation are driven primarily by changes in inflation." As a result, the catalyst to "reduce equities to cheap levels" normally involves "a material disturbance to the general price level". He also notes that "All four of our bear-market bottoms occurred during economic recessions".
So where does that leave investors today? Napier started telegraphing a change in sentiment from his deflationist views after the March selloff. I highlighted his comments from Grant's Interest Rate Observer in an early April blog post: "Government interventions to bail out an entire commercial system or portion of the commercial system, in my opinion, are entirely novel."
Since then, Napier's perspective has evolved and he explains why:
August 2020
One of the interesting aspects about investing is that many of the momentous changes that can make a big difference to portfolio performance only come around once in a great while. As a result, some of the trickiest aspects of investing are recognizing those big turning points and then having the courage to act decisively when the time comes.
It takes a unique set of skills and a unique mindset to pull this off; it is all too easy to find oneself incapacitated by indecision right when it matters most. Fortunately, there is straightforward way to hack this natural weakness: The answer is to bone up on financial history. With the winds of inflation blowing again, there may be no better time to do it.
One of the people uniquely suited to help with this endeavor is Russell Napier. He has worked in the investment business for 30 years and wrote a book on the historical lessons of bear markets entitled, Anatomy of The Bear: Lessons From Wall Street’s Four Great Bottoms. He also founded a course in The Practical History of Financial Markets. He is always quick to explain why he founded the course too: "Because the business schools don't teach it".
In the aftermath of the GFC, Napier recognized the condition of exploding levels of government debt differed from the experience in World War II. In a 2010 presentation to the CFA Society of Baltimore he noted that "Through WWII the US only borrowed money to 'kill people'". In other words, debt was drawn in extreme circumstances of existential necessity.
After the GFC, however, the rationale changed: "Now the US is borrowing money to keep people alive - which is more expensive". The ongoing and nonproductive (at least in economic terms) nature of the borrowing did not provide the necessary ingredients for inflation.
At the time, Napier's prognosis of disinflation competed with calls for increasing inflation and for a "beautiful deleveraging". His forecast was at least partly predicated on the faulty transmission mechanism of monetary policy.
As he noted in an interview with The Market/NZZ, "QE was a fiasco. All that central banks have achieved over the past ten years is creating a lot of non-bank debt." Looking back over the last ten years, Napier got the big points right.
His book, Anatomy of the Bear, also provides helpful lessons for investors. Napier describes the book as a "field guide for the financial bear" and he analyzed 70,000 articles from the Wall Street Journal to capture the contemporaneous sentiment of bear market bottoms. He also distinguishes factors that have "proven to be good markers to the future, and those that have been misleading."
The key strategic conclusion from the book is that "swings in equity valuation are driven primarily by changes in inflation." As a result, the catalyst to "reduce equities to cheap levels" normally involves "a material disturbance to the general price level". He also notes that "All four of our bear-market bottoms occurred during economic recessions".
So where does that leave investors today? Napier started telegraphing a change in sentiment from his deflationist views after the March selloff. I highlighted his comments from Grant's Interest Rate Observer in an early April blog post: "Government interventions to bail out an entire commercial system or portion of the commercial system, in my opinion, are entirely novel."
Since then, Napier's perspective has evolved and he explains why:
"It’s a shift in the way that money is created that has changed the game fundamentally ... This is money creation in a way that is completely circumventing central banks ... And more importantly, the control of money supply has moved from central bankers to politicians."
Napier explains the significance of this change in the Financial Times: "As a result, investors need to prepare for a new era of inflation.”
As talented as Napier is at analyzing the investment environment and understanding it from a historical perspective, he is at least as gifted at communicating what the implications are. Importantly, inflation will come along with a policy to cap rates below the inflation rate. As to what that means, Napier expounds:
As talented as Napier is at analyzing the investment environment and understanding it from a historical perspective, he is at least as gifted at communicating what the implications are. Importantly, inflation will come along with a policy to cap rates below the inflation rate. As to what that means, Napier expounds:
“Savers, through government-mandated bond holdings, will have to bear the burden of capped yields and will watch a portion of their savings eaten away through inflation.”
In economic terms, this is known as financial repression. This can be hard to understand for two reasons. One is that it is an abstract concept. Another is that it involves politicians intentionally causing harm to people and organizations that save money. In a separate interview with MacroVoices, Napier describes how this works in plain terms:
"I was once asked by a retired lady how I would put that phrase [financial repression] into English. Which is a very good question, I think. And I replied that it was stealing money from old people slowly. And the 'slowly' bit is important. Because you don’t want to frighten the horses. You want to try and keep them corralled in fixed-interest securities. So, on the whole, doing it slowly is probably the democratic way to do it."
While an environment of financial repression is not a good place for savers, it isn't a good place for people who invest on behalf of others either. In the same interview, Napier described that most of the skills developed by investors over the last forty years are "probably redundant".
In fact, he goes as far as to recommend his institutional clients promote emerging markets people to lead their developed markets groups. The reason is that those people are much more familiar with the "higher levels of inflation, government interference and capital controls" that will now also be pervasive in developed markets.
The investment strategy for dealing with the new inflationary environment falls into the category of "simple, but not easy". It is simple because it focuses on preserving wealth in a system designed to slowly "steal" it. It is not easy because it requires a mindset and a commitment to do something very different from what has worked in the past.
In fact, he goes as far as to recommend his institutional clients promote emerging markets people to lead their developed markets groups. The reason is that those people are much more familiar with the "higher levels of inflation, government interference and capital controls" that will now also be pervasive in developed markets.
The investment strategy for dealing with the new inflationary environment falls into the category of "simple, but not easy". It is simple because it focuses on preserving wealth in a system designed to slowly "steal" it. It is not easy because it requires a mindset and a commitment to do something very different from what has worked in the past.
“In this new age of repression, the secret to preserving the purchasing power of savings lies not in the mix of assets that are held but in the quantities they are held. Investors should hold as much gold, and as little government debt, as they feel comfortable with.”
In his MacroVoices interview he elaborates on the rationale for gold: "But that is where the gold price gets a second kick. It is not an asset which is easy to manipulate for governments". In other words, gold protects not just against inflation, but against government intervention in the form of financial repression. This also has implications for the types of exposure to gold: The less potential for government intervention the better.
Such a radically different environment for investing will also create a radically different environment in which companies operate. Historically, the beneficiaries of higher inflation are companies with large fixed assets that don't have high reinvestment requirements. Conversely, the relative losers are the asset-light companies that have been the stars of the last forty years.
Although Napier expresses conviction that inflation will emerge and be an important factor for long-term investors, he also acknowledges this forecast depends on the velocity of money increasing. While he does expect spending patterns to resume and the savings rate to decline, any delays in those dynamics would also delay the emergence of inflation.
Another factor that could delay (but not obviate) his forecast would be deflationary pressures originating outside of the US. Prior to the Covid lockdowns, Napier was concerned that outside of America "most of the credit risk still rests on bank balance sheets". Although the woes of European banks have recently been overshadowed by other news, the potential for bad debts to create problems remains high.
China could also be a factor. As the home of incredibly high credit growth and uncertainty surrounding its exchange rate, China has a great deal of potential to transmit deflationary forces. In addition, escalating tensions between the US and China threaten to further weigh on global trade which would exacerbate those forces.
All in all, though, it looks like we are finally going to experience inflation in the not-too-distant future, and this is the key takeaway for long-term investors. It is also important to remember as this unfolds, however, that official communications will not be helpful but instead will be crafted to keep the "horses from being frightened". There will be PR campaigns describing why a "little" inflation is a good thing. Other communications will describe measures as "temporary". There will be other platitudes too.
It helps to appreciate that this is probably one of the relatively few big turning points that can materially affect wealth distribution. For the intellectually curious it is a rare and exciting chance to observe and learn. For savers, it is important to understand exactly how different and how damaging this will be. Either way, it's a great time to embrace the lessons of financial history.
Such a radically different environment for investing will also create a radically different environment in which companies operate. Historically, the beneficiaries of higher inflation are companies with large fixed assets that don't have high reinvestment requirements. Conversely, the relative losers are the asset-light companies that have been the stars of the last forty years.
Although Napier expresses conviction that inflation will emerge and be an important factor for long-term investors, he also acknowledges this forecast depends on the velocity of money increasing. While he does expect spending patterns to resume and the savings rate to decline, any delays in those dynamics would also delay the emergence of inflation.
Another factor that could delay (but not obviate) his forecast would be deflationary pressures originating outside of the US. Prior to the Covid lockdowns, Napier was concerned that outside of America "most of the credit risk still rests on bank balance sheets". Although the woes of European banks have recently been overshadowed by other news, the potential for bad debts to create problems remains high.
China could also be a factor. As the home of incredibly high credit growth and uncertainty surrounding its exchange rate, China has a great deal of potential to transmit deflationary forces. In addition, escalating tensions between the US and China threaten to further weigh on global trade which would exacerbate those forces.
All in all, though, it looks like we are finally going to experience inflation in the not-too-distant future, and this is the key takeaway for long-term investors. It is also important to remember as this unfolds, however, that official communications will not be helpful but instead will be crafted to keep the "horses from being frightened". There will be PR campaigns describing why a "little" inflation is a good thing. Other communications will describe measures as "temporary". There will be other platitudes too.
It helps to appreciate that this is probably one of the relatively few big turning points that can materially affect wealth distribution. For the intellectually curious it is a rare and exciting chance to observe and learn. For savers, it is important to understand exactly how different and how damaging this will be. Either way, it's a great time to embrace the lessons of financial history.
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