'Distress in global financial system is making Yellen stay put'

A certain degree of distress looms in the global financial system, particularly the emerging markets, which has deterred Janet Yellen from raising interest rates. "Rising US rates potentially strong dollar is the last thing kind of edifice needs of the minute; so, thats the reason she is pulling back, more than anything happening domestically," he added.Below is the verbatim transcript of Russel Napier's interview with CNBC-TV18's Udayan Mukherjee.Q: I hear you are going to be in Mumbai in October as well, is that right?A: That is right. It has been a while since I have been and the exciting news is this time I am bringing my course, The Practical History of Financial Markets. It is for investment managers, it takes two days. We have already run that in the United Kingdom and Singapore. But we thought that there are certainly a lot of fund managers in Mumbai and we thought we come and we try Mumbai and see whether there is a demand for the course there. So, the course has been a great success because what we do, what I do in my work and what we do in the course is try to teach what financial history has to say about how things work and mechanisms. And there is a realisation amongst the investment community that we need to study more financial history particularly because the role of politicians is coming back, the role of society is coming back and it is becoming clear by the day that this isn't just an issue of equations. That is what we are trying to teach in the course.Q: What did you make of Janet Yellen’s statements and do you think she is saying that she can't afford to raise rates immediately?A: What Janet Yellen knows, that we know but where we she has a little bit of outer information is some of the degrees of distress in the global financial system particularly in the emerging markets. So, she has obviously, several times in the last couple of years pulled back from doing anything. What pulls her back is actually discussions with Christine Lagarde. I do not think that is often commented upon, but it is Christine Lagarde who ultimately sees the distress in the system around lot of people at the International Monetary Fund (IMF) looking for assistance. Rising US rates, potentially strong dollar is the last thing that kind of edifice needs at the minute.So, that is the reason that she pulls back more than anything that is happening domestically. In fact, if you mention, if you look at her speech yesterday and the reason she was pulling back, actually most of that related to things that were happening well outside the boundaries of the United States of America. And she specifically raised China and she specifically raised Brexit. So, it is interesting as to what extent international affairs are having an impact on her behaviour.Q: Equity markets be happy there because it seems almost every time she pulls back, there is a rapture. But should on the other hand equity markets, should they be worried?A: I think it should be the other way around. The history of this is if the Fed starts raising rates from very low levels because growth is accelerating or above expectations, then equity markets would not react negatively to that. A sign of higher growth and higher inflation is good for equity markets. Now there is a limit to that, but I would say the limit in terms of inflation would be a level above 4 percent. Certainly historically, the equity market would tend to go up as long as inflation is trending upwards, but not hitting four. And if US rates are going up at the same time, it is not a negative for the equity markets. We have got still quite a long way before we get to 4 percent US inflation.So, I am confused because I look at it the other way around. I look at the fear to raise rates as the most frightening thing out there because if this economy is an economy heading towards recession, there is very little monetary ammunition left. So, I took last Friday’s figure as something truly dreadful for global equities. And the global transmission mechanism is the impact it has on America’s external accounts. If America is not going to grow as fast and its current account deficit is not going to get bigger, then emerging markets (EM) have got some serious problems and yet they all went up, there was a relief rally because the dollar came down and US rates were not going up. So I think the markets are wrong on this.Q: The problem is markets react like this and contrary to what you are saying, they remain wrong for some period of time. How do you time this thing? Because the longer term, it looks like the trouble is brewing and it is building up, but we are in the midst of a 2-3 month rally out there.A: The simple answer might be it is impossible to time this thing. There is a nice quote from Warren Buffet, he says investment is simple, but not easy which very accurately sums it up. The way to make it easier is to have a longer term time horizon and the more we get into second guessing short-term gyrations in the market, the more we are likely to be wrong. So, I know it is not an advice that you can necessarily give to professional investor who has paid for activity, but certainly if anybody is watching this who is a private investor, it pays handsome dividends to take a longer term view and not try to time this. What you do is you build up a series of indicators that tell you which way it is going and you watch those indicators if you have a view. But if those indicators go the wrong way and you are wrong and you have to change your mind. My view at the minute is the world is still heading towards deflation and not inflation. I do not see the evidence to change my mind on that and in terms of short-term timing, we just have to, in all intents and purposes, ignore it.Q: You think markets are ahead of themselves then?A: I do absolutely think they are ahead of themselves. I think monetary policy, why are we where we are today from 2009 was because of the monetary policy. But is it succeeding and what is the definition of the success? To me the definition of success on a long term would be to have nominal gross domestic product (GDP) growing faster than debt, de-gear the global system which the general consensus is that the reason we got into this is that we were over-geared in 2007 but the global system is more geared today as a percentage of GDP than it was in 2007, so they failed.Now, if central banking fails, we are going to have another remedy and that remedy is fairly excessive active government action. I do not see how that can be good for return on capital employed for the market in particular. So, the market is still of the overview that central bankers will get us there eventually and therefore you hold on. But if they are wrong on that then we get something which will be bad for equity markets and their poster child would be Japan where I think it is becoming clear by the day that monetary policy in isolation does not have the solution. So, we may be close to a final realisation of what happens when monetary policy in isolation fails.Q: What would convince you or what would convince policymakers in the west that that experiment is not working out.A: The easy thing is a recession. If that jobs number last week is a precursor for recession that is the first obvious thing. You got to imagine that you are the President of the United States and you look around the room, you are in a recession towards the end of this year. You look around the room for advice. You are probably not going to take a lot of advice from a central banker. You are probably going to say you have been doing this since 2009 and it is not working. You are probably going to look around the rest of the table and if you are President Clinton, who knows who might be at the rest of the table, you can have Paul Krugman at the table, you never know Larry Summers will be at the table and we all know what Larry Summers would like to do and that is much more government action, much more fiscal spending. So, there is going to be a shift to that coming along. I do not fear fiscal spending for the market, but what I do fear and particularly for Japan is this combination of fiscal and monetary policy which is on Mr Ben Bernanke’s list of things you do to defeat deflation. I think it will come to Japan first.The actual problem with the next step is that it does not come in unison. Prime Minister Abe, two weeks ago was trying to persuade everybody we need to do this in unison. And in unison if it would have worked and it would be inflationary. But a U turn unilaterally by one government, Japan it is not reflationary. it has a major dislocative effect on exchange rates. So, Abe was trying to persuade everybody to do it and he failed.One of the things I am looking at is that failure what does it mean and the temptation for Abe to go unilaterally on this policy is going to become overwhelming and the more the yen goes up, the more that is the case. The impact on the yen would be pretty drastic, if Abe is the first person to go to this what was called “helicopter money” which is the fusion of fiscal and monetary policy. So, imminent for Japan but the democratic process or the nature of the logjam in the democratic process in both United States and Europe suggests that it is not imminent there.Q: It’s interesting you mentioned Japan because the year started with fears around China and the currency devaluing there. That fear seems to have ebbed a bit, but what you are suggesting about Japan would it necessarily have to trickle down to China next and they would also have to devalue their currency sharper than people are fearing today.A: That’s a great question because it would put huge pressure on the Chinese exchange rate. Remember, a weak yen is effectively strong dollar and Chinese would have to be to some extent following the dollar, but also politically they are looking for an excuse to devalue their exchange rate target. Those tie their hands somewhat in terms of the domestic monetary policy. It is restricting their ability to reflate, but politically it’s difficult to devalue an exchange rate when you are on a current account surplus and if you look at the press today and yesterday you will see a bit of a war of words between the Americans and the Chinese in terms whether the China is dumping or whether the China is anti-competitive already.You already need a good political coverage really to devalue that exchange rate and there is probably no better one when a yen going 120, 130, 140 in that direction. I do think almost as soon as the yen starts to go within a few weeks people will be focussing straight back on China and its exchange rate. I think we all know the implications if China is to devalue its exchange rate what that means for global growth and deflation. Those fears would be back on the agenda very quickly if the yen is the first currency to fall based on the first implementation of what is known as helicopter money._PAGEBREAK_Q: If you had to choose something this summer which pricks the global mood bubble, what could you rate the highest would it be resurfacing fears from China, would it be Japan, would it be Brexit or just a general realisation that maybe recession is around the corner.A: We are in London we are only a few weeks away from Brexit, if it happens clearly that something - because the first thing that happens on a Brexit is people begin to look elsewhere in Europe and say who else constitutionally is going to demand the referendum. That debate then will rage for months, quarters. If it happens to be a Brexit and I have no more insight on whether it is or nor can anybody else then it would clearly be a Brexit which really focussed it on Europe.I have got a couple of other ones which maybe not on radar for you, but the Italian banking system would be high on my list for the European banking system in general. We are looking at some of the biggest banks in Europe their share prices have halved over 12 months and that’s just not Italy, Deutsche Bank, Credit Suisse. To me it is very hard to believe on the health, robustness and recovery of an economy when it’s banking share prices are and you can use the word “collapse”. Yesterday in a pretty good market a bank share price like Unicredit very big Italian bank share price down nearly 2 percent, so I would focus on Italian banks and that’s an issue.Generally, still I don’t believe that we have solved the issues for EM bankruptcies, higher commodity prices are clearly helping some of them, but we still have significant distress in EMs. The thing that concerns me every day when I wake up and look at my Bloomberg screen is the price of European bank stocks. It is not telling us that that economy is in robust healthiness. It is telling us that some of the banks particularly Italian banks maybe heading into distress.Q: You think this rally should be sold into then the sum of what you have been telling me is not making a very rosy picture. Do you think this rally will fail this summer?A: Yeah, I do think this rally will fail. They usually fail in the summer anyway, but the focus will be much more clearly on Europe quite soon whether it is Brexit or not and how Europe really solve this banking problem because I think the evidence is building by the day, but it hasn’t . I mean this is going to be the world’s second biggest economy, how can you be bullish on a global reflation at this point really having another severe banking issue.I think the final thing I should add on this issue is, it is beginning to get more pressed and that is something up with global trade as well and the global trade is no more a dreadful, not just in terms of price. They should be lower in terms of price because commodity prices have come down, but even in terms of volumes you got a half of the world and EM trying to sell stuffs to other half and if that is not working and it is not working, that is also difficult to be positive on the global system. I think if these things happen if the market isn’t focussing on, the data points are already there and I expect the focus to come on more and more as we go forward. Q: What should emerging market (EM) investors worry more about, the fact that interest rates might go up in the US and therefore it will turn out to be bad for emerging market equities or the fact that some of these recent numbers as they are showing up we are headed towards softer economic conditions and that ultimately will hurt emerging markets more?A: You got to look at the US current account deficit, that's a transmission mechanism through which it sends liquidity into the emerging markets. The more America grows, the bigger that deficit should get and that is what emerging market needs.So, what is good for emerging markets is definitely growth in America, particularly a certain type of growth which is heavy in consumption and heavy on the consumption of goods and that is what you have got to focus on. Interest rates - I really don't care for it because if that story is to pickup I am still a buyer of emerging market even if interest rates go up. So, emerging markets are wrong, they get excited every time American economy slows.The fundamental problem we have en EMs is the US current account  deficit is really small compared to where it has been historically. At its peak in 2007 it was almost 6 percent of GDP, we are now looking at somewhere between 2-3 percent of GDP and this is an economy that is growing. It is an economy that is growing without blowing up its current account deficit and I think that is the future. I think what we are witnessing here in the way America grows is it is growing with reasonable consumption but the consumption is shifting to services. Therefore it grows well but it doesn't grow with a bigger and bigger current account deficit and that is the problem for EMs. So, there is a message in there, that this is what you should look at, don't look at interest rates, look at US growth and the current account but also a forecast  that is, even if America does pickup and I am wrong and it is picking up, I think it is going to find US growing without a significant deterioration  in its current account and that has caused a structural issue for emerging markets and that is a big story for EMs.If this is the way America and Europe is going to grow with big current account surplus, Asia and EMs needs to find a new way to grow and that is a structural challenge which they haven't really  tackled head-on yet and they are going to have to tackle that head-on.Q: EM equities have not made a lot of money for global investors over the last few years. There is a school of thought which is hopeful that this might begin to change but you are suggesting that the time is not here yet. You would be better off staying underweight on EMs?A: Yes. I wrote a book called Wall Street's four great bottoms anatomy of the bear. I looked at it 10 times in the last 25 years when Asian equities got cheap. I have looked at the conditions that made them cheap and then I have looked at the conditions today and fundamentally something happened in 1998 and 2003 that hasn't happened today and we need to happen today before we can get bullish on equities. Now it is not valuations of equities because they look pretty reasonable but it is the condition of the external accounts. Rightly or wrongly I have always believed that its important to start with EMs external accounts and work backwards, not just current account and its capital account. What we noticed in 1998 and 2003 is massive improvements in those external accounts. Now we have seen improvements in the external accounts but it is nowhere near the scale that you associate with a great bear market bottoms of 1998 and 2003 for EM equities.The data for the US current account and in terms of their imports if goods in particular it is contracting  and some of that is priced but I think there is more and more evidence by the day that actually some of that is actually volumes. So, I can't get excited about external accounts for EM and therefore even though the equities are cheap for a long term investor, I can't get excited about those equities either.Q: So, what is your prognosis that sometime this year people will realise the truth of what you are saying that, that is how the cookie will crumble and we get into another bear market kind of situation?A: Yes I think the Japanese have already realised it. I think what is happening in Japan in last couple of months is absolutely crucial. The fact that Prime Minister Abe who travels around the world telling people we are ready for a Lehman style crisis is remarkable. I don't know if he believes it or not, I have no idea whether he believes it but he clearly was doing it to try and instigate a global response to do something that he wants to do. So, the focus I think will be in Japan. Maybe I am wrong, maybe Japan doesn't have a really dramatic answer to this but I would be really very surprised if they didn't . So, if I am looking from here to the end of the year, we have talked about some things that could go wrong. When I go to visit my clients  we mainly talk about governments and central bankers and what surprises they are going to have and I would say look to Japan because there could be a very big surprise coming from Japan. The famous helicopter speech that Bernanke made, he runs through all the things a central bank can do to defeat deflation. Japan has done all of them except one and that last one is this fusion of fiscal and monetary policy. I think it really changes the world when that happens, we see just how far governments are prepared to go and that is going to be the key factor driving equity markets in the second half of this year._PAGEBREAK_Q: What will convince you that deflation has set in, that it is entrenched?A: That is a great question because deflation comes in two different formats. One just where there is too much supply of goods relative to too much demand for goods and that one actually doesn't frighten     me as much as it frightens most of the people because ultimately you should begin to control some of the capacity. But one that is really frightening is where we do we have another Lehmann Brothers event, another crunch to the credit system and if you look back to the inflation data for 2007-2008 it is actually rising. Inflation is rising, the economy peaks in America in December 2007, inflation goes up and then it just drops like a stone and it is beginning to fall before Lehmann's and when Lehmann's come it drops like a stone. So, at this location in the financial system it is a thing that would really convinced me that we were heading for deflation. Judging the powers of supply and demand is difficult. They kind of act fairly slowly, the inflation data tends to come very slowly but if you get a dislocation to the global credit system then it can just down rapidly overnight. We have seen that more than once before actually. We saw it in 1998, we saw it in 1982 and pretty spectacularly in 1982 as well.So, anything that happens to the global credit system, that is it. We are definitely heading into certainly a developed world deflation whether it gets to deflation in EM is a different issue. So, that is the key thing to look out for. Now, there are so many places where that dislocation could come from where people would not be able to repay their debt. We have huge worries about commodity, stocks four months ago. I still have lots of worries about commodity country, lots of worries about Italian banking system. So, that credit shocker is a things where you just say well, the central banking isn't going to be able to cope without in isolation. Too stressed, there is an answer but central bankers working in conjunction with government and most governments aren't ready and prepared to do that yet.Q: Is there any part of the financial market, forget the equity market for now, which is telling you that they are beginning to pick up some of the signs of what you are saying either in the way the yield curves are positioned and any of the bond prices, currency movements anywhere, do you sense that people are cognisant of the risks that you are talking about?A: I think so. There is a real conflict in the market. So, as you can tell I am pretty pessimistic on the world and therefore my own personal portfolio is pretty pessimistic and I do hold the American 30 year bonds. Well as of this morning they will be up nine percent in dollar terms this year. Is that a sign that the world is getting better, that this price of the dollar is up. The fact that gold can go up on days when the dollar is up, the fact that people seem to be buying gold as a safe haven, is that a sign that the world is relaxed and I keep coming back to that collapse in European bank equity prices.Mr Soros says this wonderful phrase, he says reflexivity, which is when the price of a security affects the fundamentals while the most reflexive security price in the world will be buying equity prices. So, it is just hard to believe. If the world is really getting a better place why are we watching many of these share prices halve in a year. So, there is lots of things going on over here that tell you things are getting worse and then you look at broad equity indices and they are doing reasonably well or are doing all right.So, there is a massive dichotomy in the markets at the minute. It is telling you two different things at the same time. Not a great surprise to me because the more the governments get involved in the markets the less the markets are coherent, the less they are able to tell you something about supply and demand because the government is such a big part in all of those things.Q: I know it is absolutely impossible to time these things but if you had to guess do you think this will be a slow drawn out kind of a process or do you think the shoe drops this year sometime?A: Yes, another great question because I have been focussing on this for several years and this has been happening but happening very slowly. Global inflation has been coming down, there has been nothing going up, there has been some distress in the credits fear, all these things have happened but happened very slowly. It is unlikely that they continue to happen slowly. I would forecast it would happen quickly when it does happen. If you look at this year, perhaps but it will happen quickly. A major decline in the end if that is the repercussions of a move to this fusion of fiscal and monetary policy has implications very rapidly.So, it is hard for me to look at the world, the structure of the global system seems to be held together with a piece of string. Frankly, it is hanging by this piece of string, it just seems to keep getting narrower and more fragile. So, it is very difficult for me to believe that this can get to its conclusion in a similar fashion. That piece of string has to break, what I mean is the credit system. Something will go wrong in the global credit system seems to be more likely by the day.