There is still a significant downside due to the problems brewing in China simply because real interest rates and exchange rates continue to remain high, says Russell Napier, co-founder of ERIC, an online platform for the sale of high-quality individually priced investment research. What looks like a very major reaction to yuan depreciation is a very small move in the exchange rate, he says. What makes it worse is the fear that central banks cannot reflate economies, he told CNBC-TV18. Napier also agreed with the Reserve Bank governor Raghuram Rajan when he told BBC in an interview that central bankers are being overburdened to fix the struggling economies globally and the consequences may be "more bad than good" if they actually act.
While advising retail investors to preserve cash at this point, he says fixed income looks more attractive than equities from a 3-6 months perspective. According to Napier, Japan looks attractive post correction. Below is the transcript of Russell Napier's interview with Anuj Singhal and Sonia Shenoy on CNBC-TV18.Sonia: This mayhem was put into motion after China devalued the yuan in the first week of August. Do you think that global markets have priced in the possibility of a slower growing China or do you think there is more to go on the downside?A: I think we have significantly more to go. China is faced with an exchange rate target, they are intervening. They have an external deficit and they want to ease interest rates. These three things are entirely incompatible. One of them will have to give in. The most likely one to give in is the exchange rate. Therefore, what looks like a very major reaction in markets is a very small move in the exchange rate. It is really a small tremor in preparation for a much larger movement in the exchange rate. If that is to come, as I believe, then there is significant further downside for the outlook for global growth and deflation rather than inflation. And perhaps most crucially a fear that central bankers can't reflate the global economy. So, therefore the movements we have seen are entirely warranted today and there is much more to come.Anuj: Do you expect some more moves from China on the currency front or do you think this is pretty much it? A: There is more to come. The key indicator we need to look for in China is likely their interest rates. The monetary policy is too tight, real interest rates are too high, the economy is not growing, they need to bring down nominal rates, they need to bring down real rates, they have not succeeded and that is the crucial thing. It is not succeeding in reflating the economy with several interest rate cuts or RR cuts. It isn’t working and if it doesn't work then they have to go to plan B. Plan B would be to tweak the interest rates and print enough money to create reflation. However you cannot expect the exchange rate to remain stable if they aggressively go towards other forms of reflation. Therefore, as long as you believe that ultimately China will be aggressively pursuing reflation, which I think is very probable, then you have to believe that the exchange rate is likely to fall significantly further. Sonia: Since you believe that there could be significant downside because of the Chinese problems, would you advise a cash preservation at this point in time or should investors across the globe continue to deploy money at lower levels? A: I would advise (to preserve) cash, particularly for retail investors. Retail investors need to know that they have huge advantages over professional investors because they have the advantage of doing nothing whereas most professional investors are paid to do something. And there are times in life when doing nothing is a good idea. Warren Buffet famously said that investors need to wait for a fat pitch — a baseball term reflecting you waiting for an easy ball to come — and that is what investors should be doing. You should be waiting and doing nothing. I could quote from Adam Smith, economist. He said the greatest cause of distress amongst men of wealth is the feeling that they have to do something and sometimes just doing nothing is a good advice. I think that is where we are today.
Anuj: Any pitch where easy balls are available right now in terms of whether either equities or fixed income, any market which you believe has become very attractive after the kind of fall that we have seen?
A: The one I single out is Japan. I am talking about the central bankers. The one in Japan is showing no more success than others. But I think we can bet on them to be much more aggressive going forward and we have to go much lower. I would still advice to sit on your hands in the short run, but if we ever get to the stage when yuan starts to fall more rapidly, then it is time to be buying Japanese equities. I mean it is difficult for the retail investor to hedge currencies, but hedging a currency would be very wise. There may be investment products available. When you are long Japanese equities, but you have hedged in the US dollar, it should be fine for Indian investors. So, I would partially pick out Japanese equities, but apart from that, it is time to be very safe. And if you are in fixed interest investments, there may be further upside.
Sonia: We have seen the US bond yield reflect the rush to safe havens at least in the last couple of days. Do you see fixed income get more attractive than equities in the next 3-6 months?
A: Yes. The treasury is being particularly remarkable. We do not know how much treasuries have been sold by the People's Bank of China (PBoC). But it is fair to say that it is probably in hundreds of billions of US dollars, just since the move in the exchange rate. Now, that yield has come down against the background of the world's second-largest owner, the PBoC, liquidating its treasury position. It gives you some idea of the scale of private sector demand for treasury, given the scale of public sector liquidation. So, let us say we remove the exchange rate that China moves the exchange rate. The PBoC is no longer a liquidator of treasuries. Also, China’s lowered exchange rate means it is going to be selling things a lot cheaper in dollar terms. There could be a huge pressure on the dollar and also on the US treasure market if China finally makes that move.
It is the resilience of the bond yields given the scale of PBoC liquidation, which suggests that when the PBoC stops, then they stop significant upside on the treasury.
Anuj: What has damaged sentiment in equity markets, in emerging markets, is really what happened with the US market over the last 10 days or so. Do you think US market right now can go further lower from here and is the US market at the risk of starting a bear market which could have its significance or impact on the other emerging markets as well or the other equity markets as well?
A: The slowness is from emerging markets into the United States of America. But it does cause major issues for the US. For instance, there is a treasury inflation protected security market for just one year. And that is pricing inflation this morning of minus 1.6 percent over the next one year. US equities, and I looked at the thing called cyclically adjusted price-earnings ratio (P/E) we have bid on that back to 1881, US equities are as expensive as they have been in 1929 and 1995 to 2000 and otherwise they have been more expensive. Now, there is nothing in the historical records to suggest that equity valuations in the US can remain incredibly higher if you actually get deflation. So, I think there is significant room for economic downside for equity valuations in the US, albeit at this stage, the flow in terms of deflation is from emerging markets into the US.
But back to that key issue, we have lived for nearly six years with the belief that our central bankers can create higher nominal gross domestic product (GDP) growth and solve the excessive debt problems in the world. What we are witnessing, it began with the move in the Swiss Franc, it is now happening with the move in the renminbi, it is that failure and if equity markets come to believe that central banks can achieve this, then there is a very significant downside. So, that would obviously feed out the second part of your question into the rest of the world because this will not be an isolated US phenomenon. If we lose fear from central bankers to create inflation and growth, then I am afraid it is a global bear market and not a localised bear market.
Sonia: Sitting here in India it becomes very hard for us to judge what the situation in China is and how it is evolving, but so far Beijing has pumped in about USD 140 billion into the markets to sort of prop up the stock markets but that hasn't helped much. How high is the fear of a hard landing in China and do you think the situation now that we are facing is much worse than what we have seen in say, 2008?
A: My fear is not about hard landing in China. My fear is about devaluation. Now that devaluation is phasing the way for another major reflation in China, whether it is a good reflation or a bad reflation time will tell, but it will be reflation.
It is the exchange rate that we have to worry about because although there may be a buffer for the Chinese economy and makes things easier in China it just passes all the problem solving for rest of the world. Your listeners or viewers should perhaps - look at a fantastic interview with Rajan with the BBC yesterday where he said the central banks are failing. Not only did he say that they are failing, he said that actions from here could make things worse rather than better and to hear that from not just any central banker but from a central banker with such a great track record, it is quite alarming and the market seem to ignore that. But it is not just me reporting this from Scotland that the central banks are failing, even your own central banker is pointing out to the world that they are not succeeding. Markets in my opinion have not fully discounted this central bank failure.
Anuj: He also said that there is too much pressure on central banks right now and there is only limited weapons in their arsenal. Do you think we are reaching a stage where the central banks would run out of ammunition and that would lead to a bit of a cascading impact in asset markets?
A: Yes, they already have run out of ammunition because they are in quite alarming stage. Look at five-year TIPS market currently and at inflation averaging just over one percent or at 1.2 percent over five years; this is in year six of quantitative easing (QE). This is an expected inflation rate which isn't that different from where we were in 2010. So, the markets are screaming that QE isn't working. They are out of ammunition.
Now, that is why you can see in the case of US dollar market. What comes next? I have got greater fear on what comes next. It is not going to be monetary policy, it is only a more direct government interference in the allocation of credit, in the allocation of capital perhaps under the guise of macro prudential regulation; you might want to call it capitalism with Chinese characteristics. But because our central bankers feel do doesn't mean to say our authorities concede to that. They come back with government action and government reaction. So, the baton has now been passed from central banks to governments and I cannot see how passing of that baton can be good for return on capital or in some cases return over capital.
Sonia: You started off by saying that there could be significant downside, but for the Indian market, we have relatively been a safer haven compared to other emerging markets. Do you think that relative outperformance will continue or do you think that it's going to be one swift move taking all markets downside in the next six months or so?
A: I can see the economy being in better position. Generally, the Indian economy can benefit from some of the disinflationary things going on in the world, but it is very difficult to say that is also true for the stock market. What should be happening, and given the decline we have seen in some emerging market exchange rates, given the decline we have seen in the oil price which is key for some emerging markets, we should see a major default in emerging markets.
It is unfortunate for India as it is for most other places that run better, has more reasonable economic policy that we tend to get sudden stops to emerging markets as a group, as an asset class. It is a form of madness. This way we have of grouping capital into little ghettos and this emerging market ghetto for capital, and I am afraid when it stops flowing to one, history shows in 1982 and 1987 and 2008, it tends to stop flow into all of them and they get caught in that spiral. But I do believe that the economy is in a much better situation to deal with it, than many other emerging market economies. So I would still be wary on Indian equities but always optimistic that the economy is in a better situation to deal with this than most people in emerging markets.
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