From Russell Napier of ERI-C
It’s Not a Pet, It’s a Falcon: How the decline of the RMB destroys belief in central banking and a successful reflation
Turning and turning in the widening gyreThe falcon cannot hear the falconer;Things fall apart; the centre cannot hold;
- The Second Coming- W.B. Yeats
First catch your falcon, as the formidable Mrs Beeton might have said if she was in need of a method of catching her main course (see Mrs Beeton’s Book of Household Management 1861- ‘Recipe for Jugged Hare’).
Having caught your wild falcon, you can now begin the training process. You are attempting to impose your will upon a creature that, in its wild state, catches, kills and devours other birds. This is creative destruction in its rawest form as those acts of savagery provide the fuel to keep our falcon flying. Taming such wild forces is not easy, whether they be birds of prey or the desires, wishes, greed and fear of millions of people determining prices through their supply and also their demand.
Let’s get some advice from the field of falconry for our central bankers, and the other handmaidens of state control, as they seek to impose their wishes on the will and acts of millions-
‘Falconry is a great sport, but there is a lot of time involved. You will want to have enough time to train your bird. If you don't have the time, or the willingness, then you might as well not do it at all. If you are one of those people who is not patient, falconry may not be for you. You should not take up falconry if you want the falcon as a pet, or something to show off. Falcons can't just be put in the closet when you are done with them. It takes time and commitment, but the reward in the end is worth it.’
(Source: WikiHow- How to Train Your Falcon)
A ‘great sport’ indeed, given the alternative sports open to government officials! Well, they have demonstrated that they have the time and they seem to have been born with the willingness, or at least picked it up pretty early in life. Patience just comes with the territory when you work for the government--- there really isn’t much of an alternative. However, they do seem to have a problem when it comes to realizing that there is not much point in turning this wild thing, that exists to efficiently convert its kill into energy and life, into a pet ‘in the closet’.
The attempt to train the wild forces of supply and demand by the authorities has really ramped up since 2009. Just four trading days into 2016 the widening of the gyre makes it very obvious that they have failed to create a pet to do their bidding. The wild forces of supply and demand have sought to deliver deflation, at least since 2008, but the falconer has demanded the lift-off of inflation. In the first four trading days of January 2016 it has become even clearer that gravity wins and this bird will not fly.
Throughout 2015, in four quarterly reports for subscribers, this analyst explained that, no matter where you and might stand, this lever of nominal interest rates is simply insufficient to pivot the world into inflation. Those reports focused on what you should buy given that failure. The rest of this Fortnightly looks at the investment consequences of this failure and what investors should do when ‘the centre cannot hold’.
The key failure of control is in China because that failure will overwhelm other seeming successes. In 2012 this analyst labelled one chart “the most important chart in the world”. It was a chart of China’s foreign exchange reserves. It showed how they were declining and The Solid Ground postulated that this would produce a decline in real economic activity in China and higher real interest rates in the developed world. The result of these two forces would be deflation, despite the amount of wind puffed below the wings of the global economy in the form of QE.
Of course, no sooner had this report been issued than China’s grand falconer got to work by borrowing hundreds of billions of USD through its so-called commercial banking system! The alchemical process through which this mandated capital inflow supported the exchange rate while permitting money creation in China stabilized the global economy- for a while.
However, by 2014 it was ever more difficult to borrow more money than the people of China were desperate to export and the market began to win. Since then foreign reserves have been falling and the grand falconer has tried to support the exchange rate while simultaneously easing monetary policy to boost economic growth. I’m no falconer but isn’t this akin to trying to get a bird to fly while tying back its wings?
Some investors, well paid to believe six impossible things before breakfast, did not question the ability of the grand Chinese falconer to fly a falcon with tethered wings.
They changed their minds briefly as the bird plummeted earthwards in August 2015 but still the belief in the ability to reflate the economy and simultaneously support an overvalued exchange rate continued. In January 2016 this particular falcon, let’s call it the people’s falcon, was more ‘falling with attitude’ than flying.
This bird does not fly and if this bird does not fly the centre does not hold. A major devaluation of the RMB is just beginning and the faith in all the falconers will wane as deflation comes to the world almost seven years after the falconers first fanned the winds of QE supposed to levitate everything.
The failure to inflate is the failure to destroy debts to the benefit of equity. Investors should be underweight equity. Of course, the decline in corporate cash-flows, associated with deflation, is bad for interest cover and the price of corporate bonds. Some emerging markets (subscribers see Why Deflation Means Default 1Q 2015) will fail to repay their heavy foreign currency debt burdens. This is dreadful news for those running open-ended funds crammed full of illiquid credit instruments- some have closed and more will follow. The Solid Ground pointed out in 4Q last year that the US$34trn open-ended fund business is simply unfit for purpose in a world of waning liquidity. While this dreadful combination leads to a credit crunch that starts in the bond market it must inevitably also impact negatively upon banking systems. Banks, already de facto utilities for the financing of government, are very vulnerable to attack from thousands of bright kids in the fintech industry. Add to their structural demise the risk of credit quality issues and the growing fear of bail-ins by their bond holders (as subscribers know BRRD will be a huge Eurozone story in 2016) and this could get very messy.
If doctors swear each year to ‘first do no harm’, investors should begin 2016 by reciting ‘first own no banks’.
Investors who buy the bonds of governments that ultimately control the money-creation process should have an almost zero risk of not receiving their payments of principal and interest. These certain and fixed payments will grow in purchasing power during a deflation and thus their price will be bid up. This analyst remains sceptical as to whether this description of a fiat currency system applies to all those countries currently in the Eurozone.
‘Whatever it takes’ may ultimately be constitutionally impossible and the ECB may not be prepared to print sufficient Euros to ensure that every government of the Eurozone makes all payment of principal and interest. If that reality dawns then yield spreads widen in the Eurozone and ultimately your interest and principal may not be repaid in Euros.
For those investors who have to be in equities, North Asia is the only game in town. They, in the form of China, Japan and probably also South Korea, will win the currency wars. Their success in winning this game triggers the scale of deflation that generates the global credit crunch that is virtually inevitable as deflation takes hold. These jurisdictions may be somewhat alien to sound capital allocation, but they keep that capital humming at high rates of capacity, via devaluations, while more market-orientated systems see their assets under-utilized. This analyst prefers Japan (subscribers see Caught in a Trap 2Q 2015) where some shift to more efficient capital allocation is under way, but even the structurally anaemic corporate capital of China is likely to be bid up as the RMB declines in response to further and further economic stimulus- increasingly possible as the exchange rate is allowed to find its own level. This analyst has never invested in a Chinese equity as he is not sure that Chinese management know what equity is but bright stockpickers can find management in China that does. Hedging all North Asian currency exposure is essential.
If you had not noticed, 2016 has begun with gold and the USD rising simultaneously. This is different and important. This is very positive for gold and very bad for the world.
The rise of both together may signal that we have just entered that period when this inert non-yielding substance is preferred to those assets that promise a yield but where the scale of future payments is subject to considerable doubt. Also positive for gold, the advent of deflation, following the failure of the easy reflationary solutions promised by non-elected central bankers, will enfranchise aggressive acts of reflation by our elected representatives. When the tough get going then the going will really get tough- at least if you’re an owner of capital.
Any political fiat, when monetary fiat fails, will be tantamount, in some way or other, to an attempt to directly control the allocation of capital/savings. History shows that this commences a giant game of hide-and-seek, and while gold may shine brightly it is also moved freely in briefcases and is easily hidden. Paper assets are easily tracked, discovered, conscripted and ultimately denuded in value. For gold to rise while the USD also rises signals that investors are beginning to see through the terrible burden on the price of the shiny stuff from ever-rising real rates of interest extant since 2011. Real rates have further to rise but a few more days of a strong USD and a strong gold price means gold has probably entered a bull market that should last for decades rather than years; its value boosted initially by its ability to avoid conscription, but underpinned by the authorities’ mass mobilization of resources to ultimately generate inflation.
From 2009-2015 investors were well paid, at least in the developed world, to believe the most impossible of the six things before breakfast: that central bankers can subvert the desires, wishes, greed and fear of millions of people who set prices every day through their actions.
You now have two choices: keep believing the most impossible thing, or accept that the wild force that establishes market prices has not been tamed. It’s not a pet, it’s a falcon and ‘The falcon cannot hear the falconer’. The ‘people’s falcon’ may be the first to enter ‘a widening gyre’ but it won’t be the only wild force that refuses to be tamed in 2016.