Russell Napier: This Has Never Happened Before Without A Drop In Stock Prices

From Russell Napier, of The Solid Ground via ERIC

It Can't Happen Here, Can It?

The Solid Ground has long flagged the importance of falling inflation expectations when nominal interest rates are so low. The Fed cannot lower nominal rates, so its control over real rates of interest rests entirely with its ability to create actual inflation or manage inflation. After five and a half years of QE, inflation expectations are very near their lows. The chart below shows the break-even inflation rate of the five-year Treasury Inflation Protected security. Over the next five years investors now expect inflation to average just below 1.3%. This level of expected inflation has always previously been associated with a decline in US equity prices. There have been no exceptions until today.

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Which force is currently depressing the corporations share of GDP? It is a question worth asking, because if such suppression lifts then the corporates share of GDP can go higher and, the likelihood is, share prices will go with it. While most questions in finance are difficult to answer this one is really easy because nobody and nothing is depressing the corporations share of GDP. The usual suspects for depriving the corporation of higher profits --- labour, creditors and the state --- are all "quiescent", to use a word favoured by the man formerly known as ‘The Maestro’. Indeed, these forces are so quiescent that most equity investors consider them to be demons which have been slain.


There is nothing in the historical record to equate dormancy with death when it comes to the future path of wages, interest rates or corporate taxation. For the equity bulls who choose to believe in the prolonged dormancy of labour, creditors and the state, all at the same time, history has a very clear warning that there is another potent force which can drive mean reversion of corporate profits and equity valuations --- deflation.


In 1919-1921, 1929-1932, 2000-2003, 2007-2009 it was not a resurgence in wages, Fed-controlled interest rates or corporate taxes which produced a collapse in corporate profits and a bear market in equities. On those four occasions equity investors suffered losses of 32%, 85%, 41% and 51% respectively despite the continued dormancy of labour, creditors and the state. It was deflation, or the fear of deflation, which cost equity investors so much. There is a simple reason why deflation has always been so damaging to corporate profits and equity valuations: it brings a credit crisis.


Investors forget at their peril what can happen to the credit system in a highly leveraged world when cash-flows, whether of the corporate, the household or the state variety, decline. In a deflationary world credit is much more difficult to access, economic activity slows and often one very large institution or country fails and creates a systemic risk to the whole system. The collapse in commodity prices and EM currencies in conjunction with the general rise of the US$ suggests another credit crisis cannot be far away. With nominal interest rates already so low, monetary remedies to a credit seizure today would be much less effective. Such a shock, after five and a half years of QE, might suggest that the patient does not respond to this type of medicine. Investors would doubt whether monetary policy in general has the power to sustain corporate profits and with them near record-high equity valuations.


In 2009, 2010 and 2011 US equity prices fell sharply as the five year TIPS break-even inflation rate fell below 150bp. The 2009 episode was associated with the collapse of Lehmans, resulting in massive losses for equity investors. In 2010 and 2011 the end of QE1 and then QE2 was sufficient to produce a rapid decline in inflation expectations and led to major losses for equity investors. In 2010 the S&P500 fell 16%, as the expected rate of inflation declined from 2.1% in April to 1.1% in August.

In 2011 inflation expectations fell from 2.5% in April to 1.4% in September and the S&P500 fell by 19%. In 2014 inflation expectations have fallen from 2.1% in June to 1.3% in December and the S&P500 index has risen by 6%! Prior to this year the minimum loss equity investors would have experienced given a decline in inflation expectations to 1.4% was 16%, but on this occasion they have made a profit of 6%! So, as Marvin Gaye was wont to ask, what’s going on?


Investors are ignoring the deflation threat, as this is supposed to be the ‘good’ deflation in which prices fall boosting consumption as a consequence. This analyst doubts whether even that dynamic will be as powerful as normal given the ageing of the baby-boom generation. However, even assuming that this is exactly how consumers behave, it still ignores the major associated negative from deflation in the form of a credit shock. This analyst has long thought that the shock would come from EM, either from a commodity-exporting nation with large foreign currency debts (such as South Africa) or from a country with a large current-account deficit which is heavily reliant on short-term capital inflows (Turkey).


Ultimately, just such a shock would come to many places if China tired of the monetary tightening implicit in its link to the world’s strongest currency, the USD. At some stage China will need to relax the monetary reins and this will be virtually impossible if it is tethered to a rising USD. The 1994 devaluation of the RMB wreaked havoc with the finances of China’s competitors and a similar, in fact even more powerful, dynamic is evident today. A devaluation of the RMB would thus be another trigger for a credit crisis. The consensus, it would seem, views this deflationary move as one without tears. With US equities trading at 27X CAPE , that’s one hell of a bet!!