Russell Napier: Growing Wealth in an Inflation Avalanche (w/Russell Napier and Stephen Clapham)
STEVE CLAPHAM: Hi. I'm Steve Clapham. I'm really excited and looking forward to my discussion with Russell Napier. Russell, welcome. What I would like to start off by doing is just painting the scene. Russell, you've explained to me in the past your views, which are quite radical, I think, about the forthcoming denouement of inflation, how equities will develop, how bonds will develop. Could you briefly just paint a picture of your views. RUSSELL NAPIER: Yeah. I'll try to get it into a very short period of time so we can get to discussing what it means for investment. But the simple way to explain this is that there have
always been two ways of creating money. One is by a central bank. But most importantly, the other is by commercial banks. And the vast majority of all the money in the world has been created by commercial banks. Now, sometimes that astounds people. But of course the idea is the central banks kind of control of commercial banks.
And therefore they are in control at the rate at which the commercial banks create money. My entire thesis is that that changed in May. It changed April, May. And it changed through the use of what we call government bank guarantee schemes or bank credit guarantee schemes. And it sounds like a very technocratic, not-very-interesting, not-very-important shift, but actually it's fundamental. And last week, the European Central Bank
recognized this. And they called it the sovereign-bank- corporate nexus, which is a classic euphemism for the fact that money is now created by governments, not by central banks. Now, I can't persuade anybody of that, even though the ECB has now come out and said it as well. Because once a government is then offering that guarantee to the bank, the bank begins to lend money. And we've seen spectacular growth in bank credit in this biggest recession in this country-- this country being the United Kingdom-- since 1708, fastest bank credit growth probably we've ever seen, or certainly one of the highest we've ever seen in peacetime. How on earth do you reconcile those? The government guarantees it. So when those bank loans are made, money is created. And that has been the failure of
central banking for 12 years, that they absolutely failed to do that. They created a lot of their type of money, which is technically called a bank reserve and sits in the banking system. But they didn't create a lot of what I call our type of money. And by what I mean our type of money, I mean citizens, people who spend it, the stuff that we pick up in GDP and measure in GDP. And my goodness, the governments are doing a spectacular job at creating that.
So to give you some numbers, the growth in the total number of dollars in the world is up 25% year on year. For the yen, we're looking at about 9% year on year. For the euro even we're getting to 10% year on year. And these numbers, these growth rates, have all doubled or tripled during COVID-19. So the first point is that it's a new mechanism. It is working. Historically, that level of money supply growth would normally create inflation. And there's a bit of people who doubt that. But at a very high level, it's almost certainly the case.
And then the second part, Steve, which we will no doubt talk a great deal about, is that that leads us to a time when bond yields are capped, when the state central bank regulator does not allow the bond yields to reflect the inflation outlook. And that is something called financial repression. And it leads us down a rabbit hole for a generation of government control mechanisms to try and force savers to own an asset they don't want to own. And if I started to talk about
that in detail, it would take me 90 minutes. But that is the outline of two things. One, inflation is coming because the control of money is coming. But it takes us to a world where we have to control the yield curve. And that takes us to a thing called financial repression. And then we're definitely not in Kansas anymore. STEVE CLAPHAM: Before we go down there, I mean, the way I look at this, very simply, is that the governments have got a lot of debt. They need to keep --- RAOUL PAL: Hi, I’m Raoul Pal.
Sorry to interrupt your video - I know it’s a pain in the ass, but look, I want to tell you something important because I can tell that you really want to learn about what’s going in financial markets and understand the global economy in these complicated times. That’s what we do at Real Vision. So this YouTube channel is a small fraction of what we actually do. You should really come over to realvision.com and see the 20 or so videos a week that we produce of this kind of quality of content, the deep analysis and understanding of the world around us. So, if you click on the link
below or go to realvision.com, it costs you $1. I don’t think you can afford to be without it. STEVE CLAPHAM: Before we go down there, I mean, the way I look at this, very simply, is that the governments have got a lot of debt. They need to keep interest rates very low. And therefore, if we do get inflation, we're going to be in a period in which there's negative real interest rates, and large. And that means that anybody that's trying
to protect their wealth will have to seek to borrow money, which means that there will be a huge demand for credit. And that's why the rationing will have to take place. Is that-- RUSSELL NAPIER: That's absolutely right. And that's a brilliant word. Rationing is a brilliant word, and a word that most people watching this will never have had to live with. And people will think it's an alarmist word as well. But let's be clear what rationing is.
Rationing is the allocating of resource by a mechanism other than price. So don't think of World War II. Don't think of queuing up to get two eggs. Think of a means of allocating anything by a mechanism other than price. So you're absolutely right. When you
get negative real yields, we'll all want to borrow really. I mean, if my wages were going up at 6%, why wouldn't I want to borrow at 2%? And if I was a corporation and my revenues were rising at 7% or 8% because I was getting price rises or 6%, of course I'd want to borrow at 2%. So we have to put in place administrative restrictions on this. And of all of the many, many things we could discuss, this is probably one of the most important. Because we've lived in an era where anybody could get credit. Dogs got credit. At least they were mailed credit card application
forms. At a right price, anybody could get credit. And the world is geared for that reason. And just one thing I'd correct you on is, yes, it is about government debt-to-GDP being high. But actually the private sector debt-to-GDP is at a record high. At least government debt to GDP may be slightly lower than World War II in some countries. But the private sector is at a record high. So just imagine a situation where we have to
unstitch the past 30 years to get debt where we need it or want it to be. How much debt will flow to private equity? How much debt would flow to allow you and I, if we ran a corporation, to buy back our own equity? How much debt would flow to gear up commercial property? In fact, what you might argue is that the government divides rationing, good credit and bad credit. The bad credit would be gearing up an existing income stream. And the good credit would be building an existing income stream. Because in building an existing income stream, we have the prospect that we're going to employ people. So you've absolutely hit the nail on the head.
And as a stock selector, of course, that has huge ramifications. Because if you can find the stocks that get that really cheap credit, there is potentially extremely good benefits for the equity. But if you are in the stock already, which has all this credit, and basically can't renew it, and has to go for equity funding, then we're going through a very prolonged re-equitization, which I would argue is probably not good for the price of that equity.
But you're the micro specialist. So what do you think? STEVE CLAPHAM: Well, that is an interesting question. I'm going to come back to that in a minute. Because this idea, if we've got inflation, well, theoretically,
if governments are trying to inflate away the debt, it might be a good idea to form leveraged companies. But if they can't refinance the credit, that's going to be a real problem. But before we get onto that, there is one sort of pushback I think people will have to this idea we're going to have inflation. And that pushback is, well, governments have wanted the inflation for the last decade-- more. And they haven't been able to get it.
So why are you so convinced that now is the time? RUSSELL NAPIER: Well, I need to give you a little bit of my own history here. So when we got to 2009, when I became a bill of equities, I said, this is going to create inflation, this quantitative easing. And you should own equities and commodities. And of course they both went up. And inflation actually went down. So inflation did get quite close to 4%. But in 2012, I completely changed my mind,
and said, we're not going to get inflation, we're going to get deflation. Well, it took a while, but as early as 2015, America was actually again reporting deflation. So why, as you say, given that governments have wanted it for so long, given that central-bank balance sheets have gone like this, why didn't they get it? Because they didn't create the sort of money that circulates in the things that we call GDP.
What that activity by the central bank acting alone did is it was buying, effectively, bonds from savings institutions and crediting the savings institutions with cash. You and I have both worked for savings institutions. So we know that the only thing that a savings institution can do with that is buy more assets. It can't buy a Lamborghini. Despite
what you read in the press, the fund manager can't take the money and buy a Lamborghini. So the money we're creating today is of an entirely different sort. And if we look at these loan programs, they've all really gone to small companies rather than big companies.
This is the ones that have come through the banks rather than the bond market. And I mean, very small companies, you know, taco stands, Uber drivers, these are the sort of people who are getting this. And these guys spend the money. They have to spend the money to survive. And they're going to spend this money. So to me, the fundamental difference is that-- and it shows up in the data. So the crucial data-- let's take Japan, the infamous Japan, where there's been no inflation back since the early 1990s. I think it's about 2%
that broad money growth has averaged in Japan over that period. And all the incredible things the Bank of Japan has done, it's been 2%. Well, depending whether you go for M2 or M3, we're up close to 10% today. Now, you can either say that's irrelevant and it doesn't
make a difference, or you can say, that's it, the world has just changed. And to me, that is what changed and who has that money. And it will be spent in GDP. And that's why, after many, many years, I'm looking at a thing I wrote. I have it on the wall. Because I wrote it in 1996. It was called Dealing with Deflation. So I mean, it's something I've been aware of since 1996. And every recession we've had since 1996, it has tipped us towards-- either into deflation or a fear of deflation. So here I am, sitting here, after writing
about that now for over 20 years, to say that it won't happen again, that this has fundamentally changed because of how money is created and whose hands it is in. STEVE CLAPHAM: OK, so our working assumption is that you're right and there will be inflation. We don't want to risk everything by betting 100% that you're right, and just going and buying gold, putting all our assets into gold and into gold miners, which would be the simple solution.
So let's just explore, OK, let's put some of our assets into gold and gold miners, but what do we do with the rest? So the first thing was to think about companies that are heavily indebted. And that's risky, because obviously companies with a lot of debt will have to refinance at some point. Your theory is that they'll just come up against a roadblock and they won't be able to borrow the money, either because the central banks will ration the credit or because the credit markets will charge them a heinously price because of the risk that they won't pay and because they want real interest rates. Is that fair enough? RUSSELL NAPIER: Well, I think the first one is fair enough. And the second one I'm going to differ on. So on the first one, absolutely. But remember, the world is being divided into good and bad. So
we can find the corporate that's allowed to access that credit because it's considered that credit is for a socially-useful purpose. Then things may be fine. I think it's very clear that green lending is going to be one of those socially-useful purposes. Another one is definitely building residential real estate. That is the American dream. it's not just the American dream, it's a dream for most people in the world to own their own homes. That's going to be good credit. There's lots of reasons why you might look to invest in companies
like that get access to the good credit. The second point was corporates are going to be starved because the yield they'll have to pay to go into the non-bank market will be excessively high. I think that's really interesting. Because in my book, I looked at 1949 as one of the great bear market bottoms. And of course that's a period of yield-curve control,
when the central bank is actually keeping yields at a certain level. The necessary arbitrage, if you were a savings institution, actually kept corporate bond yields pretty close to that yield. That worked as an anchor. It worked as an effective anchor. Now, it has to be said that most corporate balance sheets in 1949 were in a hell of a lot better condition than they are today.
But on that second bit, the fundamental way we did this after World War II was not via market system at all. So the United Kingdom had a thing called the Capital Issues Committee. And the Capital Issues Committee, if you and I wanted to issue a bond of debenture, as it was called, to raise this money, let's say to build office properties in London, it had to be approved by a committee. And if the committee didn't approve it, there wasn't any price that we could issue at. We didn't get a license to raise capital. So it didn't really matter.
And I think most people will think that's extreme. But in November last year, the Bank of England, Her Majesty's Treasury, and the FCA, announced a committee that is going to work out what productive investment is. Now, we'll just have to wait and see what that means. But when the government starts drawing a line between productive and non-productive, we could well be morphing back into that committee. So you're absolutely right. If you and I run a company which is just not getting at any price, then it's a forced re-equitization.
And that is not going to be good for the return from investing in the equity. Probably not going to be good for it. STEVE CLAPHAM: But the post-war period, which was characterized by a limited amount of trade- - I mean, we're in a much more global world today. So the Bank of England can say, to all the banks, you're not issuing loans to real estate developers. A real estate developer is just going to go to a Cayman Islands entity and issue a bond. I mean, how can the government-- I mean, even if the governments collude, can they stop global finance? I mean, I don't see how that's possible. RUSSELL NAPIER: So it is possible. And in
recent times, lots of people have done it. Of course the Chinese do it. I mean, they don't do it with 100% success, but they do it with significant success. And that's not just significant success in stopping capital coming out, it's also significant success in stopping Chinese corporates borrowing overseas and bringing it in. I mean, that got out of control up until about 2014. And they brought it back under control.
Of course, the ultimate control is capital controls themselves. And people say, well, that can't happen. The technology's so wonderful. We have Bitcoin. It'll never happen. Well, then someone better explain to me how Iceland, Greece, and Cyprus have all had capital controls within the last 10 years. They've had them and they've removed them. They're quite common in emerging markets, where they work to a certain degree. But even three of the-- well, you can't call them major countries, but three developed world countries have run these capital controls. It is very difficult to do if one country was kind of-- if you're bankrupt or over-leveraged and had to do all this in isolation. But when you look at the data, everybody's in the same boat. I mean,
China is the only emerging market that's really geared. All the developed world is really geared. So there is a reason why they will cooperate. And just some evidence of that which existed before COVID, the OECD has been forming a group couple of years to try and work out what they call base erosion profit sharing taxation, which is stuff we all know about, that every company-- Starbucks has a Belgian or a Dutch subsidiary. They pay a license for marketing and all that stuff. We-- I say "we" as a developed-world group of companies-- were working on that even before COVID came along. The secret of taxation is to extract the maximum amount of feathers with the least amount of hissing.
And when governments can collaborate-- because they all need the tax revenue-- then I think these things become much more possible. So it may not be as strict as the post-World War II situation. But that's not the point. The point is it's going to be radically different from the system that you and I spent our careers in. STEVE CLAPHAM: Well, I think this is an important point you make. Because we've had, what, nearly 40 years of falling interest rates. And now they can't fall any further unless you believe that they can go to negative 5%, which I suppose is a potential-- I mean, you can't say it's impossible. But it's probably less likely. So I think everybody that's operating in markets today has to look with a very different lens. Because you can't look back at history and necessarily conclude that this is what's going to
happen in the future. And I think you've actually really got to think a lot more radically, and start with a blank sheet of paper, and think, OK, so we're going into an inflationary environment. Let's say there are capital controls. How does that work? I'm sitting with Apple shares. Apple buys its products from China. It pays huge amounts of money to Foxconn. It sells
huge numbers of iPhones in China. It's got a service platform operating all around the world. Well, does the cash have to stay in China or wherever? I mean, how will it work? RUSSELL NAPIER: Yeah, so where you'd begin with is you'd stop capital outflow. And you'd try to divide this between capital outflow and outflow associated with trade. So I'm not saying that it works, but this is where you'd begin. So you don't want to disrupt trade. Trade keeps people employed. So somehow you can say, to a corporation, if you're Apple, and you're moving $6 billion offshore to buy something in Europe, that's not allowed. We want to at least have a look at that. But if you're Apple, and you need to move some working capital to China to do some trade, that's a different thing. I think we both know how
difficult that will be. But that's how it works. All the money that Apple has offshore, of course, it can bring back to America at any given point in time. Capital controls are like a lobster pot. You can always bring money in always. It's just that you can't take it out. But there may be a few companies that are really just struggling with far too much capital coming in. Switzerland
is already in that situation. I suspect Singapore could be there. So there might be a few companies that will try and stop you taking your money out. And we can talk about how you do that. But for most countries, it's not allowing you to take money out for the purposes of capital investment. And that's where it begins. But it becomes a giant game of whack-a-mole. Because everybody finds ways of arbitraging that, as the Chinese do. And then the government chases
everybody around, trying to make sure that it's not transfer pricing or whatever else. So that's the mechanism where you worked on. So you start with this sort of-- you target a tier. But, by definition, you spread down through the system. And you probably know that, in the 1960s,
I think the maximum amount of money you could take out of the United Kingdom was 30 sterling. Now, I'm not saying we're going to get to that level. But I keep recommending that everybody goes and reads Graeme Green's Travels with my Aunt, which is a novel. And I don't really want to give too much away, because I'll ruin the entire novel. But it
tells you something about capital arbitrage and the world of exchange controls. That's all I will say. But he's a great novelist. So worth a read. STEVE CLAPHAM: Well, you weren't allowed to take out more than a certain amount in cash. But if you were going for a long holiday, it wasn't
enough to finance your holiday. So everybody took more, right? And I mean, they didn't search you at the airport-- or maybe they did. RUSSELL NAPIER: That's what I mean about arbitrage. It turns out that your grandmother becomes an arbitrager in such a system. The Bank of England had a huge department, Steve. So if you and I wanted to move money out of the country, we filled in a huge form. It went to the Bank of England. I mean, I can't remember the numbers, but there was something like 800 people in that department.
And it basically closed down overnight. Sir Jeffrey Hodge stood up-- I think it was 1979-- said, there won't be any exchange controls tomorrow morning. And all 800 of them had to go home. So it was a really big industry, approving our movements and capital. And the other interesting thing about that is-- because when the capital controls came down, and they came down here in 1939 for obvious reasons-- what happened is that, your foreign assets, they went to a big premium. Because if I was in London and I owned some shares in New York,
and you wanted to invest in New York, and I'd say, Steve, if you want to have this dollar- denominated asset, you've got to pay me a premium. So that's a simplified way of doing it. But a thing called dollar premium developed, which you could get your money out of the country if you like. But it certainly wasn't at the prevailing exchange rate. It was at a significant premium to that exchange rate. STEVE CLAPHAM: So that presumably is what we should be doing right now, is to protect ourselves if we believe the capital controls are coming. We're sitting in the UK. Where should we put our money? Singapore? Switzerland? RUSSELL NAPIER: So the definition of who will not have to put in financial repression are countries with low debt-to-GDP ratios. So that's where we start. And we say, are there any of those? But the only ones in the developed world would actually be
Germany and Austria. But they are not irrelevant, given that they are part of the European Union. So it's not Germany and Austria. But Switzerland is all right. Singapore is probably very good. The fascinating thing, however, is if you look at countries with low debt-to-GDP, with the exception of China, they're all in the emerging markets. Now, if I said to you that we need to put our money into Mumbai to avoid financial repression, I think there would be deep, deep skepticism.
And policymakers in India are-- let's just say they can be unpredictable. So I'm not suggesting-- as you said, you don't want all your eggs in one basket. But there are reasons, I think, where we should be looking to emerging markets. Now, for me, that's not yet investing in the equities. There's a changing relationship
between the West and China coming, which will be deeply dislocative for emerging markets. But there is a prospect that emerging markets can do. Well, let me give you two historical examples. Switzerland, after the war, was a brilliant place to avoid financial repression for very obvious reasons. Switzerland didn't have a lot of debt at the end of World War II. It was a nonbelligerent. Therefore, even just putting money in the Swiss bond market,
you made money from your bonds in Swiss Franc terms. But actually you made a lot more on your exchange rate. So that was a good place to be. But I think the really peculiar one is Hong Kong, another colony that didn't have a lot of debt after World War II for obvious reasons, given that they'd been occupied by the Japanese. They did not endorse financial repression. It was famously run by a British civil servant called Sir John Cowperthwaite, who shunned financial repression and pursued a kind of more free-market approach. That turned out to be a wonderful place to make money in the kind of 40, 50 years after World War II.
So we're looking for-- but so I raise Hong Kong because who would have thought of it? If I'd said to you, in '45, Steve, you know what, London-- and, now, London had been the financial capital of the world, really, until 1914-- get your money out of London, put it into Hong Kong. You'd say, you must be nuts. And not only that, it's got all these communists just north of the border. So when you said, let's start with a blank sheet of paper, when it comes to a world like this, we do need to start with a blank piece of paper. So personally, although, it's not a huge amount, I think investing in India is probably one of the better things to do. And that will sound radical to many people. And to be sure, not a huge percent,
but it seems to me that there are-- Indonesia, I've just made an investment in Indonesia. Seems to me, for all the trials and tribulations that Indonesia faces, a need to financially repress will not be one of them. STEVE CLAPHAM: Well, I'm glad you said that, because India is actually one of my biggest country exposures in my equities portfolio. So I believe in it, not because of what we're talking about, because of fundamentals of the country. One thing I'd like to explore on the subject of inflation-- and you know, many of the people watching this will almost have no idea what inflation is. I mean, I can remember, as a child, not as an operator in the stock market, I can remember inflation. What do you think about what
sort of investment people should be looking for? And one of the things I wanted to talk about was, if you look at what will work in a period of inflation, it should be pricing power. But when we talked about this before, you said that in an inflation world, everybody's got pricing power. And what you need to have is cost control. And I thought it was--
it was quite a funny comment to me. I mean, what do you think about this? I mean, obviously, if you've got real pricing power, that's the best protection against inflation. How do we look for companies with cost control? Because it's something that people have paid much less emphasis on in the last 10, 20 years. RUSSELL NAPIER: Yeah, so, well, my personal experience of the '70s was my father was a butcher. So I used to work with
him in his shop. And the first thing we did every Monday morning was wipe down last week's prices and put up this week's prices. I think UK inflation peaked at 22%. But meat inflation was running at a much higher rate. So I remember, very well, going into a fish-and-chips shop about five years ago, and noticing, for the first time, that the guy who owned the fish-and-chips shop had bought a pricing board where you couldn't change the prices. All the prices were kind of-- he paid up, so it was all done nicely. And I thought, well,
that tells you, in my lifetime, how we've gone from wiping them down every day to a complete belief that prices could never go again because you'd paid for permanent prices there. This is the issue with stock markets, isn't it? They [INAUDIBLE]. So you're absolutely right to say pricing power is a good thing to have in a period of rising inflation. That's obvious.
But what we've got in the market today is an entirely bifurcated market. You just mentioned 40 years of disinflation. So you have very high valuations for companies with pricing power. Moats is another word that the Sage of Omaha calls them. Everybody knows that. You pay up for the moat, you pay up for the pricing power. In other words, I think it's in the capitalization of the price.
And then we have this other class of stocks. And let's just call them value stocks. Because I think everybody can kind of close their eyes and see the price chart. And we know that the value stocks are languishing down here with one of the worst-ever performances ever relative to the so-called growth stocks or pricing-power stocks. And then we wake up one morning, and let's pick a number-- I don't think this is coming that quickly, but let's say we wake up and inflation is 5%. Well, what that kind of means is everybody
gets to put their prices up by 5%, and some people get to put their prices up by more. But all these stocks down here, which have been hit because they've been price takers are still price takers, but they just had to take a lower price or virtually no price rise for 40 years. Suddenly they're price takers at 5% higher up. A, what does that mean for their valuation, just that they're suddenly enfranchised to get a higher price? Not because they're brilliant businessmen, that's just what happens in inflation. I think that is positive for the earnings. But now the second thing is the thing you raised about cost control. There are some people who just get cost control naturally. They don't have to be geniuses either. And that's because so much
of their costs are fixed. And we've discussed this in the past. Depreciation's an obvious one. There's these operating leases, which is another obvious one. There is interest if you have sort of borrowed far into the future on a fixed coupon. That's also a fixed cost. So I am fishing at the bottom for those types of stocks. I.e. they have natural cost control because they've got a lot of fixed cost. But also, and crucially, the valuation's right down because everybody thinks, these guys will never put their prices up ever again. Therefore they're worth x. This guy has
been putting his prices up at 4% per annum for 20 years. Therefore I pay a premium on a valuation up here. And all I'm saying is it will narrow. And it will narrow. And therefore there's more risk in these guys than there is in these ones. STEVE CLAPHAM: I mean, this is what makes it so fascinating, isn't it? Because people will be conditioned for years and years and years to look for those stocks with the economic bolt, to look for stocks with high returns in investment capital. And if we're going into a period in which there's consistent high inflation,
those stocks-- perversely, those stocks with very low returns on capital may actually do quite well. Because if you need to have a lot of assets, whether it's fixed assets-- I remember, in the 1980s, there was current-cost accounting. And what they did with current-cost accounting was that, there being such high inflation, they looked at the assets on the balance sheet at their replacement cost value. Because assets that were very old were generating extremely high returns on capital. So perversely, those heavy, capital-intensive industries which have very low returns could end up seeing their returns grow much faster than the ones with very high returns. Is that something you agree with? RUSSELL NAPIER: Yeah, it's something I agree with. And then when I agree with that, people say, oh,
but there's the reinvestment rate. There's the money they have to put back into the asset. So I want to tell you a story about my visit to Santiago de Cuba, in Cuba. And I think I went in 1992. And that is where the old Bacardi distillery is.
And it's still making rum. I don't think they're allowed to go in-- I don't know what the Cubans call it. Obviously the Bacardi family and the Cubans have got a few disagreements. But it's still there and it's still producing. And Cuba's most famous for those old automobiles that are still managing to trundle along the roads, whatever it is, more than 50 years ago. Well, the distillery's still working. So it has been possible, with virtually no reinvestment, to keep a distillery running from whenever the revolution was, right up until today, producing rum. So I understand that that's not the ideal way that one would produce rum. One
would put some reinvestment back into that distillery. But still, it is possible to run a large fixed asset with a minimal level of reinvestment. So the price of reinvestment, which is obviously going up in an era of inflation, isn't really massively undermining your returns.
China plays into this a lot. The people that we're talking about who have those big, fixed assets, many of them have suffered from Chinese competition. And one thinks of shipbuilding or steel, things like that. Now, this is a different conversation really. But if we believe that China is being increasingly ostracized from the global trading regime, this also lifts pressure from that type of company. And when I look at where all of these things cross, I keep looking at Japan. Now, I get a lot of kickback on that. People aren't so keen on the idea. But if you say to me, who's really got cost control? I think the
people who've really got cost control to the people who've been under the cosh for 30 years. And they've learned how to do it. And they will now be rewarded for it in an era of inflation. So I think we should be looking up at Japan. You are the expert on valuations. The valuations look reasonable. I mean, when you look around the world, you see a lot of unreasonable valuations. I think you can find some reasonable valuations up there. And I think that is more
likely to be the benefit from inflation. And it's been heavily hit by trying to compete with China. We attribute the deflation to many, many things. But I don't think we pay enough attention to just how much damage has been done to Japan through competition with China. STEVE CLAPHAM: Absolutely. And there's lots of cheap stocks there. And I mean, I agree
with you. There's lots of roads pointing there. The other thing I think is quite interesting, just talking about low returns on capital which may rise in an inflationary environment, is companies with very high stocks. Because one of the things that people won't necessarily remember is that if you've got very large inventory, as you reprice the meat each week, as you reprice the products each week, you end up getting a gain on holding inventory. So again, perversely, the low-return stocks, because they've got high inventory, will see the greatest benefit in their earnings in an inflationary environment, which I think is something that people may not necessarily-- it's not an obvious conclusion. And what this tells me is that maybe we need to throw a lot of our existing rules. Because everybody's doing screens for a "high return
on investment" stocks. And maybe they should be starting to think about screens for low-return stocks. RUSSELL NAPIER: Well, you will the name of it-- and it's in this library somewhere, this is my library-- the British government published a report on inflation accounting in the '70s somewhere which will be available now on eBay. And I think we should watch the price of that on eBay. And I think you're going to see it's going to start inflating quite quickly. Because it mentions things like that. But actually
there's a host of things where you just have to start rethinking how you value a corporation. I would add, however, that, I mean, a lot of those profits were fake profits. And you were taxed on them anyway. So in the early 1970s, things were out of control here. I think headline inflation was 22%. The corporate tax rate was very high. And as you reported fake-inflation profits, they were all taxed actual cash flow. And this doesn't apply to all companies but, for some companies cash flow
was getting sucked out of these companies. And that process was called the doomsday machine, and was run by a man that you and I both remember very well, called Tony [? Benn, ?] who was quite keen to run a doomsday machine, given that it would catapult British enterprise into public control. So I don't think either of us are talking about a level of inflation at that. So let's be clear about this. So what we are talking about has some of these marginal effects. But if you get up to that sort of level of inflation, then it's very difficult for any company.
Because your cash gets sucked out by taxation. STEVE CLAPHAM: I mean, if you talk to anybody that was an industrialist in the 1970s, they always shake their heads, obviously particularly in the UK, because it was a disastrous period in the UK, up until-- was it 1976 we went to the IMF? And I had a call very recently with a very well-known industrialist. And I talked about this idea of inflation. And I could hear him, on the other end of line, shaking his head. Because he remembered how difficult it was. When I was on the sales side, I used to follow P&O. And the chairman of P&O, Lord Sterling, told me about the 1970s, when he used to go around collecting the rent on a Friday because they had their senior management making sure that the rent was in. Because
it was hand-to-mouth, week to week, day to day. And so it's kind of frightening. RUSSELL NAPIER: This is the really important thing. We shouldn't pretend that inflation is good for equities. We're talking an element of equity asset class and which element could have see more protection. But for equities as a whole, this is not a good thing. And obviously if it's 3%, 4%, not so bad. But if it starts getting to 7%, 8%, 9%, there isn't evidence that equities protect you from inflation as a whole asset class. And of
course, the best example of that is the '70s. And I'm sure it'll be online somewhere-- and everybody who's watching this should read it-- an article that Warren Buffett wrote in 1977 for Fortune magazine, called High Inflation Swindles the Equity Investor. So that's very much a bottom-up view. But it's really worth looking at in terms of what happened to margins, what happened to effective tax rates, and why equities didn't perform during that period. It wasn't just that interest rates went up and valuations came down. But some of the reasons we've touched on, it actually became very difficult to retain cash and grow cash and reinvest. So the early stages of inflation are pretty reassuring. But in the long run, equities are not the place to be. Equities in the whole are not the
place to be. So what we are talking about, maybe heavy- asset companies, maybe Japan. We're looking at a subset of equities. So I'm very bullish on equities, because I think we're in the early stage of inflation. And that's working on all right at the minute. But this depends where we're going to and how high it's going to get. STEVE CLAPHAM: Well, of course, if we are in for a
period like that, then you can't put your money in bonds. So you've got to put your money somewhere. And it's funny you mentioned Buffett. Because I read that I read the article this week, preparing for this. And I also read his 1980 letter. And he said, well, if you look at
not the book value but their adjusted book value of Berkshire, including the market value of the quartered holdings, we've done quite well because we've increased at 20.5% per annum from 1964 to 1979. So this is that 1980 letter. He said, we would pat ourself on the back, but in 1964, a share of Berkshire bought you half an ounce of gold. And today it buys you half an ounce of gold. And you think about that as one of the best-performing companies, it's quite remarkable.
But the other thing I just wanted to touch on was, if we're in a high-inflation environment-- I mean, it doesn't need to be 8%-- presumably we need to avoid companies that have a lot of labor cost. There are two reasons for that. One is that labor costs will be rising quite rapidly, because we'll get, I assume-- and tell me if this is wrong-- but I assume we'll get that labor push inflation. But the other thing is-- and I think it's really relevant today-- is pension deficits. Because if you start to increase the inflation assumptions in the calculation of the pension liability, those pension liabilities are going to go through the roof. And of course this kind of rates aren't going to go up. So is it possible that is a ticking
time bomb in those companies with big workforces and ticking time bomb in the pension deficit? RUSSELL NAPIER: So as you know, I run this course called The Practical History of Financial Markets. Both of these are issues we cover in that. And I think the fascinating one in the post- World War period, you ask anybody, certainly in the United Kingdom, why do we have inflation, certainly, if you go down to the city of London, they'll say, oh, it was unions. It was unions. It was all to do with the unions. The unions caused the inflation. There's quite a lot of statistical evidence that actually what happened is the inflation caused the unions. It was kind of the other way around. I mean, all of us want protection from inflation. And if we lived in a world where there isn't inflation, we don't need to unionize to protect ourselves. But when inflation comes, that's when people go back to
unionization. So Steve, one day, you and I will be forming the analysts union. So I look forward to discussing that somewhere appropriate when the time comes. And that the second point is, I think, an absolutely essential point for all of us to think about in the Practical History course. When we look at the things that
make corporate mean revert, you would point towards rising labor that we're discussing, rising interest expense which we're discussing, rising corporation tax which we're discussing, rising cost of goods sold which we're discussing. But historically, we kind of never thought about the pension scheme. Because in the long sweep that we look at, in terms of that data for mean reversion, the pension schemes, they only come along really aggressively after World War II. And of course, really, they're building up into quite a big liability just as interest rates start to decline from '78 to today. So for those people who are not familiar with
pensions and accounting, that's how you value your liabilities. And suddenly the liabilities are going up as the interest rates are going down. As we now cap interest rates as inflation goes up-- and remember, quite a few of these pension liabilities are linked to inflation. They're
usually capped about 4%, not 12% or 13%. Then, suddenly, one of the reasons we might see corporate profits mean revert is because such a large percentage of cash flow has to go into the pension fund. If you look at the assumed returns that pension funds put in, some of them are putting in 7% or 8%. There is nothing in the price of bonds-- nor equities for
that matter-- which would give you any inkling of hope that you're going to get a blended 7%. So if we begin to force people to take a realistic look in that-- and crucially, the interest rate isn't allowed to go up, so the liabilities don't come down-- tons of corporate cash could be pouring into these pension schemes. I used to be a pension fund trustee. So I used to say, to our actuary-- because every actuary in the country spends most of the time in the meeting saying, to the trustees, don't worry, interest rates are going up, liabilities are coming down. And I would say to them, well, what happens if interest rates don't go up but inflation does go up? And the most normal answer you get from an actuary is, well, that's not possible. And of course, in a market system, in an economic textbook, it isn't possible.
But in real life it's absolutely been possible. And it's going to happen again. So I'm glad you raised the pension issue. But particularly for a lot of European companies, I think there are big pension legacy issues which the market is not really paying enough attention to.
And we could also-- and I will be, in the next report I'm writing for clients, looking at the life insurance industry, particularly of northern Europe, which on these numbers-- I mean, it's been in deep, deep trouble for many years because of where interest rates are. But in a world where interest rates stay low and inflation goes up, we are looking at a crisis for the savings system slash pension system, particularly for Northern Europe. STEVE CLAPHAM: So this doesn't sound like a very pretty picture all round. I mean, it sounds pretty awful. RUSSELL NAPIER: I just watched an interview with Evelyn Waugh from 1960. And we're kind of saying this is kind of a repeat of the post-World War II.
And he claimed to be broke, claimed that he didn't have any money. For those of you who don't know, he's another famous English author. And the interviewer said to him, but Mr. Waugh, you made a fortune selling books before the war, before it was taxed away, to which he replied, that's true, but I spent it all. And no honest man has been able to save money since 1945. In a world where the government is telling you what to do with your savings, it is incredibly difficult. So that's why the top recommendation is find jurisdictions where the government isn't going to tell you what to do with your savings. And that isn't easy, but that is the type of world that we now live in. STEVE CLAPHAM: I mean, one place you can go would
be commodities. Another place would be energy, because you own real assets. I mean, to what extent do you think that will be hampered by the whole move to ESG? I mean, interestingly, I listen to a podcast with Peter Harrison, the CEO of Schroders. I'm a bit behind in my podcast queue. The interview was recorded last March. And I just listened to it a couple of weeks ago. But he said something quite remarkable. He said, in five years, the term, ESG, won't exist.
And by that he meant that it'll be so ingrained in every investment manager, every institution will have that as an integral part of the process. If that's the case, I mean, is that the opportunity for the little guy, the private investor? Because no professional fund manager will want to be seen owning big oil or, indeed, oil stocks. And oil demand will continue. And there's an opportunity for the little guy to actually profit from the fads and the fashion by buying real assets. RUSSELL NAPIER: Yeah. So just when we're talking about real assets, I mean, I'll just do 10 seconds on residential real estate. That is,
to me, the key real asset, which is easier than this. We're going to have a discussion which is really quite complicated and has a lot of moving parts. I think the case for residential real estate in a world where wages were maybe going to be growing at 4% or 5%. Bond yields were 2%, 3%. I think it's probably even clearer in America, where outside of the homes of the plutocrats,
I think property is very cheap. So that's 10 seconds. And maybe we'll come back to that. In terms of commodities, there's lots of commodities which we need and lots of commodities which we need for the Green Revolution. That's the kind of irony of this. We're about to through a huge investment boom-- a series of investment booms, actually, one associated with getting us green, one associated with us buying more stuff from somewhere else other than China, and I think another one associated with shorter distribution chains, which is linked to China but actually is supplementary to China. So three investment booms are very good for commodities and ultimately will be good for the planet. I mean, ultimately not bad for the planet. One of the things that's been going on for years now is people have been moving their polluting industry to China because there's no real control. So if we are bringing stuff back from China,
I don't think we're going to go easier on the pollution regulation. So that is an investment in commodities to save the planet, despite the fact that extraction is inherently and necessarily not that green. So I don't to what extent we'll really want to come down on that in the first instance. And just one thing-- there's one obvious thing that we shouldn't be taking out of the ground anymore. And that's gold. I mean, I do realize it has its practical uses. And you can't have a wedding in India without it. That's a crucially practical use for gold. But on the whole, I think ESG means it's going to be more difficult to get gold out of the ground, which makes it incredibly bullish for the gold that is out of the ground. And I say out of the ground,
because as you know, it comes out of the ground very briefly and then goes back under the ground. So the whole ESG thing, I think, will not be as bad for commodities as we expect, number one. And number two, it could be particularly bullish for the price of gold. And when we're talking to commodities, I almost hate to mention this, but the history of inflation is really the history of commodity inflation, including food inflation. And the reason I don't
want to mention it is disastrous if the savings of the world flock into food because a lot of people go hungry. But that is what's going to happen and arguably is already happening. Now, it may be that the governments have to ultimately try and stop people's savings going into food. But it's a very good example of what can happen when you get to a tipping point in inflation, when people consider that their savings are better off in consumables than in a savings asset. And that's called the velocity of money. And that's when the velocity of money starts going up. So food is a good one. If you think back to
the Weimar Republic, who made all the money in the Weimar Republic? Farmers. Not just because they were selling food prices that were going up like this. It's because they had quite a lot of debt, long-term debt, over their farmland. So they did spectacularly well. So let's not forget what might happen to food prices. So rather than saying you should go out and buy a lot of food, which is obviously not going to happen, there are lots of countries in the world who might benefit from somewhat higher food prices going forward. STEVE CLAPHAM: So we should find some land in
the right country, agricultural land in the right country. But just going back to residential real estate, I was trying to recall-- you wrote this very good piece, Solid Ground, in 2016, talking about financial repression. And you talked about capital controls. Wasn't one of the issues, in the past, when we had financial repression, didn't we have rent controls? RUSSELL NAPIER: Yeah, so that is definitely an issue. And they have come in in Berlin, they've come in in Vancouver, and they've come in in Toronto. So you can't rule them out. So you've got to be very careful about this. I think that's one of the reasons I favor American residential real estate, because I think, while it can happen in America and it has happened in America, if you've read that report, you'll know that Mia Farrow is still paying something ridiculous, like $2,000 a month to rent her rent-controlled apartment up on the Upper East Side.
But I think, in some countries, it's much less likely than others. So I'm prepared to do that. I started my career as a lawyer in Belfast. And I remember traveling up to a place called Coleraine. And there we were doing a rent-control review for a very old lady who'd got her rent controlled in 1948. And in 1987, she was still alive, still there, and still paying her 1947 rent.
So for people who don't know what rent control means, begin to think of the consequences of that for the capital value. In fact, there were some-- and I've just been speaking to one-- there were some people who were putting so much money into the renovation of the property that it cost more than the lease. Let me give you another example of why property isn't necessarily the way to go. Continental Can owned a building on Wall Street in the '70s.
New York was not in a good place in the '70s. But property taxes were very high. And it couldn't be rented. So they knocked it down. It was cheaper to destroy a building on Wall Street than it was to keep it open. You couldn't get any income of it, and you were paying
property taxes. So you knocked it down. So it's back to this-- where we keep coming back to, Steve, we have to think very differently. So I'm happy to invest in US residential real estate on the basis that we won't have rent controls for the average citizen. And that could be wrong. But I wouldn't be so keen to do that in Paris, for instance. STEVE CLAPHAM: Do you think governments will introduce price controls? In that article, you talked about that-- was it called the Office of Price Control under Nixon? It seems almost unimaginable. But then I wasn't aware-- I mean, it's not that long ago, 50 years ago, that we did have that. Do you think that will happen again? RUSSELL NAPIER: Do you think anybody who voted
for Richard Nixon thought he would introduce price controls? I mean, that's the point. I mean, as you know, he sat with McCarthy on the anti-communist trials. He was thought to be extremely to the right of politics. So why on Earth did he bring in price controls? You do what you have to do. Or as a certain gentleman has famously said, "whatever it takes." So I there's a lot of speculation about what the Democratic party might do in America. I don't think it really matters that much. You know, politicians, under extreme pressure, do extreme things. I wrote in that article that the first man to head
the Office of Price Control was another famous communist called Donald Rumsfeld. And Donald was so busy in his first few months, he needed help. So he hired another famous communist called Dick Cheney. So the idea that Nixon, Cheney, and Rumsfeld got together to control prices tells you, in a crisis, anything is possible. So I'm not saying we're going to price controls in the next two, three, four, five years. Highly, highly unlikely, I think-- highly unlikely. But at some stage in an inflationary movement, is it possible? Of course it's possible. And most people
have never heard of it. They'll say, well, why on Earth didn't they just raise interest rates? And the answer is they thought it would be too painful-- pretty simple. I mean, Nixon knew that, by raising interest rates or persuading Arthur Burns to raise interest rates, he could tackle inflation. But he knew what it would do to the average American. So instead he went for
price controls. So I guess the answer to this is, never underestimate the ability of politicians to make the same mistake all over again, but usually giving it a different name. STEVE CLAPHAM: But I suppose the justification this time will be that we've all got so much debt, every country in the world, government debt and, as you say, private-sector debt, that you can can't really afford for interest rates to go up by much. And therefore-- well, I mean, what else can they do other than introduce some form of price controls? RUSSELL NAPIER: So there isn't anything you can do, which is called credit controls, instead. So back to kind of my opening statement here, that most of the money
in the world is created by banks. So if you and I, as the government, control the banks, and we said, look, guys, this year you're only growing credit by 6%, and therefore the growth in money supply was close to 6%, inflation should be pretty low. So that's another way of doing it. The history suggests that we end up getting a mixture of both of those. But it is worth remembering that the way inflation was controlled post-World War II, particularly in somewhere like France, was not by using interest rates or not so much by price controls. But by controlling the banking system, the governments managed to control the growth of money and keep inflation somewhat in abeyance. That's it, I think, in terms of how you
can control inflation without using interest rates. Rationing is another one. But I don't think we'll get to rationing. STEVE CLAPHAM: But presumably, controlling the banks, would that work for multinational companies? Because wouldn't companies just borrow overseas? RUSSELL NAPIER: So you obviously have to stop that. I mean, if we're doing it in the United Kingdom, we're only interested in sterling lending. Because only sterling lending really contributes to our GDP. So controlling the sterling lending would be easy. If they started borrowing euros, selling euros,
and bringing it in, well, as long as we control the supply of sterling, it really wouldn't make any difference. So I think it's possible unless you've got banks prepared to take huge kind of currency risks to run a sterling book borrowing it in Europe. So there are commercial limits on that, usually. But ultimately you can stop them
from doing that. And obviously we had capital controls after the war. So that was not an option, not an option at all. But normal commercial procedure makes that quite a risky venture. Not that our banks are averse to a bit of risk, of course, every now and then. STEVE CLAPHAM: You've said this isn't going to happen tomorrow, obviously. It's going to take quite a long time for it to unwind. What's your best guess on the sort of timescale for this? And what should we be looking out for? I mean, what are the signals? What are the milestones that we'll need to pass that will tell us, OK, now's the time to panic? RUSSELL NAPIER: So the only thing to me that really matters are bond yields. And that's what
you should be looking at. So it'd be nice for me to give you a detailed time frame and a detailed endpoint. And that's just a hostage to fortune. But there is probably more value in me saying, here's a level of long-term bond yields at which these things, these extreme measures, are going to have to be taken. So I have done a very large report on that. And I won't go through all of the details in it. But the conclusions are pretty straightforward, that on the-- and I'm looking at the five-year rate, because it's the five-year government bond yield that probably has more of an effect on the price of bank credit, particularly for corporations. And the kind of argument is, at what level of interest rates would we trigger debt defaults because interest are so expensive? So the answer, in America, is roughly 200 basis points above today. That's quite a bit to go. We're going quickly though, but that's
quite a bit to go. For the United Kingdom, it's still 200 basis points. For the European Union, it's about 100 basis points. For Japan, actually, it's probably about 100 basis points. But obviously their rates are very low. And the fascinating one is China. It's only 100 basis points for China. I mean, I think, in sort of the mess that we&
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