Benjamin Lavine, CFA, CAIA
3D had the privilege of attending Grant’s Conference held at the Plaza Hotel in New York on April 9, 2019. This is Part 1 where we highlight Russell Napier’s presentation, “The Coming Monetary Storm.” Permission has been granted by Grant’s Interest Rate Observer for 3D Asset Management to publish these excerpts. 3D interjects its own commentary and views throughout the excerpts.
Morning Presentation: Russell Napier, Orlock Advisors
Russell Napier from Orlock Advisors kicked off the conference with a dour macroeconomic outlook centered around China’s investment and monetary imbalances.
Titled “A New Monetary System? What an Over-Valued RMB Means for the World,” Napier maintains that a fixed RMB (first to the dollar in 1994 and then to a multi-currency basket in 2005) represents the prime underpinning of the low inflation / high growth that the world has enjoyed over the last two-and-a-half decades. That link is in danger of being broken due to major debt accumulations, a slowing monetary base, and a deteriorating trade balance that will ultimately force China to choose devaluation over deflation.
The pressure for China to hit the reset button by allowing its currency to free float against other currencies follows other similar outlooks such the one expressed by Victor Shih, associate professor at UC San Diego and author of “Financial Stability in China: Possible Pathways and Their Likelihood.” (Grant’s highlighted Professor Shih’s work on a 12/11/2017 Current Yield Podcast and whose work we summarized in our 2017 Year-End Market Commentary).
Similar to Napier’s outlook, Shih believes that massive capital imbalances from an overleveraged financial system combined with household ‘capital flight’ and increasing reliance on foreign capital (exasperated by a declining trade balance – Figure 1) will produce too much downward pressure on China’s foreign exchange reserves, triggering a dramatic maxi-devaluation of the RMB (this would help arrest the capital flight because household savers would have already taken the major hit on net worth).
Figure 1 – China’s Trade Balance Closing in on Deficit from Years of Surplus
This nightmare scenario would likely produce severe inflation, high interest rates, and substantial asset depreciation. Similarly, Napier believes that China’s decision to free-float its currency would initially produce a deflationary shock resulting from multiple credit events, which would then be followed by high inflation, both in China and across the world.
According to Napier, the key to how this scenario plays out rests with China’s foreign exchange reserves, which are down from a 2014 peak of $4 trillion (Figure 2). Having held steady around $3 trillion over the last three years, Napier finds the People’s Bank of China (PBOC) Fx Reserve report somewhat suspect (does not align with the decline in the trade balance) but notes that the lack of growth in Fx reserves should raise some cautionary flags. At the very least, China finds itself increasingly in need of external, foreign capital to fund its economic growth – foreign capital that may be found wanting due to China’s ‘rule-by-man’ as opposed to ‘rule-by-law’ and lack of investor protections. Ultimately, Napier believes that China cannot simultaneously grow its economy, manage its currency, and shrink its trade balance, so something needs to give and that would be China’s currency.
Figure 2 – A Deterioration in China’s Fx Reserves Would Indicate Systemic Problems Ahead
Another key pressure point: China’s debt-to-GDP has risen to an unsustainable 250% but lacks world reserve currency status and central bank balance sheet flexibility, unlike the United States. This has resulted in a slowdown in monetary (M2) growth (Figure 3), which Napier believes presages the end of this great bull market in financial assets.
Figure 3 – Does a Slowdown in China’s Monetary Growth Presage the End of the Great Bull Market in Financial Assets?
Napier acknowledges that the biggest risk to his China devaluation outlook rests with China’s Fx Reserves. If China can arrest the decline in its Fx Reserves while experiencing a diminished trade balance with the rest of the world, then China can continue to inflate its asset base as its economy shifts inward to a consumer-driven model from mercantilist-export driven model.
One way China may draw in more foreign capital is the recent decision by the major equity index (MSCI, FTSE) and fixed income (Bloomberg/Barclays) providers to expand China’s representation in world stock and bond indices. As a result, passive investment vehicles tied to these indices will increase their Chinese domestic security holdings – a boon to Chinese policymakers looking for additional sources of foreign capital. More institutional investments may be finding their way to China – Larry Fink, CEO of BlackRock, the world’s largest asset manager with $6 trillion under management, plans to become a leading asset manager in China. In addition, if financial liberalization emerges as one of the key outcomes of a U.S.-China trade agreement, U.S. and European banks will want to increase their presence in China.
Another risk to Napier’s outlook: what if it’s in China’s geopolitical interests to pursue a strong RMB rather than a sharply devalued one? If China wants to stem its household capital flight and encourage foreign investing, it would need to pursue a strong RMB – a devalued RMB would only lead to a vicious cycle of capital flight and scared foreign investors.
Moreover, China may desire to increase its presence in SWIFT – a global banking system to communicate money transfers. Credit to Larry McDonald of the Bear Trap Report (BTR) for this viewpoint. In their 3/1/2019 research note, “Great Dollar Bear,” BTR maintains that it is in both China’s and its major trading partners’ best interests to pursue a currency agreement akin to the 1985 Plaza Accord reached with Japan that resulted in a major appreciation of the Japanese yen. A new Plaza-type of accord would result in a “desperately needed global rebalancing” given China’s miniscule participation in global financial activity despite its $12 trillion economy (out of a world economy of $62 trillion).
BTR is one of several observers speculating that China desires to have world reserve status for its currency. China’s RMB only represents 1% of global SWIFT payments, whereas the Politburo would like to see this share rise to 5%. The Trump Administration and (most likely) European politicians desire to extend the current economic cycle heading into the 2019-2020 election cycles and see a strengthened RMB as a mechanism for more export sales into China (40% of Germany’s GDP is tied to exports with China their largest trading partner). A strengthened RMB would also give more breathing room for the U.S. Federal Reserve to pursue a ‘patient’ monetary policy without fear that further tightening would crack up financial markets as it did in 3Q2015-1Q2016 and 4Q2018.
When asked about a new Plaza Accord with China, Napier dismissed this as an unlikely scenario, primarily because such an accord runs against the United States’ geopolitical interests of containing China’s sphere of influence (one only has to observe the growing conflict over the South China Seas, a major commercial gateway for global shipping routes).
Regardless of what scenario emerges, the fate of the current economic cycle is increasingly dependent on what emerges from U.S./China trade negotiations. Global investors wait with bated breadth to see the outcome of these negotiations.
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