Russell napier clsa citywire november 2012

Deflation in an age of fiat currency Russell Napier

©2008 CLSA Asia-Pacific Markets (“CLSA”).

Page 2 IMPORTANT: The content of this report is subject to CLSA's Legal and Regulatory Notices as set out at www.clsa.com/disclaimer.html, a hard copy of which may be obtained on request from CLSA Publications or CLSA Compliance Group, 18/F, One Pacific Place, 88 Queensway, Hong Kong, telephone (852) 2600 8888.

Conclusions

To reach record lows (1921, 1932, 1949, 1982) equities will have to more than 60%.

Deflation produces record-low valuations but deflation remains unlikely.

Central banks strain to produce inflation but developments in EM suggest a deflation shock now likely

Capital exodus from China disrupts the creation of inflation

In the search for yield cash is trash so time to own cash



US CAPE 1881-2012

Cyclically adjusted price-earnings ratio (PE10 or CAPE)

Source: Robert Shiller

0

5

10

15

20

25

30

35

40

45

50

1881 1891 1901 1911 1921 1931 1941 1951 1961 1971 1981 1991 2001 2011

(x)



It will end with a deflationary shock and very low CAPEs and S&P500 around an index level of 450

While the US is a long way from this combination the situation in Europe is very different

Where the bear market ends

Cyclically Adjusted PE S&P Target

1921 5.2X 300

1932 5.8X 340

1949 9.1X 528

1982 6.6X 386

Previous lows for the cyclically adjusted PE and targets for real S&P



Current CAPEs

US 21.3X China 18.0X

Asia ex Japan 19.3X Europe 13.1X

UK 12.5X World 18.2X

Germany 16.0X Japan 21.3X

Italy 7.8X Greece 1.8X

Spain 8.5X Ireland 6.0X

India 24.0X Portugal 9.2X



Long bear markets are normal

40

50

60

70

80

90

100

110

120

1900 1902 1904 1906 1908 1910 1912 1914 1916 1918 1920

(DJI)

Dow Jones Industrial Index, 1900-1921




90

110

130

150

170

190

210

230

250

1936 1938 1940 1942 1944 1946 1948 1950

(DJI)





500

600

700

800

900

1,000

1,100

1964 1966 1968 1970 1972 1974 1976 1978 1980 1982

(DJI)




History shows how deflation is one of the few times when bonds outperform equities.

In periods when deflation has been probable, equities yield more than bonds.

Deflation kills equity, as assets decline faster than liabilities.

Deflation kills equity if cashflow declines, forcing debt defaults by corporations and individuals.

All the great bear-market bottoms coincide with the death of deflation.

Deflation drives low valuations



Rally ends with 4% inflation

US inflation and Dow Jones Industrial Average, 1966-1978

Source: Datastream

66 67 68 69 70 71 72 73 74 75 76 77 78 0

2

4

6

8

10

12

14

550

600

650

700

750

800

850

900

950

1,000

1,050

CPI (LHS) Dow Jones Industrials - Price Index



Beware inflation near 4%


Source: Datastream

1985 1986 1987 1988 1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

1,000

1,200

1,400

1,600

1,800

2,000

2,200

2,400

2,600

2,800






Source: Datastream

1998 1999 2000 2001 2002 2003 1.0

1.5

2.0

2.5

3.0

3.5

4.0 ('000)

7.0

7.5

8.0

8.5

9.0

9.5

10.0

10.5

11.0

11.5

12.0

CPI F(LHS) Dow Jones Industrials - Price Index





Source: Datastream

(1)

2002 2003 2004 2005 2006 2007 2008 2009

0

1

2

3

4

5

6 ('000)

7

8

9

10

11

12

13

14

15


Source: DATASTREAM



Source: Thomson Reuters Datastream


2008 2009 2010 2011 2012

(2)

(1)

0

1

2

3

4

5

6

600

800

1,000

1,200

1,400

1,600 1Y % change of CPI - ALL URBAN: ALL ITEMS : United States

S&P 500 COMPOSITE (RHS)

(%)



The S&P at 450

The CAPE and Q ratio lows of 1921, 1932, 1949 and 1982 suggest the S&P will bottom at around 450

A loss of faith in US Treasuries and the dollar by foreigners will drive the final leg of the bear market.

Treasury market structurally growing when babyboom-medicare and social security entitlement begins.

Demand for Treasuries falls as emerging world goes for consumption-driven growth and surpluses shrink.

Funding western governments squeezes private sector activity



The predicted roll over is underway

Percentage of Treasury market owned by foreign central banks

Source: Thomson Reuters Datastream



Source: Datastream, CLSA Asia-Pacific Markets

Why the EM money cycle matters

Largest economies’ contribution to money-supply growth

(%) Local-currency terms US$ terms

USA 15 10

Eurozone 6 10

Japan 1 25

UK 5 (1)

China 45 40

Russia 3 1

Brazil 7 4

India 6 2

Mexico 3 2

Korea 1 0

Indonesia 0 0

Turkey 2 0

Australia 3 3

Canada 3 2

Switzerland 1 1

Saudi Arabia 1 1



Source: Datastream

China’s 1Q-3Q12 BOP went to a deficit

China current- and capital-account surplus

(50)

0

50

100

150

200

250

300

350

400

450

Jun 9

7

Jun 9

8

Jun 9

9

Jun 0

0

Jun 0

1

Jun 0

2

Jun 0

3

Jun 0

4

Jun 0

5

Jun 0

6

Jun 0

7

Jun 0

8

Jun 0

9

Jun 1

0

Jun 1

1

China current-account balance

China capital & financial account balance

(US$bn)



Source: Datastream

Low Chinese reserve growth

China reserve growth

0

10

20

30

40

50

60

Aug 9

7

Feb 9

8

Aug 9

8

Feb 9

9

Aug 9

9

Feb 0

0

Aug 0

0

Feb 0

1

Aug 0

1

Feb 0

2

Aug 0

2

Feb 0

3

Aug 0

3

Feb 0

4

Aug 0

4

Feb 0

5

Aug 0

5

Feb 0

6

Aug 0

6

Feb 0

7

Aug 0

7

Feb 0

8

Aug 0

8

Feb 0

9

Aug 0

9

Feb 1

0

Aug 1

0

Feb 1

1

Aug 1

1

Feb 1

2

(%)



Source: Datastream

EM’s reserve growth created money and inflation

Growth in foreign reserves among largest EM holders (2007-latest)

China 112%

Russia 7%

Taiwan 45%

Brazil 109%

South Korea 30%

Hong Kong 94%

India 7%

Singapore 50%

Algeria 73%

Thailand 101%

Mexico 84%

Iran 62%

Indonesia 86%

Poland 55%

Philippines 129%



Source: CLSA Asia-Pacific Markets

Capital leaves as returns decline

Return on capital employed for the listed sector

(%) 2007 2012

USA 13.5 13.6

Europe 13.1 11.7

Brazil 15.6 10.7

China 15.6 10.5

India 11.6 9.6

Russia 15.8 15.9



Source: IMF, OECD, BIS

Borrowing offshore boosted capital inflow

Gross external debt

(US$bn) 2007 Latest

Brazil 193 306

China 389 695

India 173 346

Russia 464 545



Source: Datastream

Japan the land of 0%

Japan M4 growth

(4)

(3)

(2)

(1)

0

1

2

3

4

5

6

Sep 9

7

Mar

98

Sep 9

8

Mar

99

Sep 9

9

Mar

00

Sep 0

0

Mar

01

Sep 0

1

Mar

02

Sep 0

2

Mar

03

Sep 0

3

Mar

04

Sep 0

4

Mar

05

Sep 0

5

Mar

06

Sep 0

6

Mar

07

Sep 0

7

Mar

08

Sep 0

8

Mar

09

Sep 0

9

Mar

10

Sep 1

0

Mar

11

Sep 1

1

Mar

12

(% YoY)



Source: Datastream

Euroland 3.0% and will fall

Eurozone M3 growth



Source: Datastream

Money is inflation - UK QE fails

UK M4 growth

(10)

(5)

0

5

10

15

20

Sep 9

7

Mar

98

Sep 9

8

Mar

99

Sep 9

9

Mar

00

Sep 0

0

Mar

01

Sep 0

1

Mar

02

Sep 0

2

Mar

03

Sep 0

3

Mar

04

Sep 0

4

Mar

05

Sep 0

5

Mar

06

Sep 0

6

Mar

07

Sep 0

7

Mar

08

Sep 0

8

Mar

09

Sep 0

9

Mar

10

Sep 1

0

Mar

11

Sep 1

1

Mar

12

(% YoY)



Money is inflation- China at low end



Source: Datastream

Why Euroland money growth will slow

Loan growth to Euro-area residents excluding governments

(2)

0

2

4

6

8

10

12

14

Sep 9

7

Mar

98

Sep 9

8

Mar

99

Sep 9

9

Mar

00

Sep 0

0

Mar

01

Sep 0

1

Mar

02

Sep 0

2

Mar

03

Sep 0

3

Mar

04

Sep 0

4

Mar

05

Sep 0

5

Mar

06

Sep 0

6

Mar

07

Sep 0

7

Mar

08

Sep 0

8

Mar

09

Sep 0

9

Mar

10

Sep 1

0

Mar

11

Sep 1

1

Mar

12

(%)



Source: OMB and Historical Statistics of the United States of America

Federal debt as % of GDP, 1792-2021

Solutions for the over indebted state

0

20

40

60

80

100

120

140

17

92

17

99

18

06

18

13

18

20

18

27

18

34

18

41

18

48

18

55

18

62

18

69

18

76

18

83

18

90

18

97

19

04

19

11

19

18

19

25

19

32

19

39

19

46

19

53

19

60

19

67

19

74

19

81

19

88

19

95

20

02

20

09

20

16

(%)

20

21



Conclusions

US Treasuries could repeat their 83% price decline of 1946-81.

The supply/demand imbalance for Treasuries can be met with higher rates or higher savings and deflation.

Deflation is bad for equities but also for government bonds in the Euro area

Deflation has been good for government bonds in areas which print their own money but this will end

Cash provides optionality and foreign cash real optionality




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Russell napier clsa citywire november 2012

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