QE can’t make baby boomers spend more

The Fed cannot create inflation as long as the postwar generation is paying off mortgages and emerging markets are struggling under huge external debts, says CLSA’s Russell Napier.
Russell Napier, CLSA
Russell Napier, CLSA

There is a school of thought that reckons demographics have a much bigger influence on markets than most people realise — and that looking at the world in this way can lead to some useful insights for investors.

Today, for example, most market participants have all but given up looking at data and are solely focused on the US Federal Reserve, convinced that its monthly asset purchases are the only thing that matters. This is a red herring, according to CLSA consultant Russell Napier.

Speaking at the CLSA Investors’ Forum in Hong Kong on Monday, Napier is far too bearish to worry about whether the Fed tapers or not.

Monetary policy, he argued, is impotent in the face of a powerful and irreversible demographic trend: the deleveraging of the baby boomers. With the postwar generation entering retirement and paying off billions of dollars of housing debt, no amount of quantitative easing can stave off deflation, according to Napier.

“Mortgage debt, as it’s being repaid, destroys money,” he said, pointing to the continued decline in US household financial liabilities and bank credit, even after four years of quantitative easing. “How the hell are you going to create inflation in an economy where people are paying back their debt, bank balance sheets are shrinking and money’s shrinking?”

The necessary answer is that younger people will spend more, but the under-40s in America are struggling to borrow more money given high levels of student debt and disposable incomes that are barely growing at all.

To Napier, there is little to support the Fed’s contention that US economic growth is normalising. Inflation continues to fall, nominal interest rates are rising and credit is shrinking.

Indeed, the numbers are approaching Ben Bernanke’s nightmare scenario (outlined in his famous 2002 “helicopter” speech) of inflation below 1% and nominal rates at zero.

“Bernanke’s favourite measure of inflation is at 1.2% and the Fed funds rate is 0.25%,” said Napier, who warned that any shock to aggregate demand could quickly push the US economy right into the nightmare zone.

And the CLSA analyst says he knows where that shock will likely come from: emerging markets, where the shift to deficits is constraining demand for treasuries and high levels of external debt provide the perfect mechanism for widespread contagion.

In Poland and Turkey, for example, foreigners have more than $700 billion of exposure — in both local and foreign currency. If you include South Africa and Hungary, it’s close to $1 trillion of total external liabilities, or $2 trillion if you add up all the emerging markets with external debt at more than 30% of GDP. Lehman’s $600 million liability was tiny in comparison.

Emerging market bond funds provided a good chunk of the debt in these places, which Napier said has created an unprecedented risk.

“I’ve studied every emerging debt crisis we’ve had since 1825, and we’ve never done this before,” he said. “This is the first time in history we’ve ever put local-currency emerging-market debt into open-ended funds, and it is one of the stupidest things we’ve ever done as a financial community. This stuff is entirely illiquid and primarily owned by pensioners.”

If defaults start to happen or sentiment shifts for whatever reason, funds that can no longer sell their Eastern European bonds may need to look elsewhere to redeem — and that could spread the selling pressure to Asian markets. Can’t sell Turkey, try Indonesia.

“Asia’s going to have problems,” Napier said. “I wouldn’t be long any of the Asian equity markets, but defaults should be fairly limited. Because it’s not an Asian story, we’re not focused on it, but these sums of money have major implications for what’s happening in the world.”

With Russia in 1998 and Mexico in 1982, the US came to the rescue of emerging markets by cutting interest rates but that is clearly not an option today.

Napier’s biggest fear is what happens if markets eventually come to agree with him.

“If you come to the conclusion that bond yields are going up because foreign central bankers are not buying them, you get a very different outlook for the US,” he said. “I think it’s 1987. When people realised that rising bond yields were interfering with economic activity and when they realised they were probably going to go higher, the equity market just collapsed — and this is where we are today.”


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