«We live in a hall of mirrors which our central banks have made for us.»
Nearly ten years after the financial crisis, extraordinary monetary policy has become the norm. The financial markets seem to like it: Stocks are close to record levels and the global economy is finally picking up. Nonetheless, James Grant sees no reason to sound the all-clear signal. The sharp thinking and highly regarded editor of the iconic Wall Street newsletter «Grant’s Interest Rate Observer» argues that historically low interest rates are distorting the perception of investors. »Principally, Mr. Draghi has robbed the marketplace of essential information», he criticizes the head of the European Central Bank for example. Highly proficient in financial history, Mr. Grant also questions the strategy of the Swiss National Bank. He fears that the voluntary depreciation of the Franc undermines the status of Switzerland as a global financial center.
Mr. Grant, monetary policy remains a primary theme for investors around the globe. What are your thoughts on the state of the financial world?
We live in a hall of mirrors which our central banks have made for us and that hall of mirrors distorts perceptions. That, I think is a big problem.
Interest rates are prices. In fact, they are the most consequential prices in a market economy because they discount future cash flows and they help us to set investment hurdles and to measure financial risks. In short, interest rates are prices and prices convey information and distorted prices convey misinformation. So if you want to build a factory or estimate the financial risk in a given security today’s interest rates are just the information you don’t need to make an informed decision.
What’s the fallout of distorted interest rates?
The great Frédéric Bastiat, a French economist, statesman, and author during the 19th century, published a famous essay called »That Which is Seen, and That Which is Not Seen». In essence, he writes that when you do something there are to be two outcomes: First, the one which you intend and second, the one you didn’t actually intend but then nonetheless occurs. So when we judge the effect of these unconventional monetary policies it’s important to take into account not just what the policy makers intended but also what they brought about, although not intending it. It seems to me that the unintended consequences are very much adverse of these policies. Namely, the world-wide distortion of interest rates because markets are connected by arbitrage.
But don’t you think central bankers recognize the risks of historically low interest rates?
Mario Draghi denies that this a problem at all. In September, some intrepid reported asked him if there were not unintended, adverse consequences of these most unusual, indeed unprecedented monetary policies. Draghi just denied it and that is a very unwise thing to have said. Principally, Mr. Draghi has robbed the marketplace of essential information. To me, that is his greatest failing and it’s all the more glaring because he pretends not to recognize it. But I think he’s much too smart to not recognize it. He’s just not being forthright in not admitting it.
What about the positive effects of Mr. Draghi’s policies? It looks like the European economy is finally getting better.
We can’t know what would have happened in the absence of these central bank actions. Mr. Draghi and other central bankers contend that except for their actions we would be much worse off. I think that’s unproven and I guess it can’t be proven. What we do know is that simply adjusting downward the cost of capital does not cure the underlying structural problems of an economy or of a government whose finances are out of whack. It’s a matter of common sense to see that what the central banks are doing is postponing the resolution of problems rather than solving problems.
Where do you spot the biggest risks?
It’s hard to tell. Everything is so happy now. Every market is up and the economy worldwide is starting to appear more vibrant. All this seems as if it cannot be improved upon. So at best, these radical monetary policies have postponed the tough decisions to bring unprofitable firms into profitability and to restore government finances to something resembling balance.
And what’s the worst case?
In many parts of the economy there is more leverage than before the financial crisis. So I think it’s wrong to judge these experiments in radical monetary policy in terms of success until we’ve seen the other side of the cycle and until we have seen the consequences of the balance sheets that we collectively have built up over the past ten years.
And what’s the link to unconventional monetary policy?
Super low interest rates encourage the formation of debt. For instance, Ireland came to market a number of weeks ago with a five year note in the sum of $4 billion Euros and the coupon was zero percent. Can you believe that? This is Ireland which was exposed to national insolvency during the financial crisis. What’s more, the price was slightly above 100 Cents on the Euro which indicates a negative yield to maturity. And then the issue was oversubscribed massively. So consider what these central bank policies do: When governments can borrow for less than nothing it encourages them to borrow. On the other side, it pressures savers to buy, or at least people who act in the interest of savers like investment funds and pension funds.
So what exactly is the problem with cheap money?
There are wrong incentives on both sides: People perhaps don’t see the point of saving when the returns are so low, and governments see the ease of borrowing when the cost is so low. You also see it in the slow response of securities markets to underlying facts. For instance, let’s take a look at Toys »R» Us, the retailer that filed for bankruptcy around the middle of September. The company had notes at 7 ⅜% of October 2018 outstanding and these notes were quoted throughout the summer at about 95 Cents on the Dollar. They remained around this level into early September when rumors began circulating of a debt restructuring. Then came the announcement of the bankruptcy and the notes went from the low 90s or high 80s down to the 20s in one swoop. They just fell off a cliff.
Why is that so concerning?
One of the unintended consequences – and this is truly unseen or at least is rather subtle – is that these policies tend to prolong the lives of marginal businesses. That’s because they can be sustained through the issuance of very cheap debt. Certainly, in the case of Japan it’s clear that one of the consequences of this great post boom hangover that’s now a generation long is to perpetuate the lives of zombie companies. Capital is like a forest: It needs death as well as life. It reduces the dynamism to an economy if unsuccessful businesses don’t make way for new ones: new ideas, new people and new capital. So these very low interest rates act as a kind of a drug. They perpetuate the status quo, as unprofitable that status quo might be.
What does this mean for investors?
These policies have tended to sedate or narcotize markets. It’s not just central banks. The movement to indexation and to investing into ETFs has marginalized the securities analysts of the world. People don’t believe that security analysis adds much value these days because one particular security in a big index is of no great importance. So another consequence, which is very much a financial one, is to dull the perception or to dull the responses of markets because they have been called to trust too much in the presence and in the action of central banks, certainly in Europe.
Is that the true reason why market volatility is so low?
We have depression level interest rates, we have boom time equity and real estate values and we have graveyard level volatility – and this all at the same time. That’s rather perplexing, isn’t it?
Then again, in the US the Federal Reserve seems to be determined to normalize monetary policy. Fed chair Janet Yellen has started the shrinking of the balance sheet and is expected to raise interest rates again at the upcoming FOMC meeting.
That’s true, but I question the timing. It’s late in the cycle when we are doing this. Let us try to imagine something that is almost unimaginable: Let’s say wage growth begins to accelerate and the rate of inflation begins to accelerate, and the Fed finds it necessary to tighten and to accelerate or at least to go through with its plans to reduce its balance sheet. That means the Fed will stop being a net buyer of bonds and start being a net seller. It will do this at a time when interest rates are rising rather than falling or simply being stable. So at least it seems to be possible that the Fed will be an accelerant in a new bear market in bonds.
And what’s your take on the Swiss National Bank?
The SNB (SNBN 5370 0%) now owns well more than $80 billion worth of American stocks which it buys programmatically, I guess with an algo or with some other mechanistic technique. I’m not sure this is central banking. Central banking was meant to be about the stability of prices. But today, through its intention to stabilize, it paradoxically has become a source of great underlying instability and of risk.
So what would you do if you were the president of the SNB?
Resign! No, seriously: I do sympathize deeply with the problems of the Swiss having to live with the regime of the European Central Bank and with its determination not to allow the Euro to appreciate. I’m also aware of the dilemma of the Swiss in the face of the Franc which for some reason has been pronounced the world’s safe haven. »You must own it», say the wise ones. But I’m not quite sure why.
In the past, Switzerland had a certain franchise. It was a financial franchise based upon prudence, discretion and judgement in banking. It was based upon tradition and upon some kind of a stiff-necked independence from the rest of the world and the world’s central banks. I think those traditions and that franchise have been eviscerated to a great extend through pressure from the outside world and through the changing mores of worldwide regulation. So the Swiss franchise in judgment and discretion has now been rebranded to a franchise in secrecy which is all about the despots of Africa secreting billions of US dollars into Swiss bank accounts.
That doesn’t sound very pleasant.
That’s my opinion as an independent observer. I can describe the problem but, for the life of me, I don’t know what Switzerland should do to revert to its privileged place – a privilege well-earned in a world that has gone rather mad. The Swiss brand is still recognized worldwide. »Made in Switzerland» is one of the great phrases in the world of commerce. But I question the validity of the specific financial franchise and the desirability of the Swiss Franc. However, that’s my opinion. The world’s opinion is that the Franc is not the storm in a port but a port in a storm. That’s what the world thinks. So the Swiss must live with that and the way they do that is to depreciate the once sacrosanct Franc. They do it by creating Francs at no costs, convert them effortlessly into Euros, trade in those Euros into Dollars and then buy American equities at record high valuations.
Are you implying that the Swiss Franc is overvalued?
I don’t know what would happen if the Swiss national bank would let the Franc to find its market clearing way. What would the Swiss reinsurance businesses say? What would the exporters say? It would perhaps be a national disaster. I don’t know. But what I do know is that the extraordinary steps that the Swiss have taken to try to neutralize these outside pressures have had the effect of putting Switzerland right in the middle of the craziness of the world. The gnomes of Zurich, the most prudent people in the world, are doing just the kind of things that the rest of the world is doing. To me, that’s a sad thing to see.
Is there no way out?
I could suggest something utterly implausible, but not utterly impractical: A worldwide monetary conference to move toward fixed exchange rates and to reinstitute a fixed standard of value which would be gold. That would get currency exchange rates out of the realm of international competition. The idea would be that we, instead of moving around exchange rates and interest rates to fix problems, actually fix the problems. In the past thirty or more years, what we have done collectively with respect to money is to treat interest rates and asset prices as instruments of national policy rather than as prices to be discovered by the market place.
So what should investors do with their money today?
Almost ten years after the financial crisis we still have some of the lowest interest rates in the history of mankind. We have some of the highest asset values in modern history and it is a big problem. What’s more, very few people seem to see that there is a problem. That is one of the concerning things: the complacency in the face of these very unsound and short-sighted policies. But that’s what bull markets do. People rather enjoy them. So at «Grant’s», we don’t set up as stock market authorities or as gurus in stock market timing. But it’s quite common knowledge that valuations as customarily and conventionally measured are near their all-time highs. Of course, that does tell you nothing about what’s going to happen tomorrow, next month or next year. But I can observe rather tritely that risk at these levels of prices and valuations begins to move rather larger than reward does over the course of many years.
How does «Grant’s Interest Rate Observer» cope with that as an investing newsletter?
We try to hold two thoughts at the same time and they’re not necessarily compatible: One is to recall that cash ought to be one’s basic investment. As unrewarding as cash is, it does afford flexibility and it’s kind of a default asset. The second thought we hold is that when cash yields nothing people who must generate income or returns from their capital need something else to do besides hearing a lecture about the uses of cash during a downturn. So we look for opportunities which afford a margin of safety, which may deliver returns and which yet have to be discovered and seized upon during this great bull market.
Where do you spot such opportunities?
In stocks of deep sea drillers, for instance. The basis of this investment story is the proposition that the price of energy is worth being higher because the world economy is getting better perhaps. Certainly, there has been very little investment in new sources of oil production. In America, there has been a great revolution in fracking, but the lives of these fracked wells are shorter than people once expected. So if that were true, you look around for companies that would benefit from that, especially companies that have been ignored in the bull market. So we have identified Transocean (RIG 5.31 4.94%), Ensco and Noble. These are companies whose balance sheets allow them to survive in a difficult environment and whose stock prices have fallen, in some cases, by 90% from the peak. In the stock market, their assets are valued at much less than replacement cost which makes a truly interesting opportunity.
Also (ALSN 160.8 0%), it’s no secret that you’re an ardent admirer of gold. What’s the outlook for the precious metal?
I feel as if cryptocurrencies have stolen a bit of the thunder of our favorite alternative monetary asset. But the gold market will respond to the demonstrated failure of radical monetary policy. I have no idea when that collective perception might come that the central bankers are not fully clothed. But it will come, and a good portion of the world will come to the conclusion that gold represents a very good store of value outside the banking system and outside the electrical grid and outside the world of technology. These cryptocurrencies, on the other hand, propagate like rabbits: One day there are 900 cryptocurrencies, the next week there are 1200 and the week after that 1500. On the contrary, gold has been with us for millennia and the only way to get more is by a collision of two neutron stars or something like that. So alchemy may work in the cryptocurrencies but it’s not going to work in gold.