Jonathan Pain


Jonathan, you have a good record of predictions.  You predicted the crash in 2008, you predicted the technology bust in 2000 and you predicted that Donald Trump would get elected.  I think you’ve got gloomy again, you’re talking about a perfect storm, explain what you mean.

Yes, my latest weekly Pain Report I entitled, ‘A Perfect Storm?’  and, Alan, I do think that we’re beginning to see a confluence of various forces that are kind of setting off a few alarm bells in my head.  First and foremost, I believe that the market is under-pricing the risk of rising inflation in The United States.  In response to that, obviously the US Central Bank I think will raise rates four times this year, which means an additional two increases in the all-important federal funds rate.  At the same time, I think investors need to brace themselves for a kind of new monetary reality, namely that we are at an inflexion point with respect to the monetary policy’s cycle. 

As we all know, for 10 years the central banks globally have pumped a vast amount of liquidity into markets and that has had the specific effect of, I believe, artificially supressing long term bond yields.  As they step back, I think you’re going to start seeing bond markets kind of come out of that decade long hibernation which means higher yields.  We know that from a relative valuation perspective, the only game in town has been to buy equities because of course from a relative valuation perspective equities have been relatively cheap to very, very expensive bonds.  As bond yields rise, that is in effect the discount factor that we use to calculate net present values, and so as that discount factor rises it will provide more of a headwind, I believe, to the equity market.

There’s that aspect to my concern, namely stronger than anticipated inflation in the United States and we can develop that if you wish, and also in response a more restrictive US Central Bank and now being followed soon by the ECB and perhaps even eventually by the BOJ.

Is it fair to say that your concerns are mostly around monetary policy and inflation?

They are one of my main concerns but the other one, Alan, is of course the very well-advertised escalation in the trade dispute between the United States and China.  Here again, I think the markets are perhaps a bit too sanguine, perhaps they’re not fully yet appreciative of how determined the United States is to combat China in terms of Trumps declaration that he wants free and fair trade.  Also, Alan, the people that Trump has around him in what we’d call the kind of trade war cabinet, particularly individuals like Peter Navarro, who we know wrote the book, Death by China in 2011.  These are individuals and Navarro in particular who have it as almost their mission in life to take on China and believe that China haven’t played by the rules and it’s a situation where it’s now or never.

If they don’t combat China today then there will soon be a day when China will literally run over the top of the United States.  I do believe that we are likely to see an escalation in the trade tensions, which I don’t think is factored into equity prices.

Before we get into developing the inflation views that you have as you suggest, are you in sell everything mode?

I was actually very close to putting that as my title on my last report, but as we know, Alan, there’s some celebrated equity strategists a few years back wrote a piece of ‘Sell Everything’ and then the markets promptly rallied, so I’m always reluctant even though I am a contrarian as you know well to write such a rash headline.  But for the first time in quite a long time, again it’s this kind of confluence of forces that are coming into place.  The inflation story we just discussed very briefly, the inflexion point in the monetary policy cycle, the escalation in trade tensions and also how China is likely to respond to that.  We’ve seen a significant weakening in the Chinese currency and I think we can probably say now that the Chinese are allowing their currency to depreciate.  The last time we saw that was 2015 and into 16 and that sent shockwaves through much of the global equity markets.

I believe the Chinese are in a difficult spot at the moment, and this is the other part of my concern, is that we know that China needs to deleverage their economy, we’ve seen an explosion in credit in China post the crisis, the crash of 2008.  The Chinese themselves are on record of saying that they need to engineer a process of deleveraging.  They’re doing that at a time when the United States is looking to escalate the trade dispute with China. 

In that fundamental regard, I think the Chinese economy is particularly vulnerable right now and I believe the Trump trade team are well aware of that and hence, even more determined to go for the jugular because they feel that their opponent has been weakened and is going to struggle to really retaliate fully to the tariffs that US wishes to impose upon them.  The China factor in this is also, I think, quite important and it helps explain my greater degree of anxiety in the last few months. 

How do you feel specifically about the Chinese economy?

Well, I’ve been one of the China bulls, Alan, for a very, very long time, probably 15 years.  I’ve always been on the positive side of consensus and I never subscribe to the kind of doom and gloom, China’s an accident waiting to happen narrative that we’ve heard from some pretty high profile hedge fund managers in the last 5-10 years.  Now that I’ve started really thinking about where I see China going in the next 2-5 years, number one, if we agree that they need to deleverage, and I think they themselves are acknowledging that.  I mean, clearly there’s been an explosion in debt and history tells us that when you get such a sharp acceleration in debt that’s when you usually get some form of financial crisis in the ensuing years. 

If we accept that they are deleveraging, that in of itself will lead to a slowing in economic activity.  I give the Chinese authorities enormous credit for what has been a really kind of enviable transformation of the economy particularly in the last 5-7 years, where they’ve shifted the emphasis away from an excessive reliance on fixed asset investment growth and anyone obviously who’s been to China will see evidence of that.  World class infrastructure in terms of ports, railway networks, highways and the like and airports, or particularly across the east and southern side of China.  

I give them credit for the remarkable, almost economic miracle that they’ve engineered, but now they face a new kind of economic reality where they simply can’t continue the expansion in debt that we have seen.  We’re also seeing some weakness particularly in some of the regional banks.  We’re also seeing heavily indebted state-owned enterprises beginning to default in the capital market.  This is all evidence to me that there are problems brewing and at the same time, the United States is looking and willing to engage in a trade war with China.  It couldn’t have come at a worse time.

The other aspect to the Chinese story which is making me a little bit more anxious, everyone knows that we have a political phenomenon now in China which is really quite extraordinary.  The NPC, the National People’s Congress, basically changed the constitution and removed the term limit on the presidency so President Xi Jinping can in effect rule for life if he so chooses.  We’re also seeing an emergence of, I think, fairly strong nationalistic tendencies across China.  We see their more aggressive posture in the South China Sea and a continuation of their position on, for example, Taiwan.  I see areas of potential friction with the United States, particularly in their region, South China Sea and with regard to Taiwan.  Then, if for example we just throw Iran into the mix, as you know and as we all know, President Trump tore up the nuclear accord – now, that’s a multilateral agreement and China’s a signatory to that and China imports quite a bit of oil from Iran. 

The Chinese are not amused that Donald Trump feels that he can act in such a unilateral fashion when that was a multilateral accord which virtually every expert would acknowledge was a very successful one in containing Iran.  America was a signatory as was of course various European powers, Russia and China.  China sees Trump’s action on the nuclear accord as an act of unilateralism, as it sees Trump’s positioning in terms of the trade dispute.  They see that as being a unilateral action. 

And so the tension between the United States and China is now rising and I think one doesn’t have to be a hawk or a dove just to acknowledge that new geopolitical reality and I’m beginning for the first time now, becoming a little bit more anxious that that kind of tension in the geopolitical framework, combined with the obvious tension in the economic domain could lead to a further escalation between the two largest economies in the world.

Just take us through your concerns about inflation in the US and in particular – because it’s taken a while now, they’ve had virtually full employment for quite a while, inflation’s not moving because wages are not moving, why do you think that’s now changing?

Well, that’s exactly right.  I think every economist has wheeled out the presumption that the Phillips Curve is broken, that is the relationship between employment and inflation.  As we know, when the employment market tightens up at levels near full employment, all things being equal, wage inflation should then start moving higher because there’s a significant demand for workers.  What we’ve seen in the last six or seven years is basically as the unemployment rate has fallen, wage inflation has remained benign, extremely subdued. 

But what is interesting, Alan, if you look at the Phillips Curve going back into the 60s, we had a decline in the unemployment rate in the United States in the 60s and then once it fell beneath 4% as the civilian unemployment rate fell beneath 4%, we then saw sudden traction in that relationship, namely as we fell below 4%, wage inflation really started spiking.  I think that’s exactly the environment we’re in right now.   When I look at every survey across the US economy, for example, the NFIB, the National Federation of Independent Business Surveys, they show that all of their members are finding it difficult to find skilled workers and they’re having to increase wage compensation. 

In fact, one of their compensation measures is at the highest level in 45 years.  That is, the proportion of companies that are having to lift wages is at a 45 year high.  That doesn’t seem to reconcile with the average hourly earnings figures.  What I’m seeing in the ISM surveys as well, the manufacturing surveys, significant upward pressure on prices, on material costs, transportation freight costs are rising very, very sharply.  There’s a huge shortage of trucked up drivers in the United States.  When I look at what I call the plumbing of US inflation, I look at the kind of inflationary pipelines, I see evidence of significant upwards pressure on general prices.  I think it’s only a matter of time before that represents itself in the so-called shopping basket of inflation.  There’s always a lag, but companies are now beginning to raise prices. 

Because of the strength of the US economy and clearly the latest quarter we saw 4.1% annualised growth, for the first time in a very long time, company’s feel they have the capacity, the ability to actually pass higher prices onto the consumer.  In my view it’s only a matter of time until consumers start having to pay higher prices.  Then we throw the tariffs into the mix.  Tariffs are inflationary, full stop.  We saw 25% tariff on steel, a 10% tariff on aluminium.  There a multiplicity of companies across the United States that are now reporting they are seeing significant upward pressure on raw material prices, particularly steel and aluminium and across a range of other sectors as well also in construction.

All of these things lead me to believe that inflation which is already moving upwards, by the way, is about to accelerate at an even faster rate.  That puts the US central bank in a bit of a quandary.  We know that they’re almost on auto-pilot and their mandate is to keep inflation near 2%, but my view is we’re going to burst through those levels and then the US Central Bank will have to maintain a restrictive monetary stance at a time when we could see the US economy slowing into 2019.  Because currently we’re benefitting from very similar fiscal policy, in particular the fall in the corporate tax rate from 35% to 21% and that is served to strengthen the economy right here and now. 

But as we go into 2019, that effect will be fading away somewhat and at the same time of course, the US Central Banks would have raised rates even further.  This leads me to begin to think about an environment where we could have stagflationary type conditions prevailing at some point in 2019 in the United States.

How do these views sit with Apple hitting $1 trillion dollars last night?

[Laughs] Great point.  I mean, Apple is just a remarkable company, it’s a standout and as you say, reached that milestone of $1 trillion dollars overnight.  I was actually watching it in the early hours of this morning.  Look, it’s just a great company with some amazing products and I don’t think Apple in of itself is necessarily representative of the broader economy.  Having said that, I’m very positive on the US economy and it’s one of the reasons why I think inflation is moving higher.  But yes, I mean, look, huge euphoria around their recent results. 

Their results were unambiguously positive.  In fact, all of their geographical regions were kind of firing on all cylinders and I’m sure they’re going to launch another whiz-bang new update on their iPhone in the next couple of months.  I don’t want to take anything away from Apple.  It’s a stunning company and it’s not even that expensive if you look at it on a price earnings multiple basis.  It’s not as expensive as some of the other companies.  I think though, whilst we’re talking about the technology sector and the so-called FAANGs, I think it’s also worth highlighting. 

We saw that catastrophe for Facebook where we saw a $120 billion dollar decline in its market value in the blink of an eye and that I think serves as a timely reminder that these extraordinary companies that are, on Monday, regarded as world-beaters and can never put a foot wrong, by Tuesday can see a 20% decline.  It’s quite staggering.  I think, Alan, the decline in the market value of Facebook was about 1.4 times the total value of Commonwealth Bank of Australia, so that provides us with some kind of context here in Australia.  So I’m not going to take anything away from Apple, it’s obviously a great company with a superb earnings profile, etcetera, etcetera…  But I don’t think Apple in of itself is going to kind of change the big picture monetary and inflationary dynamics.

But perhaps what it points to is the fact that within the kind of broader economic issues that you’re talking about, there is a shift taking place that’s still ongoing within the world towards software and cloud-computing and online services and so on.  As interest rates rise perhaps, China does what it does, trade wars happen and so on, within that there is this other force going on that allows people to continue to make money.

Yes, I have some sympathy with that position.  It’s quite a phenomenal reality, isn’t it?  The universe of technology and AI and the like, these are secular forces I think that are going to be with us forever, so yes.  Those companies that are at the forefront of those new technologies will be rewarded by investors.  It’s going to be the more cyclically natured entities and maybe unfortunately some of the banks and that in Asia that will get hurt.  So you’re right, I think that constituency of technology companies that are the world’s best, the Amazons of this world, the Googles, the Apples of this world that will continue to be remarkable profit generating machines.  I don’t disagree with what you’ve just said.

Well, perhaps on that slightly more positive note we can finish.  It’s always fantastic talking to you, Jonathan, thank you.

It’s my pleasure, Alan, thank you very much.