November 24, 2023 • 48 mins
Financial historian Edward Chancellor tells Merryn how low rates resulted in capital being misallocated, and why that’s bad news for any soft landings. Plus, John Stepek tells investors how to get exposure to cheap UK equities.
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Speaker 1 (00:00):
John, do you know what it's coming up for Christmas?
This is exciting. Let's talk about chocolate. Have you got
your Advine calendars for kids yet?
Speaker 2 (00:08):
Ah?
Speaker 3 (00:08):
Yes, but we don't do chocolate. I think calendars.
Speaker 2 (00:10):
We do it all.
Speaker 3 (00:11):
It just once. Thank you very much.
Speaker 1 (00:12):
You are so middle class and I'm trying my bit. Okay,
so we did that for ages, absolutely, you know, no chocolate,
full on religion. And then my day I thought, what's
the matter with you? The kids prefers chocolate to god
guds and chocolate adving calendars. But to make it not
too awful, I started buying them their chocolate advint calendars
(00:34):
in hotels.
Speaker 3 (00:34):
Chocola right, you call me middle class.
Speaker 1 (00:39):
It's all gone very well so far, except for one
year when I bought vegan ones by mistake, not so good.
And another year when I bought the kids ones that
I thought was milk chocolate in fact were a little
bit too dark and they didn't like that either. But
otherwise I'm very impressed by the chocolate. It's all gone
very well. It's almost like not buying them chocolate admint
calendars because they're quite potch Adwin calendars. You know, it's
kind of okay, but now I'm getting worried. Hotel Chokola
(01:03):
has been taken over by Mars American company, and it's
one of the many UK small and mid cap companies
that is being taken off the UK market by foreign
investors at a massive premium to portraying share price. Now, John,
we have been telling, telling our listeners and our readers,
(01:23):
but I accept for too long that they've got to
get out there and buy this cheap stuff before somebody
else does. And it's now happening somebody else is buying
out by cheap companies, right.
Speaker 3 (01:36):
Yeah, And I mean this I mean to feel this
isn't the first one. It was just kind of particularly
eye catching, partly because it's Hotail chocolas a lot of
people know it, and also because it was one of
the two companies that get taken out that day, and
Speil the other one was it was a pub company
that get bought by another pub company. But the point
is they both went for you know, bake premiums. I
(01:57):
mean the chocolu particularly Males Clear. They just thought, no,
let's get this over and done way, we just wanted to,
So they paid something like one hundred and seventy percent
over the prevailing share price. I mean that was part
because Hotel Chocolat for all that, you know, you know,
whether you think of the product quality, they have had
some trouble recently, did a couple of profit warnings.
Speaker 1 (02:20):
Yeah, those Christmas selection boxes just came come and everybody.
Speaker 3 (02:24):
See now, you know, we take the podcast for Christmas.
But but yeah, so they you know, the point is
that they somebody sees the value in these companies and
if us as retail investors don't see that, or more pointedly,
global fund managers don't see that, well, you know, tough
(02:44):
people are just going to pick the low hanging fruit.
And you know, as a retail investor, you mate as
well benefit from.
Speaker 2 (02:51):
That, is my view.
Speaker 1 (02:52):
Well you might as well. I mean another journalist, the
one who we approve of, said the other that this
is a once in a generation opportunity for UK investors
and they don't come along very often. And I am
when I was talking to him on Twitter and I tweeted,
you know, if you missed as many of us did
twenty twenty, and you missed two thousand and nine, you know,
the markets are looking You're saying to the power cheeps
(03:13):
about here. Other people are going to buy it. If
you don't, why don't you want this cheap stuff? What
are you frightened up here? I'll still be frightening the breaksit.
This is a silly get over.
Speaker 3 (03:21):
Yeah, that's interesting because it's I mean, you said that
the last time, but it's not. These opportunities don't usually last,
and often the reason that people don't take advantage in
at the time is because at the time they're very scary.
So you know, two thousand and eight or COVID or whatever,
But this time it's lasted for ages. The backdrop is
(03:44):
arguably better than at any point. If you were scared
about Brexit in twenty sixteen, and if let's trust freak
to you a year ago, even though it wasn't exactly hard,
but let's skip over that for a moment. You cannot
deny that, you know, the political outlook at the moment
is much less chaotic than at any point, and that
it's been since exit. So even if that was the
(04:05):
thing that was bothering you, it doesn't make sense that
it's still bothering now.
Speaker 1 (04:08):
A place to go, right, I want to go on
about this, but the place to go has got to
be investment trust, right. I know you've written about this
recently about the investment trust. We've talked about this before,
and we're going to keep talking about it until it's
not there anymore. These huge discounts on investment trust So
you've got this double discount of exceptionally cheap companies inside
some of the small and MidCap focused investment trusts. So
(04:29):
you've got the cheap companies and then you've got the
discount on top of it. It really looks like something
that all retail investors should at the very least be
looking at. Right, And you've written about some of the
bigger discounts and more interesting trusts out there. That's in
John's Money Distilled newsletter. Unless you want to mention any
of them now, John, Well, it's.
Speaker 3 (04:47):
More I think you can look at the sector and
obnestly you can go to the Association of Investment Companies
website yourself and have a look as well and explore
these things. Is a really good website. The only the
one Most of these things are cheap. The main thing
I would kind of point out is that you can
look at the discounts. But one thing where we are
(05:08):
of is that. Certainly in the smaller cap site, a
lot of the investment trusts are basically too small to
be invested in because and some of them are either
winding up or you look at them in the bed
off or spread is insane. I mean, there's a couple
of ones that kind of looked at and it's like, oh,
that looks interesting and then you realize that you're losing
six percent as soon as you buy it. So it
(05:29):
does be aware of that if you can invest in
in kind of smaller trusts. So it's there's a lot
of stuff out there. So have a day of.
Speaker 1 (05:37):
About Welcome to Marin Talks Money, the podcasting which people
who know the markets explain the markets. I'm Marren sum
said web this week we bring you a conversation with
Edward Chancellor. He's a financial historian. He's a journalistic that's
not a strategist, and we have been following his work
for years. His most ways and books is The Price
of Time, The Real Story of Interest. So I started
(05:59):
the conversation with ed on his area of expertise. Interest rates.
Now at one of the things that you are an
absolute expert on, and it turns out almost nobody is,
although one would wish that there were more experts on
this is interest rates. And here we find ourselves today
in a fairly extraordinary situation where it looks like our
central banks don't necessarily understand how interest rates and inflation works.
(06:23):
And we have rates having gone up at the most
tremendous speed as everyone focuses purely on inflation and nothing else,
bringing down inflation at the expense of all else. And
it feels like we might be missing some other things
that are happening in the economy as a result of
this phenomenally fast rate and interest rates. And I'm wondering if,
(06:47):
at the same time, right now, as other people are
beginning to think, oh, everything's fine, inflation is coming down
soft landing ahead, you might be feeling a little more nervous.
Yeah I am, Yeah, I thought you might be. I
thought you might be talking about why.
Speaker 2 (07:06):
You know, the context this is that we just come
off this period of the lowest interest rates in history.
And when we last spoke, we talked about the new
book I had The Price of Time, which was a
history of interest, well not really of interest rates per same,
but what interest was when it came about and what
(07:29):
it did. And you know, we've got five millennaire of
interest rate history, and say, we've got a lot to
draw on. But if we think about the last fifteen years,
we went to this very low period of interest rates,
zero rates, policy rates, and negative rates in Europe and Japan.
(07:49):
And the question is what did those zero and negative
rates do? And my the argument in the book was
I said, I was saying, well, actually they can and
the policymakers don't really understand interest. They see it purely
as a lever to control inflation. And we should talk
about that lever a bit later on, because it is
(08:10):
something to think about. But as I in the book,
I draw attention to these other functions of interest, which
is the capitalization rate for valuing assets, the hurdle rate
for making investments, the price of risk, a price put
on risk or a price put on leverage, an inducement
(08:31):
to save, and these other functions of interest were ignored
by the central banks, and I think that they led
to huge build up of risk in the financial system,
and actually because of the impact on the allocation of capital,
to a misallocation of capital. And I think that will
(08:53):
take people who read my books and oh, Chancellor wants
higher interest rates. Well, I mean I wasn't exactly saying that.
I was saying interest rates should never be this low
or should never have gotten this low. And once you
get that low, you're in a position of what the
economists would call disquilibrium, or if you want to make
(09:17):
a slightly even more complex, you could say we were
in a state of intertemporal dis equilibrium.
Speaker 1 (09:24):
In other words, you're going to have to explain that so.
Speaker 2 (09:28):
Merin so, you know, the interest is the price of time.
All financial activities take place over time. To be in balance,
your current borrowing and saving an investment has to be
in line some or other with what your future spending
is going to be. If you distort the rate of interest,
(09:51):
you distort the price of time, and therefore the present
and the future become out of whack. Now one way,
you know, I think very easy to see this. And
you were talking to Jeremy Grant and the other day
my former boss, as Jeremy would say, if you push
up valuations, you're going to get lower returns in future.
(10:12):
Is just straight forward. And the point is we pushed
up valuations without taking on board that the overall returns
from our investments were going to come down, and therefore
we were not going to earn as much as we
anticipate in the future. Now that problem has been partly
taken away by the rise in interest rates, which brought
(10:34):
acid prices, bond prices, and equity prices down last year,
but I think that is still an ongoing process, and
there are all these other areas allocation of the misallocation
of capital, the so called zombie companies created by the
low rates, that have yet to sort of feed through.
So I think.
Speaker 1 (10:54):
Interrupt you briefly just to ask you where you think
these main misallocations of capital taken place, and we talk
about these zombie companies of the particular areas where capital
has been misallocated, and that's going to cause us specific
problems in the future.
Speaker 2 (11:10):
So if you remember I am in the chapter I
write on the impact of interest on capital allocation. I
argue that that interest really serves the function of to
propel Schumpeter's creative destruction, taking resources from low return uses
(11:32):
to high return uses. And I think that that the
very low interest rates were a form of loan forbearance,
and therefore capital was trapped in activities with low returns,
and that from what one sees, is fairly global phenomenon.
(11:52):
You see it particularly in Europe, you see it in
the United States, and you see it actually in China too.
As for the sectors, I think that's really quite across
the board, the type of sectors in which capital is
trapped in. You can think of any area in which
(12:13):
businesses that are not returning and earning enough profit to
even pay their low interest costs. That they might be
in retail, they might be in manufacturing, they might now
particularly be in in commercial real estate.
Speaker 1 (12:30):
You wouldn't so you wouldn't pick. You wouldn't pick particularly
on say a residential property or renewable energy or anything
like that.
Speaker 2 (12:39):
Renewable energy that that is, I mean, I'm glad you
picked that up because you know, the the renewable energy boom,
particularly in these wind farms and solar farms, that was
a beneficiary of the ultra low interest rates, because the
(12:59):
capital costs of these great wind turbines was all up
front and they were rendered viable by the very low
interest rates. And as you've seen, you know, the the
you know or Sted, one of the big wind farm
more brats has run into trouble. Its stock is down
seventy five percent. I think that's to a large extent
(13:24):
a function of the very low interest rates. So when
the speed of the energy transition was accelerated by the
very low interest rates, and I think as interest rates
rise that the whole thing slows down. But actually that
I want to get on because there's another aspect of
the misallocation of capital, which is in and I suppose
(13:46):
you could include alternative energy in this in venture capital
in projects that have very distant returns, whose profits lie
in the future. So we saw this massive appital flow
into Silicon Valley and the great sort of unicorn phenomenon,
(14:07):
and some of the unicorns, you know, earned earned their
their faith, such as Facebook, but the others were the
likes of we Work, which went bust in the last
couple of weeks. We Worked, the office rental company that
sort of dressed itself up as a sort of tech
renting office space over an app. The these a lot
(14:29):
of the venture capital businesses have run into trouble. And
what I understand now is that VC investments are now
trade passing hands between partners, are sub a massive discounts
to their to their official price, So I think the bench.
So it's in a way there's a sort of bar bell.
(14:51):
You have the zombies, if you will, sort of old
fashioned businesses that unprofitable where capital is locked in by
the low range. And then you have the sort of
the high tech venture capital stuff, which also is marked
by a tremendous misallocation of capital.
Speaker 1 (15:08):
You have a sense of what kind of discount on
of these non profit moting VC assets are trading it
to say their last round.
Speaker 2 (15:16):
I've heard discounts as sort of forty percent thereabouts. And
we know that huge capital inflows in the French capital
happened up until twenty one, and that those capital flows
have dried up. So I think the returns thrown the
fact that the low interest rates boost valuations. I think
(15:41):
the returns of venture capital up to twenty one over
the recent years have been frankly exaggerated by the low
interest rates, and that will resets. I would expect quite
a long shakeout in that area and people, because it's
not listed, it takes longer, as you know, for private
(16:02):
equity and venture capital to mark their investments to a
proper market price. But that would happen.
Speaker 1 (16:09):
It's rather suggested that you haven't fallen for the story
that we've heard so much over the last decade or so,
that private equity is simply better at managing companies than
ordinary listed company management, and they can do things in
different ways, and they're one hundred percent ownership as opposed
to small ownership needs that they can really make things
work better, and that explains their superior performance, not in
(16:32):
any way the very low interest rates that have allowed
them to have capital for priety glee free. And you
seem to be disagreeing with that.
Speaker 2 (16:40):
Private equity is different from venture capital. Yes, of course,
private equity is to my mind, really largely a matter
of financial engineering. It works well when interest rates are
below the returnal capital because you can lever up and
squeeze out profit. Now, one definition of interest is the
(17:01):
price of leverage. So it comes as no surprise that
the private equity business starts in nineteen eighty two with
the former US Treasury Sectory Bill Simon taking over a
leverage buyout of a greetings card business called Gibson Greetings,
(17:22):
and that is tremendously successful. And after that you get
the arrival of some KKR and Blackstone and so on.
And these people are really more investment bankers than investors,
and they know about structuring the balance sheet to squeeze
out to leverage some profit. And you're going to get
(17:42):
a profit, as I say, if your cost of borrowing
is below your return on capital. And that worked very well.
And I was covering the private equity boom going into
the financial crisis, and I thought it was going to
be tremendous shakeout then and it didn't really happen cause
the very low interest rates after the global financial crisis,
(18:04):
which in effect allowed the private equity companies that have
been hugely irresponsible up to two thousand and sem, they
basically were able to refinance their portfolio companies after two
thousand and eight at very low rates. And then you've
got big bull markets. You've got an exit for their businesses.
(18:25):
But I think the private again, private equity has been
in trouble. You've probably heard about it. There are a lot
up to twenty twenty one private equity firms in the
United States were I think they were doing deals on
nine times a bit DAR earnings before interest, tax and
depreciation and amortization, and they were putting more. They said
(18:49):
they were doing highest valuation deals with the largest amount
of debt, and a few of them. I think the
only one I know of that actually stood back was Apollo,
the buy out private equity company that actually just pulled
back when deals were very highly priced and when too
(19:09):
much doubt was going onto the companies. But I think
the rest of the industry carried on going over the
cliff and having trouble. Now, now take for instance, Blackstone
off They have something which you probably read about the
Blackstone Real Estate Investment Trust be read and there again
the market price of that has been trading below the
(19:31):
declared asset price, and there was an offer to buy
out private investors in that at a forty percent discount
to the net asset value, again a similar level of
discount that you're seeing in venture capital space.
Speaker 1 (19:49):
It sounds to me as if those critics of yours
after you published your book, they said, oh, Edward once
higher interest rates were rather right in that while you
may not have actively wanted there to be dislocations in
the economy as a result of rais rising, it certainly
will bring us back to a position where capital we
(20:09):
will be correctly allocated and where the sectors and companies
has been incorrectly allocated, will disappear, So it really can
only be seen as a good thing. And we used
to say, yeah, carry on, well.
Speaker 2 (20:24):
Look, I mean, alcoholics shouldn't be drinking a bottle of
whiskey a day. But it's it turns out that if
you take a bottle of whiskey away from an alcoholic,
you can actually kill them. I mean, in other words,
coming off an addiction is a dangerous and fraught process.
(20:44):
And yes, it would have been ideal not to be
an alcoholague. It'd be ideal not to have you know,
you know, live in a world and where assets are
over valued, capital is misallocated, people are saving too little,
and future atts on investments again to disappoint, but that's
the world, the world we live in, and the question
(21:06):
is how do you get out of that world? My
and I don't think people understand that this process is
extremely fraught, and we'll also take a long time. You know,
we could say the progress from too low interest rates,
we might you know, it was almost a twenty five
(21:26):
year process. You could say that perhaps long term capital
management blow up in ninety eight the Hedge Fund, when
the Fed responded by lowing rates and then we got
dot com bubble and then they lowered the interest rates further,
and we've got a real estate bubble and they lower
the interest rates ever further. So we've been this in
this twenty five year period of rates for coming down,
(21:53):
and that's in the context of a forty year period
of a ball market in bonds of ever a long
term interest rates. So I don't think this thing just
changes overnight. I think that the impact of the higher
interest rates takes a while to feed through. And you
(22:16):
can see this, for instance, in people what does take
people's take housing for instance, in this country, a lot
of mortgages around two to three year fixes, and it
takes a while for those fixes to come off on
floating rates. In the US, it takes even longer because
people borrow on long with long dated mortgages, so that
(22:42):
takes really a long time for the impact of higher
interest rates to feed through. It's likewise the case for
corporate boring or you know, in the area of very
low interest rates. So it's a great inducement, as you know,
for companies to take on more debt, which they could
either use to buy back their shares or to buy
(23:05):
other companies, and a lot of that debt would be
termed out, so they wouldn't they wouldn't have to as
interest rates rise in the short term it doesn't affect
their cash flow. But that doesn't that's only a relatively
temporary basis. I was talking the other day to a
(23:26):
European telecoms company that had I think around sort of
fifty billion euros of debt and about I think it
had a billion dollars of billion euros of free cash flow,
but its loans were termed out for three or four years.
It wasn't going to be an immediate problem, but at
the current interest rates, that business was going to run
(23:48):
into extreme problems if it was going to have to
refinance at the market rates of interest rates that we've
seen this year.
Speaker 1 (23:57):
And then on the other hand, you have some companies
and even these day technology companies that have huge ants
of cash on their balance sheet and with interest rates
knocking around four five percent, that's a rather nice little
boost for them. It goes both ways.
Speaker 2 (24:11):
I did you see a chart that Albert Edwards SoC
Gen showed a couple of months ago where he was
He showed chart saying that actually the net interest income
of US corporations had actually risen year today and as
a result of the cash, you know, earning more. I
think the trouble with that type of analysis is that
(24:35):
Apple may have a lot of cash, but someone else
has a lot of debts. So if one looks at
these things inaggregate, everything might look better than it actually is.
If you remember marrying before the global credit crisis, everyone
said credit doesn't matter. One man's debt is another person's asset. Well,
it just didn't really work out like that because one
(24:56):
person's one person's asset was not The person who was
in debt couldn't actually afford to pay the debt, and
therefore that wasn't particularly good for the other person's assets.
So you have to be slightly careful with this aggregate analysis.
Speaker 1 (25:10):
Fair enough, So take all that together, what do you
see from here a sort of slow burn misery for
a decade as we work our way out of this,
or a crisis of some kind.
Speaker 2 (25:23):
I don't want to sort of cop out, but one
thing I would say is that the crisis that we
have been experiencing over the last twenty five years are
becoming analytically more complex. For instance, again go back to
the dot com bust was pretty simple. You really had
(25:44):
to be done not to understand how that was coming
and how to analyze it. I think the credit crisis,
global financial crisis was much more complicated, with the structured
credit and problems in subprime collactualized debt obligations. I think
the problem that we have today is not so much
(26:07):
complex financial structures, but the fact that the low interest
rates that prevailed for so long had such wide effects.
I cite in the book the Harvard economist Jeremy Stein,
who was a briefly of FED governor. He says that
interest rates get into all the cracks. And I like
(26:30):
that comment because it should be telling you that the
problems created by the very low interest rates have got
into a whole load of cracks, some of which will
be pretty obvious. I mean, so for instance, take for instance,
just a specuative boom in SPACs and so on. There
(26:50):
was an amusing comment by the spacing chammer if you
remember him, and he said the other day the trouble
with rising interest rates is it renders your business valueless. Well, okay,
if you have an inherently valueless business, yes, the rising
interest rates exposed So we've seen the sort of we
(27:14):
saw the blow off in hyperspecutive stocks. Okay, pretty easy,
pretty obvious. But then, for instance, we knew that the
bond prices were elevated, that yields were negative, and it
wasn't tremendous surprise that long dated bonds suffered a lot
over the last couple of years. However, I didn't know,
(27:37):
and I don't know if you knew in advance that,
for instance, the UK pension funds had leveraged up their
holdings of fifty year UK index linked bonds and negative
yields and they'd levered them up five six times. Now
that that blew up in September of last year, but
it wasn't that was what I thought interesting about that
(27:58):
was we knew there was a entran problem were caused
by the ultra low interest rates, and how this inflated
their liabilities, and how they had to hedge it. You
didn't know. I wasn't quite sure what they'd done about
it until after the facts. I wasn't anticipating to blow up,
and in fact, actually a lot of as we you know,
you and I know some of the investors who were
(28:20):
caught on the wrong side of that trade so it
wasn't anticipated, even by quite smart people. The question is
to where we are going forward. Some obvious problems obviously
ones reading about problems with commercial real estate and that
would make people working from home and so on, that
you can see that commercial real estate is going to
(28:41):
be in trouble. I don't know. Take for instance, the
problems at the regional banks earlier this year with Silicon
Valley Bank going down and a couple of other big
banks going down. Now you'd have thought that, you know,
one's taught that higher interest rates are good for banks
because they gives them a steeper yield curve so that
(29:04):
they borrow short and lend long and they make money.
In fact, actually in this case the banks had borrowed
short and then they from their depositors and then had
bought medium term debt and had capital losses. So there
was a problem that one wasn't necessary immediately anticipating. And
then you know, there's for instance, with a banking system,
(29:26):
the banks, as you know around the world, sitting on
massive excess reserves. They have massive deposits, with the central
banks having served as a conduit for selling all those
bonds during quantitative easing. Now I don't quite know what's
going to happen to those excess with US. I don't
think the taxpayers at the moment are paying interest on
(29:48):
There is this whether that actually leads to problems for
the banks, whether where the governments around the world become
reluctant to pay it. So again, so as a question
mark would hold it to my mind, is over the
entire banking system. Then we've got China. The problems with
real estate in China pretty obvious with China's realistic and
(30:12):
I've been banging on about China's real estate bubble for
at least well thirteen years and the same it was
a bubble that went on and on and on and
got bigger and bigger and big and it's been blowing
off the last couple of years. And we've seen you know,
Evergrand go down and then Country Garden the biggest developers.
(30:33):
But we don't really know the long term outcome of
the higher interest rates and bringing and how and what's
going to happen to China's real estate and China's economy
and financial system. I mean, one, you know, one outcome
that I've thought possible was that China's currency would sort
(30:57):
of blow at some stage, but it or crack. Let's
say that. But I mean that's one potential outcome. But
I think there will be you know, there definitely be
problems coming from China over the coming years. I would
thought the Chinese are very good, will have been very
good at hiding debts within the system. But I don't
(31:19):
think that process it can go on forever. So that's
you know, that's there's then you've got residential real estate
that's taking I mean taking the UK for instance, it's
taking a while to come down. You know, the benign
situation there is for you know, the nominal price to
(31:42):
house prices to rain more or less level, but with
inflation eroding the value. But you know, also potential for
a crack. So i'd say that you know that there
are a whole load of areas that one, you know,
one has to analytically worry about.
Speaker 1 (32:03):
Okay, I'm going to put that down as an I
don't know, but not so scary stuff out there. There's
an answer to the original question. Yeah, Now, let's get
that fair. We're worried. That's not fair.
Speaker 2 (32:16):
That's fair. That's fair.
Speaker 1 (32:18):
I'm sorry, that's fair.
Speaker 2 (32:20):
I'm saying the problem is too complex for any individual
analyst to get their head around. It's a global problem,
and the problem and the low interest rates have got
into all the cracks and those problems because prices take
asset prices take a while to turn and take in
(32:42):
private acuity and venture capital. And because interest rates people
who borrowed fixed for a short time, that the impact
of the interest rates isn't felt immediately, either for home
buyers or for corporations. It's going to take a while
to feed through.
Speaker 1 (33:00):
Okay, Edward, right back at the beginning, you said you
wanted to come back to interest rates as a lever
to control inflation. You have something you wanted to say
on that.
Speaker 2 (33:09):
Yes, so it's actually something. It's something I didn't actually
write much about in the book. I think because it's
the one area that the central banks seem to understand
about interests that you can have You can use interest
to control inflation by putting up the interest rate. And
(33:36):
I'm actually coming to the view that this of the
various functions of interest, that actually using the interest rate
as a leader to control inflation is the least it's
the least reliable of the functions of interests. It's pretty obvious.
If you take down the discount rate, you're going to
have higher valuations. It's just sort of pretty obvious. Now,
(33:59):
the trust is a cost of doing business, and if
you push up the interest rate, you actually push up
people's cost of doing business. And for instance, if you
and if you're a worker and you've got a mortgage
and your mortgage cost cup, then you actually need a
pay rise in order to pay your higher mortgage costs.
(34:22):
So in that sense, actually the rising interest rates has
a perversely an inflationary effect. And you see this, I
think you see this where you landlords putting up rents
having faced higher mortgage payments, or farmers who heavily leverage
(34:43):
having to charge more for their food and so on.
Then there is this. If you want to get more
technical theoretical, there's a guy at Stamford called have you
come across him called John Cochrane who has something which
he calls the fiscal theory of the price level across Not.
Speaker 1 (35:03):
Yes, but now I'm going to go and have to
go and look it up and put it in the
show notes.
Speaker 2 (35:07):
I mean, it's ridly theory of.
Speaker 1 (35:09):
The price cycle. Sorry, listeners, this is what we have
to do.
Speaker 2 (35:13):
Yeeah cockrid. It's written eight hundred He's written eight hundred
page book on the subject of which you know most
of it is equations, says sort of over my head. However,
I think I understand his The basic insight, which is
it is that in a world with in a modern
world of fear currencies and so on, governments do not
(35:37):
go bust and instead they inflate away their debt. Okay,
you accept that if you have lower interest rates, the
debt becomes more sustainable, and therefore you'll have less fiscal
incentive to get to inflate away or debt. However, when
you have higher interest rates, then the debt is less sustainable.
(36:00):
Therefore it's technically more insolvent, and as it becomes closer
to the insolvency, you get more inflation to pay it off,
and that the thing that makes sense. The other thing
that it's quite interesting is if you have Although it's
true that lower interest rates made the debt more sustainable,
(36:21):
of course the politicians couldn't resist the impulse to take
on more debts. So you had, particularly during the sort
of COVID period, you had this massive increase in government
debt induced by the very low interest rates. I think
you and I spoke what three years ago about the
whole lockdown thing, and my view was that lockdown simply
(36:43):
wouldn't have happened had there not been such cheap financing
of government debt at the time. For instance, in the UK,
the Bank of England was buying up, in effect, all
of the bonds that the that the British government were
issuing and charging fifteen basis points for it.
Speaker 1 (37:06):
Without that, all the business of lockdowns and furlough and
helped to buy, helped to eat, whether they were called
eat out to help out, etcetera. Now that would have
been possible without super low interest rates, would it?
Speaker 2 (37:17):
I mean no, it wouldn't have been done because people
would have people would have thought twice. The trouble back
then is there was no thinking twice about what they
were doing. But where are we now? I saw some
data at the cost of government debt financing in the
developed world has almost doubled in the last year. I
(37:37):
think the American cost of debt servicing is running at
about fifteen percent of expenditures. British debt is you know,
so you can see that the governments themselves even if
we had didn't have any of these other concerns. We
can see that the governments again to have huge problems
(37:57):
financing their debts, having got into such having splurged so much,
and that gives them an incentive to keep interest rates
below where they ought to be in order to control inflation.
In other words, for all this talk of getting inflation down, there,
there isn't at some higher level a you know, a
(38:19):
strong incentive to do it. There's a much stronger I'm
sure you are too. I'm in the Russell Napier camp
of financial repression that interest rates will be below the
cost of the level of inflation and the debt will
be burnt off that way. And if financial repression it
can be quite in theory, it could be quite smooth.
(38:40):
And you and I know Russell. Rus Russell thinks that
it's very bullish for equities, and it probably is. Is
keeping interest below the inflation it probably helps it, you know,
it probably does help equities. I'm just concerned that just
moving nominal rates, even if they're negative in real time
of very low levels, will cause a few more hiccups.
(39:04):
And people are expecting all.
Speaker 1 (39:06):
We do now right now, we're in a very unusual
period in the UK where the interest rate is actually
above the ratio inflation stick. Come on in it cause
account today and you can for a very short period
only actually make a real return.
Speaker 2 (39:19):
Yep.
Speaker 1 (39:20):
That you know, take what you can get when you
can get it, and right now you're going to have
a real returnal They possibly not have.
Speaker 2 (39:25):
To tell Marion that I am put out a paper
on historical experiences of inflation going back years and they
one of the points they make there that inflation tends
to remain persistent in countries that they describe as having
premature celebrations. The premature celebration is when you think you've
(39:50):
got inflation under control, and you haven't quite got it
under control, say it bounces back. And that's really the
experience of the seventies where a lot of premature I
think we had three inflation cycles. If you go from
the late sixties, late sixties, mid seventies and then late
seventies is three inflation peaks, and in between you get
(40:12):
these premential celebrations. From what we've talked about already, you
can see this huge interest in keeping interest rates low,
so they will leave at any use to cut rates,
and therefore if the past was any guide, it wouldn't
be entirely surprising. If I'm plating with the bounced back.
Speaker 1 (40:30):
Yeah, and that we can say, going back to Russell Napier,
and this is very bullish for equities. Might give us
some positive news that we may see a return to
making good returns in the equity markets, even though it
might not be fully justified by valuations.
Speaker 2 (40:46):
Well, you know, when you're talking to Jeremy Grantham, as
he says, the US market is very very overvalued and
aggregate and therefore one would expect, you know, for me
that I'm a bit surprised at how strong it's remained.
And as Jeremy was saying, this bit of a sort
of AI bubble this year that has kept up the tech,
(41:09):
the big tech names. But I would expect the US
to have disappointing returns or possibly no returns.
Speaker 1 (41:18):
If we look at the US market, if we look
at all markets, but in particularly if we look at
the US market on an equal weighted basis as opposed
to a market cat weighted basis, so we do the
indices differently, it doesn't look nearly as overvalued as it does.
If you did on a market cap basis, right, So
if you effectively equal weight the astonishing performance of the
Big seven, it looks a little different, I think. So.
Speaker 2 (41:43):
I haven't been looking at recently, but in my old firm, GMO,
they will do forecasts for you know, US value and
this and that, and I don't I think that you
get much more attractive valuations outside the United States. I mean,
you you typed.
Speaker 1 (41:59):
You you came Japan, and you've been counting Japan recently.
Tell us about that quickly.
Speaker 2 (42:06):
So I've long been a japan bull.
Speaker 1 (42:12):
Yeah, that's me too. It's been a tough gig, hasn't
It been a long time Japan bull. But we're finally
getting our awards, I think. Yeah.
Speaker 2 (42:19):
I mean, actually you saw the piece I wrote. In fact,
since twenty ten, Japanese equities have returned seven point three
percent reel. I mean that's part more more than the
average long term returns to the US top market, and
really a return of you know, back to the returns
that Japan used to deliver before the the you know,
(42:45):
the end of the bubble economy in nineteen ninety. So
I think you know that some of the headwinds for
Japan were high valuations, and then this period of deflation
and deleveraging that hurt Japanese margins and return on equity.
And I think that was over ten years ago. So
that was our reason for being bullish ten twelve years ago,
(43:08):
and that's been more than vindicated. Let's say, however, one
of the problems, if you remember of Japan, of investing
in Japanese equities is that there were all these companies
that looked cheap, in particularly these so called net nets,
the companies that market cap was below the cash and
working capital. And these are the businesses that sort of
(43:30):
Ben Graham's of this world wanted to own, and then
they would go along, they'd buy Japanese companies netnets and
find that you couldn't you go to the company and say, look,
you've got much more too much cash from your ban sheet.
You've got these divisions that are not earning any capital
and not caught, not earning a return on capital, and
they're not caught your business. When you get rid of
(43:52):
them and the management, we just look at them and
you tell them to go away. And now that is changing.
And that's what I wrote about recently, and actually I
visited Japan a few times, just over ten years ago
with a colleague of mine who was a Japan expert.
He was very against Western activism in Japan. He thought
(44:13):
that they, you know that these Americans who rived in
Japan took a stake in a company and then banged
their fists on the table were doing it all wrong.
And and the firms that did that in the early
two thousands, it was one American company called Steel Partners.
They were rebuffed and they had disappointing returns. But now
my former colleague Toby Rhodes, who has a small cap
(44:39):
Japan business, he says that now the situation completely changed.
He for instance, has been made a or nominated to
be an independent director of a company in which he
has an investment. There is there are you know, we've
seen the beginning of hostile takeovers in Japan, and you've
(45:00):
seen the Tokyo Stock Exchange has told companies whose market
cap is below their book value, which roughly half the
companies listed in Tokyo are priced at below book These
companies have been told to come up with a plan
to get their market cap above book. Now, the Ministry
(45:24):
for Economy, Trade and Industry METI wants Japanese companies to consolidate,
and in order to dry this consolidation, it wants shareholders
to push companies to get rid of poorly performing divisions
and to merge. And I think that so obviously Japan
it's not the market is not as cheap as it
(45:46):
was when it was you know, roughly almost a third
of its current price twelve years ago. But now there's
potential for unlocking value in Japan, for activism and for
proper true value investing, as you probably know, requires activism.
That's what Ben Graham, who was the father of value investment,
(46:07):
he was an activist investor. And I think that now
activism is coming to Japan with the support of the authorities.
That is a major change and gives a prospect for
really decent returns from Japan going forward.
Speaker 1 (46:23):
Excellently.
Speaker 2 (46:24):
See your final question, are you ready?
Speaker 1 (46:27):
I have to because are you ready? Course you are,
and you know the answer. I have to ask everybody
this one. Okay, if I were to make you give
me all your money and lock it, lock it away
for ten years, and I told you that I can
put it for you into either a deposit account in
the UK and interest paying deposit account in the UK,
gold or bitcoin? Which would you choose?
Speaker 2 (46:53):
You know, the answer trick question.
Speaker 1 (46:56):
It's not a trick question.
Speaker 2 (46:58):
I would say. I would say because we've taught that
we expect financial oppression on deposits to hurt, and you
think bitcoin is a sort of bubble acid and you
know there's a reasonable chance if we get financial oppression
you'll get a gold bubble, as we did in the
in seventy nine eighty, in which case gold would be
(47:21):
out that ten thousand dollars. Now it's and one have
done very well, but you know I would have that.
Speaker 1 (47:28):
I've been a gold bug for so long. Wouldn't it
be nice if suddenly we had a proper gold bubble
and we'd be vindicated in it in our affection for
gold edvar Thank you so much. I think you know
you've given all the answers that I really like. By
Japhan by gold, I mean, this is fantastic. Thank you
so much. Thanks for listening to this week's Merin Talks Money.
(47:51):
We're off next week. We're back the week after. Catch
our debrief on this week's conversation on the Merin Talks Money.
After showing our normal feed and it is free to everybody,
as are all the after shows in our archive. You
asked for these to be free, We've delivered, and if
that makes you happy, go ahead and leave us a
positive review. It helps people find the show, and of
course please do tell your friends about this podcast. This
(48:13):
episode was hosted by me and marenzumsep Web. It was
produced by Somesadi, additional editing by Blake Maples Becial thanks
to Edward Chancellor and as ever to John Stepic. Please
be sure to sign up for John's daily newsletter, Money Distilled.
The link is in the show notes
John, do you know what it's coming up for Christmas?
This is exciting. Let's talk about chocolate. Have you got
your Advine calendars for kids yet?
Speaker 2 (00:08):
Ah?
Speaker 3 (00:08):
Yes, but we don't do chocolate. I think calendars.
Speaker 2 (00:10):
We do it all.
Speaker 3 (00:11):
It just once. Thank you very much.
Speaker 1 (00:12):
You are so middle class and I'm trying my bit. Okay,
so we did that for ages, absolutely, you know, no chocolate,
full on religion. And then my day I thought, what's
the matter with you? The kids prefers chocolate to god
guds and chocolate adving calendars. But to make it not
too awful, I started buying them their chocolate advint calendars
(00:34):
in hotels.
Speaker 3 (00:34):
Chocola right, you call me middle class.
Speaker 1 (00:39):
It's all gone very well so far, except for one
year when I bought vegan ones by mistake, not so good.
And another year when I bought the kids ones that
I thought was milk chocolate in fact were a little
bit too dark and they didn't like that either. But
otherwise I'm very impressed by the chocolate. It's all gone
very well. It's almost like not buying them chocolate admint
calendars because they're quite potch Adwin calendars. You know, it's
kind of okay, but now I'm getting worried. Hotel Chokola
(01:03):
has been taken over by Mars American company, and it's
one of the many UK small and mid cap companies
that is being taken off the UK market by foreign
investors at a massive premium to portraying share price. Now, John,
we have been telling, telling our listeners and our readers,
(01:23):
but I accept for too long that they've got to
get out there and buy this cheap stuff before somebody
else does. And it's now happening somebody else is buying
out by cheap companies, right.
Speaker 3 (01:36):
Yeah, And I mean this I mean to feel this
isn't the first one. It was just kind of particularly
eye catching, partly because it's Hotail chocolas a lot of
people know it, and also because it was one of
the two companies that get taken out that day, and
Speil the other one was it was a pub company
that get bought by another pub company. But the point
is they both went for you know, bake premiums. I
(01:57):
mean the chocolu particularly Males Clear. They just thought, no,
let's get this over and done way, we just wanted to,
So they paid something like one hundred and seventy percent
over the prevailing share price. I mean that was part
because Hotel Chocolat for all that, you know, you know,
whether you think of the product quality, they have had
some trouble recently, did a couple of profit warnings.
Speaker 1 (02:20):
Yeah, those Christmas selection boxes just came come and everybody.
Speaker 3 (02:24):
See now, you know, we take the podcast for Christmas.
But but yeah, so they you know, the point is
that they somebody sees the value in these companies and
if us as retail investors don't see that, or more pointedly,
global fund managers don't see that, well, you know, tough
(02:44):
people are just going to pick the low hanging fruit.
And you know, as a retail investor, you mate as
well benefit from.
Speaker 2 (02:51):
That, is my view.
Speaker 1 (02:52):
Well you might as well. I mean another journalist, the
one who we approve of, said the other that this
is a once in a generation opportunity for UK investors
and they don't come along very often. And I am
when I was talking to him on Twitter and I tweeted,
you know, if you missed as many of us did
twenty twenty, and you missed two thousand and nine, you know,
the markets are looking You're saying to the power cheeps
(03:13):
about here. Other people are going to buy it. If
you don't, why don't you want this cheap stuff? What
are you frightened up here? I'll still be frightening the breaksit.
This is a silly get over.
Speaker 3 (03:21):
Yeah, that's interesting because it's I mean, you said that
the last time, but it's not. These opportunities don't usually last,
and often the reason that people don't take advantage in
at the time is because at the time they're very scary.
So you know, two thousand and eight or COVID or whatever,
But this time it's lasted for ages. The backdrop is
(03:44):
arguably better than at any point. If you were scared
about Brexit in twenty sixteen, and if let's trust freak
to you a year ago, even though it wasn't exactly hard,
but let's skip over that for a moment. You cannot
deny that, you know, the political outlook at the moment
is much less chaotic than at any point, and that
it's been since exit. So even if that was the
(04:05):
thing that was bothering you, it doesn't make sense that
it's still bothering now.
Speaker 1 (04:08):
A place to go, right, I want to go on
about this, but the place to go has got to
be investment trust, right. I know you've written about this
recently about the investment trust. We've talked about this before,
and we're going to keep talking about it until it's
not there anymore. These huge discounts on investment trust So
you've got this double discount of exceptionally cheap companies inside
some of the small and MidCap focused investment trusts. So
(04:29):
you've got the cheap companies and then you've got the
discount on top of it. It really looks like something
that all retail investors should at the very least be
looking at. Right, And you've written about some of the
bigger discounts and more interesting trusts out there. That's in
John's Money Distilled newsletter. Unless you want to mention any
of them now, John, Well, it's.
Speaker 3 (04:47):
More I think you can look at the sector and
obnestly you can go to the Association of Investment Companies
website yourself and have a look as well and explore
these things. Is a really good website. The only the
one Most of these things are cheap. The main thing
I would kind of point out is that you can
look at the discounts. But one thing where we are
(05:08):
of is that. Certainly in the smaller cap site, a
lot of the investment trusts are basically too small to
be invested in because and some of them are either
winding up or you look at them in the bed
off or spread is insane. I mean, there's a couple
of ones that kind of looked at and it's like, oh,
that looks interesting and then you realize that you're losing
six percent as soon as you buy it. So it
(05:29):
does be aware of that if you can invest in
in kind of smaller trusts. So it's there's a lot
of stuff out there. So have a day of.
Speaker 1 (05:37):
About Welcome to Marin Talks Money, the podcasting which people
who know the markets explain the markets. I'm Marren sum
said web this week we bring you a conversation with
Edward Chancellor. He's a financial historian. He's a journalistic that's
not a strategist, and we have been following his work
for years. His most ways and books is The Price
of Time, The Real Story of Interest. So I started
(05:59):
the conversation with ed on his area of expertise. Interest rates.
Now at one of the things that you are an
absolute expert on, and it turns out almost nobody is,
although one would wish that there were more experts on
this is interest rates. And here we find ourselves today
in a fairly extraordinary situation where it looks like our
central banks don't necessarily understand how interest rates and inflation works.
(06:23):
And we have rates having gone up at the most
tremendous speed as everyone focuses purely on inflation and nothing else,
bringing down inflation at the expense of all else. And
it feels like we might be missing some other things
that are happening in the economy as a result of
this phenomenally fast rate and interest rates. And I'm wondering if,
(06:47):
at the same time, right now, as other people are
beginning to think, oh, everything's fine, inflation is coming down
soft landing ahead, you might be feeling a little more nervous.
Yeah I am, Yeah, I thought you might be. I
thought you might be talking about why.
Speaker 2 (07:06):
You know, the context this is that we just come
off this period of the lowest interest rates in history.
And when we last spoke, we talked about the new
book I had The Price of Time, which was a
history of interest, well not really of interest rates per same,
but what interest was when it came about and what
(07:29):
it did. And you know, we've got five millennaire of
interest rate history, and say, we've got a lot to
draw on. But if we think about the last fifteen years,
we went to this very low period of interest rates,
zero rates, policy rates, and negative rates in Europe and Japan.
(07:49):
And the question is what did those zero and negative
rates do? And my the argument in the book was
I said, I was saying, well, actually they can and
the policymakers don't really understand interest. They see it purely
as a lever to control inflation. And we should talk
about that lever a bit later on, because it is
(08:10):
something to think about. But as I in the book,
I draw attention to these other functions of interest, which
is the capitalization rate for valuing assets, the hurdle rate
for making investments, the price of risk, a price put
on risk or a price put on leverage, an inducement
(08:31):
to save, and these other functions of interest were ignored
by the central banks, and I think that they led
to huge build up of risk in the financial system,
and actually because of the impact on the allocation of capital,
to a misallocation of capital. And I think that will
(08:53):
take people who read my books and oh, Chancellor wants
higher interest rates. Well, I mean I wasn't exactly saying that.
I was saying interest rates should never be this low
or should never have gotten this low. And once you
get that low, you're in a position of what the
economists would call disquilibrium, or if you want to make
(09:17):
a slightly even more complex, you could say we were
in a state of intertemporal dis equilibrium.
Speaker 1 (09:24):
In other words, you're going to have to explain that so.
Speaker 2 (09:28):
Merin so, you know, the interest is the price of time.
All financial activities take place over time. To be in balance,
your current borrowing and saving an investment has to be
in line some or other with what your future spending
is going to be. If you distort the rate of interest,
(09:51):
you distort the price of time, and therefore the present
and the future become out of whack. Now one way,
you know, I think very easy to see this. And
you were talking to Jeremy Grant and the other day
my former boss, as Jeremy would say, if you push
up valuations, you're going to get lower returns in future.
(10:12):
Is just straight forward. And the point is we pushed
up valuations without taking on board that the overall returns
from our investments were going to come down, and therefore
we were not going to earn as much as we
anticipate in the future. Now that problem has been partly
taken away by the rise in interest rates, which brought
(10:34):
acid prices, bond prices, and equity prices down last year,
but I think that is still an ongoing process, and
there are all these other areas allocation of the misallocation
of capital, the so called zombie companies created by the
low rates, that have yet to sort of feed through.
So I think.
Speaker 1 (10:54):
Interrupt you briefly just to ask you where you think
these main misallocations of capital taken place, and we talk
about these zombie companies of the particular areas where capital
has been misallocated, and that's going to cause us specific
problems in the future.
Speaker 2 (11:10):
So if you remember I am in the chapter I
write on the impact of interest on capital allocation. I
argue that that interest really serves the function of to
propel Schumpeter's creative destruction, taking resources from low return uses
(11:32):
to high return uses. And I think that that the
very low interest rates were a form of loan forbearance,
and therefore capital was trapped in activities with low returns,
and that from what one sees, is fairly global phenomenon.
(11:52):
You see it particularly in Europe, you see it in
the United States, and you see it actually in China too.
As for the sectors, I think that's really quite across
the board, the type of sectors in which capital is
trapped in. You can think of any area in which
(12:13):
businesses that are not returning and earning enough profit to
even pay their low interest costs. That they might be
in retail, they might be in manufacturing, they might now
particularly be in in commercial real estate.
Speaker 1 (12:30):
You wouldn't so you wouldn't pick. You wouldn't pick particularly
on say a residential property or renewable energy or anything
like that.
Speaker 2 (12:39):
Renewable energy that that is, I mean, I'm glad you
picked that up because you know, the the renewable energy boom,
particularly in these wind farms and solar farms, that was
a beneficiary of the ultra low interest rates, because the
(12:59):
capital costs of these great wind turbines was all up
front and they were rendered viable by the very low
interest rates. And as you've seen, you know, the the
you know or Sted, one of the big wind farm
more brats has run into trouble. Its stock is down
seventy five percent. I think that's to a large extent
(13:24):
a function of the very low interest rates. So when
the speed of the energy transition was accelerated by the
very low interest rates, and I think as interest rates
rise that the whole thing slows down. But actually that
I want to get on because there's another aspect of
the misallocation of capital, which is in and I suppose
(13:46):
you could include alternative energy in this in venture capital
in projects that have very distant returns, whose profits lie
in the future. So we saw this massive appital flow
into Silicon Valley and the great sort of unicorn phenomenon,
(14:07):
and some of the unicorns, you know, earned earned their
their faith, such as Facebook, but the others were the
likes of we Work, which went bust in the last
couple of weeks. We Worked, the office rental company that
sort of dressed itself up as a sort of tech
renting office space over an app. The these a lot
(14:29):
of the venture capital businesses have run into trouble. And
what I understand now is that VC investments are now
trade passing hands between partners, are sub a massive discounts
to their to their official price, So I think the bench.
So it's in a way there's a sort of bar bell.
(14:51):
You have the zombies, if you will, sort of old
fashioned businesses that unprofitable where capital is locked in by
the low range. And then you have the sort of
the high tech venture capital stuff, which also is marked
by a tremendous misallocation of capital.
Speaker 1 (15:08):
You have a sense of what kind of discount on
of these non profit moting VC assets are trading it
to say their last round.
Speaker 2 (15:16):
I've heard discounts as sort of forty percent thereabouts. And
we know that huge capital inflows in the French capital
happened up until twenty one, and that those capital flows
have dried up. So I think the returns thrown the
fact that the low interest rates boost valuations. I think
(15:41):
the returns of venture capital up to twenty one over
the recent years have been frankly exaggerated by the low
interest rates, and that will resets. I would expect quite
a long shakeout in that area and people, because it's
not listed, it takes longer, as you know, for private
(16:02):
equity and venture capital to mark their investments to a
proper market price. But that would happen.
Speaker 1 (16:09):
It's rather suggested that you haven't fallen for the story
that we've heard so much over the last decade or so,
that private equity is simply better at managing companies than
ordinary listed company management, and they can do things in
different ways, and they're one hundred percent ownership as opposed
to small ownership needs that they can really make things
work better, and that explains their superior performance, not in
(16:32):
any way the very low interest rates that have allowed
them to have capital for priety glee free. And you
seem to be disagreeing with that.
Speaker 2 (16:40):
Private equity is different from venture capital. Yes, of course,
private equity is to my mind, really largely a matter
of financial engineering. It works well when interest rates are
below the returnal capital because you can lever up and
squeeze out profit. Now, one definition of interest is the
(17:01):
price of leverage. So it comes as no surprise that
the private equity business starts in nineteen eighty two with
the former US Treasury Sectory Bill Simon taking over a
leverage buyout of a greetings card business called Gibson Greetings,
(17:22):
and that is tremendously successful. And after that you get
the arrival of some KKR and Blackstone and so on.
And these people are really more investment bankers than investors,
and they know about structuring the balance sheet to squeeze
out to leverage some profit. And you're going to get
(17:42):
a profit, as I say, if your cost of borrowing
is below your return on capital. And that worked very well.
And I was covering the private equity boom going into
the financial crisis, and I thought it was going to
be tremendous shakeout then and it didn't really happen cause
the very low interest rates after the global financial crisis,
(18:04):
which in effect allowed the private equity companies that have
been hugely irresponsible up to two thousand and sem, they
basically were able to refinance their portfolio companies after two
thousand and eight at very low rates. And then you've
got big bull markets. You've got an exit for their businesses.
(18:25):
But I think the private again, private equity has been
in trouble. You've probably heard about it. There are a lot
up to twenty twenty one private equity firms in the
United States were I think they were doing deals on
nine times a bit DAR earnings before interest, tax and
depreciation and amortization, and they were putting more. They said
(18:49):
they were doing highest valuation deals with the largest amount
of debt, and a few of them. I think the
only one I know of that actually stood back was Apollo,
the buy out private equity company that actually just pulled
back when deals were very highly priced and when too
(19:09):
much doubt was going onto the companies. But I think
the rest of the industry carried on going over the
cliff and having trouble. Now, now take for instance, Blackstone
off They have something which you probably read about the
Blackstone Real Estate Investment Trust be read and there again
the market price of that has been trading below the
(19:31):
declared asset price, and there was an offer to buy
out private investors in that at a forty percent discount
to the net asset value, again a similar level of
discount that you're seeing in venture capital space.
Speaker 1 (19:49):
It sounds to me as if those critics of yours
after you published your book, they said, oh, Edward once
higher interest rates were rather right in that while you
may not have actively wanted there to be dislocations in
the economy as a result of rais rising, it certainly
will bring us back to a position where capital we
(20:09):
will be correctly allocated and where the sectors and companies
has been incorrectly allocated, will disappear, So it really can
only be seen as a good thing. And we used
to say, yeah, carry on, well.
Speaker 2 (20:24):
Look, I mean, alcoholics shouldn't be drinking a bottle of
whiskey a day. But it's it turns out that if
you take a bottle of whiskey away from an alcoholic,
you can actually kill them. I mean, in other words,
coming off an addiction is a dangerous and fraught process.
(20:44):
And yes, it would have been ideal not to be
an alcoholague. It'd be ideal not to have you know,
you know, live in a world and where assets are
over valued, capital is misallocated, people are saving too little,
and future atts on investments again to disappoint, but that's
the world, the world we live in, and the question
(21:06):
is how do you get out of that world? My
and I don't think people understand that this process is
extremely fraught, and we'll also take a long time. You know,
we could say the progress from too low interest rates,
we might you know, it was almost a twenty five
(21:26):
year process. You could say that perhaps long term capital
management blow up in ninety eight the Hedge Fund, when
the Fed responded by lowing rates and then we got
dot com bubble and then they lowered the interest rates further,
and we've got a real estate bubble and they lower
the interest rates ever further. So we've been this in
this twenty five year period of rates for coming down,
(21:53):
and that's in the context of a forty year period
of a ball market in bonds of ever a long
term interest rates. So I don't think this thing just
changes overnight. I think that the impact of the higher
interest rates takes a while to feed through. And you
(22:16):
can see this, for instance, in people what does take
people's take housing for instance, in this country, a lot
of mortgages around two to three year fixes, and it
takes a while for those fixes to come off on
floating rates. In the US, it takes even longer because
people borrow on long with long dated mortgages, so that
(22:42):
takes really a long time for the impact of higher
interest rates to feed through. It's likewise the case for
corporate boring or you know, in the area of very
low interest rates. So it's a great inducement, as you know,
for companies to take on more debt, which they could
either use to buy back their shares or to buy
(23:05):
other companies, and a lot of that debt would be
termed out, so they wouldn't they wouldn't have to as
interest rates rise in the short term it doesn't affect
their cash flow. But that doesn't that's only a relatively
temporary basis. I was talking the other day to a
(23:26):
European telecoms company that had I think around sort of
fifty billion euros of debt and about I think it
had a billion dollars of billion euros of free cash flow,
but its loans were termed out for three or four years.
It wasn't going to be an immediate problem, but at
the current interest rates, that business was going to run
(23:48):
into extreme problems if it was going to have to
refinance at the market rates of interest rates that we've
seen this year.
Speaker 1 (23:57):
And then on the other hand, you have some companies
and even these day technology companies that have huge ants
of cash on their balance sheet and with interest rates
knocking around four five percent, that's a rather nice little
boost for them. It goes both ways.
Speaker 2 (24:11):
I did you see a chart that Albert Edwards SoC
Gen showed a couple of months ago where he was
He showed chart saying that actually the net interest income
of US corporations had actually risen year today and as
a result of the cash, you know, earning more. I
think the trouble with that type of analysis is that
(24:35):
Apple may have a lot of cash, but someone else
has a lot of debts. So if one looks at
these things inaggregate, everything might look better than it actually is.
If you remember marrying before the global credit crisis, everyone
said credit doesn't matter. One man's debt is another person's asset. Well,
it just didn't really work out like that because one
(24:56):
person's one person's asset was not The person who was
in debt couldn't actually afford to pay the debt, and
therefore that wasn't particularly good for the other person's assets.
So you have to be slightly careful with this aggregate analysis.
Speaker 1 (25:10):
Fair enough, So take all that together, what do you
see from here a sort of slow burn misery for
a decade as we work our way out of this,
or a crisis of some kind.
Speaker 2 (25:23):
I don't want to sort of cop out, but one
thing I would say is that the crisis that we
have been experiencing over the last twenty five years are
becoming analytically more complex. For instance, again go back to
the dot com bust was pretty simple. You really had
(25:44):
to be done not to understand how that was coming
and how to analyze it. I think the credit crisis,
global financial crisis was much more complicated, with the structured
credit and problems in subprime collactualized debt obligations. I think
the problem that we have today is not so much
(26:07):
complex financial structures, but the fact that the low interest
rates that prevailed for so long had such wide effects.
I cite in the book the Harvard economist Jeremy Stein,
who was a briefly of FED governor. He says that
interest rates get into all the cracks. And I like
(26:30):
that comment because it should be telling you that the
problems created by the very low interest rates have got
into a whole load of cracks, some of which will
be pretty obvious. I mean, so for instance, take for instance,
just a specuative boom in SPACs and so on. There
(26:50):
was an amusing comment by the spacing chammer if you
remember him, and he said the other day the trouble
with rising interest rates is it renders your business valueless. Well, okay,
if you have an inherently valueless business, yes, the rising
interest rates exposed So we've seen the sort of we
(27:14):
saw the blow off in hyperspecutive stocks. Okay, pretty easy,
pretty obvious. But then, for instance, we knew that the
bond prices were elevated, that yields were negative, and it
wasn't tremendous surprise that long dated bonds suffered a lot
over the last couple of years. However, I didn't know,
(27:37):
and I don't know if you knew in advance that,
for instance, the UK pension funds had leveraged up their
holdings of fifty year UK index linked bonds and negative
yields and they'd levered them up five six times. Now
that that blew up in September of last year, but
it wasn't that was what I thought interesting about that
(27:58):
was we knew there was a entran problem were caused
by the ultra low interest rates, and how this inflated
their liabilities, and how they had to hedge it. You
didn't know. I wasn't quite sure what they'd done about
it until after the facts. I wasn't anticipating to blow up,
and in fact, actually a lot of as we you know,
you and I know some of the investors who were
(28:20):
caught on the wrong side of that trade so it
wasn't anticipated, even by quite smart people. The question is
to where we are going forward. Some obvious problems obviously
ones reading about problems with commercial real estate and that
would make people working from home and so on, that
you can see that commercial real estate is going to
(28:41):
be in trouble. I don't know. Take for instance, the
problems at the regional banks earlier this year with Silicon
Valley Bank going down and a couple of other big
banks going down. Now you'd have thought that, you know,
one's taught that higher interest rates are good for banks
because they gives them a steeper yield curve so that
(29:04):
they borrow short and lend long and they make money.
In fact, actually in this case the banks had borrowed
short and then they from their depositors and then had
bought medium term debt and had capital losses. So there
was a problem that one wasn't necessary immediately anticipating. And
then you know, there's for instance, with a banking system,
(29:26):
the banks, as you know around the world, sitting on
massive excess reserves. They have massive deposits, with the central
banks having served as a conduit for selling all those
bonds during quantitative easing. Now I don't quite know what's
going to happen to those excess with US. I don't
think the taxpayers at the moment are paying interest on
(29:48):
There is this whether that actually leads to problems for
the banks, whether where the governments around the world become
reluctant to pay it. So again, so as a question
mark would hold it to my mind, is over the
entire banking system. Then we've got China. The problems with
real estate in China pretty obvious with China's realistic and
(30:12):
I've been banging on about China's real estate bubble for
at least well thirteen years and the same it was
a bubble that went on and on and on and
got bigger and bigger and big and it's been blowing
off the last couple of years. And we've seen you know,
Evergrand go down and then Country Garden the biggest developers.
(30:33):
But we don't really know the long term outcome of
the higher interest rates and bringing and how and what's
going to happen to China's real estate and China's economy
and financial system. I mean, one, you know, one outcome
that I've thought possible was that China's currency would sort
(30:57):
of blow at some stage, but it or crack. Let's
say that. But I mean that's one potential outcome. But
I think there will be you know, there definitely be
problems coming from China over the coming years. I would
thought the Chinese are very good, will have been very
good at hiding debts within the system. But I don't
(31:19):
think that process it can go on forever. So that's
you know, that's there's then you've got residential real estate
that's taking I mean taking the UK for instance, it's
taking a while to come down. You know, the benign
situation there is for you know, the nominal price to
(31:42):
house prices to rain more or less level, but with
inflation eroding the value. But you know, also potential for
a crack. So i'd say that you know that there
are a whole load of areas that one, you know,
one has to analytically worry about.
Speaker 1 (32:03):
Okay, I'm going to put that down as an I
don't know, but not so scary stuff out there. There's
an answer to the original question. Yeah, Now, let's get
that fair. We're worried. That's not fair.
Speaker 2 (32:16):
That's fair. That's fair.
Speaker 1 (32:18):
I'm sorry, that's fair.
Speaker 2 (32:20):
I'm saying the problem is too complex for any individual
analyst to get their head around. It's a global problem,
and the problem and the low interest rates have got
into all the cracks and those problems because prices take
asset prices take a while to turn and take in
(32:42):
private acuity and venture capital. And because interest rates people
who borrowed fixed for a short time, that the impact
of the interest rates isn't felt immediately, either for home
buyers or for corporations. It's going to take a while
to feed through.
Speaker 1 (33:00):
Okay, Edward, right back at the beginning, you said you
wanted to come back to interest rates as a lever
to control inflation. You have something you wanted to say
on that.
Speaker 2 (33:09):
Yes, so it's actually something. It's something I didn't actually
write much about in the book. I think because it's
the one area that the central banks seem to understand
about interests that you can have You can use interest
to control inflation by putting up the interest rate. And
(33:36):
I'm actually coming to the view that this of the
various functions of interest, that actually using the interest rate
as a leader to control inflation is the least it's
the least reliable of the functions of interests. It's pretty obvious.
If you take down the discount rate, you're going to
have higher valuations. It's just sort of pretty obvious. Now,
(33:59):
the trust is a cost of doing business, and if
you push up the interest rate, you actually push up
people's cost of doing business. And for instance, if you
and if you're a worker and you've got a mortgage
and your mortgage cost cup, then you actually need a
pay rise in order to pay your higher mortgage costs.
(34:22):
So in that sense, actually the rising interest rates has
a perversely an inflationary effect. And you see this, I
think you see this where you landlords putting up rents
having faced higher mortgage payments, or farmers who heavily leverage
(34:43):
having to charge more for their food and so on.
Then there is this. If you want to get more
technical theoretical, there's a guy at Stamford called have you
come across him called John Cochrane who has something which
he calls the fiscal theory of the price level across Not.
Speaker 1 (35:03):
Yes, but now I'm going to go and have to
go and look it up and put it in the
show notes.
Speaker 2 (35:07):
I mean, it's ridly theory of.
Speaker 1 (35:09):
The price cycle. Sorry, listeners, this is what we have
to do.
Speaker 2 (35:13):
Yeeah cockrid. It's written eight hundred He's written eight hundred
page book on the subject of which you know most
of it is equations, says sort of over my head. However,
I think I understand his The basic insight, which is
it is that in a world with in a modern
world of fear currencies and so on, governments do not
(35:37):
go bust and instead they inflate away their debt. Okay,
you accept that if you have lower interest rates, the
debt becomes more sustainable, and therefore you'll have less fiscal
incentive to get to inflate away or debt. However, when
you have higher interest rates, then the debt is less sustainable.
(36:00):
Therefore it's technically more insolvent, and as it becomes closer
to the insolvency, you get more inflation to pay it off,
and that the thing that makes sense. The other thing
that it's quite interesting is if you have Although it's
true that lower interest rates made the debt more sustainable,
(36:21):
of course the politicians couldn't resist the impulse to take
on more debts. So you had, particularly during the sort
of COVID period, you had this massive increase in government
debt induced by the very low interest rates. I think
you and I spoke what three years ago about the
whole lockdown thing, and my view was that lockdown simply
(36:43):
wouldn't have happened had there not been such cheap financing
of government debt at the time. For instance, in the UK,
the Bank of England was buying up, in effect, all
of the bonds that the that the British government were
issuing and charging fifteen basis points for it.
Speaker 1 (37:06):
Without that, all the business of lockdowns and furlough and
helped to buy, helped to eat, whether they were called
eat out to help out, etcetera. Now that would have
been possible without super low interest rates, would it?
Speaker 2 (37:17):
I mean no, it wouldn't have been done because people
would have people would have thought twice. The trouble back
then is there was no thinking twice about what they
were doing. But where are we now? I saw some
data at the cost of government debt financing in the
developed world has almost doubled in the last year. I
(37:37):
think the American cost of debt servicing is running at
about fifteen percent of expenditures. British debt is you know,
so you can see that the governments themselves even if
we had didn't have any of these other concerns. We
can see that the governments again to have huge problems
(37:57):
financing their debts, having got into such having splurged so much,
and that gives them an incentive to keep interest rates
below where they ought to be in order to control inflation.
In other words, for all this talk of getting inflation down, there,
there isn't at some higher level a you know, a
(38:19):
strong incentive to do it. There's a much stronger I'm
sure you are too. I'm in the Russell Napier camp
of financial repression that interest rates will be below the
cost of the level of inflation and the debt will
be burnt off that way. And if financial repression it
can be quite in theory, it could be quite smooth.
(38:40):
And you and I know Russell. Rus Russell thinks that
it's very bullish for equities, and it probably is. Is
keeping interest below the inflation it probably helps it, you know,
it probably does help equities. I'm just concerned that just
moving nominal rates, even if they're negative in real time
of very low levels, will cause a few more hiccups.
(39:04):
And people are expecting all.
Speaker 1 (39:06):
We do now right now, we're in a very unusual
period in the UK where the interest rate is actually
above the ratio inflation stick. Come on in it cause
account today and you can for a very short period
only actually make a real return.
Speaker 2 (39:19):
Yep.
Speaker 1 (39:20):
That you know, take what you can get when you
can get it, and right now you're going to have
a real returnal They possibly not have.
Speaker 2 (39:25):
To tell Marion that I am put out a paper
on historical experiences of inflation going back years and they
one of the points they make there that inflation tends
to remain persistent in countries that they describe as having
premature celebrations. The premature celebration is when you think you've
(39:50):
got inflation under control, and you haven't quite got it
under control, say it bounces back. And that's really the
experience of the seventies where a lot of premature I
think we had three inflation cycles. If you go from
the late sixties, late sixties, mid seventies and then late
seventies is three inflation peaks, and in between you get
(40:12):
these premential celebrations. From what we've talked about already, you
can see this huge interest in keeping interest rates low,
so they will leave at any use to cut rates,
and therefore if the past was any guide, it wouldn't
be entirely surprising. If I'm plating with the bounced back.
Speaker 1 (40:30):
Yeah, and that we can say, going back to Russell Napier,
and this is very bullish for equities. Might give us
some positive news that we may see a return to
making good returns in the equity markets, even though it
might not be fully justified by valuations.
Speaker 2 (40:46):
Well, you know, when you're talking to Jeremy Grantham, as
he says, the US market is very very overvalued and
aggregate and therefore one would expect, you know, for me
that I'm a bit surprised at how strong it's remained.
And as Jeremy was saying, this bit of a sort
of AI bubble this year that has kept up the tech,
(41:09):
the big tech names. But I would expect the US
to have disappointing returns or possibly no returns.
Speaker 1 (41:18):
If we look at the US market, if we look
at all markets, but in particularly if we look at
the US market on an equal weighted basis as opposed
to a market cat weighted basis, so we do the
indices differently, it doesn't look nearly as overvalued as it does.
If you did on a market cap basis, right, So
if you effectively equal weight the astonishing performance of the
Big seven, it looks a little different, I think. So.
Speaker 2 (41:43):
I haven't been looking at recently, but in my old firm, GMO,
they will do forecasts for you know, US value and
this and that, and I don't I think that you
get much more attractive valuations outside the United States. I mean,
you you typed.
Speaker 1 (41:59):
You you came Japan, and you've been counting Japan recently.
Tell us about that quickly.
Speaker 2 (42:06):
So I've long been a japan bull.
Speaker 1 (42:12):
Yeah, that's me too. It's been a tough gig, hasn't
It been a long time Japan bull. But we're finally
getting our awards, I think. Yeah.
Speaker 2 (42:19):
I mean, actually you saw the piece I wrote. In fact,
since twenty ten, Japanese equities have returned seven point three
percent reel. I mean that's part more more than the
average long term returns to the US top market, and
really a return of you know, back to the returns
that Japan used to deliver before the the you know,
(42:45):
the end of the bubble economy in nineteen ninety. So
I think you know that some of the headwinds for
Japan were high valuations, and then this period of deflation
and deleveraging that hurt Japanese margins and return on equity.
And I think that was over ten years ago. So
that was our reason for being bullish ten twelve years ago,
(43:08):
and that's been more than vindicated. Let's say, however, one
of the problems, if you remember of Japan, of investing
in Japanese equities is that there were all these companies
that looked cheap, in particularly these so called net nets,
the companies that market cap was below the cash and
working capital. And these are the businesses that sort of
(43:30):
Ben Graham's of this world wanted to own, and then
they would go along, they'd buy Japanese companies netnets and
find that you couldn't you go to the company and say, look,
you've got much more too much cash from your ban sheet.
You've got these divisions that are not earning any capital
and not caught, not earning a return on capital, and
they're not caught your business. When you get rid of
(43:52):
them and the management, we just look at them and
you tell them to go away. And now that is changing.
And that's what I wrote about recently, and actually I
visited Japan a few times, just over ten years ago
with a colleague of mine who was a Japan expert.
He was very against Western activism in Japan. He thought
(44:13):
that they, you know that these Americans who rived in
Japan took a stake in a company and then banged
their fists on the table were doing it all wrong.
And and the firms that did that in the early
two thousands, it was one American company called Steel Partners.
They were rebuffed and they had disappointing returns. But now
my former colleague Toby Rhodes, who has a small cap
(44:39):
Japan business, he says that now the situation completely changed.
He for instance, has been made a or nominated to
be an independent director of a company in which he
has an investment. There is there are you know, we've
seen the beginning of hostile takeovers in Japan, and you've
(45:00):
seen the Tokyo Stock Exchange has told companies whose market
cap is below their book value, which roughly half the
companies listed in Tokyo are priced at below book These
companies have been told to come up with a plan
to get their market cap above book. Now, the Ministry
(45:24):
for Economy, Trade and Industry METI wants Japanese companies to consolidate,
and in order to dry this consolidation, it wants shareholders
to push companies to get rid of poorly performing divisions
and to merge. And I think that so obviously Japan
it's not the market is not as cheap as it
(45:46):
was when it was you know, roughly almost a third
of its current price twelve years ago. But now there's
potential for unlocking value in Japan, for activism and for
proper true value investing, as you probably know, requires activism.
That's what Ben Graham, who was the father of value investment,
(46:07):
he was an activist investor. And I think that now
activism is coming to Japan with the support of the authorities.
That is a major change and gives a prospect for
really decent returns from Japan going forward.
Speaker 1 (46:23):
Excellently.
Speaker 2 (46:24):
See your final question, are you ready?
Speaker 1 (46:27):
I have to because are you ready? Course you are,
and you know the answer. I have to ask everybody
this one. Okay, if I were to make you give
me all your money and lock it, lock it away
for ten years, and I told you that I can
put it for you into either a deposit account in
the UK and interest paying deposit account in the UK,
gold or bitcoin? Which would you choose?
Speaker 2 (46:53):
You know, the answer trick question.
Speaker 1 (46:56):
It's not a trick question.
Speaker 2 (46:58):
I would say. I would say because we've taught that
we expect financial oppression on deposits to hurt, and you
think bitcoin is a sort of bubble acid and you
know there's a reasonable chance if we get financial oppression
you'll get a gold bubble, as we did in the
in seventy nine eighty, in which case gold would be
(47:21):
out that ten thousand dollars. Now it's and one have
done very well, but you know I would have that.
Speaker 1 (47:28):
I've been a gold bug for so long. Wouldn't it
be nice if suddenly we had a proper gold bubble
and we'd be vindicated in it in our affection for
gold edvar Thank you so much. I think you know
you've given all the answers that I really like. By
Japhan by gold, I mean, this is fantastic. Thank you
so much. Thanks for listening to this week's Merin Talks Money.
(47:51):
We're off next week. We're back the week after. Catch
our debrief on this week's conversation on the Merin Talks Money.
After showing our normal feed and it is free to everybody,
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course please do tell your friends about this podcast. This
(48:13):
episode was hosted by me and marenzumsep Web. It was
produced by Somesadi, additional editing by Blake Maples Becial thanks
to Edward Chancellor and as ever to John Stepic. Please
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The link is in the show notes
Host
Merryn Somerset Webb
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If you've ever wanted to know about champagne, satanism, the Stonewall Uprising, chaos theory, LSD, El Nino, true crime and Rosa Parks, then look no further. Josh and Chuck have you covered.
Dateline NBC
Current and classic episodes, featuring compelling true-crime mysteries, powerful documentaries and in-depth investigations. Follow now to get the latest episodes of Dateline NBC completely free, or subscribe to Dateline Premium for ad-free listening and exclusive bonus content: DatelinePremium.com
On Purpose with Jay Shetty
I’m Jay Shetty host of On Purpose the worlds #1 Mental Health podcast and I’m so grateful you found us. I started this podcast 5 years ago to invite you into conversations and workshops that are designed to help make you happier, healthier and more healed. I believe that when you (yes you) feel seen, heard and understood you’re able to deal with relationship struggles, work challenges and life’s ups and downs with more ease and grace. I interview experts, celebrities, thought leaders and athletes so that we can grow our mindset, build better habits and uncover a side of them we’ve never seen before. New episodes every Monday and Friday. Your support means the world to me and I don’t take it for granted — click the follow button and leave a review to help us spread the love with On Purpose. I can’t wait for you to listen to your first or 500th episode!