Cash: A Safe Haven in Deflationary Times - Vivek Kaul's Diary
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Cash: A Safe Haven in Deflationary Times

Jun 16, 2016

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How scary is it getting out there? Fund managers increased their position in cash to the largest percentage since 2001, according to research published this week from Bank of America. There's a lot of fear in the air.

The subject of cash came up last week when my old mate Vern Gowdie joined me on the podcast. Vern took a radical position in cash several years ago. He did so while making an equally radical insight into how far stock prices could fall if debt deflation takes hold.

When we caught up last week, we talked about cash as an investment position. In a low and negative interest rate world, cash is becoming a fashionable position to hold - even for banks. It was reported last week that Commerzbank has begun hoarding cash in vaults rather than paying negative interest rates on excess reserves held at the European Central Bank.

It can all seem a bit bizarre and removed from your ordinary life, though. Vern boils it down to what it means for you, your family and your money. Enjoy the excerpt below. If you'd prefer to listen to all of the show, you can do so here.

VG: I am well, Dan. How are you?

DD: I'm good, yes.

VG: That's good. You look well.

DD: Thank you. I told Vern that it's probably just the black that's slimming. But what do you think of London? I mean, you're on the Gold Coast. You grew up there, you lived there, you retired there. But you're here in London for the summer with your wife. You've got a daughter that's here. What does it look like, financially? Just what are your observations, from walking around?

VG: Expensive. But that may be because we're staying in Chelsea, Sloane Square.

DD: Well, yes, that would be it.

VG: That could be it, but every second car's a Range Rover or a Porsche. And the real estate prices, I look in the window, and I have to keep doubling them for Australian dollar relevance, but you just go: I don't believe it, you know - £3 million for a little two-bedroom place, and it's six million Australian dollars. And you go: wow.

So it's part of that disconnect that you, you know, and then you read about what's happening in bond markets, where you know, Switzerland's doing 13 year bonds at zero, and then you have this asset price deflation on the other side of the equation, inflation, I mean.

Where you've got deflation, that seems to be happening in the broader European economy. But this asset price inflation. And it's just... I found where all the central banker money's gone, mate. It's gone into properties in Sloane Square.

DD: You know, it reminds me exactly of Australia, while I was there from, you know, between 2004 and 2015, that you have this huge influx of capital from overseas that is in to the local property market, partly as capital flight. So in Australia's case, a lot of it was Chinese capital.

Some of it was just a credit boom from the banks in Australia, or investors and negative gearing. But it does feel similar, to me, which is eerie, because - I'll let you tell this story, but Vern and I were talking before he came on. Vern published a book, late last year, in Australia called The End of Australia, which made a familiar argument to some of you who read The End of Britain argument.

But obviously, it was about Australia and Australia's financial conditions, which were unique in the 2000s with the commodities boom, and the credit boom, and the rise of China. But why don't you fill the listeners in about what that book was about, and why you think it resonated with the Australian public late last year, and then again, earlier this year.

VG: Earlier this year. I think it... well, it was about just the credit build up in the system, and where that's gone. And you can see it in Sydney, Melbourne property prices, you know, that they... I don't think to the extent of what London is, but people are just going: how are our children ever going to afford to get into this market?

And so it was really just detailing, or chronically, how, over the last 50 years, there's been this massive debt build up in the system that has, then, fed into the broader economy, which has given us this so called economic growth. But it's all been generated from the fact that people have been prepared to go deeper, and deeper, and deeper into debt.

And so... and now our government has, you know, we had a clean balance sheet. There was no debt there in 2007, and now we're rapidly adding to that with more debt accumulation, budget deficits, which is the story you see being played out around the world.

So I think it resonated with people because people just felt that something just wasn't right. That there was an artificiality to all this. And when the mining boom came off, you started to see those townships that were... the property prices were significantly increased because of that boom, were deflating.

So I think people just started to just pick up on the subtleties of what was happening around them, and I could put together the pieces of the puzzle for them, and show them how all this is being played out, and the fact that I don't think it's sustainable. You know, what we've had is just a phenomenal period in history, and it's a well said thing; it's been a debt and demographic phenomena.

And I wrote something in The Daily Reckoning in Australia earlier this week that... and quoting Bill Gross from Janus Capital, that basically, the last 40 years has been something, like a five or Six Sigma event, you know. And he said, the likelihood of this... it's more likely this event will be repeated on Mars than it will be on Earth.

DD: Yes, I saw that.

VG: Yes. It's just, you know. And then that, kind of, puts it into context. But we've come to believe this is some sort of... this is normal. But, in fact, in the history of financial markets, it's abnormal. So I think, probably giving that clarity to people read that. They instinctively knew, but yes, just putting some numbers down, and saying, hey.

And, to me, it's just going to be the end of Australia as we know it, that this credit growth and expected economic growth is not going to be there in the future. So start making some adjustments now, you know. Start trying to... if governments won't live within their means, how will households? Because that's what you'll be forced to do, at some point, whenever the reset button is hit.

DD: Yes. Well, I want to ask you about that, because I was writing about you today in Capital & Conflict, and I was giving the history of our business relationship. And I said, and I think this is the right word, I said that when we first met, and I asked you; all right, we can probably do a newsletter together, but what's your investment position? What are you going to tell people to do with your money?

And what you said at the time were that the correction in the market could be as large as 90% in stocks, and that it was 100% cash position. And I venture to say that now, people would take that more... most people would listen to that now, whereas at the time, they wouldn't have because of the idea of a debt deflation, where cash becomes more valuable.

And cash, as an investment position, becomes preferable to owning bonds. It just wasn't the case seven or eight months ago, but since then, you've launched that new newsletter. How are people reacting to that investment advice? And is that still the same investment advice you're giving to people, generally, right now?

VG: It is still the advice. In Australia, we were a little bit... when we first launched a couple of years ago, that other newsletter.

DD: It was that long ago, wasn't it?

VG: It was two or three years ago, yes, I think we spoke. We were still getting 4%, 4.5% for our money back then. So holding a cash position wasn't too onerous, you know. People were still getting a reasonable return, in comparison to the northern hemisphere, which was, you know, bumping along at zero, or thereabouts.

But as rates have come down, then that's been harder for people to hold on, if you're a retiree, as people in Britain, and Europe, and the US would know. Getting zero point something on your money, it's pretty hard to live on. You need a big pile. So it's testing people's patience, because the market correction started to happen last year, but then that was... that correction was corrected, and it went back.

And it got the wobbles again earlier this year. So that expected correction has not yet happened. But I still believe it will. Will it be to the extent of 90%? As I said at the time, mathematically, I can show you how that can happen. If you have a compression in P/E, and a reduction in earnings, then there is the mathematical case that markets could, in the US, compress by up to 90%.

Now, 90% sounds dramatic, but it's not without precedent. It has happened in the 30s, it's happened in Japan, and it's happened in the Nasdaq, in the early 2000s. So it's not a wild number I've plucked out of the air. Mathematically, I can prove it. So will it be to that extent? I don't know, but, you know, anything plus 50 is not good.

So because once you lose 50% of your money, you've got to make 100 to recover. So my argument is: why not step aside, wait for it to go that way, and then pick up the 100 on the way up. Rather than just to get back to square one, why not make one two, rather than half one, if you follow my logic?

So the cash is tough, but I don't think it's going to be as tough as, you know... When it happens, and if you go back to 2008, 2009, and I was in practise then as a financial planner, and you know, people were going... were shell shocked, you know. They just weren't expecting it. I expect the next one will be far, far worse.

So the psychology of that is going to be really tough to comprehend, and that's why I think it's just going to be... This is the lesser of all evils, and we're in a marketplace, in my opinion, where it's not he who makes the most, wins, it's he who loses the least, wins. And so yes, I'm not getting much return on our money, because the Australian interest rates have now come down to 1.75.

Which, again, I think I might have... part of my thesis at the time was that eventually, we'll see rates under 2%. And that's gradually happened. And I also took a position in US cash at the time, because the Australian dollar was about a 1.05 against the US dollar, and we're now 74.

So again, it was a cash position that has now paid off 30% something in value. So I haven't earned anything on the cash there, but for when I convert it back to Australian dollars. So there's still opportunities out there, but I just think it's basically still being cautious.

Because the market is overvalued by every measure I looked at, and you know, so yes, it can become more expensive, but that doesn't mean I've got to be stupid enough to chase it.

Please Note: This article was first published in Capital & Conflict on June 15, 2016.

Dan Denning studied literature and history, moving to Agora Financial in Baltimore fresh out of college. Working alongside Bill Bonner and Addison Wiggin, he became managing editor of Strategic Investments. He then moved via Paris and London to Australia, publishing a book - The Bull Hunter - along the way, and opened Agora's successful office Down Under. He returned to London in 2015 and became the publisher of Fleet Street Publications' financial newsletters.

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