Making bold pronouncements about the direction of the business environment is something economists everywhere like to do. But economist A. Gary Shilling, unlike most of his contemporaries, has been right about a great many of his predictions over the last 40 years. Like when he correctly anticipated the end of the high-inflation environment of the 1970s. Investors who believed Shilling and bought into 30-Year Treasuries at the time would have secured a rock-solid, virtually risk-free bond that paid a better average return than the S&P 500 over that period.
It’s an example of why keeping the big picture in mind is important to investors of all stripes. For all of the detailed research one can do on an individual stock or index, broad changes in the economies at home and abroad can ultimately play a big role in the success or failure of any investment.
Equities.com got a chance to sit down with Gary Shilling at the Strategic Investment Conference 2014 in San Diego and talked to him about some of the important global trends that could affect the American economy.
EQ: So to start, you recently wrote a three-part piece for Bloomberg about deflation in Europe. Are we staring down the barrel of a deflationary euro?
Gary Shilling: Mario Draghi, the head of The European Central Bank, came out and said what I was predicting, that they are going to trash the euro because they see it as a promoter of deflation, of which they are scared stiff.
EQ: What sort of actions might he take to avoid a crisis?
Shilling: Well, in July of 2012 he said he would do whatever was necessary to protect the euro. He got himself out on a limb because, in that instance, he actually didn't do anything. The words alone were enough to convince markets. Now, I think Draghi has got his mouth out there a country mile and, this time, he’s really got to put some meat behind it, to mix a metaphor.
So what can they do? A couple of things. One is they can further reduce their overnight reference rate, which is now 25 basis points. They could knock that down to zero.
The second thing is that they can charge member banks for leaving money at the European Central Bank (ECB). Right now, they pay zero, but they can reduce that to negative territory. In other words, they can say to banks “you have to pay 50 basis points to leave the money here,” which encourages banks to lend the money.
They can also get involved in so-called quantitative easing (QE), go out and simply buy various forms of securities, but it’s not as easy for them as it is for the Fed because there’s 18 member countries in the ECB. They don’t just go out and buy Treasuries, they have to think of 18 different issues of government papers.
They say they’re going to do something in early June unless things change dramatically, but they are clearly concerned about deflation.
EQ: How do you think these developments in Europe might affect the American economy and, specifically, American equities markets?
Shilling: In a couple of ways. One is through the currency. If we have a stronger currency, then American companies have currency-translation losses. Their earnings in euro terms, through exports or operations within the eurozone, translate into fewer U.S. dollars.
The second effect is more subtle, and it really has to do with a string of competitive devaluations. When domestic economies are weak, the urge is to increase exports. You don’t have domestic demand, so let’s let foreigners fill the gap by demanding more of our exports. Well, how do you do that? How do you make exports cheaper? Because everybody wants to export, nobody wants to import.
There are various ways, though. For example in Greece they've had what’s called internal devaluation. Their labor costs are about a third what they were before the crisis started, they’ve simply fallen because their economy’s so weak. Because they’re a member of the eurozone, there's no Greek Drachma that they can depreciate anymore, so they've got to do it internally.
Another example is France. France put on a scheme, which the Germans invented, where they simply cut corporate taxes. The idea was to lower costs and therefore lower their export prices to get more exports. And, at the same time, they offset that with a higher value-added tax. Now with the value-added tax, you can add on to import costs, which raises the price of imports making them less attractive, and subtract it from exports, making them cheaper for foreigners. So they get a triple-whammy there.
Then there’s explicit currency devaluations, that's what we seen in Japan where the government of Prime Minister Abe is deliberately trashing the yen. We may see that in the ECB, now, we see that in South Korea. The Chinese, of course, are manipulating their currency. They’re trying to drive out speculators, but they're making it weaker in the process.
The risk is that if you get into this pattern of competitive devaluations, which means nobody really wins because it offsets. I think that most countries end up devaluing their currency against the dollar. But how can the dollar devalue? The greenback is the reserve currency, there’s nothing to devalue against.
This works to the disadvantage of U.S.-based companies in terms of the currency translation losses, but also with these competitive devaluations. They tend to offset, and the net effect is lower economic growth all the way around. It actually ends up reducing everybody's exports, because exports go down when your trading partners’ economies suffer. They don’t demand as much of everything, including your exports.
So I think that's the risk. It’s a little more subtle and down the road. But the translation losses are fairly direct.
EQ: Should there be concern about where emerging markets and emerging-market companies are headed in the future if there's going be a pullback in European and American economic growth?
Shilling: They all face the headwinds from a lack of strong export demand. Because these countries, whether they're in Asia or Latin America or Eastern Europe, they depend on exports for growth. And where do those exports go? They go to Western Europe and North America. If you’ve got slow growth in both those areas, growth in demand for everything is weaker. And that's why the Chinese, for example, are trying to convert from an export economy to more of a domestic-driven economy.
But then within the developing countries, you have specific differentiations between them. And some of these countries are very well-managed, like South Korea or Malaysia. They tend to have a current account surplus. This means that the internal savings by business, consumers, and government all combined exceeds domestic investment. Now, if saving exceeds investment, what do you do to with the excess? You export it.
If a country’s exporting capital and then the hot money that’s rushing in and out of these countries leaves, it means the current account surplus is going to be less, but they’re still going to be exporting capital. They’re not going to be in a troubled condition. And those well-managed countries that tend to have current account surpluses also tend to have stable currencies, low inflation rates, and stock markets that have been stable in the last decade and low interest rates.
You can differentiate those from the mismanaged countries like Brazil, India, Argentina, and Venezuela. These countries have big current account deficits, weak stock prices, very weak currencies, and a lot of internal and external problems. If they have a current account deficit, in particular, it’s trouble if hot money flows out, as has been happening in last year since the Fed started talking about tapering their purchases of securities.
When you see that hot money rushing out and you're already running a deficit, the question is: what do you do? How do you cover the remittance of people who want to take their money out? They can jack up interest rates to try to make it more attractive, but higher interest rates curtail economic growth, which is already low enough. Or they, like Argentina and Venezuela, slap on currency controls. They simply say "You can’t take the money out." But that, of course, doesn’t induce people to want to come back for a very long time.
You have this differentiation in emerging market countries. I call the well-managed ones “sheep” and the poorly-manage ones “goats.” So I think you have both the headwinds of slow growth in demand for exports, which is what drives all of these economies, and then, on top of that, the differentiation between the well-managed sheep, with current account surpluses, and the goats, with poor management and current account deficits.
EQ: What do you think the near- and long-term future is for the American economy? Do you think that we're in for any sort of big move up or down in economic growth in the next few years?
Shilling: We’re in what I call the Age of Deleveraging. My book from 2010, The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation, is about this.
This global deleveraging, or working off of excess debt, normally takes about 10 years, that's the historical average. We’re six years into this, so another four years of slow growth could be expected. As a matter of fact, at the rate the deleveraging is taking place now, it will probably take longer than that.
And if that’s another three of four years, we'll probably have the Fed and other central banks maintain essentially zero short-term interest rates for that period. All the attempts thus far to revive rapid growth with fiscal and monetary ease have not worked, and that shows the power of this deleveraging. But beyond that, I think we’re going to see the resumption of rapid growth. That’s what I talked about at this year’s Strategic Investment Conference (SIC).
I call this “theory follows fact.” When fact continues for long enough, the theories come out of the woodwork as to why it's going to last forever. Of course, it’s very easy to sell “slow growth forever” when investors see it happening before their very eyes. People will say "Hey, right on brother, I see that right in front of me."
But I think we are going to see resumption of rapid economic growth. We're going have a return to rapid productivity growth. We have a lot of new technologies: biotech, robotics, additive manufacturing etc. that more in their infancy than they are fully developed. And they're going to drive productivity, and we’re probably going to have a lot of people come back into the labor force, a lot of people have dropped out because they couldn’t find jobs. I think we're going to reform our education system to orient more toward where the jobs are and less toward people taking a soft major in college and just assuming that because they got a college degree from Podunk University they deserve a job.
I think there’s going to be a lot of very favorable developments.
