Omaha 2014: Quantitative Easing end game – a return to double digit Inflation?
I have asked any number of economists to explain the end game for the US Fed's Quantitative Easing. Most offered a vague response that America would muddle through. The more honest admitted we're in unchartered waters so nobody really knows how things will work out. At the Value Investor's conference in Omaha on Friday, we were treated to the most rational explanation I've heard from Arnold van den Berg, founder of leading US investment firm Century Management. He outlined three possible scenarios – the most likely of which was a return to the 1970s where, after an eight year build-up of excessive money creation, inflation took hold. I asked leading SA fund manager Kokkie Kooyman of SIM Global to share what he got from the presentation – and the chat he had with Van den Berg afterwards. – AH
ALEC HOGG: Well, we just finished the Value Investors' Conference, Kokkie. There was a gentleman from the Netherlands.
KOKKIE KOOYMAN: Yes, Albert van der Berg.
ALEC HOGG: He had a very American accent. Did he speak your old language much?
KOKKIE KOOYMAN: I chatted to him afterwards. He's originally Dutch. His parents emigrated after the Second World War en hij kan nog Nederlands spreken.
ALEC HOGG: Even I can understand that. What he was talking about was a lot more complicated than just the fact that he can speak Dutch.
KOKKIE KOOYMAN: He gave a fascinating presentation, obviously more directed at the U.S. in terms of how quantitative easing could end, and it could end disastrously. He's of the opinion that in the end, it results in massive inflation. He used Japan as an example as well that showed that when Japan tried quantitative easing in the past, it led to an explosion in the monetary base, which led to a huge fall in the currency and a fall in the market. What's interesting now is I asked him about Japan now, and they seem to be making the same mistake again for the second time.
ALEC HOGG: So it's almost as though they were hit from the one side 15 years ago and they appear to be compounding that mistake.
KOKKIE KOOYMAN: Yes, much of it has to do with politics. The current Prime Minister…this is the ticket he was elected on to teach and to grow again, and the only way he could get it to grow is by getting the currency to fall. You therefore stimulate export and you get some inflation going. Japanese consumers have not been spending because in a deflationary environment, you don't spend your money. You just sit on it. If he gets inflation going, people spend. However, that's a theory, and if you look at the banking system… Think of banks in two parts. Half of their assets are invested in government bonds and the other half is banking where they take deposits and lend it out. On the banking itself, it actually loses money. The banks lose money. It's a loss-making operation because the margins are extremely narrow. Putting all of that together, if indeed the Japanese Yen goes and inflation starts going up in Japan, interest rates then have to follow – similar to what might happen in the U.S. later – the banks have such big holdings in Japanese government bonds, that those bonds then have to be marked to market and the banks go bankrupt.
ALEC HOGG: But that's a very risky situation. Have you got out of all your Japanese banking…?
KOKKIE KOOYMAN: We have nothing in Japan.
ALEC HOGG: But there are still South African companies, for example, Alan Gray and Coronation have big Japanese holdings. Are they reading it differently?
KOKKIE KOOYMAN: They must be. Look, if you're an exporter then obviously, it's different. For example, with Toyota most of the manufacturing is done outside of Japan, so it's not really a Japanese company anymore. However, your banking system is highly suspect, so I think any companies in Japan…I would let companies invest in Japan, depending on the Japanese consumer.
ALEC HOGG: How have the Japanese banks' share prices been going on?
KOKKIE KOOYMAN: They did exceptionally well last year when he started his easing because initially, interest rates going up for banks is good because your margins open up a bit, but this year they've been horrible again. They just got decimated.
ALEC HOGG: He's not the only one thinking this way.
KOKKIE KOOYMAN: There must be other investors who are starting to see this.
ALEC HOGG: But what was interesting was that he raised the question of inflation. Now, any logical individual's going to say 'if you're going to create a lot of money, you will have inflation', but no one else seems to be talking about it.
KOKKIE KOOYMAN: It's because everywhere in the world… I've been seing some of the U.S. banks so far… The inflationary pressures are not coming through yet. Generally, large companies are still rationalising staff. Loan growth is still very low. You therefore don't see inflationary pressures, but both John Malden and van der Berg said as well that their build-up is still there. They believe the build-up is coming. It takes time.
ALEC HOGG: It's like a lag effect.
KOKKIE KOOYMAN: When inflation does come through, they reckon, in the previous time in the seventies, in two years America went from – I think he said two-point-five percent – to twelve percent inflation within two years, and that's the potential.
ALEC HOGG: There's a risk that it could happen again.
KOKKIE KOOYMAN: There's a risk that it could happen again.
ALEC HOGG: Now, he said to us continuously, 'I'm not predicting this, but I'm telling you there's a risk'. Do you think he's hedging his bets?
KOKKIE KOOYMAN: No, the problem with his macro theories is that circumstances change. For instance, you were saying there's a high correlation between oil and gold, so during inflation times gold will go up, oil goes up, and commodity prices go up. However, the oil supply and demand situation is totally different from the seventies. Remember, in '74 we had the first oil shortage. Now, America is actually going to be oil-sufficient, will most probably be exporting oil and gas, so many of these things change. I think he's hedging his bets. He's just signalling a warning that we have to watch this. We have to watch the red flags or the poles etcetera for when you start seeing inflation come through, then be aware: this is what happens. If it starts coming through, it's going to go through quicker.
ALEC HOGG: From where you're sitting, he was talking about what happened in the 1970's. Clearly, a lot is different today. Do you think a repeat is possible?
KOKKIE KOOYMAN: I think there's at least a 30/40 percent possibility.
ALEC HOGG: So how do you position yourself for that?
KOKKIE KOOYMAN: What we are doing is…well, generally, we don't look at macro, but you have to be aware of that. You have to make sure you're invested in companies with low debt levels. In addition, you make sure that if they do have debt that the payment profile is not very far into the future. As inflation goes up and interest rates rocket, you're then sitting in a company that has big debt. We're making very sure that it's a company…as a moat in that sense, like a retailer can generally pass on inflationary pressures, so you don't want to be in companies that are tip-price takers. You wanted to be in countries as well, where the balance sheets are sound and where the country itself is not geared, too.
ALEC HOGG: That's broad.
KOKKIE KOOYMAN: That's broad.
ALEC HOGG: Be a bit more specific.
KOKKIE KOOYMAN: South Africa's in a bad position. India would be in a bad position if oil goes up, but your commodity producers…theoretically, Russia would actually be very good. Brazil would be very good – a producer of food and grain – so those prices tend to go up. That's why we actually are looking a lot at Brazil as one country. We're looking at Russia as well. It's actually very cheap now with all the problems. On company levels specifically, making sure for example, on the banking side – the U.S. bank or a very large conservative lending profile, and a very good funding profile: we're looking at those kinds of things.
ALEC HOGG: And the South African banks…
KOKKIE KOOYMAN: South Africa…Standard Bank would currently be best positioned because of the African exposure. They're simply the largest. They're still small in the lows, but Africa would actually benefit under such a scenario because your commodity prices would go up. Commodities tend to do well when your large currencies fall and if you get big inflation, so in that regard Standard Bank will do well. Good management like First Rand…they'd most likely sit and strategize, and be ahead of the curve, so you have to back management there as well.
ALEC HOGG: When you put it all together, there is a risk of 30 to 40 percent, that quantitative easing is going to have the result many people feared it would – higher inflation. If that happens, watch out South Africa, because the balance sheet of the country is not that great.
KOKKIE KOOYMAN: For South Africa it's going to be interesting, because the gold price might just rally.
ALEC HOGG: And platinum.
KOKKIE KOOYMAN: Quite correct, and then suddenly the Rand is strong because everybody would think generally, currency would fall. When that's the situation, maybe we'll just be saved by global inflation.
ALEC HOGG: We might just get lucky.
KOKKIE KOOYMAN: We might just get lucky.
ALEC HOGG: Thanks, Kokkie. It was a fascinating day…in fact; a day-and-a-half and we'll talk later.
KOKKIE KOOYMAN: It was well worth repeating.