American Economy | Bonds

Q: Give us the Big Picture.
A: My favorite subject. Today's version of the opium trade continues.

And China is the new Britain?
China is providing the West and the rest of the world with very low credit and very low interest rates, which is creating addiction in the form of borrowings and spending and leading to hallucinations in the form of asset prices. It seems to us this opium trade is going to last for a very long time, and it has implications on where we invest our money. The reason it is going to last so long is that U.S. corporations have a lot of leverage on politicians and on government decisions. They finance both political parties, and they're not strictly U.S. companies anymore, but global companies, and people tend to forget that. U.S. companies care about what is good for the global economy, not necessarily what is good for the U.S. economy.

The short electoral cycles in the U.S., in which every two years you have the full House up for re-election and one-third of the Senate being elected, exacerbates the problem. Everybody knows that monetary and fiscal policy takes about 12 to 18 months to have any affect on the economy and, while the opportunities are great for tactical decisions they are terrible for strategic decisions.

So give an example of how multinational companies, by embracing a more global outlook, have not served America well?
Look at profits as a percent of GDP [gross domestic product]. Historically, it averaged about 5.4%, but today it has almost doubled to about 10.2%, way above its previous peak at 7%. That's exhibit A. That's happened as U.S. corporations have moved jobs offshore and Congress has let certain policies go on longer and longer than maybe they should.

Yes, but what about the argument that companies are more efficient and more productive?
We are so efficient that we don't do anything anymore, that's how efficient we are. We are so efficient we beg the Chinese to buy something from us. We are so efficient that debt to GDP is above 200%. We are so efficient that we have a trade deficit that is 7% of GDP. Even Turkey would be ashamed of that.

OK, so what are the implications of this on how you invest?
At the end of the day, money management is a combination of dogmatism and pragmatism. While we wait for or thesis to be proved, we are also trying to protect our investors and trying to find places where we can make money without dramatically being affected by the global picture. The big questions for us when we look at the market involve inflation and the direction of equities, bond yields and currencies.

Inflation is something there should be no debate about and somehow there is. As the Bank of England observed recently, our core inflation number should include energy because energy is affected by demand from China. The same way China is exporting deflation to us by manufacturing goods more cheaply, it is importing inflation through its demand for commodities and energy. Core inflation should also include house prices and other asset prices, rather than just rental equivalents, as is done now. Again that would change the inflation picture dramatically. If you consider headline inflation and include asset prices instead of rental equivalents, the true inflation number would be between 7% and 10%. The question is: If real inflation is 7% to 10%, why don't we see it in wages?

That's been a big mystery. What's your answer?
The reason we don't see wage inflation is not just because of China, but more importantly, because people used their houses as ATM machines, basically refinancing their houses and withdrawing equity. If your wages are not enough to support your spending, your house bills or your education, but you manage to get an additional loan against your house and use that loan to refurbish your house or pay for your children's education, then you are not going to complain and you are not going to go on strike and you are not going to be militant because you are not being paid enough money. Wages, plus equity withdrawal from your house, was enough to support your living standard. Once that sort of financing dries up for the consumer, we will see significant wage pressure.

Yet, I've been hearing concerns about deflation.
Deflation is not going to happen for a very simple reason: Deflation is a tax on the poor. If you look at the typical balance sheet of a U.S. consumer, he or she is long houses and has big loans. Deflation will bring their house prices lower, and it will make it much more difficult to pay their debts. So they will get killed on both ends. It ain't going to happen. On the other hand, if inflationary prices are pursued, house prices will go up, at least nominally. making on your house and paying your debt will become easier because you have inflated debt. So far the bond market has not reacted to this reality.

But you expect it will?
Bond yields are very, very low. They are ridiculously priced, and the reason they are ridiculously priced is because the investors who decide the price are not driven by absolute returns. The biggest investors are the central bankers. Then there are the pension funds who need to match their liabilities. The funny part about these investors is that the lower they drive interest rates, the more bonds they need to invest in to cover their future liabilities. People should not be buying bonds.