Louis Gave, CEO of Gavekal Research, does not trust the recent recovery of stock markets. The economic damage caused by the pandemic is too great, he says. He is betting on gold, Asia and individual technology stocks.
Louis Gave chooses tough words for Western governments and central banks. They have underestimated the threat of the Covid-19 pandemic to the economy for far too long, and now they are trying by all means to prop up asset prices.
In an in-depth conversation, the founding partner of Gavekal Research explains why he believes the current recovery of equity markets is not sustainable. He also talks about the long-term consequences of this crisis and explains why he is buying gold, assets in Asia, technology stocks such as Amazon – and copper.
What do you make of the current stream of macro data and the behavior of financial markets?
If you're an investor, you don’t get any information from macro data today that you don’t already know. I mean, we know our economies have come to a standstill, because our governments have decided to shut them down. So GDP in the US or in Europe will maybe go down 20% or 30% or 40% this quarter. Frankly, what’s the difference? What’s more interesting is this: The S&P 500 is down about 15% from its all time high. This is the first time in my career that the S&P actually outperforms US GDP on the way down. If US GDP falls by 20%, you would expect the S&P to be down 50%, not 15%. That’s a huge difference between what macro data shows and what the market tells you.
What’s the reason for that difference?
Politics. The Fed has come out and has added $1.75 trillion into the financial system within a few weeks. So as investors we are stuck in this quandary. Do we follow the economic signals, which are pointing straight down? Or do we follow the old adage of not fighting the Fed?
Which one do we follow?
I don’t know. You don’t know which one to choose, because much about the situation we are facing is so unique. I think that increasingly, investors don’t want to make that choice, so they choose something that will do fine either way. That’s why they buy gold. We’ve seen gold breaking out pretty much against every currency. That brings me to an old Gavekal belief: Things have value for two reasons, either because they are productive, or because they are rare. Today, governments tell us to stay at home, while at the same time central banks are printing money like never before. In this environment, it’s pretty hard to be productive. So the money ends up flowing towards things that are rare.
Could it be that equity markets are just looking through the economic effects of the pandemic, and that next year all will be fine again?
Yes. Interestingly, if you look at the split within markets, you had the bigger rebound in the typical growth stocks, most notably in tech and healthcare. They were the ones winning before, and they are the ones leading the rebound. That would point to your scenario: This is a huge punch to the gut, but we will bounce back and it will all be fine again.
I struggle with that. The big question is how quickly do we bounce back? Look at China: China has been reopening for almost two months now, after their shutdown in February. All the signals we see say that China has managed to come back to about 80 or 90% of its pre-crisis level. That may sound impressive, but it still leaves you with a huge GDP drag.
What’s the reason for this drag?
One big hurdle in getting the economy up to speed again is the dislocation in supply chains. Say the Peugeot plant in Wuhan has opened up again, but it can’t get a crucial part from France. This is a result of the exponential optimization that has happened in our economies over the past twenty years. We have optimized everything; supply chains, balance sheets, portfolio construction. Every level in the capital system has been optimized. That works great as long as everything is humming along. It’s a bit like high performance athletes; they get injured pretty easily. Our economies are like super optimized athletes that have just received a big hit. How quickly can they be back on their feet? My fear is it will take longer than many market participants think. I’m not so optimistic that in a year’s time we’ll be back to normal.
If you don’t buy the idea of a quick recovery, would you say that equity markets had a bear market rally in the past four weeks that will prove to be unsustainable?
Yes, I think so. When I look at the stock market, given the huge economic hit we’ve taken, to be down 15% from the all-time high seems too little to me. Obviously we’re here because central banks and governments are doing everything they can to prop up asset prices, but I think that’s playing with fire. The message our political masters give us is not to invest money into projects that will generate future growth, jobs and profits in the way the capitalist system should work. Their message is repeated in every crisis: The system is rigged, we’re going to make sure that asset prices will never fall, and we’re just going to print more money. Over time, that’s a terrible message. It kills growth and productivity.
But still: It usually does not pay out to bet against the Fed.
That’s true. Basically, they are telling us that they will debase the currency, so as an investor, you just have to load up on real assets. To be clear: I’d rather own stocks today than cash or bonds. It’s just crazy that stock prices haven’t even corrected as much as the fall in GDP or the fall in corporate earnings.
So in effect, stocks have just gotten more expensive?
Yes, valuations were crazy high before this crisis started, and they are even higher now. During the rebound of the past weeks, it was the already expensive parts that rallied the most. The Amazons, the Googles, the Facebooks. The parts that were cheap, the cyclicals, the financials, they got crushed. The growth versus value trade has gone into overdrive. I think we’ll start to see a massive divergence within the growth sector. I would split companies between the ones that depend on the consumer and the ones that depend on corporate spending. The latter will struggle. Every corporate is out there tightening its belt. That could be bad news for Facebook and Google: I think we are going to rediscover that advertising is a cyclical business.
For a while in March it looked like there could be a big problem with corporate debt in the US. Has the Fed managed to defuse that bomb?
In the short term, yes. Not only have they come out to promise to buy BBB-rated corporate debt, but also bonds that get downgraded to junk. In essence, the Fed said: «Don’t worry about downgrades, we’ll cover you. Party on.» Of course, once you do this as a central bank, the first question is: How do you ever come out of this again? The second thing is this: You basically kill your banking system. If I am a BBB issuer in the US, and the Fed will buy my paper almost regardless, why would I ever go to a bank to borrow money again? Those are unintended consequences. They may have solved the immediate crisis, but they planted the seed for another problem down the road.
Since the oil price started dropping in early March, a wave of bankruptcies was to be expected among US oil exploration companies. Do you still see that coming?
Right now, it looks like the Trump Administration will just bail out this sector too. In doing so, Trump is actually prolonging the crisis in the oil sector. Everyone just keeps hanging on, waiting for a bailout. If I was a small exploration company in Texas, I should be knocking at the door of Exxon or Chevron, to get them to buy my assets. This is what the sector needs: consolidation on a massive scale. In 2010 to 2012, hundreds of billions of dollars, mostly from private equity, flowed into the sector. Production boomed, but in essence, it was just too much money in there. We need a downphase of the cycle, where assets move from weak hands into strong hands. Otherwise the returns in the sector will always be terrible. If the government comes in and says we don’t want consolidation, we will keep everybody alive, the US will increasingly look like Japan, with a bunch of zombie companies.
The oil market saw some turmoil last week, with prices for West Texas Intermediate going negative for the first time. What happened?
In the last minutes of trading on April 20th, the price for WTI for delivery in May moved to minus 40$. The WTI market, unlike Brent, does not allow for cash settlement, it needs physical settlement. The story we are being told is that physical storage in Cushing, Oklahoma, is full. But that’s not true. Storage levels in Cushing are nowhere near the levels of 2015/16. I think what happened was a good old fashioned bear raid. There was a lot of retail participation in that market, with a lot of money in funds that needed to roll over their futures contracts in order not to physically settle their contracts. I think some smart guys decided to squeeze those tourists. I ask myself whether we could see that again, but this time in gold and on the way up. We know that paper gold is many times bigger than physical gold supply. You could easily organize a bull raid in the gold market, where you force people to physically settle. That could create the same type of dislocation for a day or two, with the gold price going absolutely bananas.
We have seen huge dislocations in equity and credit markets in March, and now again in commodity markets. And yet, there has not been a «Lehman Moment». Do you still expect that?
You’re right. No dead whale has floated to the surface yet. I get it that the Fed is flooding the system with money, but there are still big losses somewhere in the system. Someone is holding the bag. You’d like to know who goes bust. At the bottom of every crisis, you can put a big name on your charts. Mexico, LTCM, Enron, Lehman. Here, we don’t have a big name yet. Who knows, maybe this is the first crisis in my career where I can’t put a name on my charts. It is absolutely amazing that we have the biggest economic shock since World War II, enormous dislocations, and not a single high-profile bankruptcy. I think that’s still to come.
Could it be that the whale will turn up in some emerging market? Or has the Fed defused that bomb as well, by providing Dollar liquidity to everyone?
Some of the weaker emerging markets, like South Africa, Turkey or Argentina, are struggling. Now of course, Argentina did go bust. But nobody really cares about a default of Argentina anymore. I think we are starting to see a divergence within emerging markets: Asia is doing pretty well. This is the first market crisis in my career where Asia has fallen less in the downturn than the world market. Usually in a crisis, Asia is like the redhead step child, i.e. always the first one that gets beaten up. This time not. Frankly, this makes sense to me: The collapse in oil price is a huge benefit to Asia, as Asia is the world's biggest consumer of energy. Sure, the Dollar went up, but what does Asia need Dollars for? To buy oil. Asia is in a pretty good spot.
Given this environment, where would you invest now?
First, you have to take a long term view. Given the high uncertainty, investing for the short term is more akin to gambling. So, let’s take a step back and ask: What do we know for sure? Well, we know that pretty much the entire Western world is going through a monetary and fiscal expansion like never before. Basically, they are introducing universal basic income financed by Modern Monetary Theory. UBI funded by MMT: That’s a game changer.
In what way?
I believe that over time this will lead to inflation. You’ve never had budget deficits of 10% of GDP, funded by central banks, that do not lead to a debasement of the currency. Now again, Asia is not going down this path. First, they have dealt with this pandemic far better than most Western countries, they haven’t destroyed their economies as much. Also, they haven’t gone down the path of massive deficit and money creation. So I tend to think that Asia today is a safer bet than the rest of the world, and that’s true for equities, fixed income and currencies. That’s a trend I’m willing to bet on.
Gold. Gold has been outperforming pretty much every asset class since January 2018. This outperformance makes sense, given the current fiscal and monetary policy. A third very visible trend is the structural outperformance of technology. Again, you have to distinguish between tech for consumers and for corporates. The outperformance of tech for consumers makes sense to me. We all sit at home, order Amazon packages and play video games. I’m willing to go along with that.
What other long term consequences do you see coming out of this crisis?
We will come out of this crisis with a lot more government interference in the economy. Governments will say: «If you want to sell your drugs here, you’ll have to produce them here.» They will want to retake control of supply chains. Given this trend, I’m keen to own stocks where there will be minimal government interference. In the Swiss market, I’d rather own Nestlé than Roche or Novartis. Sure, they are both defensive, but I don’t think governments will tell Nestlé where to produce their chocolate bars. But I can imagine the US government telling Roche where to produce. And they will also dictate the price. The weight of government in our economies is going to be super big, so I’d also avoid sectors like financials and utilities.
What about European equities? They are a lot cheaper than the US market.
European equities underperformed on the way up and underperformed on the way down. That’s terrible. European banks continue to plunge to new lows. This is never a healthy sign for an economy. For an economy and a financial market to prosper, you need a healthy financial sector. It’s your beating heart. The reality is Europe has decided that in order to save the Euro, negative interest rates are necessary all over Europe. That’s killing the financial system. As long as we have negative interest rates in Europe, we can’t have a healthy financial system. And without a healthy financial system, I don’t see how Europe can ever hope to outperform. Sure, there are some good individual companies in Europe. But as a whole, the market sucks.
2019 was all about the trade and tech war between the US and China. Do you expect that to continue?
Yes. The pandemic is going to make that conflict much worse. Most Western governments were caught with their pants down in this crisis. They were unprepared, they were slow to react, then they panicked. Most Asian policymakers have dealt with this crisis much better than Western policymakers. Hong Kong has seen four deaths, Korea about 240, Taiwan six. So if you are a policymaker in France, in the UK or the US, you have done a terrible job. You need someone to blame. The only ones you can turn the blame to are the Chinese. A hundred years ago you would have blamed the Jews, but you can’t do that anymore. So you blame the Chinese. So the confrontation between the West and China will get much worse. That’s why I think as an investor, you must avoid businesses that depend on production in China to sell in the West. Apple for example is hugely vulnerable. I would want to own businesses that either produce in Asia and sell in Asia, like Alibaba or Tencent, or that produce in the West and sell in the West, like Amazon.
In your latest book, Clash of Empires, you write that the world will fall into three economic and production zones: the US, Europe and Asia.
Yes, we’ll move to that kind of world. Companies that have relied on optimized supply chains to produce in one zone and sell in another, will have a problem. They’ll need redundant supply chains. Prices of these supply chains will go up, and productivity will go down. That’s another reason why I think we’ll have genuine inflation starting in 2021 or 2022.
Will that world view change with who will sit in the White House next year?
Not really. Trump is going to run his campaign by being tough on China. If I were Joe Biden, I would run on the message that the US healthcare system is a mess. Those will be the two themes: Toughness on China, and nationalization of healthcare. Both are not very market friendly And either way, whoever gets elected, the US will move away from China.
With your view of a new inflation cycle: Would you make the case for a new structural commodity bull market?
That’s too early to say. Asset prices are driven by the intersection of economic growth and inflation. This gives you four scenarios: inflationary boom, inflationary bust, deflationary boom and deflationary bust. For the past 30 plus years, we have basically gone from deflationary bust to deflationary boom. That was great for growth stocks and great for bonds. The policy mix we have today leads me to believe we‘re heading towards an inflationary bust. In that environment, gold does well, but other commodities not so much.
But in any case, that’s a horrible scenario for bonds.
Oh yes. The 40 year bond bull market is over. If you own a bond today for anything more than a trade for the next few months, then I think you’re nuts. But let me be precise: If I saw that we might be headed toward an inflationary boom, I’d take a much more bullish stance on commodities. In fact, I’ve just started buying copper on the assumption that we’ll see a rise in infrastructure spending. Another good attribute of copper: Germs don’t like it. Germs stay on iron and other metals, but not on copper. So we might see that countries that can afford it will use more copper for things such as door handles, hospital doors and so on. This is what happened after the Spanish Flu: We started putting copper everywhere, which is why Art Deco looks so cool, because it has copper everywhere. That actually came out of the Spanish Flu and the knowledge that copper is a germ killer.