«We’ll need debt monetization in the US. That’s bearish for the Dollar»: Louis-Vincent Gave. (Picture: Laurent Burst)

Das Interview «The Bond Market is the Biggest Bubble of our Lifetime» Louis-Vincent Gave, CEO and co-founder of Gavekal Research, talks about the prospects for the global economy and the new cold war between China and the USA. This, in his view, is particularly bad news for the technology sector.

Deutsche Version

For Louis-Vincent Gave, CEO of Gavekal Research, the bond market is in the biggest bubble of all time. There is no other way to understand why bonds worth around $15 trillion currently trade with negative yields.

Louis-Vincent Gave

Louis-Vincent Gave is a founding partner and CEO of Gavekal Research , which he established in London in 1999 together with Charles Gave and Anatole Kaletsky. He left the London office in 2002 and returned to Hong Kong, where he had previously worked as a financial analyst for Paribas. Louis holds a Bachelor's degree from Duke University and studied Mandarin at Nanjing University. He was also a second lieutenant in a mountain battalion of the French Army. In his spare time, Louis likes to spend time on the rugby pitch, whether in Hong Kong (where he plays for Valley RFC), or in France where he is the owner and president of Biarritz Olympique.

If there is no economic downturn of epic proportions, investors are guaranteed to lose money with these bonds, says Gave. So far, central banks have always been there as buyers. What if one day their hands should be tied?

Gave is bullish on equities – mainly in emerging markets and Europe –, energy stocks and gold. Given the prospects of a new cold war, he is bearish on technology: «Investors still go and buy tech stocks. This is like buying real estate in Alsace in July of 1914. You don’t want to own the battlefield», he says.

On a global level, bonds with a value of about $15 trillion currently trade with a negative yield. What’s going on here?

For every investor today, the starting point must be the bond market. Just a few weeks ago, we had $17 trillion of negative yielding debt. We’re now down to about 15, but even that is way too much. This is investment money that is guaranteed to produce a loss of capital. These extreme levels in today’s bond market can only have three possible explanations. One, the world faces an economic meltdown of epic proportions. Two, the bond market is the biggest bubble we have ever witnessed, and three, we have just experienced a massive buying panic in bonds.

Which explanation is the right one?

A combination of the second and the third. Yes, we had a massive buying panic this summer – and yes, the bond market is the biggest bubble of our lifetime. This is bigger than the tech bubble of 2000 and the real estate bubble of 2007.



Why isn’t the bond market just signalling a dramatic economic slowdown?

We certainly see a slowdown, particularly in the industrial sector. The reason for this is a significant, structural slowdown in the automotive sector, which helps explain the collapse of the manufacturing sector in Germany. An often overlooked issue is the Boeing 737 Max fiasco, which has unleashed supply disruptions all over the US, Canada, Germany and other economies. Trade war uncertainties have restrained capital expenditure decisions. And last but not least, the Chinese economy is slowing down. But: This is a slowdown, not an epic meltdown in the form that the bond market seems to be suggesting.

What’s ailing the automotive sector?

There are a number of structural issues, but the most significant development has been the realization that the Chinese car market is done growing. For years, the Chinese market has been growing by two to three million cars per year. Financial markets have just extrapolated this kind of growth into the future. But that turned out to be wrong. The Chinese car market has probably hit its limit at 25 to 30 million units per year. In most parts of the world, the auto sector has stopped growing. It’s no surprise then that Germany has seen such a collapse lately.

How worried are you about China in general?

I’m not worried. China is managing a stabilization around a 6 per cent growth rate. The manufacturing PMI has marginally crept back up above 50, which was the effect of a little stimulus by the central government. When it comes to China, foreign investors always have this idea that either China is on the brink of taking over the world, or they are on the brink of a catastrophic collapse. There certainly are structural issues to the Chinese economy – debt levels and demographics, to name two –, but overall, the economy is stabilizing.

Financial markets hold the hope that the Chinese government will introduce significant stimulus measures again, like they did in late 2015.

Don’t bet on that. They won’t. For one, they feel betrayed by the rest of the world. China has pulled the world economy out of the hole in late 2008 and again in late 2015, and all they get is a slap in the face by Donald Trump. The second reason is that the main lever for stimulus in China is the real estate sector. But that sector is doing fine, most of the larger cities don’t need to see their real estate prices goosed up any further.

So your overall picture of the world economy is not that gloomy after all?

No. There is a slowdown, but not a meltdown. Consider this: The consumer sector in the US is still doing fine. China is not collapsing. In most parts of the world, there is talk of fiscal stimulus. All over the world, central banks are cutting rates and governments are introducing tax cuts. How can all this be bullish for bonds? Hence my view that the bond market is the biggest bubble in our lifetime.

What has been driving this bubble?

In every bubble, you need two key beliefs. The first is that it’s different this time. You willingly have to suspend disbelief, and in order to do that, you have to convince yourself that it’s different this time. The number two factor in any bubble is the belief that you can buy these worthless assets – dotcom stocks, houses in Arizona, German Bunds – because there will be another sucker who will buy them from you at a higher price in the future. When it comes to the bond bubble today, these beliefs are in full force.

What’s seen as different this time?

Demographics, deflation and debt. These are the three factors that should combine with the outcome that we’ll have low and negative interest rates forever. But I don’t buy that. Take the idea that demographics lead us to a world of permanently low interest rates: In the past thirty years, the babyboom generation has been saving, by contributing to pension funds and life insurance policies. In effect, they were buying bonds. Demographics are now turning. When the baby boomers retire, they start liquidating their pension funds and life insurance policies. That’s not at all favorable to the bond environment.

What about the deflation and the debt part?

The debt card is undeniably strong; there is a lot of debt overhang worldwide, and that hurts growth. But I don’t buy the argument that we have deflation everywhere.

Why not?

Look at the median CPI in the US: It’s at a ten year high. Look around the world, I see small revolutions everywhere, in France with the gilets jaunes, Brexit in the UK, the election of Trump. I see a lot of angry people. You know, I grew up in France, so I had a good dose of Marx in my education. The first thing Marx teaches you is that revolutions are typically the result of inflation. Marx was wrong about many things, but he was right in that inflation is a deeply destabilizing force. We are being told today that there is no inflation, but if you take a basket of the 72 most bought items at Walmart, the price of that basket is up 4,8% year on year. So, if you are among the poorest people in America and you buy your Walmart items, your cost has gone up 4,8%, while your wages go nowhere. Should we be surprised that people are angry? One of the factors that has helped to keep inflation down was the drop in oil prices in the past decade. And here we can legitimately put a question mark behind the idea that oil prices will continue to fall, given the uncertainties in the Middle East and the collapse of capital spending in the energy sector in America.

You mentioned that in every bubble there is the belief that there will be another sucker who will buy the assets at a higher price. Who is that sucker today?

Central banks. Bond investors think that the ECB, the Bank of Japan, now also the Fed again, will always step in and buy bonds. They don’t care if the yield on German Bunds is minus 50 or minus 200 basis points. The ECB will buy them.

And you think this belief will turn out to be wrong?

That’s the big question: Will central banks continue to buy bonds regardless of what happens? And that brings us back to the subject of inflation. To me, this question is linked to energy. If energy prices stay where they are, central banks can continue with their crazy monetary policy. But if energy for whatever reason starts to shoot up, it will be much harder for central banks to say there is no inflation and therefore we can continue with our negative interest rate policy.

Have we already seen the peak of the bond bubble?

Yes. We are at the beginning of the end of the thirtyfive year bond bull market. What you saw this summer was panic buying of antifragile assets. In June, July and August, you saw both bonds and gold go absolutely parabolic at the same time. This is very unusual.

What triggered this panic buying?

I think the world panicked because of the Hong Kong events. You know, living in Hong Kong, I had seven big US clients calling me up and asking if we were going to move our offices away from Hong Kong. The reality was, if you were just watching CNN in July and August, you saw the anchorman standing outside the barracks of the People’s Liberation Army in Shenzhen, saying that the tanks will roll out any minute. There was the growing fear, looking from the outside, that there was going to be a new Tiananmen. This would have triggered a catastrophic chain of events which would have frozen China out of the global supply chains. Now of course, this is not happening. China is not intervening. Xi Jinping has been very quiet about Hong Kong. The Chinese leadership is adopting the same strategy as Macron did with the gilets jaunes. They wait this out.

What role did the escalation of the trade war play in this panic buying?

There is no doubt that the trade dispute is bad. But it’s important to understand that this is not just a trade war. This is the start of a new and long cold war. Donald Trump might be just interested in reducing the bilateral trade deficit, but for most of the Washington establishment, this is far bigger. They want to contain China economically, and make sure that the US remains the dominating economic power in the world. China can compromise on the trade balance, but they can’t compromise on economic dominance. So, the ability to strike a compromise is fairly limited, given the goals of each country. This is the start of a long struggle, which I outline in my book «Clash of Empires».

How will that war be played out?

Washington has decided to move the battle onto technology, because that’s one of the fields where the US has a competitive advantage. If this was really just a trade war, would the US government tell the semiconductor manufacturers not to sell to Huawei anymore? Of course not. If it was just a trade war, the Americans would want to sell more stuff to the Chinese. So, the battlefield of the new cold war is technology. The US government tells the American companies to divest from China. Meanwhile, China invests hundreds of billions of Dollars into building new tech competitors and into developing its own semiconductor industry.

What will this mean for tech stocks?

This is massively bearish for the tech sector. You get government intervention on both sides, that undermines their entire business model. It strikes me as crazy that the large US tech stocks are still performing so well. The battle field for the new cold war will be technology, and yet, investors go and buy tech stocks. This is insane. That is like buying real estate in Alsace in July of 1914. You don’t want to own the battlefield.

So, you see a massive bond bubble, and you see the start of a new cold war. What should an investor do in this environment?

First: Don’t own any bonds. Sometimes, success in investing is not about picking the winners, but about avoiding the losers. Many investors today own what I call a dumbbell portfolio: They own growth stocks like the US tech sector, and they hedge that position with bonds. They hold overvalued equities and hedge them with overvalued bonds. That does not strike me as intelligent. Both sides of this portfolio only do well in an environment of continued central bank easing; both sides bet that central banks will keep negative interest rate policies forever. The risk is that this turns out to be wrong.

What’s a more intelligent portfolio?

I would buy equities with an underweight in US, and I’d hedge them with energy stocks. Instead of buying bonds, I’d buy the likes of Total, BP and Royal Dutch Shell. They will give you the hedge in case energy prices go through the roof. Plus, they offer a decent dividend yield of 5 to 6 per cent. So, in a way, I see energy stocks as the new bonds.

How about gold?

I’m not a gold bug at all. I never liked the idea of owning something that does not produce any cashflow. But we have to accept that the global rules have changed. In the past year, we moved to a world where central banks, which have been net sellers of gold for 25 years, have become net buyers of gold again. This is an important change. For 25 years, we had two marginal sellers of gold: central banks, and the gold miners. We have moved to a world where the only sellers of gold are the mining companies, and because of their dreadful stock market performance, they have not been able to invest much capital into the development of new mines. This is the kind of world where we can see a large upward move in gold like we saw this summer. And mind you, this was in an environment of a rising Dollar.

Why underweight US equities?

For one, they’re expensive. Plus, I’m bearish on tech given my view of the new cold war. The third factor is the presidential election of next year. It looks most likely that the Democrats will nominate Elizabeth Warren as their candidate. And once her nomination becomes clearer, markets will begin to price in a 50% probability that Warren will beat Trump in 2020. She could be the most left-wing president in US history. Warren promises to re-regulate banks, to break up big tech, and to introduce a ban on fracking. With that, she will attack the three main competitive advantages of America: Finance, technology, and energy independence. With this in view, and now with the impeachment inquiry on top of it, many foreign investors might try to steer away a bit from the US.

Which equity markets do you like?

I’m fairly bullish on emerging markets for the coming year. Look at what’s happening there. India just cut its corporate tax rate from 30 to 22 per cent. Look at the tax cuts in China, the interest rate cuts in Russia, Indonesia, India, Brazil. Don’t forget, emerging markets are still the places where cutting taxes and interest rates has an effect. When interest rates in Europe go from minus 40 to minus 50 basis points, that does absolutely nothing to the economy. But if interest rates in India go from 7 to 5 per cent, that means more mortgage demand, that means more people borrow money to buy motorcycles, and so on. This has a big effect.

Are you not worried that crises like in Turkey and Argentina spread to other markets?

Not really. The challenges in Turkey have been fairly visible for a long time. Argentina was a little bit more of a surprise, because there we had Mauricio Macri doing all the right things in terms of economic reforms. But then again, Argentina at this point is a small economy. It doesn’t carry much contagion risk anymore. The old days where you had a crisis in Thailand, which then spread all over the region, are over.

On and off there has been the fear in markets that the Dollar would shoot up and create a squeeze in emerging markets. You don’t see that risk?

The Dollar has been trading in a range for quite some time. It had several chances to shoot up. Last year, when the Fed was the only central bank in the world on a tightening path. This summer, when Dollar bonds were almost the only ones with a positive yield. Also two weeks ago, when we had a freeze in repo markets, the Dollar did not shoot up. This shows me that we seem to have a Dollar shortage within the US, but no Dollar shortage in the rest of the world. If anything, I expect the Dollar to weaken. And that would be bullish for emerging markets.

Why should the Dollar weaken?

For one, when markets begin to price in the risk of a Warren presidency. Plus, the US government is running huge budget deficits: Government spending in the US is running away like it stole something. Every year, $1.3 to 1.5 trillion of new Treasuries need to be absorbed. With more and more foreign investors steering away from the US, I think the Fed will have no choice but to start their quantitative easing policy again. In effect, we’ll need debt monetization in the US. That’s bearish for the Dollar.

Do you see anything in equity markets that is outright cheap?

A lot of the cyclical stocks are cheap. Energy stocks are dirt cheap. Energy stocks as a percentage of the S&P 500 have never been so low. Also: Hong Kong is dirt cheap. Most emerging markets are attractively priced.

How about financials?

Most financials are dirt cheap, and they would benefit from a steepening yield curve environment. But there you can argue whether we still need banks or asset managers in ten, twenty years. The financial space is in complete upheaval, and it’s hard to see who the winners will be.

How about Europe?

One thing is clear: Pessimism on Europe is at record highs, completely out of whack. The problem with Europe is that it increasingly is becoming just a play on emerging markets. When emerging market demand accelerates, Europe does fine, when demand decelerates, Europe is just a dull place for investors because little is going on in terms of domestic growth. Now, given that I am bullish on emerging markets, I would say Europe will have a good year in 2020, both in terms of economic growth and in the equity markets. And as a result of that, European bonds are going to get destroyed. Because, if economic growth turns out to be okay, why on Earth would you want to own a German Bund yielding minus 50, or a Swiss bond yielding minus 70 basis points? It makes no sense.

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