Napier

Equity Valuation Inflation, deflation and mean reversion

Russell Napier Strategist

Conclusions

Key to mean reversion of CAPE- changing inflationary expectations

CAPE and Q drive capital creation and are reflexive

Technology is key but it is never as positive for non-inflationary growth as it seems

Deflation or inflation rising through 4% will reduce valuations

Equities can adjust more rapidly than bonds

Deflation comes next and sharply lower equity prices

The mean reversion of CAPE

468

10121416182022242628303234363840424446

CAPE

1.2

-1

-0.8

-0.6

-0.4

-0.2

0

0.2

0.4

0.6

0.8

1

1.2

-1.2

-1

-0.8

-0.6

-0.4

-0.2

0

0.2

0.4

0.6

0.8

1

1.2

1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010

qan

d CA

PE to

their

ow

n av

erag

es (l

og n

umbe

rs).

Data Sources: Stephen Wright (1900 - 1952) and Federal Reserve Z1 Table B.102 (1952 - Q2 2013) for q, and Robert Shiller (updated) from Standard & Poor's for CAPE.

Slide 4. US Stock Market Value q and CAPE.

q CAPE

But beware inflation near 4% US inflation and Dow Jones Industrial Average, 1966-1978

Source: Datastream

66 67 68 69 70 71 72 73 74 75 76 77 78 0

2

4

6

8

10

12

14

550

600

650

700

750

800

850

900

950

1,000

1,050

CPI (LHS) Dow Jones Industrials - Price Index


Source: Datastream

1985 1986 1987 1988 1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

1,000

1,200

1,400

1,600

1,800

2,000

2,200

2,400

2,600

2,800



Source: Datastream

1998 1999 2000 2001 2002 2003 1.0

1.5

2.0

2.5

3.0

3.5

4.0 ('000)

7.0

7.5

8.0

8.5

9.0

9.5

10.0

10.5

11.0

11.5

12.0

CPI F(LHS) Dow Jones Industrials - Price Index


Source: Datastream

(1) 2002 2003 2004 2005 2006 2007 2008 2009

0

1

2

3

4

5

6 ('000)

7

8

9

10

11

12

13

14

15


Source: DATASTREAM

0

5

10

15

20

25

30

35

22

24

26

28

30

32

34

36

38

40

1929 1935 1941 1947 1953 1959 1965 1971 1977 1983 1989 1995 2001 2007 2013 Prof

its, a

fter d

epre

ciat

ion,

but

bef

ore i

nter

est a

nd ta

x, a

s %

of n

et o

utpu

t.

Prof

its, b

efor

e dep

reci

atio

n, in

tere

st a

nd ta

x, a

s % o

f gro

ss

outp

ut.

Data Source: NIPA Table 1.14.

Slide 63. US Profit Margins 1929 - Q2 2013.

Gross Net

Stability of long term return from equities

-4

-2

0

2

4

6

8

10

12

-4

-2

0

2

4

6

8

10

12

1831 1851 1871 1891 1911 1931 1951 1971 1991 2011

% p

.a. r

eal r

etur

n.

Data Sources: 1801 - 1899 Jeremy Siegel , then Elroy Dimson, Paul Marsh & Mike Staunton 1900 - 2012 via Morningstar.

Slide 13. The First Remarkable Feature 30 Year Rolling Returns.

Bonds Equities Cash

Deflation in the age of QE

Inflation is always and everywhere a monetary phenomenon- Friedman

We do not live in a fiat system as so many countries manage/fix their currencies to others

For EMs external surpluses dictate monetary policy

In fiat systems money is created by commercial banks and not by central banks

Demographic trends mitigate against credit and money creation by central banks

Smaller US deficits and EM deflation

For almost two decades a widening US current account deficit was the basis for Bretton Woods II

Earned surpluses allowed liquidity creation and stable exchange rates in EMs

Since 2009, EMs have borrowed surpluses they did not earn

The round trip of capital creates liquidity in EMs

A country with insufficient surplus and liquidity can deflate or devalue and China is particularly vulnerable

(250)

(200)

(150)

(100)

(50)

0

50

1Q

90

1Q

91

1Q

92

1Q

93

1Q

94

1Q

95

1Q

96

1Q

97

1Q

98

1Q

99

1Q

00

1Q

01

1Q

02

1Q

03

1Q

04

1Q

05

1Q

06

1Q

07

1Q

08

1Q

09

1Q

10

1Q

11

1Q

12

1Q

13

1Q

14

(US$bn)

US current-account deficit

Source: Datastream

When does money printing begin?

Source: Datastream

0

2

4

6

8

10

12

14

16

18

6/1/

675/

1/68

4/1/

693/

1/70

2/1/

711/

1/72

12/1

/72

11/1

/73

10/1

/74

9/1/

758/

1/76

7/1/

776/

1/78

5/1/

794/

1/80

3/1/

812/

1/82

1/1/

8312

/1/8

311

/1/8

410

/1/8

59/

1/86

8/1/

877/

1/88

6/1/

895/

1/90

4/1/

913/

1/92

2/1/

931/

1/94

12/1

/94

11/1

/95

10/1

/96

9/1/

978/

1/98

7/1/

996/

1/00

5/1/

014/

1/02

3/1/

032/

1/04

1/1/

0512

/1/0

511

/1/0

610

/1/0

79/

1/08

8/1/

097/

1/10

6/1/

115/

1/12

4/1/

13

GDP DEFLATOR (ANNUAL %) : Global World International

US current-account deficit as % of GDP - A new era

(7)

(6)

(5)

(4)

(3)

(2)

(1)

0

1

19

80

19

81

19

82

19

83

19

84

19

85

19

86

19

87

19

88

19

89

19

90

19

91

19

92

19

93

19

94

19

95

19

96

19

97

19

98

19

99

20

00

20

01

20

02

20

03

20

04

20

05

20

06

20

07

20

08

20

09

20

10

20

11

20

12

20

13

(%)

Source: Datastream

The shrinkage in the deficit is structural

The shale oil and gas revolution means fewer US dollars in the hands of foreigners

Chinese manufacturing wages have risen 3x since end-2007 in US$ terms, US hourly wages just 12%

The baby-boom generation is degearing and saving; and this means less consumption and fewer imports

If the US is to run structurally smaller deficits. then Bretton Woods II is unfit for purpose

EMs will deflate or devalue; either will bring a global deflation

US visible trade deficit with China (% of GDP) - Shrinking

(2.5)

(2.0)

(1.5)

(1.0)

(0.5)

0.0

90 91 92 93 94 95 96 97 98 99 0 1 2 3 4 5 6 7 8 9 10 11 12 13

(%)

Source: Datastream

Chinas capital inflows and outflows (US$bn)

Source: Thomson Reuters Datastream

0

1000

2000

3000

4000

5000

6000

7000

8000

9000

2/1/

008/

1/00

2/1/

018/

1/01

2/1/

028/

1/02

2/1/

038/

1/03

2/1/

048/

1/04

2/1/

058/

1/05

2/1/

068/

1/06

2/1/

078/

1/07

2/1/

088/

1/08

2/1/

098/

1/09

2/1/

108/

1/10

2/1/

118/

1/11

2/1/

128/

1/12

2/1/

138/

1/13

2/1/

148/

1/14

Pane 1 BOP - CAPITAL & FINANCIAL ACCOUNT(DEBIT) : China ex Hong Kong and Macau(Country)

Pane 1 BOP - CAPITAL & FINANCIAL ACCOUNT(CREDIT) : China ex Hong Kong and Macau(Country)

Chinas gross external indebtedness

0

100

200

300

400

500

600

700

800

900

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

(US$bn)

Source: Thomson Reuters Datastream

Family characteristic

Secured by resi property Instalment loans

Credit-card balances

Credit lines not secured by resi

property

Other Any debt Primary

residence Other

Age of head (years) Less than 35 37.3 3.3 65.2 48.5 2.1 5.9 83.6 35-44 59.5 6.5 56.2 51.7 2.2 7.5 86.2 45-54 65.5 8.0 51.9 53.6 1.9 9.8 86.8 55-64 55.3 7.8 44.6 49.9 1.2 8.7 81.8 65-74 42.9 5.0 26.1 37.0 1.5 4.4 65.5 75 or more 13.9 0.6 7.0 18.8 - 1.3 31.4

Family holdings of debt by age of head, 2007 and 2010 surveys

Source: Federal Reserve Survey of Consumer Finances

US personal savings as a % of disposable income

Source: Datastream

Five-year-TIPS-implied inflation versus MSCI EM Index (US$)

600

700

800

900

1,000

1,100

1,200

1,300

1 Jan 10 12 Oct 10 23 Jul 11 2 May 12 10 Feb 13 21 Nov 13 1 Sep 141.0

1.2

1.4

1.6

1.8

2.0

2.2

2.4

2.6 Five-year-TIPS-implied inflation MSCI Emerging Markets Index (RHS)(%)

Source: Datastream

Gross External Debt Table

Gross External Indebtedness 3Q 2014 (US$bn)

Source: Joint External Debt Hub and World Bank Argentina 148 28% Belarus 41 53% Brazil 540 24% Bulgaria 49 90% China 874 8% Chile 137 52% Columbia 98 25% Croatia 58 100% Czech Republic 127 64% Ecuador 19 19% Georgia 13 81% Hungary 190 147% India 456 22% Indonesia 292 22% Kazakshtan* 155 34% Korea 429 28% Malaysia 213 68%

Macedonia 7 73% Mexico 419 32% Mongolia 19 158% Pakistan 56 24% Peru 61 29% Phillipines 58 20% Poland 370 67% Romania 120 59% Russia* 679 33% Serbia 36 80% South Africa 142 42% Thailand 143 38% Turkey 397 49% Ukraine 136 101% Uruguay 24 44% Venezula 119 27%

* exchange rate movements since end September 2014 will have pushed external debt to GDP ratios well about 35%

Conclusions

The size of the US current account deficit is a key driver of global liquidity but it is not growing

Structural reasons - shale oil and gas, rising Chinese wages, baby boom degearing - stop the deficit growing

The de-gearing of the baby boom generation restricts the effectiveness of monetary policy

EMs, particularly in Eastern Europe, have borrowed too much in foreign currency.

Six years after the launch of QE we get deflation anyway and a move to government action

Equity ValuationConclusionsThe mean reversion of CAPESlide Number 4But beware inflation near 4%But beware inflation near 4%But beware inflation near 4%But beware inflation near 4%Slide Number 9Stability of long term return from equitiesStability of long term return from equitiesDeflation in the age of QESmaller US deficits and EM deflationSlide Number 14Slide Number 15Slide Number 16The shrinkage in the deficit is structuralSlide Number 18Chinas capital inflows and outflows (US$bn)Chinas gross external indebtednessSlide Number 21Slide Number 22Slide Number 23Gross External Debt TableConclusions

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