This interview was published in Russian a month ago but in the light of latest issues (BREXIT, etc) its relevance has increased (https://www.facebook.com/fintechnic.org/posts/1120480491323790:0)
Buying gold is the simplest interest rate. Historically gold has been correlating with real negative interest rates. That is, when keeping money is turning to be unprofitable, the history shows that gold as a kind of assets receives additional flow from all types of funds.
Intereview with Gregoriy Klumov.
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FT: Good Afternoon! Today within a framework of Financial Technique project we are talking with the acknowledged expert in Moscow in the field of world financial markets Gregoriy Klumov. The subject matter of our discussion are negative interest rates, how they may influence world financial market and economics and what trends and consequences are possible.
GK: Thank you for such a flattering introduction! Though I have been studying, analyzing and trading foreign assets on behalf of family offices, I do not claim to be an expert. I am ready to share my understanding of the situation and I hope that your readers could benefit from it.
FT: Gregoriy, I suggest considering every market – currency market, raw materials market, equity and bond market – in the light of negative interest rates and find out what impact they may have on each of them.
GK: First of all, I would like to talk about the prerequisites of such a phenomenon as negative interest rates. The main reason is that central banks are fighting credit with the help of out-of-date methods. Customers, corporations are overloaded with debt and can’t afford to increase credit burden. But there is no need to do this – to finance consumption with credit is dangerous and assets are overestimated. Throughout the world, companies with growing business and with no credit are in deficit. Consumers are over their head in debt to pay for education, housing, cars, etc. As the result, we’ve been having zombie-world with 10 billion dollar-equivalent assets which are traded with negative rate yield. And this is instead of healing through bankruptcy process, cleansing balance sheets of economic agents of bad debts and relaunching credit cycle. Negative interest rates ruin the profitability of financial organization – banks. This tendency has increased over the last six months after the measures taken by ECB and Japanese Central Bank. The banking system of developed countries is likely to face capital deficit.
FT: We have entered the era of negative interest rates. How is it possible to leave it?
GK: This question sure is a philosophical one. But if we refer to classical economic theory, to relaunch credit cycle we need either to cleanse balances through bankruptcy, or to find a new person without a credit and without a debt and to lend him or her a new credit so that they can invest it into some business. We are in the situation when writing off old debt is de facto forbidden, because this may damage the capital of global financial institutions. New bankruptcies (like Lehman Brothers) may lead to deeper recession than in 2008, because low interest rates stimulate leverage increase and risks increase. That is why, as I think, monetization of state debt of developed markets has been chosen as an option. It is when money is created and is used to buy out the assets of these countries. In developed economies this results in the fact that you are paid for having a mortgage. For example, in Denmark the bank paid money to people, who had mortgage with an interest rate pegged to a floating interest rate, for the only fact that they owned some property. In countries with the increased country risk and high inflation as, for example, in Russia, this is not possible. Another point – inflation in developed countries is very low. In some countries we can see deflation.
FT: What should investor do in case of deflation?
GK: The simplest rate is to buy gold. Historically gold correlates with real negative interest rates. That is, when keeping money is turning to be unprofitable, the history shows that gold as a kind of assets receives additional flow from all types of funds. Gold, in fact, is a negative interest rate itself because gold price includes the pay for its storage. The simplest idea, which is linked to negative interest rates, is buying gold and companies producing this commodity.
FT: Gregoriy, and what about other precious metals, such as silver, platinum and palladium? Can they help to protect against deflation?
GK: It is too early to buy nonferrous metals as they are in the long-drawn bear market. This is the result of overproduction after inflation boom of 2005-2008 caused by the growth of Chinese economy. There were lots of merges and acquisitions, a lot of new projects which seemed profitable were launched. Steady growth of prices is unlikely to happen until market has digested excessively produced offer and a number of bankruptcies, restructures and production closures can take place. Gold production in 2015 fell down by 2,5% only. In fact, there were no bankruptcies, only restructures. All large companies changed their management. The new management has to pay back the debt acquired in the best days. One can’t stop the launched projects in the twinkle of an eye. If you have already begun a project, it is cheaper to sell it for debts than to close it. There are some conditions for market U-turn in one or two years, but not now. Among all the metals, palladium possesses the best demand/offer structure from the point of view of investment. Actually, silver, platinum and palladium will strongly correlate. Gold will come first as a blue chip. Other metals will follow it. I wouldn’t think of investing into other metals until gold is expensive. But if you desire to buy some other metal, it is better to buy palladium. But still, I’d recommend buying gold, gold equity and bitcoin. The latter is an excellent alternative to gold. The idea in this case is the same, but in contrast to gold, the offer is decreasing.
FT: How do negative interest rates influence equity markets?
GK: They are not falling down. There is a classical model of assets assessment. The basis of it is an axiom that there is a certain riskless rate that any economic agent can receive. It is the rate of the USA Fed bonds. After this, it is possible to calculate share-holding premium against bond and riskless asset holding. The main idea is that when riskless asset rate decreases, profitability of corporate sector drops (obligation prices are increasing); the difference between the profitability of equity investment and the profitability of bond investment grows effectively, provoking equity buy. Nowadays companies buying out their own equities from the market is a serious force restraining equity market from falling down as the result of economic gravitation. For example, a company creates money flow with the profitability reaching 7-9%. It can offer 2-3% to attract money. Thus, the arbitrage arises: you borrow money with 2-3% interest rate and buy American equities with 7-9% profitability. The total inflow into American equities amounts to 0,5 billion dollars annually. Companies buying out their own equities is assessed as 0,5 billion dollars either. So, we have comparable figures. Another factor, which supports markets is the purchase of equities by foreign banks. For example, the Central Bank of Switzerland invested a part of its capital into equities. Actually, central banks are private contractors and can not only issue money but also can act as a fund. All these actions are aimed at fighting credit cycle and economic gravitation. They create an illusion of the world economy state, but the reality is much worse. Europe and Japan are stagnating. China is at the verge of massive bankruptcies. Recession is most likely in the USA. The risk exists that investors may get disappointed about Central bank capability to sustain the status-quo and may re-assess risk premium in several days. In this case, equities will plummet by 30-405 as in 1987. One should take this possibility into consideration.
FT: We haven’t discussed the last market sector – bonds. What will happen to it?
GK: They will continue to grow. Totally, there are 220 billion dollar assets, among them 150 billion dollars are bonds. 10 billion dollar bonds out of 150 billion are with negative interest rate. In bonds the price movement is caused by macroeconomics – this is the second derivative affecting GGP dynamics. That is, the slower GGP dynamics together with inflation, the higher bond prices and vice versa. The quicker is GGP growth, the lower are bond prices. At the end of 2015 we witnessed the situation when USA Fed rates were increased and American bonds began to grow. Having increased the rate, the Central Bank made the terms for local loan-banks tougher. As the result, it shrank credit for the economy even more. After that, the economy started to slow down significantly. Bond price comprises this kind of worsening. Bond market is the most effective market in the world. In case state bond price increases, it means that something is wrong with the economy. This is the best indicator. But this refers to the developed countries only. In emerging markets country risk and liquidity risk are of great importance. To sum it up, I would like to advise that one should not hurry to buy equities over the next couple of years. I’d like to recommend increasing safe assets – cash, as well as gold and bitcoin. Another piece of advice – be very careful while choosing economic counterparty.