Preston Pysh  5:48  

Yeah, and I think to be honest with you, David, you’re hitting at the crux of the issue here. And I think that whether you agree with the Brexit or you don’t agree with the Brexit, I think is something that I’m not really too concerned in addressing in the podcast. I’m more concerned about it happened. And now what’s the path forward? And what does it really mean from a larger context? 

So, according to George Soros, he thinks that this is going to have a compounding impact. He thinks that this is the first of multiple countries that are going to follow in the same footsteps.

Stig Brodersen  6:18  

Well, I think Soros has made some really interesting comments. He’s talking about a further decline. He’s saying that if the UK were to vote and leave, then we might see the pound to be as low as *1.15 to the dollar. So that’s quite significant. We’re not there yet. Now. We are around 1.34 at the moment.

So I’m really happy Preston said let’s look at the countries individually because if you’re looking at a country like Ireland, their price to earnings based on the Shiller PE is 27.7, whereas Italy is 11.1. And this is from the last quarter, so this was before easily dropped us I want to say 10% to 12%. 

So yes, there might besome buying opportunities in some indexes. But Chris as also kicked this show off by saying it’s still overvalued and he’s talking about indexes has to drop 50% before it’s really value investment. In my opinion, he might be right. It’s significantly overvalued. And what I found is interesting from a value investor perspective is really is this the catalyst that we’ve been talking about on the show for quite some time? Is this where you would see investors pulling out the money from areas where there’s a lot of problems: Southern Europe, Japan? Some people would probably include China in that question as well. I don’t know it might well be.

Preston Pysh  7:38  

So Christoph and David, to you guys more on this idea of are there more countries that are going to join this movement, if you will? :et me emphasize I’m looking at a chart and I have no idea how accurate this polling is. But I’m looking at this chart from the Visual Capitalist that shows that right now in Italy, it’s showing something like 57%, almost 60% of the people want to have a referendum vote. In France, it’s over 50%. In Sweden, it’s probably around 42%, Belgium 40%, Germany 40%. I mean, these are some high numbers. And I think you could maybe see them go higher pretty quickly in kind of the snap of the finger. So do you guys see that happening?

Well, personally, I think this may well happen because we’re seeing increased polarization between the political sides within each country, the the left and the right. We’re also seeing that in America, but certainly across Europe, we’ve got very high levels of unemployment: Greece, 24%, Spain, 20.4%, France 10.2%. The fact that wages have stagnated over the last decade and concerns about immigration are rising, this is gonna lead to significant tensions within these countries. I think we’ll encourage referendums to take place. And if that happens, then we’re likely to see some kind of major disintegration of the EU. And if that happens, then that could have significant impacts upon the global economy.

Christoph Wolf  9:17  

Yeah, it’s really hard to say. I mean, first of all, I absolutely agree with David and you guys that we have this polarization in Europe. Many countries that leaning for the far right. I mean, in France, you have more independence, in Austria with just a very narrowly, almost the president of the far right. Even in Germany, despite our horrible past of the Second World War, even there, we have a far right party evolving. 

Well, if the disintegration of the European Union really will take place or not, that’s really hard to say. And I think one one very important thing that we come back to the Brexit is how this will now play out with the UK. In my opinion, because when Brexit happens, when article 50, that means the formal negotiations with the European Union and the UK will start after article 50 has been triggered. Negotiation starts. Exactly how this will play out, it will have a huge effect on the rest of Europe. 

And in my opinion, what’s gonna happen is that the European Union will make very harsh, very strict conditions on the UK to show everyone else like the Netherlands, like France, like Poland, like Greece, like all other countries that are thinking about holding also similar referendum to show them if you go out and it will by no means be any better for you. Instead, we will make life very hard for you. Well, not because we evil European or something. But just to show everyone outside nothing is really much better.

David Flood  10:52  

I was gonna say I agree with that. But the flip side is that there are certain people within the German government coming out saying, “We should make the UK an associated partner country of the EU.” And Merkel is saying we could maybe have some kind of constructive exit negotiations. I think perhaps there is some element of damage limitation on the part of the German government and the EU. So as much as they may want to punish the British economy, as an example for other countries who are thinking about leaving, I think also that they’re mindful of the impact that this could have upon the EU as a whole.

Stig Brodersen  11:31  

Yeah, the thing is that the dilemma is really interesting as you’re suggesting. First off, if they’re giving UK a good deal, which they might do, because it’s really important still to keep UK closely connected, then we will be sitting and saying, “Why don’t we get the same deal?” because UK, they have historically always been very skeptical about the EU. But you can say the same thing about a lot of other European countries. European leaders that can’t win, and we can’t go back in history and said so what happened last time the country opted out of EU? 

It actually did happen once before. And it was somewhat unnoticed. Greenland joined the EU together with  Denmark. It’s sort of a part of Denmark, and it come in 1973 and then opted out in 1982. Greenland, it’s very different. There are 56,000 people. And to be honest, the negotiations were mostly about fish. And  it’s quite more severe now. The UK is the fifth largest economy in the world. It’s significant what’s going to happen.

Preston Pysh  12:32  

So guys, I want to talk about first billionaire Howard Marks. I saw an interview where he was talking about this, and they were asking, “Well, you know, what’s going to happen? His opinion was, I think that you have to have a deep appreciation for basically saying you have no idea what’s going to happen, but you have to be open to the array of things that could occur. And I think that from his vantage point, he says in the short term, you know, businesses aren’t going to be producing less or more whatever he said. But this could spiral and he really kind of hinted at the bigger issue is really whether you have more countries that start falling out of the European Union and follow the British example, if you will. 

And so let’s talk about the elephant in the room here because what this really comes down to, in my personal opinion, really kind of getting to the crux of the issue of why this is a big deal is it all comes down to European banking. And, you know, Stig and I have been saying on this show, the risks that we see are Japan, because their monetary policy has just completely failed. We see China real estate is just a disaster. The other one that we’ve been saying is European banks. 

So where this really starts getting interesting, for me, at least, and just trying to depict this and you guys, correct me if I’m wrong. When you look at the banking and I look at a bank like Deutsche Bank, it is like the biggest debt bomb you’ve ever seen in your entire existence. Like you can’t even make the number up. This is just one bank in Europe. So now you start talking about some of the other banks, even some of the banks in the UK. 

For example, you guys were throwing off some of the numbers before we started recording of like how far some of these banks are down. They’re like down 15-20% just today, because guess what? Is the ECB going to come to their rescue now, whenever they run into default issues? So let’s talk about that. Let’s say that this expands. And I know I go into this worst case scenario. But I really think when you look at the numbers here, who else is wanting a referendum and all the numbers are like 40 to 60% of these other countries? This is a real concern. 

So let’s say Germany, and I know their numbers are a little bit lower than some of the others. But let’s use that as a worst case example. Let’s say Germany decides that they don’t want to continue to subsidize all this stuff in Greece and they want to exit the European Union. Well, that’s being controlled by the voters. Those are the voters. Do you think that the voters actually understand the inherent nature of the risk explosion that could occur with Deutsche Bank if the ECB can’t back them up anymore? You really think that people understand that? I don’t think that the typical voter understands that. And I think that Deutsche Bank is just one example of many of these ridiculously over leveraged banks that can’t get any kind of yield because the ECB and every other central bank around the world has pushed rates down to nothing. So they can’t make money there. They’re having the hardest time ever to make money. 

And as these countries continue to trickle off and not be a part of the European Union, how in the world are they going to back this up and print through the nose, which I guess was the solution here? I mean, do you see what I’m getting at? For me, that’s the critical variable here. And it’s something that we’ve been identifying as far as being a risk, but not necessarily with the European Union falling apart and how that would potentially play out. So I’m curious of your thoughts. Am I out in crazy land, or do you guys see this as the big elephant in the room here?

Christoph Wolf  15:51  

Interesting question. I mean, independently from Brexit, already in the times before we saw that especially well, Deutsche Bank I think the stock prices are in a 12 year low or something. And although many Italian banks, they really had many problems, they have huge non-performing loans and so on independently from Brexit. So well is this the big elephant in the room? It’s really hard to say. It’s one of the big elephants in the room. And not necessarily only on the European banks, also the Chinese banks, and so on. So yeah, obviously, it’s a huge concern that can always blow off. Well, maybe Brexit might be even the trigger, especially for the British bank. It was a concern before Brexit. Now, after Brexit, it might be even more dangerous, absolutely.

David Flood  16:38  

Well, personally, I’m pretty concerned about the the exposure that some of the banks have to derivatives, and we’re looking at the legislation that’s been coming through recently. The new implementation is going to be bail-ins rather than bailouts. And they placed the claimant on the derivatives which are the hedge funds as having super priority, which means we may well see haircuts for bondholders and unsecured department in these banks. This could lead to significant bank runs and major liquidity problems. 

If you look at the banks in Italy there, they haven’t been recapitalized after the last finance and they’re essentially trading insolvent at this point. I think there’s significant likelihood that we may see a more systemic and outbreak of problems within the banking system and whether or not the central banks have got the total lack of their disposal to deal with this is up for debate.

Preston Pysh  17:40  

So I think this is a really important word that you said, the bail-ins, because I think a lot of people don’t understand what that necessarily implies. And one of the things that you hear a lot of people in the finance industry say you hear this all the time, and I love this when people say this, they’re like, it’s a zero sum game. If one person loses, the other person has to win. And for the most part, that’s true whenever you’re in a pretty stable market condition. But when you start getting into a credit contraction type situation, and a company defaults, there is no winner and loser there. There’s a loser and a loser. That is a situation where something is written off of the books, and that is a loss. And that means somebody else’s income is going to be lower next month, which means there’s less buying power, there’s less asset value net worth to their name, all that kind of stuff. And when you’re talking buy-ins, occurring within some of these banks, where they’re moving from derivatives down into a lower class equity position that’s worthless. That is a situation where you have just a total loss. It’s not a zero sum game kind of thing. And I think that’s very concerning.

Stig Brodersen  18:50  

I love the discussion we had before and David when you talk about bank runs, I don’t think it’s my main concern here. I think if you look at what Mark Carney, the governor of Bank of England has been out saying, he’s saying that he’s ready to put in an additional 250 billion pounds in liquidity for commercial banks. And in a way, it seems comforting. But it actually doesn’t to me, I think if you look at the situation that you have in the UK, and you will see that the yield on the UK 10 year Treasury note, we’re just at 1.08% right now. So there’s actually no yield. If you look at the interest rate in general, you can see that last time after the collapse of Lehman Brothers, the Bank of England decided to cut the rates by 4.5%. 

Now, where are they now, they can’t do that anymore. What are they really going to do? They’re saying that we will use all means to prevent instability. But what do they really have? More or less that don’t have anything left in the toolbox when in terms of monetary policy, I’m curious to hear your take, David, on that.

David Flood  19:58  

I think at this point the only options they really have left is to move towards negative interest rates, which would not stand to see in certain countries around the world. More of the same with the QE, and then other possible capital controls or legalized confiscation of people’s funds in banks or bondholders in order to recapitalize banks that may go under. I think this will create more social unrest if this kind of thing starts to happen. 

Another interesting point I think is worth considering is what Steve Kean has been saying. He focuses on the expansion of private debt and the acceleration of that private debt and he’s listed seven countries that he thinks are due for an imminent crisis either China, Australia, Hong Kong, Canada, Norway, Sweden and South Korea. Now this guy seems pretty smart. He called the housing crisis of LA and the recent crash in the Chinese stock markets. I personally put a lot of weight on what he says. And he seems to be pretty accurate with this prediction. So I think it’s worth bearing in mind that the credit bubble that we’re seeing in China now is absolutely huge. And that could really be the catalyst that sets things off. Maybe not what happened in the EI> 

Preston Pysh  21:20  

So, David, I think you bring up a great point that Jesse Felder who we had on our show, a former billion dollar hedge fund manager, wicked smart. He was on our show, you know, he’s termed this thing “the everything bubble”  And I think that your comment goes hand in hand with what he’s saying here. So let’s say in Europe, you have all these people start trading these assets lower and that now has less buying power for people. If the UK’s currencies devalued significantly compared to the euro and everything else in countries that would trade with them, isn’t that a good thing for the UK that their currency, the pound, is now devalued? Isn’t that going to bring more business to them in the next, you know, six months or more?

David Flood  22:03  

Yes, well, I mean, the the negative impact it could have could be on the current account deficit. But the flip side of that is it could induce increased exports because it’s cheaper for other countries to buy our products. So it could end up being a net benefit for us in the long run. 

I think the other thing that’s worth bearing in mind is what we’ve been discussing, which is this deflationary pressure we’re seeing across the globe. Now, Professor Bruce Greenwald has recently commented that he sees going forward major stagnation and growth across the whole globe and perhaps something like we’ve seen in Japan for the last 25 years. And that’s a very real possibility. At this point, you just have to wonder where is the growth going to come from if China’s slowing down. Now, we could see in India but it’s still up in the air as to whether India can pick up the slack from where China’s left off at this point. And then time will tell whether that happens.

Preston Pysh  22:59  

I agree with that. Where in the world is that growth going to come? Now, i’s really interesting. We have a very, very smart individual coming on our show in a few weeks to talk about China. And I’m currently reading his book, and he’s talking about how most of this Chinese growth that has occurred is purely based in the last 15 to 20 years, purely based on their currency manipulation that’s been occurring. That’s why they’ve been able to hit such high numbers.

David Flood  23:24  

Expansion of credit.

Preston Pysh  23:25  

Exactly, yeah. Well, in the last five or six years, it’s really been that shadow banking expansion of credit. Prior to that, and during this last period, that’s been the currency manipulation that’s really just induced all this growth that we’ve been seeing. 

So the question then becomes is how much of a mirage is that over there? And then I think it goes back to this, guys. I think this is the key thing was the opening question that we started off with. Is this a buying opportunity? Or is there something much bigger going on here? I mean, my personal opinion is, I’m not touching this thing with a 10-foot pole. I mean, I can’t stay far enough away from this thing as far as I’m concerned.

Christoph Wolf  24:05  

First of all, regarding China, well, actually, in my opinion, I agree with you guys. That is really a huge debt *bubble. In The Economist about, I think four or six weeks ago, there was a special report on the China debt bubble that’s going to explode. And basically, the question was not, if this is a debt bubble that will explode. But the only question was when this was going to happen. 

Basically, they said it would be as catastrophic as Lehman Brothers and the financial crisis, because it somehow contained within China because China is not a free market. The government can really do quite a lot, but nevertheless, it will be really bad. 

The second question regarding the depreciating pound, I think it hit a 31 year low today. I think David already mentioned this. In my opinion, this is a negative part for Britain for the two things. First of all, the negative current account, they have a huge deficit in the current account. Basically, that means the importing much more than they are exporting. So if the pound gets cheaper, yes, of course, then the British export also gets cheaper, which might be good for them. But they have paid much more for the imports so it gets much more expensive. And as long as we do not have the trade agreement between the UK and the European Union and the rest of the world, which we don’t have at the moment, then all of those exports from the UK are subdued. 

Stig Brodersen  25:29  

The way I will comment on this discussion is actually first to talk about a metaphor. Nut here in Denmark, you are talking about a bridge, and it’s between the two big cities. We’re talking about a bridge for I don’t know how many years. And this is why it’s not going to happen. And this is also why you see the problems that you see in the world because it’s simply human nature. 

So what’s going to happen is that if you’re going to build something that is extremely expensive, then you will have someone who have to set aside money today, and that’s not fun, because if you had to set aside money today, it has to hurt today, then people probably wouldn’t like you. And you need your successor to do that again, and again. That’s what you need if you want to have like big sustainable things. 

Now, I see this to be exactly the same analogy as you see for the central banks. What they actually can do is they can decide to hurt a little for the next three years. Your successor, he can make it hurt at little, or he can decide to use a tool one way or the other so it doesn’t hurt us much. So if you look at how the UK is positioned right now, okay, so we talked about the monetary policy before. They probably don’t have any more tools left and the tools they have there are not useful in the current circumstances. 

So what do we do when we don’t have monetary policy? How can we just spend money that we don’t have to stimulate the economy? Well, we can do that with fiscal policy. Now we talked about the current account deficit a few times before The last quarter of 2015 it was down 7%. That is the largest recorded current account deficit ever recorded since they began recording in 1955. This is extremely important so they would go from a deficit to so-called high deficit, and perhaps borrow more money to stimulate the economy. What do you think that will do? 

And just let me remind you, the UK after Japan is the country in the world that has the most debt to GDP. This is not a good position to start from. So this is basicallyan analogy I had before. You need as an economist, or as an economy, you need to make it hurt a little from time to time so it won’t hurt you a lot at some point of time. That is why you see these bubbles. That is why Preston and me have been talking so many times about the big cycles, because you don’t want it to hurt unless it really has to hurt but it just compounds. ANd that’s really what I find frustrating right now. 

Does that mean that is irresponsible by the Bank of England? Under normal circumstances, I might have said yes. But it seems like the previous eight years has just shown so much irresponsibility that I think we were just in a new normal in that territory. So sorry for being so gloomy. I’m really curious to hear you three guys if you can find any tool that the Bank of England can use right now,

Christoph Wolf  28:23  

I don’t know exactly about the Bank of England but I agree in general that the central banks, they have really run out of ammunition. In several countries, we’re already in negative territory. In the ECB, for example, I think they’re like minus 1.3 or 1.4, which results in the bank, especially the Italian bank, as they cannot make a profit anymore, so they get problems. 

So there’s just a limit how much you can lower the negative rates, and they really have run out of ammunition. I mean, now they’re talking about helicopter money really giving people 10,000 euros or something they can spend, but it’s really such a drastic measure. But I don’t really think this has ever happened and even even if it happens in *inaudible to solve the problem. 

Those monetary policies are really at the end, but only from the Bank of England, but for the other central banks as well. And the only thing that really could solve *inaudible would be fiscal would be structural changes in the employment rules and so on. But here, the countries in Europe and also the other countries, they have not done their homework. They have just waited for the ECB, for the Bank of England, for the central bank to do the job, but they just cannot do the job. And I think that’s what the central banks always said, “We can just give you time, we can give you money, but then you must do the structural reforms.” And the Congress haven’t done that. So yeah, we have a problem. And I don’t see this happening anytime soon.

Preston Pysh  29:46  

So I got a question for David. So David, what do you think? And we’re obviously all kind of in a similar mindset here as far as we think that this has a potential to be really bad. We think that central banks have basically caused all this. But I would like to maybe with transition and talk about maybe it not being as bad as what we might think. And I guess this is where this potentially occurs, though the world leaders from the European Union and also in the UK, are saying let’s not make this as big of a deal as what we are saying it is going to be. Like when you get to the legal portion of this whenever they hash out what this actually does mean, are we really kind of blowing this out of proportion or are the people that are really kind of running these countries gonna step in and really kind of subsidize the overall impact of this exit from the European Union? Do you see that happening, David?

David Flood  30:44  

Well, I think at this point, the options are becoming increasingly limited. They can try and push forward negative rates or they can try perhaps induce some kind of capital controls, but their aim is to try and induce spending for an expansion in credit to try and stimulate the economic activity in the countries. But if the people can’t take on it on any more private debt, this becomes a very problematic thing. 

The other issue that we need to bear in mind is why of capital? Where will capital go if there is a crisis I can see capital moving towards precious metals like gold, but also towards the dollar. The dollar is still the world reserve currency, and it’s perceived as a safe haven by many. So we could see depreciation in currencies across the board and a strengthening US dollar. 

Now, if you look at the actions of the BRICS, central banks and those central banks in the West, they’ve been diverging. So the central banks in China, India and Russia have been accumulating gold for the past several years. But in the West, they’ve been pursuing a policy of quantitive easing. So I think we are seeing a diverging in the policies of the central banks. And how this plays out in the future is still up in the air but I do think we are going to see at some point fly of capital when some kind of major crisis sparks of panic. And in that instance, I think we will see a strengthening dollar and a rising gold price. 

Preston Pysh  32:13  

Alright guys, I think that we kind of captured the gist here. I mean this is a big deal. I think this is a lot bigger deal than a lot of people think and I think that if you’re oversimplifying this, especially if you’re a value investor to kind of oversimplifying this and just looking at you know, you buy when the market is down and you sell when the market is up. I think if you really look at things that simply, you might be in a position where you’re assuming a whole lot more risk than you realize with really kind of anything in the global economy: US, Europe, Japan, China anywhere. I think you might be assuming a little bit more risk just because the multiples that the people are trading these companies are sky high. The profit margins on these companies have gone down for the last six months to a year. But yet the multiples have stayed high, you know, like in the US at 26 or 25 on the Shiller PE. I mean, those are high multiples. So I think people need to have a deep respect for that. I think they need to realize that this is a very risky and volatile time. 

Another thing that billionaire Howard Marks said on the interview that I was watching, he said, “You know, the market does not do well when there’s uncertainty. When there’s uncertainty, that usually induces selling.” And so I think that that’s something that people need to have an appreciation for. But any closing remarks, anything that people wanted to say before we end this discussion?

Stig Brodersen  33:35  

So as always, let’s look at Warren Buffett and what he’s doing. What has he been saying? He is saying, “I don’t care if the British go in and out of EU. I wouldn’t change a thing.” I know, this is typical Warren Buffett comment, but I just think I should mention it here and I love that comment.

Preston Pysh  33:58  

Maybe we need to follow his advice more often. All right, David and Christoph, you guys have any final comments?

Christoph Wolf  34:06  

What would I think in summary about Brexit, I think it’s really a very negative thing. I think it’s very likely that we will see a recession in the UK. It will be very bad for the complete world for Europe, but especially for the UK. It will help the UK really nothing comes depreciating, which doesn’t really help because they have not renegotiated those trade agreements. Politically, the European Union I think we agree on that, they might disintegrate. We will see how this this will play out. Scotland and Northern Ireland they’ve already said they will not depart from the UK because they want to stay in the European Union.

David Flood  34:45  

Okay, well, I think I’d like to refer firstly to Stanley Druckenmiller has talked about in his recent presentation and that’s the fact that you’re seeing unproductive debt increasing. So we’re not seeing capital expenditure by companies to increase productivity. We’re seeing it going into share buybacks to induce earnings per share figures. So I think that’s a very important point to bear in mind. 

And then finally, I think we need to go back to Warren Buffett, he says you need to concentrate on the fundamental value of a company and its long term economics, and allow macroeconomic factors to distort your view of valuing a company. So if you look at the kind of companies that he likes, Coca Cola, Heinz, Kraft, these are companies where he knows that the products are going to continue to keep selling regardless of if there’s a recession or an economic crisis. You know, people will keep buying these products and needed dependable companies. So in a broad market sell off, these are the kind of companies that I’ll be looking towards, companies where I can determine that they have a long term economic future, and I can determine an accurate fundamental value for that company. And macroeconomic factors should just be a interesting side topic to bear in mind, but don’t allow it to distort your view on an individual investment.

Preston Pysh  36:06  

Guys, so Stig and I, we’re just so thankful for people like you, Chirstoph and David, for coming on to talk with our audience. But more importantly, we want to publicly thank you guys for everything you’ve done with our forum through the years because you guys have contributed so much to what it is that we’re all about with this podcast, with the Buffett’s Books website, everything. Just giving and trying to help other people out. And you guys, when I think about two people that have been instrumental in our organization to do that, you two are absolutely two of the most profound people for our organization. So we want to thank you for that.

David Flood  36:48  

Thanks for turning me on to value investing in the first place.

Preston Pysh  36:52  

You bet, man.

David Flood  36:54  

I came across a video on YouTube, and I’d never heard of it. I’d never heard of it before. I found one of your videos. And when I discovered it, it made perfect sense to me, like Warren Buffett said, you really get *inaudible down. It made perfect sense to me. 

Preston Pysh  37:07  

Oh, I appreciate that, David.

All right. So that’s all we have for you guys. And we just really appreciate everyone listening. And we really hope the best for everyone over there in Europe. I know this was a really gloom and doom kind of conversation. We do want the best for everyone in this world. We want everyone to, you know, be successful. We want everyone to understand the risks that are associated with things that could happen. And that’s really what’s driving our conversation. So we hope this was useful for everyone. And we’ll see you guys next week.

Outro  37:35  

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