Stan Druckenmiller, as we have previously noted here and here, is not one to shy away from criticizing the Federal Reserve for taking unnecessary risks in public. But, as Bloomberg reports, he’s also done so in more intimate settings…
The billionaire investor, who has one of the best long term track records in money management, told an audience at the Lost Tree Club in North Palm Beach, Florida, that trouble is looming…
* * *
Partial Transcript of Lone Tree Club speech in North Palm Beach, Florida
KL = Ken Langone … SD = Stanley Druckenmiller
…
SD: [My first mentor, Speros Drelles,] taught me two things.
First, never, ever invest in the present. It doesn’t matter what a company’s earning, what they have earned. He taught me that you have to visualize the situation 18 months from now, and whatever that is, that’s where the price will be, not where it is today. And too many people tend to look at the present, oh this is a great company, they’ve done this or this central bank is doing all the right things. But you have to look to the future. If you invest in the present, you’re going to get run over.
The other thing he taught me is earnings don’t move the overall market; it’s the Federal Reserve Board. And whatever I do, focus on the central banks and focus on the movement of liquidity, that most people in the market are looking for earnings and conventional measures. It’s liquidity that moves markets.
…
My second mentor was George Soros, and unlike Speros Drelles, I imagine most of you have heard of George Soros.
When I read The Alchemy of Finance, I understood very quickly that he was already employing an advanced version of the philosophy I was developing in my fund. So, when I went over to work for George, my idea was I was going to get my PhD in macro portfolio manager and then leave in a couple years or get fired like the nine predecessors had. But it’s funny because I went over there, I thought what I would learn would be like what makes the yen goes up, what makes the deutsche mark move, what makes this, and to my really big surprise, I was as proficient as he was, maybe more so, in predicting trends.
That’s not what I learned from George Soros, but I learned something incredibly valuable, and that is when you see it, to bet big. So what I had told you was already evolving, he totally cemented.
…
Probably nothing explains our relationship and what I’ve learned from him more than the British pound. So, in 1992 in August of that year my housing analyst in Britain called me up and basically said that Britain looked like they were going into a recession because the interest rate increases they were experiencing were causing a downturn in housing. At the same time, if you remember, Germany, the wall had fallen in ’89 and they had reunited with East Germany, and because they’d had this disastrous experience with inflation back in the ’20s, they were obsessed when the deutsche mark, that they would not have another inflationary experience. So, the Bundesbank, which was getting growth and had a history of worrying about inflation, was raising rates like crazy.
That all sounds normal except the deutsche mark and the British pound were linked. And you cannot have two currencies where one economic outlook is going like this way and the other outlook is going that way. So, in August of ’92 there was 7 billion in Quantum. I put a billion and a half, short the British pound based on the thesis I just gave you. So, fast-forward September, next month. I wake up one morning and the head of the Bundesbank, Helmut Schlesinger, has given an editorial in the Financial Times, and I’ll skip all the flowers. It basically said the British pound is crap and we don’t want to be united with this currency. So, I thought well, this is my opportunity. So, I decided I’m going to bet like Soros bets on the British pound against the deutsche mark.
It just so happens he’s in the office. He’s usually in Eastern Europe at this time doing his thing. So, I go in at 4:00 and I said, “George, I’m going to sell $5.5 billion worth of British pounds tonight and buy deutsche marks. Here’s why I’m doing it, that means we’ll have 100 percent of the fund in this one trade.” And as I’m talking, he starts wincing like what is wrong with this kid, and I think he’s about to blow away my thesis and he says, “That is the most ridiculous use of money management I ever heard. What you described is an incredible one-way bet. We should have 200 percent of our net worth in this trade, not 100 percent. Do you know how often something like this comes around? Like once in 20 years. What is wrong with you?” So, we started shorting the British pound that night. We didn’t get the whole 15 billion on, but we got enough that I’m sure some people in the room have read about it in the financial press.
…
One of the things I would say is about 80 percent of the big, big money we made was in bear markets and equities because crazy things were going on in response to what I would call central bank mistakes during that 30-year period. And probably in my mind the poster child for a central bank mistake was actually the U.S. Federal Reserve in 2003 and 2004. I recall very vividly at the end of the fourth quarter of 2003 calling my staff in because interest rates, fed funds were one percent. The nominal growth in the U.S. that quarter had been nine percent. All our economic charts were going through the roof, and not only did they have rates at one percent, they had this considerable period – sound familiar? – language that they were going to be there for a considerable time period.
So, I said I want you guys to try and block out where fed funds are and just consider this economic data and let’s play a game. We’ve all come down from Mars. Where do you think fed funds would be if you just saw this data and didn’t know where they were? And I’d say of the seven people the lowest guess was 3 percent and the highest was 6 percent. So, we had great conviction that the Federal Reserve was making a mistake with way too loose monetary policy. We didn’t know how it was going to manifest itself, but we were on alert that this is going to end very badly.
Sure enough, about a year and a half later an analyst from Bear Stearns came in and showed me some subprime situation, the whole housing thing, and we were able to figure out by mid-’05 that this thing was going to end in a spectacular housing bust, which had been engineered – or not engineered but engendered by the Federal Reserve’s too-loose monetary policy and end in a deflationary event. And we were lucky enough that it turned out to be correct. My returns weren’t very good in ’06 because I was a little early, but ’07 and ’08 were – they were a lot of fun.
So, that’s why if you look at today I’m experiencing a very strong sense of deja vu.
…
Let me just say this, the Federal Reserve was founded in 1913. This is the first time in 102 years, A, the central bank bought bonds and, B, that we’ve had zero interest rates and we’ve had them for five or six years. So, do you think this is the worst economic period looking at these numbers we’ve been in in the last 102 years? To me it’s incredible.
Now, the fed will say well, you know, if we didn’t have rates down here and we didn’t increase our balance sheet, the economy probably wouldn’t have done as well as it’s done in the last year or two. You know what, I think that’s fair, it probably wouldn’t have. It also wouldn’t have done as well as it did in 2004 and 2005. But you can’t measure what’s happening just in the present in the near term. You got to look at the long term.
And to me it’s quite clear that it was the Federal Reserve policy. I don’t know whether you remember, they kept coming up with this term back at the time, they wanted an insurance policy. This we got to ensure this economic recovery keeps going. The only thing they ensured in my mind was the financial crisis. So, to me you’re getting the same language again out of policymakers. On a risk-reward basis why not let this thing a little hot? You know, we got to ensure that it gets out. But the problem with this is when you have zero money for so long, the marginal benefits you get through consumption greatly diminish, but there’s one thing that doesn’t diminish, which is unintended consequences.
People like me, others, when they get zero money – and I know a lot of people in this room are probably experiencing this, you are forced into other assets and risk assets and behavior that you really don’t want to do, and it’s not those concentrated bet kind of stuff I mentioned earlier. It’s like gees, these zero rates are killing me. I got to do this. And the problem is the longer rates stay at zero and the longer assets respond to that, the more egregious behavior comes up.
Now, people will say well the PE is not that high. Where’s the beef? Again, I feel more like it was in ’04 where every bone in my body said this is a bad risk reward, but I can’t figure out how it’s going to end. I just know it’s going to end badly, and a year and a half later we figure out it was housing and subprime. I feel the same way now. There are early signs. If you look at IPOs, 80 percent of them are unprofitable when they come. The only other time we’ve been at 80 percent or higher was 1999.
The other thing I would look at is credit. There are some really weird things going on in the credit market that maybe Kenny and I can talk about later.
But there are already early signs starting to emerge. And to me if I had a message out here, I know you’re frustrated about zero rates, I know that it’s so tempting to go ahead and make investments and it looks good for today, but when this thing ends, because we’ve had speculation, we’ve had money building up for four to six years in terms of a risk pattern, I think it could end very badly.
…
KL: You mentioned in your talk that there are already early signs of excesses due to over-easy monetary policy. What are some of the signs you see?
SD: Okay. I mentioned credit. I mentioned credit. Let’s talk about that for a minute. In 2006 and 2007, which I think most of us would agree was not a down period in terms of speculation, corporations issued $700 billion in debt over that two-year period. In 2013 and 2014 they’ve already issued $1.1 trillion in debt, 50 percent more than they did in the ’06, ’07 period over the same time period. But more disturbing to me if you look at the debt that is being issued, Kenny, back in ’06, ’07, 28 percent of that debt was B rated. Today 71 percent of the debt that’s been issued in the last two years is B rated. So, not only have we issued a lot more debt, we’re doing so at much less standards.
Another way to look at that is if those in the audience who know what covenant-light loans are, which is loans without a lot of stuff tied around you, back in ’06, ’07 less than 20 percent of the debt was issued cov-light. Now that number is over 60 percent. So, that’s one sign.
The other sign I would say is in corporate behavior, just behavior itself. So, let’s look at the current earnings of corporate America. Last year they earned $1.1 trillion; 1.4 trillion in depreciation. Now, that’s about $2.5 trillion in operating cash flow. They spent 1.7 trillion on business and capital equipment and another 700 billion on dividends. So, virtually all of their operating cash flow has gone to business spending and dividends, which is okay. I’m onboard with that.
But then they increase their debt 600 billion. How did that happen if they didn’t have negative cash flow? Because they went out and bought $567 billion worth of stock back with debt, by issuing debt. So, what’s happening is their book value is staying virtually the same, but their debt is going like this. From 1987 when Greenspan took over for Volcker, our economy went from 150 percent debt to GDP to 390 percent as we had these easy money policies moving people more and more out the risk curve. Interestingly, in the financial crisis that went down from about 390 to 365. But now because of corporate behavior, government behavior, and everything else, those ratios are starting to go back up again.
Look, if you think we can have zero interest rates forever, maybe it won’t matter, but in my view one of two things is going to happen with all that debt. A, if interest rates go up, they’re screwed and, B, if the economy is as bad as all the bears say it is, which I don’t believe, some industries will get into trouble where they can’t even cover the debt at this level.
And just one example might be 18 percent of the high-yield debt issued in the last year is energy. And I don’t mean to offend any Texans in the room, but if you ever met anybody from Texas, those guys know how to gamble, and if you let them stick a hole in the ground with your money, they’re going to do it. So, I don’t exactly know what’s going to happen. I don’t know when it’s going to happen. I just have the same horrific sense I had back in ’04. And by the way, it lasted another two years. So, you don’t need to run out and sell whatever tonight.
KL: Will this unprecedented global money printing ever stop? And what is your intermediate and long-term view on inflation?
SD: Well, the global money printing is interesting because the United States is the world’s central bank. And Japan had this guy named Shirakawa running the central bank, and he didn’t believe in this stuff. So, what happened when he didn’t print the money but the U.S. was printing the money and we’re [inaud.], the Japanese yen started to appreciate and it stayed appreciating, and it basically hollowed out the country. And they were eventually forced, as you know, two years ago into flooding their system with money.
You have a very, very similar situation going on in Europe now. I know Mario Draghi and Angela Merkel don’t like QE. They don’t like anything about it, but again, the chump – I have this partner. I don’t know if he’s in the room, Kevin Warsh who’s on the Federal Reserve Board. He said Japan used to be the new chump because they had the overvalued currency. Now it’s Europe. So, their currency went from 82 say back in 2000 all the way up to 160, and it was 140 last summer, and they’re absolutely getting murdered. And now they’re apparently caving in and they’re going to print money.
I don’t know when it’s going to stop. And on inflation this could end up being inflationary. It could also end up being deflationary because if you print money and save banks, the yield curve goes negative and they can’t earn any money or let’s say the price of oil goes to $30, you could get a deflationary event. If you had asked me this question in late ’03, I’d have said well, this probably ends with inflation, but by the time we needed to, we figured out no, this is going to end in deflation. So, the fed keeps talking about deflation, but there is nothing more deflationary than creating a phony asset bubble, having a bunch of investors plow into it and then having it pop. That is deflationary.
…
But the point I was making earlier is there was a great enabler, and that was the Federal Reserve… pushing people out the risk curve. And what I just can’t understand for the life of me, we’ve done Dodd-Frank, we got 5,000 people watching Jamie Dimon when he goes to the bathroom. I mean all this stuff going on to supposedly prevent the next financial crisis. And if you look to me at the real root cause behind the financial crisis, we’re doubling down.
Our monetary policy is so much more reckless and so much more aggressively pushing the people in this room and everybody else out the risk curve that we’re doubling down on the same policy that really put us there and enabled those bad actors [ph.] to do what they do. Now, no matter what you want to say about them, if we had had five or six percent interest rates, it would have never happened because they couldn’t have gotten the money to do it.
…
KL: What’s the future of the euro currency?
SD: I think the euro needs to continue to go down because eight of those countries have such a cost disadvantage versus Germany right now. It’s about 40 percent because they haven’t been behaving themselves since the euro was put together that you have severe outright deflation not like pretend deflation like we talk about on the board. It’s real deflation. And they’ve got sclerosis. I can’t see Europe surviving without the euro going down to somewhere in the mid-80s. And if you think that’s a ridiculous forecast, when I restarted Duquesne in 2000, the euro was 82. Now, that was extreme. But let me ask you this, think of the Europe and United States back in 2000 and think of them today. Do you think Europe has made incremental gains versus the United States or declines? So, to me it’s not unreasonable to see the euro continue to go down.
The other thing I’ll say, I do analyze currencies, and it would be almost unprecedented to have a 10-month currency trend. Because all the dislocations happen when your currency is overvalued and it’s up long enough, it takes years to unwind those dislocations. And it’s hard to argue the euro is not in a trend. It’s down from 140 to 117. And using the rule of time, I don’t think it’s unreasonable to expect it to break 100 sometime in the next year or two.
In terms of the euro region itself, there’s still a lot of questions. That was put together for political reasons really to create political unity. And as most people in this room know, it’s doing just the opposite. It’s creating political disunity. So, I don’t think it’s even a given that that thing stays together.
…
But you talk about entitlement. The federal debt right now is $17 trillion. The reason it’s $17 trillion and not higher is because all those payments that are promised to Kenny, a lot of the people in this room, myself not too far in the future, they’re not on the government balance sheet. Any company in America if you owe payments of that certainty, it would be a debt. In the U.S. government accounting it’s revenue.
If you present valued what we have promised to seniors in Medicare and Social Security and Medicaid payments, the federal debt right now under gap accounting would be $205 trillion, not 17 because we have a demographic boom, which is the other side of the baby boom. As everybody knows in this room, it’s the grey boom. We are creating 11,000 seniors in this country every day. Every day we’re creating 11,000 new seniors, and we’re only creating about 18 percent of youth employed to support those payments to them. So, we’ve got a big problem, and it really doesn’t start until 2024, 2025, but if you wait ’til 2024, it’s too late. It’s not unlike climate change.
It’s probably not a problem for 30 years, but if you wait 30 years, you can’t fix it. So, you got to start now.
KL: This is my question, is there any way possible you think that we could have a soft landing from all the excesses we’ve had in the last 10 or 15 years?
SD: Anything’s possible. I sure hope so. And I haven’t committed. I’m not net short equities. I mean the stock market right now as a percentage of GDP is higher than – with the exception of nine months from ’99 to – it’s the highest it’s been in the last hundred years of any other period except for those nine months. But you know what, when you look at the monetary policy we’re running, it should be – it should be about where it is. This is crazy stuff we’re doing. So, I would say you have to be on alert to that ending badly. Is it for sure going to end badly? Not necessarily. I don’t quite know how we get out of this, but it’s possible.
* * *
