Axel Merk on Inflation, Currencies and the Likelihood of a Greater Depression
The Daily Bell is pleased to present this exclusive interview with Axel Merk.
Introduction: Axel Merk, President & CIO of Merk Investments, LLC, is an expert on the global economy, hard money, macro trends and international investing. He is considered the authority on currencies and has been named the "Currency Guru" by Morningstar. His insight and expertise have allowed him to foresee major economic developments: As early as 2003, he pinpointed the macro trend of US dollar volatility while warning about the building of the credit bubble. In 2005, Axel Merk positioned his clients to move out of real estate and protect them against a faltering U.S. dollar by investing in hard currencies and gold. In early 2007, he wisely cautioned that volatility would surge, causing a painful global credit contraction affecting all asset classes. He is a regular guest on CNBC, FoxBusiness, Bloomberg TV and frequent contributor to the Wall Street Journal, Financial Times, Barron's and other financial publications around the world.
Daily Bell: Tell us about Merk Funds. How much does it manage and in what capacities?
Axel Merk: Merk Funds manages over $600 million in four mutual funds; we invest in currencies, international fixed income securities and gold. We try to give investors managed currency risk in a variety of forms, seeking to profit from a rise in currencies. One of our products is what we call non-directional, which is more tactical in nature.
Daily Bell: As early as 2003 you identified the building of the credit bubble. How was that possible? You use Austrian economics?
Axel Merk: First, with regards to Austrian economics, many people say that I'm an Austrian, but I like to have my own way of thinking about the world. Throughout my career – and that includes my academic work as a student – I've always focused on volatility. I wrote a book in 2009, Sustainable Wealth. Without going through the entire book, basically the driving force of the environment we are in is induced by monetary policy that kicks the world into overdrive. When you have the world in overdrive, commodity prices go up and there are all kinds of unintended consequences, many of which we have seen today.
Daily Bell: Give us a sense of your academic background.
Axel Merk: I graduated with both undergraduate and Master's degrees from Brown University. Basically, I was always fascinated by integrating computer science with economics and financial modeling and trying to find different ways of looking at the markets, analyzing them.
Daily Bell: You adapted your research in applied mathematics and machine learning to the financial markets. Tell us about the paper that was published by Elsevier Science Publishers in 1992.
Axel Merk: The Elsevier Science Publishers are a very reputable scientific publisher and it was an abbreviated version of my Master's thesis on probabilistic modeling. The thesis was a way to analyze volatility, valuation and liquidity in the markets. Basically, it was an integration of finance and computer science. By nature, economics tends to ignore boundary conditions. We call them flat tails or black swans now; I was concerned about them in the 1990s.
Daily Bell: How did this affect your perception of economics?
Axel Merk: It gave me a healthy dose of humility. You cannot model everything! While I was very much quant driven in my early years, I am best known these days for a macro view. I think it's very helpful to have a quantitative background and you've got to be able to align numbers but you've also got to keep a healthy degree of skepticism about extrapolating numbers. The most recent example is the Federal Reserve. Bernanke believes that a weaker dollar will not be inflationary; well, that's because his statisticians show that historically a weaker dollar has never been inflationary. In our view, that doesn't mean it won't happen in the future. Not everything is projectable.
Daily Bell: You founded Merk Investments in Switzerland in 1994 by pooling the investments you'd been managing for friends starting in college. How did the fund come about and what was your perspective on investing at the time?
Axel Merk: In the '90s we invested in high tech stocks, equity stocks and diversified to other industries to manage volatility. At some point those correlations broke down so we became more global investors. Around 2000 we became more macro investors and more cash and precious metals based. When you see dislocations in the markets, that's a warning sign to us and sometimes these warning signs come very early ... it means that we want to be somewhere when the markets adjust and we would rather be safe than sorry down the road.
Daily Bell: In 2001 you relocated the business to California and Merk Investments became a SEC registered investment advisory firm. Tell us what that was like.
Axel Merk: Sure. As you know, we often complain about our regulators but at the same time the grass is not greener on the other side. We had our business based in Switzerland at the time and we were thinking of relocating. We looked at many countries around the world and the reason we chose the US, despite there being a lot of regulations, is that it is far more predictable, or was, than many other places in the world. That was ten years ago and things have changed a little bit ... but that was one of the key motivations to move to the US.
Daily Bell: In 2005, Merk Investments launched its first mutual fund, the Merk Hard Currency Fund. What focused you on hard currency in particular?
Axel Merk: From 2000 to 2004, we had shifted a lot of our business to cash and precious metals. One of the reasons was that we didn't like anything else anymore. We thought there would be some seismic changes in the world and we wanted to provide some additional tools for investors in the environment that we saw coming. Currencies were a way to express that.
Daily Bell: You're an expert on qualitative research and macroeconomic trends. But Austrian economics tells us that it is impossible to predict the future with any accuracy ... except when it comes to the business cycle.
Axel Merk: I mentioned my Master's thesis and how I see the world in terms of probabilities. We assign a certain probability to different kinds of events. We have our views of how the world might evolve and we communicate those views and investors can agree with those views or they can ignore them. But you've got to think about those probabilities way ahead of time, which allows us to be more conservative in our management.
Daily Bell: Your investment philosophy can be best described as an integration of quantitative and qualitative analysis. Again, how does free-market economics fit into this paradigm?
Axel Merk: We ask, what are the interventions by policymakers that distort the free markets and what investment opportunities are created? Ultimately, we believe that markets are healthiest in the free-market environment but unfortunately, that's not the world we live in so we have to look at interaction between the market forces and policymakers. If there is one thing positive to say about our policymakers, it is that they are quite predictable. So based on that you can try to design an investment portfolio.
Daily Bell: You believe sustainable wealth is built over the long term with superior insights, clear focus and commitment. Can you be more specific?
Axel Merk: Follow your grandmother's advice; I think that's the short answer. You religiously put money aside and try to build up that way. You don't want to be a speculator; you want to live within your means. It's a very simple concept and the other part of that statement is that you go to the sources. You don't rely on third-hand information. You try to have your framework of thinking about the world and then you dig deep and try to see whether the reality is matching what your framework looks like.
Daily Bell: In promotional material, you write, "We strive to invest with discipline while adapting to changing environments." What environments are changing and why?
Axel Merk: Our focus is on a strategic outlook rather than being chased by the latest and greatest move of our policymakers. The important thing is that having a strategic outlook means that as new information becomes available, you update your outlook but don't want to be knee-jerk in reacting to the latest and greatest news that is coming out. You have got to find a way to have a long-term outlook on the world; otherwise, the next company you see on CNBC is going to make you sell all your stocks and buy something and then the next day you are going to do something opposite. You have to have your own way at looking at things and that's where the discipline comes in. Also, we believe there are a number of ways to make money but you have got to be disciplined. You can't just pursue the latest story.
Daily Bell: What made you decide to create currency funds?
Axel Merk: Asset prices no longer move based on fundamentals but on the next potential intervention by policymakers. What better way is there to express the mania of policymakers than in the currency markets? In the currency space you can design a portfolio that has a low correlation to other assets. So to us, the currency asset class is really ideally suited to help navigate the world we are in.
Daily Bell: You "provide original insights, commentaries and analysis on currencies and the global economy." Give us some examples of original commentary, please.
Axel Merk: I might want to choose a controversial one here. In 2010 we were one of the few, if not the only ones, talking positively about the euro. The euro was heading down but we believed that the impact on bonds markets would move the euro higher relative to other currencies, and it did. Since then we have become more cautious, and the reason is because of the dysfunctional political process. If you don't know who's in charge, you don't want to touch an investment. But we don't mind taking a very controversial stance on an issue even if it meant being pro-euro in 2010.
Daily Bell: Give us a sense of your performance. How have you done?
Axel Merk: I can't say too much, but I will say that we have had a very steady performance with our funds, including the Hard Currency Fund – though, of course, past performance does not indicate performance going forward. I encourage you to go to the web site and look up how we've done. Look up the 2008 performance with others. We believe we have been really successful in translating our interpretation of how our policymakers are going to move ... which currencies are going to benefit and which ones are going to be suffering.
Daily Bell: Some practical questions, now. When is this worldwide recession going to end?
Axel Merk: I don't think we can talk about an endpoint of the potential for a recession defined in economic terms. We can argue that the market environment will become more volatile, however. What we are looking for is a disengagement of policymakers, but having said that, we foresee ever more active engagement of policymakers. There will be more unintended consequences and then policymakers will jump in and try to punish the so-called speculators who are actually trying to benefit from those negative side effects. This will make the markets more and more volatile going forward.
Daily Bell: That's very interesting and right along the lines of the way we see things. At this point investment returns are as much a result of what policymakers do and don't do as they are of the free market itself. So please repeat what is causing increased volatility....
Axel Merk: Interference of the policymakers.
Daily Bell: Succinct. It is for this reason we think the euro may be on the way out. Why do you think the euro and EU are going to survive as you have stated in the past?
Axel Merk: Your emphasis is on the past here. What we see these days is that Germany is going to be around in ten years, and we think Germany is going to have a currency and we think it is called a euro. It's not as simple as saying, "Hey, the euro is not going to be around." If you ask me whether Greece is going to fold ... yes, I'm almost convinced of that. But that doesn't mean that the euro is not going to be around in some form anymore.
Daily Bell: Where is gold headed? Silver?
Axel Merk: Let me answer this a couple of ways. We have gold in our flagship fund and it's directly there between 5 and 15 percent. In my personal portfolio, if I exclude real estate related assets, I hold over 50 percent in gold. Some is physical gold and some is not.
Silver is historically more volatile than gold, and gold is volatile enough for our needs. Silver should be outperforming gold but the dynamics are much more complex, given the industrial use it has as well. We try to keep it simple. That's why we focus on gold and a couple of currencies.
Daily Bell: Is the US coming out of recession?
Axel Merk: I don't think so, not at this stage. If anything we have a slowdown. What we are concerned about is the environment if and when we do come out of a recession. At some point all this money that's been printed is going to start to have an impact on price inflation. Fed Chairman Ben Bernanke claims he can raise rates in 15 minutes. Good luck with that! Volcker in the early 1980s had to raise rates to 20 percent to wring out price inflation. The reason Bernanke wants to keep rates low until 2014 is because he probably believes he can comfortably tighten at that stage. But nothing has worked out the way our policymakers wanted.
I have spoken to Fed officials and they think it's all just a walk in the park, and that they can manage interest rates very easily. I have my doubts. I'm much more concerned with what's going to happen when the money that's been printed starts circulating with some velocity.
Daily Bell: What will happen to China? Recession? Hard landing?
Axel Merk: We are a tad more positive on China than many others are. Let me give you a couple of reasons. The first one is, yes we think there is a housing bubble and, yes, we think there's a busted housing market. But what's different about China compared to the US and Spain is that not as many consumers have taken out a mortgage. Only about 15 percent of consumers have taken out a loan from a bank and another 15 percent have taken a loan from friends or family. That means when you have a shock to the housing market, it's not as detrimental as the one we had in the US.
China needs a more mature credit system. Right now, the government sets the cost of credit. What is needed is more competition in the banking system; you need market-based interest rates, and as you move in that direction you're going to unleash entrepreneurial power within China. So based on that, we think China is going to be much more successful than many people anticipate. China is moving more towards the free-market environment, more so than most Western countries.
Daily Bell: How about South America? Thoughts?
Axel Merk: When I look at South America, I see a tremendous wealth gap in many Latin American countries. Loose monetary policy is actually driving a wealth gap around the world. That's why we are having social discontent in the US and why we are having revolutions in the Middle East. We avoid South America in particular because of policies that are very detrimental to long-term sustainable growth.
Daily Bell: Is there a power elite behind such things as the growing wealth gap worldwide?
Axel Merk: Personally, I don't think it's productive to frame these issues conspiratorially because the implication then is that if you can replace the conspirators, things would be better. I don't want to think about the world in that framework. I think we have certain global dynamics that push policymakers in that direction. If you look on the monetary side right now, most of the federal bankers actually want to do the right thing. They're just stuck in the world they're in.
Daily Bell: Is central banking a good thing?
Axel Merk: I think the world would be better off without central banking. But just getting rid of central banks is not going to cure all the ills that we have because the policymakers would just try to come to the rescue through other means. I think we are too optimistic that policymakers would stay within their boundaries. Policymakers are immensely creative in either seizing power or coming up with rules to further promote their pet projects. Obviously, central banking is a great way of doing it because you have a printing press to finance these things ... but there are alternatives that our policymakers can come up with as well.
Daily Bell: Is it good for a small group of people to manage the value and volume of the world's money?
Axel Merk: I don't think it's a small group. All the mature economies in the world have processes in place, maybe very dysfunctional ones, and then we put policymakers in on a temporary basis. In some ways even the policymakers are just pawns.
Daily Bell: What would do for an alternative currency? Gold? Silver? Both?
Axel Merk: I would leave it up to every individual. One of the things that has happened over the past hundred years is that we have moved further and further away from the gold standard. Now there are quite a few people that say, at some point, we are going back to the gold standard, but my answer is, don't count on governments doing that voluntarily.
So ... why don't you just do it personally? I said earlier that I hold 50 percent of my assets in gold; the reason is that I don't want to rely on my government doing it for me. Sometimes people talk about SDRs or world currency and that sounds great on paper but if these policymakers were to come together they would not agree. Now, if we had a global currency backed by gold, yes, it would be nice, but I don't think it's going to happen anytime soon. More practically speaking, I will not wait. I live on my own personal gold standard and if the policymakers move in that direction, that's great.
Daily Bell: Did government invent money or the private market?
Axel Merk: Successful merchants invented money.
Daily Bell: What do you think of government fiat money as an alternative to the current money system? Is Greenbackerism a valid idea?
Axel Merk: Fiat money is what we are dealing with, and this currency is losing its function as a store of value. That's one of the reasons that our funds allow investors to mitigate the risk of any one currency by diversifying to numerous currencies. I wish we could say, "Let's adapt the gold standard and we'll live happily ever after." But in practice, we are living in a volatile world and I do believe the world is going to get even more volatile. We have to come up with our own currency, our personal currency, whatever our personal frame of reference is, and try to manage volatility based on that.
Daily Bell: Monetary inflation has already taken place. When will price inflation happen?
Axel Merk: Well, anything that you cannot import from China has already gone up in price. The cost of education, the price of health care, local craftsmanship have already gone up. At this stage, our policymakers have tried very hard to prevent a deflationary trend and they are pushing the world into overproduction. When you overproduce gadgets the cost of those gadgets remains very low, and that is why we haven't seen inflation break out in other places. Let the US economy truly grow a little bit and then good luck trying to contain inflation.
Daily Bell: Is a worldwide depression going to bring on global government?
Axel Merk: I think the bigger risk is social instability. If you look at the first half of the last century, those are the types of things that I am worried about. Now we've got a Tea Party that's on the right and an Occupy Wall Street movement that's on the left. In the Middle East, we've got revolutions. Egypt better elect a good chef as a next president because it's ultimately the food that people need; they don't care about democracy ... they care about feeding themselves.
Unfortunately, it's human nature to blame others. Look at what is happening in Greece. They are burning the German flags because they are blaming Germans for austerity. I think that's the sort of environment I am more concerned about rather than whether one guy is in charge.
Daily Bell: Are the BRICS collapsing too, economically?
Axel Merk: I think you have to look at each one of those separately. I don't like the interventionist approach in Brazil, for instance. Russia is a resource-rich region, which is great, but they don't have a consistent rule of law, which I think is a problem. India is on a different planet. If you have ever spoken to Indian policymakers you just roll your eyes. They are trying to micromanage their huge economy, which is impossible. China we talked about earlier. There are many challenges in China and there are many things we don't like happening in China. China is opening up far more rapidly than many people give them credit for and conversely, they are already far more open than many other parts of the world.
By the way, BRICS is written with a capital S so let me add one country to that: Singapore. Singapore is really our favorite country these days. Yes, the S actually stands for South Africa, but Singapore should be noticed. Its leaders are attracting capital by having both a steady government and a very restrained monetary policy.
Daily Bell: Will a worldwide collapse hasten the collapse of the dollar?
Axel Merk: There are no risk-free assets and the dollar is no safe haven. Search on the Financial Times, to find an online op-ed that I wrote called "The US dollar Is No Safe Haven from the Euro Zone.' In the short-run people do flee to the US dollar but then they leave again. And when they return, the dollar doesn't seem to bounce back to where it was before. We see investors in general are increasingly looking for alternatives to the US dollar.
Daily Bell: Okay. So what now?
Axel Merk: We like currencies because you don't take on equity risks and don't have the excessive credit interest or risk you have in many bond alternatives out there. I stick to what I am good with, and I encourage all investors to stick to what they are good at.
Daily Bell: Do you have any comments on the LIBOR scandal? We think central banks fix rates every day. What's the difference? We think it is a manufactured crisis.
Axel Merk: I think the scandal is blown out of proportion. In 2008 we had bigger fish to fry than LIBOR. But this may be lawyer driven. While many other things have happened in the financial crisis, the lawyers couldn't get their teeth into those. With LIBOR being manipulated, you will see more lawsuits; you will see big headlines, big settlements and whatnot.
Daily Bell: Any other points you want to make or material you want to recommend?
Axel Merk: I would like to send people to our website to sign up for our newsletter, merkfunds.com or merkinvestments.com. I also started Tweeting about a month ago ... @axelmerk is my Twitter account and I promise to offer some thought-provoking ideas on how to navigate through this rough climate.
Daily Bell: Thanks for your time. Good luck with your funds.
Axel Merk: Thanks for having me.