Podcast: Play in new window
- Gas Prices to rise as Iran takes political blow from U.S.
- MN. Fed President: We’re almost out of medicine, let’s fight the next recession now
- Corporate bond borrowing hitting all time highs
The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
FDR, NIXON, KISSINGER, SAUDI ROYALS,
IRAN & TODAY’S PETRODOLLAR MONOPOLY
April 24, 2019
“Every recession of the past has been immediately preceded by excellent numbers, impressive figures when it comes to unemployment, sentiment indicators. And so yes, it’s debt issuance, it’s positive employment statistics, a general feeling of exuberance buttressed by a belief that things are better than ever. And in fact, maybe they arebetter than ever – but that’s why weworry.”
– David McAlvany
Kevin:When I came to work with your father back in 1987, Dave, I was taught a story that I had never heard. I was a kid during the oil embargo and I had seen the high inflation of the late 1970s, I had seen the Shah of Iran fall and the Ayatollah rise. All of that was unrelated until I got to work for your dad and I was sat down, and he said, “Let me tell you a little bit of a story, and it starts in 1945.”
David:That’s right, and as you go through the Bretton Woods period, you have not only the remaking of our monetary system for a post world war period, but you also have the trade in oil which becomes directed, ordered, negotiated. There is an agreement, and this goes back to FDR spending some time in Egypt.
Kevin:Yes, in 1945, and I don’t think we realize, FDR was in a wheelchair at the time, U-boats were still an issue in 1945. They had been neutralized to a degree with some of the new technology, but there was a real risk in a U.S. president crossing the Atlantic Ocean. This was important enough, this meeting with the Saudi Royal family was important enough to jeopardize a U.S. president during war.
David:Outside of the gold standard period, we had stability within our global monetary system based on, really, two prongs. One was the gold proxy, which the dollar became in the Bretton Woods era where we had reserves which were exchangeable with any central bank, and that was our promise: “Our dollar is just as legitimate as gold, and any time you want one or the other, it doesn’t matter.”
Kevin:We always redeemed. We always redeemed until 1971.
David:But at the same time we put together the Bretton Woods agreement in that same period of time, 1944, February 14, 1945, FDR was creating, really, a friendly relationship with the Saudi royal family, and that, I think, goes hand in hand. Not only was gold a part of that stability, but also…
Kevin:It became a reserve just in case the gold wasn’t there.
David:That’s right, not only a reserve, but it guaranteed that because oil was traded in U.S. dollars we had something of a floor. There was a stabilizing factor for our currency.
Kevin:Then let’s fast forward the story. Through the 1960s when we started getting to where we couldn’t redeem in gold, all the way up until 1971.
David:Jacques Rueff had been a young man watching the devaluation of the pound sterling in the 1930s. He was the financial attaché of the French in London at the time, and he witnessed the pound sterling devaluation, and then you go into the 1960s and he is watching us in the U.S., basically default on our promises, and default on the Bretton Woods agreement, as we are doing our guns and butter policies and are unable to maintain the relationship between the dollar and gold. And he tells the leadership in France they are going to be in trouble. Take the gold as fast as you can. 1968 the Bretton Woods program started to fall apart and it wasn’t until 1971 that Nixon stepped in and closed that gold window.
Kevin:And when he closed the window, a lot of people thought this would be the collapse of the dollar, but because of the agreement going back to 1945 all oil had to be traded in dollars. Boy, wasn’t that convenient?
David:But the interesting thing is, that began to fall apart in the 1970s because all of a sudden the dollar is not as good as gold. It no longer is a “sound currency” and so you begin to see some restlessness in the Middle East as to what is going to be done with the flow of oil and the flow of currency in exchange for it. What currency will be used? What will it be denominated in?
Kevin:And of course, that is when we had the oil embargo. The Saudis were getting restless because of Israel, the 1973 war. In 1974, Kissinger manufactured a solution. It was called, according to Bloomberg – you can google this – a do or die solution. William Simon, who was the Secretary of the Treasury back in 1974, flew over to the Middle East for a two-week Middle Eastern vacation, but he really sat down with the Saudi Royal family and said, “Look, we will protect you. You just need to recycle all those U.S. Treasury dollars back to us and make sure that not a single drop of OPEC oil, from anybody, gets sold in anything but a dollar.
David:You have the oil embargo, you have Marc Rich who was the commodity trader who had left Phillips and was trading oil, actually embargoed oil from Iran, and selling it all over the world, making a fortune, on which he was not paying taxes.
Kevin:He was getting rich. Marc Rich was getting rich.
David:And the U.S. government went after him. He fled the U.S. and was in Switzerland and ultimately was pardoned by Clinton on the last day of Clinton being in office. But again, we come back to this issue of trading oil and what currency it is traded in there in the 1970s, and Kissinger knew well that if we did not stabilize the dollar that the dollar could very quickly go into freefall, and so by bringing this dollar denomination into the oil markets he stabilized what was a currency moving very quickly toward an extinction event.
Kevin:Strangely, it is interesting how you see somebody get thrown under the bus, though. The Shah of Iran was an ally of the United States in Iran, but the Saudis needed to have pre-eminence, and so at the same time that William Simon went on this Middle Eastern trip – two weeks before – he started openly criticizing the Shah of Iran. The parallels, Dave, with what is going on today are amazing.
David:The Trump administration decided that the Iranian nuclear deal wasn’t much of a deal, so last year you may recall they blew it up. Trump’s goal is now to reduce the Iranian exported oil to zero and he is going to do that through the use of sanctions. So in order to accomplish this he has removed the exemptions, where eight countries were still allowed to continue importing Iranian oil, but on a reduced basis.
This week we had Mike Pompeo step out and announce that sanction wavers for those eight countries were going to be removed starting in May. Lo and behold the oil market jumps up from an already elevated level. Now we are to six-month highs. So when you put a strain on supply it tends to push the price higher. The only country with excess supplies to moderate that and to bring them to market is Saudi Arabia.
Kevin:Who would have thought, Saudi Arabia?
David:So there are some fascinating undercurrents in the oil market here, and you look at Iran and they were exporting 2.5 million barrels a day just not long ago, and since the end of the nuclear deal they have lost about half that volume. They are at less than half of that today. You have the two largest countries being impacted by Secretary of State Pompeo’s announcement, India and China, who both buy a lot of that oil – they are the largest oil trade partners with Iran – and then followed to a lesser degree by Japan and South Korea, Taiwan, Turkey, Italy and Greece. They can get the oil they need, they will just have to get it from someplace else. In this case it is going to be, in all likelihood, the Saudi Kingdom.
Kevin:Isn’t it interesting, too, that the goal for William Simon when he went over back in 1974 was, and this is a quote, “to neutralize crude as an economic weapon.”
David:And to some degree you might say he did that from the U.S. vantage point. It was no longer a weapon to be used against us, but we were also looking for more than neutralizing, we were looking at monopolizing. And so, maintaining the currency monopoly meant neutralizing that which could erode that currency monopoly, and that again was the denomination factor. How do you buy and sell? What currency do you trade oil in?
Kevin:And we may agree with the use of it against Venezuela and Iran, but we’re using that same mechanism right now. The loss of 75-100 million in daily revenue in Iran? That has got to affect the regime.
David:Yes, that’s definitely the case, a million barrels times roughly 74, 75, 73 dollars a barrel. That’s a lot in daily revenue. And we’re doing the same thing with Venezuela. We’re cutting them off from supplies of foreign currency, which if you look at the export dollars that come into Venezuela, 98% of them come from the oil which they are putting into the market. So they are bringing in dollars and that helps them stabilize their economy.
What, in essence, we have done is destabilize the Maduro regime. Now, you have socialism which has not served the Venezuelan people well, and now as the system is collapsing we are sort of adding on a little bit more pressure as U.S. foreign policy is exaggerating the already painful hyperinflation that is in that country.
Kevin:But we brought up OPEC, which is run by the Saudi royal family still. Venezuela is a significant OPEC contributor.
David:Yes. Fascinating sort of back channel conversation because there is legislation which was proposed in the year 2000, and it has been affectionately called NOPEC, where basically, we would bring greater controls and higher expectations on everyone in OPEC, and in fact, you could bring lawsuits against individual members of OPEC if they cut supplies and it is to our disadvantage. So as NOPEC and that legislation has been brushed off and the Trump administration has begun talking about it, lo and behold the Saudis are talking about what they would do in response, which might be selling oil in RMB, that is, renminbi, or what have you.
So back to Venezuela – Venezuela is one of the significant OPEC contributors. Ten years ago they were bringing production in north of 3 million barrels a day and obviously that is being squeezed. Production is less than half of what it was. It slipped in March. It slipped below a million barrels a day.
Kevin:It’s forcing their hand. They are having to go back to their last element of liquidity. They’re having to sell their gold.
David:That’s right, so 400 million in gold liquidated here recently from the Venezuelan government, the Treasury, and 100 million of that is going, this month, to pay the Russians in a debt deal which was consummated in 2017. So China, Russia, India – these are the three that have continued to support Maduro and his regime by buying oil, and U.S. sanctions have limited what we bring into the U.S.
Kevin:Do you see the tie here, Dave? China, Russia, India – those are the three largest gold buyers, especially over the last half-decade. They are buying everything, and at the same time they are supporting a regime that we don’t support. These ties – how do you miss them?
David:I guess when you use the word regime, you’re talking about whether it is Iran or Venezuela, but what I’m interested in is the different regime, the currency regime, which is also being challenged here. So you not only have the question of the flows of oil, but also the capital flows. We talked about this last week, where the Cold War which is anticipated with China relates not so much to tanks, bombs and guns, but capital flows.
Kevin:It’s capital flow.
David:So between capital flows and oil flows, this story does begin to get very interesting. So in the U.S., as we moved energy independence…
Kevin:I was going to ask you that. If we’re energy independent, part of the whole deal that was made in 1974 was that we would stay dependent on OPEC. Now we’re going for independence. How in the world do we hold any sway then with the rest of the world with the petro dollar?
David:Exactly. I would say that energy independence in the United States is not necessarily a permanent state of affairs, but it is reshaping Middle East alliances. So you have a reformation, a reforming, of who is doing business with whom, and where these friendships are blossoming. Russia is growing closer to Saudi Arabia, even as Russia moves to a more vital role as an energy supplier, not just oil, but natural gas, to most of Europe.
But here is the bottom line. U.S. regional influence in the Middle East is waning, and yes, to some degree our influence in Europe is also being marginalized. We’ll get to Europe in a minute.
Kevin:This is one of those reasons why we have to continue to talk to the people who are looking at the big picture, the global strategic picture, like George Friedman.
David:And as we have talked about the ongoing conversation with Kamran Bokhari, particularly on issues relating to Turkey, but yes, George Friedman, as well, with a larger Middle Eastern view, that the U.S. has consistently undermined Middle Eastern leadership and made Islamic leadership, for lack of a better word, more competitive. You can go back to the Bush administration. From the Bush administration forward we have been a destabilizing factor, and as we have shifted away from energy needs being met by our long-term ally, Saudi Arabia, guess what? The trade relationship with them has weakened.
Kevin:Yes, but don’t we strengthen that relationship by weakening Iran?
David:I think that is really one of the key points here – the removal of the Iranian export exemptions helps realign the relationship with Saudi Arabia. It is complementing our long-term provision of arms. Yes, we have been selling them a ton of military hardware, and on very good terms. And of course, we have had multiple military bases in Saudi Arabia, which gives us sort of a permanent aircraft carrier in the Middle East. So the combination of long-term arms provision and throwing them what is basically a 10% bonus on top of their current production, roughly 10 million barrels, and they get an extra million barrels a day now from this deal with Iran. It holds Iranian regional power and influence in check.
Kevin:Speaking of in check, I was just thinking about this. A chessboard is 64 squares, and sometimes when you move a single piece it changes the whole dynamic of the chessboard. In a way, this is a 64,000 square chessboard and we’re moving a piece. Talk about the unintended consequences – how in the world do you keep it all together?
David:You’re right, like a chessboard you change the position of a piece and it changes the pressure on the opponent. You don’t necessarily have to attack the queen or attack the king to change the dynamic on the board, and removal of the sanction exemptions likewise increases pressure. It increases pressure on China, it increases pressure on India, and it basically takes those two and puts them off balance. The Trump administration benefits by shifting pressure, and simultaneously increasing demand for Saudi oil. So the Saudis, frankly – I think they should send us a gift basket. Or better than a gift basket would be if they could just recycle those petro dollars into U.S. treasuries.
Kevin:One of the parts of the deal back in 1974 with Simon was that we would keep secret the amount of treasury buying from the Saudis. And we did for 40 years. For 40 years it was a secret as to how many treasuries the Saudis purchased. So talk about the gift basket, I’m wondering if they’re getting that back.
David:When you think about the complexity of international trade, we have lost one of our dollar recyclers here this last year when the Chinese decided to attempt to re-engineer their economy. And now all of a sudden they are running trade deficits instead of trade surpluses. They don’t have the surplus dollars to recycle into dollar-denominated assets and U.S. treasuries. So we’ve lost one of our big buyers of treasuries here in 2018, and we need a new buyer. And if we can change the pieces on the chessboard a little bit to help align our interests – look, we have a 1.1 trillion dollar deficit that needs funding. Is it possible that this shot in the arm for the Saudis came with a quid pro quo? “We’ll scratch your back – increase global demand for Saudi oil – if you’ll scratch ours – finance the 1.1 trillion dollar budget deficit by purchasing our treasuries.”
Kevin:One of the things that has been critical in all of this – this reminds me of under Otto von Bismarck back in Germany in the 1870s. You had all these alliances that were tied together, but it was really critical that everybody played ball with the alliances. Bismarck was smart enough to keep things going until he died, and then it turned into World War I in 1914.
We’ve had the same type of thing over the last 40 years. We had Kissinger. He was, in a way, our Otto von Bismarck. He orchestrated all these things where we bought far more goods – gadgets – from China for 40 years, and they would recycle their dollars. We would buy all of our oil, and everybody else would buy their oil in dollars, and they would recycle those treasuries back to us. That is all working, as long as you have a Kissinger or a Bismarck who can orchestrate it. But what about China? China is needing to be a player on this. Are they going to play ball?
David:I guess one of the things I don’t know is who that Kissinger is. Of course, Kissinger is still alive but he is not an operator.
Kevin:I understand. The players are not playing like they used to.
David:No, they’re not.
Kevin:They’re not dependent like they used to be.
David:So if you want to think of the fat tail risk as it relates to politics and geopolitics, markets can come unhinged. And I’ll tell you, the financial market operators today don’t know how to back-test or analyze political or geopolitical risk.
Kevin:It is all high-frequency trading. It is what happened a millisecond ago.
David:Or if they are stretching back in time and developing some sort of a model which they can trade off of, they are dealing with data that goes back one or two decades. And somebody like Kissinger – he actually learned a lot from Bismarck. Kissinger learned a lot from all periods of history. He was a real student of history. I don’t know that there is the equivalent of a Kissinger today, which I think frankly means that we could end up with surprises, lots of surprises, not only in the geopolitical sphere, but then with ramifications into the financial markets.
Kevin:So who will China buy their oil from?
David:They can buy from whomever they want, because I think, frankly, enforcing those sanctions would be a challenge. Look at the conversation that they have had over the trade issues, 250 billion dollars’ worth of trade issues, and they are having a hard time figuring out how to determine the enforcement mechanisms for that, so I think it becomes very difficult for us to enforce if China is buying or not buying oil from Iran.
Kevin:What if it also puts pressure on the Chinese? What if we do these sanctions on Iran and all of a sudden you start to see that the Chinese are getting pinched?
David:The big deal there is a propaganda issue, I think, not so much the money flow, but what they do with that pressure. Because if we try and enforce the Iranian oil sanctions, I think we give the Chinese leadership a propaganda message, and it is one that comes at a critical time. The Chinese, if they could have a message that would support nationalistic unification, boy would that be helpful. And you can imagine them saying something like, “The Trump administration is telling us how to operate on the global stage.”
I don’t think so. And I think this becomes a very helpful theme in a propaganda campaign within China. It is helpful to the Chinese Communist Party in terms of crafting a communication message for the domestic audience. You stir Chinese patriotism, framing the U.S. interference as abusive, as coercive, as without boundaries. And this, too, has an echo of history. You look at the Japanese. They were able to do the same thing prior to World War II as we began to limit their supplies of natural resources. Domestically, they crafted a narrative which justified expansionism. It justified getting out and getting off the island to go after the resources that they need, and that became a widely accepted theme.
The U.S., I think, bears some responsibility for goading the Japanese by squeezing their supply lines, and frankly, this is not a bad year for the Chinese Communist government to take advantage of those same kinds of perceptions of external threat. Keep in mind, we have the anniversary of Tiananmen. They would much rather distract and move attention away from one portion of their history. I just don’t think the U.S. is doing itself any favors meddling in the affairs of the Chinese on this particular point. At some point there is likely to be revolt in the global monetary system with King Dollar being dethroned.
Kevin:I don’t want to overplay the parallels, but we are the 50thanniversary from 1969 of man’s guided descent to the moon. A lot of that was building patriotism for a Cold War that existed. The United States was very, very patriotic on this mission. It was a form of a battle win to be able to descend and land on the moon. The Chinese, this year, have on the back side of the moon, landed the first controlled-descent craft onto the back side of the moon. They have a rover right now coming off. And of course, talk about patriotism, the Chinese flag is prominent. I was thinking, “How much solar energy are they losing to actually display that much flag on the side of the lander? But there is the parallel. There is a parallel again. We have these tensions, the Chinese are trying to build patriotism. In a form, we have a cold war going on. They have just landed on the moon with a big Chinese flag on their lander. Maybe I’m overplaying parallels, but it is eerie to me.
David:This is where oil goes from being simply a commodity with supply and demand aspects, and very critical to driving global economy, to being what it was in the past, again, weaponized, or if we want to put it in slightly less hyperbolic terms, it is a foreign policy tool. And of course, it is both. It is continuing to drive the foreign economy, but it is also a foreign policy tool. Venezuela and Iran point to how the limitation of exports can crush a political regime. And if you go to the Russian initiatives currently in place to supply Europe, to supply Turkey, and to supply China with natural gas, you can see how opening supply lines opens relationships and creates long-term regime stability for the Russians.
Kevin:It is a world built on pipeline.
David:That’s right. It brings in desired revenue. But it also shifts allegiance via energy dependence. So you have Gazprom – their big deals in recent years have been Nord Stream and Nord Stream III. You have Turk Stream. And then you also have the 3000 kilometer pipeline to China, all taking the Russian state up a notch in terms of geopolitical clout. Today, Gazprom has 172,000 kilometers of pipelines, which connects to 30 different countries, and gives the Russian state a very powerful point of leverage with those trade partners, just as we have wanted to either weaponize – neutralize from our opposition standpoint – and monopolize ourselves the power of the oil markets.
So we see oil and energy transitioning. And yes, we are gaining from the standpoint of independence, but I would say some of that is fleeting, and that is just the dynamics of the kinds of wells we are drilling. We have no guar [from guar beans grown primarily in India, needed for fracking] which we just tapped into with a 30-50 year lifespan. Yes, we have reserves, but you’re talking about small pockets, and it’s drill, baby, drill in order to access those small pockets.
Kevin:When you have Germany needing 50% of their oil from Russia, if you want to have somebody’s goat you basically just make sure that you supply their energy.
David:Competition for power and influence in world politics – this is what we were suggesting last week, that the Chinese are aware of the importance of capital flows. Energy supplies and capital flows are both elements that share a common denominator.
Kevin:It’s currency.
David:The reference currency. What’s the reference currency? So as volumes of capital move from one place to another, the currency it trades in is important. And as energy flows from one place to another, the reference currency it trades in is equally important.
Kevin:We’re not talking billions of dollars here, we’re talking trillions, aren’t we?
David:There are two aspects, because on the one hand you have the oil market, itself, which trades probably 2½ trillion dollars just in the exchange of goods for capital. But then you have the futures and derivatives market where the oil markets see an additional 5 trillion dollars in notional value traded each year. You can begin to feel, with those kinds of numbers, when you are talking about trillions of dollars changing hands, how important the reference currency is within the sphere of the energy markets. And it is, of course, to our advantage to maintain currency hegemony in U.S. dollar terms, which is again, I think, one of the things that you begin to see erode over time.
Kevin:We have a brilliant economy. It’s growing, it’s booming, it’s boosting, as long as we can borrow 1.3 trillion dollars more a year. It’s a little bit like that American Express commercial. When these people first get back from their vacation they look at each other, they are in the airport, they say, “Let’s take another vacation.” So they pull out their American Express card, and of course, they can do that.
David:(laughs)
Kevin:You cannot run – you and I both know this – you cannot run a deficit economy without the petro dollar being the currency of use.
David:You mention 1.3 and the budget deficit is on tap to be 1.1. Appreciate that the difference will be somewhere between the anticipated budget deficit of 1.1 trillion and the actual treasury issuance, which could be as high as 1.5. So your 1.3 is, I think, a modest number by the time we get to the end of the fiscal year and we look at how much, in terms of new treasuries on a net basis have been issued.
Kevin:But somebody has to loan us that money.
David:That’s right. So without currency hegemony, look at sanctions. Sanctions would be far more difficult to enforce. With it, we are allowed to run deficits that would otherwise be unrealistic, and with it, we are allowed to influence the flows of financial capital throughout the world. I understand there are academics, particularly UC Berkeley – I don’t know why they cluster at Berkeley, but they are not keen on us having reserve currency status. And I still think there are some benefits. Maybe it’s a more “fair” world if we don’t have it, but it is also a more costly world for those of us living in the United States.
Kevin:Talking about a booming economy, and I, of course, say that tongue-in-cheek because it’s purchased with debt, the economy slows down every time energy prices go up. Let’s face it, we’re going into vacation season. We’re in a vacation town here in Durango, Colorado. We always feel the impact of higher gas prices.
David:I think it is an important aspect of the energy markets, and when you’re pressuring the oil price higher, you are, in effect, tempting fates with inflation here in the U.S. So you have the Economistmagazine – I love this edition – at the beginning of every year, going back I don’t know how many years but at least several decades – they have sort of a preview for the year – what they expect in 2019, what they expect in 2018, and it’s sort of their grand prognostication. So the economist magazine suggested in their 2019 overview that by late 2019 a recession here in the U.S. is a growing probability. Keep that idea in mind because when you start bringing higher oil prices in, it pressures the real world inflation factor.
Kevin:Not what they report.
David:Exactly. We’re not talking the CPI mumbo-jumbo. We’re talking about real world inflation, and it begins to tip the scales toward recession here domestically. The consumer comes under tremendous pressure with higher oil prices. I think you also have to keep in mind that gasoline prices – a distinct market from oil – but they tend to rise, reflecting higher oil cost. We’re also heading into the second quarter when many of your U.S. refineries shut down for their annual maintenance.
So it is not uncommon to see a spike in your refined products because you are dealing with a supply and demand squeeze where demand begins to increase as the weather gets nicer, people start to drive more, and yet the supply, because refineries are on furlough, or what have you, for maintenance, there is that issue. So a further rise in the price of gasoline and other refined products, I think, should be expected, even before we enter full-fledged into the summer driving season.
Kevin:And we have been talking mainly about governments, but we have a new element this particular time around. The corporate debt – the corporations are buying back their shares at record amounts, but they are borrowing to do it, so you have corporate debt right now that is also affected. If we have inflation, it can’t be paid back.
David:It’s one of the weaknesses and it ties directly to the oil markets, particularly here in the United States. We’ll get to that in a minute. I think when you look at the corporate debt markets, you have a massive expansion in recent years to the point where here recently the IMF and the Bank of International Settlements have stated their concerns at the tail end of 2017. They haven’t calculated the numbers yet for the end of 2018, but total debt-to-GDP globally moved above 217% there at the end of 2017. Of course, it is even higher today. And the corporate sector’s contribution to that has been enormous. It has been aggressively growing even as they have been doing their creative stuff, taking, actually, a lot of the debt, a lot of the reason they have acquired so much debt on the balance sheet is to take those dollars and retire shares. They are buying back their shares, creating a long-term liability, shrinking the number of outstanding shares so that their earnings-per-share numbers look better. It is the classic prettying the pig. How do you turn a sow’s ear into a silk purse? This is how corporate America does it using the debt markets.
Kevin:And they are going deep into debt at a time when interest rates are artificially, historically, as low as they have ever been. And yet, we are possibly going into a recession, higher energy costs, higher inflation. And so all of the elements here, you do have the makings of a perfect storm if something were to change at all.
David:This is what happens at the end of any business cycle. This is not a contestable point. The business cycle is long in the tooth. We are near the longest on record in U.S. history, and you begin to see issuance of lower and lower quality debt. If you look at the lower quality debt, if you look at high yield, or what used to be called junk bonds, that market has expanded rapidly here in the last few years.
Oil companies are right in the middle of that. They have leveraged themselves – these are your small to mid-tier producers, and they are the ones drilling the shale oil here in the U.S. Beautiful. They have lots of supply on the front end, but there is not a depth of reserves with the places they are drilling right now. So this is where it gets really nasty. Supplies run off pretty quickly and the financing of the drill projects only works if you keep the drilling going and introduce new revenues into the cycle – a little like a Ponzi scheme that keeps the new revenues flowing. Oh, by the way, higher prices in the oil market certainly support the whole game, and they promote a further expansion in the oil patch, increasing debts.
We have talked about this how many times before, Kevin? Asset prices fluctuate. Debt is permanent. When a sector like the oil market in the U.S. takes on significant debt, and has cyclical price volatility, there are going to be problems. And to that you add the mismatch between the long-term cash flow required to maintain payments on the debt, and the short-term production profile of the shale drill projects – so it’s a mismatch – it’s an accident waiting to happen. So the catch 22 is higher oil prices sustain the unsustainable in the domestic oil patch and keep the debt expansion game going in that lower quality tier, again, toward ever dangerous levels of debt. But the other side is high oil prices and inflation also build pressure on the U.S. consumer and ultimately have a deleterious effect on the U.S. economy.
Kevin:Lest we be accused of being doomsayers and there being no hope, there are answers to this. If you start to see these things building up cycle after cycle after cycle, like Howard Onstott said, “the cycle still pervades,” or “the cycle is still intact.” When we see these elements getting to this point, you can make sure that you have your gold and silver, make sure that you have cash liquidity, and also last week, Doug Noland – you guys did the Tactical Short Conference Call. I’m sure there are people who missed that, and that can be heard on the website.
David:Yes, the following week we have the audio available, and then toward the end of this week if you prefer to read the remarks, the transcript will be available, I think, by Friday, but the audio is available if you go to mwealthm.com. I think one of the striking comments that Doug shared last week came from the Minneapolis Federal Reserve President, Narayana Kocherlakota. This is his quote: “The Fed needs to fight the next recession now. Its tools are limited, so the central bank must compensate by being aggressive.”
He also said, “Almost ten years after the great recession ended, the growing threat of a new economic slowdown raises a troubling question. When the next recession strikes, what can the world’s central banks do? With interest rates low, and their balance sheets still loaded with assets bought to fight the 2008 crisis, do they have the tools to respond? What, then, can the Fed do?”
He goes on to say, “In my view, it needs to be much more aggressive in using the limited tools that it has. For one, if your medicine chest is nearly empty, you have to keep your patient as healthy as possible. That means cutting interest rates now to lower the unemployment rate even further.”
Kevin:Wow.
David:This is just shocking, and Doug comments that if you’re running short of medicine, the analogy of giving out what you have now fails terribly.
Kevin:“We’re almost out of morphine. Give them morphine.”
David:“Give them morphine.” In Doug’s view, and I support him in this, it is better to not encourage a reckless lifestyle. He says, don’t convince the foolhardy in the speculative community that you have a cure-all, that you have an elixir. That only encourages greater recklessness and greater risk-taking. But it is fascinating because it is Kocherlakota, it is Evans, it is Rosengren, it is a growing number of voices at the Fed who are saying, “Let’s do something now.”
And as far as I know, at least in the official statistics, we don’t have any indication of recession. But this goes back to why we named the Tactical Short Quarterly Conference Call, “What are the Central Bankers Afraid Of?” Because the Powell U-turn that we saw was, indeed, the central bank community registering fears that they cannot address publicly. But the reality is, just as Kocherlakota said, their options are limited, and they know it.
Kevin:In a way, it is like someone addicted to alcohol who says, “I’m going to be sober, so I’m going to have another beer right now, and that’s it. One more beer. I’m going to be sober.”
David:(laughs) It’s a little crazy if you think about fighting the next recession now, and it’s also a little unprecedented. I don’t know of any Federal Reserve, or frankly, central bank, who has tried to get out in front. Being reactive, being sensitive to the numbers, that clearly has been a part of the Fed’s mandate, and other central banks have said, “Look, we’ll play it by the numbers, and if we need to get involved, we will.” In this case, it is, “Nothing bad has happened, but we want to make sure that nothing bad ever will happen.”
It goes back to that analogy you used a few weeks ago about the maintaining alcoholic, someone who has struggled with alcoholism for a long time. Sobriety is painful when you have been at the bottle for any length of time, and Kocherlakota would say, “Keep the liquidity flowing so that the consumer and their sort of liquid courage continues to express itself on an indefinite basis. Gone is the business cycle, gone is the ebb and flow and seasonality. And folks, I just have to tell you, this scares the crud out of me because this is the stuff upon which monumental crashes are built.
Kevin:This is also the stuff where it helps to have been through a few cycles because this happens over and over and over. Now, maybe there are some extremes that we are encountering right now, but prices on the stock market are rising mainly because of these low interest rates. But price earnings ratios where you are 30-35 years before you even break even, on average, on any of these stocks? So the PE ratios being high, they can never go up forever. Interest rates can never go down forever. And so what happens to the bond market?
One time your dad was talking about the difference between stocks and bonds. I loved it. He said, “I want you to imagine a bathtub full of water. And then I want you to imagine pouring a shot glass of Scotch in that water. The shot glass is the stock market. There is no comparison. The amount of debt out there…” This is why Jim Grant watches interest rates. He doesn’t watch stocks. Okay, he’ll watch stocks, but they are meaningless in the long run. It’s who owes whom, and who is going to pay.
David:That’s right. Go back to the comments on the bond market, the corporate debt markets. Obviously we have had sovereign debt which has just exploded since the global financial crisis, and sovereign debt has been the big deal. Well, the next big deal is the corporate debt markets, which are booming, and this year is no different. You have issuance, 2019, at 747 billion dollars – this is corporate debt – already ahead of the previous record which was set in 2017.
Kevin:And that is just this year.
David:And then you have the Fed and the ECB indicating that they are going to be aggressive, going back to Kocherlakota’s comments, Rosengren’s comments, Evans’ comments, that they are going to be proactive here. And what it is doing is bringing a very unsound and unhealthy boldness into the bond market.
Kevin:Yes, but are there people seeing this? Are we seeing signs of professional investors starting to step back and say, “Wait a second, this smells an awful lot like 2007.”
David:Not en masse. There are small segments where there is some reserve, but I think the bond market is being convinced that there is control from the central bank community and they can kind of hold the sun, moon and stars in place.
Kevin:Back to the Titanic analogy from last week.
David:The presumption of control is massive. And where you begin to see some discretion is in segments where it is appropriate for there to be, like the CLO market. That market is a 600 billion dollar market.
Kevin:That is Collaterized Loan Obligations.
David:That’s correct. And so, you have elevated yields still there, well above LIBOR [London Inter-bank Offered Rate – a benchmark interest rate index], well above any benchmark rate, and it indicates that investors do have concerns in those structured products. I think that is reasonable. But look at it. You have products that are complex, you have products that are opaque, and you have products that have limited liquidity. So it says to me that there still are segments where within the fixed income universe investors are thinking. But again, it is this magic elixir that the central banks are pushing that, frankly, is dulling the senses of not only the stock market – that is a given – but even into the bond market there is this presumption of control.
Kevin:We live in a place that has all four seasons, and they always come. Sometimes winter takes a little longer. We have these long falls and it feels like summer is going to last forever. But there is always a winter. And if we average things out, it is usually about the same time every year, but it may be delayed at times. We have the same type of thing with recessions. Are we not getting close to the longest we have ever been between recessions?
David:Yes, that’s what I was saying earlier. The Economist Intelligence Unit – that is a group I have spoken for in the past in New York City, specifically on commodities-related issues – they were noting earlier this year that if the U.S. economic expansion lasts until July, just around the corner…
Kevin:A few more months.
David:It will have reached 121 months. That will be the longest period of business and economic expansion in U.S. financial market history, and they also note that defaults are very common at the end of business cycles. Here is the challenge for investors today, because just as it is always darkest before the dawn, and you tend to see investor psychology demoralized and down and throwing in the towel just before things are getting ready to improve, it is very difficult for investors to sort of disassociate from their current experience.
And just the brightness of this day, and how well things are happening in the economy, and the stock market being at all-time highs, these are good signs for investors. And it is difficult to imagine recession with employment rates under 4%, yet every recession in the past has been immediately preceded by excellent numbers, not only by impressive figures when it comes to unemployment, but also sentiment indicators. Then look at debt. There is massive debt issuance, and it is always on very shoddy terms. Why? Because there is so much confidence in the system. People don’t feel like they need to cover their bases in terms of quality of collateral.
So yes, it is debt issuance, it is positive employment statistics, a general feeling of exuberance buttressed by a belief that things are better than ever. And in fact, maybe they are better than ever – but that is why we worry.
