EPISODES / WEEKLY COMMENTARY

Inflation Dragon Now Too Big To Hide

EPISODES / WEEKLY COMMENTARY
Weekly Commentary • May 17 2022
Inflation Dragon Now Too Big To Hide
David McAlvany Posted on May 17, 2022
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  • “Perception management tool” is failing politicians
  • Strawman? Biden pins inflation blame on wealthiest corporations
  • Consumer Sentiment Plummets…

Inflation Dragon Now Too Big To Hide
May 17, 2022

“Here in the U.S., the most significant issue pressing on the polls and agitating voters is not abortion, it’s not the Supreme court, it’s not climate change, but inflation and cost escalation, number one. Polls register a growing concern with, again, household budgetary pressures. And so now you get politicians who are like, how do we dance around this? It’s a reality we can’t control, and how do you manage perceptions with it? You’ve got to find somebody to blame.” — David McAlvany

Kevin: Welcome to the McAlvany Weekly Commentary. I’m Kevin Orrick, along with David McAlvany. 

I’m really looking forward to Friday. We’re celebrating the 50th anniversary of the company. Basically, it was your mom first that started this company back in 1972—

David: That’s true.

Kevin: And your mom and dad are in from the Philippines. They live at one of the orphanages that they help with, and they came back to Durango for this and the 16th birthday of your eldest son. Wow.

David: Right? Well, I mean, of course, to see the rest of their kids too. My sister in California, the rest of the family towards the east coast. And it’s great to see them. We spent the weekend tent camping in Arches National Park, which I don’t think they’ve been in a tent in 50 years.

Kevin: I didn’t even know you could camp there. I’ve been there and I thought you had to leave after five. But you guys had the permit, huh?

David: We head to Moab twice a year with the five families, we call them the five families. Sounds like sort of a mob gathering or something. It is a mob when you start counting all the kids and sort of the mayhem that happens over—

Kevin: The red rock, the desert, and the kids, and the noise— Is there water there?

David: Sometimes we’re floating the river. Arches, it’s more about hiking. Other trips we’ll take mountain bikes and various levels and various ages. So we kind of scatter and then re-gather for meals.

Kevin: You were a little worried, your mom and dad, you weren’t sure when the last time was that they tent camped. Now, they’re pretty tough. They do missions work all around the world, but tent camping, was this the first time for your mom in what, 50 years?

David: I think so. Yeah, to end the weekend, it was thank you for the invitation, we look forward to coming back next year.

Kevin: So they said that they liked it?

David: Yeah. So I guess we will invite them.

Kevin: Well, good. Well, Friday, the company gathers, and again, we’re very, very thankful. We have—

David: 50 years.

Kevin: 50 years. And we were talking to shift this thing over to economics because your dad— When Nixon closed the gold window in 1971, your dad knew enough about economics and he was a broker at the time, a stock broker and a bond broker. He understood that that was the beginning of the death of the dollar. And since that period of time, since 1971 when Nixon closed the gold window and then ’72, when Don and Molly opened this company, the dollar’s lost 99% of its buying power. So I guess that he was right. If you look at it, gold was 35 bucks an ounce when they started.

David: You know, there’s a life cycle to everything. And when you look at the dollar and you look at the changes that were happening in 1970s, you could say it was creative genius. I mean, there were things that were going on that had to happen. They set the stage for a tremendous credit expansion, 40 years of tremendous asset appreciation and real estate and stocks and bonds unloosed from the hindrance of gold. 

It’s not unlike the hedge fund community. You’ve got the brightest guys in the room, and so you start with creative genius on the front end, and then you write books about those people later on. One title comes to mind, When Genius Failed. It’s not as if things are just absurd on the face of things or on the front end of things, it’s, in the final analysis, what is the cost? What is the cost when all is said and done? And the changes that were being made in the 1970s were considerable, and we’re just now beginning to see some of the long-term implications of that.

Kevin: We just came out of our briefing meeting that we have before we record, as a company. And Morgan, one of the economists that work for you, he pointed out the University of Michigan Consumer Sentiment Index. And it goes back to 1962, but I was looking at it, Dave, from 1972, when your mom and dad started this company. It was peaking, right before it fell dramatically down into the recession of 1974. It’s a very similar pattern to what we’re looking at right now. Isn’t it?

David: It is. And something that can be said that’s quite common is, you get extended in those periods of consumer enthusiasm, and we certainly were reasonably extended in the 2018 to 2020 period prior to the global pandemic. And even post-pandemic, we saw that expressed in the margin figures where people not only invested in stocks with their own money, but borrowed from the house to own a little bit more. We got to $936 billion in borrowed cash and—

Kevin: Margin debt on the market.

David: Yeah. Since the beginning of the year, that’s come down 17.4%, 163 billion. Very typically, that number contracts by 50% in a given cycle. So we do have consumer sentiment, which is now off—considerably off of its peak. We’ve got margin debt, which is beginning to move lower, and we’ve had sort of the first leg down, but again, normal contraction would have margin debt decreasing by an additional $300 billion over the next few months. And that represents significant headwinds for market practitioners. That’s a lot of liquidation of equities which they thought were a sure bet on the upside.

Kevin: Well, and there’s the Market Capitalization Index relative to GDP, which is more commonly called the Buffett ratio. And at this point, I mean, we’ve never seen numbers like it.

David: There’s a couple ways of looking at it. One, is the number itself, which is a simple equation looking at GDP and then looking at the capitalization of equities which comes from the treasuries Z.1 Report. That’s one way of looking at it. The other way is looking at it in terms of a rate of change. And to see that number accelerate gives you an idea, in a short period of time, what is happening. So for instance, in August of 1929 you had a peak. And over the two years that preceded it, sort of ’27 to ’29, it increased by 41%. This sort of rush into equities there at the tail end.

Kevin: Fear of missing out. Yeah.

David: And we had a similar rush in the recovery phase, 1937, where stocks were off of their lows of ’32 and it took about five years to get into recovery and know you were nowhere near breakeven. You actually weren’t at breakeven until 1953 as an investor in the Dow circa 1929. Nevertheless, that rush, the rate of change in terms of stock market capitalization compared to nominal GDP, an increase of 31% over a two-year period. So ’35 to ’37, those two years. Again, a rush of interest and enthusiasm. And you mentioned 1972, it was 28% increase. Again, stock market capitalization compared to GDP. So 1970, 1971, 1972, there’s a lot of enthusiasm there.

Kevin: And then everything broke, but it broke in a different way. We had high inflation. It didn’t look like the stock market was crashing, but what did we lose over that period of time after that? It was like 70 or 80 percent, didn’t we?

David: That’s right. The cumulative effect of inflation was nearly as catastrophic as the 89% decline in 1929. It just was less obvious because it was in real terms that you experienced the loss versus nominal terms.

Kevin: And that was the first decade of the company’s history. It was that 1970s decade.

David: Yeah. So you really begin to see how far out on a limb we are today. When you fast forward to the more recent period of time, the technology boom in the late ’90s. And that two-year period, ’98, ’99, led us to that 78% increase. The two-year change in stock market capitalization and GDP, 78%, burying what we saw in ’29, burying what we saw in ’37, burying what we saw in the early ’70s.

Kevin: And then the bubble popped.

David: Right. Before the recessionary ’73, ’74, before the decline in equities there later in 2000. And here we are this year, and we’ve crested at over a 95, 96% increase in a two-year period.

Kevin: Wow.

David: So 2001 and 2002, just this radical increase in the value of stocks versus the engine of growth, which we would consider to be the economy. And it just gives you an idea of how out of whack we are. So we’re still sitting with margin debt of roughly 770 something billion dollars. Off of the peak, yes. Down 17%. But—

Kevin: Right.

David: And I appreciate Alan Newman. I’m glad he’s still writing his stuff after 58 years. And I like that he keeps track of the margin debt numbers—

Kevin: He cracks me up. Yeah, he cracks me up because every time you interview him, Dave, or when we read his letter, he says, all right, now this is going to be the last. I’m going to retire. There’s just too much work. But then he looks at these markets and he’s like, I have too much experience not to speak up. Jim Deeds is like that, too. Jim calls us and sends us stuff. He’s in his nineties now, but he’s seen these cycles himself. And what he’s saying is, this is going to be really, really bad. Okay, let’s move to Japan for a second—

David: But it’s really important to keep in mind that the bear markets followed these enthusiastic bumps higher in terms of valuation. The worst bear markets of the last century came immediately after these big bumps in stock market capitalization and GDP. So 1932, 1974, 2003. 2009 was not far off of it. And arguably, if we are in the early stages of a bear market as we speak, we’ll be coming off of not only massive overvaluation, but it’s quite reasonable— It’s quite reasonable to see some of that given back.

Kevin: Why would we have a bear market? And this is why I said, let’s bring up Japan, because you were talking about the falling in. Obviously, if you can inflate forever and you just don’t care about inflation for the consumer, you can maybe keep a bull market from ever ending.

David: And somebody’s going to pay the price ultimately. And that’s where, again, over enough time, you begin to see the cost of a particular policy that’s chosen. On the front end, it may make all the sense in the world. And in terms of present tense dynamics and pragmatism, go for it. But as you get further and further along, you can count the cost. Kuroda will stay committed to the inflation target and the bond yield target in Japan. He outlined that earlier in the year, and that is regardless of cost to the Japanese people.

Kevin: Who cares what it costs?

David: He’s fixated on measured success and hitting the benchmark at any costs. You’ve got the 10-year Japanese government bond. It will not pass 25 basis points. The Bank of Japan will buy all quantities necessary to keep the lid on yields and increase inflation to their stated target. The cost will continue to be—it will continue to be because this is already in motion—significant yen destabilization. We’re no longer in freefall as we have been since the beginning of the year, but the yen now rests peacefully at a low level. It’s like a beautiful stone at the bottom of a koi pond, just out of reach and way down underneath the surface. These actions are not the first Bank of Japan actions, they’re not the first in the current currency war, but they are significant, particularly given the pressure that this creates for other Asian economies because so many economies, like Japan, are focused on exports to the rest of the world—

Kevin: Well, you brought it up last week. I mean, China, the pressure that it puts on the Chinese currency when Japan is just in freefall, it ultimately turns into a devaluation. Like you said, currency war. It’s who can devalue the quickest.

David: Yeah. And there’s a difference if you’re an exporter of finished goods versus an exporter of commodities. It may be some greater benefit from an inflationary standpoint to being a commodity exporter, but that’s not the case with these Asian export giants. So they focus on relative trade competitiveness. And for one to devalue, it’s almost like a gentleman’s agreement, no one will, unless one does, and then all must. We all will.

Kevin: It’s like, wait a second. Did you just lower your currency? Well guess what?

David: Yeah. And so it’s not surprising to see the Chinese RMB, the renminbi, face its worst bout of volatility in some time. Given up 6.22% since April 18th. It’s a decent decline in a currency that has its bona fides tied to stability, tied to control, tied to a chosen number, and here we’re seeing things get a little bit more chaotic. So if you look at the U.S., like in the U.S., you’ve got governing bodies in Japan and in China, they come up with policy objectives, they’ve got a rationale for those policy objectives. They try to get done what they want and get it done when they want it done, only to discover the true cost of implementation well after the implementation period. 

So the danger of currency devaluation, we’ve said this before, it’s a social danger. You think monetary, you think price action? No, the danger of currency devaluation is a social danger because when you move past a certain threshold, you move to the point where the public expresses itself through protest, and that’s because of the pressures introduced into the daily life of the average citizen via the weakened currency.

Kevin: John Maynard Keynes brought up that inflation really is a deceptive form of taxing. And Dave, as a company owner now, you realize, you buy office supplies— And inflation is a little bit like that itch that starts, just there’s something bugging you, but it’s not so bad that you have to actually eliminate the limb. 

Think about you’re managing a company. Okay, every once in a while somebody goes home with a paper clip or two, or maybe some pins, maybe they start making copies personally and going through the copy paper. There is a level that you’re okay with, but what if they walk out with the printer, the copy machine itself, or the computer? And it seems, isn’t there a breaking point with the public, with inflation, a little bit like that?

David: You’re right. We tolerate certain things and then we discover the threshold. And it’s not like in theory we’re condoning theft or [graft] or whatever, but the low levels of inflation are very much like that overlooked [grafting] of paperclips or other supplies in the office setting. Absconding with a stapler, it’s a little bit like the 2% inflation target. You can kind of ignore it. It’s the small scale, it’s considered a petty inconvenience, it’s a lot of effort and a lot of energy used to track every item in the office, right? But reach a certain threshold for graft, and it becomes an offense worth prosecution.

Kevin: Right.

David: And everybody would agree with that. Everyone would say, yeah, making a copy or two is one thing, walking out with a copier is another. 

So you’re saying this is like inflation. Now that inflation is a weightier concern than the stapler growing legs and walking away, policymakers are scrambling because people are saying, not happy, this is not working for us. We have reached the threshold. People are noticing. People are calling it out. So we’re over 8%, and in all likelihood we’ll average 5 to 7% for multiple years ahead, probably a best-case scenario. And these are official CPI numbers. The real world numbers are significantly higher. 

But savers are scrambling to figure out what to do. How do you de-dollarize? Investors are still unaware of what lies around the corner for them because, again, most of them have fallen in love with they have— they’ve fallen, I would say— what’s the musical in the last couple of weeks? Comfortably numb? Investors today are comfortably numb with the idea that they don’t have to factor in inflation to their return equation and they’re going to have a rude awakening over the next few years as inflation lingers. Maybe it’s not double digit, but you start negatively compounding inflation— And again, we go back to the ’68 to ’82 period, prices are bumping along for the Dow Jones Industrial Average, under a thousand points. You give up a little, you gain back, and you’ve got that glass ceiling at a thousand for the entire stretch.

Kevin: Yes, but there was inflation there—

David: Adjusted for inflation. The silent and secretive crash extracted 75 to 80%. Only slightly less than the 1929 crash, 89%. But with a lot less obviousness, a lot less drama. People really don’t concern themselves because it’s a subtle, slow bleed, as opposed to a sudden hemorrhaging which needs immediate triage.

Kevin: Yeah, currency devaluation isn’t always bad. I mean, it allows you to pay back debts with devalued currency. That’s been sort of the game, hasn’t it? I mean for the central banks for years.

David: Oh yeah.

Kevin: But it hurts some and it helps others.

David: Yeah. Depending on public finances that are already in place. If you’ve got a weakening currency, it can raise the bar for paying back outstanding loans and debt obligations. We’ve talked about that in terms of what economists call the original sin, if you denominate your debt in the wrong currency. 

This is why you had a banking crisis in Iceland a few years back. They could get cheaper financing in Switzerland, so when the Icelandic currency began to devalue and they had to pay back in a currency that was appreciating, the bar to pay back was increasing, and it forced the default. So add to that a rising interest rate environment, and now all of a sudden you’ve got this unique factor which we’ve not had for four decades, increasing debt service costs. I mean, you don’t think about it. You always get to refinance at a better number. That’s been the bonus that corporate America’s had for four decades, and the global corporate structure and sovereigns as well—

Kevin: Yeah, and the fiscal commitments. The commitments that they make don’t go away. You’ve got bills to pay.

David: Right, but think about that. What makes this environment tricky— And again, you can’t ignore inflation, you can’t ignore the implications of inflation, either, which are now a shift in the direction of rising rates. Rising rate environment, debt service costs create a nasty fiscal burden, at the same time— I read an interesting piece from the Economist Intelligence Unit this week—

Kevin: You spoke for those guys a few years ago, didn’t you?

David: Yep. Contributed to a CEO luncheon they put on in New York City. It was a commodities panel. Pretty interesting. And I like the work that they do. So it’s a part of the Economist magazine, but it’s an offshoot that looks at particular issues. 

So they make the case that in Latin America—other developing regions of the world, but specifically this paper was on Latin America—the commodity exporter is in a good position over the next few years. The commodity importer is by contrast in a real bind. But strong economic growth, which is typically correlated with a strong global demand for commodities, a boom in raw materials exports, it’s not exactly like it has been in previous cycles because there’s the other factors that weren’t present 10 years ago, 20, 30 years ago to the degree that they are now. You’ve got inflation, you’ve got public debt, you’ve got issues with current account balances. Now, with inflation, oh, guess what comes up? And we haven’t really seen much since the 1960s and ’70s. Political stability gets called into question. You couple that with a demand for regulatory control, and now you’ve got legal risk, regulatory risk, political risk, all of this tied to factors which, again, weren’t a real big deal. Inflation hasn’t been a big deal for a good long time. And because of the pandemic, we’re coming into a period of time where governments already are loaded with a lot of public debt, and it just leaves them with less leeway.

Kevin: Well, and you wonder how in the world they are going to make the— I mean, we didn’t have Chinese lockdowns back then, and you’ve got an awful lot of things that are affecting economic growth going forward.

David: Yeah. So these factors may mitigate growth, and they’re at an elevated level compared to previous cycles. So during the last commodity upswing, to your point, China wasn’t locking down cities. They were responsible for taking 60, 70% of the world’s concrete. They were consuming 50 to 60% of the world’s copper and iron ore—of the global supply. So yeah, you had a secular trend in place, a secular boom in commodities and it was demand driven. Now you’ve got the unknown variables, the unpredictable outcomes that make for heightened volatility. 

There was another Financial Times article that I read over the weekend about emerging markets dealing with rising rates and slower growth. And it argued for rising rates and slower growth introducing heightened volatility, and that being a form of financial tightening—tightening of financial conditions already being experienced. So there’s all of these things as backdrop issues. And so concluding, like the Economist Intelligence Unit, importers are clearly at risk, exporters may do just fine, but that doesn’t mean that it’s going to be the boom days.

Kevin: I mentioned John Maynard Keynes and his quote. It’s interesting. I think of the Boston Tea Party. Maybe it’s just still remembering some of the things Christopher Blattman was talking about when you interviewed him a few weeks ago, just going back to the Revolutionary War. You raise people’s taxes, everybody knows it and they may protest. You play around with inflation, and it’s like everybody just goes to sleep. It’s an amazing thing. And you know, John Maynard Keynes said that, he said that inflation was the tax that only one in a million understand.

David: Yeah. Well, in the case of state-sponsored swindle, what do we do? If they want to run inflation, what do you do?

Kevin: Right.

David: Right? I mean for the longest time—

Kevin: But you can’t throw the tea into the bay, right? And it’s one of those things where there’s nothing to do because they’re printing money.

David: Democracy is not a new form of government, but it hasn’t been as ubiquitous through time. Now it is. And so maybe we have a little bit more recourse, but I’d say recourse is limited. You still have to have enough people that understand to vote on a particular issue. So in the case of state sponsored swindle, I think your recourse is somewhat limited. If you don’t like your taxes, you can protest and you can get thrown to jail—

Kevin: Not pay them, maybe go to jail. Yeah.

David: You can protest the inflation rate or you can get hot and bothered about the interest rate suppression as an expression of financial repression. And you’re in the category of ignorable because these are ideas and things that frankly are a little too academic.

Kevin: Well, they’ve taught you. They taught us in school that a little bit of inflation is good for everybody.

David: Unless a threshold has been breached.

Kevin: Yeah.

David: And that’s when you begin to see protests. I mean, if it’s just one, if it’s you, if it’s me, no big deal. But when it goes from being the one to becoming a protest from the many, that shift in mass psychology, the broad-based protest, that becomes a real management challenge.

Kevin: Yeah. But management, we’ve been talking about management for the last 10 years. As far as perception management, they haven’t really had to do anything factually. They just come out and manage the perception of the people. Is that going to change? I mean, is that the threshold you’re talking about?

David: I think it’s the primary tool of the Fed right now, is to try to manage psychology, to try to manage people’s belief in what’s going to happen next, and we may find that they attempt to disabuse the markets of certain things. The Fed put has long been an assumption within the markets, that if anything goes wrong the Fed will be there to bail us out. And I think it’s noteworthy that Jerome Powell was elected for a second term last week. He doesn’t have to worry about whether he gets fired for a couple of years now.

Kevin: Wow.

David: And he might take off the gloves, and the market might not like that. But management of psychology is a primary public policy concern, as it turns out. And we think of issues, we think of disputes over this policy or that policy as being sort of the heart of political work, but too often, politicians are running point on perceptions, on perception management, again, sort of guiding the belief system and what they want people to see and weigh in on. Guiding constituents to see them as the effective champions of this cause or that cause. But management of people and the impressions they have is typically more effective and comes at a lower cost than actually altering policy.

Kevin: I run in the mornings, and I run with the dog, and the neighborhood that I live in, there’s five acre plots. And so there’s a little bit of territorial stuff going on. And there’s a little bitty dog, tiny little Chihuahua-like dog named Lewis, who’s all bark. And Lewis comes and runs up, but see, Lewis always is backed up by this gigantic German shepherd that follows him around. And today I noticed that the German shepherd wasn’t behind him, so I turned toward Lewis—this happened literally this morning—I turned toward Lewis, and Lewis ran away because he realized that the German shepherd that was always with him wasn’t with him. He couldn’t establish the territory. Now, I’m using that analogy because you brought that up—the Fed put. The markets are like Lewis. They don’t really have a lot of substance on their own, but they know they’ve got the German shepherd—they’ve got the Fed behind them. But what if the German shepherd doesn’t show up?

David: Well, it’s a different form of growing up. That’s a different form of discipline. You behave differently when there is a consequence to your choice.

Kevin: Yeah.

David: Management of mass or collective energy. I think this is one of the reasons why, as we get closer to the election, you see things that are more contentious. I’ve really enjoyed reading Glenn Greenwald. He’s a recovering leftist. And I say that because he at one time was a leading journalist from the political left, and has a high degree of criticism—not because I think he’s had some sort of a conversion experience or something to a different political perspective. I don’t know. I don’t know him personally, but I think he’s far more critical today than he was in the past. 

Maybe that’s not even fair, but the reason I mention him, today he publishes a lot of his stuff on Substack. And there’s this issue of politicians generating more heat than light. They like the fight. They like the energy. They like to harness it. They like to wield it as a weapon against their opposition. And so conflict and animosity are a form of political currency, and they like to print it, they like to spend it, regardless of the long-term social costs.

Kevin: Yeah. So they’ll throw things out like the Supreme Court, or they’ll throw out the abortion issue or a number of issues. Okay, green issue. That doesn’t seem to be what’s on people’s mind right now. Everybody is talking about inflation—

David: Yeah. Not according to the polls. Here in the U.S., the most significant issue pressing on the polls and agitating voters is not abortion, it’s not the Supreme Court, it’s not climate change. I think the abortion thing captures the top— It’s the top issue for 9% of voters. Significant, but inflation and cost escalation, number one. Polls register a growing concern with, again, household budgetary pressures. And so now you get politicians really like, how do we dance around this? It’s a reality we can’t control. How do you manage perceptions with it? Well, you’ve got to find somebody to blame.

Kevin: Well, you’ve got to get somebody mad at somebody else. Inflation’s hard to do that with.

David: Right. Pew research shows inflation is the top problem facing the country today and polls they’ve recently conducted, where seven in 10 view it as a very big problem. Next on the list of concerns, 55% of respondents are concerned with healthcare affordability. Number three spot in terms of top concerns, those polled, voicing their concerns, 54%, violent crime.

Kevin: Okay. So if you’re a politician, who do you blame for the inflation other than yourself?

David: Biden picked on corporations this last week. But I mean, there’s a dozen boogeymen. Putin’s responsible because oil prices are higher and that’s the cause of everything evil. Biden via Twitter last week said, you want to bring down inflation? Let’s make sure the wealthiest corporations pay their fair share.

Kevin: Oh, those wealthy corporations. They’re the ones who caused inflation.

David: There you have it, the White House’s assessment on inflation; it’s corporations raising prices that causes inflation so that profit metrics explode, and it’s all on the backs of the suffering consumer. And it reminds me that this is an administration that has routinely leaned on class distinction, race, gender, a host of other differences to whip up anger and hostility.

Kevin: So maybe they could use race or gender for the inflation problem. That would be creative. Wouldn’t it?

David: It’d be very creative. How you connect those dots, I don’t know. But as you know from the historical sayings of those who had mastered duplicitous political speech: tell a lie, tell it often enough and the people will believe it. In this case, it’s a cheap blame game. And I think it disrespects the intelligence of the American people. Scapegoating on corporate giants? Listen to discussion on inflation from academics in the field of economics. I mean, I’m thinking Larry Summers, who was just at the Hoover Institute. There’s a recognition that fiscal policy more than any other input has driven inflation in this cycle.

Kevin: So, translation: government spending.

David: Yeah. And we’re not even talking about the Fed money printing, we’re talking about government spending specifically. Inflation may be a complex topic, but most people can connect the dots to government stimulus checks getting spent and driving the price of goods up because there’s more money in the system, right? I mean, again, I just don’t think you pull the wool over people’s eyes in this way. You can’t limit the supply of something without eventually impacting the price.

Kevin: Are you’re talking about gas?

David: Last week, Biden canceled the gas leases in Alaska and the Gulf of Mexico, for example, this is of course via the Interior department. Which doesn’t seem to make a lot of sense, at least from a PR perspective. To announce the cancellation of leases the same week that gasoline prices are putting in all-time highs.

Kevin: Oh yeah. Well, it makes sense if you can fix prices, if you can make it illegal to raise prices.

David: Well, just think about that. I’m going to cancel the gas leases in Alaska and in the Gulf of Mexico, and then I’m going to blame big oil, right? For creating problems.

Kevin: Yeah. But then Pelosi’s like, yeah. And then we’re going to make them not raise prices.

David: Promoting the idea of making it illegal to increase gas prices. I think, as I expressed last week, nobody likes higher prices, but price controls are about the stupidest failed policy imaginable. There’s a whole history on price controls. You want to see scarcity? You want to see a supply shock? Shift the economics of the free market and watch the consumer pay that price for ridiculous policies as product disappears in a more dramatic fashion than even our post-COVID supply chain affairs. I mean, it would be the debacle layered upon the debacle. We could, over time, follow the Russians. I mean, again, if we want to do this sort of utopian vision of, we’ll just make everything right, top-down management style, and we could end up being like the Russians. They’re essentially today like a broken down gas station with nukes.

Kevin: Yeah.

David: That’s what they are. They’ve got supply of a product and they’ve got some nukes and they’re highly dysfunctional. The legislation we’re talking about is on excessive gas prices, it’s supposed to be brought to the floor this week for a house vote.

Kevin: So we talk about perception management, and you’ve got this insanity that you’re talking about here, where you cut the supply off of something everybody has to have, and then you say, well, we’ll just make it illegal for them to raise prices. But here’s the difference, Dave. We’ve got the statistics—

David: It’s an eventual impact, right?

Kevin: Yeah. Someday.

David: Right. But I mean, at the same time I see the Europeans trying to solve their gas supply issues, and the latest sponsored initiative is a 205 billion euro spending program on renewables. You can’t grow the renewables fast enough to replace the gas that is coming from Russia. So implicitly, what they’re saying is, on the basis of our principled approach, on the basis of our idealism, we’re willing to see the common man and woman across Europe pay ridiculously high energy prices because we have an incoherent energy policy, but at least we have our principles. So we’re going to spend €205 billion to pursue more renewables, which will never replace the hydrocarbons that we need and have to have right now in real time, 2022.

Kevin: Well, and we could spend hours talking about the insanity, but rather than do that, let’s just try to talk about the threshold because statisticians are the ones who tell us about inflation, but our spouses, if they go shopping, are actually feeling it. Our parents are feeling it. Our kids. I mean, gosh, can our kids go buy a home right now? I mean, most people, younger people, how do they do that? And so you’re looking at the inflation. I’m happy that a statistician told me that the CPI is 8.3%.

David: Well, but this is where I think the University of Michigan consumer confidence numbers tell a very significant story. They hit an 11-year low. It’s well lower than what analysts had expected.

Kevin: And these are people talking about their expectation, their sentiment.

David: Yep. How do we feel about the current economic environment? What are you going to spend money on? Why? Why not? Conditions for purchasing big-ticket items, lowest levels since that part of the survey was introduced in 1978. Consumers are experiencing the inflation, right? And statistics suggest that there’s inflation. Yeah, and 8.3 is a real number. It scrubs out a number of things. We’ve talked about substitutions and hedonics and a variety of ways that you can take a double digit 13–15% number, which is what—

Kevin: That would be consumer sentiment, 15%.

David: Because that’s what they’re actually experiencing on a real world non-scrubbed basis. But by the time you pretty up the inflation pig, you end up with 8.3%, and then we have the PPI also lower than the previous month but still above expectations. And it’s the consumer experience with inflation that I believe is so negatively impacting the University of Michigan sentiment numbers.

Kevin: Every time you fill up. Every time you fill up. You guys are about to take a trip, too. Your son turned 16. This is when you start looking for future education, and I think your trip is a long ways from here. What are you using? Diesel?

David: Of course. Well, and we’re not the only ones heading into driving season. It’s going to be intriguing to see if there are behavioral shifts in response to higher fuel prices. And I had to stop and think, truck stop chains, you have two of them, Love’s and Pilot. These are big truck stop chains, they’re warning of diesel shortages on the east coast this summer. And I’m thinking to myself, wouldn’t that be interesting? Drive the F-250 out there, we can take the dog, I’ve got to take my race bike because I’ve got a couple of things coming up in the fall.

Kevin: You may have to take 15 or 20 jerry cans full of diesel from Durango, who knows. Yeah.

David: So we’ll let you know. In August, we’ll be driving up and down the east coast, looking at colleges in the F-250, and I hope there’s diesel available. But for these guys to be out in front and say, look, this is a supply issue, right? And this is where I think, for those who are arguing that we’re in the context of a very robust economy, there’s a lot of activity, everything that’s available is being bought, and that looks like healthy activity, but a part of that is a scarcity issue.

Kevin: If you try to get work done on your house or even build a house, you’ll realize it may take several years to get certain critical parts for that house. So commodities have been rising, but this cycle’s a little bit different, isn’t it? This is not a boom cycle in commodities. What this is, is, this is actually a supply constraint boom—

David: It is different than the demand driven supercycle—

Kevin: And it’s mixed with cheap money and low interest rates because we haven’t really reversed that yet.

David: So it’s different than the last one. It’s driven off of supply constraints more than booming demand, which makes it different, if not a true supercycle. And I think it makes projections a tricky thing because supplies can come back online anytime. And there’s the increasing likelihood of stagnant economic growth. So if you’ve got stagflation, whether that’s domestic here in the U.S. or globally, how does the demand side of the equation get hit, for commodities specifically in that case?

Kevin: And you still like commodities. I mean, you would prefer commodities than say Netflix, which is down 73%. I mean, you like things that you can trip over or that would hurt your foot if you dropped on them.

David: Right. We’re bullish on real things, but at the same time, we’re cautious on commodities that are still lacking a stronger demand component. So our allocations to global natural resources are pretty darn skinny, not because we’re not bullish, but we don’t see the driver of global economic growth at present. And so the price benefits you’ve seen are more along the lines of supply constraints than sort of the demand boom. Pricing dynamics are not quite like previous commodity upswings. And granted, each commodity is unique. It always is. But it seems to be particularly idiosyncratic in a period of slowing globalization, and we’ve got increasing geopolitical conflict, we have a constrained consumer being forced to make tough prices because of an increase in pricing dynamics.

Kevin: Yeah. You talk about constrained consumers, there’s a point where it’s an inability. It’s not just constraint. And I brought up housing, and housing— Even a year ago, just a little over a year ago, you could get a mortgage rate at 2.65%, I think is what it was. And I don’t think people really realize how much it costs when you’ve got real estate prices rising and now mortgage rates rising. The difference between buying a house last year and this year is significant.

David: We’ve talked a couple of times this morning about thresholds and discovering a threshold and things changing once you’re over a threshold. And I think we are edging closer to a serious housing market issue, and it has to do with these numbers. Charlie Bilello sketched these out. Interestingly, January 2021, a 30-year mortgage was 2.65%. At that point, the new home was just over 400,000.

Kevin: So just a little over a year ago.

David: Today you have mortgage rates at 5.3, many even higher. I’ve seen a lot of conforming paper at 6%, but call it 5.3.

Kevin: So more than twice what it was a year ago.

David: An average sticker price for a new home, $524,000. So if you assume a normal 20% down payment, the monthly mortgage is, from a year ago, it’s up 80% from $1,294 to $2,327.

Kevin: That’s exactly what I’m talking about.

David: So in terms of affordability, it boils down to income limitations and household budgetary constraints. There are thresholds that you can’t go past. And last week I think I mentioned our Waffle Fests and how we would eat for a couple hours.

Kevin: Right.

David: And there’s a threshold there, too. We would always reference—

Kevin: You’d listen to Buena Vista Social Club. There’s a limit to that too, by the way. Buena Vista Social Club. I love it, but you can’t eat waffles and listen to Cuban music forever.

David: Well, there’s a Latin legal phrase that deals with thresholds, and it’s actually a reference to trespassing. If you break the close—which is quare clausum fregit—if you break the close, you’ve stepped over the line. And at Waffle Fest, you know you’ve stepped over the line when you take that one bite and now everything is soured. It’s like, oh, that was too much, now I’m uncomfortable.

Kevin: Yeah, and you don’t want waffles for the next three years.

David: You never— Exactly. So be aware of the thresholds, be aware of what changes, and be aware of what sours on the other side of a threshold. And if you do love bacon and waffles and smoothies, just don’t overdo it.

Kevin: But back to real estate. Okay, waffles, real estate, thresholds. We just had dinner with some friends of ours, and there’s been a number of realtors who’ve been coming to them and saying, you need to sell your house. You need to sell your house. And as we were sitting there on Saturday night, they said, we think we need to sell our house. It’s worth quite a bit more than what we thought it would be. And we were like, okay, so where are you going to move? Because there are other realtors telling other people they need to sell their house for more than what— See, that’s the problem. Now, second properties, third properties, but for the person who’s looking at this— See, what a realtor will tell you, and this is not to— We have a lot of friends that are realtors, and the problem right now is there’s not enough inventory.

David: Right. It’s a supply issue.

Kevin: That’s the real issue. So of course, they’re going to tell you to sell your house for more than it’s worth, but this time is different, is what they say, because there’s so many cash offers. It’s coming in from the west coast—

David: Well, that suggests that pricing is unidirectional, it only goes up. And we’ll have to see. But I mean, if you start to think about Charlie Bilello’s numbers and an 80% increase in a mortgage payment, can you do 80% above the current number? You run out of cash buyers, now you’re just dealing with the common man who’s buying a house and financing it either 15-year or 30-year, and at a certain point you start seeing the compromises. The compromises are, instead of a fixed rate to be able to afford it, you buy an adjustable rate mortgage, and that way you can afford the house still, even though it’s becoming unaffordable.

Kevin: The real estate market runs on leverage. It doesn’t matter. I mean, there may be cash buyers, but the real estate market as a whole is interest rate sensitive. Now, with that in mind, does Jerome Powell have more latitude? You brought it up earlier. Okay, Jerome Powell’s been confirmed again—

David: Second term.

Kevin: Yeah, but we are in an election year. So how do you weigh out those variables? Can he be Volcker-lite at this point?

David: It’ll be interesting to see how he plays this out because you could argue that one reason why he’s done little to nothing to this point to really tighten—yeah, 50 basis points, who cares. Everybody knew he was going to do that. And the market certainly initially liked the idea of a 47½ balance sheet runoff as opposed to 90, and pushing it off to June instead of starting immediately. And it was a dovish, not hawkish. It was not Volckeresque.

Kevin: So does the dove become the hawk? That’s my question.

David: Now that he has a second term, now that his position is not in question, maybe he does become more Volcker-like. Our guess is that a serious decline in equities will tease out a delayed response from the Fed. It used to be, oh, we’re off a thousand points, better do something. Well, what if there’s a delayed response from the Fed? A certain form of tough love might just make its way into the market. So the Fed put is not a guarantee. The market believes that it’s still there. Powell’s version of tightening financial conditions may include letting the markets figure out how to discipline themselves in light of a less muscular Fed presence, in light of a less invasive balance sheet. If that’s the case, then, look, volatility is here to stay through the summer months. Tantrums, fits, all the more common, like a child that doesn’t get its way. Still active, though. We see the Fed as still active. Reverse repo facility hit $1.9 trillion last week, nearly $2 trillion with no [unclear]. And the Fed said, yeah, okay, we’ll pay you something on that.

Kevin: And so the Fed is still there. And the Fed put is still there to a degree. It’s not quite Lewis without the German shepherd behind him yet.

David: No. And in that respect, there is still a lot of liquidity in the system. It’ll be interesting to see in the context of significant market pressures how quickly that liquidity evaporates. 

We’ve been making the case for a couple of months that putting in a market top in equities is unfolding. That’s what is happening. Financial Times ran an article this last week, “U.S. junk bonds start to crack under inflation and supply fears.” One of the quotes from the article, “the brutality of the equity market has now come to high yield.” It’s a one and a half trillion-dollar market. And it’s really critical for corporations to be able to finance their operations going forward. So to see that there’s an intensification of pain there— Love the guys at Elliott Wave. T heir financial forecast points out the divergence between the stock market, which continued higher from April of May last year up and through November, by and large, but junk bonds were already turning down in the middle of last year. 

Now, we’re seeing an intensification of that downturn in price within the high yield space. Yields are beginning to climb and things are moving in lockstep. The argument would be that stocks have a lot of catch up to play on the downside. And frankly, that bonds are not well supported, not in this environment, because this is not just a credit issue where people are looking at credit quality and saying, not so sure I want to be sitting in junk coming into the next market downturn. 

The other issue is they’re not sure they want to be in fixed income at all because inflation is staring them in the face and it scares the heck out of them. Fixed income, very interesting dynamics. Investment grade debt, $8 billion in liquidations here in the States last week. And again, as I mentioned, pressure in the high yield market. 

When you begin to see corporate America suffer on the credit side, I think that’s when you begin to see a real intensification within the equities markets as well. Actually, when I reflect on high yield, I think about the process of bankruptcy. Who was the famous writer who said, how do you go bankrupt? Slowly, and then all at once? It feels like we’re getting to that threshold within the debt markets. And to the degree that the debt markets capitulate and roll over, the equity markets are in a world of hurt. And you think, no, that could never happen. We just had a stablecoin go from $119 to an eighth of a penny in a matter of days.

Kevin: Yeah.

David: In a matter of days, to see something lose tens of billions of dollars in a matter of weeks. We don’t have the imagination for these threshold or cusp events, where all of a sudden things change. The psychology in the market has shifted dramatically, and at least for a time irrecoverably. So the threshold we have, particularly in corporate debt, is worth keeping an eye on. I hope we don’t have anything as unstable as what we saw in the stablecoins, but high yield and really the debt markets as a whole are at risk.

Kevin: And so I think thresholds, because you’ve been talking about thresholds, what was that Latin phrase again for crossing the threshold?

David: Quare clausum fregit. When you break the close, when you’ve stepped over the line, you’re basically trespassing. And it is that point at which, at least in the financial markets, like for Waffle Fest, one step too far, one bite too many, and it changes everything. This would be one tick too low, and all of a sudden sentiment shifts. We’re that close to quare clausum fregit.

Kevin: You’ve been listening to the McAlvany Weekly Commentary. I’m Kevin Orrick, along with David McAlvany. You can find us at mcalvany.com, M-C-A-L-V-A-N-Y.com. And you can call us at (800) 525-9556.

This has been the McAlvany Weekly Commentary. The views expressed should not be considered to be a solicitation or a recommendation for your investment portfolio. You should consult a professional financial advisor to assess your suitability for risk and investment. Join us again next week for a new addition of the McAlvany Weekly Commentary.

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