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The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
Is It Financial Inclusion or Exclusion?
February 16, 2022
“Inflation is the pin that bursts many a bubble dynamic. And that’s what we’re seeing come to fore is inflation is inflicting pain on fixed income. Inflation is increasing margin pressures for corporations. Inflation is hurting the consumer. Inflation is the only thing that has gotten central bankers off of their keisters to do anything. And inflation happens to be the pin that’s bursting the ego of these central bank planners.” — David McAlvany
Kevin: Welcome to the McAlvany Weekly Commentary. I’m Kevin Orrick along with David McAlvany.
Well, on everyone’s mind this week, you would think would be the Ukraine, but actually the truth of the matter is what Trudeau did a couple of days ago, Dave. It reminds me, we have heard this banter from the elite, let’s just say, that we want to try to save the unbanked. Do you remember in India a couple of years ago? The concern was that the unbanked— we needed to get everyone into the banking system, and they called it “financial inclusion,” and they said everyone has the right— I always love it when somebody tells me that I have the right to do something they want me to do. But everyone has the right to be in the banking system and financial inclusion. We just had a meeting, our office meeting before we came into the studio, and you said something really profound. You said you’ve got to watch financial inclusion because it can lead to financial exclusion. Can you elaborate on that?
David: Sure. Yeah. Looking at what JT is doing across the boarder, Mr. Trudeau. Mr. Trudeau. Sort of a soft form of martial law. It is a weaponization of banks. It’s a weaponization of the financial industry. And it’s a fascinating thing. I hope we don’t see anything like that here in United States, where free speech and the right to assemble peacefully is called into question. But this is really interesting because you’ve got basically billions and billions and billions of dollars, which did not flow through the economy as a result of government mandated closures. And now individuals who say we’re done with these government mandated closures and restrictions are being blamed for millions and millions and millions of dollars of revenue lost for Canadian businesses. The irony is amazing, pot calling the kettle black is not even to the scale that it needs to be.
Kevin: Well, and the ability to move money, right? In India, a couple of years ago, what they did was they took cash, the most common cash off the market, 500 Rupee, 1,000 Rupee notes. They gave them 30 days to get them into the banking system, open up an account, or they would lose value completely. When you talk about inclusion, that sounds great until, let’s say that you, like in China, your Sesame Credits don’t quite add up, or, in Canada, you haven’t done exactly what the government is saying. Then they say, “Well, you can no longer move money. Your banking system is now shut it down.”
David: Right. What is a peaceful gathering versus an illegal blockade? Coming back to the financial inclusion piece. In India, USAID was the sponsor and we wanted the unbanked to be banked. In many presentations five years ago, I shared a little highlight of—
Kevin: Bill Gates.
David: Bill Gates.
Kevin: Yeah. Bill Gates was saying everybody had the right to be in the banking system. What he was really saying was you had no right to not be in the banking system.
David: Well, the light side is that people have access to credit. The dark side is that creating dependencies on a system allows you to manage the flows of funds, allows you to see everything that is happening, and maybe even dial up or dial down access. So your point about Sesame Credits and social inclusion or social exclusion, keep in mind that that’s the extension of financial inclusion, to the degree that you’re not matching expectations of the current government and not necessarily a liberal democratic government. It could be a liberal autocratic government.
Financial inclusion can become financial exclusion, social exclusion as an extension of financial exclusion, all of these things when you’re trapped in a system. I did mention in our meeting in house that it’s worth reviewing. I know I mentioned this only a month or so ago, but it’s worth reviewing Alan Greenspan’s “Gold and Economic Freedom,” because what it gets to the heart of is agency and how an individual and their ability to choose and represent themselves is enabled by resources. And to the degree that your resources can be controlled, manipulated, or you can be severed from them, you are setting yourself up, in the worst of circumstances—the dark side of financial inclusion, not the light side, but the dark side—you’re setting yourself up for lack of agency, lack of freedom. And it’s a position you don’t want to be in.
Kevin: It’s interesting, too. You don’t want to be in a position where the government tells you whether your money has value or not. Gold has value whether the government says it has value or not. And a lot of times tyrants have hated that. Hitler hated that. Napoleon, he hated that element of gold. We’ve seen that in the past.
Do you remember? You and I years ago, we talked about the book The Crowd by Gustav Le Bon, and it talks about how crowds can be maneuvered and changed, and you have to watch that tide as it goes out and as it comes in. As we talk about these things, I was thinking about it, Dave, when you were speaking in the meeting, that we need to go back and refresh where our rights come from. You remember the beginning of the book of The Law that they’re God-given, not government-privileged. They’re God-given rights. And that at this point is being challenged. But I wonder, going back to Gustav Le Bon’s book The Crowd, I wonder if the crowd even understands that.
David: Yeah. Again, not to hang out on the issues in Canada forever and ever, but the words are being abused. What is democracy when people don’t have a voice? I thought democracy and liberal democracy was people having a voice and expressing it in the polls or on the streets. And certainly in a nonviolent way. What does democracy mean? It reminds me of Alasdair MacIntyre’s book, Whose Justice? Which Rationality? There’s a contention about, what are we actually talking about? What are we dealing with in terms of a true social contract? Do we all have the same understanding? Apparently not. Apparently not. I’m sorry. Gustav Le Bon is far more interesting, maybe, in this case, certainly as it relates to the markets. “The masses have never thirsted for truth. Whoever can supply them with illusions is easily their master, whoever attempts to destroy their illusions is always their victim.”
Kevin: Huh. What an amazing quote.
David: I think it fits the context that we’re in today in the markets. Cathie Wood could have alleviated pressure on her organization, that is Ark Investments, had she had a counterbalance to stock market volatility. She didn’t, of course. It’s an all-in bet. I think her shares most recently have traded in the 60s off of a peak of 160. These are the most popular bets of 2020 and 2021, and are circling the toilet. This is a very interesting environment to be in. You also have the trend of shifting from high growth to value, and I think that’s going to exaggerate the losses for those who are exposed to the most volatile portfolio allocations.
Last week, Doug added nuance to the market structure and the current deterioration in financial conditions. The financial conditions, frankly, that are necessary for a bull market in everything to continue.
David: Not all things are actually represented in a price. What we see today in the stock markets, particularly in the US, the divergences are there, subtle as they may be, but those divergences provide solid ground for protecting a portfolio, for looking for growth, but not necessarily in the media, taking a long-term view to growth. I think it reminds me that the first rule of investing is avoiding big losses. We’ve explored the role of a long-term equity portfolio complimented by a substantial gold position, and that that offers a counterbalance to stock market volatility.
Kevin: That’s why we do the triangle every time. Get a napkin out, on the back of a napkin, draw a triangle. We do that every time we talk to a client.
David: Yeah, go crazy on the left-hand side of the triangle. Do whatever you want to do with stocks and bonds in the growth and income side of the portfolio. We would believe there’s a smarter way to approach that, but if you did just go hog wild with hyper-growth thematics, you still have this rooted and grounded insurance component within the base of the triangle.
Kevin: Right. The gold part of the triangle.
David: So, back of the napkin model. It’s the perspective triangle, it breaks down liquid assets and non-real estate, non privately held businesses. Liquid assets breaks them down into three mandates. Growth and income, left-hand side of the triangle, liquidity on the right-hand side, add insurance, which is where we put gold in that category. It’s fairly straightforward, but it’s dynamic enough to gear a portfolio for reasonable rates of return. But with tremendous downside protection.
Kevin: Dave, I started here in ’87. That was the first year that we had— I was really blessed to be here for the first stock market crash since 1929 of that size. And the triangle worked. I was told the triangle would work, the gold maintained while we waited for the stocks to come back. It’s same thing with the year 2000, same thing with the year 2008, probably the same thing with 2022. I want to talk about the markets later in 2022, but downside protection, preservation.
David: It’s often neglected when upside momentum and it seemingly forces the equation and blocks out any concerns in any category, right? So, again, the value of downside protection, that’s what’s neglected when people are fixated on growth or hyper-growth. If you look at growth over an entire business cycle, you find that it’s not just momentum that you need, but you’re talking about cost basis. You’re talking about patience. You’re talking about risk management. These are critical elements to maximizing growth and minimizing volatility.
Kevin: I wonder, Dave, 30, 40 years ago, we were thinking about the Russians in a different way. Do we underestimate geopolitical risk at this point because we’re so far removed from the Cold War?
David: Being as removed as we are, I think that is a factor in market pricing. Certainly you see more of that priced into assets like oil and gold. Risks appear in many forms, as we’ve seen in Europe over the last several months. This goes back almost a year now, the original massing of troops on the border there in Ukraine from Russia was the spring of 2021. Things only got dicey in November when Putin started putting out demands, saying, “Stop moving NATO. We’re serious.” And all of a sudden our response is, “Well, what about these troops on the border?” They’ve been there since last spring.
Kevin: Okay. But I have a question. What’s more dangerous? Putin or a weak, weak leadership in the United States right now?
David: I contend that Johnson and Biden, under political pressure domestically, create a more dangerous cocktail when mixed with— Look, Putin’s got this bitter nostalgia of an earlier era’s map. We put that up on our podcast, maybe three, four weeks ago, the 1991 map of Europe, and to see where the lines were drawn then versus now, you can see where the nostalgia is a little bit bitter. So you throw in a dash of Putin bitters into a cocktail of Boris and Joe. I don’t know. I’m not sure who’s less predictable, weak leaders or strong men.
Kevin: I just wonder if you got Zelensky of Ukraine and Putin in the same room. If they’d be saying the same things we’re being told they’re saying right now.
David: Earlier this week— I often take attempts at humor and they fall flat, and I did not amuse the home crowd this week.
Kevin: You mean at home?
David: Yeah. At home. Zelensky breaks the tension on the Ukrainian border on Monday with a handwritten note to comrade Putin, “Quit Stalin and be my valentine.”
Kevin: Quit Stalin—
David: And be my valentine.
Kevin: Pun intended.
David: Only my daughter indulged me with laughter, and she usually does with bad dad jokes.
Kevin: Oh gosh.
David: I’m sure it was the note that Putin got from Zelensky and not the threat of sanctions that now has Russia removing a few troops.
Kevin: We’re seeing an awful lot of volatility, though, because I don’t know that people— We’re being forced into a new decision making process. Remember “buy the dip”? Just buy the dip. Every time something happened in the stock market, buy the dip. Now, granted, that seems to be happening again, but January stunk for the stock market. Wasn’t it one of the worst Januarys we’ve had?
David: It was. And I think, when you look at stock market volatility, when you look at bond market volatility, when you look at inflation, when you look at geopolitical factors, all of these things create sensitivity amongst investors. Nerves are exposed, and it just doesn’t take much, and you might even think what’s happening now, whatever now is, whatever the event is, seems to be “hyperized” or irrational. And it is because we’ve had some pressure exerted on the stock market,
January’s a terrible month for equities. But there’s something Pavlovian, too, that happens immediately following that. The response amongst retail investors and institutional money managers is the same again: Buy the dip. Reuters reported that US equity funds saw a major uptick in buying. It was the largest in six weeks, and that was just a week ago, right? As if hawkish monetary policy, as if the inflation news was irrelevant to long-term returns.
So what the major indexes cover over is just how much deterioration has occurred in the last 30 to 60 days. Really, if you go back, you’ve got some indexes and some stocks which were topping out June, July of last year, and then you’ve got a concerted move lower, and these moves lower are embedded in many portfolios, but they’re under-reported by the financial media.
Kevin: But if you’re a big name, the big names are the ones who’ve been carrying these indexes.
David: Exactly. And so like the bear market of the ’70s, the early deterioration in the markets is obscured by the outperformance of a few big names. And that’s always been the case. Right now you’ve got the Russell 2000, if you’re looking again at 30, 60, 90 days, Russell 2000, a much broader measure than the Dow, it’s underperformed. It’s underperformed the Dow, it’s underperformed the S&P 500. And now the big names are coming under pressure. From November’s highs the FAANG stocks are off 20%. Nobody wants to talk about heading into a bear market with the FAANG index, but here we are 20% lower.
I’m sure we sound like a broken record on margin debt. But when you look at the chart of margin debt and it gets to a new high, it’s worth paying attention to, but that was at 500 billion. And then you think, well, it is concerning when it’s at 600 billion, and then it gets to 700 billion, nearly double its previous peak.
Kevin: All those were records. All those were records. Now what are we?
David: So the size of the spike now is the largest ever, again, ever. A new record, taking the number to 935 billion—just as stone’s throw from a trillion dollars in margin debt. I don’t know that that means we’re looking at the largest crash ever, just because we’ve had the largest spike in margin debt. Probably not. But it will pay to keep the ’60s and ’70s in mind in terms of what inflation can do to long-term returns in cash. That’s probably most obvious, but also on portfolio performance. And we could get things started off, not with the slow bleed of the ’60s and ’70s, but something a little bit more dramatic and catastrophic given the unwind of margin debt.
Kevin: We talked about the big names, but actually that’s really important to look at when you’ve got the majority of the stocks declining, which has been the case over the last couple of years. And yet just a few names going way up. What that means— You were talking about the difference between inclusion and exclusion when you’re talking about a government, but you can do the same thing with indexes, right? You can say, “All right, well, I don’t care if the indexes are rising just because of five or six stocks. I’m still making money.” The problem is, when those five or six stocks start going down, that index, it can destroy it.
David: It’s in trouble. One of the ways of measuring it, just on a broad market basis, not even just the big names, but all the names. This is a data point we review as a team, it’s called the advance-decline line. Basically you’re looking at the number of advancing stocks that are stocks going up. You subtract the number of declining stocks, right? And it gives you an idea of the trend. Is there more buying or is there more selling, on balance? And not only has that number rolled over, so more selling than buying on balance, but has now attempted a recovery and failed. So we have all the ingredients for a nasty equity market here in 2022.
Kevin: The thing that also strikes me, Dave, because I brought up, 40 years ago we had an awareness of the Cold War. I remember when Afghanistan was invaded by the Russians at the same time that we had high inflation under Jimmy Carter. We had the Iran hostage crisis going on, but high inflation— That’s another thing we don’t have awareness of. If we’ve lost our awareness of the Cold War—or at least that’s grown cold, pun intended, sorry, dad joke—but if that’s happened, we’ve all also lost our awareness of how to survive a high inflation. And I was a teenager at the time, I was in high school at the time that we had high inflation before, and people had to operate differently or they just lost their money.
David: Yeah. Your big moves in the metals have come with a multidimensional backdrop. It’s not one thing like, “Oh, well inflation’s rising, therefore gold goes higher.” There’s generally a number of things in play. We had gone, if you recall, from $35 up to $400 prior to the invasion of Afghanistan by the Russians. But then with that in mind, we had the economics in mind, we had the fiscal and policy ingredients already in place, and then you throw a little bit of extra pressure, geopolitical pressure. And we go from 400 to 875. Do you remember in how long?
Kevin: Six weeks.
David: Six weeks.
David: Six weeks. That’s one of the reasons why on the program we will often harp on ROC, rate of change. When an asset class begins to go up in a parabolic fashion, it is unsustainable. I don’t care what the asset is. I don’t care how much you’re in love with the asset. The rate of change when it begins to exceed 100, 150% in a year period, it’s unsustainable. We’re talking about more than a 100% in six weeks.
Kevin: I was staying at my grandparents’ house back in the ’70s, and my grandmother got out family heirloom silverware, and she packaged it up. And I asked her at the time, because when you’re in high school, you’re not paying attention to the gold price. I’m sorry. I just wasn’t. And I had no idea what silver was doing either.
David: Goldilocks, but—
Kevin: Yeah. Maybe. Yeah, she was putting it together, and this is something that had been in the family for a long time. And I said, “What are you doing?” And she said, “We’re going to sell this silver.” She said, “Silver is almost $50 an ounce.” And they did, and that turned out to be a really good thing at the time. But I remember the tension at the time, too, because you had all these different things occurring. The very next step looked like it was going to be some sort of nuclear war. Honestly, the Cuban Missile Crisis was one of those periods of time, but when you had the Iran hostage crisis going on, high inflation, Jimmy Carter was a weak president. And so you had a weak administration in the United States. Plus, you had Russia coming into Afghanistan. That was a big deal.
David: Well, it took 40 years for a nightmare scenario to recur. I’m thinking inflation, because again, inflation has returned to levels last seen, February of 1982.
Kevin: They’re back. Remember that movie? They’re back.
David: Today, the Fed funds rate sits between zero and 25 basis points. And the Federal Reserve continues to expand its balance sheet. Amazingly, between now and March 11th, it’s another $50 billion in asset purchases, still pumping in billions into mortgage backed securities and Treasurys.
Kevin: So we’re not tightening yet. Obviously.
David: We’re talking about we’re getting there, March is perhaps the last month in a saga of excess that has tilted their balance sheet to a hair’s breadth below nine trillion dollars, 8.9. For perspective, the Fed funds rate was 15% in February 1982. So comparable inflation rates, but the Fed funds rate, they’re behind the curve a little bit, you might say.
Kevin: Wow, because we’re at 1% right now.
David: Quarter of 1%.
Kevin: Quarter. Quarter of 1%. That’s incredible. Okay. So when you hear the train coming here in Durango, let’s pretend like CPI, consumer price inflation, is the caboose. All right. And you can hear that caboose coming. You can hear that caboose coming, but actually what you’re really hearing is what’s pulling all those cars before the caboose. And let’s just pretend like that’s not only the engine of the train, but it’s PPI, producer prices when they’re rising. It’s a little like watching a train go by. If it costs more for businesses to produce what it is that I’m buying when I get to CPI, that means that the caboose is coming and it’s going to be bad. So producer price index was a real shocker, wasn’t it?
David: Absolutely. 1% for January, instead of what was expected, half a percent. So that brings the year-over-year number at 9.7 versus 9.1 expected.
Kevin: So we’re 7½ for CPI right now, but 9.7 is producer price index. That’s the engine of the train.
David: That’s right. Three tenths of a percent from double digits for the producer price index. This is the businessman’s measure of inflation. It’s the stuff of intrigue, Kevin, not because you must be a nerd to appreciate inflation, but if you are a sentient being, you have respect for anything that can eat your lunch, figuratively or literally. We’re aware of the bite sharks can take in the shallows. We’re aware of if you’ve ever read Bill Bryson’s book A Walk in the Woods, you’re aware of the bite that a bear can take out of a backpacker. And we’re all now aware of the bite of central bankers and their effect on our budgets.
Kevin: So this is inflation. Yeah.
David: Inflation is consternation is political change, right? So that’s one of the reasons why I keep on coming back to the UK and the US. There’s political pressure both on Boris Johnson and Joe Biden. And inflation creates the grassroots consternation creates political change. That is a tough thing to navigate, and the wag-the-dog moment with Ukraine—it may not be entirely their doing, but they’re certainly taking advantage of it. The Biden polls suggest he’s under pressure, and certainly the case is the same— you’re seeing mass exodus from Johnson’s colleagues. So there’s nothing like inflation to confound a political career.
Kevin: Well, look where we were at? Do you remember? We were at 2%, they were talking about, “Hey, we’ve got to really hit our inflation target of 2%” last year at this time. And now we’re CPI, the caboose, 7.5%.
David: Yeah. In last week’s Hard Asset Insights, we posted a quick visual on a year’s transition from sub 2% to the last reported CPI number, 7½. Check it out at McAlvany Wealth Management or mwealthm.com, just look for Hard Asset Insights or the Insight section. Surprising, and inconsequential for those that were fixated on short-term opportunity and ignoring structural market risk.
This is the exact same sequence as the ’70s, where, again, if you’re focused on gains, if you’re focused on momentum, that’s what you’re missing. That’s what you’re missing. The short-term opportunity. All of a sudden you didn’t realize that something structural had changed and it catches up with you. You have a bear market that stretches from ’68 to ’82, actually a secular bear with a number of cyclical upswings in the middle of it. But it was brutal not because of a 1930-style collapse in asset prices, but because of a series of low nominal returns and high rates of inflation. The Dow was basically capped at 1,000 during the entire period, ’68 to ’82, and inflation was nipping at your heels the whole time.
Kevin: We have to talk about that, because you talk about the triangle. Let’s pretend you had a third in gold on the base of the triangle back then. And you had on the left side your stock portfolio, which never topped a 1,000 for what? 14 years. Okay. A thousand points, and then you had the inflation on the right side of the triangle. But what you had was you had gold going from $35 to 800 at one point. So the base of the triangle actually is what carried the inflation of the cash side, and it actually overrode, because like you said, there were no major crashes back in the ’70s. It’s just, you lost your buying power of everything you had in the stock market.
David: And certainly prices softened. But again, not a catastrophic 89% decline like we had in 1930, ’31.
Kevin: Well, the Dow fell from 30 ounces of gold in 1966 down to one ounce of gold by 1980, right?
David: That’s right. In real money terms, it was the same journey. In real money terms, it was the same journey. The Dow/gold ratio was at 18 to one at a market peak in 1929, went to one to one at the market bottom, where you could exchange one ounce of gold for cross section of the Dow. Climbed to 28 to one by 1968, and then declined again to one to one. As that Russians are invading Afghanistan, you’ve got 875 as the gold price and the Dow is at 875 points. So you’re at a one to one ratio, today we’re closer to 20 to one. One of the reasons why I think it’s fairly attractive to be looking at exiting some equities, particularly if they’re on autopilot, and moving towards the metals.
Kevin: As I think about it, Dave, we’re talking about geo-politics of the late 1970s. We’re talking about inflation of the 1970s. Now we’re talking about finance of the ’60s and ’70s. This goes back to just your overall model, where finance leads to the economic, which leads to the political, which leads to the geopolitical, and actually bringing up Carter, that was the political part of it.
So philosophy, do you remember? One of the things that you love about economics is that you were able to marry it to something that you were fascinated with when you went to college. You’re a philosophy major, Dave. I remember when your dad, we were sitting in the office here in this building, he’s like “Dave. No, Dave’s decided to be a philosophy major, what’s he going to do with that?” But economics is philosophy, isn’t it?
David: Certainly ties in. And if you did not join us for our conversation with Pollock, I think that’s a must. I think it’s November, maybe it was August, sometime in the fourth quarter of 2018.
Kevin: Alex Pollock. That was a great book.
David: Go back to the Commentary archive to listen to our discussion of his book Finance and Philosophy. I think if we lived in the same town, we’d be friends. He recently chronicled the shift in Federal Reserve balance sheet value being impacted by a change in rates. So rates are coming up, inflation’s up, rates are coming up, the market’s driving them. The Fed hasn’t done anything yet on their own. And that’s having a consequence in terms of the value of the assets and their balance sheet because it’s fixed income folks. It’s mortgage backed securities and it’s Treasurys, and as interest rates come up, the value of those fixed income assets goes down.
Kevin: So you don’t think of the Federal Reserve as actually playing leverage, but actually leverage factors dramatically into the Federal Reserve’s balance sheet.
David: I’m always grateful to Grant’s Interest Rate Observer for coverage of details like this. But in December 2007, go back a few years, the Fed held assets of $894 billion. So that’s the assets they’ve gotten. The capital of the Federal Reserve is 37 billion. So looking at leverage ratio, comparing the two, 24 to one leverage. By 2011, the assets, remember for a bank an asset is a loan, so we’re talking about the loan book. So you’ve got their loan book, or the fixed income portfolio, compared to their capital. Now their leverage ratio is 48 to one. So 24 to one, 48 to one.
Kevin: So for every dollar they had in capital, they had 48 times that in debt.
David: Yeah. As there are a shift in the value of the assets and the balance sheet, it’s fairly dramatic. So in terms of your viability as an organization— maybe they get to play by a different set of rules. But today, Pollock points out, they’re on a smaller capital base, with assets of 8.9 trillion. And the leverage totals to about 220 to one.
Kevin: Okay. So for the listener who’s wondering what this looks like, if you remember Jimmy Stewart, okay. In It’s a Wonderful Life, he had a certain amount of money that he could pay out to different investors. What we’re talking about here is the Federal Reserve, if they were Jimmy Stewart in a Wonderful Life, and you went down to get your money.
David: You got a dollar.
Kevin: You could have a dollar for every 220 that they’ve got liabilities on, right?
David: That’s a good picture. That’s a great way of segueing to savings and loans too. Pollock’s comment is the Fed is essentially the world’s largest savings and loan.
David: Yeah, this is not SNL as in the weekend comedy act.
Kevin: Do you remember what happened—
David: It’s S&L, not SNL.
Kevin: Well, speaking of Saturday Night Live and S&L, savings and loan, do you remember what happened in the early ’90s to the savings and loan industry? Or do you even remember the savings and loan industry? Where’d they go?
David: Well, you’re right. They went all but extinct in an earlier credit cycle. So you’re stretching back to the ’80s again. Not enough capital, rising rates, too many loans on the books, and Pollock points out that a shift higher in interest rates marks their assets to a lower value.
Kevin: That ratio increases.
David: So the fixed income portfolio— as interest rates have been coming down, of course, we’ve been in a zero rate environment for some time now. As rates came down, the value of their assets was going up, right? So you bring more assets onto the balance sheet and they’re appreciating, the fixed income portfolio of the Fed showed a $354 billion unrealized gain as of December 31st, 2020. Contrast that as we fast forward to last year. Rates have barely moved higher, and yet September 30th, 2021, that unrealized gain had already shrunk to 143 billion. So from 354 to 143, oh, and now after four months of rising rates, with the last few weeks intensifying the trend, numbers haven’t been reported yet, but you’re talking about significant losses.
Kevin: Well, don’t they just rename the word loss? Once they go below zero and they’re actually losing money, don’t they just come up with new accounting principles.
David: Yeah. Not everyone has access to a second set of accounting principles. Essentially what they did with the savings and loans issues back in the ’80s, was they were able to convert losses into what were called deferred assets.
Kevin: Well, I’ll have to tell my wife that. Yeah, no, we’re not losing money.
David: This is a deferred asset. Yeah. Life’s not fair, not everybody has two sets of accounting principles to work off of, but investors are going to have to adjust to inflation and to higher rates and to lower returns and maybe even losses. Right? So Pollock was around for the fancy accounting of the ’80s. What were they trying to do? They were basically obscuring the losses in fixed income assets as the rates increased. The federal home loan bank created what they called, regulatory accounting principles. So you thought you had general accepted accounting principles, so the GAAP rules, that’s one set, right? So you’ve got GAAP, then you’ve got non-GAAP. Well, there’s another set, actually a third: regulatory accounting principles are what you polish up and pull out when things are really spicy. And that’s where they came up with that, again, losses hidden under the guise of deferred assets.
Kevin: So you’ve got white lies, you’ve got gray lies and then you’ve got black lies. That’s what it sounds like here.
David: Well, black lies matter too. I just think that the Bank of Powell, Bullard, and the rest hold the consolation of knowing that they will be spared embarrassment. Dare we say, spared humiliation. The recognized portfolio losses, because when interest rates start rising and interest rates start shoving things around in terms of values on the balance sheet, you essentially have, again, we call them regulatory accounting principles. It’s basically regulatory forbearance, second set of accounting rules for the monetary rulers, polished and put on display.
Kevin: Now that we no longer really believe that it’s going to be transitory. This inflation thing, they’re going to have to rename everything, aren’t they? It’s not just losses in one area, but they’re going to have to rename everything.
David: As much as central banker’s thought inflation would be transitory, we have the implications of excessive monetary policy, enormous fiscal policy stimulus, and growing scarcity. Okay. So this is growing scarcity, both of the finished goods—these are all the supply chain-related things which were supposed to be very, very temporary—and now we also have scarcity of basic resources. Goldman Sachs Head of Commodities Research—this is Jeff Currie—he says, “This is a molecule crisis.” And I don’t think he means by that, this is a small issue. But “this is a molecule crisis. We’re out of everything. I don’t care if it’s oil, gas, coal, copper, aluminum.” He says, “you name it, we’re out of it.”
Kevin: So he’s talking about anything that’s real. Okay.
Kevin: We’re out of. You can get as much artificial debt or bitcoin as you want, but as far as real stuff, molecules, right?
David: Sounds like a hard asset bull market.
Kevin: It does. Gosh. Yeah.
David: I mentioned it earlier. Let me just draw a little attention to it, a very valuable resource that’s available every weekend. We often talk about the Credit Bubble Bulletin, last week, Doug was on the program with us, obviously great to have him on the team and his approach could be described as top-down macro.
Kevin: Ultra macro. I love his world. He looks at the whole world.
David: Because credit in the way that credit flows is the defining factor for how the financial market is functioning, either on a very healthy basis or an unhealthy basis, or somewhere in between—a transition, if you will. Well, we also write a weekly report called Hard Asset Insights. It’s more of a bottom-up micro. So it’s in complement to what Doug writes on a weekly basis.
And our thinking is a synthesis of fundamental and technical insights, along with this marriage of top-down macroeconomic analysis with bottom-up details that inform our portfolio construction in the hard assets space. So if you like real things, you’ll love Hard Asset Insights. It’s a penetrating look into the markets in just a few pages. And again, grab a cup of coffee Saturday morning, take your pick, or look at both, Credit Bubble Bulletin and Hard Asset Insights.
So when you consider the impact of rising input costs, going back to Jeff Currie’s molecule crisis. When you look at the impact of rising input costs for goods and services, here we’ve got the CPI and the PPI. PPI and CPI might in fact continue to surprise, and surpass expectations.
Kevin: This is why I love it when you talk about, even McAlvany Wealth Management, the attitude toward your investing is, you want to buy things you can trip over, things that are real. Talking about molecules. Okay. Whether it’s a toll bridge or whether it’s specialty real estate or gold mines, those are things, literally— those are made of molecules, right?
David: Yeah. If you drop it on your toe, your toe’s going to hurt.
Kevin: And the base of the triangle is gold.
I was telling a client yesterday about a farmer client of mine from decades ago. And I remember he kept his money in just two things, gold or silos of wheat. Okay. Because he raised wheat. So he would keep silos, and what he didn’t keep in the silo, he’d keep in gold, and then he’d sell one or the other before he had to plant every year. But it was something real. It was real assets. We’re coming into that period of time where that becomes very, very important.
David: Well, he was rotating from hard asset to hard asset. I think there’s a natural rotation right now in the stock market from growth and hyper-speculative stocks to value stocks, which are at an extremely low level, relatively speaking. And I think that’s going to be one of the contributing factors to margin pressures, and I mean specifically margin debt pressures. To see 50% declines in the darlings of 2020 and 2021, not a surprise at all. In some of Cathie Wood’s picks, she’s already below that 50% mark, and people are pretending that we’re still in a raging bull market. There’s been erosion at the edges. This is what Doug talked about last year, sort of the periphery to core movement inequities. It’s the companies that don’t have much in terms of revenue, sales or positive earnings. Right? So now—
Kevin: The periphery, right? That’s another version of his periphery.
David: Yeah. So if your focus is right on the core, you might not notice that there’s been mass deterioration all around you, and the wilder aspects of this trend, I think are going to be revealed in the options market, as Doug mentioned last week, as we move towards the core. And there’s really no place to hide. Yes, right now we’ve got some rotation from periphery to core, high-growth, hyper-speculative stocks to value—international value in particular. But the obsession with US stocks is still very much there. Expiration is this Friday, coming back to options.
Kevin: That always leads to volatility, doesn’t it?
David: Yeah. And potentially an explosive rally coming into Friday, with normal squeezing of put buyers, forcing of shorts to cover. And it doesn’t change the context that we’re in. In fact, typically in a bear market, one of the hallmarks of a bear market is the explosiveness of the rallies. That dynamic is a telltale. In a bull market, you can see these dramatic drops and then a recovery. And that’s kind of— it scares you, and it causes this sense of worry, climbing the wall of worry is that psychological dynamic where people don’t engage in an equity bull market, right? But they’re violent on the downside and gradual on the upside. You have this fade, and there’s these radical rallies on the upside, which are very telling in the context of a bear market.
Kevin: Well, and this is why, going back to the triangle, it’s so important to balance things out because you can’t time these things. We don’t recommend gold as a speculation. In other words, sitting around watching charts all the time, coming in and out. Gold is the preservation base of the triangle, but gold has been somewhat range-bound for the last couple of years, Dave, and it seems like we might be edging up outside of that range. What are your thoughts on gold pricing right now?
David: It’s been very constructive in recent weeks, and we’ve seen gold move higher, break out of a range. This is about a two-year range. As it comes out of this, call it a wedge formation, and moves higher, it’s important to reflect on the metal as a safe haven asset. Okay. We’re not talking about the metal as a growth asset, where people are buying it to make money. Keep in mind, people move to gold like they move to oil. Basically, there’s an emotional component that’s not really there with other assets. When there’s fear in the market, then you see gold and oil very much— a trade, if you will.
And so we’re coming out of this everything bubble. We’re coming out of this everything bubble. Gold has caught some attention as a safe haven, there is a unique dynamic with gold here in 2022 as a variety of markets turn sour. And again, we just move past short-term issues like options expiration manipulation, you’ve got explosive rallies on things like that. Sometimes even on a monthly basis. You now have traffic from all asset classes to consider. With so few places to go, money will flow to gold. It’s going to flow to emerging market equities. It’s going to flow, to some degree, to Treasurys—again, as safe haven plays. But the inflationary backdrop adds pause to the commitments investors are willing to make—certainly to bonds, and to cash for that matter. Ordinarily the exit from a risk asset entails money flowing to cash or cash equivalents. And that’s less likely to be the case when the penalty for moving to cash is 7 to 10%.
Kevin: Yeah. Inflation.
David: When you think about inflation, it can often neglect the reality of the cost of it. It’s just a conceptual idea. It’s an annoyance. You’re having things moving higher, but when you actually frame it as, I want to move to cash. The decision will cost me 10%. It takes breath away. It’s like, “Ooh, I don’t know if I want that.” I do like cash. I do like cash versus the likely 30, 50, or even 70% declines in risk assets today. But to balance your liquid assets or cash equivalents with a position in metals, that’s a matter of prudence.
Kevin: And confidence. Confidence. I have repeated Doug. Remember when Doug last week said that gold moves inversely to the confidence in central banking? I’ve repeated that a number of times this week to people because I thought, he’s nailed it. We’ve talked for years how this whole thing is being held together with duck tape, the duck tape of confidence in central banking.
David: I like duck tape. So let me just say, how about chewing gum and band—
Kevin: Masking tape.
David: Masking. There you go.
Kevin: Masking tape.
David: Scotch tape. You can see right through it.
Kevin: Right. They’re masking our view of what’s real too, but the truth of the matter is, confidence really has held these markets together. Artificially low interest rates and the supply of quantitative easing money for this decade. That’s what’s caused all this, but is the confidence now starting to fall? Is the bloom falling off the rose?
David: Yeah. Well, I think he said it well last week, Doug did, gold moves inversely to confidence in central banking. So it’s the end of an era for rock star bankers. And if that is the case, the end of an era for rock star bankers, it may well be the beginning of the next leg up in the metals bull market.
Inflation is the pin that bursts many a bubble dynamic. And that’s what we’re seeing come to fore is inflation is inflicting pain on fixed income. Inflation is increasing margin pressures for corporations. Inflation is hurting the consumer. Inflation is the only thing that has gotten central bankers off of their keisters to do anything. And inflation happens to be the pin that’s bursting the ego of these central bank planners.
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 edition of the McAlvany Weekly Commentary.