Late Cycle Desperation: QE & Artificial Rates

Weekly Commentary • Mar 05 2019
Late Cycle Desperation: QE & Artificial Rates
David McAlvany Posted on March 5, 2019
  • $5.5 Trillion Global Government Debt Must Be Refinanced Just This Year
  • Are Bear Markets Now Extinct? Do We Just Now Have Cubs?
  • Price Of Stock To Earnings At 31 – Twice The Average Of 14…


The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

March 6, 2019

“It is a very reasonable, a very sane approach, in a world that is completely insane. What we defined last week as insane is this addiction to growth, this idea that, at any cost, without regard for the future of the price to be paid, we can pursue a path toward growth, and that that is reasonable. That, in fact, is the definition of insanity, at least as it applies to money, banking, and finance in the modern world.”

– David McAlvany

Kevin:We’ve had quite a winter. We’ve gotten, what people would say, pounded with snow. But you know, it sure is better. Some people see snow as a negative, but I see it as a positive. Remember last year when we didn’t have any and we knew it would lead to forest fires in the summertime?

David:And sure enough, we had tens of thousands of acres all around us…

Kevin:56,000 acres burned.

David:Yes. As much snow as we have had this year, looking out the window with my daughter this morning, she had this forlorn look on her face. I asked her what was wrong and she said, “I’m just sad.” I said, “Why are you sad?” She said, “Because winter is almost over. But guess what comes next?” I said, “What comes next?” And it’s not a season for her, it’s, “I get to ride my bike.” So she doesn’t get to ski anymore, but she does get to ride her bike, and she is looking forward to that.

Kevin:I love the seasons because I think that’s how God planned things. It’s amazing to me here in Durango, being at 6500 feet, our elevations as we go north go up to about 13,000 or 14,000 feet if you don’t go too far north. That is actually where our water stays. We get these snows, these warm fronts come through, and then the cold front freezes that snow so that it is almost like an icebox that keeps that water there for the summertime. So we need both. If all we had was perma-summer, it reminds me of how people are looking at the markets these days. Everybody just wants things to continue to go up, but you need those seasons because that’s the way things are designed.

David:I had a friend ask me the other day – it was kind of a devil’s advocate type question – if owning gold was really just a way of profiting from others’ misery. I’ve heard a similar question in the context of almost it being an un-American activity, where you’re not betting on the future of a great nation, almost Warren Buffet’s comments about why you would buy something so unproductive. It was a curious observation, that about profiting from other people’s misery, because it had the feel of what you experience – I don’t know if you’ve ever stood at a craps table and seen what happens when someone bets on the don’t come line.

Kevin:Right. That’s the bet against the rest of the table.

David:And so there you have this socially unpopular bet at the craps table. My response to the question was, “No, it’s not. It’s the only way that through millennia, individuals have preserved value, have stored wealth through periods of repression, through periods of inflation, through periods of social or political redistribution of assets. And so, no, it’s not just betting against something that is good. It’s not benefitting from someone else’s misery. We’re talking about something that is the anchor to just weights and measures, and it’s the only reliable savings tool through time.

But to criticize gold ownership in that manner, to me it is almost like questioning the legitimacy of parachutes. Is it fair that some people can navigate the effects of gravity better than others? That is how it would be framed, right? To me, gravity exists – it just exists – and how you navigate it? Some people navigate it pretty well and some people drop like a stone. But I think gravity exists for asset prices as much as it does for anything else on this planet, and parachutes are always a good idea from the perspective of high elevation.

Kevin:And we have to look at what is creating that misery that supposedly you would be betting against. The misery is actually being created by something that is an unjust weight and measure. It is somebody not playing fair in the game who has the ability, unlike us, Dave. We work all day long for a certain amount of money. Someone else can go in, like the government, and print that money out of thin air, and that reduces the value of the money that we work eight hours a day for.

David:One of my favorite books is The Anatomy of the Bearby Russell Napier.

Kevin:Love Napier.

David:I regularly read his Solid Ground. In his most recent letter he talks about nominal GDP targeting and how this is something that is going to be announced pretty quickly. And as we see an announcement for nominal GDP targeting, it is a back-to-the-future event where you can expect the telltale benefits to those who are on the beneficial side of the equation, and detriments to those who are on the detrimental side of the equation, that is, from financial repression.

Kevin:Let’s just put this in perspective. For those who don’t know the difference between nominal GDP and real GDP, let’s use an example – Germany in the early 1920s. If they had been measuring nominal GDP, as they were going through the hyperinflation, they would have growth of millions percent per year. The problem was, they’re currency was devaluing by millions of percent per year. So what they are talking about at this point, Dave, is measuring GDP by the numbers as we have inflation.

David:Right. So this is like the pre-Reagan era where you had a cap on interest rates and there was a very strong control dynamic and administrated interest rate market. We have, to some degree, an administrative interest rate market today. I think basically what Napier is arguing for is an extension of that. I want to read one quote from his letter. “It merely represents the end of our world.” Very positive, right?

Kevin:There’s an understatement.

David:“In the world where savers expect positive real returns on their capital, a move to nominal GDP targeting is simply a recognition that there are now more important goals than allowing for such returns. It recognizes the need to reduce global record-high debt-to-GDP ratios. It recognizes the need to redistribute wealth from savers to earners. It recognizes the need to redistribute wealth from old to young. It recognizes the need to redistribute wealth. Whether you agree with those needs is not relevant. As a move to nominal GDP targeting means that these new goals are now the new normal.”

Kevin:Wow. Wow. It sounds like a desperation move to me. But look at the effect that it has had on the markets, Dave. It used to be we would have a bull market followed by a bear market. This is a little like we talked about with seasons. We would have summer followed by winter, but that winter is what sets up the next summer. That is a healthy cyclical change. It’s not perpetual growth. But do we even have bear markets anymore? We had a quarter, the last quarter of 2018, when we had a little bit of volatility. Would you call that the bear market we were looking for?

David:Again, we go back to this idea of there being an administration of markets and of prices within the markets. We certainly have that through the central banks. And it would appear, if you are looking at what happened fourth quarter of this [past] year and into the first couple of quarters of 2019, that bear markets of the 21stcentury are taking a very different shape than those in earlier times. Again, we can do now in three months of a correction what used to take three years.

Kevin:Do you really believe that? (laughs)

David:Well, that’s the way it would appear, right? Again, in a world of administrated returns. We have had a nearly ten-year rise in the stock market. The more typical three to five-year malaise which would follow, what used to be called a bear market, has been short-circuited by central bank ingenuity, high-frequency technology, and we have been able to shrink time to a matter of about three months. We should maybe call it a cub.

Kevin:Instead of a bear, a cub.

David:Almost cuddly (laughs), and it’s okay as long as mama bear stays sort of hidden in the woods. My belief is that, yes, mama bear is still there, and you should be mindful of the fact that this little cub, as cute and as cuddly as that 4thquarter experience was, now in retrospect, because it didn’t hurt (laughs), beware of what is in the trees.

Kevin:Well, financial TV would make you think that this is all over, because look at short interest. It is back to where it was before 2007. We talked for years about how we had virtually no volatility because it was being managed out with the printed money and the debt. We’re back to low volatility again, the VIX.

David:And to reiterate, 2007 was just before the 2008/2009 crisis. There was no concern prior to the cracks widening very quickly. And so the fact that there was little to no short interest in 2007 spoke to the confidence level, spoke to the reckless nature of investors in that moment.

Kevin:And short interest is, how many people are betting the market down?

David:That’s right. We’re now at levels that are on par with those 2007 numbers. You mention the VIX. The VIX Volatility Index is back below 15. I think it is going to the single digits again. You have investor intelligence surveys. And for every one bear you have two-and-a-half bulls. It has been nine weeks – nine weeks of upward momentum, and that has virtually cancelled out the 12 weeks of 4thquarter pain and anxiety.

Kevin:Last week I said loyal listeners should stop listening to this program if, indeed, this managed program is going to continue to work indefinitely. If it is, there are reasons to be bullish, right?

David:And I think it is worth talking about that. I want to quote one more time from Russell Napier. He says, “It can take many years, sometimes decades, to experience the consequences of misallocation of capital, but it does come, and ultimately the pain falls more widely than just upon savers. There are ways in which savings can produce positive real returns in a financial repression. The most obvious one is by investing in gold. Does any reader think the gold price will go down the day the Fed formally announces that its new target, in nominal GDP growth, is 7%? So again, we’re playing with the dials.

We talked about last week whether it is inflation or unemployment as if we can walk to the thermostat and literally, choose the degree that we want. And there is that kind of hubris built in to the administrative function of bureaucrats and technocrats, both in Washington, D.C., and at the Fed. Yes, there are good reasons to be bullish, there are good reasons to own stocks. At least, this is how the argument goes, or if you were to argue for it, it would be on this basis. The Fed is accommodative, right? They are no longer reducing they’re 4 trillion plus balance sheet to the detriment of bond prices and other asset prices. In fact, they are staying pat and providing, once again, support for the asset markets. The ECB chief economist is now suggesting the return of the long-term refinancing operations. It is a program that targets the purchase of government, as well as corporate, bonds.

Kevin:Boy, they only backed away for about three months and now they are back.

David:Exactly. And that is a program that harnesses the power of the digital printing press to push prices higher and to bring yields lower in Europe. Again, we’re back to that administrated outcome, right? A chosen outcome, a chosen course, for interest rates.

Kevin:Let me ask you, though, if everything is back-stopped by the central banks, how in the world do you determine risk? Does risk even exist anymore in this market?

David:Yes, I think that’s the irony, because on the one hand you have banks and asset management companies who have been able to shift out of low-quality, high-risk paper, and shift into higher quality low-risk paper, and collect profits while doing so. And you’re right, the central bank community is there actively buying assets. In that context it becomes very difficult to discern what risk is, and if risk is even a relevant concept as you are allocating capital.

So there is no contractual guarantee when a bank is doing this, a central bank, specifically, the ECB. Just like Fannie Mae and Freddie Mac, there is no implicit backstop like the mortgage-backed securities market, but there is, with the activities of the central banks, an implied guarantor of price, and a willing party to subsidize the trend. And of course, that is your favorite central banker.

Kevin:Isn’t it strange? We think we’re talking about economics, but we’re talking about politics, because what we’re seeing worldwide is the lie of socialism, it’s just applied to money, where we all can be equal. Risk, at this point, has been socialized, if you think about it. There is no risk anymore. In fact, you brought up parachutes. No man would need a parachute if the world was made of marshmallow, right? And in a way, the central banks are making the landing pad out of marshmallow at this point, saying, “Don’t worry about it, there is no risk.” The problem is, it’s not true.”

David:So in the short run, what that translates into is for both institutions and speculators, the central banks have Fed, they have been a source of trading profits. If you know the ECB is going to buy anything, they don’t have to hold their nose as an investor because they’re not really an investor. It’s a political choice to subsidize certain markets. They don’t have to hold their nose when they are buying low-quality paper. It’s all good. And you might say, not only is it non-discriminatory in terms of the assets they are willing to purchase, I would throw into that mix, it is also not discerning.

You have heard us say this for weeks, and certainly in recent weeks, a popularly held view within the marketplace is that the markets can function in a different way. The 21stcentury it’s not just a spoonful of sugar in the case of the Chinese, it’s a ton of sugar. And what does that do? You have decline in industrial production numbers. You have a trend line for GDP growth in China which is on the down-tick. And what do they do? You pump in 477 billion dollars in a single month in the banking system, 685 billion in the total credit system and the pep is back, the markets love the feel of economic activity.

Who is to argue with the success story of the sugar high to sugar high type addiction? Regardless of how it is induced or whether the possibility exists of future economic complications. Because what we have is present tense priorities, and who cares what the consequence is if you can ride the Shanghai exchange up 20% the day that the credit spigots open wide?

Kevin:Okay, let’s look at another part of Asia. The Bank of Japan has been buying everything for years. They said that they were going to back away. They never did. Now they’re saying they’re going to come back and continue to buy.

David:The Bank of Japan has these crazy debt-to-GDP numbers, far worse than ours. And so, again, I love Napier’s comment. Maybe this is like some version of schadenfreude, I enjoy hearing someone like Napier say something like this. “Today, U.S. debt-to-GDP and global debt-to-GDP are at record highs. There is now a clear and present danger of financial collapse, and a need to inflate away that debt. We know exactly how that was done the last time, so should it come as any surprise that central bankers are adopting new targets and sharpening new tools to make it happen? What has the Bank of Japan promised to do? They promised to restart something that they never actually stopped. That is, direct market purchases of stock indexes, and of bonds, to promote price stability and encourage economic growth.”

Kevin:We likened it last week to an addiction, where we have become addicted to what was supposed to be an emergency measure, and it felt good enough, let’s just go ahead and continue it.

David:Right. So in the 21stcentury the novel idea is that what were at one time emergency measures can now be perpetual measures. They are with us forever. And those policy steps can, in time, serve as a new foundation for extending the economic business cycle.

Kevin:It’s never winter. Never winter again.

David:And we can do this indefinitely. My kids love the Narnia stories. The problem in Narnia was that you never got to Christmas because it was always winter, and you didn’t have the seasonal change to actually get full cycle, so you never saw Father Christmas. For those of you know the story of The Lion, The Witch, and the Wardrobe, it was always winter, never summer. And the white witch had her way. They would argue that it is indefinite summer, not indefinite winter. So again, they would argue that what they are doing is extending something that is virtuous.

That’s how the theory goes. It’s not that we keep those tools at our disposal in case of an emergency. This is the irony. We’re using many of the crisis-related tools in the present, ten years after the global financial crisis. And in my mind, I wonder, does that build confidence? It doesn’t build confidence in me. Does it build confidence in you, as it appears to be doing with the broader investment community? The fact that these emergency measures are now the norm?

Kevin:I agree with Napier. It sounds to me like it is a desperation move when you have to change what GDP is measured by to the nominal numbers. It’s a little like calling [an economy that still needs an extra 1.3 trillion dollars a robust economy]. Somebody is playing a game of moving the numbers.

David:And this is, again, what makes some of the moves in the stock market here in the last few weeks patently absurd. You have earnings estimates of analysts which are on the decline, even while your stock valuations are some of the highest in history. So from our perch, we see the valuations of stocks. We see the artificial pricing of bonds as symptomatic of late cycle desperation. You have the status quo which has been good for asset owners. You might call them asset speculators, more appropriately. In this context you have 5.5 trillion dollars in global government debt which needs to be refinanced this year.

Kevin:Just this year, 5.5 trillion needs to be purchased by somebody. It’s a loan to the government.

David:A variety of governments around the world, and at least another 2.3 trillion in government debt which is going to be added to that. This is according to S&P, the rating agency. Of course, this does not include private debt. It does not include household or corporate debt. You have central bankers which look at the amount of debt which has to be rolled over and financed afresh and they know that rollover risk can emerge any year, and particularly in a year when you are trying to move this amount of money smoothly and quickly through the market.

Remember what happened in 2008 and 2009? Very quickly we transformed from a liquidity crisis into a solvency crisis, and you were dealing with bankrupt situations with companies who, literally, days before said, “There’s no problem here.” And they said it with a straight face, they said it honestly, because they didn’t realize that the liquidity taps were on the verge of being shut down. And as soon as they lost liquidity – boom – by the end of the week you had solvency issues.

Kevin:I brought up Germany in the 1920s. That was a microcosm of what we’re doing worldwide. Are we really applying the same economic flawed thinking to world economics that the Weimar Republic, Germany, did from 1920 to 1922?

David:I think it’s at least a variety, or a version, of it because, again, liquidity is something we take for granted when we have it, and then it’s easy to forget how quickly it disappears. Rudolph Von Havenstein believed that he had a liquidity crisis. This is post Versailles Germany, 1921 to 1924, and he saw that providing liquidity was like the necessary greasing of the gears so that economic activity could continue, and was necessary to avoid those gears grinding, or even coming to a full stop. So what he did – the presses ran overtime to print reichsmarks and ensure that the consumer could afford basic goods and services. There was this view, again, that there was a lack of liquidity, the consumer needed it, he provided it, and thus there was ample liquidity to take care of consumer basics.

Kevin:But that creates the misery we talked about at the beginning of the program, because the consumer may be able to afford basic goods and services at the time that their printed money gets into their hands, but at some point it turns to starvation and lack of goods and services.

David:Because you’re talking about diluting the value of every reichsmark or currency unit as it is inflated. Now, our modern day Havensteins – these are your global central bankers – they see a similar liquidity issue, but it is slightly different. It is not the consumer who is unable to pay for goods and services. Central bankers are less concerned with what, in a derogatory sense, have been called the hoi polloi, but their concern with the holder of IOUs, that is the focal point of the modern-day Havenstein. This is, again, central to the financial markets, central to banking stability – the current value of loans outstanding.

Kevin:And what is that?

David:Well, we just talked about this year we will pass 50 trillion in sovereign government debt. That is not total debt – private, corporate, etc.

Kevin:That’s just government.

David:As I mentioned, 10% of it comes due and has to be refinanced in 2019, alongside the deficit financing needs of global firms, various countries that, for us, this is habitually spending more than we generate in revenue. It’s just a way of life for us. These are the primary interests of central bankers. Keep the credit markets healthy. Keep asset prices elevated. Otherwise, those whose balance sheets are tied to these assets, and are leveraged and dependent on the stability of the pricing of those assets, would otherwise be at risk. So we should now understand “healthy” to mean the perpetual growth in debt and the direct support of the equity markets, and that is what central banks are trying to maintain, a healthy asset price environment.

Kevin:I’m going to go back to just a simple example we have used before, but let’s say you had a hot dog stand that earned $100,000 a year and someone walked up and said, “I’ll pay you a million bucks for that $100,000 a year hot dog stand. That would be a price earnings ratio of 10-to-1. So basically, the hot dog stand is worth ten years of earnings. We have talked before, if you’re going to have perpetual growth, that means you don’t those prices coming down, so that hot dog stand moves from a million dollars, to two million dollars, to 2½ million dollars, to three millions dollars? Now we’re talking a 30-to-1 price earnings ratio.


Kevin:Perpetual growth – how far can it go?

David:That’s pretty rich. Where are you going to be in 30 years? That’s a lot of hot dogs.

Kevin:(laughs) That’s a lot of hot dogs.

David:That’s a lot of rainy days. That’s a lot of weekends. That’s a lot of days manning your hot dog stand to get your money back.

Ed Easterling is a guy that we have had on the program before. He heads Crestmont Research when he is not punching cows and trimming trees out in the forest up in the Northwest. In his recent commentary, he puts U.S. equities in the 99thpercentile.

Kevin:As far as overvaluation.

David:Valuations – they’re in the 99thpercentile. The easy translation is, they’re expensive. So he has his own version of CAPE. You mentioned price earnings ratios. So because there volatility with earnings and price, one of the things that Robert Shiller did years ago is to say, it’s better to take a ten-year rolling average, and it reduces some of the volatility. It gives you a much clearer picture as to where you are. Not a trading tool, but it tells you in terms of the vicinity you are, where you are and where you are going over the next three, five, ten years.

Kevin:So Cyclically-Adjusted Price Earnings.

David:And Ed Easterling actually adopts a couple of other disciplines which he finds to be credible and comes up with a derivation of the CAPE, or the PE-10 as it is sometimes called. He calls his the Crestmont PE. Virtually, the same level as Shiller’s PE, 31.6.

Kevin:Okay, so that’s the hot dog stand, a $100,000 per year hot dog stand, breaking even.

David:3.16 million.

Kevin:3.16 million – breaking even in 31 years. That’s not a good investment.

David:Well, for perspective, the average, when you are taking about liquid companies, liquidly traded, publicly traded companies, is 14.3. So at 31.6, again, it’s rich. It is three standard deviations above its average. That number of standard deviations has only been seen once in U.S. financial history. You were at about two standard deviations in 1929 at the market peak – again, two standard deviations above the average. Now we’re at three. The only other time we saw that was the 2000 tech bubble.

What is this? Kevin, it’s not a bubble. When you look at the charts from the Economic Cycle Research Institute, they compare GDP. They overlay that with their weekly leading index. The last weekly reading was -4.2. And you look at the chart, we appear to already be in a recession. Now, they haven’t called one, and they are pretty good at doing that. They made one misstep in the last I don’t know how many decades. That was back in 2001. Literally, everything was turning down. I think, probably, what had egg on their face was they hadn’t expected the markets to react so positively to Mario Draghi’s promise to literally spend anything to save the euro project.

Kevin:But the comfort we can take – there is comfort when you have company – the comfort we can take is, we have been here before. The problem was, the company that we kept last time, if that was the tech stock bubble we’re talking about, that ended…


Kevin:Many people lost everything.

David:It ended poorly. So it wouldn’t surprise me if the ECRI folks – Lakshman Achuthan and that group – it wouldn’t surprise me if they called a recession later this year, before the end of this year. So, we’ve been here before, as you say, but it was in 1929, it was in 1999 leading into the year 2000. And the perception that downside is limited from the current elevated levels – what that ties to is not the markets. It doesn’t tie to prices. It ties to the belief that central banks can influence prices indefinitely and move them higher even from these levels. So here we are, back to the same logic and argument for the efficacy of liquidity from Havenstein, but instead of consumers being the primary concern, it’s the holders of assets – stocks, bonds, real estate. And supporting those asset holders is the army of digital liquidity providers. They stand ready to accommodate.

Kevin:“Here’s your free money.”

David:And it’s not an exhaustive list, but if you just said, “All right, the top four cover at least half the global population or more and most of the world’s wealth – that’s the People’s Bank of China, the Bank of Japan, the European Central Bank and the Fed – these guys are there to prop it up. But again, travel with me over to Napier’s comments. He is saying it is now to the point where there is so much debt that they have to inflate their way out. How do you do that? How do you do that and keep people in the system? How do you encourage people that we actually have growth, and this is a good thing?

You start talking about positive rates of GDP growth and put it in the 5-7% range, and put that as a target and you know what? People are going to enjoy it. On the front edge of that, they will very much enjoy it. On the back edge is where they get sliced to pieces, because the implication is not only higher rates, but higher rates of inflation.

So this is where you are going to get exactly what you pay for. You just have to be aware of the packaging because the way it is packaged from the Fed is that it’s all roses. It’s all tulips. It’s all everything that you would ever want. It’s beauty, it’s romance, it’s everything, with a bow wrapped around it. And they’re not telling you that there actually is a desperate ploy here – a desperate ploy. They wouldn’t have to go to the extremes of financial repression if they weren’t trapped. And that’s exactly where they are – they are trapped.

Kevin:For those of us fortunate enough to have been able to watch Michael Jordan play, I remember when he would go up for a dunk shot, he would almost float a second time. It was as if he had a step in the air that he could take and float a second time up to that basket. Those who have seen him on film still can’t fully explain how he could do that, but it was amazing. It was beautiful. But it was still unsustainable. Even Michael Jordan – once he launched, he seemed to float further, granted, but he always came back down. It is overstating to say that what goes up must come down, but going back to price earnings ratios, Easterling says, these levels can never be sustained. We have never seen a time in history when levels like these – 31 times earnings – are at a sustainable level.

David:Right. So if you have peak asset levels that can’t be sustained indefinitely, then the market levels we see today are at or near the extremes. It means what we have ahead is the process of mean reversion. What we have ahead is getting back to the average. How do you get back to the average? You get there by seeing a decline in price. It is the only way excesses are corrected. You may say, “Well, that’s just negative.” It’s exactly where the friend asked me the question, “Is it all just negativity, and can’t you say something nice?” Yes, I can. What this opens up is the possibility of healthy, long-term positive investment returns. When you start with reasonable value, you have a nice long runway of the potential of double-digit returns over a period of a decade or more. But first, asset prices must fall. Here we have the third unofficial mandate, not only by the Federal Reserve, but other central banks around the world, which is to assist in defying gravity just a little bit longer.

Kevin:There you go. Float that little extra bit.

David:Just float it, float it, and does it change the course of the markets, or is it merely a change in the timeframes, that extra half a second? Because as far as the market participant is concerned, everyone is enjoying that effortless float toward the basket.

Kevin:And I think you would probably agree with me in my disagreement with you. Everyone who is in the elite, or everyone who owns assets – but let’s look at the man in the middle. Let’s look at the guy in what used to be the middle class that is now becoming annually the lower class and the very bottom rungs of the class. He is listening to this program thinking, “Gosh, this program must be just for the rich, because if everyone is enjoying this, why am I running out of money before I run out of month?”

David:You have these two conflicting groups because, on the one hand, you have professional politicians who aren’t necessarily trained academics. Most of them, in fact, studied law, and know very little about economics. So they are reliant on the second group, which are academic economists, and they don’t necessarily know that much about money, banking, and how the markets work, but they are making decisions that impact money, banking, and the way the markets will ultimately work.

So, who is fodder in the midst of this, and where are we seeing political surprise where professional politicians then have to look around and say, “I don’t know what just happened to me, but this is very unpleasant. I’m getting letters from constituency groups and this is not working quite as I planned. I’m going to point the finger at the academic group.”

Kevin:We’ve got a booming economy. How could you be unhappy?

David:But there is surprise amongst the professional political class, the political elites, by the unhappiness of the man in the middle. You could say that he was previously the middle class, or she was previously middle class. Now they are just kind of in the middle, like the middle child, right? Somebody who is a little bit overlooked or not getting the same attention as the first and the last born. And what you begin to notice is that there are behavior problems emerging for the societal middle child.

Kevin:It’s because he is waiting for change. In fact, I was thinking this when you were talking. You know, the Michael Jackson song, I’m Looking at the Man in the Mirror? I’m going to change the words just a little bit here, okay? “I’m looking at the man in the middle, and he’s still standing here waiting for his change.”


Kevin:And that’s what is happening, but he’s not getting it. He is realizing they are waiting for their payment. He is not getting change back anymore. How many people these days, actually in the middle, are saving money? They’re not.

David:So when you think about having, whether it is one minute of margin, or two cents, or a dollar worth of margin at the end of the month, when you say you’re running out of money before you run out of month, you’re talking about people that are right on the edge. And everything has to work just right for them to stay relatively happy/miserable. When you consider the violence of recent months in France, I think it is worth noting that you have the same conflict playing out – a political agenda, and ultimately an economic agenda, which is in conflict with where people are, what they are experiencing on the street. So what are the two agendas? Before you had the outbreak of the Yellow Vest movement there, you had Macron in an attempt to further his climate agenda, promises that he had made on the campaign trail, and then bring and deliver budget cuts and revenue increases. What did he propose in November? Gas tax.

Kevin:Raise the price of gas.

David:Right. So this marginal increase – it wasn’t a big increase – but this hit your rural and suburban voters disproportionately. The Yellow Vest movement had their own agenda. And I think before they were called the Yellow Vests they were just trying to feed their families and pay the bills and maintain a basic working class lifestyle. Again, any marginal increase in cost is too much. And that speaks, again, to the marginal exposure, the economic vulnerability on a mass scale. And here we are in a developed country. It’s no different in any lesser developed countries, the emerging markets, but the tensions come from this disconnect.

Kevin:Right. The elite and the normal guy.

David:Right. Your bureaucrats are just trying to solve a series of professional problems – I get that. The central bank policymakers who are trying to make the world a better place, particularly the world of asset prices a better place. And they are forgetting that wages and price inflation are more relevant to the mass of voters, and in a society that allows for dissent, that allows for voice, that allows for a vote, all of a sudden the mass viewpoint matters.

Kevin:And issues start to surface that weren’t really issues before. When you can’t pay your bills you start looking for the strawman that you can take down, and so you can have issues that weren’t necessarily the driving issue. I think of Germany. We talked about Germany in the 1920s. It led to Nazism. The Germans weren’t Nazis. There was a very, very small party called the Nazis who knew how to move that blame.

David:They hijacked the momentum of discontent.

Kevin:They did. And the fear of communism – the fear of communism was what drove Nazism. And the lack of money.

David:Clearly, there has been a hijacking of the Yellow Vest movement. That comes as no surprise. It’s opportunistic. Honestly, I experience that almost every night at the dinner table. I sat last night and just tried to get a word in edgewise, but I’ve got four little people who all have strong opinions. I have no idea where they get this.


David:And they all want to give a voice, and I’ll start saying something, the next thing you know, what I’m doing to interject and try to get the floor back again – this is what I’m saying – “You’re hijacking. You’re hijacking the conversation. This is a hijack moment. Give it back, I wasn’t finished.” But the point I want to linger on here is that you have a social wildfire that has been lit. It has ramifications for political and social stability.

And I’m not sure the underlying factors of marginal economic survival and the exaggerated pressures from having even a marginal increase in rising expenses, and yes, those expenses are in excess of the current wage growth, I’m not sure that this isn’t a universal issue. It’s not France, it’s everywhere. Yes, it’s the French. Yes, it’s the Italians.

Kevin:You can feel it here.

David:But it may be first expressed by them, but I don’t think they will be the last to protest inequality.

Kevin:Do you think that is where socialism is coming in? Even the Economiston the front page…

David:Two weeks ago.

Kevin:Yes. The front cover was showing the rise of socialism worldwide.

David:Millennial socialist. That was the highlight of the Economisttwo weeks ago. Is that so different than the Yellow Vests in France? What is socialism? It is a means of correcting inequality through attempting to equalize everyone.

Kevin:That’s how they sell it.

David:Yes. Social movements and political trends – do they occur in a vacuum? I don’t think so. I don’t think they occur spontaneously. They are in a context, just like mold grows in a wet environment, and wildfires, like we talked about earlier, occur more frequently in a time of drought. So you have political trends, too, that are influenced by an economic backdrop. So here we are in an age of asset price controls. They are being propped up. There is bound to be wealth and income disparity. And there is emerging a political desire to correct it – to equalize.

Now, with that as a backdrop, the question is – is there a catalyst to spark energy? You had it in France, you’ve have it with the Five-Star movement in Italy, you’ve had it with Syriza and a number of different groups all throughout Europe. We’ve already seen it here in the United States. If you wanted to go back to 2008 and 2009 you could say that it had one iteration in the Occupy Wall Street movement, and it has had a variety of other iterations since then.

But what I’m getting at is, the longer central banks attempt to maintain the current level of asset prices, the sooner we are likely to see social discontent and political volatility become the norm here, like in France. It has to do with this issue of tampering with the natural order of things. When you tamper with the natural order of things, there are weird, unhealthy, sometimes even dangerous implications.

Kevin:I think we would be fools to mistake this as just an organic movement that naturally occurs. There are groups out there – I brought up the Nazis before – that utilize crisis. They let the discontent grow organically. They even fuel it a little organically. And then you had talked about a catalyst. I think of the Reichstag fire in 1933. That turned out to be set by the Nazis, but they knew that the discontent with the communists was growing. Now, there may be a group right now – we can all probably think of people out there – that wouldn’t mind a crisis during the Trump administration – let this thing grow organically, and then drop the ball.

David:Listen, we have a crisis in India. We’ve talked about Hindu nationalism and the Modi government, the election that is in full swing, loss of a number of states to the party, away from Modi’s party.

Kevin:And now look at Pakistan. All of a sudden, enter Pakistan.

David:Yes. We talked about the deficit spending that Modi was employing to buy votes. And you’re right, it’s going beyond that now. We have direct conflict with Pakistan over Kashmir. We have India launching pre-emptive strikes on “terrorist camps.” Maybe they were, I don’t know. But Pakistan has responded by shooting down Indian military aircraft. The Financial Timesreported here in the last couple of days that this is the worst conflict in half a century between two nuclear powers.

Look at what the backdrop is. The economy in India is slowing, like most of the globe, below their previous growth rates. We’re in an election year that places the incumbent in a very vulnerable place. To avoid the loss of political power – you can look at history and see this over and over again – there is always the temptation to stir the nationalist pot, more easily accomplished when there is a unifying threat. Just look across the border and here we have a unifying threat – Pakistan.

A lengthy Economist article– I would encourage you to get this week’s Economist– asked whether the lines are being blurred by the Modi party between the Pakistani Jihadis who they made a pre-emptive strike against, Kashmir protestors, or even just critics of the Modi government. Because they are all, if you are in the Modi government, dangerous enemies of the state, and they can all be branded as terrorists.

Kevin:It’s wag the dog. We have that in many governments. You wag the dog in a way that distracts the people from what is really going on.

David:So the Hindu Nationalist State – Modi continues, or wants to continue to rule, and I think probably what he is up against is the election polling numbers aren’t showing a wide enough margin for him, so now we have the missiles flying.

Kevin:There seems to be a smoke screen. We know that the elite benefit from asset prices rising. We know that the elite also are out of touch with why the man-in-the street is having a hard time paying his bills. But you see this perceived sympathy, or empathy, from the Federal Reserve, these new sessions. They are called the Fed Listens sessions. “Tell us what you think of 2% inflation. Tell us how you’re doing.”

David:And it is out of touch. You think of the elite in Venezuela. They are out of touch with what the man-on-the-street is encountering, to the extent that 80 tons this last week were burned up and unused, aid that was supposed to go to people to help them from starving. What did the elites say? “We’re not letting go of the assets that we control, which is huge oil revenues from this country. The military is unrelenting. And you mentioned wag the dog as it relates to India. That is essentially what I see happening with the Fed. Those Fed Listens things – this is like theater. This is a production. This is to get people on board [unclear] perception.

Kevin:We feel your pain, we feel your pain.

David:And I’m sure it is well-intentioned, but they’re doing these Fed Listens sessions and they’re sitting down with members of the public, and on the table is this shift toward an average of 2%. That one shift in language is really important, a very subtle shift. They’ve had a target of 2% inflation. Now they’re targeting an average of 2% as an inflation target and they have positioned this in the context of being accommodative, listening to the public.

Kevin:What does that mean? Does that mean that the inflation rate would probably be higher than that if they were just looking at a long-term average?

David:It gives them the allowance to over-shoot the target. So if 2% is the target and we’re averaging 2%, then it could be a little above, it could be a little below. Again, we go back to this issue of who pays the price for that? It’s the rural, it’s the suburban voter here in the U.S. These are the folks at the financial margins. I think many of them came out and voted in 2016, and as the French are showing us, they can do far more than vote.

Kevin:Well, going back to real versus nominal, because you brought that up with GDP. When you are inflating, it looks like things are going up. Look at income. Most people, if they look at their nominal income, would say, “Gosh, I’m making more money. How come it doesn’t go as far?”

David:Nominal GDP. Again, it looks so good. Why doesn’t it feel as good as it looks? Jill Mislinski, writing on the topic of real disposable income for Advisor Perspectives, draws a chart showing the difference between real income growth going back to the year 2000 versus nominal income growth since the year 2000. So on the nominal side, again, before you extract inflation, we’re up 89.6% in nominal terms for the year 2000 to the present.

Kevin:Well, so we should be doing a lot better.

David:We’re up 34.6% in real terms, so if you subtract out inflation, that’s 55 points difference, and that 55 points comes from inflation.

Kevin:But is that what the government tells you what inflation was versus the real inflation?

David:Right. So if you want to factor that in, that being the normal inflation number, this is where there is a rub for most households. It’s because a household cannot scrub away their experience of inflation, like the Fed can scrub away their experience of inflation when they are compiling statistics. So if you wanted to say we have nominal, we have real, and then we have realreal income growth numbers which factor in a more realistic inflation number, then you are talking about wage growth which is negative probably.

At a minimum, we can say that there is a crowd that is hypersensitive to any increase in prices, and if it is being orchestrated at a 2% number, or if the Fed is successful and is actually able to run a hotter inflation number and keep it understated officially, who feels it? Who feels it?Again, make the connection here between sociological shifts, political angst, and what is happening at a basic level in the economy and try not to blame it on radicals or right-wing radicals.

No – look at the cause and effect of monetary policy and central bank positioning and how that is impacting, not just the U.S. voter, but again, people at the margins in every culture all around the world. Europe and the U.S. are most dramatic, I think, today.

Kevin:We talk about the difference between what government calls inflation and what we know inflation to be. All you have to ask is a person who is on social security who maybe even has assets in the bank. You can ask, “Are you earning interest in the bank?” We talked about that last week. Of course they are going to say no, they’re not earning enough interest to keep up. But social security – the same people who are reporting the inflation numbers are the ones that are also responsible for raising what social security will pay the next year to keep up with inflation.

David:That’s called the cost of living adjustment.

Kevin:Have you met anyone who would tell you that the cost of living adjustment is keeping up with true inflation?

David:(laughs) Well, sometimes you have to dip into the academics. I like Carmen Reinhart. She has been on our program before. I’ve never spoken with Christoph Trebesch, but they both did a piece recently on the retirement and pension crisis, which has been amplified by a couple of things. One, by central bank price interventions, because when you’re buying bonds, and you’re suppressing bond yields, the income that a fixed income investor or a pension fund is receiving on their bonds, is much less than they actually need. So low interest costs have kept government borrowing costs down. So hooray for the leviathan. It works for somebody, we know that. But it has caused concern for the solvency of retirement schemes like social security.

This is what Reinhart and Trebesch were looking at. Not only have you had life expectancy of an American worker increase by 17 years – go back to when social security was created, 1935 – life expectancy has increased by 17 years since then, but you have only seen the retirement age shift by two years in that same interim. You also have a low rate environment which has made it difficult to get enough yield to feed the increasing outflows from the social security system. So there is a demographic element to it, too.

And it has caused pension managers to shift toward equities in order to supplement returns and compensate for the low-yield environment. This is like risk upon risk upon risk within the pension system. The implication is very straightforward, but you are going to have to shift both the age at which someone can retire and the amount offered in retirement as a benefit – that will have to be altered, too. Age – that’s the obvious one.

Here is what is fascinating to me. Inflation is a tool that is being implicitly used. You have already said it. The cost of living adjustment – if they can play with the inflation numbers, you are reducing the social security liability, or burden, by understating the official inflation statistics.

Kevin:So unlike what you were asked earlier about gold investors just profiting on the misery of others, really, what a gold investor is doing is avoiding the misery, and helping others to avoid the misery.

David:Exactly. You’re saying, the system is rigged, and the man in the middle is getting squeezed out of existence. So if you are the man in the middle getting squeezed out of existence, here you have a social tension. You may be living on a fixed income, you may be a saver who has been very diligent about preparing for retirement, and not quite there. But on a go-forward basis, this is another point of tension where you run out of money before you run to the end of the month.

Kevin:Going back to last week, we talked about your haircut costing the same as it did in 1919 in gold. So one of the only ways that a person can actually defend themselves against this squeeze is with gold investment.

David:Right. Just to echo what I said earlier, now you’re talking about an individual who is interested in preserving value, who is interested in preserving wealth through periods when you recognize that governments are between a rock and a hard place, and are going to do what they have to do to survive, whether that is financial repression, whether that is inflating away debt, whether that is mass redistribution of wealth.

Again, we’re back to something that is an anchor. It is a reliable savings tool through time. It is not an opt-out, it’s not a bet on the end of the world, it’s not hoping that the world ends and that there is misery and you capitalize on that. It’s none of those things.

It is a very reasonable, a very sane approach, in a world that is completely insane. What we defined last week as insane is this addiction to growth, this idea that, at any cost, without regard for the future of price to be paid, we can pursue a path toward growth, and that is reasonable. That, in fact, is the definition of insanity, at least as it applies to money, banking, and finance in the modern world.

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