- Central Banks To Target The Middle-Class To Slow Economy
- Extreme Interest Rate Volatility In China & U.S. in 2022
- Visit mcalvany.com To See Our New Look & Latest Updates
Petro-Dollar May Someday Face Petro-Yuan
January 4, 2023
“Global recession is disproportionately painful for underdeveloped nations where a marginal shrinkage in trade impacts economic security. So that success in taming inflation, when we’re thinking about the US or Europe, if we have success in taming inflation using the Keynesian tools of demand management, there is a direct impact, a disproportionately negative impact on developing economies.” —David McAlvany.
Kevin: Dave, before we get started on today’s show, we’ve recently updated our look and our website to give our clients the finest experience possible, and to share the best of McAlvany Financial Group in one place. Listeners of the show can go to mcalvany.com to see the new website. We post daily the latest market news, insights, investment guides. Everything’s there.
David: Yeah. Whether it’s Doug Nolan’s Credit Bubble Bulletin or Morgan Lewis’s weekly analysis of the hard asset markets or even our own show. We’re publishing new and helpful educational resources there for our clients and audience each day.
Kevin: Even with a rename, we’ve updated our business name from McAlvany ICA, which has been around for 50 years, to McAlvany Precious Metals. This update was done to offer our clients a greater clarity into what each branch of our financial group does.
David: Yeah. So from the best in wealth management products to industry leading expertise and services in the precious metals sector, your future is our mission, and we want something that is that much easier to navigate.
Kevin: Yeah. So it’s still the same company, 50 years of experience, helping thousands of families achieve their financial goals. So the philosophy doesn’t change, really, Dave. From Don, your dad, who named the company ICA, to you who’ve just refined that name to McAlvany Precious Metals.
David: Yeah, go to the new website at mcalvany.com and navigate around. We hope you enjoy.
Kevin: Welcome to the McAlvany Weekly Commentary. I’m Kevin Orrick, along with David McAlvany.
David, Happy New Yea. And you had a few powder days this last weekend, didn’t you? Up in Utah.
David: Well, thank you. Yes. Happy New Year to you too. And to all of our listeners, we brought in the new year in Utah and the storm brought 69 inches of power.
Kevin: Wow, that’s so cool.
David: In some cases, closing down ski areas and forcing inter-lodge where certain ski areas wouldn’t even let you out of their lodge facilities to play in the snow because the avalanche danger was acute. So for a guy who likes steep and deep, but it’s a bit as good as you can get it.
Kevin: It’s interesting how you get the extremes. I was talking to somebody this morning who— We’re a white Christmas, white New Year. Again, it’s snowing outside the studio right now while we record, and, yeah, and we’re very thankful for that because we’ve gotten the moisture, but we don’t always get the moisture. I remember four years ago, it hardly snowed in Durango the entire winter. Now, if that was the year that you moved here, you’d have thought, gosh, these are not only mild winters, they’re extremely mild. But it reminds me there are extremes that you learn from, Dave.
When I was a kid, I would go downstairs and watch my dad. He built a Heathkit. Yeah, I don’t know if you remember Heathkit, but it was a company where you could build whatever electronic gadget you needed. He built a Heathkit oscilloscope. These days it’s called a waveform monitor. And there was no signal going into it. It was a way of measuring wave forms and looking at the shape of the wave when there was no signal going in. It was just a straight line. There was nothing. There was nothing. And then whenever he would apply whatever frequency that he would apply, you could actually see the extremes, the peaks and the valleys of those frequencies, and in between would be the median range.
But it reminded me, yeah, okay, so I think of weather, we have these extremes in weather, you can just have a pure simple signal or you can add a frequency to it and it creates extremes. You can see it very visually on a waveform monitor or on an oscilloscope. But what we’ve had in the economy through this Commentary, I mean, I’m looking back now, we’re coming into year 15, and what we have seen is extremes of the 2008, 2009, up through about 2011, then we had nothing. We had the central banks coming in and saying, “We will take care of everything.” Okay. “There’s nothing we can’t do.” And what they did was they created that smooth line. Nothing was really happening. Then we had 2020, 2021, 2022. But 2022 especially was a year of extremes. So I’d like to speak to that, the extremes, not only in employment, inflation, currencies, what occurred with the cryptocurrencies. Could we maybe look at that today?
David: Yeah, I mean, you had this sort of faux world, this false world of control by central planners and by central bankers, as you mentioned, from 2011 to 2020. And it didn’t stop there. We just had greater interventions following the onset of the pandemic. And—
Kevin: Almost an excuse, wasn’t it?
David: It did. It was almost validating, but it took things that were at extremes and took them to even greater extremes. So we’ve got a little bit of an unwind of that extreme interest rate volatility. If you’re looking at Europe and China and the US markets, I mean European sovereign paper was on a rollercoaster for most of the year. Very, very big moves in both directions.
Kevin: Well, even US Treasurys, I mean, that’s supposed to be the safest of safe places.
David: Yep. Chinese developer bonds, they were on the super roller coaster. If Europe was on a roller coaster, Chinese developer bonds were on a super roller coaster, going from very low rates to some of those developers being in excess of 250% yields on their bonds, finishing the year at only a hundred percent. It’s still high, but not as high as they were. Yeah. As you mentioned, US Treasurys, 10-year, for the year, it lost 16.5%.
Kevin: That’s unbelievable.
David: Less dramatic than other geographies. But it moved significantly when you think about that being the largest and most liquid capital pool in the world, the US Treasury market. And it was in China, the Chinese debt, which showed true credit stress.
Kevin: Well, you remember a year ago, how many trillion dollars were actually negative interest rates? We had never seen negative interest rates till about five or six years ago. And then we had trillions in negative interest rates as of last year.
David: And that’s where the rest of the world, dealing with central banks tinkering with zero and below zero rates, were largely stepping out of the world of price controls via quantitative easing, those massive purchasing programs by the central banks. And we’re moving back towards a world, in 2022, moving back towards a world where rates are market determined again. And Germany comes to mind, where their 10-year bond, called the bund, finished up 275 basis points for the year. That’s a 2.75% move for the year, reached 2.57—
David: Right, so to move 275 basis points and end at 2.57, you were starting the year in negative territory, and they were in that crowd. In fact, they were a big part of the $18.4 trillion in total debt with a negative yield, which is what we had in 2021. And here we are leaving 2022 with only 686 billion in negative yielding debt, according to Bloomberg.
Kevin: So what does that do to the person or the country that borrows, assuming that they’re going to be paying no rate or negative rates, now that we’ve got that swing, how do they maintain their debt service?
David: Well, two ways to look at that. One, you’ve got the better part of $18 trillion in bond purchases made through that period of time that are now sitting on losses as rates have come up. And only 686 remains in the negative category.
Kevin: 686 billion?
David: Correct. Correct. But the massive increase in interest rates globally, granted off of very low levels, does create an implication for debt service. And debt service payments are inflicting more pain than any other year, here in 2022 and coming into 2023, dating back to the year 2000.
And the World Bank looks at sort of their studies on poor countries. Last year, with the increase in interest rates, you saw the debt service component rise by 35% for your poorest countries. And that’s going to intensify even more this year because you’ve got rollovers of paper. The user IOUs issued at reasonably low numbers have to be refinanced in 2023. So that rollover risk is considerable.
I mean, we’re talking about, if you go back to the year 2000 where the World Bank does some of their accounting from, we’ve increased the total quantities of debt in these poor countries by three to five times, right? So let’s say from 2 trillion to 11 trillion total quantity of debt versus two decades ago. But, it was more or less manageable with artificially low interest costs. Now, as rates move to higher levels, debt levels are shown to be what they were all along, unsustainable. So that this $11 trillion for emerging market and poorer countries is very unsustainable.
So 2023 is going to look like a year of renegotiation because you’ve got the rollover risk in 2023, and that’s compounded by the original sin, what economists like to call the original sin when you denominate your debt in foreign currency. So to the degree that you have currency devaluation and you have to pay back in a foreign currency, that raises the hurdle and raises the pressure to repay that debt. But you’ve also got an increase in rates. So when you do, if you are able to find someone who will roll over that debt, it’s going to be on different terms.
Kevin: So three to five times the debt for some of these poorer countries than when we were all partying like it was 1999. You’re just saying that happened in the last couple of decades. Yeah, but we’ve got this new Band-Aid. In fact, it’s not just a Band-Aid, it’s the new cure all, it’s called Modern Monetary Theory. I thought we could borrow as much money as we wanted to, as long as we could just keep printing.
David: Well, and that was the hope of Modern Monetary Theory is that as long as you control your currency, you can print any quantities that you want. And that’s not the factor. Quantity of debt is not the factor. In fact, that should not discourage us from running massive fiscal deficits. My hope is that 2022 marks the death of a bad idea, the death of MMT.
Kevin: Oh, you’re calling it a bad idea. You’re behind in the times. Don’t you understand?
David: Well, I had a dream last night that my wife called me a curmudgeon, and I just got fixated in this dream going, wait a minute, how am I curmudgeon? Just because I can’t imagine a world where free money is actually free. Does that make me a curmudgeon?
Kevin: You really did?
David: I did.
Kevin: You really did. You know, I’m glad. I’m glad she only used the word curmudgeon. I mean, let’s face it, she might have said you were a sourpuss or something like that.
David: I know, I know. But this is where things get really interesting from that aspect of debt renegotiation, because the dream of Modern Monetary Theory, where you don’t have to worry about quantities of debt, now becomes a different form of a nightmare. It’s called debt-trap diplomacy. And debt-trap diplomacy is where countries are stuck, and they either have to go to the IMF or World Bank on terms that aren’t really favorable to them. They’re going to have to give up some resources. They’ll have to become indentured servants to the West—
Kevin: So the economic Hitler—
David: Or they can become indentured servants to the East. And so the terms—
Kevin: You’re thinking maybe the Chinese might be using something like that now.
David: Exactly. The terms of debt-trap diplomacy are going to look very different in 2023. And I think a part of that is because people look at the US, the US dollar, the US Treasury, our diplomacy, and they’re a little bit suspect. Should they be equally or more suspect of the terms offered from the Chinese? Well, yes, but that doesn’t mean that they’re not going to court all offers. And so—
Kevin: So the tactics of the World Bank and the Western central bankers might be used against them later by the East, is what you’re saying.
David: Exactly. And I appreciate your illusion to that book, Confessions of an Economic Hit Man. Now you’re going to have his name spelled different. Instead of Mr. Smith, it might be Xi Jinping.
Kevin: Mr. Xi, Mr. Xi. Okay. So let’s talk about these two things. The currency value extremes. We saw a lot of that in 2022. And then of course we have the interest rates that you just addressed, but currency values, that can really crush you when your carry trade turns into having-to-be-carried trade.
David: Yeah, exactly. I mean the yen depreciated to 30 year lows, and that was before the yield curve control policy was revised. And even now you’ve got massive Bank of Japan bond buying that’s required to keep yields at their new cap, which is half a percent, or 50 basis points, versus the previous quarter percent, 25 basis points. So you’re talking about the dollar, the yen, the euro, the RMB, the band for trading amongst the world’s leading currencies stretched between 10 and 20% for the year is massively volatile, and more than a bit dangerous for the leveraged speculator. Talking about the carry trade, there’s more than a few macro hedge funds which capitalized on the volatility, and maybe an equal number that got shellacked by the volatility and the violence in the currency markets.
Kevin: Yeah, you talked about leveraged speculators and how they get absolutely crushed when currency values change if you’re borrowing in other currencies. But even a person who watches the NFL or sports these days, I’ve just been amazed over the last couple of years how speculation craze or get rich quick has even taken over— It used to be it was frowned on to bet on sports games unless you went to Vegas and did it. And what happens in Vegas stays in Vegas. Now Vegas is coming to everyone’s cell phone, and you’ve got guys like Eli Manning and Peyton Manning, and guys who, they’re highly respected in their sports, and they were men of integrity while they played. They’re offering that integrity now to say, “Go gamble. Go gamble.” Caesar’s Palace, what have you. There has been a change since Bitcoin, FTX, all that other, before that all fell apart, there’s been a change in the mindset where it’s like, what are you doing for me today? What are you doing for me today? Can I get rich? And—
David: Those are end-of-cycle dynamics. And I think we’re already in a new cycle when there’s new cycle dynamics, which we can talk about as 2023 unfolds.
Kevin: Well, and we even see it in the options markets and futures.
David: And that’s where you begin to see those end-of-cycle dynamics expressing themselves this last year, 2022. The volumes that we saw at each expiration, monthly, quarterly, et cetera. You’ve got these 2, 3, 4 trillion in value coming into each expiration. And some of it of course is hedging, and a lot of it is speculation. But options trading ran in that parallel track with cryptocurrency enthusiasm. Another expression of a get rich quick scheme where you’re not thinking about annual returns being healthy in the 10, 12% range. You’re thinking about daily returns in the 10 to 12% range being normalized. Then of course as markets deteriorated, volumes on the put side proliferated, hedging increases. And of course if you’re unwinding those hedges, that adds to further upside volatility. Just the violence that we saw in performance within the equities markets. A lot of that had to do with derivatives trading, specifically options trading. So for the year, we surpassed 10 billion contracts, which was more than double the 2019 record levels.
Kevin: Yeah, I remember learning to play options, or learning never to play options when I was in my 20s.
David: And I’ve traded options before with some success. And what I determined is that it changed my perspective on everything. And instead of seeing things in terms of cycles, and instead of seeing how things sort of ebbed and flowed through time, the only time cycle that I was interested in was today or the next 20 minutes. And I can tell you there is a poverty that comes from thinking in terms of the next 20 seconds, 20 minutes or 24 hours. If that’s what you consider a long-term trade, if that’s how you shrink information and triggers for trades into your analysis, I can tell you, you’ve lost sight of a much bigger and much more important mosaic. And I think the cost is not a monetary cost. The cost is a cost of mindset and peace and internal stability—
Kevin: Well, and there are studies, I mean to tie this in with social media and short tweets and the way we think in shorter and shorter timeframes actually is affecting our ability to navigate, to memorize, and to critically think. Because what’s happened is our brain is just, it’s looking for the next quick hit, the next adrenaline rush, the next “like” on Facebook. The same thing can happen with investing can’t it?
David: That’s right. And in that sense, the financial markets reflect culture like art often does. So you look at the extremes in global inflation. We haven’t seen that on such a broad basis—
Kevin: Oh, since the ’70s.
David: Yeah. So take four decades. I guess what made it extreme was the broad-based experience of double digits. The world was affected, whereas you typically think of the inflation blowouts on a one-off basis. And Argentina still may have taken the prize this year, north of 40%, again.
Kevin: Again, 2014, they were north of 40% when we were there.
David: Yeah. So stagflation is an emergent issue, not only because you have inflation, but slowing economic dynamics globally. And of course it’s emergent here in the US as well. So we look at CPI, certainly 2022, you could say we put in the temporary top for CPI. The temptation will be for central bankers to run their victory laps, declare an early victory so they can get back to financial market accommodation.
Why is that a temptation? Well, they don’t like being restrictive. They’re the guys who, at one point—and gals—were running the frat parties. So the idea of taking away the punchbowl, that’s not how you make friends and influence people. They would much rather accommodate, and they would much rather have things on their watch, have them as the guys that they’re stoking the flames of glory and wins and all this.
So I think the real scourge of inflation begins one step removed. Like I said, throughout 2022, inflation is all about the surge and then the retreat. You’ve got this ebb and flow dynamic. In fact, the year I was born, inflation dropped from 11% to 5% before surging again into the teens, into the 13, 14%. And that strong push forward to double digits and then that receding back to single digits and then that strong push forward. Again, a lot of that had to do with monetary policy, and the Fed and the world’s central banks are going to have to keep rates at a very high level for a very long time for them to effectively eliminate inflation. That’s where the social pressures, the political pressures rise. And I think eventually they’ll capitulate, bring rates back down or even move towards quantitative easing again. And of course I think that’s when we see all hell break loose on the inflation front.
Kevin: Well, and when inflation recedes a little bit, I’m just wondering, that appetite for the quick money, whether it’s options or cryptocurrencies or gambling in Vegas, that appetite is an addiction. Okay. It’s not, “and so if that recedes—“
David: One more thing on inflation, because I read a couple of articles, sort of year-end pieces on inflation in the Financial Times, and I thought they were embarrassing in terms of their journalistic quality. It basically said, “Look, we know that we’ve got a global problem with inflation, you can thank the Russians for that.” And it’s like, wait a minute, minute. So you’re going to ignore 10 different inputs into the inflation equation, and then make it, really, on a cheap basis— I mean, people pay for that salmon color, and this was just stupid.
Kevin: Yeah. The Death of Money, The Death of Money, Adams?
Kevin: Yeah. When he talked about the German inflation, when it was all over, they didn’t even blame it on printing money. They blamed it on other countries. They had other scapegoats. So I guess the Financial Times has not learned, huh?
David: Well, at least in a couple of their articles to claim that really has to do with Russia. I mean, because look, you can look at even the oil price, where we finished the year on oil, we gave back all the gains. You had this spike in price in oil, we finished the year basically where the year began. So we journeyed north of a hundred, came right back down, went well below where we were in 2021, and finished basically flat for the year.
Kevin: So it’s hard to blame oil, which would tie Russia in to oil.
David: And if oil prices have come back down and wheat prices have come back down and inflation hasn’t, maybe we are looking at other causes, and it’s not just about the Ruskies.
Kevin: I brought up football earlier, but in the next month or so we’re going to be having the Super Bowl. If you’ll recall last year during the Super Bowl, a commercial that played over and over and over was the commercial of saying, “Fortune favors the bold.” And we see all these explorers—
David: Yeah, but here’s the bold—
Kevin: Fortune favors the bold.
David: If you were getting bold last year at this time, where—
Kevin: Fortune favors the bold, and I think, “should I be doing crypto? Should I be doing crypto?” Fortune favors the bold, of course you should.
David: Between last year this time and this year, this time you get Bitcoin off 64%, Solana off 94%, Cardono 81%, Ethereum down 68%, Binance off 52%, Ripple, which is XRP, off 59%, Dogecoin 60%. And so we head into 2023 not only with market volatility and the reveal of who’s been swimming naked in crypto land, but the regulatory landscape is changing and it’s going to redefine the space throughout 2023. You don’t know who survives the regulatory bar being raised.
Kevin: My guess is you’re not going to see that commercial this year. Fortune favors the bold.
David: Well it would be truly bold to see a Binance step out or a crypto.com step out and run the same ads because I think, unfortunately, it’s going to stir some memories. Investors might say, “Yeah, I was bold, I took my retirement and put it into Bitcoin and Ethereum, and my 401k is now a 201K.
Kevin: Well, okay, so lest your wife actually thinks you a curmudgeon, you can come back and say, “You know what, if we’re going to look at extremes, there is one good extreme that we can look at for 2022. And that’s—
David: We started—
Kevin: Employment. I mean it doesn’t get any better than this, does it?
David: Well it did get better than what we thought it— I mean we started the year at 3.9%. We finished the year even better at 3.7%. Maybe we finished this year at 3.5, 3.3?
Kevin: Tell your wife that. It was just a dream, right?
David: As good as it gets. So I mean actually it was so real. I have to have a conversation with her. Tonight’s date night.
Kevin: Don’t you hate that?
David: Did you say something on the way back from Utah where I was reading and maybe distracted that I was a curmudgeon, or was I truly dreaming it? I need to— It was so real.
Kevin: I’ve had those dreams. You wake up and you’re not quite sure and you’re actually angry at the person.
David: No, but I experienced this emotional, that’s a small trauma of course, but this emotional really? Really? Me?
Kevin: A McAlvany, a curmudgeon?
David: I want to go ski. I love blue skies, I love deep powder. This is not the way a curmudgeon lives. No.
So the question is, with unemployment at 3.7, is it as good as it gets? The Fed’s pushing now for economic contraction, right? So if you put these things in balance, 3.7%, the Fed’s pushing for economic contraction, you might argue yes, it’s as good as it gets. In fact, if the Fed gets what they want, we may see 5% unemployment, we may see 7% unemployment. If they lose control of these fine tools by year-end, we could see 10%. We’ll see just how much finesse the central bank tools allow for.
I think of Biden, January of 2022, Biden was quoted as saying, “The stock market has hit record after record after record on my watch.” And again, all politicians do this. This is not a slam on the Dems or Republicans, the GOP does this too. “Look what I did for you.” You had nothing to do with this, come on now. But stock market has hit record after record after record on my watch, even as the top in the stock market was being put in. And the S&P finishes down over 19% for the year, 33% for Nasdaq, 8.8% down for the Dow Jones industrial average. So maybe it was as good as it got with the equities markets coming out of 2021 and launching into 2022. I think that, 2023, we probably have seen the very best for employment figures, and I think we should prepare for worse. Now I don’t think prepare for the worst because I don’t know that we have that on the horizon, but prepare for worse because honestly it’s actually not hard to move from 3.7 to 3.9, or 3.7 to 4.5. These are marginally small increases off of ideal numbers.
Kevin: Right. I’ve heard the saying that a recession is when your neighbor loses his job, and a depression is when you lose your job.
David: Well that’s what I said years ago about my dad and Starbucks. A recession is when your neighbor loses the Starbucks down the street from him. It’s a depression when you lose the Starbucks down the street from you. He’s a bit of a chai tea addict.
Kevin: Well, and speaking of recession, because it’s strange actually talking about central bankers wanting to raise the unemployment rate, but that’s exactly what they’re doing. When people are fully employed, like we’re as about as close as you get to fully employed, they borrow more money. There’s been quite a bit more money borrowed here recently over the last couple of quarters. If that were to change, if jobs were to be lost, that would be a problem, wouldn’t it?
David: Well I think you certainly see a directional shift in terms of credit creation, and we had massive numbers coming through the first three quarters, and we don’t have the fourth quarter reported yet. So without Q4 numbers we can’t tally 2022. But through the third quarter, the numbers were staggering. Bank loans surpassed a trillion dollars in the first three quarters compared with the annual average over the past decade of 467 billion. So double the bank loans. You look at broader measures of credit creation, 2022 will be second only to 2020 in terms of credit growth. And these are staggering numbers in any period of time. And we weren’t really in crisis mode as we were in 2020.
So all this credit creation, I think actually, when the fourth quarter comes through, we’ll begin to see that perhaps the extremes of debt creation were somewhere between the third and fourth quarter, and now we see some credit contraction, which to your point a minute ago is the object of slowing demand. You raise interest rates so that there is a slowing of loan growth, a slowing of business activity, a slowing of consumption. This is planned. And I’m not saying that in a nefarious way, or you— somehow, the Fed cabal is screwing over our economy. They’re trying to moderate extreme growth, and I frankly don’t think it’s their job to do that in the first place. But this is Keynesian economics at its best. Demand management—
Kevin: As long as you’ve got the country that controls the currency and controls the oil and, let’s face it, the exorbitant privilege that we’ve had as the reserve currency of the world since the mid-’40s, okay, Bretton Woods, when that was put together. We’ve been able to print as much as we want, and the rest of the world has had to buy all of their oil in dollars. There’s cracks in that right now. Does that change? You’re talking about Keynesian economics and being able to control everything. What changes when you no longer have the hegemon of the world? Let’s say the oil is traded in yuan? What does that look like?
David: Well, the exorbitant privilege we’ve had, as you say, from ’44 to the present, I think that’s one of the transition points we had in 2022. The beginning of the end of US dollar hegemony was in 2022, with China making headway in its energy relationships. And this is not a fait accompli, this is not something that happens in a 12-month period of time or even a five-year period of time. But they have effectively driven a wedge into the existing order of oil for dollars. And so that Petro-yuan—just as we’ve popularized the idea, or had seen the idea of popularized of the Petrodollar—the Petro-yuan is something to contend with 2022 and forward.
The remaking of the global currency system is a long process, but it’s one that’s driven off of key relationships, and there is none more important than— well, two come to mind. The US-Sino trade relationship, which is under obvious pressures. I mean we’ve had, I think the number was five times the number of increased trade tensions since 2008 on an annual basis than in any year since the global financial crisis. So again, we see concessions occur and we see the trade barriers erected. We’ve had five times the number of trade barriers erected each year since 2008, 2009, specifically with the Chinese. So that is a deteriorating relationship, not as a result of Trump, but as a result of the end of globalization, which you can tie back to global financial crisis ’08 and ’09, where really global finance was exploding up to that point and then experienced a shock, and frankly has never fully recovered. Certainly the US Sino trade relationship has never recovered and is under more pressure by the day.
The second of the relationships, which I think is critical for the remaking of the global currency system, is the Sino-Saudi relationship. And really it’s the Middle East more broadly, but I think Saudi Arabia is a good representative of the trend. And there was dramatic improvement last year between China and Saudi Arabia, or the Middle East more broadly. These are things that I think, we just mark the calendar and say, “We are now going to have to work a lot harder for a lot less here in the US.”
And these trends are something that I think underscore the long-term trend of inflation. Deglobalization is not going away when we resolve the issues with Russia and Ukraine, if they are resolved. There are some key structural things that have shifted, and they’ve been shifting. Deglobalization hasn’t happened overnight, and it will continue afoot. Unfortunately, this year is just one more critical year of that development.
Kevin: And I wonder about 2023 because I think of inflation a little bit like alcohol. A lot of times people will say, “I’m not going to take another drink. I’m not going to take another drink. Oh, I’m just going to take one.” Okay, it feels so good. The creation of inflation feels good, the effects later, the hangover later, is what the problem is. And so when you have pain in the economy, let’s say people are losing their jobs. Let’s say the stock market’s going down, let’s say 2023 is not a great year, both employment-wise or market-wise. You sure are tempted, aren’t you, to go back to that bottle and say, “Just a little bit more printing”? How much resolve does Powell have? I mean, how much pain can we take?
David: Over the holidays we watched a series— this is what McAlvanys sometimes do when they binge watch. There’s particular shows that we’re very keen on. I mean if you come out with the new season of Jack Ryan, it’s not going to last the evening.
Kevin: Oh, you guys binge those?
David: Okay. Yes. And the Incredible Benedict Society, I think that’s the name of it. Great, smart kids solving big world problems. And it’s fascinating because when you mentioned inflation and alcohol being similar, this particular series, this guy creates happiness for everyone, and everyone is happy. But it’s an artificial stimulant to happiness, and at some point down the road they go into this comatose state and they can’t be retrieved.
Kevin: Wow, that is an interesting analogy.
David: Yeah, no, there’s a high cost to happiness, and ultimately it may cost you everything.
Kevin: How do you want to feel today versus tomorrow?
David: So the question is, when it comes to inflation and economic activity or economic growth, is it real or is it artificial? And that’s the problem with growth driven off of inflation, is it’s artificial growth. And we’ve grown accustomed to artificial growth regardless of what comatose state it may bring in the future. We’re not concerned about that. All we care about is the moment. We care about the happiness that we feel today—and to go back to your analogy to alcohol—even if it is artificially induced and may bear with it a long-term headache, or even terminal decline in health.
Kevin: So what is the threshold? What is that pain point?
David: That’s I think what we get to see, where, in 2023, in order to tame the global inflation beast, demand destruction as it’s been described by the central banks in their current prescription, they’ve got blunt instruments to use to bring down excess demand. Which they created—again, they created. It wasn’t Russia that created excess demand. It was fiscal and monetary policies which put too much liquidity into the system, excess demand with inadequate supply, and that’s what they’re trying to tame now.
I just wonder if it’s not a bit like the oncologist, they’ve got a systemic treatment for a localized problem. If you’ve got cancer or this particular problem— we’re just going to give you radiation and treat the whole body. Yes, there is a consequence to your whole body, but we’ll get the good cells with the bad cells, or the bad cells with the good cells.
To succeed, I think the US and global unemployment have to rise. And as joblessness ticks up, I think that’s where you begin to see a politically driven response from fiscal authorities to control the damage for the most economically vulnerable. And so, while the central banks may hold the line on keeping rates at a high level and shrinking their balance sheets, creating some chaos in the financial markets—which, I think they have sort of a range which is acceptable to them, if it gets outside of the range, they’ll relent. But if they stay within that range of pain, the real challenge is, can they continue without upsetting political authority, and that political authority is going to first bring pressure on them.
And second, move to what we saw in 2020 and 2021, major fiscal spending initiatives, targeted spending initiatives, where credit is allocated to winners, and other people will just have to lose. So to what degree does fiscal intervention cancel out inflation fighting of the central banks? I think that’s some of what we get to see in 2023. At some point, the pain thresholds of the public are going to be found. And when the public’s pain threshold is found, that’s where you’ll see political action and the real temptation on the fiscal side in terms of directed spending.
Kevin: Okay, so you were talking about binge watching. I think just about everybody who’s listening to this show every once in a while gets Princess Bride out and watches Princess Bride. I mean it’s a classic, and you might remember the scene where Wesley, who’s sort of the protagonist in the movie, he’s laying there, you talked about comatose. I mean he was mostly dead, if you recall. He couldn’t even move his body. And Prince Humperdink comes in, who’s going to be his enemy there. And Wesley’s laying in bed, he can’t really do much, but he challenges him to the pain. He says, “We’re going to take this to the pain.” And Humperdink is like, “What do you mean, the pain?” And what he does is he talks his way through it and actually even though he couldn’t fight him, you might recall the scene—
David: His body was impaired.
Kevin: But the pain only goes so far before the politicians put pressure on the central banks. The central banks may be laying there almost comatose, but the pain, the pain. So are those central banks going to be influenced again by politicians?
David: It’s possible. I wonder if they’re not aware that in this particular cycle they may lose all credibility and so maintaining some distance from the political sphere is going to be necessary. And central banks have claimed independence from political pressure.
Kevin: They claim that. Yeah.
David: Will that or some form of capitulation in the equity markets, in the bond markets, be on display in 2023? And then we come back to this issue of degrees of pain and thresholds for action—
Kevin: To the pain. Yes.
David: That seems to be the prominent theme for the global elite. You’ve got Isabel Schnabel of the European central bank, who says central banks need to prove how determined they are to protect price stability. And I agree. I think they’ve got a lot of credibility at stake. They should do everything that they can to make inflation go away. Today we see German inflation stats receding more than expected, to 9.6%. But this is a good example because in the details, how was that accomplished? Well, as it turns out, energy costs came down considerably, but it wasn’t because the price of energy came down. It was because energy subsidies reduced the sting of inflation. And who picks up that tab? And see, whether you’re looking at inflation as a collective tax burden or the collective burden coming from the state, which may still be on par with inflation. It’s just a recategorization. So taxes are required for the state to have revenue sufficient to subsidize energy costs. And all you’re really doing is window dressing the inflation number while abusing the public Treasury—
Kevin: Robbing Peter to pay Paul.
David: But it looks better, and it looks like you’re making progress, and it’s less pressure on the central banks. At odds in this sort of quagmire of central bank and fiscal policymaking are the price stability objectives with the experiences of your primary audiences. I think, as we move into 2023, your developing world economies and the middle class within the developed world, that seems to be where 2023 inflation and employment vulnerabilities are the most acute. In developing world economies and the middle class in the developed world.
Kevin: We are developed. And when you think about the developing economies, I mean, are they not incredibly vulnerable right now if we were to go into a recession?
David: Well, a large part of the world is already in recession. The World Bank and IMF suggest that at least a third of the world will be in recession this year. Developing economies suffer the most when global trade suffers. So global recession is disproportionately painful for underdeveloped nations, where a marginal shrinkage in trade impacts economic security. So that success in taming inflation— When we’re thinking about the US or Europe, if we have success in taming inflation using the Keynesian tools of demand management, there is a direct impact, a disproportionately negative impact, on developing economies. Like 1982, you had the successful coordinated central bank efforts that can and likely will keep the recessionary trend in place, which is a success story for central planners, but it remains this blunt instrument that hurts many other people around the world.
Kevin: So we’re talking about developing countries, but if we were to look, let’s say at our own country, I’ve heard—you’ve probably heard this too—that one of the great measures of a country is the size of its middle class, not its rich or its poor, but its middle class. And America has been known for many years as a country that’s healthy in that area. How does this affect the middle class?
David: Yeah, I think they’re vulnerable in 2023. Proportionally, the wage increases—that inflationary input from 2022—very impactful at the lower margins of the economy. So if you look at the extremes of rich and poor, the wealthy, while they might have suffered because of the drop in the stock market or maybe they got caught playing with cryptocurrencies, the wealthy were not helped by an increase in wages in 2022. Normally—
Kevin: Yeah, but their assets dropped.
David: Right. The poor were definitely helped by an increase in the minimum wage and more job market tightness. So the poor saw the biggest net benefit from an increase in wages proportionally, although in real terms there was not a significant improvement. The tendency to be living paycheck to paycheck—that dynamic where you’re just focusing on buying the essentials—I think they were largely able to continue to afford the essentials. So even with improvement in pay, it wasn’t that their lives improved considerably, they just kept up.
The middle class felt the brunt of inflation proportionate to their income, which is a little bit in a higher bracket, marginal increase in wages doesn’t really impact them as dramatically. The middle class is really key, to your point. They drive a lot of spending on the consumer durables, on the consumer discretionary. The Brookings Institute puts the number at two thirds of household consumption comes from the middle class. And so, to some degree, we’re playing with economic fire when real world inflation is still very high. Real wage growth is still negative for the middle class. And central banks are intentionally increasing pressure on that portion of our economy which is most responsible for buying stuff. And we’re talking about demand management. If you’re talking about demand management, you’re really talking about middle class demand management. So if you begin to shrink consumption, you’re talking about increasing pressure directly on the middle class.
Kevin: So in a way, when these guys get together and they close the door and they say, “Let’s be real.” What they’re really saying is, “We’re going to target the middle class, and we need to bring the middle class into as close to a recession as possible because two thirds of household consumption comes from the middle class.”
David: If you’re serious about demand management, that’s who you, by default, are talking about. I don’t think they would say it explicitly, even behind closed doors. But if two-thirds of consumption is driven by the middle class, then controlling demand is controlling the middle class. You can’t get around that.
Kevin: So the way we measure recession is we need to be looking at the middle class.
David: To the degree that the middle class experiences economic and financial insecurity, I think you have the makings for a far more dramatic recession. Financial markets in 2023 will have to come to terms with central bank hesitancy to provide that immediate liquidity intervention and prop up prices—that’s within the financial markets.
Schnabel is right when talking about price stability. Central bank leaders need to prove their resolve on the price stability front. But there is a cost and a series of trade-offs that come with it. And these costs and trade-offs are directly associated with the style of management in play. And we are talking about Keynesian styles here of managing an economy—command and control dynamics, in my view. I think the net result is an increase in social and political pressure, and, as we mentioned with the Fed’s hesitancy to get in there and fill the gap—that liquidity intervention for the stock market—another leg lower for financial assets.
Is that a first quarter event? Is that a second quarter event? I don’t know. I think we do have another leg lower, maybe a more significant leg lower for financial assets. As we said before, another trade off is what a destruction of economic activity means for less developed economies.
Kevin: You talk about social and political pressure, we’re going into 2023, which is not an election year, but it reminds me, Dave, of 1983. We were going into a recession when Reagan came. He was looking at a second term for the 1984 elections. And when the doors closed with their own cabinet meetings, they said, “Guys, let’s be real here. We’re going to have to borrow a whole lot of money.” They tripled. We went from $1 trillion in debt to $3 trillion in debt based on a decision that was made in 1983 so that Reagan could get reelected in 1984 and not have a recession going into a presidential election year. You talk about political and social pressure, the Democrats had the same question in 2023. We’re experiencing high inflation like we were in the ’80s, we’re experiencing the possibility of a recession like we were in the ’80s, and we just blew right through that. Reagan got his second term, but a lot of that had to do with going back to the bottle.
David: I grew up at a family where fiscal conservatism was a key talking point at dinner table conversations. So I can’t tell you the number of times I heard, “from George Washington to Jimmy Carter, we had $1 trillion in debt.”
Kevin: That’s right.
David: And then, of course, yeah, as you said, the tripling in debt from there. Which was a point of criticism with the Reagan administration around our dinner table.
Kevin: Yeah, your dad didn’t put up with it. He was like, “Wait a second, what’s Reagan doing here?”
David: He was anything but conservative from a fiscal standpoint. Now, strategically, it may have, as history is told in hindsight, bankrupted our spending, and the allowance of that spending and the Russians propensity to keep pace with that spending led to the bankruptcy of the Soviet Union.
Kevin: So you can maybe justify it 20, 30, 40 years later.
David: From a geopolitical perspective. But from a fiscal perspective, different measure.
Yeah, I was reminded, just thinking about inflation and going back to developing countries and lesser-developed countries and how they experience inflation, reminded of the adaptability that people have to that. We talked about Argentina being at 40% this year. National Public Radio—this was a few weeks ago with the World Cup coming into the final—they interviewed a shopkeeper from Argentina, who was asked, “What would you prefer, a victory in the World Cup or resolution to Argentina’s inflation problem?” And she responded, “We’ve adapted to inflation…” Or something like that. “We’ve adapted to inflation over time. It’s always with us.” Her preference was for the World Cup victory. “Leave me to suffer with a devalued peso, I’ll take the victory.” It’s just this moment of impassioned national pride. And I wonder what she would’ve said about the World Cup victory if, instead of looking at inflation, what if the contrast was to losing her shop?
Kevin: Well, and that’s the thing, Dave, that’s the thing that has just fascinated me about the German response to their hyperinflation, and that no one, virtually, understood what caused the problem in the first place. So like this lady, we can adapt to inflation, but how often do we get a World Cup victory? Wow.
David: When we look at the employment numbers being potentially as good as they can get, 3.7, moving to 3.9, maybe they move higher into the 4s, 5s 6s this year. We’ve made a lot of progress since the ’90s. Over a billion more people are employed globally today than in 1991. And we’ve already recaptured the peak of 3.3 billion employed prior to the pandemic, we’ve now surpassed that. And the Brookings Institute, going back to 2018 and the study that they did, counted 2018 as one of the most critical years in global history, a global tipping point for the first time ever recorded, 50% of the global population was now in the middle class.
Consumption—and that’s the preponderance of economic activity—rests, as we talked about earlier, with the middle class. We know that the intended result of this economic contraction—again, central bank policies that are designed to shrink demand for goods and services—we know that that is going to have an impact on employment. We don’t know the degree to which it will be there. But when would the central bank community know if their concerted tightening was enough, was adequate, if it had done too much? These tightening tools, they do know, they are willing to admit, are only discoverable on a 12- to 18-month lagging basis. So they put it in today, they hope for the best tomorrow, but you only get to see how successful it was way down the line from when it was implemented. So have they done too much already? Have they done not enough? How deep would a recession be to warrant a reversal of policy measures? We may get to find these things out in the months ahead.
Kevin: Well, and that lag time makes a huge difference. We called my wife’s mom on New Year’s Day, and there was about a two second lag on the phone lines, both directions. It really broke up the conversation. It was very hard to have a conversation because you didn’t know when somebody was actually talking for two seconds.
I think about when we send a probe to Mars, we wait 8, 9, 10 minutes for the message that we send, to see if it was received, and then we wait another 8 or 9 or 10 minutes, depending on where Mars is in orbit, to get that back. Well, central bankers are waiting, what, 12 to 18 months to see if the message that they’re sending actually worked. It’s hard to make small corrections when you’ve got that kind of time delay.
David: And that’s why I’m talking about blunt instrument. This is perceived as surgical, perceived as precise, when in fact it’s quite blunt and they don’t have any information on how the patient is doing in the midst of the procedure. So just kind of the last thought connected to demand destruction: corporate margins. Coming back to the way stocks are trading and corporate margins, they’re already tough to defend with inflation on the rise. What does it look like when sales shrink? Again, I mean if we’re talking about a concerted effort to shrink demand, we are talking about an impact for the folks who are creating goods and selling services. So what does it look like when corporations have had to absorb higher costs but now have to deal with a reduction in the volume of sales while inflation remains, not at a peak, but still at elevated levels? This gets interesting. First quarter, second quarter numbers could be very interesting, and it may be the catalyst further equity market pressures.
Kevin: I just can’t help but think how this Commentary’s gone for the last 15 years, or going into 15 years.
David: No March, we’ll be going into 16.
Kevin: 16. Okay. Wow. Okay. But as I think about the Commentary, all of our discussion, almost all of it, has had to do with this, we’ve had dollar hegemony. We are talking as a country, and people in a country, we’re just talking about managing things because we can, and because we have that power. Let me throw a word out to you that might be scary, and it might change the way this Commentary is over the next 15 years. How about instead of the Petrodollar, the Petro-yuan? What does that look like? What does that look like?
David: Yeah, erosion has implications, and I think that’s what we’re talking about is a slow process where we may wake up someday in the next 15 years and that’s the reality, firmly entrenched, and has been for the last decade and a half. But it took a long time for the erosion process to occur, if we’re looking ahead to the next 15 years.
Kevin: And countries that couldn’t pay back their debt, China actually maneuvering and taking those countries and using their power in them.
David: Debt-trap diplomacy. So the realignment of interests continues, with regional trade more critical. And this is, again, sort of a reflection of that loss of global trade, with more of a focus on regional or even domestic production and consumption. Petro-yuan is a 2023 theme with direct implications for the Petrodollar. So alongside this energy market realignment, we have the debt market realignment, which is the debt-trap diplomacy, which I think the Chinese are going to do a masterful job at. They have the ability to offer unreasonable numbers because they do operate largely outside of a market economy. So if People’s Bank of China wants to backstop wholeheartedly, completely another country’s debts, they can do that. This is a displacement of the IMF. This is a displacement of the World Bank.
Kevin: The control that we’ve understood to be in place is now in question. So let me bring up something that’s near and dear to both of our hearts, gold. What role does gold play? You’ve looked at the extremes of inflation, you’ve looked at the extremes of currencies, you’ve looked at the extremes of debt creation and destruction. You’ve looked at the extremes of cryptocurrency and some of the options, some of these other ways to gamble. What role does gold play, and is it the same role that it’s played for 4,000 years?
David: Yeah, I mean it’s a little different today because we don’t treat it as money, although that’s the way I think it should be treated. But in an era where no one references gold as currency, I think you look at gold as insurance instead. And so this fits into the category of lifeboat investing. If one vessel is foundering, and you’re not exactly sure what it means to put your foot on terra firma again, off of one boat onto dry land or off of one boat onto another, lifeboat investing gets interesting. What do you want? You prioritize real things. You prioritize things that are basic. And I do think, from an insurance standpoint, that gold and silver are hugely advantageous coming into 2023. And I look at even the things that we have in our own portfolios.
Kevin: Yeah, the MAPS strategy. You’ve got gold stocks, you’ve got real estate, infrastructure—
David: Global resources, infrastructure and—
Kevin: Real things.
David: We buried the indexes this year. Net of fees, our most aggressively invested portfolios, what we call the multiplier. This is all holdings, down 1.84% this last year versus the Dow down 8.8, 19 for the S&P, and 33 for Nasdaq. And our more income-oriented account, basically flat for the year, off 16 basis points, it’s less than a quarter of a percent. (The performance is net of fees, and a composite of all accounts in the strategy for the year 2022.) In a year that was chaotic and volatile, risk management paid. In fact, on the risk management side, our Tactical Short, which is a phenomenal product run by Doug Noland, we’re at 13.87% positive for the year. Represent a healthy proportion of the inverse of the S&P.
How do we navigate 2023? I think there is a degree of lifeboat investing. I think there is a degree of “play this very cautiously.” If you’re hoping for the best, I think you might be disappointed. If you’re preparing for the worst, you might be a little bit closer to being on point, and just be ready for anything. Do I want to own gold? Yes, I still do. I think where I started the year in terms of recommendations in 2022 was putting a priority on cash and metals. And that combination served investors very well in 2022. I think the optionality of cash will continue to serve them well in 2023. And the insulation from the stupidity factor, we’ve got a stupidity factory. Just go to each of your major political centers around the world and central banking centers. They’re cranking out bad decisions, like—
Kevin: Yeah, like Rocky Mountain Chocolate Factory pumps out chocolate.
David: Right, so I would have plenty of stupidity insurance coming into 2023. So you get folks that are still way overconfident, and I think it’s really important to reflect on the projections of 2022 from the world central bankers and the larger Wall Street investment community. Inflation was not supposed to happen, and growth in all of your equities indexes, that was a guarantee from CNBC and Bloomberg and Fox Business. They all said, “Look, 2022 is going to be a great year. We’re coming out of the pandemic. The recovery’s going to be great. We’re getting through the supply chain issues. Inflation will no longer be an issue because supply chain is the cause.”
Kevin: Fortune favors the bold.
David: Oh, wait a minute. It wasn’t just supply chain, just like it’s not just Russia today. I like the idea of staying with that same thematic of cash, gold, energy, anything you can stub your toe on. That’s the stuff you want to own in 2023.
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.