EPISODES / WEEKLY COMMENTARY

Powell’s Pointe Shoe Pivot

EPISODES / WEEKLY COMMENTARY
Weekly Commentary • Dec 20 2023
Powell’s Pointe Shoe Pivot
David McAlvany Posted on December 20, 2023
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  • Politics: Do You See What They Want You To See?
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  • Inflation Be Damned, FOMO Speed Ahead

“Already consoled that the inflation monster is wounded, the markets are moving ahead. So let’s avoid the fiscal crisis. Let’s just make the assumption the inflation monster is wounded, hopefully mortally so. The impact of rates on the high side now has to be mitigated. It’s the cash outflows that have finally caught up with central banks and treasuries the world over. Higher prices in stocks, higher prices in bonds, higher prices in real estate are generally regarded as a positive sign.” –David McAlvany

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

Well, you told me that the girls are gone. There’s a special trip and I remember these trips, trips for getting ballet shoes for the little ballerina.

David McAlvany: We are a family of dancers. I personally am not very good. In fact, two left feet is how I’m best described. And my wife prefers to lead because otherwise it’s a total disaster. But my grandmother was a prima ballerina. My wife danced both here and in London. Now, my daughter dances as well. My mother-in-law was a dancer and had a studio in Houston. So there’s dancing all over the place. And this is the first fitting for toe shoes.

Kevin: Pointe shoes.

David: Yes, exactly. Pointe shoes.

Kevin: So, what helps you pivot en pointe?

David: Absolutely.

Kevin: That’s right.

David: So they’re out there for that and the Gilmore Girls, and we’ll look forward to seeing them soon.

Kevin: Well, speaking of pivots, we may have seen a major paradigm pivot shift on pointe shoes, except for who would’ve thought that Jerome Powell was a prima ballet dancer?

David: It’d be interesting to see Jerome in a tutu. It’s difficult to say what changed for Powell leading up to the Wednesday reversal in monetary policy. You could argue that very little has changed because it’s the third announcement of no more hikes. But the markets are convinced everything has changed, and a reduction in rates is going to be the future course in 2024. So the pivot language is all the rage. Frankly, it’s even more difficult to understand why Powell would support the speculative mood and not lean against that.

This is just two days before options expiration that he meets and talks and gives the green light for traders in every asset class to be bullish. So as a consequence, you’ve got the dollar which swung dramatically lower, weakened by the prospects of easy money. And that’s back on the central bank itinerary. Stocks soared. Bonds soared. Commodities soared in percentage terms even more than stocks. And that’s very noteworthy because it tells you there’s an interesting look-through here. Gold moving—

Kevin: And gold, yeah.

David: —gold moving higher I think suggests that the danger factor connected to easy money, it’s not lost on sophisticated investors. So the primary concern is not danger that comes with easy money policies and rampant speculation. The primary concern is fear of missing out. FOMO is back. To be left out is terrifying. And if you think about it, this is enough. This is enough of a green light. Everything will run. Will it run for a week? Will it run for a month? Will it run for a quarter? I think the reality is, for those still in tune with reality, the scale of debt and deficits cap the enthusiastic upside, and that’s going to be sometime in next year. Best case scenario, we get a quarter of the way through, two quarters of the way through. But the choice here is from a policy standpoint between solvency and inflation.

Kevin: We’re coming into Christmas weekend, and I can’t help—Robert, I’m sorry, I have to sing—but people are seeing what they want to see. So I’m thinking, ♫Do you see what I want to see? Do you hear what I want to hear?♫

David: Well, no, this is voluntary behavior. I think everyone who’s participating in this little spate higher of upside, it needs to just mark their calendar and have it on record. I am a scarred participant, and I have only myself to blame. I heard what I wanted to hear. I saw what I wanted to see. I was given permission to roll the dice. I did. And I won, and then I lost.

Kevin: And two weeks ago, these are the same people who would’ve said, “Gosh, I think rates are going to be higher for longer.”

David: Well, along with Powell. Rates higher for longer has been the assumption, and it’s been the agenda item for the Fed going back several months. Powell was talking about that just two weeks ago. If you go back less than two weeks ago, 12 days prior to his dramatic pivot, he’s talking about higher for longer. We just didn’t realize that longer meant not much longer. So you’ve got an election now less than a year away, and the idea of Fed policy—that higher for longer pressuring the economy to the point of recession—now it’s off the table. Is that a reflection of partisan preference? Maybe. Perhaps.

Is it the Save the World 2.0—and that would be from another term with Trump in office? Perhaps. I think clearly it’s Exhibit A in the compromise of central bank independence. Clearly it’s only Exhibit A. We could give you A through Z, but this is Exhibit A in central bank compromise of central bank independence.

Kevin: So in dancing terms, Powell’s hatred of inflation sort of made him the black swan of Swan Lake. He’s now become the white swan. Everybody wins, but inflation is not coming down. What changed?

David: My grandmother played in Hollywood Bowl in the 1940s as the swan in Swan Lake.

Kevin: Really?

David: Yep.

Kevin: Wow.

David: Yep.

Kevin: I didn’t know that.

David: Hollywood Bowl. Pavley-Oukrainsky Dance Company goes back a ways. The old Chicago company somewhere between modern and ballet.

Kevin: Wow.

David: Well, the odd factors— And this just didn’t add up. The inflation numbers were out just prior to Powell’s public discussion. They weren’t lower. He’s got his favorite model, which is the supercore, his favorite measure.

Kevin: It’s coming up.

David: It increased half a percent month over month. It’s at 4.1% year over year. So if you’re talking about the target of two, well good luck. We’re not moving the right direction with their favorite measure. And if you look broadly at CPI, one aspect that’s kept CPI from rising—well, even more than it did—was energy costs, much lower. Gasoline off 6% during the period. It’s given a weighting of 3.4% in that composite figure. So it helps. If it’s off 6%, it keeps a cap on things at least 20, 30 basis points, 20, 25 basis points for the month of November.

Looking back, you’ve got Trump, who, on a cumulative basis—and again, this is just CPI—but Trump presided over a cumulative increase in the index of 8% over four years. Biden is locked in 17.5% in three, and he’s on pace for 20 over a four-year period. North of 20 I think is a conservative estimate. Maybe not by much. If you’re thinking about what the consumer experiences from that cumulative inflation and the fact that it’s still increasing, just at a slower pace, there has to be an economic success story to counterbalance the negativity inflicted on middle class families from that inflationary pressure.

And look, this is where you find the Fed data dependent. They promised to be data dependent, and apparently they are. Polling for Biden has been abysmal. And you even have David Axelrod and former president Obama worried about the polling numbers coming into 2024. Age is a factor. Inflation and household economics is, too. And I think what you see is Powell being willing to walk a dangerous line. Still exist in inflation, and now this issue of balance sheet largess. Frankly, from a fiscal standpoint, things are becoming unhinged. But we’ll get to that.

You’ve got Powell, who may be lining up next to Arthur Burns to be one of the many abused presidents who was head of the central bank and chose the wrong thing at the wrong time. Again, I think history is going to weigh last Wednesday in a very, very negative light.

Kevin: Well, and with energy prices so low, I’m puzzled, Dave, energy prices being low during geopolitical tensions with Russia and the Middle East. How does that last?

David: Yeah, I think that the reprieve in energy is a temporary reprieve. As long as global tensions remain—and you mentioned the Middle East with Gaza and Israel, the Russians and Ukraine—crude prices have something of a floor. Where you can see supply concerns and an increase in price, I think you’re likely to see upward pressure mid to late 2024. So a rally in energy in 2024 likely, and could see some softer prices here. And of course, this is interesting. Just from last week till now, we have sufficient dollar weakness that maybe that energy rally and the commodity rally comes early. Inflation resurgence next year this time, I think that is a given.

And inflation into 2025, that to me seems very reasonable for a number of factors. But part of it is commodity and fuel costs. But there’s another factor here, and it’s underappreciated. This tightness in labor, the unemployment rate being so low—

Kevin: That’s lasts.

David: —the wages being pressured higher.

Kevin: That lasts. When you raise people’s wages, Dave, they don’t come back down.

David: It’s no longer a function of monetary policy, no longer tinkering with rates. You have to have a major hit to the employment picture for there to be a significant decrease in compensation. Inflation is not going away. Our guest Bill King commented Friday of last week that, “despite Powell and other Fed assertions, the Fed is replicating the mistakes of the 1970s. Powell, like Arthur Burns and other Fed chairs, hiked rates to halt inflation. Volcker arrested inflation via reserve growth restrictions. Reserves at the Fed are 3.54 trillion. They started the year [2023] at 2.83.”

So we’ve got an increase in reserves. Bill continues. “We recounted that the early ’70s inflation wave was a prelude to the huge inflation wave of the late ’70s. Inflation does not just have one significant upward wave. It has multiple waves. First and second waves are mild compared to the final wave. The US recently finished wave two.” That’s end quote.

Kevin: Okay. So central banks work off of perception. We’ve talked about that before. Their credibility right now, for a short period of time, is looking pretty darn good, isn’t it? I mean, if people are ignoring the inflation side of things and all of a sudden their stocks are hitting new and all time highs—

David: Well, and not all central banks are playing the same game. I mean, if you listen to Lagarde last Thursday, she was very cautious in her comments about having whipped inflation now. She’s like, “No, we’re still fighting, and we’re very vigilant.” There was a very cautious tone in her voice, whereas the market was much more keen on locking on to Powell’s comments as an opportunity to run wild.

Kevin: So is he the new Mario Draghi? We’ll do whatever it takes?

David: It could be. Although, Draghi, and we talked about this a little bit last week with Morgan on the program, it’s a different time. It’s a different era. And a part of the constraints come from the quantity of debt that we’ve put into the system since then. So the latitude that you had in the 2012 to 2013 period, and the latitude that Draghi had to increase debt and play with rates, we’re in a very different place. And not everybody agrees with Powell. You’ve got Williams, you’ve got Bostic, you’ve got Loretta Mester, you’ve got a variety of voting members who would say, “Actually we did not commit to lowering rates.”

Kevin: Well, how about Charles Goodhart? I mean, Charles Goodhart himself was a guest of the Commentary, Dave, and he’s been vocal about this.

David: Yeah. Back to what you’re saying about credibility. The Fed’s gambling here, and credibility is kind of the assumption. Inflation levels are no longer at their peak. Part of that is supply chain issues which have subsided, and that’s one of the inflation contributors which is gone. But the Fed is taking their victory lap. Markets are melting up. There’s no more inflation. There’s not going to be a recession. And the Fed is tempted to claim, “Yep, we are that good.” But this is the danger. Credibility— You’ve heard the old phrase, pride comes before the fall. I think it’s a little early to be taking the victory lap on inflation, and that’s a part of what Bill King is getting at.

This comes in waves, and for it to be big and then recede, and then return and then recede, and have one final push higher to even higher levels, that’s what we’re getting at when we talk about the unemployment rate, wage pressure, service pricing, and this is something that Goodhart was talking about almost four years ago, almost four years ago. 2020, he was willing to put his neck on the line and say, “We’re going to have inflation.” This is when British inflation was at 1%. He said, “We’re going to have inflation, and it’s not going away anytime soon.” I would really encourage you, go to December 14th, the Financial Times did an interview with Charles Goodhart, monetary policy committee member at the Bank of England, Emeritus Professor at the London School of Economics. He was our guest on the Commentary a couple of years back, priceless interview with our guest. Again, Financial Times, December 14th. Charles Goodhart.

He, too, has been concerned with inflation, predicted, in fact, that it would be anything but transient back in 2020, remains convinced that it’s not monetary policy that’s going to end it at this point. And I agree with King. You could certainly tinker with reserves and alleviate the pressure. And so far the Fed has done none of that. In fact, the central bank reserves have increased, but he’s also looking at other factors: the availability of labor. And he’s basically saying, Look, this great resignation, which has happened not just in the US but other parts of the world in developed world economies, has taken us by surprise, that the available pool of labor has shrunk, and is not coming back. And so therefore you’ve got unit labor costs which are increasing. You’ve got services inflation. These are what many economists would describe as structural inflation problems. And frankly, they’re beyond the tools of the central bank. This inflation will not be resolved easily outside of an extreme economic shock. 

So this was a few years ago. He’s realistically assessing the inflation issue, and then I think he does a great job in this Financial Times article, or interview, assessing the political pressures, the political pressures in 2024 for global central banks specifically to cut rates. And again, for a guy who’s been on the policy committee, for the guy who understands how central banks work, I think you can sort of guffaw, you can laugh out loud at this notion of independence amongst any central banks. When push comes to shove, and ultimately power plays do resort to push and shove, that’s when you see political pressure. So political pressure in 2024, global central banks have to cut rates, not a good time to do that. He anticipates further fiscal expansion leading ultimately to fiscal crisis.

If we are going to lower rates, it may accommodate and help us avoid insolvency in the short run, but it also stokes inflation in the long run, and it doesn’t take away from the fact that in light of a diminished labor pool, we’re going to have to spend to make up the difference in terms of GDP productivity, GDP growth, and even just handouts to those who are no longer working. So whether it’s pensions or what have you, we’re going to have more outflows, basically clear to see from one of the world’s best economists. We have a fiscal expansion which will continue, and we have a fiscal crisis which is now inevitable. To him, it’s not if, but when. So grab your popcorn. This is great. Enjoy the melt up and the cross asset class reprieve while you can, but this is fleeting as performance art. This is as ephemeral as performance art.

Kevin: I had a couple of conversations with people last week. When the pivot happened—and it was strange because the pivot happened in their brains as well. These are people who were concerned about the fiscal crisis. They were concerned about inflation. And they had taken appropriate steps to protect themselves. And now, when the pivot occurred, their broker called and they were like, “Hey, it’s time to pile into stocks.” And I had a couple of people who were like, “Well, gold’s pretty high right now. I think I’m going to sell my gold. I’m going to jump into the stock market.” And these are intelligent people. These are people who understand the economics. I asked them, “How does it feel to buy the stock market at all-time highs and at all-time price to sales?”

David: Great.

Kevin: And here’s what happens with FOMO though, Dave. They understood. They said, “Yeah, I know I’m buying high, but I don’t want to miss it.”

David: Right. That’s the greater fool theory. And how does the greater fool theory feel? It feels great—until it doesn’t. That’s the nature of the greater fool theory. You buy high, and the expectation is that you sell higher, and oftentimes there is immediate gratification as prices move above your original purchase. And then you have to ask the question, but on what basis are stocks moving higher? 

Okay, so we’re just beginning to see an adjustment to higher rates. We know that we’ve got a tremendous amount of debt that needs to be rolled over both in corporate America and in the government sector, and that’s going to happen at higher numbers regardless. We’ve talked sort of ad nauseam about the average interest cost on US government debt being 1.56%, now being over 2.96% and migrating higher. Even with this most recent decline in rates, we’re talking about all the refinancing being done at an additional 75 to a hundred basis points, and that’s with the market already having factored in all of the rate cuts for 2024.

So the fiscal picture does not get better, and the debt picture is only better by a hundred basis points for corporate America. Frankly, they’ve got a longer fuse, if you will, or a longer timeframe for rollover because they did a better job. They did a better job of extending their maturities. They don’t have quite the cliff, this refinancing cliff. So, you mentioned, the stocks measured by the ratio of price, current share price, versus sales, kind of relevant for any organization moving products. That ratio is the highest levels on record. Highest levels on record.

Kevin: Ever.

David: That is ever.

Kevin: Yeah.

David: So I’m a part of a foundation board in Rome, Italy. It was an interesting meeting last week to feel the pressure of the money manager to be all in. To be all in.

Kevin: FOMO. Yeah.

David: Equally compelled, like a moth to flame, were some of the contributors to the dialogue. We are missing out on upside. And the money manager had two recommendations, “Portfolio A, portfolio B. Here’s the changes we need to make to existing positions.” Neither one of those recommendations had a single percentage point, not even a basis point exposure to cash. You talk about all in. Not a smidgen of exposure to gold and zero cash. It’s time to be all in. This is all in on the equity markets. This is all in on private equity, private credit, a full spectrum of corporate debt. It’s as if nothing historic is unfolding. It’s as if nothing that the Fed did matters in the broader context. It’s as if people can’t do the math in terms of the sustainability of debt and deficits, and the fact that— I don’t know.

So we’re waiting on the refinements to the investment policy statement as soon as those are made. Unless I can prevail and present a compelling reason to pump the brakes, we’ll be game on. Financial market autobahn, first quarter, where there is no speed limit. It’s just get in the fast lane and go. Let’s see how fast we can go. Let’s see how far we can get. Financial market autobahn, 2024, we’ve got the green light, the race flags have dropped. The central bank community is like, “All right, here we go.”

Kevin: And there’s not even a debate. I go back to one conversation I had last week, and I love this guy. He’s a great client, but the FOMO had really just eaten him up, and there was no debate as far as stocks being undervalued. He wasn’t saying, “Oh, I see that they’re undervalued and they’re going higher.” He said, “No, I see that they’re high, and they’re going higher.”

David: Well, and they have been higher if you measure it according to the P/E 10. We’d sometimes look at the cyclically adjusted—

Kevin: Right, the Shiller.

David: Yeah. And so that is only two standard deviations above the mean instead of the extreme of three.

Kevin: But still overvalued. He would even say, “Hey guys, I know what you’re talking about. They’re not undervalued. Stocks are not. I just don’t want to miss it.”

David: No, but I mean, the difference between being above the mean by three versus being above the mean by two, it means you might break even over the next decade versus being a guaranteed loser over the next decade. Might break even. And break even is sort of an average. That’s a friendly way of saying, you’re going to lose 20% one year, you’ll gain 40% one year, you’ll be down 10%. I mean, where you’ve got extreme volatility as you’re working your way over a decade’s time with nothing to show for—

Kevin: So no return in an environment of inflation.

David: Right. Right. So overvaluation is not even debatable. One thing the pivot provides is speculative money, which has been on the sidelines waiting for permission to roll the dice. We have the green light to press the new highs. How high asset prices go depends on the degree to which market reflexivity runs along without a challenge from economic data. Reflexivity is through this positive feedback loop. It creates its own positive energy. Well, all you need is a couple of bad data points, and all of a sudden it’s out the window. 

The markets are awash in derivatives trading, and this is one of these powerful forces that creates a reinforcement to the trend. Last week we had a record 44 million options contracts traded into expiration on Friday that drove the underlying assets bonkers. And again, if you ask about sanity, and a sanity check at the Fed, it’s reasonable at this point to say, “Jerome, why would you douse the fire with gasoline two days before options expiration? You’re a responsible player. You’re sober minded. You’re intelligent. You understand how the markets function. You’ve got the market experience to get it. So what changed your mind that you once were sober and are now doing things that really don’t have a justification?”

Goldman Sachs’ Most Short Index, it jumped 14% last week, up over 40% from the November lows, from the November lows, up 40%. Nasdaq, 152% year-to-date gains. Semiconductors, 62% year-to-date gains. The Dow this week, all time highs with other indices following.

Kevin: So you’re talking about Jerome, okay? And Bill King calls him Saint Jerome. I like that. So Saint Jerome Powell, if he had to argue why he’s made the pivot, before that time, he would say, “Well, we want to see inflation coming down.” You’ve already pointed out, Dave, that his favorite index is actually still rising. Okay? Or we want to see the markets come down. You’ve already pointed out, Dave.

David: But the pivot isn’t justification for bringing rates lower. The pivot was only justified if you see a shift in the second mandate of the Fed, which has nothing to do with price stability. It has everything to do with unemployment. So here we are pegged at the floor, 3.7%, right? And he’s being accommodative. How can you rationalize loosening monetary policy with stocks melting up?

Kevin: And unemployment being as low as it is.

David: Precisely. The market is now expecting— This is the market, not the Fed communicating, but the market is now expecting between six and eight rate cuts for the year. And that surpasses the three rate cuts implied by the Fed’s dot plots or the two cuts bandied around as a possibility by a number of Fed members. Six to eight demonstrates who currently holds the financial market in its grasp—maybe the other way around. This is like the horse with the bit in its teeth, it doesn’t matter if the Fed thinks it’s—and hold of the reins. This is spectacular.

The speculator is 100% in control. Bonds are back, with rates falling, prices rising. Downward pressure on rates—look, this has been swift in the last two months. The 10-year Treasury has slid from 5% to 3.9. Pretty fast and furious moves.

Kevin: And not just here, not just here. Around the whole globe we’re seeing rates falling.

David: Well, and this has been critical. This has been something that Doug has talked about in the Credit Bubble Bulletin. We’ve talked about it here on the Commentary, there is a uniformity to these moves. There’s a one dimensionality. There is no such thing as a diversified portfolio today where one asset class is performing on a different basis than the other. Everything’s moving in tandem, whether it’s real estate, bonds, stocks, crypto.

Kevin: Have you ever watched a kid try to get away from his shadow, the first time they see their shadow and they’re trying to get away from it because it scares him? That’s how the markets are moving right now. The shadow sticks with him. Everybody’s doing the same thing.

David: Yeah, so yields have been cratering, moving lower, bond prices higher, globally, in unison as market operators are betting big on the need to avoid fiscal crisis. And I think this is a really critical point because on the one hand you can say, “Lower rates. This is fantastic. This is the energy we need for a further rally.” But if you think about it from another perspective, and again, how you see things really does matter, we are bumping up against emerging markets imploding. We’ve already had multiple defaults in the last three months, actually been more defaults in the last three years than we have the last 20 years.

So all of a sudden, rates are impacting fiscal viability of countries both in the developing world and in the developed world. And rates stay higher for longer. And you are talking about that moment for whom the bell tolls. Already consoled that the inflation monster is wounded, the markets are moving ahead. So let’s avoid the fiscal crisis. Let’s just make the assumption that the inflation monster is wounded, hopefully mortally so. The impact of rates on the high side now has to be mitigated. It’s the cash outflows that have finally caught up with central banks and treasuries the world over. Higher prices in stocks, higher prices in bonds, higher prices in real estate are generally regarded as a positive sign.

Kevin: Well, of course, who doesn’t love to make money? It’s filling the pockets of everyone with their equities rise.

David: You remember the movie Wall Street? You’ve got Gordon Gekko saying, “Greed is good.” Well, this is the man in the street, the investor saying, “Green is good.” When you open your portfolio, when you log on and look at your portfolio, is it green or red? Green is good.

Kevin: Green is good, and I’ll take the steak tartar.

David: But consider the nature of this blow-off. Consider the nature of this blow-off and the fact that inflation is anything but dead. So somewhere on the horizon, we have a 2022 2.0, and in unison a stock and bond bear market. I picked up Barron’s this morning, and the most recent issue makes the suggestion that 2024 is going to be a great year for the 60/40 portfolio. Get back in stocks, get back in bonds. Worst is behind us. Well, how about this? What if you have a redo of 2022?

Kevin: Of 2022, yeah.

David: Right? And in unison, a stock and bond bear market all over again. But again, we’re a year further down the line. We’re a day older and deeper in debt. The US Treasury at that point drifting ever closer to $50 trillion in debt. And the lingering question becoming the key question for our solvency as a country. Who’s going to fund the debt binge? Who’s going to buy our Treasurys?

Kevin: Yeah, but who cares? It’s politics, Dave. Come on. Just go ahead and say what you’re thinking. We’re going into an election year.

David: Well, what it looks like in the short-term is a Santa Claus rally. But I think you’re right, it has everything to do with politics. And this is not just in the US. Recall that months ago we talked about 2024 being an election-heavy year for the globe. We have 40 countries representing 50% of the Earth’s population. Over 4,000,000,000 people will be affected by next year’s elections. You tell me if restrictive monetary policy leading to higher rates of unemployment and tempting fate with recession is an option for central banker?

Kevin: Of course not.

David: The fiction of non-political central banks or of independence from political pressure, the fiction of independence is buried in 2023, or reburied. Consider the odd facts in the US. It’s reckless. It’s reckless to suggest a lowering of rates when financial conditions are the loosest they’ve been in years. You look at the Bloomberg Financial Conditions Index, it’s ridiculous. Everybody’s like, “Oh, but we’ve raised rates 525 basis points. Look at how tight the conditions are.” This is what the Fed is saying. Balderdash. Balderdash. Bloomberg marks the conditions index. Goldman Sachs comments the same. We haven’t had looser conditions at any moment since we started this rate hiking cycle a couple of years ago.

Kevin: Right. It’s gotten looser, not tighter.

David: Well, that’s right. So the justification is, “It’s been adequately tight for long enough. Now we need to ease up.” Look, the only place you’re going to find tight lending is in the bank sector. Focus on bank lending alone, credit conditions have tightened, but private credit’s out of control, corporate bond market has gone bonkers. Investment grade junk, it’s all been on fire. This is where most credit growth is, today, and resides in terms of the private sector today. And of course, government debt has just gone bonkers too. Unemployment at 3.7%. You want to control growth, minimize a multiplier effect? Okay, government spending’s the answer.

Kevin: I could see rates coming down if GDP were negative, but GDP itself is high right now as well.

David: Yeah, I guess what I’m saying is you’re not going to stimulate as much inflation if your deficit spending is directed by the government. You want to avoid stimulating more inflation, then focus on government deficit spending as opposed to the fiscal handouts which exaggerated and exacerbated the inflation trends during the COVID period. But GDP growth, 5%—over 5%. Was it 5.2%? That’s not exactly quality growth. Not exactly quality economic activity. Does it seem strange that we’re running World War II-era levels of deficit spending while unemployment is near record lows?

Kevin: Yeah. World War II, think about it. We were funding a war.

David: Well, it’s not strange when you consider the election cycle.

Kevin: Right.

David: And we’re not alone. This is not a partisan pick fest. The GOP would do it just as much as the Democrats would.

Kevin: And we’ve seen that.

David: And we’re talking about 40 countries representing 50% of the Earth’s population, 4,000,000,000 people affected by next year’s elections. This is where any reasonable analysis—and this is echoed, this is echoed—reasonable analysis from someone who has central bank experience. Charles Goodhart says, “Yep, it’s politics, 2024.” Rates are coming lower because of politics, 2024. This is not strange when you consider the election cycle. We’ve got the Defense budget, which passed the Senate approval last week, record $886 billion, $886 billion. That is a record.

But wait, there’s more. This November was special, a record for the month. The government spent $589 billion in total, with only $314 billion of that needing to be financed.

Kevin: So they borrowed more than half of it.

David: If you can believe it. The November Defense spending just for the month, $66 billion on Defense was surpassed by the interest on the national debt at $80 billion. Only about 13.5% of total spending was going to the interest component. But wait, there’s more. The federal revenue for the month of November increased by 9% to $275 billion.

Kevin: Well, they should be happy about that. That’s federal revenue.

David: Right. So interest costs came in as expected as a percentage of revenue, interest as a percentage of revenue, 30% of all revenue. For the year, we’ve been saying it would be 19%, possibly stretching to 25% next year.

Kevin: But you’re saying it’s 30%?

David: Yeah, it’s already at 30%. Now, that’ll be volatile from month to month. So this is just a one-month look at revenue compared to the interest expense. But November just about rang the bell earlier than we thought. For comparable interest interest costs as a percentage of revenue, guess where you have to go? Pakistan, Sri Lanka, Ghana.

Kevin: Bastions of fiscal responsibility.

David: They’re actually leading the charge towards insolvency and sovereign default. But my point is we’re quick on their heels. There’s differences, of course. Sure, we’ve got the world’s reserve currency, but it’s really curious that the IMF lists these kinds of countries as problematic. They’re on the IMF’s problem list, and you could ask the question, well, will we ever make the IMF or the World Bank’s problem list? It’s unlikely because we kind of own them.

Kevin: We are sort of the IMF.

David: Yeah, but where we are out front, so we’re following just slightly, 30% of revenue going to interest expense, and they’re closer to 40 and 50%. Where we lead is on debt-to-GDP. The IMF forecasts emerging market and middle-income countries will average gross government debt-to-GDP of 78% by 2028. 78% is this scary number for emerging market and middle income countries. And again, this is the list of problematic countries whose debt compared to the size of their economy is getting out of control.

We hit 129% last year, well above the 83-year average of 65%. I think we hit a low in the 30% range back in 1981. So where have we come from? Where are we going next? Who cares? The stock market’s up. Who cares?

Kevin: Hey, we’re making money. But you said over the last three years we’ve seen more sovereign defaults than we’ve seen in the last 20.

David: Yeah. 18 sovereign defaults in 10 developing countries, which means you get serial defaults. Financial Times reports that—and again, they’re drawing on IMF and World Bank data—that is more defaults than the previous two decades combined. So we’re in an environment where interest rates matter. It’s understandable why, from a fiscal defensive position, if you’re trying to provide for solvency, we’ve gotten to a very difficult place. You either choose inflation or choose solvency, and the beauty is that inflation is something that less people understand so that’s the direction, that’s the course. That is the universal course, and we saw this triggered last week—well, not triggered. I mean this has been the policy preference for decades. But when you look at the Powell pivot, what you can say is, we’ll tempt fate with inflation because we can’t handle the solvency hammer.

Kevin: So I picture the spinning ballet dancer bit. Every time we see her come around, it’s borrow to borrow, to borrow, to borrow, to borrow, to borrow. We’re borrowing to pay interest. That’s an incredible cycle, Dave, how long does that last?

David: Yeah, it makes sense if you’re talking about decades of cheap debt, if you’re talking about easy access to capital. And a mere 24 to 36 months reveals how unsustainable the game is as we begin to see an uptick in rates, and all of a sudden the concern about fiscal solvency, how reliant the global system of debt is on more debt, and on that system of debt being held to a minimum level. So the cost of debt has to remain cheap. 

So to gamble with the possibility of higher rates of inflation versus the probability—and again, possibility of higher rates on one hand, probability of fiscal crisis on the other, we know how politicians and thus policymakers will vote. It appears we witnessed the global shift last week towards taking our chances with inflation.

Kevin: On the one hand or on the other, do we choose inflation and we feel rich for a while, or do we choose fiscal responsibility, go into a recession, and we don’t make the election?

David: Yeah, this is what Morgan has talked about in some of our inner office meetings as the temptation to crack-up boom, which is a reference to something the Austrian school has described. You get enough liquidity in the system and then all of a sudden price dynamics start to explode to the upside, and it’s positive until it becomes meaningless because it’s hyperinflationary.

So the math of higher interest rates and fiscal suffocation with higher interest costs has become too brutal. And we’re not even talking about very high rates. For the 10-year to be trading at 5%—not a real big deal if you’re looking at the long history of US interest rates. But the math of higher interest rates and fiscal suffocation from those interest costs, it’s too much. That’s already started to play out.

Kevin: Yeah, better to put it on the backs of the people in the form of inflation. Devalue their currency and they don’t really know. They actually feel rich while you’re doing it, but that’s what you’re doing. You’re defaulting in the form of devaluation, and it’s on the backs of the people, and they’re happy for it. They’re out buying stocks.

David: Then you look at the election cycle and the number of constituents who will be much happier if you create or design some sort of a fiscal blowout, and that’s what’s being lined out for 2024, so that many people end up with some sort of lined pockets. Bring rates down, keep the game going a bit longer. You can, of course, I think, be reasonably concerned with the vengeful return of inflation by 2025. Commodity prices support that notion. Sticky wages and a tight labor market support that notion. Reduced immigration. Think about the factor of election year where politicians are going to play a little stronger on the immigration issue everywhere, all over the world. But you reduce immigration and you maintain pressure on wages, again, supporting the notion that we’ve got inflation returning late 2024, 2025.

Plus we’ve got decreased importation of cheap Asian goods that supports the notion of higher costs for consumers. Then you’ve got QE from Powell & Company that supports the notion. Dollar weakness is your first evidence of the market saying, “Hmm, well, this’ll be fun, but at some cost.” Dollar weakness is your first evidence of the cost to proceed as planned, and that’s what was announced last week. We will see the ’70s on the dollar index. I could ask that as a question, but I’m fairly certain we’ll get there. Will we go lower than the previous lows on the US dollar index? Keep in mind, low rates, low dollar. That’s the way it works. High rates, high dollar. We got to 114 on the euro/dollar index.

Kevin: Now we’re 102.

David: Now we’re 102. When we break that level of a hundred, we get into the 90s and we start to tempt fate with the 70s. It’s a long process, but high rates, high dollar. Low rates, which is what everyone is designing, low dollar. Ultimately, I think the bond market looks past policy rate setting to the unviability of debt and deficits. And ultimately, I think we see rates move higher at the long end of the curve. When does that happen? I think that’s when you’re looking at the sober minded market reality of, oh my goodness—

Kevin: That’ll be the return of the Black Swan, Dave. From Black Swan to white, back to black.

David: Well, what we don’t have today is any real measure of added compensation for taking added risk. This is, again, where you look at the debt markets and it’s just unhealthy. It’s unhealthy. Yield curve inversion is one thing. Spreads on various debt products, non-existent. Lowest levels we’ve seen in a couple of years that has spreads to Treasurys. The difference between the yield on one versus the other. You can take a lot of risk today and it makes sense to. That’s the way the market is priced. 

See, you get a bond market repricing— Again, if we transport ourselves forward six to 12 months, and the market looks at the unviability of debt and deficits, you get a bond market repricing at the same time inflation is picking up. It’ll look natural for the Fed to raise rates just to keep up with what’s happening in the bond market, and they’ll have to, to maintain some sense of credibility, some semblance of credibility in the context of resurgent inflation.

Kevin: Will it be in time?

David: They’ll be too late. They’ll be too late. The problem with not killing inflation completely is that you deal with a more severe version of it down the road.

*     *     *

You’ve been listening to the McAlvany Weekly Commentary. I’m Kevin Orrick, along with David McAlvany. You can find us at mcalvany.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.

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