EPISODES / WEEKLY COMMENTARY

Runaway Train Towards Recession: Complements of The FED

EPISODES / WEEKLY COMMENTARY
Weekly Commentary • Feb 01 2022
Runaway Train Towards Recession: Complements of The FED
David McAlvany Posted on February 1, 2022
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  • Central Banks are gobbling up Gold: Demand up 82% in 2021
  • China demand for gold up 36.5%
  • Derivatives traded exceeds stocks traded

The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

Runaway Train Towards Recession: Complements of The FED
February 1, 2022

“Any reprieve you have in the markets, any violent volatile moves to the upside from here are characteristic of bear market rallies and should be sold into, sold into, sold into. Now, what do you do next? Hey, listen, I fully support an idea of buttressing a cash position. But to offset your risk of mismanagement by central banks, you’ve got to have some sort of a barbell approach between liquidity in ounces and liquidity in fiat bills.” — David McAlvany

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

Well we’re hearing it. We’re hearing that there’s going to be quantitative tightening. We’re hearing that we’re going to see interest rates rising. And I guess my question would be, when you have a leveraged market, a market that’s almost completely built on future money being moved into the present, which is what we call debt and margin, how’s that going to look?

David: Yeah. It’s a little bit like oxygen being taken out of a room. Goldman Sachs has five interest rate increases between now and the end of the year. BofA has seven. The standard measure would be four. And certainly, the markets are factoring in something on the measure of two to four. So, many years ago, my wife and I went spelunking. And so, we’re in a cave. We’re going deeper and deeper and deeper into the bowels of the earth.

Kevin: And this isn’t one of those public caves, like Cave of the Winds. This is you guys going into something without lights.

David: Yeah. So, you bring your own headlamp.

Kevin: Okay.

David: And bring your own water bottle and snacks and everything else. There’s one thing you generally don’t bring, which is your own oxygen. You have what you have, and that’s it. And the farther you go in, typically the oxygen gets pretty thin. And so, a valuable lesson learned as we get further down, Mary Catherine says, “I’m just not feeling quite right. Something’s off.” And I knew what it was. And we turned around and went back to the surface. So, lesson number one, don’t go spelunking with a pregnant wife. There’s small places—

Kevin: Pregnant.

David: There’s small places that you just can’t get through.

Kevin: Yeah.

David: And then number two, be sensitive to oxygen being taken out of the room. In this case, we’re talking about interest rates.

Kevin: Sure.

David: If it’s Goldman Sachs, if it’s BofA, if it’s just the bond market factoring in a certain number of rate increases for a leverage financial market, it is like taking oxygen out of the room. At some point, somebody’s going to feel funny. And then, that’s when strange things begin to happen, very strange things in terms of market action.

Kevin: Well, and I joke Dave as we talk about interest rates rising, confidence, if you were to look at the confidence of the people right now, economically, they’re not confident. In fact, it’s been a while since there’s been this kind of concern.

David: Yeah. In fact, the University of Michigan Consumer Sentiment number, I mentioned we were interested in watching it on a Friday when it came out, it’s finally come out. And the gentleman who runs that survey, Richard Curtin, says that overall confidence in government economic policies is at its lowest level since 2014. And the major geopolitical risks may add to the pandemic active confrontations with other countries, although their primary concern is rising inflation and falling real rates. Consumers may misinterpret the Fed’s policy moves to slow the economy as part of the problem, rather than as part of the solution. The danger is that consumers may overreact to these tiny nudges. So, again, he heads the University of Michigan Consumer Sentiment Survey. You look into the details of that survey and sentiment has not been this low. I mentioned, the economic policies of government being at a 2014 low. Consumer sentiment hasn’t been this low since November of 2011. So, to put it differently, of the 529 monthly surveys ever conducted in the series, January’s numbers, we were in the ninth percentile.

Kevin: One of the things I was reading last night, I’ve got a book, Dave, that we talk about often called Panic and Morale. And it’s a series of essays that was put together in 1958, looking back to what causes panic, what causes crisis. And one of the things that was a consistent theme was when people don’t believe it can happen to them, in fact they can’t even imagine that it can happen to them, it can quickly cause panic rather than even reasonable response to crisis. We talked about the Fed being the behind the curve on inflation, but look at the speculators. Okay. The United States is behind the curve. While US investors were liquidating gold in 2021, they’re speculating. You’ve got other parts of the world, namely Asia, China, that are accumulating aggressively, preparing for something.

David: And I want to make note that this is kind of the tale of two cities is the tale of two Americas. You’ve got the asset-rich America and the asset-poor America. And the asset-rich America is seeing the highest net worth figures ever seen in US history. Real estate is at highs. Bonds are at high levels. And stock markets are near all-time highs. And so the most recent numbers would indicate that there’s nothing wrong. So, it actually is this odd, shocking thing to see the University of Michigan Consumer Sentiment so low. They haven’t measured this low in a decade. But that’s on the other side of the asset-rich equation. The asset-poor equation says something very different. And as you mentioned, Kevin, the US investor, this is heavy on the energy, heavy on the enthusiasm, light on the thinking, frankly, is going headlong into SPACs, non-fungible tokens, cryptocurrencies, meme stocks. This is what was happening here in the United States. We in the US were liquidating gold in 2021 and pursuing those various speculations.

Kevin: Yes. But what are the Chinese doing?

David: Yeah. And that’s a good question because we were enamored with everything that’s the wave of the future, whether it’s electronic vehicles or space exploration. Meanwhile, the Chinese managed to add 1120 tons to their gold allocations. This is according to the China Gold Association. My father and I attended a conference in Shanghai put on by the China Gold Association a number of years ago. But they reported this was a 36½% year-on-year increase in terms of Chinese consumption, 1120 tons, and a 12% increase over 2019 pre-pandemic levels. Pretty brisk interest in gold. So, consumption was stronger obviously. 

And believe it or not, that 1120 tons is 24% of all global supplies, which includes recycled metal as well as new mine supply. And I think it’s worth a perspective shift. If you go back to 2010, 2011, and I know these are a lot of numbers to keep in mind, but 2010, 2011, gold is nearing $2,000 an ounce for the first time ever. And mine supply was considerably lower. So, from then to now, mine supply has increased by nearly 25%. So, we have more gold available and yet prices are hanging out pretty well. The demand equation is really what my point is here. The demand equation has been very strong in recent years. 2021 was no exception.

Kevin: We’ve learned to not pay too much attention to price on gold because it’s deceptive. It’s: he who owns the real gold makes the rules, not the paper gold. And we see price movement based on contracts. You and I both know that a lot of times, they’ll be 100, 150, 200 times the amount of gold traded on paper that actually exists as far as for delivery. And so, it’s hard to see when supplies are thinning, which, strangely enough, in some areas, supplies of gold are thinning. You’ve got the consumption of gold going up. It’s not showing up necessarily in the price right now, or maybe it is. The price of gold is not dropping with a lot of other assets. But wait until the realization comes that there’s not enough physical gold.

David: Well, and speaking of physical gold versus paper gold, we do look at the commitment of traders reports for those who are speculating, so to say, in the paper markets, in futures contracts. And you have different categories, the speculators, literally, that line item, the commercials, and then they have a broad category called Other. And part of our conversation here in recent weeks has been, the Other category continues to grow and the speculator category has become less important relatively speaking here as we come into 2021 and 2022. So, the Other category is the longer-holding pension fund insurance company. It’s a longer-term investor where your speculator you could consider sort of hot money, in today, out tomorrow. And your commercial is really just looking at protecting what is coming into the market on, the way a farmer would protecting a corn harvest, making sure that the weather trends and patterns don’t wipe out his profits.

Kevin: Well, and you also watch what above ground supplies are doing, what direction of the world are they moving? And it seems that they’ve been moving east for quite a while.

David: Yeah. I mean, western investors, primarily the US, left the market a decade ago. And having been gone for the last decade, 2012 to 2022, the above ground stocks of physical gold have shifted in large quantities toward Shanghai. And when the Western investors’ interest in gold returns, I think there’s going to be a revelation of relatively thin supplies. And it’s going to show itself in dramatic form through higher prices. I remember when we had the big liquidations in GLD back in 2013 and 2014. The question was where did six to eight hundred tons of gold go? And lo and behold, it was re-refined, turned into kilo bars, and moved to Shanghai. So, again, these are products that are no longer just sitting around at a London vault, waiting for the whim and fancy of an American investor to buy via an ETF product or proxy. No, that gold is gone and the market is very thin. And so, you combine inflation concerns with underperformance in the stock market. And I think you’ll see significant moves in gold and silver. What makes the price action so dramatic is, again, the revelation of relatively thin supplies as the years of this past decade have gone by.

Kevin: Well, look at 2020. Remember that, when you had the COVID outbreak and this realization that people may need to get into gold, there wasn’t much of it. Silver, the same thing. Remember the spreads on what it would cost to buy something physical versus what you could sell it for at the time? Explain that a little bit, too, because you’ve got the wholesale markets out there that will spread the market because they don’t know what’s coming next. And they’re not going to sell if it looks like it’s going to go up. And they’re hesitant to buy back at a higher price just in case it falls back.

David: You begin to see sort of the unhealth of a market in the distance or the gap between the bid price, which is what you would get if you liquidated it, and the ask price, which is what you’d have to pay if you were buying it. And I thought it was interesting to see this pressure emerge in that short episode of 2020, the pandemic buying in the US. It was overwhelming the markets and it was forcing those bid ask spreads to blow out. Very underappreciated was our ability to maintain a reliable price structure in our Vaulted program when no one else could.

Kevin: Spreads didn’t change.

David: Now, our technology and trading structure was put to the test and it passed with flying colors. So no one else in the industry can say the same. Again, it’s one of those things that you look back in time and you go, “Ooh, it was well built. It stood the test.” It was like the house built on a rock versus the house built on sand. You went back and having been tested by a storm, you say, “Yup, I’m glad I built where I did.” So, it’s a remarkable and easily passed over fact that we were able to handle a massive increase in volumes without missing a beat. And I think of that, I think as a savings tool it remains unparalleled. I love the fact that the vault plan, which we introduced more recently, allows you to automatically add to your gold position in small increments from every paycheck. So, simple, easy to use, vital in an age of inflation for the saver, for the wealth accumulator. And that’s really the role that plays is, look at it as a cash or banking alternative. How much cash do you want earning a negative five, six, seven percent due to inflation. That’s how it’s there’s a useful tool as a supplement.

Kevin: One of the things that we learned in economics is it’s not just the demand, it’s the supply. And it’s good to look at what’s going on again in China because when I came to work here, Dave, back in the ’80s, South Africa was the number one supplier of gold in the world. That’s been replaced with China. But hardly so, because China, even as much as they produce, they keep it all and buy more.

David: Yeah. So, why did Don McAlvany write a newsletter called the South African Intelligence Digest? I mean, of all the things that you could write about, of all the things that you could pay interest to? Well, it was because gold was on his mind. And at the time, the largest producer of gold is South Africa. They were responsible for 70% of annual production.

Kevin: Well, and you took a few trips with your dad to South Africa back during that time.

David: Sure. Now, the largest producer is a 10% producer. I mean, think about the difference. The way the market has shifted from being so singular. I mean, you couldn’t write the South African Intelligence Digest because you’re interested in gold today. Their mines are just about run out. So, yeah, the largest producer, the gold story in 2020 as supply and demand was particularly interesting in China. China leads the world as the number one gold producer, again about 10% of total supply, but even with current production levels, fell short of demand. 

So, Chinese mine supply declined about 10% last year, according to the World Gold Council. It’s coming up with about 330 tons of gold. And I mentioned the demand side is 1120. So, I mean, you’re talking about significantly more demand than supply. They’re going to tap the international markets for the remaining supply. But we saw in the categories of jewelry demand, coins and bars, ETF inflows, they were all positive for the year in China. Now, the one category that remains opaque, central bank demand, we’ve got the rare public acknowledgement of what’s been done in retrospect over the last three to five years. And those numbers are generally considered to be understated. But we don’t have anything that’s sort of fresh or hot off the press.

Kevin: Doesn’t it seem ironic or even hypocritical that central banks, they’ve been increasing their reserves of gold. Okay. Talk about a demand for gold on the supply. Central banks have been increasing their holdings of gold while they’ve been encouraging and printing, encouraging Treasurys and the Treasury bills to be printed and the US currency to be printed. So, I guess what I’m asking you, Dave, is should we do what they’re doing or should we just do what they say we should do?

David: Yeah. So, for China, it’s all forms of consumption, 1120 tons for global central banks, demand mounted to 463 tons. That’s 2021, and that’s 82% higher than it was in 2020.

Kevin: Wow.

David: So, they’ve lifted their gold reserves to a near 30-year high. And I think you’re spot on. It’s very curious that central banks in recent years have significantly increased their holdings of gold even as they have added to the most inflationary monetary backdrop in decades. Contemplate that contrast for a minute. Someday investors will learn to both listen and watch. And with their eyes wide open, perhaps they’ll also translate that into action, protecting their cash from the evisceration of purchasing power brought by centrally planned monetary policies.

Kevin: Well, and I’m going to come back to the United States because actually, this is not scolding say the European or the Asian investor in gold. They’re seeing probably more clearly than the United States investors. So, as you have US investors or US banks, what have you, liquidating, you’ve got the rest of the world accumulating. I mean, we ought to take our read from that.

David: I think there’s a subtext, which we don’t have time to talk about today, except to say a change in global leadership is expected by the Russians and by the Chinese. And that change in global leadership was indicated by our failure to succeed in Afghanistan. And if you wanted one singular nail, the final nail in US global leadership, that coffin, it would be China invading Taiwan and us being unable to really react in a meaningful way.

Kevin: Yeah.

David: The loss of Taiwan would signify to everyone in Asia that we had lost our position of dominance as a regional influencer. I mean, to me, Taiwan is, if you want to go back to the Sinai Peninsula, Taiwan is what Britain faced in 1956 with the Suez crisis. The world knew during the Suez crisis that finally, once and for all, the British empire was no longer what it once was.

Kevin: There was a shift, too, in just strategy. I was having lunch with a friend of ours—he is a retired general from the Air Force—on Friday. And we were just talking. He had a smashing success in what he was in charge of back about 20 years ago. And I was asking him, I said, “What made it work?” And he said, “You know, Kevin,” he said, “we came in as advisors, but we did not own the problem.” He said, “The problem with Afghanistan was we came in and owned the problem. And everybody just stepped back from there.” Once you start taking over, and you see this with the Roman Empire 2,000 years ago, they started coming in and owning problems that they could not afford. And it just overwhelmed them ultimately.

David: Yeah, I mean, so the reason I mentioned the change in global leadership is a significant issue to be thinking about over the next few years, and even months, is that the consumption patterns of gold in other parts of the world indicate that more volatility is expected. And this is not just financial market volatility. This is geopolitical volatility. This is a change in the status quo, status quo that we’ve maintained since the end of World War II, both from a monetary standpoint as well as the standpoint of global leadership. 

So, until people see with wide eyes that central banks are doing one thing— We should expect some investors to see before others. So, whether it’s the central bank activity, which would say, “Hey, watch what they’re doing, not just listen to what they’re saying,” but also that sensitivity to geopolitics. 

For 2021, it was investors in Europe and it was investors in Asia that continued to add to gold. While the major liquidations came in the US, one of the very largest years of ETF liquidations on record here in the United States. If you just let that sink in, if you let that sink in, one of the biggest liquidations of the GLD ETF was last year, and yet the price barely budged. In any previous year where there’s been mass dumping of the ETF, the investor has defined the price at the margins. What it says is that there is massive demand for gold outside of the United States. And the calculus is different. The set of eyes that are on these problems is very different. We’re out there playing to have fun and make a bunch of money. And meanwhile, everyone else is— It reminds me the old analogy. We’re sitting here playing checkers. They’re playing chess.

Kevin: Well, and it brings me back. You brought up 2013 when gold dropped a couple of hundred dollars in a couple of days. It was August 12th and then August 15th, that next Monday, dropped a couple of hundred dollars. And that ETF, there was huge liquidations out of the ETF. China gobbled it up, but there was a price move. What you’re saying now is last year, we saw large liquidations in the ETF and the price didn’t budge.

David: No. And the fascination was sort of the grass is greener syndrome. We were excited with Cathie Wood’s ETF high flyers. We were excited about Elon Musk’s Mars missions. We were excited about options trading on AMC and GameStop, and anything else that had a mild pulse from the standpoint of an income statement. So, speculation was the defining factor in what will be understood as the late stage of a bull market in equities. So, US equities are now searching for the last suckers. Not finding many in the month of January, here we are hitting significant air pockets. Daily volatility is and was astounding. Monthly performance was abysmal across your largest indexes as you closed out the month, the worst January performance since 2009.

Kevin: Yeah. But Barron’s wants to give consolation to the last suckers. In other words, say, “Hey, go ahead and take this bag from us. It’s fine.” So, the big investor still needs the small investor to buy so that the big investor can get out.

David: Barron’s is notorious for being on the wrong side of major, major trends shifts. The next time Barron’s runs a massively positive, all in, everyone should own gold article, you should be selling wholesale as much as you can afford to. Why? Because that’s just the way Barron’s is. The fact is Barron’s tried to console investors with an article out just in the last day showing that history holds a consolation. We should be back to break-even by the end of February, March at the latest, says the article. Only one instance that they can come up with where you had to wait till May if you had a really rocky January. Of course, what they neglect to mention was that, in their historical references, the January levels came at the tail end of vicious declines, not at the front edge of a decline where we stand today. So, you got to see recovery in the months that followed because you had already had months and months and months or years of decline in the equities market. And there in February, March, and April, you finally got to catch a bid and prices moved a little.

Kevin: They were looking at the wrong part of the chart.

David: That’s right. Yeah. I mean, the subtitle of the article was history offers plenty of comfort. Yeah. And by history, they mean the last 20 years, which is funny because the average retail investor today, for 20 years is a long time. Schwab reports that its average age trader is 35 years old. The average age of someone who’s investing with Schwab is 35. RobinHood, it’s 31 years old. So, 20 years, we’re talking about two thirds of their life. It takes you back to little league and pulling pigtails. You want to consider a longer snapshot I would think. In the last 20 years, what has that been encompassed by? Only the largest surge in global liquidity from central banks in recorded history. It’s only taken interest rates to 5,000-year lows and equity valuations on most measures to highs never previously recorded. Again, but perhaps Barron’s is right. Don’t worry. Be happy now.

Kevin: All right. I won’t sing that for you. Well, I will, yeah. (singing) Okay. So, looking at that—

David: History holds a consolation, yes. It also holds some lessons. And I think that’s what we’re neglecting is to learn some of them.

Kevin: Dave, do you remember the movie Wall Street, the original one with Gordon Gekko, that came out, gosh, probably almost 30 years ago. But I remember the scene where the young guys just couldn’t understand why the old guy wouldn’t play. The old guy had been through a number of market moves. He had seen a lot of different things and he stepped back. The young guys got themselves in trouble. That’s what it was about. But it was about money. It was about greed. It was about power. And it really didn’t matter because it was not about history. And the old dinosaur that was at the firm was just mocked. 

We’ve talked about Howard Onstatt, but Howard Onstatt, Jim Deeds, some of these men who have lived into their 90s and been able to trade on markets and actually see politics and economics and finance and absorb for 60, 70 years of their life. It’s amazing how differently they behave than the people who are going out and buying GameStop, AMC and a lot of these wild speculations.

David: I think it’s actually fairly easy to understand how a Millennial would think that 20 years is an eternity when they’re living their lives vicariously through tweets and TikTok video clips and things that have about a five-second span. And so, yeah, 20 years is a long, long time. But I think the weakness in equities, the weakness in equities that we saw in January is very easy to connect to Powell’s FOMC verbal guidance. Yeah. Again, higher rates are coming. It’s being priced in. QE is coming to an end.

Kevin: And that hasn’t happened in the last 20 years, by the way. Interest rates have not risen. And quantitative easing—we’ve only had easing.

David: Yeah. And rates have not risen meaningfully. And it’s true. Something fresh is presenting the markets with trouble. Take comfort, take comfort, says Mr. Powell. Take comfort and the economy is incredibly strong. So, he brandishes a fourth quarter GDP report, which had figures jumping well above expectations, which were 5½% growth. And they came in at 6.9%. Astounding. That’s what was there instead, 6.9% for the fourth quarter. “We should not worry,” Powell says. It’s an amazing post-pandemic economic recovery and a part of the data— Again, he’s moving back towards being data sensitive. It’s part of the data used for entering a QT, a quantitative tightening phase here in 2022. Don’t worry. Last week’s comments from Powell. He’s promising to be nimble. He’s promising to be humble. He’s promising to be data driven. And again, this is reassuring to all. I’m sure.

Kevin: Yeah. Okay. So, when he says QT, there are going to be a lot of people who hear QE, because they’ve never heard QT. I think they heard QT just for a moment in 2013 and it scared them to death.

David: Well, that’s right. So, what is this QT he speaks of? Quantitative tightening, it is the opposite of easing. And you can stretch that back nearly 12 years. So, for the person who’s been investing, who’s frankly 31 or 35 today or less, just getting out of college and maybe they weren’t jumping on their Bloomberg screens straight out of college, but are more recent entrants to the market. You had the November 2008 QE1. You had the November 2010 QE2.

Kevin: We promise we won’t do it again. And then QE3.

David: September 2012 was QE3. And of course, let’s not forget Bernanke’s announcement of the taper. He was going to introduce a version of tightening, which gave us the tantrum, taper tantrum in 2013, causing a pause or reconsideration of the Fed’s proposal to tighten financial conditions. And then all throughout the 2015 to present period, liquidity tools have continued to pump money into the markets, including the last round of QE, QE4, initiated in March of 2020 in response to the pandemic.

Kevin: A few years ago, you had Diane Coyle on and you interviewed her. And she’s one of the foremost experts on how GDP is calculated, the weaknesses and the strengths of how it is calculated. So, now that Powell is talking about a robust GDP, why don’t we break it down, maybe look at it for what it is.

David: So, here’s an alternative history, or an alternative prediction on our future history. The first clue is in that very impressive 6.9% GDP figure. So, a 6.9% GDP growth figure, if you look at the details, 71% of that advance was from inventory growth. That is 4.9 percentage points is coming from inflation-induced corporate preemptive inventory building. Yeah. So, this is your corporate chief saying, “Let’s get it on the shelves. Let’s get it back here.” And I understand, if you’re concerned about supply chain stuff, you want to load the boats and load the shelves.

Kevin: And you want to get it out of cash. I mean, buy inventory because you don’t want it in cash these days.

David: That’s true, too. But historically that puts a drag on growth in future months and future quarters. Because essentially, it’s corporate investment that draws economic activity from the future into the present when you’re building inventories like that. So, it’s good news on the front end, but it comes with a bite on the back end. And also for consideration is that when the Fed was initiating tightening cycles in the recent past—recent past for us takes us back about 30 years, that is raising rates—inflation was well below its normal run rate and near or below the Fed’s target of 2%. So, we’re talking about the increases in ’94, in ’99, in 2004, in 2015. This time, the Fed is in a very different context. They’re behind the curve on rates, and inflation is already over three times the Fed’s target.

Kevin: Last week, you talked about, even if inflation were to fall by half or more, we’d still be negative real rates of return.

David: Yeah. And those were Stephen Roach’s comments from a Project Syndicate article. I would encourage you to find it and read it. The math involved, aggressive tightening, and a reduction in inflation by half, which is possible, inflation will ebb and flow. From this point forward, though, I think it’s important to remember that it’s a real factor in all investment considerations, in all investment conversations, in a way that it has not been meaningfully a part of the last 20 or 30 or 40 years. So, we still, with those assumptions, aggressive tightening and a reduction in inflation by half, that still leaves us with the real Fed funds rate at a negative 2 to 3%, which is we said last week is more accommodative than at any time in the past 40 years. And that would be considered strong medicine for this market.

Kevin: Well, like you said, it’s air out of the cave. I mean, you’re— it’s a lack of oxygen because they need the liquidity.

David: They need a lot of liquidity. I mean, imagine the Fed’s funds rate was in real terms to go positive. Not just a negative 2 to 3%, and that being a version of quantitative tightening. But imagine if it’s actually positive, post-inflation priced in the real world above the zero line. Amazing. Imagine further that the Fed’s balance sheet was allowed to shrink, reducing liquidity in the financial markets by a trillion dollars, $2 trillion, five or six trillion. I mean, they’ve got almost $9 trillion in their balance sheets. —runoff of the balance sheet. This is a big deal.

Kevin: Yeah. And equities, what happens to equities?

David: In that future scenario, in that future history, you’re talking about carnage in the stock market, 50, 60% declines. A decline of 50 to 60%, a bond market that offers no safe haven for retirees, pension funds and insurance companies or talk about the target date funds that are heavily bond exposed. It really mimics the two-step sequence of going from the frying pan into the fire.

Kevin: Yes. But we’ve got the people who are willing to come in and speculate right now. Won’t they save the market? Won’t they be the market maker?

David: Yeah. I read an interesting piece last night as I was thinking about comments for today. And the conclusion was a 60-40 split between stocks and bonds is at best going to give you about a 2% rate of return over the next decade. And I underscore at best. At worst, it could be a negative three to five every year for the next decade.

Kevin: On average.

David: On average. Maybe a bad year this year and not so bad the next several as you recoup and get back to breakeven.

Kevin: So, you better hope there’s no inflation.

David: Right. So, into this fray comes the overconfident speculator. Not only is there little appreciation for overvaluation in the market. And again, that suggests years of underperformance for index funds as we’re looking ahead. But there’s also kind of a swagger in the step of the young guns buying options. They’re buying options like the middle class scrambles for flat screens and game consoles on a Black Friday sale. I mean, it’s just reckless abandon, who can grab it first. 

My colleague, Doug Noland, pointed this out last week on our tactical short call. You can listen to the call or read the transcript if you want to go to mwealthm.com, well worth your time. He says this, “On average, a record of almost 39 million option contracts traded daily last year, about a third higher than 2020. At $467 billion, the daily average notional value of stock options trading exceeded the value of shares traded.” Let that sink in for a minute. Can you let that sink in? Derivatives trades are exceeding the trades in underlying assets. And we think 2021 was anything short of a speculative blow off? Of course, it was. Of course, it was. And 2022 is likely to be the beginning of an extended bear market.

Kevin: Okay. So, we’re talking the financial world, which would be a bear market. But why don’t we talk about economics for a minute? I mean, are we in an expansion or are we in a recession? Liquidity’s probably going to tell.

David: Well, what’s different and critical to appreciate with this tightening cycle is that the inflationary backdrop forces the Fed to choose winners and losers. So, less liquidity suggests a recession is ahead and is deflationary for asset prices.

Kevin: The financial world.

David: Typical for a tightening cycle to bring on a recession. And again, deflationary for asset prices; stock and bonds go down. Of course, those assets have been generously boosted by central bank QE policies. So, that’s less liquidity. On the other hand, more liquidity, which could arguably bring calm to the market in the event that there’s jitters or tantrums like we had in 2013, or just a little good old fashioned mean reversion. More liquidity coming into the system would drive the inflation stake through the heart of the consumer.

Kevin: Okay. But it’s an election year. Which one do you pick?

David: Yeah. Think about that. You’ve got political audiences lining up to vote in November or mail in their ballots. Yes. I mean, ballots as in plural of ballot.

Kevin: Each person mail in their ballots.

David: Why not?

Kevin: Yeah, yeah.

David: 2022 is a year of tough policy choices. The data says the Fed should tighten, but tightening will burst the equity and bond bubbles with dramatic negative pressure on the consumer, on the investor, on the retiree. And if nothing but talk emanates from the Marriner Eccles Building, that is the Federal Reserve building in New York, you have families seething with frustration and untargeted anger. Because that’s just the nature of inflation. Where you see food riots in the third world is where people can’t account for why things cost so much and why they’re running out of money before they run out of month.

Kevin: Well, and the issues are changing at this point. The things that people were worried about last year are changing pretty dramatically, and inflation has become a big issue.

David: Right. So, the seething frustration and untargeted anger remains untargeted till the election. And to that point, one poll I viewed last week showed the cost of living in inflation taking the number one spot as the most important issue in the 2022 election. The economy and jobs is now number two. And COVID and immigration are tied for third.

Kevin: You’re kidding. So, COVID and immigration, immigration has risen to the point where people are as concerned about immigration as COVID.

David: And COVID has dropped to third, behind the economy jobs and—

Kevin: Inflation.

David: Inflation.

Kevin: Yeah.

David: Right. So, ponder that last one, ponder that last one, immigration on par with COVID. DC, Washington, DC may be in for a few election surprises. COVID is still enemy number one as far as they’re concerned and inflation is only being addressed, well, I mean, it is being addressed via political pressure on the bureau of labor statistics to change the weightings and the calculation. It’s brilliant.

Kevin: So, put yourself in the shoes of somebody who’s running, let’s say a Democrat, who’s running in November. Are they going to want necessarily Biden to come campaign for them with the approval ratings of Biden being historically— I mean, aren’t we at historic lows for any president?

David: Right. I mean, if you’ve ever seen, I don’t know if you’ve ever stood around a craps table, but there’s this point where, if the energy changes, people just walk away.

Kevin: Right.

David: The energy is positive, everybody wants to clap and yell and maybe even put on their own bets. And when the energy turns negative, it’s like, walk away. You don’t want to be sucked into this bad luck vortex.

Kevin: You’re thinking that’s what November looks like for the Democrats.

David: Yes, because the fall in the polls, I mean, we’re talking about the presidential approval ratings, it should come as no surprise given the increase in inflationary pressures. It would happen to anyone. If there was a Republican in office, they would be raked over the coals because of inflation. It’s just one of those things that the consumer cannot bear. So, inflationary pressures are building, and that has a direct play on the White House reputation, regardless of party. And I think there’s no surprise here that that political angst expresses itself as a desperate push for war in Ukraine.

Kevin: So, we’ve got a wag the dog kind of incident that possibly could come up. And it could be a very big dog that we’re talking about. When you’ve got Zelensky trying to talk Biden down and saying, “Hey, a Russian invasion is not necessarily going to happen.” That shows that somebody wants war a little bit more than the other.

David: But why were the US and UK not actively involved in the talks here in Paris? Just last week, between Germany, France, Russia, and Ukraine, I mean, other than the obvious, which is that Macron wanted to lead the conversation himself, which he did. But the US has had a near media blackout on the “Normandy style” four-way talks held last week in Paris. And now it’s equally quiet. On the next round of talks in Berlin, we’re talking about Russia and Ukraine discussing differences. We’re talking about France and Germany being a part of this conversation. Might it be that the narrative of diplomatic resolution is out of step with both Biden and Johnson’s need for political distraction? Maybe. And to your point, you’ve got the Ukrainian president, Zelensky, calming Biden down repeatedly, assuring him that a Russian invasion is not a virtual certainty. Can it happen? Yes. Is there a probability? Yes. They’re looking at it actively. But actually, there’s no difference in the kind of behavior and activity going back to 2014, according to Zelensky.

Kevin: At least Biden was making a phone call. We don’t see him much anymore. They don’t let him come out in public very much.

David: Well, he is making the rounds. And again, this goes back to the issue of, has the luck changed at the table and how is he being treated? Do you want to associate yourself with the bad luck guy? The president’s standing in his own party was criticized in an AP news article, neither particularly conservative or liberal, the AP news wire. And they were covering Biden’s trip to Pittsburgh, Pennsylvania. Pennsylvania Democrats cited scheduling conflicts as a reason to not meet with the president. And this is what the article said. The high-profile absences come as Democrats in other states have begun taking modest steps to distance themselves from the first-term president, whose approval ratings have fallen sharply in recent months.

Kevin: So, it’s like watching a Santa Claus that’s lonely in a mall. It’s like, “Hey, none of the kids want to go see Santa. Is there a problem with Santa?”

David: Well, I mean, back to the earlier comments on QT, quantitative tightening, we discussed internally here in the office that interest rate markets are now pricing in five rate increases before the Fed’s December 15th meeting. While shorter-term rates have jumped, post-Fed meeting, you’re talking about the two-year Treasurys up 17 basis points. They moved to 1.19% this last week. And you’ve got the longer-term Treasurys which are indicating skepticism of an aggressive tightening cycle. And Doug would say, “This is telling us something.” Our colleague Doug would say, “There’s reason to be skeptical here. And we’re in good company with the long end of the curve. Bond investors who are in it for the long haul, they don’t see the possibility that he’s actually going to be able to follow through.” 

So, some skepticism is reasonable. And a part of that is if you look and say, “Yes, there’s consequences,” the consequences of asset deflation, that becomes a concern if true tightening occurs, if there is less oxygen in the room for the speculators. That’s highly consequential in this market environment. And there’s your catch 22. To not truly tighten is extremely consequential as well. So, to tighten has consequences. To not truly tighten, it’s the investor class or the consumer class—

Kevin: Who votes, who votes, yeah. I mean, and I don’t know the answer to that question. Who do you pander to? Do you continue to buoy up the stock market or do you try to beat inflation?

David: Yeah. It’s a tough thing because who will win, who will lose in 2022?

Kevin: Yeah.

David: Prudence argues for strong allocation to precious metals. That’s where I go in this equation. It’s not a question of, do I get long stocks because I think that the investor is going to win, or do I sell all my stocks because I think the investor is going to lose? And the consumer class is being prioritized. I think there’s huge sacrifices and huge power shifts either way. 

And you might say, well, you buying precious metals, isn’t that a bit self-serving? Evidence from the metals mining sector is, I think, worth keeping in mind. Evidence from the metals mining sector of an increase in mergers and acquisitions, that activity over the last several years, it indicates a very similar theme to the oil sector. The oil sector has caved to pressure over the green agenda and over carbon emissions and electrification. And they’ve been very hesitant to expand production. 

Now, you’ve had different reasons for a lack of expansion within the mining space. But there’s been little priority set in recent years on expanding production, that is ounces, not barrels, but of ounces. And more emphasis has been placed on dividend payments, on debt reduction, on conservative capital allocation and making for a better balance sheet. Now, you have major producers, after years of those strict capital disciplines, they have to consider the macro cost, the existential cost, of reserve depletion. How long will they be around as a business if they don’t have enough reserves to mine, if you’re running three or five or six million ounces a year in terms of production. You’ll go through your reserves and ultimately, it’s game over.

Kevin: Right.

David: You have to replace the ounces.

Kevin: Well, it goes back to supply and demand, both affect economics. But honestly, Dave, even if their supply was just flowing at record production levels, nothing can keep up with a panicked audience.

David: No, that’s true. And I come back to these issues of sort of the environmental concerns, which are now added constraints to production and development of assets. And so, it’s not as if a gold company can say, “Well, we’re just going to go start digging in the dirt and bring on new projects.”

Kevin: Right.

David: The existing projects become more appealing. And so, gold reserves today are cheap from an acquisition standpoint. If you are a major and you’ve been conservative, you don’t want to increase your debt, on the other hand, you don’t want to go out of business, you’re going to start buying assets as cheaply as you can, particularly ones that are permitted, in production, ready to go. Right? So, so we have a similar story here where there’s been a lack of new supply being introduced. And that’s the case with both oil and gold.

Kevin: And you’ve got increased consumption, of the gold anyway, over on the Asian side.

David: Yeah. And I think of the oil markets, we are back to pre-pandemic volumes and we have yet to see the airways come back fully into play. We have not seen the aviation fuel take off because planes are not flying as much as they were previously. And yet, we’re back to oil consumption that we had pre-COVID. So, what happens if we do normalize post-COVID and see business travel and other things go back to normal? Your demand quotient is going to bury available supplies coming online. Right? 

So, in the energy space, you’ve got an argument for longer-term inflationary pressures because of oil maintaining a higher level. I think that’s what I’m trying to say. But on the other hand, you’ve got a supply deficiency in the gold market where they have not been increasing available supplies. And you get demand, which for a variety of reasons, whether it’s geopolitical in nature or economic or financial market—from the disturbances within the financial market—oriented act as catalysts for investor demand.

Kevin: So, the question is, do you have gold? I mean, whether you’re a mine or whether you’re a central bank or whether you’re an investor individually, do you have gold?

David: I think it’s a great question. And it’s one that an individual investor has to say, at this point, look at your allocations. Where are you overextended? Do you have too much cash? Do you have too many positions in bonds? Are you over-allocated to equities? Any reprieve you have in the markets, any violent volatile moves to the upside from here are characteristic of bear market rallies and should be sold into, sold into, sold into. Now, what do you do next? Hey, listen, I fully support an idea of buttressing a cash position. But to offset your risk of mismanagement by central banks, you’ve got to have some sort of a barbell approach between liquidity in ounces and liquidity in fiat bills.

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 dot 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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