EPISODES / WEEKLY COMMENTARY

Saith Inflation “I’m Not Quite Dead Yet”

EPISODES / WEEKLY COMMENTARY
Weekly Commentary • Mar 01 2023
Saith Inflation “I’m Not Quite Dead Yet”
David McAlvany Posted on March 1, 2023
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Saith Inflation, “I’m Not Quite Dead Yet”
March 1, 2023

“Think about your year-to-date volatility. Copper’s up 5%. Lumber’s down 77%. Gold is flat. Silver’s down 13½. Oil’s up five. Natural gas is down 50%. All at the same time. So the way we navigate that as a firm is we selectively own producers. We treat the positions like an accordion. There’s times to own a little, and there’s times to own a lot, based on prevailing macro conditions, company-specific developments. So on the one hand, I agree that commodities are a good diversifier, but I don’t like futures contracts, and I don’t like the idea that you can treat the commodities complex as one unified thing. They’re all moving on different bases.” — David McAlvany

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

David, I often like to listen to shortwave radio. Years ago before the Internet was popular or before we had it, I would listen to Pravda often. I would listen to the propaganda that was coming out of Russia and Cuba. I would listen to Cuban radio as well. And not because I thought that I was getting the narrative that was absolutely true, but I was getting a narrative that was different than what I was hearing. And it allowed me to sort of triangulate. What are they saying? Why are they saying it? What do they want me to think as an American listening to propaganda? So the question would be, is there any real reliable source for information, propaganda or not?

David: Well, I think this is an interesting conversation point because when we talk to Dr. McBrayer about fake news, I think one of the mistakes that we can make is thinking that there’s somehow this bifurcated path. You have on the one hand the road you go down for fake news or the other that you go down for true news.

Kevin: Truth, yeah.

David: And the reality is that information and facts are organized in a particular way, and that is so that an impression is made. And this deals with the assumptions that we have about the world, the priorities that we’re trying to communicate, the agendas that we’re trying to push. So when we look at propaganda, it’s easy to again sort of bifurcate it and say, “Oh, well propaganda is false.” No, in fact, most of what’s in propaganda is true. It’s the facts that people point to and say, “Oh, this makes sense, right?” It’s believable because it’s true. But the narrative construction is there to lead you down a certain path, and that’s what can be false, is what’s done with the facts. 

So propaganda serves a purpose, it’s communicated with a particular audience in mind, a desired reaction and outcome in mind. And it does not on its face have to be false. We are propagandizing all the time, the US is. We do things, we write things, we say things, and every country does with an audience in mind.

Kevin: Don’t you think it’s a white hat/black hat thing that can sometimes cause us to be blind to seeing what’s going on? It’s like, “Oh, well the Russians, they’re bad guys, they invaded Ukraine.” Or vice versa. We’ll get people who will call in and they say, “Oh, no, no, the Ukrainians are the bad guys. The Russians are the good guys.” Chinese, the same thing. You had just read a piece you were telling me about from China that’s clearly a propaganda piece, but there’s an awful lot of truth in propaganda.

David: Oh, yeah.

Kevin: It’s good to see what they’re thinking.

David: This is the Chinese Ministry of Foreign Affairs, “US Hegemony and Its Perils.” And I agreed with half to two thirds of it, but the narrative construction was what was off. And this is where you’ve got to stand back and either with a certain degree of perception or wisdom or discernment, know what is going on. So I go back to the Kagans and the Brzezinskis and the Kissingers, and you could say, “Well, these men were liars. They said we were going to do this, and we did that.” No, they were playing a game, and the game was not, “We all win and we’re all happy.” It’s, “We win and someone else loses and we’re happy.” There is this temptation to see the world as, we could all be friends. We could all just love each other and get along. And in some fanciful way that’s possible when you’re talking about the micro. That’s possible when you’re talking about brothers.

Kevin: Individuals, to a family.

David: Individuals to each other, within a community. But as soon as you start getting into sort of disembodied selves, when you’re talking about a corporation or a country or an organization, all of a sudden you’re now talking about a different kind of “relationship.” And that’s where Brzezinski and Kissinger, they were realists. They were playing a game, and they were playing to win. And they weren’t playing to be nice, and they didn’t care what people thought of them. And it wasn’t important that they were seen as bastions or heralds of truth. They were there to win the game.

Kevin: Well, and they were representing the country that they were there to win the game with. I think about the Super Bowl, you had two brothers playing on two different teams. Now they loved each other, I mean individually, that’s great.

David: Off the field.

Kevin: Off the field. But on the field, what were they trying to do?

David: There to win.

Kevin: They were trying to win. So I think even as we look at our, not just geopolitics, Dave, but economics. We have to understand the Fed is there to win the game in whatever respect that they’re there for.

David: Well, that’s right. So when we think of their communication, some of their communication is very genuine and factual. But keep in mind the importance of discernment and perception in bringing in historical, relevant facts. Because what someone says is not necessarily relevant. It doesn’t matter. They’re not trying to be bastions of truth and integrity.

Kevin: They’re trying to persuade and direct things in a direction that benefits the goal.

David: It’s a game. It has to be well played. And they’re trying to massage and manage perceptions, and you don’t always do that with propositional truth.

Kevin: So do you think that these rallies in the bond markets that we’ve had—it looks like they’re waning at this point—do you think maybe that was a misunderstanding of what the Fed was communicating?

David: Well, it’s a combination of the Fed and really the markets believing what they want to believe.

Kevin: They want to believe that inflation is dead.

David: Yeah, and so I think actually the Fed’s been pretty clear in that the higher-for-longer and that inflation is an issue that we’re going to have to face for some time, and the markets have disregarded it. Inflation is not dead. Not yet. We may have the stock and bond rallies of late 2022 and early 2023 dying right now. We’ve got the PCE, we’ve got CPI and PPI, three data points for inflation that point up and to the right, up and to the right. They’re moving higher, not in the right direction. Not good for consumers, not good for investors when your expectation has been for the fight to be over really before it began. Higher inflation implies tighter financial conditions from the central bank community, which makes running a business more difficult. It makes speculating—successfully speculating on business outcomes—harder to do as well.

Kevin: Right. It’s hard to manage. It’s goes back to that efficient market hypothesis. The efficient market hypothesis is that all information is being processed into the market at all times. Boy, has that been proven wrong all through history.

David: Buffett said years ago that if the efficient market hypothesis were true, he would be sitting on a quarter holding a tin can begging. The only reason he has wealth is because markets are inefficient. He sees value when other people see trash. One man’s trash is another man’s treasure. It’s the debunking in real time—Berkshire Hathaway is the debunking of the efficient market hypothesis. Earlier this week, the Financial Times leads out saying,” The record breaking global bond market rally since the start of the year has fizzled out as mounting signs of persistent inflation force investors to reverse their views on the likely future path of interest rates.”

Kevin: So the bond market, which would be considered an efficient market—or not, was wrong.

David: Well, they just had something in their minds that they thought was true. So in fact, markets had, up until two weeks ago, been pricing in considerable declines in rates by year-end. It was a narrative that had been told, and they told themselves: considerable declines in rates by year-end. We were supposed to peak in June and be down from there by the December 13th meeting. That was kind of the market’s efficient view on rates. Buffet actually in his most recent investor letter had something to say on that. He said, “Efficient markets exist only in textbooks.”

Kevin: Well, and he’s proven that by becoming a billionaire, by the markets not being efficient.

David: While many economists still believe that that theory exists.

Kevin: Yeah, and they’re poor.

David: Right. They’re still teaching their textbooks.

Kevin: Yeah, exactly. But I just got back from a trip. You travel a lot. I don’t travel as much as you, but I am amazed at the cost of hotels, the cost of plane trips, the cost of renting a car. It feels like it’s double to travel at this point. What used to be a $1,500 weekend trip now is a $3,000 trip. And it’s like, “Wow, I was just going down to see my mom.”

David: Right. Well then that’s where inflation is a real agitator. It’s a consumer agitator. I got a text from my wife last night. Dog food was outrageous. $61 for a 25-pound bag, she said, just jumped to 71.

Kevin: So it was already outrageous.

David: Yeah. We’re now quantifying how much we love the dog, she said.

Kevin: Well, she must have been mad.

David: Oh, she was ticked. When I read it, and I’m like, “Yeah, it was too much then. It’s too much now.” So did I succumb to the pressure of shopping online to see if we could order it by the pallet from somewhere else? Yes—and no. The local shop is cheaper than Petco, Amazon, Chewy—I looked at all of them—even before shipping. So basically what this is, the manufacturers jump the price, retailers are just reflecting that change and passing it along to maintain their margins. And look, I know there’s cheaper alternatives for dog food, but purebred Malinois are like sports cars: higher initial costs, higher maintenance costs. Man, I love the dog. She’s beautiful, she’s brilliant, she’s hardworking, but I’m growing more interested in mutts all the time.

Kevin: Yeah, she is a specialty sports car, that’s for sure. But inflation’s not just a US phenomenon.

David: Well, the basis of hope for investment speculators was dimmed further by the US and European inflation numbers. So Europe’s certainly in the equation, 8.6% in Europe, down from 9.2 for an inflation rate. Still high enough to impact consumer choices—like me looking for alternatives to where we source our dog food. Or do we just consider letting the dog walk out of the yard and disappear? We do love our dog, we do love our dog. 

But those kinds of numbers impact consumer choices negatively. It forces the ECB to shift towards a more aggressive inflation fighting posture, that’s overseas. PCE, which is the Fed’s preferred inflation measure, we talked about last week, hotter than expected at 0.6 for the month. The core—so strip out food and energy—signaling a longer inflation fight ahead. No surprise. Bonds and stocks last week—they got tagged. They were shellacked.

Kevin: Well, and you talked about the Europeans, but, I mean, Japan has been able to pull off something that people were using as an economic model now for three or four decades. They’ve been able to print an awful lot of money, keep their interest rates extremely low. Granted, they stayed in a recession for many years. What would happen if they started growing? What happens to inflation with all that printed money?

David: This brings us back to the idea of discernment, or maybe perception. How do we know what we know? Forgive me, one of the four areas of philosophy that you study as a philosophy student is epistemology. How do you know what you know? And certainly within the financial markets, having history speak into the present is important for knowing what’s going on. Yeah, Japan hit an uncomfortable number, last seen four decades ago. So, fastest growth in inflation since September of 1981—in the low fours in terms of percent. 

So for us it looks tame. For the Europeans it looks like a cakewalk. But within the context of Japanese markets it’s not just today’s inflation figure but what’s on the horizon as they remain unrelenting on their yield curve control, on their QE bond buying program. So the new Bank of Japan president, the nominee for that position, has in recent days suggested keeping policy the same for now. And so our concerns last week—damned if you do, damned if you don’t. Either the yen or the Japanese government bond market is moving towards a body slam. It’s inevitable, one or the other.

Kevin: You bring up 40 years. But actually yield curve control goes back to World War II.

David: That’s right. The lessons of yield curve control, for those care to consider the future costs— And again, if you’re looking at 4% inflation in Japan, you’re like, “Ah, who cares?” Well, the fact that they’ve dug their heels in on yield curve control, we did the same thing. So what can we learn from the past? March, April 1942, we kept the policy in place for nine years as we financed the war by expanding our balance sheet. We were doing the same thing, keeping a cap on interest rates and being willing to buy bonds to keep that cap in play. Fiscal authorities kept the upper hand in the argument, even after the war ended, and the policy was maintained even further because they didn’t want to see the value of war bonds go into collapse. And of course, if the bond price is coming down, rates are going higher. If you’ve got higher interest rates, what does that do to the economy overall? So fiscal authorities are very clued-in to this. They’re clued-in to the political consequences of price action. Finally, the Fed insisted that the targeting of prices end. Why? Because inflation was moving past 20%. This is 1950s, early 1950s. Yield curve control and future inflation are a highly correlated risk.

Kevin: Yeah, but that’s not going to be part of the propaganda feed. We talk about propaganda feeds, you’re going to see inflation blamed on everything but what actually caused the inflation. I mean, going back even to Germany in the early 1920s, the people didn’t even see afterward that it had to do with printing money.

David: The more palatable narrative is still that balance sheet size and monitoring fiscal policy are not, not primary inflation contributors. No, it’s Covid-related, its supply chains. ’Tis the Russians disturbing the oil markets.

Kevin: Oh, the black hats. Black hats, yeah.

David: Blame them. And with those sort of disingenuous or even diversionary tactics, you can run the digital printing presses whenever needed, and you never have to have that sort of mea culpa moment. You’re not taking responsibility because it had nothing to do with you. 

In 1951, the interest rate cap was lifted, so we were at like two and a half percent on the long bonds, I forget what it was in the shorter-term bonds. But two and a half percent was the cap on long bonds. Just play that math out in your head. 20% inflation, two and a half percent yield. That’s a negative 17½ percent real yield on US government funds.

Kevin: And this is in the 1950s.

David: Right. So rather than allow— As interest rates normalized, they basically stopped intervening and holding prices in place. Rather than allow financial institutions to see their asset values decline (those who had bought those bonds—they’d see the asset values decline in price as rates moved higher), the Treasury offered to swap bonds for higher-yielding convertible securities, and essentially they let the taxpayer be the designated loser, picking up the final tab when the bill came due for yield curve control in 1951.

Kevin: So anytime it seems too good to be true, you’re probably the sucker who’s going to pay for the too good to be true.

David: Absolutely. The conundrum for investors, the real concern in financial markets, emerges. Doug discussed this in the weekend’s Credit Bubble Bulletin. He asks these questions: Where’s the Fed put? How quickly will the Fed shift to QE, and at what size? And the more inflationary pressures persist, the more difficult these questions will be for the Fed. The day the markets begin to question the Fed and the global central bank liquidity backstop, Doug says, there is a serious problem.

Kevin: You talk about the difficulty in managing right now for investors, but let’s go back to the efficient market hypothesis and some of these models that brokers have been using for years—the whole 60/40 mix, and if you’re not going to be in stocks, you move over to bonds; if you’re not going to be in bonds, you move over to stocks. I’ve gotten the question often, Dave, here over the last few months, what happened to gold? Why didn’t gold do better? But actually it was the 60/40 portfolio that didn’t do well. Gold did just fine last year holding its own.

David: And over longer periods of time, these things come right. You look through, I have on my shelves printed in 2002, Triumph of the Optimists. And—

Kevin: That was 20 years ago or so.

David: That’s a bold study put together by a group of economists from Credit Suisse. John Authors, who is a frequent Financial Times and Bloomberg contributor, explores in his weekly blog the importance of commodities as a balance to equities and bonds. And so again, it’s now obvious. In hindsight, everything becomes obvious. Isn’t that the case? It’s now obvious that the 60/40 portfolio was a failure in 2022, and a different mix of assets is vital in a dramatically different environment than we’ve seen in recent decades. And so what Authors points to, John Authors in his blog, what he points to is, we already have the information. You read through the Triumph of the Optimists. You look at the Credit Suisse folks—who do an annual update to that book to give us an idea of how financial assets are complimenting each other, how they’re working, what the inputs were that caused this or that market action—and they come up with commodity futures.

Kevin: Yeah, he was talking about commodities and futures contracts.

David: Yeah.

Kevin: Where was gold on that though?

David: Well, trading commodity futures is the recommendation. And what was interesting to me, looking at at least the notes in his blog, significant chart that places gold above commodities futures in its correlation to inflation. So there are periods of time where stocks and bonds are both suffering from a move higher in rates as policymakers are responding to inflation. And there’s a negative impact to that 60/40 portfolio on both sides. Where do you go for less market-correlated returns and something that is directly correlated to inflation—the cause of the pain on the 60/40 portfolio? And it was just fascinating because the chart is there. He says commodity futures. The chart says gold. And so notable was that silence on the gold piece as a diversifier, even though the barbaric relic was jumping off the pages as the most reliable inflation hedge— And again, he’s drawing from the Credit Suisse report, which was out last week. John borrows from the asset performance yearbook that they published.

Kevin: And they just lump all those commodities together?

David: Commodities are lumped together in the Credit Suisse yearbook, which is an addendum to that original work—again, Triumph of the Optimists, published in 2002. It looks at a hundred-plus years, which is a study of global markets and their returns. I think it’s a must-have in an investment library. Granted, not everybody has an investment library. Not everybody cares. But it’s an important one. Princeton University Press published it back in the day.

Kevin: So let me ask you though, because— 

David: Back to commodity futures—

Kevin: —you do what he says. That’s exactly right. Commodity futures, how do you lump it all together when some are skyrocketing, some are falling?

David: You cannot, you cannot—I mean, you can, statistically. Statistically you can say here’s how commodities performed. But actually being an investor in commodities, and particularly leveraged futures contracts, you cannot do that. Tough to execute. Think about your year-to-date volatility. All right, so copper’s up 5%, lumber’s down 77%. Gold is flat, silver’s down 13½, oil’s up five, natural gas is down 50%—all at the same time. So the way we navigate that as a firm is we selectively own producers. We treat the positions like an accordion. There’s times to own a little, and there’s times to own a lot, based on prevailing macro conditions, company specific developments. 

So on the one hand, I agree that commodities are a good diversifier, but I don’t like futures contracts. And I don’t like the idea that you can treat the commodities complex as one unified thing. They’re all moving on different bases. Because supply and demand are being driven off of unique factors and uses, but I can’t believe gold is ignored. And at least Authors ignores it. To be fair, he ignored it. I’ve gone through the 53-page summary edition, that’s all I’ve read to date. And maybe the 272-page full-length 2023 review shines a better light on gold. So far it’s like, “Really, guys?”

Kevin: Well, and again, this is why you do your own homework. Even with real estate, there are places that seem to never go down. Even if we have a real estate collapse, there are these prime locations. I just wonder if that’s going to continue, going forward.

David: That is the belief. And you could look at Rodeo Drive, you could look at Manhattan’s Third Avenue or Lexington Avenue. The most interesting piece of real estate I ever looked at was on Rodeo Drive. It was a fascinating deal, and it particularly compelling to me because the rent escalator was tied to the spot price of gold, and this was an old lease agreement. The lease agreement had been made prior to gold being made illegal in ’33. This was a contract originally from the 1920s, and it was still in effect.

Kevin: That is brilliant.

David: You’d be basically assuming the old contract.

Kevin: And so rent goes up as much as gold goes up—or goes down, if gold goes down. If you go into a deflation, you get better rent.

David: There you go. It was pretty fascinating, pretty fascinating. But I mean these prime locations: Rodeo Drive, Manhattan’s Third Avenue, Lexington Avenue, also downtown Manhattan. You’ve now got commercial properties in key cities like New York and Los Angeles that I’m pretty sure they’re playing Taps in the lobby and as elevator music. You know Taps. You’ve it played before.

Kevin: I have played Taps.

David: And it’s because vacancy rates are climbing to levels that are encouraging owners to hand over the keys to banks.

Kevin: Because they don’t have tenants, is that it?

David: Interestingly, you haven’t seen much of a price correction. The reset in terms of price has yet to occur. Stress levels are rising with every tick higher in interest rates. I mean, one, you have vacancy rates, to your point, and that’s impacted by work from home trends set in motion by Covid. But you also have certain mayors who have made city living intolerable, and have triggered a flight to suburbia with a lax approach to crime and the prioritization away from policing and towards social services, this way or that. 

I’m not suggesting that solving crime isn’t a complex issue, but what we’ve done in the wake of the George Floyd events of a few years ago is nothing shy of suicidal. So suburbia is just the beginning, and you’ve got even farther relocation destinations where you’re moving to states that still value a police presence. So, unsurprisingly, the cities and states that championed defunding of the police in response to George Floyd protests are deep blue politically, and are moving towards operating deep in the red financially.

Kevin: You just wonder, I mean, it is an interesting measurement because some of these cities really are becoming like war zones. But look at how Chicago has changed just over the last few years.

David: That’s where I got married.

Kevin: Yeah?

David: I was married there in 19— No, our first marriage was there—

Kevin: Well, I was going to say, you keep marrying your wife. You’ve married her three times—without a divorce, you understand. You just keep remarrying.

David: I know. No, it’s sometimes Christians have this belief that am I really saved? And so they just keep on praying the sinner’s prayer.

Kevin: And you’re wondering if you’re really married.

David: Am I really married? No, I am really married.

Kevin: You eloped the first time.

David: I eloped the first time. We had our ceremony— 

Kevin: —weeks later. 

David: It was four weeks later, in Chicago, and then we had a rededication. That was sort of the last chapter of the book in The Intentional Legacy. Something’s done once, maybe it should be done again.

Kevin: Well, I’ve got to tell you, you sent me a picture last night, because normally we meet at Table 23 now on Monday nights, but I was actually on the plane and you sent me a picture. She was replacing me, Dave, at table 23. And I’m telling you, she’s a whole lot better looking than I am. I’m thinking maybe for the Commentary down the road, especially if you go video, you better have her interviewing you, not me.

David: Well, and we’ll just keep the camera there. And she’s wonderful entertainment. She does a lot of musical theaters, so she doesn’t mind the lights and the attention.

Kevin: So back to Chicago, though, I mean, you got married one of the times in Chicago.

David: Right. Yeah, that’s where we were going. The cities within those states that have turned a blind eye to crime, they’re facing, like Lori Lightfoot this week, tough reelection campaigns. Job performance has finally caught up with intersectionality. Isn’t that amazing? Chicago’s sister city could be Tijuana, Mexico. I took the time to look at Chicago’s police crime stats. They’re now ahead of last year’s numbers by 52% on a year-to-date basis.

Kevin: And it was terrible last year.

David: And ahead of 2021 numbers by 102%. So the way I was looking at it was like, Lori must be pulling a Daley and paying someone off to not be recognized as a war zone as bad as, or even worse than, Baltimore or Detroit.

Kevin: So you knew there would be a day of reckoning for these cities. I mean, it had to come.

David: You can’t not support the police and not have a consequence. Is that too many negatives in a sentence? Absolutely. We’re going to get comments on that. A city reckoning is about to occur. 

Back to real estate. You’ve got New York City’s Department of Finance—and this is according to Jim Grant’s Interest Rate Observer—they’ve retained 97.6% of their pre-Covid value. 172 billion dollars was the collective office real estate value prior to the pandemic. 168 billion is the current accounting. Meanwhile, the average market value of high quality office space across the country is down, not 2.4%, but 25% since 2019. And you could be tempted to argue that Manhattan’s clearly immune to decline, it’s deserving of property investment. 

In Europe it’d be like buying property in Switzerland. Prices seem to only move higher, very stable. Of course, you’ve got the rule of law argument there. Maybe it’s recession proof. I remember sitting at a pub in London, a friend of mine from Oxford, whose family is heavily invested in Swiss real estate. That was his claim, and it seems to hold, and maybe it is a truth in a low or zero interest-rate environment. But again, we come back to this longer view. More data on inflation and rates may bring a harsh critique and a harsher reality from the past into the present environment. US commercial real estate repricing is not just about rates. Yes, rates are important, but it’s not just about rates.

Kevin: Dave, my daughter lived in New York for a few years, and you had to get paid an awful lot of money to be able to afford New York real estate. Obviously she did not. So I paid about half. We split it for a couple of years, and it was a good experience for her. But I would imagine that employment would be critical to New York real estate.

David: Well, yeah, and that’s certainly what factors into Grant’s organization. Rates are not the only factor conspiring against that conclusion. You’ve got New York City unemployment that sits at 5.9% versus the national average of 3.4. So the New York City unemployment rate is 74% above the national average. New York State comes in second to last, just behind New Jersey, on a national business climate index. Not exactly business friendly. And now you’ve got the city counselors upgrading their requirements. If you’ve got properties where they’ve had a tenant for a long time and now they’re vacant, you’ve got to make upgrades to those properties. You didn’t have to during the period of time where that one tenant was there. But requirements to upgrade properties following tenant vacancy, they’re creating a conundrum. You can’t—

Kevin: More costs.

David: —recoup the upgrades with an increase in rent. Can’t rent them without fixing the old problems. Which means that owners of some commercial and residential towers would rather walk away than accept decades of negative returns. One illustration was of financing the improvements. Take $60,000 for a unit to be improved—and this is taking off the lead paint and doing this, and put in new wires, and whatever. Finance the improvements to that space, and the monthly cost to finance $60,000 over time penciled out at $400 a month. But you can only increase the rent by $89 a month. The math doesn’t work. The costs simply can’t be recouped. So landlords are thinking more and more about handing over the keys to creditors. These are significant factors. Then comes the bill. Then the bill comes due, $12.7 billion in New York City commercial mortgage backed securities are due over the next 22 months.

Kevin: That’s sort of inconvenient, isn’t it? It’s inconvenient timing.

David: Who wants to keep the buildings when daily occupancy rates are flirting with the 50% level? Refinance then at higher numbers. Well, maybe if you are a hundred percent occupied, you say, “Oh, you know the finance costs, blah, blah, blah. We’ll take it on the channel on financing costs, at least were fully rented.” No, no, no, no. 50% occupancy rates, and then having to refinance at higher numbers, this is ugly. And then the refurb costs, that’s just dead money. And then as we mentioned, crime is driving people away in droves. 

Oh, yeah. Oh, yeah. There’s the property tax assessments, which only seem to soar. It’s sort of an interesting version of statistical chicanery. You get minor declines in market values, which seem to be at odds with the assessor’s office. Values, according to the taxman in New York City, are higher by over 8%. So what’s the lag, I would wonder, what’s the lag from the assessor’s office in the event of a real market decline? Just say theoretically—theoretically—New York catches up to the rest of the country, a 25% decline in the value of office space in Manhattan. Okay, well, that would reduce New York City revenue by $70 billion. You’d be going from 277 down to about 207. Wow! Do you think the assessors are really going to want to reassess at lower numbers for the tax break loss of revenue? Uh-huh. Uh-huh. Real estate owners in Manhattan are in a tough spot for the next few years.

Kevin: Well, and this is exacerbated by the fact that we’re not going to probably see interest rates go down anytime soon.

David: Of course, the other factors above and beyond rates, but rates matter significantly. You’ve got John McClain at Brandywine, he’s a portfolio manager. I guess he handed in his badge with the New York City Police Department, now works for Brandywine.

Kevin: Oh, really?

David: Yes, John McClain. “We don’t anticipate rate cuts,” he says, “in 2023. So that’s going to eventually lead to stress in the riskier segments of credit.” And I think that’s a pretty succinct, “Yep, you’re right.” Even two weeks ago, the assumption was, rates would be coming down, inflation is dead, we don’t have to worry about it. Well, John, I’d say yippee ki-yay. Junk bonds had outflows last week of $6.125 billion. So, to his point, there’s the riskier segment—and this goes well beyond chump change. A six billion dollar outflow from junk bonds in one week is a significant signal. It ties to the Financial Times article: It’s too soon to load the boat on bonds, long bonds, corporate credit, junk bonds. 

In 2023, even though it’s started really strong, may end up having shades of 2022. Strong start to the year, but if bonds are getting punished again as they are likely to in a higher-rate environment, it’s difficult to think stocks can avoid a similar treatment. We have earnings that are under pressure. Mike Wilson of Bank of America suspects that with weak earnings and forward projections, equity prices can give up 20% easily, regardless of recessionary dynamics. In fact, it doesn’t matter one way or the other how you argue the recessionary outcome of 2023, earnings growth doesn’t support current pricing in the stock market.

Kevin: So here’s the question: Where does that leave us?

David: Well, again, reflecting on the past, hoping the insights from earlier times shed some light on the present. Yeah, I love going through the Triumph of the Optimists. Somebody may think it’s crazy to look at 800 pages of the history of interest rates, but when you look at what is happening today and compare it to what has happened in the past. When you compare it to current technical patterns, how all this ends, frankly, is anyone’s guess. But what we can say and what human nature suggests is that it doesn’t end well.

Kevin: I’m thinking about what we started talking about with propaganda and consistency of security, let’s say. You’re talking about these cities who want to defund the police, and now people are moving out. Gosh, who’d have expected that? But there’s an inconsistency there. Would you move to a city that you thought might defund the police?

David: Not a chance.

Kevin: Absolutely not. You’re not going to do that. But what if the city was going along, and very consistently it was a safe city, and then all of a sudden you had a shift. And I’m thinking about that for geopolitics, Dave, because America for so long was so powerful, with the reserve currency status, with the military, that other countries thought that they were our friends, which you brought up earlier in the program. You got to be careful, countries don’t become friends with each other. They may benefit from certain aspects of each other, but they’re not friends, necessarily. 

Let’s just look at Russia and the Middle East. We, at one point, were not pushing Russia into the arms of China, but NATO has been pushing Russia into the arms of China. Then the same thing that happened, you brought it up a month ago, we’ve done the same thing with the OPEC nations. We’ve been pushing them a different direction. 

What is it? It’s inconsistency. It’s like these cities, like New York, who, rents can’t go up, yet the laws are forcing those who own those properties to put more money in than they can actually take in. There’s an inconsistency there.

David: Right. Well, with Russia and Ukraine a year ago, we witnessed the start of the conflict. Russia moved over the Ukrainian border. If we step back from the conflict and see that choice in a broader context—we’ve talked with Orlando Figes to bring some of that context, what’s been developing over time. Well, we’ve systematically isolated Russia from the west.

Kevin: Dr. Friedman told us they’re going to be back in Ukraine. He told us that 10 years ago.

David: Yeah. And so this is a process that’s taken several decades. Now we’re witness to their turning to the east. That part is new. NATO expansion eastward, certainly that’s heightened insecurity in the Kremlin, not a new issue. Putin is meeting with Xi Jinping in the days leading up to the invasion—no doubt with the approval from Xi Jinping—and Xi has extended an offer of friendship without limits.

Kevin: There’s that friendship thing again.

David: Remains an undefined commitment to date, but is consistent with the idea of the new New World Order. The new New World Order is one that deeply discounts Western liberal democracy and the post-World War II power structures that include NATO and the IMF and the World Bank and the US dollar, which has certainly supported US dollar dominance and US hegemony. What the new New World Order prefers is a more distributed power-sharing across the developing world.

Kevin: Well, and that’s why I’d be interested— I have not read that piece that you said was put out by the Chinese Ministry of Foreign Affairs, the propaganda piece that you said there was an awful lot that you agreed with. I want to read that because there is a shift going on right now, and part of it has to do with our inconsistency with our friends. Part of it has to do with the fact that there’s probably, well, the grass is greener. You know how that goes. The grass is greener now to the east than it is to the west.

David: And I just want to be clear on sort of a nuance. There is data within that piece, “US Hegemony and Its Perils” which is factual, but how it’s organized, that’s what becomes problematic. I don’t have to agree with the conclusion to see how they are constructing an argument and see that some of the building blocks that they’re using to construct an argument are in fact a part of the fabric of reality.

Kevin: You don’t have to agree with it to gain information from it.

David: Right. So what does the China and Russia relationship mean for commodity prices? This comes back to inflation. We have within the geopolitical sphere this idea which we’ve explored with Harold James and others that de-globalization is an ongoing trend and is one of those things that adds price pressures, structural pressures to pricing of real things. What does it mean to be a partner without limits? Is there a more direct role for the Chinese in the Russian-Ukrainian conflict? That is being determined right now. 

If the Chinese facilitate violence like we do—although we describe our role as aiding in defense—the world will have some very difficult decisions to make. Who do you align yourself with? Who do you benefit from a trade relationship with? Policy alignment. All these things become very expensive. 

So this propaganda piece by the Chinese Ministry of Foreign Affairs, “US Hegemony and Its Perils,” I agree with aspects of the piece. Narrative organization is more than facts. It’s storytelling with a purpose. And the purpose woven into this narrative is deliberately deconstructive. It’s worth a read, but with an eye to understanding how and who the Chinese are playing on the global chess board.

Kevin: And that brings us to energy because we started feeling like we were energy independent, even an exporter of energy, and we forgot that we still need OPEC.

David: It’s a glaring mistake in DC, which— We’ve assumed that current US crude and natural gas production, and what we’ve developed over the last decade, which obviously ended our dependency on OPEC member imports—put us as a net energy exporter, in fact. But in the process, we’ve devalued our Middle East partnerships and we’ve pushed many of the OPEC members in the direction of the Chinese. We’ve perhaps neglected the value in those relationships in the future when decline rates have taken a bite out of energy independence in the US, and in the future negatively impacted our gross energy production—left us out in the cold. So we’re not playing a long enough game in terms of our energy strategy. Allowing the Middle East to shift towards China also opens the possibility of a real use of the yuan, or the RMB—what they might call the petro-yuan—eroding the power of the petrodollar.

Kevin: I cannot help to go back to that story that you told about that property in Rodeo Drive. And the reason I can’t help that, I would love to know the guy who set that up because speaking of uncertainty, uncertainty does remain. But what do you do— Okay, you wrote the book, Legacy. What do we try to teach our clients? If you don’t know what the future holds, you better have some gold. And that property on Rodeo Drive, this guy was basically like, “You know what? We’re always going to be able to have enough rent increase or decrease to pay the bills.” Because what does gold do? Gold consistently holds buying power value—and to tie the two together, I’ve never heard of that before.

David: Well, I think we always look at these macro problems. Inflation’s a macro problem. We’ve got lots of things that you can consider macro problems, the geopolitical issues we were just discussing. But the solutions are micro, and that’s the argument that I made in The Intentional Legacy, is that if you want to set yourself on a different trajectory, don’t assume that a big problem has a big solution. You got there over time, and you aggregated lots of mistakes, and now you’ve got a big problem. But it’s a long journey to fixing it.

Kevin: And what are you going to do about it for your own family.

David: Right. So micro solutions to the macro problems. Does gold ownership make sense in the context of inflation? Absolutely. If you look at how we view our friendships in the world, I don’t know how we engage the Chinese and the Russians. But I’ve always taught my kids: to have a good friend, you have to be a good friend. That you can own, that you can choose, that you can put in motion.

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.

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