The Crowd Is Always Right… Right?

Weekly Commentary • Jul 26 2023
The Crowd Is Always Right… Right?
David McAlvany Posted on July 26, 2023
  • CNN Greed/Fear Index Hits “Extreme Greed” Mark
  • Powell Dilemma – Fuel The Flame Or Cause A Panic?
  • A Full Year Of Inverted Yield Curve & Still No Recession

The Crowd Is Always Right…Right?
July 26, 2023

“We’ve abused the debt system globally in a pretty severe fashion, and we’ve gotten away with it because interest rates have been so low for so long we’ve forgotten that if interest rates rise, it’s a very different outcome. You can continue to increase the quantity of debt that you have if interest rates are irrelevant or they’re becoming easier as time goes on, lower rates. But if they begin to move higher, well, that’s a bit of an issue. I extend that thought in terms of GDP, and the real source of China’s surging debt is GDP growth targets that are too high, they exceed the real growth capacity of the underlying economy. Watching the commodities market, watching the oil markets for a clue to where inflation goes next means that watching China and its policies relating to GDP targeting is really key.” — David McAlvany

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

I always enjoy talking to you this time of year, Dave, because there’s a group that you have been invited to talk with and meet with, I think for eight or nine years now. I think 2015 was the first time that you attended in South Africa, this group, and I asked you, “Is this a think tank? Because you love being around these people.” And you said, “No, it’s not really a think tank. It’s better than that. These people are actually based on action, praxis, not just thinking, not just writing papers, not just presenting papers.” But then, like you said, rolling up your sleeves and getting things done. So today you’re in San Diego, but in the past these meetings have been in South Africa, Singapore, Switzerland. I think you had one year in Vail and another in Jackson Hole. So they at least pick nice places to meet, don’t they?

David: Yeah. One of the unique things about this group is that they are, as you said, very interested in action, and there’s no experts that come and speak. There’s a group of professionals in a variety of fields that come together and collaborate and try to create solutions and then put them into action. So a pretty unique group. This year, I think is the largest yet, about 260, 270 people, which 10 years ago there was maybe a dozen from all over the world. And I’d say they’re predominantly business people, but very concerned about what they see and how they can impact certain issues globally.

Kevin: And it actually has impacted us as a business, Dave. Some of the acquaintances you have made have turned into business partners. And so, it’s a long-term philosophy applied to the day-to-day. And I was thinking about this. As we look at the markets today, you have to really have a long-term philosophy when you’re getting mixed signals in, like, the economy. You have to be careful that you stick with the long-term philosophy and not compromise that based on the events of the day.

David: I think there’s a number of things that you could almost say “outside of time.” They’re not outside of time, but because we live in such a short-term, nanosecond, with that kind of perspective. When you step back, there are some charts which give some insight into what is going on, and it’s almost as if you’re stepping outside of time. 

Oftentimes, we’ll look at the Fed’s balance sheet and it’s expanded from a few hundred billion to over $8 trillion, that’s how much they acquired going back to 2002. Of course it accelerated rapidly after 2008. And some of the chaos that we saw in 2002 was a result of the shrinking of the quantity of money on their balance sheet. And that’s the challenge, is they’ve produced and introduced a lot of liquidity into the system. We’ve seen the benefits of that liquidity in the system. And then all of a sudden, as they’ve tried to take it back, it has an impact. There’s really no surprise to them.

Kevin: And that’s really where the mixed messages come from. You can make something look really good with printed money, liquidity. You were talking the other day and you said, “Yeah, just devalue your way to success,” and that’s easy to do, but the problem is, at the time there’s an awful lot of money flowing into things that we’re not quite sure have quality. Look at the performance in the U.S. equities market right now, and all the mixed data that we’re getting as far as the lack of quality.

David: Yeah, I mean, performance in the U.S. equities market year to date has been exceptional, and sentiment reflects it. As my colleague Morgan Lewis reminds us this week, measures of market complacency and sentiment are, well, they’re almost always contrary indicators. So if you have euphoric optimism when that prevails, you’re typically near a market peak. And if you have the opposite of that, pervasive pessimism, if that’s what reigns, you may be very near a market bottom.

Kevin: So the question is, where are we now?

David: And there’s a couple of measures for that which are helpful. The Investors Intelligence Bullish Percent Index, an index that measures just how bullish investors are. It has now exceeded the levels recorded in 2021, at the all time market peak. That’s for a broad measure of investors. There’s also the American Association of Individual Investors, and that bullish percent index has now exceeded their levels during everything bubble. Roughly the same timeframe, but when all asset classes were booming and there really was no reason to be pessimistic and everyone was an optimist because everyone was making money in everything that they touched, lo and behold, that sentiment measure right now is back to those same levels again, circa 2021. And then, of course we had the Covid stimulus, which lit a fire under all asset classes, sending them rising in sort of this concerted plume, only to dissipate in reverse in 2022. 

So again, these are just sort of sentiment measures. The CNN Greed and Fear Index this week has hit the extreme greed territory also visited at the enthusiastic peak. And this is— We got to the enthusiastic peak following the $4 trillion to $5 trillion in Covid-era stimulus. So I wanted to start with that reflection on the central bank balance sheet because the amount of liquidity that’s come into the system has certainly influenced how people feel. And it was as that liquidity started to drain just a bit at the margins that we had 2022 and prices begin to reverse. 

So some view this move in stocks and bonds year to date as a new bull. And who knows, maybe in time they’ll be proven correct. But others view the short and the sharp price reversals to the upside—again, the fast recovery of sentiment along with it—as sort of that echo of the copybooks, The Copybook Headings, if you remember that ancient poem, but more akin to the, “burnt, bandaged finger wobbling back to the flame.” So I’m sure you can guess what camp I come from.

Kevin: Right. Well, you’ve been burned.

David: Well, any investor who’s been in the markets for any amount of time at all has lessons that they’ve learned, and they’re generally not learned an easy way. So we’ve got short covering dynamics, the manic behavior in the meme stocks, they’re also suggestive of a less than substantive move. Look, it’s a meaningful move. It’s an energetic move, certainly, but is it sustainable? That’s the question.

Kevin: And a few weeks ago you said you really yearn to be a bull. I mean, it’s much more fun to be a bull. But also, something rhymes with yearn and that is earn, and the earnings of these companies don’t necessarily show that the justification for the stock price is there.

David: That’s exactly right. If I want to be bullish, that’s one reality, but it’s tempered by the quality of growth. And that’s worth reflecting on, the deterioration in earnings guidance as we’re getting through the earning season. And the reality, Kevin, of lagging effects of monetary policy tightening are yet to be fully evidenced. We’ve seen some impact, but again, I’m in debt to Mr. Lewis—Morgan this time, not Clive Staples—his comment a few weeks back that likened the trend in the financial markets to a microclimate creating its own weather. A little bit of positivity and just everything becomes positive. It’s sort of like a feedback loop. 

But where did this come from? Post-bank debacle and the stimulus that came out of that back in March and April, I mean, you had the FHLB, Federal Home Loan Bank, and Fed balance sheet re-expansion counting to over a trillion dollars and creating its own positivity. Reflexively, a powerful surge in price. It sets in motion a certain relational dynamic. 

With the stimulus, first came short covering. Okay, so you get the stimulus, then you’ve got the short covering, the Goldman Sachs Most Short Index is now up 35% year to date, just trailing the Nasdaq-100’s meteoric rise to the low forties, 40% higher—which means it might even make up for all of 2022 losses and get to breakeven. Keep in mind, if you lose a third, which it did in 2022, you’ve got to be up 50% to put it back on. So you’re almost to breakeven if you’re a Nasdaq investor. 

So first came the short covering, then came the FOMO, the fear of missing out, with investors needing very little encouragement—but they got it. Where’d they get it from? The AI craze. AI is going to change everything. 

Now, this is an interesting thing because AI’s been with us for 30-plus years, but it’s just now captured the imagination. The launch of ChatGPT obviously is helpful for that. I’ll make note, a part of our getting to know you exercises at this conference, which began last night, was writing a poem using ChatGPT. And so, we’ve done a variety of things, capturing economic themes with the purpose of the meeting, and then setting it either in haiku form or, if we wanted, we could choose iambic pentameter. I originally experimented in the style of John Donne, but with the whimsy of Dr. Seuss. 

So, I think one of the reasons why there’s a craze with AI is there really is— It’s fascinating when you can scrape all the data in the world and you exist sort of in a wild, wild west, where that is not regulated today. And media companies are not being compensated for the content they’ve created that is being used and reconstructed. Neither are academics. This truly is an unregulated space, which won’t last long. There’s a reason why it’s captured the imagination. 

So again, I digress. First came the short covering, then came the fear of missing out fed by the AI craze, and now, finally, we have an expansion of breadth in equities, with a broader list of names benefiting from investor interest.

Kevin: Well, and I think that’s important because we’ve been talking about this stock market rise this year being led by anywhere from four to seven stocks. What you’re saying now is the breadth is spreading out. There’s more money coming into more stocks.

David: Yeah. And in some measure that’s due to the necessary recalibrating of the cap-weighted indices. In other words, if you’ve got these indexes which disproportionately allocate funds to just the top names, and it gets to the point where it is an absurdity, and the managers of these indices see it as an absurdity, last week they rebalanced, and that’s a process they’re going to have to probably engage with again if this continues. 

But it takes these—a literal handful of five names’ too bloated allocations, and begins to broaden them and spread it out. So the effects of monetary tightening may be in the pipeline if we look at what we have coming through the rest of the year. Bank lending may still reflect the increased cost of capital as the year unfolds. And financial conditions are at this point pretty loose insofar as abundant liquidity continues to inspire speculation and promote risk in most investment categories. If you’re talking about stocks, bonds options, these are the big winners if you’re willing to take risk and feel emboldened by that abundant liquidity. A trillion plus, short covering, momentum, I mean these things kind of take on a life of their own, going back to Morgan’s comments that it’s sort of a microclimate creating its own weather conditions.

Kevin: Well, and we’ve seen that a number of times here in Durango when we have forest fires. You’ll see a thunderstorm coming, and if it’s a dry thunderstorm, that lightning can strike and create a large forest fire. But then, that forest fire actually starts creating its own cumulus clouds and its own lightning, and it feeds on itself. So it has nothing to do with what the weather actually—the macro weather—would be doing. That microclimate in itself is creating its own weather. 

Now, let’s just look at this though for a moment because neighbors that I’ve had for the last 25 years now, they were original in the neighborhood that we’re in, they’ve moved out. They were able to sell their house. And we’ve had other neighbors able to sell their houses this year. So let’s look at real estate a little bit, because I think personally, I was looking for more of a contraction in the price. It looks to me like real estate’s doing okay.

David: Yeah, I mean, it just depends on the sector within real estate. Commercial real estate remains an exception to that positivity. Defaults on loans continue to increase in number. The greed factor is in a holding pattern. Not a lot of opportunity there yet. And so, the vultures are circling, but have yet to land. I think they’re waiting for the wounded to rise in a death rattle. I see a few more additional losses and you’ll see Blackstone start deploying capital, and then the feeding begins. So private equity groups are raising capital for that purpose, but picking the meat off the bones has yet to occur. 

Other forms of real estate remain pretty steady given the wonky supply dynamics. And a part of this is, if you locked in rates at 3%, you don’t want to move and then be forced to be in a position where you’ve got double the payment because your interest rate is twice what it once was. So there is sort of this weird temporary supply issue or concern within residential real estate. But commercial is reflecting the impact of tighter financial conditions and increased rates, and that’s already playing out. So my guess is that at some point we begin to see an impact in residential as well, but time will tell. Far less inventory is available there. And so, in spite of elevated borrowing costs, prices have held pretty steady.

Kevin: So back to the microclimate: if you were actually underneath that cloud—obviously you wouldn’t want to be in a forest fire—but if you’re underneath that cloud, you’re going to be thinking rain, you’re going to be thinking lightning. You may actually, though, if you step out, realize that the weather’s very, very different everywhere else. I remember flying over a forest fire with a civil air patrol and it was a perfectly clear day for hundreds of miles as we flew over the Mesa Verde fire, but the Mesa Verde fire had its own climate. 

Now, the reason I bring that up is this, not only was it feeding on itself, but the lift coming up out of that heat was amazing. I mean, talk about tossing about in a Cessna 182, it was like being in the firestorm ourselves. And so, my question is, with all these asset classes that are performing as if there’s no threat to Powell raising rates any further, is this a microclimate, and should we react differently now, or are these long-term trends?

David: This is again where, if I referenced back to, we started with a Fed balance sheet, and this being something that is sort of behind the scenes, but very much important and present. Another thing that’s sort of behind the scenes and important and present is what we talked about last week, Louise Yamada’s comments that this is it. We’ve turned the corner. Only if the 10-year Treasury dips below 2%, stays below 2% for any period of time, would this trend negate it, if you will. What is the trend? Interest rates, when they move higher, they move higher on a very long period, and the period is decades, not quarters. And so, the notion that March 31st of 2020, with a long bond getting to 99 basis points and then turning up now, no, we are not done. And the assumption that equity prices are going to get considerably better as the Fed reverses course. And perhaps this week, this week as the Fed announces one more increase in rates, will this be the final move? 

Again, I think you need context. If Yamada is right and rates are moving higher, not just for a year—and of course they don’t move straight higher, they will move higher and then give up some ground, and then move higher. It’s that jagged movement one direction to the other. Directionality is the key here, and sussing out what that is is really important. I think when you look at the asset classes, how they’re performing—and again, we’re talking about the ones that are sort of spastically up—it reminds me. I’ve got kids, you’ve got kids—not young anymore, but you can remember back. With a sugar rush, you give a little bit of candy and it goes a long way. There’s this frenetic, enthusiastic, mad with excessive energy, but it’s on the clock. It’s on the clock, as in, when they crash, they crash hard. And you can remember the scene, cheap sugar calories flowing through a miniature human form creates this sort of carnival-esque, bouncy ball type activity, and then all of a sudden it just dies.

Kevin: And that’s the question with the economy right now. Okay, we’ve got this— You’re right, you’ve got this sugar rush that seems to be going on in certain classes. So we were talking possible recession this fall. Has that changed?

David: The narrative of that has changed. With price action up, the narrative of eminent recession has already itself receded, and in its place comes the justifications for this fledgling bull trend. But I would say be careful. I would say be very careful. The childish sugar rush is as entertaining and as fleeting as a firework explosion. It’s impressive. It’s moving. But it’s almost immediately over. There’s such a short-term nature to it.

Kevin: Well, and we do have indicators that have been very accurate all through the years, like the yield curve. How long has the yield curve been inverted and we still haven’t had the recession that we’ve been talking about.

David: On our team, there’s lively debate and conversation about what are the meanings of the data. Because sometimes the data, we think, “Oh, well, here’s the data,” but there is always this interpretation piece. And if you’re a literary critic, if you’re a scholar, you know that the text is not necessarily just the text. So there’s some disagreement even on our team about what the inversion of the yield curve means. 

Classically, the yield curve inversion was a sign and was symptomatic of what was going to happen in the economy a few months hence. So the fact that we’ve had a yield curve inversion for over a year, classically, that’s been a pretty good predictor of a recessionary dynamic. And so, maybe we’re in this new phase, this time is different, where with the full year of an inverted yield curve and now 14 months of the leading economic indicators pointing to recession. I mean, that’s 14 months in a row. You get one or two months and you pay attention. Fourteen months in a row, it’s kind of, “Nope, it’s in the pipeline.” And of course this is following a 500 basis point increase in rates, five percentage points off of the lows. 

“This time is different. It’s not going to happen in 2023.” That’s become the narrative. I guess that’s become the hope, and the projection into the marketplace is that because it hasn’t happened yet it’s not going to. And every day that goes by emboldens that notion that, “Okay, this time is different.” 

And I can agree, there are a number of puzzling counterclaims to the data which are positive and point to a relatively strong economy. And certainly, when you’re looking at the U.S. economy, there’s greater strength there than there is in the overseas markets. We’ll talk about China in a minute, because frankly I think the externalities—and this is one of the key takeaways from our conversation today—the externalities as it impacts U.S. rates market and U.S. inflation are considerable. And China plays, I think a significant role in this. 

But as I speak with folks, the only data that matters to them seems to be performance. As you said in last week’s show, Kevin, “Show me the money.” Facts and fundamentals, they’re of secondary importance when set next to the feelings of rolling in the dough. If portfolios are up, very few ask if they’re up for the right reasons. If portfolios are up, they don’t want to know if the trend is sustainable. That’s assumed. Yes. So why worry about tomorrow when today offers a reason to celebrate?

Kevin: Yes, but Dave, the years that I’ve been here, I remember 1987, the summer of 1987 before the big crash in the fall, that was the feeling that people had. I mean, there was no reason for the stock market to come down. You remember the first couple of months of the year 2000, January and February of 2000, things were just flying. Right before, you talked about the Nasdaq breaking even, coming back and breaking even. It took 15 years for the Nasdaq to break even from that crash. Are we not seeing similar dynamics that we saw with previous bear markets?

David: Well, that’s right. And during that Nasdaq sell off, you’re right, it took 15 years or whatnot to get back to break even. There were a series of rallies. I forget if it was four or five, six different rallies. And those rallies were between 20% and 50% higher before we ended the trend down as much as we were. So similar dynamics were also present as we replay the reel from other bear markets as well. One shoe drops before the other. And the interim period of gains, which relieves tension, encourages investors to come back in, and takes away the balance sheet strain for corporations. Investor nervousness dissipates, that serves to invite the average investor right back in.

Kevin: I have to remember, Dave, do you remember when you entered the water and they had warning signs about the jellyfish? What happened there? It’s a vague memory, but I think you got stung, didn’t you?

David: We don’t always remember correctly the past. I don’t think it was the trauma of the box jellyfish sting. Was it so nice outside that I didn’t see the flag because it was sort of flaccid and not flagging in the wind? Or did I see it and just ignore it because I’d been swimming the day before and it was perfect and it was beautiful and the water was a lot warmer than it is in Colorado? This is out in Hawaii. I think the flag was there. I think the true telling of the tale is, I knew I shouldn’t be getting into the water, but I couldn’t help myself.

Kevin: But it was so—

David: The water seemed calm, the clear blue skies just too much to ignore, “Dip your toe in the water. No, dive in.” And I swam for probably half a mile before all of a sudden I had this— It wasn’t really a tingling sensation. It was like fire.

Kevin: It was kind of a big deal. I remember that. Okay, so this week, I mean, because we’re all wondering whether Powell is going to say, “Yes, we’ll raise the rates, but we’re going to call this the last one,” what’s this look like?

David: Well, one more comment on the box jellyfish. I’ll try to avoid them this year, but my daughter’s been in the Philippines with my parents for the last two, three weeks. Great one-on-one time with them, and just getting to see the orphanages and spend time with some of the kids that they live their lives with there in the Philippines. And hazard duty for me, again. I mean, it wouldn’t be hazard duty for most people going to Hawaii, but halfway between the Philippines and Durango is Hawaii. So I volunteered. It’s tough work, but somebody had to do it.

Kevin: You’re going to go meet them there?

David: I volunteered. There’s a little baton pass. So I’ll pick up my daughter there. I think I will do a little bit of swimming, but I might, this time, pay attention to the red flags.

Kevin: Check the flag.

David: Okay, so you’re right. This week the Fed meets to raise rates again, and the market’s chief concern is to discern if this is the final move. And that’s what they want, that’s what they hope for, and they’re going to be parsing every word to get what they want. “What does it mean? What does it mean? What does it mean? Okay, we’re done, and we’re going back to the gravy train. We’re going back to cheap rates. There’s going to be no more pressure.” 

Keep in mind the pressure that they’re thinking of has yet to fully be implemented, and I think the best evidence of that is a comment from the Bank of International Settlements. Their chief economist did a study and said, Look, we’ve got non-financial debt of $250 trillion, with a T, 250 trillion. The real concern here is that we have yet to see most of that debt roll over. So we don’t have the impact of higher rates filtering through the economy. We haven’t had the slowing effect. We haven’t had the “tightening of financial conditions” that you would expect after this high of a rate increase. 

$250 trillion in non-financial debt, which, if rates remain at these levels for any period of time—again, they don’t even have to go higher—if they just maintain these levels for any period of time, another three years, two years, you’ll see the rollover occur. What I mean by that is that the debt will have to be refinanced, but it’ll be done at a higher rate. And the effect is the interest cost will be between $8 trillion and $9 trillion, the equivalent of the number three and number four economies, and that’s a new burden for the global economy to carry, a lot of interest payments. 

And so, I think it’s worth keeping in mind this sort of higher for longer. Powell could this week materially tighten financial conditions, but it’s not going to be because he raises interest rates by 25 basis points or surprises by 50. It’s by the warning. It’s by the warning of more increases to come. The market wants to see him say, and wants to guide him towards, “We’re done and it’s moving lower,” right? Confirm that. Right? Or he could, if he wanted to, increase the tension within the markets—and I think it would be a healthy tension, because ultimately we have to resolve inflation, and there’s one way and only one way of doing that, and it is a true tightening of financial conditions. If he mirrors the market desire for lower rates sooner rather than the higher rates for longer, the theme that we’ve spent some time talking about in the Commentary, asset markets are going to boldly march towards new highs. If he accommodates the market, then we’ll take out the old highs. And the short covering and the FOMO and the momentum that’s in place now will continue. I think it’ll be really interesting to watch. 

This is a week which may make the history books because he has the opportunity to either take the radical bullishness and temper it, or feed it, and I don’t think that would necessarily be healthy. So Powell needs market conditions to tighten. That’s the reality. That’s what he needs. But he needs to do that without creating panic, without creating a disinflationary unwind in either the stock market or the bond market. That’s a tall order given the amount of liquidity that’s still in the financial system. 

And I referenced the central bank balance sheet, but just looking at another pool of liquidity, if you will, just as sort of a proxy for there being too much money in the system: excess reserves of depository institutions held at the Fed. It’s still north of $3 trillion. This is a number that used to be less than $50 billion. There was virtually nothing held at the Fed. There’s just too much money in the banking system. There’s too much money in the financial markets. And that’s one more insight, if you will. North of $3 trillion sloshing around. There are other measures of excess liquidity, but each of them point to too much money being in the system. The catch-22 for the Fed is that if you take away the liquidity, if you take that away, you take away the sugar buzz. And then it’s blues and bust that define a market with less liquidity.

Kevin: As he looks at inflation, which is what he’s supposedly fighting right now— We’ve talked about mixed signals. Commodity prices can cycle up and down for different reasons, and that can fool the inflation number. I mean, it does look like inflation is slowing right now, but could it be just in the commodities?

David: It seems to me, Kevin, sometimes we care more about the algorithm than the elephant. And the algorithm is maybe what defines AI and a reason to think positively about market performance going forward. But the elephant in the room, it’s that thing that can step on you. And we’re so consumed by the elegance, the sophistication of something that exists in the ethereal, behind the scenes, the ones and the zeroes of programming. The elephant in the room is a big deal, and it’s the physicality. It’s where we actually live our lives, and what drives the global economy, which is, to your point, real stuff. 

Inflation appears to be ebbing, here’s a critical point. But I think we’ve got to keep the elephant in mind. There’s this critical piece in the framework. We talk about rates, we talk about asset prices, we talk about recession, the potential of recession, of when and to what degree it’s there. 

Powell knows that there are ebbs and flows in the data, the inflation data. He also knows that commodity prices have provided relief of late. Lower commodity prices equals lower inflation, both in lockstep. But he can just as easily see the increase, the rise. And so, in spite of the Bureau of Labor Statistics’ manipulation of the CPI basket, commodity prices are something that influence inflation well beyond the reach of either monetary policy or statistical chicanery. It’s going to be what it is. The elephant in the room is the elephant in the room, regardless of the algorithm. 

“Watch the energy markets.” We’ve said this a couple weeks in a row. Watch commodity pricing. The unwind of this goldilocks scenario and the equity market checkmate, if you will—what brings this rally and makes it seem almost like an echo of the move that we had in 2021 just putting in another grand super-cycle top—I think you’re looking at the demand for commodities in the second half of this year, which may come from the one place that the market has now discounted as a dud: China. This is sort of the major theme here, is the externality impacting the markets. Instead of the market internals improving, we’ve got an externality, which is key.

Kevin: And something you’ve pointed out through this last year is that China is slowing down. So how does China play a card when they actually are experiencing slowing? You’re saying that that could actually be where we see the commodity demand comes from?

David: Absolutely. Economic numbers from China, they continue to weaken. So of course you could say, “Why worry about a resurgence in Chinese commodity demand as a trigger for an upward trend in commodity prices, ergo, inflation here in the United States (and of course this impacts the globe)? Stimulus, baby. Stimulus. The Chinese government is likely to resort to rank money printing and credit creation as a means to an end. Stimulus promotes the ultimate objective in the plant economy. What is the objective? Hit the targeted GDP number. There’s no compromise on this.

Kevin: So it goes back to what we were talking about when you recently said devalue your way to success. You can print money, stimulus, and that’s what we talked about is happening to a degree here. We’re swimming in liquidity still. China has to create the liquidity to actually hit the GDP number. That sounds like cheating.

David: But it doesn’t matter because you’re talking about trade-offs. Everything in life has a trade-off. And in previous conversations we’ve looked at youth unemployment being at record levels. We’ve talked about the 11 million college graduates this year, which are going largely unemployed in China. The economy in China is not healthy. And so, you look and you say, “Well, how do you maintain social order?” You can look back through time and say, “There’s a variety of maintaining social order.” You can line up the resistors and the rebellious and just shoot them, or you can resort to bread and circuses. 

The first half of 2023, economic performance in China has been anything but stellar. That means that to meet the GDP growth targets for the full year, China will have to compromise on the quality of growth. Focusing on quantity, which in the past has meant two specific things. Either they subsidize the good sector, that is provide liquidity and various subsidies to the manufacturers, or—and/or, they could do this as well—infrastructure spending. This has been the gambit for 15, 20 years. But it doesn’t mean that just because it has not worked as effectively as they hoped it did— It doesn’t mean that because the dog has fleas that somehow you don’t love the dog or go back to— There’s even talk at the PBOC of direct stimulus to consumers. So that’s sort of the third leg of the stimulus stool.

Kevin: Just handing out money?

David: Yep. Tempts fate with consumer price inflation, like the world saw very dramatically as a result of the stimi checks in the Covid era, certainly here in the U.S. But keep these things in mind. If they’re going to hit the GDP target, the stimulus has to come from somewhere. Subsidize the good sector, which could very well be the devaluation theme. Again, if you want to capture global market share, devalue the currency and your goods become far more competitive, and you capture that market share. So maybe it’s that. I think very likely it’s the infrastructure spending. And again, it’s like breaking a bad habit. We thought we broke it. Well, there it is again. There it is again.

Kevin: Yeah. We see so much control with the Fed here, and we’re supposedly a free market economy. You can imagine, if you’re the guys planning the economy in a communist type economy like China has, GDP, that’s a big deal. You either hit the number or you hit the number, but you’re not going to miss it. You’re going to do whatever you need to, because it’s a planned economy.

David: Yeah, communist era, you had a certain kilo weight to deliver in televisions, and so it wasn’t about increasing production, it was about introducing bricks into the back end of the television so you could meet your objective. It ultimately creates distortions and unhealthy things. 

But Michael Pettis discusses the first quarter growth year over year. And Pettis is a gentleman who’s been on the Commentary a few times. He traded emerging market debt. Really sharp guy, teaches finance at a Chinese University. And I remember the last time I was in Beijing, he had a nightclub, and he’s a music aficionado. Anyways, very interesting guy. Looking at first quarter growth year-on-year, and China comes in at 4.5%, far better than the previous quarter. And then comes this most recent one, Q2, not as good as planned. Annualized at 3.2%. So it creates a blended rate, a GDP growth rate which is below the full year expectation. So again, we’re saying China is important for the U.S. stock market because they may very well stimulate and create inflation as a result of that stimulus. So keep in mind that step sequence. 

In a planned economy, not hitting your number is a big deal. For us, GDP is just a reflection of household activity between, well, three areas: household activity, corporate activity, and government activity. In China, it’s those things plus a measure of central planning muscularity. Move the number, hit the number, do whatever it takes to achieve the objective. And Pettis comments that not only is the quantity of growth less than desired, but the quality is quickly slipping. Retail sales, which are often a proxy for consumption, that’s decreasing. Which means that for the Chinese to come close to meeting their growth goal, they will try. Growth has to be stimulated in areas that are less than ideal—the two categories I just mentioned: subsidizing the manufacturers who build and export stuff, or fund infrastructure projects. 

I guess one of the reasons why I’m focusing on infrastructure is because we already have exports which are shrinking—shrinking as the global economy reflects recessionary tendencies. So you can’t produce more stuff if there’s not someone on the other side of it to consume it, and that’s what they’re finding. Exports are off 3% year to date, imports are off 7% year to date in China, so demand outside the country is not in that category of controllables—things that they can really have a direct influence on—unless they want to radically devalue the RMB. The only two places policymakers can go is household stimulus or public sector infrastructure investment. 

What are they going to choose to try to counter weak domestic demand? Will it be household incentives? I don’t know. Are they comfortable tempting fate with consumer inflation like we did here in the U.S.? Nothing’s guaranteed, by the way, when you look at helicopter money and the handing out of stimulus. The populace might choose to increase savings rather than spend the handout. So you could put it into the system and it doesn’t get all spent. Notice, that’s still happening here in the United States. Excess reserves of depository institutions at $3.2 trillion is something of an indication that the stimulus money was not all spent and it’s just sitting there as a liquidity wave yet to hit the markets. 

The other is large deficits. You leverage the system if you’re going to do infrastructure spending. You don’t necessarily have the money to do it, so you just go into debt. Leverage the whole system more in an attempt to cement the GDP growth success story. And again, there’re no compromise on this. It’s the number, we’re going to hit the number.

Kevin: Well, and you can also hit the number just simply by devaluing your currency. They become that much more competitive just simply by devaluing their own currency.

David: This is pretty interesting because there’s more and more policymakers—and I think it’s because they’re concerned about their domestic economies— So set aside financial market fragility and the potential impact of inflation and the knock-on effect that would have for central bank policymakers keeping rates higher for longer to thus deal with it. I think you’ve got politicians who are looking at the global economy, many around the world, and they see slowing activity and they’re feeling a bit desperate. And it’s not uncommon when you see a slowing economy to say, “Well, just because I’m slowing and you’re slowing doesn’t mean we both have to be slowing. If I devalue my currency, I can capture your market share and then you’re slowing, but I’m not, and I stay in office as a politician.” It’s very pragmatic. 

But a growing audience of global goods producers is revisiting the merits of currency devaluation, and they’re considering it as a means to capture export market share. So 2023 and 2024, central planning pragmatism may include measures which would—I mean, for the sound money crowd, it’ll shock them. Devalue your way to success, compete for a larger slice of a shrinking global GDP pie, employ more people at the expense of currency stability. It actually computes, particularly for a politician.

Kevin: So what you’re talking about is government spending, basically. In other words, managing this thing by giving money away. What are private investors doing in China right now?

David: Right. You’ve got corporate investment, you’ve got government investment, you’ve got private investment. And so, going back to China, private investment is shrinking, fixed asset investment is increasing. Again, that’s infrastructure, publicly directed projects. That’s already reflected in the year-to-date statistics. So we’re just saying that these trends will continue, and continue in the same direction. Public sector borrowing, public sector spending will have to fill the private sector gap regardless of the quality of growth that it creates. 

Again, nobody’s under the illusion that creating bridges to nowhere is somehow productive, but it does create jobs and it does mean that money’s flowing through the system, regardless of the long-term impact of overbuilding and overdeveloping. On the face of it, you look and you say, “Well, that’s absurd. Ghost cities, we’ve done this before. Why do this again? Didn’t we learn our lesson?” But again, bad habits. You’d think we all learn our lessons, but bad habits are bad habits.

Kevin: So how does that tie in here in the United States? We’re looking at a Powell decision on raising interest rates. How does that affect us here?

David: Yeah, tying it to inflation and to U.S. interest rates, and then I think really what is the second shoe to drop in the U.S. equities markets. If the Chinese are forced towards infrastructure expansion, and to a degree household stimulus—again, helicopter money—the commodities markets are going to revive dramatically. And not because of supply side dynamics. That’s happening already, regardless of what happens on the demand side. But we’re talking about a strong source of marginal demand for commodities. 

We began to see this, if you go back and look at a commodity price chart, let’s say the Bloomberg Commodity Index, you can see a resurgence in pricing in the October, November, December timeframe last year. And this was sort of getting in front of what was going to be the Chinese reopening. As soon as we saw lots of activity of one sort or another, then all of us commodity speculators were like, “Well, this is going to be great.” So we did that and it’s since receded. So commodity prices have come way back, energy prices have come way back, and we’ve been the beneficiary of that. In the last CPI print, three of the big indicators, 20%, 30%, 35% lower in terms of the energy inputs, and that’s really given us a free pass on the inflation thing. 

So go back to October to December, that timeframe, major increase in prices for commodities in anticipation of the Chinese Covid reopening. Now, we circle back around to global inflation dynamics and global central bank policies, the Fed included. Basically, we’ve had an increase and then a decrease, and now I’m saying that there is the potential for another increase in commodity pricing, with energy being a big part of that. 

So whether it’s oil, gas, industrial commodities, it can very quickly reverse, and what was just over the last few months an inflationary ebb, which would signal to the Fed, “Maybe you don’t have to continue to raise rates,” it can become an unwelcome inflationary flow once again, with inflationary pressures re-exerted and pressures returning just as investors here in the U.S. are enthusiastically assuming that rates are going down, financial markets are going to continue higher, we’re in a new sustainable market. The surprise is, “Wait a minute. Where did inflation come from? I thought we already won that fight.” And thus, interest rates have to stay higher for longer.

Kevin: I’m still thinking about that GDP, just pushing GDP by pushing money into the system. Yesterday I was checking something on my bank account, and you’ve got the two columns. You’ve got how much is coming in and how much is going out. And I looked at a six-month period, and because of certain expenses, my outlay is larger than what has come in. It’s not huge, critical, because I understand what’s going on. But what you’re saying is, if China were looking at their bank account as far as actual productivity versus what they’re spending, their GDP shouldn’t be rising right now. Actually, their outlay is more than what they’re bringing in. Am I reading that right?

David: Well, maybe the better way of saying it— Pettis, I think, captures this pretty well, “the real source of China’s surging debt is GDP growth targets that exceed the real growth capacity of the underlying economy.” That’s what Michael says.

Kevin: They’re borrowing to get the GDP up. They’re not producing.

David: Yeah. And so, it can only be met by further increases in non-productive investment with its country’s debt burden increasing. So that’s the reality. They have an expectation of growth that can’t be met with the resources which are in their economy. And so they’re having to juice it. And juicing it is unhealthy, but not all the things that people do in life are particularly healthy. 

In this case, we’ve abused the debt system globally in a pretty severe fashion, and we’ve gotten away with it because interest rates have been so low for so long we’ve forgotten that background issue, which we started with today. If interest rates rise, it’s a very different outcome. You can continue to increase the quantity of debt that you have if interest rates are irrelevant or they’re becoming easier as time goes on, lower rates. But if they begin to move higher, well, that’s a bit of an issue—to the point I made earlier about the Bank of International Settlements and an additional interest payment of $8 trillion to $9 trillion. 

I extend that thought in terms of GDP. And the real source of China’s surging debt is GDP growth targets that are too high. They exceed the real growth capacity of the underlying economy—Pettis’s point. I extend that thought and propose that watching the commodities market, watching the oil markets for a clue to where inflation goes next means that watching China and its policies relating to GDP targeting is really key. We think of Beijing and we think of Taiwan. Certainly there’s geopolitical tensions here, but I think what they do behind the scenes to stimulate growth, what happens in Beijing is critical. Perhaps this week—not that it happens this week—but perhaps it’s even more critical than what Powell says this week in terms of rates and where they go next.

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. 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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