The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
“We are in an 18-24 month window where there is likely to be real hell to pay in the financial markets. We’re talking about the government finance bubble. And what is the simple conclusion, to reiterate last week’s conclusion? Keep your powder dry. Is that a combination of gold? Is that a combination of cash? It is just the mandate – you had better keep your options open, and keep your powder dry.”
– David McAlvany
Kevin: David, last week’s interview with Bill King was really interesting. I love his knowledge of history, and it reminded me of something that you told me last night when we were sitting and talking and preparing for the show. You said, “You know, Kevin? Usually when you invest you need to have a good knowledge of history. But actually, those who understand history have really done the poorest in the markets here over the last two or three years. It is those who completely forget about history, that are just playing momentum trades, they are buying what they hear is popular – that seems to be the payoff right now. But that rarely ever has a long-term lasting good effect, correct?
David: It’s the issue of thinking and being engaged with the investment process such that you look for connections, relationships, and cyclical patterns. And all of those issues make history very, very relevant. In the last four to five years you would have been blinded by history. And I guess the alternative is to say, “Well, then ignore it and see what happens next.” And that’s where, again, from a performance standpoint, from a “I wish things would have been better in this market or that market,” over the last two years, three years, what have you, you can either choose to be blinded by history, or the alternative is to ignore history, but that is at your peril, as well.
And long term, I do think that persistence with particular thematics have significant payoffs and significant benefits. I would insist that history continues to be relevant, and even when patterns within the market are skewed by direct governmental intervention, it doesn’t mean that history is any less relevant, it means that you need to look at the factors that are exogenous, these external factors which are redefining the current course.
This is exactly really what happened in the last few weeks here locally. We have the Gold King mine just north of us in Silverton, and we’ve known that we’ve had a problem there for a hundred years. This is an old mine, it’s a very old mine. And we know that there are toxic chemicals in it, and we know that they dribble out in very small amounts. But what we didn’t know, and didn’t anticipate, was the EPA’s tinkering with and trying to manage this problem, which created an environmental disaster. The verdict is still out as to whether or not the EPA killed this river, as other rivers in the country have been killed by industry, going back 50-100 years.
Kevin: We talk about the EPA, and yes, it is a disaster right now and it is horrible. It is one of those things no one around here jokes about because it’s just too close to home. But you look at the intervention in the markets, Dave – we’ve been told by the Federal Reserve for years now that they are going to normalize rates. They told us when unemployment hit a certain level they were going to normalize. We have unemployment right now being reported at 5.3% — they haven’t done a darn thing. So, at this point are they realizing that they can’t step away from this catastrophe that they have been managing?
David: I picture what happened up in Silverton, and it really is an apt picture of what is happening today in the financial markets. You are walling up natural pressure and you are holding it back, and it doesn’t take very much to breach that, and then the natural energy that you’ve held pent up becomes an uncontrollable force.
Kevin: And that’s what the EPA said. They said, “We had no idea. We knew it was a problem, but we lost control.”
David: And what they were doing is digging on a berm, and a trickle became a flood. And by compromising the integrity of what was holding back this natural force, all of a sudden natural forces took over. And you do see that in the marketplace where you can suspend reality for a certain amount of time. You can manipulate markets for a certain amount of time. You can have bear rates in certain asset classes here and there, and it is very effective for a certain amount of time, and then you realize that natural forces are more important than the interventionary forces.
Kevin: Dave, there are always people who see these things coming ahead of time and they sound like fools until it actually happens. There was a letter to the editor in the Silverton Standard five days before this catastrophe occurred up in Silverton that, really, ruined our river. This man was a geologist for 47 years and he warned the people. He said, “What is about to happen could be catastrophic.”
David: “And do you know what is happening here?” And he detailed why the EPA would, perhaps, precipitate an event, because they are looking for superfunding, and they haven’t been able to convince the powers that be that they need 100-200 million dollars to create a superfund site there in Silverton, and what was actually in play was politics, not an environmental salvation, but actually, creating an issue that then required a solution. And I think that’s fascinating, too, in terms of a parallel. What do we have today where you have issues which are created, and a solution that is prepackaged to solve it.
Kevin: So, let’s talk about this, because unemployment is being reported at 5.3%. Now, that is well below what the Federal Reserve said they would start normalizing rates at, yet they haven’t done so. And you’ve talked about this fall we will probably see a very small increase in rates, but again, they are still managing the situation.
David: Yes, so for two weeks now we have been sitting on this number. Yes, it is still 5.3% and it is in the context of a participation rate that matches the recessionary period of the late 1970s, 1977 to be precise. We are talking about those who are actually working in the labor force, able to work, and are actually working 62.6%.
Kevin: So, a little less than two-thirds of the people who are out there are actually working. That’s the participation rate.
David: And I know that it has been two weeks since this happened, but I think the behavior in the marketplace was very telling. We had the non-farms payroll number. It came out and it triggered a selloff in the Dow, even though 215,000 versus the 225,000 number that was expected. That is a very minor disappointment. Think about this. It was not bad enough to be good for the stock market.
Kevin: It’s just so ironic, Dave. It takes bad news now for the stock market to go up because bad news means that the Fed may delay.
David: And it means the interventionary forces that are there, the external forces which are sort of creating a different kind of reality in the equities market, in the bond market, gets to stay, it gets to linger. So again, minor disappointment, no longer enough to motivate the Fed to extend zero interest rate policy and keep rates low, so you have September to December – that’s the timeframe for a rate rise – and as you look around the world you have a lot riding on this coming tightening cycle.
Kevin: Well, look at the currency markets.
David: They’re frayed. You have the credit markets which are beginning to, in earnest, fray. We’ll talk about that a little bit more in a few minutes. Both of these areas, both the credit markets and the currency markets – play this in reverse – they would be relieved by a delay, or indefinite postponement. So you have the prospects of refinancing, and this is where the rubber meets the road with corporations. The prospects of refinancing at higher rates in the years to come – who does that weigh on? It weighs on municipalities, it weighs on corporations, it weighs on the government, themselves, so you have a reason to keep rates low and sit on them, if you will. On the other hand, they’ve made a verbal promise and they do want to carry forward the narrative of recovery, therefore the first evidence of recovery would be, yes, because it’s recovery, we’ll do exactly what we said we would do – raise rates. But there are implications.
Kevin: But Dave, like you’ve said here over the last several weeks, we probably will see a small rate increase just to say they did, something like a quarter of a percent, something inconsequential.
David: And as Bill King mentioned last week, it’s three steps and then a stumble. The first rate increase is not a big deal. By the time you get to the third rate increase the market begins to be recalibrate and say, “Okay, we are dealing with a trend change and not just an anomaly.” The economy, quite frankly, can’t handle the series of hikes. So, just one more observation on the nonfarm payrolls number. If we are nearing full employment, and that’s the case that’s made by these academics, that we’re nearing full employment, you would ordinarily expect to see a push higher in wages.
Kevin: Right. Everybody’s income is dropping, Dave.
David: Right, but in an environment where you have full employment, employers are forced to say, “Hey, how are we going to keep the talent and not have them migrate? How are we going to attract the best talent? We’re going to have pay more.” Income is way behind the curve for this part of the “recovery cycle” if, in fact, the employment numbers are genuine. So, yes, I’m back to suggesting that the employment picture is more complicated than that simple 5.3% statistic. It is a fabrication. How do I know it’s a fabrication? Keep this in mind as we close this out. 40% of the jobs created in the last month, that is, about 37-38%, 83,000 out of the 215,000 came from the birth/death model.
Kevin: Which is made up.
David: It’s not real. It’s a statistically convenient addition. So, not only did it disappoint minorly – 215 versus 225 – but 83 out of the 215 were literally somebody saying, what are we going to pencil in this month? There’s your recovery.
Kevin: Bill King brought this out last week. He said that the very rich have been benefitting from government intervention. They are getting the benefit of QE and their asset price is rising.
David: And if you are receiving entitlements you aren’t doing poorly either because no entitlements have been cut.
Kevin: So the very poor, same type of thing. But the CATO institute just had a poll, and there are record numbers of Americans, and probably most of these people represent the middle class that are being destroyed, that feels the government is too big.
David: Right. Americans think government is too big, about 64%. Too powerful, 60%. And too wasteful. And I guess the question lingers, do any of these folks show up on election day? Because you have the makings of a political shift, a major political shift. And sometimes political shifts are very positive, sometimes they are very negative. And it kind of depends on how the wind blows on the election day. A lot of things can happen between now and then.
Kevin: Don’t you think people are sick of pork barrel spending, though, at this point?
David: That’s the question. You’re sick of pork barrel spending if it’s pork barrel spending on someone else, but is self-interest and the pork barrel benefits – do they become too compelling when it’s time to put your favorite politician in office. I think you have people with good instincts, but perhaps a weak will when it comes to voting, and what are they actually voting for? Are they voting for what’s best for the country or are they voting for their pocketbooks?
Kevin: Well, and obviously, you brought up two weeks ago, health care, and how the cost of health care is rising, the insurance side of it, rising for the company and for the employee. We’re talking, not just small rises, but health care, actually, is a couple of times what it cost before.
David: Right. So, the Bureau of Economic analysis looks at the growth in our economy and compares it to the growth in spending on health care, and the health care spending is growing at two times that of the general economic growth. And I think it is interesting, I think it is very convenient that government has positioned themselves to be in the center of this explosion of growth. Again, I think it is consistent with the CATO polls because you are talking about government getting involved in sort of the heart of economic activity. I don’t think long-term that is very healthy.
Kevin: When we talked to Pippa Malmgren a couple of months ago, she said there is a phenomenon that occurs with a goalie, and I know goalie is your favorite position, Dave.
David: That’s the position I played in hockey, and in Lacrosse, and in soccer.
Kevin: Okay, but see if this is true, because she said in her book, and when we were doing the Commentary, that a goalie feels he has to move one direction or the other to show that he is moving one direction or another.
David: And you are talking about a penalty shot, in particular.
Kevin: Yes.
David: So, you’re standing there in the middle, you’re waiting to take the penalty shot, and statistically, he would be better off if he stayed put.
Kevin: Right.
David: But you can’t just stand there and do nothing.
Kevin: Right, because then if they get the goal, they’ll be like, “You idiot.”
David: Right. So, you take a 50/50 shot and either dive right or left, if you’re playing soccer, but you make a commitment knowing that it looks better to do something than do nothing, even though statistically you are better off doing nothing.
Kevin: Well, then let me ask you – do you think that Buffet possibly did that here recently? He’s probably been sick of sitting on just a ton of cash. He’s not going to be able to get any kind of fixed income, so this latest deal with precision cast parts, so was that a goalie move to the left or a goalie move to the right just to do something?
David: I think he does have to do something. I think he is looking at a 66 billion dollar cash position, and realizing that he is getting nothing – he is getting nothing for it. In a zero interest rate environment he is earning next to nothing, and it’s time to do something. He must do something, he can’t just sit there. And he also knows he has regular cash flow coming in from his various businesses to replenish that over time and give him the ability to make another purchase in the future.
But there is a different complexity to this purchase, say, compared to the Burlington Northern – when he bought the railroad a few years ago. He is paying a premium for the company, whereas when he bought Burlington Northern he was getting it a very reasonable price. And I guess, again, the subtext here is that anything is better than nothing, and when you exist in an interest-free world, this is a challenge, not only for a middle class household, a saver, someone living on a fixed income, but even for Warren Buffet.
Kevin: And we’re getting so many mixed signals right now. The stock market, even though it has been holding near all-time highs, has been signaling, within the last several weeks, several times, it has gotten very close to the signal that it is about to go into a bear market.
David: Well, you had a seven-day stretch where the price declined to within 24 points of what technicians would call a death cross, and that is where your 50-day moving average moves below your 200-day moving average. And immediately following the seven-day decline you have a Monday rally, and it was very important because if that cross occurs, and it could occur any time – days, weeks. But as and when it occurs, if it occurs, you are talking about fireworks. So, this is a technical setup that could be a trigger for underlying unease in the stock market. And you see those areas of underlying unease in other places. You look at the falling of the media stocks not long ago.
Kevin: Dave, on Sunday nights, as you know, we like to grill steak, open a bottle of wine, and watch America’s Funniest Home Videos, which happens to be owned by Disney. And then my wife watches Dancing with the Stars, which happens to be owned by Disney. And then we watch the news, which happens to be owned by Disney. It seems that this media conglomerate has taken on the entire economy, but look at what media has done here recently in the stock market, it is sort of scary.
David: From 2009 to the present media stocks have done very well. If you are looking at Disney, Viacom, Time Warner, CBS – these have been some of the darlings that have done exceptionally well. And a part of that, I think, ties to ease of credit. The cheaper money gets, the easier it is to justify advertising in a budget, advertising dollars go out the door, and guess who benefits from advertising dollars? Disney, Viacom, Time Warner, CBS (laughs) and a few others.
Kevin: And let’s not forget about Apple. Apple seems to be an entire world unto itself, but Apple, has not been doing well – the stock, anyway.
David: And I guess the point with those media stocks is that they have been in decline, a pretty severe decline, along with Apple, for a little while. And again, it’s kind of running in a contrary trend to this, “All is well, the stock market is going higher.” I read one analyst just this week who said, “No, the next move higher for stocks, 50% higher, without a doubt.” And again, nobody knows anything about anything, really. If you tell me you know what tomorrow holds, I have to discount your opinion, because nobody really knows what the future holds. But the more certain you are about an outcome that occurs tomorrow…
Kevin: Run away.
David: Run away. Run away. And I think you are seeing Apple signal something. I think you are seeing Samsung signal something, actually suffering as much or more than Apple, along with the media stocks, and it is these breaks, violent reactions, to shares and inside shares which are disappointing, anywhere from 10-25% declines in short, swift breaks on disappointing news. What that says to me is that markets are feeling edgy. You have participants who don’t need much of a reason to sell and get out, and they are stuck with the mindset that you get at the end of a credit cycle. You want as much return as possible, and you will do that in spite of the risks becoming more pronounced. At the beginning of a credit cycle you are very concerned, you are very cautious. At the end of a credit cycle, you are just chasing yield.
Kevin: There is one institution, Dave, that seems to be very accurate in predicting recessions. Now, they have gotten timid over the last few years because they predicated a recession three years ago and it really didn’t play out and they disappeared for a couple of years. What I’m talking about is the ECRI.
David: Economic Cycles Research Institute has been crucified by the media because they called for recession in 2011, they called for recession in 2012, 2013.
Kevin: Then they went away, didn’t they?
David: Well, I think they’ve spent a lot of time defending their cycle research, and they’re back, suggesting that we are on the cusp of a 2015 recession. They haven’t said, definitively, that we are there, but I think what is interesting is you have the highest levels of direct market intervention in world history, and guys who are looking backward at history, to say, “What do we know about what’s coming next? Do we have any sense for trends in terms of hiring, trends in terms of economic growth rates, trends in terms of whether or not we are heading into, or are already in the midst of a recession, and they had good evidence in 2011, 2012, and 2013 consistent with the evidence which helped them call a number of recessions prior to that, that we were, in fact, heading into those recessions.
Kevin: They’ve got good indicators, just, they seem to be irrelevant at one point here while the intervention was going on.
David: They certainly become less relevant in the context of quantitative easing, in terms of government spending programs, both here and abroad. And so it is interesting – are these indicators flashing trouble? Were they flashing trouble in these same timeframes, as well, or are their indicators garbage? Can we suggest that because they missed 2011, 2012, and 2013, their calls on recession, that their cycle studies are irrelevant?
Kevin: It’s like what we said in the beginning of the program. If you knew history, you did poorly over the last three or four years in investing because you were investing because of historic indicators.
David: This is the challenge of analysis in a command economy. Analysis sells at a discount in the context of a command economy. Why? Because analysis doesn’t really matter. Price-setting matters, price controls matter, even if those things are not enduring, even if they cannot exist in perpetuity. If they are very temporary in nature, this is a real challenge. The levels of direct market intervention through those timeframes were astounding, I think they still are astounding in many parts of the world, and perhaps we just resign ourselves to a brave new world in which it is sort of always summer, never winter, and maybe ice cream is free for all.
Kevin: So, you have four kids, Dave, and when they come to you and they say, “Daddy, can I just have unlimited ice cream?” In a way, let’s switch this around, because later, they’re going to start understanding the meaning of money. “Daddy, can I have unlimited money?” Isn’t that what quantitative easing is? I look at what Jeremy Corbyn is recommending in England right now and he is basically saying, “Yeah, QE – stop giving it to the banks, it’s not getting spent. Go ahead and keep printing money, let money grow on trees, but let’s go ahead and give it to the people.”
David: Right. And this is what we talked about last week with Bill King. To a certain degree, QE for the people has existed for a long time in the form of entitlements. What Jeremy Corbyn is suggesting is that we ramp that up through various infrastructure projects, and new ways of doling out cash directly to the people. The problem, he says, is not of the monetary transmission mechanism. He is saying that we are trying to go through banks, and it would be far more effective if you just got rid of the middleman. And it sounds preposterous, but in one sense, I like the idea. But listen to me, carefully – okay, I hit a nerve with you – I actually like the idea, in so far as money printing is a cure-all. If money printing is a cure-all, why have a middleman like the banking system intermediating?
Kevin: So, what you’re saying is, if we’re going to assume that money printing is a cure, which is what they are assuming right now, then go ahead and just give it directly to the people.
David: If you think that QE is the answer, then streamline it, simplify it. Make sure that ice cream is free for all (laughs).
Kevin: You don’t just give the ice cream to the bankers. It melts.
David: That’s right. Again, this is maybe stepping off the edge here, but Michel Foucault was a philosophy professor who had an extraordinarily degenerate life, and he celebrated breaking all the rules. He basically said, “All the rules are conventions, man-made, and should be destroyed. Anything that represents a meta-narrative which I’m supposed to be subject to, I’m going to fight against, and I’m going to fight against, and I’m going to fight against it actively. So, his last days as a dying man, of AIDS, was going to as many places as he could, infecting as many people with AIDS as possible. Now, here is what is interesting about him. He was consistent with his worldview.
Kevin: He wasn’t a hypocrite, he was consistent with his worldview, as horrible as that might have been.
David: As horrible as that might have been, he was consistent with his worldview.
Kevin: It reminds me of the movie, Batman, Health Ledger’s version of the Joker was eerie, because he was so consistent with his philosophy. And there was a speech in that movie where he basically expounds his philosophy and you realize, this is a twisted character who truly believes, and is acting on what he believes. Hitler was the same say. In fact, it reminds me of Jonathan Swift, Dave. Jonathan Swift, when he wrote A Modest Proposal – this was in England at a time that people were having kids, sending them to the coalmines when they were well under age so that the family could eat. Jonathan Swift just simply said, “Here’s my modest proposal. Just have kids and eat them.”
David: And I think this is the point, that when you see a policy which suggests absurdity, why not just move to the logical conclusions and embrace the absurdity, because the point is, you see the absurdity of a policy when it is taken to its logical conclusions, and yet, we are in this twilight zone where quantitative easing is acceptable and printing money is a cure-all. This is where helicopter Ben Bernanke, would be proud. He was more than a decade early in his anticipation of the popularity of free money as a cure-all and as an economic stimulant. And again, if it seems absurd to hand out money to people in the streets, that’s what quantitative easing is, it is just to a different audience.
Kevin: And they don’t just use quantitative easing. Let’s face it. Zero interest rate policy has been another form of this free money, easy money attitude.
David: The irony is, Jeremy Corbyn suggesting this in the face of inflation rates which continue to climb in the U.K. They’re backing off their expected rate rise. You are getting very dovish attitudes abounding in the U.K. because they still have these massive disinflationary trends present. Again, echoing Bill King’s comments from last week, debt is the issue. We have far too much debt. It is not just us here in the United States, it is in the U.K., it is at the ECB, it is in Japan, it is in China. It is a universal issue and there is not enough inflation, and so the concern is, what do we do about that? Growth rates are expected to pick up, but the inflation rates have dropped by 50%, 0.6 to 0.3. Inflation is absent, essentially, so rates are going to remain accommodative longer. That is, the Bank of England is going to continue the same sort of near-zero interest rate policies that we have here in the United States. So here is a little handy solution. You have deflation, why not create an inflationary offset? Corbyn and the Labor Party is trying to provide the people’s money as an offset to this sort of enduring deflationary trend. See how that balances out? It’s like fighting one problem with something that creates a whole host of other problems once you have started down that path.
Kevin: Very similar to this river situation that we are talking about with the EPA. They thought we had a problem – now we have a real problem.
David: Now we really have a problem (laughs). I sometimes wonder why people fight the way they do to avoid certain things, certain outcomes. Deflation is one of those things. You want to fight the unknown consequence of a deflationary collapse where capital is destroyed and you don’t know who loses and you are not in control of the process, and you are not sure what the political ramifications are, and so you fight that fear a different way. Have you ever had a fever?
Kevin: I have.
David: Okay, so the typical response to a fever is, you take this fever-reducing pill, rather than letting your body work out its issues, and in point of fact, this is not old wives’ tales. A hot bath is the quickest way to break a fever.
Kevin: So, you increase the fever long enough to just get it out of there.
David: And it gets rid of it. Or you can fight a fever for days. You can sit in a tub for half an hour or you can fight the fever for days. And it seems like you are moving into the abyss as you let the inferno get stoked, but in point of fact, it solves itself.
Kevin: It’s like what Jim Grant wrote about the depression that occurred back in 1921. They let it happen. And it was over pretty quick because they let it happen. I look at China right now, Dave. They’re not letting it happen. They’re spending hundreds of billions of dollars to keep things from falling faster than they already are. All they are doing is slowing the fall at this point.
David: Right. You had a request for 3 trillion yuan, and now there is a request for 2 trillion yuan which is, in dollar terms, another 322 billion dollars to boost stock prices in China. Financial Times reported 24 separate policy measures since the start of July, to save the stock market from further decline. So far these hundreds of billions of dollars that have been deployed already have simply slowed the loss of between 3.4 and 4 trillion dollars.
Kevin: That’s huge, Dave. Four trillion dollars. That is amazing.
David: And toward what end? Is this a cultural face-saving device? We are trying to expand our influence and reach globally as the IMF considers inclusion in the SDR basket? They have already concluded that in 2015 that inclusion won’t happen.
Kevin: And that’s big news. A lot of people were gearing up for the IMF allowing the Chinese renminbi to be included into the SDR system this fall.
David: And it’s not going to happen this fall. They have set the timetable for a variety of things needing to take place as preconditions to open the conversation again September of 2016. So what happens between now and then? Why are they doing what they are doing? What are the protecting? It comes back to that same issue. They are protecting from an out of control market collapse, which you can get in the context of deflation. And what are they doing now? All that they can via financial engineering. That is their priority.
Kevin: And you know, back in the old days China’s exports exceeded imports dramatically. But now we can look at the economy and we can say, how are their exports doing, but how are their imports doing? And they seem to be showing a substantial slow-down, both on exports and imports.
David: To some degree, you need raw materials, both to build out your economy and infrastructure, but also for the goods which you are going to produce and export, and so seeing the imports in July decline by 8.1% was a big deal. The exports falling by 8.3% is something of a catastrophe, and that is what we were getting at with Bill this last week. The exports triggered the government’s decision to devalue the RMB by 2%.
Kevin: Which was a record. That was the largest devaluation ever.
David: Biggest single day decline in at least decades, and it’s the first olive out of the jar, a 1.9% decline in the currency. It’s not sufficient to jump-start exports, but if more currency devaluations are around the corner, I think you can expect commodity producing countries – I think you can expect other countries that focus on finished goods for the purpose of export, to devalue in lockstep. And you just need to think about that a little bit more. The acceleration trend in terms of currency wars – what does that mean for you? What does that mean for the resources that you have? How do you position yourself in liquid assets that are protected from devaluation? So the RMB declines, and guess what happens? A number of regional currencies decline, as well.
Kevin: We are connected. When the butterfly flaps its wings in China something else happens around the rest of the world. These currencies have already been in distress, Dave. You have been bringing this out for months.
David: It takes the idea of financial engineering into the realm of economic engineering where you have treasuries and central banks trying to do everything that they can to create a certain growth outcome and growth picture, a picture that people that can look at and believe in. So yes, currency wars are not a future reality, they are a continuation of the theme that we have seen in place for a couple of years now, but is intensifying. I think you need to remember the context of a currency war, or any other war for that matter, these are the players – you have politicians who are seeking social and political stability, and if that social and political stability cannot be achieved via domestic policies, then decisions are made with international implications. So, finance and capital flows end up being the new battleground. I have mentioned Juan Zarate’s book, Treasury’s War, in which he basically says, “This is how we go to war today.”
Kevin: And he was with the Treasury, so when people say, “Oh, this is just conspiracy thinking,” no, no, no, this is actually a tool in the chest.
David: Yes, he would basically say, you look at the positive outcome that we have had in Iran – that was an orchestrated outcome, directly through the U.S. Treasury. And we suggested this maybe four or five months ago, that essentially, our State Department has been unseated by our Treasury Department in terms of international relations.
Kevin: Bill King confirmed that last week. He said, we’re not getting near a currency war, we’re in the middle of a currency war. This Chinese move last week was a form of currency war.
David: And it is the currencies, themselves, which are the everyday ammunition for your equivalent to a financial firefight. Chinese are shooting. There are a dozen other countries that are doing the same, and the reasons are obvious. If you don’t protect your slice of the global GDP pie, not only will someone else take it, end up with it, but you, as a politician, may end up facing the music, and no politician wants that to happen.
Kevin: And there are benefits to cheaper currencies. Obviously, through the years we have talked about competitive currency devaluation, because one of the things that it does do is, it makes what you export out of your country cheaper, and it makes you more competitive.
David: That is the key benefit of a cheaper currency. I think of the game of Snooker. You can earn a point by scoring in the traditional manner, sinking a red ball and then a colored ball in the appropriate sequence, but you can also win points by disadvantaging your opponents and making it impossible for them to score a point themselves.
Kevin: So, you either play offense or defense.
David: You stand to benefit from their mistakes and mishaps, as well as your aggressive proactive shooting, as well. So, Snooker is a game of strategy where even a defense is an offense, if that makes sense.
Kevin: Sure.
David: So, how does one central bank up-end the objectives of another central bank? Look at what we are doing here in the U.S. If the U.S. delays a rate hike, the dollar falls, forces up the value of most other currencies, undoing the “progress” made by that other central bank. Devaluation is progress. Think about that. We live in a world where devaluation equal progress, and yet you can’t have too much devaluation too quickly or that is considered to be a destabilizing hot money flow. There is this Catch-22 of needing devaluation to promote economic growth, but on the other hand, if the devaluation is too quick and out of control, it is a destabilizing force, the kind of destabilizing force that led us to the Asian crisis in the late 1990s.
Kevin: One of the great indicators all through history has been interest rates and the credit markets. And the credit markets often tell us a story that is true before a manipulated stock market does, or a manipulated oil market or gold market. What are the credit markets telling us at this point?
David: It is what the stock market is refusing to tell us, that change is coming, and coming quickly, because credit is rapidly being reappraised, and that is, specifically, the risk associated with credit. Risk is being looked to, in the debt markets, in ways which have been absent for several years. Puerto Rico, I think, has captured the imagination of investors, and there are a number of corporate entities, too, that are beginning to adjust. In other words, their debt is selling off and interest rates are moving higher, the cost to finance their debt is moving higher, as they begin to anticipate the Fed hikes. And that has already put the credit markets on edge.
Kevin: Do remember, Dave, about a year ago, we were talking about how junk bonds, even, are starting to pay at levels that U.S. treasuries were paying at just a few years ago? In other words, the junk bond rates had dropped down into the 5-6% range, even though the risk of holding that bond long term was extremely high because interest rates had gone so low. That seems to be reversing.
David: Don’t ignore the context. You are talking about the magic 5% which an investor used to be able to get in a cash deposit at their bank. And now, again, this has been some time – a year ago the average yield on a junk bond was 5.5%. Think about what has transformed in the marketplace. Bank deposits pay you zero. If you still want your magic 5%, or maybe now it’s 6.5%, you have to go to – what? Junk bonds? We are beginning to see a rise, and yes, that means the other side of the equation is being affected. Prices of junk bonds are in decline. And yet I don’t understand it, the appetite for junk is still very strong.
We talked about this with Bill last week because he lives in Chicago. Chicago is a junk issuer. Why? Moody’s downgraded them last May and yet they have zero difficulty in oversubscribing a billion dollars in new debt. And investors seem to believe that a bad situation cannot get worse, Chicago being a case in point, already in dire straights, more debt, more interest payments, as a burden. Why isn’t that a huge factor for investors today, discouraging them from those kinds of purchases? When in fact, they do the opposite. They want to lock in higher yields.
Kevin: There is a question on a lot of people’s minds. Actually, there are two. If I am retired, where in the world do I get income off of my money. So, I am thinking that a lot of those people who are going for junk bonds are just praying and hoping that there is not a default. But we haven’t seen defaults, Dave. This is the thing that is so odd right now.
David: And I think this is one of the reasons why I say don’t ignore the context. Just because you used to get 5% in a bank deposit, now you can get something close to it in a very credit quality compromised fixed income asset, realize what you’ve just done. You have shifted from something that is relatively safe to something that is relatively obscure and usually considered dangerous.
Kevin: But history would tell you there is default in the future. We have already talked about over the last three years history has been put to the side.
David: That’s right. So, looking at modern history, default rates are going down and down and down. And this is the question. As a market participant, should that give you greater confidence, or less confidence, because the way the market reads, a declining default rate is, “We should step with greater confidence into the fixed income market.”
Kevin: Right. Even if it’s junk bonds.
David: Right. So, 13.3% was the amount of junk debt that was defaulted on, at its worst, in 2009. Now, it’s about 2.3%, according to Moody’s, and you just have to stop and reflect on that. At one end of the pendulum swing, 13% of the paper that is out there is going to go bye-bye. Now, it is 2.3%, and improving. This is my point. Markets are like pendulums. They swing from one extreme to the other. The current attitude, if locked in the present, will fail to anticipate the future. Record low default rates are not followed by record low default rates, but rather a return to higher default rates.
The swing in that direction, we think, will be a characteristic of 2016. We believe the extremes of debt default are likely to come in that 2017 to 2018 timeframe. And here is why. We have had six years of routine refinancing and re-leveraging in the corporate sector, where low grade, low quality borrowers, have gotten better and better deals. They’re interest component has come down and down and down, with the shrinking of the interest rate policy because of the Fed’s position on rates. And this, quite frankly, has kept a number of companies from going under, which would otherwise not even be going concerns today. So, in essence, you have the lowest rates in history, which have served to subsidize failing businesses. Where do you think we are at in 2017 and 2018? Not only with higher rates in these companies in a world of hurt, so not only debt defaults, but a lot more corporate bankruptcies.
Kevin: Dave, I have a friend who needs income in the next few years, and so they sat down with their financial advisor who happens to be very much leaning toward the insurance annuity side of things. One of the things that I have found as we do these insurance ratings – we have talked about doing bank ratings for clients, we have had many people call in for the free bank ratings. We also do ratings on insurance companies, and I have noticed over the last few years, the increase in junk bond holdings in these insurance companies’ portfolios, because for them to promise you, in an annuity, a good income stream of, say, 6%, they have to go find that income stream somewhere.
David: And it means they have to load their portfolio with very risky paper, which, if you think about it, if everything goes well, they will be fine and you will get your guaranteed income.
Kevin: But what if defaults skyrocket, like you are talking about?
David: You could be talking about the insolvency of the insurance company, and then your guarantee goes from a guaranteed 6 to a guaranteed zero.
Kevin: Right. So, there is a cost to complacency calling defaults.
David: (laughs) I think the bottom line is that complacency comes at an incredibly high cost. Listen, how does it feel to be complacent? It is hard to argue against the carefree nature of complacency.
Kevin: “Things will be just fine.”
David: Yes, because it does feel good. “Don’t worry. Be happy.” But the debt markets, alongside select emerging market equities, are beginning to get a grip. They are beginning to come to terms with a rapidly slowing global economy, the reality of which is not even remotely priced in to the developed markets, either developed market debt or developed market equities. Stock and bond markets are in the crosshairs.
And I don’t know if Q4 of this year, fourth quarter of 2015, is when the stuff hits the fan, but we are in an 18-24 month window where there is likely to be real hell to pay in the financial markets. This represents the final setup in the largest bubble mankind has ever witnessed. We are talking about the government finance bubble. And what is the simple conclusion, this week? To reiterate last week’s conclusion, keep your powder dry. Is that a combination of gold? Is that a combination of cash? It is just the mandate – you had better keep your options option, and keep your powder dry.
