Podcast: Play in new window
- If you keep “buying the dips” maybe you’re the dip
- Gross, Gundlach, Druckenmiller, & Singer say avoid buying the current dips
- Bloomberg called March 4 the “end of the easy money era”
The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
“Perhaps I live in a naïve world where debts created have to be paid back. That may be a basic assumption which is false. I have assumed it to be true, but perhaps no government living beyond their means in the current environment ever intends to realize the viciousness and maliciousness of an intergenerational commitment to debt slavery. Maybe it’s not on their mind because they don’t plan on paying it back.”
– David McAlvany
Kevin: David, usually when I meet you on Mondays or Tuesdays we talk about your travels over the last week. You have been speaking a lot on Legacy, the book that you wrote last year. This last week you were in Washington, D.C., invited by Morton Blackwell for the Leadership Institute. Tell us just a little bit about that.
David: They have on a monthly basis a special speaker come in and speak to their donors and the students who are there in training. The Leadership Institute goes back to 1979, Morton Blackwell, who has been training young conservatives to be involved in grassroots politics.
Kevin: He was with the Reagan administration.
David: He was one of the younger members of the Reagan administration. He has always had a passion for grassroots politics. Public policy, really, is at the heart of everything that LI does. They have trained 195,000 students how to manage a campaign, how to raise funds, how to do everything involved in direct political action, which is kind of interesting.
Kevin: If you are listening and you would like to hear David speak on Legacy that would probably actually be a treat. We talk about it here, but that talk, I believe, is probably on their website.
David: Yes, if you want to go back – it is interesting, they have everyone who has ever spoken at these morning meetings, from Rand Paul and Ted Cruz (laughs) and now I get to share some space with them, as well. So if you go to the Leadership Institute website you can listen to the speech that I gave to them on legacy.
Kevin: One of the questions that people are asking right now after this last month where we saw the volatility in the market is, are we to expect more or is the worst behind us?
David: When we experience a nine-day 10% decline in equities, that is a good question. Is it categorically a healthy correction, with growth in the equity markets still ahead of us, or alternatively, was that the first salvo in a very long and bloody battle.
Kevin: What do you think, Dave?
David: I look back at Oppenheimer’s book from the 1930s – I think he wrote it in 1932 – The Battle for Investment Survival. It is an excellent read. I would buy a used copy.
Kevin: From 1932.
David: I think more likely we are in that second category, the first salvo in a long and bloody financial battle. Price action, as Richard Russell used to say, will reveal whether it is a healthy correction, or a long-term bear market.
Kevin: Oftentimes we are watching charts – not that we’re technicians, Dave – but what are you watching right now for the stock market?
David: I think the two numbers to watch in terms of price action, you have the February lows at the end of that correction, and you have the January 26th high. If you take out the highs in the S&P 500 and the Dow, and that is confirmed, ultimately, by the transports, you can look back and say that prices have moved above those levels. What we had was a 10% healthy correction. Prices would, under those circumstances, be moving higher. Because technical analysts will look for a double top at that high watermark, you really need to see a close with conviction for several days above that number.
Kevin: And what you are talking about is a close, not something in the interim during the day. Closes become very important when you are talking charts, right?
David: That is certainly the classic Dow Theory approach, and Richard Russell preferred a multi-day close above a key number to make sure that a trend was in place, again, above those old highs of January 26th, instead of just an intra-day move above the number, it needs to be where the number for the day closes above that level.
Kevin: You can look at a chart two ways. There is always an alternative view as to how you would look at this. What would the alternative be?
David: (laughs) This is the beauty of reading a book or reading a chart or anything else. This is what they call hermeneutics.
Kevin: What’s your interpretation?
David: That’s right. What’s your interpretation of the chart? The alternative interpretation is that we had a throw-over move where the major indexes there in late January, prices quickly exceeded their upper uptrend line, and that high water mark may be the high water mark for a very, very long period of time. It is on that view that we see the February trading lows broken. Again, we saw the 10% correction. If we get back to those low levels and then break below them, you have all the evidence that you need to determine that it was, in fact, not a healthy correction, but it was, in fact, the first stage of a bear market which may be with us for many months, even many years.
Kevin: And you seem like you’re leaning that direction, that this could be the beginning of a bear market.
David: We favor the latter interpretation. That’s right.
Kevin: In December, you had a single bitcoin hitting $20,000. And you could see in the activities of people even around us here at the office, Dave, the thought that, “Well, maybe I need to go buy some cryptocurrency. It turned out, so far, to be the top on these cryptos. Do you think that maybe that was a signal, a shot across the bow, for the larger markets, that the cryptocurrencies, the easy money that was coming from them was ending?
David: Yes, it is fascinating because what we saw was a change in temperament. People started to say, gold was up 10-12% for the year last year and everybody kind of yawned. And the stock market was up 20% for the year, and everyone kind of yawned. Why? Because you had a 10% improvement per day in the cryptocurrencies.
Kevin: (laughs) Right, or more.
David: Yes, versus those kinds of returns for the year, and that became the normal expectation. So yes, I think the December blow-off in the cryptocurrencies, that is a complementary move which spoke to the excessive optimism in the markets in general and is a complementary sign of the times in which people were beginning to consider those 10% moves per day normal, expected, that is what was going to happen from this point forward.
Kevin: Going back to our training, Dave, when we were learning to fly. Remember when we were doing stall training? I have to admit, stall training is not my favorite.
David: (laughs)
Kevin: I do get a little bit queasy. But what would happen is, you would go from a normal incline as you were pulling the stick back to pushing the throttle in and going parabolic for a period of time. Remember how that felt? You would look at the altimeter, and if you were to judge your altitude gain during that parabola, you would say, “Gosh, I’m going to go to the moon.” The problem is, you don’t. It is right before you turn and you fall and you spin (laughs).
David: (laughs) That’s right. Much of last year’s discussion, at least throughout the fourth quarter, related to ROC, the shorthand for rate of change, and that is an idea that the acceleration of momentum is there most exaggeratedly toward the end of a trend. The trend peaks at the end of a move and the parabolic event that sees prices increasing in shorter periods, increasing radically in a period of days or weeks. Everything is crunched down, everything is compressed. The type of change in terms of price that you would see stretched over years, or even decades, is now being squeezed into a very short period of time. That is why we describe it as a parabolic event, and you’re right, the picture of the plane moving up until it stalls – there is not sufficient energy to beat gravity.
Kevin: The greatest amount of money is made during a parabolic event, just like the greatest amount of altitude is gained right before the stall.
David: And the greatest losses accrue in the timeframe that immediately follows. As investors, there is a reluctance to tame or to curb enthusiasm, and they will often buy the asset all the way down, forgetting the proverb, “Never catch a falling knife.”
Kevin: You have always kept a journal, not just of your successes. Actually, I think your journal is more riddled with your failures. I don’t think you actually write down your successes.
David: I don’t have a journal of successes.
Kevin: You do remember your failures and you talk to your kids about them.
David: The important part of journaling your failures is that through time we have a way of scrubbing and editing the past, and it is part of ego management, it is a part of psychological preservation through time.
Kevin: (laughs) Right.
David: We need to feel a certain way about ourselves and about the future. And so, I do journal the failures so that I can’t re-sketch or rewrite history. I illustrated catching the falling knife and what an investor is not supposed to do recently with my kids as we were talking about a significant loss that I took back in 2001. It has been nearly 20 years, but we still reminisce about these things – the preferred shares of the Williams Company.
Preferred shares of the Williams Company were offered at $25. I averaged into a position between $20 and $25 per share, and those preferred ended up trading at $12 as the energy sector suffered through the panic phase of what was a total debacle in the energy space. So you had a re-organization the likes of Dynergy, Calpine, Enron, and Williams, too, and many others. But there was, just preceding this unwind in the space, massive enthusiasm. Enron was the Wall Street darling. Everyone had to own it. All of your banks had massive exposure to it, and were financing things for Enron because this was really the company to be a part of. They were redefining the financial landscape in the energy sector and were getting ready to do that with bandwidth, trading bandwidth and everything else.
So that was the incredible story in the late 1990s, one of many I suppose. But ultimately, just as incredible was the capitulation, which took the better part of a year to unfold. So the company, Williams, was sound, at least sound enough to survive. But the market swept those shares to what appeared at the time to be the edge of an abyss. And I made the mistake of selling out near the lows.
Kevin: Right. You had reached your threshold of pain. You and I talk about this often in various areas. What is the threshold of pain? When does the capitulation actually occur?
David: That’s right. I quit thinking. It became an emotional issue and I just couldn’t engage with the substance of the company, the scale of the company, their balance sheet – those factors became less and less relevant as the pain increased. I told my kids, had I chosen to not catch a falling knife, and not capitulate at the end and sell out at the bottom, I could have owned the common shares at $1.25 per share. $10,000, or 8,000 shares just three years later would have been worth $365,000 as the shares rebounded to $35-$40 per share.
It is a classic case of an opportunity missed because emotions were in the driver’s seat. That is something that if you don’t learn from – if you don’t learn from your mistakes you are doomed to repeat them. Some temptations are often too great for an investor, whether it is buying all the way down – yes, that is a mistake – or making the mistake, as I did, of selling out at a capitulation low. That, too, is a mistake. And if you don’t know yourself as an investor, this is where you can get into real trouble.
That is one of the reasons why I discuss these things with the kids so they can understand themselves, they can understand investor psychology, they can understand the temptation to buy all the way down, or sell at capitulation lows. And they know – they are the ones more than anyone – well, I guess Mary Catherine knows more than anyone, my imperfections or failures. But it is not something that we hide. It is something that I hope they learn from and can grow through.
Kevin: One of the things, too, you didn’t have this on margin, I don’t think. You weren’t margined in Williams. Sometimes margin can put you into a terrible situation. I am thinking about a client of mine who was into the tech stock bubble. He was buying Palm Pilot, and continuing to buy Palm Pilot, but he was careful about it. He said, “Kevin, I’m going to continue to add to my gold position, keep a third in gold, as I accumulate Palm Pilot.
Well, what happened was, he did that only once. He started with $35,000 in gold when he had $100,000 in Palm. But he started getting addicted to the gains in Palm and he started margining. And instead of buying gold, he took that money and he actually used it for leverage. He had that $35,000 in gold all the way up as he became a millionaire, and then a two-millionaire, and then a three-millionaire.
And then Palm Pilot starting going away. And instead of him selling out or meeting the margin call, what happened was, I got a call, Dave. He said, “Kevin, I’m down to my last $35,000. What is that gold worth? $35,000? I need to sell it. I need to pay a margin account.”
So it is one of those things where you can get caught. Now, you didn’t get caught. This is an interesting story on Williams, but probably the real issue here is, if you’re trying to catch a falling knife, don’t continue to chase it with margin debt.
David: There are disciplines as a market moves down, there are disciplines as a market moves up. And he would have been wise to take money off the table rather than compounding and pyramiding up as time went on.
Kevin: Isn’t it interesting that we have gold 27% higher from the December 2105 lows, yet Wall Street is not paying attention.
David: No, in fact, we have some firms that we work with that we provide metals to, and have for years. This goes back to our original business as a wholesaler into the financial universe in Wall Street firms selling out their metals positions lock, stock and barrel.
This is a fascinating thing. I was in discussion with someone just two weeks ago who shared with me that Merrill Lynch has made the policy that their investment advisors cannot sell products that short the market – cannot sell products that short the market. They are not allowed to hedge.
Kevin: (laughs) Really?
David: That’s different than what I’m saying here about gold, but again, there is a capitulation here where people can’t handle not participating in the upside of the stock market. And whatever they had invested in gold, a few of these Wall Street firms that we do provide metals for are selling out lock, stock, and barrel. They don’t care that gold is up 27% from the December 2015 lows. That is irrelevant to them because a part of the equation is not just the metals piece and being up, but they are not up enough. They are not keeping up with the outperformance of stocks, and so they need the all-in bet. They want even more than they already have. There is no sense of balance. There is no desire to create diversification. And in the case of Merrill, so I’ve been told by some of their wholesalers, they are no longer allowed – no longer allowed – to have shorting products within their portfolios.
Kevin: I can hear your dad, over and over and over in mind, as you’re saying this. And you can hear this same thing. You can even hear the tone of his voice. “The majority is always wrong. The majority is always wrong.” Now, you have reason to believe that we possibly have already seen our high and we are beginning a bear market at this point.
David: Exactly. The February shock here in 2018, I think it was just the beginning of the market unraveling. Over the last two months we discussed the role of inflation and rising interest rates as critical drivers in the asset markets. Ed Easterling’s work on these topics is helpful for those of you who care to invest further time and energy on this topic. He wrote some books five, 10, 15 years ago, which would be helpful there.
Those trends are the backdrop issues. They are the ones that end up determining the assumptions that investors have and use, and on the basis of those assumptions, ultimately, the allocations that they make. And the allocations ultimately have to shift if those backdrop issues are shifting. And in fact, we do see them now shifting – interest rates higher, inflation concerns. I’m not even thinking about this week’s CPI number. That is almost irrelevant in the grand scheme of things.
The easiest attitude to adopt, even though Wall Street warns against it all the time, is assuming that past performance is an indication of future results. You have probably heard it a thousand times – past performance is not a guarantee of future results. And yet, investors – this is the colossal mistake. A few weeks ago we discussed Buffet’s attitude and his disposition of the markets. Remember, we discussed the actions that he is taking and that you should watch what he does, not what he says. He has a growing cash hoard. There is a hesitancy to buy anything at these levels. Here is the issue. When a value investor makes a purchase, it very commonly is in an environment of poor performance, not of outperformance.
Kevin: Yes, you would almost ask, “Why did you buy that? Nobody is making any money on that.”
David: (laughs) Yet, most investors make the judgment of what they want based on the one very simplistic metric, performance, meaning that the easiest mistake an investor can make is not identifying where they are in the investment cycle. They just get plowed into some sort of momentum trend. Momentum investing is not inherently bad, it is just progressively more and more dangerous. So if you can’t identify where you are in a trend, in a cycle of evaluation or a psychological cycle of exuberance and enthusiasm, you probably don’t recognize the danger involved there in your decision, or as time passes, how much more dangerous it becomes.
Kevin: I was saying I heard your dad’s voice saying the majority is always wrong, but there is a handful of investors that throughout history, decade after decade, don’t follow the majority the majority of the time. I’m thinking about guys like Bill Gross and Jeff Gundlach. There is a community of people right now that are looking at this market and saying what you are saying.
David: The bond guys would be Jeff Gundlach and Bill Gross. They would be more or less in our camp, concerned about market turbulence immediately ahead of us.
Kevin: How about the equities guys?
David: Paul Tudor Jones, for sure, and Stan Druckenmiller, as well. Druckenmiller was the guy who actually promoted and put on the trade for George Soros. He ran Duquesne Capital, and was the chief trader for the Quantum Fund. You remember when Soros was betting against the pound? It wasn’t Soros’s idea, it was Druckenmiller’s idea. He is an amazing trader, and he has made some amazing calls in the past. But both of those guys, Paul Tudor Jones and Stan Druckenmiller are very concerned about turbulence immediately ahead of us.
Paul Singer is a different kind of a guy. He is a lawyer that trades on the basis of cracks in the system. He is looking at legal documents and saying, “Can I apply pressure here?” (laughs) He actually got into a lawsuit with the government of Argentina and won. That is the kind of guy he is.
Kevin: Do you think they are following the popular advice right now, BTD? Buy the dip? That is what they are telling the dips right now, actually. They have been telling them for years, just BTD, BTD, buy the dip, buy the dip. You’re not the dip, buy the dip. And I don’t think they’re following that, do you?
David: That group, and we would include ourselves in that small group of people, all view the current market environment not as an opportunity to buy the dip, not as a healthy correction, but rather as the first move, the first salvo in much more turbulence ahead. For us, we would define that as a long-term bear. I wouldn’t speak for them as to say whether or not they view this as a cyclical or a secular bear, but I do know when you begin to see Bill Gross talk about a secular bear market in bonds, I can tell you if there is a secular bear market in bonds, that implies interest rates going considerably higher, and by default, rates going considerably higher, the cost of capital increasing, and your hurdle rate for equities immediately goes up. Yes, you have a significant, if not catastrophic, bear market in stocks.
Kevin: You don’t want to talk for Paul Tudor Jones, but he is probably saying what you are saying – a long, bloody war.
David: Right. In Fred Hickey’s recent missive, he quotes Paul Tudor Jones as saying to the Fed Chairman, Jerome Powell, that Powell’s situation is like that of General George Custer before the battle of Little Big Horn, more or less on the edge of a massacre. So I guess a word to wise would be, get ready for a little greasy grass (laughs) – that’s what the Indians called it.
Kevin: Red greasy grass is what you are saying.
David: That’s right. And I think when you combine the view of the bond guys, as well as the equity guys, you’re talking about carnage both in the equity and bond markets.
Kevin: But you’re still watching the highs and the lows. You’re not proclaiming that you’re right, right now, you’re just saying watch out.
David: Those are your indicators. They will either reinforce that we’re in an uptrend, or reinforce that we have a complete breakdown of the trend from the last nine years. And here we are celebrating in March the 9th anniversary of a move higher in equities.
Kevin: Easy money.
David: Bloomberg commented just this last week, March 4th, “The end of the easy money era,” they wrote, “which spanned the global economy for the last decade, came into sharper focus,” they wrote in their article, “as the Bank of Japan gave fresh insight into when it might slow its stimulus program.”
As I read that a week ago, “the end of the easy money era” – people get it. People understand that there was an easy money era, and that asset prices boomed as a result of that. And there is this big question mark hanging out over the marketplace – what happens if you go from QE to QT? What happens if you tighten monetary policy? Is there a negative impact in the markets? And you have the bulls on Wall Street saying, “Are you kidding me? Look at the strength of the economy. Look at the strength of the economy. We don’t need monetary stimulus anymore. We have economic activity that will more than supplant the role that central bankers have played in the last decade.”
Kevin: It reminds me of Richard Duncan, a guest that we have had on numerous times, and actually will be having on in the next week or two, who says you have capitalism, you have socialism, but this is debtism. In other words, we don’t produce what it is that we grow with. We actually go into debt to grow.
David: Or if we are talking to Bill King who would say capitalism died 40 years ago. Capitalism is dead, the free markets are dead. And I don’t think that is him being cynical, it is just watching the behavior of the markets and realizing that more and more things are controlled all the time. But Duncan would say, “You’re right, capitalism died, or was replaced, supplanted by debtism.”
Kevin: And he says to just go ahead and get used to it. That is the one that always ruffles me. He is just saying, get used to it. Don’t try for a return to capitalism, it will kill us.
David: Well, in his thinking over the past three to six months, there is the idea that the system which has become dependent on credit expansion cannot avoid recession if we see credit growth contracting or shrinking back.
Kevin: Because you won’t get it with productive growth, you will only get it with credit growth.
David: It is a little bit like – you remember what Ian McAvity’s doctor told him. Unfortunately, Ian McAvity passed a year or so ago. He was a chain smoker. Everybody who knew him knew that it was multiple packs a day. He at one point suggested to his doctor, perhaps I should quit. His doctor said, “Are you kidding me? Do you understand system dependencies? If you want to die tomorrow, quit tomorrow.” It was just a very clear message. The system gets so addicted that now it can’t live without it. And it’s really what you have in Duncan’s analysis is that QT, or quantitative tightening, will crush the value of assets.
Kevin: Is central banking talking about normalizing rates, then, a little bit like McAvity quitting smoking?
David: That’s Duncan’s concern. So in his overall appraisal I hear an Austrian boom-to-bust cyclical pattern, but then he says, “Looking at the scale of credit which has been created, you have no idea the consequence when this bust cycle occurs. It doesn’t matter if you are given to wanting to see a naturally corrective market. It doesn’t matter if you are expecting the bust. You have no idea the pain and carnage this will bring. This will reconfigure the world politically, and it won’t be positive. So his instinct is to say, “Please don’t let it happen.”
And I think it is a fairly straightforward logic in the sense that QE props up asset prices and QT, or quantitative tightening, should suck the value out of the asset markets that was there artificially. So artificial growth and asset prices – if you restrict easy money, you’re going to have a negative impact. And I’m sure he will have plenty of comments. A lot of his commentary through the years has related to the Z1 Flow of Funds reports where he looks and says, “Well, how much credit is expanding in the United States at the corporate level, at the federal level, at the household level?”
And a lot of his conclusions about aggregate credit growth are based on that Z1 Flow of Funds report which was just out. So I’m very interested in talking with him. While I personally have a negative view of debt-driven growth, Duncan and I agree that without it our markets today are a little bit like a crack junkie, likely to die without the next hit. And I’m also curious to ask him about Chinese credit expansion and whether their unprecedented lending serves as a substitute for contractions in credit growth elsewhere in the world.
Kevin: Yes, because isn’t theirs double ours? It’s huge.
David: Right, you are more than double if you are talking about their commercial banking sector. It has reached 40 trillion dollars. So we did see the baton passed as the Federal Reserve instituted QE and then ultimately they passed the baton to the European Central Bank and to the Bank of Japan. So I’m just curious to see if credit expansion via the commercial banking sector in China, if it is growing at such a radically aggressive pace, does that have a positive knock-on effect globally, or does that increase the risks globally, inherent to the credit markets as a whole. I guess I will ask that question next week.
Kevin: Back in the 1990s we bought a boat, and I had an old Jeep that I pulled that boat with, and we would go over to [Lake] Powell, which was three-and-a-half hours from Durango. The other guys I would go with had vehicles that actually could pull their boat. My vehicle, I actually needed momentum down the downhill to get up the uphill without overheating. I literally would get the maps out the night before we would go home and I would try to figure out the best route home so that I didn’t overheat the engine. My wife told me, “Kevin, if we’re going to buy a boat, we need to buy a truck.”
But I’m going to give you an analogy and see if this works. When you have debt – talking about 40 trillion dollars in China, talking about the debt that we have – that’s like the big, heavy boat. You have to pull that debt with GDP. So the truck would be GDP. That’s production. What I found with the boat that I had that I pulled to Powell was, I didn’t have enough GDP. I didn’t have enough horsepower to actually pull the boat. We ended up getting something a little larger, an 8-cylinder engine, and it was fine after that. But I’m looking at this and I’m thinking, what is the GDP-to-debt ratio of some of these countries? Can we pull the boat?
David: I think that’s very important. Household debt numbers here in the U.S. – going back to the Z1 figures, at least for the United States, and then we’ll talk about China, as well – rose last year. You had mortgage and consumer debt, which was on the rise. You had corporate debt, which was on the rise. You had federal credit growth, which actually fell. And if you want a summary of those things, Doug Noland’s piece over the weekend, the Credit Bubble Bulletin, covers this very well.
I will just mention a few of the complementary themes. As we look at the tail end of 2017 we have a total debt and equity securities value – add up all of your stocks, all of your bonds, globally – 449% of GDP.
Kevin: So that’s the boat – 449% of GDP.
David: The boat is four times larger than the car that is supposed to pull it. The previous peaks were 379% – that was in 2007.
Kevin: Before the crash.
David: 359% – again, you’re talking about a big boat to pull, with maybe not quite enough horsepower, and that 359% of debt-to-GDP was at the cycle highs of 2000.
Kevin: Right before the crash.
David: Right, as Doug points out in the Credit Bubble Bulletin this last week. For perspective, the ratio ended in 1970 at 148%, ended in 1980 at 128%, ended in 1990 at 189%.
Kevin: So up to that point it had not gotten past two times. The boat wasn’t two times the truck. Now we’re 4½ times the truck.
David: Exactly. So the ratio at 2x was manageable. At 3½x it became unmanageable. And now we’re at 4½x. Again, I like your analogy comparing the economic engine, which is GDP, to the value, the stress placed on that engine, which is the sum total of all your asset prices. So last year you made some of the conferences that we were at, meeting clients as we traveled across the country, and I referred to a chart showing current household net worth here in the United States. So instead of just a global view which we just talked about, global assets of stock and bonds compared to global GDP, just here in the United States, net worth compared to GDP, we ended the year 2017 at 500%. Again, the previous peaks of 1999 and 2007 were 445%, 459%.
Kevin: That’s a big boat.
David: Right. The question is really, where do you go from here? Net worth is tied to two primary assets. You have financial assets, blended stocks and bonds, and of course the second one, the big one, is real estate. This is where we go back to rates and inflation.
Kevin: The two I’s. I know you call it rates, but let’s just go ahead and call it “I” for interest. Interest or inflation, we really haven’t had a scare either way, and we haven’t had any volatility. If we have volatility in these markets like we saw last month, do we see the two “I’s” start to factor in?
David: This is where, going back to Eddie Stirling’s insight, he doesn’t care one way or the other. It is volatility in those two categories that triggers either deflationary catastrophes or inflationary catastrophes. So it’s almost like it doesn’t matter. If you have gone through a period of stasis, and then you have volatility, either with a decline in interest rates into the zero bound, or an increase in interest rates because of concerns over inflation, it doesn’t matter one way or the other. The impact on the financial markets is the same. Volatility with interest rates, volatility with inflation, either inflating or deflating, the volatility, itself, is what sets off a catastrophe within the financial asset markets.
Kevin: Those who have problems with blood pressure understand exactly what you are saying, because it is not necessarily high blood pressure that kills. It is the volatility in the blood pressure that ultimately wears things out and turns into either a stroke or a heart attack.
David: Interesting. 2017, so far, the trend has been with a decline in currency, and with interest rates moving up. It’s suggestive at this point of an inflationary shock within the asset markets. That requires a major rethink of the post global financial crisis deflationary engineering which has been put in place by the central bank community. To assume that they are caught flat-footed here might be correct. If anything, they are under-estimating.
To give you an example, listen to some of the interviews done in Davos in January at the world economic forum. Ken Rogoff is talking to a couple of bankers and the chief securities administrator in China. One of the things that they start talking about is the surprise of inflation. Around the table you could tell that some of smarter people in the room were assuming that inflation was going to be the surprise element, and that the central banks really were assuming they had greater control over this inflation beast than they actually do.
That is where I was beginning to see, as critical as I have been of Rogoff in some respects with his book The Curse of Cash, he understands the history – he does understand the history of the markets and where the vulnerabilities lie. And those vulnerabilities which he explored in his book This Time It’s Different, which he wrote back in 2008 or 2009, really gets to the heart of the matter. Yes, interest rates rise. Yes, inflation becomes an issue. Yes, you get the death of the equities market.
Kevin: Isn’t inflation something that central bankers have to be ahead of always. They can never be behind.
David: If you get behind, the consequence is grave, and it requires a Volcker-esque move to kill inflation. And that would be almost unthinkable with 65 trillion dollars in debt here in the United States – private, corporate and governmental. Imagine what a Volcker-esque move to interest rates would do to the economy. It wouldn’t throw us into a recession, it would be the death of the United States, because keep in mind, when Volcker was doing that, debt-to-GDP figures were between 30% and 40%, right?
Kevin: While we are talking about debt, it is the credit creation that has financed the overvalued assets.
David: And that is a key point. If you go back to Doug’s comments over the weekend, a very critical point from Doug’s comments – “A large percentage of new credit creation,” to quote him, “has financed those overvalued assets.” So you being to see any reversal in the prices, and all of a sudden you have the unwind of a daisy chain within the financial markets because those overvalued assets were all financed. Ironically, it would appear that an inflationary overshoot and a rise in interest rates may give us pockets of deflationary collapse – pockets of, not broad, systemic deflationary collapse, in my opinion, but pockets of deflationary collapse as those assets, the underlying assets, shrink below critical thresholds relative to the debt financing associated with them. Just imagine, if you would, the world’s greatest margin call.
Kevin: We talked about something that could be an unknown. Last week we talked about how China is a command and control economy, yet it is also sort of a free market economy. And so, in a way, maybe with all this credit expansion they were able to buy a model that can’t last. Now, can they continue to buy the model that can’t last? And even though we see market dynamics here in the west, can China overshadow that or put a gigantic Band-Aid on it?
David: You and I have spent many evenings talking about debt and the possibility that debt creates a short-term reality and a misperception of reality, and ultimately the story ends very differently. But there is an interim period where debt can color or change one’s perception of reality.
Kevin: So China.
David: I wonder about the Chinese system often. Is it different than our system? What stresses can they bear which we cannot? What thresholds can a command and control system maintain which a truly market-oriented economy cannot? Their commercial banking system is, today, over 40 trillion dollars in assets. When I say assets in banking, you have to flip that around. They have 40 trillion dollars in loans in the marketplace.
Compare that with our commercial banking sector, which has 17.4 trillion dollars in loans outstanding. Our 17 compares nicely with an economy, total GDP here in the United States of 19.4. 17 versus 19, we actually have a larger engine compared to the loans, at least in that segment of our economy.
Kevin: So what we are talking about is, can China pull the rest of the world – we were using the boat analogy. But how much of that debt makes up the GDP of the world, because we are talking about, can China save the world?
David: The Chinese have an economy of 13 trillion. They have 40 trillion in commercial loans. That 40 trillion in loans is the equivalent of 50% of world GDP.
Kevin: Wow.
David: So Jim Grant’s team wants to know how you constructively loan 3-6 trillion dollars each year into a 13 trillion dollar economy. And I think it’s a great question, 3-6 trillion dollars in lending into a 13 trillion-dollar economy. And the key word there is constructively, because the 3 trillion matches 2017 credit growth rates of 8.7%. The 6 trillion-dollar figure matches the 2016 growth rates in bank assets, so 2016, over 6 trillion dollars. And again, the word is constructively. How do you constructively loan between 3 and 6 trillion dollars, and you’re doing this every year, into an economy that is 13 trillion dollars in size? The numbers don’t match up. It’s too much growth in bank assets. It’s too much growth in loans relative to the economy, which can service those loans. The math doesn’t work.
Kevin, you and I have discussed how you have the great monuments throughout history – the pyramids, or pick any other historical colossus. If you want to look at Percy Bysshe Shelley’s poem, Ozymandias, it’s the same question, of the colossus, the historical colossus.
Kevin: And those were never built by willing participants. Any time you see a huge building project – even being in Israel this last fall, looking at Herod’s work. Those people were not willing participants who built these incredible structures like the temple and the wall. They were not willing participants. It’s usually slaves from outside.
David: My guess is when you visited Petra, that was built by craftsmen who were not compensated commensurate with their skill levels. They were fed a mess of pottage and grateful for it. But does debt change this? Does it allow for one generation to enjoy the fruits of expansion at the expense of the next generation?
Kevin: Right, so instead of having current slaves do it, you are actually enslaving the next generation.
David: Right, the old-fashioned slave labor was the means by which dictators of old built their empires. The subjugated masses had no voice, they could not protest, they could not escape their plight. But isn’t debt really a form of generational sleight of hand?
Kevin: Yes, pushing it forward.
David: Subjugation of a future generation, and it is far enough removed from the present generation to take away the reality of the burden being created. That’s the question. Is there a reality with that burden, or can you somehow make it go away?
Kevin: Then let’s use our imagination. Could the pyramids, if these institutions existed at the time, have been built by the Federal Reserve, the European Central Bank, City Bank, you name it, and everybody be happy and fed at the time, but the next generations would be the ones who would have to pay the debt back? They would be the enslaved.
David: I just don’t know where it ends. I don’t know where it ends. Perhaps I live in a naïve world where debts created have to be paid back. That may be a basic assumption which is false. I have assumed it to be true, but perhaps no government living beyond their means in the current environment ever intends to realize the viciousness and maliciousness of an intergenerational commitment to debt slavery. Maybe it is not on their minds because they don’t plan on paying it back.
Kevin: Think Reinhart and Rogoff.
David: Right, and if that is the case, then debt is merely a shell game, in which case, the people who are playing in that shell game, the investing community (laughs) are the ones that do pay the price, over and over and over again, like the burnt, bandaged finger, wabbling back to the flame. If that is the case, then there are the old two possibilities – one, default on the debt.
Kevin: Right, that is the Reinhart/Rogoff this time is different.
David: It will cost a lot for the wealthy and the politically connected. I’m reading another book right now. I would love to talk to the author, Walter Scheidel, The Great Leveler: Violence and the History of Inequality. He talks about there being four things which ultimately eliminate inequality – war, revolution, plague and financial collapse. So you have financial collapse when you have a default on debt. So that is an option, but you will eliminate the aristocracy, you will eliminate the politically connected.
Kevin: Yes, so other than default, the politically connected can get away with murder if they just inflate the debt away.
David: That’s the penchant. The penchant and the natural tendency is to inflate the debt away. In either case you have a degree of instability within the financial markets which makes gold a foundational asset. It is a foundational asset in a legacy portfolio. By legacy portfolio, I mean one that transfers value through time and through the disruptions of the immediate, any of the disruptions immediately on the horizons to future generations. It is insurance against mal-investment. It is insurance against the inappropriate management and gerrymandering of the financial and economic system.
Kevin: I read a Bill Bonner quote, just short, simple, sweet, but it is true – “Printing money is just another way of going broke.” So what you’re saying is, when you own gold you are just preparing for them to print money as long as it takes to go broke.
David: That’s right, and ultimately, it is insurance against that event. So the Chinese are experimenting with some sort of a bastardized version of dictatorial control and capitalist free markets. By the math, looking at their debt figures, they will fail – by the math. But by the resolve, and willingness to allocate losses to certain economic players, perhaps they will not fail. I don’t know. They’re not limited by consensus. This is one of the things that we are bound by in a democracy. They do not have to win the popularity contest.
Kevin: Not anymore. Not after this week.
David: Exactly. Last week we talked about Xi officially gaining lifetime dictator status. It’s official here on the 11th of March, with a limitless timeframe to manage opportunity and whatever crisis may emerge, we have Xi Zedong, or Mao Jinping, however, you want to see him – he may be able to force the math. Now, I don’t know at what cost he can force the math, or who ultimately has to pay the price.
Kevin: But the rest of the globe is going to feel it.
David: That’s the question. What are the global ripple effects? Because if you avoid a collapse in China, it still comes at a high cost. You have mismanaged your finances so egregiously, there will be a cost somewhere and to someone. And does it spread beyond their border? Managing a crisis by silencing those negatively affected? Sure, they can do that. Intervening quickly, certainly more quickly than our system allows? That is certainly an advantage of the Chinese. But it is still a matter of doling out costs and consequences. Is that a domestic issue for the Chinese, or does it migrate internationally?
You may recall, we have spoken with Minxin Pei and Victor Shih. I would love to bring them back on the program this year to discuss this in detail, because China does seem to be a very important piece. 2018, 2019 – credit continues to expand. We’ll talk about domestic credit expansion next week with Richard Duncan. But there is this other very significant credit growth piece which we have to look at.
Until next week, and our view from the Far East with Richard Duncan.
