About this week’s show:
- Argentina default: Eighth time’s a charm!
- U.S. on Armenia/Azerbaijan: It’s still about oil
- Interest rates rising: 2015-2045
The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
Kevin: David, we’ve talked about certainty over the last few weeks – the markets, themselves, the stock markets, the interest rate markets – they seem to have built-in certainty. Yet, there are fingers of instability everywhere. We are hearing horror stories coming out of Africa. We are also hearing Africa in the news right now. Obama is saying that America’s new direction is that we are going to help Africa from a business standpoint over the next ten years.
David: What is interesting to me is that the African Congress, which is going on this week, with heads of state from 50 countries attending state functions in Washington. We’ve missed the boat, for a decade. And it has been Europe and China who have locked up the continent, they have been chasing natural resources, and certainly the Chinese have turned a blind eye to the issues of human rights violations throughout Africa by existing leadership, so there has been a trade deal set probably every week and if you go to any African country you will see Chinese everywhere. But the Europeans are quick on their heels. I can’t believe we’re coming at this and saying that this is the next future and greatest deal, because frankly, our biggest trade deal was oil. We were importing – past tense – importing a tremendous amount of oil from Nigeria, from Algeria, and as we have increased our production here in the United States the shale revolution has caused about an 85% drop in our African oil imports. This went from being a 100-billion dollar a year commitment to Africa, to now about a 15-billion dollar a year commitment in terms of oil trade. So, we are at a 40-year low, and I just don’t know what Obama can offer other than promises not to develop U.S. energy resources, because that certainly would roll the clock back. The last five years of our moving toward energy independence has really cut the Africans out, and it is because they have the same quality of oil that we have, the light, sweet crude.
Kevin: It seems like it may be just window dressing. We’re hosting the meeting so we have to say something nice. It reminds me a little bit of the space program. Various presidents recently have talked about going to the moon, or going to Mars, or going to an asteroid, but the reality of the situation is that nobody has the inclination, the money, or the interest anymore to do anything in space. A big part of that is, we have 17 trillion dollars in debt, Dave. We can’t do much with that kind of debt. Look at Argentina. They have figured it out.
David: But on the other hand, just because we have lots of debt doesn’t mean we can’t print more money out of nothing. Again, promises are one thing, being able to deliver on them is another. I think frankly, what we have done, or undone, in terms of our oil relationship with Algeria and Nigeria, we have dropped our imports from Algeria by 75% in the last year. This is the kind of thing that reshapes political alliances and creates continental priorities which cannot compare with any sort of aid packages which we might put together in the interim.
Kevin: You have talked about human rights. Obviously, we have to turn a blind eye to human rights if we are going to get involved with Africa, because it is horrible there. I remember Khrushchev said that one of the goals that Russia would have it to take Africa, because it was a natural resources depository. He didn’t care what happened to the politics in Africa, he just wanted the gold; he wanted the diamonds; he wanted the platinum. There really are a lot of resources in Africa, and frankly, if they do ally away from America, look at platinum. Almost all comes from either Russia or South Africa.
David: And you mention Argentina. The debt issues both here and there are a big deal. Perhaps this is a little bit less of a crisis scenario. As of last week they defaulted on 30 billion dollars in debt, which is a fraction of what they defaulted on in 2001.
Kevin: But don’t cry for me, Argentina, because they’ve done this before, right?
David: Eight times in the last 200-odd years, so it is a little repetitive. It is like the scratch in the record. It is just a question of how long it takes to circle around. Is it about ten years, now? Should we default again? Should we destroy our currency? This time it is actually for legal reasons and not financial reasons, so there are a lot of folks who are betting on a sharp rebound. I don’t know. Pro-business replacement for the Kirchner clan – I don’t know if we will see that or not. Will we explore opportunities in Argentina? You and I are taking an exploratory trip down in October in anticipation of political change, and there is the possibility that just like in the 1982 Falklands conflict, that preceded the collapse of the regime, and was used as an excuse. There is this conflict, and everyone should not look at the economic chaos that is going on. We have this conflict right off of our coast, and of course, it was about a year after that that the dictatorship collapsed. So, we have the current default cycle, and maybe it negatively impacts the Kirchner legacy, but it is so hard to judge politics in Latin America because they can just as easily rally around nationalist feelings, pointing to the foreign devils in pinstripe suits who are coming down as what they call vulture capitalists, to buy debt and redeem it at full value.
Kevin: Argentina is an interesting Petri dish for any country that goes through a debt situation where they have to either default or devalue their currency. One way or another, debt gets paid. It is either the person who owns the debt, who loses everything, or the person who owns the currency, and they end up losing everything in the devaluation of the currency.
David: It is not as if this is uncommon – eight times in the last 200 years, six of which have happened since 1950 in Argentina. Peru is no different, five defaults just like this since 1950. Dominican Republic, probably less, maybe two since 1975, but it’s not as if this is just the Latin world. Turkey has had eight defaults, Greece has had seven. Austria in the same time frame, going back to 1800, has had seven defaults. Spain – six. Russia – five. It is not just Latin America. As you look around the world, it is actually a fairly universal constant. Again, that idea of a scratched record. It is just a matter of time, when you are dealing with high levels of debt and fiat currency together, you know what you end up with? A pretty predictable recipe: You get in over your head, and then you print like mad, and then ultimately, you either default explicitly or implicitly. It just depends on what the political or geopolitical ramifications are.
Kevin: David, patterns can be recognized if you have enough time to actually see the patterns. We live very short lifetimes – it’s just a flash. But if we had lived 500 years, we would realize that default is actually the norm. You take out debt and then you default. You take out debt, you print money, you default. With that being the case, the person who owns bonds, I don’t care what country, even the United States, probably needs to take note at this point and say, “You know, what kind of default am I facing? Any time I buy debt, what kind of default am I actually buying into?”
David: You know, it’s funny. When you look back at the 1500s, the 1600s, 1700s, the better bets were corporate loans. The worst bets were the sovereign loans, because you were pressured, when a king needed to borrow money, or a queen needed to borrow money, there really was no option, you had to loan the money, because they could really do damage to you. They could throw you in jail, they could make you disappear, and there really was no legal recourse. So, you loaned the money to the monarchy, you loaned the money to the throne, but you knew you were going to take a hit, and fairly predictably – 1500s, 1600s, sovereign debt was always defaulted on. It’s funny, because in the history of borrowing, it is considered now that sovereign debt is the best place to loan money. You are not going to lose money there, but you could lose money to a commercial enterprise, and quite the opposite, in the history of borrowing, it is only in the last 50-60 years when that has become a different scenario, and we only think about sovereign defaults in the context of say, Latin America.
Kevin: David, default doesn’t necessarily have to be during a time of geopolitical stress. We have had a period of relative peace since World War II. Let’s face it. We had World War I, which was continued into World War II. World War I, we pointed out last week, or a couple of weeks ago, we reached the 100-year anniversary of the beginning of that war. But now what we have is a lot of different alliances going a lot of different directions. Let’s say that you did have debt or currency of countries back in 1914, 100 years ago. Well, all bets were off in 1914, even the gold standard bet was off at that time, but I’m thinking about alliances that we are looking at right now. I was watching NASA TV last night. Granted, I am a geek. But the Russians now are somewhat separated from the Americans. They are both occupying the same station, but this alliance, this wonderful worldwide, let’s hold hands, build a station together, and call it peace, now it looks like we’re going to war with each other. Alliances are strange. They can shift, can’t they? Let’s look at it. We are a predominantly Christian country. We are fighting predominantly Muslim countries at this point. I think of the situation that is going on right now with Armenia and Azerbaijan. It reminds me of 100 years ago.
David: It is very interesting, because 100 years ago you had the alliances which behind the scenes quickly embroiled the whole world in a conflict, and it seemed that a small skirmish here or there could have been easily contained or ignored, and now it has snowballed because of alliances behind the scenes. Those alliances exist today. We in the U.S. are definitely connected to Azerbaijan.
Kevin: Which is Muslim.
David: Exactly, which is ironic. It is about 90% Muslim, predominantly Shi’a. And then there is Armenia, which is a Christian country, largely. And they are allied with Russia. My wife and I lived in the largest Armenian community outside of Armenia, which is in Glendale, California, for a number of years, 10-15 years ago. But what is happening. You have 18 people who were killed in fighting the last few days between Armenia and Azerbaijan, and the conflict, most recently, dates back to the early 1990s. There was a peace negotiated in 1994 and that appears to be breaking down. It was over a contested territory which Armenia had taken from Azerbaijan. You can look at this part of the world, the Syrian Empire, Alexander the Great, the Austro-Hungarian Empire. Literally, over a 2000-year period, whose land was it? It depends on which time slice you are talking about, because it has been contested and held by various empires, and now you have people who believe that they have a right to this land, and they know what they know what they know, because their great-grandfathers, and their great-grandfathers before them, told them the stories of why that land was theirs. This is really what you end up with. Our interests are allied with Turkey and Azerbaijan. Why? We have two pipelines through Azerbaijan which deliver Caspian Sea oil to Turkey and to Europe, and it circumvents Russia, so these pipelines are very critical to us and we are only too happy to be on friendly terms with the 90% Muslim, predominantly Shi’a population, and be in opposition to the Armenian Christian population and the country which is actually supported by Russia.
I hate to say this, but when we look back at wars that were fought for an ideal, that might not necessarily always be the case. I know Common Core is trying to each a very different type of history at this point, but I think we have to be realistic with the history that we have already experienced, and that we are experiencing at this point, Dave. It is not necessarily human rights or human interest. We talked about Africa, we are talking now about Armenia. Those lines are drawn for different reasons. In Economist magazine this week, it walks about the lines were redrawn after the last couple of wars, and you see these countries change. After World War II the lines, the national boundaries, were changed, just like World War I. The guys who draw those lines are treaty makers and we know that the seeds of the next war are in the last treaty.
David: It has also been said that truth is the first casualty of war, so why we are in any conflict is always a question that will be asked in future generations and I think, getting to the truth of the matter is always a very, very challenging thing. But what is ever advertised by the mainstream media or the current political powers, you can assume that 95% to 98% of it is unmitigated balderdash. In the Nagorno Karabakh region, which is in dispute between Armenia and Azerbaijan, a region which is 30 miles from the Baku-Tbilisi-Ceyhan pipeline, this is one of the two Russian bypass lines. This one, in particular, is capable of 1.2 million barrels per day, taking oil from the Caspian Sea through Azerbaijan to Turkey.
In case you are wondering who is the big Western corporate interest here, it is BP. British Petroleum is the big Western company with a stake in that pipeline. You wonder how backroom deals are sealed, you wonder why alliances exist, and ultimately, oil is a major issue. We have been talking about that in relation to Ukraine; we have been talking about that in relation to Joe Biden’s son being involved in the gas company in Ukraine. These are issues which are very concerning, and ultimately, should we find another European conflict, keep in mind, from 3600 B.C. forward, we have gone into some sort of regional or even national war, and in some instances global conflict, every five months, so it is not as if the history of the world is one of peace. It is actually a history of warfare. And then the question is just how you divide up personal interests and national interests, and how you advertise things. That is a question for the PR people.
But what is done in terms of statecraft to benefit individual country interests, this is where the rubber meets the road. You can be critical of U.S. policy, displacing the Native American Indians, and you can always find a reason for policies that were put in place. The truth is always very different than what was advertised, and I think, quite frankly, the easiest way to cut through the subterfuge is to ask one simple question: Where is the money? This is where we see that a minor conflict today, perhaps, not to minimize 18 soldiers dying on both sides, but a minor conflict between Armenia and Azerbaijan has the potential of bringing the U.S. and Russia into extreme conflict. Why? Because these are the bypass routes for Russian oil into Europe, and if we can, in any way, as we discussed last week, begin to change the energy balance of power and cut out the Russians, then we ultimately have greater sway in terms of European relationships, and even our ability to export U.S. oil to that part of the world.
Kevin: We were talking about fingers of instability. Just as you were talking, I was thinking what an incredibly complex world to try to manage, which is exactly what we seem to be moving more toward, a UN style of management, or a World Bank style of management. We have talked to people from the Council on Foreign Relations. The goal is more of a centralized control, yet you have these regional complexities. I think about what an airliner from Malaysia, shot down in Ukraine, has to do with Russia. It has to do with Europe, it has to do with energy, it has to do with alliances in Israel, it has to do with Hezbollah, it has to do with Iran. And now we have Armenia and Azerbaijan. All of these elements all have different links and these fingers of instability, and we haven’t even started talking about the financial yet, Dave. The bailout in Portugal. How do you manage this?
David: It is interesting. Lisbon decides that, no, this bank cannot fail, and it is really an issue of uncertainty. What happens when debt liquidations cannot be contained, and they spread from one banking institution to the entire banking and financial system? A central bank which was more than willing to spend 6.6 billion dollars to bail out these liabilities. Of course they wiped out the equity holders of the BES, that is, Banco Espirito Santo. This is a bank that has been around for almost 120 years and yes, they were overextended; yes, they were enmeshed in terms of their corporate structure; and ultimately, they failed.
Kevin: It is interesting, Dave, that they were chosen too big to fail, because they were the domino that could start many, many other failures, and it would spread like a firestorm.
David: You have Draghi on the other hand, who is doing everything that he can to create bank stability and make sure that banks in Europe are buying government bonds. Why? Because the ECB mandate doesn’t allow for direct financing of a particular government, so you can’t have the same sort of fiscal and monetary enmeshment with the ECB that you have with the Bank of Japan, that you have with the Fed, because of constitutional rules, because of the bylaws, if you will, of the ECB, when it was originally set up. So what is Draghi doing now? In June he began charging fees on excess reserves held at the ECB. He wants to take that money which is being set aside as a safe position outside the banking system and he wants it back in the banking system because he still wants to stimulate growth. He sees very tepid, very slow growth in Europe, and he is trying to do everything he can, including by mandate, to get those euros back into the banking system, and thus, into the economy.
Kevin: Do you think the free market is, in a way, saying no, I’m too scared to grow. I’m just going to keep it at the ECB, even if they charge me a fee.
David: The funny thing is, he can try to do that, but you have European banks which also keep deposits with the Fed, and if you look at the equivalent number, if you will, what we call excess reserves of depository institutions, there is about 2.7 trillion dollars of excess reserves of depository institutions sitting at the Fed. Very curiously, only about 1.3 of that is U.S. bank money. Over 1.07 trillion dollars, nearly half of it, is European banks that have branch operations in the United States and they are willing to take their money and park it with the Fed. The unintended consequence of Draghi charging fees on excess reserves held at the EBC, is that money can just as easily flow into the United States and sit on the liability side of the Fed’s balance sheet. I think what we have is a Fed and an ECB and a Bank of Japan who are exploring every last option to try to stimulate growth in the economy, and it is getting more and more difficult to do so. Again, maybe it is the proverbial pushing on a string. You can do whatever you want, but the dynamics are such that you are not going to have the effect that you are hoping for.
Kevin: You see this control in the markets when you look at charts. We were just looking at a comparison chart of gold, the stock market, and the dollar just a few minutes ago. We were looking at the last 5-6 years, when the stock market really had its crash, gold came down a little bit and then it went way up, but then it got knocked down and has stabilized and gone sideways now at these new levels for the last year-and-a-half or so. We have seen the same thing with the value of the dollar; we’re seeing the same thing with interest rates. You can see the hand of control there. Now here’s what is interesting. When you look at the stock market, the only market actually rising in those charts, stock market gold, the only chart that actually shows continued rise is the stock market, yet we are seeing volumes drop. There are a lot of people who are not in the stock market, but the few that are there are taking out massive margin debt, because let’s face it; are they trying to speculate to bring in income, some of the fixed income people? You have been watching margin debt. What has been going on recently with the margin debt on buying stocks?
David: This was an extended discussion point in our wealth management conference here in Durango, where we had a number of our wealth management clients fly in for a couple of days’ briefing, and what we talked about at the time was that the major moves higher in margin debt were an indication of the last gasp of speculation in the stock market.
Kevin: It is always a sign of a crash.
David: Sure. 2000, the spike in margin debt preceded the decline in 2001. The spike in margin debt in 2007 preceded the decline in 2008 in equities. And 2014 is going to reach the history books and be one of those same periods. I think 2014 is an up year for the equity market and it is either 2015 or 2016 where we see an absolute catastrophe in the U.S. stock markets. June’s numbers are in; we got those at the end of last week, when the numbers were released. It jumped 25 billion dollars in a single month.
Kevin: So margin debt is up 25 billion dollars in one month.
David: That’s right. And it is 1 billion off the all-time record number in nominal terms, and then if you wanted to say, well, nominal terms, things change with inflation, you have to have some way of calculating it that doesn’t just look at nominal values. As a percentage of stock market capitalization, it is at its highest level ever, and that would beat 1929, and that would even beat the 1999-2000 period, as a percentage of stock market capitalization, the speculative money, that is, money borrowed from a bank to speculate in stocks is at an all-time record high.
Kevin: Could this be a reason why Warren Buffet has moved 55 billion to cash? I’m not trying to think like Warren Buffet, I don’t know that I can, but his cash position right now, I think, is as high as it has ever been.
David: That is interesting. The last nine days most of the major equity indexes have reached all-time highs, then they sold off a little bit, they are not quite at the top. And guess what? The Wall Street cheerleaders have stepped in to say, “Buy the value. This is such a great opportunity. Look, the market is backing up. You need to put money into the market right now.” You mentioned Buffet, the master of buying value. He sees nothing to put 55-1/2 billion dollars in cash into. Meanwhile, you have the little guy coming into the market, last week 379 million, not a lot, but 379 million dollars in retail investor funds coming into equities, and at that same time institutions pulled 7.97 billion out of the stock market. You have institutions saying, “Time to mitigate some risk. Time to tighten the belt. Time to move things to cash.” And the guy, John Q. Public, is still coming into the market saying, “Yeah, bubble-vision just told me, I need to be buying stocks right now.” John Q, frankly, doesn’t match up to the Oracle of Omaha in terms of being a judge of value.
Kevin: I think it is worth repeating, 7.97 billion coming out, liquidations of institutions, and only 379 million for the small retail investor, that would be a guy like me going out and buying a stock. You are talking over 20-fold, the sales versus the buys, institutions selling versus retail guys buying.
David: The market internals just aren’t pretty – breadth, leadership, momentum. Small cap stocks are rolling over, junk bonds already have in the last couple of weeks led on the decline, and then here in the last couple of days the Dow-Jones utility index was the best average out there in terms of year-to-date performance, and guess what? They’ve sold off 8½% in a matter of days.
Kevin: Talk about cheerleaders. We are now hearing that GDP growth, anytime they get a good number they love to annualize it, anytime they get a bad number, they explain it away and just call it bad weather. But since they got what they felt was a good number, they are saying that the GDP growth annualized, if we keep this number up, is 4%. Why wouldn’t that be good news?
David: A couple of things. Nearly half of that number, the improvement to 4%, came from building up of inventories, so that is a reality. Plus, this is an estimate. We don’t know until the end of August, really, what our import/export numbers are, and so the volatile factors that impact GDP growth are not settled yet. But by the way, building inventories is not selling product, so there is a part of the GDP statistic which, to me, is a little bit irrelevant. It hurts you on the 1st quarter, it helps you on the 2nd quarter, and it is inventory drawdowns, inventory buildups. Again, I am more interested in actual activity, consumers buying, maybe it is government spending, but something being done, as opposed to just sort of filling the pipeline in the hope that there is going to be economic activity.
Kevin: So buying inventory shouldn’t necessarily be counted as growth until selling inventory actually occurs.
David: Yes, running a business I think I’ve got a pretty good bead on that. He’s sitting on lots of inventory (laughs), it’s very different than actually closing a sale and eliminating, or rolling that part of that inventory.
Kevin: Let me just bring up that this is the 4th election year that we are going into since we started this show, and it seems that each time we go into an election year, every two years, the numbers start getting better and better from about July and August on, until we get to November, because the guys who control the numbers are the incumbents. They are the guys who want to get back in.
David: Well, it is interesting. There are a number of elements of Obamacare that are not being implemented until after the election, were on schedule – on schedule – to be implemented already, and they have been postponed until after November. Call it coincidence, all it what it is, political convenience, and I think what you find is that, yes, the numbers, whether it is GDP or the jobs numbers, these are tools that advertise success, and if you can do anything to manipulate those numbers, you will. Last week’s jobs number was anything but exceptional, and it would have been worse, had it not been for the inclusion of 80,000 jobs which were fabricated. The birth/death modeling added 80,000 jobs and even with that we still moved up from 6.1 to 6.2, a 10th of 1% in the wrong direction. And of course, we missed expectations, and again, they are going to do everything they can to fix the numbers. Our suggestion is that you look behind the scenes and figure out what is actually happening in terms of economic activity.
Kevin: I know that several indexes that you like watching have to do with the movement of freight. As strange as it sounds, that is a good way to see whether you have a real recovery going on, or if you are still staggering a little bit. What are the movement of freight indexes doing at this point?
David: I think it is important to look at both indexes, because on the one hand, HARPEX looks at more of your dry bulk goods and the Baltic Dry Index actually captures a number of the tankers, whether it is the Suezmaxes and what not, where you may be hauling oil, you may be hauling a variety of goods, but the Baltic Dry and the HARPEX – if you keep an eye on both of those, what they are really showing you is very tepid recovery. What are they? They are freight costs. What does it cost you to rent a boat? What is the day rate to rent one of these monstrous boats that you can put tons and tons and tons and tons of either raw material or finished product and deliver it to an end distribution point?
These are freight costs and they tend to increase with traffic, so if the economy is recovering, both in the United States and globally, you would expect to see freight costs increasing as there is an increase in traffic, and lo and behold, traffic has remained low and prices to rent a boat are 75-80% below their peak levels. And you may say, okay, that’s a little overdone, because relative to a peak, let’s talk about more relative to an average through a 20-year period. That’s about 50% below a historic average. It is sort of like looking at the Chinese GDP statistics and then asking, “How much energy is being used?” For instance, what are electricity or utility rates doing, and what is usage in China?” And you often find a very different picture, growth going off the charts, and yet a major contraction in energy consumption, and you have to ask the question, “Just how political is the GDP statistic in China, or frankly, anywhere in the world?”
Kevin: Let’s say that you are Janet Yellen right now, and you have to make a public statement, so you are going to come out and say, “We’re watching GDP grow, we’re watching employment coming back. We know those are probably false numbers. She is not saying that, but down deep inside, she has to know those are probably false numbers, especially moving into an election. Yet, she is still coming out and saying, “We’re going to use those numbers as our indicator as to whether we are going to cut back our quantitative easing. Dave, for the last few years, we have been adding over a trillion dollars a year just by buying our own debt with printed money. That’s what quantitative easing is. How do you keep interest rates low and stop buying that debt? Is there somebody who can step in and do that? Are we really going to ease quantitative easing going into an election?
David: It is an interesting proposition, and I am still wrestling with the whole timing of QE. It is coming just before an election, I don’t fully understand that. Is the assumption, or understanding that something, somewhere around the globe, will be so ugly that safe haven demand for treasuries will keep rates low in the place of the Fed doing most of the buying? I don’t know, but there is a growing expectation in the marketplace for a shift in rates to a higher level. Let’s say we return to 2006-2008, that timeframe, when the Fed funds rate was closer to 2% instead of less than ¼%. That would put the ten-year somewhere between 4 and 4¾%.
There are consequences to that. You have a nasty effect on leveraged real estate, and that assumes that financing costs are still a significant factor in the pricing of that asset class. Campbell Real Estate Letter, a great group and letter, particularly if you like California real estate. He is out of San Diego. He suggests that a 10-11% increase in mortgage payments should be expected for every 1% rise in mortgage rates. So, the ten-year treasury moves higher, mortgage rates are moving higher, that is axiomatic, and the 1% rise in mortgage rates causes an increase in mortgage payments. What does that do to the person trying to sell their home? Most people who are on the buy side are looking at cash flow constraints. What can I afford? What does my income allow me to purchase, in terms of a home? So, that increase in mortgage payments, because of the increase in mortgage rates, all of a sudden impacts negatively the price of real estate. Campbell would suggest that in that rising interest rate environment, even just normalizing rates back 150-200 basis points higher, you are going to see a decline of 20% in terms of real estate values on that normalization theme.
Kevin: We’re wondering how you replace quantitative easing. We have talked about this, we have speculated on it, but we were trying to figure where the money would come from if it is not the Fed doing the buying. For three weeks now we’ve been talking about money market funds, and the changes that the government is coming up with that may just answer that question.
David: That’s right. It is Bloomberg that has finally realized what is happening with the money market funds and the SEC ruling which recently went into effect. You basically have 500 billion dollars which is expected to roll into treasuries. So who wins and who loses? This all of a sudden becomes very easy to figure out. It is like that moment in a Shakespeare play when you realize the plot is thickening. The treasury has a new source for buying, and that is the money market funds that want to maintain their status as one dollar constant net asset value. Guess who loses, though?
Kevin: The corporates.
David: Yes, the corporate borrower gets the short end of the stick. And granted, these rules are not fully implemented until 2016, but the market begins to adapt long before the rules are fully in effect, and I think, again, that is a very interesting timeframe to keep in mind. About 2016 you have a shift in emphasis, money market funds are buying more treasuries. Corporate borrowers who have been adding to their total stock of debt, aggressively, are now in the awkward position of having to finance it at higher rates, and they don’t have access to the commercial paper markets via the money market funds without some penalties attached. So, these are the changing complexities, both within the worlds of finance and geopolitics. The way you described it, I think, is apt – fingers of instability. We don’t know exactly how this plays out, but it is going to require that the ball bounces exactly the right way, or we may have a negative outcome in the marketplace.
Kevin: You have pointed out many times before, Dave, we have enjoyed about 32 years of decreasing rates. When you build a paradigm around that, when you say things are always going to be this way, when rates get pretty close to zero, that is not necessarily the case. Now, what you are telling me is, if interest rates rise even 1%, according to the Campbell letter, the cost of buying a home goes up about 10% on the mortgage and the value of the home for the person selling the home may actually drop by 20%. We’re only talking 1% here.
David: It may drop by 10% for every 1 percentage point increase, so if we go and normalize by 2%, then you are dealing with a closer to 20% decline in real estate.
Kevin: I see. But still, it is very, very substantial. Bill Gross has pointed out that what we have had in the past may not be what we have in the future.
David: That’s right. It’s the tailwind that we have gotten. Corporate profits have been improved because of a decline in interest rates, and that declining interest rate trend has also, when you are looking at real estate, improved the cap rates, or decreased your caps rates considerably. And this, in his opinion, and in ours, is reversing. So, if declining rates were a tailwind for growth, what are increasing rates then. They would have to be a headwind, and this is a state of affairs that we expect for the foreseeable future.
Kevin: Then let’s look at running a corporation. We know that cash has been very, very, readily available during this period of time of bailout, quantitative easing, low interest rates. We know corporate cash is at a record level, but there is another record that is being set at the same time, and I think there is something to read into that, and that is, a record level of debt. What is that telling us about the corporation here in America?
David: A couple of things. There is cash that could be utilized for operations and it has been held overseas by most of the multinationals because they don’t have to pay 35% tax on it as long as they leave it with their foreign subsidiaries, so basically, corporate America is raking in profits and not having to pay taxes on it because of what they call attacks or jurisdictional arbitrage, and they are masters of this, where, essentially, trillions of dollars in revenues goes untaxed until they repatriate it. So, there are those cash profits sitting out there and they don’t want to bring them home because they don’t want to pay taxes on them. They can always expand their business overseas so it serves a long-term purpose in terms of development of their business.
But on the other hand the balance sheet, as you mentioned, in the 1st quarter of this year, corporate balance sheet has been debauched to the tune of 223 billion dollars. That’s 223 billion dollars in debt that was added to corporate balance sheets just in the first quarter of this year, and that is okay, as long as business picks up and we have growth as the thematic, but even if you have a marginal drop in business, now your interest payments are that much harder to make, not to mention if the bond king, Bill Gross, is right, and we actually see a reversal in trend in interest rates, now all of a sudden the burden of higher rates on corporations, now you’re are talking about a real headwind in terms of earnings growth.
Kevin: So, what they are really hoping for is recovery, because if we don’t have recovery those increased debts are going to be a huge lead weight around their necks.
David: That is exactly right. And then you have what you might even call the Snowdon effect. People aware of the reach of the U.S. government and not being comfortable with it, whether it is at treasury, or with our state department, or with our military interventions. We talked about Russia and Ukraine more last week, but you have Russian companies that are now shifting out of their cash positions that have comfortably been held in U.S. dollars, and they are moving out of dollars and moving toward what gives them a proxy for the U.S. dollar, that is the Hong Kong dollar, because the Hong Kong dollar is tied to the U.S. dollar in terms of its valuation, but who controls the Hong Kong dollar? Is it the U.S. treasury? No, it is not, and it gives Russian companies, and any other company, frankly, for that matter, that is concerned about Treasury interference, or freezing of assets, or further sanctions – it gives them latitude to continue to operate, and do so without the incursion or the complication of the U.S. government.
I think one of the interesting elements there is that this is an element of erosion, in terms of dollar priority. The dollar has been the assumed holding in a cash position, for corporate America, for international companies, for governments, and there is this growing concern that our adventurism out there, our extraterritorial requirements, you see it right now, the French are basically saying, “You just handed down a 9 billion dollar bill to one of our banks and our question is, do you have jurisdiction here?”
Kevin: It’s not just the French. In Rome, Berlin, London, these guys are saying, “Yeah, we’re with the French on this one. Sorry, that’s too much money.”
David: Right. Not only too much, but what exactly is your role in our part of the world? Last time we looked, we have our own people doing what you do, and we kind of recognize our national boundaries. It is in about ten different areas where you see this assumption of U.S. presence and that it is justified, and yet, the world is looking and saying, “We don’t need your dollars. We’re happy to take Hong Kong dollars. We don’t need your rules. We make up our own quite well, thank you very much.” And it is this strange disconnect between the way we operate and the disposition in which we operate, and the way other people are sitting with their hand on their chin, looking at us quizzically, saying, “What in the heck are you doing?”
Kevin: And they’re not just talking. They’re signing treaties. They are working around the dollar. I am thinking right now of the treaty that was signed in May between Russia and Belarus and Kazakhstan, the Eurasian Economic Union. Dave, in our lifetime, we have seen the dollar completely unchallenged. When you and I were young, the dollar was completely unchallenged as a worldwide trade currency, and then we saw the EU come in, and it has held up quite nicely, even with all the debt problems that they have. The euro has become an issue, but now we have the EEU, the Eurasian Economic Union, and probably more to come from there.
David: It is important to watch natural resources. It is important to watch capital flows. It is important to watch the trade relationships that have developed, because ultimately, trade drives the long-term political relationships that you see develop or devolve in the world picture. And the fact that they are moving east, moving toward China, and there is an energy complex which we don’t control, namely, the Middle East and Russia, it really means that our interests, ultimately, are pitted against the Middle East and Russia, and this is where you see our foreign policy take shape.
I frankly don’t know what to think, Kevin, because when it comes to an ethical appraisal of our foreign policy, I know how it measures out from the standpoint of morality. From the standpoint of sheer self-interest, it is a very different calculus, so we will do what is in our best interest, but it may not be the right thing, or the good thing, to do, in terms of a way that others would feel respected and appreciated in the rest of the world. Perhaps that sounds pitifully naïve, or perhaps even like a Jimmy Carter-esque statement, but there is a conflict between the way we act, and the way we talk. When we talk, it is as if we are morally unchallengeable, and yet, if we really knew what drove this country, what drove our international politics, what drove our foreign policy, I think all of us would want to go outside and throw up.
My suggestion is this. As we look at these fingers of instability, political and geopolitical rancor, truly an unsolved financial problem, not only in Europe, but here in the United States, as well, and an economic growth problem which has yet to be solved, it can’t be done with the printing of money, has been tried over and over again, and the results have been terrible in each instance, where you are either getting rid of debt via the printing press, or destroying culture thereby.
You know what? We think this is still a time to batten down the hatches, be very comfortable with a cash position, be very comfortable with a precious metals position, physical gold and silver. Again, the time that lapsed between 1909 and 1914 was very short, and no one in that short period of time could have expected or anticipated the changes which were immediately ahead of them. You look back to the alliances which existed before these minor skirmishes and conflicts occurred, and it was those alliances which acted like a megaphone. A very small voice became a very loud message, one of conflict and chaos, and that is what we feel is immediately in front of us.
