Podcast: Play in new window
- Steph Pomboy: “The U.S. Fantasy Is That The World Needs The Dollar”
- Government’s Big Mistake Is Financing Our Debt On The Short End Of The Curve
- “My Hunch Is That What’s Coming Will Make 2008 Look Like Child’s Play”
“Gold is going to play a major role in stabilizing the monetary regime. Whatever that monetary regime looks like on the other side of this bust that I believe we’re about to go into. My sense is we’re headed into an economic recession, but the financial bubble bust associated with that will compound the damage dramatically.
“So, the economy might naturally slow a fair amount, but when you layer on the deflation in financial assets from these spectacularly overvalued levels, you’re talking about the repeat of the 2008 economic downturn that will beget massive fiscal and monetary stimulus. Gold is going to have to play a part in that monetary regime. I just don’t know how else we can come out of where we’re headed.” —Steph Pomboy
Kevin: Welcome to the McAlvany Weekly Commentary. I’m Kevin Orrick along with David McAlvany.
One of the things I’ve really enjoyed about you, Dave, through the years, is you like to talk to people who don’t necessarily agree with you, and we’ve learned a lot. I mean, there are central bankers that you’ve interviewed, and I’m thinking, “What in the world are we doing talking to this guy, or whatever?”
But there are times when it’s a breath of fresh air to talk to somebody who says, “Yeah, yeah, I get what you’re doing and I get why you’re doing it. And we’re in agreement on an awful lot of things.” I have to say, Steph Pomboy is probably someone who’s going to say, “Yeah, we agree.”
David: Some of my favorite pictures are panoramic. And it just takes in the full view and duplicates what you have in your mind’s eye, which you know to be the reality, and I love that you can capture that.
I think I do find that Steph and I have some commonalities. And the fact that there’s an analysis of context and comparatively really a lot of complementarity or compatibility, it makes for a comfortable conversation.
Kevin: Well, and how many people—
David: Not all conversations are comfortable, although all are very important.
Kevin: How many people can you talk to that can actually talk about the Dow-gold ratio? I thought you were unique on that.
David: Well, it’s decades of market experience, and when you have that, you have perspective and you have insight, and Steph has that. So, through the ’90s, through the aughts, through the last 10 years, if you start stacking in the decades of learning and reflecting, there is that bird’s-eye view, which gives you, I think, an ability to navigate in a different way.
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David: Well, it’s the occasional tweet that catches my eye and I think to myself, “She gets it.” Maybe there’s a little confirmation bias on my part. But Steph, your observations are intriguing. It was one of my colleagues that met you at a conference recently and inspired this interview. Obviously, the precious metals arbitrage and the money management business that we do a little bit differently might’ve been intriguing to you as well, but regardless, here we are.
Economics is something you focused on for a lot of years. You’ve been interested in economics. MacroMavens is something you’ve been writing now for a good long while. Tell us a little bit about MacroMavens and about yourself.
Steph: Well, thanks for not revealing my precise age in that introduction. David, you’re right. I’ve been doing this longer than I care to count, and thank you so much for having me on your podcast. I did get to enjoy meeting one of your colleagues at a conference in May sometime, and found what you guys were doing there very interesting. And it’s no secret that I’m a real gold bull, so we were kindred spirits in that regard.
But as relates to MacroMavens, life takes you on these paths and then you pick your head up decades later and go, “How did I get here?” I will confess, I didn’t spend my childhood fantasizing about being a pontificator on matters macroeconomic, but that is where my journey took me, and it turned out to be something that I actually developed quite a passion for. It is never dull, so it’s great intellectual stimulation, always something going on somewhere around the world that’s new and interesting. These days, there’s obviously a lot going on everywhere. It definitely keeps me busy.
But one of the things that I hoped to achieve with MacroMavens was to identify areas where the markets were missing potential turns in the macroeconomic landscape. For example, when I first started marketing my service to institutional clients, they would say, “Oh, well, we’re bottoms up. We’re not top down. We’re bottoms up. We pick stocks based on the individual companies, various valuation metrics,” or whatever their focus was at the time.
And I would always ask them, “If I told you we were going into recession tomorrow, wouldn’t that factor in to your investment approach?” So, it always struck me as interesting that people would get so focused on the minutiae that they’d miss the big picture, and things like 2008 would happen and everyone would kind of be like, “Hey, where did that come from?”
Meanwhile, for those of us who look at the big picture stuff, you could see where the train was going for years before the financial crisis actually started. So, my whole raison d’être at MacroMavens is to identify areas where the markets are missing the economic reality. And it turns out that that’s been a fairly fruitful niche, since very few people actually want to hear what they might be missing. They usually look for reinforcement of their own thought process.
So anyway, that’s what I do. So my analysis tends to be inherently contrarian, which can be good and bad. It’s good when it works, but when the market is in a sort of insouciant blow off, let’s say, you look like a first class moron, so I’ve had my fair share of that.
David: Economic data has been mixed, with the necessary caveat that there’s accounting and statistics which have taken on sort of a postmodern flare. You can do with them what you want. There are compelling data points that you believe are clarifying in making the case for a hard landing versus a soft or no landing scenario. Maybe you could share some of those with us.
Steph: Well, I think you’re dead right about the data, and that’s another challenge these days is discerning which data are important to look at and which facets of that data are important to look at. And one perfect example is the monthly employment report, where people have finally figured out there are two measures and one tends to be more accurate at turning points and the other one tends to lag. And now, Wall Street has sort of woken up to that reality.
But in terms of actually looking at the data right now, my starting point, because I like to keep things simple, is really to start by focusing on the US consumer because so far the consumer continues to be the engine of growth, really, for the US economy. So, I think the direction of the US consumer, odds are I’m going to get the story right. And so, I have been watching very closely what’s been going on with the consumer post-COVID. And obviously, we had this period there where we were just throwing money at consumers even after the pandemic had ended, and that was really supporting consumption.
And we were seeing that during the pandemic, really, focus was on goods because people couldn’t go out and do the stuff. So, they were redecorating their homes, and building home offices, and just stocking up on stuff. And then when that all started to fade, everyone said, “Well, don’t worry about the collapse in durable goods spending and all this stuff. It’s that consumers have now shifted to prioritizing spending on experiences over stuff now that they are liberated and they can go out and travel and eat out.” That’s really the key things.
And that’s fine. It was a reasonable story for let’s say the first year or something after COVID. But we’ve had a period now where the goods consumption has been really at sort of recessionary levels.
For two years now— I like to look at retail sales at a window into discretionary spending, and if you adjust that for inflation, they’ve gone nowhere for two years. That’s unheard of outside of a recession. So, people on Wall Street have cavalierly pooh-poohed that and said, “Yeah, but the $200 prefix restaurant I go to in Upper Manhattan is still completely crowded and I can’t get a table and this and that.” So clearly, the consumer is great.
You hate to point out to them, “Hey buddy, not everyone is eating $200 prefixed dinners at Le Bernardin, so maybe you want to look around a little bit.” But what I’ve noticed since the beginning of this year is, there are industry groups that report on the travel and leisure industry, not surprisingly, and I’ve been following very closely the National Restaurant Association that has a monthly performance measure, and they ask restaurateurs a variety of questions about their business and their outlook.
And in January, that measure hit its lowest level since restaurants were closed for business during COVID. So, sales and traffic were as bad as they were when they were closed. And I thought, “Well, geez, that’s stunning.”
But you don’t want to extrapolate one month, so I waited and looked at February, and February showed this really modest bounce. If it was a chart and a chart had gone down an inch and a half in January, it went up two millimeters in February—this is real hardcore statistical analysis I’m giving you here. Then March came and it moved sideways. Then April came in, and it moved back lower.
So basically, the restaurant industry has seen a real sharp slowdown since the turn of the calendar year, and it’s traffic, but it’s also sales. And obviously you see the anecdotes every day of a lot of these chain restaurants that are shuttering locations. Or in the case of things like Red Lobster actually going out of business.
Today’s story came to us via Hooters. I don’t know if you saw that one, but they’re shutting a lot of locations, and I snidely observed that when people are unwilling to pay up for a special scenery, that’s probably not a good indication about the state of the economy.
So, my point is that the consumer had already been signaling that they were in recession with the collapse in goods consumption as reflected in real retail sales activity. And now, the final shoe appears to be dropping in terms of the spending on experiences, services, et cetera.
Smith Travel Research, which is sort of the authority on the hotel industry, just lowered their forecast for occupancy rates and advanced daily revenue for this year and next year. And they had had both going up modest single digits or something, and now they see them down. That again is another real shot across the bow.
And there are a ton of measures that suggest the economy’s in recession. Obviously, traditional ones like the yield curve and the leading indicators. One that people don’t really recognize that we’re seeing a decline in full-time jobs, but they don’t realize that anytime you see a decline of full-time jobs, you’re in recession.
Myriad regional Fed indices are in recession territory. We had that Chicago business barometer that hit the lowest level in decades last month. And then obviously, you have things like consumer credit card and auto loan delinquencies that are already back to where they were following the global financial crisis. So, it appears to me that the consumer has done the Road Runner off the edge of the cliff, and gravity is starting to exert its inexorable pull.
David: Any thoughts on the divergence between the payroll and household surveys?
Steph: Yeah, it really is something that’s very classic. It seems to happen at economic turning points every time, whether it’s return out of recession into expansion, or from expansion to recession. And the reason why the payroll survey tends to miss those turning points is because the geniuses at the BLS— Well, that’s not really fair, because I understand why they do it, but they try to impute new business job creation.
So, for companies that just get started and haven’t yet set up a payroll or maybe aren’t large enough to make the payroll survey, they come up with some imputation as to how many jobs were created each month by these phantom new businesses, and to come up with an estimate for that, they basically rely on new business formations from the year prior as reflected in the IRS tax data.
So they’re looking at year-old economic numbers to determine where we are today, which, when you’re at a turning point in the economy is not instructive, and tends to lead to these massive overstatements of employment as the economy is going into recession and vice versa. They’ll persistently understate employment growth when the economy is turning out of recession and people are hiring, because they’re assuming jobs are still being cut by businesses going under.
One thing that’s really important to note, too, is that you’re now starting to see reinforcement from the weekly unemployment claims measure, which is really powerful as an indicator. And it’s sort of been head scratching as to why it’s taken so long for that to increase.
But I think a lot of it has to do with the still-meaningful stimulus that was provided to the state and local governments. All of the post COVID stimulus helped support a lot of non-traditional, let’s say, social supports. Bloomberg did a whole analysis talking about why it was that so many people who were eligible for unemployment weren’t taking the unemployment. I mean, that had the effect of suppressing the weekly unemployment claims.
And a lot of them weren’t doing it presumably because they were getting paid more on all these other programs that states like California were rolling out. So it behooved them to just take advantage of those rather than filing unemployment. But now as that stimulus runs out, you’re seeing it manifest in an increase in the unemployment claims.
David: In high school I drove a Ford F-150 and I remember the first time that I completely exhausted the leaf springs in the back. I didn’t think you could overload a truck, and there it was, way too much stuff in the back. And I think about the U.S. Economy, I think about our balance sheet, our fiscal position, the idea of fiscal dominance. Is the engine of growth sufficient to drive us forward, or have we overloaded the back of the truck with too much debt?
Steph: Well, I know in your case you were just loading the back of your truck with gold bars, so that’s a distinctly different scenario than what we have right now. That’s a high quality problem.
David: Never enough. Never enough.
Steph: Exactly. That’s a quality problem. Where we are today is pretty much the opposite of that. We’ve got to go back so far and talk about policy missteps from so long ago, but this is where we find ourselves. In essence, we have created an economy that is really dependent on debt to go. Debt, for lack of a better analogy, would be the fuel in the tank of the F-150 moving us forward. And the problem is, as we’ve used this model, we’ve passed the diminishing marginal returns on that credit. So we’re getting worse miles per gallon, as it were, for every dollar of borrowing that we undertake, and we get less GDP dollar for every dollar of credit.
The upshot has been that every time the economy bumps its knee, the Fed and the federal government come in and they flood the system with stimulus, but the recovery we get is less and less meaningful each time. And you will recall that head scratching as to why it was that the recovery wasn’t as profound coming out of the global financial crisis, for example, when the Fed undertook for the first time quantitative easing—you know, these unconventional monetary policies. And I think we’ll find ourselves in a similar situation today.
Over the last 12 months we’ve added 3.8 trillion in debt to the economy, and for that we got 1.4 trillion in nominal GDP growth. So it’s a fraction of every dollar in debt for every dollar in growth that we get out of it. And it’s even worse when obviously if you look at what we got in terms of real growth, you’re talking about 600 billion. So it’s a joke. And even on the consumer spending side, the numbers are really uninspiring. But we’re in the situation where if we don’t provide enough credit fuel in the tank, the economy will just stop.
And so who’s going to provide that credit? You know, we’ve got this situation now where you’ve got consumers who, last month anyway, said, “We’re done. We can’t borrow anymore on our credit cards.” We actually saw a decline in credit card borrowing for the first time since they were using their CARES checks to pay down their balances. And in the corporate sector, the borrowing is really just refinancing all of the high cost debt and trying to play games with that.
So it’s really the federal government that’s driving the bus here. And that is to my mind a very uninspiring backdrop against which to be investing. But that’s where we find ourselves. And I think this is why I keep coming back to gold, is, if the economy relies on credit and we’re going to really have the federal government be the marginal engine of that, who is going to fund it? There is no other party that can finance this expansion of the federal government other than the Fed because the rest of the world is rushing in the other direction. They see the writing on the wall and are not impressed with our abuse of the dollar privilege.
But this really has been the story, and it’s been unfolding for decades. But here in the U.S. we continue to indulge this fantasy that the rest of the world has no choice but to be beholden to the dollar, and that we can continue to wantonly debase it with these repeated quantitative easing gambits, and that there is no limit to our capacity to do that. So why wouldn’t you run up massive fiscal deficits at a time when the economy is theoretically in a healthy expansion? There’s no downside to it as far as they thought.
David: Setting the yen aside for a moment, the Japanese are something of an example of running up large quantities of debt and not having to worry about it at all. You know, if we look at that and say, “Okay, well those dynamics could exist, now come back across the pond.” Do you see the Fed as caught between needing to keep rates higher for longer to fight inflation and maintain institutional credibility on one hand, and on the other hand the need to cut rates to keep higher interest expenses from blowing out government debt and deficits, trying to avoid what could be a very hard landing?
Steph: Yeah, absolutely. I mean, I think that the priority is definitely to keep the fiscal situation manageable. And that’s why I’ve always thought it was kind of laughable that they ever undertook QT because you knew that the timeframe on that was going to be incredibly finite. There’s no way they can continue to shrink their balance sheet, particularly as I mentioned, at a time when our one-time foreign creditors, which was foreign central banks, are running in the other direction.
So it just seemed to me like when they started quantitative tightening, it was just a matter of time before they tapered and finally stopped it and then ultimately end up re-upping QE. So I think the Fed is really in a tricky situation quite clearly, and they’ve done everything they can to manage it in conjunction with Yellen at the Treasury, whereby you can’t even make this stuff up. But they’ve been financing these largest deficits in the history of mankind with T bills. Like who does that?
David: Right.
Steph: It’s just insanity. And they passed up the opportunity issue hundred-year bonds back when rates were at the lowest in a generation. But here we are now in an attempt to keep a lid on long rates. They are really stuffing issuance at the front end of the curve, and that is going to have this massive impact. And we’re seeing it already on the interest expense, unless or until the Fed dramatically cuts rates.
So we’ll see what happens there, but I think it’s just a matter of time before the Fed ends up having to cut, but also more importantly, to re-expand its balance sheet. And that of course will just accelerate the foreign exodus away from the dollar.
David: We have seen this movie before.
Steph: Yes.
David: Do you remember Jane Fonda in Rollover?
Steph: I didn’t see that. No. I’m going to have to—
David: Oh my gosh. The story is we get to the point where we’ve got a huge Treasury issuance and we’re expecting our trade partners, specifically those in the Middle East, to step in and do what they always do. And yet they back away. And all of a sudden there’s a debt crisis and it cascades from Treasurys to corporates. And I mean, this is an old story. Believe it or not, that was my introduction to Jane Fonda in the second grade or something. We had an odd family dynamic I suppose.
But, you know, last week we had the lowest close of the yen dating back to 1990—thanks to my colleague Doug Nolan for the reminder. So right now we have pressure for the RMB, we have pressure for the yen, we have pressure for the euro. Those factors give a bit of a boost to the current value of the dollar. And yet we have gold still north of 2300. How do you parse the currency markets and what do you make of gold in that context?
Steph: Well, I think that what gold’s telling you is that the dollar isn’t up, it’s just that it’s down less than all the other currencies out there. The ultimate arbiter of currency integrity is gold, in my view. So I had these stats now. I haven’t run them in a little bit. But I think the last time I checked, gold was up something like 12% for the year, and the dollar was up, call it four. And everyone’s saying, “Look how strong the dollar is.” Well, it’s not, actually. It’s down, you just don’t know it because you’re comparing it to the yen and the renminbi and the euro and the pound and you’re missing the real story.
And so I’ve always said rather than engaging in this fruitless exercise of gaming insignificant squiggles between one fiat currency and another, I’m just going to buy gold because that way I don’t have to figure out which central bank’s going to cut first or most aggressively. I mean, I’ll be covered either way.
And in the current environment it seems pretty clear that these central banks are all going to have to do the same thing, especially in the developed world. All the major currencies. Those economies are all facing the same issues. And they are: old decrepit population, so they’ve got really bad demographics, and they’re massively indebted. And that combination, when you’ve got these enormous unfunded liabilities to an aging population that you’re funding with ever-increasing amounts of debt, there’s only one way that you can resolve that issue, and that’s printing money to fund those obligations.
So I think it is going to be an ugly contest between Europe and the UK and Japan and the U.S., and that’s why I think it’s not an accident that you’re seeing this aggressive movement by the youthful and positive creditor nations of the BRICS world come together to come up with an alternative because they see what’s coming, and they want to get as far away from it as they possibly can.
David: You know, in the time we have left, I want to make sure we talk about banking, shadow banking, and corporate credit. Three fairly broad areas. Lower rates, if we get them, should alleviate pressure at the banks. They’re currently sitting on almost 500 billion in unrealized losses. The market wants to see that, believes it’s going to see that. Of course, they’ve had to adjust their expectations. It was six to seven cuts at the beginning of the year, and now it’s a little bit less. What if they get what they want, lower fed funds, but don’t get what they need, any relief to a securities portfolio with more extended maturities?
Steph: Mm-hmm. Yeah, that’s what I was going to say is the assumption that lower rates will repair the problems is one that I’m not ready to make. Because even if we assume that a cut in the fed funds rate will lower Treasury and agency yields, the environment against which they’re cutting rates is going to be one where this corporate credit that—right now we’ve got over half of what’s categorized as investment grade is triple B or lower. So it’s basically one toe stub away from becoming junk.
And the banks have exposure to this. They have exposure to levered loans. God knows what kind of opaque—I would use a four letter word—they have on their balance sheets. And so you may see a mix shift where suddenly the unrealized losses aren’t in tTreasurys and agencies, but they’re in all this other stuff.
But I’ve been thinking recently more about the idea— There was a fellow, I don’t know if the name will be familiar to you, Stan Salvigsen, many, many years ago had a fund called Comstock Partners. And he was famously very bullish on gold and commodities in general. And one of his central theses—and he was well ahead of his time, obviously—was that the government would become a larger and larger share of the economy, and that you would get to a period where you had, because of all the leverage, deflation with higher rates.
And when he said higher rates, he meant government bond yields. And the reason that you would get into an environment like that is because people say, “This fiscal situation’s untenable.” So you get the bond vigilantes, for example, coming back and saying, “The economy slowing down isn’t a rationale for rates to go lower in terms of government bond yields. It’s actually a rationale for them to go higher because think of all the more debt they’re going to have to issue. And isn’t that just a black eye for the U.S. economy and the safe haven status of Treasurys?”
And it’s an interesting notion, it would really be something else if it happened, but not withstanding the possibility that Fed rate cuts actually do little to alleviate the pressure on the Treasury complex, I do think the more important story is we know it’s going to be negative for private credit and all the corporate credit that the banks also have sitting on their books, to say nothing of what we’re already dealing with from the real estate side.
David: Well, you triggered a memory. If it’s the same Comstock Partners, Mario Gabelli, I believe, took over the mutual fund, if it was a short fund. And I talked to Mario about buying that, and he had insisted on keeping it to balance out tax consequences for other funds.
Steph: Oh, okay.
David: It was down to about 10 million in assets, and because we run a short fund as well, it made sense to merge them and have the structure of the mutual fund already set. So I think that’s the same Comstock Partners now under the Gabelli umbrella.
Steph: Yeah, and I would believe that.
David: Well, what’s keeping corporate credit alive? We’ve got credit spreads which have been impressively narrow. Is that a marker of confidence or a marker of complacency? What do you think the road ahead looks like for investment grade and high yield debt?
Steph: Well, initially, I thought the rationale for tight credit spreads was that, even though we have this wall of maturities that come due this year, next year, and the year after, I think we’ve got three trillion in corporate bonds, I’m not talking about private credit and all that stuff, but just corporate bonds that are coming due, and for example, let’s say you were a junk rated borrower and you were borrowing at 4% before the Fed started raising rates in 2022, you’re now paying 8% on that kind of paper. So to my mind, this was going to wipe out a whole swath of companies that could only afford to exist at 4% and couldn’t roll their paper at eight or even seven. And we have seen this huge wave of corporate bankruptcies, but, as you mentioned, none of this has been reflected in credit spreads at all, which remain pinned to the mat.
Initially, when I was really puzzled about that, I thought, well, okay, maybe the confidence in this Fed pivot is so great that everyone’s thinking, look, higher rates are a temporary phenomenon. At first, it was, if we can just get from here to March of 2024, we’ll be great. Now it’s June. Now it’s September. So they keep pushing the pivot out, and spreads still hang in there at these low levels. But I think that was a huge part of the rationale, was, look, this is just temporary. If we can just duct tape and suspenders this thing together and get to the point where the Fed pivots, everything will be fine and then we can breathe a sigh of relief. And perhaps because that was so widely anticipated, creditors were willing to negotiate.
And I think that’s been a huge thing that I didn’t anticipate, that the creditors were saying, “Look, we know we’re not going to be able to get 8% from that junk borrower whose paper at 4% is coming due, but we’ll work out a deal with them at six because it’s still going to be better than we’re going to get once the Fed starts cutting rates.” But it doesn’t put them out of business. So the creditors have been incredibly accommodating, but I think, again, it was all built on this idea that we’re going to see material rate cuts and soon, and we’ve clearly pushed the timeline out on that. And then I think the other assumption there that may be called into question is, how beneficial is a 25 or 50 basis point cut in rates over the rest of this year?
I mean, again, if you’re a junk rated borrower whose borrowing costs just doubled from four to eight, saving 50 basis points might not be enough to keep you in business. So I think that’s going to be the next conversation that creditors start to have with themselves. The Fed’s going to have to cut, in my view, all the way back to where they started to preclude this massive issue with rolling all this paper at higher rates. And again, as I mentioned, we’ve already seen the highest number of corporate bankruptcy filings since the back end of the crisis. And in theory, the economy isn’t in recession, so wait until that happens. So I think that’s one part of it.
The other part of it is the earnings side because, obviously, if your interest expense doubles, but you’re making a ton of money and your profits are going up double-digit, then you can handle that and you can certainly handle getting through that period until the Fed does pivot. And I think that’s been one thing that’s kept spreads down.
But we’re seeing, as you all and your audience knows full well, a real sharp bifurcation between the haves and the have-nots in the corporate sector. FactSet did an analysis of the first quarter earnings and said, I think, first quarter earnings were up something like 5% in the quarter. If you took out the magnificent seven, they were down two. So the average company out there is already losing money. It’s just being disguised by these seven stocks that everyone’s so mesmerized with.
And I think that’s something that will come home to roost in credit spreads as those earnings forecasts get revised lower on the deceleration of the economy and increased probabilities that we’re going into recession. People are going to start to revise their economic outlook and earnings forecasts will come down along with that. And I think that’s when you’ll see credit spreads finally start to widen out.
David: I want to tie shadow banking to private equity. We’ve got tens of thousands of private equity acquisitions, last estimate 28,000 companies, that are in queue to be liquidated, to be sold. So they’re like planes circling a runway, looking for an ideal time to land. What kind of time frame do you imagine we have till these entities drop from the sky, either to more reasonable valuations where they can be moved and sold, maybe not at the profits PE groups were hoping for, or just kind of onto a heap of defunct vehicles?
Steph: Yeah, well, I wish I had the answer to that question. I’m always blown away, and I don’t know why I should be, at the ability of the powers that be to kick the can down the road. So you’ve heard of continuation funds now, where that’s the thing. You couldn’t sell the company in the time frame that you wanted to, so you sell it to yourself in a different entity and get new investors. So they’re playing the shell game. And I guess the question is, how long can you do that before someone says, “Look, I actually need the income stream. This isn’t just money that’s being socked away in the background somewhere, but I actually depend on that income stream,” to finance whatever they’re in turn doing?
I’m thinking of annuities or pensions, where, if they’re suddenly not getting income that they anticipated they were going to get, it becomes a problem in the here and now. So I think that’s where the rubber meets the road. I think it was Jeff Gundlach did an interview recently, and he was talking about Harvard’s endowment and how I think they actually had to go out and borrow money—Harvard Endowment—because they weren’t collecting the money because of these “alternative investments,” and they’re so illiquid that they aren’t throwing off the income that they had anticipated. So, I mean this is the environment we’re in and, right now, I guess the credit markets are accommodating enough that Harvard figured, well, we could still borrow it. It’s not that big a deal.
But I think that’s where the rubber meets the road. It’s on the investor side. And I really worry about the pensions and annuities. I’ve done a lot of work on the pensions, particularly because they think that’s going to be something that blows up in a way that people aren’t expecting, and that will blow up in such a big way that it will be something that has real implications for the future of the dollar as a reserve currency. Because if we have to bail out these pensions, we’re talking $7, $8, $10 trillion, and that sounds crazy, but the pension shortfall doubled after the global financial crisis and after the dot-com bust—on average the public pension shortfall doubled—and we’re around 5 trillion of a shortfall right now, even though the markets are hitting record extremes. So you double that, you’re looking at 10 trillion.
And, again, we have an aging population, those people need their money. They’re knocking on the door every day with more and more people retiring. So I think that’s going to be another issue.
David: I think you’ve reflected on 2007, ’08, and ’09, and maybe find some similarities this summer to the summer of 2007. One of the remarkable things is that sophisticated money sometimes is not that sophisticated. We were just talking about Harvard and the endowment and the adoption of the large positions in private equity and hedge funds. They want the illiquidity premium. I wonder if they’re beginning to second guess and say the illiquidity premium could actually be an insolvency premium. 12%, 15%, 18% compared to junk bond yields would put it really at a sub-sub-subprime category in terms of credit quality. And yet sophisticated money is being railroaded into private credit like it’s clean, it’s neat, there’s nothing wrong with it. That too sounds like and feels like the CLOs, the CDOs, and the really beautifully complicated, but ultimately stupid, structures of 2007 and ’08.
Steph: Well, the more complicated you make it sound, the more perfect and unassailable it appears to be—well, that’s so complicated that it has to be a really good investment. And you find out, of course otherwise. But if by sophisticated investors in alternative assets, you’re referring to the pension funds, I guess I would not call them sophisticated, but I think you’re probably more referring to the hedge fund guys.
But either way, I think the motivations are very similar, and that is, look, these vehicles are turning out incredible returns, fictitious though they may be, temporary and fictitious though they may be, and you just can’t afford to miss it. I don’t need to tell you this, but the business has transformed so much just in the few decades I’ve been at this, from a day when hedge funds actually hedged—you were long and short. Now, basically, you’re trying to outperform the stock market, which essentially is everyone’s closet indexed to the market. So if you don’t own the seven stocks that are essentially the entire market, then you’re out of business. And as a hedge fund, you have to do that, but you’ve got to add the secret sauce of leverage to get a little extra return so you can charge two and 20 and not lose all of your clients.
David: So how much leverage do you think is in the financial system today? We’ve got basis trades, carry trades, margin debt, private equity, hedge funds. I mean, how do you wrap your mind around leverage as a potential catalyst for downside?
Steph: Yeah, well, I’m going to fall back on Alan Greenspan and say we know it’s there and we won’t know how big it is until after it bursts.
I mean, it’s a cop-out, but it’s true. I mean there’s really no way to know, and especially when it comes to the shadow banking sector. I know the Federal Reserve is trying to sort of get a handle on quantifying some of this, but it’s just really— It’s just impossible. It’s so opaque, and so many of these vehicles are illiquid, but you do know that there’s a lot of leverage being built up in there just like the CLO, CDO squared, cubed, whatever during the mortgage frenzy of 2007, 2008.
So I hate to say it, but I don’t think we’ll know till after, but my hunch is that it’s going to make that episode look like child’s play. I mean, when you look at just the corporate sector alone, their debt has doubled since then, and as I referenced earlier, the quality of that debt is far, far lower.
I mean, I think back before the global financial crisis, something like 26% of investment grade debt was triple B or lower, and today it’s the vast majority, it’s 55% or somewhere in that neighborhood.
So we’re really in a different environment and not in a good way, but I think we’re going to find out, unfortunately, exactly how much leverage is in there and that’s going to be painful.
David: It’s kind of an IQ test. There are different gradings, and the Federal Reserve, as you’ve said, and the Treasury have basically said, we’re going to finance everything with T-bills.
Corporate sector did a little bit better job. Their maturity wall is still set out 24 to 36 months, so they don’t have quite the rollover pressure, but it’s coming, it’s coming.
Immediately though, the government has issues. We see that. I’ve seen you discuss the stock bond ratio before. In the current environment, would you get a better read on value, a better read on risk looking at the stock-gold ratio, or what people have called the Dow-gold ratio?
Steph: Yeah, absolutely, and that is another one I look at, and I think you’re right to point out that that definitely would be a better measure going forward, especially if you have any weakness for that argument that I laid out of Stan Selvigson’s, the idea that you could have deflation with higher rates where US Treasury debt actually commanded sort of a yield premium because of our reckless finances, in which case it makes it a little bit harder a metric in terms of measuring risk versus safety, which is really why I look at that. It’s sort of the simplest expression of risk appetite, this stock to bond ratio, and that may cease to be as useful going forward for the reasons you mentioned.
As I sort of have confessed already, I view gold as the ultimate arbiter of financial integrity. One thing that I like to look at is the gold to copper ratio. I’m sure you guys look at that as well, and even today with gold down, the gold/copper ratio is actually up. So this is a barometer that I think is really useful in terms of being sort of a canary in the coal mine for financial crises.
When you’re at a turning point, generally copper is weak and gold is strong if you want to really oversimplify, and we’ve been seeing that creep up to pretty high levels here, and I’ll continue to watch that, but I think that’s another good metric to follow.
David: This is a significant shift, but the Financial Times last week highlighted, I think the numbers were coming from the World Gold Council, but how Developed World reserve managers, the central banks in the Developed World are following in the footsteps of the Developing World central banks—adding to gold positions.
This is unique. Is the consensus among reserve managers that you need inflation protection, or is this more of an expression of, post-2022 you need to have sanction-free reserves? How do you read it?
Steph: Yeah, well, I would guess it’s a combination of both things. I mean, I think definitely the weaponization of dollar reserves with the sanctions on Russia, or weaponization of reserves, period, not just dollar reserves, was sort of a turning point for reserve managers globally.
But I also think you have— I don’t want to get political, but I would say you clearly have signs that even our allies around the world don’t have the confidence they had that the US has their backs from a military standpoint. Japan has been one of the largest net sellers of Treasurys, and they’ve been spending enormously on beefing up their own military for the first time in decades.
So this is a shift, and I think that it’s not an accident that you’re seeing gold go up and the dollar share of global central bank reserves wither. I mean, in the last quarter, no one seemed to pick up on this, the dollar share of global Forex reserves hit its lowest level in 29 years. I didn’t see that on the cover of any newspapers, but it should be. And I think when you get someone like Japan that’s been a long-time ally, that’s one thing.
Then, of course we had the latest shot across the bow with the Saudi story, which I think was probably taken a little bit out of context and maybe made more out of it than it needed to be. But still, you’re talking about countries that have clearly decided that the US isn’t what it used to be in terms of the global power, and they’re going to have to look out for themselves and go their own way and protect their own assets.
David: Yeah, I think the dollar reserve, was it in the 70s? Now it’s in the upper 50s.
Steph: Mm-hmm.
David: The threat was that the euro would sort of displace— And of course there’s so much chaos even in recent weeks, questioning the viability of the euro as you see the French move towards what could be a fiscal blowout. The rule is 3%, and yet their annual deficit is running at 5.5%.
You bring in a new government and you could completely blow it out of the water. What is the alternative to the dollar if the euro, the most viable alternative, is no longer particularly viable or attractive, and all of a sudden gold starts to play its classic role as a reserve, as a reserve asset.
Steph: Well, I also think, and maybe I’m just too far out on the edge of the spectrum with this view, but I keep coming back to this BRICS+, and while we don’t know exactly what the currency agreement that they’re working on fastidiously is going to look like, everyone has the view that it’s going to reflect some weighting in gold. And the latest thing I heard was 40% weighting in gold, 60% basket of currencies.
But whatever, gold is going to have a huge role in whatever that unit that they create is going to be. And if you’re going to set up an environment where you have a huge block, and these economies have the majority of GDP from a global purchasing power standpoint, they control all of the natural resources, or the vast majority of them as well. And again, they’re net creditor nations rather than being debtors, and they’re youthful, better demographics. If they’re going to have a currency that is essentially a hard currency, it’s not a fiat currency, how does the developed world compete with that, if not by beefing up their own gold reserves in equal measure?
I mean, I feel like gold, whether it’s directly linked to currencies going forward or if there’s some kind of indirect reference to it, gold is going to play a major role in stabilizing the monetary regime—whatever that monetary regime looks like—on the other side of this bust that I believe we’re about to go into. My sense is we’re headed into an economic recession, but the financial bubble bust associated with that will compound the damage dramatically.
So, the economy might naturally slow a fair amount, but when you layer on the deflation and financial assets from these spectacularly overvalued levels, you’re talking about a repeat of the 2008 economic downturn that will beget massive fiscal and monetary stimulus.
And the only way that we can rein in the inflationary impacts of that and resurrect the dollar will be to have some, whether it’s, again, a direct link to gold or some reference, gold is going to have to play a part in that monetary regime. I just don’t know how else we can come out of where we’re headed.
Boy, that’s dark.
David: Well, and maybe I like you because we agree on a lot. In-house, we prioritize hard assets of all kinds, whether it’s the precious metals business, which we’ve been in for 53 years, hard asset equity management the last 16 years. I mean our in-house thesis is that we have a bubble in credit, and there’s some common ground with your analysis.
My question is, why is our view still contrarian or seemingly underappreciated by the majority of people running money, these sort of end-of-cycle dynamics? I can’t believe people aren’t cognizant of them.
Steph: Well, I think for a while, the reason why was that there was no money to be made in that. You can make a lot more money trading NVIDIA on the way up than you can being concerned about what the monetary regime is going to look like 10 years from now.
But I think that is starting to change. I mean, you see now when you tune on some of the financial media, they’re talking about fiscal dominance, and people on the rare occasion might actually mention gold here and there.
And occasionally you do hear a reference to the BRICS countries and what they’re doing. But generally, I wrestle with the same question, David, and I wonder if the truth is just too painful. People don’t want to think about what could go wrong, which again is sort of fruitful terrain for folks like you and me.
But I think that when, what’s the expression, like, nothing matters until it does? We’ll get that moment, and I feel like we’re getting very close.
David: Okay, as soon as you settle out here in Colorado for the summer, let us know. We’re going to come up and we’ll do a day hike, mountain bike ride, something.
Steph: Love it.
David: But it’s too close, Durango and your neck of the woods. So do let us know when you’re established and we’ll look forward to spending some time.
Steph: I will do that, and I may actually have to come to Durango as well because I’ve never been, so I definitely will want to see that. But yeah, you don’t have to tempt me into a hike. That’s why I go out there in the summer. It’s just so spectacular. So I will very much look forward to that.
David: Get out of the Florida heat as quick as you can.
Steph: Yeah.
David: All right. Well, Steph, thanks so much for joining us. Real pleasure.
Steph: It was my pleasure entirely. Thank you so much, David.
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Kevin: You’ve been listening to the McAlvany Weekly Commentary. I’m Kevin Orrick, along with David McAlvany and our guest today, Steph Pomboy. You can find us at mcalvany.com, and you can call us at 800-525-9556
This has been the McAlvany Weekly Commentary. The views expressed should not be considered to be a solicitation or a recommendation for your investment portfolio. You should consult a professional financial advisor to assess your suitability for risk and investment. Join us again next week for a new edition of the McAlvany Weekly Commentary.
