The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
Kevin: David, today Ambrose Evans-Pritchard is going to be on the line. Why don’t you talk about the reasoning behind why we wanted to talk to Ambrose at this time?
David: As we look at the global economy, at U.S. growth trends, at European trends, and things that are either accelerating or decelerating in terms of a point of crisis in the eurozone, as we look at China and their lowered estimates of growth, it is important that we continually look for various viewpoints, some that we agree with, some that we don’t.
But in order to gain the right perspective on what is actually happening, there is not only a huge amount of information, but there is a need to sort through that information, sort it effectively, and create a synthesis, if you will, of what is actually happening.
Our attempts to do that, with various guests, and certainly Ambrose today, is to look at oil, to look at global currencies, to look at global equity markets, to look at the global economy, and try to get a snapshot of, from his perspective there in Great Britain, what exactly is happening today.
Kevin: David, when we get to the end of each year, Ambrose is almost always one of the clips that we like to play when we do the “best of” shows. We go back and look at them and ask, “Who brought something to the conversation that was new?” Ambrose has been reporting internationally for 30 years. He works for The Telegraph, but really, that is probably putting him in too small of a box, isn’t it?
David: Kevin, my frustration over the years has been that whenever I am in Europe, he is someplace else, whether it is China or wherever else. Here in the next week, I will be in London, but he is not going to be there. He will be in Germany. Actually, I will be in Germany, as well, but it will be two days after he is in Germany. We, at some point, will sit and either have a cup of tea or a good pint, and be able to have a good conversation across the table instead of across the pond, and via the long distance phone lines.
Kevin: One of these days we will just have to nail either your feet or his to the ground somewhere so you can spend a little personal time together, other than just on the phone.
David: That would be great. Until then, Ambrose, thank you for joining us again. Aristotle said that youth is easily deceived, because it is quick to hope, and it appears that the equity markets today are full of hope. We have a liquidity-induced rally largely built on that one factor – hope. We wonder what else the markets are rising on the basis of, and we will get to that in a moment. Before we do, some of the headwinds to recovery seem to be in the oil market. We have Brent above $120, West Texas Intermediate above $105. Is this a factor that you think could derail a recovery, either domestically, in the U.S., or a global recovery?
Ambrose Evans-Pritchard: The head of the IMF, Christine Lagarde, has been warning repeatedly over recent days of an oil spike that could, basically, abort the global recovery before we have a fresh cycle of growth safely underway. It has now emerged as a new threat after the European sovereign debt crisis has gone into abeyance for a while, or into remission, I would say, because it has not gone away.
But we are at a level where energy costs are nearing 9% of global GDP, and typically, that has been the trigger point for global recessions over the last 40 years. It is not inevitable and it depends how long prices stay there, if it is just a few days or something like that. But if they go much higher than this, and they stay there for a couple of months, that is going to cause serious damage, I think.
David: What sort of range is oil likely to trade in, on the high side or low side? We have demand destruction, as we see GDP growth estimates, in Europe, China, and Australia, in decline. In the U.S., I suppose we have GDP growth estimates on the increase, so that is one positive in the mix. But this would argue globally for demand destruction and maybe lower prices.
Ambrose: What is so strange about this is that there is, essentially, quite a sharp global slowdown right now. We have Europe in recession and likely to contract for the whole of 2012. We have China paring back its growth estimates all the time. Whether it is a soft landing, or something a bit harder, it is harder than people expected a few months ago. And yet, even so, we have quite mild slowdowns in India, and Brazil, and other countries. Even so, we have Brent trading up near record prices, certainly in European currencies, around $125 a barrel.
David: Which raises the question of the Middle East tensions.
Ambrose: Exactly. What this tells me is that there is a fundamental structural shortage of oil in the world, that even when we have a major global slowdown, which normally should eat into demand and bring prices clattering back down to $60-70 a barrel, it hasn’t done so at this time. They are still at, or near, record highs. So what happens as soon as demand picks up again? We are going to run straight into the constraint. On top of that, we have the wild card of a potential Middle East conflict.
I am not in the camp that thinks Iran is going to close the Strait of Hormuz. They might try, but if they did so, it is questionable if it could succeed for very long. But if there was a Western strike against Iran, it would have huge political ramifications and potentially destabilize the region in ways that cannot be predicted, and set off inter-ethnic conflicts, and Shia uprisings, potentially, in Saudi Arabia and Bahrain. It is really a pretty unstable situation. A lot of unpredictable things could happen. I think that is the risk.
Certainly, there is a bit of that premium in the market price for oil right now, but the real cause is fundamental. We have eroding oil fields in the North Sea, and in the Gulf of Mexico. There are endless disappointments in global oil supply around the world. It keeps falling short of what was promised, and they are having trouble finding new reserves that are economically viable to tap. That is the fundamental problem.
David: Coming back to the idea of ethnic conflict, a Shia uprising, this might be one war too many. We have already seen the Russians and the Chinese line up against a Western strike, and it seems that might, in fact, be a trigger for them to say, “Thanks, but no thanks. Our protest will be an economic protest. Our contribution to the new and fresh Iranian conflict will be via the currencies. We don’t need the dollar, and we don’t need the dollar system. We are sorting ourselves out in other ways.”
Ambrose: Yes, it is very hard to read, diplomatically, what China and Russia are doing here. Essentially, I don’t think China wants to rock the boat. They are sort of looking for a way of navigating through this and keeping their head below radar, essentially. I don’t think they are about to launch some kind of punitive strike on the United States in retaliation through the currency markets. I think what will happen is that the Chinese currency will, over the next 3-5 years, become a global currency. It will be liberalized, it will start trading through Hong Kong, and then it will quite quickly achieve full status as a global reserve currency.
Let me point out, the reason why China, with $3.2 trillion of reserves, by far the biggest in the world – the reason why it holds about $1.8 trillion of U.S. debt is not that they are doing a favor to the United States. It has been doing that in order to hold down its currency. That is the automatic effect of its mercantilist currency manipulation of holding down the yuan to gain export share.
If it ever launched an attack on the dollar, or ever pulled its investments out of the United States, it would automatically see its own currency shoot up, and it would put a lot of its exporters out of business. This is simply the flip side of its whole exports, trade, mercantilist policy. It accumulates reserves, it buys U.S. bonds. It has to do so, and as soon as it stops buying those bonds, its currency will shoot up, so they will shoot themselves in the foot, in my view.
David: Yes, we would agree, because it is the TIC flows and the gradual reduction of Treasury exposure that everyone assumes, on the slippery slope basis, will become a flood out of Treasuries, and we would say that no, in fact, that would have them hanging themselves, with a noose of their own creation. In fact, they have bought the Treasuries for political purposes, to maintain a high level of employment and continue export growth, and they are having a very hard time transitioning from being an export-centric economy, to being an internally generative economy.
Ambrose: Yes, an interesting point, that they have accumulated, in reserves, equivalent to 6% of global GDP, and to my knowledge it is only twice in modern history when this has occurred. Once was Japan in the 1980s, which, of course, ended very badly for Japan. The other time was in the United States in the 1920s, which ended very badly for the United States. Both episodes were succeeded by depressions. There is a connection between them.
Accumulating vast reserves in this fashion is not a sign of a healthy economy, it is a sign of a completely distorted economy that is relying on an undervalued currency to gain global market share. As soon as somebody else yanks away the rug and the game ends, you are in trouble. I think that is the risk that China faces, that potentially, the open global trading system, as we have known it for a generation or two, starts to close. And then, if you’re the great surplus power, you’re the one in trouble.
All the deficit countries can start using protectionism to revise their own industries, but if you’re the surplus power, and you are entirely reliant on your global markets, then you’re in trouble. This is something that has occurred over the last 200 years a few times. I don’t see this huge imbalance in the world as particularly an advantage to China. I think it has all kinds of risks for China, itself.
David: It seems there are some peripheral risks to it. We see slowing GDP growth in China to 7½% with a gradual drift, by many economists’ estimates, to 3-4%, and as you said, massive loan growth in recent years, surpassing the record numbers relative to GDP, set by Japan in their bubble years. It is not a stretch to see a similar outcome, but at the periphery, there is Australia, there is Brazil, and their primary commodity trade partners, which are vulnerable to a slowdown in demand for that product, not only as they export, but as they are growing their own domestic infrastructure.
Ambrose: Yes, we have the Australian mining group BHP Billiton warning today that China’s steel demand has essentially plateaued, it is just tailing off now. This is a fundamental change for the iron ore producers of Australia and Brazil. There are two issues here. What does a soft to hardish landing in China do to China, but also what does it do to the rest of the world?
The Chinese stock market has already discounted a major adjustment in China, if you like. It has already fallen about 62-63% from its peak four years ago, and in real terms, by the way, it has fallen almost as much as Wall Street fell in the early 1930s, peak to trough. That was because America was deflating in the 1930s. China has been having inflation. If you look at it in real terms, the stock market collapse in China has been almost equal to the United States between 1929 and 1933. That is a fascinating fact that very few people are aware of. That is already anticipating some problems in China.
The insiders in China know that there are a lot of problems coming up. But commodity producers around the world, the commodity countries, like Australia, Chile, and other countries, have not adjusted in the same way at all, and yet, their economies are essentially levered and trading off supplying the voracious industrialization demand of East Asia. So there is something wrong here, something is out of alignment. Either the Chinese stock markets are right, or the Australian and Chilean stock markets are right, but they can’t both be right. One of them is wrong.
David: And it seems that it is a different of opinion in terms of a return to the growth trajectory that we had prior to 2007-2008, or in fact, a slower period of growth, and in fact, a decline, for the foreseeable future, which would be heralded by the Chinese equity markets.
You have spent a lot of time in the European space, and I am very interested in your opinion. You said that this may cycle back around. Are we post crisis, or is what we see today really a delay on the basis of these LTRO maturity schedules? We have bought three years. Is that the time frame we have, or the fuse that burns, so to say?
Ambrose: Yes, in terms of the global picture, I think the stock markets and risk markets around the world are basically assuming that three things have happened: That China has basically touched down, and has had a soft landing over the winter, is now beginning to recover. The ECB, the Draghi bazooka in Europe, has basically saved the European banking system, conquered the sovereign debt crisis, and basically, it is all back to the races. And that America has finally gotten out of its troubles, the subprime crisis is over, the property market has stabilized, and we are back to a new cycle of global growth. That is essentially what a large part of the markets are saying. This is the theme that a lot of the analysts are all pushing on.
In terms of the European bit of it, what Draghi did was very important, because in October/November, the European banking system was going into meltdown, especially in Spain and Italy, and it was extending to France. We had a calamitous slide underway. If they hadn’t done anything, I think we would have had a series of major sovereign defaults, a completely calamitous chain of events, and who knows what would have happened? You can argue it would have cleared the air, you would have taken your punishment early, painfully, and quickly, and got over it. Instead, it drags on.
But anyway, he intervened, and it was incredibly important. It has taken away the tail risk of a collapse of the European banking system. That is no longer going to happen. But, they have not solved the fundamental problem here, which is that Northern Europe and Southern Europe cannot share a currency union. Southern Europe is probably 30% overvalued against Northern Europe. How this has come about is a long story, but essentially, we are now where we are, and the South having to claw back to competitiveness by deflating the old-fashioned way, what is called an internal devaluation. They can’t devalue their currencies anymore, so they have to do it internally by cutting wages and going through deflation.
The laboratory for this was Greece and we saw what happened. The more they cut, the more the economy contracted. It went spiraling downward. The Bank of Greece announced today that the deficit is still over 10% of GDP, and this is in their fifth year of recession. The economy contracted 6.9% last year and the budget deficit hardly came down at all. There were all these massive cuts and it simply tipped the economy in such a vicious downward spiral, they are not even getting a reduction in the budget deficit. It is just simply destroying the tax base, so it has become self-defeating.
That is essentially the model that has now been imposed on Portugal. Portugal is about 15 months behind Greece, but it is proceeding on very much the same policies. It has the same fundamental lack of competitiveness, the same sort of trade deficit, current account deficit, equally overvalued as Greece. It is less well educated than Greece, and it has a much bigger aggregate debt than Greece. Its combined public and private debt is 100% of GDP, more than Greece’s.
Greece has actually one of the lowest debts in Europe – as a percent share of GDP, it is only 250%. Britain is higher, the Netherlands are higher, Denmark is higher, Spain is higher, Italy is higher. Greece has actually one of the lowest. This isn’t actually a debt crisis at root, but the debt problem has surfaced because these countries cannot compete. That is the problem, and that problem has not been addressed.
Essentially, they are trying to paper it over, and paper it over, and paper it over, because nobody will bite the bullet and recognize that the whole venture of currency union, the whole venture of the euro, is a failure. It has created huge structural problems. It is acting, now, as the gold standard did, in its deformed structure in the early 1930s, when it was causing all the weaker states, the deficits, to carry all the burden of adjustment, and tighten their belts, and tighten their belts, and tighten their belts, until they eventually took the whole system down.
We are going through this stage by stage, and you could almost go back and look at the years from 1929-1936 and then transpose this onto Europe and see what they are going down. We are probably similar to around 1933-1934 now, and finally the whole thing blew apart in 1936. We are going through this stage by stage, and they are repeating exactly the same policies. It is essentially a fixed exchange rate system that has a deflationary, contractionary bias in it, and the weaker countries are the ones that get hit first, until they are ground into the dust.
Unfortunately, in the case of Greece, it has taken quite a debt haircut. Creditors have lost three-quarters of their money. That set a terrible precedent, by the way, because the markets and investors eventually don’t believe Greece is a special case, they think this is going to be transferred to Portugal quite soon, and ultimately, then we have Spain and Italy. We know they are further off. It is not as acute there, it is a slow grind. But we are seeing in Spain that youth unemployment is already 51.2% – already, now. And they are only now embarking on a quite draconian fiscal squeeze, this year.
David: A couple of things. I started with a quote by Aristotle, “Youth is easily deceived because it is quick to hope.” It is also quick to anger, and I wonder if there isn’t a political fuse of some sort that is lit in these Southern European states. Is the fuse out in Greece? Are they not only out of the limelight, but out of the point of political strain in that country, and thus having more to focus on with Portugal, Spain and Italy? Are you arguing that actually you can see all of these still engulfed in flames, so to say, of a political nature?
Ambrose: I certainly think that we have moved from a phase where it is moving from being a purely financial crisis to being a social and political crisis, and the politics will determine the outcome. In the case of Greece, because they are sort of cut adrift, on the edge of the Balkans, right next to their historical nemesis, Turkey – to them, it is an existential issue. They will go through anything to try to remain part of Europe, so their willingness to tolerate a lot of these sacrifices and do whatever they think it takes for Europe is perhaps greater than for some countries. For them, their cultural lifeline, their sense of identity, of being Europeans, would be at risk if they got thrown out of the euro. And they are also quite a small country of only 10 or 11 million.
When you start talking about a country like Spain, it is a whole different game there. It is a country of 48 million, a very, very proud country. It is not as isolated, and it won’t let itself be pushed around by Brussels and the EU system in quite the same way. We have already seen a showdown, with the new government coming in and pledging to do austerity, a really quite nasty fiscal squeeze this year.
Then they looked at the books, and discovered it was far worse than they had feared. They were advised by their top economist that if they carried out the cuts demanded by Brussels, unemployment would reach 6 million by the end of the year in Spain, which, for a country of 48 million, is an awful lot of people. They would be getting up to 25-26% unemployment levels by the end of the year, if they did that. And they said, “No, we’re not going to do this.”
They simply did, to my knowledge, what no country has really done in all the years I have been covering European affairs on and off, 20 years or more. I have never seen this happen before. They simply, absolutely said, point blank, “We refuse to obey the EU budget rules. We’re not going to do it. It is suicidal.” This is the beginning of what I think is a mutiny in the South, in what I call the Latin Block, and I think we are seeing it in different forms, developing in different countries.
We are seeing the new prime minister in Italy, who is actually a former EU insider, for ten years a commissioner in Brussels, himself, now beginning to lead a kind of Latin Block that is saying, “Right, well, why should we put up with destructive policies being enforced upon us? If we form a united front we can change the whole terms of the debate. We can stand up to Germany.”
We have had this new dynamic developing in Europe with these big countries – Italy, Spain, and all the small countries coming around with them – standing up to Germany, saying, “No, we don’t agree with you.” At the moment, it is still polite, but the beginning is here of a major, major clash between the North and the South of Europe, and how is it going to play out? We have French elections coming in May, and the Socialist candidate is likely to win, Francois Hollande. He is likely to throw his weight behind the Latin camp that wants a complete change in policy, which is to move from an austerity policy toward a growth policy, essentially.
When that moment happens, it is going to cause huge conflict with Germany. Then the issue will be who leaves the eurozone first. Do the Germans simply say, “We’re not going to put up with this any longer, we totally disagree with the way this is going, we’re going to leave.” Or do the southern states get pushed out? I think it is a toss-up, actually. I think it is incompatible. I think this has to break up, but how it breaks up, whether the North leaves or the South leaves – there are all kinds of way it could happen – it is not yet clear.
David: Shifting again back to the global economy, we have slowing growth, and that is likely to be a continued theme through the second half of the year. Would you pick a point on the calendar where you would say that we have likely seen a peak? How would you gauge the trajectory coming into the end of the year?
Ambrose: This is the kind of huge question that everybody is asking themselves. There are a lot of skeptics out there. There are a lot of very sophisticated economists and analysts who just don’t quite believe this recovery is real. They don’t believe there is a new cycle of global growth under way that is going to last several years, that the great deleveraging hangover from the bubble is not yet over. But exactly what is going to cause it to tip over, I don’t know.
When I look at the money supply closely, I notice that the real M1 for the biggest 14 economies in the world, the biggest seven developing, and the biggest seven emerging market economies, has begun to tip over. It peaked in November, and then it has been contracting every month since. The rate of growth has been slowing quite sharply ever since, and that is a very good leading indicator. It really slowed quite dramatically by February.
That tends to give you about a six-month lead time. That would tell you that the global expansion is going to roll over in the early summer and the second half is going to be lot more stark, really. Markets tend to anticipate this sort of thing. They tend to sniff it out before it happens, so you would be talking about maybe the markets peaking in late April or early May, and rolling over.
I think in terms of America, specifically, we have had a major money supply growth, but it has actually stabilized over the last two months. I think Bernanke warned that the U.S. faces what he called a massive fiscal cliff at the end of the year, when all these automatic tax rises come in force unless Congress decides to do something to prevent that happening – the payroll tax holiday, the Bush tax cuts end, and all these Medicare taxes – there is a whole range of them, all going to basically hit at once – and he was warning this is going to be quite a shock to the system.
I also think the markets are going to start thinking about this as it approaches. They aren’t going to wait for it to happen. It is probably going to be one of these cases where it is settled in May, and come back on Labor Day, or whatever it is. Suddenly in the summer, everyone says, “My God, we got over-excited about this. We thought everything was back to the races, and it is not. We’ve suddenly got all these other problems re-emerging. We have the delayed effect from the oil price being at $125 a barrel, which as we saw last year in the Arab Spring when this occurred, oil prices were at this level at that time a year ago, but it wasn’t until June, July, and August, that people really began to feel the full consequences of the global slowdown.
David: There are a couple of dynamics here. There is the “sell in May and go away” thematic. There is what we would have considered the “beware the Ides of March,” maybe being sooner than May, on the basis of the S&P trading up 20% off its lows in October, and now two standard deviations above its 50-day moving average.
Ambrose: Yes.
David: These are incredibly high over-extended levels, but it is not turning down, and the question is, again, coming back to that key word, “hope,” are we hoping that a central bank, undisclosed, but a central bank somewhere in the world is going to juice the system? The Fed has been on hold, the ECB took their turn in the late months of last year through the refinance operation, the “LTRO.” Is it the People’s Bank of China? What is likely, in your opinion, to keep things elevated to May, other than hope, or some promise of new monetary stimulus?
Ambrose: Well, there is a lot of confidence that has returned, and that has the same effect. You must remember that U.S. corporations alone are sitting on 1.2 trillion in cash reserves. That is a heck of a lot of money. They have been waiting for signs of optimism to start throwing them back into battle, so to speak, and maybe some of that is going to happen, and maybe it is happening right now.
I think there is still, essentially, what used to be called “The Greenspan Put,” the assumption that central banks will come in and save the day, if necessary. That is still there. People think, “Well, if things get tricky, if we have misjudged this, the ECB, and the Fed, and the Bank of England, will step in again and just throw more money at it.” I think, right now, that’s not going to happen. I think the threshold is quite high, both at the Fed and the ECB. I think they have begun to talk about inflation again at the Fed.
David: That is why we started today talking about oil and why it is such an important component. On the one hand, they want to continue the growth trajectory and these “green shoots,” the conversation piece from two years ago, but the consequence of any stimulus at this point, with Brent at $120 and higher, West Texas at $105 and higher, is that any attempt to juice the economy is really derailing the recovery. Energy costs, as you well pointed out, are already above 9% of global GDP, so the minute they step on the pedal, so to say, is the minute they throw us right into recession, classically triggered by these energy costs – really, on the horns of a dilemma. I, frankly, would hate to be a central banker today, for many reasons, but least of which, that they don’t have very good options.
Ambrose: That’s right. They would have to wait, I think, for very, very clear signs of a slowdown emerging before they act again. I think the political resistance, in Europe, to any more stimulus by the ECB, is pretty big. We have the head of the German Bundesbank, and the former chief economist of the ECB, who is German, coming out and publicly slamming the ECB for behaving irresponsibly and destroying liquidity all over the place, and storing up all kinds of problems of moral hazard and future inflationary risks, and so forth.
Basically, they are speaking for the German nation, and when the German nation says the ECB is behaving irresponsibly, my goodness, it makes it extremely difficult for an Italian president of the ECB to continue doing this. The political constraint on them is enormous, so I think that card, basically, is played. I don’t think they can do any more of these LTROs. Furthermore, I think by doing them, they have prevented themselves from doing QE. QE would have been more effective, in fact.
David: Ambrose, as we wrap up, I am curious if you would venture an opinion on the two greatest areas of market risk today – in the bond market, in the equities market, in the commodities space. If you had to pick two areas you thought that perhaps you don’t want to necessarily walk through, where you would be very, very cautious, what would your instincts tell you?
Ambrose: This is a really difficult moment. I don’t have a firm conviction on that. I am just watching and waiting. I suspect that Treasuries and government bonds are going to sell off quite a bit, there is going to be a nasty little bear market, but it will go too far, and then, bonds are going to rally yet again, Treasuries are going to rally yet again. When people realize that this fundamental crisis in the world is not over, I think they will come down again to below 2%, and it is actually stocks that will become more vulnerable.
For the next few weeks I don’t see that as a problem, but we could have a phase where stocks go shooting on up, there is a massive sell-off in bonds, everybody is buying, it is a recovery story, until suddenly a series of things happen, fundamental economic events and data that cast a pall over this, they realize that the problems are not solved. At that point, I think we would have one more big rally of U.S. Treasuries, and bunds in Germany, and gilts in Britain, and that has not played out yet.
David: Perhaps we should abide by the old trader’s wisdom of “sell in May and go away.”
Ambrose, thanks so much for joining us, and we look forward to seeing you at some point on the other side of the pond.
Ambrose: Jolly good. Thanks. Bye.
