Podcast: Play in new window
- Jamie Dimon Says Bond Market Will Cause Panic In Future
- Section 899 Of Bill Could Scare Money Out Of Dollar
- Is Private Equity The New Money Trap
"We go back to the 30,000-foot perspective and see that interest rates are the issue for the Treasury Departments in the UK and in the US and in Japan and in many other places. So we have this convergence ahead of us between fiscal mismanagement—and the bond vigilantes are sniffing this out—combine that with financial market frailties, and many of those things are baked into the cake through shadow banking. Then include the weaponization of capital and, at an inflection point—and we are not there, the global markets desire to opt out of risk. Where do you go?" —David McAlvany
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Kevin: Welcome to the McAlvany Weekly Commentary. I'm Kevin Orrick, along with David McAlvany.
Well, your dad hired me, Dave, back in 1987. He was a 47-year-young man. He was 47 years old. I was 24 at the time. But I can't believe it, this week he turns 85 and he's still going strong.
David: Oh, yeah. It'll be good to see him. I know that we'll get some good time, a few shared meals, and then we're off to a family reunion. So, yep, 85 this week, and then on to a little rest and relaxation. It was just fun to be with family.
Kevin: I don't know that we're going to talk about these things that we're talking about today with Don because there's so little time, but what would he think about Democrats thinking that inflation going forward is going to be 9.4% and Republicans think it's going to be 1%? Has he ever seen a division like what we're seeing now?
David: Well, I think the nature of politics is to be panicked if your people are not in power. And so what is consistent is there's always half the country that's planning on moving to Canada and the other half of the country is figuring that now things are better again, and then it flip-flops. So I think the only difference is the color of your jersey.
Kevin: Isn't it funny how we do pick sides? Well, I guess to be objective we probably ought to even that out somewhere in the middle—the expectations of inflation—probably somewhere between 9.4% on the high side and 1% on the low.
David: Yeah. The Conference Board Consumer Confidence last week had a positive surprise. Friday's University of Michigan numbers were not as sanguine, but still improved. It was the inflation expectations component that came down, to your point, strikingly different depending on who you ask. One year expectations for Democrats, 9.4% is the annual inflation rate which is expected, and for the GOP, inflation expectations of 1%. So again, this contrast of we're nearing Nirvana or we're nearing some version of hell.
Kevin: Well, what do you think about tariffs, then? You think they're going to add to the inflationary impact?
David: Well, I think that US inflation metrics— This is where last week was also interesting—and improved, if you're looking at the Fed's favored PCE metric—and tariffs may yet have an inflationary impact. But at least for April, it fell to a four-year low, with the supercore hitting its lowest reading since March of 2021. So when we look at bond markets and we see how cautious they are, it's really not inflation that's the primary pressure point. Fiscal sustainability seems to be the issue.
In the US, we had the TLT, which is the 20-Year Bond ETF, lost 3.57% for the month of May. And basically rates go higher, bond prices come down. And that's what the bond mark is suggesting is we have reasons to be concerned, but, as I said earlier, it's not inflation per se.
So actually supercore, the reading—if you're looking at month over month—was negative 0.023%, almost a rounding error, but you could read it as deflationary. The Fed is unlikely to do anything about that. They're going to say, "We need more data." Fair enough. And May inflation readings will capture a larger time frame impacted by tariffs. So perhaps upside surprise in May,
Kevin: You had said fiscal sustainability may be more important right now than inflationary expectations. But I think we should talk today about any kind of debt payability or sustainability, even beyond the fiscal sustainability.
David: Yeah, certainly corporates have their issues as well, and the rage today is private equity, private credit, leveraged loans. One more thing just from an economic standpoint, we've got a full week this week, lots of data. I wonder how this week's ISM manufacturing data will factor into the Fed's thinking. Again, they're "data dependent." But we had the PMI index, which dropped to 48.5 in May. That's below the April reading of 48.7. 48.5, that compares to what was expected, 49.3. We're now at six month lows, this is the fourth time in a row we've had a lower than expected reading. So again, if you're thinking if there's an economic concern, perhaps the Fed will lower rates. We'll see about that.
Kevin: And sometimes we're watching things on an economic scale where we're like, okay, if all things continue the way they are, we can watch for inflation, we can watch for fiscal sustainability. But what happens when there's a Pearl Harbor kind of event, Dave, not anywhere near the economic markets or the financial markets? Look what happened to Russia this week. I mean, gosh.
David: Yeah. Broadly you can split risks into two categories, endogenous and exogenous. The endogenous is we did it to ourselves. In other words, the problem came from inside.
Kevin: Printed too much money, whatever.
David: Yeah, too much debt, what have you. Exogenous or from the outside, would be those things that you weren't really expecting. I think the most interesting and worrying aspect of the Ukrainian attack on the Russian strategic bombers was that the drones were concealed in shipping containers. I'll give you a quote, "It shows that Ukraine has managed to weaponize the global logistics system. It's an interesting observation from one contributor on Twitter, or X. And Bill King added further color to that, saying that China is the big cheese of shipping containers.
It makes you think twice about what we import. Ukraine was able to get their containers to within a very short striking distance of hardened military targets. And that is getting the shipping containers through a war zone. So we have 40, 41, I think was the final count, of 150 bombers gone. $5 to $7 billion in damages in a fleet that hasn't been added to since 1993. And Drudge, that was the headline, "Russia's Pearl Harbor Moment."
Kevin: Well, and you think about how unpredictable some of these things are. Remember the cell phone incident with Israel, the cell phones that exploded. And then the Russians last year when they crawled through that pipeline over into Ukraine. Things are being done very different at this point, and so warfare is being fought in a different way. But let's go over to Jamie Dimon because Jamie Dimon sounds like he's possibly wanting to make sure that he's on the record saying that he doesn't like the bond market right now.
David: So this goes back to the endogenous issues. Jamie Dimon, he is the occasional Cassandra of Wall Street, and he's managed through his tenure to extend the reach of J.P. Morgan. They have more assets, more clients. They've picked up discounted assets and client accounts at each pressured point in financial markets over the last 25 years. I see a common theme amongst successful bankers: they worry a lot.
Kevin: The successful bankers worry a lot?
David: Yeah. Sometimes too much. But you seek out the alternative, professional graveyards are littered with optimistic bankers.
Kevin: It'll all turn out fine.
David: Yeah. I think we're on the upturn. Take more risk. Dimon is not doing complex math in his recent assessment of the US debt markets. The Treasury bond market has expanded from $5 trillion in 2008 to $29 trillion.
Kevin: Can you believe that? Those are the years from the time the Commentary started, Dave, until now? 2008 until now. $5 trillion Treasury bond market debt back when we were doing this program for the first year. Now it's almost 30?
David: Yep, that's right. And that's according to the Financial Times. Which is an outcome that you could definitely anticipate. If Dimon is saying, "There's going to be an issue here," well, little surprise, you increase spending, you don't have tax hikes to match it dollar for dollar. What is that? It's a spending problem. And Dimon says, "I just don't know if it's going to be a crisis in six months or six years."
And he goes on to say, "You're going to see a crack in the bond market. I'm telling you it's going to happen. And you are going to panic." And then he goes on to say, "But we're not going to panic and we're going to be fine." And I think you're right, there is a, "Just for the record, we told you it was coming." And it's okay because the occasional Cassandra, even if you get it wrong, you only have to get it right once to be written up in the history books as the guy who saw it coming.
Kevin: But he's not alone in the room. He's got other guys saying similar things.
David: Well, that's right. Goldman Sachs' COO John Waldron echoes the concern. He says, the big risk is long-run rates continuing to back up and the cost of capital in the economy rising and fundamentally becoming more of a break on economic growth. One man looks at financial market panic. The other is looking at the economy with less oxygen than it needs to thrive. But both this consistent theme of endogenous, we did it to ourselves.
Kevin: Yeah. But these guys are bankers, they actually have to follow certain regulations. There's an entire non-banking world out there, Dave, called shadow banking.
David: Yeah, in a moment we'll talk about the shadow banking industry. Thinly regulated, opaque, highly-levered. And growing to a point that you've got European regulators on edge, whether it's the Bank of International Settlements or— There's three or four other organizations within the EU which are looking at commercial banks, looking at their exposure to different products within private credit and private equity. Interest rates are at the center of risk in this space, the shadow banking space. And a rise in interest rates, the primary cause of dysfunction, which has already existed in that space for going on three years— We'll get to more of that in just a minute.
Kevin: Okay. So I want to go back to surprise attacks. Surprise attacks, whether it's a cell phone attack or a drone attack that comes out of shipping containers. Sometimes a big, big, beautiful bill might have a surprise attack or two built into it. And I think that's starting to become apparent.
David: I love the way Gillian Tett started an article in the Financial Times this last week. She said, "When I started in journalism. I had someone give me the advice, when you're looking through a big piece of legislation, what you're really looking for is the bombs that no one really sees. So again, she's one of my favorite contributors at the Financial Times and she dove deep into the Big Beautiful Bill, pointing out the financial equivalent of an IED.
Kevin: There's the bomb.
David: Exactly. Section 899, which colleague Morgan Lewis discussed in last week's Hard Asset Insights. It allows the US Treasury to impose penalties and taxes on foreign-held US assets. And it's described by some lawyers as a revenge tax, withholdings of up 20% on US assets held by foreigners.
Deutsche Bank analyst George Saravelos said that, "Section 899 challenges the open nature of US capital markets by explicitly using taxation on foreign holdings of US assets as leverage to further US economic goals."
So, you've got Gillian Tett, her greatest concern is that this clause allows the Trump administration to turn a trade war into a capital war.
Kevin: Yeah, so in other words, we're not just tariffing, we're basically possibly taking.
David: Yeah, what is the gravest consequence of a trade war turning into a capital war? You just create more reasons for the US capital markets to be unattractive, and the upward pressure on interest rates is all but inevitable, regardless of the Fed rate-setting mechanism.
Like it or not, we here in the United States need foreign capital to finance our budget deficits. And if we go about discouraging overseas investors from doing so, it drives capital elsewhere. And it's at a time when we need those funds to keep a lid on interest rates.
Kevin: Yeah, we were talking about being able to sustain our ability to pay, and we've said this for years, and Dave, you've taught me this. If you need to read a three or four or five hundred-page book on interest rates, what you're really reading is the cost of money. And when money's expensive, things go down, things go badly. And when money's cheap, like what we've experienced pretty much our adult lifetime, things go up.
David: We've got a guest on the Commentary at the end of the month, and we'll explore a little bit more of the nature of economic warfare in the current context. Very excited to do that.
But when you think about interest rates, the level is one thing. The velocity of interest rates to the upside, that's another. And the velocity of interest rates to the upside will define the velocity of equity and bond market volatility to the downside. And in that sense, we have not escaped the 60/40 trap.
That is the classic allocation, 60% stocks, 40% bonds, or as you mature you shift that around to having less "risk" in fixed income. So, to many investors, they still are of the belief that bonds are an offset to equity risk—creating that balance, creating the 60/40 ideal portfolio mix.
And they're forgetting that the cost of capital coming down, interest rates decreasing over the last 40 years, has put both of those assets on an upward trajectory through the last cycle. And the correlation works in reverse.
Kevin: I think sometimes— Many stockbrokers have been taught this, and they'll teach their clients this, that the stocks are almost like a boat by the dock. You step into the boat every once in a while, and then sometimes you step over onto the dock. Maybe you keep 60% of your weight on the dock and 40% in the boat, or vice versa.
The problem is, this is a dock that sinks. You're talking about the boat and the dock sinking at the same time.
David: I had a great call with two clients this last week, and we were talking about needing to set aside some funds for a dock repair because when the storm hit, it wasn't good for the boat, wasn't good for the dock.
Kevin: Oh, well, perfect timing then.
David: Yeah. Both assets can circle the drain at the same time.
Kevin: Stocks and bonds.
David: That's right. For the same reason. So, if financial institutions have already begun diversifying away from US assets, foreign financial institutions, there is now an 899th reason to do so.
You've got a pressured currency, the US dollar, higher rates, and that combines with the Damoclean tax sword hanging over foreigners heads. Assuming that they get this Big Beautiful Bill passed and they keep in the Section 899 piece.
So, you put those three things together—currency under pressure, higher rates, and then potential tax liability on top of it—and you're talking about foreigners considering their investment options, reconsidering where they deploy their capital.
Every unit of investment from overseas that opts for a different venue is a unit of investment that the US Treasury has to find from someplace else, somewhere else. Given, of course, it's spending cuts are as scarce as hen's teeth, and so they continue to need someone to finance the deficits.
Deficits are still very much on the rise. So who will be the person holding the IOUs? We talked about the bond vigilantes last week.
Kevin: Well sure, that's the thing. This is a volunteer market. People are not forced to buy our debt. It's a volunteer market. What we're basically saying here with this 899th, let me explain it back to you so that I understand it. What they're saying is, you have the possibility of, if you're not popular with the US Treasury, losing 20% of your asset.
David: Yeah. And let's make it discriminatory. Let's say, for instance, that we don't get what we want with the Chinese.
Kevin: Right.
David: It wouldn't be uniformly applied. It doesn't have to be uniformly applied. We may, for any Chinese capital in the United States, charge an extra percent, 20%, 5%, whatever it is. It can be up to—
Kevin: It's like a Mafia kiss. You know what I'm saying? Where you get kissed on both cheeks and that's it.
David: You can stay in the neighborhood, but it's going to cost you.
Kevin: Yeah.
David: So, we talked about the bond vigilantes last week, and there are many reasons why the US debt markets are under the microscope. One of the points we made last week is that it's alongside the Japanese, it's alongside the UK markets.
Now, specific to the US markets, and this is where that Section 899 is really important. Specific to the US markets is that a further weaponization of financial instruments creates a political choice for our creditors and for overseas investors, just as the weaponization of reserves in 2022 recalibrated central bank reserve manager allocation choices. And what was that in favor of?
Kevin: Gold.
David: Gold bars. So, here is another category of weaponization that forces a re-examination of allocations, this time amongst sovereign wealth funds and financial market allocators from overseas.
Kevin: So, if the bond vigilantes say, "Hey, we just don't like this weaponization of financial instruments in the United States," where would they go?
David: I think it's fair to say that the bond investor today has a lot to consider, and there's a different calculus amongst the vigilantes when you're looking at, for instance, the Japanese government bonds or the UK gilt market.
The fiscal sustainability and inflation—again, we talked about inflation not being much of an issue here in the US according to the PCE. It actually went down. Japanese inflation, on the other hand, hit 3.5% in April.
And of course we know debt sustainability is certainly a concern, with rates creeping past the three and four decade highs in Japan, and now well past the Truss crisis levels in the UK.
But whatever the considerations by the bond vigilantes, the demand for higher compensation is there when they see elevated risk, and we do see that extending across the globe.
Kevin: Well, this is just simple, but you raise interest rates on what you're paying. When you're borrowing money, you pay a higher interest rate to attract more money into your ability to borrow. I mean, there should be an increased inflow to the US Treasury if they're paying higher rates.
David: Traditionally, that's the case. That's the normal correlation is that higher rates attract capital into those higher rates and you actually have support for the currency.
The Financial Times points out that "pressure on bonds"—where prices drop and yields go higher—"usually attracts an inflow of capital to capture the increase in cash flow." And as we pointed out last week, bonds and currency weakness occurring at the same time is a vitally important signal.
Kevin: So interest rates are rising, but it's not enough to keep the currency strong.
David: That's right. And the Financial Times agrees with this. This is the conclusion we came to last week, supported by the FT in this week's article.
So you typically see, and this is what they had to say, "You see this lower currency value, higher bond yields in emerging market debt, but not in a market like US Treasuries." In essence, they're saying we're starting to behave like an emerging market country.
At least, the bond market and our currency markets are reflecting the normal behaviors of an emerging market economy.
Kevin: Which is hardly a reserve currency, the old as-good-as-gold US dollar.
David: Yeah. So, the dollar declined since Liberation Day back in April, almost 5% lower, combined with a 26 basis point uptick in the US 10-year Treasury. It's concerning. The article was titled, if you're interested in reading it, "Dollar's Correlation with Treasury Yields Breaks Down."
Kevin: Well, one of the things you've been saying, Dave, is the dollar's probably not going to be replaced quickly because just of habit, institutional integrity, whatever you want to call it, it's harder to trade other currencies than the reserve currency of the dollar.
David: Yeah, it was the head of interest rate trading at Citadel Securities, Michael de Pass, he observes that the strength of the US dollar comes partly from its institutional integrity, the rule of law, independence of central banking, and policy that's predictable.
Kevin: Right.
David: These are the components that create the dollar as the reserve currency. I would add a few more things to that list. And as we've talked about in the past, Kevin, part of what keeps the dollar strong is our military—
Kevin: Right.
David: —and its presence on the high seas. But he concludes, "The last three months have called that into question. A major concern for markets right now is whether we are chipping away at the institutional credibility of the dollar."
Kevin: So, no longer as good as gold.
David: Goldman Sachs analyst—there was commentary on Friday, and this was in the same article. I would encourage you to read it. Noted in the same article, suggested that "investors should position for dollar weakness, especially against the euro, the yen, and the Swiss franc." So they see those currencies appreciating vis-à-vis the dollar, "all of which have risen in recent months," and they add that "these new risks create a strong basis for some allocation to gold."
Kevin: Which is as good as gold, by the way. Yeah.
David: Goldman on gold.
Kevin: Yeah.
David: You should be adding to your positions.
Kevin: Wow.
David: What I find most interesting about the Goldman comment from Friday is the context of Treasury and dollar stress. These are factors that are not quickly resolved.
Kevin: But you've got Goldman Sachs saying it's time to buy gold. But, Dave, that meeting that you guys had a couple of weeks ago, 850 people heard that the general investor hasn't even smelt gold as much as bought it.
David: Yeah. Two weeks ago, we did that conference call, 850 people registered to hear our take on the markets in general, gold and hard assets in particular, and this was a small part of our consideration in that presentation. The case we made was that investors have largely missed the move in gold to date, and we've watched central banks do the heavy lifting on price.
Implicit to our argument was that another wave higher in precious metals is still on the horizon, driven by institutional asset allocators, driven by the public. We'll include the link to the call. If you missed it, it's well worth your time.
Kevin: Well, you're going to want to go to McAlvany.com and watch that. Even if you just watch the first hour or so—the question and answer period was great, as well—but do yourself a favor and watch that.
But why don't we go back, Dave, to something that may be even larger than the things we're talking about, which is hard to believe? But there's an entire world out there that loans money to each other outside of the banking system. What's that looking like?
David: We've been talking about endogenous risk, and a part of this is thinking about the role that the Fed plays as the buyer of last resort, and how during different periods of market stress and chaos, they're willing to step in and guarantee financial market stability. When they've had to do that in past periods of crisis, it's because the crisis has sort of snuck up on them in some way.
And so for us it's hiding in plain sight, but to date, the US Fed and the US Treasury Department have not done anything. There's been no regulation to limit what is developing within the shadow banking world or community, and I think that is, again, where we see the potential for a financial markets crisis, but where the Fed is already hogtied, there's very little that they can do. There're sort of cornered or trapped.
Primary consideration for today, shadow banking. The Financial Times—I've read a lot over the weekend from the FT—"critical question, is private equity becoming a money trap?" And I think the better question is, when did private equity become a money trap? That's the better question. And I'd answer that by saying: three years ago. Three years ago.
You might ask, why are we talking about private equity in the context of shadow banking? And it's because the leveraged deals done in private equity are not usually financed by commercial banks, at least directly. There is a lending system outside the regulated lenders, and that's why it's called shadow banking. Wall Street loves to creatively concoct financial instruments. That of course is not new, but it's taken on a life of its own in recent years in the form of private equity and private credit.
Kevin: Well, and we mentioned that we started this Commentary in 2008, and mortgage-backed securities were the big problem at that time. At this point, private equity might be the new mortgage-backed security, right?
David: The article notes that 12,000 portfolio companies accumulated by private equity through what is really just a leveraged buyout, today cannot be sold profitably.
Kevin: 12,000?
David: The actual backlog is closer to 30,000 companies. So the assessment here is that it would take eight years to clear the inventory at the current pace of 1,500 a year. And again, the actual backlog is larger, but I think what they're focused in on, I think the focus was on deals that are deeply underwater, which is probably 1.8 trillion of the total $3 trillion backlog.
You look at other sources and it's actually bigger than that, not just a $3 trillion backlog. Institutional investors, which is a research group and a very unique and helpful website, it tallies to 3.6 trillion, is sort of the backlog of companies to be sold.
Kevin: Stuff that can't be sold right now for a profit.
David: Yeah. So 50% then, the 1.8, would be the companies that are underwater. Rates are higher, which basically takes the last five years of deals that have been done and leaves them in an iffy category. Iffy, like pull a jug of milk from the fridge and give it a sniff test. That's what I mean by iffy.
Kevin: It reminds me of when Bear Stearns tried to sell its toxic debt and could not.
David: And it was such a small fund, $400 million. It didn't seem like a big deal at the time, but that was the beginning of, have you checked your sell-by dates?
Kevin: That was the sour milk. Yeah.
David: Yeah. So private equity has underperformed the S&P 500 on a one year, on a two-year, and on a three-year time frame according to McKinsey & Company, which has created some anxiety in the pension community where groups like Yale and Harvard have pushed the allocation ceiling in the private equity category to 40% of assets.
Kevin: Gosh, Harvard. Harvard has got some troubles in many places.
David: Right. Well, what yesterday seemed reasonable is today being viewed as, and this is to quote the Financial Times, a massive over-allocation to a very illiquid asset class. And private equity is a little equity and a lot of debt. In essence, the asset class is a misnomer. The whole operating model is heavy leverage.
And here is where the rubber meets the road: yields being paid—and this is according to PitchBook—yields being paid are in the range of 9.5%. Most of the debt is floating. And so you've got deals that were made when interest rates were 2%, 3%, 5%, even 7%, and now all of a sudden you've had the adjustment. Rates are floating. They've come higher. And these deals which looked magical at 2%, 3%, 5% interest rates with the assumption that rates would go down, your multiples would expand, and you could sell at a profit with a lot of borrowed money, the whole game is being turned inside out. And it goes a long way toward explaining the 12,000 portfolio companies which are upside down and unsellable.
And it's the 30,000 companies in queue to sell, not just the 12,000 that are very, very unsellable, that explains why private equity operators have in the last 24 to 36 months pivoted to also being private credit operators. If you can organize a new round of lending, why not make money off of the carcass-like inventory of entities which have dwindling value, but which you still own? You just lend them more money, but now you can collect some interest on. It's a bizarre and very incestuous world, private equity and private credit.
Kevin: But like Solomon said, there's nothing new under the sun. I mean, basically, what you do is you chop it up, you repackage it, just like they did back in 2007, 2008 when we had the crisis. Or actually, that was happening before then. Then we had the crisis. So I'm going to rename private equity, Dave, because what you said was private equity is a little equity and a lot of debt, so let's call it puny equity. Let's just call it puny equity from this point forward.
David: No, that's great. I love it. Well, cue the cynical side of me. Would it surprise you that private equity now wants the public to have access to the asset class via exchange traded funds and other non-institutional funds? You only have access with tens of millions of dollars on the basis of being introduced. Now, it's turned and there is a different distribution mechanism. No longer is it invite only, it's find anyone you can. And so that turn, retail investors are being teased with the opportunity of a lifetime.
Kevin: Oh, yeah. Do you want to invest like the rich? Now we can do that for you.
David: Access which only the super wealthy and the institutions have had access to prior to this. Retail, and again, this is me perhaps being a bit cynical, but retail is the dumping ground.
Kevin: You've seen it, Dave. Back in the days when you were a stockbroker. It's a little bit like you got to move the fish, it's starting to smell, right?
David: Yeah. And hedge funds, I remember talking to a gentleman out on the East Coast, and he's like, "This is great. You know how much money is going to come into the hedge fund community? This is the place to be." I'm like, "What are you looking at?" He said, "Oh, well, we just changed the minimums. You can access hedge funds for $50,000, in some instances as little as $25,000." And I'm like, wait a minute. You're democratizing access. I think what you're really talking about is an exit strategy for people who can't get liquid.
And sure enough, that's what we have. Private equity companies want to see funds open to create a secondaries market for their unsold businesses. So they've got fancy words for them, continuation vehicles, evergreen funds, and it's a little bit like the ground beef of private equity. It's the trimmings. It's the unusable bits.
Kevin: I like that.
David: It's not so bad when it's served up as a burger, but the reality is-
Kevin: You mean his bone in this?
David: It's just the waste products that you don't want to throw away. Orlando Bravo—he's a partner, one of the main guys at Thoma Bravo, managers of $179 billion in private equity funds—and he says his firm doesn't want to be left out of the incredible flows of money arriving into the sector from individual investors, wealthy investors, because ultimately there's only so much money from the institutional community that you can access. They get great report on Thoma Bravo and Orlando. Financial Times, May 21st.
Kevin: Yeah, they need bag holders, right? The guy who's holding the bag when everything else falls apart. So let's go back to the milk analogy. Yeah. The other day, I did open one of our fridges out in the garage, and it was like, "You know sweetie, there's a sour smell in there." So what does that look like as we go a year or two or three out with these repackaged private equity containers?
David: Okay, imagine a time travel machine. Fast-forward 18 months. Private equity has offloaded half its backlog of unsold and unsellable companies to investors who are willing to actually pay a premium for assets that in 2025 couldn't be sold even at a discount. We don't know what the interest rate environment looks like in 2025, but again, this is just a work of fiction. Let's assume that the rates are higher than they were in 2025. What is a leveraged bag of garbage worth 18 months from now at an even higher interest rate?
And I can tell you, there's only one group that really cares. It's the investors. It's the bag holders. If you're talking about KKR, they will have gotten out. Apollo will have gotten out. EQT, Blackstone, CVC, Silver Lake, Carlisle, all the rest, they are no doubt eager to, as Orlando Bravo said, "Take advantage of the incredible flows into the sector." Well, Kevin, what could go wrong?
Kevin: It sounds like a barker, doesn't it, at a carnival? The, "Take advantage of the incredible flows into the sector."
David: So, from Institutional Investor, the group I mentioned earlier, they offer this summary in a late March article, they say, "Last year buyout funds raised 23% less capital globally than they did in 2024." And then Bain said, "Fewer funds closed during the year. And those that did, more than a third had been on the road for two years or more." Just having a hard time raising capital.
Kevin: Okay. So, the other night we went over to the house, and you served a wonderful vintage wine, Dave, and it had come from an auction. We were blessed to have shared it with you. But you warned us, you said, "Now this vintage could have turned to vinegar during this same period of time." You popped the cork. "It could be vinegar, it could be a good vintage." It was fabulous, but what does the vintage of these products, what does that yield, Dave? Does it start as vinegar? That's what I'm wondering.
David: That's a good question. Bain & Company compared the environment to that surrounding the global financial crisis, when assets under management rapidly grew in the run-up to the crisis. Again, this is from Institutional Investor. It was followed by a dearth of exits. Everybody was in, nobody could get out.
So for example, "the 2005 to 2006 fund vintages that were launched right before the global financial crisis took over nine years on average to return capital to investors, raising fears that the capital lodged in current portfolios will take equally long, or even longer to pay back." What's fascinating about that quote from Bain & Company, you have to remember, Bain has its own private equity group. They have a dog in the fight. It's almost like a moment of self-reflection.
Kevin: Okay. So help me with this. The shadow banking actually still does a connection to commercial banks. They have exposure and vulnerability, even though it's not necessarily— The shadow banking part isn't the bank.
David: Ordinarily, no. Ordinarily, there's no connection. What has happened in recent years is that commercial banks have been losing market share to Wall Street firms that are using these shadow banking techniques and tactics. And commercial banks have basically conceded and said, "If we're going to play, we can do so on an indirect basis." So, one new aspect is that private equity and private credit have tapped funds from commercial banks, now—this is kind of mind-boggling—to the tune of 10% of outstanding loans in the commercial banking sector.
Kevin: No longer a shadow.
David: Right. So, banks have lost out, have lost market share, until they figured a workaround: indirect lending. And it's not to the small and the micro cap companies that couldn't qualify for commercial loans, but they'll give the money to PE companies and private credit operators, and then they can disperse the funds. So there's a line of defense, if you will. Perhaps it's safer, but you don't understand the amount of leverage that's involved on the other side of that wall. So, there is a layer of exposure to commercial banks from the shadow banking industry.
It's also popular—this is one other dimension of risk in the financial markets—it's also been very popular over the last five years for private equity companies to hoover up insurance companies. Where insurance companies have these vast portfolios, they have to be invested somewhere. You've got the proceeds coming in from insurance contracts, and until they're paid out, those are the long-term liabilities, you've got a long period of time where you can invest the funds. Insurance company portfolios can also be a dumping ground for the nasty bits that won't sell at optimal multiples.
And so the private equity companies have figured this out, and guess where the nasty bits are going? We see these companies that can't be taken public for profitable exit, they can't sell them on, they can't go private or come out of the PE structures profitably, and so you just find a new structure to tie it up in and make it go away. Buy an insurance company, sell your private equity portfolio companies into the insurance company's bevy of long-term assets, collect your fees, call it a success story, and let the rot be discovered in a different domain once you no longer have that vintage on your books.
Kevin: So Churchill was right. The further you can see backwards into history, the further you can see forward. I mean, this is really not new. But let's go back, because full circle, we were talking about the price of money, which is interest rates. The price of money is also the price of time, because you're moving the future into the current. And we even had a guest, not recently, that talked about that.
David: When Edward Chancellor, who was on with us to discuss The Price of Time, this is just one of the many reasons why interest rates are so intriguing. In this case, we're talking about a different kind of time. The time it takes for the fuse to burn down to nothing. Higher rates have hobbled the levered speculator and driven cleverness and creativity with these PE and PC companies going more or less into survival mode. The retail public is being prepped to take on the unwanted liabilities—assets, if you want to call them that—of the private credit and private equity marketeers. They've got their evergreen vehicles, they've got their continuation vehicles, they've got secondaries.
Think of the danger that emerged from the mortgage market throughout the global financial markets via distribution from Wall Street operators. Again, if you're talking about the US mortgage market, it's localized, it's just the US. Except that Wall Street was able to slice and dice, and put those into financialized products that were then distributed globally. So you've got groups like NatWest and a lot of UK banks going under; we lost significant banks in Iceland. It becomes a global issue because of how Wall Street slices and dices.
And so this is where I think of a similar play today. Insurance companies, commercial banks, and of course your Wall Street [unclear] guys, they're all at risk. We are at the stage of the game where offloading risk is critical, and they are motivated to do it. Someone knows something. Someone does not. Who do you think has the better information in this case? The seller, or the buyer?
Kevin: Yeah. So Dave, there are people, the people who do know something, a lot of times they can be out in time. You remember, James Grant wrote a book on the man during the period of time of John Law. He was able to get in and out in time, and become very, very wealthy right before everybody lost everything.
David: Richard Cantillon.
Kevin: Richard Cantillon. That's right. That's right.
David: But the funny thing is, then he saw people continue to make money, and even though he thought, "This is a total fraud," he just couldn't bear other people making money, and he wasn't, too. So he put money back in.
Kevin: He FOMOed.
David: He totally FOMOed.
Kevin: He feared of missing out.
David: And he lost the money. He was in, he was out, and then he couldn't help himself. He was back in and he got spanked.
Kevin: Wow.
David: We go back to the 30,000-foot perspective, and see that interest rates are the issue for the treasury departments in the UK and in the US and in Japan and in many other places. So we have this convergence ahead of us between fiscal mismanagement—and the bond vigilantes are sniffing this out—combine that with financial market frailties, and many of those things are baked into the cake through shadow banking. Then include the weaponization of capital and the global market's ultimate desire, at an inflection point—and we are not there—but the global market's desire to opt out of risk. Where do you go?
Kevin: There's 899 reasons to say gold, Dave. I mean, at least.
David: Well, at least one reason, and maybe 899.
Kevin: Yeah.
David: Dimon says, "I just don't know if it's going to be a crisis in six months or six years." And this is what we mentioned earlier. "You're going to see a crack in the bond market. I'm telling you, it's going to happen, and you're going to panic." Kevin, maybe the occasional Cassandra of Wall Street has this one figured out.
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You've been listening to the McAlvany Weekly Commentary. I'm Kevin Orrick, along with David McAlvany. And 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.
