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The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
“So that’s the problem. We’ve created a structure within the financial markets which requires greater and greater liquidity to see those assets prices maintained or propelled to higher levels. If you don’t provide the liquidity, you see what Druckenmiller described as potentially the greatest deflationary collapse the world has ever seen.”
– David McAlvany
Kevin:Well, the fire we’ve been talking about has spread now to 52,000 acres. Dave, we’re in week five. We knew we had a very dry environment. We knew that we could expect something like this. It is amazing to me how quickly something like that can blow up.
David:We have a whole community that sounds like they’ve been smoking Camel filterless cigarettes for the last five weeks.
Kevin:It’s a lot of smoke.
David:(laughs) It’s a lot of smoke every day.
Kevin:I was thinking about it, though, Dave, because we’re looking at the news with Venezuela. It’s so sad. I don’t think people really understand the tragedy of hyperinflation, but the tragedy means that some people literally don’t eat. I heard the latest statistic that their inflation rate has blown to 42,000 to 43,000 percent, where a month’s wages will buy three cups of coffee at this point.
David:When you look at something like that, whether it’s the fire here in Durango, or hyperinflation in Venezuela, a lot of it is tied to context. You have the appropriate context for it to take place. In the teens, early ’20s, you had the reparations, the payments from the Treaty of Versailles, and there was an unsolvable problem. And yet they found a way to move forward through the printing presses. But the context was set. And it was an insurmountable debt that had to be repaid. That was the backdrop issue, the primary issue feeding into the Weimar hyperinflation. You could have looked at Venezuela and seen something like this coming years and years ago. And certainly we have the fuel to feed the fire here in Durango, and it kind of is just a matter of time before you have a lightning strike or something else that gets it started.
Kevin:And it’s not just Venezuela. We can look at our own economy and say, “Look at the trillions of dollars that have been printed.” In a way, that’s a little bit like a dry forest. It hasn’t turned to inflation yet, but I’ll just tell you, with the dryness that we had over the winter this year, the environment changed enough that I called my insurance agent and raised my fire insurance on my house knowing that we probably would have something like this. We haven’t really experienced much inflation right now in the United States.
David:This is one of the points that I was going back and forth with Bill King here in recent weeks, because this issue of the monetarist school of thought, assuming that the monetary base, as it increases, translates into greater inflation.
Kevin:Right. That’s what we’re taught.
David:Inflation is everywhere and always a monetary phenomenon.
Kevin:Print money, you get inflation. Decrease the printing, you should have a deflation. That’s the theory.
David:So what do we have here? Is it that that rule no longer applies? Is it Milton Freedman being thrown out on his ear and the whole theory being turned upside down and inside out? Or is it a question of sequencing? The fixation that I had with Bill King in the conversation on globalization is this link between what should be a monetary axiom – create lots and lots of credit money and you end up with inflation, and something that has reduced or tamed inflation in the short run. So again, is globalization that trend? That’s what I wanted to note. Is it the trend which has taken the monetarist equation out and upended it, or is it something that we’re just waiting for? I know from our conversations in house with Doug Noland and others who focus on credit, clearly there has been massive inflation in asset prices, and the central bank community has done a masterful job of focusing liquidity flows toward one particular place. So rather than seeing a radical increase in the cost of goods and services, we have had a radical increase in the price of assets, as intended, as the playbook was set up by Ben Bernanke during the crisis.
Kevin:Look at the 20thcentury. Could you imagine, Dave, if they weren’t printing money and we were on a gold standard, how much prices would have actually dropped? The cost of living would have actually dropped as we globalized, because when you do the globalization thing right you’re actually becoming more efficient with labor and what have you. Now, I’m not necessarily saying I am a proponent of current globalization, but our prices and our cost of living should have dropped. So what they have done instead – you’re talking about changing the equation – we should have had the kind of deflation that is good for all of us, but instead the Federal Reserve has been printing, and moving that money to where, actually, my cost of living is still increasing. Look at the Fed’s inflation gauge.
David:Yes, within free market circles there is the story of the pencil, and how it’s created, and what goes into creating the graphite that goes into the lead part, and where you harvest the wood from and where that metal band at the end that holds the eraser on – where do you get all of these parts and how long does it take to create a pencil if you’re doing the project alone? The value of open markets and the value of free trade and the value of globalization in that sense is that you get to specialize.
And when you specialize, the cost of the pencil, instead of being worth $20 or $30 because of the labor hours that go into it, is now pennies. And it means that nobody really thinks about the cost of a pencil anymore. Those are the benefits of a deflationary environment where we actually see a massive increase in our living standards because things get cheaper.
If you look at the Fed’s inflation gauge – and we had these numbers out here this week, they prefer something called a PCE Core over the CPI. You and I are stuck with the Consumer Price Index. That is the reference that we have. That’s the reference they use for cost of living adjustments, etc. But they prefer the PCE Core. It’s now at 2%.
Kevin:They started using that primarily in 2012, didn’t they?
David:We’re now back to 2% for the first time since 2012. A not-so-surprising study here in the last week or two shows that Social Security benefits buy you 34% less today than they did in the year 2000.
Kevin:That’s a retired person. That’s exactly right; has their standard of living with what they’ve been bringing in dropped a third? Absolutely.
David:Right. You have your goods and services, which are, in fact, rising faster than the cost of living adjustment, and is that a shocker? The cost of living adjustments, of course, are tied to the CPI. The CPI ends up understating inflation, and it’s a huge benefit to the government in terms of the benefits that have to be paid out to individuals, the obligations, that gap. There is a decent difference between PCE and the way they measure their own inflation, and the CPI which ties them to a long-term payable obligation. The CPI just doesn’t reflect real world inflation.
It’s going to be an interesting thing when the public finally discovers this. You realize there are enough people in the general public who are experiencing some level of discontent. There is a baby boomer angst which is tied to making ends meet in retirement, and this is one of the big contributing factors. What does your money buy you? Well, by 34% less than it did in the year 2000, you can see that income is not matching up with expenses.
Kevin:We really haven’t experienced the kind of inflation that would represent the amount of money that has been printed. I remember Adam Ferguson. We read his book and then we were very pleased to have him on the program. His book was When Money Dies. That was probably one of the better books, from a human interest perspective, on the inflation in Germany.
David:Certainly one of the archives I would go back and listen to.
Kevin:One of the quotes that he has on the last two pages of the book when he is going back and analyzing what happened to Germany, here is what he said, just in short. He said, “What really broke Germany was the constant taking of the soft political option in respect to money. The take-off point, therefore, was not a financial one, but a moral one.” What we’re talking about here, Dave, is a moral issue. Let’s look at Venezuela for a minute. Let’s look at what Maduro is doing. By the way, he handily won another six-year term. I’m sure those elections weren’t rigged since people aren’t eating.
David:(laughs) That’s right. Well, this is the question of the hour. Actually, hyperinflation is the question of the minute. There in Venezuela you have a real-time laboratory for financial and monetary mismanagement, and it is based on a political ideology. Honestly, I can’t believe that there is still a debate here in the United States on the merits of socialism. We continue to elect people who are proponents of some degree of socialism. And of course in the ivory tower it’s a free-for-all for, really, the dominant themes of academia.
Kevin:This isn’t just a pocketbook thing, this is a life type of thing. We’re talking true bleeding here.
David:Because the cost of bad ideas is not merely wasted tuition dollars. That’s not the cost of bad ideas. In the 20thcentury, as the 20thcentury has attested to, you have massive amounts of human suffering and death that are attributable directly to bad ideas. Hyperinflation is, yes, a monetary panic. And yes, it is an extinction event for a currency.
And that’s what you get in that book by Adam Ferguson, When Money Dies. It’s a currency extinction event, but it’s coupled with social collapse, and that social collapse piece is very complex. I like the way you framed that. When Money Diesis probably the best look at inflation from the standpoint of human interest because you begin to see the face which is in the statistics. You begin to know the family stories and narratives behind the statistics and numbers.
Kevin:We talk about dry forests being a predictor of a forest fire. We can also look at printing of money being like this dry forest. The IMF warned us about Venezuela and inflation. They said it could be as high as 13,000% this year.
David:(laughs) And we’re now over 40,000%. You’ve got a guy at Johns Hopkins, an economics professor, Steve Hanke, who admits that it is impossible to predict either the duration or the depth of a hyperinflation. So yes, the IMF was off a little bit. Now in Venezuela you have 90% of all civilians who are in a poverty situation, below poverty level. And President Maduro responds here in the last few weeks by tripling wages. He tripled wages to 3 million bolivars a month. That is just over 3 million bolivars translates to just over a dollar at the current black market exchange rate.
Kevin:And that’s a dollar a month.
David:Right. So it is difficult to gauge the duration and the depth of a hyperinflation because the currency collapse is not as much about running the printing presses as it is losing the confidence of the people. When you lose the confidence e of the people they no longer want what they once considered to have value, and now has no value to them, won’t get them what they need, there is a repudiation of that particular currency, and an expulsion of it, people trying to get rid of it as fast as possible. So very ordinary, within the context of a super- or hyperinflation, to see velocity pick up. Again, at the front edge of an inflation, velocity picking up is taken by most economists to be economic activity, and a healthy sign.
Kevin:Well, and it is to a degree. Let’s face it, a dollar bill velocity, how many times it circulates per year, if it’s down in the one to one-and-a-half range, which it has been since the financial crisis, then you don’t really have that much economic activity. If it gets up to two or three, then you are doing well, but when it gets up to tens of thousands – right? I mean, that is a total collapse.
David:Well, it’s like a national game of hot potato, and at a certain point it’s no longer a monetary issue. It’s a sociological and psychological event, more than a monetary one. You mentioned the election results we had here recently. He was given another six years. I think the reason why, in spite of the inflation that is brewing up through his administration, why he gets another six years – certainly there is political corruption. He probably did a stent with the Dalys in Chicago. They do everything to win an election (laughs), literally raise people from the dead for the purpose of votes. What it means is, not one in a million understands inflation, and I think that plays to his benefit.
Kevin:That was something that just amazed me, when we were studying the German hyperinflation, and working here I’ve studied it for 31 years along with you, it is something we have talked about a lot. But when Adam Ferguson wrote this book, he went back and interviewed people who had lived through it and right after that hyperinflation, people really did not even know that it was the printing of money that had created it. It had been blamed on other things. It is amazing how people don’t see, even after they go through this starvation event, the real cost.
David:I think it’s important to look at Ferguson’s book. As a listener, I encourage you to order it and read it, because it gives you a sense of compassion for people who are really a stone’s throw away from us. This is right off the coast in the islands of Trinidad and Tobago. We’re talking about one of the largest oil producers in the world. And in spite of oil prices getting into the mid 70s, there is virtually no benefit to the state-run firm that is there. They have promised so much to the people, that it doesn’t matter that they have a healthy revenue stream from oil. They’ve committed too much in terms of obligations, and it is all coming unraveled for them.
Kevin:And now the people are starving for it.
David:Right. So having a greater sense of compassion for what it means to walk through that kind of event, I think is very important.
Kevin:May I read just the last couple of paragraphs in Adam Ferguson’s book When Money Diesbecause it is for the Venezuelan people right now? Here is what he says: “Money is no more than a medium of exchange. Only when it has a value of knowledge by more than one person can it be used. The more general the acknowledgement, the more useful it is. Once no one acknowledges it, the Germans learned, their paper money had no use whatsoever except for papering walls, and darts.” He said, “The discovery which shattered their society was that the traditional repository of purchasing power [that’s like our dollar] had disappeared, and that there was no means left of measuring the worth of anything.”
He goes on to say, “In war, boots; in flight, a place in a boat or a seat on a lorry may be the most valuable thing in the world, more desirable than untold millions. In hyperinflation, a kilo of potatoes was worth, to some, more than the family silver, a side of pork more than a grand piano. A prostitute in the family was better than an infant corpse. Theft was preferable to starvation; warmth was finer than honor, clothing more essential than democracy, food more needed than freedom.” See, the effect we’re talking about is more than just numbers. We talk about 43,000% inflation, but if your money doesn’t buy anything, just for a moment the listener should put themselves in that position. What if your money bought nothing?
David:And it happens in a moment in time. This is long periods of time which proceed where it seems that nothing is happening, and then in a moment it comes to fruition. You see the character of Jean Valjean in Les Miserables, and is he a thief with an evil heart, or is he a desperate man trying to take care of a family?
Kevin:And that was during a high inflationary period, as well.
David:Yes. You have a political shift, a social shift, even a shift in morality which is necessitated by something which started as a moral compromise.
Kevin:Well, when you start morally compromising and printing money, the one thing that you still have control over in some respects is the narrative, for a while. Maduro had the narrative. We have talked often about how the Federal Reserve is managing a perception narrative. Now, that seems to possibly be changing now with all this trade talk. Are we seeing the new perception propagandists change from the Federal Reserve possibly to people who are discussing the impact of trade?
David:It certainly looked like it last week. You have Peter Navarro, his rally early last week. Stocks were tanking. Last Monday Navarro makes this unexpected press announcement that the implementation of restrictions on foreign investment in U.S. firms, there is going to be no immediate timeframe for that. So stocks were badly beaten up during the session and they rallied off of that announcement.
Kevin:Sure. It reminds you of a Fed announcement when they say, “Well, yes, but maybe we won’t raise rates soon.”
David:Exactly. Or you have one Fed chief that says something and then on an unannounced basis another Fed chief comes out and says something different just to balance the equation. Last week Bill King pointed out that Powell is a different kind of central banker. He has some real world experience. He is not merely an academic. I guess the question here is, has Powell over at the Federal Reserve passed the management of the markets on to Trump’s trade advisors? Because by all indications Powell is far less committed to smothering volatility, to smoothing out the market and eliminating market signals, directing support for market pricing the same way that Yellen and Bernanke had before him. So who is the new verbal intervention brigade? Who is it going to be made up of? Is it going to be Steve Mnuchin? Is it going to be Peter Navarro? We’ll have to keep track of that moving forward.
Kevin:And we have the question to ask also, the political side of the Federal Reserve, or the political side of some of this narrative, because if it’s Democrat controlled, could we possibly see – you and I just sat and tried to strategize last night. We said, “Okay, let’s assume that we’re in charge of the Democratic machine at this point. What do we do to get people to focus away from Trump’s success? And really, the only thing that we could come up with is pulling the rug out, or raising interest rates – doing something to the economy – because we do have that fragile dry forest at this point.
David:That’s right, feeding the natural consequences of a tightening cycle into the asset markets. We mentioned this a month or so ago, heading into the midterms we’re getting a lot of regional Fed chiefs which are shifting from doves to hawks. Certainly, the PCE inflation number and the unemployment figures justify the migration. But again, so does an agenda of tightening financial conditions such that an epic – really epic – bout of financial chaos, if that were to occur prior to the midterms, would help shift the political conversation favorably to the Democrats.
Kevin:And the Fed leans to the Democratic party.
David:Yes. If you check the Fed roster, the GOP is in the minority. They are sort of the splinter there. But that’s looking at it from one perspective. From the other perspective, Trump is incentivized to keep the verbal interventions alive and well, from whatever source, a new source, and yes, that constitutes sort of a short term manipulation of sentiment and pricing in the stock market. But here’s what he has to avoid. A collapsing stock market is really the best hope of the Democrats in November. Other platform issues they have tried to raise and it hasn’t really gained enough traction.
Kevin:He is very popular right now.
David:Yes. If you’re looking at polls it’s fascinating to see what progress he has made here in 2018. But a Republican landslide is likely without the markets getting tossed around. Because again, it’s the economic narrative that is so powerful, probably the most important element in an election cycle, and the economic narrative is controlled by the Trump organization today.
Kevin:And when the stock market is going up people think the economy is doing well. That’s not necessarily always the case, but they look at the market.
David:You’re right. You have CNBC reporting that 54% of Americans say the economy is good, or excellent. That’s the highest figures they have recorded in a decade. That supports the GOP this fall. And again, we’ve had multiple attempts to redirect the narrative. I think the only way they can do that is by hitting at the stock market. The economy is really the bedrock to political success or failure.
And you and I know that there is a huge difference – there is a hugedifference – between the financial markets and the economy, but the general public has forgotten that. The general public uses the stock market as a proxy, as a picture for whether or not we are in a period of prosperity and growth or not. So if you’re able to trip up the stock market then you are able to change, or begin to change, the economic narrative, you have some possibilities there if you’re a Democrat.
I know that sounds conspiratorial, and that’s why I’m happy to lean heavily on the fact that Dudley is the most recent dove turned hawk. He is the most recent one here in the last week to say we really should start raising rates more aggressively as we come into 2018. He has justification. The PCE inflation numbers which we talked about earlier hitting 2%, he has the justification for. We have 3.8% and who knows what the next round of unemployment numbers are going to be, but we may actually be at a better number with unemployment than we have seen since 1969. Again, there is legitimacy for migrating to the hawkish side of the equation and tightening credit.
Kevin:So he can justify it, even if it is politically motivated – raising rates. He can justify anything with the numbers that we have right now. But the Dow has been closing below the 200-day moving average. Now, that may not be ominous at all. There are some signals right now that the Dow could be weakening in its strength.
David:Sure. So first it’s the price closing below a significant moving average. Then it’s one moving average, let’s say the 50-day, closing below the 200-day, which suggests that a longer-term trend – it’s not just a day, a week, of lower prices, but in fact we might have months, or even quarters, of lower prices. So we have the Dow, which has closed below the 200-day moving averages multiple days sequentially in the last week, which is very significant. There is that additional question of do the other shorter-term moving averages also cross over below the longer-term moving averages.
Kevin:I’m going to ask the question that Andrew Smithers would ask. He would say, “Okay, but tell me how much the corporations are still buying back from themselves, because that has been a big driver of the stock market. The corporations have been taking whatever money they have, even borrowed money, and coming back and buying their own shares.
David:Yes. I think that is worth keeping in mind. Smithers is a huge fan of the cyclically adjusted price earnings multiple, which sits about 32.1 or 32.2. It is the second highest in all of financial history, which for him would be just, “Hey, wash your hands of this market. Walk away. Sit in cash and be patient.” Again, as King mentioned last week, you’re now being paid to be patient. You can sit in short-term treasuries and earn 2% or 3%, and that’s better than the risk that you’re taking in the marketplace. And it is some compensation for the inflation that you have to endure.
So something has radically shifted in the corporate world. You go back to the period of 2004-2014, a ten-year period, New York Stock Exchange-listed companies were spending right around 2%, to your point, on buy-backs. They were spending 2% of profits.
Kevin:And it is a lot higher right now, isn’t it?
David:The rate is running at 51% of profits.
Kevin:Wow!
David:Now, that is amongst your largest U.S. companies. It makes you stop and wonder, not only are we at an over-valued level, but what are the alternatives? If you’re managing a business and you’re spending over 50% of your profits to buy back shares, what about R&D? What about expansion? What about acquisitions? To me, it’s highly suspect. What else can corporate executives be spending money on? Retiring shares, if that’s the best alternative you have for the company’s treasury cash, again, I go back to the issue of, yes, you’re exaggerating earnings per share growth because you’re shrinking the number of shares outstanding so the earnings get divided by a smaller number.
Kevin:The executives are bonused on the earnings per share.
David:And that was one of Smithers’ big points. We have misaligned the incentives with executive compensation packages and remuneration, where with earnings volatility you trigger options bonuses for executives, and you’re able to spend cash to get what you want as an executive, which is money in your pocket. It’s amazing that this has not been addressed. And it is even more, in my opinion, hilarious that you hear the media talk about it as a return of shareholder value.
Kevin:Nice euphemism.
David:It’s great. Return of shareholder value. Corporations in the media have forgotten that the shareholders that really matter are the ones that hold through many cycles, not just the ones who are looking for a quick buck today. So the trend indicates that companies are not being managed with the long term as their first priority. They are subject to the whims and fancies of a very judgmental public that holds them for nanoseconds, not many years or decades, or through many business cycles. Go back to the archives on that one, too. Andrew Smithers was pointing this out years ago – remuneration packages, compensation committees – they have misaligned incentives for corporate leaders, and in the wake of 2008 and 2009 that fundamental flaw has actually gotten worse, not better.
Kevin:One of the things that I think the corporations have really enjoyed is the benefits of Trump’s tax cuts. That has to have an effect right now both on the profits of the companies, what they can use, that 51% that they are using to buy back shares. A lot of that money is probably coming from what would have been taxes.
David:Healthiest first quarter in recorded history, in terms of repatriated cash coming back into the United States from corporate America. The new corporate tax incentives under Trump have successfully brought back 300 billion dollars from overseas corporate coffers. That is according the Bureau of Economic Analysis. And it is the most in any single quarter ever. So I think there are two points to make here. First is that here is another small signal of the waning of globalization. You have tax and labor arbitrage which have been the hallmarks of the era of globalization, where you have an office or a business set up in a different geography, and that changes the tax ramifications for the revenue that is generated in that locale. That is tax arbitrage.
Labor arbitrage is just moving to a place where the cost of labor is cheaper. So you’re manufacturing your goods, or providing services, whether it is a call center or any other kind of service, and you’re able to deliver that with higher margins because your labor costs are considerably lower. These are the hallmarks of this last era of globalization. You remove the incentive structure for retaining earnings in overseas jurisdictions and that chips away at the tax arbitrage game. So that’s the first thing to point out there with that 300 billion in repatriated dollars.
Kevin:So that’s where the money is coming from for these buy-backs.
David:I think that’s a healthy share of it. Second, there is more capital for buy-backs in 2018 as a result. That’s the second point. Why shareholders don’t object to cash where it is being allocated at or near market peaks, that I will never understand.
Kevin:Right. So your 32 years of earnings, when we talk about PE, what that means is you’re buying a business when you buy share in a company. You’re buying a business as if you won’t break even for 32 years of earnings. Like a hot dog stand, you say, “Okay, a $100,000 a year hot dog stand, I’ll go ahead and pay 3.2 million dollars for.” Well, you’re going to stand out there selling hot dogs for 32 years before you break even.
David:(laughs) That’s a lot of rainy days selling hot dogs, waiting for your 32-year break-even.
Kevin:And this is when they’re buying their own shares back.
David:And that’s what doesn’t make sense to me because as a value investor, you’re paying peak prices for those shares. And admittedly, this is the Cyclically Adjusted Price Earnings Ratio, CAPE, or Shiller PE as some will call it, and it’s a ten-year rolling average. The benefit of using a ten-year rolling average for your PE is that you don’t see the radical volatility from quarter to quarter, from year to year, which is a part of the gaming system that executives use for that compensation triggering. They get their packages triggered by earnings volatility. The CAPE gives you the ability to kind of look through all that garbage and see a long-term trend of either valuation – cheapest, inexpensive – or over-valuation on the other end of the spectrum.
Kevin:Okay, but we’ve been talking about Trump, talking about the mid-term elections, some of the things that people are excited about right now, whether right or wrong. The stock market is still high, the tax advantages, corporations are coming in and buying their shares back, so that can give a little bit of a misread. But we really are in a different timeframe, Dave, for the first time in 70 years we’re pulling out our military from Seoul, South Korea. This is the first time in my life, and I’m 55, so it had been there 15 years before I was even born. It is a brave new world.
David:Yes, I got to spend some time with my dad this last week, back from the Philippines, having conversations about Duterte and the leadership in the Philippines. There is a change in who we are aligning with and how we are aligning with foreign powers in the Philippines, and in Japan, and in South Korea. You’re right, for the first time in 70 years we will no longer have a presence in Seoul.
Kevin:And you’ve stood right on that parallel. In fact, you’ve stood a little over that parallel. I remember the story.
David:That’s Panmunjom. That’s the peace gathering where they negotiate strategies…
Kevin:That’s the 38thparallel.
David:Yes. So, we will have a military presence in the country, but we’re moving away from Seoul. And what’s interesting about that is we’re shifting our commitments. I think we should expect more of the same as we look at NATO countries in 2019. What is very difficult to anticipate at this point, living in a completely complex world, a very complex world, it is difficult to say what the unintended consequences will be.
We can look at the economic benefits or the cost reductions of military spending in other countries, and that is certainly what Trump has thrown at Angela Merkel here in recent weeks, but to the degree that we’re realigning the political and geopolitical landscape, we really have no idea what the next ten years hold. We have no idea what the unintended consequences are. All we know is what we’re doing and the reason we’re doing it. We cannot anticipate the actions of the counter-parties, whether they are going to be rational or irrational, and how they will react to what we are putting in motion.
Kevin:Sometimes markets can sort of give you a sense of what the temperature is, even when people don’t know it. They might be subconsciously pulling out of areas that they are worried about. Do you think these changes, this breaking down of globalization, this complexity that is changing, Trump pulling out of South Korea, the tariffs, the trade wars, that type of thing – do you think that is why a lot of the globally focused equity funds are starting to see an outflow, not an inflow?
David:Yes, but in fairness, let’s think about this because it was Harold James who wrote his book almost 15 years ago called The End of Globalization. And this is long, long before Donald Trump started talking about running for the presidency.
Kevin:He saw a trend back then.
David:Yes, the trend of deglobalization has been in place. Now you’re just talking about catalysts and trigger points, and that may be trade wars started from something that Trump says. But there has been a trade here, and there has been a trend here of deglobalization for some time. You can look at the minutiae of the markets, and yes, from the beginning of the year until now, CNBC noted, actually, toward the tail end of 2017, that in fact emerging markets and the rest of the world was the place to be. And actually, there was more money flowing into foreign markets than was normal, certainly. But CNBC notes that investors are pulling funds from those globally focused equity funds now, today, pulling them out. Put them in late last year, now they’re pulling them out, at the fastest pace since October of 2008, right in the middle of the financial crisis.
Kevin:Wow. Wow.
David:So that’s the irony. The irony is that 2018 was said to be the year of global synchronized growth, and up until April had some of the largest influxes into global equities.
Kevin:But something has changed. Something has changed.
David:Right. So the march at the time was yet another lemmings parade, coming into the emerging markets very late. This is not an accounting sequence, but it is sort of last in, first out. The last people in, all of a sudden they look around and they’re like, “Ah!” It’s almost that Wiley Coyote moment where he gets across the precipice and says, “Uh-oh,” and he is, in fact, airborne.
Kevin:Well, look at the change, though, because one of the things that really hurts these emerging markets, and you’ve been bringing this up for the last month or so, is this increase in the value of the dollar, because these countries owe money in U.S. dollars, so it’s really hurting them as the dollar strengthens.
David:Yes, it’s a reversal of last year’s big story – dollar weakness in 2017 turned to dollar strength in 2018, with a huge reversal in fortune for the emerging markets. And here we are with the dollar index today just below 95, and that threshold, and still with a shot at 102, which we talked about a month or so ago, which would cause more pain in the emerging markets between now and year-end. It has been your Latin American countries and your European countries who have been under a lot of pressure. I’m thinking Brazil and I’m thinking Turkey and Italy.
But the Asian countries here in the last few weeks have been under considerable stress, under acute pressure, and they’re joining into the host of Latin American and European countries, pressured by increasing interest rates, declining currency values, and now all of a sudden we’re beginning to see significant shifts in their equity markets, as well. So who gets it last in any equity market turn? It’s the equity owner. You see changes in currency volatility, you see changes in bond markets and spreads between credit instruments. And then, of course, you have the guy who owns stocks. He gets it last. That’s happening. That’s playing out in the emerging markets right now.
Kevin:I’m just looking at the strong dollar and looking at some of the things we were talking about, and if you were the other side – I’m going back to our little role-playing game that we did last night trying to figure out how you would shift the elections, if you had power to do so, over to the Democratic side this fall. And I was reading Ian Bremmer’s book that you bought me. He was talking about what causes people to become violent? What causes them to throw rocks in a political situation – literally throw rocks or start fires? He says it’s when they don’t feel that they can make any difference whatsoever. Now, it’s strange. I’ve seen some celebrities here recently actually proclaiming that they need to show violence against Trump. What is that?
David:I don’t know. So in the category of what not to do? I’ve read at least half a dozen comments from left-leaning notables – it might be Michael Moore, or Peter Fonda, and others who are bringing in this idea of the threat of the use of physical violence to counter the Trump administration. You had Maxine Waters calling for sort of verbal harassment and even physical confrontation of political opponents, particularly of all things Donald Trump. Actually, she went so far as to draw criticism from Nancy Pelosi and our dear friend, Mr. Shumer.
Kevin:You’ve got to step way over the line to do that.
David:But fascinating. You know what? When Maxine was on her rant, two people who were very quiet in the context of Pelosi and Shumer actually saying, “Hey, you don’t have to get that mean with Donald Trump. Political opponents don’t require that kind of verbal abuse.” Paul Ryan and Mitch McConnell were silent.
Kevin:They may be silent but I can smell RINO in the background.
David:Well, for Donald Trump, I think it’s McConnell and Ryan who – you’ve heard the phrase, keep your friends close and your enemies closer? I wouldn’t be real worried about Pelosi and Shumer. You know exactly who they are and what they stand for and how they stack up in the political order. For Donald Trump it’s McConnell and Ryan who are the enemies he should be keeping even closer (laughs). Shumer’s not so much – he’s an old buddy! If you think about it, Trump, remember, he’s bi-political.
Kevin:He’s not a Republican.
David:No.
Kevin:He’s not a Democrat. I like that – bi-political.
David:I don’t know if that’s a phrase.
Kevin:I wonder if there’s a bathroom for that – bi-political.
David:I know. He’s GOP, he’s Democrat, depending on the polling, depending on the market testing. It was a very significant insight from King last week. You don’t know what the guy believes, but he reads the room pretty darn well.
Kevin:He does his homework.
David:Right. And on that basis, he’ll stand for whatever he thinks the general public is going to stand for, totally bi-political. It’s one of the reasons why he and Shumer have some history as being buddy-buddy, right? (laughs) That’s the farthest thing from the enemy that Trump has to worry about. The Washington Post had something to say on the same issue, which was that the blatant hostility toward Trump may, in fact, galvanize the GOP base.
Kevin:Oh, I can see that, yes.
David:Again, in the category of, if you’re a Democrat, here is something not to do, don’t get louder, and don’t get angrier. The shouting, àla the Tony Awards, all you’re doing is increasing the likelihood of a GOP sweep because it drives the GOP base off of their butts.
Kevin:They say, “Okay, let’s go vote. We weren’t going to vote, but let’s go vote.”
David:Yes, they actually show up and vote if they’re given a reason to not stay home. I’m all for reasonable critique. I’m all for public dialogue on issues, done in a very gentlemanly way. That should always be welcomed. But what happens when you have threats? Peter Fonda was actually suggesting some pretty awful things relating to Donald Trump’s youngest son. “Hey, just lock him in a cage with a bunch of pedophiles.” I’m thinking to myself, “Where’s the decorum? Where is the basic level of human respect here?”
When you stir something visceral, I think this is where the Democrats have to be very, very careful. If they stir something visceral they’re going to see the Republicans come out in force. They will see the Republicans come out in force, something the Democrats cannot afford in the midterm. Again, allow the cultural war issues to be highlighted too much, words and deeds and whatever else, and you will find yourselves on the outside looking in, in terms of the political halls of power for a long, long time. Anytime you have the opportunity to, whether you are a Republican or a Democrat, bring light and insight to something, don’t bring heat to the exchange.
Kevin:Boy, and we had a delicate issue, again, going back to the think tank, if we were actually Democratic planners here, how do you handle the retirement of Chief Justice Anthony Kennedy? They’re going to lose either way, because if they are, like you said, visceral, against whatever Trump brings up, it’s just going to bring the Republicans out.
David:Yes, and I don’t know the full list of people involved. I know the Wall Street Journalis writing up Bret Cavanaugh as the top pick – at least this week – but I think timing is everything. Looking back to, I think it was the fall of 2017, you had Dick Durbin and Diane Feinstein getting mean and nasty on public television with Amy Barrett. If I were Trump – again, we’re kind of role-playing today – if I were Donald Trump, I’d probably bring in Amy Barrett as the first nomination. It doesn’t matter if she gets confirmed at all, but for the purpose of a mid-term election, it matters how people view the Democratic response to the nomination.
And we have already had a pretty good taste of that with Mr. Durbin and Ms. Feinstein. They choose to get feisty again, you’ve got a bunch of midwest states which are heavily Catholic, and you put her on the spot like you did in November, and it was basically Feinstein’s conclusion, “You’re too religious to be a Supreme Court Justice.”
I think there are a lot of people that, again, if you want to galvanize the GOP base, allow that to go on air, where the Democrats are trying to rip on a reasonable – I don’t know Amy Barrett, I don’t know her background, really, but whoever it may be that gets nominated, that’s how I would play it if I was Trump. Put up a woman. Look, in the wake of the Me Too movement, absolutely, sponsor a woman and let the Democrats squirm with trying to get a woman out of there – out of the nomination process.
Kevin:We talked about a changing world. I want to go overseas just for a moment because China, the second largest economy in the world, is struggling with that balance between how much do you stimulate the market, and how much do you pull back? Right now, there is a fear that there could be a market panic at some point in China. Now, that may sound way across the sea, but that actually has a direct impact on what we are talking about.
David:We may be in a process of deglobalization, but that doesn’t mean that we’re any less connected today than we were a week ago, a month ago, or five years ago. If anything, we’re more interconnected, if you look at the interplay of financial instruments and derivatives and swaptions and all kinds of things, China’s issues are not primarily trade-related. This goes far beyond, this precedes the threat from Donald Trump of $200 billion in tariffs.
Market panic is just under the surface in China. We’re talking about economic growth which continues to slow. We’re talking about the PBOC, the People’s Bank of China, who here in the last few days has responded by creating more liquidity in the banking system, freeing up money by changing their reserve requirements, freed up about 108 billion U.S. dollars, for further loans to be made, and gosh, as if they need it, more credit expansion at this point. That actually is one of the bases of future instability in China.
But Bloomberg was reporting on a Chinese think tank, the National Institute for Finance and Development, which inadvertently leaked a note on the high potential for financial panic on the mainland. They’re looking at the leveraged purchasing of shares, which by the way we do plenty of here. Checking in with Alan Newman here in the United States, our current statistic of 668 billion, the largest amount of borrowed money going into the U.S. stock market in history, and this think tank in China saying, “We’ve got a similar problem. We’re at record levels in terms of margin-buying for shares.” And last time we had a significant shift, a significant decline in equity prices there in the Shanghai Exchange, the yuan was being devalued. It’s being devalued now. And that was sort of a precursor to a major blow of the stock market.
Kevin:One of the guests that we have had a number of times on here who lives in China – you’ve actually gone to see him – is Michael Pettis. His feeling is that that probably will continue, right? The devaluation of the yuan?
David:Yes, that it will continue, but not indefinitely, that it is a deliberate thing, that this is not market-generated, but that this is actually being administered, and the devaluation is likely to have limits.
Kevin:And didn’t that cause a huge downturn in the markets the last time they did it?
David:The last devaluation did spark a stock market liquidation. It wiped out about five trillion dollars of value in the equity markets there. And again, the fixation point here is that the leveraged purchase of shares is about the same level as it was in 2015 just prior to that. It was only a week or so ago, June 19th, Bloomberg reported there were over 1,000 companies on the Shanghai Exchange, 1023 companies, which plunged 10% on one day. So if you look at this, you have to say sentiment is unambiguously concerned – concerned. That is the basis of a market panic. In an interconnected world, panic is very difficult to contain.
So what happens in China matters for the rest of the world. What happens in Vietnam matters for the rest of the world. What happens in Japan matters for the rest of the world. What happens in Turkey matters for the rest of the world. But if you look at that one-day plunge in the Shanghai, that was not a fat finger move. That was not one company leading the charge on the downside. Over 1,000 companies were liquidated en masse. And again, sentiment is very concerned, and it is unambiguously concerned.
Kevin:Just looking at the temperature here in America as we celebrate liberty, the 4thof July, and the summer months, I’m feeling like people are fairly content right now. You look at the price of the metals, you look at the lack of volatility in the stock market. The stock market has sort of settled down here for a little while. Granted, it has gone down. But I think people, these two months, June, July, maybe a little bit in August, start to go to sleep. Their sentiment actually just goes into vacation mode. But the smart money, the money that is paying attention right now, seems to be moving a different direction than the overall surface of what we are seeing in the marketplace.
David:Stanley Druckenmiller said something the other day. He said, “If the central banks of the world wanted to create the greatest deflationary collapse the world has ever seen, they just do what they’re doing right now.” And so we do have these sort of crosscurrents of radical monetary policy which has been very accommodative. We created trillions and trillions and trillions of dollars in terms of the expansion of central bank balance sheets and liquidity that has gone into the equity markets and the bond markets of the world. On the other hand we’re created a situation where those financial markets are dependent on the continued flow of that liquidity.
Kevin:They have to have that artificial liquidity stimulation.
David:And so what happens when you have a world of elevated prices, stocks and bonds, deflation is nothing more than the shrinkage of price. So there is a positive deflation if you’re talking about consumer goods and services, but it’s a negative deflation if you’re talking about a radical and very short-term decline in asset prices. So that is the problem. We’ve created a structure within the financial markets which requires greater and greater liquidity to see those asset prices maintained or propelled to higher levels. If you don’t provide the liquidity, you see what Druckenmiller described as potentially the greatest deflationary collapse the world has ever seen.
Twice in the last week – twice in the last week – I’ve seen the same chart come across my desk, the Smart Money Flow Index from Marc Faber and from Bill King. This chart is an indicator that has led the stock market, preceded the market in terms of time and trend, for years. And it has not merely corrected this year, and in recent months, it has crashed. It compares the first 30 minutes of trading with the last hour of trading, and it tells you who is coming and going from the market. So you’re talking about the knee-jerk, “I’ve got to have some of this,” and the more steady, cautious hand in the market, which says, “What is the market telling us? Are we going to buy and sell?” And you tend to see radically different participants in the first 30 minutes of the market than in the last hour of the market. So again, this is a significant picture of what is happening.
Kevin:So if this is an indicator, for those who are sleeping on the job right now, maybe taking a little longer vacation, getting a tan, they should be paying attention because we are coming into a mid-term election year with a Federal Reserve that is leaning the other direction, and we’re set for the ice to break if it needs to.
David:Right. At this point the Fed is being led by someone who is not naturally accommodative to the stock market. You have tightening which is occurring in Europe, as well, with the ECB and the hand-off year-end to a new ECB chief, European Central Bank chief. You have an election here. You saw the political rancor in Italy roil not only the Italian stock market and bond market. Do we think that somehow we’re going to be different here in the United States? So this is very significant. You look at this chart and it tends to lead the market up or down by a number of months, and it started to move lower – crash – several months ago.
The bottom line is this: The fall of 2018 really could be the big one.
