Podcast: Play in new window
- Trump’s Trade War has a deeper agenda than the obvious
- Central Bankers “Don’t worry, we will just sterilize the credit growth”
- Doug Noland Q2 performance update call – Click Here To Register
The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
WORLD DEBT EXPLODES: $30 TRILLION IN FIVE QUARTERS
July 18, 2018
“Our financial system is being played very aggressively. Central bankers used to be concerned about the quality of credit when the quantity was increasing beyond a certain threshold. But again, quantity is now at such extreme levels, quality is actually going by the wayside, as well. What it tells you is where we are in the cycle. When quality is no longer an issue, and quantity is no longer an issue, you know that you are very close to the end of the cycle.”
– David McAlvany
Kevin:This week Trump met with Putin, and it was interesting to listen to the different remarks. Of course, the press on the left already had their remarks pre-packaged. They were incensed, it was horrible treason. Then you said you were watching Fox News, which would normally come across conservative. There were a few of those who were incensed there. We talked about that last night.
Then I went home and my wife said, “You know, this is really confusing.” You have the left who are completely trashing what Trump said, but they do that all the time. You have the right who are uncomfortable agreeing with or endorsing him, but they are uncomfortable with looking like they’re the left. And then you have the people in the middle who are saying, “What in the heck is Trump doing?
He seems to be doing politics in the form of trade sanctions, or whatever, but there seems to be something under the surface. Whether he means it or not, there is politics being played out that may have more to do with geopolitics and strategic types of things that are masquerading as trade tariffs. What do you think?
David:I think sometimes people are uncomfortable with the way other people make decisions. If you happen to be one of those people that is sort of in your head, and you think about things and you process things rationally, and you need to connect the dots for things to make sense, to see the process involved. “Give me evidence, show me proof. What are your bona fides? Okay, now I can agree and assent to that.” That is one way of processing information and making decisions.
Another is where people just feel a certain way, and I tend to see this as, again, maybe more of an MSNBC and left-leaning… There is a certain degree of compassion that is built into the liberal mindset where you just say, “Hey, it’s for the people, it’s for the children, it’s for whatever it is.” But the plea doesn’t necessarily have to be according to statistics and numbers. Sometimes it is very rational, but often the base is not rational. The motivation underlying is this heart-related thing.
I think what irritates everyone is that when someone operates at a gut level, the way Trump does, it’s neither heart-felt nor rational. It’s not necessarily irrational, and it’s not necessarily heartless, but when someone is operating at a gut level, it’s just confusing and awkward for everybody.
Kevin:And it seems there is an awful lot of success that seems to be coming from this right now and I’m wondering if the confusion that he puts out when he talks isn’t working in his favor. I mean, what did he say?
David:I think it is. Let’s match him up against Merkel. Merkel is highly rational, highly process-oriented, a scientist, a chemist before entering into politics, and understands “show me the process and then we’ll come to a reasonable and rational conclusion.” And he is willing to just blow things up and mix things up. Consider all of Europe as this massive, complex, very hard to move mix of people and cultures, and sometimes objectives that aren’t necessarily even compatible. You can’t operate clean and fast in that environment. The whole euro project is mired in complexity.
Kevin:All based on subtlety, complexity, innuendo.
David:Everything has to be run through 50 different committees, right? Well, Trump cuts through all that and just says, “I’m going to do what I want to do. I’m not looking for a committee, I’m not looking for approval, nobody has to agree. It’s my way or the highway.” And it’s totally frustrating to those who are making decisions on the basis of committee. The reality is we have a strategic advantage in Europe because there is no committee approval process with the Trump White House. I’m not arguing that his policies are pristine or perfect. I’m not. But I’m saying that there is a strategic advantage to someone who is willing to make a decision, and even if they make the wrong decision, go back and then very quickly fix it, as opposed to being lost in the complexity that is the Eurozone.
Kevin:Let’s go ahead and look at that, then, with Asia, because he is doing things with Asia right now that probably are accomplishing goals that are beneath the surface of trade tariffs. So let’s just talk about this trade war. At first, these are just little token gestures, 25 billion here, 50 billion there. Now it’s getting to be real money. But is it really about trade, or is it about China asserting itself a little bit too much and Trump standing up straight, raising his chest, and pushing them to the back of the ring.
David:Yes, trade is the talk of the town. That’s where the focus of the conversation is. A few weeks ago, 50 billion, 25% tariff on a certain select number of imports into the United States, or exports from China.
Kevin:Which is meaning what? That is the total?
David:The total quantities, yes. 200 billion now on the table at a 10% tariff ,which seems to miss the bigger issue, and I think this is geopolitics, really, in the guise of economics. Again, this is where if you get lost in the language of a trade war you might miss something that is happening here, because if we wanted to roll back our numbers in the trade deficits we’re doing a very poor job of that. The conversation is about reducing our trade deficit numbers. Look at the most recent numbers. Our trade deficit is still growing, and a part of that is because consumers are not changing their habits, we’re not changing what we actually import or export, so our trade deficit continues to grow. We’re failing if our real objective is, in fact, to reduce the trade deficit.
Kevin:Okay, so there is a larger agenda.
David:It makes you wonder. It makes you wonder if that is not just the guise under which Trump is driving a much larger agenda, and that is a direction that I personally lean. Last week the Financial Timeshit the nail on the head. To quote from an article that they wrote, “The concern in Beijing is this trade war is not really about surpluses or unfair practices, but about Chinese aspiration.” I think that is onto something because you have the one belt/one road which is redefining for the region, and maybe redefining for the global economy.
Just for perspective, this is where China, going back to 1988, per capita GDP was 4% of that in the U.S. in purchasing power parity terms. Now it’s 30%. So you have seen an eight-fold increase in three decades. Stephen Roach wrote about this in an article in Project Syndicate a few weeks ago. Massive growth there, and there is no reason to consider that changing anytime soon.
If you’re looking at total growth of GDP, of the world growth of GDP, 85% of it comes from two countries, the United States and China. We’re responsible for 35%, China is accountable for 50%. So we do need to be concerned with what these two countries are doing, and what they are saying, but frankly, more importantly, what they are doing. China is the centerpiece for global GDP growth.
Kevin:I was reading an article by Barry Eichengreen and he was saying, “How come we haven’t had a Smoot Hawley type of correction in this market?” What I am referring to, of course, is the Smoot-Hawley tariffs that came about in the 1930s. There was a substantial reaction to that, and we’re not seeing anything right now in the markets. Now, granted, the central banks have been able to smooth out everything, but there is really not a reaction to these trade tariffs.
David:You have the one belt/one road in process. You have the liberal media which is in hysterics over the implications of a trade war. We don’t have the markets reacting yet as if there are implications to the trade war. Maybe that’s just a delay factor. We don’t know, we’ll have to wait and see. But you’re right, so far the shadows of Smoot and Hawley have not cast themselves into the present market context.
Kevin:But if there is a larger agenda, then could it also have military types of aspects?
David:We’re already sending warships to the Straits of Taiwan. This is happening as we speak. But trade is the talking point in a larger shift. The reality is that China is viewed very differently by the current U.S. president than by past presidents. If you go back to Clinton, according to a Financial Timesarticle, we viewed the Chinese as a constructive strategic partner under Clinton. Under Bush the Chinese were a responsible global stake-holder.
Kevin:Under Obama they were a place to send our technology. (laughs) I’m sorry.
David:(laughs) But today we are viewing them as our principal competitor. So if that is the reality, then are they a competitor simply in economic terms, or does, ultimately, the economic leader of the free world end up being the political and geostrategic leader of the free world? So you are talking about who is the global hegemon, not just economic competitor, but who, ultimately, is the primary resource allocator, and who is the agenda setter for global policies and global leadership. And that comes back to something my father has said for probably the last decade. The 21stcentury belongs to Asia. The 21stcentury is the Asian century.
Kevin:Isn’t it interesting, we’re talking about China and the trade wars actually having a deeper meaning, maybe for the one belt/one road. We also have the pipeline discussion and we have Russia right now involved, and so there are politics that are underneath some of the confusing rhetoric and speech. It is amazing to me how people can spend so many hours picking sides, either the liberal media or the so-called conservative media, when really, that’s not what is going on. There is really something else going on under the surface, under that confusing rhetoric.
David:I watched a little bit of the back and forth between Putin and Trump, and I kept on thinking, in an alley, I know who wins this fight. In a boardroom, I’m not sure who wins the fight. But in an alley, I think I know who kicks somebody’s butt. I know you have some background in martial arts. Isn’t a part of what Trump is doing, oftentimes what you can do, and try to do, in the context of martial arts, which is to put someone off balance? If you can take them off balance you gain an advantage. It doesn’t matter if you are a worse fighter. If you can get your opponent off balance you gain an advantage and can press that advantage.
Kevin:And in a good martial art that is done, actually, with the opponent’s strength. Putin, let’s face it, where he exerts energy is in his pride. So if Trump can use that pride to keep him off balance, who knows what is going on underneath?
David:Right. We tend to look at things through a very sophisticated lens when we are critiquing someone as president. And I think it is appropriate to do so. Leader of the free world and representative of the United States, you want them to have some cosmopolitan sophistication. And he doesn’t. You can walk into the Trump Tower, you can walk into anything that he has ever developed and it’s like the modern version of baroque. It’s too much. It’s too much gold, it’s too much everything. It’s just over the top. Money does not equal class, and he is a perfect example of that. But he is doing a masterful job of putting everyone off balance. He puts the Chinese off balance. He puts the North Koreans off balance. He puts Angela Merkel off balance. He puts Macron and Trudeau and everyone off balance.
Kevin:Even people in his cabinet can’t really figure out why he likes them that day.
David:Again, from the standpoint of cosmopolitan sophistication you say, “This guy’s an idiot.” But the reality is, he is used to getting what he wants, and a part of that is by getting people off balance and then pressing an advantage.
Kevin:I’ll never understand politics, I’m not going to even try. I’m not going to understand what Trump says most of the time, but I’ll look at what the outcome is. One of the ways, however, that we can see future events, looking through the front windshield down the road, is credit motion. When you can see where liquidity is going, or where credit is, then you can say, “All right, well, we don’t know the exact timing, but we know that this must happen.” Doug Noland, of anyone that we have ever read, probably is the most masterful at looking at the credit bubble and seeing what that shows.
David:For decades we were on the outside looking in as readers of the Credit Bubble Bulletin.
Kevin:Before you hired him.
David:That’s right. Now he is a part of the McAlvany Wealth Management Team. Thursday of this week we have our quarterly call. I can’t believe another quarter has gone by, but here we are again at the Quarterly Call for the Tactical Short. Join us, register if you are interested in that product, or what Doug has to say.
Kevin:You want to register early. You go to mwealthm.com. That’s Thursday, 4:30 Eastern time, 2:30 our time here in the mountains.
David:That’s right. It will be a fascinating look at the global financial picture, market structures, Trump tariffs, higher rates, markets at a precipice. That would be a question for us. We will look at Q2 performance. We will look ahead to where we think we go in the third quarter. I think one of the things you are going to hear from Doug in this quarter review is, you really get to see the value of the methodology and the discipline that he is using in the Tactical Short, because one of the things we get to compare is pure performance, which year-to-date has been an absolute disaster for our peer group. So the Tactical Short has done very well relative to everyone in the space.
Kevin:Correct me if I’m wrong but most short funds don’t have a methodology. They just short the market. The problem is, you get eaten alive. But Doug has a specific methodology. He is short sometimes, and sometimes he’s not.
David:That’s right. So we are able to toggle back a lot of that risk, and actually, if you look at the performance year-to-date on many of the short funds that are out there, they have not only done the inverse, but they have done two to three times worse than the index that they are supposed to track, again, on an inverse basis. But I was pleased to see the experience of a veteran on display. There are some obvious merits there, and I think it is a compliment to Doug that in a very challenging environment his peer group is suffering, but second quarter stocks, of course, in the market were up, and Noland and the Tactical Short performed according to the design of the product, and that cannot be said of 95% of the other short products out there.
So we’ll cover some of the differences, we’ll look at the cracks in the global bubble, we’ll look at trade and other factors which are nipping at the heels of this particular bull and this bull market, factors that we think have the highest likelihood of turning the bull and heading things in a sharply different direction. So while our Tactical Short and that offering is an opportunistic strategy, I think the best way of seeing it for its hedging qualities, the complement in existing money management programs.
Kevin:So if you already have stocks, a lot of portfolios have to maintain a stock portfolio.
David:This is a great complement to reduce your volatility and increase cash in a down market. So register soon.
Kevin:They can send questions, can’t they?
David:Of course, any questions, and we will address those questions after Doug’s formal remarks. We’ll have some slides for you to view also on our website, so as we go through the program you will have a few visuals to look at, as well.
Kevin:One of the reasons I think we want to watch credit is because money has changed. It has morphed. Call it evolution – I think it is devolution – but money has become debt. Debt is money. Richard Duncan is a guest of ours, makes people mad because people don’t like to hear what he has to say, but he said, “Look guys, learn the fact that money isn’t what you thought it was.
David:The definition of money has shifted. We now have a broader idea of what money is in the modern era. Credit is money, in so far as it is the primary means of introducing liquidity into the financial system. So to consider credit expansion is really to consider growth in global liquidity, or growth in the total quantity of money.
Kevin:Sort of the new printing press.
David:Yes. So if you think about the last five quarters, this is just over a year’s timeframe, what is credit? It is just a debt obligation with an interest component attached to it. Somebody owes somebody else money. Credit has grown by 30 trillion dollars.
Kevin:Oh my, say that again. 30 trillion dollars. That’s one-and-a-half times our entire U.S. debt for the last 240 years.
David:That’s in a matter of five quarters.
Kevin:That’s in five quarters that credit has grown 30 trillion dollars.
David:We should give, I think, some perspective on that, because the central bankers will argue that it’s different this time. In one of our conversations a few years back with a veteran central banker, you might recall Charles Goodhart. “When a measure becomes a target it ceases to be a good measure,” is the quip that has become Goodhart’s Law. That’s the guy who blithely stated in our interview, when I asked him about increases of central bank balance sheets, he said, “We don’t worry about credit expansion because we sterilize credit growth.”
Kevin:We looked at each other and thought, “What exactly does that mean?” That has never worked in the past, has it?
David:Right. Sterilization – you might do that to a cow, or to a dog, being spayed or neutered.
Kevin:How do you sterilize credit growth?
David:It’s really to say that the central banks have taken an opposite action which negates the negative effects of the former, and therefore they have no concerns about inflation. On that basis, they believe that they can create infinite amounts of money in and through the credit markets. Of course, Bill King is another Commentary regular. He has noted that sterilization language, even though it is brought out as if it is a brand new tool used in the central bank community and therefore it is different this time, he says, “No, absolutely not. This is not new, it is not novel. This is stuff that they have been talking about and playing with since the 1960s and 1970s, and it has never worked in practice the way that central bankers say that it does in theory. But there are some natural limits, even to the “sterilization” which occurs, or the balancing act where you see central banks intervening to stabilize a currency. And some of that has to do with what happens in the foreign currency markets and the resources that central bankers draw on. We’ll come back to that in a minute.
The conversation point here today, again, back to credit expanding globally, our team cares a great deal about valuations and about bubble dynamics. Of course, that is the title of what Doug has been doing for decades now, the Credit Bubble Bulletin.
Kevin:The Credit Bubble Bulletin. We didn’t miss it.
David:The reality is, when you are seeing credit expand it feels good for a season, but in all instances of financial history it has brought a major crisis with it. And that’s where we see ourselves today, on the edge of crisis again.
Kevin:On the issue of credit bubbles, you have the rich getting richer and the poor getting poorer. There are a lot of people who are listening to these programs and saying, “What expansion are you talking about? I’m certainly not experiencing it. I’m working three jobs instead of the one that I lost before the financial crisis, or my portfolio that everybody said came back, and the stock market really never did in the way that I was invested before.
One of our listeners wrote a great analogy. I was reading our comments, and I loved what he had to say. He said, “These crashes are a lot like a sinking ship.” If you look at a ship that sinks, one end goes way up, the other end goes down. Now, the end that is down, everybody is in the water. The end that goes up – remember the movie Titanic. Everybody was up there at the top of stern of the boat before it finally sank. In a way, that’s where we are right now. You have a portion of the economy that has never been richer, and they’re getting rich – you said 30 trillion dollars in five quarters. I’m not getting much of that. How about you?
David:The reality is, even if you participated in the stock market run-up here in recent years, year-to-date 70-80% of the increase in the S&P 500 has been in four stocks – Facebook, Amazon, Netflix and Google.
Kevin:I read that. It was just those stocks.
David:If you did not own those four companies, the indexes are moving higher in your portfolio isn’t necessarily moving in lockstep.
Kevin:If you didn’t have FANGS you’d be down.
David:There is nothing new under the sun, and there is nothing new about the dynamics afoot here except the degree to which, in terms of this credit expansion – we talk about 30 trillion dollars globally over the last five quarters – the degree to which the whole world has been caught up in it – that is different. You have the Institute for International Finance, which also marks out that credit growth expanded just here in the first quarter of 2018 by 8 trillion dollars, which brings total global debt to 247 trillion. That’s a large number. That’s 318% of global GDP – 318% debt-to-GDP.
Kevin:When normally, 90% of GDP is…
David:That’s problematic.
Kevin:Yes.
David:If your debt-to-GDP number exceeds 90%, you should be aware of it as a problem. 318% — yes, it’s a problem. And it’s growing at double-digit growth rates of just over 11.1%, which puts us on track for a six-year timespan of doubling that number to 494 trillion dollars in debt instruments which have an interest component attached to it.
Kevin:We’ll never get there, Dave. Six more years of this? I don’t think so.
David:I don’t think so, but time will tell. You have two of our asset managers, Dave Burgess and Doug Noland, that argue that these excesses go beyond what you think they can, and when they correct, they correct harder than you can imagine. I mentioned a minute ago, we know that one of the benefits to our trade partners running trade surpluses has been the accumulation of foreign currency reserves.
Kevin:You’re talking dollars.
David:Yes, and that’s a very solid cushion for these countries. But it is a finite cushion. China was at over 4 trillion dollars in FX or foreign currency reserves, and in recent years they have actually been required to spend 900 billion of those reserves to control the value of the RMB to step in and influence in the short run. This goes back to what we were talking about earlier, those natural limits in terms of intervention. When you run out of foreign currency reserves, you lose the ability to push the market, particularly your currency markets, in a powerful way.
Kevin:It’s like spending your savings to pay bills. Savings are supposed to be savings, but sometimes you have to spend it to pay the bills.
David:Reserves allow for the game to go on. You can think about this in a lot of different ways, but if you have personal emotional reserves, they are the same way. They allow for you to engage, and go through things that are energy intensive and taxing, and if you’ve got the reserves you can make it through. Fat stores in the body are similar. Foreign currency reserves are energy. They are energy for tasks which are available on demand for the central banker. I think that is something critical to be mindful of.
Kevin:Last week we talked about your training for this next half-ironman, and I know you were training this weekend with somebody who does the full ironman.
David:I did a great swim and run with him. He is an athlete out of Kansas City. He is a friend of mine who competes several times a year in the full distance races. We talked about his first few races, how he had not figured out his nutritional requirements and his body went into deficit. That was the end of the race. You have these reserves, and you either have them in your body, or you have to feed them. Energy consumption is required for the machine to work. You run out of energy and the machine no longer functions as desired.
Foreign currency reserves are no different. Our financial system is being played very aggressively. Central bankers used to be concerned about the quality of credit when the quantity was increasing beyond a certain threshold. But quantity is now at such extreme levels, quality is actually going by the wayside, as well. What it tells you is where we are in the cycle. When quality is no longer an issue, and quantity is no longer an issue, you know that you are very close to the end of the cycle.
Kevin:I look at some of these athletes who are top performers. You were talking about training. I remember when we trained for that first half-ironman a couple of years ago. I was amazed reading just how extreme people will go because of the science of the body. They have learned to push things to extremes. But frankly, I wasn’t really willing to do it. I was happy to do it, it was a lot of fun, it was hard, but there is no way that I’m going to eat and do the things that these people do to have peak performance. But some people do. I wonder if the financial system isn’t getting that way, too, where if you’re not taking your hormones you can’t play football anymore. If you’re not doping you can’t…
David:Win the Tour de France without some extra help?
Kevin:Are the central bankers doing it, as well? Are they pushing things to physical limits, maybe even doping the machine to win the game?
David:My only problem with that analogy is I’m not sure that the system is running optimally because it’s not as if quality is in play here. We’ve compromised quality just to maintain the game. You have the latest increase in junk bond distribution, you have credit card debt growing. The May numbers ticked up to 24.5 billion dollars, and I would say…
Kevin:So we’re tapping into reserves already. We’re tapping into something that we can’t reproduce.
David:We’re at the outer limits. Again, this is the end of a credit cycle, not the beginning of a credit cycle. You’ve already placed as much credit as you can with the good bets, that is, the companies that you know are going to pay you back, the households that you know are going to pay you back. So credit growth now continues, but it’s not with quality in the equation. In that sense it feels like 2006 and 2007 all over again. Credit growth is to under-qualified borrowers and those who are more likely to be delinquent making payments.
Kevin:Something that my wife and I learned the hard way when we first got married was that you can afford debt, you just can’t afford the interest on the debt.
David:(laughs).
Kevin:(laughs) You can always afford the thing you’re buying that day because they look at you and say, “You know what? If you can just give up two sodas a day you can have this encyclopedia set, or you can have this VHS recorder. Back in those days, that’s when we first got married back in the 1980s when VHS was the big deal. We could always could afford it when we were buying it. The problem was we couldn’t make the payments.
So what would happen is, as we got toward the end of the month– and I know this isn’t unusual, but it was unusual for us. We got married when we were young, we didn’t understand fully. But we ran out of money before the month was over and we were wondering what happened, while we watched our VHS and our big screen TV and the dog that we saved from the pound, all with the credit card. We had to learn the hard way.
David:I remember sitting at the dining room table with my parents and they were selling a home in my teen years, and I was privileged to see the paperwork process. There was this shocking moment when the sticker price that someone was paying us, when you did the interest calculations, and they finished paying for the home, they actually were buying the house twice because of interest. What could that money have gone to? A number of other things other than the banking community. That interest is a big piece.
You have the process of credit growth, which is really no different. It runs into natural constraints. You have individuals, you have corporations, you have governments, which can afford to pay on the debts that they carry. This is all about a cash flow equation. What are your revenues, or what is your income, and how much of that can go to debt service before it impacts other things in your eco-system? For a corporation, when does it impact earnings? Or do it in distributions. When you can no longer afford ballet lessons for your daughter because you have to prioritize the second mortgage, then it becomes a real issue.
You remember last week we were talking about Australians. This is the reality. You have this huge percentage of Australians who financed their homes on an interest-only adjustable rate mortgage and you’re now in the phase over the next 1-3 years where it adjusts and it ratchets higher where their cash flow for that is going to increase 30-40%. It’s going to be a surprise. And as we said, we talked about the Secretary of Finance there in Australia whose concern was that the majority of people who were signed onto those loans don’t know the complexity of those loans, and are not anticipating the increase. And I would argue that very few on Wall Street, even, are anticipating this ballooning of the interest component which is around the corner here in the United States, as well. This is not just an Aussie issue. This is a global issue.
Kevin:Floating rates are a major concern at this point.
David:Right. And again, I think of ballet lessons for my daughter because I would rather skip that than miss the mortgage payment, right? Floating rates are a concern. Short maturities are a concern. With short maturities you have liquidity demands, you have requirements that have an acute time sensitivity. Rollover risk. This we talked about last week, as well. 20% of U.S. Federal debt has to be rolled over each year over the next five years, and that is going to be at higher and higher rates, theoretically, certainly if the Fed gets its way and is raising rates as they are targeting, as they are planning, as they are speaking into the marketplace.
Kevin:When we were in economics class we were taught that a certain amount of productivity, or income, was required to actually grow. Richard Duncan brings up a great point. We don’t do that anymore. Productivity, really, is almost meaningless. It’s how much we grow our debt. There is actually a number, there is a rock solid hard number that you have to hit in growth of debt just to survive.
David:You’re right. So back to Duncan, another point that he champions is that economic growth has developed a certain dependency on credit growth, that is, ever-expanding levels of debt. And if we fail to see credit growth of 2% — that’s a net number, net of inflation – then we have a recession. It’s the math, it’s very straightforward. The problem is, piling more and more debt onto the financial system also slows the system down by diverting an ever-greater quantity of dollars to servicing interest costs instead of toward productive investment.
Kevin:I want to go back to an analogy that you have used several times at conferences, which has to do with if you had to run across a room, you could run across it in a given period of time.
David:50-yard dash.
Kevin:50-yard dash, what have you – short period of time. If, however, I were to hand you a 50-pound bag of concrete you’re going to be a little bit slower. If I hand you two, you may not be able to run at all. If I hand you three, there is a point where you’re going to crawl.
David:It’s a shuffle, it’s a waddle. I’m not moving much. So, back to that analysis by the Institute for International Finance. Sonia Gibbs is a senior director there. She says, for the emerging markets which rely heavily on bank financing, higher borrowing costs for banks are likely to be passed through to corporate and household sectors, something of a hidden risk in terms of this floating rate for borrowing.
Kevin:In other words, it flows downhill.
David:That’s right. So as rates increase, the surprise is going to be for corporations, the surprise is going to be for individuals, and the surprise is going to put a real squeeze on people at the end of the line who are responsible for driving real economic activity, which is buying stuff – corporations, business, what have you.
Kevin:She’s not just concerned about emerging markets, she even brings it home here.
David:Right. U.S. debt is also an issue. If you said, “What’s our concern, in house, at the McAlvany financial group of companies?” Ours is more of a global concern, just in contrast, to give us perspective. You have much higher figures of debt elsewhere, and a higher likelihood of blowing up first.
Kevin:In the emerging markets.
David:Someplace else. It could be Turkey, it could be Argentina, it could be Brazil. Then you have the daisy chain effect, or if you want to call it the domino effect, through the wider financial landscape. But that has implications for the U.S. And certainly, it is not as if we’re immune. We’re aware of her concern. Yes, we’re above 100% debt-to-GDP, 90% isn’t healthy.
Kevin:In the United States.
David:Yes. So we’ve passed thresholds, and we continue to increase spending under Trump. The U.S. now has funding needs, annually, of 25% of GDP. That is worth thinking about. When the Institute for International Finance says, “It’s going to be a bit of an issue, funding needs annually of 25% of GDP.” What that is, it combines the growing budget deficit because, yes, we’re spending more than we’re bringing in. And also the debt, which is maturing this year.
So in Sonia’s words, that’s a lot of financing needs affecting the market. Oh, by the way, in our words, in the context of rising interest rates, is that a problem? Again, the budget deficit grew 16% so far this year. That’s 607 billion dollars, and that is through the third quarter. We’re talking about fiscal year, not calendar. We’ve just finished the third quarter fiscal year for the U.S. and we’ve increase our budget deficit by 16%, 607. We still have a quarter to go.
Kevin:Dave, you know how much I love my wife. She has been married to me now 35 years. 31 of those years have been working for McAlvany. So when I come home she will oftentimes say, “What happened in the markets today?” She will watch the news and she will say, “That will probably affect the market tomorrow.” Actually, it’s falling on deaf ears. Last night I came home – this was after Trump and Putin – and she said, “I’ll bet you the market is going to react tomorrow.” And I said, “Sweetie, no. No, the markets don’t react to anything anymore.” The problems, Dave, are in plain sight, but the markets aren’t reacting to anything. Now, you’ve said that this is the central bank footprint. If you’re creating 30 trillion dollars out of thin air…
David:Facilitating that.
Kevin:In five quarters. That is obviously going to show up in stabilizing markets that normally would react.
David:And of course that translates into massive amounts of asset price inflation. While we don’t see a ton of inflation officially in the Consumer Price Index, we see asset price inflation everywhere, and it’s monstrous.
Kevin:We got slapped down in one of the comments. Somehow, some way, we said something about inflation not showing up.
David:We’re talking about an official statistic. We understand that real world inflation is much higher, and we also understand that the transfer mechanism from the central banks has been directly into the asset markets and not into the Bureau of Labor Statistics respectful of reality, they can do and say whatever they want.
Kevin:Exactly. One of our listeners from Tahoe said, “You should see the value of my house. It just doubled.”
David:The average single family home in San Francisco now is 1.62 million dollars, and if you want a condo, the average price, I think, is about 1.2 million – a condo in San Francisco. These are numbers which are continuing to move up, annualized rates of double digits. That’s not sustainable.
Kevin:So for the person who is standing up on top of the ship that has not sunk yet, they can still afford that house.
David:Right. You kind of have an indication in terms of percentage of income which is going to housing expense and in probably a dozen areas around the country it is now north of 50%. Those are your premium areas. But even if you’re making a million dollars working for a Silicon Valley start-up, if you have to spend 50% of your income to keep up with the Joneses – that’s how that translates. After tax you’re spending a huge percentage of your income. Those kinds of things happen at the end of a credit cycle, end of a housing boom, end of a stock market boom.
The real failure here is a failure to connect the dots. The equity markets aren’t connecting the dots. July 9th, Wall Street Journalarticle – great article – they are highlighting the cumulative foreign exchange reserves. Back to our issue of how long is the fuse here, and how much time do we have, I think this is very, very important to keep in mind. The foreign exchange reserves of the emerging market central banks. These are largely the dollars which have been accumulated through running trade surpluses. Where the trade deficit is out of the equation, these foreign central banks are the trade surplus side of the equation.
Kevin:And they are gathering reserves, or they have reserves.
David:That’s right. Cumulative, six trillion dollars. Three of that is China. It was four, now three. Remember, I mentioned they spent 900 billion to maintain stability in the RMB.
Kevin:Don’t they benefit? We talked about the danger of the dollar getting stronger because what they have to pay back in is dollars. But don’t they benefit with those reserves as the dollar strengthens?
David:This is what I’m getting at. In order to stabilize their currency they have to spend those reserves. They spend those reserves to bring currency stabilization. If they don’t stabilize their currency as the dollar appreciates, it increases stress on the emerging markets, first on the currencies. But the real issue there is the dollar-denominated debt, masses of it, which are more difficult to pay off as the exchange rate differential expands. That’s what they are really defending. Central banks use the FX reserves to play the stability game. They smooth out and control the volatility. And, to your point, there is a problem in plain sight. It’s dysfunctional, it’s unhealthy, it’s inappropriate, it’s limited, and you’re running out of reserves. You are actually spending your reserves to just perpetuate and enable something that doesn’t work.
Kevin:Have you ever had a situation, Dave, where everybody in the room knew something but nobody wanted to say it? It’s almost that elephant in the room feeling.
David:Mary-Catherine and I enjoy entertaining, and hospitality is something that is fun for us. We love it, whether it is opening a bottle of champagne or wine, or fixing a multi-course meal, we enjoy having people in our home. Our very first dinner party, Boston, the year 2000. Problem in plain sight (laughs). A friend of mine is there from Harvard. And then another friend of mine, my oldest childhood friend. He is a professional musician, great guy. And then there was also a couple that I had known for years. He was doing graduate work at Boston University.
Well, they show up, and the guy from the couple – he is drunk. At one point in the evening he excuses himself to go to the restroom. Very demanding – “I want another drink!” It’s like, this is going to be awkward. All the art that is on the walls, half of it my wife has painted – she’s an artist – and he’s telling us about all the post-modern motifs in the artwork which are wrong for this and that and this reason, and why it doesn’t capture any real, true form of beauty. I mean, he knows that it’s Mary-Catherine’s.
Kevin:Everybody in the room is just looking at each other.
David:This is awkward. This is really awkward. So my comment, when he excuses himself, I just lean over to her and I say, “Bless your soul. Bless your soul.” Because I can tell that she is under pressure, right?
Kevin:And then she knew. She knew that you knew.
David:That was the aha moment. The game was up because she knew, in that moment, something that she had pretended didn’t exist. Everybody else knows, everybody else perceives the problem, everybody else gets it. And that was it. The problem was in plain sight, and now everybody … it was like the king-has-no-clothes moment.
Kevin:When you’re talking about having these reserves to smooth things out, sometimes when you’re spending savings and you’re out of money otherwise – let’s say you don’t have an income coming in – you can actually portray an illusion for a while. The markets right now really don’t react because the illusion is still firmly in place.
David:I’m looking at, yes, 6 trillion dollars is a lot of money, but you’re talking about the aggregation of the world’s central banks, and they’re using these reserves to smooth things over…
Kevin:What happens when they dwindle?
David:That is an issue, and I think you, as an investor, need to keep in mind that as reserves dwindle, it’s like watching a fuse burn down. Nothing explosive is happening right now, time passes without crisis, but you run out of reserves and the impact of too debt, the impact of payment default – that becomes a reality. The fuse was lit a long time ago, but it doesn’t burn forever.
The same Wall Street Journalarticle that I was mentioning from July 9thtunes into this. The emerging market central banks used up, in the month of June, 57 billion dollars in foreign currency reserves to stabilize the markets. That was the largest single month since 2016. The article concludes with this comment: “When you have dwindling reserves, it ultimately incites a rush to the exits. We know this.We’ve watched it happened in Thailand. We’ve watched it happened in the Soviet Union. We’re watching it happen all over again in Argentina. When you get to this crushing point where you no longer can operate as a central bank – Venezuela, as well – then all of a sudden things crack up.
And so, cracks are widening. It’s in plain sight. Yes, 6 trillion dollars seems like a lot of fuse. Not really. I thought 30 trillion dollars was a large amount of money, but that’s just over a year’s worth of credit accumulation, debt growth, globally.
Kevin:You brought out, we’re actually growing quicker than that right now. That debt is growing quicker than that figure. But why is it always a surprise, Dave, when it comes? If it is so obvious, if the problem is in plain sight, how come crash after crash – and after 31 years here I’ve been through a few of these – everybody acts like they didn’t know it was going to happen?
David:Financial crises, they do come as a surprise. They always do, at least for the majority. But I think, admirably, there are always those that see the growing imbalances and they do something about it. Maybe they hedge, maybe they own gold, maybe they buy treasuries, maybe they prefer zero-coupon bonds. Whatever your actions are to soften the blow, it’s perspicacious, it is wise action taken in advance because you see something that has to be addressed. And that does not define the majority. That never will define the majority.
I just reflect on that 6 trillion dollars. The fuse is, indeed, lit. Wouldn’t you love to know precisely how long it is? Well, actually, we do. We do.
