EPISODES / WEEKLY COMMENTARY

What Do 2000, 2008, & 2023 Have In Common?

EPISODES / WEEKLY COMMENTARY
Weekly Commentary • Jun 21 2023
What Do 2000, 2008, & 2023 Have In Common?
David McAlvany Posted on June 21, 2023
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  • Michael Hartnett “A Combo Of 2000 & 2008 – Big Rally Before Big Collapse”
  • Index Prices Rising As Majority Of Stocks Decline
  • Kissinger, Yep, That Kissinger Predicts Probable Military Conflict In Taiwan

What Do 2000, 2008, & 2023 Have In Common?
June 21, 2023

“The more uniform, classically, the more likely to reverse trend as the next step or the next move in the market. It’s almost like the immutable law of the last person. I don’t know that this is an actual law, but I’m just going to say, it’s like the immutable law of the last person. You run out of buyers and the price is going to go down, you run out of sellers and the price will begin to recover. So, let’s call that the immutable law of the last person.” – David McAlvany

Kevin: Welcome to the McAlvany Weekly Commentary. I’m Kevin Orrick, along with David McAlvany. 

Sometimes, Dave, actually not sometimes, but all the time, we should really try to understand the past through narrative. We’re built for story. I think when I was younger I would watch a movie and think, “Ah, this is just a girl’s chick flick. It’s just a love story. I know how this goes, repeating pattern.” Or, if it’s a horror film, I’m like, “Ah, I know how this goes. They’re going to walk into danger, not knowing what’s happening, and then all of a sudden the tragedy strikes.” But when we look at the markets, I’m going to be honest with you, Dave, I have never actually clearly seen the future exactly the way it would play out, but I can pretty clearly see the narrative of the story, looking backwards. It seems to be a repeating theme.

David: We’re in Tennessee this week at a family reunion. And spending time with family, you get a lot of that narrative look back. A part of it is nostalgic. A part of it is a recounting and telling of the tales. It’s great having my parents be able to spend time with their kids, their grandkids, their great grandkids, and just tell stories. You do illuminate the present and see a little bit more of the future when you appreciate the past. Part of that, from a family standpoint, is identity. 

But I think when it relates to the markets, you are talking about the context and understanding trends. When you look back, yeah, we’d better see ahead. This is true of historical and social insight. It’s also true of technical analysis, to understanding current market dynamics. So, patterns are revealed in these narratives and patterns are revealed in the price movement of assets. Those patterns are behavioral reflections. Those behaviors are informed by ideas and bias and belief and sentiment. So, you get this whole spectrum, the spectrum of hope or greed on the one end, and on the other end, fear. 

So, if you’re looking at the market today, we now have the highest reading of bullish investment advisor sentiment since November 23rd, 2021, which came about six weeks before the market’s all-time high. I think that’s worth reflecting on, as sage technical analyst and our occasional Commentary guest Alan Newman reflected this week. First of all, you’ve got the average of issues traded on the New York Stock Exchange, which continues to fall even as stock prices are rising. In addition to that, you have breadth, which is still underperforming price. So, to peer into the pattern is to observe a divergence, a divergence in trend between the upward tilt of the S&P pricing—it’s going higher—and the downward slide of the advance-decline line. 

If you overlay those two things, the price action of the S&P and the advance-decline line on the other hand, one overlaid with the other looks like the jaws of a beast opening wide, That kind of divergence, it’s helpful first as an indicator of something being off track, and second as a marker of unsustainability. So, the question is, how do those jaws shut tight? Does price fall to get in line with the advance-decline line at a lower level, or does the advance-decline line rise to catch up with price? We don’t always know how a divergent trend resolves itself. All that can be said with certainty is that something is not quite right.

Kevin: Well, and you had quoted Alan Newman, and I love reading Alan Newman. He cracks me up, because he’s always like, “All right, this is going to be my last newsletter.” He’s been trying to retire, I think, for 20 years, but he can’t help himself. What he’s seeing right here, he has seen these signals not only going all the way back through his lifetime, but he looks back through his dad’s lifetime and he goes, “I’ve got to tell this story. I see the narrative.” One of the things he’s told us is one of the signals we’re getting right now is that we have not really seen people get sick and disgusted of their stocks. I think he calls that capitulation.

David: My godson came over the other day, and he brings this book of stock certificates, and I was like, “Where did you get these?” It was from the Tom Reed goldmine. And he said, “Well, I was out in the woods up near the ski area, came across this old cabin. We went inside and inside this box was this plastic bag. And inside the plastic bag were these stock certificates.”

Kevin: Really? Wow.

David: All these years ago, someone had bought a ton of stock in this company, this mining company in Arizona. So, to begin to sleuth what happened here, “What was the narrative? Who were these people who were investing?” It’s the same as Alan Newman’s dad. He went through the Great Depression. You know the story, we’ve talked about it before, and he was so demoralized by the 89% decline in the Dow that as a stockbroker, he not only quit his job, but he took his stock certificates, put them in a box, in this case, a safety deposit box, and handed the keys to Alan. Alan didn’t go look at them until the mid to late fifties, if I remember the story correctly. That is an example of capitulation, right? 

So this is, I think, one of those things that Newman brings, and he reminds us so powerfully, we include into the frame other signals which might substantiate the case for market movement up, whether it’s a bullish trend or down in a bearish decline. But the observation that Newman makes, I think it’s worth quoting, “If we learned anything in our long career, it is that bear markets do not end until you see capitulation. Prices do not become truly attractive until participants are literally throwing stocks away—a sell-at-any-price mentality.

Under normal conditions, we would expect as many as 44 sessions of one part up to nine parts down. In the last 1,530 days, we haven’t had a single one. So what he’s saying is, of course, that you’ve got increasing volume of one part, decreasing volume of nine. So, this overwhelming desire to sell and to get out, that capitulation we haven’t seen. Out of the last 1,530 days, we haven’t had a single session. If you just look at statistics through any period of time, we should have had at least 44 of them.

Kevin: So going back to the movie theme, you have a character in this particular narrative—or characters, called central bankers, and they somehow show up and make the story look better than it really should be, over and over and over. I just wonder if this pause that occurred with the Fed last week, if that’s not just an element to extend the story and actually maybe extend the consequence.

David: This past week with the help of Jerome Powell and his Federal Reserve cohort, you’ve got market participants that have decided it was high time to toast the monetary policy pivot. So, the glasses are raised and spirits are elevated. They’re both in lockstep with stock performance. This pause in rates, this comes after 500 basis points of tightening, and it was welcomed. It was welcomed by the market like happy hours at the end of a stressful week. The S&P added over two and a half percent last week. If the pause was the start of a pivot, again, towards lower rates, then easy money in many respects, like rain after a drought, it’s welcomed by speculators. That’s what everyone was cheering. It was “l’chaim!” or “prost!” That was that raise-the-glass moment last week. 

I’ll return to this if we have time, but central bankers this week began to diverge from one another in terms of a uniformity of policy. We’ve seen looseness and then tightening all in concert, but the Fed paused its hiking cycle. The Bank of Japan similarly remained accommodative, wildly accommodative, with no new discipline applied from the new central bank chief, that is Ueda. The ECB tightened to three and a half percent, and they’re still in a deeply negative real-rate environment, alongside the Japanese, deeply negative real rates. Then you’ve got the PBoC, the People’s Bank of China, they cut rates, giving a nod to larger interventions on the horizon as a means of supporting economic growth, which, I think if you’re looking at Chinese economic activity today, it’s generously described as anemic.

Kevin: Well, the commodities market loves it if it looks like things are loosening.

David: Particularly if the Chinese are going to start pumping money into the system. That is really something that commodities get excited about. The CRB commodities index was up 3.98% last week. Dr. Copper gained a little bit more than the broader US market. It was up 2.67. I mentioned earlier that the S&P was up about two and a half. So, commodities really like the fact that China is going to be ginning up the economy. Easy money is an unhealthy form of stress management for the market, but it’s welcomed. It’s welcomed by the speculator community, and frankly, it’s in every geography. So, lest we forget, when the Bank of Japan maintains an accommodative policy suite—and this is kind of the continuation of the last central bank president to the new one—all that does is continue carry trade dynamics. And the carry trade speculator is someone who is borrowing in yen at zero rates or negative rates, and is then funding speculative ventures elsewhere in the world. So, you’ve got these massive trades everywhere, funded by the yen.

Kevin: Yeah, and that works fine until the value of the yen goes one direction or another more violently than they thought. So, we’ve seen that. I know we’ve talked about this in the past, but it’s worth talking about again. It was a yen carry trade that brought the death of one of the oldest, largest, most well-situated banks in the world. Wasn’t it Barings Bank that went down off of a carry trade mishap?

David: Right. You see these inter-linkages in global finance, and you wonder how Asian markets are so directly tied to New York markets and London markets and European markets. It has to do with these borrowing arrangements, and the yen carry trade—the fact that Ueda is not tightening policy in Japan, the fact that he is making money as easy as it’s been for the better part of a decade—means that we continue to be in this world awash with excess liquidity, and it feeds speculative dynamics. It feeds risk taking. It feeds a misallocation of capital. 

So, the inter-linkages in global finance, these are very pro-cyclical. In other words, they exaggerate trends in either direction. So, the day that Ueda decides to tighten, and the day that the yen finds its feet, stabilizes, maybe even moves to a better level, increases in value, that’s a dangerous day to be playing in risk assets. We just don’t know how long this is truly sustainable for the Japanese. Until then, Ueda is playing with high odds of a yen currency crisis. Because I mean this is where you’re tempting fate. You can abuse your currency to the benefit of this exercise or that exercise. The trade-off is you can lose confidence in the currency, and that crisis dynamic. Boy, that’s an interesting thing, but until then, it’s just feeding the global misallocation of capital.

Kevin: You talked about losing confidence. There is this illusion of control from the top, and it may work for a long time. The central bankers may feel like they’re controlling interest rates, the political leaders may feel like they’re controlling economic factors and financial factors, but when they do lose control, I mean it really is, going back to the narrative again, it is a false hubris, basically, that says you’re going to be in control all the time. We have seen free markets sometimes take over, on their own, and say to the control factors, or the guys on the top of the hill, “No, we’re not going to do this.” Let’s look at the bond market for a second. Someone once explained the bond market to me, this was when I was in college, like a seesaw or a teeter-totter. So, when interest rates rise or the expectation of interest rates are going to rise, the value or the price of that bond falls. So, the guys who are trying to control and make people think, “Well, money’s going to be easy,” this week, the bond market is still saying, “No, we think rates may be higher.”

David: We mentioned two things last week that I want to come back to this week. One is a change in rates in the UK, and the other is continued pressure in the Chinese economy. These, again, are signals and symptoms of significant issues which have implications beyond just the world of finance. 

So, yes, it was a week of policy divergence, coming back to the central banks, but we did see a fairly uniform week when considering bond market rate increases. Prices were down across Europe. Of course, when prices go down, like that seesaw you’re mentioning, then rates are going higher. 

So, you’ve got an asset that’s being sold off, short-dated paper was under pressure, UK yields were higher by 40 basis points last week, 58 basis points over two weeks, and they’re now above levels that we saw when Liz Truss had— Her fiscal plan brought this existential angst to the UK bond market. That was last fall. You remember, she got thrown out on her keister. Then we brought in Rishi Sunak as an alternative and a different strategic plan, fiscally speaking. The lows that were in the market in October, serve as the lows for all of the global markets. We’ve seen things move higher from October of 2022 to the present, and the lows were commensurate with this Liz Truss fiasco. 

But think about this for a minute. We now have the UK bond market in as bad a place as it was last fall. So, for the UK bond market to be in as bad a place as it was last year— Now, granted, we’re talking about short-dated paper. This is not long-dated gilts. They’re not quite up to September’s number. But stress, nevertheless, is present. I think this is really fascinating because not only is Liz Truss not in place, we’re not talking about a fiscal situation which can be tied to a particular policy suggestion. This is just the state of the union in the UK. 

I think it’s really fascinating because the likelihood of bond prices continuing lower and yields moving higher regardless of what central bank policies put in play, this is a strong reminder that the markets ultimately are in control. You can manipulate a market, you can have a policy measure which gooses things in one direction or the other in the short run, but ultimately Mr. Market prevails, and that’s what we’re seeing in the UK bond market today.

Kevin: You brought up investment advisor sentiment, and it just makes me smile, because almost always, Dave, when I’m talking to clients and they’re like, “Yeah, I’ve had my investment advisor for years.” And I’ll say, “Well, how have you done with him?” He’ll be like, “Well, pretty good. He didn’t see this coming or he didn’t see that coming. But he’s really optimistic right now.” The sentiment for investment advisors almost always is positive at the wrong time.

David: I started our comments today with that investor advisor sentiment, and for some that may sound like mass confirmation of a bullish trend, “Look, all the professionals think we’re in a good place.” But for others, and I include myself in that, it’s actually a contra-indicator. I just spent a few days with 47 family members in the waterways and the hills of Tennessee. Family reunion comes every few years, and with my parents living overseas, it’s always special to gather and to talk and to play. There is this dad-ism, this McAlvany quip, a principle that was often noted in speeches that I heard growing up, which was, “The majority is always wrong.” So, when I hear the investment advisor sentiment is now getting to levels that we haven’t seen since the fall of 2021 as the market was putting in its peaks, well, I think to myself, “The majority is always wrong.” 

While that may be hyperbolic to say the majority is always wrong, frankly, it just sounds odd to say “almost always” or “mostly always.” So, as we reflect on the uniformity of behavior in the market, the more uniform, classically, the more likely to reverse trend as the next step or the next move in the market. It’s almost like the immutable law of the last person. I don’t know that this is an actual law, but I’m just going to say, it’s like the immutable law of the last person. You run out of buyers and the price is going to go down. You run out of sellers and the price will begin to recover. So let’s call that the immutable law of the last person.

Kevin: And when you said you don’t want to say “always wrong” so you say “mostly always wrong,” it reminds me of Billy Crystal. Remember Billy Crystal in Princess Bride when he is like, “He’s only mostly dead. Mostly.”

David: “He’s only mostly dead,” I love that. 

Well, the fascinating thing about a countertrend rally is that you have price action that suggests the bull market’s back. But if you look more closely at market dynamics, there’s a strange lack of buyers in queue to purchase. That’s why—we were talking about Newman earlier—the advance-decline line divergences, breadth, issues, volume—again, the Newman highlights—that leads us to this agreement with Bank of America’s Michael Hartnett on what he calls being in a bull trap. You think you’re in a new bull market, and it’s actually a sentiment trap because you’ve been convinced that it’s only going to go up from here. This was his brief but disturbing comment on a bull trap last week, “A combo of 2000 and 2008, a big rally before a big collapse.”

Kevin: Wow. Okay, so relating it to 2000 and 2008— Now, I think in pictures, Dave, okay, I know I keep bringing movies up, but when you have five to seven stocks leading a market of hundreds and hundreds of stocks, as far as indexes go, it reminds me— Let’s say you hear that there’s this blockbuster movie, and you go down there and you see three people in the theater and maybe three people in line and you’re like, “Well wait, this was supposed to be a blockbuster movie.” And it’s like, “Oh yeah, it is. This theater just made thousands.” And it’s like, “Well, how much did you pay for that movie?” “Well, we each paid a thousand dollars for the movie.” So, instead of all the indexes going up, you’ve basically got people paying very, very high prices and they’re going higher, for things like Nvidia, Amazon, you name it, Tesla. But for the most part you have volume and breadth going down, the other direction. It’s like a blockbuster movie that’s not a blockbuster at all. He compared that to 2000 and 2008. Dave, you and I both lived through 2000 and 2008 in the markets. They were very painful for the people who were in the wrong place at the wrong time.

David: Yeah, and obviously sentiment had never been better. So, that’s one of those things you’ve got to keep in mind. You listen to a Hartnett to see this echo or reminiscence from 2000, from 2008. I think there is this notion that if we reflect on the past, we can see the future more clearly. In that respect, consider yourself forewarned. Whether you are forearmed depends on how you choose to manage risk. Your choices, there’s not a whole long list of choices, but they’re all effective. You can increase your liquidity, you can maintain a healthy precious metals exposure. You can short or hedge existing positions. Now ironically, and this is also symptomatic of the environment we’re in, short covering continues. You’ve had hedge funds removing, removing a mass short position, short exposure last week. Bloomberg reports that it was one of the five biggest periods of short covering over the past five years, since 2018.

Kevin: Doesn’t that make shorts a lot cheaper though? When you’re hedging a market, when you’re long something, let’s say we’re long gold and we want to be neutral on the market, we’ll short gold, but there’s a price to pay if a lot of people are shorting at the same time. It can be very, very expensive. When everybody’s throwing their shorts away and they’re saying, “No need to hedge, the sky’s the limit,” I would imagine shorts are probably pretty cheap.

David: That’s right. Everyone’s naked too. So, equity market hedges don’t cost very much when people are getting rid of that hedge exposure. You can hedge any position, like you said, with gold or any other asset as well, but it tells you something. Again, these are little signals and signs. There’s a lot of tension in the markets. People pay to be protected on the downside, and the cost of that protection is going higher and higher. Or, as we have right now, the cost of protection is very, very cheap. You get hedge funds who are basically saying, “We just don’t need short exposure, it’s time to go long.” Again, I would count it as a contra-indicator that we’re ready for a significant decline.

Kevin: One of the things that you look at all the time and we talk about all the time is the volatility. Because volatility, the VIX, that’s an index that if you’re watching it closely, you can see if people are nervous or not.

David: Well, that’s right. The volatility index, and of course this relates to the US equity markets, and so it’s probably not a surprise that last week US equity funds saw their largest weekly inflows, new investor money coming in, since 2021. Again, 2021 being that timeframe of putting in the market peak. This is despite 500 basis points of tightening over the past 12 to 15 months. The major market indices are now trading at higher levels than when the tightening cycle began. So, thank you Jerome Powell and the whole group at the Fed for creating these really tight financial conditions. I mean, they’re supposed to be clamping down on inflation. The unintended consequence, or the side effect, is that you should see a tightening of financial conditions. Yet we have speculation at a level on par with what it was before they even started the project.

Kevin: So is it a new bull market?

David: Or is it the end of that rally Hartnett referenced? So, clearly the Federal Reserve is not trying to break the bad habits of speculators. We go back to VIX, given last week’s volatility index measurement, reading at 13.53, that’s the lowest since 2021, and that topping period of about a three to four month period. What it just says is investor enthusiasm is great, and the net effect of raising rates has been that stocks have dipped and recovered to pre-tightening levels, which is truly, truly remarkable. Doug Noland, in his words, “That which does not burst a bubble only makes it stronger.” 

That’s what we have. We have a growing government bond bubble, and it’s not just in the US, it’s global. It would almost appear that the Fed has succeeded on two of its three mandates. Number one, market price action. You’ve got— price action is up. What some see as stability within the stock market, but which I think is more akin to the sort of un-health of manic behavior. It may look cheery, but it’s not necessarily sound. Just coming back to market price action being a mandate, just as a reminder, that number one is not actually an official mandate. It just appears that they support and intervene to keep prices up, because they’ve got this deep loathing or fear of asset deflation.

Kevin: But employment is one of their mandates.

David: Yeah, and that’s one that you could say, “Yep, okay, they’ve succeeded. Unemployment is down, it’s at 3.7%,” and that’s actually what they’ve been toying with. Maybe we need to get— in order to beat inflation, we need to bump the unemployment rate a little bit higher. We need a few more people out of work so that there’s less wage pressure, because they’ve assumed that it’s the wages that are causing inflation. So now they just need to focus on securing the third. If the first is a positive, stable stock market and the second is unemployment—which they’ve mastered, it’s now down to 3.7%, then the third is price stability. Price stability, this thing we call inflation, has been stubborn. 

I was fascinated to read a bit of intellectual candor, maybe even humility from the Fed. They’re reconsidering this relationship between tight labor markets and inflation. Reconsidering, as in, “We assumed that we’d solve inflation by tinkering with employment,” and now they’re saying, “Maybe this isn’t actually the real connection.” Which just goes to say they don’t know what they’re doing. They don’t know what they’re doing. I wonder what new model they’re attempting to conform reality to since the data is no longer cooperating with them.

Kevin: So, the question would be in the minds of the market, and honestly in the minds of the person who’s going down to the store trying to whip inflation now, trying to somehow live with the inflation we have and hope to see it go down, the question, Dave, is how much more tightening do you think is on the horizon?

David: Yeah, the market prices this at one level. We may see that level. It may be higher. It may be lower. CPI and PPI were both refreshingly lower last month, on account of lower energy costs. Core CPI was not quite as helpful. It was the one that was sticky. Federal Reserve governor Chris Waller remarked to that effect, “Core inflation,” he said, “is not coming down like I thought it would. Inflation is just not moving, and that’s going to require probably some more tightening to try to get that down.” That’s what he said last week, even after Powell’s comments and the pause, so to say. 

But with those words in mind, Kevin, you might wonder if Mr. Market is getting ahead of himself on the pause, pivot, hope train. Are we there? Because the market is pricing in 5.6%. I need to clarify, let me back up. The stock market believes that we’re at the pause pivot, and that’s where the hope train is. The bond market is pricing in higher rates still. So again, you’ve got these divergences where the stock market says, “No, we’re done. This is good. Let’s get giddy again.” The bond market says, “You didn’t get the memo. Not all is clear, not all is well. The economy, both domestic and global has some issues, and I think we’d prefer fixed income at this point.” So, 5.6% is the expected terminal rate, with two more increases anticipated in the remainder of 2023. That’s what the bond market expects. That’s what the bond market is pricing in. Meanwhile, happy days are here again in the stock market, oblivious and already assuming that, again, we’ve boarded the pivot hope train.

Kevin: Going back to the— Looking back and not knowing the future, but we at least know the patterns of narrative in the past. We know that all through history we can talk all we want about economics, we can talk all we want about national politics, but there’s always some unexpected surprise that shows up. I mean, that’s the twist in the story where you go, “Gosh, I didn’t see that coming.” I had lunch with a good friend of mine, and he was a general in the Air Force before he retired, and one of the things he studies is Sun Tzu. When he would go to war, he actually said, “I took two books with me, Sun Tzu and the Bible.” And he said, “I studied both.” And he said, “With the Chinese,” and I’m throwing in maybe one of the unexpecteds, because we’ve been talking about this tension between China and Taiwan. He said, “You have to watch with the Chinese, they really do know Sun Tzu, and they will delay much longer than you think, and then surprise you.”

David: I don’t often consider Henry Kissinger’s company to be really complementary. But you might recall that last week we commented on Taiwan and China, and that’s the point of conflict. It’s not really the US and China that you need to be worried about, but it’s Taiwan and China. Bloomberg reports that you’ve got the former Secretary of State, Henry Kissinger, who believes that military conflict between China and Taiwan is likely. It’s likely if tensions continue on the current course. So cue, if you will, Dr. Strange Love’s voice, “but on the current trajectory of relations, I think some military conflict is probable.”

Kevin: That’s not a bad imitation. But the thing is, what is our policy if there is a conflict between China and Taiwan? Biden has already said, “Oh yeah, we will be there.” But my friend that I had lunch with last week, he just looked at me with a smile and he goes, “That’s not our policy.”

David: Our official policy is that we’re hands off as it relates to China. Now what we’ve said is that we’ve got a red line. Obama had red lines, Biden’s had other red lines. Yeah, I mean there’s a whole bunch of awkward situations from a geopolitical standpoint that we’ve faced over the last 15 years where we said, “This and no further.” And then our enemies are like, “Okay, we’ll test you on that.” They test, we don’t respond, and it has proven to the world that we’re a bit of a paper tiger.

Kevin: Well, and oftentimes those red lines really have nothing to do with why we would actually do something in the first place. Oftentimes these incursions that you have between nations have to do with something completely different, like a distraction from other problems.

David: Yeah, I doubt very seriously that if we were to be involved in conflict with China over Taiwan that it would have anything to do with morality or with ethics or with some sort of statement of justice—international justice, international law. You can certainly cut and paste some of those things into the narrative, but there is more to the story. If you’re looking at other Chinese news, and if you want to support a probable conflict between China and Taiwan, which may have more to do with scapegoating and distraction—distraction of the masses—rather than the possible, the suggested deliberate de-escalation via dialogue. You’ve got youth unemployment. Another month goes by, we were at 20.4 last month, we’re at 20.8 this month. It’s getting worse, not better.

Kevin: That’s in China?

David: That’s in China. The labor disputes there are increasing, according to Reuters, now at a seven-year high. Again, there’s implications to slowing global economy. A weak global demand dynamic forces exporters in China to cut workers’ pay and to shut down plants. That’s exactly what’s happening. The global economy is truly not doing well, and the manufacturer to the world is, by extension, not doing well. Under increasing pressure. So, you’ve got working Chinese which are facing more angst. You’ve got youth unemployment, which is running at four times the overall jobless rate in China. Again, that says demand for finished goods is being constrained by a global consumer that has had to shift focus to necessities—food, rent, energy—as prices of stuff has gone up. They can’t buy as much from China. 

So, there is an income deficiency in China, and when there is a broad-based repricing of assets, and we’ve already begun to see this in Chinese real estate, but just imagine that happening in other areas—a significant depression in value within Chinese equities, bonds—not just within the real estate sector where there’s already been a massive devaluation. In that case, we find the number-two economy in what is known as a balance sheet recession.

Kevin: So what about the number one economy? We’re just barely number one on the economy, but when I talk to clients and say the numbers are saying recession probably this fall, I’ve had a few clients say, “What are you talking about? We’re in a recession right now.”

David: Yeah, we’re not far behind the Chinese on a road to balance sheet recession. A part of that is our economy is geared towards growth if and only if we have an increase in credit. Households have certainly been more cautious there. We’ve seen corporations increase their debt. We’ve seen the government increase its debt. So, if you’re looking at the big picture, certainly we still have some economic growth, and it’s being driven by those two larger parties: corporates and government. But households have been de-leveraging. 

This is very similar, the Japanese were afflicted by this balance sheet recession in the nineties, and I think we’re coming close to having the number one economy, and now the number two economy of China, to be there in full force over the next few years. Richard Koo, who’s the chief economist at Nomura Securities, has written a couple of books. One back in 2003, I think his second one on balance sheet recessions was 2014. He’s the Chief Economist at Nomura Securities. I think he’s done the best work on this idea of a balance sheet recession. 

It’s a combination of things. As asset values go higher, it’s kind of natural— Or maybe asset prices are going higher on a natural basis or they’re going higher on an artificial basis, with QE stimulating asset inflation. Your stakeholders, your decision makers become more comfortable taking on debt. But if there’s ever an episode where asset values drop, we go back to Richard Russell’s comment years ago: asset values fluctuate, but debt’s permanent. 

Your debt relative to equity becomes an unbearable burden, or a burden that saps all other energy. The incentives shift to then paying off debt versus accumulating more of it. You’re required to, or you’re talking about bankruptcy. 

So, the balance sheet recession really centers on this notion of de-levering of the balance sheet. When you get into the mindset of either corporate board execs or households—that it’s time to pay off debt—that’s not new economic activity. When de-levering of the balance sheet occurs, it’s not helping growth statistics. All it is is a catch-up game. You’re finally paying for what was already spent. You’re finally paying for what you already enjoyed and tallied up in the past.

Kevin: Well, and that’s many, many trillions in China. I mean, what is their debt right now?

David: Non-financial sector debt, 49.9 trillion.

Kevin: Wow.

David: Call it $50 trillion. It’s three times what it was 10 years ago. The Bank of International Settlements is particularly critical on this point, that you’ve had this massive expansion of debt, and it’s to build apartments, it’s to build bridges, it’s other infrastructure. Of course, households have been along for the ride too, but that’s a lot of debt to carry. Now you’ve got many in China, particularly households, who want to pay their share off. But again, we come back to this notion that modern economics is driven by debt expansion. So, if you have the opposite, if you have contraction, that hits economic growth severely, thus you get the balance sheet recession. If China is indeed moving, at least the private sector level, if they’re moving to pay back what they owe, we’re talking about a balance sheet recession. We’re also talking about a set of circumstances which temps Xi Jinping to stimulate growth artificially via monetary and fiscal policy tools. 

So, now you’re talking about variables which can jeopardize the RMB’s stability, currency stability, increase inflationary pressures, which has its own nasty feedback loop into social and political dynamics within China, and reinforces this tendency to find someone or some place to redirect animus. I’m not suggesting there’s a direct connection between a balance sheet recession and Chinese aggression, except there kind of is. Because when you begin to see this economic malaise, workers are hitting the streets in protest, and smart graduating students can’t find a job, that angst is going to get expressed somewhere. If the government doesn’t redirect, refocus, it becomes the next revolution. This is not the kind of revolution the communists want. It may be more like a Tiananmen revolution rather than a Maoist revolution. 

So, Goldman Sachs here recently concluded that you’ve got the Chinese property sector. Best-case scenario, property sector is going to have an L-shaped recovery. I can’t help but think when I read this, I’ve got teenage kids and they hold this L shape up to their forehead and, “Loser.” That’s what we’re talking about, is an L-shaped recovery. It’s an admission that there is no light at the end of the tunnel in the short run. If other GDP contributors also go dark, then Kissinger’s suggestion of conflict becomes even more probable. State-sponsored violence is more probable than de-escalation and dialogue if these economic variables are spinning out of control. 

Everything’s possible, and I think certainly we could be having healthy, constructive dialogue as long as you’ve got people who are happy and an economy that’s growing, but you’re dealing with these threads in the fabric that are already frayed. If things unravel from here, it remains to be seen. But you can see how they very easily would. So, I’m concerned that Kissinger’s suggestion, it gets fed a whole lot of fuel as these other GDP contributors capitulate.

Kevin: So, like we started, I’ve seen this story before. It may not look exactly the same. History repeats itself to a degree, but it certainly does rhyme with itself. Through the years, Rogoff and Reinhart wrote about this where they said this time is different, but through the years we see default over and over and over. In other words, somebody makes a promise to pay something back, and it never really does get paid back. But we live in an age, for the first time in world history, where the whole world can print money. It’s fiat currency, it’s a fiat world. So the question would be, on whose back does the default fall? I would say, Dave, that we’re looking at default by devaluation. You talk about maybe we’re going to have military types of things happening worldwide, but they all cost money, and where does the money come from when you don’t have it? It’s default by devaluation.

David: I read a really fascinating paper over the weekend in between conversations with the family, about military spending, and how we’re at one of the lowest levels of military spending relative to GDP in the last 50, 70 years. The increases that we’ve seen in military spending have been primarily to payroll and not to arms fabrication, and that we are on the cusp of this new era of military spending. This time, it’s hardware, right? Military-industrial complex is going to love this, right? But in the backdrop of politics, in the backdrop of international relations, is the confidence game. It’s a confidence game held together— it’s perpetuated by central bankers. So, let’s go back to the UK, just as we wrap up, because Bloomberg reports that 21% of those polled in the UK are satisfied with the Bank of England’s policy course. All right, 21%.

Kevin: Not many.

David: Not many. So the other side, some percentage of those absolutely hate it. Some people don’t even know what the Bank of England’s policy course is, but you’ve got a slim minority of people who think that what they’re doing makes sense. So, currencies, bond markets, equity markets, these are all indicators of confidence. Think about that. Currencies, bond markets, equity markets are all indicators of confidence.

Kevin: Right, but currencies collapse when confidence goes away.

David: Well, and currencies are often at the vanguard of a collapse in confidence, with then the fixed income and equity markets falling like so many dominoes thereafter. After 114% inflation in Argentina this year, you can expect to see increased pressure in the bond market. Yes, you could look at the Argentinian stock market and say, “Yes, but it’s one of the best-performing stock markets in the world today.” Just you wait. Just you wait. There’s the next domino to fall. Currency, fixed income, equity markets, falling like dominoes. Now, consider the RMB, consider the yen, consider the dollar, consider the euro. 

These are things that are really important to watch over the next 12 to 18 months. We talked about the yen earlier, very critical to watch. The RMB, we may well see a run on the RMB. Lest we forget, these are fiats, these are fiats, and they trade in relative weakness to each other. We like to think of relative strength, one trading up versus the other. I think it’s better to describe fiats in the way they trade next to each other, trading in relative weakness. If you want a clear view to a collapse in confidence, certainly you can begin to see these dominoes falling. Currency markets, fixed income markets, equity markets. But if you want a clear view to a collapse outside of all of those currencies, not trying to pick a winner versus a loser, watch the price of gold. That, more than anything, will tell you when the music has stopped.

Kevin: You’ve been listening to the McAlvany Weekly Commentary. I’m Kevin Orrick, along with David McAlvany. You can find us at mcalvany.com, and you can call us at (800) 525-9556.

This has been the McAlvany Weekly Commentary. The views expressed should not be considered to be a solicitation or a recommendation for your investment portfolio. You should consult a professional financial advisor to assess your suitability for risk and investment. Join us again next week for a new edition of the McAlvany Weekly Commentary.

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