About this week’s show:
- Bernanke to Yellen:”Good night and good luck”
- Emerging Market Chaos
- Currency Crises: Replay 2008?
The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
Kevin: David, I’m very uncomfortable right now with my bank asking me what I’m going to use my money for when I start taking money out. This has been the news this week with HSBC, but it’s an attitude, isn’t it?
David: If we don’t already have an Orwellian context, you have suspicious activity reports, regularly being filed by banks, on the basis of subjective appraisals of client behavior. What might be suspicious? Well, it’s interesting, HSBC gives us, I think, an insight this week. Suspicious behavior, from a banker’s perspective, is wanting your money back!
Kevin: It’s amazing. “I think I’ll take a little bit of cash out, please, which is, I think, why I had the money in there in the first place.”
David: “So what are you going to use it for?”
Kevin: Well, that’s the question that they are asking.
David: “Well, that’s not a good enough reason. We’ll give you less, but not what you requested.”
Kevin: If you get on the internet, you can read story after story of HSBC customers now coming out and saying, “You know, I couldn’t get $9,000 out because the reason wasn’t good enough.”
David: Or $7,000, or $5,000, or $4,000, or $3,000. I mean, quite frankly, if a bank will not give you your money, when you request it, no reason given, I suggest that you take all of your money out. Why? Because if they are so reticent, it’s almost like removing the scales from someone’s eyes. “Wait a minute, you mean, you’d actually have a hard time giving me such a small amount of money? How well capitalized are you?”
I think it goes a long way toward showing just how frail the banking system is. What has changed in recent decades is the nature of being a depositor. A depositor used to reasonably expect a return on capital, for the use of that capital by the bank, for the purpose of lending into the community.
Kevin: Well, give me a break, talk about return, we all have gotten our end-of-year statements and it’s like, why even put it on your taxes? I don’t care how much money you’ve got on there, it’s like, okay, so I made a buck?
David: But with a bank you should never be asking the question, not return on, but return of. If they won’t return of, in other words, they won’t give it back, again, there’s a different dynamic afoot.
Your money center banks now derive far more profit from trading stocks and bonds than they do from lending to corporations and individuals. We know that’s been shrinking, and that is reflected in your velocity numbers, where, basically, the liquidity created by the Fed and various world central banks is not getting into the broader economy. But as a depositor, you, now, this is the changed relationship, no longer lending into the community and capturing some percentage of that for your own benefit, but as a depositor you are nothing more than an unsecured lender to the institution.
Kevin: That’s what I’m talking about, attitude, Dave. Last February we started hearing about this new concept. It was a new word called “bail-in,” and if you were in Cyprus and you had deposits over 100,000 euro, you were expected to pay your dues back to the debt of the country. I saw something yesterday, Dave, on Japanese banks are now saying, “Why don’t we tap into inactive accounts that haven’t been touched in ten years and start paying back some of the debt that we have in this country?”
David: Absconding with, what is it, 100 billion dollars? It is no small sum. Granted, it’s not big enough to make a difference in terms of their fiscal picture, that’s a disaster, and it is on a scale that, again, you are talking about a spitball in comparison. But when you go to that concept of being an unsecured lender, when you are a secured lender, you are first in line, you have a protected interest, and you’re not paid as much. But as an unsecured lender, you should be compensated handsomely. Is that the case today?
Kevin: Well, we’re making just fractions of a percent, so let me ask you, Dave. Why do I put money in the bank? It’s a habit, I know, I’ve done it since I was a kid. When I get paid, I put money in the bank, and then I go spend it, but why does anybody keep money in the bank?
David: I think that is really the basis on which we operate most of the time, is autopilot, on the basis of behavior which has become ingrained. The bi-weekly check goes in, you withdraw money, and you assume that you are receiving something in interest along the way. They help facilitate the transaction process, maybe you’ve got auto bill pay and they facilitate that. Is it the interest that keeps you coming back?
Kevin: It’s not the interest, but you had mentioned something. Some of it is the convenience, Dave, the auto bill pay, that type of thing. So I guess the question is not why do I keep money in the bank, but why would I keep anything significant in the bank?
David: Right. In any case, I have to say, there is very little value added, and now there is a growing concern over the attitude in the banking community, which confuses whose assets are whose? There is an implicit expectation that your investment, or your consumption decisions, should be known, and should be traceable. And I’m sure the NSA loves this, but bankers, under the guise of “know your customer,” are being trained to create an expectation of disclosure. And then, run it through the sort of Big Brother suspicious activity reporting grid if something doesn’t seem right.
Kevin: And I think we should bring up that reporting over $10,000 coming in or out of the bank in cash has been the norm since 1986. The banking secrecy laws that came out at that time, form number 8300 had to be filled out any time someone took $10,000 out, but now it’s more on a discretionary basis. That’s what HSBC had a policy of, really, until a couple of days ago.
David: Kevin, that is specifically cash transactions. And I think this gets to the issue. Cash is suspect for the same reasons, ultimately, that precious metals are suspect, by the larger establishment. There is privacy and anonymity in transactions. They are outside the view and outside the control of regulators.
Kevin: Right. It doesn’t mean it’s illegal, what you are doing, but they want to see everything that you are doing.
David: It’s really presumption at the highest levels of government, and that has set the standard. We now have snooping and government-to-citizen espionage. That’s just ridiculous, but the only thing more insulting and angering than our government spying on us directly, is the creation of a culture where we spy on each other, and consider it a duty.
Kevin: Dave, it’s sad. We clearly have not been taught, at least the last few generations, about the communist bloc, and the schools just don’t bring out what privacy was, and why it was important constitutionally.
David: If we could dust off the recent Eastern European history books and compare regulatory over-reach, which we have today, corporate policy is reflective of the same from the perspective, I think we would see that, again, the snooping and knowing of everything, the documenting of everything that everyone does, you can assume the best about your leadership, and we do, but we do have the historical record that says that politicians, themselves, change over time, because power corrupts, and absolute power corrupts absolutely. That’s from the seven-volume book on the History of Liberty, by Lord Acton. That notion is well-established in the historical record. But it’s not just an individual being corrupted. It’s also that you can go from one person in power to another person, who may not have the same respect for individual autonomy and sovereignty.
Kevin: Also, I’ve talked to younger generation people for whom it’s just normal to be on Facebook and sharing just about everything in your life. It’s strange, Dave, but this seems not to bother the younger generation like it does us, because they have really somewhat given up their autonomy.
David: It’s interesting, because it is very easy to communicate with friends and family, and if you were doing that in a private world, that would be normal, and we would love the technological innovation which enabled that direct communication. But the notion that it is not just direct, it is direct, and it is also to the cloud, it’s also to infinity. In every area of life we are careening toward statism and the elimination of individual autonomy. You would expect this in an era of group think and social compliance, and that is really what we have built into our education system today. I find it very disturbing.
But again, the inability to think for yourself, the notion of social compliance, I remember sitting on a plane with a gentleman and he was very angry, it was two minutes after the door had closed on the plane and I was still turning off my phone, and he knew how dangerous this was to the avionic systems of the airplane, and I just looked at him and I said, “I’m almost done, it’s not that big of a deal.” And he said, “You have no idea what kind of irresponsible behavior you’re presenting to your children!” My son was sitting right next to me, and I just leaned over to my son and I said, “Son, this is an example of someone who has been well-trained to be compliant with every rule, and someday we will find that these rules are completely irrelevant, and don’t affect the avionics of the plane, but he is a good trained monkey.”
Granted, I wasn’t all that respectful, but I felt like I was being attacked for no good reason, and I was moving toward compliance anyway. Now, as we know, you can have your phone, not in communication mode, but you can have your wireless on, you can check your emails, you can check your stock quotes. Why? Because, actually, it’s social control, and again, this notion of individual autonomy. You just need to find your role in social compliance. That’s the expected mode today.
Kevin: And they are resetting what is normal. We talk about during quiet times and when you are not in a crisis that’s really not that big a deal. But in a crisis, Dave, they’ll put on Draconian controls.
I want to go back to the banks, because I asked you the question, why would be put money in the bank? Even going back to the movie, It’s a Wonderful Life, we realize that the banking system, itself, is just a gigantic façade, with very little core value.
David: If you remember the Jimmie Stewart comments, he said, “You know, Sally, your money’s not here. It’s in Joe’s house. And Tom, your money is not here at the bank. You want it, but I don’t have it. I lent it to Sally.” What is amazing to me and I think you need to never, ever forget this, your local bank, if it is a small institution, they keep less than $50,000-75,000 dollars in house.
Kevin: Well, Dave, I know we can’t name names, but don’t you have personal experience with this, with a withdrawal, over the last few years?
David: Oh, sure. Yes, in the summer of 2008 I requested a certain sum of money and they said, “Well, listen, that would put us in an awkward position.”
Kevin: It wasn’t a lot of money.
David: No, it wasn’t, but nevertheless, they said, “Could we split that up over two weeks, because we’d have to make a special order to have more money on the floor?” That’s a small institution. What about the larger institutions? You could pick your national franchise, but at any of your branches of a national franchise bank, you can have less than $200,000 on the floor. Your money is not there. And I think, when you look at this HSBC policy, they’re not alone in this. Not only is the money not there, it’s not yours.
David: Provide the reasons you need it, what you are going to spend it on, and then consideration will be given to releasing funds.
Kevin: It sounds ludicrous, but it’s the new norm.
David: My suggestion: Keep three months expenses on deposit, eliminate all other bank exposure. You are living in an era where you need to ask this question: Is it prudent to be an unsecured creditor? Is it prudent to be an unsecured lender? And I suppose if you were being compensated adequately for it you might have one response. But if you are not being compensated as an unsecured lender, then look at your bank relationships in a slightly different light. Or I guess you could keep faith in the solvency and wherewithal of the FDIC. But frankly, when you do that, you’re just putting lipstick on the pig.
Kevin: Speaking of lipstick on the pig, the Federal Reserve is going to either raise or lower quantitative easing, but that’s going to be dependent on a growing economy. They’re going to look at the economic numbers, and these numbers have been disappointing, Dave.
David: Well, you have durable goods numbers, which were disappointing this week, and that’s being largely ignored, with media attention going to positive earnings from Caterpillar, Honeywell, and a few others, and boy, the market does not like lower expectations in the future. Very few exceptions. Share buy-back schemes, which we’ve talked about, they continue to perpetuate the myth of a booming global economy and improved earnings, present and future.
Kevin: Let me interject, Dave, because not everyone, maybe, has heard the last couple of shows. When you are talking about share buy-backs, what you are talking about is reducing the amount of shares outstanding, and that increases the earnings per share. It’s not illegal, but it is a way of making things look better than they are.
David: Right, and you would hope that a company is looking ahead and saying, “We’ve earned this capital. We’ve risked capital in the marketplace. We’ve grown our business. Here are the revenues. Now we want to grow the business. Here is how we’re going to do that. We’re going to buy out a competitor. We’re going to improve and increase our research and development. We’re going to come up with a new product. When they go to buying back their own shares, it’s because there is nothing else better to do with the money, which again, is something of an indicator of what the opportunities are from an economic standpoint. The opportunities, or lack thereof, and the fact is, if you are not going to be able to grow your company organically, you might as well continue to receive your bonus, as an executive, by seeing your numbers continue to improve, even if the economic backdrop doesn’t foster growth in the underlying business. It’s not organic growth, that’s what I’m saying.
Kevin: And these are big numbers. Honeywell, 5 billion. Caterpillar, 10 billion.
David: And Honeywell, they announced that in December. They’re in the midst of a 5 billion dollar share buy-back. Caterpillar just released plans for a new 10 billion dollar share repurchase. They have positive numbers, they have great revenues, I appreciate all of that. But understand that there are some issues along the way which have to be taken into account. Now, in terms of future expectations, you have Apple. Apple dropped 8% in the aftermarket this week, suggesting that the next quarter will come in close to 10% below expectations. You had the iPhone sales which didn’t meet expectations, even though they were record numbers. And you have new contracts which have been signed and products being distributed to China. That sort of thing, conditioning, is critical. The market conditioning of expectations is a key form of manipulation used by corporate executives, with the support of the media, to keep Joe and Suzie Lunchbox coming back to the market.
Kevin: Dave, I know you are interviewed often, 2-3 times a week on national financial TV, but CNBC is a dying breed, it’s just falling off the cliff at this point as far as viewership.
David: Yes, and I guess this gets to just how sensitive the markets are. For the numbers to come in better, revenues to have increased, for Apple, and yet the stock sales are off 8%. Investors are conditioned to believe that tomorrow is going to be better on every front. And if it’s not better, as a multiple of growth from the previous quarter, the previous year, etc., etc., “Oh, well, our expectations have been disappointed, they’ve been dashed.” You mentioned CNBC. It is dying, and this really runs contrary to past periods of prosperity, where viewership was increasing alongside economic growth, and the stock market’s gains were growing in lockstep with the thriving economy.
Kevin: So you’re saying it’s different this time.
David: Well, we conclude it is a little bit different this time. Viewership is off because the average citizen is not better off. The economy is not improved. We have asset prices which have improved. The middle class, they are in a different position altogether. They need an income boost. So even with asset price appreciation, you still have the balance sheet of the average American floundering. We have 8 million homes that remain under water. We have a million of those in California, a million in Florida. You have the foreclosure pipeline which has shrunk with home values rebounding. So, yes, granted, this is an improvement. We don’t have millions and millions of homes in the foreclosure pipeline. Now there are only 1.2 million homes in the foreclosure pipeline. Last year, and this is remarkable, 336,000 homes were bought by Colony Capital and Blackstone, off of bank balance sheets, out of the REO pipeline. That reduces overhang. That’s positive.
Kevin: Yes, but that’s not the general person coming back in and buying. This is like a large hedge fund coming in and buying those properties.
David: Exactly. It doesn’t signal a return of lending. It doesn’t signal the middle class gaining confidence. Those homes represent, actually 336,000 homes taken out of receivership, if you will, they represent the crushed hopes and dreams of hundreds of thousands of one-time homeowners, now renters.
Kevin: And we’re looking at an economy that has been on life support. We call it quantitative easing. So it was 85 billion, now it’s 75 billion. The Fed is meeting this week to determine whether they are going to go up or down, but the thing is, we are still in need of this life support. So when you look at the fact that the economy is not growing, Dave, let’s talk about the Fed. We have Yellen coming in. She’s replacing Ben Bernanke. What are we going to see?
David: Of course, anything can happen, but I think the chances of further reduction of QE are unlikely. You look at the last week to ten days of behavior in the emerging markets, you look at the stock market here in the United States having 3-4 off days, and it sets the market on edge. Now, the question is will Yellen be sensitive to the markets being on edge, and basically say, “Hey, we took 10 billion off out of quantitative easing in the last meeting, and we will probably do the same thing at some meeting in the future, and we are still looking for confirming evidence that the economy is improving. “ If they don’t take another 10 off the table, move it from 75 to 65, you will see a nice rebound in the stock market, knowing that the Fed still has the back of asset prices, and of the stock market, specifically. If they do take another 10, or more, off the table, as has been encouraged by Dallas Fed president, Mr. Fisher, and others, who are a little bit more inflation hawks, if you will, concerned that the liquidity created could create future problems far greater than any that they have been addressing in the past through quantitative easing.
Kevin: It has been so strange living in this era of quantitative easing, Dave, because actually, when bad news comes out about the economy, it is seen as good news by the stock market, because it’s like, “Oh good, it’s still bad, so they are still going to put money in.”
David: Still putting in that artificial lifeline.
Kevin: You don’t talk often on this show about technical chart types of things, but the S&P 500 has been interesting, and you have mentioned that to us, and I think it would be worth looking at.
David: Sure. So if you assume that the Fed remains highly accommodative, buying assets, billions each month, and they keep rates very low, a couple of things: One, I mentioned if they do not take away another 10. They met yesterday, they met today, this is the issue. The S&P broke down out of what is called an ascending wedge pattern, and it should rally back over the next several weeks. If it does, you may be developing the right side of a head and shoulders, top. We already have two-thirds of the pattern in place. If the last segment is completed over the next 10 days of trading, the subsequent breakdown targets $1700, potentially lower, and our longstanding concern is not that we revisit $1700 on the S&P. That would be, frankly, a very shallow correction off of the recent peak numbers. Ordinarily, you would see a 20-30% correction, given the amount of gain that we saw in 2013. Of course, no one in the financial media wants to embrace that idea, but frankly, it’s more normal than you think. 10% corrections happen all the time. 20-30% corrections are not out of the normal.
Kevin: The thing is, in this particular case, there is so much margin owning those shares. There is so much debt owning the shares, so if you have a 10% correction, plus, there is a point where people have to liquidate their shares.
David: That’s our longstanding concern. A normal correction of 10% could be exaggerated, exacerbated by, a deluge of margin account liquidations. What do I mean? When investors borrow from the bank to buy stocks, the clock is ticking. And that investor needs to be proven right quickly. After all, you are paying interest for the privilege of using someone else’s money to speculate with. When you begin to lose someone else’s money, you can either receive calls from the lender to add money to the account, or you have to sell assets and repay the loan in full.
Kevin: That’s called a margin call.
David: Yes. And so, December’s numbers for margin, that is, money borrowed to go speculate with, they edged up 5%. Now, think about this. When you are talking about an already record number, to move that needle 5% is a big deal. We went from 423.7 billion to 444.9 billion in margin debt.
Kevin: That’s an all-time high then.
David: Yes, it is. And this is a lot of potential liquidation. And for past perspective, we’ve never seen record margin loans, without subsequently seeing an unwind of those purchases, and we are talking about 444 billion dollars in liquidations.
Kevin: Almost half a trillion dollars in liquidations.
David: So previous peaks in margin debt were in the year preceding a catastrophic decline, so we had margin debt numbers peak in 2007, followed by major problems in the market 2008. We had margin debt numbers peak in 2000, with major problems in the stock market in 2001. We had major margin debt peak, actually the early part of 1987, and that fall, not a different calendar year, we began to see an unwind, 20% in one day. So the same thing in 1973. Now, I mentioned this on Fox Business this week with Jerry Willis. You don’t want to be caught in that avalanche. It’s not a market timing device, but it is another one of those very important canaries in the coal mine.
Kevin: Yes, and we talked about canaries last week. You have to watch certain indicators. You know, you have to look outside of the borders. Talk about a story. This last 3 days in the emerging markets, my gosh, everybody is starting to say, “What’s an emerging market?” Even people who don’t follow it any more.
David: Our last discussion with Russell Napier, November 13th, covered in detail the high probability of emerging market chaos in the near future. At issue were the growing quantities of loans taken on by a variety of countries, that would be coming due. But, they are denominated in another currency. They are foreign-denominated bonds.
Kevin: And I think that’s important to point out. We, as Americans, can borrow in our own currency. When it goes up or down, we are really just either printing or paying it back in our own currency. But gosh, Dave, if you are in another country, and there is a currency move, it can cut their throat.
David: What we have seen, looking at various charts on emerging markets, it was in November that the emerging market indexes began to move lower in earnest. There was an initial move lower May and June of last year. It recovered through the fall, and then it started tipping over in November. Select countries had reached a tipping point even earlier in the year, but with the index for emerging markets coming under pressure severely in November.
Kevin: One of the arguments on those indexes dropping, though, Dave, is that the Fed has begun tapering this quantitative easing, and the impact that that not only has on us, but has on these emerging markets. Why don’t you name a few of the emerging markets so people know what we’re talking about?
David: We’re talking about South Africa, we’re talking about Brazil. We’re talking about China. We’re talking about Turkey. We’re talking about Argentina.
Kevin: The South American countries.
David: Yes, on multiple continents, this is not a continent-specific issue, it’s not even a country-specific issue, but there are a couple of elements here. The argument has been that the Fed is going to reduce asset purchases, known as quantitative easing. They floated that idea in the spring of 2013. That started the pressure in the emerging markets. And indeed, emerging market currencies and bonds were the first to be negatively impacted. Then you had emerging market equities, which followed, and have continued to deteriorate since this last fall.
Kevin: Well, it’s not just the Fed. The Bank of Japan also has been easing. We saw the downturn in their own currency.
David: For us, and this is not axiomatic in the financial media, but it goes without saying for us, that Fed and Bank of Japan liquidity provisions have magnified risk. Lower rates and ample money have promoted speculation, and it also changes the way people view risk. Not only have insurance companies and pensions had to take on more risk to meet income expectations, but you have also had households doing the same thing, increasing risk and buying every manner of bond on the planet, with a higher yield. The world is income-starved, it’s not just here in the United States. But that is a course that the Fed has served up on a silver platter, not last year, not 2012, this goes back five years now, with interest rates held at an unnaturally low level.
Kevin: And it has forced people who would never take risk in the stock market, or very little risk in the stock market, to throw everything in either the stock market, or an emerging market, or something that can take that money away very quickly, versus a very consistent bond paying a reasonable interest rate.
David: I saw in Bloomberg this last week that the average yield on a ten-year government bond, if you combine all of the developed world countries, is 0.63. That is less than 1%, 0.63. That is a ten-year piece of paper. So they just averaged it all in, and of course, you have Japan, and you have the euro, and you have us here in the United States, and they are basically saying, “If that’s the case, if you can’t get any money in bonds, why not get 3% in equities? I can choose a blue chip, I can increase my income component dramatically, but what you have just done is increase your risk profile considerably. If you think of the insolvency sequence, a company goes into insolvency, a country for that matter, the bond-holder, the secured creditor, is paid first. The stock-holder is at the very end of the line. You may get nothing. Once the company, or whatever, is liquidated, guess what? You get the scraps, if anything. But you are willing, for sake of income, to completely reappraise what is normal risk to you, and do that without reflecting on just how impactful the Fed and Bank of Japan liquidity provisions have been. Yes, they have magnified risk-taking, and they have also covered over the implicit risk in the investment markets by depressing yields.
Kevin: Speaking of depressing yields.
David: They are depressing.
Kevin: Let’s put that 0.63 into perspective. It used to be if you had a million dollars, that was a pretty good retirement nest egg. But what we are talking about is $6300 a year. Can you live on $6300 a year at 0.63 on a ten-year treasury?
David: It was a Financial Times article, just to correct. If anyone is looking for it, it was a Financial Times article, not a Bloomberg article, from the weekend.
Kevin: So Dave, being a millionaire at this point, you have to go into the stock market to earn more than that $6300. You can’t pay bills on that. That’s below poverty wage.
David: You’re better off being a millionaire, and moving to Hawaii and putting yourself on welfare. You’re going to receive more in welfare checks than you would a millionaire receiving income on your deposits.
Kevin: And this is what is causing the speculation. People are saying, “Look, I’m backed against the wall, I have to put this into something that I may lose.
David: This is the destruction of the rentier, as Keynes described it. It is a process by which the socioeconomic class which has assets and which generates an income from them, you can call that the rent, if you will, they are pressured to speculate, or spend those assets, in the absence of sufficient income. Keynes and other economists have looked at savings as a problem for the economy. In their mind, it’s less grease in the gears. And so then you have this financial repression implemented by Ben Bernanke, zero interest rates have been with us for five years, he is handing that baton on to Yellen at this point. It is a part of this economic legacy, inherited from Keynes, of driving money into the market by disincentivizing savings with rates that punish behavior. Saving and investing, do you think that’s normal behavior? Do you think that’s healthy? I do, you do. But the central bank would say, “No, your money should be in the economy and we need you to spend it, not save it.”
Kevin: And aren’t we being re-taught that there really is no risk and what you are talking about these risk investments because they Fed have already told us, “Look, if it’s too big to fail, we are going to just come on in and bail it out. They have programmed a response that, unfortunately, cannot continue or be sustained.
David: And the problem is, they continue to intervene in the markets at higher and higher levels. Which means that ultimately, when a large bailout is needed, you wonder how much ammunition they have left for a real financial firefight. You have the Fed asset purchases, yes, they’ve increased the speculative elements in the market, that’s what we have been talking about. Now they are pulling back. They took away 10 billion out of the 85, that leaves them 75 billion in asset purchases each month, and that does alter the risk landscape. Even the suggestion of it last May and June began to alter the risk landscape. We’ve seen the foreign currency markets getting a jump on that for the last nine months.
But as many commentators point out, it’s the equity investor that gets it last. The foreign currency investor, the bond investor, they are, to a degree, smarter than the equity investor. They started pulling funds, when? Oh, last spring. And it’s no surprise, again, that the foreign currency markets have been anticipating this, and it’s just now moving to the forefront of the equity investor’s mind, the equity market rout in the emerging markets. Let’s look at this in theory and then let’s consider a couple of countries working through the proverbial meat-grinder. The currency crisis, that stirs credit crisis. What I mean by that: If we can linger on this point, it’s a very important one. When you have countries that borrow from other countries, and do so in the lender’s currency, let’s say Argentines borrowing in dollars and not pesos.
Kevin: Right. Like we were talking about before, they’re at our mercy, to a degree, when they borrow that way.
David: Any devaluation of the borrower’s currency raises the probability of default by making it more difficult, more costly to pay back the debt.
Kevin: So what you are saying is, let’s say Argentinean dollars, let’s just do 100 and 100 to start with to make it easy, don’t use the currency changes. Let’s just put this on an even playing field and see how this works, Dave. Argentinean pesos borrowed for dollars. Let’s say it’s 100 and 100. They’re not equal, but let’s say they are. And then the Argentinean peso devalues. Now, to pay back that same amount of dollars they have to come up with more Argentinean pesos.
David: Right. And the problem is, they learn their livelihoods, not in dollars, but in pesos, so you have to have more economic output, you have to have more income, just to pay back the old debt. The hurdle, if you will, to be able to pay it back, is that much harder. Now, we’ve had a 35% devaluation in the Argentinean peso in the last 12 months. 15% of that came in the last week!
Kevin: Which means their debt is going to cost that much more to pay back.
David: Right. And this may seem like an insignificant issue, but liquidity from the Fed, along with record low rates, have spurred an unprecedented dollar-denominated debt binge.
Kevin: Well, why wouldn’t you? If the currencies didn’t move, why wouldn’t you come into the United States and borrow dollars?
David: Rates are cheap. And if you look at it from just the level of interest rates, not necessarily foreign exchange, you tell me. Would you like to borrow in Argentina for 8%? Or would you like to borrow at 10%, 11%? Would you like to borrow in the U.S. markets at virtually nothing.
Kevin: But, it’s not just in the United States. This is happening also in Japan.
David: You look at anywhere there has been huge financial repression, in other words, the central bank stepping in and taking rates below a natural level, and you are going to see people taking advantage of those cheap rates. It just happens a lot with the yen, it has classically, to a smaller degree, with the euro. But central banks in the U.S., Japan, Europe, Britain, they have eased lending conditions. They have been issuing credit or loans, denominated in their own currencies, and emerging markets have been only too happy to lock in low rates, the terms have been compelling, because frankly, they’ve been unrealistically low!
Kevin: Right, they can’t do it in their own country at that rate. Now let me ask you a question.
David: And they should not be able to do it in our own country. Again, you are mispricing risk, and this is all compliments of the Fed, Bank of Japan, and what we would call central bank activism.
Kevin: Isn’t this a world version of what Germany did in Europe with the countries that are the outliers, like the Cypruses and the Greeces. They came in and got German rates, which were lower, in a country that should have been higher.
David: Right, and so what you had was a mispricing of risk, people taking too much risk, people developing things which they shouldn’t have been developing, property development in Spain, which never should have happened, except that credit was mispriced, Spanish credit was not the equivalent of German credit, but Spanish credit was being treated like German credit. Therefore, lowering of rates caused a real estate boom and a subsequent bust. Is it any wonder that five years on, we have gone from a debt crisis to a debt crisis, because the only thing we infused into the debt crisis was more debt!
Kevin: Yes, but there was somebody to bail out, the European crisis before. We were very involved in that. There is no one left to bail out except for, oh my gosh, the way we started this program, the actually private individual, because the IMF at this point has talked about, they’ve floated us twice now, that we should have a one-off 10% wealth tax, and everybody just try to pay off this unserviceable debt. Is that coming?
David: It was disturbing to see the German Central Bank, the Bundesbank, make that same suggestion this last week as it applied to all your peripheral European countries. They would say, “Hey listen, it’s not our problem, and we’re not going to bail you out, but here’s what we should do. If you’re an Italian and there is an Italian banking problem, we should look at the net worth of the average Italian and they should take some sort of a hit and that will recapitalize the banks.
Kevin: That’s that same attitude we addressed earlier.
David: It is. “It’s not your money, it’s the system’s money. You need to think corporately. You need to think about your social contribution. But listen, it’s privatized gains on the one hand, socialized losses on the other, and if you are a good socialist, as you should be, as you have been trained to be, then you just ante up. Again, we have emerging market currencies. They are reflective, right now, of 2008 and 2009 levels of dislocation and concern. Think about that. We don’t have a global financial crisis, according to the media. We don’t have a global financial crisis, or economic crisis, according to the most recent reports from the IMF and the World Bank. And yet, if you look at where the South African rand is, if you look at where the Turkish lira is, if you look at where the Argentine peso is, they are signaling something very different. They are signaling chaos, the underbelly of the market.
Now, what’s the underbelly? The underbelly is the money market. The underbelly is your cash rates. The underbelly is, again, your currency exchange, and to see a number of these currencies be upended, upended, in the last 6-9 months, with it becoming much more dramatic, coming under intense selling pressure this last week, oh boy. Last week the Turkish lira fell 4.4%, the Brazilian real 2.3, Russian ruble 2.9, South African rand 2%, Chilean peso 2, the Columbian peso 1.5, the South Korean won 1.9%, the Argentine peso, as we mentioned, 15.1% last week!
Kevin: This is how much more items are going to cost in those currencies.
David: No, no, no, no, no. In Argentina, they depreciated, they devalued by 15%, and costs rose by 20-30%.
Kevin: Which is the real inflation rate. Is it not 26% inflation rate right now in Argentina?
David: No, the official rate is 11%.
Kevin: Oh yeah, that’s what they’ll tell you.
David: But then the IMF has gotten all over the Kirchner government, saying, this isn’t realistic, you are lying to us, your statistics are fabricated, 11% doesn’t reflect the cost of goods and services the way we calculate it and we’ve tried ten different ways, it’s 26%, not 11%. So you’ve got understated inflation. You’ve got store-owners looking at a 15%, two-day devaluation, in the Argentine currency, and they’ve got inventory. They don’t want to sell it too cheap, but they don’t want it to be expensive, so literally, in a matter of two days, a washing machine goes from 21,000 pesos to 27,000 pesos. It gets marked up 20-30% in a matter of days. Why? Because the shop-owner doesn’t want to lose his shirt. Keep in mind that the exchange rate now, Argentine peso to dollar, is 8-to-1, and that’s not the blue dollar rate. The blue dollar rate is what they call the black market exchange rate.
Kevin: This is if we were really doing it on the street.
David: See, you are actually looking at a depreciation, or a devaluation, which is 60% worse than even the news media would say, because that is what you are dealing with in real-time on the street.
Kevin: This training, David. We’ve talked about training our impulses to the new norm, and we have been trained that the Federal Reserve or central banks, in general, can come in and intervene and control whatever they need to control. We have started to believe that as a society, not you and I, but I’m talking as a society, yet, look at what happened with Turkey a couple of days ago. They intervened, but it didn’t stop.
David: How well did that work for them? They spent 3 billion dollars trying to prop up the currency from collapsing further and it didn’t do a thing.
Kevin: The chart just kept falling.
David: It didn’t do a thing. Again, South Africa, you’re back to 2008 levels. Brazil is under pressure, Indonesia is under pressure. Malaysia is under pressure. Venezuela, that’s a basket case, 56% rate of inflation this year. And a lot of this ties into our China thematics. We have been fixated on China for a better part of a year, knowing that the way they went would be the way that the emerging markets go. They really are the tip of a much bigger emerging markets iceberg. And the fact that this last week the PMI numbers, the purchasing manager index numbers declined below 50. The HSBC PMI dropped to 49.6, the expectation was actually for a positive move, that’s a further confirmation that you have weakness in China.
Ergo, weakness in China, less demand for copper from Chile, less demand for iron ore from Brazil, less demand for any commodity. Is it any surprise that the Australian dollar is breaking down. We talked about canaries in the coal mine for deflation last week. Is it any surprise that the Canadian dollar is down, that the Australian dollar is down? As goes China, so goes the commodities complex, and most of your emerging markets, with a few exceptions, are tied to the commodities trade, very sensitive. So we have all of these themes coming into play at the same time the Fed is saying, “By the way, we’re pulling back, not going to have as much money up there as you had hoped for.”
Kevin: And this debt is coming due at the same time, as well. Just going and looking at this, Dave. Reinhart and Rogoff wrote a book called, This Time It’s Different, and they showed century after century. What was it, eight centuries that they looked at? Countries would go into debt and then they would default on their debt. Then they would go into debt, and they would default. We’re not talking about the United States here, because we borrow in our own currency, we can print our own, but do we see an Argentinean default coming? We almost had a major default in China, but someone came in day before yesterday and snuck in a bid and basically bailed it out just in time.
David: Definitely government stepping in to bail them out. They learned from Lehman and they know that even though it is a 1.7 trillion-dollar industry, this shadow banking industry in China is more like 4.8, but about 1.7 of these financial products – trillion dollars, by the way. So, what’s 500 million in the context of 1.7 trillion? A gnat on the backside of an elephant. And yet, they did see that if they didn’t bail it out, they could have major systemic problems.
Kevin: I wonder if they wished, back in 2007, Dave, I remember when Bear Stearns came out with 400 million dollars worth of what we now call toxic debt, it didn’t sell, I wonder if they looked back and said, “You know, we should have stepped in and just gone ahead and bought that. Maybe we would have avoided a Lehman.”
David: But you ask about Argentina. It is reminiscent of the 1997 Asian prices. Argentina is trying to preserve its dwindling central bank reserve position. So what they have been doing is taking their foreign exchange reserves, and they have been intervening in the market to prop up the Argentine currency. They made the decision this last week to not spend their dwindling reserves on that effort, and that’s why you had a 15% decline in one day, because they basically backed away from the market. But keep in mind, when you have shrinking reserves, that serves as a trigger for hot money flows. Think about this. When central banks get nervous and start protecting the eggs that they have in their basket, investors get nervous, and they start protecting the eggs that they have, and they start pulling it out of that particular basket. All major speculative trades run into trouble when your carry trade currencies start to strengthen, whether it is the dollar strengthening, the yen strengthening, relative to the devaluing currencies. Does this make sense?
Kevin: It does.
David: And the money has got to go back. The loans have to be paid back, and they can’t afford the gap between the place that you’ve been speculating, that asset class, whether it’s bonds, stocks, currencies, what have you, if you start taking losses there, and you are beginning to see an appreciation in the lending currency, you’re going to get squeezed, and you’re going to get squeezed hard, because keep in mind, this is a leveraged bet. Kevin, we have more leverage in the system than we have ever had in the history of mankind.
Kevin: So, let’s have a moral to the story as we end this up, Dave. Okay, if I’m hearing you right, you are saying stay liquid in the things that are the safest, whatever that would be. Don’t put too much in the banking system, and definitely, don’t be speculating on the market, especially on margin, at this point.
David: I think you need to recognize that quality is not protective. Many people will say, “Well, listen, if there is going to be a problem with the bond market, by all means, go to a corporation that pays a decent dividend, and has a history over the last 30-40 years of increasing dividends. Let me explain a market panic. Quality is not protective. In fact, it is often the go-to for liquidity. It is not unusual to see the best quality companies initially take a far worse hit, because as people are clamoring for cash…
Kevin: There’s a bid, at least for the better companies.
David: At least they can get something, and at least they’re not taking an extreme haircut to get their money out, whereas, with a smaller company, you find that liquidity dries up, and all of a sudden, the bid-ask spread is horrendous. So, I think in this environment you are looking at emerging market weakness, you are looking at the stock market in the U.S, it has taken its first little trip up. I’d say the first loss is the best loss. Yeah, maybe we have a rally in here. As I mentioned, technically, that rally could form the right-hand shoulder of a head and shoulders top. That could take weeks, that could take months, to form. If it takes months, understand what we are putting in is one of the larger tops we will have seen in a long period of time.
What I am suggesting is that in 2014, if we continue to see the pulling back of the Fed, deterioration in emerging market dynamics, an inability to pay, potential defaults and impacts into the credit markets, as we were seeing in China, even through the last couple of weeks and days, you have the makings of a 30-40% decline in the general equities market. Are you prepared for that? Do you have enough in cash? Do you have enough in gold? I would suggest this is the time and place to batten down the hatches. If you are sitting fat and happy with large wins from the equity market, large wins from the bond market, yes, maybe this would be the one contrarian comment for the day. You probably have 6-12 months of a benefit to being in U.S. treasuries. I don’t like U.S. treasuries. I think that on a longer-term basis they are anathema, they shouldn’t be in your portfolio. But to the degree that we continue to see a meltdown in the emerging markets and that transfers over into the developed market equity space, guess what you’re going to have?
Kevin: There will be a rally in the treasuries.
David: A rotation into treasuries, and to some degree a rotation into gold, but that is the safety bid. That is the safety play. And I think, for anyone who is thinking from a macro, 3, 5, 7-year planning perspective, how to grow and protect your wealth, this is a perfect opportunity to be reanalyzing, reassessing risk in your portfolio, and getting, I think, in line for some of the best value opportunities of a lifetime. Quite frankly, I think if you move out on a timeframe of 3-5 years, the emerging markets will offer very compelling values. They are compelling values today, but one thing we know, how the pendulum swings in the market. You go from over-valuation, extreme levels of over-valuation, to extreme levels of under-valuation.
You should never buy a fair-value stock. Why? Because you don’t know which way the pendulum is swinging. You should be selling when you are extreme values of over-valuation, and you should be buying when you are at extreme levels of under-valuation. We are not there yet in the emerging markets. Even though they are a fair value relative to U.S. stocks, they should still be avoided until they reach that extreme level, and I would say the same of U.S. equities. We will have that opportunity over the next 3-5 years, and a reallocation process for gold ounces and treasuries into that kind of a position, I think will be the making of millionaires in this decade.