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The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

August 22, 2018

“This is where you have to flip things on their head. Where there is risk there is opportunity, particularly if you prepare for it. You will be rewarded if you prepare for it. Or, you could stay on. You could stay on with a steady Wall Street course, and I think you will be abused by the markets. That is the highest probable outcome. But I think that choice is yours.”

– David McAlvany

Kevin:Honestly, Dave, I would have liked to have you as a dad, only for the fact that I don’t remember my father matching any time I wanted to buy precious metals. I don’t remember him doing that, but that’s how you handle things with your household.

David:We started early getting them thinking in terms of saving in real money terms, gold or silver, and any time they are interested in taking greenbacks and converting to hard currency, happy to do that for them, and I incentivize it. Now, I have had a couple of them try to play the game where the next day they want to come right back out and instantly double their money, and we put the kibosh on that.

Kevin:But last week, right after our program – our program comes out Wednesday morning – a few hours later we had this amazing gold dump in the market. It was all short contracts, a huge amount slanted toward the shorts. We had actually talked a little bit about that, but I think that sort of caught you off guard when you got home.

David:I went home and maybe it was a dour look on my face, but I just mentioned, “Hey, the price of gold is X, Y, and Z, and silver just slipped below $14.50.” And no faster had I mentioned that than the room cleared. People went running from the room and they came back with greenbacks in hand.

Kevin:These are your kids.

David:(laughs) They were ready for the match. They knew they could maximize their dollar exchange to silver. So yes, I got fleeced last week.

Kevin:So they drained the piggyback to buy silver. I think that is just a great thing with your four kids. I don’t know if you do it with your wife, but she would be smart to think that one through.

David:Everybody’s got a cigar box and some are heavier than others, but it is fun to have those treasure chests.

Kevin:Why don’t we talk about what happened last Wednesday because over the last few years all of us who own precious metals carry some scars from purposeful manipulation in the market. I remember 2013 when Merrill Lynch and Goldman-Sachs came in and dumped 400 tons of gold on the market in two hours. Now, it took 400 tons to cause gold to go down in a couple of days a couple of hundred dollars. This time the gold dump on the shorts, which, again, we alluded to before it happened, but this gold dump on the shorts was about 2½ times what it was in 2013. Yes, we had about an $18 drop on gold, but it certainly wasn’t the effect that they had five years ago.

David:Last week when I said, “Prices be damned,” the reality is that the price that you see prints from the paper contract market. And if you go to buy a Silver Eagle, a Silver Maple Leaf, a Silver Round, a 100-ounce silver bar, or any gold products, you are going to find significantly higher premiums.

Kevin:Premiums are starting to increase.

David:The real premium, the real price that you pay for physical metals, is a higher price, a much higher price, than that spot price.

Kevin:Because it is not represented by the paper market.

David:That’s right. What you see is the difference between a paper contract and the physical market. If you want to own the real thing, you actually have to pay more for it. That, again, is what we saw precisely in the 2008-2009 period. We saw increased physical demand, even as the paper price was dropping and the premiums started to expand, that was one of our first indicators that the price was, in fact, recovering.

But back to that issue of shorts and short covering, I think this is very significant because what we implied and said specifically last week was that they have to close out their trades, their short positions, which means they have to buy back a certain number of ounces of gold to lock in their profits. This happened in 2006, 2007, 2013, and twice in 2015. And the price gains which occurred thereafter were, I think, very significant.

So back in 2006 when you had a significant short position and they covered, 12 months later the price of gold was 20% higher. In 2007, when you had a significant short position and they were forced to cover, or they chose to cover, the price of gold 12 months later was 37% higher. In 2015, 12 months later, it was 22%, almost 23% higher. And 2015, again, December of that year, not July, when you had another instance almost like the one that was earlier in the year, the price of gold moved up 12 months later by 8%.

Kevin:So on all of those occasions we had huge short contracts that were pushing the market down. Then they had to cover, like you mentioned last week, and on average, taking all those numbers that you just mentioned on average, it was up 17.8% within 12 months.

David:And that includes if you average in the 2013 anomaly where, you did, in the six months that followed, have a 10% increase, but by the 12-month mark you basically had zero change. So the one anomaly, in terms of short covering and significant increase in price for the gold market, was 2013. But if you take all of them, and as you say, if you average them all you end up with about 17% increase in the price from the point they chose to cover.

Kevin:Something you brought out last week, and I think it is important to go back to is that you have this algorithmic trading that looks at just the numbers. It doesn’t really take history into account. We were talking about context. You and I both have been to the Louvre Museum, and as we stand and look at the Mona Lisa, some people might be standing there wondering, “Gosh, is she smiling or not? Or what gives Leonardo’s technique the three-dimensional feel?” All of these things are contextual.

But if you had a computer or a robot doing the same thing the robot probably could tell you that the picture is a certain width and length and it could tell you the different color schemes, but it wouldn’t really understand the context. There is a lack of humanity, wisdom, whatever you want to call it, in just algorithmic trading. Now, context still matters, even though we live in a day and age where it doesn’t really feel like it, does it?

David:Well, that is the transition we have been in for probably 20 years – moving away from analog and moving toward digital. And there are huge benefits to being in the digital age. Think about what it is like to travel across country with your ten favorite books. Well, in the analog world that is a lot of weight and a lot of heft. In the digital world it is on an Ipad or on a Kindle, and you could have ten or you could have 10,000, it doesn’t matter.

There are some advantages. What you lose, to some degree, when you move to the digital world, is the context in which facts and data exist. You see this on Wall Street where data becomes king, but context loses relevance. We have a very strong opinion that context matters. Too often it is that the forest is lost for the trees, by both individual investors and Wall Street analysts.

For several weeks we have referenced our friend Russell Napier as a critic of the current trend in market analysis which is laid out nicely. Current market analysts do this in terms of spreadsheets and they put it into a format where it is all neat and tidy. It oftentimes neglects background issues, and that is up to and including your political and geopolitical trends, which frequently don’t have an economic driver to them. They don’t have an economic calculus.

You find in areas – when we talked to Minxin Pei, he liked to say that the difference with the Chinese is, when they make economic decisions sometimes they have a political motive which is different than what we might expect. So it’s not just about maximizing shareholder returns, it’s not just about growing private sector wealth. Politics ends up being, at times, irrational, or at least seemingly irrational. Politics is almost always dirty, and this is where the surprises are within the market.

I think there are two categories of people here, either the uninitiated or the intentionally blind. You can’t just put your head in the sand and pretend like context, geopolitical and political issues are irrelevant. But again, this is where the contextual issues are so important, and I think, frankly, where Napier hangs out a lot as a market historian.

Kevin:I’ve been going back, Dave, and reading some chess history. I’m not much of a chess player, but I do love reading about the characters who play chess. Oftentimes, I hate to say this, it leads to mental disability. The guys become obsessed with chess. You can go back and see that life becomes almost too difficult for them outside of the 64 squares and the 32 pieces. I was reading a quote from Bobby Fisher, who said, “What is chess other than a search for the truth?”

But he grew to hate the game that he actually mastered, partially because he was not able to handle life outside of the 64 squares. I wonder if these computer programs are similar to that. They are looking at the 64 squares, they are analyzing the perfect move, 20 or 30 moves out, way beyond what a human can do. But what happens when the chessboard is knocked off the table, or a fire happens and burns the chess house down?

David:I think this is what was lost to the game of chess in the move from analog to digital. The search for truth, which Bobby Fisher talked about as part and parcel to the game – it is no longer about that. It is about maximizing moves. And the most precise move is the move that you are searching, versus something that is perhaps more ethereal and philosophical in nature.

Kevin:His favorite player was a guy named Paul Morphy, considered the romantic of chess. A lot of the moves that Morphy made you can go back and analyze and say, “That was just absolutely the wrong move.” But the man was fascinating and incredible to watch because he could beat the guys who were coming up with exactly the right move. Bobby Fisher said the thing that he hates about chess – this was right before he died – he said, “The thing I hate now about chess is that it is all theoretical.” At this point it is just whoever knows the best move 15-20 moves out. And of course that can only happen with computer analysis.

David:You get that same sense, again, going back to tight analysis and a spreadsheet, about what a particular asset class will do, what its correlations are, and how you measure that in terms of standard deviations and volatility. There are lots of different ways to get toward precision, but I think oftentimes you are losing the context.

Kevin:Precision is optimistic. Precision is basically saying things are going to get better and better. Usually, when you put something into context, you’ve almost got somebody who is crying wolf or saying, “You know what? You’d better be careful.” Nobody likes to hear that.

David:And that’s Napier, frankly. The market historian is often mistaken for a Cassandra because they’re always right, but they’re never heeded. That was the curse that Cassandra was under, so, not the person who is most welcome at cocktail parties unless the world happens to be melting down, and then of course, they offer some insight as to what and why.

But look at the bond market, again, as an example – again, forest and trees. You could look at the inflows and the outflows from a particular segment of a fixed income market – that universe. And it is helpful to know what is waxing and waning in popularity, where people are going and their clues. We talked about spreads last week and how there is a political party in Italy who is demanding the control of the spreads between bonds.

So these details are important, but it is also relevant to recall the larger context that you are in. Here is the context for the bond market, at least here in the United States. The bottom in yields was put in two summers ago, which, in retrospect, marked – and this is our opinion, of course – the beginning of the long-term secular bear market in bonds. We are already in that. So, there are the arboreal interests in the daily flows and that sits in the context of a changed structural market backdrop.

Kevin:And we have talked about that being a generational shift. You and I really don’t know, in our adult lives, a rising interest rate market. We don’t remember that because it has been falling virtually all of our adult lives.

David:That’s right – the generational shift in the cost of capital. These are shifts which play out for decades, not days, and they have a broad impact on all asset classes, from equities to real estate, not just bonds in the fixed income universe. Everyone should care, and I think very few do, in large part because it is like watching paint dry. Whether you’re talking about the shift in interest rates to higher levels, or to lower levels, in either case if you wanted to try to document, in real time, a macro-evolutionary change, you’re talking about something that takes place, theoretically, over so long a period of time. And yet, you want to march with it through the daily gyrations? You’re going to miss it, or you’re just going to be bored by it – bored to tears.

Kevin:So if you’re a real estate investor who for the last 10, 20, 30 years, has made money with low interest rates, this is something that should be taken in mind at this point.

David:Not just low interest rates, but declining rates.

Kevin:Yes. There you go.

David:So for the real estate investor, you need to care. You need to proceed with greater caution as you structure deals and as you look at your purchases, because the next several decades you are likely to have a few more headwinds.

Kevin:So watch those adjustable rate mortgages.

David:Oh sure, and for the equity investor, too, we’ve had, the past several decades – well, let’s at least take this decade in particular – it has rewarded the autopilot indexer, coming in as they did at the tail end of a compression in interest rates, or in yields, and at the tail end of a multi-decade decline in rates.

Kevin:Let’s contrast that. When you say an autopilot indexer, you are actually encouraged and rewarded to not pick stocks, to not look at values, to just buy everything. They call it the everything bubble. You are rewarded by not actually using discernment. The opposite of that would be somebody who would be looking for value and actually having to weigh out profits, losses, debt – that type of thing.

David:Which is why this backdrop issue, this contextual issue, I think, will redefine allocations within the equities markets for decades to come. More likely than not, we are moving toward a timeframe where that old-fashioned stock-picking and the higher rates of returns that we saw from that in an earlier generation is moving back on the scene as relevant, and it going to become more profitable than riding the wave of monetary excess.

Because again, you have this index craze, which, obviously, if you look at Vanguard’s history, it started in the 1970s, but really, the popularity curve, if you’re looking at growth and assets under management, has only exploded in the last 10-15 years. It has only exploded in this period of time when monetary excess has been the primary driver.

What do I mean by that? An increase in the amount of credit that is out there and the lowering of the cost of capital, the lowering of rates, to get you there – the lowest rates in thousands of years. Again, this is a very unique contextual play, and it played a significant role in ultimately homogenizing returns such that one of the most relevant factors in investing – and again, this in only of late – has been the expense side of the equation.

Kevin:When you are raising kids, one of the things you want them to understand – we talked about your kids running to their rooms and getting money because they realize that what silver cost was less than what they paid before. Cost is important in a transaction, but we have lived in a decade where cost really wasn’t factored in.

David:I think it is always relevant, but it is not always the first consideration, and I think we are moving beyond the point at which it was super-relevant. In an age of 0% interest rates…

Kevin:Money is free.

David:Like we have had, yes, finding a fund with an expense ratio of seven basis points may be key to your survival. But in a world of 4-6% as the benchmark in the ten-year, seven [unclear] is hardly a blip on the screen. I think this is now, again, where we are transitioning back to the age of better thinking, likely to provide better results. And you, once again, will get what you pay for. So if you are paying seven basis points, you are going to get exactly what you pay for – the average rate of return.

Kevin:When you are talking about context, and forest for the trees, we have to actually go beyond this last interest rate cycle, but the last half of the cycle, this last half of the waveform, is where we went from high rates to low rates. I was in my twenties, you were a little younger than that, when rates actually peaked out back in the early 1980s. But if we were to go to the first part of that waveform, the rising part, we weren’t even born yet. We’re talking 1946 was the last time we would have been having this conversation about rates bottoming out and starting to rise.

David:People don’t appreciate the consequence of control and demand dynamics within the marketplace, but we had that during World War II. We actually had price-fixing for commodities and things of that nature during our wartime effort. And you didn’t have that come to an end, leaving the wartime footing, until about 1946. Interest rates responded first, and the equity markets didn’t really start responding until, let’s say, 1948 or 1949. But markets gradually shifted and the managed price dynamics went away, and the bond bear emerged from its den and he stayed on the prowl from about 1946 to 1981.

What does a bond bear look like? A steady increase in the rise of rates. On the other side of the equation is a steadily declining value in the price of the bond. So the bear is on the prowl from 1946 to 1981. What is he doing? He is gutting and eating fixed-income investors throughout an entire generation. That is hardly remembered by today’s generation of investors, let alone fixed-income investors. But the reversal in trend came in 1982, and if we are correct, it ran until the summer of 2016, 34 years later.

Kevin:That’s 34 years from 1946 to 1981. That is a long time for the bear to kick in. And now the bear has been hibernating all of our adult lives and all of a sudden – hey, here in the Durango, we do have bear, and there are times when you hear the trashcan outside shaking and you go out with a flashlight. But then you start going out with the flashlight and the sidearm because, you know, they’re dangerous.

David:A funny story. My brother, back from Indonesia with his family, and he is staying with his in-laws. He woke up one morning to the sound of that bear in the trash can, and he doesn’t know what it is so he opens the door, and literally, two feet from him is the butt of a black bear and the rest of his body is buried in the trash can. The bear hears him, steps out, runs ten feet away, and stands up tall. They usually stand up when they want to know what is going on. Well, my brother has a choice. He can either shut the door, or he can do what my little brother would do.

Kevin:What would Scott do?

David:He runs at the bear yelling as loud as he can, “Ahhhhh!!”

Kevin:That’s Scott, yes.

David:And the bear tucks tail and runs. I don’t know that that would have been my choice, but that was his choice. So yes, 1982 to 2016 – that’s a long time for the interest rate bear, the bond bear, to hibernate, and I think the bear is back on the prowl. You have the shortest interest rate trend in U.S. financial market history came in at 22 years, according to Louise Yamada and Alan Shaw. Alan is an amazing analyst, started as a fundamental analyst, ultimately ran the technical analysis department at Smith Barney before he retired in 2004. But the longest term interest rate cycle – I think 37 years, if memory serves correct, with the average sitting in the upper 20s or lower 30s. In other words, a very long time, and many days of market gyration and volatility.

So yes, we can talk about the trees – it’s very important what happens on a daily basis within the bond market. But the most important factor, if you’re thinking in terms of an Aristotelian view of things, may, in fact, be those daily gyrations, right? I want to give the trees their due. But the aggregation of the trees? The defining of the long-term trend? I think that is foundational to appreciating the long-term strategy or proper portfolio allocation over a longer timeframe.

Kevin:When you have these longer cycles when you go 30-35 years, what happens is that all the investment models get designed for the last few decades, but that’s the thought – it’s always going to be like this. I think about Wall Street strategy. As people get older the strategy has been, have more bonds – fewer equities, more bonds. In a perfect world – let’s say that you’re in a biosphere that doesn’t have these cycles – maybe you would want more bonds. But if you’re in a rising interest rate market, the value of those bonds is going to continue to decrease. At a period of time when you are retired, you can’t afford that.

David:Right. The basic math that the Wall Streeters like is, take 100, subtract your age from that number, and it gives you the allocation between equities and bonds. What the math translates to is, as you get older you have a shrinking allocation to equities and an increasing allocation to bonds, according to your age, as if your age is a primary consideration for market pricing. This is where, again, context is key. That works if you are living in a bubble. It does not work if you have an interest rate cycle that is misaligned with your timeframe to retirement.

Kevin:And think about that last interest rate cycle back in 1982. How high were interest rates at that point? I know I had a mortgage that was either 14% or 15% at that time. Interest rates sky-rocketed. It would have destroyed a bond portfolio.

David:The argument goes that bonds are less volatile and less risky because you are higher in the capital stack, assuming crisis dynamics. In a bankruptcy, creditors are favored over equity investors, who typically won’t get much of anything. I think there is also that aspect of income orientation as you shift toward retirement, the replacement of income from your previous employment. So bonds have some appeal. And in a rising interest rate environment you will be compensated with higher rates.

What that really speaks to is the need to adequately ladder a portfolio, if you are going to have a fixed-income portfolio, so that you are getting constant liquidity events which occur and allow you to recalibrate the interest rate you are receiving. But if you have to exit a fixed income portfolio at any point on a forced basis, understand that the value of your bond portfolio will be significantly diminished in that context of rising rates.

So again, I think there is a bit of truth to what Wall Street has put together in terms of, yes, you are higher in the capital stack, and yes, they are less volatile under normal circumstances, but I think what the average investor has benefitted from here recently is central bank activity in the marketplace, central bank activity which has pushed interest rates to unheard-of levels. And that has created capital gains which has been, actually, far more of the interest for the bond investor here recently than even the income component.

That deliberate central bank manipulation of yield – I don’t know if that gets to stay. So yes, Wall Street bond allocations – that’s fine in a particular time slice, but I don’t know that it gives you enough context to make the right allocations at this point.

Kevin:One of our listeners wrote us and he said, “So this time Turkey is the trigger?” He said, “We’ve seen so many episodes on triggers already – Spain, Greece, etc. Is this one really going to be it this time?”

It is interesting, you and I have talked about this – we really don’t ever know what the trigger is. We just know that there are danger points. We talked about Turkey last week, so let’s go ahead and spend some time on Turkey because it seems with Spain, with Greece – go ahead and talk about Italy, as well – and now Turkey, there seems to be some rider on a white horse that comes in quietly and at least dispels the panic at the time.

David:I think for us, too, there is the contemplation of what may be thetrigger, but never the assertion that this isthe trigger. And I think we have said this in the past in terms of my interest in back country skiing. When you got out in the back country, you need to analyze the snow conditions and appreciate that you are in an environment of instability where you have snow load on a certain slope angle that is just begging for any trigger. And you need to be aware of as many, or all, of the possible triggers, and appreciate that you may, in fact, be the trigger. So there is a certain degree of caution and humility as you enter the back country, knowing that if you don’t analyze those unstable contexts and take all possible triggers into account, you could end up dead, or buried six feet under snow.

Kevin:Dave, two weeks ago, I told you I went up to a gold mine with the guy who owns the gold mine. It is up near 12,000 feet. He told me a story of a miner who was up there who was up prospecting and he got caught in an avalanche. He literally dug his way out of an avalanche – hours and hours and hours of digging – and he survived it. As he was working his way down from La Plata Canyon, our county manager – I won’t name him, he’s still our county manager – threw a stick of dynamite out of a helicopter to trigger more avalanches. They had no idea that this guy had survived an avalanche, so the guy gets covered a second time.


Kevin:Unbelievable story. Of course, it was completely unintentional. The guy had to dig himself out of two avalanches. So when we talk about triggers, when something like that is triggered, you can have an awful lot of tension on the slopes. You never know where it is going to come. You certainly don’t want to have to dig yourself out twice.

David:I think this is one of the advantages that somebody like Doug Noland has in the management of our Tactical Short product because we look for cracks to begin to widen where we begin to see fault lines and clear points of tectonic shifts. And if, in fact, they open wide we can be 100% short. And if they close up because they are either filled up because of central bank interventions, or what have you, we can certainly move that position back to zero in short order.

Kevin:But you need to analyze where the tension is.

David:You analyze where it is and you determine whether or not it is moving from bad to worse, and is moving to that state where you could describe it in hyperbolic terms.

Kevin:Let’s talk Turkey here for a second, because we did talk last week, and Qatar seems to have been that rider on the white horse.

David:Yes, the nadir in lira trading we had Tuesday. All of a sudden Tuesday, Wednesday, Thursday come around and there is the discussion of 15 billion dollars coming in from the Qatari government.

Kevin:Is that really much money in relation to what they need?

David:I’ll tell you, it reversed the lira, sent it soaring over those three days. 15 billion is a few more dollars than I have. And it is quite a bit of money. As we also discussed last week, though, you have Turkey’s annual liquidity needs which are about ten times – actually, more than ten times that amount. So you’re talking about a drop in the bucket compared to what they actually need in terms of a real fix.

Kevin:So this relieved perception of a crash, but it didn’t necessarily relieve the default.

David:Yes, relief rally. But we’re not convinced that the worst is behind us. So, you have Mohamed El-Erian noting last week that contagion concerns were acute enough throughout the week, even through Thursday and Friday, that it prompted numerous central banks to intervene in their own markets in order to keep those issues at bay. So you have Argentina raising rates, you have Hong Kong also active, stabilizing their currency, Indonesia raising rates unannounced, so by surprise to the markets. And they were all taking these actions to ensure, as counter-measures, that there was not going to be contagion from Turkey into their markets.

Kevin:When you and I went to Argentina one of the things that was really education for us was to be in an environment where you had 40% inflation. It looks at this point that interest rates are having to start to match some of that inflation.

David:Yes, Argentina seems the most extreme. Last week they raised their benchmark a full five percentage points in a week, and that is on top of the 40% that it was at prior to that. So you have the benchmark interest rate in Argentina at 45% which tells you something of what inflation looks like and what rates do, or have to do, to accommodate a market that is dealing with inflation realities.

Kevin:Well, those poor Argentinians, unless they had some way of being in dollars or gold or something else, they were just being fried.

David:Do you remember the Argentinian man I sat next to en route to Buenos Aires a few years ago. At that point I think inflation was between 30% and 35%. It’s a little bit more now. He was a Nike shoe manufacturer. He was actually a contractor, he didn’t work for Nike, but they outsource some of their manufacturing to various people. One of the reasons they do that is so that the commodity swings do not hit Nike’s bottom line, they hit the contractor’s bottom line. So they are somewhat insulated from the change in the price of rubber, or the price of oil as it hits the synthetic materials that go into the creation of shoes.

Kevin:Hadn’t this guy padded his contract, though, at least his own personal pay, from those swings?

David:Yes, so his company still had some exchange rate risk and commodity rate risk in that contract with Nike, but he did carve out a compensation piece which tied to the U.S. dollar. He personally was paid on an adjustable rate, tied to the inflation rate versus the dollar, which to him was the equivalent of getting a 30-40% nominal increase in pay each year. That basically kept him at the same level as a consumer in terms of his purchasing power. Obviously, that is a rare carve-out. Not all Argentines, not all Turks, are so lucky.

And so, that comes to mind, but El-Erian was considering, too, that those external funding needs of Turkey far outstrip the Qatari gift, and his assumption was that they will be moving to the IMF very soon, that those loans from the IMF will be needed, or as we suggested last week, maybe a new benefactor from the East.

Kevin:You brought up that China might be willing to step up on something like that, but more significant, Dave, is that you have an awful lot of twists and turns and different alliances in the Middle East. We have Saudi Arabia and Israel that are unhappy allies because of some of the changes in Iraq, Iran, Turkey, Qatar. You have Qatar who is fighting right now with Egypt and Saudi Arabia.

So what does this mean for the Middle East, because we have Kamran Bokhari on every once in a while and he explains some of these dynamics, and as complex as they are, a lot of them add up to the void that was created when Saddam Hussein was taken out of Iraq, which was the central piece. You had Iran on one side trying to fill that vacuum. You had Turkey on the other trying to fill that vacuum. We talk about the Ottoman Empire with Turkey. This Qatar/Turkey relationship – why would Qatar send them 15 billion dollars unless there is a larger plan?

David:That’s the deal. I think because Qatar is on the outs with Egypt. Qatar is on the outs with Saudi Arabia. There have been tensions there in the Middle East. And so the Turks helped the Qataris a few years back and now they are returning the favor. But who is allied with whom in the Middle East will take on more significance in the months and years ahead.

I read this anecdotally, and maybe I need to confirm it before I even mention it, but a young couple decides to ride their bikes through ISIS territory trying to prove that there will be peace in our time and that, frankly, there are aspects of the Islam religion that are completely misunderstood. Tragically, that couple died last week, as the story is told. I’m going to double check that. But there are realities in the Middle East and real struggles and the idea of a Caliphate is not just an idea, it is a reality to many people. The establishment of a Caliphate is something that is intended and it is a timeless goal.

So to see struggles, to see alliances, to see different countries organizing their finances in support, I think it is worth considering what the Middle East looks like over the next 10-15 years. Keep in mind, when the Russians invaded Afghanistan – my boys were playing Risk the other day and I was explaining to my younger son that he would probably survive there in Afghanistan. The Mujahidin were amazing fighters. They knew their mountainous landscape very well, and like a Tennessee tick they were tough to dig out.

The U.S. has largely failed in that effort, and the Russians failed before us. They could not get it done. But the whole point of the Russians coming in to Afghanistan in the first place is they wanted control of the oil fields. Lest we forget, oil is still a vital product. We can think in terms of solar, we can think in terms of alternative energy, but we will live in a world that is dominated by coal and crude. And so the people who control those oil flows – we have to pay attention because ultimately it plays into a world of inflation or lack thereof.

Kevin:When you have the combined struggle of these Imperial powers, whether it was the Soviet Union back when they were around, the United States, Russia, China, they had their own agendas, but in these areas you also have tribalism and as we talked to Kamran Bokhari, the thing that is very difficult for people to understand is that the Muslims are fighting each other. You have the Sunni, you have the Shi’a, you have the Mujahidin which is also tribal. You have what is going on in Saudi Arabia with the Wahhabi. You have all these different dynamics.

David:And you have personal interests within family factions within the Saudi Royal family.

Kevin:Exactly. Now, let’s go to South Africa. When I first came to work for your dad back in the 1980s, he was warning about South Africa. He said this is a beautiful country, granted, they have problems, but there are Imperial forces that want to take over. The Soviet Union had designs on South Africa. You had different dynamics, and the press was portraying it as a completely racial issue. I know that it wasn’t because your dad would bring back people from South Africa that were in fear for their families, not because of them being black or white, but because of the tribe that they were in, the dominating tribe.

David:And it is true, there were racial concerns all throughout that period of apartheid, but the grand strategy of the Soviet Union at the time was to not only control the resources in the Middle East and the oil flows there, but also South Africa. Why? Because between Russia and the Soviet Union you have 98% of the world’s strategic mineral reserves. In other words, you cannot make today’s bombers or circuitry that goes into the creation of the computer networks that keep our world going as it is without these two strategic players.

Kevin:And so they went into Afghanistan in the late 1970s and that was part of that push, you mentioned the Mujahidin, and then of course they were also working their way into South Africa using the racial problems as a method to get the world on their side.

David:Where this ties in this week is that we have emerging market concerns which for the last month or so we have talked about. South Africa is certainly in that mix. And you begin to see flight capital as foreign investors re-appraise all of the emerging market players. But the rand did not recover. Some of the emerging market currencies started to recover last week as the U.S. and China started to say, “Hey, listen, we’re going to come back to the table. We will talk. Everything is going to be fine.”

Kevin:But the rand just continued to freefall.

David:Right. And Qatar suggested, “Hey, listen, we have 15 billion dollars, we’re willing to help,” and the lira starts to recover. And this is the exception to the rule here where the rand was still in free fall and I think there is more to the story there. Chinese and U.S. officials, yes, we hit the panic button and the PR campaign came out and we’re going to have some talks, either just before or just after the election, I forget, but sometime in November. And I think this ties to Ramaphosa, who is mimicking Zimbabwe’s land confiscation and redistribution.

Kevin:Ramaphosa being the head of South Africa.

David:Yes. The head of the ANC party and current big chief. So it has begun. That land confiscation and redistribution has begun. That is, white farms are being seized, given to blacks with no compensation for the land which is being taken. Basically, South Africa’s Mugabe has arrived.

Kevin:We talked to two gentlemen who had their farms taken away in Rhodesia under Mugabe.

David:I think it’s worth going back to the archives and listening to that interview because it is a very chilling story. There was a member of the British Royal Family who is a client of ours who had about 100 million dollars’ worth of land, who left and – this is classic – drove her Rolls Royce south to the border, and the only thing that she had with her was the Rolls Royce and three diamonds rings, all turned inward so that the diamonds weren’t obvious. And she was allowed to exit.

She exported her car to Southern California and rebuilt what she could of a real estate sales empire off of what had been wealth created from the breadbasket in Rhodesia. Needless to say, it was a very different world for her. It didn’t matter that she had family and was well connected in Britain. Her world changed dramatically. She chose to get out and left 100 million dollars’ worth of property behind.

Kevin:And she probably made a good decision.

David:I think she probably did make a good decision because confiscation and reallocation in South Africa, if this is truly a Mugabe moment in South Africa, this is not even the socialist or communist dictum of, according to ability and according to the need, which the communists prescribed. You’re talking about redistribution according to race and tribe that I can hardly wrap my mind around. But I think at this point we can say, and I think time will prove, that the whole lingering discussion over apartheid – because it is lingering – is naïve, it is out of date. It applied prior to Mandela. It really doesn’t apply anymore.

To me, and again, I’m certainly open to discussion on this, but it is like seeing racism as a defining factor in our culture here in the United States today. Past tense, absolutely, I agree, it has been an issue. Present tense, really? We elected a black president, not once, but twice. I think anyone who is playing that card today is driving simply for greater redistribution of resources, and is playing off the past. They are not living in the present.

Kevin:There seems to always be a larger agenda.

David:This is where party politics comes into play on this particular issue. We have a cultural dialogue on this issue, but it plays to those who are trying to whip up concerns. Again, businesses here in the U.S. increased by 400% in the last year. The fastest segment of new businesses to grow in the United States, and to open, are owned by black females. This is fantastic. There is greater equality in 2018 in the U.S. than in any other time in American history.

That is not to say that it can’t continue to improve, but we’re talking about 98% of Americans which I think are color-blind, 2% which are not. But I think for those 2%, they should not be the ones defining the cultural debate. And where it is being defined in those terms I think you’re talking about political hacks who actually benefit from a divided nation and love to heap as much fuel on the fire as they can.

Kevin:I’ll never forget when your dad brought back a man who was mayor of a township. Again, he was part of the wrong tribe. He was black, and he wanted to let us know here in the United States his family was in danger for him even being here. This was a Christian man who was talking about how the truth of what was going on in South Africa was much deeper than racism. Now we’re starting to see the social justice going the other way.

David:And I think the rant on social justice in South Africa is probably a decade old. It’s been around too long. I think Mandela brought very positive change. He brought an end to real race disparity. But post Mandela, you have South Africa which has devolved into that tribalist reverse racism. Visit there if you want to experience it firsthand, but have a conversation with the Indian community. They lament being the wrong color because they’re not dark enough. You talk to Zulus and they lament not being from the tribe of the ruling party, the ANC, which is the Xhosa tribe. Black on black injustice has been common since the days of Mandela, and really, think about this. God forbid you’re colored. That’s what black South Africans describe as a person of a mixed race parentage. Coloreds are in a truly difficult social space in South Africa.

Kevin:Or even Zulu.

David:So keep in mind, we have a very open conversation about race here in the United States. You go to Africa and it is actually a little bit more complicated, and you find that color is not really the issue, but you can have exclusion and prejudice which goes beyond race. And again, it’s fascinating. The social justice warrior cry – I think it’s a cover for theft and a justification for graft. If South Africa wanted equality for everyone, they had the opportunity, and equality of opportunity is really what I’m talking about. You saw that Mbeki and Zuma could have solidified that on their watch, but what they opened the door for – Mbeki first and Zuma – very clearly, they opened the door for the worst kind of political opportunism. The rule of law is something that is quickly slipping from the South African country.

Kevin:So do you see a reprieve from this, or is the rand doomed?

David:I think when we look at emerging markets as an opportunity to buy and invest in individual countries, this is a very important aspect, the rule of law. The rand, I think, is going to visit every circle of hell just like the Zimbabwean currency did if this insanity doesn’t stop. But you have investors in foreign capital. They may fear giving a critical voice to Ramaphosa’s policies, fearing the racist tag, but they will, nevertheless, vote with their feet.

Kevin:Right. So the investors will leave.

David: Yes. So if I were a South African I would consider emigration. If you aren’t directly tied to the ANC, I would consider emigration, whether you are white, or Indian, or black, it doesn’t matter. South Africa is moving past that point of no return. That is not to say that it can’t do an about face at any point, but if you are invested in a company with South African assets, what should you be doing right now? Again, this is where context absolutely matters. You are talking about the radical deterioration of the rule of law, the elimination of property rights, with zero compensation after confiscation.

Again, this goes back to context. The rand may tick up today, it may tick down tomorrow, but the bigger picture is sad. Constitutional changes set in motion by Mandela brought about hope for lasting change in South Africa, but gradually this has been compromised. It was Mbeki first. It collapsed completely under Zuma. You realize when he left office there were 750 separate corruption charges with Jacob Zuma. And now, frankly, in terms of that issue of constitutional formality and protection under Ramaphosa – you’re talking about them being nonexistent.

So it could have been different, but South Africa today reflects most of the African continent – not all – but most of the African continent where tribe and family tree define your opportunities, and I think the big opportunity that they have had has been squandered – an opportunity to lead, an opportunity to demonstrate difference. It has been squandered to demonstrate reconciliation. It happened once and now it is being set aside. Forgiveness and cooperation based on mutual respect, on shared values, on individual equality….

David:Let’s address equality. Remember, Orwell talked about this in Animal Farm.

Kevin:Equality only exists for those who are little bit more equal than others.

David:That’s right, some pigs are more equal than others, and that seems to be the gist of current policies in South Africa. You need to be connected directly to the upper echelon of the ANC. But listen, for the record, I want to make this very clear. Our family is not racist in any way. With open arms, and an incredibly open heart, we embraced a man from Nigeria into our family, my sister’s marriage partner, years ago.

So don’t misunderstand this criticism. Anyone who feels that my opinion is too sharp-edged or had a racial tone, you need to stop it. This has everything to do with a reading of current events from the standpoint of Edmund Burk’s Reflections on the Revolution in France. If you haven’t read it, I encourage you to read that before you start writing nasty comments, because you might think about unintended consequences and policies that have a rationale to them, or seem to be justified, but are ultimately devastating. So please, please, please, read Edmund Burk’s Reflections on the Revolution in Franceand you will understand where I am coming from.

Kevin:Sometimes you have to have a construct that reminds you that, historically, man is evil. Chief Justice Ginsburg was looking at the South African constitution and saying, “Gosh, if we were to rewrite it today, this would be the one that we would use.” But in actuality, that is just applying situational ethics at the time, is it not?

David:It is, because the basis of that quote was the embracing of basic human rights. That was her focus. And you are right, she said, “I would not look to the U.S. Constitution.” This is our chief justice. This is galling.

Kevin:This was six or seven years ago?

David:Yes. In all fairness, context is key. It was then – not now. “I would not look to the U.S. Constitution,” she said, “if I were drafting a constitution in the year 2012. I might look at the constitution of South Africa because if its embrace of basic human rights. Well, look, the difference between our constitution and theirs is that ours has stood the test of time, one of the few in all of history to stretch as far as it has through time, providing a protective cover from governmental or interpersonal abuse. And where it has failed on those fronts, the necessary amendments have been made for it to become more inclusive and a better document. Theirs is failing in less than 25 years.

Kevin:One of the contacts that you have who has been on our show a number of times is Hernando de Soto. He talks about the rule of law and contract law, the ability to hold property that you own. What we are seeing in South Africa is just one more occasion of the breakdown of that law.

David:It is a pillar for investment, this stability factor, the rule of law. And emerging markets – what are they? They are speculation on global growth. But they are given that much higher risk, and where you begin to see money go in or money go out – we talked about liquidity last week and current concerns of liquidity. If there is concern that you can’t get your money out of an investment, you generally see a mass stampede to the doors, so you have to have guarantees.

This is what we talked about last week in terms of Turkey, and this cross-border problem. You don’t have access to the collateral when capital controls are raised. There has been a practice of capital controls in South Africa for decades. I remember in the 1990s your limitation was you could extract no more than 25,000 rand per year, per person leaving. If you were a South African citizen that was your limitation.

Kevin:One of Hernando de Soto’s points – his main point – is that poverty is an outcome of the breakdown of the rule of law and private property rights. And abundance follows the rule of law. When you have the rule of law, and property rights that are adhered to be a constitutional mandate, then you have abundance.

David:That’s right. This is what is so frustrating when I imagine South Africa ten or 20 years from now. By eliminating this aspect of the rule of law and property rights, you are destining yourself. You are creating your destiny to one of poverty. So Hernando de Soto – if you haven’t read The Mystery of Capital, again, a classic book, you must read it – must read it. But where law is over-ridden by human greed, by avarice, what you have is corruption which comes to define the landscape. Corruption defines the landscape. There is always, in that place, going to be under-development, not a continuation of development. Instead of having a developing or an emerging economy, we go back to having a submerging economy.

I’m not sure we don’t have our own whitewashed version of corruption here in the United States. I’m not saying that somehow we are the city on the shining hill, perfect beyond measure, applying the rule of law perfectly. In fact, there have been erosions of that. I would concede that gladly. But you look at Francis Fukuyama, as an example. He considered the ability of some countries to grow based on one aspect, and one aspect alone – trust. Delegation comes with trust. And you are able to expand and grow, whether it is an enterprise or a country, when you have this element of trust.

And I would suggest that the rule of law is an undergirding aspect to that, creating accountability, bringing transparency, and a willingness to trust. But trust, where it is extended, where it is protected by the rule of law is that much more possible. It is a possibility. Fukuyama was observing in his book, the title of which was Trust, under-development due to a lack of trust extended, and it is typically under-development in a place where you depend on control according to family or tribe.

Kevin:For the sake of context, which we started the program with, we are going to bring the context back, because the final analysis in this is, an algorithm is not going to be able to figure out, at all, what you just now talked about. We talked about family history, we talked about national history, we talked about contract law. We have talked about all these things because these are contexts for risk and opportunity. This goes back to the fact that these algorithms are not going to win in the long run.

David:That’s right. Risk and reward – those two things – end up straddling these core backdrop issues. Yes, there are greater growth opportunities that exist in the emerging markets. There is no doubt, not only in terms of population boom and natural resource availability and under-development moving to over-development there. They are immature economies relative to the more mature Western economies, but yes, the risk is concentrated there, too, with a more tenuous implementation of the rule of law. So look to those countries that have a robust application of the rule of law and are on the younger side, and yes, you have a healthy growth dynamic.

But we begin to see shifts in the credit markets. We begin to see a preference here in recent weeks for risk-off. And it is not at all to see the emerging markets return to that submerging market category where the risks are recognized, and frankly, there is no amount of reward which is adequate. Think about that – 45% interest rates are not enough in Argentina to bring people in, just to illustrate. This is amazing! We will ultimately see a full cycle of risk-off. We have central bankers whose short-term interventionist measures seem to make it irrelevant.

But I think it is the traffic of individuals voting with their feet, heading to the exits, who will define market prices going forward. Until then, what do you have? The continual volatile massive market swings, whether it is the lira up 8% one day, down 16% the next. It is a tug-of-war. That is truly what is happening, a tug-of-war between command control and free market dynamics.

Kevin:We talked about the tug-of-war between Imperial forces and tribalism. That is going to go on for an awfully long time. But the tug-of-war between command and control, where people think that you can just have artificial interest rates – you can print money and not have any real consequence to that – the command and control only lasts so long, because actually, free market dynamics is not just an ideology. That is like gravity. That is the law of nature. Free market is the law of nature.

David:It is an aggregation of individuals operating according to self-interest. Why do free markets continue to function and why are they predictable as the winner in the end? Because when you aggregate free choice, when you aggregate an expression of self-interest, you ultimately overwhelm bureaucratic management. They are trying to manage prices and signals, but that is where, ultimately, markets, I think, break down as free markets express themselves in an overwhelming fashion.

Kevin:You mentioned the word signals. In our lives we are continually analyzing signals. You just read a book about deleting certain things. You are now reading a book on memorizing certain things. Our minds can only handle a certain amount of data at a time, so we have to forget that which is unimportant. We have to see that which is important or at least remember that which is important. Those are called signals, and whoever sees the greatest amount of signals, or the things that apply the most, that is the winner of the game. Remember when we interviewed Pippa Malmgren, the author of a book called Signals?

David:Yes, and just as important as the title is the subtitle – The breakdown of the Social Contract and the Rise of Geopolitics. As we have suggested for works, you have emerging markets which are a signal. You have industrial commodities which are signals. I’m glad everyone is enthusiastic about 4.1% GDP growth here in the United States, but commodities are telling you a different story about global economic activity and growth – shrinking global liquidities.

We talked about from the Gave/Cal guys last week – it’s a signal. The days are long, but the years are short – you know that phrase – and it’s not too long before these signals reveal the underlying weaknesses in the global financial structure.

Where there is risk, and we see it increasing daily, this is where you have to flip things on their head – where there is risk there is opportunity, particularly if you prepare for it. You will be rewarded if you prepare for it.

Or you can stay on. You can stay on with a steady Wall Street course, and I think you will be abused by the markets. That is the highest probable outcome. But I think that choice is yours.

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