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The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

Artificial Bliss: FED Strong Arms The markets As Guaranteed Buyer
September 29, 2021

“When rates move higher in earnest, it won’t be because the Fed wants them to, it will be to a degree that makes the Fed squirm very uncomfortably because they’re going to call their friends over at the Treasury who are saying, wait a minute, you understand that interest, this line item on the national budget, interest is now creeping towards 10, 15, 20, 25% of the total of our budget. All revenue that we generate from taxes, more and more of it’s required just to pay interest.” — David McAlvany

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

You could dream Dave, if you wanted to that you were the bond market instead of the gold market because you and your family have been in gold for— this is going to be 50 years coming up on 2022. What if you had a guaranteed buyer of every piece of inventory that you had? So when we keep the inventory board, what if you had a guaranteed buyer, what would the price be? If you knew somebody was going to and buy everything, always, all the time. And I’m of course I’m referencing the Fed right now. And when the Fed talks about market cycles, whether they’re cyclical, the short ones, or the secular, the long ones. And when people try to do analysis, what they’re really doing at this point with the bond market, especially, and with the debt market, is they’re trying to analyze something that there has been a guaranteed buyer already baked into the system. How in the world do we even look at these markets anymore?

David: Yeah. This is the new great power, where you can just choose the price and spend whatever you want to determine the price. It was Bill Clinton’s political advisor James Carville who said, “I used to think that if there was reincarnation, I wanted to come back as the President or the Pope, or as a baseball player with a 400 batting average. But now I would like to come back as the bond market. You can intimidate everybody.” And it’s true. There used to be this thing in the bond market that was alive and well, and it was discipline to the marketplace. And that discipline has been wrecked by the Fed’s footprint, basically taking away or temporarily stripping power from the bond market and claiming it for themselves.

Kevin: Okay. So the cycle, okay. When we talk about cycles, those are shorter term, but secular in the bond market, the secular cycle can last 35 years, but that secular cycle’s also affected at this point. It’s been lengthened, hasn’t it?

David: And I think that’s really what we’re talking about is the short-term stripping of power. It’s actually not a surprise that secular shifts and secular trends are ignored. You have Jerome Powell 30 years ago, who was working as the Assistant Secretary of the Treasury. And he argued that if we’re just regular about our bond options, if we’re predictable, the market’s going to appreciate that. And we’re going to continue to see a reduction in bond yields.

Kevin: And that was back in the ’90s.

David: That’s right.

Kevin: That was when the market was a little freer than now that Powell’s at the helm.

David: Well, and maybe it was true, but the context in 1991 was that there was a secular shift from record high yields a decade before.

Kevin: Right.

David: To normalizing yields at lower and lower levels.

Kevin: Inflation was not as bad at that time.

David: That’s right.

Kevin: That’s the ’80s.

David: It had been fading. We were entering a post-cold war period of labor cost shrinkage. There was diminished capital controls all over the world and in expanding free trade on every continent. So again, these are the contexts, these are the secular trends, and there’s Jerome, young Jerome Powell, Assistant Secretary of the Treasury, saying, I think we just need to publish when we’re going to ask for money, and that’s going to drive interest rates even lower. And it’s like, actually, Jay, there’s other things in play. And terms were more generous for a variety of reasons. And I think, again, Jerome thought that if the Treasury was clear on what it was going to do, rates would shrink. Maybe it’s peripherally true. Maybe it’s coincidentally true, because you had those secular factors which were clearly at work, and rates have in fact come down for a combined total of 40 years.

Kevin: Hmm. That’s one of the longer cycles too, isn’t it? Secular cycles. Rates coming down 40 years. Isn’t it normally in the mid 30s?

David: The average interest rate cycle in the US is in the 30s. And the shortest is a 22-year cycle. So we are now, this is now the longest. If we’re averaging numbers, this is now the longest interest rate cycle we’ve had.

Kevin: But when the central bank wants to exert pressure on prices, different than what the cycle would actually yield—pun intended—then it does change the look.

David: Yeah. And I guess a part of what is in play is unnatural. putting in a low in rates and a high in bond prices—

Kevin: It’s artificial. Yeah.

David: It’s had less to do with secular trends and more to do here recently with central banks’ strong-arming of market dynamics. So when the ECB, the Fed, the PBoC, the bank of Japan, the bank of England, and others decide that they want to fix prices at a high level in order to fix the cost of debt at an artificially low level, the secular trends go out the window, and in their place, albeit temporarily, comes the market fix.

Kevin: Okay. And that goes to the guaranteed buyer question that I had right off the bat.

David: Yeah. And the Financial Times this week said the same thing. “It’s hard to have rational price discovery,” they said, “it’s hard to have rational price discovery on an asset with a guaranteed buyer.” So is Powell willing to remove himself and the Fed from the equation? I mean, when we talk about taper, when we talk about beginning to raise rates, we’re basically saying we’re going to get out of the way and let the market do its thing. Look at the numbers involved, though. The 30-year bond is yielding under 2% with inflation a full 3.4% above that number—above that number. So we’re talking about in the fives, right?

Kevin: So you’re negative already?

David: Yeah. I mean, it might suggest—

Kevin: The Taylor Rule is out the window.

David: Yeah. It might suggest to the rational investor that letting go of the bond market fix and letting secular trends reemerge might be too consequential for the markets and too high a price for the Powell Fed to pay.

Kevin: Okay. But what Powell would basically say at this point is the inflation that you just quoted, Dave, don’t you worry you about. It’s transitory. It won’t be here. It may be here today, but it’s not here tomorrow.

David: And it’s wonderful if true, and it’s painful if it’s not. Particularly for investors that have continued to maintain the belief that central banks direct markets instead of the contrary. These are articles of faith. They really are. When you think about how the world is constructed and what makes the world go ’round, central bank policies may coincidentally be moving in lockstep with a larger reality, but there can be some confusion between secular market causes and effects. And there is the belief, at least sponsored by the Fed, that they are the ones in control of the outcomes. And I appreciate the cheeky description of the US bond market by the Financial Times’ contributing editor. He says that, “Treasuries are a special, rational bubble.”

Kevin: There’s so many special things these days. But doesn’t that also push money over into other assets? And artificial can go both directions. You can have artificially high stock prices if you’ve got artificially low yields on bonds.

David: And that goes back to the risk-free rate. We’ve often bemoaned the fact that the most important market signal, the “risk-free rate,” is muted when you start controlling bond prices, obviously, and all sorts of misallocated capital gets thrown into a other assets—non-bonds, non-bond assets that didn’t deserve the time of day, but nevertheless see excess liquidity gush and flow into them.

Kevin: So did you go to the website? We talked about this digital rock that you can buy for several million dollars, if you want. They only made a hundred of them. They’re digital rocks. They exist only on the screen. And when you go to their website, it basically says now this has no real function other than for you to sell it to somebody else at a higher price. That’s amazing. It, there is no function. So we talk about assets. If I can’t earn or keep up with inflation on government bonds, let’s say, maybe I’ll just by a digital rock. And I’ll be the only guy who has it. Maybe I can put it on my thumb drive and walk around with it.

David: I remember reading an article in the Wall Street Journal which basically said gold’s nothing more than a pet rock. That was the accusation at the time. Never mind the fact that it’s been treated as the core of monetary systems going back four, five millennia. So EtherRock—

Kevin: EtherRock.

David: —is scarce, like gold is scarce, right?

Kevin: Yeah.

David: No, not actually. Not actually exactly like, so yeah, you can buy an image of a rock. It’s a digital one, not a one-of-a-kind image, but you can buy it for a couple million. I think it was 2.2 something million dollars. And if the tulip bulb mania seemed to be touched by madness, the idea of paying years’ worth of wages or an entire fortune for a single tulip bulb, what is it that’s touching the minds of the non-fungible token investor? So you’ve got billions of dollars which have now come into this little space, and utility’s not a consideration. Beauty is not a consideration. You might say, well, no, but it’s art. Not really. Cash flow is not a consideration. It’s only speculation that the price tomorrow will be higher than the price today.

Kevin: Greater fool.

David: Yeah. That’s the true consideration. And it’s irrational exuberance—actually that’s too kind a reference for the greater fool strategy that’s employed for the non-fungible token investor.

Kevin: Dave, this is a point where we need to re-recommend a book because I don’t know that we’ve talked about this in the last few years. So for the newer listener, get Extraordinary Popular Delusions

David:and the Madness

Kevin:and the Madness of Crowds by a guy named Charles Mackay. It was written in the 1850s, so this is not new material, and he goes back. But when you brought up tulip bulb mania, I’ll never forget one of the stories. You remember the story of the tulip bulb that one of the sailors on the ship— they were bringing tulip bulbs at that point were worth hundreds of the thousands of today’s dollars because they’re just like these digital rocks—because everybody thought so—and one of the sailors ate the tulip bulb. I didn’t realize you could eat a tulip bulb, but it’s a little bit like, I guess, an onion or something. So he ate it. The tulip bulb that he ate was worth more than the ship that brought it over. And now, of course, the end of the story is, when you go to the Netherlands today, the tulip bulbs are back to normal price. What they should be.

David: What a surprise? Yeah. I wonder what EtherRock will ultimately be worth. Probably what it’s worth, intrinsically, too. Powell, if he were operating in the sphere of reality today, he might reflect as he did 30 years ago on the value of predictable behavior. And if he did, what he’d see is that market participants are gaming his information flow, they’re gaming, the predictable behavior of the central bank community. And every speculator is willing to keep the dance music pumping, the beat thumping, and prices jumping so long as excess liquidity is still on offer. And so that’s what he should be reflecting on.

Kevin: So you’re talking like the reverse repo market. You’re talking about the money that they’re just feeding into the system at this point.

David: What—

Kevin: By the trillion.

David: What that reflects is that there’s way too much money in the system. We know there’s too much money in the system. The reverse repo market with overnight operations consistently over $1 trillion is now a clear illustration of the Fed’s excess liquidity creation. And it’s unable to find a legitimate home. So you’ve got banks stymied in the credit creation process outside of those areas we’ve talked about in previous shows. The underwritten and sort of risk-free loan program sponsored by the government.

Kevin: But this isn’t for farms or factories. This is for speculation. This is for pet rocks on your computer.

David: Yeah. Demand for money for productive purposes is low, demand for money for speculative purposes has never been higher. So exhibit A for lunacy is the non-fungible token world. Exhibit A for excess liquidity is the reverse repo market, again, consistently above a trillion dollars overnight. Exhibit B, C, and D on the liquidity front we’ll discuss in a minute because we’re going to come back to the Z.1 report, the quarterly report. 

So if we go back to lunacy, returning to lunacy for a more familiar kind, consider the S&P 500. We’re at one and a half percent of all-time highs. We’re near one and a half percent of all-time highs, and margin debt is taking out the old records. It was higher by 8% in August, to $911 billion. You look at 911, and you wonder if somebody might subconsciously worry after looking at the number, like, “call 911, the markets ablaze with irrational energy.” It’s just interesting because never have so many people been so confident gambling with someone else’s money.

Kevin: We just came out of our weekly staff meeting, and someone was talking about China outlawing Bitcoin and Bitcoin coming down. And it’s just interesting, Dave. I remember the 1987 crash before the crash. And everything seemed to people who weren’t seeing it as if it was going to continue to go up. And then we had the greatest crash since 1929. We could say the same thing about the tech stock bubble. It was like, this doesn’t even feel real. Let’s remember what this was like when this thing crashes. Well, it did. 2008, the same type of thing. It feels like that right now, we need to encourage each other to remember, we’re going to remember these digital rocks someday. And we’re going to say, “there were actually people who believed that they had value.”

David: Yeah. And I guarantee you, there’s the same trends in play with the US government as there are with the Chinese government today. Can’t mine digital currencies. That was the first stage. Now you can’t trade them. Now it’s not to say you can’t own them. You just can’t do anything with them. So keep them happily on your thumb drive. And you’re in trouble if you do anything with it. If you take it to an exchange and try to trade it for another currency, whether it’s a digital currency or an actual fiat, you’re in trouble. But you’re right. Remember, you were there.

Kevin: Yeah. We need to remember.

David: And these behaviors and allocation choices to non-fungible tokens, cryptocurrencies, with even stocks and bonds, they were normalized by the media. They were normalized by brokers and money managers. I mean, to the point where things that historically have been a great guide: cyclically adjusted price earnings ratios. If it’s above 20, you pay attention. It’s if it’s above 30, there’s alarm bells going off. We’re now at 38, right? 

Even as structural economic changes were shifting in the backdrop, we should remember. A move away from capital to labor that’s happening on a global basis. With wages increasing, it’s very clear that corporations, Wall Street, and their minions are now being pressured. Wage pressure is now solidly on the rise, a diminishment in global cooperation and trade. These are firmly entrenched structural economic changes. And it’s almost as if we’ve just watched and we’re still celebrating the Turkey’s happiest day. That’s behind us.

Kevin: Right, the day before Thanksgiving.

David: Yeah. He’s stuffed and awaiting slaughter.

Kevin: Okay. That takes us to inflation because something that’s always blown my mind is when you have high inflation based on the fact that you’ve printed trillions of currency, people don’t generally see that. What’ll happen— because we’re experiencing inflation. You mentioned wages. Wages, aren’t transitory. How often does somebody say, “Well, we’re going to cut your wages back because inflation’s a little bit lower”? That never happens. But look, with a lot of the supply chain problems, that probably, Dave, if in five or 10 years, if we go through a really high inflation period, which we probably will, they’re going to look back and there’s, they’re going to say, “Well, it really had more to do with supply chain than it did printing of money.”

David: Yeah. But we’ve had monetary policy which has been very loose, obviously. And that’s led to asset price inflation. We’ve had fiscal policy which has been very loose, and that’s contributed to consumer price inflation. And you’re right. There’s going to be sort of a retelling of history. But look, it’s now the end of September, and it’s odd, but you just said supply chain bottlenecks are going to be written into this part of history. Supply chain bottlenecks, which were assumed to be the primary cause of transitory inflation.

Kevin: They’re still here.

David: They’re still here.

Kevin: Yeah.

David: I mean you’ve got global automotive companies. They’ve doubled the expected impact of microchip delays. Again, this is a supply chain issue. Originally it was thought to have increased their costs and decreased their revenues by 50 to $60 billion on a global basis. But they expected to be revolved.

Kevin: Resolved.

David: They expected to be resolved within months. More recently, that number— It’s no longer 60 billion, it was increased 110 billion. And now it’s almost doubled to 210 billion in revenue depletion as the costs continue to rise. And yes, the shortages remain. So we’re still dealing with the supply chain bottlenecks, but we’re also now dealing with a bunch of other things as well. So finished goods that are making their way from Europe and Asia to American shores, they’re stuck offshore. Between a lack of longshoreman and a lack of truckers, there are two few workers moving products. Unless you’ve got logistics and transport costs moving higher in lockstep with wages also on the increase, needed to bring people out of the woodworks and actually get stuff done. So on that point: Imports, you’ve got the current account deficit, which had a 14-year high, 190.3 billion for the last quarter.

Kevin: In a quarter. Single quarter.

David: These are on par with the numbers that we saw in 2007.

Kevin: Yeah. Remember what they said though back then? Deficits without tears.

David: Well, and that goes back to even the ’60s and ’70s, where the contention was, you can’t do this forever. And I think it’s without tears until the tears flow involuntarily.

Kevin: So that brings me back to wages, though, because you’ve already got large companies like FedEx, 3M, they’re already saying they’re having to raise wages. They’ve been warning about inflation, they’ve been talking about the costs. Once you raise a wage, like I asked earlier, can you really adjust wages back down when inflation starts coming back down?

David: There’s certain prices you can move up and move down. So if Corn Chex sees a bushel of corn go higher, yeah, you may bump the cereal box higher by 25%. Or you may just shrink the box. There’s lots of ways of addressing that. And if you want to bring it back down, you can. And you’ve got commodity price volatility, which is constant.

Kevin: But Dave, you’re an employer of many people.

David: Right. You raise a wage. There’s nothing more demoralizing than saying, “Oh, I’m sorry, taking that back.”

Kevin: Yeah.

David: You you’ll have to be happier with less. Now, everyone’s always happier with a little more. I understand that. But once the commitment has been made on wages, there is something very deleterious to morale when—

Kevin: If you called it transitory.

David: If you call wage inflation transitory, you’ve got issues.

Kevin: Yeah, your paycheck was transitory by the way.

David: That’s right. So the issue with wages— by the time they start to move, it’s the stickiness in sticky price inflation. Again, new round of repricing of goods which factors in higher input costs. And then you have the new higher level for consumers to get used to. All these things are very important. 

FedEx cut its full year earnings per share estimates on higher operating costs. We already talked about 3M if few weeks ago. These are bellwethers, Kevin. These are worth watching because you’re talking about logistics and material costs and labor. But note that the conversation is no longer strictly about supply chain concerns, labor logistics, material costs, right? It’s all of a sudden C-suite participants that are sensitive to these issues, right? CFOs COOs, CEOs, but the Fed is stuck on being right. And they can’t seem to see inflation anywhere other than where they’re choosing to look for it.

Kevin: And that’s what they tell us. I mean, they can’t be that stupid. Can they?

David: No, I don’t think they are, but I mean, last month’s CPI number lower than the month before. That’s all they needed. You’re like, oh look, hotel room rates fell 2.9%. Look, look. Used car and truck prices are down 1.9%. Wall Street gets emboldened with this notion that, okay, well maybe the Fed’s right. It’s transitory, and we’re beginning to see this receding of increases in inflation. But think, I mean, think about FedEx, as you said, it’s difficult to lower wages. $450 million in increased wages. That’s, I mean, FedEx is going to take a hit to their numbers in part because of $450 million in increased wages. Is that transitory?

Kevin: Mm-hmm (affirmative).

David: When was the last time employees were happy to take a pay cut? Raise it and it’s stuck there. 

Costco conference call this week. Labor costs, front and center. Freight costs, container shortages, port delays. I mean— so there are still the factors of supply chain issues, but they go through a long list of products that they’re having to bring in at between five and 11% increase in cost. And that does not include any of their meats. So these are all low double digits, but you’re, I mean, you’re moving into the teens.

Kevin: Okay. So I want go back to what Financial Times said. When we were talking— Okay, I started the program saying if you had a guaranteed buyer now— What I mean by that—because we’ve seen this in Europe as well with the European central bank. The bonds, the yields on bonds, don’t have to go up if they know that the government’s going to just buy them and buy everything. But something seems to be changing. 

Jim Deeds, I remember he told me this— Jim has been a guest on the program, worked here for a while, has been a friend of your dad’s, really, since the late ’60s, stockbroker, a very, very connected guy. And he said, Kevin, he said, “When they can’t keep interest rates down, when inflation is going up and interest rates start going up and it’s no longer completely in the Fed’s control, that’s it. Game’s up.”

David: The power of the Fed is not in the money that they spend, but in what they project. And it is a persona. They have the control, or do they? And as long as you, the market participant, believe they have the control, then they do. And you’ve seen this happen with the ECB, the ECB—

Kevin: It really is a curtain with Oz. Pay no attention.

David: We will buy in any quantity, the number of bonds necessary to keep rates lower.

Kevin: The Great and Mighty Oz—

David: Do you remember German bunds, just a few months ago, were negative 60 basis points? Now they’re negative 20 basis points. There’s the market perception. And again, we’re talking about almost a non-existent yield. I appreciate the fact that these are 10 year—

Kevin: Negative rate.

David: Negative rating, but, and this isn’t a real rate. This isn’t— the nominal yield is negative 60 basis points. Now it’s negative 20 and change.

Kevin: But it’s creeping up.

David: It’s creeping up as the reality gets into the minds of the market participant that, wait a minute, will the ECB always be the buyer of last resort? Will the Fed always be the buyer of last resort? Is it always going to be profitable to front-run the next QE initiative?

Kevin: So is that happening here? Not just in Europe?

David: It’s too early to say, but I know last week the bond market appeared to change its tune and direction with some sensitivity to inflation. So 10-year Treasuries backed up with yields moving towards 1.46%. I think what you saw last week was the bond market and the man on the street seeing the world—or at least the speculator seeing the world—from a similar perspective, not the perspective of the Fed. Yet bonds and energy, which were moving in tandem, suggesting that the market knows what is going on. Even if the Fed is not looking where they could or should look. The New York Fed reports consumer’s expectations on inflation, which is— it’s a different measure. Again, consumer expectations are different than their preferred measure. PCE comes out later this week, and this number from the New York Fed is important because you remember, expectations guide outcomes. And those expectations are above 5% for this year.

Kevin: This is the public?

David: Yeah that’s right. And above 4% for the following three years. And that’s well above the Fed’s target of 2, it probably goes without saying, and it’s also well above the current rate structure. The 30-year yielding right around 2%. So expectations have shifted. And so we would argue the die is cast.

Kevin: Okay. Let’s take the other side of it. The person who’s out there speculating is saying, “Hey, the Fed’s got our back. It’s worked for the last decade since the last global financial crisis. Why wouldn’t it keep working?

David: It’s an article of faith. Some still believe the Fed controls the bond market. Some still believe that the Fed controls inflation. Some have the belief that the Fed controls economic growth rates. But I think there’s a few more investors each day that are figuring out that secular trends define a course, and central bank activity is almost coincidental to those market forces. Certainly there’s timeframes, short-term timeframes, where market forces can be manipulated controlled, even bullied.

Kevin: But just for the short run. Not the secular trend.

David: Ultimately those market-driven forces overwhelm even the best-intentioned policy course. So when rates move higher in earnest, it won’t be because the Fed wants them to. It will be to a degree that makes the Fed squirm very uncomfortably, because they’re going to call their friends over the Treasury who are saying, wait a minute, you understand that interest, this line item on the national budget, interest is now creeping towards 10, 15, 20, 25% of the total of our budget. All revenue that we generate from taxes, more and more of it’s required just to pay interest. So the conversation about interest rates going higher and the back and forth between the Fed and the Treasury, I think it’s going to get very interesting in the coming years.

Kevin: There’s a saying that says, tell a lie long enough, and the people will believe it, but you can only do that when the lie is relatively close to the truth. Do you think inflation at this point is going to be something— anybody who hears what the Fed says is inflation, you talk to somebody who goes to the grocery store and they just laugh.

David: Right. Inflation rates at present are likely the shot across the bow. You’ve got Fed credibility implosion which is closer by the day. There’s a host of ramifications from that. If you’re talking about financial market liquidity, if you’re talking about asset price volatility—very significant when that credibility bubble bursts.

Kevin: Well, this is a good time to probably go back and say, you can listen to the Commentary every week and hopefully get good information. But, Dave, you’ve been very generous in offering things that— high value— if somebody wants more deep insight into some of the— like you said, inflation being a shot across the bow. 

Well, rather than just talk vaguely about something, you can actually get detailed from the Credit Bubble Bulletin the hard asset insights, all of this is offered for free on the McAlvany Wealth Management website. And so I recommended the book earlier, Extraordinary Popular Delusions and the Madness of Crowds that is a—the first three chapters is a—must read. But on a weekly basis, for the person who wants to dig deeper, I mean, Doug Noland, we’ve talked about him before. I still pinch myself that he actually works with us.

David: Yeah. We don’t bombard your inbox with email after email. So the benefit from Hard Assets Insights or Credit Bubble Bulletin—to benefit from that resource, you’ve got to go get it. So Hard Assets Insights is only a few years old. Credit Bubble Bulletin dates back 20-plus years. And so for the financially curious, for the historically inclined, for the seeker, I tout Hard Assets Insights and Credit Bubble Bulletin because they’re valuable resources that come out later in the week and allow us to dig a little bit deeper on particular topics as they relate either to our asset management style from one of our companies or because we want to check in on the chronicling of one of the greatest bubbles in financial market history.

Kevin: How do you distinguish the two, if you had to explain to somebody in short order, the difference between the two reports?

David: Well, I mean one’s page and a half long and the other’s 25 pages long. That’s probably the easiest way.

Kevin: So the Credit Bubble Bulletin [is the longer read], yeah. But you can get a lot out of the first three or four pages of the Credit Bubble Bulletin.

David: Yeah, there’s a nice summary there at the front of Credit Bubble Bulletin. And one of the things that I really enjoy about what we have on our wealth management site, under the Credit Bubble Bulletin section, Doug curates a newsfeed there, and you get to see articles from the Financial Times and Reuters and dozens of different sources.

Kevin: Stuff he’s reading and finding important.

David: So consider the three hours that it would take to find the articles and read them versus the 10 minutes that it takes to go to that site, read the page, and go directly to the articles. Again, there’s a tremendous time saving here. And it’s one of the most valuable— I mean, Doug is a— I’m grateful for the effort that he puts in every day. This is seven days a week.

Kevin: It’s a labor of Love. We talked about that last night, about a friend of yours that you went to school with in seventh grade. Yeah. A lot of people want to be an artist professionally. This guy—

David: Can’t help it.

Kevin: —he can’t help it. It’s a labor of love. It has to happen. Doug would do this whether he was paid or not.

David: And he loves it.

Kevin: Yeah.

David: He loves it. So both of these [publications] shed light on our team interactions because I think between Hard Asset Insights and Credit Bubble Bulletin, they crystallize the internal conversations and concerns that cross our desks that enter into the debates that we have on a regular basis.

Kevin: Okay. Give me an example from this week.

David: Z.1 report. You know, Doug covers it in the Credit Bubble Bulletin, but it’s going to be highlighted in the conversations that we have at a very high level as we’re looking at macro trends. Let me give you a sampling, just kind of cherry pick a few numbers. And if you want to look at all of them, you can again go back to this weekend’s read. 

The past quarter—so we’re talking about Q2—we have equity values which surged $5.7 trillion—this is in the US—to a record 75.39 trillion. Compare that to total equity values at 27 trillion in the year 2007 and 20.95 trillion in the year 2000. Those are both cycle peaks, that’s why we referenced them. We’re now at equity values of 332% versus GDP.

Kevin: Wow. I’m thinking Buffet here, because this is what Buffet looks at the most.

David: Of course. And the cycle peaks previously were 188% or 210%, so 332 is a significant number. And why do we look at these? Well, again, I know numbers can run together, but on this metric, stock market capitalization versus GDP 332% versus 188 or 210, currently stocks are 50% more overvalued than the last two cycle peaks. Is that a nice little nutshell takeaway?

Kevin: Let’s just define what we’re talking about. A stock market should actually reflect economic productivity. And that’s what GDP is.

David: Yeah, the measure of total economic activity, that’s GDP.

Kevin: And if the stock market it is way, way more than that. Okay. Higher than what you’re talking about. Buffet basically says, no, I’ll just stay in cash.

David: You’re paying premiums for the activity that’s being done. Now traditionally you make money when you buy things discounted, not paying premium. I said, this, let’s just hang out on this statistic because this is Warren Buffett’s go-to gauge for over and undervaluation. If stocks outstrip, if they surpass the engine of growth, again, GDP, what they derive value from, it’s not sustainable. Don’t buy them. 

When stocks are a fraction of the size of that growth engine, they should be bought with both fists. So, no surprise. I mean, in the same period of time, get household net worth. You bring in real estate to compliment financial assets. Also at record levels, 623% of GDP versus 445 and 491% previously. So there’s Buffett sitting on $144 billion in cash, not buying with both fists. Does that communicate anything to you? Does it mean anything to you?

Kevin: What’s also scary, if he’s sitting on 144 billion in cash, he’s not keeping up with inflation. He’s going backwards, and he’s finding it worth more than owning stocks right now, hitting all-time highs.

David: Imagine that. Many believe Warren Buffett to be one of the smartest asset allocators. He’ll take a 3% loss to inflation, 5% loss to inflation, depending on what he’s earning on his money, rather than take market risk. What does that say about his attitude and his disposition towards market risk at this point? The everything bubble is still in play and saner angels are still on the sidelines. 

It’s noteworthy that last week, we did see the worst outflow in three years, $28.6 billion pulled from US equity funds. So if we go back to the comments from last week on options volume, when we talked to Bill King, we’re talking about crazy volumes, expecting the markets to go higher. Well, last week we had the first trickle out of stocks, and it was actually the largest outflow we’ve had in three years, 28.6 billion pulled from US equity funds. A trickle could become a torrential flood, and frankly, only time and policy responses will tell.

Kevin: Okay, so that’s Z.1, but what else do you guys talk about when you meet?

David: Yeah, the last number to ponder came from the rest of world holdings of US assets. So if you go back in time, 2004, we surpassed 10 trillion for the first time. This is every other country, every other investor, every other money center, whether it’s London or Santiago, everywhere, 10 trillion in aggregate US assets held someplace else. So we went to a fresh high in Q2 this year, 43.59 trillion—is 43 trillion. This includes stocks. This is corporate bonds. This is Treasuries. This is everything. And you hope that the current holders are happy holders and don’t become sellers, even marginally so. And the real—just for perspective—I mean we went from 10 trillion to 43 trillion in a 16-year timeframe, but we added 13 trillion in the last 10 quarters.

Kevin: Wow.

David: We’re ramping up.

Kevin: Wow.

David: Everybody’s buying—

Kevin: Acceleration.

David: It’s an acceleration. And one thing is true. If you’ve looked at markets for any length of time, rate of change or acceleration, momentum, you can gauge kind of where you’re at, depending on how vertical the hockey stick is. This is the everything hockey stick.

Kevin: Yeah. Dave, I hear you but when you all meet, everything can’t be a threat. And this is the interesting thing about money management or just actually life. You have to look at what the real threat is and ignore the non-real threat. And it’s interesting the last few weeks, Evergrande has been in the news and the size of it is huge. You’ve talked about it. A lot of people talked about how this could take the Chinese financial system down, but is it a real threat or is it something that China as a whole can just go ahead and put money into and bail out a little bit like the too big to fail maneuvers that we’ve seen here in America?

David: Well, I mean, there’s no doubt that it could be Lehman part two, the Asian version of a Lehman moment. On the other hand, we also have a polished policy suite which the Chinese may have learned something from in that 2008, 2009 timeframe, and may employ. Stephen Roach comments on China that the government will spend to fill the gaps. So if Evergrande implodes, you’re going to have some losses, but on that front, he’s not particularly worried because he thinks they have sufficient capital to fill the gaps. Maybe that’s true, maybe it’s not. But his big takeaway was what we talked about in previous shows, Kevin, common prosperity. That’s not a passing fad.

Kevin: Right. And that when you say common prosperity, that is a title that’s Xi Jinping basically labeling a new economic plan.

David: Yeah. It’s the wave of the future. And it is contrary to the market dynamism and entrepreneurial expressions we’ve seen over the past four decades in China. So anything that we’ve experienced from Deng Xiaoping to the present will be different going forward in China. 

So perhaps we should reflect further on China’s total contribution to global GDP and what healthy expectations could be from the World Bank, from the IMF, from the OECD countries to say, what are we going to see in terms of US growth, European growth, Chinese growth, because what Evergrande does represent is a major sea change where they’ve ginned up a tremendous amount of growth on the basis of malinvestment in real estate. Now some of that gets to be unwound, and they’re going a different direction. 

So part of our conversations internally— China’s total contribution to global GDP is one thing, but bear in mind, they’ve also been the largest buyer of commodities on a global basis. If the engine of growth for China is changing, it certainly impacts certain commodities. So we have to look at things from a portfolio allocation perspective. You have to start seeing things from the standpoint of differentiated supply and demand dynamics, from one commodity to the next differentiation is really key.

Kevin: One of the things you’ve tried to do is talk to the guys who were boots on the ground. You quoted Stephen Roach, who of course, he was with Morgan Stanley for years. And that was the China side of things. I mean he was in charge there, but you know some pretty eclectic guys, and Michael Pettis is one who lives in Asia. He owns, I think I haven’t been there, but he owns, it’s like a disco-like club downstairs and then his office upstairs.

David: Yeah.

Kevin: You had a drink with him, didn’t you?

David: Sure.

Kevin: And he’s just— but his insights into China. I mean, I think, I don’t know, wasn’t he born in Spain?

David: I don’t know if he’s still running the nightclub, but he kind of fancied himself as starting a new music scene, global music scene, and participating in running a label.

Kevin: But yeah, when he looks at economics, he’s a smart guy. Yeah. It’s a little bit like the guy who’s standing in that one spot with the elephant that you’ve never seen before.

David: He’s an emerging market bond trader.

Kevin: Okay. 

David: For years. And now teaches finance.

Kevin: And he’s focused on the five-year plan. China has five-year plans and they’re patient.

David: To some degree you could say that his views currently on China mirror Steven Roach’s. You got the five-year plan coming up. That’s 2022. And between the PBoC and the politburo they will pay for stability between here and there.

Kevin: Okay. So this is the everything buyer. It’s just a different way of doing it.

David: Yeah. So what is it going to take, and yes, they’re pumping the brakes and they’re going to have this policy and that policy, which tightened things up. And then last week they threw in another $71 billion in the banking system. So on the one hand, they’re tightening the screws on this segment of the economy or this particular business community. And then on the other hand, they’re re liquefying. 17 billion here.

Kevin: Easy come, easy come, easy come.

David: But I mean, what we have is cracks in the Chinese credit markets. They’re there. If they widen the cost to maintain financial stability, we’re talking about requiring additional hundreds of billions, likely trillions, of dollars. And so we can also look at 2022, post-their five-year plan, and begin to see currency trends, the RMB and emerging market currencies being very dramatically impacted. And of course, there’s commodity trends, which we talked about just a minute ago where things like industrials, that’s not the same as energy commodities. Iron ore stands out like a sore thumb given that the consumption dynamics that we’ve had in the past with China versus what they might be, assuming that you have a change in the real estate sector within that country.

Kevin: So for the listener who says, yeah, but we’re talking, I mean, that’s China, that’s a long ways away. I’ve never even been to China, they say, does that affect the inflation here on our shores?

David: Well, I mean a massive Chinese reflation fits in the larger context of already heightened global inflation pressures. That’s already here. So we the OECD chief economist last week said something to the effect that managing inflation would be very difficult for policymakers, a difficult balancing act. And it is global. We’re experiencing it everywhere. Not everyone is particularly cognizant of what the man in the street is experiencing. I got this picture from a Financial Times article. The ECB has promised to vigilantly watch for any signs of supply-side bottlenecks and higher wages driving prices higher than expected. So they’re going to watch out for it and they’ll let you know when what happens.

Kevin: So they’re telling you that they’ll tell you when they hear the train coming through town, but I think the train’s passing.

David: It’s like they haven’t left the house for 12 months. It’s like they’re still in lockdown.

Kevin: We’ll listen for that inflation. We’ll let you know when it becomes a problem.

David: And there’s two things this last week which may end up being significant. Again, time and policy responses will tell, but we had two things that stood out. And again, this is sort of front and center in our asset management conversations this week. Change in market internals. The first was a shift in corporate credit. And the second was a shift in sovereign debt, particularly credit default swaps that apply both to US corporate bonds and specifically Chinese sovereign paper.

Kevin: That’s the cost of insuring volatility, basically on—

David: Cost to insure against default, we saw credit default swap prices rise. And then this week remain elevated in both cases. So into this week. So this is key because we haven’t really seen much happen with US corporate credit. For all the volatility we’ve seen on and off and on and off, you could look at a chart of the VIX and we’ve had volatility.

Kevin: Volatility. Yeah.

David: Yeah. We’ve had volatility as VIX measures, put/call ratios and volatility there, but in terms of the market internals, no one has been concerned until last week. And it carried over into this week.

Kevin: And they’re buying insurance.

David: The first time that you’ve seen a significant bump in the insurance cost for corporate credit and for Chinese sovereign debt just happened. And again, will it continue? We’ll have to see, but if there is further deterioration on those two fronts, we could be launching into a real market squall.

Kevin: Okay. So for the person who’s actually analyzed how the Fed makes decisions, they’re going to have to start analyzing again, because some of these guys were caught—are we allowed to say this? That they were caught trading the very things that they were printing money and buying with Fed money, but it was in their personal portfolios. Dave, is that legal?

David: I think you have to go back to reading Animal Farm to recognize that—

Kevin: More people.

David: —some pigs are more important than others.

Kevin: More equal. Yeah.

David: So I know, it’s funny how fast Kaplan and Rosengren walked away from their Fed positions.

Kevin: They’ve got health issues.

David: One’s got kidney issues. I don’t know if that means he peed himself when he found he was going to get in trouble for insider trading or the equivalent thereof. I don’t know.

Kevin: The mighty Fed. At the mighty Fed you’ve got insider trading within the presidents of the mighty Fed.

David: They’re not going to call it insider trading.

Kevin: Of course not. 

David: It’s going to be personal portfolio allocations, in the case of Kaplan. And it’s 27 different positions, each a million dollars. And we’re talking about a sizeable speculation on market outcomes. But isn’t it interesting, coming back to where we started, the Fed hopes to determine market outcomes. So how is it that people are betting on market outcomes they believe they can control?

Kevin: Wow.

David: I think it’s actually quite convenient that they’re leaving, sort of exit stage right at this point, because the realities of market dominance and market power and the humiliation of that market pretense currently held by the Fed, that’s what’s about to be on display.

You’ve been listening to the McAlvany Weekly Commentary. I’m Kevin Orrick, along with David McAlvany, you can find us at, And you can call us at (800) 525-9556. This has been the McAlvany Weekly Commentary. The views expressed should not be considered to be a solicitation or a recommendation for your investment portfolio. You should consult a professional financial advisor to assess your suitability for risk and investment. Join us again next week for a new edition of the McAlvany Weekly Commentary.

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