The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
“Anything is possible. We have melt-up dynamics in the stock market. As we mentioned last week, technical and fundamental factors are temporarily irrelevant when the bulls get running. The two most important factors heading into 2017 will be interest rates, and the direction of interest rates, and the rate of inflation. These are factors, even if ignored in the short run – they run the markets in the long run.”
– David McAlvany
Kevin: David, I just want to take the moment now to wish everyone a Merry Christmas. I can tell you that Sunday I got a chance to see both your wife and your son, who as Tiny Tim, your wife as a number of characters in a fabulous rendition of A Christmas Carol. I’ll tell you what, that story really puts things in perspective.
David: It’s one of our favorite stories as a family and it was neat to have Tiny Tim, the ghost of Christmas past, Bob Crachit’s wife, and all of that kind of bundled into our family this year.
Kevin: You know what it reminds me of, though, Dave? As Charles Dickens was writing this story – actually I was talking to my wife about this as we drove home – I just wonder how many lives that story has affected? You see the same types of concepts biblically, of course, where you look back in the past – that was the ghost of Christmas past – and you remember. The Bible talks a lot about remembering. You’ve talked a lot about remembering in your legacy book.
Then you come to the present. What’s really going on in the present that is important, not necessarily urgent? There is a difference between importance and urgency – the urgency of the moment. Then of course, you have the ghost of Christmas future where you look ahead and you say, “What really was my life all about?” It’s a Wonderful Life does the same type of thing. Those two are timeless – A Christmas Carol and It’s a Wonderful Life.
David: Good literature and good storytelling do that. They make you reflect on different issues within your own life. Charles Dickens looks at legacy in a unique way, the book that I wrote and is now available on Amazon – that is, I think, captured in Dickens’ quote, “Men’s courses will foreshadow certain ends, to which, if persevered in, they must lead.” This is what Scrooge said. “But if the courses be departed from, the ends change.” Very importantly, though, if those plans do change we could see different ends.
The verdict is out, and we’ll see in 2017 and 2018 if, in fact, our national legacy of debt, of overconsumption, and things of this nature can, in fact, be shifted. We’re hopeful, but I think also realistic in terms of the limitations. And you know, I think one of the biggest limitations, as I read through the most recent copy of Foreign Affairs, is that the folks who are interested in an international order, I would strongly recommend reading the January/February addition of Foreign Affairs.
Kevin: That’s the publication of the Council on Foreign Relations. These are the people who would like to see a world order.
David: And they’re disturbed right now. They’re very disturbed. And you get that in the articles that they’re reading: World Order 2.0: The case for Sovereign Obligation; Liberalism in Retreat; The Demise of a Dream; The Once and Future Order: What Comes after Hegemony?; Will Washington Abandon the Order?; The False Logic of Retreat. Just over and over again, there is this sense of, “Guys, we’re losing, here.”
Kevin: “Everything we’ve worked for, for this last 100-200 years, could all be lost to individualism and freedom.”
David: That’s right. And Trump faces what I think is considerable opposition, and considerable backlash from the victory.
Kevin: They’ve declared war against what they think is going to dismantle their system, Dave.
David: We have the Dow at 20,000 and that’s an interesting place to be as we head into the end of the year. I believe it’s the new 1,000. And if you look at the rise in stocks, the bull market from 1949 to 1968, it was driven, for many good reasons and for many bad reasons. But one of the things that we saw throughout the 1960s was the guns and butter policies, which had to ultimately be paid for in the next decade.
Kevin: Right. It was the building of debt. We had to go off the gold standard during that period of time, as well.
David: That’s right, just a few years after that, and the real problems began in 1968. Guess where you saw them first? You saw them in the currency, you saw them in the unwillingness of the French to take dollars in payment of debt. In fact, they were insisting on gold. That began in 1968. If you go back to the articles written in Le Monde magazine, by Jacques Rouffe, his real compelling arguments against the U.S. dollar and against our stability were in that 1968 to 1970 period.
Kevin: He saw the handwriting on the wall and he was actually warning France and de Gaulle to go ahead, while he still had the opportunity, to redeem his paper dollars for gold.
David: That’s right. And actually, he wouldn’t have written in Le Monde if de Gaulle had paid attention up front. But de Gaulle refused to listen, and so he went to Le Monde and started publishing the articles and it became a popular idea. And all of a sudden it was almost like, politically, de Gaulle’s hand was forced and he saw the light of day.
Kevin: That’s interesting. I didn’t know that part of the story. I thought de Gaulle just listened to him.
David: No, no, no, de Gaulle was not open to it at first, but again, there was a bit of public persuasion that occurred between 1968 and 1971. So, when we look at the U.S. stock market, we got to a peak in 1968 which was not taken out until 1982.
Kevin: That became almost a ceiling. People thought, “Well, once it hits 1,000 it’s going to go straight on up from there.”
David: That’s right. And the real issue was that during that period of time, 1968 to 1982, you had a massive rise in inflation. And that, quite frankly, was not helpful for equities – not helpful at all. Even though you could say, “Hey, we’re sitting here around 1,000,” you certainly had 30-40% downside during that period of time – 1974, the year I was born, was a tough year in the stock market.
Kevin: You mentioned inflation. With the fiscal spending – Johnson was very much a fiscal spender. You were talking about guns and butter. We were spending money we didn’t have. That’s why we had to cut off the gold window. We could no longer redeem cash for gold because we had too much cash circulating out there and not enough gold to back it.
David: One of the critical ingredients to keep people invested in U.S. equities in the 1970s was the price action leading up to that 1968 peak. If we could get to 1,000, we could get to any number, and it really blew people’s minds that you could this high. It captured their imaginations and all of a sudden thinking in terms of 2,000 or 3,000. It was like, “Well, we’re at a 1,000 now, why can’t we go even higher?” And they stayed invested in a really tough period of time. Again, 1,000 was a number that represented a ceiling for better than ten years.
As the inflationary impact of monetary and fiscal policy filtered through the economy and showed up in the markets, not only did you have the volatile sell-offs that brought the price levels down 30-40%, but again, recovery is kind of capped at that 1,000 mark. Inflation, during the interim, was massively eroding your returns. So again, the annual inflation bite ended up reaching double digits, so even though you may think, “Well, I got to 1,000, I’m staying at 1,000,” or let’s say it’s today, “We’re at 20,000, we stay at 20,000.” I think inflation is what catches you by surprise over the next decade.
Kevin: So those three zeros behind the number back in the late 1960s became a ceiling, and what you are saying at this point is, the 20,000 – the 2 with the four zeros behind it – may become that same type of ceiling. You talked about it last week. We, right now, from over-valuation point of view, just looking at the various numbers, we’re more over-valued than we’ve been any time except for three other times in history.
David: That’s amazing. John Hussman noted that the four-week average of investment advisor bullishness is at the highest level ever.
Kevin: Oh, so it’s a new high. It’s not three or four times back, it’s the highest level ever.
David: Well, again, he echoed our comments that, looking at other valuation metrics it’s the third most over-valued extreme in history. But the four-week average of investment advisor bullishness – that is higher today than either the year 2000 or 2007 at those peaks. And it is worth noting that Hussman sees, actually, much lower rates in the future, and would argue against a real trend reversal in bonds at this juncture. He is a bond guy through and through, and I never ignore the man. He knows fixed income very well, and he is suggesting that we all know what over-priced looks like, but not everyone can stay away.
Kevin: Dave, it’s contagious. It’s contagious. When you combine things that are unrelated, when you say, “Oh, wow, that was an amazing change in the political process when Trump got in.” Or Brexit. Or this Italian referendum. We’re starting to combine things and say, “Maybe things could be different. Maybe the stock market is the place to go.”
David: I think it’s the moth/flame syndrome in full effect. It’s just fascinated by the light. “We must get closer.” And we are absolutely transfixed by the warmth and the light.
Kevin: Are you disdaining hope, Dave? Are you throwing hope out the window?
David: Well, I have a great idea. Let’s do this. Let’s sell every ounce of gold and silver, let’s go into stocks – actually that was a conversation I had with a client early this week, and I think the context helped dissuade the decision. Here’s what we consider. Look at 2015. Do this as a reflection on the last two years, and perhaps why I say with tongue in cheek, “Sell every ounce of gold and silver and go into stocks.”
Kevin: So you’re going to 2015.
David: 2015. For the first time in 5,000 years the world accepts negative nominal rates and the U.S. continues to operate at negative levels in real terms, when you factor in inflation.
Kevin: Let me repeat that back, because before 2015 there had never been negative rates. And within a very short period of time after 2015 started we started seeing it actually get up into the trillions in negative rates.
David: Right. Now 2016 rolls around and there is a shift to remove cash from the system. And the context is, of course, critical. You have a welfare state which requires more in resources each year to merely exist, and its needs are increasing. Thus, the value extraction –value extraction is the operating principle. Let’s review this again. You have negative real or nominal rates, and then the next year we have the initiatives to lock down the financial and banking system by closing the exits, and that begins in earnest in 2016.
Kevin: Like we’ve seen in India, what’s going on in Venezuela, what’s going on in Europe, actually, in some of the Scandinavian countries.
David: In our office meeting this morning, Kevin, we have a gal here whose daughter lives in India. So this is as close from the horse’s mouth as you can get, one step removed from a gal who lives there and is dealing with the long lines to get cash. Incoming wires – bank wires – they’re charging between 20% and 30% just to receive them.
Kevin: So the wire gets there and they just go ahead and take their transaction cost.
David: That’s right. And the other change in the last two weeks has been a confiscation of gold, where married women are allowed 250 grams, which is the amount that you are allowed to wear on yourself. An unmarried woman is allowed to keep 150 grams. Men are not allowed to keep as much. And they have gone house to house collecting gold. Now, there is an issue in play, here, which Modi is trying to address, which is, the vast majority of Indians are not in the tax system, and he wants to ramrod getting everyone into the tax system. So from a central planning standpoint, I get what he is trying to do. But what is fascinating is the amount of change in an under-developed world that is being squeezed into the last quarter of 2016. You have a national ID that is attached to a phone number, a bank account. There is a biometric component to it. All of this is being sold by Modi as modernization.
Kevin: The strange thing is, Dave, I’ve talked to a couple of people who know people from India who are upper middle class, highly educated – they live here in America – and they’re actually all for it. They were surprised it happened so quick, but they said, “You know, we’re finally modernizing.”
David: Right, but from one vantage point you can understand, if there is less than 10% of people who pay taxes at all, bringing them under the tax roll allows for better organization of a democratic institutional – whatever. But here’s why I’m cautious to concede very much on that front, because I know that governments never stop growing, and giving an inch, they will take a yard. This is the notion in Robert Higgs’ book, Crisis and Leviathan, that there is no amount of revenue that a government will say no to. They want it all. Ultimately, they want it all. Now, they know that if they ask for it all, they’re not going to get it all, and that’s the notion of being able to steal surreptitiously through inflation and negative rates and other ways that increase the tax burden on a public without doing that on an announced basis through normal legislative means. But you have folks who are wanting that. And it’s just fascinating to watch what is happening, because if you eliminate cash, what is the go-to in terms of an opt-out from a financial system? It is gold. So, now in the aftermath of eliminating high-value cash notes in India, they are moving to gold. We are seeing smuggling premiums on gold as high as $300 an ounce. What did I tell you a few weeks ago? The best way to guarantee a 1,000% return would be, what?
Kevin: To go ahead and hire some sort of pack animal.
David: Organize your mule train through Pakistan, through Kashmir and India, and just smuggle gold from the Middle East.
Kevin: Even if Trump doesn’t have the same intentions, let’s face it. Modi was put into office as pro-business and pro-modernization. We’re hearing very similar types of things from Trump. And again, I’m not trying to throw egg on Trump’s face, he may be stuck in a system that is already built this way, but let’s go back to 2015. To have negative interest rates and force negative interest rates on someone, you also have to take their option to retreat, or their option to exit, out.
David: Yes, and I think this is what’s happening. We’ve had test case after test case, if you go back and look at Europe, from 2011 to 2013, if you include the Cypress events, the ongoing Greek debt debacle. By the way, this week, Greek is back in the news with major debt issues recurring.
Kevin: Not just Europe, look at China – people trying to get their money out of that system.
David: That’s right. So, you’ve got capital flight, with it, financial destabilization, the rush for the exits in China. On a month-to-month basis, they were averaging 50 billion a month. I think it pushed closer to 60 billion last month. And it’s leaving the country with this desire to reinforce an imperative – gain control of all capital controls, don’t allow money or capital to flow freely. And what I want to do is, next year, kind of postpone this conversation, but there is the emergent social credit system in China – again this is really for next year – but it is interesting that as the Chinese bond market hits the wall, this week capital continues to hit the exits, the Chinese government is hitting the go button on digital totalitarianism.
It’s basically a reward and punishment metric tied to your state file. So, if you’re a good boy, you’re going to do this and this and this, and you’ll be able to travel and you’ll be able to invest and buy a house, and you’ll be able to enjoy the niceties that we have in modern China. And if you’re a bad boy, and you oppose our policies in any way, you’re basically on lockdown.
Kevin: It’s a merit system. It’s interesting, there have been a couple of people that you’ve talked to on the Commentary, Dave, that you’ve had to talk to ahead of time to ask what you can talk about, and what they were not willing to talk about, because they were actually speaking from within the borders of China. We don’t think this way here in America, but if you are noncompliant in a quasi-communist system, you either go to the gulag, you go to Siberia if you’re Russian, or in the Chinese case, maybe you just have some merits taken away and some opportunities squashed.
David: You have central planners today that have the tools, they have the intellectual arguments, and in many geographies, they have the mandate. And that, actually, is easy enough to get when a crisis dynamic moves into play.
Kevin: Could that happen here in America?
David: If you were told that moving toward a cashless society here in the U.S. was a key ingredient to making America great again, the question is, who would object? Or, who could object? Because now you’re opposing American greatness. The way things have been structured, the dynamics and the rhetoric used in the election and up to this point, if you object to anything that Trump wants to propose, what kind of a person are you, and why would you oppose us becoming great again? Actually, what sympathies do you keep to yourself, or harbor?
I think 2015 opened the door for 2016. That is, essentially, what we’re saying. Negative rates open the door for a move toward a cashless society. That’s being experimented with in various geographies. 2016 opens the door for a bold new top-down action to be implemented in the realm of money and banking, and I don’t know exactly what they looks like, but we know that 2017-2018 is a brave new world here in America.
Kevin: Well, okay, for the person that you mentioned before that wanted to just go ahead and pull out of gold and invest in the hope of the stock market going up, even though it’s hitting all-time highs, what you and I were talking about after we heard that was, “Well, you know, this guy’s going to be right, until he’s not right.” And the moment he’s not right, there just isn’t time to shift things back around.
David: Well, and I want to come back around to talking about interest rates and inflation in a minute because these are two of the variables that fly in the face of a successful implementation of Trump’s policies in terms of creating long-term sustainable economic growth. But you’re right, we assume that all is well until all is not well. And it can be frustrating at times to look at unsustainable finances and witness them going from bad to worse, without any concern being expressed by those around you, or being acted upon.
We’ve recalled in our client presentations throughout 2016, what we called the year of transitions, I quoted Lenin wherein he said, “There are decades where nothing happens, and weeks where decades happen.” And we’ve seen this in real-time here recently with the withdrawals from the Dallas pension system which have been frozen. Those withdrawals have been frozen. You have had 500 million dollars yanked since October 13th.
Kevin: Talk about people seeing the handwriting on the wall, we talked about de Gaulle back in the late 1960s, the people with pension funds that are out of Dallas are taking money out at three, four, five times the rate that they were just last year.
David: Yes, the total for this year, 2016, is at 600 million. Contrast that with 81 million last year.
Kevin: Okay, so over six times.
David: Yes, they started the year with 2.8 billion dollars and sufficient funds for 45% of all future obligations. So, yes, they were under-funded to begin with, but obviously, the funding percentages are worse after the withdrawals which have occurred. This is the equivalent of a modern day bank run where, after the cost of living adjustment which was well above the CPI at, frankly, reasonable in my opinion. But you did have over-generous pension promises. You had the old guard see the increasing odds of there being an adjustment, a cut in benefits.
And so what is their response? Seeing the handwriting on the wall, as you say, they yanked out as much as they could, moved to retirement, and I think that’s a fascinating small little picture of, yes, the finances were unsustainable, and actually, you were fine until August 12th. But the difference between August 12th and the date today – half a billion dollars just disappeared, and it is what caused their pension scheme to go from more than mildly under-funded to desperately under-funded.
Kevin: The difficulty we all have is, when we see the cracks in a system, we sometimes need to know when to get out. There were pension funds 10-15 years ago – I have clients that were very, very concerned about their pension funds, they saw cracks, they went ahead and pulled out – and now those pension funds are still in existence. And then there are other people – I remember in the airlines, especially, where they saw cracks in the system. I have a pilot client of mine. Had he not have gotten his pension out in time, it was gone.
David: That’s right. Yes, just get ready to work an extra 20 years. In preview, a couple of things that we have to consider today. You have fiscal spending, along with three or four other factors which are likely to drive inflation and interest rates higher. And these are the two factors, inflation, and interest rates being on the rise, which threaten to pop the bubble in asset prices. First, we’re going to get economic growth from fiscal spending, and that is probably going to be late in 2017 that we see that positively impact economic growth. But second, you have a continued rise in interest rates with that third component being a stumble in asset prices as stocks and bonds weaken in tandem. This is some irony because, again, rising interest rates begin to pressure the bond and stock market and we could actually see weakness in both of those markets continue, even as economic growth is improving.
Kevin: Dave, I think it’s important to look at how America has grown over the last 30-40 years, because we have to understand, there is a symbiotic relationship between us running deficits with other countries like China. Let’s just go ahead and say we run a trade deficit with China, which means China sells us more goods than we sell them. They have more dollars after that – they receive dollars. And the agreement – it’s sort of an old boys’ agreement – “Hey, listen, we’ll continue to do this as long as you loan us back that money.” It’s the same thing with oil in the Middle East – petro dollars. That has worked now for decades. What Trump is talking about is bringing that home and pretty much getting rid of the trade deficit. So, what does that look like?
David: You know, any reduction in the current account deficit decreases the capital inflows into the United States, and it makes it more difficult to finance our budget deficit. So, in essence, a new target audience for treasury purchases has to be chosen.
Kevin: So if it’s not the Chinese, and it’s not the petro dollar nations, then could it be us?
David: Audience A would be you and me – conscripted accounts. Audience B would be the Fed, who may be willing to expand their balance sheet again and purchase treasuries under the right circumstances. At present, you have massive central bank purchasing of paper and there has been an artificial scarcity in the fixed income markets.
Kevin: Because you have an unlimited buyer, Dave.
David: That’s right. So, you have a boost in asset prices, a suppression of interest rate yields, and that artificial scarcity is created by an artificial buyer. As we’ve suggested in the past, when Europe and Japan start to shrink their purchases, which the ECB has recently announced, the liquidity provided to the market, which is allowed for financial asset prices to inflate, it’s going to have to be provided by another central bank, or guess what the consequences are? Asset prices which have been inflated on the basis of those capital flows will revert to their mean. They will drop to more natural levels without that continued influx of new capital.
Kevin: Well, now, let’s take things from an opposite perspective here for a moment. What we’re talking about is when the United States borrows money from China with dollars that China had received over and above what we received of theirs, that actually financed the growth here, and the growth in China. Now, you have been bringing up the rise in the dollar value, which, if we go backward and we say, okay, what about those countries that borrow from the United States in U.S. dollars, or even from each other in U.S. dollars? The dollar has been on a rage, Dave. It’s just tearing to the upside at this point.
David: Yes, we’re just shy of 104 on the index and if we can clear 104 there appears to be nothing keeping it from going to its old highs of 120. And it appears that Trump’s policy proposals have a few embedded issues. Not only has the prospect of the Trump presidency raised the value of the U.S. dollar, but as you mentioned – and this is where it gets really critical – that creates a stranglehold on global liquidity. That has already happened. But the implementation phase of his fiscal spending quite likely will continue these trends, taking us to a higher level of interest rates, and a stronger dollar, and actually, a rise in inflation, as well. That is a dangerous cocktail. Don’t think Manhattan, here, think Molotov cocktail. The financial system is highly geared, and it’s over-leveraged, and bringing in to an indebted society an interest rate increase is a bit of an issue.
Let me just give you an example. Out of the 70 trillion dollars which we have in the financial system here in the United States today which represents debt, 20 trillion of that, Kevin – 20 trillion of that – has to be refinanced in the next two years. So, you basically will be paying higher interest rates on 20 trillion dollars just here in the United States. So, when you get an interest rate reset you’re talking about a major cash flow requirement.
Kevin: I think you knew what the question was that I was going ask you, because Janet Yellen has already said she is going to raise rates, possibly three times, in 2017. Raise rates on what? It’s on the 20 trillion dollars in debt.
David: What that means is that you’re going to increase your budget line item, if you’re just talking about the national debt, our U.S. debt, by probably 200 billion dollars next year. You raise rates three times and you’re probably increasing that line item by 200 billion. I don’t know what it would be if you’re talking about corporate and private debt because you’re talking about a radically different yield curve, if you will. Private debt is a lot more expensive – 4, 5, 6% as opposed to the 2 to 2.5%, on average, that the Feds pay.
Kevin: But this time last year Janet Yellen talked tough and we didn’t have any interest rate increase until just recently. Now she’s talking tough again. But you had talked about Foreign Affairs, the CFR, the central bankers. Are they happy enough with Trump to not raise interest rates on him, or could they pull the rug out from under him by literally, while Yellen is still in office before she gets moved out – could she actually be the mouthpiece of the CFR, or whoever, and just pull the rug right out of this whole plan?
David: It’s an interesting thought experiment, and again, I encourage you to read January/February 2017, the Foreign Affairs magazine from cover to cover because you do get the sense that sort of the established world order is not happy. No happy at all.
Kevin: Do you think they might declare war on Donald Trump while they still have the power of the central bankers?
David: And the only time that they have power over the central bankers is in 2017 because you have both Stanley Fisher and Janet Yellen leaving in 2018. So if there is going to be any major changes, policy shifts of a monetary nature, it’s 2017, baby. And if you want to tighten the economy and create something of hell to pay for the Trump administration, do you do that now? Do you send a message now? Do you damage reputation now? Because you have folks that are very interested in a globalist agenda which has been set back considerably by this populist trend.
If it continues, and he ends up being a success story, he gets marked in history as a major turning point away from that globalist agenda and back toward something that is far more nationalist. And I can tell you, the folks in Europe who spent 25 years putting together the euro project are no less concerned, and they’re certainly not interested in seeing the kinds of things that are happening in Italy with Renzi, or with the five-star movement in that same country.
Kevin: And remember, in the Federal Reserve alone, it’s almost all Democrat. They may have a couple of token Republicans in there, but for the most part, that’s where their funds go as far as their own personal funds. It’s a Democrat organization. So, like you said, it’s a thought experiment, you’re not necessarily predicting an all-out war against Trump, but interest rates – that war could be fought with interest rates and debt, could it not?
David: Well sure. And think about this, because you’ve got until late 2017, at the earliest, that we’ll see any impact from new fiscal policy measures. The stock market has gotten happy and excited, and has priced in the success of those fiscal policy measures before they’ve, one, been announced, two, been implemented, three, been proven to be successful and show positive ROI.
Kevin: Right. It’s hopeful exuberance. That’s all it is.
David: It is, which means that there is about a three-quarter gap between the enthusiasm that is priced in and the actual delivery of dollars into the economy. So this is the danger period, from right now until the fourth quarter of 2017, because we could have monetary policy tightening without fiscal policy largesse being rolled out with real dollars being spent as some sort of a substitute for that monetary policy tightening. I think having too much debt – this is the issue that serves as a backdrop – it can be managed as long as we keep interest rates at a low level.
But when too much debt meets higher rates, that is when the wheels tend to come off. So I fully expect 2017 to hold the seeming contradiction of improving economic statistics and declining equity and bond values as we begin to feel the impact of higher rates and a strengthening dollar translate into both balance sheet and income statement realities, which in my opinion are financial market negatives.
Kevin: So if interest rates go up, consumer spending goes down. If people have to pay more to borrow, what replaces that?
David: Government spending will offset the decline in consumer spending to a degree, but one of the consequences of higher interest rates is just that – you’re going to have to have the government step in and replace the consumer. But here is the added question. When infrastructure projects come to a close, and interest rates have settled in at higher levels, the consumer is not going to be stepping back in to spend to the same degree. That’s what happens in a rising rate environment.
But just to make sure we’re not getting ahead of ourselves, we go back to the need for deficit financing, and as we attempt, under the Trump administration, to “bring the jobs back from overseas” and create and consume more of our own products, and as we increase oil output domestically – not a bad idea in my opinion – guess what happens? The trade deficit shrinks, and that requires creative financing of the budget deficit because again, trade deficit is our dollars going out, and then those dollars coming back in as capital flows to finance with the deficit dollars that went out in the first place. If you can’t recycle that, you’re in a real bind.
Kevin: You know what this reminds me of? I was just talking to a doctor the other night when we were having dinner. I said, “You know, I hate to admit it, when I had eye surgery, I really liked taking Vicodin. I liked it. It gave me just an overall feeling of everything was good. It wasn’t a high, it just made everything good. And from an economic standpoint, the Vicodin of the economy over the last few years – I’m hearing this little bug say, “QE – you want your QE – quantitative easing.” So, you can manage it with interest rates, but do you think we’re going to see a reinsertion of something that worked so well before, that we could almost get addicted on?
David: Yes, there is the expectation of greater QE in the future, in my opinion.
Kevin: “Here’s your Vicodin.”
David: It’s either QE to infinity, or it’s corralling of investors into U.S. bonds. And the global trend which we talked about earlier toward pushing all savings into the financial system is a near certainty in the U.S. over the next four years.
Kevin: And what that does is, it leads to inflation.
Kevin: If debt is too high, you have the two Ds of debt. If I owe you money in your currency, I can either default in the currency or pay it back. And if I can’t pay it back I’m going to default. That’s D number one. If I owe you in a currency that I can print, I just devalue the currency. I just print it. It’s QE. It’s Vicodin. And that creates inflation.
David: Right. And we’re going to reach a certain point, and maybe that’s 104, maybe it’s 120 on the dollar index, but at some point you have, as we suggested a few weeks ago, a return to the Plaza Accord where we had a 50% devaluation of the U.S. dollar orchestrated by the Bank of Japan, the Bank of England. The German central bank was also involved with that, along with our central bank.
Just to summarize then, we have a shrinking trade deficit, which is a big objective for Trump, that forces the Treasury to get creative on budget deficit financing, and if it’s not from abroad then you have domestic savings which will do the trick, conscripted, of course. Or you have quantitative easing. Borrowing from abroad, frankly, is not likely, because you typically see capital inflows shrink with the shrinking of a trade deficit.
Kevin: We talked about how the United States grew over the last 40 years. You took us back to 1968. That’s really when things changed.
David: Rapid credit growth from 1968 forward, largely stimulated by policy shifts. We had the death of Bretton Woods. We had the expansion of central bank mandates. We had the late 1990s deregulation. These opened up periods of hyper-growth in credit. And that system works, but it requires a lowering of interest rates to balance out the increased burden of debt, so that at least from a cash flow perspective, it’s manageable.
Kevin: Well, and that’s been happening since 1981.
David: But it backs up and dies in a rising rate environment.
Kevin: Which we have not experienced, Dave, in our adult lifetime.
David: So the bottom line – an interest rate rise will trigger a collapse in asset prices. We have an over-leveraged system – everybody knows that – and it cannot take the strain of higher rates. So that leaves us with this question. Today we’re posturing for a three times increase in rates next year, and again maybe that happens. I think it begins to put the bloody terror in the stock market, if that’s the case. Objectively, we talked about the Taylor Rule a few weeks ago, and how the Fed is already behind the curve. They should have increased interest rates more than they have. They’re behind the curve.
Markets are signaling higher rates, and now the Fed is suggesting the three separate increases in 2017, very similar to the four slated for 2016. Only one of those occurred. What is the impact? That’s what I’m after. What is the impact? Let’s look at something that has not been in the news for a while, but may very well be in the news in terms of a major catalyst for crisis in 2017 and 2018 – derivative market growth.
Kevin: We haven’t heard that named much since the financial crisis, really. We haven’t heard much about derivatives.
David: From 1987 you started seeing that market grow exponentially. Prior to 1987 it was maybe a 900 billion dollar market.
Kevin: So, less than a trillion bucks back then.
David: That was in the late 1980s. Fast forward to 2000 levels and you would increase to 100 trillion. So in the decade-and-a-half, roughly, less than a decade-and-a-half, it moved up 100 times. When major deregulation occurred, that’s when you began to see even greater growth. This was under Clinton, and it was at the direction of Robert Rubin, former Goldman alum. That deregulation occurred, it opened the door for OTC derivative trading to reach 700 trillion by 2008.
Kevin: And that was best estimates, because I heard some people say it was even over a quadrillion.
David: That’s right. So we’ve fallen from the 700 trillion notional value numbers to current levels of 550 trillion. It’s still multiples of the year 2000 level, and still a very nontransparent area of the market, where frankly, if you’re going to manipulate currencies, commodities, fixed income markets and equities, it’s a great place to go. Why? Because there is not a lot of recourse, and the SEC basically says, “Don’t ask, don’t tell.”
Kevin: Well, let’s review what a derivative is. First of all, no derivatives look alike. You have trillions of dollars worth of derivatives, but the reason they’re hard to figure out is because they’re quantized into different areas. But a derivative is really sort of an insurance policy against a number of different things happening. Or it’s a bet on a bet, on a bet, on a bet. So, if I understand right, the reason they can’t really quantize a derivative is because each one has its own hybrid and they don’t really know how to factor in the risk.
David: Yes, and there are some derivatives that simply don’t trade. They’re contracts that are written. And a three-inch stack of papers could represent one contract, and there are two people on the planet that have read it, but there are thousands of people that are implicated because of the obligations made through that contract.
Kevin: So the question is, why do we even mention derivatives? We can’t value them, and have we seen them pose a risk in the past?
David: Well, because there is a multiplier effect in the financial market due to the presence of this quantity of derivatives. If you impact asset values in a negative way, you trigger a daisy chain of interconnected financial losses.
Kevin: A little bit like what we saw with AIG?
David: Because, well, derivatives derive their value off of a base asset, and that could be in the fixed income market, a particular currency, that could be in the stock market, a particular sector within the market, or a particular stock, itself. Commodities and derivatives, specifically, connected to one or more commodities, fixed income derivatives, credit default swaps and things of that nature, related to interest rate differentials – these are all derivations, or they receive some value off of the base asset. So if you impact asset values in a negative way, you trigger that daisy chain of interconnected financial losses.
This is important for the banking sector, and of course, for individual investors who are sitting in cash, sitting in stocks and bonds, because what it does is, it changes the math. It changes the implications of small losses. And it means that small losses are not necessarily contained losses, and can become much bigger. Since the global financial crisis, the plumbing of the financial sector has been changed, and I think this is particularly important right now.
Kevin: Is it for the better or the worse?
David: Well, there are firms that have specialized for decades, even centuries, in making a market in a particular stock, or a particular segment within the bond market.
Kevin: In other words, they’re saying, “Look, if you ever need to sell this, call me.”
David: They stand at the ready to purchase, they made an inventory of those assets. But those ranks of market-makers have been trimmed by 50% or more. And you have market-makers in fixed income securities that have all but gone away. So here we are sitting at an inflection point, with bonds on the cusp of moving into a secular bear market. Again, we’re still waiting for 3.5% on the 30-year as confirmation, but there is a greatly diminished audience of wholesale buyers, the folks who would represent your liquidity for fixed income instruments, unless, of course, you want to count the artificial buyers we discussed earlier.
Kevin: Which are the central banks.
David: That’s right. So with the advent of dark pool trading and with high-frequency trading, equity market-makers are in a similar position. Either they join the ranks of the millisecond speculator, or they get run over by an algorithm. And the pools of capital that are willing to buy and backstop the financial markets have changed.
Kevin: But Dave, we have this voluminous new set of regulations called Dodd-Frank.
David: And to some degree it’s actually exaggerated this trend and gotten rid of even more market-makers, people who would have represented liquidity for the stock and bond investor. The net effect – when a lot of people want to sell, the volatility is going to be far greater. The price swings, if you set aside for a moment the Plunge Protection Team, their interventions, the price swings are going to be deeper. These are all moot points. These are all moot points if we’re comfortable with the nationalization of the securities markets where government control comes in and represents the largest footprint in the market.
Kevin: A guest that we have on a regular basis, Dave, a friend of yours, Bill King, has continued to say that that is what had occurred. There has been a nationalization of the markets. The markets don’t represent reality at all right now.
David: Which is one more reason why I struggle with folks who would go into the stock market, just into your general equity funds today. Why? Because you’re not talking about capturing the strength of the U.S. economy in this marketplace, where the best of ideas rise to the top, and where entrepreneurialism and good ideas meet with rewards of capital allocated in their direction, businesses thrive, etc. If the stock and bond markets have been nationalized, as is suggested by Bill King, what are you investing in? You’re investing in a rigged game that is a little bit like the Bernie Madoff rig. It’s going to work until it didn’t.
Kevin: It’s a disconnect with reality. When you have these hitting all-time highs and all the meters that have told us when there would be a collapse before, it’s not your patriotic duty just because you like Trump to go out and buy stocks right now.
David: I want to consider just a couple of the market dynamics that sort of illustrate a quasi-psychotic character in play right now. Again, you know what psychosis has to do with. It’s an impaired relationship with reality, right? So exhibit A – last week, November housing starts. November housing starts were expected to be pretty strong. They declined by 18.7%. That is a very significant decline. November permits declined by 4.7%. What would you expect home-builder sentiment to be?
Kevin: Which is when they call and say, “Hey, what do you think about the future?”
David: Right. And you have massive declines, both in housing starts and in permits. Well it’s going nuts. With Trump coming in, home-builders are positively beside themselves with glee. Never mind the fact that re-fi’s are falling off a cliff, that mortgage rates are now 30-40% higher than recent levels for new home-owners and home-buyers. But home-builders are convinced that these factors are not impactful. I guess we’ll wait and see.
Also, we have something happening here at the tail-end of the year. Selling dynamics that are typical right now are being skewed in favor of a wait-and-see on new tax rates in 2017.
Kevin: That’s what I’ve heard. I’ve heard people say, “Well, you know, normally I would sell about this time of year, but what if I have lower tax rates next year?” That’s hopeful.
David: Book your gains, books you losses, wait until next year and see what Trump holds for you. What that creates is a dynamic where there are more buyers and sellers, just by taking a few of the sellers out of the market, and that means the stock market continues to levitate. So your normal seasonal sellers can wait a few more days.
In fact, looking at Walter Murphy’s stuff, a good technical analyst, he notes that there is another manic market dynamic which hasn’t occurred since 1962, where in three consecutive days we’ve had higher highs and higher lows. He points out that it is very noteworthy that this kind of manic behavior comes at inflection points, where we either break out and sprint to 2500 on the S&P, or we have a significant correction materialize. But again, this sort of manic behavior – higher highs, higher lows, in multiple sequential days, usually is at an inflection point.
Kevin: And that would be what we would call frenzied bull market activity. We saw this in the tech stocks in 1999.
David: Anything is possible, Kevin. Anything is possible. We have melt-up dynamics in the stock market. As we mentioned last week, technical and fundamental factors are temporarily irrelevant when the bulls get running. The two most important factors heading into 2017 will be interest rates, and the direction of interests, and the rate of inflation. These are factors, even if ignored in the short run – they run the markets in the long run.