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The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

Dollar Depreciation Certain… Election? Not So Much
November 18, 2020

“But here’s the deal. We go farther into the risk-taking mode, and there’s a greater reliance on interventionist measures to come in and save the day. It’s like a version of game theory. Speculators believe that regulators have too much to lose in an interconnected financial system to not intervene. So they take outsized leverage bets, leaving the whole system subject to spectacular collapse, knowing that they’re covered, at least, because the actions of the central banks are that predictable.”

– David McAlvany

Kevin: Well, you know, we’re all waiting to hear how it went. Let’s face it, 2020 has been a really weird year. But for you, you had quite an accomplishment, Dave. You set your mind and your goal on a full Iron Man. And I warned you ahead of time, “Have you talked to your wife about this?” She was supportive. So tell the listeners how it went. There you were last weekend. What was it, 140 miles?

David: Yes, it was a great day. It was a beautiful day. It was fantastic. The swim was enjoyable, went too fast. The bike was tough just because it’s a long time to be on a bike.

Kevin: You were saying 80 miles on, at that point you’re starting to hurt a little.

David: You’re just uncomfortable, and that’s a part of the race is actually just getting a little bit of comfort with being uncomfortable and staying uncomfortable because the marathon is – no part of it is comfortable after doing 112 on the bike.

Kevin: And then there was the run. I was watching on the app. Iron Man has an app, which is an amazing thing. If the listeners know anybody who races, just tune into the Iron Man app. There are checkpoints so often that I could actually watch how you were doing. But you slowed way down on mile 14 of the marathon, the full 26 miles. You slowed way down for just a short period of time. Now I was mistaken. I thought you were hurting. I was like, uh-oh, he went from nine plus minute-miles to 11-minute miles. But then you told me, actually, that wasn’t the case. You stopped for refreshments.

David: Yes, stopped to fuel, make sure I had the electrolytes and I didn’t cramp up in the last half of the race, and I was able to finish pretty strong, happy with the time.

Kevin: And where you stacked up in your category. I’m not going to say it. I won’t say it, but it was excellent. It was better than the top 10%.

David: Good for a first race, for sure, and I’m excited about doing a couple of half Iron Man’s next year. But yes, checking in with Mary Catharine, it would be a big commitment to keep on doing that length of race, just in terms of the weekends.

Kevin: It’s the training.

David: Yes, but honestly, what was what was most rewarding in the whole process was not the race. It was getting ready for it. I think a lot of is missed when we put this sort of pinnacle event on the horizon and forget, actually, the process of getting there. I’ll never forget, Thursday nights are game nights with the guys in our house. And so we’re playing cards and sometimes we’re watching movies, and sometimes when we finish the movie, the guys go run with me. And rain or shine, these are memories that I’ll always have. They were a part of the process.

Kevin: Yes, you included the family. And that’s what you do, Dave, on so many occasions. One of the things, and this is just an observation before we dive in, we’ve talked about the value of thinking and being quiet and being alone, just spending time with yourself basically. And when you train all those hours, there’s an awful lot of time to process and get quiet.

I remember when you encouraged us to go do the half Ironman about five years ago when we went down to Hawaii, and what I enjoyed the most about the training, honestly, was overcoming some of the fears. I was fearful that I wasn’t going to make the swim, and I finally learned how to swim well. But the other thing was the time that I had to just think and to pray and to just be quiet and process while my body was moving. I think that’s probably what I miss the most about the long training times.

David: As there’s been a physical transformation, I think there’s been some transformation to who I am as a person. I’m a verbal processor. If it’s not on the tip of my tongue, it’s probably not getting processed.

Kevin: And I’m glad for that because of the commentary. That helps.

David: Yes, and I’m an extrovert so I’d much prefer to be with people than be alone. So that’s been an interesting shift, because at this point I’m very comfortable with my own thoughts. And I’m very comfortable with time to myself. Maybe too comfortable, because now I have to completely re-engage. Fascinating, 2021 we’re going to go back. We did this as an office five to six years ago and had 10 people head out with us. You were part of that group.

Kevin: To Hawaii, the big island.

David: We got about 25 people registered this time, and we’re just excited about it. It’ll be a fun process. Again, it’s about getting there. I think one of the things that I learned in the long-distance race is how important reserves are. It’s something that we often forget in the process of allocating assets, in the process of creating a portfolio, that sometimes having reserves, the value of a reserve is intrinsic to itself.

And you need it, and you think, “Well, how is it getting used?” Because we want productivity and we want performance and we want gains and we want growth. And it’s really important to measure performance and respect the reserves that are necessary. And I think if you’re running the long financial race, that’s very important. It’s one of the reasons why, philosophically, when I think about cash reserves or gold reserves, these are things that just compute. They have a huge purpose, and you want them there.

This is where I think we stand in stark contrast with the folks that are hopped up on modern portfolio theory and they’d say you really need to be all-in, all the time, but adequately diversified. I would say, actually, you don’t have to be all-in, all the time. And sure, diversification has its place, but do not overplay that theme. I’m really excited to see where the next couple of years take us. Not only the company. I think we’ll continue to grow and develop individually and things like the Ironman are a great way for us to, as a team, continue to solidify how we work together.

Kevin: Well, and your philosophy, what you’re talking about, too, on reserves. You know, we both read a book about the first Ironman and one of the analogies that they had in there is that you’ve got a matchbook of about 24 matches, if you can imagine that, on that race, and you have to burn those matches at the right time. If you run the race and run out of matches, you’re not going to finish the race. And if you finish the race with way too many matches, then probably you weren’t efficient in the way you employed the energy.

And what we have right now – I mentioned 2020. 2020 is a really weird year. But I have to go back to 2019 because in September of 2019 we started saying, “Wait a second. There’s an unlimited flow of new quantitative easing. There’s new money coming into the market.” We were warning people ahead of time that there was this flow of emergency liquidity. It was almost like adding matches because we knew we were out of the matchbook at that point.

Well, 2020 took the blame because of Covid. But actually what we had was a liquidity crisis in 2019. So let me ask you, because at this point people have softened their attitude toward what is termed modern monetary theory, just the printing of money, adding it to the system, not worrying about how much debt you go into. Is that the new model?

David: It’s an opportunity to soften your judgment, really, about debt and the consequences of debt. Debt is the opposite of reserves. Instead of leaving something to be utilized, a reserve energy, energy to be applied in the future, where and when necessary, it’s a sucking of energy from the future into the present.

Kevin: Yet some people call it an asset. This new modern monetary theory says, “No, no, no, it’s not debt. It’s an actual asset.” When does debt become an asset, Dave?

David: Stephanie Kelton is kind of the current champion of the idea. She worked with Bernie Sanders as an economic adviser, and I’m sure will play a more prominent role as we see various strategies launched by what appears to be the new incoming president. There is a client that recently asked whether the federal debt is a threat or is a manageable lifeline.

And the question is interesting because I think it fits right into the modern monetary theory conversation. I think we have to consider the question in a time-specific way, as in, what should our attitude be in the present tense, and what is our view over a long period of time? And I think one of the things that is softening in the context of Covid is our total view of debt, our long period view of debt. So if we’re not careful, we allow the present tense urgency of, “Look at how slow the economy is and look how necessary it is for government to prop up aggregate demand, therefore, it’s important to…”

And again, what we find is a slow compromise in terms of the value of debt in the equation. Is it period-specific and very limited in use? Or does it become something that we’re just incredibly comfortable with under all circumstances? And that’s actually the theoretical framework that Shelton has laid out, where we’ve seen this kind of reframing. We’ve seen debt as a bad thing. It’s not a liability of the government, it’s an asset of the people.

Kevin: Well, you know Doug Noland – the moneyness of debt is what he talks about. But let’s face it, currency is really just debt that doesn’t earn interest.

David: Yes, so the reframing is to see debt as a form of currency with an interest component. So all we’re doing is swapping, if we have savings, a non interest-bearing currency for an interest-bearing currency. That’s what Shelton would argue. And so the national debt is an asset of the people. And again, that’s how she would argue it.

And I think both of those are problematic issues. But if you grant them, for the sake of argument, then you have to ask about the direction of interest rates. I mean, as a bondholder, let’s say, for instance, we look at the national debt and consider it a national treasure instead of an albatross. If we have this asset, is the value of the asset impacted by a change in interest rates? And the answer is, of course, yes.

Kevin: So that’s going to bring up the next question. What causes interest rates to rise but inflation? You have to try to beat inflation. That’s what interest is for.

David: Yes, so but this is the central problem of our time. Does the market get to respond to those variables in the anticipation of change in inflation rates, or what have you? And then a change in market pricing for stocks, bonds and every other currency, commodities of various sorts, to reflect these new economic inputs? Or are we in an age where central banks are trying to call the shots and actually overcome natural market forces?

I just want to quote from something that Kelton says in her book, The Deficit Myth. I think this is really telling, and I’m not even sure she can hear herself. She writes, “August 15, 1971 marked a major turning point in monetary history. President Nixon’s decision to suspend gold convertibility increased monetary sovereignty to the United States, forever changing the nature of the relevant constraint on federal spending. Under the Bretton Woods system, the federal budget had to be fairly tightly controlled to protect the nation’s gold reserves. Today we have a purely fiat currency. That means the government no longer promises to convert dollars to gold, which means it can issue more dollars without worrying that it could run out of the gold that once backed up the dollar. With a fiat currency it’s impossible for Uncle Sam to run out of money.”

Again, she views this as monetary sovereignty, and I view this as the long march towards monetary depravity.

Kevin: A pure devaluation of the dollar is what you’re talking about.

David: And in fact, if you look at a chart of the U.S. dollar you take these major stair steps down at points of, basically failure, reliability failure. And this is 1933 when we devalued under FDR, a 65% evaluation, and then the next major devaluation comes late 1960s or early 1970s. 1071 marking the serious decline, and it’s been fairly gradual ever since then.

We look at this and we say, “Okay, well, this is okay and we’re not concerned about inflation because we’re told there will never be inflation again because the central bankers control it, the market doesn’t. We’re told that interest rates will not go higher, and therefore the national debt is not a problem. And we have the ability to tax, which gives the government the ability to control an increase in the money supply. It’s interesting to see just how large a role the government plays in making sure that things don’t get out of control.

Kevin: So when we raise our kids, we say money doesn’t grow on trees. But that’s really not the case with MMT. Money grows on trees. To use the analogy, Dave, of what we were talking about with the race, are we really burning all the matches right in the beginning of the race, thinking that there’s going to be more later? That’s what I’m wondering. Is there a cost to pay when we run out of matches?

David: That’s right. This is an infinite match theory where you don’t run out of matches, you have all the energy you need.

Kevin: 140 miles, that’s nothing. Let’s just do 300, 500, whatever, it doesn’t matter. We’re not going to run out of matches.

David: Make it a trillion miles. It doesn’t matter any longer. We can go farther because we have a different understanding of our reserves, of our resources. We redefined money and that redefines everything, including the attitude, our disposition toward debt.

I thought was fascinating, Wilbur Ross is in an interview with Gillian Tett of the Financial Times. Wilbur is the U.S. Commerce secretary. He said this last week. “Investors need to start thinking about inflation again,”

Kevin: Oh, you think?

David: And what he suggests is that includes a portfolio adjustment that anticipates the re-pricing of assets which are sensitive to inflation. You look at Wilbur Ross’s current role in the Trump administration, reflect then on his past role in business experience acumen that goes back decades and decades. He knows something about business cycles. He knows something about success and failure, and in fact, he’s been around long enough to appreciate what the value of the dollar was and what it is today and what it may be tomorrow.

So when he’s suggesting that there is a re-pricing yet to occur and that we need to gain a sensitivity to inflation, bonds come to mind, certainly. Now all of a sudden we go back to that issue of can we have all the debt in the world, and does the central bank actually control inflation? And again, is it my asset? This debt – I have a hard time thinking about it as anything other than a burden. But if it is in fact an asset, then I have to care about the value of that asset.

And the value of that asset is tied to interest rates. And what Wilbur Ross would say is inflation is coming and there’s going to be a re-pricing of assets. Two things come to mind, bonds and gold. Those two things get re-priced as you have more inflation in the system. You could look at gold today and say the gold market’s already figured out that there are changes coming. The gold market has already figured out that there are going to be consequences to – call it de-evaluation, but certainly reckless fiscal and monetary policies, the comeuppance and the consequence of those policies.

So we see gold today in two lights. It has two trends. The short-term trend, the consolidation, is happening now, and that’s in the context of a longer-term bullish trend. We started this year 20-30% lower. It’s been a great year for the precious metals, an even better year for silver. It won’t surprise us to see gold continue this short-term correction consolidation to $1800 -1820. And that’s not a problem. The trend bigger picture is still very bullish.

Kevin: When you recall, the last couple of years we were talking about gold hitting all-time highs in other currencies, just not the dollar yet. Well, of course, now we’ve seen it with the dollar this year in 2020. It’s interesting, 2020 is not too far off what the gold high was, anyway. So it’s a good one to remember.

But in this particular situation, you’re talking about a correction down, which is just almost meaningless if you look at the longer-term chart. The devaluation of the dollar has been hidden in one respect by the de-valuation of all the other currencies in the world. They were hitting all-time highs in gold before the dollar. Now the dollar is hitting all-time highs, or pretty close. So what is that saying about the worldwide depreciation of fiat currency, not just the dollar?

David: Yes, I think what this anticipates is what we might call the great rotation, where we look at financial assets and they’ve been appraised in a certain light for a good period of time and a reappraisal of financial assets and a great rotation into other assets.

Again, going back to the Gillian Tett article. I think she’s a good writer. I think she’s solid writer and maybe that’s because sometimes I agree with her conclusions. The subtitle of that article, I thought, said it nicely. “Don’t be blindly addicted to free money and risk a shock when conditions change.

Kevin: Wow. That reminds me we keep using this racing analogy, but my son was talking about a race that he was doing on Zwift. You can race online now. You don’t just zoom call, but you can race online. I think you’re on the Zwift program. He was doing a race the other day and he misjudged the finish line by only a mile and a half. But he gave everything he had and realized that he had misjudged the finish line and there was still a mile and a half to go.

That’s what we’re talking about here. There is still scarcity of assets. Don’t call unlimited debt an asset. I’m sorry, that changes everything, doesn’t it? So with that being said, if we are going to have inflation, then we’re going to have to see interest rates rise at some point. The technical term of that is the yield curve will increase, right?

David: Exactly. And I think that’s where Goldman-Sachs is finding themselves looking at a steepening yield curve in 2021, calling for a depreciating dollar in the same timeframe, fairly modest 6% depreciation off of the 2020 peaks. But they would extend that trend on a steady decline for several years, through 2023. They think it’ll be a cumulative decline of about 15%. Again, that’s just a downside estimate from Goldman, along with a 2021 expectation of a steepening of the yield curve.

Now again, a steepening of the yield curve simply means that interest rates are going higher. If interest rates are going higher, credit is tightening, and there are ramifications for a very leveraged financial system when financial conditions tighten. And we’ll talk about that in a minute because I think derivatives have very low tolerance for those kinds of things.

Citigroup echoed the same kind of negative prognostication on the dollar, more aggressive 21% decline in the dollar, and they tie that to the disproportionate vaccine benefit in emerging markets. So those economies, if you see improved global trade, a return to a stronger global economic activity, you’re going to see commodity exporters, and on a relative basis, as those commodity exporters do better, their currencies do better on a relative basis. That hurts the greenback.

Kevin: So what we’re seeing is Citi, and we’re seeing Goldman-Sachs, actually echoing Stephen Roach because we’ve talked about what Stephen Roach was calling for about a month ago. He said over this next year we’re going to see a pretty substantial de-valuation of the dollar.

David: I think Stephen Roach’s thoughts are the most persuasive. It’s the outside estimate at this point, a 35% decline by the end of 2021, but in the rationale based on continued deterioration in the current account balance and then, of course, relative gains in the euro and other emerging market currencies, that resonates with me, not because I’m anticipating it with great glee, but I appreciate his thinking. It was articulated back in September. It was not tied to any particular election outcome. It’s just math driven off of what’s already in motion from a macroeconomic picture.

Kevin: Let’s talk about that just for a moment. We don’t have to get too political on the program today, but at the beginning of the program you had mentioned that it’s more than likely, it sounded like your thoughts are that Biden is moving into the presidency. That’s pretty controversial right now because there are recounts. Now, of course, there are people who are saying, “Oh, it’s completely unfounded. That’s mainstream media. They’re saying it’s just ridiculous that we’re even doing this.” But there seems to be some pretty reliable evidence that we should at least let the process go. And we have mechanisms in place that can actually say, even if it is completely clear that the election was fair and just, we have mechanisms to check that.

David: Yes, I’ve heard Michelle Obama talk about how embarrassing this is, and this is not normal process, and Biden, too. What an embarrassment for the country that this is not happening according to the way it normally does. I think back, and I think, let’s just let the process play out. We certainly had toleration for it when we had hanging chads in Florida in the Gore era. Can we let the process play out here?

Kevin: And that took us into December. For people who have short memories, I think we were mid-December, weren’t we, before we really knew who the president was?

David: Yes, December 13th, if memory serves correctly. I don’t want any of our listeners to misconstrue this as advocacy, but if integrity is in question, then let the questions and the allegations be heard. I think that’s fair in any circumstance.

Kevin: In the court system. That’s what it’s designed for.

David: That’s exactly right. And it’s not in the court of public opinion. It’s not to be determined by the mainstream media. The courts will determine the merits and strength of the evidence. I have confidence in that. There’s a process here for a reason, and processes help remove emotion from any equation. The truth is the truth. We talked about that last week with Professor McBrayer.

Kevin: Yes, but what about technology? Technology is supposed to be giving us more advantage. Can we not validate things these days with technology?

David: I don’t think technology increases security in an election process. Claiming that is, I think, merely revealing that you don’t know about even your own technological vulnerabilities.

Kevin: I’m being tongue in cheek. Remember Polverini? He basically makes his living because technology can be tampered with all the time.

David: That’s right. If you think that voting machines are somehow not subject to tampering, and I’m not saying that this is the Democrats. This could very well be the Chinese, the Russians, whoever.

Kevin: It could be our State Department. I probably shouldn’t say that.

David: Well, but if the NSA can be hacked, if any government in the world can be hacked, do you think a private corporation with a defined and limited security budget is somehow impregnable? So if there is a question about the integrity of the election, then just let the process go and be patient and we don’t need to name call. There’s nothing abnormal happening here.

Kevin: Well, it’s not a new problem. This is not a new problem. This has been brought up over and over in the past.

David: And, in fact, Huffington Post, 2012, it was a Pennsylvania issue with a voting machine. This was between Romney and Obama, and the allegations of vote switching were specific. We’ll give you the link to the Huffington Post article where it’s talking about, I think it was an Obama vote being shifted to Romney. And there were allegations of vote switching.

Kevin: Were these Dominion machines?

David: I don’t know. I don’t know if 2012 was. I know that there were specific issues, and I’ll give you the link on this one, too. You’ve got Elizabeth Warren, Amy Klobuchar and Ron Wyden, in 2019, up in arms about the Dominion machines, and to quote Elizabeth Warren, “These problems threaten the integrity of our elections.”

Kevin: And you’re trying to be nonpartisan about this. Last week’s program about fake news, right now look how hard it is to get actual real news from the mainstream media. You realize you’re being manipulated. No matter where you go, you’re not getting the facts. That’s what Justin was talking about last week. He was saying that you’re going to have to come up with some method, yourself, to evaluate truth.

David: Yes, and I think it’s worth looking at the PDF attachments on this. They are directly from Senator Warren. I will include the link from these Democrats, citing particular documented cases of the Dominion machines switching candidate votes after the ballots had been completed. Again, this happened in 2019, they’re talking about it in 2019, it’s a problem in 2019, and now all of a sudden, it’s some sort of a conspiracy theory.

I don’t understand the mainstream media’s block on this. At least have a conversation. Is it possible? Is it not possible? If you can’t even engage with the content, I think it marks a low point in the integrity of reporting. For over a week now, every single article I’ve read on the president’s lawsuits in motion, it’s a baseless claim, there is zero evidence, the assertions are without a shred of truth. Again, let the process play out.

Kevin: Don’t tell me how to think.

David: Yes, don’t tell me how to think. I have confidence that the folks who are in our judicial system will look at it and say, “This is bogus. This is balderdash. This is inflated.” Or, “Folks, we’ve got a problem here.”

Kevin: I was sitting at the table talking to my wife at breakfast the other day, and I said, “Sweetie, I have my preference as to who would be president, but that really doesn’t matter. It has never really mattered in any election what my preference was.” But I did trust the election process. What’s at stake right now, Dave, is something far greater than who is president. It is, does the election process at all have integrity?

David: Yes, given the history we have with Dominion, and again, this is the Democratic critique, and, of course, very unfortunate. And of course, they pulled the machine and fixed it back in 2012 as it was reassigning votes from Obama to Romney.

Kevin: “We’d better fix it quick.”

David: Equal opportunity company owned by private equity, which is really the issue that Klobuchar and Warren had. They were saying, “Look, you’ve got these private equity guys who own the company and control the outcome. Let’s be honest, they control the outcome. That’s the case made in these letters written from the Senators. So I think, given the history we have with Dominion, that they control the election infrastructure, if you have certitude in this environment, 100% certainty about what happened or didn’t happen, it just seems either convenient or partisan or whatever, I think it’s best to sort of skip past the Twitter references and other news sources, go straight to the congressional letters. Read the link. Vote switching is just one of the complaints that they list there. Election integrity is pretty important. It should be for everybody insofar as you care about this version of democracy, and I think the reality is that integrity, if we say things have not been done perfectly, this stretches back for at least 20 years. I take that back. This is something that’s embedded in history. As long as you’ve had a vote, you’ve had the opportunity to push, massage, influence, whatever. Napoleon III is quoted on this issue. Sometimes it’s attributed to Stalin, but it was actually Bonaparte’s nephew. He said, “I care not who cast the votes of a nation, provided I count them.”

Kevin: (laughs) Well, that’s the truth. There really is nothing new under the sun, bringing us to the next point. Money speaks. When you’re watching an election and you see the betting lines in Vegas as to who’s going to win, sometimes that’s better than watching polls. In fact, most of the time it’s better than watching polls. But look at the bets that were placed for the president, $600 million that’s still sitting there because they’re saying, “Mainstream media may have decided who the president was, but we haven’t yet, and we’re not paying out yet.”

David: That’s right. So, kind of bridging back to the markets, the betting odds of Trump retaining the presidency were up last week, and again, $600 million in limbo can’t be paid out, Even though the news outlets have determined who won it’s not official yet, so the money is stuck. It’s stuck based on an inconclusive and uncertified outcome. We’ll get that. I’m not worried about that.

A lot more, though, is in limbo. And when I think about the implications of the election from a financial aspect, when I think about what they mean specifically for investors, there’s a lot in limbo through January till we know the outcome of the Georgia runoff. We could have an evenly divided Senate, which throws the Vice President into all legislative tiebreakers, and I think more clearly defines a legislative course for 2021 to 2024.

Kevin: One of the things we have to be careful about is having our ideology determine how we invest. In other words, we may have hopes for a particular outcome, but also, Dave, you run a business and you have to try to determine what’s going to happen to the tax code if it’s Biden? Or if it’s Trump, what’s going to happen with the outcome, and how do you make those decisions right now while we’re in limbo?

David: I think this is a really fascinating thing because we have the Georgia run-off and we won’t know until after year-end. And yet anything that a family or a business would want to do as a response or reaction to potential changes, we just we can’t say what the implications are of the 2020 election.

Kevin: Is that why you put a memo out to the office and said that we’re moving to Georgia and we hope you vote?

David: No, we’re moving to Puerto Rico, where we don’t have to worry about taxes at all. I’m kidding. But we don’t know until we get past the end of the year, and that’s the awkward piece. It’s awkward because people are going to want to take action, but it will have to be based on an undetermined outcome. Making any special year-end dividends, which is a pretty predictable corporate decision, estate planning changes, trust plans.

There is a whole host of things that are likely to change from an estate planning standpoint, death taxes and what not, other strategic shifts. They remain on a purely speculative footing. There may be a lot of changes. There may be very little. A lot of that has to do with what happens in the legislature, not in the Oval Office. And we wonder how the odds stack up there.

So, investors are going to have to make decisions in December without a clear view into the next two to four years. So in that sense, regardless of what’s happened this week in terms of Covid and whatever, uncertainty remains in the dock.

Kevin: The only certainty that actually exists is the certainty that the central bank is going to continue to pump money into the system. But I think people are mistaking that for, “Oh, we’ve got a vaccine this week, or we have the possibility of ending Covid in the next six months, or what have you. Are those all just misappropriated hopes?

David: I think one of things it could be is a timing mismatch because you know, the markets’ enthusiasm for getting back to normal, and they’ve got the imagination with the announcements from Moderna and Pfizer for post-vaccine and post-Covid reality.

Kevin: Boy, the stocks moved. They thought that was very, very positive.

David: Yes, we saw that on display, huge moves in equities, huge moves in junk bonds, huge moves in investment grade debt, inflows off the charts. Huge sector rotations, huge carnage for the long and short funds. And for just the short funds, yes, we lost, but lost considerably less in our Tactical Short product than the competition running high beta strategies and failing to rein in risk. And this week we’ve got runaway risk with those high beta strategies. So people getting killed out there and really proud of Doug’s disciplines. Tough environment to manage in, but doing a stellar job.

Kevin: It’s hard to bet against the Fed when they can print money and you can’t.

David: Yes, but we were already at all-time highs, which is to say, we’ve been disconnected from economic fundamentals for a while. So now we are to believe that improving economic fundamentals – it hasn’t happened yet, but theoretically, improving economic fundamentals tied to getting back to normal, again, which is a factor that’s been irrelevant for some time, now we are to believe that that is the wind in the market’s sails.

Kevin: You think so?

David: I’m skeptical. I think it’s helpful that uncertainty is diminished with the announcements from Moderna and Pfizer, but the market was already looking over the valley. Keep in mind, we weren’t coming off of historic lows and recovering, we were at historic highs, and now we’re just going higher. The market wants to believe and price in today a reality which is still months or quarters away. There are lots of things that can happen in that timeframe.

So again, that’s why I say a timing mismatch between what it wants to believe and how it’s adjusting. And when we actually see some positive results, because there is a lot that happens, a variety of unknowable elements. Vaccine distribution – is it going to be generally accepted by the public? To what degree do people come back for the second shot? That is unknown, if you’re talking about medium to long-term efficacy of the vaccines. Those are unknowns.

Kevin: I want to know the genetic impact to it because once you change your genes, you’re passing that down to all the future generations as well.

David: Right. We’re very much a quick fix generation. That is the problem. Give me a solution, whether it’s a medication or whatever else – help me, help me now. And there’s really not a lot of thought given to the long-term side effects. Obviously, time has been compressed in the context of crisis. We don’t have a series of tests to show us what these RNA messaging – this is incredibly innovative, and I’m hopeful that this is a very good solution to the problem, but we don’t know what the long-term side effects are. We have no idea. We have no idea if this helps the problem for the next six months, but then you could be reinfected six months from now, and you also have to deal with long-term side effects, and now you get both of the worst case scenarios. I don’t know.

And you brought this up. This is a huge issue in the back of my mind. Tampering with RNA messaging – does that impact DNA negatively in the future? Does it impact it now and in the future? We don’t know what result it has to our immune system. Very positive in the front end. Are there any negative responses long-term?

Kevin: I can’t get the movie out of my mind, Jurassic Park. Malcolm, who is my absolute favorite character in that movie, he’s basically questioning exactly that, because what Jurassic Park is really about is tampering with DNA. Granted, you’re bringing dinosaurs back. He asks the question, I think, something to the point of, “Just because you could doesn’t mean you should.” And, we really don’t know that much about it now. It doesn’t mean it’s bad thing, but like you said, we’re going back to uncertainty in the markets. If the markets, every time they see a news event, “Hey, we’ve got a vaccine,” and all of a sudden, “Let’s go buy stock.” Does that even match?

David: And that’s my point, is the markets reacting to news, good news, algorithms are reinforcing and creating buying dynamics, but we don’t know everything we need to know as individuals to make sane personal choices. To be to be frank, I’m 46 years old this year, and my risks are fairly low in terms of dying from Covid. And so I’ve got a known mathematical variable and an unknown consequence to taking a vaccine. I’m going to look at that and say, “Does it make sense for me to do this or not do this?” And if the state wants to mandate it, I have to ask the question, “Does this make sense for me to do this or not do this?” Because I’m going to continue to do my own thinking and I will do as much research as I can. I’ll tell you, I’ve got about 20 tabs open on various research that are tied to the two doctors at Moderna. They’ve been working on MRNA projects for some time. And I’m grateful that this is a potential solution. But I want to know what the downside is, and I don’t need a professional telling me what to think.

Kevin: You’re practicing what Dr. Justin McBrayer taught us last week, and that is, think for yourself. Try to figure this out.

David: And it is going to be a little while before I think I can make a sane personal choice.

Kevin: Back to the markets because there’s the old saying, “Buy the rumor, sell the news.” Hasn’t the market already factored in the vaccines? And at some point, there will probably be a sell-off as we start to see it come to reality.

David: I saw a very interesting case about shorting Moderna. I’m not short, I wouldn’t go short, but the case was basically, “Look, this is a one and done deal.” This is not a product that has an annuity structure to it, and they have already been paid for a certain number of doses from the U.S. government. I forget, it was 50 million doses or something. That is a huge number of doses, and so there’s already money in the bag.

So the market’s getting excited about, as you say, something that’s already been largely absorbed. You’ve got the discounting mechanism in the market already engaged. It was engaged prior to, and I’m thinking about the broader market, engaged prior to the Pfizer announcement, prior to the Moderna news. And now all of a sudden we’ve got one more catalyst for short covering, for unhedging, and I think all of that short covering and unhedging has been confused as organic buyers entering the market.

Yes, there’s evidence of investors shifting back to the markets, but this discounting mechanism was already perversely in motion. Here’s how it is perverse. If Covid worsens, then there’s more easy money that will flow and fiscal funds that will be freed up from the world’s treasuries, and so we have reason to buy stock. And if conditions get better from this point instead of worse, that’s cases as well as deaths decreasing, either naturally or as a result of vaccine, prices are going to go up, too. So you’re going to win either way, you just need to be long equities.

Kevin: Right. More matches, more matches. So, really, the risk appetite right now is being fueled, not by announcements about vaccines. It’s being fueled by the knowledge that there’s free money.

David: Yes, the market is driven by sentiment. It’s driven by speculative risk taking­. And the underlying reality is that central bank accommodation is what buttresses the price structure of the market.

Kevin: That’s the bet. That’s the bet.

David: That is the bet. So you can pretend that this is Moderna or Pfizer who have just solved Covid. No, actually, what we’ve solved is the money tree issue. We’re back to the issue of, are we going to burn one match with a limited number of matches to burn? Are we going to run out of reserves and resources? Or do we have infinite resources – the infinite match theory? So making equities a uni-directional market is the direct consequence of the central bank’s buttressing price structure in the market today. But lest we forget, lest our memories be just that short, the equities are a uni-directional market until they’re not, just as we saw in March.

Kevin: Earlier you quoted someone talking about not getting addicted to free money. That really is the truth of the matter, isn’t it? At first we test it and then we start using it. Remember, you talked about that sequence, and then we have to do it. How did you put it? We could, we should, we must? Remember a few weeks ago? We could. And then we should.

David: And now we must.

Kevin: And now we must. And in a way, that’s what that addiction process is.

David: Yes, and I think a part of that is driven by the proliferation of derivative products. This is where you see the popularity of vehicles which have internal leverage to a market move, and it’s great on the upside, but it makes any correction in the market, a move lower, far more violent, and far more difficult to control.

But here’s the deal. We go farther into the risk-taking mode and there’s a greater reliance on interventionist measures to come in and save the day. It’s like a version of game theory. Speculators believe that regulators have too much to lose in an interconnected financial system to not intervene. So they take outside leveraged bets, leaving the whole system subject to spectacular collapse, knowing that they’re covered, at least because the actions of the central banks are that predictable.

Kevin: And predictability sort of a self-reinforcing mechanism. We’ve talked before about the concept of being able to get away with something over and over until you think that there is no risk. Look at what’s happened in China. We’re talking about top-rated companies at this point, defaulting on their debt.

David: Yes, and I think that’s a great example of speculators tempting fate. Last week, Friday, a triple-A rated coal company defaults on its short-term debt.

Kevin: Triple-A rated.

David: That’s interesting all by itself, right? Triple A. What’s downstream from Triple A? So the debt sells off rapidly. Then you’ve got vulture investors who step in. They’re picking the meat off the bones. And as Michael Pettis describes this behavior, he says, “This is just Russian roulette. In other words, you’ll probably win any given round. And every time you win, you will be convinced more than ever that the odds are in your favor. But they aren’t. This strategy always ends the same way.”

In another context, he would describe that as catastrophic. He says. “The irony here is that the longer the game goes on and the more investors play the game, the more they undermine the long-term ability of the market to act as an efficient allocator of capital and the more costly they make it for regulators to keep preventing defaults.

So once regulators believe that the long-term costs of keeping the game going exceed short-term costs of allowing real defaults, or once too-high debt levels reduce their ability to kick the can further down the road, they bite the bullet and allow defaults to take place.

Remember who he is. He has been on our program a couple times. I’ve met with him in China before. Fascinating guy. He used to trade developing country bonds. Now he is a finance professor in China. He basically says, “As a bond trader I have seen too many versions of this game before.”

Kevin: This goes back to the one bet that we know that everybody is placing right now, and that is the continuation of the central banks being the buyers of last resort. Or why don’t we just call it the buyers of first resort? Because that’s the truth of the matter. If you look at the European Central Bank, they’re buying up so much that the investors hardly have anything to buy after them.

David: Yes, so there’s this idea that somehow inflation will not be an issue, deflation is what’s on the horizon because we’ve got so much of a quantity of debt and that continues to sort of suppress growth rates. And I think there’s some really good writing that’s been done on that. I appreciate the logic. I think it’s a very well built-out case. I think where it begins to fall apart is when you introduce a new idea. We can deal with old math and old theories, and I think they hold.

But now you introduce a new idea – modern monetary theory, the infinite match theory, we have as much reserves as we want. And then all of a sudden you start to shift this notion of debt being a burden to being an asset. You assume certain things about control in the system to make it all work. And this is where that argument of too much debt always leads to lower and lower rates and more and more deflationary trends. This is where all of a sudden you have that inflationary surprise that Wilbur Ross was talking about, and I think what ultimately becomes a trigger for the great rotation.

Kevin: Can you imagine what gold price will do if we actually expect inflation? The thing is, gold has risen nicely over this last couple of years without this implied expectation of high inflation. Can you imagine the difference in the price movement if there was an overall expectation that we would have inflation?

David: John Paulson puts it this way. I think he’s actually quoting Tom Kaplan, who said, “Once you get inflation, it’s like the Hoover Dam trying to empty out into a garden hose. This is the issue because you’ve got so much money built up in the financial assets. The gold market today, $2.6 trillion versus the financial assets, stocks and bonds, 285 trillion. 285 versus 2.6.

And here’s what John Paulson says. “I’m sure you’re all aware of what happens to the price of a 30-year treasury bond if interest rates rise. At 1.52% last week, the bond was trading at 96.” He’s quoting a price there. “But as the yield rises, you start suffering a massive loss. Even a rise of 200 basis points to 3.52% would result in a 36% loss in the treasury bond, and a 12% yield would translate into an 85% loss.”

So if we get back to inflation like we had in the 1970s, fixed income investments will be devastated. And that’s what causes the demand for gold. That’s what John Paulson says. That’s one of the reasons why he’s still a very significant owner of gold. But this is again coming back to this notion of the great rotation, where today we’re assuming certain things about the financial markets, we’re assuming certain things about the stability within the financial markets, and now we’re actually beginning to craft a view of the paper asset world, specifically of the debt markets, not as an obligation, not as a burden, not something that we have to fear, but instead something that we can get excited about as an asset.

Oh, but, that presumption of control as it relates to interest rates. If they go up, if Goldman-Sachs is right and we have a steepening of the yield curve, what are the implications to the value of what some would have to argue is our greatest asset. Now again, I have hard time saying that because I still see it is our greatest liability. And it’s actually not our greatest liability. We’ve got unfunded liabilities that get us up to 200 trillion.

Kevin: But just because you can doesn’t mean you should. Again, I’m going back to Jurassic Park. The dinosaurs started eating people. What they thought was good turned out to be very, very bad. The debt at some point is going to get out on the island, and it’s going to start eating people, Dave.

David: I know, so the rotation dynamic in U.S. equities, we saw this over the last few days in a very dramatic way. Covid trades are getting killed. Deep value is catching investors’ attentions. So you’ve got Zoom down 19%. They’re getting slaughtered. Airlines and oil soar. Not all boats rise, but risk is on. Junk bonds go to record low yields, that is, high prices, on the other side of the equation. You’ve got further compression of spreads in the fixed income markets which are taking us back to pre-pandemic levels. Think about that. A spread is the difference between the benchmark rate, which would be the U.S. 10-year treasury, and any other fixed income instrument. How much more interest are you paying, and it tells you how risk is being weighed vis-à-vis the risk-free rate. So spreads are back to pre-pandemic levels.

Kevin: No risk anymore.

David: Pre-pandemic levels. It’s as if it’s already behind us. You have Italian debt, which enters negative yield territory. The 5-year is now in negative territory as well. Total quantity of negative yielding fixed income back above 17 trillion. What is fixed income without the income? It’s a fixed market, right? Seems like you can fix just about anything these days.

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