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The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

Doug Noland: A Core Crisis (from the Periphery)
July 27, 2022

“The world has never seen anything like what we’ve witnessed for the past 13 years. I mean, we talk about China; it’s the emerging markets; what’s happened here in the US; the debt growth in Japan has been just crazy. So from my standpoint, David, this has been the worst-case scenario. As an analyst of bubbles for three decades, I never thought it would get to this point, and I hope things are not as dire as I suspect they are.” — Doug Noland

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

Well, I always love this time, Dave, when Doug is in the studio—Doug Noland. Of course, for decades we’ve read his work, but I just pinch myself that he actually works with the team here at McAlvany. I love it when you two talk.

David: Last week, we gathered with clients and interested parties and our Tactical Short offering to review the last quarter. I encourage all our Commentary listeners to take the time to read the transcript or give it a listen. The content is so critical. I wanted to have my friend and colleague Doug Noland on to candidly talk about the markets here in what is a vital week inside a vital quarter and a really intriguing year. There are some key transitions we need to unpack. Doug, is there anything that we absolutely can’t miss in our conversation today?

Doug Noland: Well, David, thanks for having me on. It’s great to be back with you. I would just say a lot of my focus is on international developments that don’t get a lot of attention these days. We talk about these things throughout the week, David, so I’ll just follow your direction.

David: Well, you followed the evolution of the credit markets for decades now. First, the nature of money shifted and fiat was born. Then credit became a near-money equivalent. Finally, all sorts of financial assets became “money-like.” So this evolution—maybe it’s a devolution—of money and credit has promoted a unique form of growth. Let’s talk about its flaws. Let’s talk about its sustainability.

Doug: David, as you know, I’ve been following this now for— it’s been three decades. It was back in the early 1990s that I saw these fundamental shifts in finance where we started to gravitate away from traditional bank lending as the focus of credit growth to market-based credit. I watched the evolution of policymaking to bolster this market-based credit. I’ve always been concerned about this because the history of credit— Credit can be very unstable. It tends to be very unstable. Then if you make it market based, you don’t have hedge funds speculating in bank loans. They speculate in marketable securities. You don’t have leverage like that if bank loans are your credit. We changed this into all these market-based instruments that we leverage, we speculate. And the credit bubble kind of took on a life of its own through this evolution to more market-based credit. Then the Fed, of course, anytime this market-based credit turned unstable or a crisis, then they would act to perpetuate the growth of this credit. Unfortunately, I think we’re kind of at the end of the road for the great credit bubble.

David: So the bubbles have been created, and then they somewhat resolve themselves only to be propped up through policymaking and central bank interventions so that we don’t end up with something the equivalent of Armageddon. So there’s an interventionism, and it seems like that causes a migration. So we had the technology bubble, and then it moves to the mortgage-backed securities and housing bubble, which, of course, gave us the global financial crisis. Now we’re in a different kind of bubble, at least different in scale and scope. Maybe you can talk about that.

Doug: Sure. I use the example, if you have a bubble in junk bonds, high-risk corporate credit, you could have a spectacular bubble. We’ve had them. You could point to the tech bubble that was financed by telecom debt and corporate debt, etc. But that bubble will have a relatively short life because people will only buy so many junk bonds, and eventually they say, “No, no, no. We know it’s risky. Enough of that.” And that’ll bring that bubble to an end before it becomes deeply systemic. 

My argument has been that this bubble has gone to the heart of money and credit. It’s gone to the safest money-like instruments—central bank credit, government debt. That has allowed this phase of the bubble to go on for 13 years after the great financial crisis. It went global. It went everywhere. We’ve all heard the term, the “everything bubble.” This bubble went to stocks. It went to bonds. It went to government debt. It went to real estate, private equity, the hedge fund industry, venture capital. That’s what’s dangerous about it is that a bubble and money can go on and on and on because money, we have insatiable demand for it. As much central bank credit as they create will find a home—government debt, basically unlimited demand. So this is a much, much more systemic bubble, dangerous bubble, than the ones we’ve seen in the past.

David: It seems, too, like the popularity of central bank interventionism and this sort of migration to the heart of money and credit, we’re not just talking about US money and credit. We’re talking about European money and credit, Asian money and credit. We’re talking about a global issue, as it’s been the way these dynamics have played out. All central banks have been doing virtually the same thing.

Doug: Right. If you go back to 2009, that’s when I began warning of the potential for what I called the global government finance bubble, that’s following the mortgage finance bubble. Because Fed policies, when the Fed unleashes a trillion dollars worth of QE, it allowed all the other central banks in the world to do it. Why won’t they do it? So everyone moved forward with inflationism of central bank credit that fed in to corporate credit, leveraged speculative finance, and it became truly a global bubble, much larger than I ever imagined when I could see these dynamics unfold back in 2009. I never imagined we could get to 2020 and the Fed unleashes another $5 trillion of QE in two years. I would’ve never imagined anything like that.

David: Well, in the last several weeks, we’ve seen an increase in central bank monetary policy tightening, and we’ll have more of that to some degree with the Fed this week. What’s the sequence of events you see unfolding as central bank officials attempt to move the other direction from loose credit to— at least they’re suggesting they’re going to attempt to tighten credit and tighten financial conditions in order to tame a global inflation problem?

Doug: Well, yes, we’ve started the first tightening cycle since 1994. Since 1994 and that bond dislocation and the problems, the issues we had in 1994, the Fed basically changed their doctrine and had little baby steps rate increases and never really tightened finance. That’s one of the reasons you had all these bubbles. Well, now inflation is such a problem. It’s been unleashed here. So now they have to really tighten financial conditions, so they’re raising interest rates, and the Fed has started to reduce the size of its balance sheet. The problem is, I think it’s going to take a lot of tightening to get these inflationary pressures under control, but the system is too leveraged. There’s too much leverage in the markets in real economies, and that’s at home and globally. I don’t think financial conditions can tighten the way central banks hope they can to tame inflation without leading to a financial crisis.

David: How that translates, it would seem, is to major pressure on asset prices. On the one hand, we’ve got inflation. On the other hand, the necessary tools to fight inflation, raising interest rates, tightening financial conditions, with the consequence being in the stock market and the bond market and the derivatives market, the potential for something that’s quite deflationary. So how do you square the existence of these two things, which most investors consider sort of opposite ends of the spectrum? We have either one or the other. Yet, in this scenario, it looks like we already have one, clearly, all the statistics show it, but we could also have some dose of the other to the degree that the Fed takes seriously this notion of tightening financial conditions.

Doug: It’s a huge predicament for these central banks because they have to tighten, of course, to rein in inflation. At the same time, you have these markets that— they can’t take a tightening of financial conditions again. There’s too much leverage. There’s too much speculation. It doesn’t work in reverse. So it’s a real dilemma. It kind of points to this scenario where you could see increases in consumer prices, commodity prices, prices of real things, while bubbles are pierced in asset markets and you have asset market deflation. So that’s kind of the direction this looks right now. 

From my standpoint, central banks— there’s more QE coming because if you get in a big de-risking/de-leveraging, the leveraged players de-leverage. That means they have to sell things. There is no one with enough liquidity to offset this de-leveraging other than the central banks. The way I see it is you could have a crisis bursting bubbles in the asset markets. The central banks are coming in, adding liquidity. The liquidity that they add doesn’t want to go back into the asset markets because that bubble’s burst. So that could go into commodities and real things. So that could be a real predicament for the Fed, where you’re dealing with a financial crises but you still have strong inflationary pressures in consumer prices. 

Obviously, inflation’s very complex. There’s geopolitical considerations where— these supply chain issues, China, it just doesn’t look like it’s going to go smoothly, and it doesn’t look like, to me, that it’s either asset, or it’s either inflation or deflation. To me, it’s wild instability in prices and divergences in different types of prices. I think that’s kind of the direction we’re going, very complex, very complex.

David: Doug, these are incredibly complicated and volatile and challenging markets. As a veteran of many decades, three decades, you’ve got your finger on the pulse. You look at a variety of indicators, not dozens, a hundred-plus indicators, and this is on a daily basis. This comes into our conversations on the asset management side. What is surprising you the most at the moment?

Doug: David, in our meetings we talked a lot about China. We have a historic apartment bubble there that’s now collapsing. We talk about these every day. We watch these prices of these huge developers in China. If you add a few of them together, we’re talking a trillion dollars with liabilities. These bonds are collapsing. You have yields above 100%. You have bonds trading six, seven, ten cents on the dollar. It’s historic. Yet here, no one even cares. No one even talks about companies with trillions of dollars-worth of liabilities where the market is saying, “they’re not going to make it.” Not only are they not going to make it, they’re not worth much, if anything. Here in the US, we’re saying, okay, bond yields are down. Commodity prices are down, peak inflation. The market’s put in a low. I think there was a manager last week from PIMCO who countered Jamie Dimon’s warning of a hurricane, saying, “Well, I think it’s just going to be a shower,” and I just scratched my head. I’m just surprised at the complacency considering what’s going on globally, that somehow we’re going to remain isolated from that. That’s surprising.

David: Chinese credit markets have gone from bad to worse, and really, last week, the last two weeks have been pivotal. You could see the change happen as you looked at those indicators. If we look at those dynamics, can you explore how what is today a Chinese credit market problem becomes a dynamic that impacts global markets?

Doug: Right now, the issue is you have a huge de-leveraging. You have money coming out of China. You have liquidity tightening. Once that begins, then you have contagion. That’s already started in the emerging markets. They’re under a lot of pressure, their currencies, their bonds, their stocks. The way contagion works is, if you have illiquidity start to show up in one market, then there’s worries that it’s going to move to the next market. So you have this risk aversion and you have selling. It starts to gain momentum, and it just kind of spreads around the world. I talk a lot about this periphery and core analytical framework, where right now you have the periphery under a lot of stress. The core can actually seemingly benefit for a little while, and we’ve seen it the last few weeks. Our bond yields are going down. Commodity prices are going down. The view is now that the Fed won’t have to tighten as much. So the perception here is that we’re through the worst of the storm when the storm is actually just getting going for this unfolding global crisis.

David: The periphery-to-core dynamics are intriguing in that you see strength. That’s something that, whether it’s a PIMCO analyst or the general public, the strength at the core, again, driven inadvertently or indirectly by weakness at the periphery, it’s heralded as, “the worst is behind us.” That is fascinating because many people are hoping that, after a rough first half in 2022 in the general equities market, in the bond market here in the US, that now we can return to normal. The question is, if we just finished the end of a cycle of loose financial conditions, and this is the first tightening since ’94, is there any normal to go back to? What was normal about the last cycle? So the desire is, okay, the worst behind us. We don’t get to go back to normal, do we?

Doug: No. Let me briefly give a real life example of this periphery and core dynamic. If you think back to the mortgage finance bubble in the summer of 2007, that’s when you had the subprime eruption. Subprime started to basically blow up. That was the beginning of the end of the mortgage finance bubble. But at that point you had a big rally in the bond market. The Fed started cutting rates. Everybody believes subprime is not much of an issue. The AAA rate in mortgages rallied. Everybody loved them. It perpetuated the bubble for another 15 months, the drop in interest rates. What I’m arguing now is that we’re at the beginning of a new cycle, this previous cycle that went global after the ’08 crisis. Bubbles are now bursting across the globe here. It’s to the point where the old fixes aren’t going to work this time. The central banks can’t come in and just make things good again because there’s an inflation problem. The Fed put isn’t going to cure what ails the US and the global financial system. We just have to go through this difficult adjustment. Financial conditions are going to be tighter, and tight financial conditions change a lot of things. It changes the type of companies that can borrow money. It changes growth dynamics. It certainly changes the amount of risk people are willing to take in the markets. Hedge funds are not going to be leveraging like they did before because the Fed liquidity backstop is ambiguous now. It just changes a lot of things, and I think it changes them enough to where this is the start of a new, very different cycle. Clearly, there’s a geopolitical component to it as well.

David: Well, I want to get to the geopolitical component in a minute. But this notion that tightening— you said a few minutes ago that ultimately you tighten to the point where basically something breaks and you’ve got to go back to QE, so you go from tightening to loosening. Does that mean that that’s the end of this cycle and that this tightening cycle is just super short, or are we talking about just the Fed being trapped? They need to tighten. They may have to loosen on an emergency basis. I just wonder what that does to the currency in the midst of going back to balance sheet expansion, etc.

Doug: Right. The way it works, David, is that if you have a bubble, and if the bubble bursts, and if you reflate again to reflate out of that bubble, then the next bubble is bigger. The mortgage finance bubble was much bigger than the late ’90s tech bubble. The global government finance bubble is much bigger than the mortgage finance bubble, the global government finance bubble again. So the issue today is, we had $5 trillion of QE for the pandemic crisis back in March of 2020 for two years. So my argument is, that bubble’s even bigger now, so the amount of QE to resuscitate bubbles is enormous in the system right now. You couldn’t throw that amount of liquidity in because of inflation. The bond market would panic. The bubble’s too big to be managed the way it’s been managed previously.

David: We’ve got this everything bubble with higher prices here in recent years. That’s given way to the first half of 2022 where everything is going bust. It seems like the asset class that ends up having a greater longer-term impact in the context of a bursting of bubbles might be the bond market. Is that fair to say?

Doug: Well, the bond market is just an accident waiting to happen here because of inflation and because of the potential for a lot more QE in a financial crisis environment. You had mentioned the currency. I worry about the bonds and the currencies for this next attempt to reflate the bubbles.

David: I’m curious about your view on rising rates. We talk about it in-house quite a bit, but if you’d share that with the folks listening today. I think investors are hoping that interest rates fade lower, and maybe the worst is behind us, yet— Your view on that?

Doug: Well, I actually don’t think the Fed has that many more rate increases left here. Maybe they go 75 [basis points] next week. But I see this global crisis bearing down on the core, and I just don’t think the Fed could raise rates in a crisis environment. That’s a short-term dynamic. When things calm down, I think, down the road into the future, inflation will continue to pose a problem, and there’ll be more pressure on them to raise rates. But I think the tightening cycle is probably going to run its course soon.

David: This kind of brings us back towards the geopolitical. What are your thoughts on the importance of globalization, or perhaps now globalization in reverse?

Doug: Right, David. I talk about this dynamic, during the up-cycle when the bubble is inflating, in that environment the perception is that the economic pie is getting larger. With the economic pie getting larger, then the view is that integration and cooperation are an advantage for everyone. So these up-cycles, you integrate, you cooperate, trade agreements, etc. As the cycle ages, then the perception is that the pie is not expanding, the pie might be contracting, and that changes a lot of things. Then it starts to be more of a zero-sum game calculus, where everyone’s trying to get as much of the pie as they can, and you have dis-integration. You have a lack of cooperation. You have angst and conflict. It’s just a very different dynamic than the upside of the cycle. I certainly think we’re seeing that all unfolding now globally, unfortunately.

David: We have Europe under acute pressure, both politically and economically, and you see indications of some of those stresses. Mario Draghi hangs up his cleats this last week. You’ve got the euro quite weak, in fact, slipping past parity at one point here recently. Japan is devaluing the yen. The RMB could have problems there in China. Maybe that’s future tense given credit market dynamics in that country. Can’t you argue that a weak euro, a weak yen, and a dangerously positioned Chinese currency are all supportive of continued dollar dominance?

Doug: Yeah, you could make that argument. But the problem is right now that this strong dollar is just putting a lot of pressure on a lot of countries, especially in the emerging markets, and you’re seeing de-risking/de-leveraging. You’re seeing a lot of hot money leave the emerging markets, the periphery, the fringe. These economies can’t take that kind of capital flight, so it’s just feeding crisis dynamics. So the strong dollar is a huge problem for the global financial system right now, and the strong dollar is certainly being fed by these policies. The ECB raised rates 50 basis points, yet they’re not even positive yet. The Bank of Japan is pegging their bond yield at 25 basis points. These are kind of crazy, crazy policies that maybe it suits them well domestically, but if you put it all together, it’s, again, a lot of pressure, strong dollar pressure globally, which is part of this bursting of global bubbles dynamic that’s unfolding.

David: Can you imagine if you rolled the clock back 20 years ago and said that the European Central Bank is going to be the real inflation fighter. They’ll have close to double-digit rates. Right now, the eurozone’s average is 8.6%, but their version of real inflation fighting would be getting rates to zero. It’s kind of funny.

Doug: Their first rate increase in 11 years, right? Mario Draghi went his whole term heading the ECB and never raised interest rates. What kind of central banking is that?

David: Well, one-sided, one-sided. Accommodate, but don’t ever pull back. I’m curious about bubble dynamics, and as they begin to unwind, can you think of instances where the unwind remained orderly? Is that even possible in the current world of hyper-leverage?

Doug: No. I’ve watched these bubbles. It goes back to the bond market bubble that burst in ’94 and then Mexico. Then it went to the Asian Tiger countries in ’97 and Russia in ’98. Brazil and Argentina had issues. Obviously, we had our tech bubble, the mortgage finance bubble. So I’ve seen these bubbles, and they do not end well. I clearly subscribe to the Austrian view where the downside of the cycle is proportional to the excesses during the upside. So I really worry about how this is going to unfold because the world has never seen anything like what we’ve witnessed for the past 13 years. I mean, we talk about China. It’s the emerging markets, what’s happened here in the US. The debt growth in Japan has been just crazy. So from my standpoint, David, this has been the worst-case scenario. As an analyst of bubbles for three decades, I never thought it would get to this point, and I hope things are not as dire as I suspect they are.

David: Well, this goes back to what I asked earlier about this idea of a return to normal, where we assume that the last 13 years was somehow normal when in fact it was kind of an anomaly in all of financial market history. You don’t want to go back to this as normal. You can’t.

Doug: Well, we’ve been papering over these things for a long time. For example, we run massive trade deficits. That’s a structural issue. We shouldn’t be running massive trade deficits. Why? Because we print all this money and we import, and we flood the world with dollar balances. The dollar balances come back and inflate our markets. It’s just been such a dysfunctional cycle from the finance—but also it feeds into the economic—structure. Over the last decade, there’s been a proliferation of companies that lose money. There are negative cash flow companies that are uneconomic. It didn’t matter because finance was so loose. There was money for any crazy idea. Well, money’s going to tighten now, and a lot of these companies are not going to make it. This system is going to have to cleanse itself, and we’re going to have to get back to producing things and not have the kind of economic structure of, “We don’t care if companies are profitable or not. We don’t care what they produce.” It just hasn’t made any sense.

David: Lenin used to say that worse is better, and I suppose it’s not if you’re owning a bunch of stocks and are not paying attention to risk. But perhaps it is a little bit better if you run a short fund and anticipate this, and are able to offset some of that risk. Tell me a little bit about how you imagine the perfect matchup between Tactical Short and an institutional portfolio, a client portfolio, and the service that you provide.

Doug: What we’re trying to provide at Tactical Short is a hedging vehicle with a reasonable amount of risk to help offset risks in the larger portfolio that an investor would have. We just want to be a component. We’re not out there saying, “Buy Tactical Short and make a big bearish bet against the market.” We’re saying, “Having an allocation towards Tactical Short will lower the overall volatility of your investment portfolio. We’ll provide you some downside protection.” We just think, in this environment, it makes a lot of sense to try to take some risk off the table. One way to take some risk off is to incorporate a well-managed short component. We think it’s a unique strategy. We’re not a high risk, high volatility short strategy. We’re tactical. Yeah, I think this is a right environment for it, candidly.

David: Where we started the conversation was talking about the discussion we had with clients and interested parties about Tactical Short. I can’t emphasize enough, coming back and listening to or reading the transcript, I think folks will benefit from not only the analytical insights in terms of the market, but also just considering, how much risk do you want to be taking at this point? You can invest with hope being the primary pillar of your investment strategy. Over time, I think people with experience in the markets would say hope is not much of a strategy. So being mindful of the risks in play, being mindful of not only the potential reward or lack thereof, but the risks in play today, is absolutely critical. 

So I just would encourage our listeners to avail themselves of that resource. One of the most important resources that I go to on a daily basis is what you curate in a newsfeed where the most important articles on a given day are curated. It saves me hours a day, hours a day. I just would encourage all our listeners to tie into that with our Credit Bubble Bulletin in the section on our website with Credit Bubble Bulletin. You do an amazing job. It is an amazing time-saving device for anyone interested in the markets. This is a go-to on a daily basis. Then, of course, on a weekly basis, you do the [analysis portion of] Credit Bubble Bulletin, and have done that for several decades. 

Thank you for your commitment and your dedication to chronicling one of the great bubbles of all time. I just want to say it’s an honor to work with you. It’s great to have you as this vital component. We couldn’t do what we do without you. We really can’t. So thank you for the disciplines that you bring, the insights to our process. Of course, when it comes to managing risk, this is really, really critical. So I’m appreciative, and I just want to invite our listeners to engage with the work that you do on a daily basis.

Doug: Well, thank you very much for the kind words, David. It’s an honor to work with you, and I deeply appreciate everything you do to inform and educate, because that’s really what we’re trying to do. What I try to do in my presentation for Tactical Short, or what we did together, we’re trying to provide an analytical framework for people to try to make sense of a confounding world. It’s a very complex world, and it’s easy to be numb. I think a lot of us are numb. We’re going to pound the drum and say it’s not the right time to be numb. It’s the time to dig in and try to better understand what we’re facing here. I think it’s just critical. You do so much in that regard, so thank you.

David: Well, we’ll need to revisit a conversation like this later in the year, for sure, because these are very intriguing markets, incredibly complex, and I think our listeners benefit from you unpacking that complexity for them. So thanks for joining us again today, and look forward to having you back on the program.

Doug: Thanks so much, David. I’ll look forward to returning. An honor to be on with you today.

Kevin: You’ve been listening to the McAlvany Weekly Commentary. I’m Kevin Orrick along with David McAlvany and our guest today, Doug Noland. You can find us at mcalvany.com, M-C-A-L-V-A-N-Y.com, and you can call us at 800-525-9556.

This has been the McAlvany Weekly Commentary. The views expressed should not be considered to be a solicitation or a recommendation for your investment portfolio. You should consult a professional financial advisor to assess your suitability for risk and investment. Join us again next week for a new edition of the McAlvany Weekly Commentary.

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