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The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

Eco-Spasm: Economic Inflation & Deflation All At Once
April 28, 2020

Should exports fall more and household consumption rise sufficiently, you are talking about a powerhouse economically. And of course, this is not to take away from the stresses and strains that they have within their financial and credit markets, but just looking from an economic perspective, not strictly or specifically from a financial market perspective. From an economic perspective, you’ve got a combination here driving old Cold War dynamics that I don’t like.
                                                           –David McAlvany


Kevin: 1987, I came to work for your dad, Dave, and there was a shelf piece, even though he produced a monthly newsletter, there was something that we put in the packets that we sent to clients and readers. It was called Eco-Spasm. It was a special report that your dad had written, and it had to do with the combination that someday, he said someday something is going to happen where we have a combination of inflation in one part of the economy and deflation in the other part of the economy. Little did he know, okay, that was 1987, little did he know he was talking about this week.

David: Yeah, well, when we see radical expansion of money supply and we see radical interventionism from the global central bank community, sometimes we lose perspective because today we’re talking about trillions. And back then, and this is again February 2001, he’s talking about eco-spasm and this massive monetary expansion of $150 billion in the quarter. This is a 31% increase in money supply, again, in just a very short period of time. 

Kevin: And he had updated that … that was the 2001 issue. He had actually written this back in the 1980s, and the numbers were even smaller than that.

David: Right, well, I mean again, this is well, maybe not a quarter but six weeks of monetary expansion, and that was 150 billion for M3. Well, guess what? We quit reporting M3. The only ones who still use the equivalent of M3 for monetary policy planning is the German central bank, where they think, yes, it’s still very important for getting a gauge on inflationary trends and other economic trends.

Kevin: Well, they took it away from us, do to remember that? Because it was like, ooh, this is something we really don’t want them to see. I think John Williams of Shadow Statistics still reports his own version of M3.

David: Yeah, you know, back-of-the-napkin math on getting to M3 from M2 is take M2 and multiply by 1.5. And so, you know, we’ve had an unprecedented seven-week expansion in M2 of 1.362 trillion…

Kevin: Not billion, trillion.

David: (laughs) It’s really mind boggling, where all of a sudden, you know, the fact that M2 is, for the week, up $125 billion. That’s M2, the equivalent in M3 terms would be $187 billion. That’s for the week! Not for six weeks, not for twelve weeks, not for a quarter.… Things are happening on a much more rapid pace. Numbers are much larger, and again, you know, we think well, 20 years ago, that’s forever ago. It’s actually not that long ago.

Kevin: Well, and you know, you look at the amount of money that’s increasing, which is the true definition of inflation. I think we sometimes think inflation is prices rising. No, it’s the creation of money. That always leads to prices rising. Someone brought up recently that you have this M2 just exploding at the same time that you have money velocity. Dave, you’ve talked a lot about velocity in the past. Velocity is way down. And so it’s a stealth form of inflation when you’re printing a lot of money but the money isn’t turning over. What happens when the money does start turning over?

David: That’s right. So, I mean, this is where I think my dad hit the nail on the head. I think the first time he referenced eco-spasm was back in the 1980s, and, again, phenomenon of an inflationary recession as a part of that eco-spasm scenario, it combines inflationary themes with very low business activity, right, so you’ve got an increase in money printing but a decrease in activity and so you have a depression and what can be construed as a deflationary environment. Meanwhile, the monitoring machinery is inflationary to hyperinflationary.

Kevin: You know what he likened it to over and over and over? I probably heard this a thousand times as he spoke, but he said it was a little like pulling up to a traffic signal that is turning green, yellow, and red all at the same time. No one really knows exactly how to react.

David: Well, in a 48 hour stretch last week, the US approved a $484 billion stimulus package, the European Union proposed a $2.2 trillion bailout plan, and then the Bank of Japan was suggesting throughout the week an unlimited bond-buying program to keep Japan from depression. And over the weekend, they delivered on that bond-buying program. It’s worth pondering because it’s not every day that these kinds of things happen, where carte blanche is on the table; you can write a blank check. Carte blanche only comes around on rare occasions.

Kevin: You know, I wonder if you were in a sinking boat, like the Titanic, and had everyone bailing. In a way, if you were measuring how many gallons were being bailed out of a sinking boat, in a way that’s exactly what we’re talking about. We’re talking about a massive amount of gallons of water being bailed out of a sinking boat. The problem is, the boat is sinking at a quicker pace.

David: So, fiscal and monetary restraints, they’re, again, if you’re talking about the U.S., Europe, and Japan, and certainly within China as well, they’re gone. Those fiscal monetary restraints are gone. Japan quadrupled its previous limit on corporate bond buying. It’s now about $186 billion in US dollar terms.

Kevin: They are just buying everything.

David: Basically, yeah. So you had one astute financial observer in the Financial Times noting that, relating to this Japanese announcement, that the pace and scale of what has already been announced is going to make it a lot harder for central banks to bring a positive surprise to the markets from this point forward.

Kevin: Okay, so we talk about positive surprise. See, you have brought out that this whole thing has been perception management because, in reality, even the currency that they’re printing has no value unless the perception is that it has value, there’s no backing to that currency. So the only thing that the central banks have really had is the surprise element, like what you’re talking about. At this point, the delusion is so huge that how can they surprise anymore?

David: And this is particularly critical when you think about perception management being key. You’ve got investors pinning hopes of economic recovery on stimulus from central banks. And again, impressions are key. So you get the ECB loosening its rules last week, and, again, this is about collateral that they’re willing to lend against, and they’re bringing in the so-called fallen angel bonds.

Kevin: You like the terminology there, don’t you? Now, a fallen angel in the Bible is a demon. So I’m just wondering…fallen angel bonds, is that something worth buying?

David: These are the dirty dudes. We’ve talked about bonds getting re-rated. We’ve talked about the bulging triple B bracket, right? So BBB bonds are the lowest rung in the investment grade category, and once you get downgraded from there, you’re now in junk status. It causes complete re-categorization. Certain mandates don’t allow for anything but investment grade up to including that bulging lowest bracket. Again, the triple B bracket. And the US, we already had this a few weeks ago. The US has already committed to purchasing that kind of paper through exchange traded funds.

Kevin: So, is there a consequence to this? I mean, are we really, really going to suffer any kind of consequence from all the printing of money and the buying of junk?

David: Well, that’s, I think, what you see in real time in the commotion of the fixed income markets and the patching together of a solution by the world’s central banks. Essentially, they’re removing consequence, and I think there’s a natural appeal to that at many levels. I mean, if you were a child of six and you could do anything you want and you took away the consequences, if you were a teenager and you could do whatever you want and just remove the consequences. Or if you were a leverage speculator and you could use other people’s money to leverage up and speculate with the removal of consequence, that is what we have today is within the financial markets a removal of consequence.

Kevin: Is that why they call it moral hazard? Okay, so do you remember Dave, of course you do, I shouldn’t ask it this way, but the Federal Reserve had a very small balance sheet, a little over a trillion dollars, and then it jumped to four trillion during the global financial crisis. What they said was they were going to actually reduce that; they were going to taper that off. Remember that?

David: Yeah, we went from four and a half down to the threes, right, and that was some progress for the time being. But last week, that Fed balance sheet was up another $205 billion, just for the week, so their total liabilities are now at $6.573 trillion. We are talking about coming up on seven trillion when we were in the threes at the beginning of the year.

Kevin: We started October of last year with the quantitative easing forum. We talked about it on the commentary, but the ECB has their own QE program. They’re adding trillions, not billions, not hundreds of billions.

David: Well, the latest QE program from the European Central Bank is now up to 2.8 trillion euros in purchases, and they have another program, the PEPP program, they’re putting in $5 billion a day into the debt markets and what you see is kind of a defense of the debt markets. You see a defense of the fixed income space, and I thought this was really a key point that Doug Noland made in our tactical short call this last week. If you haven’t heard it, number one, the Q&A was good. I think it was very helpful.

Kevin: And that was recorded.

David: Yep, and the comments too, I think it give a really good perspective on where we’re at and where we’re going. But one of the things that Doug said which I thought was critical is that we assume that markets are both liquid and continuous. And when you look at the ECB’s program, the QE program, when you look at the Fed’s balance sheet expansion, what you’re talking about is a backstop of these two critical variables. They want to make sure that these markets continue to be liquid and continuous because, in fact, we saw in March they were falling to pieces. They were seizing up. They were neither liquid nor continuous.

Kevin: What we saw over the last decade was the baton being passed from the various central banks, right? We stepped in for a while. The European Central Bank stepped in on their QE. Japan did that. So let’s go ahead and take the four biggest central banks. Okay, the Fed, the ECB, the Bank of Japan, People’s Bank of China, with all that’s coming in, the coordination or the lack thereof, how much is it adding up to now?

David: The average is right around five trillion apiece, if you’re just averaging it. So the Fed, ECB, Bank of Japan, PBOC, in aggregate their balance sheet assets, the assets, are at 21.6 trillion. As a percentage of GDP, which is kind of an interesting way to look at it, the Fed, and this is compliments of Ed Yardeni, he does some great research and chart work. The Fed sits the prettiest in terms of their aggregate balance sheet assets. They’re sitting at 18% of GDP, the ECB bumps up to 39%, the PBOC bumps to 40%, and the Bank of Japan, again these are aggregate balance sheet assets for the Bank of Japan relative to their economy, basically 105%, 104.7.

Kevin: Let’s talk about what that does to price discovery because it wasn’t two months ago that we were talking about Italian bonds, actually looking, interest rate-wise, what they had to pay, safer than U. S. Treasuries. Now…and I remember you saying, yeah, right. Okay, Italy? Come on, Spain, Greece? You know, in the past we’ve talked about how these bonds go down, but they don’t have to pay interest when you’ve got a central bank buying those bonds. But look at Italy today.

David: Prices are these helpful things that help us differentiate between the value of a particular asset. And it also helps differentiate what the risks are, associated with a particular asset. When you have these central banks buying everything in the kitchen sink, you lose the ability to differentiate quality, and you also lose the ability to differentiate variables that relate to risk. So what are you getting into? We know what everyone’s getting out of, and that’s really what you see is sort of a mass stampede to the exits from the fixed income markets, where the central banks have basically said we’ll buy it all. You can get liquid, you can get whole, if you were underwater, now you’ve actually made money on those assets. And that’s what we saw when the Fed started stepping in to buy investment grade debt and high yield debt. All of a sudden, this massive…you actually have many of the exchange traded funds which hold that paper, which were selling off precipitously just a few weeks ago. Now they trade at premiums to their net asset value because there’s a buyer, a buyer of last resort.

Kevin: Okay, but let’s say you’re Standard and Poor’s or Moody’s or one of these guys who has to go in and say, okay, we’re gonna weigh the risk anyway. What do Standard and Poor’s do when they’re looking at these? Let’s take Italy as an example.

David: Italy’s on the edge of a downgrade, and the S&P folks, you know, it was fascinating, just last week they basically said on the basis of the ECB purchases…

Kevin: So really, the only reason they weren’t downgraded was because the ECB was the backstop.

David: And then this is what I thought was fascinating about this little S&P release because, you know, on their own merits, they’re toast. But on the merits of the ECB and the ECB purchases of Italian debt, they are okay. And in essence, this is allowing the leveraged speculator in the marketplace to take out the garbage and get paid for the disposal. It’s just an amazing thing. Yes, it frees up credit within the markets and continues to allow for expansion in the credit markets. But it’s just fascinating to me. I didn’t know the ECB pledge was a critical variable in assessing any individual country’s creditworthiness. I thought they had to stand on their own two feet. But apparently, according to S&P, that is not the case.

Kevin: What would Standard and Poor’s, then, say about the ECB? I mean, that alone scares me. You know, Dave, ten years ago, you had Stephen Roach on the program, and he was the head of Morgan Stanley in Asia. When you talked to him about where China would have to go, we have to put in context where we were ten years ago. But ten years ago, you know, China had just come from 30-35 years of running huge trade surpluses with us, and we had deficits with them. They had, you know, $300-400 sometimes billion dollars extra a year to re-loan back to us by buying our treasuries. Okay, so that was the symbiotic relationship that we had really all of our adult lives. And Roach was telling us that they’re going to need to change. They’re going to have to become more independent. They’re going to have to actually bring their own consumerism into the economy. Now, looking in the rear view mirror, I just read a Stephen Roach article that you turned me on to this weekend, and in the rear view mirror, he was right. They have done that, and it’s broken down this symbiotic relationship. And now he’s saying something that’s just bone chilling, okay. And that is that this trade war that started as a trade war is now possibly going to move into a major cold war.

David: Well, and they have attempted to make that transition from the mercantilist model of export-driven growth towards internal consumption. They haven’t moved the needle as much as they need to. Still a very large percentage of their GDP is based on exports, but if you look at what they’ve done in their credit markets in an attempt to make the transition possible…

Kevin: They’ve borrowed it to do it.

David: Yeah, and they still have not completely accomplished what they set out to do. So, yeah, what began as a trade war just here in the last few years between the U.S. And China, what Stephen Roach argues is it very well made devolve into a cold war. And this is, frankly, the sourest tone I’ve ever heard as he describes the relationship between the two most powerful nations in the world, and, you know, so go back in time, he’s been in the commentary a couple times, actually. But before joining the faculty at Yale, he spent the decades prior to that as a Morgan Stanley economist, and then in his final years as chairman of Morgan Stanley Asia. He spent a lot of time out there. When he was on the phone with us, he said, you know, this was a year like any other where he traveled, already, it was about mid-year and had already traveled about a million miles going back and forth to Asia from the New York Morgan Stanley head office. But this Project Syndicate article I’m referencing, I think it is worth the read. He’s always been a very perceptive China commentator.

Kevin: Some of the guests that we’ve had have talked about nationalism on the increase and globalism on the decrease. Harold James wrote about it 20 years ago. He’s been a commentary guest several times. You had Peter Zeihan on about three weeks ago talking about nationalism. Nationalism is growing economically, but emotionally nationalism is on fire right now because of COVID-19.

David: Right, so fast-forward through the trade war, and the January to March period has sort of increased the rancor in terms of conversation and reporting between these two countries. You’ve got nationalism on both sides of the Pacific, and it’s being fed by suspicions over coronavirus. So, as much as evidence points to the lab creation of COVID-19 and the continued experimentation with coronavirus pathogenicity, as the way it’s been described by both Australian and Russian molecular biologists, all of this happening in Chinese labs. So, too, you’ve got the Chinese public, which sees the world through the same lens but in reverse.

Kevin: Yeah, they think it’s our fault.

David: It’s not a Chinese lab, it’s US labs. It was created and it was given to them, we infected them in Wuhan.

Kevin: So this is populism.

David: Yeah, there’s a populist rallying cry which politicians on both sides of the Pacific are happy to see inflamed because one of the net benefits of populism and really nationalism is that it takes heat off of the policy makers in both countries. The blame game does have implications, and I think this is where you see Stephen Roach particularly on edge, because this is the most important bilateral trade relationship that we in the United States maintain, and maybe it’s the most important bilateral trade relationship in the world. The US is China’s largest source of foreign demand, and China has become key to US exports. It ranks now number three on the list of U.S. exporters, and China still remains the largest demand pool for US Treasuries, right? So this is a particularly relevant fact as we consider what it means to finance our budget deficit, which is going to come close to $4 trillion for 2020.

Kevin: That’s unbelievable.

David: Four trillion, and that assumes that we get back to normal and we just have to finance what we’ve already committed to, plus what was in queue already for 2020, prior to COVID-19. If we stay on lockdown any longer, boy. Okay, five trillion, it could be any number, pick a number.

Kevin: Remember how we were shocked with one trillion? But let’s go back and look at the framework of how we’ve run over the last few decades because…

David: But by the way, we’re not the only ones running budget deficits.

Kevin: You mean other people are going into debt?

David: This is a very relevant fact, because not only do we need someone to finance our budget deficit, but everyone else has been running comparable deficits relative to GDP, and they need financing. It’s either going to be foreign or domestic. And how are they gonna pull those levers? It’s a very competitive environment right now.

Kevin: So last week we talked about oil, and five weeks before that we talked about oil. When the Russians decided not to cut production and it turned out that that was just a shot over the bow between Saudi Arabia and Russia. But let’s just look at the two main sources of our being able to borrow. Okay? For years, it was the petrodollar. As long as we bought our oil from the OPEC nations and as long as the OPEC nations only sold oil in dollars, they would recycle those dollars back into our US Treasury markets, they would allow us to run on debt. We did the same thing with China with cheap goods, cheap services, cheap, cheap. And what we would do is we buy more of their stuff, they’d get dollars, they’d recycle those dollars back to us. It’s worked so far, but we’re losing both of those sources. Where do we finance $4 trillion?

David: You’re right, that keeps the trade game going, that whole petrodollar recycling. But one of the things, if you are on the other side of the equation selling oil, is you’re looking at a currency which was pretty stable, right?

Kevin: Right.

David: And you could also look at the interest rate component and say, well, it’s reasonable. I have interest rates above the rate of inflation.

Kevin: Well, and when you have a buyer, don’t you have low rates? When you have a lot of buyers, you can keep rates low. But we’re losing the buyers.

David: Yeah, so now we have this environment of incredibly low rates. And in fact, those rates are below the rate of inflation. The dollar, it’s still in a stable category, all things being equal relative to others in the universe out there. But the trade aspect is being damaged by shale. The interest rate component is no longer interesting, intriguing, or positive. In real terms, we have negative rates here in the United States. Real, meaning you factor in the consequence of inflation to that. But then you’ve also got this notion, this notion which was very popular for a long time, this idea that low rates were a consequence of having too much in savings, the savings glut theory. 

You look at low rates today and you think, what? I mean, did that ever hold water, did it ever make sense? Does that notion still compute? No, I don’t think it did or does. But financing deficits has become the domain, not of the saver or investor, even if for the sake of argument you said it was excess savings, but now it’s the domain of monetary policymakers, right? So this is where, all of a sudden, again, financing deficits…it’s not the investor taking a chunk of bonds and sitting on them, collecting the interest or getting a return on investment from the coupon payment. But it’s the monetary policy maker. You’ve got a flood of financing needs which are overwhelming the total quantity of savings, and they require either the kindness of strangers—again, we’ve talked about that in foreign financing—or they’re requiring the printing press, the money printing capacity of the global central bank community. This is a key transition point.

Kevin: Everybody is trying to borrow at the same time, you said.

David: That’s that competition. Competition is growing for foreign external financing. We are deliberately cutting out the petrodollar recycling, which for decades provided support and stability for the U. S. dollar and a consistency and some visibility on our U. S. Treasury market financing. With more and more deficit spending and less and less trade surplus recycling with the Chinese and petrodollar recycling in the Middle East, who’s buying the debt instruments? Oil or manufacturing goods, those were the economic ties that once bound together the relationship between our nations and China, along with most of our key trade relationships, are now being sort of unraveled.

Kevin: And the popularity of China right now in the eyes of Democrats or Republicans, I read that Pew survey, and whether you’re Democrat or Republican, you just plain don’t like China. That’s the majority right now.

David: The key take away from the Steven Roach article, Project Syndicate, is that we’ve got a five-decade relationship. It took five decades in the making, it is under pressure. He references it, I’ve seen that research referenced in another place: the Pew Research Poll, where 66% of Americans view China in an unfavorable light. It is the highest number since Pew began asking the question fifteen years ago. On top of that, you take the perspective of Foreign Affairs magazine, the Council on Foreign Relations folks, they over the weekend highlighted the One Belt, One Road initiative. This is what China put in motion years ago, basically to open up the old Silk Road and doing that in terms of energy and technology, really was just an excuse to create interlinkage with everyone in the developing world and extend loans to them…

Kevin: And interdependence. That which would help, too.

David: Yes, yes. And so again, they put that in motion years ago. And this article in the Foreign Affairs magazine discusses the interlinkages they’ve created financing development in dozens of countries. The bill comes due, and sometimes it’s not money that is due. It’s an exchange of loyalty and preference. Those have a greater value than principal and interest payments.

Kevin: Well, this isn’t just a COVID-19, last two weeks, three weeks, five weeks, two months…this has been in the making for a while. We’ve been backing away.

David: Well, so the erosion of U.S. Foreign policy, which has really been in retreat for a dozen years at least, with China then filling gaps that we used to be in, right? They’re using the Asian Infrastructure Investment Bank. They’re using the Belt and Road Initiative as a means of cozying up to global leaders everywhere. Just as you’ve heard it said, nature abhors a vacuum, power abhors a vacuum. And this is where again you look at these currents of anti-globalization trends here in the United States, those taking hold. Angry Americans, angry politicians who were then benefiting via deflection and being able to point and say, “That’s the Chinese, this is where the disease came from.” Same thing is happening from China to the U. S., and this is all happening in the context of our fiscal position slipping from what was relatively strong to weak, in absolute terms. It creates real economic vulnerability. 

With that, you add the negative feedback loops of higher interest rates. This is one of the things that I loved about Roach’s article, just very realistic. You don’t get to keep interest rates at these levels forever. It will rise. So what are the consequences when you start seeing an increase? Okay, well, now you’ve got higher annual deficits, you get tighter credit market dynamics, and this is likely to reinforce the negative feelings we have from country A to country B. And this is where politicians love, they love anger management via the jingoistic piñata. You know, who’s the enemy this week. That doesn’t matter. I mean, it’s just as long as you’re not the enemy of being the public policy maker. And you might recall, Thomas Sowell has said, “there’s nothing so bad that politics can’t make it worse.”

Kevin: (laughs) Politics and leverage of politics. Because, you know, last week when you were talking about oil going negative, it went negative because contracts don’t necessarily recognize reality, there’s a lot of leverage in the system. We’ve talked about this with gold. Okay, so you may have 100-200 ounces of gold traded on contract for every one ounce that actually exists. The same type of thing can happen with oil. So you see these amazing manipulations in the market. I thought it was interesting, Dave, that China is sending 84 tankers for West Texas crude. They want to fill it up at a cheap price. Could they, could China have been behind some manipulations in the leverage markets in oil like we’ve seen with gold in the past?

David: You know, they bought a lot of oil in the month of March. And so maybe it was a little bit before the major gyrations in the oil market. It had already sold off in response to Russia and Saudi in the OPEC Plus boondoggle.

Kevin: But they had a place to put it. Remember last week, I said, if I dug a hole, I could get oil for real cheap. Well, they had tankers, okay, and they could get oil real cheap.

David: They did have a place to put some of that oil. So there’s a side note on oil. The Bank of China, this is not the People’s Bank of China, which is the central bank, but the Bank of China is one of the top five banks there in China. They reported this last week client losses of a billion dollars from that May WTI contract blow-up. Again, remember, we’re not talking about just a product and a price, we’re also talking about the obligation, we talked about that last week, the obligation to deliver product at a set price, time and place, and the obligation includes time and place. 

Those complicating factors are what flipped the price upside down because time and place, oh, guess what? No place to put it, that ends up being a real issue, one that I think we’re going to see again because we haven’t solved the June contract either. Back to this Chinese issue again, it’s interesting that U.S. commodity prices are, as we described last week, run by a global, global leveraged speculative community. And that’s primarily via your futures contracts instead of just your typical supply and demand dynamics for the asset itself. So we’re talking about paper contracts, leveraged global speculators, not just producers.

Kevin: Can big central banks like the Bank of China, the central bank in China go in and actually become a speculator as well?

David: Well, again, there’s two different things: the Bank of China and the central bank of China, two different groups. But I think it’s worth asking the question, because if the Bank of China can place bets on US commodity prices and either go very long or very short, why can’t the People’s Bank of China, the central bank or any central bank do the same?

Kevin: Well, if you can print money then you have unlimited power, unless they limit in some way the contract.

David: So what are the implications of being able to drive prices either higher or lower, again when you have no, as you said, no position limits, and we talked about this last week, this is what’s absurd about the futures market, there are no position limits. What happens when you have the possibility of an individual bank or a central bank if they so chose to even back a private bank to go speculate in a particular commodity, driving the price considerably higher or considerably lower? It’s disruptive. We saw how disruptive the price was last week in oil, but could it be equally disruptive for iron or copper? Gold? Silver? You have futures contracts for Treasuries, treasury bonds, for stock indexes. Imagine if a central bank wanted to put the power of a printing press behind the initiative to drive prices whatever direction they wanted to. Again we’re beyond the pale here, futures are no longer producers hedging production. This is leveraged speculation. It is global. There are no bounds and limits, no capacity limits here.

Kevin: So, to be clear, what you’re saying is position limits, they need to be put into place. Otherwise, any person who can print money and have unlimited leverage has unlimited control of the price.

David: Well, yeah, I mean, we think of like the scientific uses of lasers, not sort of the weaponized version of a laser, but imagine the financial market chaos possible, commodity markets, fixed income, equities, when prices could be ramped in either direction with an unlimited quantity of money generated by a central bank and focused like a weaponized laser with the intent of destabilization. Why aren’t we implementing position limits? It needs to happen.

Kevin: Well, and especially with tensions rising between what had been allies. It’s looking like we’re not having the same allies. So let’s look at Russia because Russia is an oil nation. Okay, they produce an awful lot of oil. In fact, I think there was a point where Germany was getting half of their petroleum needs met by Russia. You were talking about China. Now Russia. These are not necessarily allies in this particular environment.

David: No, but I think it’s a continuation of the same theme. So we talked a little about US-Chinese relationships being under pressure, and it’s not much of a transition at all to go to Russia. We still have sanctions in place with the Russians. We don’t like the energy dependencies that they’ve orchestrated through various pipelines to Europe. Now Europe looks to Russia in ways that are not healthy for us. They don’t like the market share, they, being the Russians, don’t like the market share which the US oil giants have captured via the US shale move, and this is largely from 2016 to 2019. So the tit for tat is alive and well here as well. And so when we think about the emergence of a cold war between us and China, you know, this is not exactly like the Cold War that we had with Russia, you know, in the Brezhnev Gorbachev era. But it’s not exactly warm and friendly, either. With chaos in the US oil markets, we’ve had a play through globally, the price of euro crude has traded well below what the Russian Central Bank has put into its risk scenarios sort of a worst case scenario. So in April, seeing that euro crude was very cheap, you had both China and Belarus gobble up record quantities of Russian oil at very, very low prices.

Kevin: Well, and we talked years ago about how Russia needed between $80 and $100 a barrel of oil to be able to be in a surplus. They’ve changed that. They’ve changed their budget, drawn it back down. They’ve sold an awful lot of US treasuries, they’ve bought an awful lot of gold. Okay, over the last couple of years, it seems like they are defining themselves with a much lower cost. So what price does oil need to be for the Russians to actually meet their budget without a deficit?

David: Exactly. And this is not a break even on oil production. This is a break even in terms of their fiscal obligations. So the Russians drafted their budget for 2020 and they would stay in surplus with oil at $42.45. Needless to say, they won’t be in surplus this year. They’ll be in deficit this year versus the expected surplus. And this means they’re going to be draining their foreign currency reserves. And they’re going to be draining a part of their sovereign wealth fund. What they call the NWF or National Wealth Fund.

Kevin: You know, you’ve talked about duration, though, Dave, you know, a month ago you talked about how the Russians, it looks like it was a calculated move to say, all right, we’re going to lose money. But in the long run, shale is going to take more from us. So let’s go ahead and lose money for now. Break the shale market here in America and then come back in and get the higher prices on oil. You think that was, I mean, duration is the whole deal. They’re going to run out of money if they were wrong. If they weren’t wrong, it’s going to be a completely different scenario.

David: They didn’t miscalculate. What they couldn’t have foreseen is the implications of coronavirus to global demand. So they’re assuming that they can handle this little war with US shale on the supply side. And no one considered that you could see a 40% collapse in demand in terms of global demand for oil. So this is where all of a sudden what I have in mind is the Cold War thematic and the re-alliance of the Russians and the Chinese, with us being on the other side of the table, because, again, you’re talking about the National Wealth Fund being empty before 2024. If we don’t see a pretty quick increase to the price of oil, they’re gonna drain their National Wealth Fund.

Kevin: That’s a short fuse, Dave.

David: Yeah, they will have to go through their foreign currency reserves, and then what happens next is very critical. You’re talking about a significant ruble devaluation, currency devaluation, and with currency pressure, think about how the dominoes fall. With currency pressure comes consumer price pressure. With consumer price pressure comes an agitation of the general public. And now it’s a question of, can you control the hoi polloi in your particular geography? Whether that’s Russian or Chinese, it’s not unreasonable to think that for different reasons, both China and Russia could see currency pressures in a similar time frame and slip into a common narrative that is very anti-US.

Kevin: Yeah, who better to blame than the United States? It’s not their fault. It’s the dirty Americans.

David: Play it out. You’ve got two autocrats that have shifted term limits and may be in power for life between Xi Jinping and Mr. Putin, right? They have domestic unrest on the horizon and a foreign source to blame for the discomfort that is felt by their people. You’ve got Cold War companions, you’ve got new Cold War dynamics for the 21st century, and this time with a superpower, China specifically, that has an economy that may well drive itself. Again, we’re still talking about a transition which is not complete. But should exports fall more and household consumption rice efficiently, you are talking about a powerhouse economically. And of course, this is not to take away from the stresses and strains that they have within their financial and credit markets. But just looking from an economic perspective, not strictly or specifically from a financial market perspective. From an economic perspective, you’ve got a combination here driving old Cold War dynamics that I don’t like.

Kevin: We started this program talking about an article that your dad had written back in the 1980s, Eco-Spasm and it’s interesting to watch it unfold now. But he also handed me a book written by a guy named Anatoliy Golitsyn. You had the book too, it is called New Lies for Old, and it was a Russian who had defected and had used a pseudonym because, of course, his life would be in danger. But he wrote a book about a 50 year think tank. You know, the Communists love 50 year time periods. They’re very, very long-game guys. 

And in this book, you’ll recall there was one thing that really was critical. Okay, now at the time that he wrote the book, China and Russia were supposedly archenemies. But he said part of the 50-year plan was something he called the pincer move, that the United States could arm itself against Russia, which we were doing at the time he wrote the book, or it could arm itself against China and look at them separately. But they wouldn’t have a hope if the two had united. Now that was the thought process back when he wrote this book. I remember it registered at the time, and I thought, well, I’m going to just watch this. Now I’m 57 years old. This is 30 some odd years later after reading the book and the possibility of a pincer move of a unification of Russia and China, at least against the United States, is more real now than it has been in my lifetime, Dave.

David: This is where I mentioned the book I was reading to you, The Passions and the Interests. This is a defense of capitalism before capitalism had won the day, and I think it’s an important read. But when you talk about Russia and China, the Chinese coming from Deng Xiaoping forward were given something like a giant golden apple or a giant carrot. And while we were still beating the Russians with a stick, we gave the Chinese the opportunity to embrace the Gordon Gekko greed is good.

Kevin: We bought their friendship.

David: We did, and we said we basically said success is what you have ahead of you. Wealth is what you have ahead of you. Development and growth is what you have ahead of you.

Kevin: And to a degree, that was right. To a degree, that was right. I mean, look at China, how it’s gone from Third World to First World.

David: They took the golden carrot, and, to some degree, we’re still beating the Russians with a stick. But we have this different relationship with the Chinese, and the question is, would we ever undo, would we allow for an undoing of a 50-year relationship? Basically, from Deng Xiaoping forward, the progress made, would we undo that and perhaps push them back in the direction of the Russians? That’s really what Roach is saying is at stake. We can change the world order for the worse if we want to make them into outright and obvious enemies.

Kevin: Well, maybe it’s not even deliberate. Maybe what is happening as history is actually playing itself out. And you don’t necessarily have someone saying, all right, we’re gonna break those 50-year relationships. It’s just happening. And so, but everyone is in debt. Ok, on this pandemic, we’ve been running a world with too much debt, a world that we can’t pay without actually printing money. But at this point, Dave, we were shocked at a $1 trillion deficit just a few weeks ago. Now we’re talking about four trillion, maybe five.

David: In the last 20 years, we’ve seen the popularization, the idea of the rise of the rest. And so, you know, this was originally the BRICs which was popularized by a Goldman guy who was, you know, BRIC was acronym for Brazil, Russia, India, China. The concept of the rest of the world catching up to the United States and the rich world, this is really, I think, one of the critical aspects to think about when you think about COVID-19 and the consequence of taking on so much debt as it relates to COVID on top of the debt that already existed. 

The rich world is deeply in debt post pandemic. Probably the best article I read in the past week came from The Economist. Get the most recent copy of The Economist. It’s about a six page article, and it deals with advanced economies having to absorb these deficits, which on average will run this year about 11% of GDP if you’re talking about the advanced economies. With the rich world being deeply in debt and in essence being hamstrung, then you look at the rest of the world and these two major players. Russia from a resource standpoint, China from both population and consumption and manufacturing standpoint, there’s constraints being put on the previously powerful, and it’s going to be really interesting to see how we deal with our constraints, that is, constraints in the form of debt, as they deal with global change in perhaps a very different way.

Kevin: Well, and how is debt paid? It’s either paid by the taxpayer, right? You can raise taxes and pay debt. That’s one way to do it. But you have to have a buyer of that debt. Now if everybody is in debt, where are the buyers?

David: And this was one of the key elements of this Economist article, debt is rising for everyone. Will it be paid back with taxes? That’s certainly one consideration. Is it gonna be haircuts to creditors? Which is a nice way of saying default through a negotiated process? Will it be taking the debt and trying to evergreen it over time? Just extend the terms and try to pretend that it’s not really that big of a deal, which is kind of kicking the can down the road. We’ve seen a lot of that in the U.S. and in Europe, and what that really counts on is, and this is where the article is just, we’ve talked about this before, Kevin, but this article makes it very transparent. When you’re evergreening debt, it counts on economic growth rates plus inflation being higher than the rate of interest paid on the debt. So that allows you to shrink debt to GDP over time. So everyone would say we’re having too much. What do you mean? We don’t have too much debt, we can increase the amount just like the Japanese have done, and we can manage it. What they’re basically saying when they’re talking about managing it is managing it on the backs of savers and pensioners because think about the variables, and I know this may sound complicated, but if you’re running economic growth rates plus inflation in excess of your interest rate, the other way of saying that is your interest rate is below the inflation and growth rate, which means you’re not being compensated adequately, right? You are being screwed.

Kevin: So if you’re a consumer, let’s say you’re retired.

David: Savers and pensioners are the ones in the crosshairs.

Kevin: Crosshairs is the right word. Okay, do you remember the Gary Larson cartoon, the two dear are standing there, and one of them has a target painted on his chest and the other one goes, “bummer of a birthmark, Hal.”

David: (laughs) Well that’s the equivalent of the saver or pensioner today. And it’s Ken Rogoff from Harvard who is saying that yes, you can. Yes, you can make the math work, but the process is most definitely one of designating losers. Financial repression, this is what academics like to call it, this is the deal. The investor or saver is put in the crosshairs. Bummer of a birthmark, Hal, and the crosshairs are the twin lines of low interest and high inflation. Debt is not a problem if you can sacrifice the rentier, that is, anyone living on their investment income or rents.

Kevin: Well and see here is the excuse: you don’t have to sell this to anybody, even the IMF paper talking about negative rates…

David: Deeply negative.

Kevin: Deeply negative rates last April, spent the last 10 or 12 pages of 83 pages explaining to the banks how they could psychologically sell something that would be very, very unpopular. You don’t have to psychologically sell it now, people are accepting anything that will restore some degree of comfort and keep them safe.

David: Right, so the important twist in this article came on page three, where the author describes the politically demanding times ahead.

Kevin: In quotations, “politically demanding,” we have to do what we have to do.

David: Right, because to properly implement the monetary policy of Ken Rogoff, you would need public acquiescence, which is only ever given during wartime. Because you’re talking about things like capital controls and fixed exchange rates and rationed lending and caps on interest rates, caps on interest rates. What we consider to be the new normal is something that was only ever accomplished during wartime, during a period of extreme, as they say, politically demanding periods of time. Right? But this is where leaders are not constrained by investor preference or the normal expectations of a saver.

Kevin: Okay, but we were talking about the retired. They’re the ones, okay, they have limited income, and we all know that they’re not going to raise Social Security with true inflation. So does the U.S. default on retiree obligations? I mean, is that a possibility?

David: Not before they get one over on the Chinese holder of US Treasury debt. I mean, if you were if you were a US politician and you said, look, we owe a lot of money and future obligations in the form of Social Security and Medicare, and that’s a lot of money…

Kevin: Or we can extract it from the Chinese.

David: Or we’ve got a couple trillion dollars that we can basically default on with the Chinese. Who do you care about as a local politician, right? So, yeah, all of the obligation, so Social Security, Medicare, pensions, then the official debt obligations. I think the route is, and this is the case that we’ve made for a couple years now, it’s default of a more subtle nature and it is default on everybody. And so rather than sort of creating two groups and saying, you’re the winners and you’re the losers, everybody’s the losers. You just do it in a way that most people don’t understand. Inflation and repression are the one-two punch needed to manage your mountain of debt. And frankly, this is what makes it really interesting. The rest of the world might just follow our lead. Central bankers around the world do the same thing. Try to run a higher inflation rate and lower interest rates. And it’s the savers, the rentier class that absolutely gets put to the wall.

Kevin: So how do you win? I mean, how in the world do you win when you know that interest rates are going to be below inflation? Do you sit on cash and just watch it wither away? Do you loan the government money or, I mean, I do know one answer. Okay, you do put it into hard assets, some gold.

David: The temptation when you’re looking at the potential deflation of assets, assets that have been inflated through the last 10 years of monetary policy. And maybe you could argue for the last 40 or 50 years of monetary policy, you know, credit growth has been on steroids since we got off the gold standard in ’71. But transport me and time out five or even 10 years. And do I want to play the market solely in cash and Treasuries as a world of inflated assets deflates? I mean, that’s one way of playing it. But how can you take that step when you have an indication of geopolitical conflict and a disintegration of global order, which suggests that you really can’t assume that you’re going to have liquid in continuous markets. Things won’t necessarily operate the way you would expect them to. Plus, you’ve got a justification, not just for US domestic currency devaluation. Again, we’re talking inflation meets repression or repressed interest rates for a long period of time, but you’re talking about justification for a global currency market meat grinder. Is that really where you want to be? You have to balance the lesser of two evils. I don’t think you could be 100% cash and Treasuries, it’s too much of a risk.

Kevin: Well, and our discussion has mainly been economic, just assuming that economics continues to function. But we’re not in one of the countries that are actually using this COVID-19 for darker excuses. Just a power grab by the state. You look at some of these countries, and what they’re actually doing right now in the name of protection from COVID-19 is something that we wouldn’t normally see until we did see a war.

David: Well, that’s another article from The Economist, which was discussing the autocrats stepping in and using COVID as an excuse to grab power. And could it happen in a place like the US? Maybe, but we’d probably call it something neat. We’d feel good about it, like we did the Patriot Act. You’re all for it because you’re a patriot, right?

Kevin: Take your shoes off. Take your belt off. Go ahead and get undressed before you go through the metal detector before you get on the plane. No, you can’t bring water.

David: Does that rub you the wrong way?

Kevin: No, no. I’m good. Well, I don’t have to fly anymore. COVID-19 shut the airlines down.

David: (laughs) You’re good, but what about that tic I see? Minor twitch, no big deal.

Kevin: (laughs) Maybe we need to do this recording remote from now on, okay?

David: Well, but actually I was encouraged by Attorney General Barr’s reminder to the Department of Justice that local and state politicians cannot run roughshod over constitutional rights. In the context of COVID-19, there is something that is supreme in the land, and it is the law of the land, and it can’t be set aside in the context of crisis. The difference between the US and other countries, it becomes more obvious when you compare them. Bolivia has basically said if reporters cause uncertainty that they could be jailed for between one and ten years.

Kevin: Wow. Wow.

David: Now think about if that was the bar you had to be above and you were writing articles, what can you say that could be construed as contributing to “uncertainty”?

Kevin: Causing uncertainty. We would both go to jail. Okay, doing the commentary, there’s nothing more than causing uncertainty, right?

David: One year, ten years, you know, how do you multiply that? We could be in jail for a century. In Turkey, arrests are occurring for the spread of misinformation.

Kevin: That’s vague as well.

David: How you define misinformation? If it doesn’t meet the party line, right? So in Cambodia you’ve got unlimited surveillance, which is in effect on private citizens. In Moscow, you’ve got the consideration of a new registration and location tracking, which would correspond to all of your financial transactions. So basically, if you’re leaving the house, you need to pre-announce your destination. Where are you going? That has to be announced and then you’ll be verified by where your transactions occur, and that goes into a database. Again, you’ve got China, which is taking the opportunity while everyone’s concerned about COVID-19 to go ahead and start making their big arrests in the pro-democracy movement there in Hong Kong.

Kevin: Yeah, you didn’t see that coming, did you?

David: Well, I mean, yeah, for a while there, you thought Hong Kong and the pro-democracy protesters were kind of gaining an upper hand. Now everybody’s too concerned about…

Kevin: And they have digital pictures of everybody. So, yeah, it doesn’t take long.

David: You’ve got India who is blaming the Muslims for the virus. In essence, what you’re seeing is that opposition political parties are being wrapped into the COVID danger vector, and they’re being processed as quickly as possible. Crisis is more than an opportunity here because you’re seeing outright power grabs. It’s more than an opportunity be cause it’s covering for abuse of power.

Kevin: Dave, we’ve talked about Howard Onstott, our friend Jim Deeds and some of these men who in their eighties and nineties have stayed sharp and clear. And yeah, I’ve really followed the philosophy of making older people your friends and listening to them. And, you know, your dad, he’s going to turn 80 here in just a few weeks. You know, these people have impacted my life, and I’ve now had decades to watch, to see if they were right or none. So I go back to Don handing me Anatoliy Golitsyn’s book, New Lies for Old. It took up until now and maybe even into the future for that to play out. But I also remember every packet that I would send out to clients, and any time I’d have a conversation, sending that Eco-Spasm article out about inflation and deflation and the chaos that it causes, and that that day is coming. It’s inevitable.

David: It’s fascinating because, you know, just looking at February 2001 what Don wrote was very intriguing because, you know, you said on the one hand we’ve got this massive increase in M3. We’re heading into a bear market in stocks. And, you know, at that point, it was already rolling to the downside. Company reports right now, Kevin, company reports for the first quarter of 2020, 28% are complete in the S&P 500. According to the GAAP earnings, they’re down 29% year over year, right? So there’s a parallel here to 2001 when my dad was writing this. One of the things that he includes in this is a discussion of commodities, where basically commodities were the lowest they had been in a long time within a 12 to 24 month period of this. So year 2000 we were putting in lows for commodities, whether you’re talking about sugar, soybeans, natural gas, oil…and at the time, he was involved with the Rogers Raw Material Fund, which Jimmy Rogers had put together, and we now have a commodities index, which is based on these basic things that people eat, right? Here we are again. The CRB Commodity index is at its lowest level since 1972, lowest level since 1972. It’s down 75% from 2008 highs.

Kevin: Well, that’s interesting, because 1972 is when your dad, a stockbroker, said, I need to start getting people into gold. From 1972, gold was 35 bucks an ounce.

David: I know! So we talk about demand mattering. Yes, demand matters for oil, demand matters for all these commodities. But if you look for opportunity in the context of crisis, I think one of the things that you find is that there are some assets that are on sale, and there are some assets that may go even more deeply on sale as this depression, we have yet to see what the duration of it is, but as this depression unfolds. Depth and duration of a depression are tough to gauge at this point, but we know where the value already is, and maybe paper assets catch up on the downside, where the stock market trades considerably lower. But in 2001, my dad was talking about how real things made sense. Do you know what happened between 2001 and 2008?

Kevin: Yeah.

David: I mean, a radical increase in the price of all commodities: gold, silver, platinum, natural gas, oil, sugar, soybeans, you name it. If it was a real thing, it was moving. And it’s just, it’s an interesting thought experiment.

Kevin: So buy real things right now.

David: Where would we be, where will we be five years from now? Seven years from now? Would you rather own assets that could potentially deflate? Assets, whether it is mortgaged backed securities, asset backed securities…as we talked about last week, do you want to own any asset that has a stipulation to it? That has…

Kevin: A counterparty.

David: An obligation. We talked about the complicating factors of the WTI contract where the obligations attached to it, not just that it was a real thing, but that it had complications attached to it, obligations attached to a time and place. 

Kevin, I want to come full circle to where we began the conversation, talking about China and also sort of the carte blanche nature of what our fiscal and monetary policies represent today. One of the great restraints to inflation over the last 20 years has been globalization and access to products which are produced very cheaply overseas. We’re in a transition back. Perhaps there’s a healthy transition back in terms of on-shoring, but there is a costly transition back to not having imports of cheap flat screen televisions and iPhones and whatever else we buy to offset the rising costs of other things, whether it’s college education or healthcare or food. This is where we’re walking away from one of those core deflationary inputs as we walk away from a Chinese relationship. And the surprise element, over the next two or three years, I think will be on the upside in terms of inflation where you have not only an increase in commodity costs with a return to normal, COVID-19 won’t be with us forever, but also a change in relationship where one of the dampening effects to inflation, the deflationary impact of a lower cost of goods being imported, that too is gone. So what does an investment thesis look like? If you’re trying to judge not what you have today, but as you’ve suggested from Jim Deeds, where do you judge the market to be two years from now?

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