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  • Powell’s .75% increase: ain’t Volcker, but it’s somethin’
  • Europe deploys “anti-fragmentation” grenade
  • China & Empire… Rolls out third aircraft carrier


Everything Bubbles & Endless Summers… End
June 21, 2022

“We had speculative darlings that got crushed last week, tech and cryptos under the most pressure, 20, 30, 40%, but everything got sold, right? Now what do we get? Do we get a summer rally? Do we get the month end, quarter end rally attempt? Do we have endless summers? Is that what we’re back to? Hey, the nightmare of the first two quarters is behind us. Now all we have is blue skies and perfect waves.” — David McAlvany

Kevin: Welcome to the McAlvany weekly commentary. I’m Kevin Orrick, along with David McAlvany. 

I was thinking, we had the everything bubble provided by the central banks for a long time, and it reminded me of a movie, Dave, that came out at exactly the perfect time in American history, called Endless Summer. And this movie was the dream movie for teenagers because it’s guys who were— It was 1966 that it came out, and it was a documentary of surfers going from Australia to New Zealand, then to Tahiti, Hawaii, Senegal, Ghana, Nigeria, South Africa. They just chased summer and surfed all the time. And that’s sort of what we’ve had. 

Unfortunately, winter does come, and endless summer, unless you can travel the world and chase the summer all the time, winter comes. I know it’s the summer solstice this week. And so, yes, we’re at the peak of summer. That got me thinking about it. But if we don’t start preparing for winter now, it comes as a shock. And there was nowhere to hide last week. I mean, winter, almost, it was sort of shocking, wasn’t it? The everything bubble wasn’t looking so everything.

David: Yeah, it was reality setting in for those who had been on vacation chasing the perfect waves. Reality, even for the trustafarians.

Kevin: Trustafarians.

David: No place to hide last week, certainly that was the case. It’s often said that in a bear market everyone loses, and the person that loses the least, that’s the winner. And for us, it’s tough to feel great about losing less. I would rather own hard assets with cash flow than anything else in this environment.

Kevin: Yeah. But how about losing one or 2% versus 20%? Yeah, I think I’d rather lose one or 2%.

David: Sure, sure. The credit markets are in a tough spot. You’ve got sovereigns, sovereign debt, which has suffered in many cases even more than corporate debt, and I don’t think that’ll always be the case. Right now, you’re beginning to see the credit default swaps, what it costs to ensure against default, beginning to move, both for investment grade and high yield debt. And investment grade bond funds had their 12th week in a row of outflows. And as we know, as goes corporate credit, so go corporate equities.

Kevin: Mm-hmm (affirmative).

David: So new issuance, this is really key. Corporations have gotten used to sort of rolling debt. It comes due, they issue more, it’s at a cheaper price. It’s all good. They continue to debauch their balance sheet but it doesn’t matter because it’s always on better and better terms. So watching new issuance of debt is key to markets, seeing how they’re functioning, that they’ve been functioning so well is something we now take for granted. And we are now dependent on continued securitization and new issuance in the form of junk and investment grade debt. If those markets slow, if they halt, we begin to see major, major problems, and that’s when you’ve got something of a catastrophe in both the bond market and the stock market.

Kevin: Well, I’m wondering if it’s going to affect the confidence in the central banks?

David: Dislocations in the credit markets are a game changer, and the central bank community may not be able to credibly do anything about it.

Kevin: But they have a new tool. What do they call it? The anti-fragmentation tool. It sounds to me like throwing good money after bad, but they call it anti-fragmentation. Can you tell me? There are certain jokes about fragmentation and how you get caught in a grenade. I’m not going to bring those up right now, but so tell me about European anti-fragmentation central banking tools.

David: Well, when I say central bank may not be able to credibly do anything about a credit market dislocation, I say credibly because we got to see the ECB launch a worthless new tool last week in response to a meltdown in Greek and Italian debt.

Kevin: An anti-fragmentation grenade.

David: Yeah. It’s new. The anti-fragmentation tool sounds pretty interesting, but really it isn’t. You sell French and German paper, the highest quality paper that you have in Europe, to buy— And actually, I should say that differently. If we want to keep it in order of quality, German and French paper to go buy Greek and Italian paper.

Kevin: Right.

David: Or any other peripheral European debt that’s hitting the wall.

Kevin: Oh, so you would trade German debt for Italian debt or Greek debt? I guess that’s what they did.

David: Yeah. This is a sophisticated new tool, anti-fragmentation tool. And you’re selling the quality. Again, this is supposed to be balance sheet neutral because you’re not— You’re just saying, “Okay, we’re going to own what we’re going to own. We’re just going to own a little bit more of this and a little bit less of that.” Think about what that has in common with the US educational system. It’s like lowering the average expectations in terms of performance.

Kevin: It’s the lowest common denominator.

David: So we all have equality of opportunity.

Kevin: Yeah.

David: And then we’re going to be proud with the results, right? Everybody passes the class. Of course, it didn’t take much to pass the class. In this case, all they’re doing is eliminating the siren sound of widening spreads between German bonds and Italian bonds. German bunds and Italian bonds. I forget what they call Italian bonds. I thought about maybe referencing them as cannolis. They’re filled with something. But, and actually I like cannolis, but you’re selling the good and you’re buying the bad?

Kevin: Yeah.

David: You shrink the spread by artificially decreasing the supplies of the debt that’s under pressure and increasing the supply of the good stuff.

Kevin: That’s a little bit like the United States if we came in and just swapped Mexican debt for US Treasurys. How would we feel if we were bond holders of US debt and we swapped it for Mexican debt and it just completely destroyed the value of our bonds?

David: Well, I think if anything, what we’re talking about is destroying is, again, central bank credibility.

Kevin: Right.

David: This is supposed to be a sophisticated solution to a bond meltdown is, “Hey, we’ll stay balance sheet neutral and we will sell German paper and instead, go buy Italian.”

Kevin: Is this just another form of price control?

David: That’s all it is.

Kevin: Yeah. Just come in and say, “Oh, well, we don’t like the price on these Greek bonds.”

David: That’s why it agitates me, because anti-fragmentation, it kind of sounds like, “Oh, we’ve got something really special here. Madam Lagarde has come up with something really neat.” It’s just another form of price controls. You’re targeting this time specific countries so that you don’t increase the fiscal strain and have rising rates ultimately sink the whole euro project.

Kevin: Yeah. So, in a way, instead of having these bonds actually just fail, which is what they could do. I guess another word for that would be extinction. They don’t want them to go extinct.

David: Well, I don’t think we’re anywhere close to failure of Italian debt. I mean, if you look at a 4% yield, that’s nothing like what you’ve got with Evergrande paper, which is over 145% yield.

Kevin: Right.

David: Which is like, how many different ways can you say you’re dead? I mean, we talked last week about the guy. We’re not quite dead yet. No. Actually, if you’re Evergrande, you are very much dead yet. It’s Vanke and Sunac and some of the others, Country Garden, which are not quite dead yet, but still have yields of—some of them, 60, 80%. So the Italians are not failing, but they have so much debt, and their debt-to-GDP figures are such, that an increase in yield is very consequential to what they can pay in terms of interest on that debt. It becomes very expensive, and it means that they don’t have the money for everything else they’ve committed to fiscally. So as open-minded as we may be to evolution, we see the ECB and other central bankers sure fighting like hell to avoid an extinction event. And it’s not for Italian debt, it’s for the euro project.

Kevin: But it’s a reshuffle. That’s all it is. They’re reshuffling bad for good.

David: Sure. Yeah. ECB is trying to hold one of those extinction events at bay through a creative reshuffle of what’s on the balance sheet. It’s not an improvement in quality. And at some day, somebody is going to want to think about that. That the quality of balance sheet does matter. In essence, they’re just taking action. They have an emergency meeting, and we’ve got our anti-fragmentation tool, a new tool. All they’re trying to do is hold back the tide.

Kevin: Well, speaking of tides, let’s just go across the ocean then, because as the West comes up with their anti-fragmentation tools and raises rates and reshuffles bonds— Remember when you had Michael Pettis on a few years ago, and Pettis said, for China to survive long term, they’re going to have to shift from the model that they’ve used for the last 30 or 40 years, which is manufacturing cheap stuff and selling it to the West. They’re going to have to shift and get their own people to become the consumption base of their economy. So, where China is right now, do they have similar problems that we have in the West and has that shift actually occurred?

David: Well, I think the commonality between the East and the West is that we’re all trying to control something that should not be controlled. There’s natural forces that if we just let them play out in—

Kevin: Mr. Market.

David: Yeah. It invites you and me and individual autonomous decision makers to have a say in the direction of things, right? So price controls fly in the face of that. The command and control dynamics that you get in China in terms of how they engineer their economy, it’s less than ideal. You had some really eye popping numbers come out here recently. The Chinese trade surplus, largest ever recorded for the month of May, came in at 78.8 billion.

Kevin: Isn’t that how they have run for the last 30 or 40 years? If they can keep a trade surplus, that actually fuels without having to cause the Chinese consumer to become the replacement for the American consumer, doesn’t it?

David: Yeah. I mean the two points of emphasis have been sort of the mercantilist model of growth where you manufacture and sell lots of stuff to the world, and then just investing in infrastructure. So, the signal is clear. Domestic consumption still is behind. It lags the manufacturing emphasis and the very non-productive infrastructure spending, which, 20 years on, virtually no progress has been made, moving away from that mercantilist economic model to one that recycles wealth internally with a robust middle class consumer as the prominent feature.

Kevin: So you’re saying manufacturing and the building of things, infrastructure, that type of thing. That’s been the economy for China, and it’s worked up to this point.

David: Yeah. Well, it’s the command and control dynamics that they just can’t let go of. When you focus growth through manufacturing, what they’ve done is they’ve provided heavy subsidies, and it’s specifically to businesses—and particular businesses. Again, it’s all winners and losers and how you choose them. So whether it’s price controls or command and control dynamics or choosing winners and losers, I mean, this is the theme that we continue to see over and over again, is what I would consider an abuse of authority. It’s not necessary. Your footprint isn’t needed here, and yet here you are. But yeah, infrastructure spending, that’s the hardest habit for the Chinese to kick. It allows for investment from the government to maintain a huge role as a stopgap for economic growth. If you want consistent economic growth of between 6, 8, 10% and it looks like an economic miracle, just remember that it’s not happening naturally. These are command and control dynamics, and this is one of the old habits that’s hard to kick. The Chinese consumer, still way down the list from priority number one.

Kevin: And it seems to always gravitate back to debt. Everything is debt if it’s not actual GDP growth. I mean, debt to GDP. That’s something that you watch. I know that’s something that Warren Buffet loves to watch. How about Chinese debt to GDP?

David: Well, the times are changing. We know that. We’ve got inflation and we’ve got interest rates on the rise. And all of a sudden, what worked in a past period of credit expansion, it doesn’t work quite the same. So, if infrastructure and government spending are central to Chinese GDP growth, debt accumulation will continue to run in a parallel track, and that represents a long-term challenge to their financial stability. Debt levels grew at a 10.7% annualized rate in China. Their most recent figures show 0.9% for the month. Again, annualized 10.7. That puts debt-to-GDP their ratio at 288% versus 2021’s GDP.

Kevin: Do you remember the movie—

David: 288’s a big number?

Kevin: Yeah, I was going to say, do you remember the movie with Kevin Costner Field of Dreams? It’s a great movie, but there’s a phrase that shows up in that movie. “If we build it, they will come.” 

David: Now they’re tearing down their [unclear] because they didn’t come. 

Kevin: They built it, they wanted them to come and it really wasn’t the field of dreams, was it?

David: Right. And in some instances, they have had the modern miracle of migration from the agrarian culture into something of an improved “middle class.” But again, if you look at the dollars involved, and Michael Pettis points out that rather than stimulate demand amongst consumers, the Chinese approach has been to stabilize the supply side of the economy, giving out tax rebates and subsidies for businesses, pressuring banks to lend to businesses at reduced rates, promoting investment and transportation and logistics. And the net positive, at least compared to the US and much of the world right now, is that inflation has not been a huge problem for the Chinese, in part because of neglecting the demand side. Right? 

So here we are on the opposite end of the equation. We over-stimulate demand in the US. We’ve talked about there being too much demand and thus a scarcity issue. So we over-stimulate demand in the US, and we’re surprised when supplies are inadequate and prices rise and we’ve got supply chain issues, which of course exaggerate that, exacerbate that. But it starts with major pumping of money supply on the one hand, and then fiscal handouts on the other. So it’s a different approach to a planned economy in China versus our version of a planned economy.

Kevin: You’ve often pointed out that the financial moves to the economic, which moves to the political, and then ultimately, the geo-strategic. What we have that’s different than 40 years ago with China is something that America found out. The power, back right after World War I, they found out the power of having a floating mobile runway and a floating mobile military base. In World War II, a big part of World War II was won because we had figured out that you needed these big mobile floating runways with military bases on them. You can have Marines on there to deploy. You can have the Navy on there. You can have air support. And the bottom line is these guys are coming up with that idea at this point. So it’s not just the spending and the economic side, but now we move to the political. You’ve talked about Xi and the political, but now we’re also moving to the geo-strategic. What does it look like when China’s making these big mega carriers? How many do they have now?

David: Three, as of the launch of the Fujian this last week. Third aircraft carrier completed and launched from Shanghai shipyard.

Kevin: What does that have to do with Taiwan?

David: Well, prior to that, you see regional projection of power through sort of the colonization of these island chains. And I say colonization, sometimes they’re actually building out something that was just a reef into a military base.

Kevin: Mm-hmm (affirmative).

David: But that’s sort of regional projection because you can’t float the island. It suggests there’s a different kind of activity. The Taiwan Strait is boiling with activity and attention this week. Yes, we’ve got the third aircraft carrier completed and launched. And it’s the style of fleet that suggests the intended reach of Chinese ambitions is changing. There is a regional ambition, but it can stretch beyond that. And so I think where you want to extend, we’ve talked about hard versus soft power, where you want to extend hard power, not just soft power, but extend influence and leverage. Maybe you want a little military hardware that can get to places that you couldn’t have gone previously.

Kevin: We’ve talked about how the US Treasury has fought war using their methods. Okay. The value of the dollar, the ability to trade using the SWIFT system. Our Treasury Secretary right now, Janet Yellen, she’s talking not about inflation. She’s talking about climate change. She’s talking about social impact while we rage with inflation. But in the past—I’m shifting gears because here we’re talking about geopolitics—the Fed and the Treasury have tried to solve and control everything with the prominence of the dollar domination. What’s that look like now? I mean, the Fed can raise interest rates, certainly not Volcker-style yet, but do we maintain world peace—not with carriers, but with Treasury action like we have in the past?

David: Last week was significant from the standpoint of the Fed’s choices. And certainly, you asked a question about Treasury activity, and that’s one way of creating influence. No, I don’t think we’re going to do anything significant to climate change or global social justice via the US Treasury. But it’s our means of putting pressure on Russia, and it has been our means of putting pressure on Iran and South Korea.

Kevin: Yeah, and even China, right? To a degree.

David: Yeah. Last week, significant really from the standpoint of Fed’s choices—the Treasury’s on the sidelines here—but in terms of the market response to that change, also very important to keep in mind, fed funds rate was raised to a new range of 1.5 to 1.75. That was a surprise 75 basis point increase. Powell had previously said that 75 basis points was not being considered, but after getting a fresh inflation statistic and looking at the university of Michigan consumer sentiment numbers, the committee voted, with only one dissenter, to increase more than they had previously signaled.

Kevin: Mm-hmm (affirmative).

David: As we had suggested they would.

Kevin: Right. You said that last week, yeah.

David: So one big question for the market to wrestle with here is whether or not the Fed has done away with forward guidance. Is that a thing of the past? Because they’d made very clear, 75 basis points is not on the table. That’s not something we would consider in the future. And then all of a sudden, that’s exactly what they did, contrary to what they had previously said. Forward guidance has been this thing that we’ve crafted over a 20- or 30-year period, where we want to create an expectation, and we want to manage the markets through the expectations that we create. So is forward guidance a thing of the past? I don’t know. I mean, we’ll have to see. I think the inflation numbers continued to dismay the professional economist class because they’re not supposed to be where they’re at. So you get another surprise to the upside, 8.6%, and it’s just one more round of consternation, of frustration, of surprise. Something’s not cooperating with our models here. And so, what are we supposed to do about this?

Kevin: Oh, there’s inflation here. Please leave the room. Leave the room. Our models don’t work that way. But I’m thinking about what the— Okay. Being an old guy here, I was around in the 1970s. Paul Volcker raised the fed funds rate to 20%. I mean, it was huge. So we’re talking about 1.75% here, or we’re talking— What is that in relation to 8.6% inflation? And truth of the matter is, Dave, the inflation’s twice that. You and I both know that.

David: Now the reality is, you may be the old guy in the room, but 1970s, you were skateboarding. So you’re not that old.

Kevin: Yeah. That’s true. That’s true. Endless summer. Endless summer. Now that was about—

David: Your own version of endless summer. You went for it too. You were just going to disappear into the sunset.

Kevin: I planned on running away from home with a skateboard, becoming a professional skateboarder, and I don’t know what I was thinking. I couldn’t even do a kick flip. Okay? But skateboarding was fun. Yeah.

David: We all have our imaginations. Well, this was the largest single move in interest rates since 1994. So keep in mind the last significant encounter with inflation, and balance those two things out because, while 75 basis points was a large move and it was the largest move in 20 something, almost 30 years—

Kevin: That ain’t no Volcker.

David: Inflation topped at 15%.

Kevin: Yeah.

David: And Volcker took that same fed funds rate.

Kevin: Yeah.

David: Now, whoa. 1.75. He took it to 20%.

Kevin: Yeah.

David: Right? So also, bear in mind that if we were counting inflation as Volcker did, you just mentioned this, that would provide us with a current tense inflation rate of approximately 14%. 8.6 is stiff. Right? I’m not suggesting that’s a small number.

Kevin: Yeah.

David: But just counting things the way they were counted— A few months ago we were at 13 and change. Now, we’re closer to 14%.

Kevin: Just using the way Volcker used to count. Yeah.

David: That’s just a wee bit from the late ’70s peak.

Kevin: Yeah.

David: Right? Now we can pretend it’s close to half of that. But we look at the fed funds rate, the increase of 75 basis points. And that may seem like strong medicine, but rates are still well beneath levels that would actually tame inflation. Negative rates, that’s what we have. Negative rates across the yield curve suggest that we have a lot further to go.

Kevin: But here’s the difference. Okay. Here’s the difference. I remember the 1970s, inflation was something that lasted that whole time. I was telling my wife this morning when we were having breakfast, I said it wasn’t but seven or eight months ago that we had no inflation. They were calling it 2%. We’re not even one year into this high inflation rate. So this is— No wonder these guys are shocked by inflation. These are young guys who weren’t around in the ’70s. A lot of times these economists, they were in school or not. They were getting their PhD when? A decade ago? And so, the point is, inflation had been around. You remember Greenspan? In 1976, [as President Ford’s chairman of the Council of Economic Advisers,] Greenspan came up with a campaign called WIN, Whip Inflation Now. And it was like price controls. It was basically trying to guilt people into not raising prices even though we had high inflation. That was ’76. Volcker didn’t come for three more years.

David: Well, yeah, I mean the duration was one factor. We’re only a year in. And so we’ve got one year of rising inflation versus the decade of rising inflation rates seen in the 1970s. And there is a difference. If you’re averaging 5 to 8% each year over a decade, and then it spikes to 15, what you ended up having, we’ve highlighted this before, but it is as consequential to an equity investor as the 1930s crash. It’s just less acute because you spread the pain out over time. The pain was stretched out over that decade. Well, a little bit more than that. ’68 to ’82. 

Do we have years ahead where inflation is still with us? Central banks say no. They’ve been surprised by the fact that it’s here at all. They’ve been surprised by the height that it’s gotten to, and who knows, maybe they’re right. Maybe this is just a blip on a screen, and 2022 is the worst, and we moderate from here. I think there’s a number of inputs that could argue to the contrary. You look at the yield curve, certainly there’s bond investors that feel that this is a short-term issue as well. Short-term issue with inflation, again, because the yield curve would suggest maybe it’s something we’ll have to deal with for another two, three years at most. Time will tell.

Kevin: Going back to 1974, Gerald Ford came up with the Whip Inflation Now. He wore the Whip Inflation Now button. It was to guilt people into not raising prices, even though they had printed a lot of money. And so, yeah. This whole inflation thing that just showed up all of a sudden here is nothing like the 1970s because ’74, and then of course, ’76, ’78, we saw the gold move all the way up to, what was it? 850 bucks an ounce by the time we ended the ’70s. And like you said, the stock market lost as much—just about as much—as it did in the 1930s. It was just done in a different way.

David: Yeah. The official commentary is that inflation is not entrenched today, not as it was in the 1970s, and therefore a very different animal. And so maybe that’s why we see a different approach in terms of the raising of rates. And it is gradual. It’s 25 basis points here, it’s 50 basis points there, depending on which global central bank you’re talking about. Is it only entrenched if it sticks around for a decade? And maybe it’s in that sense, like a recession, you can only say that it’s entrenched once it’s been entrenched for a long time. Recession. We’ll tell you six months from now if we were in one yesterday, last month, a quarter previously, et cetera. So how does inflation become entrenched if it’s not merely an after the fact measure of time? It’s when we pass a psychological threshold.

Kevin: Right.

David: And beliefs about the future change, which are then reflected in consumer behavior, how we spend money. It’s when people encounter rising prices everywhere, then they respond, right? So you go out for fast food and it’s no longer cheap food.

Kevin: Oh, it’s 10 bucks to just get a big Mac and some fries and yeah. Fast food’s not cheap anymore.

David: When vacations stretch beyond budget limits, not because of extravagant destinations, but because fuel costs all of a sudden narrow the range of what you can do, how far you can go, right? Inflation is entrenched when it hits the labor market and costs are on the rise from the standpoint of hourly income, and passes ultimately through to the consumer at new and surprising price levels, both in terms of goods and services.

Kevin: What if you’re moving stuff? Truckers? What does it take these days to fill up a truck?

David: Truckers deal with it when— They typically, if you’re cross country driving, 300 gallon tank, 1,750 bucks, and that only takes you halfway across the country, right?

Kevin: Mm-hmm (affirmative).

David: So close to four grand in fuel costs. When truckers pay, we all pay because everything we consume is moved from point A to point B for our convenience.

Kevin: Okay. But last week we talked about, let’s say Powell’s in here. We know he’s between a rock and a hard place, but here’s the problem. That rock and a hard place is very narrow. The rock is raising rates more than 1%. The hard place was raising rates less than half of a percent. Either way, there’s a consequence. And so, it had to be 75 basis points.

David: Yeah. Doing any more, up to 1%, risked direct culpability for a recession.

Kevin: Yeah.

David: And probably a trigger for financial market chaos. Any less, 50 basis points, 25 or what have you, and you get the bond markets in revolt, even greater revolt over the central bank reality disconnect. And you can only dismiss inflation for so long. So Powell landed where he should have for last week’s meeting. And we’re now in a position for markets to rally into month end, coming off of very deeply oversold levels. Worst week of performance since the onset of the pandemic. And we had options expiration. It did not result in a crash, which was far from certain last week—although the stress points are still revealing themselves. You look at commercial banks globally. You look at the bond markets, both sovereign and corporate. A lot going on there that suggests a little bit of stress.

Kevin: We talked about endless summer and how these guys went from Australia. And they just moved around the world with their surfboards, but actually interest rates, those have been moving around the world with their surfboards. It’s a little bit different, though. The tide is overwhelming them right now. Australia, what was it? South Korea? New Zealand? I mean—

David: In the last 30 days, you’ve had a bunch of countries that have raised rates: Australia, South Korea, New Zealand, England, India, Chile, Canada, Switzerland—which was a big surprise last Friday, Peru, Argentina, Philippines, the Czech Republic. And a couple of those have raised rates, if you stretch back, say to 60 days, two or three times they’ve raised rates. So the US surprised with 75 basis points. Get this, the Swiss surprised by moving from negative 75 basis points—that was the official rate, negative 75 basis points—to a new target of negative 25 basis points. How generous. How generous.

Kevin: Wow.

David: So last week was unreal.

Kevin: How do you judge currencies these days? I mean, how do you know when somebody’s going to do that? I wouldn’t want to be a currency speculator right now.

David: No way. What the volatility suggested was that there were unwinds of major, major trades. The radical currency swings last week were just for the record books. Big currencies, too, not the wee small ones. The pound, the euro, the yen, the US dollar. To a lesser degree, the Swiss currency. Not quite as big, but still all moving violently. 

It tells a fascinating story, and is a complement to the one told in the bond markets as a result of rates moving. The dollar, it’s near a 20-year high. And you find all of these extremes in various places. The Indian Rupee at an all time low. And it’s just all this massive volatility where you see a 3-, 4-, 5-point swing from one day to the next, whereas you might ordinarily see the equivalent of a 25-cent swing as normal daily volatility. Now we’re talking multiple points.

Kevin: So the question would be, okay, using the surfing theme, is this just a series of short sets, or is this a complete tide change, long term? I mean the guys who are asking inflation to leave the room, they’re basically saying this can’t be long. This is transitory.

David: Won’t last long. Won’t last long.

Kevin: But is this going to be a long, extended— like we talked about in the 1970s?

David: In the Financial Times, Muhammad El-Erian joins our chorus. He says, “It’s undeniable that after years of massive liquidity injections and floored policy rates, the world is in the grips of a generalized tightening of financial conditions that feeds on itself. This is not a cyclical phenomenon that will soon unleash mean-reverting forces. It is a secular regime change forced on reluctant central banks by inflation that has got well ahead of them and threatens livelihoods, worsens inequality, and undermines financial stability.”

Kevin: So an old saying is, yes, but real estate is always a great investment. In the long run, real estate is a great investment. And I remember, we’ve told this story before, but a client of mine, Richard, was talking to your dad back in 2005-ish, ’6-ish, before the real estate collapse, and your dad said, “Sell. Real estate’s not always a good investment. It sometimes comes way down.” And this client of mine, he did. He sold over a hundred properties that were highly leveraged. He went into gold, he waited, and he tripled his real estate holdings after the crash, after the crash of real estate. Are we going to see something similar to that in the real estate market?

David: Whether it’s investments or various cultural inputs, I think it’s so important to be able to stand outside of the current zeitgeist or perspective that the world has on things, and try to gain a perspective that is outside of this particular period in time. If you’re talking to real estate investors, man, it’s a frenzy. It’s never been better. We’ve made a bunch of money. We’re just going to double down again and again and again and again. And doubling down again and again and again on a leveraged asset is pretty attractive, right?

Kevin: And that interest is going up. Mortgage rates are going up.

David: But just like there’s social trends which we should probably step back and say, “Is this normal? Is this natural? Is this really something that is beyond a fad that will fade?” The same with real estate, how do we see where we’re at in a larger timeframe? If we can remove ourselves from the current moment, I think it would be helpful. Yeah. We’ve got mortgage rates stretching to 6%. We’re talking about a 30-year fixed rate mortgage for residential property, and that’s a problem because if the notion is that you always make money in real estate, maybe you don’t know what it’s like to buy and sell or to own and try to move out of, get liquid from, real estate in the context of rising rates. And again, there’s a difference between a minor uptick and a secular shift in trends. And again, maybe I’m over-reading from Muhammad El-Erian. He’s at Queens College, Cambridge. He’s an advisor at Allianz. He was the number two guy at PIMCO. And then, I think the number one guy after Bill Gross left.

Kevin: Yep. Economics change. Real estate changes. Everything changes when money’s expensive, not cheap.

David: Regime change forced on reluctant central banks by inflation. Is he right about that, and does that have an implication into the fixed income markets? If so, then 6% on mortgage rates— maybe we recede to five on our way to seven or eight. Real estate is now solidly in the crosshairs. Price corrections of 20 to 30% are a given, in my opinion. That’s enough to negatively affect the consumer. It’s the wealth effect in reverse. And this is something, if we thought the University of Michigan sentiment numbers were bad already, that’s in the context of a lot of people having the largest amounts of equity in their home that they’ve ever had—ever, ever. So as equity vanishes, residential real estate, investment properties alike, they’re impacted. They’re impacted by the cost of capital.

Kevin: Cost of money. Price of money.

David: Interest rates are on the rise. And just as equity investors, those are in the stock market have benefited from valuations stretching to crazy limits, somehow real estate investors consider themselves less vulnerable. The only reason they’re less vulnerable is because things don’t get priced on a mark-to-market basis second by second, sometime between the New York stock exchange open and close. You look at cap rates, and they’ve gotten just as silly—silly small—as valuations have for equities. And in the context of rising rates, cap rates will go where interest rates go. If we see rates go negative, cap rates are going to shrink again. And if interest rates are rising, cap rates will go with them.

Kevin: Explain to the listener cap rates. If they’re not familiar with that term, what is that?

David: The equation is simple. Net operating income, so take your income, excuse your primary expenses, and divide by the market value of the property. That gives you something the equivalent of a bond yield for real estate and it’s called a cap rate.

Kevin: So what’s a reasonable cap rate?

David: Well, I can tell you what’s not reasonable. If you’re buying real estate, which is an illiquid asset, and your cap rate is in the neighborhood of the 10-year Treasury, you’re probably in trouble. A lot of cap rates have gotten actually lower than where the 10-year Treasury is today. 3%, 4%, and it can’t remain the case. That can’t remain the case. So again, if interest rates are zero, a 3% cap rate is attractive, but if bond yields and interest rates, your 10-year Treasurys, 3, 3½%, then you should see cap rates of closer to 5 or 6%.

Kevin: So about double?

David: Yeah. And that would still be palatable given the liquidity differences between the asset classes. But think about this. For a cap rate to go from 3% to 6%, the market value of the real estate has to decline by 50%.

Kevin: And rising rates do that?

David: Oh sure.

Kevin: Yeah.

David: Rising rates are not good for real estate holders, and inflation may be taking rates considerably higher. Now, I mean, of course the arguments for real estate are that you’ve got some ability to raise rents, and if you’re talking about leveraged properties, you are inflating away the burden of that debt. And that’s certainly true. But just don’t look to be flipping properties and making a profit on it because you could be looking at a cash on cash return, which is very attractive in real estate. But if you go to sell, again, it’s going to come down to something that’s very relevant. And it does relate to where interest rates are. You’re not in some magical void. If interest rates are 4 or 5 or 6%, again, you’re going to see cap rates following that, and it means a discount to property values—a significant discount. Twenty, thirty is a very conservative estimate on the downside.

Kevin: One of the things that I think is very valuable is to understand your blind spots. Okay? And Dave, we’ve talked before, our entire adult life has been a falling interest rate environment. I mean, this last rate rise was the largest in 27 years. Now it doesn’t sound like much, but it was the largest in 27 years. So I think, I have to admit, I have a blind spot. I don’t know what it’s like to be in an economy that goes through decades of rising rates. I remember inflation, but I was a teenager. Okay? I remember rising rates, but I was a teenager. I mean, the stuff I remember is my grandma getting the silver out and selling it when silver hit 50 bucks an ounce. And I do remember Ford with the Whip Inflation Now, but it didn’t really affect me because my parents were paying the bills. What does this look like? I mean, if El-Erian’s right, that this is not just a short set of waves, but this is a long secular tidal change, that’s pretty critical, isn’t it?

David: Absolutely critical, and that contrast is what I think a lot of people can lose sight of. We’ll have the stock market rally some point in here this year, maybe this week, maybe coming into the end of the month, and at the end of the quarter. That doesn’t mean that all of a sudden we’re off and running to a new bowl, right? That’s just a short-term blip of positivity. We’ll take it. No problem. Love it. But be clear on what has been driving growth, and if the inputs that have been driving growth have now shifted and are no longer supportive of growth in the economy and for corporations, then you can’t see prices go up to infinity. Not just because interest rates—again, I come back to El-Erian’s contrast between cyclical and secular—not just because the rate increase was the largest in 27 years, but there is a gradual impact to be seen in every asset class when you start to see a tightening of financial conditions. It oozes into. It permeates slowly. What started decades ago has ended. What has begun in the last 12 months is now in its first year.

Kevin: Wow.

David: The question is, is it of many years or of many decades? And we have no idea.

Kevin: So the voices that we’re saying you need to invest in the most speculative things you can, whether it’s cryptocurrencies or Cathie Wood, who, she’s a risk taker, right? Tesla was one of her biggest holdings, but where are those voices now that maybe summer’s gone?

David: Yeah. Well, I mean, they would argue that this 12 months of inflation, it’s all we were going to see, and the worst is behind us. The increases in interest rates, we’ve already seen a radical rise in interest rates, and that too is behind us.

Kevin: This is what they’re saying?

David: Lacking perspective that there is a long journey between 1.75 and 20 points.

Kevin: Which was Volcker, right?

David: Right. Yeah. Cathie Wood was out and tweeting last week that we now have tighter financial conditions after Powell’s moves than in 1980, post Volcker.

Kevin: How does she figure that? At 1.75% versus 20% with Volcker, how does she figure that?

David: I think she’s figuring off of basically a 0% interest rate, and the rate of change or the percentage change from zero to 1.75 is mathematically more extreme than, say, a change from 5% to 20%.

Kevin: It sounds like she’s living in illusion like I was with my skateboard days.

David: Because that would bas— If you went from 5 to 20, you’ve increased fourfold versus a 0 to 1.75. I mean, have you gone up, I don’t know, incrementally 7, 10 times? I mean, the multiples of increase appear mathematically to be greater to her.

Kevin: Yeah. But it’s still comparing to inflation. The inflation rate right now is almost what it was when Volcker was in office. So 1.75 doesn’t matter.

David: What it suggests is that there’s many market operators that are underestimating the trends that are now in play, and they have no idea what pain looks like. A part of the secular shift underway is a move away from believing that central banks can solve every problem in the known universe with just one more set of inflationist policies. Easy money, easy credit allows for fabulous, even spectacular growth as it is the input. It’s the first input, right? Liquidity flows, and it allows for loans to be made. And then those who made those loans get to offload them into other financial homes that securitize loans, which are originated, then are quickly offloaded to someone else. The process of liquidity provisioning, financial structuring, product distributing, it comes to a halt when you either lack the end buyer of the product being pushed and distributed or when the liquidity dynamic from the central bank, the ones at the front edge, when that changes. Right? 

So the growth rates, talking about economic growth rates in the US, the growth rates in the US, they are coming down. But again, don’t factor in the outsized benefit of growth rates that have been tied to free money all these years. Now it’s less than free, and we see the World Bank come out with their 178-page global economic prospects, and the basic conclusions are: Don’t be overly optimistic. Don’t take high inflation lightly. Don’t leave vulnerable people in economies unprotected against the shocks themselves or their painful legacies. This is Martin Wolf giving sort of a summary of 178 pages in the Financial Times. In other words, there’s a lot more to unpack as this unfolds, and it may mean that the worst is not behind us, and we’ve got some challenges ahead.

Kevin: And the challenges— See, when we think of the financial moving to the economic and then to the political and then to the geo-strategic, the financial— A person can say, “Ah, it’s just my 401k. It’s down 20%, right? It’s the financial. No big deal.” The problem is, that translates later into the economic. I mean, we’re not in a recession yet, but I remember hearing that a recession is when your neighbor loses his job, a depression is when you lose your job. But that’s what the financial moves to. Okay. So your 401k, maybe it’s only down 20%. That sounds like a lot to me anyway. But what you’re saying is growth. Now we’re talking economics. Now we’re talking jobs. Are we going into a recession, Dave?

David: I don’t want to be dismissive of financial change because here we are with this interesting demographic bulge. We’re currently at 55 million people in the retiring age bracket. It’s going to grow to 80 million by the time we get to 2040. So give us 10, 12 years, and we’ve got 80 million people who are more or less dependent on their assets and a little bit of something coming in from Social Security. Hopefully, your little bit of something from Social Security still buys you a little bit of something you can put in your stomach. But there’s the financial aspect, which is pretty intriguing if you have less resources and you’re relying on those resources more and more as time goes on because you have retired. 10,000 people a day still retiring, and that’s where you’re getting to 80 million over the next decade. That’s a lot of retirees. 

We’re not in a recession yet. So going back to this economic side, Goldman Sachs points out that the odds are increasing, the event horizon is quickly approaching, where we are more likely to have a recession. That makes tightening—monetary policy currently tightening—into a recession a really fascinating dynamic for the Fed. We’ll have to see what they can actually do to reduce their balance sheet as a part of this tightening regimen. Rates are one factor. Powell has a lot of catch up if you want to join the ranks of Volcker, in our opinion. Perhaps we differ from Cathie Wood on that, from that perspective.

Kevin: Well, how’s that working out for her this year? I mean, where’s she at? Do we take her advice or not right now?

David: Well, that’s not fair. She’s down 60%, but she could be up 300% tomorrow morning or down another 60% tomorrow morning. That’s the nature of that beast.

Kevin: Mm-hmm (affirmative).

David: No, but the balance sheet runoff is going to be interesting. Last week kind of balanced these tensions between what we’re focused more on as asset managers. There’s financial market stress and strain, which was acute coming into options expiration last week, and it’s not as if it’s gone away. It’s just not the fuse burning down to the nub on a stick of dynamite. That was the case last Thursday and Friday. 

We also saw, last Thursday and Friday, something significant shift from the early part of the week, and that is the sensitivity to economic stress and strain. For us, the juggling act included watching economically sensitive commodities begin to take the threat of recession more seriously, with demand destruction a real outcome to weigh. So we see the oil service sector sell off almost 20%. We see natural gas off considerably. We saw crude off. And these have been, not necessarily safe havens, certainly they’ve been great performers. Natural gas was up over 100 percent for the year, and crude up over 50, 60% for the year, prior to last week. Why the sell off? Why the pressure in industrial commodities? 

Because there are financial market issues in play, but there are now growing concerns that it’s not just the financial markets, that this argument that actually we have quite a strong economy—I mean, listen to the Treasury Secretary last week. Economy is great. It’s great. And Powell’s comments midweek. “We have no concerns with the economy.” Oh, okay. Okay. That’s really interesting because the commodities market suggested something very different last week. We had speculative darlings that got crushed last week. Tech and cryptos under the most pressure, 20, 30, 40%, but everything got sold, right? Now what do we get? Now what do we get? Do we get a summer rally? Do we get the month end, quarter end rally attempt? Do we have endless summers? Is that what we’re back to? Hey, the nightmare of the first two quarters is behind us. Now, all we have is blue skies and perfect waves.

Kevin: Yeah. There’s a reality to that, though, Dave. We talked about the endless summer, and we really have as an economy and a financial system, we’ve borrowed our endless summer for the last at least decade. And yeah, I think of, since I’m going back to those days, Don Henley, he was the lead vocalist for the Eagles. He had a song called “After the Boys of Summer Have Gone,” and there’s a line in there that says, “Out on the road today, I saw a deadhead sticker on a Cadillac. A little voice inside my head said, don’t look back. You can never look back.” He says, “Those days are gone forever. I should just let them go.” And then he goes on. He says, “I can tell you, my love for you will still be strong, after the boys of summer have gone.”

David: Well, I can tell you, after the boys of summer have gone, we have to start dealing with what the future’s markets are telling us could be a crazy, crazy fall. Looking at the Japanese currency, and particularly the Japanese government bonds, I woke up on Monday morning of this week and I thought I had a bad read because I’m looking at Japanese government bonds, they’re the equivalent of the 10-year Treasury. And they’ve made this commitment to hold them at 25 basis points.

Kevin: Yeah, you said that last week.

David: And I’m looking at it at 43 basis points.

Kevin: Oh, wow.

David: And I thought, how is it at 43 basis points?

Kevin: Where’s the commitment?

David: I scoured the news to see, “Okay, what kind of chaos is this huge move in Japanese JGBs, Japanese government bonds? What kind of impact is it having in other markets? Well, as it turns out, I was looking at the September futures contract and not the current price.

Kevin: So it’s what we think about the fall, after the boys of summer have gone.

David: And what it suggests is that the Japanese, the bank of Japan, will lose control between now and September. And more recently, the September futures for the 10-year government bond in Japan is at 84 basis points, up from 25. Talking about complete loss of control. So we can pretend, whether it’s the Chinese and their favorite mechanisms of control and directing capital to infrastructure. We can pretend that adjusting our balance sheet and increasing interest rates— that we’re still in control. I think after the summer, it gets very, very interesting. September, October of 2022. Well, if I’m going to stitch El-Arian and Henley together, those days are gone forever. Don’t look back. You can never look back.

Kevin: You’ve been listening to the McAlvany weekly commentary. I’m Kevin Orrick, along with David McAlvany. You can find us at And you can call us at (800) 525-9556.

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

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