Podcast: Play in new window | Download
Subscribe: Apple Podcasts | Google Podcasts | Spotify | RSS
- Is Russia/Ukraine an energy heist?
- Putin “will sell oil for Rubles” – Ruble rebounds
- Stimulus money still a coiled spring, only 30% has been spent
The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
For Lack of an Affordable Nail…
April 5, 2022
“Words are signals, signals are useful for creating impressions with a particular audience, it’s psychological engagement. It’s not truth telling. Again, when you hear the words, safeguarding, security, peace, looking for democracy, a democratic world order, just, mulipo— This is not truth telling, this is psychological engagement. Just? Just to whom?” — David McAlvany
Kevin: Welcome to the McAlvany Weekly Commentary. I’m Kevin Orrick along with David McAlvany.
We were talking last night as we always do on a Monday night, with Talisker, and you explained to me something that we should know intuitively, and that is the price of nails and how that actually tells us more about economics, probably, than a number of PhDs can today. So for want of a nail, the shoe was lost. For want of a shoe, the horse was lost. For want of a horse, the knight was lost. For want of a knight, the battle was lost. For want of a battle, the kingdom was lost. So a kingdom was lost, all for the want of a nail.
David: The fun thing about taking an interest in economics is that it takes you to so many various rabbit holes, and the National Bureau of Economic Research had a working paper from December of 2021 on the price of nails since 1695. And “A Window into Economic Change” was the subtitle. And it’s interesting in the same way that the Big Mac Index is interesting. The Big Mac Index tells you, on the street level, what’s inflation doing. If you’re in Turkey, what’s a Big Mac cost you.
Kevin: I think that was Richard Russell, wasn’t it? The Big Mac Index. He was the one who reported on that, I think.
David: Maybe it is. The idea is that you’ve got some gauge of pricing and so, the story of the nail from 1695 to the present is also intriguing because it tells you something about the benefits of deflation over time. Now, there’s a few factors. There’s a decline in price for nails from the 1700s to the 20th century, and a part of that is that material prices are coming down, part of it is that productivity is increasing, and that’s through a variety of factors, manufacturing, specialization, what have you. And as GDP grows, as you have greater wealth, the scale and scope of what nails contribute to GDP is shrinking through time. Then all of a sudden, mid-century, the 20th century, we see real nail prices start to rise, and they’re still rising. So, just like the Big Mac Index is telling you something, the price of nails does too.
Kevin: Do you want to tell us what it is telling you? I mean, I think I have an idea. When money is stable, you start to become more and more efficient as a society in manufacturing nails, and you grow as an economy, so like you said, the percentage of the use of nails as far as the growth of the economy goes away, the percentage drops down. But when you take gold or when you turn a currency into something that’s not stable, you start stealing that increased productivity and putting it in the pockets of inflation.
David: Since the 1930s, we’ve had this notion that deflation is bad because we experienced a catastrophic asset price deflation, and now all deflation is bad. But if you go through the history of money and the British Empire, and in the early American Empire, you see that there is a positive deflation where your dollar is buying you more, not less, through time.
Kevin: Which is good for us as consumers, not bankers, but as consumers.
David: And I think one of the big changes that occurred at around the turn of the century was that growth in government required growth in revenue, so taxation became critical. Well, there’s no sense in having your income increase without having to also pay taxes on it. There’s an interesting connection here between the deflationary impacts of the gold standard where you may get the equivalent of a pay increase as things cost less through time—
Kevin: Sounds good to me.
David: As opposed to paying more in taxes. By the way, the Federal Reserve was created in 1913, so was our income tax, our—
Kevin: And the nails started going up not long after that.
David: Yeah. So gold is a limiting factor, deflation prioritizes the consumer, inflation prioritizes the government, and you can see this play out in particular ways. I get to talk to folks who are coming into retirement every day, and it’s not a rare occasion where I’m talking to retirees who’re having to leave their homes because the property tax that they pay is far in excess of what their mortgage payment was originally. They paid for the house a long, long time ago, but as there’s been an increase in value in the property itself, property taxes keep marching higher too, to the point where it’s no longer affordable for them to even stay in their own home.
Kevin: And so, you look at the inflation over the last century because of this, well, the government has sold us on this, to be honest with you, as far as this fear of deflation, in other words they’re like, “You should fear that your dollar is going to go further and further and further.” So what did we do? We went off the gold standard and they said, “We’re doing you a favor, but here’s what we are going to do, we’re going to leave the dollar on a petro-standard.” In other words, you can’t buy oil without US dollars, and that gives the stability to the dollar. So even though we’ve had inflation, the dollar hasn’t completely collapsed because up to this point you could only buy oil in dollars. Now, that takes us to what’s going on over this last week, Dave.
David: And there’s some definite comment there for Russia. I just want to say one more thing about social change through time. You think we’re making more money, and we are, but it’s not buying what it used to. I think one of the best social reference points here, to move past the Big Mac Index and the price of a nail: we used to be able to operate just fine in a single-income household, and now it’s almost impossible to survive—
Kevin: Now you need two and a half people.
David: That’s right. So, just the math of who has to work just to make ends meet tells you something that has shifted dramatically. There’s a real cost to inflation.
Kevin: Okay. But we really have enjoyed exorbitant privilege here as Americans because, in a way, the dollar still has been used as the reserve currency of the world. Now, we have had a shift here recently, and that is Putin saying, “You know what? We’ll sell our oil, if you’re not going to let us do it in dollars, we’ll do it in rubles.” And there’s sort of a gold hint behind the ruble as well right now.
David: Yeah. One thing I want to say about the next week or so, just to put this on your calendar, we’re on the eve, we’re close to the happiest day imaginable for US taxpayers, going back to 1913. And we celebrate this around our house with kumbayas and roasting marshmallows and—
Kevin: So it wasn’t just the Fed, but it’s the IRS that came about and—
David: April 15th, we love the day. It’s one of the happiest days imaginable for US taxpayers. We are going to be doing our tactical short quarterly call on April the 14th, the day before—the eve of the happiest day imaginable for US taxpayer. You can join us, Doug Noland and myself, the eve of that happy day, April 14th, and we’ll talk about instability 2022, inflation, war in China. If you haven’t had a chance, register for that.
Kevin: Yeah, register at mwealthm.com. That’s mwealthm.com.
David: So, as we’ve described, we’ve got record trade surpluses in Russia. That’s continued with oil and gas flowing and the free flow of currency never ceasing that inbound track to Russian companies.
Kevin: So even with sanctions, they’re seeing record trade surpluses right now.
David: We didn’t cut them off from oil and gas. Certainly Europe didn’t. So, it’s not been a unified move. Many have wondered about the request to be paid in rubles for oil and gas, which, like the petrodollar of the 1970s, ends up supporting the currency by generating a forced audience of foreign currency holders. Is it reasonable to think that the request the Russians have made amongst their trading partners will be carried out? I think it certainly seems a reasonable probability from China. There’s other trade partners that perhaps would be less inclined. I guess it depends on your preferred association. The established world order, or the New World Order, in which the Russians and the Chinese have a prominent role.
Kevin: So, you’ve got the New World Order, you’ve got the new New World Order, like you told me last night. How many world orders do we have? But oil has always seemed, I mean, if this happens, where oil is now sold for rubles, this is a first, Dave, because we’ve militarily intervened in the past when countries wanted to move something in oil in something other than the dollar.
David: And you can see why China would be supportive of the move because, in essence, it’s the first olive out of the jar. Why wouldn’t you begin to condition the world to seeing global trade, not just for commodities, but finished goods in a particular currency? And don’t the benefits begin to accrue in terms of the stabilizing of the RMB and the— let’s create the universal presence of the RMB within the global financial system by requiring that those trade contracts are settled in RMB, just like is being proposed with rubles for oil.
Kevin: So what’s going on is not just a geopolitical realignment. What we’re talking about is a geo-financial or geo-economic realignment at the same time. So let me ask you, global oil production, the United States, I think, edges out Russia slightly, but not by much, do they?
David: No, that’s true. And this is really an important and underappreciated point, that currency stability is a part of kingdom stability. And so we want to see dollar stability if we’re going to see dollar leadership continue in any way, shape, or form. And to the degree that you see currency stability emerge with other countries, then that leadership is to some degree challenged.
Kevin: So in a way you’re saying, for want of an affordable nail, a kingdom is lost.
David: Well, this last weekend in Hard Assets Insights, my colleague, Morgan Lewis wrote about how crucial this issue of currency stability is and pointed to the fact that under the gold standard credibility and stability were one and the same thing. It was embedded in the currency itself. When we moved away from the gold standard, credibility became tied to the actions of the Federal Reserve, to the central bank community, so now credibility is only sustained by the actions that they take. What is left of it can compromise currency stability, and that has a whole set of consequences, including even higher priced nails.
Kevin: Yes, I agree with Morgan as far as the Federal Reserve being the main provider of stability. But there is something else. Our military has provided stability through protecting the petrodollar, and that’s why I would like to look at global oil production, and just what role does Russia play if they are starting to take rubles for oil?
David: We’re still at the top of the pack. Global oil production by ranking begins with the US at roughly 12%, Russia is second at 10%, Saudi Arabia is right behind Russia in terms of crude production. And a small note, the IEA pencils out percentages differently, but the rankings are the same. And then you’ve got natural gas, the other major energy input, and natural gas production has Russia in the number two seat behind the US, but with even larger reserves than the US has. So Russia has the largest reserves in the world.
Kevin: And I wonder if they’ll have even larger reserves if they stay in the areas that they’ve been taking in Ukraine, because Ukraine has huge, huge, natural gas reserves.
David: There’s a Harvard International Review back in October of 2020 that highlighted the Ukrainian development of its own natural gas fields as a massive economic growth opportunity and as a move towards independence. And they are the second largest reserve in Europe behind Norway, and that’s before you count the deep water reserves. Most of those reserves, the onshore reserves, are concentrated in the Donbas region in the form of coal and natural gas.
Kevin: Which is Ukraine.
David: Should it come as a surprise that the energy riches of Ukraine are the two areas where Russia has concentrated or supported conflict for nearly a decade? You’ve got Crimea and the Donbas. So, at the end of 2020, BP did a research of global oil reserve supplies, production, and projected production going forward, and they listed Ukraine with 38½ trillion cubic feet of natural gas reserves, 34 billion tons of coal, equal to about 3.2% of global reserves. It’s really important to see what is just off the coast of Crimea.
Kevin: That would be an interesting report to attach to the show. So, do you want to go ahead—
David: Happy to do it.
Kevin: —and attach those to the show?
David: Happy to do it.
Kevin: Both the IEA report and the BP report on energy economics. So, if we were going to look at US strategic policy over the last 30 or 40 years, we can definitely see the reason why energy played such a role in the mix, because the dollar was the petrodollar standard. So gas reserves, I know the Black Sea is known for its gas reserves as well. What if we just had glasses, Dave, when we put our glasses on that just looked at things in energy terms, would it explain what Putin is doing in a more reasonable way?
David: Well, it might. And this is a possible explanation, but you do have significant gas reserves in the Black Sea that have been left unexplored by the companies that had negotiated the rights to do that back in 2012. So you had both ExxonMobil and Royal Dutch Shell in cooperation with a Romanian company that had the rights to explore and exploit the deep water resources off the coast of Crimea. And so, as jurisdiction became an issue in 2014 following the Russian seizure of Crimea, they’ve done nothing with it, nothing’s happened. So with Crimea, the Russians picked up valuable ocean front property, warm-water ports, and they also have the deep offshore energy assets. So between Crimea and Donbas region, you have most of Ukrainian energy assets.
Kevin: You bring up warm-water ports, but you not only have to be able to have the energy, but you’ve got to be able to move it. So those warm-water ports are really critical. So let me ask you a question, then. Is Putin just simply expanding his energy footprint worldwide? Is this an economic decision as much as any other type of ideological decision?
David: Throwing into the mix a New York Times Op-Ed for March 29th might shed some light on that. The title is, “What if Putin Didn’t Miscalculate?” What if this is a heist as much as it is a war? If this is about securing Russian energy dominance in the 21st century and underscoring monopoly-like flows to Europe, then Putin doesn’t need all of Ukraine, he just needs the territories that are asset rich from an energy standpoint.
David: So the Op-Ed finishes with a healthy reminder that, and the writer says, again, “in war, politics, and life, it’s always wiser to treat your adversary as a canny fox, not a crazy fool.” So, I thought that was an intriguing look at what may be a more reasonable explanation of what—
Kevin: So a heist.
David: —is happening.
Kevin: A heist.
David: It’s not just an insane thing that he’s doing as a result of bad health. It’s a heist. One thing is certain: You’ve got Putin, who’s done the math and will pay in Russian blood and bodies for Ukrainian resources. You look at how Chechnya was handled, you look how Grozny was handled. If frustrated, Putin will attempt to win by any means necessary.
Kevin: So he’ll pay in Russian blood for Ukrainian resources, for oil, basically, but he’ll take payment in rubles. And talk about currency stability, what Morgan was talking about, currency stability is very, very critical, yet look at what happened to the ruble, Dave. When the sanctions came on, the ruble tumbled. Now it’s back.
David: When we came off the gold standard, it was clear that we had problems, and that’s when Kissinger negotiated the sweetheart deal to have oil traded in US dollars. Again, that issue of forcing accounts to hold dollars in order to transact what is the lifeblood of the global economy. And so, to see the US dollar losing credibility and then credibility be regained, not actually by the Fed, but by this transaction mechanism, it seems that sanctions, going to Russia now, sanctions created a temporary pressure on Russia, and we saw the ruble to dollar exchange rate, it fell from 81:1—I think it was actually maybe even 75:1 prior to the invasion—to 140:1. And as—
Kevin: So it lost almost half of its value relative to the dollar for a season, for a—
David: But the exchange rate is back to 81:1, and the flows of energy to Europe have not shifted. They did not stop. It was Poland’s Prime Minister here in the last few days expressing frustration that sanctions don’t have the kind of bite they could have because of the way Germany has road-blocked, or has basically prevented that from happening. Of course, they haven’t been willing to sign on to the US in not taking Russian oil. So you had US cessation of imports from Russia, and that’s eventually a demand factor, as we’ve noted, but supplies cannot be increased significantly if you’re talking about exports from Russia because of the mechanisms of transport.
Kevin: So pipelines and tankers, that’s how you transport it, right? Pipelines and tankers.
David: Right. So we go back to a couple of potential points where you could take oil out of Russia to other places, and you do want a warm-water port because China, if we’re just thinking about China as a potential consumer for Russian oil, existing pipelines are at capacity, and your very large crude carriers that are needed to move bulk crude, that’s 2 million barrels per boat—
David: —they take about month and a half, two months to get to a destination, and that changes the economics of energy trade and energy finance for a lot of people, changes the dynamics of that market pretty dramatically. But you can appreciate why ocean front property is intriguing if you need to redirect and shift your supplies and sales, but your pipelines are already at capacity.
Kevin: You were sharing something with me last night that was really fascinating, and I don’t know if— I don’t want to get too distracted on this, but these VLCCs, these extremely large tankers, their draft under the water is so deep when they’re full, they can’t get through the Suez Canal, they can only be half loaded. So, you think about things, it’s not just about— It goes from everything from war to pumping oil, to moving oil, warm-water ports, there are so many things to consider. I was telling my wife this morning, it’s really hard to analyze the news right now because I already know that there’s a narrative, they’re trying had to get me to think a certain thing based on story, by story, by story. But there are a lot of technical things that go behind even the movement of oil, Dave, that could actually, like you said, be costing a lot of blood right now.
David: Yeah. The bottlenecks, the transport bottlenecks are very real if you’re talking about redirecting resources, that is natural resources, commodity resources to another destination. Very fascinating to watch India jump on the opportunity to buy cheap Russian oil. And that in itself may be one of those defining things because India has been more aligned with Australia and Japan, the US, and if they in fact, given a thirst for oil and energy, shift in the direction of Russian and China, it’s an interesting development to watch. So that issue of a transport bottleneck, it’s just because there’s not that many ships that can actually carry it, and you think, well, two million barrels is a lot. Yeah, but keep in mind, we’re consuming basically 100 million barrels a day, and there’s 800 very large crude carriers on the planet.
Kevin: And these carry two million barrels per boat if they’re full.
David: Right. But can’t go full through the Suez, which means you go from a one to two week straight shot, short distance, to something that could take as much as two months to deliver oil.
Kevin: Because they have to go another way.
David: Right. You get 800 VLCCs, 700 Suezmaxes, 600 Aframaxes, and each one of those different grades of tanker is moving down from two million to one million to 600,000 barrels of oil which can be carried. And so, they’re each designed for either short-haul or long-haul trips. But long haul, again, changes the economics of the oil business very dramatically.
Kevin: Isn’t it fascinating? The Suez Canal changed politics for forever back in the 1950s as far as Britain’s hold on world empire. Now the Suez Canal is also factoring into what we’re seeing today. So, let’s take it back to politics, though, because Biden got up and he said, “Well, this inflation is due to Putin.” Is the inflation really due to Putin, Dave?
David: There’s no such thing as Putin’s price hikes, except in the minds of Biden’s speechwriters. I mean, the February PCE, which is the preferred inflation metric used by our central bank, came out last week. It confirms that inflation through the most current reported period was in motion prior to Putin. Again, remember, this is a February number. So it gets to 5.4%. We already had CPI reported and PPI reported for February, but we didn’t have PCE.
There is likely to be an additional bump because obviously the March period is just ending, and the global inflation problem’s not going to be solved if we think that Putin is the cause and therefore regime change is the cure. And that this is how it’s being set up, which is, it has its own dangers in terms of misdiagnosis from both an economic inflationary standpoint and a geopolitical standpoint. And again, it’s not fair to say that inflation as it showed up in the US and globally—which, you look at all the charts, and all the statistics say that they predate the Putin buildup and invasion of Ukraine. This is where it is solidly in a speechwriter’s mind.
Kevin: Okay. So inflation along with war, like I said before, for lack of an affordable nail, a kingdom could be lost. And you were talking about India realigning with Russia, but really, this whole Russian thing, it’s China that we need to be watching, China and Taiwan. You had just read a piece by Niall Ferguson, as we look at the horizon, what are the potential changes and outcomes that we should look for?
David: The Bloomberg piece that you mentioned, Niall Ferguson added some historical perspective to the current conflict. It was a piece titled “Seven Worst-Case Scenarios From the War in Ukraine.” I think it’s worth a read. He too is keeping a watchful eye on the Chinese in Taiwan, and would not rule out the possibility of a World War. A World War III scenario is not out of the realm of possibility as far as he’s concerned. You got Russia in Ukraine, that’s one crisis, multiple other geographies are in play as well. And he highlights what he says is the increasingly aligned regional foes, the Arab states and Israel, which are not keen on seeing Iran with nuclear weapons.
So look at US foreign policy where we’re trying to resolve some sort of a negotiation with Iran that’ll positively free up barrels of Iranian production, which could have a net positive effect on inflation and obviously fuel supplies for the world. But you look at how the Arab states and Israel are very keen on not having Iran, just in the oil business as a competitor, but with hardened nuclear arms. So if Iran’s oil supplies could take some of the import pressure all off of a reduced flow to the US from Russia, I see the rationale, but you’ve got a bunch of other people, again, the Arab states and Israel, which would say, we appreciate your rationale and it’s shortsighted.
Kevin: Yeah, but what about our strategic reserves? Can’t we just continue to tap into that? I think I know the answer to that.
David: That’s last week’s deal. So speaking of last week’s Strategic Petroleum Reserve promise, sure, we got the release from the SPR. Is it a big deal? Yes and no. I mean, it’s helpful for a short stretch, but it’s actually very unhelpful in the long run. Keep in mind that, I just don’t want to forget this, Schumer was the lead protest behind not topping off our reserves in 2020 when the prices were scraping zero and teen levels. So we had the opportunity to fill it to the brim, and there was a huge protest, environmental concerns, we’re decarbonizing, blah da blah di blue. So the problem with the reduction in reserves now is it’s not a sustainable choice. What’s the encore? Where are the reliable flows coming from thereafter? You are essentially burning through an existing and finite stock of barrels versus fixing a flow issue.
Kevin: Right. So we’ve got an oil issue, but I look at the players right now that are on board, Dave. We’ve got China, which is a nuclear power. We’ve got India, which is a nuclear power. We’ve got Pakistan, nuclear power; we’ve got Russia, nuclear power. We could go on and on, but not only nuclear power, I read an interesting book on the Soviet Union’s buildup of biological weapons, and a lot of their ICBMs were actually armed with biological smallpox types of things. So we have the potential, if the stories coming out of Ukraine right now are even half true of some of the massacres that are going on, even if they’re half true, and I understand they’re trying to manipulate the way I think, I get that. I don’t necessarily know exactly what’s going on. But if they’re half true, Dave, and you’ve got somebody who can press a button in any of those countries, then this next decade, we should probably be prepared for things to change from this decade on for what we’ve seen over the last 30, 40, 50 years.
David: Yeah, sure. Back to that Bloomberg article, Ferguson has put on a bet that he wishes to lose, he doesn’t want to win this one. The bet’s with Steven Pinker, that’s the author of The Better Angels of Our Nature, back to 2012. The bet is that by the end of the decade, the world will have experienced conflict, either conventional warfare or nuclear warfare, which claims a million lives. So the academic argument that Pinker and many others put forward is that statistics show a decline in conflict since World War II, and so something different happening.
There’s a bit of extrapolation going on, extrapolation of that trend suggesting that peace is now more of what you can expect, yet there’s a wide acknowledgement that having been less prone to war since 1950, just because this short period of time suggests we haven’t had as much, that in no way guarantees the future will be peaceful. It’s that issue of correlation being different than causation, remember?
So, we have a hope-filled recent past, but not enough of the future unfurled to see peace, and if this peace will hold. It’s a little like the equity markets and investors, their tendency to extrapolate past performance into future expectations. We’re warned not to do that—past performance is no predictor of future results—but that’s exactly what people do. 401(k) investors look up the best performing mutual funds from last year, which gave them the most money or could have given them the most money, and they allocate today’s dollars into the most appealing offer.
Kevin: I had a story occur in my own life over the last couple of weeks. I’ve got some neighbors that we don’t know real well. I don’t know them actually at all, but they were driving across our property and then using the subdivision’s private road.
David: Just literally cutting across your land.
Kevin: Cutting across our land because it was more convenient and they’re driving on our road, and we all pay, the people who live in our little subdivision all pay $700 a year to maintain this dirt road that they’re just driving on. I don’t need to go on, but I finally broke down and built a fence, and I put no trespassing. And I don’t like having to do that with neighbors, but I had heard an old saying that good fences make for good neighbors, and they have stopped doing it. We didn’t have to have an altercation, what have you. But I look at the last 40, 50 years, what you’re talking about, Dave, and the good fences that we had, a lot of it had to do with the United States enforcing empire worldwide. That seems to be breaking down. The dollar’s breaking down. Militaristically we’re breaking down. Politically we’re breaking down. So what leads to war sometimes— what keeps people from war is good fences, and you’ve met this man, Christopher Blattman—
David: Yeah. We’re just a few weeks away from our conversation with him. We’ll talk about war, we’ll talk about peace, we’ll talk about the issues that contribute to one or the other outcome.
Kevin: He’s the author of Why We Fight.
David: Yeah. And I was glad to find in his bibliography, several references to Bob Jervis, he’s a commentary guest from 2019, very good conversation. I suggest you find it in the archive. What Jervis brings in as a very critical element to appreciation of international relations is psychology.
Kevin: Right. Narrative.
David: And how people are perceiving things and how they react to those perceptions. There’s room for propaganda. There’s room for deception. There’s room for misunderstanding. And it crosses over well into some of the themes that Christopher Blattman has, again, on war and peace and how we exist in one state or the other. So, thinking back to this Bloomberg article with Niall Ferguson, World War is not inevitable. It may be more likely than, say, it was 10 years ago, but I think his point is that peace is not inevitable either.
Kevin: I think about Jervis, what you’re talking about, and then exactly what my conversation with my wife was this morning, which is: What’s the narrative they’re trying to sell me, no matter how true the news story is? And you look at Lavrov, who is Russian’s foreign minister, the way he describes the war from Russia’s standpoint doesn’t match at all the narrative that I’m hearing.
David: Well, yeah. He said, “A real war, a total war was declared on us.”
Kevin: So that’s he’s perspective.
David: Again, this is Russia’s foreign minister taking a victim’s perspective, really interesting. He said, “A total war was declared on us to destroy, break, annihilate, strangle the Russian economy and Russia as a whole.” And Kevin, this is fascinating because the Lavrov-Xi connection, this is where it gets troubling, in part because meanings and definitions are used with, let’s say a lack of clarity. And so, Lavrov paints the picture of a New World Order, saying, “We’re living through a very serious stage in the history of international relations. We, together with you, and with our sympathizers will move towards a multipolar, just, democratic world order. Then, in compliment to that, you’ve got Chinese foreign minister Wang echoing the same sentiments: “There is no ceiling for China-Russia cooperation, no ceiling for us to strive for peace, no ceiling for us to safeguard security, and no ceiling for us to oppose hegemony.”
Kevin: So the pincer move, Dave, 35 years ago, I read the book by Anatoliy Golitsyn, New Lies For Old. New Lies For Old, even the title, New Lies For Old. And he predicted that the Berlin Wall would fall. I couldn’t believe it when I read it, but sure enough it did. But he also said, within a 50-year period, there would be Sino-Soviet agreement that would basically enable them to be a superpower that is much larger than the United States or Europe.
David: Getting the band back together. Wasn’t there a song “Back in the USSR.”
Kevin: That’s the Beatles. And “Getting the Band Back Together” is The Blues Brothers, so you’re referencing a lot of stuff.
David: Great. Well, this is interesting. What do they mean by multipolar?
Kevin: Or just?
David: What do they mean by just? And democratic world order, I mean, when I think of a Sino-Russian version of democracy—
Kevin: You think of democratic world order? Yeah, right.
David: It’s hard for me to push this out of my brain, but I think also of the idea of equality and fairness being institutionalized by the Taliban in Afghanistan. What? You’re doing what? What do you mean by equality and fairness? I don’t think it’s the same thing as what I mean. Same words, different language? So this is one of the things that I go back to Thomas Schelling and I go back to Robert Jervis— Bob Jervis: words mean nothing, actions mean everything.
Kevin: But words can alter actions.
David: They can. Words are signals, signals are useful for creating impressions, desired impressions with a particular audience. It’s psychological engagement. It’s not truth telling. Again, when you hear the words: safeguarding, security, peace, looking for democracy, a democratic world order, just, multipolar. This is not truth telling, this is psychological engagement. Just? Just to whom? Multipolar? Look, we do the same things. It’s not as if the West has a monopoly on language, we can use language and abuse language as well, but, again, opposing hegemony, I don’t think they’re opposing our hegemony as much as they are displacing it with a new power structure. Keep in mind, power abhors a vacuum, and it’s not as if they just want us out, that’s not what they’re moving towards, they’re moving away from us, and towards something very clear. It is their displacement of our power with a new power structure. So their hegemony in replacing ours is the way forward, that’s getting the band back together.
Kevin: Dave, it seems almost trite to talk about the financial markets, but they are an indicator oftentimes of how things are going. We just finished quarter one, now we’re about to get the results and see how it went. It’s been wild, hasn’t it?
David: Yeah. And prices are their own language. And again, we come back to issues of interpretation, what do they mean? We talked about this last week when we talked about yield curve inversion and the interpretations of the long bond not moving while the short bonds and the short end of the curve are moving higher. And so, there is an interesting overlap between the linguistic confusions that we have as we look at international relations and what people take certain signals to imply about a future in terms of prices and the directions of the markets. So—
Kevin: Well, Russia’s not the only thing, right? I mean, quarter one, it’s been wild, but Russia was a late-comer to quarter one.
David: Right. If we look at Q1 in review, very much a wild start to a new year. Russia’s in the mix, but the action in the financial markets predates, as much as inflation predates, Putin, so I think the easy scapegoating is not the equivalent of quality analysis, and it doesn’t lead you towards anything that would be fruitful, certainly from an investment thesis.
Kevin: So, what does Mr. Bond tell us today?
David: Well, for Q1, US bonds had their worst quarter in 40 years, and so maybe we see an immediate bounce, some sort of relief as we come into the second quarter. We don’t want to extrapolate along a trajectory indefinitely, that’s very easy to do, but the bond market interest rates are going higher and higher and higher and higher and higher. Maybe we have some moderation of that here in the second quarter. I think, if you took a long-term view, that may be true—that interest rates have a longer-term trend to fulfill the bond bear market, which we experienced in one quarter of 2022 after a 40-year bull market in bonds. You could hardly argue that 90 days is sufficient to work off 40 years of a head of steam and excess within the lending and credit market.
Kevin: The investment bonds, I mean, it was a radical drop.
David: So, performance-wise, you got the worst performance in US bonds in 40 years. Investment grade bonds lost 8% in one quarter.
Kevin: In a quarter.
David: And these are investment grade. High yields—high yield bonds—nearly 5% down, long Treasurys over 10%. Spend a little time looking at the charts of LQD, HYG, and TLT, the ETF bond indices. That’s where you’ll begin to see a picture of what I’m talking about. Then you had peripheral European debt, which exploded higher, so bond yields were higher in France and Spain, Portugal, and Italy. And this was even in the context with Madam Lagarde promising to do what’s needed to accommodate the financial markets. Go a little bit further around the world, JGBs, Japanese Government Bonds, went seven basis points into the twenties, and that brought Kuroda out to proclaim his capping of bond yields with a guarantee of any quantity of buying necessary to do so.
Kevin: Just like the European union did years ago.
David: Yeah. And the yen absolutely loved that. A quote from Haruhiko Kuroda, “The yen’s appreciation has a more beneficial impact than a negative one so long as the depreciation is gradual and in line with the nation’s economic fundamentals.” And he went on to say, “There is still no need to tighten monetary policy in response to a transitory trend as opposed to a sustained one. The economy actually needs a continued loose monetary policy to keep the recovery on track from the Covid pandemic.” So, here’s a holdover from the transitory crowd. He’s sticking with that, and, lo and behold, the yen has moved to multi-decade lows. So, plenty of volatility there. Plenty of volatility in the yen market. Note that gold in yen terms is looking pretty good.
Kevin: That’s looking good in everything right now.
David: So we could talk about the yen and the RMB all day long, there’s a great case to be made in the most recent Grant’s Interest Rate Observer for the yen depreciation triggering an RMB depreciation, and so to see a forced devaluation within China, that could be quite intriguing. With that, the assumption would be that US equity markets are put under pressure.
So, back to bonds, we had the bund market, which is the German treasury market, went from negative 20 basis points to positive 50 basis points, so, huge losses in bond-landia. And in what is considered a boring and safe asset class was in the first quarter real turmoil.
Kevin: And bonds are no hedge for inflation. This quarter, gold added 100 bucks, silver came up a buck and a quarter, but oil, let’s say you were to annualize any of these numbers, oil up 33%, and look at the other commodities, it’s just huge.
David: Yeah. Commodities had huge moves in the first quarter, all asset classes had very intriguing moves. You mentioned gold up 100 bucks, silver, call it a buck and a quarter, crude up 33%. It was trading 50% higher during the quarter and then moderated that with the Strategic Petroleum Reserve—
Kevin: Which translates to gasoline.
David: —and in addition to that, the closing of the Shanghai business activity that basically put it under quarantine. So gasoline was at 41%, at least gasoline futures. Natural gas, 51%. Nickel ended the quarter at 55%. This is one quarter. Aluminum, 24%. Iron ore, 39%. Zinc was up 18. So those are your industrial commodities.
It’s worth noting that, going back to the 1970s, you had a move higher in your industrial commodities which basically topped in ’74 and then moved lower. And inflation continued higher for another six years, so it becomes something more than a commodity move. Inflation is not just commodity prices increasing, and that’s, I think, one of the things that is key if you’re talking about the psychological aspects. Not just the numbers, the math, the widgets and digits and bushels and barrels and everything else that’s moving. Speaking of ag, they moved painfully higher as well. Cotton was up 23%. Soybeans up 20%. Corn was up 26%. Wheat finished the quarter up 34%, but in a pretty wide trading range and it was as high as 77% during the quarter.
Kevin: And you brought up last week that corn, the Chinese have 70% of the corn. Oil, they have 70% of the oil. They have 80% of the copper. So, the Chinese made a really interesting play a couple of years ago, didn’t they? Because the commodities are paying off nicely. I think you could figure Russia in the mix as well.
David: Yeah. We’re spending our petroleum reserves to lower prices, they continue to hoard, and it may be because they’ve got more on the timeline, and they’ve got a longer timeline than we do.
So, at the tail end of the quarter, Biden announced the invocation of the Defense Protection Act. And he’s looking at the inflation numbers, he’s saying, “We have to increase what we can do for electrification of vehicles, and we’ve got to get batteries moving again. We’ve got supply issues and we need to resolve that.” So, the invocation of the Defense Protection Act is to increase the sourcing of minerals needed for EV batteries. Maybe that’s going to open up domestic production. I doubt it because you’d have to get the EPA on board and get some permitting done. We have some really intriguing resources, between mines—well, not mines, but properties that could be turned into mines—up in Minnesota, in Arizona, and in Nevada. There’s a variety of states that are stuck right now in the permitting process, where we could bring online some of the largest in-ground deposits of copper, nickel, palladium, and a whole variety of things that would help with the EV—cobalt—that would help the EV battery situation.
Kevin: But wouldn’t we rather be dependent on China? I mean, let’s face it.
David: Well, that’s the irony, is I don’t think we’re going to move the needle, even with the Defense Protection Act in motion. Current sourcing is not predominantly domestic. And the majority of processing for EV materials is dependent on China.
Kevin: So let me get this right. So we’re dependent on China for electric batteries, and what we need for that. We’re dependent on the Russians to negotiate with the Iranians. Right?
Kevin: Right now.
David: Yeah. So the insanity factor here is— it tells you something about the world we live in. We need the Russians to negotiate an Iranian deal for more oil for us, so they get nukes, we get oil, and we’ll need the Chinese to grant us permission to move towards decarbonization. If commodity prices didn’t send a signal of global dysfunction in the first quarter, I’m not sure what did. This is a crazy world.
Kevin: You can watch commodities for more truth than you can the stock market. You can watch bonds for more truth than the stock market, but the stock market itself, which usually is the last guy standing, let’s face it, the stock market doesn’t pay attention to anything until it drops big. But equities, this first quarter, equities have not been the greatest place to be.
David: No. It’s interesting, I listened to an interview with one of the chief strategists at Macquarie, I believe they’re out of Australia, and they had a theory about how Chinese equities were going to absolutely soar in the first quarter. And there was really elaborate description of what was going to happen, and this comes back to the difference between words and actions. Prices tell you something more clearly than the theory, and it’s price action which you just can’t argue with.
So, equities were mostly down. It’s price action which was telling you something. And I think we can interpret what it means. A spirited rally in the last 10 days cut those losses by a half to two thirds, which is intriguing, and I think worth some comment. But even with that spirited rally in the last days of the quarter, the SNP was down 5.4%, the Dow off over 5, the transports were worse than the industrials, which is very suggestive of recession being on the horizon. Transports giving you an indication of what is actually moving stuff, moving by rails and road. So the transports were worse than the industrials, and even worse in terms of performance and price action were the small caps. Your technology companies and the Nasdaq-100, they finished the quarter off 9.8%. Nasdaq-100 finished off 9.8%, and that’s after regaining 14% off the March 14 lows. So from March 14 to the end of the month, you’ve got a sprint in the Nasdaq-100, some combination of short covering, some combination of chicanery and painting the tape into the end of month, end of quarter. Kevin, actually, only Brazil, Mexico, and India, they were among the few equity markets which were positive in the first quarter. Brazil, Mexico, India. Just about everywhere else, and including in those places too, but about everywhere else, inflation, a global reality and a growing source of pressure on asset classes, made itself known, and geography was no protection.
Kevin: I was proud of McAlvany Wealth Management though because lest it sound like everything is off, if you look at gold stocks and specialty real estate infrastructure, natural resources, when you’re placed in the right places, you don’t have to have the same losses as just the general markets do.
David: Positive first quarter for us. And I would just say this, that’s no reason to work with us. You work with us because we’ve got a great team, you work with us because we’ve got a great process.
Kevin: It’s a thesis that you may think matches the world we live in.
David: And again, you get tested in real time. Price action tells you if the theory and the thesis is more than that.
Kevin: Well, part of the thesis—
David: It’s not that you win all the time.
Kevin: Well, you have to bet on whether inflation is transitory or not. I mean, those types of things. I think if you were asked right now, is inflation transitory, you would say, no, it’s not transitory. But there are other people who agree with you right now, I mean, think about Larry Summers.
David: Right. So with all respect to governor of the Bank of Japan, Haruhiko Kuroda, no, it’s not transitory. No.
Kevin: And Larry Summers would say the same thing.
David: He was in a New York Times interview that emphasized that inflation has not been, and will not be, transitory. So yes, we have a supply shock, and there’s a variety pack of supply shocks, but different than the ’73 supply oil shock. This is food, it’s oil, we’ve got some complications and crossed currents with supply chains more generally, but echoing what we’ve argued over the past year, Larry, in this New York Times interview said, “There’s too much demand.” And we’re not talking about pent-up demand from the Covid lockdown debacle. We’re talking about fiscal policy-driven excess spending which was converted from services pre-Covid to product spending during and after Covid.
Kevin: Well, and a lot of people would say, that’s the stimulus checks, and they’re going to run out. But a lot of those stimulus checks were never spent.
David: Very critically, Summers points out that only about 30% of the stimulus checks were spent. So we can confirm that, talking to bankers across the country who complain about excess deposits and nowhere to put them. There’s nowhere to put money to work.
Kevin: A banker that doesn’t want any more money coming at him. That’s an anomaly.
David: Let that sink in. If excess consumer demand is a key contributor to inflation, increasing wages and yet-to-be-spent stimulus checks, they’re going to continue to impact inflation statistics over an uncomfortably long period of time. We’re not talking about months, we’re talking about years, not months. The rate of increase, that should moderate. Are we going to have the same kinds of increases we’ve had over the last year or two? I doubt it. But consider a 5 to 7% CPI range over a three or four or five-year period, and all of a sudden it begins to feel more and more like the ’70s where the negative impact of inflation, it’s accruing, it’s accumulating, and it’s gaining force in terms of its negative impact on a portfolio. It’s gaining force over time.
Kevin: One of the things that we’ve really gotten used to over the last couple of years is, most people know that they can go get a job anywhere because there’s just so much available and so much need. I remember hearing a saying that a recession is when your neighbor loses his job, a depression is when you lose your job. What we haven’t really experienced, Dave, in the last few years is either recession or depression. But what we definitely haven’t experienced is recession tied to inflation. And I’ve always hated the word stagflation because, to be honest with you, that’s an understatement to a very painful time.
David: When you don’t have as much economic activity and when you have prices increasing, even if you’ve got wage growth, which can be a part of the factor on inflation, it’s just not keeping up, it’s not keeping up. The anxiety, the stress that that creates, the destructive impact from a family standpoint, the severity of inflation in terms of its social impact is always tied to its duration. And I think we’re talking about stagflation settling in for a long-term stay.
So, the duration of this inflation is at least several more years, excess demand, again, coming back to this notion that there’s a lot of money that through fiscal stimulus has been put into the system, and we’re talking about unspent stimulus checks. This is a huge factor. If Larry Summers is right and just 30% of that stimulus has been spent, we’ve got double that amount of stimulus that’s already been put in waiting in the wings, outsize bank deposits, it’s all there.
Kevin: We talked about this. I’ve got a client friend who is a banker, and he called last week and he said, “I’ve got all this cash coming in. I’ve got an amazing amount of cash that’s come in over the last year. I’ve tried to stay on the sidelines because I understood what was going to happen to the bond market, but now I feel like I have to deploy it somehow.” So as a banker, he’s caught between a rock and a hard place. It’s too much money on deposit, but inflation is eating that up, and the bond market right now, if he jumps in, will interest rates rise and that yield curve invert again? And it’s a tough time.
David: This is one of the reasons why we spent some time last week talking about real rates and looking at the math of, even as interest rates increase, if inflation hasn’t moderated, you’re still underwater. So when real rates are negative, money today is worth more than money tomorrow. So demand is accelerated, and we’re seeing the crunch that creates. It’s on a magnified basis with supply chain issues, but take away your supply chain concerns, and excess demand is still front and center.
Jeffrey Gundlach was onto a similar line of thinking when he compared goods spending over the last 20 years in a chart showing a break in the uptrend in terms of consumer goods spending back in ’08 and ’09. That comes as no surprise, it’s global financial crisis. And then, post-global financial crisis, goods spending recovers and you’ve got a steady line of growth in consumer spending on goods from 2009 to 2019, an 11-year cumulative of gain of 48%. Then the fiscal stimulus you have from the government, and a 46% increase in consumer goods spending, not over an 11-year period, but in a single year.
David: How do supply chains keep up with that? And keep in mind, most of the stimulus checks are still unspent, that’s what I’m getting at. There is a lot more fuel for the inflation fire. A lot more. Summers concludes that New York Times interview looking at a study of business cycle history. And he basically says, if you assume a 4% rate of inflation, so half of what it is now, that’d be nice, and a 4% unemployment rate, which is just a skosh higher than we have now, 3.6 as of last week, those are both modest numbers. He would say, here’s the math, you’ve got a 50% odds of recession next year, 75% odds over two years. Now, we don’t have, we have not had inflation moderate yet, and maybe we’ve got the benefit of a 3.6% unemployment number. So, how you mix those two precisely, it’s the four and four, which gives you the 50 and the 75.
Kevin: Yeah. And he’s not even looking at interest rates. I mean, we’re in a rising interest rate cycle at this point. We talked last week that the Federal Reserve really can’t have a Volkerization of interest rates, but you do have people like Brainard who are talking about shrinking the balance sheet, you’ve got people who are talking about taking rates quite a bit higher. We’ve talked about how they can’t probably do that, but Summers is only looking at inflation and unemployment rate in a rising interest rate environment, Dave, I don’t know what the likelihood of a recession is, but I think we’re there.
David: Look, it’s a good idea. If you’re going to take away the stimulus, that makes sense, that’s what they’re supposed to do, that’s their job. Well, actually, their jobs—
Kevin: They’re late.
David: Very late. So for Lael Brainard to shrink the balance sheet, it’s like, okay, master of stating in the obvious. Sure, you should. And Bullard wanting to pop rates and get them higher faster, yeah, no problem. But you might have thought about doing that a year or two years, three years ago.
Kevin: So remove the punch bowl. Remember the old remove the punch bowl.
David: William McChesney Martin made the case that the Fed should take away the punch bowl before the party starts. And in our case, a Fed brought $8 trillion, actually bought $8 trillion in assets to keep the party going. I mean, they were like refilling the punch bowl as the party went into the wee hours of the morning. So, too little, too late is how the central bank will be remembered in this cycle. All they can do now is further exaggerate asset price volatility.
Kevin: I’m going to say this one last time, Dave, before we wrap up, but I’m going to change it just a little. For want of an affordable nail, the shoe was lost. For want of a shoe, the horse was lost. For want of a horse, the knight was lost. For want of a knight, the battle was lost. For want of a battle, the kingdom was lost. So kingdom was lost all for the want of an affordable nail.
David: Ironically, Kevin, from my eight-year-old son, I get this the other day at the dinner table. Dad, what does the nail say to the hammer just before he gets hit? I’m screwed.
Kevin: You’ve been listening to the McAlvany Weekly Commentary. I’m Kevin Orrick along with David McAlvany. You can find us at mcalvany.com. That’s M-C-A-L-V-A-N-Y, .com. Or 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.