Inflation? Pay No Attention To The Money Behind The Curtain
August 3, 2021
“The reality is, a lax approach to risk management is all too common amongst individual investors because everybody’s riding the wave and nobody’s second guessing gains. That would seem like an emotional or psychological impossibility. I think if you’re making money, you want to continue to make money. Very few people are willing to say, “It’s been a good day, it’s been a good week, it’s been a good quarter, it’s been a good decade. Maybe I should adjust slightly.” — David McAlvany
Kevin: Welcome to the McAlvany Weekly Commentary. I’m Kevin Orrick, along with David McAlvany.
David, last week you were attending a conference that you’ve been asked to speak for since 2015. I know that you’ve attended that conference in Singapore, in South Africa, in San Mortiz, Switzerland, and California one time. Jerusalem was supposed to be last year but they canceled the conference based on the fact that COVID was so prevalent. This year was in Vale, and I know the topic of discussion was really forefront on inflation.
David: Well, certainly that was my topic, and they covered a lot of different bases in terms of social issues that need addressing and economic considerations. So, yeah, because inflation is something of interest for me and the markets, these are things they asked for me to give comment on. It was a great gathering, and I’m always impressed by the attendees and the quality of dialogue that occurs. Declan, my oldest son, has been going to these with me as often as possible since 2016. He was 10 years old at his first conference, and even had some comment and contribution to make then.
Kevin: And now he’s driving.
David: It’s good to see him.
Kevin: Yeah, now he’s driving.
Kevin: Well, on that subject, last week, while you were at that conference talking, we wanted to play for the listeners two interviews that had to do with the deconstruction of globalism and inflation with Otmar Issing and Harold James. We wanted to do that because sometimes it’s important, Dave, to go back and say, “Okay, what were people saying in 2015 or 2011? What were people saying back in the year 2000 maybe about elections?” And I want to talk about that today because context is interesting. You can see how going back and listening to things from the past can actually enlighten you for current day issues.
David: Certainly. Yeah. Otmar brings a voice to the present conversation which remains important. You’re right. Last week, we wanted to feature an economist with a history of guiding the Bundesbank and the European Central Bank through long stretches, and who, in the present, has concerns that global inflation has far more to do with the structural shifts and the significant increases in money supply, in addition to the supply constraints which are all around us, which he believes, I think we do too, that these will be sorted out with time. But this is sort of in contrast to the White House view that no intelligent economist believes inflation will have a lingering presence.
Kevin: Yeah, so I’d like to hear, while you were preparing for last week’s conference to speak on inflation, what were some of the thoughts that you put into it?
David: Yeah. As I prepared for the conference last week, the distillation of a few ideas on inflation, knowing that the participants would want a view of the financial markets as well. I wanted to include some information that was specific to the U.S. markets, but with attendees coming from all over the world, I wanted to also include Chinese credit markets in my market commentary in the financial market commentary. So little bit more on the Chinese credit markets in moment.
On inflation, today’s economic orthodoxy rejects the quantity theory of money. This takes us back to the monetarist days, specifically Milton Friedman and his ideas that inflation everywhere always is a monetary phenomenon. But it’s interesting because most people don’t realize that your standard economics PhD today doesn’t agree with that. It rejects the quantity theory of money, but at the same time, keeps the Philip’s Curve alive, which is kind of an extension of that older orthodoxy. And again, the Philip’s Curve is just that low levels of unemployment lead to accelerating inflation. And we’ve talked about how the Philip’s Curve should’ve been thrown out 40 years ago.
Kevin: There’s a lot of things that the economists use that should’ve been thrown out. I think of the book by Adam Ferguson, and we read the book. And then we found out that, gosh, Adam Ferguson is still alive. Remember that? The book was written in the ’70s about the German hyperinflation of the 1920s. But when we read that book, before you interviewed Adam Ferguson, Dave, we were talking about, toward the end of the book, after all of the devastation of the inflation, how few, in fact hardly any, of the people in Germany actually understood that the inflation had come from the printing of money. Isn’t this the same mistake that we’re seeing now with the economists who are throwing out the theory of money? Milton Friedman’s famous statement that it’s always a monetary phenomenon?
David: Yeah. And that’s right. So if we think about how out of step the Philip’s Curve analysis was in the ’70s when stagflation discredited the theory. It was market practitioners who then took note and said, “This isn’t working. This isn’t a factor here.” And money supply has been something that, again, market practitioners have held onto, but a majority of academic economists have said, “We’re going to keep the Philip’s Curve, but we’re going to get rid of money supply having anything to do with inflation.”
So the general consensus today includes this analysis while remaining unconcerned by the growth in M2. You got Olivier Blanchard who spends his time now with the Bank of International Settlements, and he explains in his textbook on macroeconomics that targeting a low rate of money growth for a long time implied a low rate of inflation. But in his view, that didn’t work well. So money supply and inflation, and money supply and interest rates, they were not tightly enough connected in his view to be reliable. Again, this is in his opinion.
I guess the difference is, between his view and mine, I don’t need to see simultaneous impact to justify reasonable correlation, and he’s looking for something that is very, very tightly correlated. But the shift towards targeted inflation in the 1990s and the use of guided interest rates, it fits a different mode of existence among central bankers and amongst academics, too, with a predisposition toward a hands-on policy direction versus the more neoclassical economic views, which, if you want to look at almost their philosophical bed, is laissez faire. It assumes that you should be more hands-off, that the market will direct itself to a degree. And again, that laissez-faire approach, the neoclassical approach is out. And you have a new orthodoxy which says management from the top down is more appropriate, and oh, by the way, we don’t see the connection to money supply.
Kevin: I love how they complicate things. I think sometimes the best way to return to common sense is to say, “What would you tell your kids?” And if you told your kids that there’s a certain amount of goods and a certain amount of money that can buy those goods, if you increase those goods and the money doesn’t increase, the goods will go down. If you increase the money supply, the goods will all go up. I don’t think it would be that hard.
I often quote Jurassic Park. I know it’s a weakness of mine, but I love Malcolm in Jurassic Park. Just because you can make dinosaurs and put men with dinosaurs doesn’t mean that you should. You could bring that to your kids, too, and say, “Hey, if we could recreate T-Rex and put him in our back yard,” that may sound great for a little while, but is that really a good idea? You could ask your kids, and I think economists sometimes way over-complicate things possibly to publish papers and then possibly for other reasons.
David: Well, in the case of Blanchard, you’re talking about the current economic orthodoxy reframing that kind of an idea. Just because we can, does that mean we should? It gets reworked by the Blanchards of the world as a statement and as a credo, not as a question, which would be, we can, therefore, we should.
Why does it matter? Because when you find yourself out of step with consensus, in this case we are on the outside of economic orthodoxy today, it’s helpful to reflect on what’s changed and what has not. And one of the things that I think has changed clearly is a simple definition of price stability. Price stability in one generation implied inflation as close to zero as possible. And that’s not what it is today. Price stability is understood not as static, but as predictable, and not so volatile as to change consumer behavior and future expectations of inflation. That may be a subtle distinction, but it’s very, very consequential.
Kevin: David, this conference that you went to last week in Vale, you have a lot of international, very brilliant minds. They’re actually succeeding in business, not just writing papers. What was the consensus on inflation with these guys who are actually operating in the world marketplace?
David: Yeah. Consensus at the conference was that inflation has a long life to it and will remain consequential to the consumer and to pricing for some time. This is not going away quickly. So to establish this concern in a broader context, actually I think this season of quarterly earnings is a helpful reference point.
Kevin: Why don’t you give us a few examples because we’re seeing selloffs on companies that are actually making or beating their estimates for earnings.
David: We’ve got a unique set of data points here as we’re in the middle of earning season, and it does again come back to this issue of inflation. And perhaps one of the things it’s telling us, 3M beat expectations of $2.27 for the quarter coming in with earnings per share of $2.59, but sold off 3% on inflation concerns. And what they included in their comments was the company was warning that soaring raw material costs were offsetting higher selling prices. And you saw this last week where the Wall Street Journal noted on the 29th a bunch of different companies. They said the makers of some of the world’s best selling foods and drinks brands warned they would need to keep raising prices as they grapple with the strongest inflation in years. Nestle, Diageo, Anheuser-Busch InBev and Dannon all said Thursday that sales were rising as key markets rebound from pandemic, but that the recovery was also leading to rapid increased costs for ingredients, packaging, and transport. So to preserve profitability, they’re increasing their prices.
Kevin: Well, and it’s not just the ingredients that go in, it’s infrastructure itself.
David: We had the next day, the Wall Street Journal reported Proctor and Gamble’s very somber outlook predicting slower sales and historically higher costs for raw materials and transportation—to your point, Kevin, on the infrastructure backing it—as inflation picks up and global health crisis continues. The Wall Street Journal two days back to back looking at a variety of companies consumer-related, which I think is important because these are not companies that are likely to drop their prices after an increase.
Kevin: Yep. Biden said that no serious economist actually believes that inflation is a concern.
David: But there are serious CEOs, CFOs and CIOs across the spectrum who are reporting their earnings today and are saying, “While I don’t have to be an economist, I can tell you what my reality is, and it’s if I don’t increase costs, my profit margins will be squeezed. Ergo, we’re raising prices.” And expect to continue to do so throughout 2021. So Kevin, the consensus among today is orthodox economists is that inflation is not a concern, and it’s fascinating because the two points that I’ve seen over and over again, the notable increases, are in used automobile prices and lumber. These are the favorite references both from the Fed and the orthodox economists of our day.
Kevin: Well, and don’t they credit that with a decrease of supply? In other words, they’re not saying it’s the printing of money. It has to do with a lack of supply.
David: If you look at supply chains, particularly in the auto sector, you’ve got issues where supplies have been limited. So new car buyers have shifted to the used auto market for available product, and it’s easy to see demand normalizing as supply chains mend. Fair enough. Fair enough. And lumber is one part housing demand related and some supply constraints also are in play.
Kevin: But parts and infrastructure, parts and infrastructure. I mean, some of these companies can’t operate because they can’t order a part.
David: Right. Well, I was speaking with a friend of mine that runs a sawmill operation. Ordering parts and new equipment for the mills that he runs, he’s now back ordered six to 12 months, in some cases 18 months. And lumber mills are ripping as fast as they can, and anyone who could buy the machinery has. So it’s been fascinating to see. High prices, as we’ve talked about before, are always the solution for high prices. So supplies are normalizing in lumber because they’re creating more product. Then prices are moderating. But these two inputs, again, they’ve become the Fed and economist references for the supposed inflation boogeyman.
Kevin: Right. So we just completely ignore that we’re printing trillions and trillions and trillions of dollars. Again, this goes back to the 1920s in Germany. The Germans, Adam Ferguson pointed out, the Germans did not, even after the devastation, credit the inflation with the massive printing of money.
David: There’s no notice or comment which is given to explosive money supply growth. And again, the new orthodoxy doesn’t connect money supply and inflation. That is a part of their theoretical framework. It’s no longer a relevant connection to make, in their view, and no references to de-globalization are there as well, structural, macro determinants for inflation going forward, and so you have that conclusion from the White House. No intelligent economists are seeing inflation as an enduring issue. Really what that means is no intelligent economists that disagree with the White House’s economic advisors. So yeah, inflation remains a contentious issue for some and an obvious issue for others.
Kevin: Well, and the word transitory, the word transitory, transitory. If you are seeing inflation, don’t worry because tomorrow you won’t.
David: Yeah, so for the sake of argument, if the White House is correct, let’s give them the benefit of the doubt and say that inflation is transitory. Then guess what? 2022 is going to be an easier political victory, but I sense that it’s the poor and the middle class that are not only experiencing the worst of the inflation, but if that continues to heat up instead of dissipate, inflation is a factor that will drive a wedge between the political interests of the Democrats and the potential outcomes in 2022. So if they’re wrong, 2022 is going to be an uphill battle and present a growing obstacle for the midterms.
Kevin: And I wonder, with the— Eviction is now possible. If you’ve got an increase in prices, people are already feeling the squeeze, and now they’re kicked out of their house. They’ve been able to not pay their rent for the last year. 2022 could be very interesting.
David: Listen, I have some friends here locally who have not been through an eviction moratorium. Right? They were paying their bills, and everything went normal. They just got to the end of their term, and all of a sudden, their rent is up between 30 and 50%. 30 and 50%. That doesn’t get factored in the inflation equation because the inflation numbers only care about “owner equivalent” rent. So you call a certain number of home owners, and you say, “All right, so what do you think? What do you think here? If you were to rent your house, what do you think you could get for it in this market?” And this is a survey that gets factored into the statistic which is very different than the reality of rent increases which people are dealing with. I mean, I talked to a couple of people that I know here locally who, literally, they had reasonable rent between 12 and $1500, and their most recent increase in rent was $600 to $800. We’re not talking the $50, hardly even noticed it kind of increases. These are big increases. And you’re right. You bring up the, this is going to be a big deal, between the very liberal contingent and the Democratic party and the folks who just went on a six week recess. They did not extend the terms on the eviction moratorium, and I think there’s going to be hell to pay there.
Kevin: So doesn’t this discredit the transitory inflation theme right there? That discredits it because the rent’s not going to go down later, Dave.
David: I think if we could see a discrediting of the transitory inflation theme, if that continues to be a strain on the middle class, what that sets up for is a loss of legislative monopoly in the midterms. And listen, the Democratic party is not under-appreciative of these economic realities. And this puts political pressure on the Democrats. So this is a highly speculative thought experiment, and by that I mean, cut me some slack and do a little extra reading on this before you absolutely blow your top, but with this political possibility looming, it comes as less of a surprise that the Biden administration is talking about COVID lock downs again. You got economic statistics which are slipping, and inflation—
Kevin: Now we’ve got a disease problem. It’s time to lock down. It’s time to lock down. Diversion.
David: Well, looking at the contagion rate versus the death rate for the latest surge in COVID, you can see that this is an easily transmissible but not particularly deadly wave hitting the U.S., and obviously, it’s hitting with more devastation other parts of the world. That does speak to some people in people groups being certainly more at risk. But yes, this is what’s contentious, mail-in ballots are an interesting factor in any election, and no, they are not without issues. Of course, raising this issue, any questions raised on the issue of election integrity from the 2019 period to the present, they’ve been met with hyperbole, they’ve been met with knee-jerk anger and a degree of certainty on the matter which suggests a lack of desire to look at the issue from a historical or global perspective. Just to remove a little bit of the pressure from me, what I’ve done is, I’m including links for those of you that would like to read comments on the topic prior to the recent election. So feel free to disagree with me. I’m okay with that. In the end, I may agree with you, but I consider the possibility all the same.
Kevin: So are these articles… these are articles from 20 years ago, right? Isn’t that what we were talking about? These are articles from who, the New York Times, Atlantic, who else?
David: They span from the year 2000 up through 2017 and ’18. So just consider the possibility that driving a strong virus narrative provides the backdrop for absentee ballots that are typically safe, but not necessarily so. So in this vein I particularly like Alberto Simpser’s book, Why Governments and Parties Manipulate Elections: Theory, Practice and Implications. It was published in 2013, and he does a particularly good job correlating the manipulation of election outcomes with economic circumstances, which frankly suggest a lower probability of fraud in places like the U.S. and provides higher evidence for such outcomes in developing economies, which does argue against my hypothetical scenario.
But nevertheless, you’ve got ballot boxes which are a sensitive issue anywhere in the world throughout any period. And democracies are not immune according to this and many other resources. So in the notes to the show, I’m providing a sampling of some of my reading on the topic, most of which was authored prior to the 2019/2020 election, but you’ve got hours of fun reading. And you’re right. It spans the New York Times, the Atlantic, the Economist and then a number of more academic looks, including a long look at the countries in Europe which do not allow for any mail-in ballots, which is interesting in and of itself.
Kevin: So your thought experiment has something to do with command and control. So I want to go back to China at some point, but what we found, Dave, as long as the stock market’s going up, as long as the S&P500 and the DOW are showing positive earnings and positive growth, people seem to be happy. That seems to be changing.
David: Yeah. One of the big contributions to my comments at this particular economics conference had to do with Chinese credit and the frailties we see emerging within the Chinese market. So I do want to circle back around to that. But one of the things that has stood out, just extending back to our earlier comments on earnings and some of the very interesting dynamics within this quarterly earning cycle. Our friend Bill King noted last week that the S&P500 now has a negative total real yield for the first time since 1946. So what does that mean? Well, this includes your dividend and your earnings yield. So both of those factors tally to less than the rate of inflation. And his point, this is very rare. 150 years of data, you can count this on one hand. And the most recent period was 1946, so keep in mind where we were at in terms of World War II, just launching… Anyways, the easy translation is, no bueno. Dividends are low. Inflation is high. And the way that should translate for most investors, although it’s not translating this way, but the way it should is that investment prospects are pretty poor over the intermediate term.
Kevin: Well, okay. So I’m going to challenge you on something, though. Are we actually not seeing investors becoming a little bit timid because you were talking about corporate earnings, and we’re getting beats on all these corporate earnings. These are nice corporate earnings. And the investors are using this to sell not to buy.
David: Well, I think there’s two kinds of investors. I think there’s the man on the street who knows enough to follow a good meme, and you’ve got your more seasoned institutional investor who knows exactly what to do with the information that’s coming out and is taking an action. You’re talking about selling on good news. So the news is good from corporate America. There’s a consistent theme in this earnings period, which has been revenue beats. We covered this in Hard Asset Insights last week. I suggest you look at it each week. This is one of our weekly resources not unlike the Weekly Commentary which we do. This is a one- to two-page summary of our emphasis on hard assets, which everyone should know at this point is infrastructure, specialty real estate, global natural resources, precious metals mining companies, the kinds of things that we invest in for our asset management clients. So I do suggest you take a look at it each week. It’s very insightful.
Kevin: Saturday morning cup of coffee. We’ve had listeners say, yeah, they pour themself a cup of coffee on Saturday morning and they sit down and that’s what they do.
David: Yeah. So your double whammy for Saturday morning, Hard Assets Insights and Credit Bubble Bulletin, particularly stiff cup of coffee if you extend it to CBB, but worthy of note, again, is the investor response to positive upside surprises. And the response has been sell the news. I mentioned 3M earlier and the selloff there, which was inflation related, but if you look at a whole list of other companies from Microsoft to Apple, this is where it becomes very interesting. Microsoft earnings were $2.17 per share versus $1.92 expected. So that was positive. Revenues were 46 billion versus 44 and change expected. Again, great numbers. Sold off on the news. Apple’s the same. 81 billion in revenues, 73, almost 74 billion expected. Earnings per share, again, a beat on the EPS number, $1.30 per share versus $1.01.
Kevin: So it’s a huge beat.
David: That was expected.
Kevin: That was a huge beat.
David: Yep. And you had the initial jump, which we rescinded, and sell-off continued to a four-point loss. So just fascinating to watch. Alphabet, too, earnings per share of $27 and change on $19 and change expected. Revenue of 61, almost 62 billion, 56 expected. Looked like a yoyo. Tesla’s selloff on great results, and all of these suggest the underlying energy is shifting, using good news to sell into it is not a great dynamic.
And I think the hard asset commentary from Friday describes an important setup for the third and fourth quarter where you get expectations of earnings which are soaring, and as they look for third quarter and year-end numbers, everyone is now moving their expectations even higher. But this is one of the key distinctions made over the weekend in our commentary. GDP figures are reversing lower. So institutional traders are liquidating already. Meanwhile, your man on the street’s just coming into the market with vim and vigor and margin debt.
Kevin: Well, and they’re moving into the worst three months, historically, of the stock market. Every year. I mean, are we not moving in to the quarter where you sort of move away from the stock market?
David: Sure, from the standpoint of seasonality, that’s exactly right. So I think market dynamics could be very wild and wooly. You get all that we just described in terms of declining GDP growth and, at the same time, you’re seeing a moon shot in earnings expectations, and enough investors, and again I make that distinction between the man on the street and your more seasoned investor. It’s the more seasoned investor who’s selling into strength here. So negative seasonality from now to the end of October. It’s quite the setup. So we said it before. Hedge your positions. Hedge your positions. Tactical short is a great option for that. Raise cash. Lower your total market exposure one way or the other, and don’t assume that value plays will help you in the short run. I’m specifically thinking of the greater value plays that you can find in the emerging markets.
Kevin: And this is a good time to tie in the way you think, Dave, on the emerging markets because we have seen the selloff in China, and as China goes, so go the emerging markets. Has that changed?
David: No, that hasn’t changed. So that’s a key point. As goes China, so go the emerging markets. So just because the emerging markets are cheaper relative to developed world financial markets doesn’t mean they can’t get cheaper still. And a selloff in China and subsequent selloff in emerging markets may ultimately provide an excellent long-term entry point, but I wouldn’t jump the gun on that. It’s something that I would look sort of with a greedy eye, but would assume that you’ve got adequate powder dry to take advantage of at some point.
So I’d say odds are 50/50 that Chinese markets continue last week’s deterioration. Very notable. It was notable both in terms of the scale of the decline and its contagion effects. Chinese tech and education names alongside financials were under extreme pressure, and at last week’s economic conference, what I wanted to discuss was particularly the weakness in the junk bond market and the particular standouts in the corporate bond sector, Evergrande and Huarong. And privileged to have Doug Noland to keep an eagle’s eye on those numbers for us on a daily basis. The Evergrande bonds that were selling at 60 cents on the dollar early in the week, and they found a path towards 44.7 cents during the week, ultimately yielding over 36%. Just let that sink in.
Kevin: Wow, 36% annual.
David: Yeah. You’ve got Chinese junk bond yields, which, since late May, those yields have increased by 50%. So this is not just a single company under pressure. It signifies a broad level of credit market concerns within the Chinese market.
Kevin: And we’re not talking about a small market. China is a gigantic credit market bubble.
David: Number two, number two credit market in the world, 12 trillion in aggregate credit. So beyond the AMCs, that is the Asset Management Companies that were created in 1998 and 1999, AMC. I’m not talking about the theater company. You’ve got developers like Evergrande, which I mentioned, growing financial strain is evident in lots of different places. Again, that’s the importance of the junk bond yields being as high as they are. Huarong bonds are knocking on 16%. You’ve got individual stocks last week which were subject to new regulatory actions and sold off between 40% and 60%. 40% and 60%.
David: That’s last week. Some of the year-to-date losses for those names are now pushing 90%.
Kevin: Okay. So let’s talk about something. Let’s talk about a concept that a lot of people still grapple with and don’t really understand, and it’s called a carry trade, where you borrow in another country’s currency at a low rate and then you invest in a country where you’re going to get higher yield. The carry trade actually killed Barings Bank. Remember, one of the oldest banks in England? You had one guy who was operating the carry trade. I think it was with Japan, wasn’t it? I mean, this was years ago, but it took the entire bank down. China’s a carry trade, isn’t it?
David: Oh, that’s right. I appreciate you mention Barings because this was known as the sixth great power. I mean, today we think of the G7 and the G20, even the G5. Well, basically, the argument was, from a financially important standpoint, you had your five largest economies in the world, and then you had Barings. And Barings Bank was the sixth great power in terms of a global force to be reckoned with. And you’re right. They unwound being on the wrong side of the carry trade. So this is fascinating.
China’s worth watching. It’s very much worth watching, and the credit markets, they’re forcing many issues within China. From an international financial markets perspective, the carry trade is concerning. You get the RMB, which was showing signs of characteristic stress last week, and that could continue, and would create cross-border destabilization in any number of markets. So you just have to find who’s complicit with the funding, who’s complicit with the leveraging of trades. On top of that, you have policy issues in China, which last week were front and center. And you could argue that the volatility last week within the stock markets was triggered by regulatory issues, but it’s also important to remember, to not forget, that the context was also already set with a very frail corporate credit environment.
Kevin: See, and this is an important thought because again, going back to— I like to just simplify back with your kids. Let’s say your kids are borrowing money. You’re going to loan them probably some, if they’re getting restarted. Let’s say they’re buying a house or whatever, you might loan them some. But if they keep coming to you and keep coming to you, and they start realizing they don’t have to pay back, that creates something in the economy world called moral hazard. In other words, people start realizing they don’t have to pay back, and China’s having to deal with this right now. They’ve created this huge credit market bubble, and now, when you talk about regulatory issues, we’re talking about the decision, do we stop doing this, or do we continue?
David: It’s really important, I think, for people who want to reflect on the importance of credit in the modern era and see the ways in which it has created temptations for perpetual growth, to go back and look at The Economics of Good and Evil. Sedlacek’s book has a profound influence on me. I would list this as sort of a top-10 book for anyone interested in economics and finance, maybe top-five.
Kevin: The Economics of Good and Evil. Yeah. Beautiful book.
David: It certainly has changed my views on more economic issues than any other single volume, and this is in a 20-year period. So the philosophical, but ultimately practical, questions are on the table when you think about China right now in the credit markets. They’ve continued to grow. They’ve continued to promote growth economically through a fairly reckless expansion of credit, and that’s one of the things that ties back to Sedlacek’s book, which is why are we doing this? What is it that we have? What kind of a love affair with perpetual growth do we have? And are we ultimately willing to pay a price for that economic growth which is dependent on credit growth?
So again, this brings in the question of moral hazard because the People’s Bank of China has to decide, are they going to continue to promote growth by promoting credit in a somewhat reckless fashion? Or are they going to bring market discipline? It really ultimately boils down to a policy choice of high growth rates or low growth rates. They get high growth rates by allowing unhealthy credit growth in sectors which are not creating long-term value anymore. This is Evergrande on display, excessive land development. This is Exhibit A in terms of unhealthy credit growth, but you get the benefit of strong economic numbers. Or are they at a point where they’re going to rein in that credit growth and accept lower economic growth rates?
Kevin: So Dave, I have to tell a quick story. There’s a young man who got his economics degree, and we became friends, and he wanted to start meeting for breakfast. And I remember one time, we were meeting over at Carver’s, which doesn’t serve breakfast anymore because of COVID, but that was the breakfast place in Durango. And we met monthly. One time he asked me, he said, “Why do we need to grow every year?”
Now, this was before Sedlacek was on the show, so I started using the economic defense that I had been taught in school without actually thinking it through. But what he was asking me, Dave, is similar to if you were a farmer: Why can’t we make it summer all the time? Why can’t we do that? If we could, should we? Goes back to Malcolm. If we can do it, should we? And Sedlacek, when we read the book, and he was on, he was like, “Wait a second. Do you not understand that perpetual growth is almost a false religion? It’s a fake religion of always being able to grow, not accepting cycles.” So my question now, in China, do they opt for summer all the time?
David: I suspect that they’re going to opt for the high growth rates and the continuation of moral hazard. And emphatically I have to say I don’t know, because we’re talking about one of these being political choice and the other would lean towards the financial markets and frankly some unknown outcomes. My suspicion is that control and dysfunction, credit dysfunction, are easier to choose than the unknowns of a financial market contagion likely to continue if they are in fact applying market discipline. And if I’m right and they allow for continuation of moral hazard, then guess what? Chinese corporate credit is probably an excellent purchase in here, should rally significantly, and all we will have seen is a gargantuan day of reckoning pushed into the future. It’s the same playbook of every modern central bank to date.
Kevin: But this time it’s the carry trade, the carry trade. It’s not just China. You borrow cheap in another country’s currency, but what happens with the carry trade when that happens? Does China take everyone else down with them?
David: Yeah, and this is where I’m not advising that you step out and buy Evergrande debt with a 36% yield. I’m not saying that at all. Please don’t do that because there are greater sets of risk that can stack up, that are stacking up against you. And the carry trade dynamics as a part of global credit contagion from China are worth keeping on the radar.
At the conference, I had a fellow panelist and friend from South Africa, Johann DuPris. He was a turnaround specialist for a variety of publicly traded companies, and today is the CEO of Sod Holdings, which is a private equity group. He’s a private equity guru. And in his comments, he was highlighting the risks of carry trade dynamics, which are very important. Not only is South Africa used to this, he has seen the unwind of that trade multiple times. And what it means is massive currency depreciation that follows. So it’s the money that flows in on the basis of higher yields.
Again, you borrow from a country that has zero or even negative rates, and you move to countries that have five and seven and 10% rates, and you basically operate your private mint until some variable changes, and then you have to unwind the transaction. And that’s what’s so disruptive. It’s a hot money outflow. South Africa’s used to it. He’s seen it before. Massive currency depreciation follows on the tail of that unwind, but consider the scale of the trade and the carry trade dynamics with China. We’re talking about the world’s number-two credit market.
Kevin: That’s huge. That’s just huge. Dave, yesterday, I had a first call with a referral. It was the father of one of my clients, and they had been missionaries in Russia for years, and then in Kazakhstan. So they had lived around the world. They had seen the dynamics of communism, but they had a 401k here in America. He said, “Kevin, when we did the triangle,” which of course is gold on the base and stocks and bonds on the left side and cash on the right side, “When we did the triangle,” he had no gold. He had a little bit of cash, but everything was in the stock market. But he said, “Kevin, we lost 40% in 2008, and I think it’s coming again. I can’t be lax on risk management this time around.”
David: The reality is, a lax approach to risk management is all too common amongst individual investors because everybody’s riding the wave and nobody second-guesses gains. That would seem like an emotional or a psychological impossibility. If you’re making money, you want to continue to make money. Very few people are willing to say, “It’s been a good day, it’s been a good week, it’s been a good quarter, it’s been a good decade. Maybe I should adjust slightly.” But it would surprise you to know that it’s no different with financial institutions. Over the weekend I reviewed Credit Suisse’s 172-page report on the Archegos blow up earlier this year. It was absolutely fascinating to read the most compelling—
Kevin: Only you, Dave. I love you, but 172 pages, tell me about it.
David: So the cost to Credit Suisse, $5.5 billion in losses with this single exposure, and it’s fascinating. Very insightful read. We all want to be bullish. We all want to be optimists somewhere deep down inside. We don’t want to bet against our lives or our future or our children’s future. We all want to be optimists.
I come back to the classic book, Triumph of the Optimists, and it’s a testament to Wall Street’s biggest bets on the future. Frankly, you could say nine days out of 10 it’s a very bright future. What was often missing is the punctuated turmoil experienced on rare occasions which can, for some firms and individual investors, be a form of game over. They’re typically under-reserved. They’re typically under-hedged. They’re lacking any real operable and disciplined risk management tools. And this was written all over this 172 pages. It’s not as if they didn’t see the risk in front of them, but their operations and risk management tools were way out of— I mean, it just hadn’t been polished in a long, long time. But that puts the best of the optimists at risk. If you’re under-reserved, if you’re under-hedged, if you don’t have a disciplined risk management toolkit, even you as an optimist are at an incredible risk.
Kevin: So you look at the size of, okay, Archegos. What is it, five billion bucks? But actually it wasn’t five billion bucks. It was 20 times that, wasn’t it, or more than 20 times that because of the leverage?
David: Well, exactly. Artfully done. Artfully done. Archegos, when the hedge fund was unwound and Bill set himself up as a family office, he started with $500 million in capital. So he’d done well as a hedge fund manager, and leveraged up that position and grew it to several billion dollars. And then between 2018 and 2020 took very concentrated positions, worked with a number of prime brokers, his previous connections in the hedge fund space, and they allowed him to leverage these concentrated positions.
So 5.5 billion, that was the corporate loss for Credit Suisse, and they did not grasp the backdrop issues until after they had counted their dollars and losses. They didn’t know what was in play. Bill had $9 billion in assets, leveraged to $120 billion in market bets, and this is one family office. So he’s playing with concentrated positions which, again, if you’re talking about concentration risk, a number of his positions were large enough that he was one of the single largest shareholders, and it would’ve taken him anywhere from eight to 10 days to unwind his position, assuming that he was in an orderly market, and he wasn’t driving the price down in mass liquidation. Right?
This is one family office. I just want you to think, when we consider the Chinese credit markets, when we consider the carry trade dynamics afoot, it would be wise to consider the backdrop issues now. Right? Credit Suisse did not grasp the backdrop issues. They were looking at the trunk and not the whole elephant. They had no idea there was $120 billion in bets in play, whether part of this was chosen blindness or whatever it may have been, they failed to consider the backdrop issues. As we look at the Chinese credit markets, as we look at current carry trade dynamics, we have to consider the backdrop issues. We have to hedge accordingly. You were talking about the global financial system. Again, apparently, it’s on a sound footing. It’s just not far removed from free fall.
Kevin: So in the last few weeks, though, you’ve pointed out that there is money flowing into government debt, which is safe-haven movement. And the gold markets, they’re not exploding, but you have money that’s moving away from these markets. I think you talked earlier, this is probably sophisticated money that’s hedging against what could be a pretty severe downturn this fall.
David: Well, that’s exactly right. We continue to see a melt up in bond prices, which is on the other side of the equation, a melt down in yields. So if you’re looking at some of the yields, which is frankly shocking, Italian debt, 57 basis points, Greek debt—this is 10-year treasury stuff—55 basis points. Spain earlier this week, 23 basis points. Portugal, 13 basis points. German Bunds, again 10-year paper, negative 49 basis points. We’re hanging around 115 basis points this week, again.
The move into government debt is absolutely worth keeping an eye on. Government debt and the gold markets have been communicating something significant on the horizon. It’s something unpleasant. It’s a growing probability that happens between now and October. We talked about market seasonal weakness, particularly in U.S. equities, that remains to be seen if we’re talking about a plain vanilla 10–14% correction, or if in fact we’re coming up on one of those rip-your-face-off bear-market disasters.
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, M-C-A-L-V-A-N-Y.com, and you can call us at 800-525-9556.
This has been the McAlvany Weekly Commentary. The views expressed should not be considered to be a solicitation or a recommendation for your investment portfolio. You should consult a professional financial advisor to assess your suitability for risk and investment. Join us again next week for a new addition of the McAlvany Weekly Commentary.