March 18, 2015; The U.S. Dollar Carry Trade Nightmare

The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

How do we get from here to there? What sets you apart from being sucked into the state apparatus? What sets you apart from being sucked into the financial markets’ vortex? I think you should do everything that you can as an individual to move against that trend. Are there simple things that you can do to ensure individual freedom and autonomy? Make a list, and get it done.

– David McAlvany

Kevin: There has been so much money coming into the dollar, for various reasons, but probably one of the main things is that you can borrow dollars at virtually zero interest rates. The problem is, though, Dave, when the dollar rises in value, those loans that they were taking at such low rates, now have to be paid back with higher priced dollars. Now, that’s causing a problem, or could cause a huge problem in the future, could it not?

David: That’s right. It’s called a currency mismatch. And I think it’s important to recognize that currencies are a zero sum game. You’re looking at the whole world. If the dollar is up, that means someone else is down; someone else being down means the dollar is up. And a part of it does have to do with flows of capital. Part of it has to do with purchasing of dollar assets, but a part of it, again, is just a reflection of weakness elsewhere. For instance, the euro has been incredibly weak. Now, that’s going to show up as dollar strength, and it doesn’t have to be dollar buying for it to reflect the difference. Does that make sense?

Kevin: Sure does. And then, let’s face it. Some of the money that is coming in is not loyal to the United States at all. It’s money that may be here as long as the euro is weak and then flow right back out. I know when we look at the bank reports, when we do the bank ratings, we look at a key factor called hot money. Hot money is just merely large pieces of money that are maybe in a CD sitting at a particular bank, that have no loyalty whatsoever. It will flow right back out as soon as someone else is willing to pay a higher interest rate.

David: I have a friend that has borrowed several million dollars from a European bank, and that was in euro terms, and he has put it in U.S. dollars and he is going to pay back his European loan, but of course, the euro has dropped 30-40%, so he is paying it back cheaper than the euros that he borrowed. What we are seeing right now, Kevin, and this is what I would describe as a major trend, the core, which would be the United States and Europe, is seeing capital flows, and it is capital flows that are coming from the emerging markets. Money is exiting what is considered to be risk geographies, and this is in the context of a contracting global economy. So you have a contracting global economy, people are taking risk out of their investment portfolios, those emerging market economies which have promised more in terms of returns, some of those bets are being trimmed back a bit, and that money is being, essentially, repatriated. Wherever it came from originally, that is where it is going back to.

And it reminds me a lot of what the body naturally does, automatically shifting the flow of blood to vital organs and away from the periphery when you start getting cold. Have you ever wondered why, when you visit Colorado to go on a ski trip or what not, or perhaps you live in Vermont, or Maine, or well, New York this year, seven feet of snow in certain parts of upstate New York in a very short period of time – why is it that your fingers get cold? Why is it that your toes get cold? It is because your body has a natural response. In cold environments, your body says the brain and the heart are the most important things to keep functioning. And in order to keep sufficient blood flowing, a healthy amount of blood flowing to the most vital, guess what happens to the peripheral? Your fingers get cold. You’re getting less blood flow.

Kevin: Well, and that’s why the body even chooses frostbite and even losing limbs over the core.

David: To life.

Kevin: But doesn’t it seem, though, we’re in the week right now that the Federal Open Market Committee meeting is coming, doesn’t that seem to put them in a box, because the dollar is already strong? If they start raising rates now, what happens there?

David: To raise rates or not raise rates, that’s the question. When you look at what the Fed has done over the last 5-7 years, their zero-rate policy has pumped trillions in U.S. dollar liquidity into the world, and now it’s coming back. So, what do we have? We have funds that were borrowed at near zero percent, and they are now having to dance the foreign currency dirge, as it were. As the U.S. dollar moves to the highest level that we have seen since 2003, every one of those dollar-based loans is more dear to pay back.

The BIS, that is, the Bank of International Settlements in Basel, Switzerland, has an excellent paper on this. “Global Dollar Credit: Links to the U.S. Monetary Policy and Leverage,” is the title of it. And it lays out in, quite frankly, not so clear terms, that for the Fed to raise rates, will be, in essence, to sacrifice Asian and Latin American economies, and this is not just some sort of political theater, this is an actual issue in terms of capital flow. Nobody has an axe to grind here. The BIS is just trying to figure out how to manage the banking system, because as you know, the BIS is sort of the central banks’ central bank.

Kevin: And we are in new territory now, Dave, because we are not talking billions of dollars, we’re not talking hundreds of billions of dollars, we’re talking close to ten trillion dollars that these foreigners have borrowed in dollars.

David: Yes, and it’s pretty easy to see why. You have foreigners that are attracted by low yields, debt service at incredibly cheap prices, and they’ve borrowed close to 9 trillion dollars. And that is, again, in U.S. dollar terms, and that is increased over the last 15 years from 2 trillion. So roll the clock back to the year 2000 and we have seen an increase from 2 to now 9 trillion dollars, in borrowed money. This is known as, again, as I mentioned earlier, a currency mismatch. Because the real problem, and you can look back, actually, at 150-200 years of lending history, the problems come with a currency mismatch where one currency borrows in foreign currency terms, and then as their currency depreciates, or as the other currency, which they borrowed in, appreciates, you see a squeeze, and it becomes almost impossible to pay back the loans. And so the history of debt defaults for the last 200 years have been tied to this issue, in most instances, this issue of currency mismatch.

Kevin: I remember 17 or 18 years ago when that happened with Asia. They called it the Asian contagion, and I think Russia also had a default not too far from there.

David: Well, that is exactly right. The consequences of the last U.S. dollar liquidity squeeze, you had the Russian default, you had the Asian contagion, both of those occurring circa 1998 where hot money flowed out of Asian countries, causing both currency and equity market collapses. Russia, similarly – they were unable to pay their debts as the ruble came under pressure. So what does the score card look like today? How is the dollar doing today? Because again, if we are doing well in terms of dollar appreciation, and we know that the other side of the coin, so to say, is liquidity squeeze elsewhere, then small percentage gains equal small liquidity squeeze, large percentage gains equal large liquidity squeeze in the emerging markets, 24% is where we are at since last summer, 40% increase in the U.S. dollar since 2011. So, you’re looking at U.S. dollar borrowers who are under serious pressure. The majority of the new borrowers are, in fact, corporations, not governments, and again, enticed by very inexpensive paper.

Think about this. You’re in Brazil and the average lending rate is between 10 and 14%, but you can borrow in U.S. dollar terms at 2%. Is this a no-brainer? You’re the CFO for a company and you say, “Listen, the real has been one of the strongest currencies on the globe, and we are able to borrow at very inexpensive terms. We can reduce our interest expense by 80% if we borrow in U.S. dollar terms.

Kevin: And David, that is called the carry trade. We have seen carry trades for decades, but the problem is, you always see carry trades go terribly wrong when the currency starts to rise.

David: What we have today is what we just described happening in reverse. The result is like having your interest expense, rather than reducing it by 80%, it’s like having your interest expense right 5-10 fold. So, here is a very interesting question for any of you who are quantitative out there. What is the present value of emerging market equities when you are running a discounted cash flow model if you now have interest rates which are 5-10 times what they were hitherto? And this is one of the reasons why you can continue to see a tremendous amount of pressure, downside movements in emerging market equities. If there is sufficient chaos created in this episode of currency flows, again, outflows from the emerging markets, Asian markets, Latin American markets, even European markets, you may have the global community asking a very basic question. They have asked it once, they may ask it again, and perhaps they will ask it for the final time, whether the dollar standard is the currency standard that is most desired, that is most equitable, that is the most stable, etc., etc.

Kevin: Is it any wonder that the Chinese, the Indians, the Russians, these people who are affected by these possible future flows, are buying all the gold right now?

David: There is a difference, though, between – you have central banks, who, on the one hand are buying for their own account. You have individuals who are buying for their own account. But still, if you looked at the financial markets as a whole, there is a lack of buying in the gold market, because there is this bias. Again, what would you rather own? Dollars or gold? Ask the average central banker what they would rather own, and they would say, “Dollars, of course, or U.S. treasuries.”

Quite interestingly, the Bank of International Settlements back in 2012 relisted gold as a Tier 1 asset. So, now you have a zero risk waiting for gold on a balance sheet, which allows you, as a bank, anywhere in the world, to have the ability to borrow against, heavily, what is viewed by the BIS to be a very stable asset.

Kevin: And it is a Tier 1 asset that will always be a Tier 1 asset because it is gold. I want to talk a little bit later about Tier 1 assets that maybe shouldn’t be Tier 1 assets that can catch you off guard.

David: But I think as that question is asked again by the global community, if the dollar standard is going to be the enduring monetary standard, I think gold will have its day again as a part of the global monetary regime. Prior to that, there will be more chaos in the global currency markets.

Kevin: Dave, when we talked to Otmar Issing, one of the key motivations that he had for bringing about the euro and seeing that the euro project survived, is to keep us from war. Now, a lot of people would say that the stability of the dollar, this reserve currency status, and our ability to leverage people with this reserve currency, is one of the things that has allowed us to have relative world peace. Now, as we see these currency wars continue, could they break down to actual military war like we have seen in Europe over the last 100 years?

David: In American history we have had this bias toward avoiding entangling alliances. The founders have suggested that, as it has been a theme carried even through World War II, and really, what that political predisposition has to do with is managing complexity. And things can fall apart very quickly when you are in a very complex international relations environment. What Issing was suggesting, as you mentioned, is to actually engage in entangling alliances, because if we are so entangled together financially, if my interest is your interest and your interest is my interest, then we are less likely to move toward tanks and bombs and guns.

Kevin: It is like Mutually Assured Destruction, only the opposite.

David: Mutually Assured Satisfaction or something like that.

Kevin: Exactly. Mutually Assured Dependency.

David: So, with the notion of currency wars, the challenge is always going to be, do they give rise to, or justification for, actual wars? And this week has been fascinating to watch the German response to Greece. You are starting to see, at a grass roots level, “We’re throwing in the towel. We want to cut off the relationships.”

Kevin: Anger. Nationalism.

David: Diplomacy is now something that is second to personal and national self-interest. As you say, nationalism is on the rise in Germany as a response to what they consider to be an affront from Greece. So again, you have pressures which are developing sort of subcutaneously under the surface, and ultimately, do they serve as justification for actual war?

Kevin: Strangely enough, we are seeing war games get to be a little bit less like a game.

David: It is no coincidence. You have Putin, who has moved the navy’s northern fleet to full combat readiness this week, and started the most extensive military exercises since the end of the Cold War. Think about it. You have the ruble, which is down. You have oil revenues, which are down. You have Russian nationalism, which is up. And you have a lot of saber rattling. This should come as no surprise. When we’ve talked for the last 5-7 years about the crisis domino effect from something being purely financial, moving to a broadly national economic level, but then encompassing political problems, and then engulfing, ultimately, a geopolitical context where interests, internationally, are called into question. This is what you have in real time. What happens when the ruble declines? Is it a natural consequence to see saber rattling? Absolutely, if you see the interconnectedness of the world.

Kevin: Russia is the ‘R’ in BRIC, but let’s start with the ‘B’ in BRIC because the BRIC countries, and Russia has been leading the charge on this, are coming up with their own alternatives to the IMF, to the Bank of International Settlements, to payment systems, and so, let’s look at Brazil right now, because Brazil is really suffering from the rise in the dollar.

David: And again, this serves as fodder for significant change in the world monetary system, in the world bank settlement system, etc., etc., but what you have in real time is a major squeeze, what we have described as the currency mismatch, and this really illustrates the currency pressure. If you think about any Brazilian company, any Brazilian firm that borrowed in U.S. dollars, the real in recent years has dropped by 50%, so the scale of debt to pay back, if you want to translate that, has increased by 100%.

Kevin: It has doubled, Dave.

David: Which is the equivalent of a radical increase in rates, what I am suggesting as the equivalent of a 5-10 times increase in interest expense. So, once again, a strengthening dollar in an over-leveraged, dollarized world, is massively contractionary on a global basis. You have massively deflationary consequences for the borrowers of dollars and we are talking about, again, 9 trillion in dollar borrowing that is sitting overseas. Chinese companies are in the same boat. They owe 1.1 trillion in U.S. dollar debt, and fortunately, you have seen their currency move in lockstep with ours because they have the dollar peg. God forbid, what happens if, or when, they actually devalue.

Kevin: But thank goodness for the derivatives market, Dave, because you can hedge. Okay, if you were taking a loan out in dollars and you were Chinese, you can hedge against the dollar rising. The problem is, and the paradox is, doesn’t that actually create more dollar strength when everybody is hedging that direction?

David: You’ve seen the little dust devils, if you will, and they start small, and they gradually start to lift things off the ground. It is a little dirt here and there, and ultimately, maybe dry branches and leaves and sticks.

Kevin: Then it turns into a tornado.

David: Well, it can, on a large scale, and that is what they call a vortex. And that vortex creates – and actually, the physical process of a vortex is that it is almost self-reinforcing. And what you just described with the derivative products creating an offset for losses in the foreign currency markets, which corporations all across the world are trying to do, U.S. corporations, multinationals, are trying to hedge their currency risk, but you understand, by hedging their risk, they are, in fact, increasing the trend. You see what I’m saying? They’re driving the dollar even higher by hedging against an increase in the dollar.

Kevin: Well, and it is not just in the dollar. Aren’t the guys who are borrowing in Swiss francs, which also have been rising, doing the same thing in Europe?

David: Again, a currency mismatch; this is not a new concept. It is done all the time. It is usually done not very well. And the crazy thing is, yes, you are right, bankers all over the world – they love to lend money. Very simply, bankers love to lend money.

Kevin: It’s what they do. MacDonald’s sells hamburgers, bankers lend money.

David: So for years now, you have had Eastern Europe which has seen a ton of cross-border borrowing, in Swiss franc terms, and as the Swiss franc is strengthened there is some question as to whether these loans from Swiss banks will be paid back. Currency mismatches are common because, number one, you have people who are suckers when it comes to rates, and number two, bankers always want to make the loans. So, low rates – yes low rates entice excessive and risky borrowing, and I guess you could look at this on the other side of the spectrum, too, because people are suckers when it comes to rates, at both extremes. Low rates entice excessive and risky borrowing. High rates entice excessive and dangerous investing. How many times have we said it?

The greatest crime, financially speaking, in our era, was not Bernie Madoff making off with millions. It was not Ebers with WorldCom. It was not Jeffrey Skilling from Enron. It has been the distortion of rates by central banks driving rates to unnatural levels. Doing this for the last 5-7 years, the Fed has loaded the global financial system with nuclear material, with so much liquidity that, as and when, whatever the cause is for that liquidity to be dislodged, you’re looking at something that is incredibly disruptive to the world financial system.

Kevin: And we’ve talked about price discovery being virtually nonexistent. Correct pricing in interest rates, correct pricing in gold, equities, you name it, is messed up. But the people who are doing this right now, Dave, they’re looking at the situation, and the ones who are pretty intelligent are saying, you know, if we pull back, this whole thing falls apart, so what they are seeing this as is a collective move. Yes, granted, you are going to lose some of your individual market-making capacity, but a collective move to save the universe.

David: And I think that’s another major trend which is a move away from the individual. And if you looked at the free-wheeling ’80s and ’90s, certainly in the United States, an era of less control in the marketplace, and the same was true in Europe, as you saw capital controls come down in the ’80s and ’90s and a free flow of capital in between European states and around the world, there was a move toward the individual. Now we have the opposite, which is a shift from individual decision-making toward the collective. This is from freedom of choice to emphasis on collective, and really, a control of choices by the state apparatus.

Kevin: And prices.

David: It’s a sign of the times. We have, obviously, a variety of reasons for that, but if you look at the man on the street who doesn’t necessarily understand what’s happening at a sociological level, or perhaps a deep economic or fiscal level, financial level, what he doesn’t like is uncertainty. What he prefers today is security. And if that is what is on offer, we will solve the problem. It should come as no surprise that general security in a context like this, people are ripe for exploitation by powerful elites.

Kevin: Ben Franklin had warned about that. When a society starts craving security and they are willing to give up individual freedoms for that, they are going to end up losing both, and I think that is what we are seeing at this point, Dave, we’re seeing it in the pricing in the market right now.

David: When you think about the balance of world power, this is where, certainly, we are in a period of greater quantities of unknowns than knowns, and that adds to a general sense of insecurity. We don’t know what is happening in the world, we don’t know if we’re in control, and this is both economically, as well as politically. If you look at the Cold War, it offered the comforts of a simply divided world between good guys and bad guys. You had black and white, and now it’s not so clarified.

Kevin: Dave, even my son, who is too young to remember the early James Bond movies, but as we watch them, he loves the ones where there are good guys and bad guys. Cold War James Bond was so much better than save the trees, or save nature. You know what I’m saying?

David: There’s a battle today. James Bond is fighting himself and his own psychology, as much as he is the bad guys. And on the one hand, it makes for a more complex story, and the acting, you could argue, is one dimension deeper, but like you, I still like black and white – who are the good guys, who are the bad guys? We don’t have that anymore. And it fits the notion that Strauss and Howe had in their book, The Fourth Turning. You’re moving from the freedom era into an era marked by crisis and crisis management. We’re 7-8 years into what Howe described as the Fourth Turning, which is some sort of a sociological, financial, political winter. This is where all the rough stuff happens, and according to his timeline, we’ve got another 5-7 years of chaos. So where are we in terms of the global economy, in terms of the domestic economy? Because on the one hand you have the argument that all has never been better. And on the other hand you’ve got numbers which, certainly for the first quarter this year, don’t support that.

Kevin: For the person who hasn’t read The Fourth Turning, just a quick review, Dave, because you’ve interviewed Howe, it talks about society going through a continual cycle, sometimes between an 80 and 100-year cycle where it starts out like childhood, everything is free, it’s a little like the late 1940s, early 1950s in the United States. Then you start going through your teen angst in your 20s, a little bit like the 1960s, early 1970s.

David: Expressions of radical freedom.

Kevin: Yeah, so that would be the second phase. The third phase is more like going through maturity, middle age, and then the fourth phase is actually a crisis phase where things fall apart and you’re getting ready for a new first turning. That fourth turning is really a very difficult time to manage because it is the end of an era and the beginning of a new one.

David: Strauss and Howe do a good job of looking back at 500-600 years of data, British and American history, to say, in these “first turnings” or you might think of an analogy, springtime. Most of your spiritual awakenings, in fact, all of your spiritual awakenings in British and American history, have occurred in this timeline post crisis. And so, lest we be tempted to think that it’s only bad news on the McAlvany Weekly Commentary, our view is that given a somewhat cyclical nature of history, that good precedes bad and bad precedes good, as we said last week, nothing is permanent, and we are in a state of flux. Politically, we have reached a point of excess, fiscally we have reached a point of excess, and there is going to be a lot of change over the next 5-7 years.

Kevin: And we’re looking for a collective solution at this point, which hopefully will bring us back to the individual solution, the freedom solution, afterward. Dave, you’re putting together a program for home educators, to teach economics, to teach freedom concepts based on economics.

David: Economics, entrepreneurship, investment. It covers a lot of bases.

Kevin: Don’t you think it’s incredibly important, this younger generation, your kids’ age, to train them for whatever it looks like when we come out of the tunnel?

David: Yes. You know, it’s fun, with the boys we have been watching an HBO series, John Adams, and the cast is fantastic. And the boys are fascinated by his legal background, his fluid speech, the power that he commanded in the original Continental Congress. And also the conflicts of interest between those who were there still yearning for the old days of close ties to King George. And you have this conflict and you have people looking for solutions, some of which are based on freeing the individual to prosper, and the collective prospering as the individual prospers. And then much more of a top-down approach, which was still borrowed from the Motherland, so to say.

Kevin: Sure. Make sure that you are true to the king, and he’ll be true to you.

David: You saw that with people like Alexander Hamilton, who certainly had much more of a statist approach. They thought the lessons we learned from the king should not be neglected. The lessons of something of a command and control economy should not be ignored just because we celebrate the individual. Anyway, I digress. You have the economy here in the United States, February economic numbers. With the exception of the payrolls number – that has been the one positive light – the rest of your February economic statistics have been negative. And this is very consistent.

Kevin: Recessionary.

David: It is, and it has actually consistent with the fourth quarter GDP statistics which are very much below second quarter and third quarter of last year, and of course, everyone got very excited once we had a 5% quarterly number and pie in the sky dreams started to appear, sugar plums dancing, and these notions, again, not only of green shoots, but we are in full blown economic recovery – that was the story, Q2 and Q3, of 2014. We have had revisions since then, revisions lower now, casting a shadow on the first quarter of 2015. That is in lockstep with Standard and Poor’s earnings for the stock market. Estimates have been pulled down from 137 to 117.

Kevin: Dave, doesn’t that actually increase the price earnings ratio? We’ve talked about the Shiller price earnings ratio, which is the price of a stock based on earnings, the ratio between the two, and what you want to try to do is, you want to try to buy a stock when the PE shows that that stock is a relative value based on earnings.

David: Yes. The difference between PE and CAPE, or the Shiller Cyclically Adjusted Price Earnings ratio, is that the Shiller PE doesn’t move as quickly.

Kevin: Well, it’s taking ten years at a time.

David: It’s a ten-year rolling average. So it smooths out some of the volatility, which I think is quite helpful. It makes it a more useful tool in the end. But you’re right, if earnings are coming down, and all of your Wall Street firms are now lowering their estimates for 2015, 137 to 117, and I think we will see lower estimates, still, as we progress through the first quarter earnings season, you know what we are going to end up with? We’re going to end up with PE ratios which go even higher.

And then the question will be, for 2015 and the recorded price earnings ratios for 2015 – will they ultimately match 1929? Will they ultimately match 1999? Time will tell. But the ugly reality is that stocks are elevated, as we speak, while the economy is shrinking, and those variables put the Fed in a trapped position, in a very difficult position. Inflate or die is the only real choice, and you could say, credit create or die, because that is truly what happens. On the one hand, you have the economy, which is requiring more juice. On the other hand, you already have bubble dynamics afoot in the stock market, and of course, in the bond market it is already crazy.

Kevin: If you think about the Federal Reserve, Dave, we talk about the only tool they really have is to print money, and that’s true if the economy is not doing its work on the other side. If you’re a Federal Reserve Chairman, let’s pretend the Federal Reserve is there to help, which I think that they think they are, then they will print money when the economy is lagging until the economy picks up the ball and runs with it. And then, really, a good Fed chairman is going to say, all right, now it’s time to raise rates, it’s time to tighten, it’s time to do the Paul Volcker.

The problem is, like we talked about in the beginning of the show, the economy is not running, the dollar is running, the Federal Reserve is in a corner, Janet Yellen cannot do what a good Federal Reserve Chairman should do, which is tighten after loosening. And so, if the economy is still slumping, Dave, after printing all these trillions of dollars, what is going to pull them out? Let’s face it, the savers right now are not spending. They’re saving more and more, but they’re not spending.

David: And that’s why these dynamics are actually more dangerous than 1929 or 2007, because you have the Fed who has yet to take away the punch bowl. The markets are rising. As the economy falls, or if it would accelerate, in terms of a decline, what do you do? You have to gin up the punch bowl, you can’t take it away. And that’s the awkward position they’re in.

Kevin: It’s lower rates and more printing.

David: And you’re right, but the flip side is that you’re seeing individuals who, with a very low rate environment, and with some concerns about true recovery in the economy, are saving more. The savings rate is on the rise. We’re now at 5.5% on the savings rate, and it’s moving in the wrong direction for central planners because their intent is to get savers and households to spend. Saving is anathema if aggregate demand, and an increase in aggregate demand, is where you hang your hat as an economist. And that is the Keynesian dream, an increase in, and steady maintenance of, aggregate demand. So, if the savings rate is going up, this is also consistent with what we have now as three months in a row of declining retail sales.

Kevin: People aren’t spending money.

David: December – declining retail sales. January – declining retail sales. And of course, you had the excuse in December of weather. Maybe January it was weather. Is February weather? Will March be weather? At a certain point, it seems that there is a trend, and it is U.S. consumers which, quite frankly, are on hold, very reasonably, looking for more evidence of a recovery, than perhaps a singular economic input which is the payrolls number. So, for us, that number is fairly dubious. We talked about it last week in terms of the death/birth modeling and the seasonal adjustments which tend to help when you need it, so yes, it is reasonable for consumers to be on hold, and it’s reasonable to see retails sales falling in that environment.

Kevin: And a good part of our economy, last year, oil was about $100 a barrel, between $80 and $100 a barrel. So, the guys who were out in the energy fields, which was a huge part of our GDP…

David: You mentioned that last week.

Kevin: Yes – that has been cut back.

David: Right. So, what you didn’t see in the February payrolls was the shrinkage in jobs in that sector, in terms of oil and gas. In fact, for January, they showed less than 1900 pink slips, which was kind of funny, because when you looked at what was happening in the Texas oil patch, there were 3300 oil and gas job losses, and yet, the federal number only picked up 1900 of those. What does that mean? The folks in Texas know that there are over 300,000 people working in the oil patch. When one of them gets fired, they’re counting the numbers, but at the federal level, somehow 3300 translates into 1900.

Kevin: That’s called a function in mathematics, Dave, when you have an equation that can change a number. And so, if you’re in Texas 3300 people who get fired turns to 1900 on paper in Washington.

David: I think that function is called politics.

Kevin: Oh! Okay. (laughs)

David: As I tell my kids, politics – what is a politician, what is politics? Poly and tics – many blood-sucking creatures. The reason why we don’t have much respects for politics is because we really don’t like leeches, fleas, mosquitos, and other things that suck blood aggressively. Well, I digress again. You have Halliburton, which is shrinking their work force by 8%. That’s 6400 jobs.

Kevin: In Washington that’s 2200 jobs.

David: Well, exactly.

Kevin: I just wanted to let you know, yeah.

David: Given the mathematical function, expectations, ours and others, are that significant layoffs are around the corner. Though the announcements from the oil patch have lagged your major drop in drilling activity, they’ve shut off the machinery, now the question is are they going to shut down payroll, as well? And we suggest they are going to do some major trimming over the next several months.

Now, again, you could argue that this is resilience in the sector or the calm before the storm, and I would probably stick with the latter. This is the calm before the storm. You have had Texas which has been the standout jobs producer for the last four to five years relative to other states around the country, and it has had a very robust economy. But, of course, while those in Texas would like to say it’s very broad-based, it’s difficult to argue with elevated oil prices for four to five years, bringing us to a peak last summer. And the new sheiks in Dallas – you can take sheik either way you want, Dallas and Houston – yes, they have been enjoying the oil boom times. And you know what? They are a little bit like the economic caboose. And we saw this in the ’80s, too. The oil patch was more elevated for a longer period of time, then ultimately, they took a hit on a delayed basis, and it was a pretty grand one.

Kevin: The only place that we are really seeing any cheerleading, then, is in the stock market, and like you pointed out last week, Dave, a lot of the stock increase right now is just basically corporate buy-backs. These guys are just buying their own stuff back.

David: We did talk about the 500 billion in buy-backs for last year, but we did not include dividends, which would also be in that category of “returned shareholder value.” Now, that’s an additional 400 billion, bringing the total for last year, in terms of corporates, making money in the distributed shareholders, roughly 900 billion. And quite frankly, that 900 billion didn’t work its way into the economy, as would have been hoped, certainly, from dividends, as they circulate into individual balance sheets, and ultimately, you could argue, there would be some wealth effect – not much of it. So, returning to that same topic this week, it is intriguing, because we have a very curious outcome from the bank stress tests.

Kevin: They say those bank stress tests went real well.

David: To some degree they did, but the financial sector now gets to play the same games for the foreseeable future, and gin up their earnings per share results to increase compensation and bonus packages for executives. Call it what you want, but the stress test results lead to a huge payday for bank and financial executives.

Kevin: Doesn’t it loosen the tightness of regulation on the banks, that banks at this point have more latitude?

David: That’s right. They’ve been unable to significantly ratchet up dividends or share buy-backs, until they could substantiate having adequate capital. Post crisis 2007-2008-2009, banks have had to sit on their hands quite a bit, sit with closer to razor-thin dividends, and restrict the amount of buy-backs, so they needed the extra capital in case of another crisis. So buy-back frenzies, this is typical, and we mentioned this last week, as an indication of a market peak. Corporations are playing with earnings per shares, there are those games. They are paying way too much for the shares.

Let me just offer this, as sort of an alternative. Owning a company. If you want to shrink the number of shares outstanding, the best time to do that is when the shares are selling inexpensively. So, to manage your cash effectively, as a company, and then be able to step in and buy those shares, at a discount to book value, for instance, would make sense.

Kevin: That’s just good business sense.

David: So, if I know that the book value of my shares in $10, but I can buy them for $5, a corporate manager should, should, absolutely should, buy back shares. I’m not saying that there is anything evil about buying shares back, I’m saying the timing of it makes the activity suspect when you have no real financial or economic justification, given that you are paying record high prices. Does that make sense?

Kevin: You have a slumping economy, you have corporate profits that have been falling for the last two years, you have the price earnings ratio on the stocks at close to the highs that we see before a crash. You have margin debt at the highs that we see before a crash.

David: Amazon selling for 17 times book value. And so, if you ask me, when does it make sense to buy Amazon shares, if you’re Jeff Bezos, to retire shares? Is it when they’re selling at two times book? Five times book? Less than book value? Or when they’re selling at 17 times book? And this is what you tend to see, people have some cash, they’re willing to throw it around, and they ultimately regret the decision when the dust settles. But this is what you might expect from financials and your banks is that they report in the first and second and third quarter this year. Over the next several quarters, they get to play the same Wall Street games that we discussed here, ad nauseam. That is, they are at the tail end of the earnings per share manipulation game. And now they get to do it in earnest. And we saw this starting last week – 57 billion in buybacks announced by the financial sector last week. Follow the stress test and now the floodgates are open.

Kevin: Dave, there is another area that they are spending their money, not just on shares, and actually, this reminds me a little bit like having to carry cash in a South American country. You have some experience with that. But when the cops pull you over, they’re not really looking to enforce the law, they’re looking for a payoff.

David: They’re not looking to hand you a ticket, they’re looking for you to hand them a little baksheesh, something to grease the palm, so to say.

Kevin: And that’s what seems to be happening in our regulatory environment. I saw the SEC Chair, the man who was the head of the SEC for ten years, come out, and now that he is retired, or now that he has stepped away from the SEC, he says that the markets are rigged, he just couldn’t say anything when he was in there. Now, the regulators – okay, I’m going to bring up something else, Dave. We saw last week that ten firms are going to be investigated for manipulating the gold price. Now, some of them, yes, they’ll probably find some guilt in different places, they’ll pay their fines, and they’ll continue to rig the gold market.

David: Regulators aren’t looking to stop bad behavior, because bad behavior is a cottage industry on Wall Street. And it has become a cottage industry for the regulators, because when you look at the fees and settlements – now, of course, the legal fees go someplace else, but certainly the settlements, just for the financials! We’re up to 200 billion dollars in legal fees and settlements. And so, does this reshape the way regulators plan on doing business?

Kevin: Well, do you want a fifth of a trillion dollars, Dave, by regulating and maybe taking a little bit of a payoff?

David: Government is moving to the “tax by I gotcha” mode. And that is reality. One more thing on buy-backs. The Harvard Business Review finally criticized the practice of share buy-backs, and they included a quote in a recent article from Bob Lutz, a veteran auto executive, saying, and this is quote, “Stock buy-backs are always a harbinger of the next downturn. In almost all cases, you regret it later.”

Kevin: Dave, I brought up bank stress tests a little bit earlier, and you were unimpressed with the results. To you, you saw this as maybe something more.

David: Well, you have the recent events in Austria. They illustrate the weakness in modeling and reporting, which is rampant throughout the financial sector. So, take the German real estate lender, Düsseldorfer Hypothekenbank, which is facing the music now because of its exposure to the Austrian lender. Remember at the end of the program last week we mentioned an Austrian lender that was going toward a bail-in, where creditors were now going to be shareholders of the banks, and it basically was a problem with Triple-A paper on their balance sheet that had not been marked to market? And they checked and they finally said, “Well, what is it worth? Oh, it’s worth zero.” So, what happened is, the German real estate lender is now in trouble because of its exposure to the Austrian lender, Hypo Alpe Adria’s, bad bank assets.

So, Austria has not been marking assets to market, and what was considered Triple-A paper, and by the BIS considered Tier 1 capital, now over 10% of it blows up overnight, and you have bank insolvencies. This is the danger of mark-to-make-believe. You can call an asset – “Is it worth 100 cents on the dollar? Well, it may be worth 50 cents on the dollar, but I’m going to call it 100 cents on the dollar, and we’re going to put a stamp of Triple-A on it, and it’s going to be Tier 1 capital, and we can lend heavily against it, and it’s called zero risk weighting in terms of how it fits into the total capital structure.” I’m thinking to myself, is no one paying attention?

Kevin: Does no one know history, Dave? Austria – isn’t where that started back in the 1930s? Creditanstalt?

David: Sure. And one step behind that, because you had the merger of Bodencreditanstalt, with Creditanstalt, and they absorbed a bunch of bad loans, which ultimately compromised the security of Creditanstalt, and people point to that as a trigger for global depression.

Kevin: Okay, but this is Tier 1 capital that we were talking about. Now, remember, we talked earlier in the program.

David: This is the best of the best.

Kevin: Gold is considered Tier 1, but Tier 1, if it’s gold, doesn’t fail. Tier 1 capital, if it’s something that is not counted at the market, that can fail.

David: Right. You can throw government paper into the mix. There is a variety of things which are considered Tier 1 capital at banks, and they are considered riskless assets. So here we are doing stress tests, whether it is in Europe or the U.S., and granted, methodologies may differ, but the simple assumption of quality is applied to Tier 1 capital, and as the Austrian assets illustrate, trash and treasure are still subjectively, not objectively, appraised. So, you can throw a blanket over bad assets, and you can call them anything you want, but quite frankly, this is a recipe for financial market chaos.

You may argue, well, that’s Austria, we’re a long way from there. It goes right back to the issue of Creditanstalt so many years ago, and Bodencreditanstalt. You have bad assets, and you are not marking them to market. That is a present day reality. Here in the United States, we don’t have to mark bad assets to market, and I understand the justification for not doing that. You can have incredible volatility in terms of the share price of companies, and you can compromise the ability for a bank to operate if they have to deal with the daily fluctuations of the assets they have on their balance sheet, so they are allowed to mark them to model instead of mark them to market. And then when they have bad assets, what do they do with them?

Kevin: They mark it to fantasy.

David: With some of those they just put them in an SPV, a Special Purpose Vehicle, and it’s the official means of white-washing assets. Move them off balance sheet, move them out, and now they don’t impair the total balance of assets on your balance sheet. And again, this is helpful, but if you don’t mark assets to market, you really are not dealing with real values, real underlying realities. Everything gets weird when you are allowed to creatively make stuff up.

So, am I impressed by the stress tests? No, not particularly. They passed with flying colors. Great. Let’s see how they actually do, not in a model scenario, but in an actual crisis, because I think what you will find is, as Jim Rickards said on the program here, it has nothing to do with the bell curve, it has everything to do with the power curve, and an exaggeration of compounding problems. They can assume that they have this problem, this problem, and this problem – let’s call them problems A, B and C. The problem is, in a financial crisis, you get A to Z and they are not in order, and you weren’t prepared for it, because you assumed A, B and C. And you get A, you get K, you get Z, you get Y, you get T, you get S – you get a ton of stuff thrown at you, and again, you’re not prepared for it if you are allowed to, creatively, make stuff up.

Kevin: Everything we’ve been talking about just makes me think that there is a misunderstanding of causes – first causes. We talked about that with currencies. Causes are so important in everything in life, and if you don’t understand what is causing something, you can make bad decisions. Let’s just look at the European stock market right now. The European stock market is probably gaining, mainly because the euro is being destroyed.

David: You’re suggesting that I can’t be happy about something. Okay? You’ve got the FTSE, the Euro 300, large 300 companies listed on the European exchanges – they’re up 21%, year to date! Year to date, up 21% – that’s not bad for less than a quarter’s work, and you’re suggesting to me that that is not good news? And yes, I will agree with you, it’s not good news, because all you have is a recalculation for a currency which has depreciated considerably. And this is the perennial confusion over devaluations. Equities, in nominal terms, appreciate. You saw this in the German hyperinflation. The German stock market did very, very well. Now, if you netted out the loss to currency, you were being eaten alive.

Kevin: Right. You lost more than 90% of your money as you made – what was it? – tens of millions of percent gain in the stock market.

David: Arguably, equities were a better place to be than cash or government bonds, but you still had to do the conversion. It was not enough to look at nominal terms. And so this is what we are talking about. European equities are moving higher in nominal terms, but they’re really just adjusting to a lower currency value. And it was John Authors in The Financial Times who hit the nail on the head. He said yesterday, “An apparent rally is merely an adjustment for currency moves.” And so, as an asset manager you may pat yourself on the back for a 21.65% year to date gain in euros, but as a U.S. investor looking at European equities, you’re not up 21%. When you convert back to dollars and come this side of the pond, you’re down 7%. The difference between nominal appreciation in euros and actual appreciation in U.S. dollar terms – positive 21, negative 7. Can you see the difference? This is why currency values matter. This is why when we talk about the currency wars afoot, when we talk about capital flows and an appreciation of the U.S. dollar, all is not as it seems. We can’t leave it with surface appraisals.

Kevin: And not just with surface appraisals, we’re using real math here, as far as the currency devaluation, with stock market revaluation over in Europe. Those aren’t government reported figures. Now, the government is telling me here, Dave, even with all the trillions of dollars that have been printed, that inflation, CPI, is still in a downtrend. But I can tell you, going to the grocery store, especially what my wife says, inflation seems to be rising. Now, there are other measures, other than CPI. We don’t have to depend on the government to see what is really happening to prices.

David: What you find is that politicians will cluster around the academics that support their position, and give them intellectual cover. And so, you have the Billion Prices Project, which was originally a project put together by MIT, not particularly popular today, because it is showing a turnaround in inflation. It is showing – that project appears to be turning up, meanwhile you have CPI, the Consumer Price Index, which is still indicating inflation is in a downtrend, and deflation is more of the problem. In that same vein, you have Larry Kotlikoff at Boston University, and again, not politically popular, he is not the academic that Wall Street or Washington are going to.

Kevin: He was a guest on the show, and you’ve gone out to see him.

David: He teaches at Boston University. I picked up a great book, just around the corner from his house, we had a several hour conversation. Kotlikoff said this recently. He said, “The CBO (that is, the Congressional Budget Office) in my opinion is deliberately misleading the public and Congress about our nation’s true fiscal condition. The real fiscal gap is 16 times larger than the official debt,” still continuing the quote, “which indicates precisely how useless official debt numbers are for understanding our nation’s true fiscal position.” What he is arguing is that the government says, “We only have about an 11 trillion problem.” And he says, “Yeah, but by the time you look at what is on the books, and what is off the books” (on the books is your treasury bills, notes and bonds, and the off-books is your Social Security, Medicare, Medicaid, and prescription drug benefits), actually, we don’t have enough money to pay the bills, we’re missing about 210 trillion dollars.” That’s the gap. The gap isn’t the 11 trillion that the CBO admits to. It’s closer to 210 trillion. And he says, the gap is not growing at half a trillion, as the CBO suggests, but actually at 5 trillion a year. Because again, he’s looking at off-balance sheet, or off-book and on-book liabilities.

Kevin: So Dave, if the Fed can’t print our way out, which is showing up as a failure, and if the economy can’t grow its way out, Kotlikoff’s suggestion is very, very painful, because his suggestion is that we all pay a lot of tax.

David: And this goes back to that second major trend which we talked about today, a shift from the individual to the collective, and the state determining – we’re talking about the powerful elites in Washington determining who wins and loses – and this is where it does get ugly.

Kevin: It’s like what you said with Pettis, assigning the losses.

David: Assigning the losses.

Kevin: Somebody’s got to have the power to assign the losses.

David: Now all we have to do is choose the winners and losers. And Kotlikoff says it’s not as if we can’t work this out. In terms of the fiscal side, if you’re looking at cash flow, we can certainly increase our revenues. We can increase the cash flow to government. But you’re going to have to raise taxes across the board by 60%.

Kevin: A 60% rise in taxes.

David: Yes, and that will cover our fiscal gap. So, we’ve worked our way into a problem, we’ve spent more money than we had. Generationally, we’re passing on the curse and burden of debt, and the one solution to this, after living large for several decades, is to pass on to the next generation, not only the debt burden, but the means by which it will be paid back, and that is an across the board increase in taxes. That would be the lowest tax bracket, 10%, paying 16%. That would be the 25% tax bracket paying 40%. That would be the 35% tax bracket paying 56%. And the highest tax bracket, 39.6 currently, bumping it to 63.36%. That will get us there.

Now, what happens to business? What happens to industry? What happens to dreams of an entrepreneur? I can tell you, this is the kind of behavior which causes money to go quiet, which causes money to go underground, which causes ounces to find the mattress pretty quick. And this is the kind of environment we had in 1944, 1945, 1946, 1947, and it’s the environment we’re going to be in over the next 3, to 5, to 7 years. Lest you lose hope, there is a 1949 on the horizon. Equity values, I think, over the next 5-7 years are going to be decimated. And on the other side is what? The same kind of opportunity we had in 1949, which is the same kind of opportunity as an investor that we had in 1932, which is the same kind of opportunity that we had again in 1982.

Strauss and Howe are interesting, and I would highly recommend reading the book because it looks at the cyclical nature of history. I don’t know where history ends – I think I kind of kind of know where it begins, we can speculate about the rest – but we do know that if there is some future ahead of us, human nature hasn’t changed all that much through time, and human behavior, reacting to various circumstances, ends up being fairly predictable, which means that we do have a move toward statism, control, emphasis on the collective. In the terms of supply and demand, order offered up by the state apparatus, is in great supply, and the public is going to demand a lot more of it. I think that defines crisis. I think that defines the compression of time, and ultimately, the opening up of opportunity that we have on the horizon.

How do we get from here to there? Well, that’s a very interesting issue, because perhaps counter-intuitively, I would suggest to you, you need to reconsider, completely, you need to consider what sets you apart from being sucked into the state apparatus, what sets you apart from being sucked into the financial markets’ vortex. And if it’s as simple as getting an official bank safety rating on your local bank, by all means do it. We have actually offered that service for decades, but it’s worth considering.

Kevin: Yes, and there’s no charge. Anyone who is listening to this program can call us, we’ll be happy to give them a safety rating on up to three banks for free.

David: To me, it’s painful to think that the general consensus is being shaped by stress tests, which really don’t warrant the confidence that will be put in them. I would rather look at a private institution that has no axe to grind whatsoever, looking at the financials of individual companies, individual bank institutions and seeing what are their nonperforming loans? What are their hot money ratios? What are all the jots and tittles that make them an A through F-rated bank? And that is, in my opinion, one of the simplest and surest ways of gaining a little pillow comfort in the times that lie ahead, knowing that the people that you are doing business with are trustworthy, knowing that the institutions that you are dealing with have financial integrity.

If you roll back to an earlier generation, it really was that simple. Doing business was on the basis of a handshake, not a contract. Looking at things from a very intuitive or common sense perspective, that’s what you needed. You didn’t need the complex formulas that have been put in place today to tell you it’s okay, you’re going to be okay. What that actually is, is a manipulation of reality in order to bring you, the general public, into the role that you have been pre-fitted for – the role as a consumer in our economy.

That may or may not be the ideal for you at this particular time, but that is the hole that you are being force into. Round hole, square peg, don’t know. But I think you should do everything that you can as an individual to move against that trend. If one of the major trends we have in our day is this move toward statism, there are simple things that you can do to ensure individual freedom and autonomy. Make a list, and get it done.

By | 2015-03-19T16:08:41+00:00 March 19th, 2015|Transcripts|