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The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick


January 16, 2019

“You see the increase in socialism, you see the increase in populism, post 2008. So translate the same dynamics to the U.S. With economic prosperity comes greater probability of peace. With economic crisis or stagnation comes an increased probability of a very muscular foreign policy.”

– David McAlvany

Kevin:I was having lunch with a good friend of mine last Wednesday. He has been diagnosed with terminal cancer. He is fourth stage. He is an amazing guy, though. He’s ready to go. He is one of the toughest guys that I know. But he shared with me something very personal that I think is profound, and I think a lot of us would relate to, Dave. He said, “Kevin, I look back at my life, and I think the guys who were the toughest on me were the ones who cared the most about me.”

It reminded me of a conversation you and I had a couple of nights ago as we prepared for this program. You shared the thankfulness that you had for some of the people who were in your background.

David:Going back to when I was in college, the professors who were the hardest on me are the ones who I, today, continue to have the greatest amount of respect for. I woke up from a dream of some sort a year ago, and I had in my mind a couple of the men who had left major impressions on me, and I have been thinking about writing them a letter just to express my gratitude for their investment, and just who they are. But what they required of us as students was remarkably different. Not all teachers are the same, and some have a real concerted purpose to what they are doing. So I’m getting some of those letters written and I think it is a good practice to look at that for which, and to those, who we are grateful for.

Kevin:It reminds me that there are a lot of times in our lives where friction is the very thing that we need, the type of person, those tough teachers, this person that my friend was talking about, these people who were tough on him, who he now looks back and realizes they cared the most about his outcomes. Those friction moments are actually the way that we are sharpened – iron sharpening iron. I think of some of the people, Dave, that you surround yourself with now. They don’t always agree with you. Oftentimes you have some pretty heated conversations about what you are trying to analyze. But that’s what this program is for. I think of even Doug Noland, or Jim Deeds, or people in your background, some of the people who have passed – Ian McAvity, some of the guests that we have had on this program.

Speaking of Doug Noland, who is somebody that you have followed for years, and I have, too, we have another conference call coming up for the Tactical Short with Doug Noland on it.

David:Yes, January 24th, next Thursday, mark your calendars. We have the Quarterly Conference Call for the Tactical Short offering. You can register and join us for the discussion of 2019 – The Secular Shift Beginning the Long and Difficult Road.

Looking at Doug’s comments from the weekend, the Credit Bubble Bulletin, on crisis dynamics and how they tend to be a process, he says, “There is the manic phase followed by some type of shock. There is at least a partial recovery and a return to optimism that is often bolstered by a dovish central bank response. It is the second major leg down when things turn more serious, for sentiment, for market dynamics, and for illiquidity. Disappointment turns to disenchantment, and eventually, revulsion. It has been a long time since market participants were tested by a prolonged, grinding bear market.

Kevin:So what he is saying is, “How many times can you goose the system artificially until it starts to actually recognize that we are in a bear?

David:Yes, there is a consistent theme of slowing economic activity globally, and some of those indicators are now in the U.S. as well, although we have held up pretty well here in recent years. We have corporate tax receipts down 9 billion. Of course, you can look at the tax deals that have been done and maybe lay it at the feet of those negotiated pieces, but individual receipts are down 17 billion. This is the interesting thing for me. You have interest costs on the national debt which are up 16 billion dollars for the quarter as we close out this last year. So interest costs for December are up 47% compared with December of 2017.

Kevin:It reminds me of our guest Alex Pollock, who was on a couple of months ago. He said, “Your income can fall, or your assets can fall, but your liabilities stay the same. What you are pointing out here, with the tax receipts being down, is our income is falling and our liabilities are actually increasing.

David:Because of the structure of our debt. With debt at 21.9 trillion, just a hair below 22 trillion dollars, and growing at a greater than 1 trillion dollar annual pace, there is the component of a growing base of debt, but the bigger issue here is that we have seen a bump-up in interest rates, and that interest cost, again, from 1 December to the next, is up by 47%.

Kevin:For the few people who actually make things still here in America, factory orders are down, are they not?

David:Exactly. So that economics slowdown which is happening globally, you are seeing some indications of it here on our shores. U.S. factories ended 2018 on a very sour note. Bloomberg noted that you had all five regional gauges which were down for the first time in two years. Then we had the announcement January 3rdfrom the Institute for Supply Management. That index dropped the most since 2008. The gauge dropped 5.2 points, and a decline of that magnitude, according to Bloomberg, has only occurred twice in this century. Both times were in the context of recession. One was the financial crisis a decade ago, and the other was following the September 11, 2001 terror attacks.

Kevin:These dates are so important because a lot of times when these things occur you can go back and say, “Well, gosh, that was right before the last two crashes.” Now, we were talking about U.S. factory orders and growth, but this is not just a United States phenomenon.

David:No, factory growth fell to a three-year low in the eurozone, so you have that in that neck of the woods. Also in Asia you have China leading on the downside as factory gauges signaled a contraction for the first time since the middle of 2017. On their heels you have Taiwan, Malaysia and South Korea, which, according to Bloomberg – again, China sort of leading the pack on the downside in terms of factory growth – South Korea is an export giant. We know China is, too, but the summary here is, this is not a country-specific issue, this is not even a regional issue, but there is a global slowdown afoot.

Kevin:When you go to Munich, Germany, one of the most prominent high towers is the BMW factory. Germany really is the engine of growth in Europe. If you think about it, we look at these other surrounding countries, but Germany has really been the engine of growth, and I think that they are slowing down, as well.

David:That’s what we saw last week when we got the German industrial production numbers, weaker than expected, making for two months back-to-back industrial production declines, and it suggests that Germany is very close to recession. As you say, this is the economic engine of Europe, and I think maybe if we look for the next month’s number, the next release of the German IP numbers may be definitive in terms of that German recession, and ergo, I think, European recession.

Kevin:One of the things that allowed us to ignore the fact that there has been a slowdown, because this has been happening for a while, is that the stock market had been gaining each year, but 2018 changed that.

David:(laughs) It marked the worst year for stocks in a decade, and as we talked about last week, the performance numbers, while negative, were not all that bad, 6-12% was the range with the Russell 2000 down just over 12%, the S&P down 6.2, and the Dow off 5.6%. The real weakness was in that last quarter because we actually had most of the year which we were just fine and everyone felt fine and nothing appeared to be wrong. But here we are with the fourth quarter being behind us, this three-month rough patch, and we are to understand now, according to the new media, that this decade-long bull market in everything, in every asset class, was moderated and the excesses of that period were corrected in a matter of about three months.

Kevin:Durango is known for its steam engines. We have the trains running three times a day, up north to Silverton. When you’re near the roundhouse and they get those things stoked up, they have something where they let off steam. That’s where we get the term, letting off steam. I think a lot of people would say that this letting off steam has now moderated the market and we have only to go up from here.

David:That’s right. You have a bunch of the banks saying, “Look, there is a good reason for us to just motor higher from here. BNP Paribas in France, Morgan Stanley, Goldman analysts – they think, and in credit they are kind of seeing the world through the glass half-full analysis. There is the belief that trade compromise is going to emerge. And they may be right, but again, nothing in terms of details has emerged yet, but there is this belief that we’re going to get a compromise there, and China is going to pull through economically, and Brexit is going to pass over, after March it’s not really that big of a deal, and so all of these areas of political uncertainty are going to dissipate.

Doug Noland and I were talking yesterday and he said, “This was commentary that we used to get in the 1990s all the time. It was called, “Looking across the valley.” So you try to ignore what is immediately ahead of you and directly below you, and you keep your eyes on the rise across the valley. Let’s not be distracted by what is going to happen today or tomorrow, but, thinking positively, we’re already on the other side of the valley.”

Kevin:Speaking of valleys, I think of Sonoma Valley, and you can sometimes have a little bit too much of the vin of the grape, even when you are visiting Napa. They’re great wines, but you have to moderate. We have excess wine in the form of liquidity over the last decade, and in a way it’s a little bit like walking around in a drunken stupor. I wonder if people are analyzing the economy based on just a continual consumption of this elixir?

David:I’ve got a race in Sonoma at the end of July, so I’ll be there, but I won’t be imbibing all that much, until at least in the recovery phase from the race (laughs). But you’re right, the excesses of a decade – we have had the loosest monetary policy here in this past decade outside of major hyperinflationary events. So you could say this is as generous as the poors could get. This is the most liquidity that we have seen outside of acute hyperinflationary events.

Kevin:Yet we’re still seeing bankruptcies, we’re still seeing companies close forever.

David:The fascinating part to me is that Wall Street has this ingrained belief and bias that three months of market volatility cleans up a decade’s worth of that kind of excess liquidity. Okay, I guess that’s possible, but you have Sears which is gone, a 126-year-old business which this last week called it quits. 50,000 people are going to be looking for work. (laughs) Not to worry, you talk to the Bureau of Labor Statistics, 50,000 unemployed, that’s a rounding error.

Kevin:Yes, but they’re not employed right now. The Bureau of Labor Statistics right now are not even doing the numbers. Remember, they’re not getting paid.

David:Oh, that’s right. Pobrecito.


David:That’s what we would say in our family – “Poor little fella.”

Kevin:Well, speaking of that, let’s look at the politics, then, because we not only have an economic situation that has been fueled for ten years with free money, this elixir that I was talking about, but the political environment has never been so divisive.

David:I love seeing the Financial Timesjust kind of transitioning back from that comment about so little time to correct such a long bull market. The Financial TimesJanuary 7thsaid, “If 2008 was the first year that tested the resilience of the global markets to a switch from quantitative easing to quantitative tightening, the results did not inspire confidence. Investors began the year unprepared for the renewed volatility that came as the Federal Reserve rolled back more of its insurance liquidity.

“The fact a strong U.S. jobs market and historically low policy rates could not prevent U.S. stocks having their worst December since 1931 confirmed that a decade of repressing volatility had left the market with a weak immune system. The central issue facing markets now is where the new clearing level for risk lies. Has recent turbulence reset market fundamentals to more sustainable levels or does it portend greater pain to come?”

Kevin:Well, let me ask, does the market, even if it could go up, does it ignore what is going on politically?

David:Bill King commented on it last week. The political environment is now conducive for a bear market, he said in one of his recent reports. Reflecting, it’s not just that we have a divided government, it’s more than the government shutdown, or Fitch, the rating service, is now threatening to downgrade U.S. debt should those circumstances with the shutdown persist. It is more than that. It is uncertainty which has come into the air, it is a climate which begins to change, and that allows for a persistent long-term bear. It is one where positive sentiment is replaced with risk aversion. It’s where, again, sort of, the happy days are here again is somehow undercut by cynicism and skepticism is, now that the market responds people say, “Oh, no, no, no, it’s not going higher.”

Kevin:Am I hearing you breathe life, then, into some of the danger investments, the hedge investments, like gold?

David:Well, gold does very well, not only in periods or environments where you have political turmoil, but obviously, where, whether it is political turmoil or other causes of uncertainty, gold does very well, because, you go back to this behavioral shift, this allocation shift made in the context of uncertainty.

Kevin:Do you remember when Draghi came out and said, “We will do whatever it takes.” That was in 2011 when gold was hitting its all-time high, and sure enough, everything changed after that.

David:Very critical, because King was also commenting, as we came into the new year, that gold hit its all-time high in 2011. Then something happened that torpedoed gold and induced investors to turn to stocks.

Kevin:Free money.

David:Yes. This is King’s commentary here: “Obama was aided and abetted by negative-to-zero interest rate policies, three quantitative easing programs, a twist, and beaucoup verbal interventions, if not actual manipulation. At some point, large investors and private equity behemoths will become alarmed and rethink the conventional wisdom in regard to the value of paper versus real assets.”

Sometimes King waxes on about something that happened in the past. In this case, he looks at these major transitions in the 1990s. He says, “In the 1990s you had the demise of Japan, the USSR, communism, as well as the ascent of democracy, market economies and globalism, which induced investors to buy paper assets and jettison real assets. “

Kevin:In a way, it was a perfect storm of good news.

David:Yes, right. And so the uncertainties of the cold war era were behind us and now we could think differently. In addition, there in the 1990s we had massive changes within the U.S. banking system which allowed for massive consolidation and increase in the flows of credit, not only within the banking system as we know it, but really, the 1980s through the 1990s launched our shadow banking which was a massive credit expansion in nonconventional, nontraditional avenues.

Kevin:Okay, but look at the perfect storm that started in the global financial crisis in 2008. You had the seeds of things going backwards.

David:Back to King’s comments. He said, “After the crisis of 2008, socialism, nationalism and populism are on the march.” That’s very interesting. If you stop and think about this insight it’s critical. It’s after the crisis of 2008 that socialism, nationalism and populism are on the march. History is clear, he says, that socialists and their ilk not only come for income, they appropriate assets, including their benefactors’ wealth. It is needed to pay for their agenda and assuage the people that put them in power. This goes back to the discussion we had about Law and how once the Mississippi system was failing you still had the wealthy who, in spite of the risk of complete asset confiscation, were willing to hoard gold because they knew that the alternatives were less than options. They would compromise safety in anything but a specie holding. Specie, in that day and age, being actual gold and silver coins.

Kevin:It’s interesting, people who are out there saying, “Well, for the greater good you need to give up this – the greater good, the greater good.” What I find is, the greater good, where people are saying you need to pay more taxes, it is usually billionaires that have foundations that have very little income, they are willing to pay 90% taxes on their income because they have none.

David:They already got rid of all their assets and moved them, in a very tax beneficial way, to the foundation format. People act in their own self-interest, and you are right, the arguments of the greater good, personal sacrifice for the common good – it rings hollow. It’s great as a stump speech, or as an article in the New Yorker, but honestly, when you start putting pressure on people you find that they do move toward things that give them security and safety, and don’t allow for their pockets to be picked.

Kevin:One of the things that really calmed me down over the last week was Pelosi and her view of balancing power in Washington. She somehow claims that her position, at this point, is equal to Trump’s.

David:Are you shooting for an alliteration here – Pocket-picking Pelosi?

Kevin:(laughs) That was yours.

David:Our congratulations to Mrs. Pelosi, in all sincerity. We are very excited to have her back swinging the gavel.

Kevin:Oh, stop saying all sincerity. That’s a lie, Dave.

David:(laughs) It’s not! Her recent comments about the Constitution and how the Constitution considers her equal to Trump – I thought that was very insightful. Very insightful. I think it should be understood as her reading of the Constitution which makes her equal to Trump.

Kevin:I guess you can read things with different interpretations. There is a fancy Latin word for that. I can’t remember what it is.

David:Hermeneutics comes to mind. We could give her an A for effort with her hermeneutics (laughs).

Kevin:Now, is hermeneutics Latin or Greek (laughs). It’s a different Constitution to me than it is to her.

David:Right. And again, that’s because we perhaps see things through a slightly different lens. But I think between Pelosi and Ocasio-Cortez we have so much to be excited about in the beltway this new year. Talk about really fun stuff, I love the idea – Ocasio-Cortez has said 70% tax on the ultra-rich. This is really where things get interesting. We have the new deal. Did you know that we had a new deal?

Kevin:Is that the green one?

David:It’s the green new deal.

Kevin:Well, it’s not easy being green. Kermit the Frog sang that song. So you have to have some money to do that.

David:(laughs) Well, the last new deal felt pretty red to me, so maybe this one is green by comparison.

Kevin:So Buffet, Bezos, Bloomberg – these guys, I’m sure, are happy to pay that kind of tax.

David:They’ll be first in line to contribute. If it’s a 70% tax on the ultra-rich, these guys are also, again, beyond the champagne that they toast, you know how the guilt complex is, the champagne socialist complex (laughs).

Kevin:It is interesting, though, we’re not talking about the top 1%, we’re talking about the top .0001% who have foundations. The top 1%, a lot of those people actually fall into the class of not having foundations, and having a pretty substantial income that has to be taxed at this point.

David:Yes, the 1% do pay a lot, and let me change tone and be a little less tongue-in-cheek. The top 1% pay about 39.4% of all federal income taxes. And if you are talking about the top 20% of income earners, you have over 88% of all your federal taxes paid by 28% of the population. So the majority of the population pays very little of the overall tax bite.

So if you’re talking about 80% of the population, they only have to cover the last 12%. But again, the social justice warrior in Ocasio-Cortez, the redistributionist in Ocasio-Cortez, says that we have a problem, and that problem is that there is an out-of-balance economic equation, and she can make that right.

The problem is not in tax revenues, in my opinion, it is in spending. It is in the unlimited political promises which, basically, are given to voters in exchange for their votes. It is the tendency that we have toward adding a trillion dollars in new debt each year that we continue to accrue annually, and the fact that that is coinciding with a rise in rates. These are issues which ultimately present significant cash flow problems for the government.

Kevin:I think of the nobility of billionaires’ recommendations to the rest of the people, the nobility of the elite politicians who are literally willing to get rid of national sovereignty. They think, “You know what? We need to even give up that for the greater good.”

David:You’re talking about Merkel. I wonder when I hear of the crises in Europe, and I understand that there is TARGET2 problems between specific countries where debt loads are huge, Italy being probably the worst offender, close to half a trillion dollars in debt owed to other European countries. But it’s more than financial. Merkel was speaking of Berlin just this last week or two. Nation states should be willing to give up their sovereignty today, was one of the themes of her speech. That is quoted from her speech – “Nation states should be willing to give up their sovereignty today.”

To me, this is a factor in the pressures currently felt within the eurozone, politicians that represent their own globalist political views rather than being representatives of the people. There is a reason why I think her political party is on the way out, and therein, full-blown crisis.

It is also odd to me, the public schools here in the United States have, for the last 20-odd years or so, been about celebrating multiculturalism. And yet, when you start saying, “Ditch your sovereignty, move toward some sort of blissful union,” they’re really talking about uniculturalism, aren’t they?

Kevin:I remember, going back on this program almost ten years ago, when you had the interview with Otmar Issing, who was the first European Central Bank head, and he also was really the backbone of the founding of the euro. We asked him about the outcome of the euro and the likelihood that all these separate countries with separate laws would be able to make it work. He seemed to intimate to you that they knew that if they launched a currency it would lead to this question, that the currency, itself, would probably not hold together unless, ultimately, nations yielded their sovereignty. Do you remember that in the interview?

David:Sure, and the conundrum was, they wanted to launch the currency because it was the most palatable first step, and yet there are major issues because you are still fiscally separate and politically separate.

Kevin:They almost needed it to go to a crisis mode for what Merkel is proposing to actually make sense.

David:The impossibility on the front end would have been to ask for sovereignty. What they wanted to do was create an environment where there were so many economic benefits shared between nations that you could begin to rationalize the giving up of sovereignty. But it’s not as if you are giving up complete sovereignty. You’re giving up sovereignty to someone, you are ceding control to someone.

Kevin:Somebody you didn’t vote for, by the way.

David:That’s the way Brussels operates. So giving up sovereignty to whom is the big issue, and I think you’re right, there is really not a willingness to move toward giving up sovereignty and fiscal control except in the context of crisis.

Kevin:I think that’s why it is important, as we do these shows and as we look back at history, to understand that crisis is not necessarily the enemy of the person who is thinking ahead like the elite politician. Crisis is actually a tool of policy change.

David:Kevin, I don’t remember which guest it was that was on with us that said, very matter-of-factly, that crisis compresses time.

Kevin:Oh, that was brilliant.

David:That stuck with me because there is this idea that there are decades when nothing happens, and then weeks when decades happen, and that idea of being able to ratchet forward progress, and maybe it is regress, or not a direction you necessarily want to go, but a lot happens politically in a short period of time. It’s because that is the nature of crisis.

Kevin:I sort of wondered about this for the last ten years because they have been crisis free, and it has been paid for with financial repression, with interest rates that are lower, sometimes lower than zero. They have smoothed out the volatility until 2018. And I’ve wondered, Dave, and I honestly don’t know the answer to this. If I was an insurance company that was trying to pay a certain amount on an annuity, or if I was a pension fund that had a certain guaranteed return to people who are taking pensions, how in the world with negative interest rates can you have some sort of guarantee? The stock market has been rising so it has been smoothing that out as well, but the stock market is not rising right now.

David:Last week we did comment on Richard Bookstaber’s idea that even as he contributed to the drafting of Dodd-Frank and the resolution of the last war’s problems, if you will, the last crises’ problems, we’re setting the stage for the next crisis. When it comes to insurance companies and pension funds, I think you could say that the Federal Reserve and the global central banking community has done the same thing setting up the next crisis through their negative and low interest rates over the last decade. Trying to solve the problem? Sure. But it does have unintended consequences, and you see that showing up in places like the liability structure for insurance companies and pension funds.

Stephanie Pomboy was noting that it was Federal Reserve policies that have done just that, bankrupted U.S. pension systems. The whole system, the funding shortfalls now stand at 6.18 trillion dollars, roughly 30% of GDP. She looked back to financial repression as the primary contributor to that. That is, the monetary policy tools that were used, the macro-prudential tools that were used by our central bank in the last period of crisis

Kevin:And it works as long as the stock market is rising.

David:Yes. That brings up the second point, which is, although negative rates and financial repression have put the pension system, really, behind the eight ball, we see the coming bear market in stocks and bonds as an even more critical factor moving forward, because although you have a six trillion dollar shortfall today, that six trillion could exceed 12 or 15 trillion before it is all said and done, when you look at the coincidental decline in asset prices and the simultaneous increase in payouts. Because the pension payments from those pensions are in the process of ratcheting higher as boomers continue to retire en masse. Factor this in when you’re thinking about investing in corporate America over the next few years. This is one more significant drawdown on the future income of corporate America as a lot of corporations have to make contributions to their pension funds to make up the shortfall.

Kevin:Many people would have said that the banking system is what created the last major crisis, speaking of crises, yet I don’t remember seeing bankers actually losing money. The bankers made some pretty substantial bonuses through the last crisis. So you have winners and you have losers. Strangely, the winners are often the people who create the crisis.

David:I chuckled reading a Bloomberg article that was quoting Larry Summers, and he had this sort of mea culpa where he said, “At best, negative rates have been irrelevant, but potentially, contractionary due to the negative effect on bank profits.” I thought to myself, “Wait a minute. I understand his context as a person in the public policy sphere, but bank profits? Really?” Negative rates have always been used to rebuild bank capital at the expense of depositors.

Kevin:I’m not earning any interest. It’s a joke when I look at the three cents that I earn in interest.

David:(laughs) Not even a cup of coffee on offer there. They used to offer you a coffeemaker to induce you to open an account. Now you can’t even buy a cup of coffee with the income from the account. So I say, what about the depositor? At best, a haircut (laughs). At worst, you have a fleecing which prohibits that depositor, that retiree, what have you, from making ends meet, from paying their bills.

Kevin:Another multiple-time guest on the show, Stephen Roach, asked the question, “Is Apple the canary in the coal mine?” You and I are both talking about the stock market now turning down, but the economy – we have not been in a recession in a decade. We haven’t really had a stock market fall until this last year. So you have these two factors that are new, and then you have Apple. We talked about the FAANG stocks. Apple was worth more than a trillion dollars just a few months ago and it has lost – we talked about it last week – about 40% of its value almost. So is it, as Stephen Roach asks, the canary in the coal mine?

David:We need to have him back on the program. I think it has been too long. He was chairman of Morgan Stanley Asia. He had a five-year stretch of doing that, and traveled a million miles a year.

Kevin:That’s crazy.

David:That’s serious airline miles.

Kevin:He doesn’t do that anymore.

David:No, I hope that he is using some of those airline miles to travel more pleasurably. Of course, I think at a certain point you just say, “I’m done with traveling. I don’t like it, I want to be home.” So homebody professor at Yale, Stephen Roach, we haven’t talked to him. He was still in the trenches with Morgan Stanley the last time we had him on the program.

Kevin:Yes, so it would be good to talk to him now that he has the new position.

David:This is about the U.S. and China and the trade war. It is certainly a commentary on earnings, but when Apple announced, not only a disappointment on earnings, but lowered forward guidance, that’s what he was saying. “Look, Apple is probably the canary in the coal mine.” Roach says, “There is likely to be more to come.” I think he is thinking about this back and forth between the U.S. and China.

As I read the quote further, “To think that what affects the Chinese has no bearing whatsoever on an otherwise resilient U.S. economy I think is ludicrous. So again, be careful what you wish for. We win the trade war, but keep in mind, they are our third largest export market, and the largest growing export market for the United States. So to the degree that we are hurting them and winning, we are also losing simultaneously. And to the degree that they suffer economically, we do, too. We’re sort of tied at the hip. That is the nature of a world that is globalized.”

Kevin:Could we see a major change based on a Supreme Court decision?

David:That is an interesting point because on Apple, I think the original forecast of revenue was between 89 and 92-93 billion dollars, and they came in at 84 billion. So the revenue and the earnings were one issue, but maybe the real issue is not that that market is saturated. Yes, it is saturated and they just cut their iPhone production by 10%. But to your point, it could be that the Supreme Court decision that is kind of hanging out there threatens Apple’s service business. You have their app store sales, and it is being argued that they are operating as a monopoly business.

Kevin:No way. Apple, a monopoly? No. That’s like calling Amazon a monopoly.

David:(laughs) No! Certainly not. And there is no political risk in Amazon or Apple. Equal to 37% of all of their service revenue is the app store sales, estimated to come in at about 46 billion dollars in 2019. You might consider that a material event if, in fact, they get a negative ruling. So earnings season is getting under way, not just for Apple, but we have lots of folks who will be doing exactly what we saw City Group do here recently.

The classic trick is to lower earnings estimates just before the release and then on that basis you announce a surprise number above the just recently lowered expectations, right? (laughs) And you look like a hero! Sometimes you need to look a little deeper, look at revenue, look at sales growth, and see if they’re not just playing the earnings game, the announcement game, and the share buy-back game, all to sort of game the system and to basically treat the average investor like a patsy.

Kevin:Again, these games work when you have low volatility, which we had, really, for the last decade until last year. I think of low volatility when it is being managed by the Federal Reserve like somebody saying, “Nothing to see here, citizen. Move on. Nothing to see here.” But when you have volatility, the games you are talking about don’t work.

David:Whatever is in play gets exaggerated. We had 64 days this last year when the S&P was up or down more than 1%. Compare that, a volatile year, with a year with virtually no volatility. By contrast, there are only eight of those days in 2017.

Kevin:We took a nap. In 2017, you and I talked about a lot of things, but we couldn’t talk about volatility because it was not there (laughs).

David:No, no, no. The last year here in 2018 saw the Dow fall more than 350 points six different times (laughs). That’s a ten-day period.

Kevin:Yes, but we got it all back. Remember that 1000-point gain?

David:Sure, in terms of points, the largest single rise in the Dow ever. What we expect in 2019 is basically a continuation of that kind of volatility, that kind of trend. There are implications here, certainly implications for the leveraged community, and I think anyone who wants to press a little deeper. We mentioned the Tactical Short Conference Call. Certainly, join us for that – 2019, the Secular Shift Beginning the Long and Difficult Road.

But I would also encourage you to look at a very fascinating discussion of the currency market implications in 2019. Doug Noland wrote that up in the Credit Bubble Bulletin this weekend. Because you’re talking about currencies which have been used to fund leveraged speculation, and now with greater volatility in the asset markets, it makes your leveraged bets that much harder to manage. So as a consequence of the volatility, you not only begin to see an unwind of many of those leveraged bets, but then you also begin to see volatility in the borrowing currencies, the carry trade currencies. So, a very interesting Commentary, I would encourage you to go back,, look for the CBB, Credit Bubble Bulletin page there, and you register for the conference call at the same time.

Kevin:Well, my heart has ached over the last ten years for the person who needs income from their retirement, because you can either get it from treasuries and safe bonds when interest rates are not controlled…

David:Or you can chase yield (laughs).

Kevin:Or you can chase yield. You can be in the stock market, but a lot of people say, “No, I’m not going to play in the stock market, I’ll just buy bonds.” Well, the problem is, bonds – we’re not talking about A or B bonds – the only way a person can really get an income on bonds is by what used to be called junk.

David:And junk bonds are interesting, but before we move past that idea of investors moving from a reliable income source to speculating in stocks because of the dividend ploy, or the dividend play, in an environment where there was low volatility, the case was much easier to make that you have low interest rates in CDs, low interest rates in treasury bills. You can beat those annual income returns by buying the stock that is paying you 3%.

Kevin:Sure. Could Apple even fall?

David:The interesting thing is you go up 1%, 1.5%, in your income, and here in 2018-2019 you see that you can actually lose 20% or 30%, 23% if you’re talking about off-peak numbers for some of your indexes, you can lose far more than your extra 1%, 1.5%, in income, in how long? Weeks? Months? Not that long.

Kevin:Compressed time.

David:It compresses time. Junk bonds are an interesting story because junk bond issuance as we came into the end of the year, obviously you have the financial market seizing up a bit, and greater concern about what it meant to issue new bonds if there was going to be an appetite for it. Actually, total issuance for the year declined by 42%, so there was a lot smaller appetite for the issuance of bonds. This week marks the first issuance in over a month of high-yield debt, and that kind of a time-out hasn’t happened in over a decade. So couple that with last year’s liquidation from junk bond funds – 60 billion dollars was liquidated last year from those funds. So low issuance, net liquidation of 60 billion, a total dry spell at the end of the year, just broken here this week. Of course, that is with rising interest rates and the decline in oil prices, which are exaggerating all of those trends in high yield. It is very interesting to see that the dynamics within the market can change in a heartbeat.

Kevin:Yes, the appetite for risk sometimes shows up in different ways. The appetite for treasuries has been very, very low because when you can make the profits that you can make in the equities market, or maybe a junk bond market, why would you buy treasuries?

David:I think maybe there is a small re-appraisal going on with treasuries. It is a traditional safe haven, and yet even with the machinations there at the end of 2018 in the stock market we didn’t have massive interest in the treasury market. It is very interesting, we were just talking about the high-yield or the junk market, but fascinating that in the fixed-income markets at the other end of the quality spectrum in U.S. treasuries we had the lowest bid-to-cover ratios in at least a decade for U.S. treasuries. Dave Burgess mentioned that in his Friday wrap-up this last week. But what that means is that last year saw the shortest line of investors waiting to buy treasuries in a decade.

So as we look forward to 2019, not only do we continue to increase the amount of debt that we have, we have rollover stuff that has to come and either be repaid or just extended into the future – evergreen, so to say. Who will be in queue this year? China does factor into this. We need participants. We need people who are buying our treasuries. Who is going to be in queue if last year, 2018, saw the shortest queue in a decade?

Kevin:It is interesting that you bring that up because Russia got rid of virtually all of their treasuries, and China has not been a big buyer of treasuries. So like you are saying, who is going to actually fund our debt? The whole program worked for about 40 years where China just bought everything that we were going into debt on, and we just bought everything from them for cheaper than what we could make it here.

David:(laughs) A reasonable quid pro quo.

Kevin:Speaking of China, that’s a hope. Right now people are hanging on the thin thread of hope of really good news coming from China, trade negotiations. The thing is, it seems to be dragging on, Dave. I keep hearing about this hope of some sort of breakthrough with China and Trump keeps tweeting about the progress that they are making. Is it a false hope?

David:Yes, I think it was over six months that Donald Trump was announcing from Mar-a-Lago that he had worked something out with the Chinese and this was going to be great. Actually, I think for six, nine, 12 months now, it’s been kind of…

Kevin:Just you wait! Just you wait!

David:Yes. We’ve come up with the agreement. We’ve got it here. But not only is Trump not specific, the Chinese – and this is an inside again from Bill King – appear to be utilizing the U.S. trade negotiating strategy that Japan employed for decades, which is, you agree to the negotiations, you make broad promises, but you make no concrete concessions on the belief that the U.S. will eventually go away.

Kevin:Yes. Isn’t that interesting? Talking about compression, time is starting to compress for China, because as long as they’re growing, and as long as things are going well politically and financially and economically, they can get away with a lot of time But at this point China is at an interesting juncture, wouldn’t you say?

David:Absolutely. I’m reading a book right now about credit and politics and the intersection there, and basically how when we look at banking crises, they are always caused by political choices. It is not just about inadequate loan loss reserves or reducing reserve requirements to the point where there is too much leverage in the banking system, or there are political players who are catered to, and that is what gives us credit and banking crises.

Kevin:And so regulation actually plays to the winners and picks the losers.

David:Yes. You can’t separate politics from banking crises. And that is the case of this book. It is a 500-page case and I think he makes it very well, looking at both British and American history, actually, beyond that. He looks at Mexican banking, Brazilian banking – a whole lot of different case of this.

Kevin:You have spoken of having him on next month when you finish the book.

David:Oh, absolutely. But China is at this interesting juncture because, one, you have the equity market which sold off 25-26% last year. The backdrop is what is really critical because you have 40 trillion dollars in bank assets.


David:They’re banking system is bigger than ours, which on the basis of a smaller economy doesn’t really make sense. But the official line from the Chinese is that they have minimal loan loss.

Kevin:Trust us. Trust us. We have minimal loan losses.

David:No losses here. Move along. And yet, again, these are just things that don’t quite add up – 65 million recently constructed apartments which are sitting vacant (laughs).

Kevin:Oh, that’s no problem. That’s a low vacancy rate.

David:If anybody is familiar with land development, that’s a couple of properties.

Kevin:65 million.

David:65 million empty apartments, but the banking system is fine, it’s healthy, we’ve got 40 trillion in assets.

Kevin:Move along, citizen, nothing to see here?

David:Something doesn’t add up. This last year we have India which surpasses China as the primary driver of global GDP growth. That’s an interesting story. Obviously, the economy in India is still smaller, but they were a greater contributor to GDP growth this last year. China is, as we mentioned earlier, our third largest and most rapidly expanding export market, and the U.S. is absolutely indicated in the financial market and/or economic disruptions to the status quo there in China.

Kevin:Well, and we’re talking about a different system. China hasn’t felt like a different system over the last 10-20 years, but we’re talking about a system that is communist. They deal with compression of time, these crises, very differently than a free market would.

David:This book by [Charles] Calomiris, [Fragile by Design], I’m just getting to the section of that book where he deals with autocracy. I haven’t read it yet, but the way that credit and credit crises and banking crises are handled in a top-down management structure, as opposed to how it is handled within a democracy – it is still politics, and there are still chosen winners and losers, but the process is different.

Kevin:I think a little more blood flows from the top down.

David:I was going to say the process is probably a little bit more violent. But here we are at the 100thyear anniversary, May 4th, where the protests that led two years later to the creation of the Communist Party in China, you have some unsettledness within the Politburo this year because 70 years after May 4, 1919 was the Tiananmen student massacre, 1989 to be precise.

Kevin:I remember in the trade room here at ICA, actually, when we were in the Denver office we had the TVs on and we saw that tank, and we saw that student. Tiananmen Square – that was very present at the time.

David:One notable development in 2018 – we have banking crises which are looming. I don’t know how you avoid the cleanup or the necessary loss taking on the 40 trillion dollar stock of loans which has been made there in China, but one of the notable developments is that the Bank of China hasn’t slowed down in their lending. In fact, they moved to being the top underwriter of emerging market bonds last year. So they are continuing to forge ahead. Not only in recent years have they launched their first aircraft carrier and expanded their geographic reach with the Spratly’s and the Paracel Islands, but (laughs) they are also launching a different kind of aircraft carrier. It is the banking relationship, it is the loan with perhaps a few strings attached. Being the largest underwriter of emerging market bonds last year, I think, was very significant.

Kevin:This leads me to remember what we have talked about now this whole time on the program. You repeat that the financial moves to the economic, which moves to the political. And then you get to something, the geostrategic or the geopolitical, and that is when real war occurs. We’re not talking just about people’s retirement or their 401k going down if there is a dislocation in the market, we’re literally talking about a change in world geopolitics.

David:These are the crisis dominos that we have been talking about for the 10-11 years that we have been on the program. Again, roll the clock back ten years ago and you have the financial leading to the economic, and the economic leading to the political. We have had Dodd-Frank and we have had different iterations of political machinations and changes in other parts of the world. And I think that last crisis domino is still in front of us, the geopolitical. The probabilities of a market dislocation here in 2019 are pretty high.

That is only one of the issues, though. The difference between democracies and autocracies in the way that they solve most of their problems, again, is very different. You were talking about letting off steam earlier in the steam train. In worst-case scenarios, you end up with very different behavior within a democracy versus autocracy. In a democracy you push for changes at the grassroots level, you seek to have representation, you have change which is driven by a particular constituency, by a particular agenda, and there is the competition for the control of that agenda. That defines the political fracas in the D.C. beltway every day. That defines the political – whatever we have. Whether it is healthy or not, it is certainly healthier than what we have in an autocracy.

But this is acute in election years. The press talks about it and that is a privilege, too. The press doesn’t always talk about things from an objective point of view, but at least they’re not being censored. So we have that freedom in the West, a free press. That’s not so in China. You have opposing views to the Politburo, which are not tolerated. You have, as we mentioned last week, this professor in China who is being censored for talking about GDP growth being more like 1.67% instead of the 6+% that is the official number from the people. So the established party line defines reality. And the established party line reflects not only the social engineering ideals, but it reflects the expected code with which everyone is supposed to comply.

Kevin:It reminds me of a conversation I had last night with one of the gentleman in the restaurant. He was just wishing that there was less fake news. I was thinking, “No, we can deal with some of the fake news, we can deal with some of the noise if we have a free press.” We talked in the beginning of the program about how friction can be good for us. It is good in a democratic society or a republic to have that kind of friction where maybe you can’t trust all the news, maybe there is an agenda, but you have the ability to filter that out yourself.

I look back at Pravda, especially when Russia was the Soviet Union. You had three Pravdas. You had the white Pravda, you had the green Pravda, and then you had the red Pravda. And different layers of that society got different levels of clarity, and maybe it was manipulated news, but you got better and better news as you moved your way up through the party.

David:There is a debatable issue here with fake news. I understand bad information and false information. But I think more oftentimes what we have with journalism in the West is biased news, which is not necessarily fake, it’s just information with a particular slant.

Kevin:But you can filter that yourself if you know the bias.

David:That’s where, again, if you have a process of interpretation, back to that word hermeneutics from earlier, if you have a process of interpretation, a way of figuring out what is fact and what is an interpretation of that fact which is, perhaps, above and beyond what is necessary, I wonder if there is not, really, an exaggeration with that idea of fake news. We go back to the idea that the New York Timesis going to be biased in a particular way. CNBC and MSNBC are going to be biased in a particular way. Fox News is going to be biased in a particular way. No one is objective.

Kevin:You’re making me think that I’ve actually been trained to use a word that I would have never used before. We have to watch that, because just listening to you right now, I’m thinking, I never used the word fake news until I was taught the word fake news since Trump has gotten in.

David:Right. It is more important that you think critically about all news than that you just excuse it outright as fake. News is news, and it is either true or false.

Kevin:And it’s biased. All stories are biased.

David:They always will be. I read a fascinating expose from the former editor of the New York Times. It was interesting because she said very candidly, “We knew that it made sense in the first year to run as many stories anti-Trump as possible and it was to improve our readership because we knew exactly what our readership wanted. So we printed everything that we could of a negative nature and we saw our subscriptions go through the roof.” If I can find the link I’ll include it, but it was a fascinating quote from her. She spent four years as the head of the New York Times.

Kevin:But at least it allows us in the West to let off steam.

David:(laughs) I guess that is the point, that we get to let off steam in our political process. Maybe it’s rancorous, maybe that’s how it seems, but guess what it is? It is relatively peaceful and there is not a lot of blood that flows. In a command-and-control environment, dissent is not an option. And so when steam builds up under the surface, it tends to end up being, or the potential is there for it to be, far more explosive. We haven’t seen any explosions in Hong Kong, but certainly, bringing in the New Year we had loud protests there in Hong Kong, with tens of thousands of people, and you have on average 70,000 protests held across the country in China each year.

My point is this, not only does the press not cover that, but there is more pressure on the people, more control elements within China, and it takes a measure of social and political pressure in China. But the environment in China is one of suppression. You don’t get to express your opinions. And so when you have social and political pressure building, if you can’t control it, if you can’t eliminate it – all this is going back to the geopolitical domino – if you can’t control and eliminate social and political pressure, then there is an increased probability of geopolitical conflict.

Kevin:And sometimes that can be planned. The communists – no one is better at planning a demonstration or a nationalist movement than the communist party. We have even seen that in this country.

David:And war is a distraction. You don’t have to read Orwell to know that, but because there is nothing like a nationalist conflict to rally the people, to create a crisis environment allows you to distract an otherwise unhappy group of people. You don’t have to be an autocracy, you can be a democracy to do that. But to crack down on dissent – what happened 30 years ago in Tiananmen – you can re-focus the negative social energy toward some positive external goal, and think that is really what we are talking about. You have trade wars, you have the potential for a financial crisis because of the amount of debt and unsustainable levels of debt, and bad loans within the system. And here you may be looking at kind of a scapegoat. 1919 rallied together the people who would forge the Communist Party. 2019 is a year of unease for the Chinese leadership, whether it is superstition or suspicion of a potential repeat of the 1989 protests, you have technology aiding them, and that may, with enough surveillance and control mechanisms in place to maintain order. But here is my point. When you mix domestic frailties with an international trade war, the complexity of those things creates not only financial market problems, but geopolitical problems as well. I would hate to be Taiwan right now, because it is an easy “Let’s do something nationalist, let’s do something that all the people who are about to protest rally behind.”

Kevin:They can be the mouse amongst two elephants that are fighting.

David:And they could be the inspiration for re-expanding the Chinese army from two million back to six or even ten million.

Kevin:None of these crises really come to the surface if people are prosperous, if their wallets are thick. But when the wallets start to thin down – and right now the economic transition in China doesn’t seem to be going well.

David:No. And I think you can read the tea leaves. Credit expansion has happened on an unprecedented scale, and that has created the perception that not only within China was the global financial crisis skillfully handled, but that any crisis can similarly be taken in stride. And I think that is a misperception. That issue you raised, the economic transition – no, it’s not gone well. You still have too high of a dependence on exports, not enough internal consumption to create some independence from the old model and the vulnerabilities that come with that. But it raises the question of the implications of infinite credit creation, ultimately destabilizing, we would hold. We think that is the case. How does that express itself? The official numbers are always going to tell the story that needs to be told.

Kevin:That’s the Pravda of economics.

David:So the expression of the reality won’t show up in the official economic numbers. It might be an expression on the streets. It might be expressed in the negotiating rooms – perhaps even on a battlefield.

Kevin:And so, for the generation who grew up where Russia was the danger, and even recently Russia has captured a lot of the attention, actually, we should be focusing on the greater economic giant.

David:Yes, relatively speaking, Russia is a toothless tiger compared to China. Chinese financial excess – you have economic instability built on an unsustainable mercantilist model – that may lead to destabilizing political and geopolitical relationships in the months and years ahead. Do we have an established red line with the Chinese on Taiwan? Of course not. We took the position back in 1979 that Beijing is the sole center of power for the Chinese and officially we have not supported the independence of the Taiwanese. So there would be little threat of an expanded global conflict.

But going back to this nationalist lay-up, if they need to score some points with their population, Taiwan is an easy lay-up because it’s not going to implicate us. We have told them solidly since 1979 that we won’t be involved. So there are the domestic political gains for the Chinese if a distraction were in order.

Kevin:We’re talking about China, but Trump rode in on the wave of populism based on dissatisfaction. The wallets were already getting thinner for Main Street even though Wall Street was doing quite well.

David:Again, King’s comments. You see the increase in socialism, you see the increase in populism post 2008. So translate the same dynamics to the U.S. With economic prosperity comes greater probability of peace. With economic crisis or stagnation comes an increased probability of a very muscular foreign policy.

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