In PodCasts


The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

If Growth Is So Great Why Do We Have To Borrow So Much?
July 30, 2019

“There are no concerns with the U.S. economy today. There are few concerns with the U.S. financial markets today. There are some concerns with the global economy today. And there are now grave concerns with the Chinese financial markets today. A proverb comes to mind – ‘The prudent see danger and take refuge. The simple keep going and suffer for it.’ Which one are you?”

– David McAlvany

Kevin:Last week Jim Grant talked about how risk is no longer something that people actually worry about. I was thinking about it. Do we really live, Dave, in a world where risk and responsibility have been managed and overpowered with the magic of the central banking system?

David:It certainly gives us a sense of carefreeness. You get to engage the markets without an idea of there being consequence to bad choices. In fact, the more risk averse you are, it’s almost like…

Kevin:You’re out of touch.


Kevin:You’re out of touch if you’re risk averse. We have a bull market in everything. We’ve asked the question, what does a bull market in everything look like when – if – it ever turns into a bear market in everything, when everything is falling at the same time. That would be something worth looking at just because we are in this magical time when everything is going up. Even Trump criticized the Federal Reserve when it was under a Democratic administration for being too loose, and now he is criticizing it for being too tight.

David:I sat at dinner this last week with a gentleman who ran the venture capital side of the Harvard Foundation. Venture capital is his deal, as a trained engineer. It was a fascinating conversation and a part of it did relate to things that are changing, and of course, he is interested in new technologies and innovative shifts within the economy, old economy versus new economy, and where there is opportunity, obviously, as a personal investor today, and in his prior post there at Harvard, part of their foundation group.

Part of our conversation revolved around the influence of central banking and how that has distorted asset prices. He was very intrigued by this article from the IMF.

Kevin:Yes. The white paper.

David:I sent that to him the next morning. He was like, “Get that to me immediately. There are some guys that I would really like to discuss it with.”

You look at, today, global manufacturing is weak and the trend of shrinkage in the manufacturing sector here in the U.S. is, and has been, down for many years. And yes, that is a function of transitioning more and more toward a service economy. And yes, there are improvements in technology, and there is a shift in consumer patterns which accelerate these trends.

Kevin:Yes, but we have growth. That’s what we’re told.

David:Yes. On the other hand, if you go to the other end of the spectrum, there is significant growth. I honestly tend to be a little bit cynical here, comparing the requirements of a manufacturing economy in which you have design elements and production elements and marketing and distribution elements, what goes into fabricating a product.

Kevin:It feels more real, doesn’t it, than the technological or service industry.

David:Well, I can see the jobs, I can see the money created, I can see the money dispersed and then recycled through the economy. Contrast that to 21stcentury growth where, like with Google, really, what you are talking about is a new version of advertising. And I know they are more complex than that, but at least how they started, it is kind of an advertising engine, or a digital post-it board for personal moments. It’s like online scrapbooking – Facebook.

Kevin:It feels like it adds productivity, dramatic productivity, to the world economy.

David:Yes, so online scrapbooking gives a quarterly revenue of almost 17 billion dollars, and I think to myself, “Old economy versus new economy, I kind of like the idea of making stuff.”


David:But again, I tend to be cynical. Let me set that aside. These companies – Google, Facebook, Amazon – they reported very impressive increases in revenues this past quarter. Second quarter revenue, if you take those three tech giants, came in at a hair below 90 billion dollars combined. What gives me pause is wondering how many jobs in the old economy it would have required to generate that kind of a quarterly number.

So my mind goes all over the place, you’ll have to forgive my rabbit trails this morning. But I ponder velocity. Why is velocity of money down? Part of it is we are moving toward an economy where you don’t have an income distribution which gets the middle class the money that they would have had, and spending the money they would have had.

There is a really interesting shift in participation there in terms of wealth creation, recirculation – that, too, is a different dynamic that we may just have to get used to.

Kevin:Wealth is concentrating at the top. The middle class is running out of money much quicker. But the concentration of wealth is up at the high side.

David:I guess my point is this. As the economy changes, as the drivers of growth shift, there is a group that benefits, there is a group that does not. There is a concentration of wealth. Part of that, if you’re thinking silicon valley, geographically minded, and it’s not the heartland.

And here is where I’m fascinated, thinking in a sort of multi-disciplinary way. There are political implications to that. That is really my point. Progress is not bad. Technology is not bad. But there are costs in terms of change and realignment. And some of those costs are not economic.

Kevin:Well, let’s talk about economic, because honestly, economic growth is good for everyone, if it’s true organic economic growth. But if you really look at it, right now, look at the current administration. What they are basically saying is that the stock market is doing great. That must mean the economy is doing great. But I want to go into this a little bit later, Dave, it’s costing us over a trillion dollars a year for it to look great.

David:Yes, so you look at [President Trump’s] campaign messaging and what you can expect over the next 16-18 months as he refines it. And you’re right, stocks are doing great, everybody is doing great, we have a great economy. And there is a conflation, a confusion of economic realities with financial market realities. And I think there is a difference there, and it is worth noting. We would all be doing even better if the Fed would get out of the way.

That’s what he has sort of hinged on and said, “Look, GDP growth is great, but it could have been 2-3 points better if the Fed would just get out of the way.” I think what he is going to find in this election cycle is not everybody is doing great. He has narrowed his reference to the “economy,” specifically, to the stock market.

Kevin:Let me ask you that. We’re 15 months away. That is a long time. Is it dangerous that he is looking so closely at the stock market as his measure of success?

David:I think it’s an easy meme to put out there and just kind of take credit for, but it’s dangerous politically given the fickle nature of pricing. And you’re right – 15, 16, 18 months – this is a timeframe where I think, given the fickle nature of pricing it’s very dangerous. I think, in doing so, he has also forgotten who put him in office. Again, it’s the disenfranchised middle. There you have the gap between those with assets today – those with assets that are appreciating compliments of central bank largesse – then you have those with debts living paycheck to paycheck.

And the irony is, it’s those that are under pressure economically, those who don’t have as much cushion, that came out to support Trump in the last election, and Obama was riding the wave of stock market appreciation post-2009. Here is the issue. The blue-collar world didn’t participate, didn’t see it, and resonated with Trump’s message. How does Trump hit the campaign trail this time and say, “You’re doing great. Look at how much wealth has increased on my watch,” when wealth is only increasing where it previously existed.

Kevin:Well, does he then try to approach a different voter base, the voter base that has the concentration of wealth?

David:It doesn’t matter in a democracy. Frankly, it’s too thin a slice of the pie for that to matter. He captured the disenfranchised middle in 2016, and a part of his spiel was, Obama was working with a fake economy. Trump was, at that point, bashing the Fed for boosting Obama’s fake economy using low rates. Again, I step back and think to myself, “How do you recognize irrationality in bipartisanship. This is one of the things, because Democrats are so blind with rage. These are a few easy ways of attacking this guy.

Kevin:Well, you know how they could attack. They could attack using the retirees. They’re voters, as well. The retirees have paid for the global financial crisis for the last ten years. But the zero interest rate policy is still in effect. Trump is calling for lower interest rates.

David:You bet, and this is where, again, you could say, what changed? Trump was bashing the Democrats working off of a fake economy and low rates, and now he is requiring the Fed, or at least verbally doing so, to lower rates even further.

Bill King observed, similarly, Kevin, the best way to rile Trump is to ask him – again, this is Bill’s comment – why it is that he advocates for the appropriation of retirees, the elderly, and average Americans’ interest income to boost stock prices for the elites. The Democrats should be all over this, saying, “Hey, wait a minute, what about the inconsistencies here? Hey, wait a minute, who are you fleecing, to whose benefit?”

Kevin:Right. Not that they’re consistent, it’s just that you’re talking about how the game is played.

David:And also, just again, the blindness to strategy and tactics just because they’re angry. Elizabeth Warren is the only one really asking about debt limits and economic challenges (laughs). I’m not a fan, but nevertheless, she is bringing that into the conversation. She is the only one asking about those things. And so this comes back around to politically dangerous moves by Trump. Trump is gambling on the stock market being higher 16-18 months from now, and his determination to make that so, to make that happen, comes through in every high-pressure tweet that is sent to the Fed – “Lower rates. Economy. Right now.”

Kevin:Something that I’ve noticed after 30-some-odd years of talking to people every day on the phone, you can tell when people are saving money, actually coming up with a surplus, or going into a deficit state. I really believe more people are spending principle than actually saving surplus to principle.

David:This last week I was attending an economics conference in Park City, Utah. Great group of people. And I made a simple observation to a couple of the business owners and ladies that we were spending time with. And they appreciated this because they see it as a part of how they operate their own enterprises. Good times are for building surpluses. And bad times are for running deficits when absolutely necessary. They agreed.

What has happened is that we’re celebrating the economic good times right now, but we’re not creating margin for the bad times. Where are the surpluses? This was the point in conversation with them. The economy is doing well, right? Why are deficits running at a trillion dollars annually?

Kevin:Shouldn’t we be having surplus put aside at this point?

David:Yes, because we’re not at war, are we? We’re not in a recession, are we? Those are the understandable contexts for deficit spending, so why are we spending close to a trillion dollars more than we need to now? And again, we’re sort of heralding the good times, happy days are here again (laughs). We should be putting away seed corn and savings and building surpluses. That is the prudent thing to do in good times, assuming that you actually have them.

Kevin:In the late 1990s, one of the ways that we justified in our minds these incredible stock prices in the tech industry was that the world had changed. You didn’t really have to make anything anymore, you really didn’t even have to profit. What you had to do was have a really good idea this someday may pay off. I’m wondering if the nature of growth, itself, Dave, in our minds, has changed from making things and saving and surplus, to good ideas and fanciful future fantasies.

David:There’s no doubt that there is a change in the nature of growth, but one of the things that has not shifted through time is human needs. Human needs haven’t changed for food, shelter, income. These are really basic things that we do seek. So even though we may be fascinated by a growth thematic as investors, and prioritize that over income, I think it is important just to recall that human needs haven’t changed, even if the nature of growth has changed, as we mentioned earlier. So you have the winners and losers in the economy, which have shifted and they have shifted toward services and shifted toward tech. The nature of growth, well frankly, that has also shifted, and it has shifted in favor of credit growth. You look at the post World War II growth – if you capture that time slice from mid 1940s to the late 1960s, a significant period of economic growth in the United States, and then we went through a slump, a real recession, as we went into the 1970s and early 1980s. But look at the 1980s and 1990s. Even in those two decades there was a greater role for credit to play. It was a period of growth, for sure, but credit played a role as the Reagan administration was doing some deficit spending on the front end.

And then all of sudden we got the peace dividend as the wall came down, the Russians threw in the towel, and all of a sudden we had this expansion of globalization and major capital controls which have been in place in many jurisdictions throughout the world – those came down – so the free flow of not only people, but capital, all these things were opening up in the 1990s. But note that in the growth phase post World War II, credit was not a big deal. Then in the 1980s and 1990s credit played a more significant role. And now it is as if credit isthe deal. It is thedeal. It is the onlything.

Kevin:Is there a price to pay if I pull my credit card out and spend, let’s say, $5,000, and call it growth? Because in a way, that’s how we factor GDP.

David:So again, the GDP figure is imperfect, and we had a long conversation, many debates, some of them heated, at this economics conference. What does GDP tell us? What does it not tell us? So I would say our GDP figure, as imperfect as it is, factors in a variety of sources of spending, but it disregards whether the spending is credit-related. In other words, I see a time arbitrage at work through the use of credit, a time arbitrage in the sense that credit is drawing future consumption into the present. Future consumption – you get it now. That’s household consumption, that’s government deficit spending, that’s corporate sector spending.

All you’re doing is, in essence, raising the hurdle height for those who are further down the track. For you it’s great. It gives yourself a present tense benefit. You spend your $5,000 on your credit card you have the benefit of, but there is, ultimately, a payback. And GDP doesn’t distinguish the quality of spending. By quality I mean, is the spending coming from existing capital – from savings – or is it coming from credit?

So we have credit as a key component to our economic health today, and without credit growth – this is so critical, and this was not the case in the 1980s and 1990s, this was not the case in that earlier period of growth, call it basic nuts and bolts, almost manufacturing driven, certainly post World War II – without credit growth, we no longer have economic growth. Ponder that.

Kevin:That is the key, Dave. This is a monster that you have to continue to feed. I think I’ve told you the story, when I was a little kid I had a Fisher Price record player, and I think I had only two little records. One of them was a story called The Big Oven. It was about this man who had the largest oven in town, and everybody loved to see that his house was always warm. It warmed the whole house and actually even radiated out into the neighborhood. The problem is, you always had to feed the big oven.

The way the story ended, and I remember hearing the wind and the cold as a little kid, the way the story ended was, he had to tear the house down to feed the big oven. He had to take the walls down, take the furniture. Everything fed the big oven. Credit growth, as accounted to GDP, or even the stock market. These stocks guys are just waiting for the next Fed basis cut.

David:So we think about a growing economy, and we just had our latest GDP figures, and 2.1% – that’s great – but when you start looking at the components and say we don’t get to that number unless we’re using that deficit spending. In fact, you suck out the government deficit spending, consumption by consumers which is credit-based versus from savings, all of a sudden we’re notgrowing. And that doesn’t advertise well.

Kevin:I think that’s called red ink, to an accountant, isn’t it, normally?

David:Sure. How quickly the markets forget. We’ve got equity traders who, this week, are hanging hope on a 25-50 basis point rate cut, a ¼ percent to ½ percent rate cut, this week. The issue of market expectations is now in play. Think about this. This is the way I consider it. Doing nothing is a disappointment of expectations, ergo the market selloff – that’s not an option. Cut a quarter point, the market believes that is the bare minimum – you get a ho-hum response from the market.

Kevin:Or you give them a gift.

David:Or you give them a gift. How about 50 basis points? You might see a little positive surprise in the equities market. The currency markets figure out that that is really not good in terms of the contribution to long-term currency stability, so the dollar probably sells off, gold does well right alongside the stock market, etc. So cut by 50 basis points and you see some fireworks. The point is, your expectations determine whether we, as individuals, or as a crowd, are pleased or disappointed. This goes far beyond the markets, obviously, but expectations, what you thought was going to occur, what you hoped was going to occur, what didn’t occur or what did occur – really, how you feel has everything to do with your expectations.

Kevin:And fragile markets you do not want to disappoint. Remember when Bernanke was cutting rates and everybody was expecting things to recover, and Bear Stearns crashed not long after that.

David:The markets forget. What have the markets so quickly forgotten? That when it comes to insurance-oriented rate cuts, which is how that potential 50 basis point, or even the 25, which frankly, is not supported by the U.S. domestic economic figures. The U.S. domestic economic figures look pretty positive, so why we’re doing it with record low unemployment is beyond me. Now, it’s not beyond me if you start thinking about the global scale of things and potential weakness within the global financial system.

Kevin:They cannot disappoint. They cannot disappoint anymore.

David:But that insurance rate cut. What have the markets so quickly forgotten? The insurance rate cuts are no promise of smooth sailing. Bernanke implemented rate cuts four times between August 2007 and February 2008.

Kevin:Before the crash.

David:Oh by the way, it wasn’t a 25 basis point cut. In total, it was a 225 basis point cut. So you’re talking about 2¼ percent lower, and that was before the Bear Stearns collapse. So much for ensuring that nothing bad happens, getting out in front of it, trying to create this insurance cushion. What did they insure against? What did they prevent? We’re talking about getting, today, out in front of a global economic weakness with half a percentage point. Really? Really? It’s worth discussing. It’s worth recollecting that when market sentiment diverges from a desired policy-driven outcome, it just does what it wants to do. Markets move and then they’re not in control at the Fed. Nothing the Fed implements can stop it when it decides to go.

Kevin:One of the questions I think we all have is, how many arrows does the Fed have in its quiver? Reading that IMF paper, it talked about the poison, being able to stop the poison of people pulling their deposits out of the banking system. So it shows the attitude of the bankers that the money is theirs until you get it back out.

David:Right. Yes. So that’s why a few weeks ago we raised the issue of latitude. The importance of that paper can’t be overstated.

Kevin:We should re-attach it onto the show. So please read the paper.

David:Yes. Again, because we’re talking about the latitude the Fed may have, which has been reserved to this point for the imagination – our imagination – deeply negative rates orchestrated…

Kevin:That’s their word – deeplynegative rates.

David:Exactly – orchestrated through commercial banking entities that we use for keeping savings and checking accounts. The reference to the IMF paper on negative rates – you may not be accustomed to reading IMF academic explorations or policy prescriptions, I grant you, it’s not normal, but this is one that is important to keep in mind. With a market swoon, a market sell-off, you have the Fed who has already communicated a hypersensitivity to being proactive. They will be proactive. With rates already at low levels, what does that mean? That they will stretch the limits, and will get creative in terms of the tools that they use to address those particular circumstances.

Again, we ask the question repeatedly – aren’t they almost out of ammunition? Yes, as long as we’re dealing with conventional tools. And here they’re talking about radically, almost imaginary – choose-your-own adventure with super-human powers. It’s almost like – did you ever do any of those choose-your-own adventure stories growing up?

Kevin:Sure. Turn to page 63 if you think he turned right.

David:What if you could actually also include into that some super-human strength where you could actually alter the course of the choose-your-own-adventure by cutting and pasting in your own narrative and that narrative includes, “Oh, but I have Superman’s cape.” It’s almost, in essence, what they’re doing with negative rates. It’s like choose-your-own adventure.

Kevin:Yes, but here’s the adventure. We were told by Carmen Reinhart that this could be coming, and that is, create a captive audience. They can do anything they want with us if we’re captive.

David:How many times have we referenced that interview?

Kevin:Yes, it’s amazing.

David:As we prepare for our commentaries, you and I talk about this all the time, that the Reinhart interview – she co-wrote the book This Time It’s Differentwith Ken Rogoff. She still teaches are Harvard. If you haven’t listened to that in the archives, it is a must listen. It basically is a candid exploration of, yes, when you get into tough spots the rules change and you don’t respect the actors in the same way. That wouldn’t have been her language, but it was basically, as you said, you create a captive audience and assign losses. It has always been that way. Why would it be different this time?

Kevin:So a deeply negative interest rate, let’s call it what it is. It’s a confiscation of a portion of a person’s deposits in the bank.

David:Yes. That is the reality of something which the Fed is likely to implement. What is the perception of the crowd? What is the perception by the general public who may not understand what financial repression means, may not understand that by putting rates in negative territory, nominal negative territory, it’s like dealing with a small pick-pocket. People don’t understand it, so they’re not going to worry about it, so really, what the Fed is doing is managing perceptions. And that is the key to management of sentiment in the marketplace, because they cannot be perceived as trapped. They cannot be perceived as cornered or limited in terms of policy responses. That would be a bad thing.

So recognize that the man-on-the-street is going to consider the extraordinary measures that they introduce bizarre – again we’re talking about deeply negative rates, the cost of which they are not going to understand. But I think this is important for you, the listener. You, now, can anticipate and plan accordingly.

Kevin:In this area, Dave, here in Colorado, we have a lot of avalanches. In fact, I think I read that between here and Silverton we have more avalanches per – whatever it is, per square mile – than anywhere in the country, maybe anywhere in the world, I don’t know. They have the Silverton avalanche school just so that people can tune their perception of danger, because before an avalanche the snow looks the same as after an avalanche. The snow does not necessarily tell you that there is going to be an avalanche.

I remember you telling the story when you guys were climbing Mount Rainier and you felt – what do they call it? A plate? You actually felt it shift, or you felt it collapse.

David:Yes, the whole field we were crossing settled, and this was after three days of 80-120 mph winds at the peak of Rainier. We were locked in, in the stone structure – I forget if it’s Muir Camp, or what they call it – but we’re locked in there and people just keep on coming in who were trying to climb the mountain. The capacity is supposed to be like 25, and we ended up with about 70 people in this room. I’ve never smelled so many dirty socks in my life (laughs), it was really amazing.

Kevin:(laughs) Maybe too much information, but your perception of the danger at that point led you to, basically, end what was a pretty expensive adventure.

David:Oh yes. You have to know when to hold ’em, know when to fold ’em, know when to walk away. And in this case, we knew when to run. And so, we came off the mountain, had a great ski day, but did not ascend to the top. And a part of that came from the training we got in Silverton. I was 16 years old when I went to the avalanche training school for search and rescue. My best friend and I wanted to spend more time in the back country and figured we needed the skills. If I was buried, I wanted him to have the skills.

Kevin:But you had trained your perception of danger.

David:Absolutely. This year is a unique year here in Colorado. We have been through seven or eight years of drought. Drive through the high country here in Colorado and you can see the aftermath of the numerous avalanches that got rolling this winter, 300-500% above normal snowfall made for incredible skiing, but it also made for a huge number of avalanches, both in terms of the number and the size, and the San Juan mountains, as you said, with a very high concentration of those to begin with.

But most striking as you drive around the high country this year, you look at these massive trees that were hit by a wall of snow going 200-300 mph.

Kevin:They were toothpicks.

David:Snapped like twigs. Growing up on Colorado as a boy, I always imagined, “Wow, if there is an avalanche, I’ll jump behind a big tree. Even if you saw the avalanche coming your way, you could always jump behind a big tree.” Well, these debris fields, many of them that I drove past in the recent weeks, are equally incredible, because at the bottom of the slope you have 50-100 foot tall trees – massive trees – piled up like giant toothpicks. Because once the avalanche gets running, it doesn’t stop until it runs out of energy. Typically, that is at it is climbing the other hillside on the other side of a little valley or ravine, or whatever, and it is no longer working with gravity, but it is fighting against it, and that’s when it stops.

Kevin:So to use the analogy, is the Federal Reserve actually trying to keep the snow from breaking?

David:I think the Fed doesn’t believe in hiding behind trees. In the midst of a financial market avalanche, they believe in getting in front of it and through creative and superhuman force, just standing there and holding back the forces of nature expressed through the markets. This is, again, where I think you are going to see them attempt that kind of, with bravado and confidence, “Deeply negative rates will suffice, this will solve everything. You didn’t know we could do it, but it can be done.”

Kevin:“Oh, and by the way, you can’t take your money out of the bank while we’re extracting the deeply negative rates. “

David:There is something the people won’t appreciate, but in the context of panic maybe people just won’t care.

Kevin:I don’t know.

David:Maybe people just won’t care. But here is what no one knows. In 4,000 years of interest rate history, it has never been done.

Kevin:Grant alluded to that – Interest Rate Observerauthor – he said, “Well, maybe it will work.” But I heard in his voice that, no, it’s a little bit like saying that gravity has been defied for forever.

David:Late August Richard Sylla is joining us, Columbia University Professor Emeritus in Economics. He literally wrote the book on interest rates [A History of Interest Rates]. It is about an 800-page book on the history of interest rates, and he would be the first to say, “In 4,000 years of interest rate history it has never been done.” And I might add, perhaps for good reason. But again, what do we know. We know what we know. We don’t know what we don’t know. And in this case, we don’t know how people are going to respond to being in a system which is closed for their benefit. Note – for their benefit – for their benefit.

Kevin:Let’s go back 10 or 12 years. When the Federal Reserve chairman starts chasing rates down to try to save a crisis, it’s a little bit like that avalanche. Sometimes it’s too little, too late.

David:And that’s the point. If we move 50-100 basis points, or whatever, in this environment, again, there is this spectacular failure of memory here, from investors and from Wall Street. We talked about the Bernanke insurance cuts – four of them, 225 basis points – no use. That was before Bear Stearns. Then before Lehman failed, Ben cut rates again to 2% and did a bunch of credit market acrobatics. You remember the term auction facility?

Kevin:(laughs) Yes. You know, almost forgot it.

David:This was before TARP and TALF and the rest, but you had the term auction facility, which was introduced before Lehman. You had the term securities lending facility. You had the primary dealer credit facility. And these were all in motion before Lehman. They knew that there were issues in the credit markets. They were a big deal. They were exaggerated by derivatives and structured financial products creating this web of interconnected assets and liabilities and some of those assets were blowing up. They wanted to be proactive, but nothing they did could have changed the outcomes. And this is, I think, kind of a bottom line take-away.

Kevin:Sentiment had changed.

David:And sentiment is powerful. It’s trending. And it’s trending either one direction or the other. And the reality is, all they have, at a certain point in time, is the power to bluff. Sometimes that works. And sometimes, I don’t know if I’d want to bluff. When I was 16 and I heard for the first time that snow travels down the mountain at between 200 and 300 mph, that blew my mind. I thought, how could it go faster than a car? And it’s gravity, it’s momentum, and nothing stands in its way. That is what happens in markets where sentiment turns negative. Nothing stands in its way.

Kevin:I remember when I first started taking economics. I took a course called Microeconomics and that was how a business needs to run, both in good times and bad. It was sort of the small picture. It’s where you use the microscope. And then there was Macroeconomics, and money and banking, and all the bigger ones where it’s more like the telescope than the microscope. In a way, when you’re managing money you really have to have both. You have to have the microscope and the telescope and continually ask the question.

David:We do something similar for our portfolio management team twice weekly. The portfolio management team corporately reviews both the macro considerations and the micro company specific portfolio risks and opportunities. We start with Doug Noland’s analysis of credit spreads. That’s like clockwork. If it’s a Monday morning, if it’s a Wednesday morning – credit spreads. Investment grade bonds, the spreads between high yields and treasuries, and then we kind of move through a number of metrics that tell us what is shifting, if anything. Movement in those spreads often indicates a shift in trend, a change in sentiment, aversion of risk-off.

And we’re looking for these indicators within the currency markets and the fixed income markets, which are helpful as early warning signals, and as triggers for action that we may take to either employ risk or de-risk our own portfolios. And of note is, right now, there is little concern today. Little concern. Very little has changed in terms of credit spreads. We mentioned a few weeks ago, 70-odd billion euros’ worth of a bad bank structure being put together for Deutsche Bank. Not even Deutsche Bank CDS, Credit Default Swaps, are pricing in anything that indicates concern. At least, at present.

Kevin:It’s like walking across the snow field, over and over and over. You and I read a great book called Deep Survival, by Gonzales. One of the things he talked about was the reason huge, huge survival events occur, or death events occur, is because a person gets used to doing it over and over and over without consequence. Over this last 10-11 years we have created no consequence. It’s a land of no responsibility, no consequence. Even Grant, last week, was talking about how it used to be that people would actually pay a premium for security or lower risk, and at this point there is just no premium in that.

David:Step back from the details and ask whether the compression of spreads on high-yield bonds, the difference between what a high-yield bond yields and a treasury yields. We’re looking at investment-grade debt. Yes, that can be exaggerated by central bank influence. We have that, and that’s obvious, because they have been buying assets in the market. But the additional question is, is that also amplified by a real complacency with credit risk.

Kevin:Right. What risk? What are you talking about? We have seen no failure in the credit markets.

David:Does it make sense to you, side-stepping if we kept it to sovereign debt just for a minute – to see ten-year Greek treasuries yielding 2.05 percent when the ten-year U.S. treasury is yielding 2.07%?

Kevin:When five years ago you and I were talking about whether or not Greece was even going to survive as an economy. That doesn’t make any sense.

David:Does it register that the Greeks are financing ten-year paper more cheaply than the U.S. is? Again, this issue of complacency with credit risk – yes, there is a central bank footprint. Yes, there is a desire and implicit belief that the ECB is going to support Greek debt and so you might as well go there for higher yield and you will be safe. It’s almost the game that was being played in 2007 and prior, where people said, “Just buy mortgage-backed securities, asset-backed securities, because at least with the MBS market, it’s got the full faith and credit of the U.S. government behind it?” Isn’t that the Fannie Mae and Freddie Mac implicit guarantee? That’s why so many billions and billions of dollars were moving into the MBS market without regard for greater implicit risk. We’re doing it all over again.

Kevin:It’s a different form of inflation. We ask ourselves, “Where’s the inflation if we’ve printed trillions and trillions of dollars to get us out of this financial crisis?” It’s actually manifesting in an asset bubble. Everything is going up except for the interest that a person can earn in a bank.

David:And I know we have been harping on this for a long time, but the importance of pricing in the bond market is critical to the pricing of all assets – to all equities, real estate, everything. And central banks playing with those yields, and thus, setting prices in the bond market – that has a knock-on effect across asset classes. It gives us the bull market in everything . That’s the net result.

This week I feel like we have a little bit of a chorus. Our concerns are echoed this week by the UPS CEO, Union Bank of Switzerland CEO, Sergio Ermotti. He said, “I would be very, very careful about growing the balance sheets of central banks.” Of course, he is talking to the ECB because the ECB is getting ready to initiate a new push. With the hand-off to Lagarde, Mario wants to go out on a high note in terms of accommodating the markets.

Kevin:“Here’s some money.”

David:Yes, and I think the U.S. is in a similar position. As and when we have any hiccups within the market, our balance sheets, the Fed balance sheet will expand. He said, “I would be very, very careful about growing the balance sheets of central banks. We are at risk of creating an asset bubble.” And I would say we probably already have one. But that is what he told Bloomberg this week. What Sergio is concerned with is not the creation of a bubble, because bubbles are actually kind of fun. What he is concerned about is how bubbles create destruction when they burst, as they invariably do burst.

Kevin:And a lot of times these guys want to be on record before it happens. I remember when Greenspan came out, he created a bubble and then he started calling it “Irrational Exuberance.” Do you remember that?


Kevin:So it was like, “Well, wait. You created this bubble.” And I remember also – so do you – he stepped down. He stepped away from the Fed before the global financial crisis, and warned people.

David:This goes back hundreds of years because we have phrase like “the pot calling the kettle black.” So there is sort of a social norm where people are like, “Ah, but what about this?” And it’s like, “Yeah, but it’s your problem, too, you know.”

Kevin:The maestro calling the kettle black, yes.

David:So with a bubble bursting, collateral damage is a given. By collateral, I mean figuratively and literally. The unknowns – and this is what really, I think, keeps central bankers up at night – the unknowns are how that collateral impairment creates overnight insolvency issues with particular financial institutions which are too big for any entity but the central banks to resolve and get into the mix and help sort out. Resolve is probably not the best vocabulary choice, but to try to patch up – triage.

Kevin:I think of the walnut shell game where you have a pea underneath and the pea, actually, in this particular case, would be the bad debt. Deutsche Bank, a couple of weeks ago, took that pea and they shifted it under another walnut. The Chinese are doing this. They have walnuts all over the table and they have peas all over the table. They are going to actually have more peas than walnuts pretty soon.

David:I spent some time this last week also with a guy who was in a documentary film. He is really a neat guy in his 70s. The documentary film that was made of his life is called Dealt. He is what he calls a card mechanic. He could take anybody in Vegas. He has practiced cards since he was a little boy, and lost his sight when he was nine years old, and has such a feel for cards that he knows exactly what is going on in the deck. He actually has an interesting visual – I don’t even know what it is called – where he can see things without being sighted.


David:Yes, so it’s a bizarre combination of card trick type – I mean, it’s not magic – but you mentioned the shell game, and he would say, because he was playing with cards and doing this for me for just a minute, and it was like, which card is it?, like you’re playing the shell game. Then he said, the reality is, if you’re picking a pea under a shell, it’s not under any of the three. It’s never there. And that’s the reality. You think you’re dealing with a certain set of factors. No, you’re not in control of those factors, and what he wanted to prove over and over again is that he was in control with the deck 100% of the time.

Kevin:And this is why he was also in control of any surprise that would occur. The surprise is because you can’t expect it and you couldn’t have predicted it.

David:And you can look at 52 cards and say, well, there are only a certain number of variables and so you are controlling for a controlled universe. You are dealing with a controlled universe.

Kevin:But there is an unknown out there, like you said.

David:We’ve talked about this, too, with Ken Rogoff. Ken Rogoff is a very bright guy, I like his writing, and he has made some very significant economic contributions, but as a grand chess master, he is used to thinking in terms of a set number of squares, a set number of moves, and everything is, ultimately, solvable. What you can’t solve, and this goes back to a famous book, Extraordinary Popular Delusions and the Madness of Crowds. Central bankers can’t wrap their minds around things that aren’t particularly rational or contained within a limited 52-card deck, or I forget how many squares are on a chessboard. But this is where, again, we’re dealing with unknowns, we’re dealing with sentiment that can be stirred for a variety of reasons.

It makes me think of China. Yes, we have prickly relationships with China, and prickly is probably important to keep in mind, prickly in the bubble environment that we are in because anything can pop this bubble. If there was ever a credit bubble to talk about, China is it. In our last portfolio management meeting, I mentioned that Doug leads off with some of the credit market indicators, but one of the topics was the second banking issue to emerge here in 2019 in China. Again, it’s like the second significant domino falling. The first was Baosheng Bank, immediately taken over. The second is Bank of Jinzhou. It is a small bank, 113 billion dollar bank, small in Chinese terms (laughs), 113 billion dollar asset bank. No bailout on this one.

Kevin:Lifting the walnut – there’s the pea. No bailout on this one, but the other one – oh, we shifted that.

David:Yes, so no bailout on this one, and it is as if the PBOC is trying to establish the ground rules for what is ahead. Remember what happened in 2008 and 2009? We had our series of shotgun weddings of financial entities here in the United States? That’s happening as we speak in China. Three strategic partners were chosen. I don’t know if they volunteered (laughs) – I think they were chosen – to take on a part of the Jinzhouequity. Two so far. This is like cockroaches. When you see one, when you see two, there are more that you haven’t seen yet.

Kevin:I know it wasn’t in China, but in a way, Deutsche Bank did the same thing with – what was it – 70 billion dollars’ worth of debt?

David:The pressure is on. The pressure is on in the Chinese credit markets. We have already seen cracks within Deutsche Bank, as you mentioned. And this goes a long way to explaining why the Fed is in a dovish mode because they do not have the data to support the decision they are making this week. They don’t have the data. The data says you should be raising rates or staying flat because we have great unemployment numbers and we have GDP figures which are supportive of growth going forward. What is the data? They said they were going to be data-dependent? What data? Why are they being dovish now? What did they see?

I think as we look at, again, the roach motel, which is the Chinese financial system today, the credit markets in China, it goes a long way to explaining why the Fed is in a dovish mode. It may also explain this mad dash by the investment community into bonds. This was something else that Doug was pounding the table on this week, 254 billion dollars year-to-date, on track for 455 billion by year-end, has flown into the bond market, and that is just to give you some context. Over a ten-year period you have seen total inflows of 1.7 trillion.

Let that sink in, a ten-year period, 1.7 trillion of inflows into the bond market, and now we’ve got on track for 455 by year-end? That is a massive influx into bonds. Yes, that is yield-hungry investors. They will take what they can get, credit quality be damned, duration risk be damned, inflation risk – well inflation risk is laughable, the central bankers are trying to stoke inflation. Inflation risk is clearly not, if you’re looking at the price of bonds, priced into the fixed income markets.

Can I go back to Greece for just a minute? Are you telling me that there is not going to be more than 2.05% inflation in Greece of all places?

Kevin:Yes. People are running to safety, because if you look at the gold buying, it’s the highest in 50 years. We had central bankers buying over 70% more gold last year. I think it was 74% more gold last year than the year before. Somebody knows something.

David:It’s not the man-on-the-street. The man-on-the-street is not buying gold at this point.

Kevin:But the big boys seem to know something.

David:That’s exactly right. So the Fed is concerned, central banks are allocating to metals, investors in the know are allocating to safe haven assets.

Kevin:So I’m going to repeat the question from earlier. When we have a bull market in everything, everything goes up. What does it look like when we have a bear market in everything?

David:It’s a great question. What safe havens, in that context, have universal appeal? Ordinarily, you would say treasuries. But as Jim Grant pointed out last week, you look at the global government bond market today, and for the first time in history, gold is a high-yielding safe haven asset, relatively speaking.

Kevin:It’s paying greater interest than 13 trillion dollars’ worth of bonds. That’s what he said.

David:Isn’t that amazing? But there are no concerns with the U.S. economy today. There are few concerns with the U.S. financial markets today. There are some concerns with the global economy today. And there are now grave concerns with the Chinese financial markets today.

A proverb comes to mind and it’s just a bit of ancient wisdom we can end with: “The prudent see danger and take refuge. The simple keep going and suffer for it.”

Which one are you?

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