The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
“In contrast to earlier cycles of debt crisis and economic growth, guess what we have that you didn’t have in earlier cycles? We retained the baggage from the last crisis and now are moving into an environment of ‘rate normalization’ which is really difficult to see the central banks wanting to happen when you look at the total stock of debt and what it means for re-pricing the cash flow costs of a move higher in rates.”
– David McAlvany
Kevin: I always look forward to this time of year, Dave, not just for being thankful, and Christmas coming, but this is when we get our questions in from our clients. We always have a “Send us your questions” period of time toward the end of the year. Speaking of great commentary coming to us, blogging after people hear us on YouTube, our clients actually send us the questions and you try to answer all of them.
David: You can send those questions to firstname.lastname@example.org.
Kevin: We’ll probably dedicate two, maybe three shows to getting those questions answered.
David: Yes, as we head toward the end of the year I want to make sure we get this in under the wire.
Kevin: David, with so many things to be thankful for, I’m just going to bring one thing up that most countries throughout history have not had, and that is, free speech. Look at what has happened over this last year. Granted, we’ve seen the slant of the media, but free speech still has been prevailing on the Internet up until now, Twitter – (laughs) I hate to bring up something negative on that – but we should value that, with the Commentary on YouTube, on iTunes, on our website, we can say pretty much what we want.
David: We can, and I think one of the things we always reflect on is the appreciation for content. There is, I think, a growing sense in which without accountability on the Internet, kind of a Wild, Wild West, that there is a divergence from focus on content to tone, and tone can become pretty nasty. What I’ve noted over and over again, as we talked about last week, is that in the context of our Commentary, there is an incredible degree of civility, and I think it’s amazing. I love seeing it because as I bounce around here and there on the Internet I’ll read different threads, and man, when someone gets their toes stepped on, rather than responding in a civil way and saying, “No, I don’t think you understood, this is what I was trying to express,” or clarifying an argument or discussion point, it’s just a trashing of the individual.
Kevin: It’s name-calling, or what have you. They call those people trolls, people who purposely get out and just leave negative comments. I’m thankful that we have very little of that on the Commentary.
David: This last week I got an email from one of our listeners who was commenting, in addition to what we talked about with Becket last week, and wondering about the nature and character of a man who has now been given a very unique office, one of the most powerful offices in the world, the President-Elect, in our country, and will there be a change in who this person is and how he approaches life coming into this office?
Kevin: A sobriety of office, basically.
David: That’s right. I got this email and it suggested, “Hey, I know you like history. Take a look at this election back in the 1800s. It’s very interesting. I think you’ll enjoy it.” I loved that. I thought, “Wow, this is a great interplay.” We are in a position to continue to learn and grow, and never at any point, as strong as our opinions may be on this commentary, never at any point do we feel like we have a corner on the truth. We’re seeking the truth, that is for sure, and we will make bold claim to it, but we are more than willing to say, “Hey, no, actually, this was helpful. We see more clearly now,” after someone has shared something or shared an insight with us. So we invite that continually, and hope that our process of growth is in parallel track with that of our listeners.
Kevin: And as we’re thankful for free speech, we’re thankful for possibly a change in administration, a change in the way of doing things, we also want to be vigilant. I got a chance the other night, Dave, to talk to your dad in the Philippines. We recorded that conversation so we’ll send that out to listeners and clients at some point. But I thought I would just let you know, it’s really refreshing to hear from his point of view. One, he was very excited about the Trump win. He made no bones about that. But then, I heard the Don McAlvany that was vigilant and concerned and realizing that there is a truth to the fundamentals that we have. Donald Trump, Hillary Clinton – it really doesn’t matter who is President, there is an inherited problem that is going to take a while to turn around.
I heard the other day, to stop one of those large ocean tankers it takes five miles, just because of the large mass of it. You look a the U.S. equity markets, you look at the debt markets, you look at the things that Trump is inheriting, and we can be hopeful about good policies that will play out down the road. But right now, 2016 is a real transition point into what could be a very tumultuous 2017.
David: I have one comment, too, on my dad. It’s not that he has a love affair with the man who has taken the oval office (laughs), it’s just that your enemy’s enemy is your friend, and he would say, “If the establishment hates him, there has to be something about him to like.”
Kevin: That’s exactly right. He wasn’t a Trump fan from the get-go, but he definitely wasn’t a Hillary fan.
David: That’s right, but if the political establishment hates him, there must be something to like. That’s the conclusion that I have in my conversations with him.
Kevin: Let me ask you, Dave. The celebration from the people who feel like they won is turning into also an investment celebration. The ETFs that are equity-based, stock market-based, have had a tremendous inflow of capital here this last couple of weeks.
David: And I think you should be sober in your judgment of that and make sure that you remain reasonable. The U.S. equities ETFs had their largest weekly inflows ever this last week. This 27 billion dollars came off the sidelines. And that’s a lot of team spirit. You have small caps, which moved in a major way. Small caps have moved higher by 13% in the last ten days, and this kind of behavior comes twice in any cycle. It comes at tops, and it comes at bottoms. So the question is, then, where are we at? And this is why sobriety, I think, is certainly a part of the equation here, or should be. Does a two-year sideways consolidation where the equity indexes have gone nowhere, but earnings in those same corporations have declined each quarter – does that set you up for a move higher?
Kevin: It doesn’t sound like a bottom to me.
David: Is this a bottom in front of a major advance? The fundamentals don’t support it. And so here is what you might argue. The fundamentals don’t support it, but we’ve just seen a radical shift with the Trump election and the markets are recalibrating. I would take the other side of that and say, “No, I think we have retail investors who have been sitting on the sidelines and they can’t take it anymore.”
Kevin: And the retail investor is not your hedge fund, it’s not your professional fund, it’s not your sovereign wealth fund. It’s guys on the street who are saying, “Okay, maybe it’s time to buy a stock again.”
David: So the conclusion is, the government will spend, the cash will flow, profits will soar, stocks will rise, and we’re going to exceed our long-term financial goals ahead of schedule. Again, I think, really, this is an issue of people not being willing to stay on the sidelines and sit on their hands, when that’s exactly what they should do. They’ve probably watched Jim Cramer hit that button one too many times and ring the foghorn and of course, Jim Cramer is singly responsible for bringing in every bull market, right? And this is the gist of it. The energy is high. What I would say, however, is that if we are, in fact, at a bottom instead of a top, your big moves off the bottom are never popular. Your big moves off of a bottom are never trusted.
Kevin: A bottom – nobody wants to own that at all.
David: And they are never participated in by the retail investor because the big moves off of a low level are contrarian in nature because they’re going against the established trend. The established trend is down, and then all of a sudden you have a move up, and everyone is saying to themselves, “Not me. I’m not that guy. I’m not the sucker. I’m not the guy who is going to pay the ultimate price.” And so, again, there is a difference in character. There is a difference in feel and psychological dynamic.
Kevin: Let’s just look at a year ago, Dave. A year ago it was perfect timing. It was a bottom in the gold stocks. It was perfect timing to go buy a gold stock. Nobody wanted to play.
David: Right. The biggest moves of the year came January, February and March. Gold stocks rose off of lows between 50% and 150%. Not a bad return in a single calendar year. I remember speaking to one client last December, encouraging them to add to positions in gold stocks, and it was not a popular idea. The feeling at the time was that the sector would never recover. That leads me back to the current dynamic. People today are afraid, but they’re afraid of being left behind in the new Trumponomic miracle, which is not the kind of fear that is characteristic of a market bottom. So let me qualify my perspective. We’re at the front end of inflationary fiscal policies, and inflationary fiscal policies are popular with equity investors.
Kevin: In the beginning stages.
David: That’s right. Inflation presents itself very well and it looks like economic growth in its earliest stages. While government spending certainly will create economic activity, here’s what lies beneath. The type of spending is critical for it to ultimately translate into long-term economic growth. So are we talking about the kinds of investment that will create jobs which for two years create income to a small swath of individuals, and yes, that creates spending at restaurants and shops, and on housing, in those little locations and locales where the infrastructure investment has occurred?
Kevin: Even Obama did some of that after the financial crisis.
David: And the results really don’t need any commentary (laughs). You can spend 100 billion dollars and still not see sustainable economic growth in the economy.
Kevin: You and I were talking about – have you ever seen a fiscal project that actually turns into long-term economic growth for the United States? I can’t think of any.
David: Well, that’s just it. Economic activity? Yes. But long-term growth? Not necessarily. So if you could find a project that has a positive return on investment, say, over a 10, 15, 20-year period – not at the end of 10, 15, or 20 years, but through a duration of 10, 15, 20 years, that is creating jobs on a long-term basis, not just on a project-by-project basis. I think that’s the difference. What does that look like? We’re going to be very interested to see what the Trump administration unveils.
So far, here is what we have from the Trump administration (laughs). This makes me laugh. So far what we have is a new way of accounting for deficits that leaves us with only gains and no losses, only upside and no downside. This is hilarious if it wasn’t just, again, sort of playing with assumptions, playing with ideas, playing with definitions, and playing with concepts.
Kevin: Well, there are concepts that get you elected and then there are concepts of reality. Now they’re going to have to play the reality card.
David: But this is what is driving the new economic model behind Trumponomics. They are changing their modeling of debt to what is known as dynamic analysis, in contrast to static analysis. So you have the old school, which is the static analysis, but now – wait – wait – we have dynamic analysis. And that says that we can treat debt differently. And now it includes heterogeneous agency.
Kevin: What in the world is that?
David: Don’t you know that it is important to factor in the various agencies, that is, individual actors within the economy, and not take the economy as a whole? And trust me, there are academic arguments for these things, but these new models – do you know what they do? They take trillions in new debt, and they basically say, “Yes, but it’s not going to be new debt.” I mean, if it’s four trillion dollars in new debt, what is it? “Oh no, that’s not four trillion dollars in debt.”
Kevin: It’s a smoother road, it’s more lights, it’s better bridges.
David: That’s old math. That’s old thinking. We have new assumptions, we have new conclusions, which we are led to by these assumptions. By the way, these are the desired conclusions, of course. This is the reality. Unless it is an infrastructure project which radically enhances the efficiency of an existing business, or the profitability of an existing business, I’m the guy who’s going to be skeptical. Why? Because we have the shadows of Athens in 2004 (laughs), of Sochi in 2014, of Rio in 2016. The Olympics – what do they suggest? That building stuff does not, in fact, create wealth, except for a few contractors (laughs). If you get to build the stuff, yes, it’s good for you. But there is not an economic advantage, or a long-term growth trend, which is created by building stuff.
Now, look, if we could reduce the price of energy by 50%, that would be intriguing, because that has a benefit to, not only households, but businesses, alike – a massive benefit. But what does that look like? Well, the Trump Administration may do that. They may flood the market with supply. That means opening up drilling, that means doing all kinds of things. And on the face of it, yes, you would say energy independence, we get a huge economic benefit, and that’s true. One of the things we’ll have to balance with that is the unintended consequences of changing the geostrategic map, bringing Saudi Arabia and Russia to their knees, financially, in the process of creating cheap energy in the United States. And of course, you have an administration who, if they do pursue that, is going to be in a billion lawsuits over the environmental controversies of drilling, fracking, opening up wildlife reserves, etc.
Let me tell you who this is actually a hardship to. You open up oil supplies and you think, “Well, that’s got to be good for oil companies.” They make less money on every barrel that they produce. So I imagine someone who has a royalty interest in an oil or natural gas well – guess what happens when you flood the market with new oil and gas supplies?
Kevin: Right. They can’t afford to pump it.
David: Price goes down, and all of a sudden the royalty interests diminish, your income goes away, to a large degree. So there are good sides and bad sides to everything. I’m just interested in seeing what the concrete proposals are and hopefully it’s not a repeat of Athens, Sochi, or Rio.
Kevin: One of the things that fiscal policies usually drum up is inflation, and inflation is fine if it’s 1% or 2% and you’re getting 3% or 4% in interest. But the nightmare, I mean the real nightmare, is if inflation is beyond what the interest payment is, and that’s where we are right now, even with low inflation, what happens when the inflation kicks in?
David: You mentioned nightmares, and it is interesting that it is in our dreams that we process things subconsciously. For the investor, to be able to process the subconscious impact of inflation, this is where the night terrors begin – not nightmares, night terrors. The night terrors begin for investors when inflation begins to creep ahead of a rise in interest rates, and we’re beginning to see the talk, the suggestion, the idea. Certainly, the market has already moved interest rates up.
Now the question is, does the Fed follow? You need to recall the distinction between actual inflation rates and the expectations of rates, which is what the Fed has tried to control through time is, with its language it occasionally will try to squash this sort of nascent expectation, or market psychology, as it relates to rates. A change in expectations usually leads to a rise in inflation. It’s a little bit like a self-fulfilling prophecy. Inflation is just, as we speak, beginning to peek out of the shadows and it has become more of a discussion point as analysts consider the impact of fiscal spending.
So fiscal policy is now on the table and inflation is a conversation and a discussion point once again. What many really don’t have the imagination for, and I think this is the crux of the matter, combining naturally inflation-oriented fiscal policy with record levels of excess reserves in the banking system…?
Kevin: Let’s talk about that because over the last three or four years you have mentioned that that built-up liquidity, those reserves, trillions in reserves, that never really got to the economy – in fact, we interviewed one guest who was a central banker who said that they would use sterilization methods to keep that from turning into inflation. There has been a concern for inflation even amongst the central bankers based on those reserves.
David: Again, can you sterilize them, or can you not? We view those reserves as liquidity, like liquidity held behind a dam. If there is a breach in the dam, then you have a major problem downstream with liquidity flows. And so, what you have with inflation-oriented fiscal policy, and high levels, in fact, record levels of excess reserves in the banking system, is monetary policy distortions combined with inflationary policy, which to us is like whiskey with a beer chaser (laughs). It’s a ’70s-themed inflation party and it’s going to get off to a very quick start.
Kevin: You brought up the 1970s. One of the things about the 1970s is we had inflation get ahead of interest rates. And then, most people can remember the extremely high interest rates. You could lock in a CD, I think, at 16%, 17%, 18% at one point, but that was because inflation was so high. Now, rates on the rise – that destroys the financial markets.
David: Well, particularly when the financial markets have balance sheets that are extended, in other words, loaded with debt.
Kevin: Yes, they have already borrowed up to their maximum.
David: Too much debt in the system getting more and more expensive, means that corporations and households, and even governments, have a cash flow adjustment to make. Increasing rates require an increase in cash flow directed to servicing that debt. And as we will discuss in a moment, we have an incoming, let’s say, quasi supply side economic theory which proclaims that a massive increase in debt has nothing but positive effects on the economy. While some aspects of the supply side do, in fact, make sense, I think that’s a rationalization for an increase in debt. Again, increasing debt has always been one of the hallmarks and high talents of the Republican Party supply-siders.
Kevin: But supply-siders aren’t always wrong when it comes from excess savings and tax cuts. If you have excess savings coming in and you have tax cuts that are working out, supply side actually can have a positive benefit.
David: Right. And so you have that stated goal, the assumption that if we can increase savings, we can ultimately increase investment and improve economic growth. That’s a supply-side goal. The classic supply-side model attempts to create excess savings from tax cuts, spending initiatives that are intended to trickle down, benefits from the rich to the rest of the economy, and the attempt is, really, to solve a lack of capital problem, by directing more capital to the business allocators, which will invest in a way that creates long-terms jobs and income growth.
Kevin: It hasn’t been a lack of capital problem. All through these years, that capital is there, it just is not getting spent, it’s not getting incorporated.
David: Yes, I’m not exactly sure how you approach a supply-side issue with a very different backdrop than we’ve had before because we have savings, we have liquidity, we have central bank credit that is the highest of any in recorded history. Michael Pettis discussed this in reference to the Hartz reforms in Germany between 2003 and 2005. Basically, what those reforms did was to shift money from labor income to business profits by shrinking the income growth for workers, and it made profitability for corporations in Germany, in that period up to the global financial crisis, very attractive. The excess dollars, or in this case euros, were not invested back into the German economy, as it was hoped, but in fact they became the surplus corporate savings in the system, which ultimately financed the housing booms in peripheral Europe (laughs).
And of course, fast forward just one or two years to 2008 and 2009, and this is what left the PIIGS – Portugal, Italy, Ireland, Greece, Spain – gutted when those loans, which had their source, ultimately, from the high savings rates in German corporations, were ultimately reappraised in the context of the global financial crisis. What the story illustrates is that supply-side engineering does not guarantee the desired flow of capital, and in fact, it can be harmful.
Kevin: Just that thought process has sort of gotten the central banks into a corner. Do the central banks have any idea how to actually fight inflation if it starts to happen?
David: (laughs) No, I think that’s the big key here. Central banks – are they prepared for it? Are they preparing to go from a concern about deflation – the last several years have been a focus on disinflation, or outright deflation, with the stated goals of the central bank community being a deliberate increase in inflation in order to avoid deflation. This is, of course, keeping us from the brink. Back in 2008 and 2009 what they were trying to do is keep us from sort of a deflationary vortex.
And what did they do? Every lever, every tool in the box, was used to create inflation, including asset price inflation, very specific asset price inflation, via outright purchases from a number of central banks. I’m thinking, specifically, of the Bank of Japan, the European Central Bank. Of course, the U.S. Fed did their part, too, in buying mortgage-backed securities and things of that nature prior to 2014.
Kevin: We talked about turning a tanker around, or at least stopping a tanker. To stop a tanker, one of those large oil tankers, you have to think five miles ahead – five miles ahead. Inflation is a little bit like that for a central banker. If you’re not fighting inflation before it occurs, you’re not going to get that tanker stopped before it hits the dock.
David: Which means that the central banks are already behind the inflation curve, and very rarely, once they get behind, are they able to catch up. So this is that issue. Expectations shift, consumers, investors, and governments shift emphasis, and then how quickly and how dramatically does central bank policy shift from the disinflationary fear to reigning in inflationary forces. And what you are saying is, you have to start reigning in the inflationary forces before they show up.
Kevin: Isn’t that what John Taylor was saying? When you interviewed John Taylor a few years ago he talked about how the interest rate had to be above the inflation rate, and the Taylor rule gives a specific amount to keep things under control.
David: That’s right. By the Taylor rule the Fed funds rate should be sitting today at 3%. So this is the question, and this is the answer – is the Fed already behind the curve? Only by 2½ percent. By that measure, by the Taylor rule, they are behind the curve. It was Bloomberg that was suggesting last week that Japan is nearing a taper, that 2017 may be their version of what we had in 2014. The ECB may very well slow its pace of balance sheet growth in 2017. You have some critical elections coming up and there are going to be some contentious issues that are solved, and it may be – we’ve had Brexit, we’ve had Trump, we may have Frexit, we may have a variety of things in Europe which are destabilizing, and I think Draghi is going to play toward political cohesion rather than risk losing the European project altogether.
Kevin: So talking about tapering. Tapering is monetary policy. So is quantitative easing. That is monetary policy. The other side of the equation is fiscal spending. Do you think these guys are going to do what Trump is talking about and start incorporating fiscal spending?
David: Well, and that’s the issue. Certainly, in the ECB you may have sort of a copycat deal where we start the fiscal initiatives first here and that relieves some pressure, in the ECB and on Draghi, to have monetary policy as the primary tool being used. There has been a huge reliance on Draghi’s monetary policy, and very few of those states have stepped up and said, “We’re willing to do this and this and this.”
Kevin: And it has not really worked. The monetary policy has just delayed things.
David: Last week the Deutsche Bank CEO was quoted as saying, “There is an irrational buyer, by definition, in the market.” He went on to say, “There has absolutely been no price discovery now in corporate bonds so we don’t really know the price of credit,” which is a dangerous situation.
Kevin: Yes, pricing risk.
David: So Kevin, imagine the re-emergency of price discovery, and again, the elimination of that irrational buyer, which is the ECB (laughs). That’s who he is being polite in talking about. But imagine if they go away and you have the re-emergence of price discovery, right as inflation begins to move higher. And the pendulum in the bond market swings from artificially low to a more accurate pricing of credit, or pricing of credit at reasonable levels. And then, as you might expect from any pendulum, inflation expectations carry interest rates to unreasonably high levels.
Kevin: Well, and as you’ve said, Dave, bond markets travel in 30 to 35-year cycles where you have rising interest rates for a period of time, which of course, is the decrease in the value of bonds. But about 33 years ago that reversed.
David: Right. I’ve been more and more comfortable about being wrong about bonds. It has taken me about six years to comfortably wear two left shoes when it relates to… (laughs).
Kevin: Well, because the cycle lasted longer than you thought.
David: The cycle has lasted longer than almost any on record.
Kevin: We’re talking about the cycle of dropping interest rates. Right now we’re close to zero. This has got to be close to the bottom.
David: And I never anticipated, and I don’t think many people did, the nature of rates going negative. And it’s not to say that the cycle is over, that the bond bull market is completely done, because again, desperate central bankers will do desperate things, and to take nominal interest rates into negative territory – I’d like to think that that is over. That is certainly what the bond market, at least in current pricing, is telling us. But again, if inflation expectations re-emerge at the same time that we’re re-pricing credit, in Europe and the United States, and that mystery buyer, the irrational buyer, goes away, what you are talking about is the death of a 35-year bond bull market, and the birth of a bear market that will gut the financial system and leave fixed income portfolios cut off at the knees.
Kevin: You’ve been talking about 2016 being a year of transition. Do you think we’ll look back in hindsight and say that 2016 is actually the year the bond market topped out?
David: One massive transition is in respect to this focus on deflation, being so comprehensive that any concerns with inflation have been entirely ignored.
Kevin: It doesn’t exist anymore.
David: No, and this is where central bankers, the whole global community of central bankers, is flat-footed. If we have a shift toward inflation, every one of them is behind the curve. And what might, ironically, (laughs) bring deflation back in force. And I’m talking about a deflation of assets, I’m talking about a collapse in asset prices and the deflationary effects of that, is the sort of perverted dance that exists between inflation and deflation, and it may very well be inflation that is the cause of a deflationary collapse.
Kevin: We’ve experienced two weeks now of the yield curve steepening pretty dramatically on the long side. The long bond is already saying, “Hey, we think inflation is baked into the cake.” Is that something that is going to happen globally?
David: Well, that’s right. There is a shift across the entire yield curve, globally. Does that sound like a good idea, if you have loaded in hundreds of trillions of dollars in debt into the global financial system, with some percentage of that debt already mispriced? Generally, a debt crisis like we had in 2008 and 2009 clears the system of bad debts.
Kevin: Sure, because everybody is allowed to go ahead and default.
David: Right. So the purge cleans out the otherwise toxic system which is suffering from what had been a debt binge, and the earlier dynamics.
Kevin: The central banks never let that happen, Dave.
David: That’s the problem we have today because central banks never let the system clear out the bad debts in 2008 and 2009, as we head into this particular part of the cycle. In contrast to earlier cycles of debt crisis and economic growth, guess what we have that you didn’t have in earlier cycles? We retained the baggage from the last crisis, and now are moving into an environment of “rate normalization” which is really difficult to see the central banks wanting to happen when you look at the total stock of debt and what it means for re-pricing the cash flow costs of a move higher in rates.
Kevin: I’d like to use an example that you used last year. We spoke about this once on the Commentary, but it’s a good picture for people to have. You were talking at a conference in Idaho last year, Dave, and you were trying to explain what carrying too much debt feels like. You looked around the room and you said, “All right. Pretend like you have to run from one end of this large conference hall to the other.”
David: It was just a 100-yard dash.
Kevin: It’s not that big of a deal.
David: You may not break any land speed records, but you can still do it at a respectable pace.
Kevin: And then you said, “All right, now I’m going to hand you a 50-pound bag of concrete, and I want you to do the same thing.”
David: How is your performance affected?
Kevin: Well, with the 2008 and 2009 debt never being allowed to clear out, it’s almost like handing two bags of concrete, or three bags of concrete. There is an impossibility this time around.
David: We can’t move rates higher without triggering solvency issues in the financial system. Deflation is a massive issue ahead of us and inflation ends up driving rates higher and pops our debt bubble. Again, remember that when you go through these cycles, we should be at a point where debt is not a burden to us. We should have cleared it out. We not only have the old debt of 2008 and 2009, but the system has added 70 trillion in fresh debt just since 2008 and 2009. That sort of financed the recovery. And only we don’t have a recovery, and now we’re moving to fiscal policies inherently inflationary on top of monetary policy, which has created a vast sea of liquidity not yet in the financial markets and in the economy. What does this look like? I think we were right in thinking that 2017 is sort of the first fruits of what was a transition period in 2016.
Kevin: You were talking about clearing debts out. The other thing that clears itself out, and this can be very helpful, is to allow the stock market to crash. We’ve had a 700+ day period with the stock market up in the range that it is in now. We continue to comment that the economy, itself, was slowing for the last 24-36 months while the equity prices were being held at an unnaturally high level.
David: Right. So it’s not out of the question that fiscally-driven economic activity changes the short-term growth dynamics and pushes those growth dynamics into positive territory, even while the stock market sells off. That’s kind of a variation on the theme of “buy the rumor and sell the news.” And as we mentioned a few minutes ago, the retail investor is notorious for stepping in to buy at precisely the wrong time, and stepping out of the markets at precisely the wrong time selling at lows, as well.
Kevin: Well, there is another bag of concrete, too. I’m not saying that a strong dollar is bad in all ways, but a strong dollar actually makes our goods very expensive worldwide. And the dollar has been hitting highs that we haven’t seen in over a decade.
David: It depends on what part of our trade policies you want to put emphasis on. But if you want to increase trade with the rest of the world, and increase exports, certainly you’re not helping yourself with a stronger currency. We’ve seen some distressing tendencies there since the Trump election, and this is massively significant shift just since early November, which is, the dollar has moved to 13-year highs. If it’s a short-term shift, then it may not be all that significant to multi-national firms. But if these levels, 13-year highs, are held for a quarter or more, two quarters, half a year, then you’re going to see a nasty impact to earnings – a very nasty impact to earnings. So again, we look and say that we could see an improvement in economic activity in the short run, even while the stock market trades lower. One of the reasons for the stock market trading lower is tied to this dollar dynamic.
Kevin: Well, we talked about it being expensive to buy American goods. The effect of a higher dollar on our trade partners is very negative.
David: Well, the improvement in global trade, the dynamics which gave us trade deficits on our side, trade surpluses on the other side of the pond – surpluses, as far as those countries were concerned, were a boon. That was massive dollar flows.
Kevin: That was a huge benefit to them, and to us, if they would turn around and loan us back the money and buy our treasuries.
David: Oh, that’s right. So it gave us the ability to, via running a trade deficit, have a captive audience of people who were very interested in recycling those trade dollars and basically subsidizing our budget deficit. So there was this strange relationship going on there. And those countries that have benefitted from the double-down, the double-down move of both currency and global interest rates – keep in mind both of those have been moving in lockstep – they have had for some time a form of debt relief as a result. And they are now on the other side of that.
Kevin: Right. And they have to pay back their debts in dollars (laughs). That’s horrible.
David: Exactly. Dollar appreciation and higher rates are a form of financial weight, like you were picturing with that bag of concrete. It grows on the shoulders of those countries that denominated their debt in U.S. dollars. It’s not an insignificant number. It’s a number in the tens of trillions of dollars. So what we see with those emerging markets in the next few years, coming under more and more financial strain, I think will be like what we saw in Brazil and Mexico in the early 1980s, ultimately leading to a capitulation moment. “Nope, we can’t make that payment. We’re done. We’re out.”
Kevin: That’s default.
David: That’s right.
Kevin: “Capitulation moments” is sort of fancy words for not paying your debt.
David: It’s fascinating to me as I listen to the Trump economic committee as it is being formed, sort of touting getting rid of our trade deficit, if Trump’s campaign promises of shrinking that trade deficit are pushed forward, just understand that we’re talking about turning the emerging markets into the killing fields, financially.
Kevin: Well, it’s like a lot of things, Dave. It would be nice to not have an economy where trade deficits were necessary, but we’ve sort of seeded this into the whole world where it’s an addiction, and if they don’t have surpluses from us, those countries just go under.
David: I’m not a champion of trade deficits, but there is a consequence to change, and that’s what I’m getting at. You shrink the trade deficit here, and it naturally shrinks surpluses elsewhere, which would introduce economic stress into the emerging markets that we haven’t seen, really, in 20 years – not that kind of stress. What happens when you have economic stress in any given country – well, look, you end up having social and politically destabilizing trends.
And so, I think you see that as a hallmark of 2017, 2018, 2019. A lot of politicians who say, “We really don’t like Trump because his focus economically has gutted us politically. Now we’re dealing with riots and social unrest that we wouldn’t have had otherwise. Those domestic economies, when they have less capital flow to work with, it changes relationships. And maybe the unintended consequence of that is a deepening of relationships between those emerging markets in China.
Kevin: Well, and not only does it increase the tensions, but if we reduce the surpluses that these countries are taking from us, like the Chinese – the Chinese have held an enormous amount of our U.S. treasuries and we’ve really depended, the last 30 years or so, Dave, on them being buyers of our debt.
David: That’s right. They’ve got dollar holdings in the trillions, and U.S. treasury holdings, still, of about 870 billion, if I’ve got my numbers correct. Saudi Arabia is in the same boat, with about 89 billion in treasury holdings. And remarkably, both of these countries, along with other central bank holders, have reduced their holdings pretty considerably – 343 billion dollars in treasuries have been liquidated since July of 2015. And we’ve watched the Saudi’s balance shrink by one-third since January of this year, suggesting that our audience, who classically would have financed our budget deficits, will not be available in the years ahead.
Kevin: And who is going to pay for the fiscal spending then, that we’re talking about?
David: That’s spot on. So here we are thinking about 2017, a 1-2 trillion dollar deficit spending spree Trump is proposing. Who will buy the treasuries? And I’m not convinced – I’m really not convinced – that changing the models in how you count for debt is going to be sufficient. I really am thinking that just moving to heterogeneous agency and dynamic analysis is not going to change the burden of real debt. So that moves us toward an interesting dynamic. Could the Fed open up and start another round of asset purchases to replace the two trillion dollars in global liquidity, the credit currently coming from the ECB and Japan and to take the place of our former financiers, the Chinese, and the petro dollar recyclers in the Middle East?
Kevin: Well, if they do that, they’re going to have to come up with some way of making us captive to the system. Remember when you interviewed Carmen Reinhart, she talked about creating a captive audience? The war on cash we’ve already seen. We discussed the war on cash in India, the potential war on cash in Australia. But the whole idea of the war on cash is simple. You get people to not have the opportunity to own it. They have to put that money into the electronic system so that financial repression, low interest rates, and the whims of the government, can be had without people having a dissenting vote.
David: So if captive audiences are more and more the order of the day, and the war on cash is going to continue, your primary complicit parties are banks. Why? They benefit. We just watched this happen in India. There was a mad rush to put billions of rupees into the banking system before those 500 and 1000-rupee notes were made worthless. And by the way, you think those were large denomination bills – we’re talking about currency notes that are worth less than 20 dollars.
Kevin: Yes. 7.50, 10 bucks – those are not large notes.
David: No, they’re not. But the same shift – see, this has nothing to do with Republicans and Democrats. It has nothing to do with Obama versus Trump. There are policy shifts that are sort of trans-party shifts. They are far above and beyond anything that a particular party might champion, and the system is champion for. And in this case you have Europe very much in favor of moving toward a cashless society. You have Australia, who is being encouraged by UBS and City Group. City Bank, actually, in Australia, is at present moving toward cashless operations at a number of branches in Australia.
Kevin: Well, and there is something to learn from that, if we look at what happened in India over the last week or two. The cash – the large-denomination bills that were going to be made illegal, were starting to sell at a discount. Now, that’s not something you see very often, but when you have a 1000-rupee note selling at 750, or 500, just for the person to get out of it, that’s step one. Step two is, there was a huge move to gold in India, just on the streets.
David: I mentioned Russell Napier’s recent take on fiscal expansion, that financial repression is inseparable from fiscal expansion. And he concludes, as we do today, with the ten most dangerous words in the English language: “We’re from the government, and we’re here to help you.”