In PodCasts

The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

“You don’t have to worry about staggering levels of debt as long as debt service levels remain low. That, of course, is a function of interest rates. As interest rates rise, the real issue emerges for those entities that don’t operating a printing press. So that contrast between the governments and the corporations – this is where the rubber meets the road. This is where corporations get into the crosshairs.”

– David McAlvany

Kevin:David, I’m not the kind of guy who drives across town to save two or three cents on gas, to be honest with you. I know people who do that, but I wonder if they are actually spending more just to save three cents. But I’ve noticed here recently, gas is creeping up. It was $2.39 for the longest time here in Durango, and it crept up and crept up. Now, we’re at $2.89. We’re getting close to $3.00 per gallon. I’m wondering if this is a sign of something else.

David:It’s a sign that we live in a saner place than California because on my last trip to California it was almost $4.00.

Kevin:Oh my gosh! Well, let me ask a question.

David:The national average is one thing, but I’m glad to live here and not be at one of the extremes of pricing.

Kevin:Most people don’t pay much attention to the oil markets. They don’t pay much attention, honestly, to world politics. They may see it on the news but they don’t really know how to put it together. Let’s say that your left arm starts hurting, and you think, “Well, gosh, my left arm has been hurting for a while now. That could be a sign of something much bigger. It could be a sign of a heart attack.” And I’m wondering if the creep in gas prices – we know what’s going on with oil because we watch it – this rising price in oil, let me ask you, is this a sign of something geopolitical, something much larger, like the left arm hurting? Maybe the heart attack is coming?

David:Sometimes when you look at gas, you do have that connection. Other times it just relates to the seasonality of when you shut down refineries and you have these artificial bottlenecks when it comes to turning crude into its various byproducts. But crude oil has risen $20 since the summer of 2017, and that’s a big move. It is now $70 a barrel, right around that, and it is not really based on lower supplies, it is not based on higher demand or a recovering economy and more demand for the stuff. But it is really reflecting the dysfunction and deterioration of relationships in the Middle East.

And the thing is, it is not, as some would like to say, “Here, we’ve got this issue with Iran. Are we going to stay engaged, disengage, rewrite the agreement that we had? Bring John Kerry back in on a pro bono basis to patch everything up and make it right?” The reality is, it’s been rising from the level of $49 since the summer of 2007 and it had nothing to do with the failure of the Iran deal. That may be worth a few bucks, but you’re talking about a larger backdrop of dysfunction.

Now we’re in the middle of a price trend, because we’re 100% above the recent lows, that is, $35 a barrel after it cratered. $140 was the high way back in 2008, $140 a barrel that then cascaded to $35. We’ve doubled off of that. But again, $70 – we’re halfway to those old highs again.

Kevin:And there is a complicated tie between the value of the dollar and the value of petroleum, the value of OPEC being able to supply us our oil. We’ve talked many, many times about that. But in this particular case you said Iran could be a factor, but there are probably other factors. Saudi Arabia, Israel – there are a lot of players in this.

David:I remember doing Bloomberg interviews every Wednesday on the oil price and they were always looking for the cause of the move of the oil price that day. I always felt like it wasn’t particularly relevant except to the short-term trader what was moving the price of oil on any particular day. I was more interested in the macro than the micro, and of course what they need for news articles and news flashes and fresh off the press and frankly filling time on air, is a fixation on the micro, which to be honest isn’t really relevant.

Again, yes and no. The catalysts at present aren’t economic as much as they are political and strategic. Definitely, Iran factors in. Stability in Saudi Arabia factors in. Israel – you have the regional relationships which factor in, certainly with Syria, missile attacks in Syria against Iranian-backed forces. That continues on a routine basis. And Israel remains close to a more direct confrontation with Iran, even beyond the Syrian proxies.

On the walls of our Wealth Management office you have the old brick façade and then the empire maps of the past. These are all the great empires going back thousands of years. I keep them there as a reminder that everything that we believe is permanent and will not change is entirely flexible, maybe even fluid. All of those maps, all of those empires which were seemingly unstoppable are historical footnotes as time has passed. Many of those maps are in the Mediterranean, they are in the Middle East, and I think it is good to remember from a historical perspective that oil is a sensitive indicator and it is a bit of a tell for the regional instability in the Middle East. But the Middle East is a cradle of conflict, and has been for millennia.

Kevin:It is so easy, too, when you actually live in what is the current empire, or what has been the current empire, to become very self-centered and look at the prices of things just in your own current empire. I think of these maps, Dave, and some of the past reserve currency world influencers, like the Netherlands, Spain, Britain, up through about World War II, and then the United States. I think sometimes we say, “Is something rising or falling?” And we only look at the dollar, being Americans, because we have been, and are, the current empire.

David:And of course it is relevant if you’re a commodity trader because there are a lot of contracts that trade in U.S. dollar terms. But the U.S. dollar is moving higher right now as the euro currency is correcting and the dollar is roughly three points away from its next destination point – 95 on the euro dollar index would not surprise us to see that over the next few weeks, or even a month or so. Go back a little way to January 2017, the dollar index was at 102, 102-103, near parity with the euro, basically trading at the same level before the euro jumped to 125 and the dollar sank to 88.

So we’ve moved up a little bit. Here we are at 92-93 and looking at dollar charts we probably do have headroom to 95. And if we really get a gust of steam behind us we might even get up to 102 again. But the currencies are important because gold reflects the increased or decreased value of each of these currencies. So to see a declining trend in the euro, gold is, in essence, rising in euro terms. And that audience sees a price increase and takes notice. In U.S. dollar terms, you have a modest decrease right now in gold. Of course, the U.S dollar is strengthening. In essence, the U.S. dollar is buying more ounces with the same fiat on a temporary basis.

And the weekly price averages which kind of strip away some of the daily noise and reveal more of the intermediate- to long-term trends continue to be positive in terms of the gold price. So most recently we have the 65-week moving average, which increased another dollar or so, $1287.30. You remember, that was in decline until about December of 2015 and it has been moving in a positive direction for well over two years.

Kevin:So if the dollar strengthens up to this 95 level that you are talking about, do you think we might test that $1287 level?

David:Sure. We go below $1300 temporarily and go back to $1287. You’re talking $20 to $30 from here, and the most recent move where we could not get above resistance, if you will. The glass ceiling for gold has been about $1365, and as we said, $1360 to $1400, that glass ceiling breaks and you have a significant move in the price of gold. I think we get above $1400 and you might as well be looking at $2400. Adding $1000 an ounce is not going to be difficult getting above that glass ceiling.

Kevin:And if you’re in a foreign country and you’re already seeing gold rise because your currency is falling, that trend has already begun in foreign currencies. But I think about how you have often brought up the danger of countries owning dollars if the dollar starts to strengthen and they already have debts in dollars that they can’t pay back.

David:Yes, it’s the dollar-denominated debt that is a big issue. So again, the dollar was up 1% last week, and as we will talk about here in a minute, I’d like to point out some of the foreign currencies which absolutely got decimated. Because again, the dollar strengthens in the short run and emerging market currencies see a 2x negative volatility move. So one point in the dollar creates an exaggerated move of pain in places like Brazil and Turkey and Russia.

Kevin:Yes, these are countries that probably can’t pay their debt back even if the dollar didn’t strengthen.

David:That’s right. So keep in mind, again, that currency weakness around the world, which is kind of the flip side of dollar strength, you’re expanding the audience of people who say, “Hey, wait a minute. Maybe I want to be in dollars. Maybe I want to be in gold. But maybe I don’t want to be in the domestic currency.” I agree, like you said earlier, Kevin, it is sometimes strange for Americans to conceive of a price trend outside of U.S. dollar terms.

If you live in Japan, for instance, the U.S. dollar gold price is only relevant to a trader, not a buy and hold investor who in that country would convert yen direct to gold, and thus is more sensitive to the price of the metal in yen terms. The U.S. dollar market for gold is not the largest market, by the way.

Kevin:I think that is such an important point. We think of ourselves in a self-centered way because, in our minds, gold is denominated in dollars. We’re not the biggest consumer. You named, actually, Turkey, Russia and China. These are the guys buying gold.

David:Right. Now, as we have contrasted before, the paper market, and by that I mean the futures and options contracts that you can have on any particular asset in gold, to be specific – that is still denominated by U.S. dollar traders. So if you’re looking at Chicago and New York City, it is still more important than Moscow or Istanbul or Shanghai, because the amount of paper that is traded there is amazing. That has been eroded somewhat by paper trading in Shanghai, but the leverage which is allowed for commodity speculators in the U.S. still draws them to U.S. dollar trading of paper contracts.

Kevin:Let’s look at that for a second because the U.S trading of paper contracts – that’s exactly what it is, paper contracts – there have been times when one ounce of physical gold would represent 500 ounces, or more, traded on these paper contracts. What about the physical market, though? The physical market is not dominated by the United States. The physical delivery is dominated by Asia, is it not?

David:Yes, and I think a more typical ratio is probably 100-to-1 where you have 100 ounces in claims against one available ounce for delivery off of an exchange. But the physical demand dynamics have, of course, been dominated by the Asian markets. The 2017 surprise was to see not only the euro currency strengthening, but investors in gold in Europe not being shy at all about piling into exchange-traded products.

So, your metals that you can buy with a click of a mouse – now you can’t take delivery of them unless you’re taking delivery of $500,000 or $600,000, or millions of dollars’ worth of product. There are some strict limitations to those products, which make them a good trading tool, which make them a good tool for a short-term investor.

And that’s what you saw in Europe last year. The euro is rising. Gold is doing you no favors in euro terms, and yet some of the largest purchases in the exchange-traded products were, in fact, European investors saying, “Look, the whole landscape – I don’t like what I see, I don’t like the language of normalization. I don’t know what the handoff is going to be if Draghi moves on. Is it Weidmann? Who else is going to be running the ECB, and will there be a different policy direction. What does that mean for the financial markets? I think I’m going to hedge, or begin hedging, with gold.” They were very much ahead of the curve.

Kevin:This is why I think it is so important that people read your latest report called “The Third Wave” on gold. You wrote about what this next wave will look like, and what the dynamics behind it will be, and it is not anything like the dynamics that we have seen from 2008 until 2018.

David:If you’re happening to listen to this online, you can click on the linkand request “The Third Wave” or just call our office, 800-525-9556 and we will get a copy to you. I think the equity markets, as they transition from a bull to bear, a negative dynamic, I think that is going to provide ample support for U.S. dollar price of gold and silver. A significant shift of safe haven buyers will, I think, come into the market here domestically. And I think that is what will drive the price much higher; 2011, 2012, those highs which we saw, roughly $1900. It is not going to surprise me at all to get back to that level. But again, “The Third Wave,” the article that you mention, is where I make my case for such a move, and please get a copy.

Kevin:Let’s go back to looking at things from an international point of view because regardless of how the United States investor feels, the support for the metals market since 2015 has been overseas. You’ve brought that out.

David:And that is likely to continue as long as sophisticated buyers remain concerned with global political dysfunction.

Kevin:Did you see what the guy from Egypt did? This is a billionaire, and he obviously doesn’t have confidence in anything but gold.

David:He is the second wealthiest man in Egypt and I think there are two things to consider. Number one is that he thinks like a contrarian to begin with because he has taken positions in a number of precious metals mining companies and has board seats on those companies. This isn’t something that he just snapped his fingers and said, “I think I want to own a few shares.”

He has taken a vested interest in helping the management, organization and future direction of those companies, being a board member, so that is something that has been put in motion over the years. But his comments to Bloomberg recently that he has added to those positions, significant positions in the physical metals – again, we’re talking about a 50% allocation, several billion dollars.

Here is what it really communicates. It communicates deeply what an informed, educated, connected, and wealthy investor in the Middle East sees, what he feels, what he anticipates, and the actions that he believes are quite reasonable in the context we are in today, and really, the context that he is in there in the Middle East, oil is signaling conflict on a larger scale.

Kevin:There is that pain in the left arm. It is signaling something bigger.

David:Right. Well, gold is going to echo that at some point, with many of the other contributing factors driving the price. We’re talking about fiscal and monetary policy issues combined. Here is a guy whose niche is telecom.

Kevin:So he made it in communications.

David:That’s right. This man is in Egypt. Gold is now his largest position outside of telecom. 50% is significant. And I agree with him. In the interview he talks about $1800 being a reasonable price for gold to get to, and I think that is going to sneak up on us because after rising for two years in stealth mode the precious metals are really not on the radar screen, nobody is looking at them. People are looking at FANGS, people are looking at biotech, people are looking at emerging markets because they are cheaper relatively speaking than your domestic markets here in the United States. So all of a sudden the breakout will, I think, take the market by surprise.

Kevin:We’re seeing gold rise in these other currencies, but something that we miss here in America – we sit around talking about whether we are going to have a quarter of a point rise by the Fed – interest rates are sky-rocketing in countries overseas right now. It is amazing to see. We’re talking huge jumps.

David:I think, just to rehearse what I anticipate is the pattern over the next couple of months, you have gold wanting to touch the 65-week moving average, so prices are depressed from here to $1285, $1287 – that price range.

Kevin:That’s a meaningless margin there, yes.

David:It means – no, that’s great. I mean, if you’re a buyer, these are the things that you look for, an opportunity to reasonably enter on the low side.


David:And watch for these two things to follow them – a breakout above $1400, and for the gold-silver ratio to confirm the move higher in gold by shrinking 10-15 points from the current level of 80-to-1.

Kevin:Down to 70-to-1 or 65-to-1?

David:Yes, absolutely. Silver should outperform in the next cycle, and I think the gold and silver miners will outperform in the next cycle, as well. But buying gold like an Egyptian billionaire – remember this. It’s not for profit. We talk about performance, and we talk about this and that (laughs) – I don’t think a man worth five plus billion dollars is really concerned about…

Kevin:He’s not speculating, he’s preserving.

David:No, no, it’s protection and asset preservation. Doug Noland posted these thoughts, specifically, to our Tactical Short clients on Monday. He summarizes the emerging market chaos. We talked earlier about the dollar going up 1.1% last week. The U.S. dollar goes up 1.1% and Doug says this: “The dollar index jumped another 1.1% last week as stress intensified in emerging equities, bonds and currencies. The Argentine peso sank 6.1%.”

Kevin:Yes. We went up 1%, they sank 6%.

David:Right. I said 2x – in some instances it’s more than that. He goes on to say, “As Argentina’s central bank hiked rates 675 basis points.”



Kevin:In what period of time? In a week.

David:To 40%. Their base rate is now 40% to support its their collapsing currency. The Turkish lira dropped 4.5% to a record low as ten-year yields surged almost 14%. The Mexican peso dropped 3.4%, the Polish zloty 2.4%, the Brazilian real 2%. Stocks were down 4.7 in Argentina, 4.7 in Turkey, 3.8 in Brazil, and 2.7 in Mexico.

Kevin:We talked about Argentina last week. It gave us a picture of what inflation looks like, but it seemed to calm for a while and now it’s restarting again with a passion.

David:Last week’s rates were being raised aggressively. They were already in the 30s. If you’re looking at something that is trying to keep up with inflation and squash inflation like Volcker did, this is what central banks will often do to snuff out the fires of inflation – make borrowing very expensive.

Kevin:Right. But that was last week – the 30s. Where are we now? We’re in the 40s.

David:This week exceeds 40% and the central bank is aggressively moving to stabilize the currency and address inflation head on. And again, it is sort of a last ditch Volcker-style move. Inflation figures have been creeping up, unfortunately, but it is a result of fuel and transport subsidies being reduced, for years. Under the Kirchners, fuel was almost free, and transportation was almost free.

Freebies. When you think freebies, you have to remember that this is about buying votes. How does a corrupt politician – anybody around the world could scratch their head and say, “Are they qualified to lead? How do they do this?” It’s all about who you give money to.

Kevin:Margaret Thatcher. Remember what she said? “Socialism works until you run out of other people’s money.” This is what it looks like when they run out of other people’s money.

David:Right. I think the middle class has felt the pain, particularly, of the increase in transport costs, the increase in fuel costs, and there are indications at present that Macri will not be re-elected for a second term. And if that is the case, the progress which has been made over the last couple of years under a business-minded leader will be sacrificed for pain relief. And it is of a temporary nature, but the crowd will love it.

Kevin:One of the things you talked about when you were talking about bitcoin at the Paleo Conference was that one of the movements into bitcoin came from Venezuela when people were trying to get money out of the country. We’re seeing the same type of thing in Argentina right now, right? Capital flight – you need some way out.

David:Bitcoin gives that little extra boost, but capital flows were aggressively moving out from Argentina this week. Capital flight ratcheted higher in the last ten days. Macri is in decline in the polls and they know that the man who is running against him may, in fact, win. I think you’re looking at international investors, and I think you’re looking at wealthy Argentines who have a different read, and are saying, “We had better start moving some money out.”

Argentina illustrates that when a budget is politicized and fiscal handouts become the norm, you have critical economic growth and reforms that are necessary to put some of those economic growth agenda items as a priority in motion, they can be stifled. And ironically, they are stifled by democracy.

Kevin:The dangerous form of democracy where people start voting money into their pockets.

David:I know this sounds a little bit like heresy. It’s not like I’m for totalitarianism as an alternative to democracy. But as de Tocqueville suggested, democracy loses its vitality when the mass of people figure out that they can vote money for themselves from the treasury. I think that is the conflict that you are dealing with in Argentina, an electorate that has grown comfortable with governmental fat and largesse, and they are having to operate on a more strict diet and they don’t like it.

Actually, you are seeing economic growth. Did you know Argentina has been growing at 3% a year? Their economic growth is surpassing that of the United States. Yes, they still have an inflation problem. Yes, their currency is still in a vice grip. They are far from being out of a difficult situation. But what Macri has put in place has been very helpful. That can all be reversed and I think that is what we are beginning to see in terms of capital flows out of the Argentine peso.

Kevin:Don’t you think this is sometimes the danger? We have these shorter terms in elected types of politics. The shorter terms, I love, and I love term limits. I love all those things. But the problem is, if you have a socialist who ruins the country, and then you have somebody who comes in and tries to fix it, Macri hasn’t had enough time to actually have these things take effect. We have even seen this here in the United States. Clinton got an awful lot of credit economically in the 1990s for what actually was fixed in the 1980s.

David:I think for both of us, this has been an interesting ten years doing the Commentary, but we sat here and looked at each other with this epiphany as we chatted with Giulio Gallarotti. He was explaining how after World War II there was the politicization of the budget, and since that time this has been a challenge in democracies because prior to World War II no one cared about the economy.

Kevin:The politics and the economics were disconnected.

David:And now the budget has been politicized, and to get anything done economically there is a consequence that people will feel and people have connected the dots and they vote accordingly, whereas before the consequence and the changes in politics, somehow there was a disconnect prior to World War II between economic policy and politics. So that got crushed after World War II.

Kevin:So Macri is trying to fix something that was already broken, and he may not have time to get it done before he is out and the next socialist is in.

David:Yes, and I think the U.S. is at a different stage of decay compared to Argentina in that respect. We have nothing compared with what they have had to endure – the disastrous economic policy of the Kirchner dynasty – and I think we have an infinitely longer fuse. But you’re right. I think he is fighting an uphill battle, like the doctor who is dealing with a bone that has been broken (laughs). It has already been broken and it has been partially healed, and he has to reset the bone many weeks after the break.

I feel like Macri is saying, “This is going to hurt, guys. If you want it to grow straight, if you want it to grow right, you have to take the pain before we can see the gain. Are you willing to do that?” Everybody said, “Yes, that is why we are hiring you because the other system is not working.” And now they have the pain and they are saying, “Ah, I can’t take the pain. I can’t take the pain!” (laughs) It’s just interesting to see.

Kevin:I was talking about Clinton and how he sort of inherited the economic benefit that came from the Reagan administration. Maybe everybody doesn’t agree with that, but usually there is a delay. Now, look at countries like Turkey where you see something that looks like dictatorial socialism, or whatever you want to call it over there, and it seems to be working because Erdogan just happened to be lucky.

David:Yes, on to Erdogan in a minute, but I think that we could linger on Clinton because, ironically, he was more fiscally conservative than Reagan was. In many respects, he was more fiscally conservative than either of the Bushes. There are probably conservatives whose hackles are being raised, but there have been very few presidents who have balanced the budget, and Clinton was one of them. That is embarrassing if you’re a conservative because the language and the rhetoric of the conservative party…

Kevin:Is all conservatism.

David:That’s right, which really underscores a point. They don’t give two rips – they don’t give two cents – about actually balancing a budget, about actually being fiscally conservative. It is only rhetoric, and it is for an audience. And the audience is stupid enough to believe that conservative politicians are going to follow through on what, rhetorically, they give lip service to.

Kevin:So is this the old, “There is not a dime’s worth of difference between the two?”

David:(laughs) Yes.

Kevin:Yes, I’ve heard that many times, and I think it’s right.

David:Right. But back to Macri and Erdogan, I don’t think Erdogan is anything like Macri. Erdogan benefitted from a coincidence upon his election. Yes, Clinton came in and he got to be a part of a massive credit expansion, and he got to be a part of a massive increase in equity prices. And Clinton benefitted, certainly, from the tailwinds of credit getting cheaper and cheaper and cheaper. And to some degree, Erdogan had the same thing. His first several years were not a reflection of policy perfection, but more like the market’s dead cat bounce.

If you look at the Turkish stock market, it was dead when he came in. That’s what he inherited – “It doesn’t get any worse than this.” Now you have the lira at fresh lows. He is facing all kinds of political pressure. He was on a track to integrate into the euro and ran headlong into a fight with the iron fist of the German woman (laughs). Yes, immigration has been lax in Germany, but the glide path to integration into the Eurozone was shut off by Angela Merkel.

Kevin:And with the lira low – Turkey owes the United States and awful lot of money. That’s one of the countries I was talking about. They couldn’t pay it back anyway, and now with the dollar rising against them, a default is still in the future.

David:That was an early theme for 2017. Our friend, Russell Napier, pointed out last year that Turkey has a lot of U.S. dollar-denominated debt. And that becomes much more burdensome with the strengthening of the U.S. dollar relative to the lira. The lira is at all-time record lows. That is the kind of environment where defaults are not unusual – not unusual in the history of credit, when these elements are in play, which goes back to Noland’s summary. Emerging market pressures are axiomatic in a rising dollar market. So the reprieve that we have had as the dollar moved 10% lower in 2017 is the emerging markets fared much better. Now we get to see that in reverse where emerging markets are under pressure.

Kevin:When you reverse something that people have enjoyed for years and years, it can be really quite a shock. And corporations here in the United States have been taking advantage of these artificially low interest rates. Now interest rates are starting to creep up, and I think before the last financial crisis corporations didn’t have near the debt that they have now.

David:Right. So consider this. You have national governments who love the fact that interest rates are low. And they are willing to take advantage of increasing their balance sheets and financing things with debt, and they are doing the majority of it on short-term paper – ten-year, five-year, two-year, or less. There are a handful of corporations that have financed themselves in 20-year and 30-year paper, even 50-year and 100-year paper. That’s amazing. That’s actually pretty intelligent.

But twice in the last week there have been excellent print articles on the issue of corporate leverage, and I think these are worth looking up and reading. Bloomberg covered it first on May 2nd, and then The Economist in this week’s print edition. And both came to the same exact conclusion, that structured finance, while that was at the epicenter of the last financial crisis, and the consumer was the weakest leg of the stool, at present it is corporate debt which is the weak link, far more than consumer debt.

And so your creative CDOs, CLOs – all of the derivative products which brought us the nightmare scenario of 2008 and 2009, with the consumer being implicated – both of these articles make the case, “No, not the next time. The next time we have fairly well cleaned up the private party balance sheets, that is, the consumer balance sheets. They are in a lot better shape. The massive expansion in debt since the global financial crisis has been, of course we know, on government balance sheets. That’s not really concerning because you can inflate it away or default with limited consequences.

Kevin:Corporations can’t print their own money.

David:That’s the real deal. Corporate debts are the other massive elephant in the room. Company executives have fallen prey to the temptations of cheap money. And you don’t have to worry about staggering levels of debt as long as debt service levels remain low. From a cash flow perspective, as long as rates are low, massive amounts of debt are not a burden. That, of course, is a function of interest rates.

As interest rates rise (laughs) the real issue emerges for those entities that don’t operate a printing press. So the contrast between the governments and corporations – this is where the rubber meets the road. This is where corporations get into the crosshairs.

Kevin:So we call the old 2008 crisis the global financial crisis, but the next one could be caused by corporations, the corporate global financial crisis.

David:Yes, the global corporate crisis. Only a select number of corporate balance sheets were in bad shape prior to the GFC, the global financial crisis. And The Economistarticle explains that now nearly 40% (37%) of global companies are highly in debt. The argument has been that debt is a more efficient way of raising capital because you have the interest payments, and along with the interest payments you have the advantage of tax deductibility with your interest payments. So it is a very efficient way of raising capital without giving up ownership.

But what The Economistarticle also notes is that as rates have fallen debt levels have increased. Of course, the quality of the borrower has also been sliding, so your average credit quality was, say, A-rated among your corporations, taking in debt to your triple A level and saying, what’s the average? A. Now it’s triple B.

Kevin:People have been buying stocks now on autopilot, especially since we have the passive investment thing going. I don’t think people look anymore at the actual debt of a company when they are buying their stock. They just say, “Hey, I think I’m going to buy Apple today, or Amazon, or what have you.” They don’t look at the debt of the company. At some point people are going to have to go back and do what stock buyers have done all through history and look and see what the equity versus the debt of a company is.

David:Something that Dave Burgess does in our office when it is quarterly earnings season is listen to the earnings calls, and we will get on some of those calls, and of course we see everything that everyone else does on Bloomberg and CNBC and so and so, the earnings per share estimates by a penny or five pennies, or whatever, and we go straight to the balance sheet. And we say, “What did they have to give up to get that penny?” And oftentimes what we see is this ratcheting higher in debt. Sometimes they get it by acquisitions, an increase of revenue by acquisitions and debts going off the charts.

And if you don’t keep in mind this balance, what you have on a balance sheet – assets versus liabilities – if you don’t keep in mind the debts and the increase in debts, you don’t really have a clear picture. You don’t have a clear picture of Apple’s earnings last week if you don’t look at inventories. Inventories were up 164%. Something is not going well with Apple. They only saved the call, and saved investor sentiment last week by saying, “We’re just going to give you lots of money. We’re going to buy back 100 billion dollars’ worth of our shares.” Meanwhile you have rot in the Apple. Look at the inventories. If you look behind the scenes there is a little bit more rot, whether it is balance sheet or inventory levels, at a number of corporations.

Kevin:And you brought up last week that insiders – the CFOs, the guys who actually run the companies – are divesting from their companies right now. They obviously see this.

David:The Caterpillar CEO got in hot water after his earnings call because he said, “This is it. This is as good as it gets.” (laughs) Caterpillar sells off 6% instantly as people say, “What do you mean, this is as good as it gets?” He is just saying what he sees.

Kevin:Don’t be honest.

David:Well, isn’t that the case? Keynes used to say that investing is a little bit like a beauty contest. You don’t have to pick the prettiest contestant, you have to know how the judges are going to vote.” And in this case, the Caterpillar CEO just said, “Hey, I don’t need makeup, we’re not wearing makeup, I’m not going to wear makeup. You’re going to have to wake up to something that’s not quite as pretty tomorrow.” That is, in essence, what he was saying. And the market was like, “Uh, no. I don’t think so.”

Kevin:Yes, so that’s CEOs. CFOs, the financial guys, are also taking notice at this point.

David:Well, rates are rising. CFOs have to take notice because rates are beginning to rise. And when you look at the mountain of debt that you have accrued and know that you are going to have to refinance it or pay it off, you have either got a liquidity crisis or a refinancing issue which could ultimately impact your earnings and income in the future – yes, they are taking notice. Matt King from Citi Group drew attention to this in a Bloomberg article this last week, equating it to chairs being removed from a game of musical chairs. Central banks are withdrawing stimulus. Rates are normalizing, that is, they are going up. And it is like removing chairs from the game.

The same Bloomberg article echoed concern. A gentleman by the name of Greg Litman – he used to work for Deutsche Bank, and was one of the traders that put together the Big Short, profiting significantly when the subprime meltdown occurred – said this: “Companies have been the ones gorging the most on ultra cheap interest rates during the past decade. If the first quarter volatility is a harbinger of something bigger, I think that we are going to see a lot more trouble in the corporate market and in the equity market that in the structured products market.”

We have commented about this before. There is an asymmetry in the bond market. You find huge amounts of traffic that goes into a bond market, but when the dynamic shifts from bull to bear, you end up with a very different kind of market. It’s like gridlock.

Kevin:Yes, nobody wants to buy. Everybody wants to sell, nobody wants to buy.

David:Have you ever been on the 5 Freeway in five o’clock traffic? Nothing moves. The Credit Bubble Bulletin, I think, summed it up well this last week. Going back centuries, the money market has traditionally been the financial crisis epicenter. From traditional bank runs to the 2008 run on Lehman’s repurchase agreements, it’s the panic liquidation of previously perceived safe and liquid instruments.”

Doug continues on, saying, “Money has special attributes to be coveted and safe-guarded. To purposely bestow the perception of moneyness upon risk assets,” (and in this case, Kevin, I’m suggesting that this is what we have done with corporate bonds. We’ve given them money-like qualities when, in fact, they are risk assets.) “When you do that across asset classes on a global basis, this is one of the great transgressions in the history of central bank monetary management.”

Kevin:To treat bonds as money – they’re not liquid like money. They may be liquid when you’re buying, like you said, but when you need to sell, it’s not money if you can’t sell it.

David:No, and that’s the five o’clock traffic jam in your credit markets. You give them money-like attributes, under certain circumstances things flow, and then all of a sudden circumstances change and you come to a grinding halt. And everyone says, “But I thought … but I thought … I thought I could just sell with the click of a mouse.” Particularly, junk bonds and lower quality corporate bonds have been described as trading by appointment (laughs). Do you remember, actually, a conversation we had with Jim Deeds a few years ago?

Kevin:I was just thinking that – with the stacks of bonds in his boss’s office.

David:That’s right. This was back in the day, obviously, before digital settlement. You provided your stock certificates, or your bond certificates, upon liquidation, and then ultimately the transaction settled. But no one was buying, so the branch office that Jim Deeds worked at – they were just stacking up bond certificates, floor to ceiling bond certificates. There was no buyer on the other side. It was, literally, by appointment. “When we find a buyer, we’ll let you know.”

Kevin:“We’ll call you.”


Kevin:There is almost always a buyer for something at enough of a discount, but the problem is, if you’re a bond-holder you don’t want to sell at a discount. A bond is supposed to be something where you see stability. We were talking about this at the meeting just a few minutes ago before we started recording, Dave, how stocks and bonds – your stock broker is going to say, “Well, if we’re aggressive we’re going to go into stocks. If we’re conservative we’re going to go into bonds. The problem is, in this particular case, you’re going to see stocks and bonds falling at the same time.

David:I think this is interesting because Mnuchin just this last week said, “Look, we successfully financed over 480 billion dollars in the first quarter. We can do this again and again and again. We’ve proven that there is an appetite for U.S. debt. We’re not concerned about expanding at a faster pace than possible.”

Before we wrap up today, Kevin, I think we would be remiss – our comments would have a void – if we didn’t mention the twin deficits. We are expanding our budget deficit considerably.

Kevin:And our trade deficit.

David:On the one hand I appreciate Mnuchin’s confidence, but I think it is bordering on over-confidence. Do we reach a tipping point in the bond market as we see these government auctions come off, and do we see 2018 as a real turning point? I think we very well could. Maybe that’s later in the year. Watch interest rates. Are we going to continue to see them rise? Are they going to tack on 75 basis points later in the year? And will that help or hurt us? I think time will tell. The other deficit, the trade deficit, is interesting. We are increasing, on the one hand, with the Chinese, decreasing with Germany and a couple of our other trade partners. And we spent the weekend debating our priorities with the Chinese.

Kevin:You were telling me that everybody went in with smiling faces to start with. It looked like things were going to happen.

David:Monday’s reports were that the weekend was a disaster. We agreed to nothing. And then, of course, Tuesday of this week you have Trump saying, “Look, we’re best friends. We’re sorting this all out.” (laughs) Very nondescript. The larger issue with China is really not this trade deficit issue, and it is not if we can shrink our trade deficit by 100 billion a year between now and 2019, 200 billion between now and 2020. That, frankly, is irrelevant. It is about who is the largest and dominant economy in the world. It is about, ultimately, who has the world’s reserve currency.

Kevin:And China is saying, “Oh, that would be us.” As far as the largest economy, that happened two years ago. So they are saying, “Oh, that would be us, but you still have the reserve currency.”

David:And that is only on a purchasing power parity basis. We still are the world’s largest economy – the U.S. is – but they’re number two if you don’t aggregate all of Europe. Germany is close. It’s still in the top ten. Obviously, Japan is still in the top five. But the trade deficit is not the issue. The issue is, they are flexing their muscle, and they’re doing it more aggressively, not only in economic terms, but also in physical military terms.

We mentioned last week, or the week before, the radar jamming equipment they put out on the Spratly’s. What I failed to mention is that they also put surface-to-air missiles on the Spratly’s, and have the ability to not only take out boats, but planes, in this contested region of the South China Sea.

Kevin:Oh, but it’s not military at all. It’s just like having a security camera at your business. This just happens to blow you up.

David:Right. So the larger issue is regional hegemony, ultimately global hegemony, and there is a tug-of-war going on right now. Circumstances are going to have to play out, I think, over the next five to ten years, where we know for sure if we’ve lost control or ceded power. Go back to 1956. This is many years, over a decade after World War II. Not only should it have been plain that the British had lost power and dominance in the financial markets, but it was really only the final nail in the coffin. This is Suez, 1956, where it was clear that the British had been beat. They were no longer the dominant global power.

Kevin:You could see the signs coming, like you said, a decade, maybe two decades, before. But that was it.

David:And there was an erosion that was occurring all along the way. There was an erosion which was occurring even in the 1920s and 1930s. World War I, they took a beating. World War II, they took a beating. And they never really recovered, but neither did the world concede the defeat of the once great – controlling 75% of the world’s land mass is not a small feat, and yet, it was finally done in 1956.

That’s what is in play with China. What is in play is a multi-decade game for who will dominate and control most of the pawns and critical pieces on the global chessboard.

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