The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
“When the mass is moving a certain direction, try to stand back and appraise it as objectively as possible, because history, as a guide, will tell you that the majority is always wrong. The majority is being clustered and focused by central planning in such a way that is driving new and different behaviors, and those behaviors, ultimately, are not sustainable.”
– David McAlvany
Kevin: David, you’ve had a chance to think about relationship this weekend. I know that you had gotten a call that you had lost a family member and you jumped on a plane and went out to the service. You just shared some thoughts with some of the folks here at the office that I thought would be worth reviewing in reference to legacy and relationship.
David: Larry was a solid guy, and the family, what they remember of him, not that he was a successful banker – he was that, retired at age 55, died at 79, spent quite a few years shucking pecans and playing golf.
Kevin: Reading books.
David: Reading books. His father was a member of the Atlanta Fed and his entire career was in banking. It reminded me that how we spend our lives, with whom we spend our lives, the conversations that we have, the relationships that we advocate for, the places where we invest relationally, this is where real impact lies. Because honestly, it doesn’t matter, square footage, the size of a bank account, all of these things are the niceties of life, but guess what happens to them, ultimately? They go away.
Kevin: You had a particularly fond spot in your heart for him because your dad, honestly, amongst bankers, and amongst, I would say, the elite class, is sort of an oddball, and your uncle, even though he was also in the banking industry and fit right into that, was a real champion for your father and his unique ideas about the economy.
David: It’s interesting, looking at the expectations of my father, coming into that family. He didn’t really fit.
Kevin: I wonder why.
David: Well, and he didn’t really represent social progress (laughs). He was regress in the family story. Larry was very generous. He was very adult and we’ve always thought highly of him.
Transitioning to this week and seeing Hugh O’Brien and Phyllis Schlafly both pass away, Hugh O’Brien, of course, the Wyatt Earp from the 1950s, and Phyllis Schlafly, very influential in social politics from a conservative perspective.
Kevin: Hugh O’Brien, an all American cowboy, and Phyllis Schlafly – your dad knew her.
David: Both champions for particular causes. Just reflecting back to what inspired Hugh O’Brien, it was an encounter with a doctor in Africa. That encounter made him reflect on his life and think, “There should be more purpose in what I do. Yes, I’ve made some movies, yes, I’ve made a few million bucks.”
Kevin: He was sort of a millionaire playboy up to that point, right?
David: And all of a sudden he wanted his life to matter, and he made a very different set of choices the last 30-40 years of his life. Very interesting to see someone driven by purpose as opposed to just finding a place in the cultural milieu, which he had already done through his movies. So, I thought it was an interesting weekend. Coming through Labor Day I was reflecting on the value placed on different people and the things that they have done. We could point at the biographies of each of these people, including my uncle, but really, what has mattered most, if you were to sit at the funeral service for any of them, is the way in which relationships were developed, and mattered. Where there is a lack of relationship there is bitterness and sadness, and where there is flourishing relationship there is a deep sense of satisfaction and gratitude. And you can tell the difference.
I don’t want to say I like going to funerals, but there are interesting observations that you can make at any funeral about the qualitative side of someone’s life, which is fascinating, because as we have talked about GDP, as we’ve talked about economics, as we’ve talked about the things that today’s social scientists try to measure and put a value on, actually, the things that we care most about in life, are difficult to put a value on. That’s part of our conversation with Diane Coyle last week, the difficulty that those who calculate GDP have in putting value on things that, to some degree, transcend value as we can calculate it.
Kevin: She brought out that her dissatisfaction with what we measure. It’s not only inaccurate and liable to some manipulation by the powers that be, but it also just doesn’t measure the important things. She talked about the way the Victorians 100 years ago made decisions based on looking forward 100 or 200 years. If they built a Victorian type of building back in the 1800s, that building probably is still standing today. It is the same thing with institutions.
I was talking to a client, Dave, about the GDP discussion with Diane Coyle, and the client, a very loyal listener to the Commentary, said that it reminded her a little bit of what Tomas Sedlacek was talking about, as far as, are we measuring what’s important? Are we really looking to the long term? I think of the new book that you have written that will come out in November on legacy. That’s what you’re really pleading for people to look at, at this point, to stop looking at the short term, and look at the long term. We could go on and on about legacy, but it’s important for our listeners to continue to try to realign their thinking that way, and maybe look through those glasses.
David: While I was in Mississippi, I was reminded of my cousin who is in the mortgage business, and we had a conversation while I was there. He is actually in Louisiana. I loved listening to him describe the corporate culture that he has, through many years, developed. As you know, there were recent major floods in Baton Rouge and other areas in Louisiana. It was just interesting to see how they took that in stride. Forty of the folks that he works side by side with every day, their houses were destroyed, and they needed to get those people back into a position of having hope, of having perspective for the future. The company came in and just basically said, “Look, we’re going to help you.” They had their houses gutted, they’re in the rebuild process, and within a week they had 95% of their employees back to work, and within two weeks, 100% were back to work.
Kevin: Wow. And this was originated by the company, not the government.
David: Yes, that’s right. Something else that I thought was interesting as we were talking, employees, right now in their business, the mortgage business, are making more money than they ever have before, and yet – this is something he mentioned which I thought was fascinating, and this was actually prior to the flooding, loans from the company are the highest they’ve ever been.
Kevin: What were the reasons for that?
David: He cited health care costs and a rise in rent as the two killers. We’re talking about rising prices, which are basically crowding out a potential increase in consumption. This goes to what Albert Edwards at Societe General has pointed out, that the U.S. consumer is the crutch for U.S. GDP growth. Without consumption growth we lose GDP growth, and in fact, if you take out the consumer to any real degree, you swing from positive economic growth to negative numbers. So as I’m conferring with my cousin, he is amazed that even with an increase in pay in his industry, people are more strapped now than they were back in the halcyon days of 2005, 2006, and 2007, when the mortgage business was booming. Yes, they went through a crunch period, but actually, they’re back, baby, they’re back.
Kevin: Yes, so wages are rising, but they’re not rising fast enough to keep up with health care, and then, you brought up rent.
David: Right. Essentially, healthcare costs are on the rise and you have Obamacare which is crushing the consumer by transforming healthcare into an increasingly expensive proposition. So here I am on my return flight from the south, I’m having a candid conversation with a gal. I didn’t get much sleep for about a 48-hour period, to be frank, but I’m an extrovert through and through, so I’ll feel compelled to chat with the person next to me, and she was more than willing to share that things are tight financially and she is willing to take the fines for non-enrollment in Obamacare, because she can’t afford to be in the system.
Kevin: Right, which is contrary to what it was supposed to be originally.
David: I know. So there is this growing divide between the interests of the state and the individual. Think about this. I can tell you how the individual acts and what they choose when they’re put under pressure. Unfortunately, I can also tell you how the state responds. If you go back to our commentaries with Robert Higgs, the leviathan will do anything it has to, to stay alive. So, in regard to our monetary system, I think we are getting ready to see similar things – top-down controls, cashless society stuff. Go back to Larry Summers. He was an advisor with the Obama administration, before that, President of Harvard University, and we’ve talked about him for many years because of his contribution to the Summers-Barsky thesis and his understanding of gold and the relationship between gold and interest rates.
Kevin: He’s calling for negative interest rates to last for a long, long time.
David: What he is suggesting is that there is secular stagnation, and the economy is going to be in the doldrums for a very long time. When you think about that, you think about current monetary policy and yes, low-to-negative interest rates become an enduring reality if, in fact, that is the case.
Kevin: Right, probably along with quantitative easing.
David: Right. So, we have to see, have we had the labor market improve? Sure, to some degree it’s improved, but we have to see if wage increases are sufficient to offset the increase in rent, the increase in healthcare costs. This is not hard science here, but anecdotally, talking to my cousin, I’m excited for him, his business is doing well, but he has just put out a little mini-crisis with the floods which were impacting a large number of employees.
Kevin: He talked about healthcare, but he also brought up that rent is rising. Why is rent rising? Aren’t we in a deflation at this point?
David: It’s ironic. We were talking about business-related things and he said, “So we have a reasonably big business today, but I’m 100 basis points away from being a small business.” So, interest rates move in one direction or the other and the mortgage business is dramatically impacted by the cost of capital. Why is rent on the rise? Look at low rates and think about this. You have low rates, which spur asset price inflation.
Kevin: Yes, the stock market has been doing just fine, thank you very much.
David: Real estate has recovered and moved to new highs in many places around the country. You have old property owners who are looking at the value of their properties and saying, “Now is not a bad time to sell.” They monetize the assets, they exit the market at all-time highs, they cash out. Now you have new owners who are staring a low-return asset in the face and to boost yields on returns, guess what happens? They start raising rents so that they can live for a longer period of time and take in the vagaries of the markets, which might be not having full occupation. And that’s what they’re trying to do is create a little bit more cushion so they can deal with what you sometimes see in real estate – vacancies.
What I am suggesting is, this is a sign of mal-investment, or an exaggerated interest in income-producing properties, with any yield, as a result of traditional savings and investment vehicles looking so unappealing because of the prevailing interest rates being so low. So, you either have no yield on the one hand, or you say, well, I guess I could have a real asset with an income stream, as well. Yes, I’m paying a lot for it, but, tell you what, 4% beats nothing, 3.5% beats nothing. So, we’re seeing the transformation of the property sector as the result of low interest rates.
Kevin: Talking about malinvestment, when the central banks keep interest rates artificially low, like you said, there is a point where negative interest rates cause people to vote with their feet. You brought up how you could barely get a safe in Japan, they couldn’t get them in there quick enough, because the Japanese were pulling cash out of the banks.
David: That’s right. Back in July we were talking about the demand for gold on the increase as a consequence of trying to stimulate the economy using negative rates, and the response from the consumer being, “Why should I have money sitting in the bank, or why even sit in yen, when I can have gold, or worst case, yen sitting in a safety deposit box? At least I’m not getting taxed by a negative interest rate.” The Wall Street Journal reported this last week that German savers are doing the same thing, moving from savings accounts to home safes. This mirrors what happened in Japan earlier this year. It’s important to recognize some of these strains, and connect the dots. We mentioned some of the articles from Ken Rogoff and some of the academic work being done by Michael Woodford, who wrote Interest and Prices, and we have Rogoff with his new book out this month called The Curse of Cash. He makes this elaborate argument that we should avoid cash altogether because of its many nefarious uses “Don’t you know the underground economy is driven by it? All kinds of bad things happen, from human trafficking to arms trafficking. We would have a cleaner world if we weren’t dealing with cash.”
Kevin: And he’s right on those things. All of those things occur with cash, but like Otmar Issing said, who was the head of the European Central Bank for seven years, “Cash is coined liberty.”
David: This is, I think, what people have to remember. When someone presents an argument, you may say, “That was a compelling argument,” but why was the argument being presented in the first place? This is what ends up being so disingenuous about Rogoff’s book. His real purpose in writing the book is to create a popular appeal for something that academics say they need, to continue foisting negative rates on the financial system, and eliminate this opt-out that we’ve already seen in Japan, that we’ve already seen and is being reported by the Wall Street Journal in Germany, where they’re basically saying, “Look, if we’re going to be put under the gun, if we’re going to be put under pressure, and we’re going to be taxed via negative interest rates, taking financial repression to a new extreme…”
I’ve seen studies where if you applied the Taylor rule to the crisis dynamics of 2008 and 2009, we could have had rates as low at negative 9% in order to accommodate inflation, deflation, and the machinations of the financial…
Kevin: If they were using this policy up to that point, but it only started in 2014.
David: Right. Rogoff is saying, “We need these tools in place prior to the next crisis, and we must have them because what we’re really fighting is evil.” It’s just interesting to me that he can create an argument around the idea that not only are we rock stars as central bankers, but we’re also going to be superheroes.
Kevin: And to his defense, we may not agree, necessarily, on his cash position, but he and Carmen Reinhart wrote an excellent book called, This Time is Different. There is an understanding of economic history, the past defaults of the last 700 years of various governments. He is seeing this and he is saying, “Well gosh, maybe we don’t have to default. Maybe we just take people’s right to their money away.”
David: You’re right. I remember late 2009 I was on a plane to Buenos Aires, Argentina, and that was the book that I wanted to take with me and read while I was on the plane – overnight flight, a good 10-12 hours to read. And man, I learned so much. I have a debt of gratitude to Rogoff, and to Reinhart, for the insights they brought in the study. And listen, they’re both very good academics. I’m just saying there might be a blind spot on Rogoff’s part in thinking that what he is doing is solving one problem, and not seeing that he is actually creating other problems in the process. And yes, it may be an elegant solution to get rid of cash – those are his words, “an elegant solution” – but there different things that get put in motion from a socio-cultural perspective, which are outside of the elegance of the economic math.
Kevin: You’ve talked about equations and how you can sometimes try to fix an equation, but actually make the problem worse, and in this particular case, you’re right. You take the ability of people to make a choice to walk away with their cash, the central bank equation becomes far easier.
David: There is more than a small bit or irony in that central bank policies have created conditions that, to some degree, undermine recovery and increase risk in the sector. That applies to real estate, but ultimately it applies to banking as well. You have the CEO of Deutsche Bank saying, “Negative rates are killing us.” As an institution, Deutsche Bank is up against the ropes. Why? They’re up against the ropes for many reasons, but his argument is that interest rates are certainly not helping, they’re hurting us as a financial institution. So again, central bank policy steps in to help the financial institution, now they can’t get out from what they’re doing, something of a trapped position, if you will, and it’s hurting the institutions they were originally going in to help. Again, I think people are having a hard time with connecting the dots between policies that are put in place, and ultimately, seeing the socio-cultural impact, the change in market behavior, if you will, as a consequence of that. You have that with Dodd-Frank, as well.
Kevin: The Economist magazine had warned about Dodd-Frank, that there were a lot of unintended consequences and confusion, and a huge, huge amount of verbiage that could hardly be analyzed correctly because of the complexity of it. Speaking of money markets, all the years that I’ve used money markets, I just expect a dollar a share. I put a dollar in and I expect it to at least be a dollar when I take it back out, along with, hopefully, a little bit of interest.
David: Right, so if money markets are the equivalents of cash in a brokerage account, or in an IRA, that is changing this fall as a consequence of Dodd-Frank. If it is a money market fund which has anything other than treasury bills, that money market fund is going to have a floating value. If you’ve grown accustomed to thinking of share prices as one dollar, constant value, great. But understand that in a zero interest rate environment, these funds can barely exist without taking more risk, which quite frankly justifies a floating share if they are taking more risk. It’s also important to keep in mind that the safety-conscious investor says, “Maybe I don’t want to have commercial paper, maybe I do want to have treasury market exposure. And so the only way that I can have the guaranteed dollar value in, dollar value out, without fluctuating value in between in my money market fund, is to buy treasuries.”
Kevin: It’s an amazing gun to the head, if you think about it, because you’re sitting there saying, “Commercial paper might get me a little bit of interest, but I want that dollar-per-share guarantee.” Only the government is allowed to guarantee a dollar-per-share guarantee.
David: How convenient. It ends up driving yields in the treasury market even lower, or perhaps even more negative. And at the same time, it shrinks liquidity in the commercial paper market by seeing those safety-conscious investors step out of commercial paper or other forms of liquidity that go into a money market fund, and into a treasury-only fund.
Kevin: It sounds to me like this is going to drive interest rates up in commercial paper, Dave.
David: And all this is compliments of your negative or low interest rate policies.
Kevin: Dave, you brought up Deutsche Bank. They’ve been in the news pretty consistently now for the last few months. They’re crying foul on the low interest rates. They’re looking at their own books and saying, “We can’t survive this.” But their own analysts right now are saying, “If gold would be left alone it should be $1700 an ounce right now.
David: It’s an interesting conclusion to come to. Their analysts highlight the correlation between central bank balance sheets and the price of gold, concluding that any increase in the scale amongst the four largest central banks, the European Central Bank, the U.S. Fed, the Bank of Japan, and the People’s Bank of China. You’re talking about the big boys’ club. At the four largest central banks, you’ve seen their balance sheets, in aggregate, grow by 300% since 2005, and that should reflect itself in the gold price and their conclusion is that the dollar gold price should be right around $1700.
I think it’s very interesting, this is not a part of their research, but if you look at the St. Louis Fed annual meeting at Jackson Hole this last couple of weeks, what was one of the take-aways? Subnote: One of the papers presented – and this is why footnotes are always important – one of the footnotes in one of the papers presented says, “Look, we don’t have to take rates negative, but we can have a similar economic impact if we expand the central bank balance sheet by other assets. But we should consider expanding the bank balance sheet at the Fed to 10 trillion.”
Kevin: Which is doubling, or more than doubling.
David: More than doubling, from 4½ trillion today. Keep in mind what we’re talking about. I think there is some rationale to what the Deutsche Bank analyst is suggesting. Yes, a correlation between the gold price and central bank balance sheet size and scale. So, if gold is allowed to behave as a currency, that’s what happens. Two exceptions to this correlation were 2008, when gold sold off, even as central bankers started to get really active in the market. That was temporary, and ultimately the correlation came back into line. But 2013, when central banks intentionally massacred the price of gold in an attempt to break down the psychology in that market and bolster or boost interest and belief in the economic recovery meme at the same time. Again, we already have correlation re-emerging, and the gap to fill is about a $400 gap to fair value.
So if you want to keep in mind that the Fed is moving toward that idea of a ten trillion dollar balance sheet, you can do the math. Central bank activism is going to be a critical driver of private party gold purchases over the next 3-5 years as gold remains one of the only viable opt-outs from a financial system which is growing in terms of its leveraged risk which is built upon an economic base that is dwindling. Think about it. This last week you have Hanjin Shipping, one of the largest shipping companies out of China…
Kevin: Right, they just declared bankruptcy.
David: That’s right. Why? Well, in a period of growth, if you have lots of debt, your growth is covering over the need to pay the finance monster. But if your economic activity slows at all, if your business activity slows at all, and you have too much debt, guess what? Debt takes you out of the game. So we’ve had a slowing in global economic activity, the shipment of goods and services, from Asia to the United States and to Europe, and guess what? Now one of the big boys fails. We just need to keep in mind the risks involved in high degrees of leverage, which is to say, when you have lots of debt in the financial system, you’re moving onto thinner and thinner ice.
Kevin: Talking about central bank assets, ten trillion dollars over at the Federal Reserve, you asked the question, what would the gold price be? I think it’s worth repeating, an unusual thing that a person really ought to get a piece of paper out and make a list, go back to the 1970s, gold started at $35 an ounce. So write $35 down. Above that and to the right, go ahead and write $190, because of course gold rose to $190 by about 1974. And then it fell.
David: Close to half.
Kevin: Yes, it dropped to $105. Write $105 down.
David: Two-year cyclical bear market takes it to $105.
Kevin: And then finally, as everyone knows, we saw the Russians invade Afghanistan, we saw the Carter years, we saw the inflation. But by the end of the 1970s we saw $850 gold. That’s the last figure you write down. Here is the unusual thing, and you’ve brought this out, David. Add a zero to each one of those, $350 gold was where we were at in the early 2000s.
David: $1900 is where we peaked a few years ago.
Kevin: Back in 2011, yes. And then we dropped to $1050, roughly, which is adding a zero to that $105.
David: And we don’t know where this game ends, but in a game of musical chairs where you have the array of central bankers playing the music, how do you guarantee that you have a chair? How do you opt out of the whole game if you think it’s just a dangerous game to begin with? I think gold begins to see the kind of play that we saw late 1970s – 1978, 1979, 1980, 1981. In that time frame, the swing vote in the market, which was the investor, came in, in a significant way, and took what was a very inelastic market when you look at where most of your mined gold goes each year, into jewelry, into industry, what have you.
It’s a very thin market to begin with, a little bit of buying drives the price up. A little bit of selling drives the price down, which makes 2013 so significant, because it was a lot of selling, and it wasn’t the market practitioner, it was central banks hammering the gold price to make a point. You can see that on the other side, too, as we’ve seen, and I think we will see over the next couple of years, taking us exponentially higher. Why? Because, again, it doesn’t take very much at the margin, in terms of buying, to be compensated for, or adjusted for, in terms of the price moves.
Kevin: Let’s look at what happened in 2013. Gold wasn’t just hammered, but the stocks were very actively purchased at that time. The asset purchases that we were seeing were somewhat backed by Federal Reserve largesse. Look at the stock market now. Marc Faber has pointed out in the past, when a stock market starts range trading after making new highs, it very well may be a top.
David: Where are we? Where are going? That’s what the market is asking when it is range-bound. Where are we, where are we going? Is there a catalyst for decline, or is there a catalyst for growth? And in the absence of either it just kind of sits there and goes nowhere.
Kevin: And we’ve been in the 18½ range for a while now in the stock market.
David: If you’re looking at the summer months, this has been a very dry, boring, slow, range-bound summer. What does that open up? Could the market go higher? Certainly, it could, but what would that catalyst be? It has yet to be revealed. I can think of at least a couple of things that might cause a significant decline coming into the end of the year. If you look at the last two hand-offs, we just finished the Olympics and there was some interesting things to learn about passing of the baton. The passing of the baton between the Democrats and Republicans, to the Bush administration, you had a 40-45% decline in stocks on that baton pass, because of market uncertainty about what would change, what policies would be implemented, and what the ramifications were for asset values moving forward.
Kevin: I think I know where you’re going with this, because 2008 – look at that.
David: We went from the Republicans to the Democrats, and again, a 40-45% decline, coming through October, November, December, with those being very, very dicey months. Yes, we could see the Fed raise interest rates 25 basis points later this month, but it still makes me think that we could have a potentially disastrous October in equities. You can hardly call 25 basis points tightening, in terms of monetary policy, but I think that the hand-off from one party to the next is enough to be very disconcerting for the global equities markets.
Kevin: There are tensions rising on globalization. Globalization is merely the ability of countries to do business with each other. We had the G20 meeting this week, and I don’t know if you noticed this, I know a lot of people did, but when Obama’s plane landed in China they did not roll up a ladder to let him off. He had to come out a different exit. There was a red carpet, but there was no ladder (laughs). There is tension right now. The Philippine president doesn’t like Obama, the Chinese are treating him pretty coldly right now during the G20. Harold James, one of our guests in the past, worries about the breakdown in globalization because when that happens, a lot of times, violence increases.
David: If you haven’t read James’s book, The End of Globalization, you have to. That’s a must-read, not one just to have on the shelf, but a well-worn copy on the shelf is better. He brings some very valuable historical insights into that. He wrote about that almost eight years ago, keep that in mind. This is a book that is getting some age on it, and he said then what is happening now. Globalization is on the ropes, the G20 is trying to re-invigorate and encourage trade cooperation and financial flows. You have the Chinese, and the center of their world and attention is the new Silk Road, what they call the one belt, one road project in China. It opens up possibilities for growth between China and the European continent. And of course, it is a policy that is good for China. But you have to look and say, in terms of U.S. economic dominance, do we want to compete with the Chinese? The policy is good for China. It’s at odds with U.S. economic dominance. I think they should pursue it. Of course they should.
Kevin: If you’re a Chinese person, of course.
David: Well, that’s right. I’m just suggesting that the U.S. State Department officials are not going to make it easy. You have the inclusion of 4.4 billion people that benefit or participate in, and are touched by, this project called the new Silk Road. It basically creates the center of the economic universe as the Chinese economy.
Kevin: They’re talking about it being twice what the United States economy is within a matter of two decades.
David: So if you saw projects that included 4.4 billion people and affected, ultimately involves dozens of countries, as the State Department, would you be underhanded from behind the scenes? I think we’re going to be. I think the day we get caught being underhanded with the Silk Road project, you want to see cold relationships go icy between the U.S. and China? There you have it.
Kevin: Strangely, Harold James points out in his book, when tensions are rising and things aren’t going well, people become nationalistic. They start drawing their protection in, start talking about building a wall. That becomes a more popular type of theme. Immigration seems to be a very big deal when people are hurting or they are strapped.
David: That’s very true, and you see the same theme developed in several of Niall Ferguson’s books several of his books dealing with World War II, where he basically says, it’s not always economic decline that causes an emphasis on immigration and a focus on the other, differentiating us versus them, but just any economic change where you have someone who is advantaged and someone who is disadvantaged. That is enough. Economic change, itself, creates enough social cultural tension to exaggerate a trend toward xenophobia, racism, or in this case, just a concern of, “Will I have a job if we keep on bringing people in who may ultimately displace me?” Immigration playing on that fear, to some degree.
Kevin: Sure, because the pie is shrinking, and you’re wondering if you’re going to get a piece.
David: So G20, the conversation is, of course, how do we re-invigorate and encourage cooperation. The problem is, the fly in the ointment is, the global economy is not growing as it once was, which means, as you say, the pie is beginning to shrink, and all of a sudden we have immigration and domestic national concerns coming to the fore, and that ends up displacing a political will which would otherwise be focused on being more magnanimous and generous with everyone, increasing trade deals and capital flows. Instead, you’re seeing them be constrained.
Kevin: It’s not just immigration. At this point, when we’re talking about shrinking pie, it’s also plots of land. Scarborough Shoal has been under a lot of controversy and lines are going to have to be drawn at some point, possibly militarily, as to what side the United States and other countries take, either China, the Philippines, or everyone else who is looking at that area, saying, “That’s mine.”
David: If you want to understand Asian politics and potential geopolitical conflict over the next three to five years, you need to get out an atlas and you need to look at the Scarborough Shoal in the South China Sea. And you also need to look at a map of the nine-dash line. Just google it – nine-dash line – and look at what the Chinese are claiming as their territorial waters. And when you see the map of the nine-dash line, you’ll understand how preposterous the claims are, because it basically is encroaching on what you and I, with no geopolitical axe to grind, would say, “Gosh, that’s awfully close to the marine territory of six or seven different countries.”
But back to this issue of immigration. Merkel lost significant ground over the weekend due to immigration. The German economy is not booming. If it was, she could manage this issue. And because it’s not, we have immigration as a major issue. It’s a major hot topic. And in some local elections her party just got destroyed over the weekend.
So we have the Premier in China, who is at the G20 meeting, and he is saying, “Look, we know we have a rise in protectionism. That has to be addressed. That’s a major concern. We know we have a highly leveraged financial market.” And he’s not just giving commentary to the Chinese economy, but he is also talking about the global financial system. And he is identifying two really key points because these two key points, when you bring in protectionism on the one hand, and a highly leveraged financial system on the other, and a contracting global economy, which he did not include as a third variable, this is a little bit like a mule cart pulling nitroglycerin down a street full of potholes (laughs). Which pothole is the one that causes the thing to blow up? Just back away, watch the baton hand-off from Obama to whomever takes office next. I think we are front row to some very interesting market volatility over the next 90-120 days.
Kevin: Some of the indication that we got in Germany with Merkel’s posture on immigration, we’re starting to see that show up with Trump. Over the weekend, we’re starting to see the numbers – they’re saying that Trump actually has a lead over Hillary. This is the first time, ever. Why is that? You have these same issues showing up time and time again.
David: When my dad and I were in Hawaii this last year we talked about Duterte, the newly elected president who came in in May in the Philippines.
Kevin: Yes, your dad lives in the Philippines.
David: That’s right. Both my parents live in the Philippines. It was interesting, because he described him as the Donald Trump of Asia. A no-nonsense guy, doesn’t take crap from anybody, has his opinions, and isn’t afraid of stepping on toes. And if a job needs to get done he’ll do anything he can to get the job done. Don’t get in his way, because that might get you shot. And it’s funny because, at a popular level, he was swept to power, very unexpected. Very unexpected. But people want a can-do guy, somebody who is no-nonsense and has a plan.
This is the case in the Philippines. The Japan Times reported over the weekend that he is absolutely livid about what is happening in the Scarborough Shoal, because remember, you have contentions between China and the Philippines as it relates to these territorial waters, too. And why is he upset? The evidence most recently is that the largest flotilla yet, a collection of boats sitting out there on the Scarborough Shoal, includes the kinds of barges which you would use to begin construction projects.
Kevin: He sees the hammers and nails showing up at this point.
David: Right. They’ve already been told by the folks in Europe, “Back off, you don’t have a legal claim.” Now they’re just saying, “Look, we don’t accept your jurisdiction here,” and in all likelihood they’re beginning a building project. Now, if you want to stop someone from a building project, it’s going to take force to do it, because they’ve already acknowledged that law and the international courts have no bearing on this. So now the only way to stop them is by force.
Kevin: Talk about tensions, he called Obama something that they can’t print in the paper.
David: It wasn’t as bad as “son of a motherless goat,” but it was in the same genre.
Kevin: Right. And so Obama, at this point, won’t meet with him because he was dishonored, I guess.
David: (laughs) Now, you may not think about the Scarborough Shoal as significant if you’re age 40 and above, but it’s going to be very significant for anyone 18-30 because our involvement in a military conflict, conscription of soldiers, may have everything to do with the nine-dash line, Scarborough Shoal, and this maritime fight in the South China Sea. So again, who are the interested parties? Where is there a greater likelihood of hot conflict? You have something that is developing in real time there, and by the way, does this get layered into what happens to the financial markets, what happens to the U.S. stock market, global equities market, emerging equities markets, and even the price of gold? Well, of course, because remember, the critical variable late 1970s was not economic or financial, which ended up driving the price of gold from $275-300 up to $800.
Kevin: Right. It was strategic and geopolitical.
David: On any economic equation you should have stopped at $400. It was fairly priced. Why did it more than double its justifiable levels? Because of geopolitical tension. So why are we always interested in a commentary and a dialog that includes the economic, the financial, the political, the geopolitical? Because they all overlap in a very interesting and, ultimately, in terms of price action, compelling way.
Kevin: It’s not just Asia. We saw the unification, supposedly financially, of the European continent. We saw Brexit pass a few months ago. Brexit is going to be the British exit out of that system. But now we’re seeing France – that’s a big part of the European Union – Frexit.
David: Yes, Le Pen. Le Pen is like Duterte. Again, what you’re seeing is populism in different colors, different shapes, different sizes – different genders even – and guess what? They’re all expressing some level of discontent amongst an emergent middle class, or in the case of the United States, a middle class which was well-developed which is getting squeezed more and more.
My take-away from talking to my cousin in the mortgage business is that you’re dealing with middle class families who are living the good life, but living right on the edge from paycheck to paycheck. And if you increase their expenses by $100-150 a month, it means they need to borrow $1000-2000 by the end of the year just to make ends meet.
Kevin: They’re just on the edge.
David: And it creates some underlying tension because they don’t feel like they’re living extravagantly, and yet they are now living beyond their means. Why? Because things are changing around them which are driving prices higher and there is nothing within their power to do that. So why would the middle class in America be interested in Donald Trump? For the same reason that Filipinos are interested in Duterte, and you’re seeing a growing number of people interested in Marine Le Pen in France. Again, you’re talking about changes which are intolerable to a middle class segment.
And could we see Frexit, as you said, just like we had Brexit, a French exit from the EU? Anything is possible because politics can change with the wind, in the blink of an eye. It just depends on what the pressure points are as to how people respond to them because if you go back to Brexit, remember that Ireland was very critical of this and it was like, “No, you should not, you cannot, it’s not in your interest to do so.” But when you align self-interest in just the right way, you might even find Ireland balking at staying in the EU.
We had a tax ruling which went against Apple, and of course, Apple is one of these multinationals that has a hybrid domicile, and they don’t really exist in the United States or in Europe. Via Ireland they have a domicile which, in theory, exists somewhere over the Atlantic Ocean which gives them the ability to not be taxed the way a U.S. corporation is, not be taxed the way a European corporation is, and this hybrid tax structure, now the EU is saying, “No, no, no, you’re about 14 billion dollars behind on your tax payments,” and now they’re putting their sights on a number of other U.S. multinationals, as well, who have been doing this sort of tax arbitrage, if you will, in having multiple domiciles.
Let’s say, for instance, that Ireland is no longer a tax haven within the EU. Does it make sense for Ireland to reconsider their loyalties to the EU when their corporate partners begin to exit en masse because the only reason that they were there was for tax bennies? Take away the bennies, take away the corporations. Now all of a sudden Ireland is being put under the gun, and Ireland has to ask the question, “Do we really think it’s as good an idea to be a part of the EU?”
Kevin: And it’s not just Ireland. We’ve talked for years about Portugal, Italy, Spain. The European Union could be a thing of the past unless they do something fairly quickly.
David: I’m not meaning to sound conspiratorial here, but think about this. What events would unify Europeans and solidify the theme of centralization versus fractured national interests? If we have those events occur, it’s worth asking, “How did they occur? By whose direction?”
Kevin: That’s one thing that you can always count on throughout history. Any time you’re in a discussion with somebody you want to say, “What is your motive? What game are you playing?” It’s not that we’re all playing games, but we all have a self-interest. We all have a goal. And so, to criticize the state for actually just sticking up for their own goals is a misunderstanding of history. Yes, we may not like that, but they’re going to do that. Look at the central bankers right now who are saying, “Hey, these negative interest rates actually have worked. You just maybe don’t see it.”
David: Right. Well, Kuroda is having second thoughts on the other side of that equation on negative rates. He would say, actually, it’s damaging financial institutions’ profitability, and it’s something that maybe we’ll keep in place, but I don’t know that we can do any more. We’ve kind of come to our limits and I don’t know that it’s working.”
Kevin: That’s a little bit like a cigarette manufacturer saying, “You know, we’re thinking possibly cigarettes may not be the best thing.”
David: Right. He’s actually acknowledging that he is now moving in a contrary fashion to what central bankers were doing in the post 2008-2009 period. After the global financial crisis they wanted to fortify financials which were under pressure so that the economy could continue to grow. Now the economy is flat, financials are under pressure from the very groups that attempted to save them in the first place. And Kuroda is at least acknowledging, “Not sure that this is the right step to take,” in contrast to Stanley Fisher, who this last week said, “I think negative rates are working very well. They seem to be working other countries.”
And then, this is really fascinating when you step into the mind of a central banker like Stanley Fisher. Bright guy, by the way. Very bright guy. He managed the National Bank of Israel through the global financial crisis with real finesse. So I don’t think I’m being overly critical here, but do think about this mindset. What is working? And what does, “It seems to be working,” mean?
Kevin: Well, to whom?
David: Stanley Fisher. I quote from this last week. “While, clearly, there are different responses to negative rates, if you’re a saver, they’re very difficult to deal with and to accept. Although typically, they go along with quite decent equity prices. But we consider all that and we have to make trade-offs in economics all the time, and the idea is, the lower the interest rate, the better it is for investors.”
If you’re wondering what gets the ire of the man in the street, it’s a rationale that says, “Hold on a second. So, the money that I saved for retirement, which was going to supplement my social security income, which now no longer gives me any income whatsoever unless I’m willing to take extravagant risk, you’re telling me that it’s okay, on balance, if I’m suffering, it’s okay.” You’re about to wrinkle the general public in a way that you haven’t seen wrinkled in a long time.
Again, I think Trump is a creation of public sentiment. You might ask yourself, “How can this happen? How can a Donald Trump be someone who is possibly electable in the United States?” Because he reflects the United States. And if you’re a Democrat you may say, “Well, he doesn’t reflect my interests.” No, he reflects what people feel right now.
Kevin: And this is why Bernie Sanders will not go away in the minds of the people on the Democrat side. He also is a reflection of the United States. Not his policies, as much as what he represents to a dissatisfied audience.
Well, Dave, as a social shift is occurring, the people who are going to lose – we talked about motivations – what is the motivation, necessarily, of a central banker, or a government official who represents the establishment that is now being offed by the public? They’re going to scramble. They’re going to do anything they possibly can. The European Central Bank has been so busy buying up debt trying to keep this movement from occurring, it’s running out of things to buy. And the markets are being manipulated here. Think about your job, Dave, even as an analyst. How can you make good judgment calls on investments when somebody from the top who is trying to maintain the status quo as the status quo is falling apart, manipulates the market the direction they think it needs to go?
David: A generous interpretation of what central bankers are trying to accomplish is, “I just want to make things better.” And they’re looking at all their tools and saying, “How can we make things better?” But again, whether it’s changing the nature of money market funds and driving capital from commercial paper into treasuries, accidentally – maybe not accidentally, but let’s just assume accidentally – or even changing the flow of capital from actively managed capital pools to passively managed pools. Vanguard has seen 200 billion dollars in inflows this year after a 236-billion dollar inflow last year. From a social standpoint, what does this mean?
What it really means is that we’re in this twilight zone where thoughtful analysis of valuation metrics doesn’t matter anymore. Asset managers of a professional ilk cannot add value when the markets are being rigged.
Kevin: Right. Vanguard is a passively managed fund. In other words, people are saying, “Look, I don’t want you trying to time this thing. I want you to leave it alone.” Nobody can analyze anything anymore.
David: People are not looking back far enough, however, to say that, actually, there is value added in the analysis process. And yes, it’s true, analysis does not matter when markets are being rigged, but on that basis you’re seeing a massive shift of capital, people saying, “Well, then, I’m not going to pay for it.” But what is, in essence, happening here? You’re moving to autopilot at exactly the wrong period of time. When the second shoe drops in the global financial crisis, that is, part two of what began 2008 and 2009, who is going to be left to blame? If people can’t stomach blaming themselves, in the absence of professional asset managers, because remember, if somebody else is managing your capital and something bad happens, guess what? You point the fingers, “Oh, I can’t believe this.” But if it’s you managing it through passive vehicles, guess what happens? You’re talking about a once in a generation exit from the financial markets which may mark a generational low in terms of an interest in investing at all.
Kevin: Like after the 1930s where people were like, “I’m never buying a stock again.”
David: Right. So take the central planners out of the equation, and yes, you find a massive need for professional management. But what I see in some of these socio-cultural shifts is an insight that comes from my dad. I’m stuck on an adage that he said at the dinner table, and in almost every speech I ever heard him deliver, which was, “The majority is always wrong.” If you look at the mass currents of people, whether in the markets or in politics, when the mass is moving a certain direction, try to stand back and appraise it as objectively as possible, because history, as a guide, will tell you that the majority is always wrong, doing the wrong thing at the wrong time.
That’s what I see taking shape. The majority is being clustered and focused by central planning in such a way that is driving new and different behaviors, and those behaviors, ultimately, are not sustainable.