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The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick


August 15, 2018

“But I’ll tell you what – in a world of chaos defined by increased capital controls, to me gold makes an enormous amount of sense. Price be damned. I don’t care if the price goes up or down in the next two weeks. It’s a real financial asset, it is outside of the financial system, and I’ll tell you what, those merits – those merits– are going to add premium in time.”

– David McAlvany

Kevin:David, if there were a hundred people in the room right now and we were to ask, “how many of you are bullish on gold?,” six of them would raise their hands. The markets are not giving us any encouragement right now. Can you address right off the bat the gold market since you’ve talked so much about it?

David:That seems kind of counter-intuitive, when the sentiment is this negative, how can you say anything positive about the gold market. But that is exactly the point. The way markets trade, regardless of the asset in question, when everyone is very, very excited about something, it is generally the timeframe when you should not be excited. And when everyone is at peak pessimism, the point at which you just say, “Well, nothing good can happen,” that’s generally the point at which you should be very interested because prices are about as good as they are going to get, in so far as cheap prices are to the advantage of the long-term investor.

Kevin:And you’re not just coming up with something off the top of your head. There is a mathematical reason why gold has to go up when you have so many people shorting the market. When bullish sentiment gets down below, say, 8-9%, we know that there is going to be a turn in the market because, frankly, they just have to go cover the short bets, the bet down on gold. Those paper contracts have to be covered.

David:Yes, and so part of it is a sentiment issue and a part of it is just how many people have stacked in on the paper side of the trade, pushing the price lower. So there are more shorts today. Those are people who are hoping to benefit from the decline in price, and particularly, this is in the hedge fund community, what we would call the managed money section, if you’re looking at the Commodity Trader’s report, the COT report, more of those shorts today than there were in December of 2015.

Kevin:Which was the bottom down at $1050.

David:That’s right. So the net position has gone past 42,500 short contracts. Again, it’s the paper markets that are driving the price, and there is the strong correlation between the price of gold and the managed money positions – that’s a very strong correlation – and they drive the short-term trends because they are using a tremendous amount of leverage. These are temporary bets, this is not a long-term trend, but I think the fascinating fact is that they are always the most committed, either long or short, at exactly the wrong time. So you see the biggest short bets when the market is getting ready to head higher, and you see the biggest long bets, that is, people who have bought gold with great enthusiasm, vim and vigor just before the price is getting ready to head lower.

Again, that may sound counterintuitive, but that is just the way it is. I think they will have a diminished impact on the price as time goes on, but right here, right now, those short positions have certainly driven the price lower. That’s a very small consolation, I know. What makes that a good news story is that you have to buy the asset back to cover that short position, so you’re talking about a lot of pent up buying just to close out the position, and I think that is just around the corner.

Kevin:I think it is worth looking back at history just a little bit. We all remember April 12, 2013. That was a huge down day for gold. Gold dropped almost $100 on that Friday, and then that next Monday, tax day, April 15, 2013, it dropped almost another $100. What had happened was Goldman-Sachs and Merrill Lynch had come in and in a couple of hours they had dumped the market on Friday with 400 tons of paper gold contracts.

What was interesting about that – you and I were talking about this the other day – that doesn’t represent physical gold, but it forced physical gold selling out of the ETFs. It came about that we saw about 700 tons of physical gold, because of leverage, forced to sell out of the ETFs. Well, China ended up accumulating about 700 tons of extra gold that was off the record, we found out at the end of the year.

What we are seeing this time, Dave – again, these paper markets can control the price to a degree, but the physical selling of actual physical gold – we haven’t really had that capitulation. We don’t have, as a company right now, hardly anyone selling us gold, and I think that is probably the case worldwide. Physical gold is not necessarily being sold.

David:Yes, so the ounce price has held up pretty well with the quantity of short positions which are in the market, and the shorts do have to cover to capture their profits, as we mentioned. But that means that we can, to some degree, count the upside. We can count the next move higher from here, assuming that, as you are suggesting, they don’t trigger a stampede of physical liquidations. And we’re seeing very little by way of liquidations right now. That is in stark contrast to that market purge of December 2015. But if the physical stampede for the exits were to begin, then you have the short covering rally which is offset by that physical stampede and you would have a muted move, or very little move, higher.

Kevin:The last time those shorts got to be to this level, or close to this level, we had a pretty substantial upturn, percentage-wise, in the gold market.

David:That’s right. Yes, the selling stopped and the short selling stopped, too, and reversed course. And the last rally off of the kinds of numbers that we are seeing on the short side of the market, that is, the managed money or hedge fund shorts, was about a 30% rally. That implies off of these levels a move in the metals priced about $1550.

Kevin:That for gold. How about silver?

David:If you assume a fairly conservative gold-silver ratio, let’s say 65-to-1, maybe $24-$25 silver. So the last run, gold shares moved up 160%.

Kevin:Yes, the mining shares really (laughs)…

David:Now that was a less than six-month period, and I think that above $1400 on the gold price, those numbers for the miners might be conservative, because you’re all-in sustainable costs have come down for many of those mining entities and the space has really been left for dead. So two strong recommendations, and this is consistent from what we have talked about here on the Commentary for the last 12-24 months.

First of all, I would say, don’t be afraid of cash. Raise some cash from your equity portfolios. If you’re sitting in index funds or you’ve been managing your own portfolios in 401ks or what not, you want to get as conservative as possible. If you are the do-it-yourself-er I would ever recommend adopting a hedge for those positions, something like what we do on the Tactical Short.

Second, I would offset your financial market risk, I would offset your systemic credit risk, I would offset your currency risk, with a healthy allocation to precious metals. So, again, consistent from us in the last 12-24 months has been, raise cash and offset any of the risks that may be implicit to that liquidity position with a precious metals position. So gold is your asset for preservation of capital and silver has more of an enhanced growth profile. So in combination, those two, I think, get a lot done.

Kevin:There is a general consensus right now when I talk to people out on the street that we are seeing economic growth here in America. But if you really look worldwide, we could experience inflation and shrink in the growth. There seems to be a liquidity problem worldwide right now, maybe not in America, as we speak, as the dollar is getting a lot of attention. What is your thought?

David:I think, in relative terms, that puts us as the winner to the rest of the world. But the reality is, the whole world, in terms of GDP growth and economic activity, tends to move in lockstep anymore, so it’s not as if the U.S. can avoid a slowdown, if that slowdown is, in fact, materializing everywhere else in the world. It just means that we might respond to a slowdown in global GDP growth on a delayed basis. The folks at Gavekal Research are assuming a recession in 2019, by no later than March.

Kevin:Is that in America, as well?

David:I think they are talking global. I met with Charles Gave in Hong Kong a few years ago and I regularly read Anatole Kaletsky, the other half of the company, you have Gave and Kal (that’s Kaletsky). He is regularly featured in the Financial Times.And I don’t always agree (laughs). About 60% of the time I don’t agree with Kaletsky, but he is a very thoughtful writer. I think the assumption by their firm is that global liquidity is shrinking right now, and when it reaches a certain threshold which they expect to hit shortly, that recession happens within about six months’ time. So it is all too common to have recession when global liquidity is shrinking.

And I would add that in a period of rising inflation and shrinking global demand, and again, maybe we create a little carve-out for the U.S. because we are the ones who are likely to experience that slowdown last, but you’re talking about shrinking global demand, rising global inflation – you’re talking about global stagflation, and that can’t be ruled out. I can’t begin to put a price on gold in a scenario where you have global stagflation.

Kevin:Where you have economic shrinkage and inflation combined.

David:That’s right. As we’ve mentioned before, you have home-builders – they’re not giving you any evidence of economic growth and activity here in the United States. Dr. Copper, which is a great leading indicator of economic activity, not just domestically, like the home-builders might be, but Dr. Copper gives you a much better picture as to economic activity globally. And they seem to be indicating a slowdown on the horizon, not a ramping up of global growth. So a word to the wise, just continue to watch the industrial commodities, and continue to watch the emerging markets for indications and signs of global GDP growth or contraction.

Kevin:Okay, so we have to talk about now the elephant, or the ostrich, or the turkey in the room. I’m sorry, we have to talk Turkey. I think most people see Turkey as a country somewhere in the middle of the European continent, somewhere near Asia, maybe Europe, but it is really inconsequential to the average Joe here in America. Unfortunately, that’s not the case. 500 billion dollars says that we could see this global slowdown triggered, talking Turkey.

David:Kevin, we’ve had an interest in Turkey for a number of reasons for quite a few years. We have reached out to the folks at STRATFOR and they have given us some insights into the Justice and Development Party and the return to a religious state. As you know, when Kemal Ataturk took the reins he moved toward a secular state and there was a radical shift for decades and decades within Turkey. On that basis they might have ultimately been far more compatible with being integrated into the European Union.

But here in recent years, and certainly under the leadership of Erdogan, you see a move toward more radical Islamic expression, and the faith is certainly very real. So there is a geopolitical aspect and there is a part of who is going to rule the Middle East and who is going to be the influencer, whether it is Iran or Turkey. That’s one of the questions that we have asked for a long time about Turkey.

Kevin:Just a little background because I think sometimes we have to understand what motivates people before we judge what the next step will be, and for hundreds of years Turkey, that Ottoman Empire, was the Caliphate. That was where Islam was united. That ended in 1918. Now, if I understand correctly, Erdogan’s belief, and that of a lot of the people there in Turkey, is that they are now initiating the next Caliphate.

David:Re-establishing the Caliphate in Turkey is the center of a re-emergent Ottoman Empire. So Turkey is here now at the middle of the emerging market concerns and you have many in the financial press who have described what is happening in Turkey as highly idiosyncratic and well-contained to just that geography there in Turkey. And I think there are huge problems with that analysis because, first, it remains to be seen just how much the events in Turkey actually do stay in Turkey.

And a part of this is hard to know in advance, but will there be a mood impact? Will there be a sentiment impact that shifts sentiment from Turkey to other emerging market countries as people say, “Hey, wait a minute. This kind of risk that we are seeing emerge in Turkey is just as applicable in other countries. In fact, you have the same balance sheet considerations, you have the same kinds of weaknesses elsewhere. And so you could see that sentiment shift occur.

Kevin:Let’s talk about that sentiment shifting. You talked about balance sheet similarities. The balance sheet similarity is what you have called the original sin, and that is, if you are going to borrow money, make sure you can print your way out of a hole. That is what America has done. That’s not the original sin, that’s just getting away with murder. The original sin is to go borrow money in somebody else’s currency. If that currency increases, what you have to pay back increases.

David:And this is where you see the political posturing by Erdogan as very convenient. Contrary to Erdogan’s claims that this is a Western assault on his country and that we are trying to take him down, the issue at the core, the most basic, is that they have been building instability within the credit markets for the past decade. And you’re right, this goes back to what we described weeks ago as relating to the original sin. Much of the debt that Turkish corporations took on was on better terms. In other words, they got lower interest rates than they could get locally.

Kevin:From Germany, or America, or you name it.

David:Yes, but it was denominated in U.S. dollars, or instead of in lira it was denominated in euros. So that takes away the ability to default, frankly, the way most government’s do, which is just print your way to nirvana. And you make the debt burden go away by inflating it away. You devalue your currency and inflate away the debt burden. That is not an option when your debts are denominated in someone else’s currency.

And that is the mistake they have been making over the last decade. The BIS has followed this very closely. They have seen the instability. Again, Erdogan can claim that this is us attacking him. What it is, is a growing audience of investors saying, “Wait a minute. We have issues and it is no longer on the horizon, it is in the here and now.”

Kevin:Oftentimes you have brought up that we have people right now investing in Spain or Italy for that extra half of one percent, just a little bit extra. But Turkey, same type of thing, you have money that has come into Turkey from the outside because of a little bit of a better rate. That would be called hot money if you were a bank. Hot money means that if you’re not getting a better rate, or if there is a danger, it just all flows right back out the other direction.

David:Part of the conversation we have almost every day with clients is, if you have excess personal reserves sitting in a bank you should know how stable the institution is. One of the things that makes an institution like a bank stable or unstable is the reason why people are there. So if people are there only for the yield, it means that if that one variable changes, all that money is gone.

Kevin:It’s called the hot money index when you’re doing bank analysis.

David:That’s right. So it’s a measure of the loyalty of your client base, and it’s also a measure of the potential instability for your bank deposits because you borrow short and lend long, you need to know that not everybody is going to ask for their money back at once or you have the equivalent of a bank run, because if you have lent everybody’s money out then you don’t have access to it.

And that’s the issue with a country like Turkey where you have people coming in. These hot money flows come into the country, foreign direct investment that is seeking higher yields, but then when the equation changes you have foreign investors who are no longer so inspired to be there. So you have Erdogan, who has not been very helpful in recent months. He has made these sort of Chavez-style pronouncements.

Kevin:Right. It is feeling like Venezuela in a way, isn’t it?

David:What do foreign investors do? How do they respond? It really has put them on notice. And so the hot money flows during the past ten years have moved to Turkey in part because the economic growth rate in Turkey has averaged something close to China’s, between 6% and 7% annual growth over the last 10-15 years. And the returns have been more generous. But to listen to one of the many strongman leaders on the scene today, if you listen to him, if you could just take away the accent you wouldn’t know who is speaking, Erdogan or Chavez.

Kevin:I think about Will Rogers. He was famous for saying, “I’d rather have a return of my capital than worry about the return on my capital.” At some point there is a shift.

David:Right. So from Chavez to Maduro, it doesn’t matter who is in office today, it is the same language, and investors are appreciating that more and more. Their money is in a place where there are no constitutional safeguards for the return of capital. So you are right, “return on” becomes a fixation of “return of” capital, and it focuses investors’ attention – how do I get my money back? This is a totally different way of approaching things because up to this point they have been willing to ignore risk attributes and just look at potential returns.

Kevin:We’re only talking about past debt. Erdogan just got elected again with an awful lot of future promises.

David:(laughs) This layers in a fiscal concern because you have budget deficits and fiscal mismanagement. When you come into office and you say, “Look, I’m going to promise you the sun, moon and stars,” not only do you have debt going back to the original sin – that issue – then you have hot money flows which are part of the reason they are uninspired to remain – currency fluctuation – but also you look at the budget deficits which should blow out in the next 12-18 months on the basis of Erdogan’s promises. This is just one more layer – budget deficits, fiscal mismanagement, currency chaos. And then you have new debts which are going to be required, added to the old ones, the need to either roll over or refinance those existing debts.

And here is where it becomes really critical over the next 12-24 months. You have ABN AMRO, combining the funds which are required to maintain foreign debt obligations – that’s one element – combine that with a current account deficit, and they arrive at an annual external financing requirement – keep in mind, this is annual – external financing requirement of 218 billion dollars. So Turkey is between a rock and a hard place.

It is always fascinating to me, if you think about how investors approach the markets, they tend to ignore maturity schedules. You can see this with corporations today, too. If you looked at the amount of debts that – recently we were picking on Time Warner – and so you have another merger, and they have hundreds of billions of dollars in debt. But more important than the quantity is the schedule for payback.

Kevin:When you do owe me that money?

David:That’s right. You need to figure out where the pig in the python is, because at some point you are going to have more acute problems given the amount of money that has to be financed at a point in time. It fascinates me that those maturity schedules get set aside.

Kevin:Let’s just look at the United States. Over the next five years how much of our U.S. debt has to be refinanced or repaid? What is that?

David:If we say that the average maturity for all of our debt is five years, then here is a rough estimate. It is not precise, but a rough estimate is that we have to pay off 20% of all of our debts each year over the next five years. It is not exactly accurate because we have some that is financed longer term, but on average we have to refinance 20%. The reaction of the bond market here in the U.S. is likely to be a little bit more agitated in future years.

Kevin:You mean higher interest rates?

David:Yes, I think the bond investor is going to require higher rates to compensate for inflation and other factors. When you think about this just from the standpoint of cash flow, it is going to cost government more. This is irksome if you’re managing a budget because rates that you are going to be paying in the future are not likely to be the low-to-zero rates of the recent past. Already we have our interest expense, which is the fastest-growing government expenditure. It is not quite 8%, 7.4% of all of our expenses, and it is an even higher number as a percentage of total revenue.

Kevin:And we’re looking at higher and higher interest rates here in America. The expectation on Wall Street right now is that they are going to continue to raise rates.

David:Yes. Now, a part of the reason why that number continues to grow as a percentage of total revenue is that revenue is down, which is due to corporate tax breaks, and what not. But you are right, you check in with the folks there at J.P. Morgan and Jamie Dimon. Dimon would say, “Hey, look, we should already be at 4% on the ten-year,” so 100 basis points, a full 1% higher than we are now, and he says, “But you should be ready for the ten-year to be at 5% or higher.”

But there are hugeimplications from that. Go ahead and tack on an extra two points if you’re financing a mortgage, so if the ten-year is at 5% you can count on a 30-year fixed rate mortgage north of 7%. Now, what does that do to the price of housing? You begin to see this relationship that we have described as a see-saw where as interest rates increase the other end of the seesaw, which is pricing, has to come down.

We have had an era where rates have been rock bottom and prices have been sky high, and there is that opposite natural relationship – as rates rise, prices have to fall. And frankly, it is not just in real estate. It is also in bonds and stocks, too. As your hurdle rate for stocks, if you’re doing discounted cash flow models, then you know that as interest rates rise you have to see a recalibration in price. Nobody thinks in these terms, but it is coming anyway.

Kevin:Let’s go ahead and flip back to international. The emerging markets could be like a contagious disease as their debt starts to fail. We’re talking about the United States but we are no longer in a bubble. I think of one of the great authors, one of the greatest books that we have probably read on the markets was Anatomy of the Bearby Russell Napier. You went to Scotland to spend some time with him. Interesting guy. But he is also looking at these emerging markets and he is saying, “Guys, you had better be paying attention to what is outside the door. Don’t just look at what is in the house, look outside the door, because it’s coming.”

David:Right. Smithers, Napier, a number of people taught a class on financial market history at the business school there at the University of Edinburgh and it was fantastic. I am glad that I did spend some time out there. The issue of contagion is not merely one of sentiment affecting the emerging market countries. It is not, “Are we going to see broad-based selling of an index which contains a whole Smorgasbord of smaller economic players?”

The bigger issue is that contagion, in this case, when we’re talking about Turkey, ties right back into Europe. You’re talking about the bank exposure in Europe, which is substantial. And so, go back to our Commentary with Russell Napier, say, two years ago, and that was what we were talking about. The issue has been cooking for a while. This is long before Trump. This is not about Trump picking on Erdogan. Again, you have had balance sheet issues and imbalances which have been brewing for a little time now.

Kevin:Let me ask you a question, then. One of the things that is fascinating to me is, the last 31 years that I’ve been here, when we have a stock market crash, gold initially goes down because it is the most liquid item that people can sell to keep whatever position that they are going with. Of course, gold immediately recovers after a stock market crash, but initially, especially the first few days, maybe the first week, it goes down. Now, when Turkey is about to go down, strangely enough they are also having to sell gold to cover commitments.

David:Yes, this is defending normal, right? This is where, if you look at the financial crisis 1998, Putin was wise to look back and say, “Look, I understand what was nearly the demise of our country when Russia was forced to default.” And what he did up to 2008 and 2009 was set aside about 600 billion dollars in cash and the Russians were able to get through the financial crisis because they had liquidity.

Kevin:They had savings.

David:Now, they have liquidity in a variety of forms. So do the Turks. And when you look at the Turkish government, they were sitting on what, for them, was a record, I think, over 500, maybe 550 tons of gold at the end of last year. They have whittled that down to about 200 tons. They have had to liquidate quite a bit of it and use it to defend the lira from further decline. So year-to-date, their cache of gold has been cut more than in half. And again, if the reports that I have seen are accurate, that started from over 500 tons.

That is a very interesting thing. There are other reasons we have weakness in the gold price, which we have already mentioned – the short-selling in the paper markets. Trust me, these quantities of gold coming to market certainly don’t push the price higher, but a couple of hundred tons coming to market in a short period of time certainly does enhance the pressure on the downside.

Kevin:When I talked about it being the elephant in the room, or the ostrich, or the turkey – a little play on words here, but what we could be witnessing, according to Napier, is the largest default in financial history if this happens.

David:And it is bigger than the 2008/2009 Lehman moment.

Kevin:That’s hard to believe.

David:We are all too familiar with that, but de facto, this becomes a default when and if the Turks, or Erdogan, or anyone who manages their financial markets, announces capital controls. When they announce capital controls, then you have a de facto default on close to 500 billion dollars in liabilities. And here are the considerations you have to keep in mind, because again, we’re not talking about just a sell-off in indexes that represent emerging markets. You’re talking about direct implications into the banking system within Europe, and that becomes very contagious, not just in the setting of emerging markets, but in any financial sphere.

Kevin:He is motivated by other things, too. We talked about this Caliphate, but he does not like Trump. So whatever Trump is going to try to force on this issue, he will probably fight back.

David:Right. So your two issues are, number one, you have 500 billion dollars, which is your total liability, which is at risk. And the second thing is that contrary to the past periods of economic crisis in Turkey – you can go back to 1994 when they had a significant lira collapse, and then in 2001, as well – this is different this time. Erdogan is not likely to beg for money from the Washington-based franchise.

I was coming into the office this morning and listening to NPR and they had somebody on from the Peterson Institute, and they were saying, “Well, it’s not a big deal, they just go to the IMF.” I don’t think Erdogan is going to go to the IMF. The IMF is a Washington-based franchise, and again, he is not going to beg Washington for money after having positioned the problem the way he has.

What this implies is that he is not going to be extending terms or renegotiating loans as you would ordinarily see at a default scenario. What happens when a country defaults is that the creditors usually get some of their money back. Everything is renegotiated. The normal means by which creditors are ultimately made whole, or partially whole, is that you just massage the terms.

You had ten-year terms on the debt – now it’s 30 years. And maybe the interest rate was 4% and now it’s 3%. So the terms get easier so that it eases up on cash flow. But the significant difference, I think, is that you have ego butting up against ego. And when ego is butting up against ego, Erdogan has made it clear from his perspective, that Trump and the West are attempting to undermine this re-emergent Ottoman Empire.

And he has already gone to the Turkish people and said, “It’s your patriotic zeal, it’s your personal sacrifice, it’s your direct appeals to Allah, which will allow for the Turkish people to get through this.” That doesn’t sound like positioning for a quick pivot to foreign aid from the IMF. It just doesn’t have that feel to it. That may change, but…

Kevin:Something that is making the world very, very different for all of us right now is that China is on the rise. You almost have two worlds going on right now. You have the Asian world and you have the Western world. China is talking about their currency becoming more and more valid as far as a reserve currency. You have bank loans coming in from China. You have this one belt/one road push. I’m just wondering, Dave, if Erdogan needs money, is China where he goes?

David:(laughs) Some people would say that Goldman is always doing “God’s work” and out there saving people when they need money and what not. The PBOC, you could say, is doing God’s work as well, and maybe that’s what Erdogan is talking about when he is talking about praying to Allah. Allah may deliver, but the earthly source of salvation may be via the People’s Bank of China.

And I think it would be an interesting historical plot twist because here in recent years you have the Asian Development Bank which has been put in motion to directly compete with the World Bank. And what they want to do is basically, using soft power influence, come in and fund infrastructure projects and create good feelings, create good will toward China and the other members of the Asian Development Bank and replace that goodwill which in the past has been extended to the West and the World Bank.

Now we can imagine also a substitute for the IMF and the availability of liquidity coming from China – what would that do in the scenario? I think it would send a very clear message to the rest of the world that the West is not the only franchise in town, and if help is what you need, then what you first do is compare terms, because the Eastern requirements are going to be far less restrictive, certainly when it comes to human rights and pro-democracy requirements as a quid pro quo.

That has always been the case. The IMF has this laundry list of, “You will do this, and this, and this, and this, and on those conditions we will give you some money.” What if China comes in and says, “We’re not interested in getting involved in telling you how to live your life. We’re not going to tell you how to treat your people. We’re just going to tell you that we’re here to be your friend, and here is a very reasonable loan, and we’ll make it work for you.” Again, what we are doing is creating a space where the Chinese can come in. That’s a possibility I think we need to watch for.

Kevin:They haven’t been publicly positioned in the minds of the Turkish people or the Europeans as the bad guys. You think about the loan sharks that the West is perceived as, especially the way Erdogan talks about that, China can almost come in as the cowboy on the white horse with the white hat and say, “You know what? You guys need help. We’ll save you. These loan sharks are trying to take advantage of you. But not us.”

David:Napier’s recent comments, I think, were fantastic. One of the things that he points out is that we have a whole community within the financial universe and they analyze things according to spread sheets and calculus, and it is fairly historically ignorant. He goes on to say, “Having the ability to pay does not translate into a willingness to pay.” Even if the Turks could pay off 500 billion dollars’ worth of loans, it doesn’t mean they will. And this is, again, where your spreadsheet says, “Oh, but they’re a good credit risk.” And the reality, and the historical context, and the motivation to pay, doesn’t always translate into payment, particularly – I think you used the right words – particularly if you view the institutions as loan sharks.

And that is what they would view the IMF as – loan sharks enslaving the Ottoman Empire. Who wants that? That is not the kind of image that Erdogan wants to portray in the Middle East. We have a destabilized Middle East and a competition for who is going to be the dominant player. Other countries are going to gravitate toward leadership. This is not the time and the place for Erdogan to say, “Yes, but I do need that extra money from the IMF.”

Kevin:If I’m a European bank, though, who is at risk right now? What European bank should be looking twice in the rear-view mirror?

David:This is where I think you could see European banks take a hit which is on par with the kinds of chaos they saw during the global financial crisis. You have UniCredit, you have IMG, you have Deutsche bank, you have Commerzbank – so a couple there from Germany – BBBA, BNP Paribas from Paris, and a few others that are massively exposed. But the BIS, the Bank of International Settlements, follows cross-border banking exposure. That is the category that they put it in. And they count 148 billion dollars in U.S. dollar exposure.

Again, this is cross-border banking exposure that Turkish corporations and banks owe – 148 billion in U.S. dollars, and another 110 billion in euros. And that is euro-denominated exposure. Spanish banks have loaned out 83 billion dollars. We talked about original sin. Here is what it looks like. If 83 billion dollars was sitting at an exchange rate of 4-to-1, you are talking about an original loan, U.S dollars, 83 billion – translated into liras, 332 billion. Now, as the exchange rate has deteriorated, you go from owing 332 billion lira, on the other side of exchange rate deterioration you now have 600 billion lira.

Kevin:So that was almost doubled.

David:Right. And this is why that whole issue of the original sin is such a big deal because very quickly, with exchange rate deterioration, the burden of debt becomes so unbearable that you say, “Look, I’m collecting revenue in lira. There is no way that my revenue is doubling such that I can keep up with these lira payments. No way.” So you have the Spanish bank’s 83 billion in loans to Turkish corporations. French banks are owed, currently, 38.4 billion. Italian banks a little bit less, 17 billion. In total, over the next 12 months you have 51 billion dollars scheduled for repayment. Of course, they can refinance that, but on what terms? What is the interest rate going to be? Is anyone going to want to redenominate to Turkish lira? (laughs) I don’t think so.

Kevin:I’d like you to talk a little bit more about capital controls because that is something that here in America we don’t think much about, but that is one method of default that is devastating once that occurs.

David:Yes, and there is a difference between a regime which has been in place for a long period of time, and the imposition of capital controls in short order. If you go back to the 1990s all we had in Europe was capital controls. There was no free movement of capital between one country and another. It came at a very, very high cost, and with strict limitations. Those capital controls went away by the mid 1990s and the free flow of capital started to bring about a huge resurgence of economic activity and business activity on a cross-border basis. What we are talking about is the possibility of going back to capital controls where there is a limitation in the amount of money that you can take out of the country. We go back to that issue of hot money and this is where it gets very important.

Kevin:You become captive.

David:Yes. The money that is there has to stay there, and it doesn’t matter if it was foreign direct investment which is now locked up inside the country, but also domestic currency holdings are not allowed to leave because you end up gutting the economy if all the liquidity leaves.

Kevin:As people are slinging these tariffs back and forth, it seems like it is building more of a nationalistic type of mentality anyway. Capital controls would almost be an obvious outcome of a currency war or a tariff war.

David:Right. So we have tariffs – that conversation is in the air. We have the themes of more nationalistic-driven trade, competition – who is going to keep a larger slice of the global GDP pie. And I think these are significant marks of deglobalization. But probably the most significant mark of deglobalization is the possibility of capital controls. And reading a Financial Timesarticle and one particular analyst saying, “Well, of course, that’s what they have to do. The Turkish government has to impose capital controls immediately.”

And there are implications to that. We have already seen the Chinese ratchet up restrictions on outbound moneies. They don’t want to see money leaving the country, they put limitations. And if money is leaving the country, it is doing so on an illegal basis. Now you have the Turkish people looking at a similar scenario. Close the exits before any more vital liquidity can move out. And that is the real key. An economy has to have a certain amount of liquidity in it to keep on moving. It is grease in the gears and if you take away the liquidity, the gears come to a grinding halt.

Kevin:So a liquidity crisis ultimately leads to somebody not paying their debt – insolvency.

David:There we go. That’s the sequence we have mentioned over and over again – liquidity crisis often precedes solvency crisis. Capital controls are an attempt to stem the tide of liquidity exit. They implicitly shut off payments to external creditors. That is where you end up with a de facto default there in Turkey. So far more concerning – again, you can ignore the conversation on tariffs because it may happen, it may not. We don’t know what all of the economic ramifications are going to be. You can ignore stock market volatility because it may happen, it may not. We may have central banks step in and save the day, and we have gotten used to that.

So financial markets don’t really care about the possibility of stock market volatility, or the conversation about tariffs. What they do care about is a radical shift in liquidity. The concern about stock market volatility – set that aside – it really is more about a shift in liquidity, a radical shift in liquidity. And if you imagine the liquidity being like the game of musical chairs, it is there, the music is playing, and no one cares. When the music stops you have the mass movement to lock down a seat, and that happens in an instant. So people are not focused on liquidity, and then all of a sudden that is the only thing that they are focused on, and in one moment the players are listening to the music, enjoying it, and the next moment their fixation is only on the real estate they are scrambling for. Not everyone is going to get a seat and you have to make sure you that you get yours.

Kevin:I can remember a few incidents in the past where we have seen flight capital that really boosted the value of the dollar because somebody was fleeing or trying to get their money out of the country. The same thing – it is interesting when you have flight capital going into the dollar, oftentimes it is also going into gold. It is one of those occasions where you see the dollar and gold rising at the same time, oftentimes. Do you think, with the potential of capital controls, as that liquidity tightens, you will see a lot of that go into the dollar?

David:Yes, I think you will see a lot of it go into the dollar. I don’t know how much will go into gold. I think the long-term story for gold hasn’t changed at all, but the short-term story for the dollar could be up, up and away. In a highly leveraged world, what you have with the events in Turkey becomes extra critical, because liquidity is getting scarce in a particular country and that may translate to liquidity getting scarce in Europe. And then in a daisy-chain manner that may very well translate into a scramble for U.S. dollar liquidity on a global basis. So remember that what we have achieved in the last 20-30 years, our primary export has been U.S. dollar-denominated credit. And so, for all the debt that we have pumped into the world denominated in U.S. dollars, it requires dollar liquidity for payment.

Before we move too far away from Turkey’s past and their economic crisis, I mentioned 1994 earlier, but I think it is worth noting that the backdrop issue in 1994 was the hike in rates here in the United States. So we set off chaos, whether you are talking about Orange County, California, or Ankara, we set off global chaos (laughs) by an interest rate increase cycle.

Kevin:So we were the trigger event. Even though they had the weakness already built in, we were the trigger.

David:That’s correct. So we’re the trigger event, we create something that tightens global finance. And I’ll tell you what, global finance is even more interconnected today than it was in the early 1990s. So again, it is our normalization of rates which has a huge ripple effect, both in the spheres of interest rates, but also in the spheres of currency values. So emerging markets is where all of a sudden you factor in … we’ve seen some pain in the emerging markets. We’ve seen some underperformance – actually moving into the bear market territory if you’re talking about the Shenzhen and Shanghai exchanges.

But the emerging markets are nowhere done experiencing pain. God forbid we see a runaway dollar market where the U.S. dollar spikes to $110 or $120 on global financial market deterioration, because what would happen on the other side of the equation is emerging market carnage. As the dollar moved higher, that would be a cruciform for every emerging market currency. The dollar moving to those levels would be a hallmark of the greatest global depression in history. I don’t see the dollar going that high, but I certainly do see a reasonable possibility of it getting to the $102 area from the current mid $90s where it is today.

Kevin:Europe has already experienced an awful lot of potential default in various countries. We saw Greece. We saw Cyprus. Is Europe in a position to swallow tens, if not hundreds of billions, in losses?

David:No way. No way. I think the U.S. banks, frankly, are more adequately capitalized at this point and could take a significant hit, but we’re not the ones with the tens of billions of dollars of exposure to Turkey. So I think those banks now have to consider with a fresh perspective that the cross-border loans which they made, and they made with adequate collateral, now all of a sudden they are in a position where it is going to be very, very difficult for them to gain access to that collateral.

The beauty of a loan is that you have an asset, generally, which backs it, except that when you do a loan on a cross-border basis, you bring in a political, and even a geopolitical, element where Erdogan may say, and may position it such, that it is almost impossible for the foreign lender to get access to that collateral. So you look at the loan and you say, “Well, it’s adequately collateralized.” But what if in a day, all of a sudden you have no access to the collateral whatsoever? It changes the equation completely. The quality of the loan has to be significantly discounted. Maybe even it is marched to zero.

I think this gets very, very interesting because Europe was already in a hard place. Turkey underscores just how difficult it is to manage en masse for many countries, both on a monetary and a fiscal level. It’s not telling us anything we didn’t already know, it is just drawing out what the issues are.

Kevin:Oftentimes the map is reorganized. After World War II we saw the map redrawn. After World War I the map was redrawn. We could go back to the 1870s and look at Europe – the map was redrawn. But the map for the last 60 years or so since the end of World War II has really been Western banking giving all the loans. We talked a little bit earlier about two worlds now are emerging. We almost have the Axis and the Allies. I don’t want to necessarily say they are the enemies. But you have China – China, in a way, could help redraw the map, and I’m not talking just Turkey. I’m talking also Germany and some of the other players.

David:Yes, and I do think they factor in in a large way. If you think of the pressure the U.S. is creating globally and the realignment which is possible in this period of pressure, certainly there is no stretching the imagination to see Iran and Turkey and Russia all shift closer to China. And in recent days we have actually had the Germans protest our U.S. Iranian sanctions. And they have been indicating that they are not going to comply with the U.S. unilateral dictates.

What does that mean exactly? It means that they may continue to do business with Iran and that gives us an excuse, at least as we have postured; we will not be doing business at all with any country that is working with Iran. So now it further orients the Germans toward a new economic block, as well.

Kevin:Not to mention they get half their oil from Russia, so there are ties.

David:Yes, huge ties that already exist there. And remember that Turkey – and this is what is weird – Turkey is a longtime U.S. ally. Everything that we have done in the Middle East in the last 10-15 years has required or involved Turkish involvement. They are also a NATO member. So here we are in the process of undoing a pivotal NATO member. And the question is, are we rekindling old alliances?

Kevin:Kamran Bokhari is the one who told us that there was a void, there was a gap created when we took out Saddam Hussein and created that gap in Iraq. You had Iran on one side and you had Turkey on the other, and it was critical – one of those two was going to fill that void. This is the redrawing of the map. This is a long-term redrawing of the map, is it not?

David:Right. You’re talking about politics on the one hand in terms of redrawing of the map and perhaps the redefinition of a modern-day caliphate. But the other issue is financing, and who provides financing for a fledgling caliphate. And perhaps it is, again, this next phase of globalization, like the recent phase of capitalism which we have had, takes on decidedly Chinese characteristics. So we have talked about capitalism with Chinese characteristics. Maybe it’s globalization 2.0 with Chinese characteristics this time around, as well. What does that mean exactly? It is the Sino-centric command and control dynamics which are written all over it.

On a side note, here in the last couple of days you have had the Italians which are feverishly demanding that the ECB guarantees bond spreads or they’re going to dismantle the euro.

Kevin:So that is fixing the price. There is no free market at that point, you’re just guaranteeing. Talk about artificial interest rates.

David:Yes, that’s right. So, “You fix the price and cover the market cost of doing so or we leave.” That’s basically what the Italians are saying. And that is a direct request for, essentially, command and control dynamics. It is a request for the death of free markets (laughs). It’s fascinating. To guarantee the spread between two fixed income assets is to eliminate differentiation.

Kevin:Right. You take the risk equation out.

David:Well, right. But you and I need to be able to measure risk and know the difference between loaning money to an Italian versus loaning money to a German, or the Italian government, or the German government, or a German bank, or an Italian bank. Is there a difference? You are going to see it in the spread between those two things, and the Italians are basically saying, you need to guarantee that the spread is the spread that doesn’t move. That kills a market.

What does it do? It introduces that command and control dynamic. To me, that has the specter of the 1940s written all over it, which is a period of time where private capital went very, very private. In other words, it went underground.

Kevin:Can we just assume that China can come in and do this, though? Their GDP – they have to have very, very strong growth numbers just to keep up with what they need with the debt that they have put out. Their debt-to-GDP ratio is enormous at this point, even before all this happened.

David:Still growing – 171% is where it was prior to the global financial crisis and now it is close to 300 – 299%. And their corporate sector is the world’s most indebted, yet they control the markets – sort of. We say they control the markets, and they assume that they control the markets, and yet you have, as we mentioned a moment ago, Shanghai and Shenzhen, those stock markets now in bear market territory. Are they really in control of those markets when they have sold off, precipitously, better than 20% in a fairly short period of time? This is where, again, I think there is a difference between what we pretend to be the result from command and control dynamics and what the actual results are. There is a difference.

Kevin:Speaking of a change in the map, one of the things that we have always been able to count on, at least the last three to four decades, is that the Chinese currency is tied to the U.S. dollar. Now, if China is trying to exercise some independence and express themselves in a different way, they would disconnect from the dollar. Aren’t we getting signs of that right now?

David:(laughs) That’s right. So again, the conversation about tariffs? Everybody is talking about it. You have trade conflict. It not only captures the headlines, but if you look at the Ph.D. economists, globally, they continue to ulcerate over these issues of trade conflict and tariffs. But the real big change is in the currency world, and Napier pointed out in his most recent research piece that the U.S. dollar/renminbi exchange rate, which for 20 years has been hyper-managed, and in order to deliver a particular economic outcome to the benefit of the Chinese it now appears that that exchange rate target has vanished.

Kevin:Taking away the predictability that we have had.

David:Right. This is a topic that we are going to explore fully with Russell on the program later this fall. But there are massive implications stemming from a monetary regime change, but that is exactly what we have. One of the key elements in what we have done, our trade relationship with China, has changed. And the change, in large part, was forced by what the Trump administration has set in motion and how the Chinese have looked at the implications of the evolving landscape and want to position themselves somewhat to insulate themselves from a further decline in the emerging markets.

But I’ll tell you what – in a world of chaos defined by increased capital controls, defined by debt repudiation, which we are talking about in Turkey, defined by counter-party claims which exist but nobody really cares about until the moment of crises when you have to double check and make sure that you have access to your capital and can actually get ahold of your collateral, get ahold of your capital…

Kevin:It sounds like the music is still playing but is ready to stop.

David:It’s like too many dancers seeking too few chairs. To me, gold makes an enormous amount of sense. Price be damned. I don’t care if the price goes up or down in the next two weeks. It’s a real financial asset, it is outside of the financial system, and I tell you what, those merits – those merits– are going to add premium in time.

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