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- Jay Powell punches the market in the face
- European energy costs could rise 10-fold this winter
- Gold up 20% in Yen for the year
The Dollar Is Temporarily the Best Horse (In the Glue Factory)
August 31, 2022
“Europe, and Germany in particular, is experiencing nothing short of the U.S experience in the 1970s. The OPEC oil embargo, radical inflation numbers, and very significant consequences from that. Imagine the 1970s inflation on steroids in a place like Germany, the inflation numbers from German PPI, that’s not going away anytime soon unless Putin decides he wants to get cozy and friendly with all of Europe.” — David McAlvany
Kevin: Welcome to the McAlvany Weekly Commentary. I’m Kevin Orrick, along with David McAlvany.
David, you’re still in Kuala, Lumpur, but you’re learning a new sport, aren’t you?
David: Badminton. Who would have thought that badminton was so very popular? I’ve been other places in the world and if you turn on the television, you’re going to see cricket matches. Or if you’re in the U.S., certainly there’s American football. Anywhere in Europe, you’re guaranteed to see football of the other variety, soccer. Here it’s badminton and we have a new world champion this year, men’s doubles badminton, Malaysian, and they are excited. So that comes at the same time as independence day. Today is independence day, 65 years of independence from the British. So this is like the 4th of July. There’s a party outside my window. It’s almost midnight and the festivities have begun.
Kevin: That’s one of the wonderful things about travel, Dave, because you didn’t expect to be watching badminton. You probably didn’t know about the independence day. So when you travel, I just got back from a trip to Maine, saw one of our Treasured clients, got a chance to talk at a conference that he put on, and I just thought about it. I had never been to Maine before. I love having fresh lobster and blueberries and maple syrup.
David: Of course.
Kevin: The people up there were great, but I thought about it while I was traveling and I thought, you can read a lot of books and that’s very helpful, but it’s good to be put into the travel circumstances where you don’t know what the next thing’s going to be. I’m sure it’s a great way of rewiring your brain.
Well, getting to the market right now, last week you said that Powell had a choice of either a light slap across the face or punching in the nose. It looks like he punched the markets in the nose.
David: Yeah, decent jab. We talked about Dr. Kaufman’s or Mr. Kaufman’s comment that a hand slap would not change the risky behaviors of the speculative community, but a punch in the face sends a clearer, more definitive message. Jerome was impressively unambiguous with his eight minute right/left combos.
Kevin: Well, it’s sort of nice to have straight talk, if indeed he’s willing to back it up.
David: That’s right. Non-complicated communication was a hallmark of his eight-minute speech. He had 30 minutes scheduled, and finished in eight, which, again, was just very, very compelling. I mean, in a nutshell, he said inflation is too high. Rates must go higher, interest rates must go higher. We’re going to pursue that course regardless of the pain it inflicts, knowing that if inflation endures even longer, it will cause an even greater pain. That is the truth. If you want some of the “best of” quotes from the speech, Credit Bubble Bulletin does a great job of gathering those together and you can find some compelling ones in Hard Assets Insights as well.
Kevin: If you recall, we interviewed a man who was with the Reagan administration in the economic side of things who was there when Volcker came, and he was tough. He punched the markets in the face, and the Reagan camp at the time didn’t like Volcker one little bit. Politics and central bankers should be separate. You’ve interviewed a number of people, Dave, who’ve talked about how you need to have that division, and not completely lean on central bankers to aid politics. I wonder what the Biden administration is thinking right now about what Powell said.
David: Yeah, this is the interesting point because Powell knows what needs to be done, but there is an uncomfortable part to it, which is, it may very well cause or contribute to a recession. So if you’re going to shrink back demand in the economy, which is just a way of saying shrinking back activity, there’s going to be a price to pay. You’re going to have more jobs lost. You’re going to have slower GDP growth, and that’s what’s unsavory to a politician. So why would Reagan not like Volcker? Because he was responsible for bringing in a pretty nasty recession.
Now, he was also responsible for solving the inflation problem, but if inflation endures, says Jerome Powell, then there’s an even greater pain to be experienced. We’re talking about social and political unraveling. That’s a real possibility in the context of elevated and enduring inflation. We have enough of that in terms of the social and political unraveling, just because of unscrupulous leadership in DC, which is fast becoming a diabolically corrupt political class. And the sociopolitical trends of extreme partisan behavior, cultural toxicity—they get worse when they’re magnified by socioeconomic anxieties, and that’s what we have resulting from fiscal policy, monetary policy, and the supply chain mash-up. Pushing prices higher, you can already see that consumers there at the margins are being pushed to the wall.
So we have growing pressure, again, socioeconomic pressure, already. Don’t get me wrong, but bad decisions can make things worse, and good decisions may make things better. Good decisions are not always easy or pain free, and that’s where rubber meets the road in terms of monitoring policy and political popularity.
Kevin: With all the travel that you’ve done, Dave, and the little bit that I did this last week, each plane had babies in it. I love babies. I love being around babies, but you could tell the parents that had some consistency in their discipline, and other parents that had no consistency in their discipline. The parent that never disciplines, but basically says, “All right, I’m going to count to three,” and then they end up doing something else and doing something else, but they really never follow— We talked a few weeks ago about follow through. You can definitely see it in children. The markets are a little bit like children. Do you think maybe with the inconsistency that we’ve seen from the Fed, always getting candy from the sugar can, that there’s going to be a follow through this time, or is it just Jay Powell talking?
David: Well, I would say you can also tell the difference between parents that are wearing ear plugs and those who are not wearing ear plugs, particularly on a plane. There is peace and calm, a certain serenity, in spite of the screams, and then there are those who are tearing their hair out. I highly recommend traveling with earplugs. You can find a strong market for them, even amongst your fellow traveling companions, if you’re carrying more than what you need for you and your family.
So now to your point, history’s going to weigh Jay Powell’s Jackson Hole speech, and they’re going to weigh that against the FOMC actions and see if there is consistency, if there is follow through. He was sincere in what he said, and now we get to wait and measure the resolve of an actual tightening of monetary policy and the impacts that that has on economic conditions and, of course, the way that those economic conditions end up shaping or influencing the social mood. I think Doug Noland, my colleague on the wealth management side, refers to this as a shift in the threshold of what the Fed considers acceptable market instability. So speculators, they had their opportunity to sell this rally. I hope they did. If they didn’t, the reality is the Fed has a wider margin of pain that they’re willing to allow the market to go through before they intervene.
Kevin: Dave, one of the men who was speaking at this conference had been the advisor to the governor of Maine on energy, and his talk just took my breath away. I learned a number of things. Just how vulnerable our entire system is to the loss of energy. Refrigeration. I had no idea. Refrigeration takes one third of all the energy consumed, and he explained what it would be like if we lost electricity, if it became unaffordable. I asked him, when we were between talks, I asked him about the European situation because I had heard about the radical increase per megawatt hour. A €250 bill to heat a house is probably going to be up to €2,500. Think about that, if your heating bill went up tenfold. So we’re talking about Jay Powell, we’re talking about inflation here in America, and yeah, it’s an issue, but Europe is facing an absolute existential crisis right now, are they not?
David: That’s right, and we can feel it a little bit. U.S. consumers, again, these are really sort of at the margins, are already at an impasse with their energy bills. Because we’ve seen an increase of, say, 15%, and one in six are now late by many months in paying for utilities. Can you imagine what the delinquency numbers would be, and what the social mood would reflect, if, as in Europe, prices were six to 10 times last year’s cost. That’s what you’re getting at. We have a shot at a recession, and Jay Powell may help with that, again, in order to slow demand and ease pricing pressures. But they in Europe have a shot at depression, certainly in Germany that would be the case.
Kevin: Well, this man who gave the talk was an inventor, and he really understood thermodynamics in a way that I had never heard before. It was fascinating. Talked about how cooling something is sucking the heat out of something. Rather than cooling it down, it’s sucking the heat out, and he’s developed several technologies that suck out the heat in refrigeration of the food and then heat the very building where people are shopping. It was really fascinating. So I asked him, I said, “What could Europe do right now? What could Germany do?” Because they’re in a real crisis. He said, “To be honest with you, they should just fire up those nuclear plants.”
I asked about alternative energy, and the greener the country, the more dire the consequences. He just actually showed the numbers and the impossibility—and this may make some people mad who are listening to the conversation—but he showed the numbers of the impossibility of actually meeting the energy demand with wind or with solar, and how it’s a fool’s lie right now. It’s not something that you don’t use at all, but you can’t replace what Europe has been using for many years with green. Now that we have this geopolitical situation with Russia, it’s going to be very bad. What are they going to do? They’re just probably going to have to socialize this and tap the coffers of bonds. Now they’re going to have to issue bonds and just create some money and start paying for energy that way?
David: Play out the political consequences of the Russian energy squeeze. You’ve got the European Union, and of course the pressure is felt country by country according to the degree of pressure felt—and this really ties to their individual, unique, country-specific energy strategies, but yeah, they’re going to. Each of these countries is going to tap the individual state coffers for a fiscal subsidy so that households can make it through the winter, and that is the state shouldering the astronomic energy bill.
Some states are worse off than others. The greener the politics, as you mentioned, the harder pressed they will be. This is where, look, we’ve had one of the hottest summers in many decades, if not centuries, so hydro is an issue, wind and solar have shown to be inadequate to fill the gaps left by the Russians as they’ve tapered off their supplies of oil and coal and natural gas. But if you look at Europe as a whole, it’s Germany which is in real trouble. France is okay. This is what’s really interesting to me. Likely this is an inflection point for European leadership. I mean, Germany forever has been sort of in the Vanguard, with France playing number two and occasionally pretending to play number one. But here you have a change in European leadership and economic anchoring as the economic engine of Europe sputters and gets shut down. It’s a fascinating, fascinating thing.
Kevin: So is the reason why France is not as affected because it did not move to all those alternatives? I think they’re still doing nuclear right now, are they not?
David: Correct, and they have embraced alternative energy for sure, but they didn’t shut down their nuclear power plants. When I was in France doing that race a month or so ago, or a few weeks ago, we were in EDF’s— one of their big lakes which they use for hydro, one of the largest hydroelectric systems in the world. So they’ve got a combination of things, but nuclear has been very helpful. So Germany’s being undone. France ends up picking up prestige and importance on the continent. Again, on balance, advantages accruing to the nuclear-progressive French. Macron, of course, in the next period of time, he’s going to have domestic challenges with a divided government. But from a continental perspective, France has significant leverage at the moment, largely insulated from the Russians by their more robust and what I would describe as a real world sustainable energy blueprint.
Europe, and Germany in particular, is experiencing nothing short of what the U.S. experienced in the 1970s—the OPEC oil embargo, radical inflation numbers, and very significant consequences from that. So imagine the 1970s inflation on steroids in a place like Germany. We mentioned the inflation numbers from PPI, German PPI, last week. That’s not going away anytime soon, unless Putin decides he wants to get cozy and friendly with all of Europe. Maybe he gets what he wants, and that becomes the case, and all of a sudden this becomes a moot point. But you mentioned electricity. Electricity prices over €600 per megawatt hour. Some analysts equate that to being like oil at a thousand dollars a barrel.
David: This is a big deal. So yes, state interventions may prevent social chaos. Again, we’re talking about the paying of power bills through the winter months, but that eventually reinforces downward pressure on the euro. So whether it’s France or Germany, and maybe it’s even localized in Germany, you’re still talking about major downward pressure on the euro as the liquidity issues become more obvious and credit standing is compromised through time, again, through these state interventions.
Kevin: You talk about the currency going down even further. Obviously, we’ve been getting some calls from clients saying, “Well, gosh, what’s the matter with gold? How come it’s going down?” All I have to do is just go pull up on the screen what gold has been doing against the euro, the Japanese yen, the British pound. Gold’s up double digits this year. So gold’s rising in these other currencies. The dollar, though, just continues to be strong. I mean, is there a ceiling on the dollar? Obviously gold looks like it’s going down in dollars, which it is, but it’s because the dollar is so doggone strong. If you look at the rest of the world, gold’s actually doing quite well and the currencies are sucking it up.
David: I mean, in fairness to the gold market, we’re off 4% to 5% for the year, and the dollar’s up 13%. So there is some weakness in gold, but not as much as there is strength in the dollar. Coming back around to Europe, if you want to understand the story of dollar strength, look, the eurozone game of wintertime energy brinksmanship with Putin, that puts even more support as we come into the end of the year for dollar strength, and, no, I’m not sure where the ceiling is. I think 112 is a target.
But this to me feels like snooker. I don’t know if you’ve ever played snooker before. It’s a little bit like pool, but you’ve got multiple colored balls. I learned to play it when I was in England with a bunch of English people who I learned are very diplomatic about everything that they present, and somewhat devious at times. This is a game where, if I want to win, I don’t have to make all of my shots. I can pick up points and ultimately win the game just by preventing you from making your shots. So, in other words, the euro continues to weaken, and as long as the euro’s weakening and the yen’s weakening, we win. But it is a little bit like snooker. As long as you lose, we win, which is kind of an interesting thing.
Kevin: So you were talking about the dollar not having an upper bound. Do you think it could go above 112? It looks bad for Europe right now, and actually Asia. With Japan’s policies of not raising interest rates, those currencies look like they might just continue to fall.
David: Right. The dollar does not have an upper bound in a world that is falling to pieces, and this is particularly true if you think of ramifications into the emerging markets, which we have yet to see in a DEFCON 1 stage with the Chinese melting down and the developer sector becoming much more broad in terms of financial markets and economic crisis there in China.
So the dollar, I wonder how high it can go. I don’t know. There’s a pretty decent point, if you’re just looking at points on a chart, 109, it’s been here once, it’s now gotten here twice. Could we be putting in a double top here and the dollar’s now going down? If you just look at the U.S. from a balance sheet perspective, assets versus liabilities, our ability to make payments on our debt, how we’re spending our resources, where we’re ramping up, not particularly heartened, frankly, by the most recent games being played with student loan forgiveness. By any estimates, 330 at the lowest, 500 billion at the mid mark, and some economists are putting it as a trillion dollar commitment. Well, trillion here, a trillion there, eventually you actually have to have the money and the wherewithal for these commitments.
So I look at the dollar as a short-term winner and a long-term loser. Could I see it trade to 70, the low 70s? Absolutely. But how high does it go in the short run? Anyone’s guess. It makes precious metals a very interesting call. Again, on a long-term basis, where’s the ceiling? But you can make a case for them trading inverse to the dollar.
I think that I am probably a little bit more philosophical about the ounces that I own. I would ask you, in a world that is rapidly destabilizing, with currencies a useful tool for buying social and political stability, which Fiat instrument do you wish to plow your savings into? Is it the euro? No, I don’t think so. Is it the pound sterling with double digit inflation, 10.2 at the last count and rising? No, I don’t think so. Is it the yen? Certainly it’s a liquid fiat currency, but they’ve communicated over and over again that they are determined to destroy themselves financially.
I realize that, as an asset manager, we have over 50% of our assets today in U.S. dollar cash equivalents. Versus the dollar index, that portion of our portfolio is up over 13% here today. Now, it doesn’t jump off the page because it doesn’t show gains. It just shows as a cash position and it doesn’t show the gains unless you go shopping it for another currency. So frankly, having half of our portfolio in cash, I’m not encouraged by that. Not particularly. I feel like, to some degree, in the short run, I’m betting a huge chunk of savings on Biden, Pelosi, McConnell.
Again, this is why I have more interest and comfort with gold. It brings me full circle to the reality of fiat. We win today because of more extreme losses elsewhere if you’re sitting in U.S. dollar assets. Someone is worse off than us, and that someone is, frankly, nearly everyone at the moment. But how long does that last? I would not be making a long-term bet on the U.S. currency.
Kevin: So when you have those temporary rises based on everybody else’s weakness, if gold goes down, this is a great time to add gold. Look at it. The euro, the yen, the RMB, look at the south Korean won. Gosh.
David: I think just as the dollar, arguably just from a chartist perspective, could be putting in a double top at 109 and change, you could make the same case that gold is reaching a temporary low and is ready to move higher. I’m not particularly concerned about 1725, 1675, 1775. I think it’s in a reasonable range, and I would be adding to it.
The South Korean currency is called the won, W-O-N. So for us in the U.S., we would say won. You won, I lost. I won. No, you lost. South Korean won is not the winner this year, 13-year low. Again, it’s this fascinating thing of, you look at currencies and they’re submerging. They’re submerging. We’ve got downward pressure reemerging. Again, this is the euro story, this is the yen story, even the RMB, Chinese currency. Dollar’s the winner, although no one has really won yet.
Kevin: Looking again at Europe, 37.2% on the producer price index, announced last week. My question would be this, Dave. Recession. Recession usually is isolated to a particular country, but in this particular case, if we go into a recession, when I say we, is that the world?
David: Well, economists have often argued that a lower currency value will promote trade. So think about this. Germany is really in an awkward position because as the euro depreciates, they should be gaining a trade advantage. As the yen depreciates, they should be gaining a trade advantage. Yet we don’t see that translating.
We see, at least in Europe, an inability to keep up with energy demand for the corporate sector. I mean, these are manufacturing companies that are having to run odd shifts. They can’t run their normal shifts, whether it’s one shift a day, two or three shifts a day. It’s having to be done in a very awkward fashion because of the energy crisis.
So, very interesting looking at the PMIs, both for Japan, Europe, and the U.S. These are the purchasing manager indexes. They’re not in the catastrophic zone. As we were running through last week’s numbers, they’re not in the catastrophic zone, but if you’re looking at both the manufacturing PMIs—we’re talking Japan, Europe, and the U.S. —and the service PMIs, they leave a lot to be desired. The bottom line from these surveys is that pressure is emerging everywhere, with more acute concerns there in Japan and Europe.
Kevin: We’re coming into an election time, and we’re hearing more and more about this student loan forgiveness. You brought it up a little bit earlier. Somebody’s got to pay for this. There’s no such thing as forgiveness of student loans. Let me ask you a question. Okay. I paid for my daughter’s college and then I paid for my son’s college. Am I going to be paying for everybody else’s college now?
David: Yes, that’s true. I mean, the student loan forgiveness scheme. I kind of think of it as a debt swap. You have an actual debt, and you can swap that for a social obligation to vote for the big guy. Because if you’re getting $10,000 off of your liability list, maybe there’s a little quid pro quo in there. I think what is really suspect is, a move like this, it’s obviously of a highly political nature coming into the midterms.
As recently as last April, we had Nancy Pelosi scolding the president for suggesting the forgiveness of student debt because the Oval Office doesn’t have the authority. So she knew. Note to self, something that Nancy knows that Joe doesn’t, that itself is interesting. This is the work of the legislative branch. It’s not something that can be announced or implemented by the executive branch. So it would require our legislators taking up the cause and bringing that about.
I think worst case scenario for Biden is that nothing is done, legislators don’t do anything, but there’s still an initial benefit to the party with the constituents that favor the student loan forgiveness out with a vote of gratitude for the president’s party. I would guess a majority of those were likely to vote Democrat anyways, but this might bring a few more bodies out in November. Your worst-case scenario is that nothing is done. Again, this is from Biden’s perspective.
Best case scenario from Biden’s perspective is that it’s written into legislation, and he has a campaign trial promise delivered to the progressive end of the party. I was noting very interesting commentary from many of the progressive end, who said, “Yeah, good try. Not nearly enough.” So that potentially trillion-dollar bill— It’s amazing. But the flip side is, Kevin, that there’s a lot of blue collar workers, white collar workers for that matter too, but can you imagine being a blue collar worker who doesn’t have a college degree, and you look at this proposal and find it objectionable. Why? Because you’re being asked to pay off someone else’s debt. You never went to college. I think he’s got a mixed bag here in terms of audience approval.
Kevin: I think those workers and, well, anybody who doesn’t want to pay for somebody else’s debt would say, “Wait a second, the government does not produce anything. All they do, they just redistribute somebody else’s wealth. They don’t produce anything. They’re not an engine of economic growth.”
David: I should say, just to be clear, there’s plenty of great blue collar folks out there who do have college degrees, so I’m speaking in generalities here. I don’t mean to be insulting. But you got to remember that government doesn’t create wealth. All they do is redistribute wealth. Wealth is created in the private sector. So all the money used to make those debts disappear, it comes from a much broader base of voters. The estimates are that between 12% and 15% of your typical voters qualify to receive the benefit. Again, this is at the expense of all voters. So a small segment of voters are benefiting from money that’s got to come from somewhere, and that may irk the working class. Could potentially backfire. I noted that the NAACP was a vocal objector straight out of the gates.
Kevin: Well, Dave, you’re still in Asia, and talking about a government that doesn’t really produce anything, the real estate situation in China has forced them to talk about redistribution of wealth that a lot of fiscal promises are being made right now. I mean, in the trillions of yuan.
David: Michael Pettis has made the case and pounded the table a number of times, even on our program, that the key for Chinese success in the next century is making sure that the household sector is adequately brought into the economy. What that means is making sure that a lot of the redistribution that the state prefers, because they kind of like having control of the reins, they actually have to let go and let the market become a market. This week we’ve got Chinese interventions, they continue afresh. One trillion yuan. You can divide by roughly six, about $150 billion U.S, was promised for infrastructure spending from the government. If you look at market action, it certainly helped a few of the developers’ bond yields come down in recent days.
Kevin: Yeah. A trillion here, a trillion there. If you were in Asia right now, it is a good time to buy gold, isn’t it?
David: Yeah. Anywhere I go I’m interested in seeing kind of what is happening within the gold retail space, and primary interest in gold here in Malaysia is, number one, dominated by the Chinese community. And number two, no surprise, followed by the Indian community. By the way, Malaysian cuisine is very much like Southern Indian cuisine in many respects, which you would have at a place like [unclear]. It’s amazing. Absolutely amazing.
But again, the Chinese and Indian community, they’re the gold consumers. If I could stay in Japan longer than sort of a transfer in flights, I’d be really curious to do some sleuthing and learn what yen depreciation has done in Japan to raise the profile of gold. Because frankly, 20% returns in any asset class generally garners some attention, and that’s what you’ve got. Year to date, which, not bad at just past the half point of the year, gold’s had an exceptional year in yen terms, and Bank of Japan does not want to raise interest rates in competition with other central banks. They’ve sealed their position in last place in terms of currency performance, at least in Asia. I mean, you look at a place like Turkey, it’s far worse, but in Asia, the yen is just— it’s circling the drain.
Kevin: When we went down to Argentina, the inflation rate down there at the time, this was in 2014, was about 40%. It got worse, but I remember there was a cost to exchange currencies. In fact, as you fly around, Dave, I remember coming out of Germany one time, and the cost of exchanging German marks at that time for dollars was too expensive. So I just turned all my marks into GODIVA chocolate, and brought it on the plane. That was my barter. But you brought up Turkey. I’ve heard that nobody wants to hold the Lira right now.
David: We talked about globalization and deglobalization, and how deglobalization is one of these significant structural shifts that reinforces the longer-term nature of inflation in this particular timeframe. As a part of globalization, we had a reduction in the cost of moving capital, and that’s what you’re talking about, is at an institutional level from country to country, we used to have capital controls everywhere. Now we’ve got capital controls nowhere, but you can begin to see where there’s economic frictions, where there’s concerns. I went to exchange dollars for ringgit the other day, the local currency, and just sort of back of the napkin math revealed a very interesting market bias. Most currencies, including the U.S. dollar, were trading at about a 4% spread. So the bank’s making some money, and you’d expect them to. Used to be that when you went to a bureau de change or whatever, kind of the street corner spot, you might pay 10% because they really were padding their pockets with the spread on the currency. But here, largest Islamic bank in Malaysia, not a street corner currency exchange, and 4%. That was the number. The Turkish Lira, very different. The Lira exchange rate was at a discount of 43%.
Kevin: Wow. Wow. You give up almost half.
David: Yeah, just to get out, right? Again, this is not your corner currency exchange. This is the largest Islamic bank in Malaysia. The Lira is either unhedgeable at this point or just generally regarded as toxic and untouchable. The clear message: we don’t want to buy your Lira.
Kevin: Yeah. You just don’t want to print too much currency. Well, I’m going to shift to real estate now because just a few weeks ago— Well, I’ll change that to a few months ago. You could not keep a property on the market. I mean, people would pay extra and outbid each other with cash. At this point, U.S. real estate, I’m hearing a really quiet room right now. I’m wondering if I could hear a pin drop.
David: For whom the bell tolls— and maybe that’s appropriate to associate with the real estate market. I think there’s some issues in the real estate market. One of the signals that is obvious here in recent days, you’ve got one of the largest single family home landlords, which was bought out by Blackstone maybe 18 months ago, sometime in 2021. Blackstone here in recent days has put a moratorium on new purchases in 38 states. So a major source of institutional demand has now finally asked a reasonable question—and this comes back to Jay Powell and the direction of interest rates. How reasonable are home prices, right? Is there sufficient cushion on the purchases being made if rates do continue higher?
Of course, if rates go up, that changes the nature of cap rates on housing, and whether or not something is profitable or not profitable and whether you can make money if you sell that property or not. Jay Powell answered the last part of the issue last week. Fighting inflation’s going to take interest rates higher. That he made very clear. Mortgage rates are somewhat tied at the hip to the 10-year Treasury. So upward movement in one becomes very relevant to the homeowner needing financing with mortgage rates, again, following suit on that upward trajectory.
Kevin: Yeah. So I remember 2005, 2006, 2007. In fact, we’ve sent out a CD with your dad talking, telling everyone that it was time to get out of real estate. That was timed very well because we had a real estate crash in most places. Will this be a crash?
David: It’s a good question. I mean, certainly if you think about the dynamics of the bond market being somewhat similar to the dynamics in the real estate market, it’s like the actions of a seesaw, if you can imagine that. Borrowing costs increase on one end, seesaw, home values decrease on the other end. Is it going to be a crash? No, not likely. Our best guess is that the 30-year fixed rate mortgage finds its way back towards 6½, 7%, and real estate values necessarily have to adjust lower by 20% or 30%. Is that a crash? No, and for most people you won’t even feel it because it’s not like your asset is being repriced by the market second by second as a stock portfolio would. So for most people, you won’t even know, but for anyone trying to liquidate, yeah, there’s going to be an awkward moment or two. So I think the Blackstone issue is an interesting one.
If you look at household net worth, housing is a big, big component, probably the largest component for the average household with stocks, bonds, real estate assets, things like that being in second position. But if you are seeing a decline in real estate, it takes a toll in household net worth. At the same time, stocks and bonds, sort of bonds other than Treasurys, they’re likely to be in the tank because basically every asset that has been leveraged, which includes real estate, is likely to see price compression.
Again, just the mechanics, that seesaw mechanical model, of interest rates higher, real estate prices lower, there might be exceptions to that on a location by location basis. But generally speaking, I think that’s what we have. And looking at the action in the stock markets, I think we were right calling the seasonal equity rally over and the bear market reemergence as we come into the September, October timeframe. So now you’ve got sort of a triple whammy on household net worth as we come into the end of the year.
This is one of the things too we have to keep in mind because it gets in people’s heads. Sentiment and economic activity ties to how people feel. Next week we’ll talk a little bit with Andrew Smithers, and one of his key points is that the economic models the Fed or the Treasury or other professional economists are using, they don’t account for some really basic things. Prior to the global financial crisis, there was very little attention paid to social dynamics or social psychology, market psychology, and now that’s been rectified. But there’s other issues that he addresses, and says the models still don’t account for some major inputs, and that leaves us highly vulnerable.
Kevin: You talk about perceptions and feelings. Quantitative easing has been a little bit like a drug for the last decade—that Fed just continuing to do quantitative easing. Now they’re in the tightening cycle. You talked about September, October, a reemergence of a bear market. September 1st, the Fed is supposed to, call it increase quantitative tightening, but that’s the same thing as decreasing quantitative easing, isn’t it?
David: Well, exactly. I mean, September 1st is when the Fed’s supposed to increase its quantitative tightening to 95 billion monthly. Translates roughly as 95 billion in liquidations, shrinking the balance sheet, selling assets like mortgages and Treasurys that are now in the books. So with recent equity market volatility, it has been fascinating to watch U.S. interest rates, particularly in Treasury market, remain relatively tame. As you look at high yield, as you look at mortgage rates, as you look at investment grade, there’s a whole bunch of other places where there’s been plenty of volatility with rates back on the increase.
But peace and calm in the Treasury market, the question is will that remain as there is this surge in fresh supply on the secondary market. $95 billion a month, that’s some real cash. But like I was saying with U.S. Treasurys, they’ve been fairly well capped. Anticipation of market turmoil has, it would seem, kept a healthy appetite for U.S. paper. Even with the anticipation of rates finishing the year much higher than current levels, the U.S. Treasury market—2, 5, 10—hasn’t really reflected much of a move, post-Powell’s comments. It suggests that the bond market doesn’t like the look and the feel of this new style of monetary policy, at least its impact. Stocks will be bruised, and that may in fact benefit bonds.
So we’ll see how the next few months of unwinding assets goes, but as for the Fed balance sheet changes, again, we’re talking mortgage backed securities, that translates to higher mortgage rates. That’s going to be part of this unfolding real estate debacle. I remember less than 90 days ago, local realtors were telling me a correction wasn’t possible. Rate increases didn’t matter. There was an endless supply of cash buyers. Again, I come back to Blackstone. They were cash buyers, too, and they just said, “We’re not doing any more of that. Not for the time being.”
Kevin: Funny how models, you were talking about economic models, and I’m really excited that Andrew Smithers is going to be back on. I think the last time he was on was when you did that interview over in Scotland and we heard the harp in the background. But honestly, reading his book, Economics of the Stock Market is fascinating, but I realized just how little vocabulary I know when economists are talking to economists. So I’m hoping when you ask these questions next week, Dave, you’re going to be able to put those questions into terms that I can at least understand. Excellent book, but what he’s doing is he’s challenging the efficient market hypothesis, and saying, “You know what? Markets are not efficient. Your models don’t work.” He’s challenging, from reading the book, the random walk theory, these models that economists have been holding to that have clearly not worked. This is one of his points. They’ve clearly not worked for the last 40 years, yet they are still being held to. He’s proposing not just cleaning up the old models, but throwing them out and looking towards new models.
David: Listeners may sometimes wonder why we talk about things like structured scientific revolutions. What does that have to do with the markets? What does that have to do with economics? This is a perfect case in point because, yes, the model has been broken, and Smithers would say the neoclassical economic model should be thrown under the microscope for greater scrutiny, and it’s not been done. Even after the global financial crisis, very little soul searching was done amongst economists to figure out why they got it so wrong.
A part of this comes back to Thomas Koon’s book, where he suggests that you have these “textbook biases,” and what you learned, what you studied, what you wrote your master’s thesis on and your PhD thesis, you have far too much invested in to come back and upend and sort of redo. So you just keep on working off of the same old tired, broken down assumptions because, frankly, there’s too much ego involved to say, “I was wrong and I’ve been wrong most of my professional career.”
So the economics of the stock market, and I agree with you, as I read Smithers, there were parts that stretched beyond my background in economics, and conclusions that he robustly supports—coincidentally I already assumed to be matters of fact—but what I like about the book is he builds and buttresses the case for the importance of the stock market in economic theory. May sound strange that many economic practitioners don’t consider the financial markets, don’t consider leverage, don’t consider the banking system as they construct explanatory theories of human behavior with measurable economic results. We do. I mean, as a part of our weekly conversation, we’re talking about the influence of liquidity. We’re talking about the markers of the ebbs and flows, financial market frailties that do, in fact, impact economic variables, and are massively important for that overlapping piece, psychology in the markets, and of the agents in the economy driving activity. Most economic models leave those factors out.
So Smithers spends a good bit of time looking at the importance of companies. Again, you may say, “Is this is really important?” Economic models treat the private sector as one thing, and he looks at them and says, “Wait, there’s a distinct and important variable in the private sector.” As you look at, and this will be common if you’ve read his other books, and we’ve talked to him about some of these things too, issues about corporate remuneration, executives getting paid as handsomely as they are, and their compensation packages being tied essentially to earnings per share volatility.
So due to these shifts in recent decades in remuneration, managers—particularly of publicly traded companies—have a different set of priorities—different than owners, different than households—but again, these economic models look broadly at the private sector versus the public sector and don’t make the distinction within the private sector of households, corporations, and the extra motivating factors that corporate leaders, corporate execs, corporate managers have today. How are they gearing their corporations? What decisions are they making in terms of spending? The key here is that management decisions, whether it’s about balance sheet, leverage, investments, raising capital in the form of equity or debt, they’re consequential, and they’re not being factored into economic models.
So we go back to the global financial crisis. It occurs, the economic model suggested it wasn’t possible because the behavior of firms was not understood, was not anticipated, was not incorporated into the model, so we continue to find this frail financial system. Part of the construction comes from this self-interested, short-sighted motivation of managers. Again, benefit in the short run from things that can ultimately and long term impair those companies, compromise the safety of the markets in total, but hey, you get your bonus.
Kevin: Yeah, Dave, I was sharing with you before we started recording, I had to come back to the book about three times because I thought, “Well, this is economics. It’s over my head,” but as I continue to absorb it, you know how sometimes you get used to the vocabulary and you start understanding there is an overall spine to this. What I felt like he was saying was, in private sector, not counting the government, the managers of corporations are basically, like what you were saying, they’re happiest with high stock prices, whatever that takes, and not as concerned about the overall net worth of the company, because the board of directors is looking at stock prices, oftentimes their bonuses have to do with earnings per share and how are things going, what’s that perception?
It’s very different, however, with the households. Like the people that we work with, people who are saving for retirement or are already retired, they’re not as concerned about speculating and making money and increasing their standard of living in the future. Their concern mainly is about not being poor, poverty. Their concern is not being poor when they’re retired. So preservation is a much bigger key. Well, that plays a lot into whether you look at the bond market or the equities market, and even the tangibles market, doesn’t it?
David: Yeah. What resonates with me in talking about that spine that goes throughout, or the thread that goes throughout, each of his books. What resonates with me is cyclicality within the markets and reversion to the mean. Mean reversion is one of the— that’s a cornerstone within Smithers’ thinking. In the final analysis, Smithers returns to his other books, because this was something he covered there. Mean reversion is key if equity returns over a long timeframe are somewhat of a known factor. Your over-performance in terms of portfolio performance or under performance relates to what you paid for it. Did you pay too high a price? You’re going to underperform in the years ahead. Did you pay a ridiculously low price? You’re going to outperform in the years ahead. So value matters in this notion again of mean reversion.
This is why we look at something like a gold/silver ratio. We love the gold/silver ratio because I don’t care if the price of silver or gold is going up or down. What I do care about is the relationship between the two metals, and the relationship between the two metals is fluctuating above or below a mean, and I need to know where it’s at relative to the mean so that I can continue to compound ounces using the gold/silver ratio to do so.
So mean reversion, whether you’re applying it to gold and silver, or mean reversion if you’re applying it to stocks or investing in other assets, he particularly focuses on the stock market because he’s got great data going back centuries, it’s a really helpful way of framing things. To me, that’s what the nub is. He’s basically said, “Look, there’s going to come a day—” Let me speak for him. I don’t know if he’s said this, but let me speak for him. There’s going to come a day when the neoclassical consensus is acknowledged to be a complete failure, and what we know about theory, going back to Thomas Kuhn’s Structure of Scientific Revolutions, is that you have to have a theory waiting in the wings to replace it. So he’s providing something that is very dense, is fairly— it’s tough reading. It’s tough reading. But it’s the theory and the tested version of what he thinks could be a good complement or substitute to neoclassical models and economics.
So it’s very intriguing to me, again, because it ties back to this notion of, when do you play and when do you not play? If you understand mean reversion, then you care about values and valuations and you’ve got to know where you’re at in the continuum. You can make a better decision on an unbiased basis. You can let the math speak. Again, we go back to the gold/silver ratio. Let the math speak. What’s your next decision? Let the math speak. Are you caught up in a blow-off bubble phase, or are you taking a different tack as an investor? Let the math speak. I think that’s what you find with mean reversion. So, look forward to the conversation with Smithers here in just a matter of days,
Kevin: You’ve been listening to the McAlvany Weekly Commentary. I’m Kevin Orrick, along with David McAlvany. You can find us at mcalvany.com. M-C-A-L-V-A-N-Y dot.com, and you can call us at (800) 525-9556.
This has been the McAlvany Weekly Commentary. The views expressed should not be considered to be a solicitation or a recommendation for your investment portfolio. You should consult a professional financial advisor to assess your suitability for risk and investment. Join us again next week for a new edition of the McAlvany Weekly commentary.