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- Is your broker still managing as if there is no inflation?
- Can we really blame the Russians for $100 oil?
- James Grant: “Inflation is kryptonite to the financial markets”
The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
The Ukrainian Tug Of War: Oil Is The Rope
February 22, 2022
“I think we could be looking at a 50% to 60% decline in equities between 2022 and 2023. The stage is set. You have all of the ingredients, including Superman pretending like nothing can fell him. That’s the financial markets today—not unlike Superman. Faster than a speeding bullet, more powerful than a locomotive, able to leap tall buildings in a single bound. Nothing holds us down—except a little kryptonite.” — David McAlvany
Kevin: Welcome to the McAlvany Weekly Commentary. I’m Kevin Orrick, along with David McAlvany.
There are some major changes sometimes in countries and in the world, Dave. I think about the railroad and the impact that it had on the United States. The main ports for the United States were of course in the East: New Orleans, New York. Those were the main ports, but when the railroad was finished, San Francisco became a critical port. And I remember going to Germany and I remember the impression that I had when I was in Hamburg. Beautiful, beautiful city, but it reminded me of San Francisco. You know how some of these port cities that come on a little bit later, they remind you of far away places? And the reason I bring that up is you and I have been talking about this as to how does that apply to the Ukrainian situation. And what I’d like to do is I’d like to go back and have you tell the listeners a story that I got a chance to hear when you and your son went to the Hamburg Maritime Museum and what you learned there about the shift in world, or at least European, politics and how Hamburg played into that.
David: Certainly the reorientation had to do with Lübeck and Hamburg, these two trade cities in Northern Germany. And there was a dramatic shift that happened, particularly as the steam engine came into play, and Hamburg became a provider of products to the world, and a significant European hub. It was a change in orientation in Europe towards the West and away from the East and away from the Baltics, Lübeck being on the Baltic Sea.
Kevin: It was a little like the railroad for the United States. It connected to the West and Western trade through San Francisco. Lübeck before that was oriented toward the East and more toward a Silk Road, Eastern orientation.
David: Yeah, and certainly towards Russia. The fun part of being in Hamburg on that particular occasion, my son and I left, we had some historical insights. Great museum, by the way, Hamburg Maritime Museum, not to be missed. But we’d parked outside, and we emerged and our car was gone. And I didn’t know if it had been stolen. I was parked legally, but apparently what is legal in one moment is illegal in another. We stayed past our permitted time, and all the other cars that we had been parallel parked along with, they had driven on and gone home.
Kevin: And you’re a foreigner now without wheels and without the language?
David: And I don’t sprechen sie Deutsch, not very well. So we scrambled to recover the car, which has been impounded, and what a great adventure that was, a crisis to adventure. I think my son will never forget it.
Kevin: And I want talk about this, the Hamburg-Lübeck connection, though, because in a way we’re seeing something like this right now. And it has to do with a world shift in geopolitics toward the East, Russia and China, or continued with the West, which of course would be the NATO nations and what have you. So bring Hamburg into that picture because I think it applies to what we’re seeing right now in this geopolitical struggle in Ukraine.
David: So for context, you’ve got France’s foreign minister this week describing the Russian move to recognize the independence of these two statelets in the Donbas region, describes that as a weaponless aggression, but no less than a breach of the Minsk Accords. And the Minsk Accords were the beginning of a cease-fire between Ukraine and Russia. This goes back seven, eight years. There are now unknown geopolitical risks developing, and they’re developing momentum. And for now I think you could say that escalation is an apt descriptor.
Kevin: If you’ve ever seen a tug of war, if you’ve ever been part of a tug of war, that center part where the rope doesn’t have anybody touching it, that would be a little like the Ukraine, that 500-mile expanse. That’s the tug of war. Where do the Ukrainians stand?
David: NATO’s on the one end of that power struggle, and Western Europe, and then Russia on the other, pulling the rope the other direction. I spoke with a couple in our community from Ukraine. One’s Lithuanian actually, and the other Ukrainian. And they were adamant that Russia was underdeveloped and more of an extension of Ukraine than Ukraine being a part of Russia, as Putin argued in this Monday’s speech.
So Putin’s view is that Ukraine is, this may not be a perfect analogy, but it’s a little like Texas. It’s a part of a larger country with a few unique aspects of independence, but from a federalist perspective, still a part of the country. So that’s Ukraine to Russia, Texas to the United States. This couple wanted to entertain a longer swath of history where Kiev was the cultural and political center long before Moscow, and that Putin’s history really seems to begin at about 1917. There was nothing of value before the Bolsheviks. Anything prior to 1917 would be an illegitimate history. And of course that sounds like what we know: those who win the wars tell their tales and write the history. So not a surprise that Russian history more or less begins in 1917 with the Bolsheviks.
Kevin: We know that everything back in that area is ancient. Man’s been there for a long time, so you have to go before 1917, but let’s just take it to current times. The Sochi Olympics, remember in 2014, Ukraine became an issue right after the Olympics. Now we’ve just finished the Olympics here. What was interesting, though, it actually started in 2013, and the West’s presence in it actually began in 2013 when we had a quiet coup of an Eastern-leaning leader and we put in a Western-leaning leader in Ukraine.
David: And I think this is where things get muddled. The State Department was one of the sponsors in the coup in Ukraine in 2013. It ousted a Russian-friendly president and replaced him with a US-friendly political partner. We’ve been a part of the majority of regime changes in the last 60 years. That is our US State Department. And the benefits always accrue to the US in some way, in some instances to US politicians.
Kevin: Isn’t oil involved in this? I mean, oil seems to be involved in a lot of the State Department decisions.
David: Yeah. Now, I mean, things were a little bit different. You referenced Sochi and the Olympics, that’s a 2014 response to what happened in the 2013 coup. And the Russians basically said, “Yep, we’re taking this back. And it’s a warm water port that we’d like to keep.” And I think it was Khrushchev gave it to the Ukrainians in ’53 or ’54, I forget what year. So they had a rationale with justification. Everyone does when they have geopolitical moves in motion.
Kevin: But do you see a strategic advantage? I mean, countries are still going to fight for their own advantage, right?
David: Yeah. The strategic advantage of diminished Russian alliance in Western Europe is I think what we have in motion today. So I see the strategic advantage for us if we can undercut— if we can diminish Russia’s ability to control Europe to some degree. And again, a number of reasons to rejoice over the suspension of Nord Stream 2. Not that I hope for higher energy costs in Europe or for the Germans, but the alignment of interest through Nord Stream 2 shifts dramatically Eastward, and that does have a troubling long-term implication. Nord Stream 2, if ever operable, will shift political alliance back towards the Baltics and back towards Russia.
Kevin: So that’s reminiscent of what you brought up between Hamburg on the West and Lübeck on the Eastern side. So, in a way, before the sea with steam power became a possibility on the Hamburg side, you actually had land trade that was oriented toward the East for thousands of years. I mean, we call it the Silk Road, right?
David: Yeah. So the Hanseatic North, you’ve got medieval trade which centered through Lübeck. I think it’s an interesting history. Prior to the 16th century, Lübeck was the primary center of trade in North Germany, and the orientation was Eastward. Again, situated right there on the Baltic Sea. Gradually that started to shift to Hamburg. And then again, as you look at technology recreating the stretch and the reach and the breadth of the world, now you’re talking about steamships opening markets to the West and the whole world, and Lübeck’s significance, along with a German orientation Eastward, an Eastern orientation in trade and political influence, it begins to die.
So you’ve got the tale of those two cities and it’s always reminded me of a couple things. One, how real estate values are not constant and how structural change can permanently impair what was previously an ideal location. So in real estate, people say location, location, location. Here we are on water, here you’re in the middle of a trade center, and yet time can change things. So I also reflect on Lübeck and Hamburg in terms of how economic growth and political alliances are tied together. The Baltics faded, Northern Germany shifted from a regional trade audience to a global trade audience. And again, you’re talking about two cities that are only 40 miles apart.
Kevin: It’s an amazing thing how close they are together. But we’re also talking about a tug of war, and Nord Stream 2— this involves oil from the East versus oil from the West.
David: And I think Nord Stream 2 is a reversal of that multi-century trend. Energy dependence, like an earlier trade alliance, it reorients culture and politics over time. In this case, we’re talking about a long-term reorientation towards Russia. So it’s no surprise that NATO is conflicted. And frankly, Germany is conflicted, but they’re also in need of cheap and reliable energy, so they’ve pushed that project along.
Kevin: In recent weeks, we’ve talked about how Biden and to another degree Boris Johnson need— or they’re acting like they almost need a war. But in other ways, Dave, as a Westerner, I can see where there might be a need to interfere in the launch of Nord Stream 2.
David: That’s where the conversation gets interesting because you can look at things from an amoral, chess board perspective and say here’s the right move, but when you bring in the ethics of involvement in other countries— Again, from the chessboard perspective, there’s a case to be made for interfering in the launch of Nord Stream 2. Is this really about the Donbas? Is this really about Russian militarism and Putin being a strong man in Russia and extending? Is this about Ukrainian independence?
The fact that Biden and Johnson have so aggressively pushed for conflict, that in itself is intriguing. It’s not like the two of them are global champions of the underdog, or that the two of them are standing up to strongmen everywhere with equal honor and integrity to fight evil and injustice, because frankly, the world ignores real catastrophes every day. I think of Myanmar. That comes to mind. We’ve let military-led violence flip that country upside down in the last 12 months, with child soldiers— I know this directly because my parents are involved in a children’s home there, where the kids are being recruited. Okay, this is high drama, real evil ,and we don’t care. Barely a whisper from the media or from politicians.
Kevin: It doesn’t play into the strategic alliance of the world. And just an observation, Dave, just working here the last 35 years. If I go back and look at any US war other than Korea and maybe Vietnam, just about everything else has had to do with this oil power struggle and even the dollar strength with oil, what we call the petrodollar. So you’re right, you don’t want to get involved, but if you don’t get involved, do you lose the power?
David: But this is where it’s difficult as an analyst of economic and political trends to look at things again from the chessboard perspective, and then to look also from the standpoint of moral obligations, to see that there’s actually multiple ways that people address these things. Is it through the lens of moral obligation or is it just pragmatic engagement? I think what you find is there’s no vocal protests on a number of things that are really, you could argue, a moral obligation. And then here we have a pragmatic engagement. I would see it as a pragmatic engagement.
Vocal protests are more common where interests are being challenged. I mean, interests, my interests, your interests, our country’s interests. The West doesn’t give a nickel about places like Myanmar, but it cares about Ukraine because there are wetted beaks in Ukraine, and it certainly cares about a rapidly changing world order.
So you’ve got the US and Europe that are in a slow process of losing control. Yes, China has been on the ascent. Might they press for advantage selectively through situations like this? We’ve got trade relations. We’ve got the One Belt, One Road project. We’ve got the re-engineering of a financial backbone to displace Western control flow of funds. I mean, we look at SWIFT and this being a potential hammer to swing at the Russians, and yet the Chinese are there to re-engineer something that is a non US-centric alternative.
So the cooperative pressures between Russia and China on the old order are opportune, and I think we’ll see them even more frequently as time goes on. What I’m saying is that Russia and China have an opportunity to test and measure the strength of the existing global order. And they will, as they watch our responses, develop a tailored strategy in light of what they observe in the coming months and years.
Kevin: I read a book that your dad turned me on to back in the 1980s called New Lies for Old, and Anatoliy Golitsyn was the author. He was a defector out of Russia and he was actually hiding somewhere in England. But what was interesting about the book, at that time, we saw Russia or the Soviet Union as one very strong entity, let’s say. We saw China as a very separate entity, they weren’t unified. But he brought out that the 50-year plan, at least from the Soviet side, was ultimately to have a Sino-Soviet agreement that he called the pincer. And I thought, wow, that’s interesting. Communists think in 50-year plans. We know the Chinese do, and the Russians did too. Now we’re looking at business, and when we look at business and politics, sometimes we think, well, maybe that’s not the larger move. So the Clintons being involved with their foundation, or Hunter Biden, let’s just talk about that. But that’s not the main thrust, is it?
David: Yeah. I know this is controversial. We all have ideals and pictures of leaders that we need to keep in mind. This week we celebrate George Washington’s birthday, and there’s a certain elevated position that leadership takes. And it’s helpful for us as citizens, not that George Washington was the monarch, but you can look at the UK and say, well, they have this group of people that’s elevated in their minds, and it’s important for social stability to see that.
So it’s sometimes difficult for me to go through some of these details, but the reality is, politics is dirty and deals are done all the time that if a bright light was shined on them wouldn’t necessarily make sense. I mean, yeah, the Clinton Foundation brought in $145 million from various Uranium One stockholders and board members. And I’m sure that was all clean, right? But the Uranium One deal got done, and they did see a huge benefit. Maybe they’re disconnected. Okay, maybe it’s not a big deal that the Clinton Foundation had $8.6 million coming in from a Ukrainian pipeline oligarch, or that Burisma hires Hunter Biden to be a board member.
For anyone who’s been around politics, this is not controversial. A classic pay to play move for the children of a political elite in order that mommy and daddy’s Rolodex can be monetized, this happens. It doesn’t matter if you’re a Democrat or a Republican, it’s the same game. So Ukraine has been a source of US political graft for some time now. US aid flows over, kickbacks, carve outs, opportunities accrue to US politicians or their kin. What’s confusing is I’m not sure if our standing up to Putin is along diplomatic or philosophical lines, defending the territorial integrity of Ukraine, or if those lines are blurred by private party opportunism.
Beyond graft, we have a midterm election here in the US, and I think we can thank God for that for many reasons. The midterms seem to have cured COVID, so that’s an amazing thing. Pfizer didn’t do it, the midterms did. But note that there’s also the drumbeat of war aligning with an appetite for retained domestic power. In previous weeks we’ve talked about that—distracting the masses. Biden and Johnson are both hurting right now in the polls, very much so. So who is today speaking like Mark Antony, “Cry havoc, let slip the dogs of war”?
Kevin: Okay. And it’s not just the Ukraine. We talk about the center of the tug of war. It seems that Germany has been a key element, and the leadership of Germany, as to what direction do they turn their compass needle for their oil. That seems to have been— Well, we can look at the 20th century and we can look between Stalin and Hitler, there were alliances until they were broken, and when they were broken, Stalin hated Hitler.
But going further back, we can see this German-Russian alliance, Catherine the Great, what have you. Going forward, if Germany and the leadership of Germany were to turn to the East again, and you were just talking about Nord Stream 2, that would have a powerful impact on the rest of Europe and the world, would it not?
David: Yeah. I’m reminded of some of these intriguing connections I have personally. I have a coin collection of old German coins. Some of them are 15th century, 16th, 17th, 18th century. But as you start seeing the names and the city states, particularly as you get into the period of the German city states, there’s such a crossover in the family tree between England and Germany, Germany and Austria, Germany and Russia. I mean, it’s just one royal family in Europe. So it’s kind of, are you favoring one side of the family or the other?
Kevin: Well, and Germany feels like the center of the world when you’re there. It’s interesting, you go to Berlin and you just get that feeling that— Charlemagne’s throne was in Germany. That was his second throne. So you had Rome and you had Germany. So world politics for the last 2,000 years seemed to have hinged on Rome and Frankfurt and some of the key areas of Germany. Now Russia has been vying for their business.
David: Yeah. As we see an escalation between Russia and NATO countries, what we have proven is that Russia’s serious about ending the Ukrainian migration towards NATO. That’s clearly a touchy subject for them. Nord Stream 2 was suspended this week by the Germans. So you’ve got Scholz, who takes a hard line on the Donbas recognition, and I think that’s good to see. That’s probably a blow to his predecessor. I wonder how Gerhard Schröder feels this week. He’s the ex-chancellor of Germany who in recent weeks was nominated to the board of Gazprom.
Kevin: Isn’t that Russia?
Kevin: That’s Russian energy right there.
David: And he’s been chairman of the board for Nord Stream 2 for several years.
David: So again, if you’re a skeptic about the nature of politics and money and my earlier comment on political influence being hireable, Schröder anyone? That’s not conspiratorial, that’s just the way the world works, like it or not. We prefer again to keep leaders in an elevated and pristine position and condition, but they’re human beings. They’re looking for opportunity. They’re looking for a leg up. They’re looking for— I don’t know. But this week we’ve got Russian stocks. They traded lower on a wholesale basis. We’ve got their bank stocks down 20%. You’ve got Russian energy companies down 20%, 25%, Gazprom included. Sorry, Schröder, your Rolodex didn’t count for much this week.
Kevin: He’s got to seem like a turncoat to the West, with him being with Gazprom at this point. But can we blame Russia for $100-a-barrel oil? I mean, we haven’t seen oil this high in a while.
David: Only to a degree. They’re really only responsible for about 2 bucks, 15 bucks, 20 bucks of geopolitical fear premium. If you want to appreciate the lofty perch of $80 from which the fear premium launched you, you can wag your finger, you can point towards Biden’s green agenda and the collective global conscience, which is harassed by the idea we’re incinerating ourselves through climate change, and the use of fossil fuels are driving mass carbon emissions.
What that’s meant is that oil companies have underinvested. They’re not replacing their reserves. Best evidence of this is that you’ve got the largest share buybacks of oil companies in years. I think it’s between $38 billion and $41 billion, and that’s share buybacks. Companies will tend to buy back more of their shares when they don’t have better things to do with their money. So we’re going to see a big bump in dividends from your energy companies, big share buybacks.
But again, they wouldn’t have that capital available if they were working on development projects. They’re putting their finger to the wind and saying, again, whether it’s Angela Merkel, who was like, “Look, we’re done with nuclear. We’re done with fossil fuels.” There’s been a universal theme that we are moving towards electrification and decarbonization. And so, again, I think you have to look at the unintended consequences of political agendas the world over. Then, of course, I think you can also include in that the investment dynamic of speculative dollars flowing into the oil market hedging against inflation.
Kevin: Well, why not? I mean, you do it, Dave, honestly, with your management.
David: Of course.
Kevin: You’ve done that as well.
David: Well, of course.
Kevin: And we see an increase in gold buying right now because of inflation, but we’re seeing oil is a hedge too.
David: But isn’t that reasonable after a 24-month binge of US credit growth? I mean, in that timeframe, 24 months, we’ve expanded M2 by 41%.
Kevin: Oh, so it’s not just supply chain, it’s actually expanding? Printing money actually creates inflation, Dave? Wow.
David: There’s supply and demand dynamics impacting the oil markets. There’s investor demand on the basis of inflation hedging. Yes, there’s a fear premium because of Ukraine and Russia. But other central banks have done the same thing as us. To see our monetary expansion of 41% over a 24-month period—not that it was coordinated; maybe it was more of a copycat-type thing—but other central banks have done the same thing. So as a sea of liquidity hits the asset markets, there’s no surprise that inflation has entered the investment context in a real way for the first time in several generations. So truthfully, truthfully, the shifts in the credit markets and the change in footing for monetary policymakers, although it’s less intriguing than Russia and Ukraine and the drama involved, we’re getting pounded in the news by that, frankly, it’s more important. It’s far more important.
Kevin: So I was talking to a client that we both know this week and his family, they did real well in the stock and bond market over the last few decades with a man at RBC and also another man at Merrill Lynch. And I asked him this week, because he’s considering moving a large amount of money into something else, but it’s very hard because, as a family, they’ve done real well in stocks and bonds with typical management. I just asked him, I said, “What is your advisor doing now? I understand loyalty, but what is your advisor or your broker doing now differently because of inflation?” And that’s where the long pause came. He says, “That’s the problem.” He says, “He’s just managing as if there is no inflation.” Because really, let’s face, it’s been 40 years, Dave, since we’ve really experienced inflation. Hardly anybody out there has been in the business that long. They don’t know how to do it.
David: I read a piece this last week, arguing that the bond market blues of the last several months were nearing an end and that our concerns should now shift to a refreshed allocation to the market, which, look, bonds provide protection, lower volatility when you match them up with stocks. The advice by this columnist was buy bonds after this latest selloff because they’re on sale. And what amazed me—as this financial expert waxed on confidently about the reasons to own a 50-50 portfolio of stocks and bonds—was that he managed to avoid any reference to inflation.
Kevin: Isn’t that interesting?
David: This is a piece talking about a bond bear market, and not once does inflation come up. Credit risk is covered. Duration risk was mentioned, which may be a slight nod to what can happen to you through a long stretch of ownership up to and including inflation, but the word was not mentioned once. And you would think, if you were making the case for a bear market in bonds coming to an end, you would respect the carnivorous aspects of inflation, which takes a significant bite out of returns. Not a single mention of real returns, either. Everything was nominal this, nominal that.
What it suggests to me is that we have yet to see outflows from the bond market in earnest. Last week, we did see $2.54 billion exit from investment grade bonds. $3.55 billion was the dump from the junk bond market. And year to date, new issuance in the junk market is about 50% of what it was by this time last year. The wheels are not coming off in the fixed income markets, but there is growing pressure on all fixed income. From high yield, that is junk bonds, all the way to Treasurys, losses in virtually every category of fixed income. So that piece I read suggested that the best way to own a bond is just to never look at the price, clip the coupon. And I thought, in time maybe you’ll be fine, but again, how inflation and real rates can be left out of the conversation on bonds, that’s strange to me.
Kevin: And we have to look at inflation. You have to make a return greater than inflation in the long run to be able to keep up. But just this 50-50 or 60-40 common allocation that these guys have been taught, as of the first of the year till now, we’re down between 10%, 12%, 14% with that allocation. Not everybody. Not everybody. McAlvany Wealth Management seems to be doing a whole lot better than that, but I’m not allowed to talk about that on the Commentary in specific.
David: Like that we actually have positive returns this year while all of your indexes are negative?
Kevin: No. That’s what I was trying not to say, but yeah, I guess you can.
David: I talked to a prospect earlier this week who didn’t have a 50-50 portfolio, didn’t have a 60-40 portfolio, had a 70-30 portfolio, but it was the wrong way because when you’re setting up those portfolio structures, according to modern portfolio theory, he’s in his 70s and it should be 70% bonds, 30% stocks. He was 70% stocks, 30% bonds. And I guess Fisher loves that kind of risk taking in the equity market, but the portfolios, again, if you’re looking at any of those mixtures, not only have they suffered since the beginning of the year on both sides, losses in stocks, losses in bonds, but they continue to. So much for safety provided by dual assets, diversification. They’re finding that, under certain circumstances, those portfolios have a correlation of one. Everything trades as one asset.
So you’ve got the merits of risk parity and other strategies that are supposed to hedge equity risk with bonds, which are now being called into question. And the reality is the 60-40 portfolio works in a certain context, the 50-50 portfolio, the 70-30, either way, whether it’s over emphasizing bonds or over emphasizing stocks. Success in any asset class, it ends up being idiosyncratic, it’s context-bound.
Kevin: Well, let’s also expand that to the indexes because a lot of people, they have their 401k in something called the 2030 Fund or the 2035 Fund or the 2040 Fund. And what it does is it just takes that same asset allocation and maneuvers it based on when they think you’re going to retire. It’s not a different strategy, is it?
David: Another fascinating conversation with a couple from the Southeast that spent a lot of time on a boat, love their catamaran, were sad to sell it recently. And they said, “We love sailing. You have to appreciate that you can go from having your best day ever, the most exhilarating moment, to being absolutely terrified. Nature does not care about you.” And I think that’s one thing that the market has forgotten, market investors have forgotten. The market doesn’t care about you. And you can go from an exhilarating moment of excess profits to a moment of extreme terror. And if you thought that the math of my retirement date is X, Y, and Z, therefore I’m invested for my retirement, the market’s not keeping track of your timeframe. It doesn’t know you by name, doesn’t care about you, and will either help you or harm you with no personal vindictiveness or love either way.
Kevin: And so we’re talking about context, weather is context. When you’re in sailing, context is the weather. The weather can change, and you can be terrified. Are we in a new inflationary context?
David: Of course. This is a fresh context that’s not likely to disappear overnight. Concerns over inflation are now being factored into collective decision making, that is consumer decisions, credit decisions, bank lending decisions, investment allocation decisions. Inflation has not been a major factor in 40 years. And investment managers have by and large come to view it as a fictional character that rarely appears and plays little role in the markets at all.
Kevin: At least once a year, you go out to New York to Jim Grant’s conference, and of course, we have him on the Commentary as well. Brilliant guy. But if you think of the dollar and the markets and the financial markets as Superman, he said something this week that I thought was interesting, it’s kryptonite. Inflation is kryptonite to the financial markets. It destroys—
David: That’s right. That’s right.
Kevin: But the wind in the sails, using that also. The wind in the sails—it sure changes.
David: Yeah, “it goes without saying that inflation is the kryptonite of financial assets,” as from his most recent weekly missive.
So, Kevin, the role is small, but it’s powerful, and I think that’s worth keeping in mind as we consider the long march of commodity prices of supply-constrained and demand-pressured prices. It’s worth keeping in mind as all markets wake up to weakness, and we’re talking about stocks and bonds and private equity and private credit. They’ve seemed to only have known strength, and inflation is the kryptonite of financial assets.
We have all the factors in play that keep inflation a real economic factor going forward in time. No longer can we point to supply chains. We’ve got the self-reinforcing dynamics around inflation, including a change in consumer behavior, higher wages, drawing up the floor on prices to new and permanently high levels. The most recent University of Michigan sentiment numbers were very interesting to me because on the one hand, they’re negative, even as retail sales were positive. That may suggest that we’ve got an increase in buying as buying ahead, out of concern over rising prices. And that is characteristic of the self-reinforcing inflationary spiral. The knee-jerk political response is, of course, when they see the price spiral to reconsider price controls.
Kevin: Yes, but what if we had the Build Back Better? Supposedly spending trillions was going to decrease inflation? Isn’t that what we were told?
David: That was an interesting part of the sales pitch, yes, this was fiscal spending that would not have a positive inflationary impact. It was actually going to draw inflation levels down.
Kevin: Yeah. What economics textbook are they reading?
David: I would guess one from Harvard and MIT, but that’s another story.
Let’s not forget the political permission granted to spend trillions. As we’re talking about the dynamics which have pushed inflation and maintain inflation levels. Great appreciation for Joe Manchin for stalling the Build Back Better boondoggle. And again, another trillion dollar plus spending package, as you said, presented as an inflation reducer? Yeah, laughable. But it would’ve been, could have been more fuel for the fire. And I don’t think we’re done with fiscal spending, not after what Republicans and Democrats alike have discovered as an amazing tool for lining up votes in the next election. And nor can we neglect— here we are talking about fiscal and supply chain stuff, and we can’t neglect the central bank policies, which have created trillions out of thin air. Also a factor in this kryptonite production.
And it’s still there, this is what’s amazing. We’ve got an inflation problem in Europe. The ECB deposit rate is still at a negative 50 basis points, and quantitative easing operations are still in effect even as inflation in Europe breaches 5%.
And it’s no different in the American context, 7.5% inflation. The Fed has yet to halt mortgage-backed securities and Treasury purchases. I mean, we’re talking $30 billion, $60 billion, $80 billion between now and— maybe they do end it. QE is coming to an end, but it hasn’t ended yet. Isn’t that crazy that the Fed funds rate still sits between 0 and 25 basis points?
We’ve got the recently adjusted CPI measure marking the highest high water mark for 40 years, yet the Fed, like the ECB, stays on the path of balance sheet expansion. I mean, this is where it’s tragic, forever marking their credibility down. They’re essentially marking their credibility to basement levels that match interest rates. It’s subterranean stuff. It’s not a positive ratings scheme.
Kevin: So, like the question that I asked my client, what is your financial counselor doing different now that there’s inflation, and there was nothing. You could ask the same thing of the central bankers. Okay, so let’s go to oil for a second because we talked about $100 a barrel oil, but let’s say this Ukrainian thing just goes away. You said that $80 of the $100 is already built into the structure. So we might lose $20. If all of a sudden Ukraine, it became a non-issue and the geopolitical concern goes away, we still have $80 a barrel oil, right?
David: Oil has $80 worth of momentum and demand-driven pricing in it.
David: Now, with closer to $20 tied to geopolitical premiums, we’re close to $100 for the Brent contract. And we have a perfectly disastrous mix of inflationary pressures on top of spiraling wages and credit expansion. But on the oil front, it’s the fact that we’re sitting at 11.6 million barrels of production per day. We’re not back to the 13 million that we had previously. Globally we’re producing or will produce this year 99.7 million barrels per day. So we’re still roughly a 10% producer, just over 10%. We can’t really expand that much because it requires the drill baby, drill mentality. And it’s not politically supported. On the other hand, there is a political intolerance for high levels of inflation. So this is the point where, yes, it’s no surprise, Biden’s calling OPEC and calling the Saudis and saying, do something.
Kevin: So it wasn’t just orange man, bad? Orange man, bad, wasn’t the only guy who liked to drill for oil, it may be Biden at this point?
David: Well, but he doesn’t want to drill here because that would tarnish his green credentials. So he has to maintain his impeccable green credentials moving us towards decarbonization. At the same time, he’s got to face the political gauntlet and his whole party has to face the political gauntlet of rising inflationary pressures. And so, yes, he’d like to take the sting out. Yes, he said, “Look, we’ll just take away the federal tax on gasoline.” It’s a little too little, a little too late to me. You’re helping at the margins, but is that 10 cents? Is it 18 cents? It’s insignificant relative to $3 to $5 gasoline. Every little bit helps, but it’s more of a political posture, just like drawing from the strategic petroleum reserves. It’s a political gesture. It doesn’t solve the problem.
Kevin: Well, what if a lot too late happens? You said a little too late, but let’s go back over to interest rates, because remember when you interviewed John Taylor? I mean, every economist out there is going to give the nod, oh yeah, we know the Taylor Rule. The Taylor Rule means that interest rates need to be a couple of points or a percentage or two above what the inflation rate is.
David: Yeah, but this is why as much as there’s drama, you can look at what’s happening across the border in Canada and say, my god, what’s going on here? This is terrifying. Moving to martial law, and these are peaceful protests. This is really an interesting pivot in the history of what Trudeau calls a liberal democracy.
Kevin: Confiscating the guys’ trucks.
David: The drama is there. The drama is in Russia and Ukraine, but where the rubber meets the road. Where we see a complete repricing and really the potential for eviscerating the middle class is with an asset structure which implodes on the basis of inflation continuing and interest rates following whether the central banks like it or not.
Kevin: So what’s the likelihood of “in steps a Volcker”? That’s what I’m talking about, a lot too late. That’s what happened in 1980.
David: Nothing like that will happen, not on a voluntary basis. There’s no one—
Kevin: The debt’s too large now.
David: Debt’s too large. On $30 trillion, you can’t take rates to 18% or 20%. You can’t do that. If Volcker caused a recession, to do that with $30 trillion in tow—and that’s just federal debt, that has nothing to do with corporate debt or private debt, household stuff—you’re talking about game over. Game over. Bankruptcy. It’s done. That’s not going to happen.
What we needed was a measured approach to inflation along the way instead of the gamesmanship that we had, and now they’re way behind the curve. Last time we spoke to John Taylor, he’s an econ professor at Stanford, and back in the Bush era, George W. Bush, he was the Undersecretary for the Treasury for International Affairs.
So the Taylor Rule, we’re looking for the gap between the inflation rate and the Fed funds rate. And back when we talked to him last, that gap was fairly small. So the Taylor Rule gave you a guidepost, like you don’t want it to be more than 2% different. You’d like the Fed funds rate to actually be 2% above the inflation rate.
The theory behind the Taylor Rule is essentially that that rate, the Fed funds rate, should be a few points over the inflation rate. That keeps inflation in a reasonable place. It keeps GDP growth going. They’re in balance. The inflationary pressures are held in check. Now to get to what the Taylor Rule suggests, we’d need 37 incremental moves higher, 37 25-basis-point increments. To tame inflation, the Fed, according to the Taylor Rule should have rates at over 9.5%.
Kevin: So sons of Volcker, in other words, let’s say we don’t have the possibility of a Volcker coming in and actually making this happen, what we’re really to talking about is learning to live and manage with high inflation. So what’s the suggestion, Dave? I think I know: the triangle.
David: Well, think of what the Fed has not done and what the market has already done. When we say the market is pricing in four to five 25-basis-point incremental increases, it’s because it’s already priced into the bond market. The bond market moved and is not waiting for the Fed to do its job. The Fed has already proven to be on vacation.
Kevin: So the invisible hand still is there?
David: The invisible hand is there.
Kevin: The market.
David: With real concerns over inflation, the invisible hand of the market is back and saying, “No, this is where it should be. It’s where we think it’s going.” And actually, if inflation continues, the Taylor Rule would imply a 9.5% Fed funds rate.
Let’s close with an imaginative experiment. We look at inflation, we look at interest rates, we look at the nature of kryptonite. It’s this small thing, but it can fell the giant. It can fell the Superman. And so what happens if inflation does continue?
And then this is again where I think Nord Stream 2 and the real issues behind Russia and Ukraine and the geopolitical risks faced in seeing a reorientation towards Russia and towards the East. Really, it’s not just towards Russia, it’s towards the East as in Russia and China as a team. What does it look like for inflation to be continuing on? What toll does that take on stocks and bonds in 2022? Is it a 20% “correction?” Do we head past 20% into a full-blown bear market? Or do we ultimately move towards fair value with the Dow being at say 15,000?
I think we could be looking at a 50% to 60% decline in equities between 2022 and 2023. The stage is set. You have all of the ingredients, including Superman pretending like nothing can fell him. That’s the financial markets today—not unlike Superman. Faster than a speeding bullet, more powerful than a locomotive, able to leap tall buildings in a single bound. Nothing holds us down except a little kryptonite.
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.com. And you can call us at 800-525-9556.
This has been the McAlvany Weekly Commentary. The views express 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 addition of the McAlvany Weekly Commentary.