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The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
THE TITANIC & NOW WALL STREET – NO NEED
FOR LIFEBOATS, IT’LL NEVER SINK
April 15, 2019
“They’re already talking about further unconventional approaches to stimulating inflation. Wouldn’t it be ironic that we are, even as the Fed and other central bankers are doing everything that they can to create inflation, were on the monetary cusp event which reshapes the way we look at money and banking for a generation or more, and they’re actually trying to stoke it.”
– David McAlvany
Kevin:Sometimes the notes that we make to ourselves – I know, I write in my books, you write in your books – the notes that we make to ourselves sometimes become our best friends going forward. It’s called marginalia. Throughout history, if you can get the books of a thinker and then go look at what he was thinking when he was reading, you can actually tap into a greater diamond mine.
David:A good friend and mentor for both of us has been sending us books, and he is getting rid of a part of his economics library.
Kevin:He is 92 years old. He was my free market mentor the last 32 years.
David:It’s like Christmas when the boxes arrive, and when you open them, not only are the titles intriguing, but even more so, opening the book and seeing what Howard’s thoughts were on this particular topic, seeing what was important, and what were the action points from this particular conclusion. Again, it’s a sketch of a human life, but also, wisdom distilled that we are the beneficiaries of.
Kevin:It reminds me, there is an obsession that mathematics had for about 300 years. It was called Fermat’s last theorem. It was finally solved back in the early 1990s, but men spent their entire lives trying to solve this. It basically just simply said Pythagoras’ theorem, A squared plus B squared equals C squared, doesn’t work with any other exponent, or any other power as it’s raised. Yet mathematicians had a hard time proving it.
But you know what’s interesting, Dave? Where they found that theorem, or that question, was an amateur mathematician who did his work over 300 years ago, a man named Fermat, and it became known as Fermat’s last theorem. But it was in the marginalia of one of his math books. That’s exactly right. Well, you were in New York last week and you came home with a box of treasure.
David:I did. It was at Grant’s conference. As you know, Jim Grant is moving offices from Wall Street down to the Woolworth building and they don’t have as much library space. So he had a huge table full of books. I went through the titles, and some of the titles stood out to me as things that I just wouldn’t ordinarily have, but I was interested in – The Manly Art of Bare Knuckle Prize Fighting in America. It’s not often that you come across that. Or from 1924, the agricultural prices 1920-1923 dealing with the British agricultural crisis of that period. There was a book from the 1950s, 1958, written by the chief economist, if you will, of West Germany, laying out the course forward, Prosperity Through Competition, by Ludwig Erhard. There was even one by a gentleman who I knew, David Darst. He was the person I did my training with at Morgan Stanley, who in the 1980s wrote The Handbook of the Bond and Money Markets, as a young man at that point. So, fascinating for me.
One last treasure was a book I already owned by Bernard Lewis. I am interested in the Middle East. For us to look at and try to mitigate risk as it pertains to geopolitical or political volatility in the Middle East means that a part of our process is to go back and time and understand who we are dealing with, what we are talking about, in more concrete terms.
Kevin:He was in his 90s when we interviewed him, Dave, over a decade ago.
David:Still at Princeton. I think he is still alive. Last time I checked he was. I don’t think he is doing interviews anymore – The Middle East: A Brief History of the Last 2000 Years by Bernard Lewis. And guess what I have? I have Jim Grant’s marginalia. So he is interested in understanding why the assassins were a Shi’a cult that terrorized the Sunnis.
Kevin:He hand wrote it in the book, I’m looking at it right now.
David:Of course. It’s a fascinating look, not only into the history of the Middle East through the eyes of Bernard Lewis, but then also through the mind of a man that I have great respect for.
Kevin:Right. He is asking the questions. You get to see the questions as he is an inquiring mind. I have often said, to be interesting, you have to be interested. And the people that we interview, these books, the marginalia – it’s interesting. Oftentimes, it is not the information in a book that is important, it is the thought that goes behind it and the linkages that take you back into history. I think right now of the tragedy that happened at Notre Dame in France. It is really not the building. We have both been to the building. The building is an old building, but it is everything that has happened in and around that building for 800 years.
David:Exactly. The building that endured through multiple world wars, revolutions – a few weeks ago we talked about currency collapse in the 1720s, and then 70 years later, again. And here in a 2½-hour period, something that stood from the 12thcentury, burns – not to the ground, fortunately, but a good part of it did. And I watched the Notre Dame tower fall, in disbelief.
Kevin:You trained at Morgan Stanley in New York when the World Trade Center buildings were standing. You also watched the south building fall, along with the other building. What did that feel like?
David:The same thing – disbelief. I was there at Morgan Stanley, and having been there, I think it is natural to feel a sense of solidarity with the French. I have to tell you, this was an emotional experience watching Notre Dame cathedral. Not just because I have been a tourist there, but because this is meaningful to the French and I know it is something that represents identity.
Kevin:Do you remember when we watched the World Trade Center fall, the disbelief? We had both been there, and it just didn’t seem real. When you saw them collapsing, it didn’t seem real. You brought up a book to me last night when we were talking about the Titanic. That was a boat that was not supposed to sink either, and people who were on it, even, didn’t believe it could happen.
David:That sense of disbelief – again, we look at these experiences through time, and the books that we read, and the authors that we engage with, and the marginalia we encounter – we’re looking for wisdom and we’re looking for a common experience to better understand our own circumstances. Sunday marked the 107thanniversary of the sinking of the Titanic in 1912 on April 14th. It took less than 2½ hours to sink below the water. It had been described as a boat that not even God could sink. It was a mark of progress, it was mark of industrialization, and it was something that great pride was taken in.
Kevin:It was on a Sunday. 1600 people never made the Monday.
David:Monday never came for those 1600 people. It was in a ratio of 9-to-1 that men died and let the women and children go first. There were women who died, too, and many valiantly, who sacrificed their lives. From our perspective, remarkably, chivalrous choices were expected actions of a gentleman in those days.
Kevin:Even the rich. Some of the richest men on earth died on that ship.
David:I think death is nature’s form of affirmative action. You look at the Asters and the Guggenheims and the wealthy travelers who perished alongside men of little to no means, and it is not really discriminating at all. Everybody pays a price when tragedy occurs.
Kevin:Isn’t it strange with Notre Dame, something that you would never think would disappear like that? And it didn’t just disappear, much of it burned. That was on the same week as the anniversary of the Titanic.
David:It is interesting, because the events of this week, and those of 107 years ago, both create this initial sense of disbelief. I could have just as easily thought that a doctored videotape was being aired. And I definitely asked myself the question if the yellow vests could have been that stupid to have jeopardized all that they were fighting for in Europe, particularly in France, with a move like arson or something like that.
Kevin:Isn’t it amazing that’s where our mind goes because that’s the culture that we’re in right now. But take 100 years ago when the Titanic sank. This was the boat that had, for the first time, swimming pools on it, tennis courts. This was the lap of luxury, and only the richest could actually cross, at least on the upper cabins.
David:What we have today makes this seem almost trivial, because for $299 you can go on a five-day cruise through the Caribbean. You can have multiple pools, you can have – how many things? But at 11:40 p.m. the boat grazed an iceberg. It was on the starboard bow and the impact was 947,000 tons of pressure. You’re cruising along at 21 knots, and still below the full capacity of the ship. They could have actually traveled faster. The Titanic was heading west at a very high latitude and the effort was to shave three hours off the travel time, to potentially set a new travel record. Minutes before the impact, from the crow’s nest, you have a call down to the bridge because the iceberg was sighted. And no one answered. And then you had frantic attempts over that two to three-minute period of warning that someone has to respond. And there was no response. It went unheeded for two to three minutes.
Kevin:They felt the impact. The passengers said, “Yes, we felt an impact.” But they just ignored it. They were on the ship that couldn’t sink. They weren’t worried.
David:And finally, the phone was picked up, but there was no time to respond. The gentleman who answered the phone on the bridge shortly thereafter committed suicide. He knew that the cause was not picking up the phone. I don’t know what he was doing in that two to three minutes, but he was not at his post. So the passengers felt the impact, but they didn’t think anything of it. Many of them returned to bed, others returned to playing cards or smoking cigars in the parlor. Some of the sirens began to wail. When you are on a boat, you hear horns whistle and you hear different things go off and you just think, “Well, something is going on but it doesn’t have anything to do with me.” So the passengers disregarded the crisis, and a part of it was because they had faith in engineering and that blocked their imagination from running the full spectrum of potential outcomes.
Kevin:It was outside of their paradigm. The thought of sinking – you have a boat with a swimming pool, Dave, that cannot be sunk.
David:You had jokes that were being exchanged. Then you had the crew encouraging people to put on life vests, but the travelers were joking about it, taking them on and off and saying, “Well, this color, of course, is the latest fashion this season. They had no idea, they weren’t seriously considering that within minutes everyone would be making decisions of life and death. The captain asked for a report on the hull. The first report came back that there was no trace of damage to the hull. Obviously, they didn’t look very closely.
Kevin:That was a wrong first report.
David:Again, you have these things where confidence is there, and confidence is based on facts. Three millions rivets – the rivets, alone, weighing 1,200 tons – and then an additional half million rivets, almost 270 tons of rivets holding together the double hull on the underbelly. So it was unthinkable that a boat like this could have problems, even on a first look appraisal – “No, there’s nothing wrong.”
Progressively, ship designs had been improved since the 1860s. If you look at the laundry list of ships that sank between 1866 and 1912, you would be shocked at how many actually went under and how many lives were lost in transatlantic travel.
Kevin:But not this one. It had a swimming pool, and tennis courts. Why?
David:Every lesson had gone into this. This was the most progressive, the most luxurious, the most stable ship to ever sail. And it had everything, you’re right, from swimming pools to tennis courts to gymnasiums. They had a grill room, they had a palm room, they had elevators. Again, for us this is no big deal, but these were all stunning luxuries of the day. There was a notable deficiency, we know that, because we have our luxury of looking back in time and appraising this – there weren’t enough lifeboats.
Kevin:Isn’t that amazing? That’s the one thing they didn’t have enough of. They had pianos. They had tennis courts. They had grills. They had everything a person would need for luxury, but they didn’t really think that anything bad could happen. This was a controlled environment. Gosh, does that sound familiar?
David:Two different life rafts were available – 24-footers and 36-footers. The cost of them was between $200 and $400 dollars. And these were line items that literally went ignored. They were building a 10 million-dollar colossus. 1912 to the present, cumulative inflation from then to now is about 2600%. So do the math. A 10 million dollar boat then, still expensive today. But the point is, who needs a lifeboat when the ship is unsinkable? That is the presumption, that’s the belief, that’s where faith is. And their belief was, it’s unsinkable even by God. That’s the feeling today in the financial markets.
Kevin:That’s exactly right.
David:That’s a faith which has shifted to the financial engineers of our day because we know that nature has been tamed. The cycles are a thing of the past. The Ph.D. is three letters with more power than G-o-d, or any natural cycle. Does that make sense?
Kevin:Well, you know what Howard told me, the person you were talking about who sends us books? He is in his 90s, he has studied economics all of his life. He was a lobbyist, in politics. I asked him before I got off the phone the other day, “Howard, are there any words of wisdom you want to leave me with?” He said, “Yes, the cycle is still intact.” That’s all he said, the cycle is still intact.
David:The cycle is still intact. To founder, if you were on this ship, or if you are in the financial markets today, to founder is unthinkable. And if you want to discuss it, it is disagreeable.
Kevin:Talking about a possible crash? That’s so yesterday.
David:To discuss it this week, Thursday, Doug Noland and I are going to conduct the quarterly conference call for our Tactical Short offering, so Q1 was the best stock market performance of a single quarter going back many decades, and Doug proved his value yet again in mitigating risk, yes, maintaining a short exposure, but mitigating risk, maintaining the short exposure with the least possible impairment. And as a note, our other wealth management products will have a similar quarterly conference call starting at the end of Q2. Very constructive movement is being made across the MAPS offerings here in Q2. I’m excited to talk about that a little bit more in the weeks and months ahead.
So Tactical Short. Register. Listen to it. Doug and I will share some analysis of the current market backdrop and I think it will confirm more than a few of your suspicions. So 4:00 p.m. Eastern time Thursday. You need to pre-register, and you can register at mwealthm.com.
Kevin:You talked about this last quarter in the stock market being one of the best rising quarters in a long time. A short fund normally would get crushed in a period of time like that, so we have to talk about these strategies. When a person says, “I think we’re getting toward the end of a cycle. I think I’m just going to go ahead and short the market,” that has been the doom of many a person.
David:Right, because crazy things happen at the end of a cycle, and if you’re not mitigating risk – this is where the Tactical Short really has its distinction, because anyone who was short the market in a fund that doesn’t modulate or moderate exposure, in the first quarter they were crucified. Most of them performed worse than the inverse of the market, greater than 100% loss relative to the market. So if the Dow is up 13%, the S&P is up 16%, you might say the inverse of that would be to lose 13-16%. Oh, no, no, no, no. Most of those short products lost far more than that. This is where the distinction with Tactical Short comes through loud and clear. You can mitigate risk. You can have a short exposure and still be very intelligently managing your risk exposure on the upside.
Kevin:As you brought up, rising prices don’t always tell the whole story. We have had rising prices this quarter, but we have actually had falling volume.
David:That is where some of the internals of the market really tell more of the story, and that has been the trend – rising prices on falling volumes. That has been the trend in the stock market since December. Even with healthy price action, there is that unhealthy – for lack of a better word – participation trend.
Kevin:Well, can you manipulate a market easier if you have less participants?
David:I think that is one of the things that you gain with a thinning of the audience. The other is that you ultimately run out of buyers and you have a correction that sets in. So the move off of the December lows – it feels good. But bear this in mind. Alan Newman, a frequent guest on our program, has often pointed out that flows into the equity market fall off hard after April, and are typically dead through October. So this dead season from May to October is a seasonal period that is unfriendly to investors.
Kevin:That is the old saying, sell in May…
David:And go away. Mutual funds see a surge in new funds in the first quarter, typically because of an influx from retirement account contributions. So that follows the April cut-off for those contributions, and thereafter it gets rough. Sell in May. It is not a perfect strategy, but it serves as a reminder that there is a season when the winds change, and they are no longer behind you. They are no longer helping put wind in the sails.
Kevin:Mutual funds were the big deal 20 years ago, but at this point ETFs have just sort of dwarfed the mutual fund market.
David:At least in terms of growth. If you’re looking at total assets under management, mutual funds are still the mammoth, but the migration has occurred, and the transformation of the markets where mutual fund flows now tell only part of the story. They’re still an important part of the story. They’re still an important player, but the ETF flows have captured capital in the last decade or so, that used to be in mutual funds.
Several things, I think, are important here. The first is that there are far more ETFs, Exchange-Traded Funds, funds to represent a low-cost basket of stocks, than there are publicly traded stocks.
Kevin:Say that again because it is interesting. The funds that actually hold the baskets of stocks – there are more of those than there are stocks to hold – (laughs) amazing.
David:That’s right. There are a greater number of baskets than there are stocks to actually hold. It is a little absurd but the derivations of market exposure using a structured and fee-collecting product exceed all the pure exposures to the underlying companies. So on top of that, I think another important piece with the ETFs is that capitalization weighted indexes create this self-reinforcing popularity spiral. It is disconnected from company fundamentals.
Kevin:It’s like what the FAANGs did last year.
Kevin:The FAANG stocks, five or six stocks, were leading everybody, but it was their capitalization that got those ETFs to buy them.
David:If you’re buying the “market” then there is a disproportionate number of dollars that go to those that have the largest total value, or stock capitalization. For instance, Netflix gets a larger continual flow of money from the indexed ETFs than a pharmaceutical giant like Eli Lilly. Alan Newman points out that Eli Lilly is far larger in terms of revenues, in terms of profits, in terms of the number of employees, but any new money that comes into the S&P 500 index, that is SPY, goes in larger quantities, larger sums of money, to Netflix because, again, it is a cap-weighted, or capitalization-weighted, index.
Kevin:Even though Netflix isn’t making any money. They’re just taking in investor money.
David:That’s right. I think the last thing to be said there is that the market reflected by mutual funds used to maintain a managed feel, or managed orientation, and that allowed for cyclical decisions to be made where you could increase cash and decrease asset exposure. There is some discretion there.
Kevin:Correct me if I’m wrong, but one of the big differences between mutual funds and ETFs – I remember when mutual fund cash would drop below five and people would start saying, “Uh-oh.”
David:We’re going to have a market cycle.
Kevin:Yes, because they’re going to have to sell stock to actually take in redemptions but ETFs don’t have any cash, do they?
David:Right, so the migration away from mutual funds takes out some of the cushion in the marketplace provided by the cash component in those funds because if someone starts to sell, the first thing that they can get in terms of a redemption is the cash portion that is already sitting there
Kevin:It’s like reserve banking.
David:And it doesn’t require that the asset has to be liquidated, so there is not a negative reinforcing cycle on the sell side. But with ETFs there is that negative reinforcing sell because it is instantaneous. If you are redeeming money from an ETF you instantly have to sell the product. That cushion goes away. I’ve shared anecdotes about friends of mine in the mutual fund management role, but there is a trend within the mutual fund industry that pressure is being created on fund managers to diminish their cash holdings. You may say, “Why would that be the case?” Mutual fund companies now view cash as a four-letter word because any allocation to cash in this cycle has meant that you are under-performing the indexes. You are under-performing an exchange-traded fund and you may face an existential threat where money leaves you and goes to a low-cost index.
Kevin:The stock market, at this point, is the ship that God can’t sink. That’s what you’re saying.
David:Yes. There is this all-in approach. You mentioned cash levels getting below 5% and that being a warning sign. We’re at 3% — 3% allocated to cash at present, buttressed by 581 billion dollars in margin balance.
Kevin:That is just pure debt – margin balance.
David:If you’re looking at Rydex assets, comparing bearish versus bullish bets, a 26-to-1 ratio of bullish assets compared to bearish allocations. In short, what Newman would describe this environment as is excessively optimistic. On a 10-point scale you’re at a 9, so it could be even more excessive, theoretically, if you go one more notch. But he says this: “We are not dealing with the possibility of a bear market. We are dealing with a possibility of the major averages eventually losing 45-50%.” And he maintains his long-term Dow target of around 15,000.
Kevin:So we could lose that amount. Now, you were in New York last week with Russell Napier who wrote the book, The Anatomy of the Bear. We bring it up often on the program. He is feeling the same way, that where the capital flows are going right now has to do with capitalization. Discretion is not really being used as to what is a good investment, it is just, “Where is all the money?”
David:Right. And he would describe that passive movement of funds without a lot of analysis as sort of “dumb and dumber.” So Napier is making a similar point relating to ETFs, and specifically tying it to the Chinese market in anticipated capital flows. You have foreign capital flows into China, which are expected to rise in the coming months, and again, he puts that in the category of “dumb and dumber” because he is looking at two particular funds, the MSCI Equity Index and Bloomberg Barclays bond index, which are becoming more expansive in their Chinese holdings and it automatically brings capital, foreign direct investment, into China.
Kevin:Let me understand. This indexing isn’t just a national phenomenon here. These are world indexes. We’re seeing indexes going, this is affecting the world and China is changing dramatically anyway, just for the fact that they are no longer a surplus nation. We’ve counted on that surplus for a long time here in the United States, to be able to go into debt.
David:And I think the reason why Napier cares about what is happening in terms of capital flows is because of this issue you raise. We have the surplus days, that is, Chinese trade surplus days with the United States, behind us. The current account surplus is shifting to a deficit which is a monumental shift. We have talked about that countless times on our program, but it implies that there is a much smaller pool of capital to recycle into U.S. treasuries, and those trade dollars that have been recycled into U.S. treasuries help finance our budget deficit. So now you have investors who will go into the Chinese markets, not with a thoughtful appraisal of risk and reward, or of the credit quality of a particular company or of any particular bond, but because you have an increase in Chinese exposure in two indexes, the MSCI Equity Index and the Bloomberg Barclays Bond Index. Again, Napier refers to them quasi-respectfully as “dumb and dumber” money flowing in, not because they are attractive assets.
Kevin:Right. It’s because everybody else is going in.
David:Exactly. I love the irony here because you have the contrast of local investors, local money, Chinese capital that is trying to get out of the country. In the last decade they have sought to evade and escape the borders with mass quantities of liquidity, so foreign capital flows will increase because of a composition adjustment in the indexes. This is foreign money coming in while domestic money is getting out. Again, it is ironic because we think there is an opportunity, but the smartest money has already left the room, has already left the country.
Kevin:Those who live in the room, those who live in China, want their money out because they are seeing increasing control from the government. They have seen this before. It was sort of free-markety. Now we’re seeing command and control.
David:That’s right. Napier’s primary point here is that when you have a decline in the rule of law, and an increase in the rule of man, as you have had under Xi Jinping, watching domestic investor behavior is telling. Ignoring it looks like the “dumb and dumber” money which is flowing in. So the problem is that those sources of capital that are flowing in to China are not likely to be sufficient to improve the capital accounts and the capital account is just a measure of capital flowing into or out of the country and is a part of the larger balance of payments equation.
That is just for context. Recall that for 20 years capital has flowed out of China and into the U.S. treasury market, into the GSE market, that is, Government Sponsored Entities like Fannie Mae and Freddie Mac, and a host of other U.S. dollar-denominated assets. Those flows have been critical to asset price appreciation. They have improved the value of the U.S. dollar. And what we have circa 2018-2019 is a shift in capital flows which is very consequential if you are looking at the decades ahead.
Kevin:So look at the decades behind us. The last three, maybe four decades, what we have counted on is the Chinese pegging their own currency to the dollar, and treating the dollar as the world’s reserve currency. What we have seen over the last six to seven years is China just aggressively consuming and buying all the gold, virtually all of it, 22,000-24,000 tons maybe, which is three times what they say is in Fort Knox. That’s not to speculate on the gold market, Dave. They’re looking at a currency shift. They are looking, possibly, at the U.S. dollar not looking like it did back during the Bretton Woods days or even the post Bretton Woods days.
David:It’s funny, because Russell and I exchanged some emails before we got to New York and I sat with him in New York City last week and we spoke briefly before he presented to the audience, and then sort of hastily returned to Toronto for the course he is instructing. But in our email conversations he is very interested in the direction of gold, and convinced that what will happen in the currency markets will define the gold market for the next 20-25 years. I heard in his voice maybe even a small bit of envy that we are in the business that we are in, knowing what we are getting ready to experience on a global scale, and what the supply and demand dynamics are for an asset that is very scarce.
Kevin:Dave, the company is 48 years old. If there is a shift, we are in the catbird’s seat.
David:I know. And it is his view that we are on the edge of a shift in the currency markets as critical as the 1971-1972 Bretton Woods period. So from 1994 to the present, the renminbi, the RMB, has been pegged to the dollar – it is a loose peg – and he sees a growing probability of an RMB floating exchange rate. So again, the trade surplus days are over, money supply growth is likely to decline in China, requiring greater capital inflows into China. Here are the factors, because money supply growth was averaging 16-17%. We look at where it is today and it is still eye-popping in the 8 to 8½% range, but it has already dropped by half.
So foreign currency reserves grew dramatically in the era of trade dollar recycling when they were running massive trade surpluses. They are now shrinking. Compare that with the TIC data we have from the Treasury Department here in the United States and it shows U.S. savers are being forced to step into the treasury market. They are the ones who are doing some of the buying, even as the Chinese move to liquidate exposure, and other central bankers, too, eliminate exposure to U.S. treasuries, at the margins, not completely. His suggestion is that pressure will grow and the greatest financial market shift of our generation will be the flotation of the RMB. In his words, it changes everything for the next 25 years.
Kevin:So the flotation of the RMB is just simply that the dollar no longer is the peg. The dollar may not even be the reserve currency as China flows forward.
David:It also brings in another interesting element, that of the export of inflation from the Chinese, where all of a sudden, the inflationary trends which we have not been able to conjure – central banks have been worried about the deflationary trends – in fact, could sharply shift, and very quickly. So the conclusion is that we have thought of Chinese exports representing the price-dampening element for the U.S. and global consumer. You buy stuff, you buy it cheap, you buy it at Walmart, you buy it from Amazon. You buy it cheap because it’s manufactured in a place where they can make it for next to nothing. What if the Chinese became a significant contributor to global consumer price inflation instead of a contributor, as they have been for 30 years, to that price deflationary trend?
Kevin:One of the ways we have fought war without tanks and guns and ships is just simply competitive devaluation worldwide. I am wondering if the capital flows aren’t also going to possibly be a form of financial war that is a non-shooting war?
David:That’s the front line of the war. It’s not a trade war. What we see happening between us and the Chinese right now, if you think this is about trade you don’t understand the real issue here. Because there, you are only talking about the flows of tens or hundreds of billions of dollars. You cap it at 250 billion dollars and the ancillary effects of 250 billion churning around in the global economy, who cares? When you are talking about the FX markets, you’re talking about trillions of dollars changing hands on a daily basis.
Kevin:That’s the bigger war.
David:Napier suggests that capital flows are on the front line of a war. It’s not a trade war, but it is the beginning of a 21stcentury cold war with China. And he points to Mike Pence who gave a speech at the Hudson Institute last fall in October supporting the stance, where Mike made it very clear what the issues were, and what the current agenda was, according to the current White House and Oval Office.
Kevin:So do you think that he is thinking that we will see competitive devaluation, and it will start in China?
David:Devaluation in China is an increasing probability. Like we talked about last week, you have the modern so-called monetary theory and nominal GDP targeting around the corner here in the United States, inherently inflationary, so if you look at it and say, devaluation in China – growing probability. Devaluation here domestically, as well? On top of what the Fed is considering now, they are already talking about further unconventional approaches to stimulating inflation. Wouldn’t it be ironic that we are, even as the Fed and other central bankers are doing everything that they can to create inflation, we are on the monetary cusp event which reshapes the way we look at money and banking for a generation or more, and they are actually trying to stoke it.
Kevin:Let’s look at the tools that central banks use. We’ve talked about repression, purposely keeping interest rate artificially low, and inflation. Really, the goal is to borrow a certain amount and then to inflate the dollar just a little bit more than that so that debt gets ultimately paid off with the devaluation of the dollar. It’s a dirty little secret, but that is exactly what has been happening all of our adult lives.
David:Yes, as long as you can maintain growth in the economy above the growth in debt, they’re not concerned. So the other issue is, we are intent on inflating away those debts. So further corralling of capital is a given – it’s a given. If you look back at our conversation with Carmen Reinhart it was absolutely an intellectual touchstone. For those of you who have not listened to it, go back to the archives. It is required listening, because repression and inflation are the one-two punch of the central banking community, and individual investors are going to have to determine how they legally side-step those swings, because if they don’t they are going to get clocked in the financial face.
Kevin:We’ve talked for a long time that you want to have a third in physical gold and silver, things that will keep you from losing money during the devaluation. But even the cash portion that you would normally leave in greenbacks can be put into a cash equivalent. You have brought out Vaultedhere recently, Dave, which is a cash equivalent based in gold.
David:Right. Vaulted has become that for me, a money and banking alternative, where you’re talking about historical reliability, and combining that with 21stcentury transparency and accessibility for a savings and banking alternative. I don’t look at it as gold, it just happens to be reliable savings denominated in a currency that I have more confidence in. And I don’t have as much confidence in the Ph.D. we were talking about a few minutes ago. Institutional managers of money – get this – institutional managers of money and the entire central bank community are of one mind, and that is that it is impossible to create inflation today.
Kevin:It’s the boat that God cannot sink. But let’s be fair. They have created trillions and trillions of dollars and we haven’t really experienced high, or hyperinflation, at this point.
David:Yes, and my view definitely differs from the institutional money managers of the day and certainly the central bank community, because inflation has been created. It has already been created, but not unleashed. There is a variety of things that could instantly unleash that inflation. We just mentioned a structural change in the Chinese system – instant. A reversal of the payments on excess reserves.
This is a standard policy today that has never been done before. You have reserves that are held with our central bank that would ordinarily be lent into the system and there would be a money multiplier on those assets. We haven’t seen that because those reserves are being paid. The excess reserves of financial institutions are being warehoused with the Fed and they are receiving interest on those deposits. There is no reason for them to lend it out. So the liquidity is there, that is what I am saying. It is already there, it has been created. It has not been unleashed.
Kevin:Don’t we see that the Fed is in a corner though, because they have been talking about normalizing interest rates, but didn’t’ we see in the fourth quarter of 2018, that they learned a lesson? We really can’t push those rates up past 3%, can we?
David:No, we can’t. Again, this goes back to that issue of, now you don’t see it, now you see it. What you cannot see today, inflation, is something that can be very pervasive tomorrow, literally with the stroke of a pen. All that stands between viable savings and a massive competitive devaluation, global in scale, is the stroke of a pen. We’re not paying interest on excess reserves anymore – stroke of a pen. We’re letting the RMB float – stroke of a pen. The stroke of a pen unleashes inflation. You think it’s the printing presses. No. The credit machinery has already been cranking out more liquidity than the world knows what to do with.
Kevin:But if the velocity of that cash increases, we could have inflation very quickly. And going back to the Fed not being able to raise rates, how do you fight inflation? You raise rates.
David:So on the program here in the next few months, we are going to have Steve Hanke. He is theexpert on hyperinflation. I cornered him after his presentation at Grant’s conference and we debated velocity. It was a great conversation. We’re going to open up that conversation on the airwaves as he comes to be a guest on the Commentary. But he doesn’t think velocity is an issue. Of course, he is only interested in hyperinflations, not low levels of inflation, high inflation or super-inflation. And by the way, this is the guy who came in to solve the Bulgarian hyperinflation, the Romanian hyper-inflation. He has been a consultant on the Venezuelan issue right now.
Kevin:So he knows a little something about high-speed velocity changing to the point where you don’t call it velocity anymore, you just call it a collapse.
David:You just call it a currency collapse. The velocity is not worth measuring. It’s just like, “Yeah, that’s an issue when people don’t want it.”
Kevin:“We want it. Now we don’t”
David:That’s right. So I’m quibbling with him about the psychological transition point and he’s like, “Yeah, but it doesn’t matter.”
Kevin:It doesn’t matter. People get hungry in about three days.
David:But your point earlier – this is really important because the Fed proved a very critical issue in 2018. The debts outstanding, copious amounts of debt on the world scene today, the debtors responsible to pay them. These two categories – they can’t suffer a rise in rates above 3%.
Kevin:That’s a small box.
David:There is a low tolerance threshold for rising rates. There is a notolerance policy amongst central bankers for allowing assets to be repriced to a new cost of capital. That is really the issue, that when you have a repricing of assets in light of the increasing cost of capital, you are dealing with extinction events for a number of financial firms. Leverage is very high in the financial system. The amount of debt in the system – very high. When you begin to adjust asset prices even marginally in a leveraged universe, you are looking at major, major issues.
So, going back to Reinhart. The chosen losers in this scenario – we already see it. The chosen losers of the world today are the savers, the people who need income.
Kevin:The retired. The savers.
David:Savers in recent years have given up hundreds of billions of annual income, which has instead acted as a subsidy for two over-leveraged segments – the corporate sector and the government sector. Do you think that is going to change? Think again. You have repression, and you have inflation, and this is the one-two punch. You’d better get used to it.
Kevin:I have a question for you, though, because you manage money. How do you manage money to keep up with the indexes and to try to give people what they believe that they are entitled to in the rising markets, and still not be invested in a place where they lose their shirts with the sinking of the Titanic?
David:As an asset manager, the challenge set before me for 2019 and 2020 is how to marry a portfolio of real assets with inflation protection implicit to the assets themselves with real-time income generation. So I’m excited to be announcing a few things here in the 2ndquarter that I think will fill a void. It is a void in the marketplace that is growing as the one-two punch I described a minute ago is on full display and is only going to intensify over the next few years.
Kevin:Back when I was just coming out of high school, a man named Paul Volcker came along. He had to deal with inflation. We were going out of control. These were the late Carter years, early Reagan years. Paul Volcker just yanked the interest rates right up to what he felt they needed to be to break that inflation. Do we have a system that that could work in?
David:Napier was interesting. He just finished Volcker’s book, and I’ve learned some things from Volcker’s book previous to this about his stance on gold and how he would have treated the gold market differently if he had it to do over again.
Kevin:He would have manipulated it, if he had it to do over again.
David:Volcker in his memoir describes the current monetary system as a non-system – as a non-system. And I think that is honest. I think it is accurate. Post Bretton Woods, an entirely floating currency system – what kind of a system is it? It is a free-for-all. You can get away with murder from the standpoint of printing and creating unlimited amounts of currency and credit. That is the system in which faith and confidence has been placed. I consider it a non-system, nevertheless, it is a system in which faith and confidence have been placed.
Kevin:Enough so that you don’t have to have enough lifeboats.
David:It’s assumed to be stable. It’s assumed to be well-engineered. It’s assumed to be enduring. And it’s assumed that we can use the system that we have, the monetary system that we have, to travel faster and in greater luxury than ever before. The monetary system of our day is a system that not even God can sink – or so it is believed. There is nothing new under the sun. I think this is where we circle back around to what we have learned from history, and the things that, even though the machinery and technology may change, people don’t. People don’t. There is nothing new under the sun. We will always be at our greatest degree of risk and peril when feelings of confidence and poise are the greatest. Take an assessment of your life – you will find that to be true. Take an assessment of the financial markets – you will find that to be true. You will find that to be true of great leaders, and even that that old poem by Percy Bysshe Shelly, Ozymandias of Egypt, points that out.
“I met a traveler from an antique land.” This is someone who goes through the Middle East and says, “I found these stumps of a statue. Just the ankles were left. And on this placard next to the stumps it says, ‘Look at my greatness and despair.’” And he looks around at the vastness of the empty desert and realizes that all that was once great is gone. It’s gone. Hubris is the element which builds the most majestic monuments, but it is also the preceding ingredient for the memorials which mark the wreckage throughout history.