The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
“Now we’re talking about nominal growth rates today of 2% plus/minus. They should not be raising rates unless they intend to recreate the 1937-1938 period where too much tightening too soon in the wrong context precipitated the 50% decline in equities. We may be experiencing that again.”
– David McAlvany
Kevin: We read a book about five years ago, Dave, called This Time Is Different, written by Reinhart and Rogoff. It really was a historic look at hundreds of years of multiple debt crises turning into multiple debt defaults. We have one of those R’s coming, it’s not Rogoff, but it’s Reinhart, next week. I think we should probably chat about what she is going to talk about.
David: Carmen Reinhart is the Professor of International Financial systems at Harvard University and the Kennedy School of Business. I read a paper that she wrote last year titled Sovereign Debt Relief and Its Aftermath,” and tied to some things that we were reading in 2009, 2010, and a whole study that I had done back then, Lex Rieffel’s Restructuring Sovereign Debt: The Case for Ad Hoc Machinery, and a number of other resources which looked at how you deal with having too much debt. We’ve said for a long time that one of the main problems that we have, not only here in the United States and in Europe, and virtually everywhere in the world today, is that we have too much debt.
Kevin: The timing of our reading the book and their writing of the book and some of these other studies that you did, Dave, was appropriate because in actuality, by about 2011 we probably should have seen some of this debt default crisis coming about, but they seemed to delay it with regularly low interest rates, obviously, what we call financial repression, the quantitative easing. Who could have predicted the amount of money they actually would have printed. So if history is our guide, are we now cycling back into a period where we should be looking at wide-scale worldwide defaults on some of these debts that are unpayable.
David: That has been Carmen Reinhart’s suggestion. She wrote a recent article, about a three-page article at Project Syndicate titled “A Year of Sovereign Defaults?” She says that if history is a guide, these are the conversations that we need to have in 2016. So what is a default cycle, and yes, if we are heading into a default cycle I think it’s worth spending some time on this. We’re talking about restructuring the terms of a loan. We’re talking about cutting the total quantities owed. We’re talking about allowing for grace periods. We’re talking about lowering the interest or extending the term. Instead of a 30-year bond, maybe it’s a 50-year bond. Maybe you create a perpetual note where it’s at a low rate but it goes on forever. That actually does reduce the burden of debt, although it doesn’t restart the system in the sense that we still have a system that is deeply debt dependent. And again, when we talk about a default cycle, it does not mean wiping out debts entirely, it just means reducing the immediate burden in hopes that a reduction will allow for a more robust economic growth cycle to emerge.
Kevin: I mentioned unusually low interest rates, but actually, there has been a canary in the coal mine for the last couple of years. If you look at the last year-and-a-half to two years, junk bonds, which are the most likely to default first – let’s face it, that’s the highest risk, it’s the highest interest paying – junk bonds have been weakening. They’ve been showing us that at least the free market part of the interest rate cycle wants to rise. And this, of course, means that governments that went into debt with the low interest rates are now having to pay higher interest rates on their own debt.
David: That’s right. Watching junk bonds weaken for the last 18 months, there has been a persistent warning for those that pay attention and that is that high yield deterioration precedes deterioration in higher quality and typically also precedes equity market declines. In fact, I would say high yield deterioration and equity market declines – that’s almost an axiomatic relationship.
Kevin: Right, but the rating services weren’t much help before we got into the first financial crisis back in 2008. Are rating services going to give us the warning this time?
David: They played catch-up in the 2008 and 2009 period, and the rating services are now downgrading investment-grade debt at a pace that we haven’t seen since the period of 2008, 2009, which will ultimately flood the market with more junk paper because think about this. We’re talking about what is, today, long-term investment grade debt. As it gets shifted to junk status, you’ve just increased the total supply of junk paper. So much of it, thus, has longer than normal durations. Most people who buy junk bonds might hold paper for three, five, or seven years. But if you have investment grade paper that gets downgraded, that investment grade paper is generally financed on 10, 15, 20 year terms, and so now you have junk paper with longer durations than most investors are interested in holding, and it creates a very nasty dynamic inside the junk space where you have too much of stuff that no one wants.
Kevin: And it is worth pointing out that for every interest rate rise of, say, 1%, the longer the duration, or the longer the maturity, the more dramatic the impact on the principle value of that bond. But let’s just jump to how governments are going to handle this. Governments have, up to this point, been pretty comfortable with the debt because they know they can just print money. Let’s face it, that’s how they pay off their debts, oftentimes, is just devaluing their currencies.
David: You’re right, the general comfort level with a high level of debt is because the burden of that debt can be reduced, and theoretically, at the same time the stimulative nature of inflation as almost a planning tool – we’re planning for growth, we’re planning on reducing the debt over time, and so inflation is a very critical tool for central banks. The quagmire that central bankers are finding themselves in now is that it is proving more difficult to create inflation, so the tool they need to continually ward off the ever-growing burden of debt has been dulled, so to say.
Kevin: So let’s look at the cycle because, really, if they’re printing money and people are still spending money, then they can create that inflation that they’re looking for, they can create that growth. But we’ve seen a cycle, Dave. We went from higher rates down to low rates – that was step one. We went from low rates to zero rates. We’ll call that no rates.
David: You’re talking about the interest rates which central banks have set.
Kevin: That’s exactly what I’m talking about. And then the next step, obviously, is negative rates here maybe, we’ve already seen it in Europe, so how in the world can they get this thing restarted if they print money and it’s not actually being cycled?
David: Yes, it’s an era of tough choices. They’re being made now, they will continue to be made, and these are the questions that are in front of us. Will we see radical financial repression with more central planners around the world moving the rate of interest into negative territory? In doing that we know that the central planners are nominating households and savers to be the sacrificial subjects.
Kevin: Right. It takes away their income, but it also forces them to spend. Why save if you’re going to lose interest every year?
David: Or, on the other hand, will we see outright defaults or renegotiations of existing debt? That is what Carmen Reinhart is suggesting, that’s why we’re going to be discussing this with her next week. The banking sector, if this is the case, will claim that this represents an existential threat. And they will, certainly, hold politicians hostage to the idea of a financial zombie apocalypse. Maybe the big banks can avoid taking these big losses. After all, it’s the Federal Reserve which will be taking up their case.
So again, if you’re going to renegotiate an existing stock of debt and reduce its total value, how do you think creditors feel? And we’re talking about banks as the largest creditors out there. That’s why they’re going to argue, “No, this is an existential threat, because we can’t reduce the value of those holdings very much without it compromising our total stock of capital. We’ll be bankrupt if you do this to us!”
Kevin: We talked about the printing of money not actually coming into the economy. I have to retract that to a degree because actually a lot of that printed money went in to buoy up stock prices, and other asset prices, even real estate in New York.
David: The oldest trick in the book is to inflate away debts via the printing press, and the challenge is that that liquidity, as you say, has found an easier path into financial assets, and it has not flowed into the real economy, which translates into asset price inflation, which we’ve had, but not a general rise in inflation at the level of consumer prices, and certainly not at the level of wages. So in essence, the Federal Reserve has lost control of V, they’ve lost control of velocity. They’ve created liquidity, but they’ve lost control of the amount of times that liquidity gets recycled through the economy, creating economic activity. They’ve lost control of V.
Kevin: So lets’ say the Fed prints a one-dollar bill, and that one-dollar bill gets spent three times in a year, V would be three, right? I think the average, for years, was around one-and-a-half, 1.7 times a year, a dollar would change hands. But this time around, Dave, it seems that V has just tumbled down to where a dollar bill hardly changes hands even once a year.
David: Right. And the monetarists assumed the 1.7 was what they needed to figure as velocity. It was something of a constant. And as it turns out, velocity is not constant, it can go up and it can go down, and it has gone down disappointingly. The only way to regain control of velocity, of V, in the equation seems to be to do away with our existing currency system and introduce the next incremental iteration in money.
Kevin: Reinhart’s partner, who helped write This Time Is Different, has written a paper on exactly that – getting rid of cash, getting rid of currency, and going to a cashless society.
David: That’s right. A move toward a cashless society, as Rogoff, who is also at Harvard – as he describes, then and only then can power over velocity be regained, and the central planners then retake the reins – (laughs) this is very important – they retake the reins from the market, and then they can freely choose to use the tools of either carrot or stick available to them to drive aggregate demand and re-invigorate monetary policy effectiveness.
Kevin: Dave, have you ever given a gift certificate for Christmas to someone who didn’t use it in a year and down at the very bottom of that gift certificate, even though you paid the full amount – let’s say it was a $100 gift certificate to a restaurant – down on the bottom it has a little disclaimer that says, “Must be used in one year.”
David: It’s happened to me. Those gift cards go into the top drawer in my desk at home, and they’re not at the top of my mind, they’re in the top drawer, and it may be six months, it may be twelve months – I’ve actually gone two-and-a-half years before getting back to those – and a $25 gift card is now worth $12.
Kevin: Right. So is it going to be like a gift certificate that slowly or quickly loses its value if you don’t go out there and spend, spend, spend?
David: The only way that you can enforce a negative rate environment over a long period of time is by taking away the ability for people to stuff cash into a mattress and say, “I’m opting out, I don’t like this, you can’t force me to have it on deposit. You’re not going to tax me, you’re not going to give me a negative rate, charge me for being in the banking system. I’ll just take my marbles and go home.”
Kevin: But what if they don’t give you your marbles because they don’t exist anymore?
David: That’s right. “We did away with marbles.” So that’s the issue, they believe they can force consumer behavior, either with carrot or stick, either an incentive or a penalty, which you just described the penalty side of that equation.
Kevin: This goes back to an economy that is driven by debt and not by growth. Richard Duncan has called it “debtism” and it’s a form of an economy only growing if the people continue to spend or go further into debt.
David: So one of the ways forward for a world drowning in debt. Here are some of the uncomfortable realities in the context of what you described as debtism, and Duncan describes as debtism. Number one, debt has become the primary driver of growth, even if over time that has been on a diminished basis. Second, we’ve reached levels in most of the developed world economies where the debt level relative to the GDP of that country is now at a suffocating level. Debts are continuing to grow exponentially, but economic growth is in long-term structural decline and now it’s reaching a critical and unsustainable point.
Kevin: I’ll never forget a word picture, Dave. I think I’ve mentioned it on the program before, but we were at a conference up in Idaho this last October, and you were explaining this concept where the debt relative to GDP is becoming suffocating. We were in a big conference room. You said, “Imagine on the left side of this room you are standing there, and you are told to run all the way across to the right side of the room.”
David: Like a 100-yard dash.
Kevin: Yes, like a 100-yard dash, as quickly as you could. Most people could imagine themselves getting through that ordeal, but then you said, “Now, I’m going to hand you a 50-pound bag of concrete and I’m going to ask you to do the same thing. How’s that feel?” And the 50-pound bag of concrete is the debt. Now if you add another 25-pound, and another 25-pound, not only are you not going to be able to run across the room, you’re not going to be able to move.
David: You’re barely able to move, and that’s the nature of an economy which is bearing the burden of too much debt, which gets back to Reinhart’s contention, 2016 is when we start seeing a major restructuring of debt, in both the developing world and the developed world.
Kevin: So this takes us back to Reinhart. You’re going to have to cut the debt back down, you’re going to have to take that 25-pound or 50-pound bag out of their hands at some point.
David: That is what I would say is the third uncomfortable reality here, which is to allow for greater economic growth in a debt-dependent system, the solution is likely to be just cutting the existing stock of debt or putting it on more favorable terms so that more debt can be added to the future. That may almost seem counterintuitive. If you have a debt problem why do you continue to add more debt to the system? (laughs) “Well, we’ve been doing that for a good bit of time. Don’t tell me it doesn’t work. It has to work. It must work. It’s the only way we know of doing things anymore.” And so that is what is on the table.
Kevin: But if I loan somebody money, I don’t want my debt restructured, I want my money back.
David: You do. The argument will be, do you want none of your money back, or some of your money back? Because as it stands, the debtor in question is not going to be able to make payments. There is not enough growth in their economy for them to make any payments at all. If you reduce the total burden, it will allow for economic growth that is sufficient for them to make some payments instead of none. Your choice. Some or none.
Kevin: So one step forward, two steps back in this particular case, if you’re still standing.
David: (laughs) So as countries reach what Reinhart and Rogoff describe as this critical or dangerous level of debt to GDP, restructuring is, as we have said before, about choosing the winners, it’s about choosing the losers, and no, creditors are not interested in taking a loss on a loan, but when it can be shown that the probabilities of any payment are improved with a minor reduction in the debt burden, or a major reduction in the debt burden, then you do have their attention. It’s that proposition of, “Do you want nothing, or can we negotiate toward something here?”
Kevin: And it’s rarely ever just a one-time deal. Isn’t this a death of many cuts?
David: And that’s the point of her paper most recently, that actually, when you begin a restructuring process, it can take the better part of a decade, and it takes more than one attempt at restructuring, it can take three, four, it can take as many as six or seven different iterations. In other words, the first cut is usually insufficient, as are the next five. It takes, on average, close to seven times before you’ve come up with something that works. So, seven times, and a decade later, you’re finally getting out of a debt crisis. And Rogoff is saying, “China is the last big domino to fall as we come to the end of a debt super-cycle.” In other words, we’re looking at a major contraction in debt at a level we probably haven’t seen in our lifetime, maybe even in 100 years.
Kevin: And this is not blind speculation, just predicting into the future like reading tea leaves, these are historians. They’ve gone back and created a checklist, just a few things to say, “Okay, what is it over the hundreds of years that we’ve looked at that would be a checklist for a global debt crisis?
David: It starts with having that quantity, where it’s not axiomatic that if you get above 90% debt to GDP you will be in a crisis, because the Japanese are at over 250% and they’re not in a crisis. Well, they’re in kind of a perpetual crisis (laughs), but that’s different. What they’re suggesting is that you’ve set the context for crisis once you get past that 90% threshold and the probabilities are so increased, then it’s just a question of, are there any triggers? What might some of those triggers be for a global debt crisis if that context is set? Number one, rising interest rates. Check, we’ve got that. Number two, a collapse in commodity prices. Certainly, that would be a trigger for a debt crisis in the emerging markets where a lot of those economies are tied to commodity exports.
Kevin: Look at copper and oil. That’s all you have to say.
David: Number three, when you have currencies which are in decline, which then raise the burden of cross-border debts. (laughs) We’ve talked about having a tremendous amount of volatility in the currency markets. We’ve lost anywhere from 10-37% if we’re talking about the Brazilian real, massive declines, massive depreciations in currencies. And again, why does that trigger a debt crisis? Because when the debts of that country are priced in another currency, or denominated in another currency, and their home currency has devalued, it makes it that much harder to pay back the existing debt.
Kevin: This is why the book This Time It’s Different may not be something that somebody sits down and reads cover to cover, but you keep it so that you can go back and reference and say, “Hey, have I seen this before?”
David: I would say that this is a book that should be on your library shelves, and if you haven’t read it cover to cover there certainly is a healthy sampling that needs to be in your repertoire, just to have some perspective on financial history. Her work in 2009 with Ken Rogoff explored the history of debt problems, and developed that general threshold in the debt markets, that red line, if you will, debt to GDP exceeding 90%. Yes, problems are coming when you get past that. The transition from then, when the book was written, before we had, really, the concentration of pressure in the European markets, which was circa 2011, the transition from then to now has been that the vast majority of developed world economies are now beyond that threshold of 90%. The vast majority were not, and now they are past that threshold.
Kevin: Would you say that is emerging markets, as well, inclusive? We’re talking about the BRIC countries, as well.
David: I think we’ve seen emerging market debt, which has risen dramatically. And of course, China is front and center in that, in terms of their responsibility for probably the largest amount of debt accumulation over the last several years. And by the way, much – not all – but much of the emerging market debt is dollar-denominated. And it makes sense, if you are a creditor from a foreign country, you prefer to set the currency terms instead of giving debtors the opportunity to go through what we described earlier as a soft default.
Kevin: You can’t print your way out if you’re in debt in dollars if, let’s say, you’re Chinese.
David: That’s exactly right, so it’s to the creditor’s advantage to denominate those loans in their currency versus their debtor’s currency. But it’s interesting, because as devaluation occurs, debt problems are magnified. The probability of payback, even though you were protected up front, the probability of payback and the probability of having to restructure, also increases.
Kevin: A guest of ours, Felix Zulauf, who Barron’s has just written about again this year, because he is part of the Barron’s Round Table and so we get to see how he is performing each year, Zulauf pointed out something very, very dangerous about China. We keep talking about large reserves in China. “Don’t worry about paying off debt in China, they have large reserves.” But Zulauf says, “Yeah, if they were liquid.”
David: Reading Zulauf – he is a very bright guy. He’s a good macro thinker. And half of his calls were off last year, pretty significantly. Half of his calls were okay for the year. Sometimes I read Zulauf and I feel like I’m suffering in good company because I have a lot of respect for him. He says that the Chinese reserves – 3.3 trillion, they were 4 trillion last year, they’ve spent upwards of 700 billion dollars trying to keep their system alive and healthy. He says, “No, you’re not looking at 3.3 trillion of actual reserves which you could use as a currency war chest, because actually, 1.3 of those are illiquid, invested in things that you couldn’t turn into money instantly, and so you’re really only dealing with about 2 trillion dollars of liquidity,” and he says, “Look, you could run through that in a little over a year.” So by looking at liquid versus illiquid reserves you’d think that China has an infinite amount of time to fix things, but actually, when you look at the available liquidity, you have to radically reduce the game clock.
Kevin: I think about the arrows in the quiver for the central banks, and we’ve watched them shoot a lot of arrows over the last few years to make things stable. It reminds me of when you watch a movie and someone is an archer in the movie, I don’t know about you, but I sort of obsess on how many arrows they have left. I’m not really watching the movie, I’m watching how many are left in the quiver, especially if they’re rapidly firing. It seems that the central banks are in the same position right now. I’m obsessively watching the quiver and I’m seeing maybe an arrow, maybe two? How many more shots do they have?
David: It’s hilarious, movies are that way, whether it’s arrows or six-shooters, or fully automatic weapons. A fully automatic weapon – did you know that there is magazine capacity of about 3,000 rounds?
Kevin: If you’re in the A team.
David: And if you have a six-shooter, did you know that in the movies you have 18 shots?
David: And the quiver, it’s like an infinite quiver. How many arrows do you need, because it seems that the well never runs dry, you just keep on drawing from behind yourself, and there are more and more and more. It just brings to mind, I read this past week from two different sources, Dundee Economics and Zulauf’s research, again, global liquidity is deteriorating, and it has been for a number of months here.
And the critical side of global liquidity deteriorating is that it means that it is almost impossible to avoid a significant economic contraction. Liquidity is like grease in the gears of the economy. You take away that grease and the gears of the economy start to grind dry and hard and almost seize up, and that’s really, I think, what we’re moving toward. Money is gradually moving to the sidelines, you have central banks which are reversing their long-held positions in order to defend their currencies.
Kevin: And that’s the point, that’s the quiver versus the arrows. Banks are reversing long-held positions to defend their currencies, you said.
David: Specifically, central banks, yes. And when they’re doing that, they’re creating a form of monetary tightening. And so, just about the time that China needs – oh by the way, last week, what did they spend? 61 billion dollars in one day to goose the system.
Kevin: “Oh no, the stock market’s falling, put more money in.”
David: That’s right. And it’s coming straight from the PBoC, the People’s Bank of China. That’s what the central bank spends in a month in Europe to prop up the economies of Spain, Italy, Portugal, Greece, France. 60 billion spread over half a dozen countries as opposed to 61 billion for one country, one market, was actually pretty remarkable. But as the Chinese are spending through their reserves to prop up the monetary system, it is this balancing act of spending 60 billion dollars in a day, and the natural tightening which is occurring in their economy as they reduce their liquidity. Then you cross just a little way across the pond, the overt monetary measures which are winding down in Japan.
Kevin: Yes, the QQE.
David: Kuroda has conceded defeat, the QQE was a failure. More of it will not help, and so the same kinds of measures, QQE in Japan, he says, are not coming. Here in the U.S. you have the Fed which is trapped between the rhetoric of recovery and the reality of an ailing economy. On paper the Fed – this is the official dot plot system – the Fed says they’re going to raise rates from now until 2017 eight times. Their appraisal of the economy says, “Look, this is the course we’re setting. We’re going to raise rates eight times between now and the end of 2017.” Again, that’s on paper. In reality, which is the tougher place for Fed officials to spend any time, they are not sure what to do with the kind of market volatility and rise in uncertainty that is taking place on a day-by-day basis.
Kevin: Let’s just look at what has happened since they raised rates once in six or seven years.
Kevin: Was it is six, seven, or was it eight years? How long was it since the last time they raised rates? It happened once and the stock market is off several thousands points. Let’s go back and look at history.
David: Let’s look at our own history. We were wrong. It’s supposed to be three steps and then a stumble. Traditionally, it is three steps and then a stumble. It was just one step and a stumble this time. This stumble came sooner than it was supposed to happen. I don’t know why the markets are so on edge. They should have waited until the Fed raised rates another couple of times. But it’s almost shoot first, ask questions later. Get out, and let’s sort if out later.
Kevin: Didn’t the investor know that we were in a recovery, a robust recovery? Maybe they didn’t hear the news.
David: The context for raising rates, if you go back to 1945, this according to Barron’s. The Fed has raised rates 118 times since 1945. On 112 of those occasions, nominal GDP was growing at a 5.5% rate.
David: Only twice was it below 4.5% growth rates. Go back to 1982, that was the most recent, saw a 4.5% level. The Fed started to make moves and they had to immediately abort.
Kevin: Which means you have to have robust growth to raise interest rates.
David: That’s right. Now we’re talking about nominal growth rates today, officially, of 2% plus/minus. They should not be raising rates unless they intend to recreate the 1937 to 1938 period where early tightening triggered a 50% decline in equities. Monetary policy, 1937, too much tightening too soon in the wrong context precipitated the 50% decline in equities. We may be experiencing that again.
Kevin: Let’s look at that because there is some difference right now. Usually when you see a major decline in equities like we’ve just seen over the last several weeks, you see a bond boom, a treasury bond boom. You know the old adage, if you come out of stocks, you go into bonds. Well, why not? This is not happening right now.
David: It’s a key dynamic in the treasury market. Ordinarily, you have stocks selling off, you see the big jump in the value of bonds as people move there, they protect themselves, it’s a safe haven trade. And that dynamic is being neutralized to a large degree by the vast amounts of treasuries being liquidated by sovereign wealth funds and central banks. Why? They are attempting to defend their currencies and they are selling off one asset so they have the resources to do what they need to do to stabilize their currencies. And it’s a very interesting turn of events. And I think it’s a key change in market dynamics. You have the price fluctuations we have seen which are not matching up with what you would ordinarily expect to see on the other side in the fixed income space.
Kevin: Do you think maybe it was because we had the perception that we were still in a bull market by a lot of the investors out there, even though we were creeping down and actually probably in a bear market for the last year or so?
David: Yes, well, the reality is, we are seeing the dynamics of going from stocks to bonds, but the amount, the quantity, the total stock of liquidations from central banks is far greater than what’s being…
Kevin: So it’s neutralizing.
David: It’s being neutralized, that’s the reality. Last year we had a stealth bear market in the stock market. You had the indices which were doing a great job – the indexes like the Russell 2000, the S&P 500, the Dow Jones Industrial Average – they did a great job doing window dressing. But the interesting thing, and we’ve talked about this over and over again in terms of breadth and internal market dynamics, 70% of the stocks in the Russell 2000 were down more than 20% from their highs last year. 49% of the S&P 500 companies were in the same boat, down more than 20% from their highs for the year. 68% of NASDAQ companies were down that much and more, and yet the indexes gave you the impression that all was well. That’s why we call it a stealth bear market. The indexes gave that impression and people are just now in the first couple of months of the year addressing this surprise element. “We thought everything was okay. The Fed was raising rates. Why is the stock market selling off?” Actually, the stock market was selling off hard all last year.
Kevin: Except for 20 or 25 stocks that had a tendency to pull the whole index up.
David: Yes, and it illustrates the internal weakness in the marketplace. Breadth was awful, as we have been saying. As of last week, 765 NASDAQ companies were trading at their lowest level in a year. So not just 20% off of their peak, but you have 765 NASDAQ companies which were trading at their lowest level for the entire year on the floor.
Kevin: It sounds like the financial crisis seven or eight years ago.
David: It’s the highest number since November 2008 – Bill King reminds us of this – it’s the highest number since November 2008 when the levels reached 1,211 companies trading at their lows for the year all at once.
Kevin: Yes, but perception managers still continue to give their rhetoric. I’ve been listening to Mario Draghi and he is basically saying, “Oh, there’s no reason to worry. You need to understand that there is no sign, whatsoever, of financial instability.”
David: That was his quote this week, his speech this week. “There are no signs of serious financial instability.” That’s what he said. And it directly contradicts his suggestion last week which is that the ECB is going to consider a more extreme set of monetary supports when it gets together in six weeks time in March.
Kevin: I hear the pied piper’s tune. I can’t remember exactly how that little fable ended, but I don’t think it ended well for the mice.
David: Well, which is it? A real need for more intervention beyond the existing 60 billion dollars of lifeline coming from the ECB, or are they on track to meet their growth and inflation expectations? Which is it, Mario? Which is it? It’s fascinating to me. He spent a good bit of time trying to convince the audience – again, when someone is arguing a certain point you can tell that they’re trying to address a real concern and issue. He spent a good bit of his time in this particular speech this week trying to convince the audience that a zero interest rate policy, or a negative interest rate policy is actually not harmful to people. “It’s not harmful to be at negative rates, it’s ultimately going to be good for you.” And maybe the operative word, I chose that, he didn’t, but ultimately is the transition word, because it’s like, on balance it will be good for you because if the economy recovers, then you’ll be good. The reality is, NIRP and ZIRP, negative interest rate and zero interest rate policies are incredibly negative and incredibly painful for the saver.
Kevin: He has a nickname. They call him Super Mario. If you’ve ever watched the Super Mario game, a lot of times Mario is running from the evil mushrooms, or this or that, and it seems like Mario is actually running from the evil mushrooms trying to make us feel like they’re the friendlies. They’re not!
David: (laughs) That’s right. What is the net effect of a negative interest rate or zero interest rate policy. It subsidizes the over-indebted while penalizing the prudent saver.
Kevin: Right. It’s theft, Dave.
David: And you can tell me that that is good for me, but if I’m the prudent saver and I’m being penalized in order to subsidize a company, an individual, a country (laughs) – not harmful to people?
Kevin: Instead of subsidizing a retirement. A lot of these people have gone back to get a job because they’re not getting any interest and they don’t mind, I guess, subsidizing other companies and governments.
David: If he is not careful, he is going to accidentally send the message that the next generation, we don’t give any thought or care to, because debt and the subsidizing of debt is really what is important to us. And it basically means that the next generation is being signed up without their permission, without their approval, for a life of debt servitude. And he is not explicitly saying that, but when you continue to create and support a system that increases debt and pushes the burden into a future generation, I’m sorry, whether it is a zero interest rate policy, a negative interest rate policy, with the debtism that Duncan has described, and we’ve been discussing today, this is very painful, not only for the existing saver, but also for the future child, future saver. What we’re communicating is that we value our own experience of living beyond our means far more than we do their experience of even living.
Kevin: So when the rhetoric, the propaganda, this perception deception changes – you know, Mario is actually doing the only thing he can right now, and that is printing money and trying to tell everybody everything is okay. This takes me back to Reinhart. She is basically saying, at some point here, when the truth prevails they’re going to actually just start forgiving debt.
David: That’s exactly right. Forgiven, restructured, defaulted – whatever language you are comfortable with, there is a winner and there is a loser in every game, and the game is on, the game has begun. Your primary goal as an investor today, I think, is to avoid being the biggest loser and increase your odds of winning, because actually, the system is set against you in its attempt to assign losses to you.
Kevin: In this program over and over we have expressed how China has been preparing for something. It may be a new currency type of regime other than the dollar, it could be these debt restructurings, but China has completely dominated the demand for gold while they’ve lied about their official numbers. The numbers just came out for 2015 and they were extraordinary, Dave. I think we should be looking at that.
David: 2015 import numbers for Hong Kong jumped up to 862 tons for the year. That is an increase from 2014 which saw imports into Hong Kong of 813 tons, so a significant increase into Hong Kong. As the year ended the pace increased. November was 79, December was 129 tons. As we look into 2016, down the pike, gold seasonality might be lumpy this year. We have demand in January, which is typically good – I think we’re seeing that. We’re entering the Chinese New Year so most of the demand is in the Asian markets. This can represents the January period, a short-term peak before we go into a rise in the spring. The summer months leading to Ramadan could be very good with the Saudi and Iranian tensions running high, and with ISIS threatening regional instability. As we move into the fall, depending on the weather you have the Indian demand which may be weaker than usual, as cash flows from harvested crops do have a big impact.
2016, I think, though, is shaping up to be a very good year for the metals. There are the base sources of demand, the most stables sources, which we just talked about, in the Asian markets. The swing vote, which radically alters prices, is in the investor category. You have short positions by your speculative investors, which are close to the largest on record. Meanwhile you have the commercial positions. These are the miners, the folks who are in the industry, itself. They are positioned for a rise in price, not a decline, and they’re pretty savvy when it comes to hedging their production. So when they’re lined up against the shorts, usually you have the opportunity to see a pretty significant short squeeze, where the commercials win and the specs lose. As the sovereign debt crisis begins to heat up, your traditional safe haven play of government paper is likely to be in the crosshairs, I think it is likely to be far less attractive, and that is going to drive even more traffic into gold as the year progresses. All in all, while we’re not out of the woods yet, we are, I think, on a 24-month turn that is going to surprise and delight the holder of gold as we head through 2016 and into 2017.
Kevin: You talked about Indian demand and some of the other demands for physical gold, and even if that were to drop off a little bit, look at China. It seems to be overwhelming all the gold that is coming out of the ground right now. The Western media doesn’t really print that, but in reality, what is mined, about 3,000 tons a year?
David: That’s right. And very rarely, whether it is the Financial Times or the Economist, or Barron’s, very, very rarely will you find either the European or the U.S. media outlets saying anything good about gold. But investors and institutions set a fresh record in 2015. We talked about Hong Kong just a minute ago. The delivery off of the Shanghai gold exchange for 2015 was 2,596 tons. That, combined with the Hong Kong markets puts you at 3,540 tons withdrawn off of their exchanges, physical gold taken delivery of for 2015 – 3,540 tons in a year.
Kevin: When only about 3,000 is pulled out of the ground every year.
David: That’s right, you’re exceeding total global mine production by about 500 tons. So you have cheap prices which, if your mind is influenced by the Wall Street PR shills, cheap prices are a bad thing. But in Asia, they like to stock up when the cheap prices emerge. And I think there is a time coming, Kevin, when the Western investor will attempt to fill an order, buy gold, click his mouse, buy GLD, put an order in for physical metals, what have you, and find that the metal is unavailable except at radically higher prices.
Kevin: Right, because we’re talking about real metal. When we’re talking about 3500 tons consumed or brought in, that’s physical metal. We’re not talking about contracts which can exceed by 100, 200, 300 fold, the actual gold that is behind them.
David: This is the harsh reality coming. Maybe it’s a reality we see in 2016, maybe it’s 2017, but this is a hard reality. Asian investors have for five years stripped the above ground supply at low prices, which will create a dramatic supply/demand problem this year or next. 2017 will be even more exaggerated as we get into what the World Gold Council described several years ago as the first year of being past peak production. 2016 is peak production for gold as they are studying all the mines and where the supplies are coming from, peak gold occurs 2016. 2017, we’re now in a structural decline in the quantities of gold coming from mines.
Kevin: So the supply contracts as the demand increases.
David: Right. So to reiterate, because this is a very important point, we are now going into a multiple-year cycle where less and less gold is being produced from mining, even as investor demand returns. The surprise in the gold market is not going to be the rise in price, the surprise is going to be how rapidly that rise occurs when demand runs into scarcity. These are the classic dynamics of a third-phase structural bull, a parabolic rise. I think it’s on the horizon.