The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
Kevin: David, it’s nice to have you back in the studio today. We are recording this on Election Day, so we really can’t talk about the outcome either way. With that said, ours isn’t the only election, or the only regime change, possibly coming. Probably one of the bigger issues is not a four-year term here in America, but a ten-year period of time that is coming up for China.
David: Exactly. We record on Tuesday for Wednesday, and by the time this airs we will know which of the two most popular personalities will be in the White House. I think what we have to consider is the policies they have to implement going forward, regardless of which party is in power, the policies that determine the future course for us fiscally, are absolutely paramount. And as you said, there are other political changes around the world that are incredibly important, and actually have direct bearing on the U.S. Treasury market and U.S. dollar stability.
Kevin: And those are coming up in the next week.
David: Exactly. November 8th is the beginning of the hand-over. Congress begins meeting on the 8th and President Hu Jintao is due to hand over the Communist Party leadership to Vice President Xi Jinping, and again, that begins November 8th. The real issue is, the implementation of this 5-year plan and the transition after that to the next 5-year plan. These two together are what the new leadership will be putting into place.
Kevin: David, it’s worth talking about this today because you are right, we don’t know the outcome of the election today while we are talking, here in America. But our largest creditor is China and there have been numerous 5-year plans, the latest one just kicked in the beginning of this year, but we do have leadership change coming, and there are different opinions worldwide as to whether that is going to positive or negative for the world economy.
David: There is this thing called the middle-income trap that many countries in the process of development slip into, and it basically is a higher plateau. Incomes reach a level that they just can’t seem to get beyond, so improvement, improvement, improvement, and then a stall, and that is really the concern in China. The transition that they are trying to put in place would take them from that middle-income trap potential into a long-term sustainable growth path of 3-4% GDP growth per year.
I think what we see is an effort being made. We don’t know if they will be successful, but we do have this 5-year plan, which has been explored thoroughly by the world bank, 300 pages of exploration of how they can be successful in implementing this 5-year plan, and some of the policy constraints that they need to encounter and resolve with this new leadership.
Kevin: David, we have to realize, here in America, two things that are definitely affected, and that affect our pocketbooks, is the way China buys our bonds. That affects the interest rates, a well as commodities. If there is a change in the growth pattern in China, there is a change in the value of the dollar, in the value of our ability to get loans.
David: This was certainly one of our primary topics in this year’s DVD, as the Chinese maintain a dual orientation to both external growth, that is exports, as a major input to their economy, and investment. What we mean by that is building out infrastructure – bridges, roads, railroads – things that will allow them to grow in the future. That investment is very intensely natural resource-dependent. So of course, over the last 3-6 years we have seen a massive increase in demand for basic commodities.
Kevin: Like copper and steel and those types of things. If there was a slowdown, we would definitely see a change in the price in those commodities.
David: With many of those commodities being consumed, 50% of global demand, being consumed by China alone, a change in orientation has a dramatic impact. Why is this important for us and why are we talking about it, particularly now in our own election cycle? Because frankly, we have some major decisions to make, whether it is the U.S. fiscal cliff or our annual deficit, let alone our long-term liabilities that have to be addressed in the next administration, and it’s happening at a time that is very inconvenient, because the Chinese, our primary creditor, may not be stepping up to finance our deficits the way they have in years past, as they focus more internally on their own transition.
The question for us, in terms of Chinese leadership, is a compelling question: Will they be more hardline? Will they move back toward an even greater internal focus? And with diminished trade reserves, and we are talking about trade surplus dollars which have come from the United States and our penchant to overconsume, will they be recycling into U.S. Treasuries and support our budget deficit, as they have in years past?
Kevin: We have talked about interest rates being artificially held low. One of the reasons we can do that is because we have people who are still buying our debt. Something fascinating about what has gone on in Europe is that a lot of people were seeing the euro as a transitional replacement currency for the dollar, yet what we are seeing in Europe right now is actually adding strength to the dollar.
We have seen dollar strength because of the change in the euro, the difference in the value of the euro, but there are other currencies out there, and when people start to get worried about risk in any economy, they still seem to run to the dollar. Even though we may be long-term dollar bears, the dollar still seems to be a place where flight capital runs.
David: Let’s talk about zero interest rate policies, because what the Fed has done by setting interest rates so low is to create a context in which we are a funding currency. In other words, in terms of international carry trade dynamics, individual investors and institutions will borrow in U.S. dollar terms because of the very low interest rates that they have to pay back, and then take that borrowed money and invest it in countries where sovereign paper is paying more. Literally, if I can borrow for less than 1%, and invest in a country that is paying over 3%, and pocket the difference, I’m using someone else’s money to make a fortune.
Kevin: That was the game here in America ten years ago, called the carry trade, with Japan. We would borrow at virtually nothing in Japanese yen and buy Treasuries.
David: The issue is that you end up having to unwind that trade, to some degree, as the dollar appreciates, because you have to pay back those dollars with more expensive dollars, and if there is a change in interest rate dynamics, of course, that exacerbates the issue, as well. So downward pressure in the foreign currency markets, and upward pressure for any reason in the dollar market – that is not necessarily gold-negative.
I guess what I’m trying to say is that in the short-run we could see dollar strength and that is not necessarily gold-negative, because I think one of the things you have to figure on the other side of the equation is dollar strength equals foreign currency weakness, and to the degree that we have foreign currency weakness, we have good strength in those other foreign currency terms.
Kevin: Like this week. Didn’t we hit, in the last couple of weeks, a new high versus the euro, gold to the euro?
David: Exactly. If you price gold in euro terms, it has just been within the last few weeks that we have made all-time highs. This is the dynamic. No one in the United States likes to see the price of gold go lower in U.S. dollar terms, and yet, it is not going lower in global currency terms.
Frankly, the more important audience today is not a U.S. audience, it is an international audience, with a greater penchant for owning gold than the average U.S. investor, or certainly, the U.S. central bank. So you have foreign central banks and foreign investors who see their currencies depreciating, frankly, in lockstep with the dollar, but it just depends on the day, or the given week, which is depreciating more.
They are compelled to own gold, and I think that is important to note, because it is not necessarily the case that the dollar goes higher and gold must go lower, because, in fact, it did not happen that way in the 1970s. We saw dollar decline through 1973, 1974, and 1975. By about 1976 it started to taper off. Five central banks came in, intervened in the currency markets, the dollar stabilized, and from 1978 forward, guess what?
Kevin: They both went up, didn’t they? Gold and the dollar?
David: We actually saw the dollar begin to rebound. Gold was going up, and the dollar was going up, and many people were confused because they thought that the gold price and the trajectory of the gold price were dependent on dollar weakness, which is not the case. It’s not the case, particularly, in an environment like this where demand for the physical metal is not U.S. or dollar-centric, but it relates to other currencies and other places around the world. They have far outpaced demand versus what we have seen here in the United States.
Kevin: Talking about other currencies, I want to shift back to China. Their economy, on a world perspective, is less than 20% of the world economy, but the money that they have created is about half right now. All new monetary growth is coming straight out of China.
David: You are talking about broad measures of money supply, and yes, since 2007 they have accounted for between 40% and 50% of all growth across the 16 largest economies in the world. This is an expansion from 5.47 trillion dollars back in 2007 to where the broad money is today at 14.49 trillion dollars.
Kevin: You are converting renminbi to dollars just to give an idea of the scope.
Kevin: That’s almost what our deficit is.
David: And the concern is, of course, that with such a rapid expansion comes major increases in nonperforming loans, and major problems in the banking system. It is important to reiterate that the bull market dynamics, in the gold market, we tend to fixate on a very U.S.-centric view of gold, which has been, and will continue to be, frankly, irrelevant, except in the case of the U.S. bond and dollar markets moving into the limelight. And then I think over the next 3-5 years, then you can begin to see demand dynamics here in the United States pick up as we deal with our own issues, domestically.
Kevin: So, what we are going to have is an awful lot of money chasing a certain amount of items. We know that the Chinese are buying more gold than anybody right now. The Chinese and the Indians are overwhelming the gold market. But there is also a tremendous amount of flight capital coming out of China and going into other countries and there are mechanisms that these guys are using to try to get away with it.
David: One would think, given the massive amount of flight capital from China, that insiders are anticipating a radical shift in economic engineering, away from their interests. These are the corporate insiders, the government insiders, who have through graft and theft and corruption been able to carve out as much as 17% of Chinese GDP to line their personal pockets.
We are now at the cusp of a decade-long leadership change. Is that group of very interested and already-benefited people looking and saying, “This won’t be good for me. This won’t be good for my pocketbook.” What if we end up with a group of hardliners coming in and radically altering that system of vested interests? Maybe they will even address the pervasive corruption in the Chinese economy.
This is, I think, stunning, frankly – the Reuters article out last week that detailed the smuggling of funds out of China. We have looked at Treasury reports going back to 2010 and have been surprised to see how large the numbers were. What Reuters put together was an estimate of 3.79 trillion dollars being smuggled out of the country over the past decade, close to 4 trillion dollars being smuggled out, from 2011 alone, 472 billion dollars leaving in 2011, which is extraordinarily high when compared to the foreign direct investment figures. Those are outside investors coming in and building plants and infrastructure in China, thinking that their company will have some benefit from doing so. Foreign direct investment figures, going back from 1998 to 2011, cumulative figures of 310 billion dollars. Foreign direct investment of 310 over about a decade. In one year you are outpaced by capital flight of 472 billion.
Why is this important? Why are we fixating on it? Because frankly, the insiders in China know that radical change is getting ready to take place. Connect that dot with the change impacting the U.S. because if, in fact, they are successful in implementing their 5-year plan and move toward being more internally consumption-oriented, that implies two things. It implies higher currency values, and it implies increased wages for the average worker there in China.
What that means is that they are no longer competitive in terms of an export advantage. They don’t want the export advantage. If they are, in fact, being consistent with the five-year plan, as stated, they want to drive internal consumption, and these two benefits get them that much closer to it. The change in game means that the old players have to leave, and they are doing so as we speak.
Kevin: Which means we have to find new people to loan us money. I’m going to go back to China, though, for second. Here, in America, quantitative easing, the printing of money, supposedly translates into higher stock prices. We have seen that. We have seen higher stock valuations here. If China is creating all this new money, why is the stock exchange at 4-year lows?
David: I think a lot of the money has gone into real estate and real estate development projects. A lot of the money has gone into wealth management products that have had little to nothing to do with the stock exchange there in Shanghai. So yes, we are sitting at 4-year lows, and a rally, frankly, is quite possible, particularly as we move past this power transition and investors know how to adapt and how to adjust. The reality is large investors are in a wait-and-see mode as to who will be in the top leadership positions, and how they will govern.
Kevin: Even if there is a rally, Deutsche Bank and other large institutions are waiting and watching because they think maybe the long-term trend is not so great for China.
David: No. In fact, we have Deutsche Bank saying, basically, that the underpinnings in China are very negative. On that basis, they are not interested in Russia, they are not interested in Brazil. They are not interested in a number of countries that supply basic materials to China.
Kevin: Let’s stop and look at that, because that can sometimes be confusing when someone says, “We’re not positive on China’s growth, so we’re not going to buy something in Brazil.” Explain the thinking there, because Brazil, Russia, and those who supply those industrial commodities to China are dependent on China.
David: And Australia. When you start looking at not just 1% of GDP, but 3%, 5%, 10% of GDP, which is moving toward one particular customer, this is what most business-owners fear, having one customer that represents too much of their business, because if anything changes with that customer relationship, your business is going to hurt. The ability to keep the lights on is not on the basis of losing 50%, but it is usually a much smaller margin that determines whether or not you are in business, or not in business.
Kevin: So just like we need China to borrow money, they need China to buy things.
David: And the view of Deutsche Bank and a couple of their analysts there is that Chinese growth and the changes that are happening there, the slowdown is structural and not cyclical. And what that basically means is that this is a long-term trend change, this is not a short-term veering from the path, in terms of growth. We thought it was going to be double-digit forever and a day. It is no longer going to be double-digit. Now it is 7-8% growth rates in China, moving toward a 3-4% growth rate, and again, this is a normal, expected course, and it assumes that they are, in fact, going to be successful in transitioning to being an internally consumption-oriented economy. As you reiterated, the grave implications for the U.S. is that if they don’t have trade surplus dollars to recycle into Treasuries, where are we going to get our deficit financing?
Kevin: David, what is coming up next, this fiscal cliff, reminds me a little bit of Sandy, the hurricane that hit last week in New York, the worst one that they’ve ever had, and now there is a tropical storm brewing again, possibly another Atlantic storm that is going to come in. I’m thinking about, if China does change, and our main creditor stops buying, or we have to come up with something else, as we said before, the people who are listening to this commentary today already know who the new president will be. Whether he is new, or whether he is still the old president, either one has to face the fiscal cliff.
David: There are a couple of things that, regardless of who wins, are going to make it a tough road to go down. The winner will have to stand by and see if the House and Senate work together to resolve the fiscal cliff, and then address head-on the growing problem of deficit spending. When we look at things, it is from as neutral a position as possible. Win, lose or draw, what are the issues in play for the victor? And policies proposed after the inauguration will, even then, face implementation risks.
Kevin: So would you say, economically, the two things that they are facing are the fiscal cliff and budget deficits? Let’s look at the fiscal cliff just for a moment.
David: Exactly. Those are the primary considerations for the victor, the fiscal cliff and budget deficit. The balancing act, if you want to look at what we are spending today versus what our national income is — this is why we have a major problem. We are spending greater than 22½% of our gross domestic product, we are bringing in the equivalent of 15.7% of our gross domestic product, and that gap is what we define as the deficit. We’re spending more than we are bringing in, it’s quite simple.
The fiscal cliff is the first problem, and if it is left unresolved the equity market is likely to sell off considerably, with U.S. interest rates rising. Regardless of Fed manipulation of pricing in the bond market, the free market will overwhelm the Fed, and I guess if you want to draw that distinction, between the free market and the Fed market, the Fed market has been driving interest rates lower, not the free market.
The free market can reassert itself at any point, and this is what they popularly call the bond vigilantes, saying, “We don’t think that this is going to be resolved nicely, and we are going to have to factor in more credit risk, and receive more interest for the loans outstanding.” In other words, people start liquidating bonds, and interest rates go up, regardless of Fed activity.
Kevin: David, if they could resolve the issue, we may see low interest rates continue for a while. But if they can’t resolve the issue, this should be a big, blinking red light for the person who has a large bond portfolio.
David: Certainly, because you are trusting the now AA rating, not the AAA rating, of U.S. debt – it has already been downgraded by Egan-Jones and S&P. The question is, do the lonely voices of those two rating agencies become a chorus, with Moody’s and Fitch, and others, stepping in to say, “You’re right. You’re really right. There is more credit risk here. We don’t see the House and Senate working on a real solution here, and we’re going to have to factor that risk into the rating of U.S. debt.” A downgrade, I think this time around, will equate to considerably higher interest rates.
Kevin: Okay, but let’s go on to the enduring problem, the problem that just continues on and on, and there is no administration that has really answered to this, and that is, the budget deficit. The government cannot afford to go into debt forever, but right now they are reporting positive GDP growth of 2%, but in reality, 8-10% of that growth is coming from government deficit spending money.
David: This is why you describe it as an enduring problem. If you look at the decades of the 1970s, 1980s and 1990s, we were spending more than we were bringing in. We ran deficits every year from about 1972 on, and then for a few brief years in the late 1990s and into 2001-2002 we actually ran a surplus, but it was almost an accident to run a surplus, coming at the tail end of a massive bull market, the largest bull market, in fact, in U.S. equity history, where incomes were off the charts, and tax revenues, on the basis of exploding incomes, were off the charts. We had incomes on the rise, and spending was in decline as we came into the turn of the millennium. Why do we have an enduring problem? It’s the same problem we had in the 1970s, 1980s, and 1990s. Government spends too much money.
Kevin: But back then it was in the billions, now it’s in the trillions. If we really were accounting, the way you have to account, as a person who runs a company, if we were actually using accounting standards, is the deficit that we are being told about the actual deficit?
David: Right, because the current deficit of roughly a trillion dollars is the equivalent of 8-10% of GDP. This is massive, Keynesian deficit spending to fill the gap where the consumer left off, but if you accounted for it as the generally accepted accounting principles instruct you to, as a business owner, as a corporate entity, must, then our 1 trillion-dollar deficit for fiscal 2012 was actually more than a 5 trillion-dollar deficit. That factors in long-term liabilities into current reality.
Kevin: David you talked about the downgrade that we had from rating agencies on our government debt, from AAA down to AA. That has implications that a lot of people don’t really realize. There are portfolios out there that have to, by prospectus, hold a certain degree of debt, as far as quality of debt, and when the downgrade comes, they have to liquidate that debt.
David: A forced liquidation.
Kevin: Yes. So what are we looking at for 2013 with these rating agencies?
David: The fight is going to be to convince the rating agencies that our fiscal house can, and will be, put in order, and quickly, which carries with it abandoning political intransigence, and this is where, in an election year, we have seen a lot of it. This is not to blame one party or the other. On a partisan basis, everyone has been looking to gain an advantage, and perhaps blame the other party, for this problem or that. The issue is that we can’t afford intransigence as we come up to either the fiscal cliff or a budget deficit, because we are now in a testing phase where the rating agencies will be looking at us on a much more detailed basis, if you will. We will be under the microscope.
Kevin: And being under the microscope, with so much division right now in Washington, David, do you really see the House and the Senate working together on this fiscal cliff?
David: The real question is whether the resolution is temporary, or a permanent solution, and it would not surprise me at all to see them patch together some plan that kicks the can into 2013 or 2014. That is what we have seen politicians do so effectively, disavow any responsibility for a problem, to make sure that on their watch they can’t be blamed, and to push the issue into the future, hoping that something – time and the tide of events, perhaps the grace of greater capital flow coming from the Fed, cheap and easy credit, cheap and easy money – will solve the problem. They don’t want to do the hard lifting. But can they put something together? I think that is, at best, what they will do, sort of a patchwork quilt of something that will carry them through this end-of-year crisis and maybe toward the end of 2013 or 2014.
Kevin: It’s like Europe. Nobody wants to feel the pain right now. It’s human nature. Nobody really wants to feel the pain, but it’s coming.
David: The first test, as we said, is prior to January 1st and the inauguration. The House and Senate are not seen working together on the fiscal cliff. We’re looking at a 2-3% drop in GDP heading into 2013, then downgrades on U.S. debt are sure to follow, along with the potential for an equity market bloodbath.
It will be difficult to avoid the attention of the international media and this may, in fact, serve as the transition point from media maintaining a euro-centric focus. We have been enamored with, or have gotten a free pass, for the last three years. Europe has been in the spotlight; we haven’t. And I think that may be a change, if you will, a transition point, where certainly Spain, Portugal and Greece can re-emerge as problems in the beauty contest, or the ugly contest, if you will, but we are in the process of throwing our hat in the ring.
Kevin: So we get to be the ugly duckling for a while?
David: We very well could be as we head into 2013.
Kevin: David, the jobs report that came out last Friday was supposedly very, very exciting, very positive. It almost looked like it was ploy put in by the Democrats, but the markets didn’t take it that way, did they?
David: No, they didn’t, because it actually was not that positive. It is fascinating, listening again to the political pundits coming into the election, everything was dependent on interpretation, and I think the interpretive lens that was put over the jobs report, at least on the Obama side, was that it was very positive.
171 was a great number, it beat any of the estimates that were out there. Meanwhile, the number U3 jumped from 7.8 to 7.9. I think the story is always in the details. The devil is always in the details and the fact that 90,000 of those jobs were fabricated, statistically, through the birth/death models, to me, says everything. 171 was fiction to being with, and I don’t know why we even bring it up.
Kevin: But the better part of half of that was fabricated.
David: Exactly. But I think the bigger issue is that, whoever wins or loses, the market is trying to figure out what the implications are, and Friday was very revealing in terms of what they think will be the victory story. Friday, on the basis of the jobs report, would have put Romney as a winner. Everything was down except for the dollar because it represents the end of QE, easy money around the corner. If Romney does get elected, then there is going to be a change in leadership at the Fed, and what the market has grown dangerously dependent on. Cheap money could go away, and that will hit all of the “risk-gone assets.”
Kevin: David, we still don’t know who the winner is going to be, so let’s go ahead and go with the Obama side. Let’s say Obama wins. What happens to equities?
David: The opposite stands to reason with an Obama re-election: Dollar weakness, more easy money, and a prop to your risk-on trades. But it is interesting, even in this context, Kevin, where we have had the most heavily owned equities coming under tremendous pressure, Apple and Google. And then if you look at a sampling of the most heavily owned equities by hedge funds, which is supposed to be the most sophisticated investment group on the planet – Apple, Google, Microsoft, J.P. Morgan, Qualcomm, City Group – these are the top investments and they are all tech and finance. Tech and finance, tech and finance, throw in some telecom.
This is fascinating to me, because we are actually seeing a breaking down of the leadership. These are the most heavily owned stocks, not only by hedge funds, but by 401ks and the general investment public, and now Apple is 17% off its peak, and Google is cracking as well. What does this portend? Let me go back into the archives, because I used to pay attention to the chief economists at Morgan Stanley when I worked at Morgan Stanley, and I liked to see how the company paraded out their chief economists on occasion, to make a point, and to prove a point. What I am recalling, Kevin, is the 2001 period where equities had been in decline, and Morgan Stanley drew out all of their economists onto the stage and said, “We have consensus. We never have consensus, but everyone – everyone – thinks that the stock market is going higher.”
Kevin: Well, except for one economist, whom we have spoken to a number of times on this commentary.
David: And as you look at the chairs on the stage, there was one chair missing. It wasn’t that it was empty, but their four chief economists became three, for the consensus to be made, and the consensus was, “We’re moving higher.” Stephen Roach was absent. They did not include his voice in the picture.
Kevin: And look who was right.
David: But one of the perma-bulls, and he has always been a perma-bull, is Byron Wien, and also Barton Biggs. These are the guys who, in that day, were the perpetual bulls of Morgan Stanley, always calling for higher prices in equities because it served, frankly, their corporate clients’ interests, to do so. The perpetual bull, Byron Wien, today has five reasons why he is concerned about 2013. This is just fascinating commentary to me because for a perpetual bull to look at 2013 and say, “I don’t care who wins, I think we have problems immediately in front of us,” that registers for me.
Kevin: You’ve been following it so long.
David: I know that, like a broken record, he is always bullish. I don’t have to read anything that he says, because I know exactly what he is going to say. Except when I read something and it doesn’t sound like a broken record.
Kevin: It got your attention.
David: That gets my attention. Just to look at some of the points, clearly he sees a decline in profits for the Standard and Poor’s 500. Everyone is expecting greater than $100 per share, and he thinks it might actually disappoint. What that means is that profit margins are peaking. The companies who have had a good year in 2012, he is arguing, cannot do a repeat performance in 2013, or certainly, will not be putting in even better numbers in 2013. They are also very concerned with the fiscal cliff, and a potential slice, 3%, out of GDP, and they are assuming, as they look at a slice out of GDP, much understated inflation numbers.
We have said this before, that if you understate inflation, you end up overstating GDP to begin with, so the GDP figure for us is almost an irrelevant number. We would look at the income of the average consumer. Is their income increasing? If their income is increasing, then the economy is going to be growing. GDP ends up being a manipulated number because you can manipulate the inflation statistic, which ends up overstating GDP to begin with.
Kevin: But David, income is falling, we know that. And we know that we’re borrowing too much money. Deficits, I think, was one of his issues, as well.
David: Of course, the annual U.S. deficit, without both cutting expenditures, which now represent close to 24% of GDP, and raising taxes, which is close to 17% of GDP, there is a crisis, and Washington has to do something.
The last point that he makes, and we haven’t included everything here, is the potential for an Israel first-strike on Iran, like we saw with Osirak many, many years ago, not on a permission-granted basis, but just because they recognized an existential threat. What does that do? Brent crude soaring to $150-200 a barrel, the Straight of Hormuz being closed temporarily, and that exacerbating problems in terms of recessionary trends, both in Europe and the United States. When I see someone who is perpetually bullish, always thinking that things are going to be better tomorrow, and now they are not, it does give me pause.
Kevin: David, just to remind the listener, you have already produced two DVDs this year. For the third of the three-part series you have been waiting for this election result, so over the next few weeks you will be doing an analysis and giving a very clear direction as to what we see coming with whoever is president, and whatever regime changes there are worldwide.
David: That’s right, the last installment of this year’s film series is a post-election synthesis. We have looked at Europe. We have looked at Asia, China in particular. The last one will be the implications into the equity, bond, and dollar markets over the next 3-4 years, 2014 and 2015 being particularly critical, as a result of this election, and the potential policies that are implemented over the next four years.
Kevin: So our listeners should be listening to this program to find out when they can see that next installment of the video.
David: Probably coming out around January 1.