The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
“Imagine launching a car off of a ramp. Your maximum acceleration combined with maximum ramp angle launches the vehicle into space. There is an apex where velocity is at its max and then energy is lost. And markets are no different. You have flows of liquidity, which drive prices, and prices can increase more and more quickly, but to sustain that it takes more and more liquidity. “
– David McAlvany
Kevin: David, I went back and read a quote this week from George Orwell that I think pretty much summarizes the way things feel right now in this country, with the election, with the central banking, the general deceit that we seem to have. George Orwell said, “During times of universal deceit, telling the truth becomes a revolutionary act.” Doesn’t it feel that way, Dave? It seems like George Orwell hit the nail on the head 70 years ago when he said that.
David: That’s right. It reminds me of Oliver Sachs and his little piece on aphasiacs, who really are almost brain-dead most of the time unless there is something deceitful or duplicitous which is being spoken, and then they can’t help but laugh uproariously.
Kevin: Because they know it’s deceit.
David: Because they know it’s deceit, and although they appear to be comatose and almost lifeless 98% of the time, if a lie is put in front of them, they laugh hilariously. It’s this great little vignette of a fine-tuned element. They have this BS-o-meter and the way that Oliver Sachs found it was during the context of elections because every two years there was this crazy thing that happened in the aphasiacs ward (laughs). You look at deceit, and you look at honesty, and, yes, it’s become a novelty to tell the truth, particularly in an election season.
Kevin: We seem to have a lot of truth and deceit coming at that same time. They would be laughing their heads off, like you said, because we have the WikiLeaks coming out and there are so many amazing revelations coming out through WikiLeaks, yet the Russians are being blamed. So, I guess Vladimir Putin is the expert at the Internet.
David: But interesting that better evidence is that, actually, the security community is a part of this, not, actually, the Soviet Union.
Kevin: Yes, it’s being revealed that it could be within the NSA, itself, that this information is coming out.
David: Right. And in fact, that Clinton is not the desired candidate in terms of the intelligence community – what they would prefer. Podesta, as you know, was right there in the campaign with Hillary, and you see the same kinds of shenanigans being played with polling numbers. And polling numbers are, today, telling us that there is a widening gap between Clinton and Trump, and yet, the sampling for the polls that are being done…
Kevin: The policy of over-sampling came from Podesta.
David: That’s right. And this is from an email directly from his inbox. Would you like to know what Podesta has said, in his inbox? In this day and age where there is no privacy, I can tell you exactly what Podesta said. “I also want to get your Atlas folks to recommend over-samples for our polling because we start in February, by market, regions, etc. I want to get all this compiled into one set of recommendations so we can maximize what we get out of our media polling.”
It’s very fascinating because right now, Kevin, they’re taking the tack that we just need to assume that Trump is buried, he’s done, we’re going to move on and discuss the Senate and the House as if that’s all that’s left to talk about because Clinton’s already won the election. The Democratic strategy is, the polling has already given us the election result so let’s just move on.
Kevin: That was part of the strategy. Another Podesta email basically said, two weeks before the election, “Let’s declare Hillary a winner and then move on to Congress.”
David: Right. And it’s fascinating because there is a bit of repeat, or an echo from history, where Democrats had a major lead coming into the election – I’m thinking Carter and Reagan, and then the Republicans, actually, by the time we got to the end of October, the sentiment was, “No, he’s buried, he’s a goon from Hollywood.” And yet, he won in a landslide.
So, fascinating that since 1972 you’ve got Democrats who’ve polled much better in the August and September months, and then finally in October – again, this goes back to 1932 – October you start to see a return to more accurate polling and the conjecture there is that the groups that are doing the polling do want to keep a bit of their integrity intact, and so they go back to normal polling practices just before the election. But you’ve got this August/September timeframe where they’re intentionally over-sampling certain people groups so that it gives the result they want, and basically gives free advertising to the person that they hope is elected.
Kevin: So this really is not new. Now, let’s say that these strategies don’t work and the letting everyone know that the victory has already been attained by the Democratic party doesn’t work. You still have voting machines, Dave, and I hate to say it, remnants of Hugo Chavez, if you go back and look at Venezuela. The same voting machine company that George Soros is connected to, they’re the ones who supplied the voting machines in Venezuela, and back in 2006 people were crying foul. They were saying, “Wait a second. This thing was rigged.”
David: That’s right. If you pay a little extra you can have your Smart-matic counting machines designate who voted for whom on a pre-established basis – now, I’m kidding, of course.
Kevin: We have 16 key states here in the United States that are using those machines that were provided by Soros.
David: It’s interesting. I’m sure you watched the last election debate.
Kevin: Oh sure.
David: This back and forth about, “You’re trying to let the Russians undermine the election process.” At the same time we have smoking gun emails, again, provided by WikiLeaks, that show the DNC funding the disruption at the events in Chicago. And it’s like, well, so is there a connection between Trump and Russia? I don’t think there is, but if there is, the DNC certainly doesn’t mind disrupting the election process themselves, which, categorically, when we’re talking to our kids, that’s the pot calling the kettle black.
Kevin: Yes, telling these guys that you’ll pay them to start a fight at a Trump rally.
David: And then insisting when the election results are in, you promise you’re not going to contest it, right? And I’m thinking to myself, but what if there’s a hanging chad? We’ve been down this road before where Democrats have, themselves, contested an election, and have filed lawsuits toward that end. Why would a Republican not be able to do that? I have to tell you, quite frankly, I’ve already voted. My election vote is in. My mail-in ballot, I put in the mail today, and I didn’t vote for either of these. My conscious would not allow me to. I realize I’m open to criticism now from 100% of the population that knows me, some of whom are Democrats, and some of whom who are Republicans. But my conscience, and the rationale which I can share with my children, is perfectly clear, and what I’ve demonstrated to them, I think, is completely defensible.
Kevin: This is causing division in my own household. There are some who believe, “Look, you’ve got to vote because look at the other side.” Or there are those who say, “We’ll never have a solution to this unless we write somebody in and start doing that on a more regular basis.”
David: On our ballots here in the state of Colorado, Lawrence Kotlikoff showed up, and it was a surprise to me because I didn’t know he was running.
Kevin: He’s an economist.
David: That’s right.
Kevin: We had him on the show. He did offer a solution to the budget problem.
David: Well, I didn’t vote for him. One of the things that I do appreciate is that he is willing to put something out there. The world is full of critics and not very many creators. It is interesting to see someone actually craft a proposal and say, “Well, try this on for size.” And yes, it’s open for criticism, but so much better is something put on the table that has been creatively thought through than just the armchair critic who never does anything and only has criticisms of what other people say and suggest.
Kevin: One thing this election has done – it has put the establishment on notice. Pat Buchanan wrote a great piece this week talking about the fear that the entrenched establishment now has. They know that they have to fear the people. Now, Hillary may win, or the establishment may win this election. Probably will win the election – who knows? But there is a fear, and we see it in the central banking community, as well, Dave. The volatility index, which is a means of seeing trades going up and down – what is the price of stocks or ten-year treasuries, or gold? That volatility index has almost flat-lined now for about three months. People looking at the Dow-Jones Industrial Average saying, “Gosh, it’s 18,000 and something every day for months, for a quarter.” That’s unheard of unless there is someone trying to stabilize things and keep the people satisfied.
David: I’ll tell you, things that would be very unstabilizing to the stock market – we have Mohammed El-Erian who suggested two things: A clean sweep with Democrats gaining control of both houses of Congress and of the White House, or at the other end of the spectrum, Donald Trump winning the presidency. The market has listened to the mainstream media and has basically said, “We think that Hillary is going to win.” So, to be caught off guard at this point, to see a Trump election win, and the market wouldn’t know what to do with that.
What is interesting is, you have State University of New York professor who says this: “Trump now has an 87% chance of winning the election. This is fascinating because he did some comprehensive analysis, running a model on earlier campaigns which comes up with a correct outcome for every race since 1912 except the 1960 election. It was Bill King that brought this to our attention, where he says, “The model didn’t account for Chicago and Texas shenanigans.”
But what Professor Norpoth wrote is that although the race looks decided, current polling methods are bunk. Instead of opinion polling, Norpoth relies on the statistics from candidates’ performance in the party primaries and in patterns within the electoral cycle to forecast the results. So again, he’s only missed one election since 1912 and that was because some strange things were happening in Chicago and Texas. Other than that one election, 1960, he has been spot-on. And according to his stats, Trump has an 87% chance of winning.
Factor that into, again, El-Erian’s comment that this could be massively disruptive and the markets could go haywire on a Trump victory. And it’s mainly because the markets have no clue that that is even a possibility. They’re listening to the mainstream media who is saying, “Look, he’s going to get buried. It’s all a bit embarrassing. Now let’s talk about the House and Senate. We have better things to talk about now.”
Kevin: One indicator, going back to the Volatility Index – it’s called the VIX – if you go back and look at the ten-year treasury, just the movement of interest rates on the ten-year treasury, any time the VIX drops below their 3.95 floor, we seem to have a massive spike in volatility. That happened in 2007. That happened in 2013 and 2014, where it hit 3.95 and then it spiked. Well, guess where we are right now?
David: About 3.95 on the ten-year treasury.
Kevin: Yes, so something’s going to change, whether it’s Trump, whether it’s Hillary, whether it’s war, whether it’s financial crisis. Something’s going to change in the next few weeks, probably.
David: Speaking of things that change, we have this strange, unhealthy dependence on technology, and we don’t realize how much we’ve brought technology into our lives and how inseparable we are from it.
Kevin: Unless we lose it.
David: That’s right. So the Internet of Things – we were reminded this last week, as a ton of your huge, massive websites were taken down…
Kevin: It was half of America, Dave. Half of American websites.
David: That’s right. So, we’re talking about a concerted attack from Anonymous and another group that I’m less familiar with, New World, and they basically said this is retaliation for the Ecuadorean government’s decision to cut off Julian Assange’s Internet access. And they basically, on Friday, paralyzed half to two-thirds of the United States in terms of their Internet access to these particular sites. And the interesting thing – to do this sort of a Dyn attack, they’ll send messages from various Internet-connected devices to a server to cause a collapse in that particular site and a jam-up of that particular service.
Kevin: And that server is like a bridge. The bridge basically goes to a number of sites like, in the case of Twitter, Reddit, The New York Times – those were the sites that were affected, amongst many others last week. Now, Dave, we’re in our 40s and 50s. If you actually talk to someone who is in their 20s who is a gamer, who is on often, one of the techniques of gamers is to do this very thing to overwhelm, let’s say, a team online. What they will do is, they will co-opt a lot of other devices and they will overwhelm them and knock them off the platform. This is something that gamers can do any time they want. It doesn’t take a Vladimir Putin. It doesn’t take the deep recesses of the minds of the highest of technology. This is something that is going on all the time. It just was applied focused in a way to make a political statement.
David: You are basically creating an artificial bottleneck.
Kevin: Yes, that’s exactly what you’re doing.
David: Yes, and you’re doing that by using, again, the Internet of Things, using devices which are Internet accessible, but have less security protocols on them because they’re not usually data-specific machines.
Kevin: Right. You’re actually doing what Christie did – or he’s been accused of doing – with a bridge between New York and New Jersey, for political reasons.
Kevin: You basically just create a backlog or a jam where nothing can get through.
David: That’s fascinating — Christie and Anonymous.
Kevin: (laughs) Well, I’m glad you brought the Internet situation up from last Friday because that actually is one of the areas where we could see volatility increase. I had read a report that traders in Wall Street had actually backed aware from trading on Friday, thinking, possibly, that this attack on the Internet would affect their trading practices.
David: Well, you might get stuck owning something for more than five seconds, and that could be tragic.
Kevin: (laughs) Well, that’s true. In these days of high-frequency trading where you can trade multiple times a second, you’re exactly right. But when volatility increases, Dave, there has been something that has been bugging, I think, most of our listeners, and that is that gold has been stuck between 1250 and $1300. Now underneath, the 65-week moving average has been nicely moving up, which is a confirmation of a bull market. But on a day-to-day basis when we wake up and we look at the gold market, it doesn’t seem like much is happening. Now, that can change. One of the top voices, actually, for emerging markets, and sort of looking forward in money management, is a man named Mobius.
David: He took the place of John Templeton at the Templeton Funds. He manages a specific little enclave within the Templeton Funds, the emerging markets.
Kevin: And he likes gold right now.
David: He does. He thinks 2017 we’ll see gold rise an additional 15% from current levels, taking us above $1400, if I’m doing my math right. And we tend to agree, and for similar reasons, too. We’ve talked about the importance of real rates, and this is his focus. It doesn’t matter if you’re moving interest rates up, if you’re also moving inflation rates up, this is very significant. Carmen Reinhart, in our discussion with her, suggested that this was the direction the Fed was exploring at the last Jackson Hole consortium, and they basically said, “Yes, we need to start moving the inflation rate higher.” Now, the euphemism for this is, moving toward a high-powered economy, “high-powered economy.” Who doesn’t want a high-powered economy? Everybody wants a high-powered economy. What are we voting on? When you go to your ballot and you’re looking at Exhibit A, B, and C, and you’re checking the box, remember that words have meaning, and you may not understand the intended meaning. High-powered economy is something that you’d say yes to all day long.
Kevin: Except what it really means is negative real rates of return.
David: That’s right, because if you’re driving inflation up, then the reality is, what you make in terms of an interest rate, you subtract out the inflation rate, and now you’re left at a zero or negative level.
Kevin: Okay, so Dave, I’m a salesman. I’m the Federal Reserve and I’m saying, “Okay, here’s what I have to offer you. I want you to take out a bond.” And you’re going to say, “Well, how much are you going to pay me in interest?” And I’ll say, “Oh, no, no, no. I’m going to pay you negative 1% interest.” You’re going to laugh at me, but if I sit down and I say, “Okay, I’m going to pay you 3% interest.”
David: “Well, that’s better.”
Kevin: And you say, “Well, what’s the catch?” And I’ll say, “Well, we’re not going to talk about the 4% inflation.” It’s the same thing. If there is 4% inflation, and I pay you 3% interest, that’s the same thing as zero percent inflation and me paying you negative 1%.
David: That’s right. This is like magic and showmanship. You’re redirecting, you’re causing someone to believe that something is happening, when in fact, the art of magic is doing something that no one understands or can perceive.
Kevin: And this is what John Maynard Keynes said not one in a million understands.
David: So to conclude, you’ve got Mobius saying, “You look at real rates and it doesn’t matter if they start raising rates next year because they’re also raising the inflation target. And so, the reality is, gold will probably do quite well next year on that basis.” And again, we tend to agree.
Kevin: Dave, I’m going to use an analogy here to point this out. Pretend like you and I are playing a chess game. You represent China, I represent the United States. We’ve been playing back and forth for the Pacific theater. We’re looking at the Pacific Theater, and of course, the United States, one of the key players in the United States, believe it or not, is the Philippine Islands. The Philippines being an ally for over 100 years, we’re playing that piece as if it’s our own. Pretend like that piece is directly in front of my king and it’s protecting my king.
So I’m sitting here thinking, “All right, I’ve got the protection of this Philippine Island – let’s call it a pawn, whatever – and then I find out, wait a second, it’s the other guy’s piece. It’s the other color’s piece. No long is it protection, but it’s now a threat. That seems to be what has happened in the last couple of weeks between the United States and China and the playing piece call the Philippines.
David: Yes, so this is where you’ve had, basically, a political catastrophe occur. It’s like the change in the direction of a joke. You think you’re going one direction and then catastrophically it moves someplace else that you weren’t expecting, and that’s what causes laughter, because you thought you were following, and then a shock occurs. The shock in the Philippines is Duterte. There is this fascinating shift on the Scarborough Shoal. Just for context, you remember that following the end of the Spanish-American war, the Philippines became a U.S. colony. They were a colony of the United States from 1898 to 1946. So basically, follow us through the end of World War II. Now we’ve got current events which put in focus our conversations about Scarborough Shoal and the Chinese 9-line.
Kevin: Which is hotly contested between China and, actually, everyone else in the United Nations.
David: And everyone else in Asia. China basically says, “All of the South China Sea is ours,” and you have all these other countries who are bordering the South China Sea saying, “Wait, we have some maritime space here and you’re encroaching upon what is ours. You’re talking about stuff that is 1000 kilometers away from your shoreline and only 100 or 200 kilometers away from ours. We have a clear claim on this.” And they say, “No, no, no. The 9-line makes it clear. We’re basing this off of a historical map.” Well, they made the map (laughs).
Kevin: Right. And the international courts did not agree with China, and actually, gave a favorable ruling toward the Philippines.
David: That’s right. So you have the Philippines being handed a victory. That pushes back on Chinese territorial ambitions in the South China Sea and establishes for the whole world a firm red line. And then you have the Chinese who decide – it’s just so fascinating Kevin. Do you remember that song, Can’t Buy Me Love? Well, it’s simply not true. Or, it’s not going to be believed by the Chinese. Because you have 24 billion dollars now on the table with the Chinese, and Duterte, again, becomes that chess piece, in your analogy, or this freak accident that occurs, we thought we were heading one direction, and now, based on the election, something has just radically shifted.
Kevin: “I’m no longer an ally of America, I’m an ally of China.”
David: Right. So, on the one hand you’ve got Duterte, who has been pressured by Obama and the U.S. State Department to play sort of an appropriate role in America’s Pacific strategy, I suppose, if you can call it that. And on the other hand, we then discover that Duterte is being wooed by the Chinese and prefers the Chinese to the Americans.
Kevin: And you’re talking 24 billion dollars. That’s sort of an enticement to get this thing to shift.
David: That’s right, 24 billion dollars in cheap funds from the Chinese, to start with, and there is no doubt more intriguing trade deals will follow. But China has promised to increase its imports from the Philippines. That includes fruit. I’m thinking of my dad here, because he just can’t get enough of the mangos from Cebu.
Kevin: By the way, your father, for those who don’t know, lives in the Philippines.
David: That’s right. And we all love mangos in our family. One thing I discovered this last year, just as an anecdote, is that mangos are in the same family as poison ivy. You never want to pick them ripe, or eat them too ripe because that white, milky substance that comes from the stem has the same exact reaction on your skin as poison ivy because they are, in fact, from the same family as poison ivy.
Kevin: Well, good to know.
David: (laughs) Well, Duterte – what he is going to do is, he is going to establish rail lines, he’s going to build out other infrastructure projects, with inexpensive loans from the Chinese. And of course, that allows him to put people to work, it deepens his domestic appeal by being able to create jobs, doing infrastructure projects funded by the Chinese. And the tragedy here is the shift in loyalty to China at the expense of – to be quite honest, it’s an aged relationship and it’s long been taken for granted by U.S. diplomats. So the world moves on from past debts and the Philippines and the Filipino people move on from past debts. If you will, we saved their bacon through the war and now all of a sudden they just have no use for us. Duterte said this. I’m literally quoting him: “I announce my separation from the United States.” Interestingly, this is another feather for the Obama cap.
Kevin: Yes. Well, you know, the thing is, whether a person agrees with Imperialism – call it what you want – there is a stability that comes from knowing your allies. We talk to Dr. George Friedman sometimes from STRATFOR. He also looks at the world, I had mentioned, like a chessboard, but he looks at it from a power standpoint. And when you lose a key player like the Philippines, if that is actually happening, and it seems like it is, then it destabilizes the whole world.
David: Our current foreign policy continues to remake the modern world, and you see that in the Middle East. Now you’re seeing it more in Asia. And it is destabilizing. Not only for the next administration who sort of inherits this, but also for the next generation. Because loyalty isn’t something you ever want to lose. And you have to say, rarely, when it is lost, can you get it back. Bloomberg, late last week, quoted the Filipino Communication Secretary, Martin Andanar, as saying, “China is not only a friend, China is not only a relative, but China is a big brother.” You have to wonder, for us, here in America, does this alter our military presence in the Philippines, a very strategic location for us in the past? Does it change U.S. support efforts in the Southern Islands, because for a long time we’ve been helping the Filipino military to suppress Abu Sayyaf and the growing Islamic radicalism in Mindanao and the southern end of the archipelago. As recently as March – again, Duterte is an X factor. We signed the Enhanced Defense Cooperation Agreement with the Philippine government in, I think, March of this year, and then June, Duterte takes the oath of office. And that quickly, between June and now, we went from having an ally that we were going to start using eight different military bases in cooperation with them, to him saying, “I announce my separation from the United States.” What are the implications there? I hope we’re not reading too much into it. But you look at the Scarborough Shoal and it is strategically located in the north, close to the old U.S. military bases which were throughout Luzon, the northern part of the Philippines, and now the Chinese, in spite of the Hague’s ruling, are going to proceed with building out a presence there and they are agreeing to all the free access for Filipino fishermen in and around the shoal, which was really the deeply contested part. They don’t want to give up their old fishing rights.
Kevin: We’ve talked about the Scarborough Shoal, and this particular tension, for several years, especially the last few months, being possibly a military concern. But what we’re seeing right now is, when the economic overpowers the military. So instead of it being guns and bullets what we’re talking about is 24 billion dollars, plus probably, future loans.
David: That’s right. That’s what we conclude, that the wars of the 21st century are far more likely to be financial and economic in nature. We’ve mentioned Juan Zarate’s book, Treasury’s War, in the past, where he highlights the role of the U.S. Treasury in destabilizing various regimes around the world, again, bringing in the financial and economic as the tip of the spear in terms of war. And here we see this again, an economic shift of this nature is of great significance. It’s like losing a battlefield ally. Like you said, you think you’ve got a good defense until you realize that they’ve been co-opted and, actually, you’ve got betrayal right in front of you.
Kevin: Another form of this warfare – we’ve talked to Jim Rickards about this – is currency wars. The Chinese currency has been pegged to the dollar so that we haven’t really fought a currency war, necessarily, with China for many years. But what we’re seeing is a depreciation of the Chinese currency at this point. So that brings another dynamic to what we’re talking about.
David: Yes, you have the Chinese currency depreciated probably 4.2% year to date. Just as a habit, I read Doug Noland’s comments at the end of every week, and I highly recommend you do the same.
Kevin: They’re very intelligent.
David: Credit Bubble Bulletin. He’s been writing since the mid 1990s when he was writing with Kurt Richebacher, a great credit analyst. And then he started, actually, the Credit Bubble Bulletin in 1999. For the past decade, I do this every day. Part of my daily routine is going to his site and looking at the consolidated news articles pertaining to the Bear case. So this last week he explored an interesting set of numbers from China and I just want to share those with you. You have real estate, in spite of the best efforts of the State of China, who is trying to cool prices, trying to end speculative excess in the real estate sector, they have continued to see a move up in the value of real estate prices, seemingly defying gravity. So, year-on-year prices increases were up in Shenzhen 34.1%, in Shanghai 32.7%, and 27.8% in Beijing.
Kevin: Dave, that’s like a $300,000 home here in America going to $400,000 in a year.
David: Right. So, I want to bring those price moves into sort of a relationship with U.S. house prices just for perspective so it makes sense to us here in the U.S. If you look at the average price of a house here in the United States, and compare it to household disposable income, and create a ratio, you have a ratio in China of 18-20. In the U.S. it’s 5.25. In other words, a U.S. home is 5.25 times current disposable income.
Kevin: And China’s 18-20 times…
David: …times current disposable income. So, if we were priced in the United States like first-tier Chinese cities at that 18-20 times number, you’d be talking about the average single home price in the U.S. selling for between $810,000 and $900,000 apiece. Not San Francisco real estate we’re talking about, across the entire country.
Kevin: So it sounds very over-valued.
David: Is there a bubble in Chinese real estate? So again, let’s look at comparisons. This is compliments of Doug. “In London it takes 29 years of the median income to buy the median priced home. Using every dollar of income, it will take you 29 years to pay it off. So you could say, yes, real estate in London is very expensive. Tokyo 23 years, New York 15, Sidney 12, and Shenzhen? Well, on this basis, you’re actually more expensive than London because it will take you 41 years of median income, the average income, to pay off the average home price in Shenzhen. It’s 34 years in Beijing, 32 in Shanghai. This is really important because we’re turning to those year-on-year increases, that 30% plus change from last year. You have to understand the importance of the rate of change.
Kevin: Right. It seems like the curve is steepening. It’s almost going vertical.
David: That’s right. So when you measure rainfall for a year, its distribution is important, right? Does 36 inches of rain come over a nine-month period, or does it come over a nine-day period?
Kevin: Well, the difference is between just regular rain, and flood, like we saw in the south here over the last couple of weeks.
David: That’s right. In the first case the distribution is manageable, and in the latter, you’re right. You’re talking about major flood. The same thing applies to price increases. If a price increases gradually over a long period of time, that’s relatively stable. But if that gradual move then becomes more and more rapid at a later stage, you’re moving toward what is ultimately an unsustainable rate of price change.
Kevin: So, like shooting an arrow into the air, what goes up does come down.
David: Right. Or imagine launching a car off of a ramp. Your maximum acceleration, combined with maximum ramp angle, launches the vehicle into space. There is an apex. There is a peak point where velocity is at its max, and then energy is lost. And markets are no different. You have flows of liquidity which drive prices, and prices can increase more and more quickly, but to sustain that it takes more and more liquidity. And the same thing happened in Japanese real estate. There were maximum thresholds where you got to thousands of dollars per square foot, and then you basically ran out of buyers.
Kevin: Yes, and that was in the late 1980s, Dave. I remember your dad getting up in one of our meetings back in 1988 or 1989, and he was talking about Tokyo real estate being thousands of dollars per square foot. Now, that was the stalling point of Tokyo. That was the apex, what you’re talking about. We really haven’t seen that return ever since.
David: You ran out of energy, you ran out of buyers, you ran out of people who were willing to step in and keep on driving the price even higher. And you might say that in the case of the Chinese, “Look, you have a massive migration occurring, you have people coming in from the farm, from rural areas, and are moving to the city. And that kind of migration is going to keep demand steady.” But here’s the question. They don’t have the money. We’re not talking about the rich, the leisure class, moving from their country estates into their city apartments. No. You have to ask where does the money come from? Ag workers from the interior are not your best quality buyer. They don’t have the most reliable means of paying back loans.
Kevin: Dave, what this reminds me of is the sub-prime movement that we saw back in the 1990s and into the early 2000s where people were being given loans with no real means of paying them back.
David: This is the point. You have new loan growth for September which was double the forecast figures. It was up 30% from the previous month. And again, an unsustainable rate of change is marked by not only a rapid price increase but also a surge in transactions. You have the Chinese who are figuring out now how to arrange a line of credit with no questions asked as to usage, to then use those resources for the down payment, financing the remainder with your more traditional mortgage loan. So again, does this sound like 2006-2007?
Kevin: Oh, my gosh, that sounds like a subprime loan problem in China, but larger than ours.
David: Right. No skin in the game, 100% financed. How might that end? Bang or whimper? And we could certainly share from our experience on that front.
Kevin: Somebody that we’ve talked to on a number of occasions, Stephen Roach, who seems to be an expert on China, has in the past warned that a lot of the growth is unsustainable. How is Roach approaching this?
David: On the other hand, he remains relatively optimistic longer-term for China. So he would not be counted as a China bear. He might be one of the remaining China bulls, which is not to say they have a clean and easy path ahead, but he is not convinced that they can’t manage their way through this transition to a service-based instead of a manufacturing based economy.
Kevin: You’ve brought up in the past that the China numbers are played with, just like our numbers are played with. The 6.7% growth – is that a real number? Is that something to take into account?
David: Again, that relates to Stephen Roach’s more optimistic comments. I’m uncertain as to whether he still considers the official growth rate, that 6.7%, the genuine article, or something like a Louis Vuitton knock-off. It’s great-looking, but it’s not real. China is good at those. You know that. 6.7% — if that number proves false you’re talking about very, very significant implications. The IMF has actually, in their most recent report, out October, 289-page report on the global economy, they have an entire chapter which is designated for spillover effects from China. So they are realizing that as China has grown in economic importance in terms of their share of the global economy, if something goes wrong in China, there are also ramifications for other countries.
Kevin: Let me just remind everyone, including myself, that China has been seen over the last decade as the great hope to pull us out of this financial crisis, because we really don’t have growth in America, we don’t have growth in Europe. China has shown at least a high GDP number, and so the hope was that China would be the next horse in the game.
David: And that was particularly the popular meme between 2009, 2010, and 2011, because while we were on our backs and trying to figure out how to finance our way out of the global financial crisis, they went straight to spending initiatives, a trillion, two trillion dollars. Basically, it was the largest financing binge on record.
Kevin: But the point is, we’re not just talking about China, we’re talking about the global economy here.
David: Right. The IMF pencils in the Chinese share of the global economy at 17.3%, which means that if they are growing their economy at 6.7%, Roach does the math and says, “You’re contributing 1.2 percentage points of global growth, of world growth. So you look at their percentage share of the total economy, how much it’s growing, and 1.2 percentage points of all of global growth is coming from the Chinese, which is basically half.
Kevin: But what if real estate does apex out and start turning down?
David: Right. Without that large number, whether it’s real or not, the headlines around the world would already read “Global Recession.” If the real estate market moves in reverse, like you are suggesting, loan growth contracts instead of expands in China, you would find a very sharp contraction, and in the place of that rosy 6.7% figure, guess what? You have a negative domino effect into your resource economies. You have Australia, you have New Zealand, Canada, Russia and Brazil, and all those countries, actually, right now are already between a rock and a hard place for a variety of reasons.
Kevin: But they’re very dependent on China continuing to grow.
David: That’s right, because they export a lot of their resources and China has been an importer of many of those resources. But when you’re looking at those countries, it also suggests, anecdotally, that Chinese growth rates are, in fact, garbage, because they’re between a rock and a hard place. Strong growth in China or not, you would see ancillary support for that thesis in these trade partners’ economies, and you’re not seeing it. So again, those countries I just listed make up another 9% of global GDP and they’re already a drag on growth. It can get worse for them if the Chinese economy deteriorates. Stephen Roach also notes – by the way he is no longer at Morgan Stanley, he is teaching economics at Yale. He would be a good economics professor because he’s kind of a guy who has been in the trenches, not just in theory, but he has been an operator in the financial markets and kid of understands, beyond theory, what happens in practice. If I were studying economics he would be an interesting guy…
Kevin: What I would really like from Stephen Roach isn’t just an economics education, but actually his frequent flyers miles, Dave.
David: (laughs) A million a year.
Kevin: Yes. Roach complained to you that he was always on the plane when you would interview him.
David: A million miles a year means that in retirement he can fly anywhere he wants for free, right?
David: But what I was saying is that Roach is also interested in the interconnectedness of Asian trading partners with China. So, we already talked about Duterte, and China, and improving trade relations with the Philippines. We talked about that earlier. But these interconnected Asian relationships would include the Philippines, Indonesia, Thailand, Japan, Korea, Taiwan. And this is another 11% of global GDP. So let’s tie this all together. Tied to Chinese growth stats, you get 17.3%, that’s their contribution to the global economy, 9% from your resource-based economies, another 11% coming from your Asian trade partners. 37.3% of the global economy…
Kevin: …is just this China conglomerate.
David: …is very closely tied to China. And so you’re knocking on 40%, and we haven’t even mentioned U.S./Chinese trade relationships where China is now the third-largest export market for the U.S. Do you realize that? And the fastest growing export market for the United States. The bottom line is this. We’ve got our friend, the Chinese economist, Peter Chao, who says that these growth statistics are way too generous. They’re not reality. Then we have our regular Commentary guest, Michael Pettis, who lives in Beijing, teaches finance there. These growth statistics, according to him, are way too generous. What does this lead us to conclude? That the confidence that some economists have of a return to a growth path and a global economy is way too optimistic at this point – way too optimistic. And in fact, if you look under the hood, we probably are just about where we were circa 2008 and 2009, if not just slightly above that level.
Kevin: This brings us back to a difficult question because if China isn’t the horse that is going to get us out of this, we have to go back to the dollar, which strangely enough continues to stay strong. It looks like there is really no competition for the dollar, even as weak as it should be, because everyone else is falling apart, too.
David: That’s right. So, it’s strong on a relative basis, not necessarily on an absolute basis. We go back to the dollar for a minute, the euro sells off, now sitting around 108, and it looks like it’s ready to make new lows, breaking below 104.
Kevin: Which is new highs for the dollar against the euro.
David: That’s right. And the dollar, relative to the pound, and euro, again, is doing very well. The dollar is, according to our late friend, Ian McAvity, “the best looking horse in the glue factory.”
Kevin: I loved it when Ian McAvity used to say that.
Kevin: Now, Dave, you’re just about to head to the New Orleans conference, and actually, I sort of had a somber thought this morning. This is the first time you’re ever going to go to the New Orleans conference when Ian McAvity is not there. This is the first year.
David: That’s right. I don’t think he missed it for 40 years. He was there when my dad was regularly going to the conference and speaking at it, and when I was, as well. And I’ll go again this year. I’m looking forward to having dinner with David Tice and Robert Prechter, and the Aden sisters, and Gary Alexander.
Kevin: But there will be a gap this time, Dave.
David: There will be.
Kevin: There will be a gap, because Ian McAvity was almost a personality that represented that conference, if you think about it.
David: That’s right, sitting next to Adrian Day on one side and Ian McAvity on the other. Last time we had dinner, Robert Prechter was teaching my son Declan Fibonacci numbers, and how to use Fibonacci numbers in trading.
Kevin: And Declan is 11.
David: Not yet. He’s just ten. But soon enough. He was nine at the time. But we’re going to miss McAvity.
Kevin: I always loved the way he turned a phrase, and what you were talking about, the best looking horse in the glue factory, that said it all for the dollar.
David: Right. At present, there’s an issue with the dollar, though. And it is that we’re running into dollar shortages in the overseas markets. Carmen Reinhart, who was on with us a few months ago, highlights in a brand new Project Syndicate article that it was the Marshall Plan, which was designed to relieve dollar shortages after the war.
Kevin: To provide liquidity and a sound currency at the time.
David: That’s right. There were dollar shortages in Europe and the Marshall Plan brought that liquidity in. And we saw a similar lack of dollar liquidity emerge during the global financial crisis, just 2008-2009. Now, in a number of cases, this is re-emerging. We have dollar shortages in Egypt, Nigeria, Iran, Angola, Uzbekistan, and South Sudan, according to Carmen Reinhart. And of course, all of these are problematic spots, from a political standpoint. There is a twist which Carmen introduces in a brilliant way. I read through the whole article and honestly, it was like chewing on chalk until the last sentence. And then, she makes the suggestion, in each case of dollar shortage, either a black market emerges, or a parallel market for foreign exchange emerges, and her insinuation is that the Chinese may fill the liquidity gap.
Kevin: Well, now, this is important Dave, because this is new. No one has used Chinese currency in the past, that I know of, as a black market currency.
David: Or to run in a parallel track with the U.S. currency, and fill the gap of liquidity. So, Roach sees a managed transition to a service economy, but he sees that as predictable. It’s not an easy transition, it’s certainly not fait accompli. You have Duterte, who is shifting alliances financially toward China. Apparently love of a certain sort can be paid for, it would seem. And the extension of the RMB, the Chinese currency, into these far-flung geographies into places that the Chinese are more willing to invest. It may allow for an appetite for yuan, or RMB, whichever you want to call it – it may allow that appetite to grow for usage to increase, for distribution to occur, given the dollar liquidity gap, which needs to be filled.
Kevin: We’ve talked about the SDR, the inclusion of the yuan in the SDR. One of the questions that was probably overplayed this fall was that the dollar was going to collapse because the yuan was now going to be added to the SDR with the IMF. Now, we poo-poo’d that every time we were asked about that. We said, “No, no, no. It’s not going to collapse the dollar.” But there is, just like there was with the euro, a displacement over time of the dollar share of world currency trading. How is that important? The dollar is not backed by gold anymore. It’s losing it’s reserve currency status.
David: So if there are not enough dollars to go around in these far-flung geographies, and the Chinese currency begins to run on a parallel track with the U.S. dollar, it is not that the SDR displaces the dollar from global importance, but it’s just a liquidity strain which requires something to occur. What is that something?
Kevin: The habits get changed.
David: And again, this is Carmen Reinhart’s suggestion, that yes, there is nature abhorring a vacuum yet again. And it seems that whether it is, in our opinion, comprehensive foreign policy which has been lacking, or in her opinion, currency shortage, the Chinese are deftly filling gaps.