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Disclaimer: The views or opinions expressed in this blog post may or may not be representative of the views or opinions of the Financial Repression Authority.

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Disclaimer: The views or opinions expressed in this blog post may or may not be representative of the views or opinions of the Financial Repression Authority.

Download the Podcast in MP3

FRA Roundtable Interview: Nov 20th

By: Tenzin Lekphell

FRA: Hi! Welcome to FRA’s Roundtable Insight! … Today we have David Rosenberg, Yra Harris, and Peter Boockvar. David is Chief Economist and strategist at Gluskin Sheff. He has a focus on providing a top down perspective to the firm’s investment process and asset mix committee. Prior to joining Gluskin Sheff, David was Chief North American Economist at Merrill Lynch in New York for 7 years during which he was consistently ranked Institutional Investor All Star Analyst Rankings. Prior there too, he was Chief Economist and strategist for a Merrill Lynch Canada based out of Toronto. David is also the author of Breakfast with Dave and Espresso with Dave (publications of his economic and financial market insights). Yra is a hedge fund manager and global trader in foreign currencies, bonds, commodities, and equities for over 40 years. He was also CME director from 1997 to 2003. And Peter is Chief Investment Officer for the Bleakley Financial Group and Advisory. He has a newsletter product called BoockReport.com which has great macroeconomic insight and perspective with lots of updates on economic indicators.

Welcome gentlemen!

Peter: Thanks Rich!

David: Great to be here!

Yra: Thanks Richard! It’s a great pleasure to be here.

FRA: Great, awesome! I thought we’d begin and look at the Central Bank policy. David you recently feel that the Bank of Canada should pause on its interest rate hikes but the Fed reserve does not have to. Can you elaborate?

David: Well firstly, I think that the US economy for the time being is already, not just at full employment but at 3.7% unemployment, is already through full employment and the FED is below it’s own an estimate of neutral so I always felt comfortable with the view that in the United States and the fully employed stable price environment, you don’t have a 2% Fed funds rate, you have a 3% Fed funds rate. We’ll see if the Fed ends up getting there this cycle. There’s more skepticism on their view than there was just a few weeks ago. Look, the Bank of Canada, the level of capacity in the economy is far different. Canada is not nearly as late in the cycle as the US is point number 1. The Bank of Canada never stimulated the economy in Canada by expanding its balance sheet and never had a present balance sheet to provide stimulus. That’s point number 2. And we don’t have fiscal stimulus in Canada so that may change with next year’s budget but that’s a long ways off but the reality is that if you look at capacity levels, unemployment, fiscal stimulus, there’s far more reason for the Fed to be more hawkish than the Bank of Canada. And so that’s been my premise here that the Bank does not have to follow in the same footsteps as the US’s on those basis.

FRA: Yra do you feel likewise?

Yra: (inaudible 3:11-3:13) I think Canada is really well taken. It’s been one of those things that when you have to look at if the Canadian economy could really muster some continued growth. I mean it has to move back but they won’t have to overcome a balance sheet situation because I think they, well first off they weren’t in the same situation because of the banking laws and regulations in Canada and the dominance of the (inaudible 3:40-3:41) and the way they do their business so they didn’t have that situation but outside of that, yes I agree.

(inaudible 3:46- 3:48) a good point and I scratch my head for quite a while why the Canadian dollar hadn’t been stronger through this period? Yes I know that it’s tied heavily of course to the energy markets, some would say commodity markets. Canadian oil has blown a price of discount for quite a long time first of all because of the nature of a lot of it (inaudible 4:17-4:18). But I agree. I agree with that very much.

David: (inaudible 4:22-4:23) that Yra just said, the Canadian benchmark gold prices are down to $14. Now we know that every benchmark comes down but (inaudible 4:32) to say that if WTI got down to $14, we’d be talking about recessed in the US and the Fed easing policy. Well that’s where the Canadian benchmark is right now is $14. On top of that, household credit demand numbers in Canada have really slowed down remarkable. I mean maybe I’m old school but normally when you have decelerating credit demands, interest rates aren’t going up, they tend to go down. So, I think the Bank of Canada is offside if they continue to raise interest rates in this environment.

FRA: And your thoughts Peter?

Peter: Well I was gonna add to what David just said about that last point about Bank of Canada having to manage high debt levels of moderating housing market in certain markets and you know creating some sort of, I don’t want to say deleveraging because it’s not really deleveraging, it’s more of a slow credit growth type situation.

FRA: And let’s move to a discussion on trade challenges, given local and global trade challenges, what are the trends that you see on economic activity resulting? David your thoughts?

David: Well look, if your an investor right now, not just an investor but a business, you’re fighting a war here, I guess Jamie Dimon called it a squirmish, he was being polite but its truely multifaceted. For one thing, we’re all waiting with (inaudible 5:54) whether or not there’ll be some sort of agreement at the G20 summit at the end of the month and that’s an on again off again situation. But I was telling everybody that even if we managed to cobble together some sort of agreement with China, which I think is going to be very difficult when you think about what Xi Jinping actually put down in the constitution on what they can actually do to the appease the U.S. How this ends up, I just say that I don’t think there’s going to be some some big deal that causes a lot of euphoria and then we’re going to be left on January 21st where the tariffs on China are going to escalate dramatically from where they are right now. Remember that’s January 1st. That’s what’s hanging in the balance.

But let’s even assume that we have a trade agreement with China that reduces the pensions. Then the next phase is the trade war with the EU. The next phase is trade war with Japan and now all of a sudden, we got the House of Representatives, which are now controlled by the Democrats, who don’t seem as a group to thrilled about the USMCA and there’s no more for negotiating a new North American trade deal because Donald Trump signed that with the with the outgoing Mexican government and will not be able to cobble the same deal with the new Mexican government. So we can a situation where we’re back even if you assume that things with China go great, we’re back to uncertainty over NAFTA because if Trump doesn’t get this deal through with Congress, and I think that actually doesn’t get discussed but that’s gonna make the front pages for the next couple of months.Then we’re back to first principles with the President when he said, during the campaign and after, that his preference is to walk away from NAFTA. So that’s actually the dark (inaudible 7:46-7:47) that people aren’t talking about right now is that this North American deal is not a done deal at all.

FRA: Yra your thoughts? Do you agree?

Yra: You know there’s so many moving parts here that I can’t even disagree with. There are great many moving parts. But the overhang to this entire market of course is the fact of the global supply chain and we don’t know what the effect is going to be, about how much disruption is going to take place through all of this.There are so many unknowns and when they get to the G20, as long as we’re going down that road, (inaudible 8:22-8:24) come away with some type of positive outcome especially the Trump Administration is so attuned to the equity market that they’ve tied themselves to the mass of a positive equity market as being the velometer of their success. So they’re gonna have to figure out something (inaudible 8:47-8:48) equities market under (inaudible 8:50) you wait for (inaudible 8:53-854) Mnuchin to show up with some kind of statement, oh we’re doing this, we’re doing that.That’s kinda getting old. Unlike the last G20 meetings, I probably wouldn’t say last, 5,6,7,8 G20 meetings where they really accomplished nothing except maybe climate change and I’m not minimizing that as nothing. We can disagree about the science but the outcomes maybe we can’t get away from.They need something here and China, you know Peter and I were going back and forth this morning because Peter wrote a really good piece this morning and Pence’s speech, you know these people all have short memory. Pence says, we don’t load our friends up with debt. Oh really?! I studied American economic history for quite a while let alone American history and we do load our friends up on debt and in fact, we use to collect it like the Brits did with (inaudible 9:53) diplomacy. So the better go back and redo their analysis. Of course we did! Whether one is (inaudible 10:00) and the other is (inaudible 10:01) financed (inaudible 10:03).

So they have a long road to hold and they have to be careful because the Chinese have a different memories about the colonial nature of the western world and that come to play in this. So I’m not disagreeing with David. I agree with him and I think (inaudible 10:25 -10:26) harder to get to.

FRA: Just a quick question on that, Yra do you see challenges as being negative upon the US agricultural commodities market?

Yra: Well I think that they’ve explained that already and you and I,Richard, we talked about that long time ago. They couldn’t have time that worse for the agricultural sector because (inaudible 10:51-10:52) right when the Brazilian crop was being harvested, the Brazilian, Argentinian, South American crops were being harvested, and they’re offering discounts because there was so much product, so much Supply.

So the Chinese could afford to play this game and all it’s done is just like it did in the seventies with the Russian wheat deal, you start losing markets. More than the low prices in the short run, the farmers are really upset that markets are trying to build a route in diminished because of this tariff.

Yes, I always laugh when you put on tariffs and through the backdoor, you start offering subsidies to the businesses. You have to scratch you head. It’s a stupid policy, it was mis-timed, they came out with guns blazing because they wanted to make a point and the rural sectors of the United States economy held strong in supporting Trump. But you couldn’t have timed that worse. I would have waited until now but they were in a hurry because of the election cycle and the election cycles are more important than anything else. It’s a terrible, terrible policy in that regard.

FRA: And Peter your thoughts?

Peter: So I breakdown of the goals of the administration in 3 lanes.

1) One is economic ignorance and that’s their desire to lower trade deficits which is nonsense

2) Then its the technology threat by Chinese companies stealing. Well there are ways of dealing with that and right now the U.S government has essentially cut off a Chinese company that was accused of threatening technology for Micron. Not only is that company being cut off from doing business with American companies but they’re also getting tossed into some international courts. That’s the way of handle the theft of technology.

3) And then you have forced into joint ventures where you have to transfer technology. Well no one is forcing an American company to do a joint venture in China and if they do, then hand over their technology. US companies don’t have to agree to that. They voluntarily do it. I’m not saying that’s the right thing for China to be doing, to force the transfer of technology, but no one is forcing US companies to do business in China. They honestly want to do it for growth but its not being forced. So my point is that throwing tariffs to address these 3 things is like throwing a football at a catcher at a baseball game. It just doesn’t apply. The problem now is that your literally freezing global economic activity, (inaudible 13:49 the CEO and CFO of multinational business, you’ve clouded up all visibility, we’re seeing trade numbers from China, to Japan, to Germany, to the US all slowing across the board. So what’s happening is that the administration is taking for granted what was a decent economic start to the year and throwing it in the winds and hoping that t can somehow withstand these tariffs. The problem is, and I talk to and listen to alot of conference calls, 10% tariffs is not good and not fun but companies can handle it. You go to 25% and all bets are off! In terms of what Yra mentioned earlier about supply chains, well many companies that do business in China aren’t going to just pick up and go to Bangladesh, or Vietnam. They’re well entrenched there. They’re happy doing business in China (inaudible 14:41) products and their just going to have to eat this or their customers will eat this because when you throw tariffs to somebody else, it’s your own people that ends up paying for it.

FRA: Great insight! I guess the big question now is, given these trade challenges and transit economic activity, will there be a massive infrastructure fiscal stimulus? And if we can look at that question from the perspective of will there be a massive infrastructure fiscal stimulus in Canada, in the US, and in China where there has been a lot for the new silk route initiatives and also in Europe? As you mentioned Yra, the key to European infrastructure program will be the issuance of a Eurobond, which will begin the process of unifying the European financial markets. Maybe we begin with Yra your thoughts on that, for the massive infrastructure stimulus, will that happen? Yes or no in those jurisdictions?

Yra: When I listen to President Macron, he would like to get there yesterday and then when the Dutch Finance Minister came out today and said he was opposed to what Macron and Merkel had reached on the budget agreement, but that’s really not the issue.

(inaudible 16:02-16:03) George Soros and many others (inaudible 16:05-16:09) I can probably go back to (inaudible 16:11), and if you gonna do this, you needed a real Eurobond not individual sovereign bonds. (inaudible 16:19-16:25) including the French. The French never wanted to relinquish their sovereignty by surrendering their budget. (inaudible 16:33-16:36) but to give up your fiscal policy, that was a step beyond.

Now they realize that Soros and the others were right. You have to create a Eurobond. Now a good way, economically, (inaudible 16:51-16:52) Rahm Emanuel, the Mayor of Chicago, Chief of Staff to Obama would say, never let a crisis go wasted.

Well the Italians, I think are much more flexible in those demands, if they knew they were getting a massive infrastructure spending financed by the capital level (inaudible 17:20-17:21) in Europe and

you could do that! You could do this. You could do this at the G20 and say, hey, we need the infrastructure spending. Let’s do 500, it’s just a number, but what difference does a number mean anyways? They’ve already bought 3.5 trillion of debt that Dragi (inaudible 17:41-17:45).

But if you went a very long way to (inaudible 17:48-17:50) whatever it takes to sustain the Euro. Why go half way?

I think the infrastructure for Europe is easy and you get that Eurobond and to make it all a bigger joke, you have the ECB buy the debt anyways. So go to the German court or European Court of Justice but it would be a needed step that they need to undertake. Is it the best step? No. But they’ve already gone this deep so why stop now?

Which is really the (inaudible 18:31) and it will buy off (inaudible 18:32-18:40) you’ll get the optics of the Italians saying, ok, we’ll back off and everybody becomes a winner and you’ll do it with German money. What better way is that?!

FRA: David your thoughts on potential for massive infrastructure spending in Canada, US, China, and Europe?

David: Well, I’ll just give my thoughts quickly on Europe. The bottom line is that the only country that has the fiscal capacity to fund something like that will be Germany and their infrastructure is top-notch. It’s one of the best in the world so I really don’t know how that’s going to be facilitated.

I look to the US and infrastructure for election is just a classic motherhood. 14 letter word for motherhood, infrastructure, we hear it all the time. It gets people excited all the time. I remember we had an infrastructure package with Obama in 2010 and I don’t remember (inaudible 19:46-19:47), people will talk about how the money never really got spent although I continue to hear things were (inaudible 19:52) already. You can use Canada as a poster child. I mean there’s no plan to boost infrastructure in Canada. There’s other issues here that have to be addressed but the Trudeau government, who got elected at 2015, the first thing they did was embark on motherhood and infrastructure was part of their key campaign plank.

Canada has already started to see that money flow into the economy and at the same time, the Canadian economy is slowing down after never really doing a heck of a lot. I don’t see a infrastructure was a big antidote at what happened at the energy sector and now residential investment is gonna be going into a bear market because of its over capacity.

So I know that infrastructure makes for a nice headline, you know if you’re long on bonds in the United States, you really want to hear about how the federal government will fund infrastructure for the local governments. I’m not convinced that’s gonna happen but if it does happen, you have to remember that the (inaudible 20:52) period for infrastructure is in years.

This is no magic bullet. I’m not gonna say that we can’t use infrastructure to upgrade roads and highways. I’ve been hearing infrastructure for 30 years. We always need infrastructure but as a tool to boost the economy, it’s not very effective. As a tool, to say, upgrade the capital stock on a long term basis, I’m all for that. I’m not so sure given the level of acrimony between the House Democrats and the Administration, I’m not very hopeful we’re gonna get something done on that.

Even if they do, it’s not changing my overall investment philosophy which is extremely defensive at the moment.

FRA: And Peter your thoughts?

Peter: Public infrastructure spending it’s tough to get more inefficient than that and all you have to do is look at, I live in New Jersey, look at New York airports, the New Jersey transit system, the New York City subways, that’s not for lack of money, that’s for a complete waste of existing money and existing resources. So to think that okay we’re going to build some bridges and roads, well that’s being done all the time at the state level. So to see that we’re going to throw some more money at it and to think that’s gonna be efficient use of spend is complete nonsense.

Then it gets to the point where, okay let’s just say we passed something, we allocate money to these different jurisdiction, who’s gonna actually work on these roads? Where’s the skilled labour that’s gonna be tightening bolts on a bridge? I’m not sure if there are plentiful right now so I don’t even know if something was passed that anything would actually get done.

This laundry list of wasteful spending projects that has ended up costing billions and billions more than what was forecasted and for what?

So I would argue that the multiplier is less than 1 and yes overtime, you want a train system that works and you want a bridge that doesn’t collapse, I get that. But the multiplier is typically less than 1 when your dealing with public infrastructure spending.

FRA: Peter moving on to your forecast, what are your thoughts for the U.S Dollar and US interest rates for the next 6 to 12 months?

Peter: What the US dollar faces is a Fed that’s gonna either blink and pause, which is a growing possibility at the December meeting and I would argue that if they pause, they won’t have the either the guts or the data or the markets to end up hiking. Now granted that they can hike every meeting next year because everyone’s alive meeting. I’m more worried about European bonds and what the ECB has done and I do think that we’ve entered a longer term bear market in bonds generally but that could take awhile to play out.

With the dollar, the challenge the dollar then faces is if the Fed blinks, the dollar is going to be in trouble and interestingly the dollar has two different phases this year.

In the first half of the year, it was strong against emerging markets and traded actually relatively poorly against more developed currencies.

Then the second half, or at least the last couple of months, you’ve seen a rally in emerging market currencies and you’ve seen dollar strength against the Pound, the Euros more related to Italy. But I see these currency movements and the strength of the dollar is not because of something great is going on here, even thought someone could say rates are going up and the economy is better here than elsewhere, but a lot of it is I think shot in the foot type behaviour in overseas economies

But the second the Fed blinks the dollar’s gonna be in trouble, that could be the end of the dollar rally because the US government is still facing massive debts and deficits, which overtime is gonna be very dollar negative and just as the years go on, there’s gonna be less dollar transactions taking place. That’s a very long term story. I know it gets a lot of press now but I see lot of secular headwinds for the US dollar notwithstanding current (inaudible 25:08) against certain currencies.

FRA: And David your forecast for the US dollar, and US interest rate for the next 6 to 12 months?

David: Well I think that, well firstly on the US dollar, its been very tempting to be bullish on the US dollar because the FED, you know textbook economics, easy fiscal policy, tight monetary policy will always and everywhere, give you a bull market in your currency. But I think that story has largely played its course. I’m getting a little nervous over the bull market in the US dollar and I’ll tell you why. Firstly, the chart today looks absolutely ugly of the DXY but I’m looking at latest (inaudible 25:52) in the traders report and I’m looking that on the intercontinental exchange the trade weighted US dollar has a net speculative long position of over 40,000 contracts. I mean we haven’t seen this in about a year and a half. So there’s a huge overhang of speculative naked longs right now that could easily exit this over crowded trade and set the condition for this pretty big reversal in the US dollar going down as opposed to up.

I agree with Peter that the most important determinant in a currency is the relative interest rate differentials and one of the reasons why the US dollar is succumbing right now isn’t just that the naked longs are starting to exit the markets but the reason why and that’s because of the Fed, in a matter of about 6 weeks, has gone from hawkish, and I wouldn’t say dovish, but certainly less hawkish enough that you’ve had already just the matter of weeks of full wage hike priced in for next year come out of the marketplace.

We were supposedly at (inaudible 26:56-26:57) Oct 3rd, a long way from neutral, we may have to beyond neutral and now everyone’s talking about, no neutrals enough and by the way, maybe one or two rate hikes away. So that’s undercutting the US dollar at the current time.

(inaudible 27:13) interest rates, a lot could happen in a year. Probably at this stage, maybe less bearish on treasuries than Peter is, I think we may look back and say that when we approached the 3 and a quarter percent of the 10 year, maybe that was the peak and I think that there’s a lot of cross currents.
You have the cost push inflations forces from extremely tight labour market and from these tariffs but at the same time that’s battling the cyclicality of a decelerating global economy and US economy. So I think that we should just take our (inaudible 27:54) from the market itself. Here we have taken out a full rate cut for next year, here we got a lot of slowing growth, another turn down in the stock market and the best we can do is 3.05 on the 10 year note. You know the 10 year note in this mix of widening credit spread, deteriorating stock market, less bearish view or hawkish views on the Fed and the best you get is 20 basis points off the 10 year note.

I mean normally in the past when you had this sort of condition, especially in the stock market, the 10 year note yield was down 80 basis points not 20. So the market’s telling us something here and maybe it’s over beyond just talking about tariffs, cost push inflation, wages, the cost push inflation, but the fact that we’re really choking on supply. I mean Peter Boockvar comments all the time on what’s happening with these treasury options and the reality is that this time last year, the deficit was supposed to be $600 billion dollars this year. Well it’s gonna be worth more than a trillion dollars. So we were choking on treasuries supply that we weren’t supposed to get except the bright lights in Congress and the White House saw that cutting taxes at a time of full employment was a really great idea. Newton’s 3rd law of motion, every action has an equal opposite reaction is that bond yields are not falling when they should be falling and that ends up being another problem for the stock market because stock markets put in the lows. When you get to a certain relationship between the bond yield and the earnings yield on the stock market, the problem for the stock market and maybe for those people uber long treasuries is that you’re not getting a normal response here.

The reason is that there is too much supply. The streets left with too much product after these auctions and the dealers have to dump this product and this is putting (inaudible 29:42-29:43) on bond yields right now. To me that’s the big story. So I think we’re stuck in a range for the foreseeable future as far as the treasuries markets are concerned.

FRA: And Yra your views?

Yra: Well I’m gonna be very sympatico with this but let me pick up where Peter Boockvar was just talking about on CNBC, which is of course a huge amount of corporate investment debt to throw onto this and how much of it actually is LIBOR based which makes it even more telling. As we’ve talked about, Richard and Peter, and David a little bit, debt, debt, debt, is to financial markets is what location, location, location is to real estate. That’s the way I knew it, and I hold true to that and I think that David’s warnings are very, very important and Peter’s been there too cause we turned bearish a dollar i think at the same time at February of 2017 when we saw the move come, Peter and I. This movement of dollar, the dollar is going up grudgingly and I like David am old enough to know that when you have these interest rate differentials and with negative nominals, forget real, but nominals wage being negative in certain parts of the world, yet those currencies are not really weakening as they ought to and couple that with David’s comments about why aren’t these bonds a lot higher, that poses the question that United States is really drowning in debt and the world sees it. It’s like you hold your nose when you buy dollar assets today because there’s very little else to buy. You buy it cautiously and I think some of it is right because it’s to expensive right now to hedge it away. So a lot of people buy it and go, if I pay for the hedge, I’m basically breaking even so what’s the sense of doing that? So some people stay away from it. With David’s point is absolutely well taken on.I’m watching these curves. Right now, the 530 curve, which I call the speculative curve, is getting interesting because it’s moved while the 210 has kinda stayed stagnant. But I would say that’s because people have more duration matches that they have to put on. But as I tell people, if you buy a US bond of longer than 5 year duration, you need your head examined and ought to go looking for another profession because you’re an idiot. You’re an idiot! Unless you have duration that you have to cover because it makes zero sense cause as David talks about, this budget/ deficit this year is over a trillion. And this is, I’m not an anti-Trump, you know again, I’m from the school of Deng Xiaoping. I don’t care whether the cat is black or white, as long as the cat catches mice.

This is a president who’s never met a debt he doesn’t wanted to take on. So if he really gets into trouble, and that has been my point and that’s why I agree about the structural basis of infrastructure spending, this is somebody who’s looking to spend, spend, spend.

And If he finds sympatico voices from the Democratic party in the house, he will get his way cause he’s already said, he doesn’t care about debt. You know what, the freedom caucus, who was the voice of fiscal austerity and soundness and responsibility, their on their heels right now.

I would not buy a piece of US paper over 5 years. I think you’re out of your mind.

The equity market, that David points out, is telling you that because as we look at this board, (inaudible 33:52-33:55) 3.05? Really? That’s all you got after a 15% drop from the high to the recent low in the equity market.

That’s all you got? To me that’s a warning sign.

Peter: In the month of October, the stock market and bond market went down. Yields rose across the curve in October when equities fell as much as they did.

FRA: And finally lets look at what investors can do for investing or protecting themselves going into 2019. David, you’ve referenced 4 letters, Q.L.D.S, Quality, Liquidity, Defensiveness, and Selectiveness. Can you elaborate?

David: Sure. I think that when your talking about a step up in quality both across the capital structure, equity and debt. If your mandate is equity, I think you have to be very mindful of the degree of cyclicality that you have in your portfolio and focus on earnings visibility, and limit as much as you can your overall GDP sensitivity.

I think classically late cycle, I think we’re in the top of the 9th, and I think when we get to the top of the 9th, historically its the rare period where value outperforms growth and I think that will continue to be a theme, maybe a theme that works for relative terms and absolute terms but it will work in relative terms.

I think as Yra has said and Peter would agree that being very mindful of your duration in the fixed income portfolio is very important. Really until you see the (inaudible 35:44) eyes of the recession, which I think at some point will come next year, is like an odorless gas you know everybody likes to say that, oh I don’t see recession coming. Well most people don’t see recession coming when it’s already hit. So you want to be mindful of that up until a certain point when things start turning around (inaudible 36:03) keeping in mind that inflation is gonna be a problem but at the same time, a bit of a lagging indicator as we saw in 2008. So that’s the quality part. Liquidity, I think it’s pretty obvious, you want to have cash on hand for optionality or maybe more than that.(inaudible 36:24) at the beginning of the next cycle in other words, transitioning out of this long bull market. So you wanna use cash and look at this time last year, cash paid you 1%.Today cash, looking at the 4 year treasury bills are trading, you’re getting well over 2%. You’re getting better than they get in the debit and yield in the stock market. So you’re getting paid to be in cash today and I think that was a very prudent thing to do.

You wanna end up being, when all said and done, a lender in this market not a borrower.

You know LQDS, D for defensiveness, that goes back at the quality, basically perhaps, subsets that again be mindful. The OECD leading indicator is down 10 months in a row so you haven’t seen anything yet. This is a financial wedge. The global economy is gonna be weakening even more next year than it has from the previous year. So that means you have to be defensive and of course I would go back to fixed income markets especially in corporate when you can consider that next year is the first of the next 4 years for you’re gonna have a tsunami of debt refinancing in the corporate sector at a time where 50% of the investment grade universe is rated BBB. There’s gonna be a lot of volatility. Defensive also means very mindful in your fixed income portfolio and credit as to what the maturity schedule of the debt looks like and the companies that you own. Selectivity just means style investing, no different than late cycle value over growth. Late cycle means you wanna own as few stocks and few securities as possible. You wanna cull the portfolio. If early in the cycle, you own 60 stocks and mid cycle you own 40 stocks, you wanna have 20 late cycle. You wanna get down to your most blue chip, liquid, relatively safe names. So that’s what selectivity really means to really just have best idea portfolio and nothing else.

FRA: Peter your thoughts?

Peter: Yeah and to add to that, if you’re going to be in equities, at least for many listening possibly US and Canadian equities, boring is good. Boring businesses, peak valuations, not exciting that’s what people should be focus on. And I think in this downturn overseas, particularly Asian emerging markets that includes China, I think there’s a lot of value being created. The Chinese stock market has been as inefficient as it is. It’s been through a bear market down 60%, well now probably about 50 from its 07 peak let alone where it’s all from its 2015 high. And to add again, short duration, I’d be in gold and silver as part of my weak dollar belief next year when the Fed blinks. I think gold and silver are gonna be up a lot when that happens. I think it’s simple as that and having cash. There’s time to play offense and time to play defense. This is one of those times to play defense. There’s time to own gold and silver. There’s times not to own it. Now’s one of the times to own it.. So boring is good and I would stick to that.

FRA: And finally Yra?

Yra: There’s so much that I agree with here. The medals, I think they’ll have their day. People have been a little bit unnerved because of rising interest rates in the United states. You know its more than just rising interest rates cause we see 8% in Mexico and I would argue that Mexico is a probably a far better investment right now than a lot of other places. Yes I know that (inaudible 40:10) is coming on and there are some uncertainties of course that exist there but US is its own inconsistency. Part of it is who’s running this show. I don’t think we’ve had a high quality secretary of treasury probably since, and we can argue about that, the Rubin Summers years. I was not a Hank Paulson fan. I was certainly not a Jack Lew fan. I was certainly not a Tim Geithner fan. I’m less of a fan Mnuchin and yet all of this is taking place.

So when I buy a country’s sovereign bonds, I’m buying not only what their balance sheet looks like and what their financial statements, I’m also buying the credibility of the people in charge.

So again, you gotta be very careful here. I think that David and Peter are both making really great points about where yields have gotten to this in the face of all this and the inability of the dollar to really have a sizable rally cause David hit this right on the head.

I know I traded my way through Volcker and Reagan so we have the classic case of fiscal stimulus with tight monetary policy and the dollar boomed so the dollar strengthened till much of

the course they had to undo it through the (inaudible 41:36) accord.

We’ve got nothing out of this! Really, when you look at it, if you put up a long term chart or last year’s, okay, you know I can say the Euro was born 1,17,85 in January 1st 1999.

We’re not that far. We’re 1,14,50 and Europe is saddled with nothing but problems and still the dollar doesn’t rally. Now that doesn’t mean today it can’t rally, tomorrow it can’t rally, next week, but when you look at it’s overall performance, I would be very weary. There’s movement afoot here. There’s things underneath the surface, that are bubbling that you have to be attentive to and it’s what ought to be happening that isn’t happening and that should be a warning sign to everyone!

FRA: Great insight gentlemen! How can our listeners learn more about your work? David?

David: Well you could either call me directly at 416-681-8919 or email me at rosenberg@gluskinsheff.com and I’d be happy to get anybody on a trial for me two morning publications at Espresso With Dave and Breakfast With Dave and the best way to reach me once again either phone or email.

FRA: Great, and Peter?

Peter: You can reach me at peter.boockvar@bleakleyadvisory.com and I have a “C” after the double “Os” is my last name. For wealth management advice or macro market advice where you can go to the website boockreport.com.

FRA: Great, and Yra?

Yra: Just notesfromunderground or you can go to yraharris.com and register for there and if you write to notesfromunderground and it’s not low quality trolling but high quality, you’ll get an answer because a lot of people will respond to you tonight, give and take on the blog. Again, it’s not a tout sheet, we’re not a tout. We try to create ideas and you’ll do the work, we’ll just try to point you in a direction to see if there is any possible investment reward. To me is a great place for two way communication and for dialogue which so much in this business is. It’s about dialoguing with people who we respect and nothing does it better than this podcast that we’re sitting on right now.

FRA: Great! Thank you very much and we’ll end it there. Thank you very much gentlemen!

Disclaimer: The views or opinions expressed in this blog post may or may not be representative of the views or opinions of the Financial Repression Authority.

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FRA: Hi Welcome to FRA’s Roundtable Insight .. Today we have Charles Hugh Smith, author, leading global finance blogger, and philosopher, America’s philosopher we call him. He’s the author of nine books on our economy and society, including A Radically Beneficial World: Automation, Technology, and Creating Jobs for All, Resistance Revolution Liberation A Model for Positive Change, and The Nearly Free University & The Emerging Economy. His blog oftwominds.com has logged over 55 million page views and is number 7 on CNBC’s top alternative finance sites. Welcome Charles!

Charles: Thank you Richard. It’s always a pleasure!

FRA: Great and today’s topic is socialism. What is driving the majority of millennial’s to that? So we want to explore, you know, what’s behind that trend (Especially in the US and in Canada)? You know what is socialism? Misconceptions on socialism? We’ll get different models like the Nordic model and how does that look, positives and negatives. And just in general also how this could lead to increasing levels of political instability and even political violence in the coming months.

Charles: Right and it’s a great topic Richard because we all know that the younger generation, the millennials in particular, are publicly attracted to socialism as a more just system than what they see is unbridled capitalism, which in its current iteration has created extremes of inequality and opportunity.

So I thought we’d just start out by laying 3 different flavours of socialism or what’s commonly called socialism. In classical socialism, that means that the state or the government, owns the means of production and in other words, factories and the resources are owned by the democratically-controlled or structure government so that the benefits from the means of production are then distributed relatively equally amongst the population. In today’s world, most young people according to polls understand socialism not by the classical ownership of the means of production but by social welfare. In other words, the government collects taxes and it distributes it in some sort of fair fashion to the entire populous and so I call that the social welfare version of socialism. And the Nordic model, the Scandinavian countries which are often called socialist but as you’ll explain in a moment, is not technically not really true. But what they do have is a model of deep cooperation between unions, you know labour, big corporations and the government and so there’s a there’s sort of a cultural social contract there that creates a more equal society because the wealthy pay very high taxes and there’s a lot of social welfare programs and also programs to create jobs.

FRA: And I think the millennials are coming to this from the social justice perspective so they sort of focus on that first and then they branch out into economics areas in terms of like socialism. Would you agree?

Charles: Right! Exactly! How do you achieve economic justice and they’re looking to socialism as the answer. But you know that start with the Nordic model because it’s widely understood to be successful in these is relatively small countries. I think Denmark has less than 6 million people which makes it smaller than the inter counties of the San Francisco Bay Area and considerably less than the county of LA and I think Sweden is around 13 million people something like that which puts it on par with the County of Los Angeles. So these are really small nations in terms of their population and so it’s a lot easier to have a unifying culture than it is to have a very large multicultural nation like Brazil or the United States but having said that, you mentioned a quote from the prime minister of Denmark which I thought was really insightful about the Nordic model of socialism.

FRA: Yes, exactly! The Prime Minister of Denmark recently said, “Denmark is far from a socialist planned economy. Denmark is a market economy”. And yeah just to further elaborate on that, the Nordic countries do not generally interfere with free markets so they are promoting free markets, they are promoting free trade, global trade, globalization, and generally do not nationalize industries, and do not subsidize favourite Industries which is a common misconception.

Charles: Right and I think the another common misconception is that they just give away a lot of free money to everybody but in actual fact, they have very strong work ethic. In other words, a lot of their social welfare programs are aimed at retraining people and helping small businesses emerge and hire people. So they’re really focused more on creating jobs than giving free money away and so that’s why universal basic income, which a lot of people feel is the source socialist solution. In the Nordic countries, they’re not really big fans of just giving away free money with no strings attached. They want to help people gain livelihoods. That’s really their culture focus. We were having a conversation about the culture aspects of the Nordic modelling and before we started recording, it’d be great if you could elaborate on that that topic.

FRA: Yeah the first question I usually ask when people make reference to that is have they been there before and then I mention I’ve been to Sweden, I’ve been to Norway, and what I have observed in the nature of the people generally, that in the culture, is a very strong sense of fiscal responsibility and a high level of education. Making very efficient use of government resources and even in the buildings they stay generally not looking to build brand new government offices but working in very frugally, meager type of facilities, government offices or old buildings perhaps and making the funds of the government go much farther in terms of very efficiently. That I think would be very difficult in North America given a lot of politicians are more concerned on getting themselves more lavish pensions.

Charles: Right. I think you are absolutely right and I had a chart that flabbergasted me actually that in the state of California, where I live part-time, that the taxpayers contribution to the public union pension plans there was less than a billion dollars in the early 2000’s and now it’s something like 45 billion.

So the people kind of promoting social welfare versions of socialism, they’re not a tuned to the fact that socialism limbs itself, if you have the wrong cultural traits, to cronyism and exploitation of the state rather than as you say of a fiscally prudent use of state funds to help everyone. So that leads us to, I think, Venezuela which pursued as policy both a classical form of socialism meaning that they nationalized a lot of the industries in that country, the oil industry, and so on. And they also instituted a very broad social welfare programs. And so, as we all know, the Venezuelan policies of the government have led to a complete collapse of their currency, trading at something like 300,000 or to $1. Might even be 3 million to one now. I’m not sure but they’ve impoverished of literally everyone in the country except those high officials and cronies who escaped and then it took their money to Miami before the currency collapsed. So that socialism is one version of it and we really have to ask, what did Venezuela do wrong because they pursued socialism as most people understand it

FRA: Exactly and that contrasts between them and the Nordic countries, in terms of their approach, what has resulted?

Charles: Right and the government ownership of means of production doesn’t guarantee you any efficiency and if the enterprise, where its owned by the government or owned by private parties, it’s still has to create a profit, it still has to use the efficient otherwise it just becomes a source of losses and it’ll take or who ever owns it. So Venezuela, I’ve never been there but I have sources there, I have contacts there, and it seems pretty apparent that the government owned infrastructure and resources are very poorly managed. They were undercapitalized, under investment, and cronyism has run wild there. So that raises the question for millennials, how do you make sure the socialist model that you find attractive is more like the Nordic model and less like the Venezuelan model because socialism as an ideology or as a way of organizing the resources and the means of production of society. It’s not one-size-fits-all and you have catastrophic failure right beside so called success. So socialism as a system is not the answer if it goes the path of Venezuela.

FRA: Just to point out a few more facts on the Nordic countries, their countries economic successive before they built their welfare states. A lot of people don’t realize that it was the actual wealth that allowed the luxury of the generous programs that followed so that’s one fact. Another one is a lot of people don’t realize is they don’t have minimum wage laws in the Nordic countries. None of the Nordic countries have a minimum wage law. Another fact is in Sweden, they have complete school choice so whereas your property taxes may go towards government schools only in North America, there’s a choice in Sweden. You could actually apply those funds instead to even go to a private school to attend private run school if you think that’s better for your children so a lot of people don’t realize that but yeah the result though, I mean is it all bliss, not necessarily. If you look at what’s happening now in the Nordic countries, there are problems, maybe not as bad as Venezuela but in terms of the increasing racial tension, ethnic tension, especially from a lot of new recent migrants that are looking to capitalize on that welfare system that they have in place. They’ve also suffered recently from the oil revenues that go in mainly to Norway and Denmark so that hasn’t been as good. A lot of people don’t realize that in many of those areas, there’s actually the highest consumption of antidepressants in the world. So that’s a fact. That is quite amazing as well. And then even recently what they’ve done is moved to a to do a certain activities which a lot of people are not aware of in terms of strong movements now to cut taxes, limit public benefits, reduce welfare spending, pension savings have been partially privatized, for-profit forces have been allowed in the welfare sector, state monopolies have been opened up, so that there’s a lot of change happening even in the Nordic countries.

Charles: Right those are excellent points and it goes to show that what we’re talking about is not a purely economic system that socialism, in whatever flavour we’re speaking of, is a social system and a cultural system. It’s not simply a financial arrangement. So just to kind of speak of change gears a little bit and go through some slides, I have about the social welfare model of a spending on infrastructure and public spending as sort of like a way of distributing the wealth of the nation right (inaudible) and so I have a slide here of infrastructure. Everybody loves infrastructure and it’s a very politically popular way of creating jobs and distributing resources and so we see that globally, China of course has spent huge amount of their capital on infrastructure, you know, and we all know that they have High-Speed Rail and and Subways and they’ve gotten a lot of public benefit as well as jobs from their infrastructure. But at some point, you’ve already built out all the subways you need and all the high-speed rail and then then you wonder what do you spend the money on next if that’s your social welfare program, you know building infrastructure. And here in the US, its well known that in the US infrastructure’s ageing in many ways. The water, electrical systems, roads, and so on all need more investment and that can be seen as a productive useful of public money. In other words, the public is getting some broad based value and jobs are being created as opposed to just giving money away without any strings attached like universal basic income. And then to show another failed way of distributing funds, I have a chart here of higher education student loans in the US and of course, we all know that there were no such things prior to like the 1990’s and now there’s about 1.3 trillion dollars of student loan debt which is guaranteed by the federal government. So it’s a form of socialism that ends up turning students into debts surfs and a lot of people are saying what we need to forgive all that debt. But that debt was issued by for-profit firms and so we have to be really careful when we talk about socialism like who’s skimming profits from these government programs. Then my last slide here is showing the state and local government expenditures, which tend to be the most boots on the ground or the the most visible forms of social welfare spending, tend to be state and local in other words, infrastructure on local roads, local welfare, local school districts, and so on and we can see that all in the US, the state and local government expenditure has soared the rate of expansion far beyond the actual GDP that the domestic economy. And so then we start wondering how are they spending so much money than the economy is creating and then the answer is of course we’re going very deeply into debt. I mean local governments are selling bonds and globally you can see the tremendous expansion of government debt as well as corporate and household debt. So if we’re if we’re funding all of our social welfare and infrastructure with debt, then we’re creating another issue that doesn’t have anything to do with socialism or capitalism. It doesn’t matter! The debt is creating a lot of imbalances and could bring down the entire economy. People always love infrastructure and they love social welfare, they like the government spending more money but where’s the money coming from and what are the consequences of using debt to fund social welfare.

FRA: Yeah essentially putting the burden on future Generations increasingly with the increase in debt as the result. And then some would say maybe we should just say tax income on millionaires but there’s actually a fact that if you even put a 100% tax on income from every millionaire in the US, that would only fund that US government for 4 months. So that’s quite amazing fact. Another one is that even if you confiscated the entire wealth of America’s 537 billionaires, that would not be enough to fund the nation’s budget for even one year. So there’s simply just not enough money out there but there’s a perception that there is.

Charles: Yeah that’s a very good point Richard. I believe the federal budget is pushing for a trillion a year right. I think it was 3.7 trillion and so that’s a big chunk of money and I guess we’re coming back to the question of what’s the downside or the risks of pursuing a socialism and I think if you’re going to follow the classical socialism of the government taking ownership of the means of production, then you risk gross inefficiencies and cronyism, mainly insiders basically pillaging those assets to their own benefit and then impoverishing the nation by under investing or mal investing the state money.

That’s that’s one danger. And in the Nordic model you’ve described it may not be affordable, you know, it as revenues decline even prudent governments end up starting to borrow money and living off of asset bubbles as a way of generating their revenue so that’s the danger. And the US model of just borrowing trillions to pay for infrastructure and social welfare programs. That creates of a really great risk of a currency collapse or a loss of of faith in the entire Financial system.

FRA: And now we go further to that if you look at the history of of socialism and the evolution of it. In particular countries, generally there is a very strong decrease in the standard of living that ultimately results in brain drain and wealth-trained so you get to a point at some point where it nonlinear. A lot of people begin leaving, looking for opportunities elsewhere if they’re educated. Wealthy people don’t sit there as sitting ducks. They’re likely to move at some point together with their wealth somewhere else so that’s also the potential for that to happen, brain drain and wealth drain.

Charles: Yeah and my last point Richard would be that you know socialism like capitalism itself, however you want to define it, it tends to work much better when things are decentralized. When powers decentralized, ownership of assets are distributed, and people have a say both as consumers and owners. My example here is water systems. In very localized places like a city or a county, public ownership of water has been very successful because the agency localized their only specific assets in the community and the community is democratically organized so they have a say about how that resource and asset is managed and they can vote out the board if the board is corrupt or incompetent. And so socialism, on a very small decentralized scale, can work very effectively in protecting public assets in the same way that capitalism really only works if competition is allowed to thrive. So we’re talking about when things are in very large scales like centralized power, then you get rid of competition and you usually get rid of the benefits of public ownership of assets.

FRA: And I think overall the majority of millennials have not been able to understand how and why there was a financial crisis back in 2008, 2009 and what the role of the Federal Reserve and Central Banks in general has been in causing that as well as in causing a wealth and income inequality from various Central Bank activities and Central Bank policies, we’ve covered that a lot in prior podcasts how and why that happens. So I think that’s been also a major driver for the millennials to misinterpret/ misunderstand what’s happened and therefore, go to maybe bad conclusions if you will.

Charles: No I think you’re absolutely right Richard. The financial repression of zero interest rates and quantitative easing for the the banks and so on. Yeah that’s what disrupted the opportunities and created the inequality the millennials want to resolve and we understand their desire the justice of resolving those inequalities but it’s how do we do that? And if we’re going to pursue the Nordic model, then what we’re really talking about is, then you need a market economy and a cooperative government and a culture milieu that supports fiscal prudence and wise investment of resources and not just throwing money away and giving it away.

FRA: Yeah exactly. There was also a recent study I saw where it was pointed out that the minority of radical leftist are actually dominating the Democratic party agenda. So this is interesting because between Democratic Socialist Party of America and the traditional democratic party, which is now having their agenda control or dominated by radical leftist, is quite disconcerting you know in terms of what could happen to the potential for extreme socialism in America.

Charles: Right and again what we’re trying to elucidate here is that there are models of like private or public ownership of assets on a small scale like I said that they have a long history of functioning like public ownership of the water works but what’s being proposed is not really classical socialism. It limbs itself to free money for everybody and if we have to borrow the money, then fine. So that’s not really socialism and it’s not on classical socialism nor is it the Nordic model that so many people look too as a successful model.

FRA: Yeah exactly, and we’re essentially in general agreement to conclude as some final words in terms of what could make sense so we don’t take sides on any parties but generally, we see a more limited government approach that is decentralized with minimal special interest group lobbyist, if any at all that lends itself from a centralized form of government that has been optimal. Would you not agree in terms of that approach?

Charles: Yeah absolutely that a planned economy is a failed economy. That’s really what we’re talking about. A planned economy mean insiders benefit and it’s lost all of its adaptability, flexibility, and efficiency.

FRA: Exactly. What do you see as potentially evolving as a final question to consider in a coming years in terms of the evolution of where America’s going?

Charles: Well that’s a big question Richard. I think people are struggling to find some sort of answer to rising inequality and the concentration of wealth and power and they haven’t really come up with anything and so a lot of millennials view socialism as the answer. Other people view like reforming the government so that there’s less cronyism and so on but I don’t think that they’re going to get the results they want from those kinds of policies. I think we need a radical decentralization of power and a radical redistribution of opportunity and that’s going to be breaking up all the cartels that are, you know, basically state managed cartels, which controls most of the US economy, and get rid of the financial repression that we have described. It’s totally centralized and it benefits centralized wealth and power

FRA: Great insight Charles and we’ll end it on those words of wisdom. How can our listeners learn more about your work?

Charles: Please visit me at oftwominds.com and you can read the first couple chapters for free of my new book, “Money and Work Unchained”.

FRA: Excellent, we’ll end it there. Thank you very much Charles!

Charles: Thank You Richard.

Disclaimer: The views or opinions expressed in this blog post may or may not be representative of the views or opinions of the Financial Repression Authority.

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OCT 24th Podcast: Yra Harris and Peter Boockvar

By: Tenzin Lekphell

FRA: Hi welcome to FRA’s Roundtable Insight!  .. Today we have Yra Harris and Peter Boockvar. Yra’s a hedge fund manager, global trader in foreign currencies, bonds, commodities, and equities for over 40 years. He was also CME director from 1997 to 2003 and Peter is Chief investment officer for the Bleakley Financial Group in advisory. He has a newsletter product called boockreport.com which has great macroeconomic insight and perspective with lots of updates on economic indicators. Welcome gentlemen!

Peter: Hey Rich, hi Yra!.

Yra: Hey Rich!

FRA: Great! I thought today we’d focus on a number of aspects for the global economy and financial markets, Central Bank policy. You recently made some observations that the Federal Reserve could be hiking the US into a recession. Can you elaborate on that on your thoughts?

Peter: Well it’s what they typically do. Most rate hiking cycles end that way and not sure why this would be any different. We have to understand that not only are they raising rates but they’re also letting their balance sheet roll down so there is a double tightening going on that only recently markets have began to appreciate it.

FRA: And how do you see that playing out currently in the financial markets globally with all the volatility?

Peter: Well from a market perspective, we’ve already seen a bunch of different potholes this year, I think driven by the rising rate so the 10-year yield of beginning of the year one from 240 to 270 and you blew up the short fixed rate. Then turkey was exposed for the debts and deficits and rising inflation that they have, which is no mystery they have political issues for years but in a rising-rate environment, vulnerabilities get exposed and it started in Turkey then went to Argentina and of course you had a blow up in the Italian bond market just as the ECB is wrapping up there own Q.E program. From an economic standpoint, the rising rates is already slowing down the pace of transactions in the housing market and in the auto sector. And also we have to pay even now closer attention to corporate balance sheets where a lot of the excess has been created in the cycle. You look at small cap stocks particularly those in the Russell 2000. 40% of debt on Russell 2000 balance sheets is floating rate, which is obviously now very susceptible to the rising LIBOR and the question is whether cash flows can then deal with that rising cost of capital. Also from a leverage standpoint, small companies in the Russell 2000 have a debt/equity ratio twice of those in the S&P 500. So this rising rates, this rise in the cost of capital is beginning to have an economic impact and as I mentioned before, a market impact.

FRA: Do you see this being bearish on credit sensitive cyclical sectors ?

Peter: Well so far because you’ve thrown into the mixes, of course the slow down in the global economy, particularly in China and in Europe, so a lot of industrial are obviously cyclical, they have high fixed costs, and very sensitive to changes in economic activity. So a lot of confluence of events are combining for what is obviously a much different market this year compared to what investors are used to over the past couple years.

FRA: And is this all creating an emerging market crisis as well as emerging crisis in the European bond market?

Peter: Well I don’t want to speak broadly when you mention crisis. Certainly in Turkey there has been one. Certainly one in Argentina there has been one with with short rates north of 60%. That’s a crisis. We have to see how it plays out in China but China has a long road to hoe in terms of the enormous amount of debt that they have, the weakening in currency, the capital flows for current account deficit and so on.

So the crisis, I don’t want to say that just yet, but certainly this rise in rates, this drain in global liquidity creates a lot of potholes as I said and if you look at just the ECB, the Fed, and the B.O.J this year or this quarter, beginning October on a monthly basis, there is a net-zero of liquidity injection if you add in the behaviour of those three central banks so that creates also a drain and I think also is responsible for a lot of the fragility that were seeing now in markets.

FRA: Will this all create strengthening of the US dollar?

Peter: Well it has against certain currencies. It has against the Yuan of course, it has against the Turkish lira and Argentinian peso but if you look at the Euro heavy dollar Index, the average level of the dollar index over the past two years is 95 and say we’re a little bit over 95. So for all the talk about Fed rate hikes and how our Central Bank is far ahead of the curve relative to others and US growth is so quick compared to everybody else, the dollar index is basically in line with its average over the past two years. So it’s been strong against certain currencies and it’s done nothing against others.

FRA: And what about in China? You have observed that off balance sheet, government liabilities and the regions of China has amounted to $6 Trillion US dollars. Do you see that as a gigantic credit risk?

Peter: Yeah that on top of the amount of assets in their banking system relative to the GDP so we’re about to see how they handle this enormous debt load. Is it something they can paper over? Is it something that can grow their way out of? Is it something that’s gonna be like Japan that’s just gonna linger for 30 years? We’ll just have to see but there’s some serious challenges in the short-term. I mean long-term, I’m pretty bullish on China. I think that they’re the economy of the 21st century but I certainly don’t discount and don’t take for granted that in the next couple years can be a tough road for them.

FRA: What do you make of the standoff between Italy and the European Union, Brussels? Yra you’ve observed that Rome knows that the higher Italian yields are forced by the rhetoric of Brussels bureaucrats. The greater the losses for institutions forced to sell in any type of panic you have observed in your blog, what do you make at the standoff?

Yra: Well the standoff is real. Unfortunately, I think there are a lot of people who talk in Europe who really fail to understand or they don’t want to understand cause (Inaudible 7:20-7:21). The Italians… they understand perfectly what’s going on here. And I think that, if I were to (Inaudible 7:29-7:36), they know what they have. The problem for the Europeans is of course, and we saw (inaudible 7:46-7:54) it’s a compounding problem for Europe. They have the Italians, who understand whats going on here, they have the Brexit situation, and they have Trump, that they have to worry about. One thing we know about the president is he doesn’t forget flight. We know that. That doesn’t mean he actively pursues a vendetta but he does not do well with flight. In the G7 meeting, Merkel and Macron and two others really (inaudible 8:31) him, you know the famous picture. It wasn’t pretty. So there was an article in the (inaudible 8:41-8:42) last week titled: Donald Trump Looks To Start (inaudible 8:45) US-UK trade talk. There’s three things to look here;

1. You have the Italians who understand the pressure because there’s really nothing Brussels can do because the whole QE program has tied them up. I know we talked about this quite a bit over a couple of years that Draghi piling up all that debt.

The bigger problem is the zero risk waiting under the (inaudible 9:20-9:21) rule. They’re carry all this Italian debt, all these banks carry these debts Including the ECB and there’s no risk to it according to the rule of (inaudible 9:31). That presides a potential problem.

1. You have Trump who will throw a lifeline to the Brits. Unlike Obama who made a categorical mistake (inaudible 946) in real time that to say, you’re going to the back of the Que, and Donald Trump says, U.K you’re going to the front of the que and we may even create a free trade zone with you involved in it, which would be death for the Germans cause of all the auto capacity, manufacturing capacity that was built by the Germans and the Japanese in Britain. You have that and this really locks up Europe. They don’t have any leverage. But I hear people talking about what leverage they have. What leverage? The Italians say, what are you going to do to me? Our rates are gonna go up. We saw rates in Greece go up by 40%. And you know what? Greece is still here and they’re talking. We need growth. I think there are actually more people in Europe who support the Italians position than we hear reported. So I mean we have the (inaudible 10:48-10:50) really into Salvini and De Mayo’s hands. It gives them a lot of strength. I don’t think Brussels has any strength in this negotiation.

FRA: And Peter your thoughts?

Peter: It’s interesting because one of the proposals from Salvini in this proposed budget, which I only really read about is lowering taxes and having a flat tax. That’s growth encouraging and huge growth incentive. The spending side, that’s not really long lasting in terms of generating growth so you get stuck with more debt, higher deficits, and you don’t really get the growth. So I think that’s what the concern is. The Keynesian side of this budget, that I think is the concern, and the assumption that it’s going to magically improve the long-term competitive and economic growth rate of Italy, which it wont. Only lowering taxes and the massive regulatory state will. Paying people universal income and getting rid of the extension of retirement age and pensions, that’s not growth enhancing and so that’s what I’m worried about that they’re not going to get the growth they’re hoping for. And bigger picture, I keep arguing that the behaviour in the Italian bond market and response to what’s going on is the canary and when now the European Central Bank is 2 months away from stepping away from its purchases, who’s going to buy these bonds? I mean they were really the only buyer. Even Germany, which has a budget surplus which has a grade A fiscal situation, who’s going to buy German bundits 40 basis point when inflation is running 2%? Or PPI today which printed 3.2% for September? Who’s going to buy these French OAT for less than 1%? Who’s going to buy these things? I think that’s a big question and I think that has broader implications for the entire region and that Italy is really the poster boy initially because of the enormous amount of debt that they have and so little growth that they have to the point where their financing cost are now running above the rate of nominal GDP growth which means that their debt to GDP ratio begins to spiral upwards.

FRA: So do you see Italy changing their budget per the request by the EU Brussels?

Peter: I mean I’m sure, Yra has been saying this, there’s some agreement because Italy is really carrying the leverage here. There’s only so much the EU can do but I do think that everyone realizes it’s in their best interest and I think that the end of the day, it’ll be the EU that folds and gives into what Italy wants to do. I don’t think what Italy trying to accomplish, as I mentioned, is going to work but I think the EU has no choice but to at least give them a try. And you know the ultimate decision-maker a year of how this is gonna go is going to be the market. If the market sees that Italy can’t generate the 1.5% GDP growth that they’ve budgeted for next year, and it’s going to be less than that, then the bond markets going to speak up and you’re going to see a much higher rise in interest rates because even at a 3.5 or 3.6% 10 year yield relative to the fiscal situation in Italy, that’s still a historical low yield.

FRA: Yra, did you see that same rise in interest rates?

Yra: I think Peter is right about that but I’m looking more in the short term. What the effects are going to be? Europe needs an infrastructure program bad. Even the Germans seems to be admitting to that. So with that, there is going to be some deal. I truly believe that. If they think this through because if we look at this through those eyes you know of what George Soros and others have been recommending for several years, and not wrong but they’ve just dragged their feet for so long and that’s what they should have done to begin with. They could create a European almost like what Obama did with those infrastructure bonds, build an America Bond.

So you could do a build Europe, and I’m not saying that it’s gonna be responsible in any ways.

You could put together a package, lets say, 500 billion euros to build infrastructure projects all over Europe and use the capital key for those ratios and get this done. If you did it with the European wide bond, you would actually start doing what people have suggested as long as you see this project all the way through to its conclusion so your gonna need a European bond. So you could do this and get the Italians. From everything that I read, the Italians would buy into something like that because that’s what they’re really pushing for anyways. So if they did it across the European wide situation, I think that’s doable. I don’t know if they have the political strength to do it, and again I think Merkel has really dragged her feet here and Macron would have pursue this. He’s been dreaming about this. So I think you could see it and they can sell it in the short term. That way it eases the pressure on the Italians and everybody gets a little something. We’re probably (Inaudible 16:57) equity markets. Any sense of discussion is (inaudible 17:01) of equity markets that are looking for anything in the short term to give them some support. I think we’re gonna see something out of this group cause it’s bad. The election was 2 weeks ago and (inaudible 1750) the results were terrible. There’s an election this week in (inaudible 17:20) so everybody will be watching for this and they’re losing the middle ground so badly. I mean the worst part of the German election, a week and a half ago was that the Social Democrats, who have always been a mainstream, middle of the road policy they polled below the alternative for Germany. So there’s real problems going on and they need something and I think that’s what you’re gonna get out of this cause its a way to placate a lot of people in the short term. I agree. Peters right, who’s going to be buying these bonds? Let’s be serious, it’s a terrible flawed policy that is now coming home to roost. We’re not quite there yet. We still got 15 billion to be bought of fresh money every month so there’s still work in it. Peter’s a hundred percent right. It will come to no good. I just don’t know what the timeline is.

FRA: And what about the effect of any political movements in Europe? How could that affect all of this like the recent elections in Bavaria, trends towards populism, and the movement away from the Merkel government power?

Peter: I’ll leave that to you Yra.

Yra: The populists are trying to make this into a global phenomenon. There are a lot of people that feel like they’ve been disenfranchised by the what I refer to as the (inaudible 18:50) elite, people who sat there and made their policy or projected a sense of making policy with little regard for basically middle classes of the world. Let’s face it, globalization has benefited capital far more than labour put it into Marxist term.

I saw the interview that Alan Greenspan had in (inaudible 19:18) this weekend. It was interesting because he actually gave a Marx high grades for certain things that I thought from him was interesting, because I think that’s right.

And that’s what the world has had to answer was the shift and the reward for global capital vs. labour and its what we’ve dealt with which is why I believe that it’s a major flaw in the modelling of the Phillips curve but that’s a different discussion for another time.

So I think these are real and you have to find someway to placate those voters who really have been….and wages have not kept up and that’s by design.

You know the whole (inaudible 20:07) Germany was to free wages to sustain jobs in Germany rather than moving them to Eastern Europe.

NAFTA, when you go back and look at the beginning of NAFTA, it was meant for the North American region to take advantage of the Canadian natural resource base, combined with US capital and combined with Mexican wage rates. I mean it simplifies it but that’s a big part of it. So wages has been the real drag here and which is why we’ve seen the stock markets to get to levels that are…..we could argue historically where they’re at but they’ve been rewarded vs labour. It’s now starting to change and how everybody adjusts to it, I don’t know.

There’s a movement afoot but we shall see. But to diminish it and to pretend that it doesn’t exist is a major mistake which is why we got Donald Trump.

FRA: You’ve recently observed, Yra, a quote by last vice chairman of the Fed, Stanley Fischer, who said, “we the central Bankers cut interest rates severely to encourage growth and to support equity prices”. That adjustment hasn’t been fully made yet and then you point out a dilemma that Nehru vs Nehru. Can you elaborate?

Yra: Well, we come back to the wage thing. They all admit that they don’t understand why there is no wage inflation. I’m not saying that’s the answer but the Nehru model, I think is flawed I believe it’s flawed for many years and when you have the mobility of capital, and not the mobility of labour, you wind up with a lot of downward pressure on wages. When you’re given the alternative, Do I want my job or do I want a wage increase? Well Peter’s younger than I am Richard and I’m not sure how old you are but in the 60’s and 70’s, when I was a teenager starting to get in the work world, unions had a lot of power because we’re still in the post World War 2 situation capital wasn’t that mobile yet, breakdown Bretton Woods but when capital becomes so mobile that can go in search of lower wages and you have the transportation mechanism, you know ships, and containers today, we can move products today so you have the ability and therefore, labour comes up in the short end. And that’s what we see and so it’s not a surprise and now you have a billion Indians coming up in the global labour markets just like you had over a billion Chinese, of course those aren’t exact numbers. And to the global labour force, you had Eastern Europe unleashed into the global labour force. These have kept wages flat even if profits grew. So we built up this whole Q.E mechanism searching to push inflation higher but if its a phenomenon that has a lot to do with the global capacity, which is vast, the Chinese have a vast amounts of capacity labour force and it keeps prices down. But they built Q.E to push us out but if it’s not happening because the models are flawed, we’re in a serious dilemma. How we resolve it is going to be the big question.

FRA: And your thoughts Peter?

Peter: Well just to quantify a couple years ago the wage for the labour portion of the profit pie, that percent is low since World War 2 and that has now shifted and labour is gaining more leverage. And I do expect and I do think the wage data has been understated, especially over the last 6 months because most of the entrance into the labour force are young people and those with just a high-school degree. So when you measure the average hourly earnings for example, that’s most of the entrance, well that’s lower than the average. For those that are already working, I think wage pressures are pretty persistent and I think that’s being seen and in many different places because if companies are in search of labour and they cant find it, well they just have only a few choice in order to get it and raising wages is a key way of doing it.

And today’s Richmond Fed survey, not really saying anything we don’t already know but highlighting again, they said quote, “firms were unable to find workers with skills they needed as the skills index drops to an all time low”. That’s also a problem as well that there may be some workers out there but there’s a mismatch of between what’s demanded in the labour force and what’s supplied. I mean we know the demand side, there’s a record amount of job openings

But the inability to fill that is a problem and for those that can fill it, at least now has leverage and are gonna be paid a higher wage. And you throw in Amazon, which is raising their minimum wage which then forces and puts pressure on a lot of other companies to respond and sort of raises the lower end of the wage band.

So how that filters into consumer prices is obviously the main question. If productivity picks up, then it would not be a big deal but if companies find the need to pass it on in to higher prices, than you know then you got that wage price spiral that was similar to the 1970’s, not that this it’s gonna be repeated this time around but it gets to a broader picture here.

When you look at, and it combines with my comments on interest rates, the two biggest drivers of profit margin expansion in this recovery was

1. Lower interest expense, which allowed companies to dramatically reduce that with low interest rates.
2. Low wage costs.

And now both of those are turning upwards. So can revenue growth be quick enough to deal with that? Well likely not if 40% of S&P revenues are sourced overseas and see what’s going on overseas. So you have profit margins that in my opinion have peaked out or going to regress to what portion to the long-term mean we don’t know because technology is so dominant factors nowadays but I think that profit margins have peaked out in this cycle.

FRA: And finally what everybody is wondering about the last few weeks is where are global equity and bond markets heading and what events and risk factors should we be looking out for in that regard starting with Yra?

Yra: Well I think, Peter and I would agree on this. First, I think bond rates are going higher. I was not looking for curve inversion. I was interested in watching to see where they were gonna hold here so it’s interesting that 530 as we talk is breaking out above its 200 day moving average for those who are technically oriented for the first time since I think in 2 years. So I find that interesting.

You have Greenspan again and his interview (inaudible 18:23) but of course he raises the issues of entitlements and the pressure it puts on, well he thinks productivity and bond values. I mean Europe is an abomination and those bonds value, we know, some of the populous fever in especially in Northern Europe, you know, people forget that this populism is taking place in a very healthy environment. Yes it’s starting to slow a little bit but you measure this stuff by historical perspective, this is not when you get populism. You don’t get populism when unemployment rates are as low as they are. This is supposed to be the feel good era but yet something is broken.

This mechanism is broken economically and politically and you can’t divorce one from the other. You certainly can’t divorce politics from the economics. It’ll be healthy if bond rates would actually go up because I believe that interest rates are a very important signalling mechanism for the entire global financial system and its been broken for so long that its trying to reassert itself. Peter is the one is the who really first one to coin the phrase quantitative tightening. Its impact? Well we don’t know the impact was but I think we’re starting to see it.

It’s amazing to me, even the Fed admits it, that they don’t pay enough heed to the fact that they’re raising rates while the balance sheet is beginning to shrink. That’s a dual edged sword. Then of course you have the Europeans cutting back dramatically. And yet you are dealing with lax fiscal conditions especially in the United States, you have the deficits growing regardless of what Larry Kudlow has to say. I’m looking for bond prices especially to be moving higher and we’ll get a good picture in Europe after January 1st because then the ECB will be replenishing rather than increasing the balance sheet.

While there won’t be quantitative tightening, there won’t be the act of participation by the ECB and the Japanese we don’t know what they’re doing. It’s too hard to tell. They own so much of the market so we’re trying to get a sense of it.

The Chinese, the book is still out. Everybody who’s talking about the Chinese…I think what they failed to understand is that China borrowed a lot going forward when they began a lot of stimulus in 2015 and 2016 so I think the stock market in China is more a story about, hey they borrowed a lot from the future and the future is here. They got some issues about how to deal with what they borrowed from the future. So it doesn’t surprise me that the Chinese capital markets are as weak as they are.

FRA: And finally your thoughts up here on the transfer equity and bond markets?

Peter: I definitely agree with Yra on the interest rates and its a variety of reasons why rates are rising and I expect them to continue and it’s very easy for people to take out their historical playbook and say, okay, inflation and growth are the two drivers and whatever that plays out that’s where rates will go but unfortunately, we have to throw in the normalization and reversals of the central bank balance sheets on top of Fed rate hikes. We have to deal with foreign appetite for US treasuries which has been dramatically reduced partly due to the cost of the hedging but certainly also related to the dramatic reduction in reserve buildups that we’ve seen in China. Then you can throw in some other reasons that I think combine for a rising rates which will continue and I think the big question going at the 2019 is how do European bond yields respond to the ECB not adding more to their balance sheet? I probably said this on your show before but just to quantify the extent which ECB was buying European bonds at the peak when they were printing 80 billion Euros a month, they were buying 7 times net issuance. 7 times! An extraordinary ratio! For the Fed was never buying really more than 25% of Net Insurance.

That all changes as of January 1st, granted they’ll be reinvesting but on that basis, they will not be expanding their balance sheets and again who’s going to buy the stuff? So if you get a rise in German Bund yields, you have to believe that you’re going to see a coincident rise in US treasury. With respect to US stocks, it’s been a party for 10 years and what typically ends the party is Fed tightening and I think it would be hard to think that this is not going to happen again. Valuations are very expensive in the US. If you look at metrics other than P multiple(inaudible 33:55-33:56), If you look at variety of other (inaudible 33:58) prices cell ratios and are very expensive. Also, the rising rates are having an economic impact which has potential hurting earnings so I’m pretty defensive when it comes to US equities.

I am becoming more intrigued with the values being created overseas market that have got hammered. You look at China for example and China’s gonna have a couple of years of serious challenges no question but the markets gone pretty cheap and its down almost 60% from its highs in 2007. And even Japan, the Nikkei is down almost 50% where it was from 1989. I know that it’s been the case for a long time now but your looking for value so it’s unlikely going to find much on the US but you’re the potential finding a lot of it overseas.

And then lastly, I remain bullish for gold and silver because I think it’s respite in this crazy environment. The dollar has been strong against some emerging market currencies particularly the Yuan and then the troubled ones like the lira and the Argentinian peso and certainly the British pound related the Brexit but the dollar index over the past two years has done nothing. It’s gone up and gone down. It’s pretty much at the same level it’s been. I think that it points to major headwinds for the dollar and then maybe it’s the twin deficits that people are beginning to focus on.

FRA: Well great insight as always gentlemen. How can our listeners…

Yra: Richard can we come back to one thing?

FRA: Oh yeah sure.

Yra: In regards to China? You know unfortunately the airwaves get filled with ludicrous assessments, I mean it’s really ludicrous. I had to listen to some of these tirades yesterday what the United States, with Trump and Navarro especially, were trying to do is force regime change in China. That’s such a ridiculous concept. If that was the case, then you’d be verge of not a cold war but a hot war because if you think the Chinese would cave to US pressure for regime change… I had to listen it to 10 mins! Its ludicrous! People need to be, this is just a warning, be careful of about what you hear and what you listen to. There are a lot of people out there with ridiculous narratives. Ridiculous narratives! That one was mind boggling because that has not happened. That shows no understanding of how China works of the politics of China. China, we want to think in terms of a western style democratic capitalists model. It’s just not appropriate. You may wish that for the end result for China and they may get there but the present situation is far so from that and any discussion of what the Trump administration is really pushing for and what they think they are able to get because why would you pursue a ridiculous policy if you had no chance of ever attaining it? Let’s just be cautious. You need a filter, that’s what I’m advising. You need a filter and you have to understand what the entire global perspective is rather than somebody who may be selling something so be very careful!

FRA: Great and we’ll end it on those words of wisdom. Thank you very much gentlemen! How can our listeners learn more about your work? Yra?

Yra: By blog at notesfromunderground. It’s a pleasure and of course doing podcasts like these, it makes for important discussion. I advise you, you need to read! You need to subscribe to people like Peter’s work because you can’t do this alone because this is an endeavour. To be a trader and investor takes a lot of effort. It takes a lot of discourse between people. I remember when I was a floor trader, one of the great things on being on the floor was you had opportunities to discuss things with people. Now that we get more isolated, anatomized by computers, we lose that ability. So anytime you can involve yourself in any of these discussions and to read as much as possible. There’s quality work out there. Peter’s work is quality. Avail yourselves of these opportunities and listen to these podcasts.

FRA: Yes exactly and Peter?

Peter: Thank you Yra for that. You can read my daily work by subscribing to boockreport.com. If you’re interested in assistance with wealth management, you can reach out to me at bleakley.com

FRA: Thank you very much gentlemen! We’ll do it again.

Disclaimer: The views or opinions expressed in this blog post may or may not be representative of the views or opinions of the Financial Repression Authority.

Download the Podcast in MP3

Disclaimer: The views or opinions expressed in this blog post may or may not be representative of the views or opinions of the Financial Repression Authority.

Download the Podcast in MP3

Charles Hugh Smith Podcast

By: Tenzin Lekphell

FRA: Hi! Welcome to FRA’s Roundtable Insight! .. Today we have Charles Hugh Smith, author, leading global finance blogger, and America’s philosopher. He’s the author of nine books on our economy and society, including A Radically Beneficial World: Automation Technology and Creating Jobs for All, Resistance Revolution Liberation: A Model for Positive Change, and The Nearly Free University & The Emerging Economy. His blog oftwominds.com has logged well over 55 million page views and is number 7 on CNBC’s top alternative finance site. Welcome Charles!

Charles: Thank You Richard! I hope I live up to that very nice introduction!

FRA: Oh you always do. Thank you for being on the show! And so I think today we wanted to do a bit of a change and look at the economy as a whole and some very interesting trends that are happening, namely a software automation and robotics process automation and artificial intelligence and how that is changing the economy, the job market, how organizations are being affected by these changes, what are they doing, and if people cannot be redeployed elsewhere within our organization, what’s the answer? Do we do a lunar Apollo crash program or, you know, just some of your thoughts on that? And just like to point out so you’ve written a book on Radically beneficial world on automation technology and creating jobs so that could be quite relevant here and also a number of articles as well.

Charles: Right! Right! Well this is a fascinating topic to me Richard and so I spent a lot of time trying to get up to speed on it and of course it’s evolving so quickly that those of us that aren’t really in the field, we’re always trying to play a little bit of catch up so I’m not claiming to be cutting edge here but I think I have thought a lot about it and tried to help my readers navigate it. So, I would start with what’s the context of automation, and robotics, and AI, the impact on the economy as a whole? And I called it, this whole sector trend change, the “emerging economy” because it hasn’t yet occupied every sector of the economy but we know it will right? So that’s why I call it the emerging economy. We see it everywhere but it hasn’t yet, it’s still quite a ways from fully manifesting in every sector of the economy. And one of the issues that you raised here is what happens if we can’t employee people in a sustainable fashion at a relatively high rate of pay? Then who’s going to be supporting the consumer economy? Right? In other words, the basic answer for a lot of people is we give everyone universal basic income but that’s like a $1,000 per person per month is for the general gist of that. That’s not the equivalent of a real middle-class job. That’s just survival pay so that’s not really gonna solve that issue. So that’s one issue and that’s I think the impotence behind your question. We really need people to be working. Not only because we need their productive and capacity but we also have to give people a way to generate enough income to have a good life as prices continue to rise and so on.

FRA: Yeah exactly and what’s happening here is generally technology companies will be able to transform an organization or provide some assistance in the areas of software automation robotics, process automation, and artificial intelligence. But what happens is after some work through organizational change management, they’re able to identify other areas of the organization where those affected by the job changes can be redeployed elsewhere in the organization but it doesn’t work for everybody. Some cannot be redeployed elsewhere within the organization and so they would be let go and then it becomes a societal problem or a government problem at that point. So that’s the big question what happens at that point?

Charles: Right! Just to provide some context, I have assembled a few graphics here that will help us, I hope, contextualize your question. The first is the iPhone supply chain, which goes to show just how global the tech economy is.

Now of course, this is not the entire economy because I read somebody noted recently on the internet that you can’t get a haircut on the internet. Right? So my point here is with the iPhone supply chain is to show that automation is a global phenomenon right? Their automating in China despite the lower labour cost because the labour costs is rising there too. So it’s not just an advanced economy problem, it’s global.

And my next chart here is the labour share of the GDP.

In other words, how much of the gross domestic product (inaudible 6:01-6:02) how much does that end up in the hands of labour as opposed to capital or other investment? We can see from this chart that labour share rose considerably in the dot com era because there was a huge expansion of employment to build out the basic infrastructure of the internet and so that created a lot of real employment. But when that got built out then the labour share of the GDP plummeted and it hasn’t recovered despite the so-called global recovery. So my point here is to show that we really need to keep labour share of the GDP high enough to support consumption or else the model of our economy no longer works.

My next chart is the acceleration of technological adoption.

Of course we all feel this intuitively but this points out that it took like 26 years for television to become ubiquitous and then it took social media only 5 years. So this puts a lot pressure on individuals and organizations because we can see this trend of automation is speeding up. It’s accelerating. It’s almost like whatever skill you learned in college, if it’s 4 years later, you’re already behind the curve. It requires, more or less, constant learning because of this accelerating adoption rate.

Although we’re talking about the economy as a whole, I have a graphic here of the United States which is an example of an advanced economy, you could call up a map of China or Japan or Europe and have a similar discussion.

The so called creative class, sort of the generalized term for people with higher education degrees and experience in the emerging economy, these of course are clustered in certain areas. So we’re really talking about two separate economies. So when we try to answer your important question, what do we do with people who aren’t able to transition to an emerging technology kind of economy? It’s a regional thing too because obviously the places like the San Francisco Bay area and equivalent places have the human capital, If you will, to address these issues better then areas with a less educated, with less mobile kind of employment foundation.

My next chart shows, this is in the health care sector in the United States which we all know is troubled for a lot of reasons, that the number of physicians have been added to the sector is minimal in the last 30 to 40 years where the growth of administrators is up about 3000%.

So I bring this chart to our attention as an example of a sector that is obviously ripe for disruption and there’s a lot of low-hanging fruit in terms of work that could be automated or streamlined in sectors like health care. In other words, this is not just high tech like we’re not talking about chip design or social media or mobile apps, we’re looking at these very large sectors that employ millions of people which are ripe for disruption by the forces that we’re talking about here.

My last chart is distribution of family income which shows, that as we all know, the top 10% has basically lifted away from the bottom 90% in terms of income.

The reason why I bring this up is, there is a lot of reasons for that, but one of them is that this top 10% tends to be the most highly educated, the most dynamic sector of the population. They’re the ones that are acquiring the skills and managerial skills to navigate the emerging economy and this is reflected in their much higher income. And this is the danger of a what we’re talking about here is even if we can maintain some generalized employment, if most of the rewards are going into the top ten percent then that also called into question or our whole mass consumption model of our economy. Now having said all that, how are organisations being affected by this change and how is it affecting the job market and how do how do organizations take the initiative to redeploy or train resources affected by these? These are all excellent questions and of course it depends on the sector. Say, just to give a brief example, the construction industry. There’s a certain amount of technological innovation there in terms of components fabricated in a factory and then shipped and assembled on site to reduce labour but there’s a lot of, let’s say, remodelling work. It’s very hard to automate that kind of stuff because it’s unique to each particular dwelling or each project and we still need workers with multiple skill sets.

So I think as a general rule, what we want to train our people for, whether there within our organization or if their students or laid-off workers is we want to give people a menu of skill sets not just a specialty. I mean a specialty skills works great if you are designing really high-end chip sets or you’re a physician but like for the rest of the populist, specialization means that you can be replaced by automation a lot easier than if you can have multiple skills. That’s one issue here is that we want to broaden peoples skill set. Another thought here is that some labours are hard to automate like creative work, design, editing, etc. But even those kinds of advanced skill sets are being are being automated too as automation eats its way up the food chain.

Another sector of work that’s fairly protected is managing people, you know managerial skills which is really hard to automate and also any kind of employment that’s based on high touch. What’s known as high touch, meaning that your interacting with humans is what creates the value of your employment and so of course it’s going to be like nursing and childcare and so.

I think what we’re really talking about here when talk about how to organization responds, we’re talking not about those professions that are very difficult to automate but we’re talking about the professions that have to work with automation. They may not be completely replaced but it demands the employee’s augment the processes and learn enough to increase productivity because that’s another thing we’re talking about here as automation and A.I spread throughout the economy, we’re finding productivity is still stagnating. So we’re not really getting the gains of that. I mean you must have some thoughts about that too right? Because technology is supposed to enhance productivity. That’s the wealth creation part.

FRA: Yeah, and you’ve also explored in recent writing as well how organizations are being affected by these changes. Not only as you just mentioned on the productivity results but also on profits. Can you elaborate on that? And in recent writings, you mention that the automation doesn’t just destroy jobs, it destroys profits too.

Charles: Right and that’s counterintuitive for a lot of people Richard because they assume that the robot, because it’s replacing human labor and it’s cheaper, that it’s kind of generate huge profits or the other company that replaced their employees with robots but it doesn’t work like that and the reason why is “commoditization”. When we commoditize something, whether it’s labour or capital or goods, it means that they’re interchangeable. They can be produced anywhere in the world and so this is what the globalization phenomenon has (inaudible 15:41) why it’s reduced cost so much is labour is interchangeable, computer chips are interchangeable, computer design centres are interchangeable so a robot is like a good example of a commoditized tool where anybody can buy the same robot that I bought and they can put it on their line. So therefore where’s my scarcity value? Where’s my Competitive Edge? and so as soon as you get robots involved then profits fall because everything becomes a commodity and we can see this in technology that when something is commoditized, the value drops, the price drops, and the profit margins drop to near 0. Like for instance a tablet. Right now if you have the special software that Apple sells right it’s tightly bound to its Hardware, that’s their scarcity value you can only get the certain features that Apple has by spending $400 on an iPad right? But if you’re going to get a generic tablet, those are like 30 bucks a piece in China with free software loaded and they have to have an 80 or 90% of the capability of the more expensive one. That’s the same thing that’s gonna happen to robotics. Everybody can buy the same Robotics and a lot of the tools why automation are free or software they’re free or they’re very cheap. So that’s why profits are going to plummet as automation enters the supply chain.

FRA: Interesting! And in terms of how organizations are addressing this, I think it’s also interesting to note how you can almost divide the pool of resources into some certain scenarios. One is the resources that need to be trained for extra skill sets on how to manage the increased level of automation or robotic process automation or artificial intelligence that will come into play in the organization. And then there’s others that would need to be redeployed within the organization elsewhere overall increasing productivity in that way. And then there’s the pool that where there’s no opportunities identified. They are not able to do increased levels of activity of services and they’re not in the pool of being able to be redeployed elsewhere. Your thoughts on that?

Charles: Right! It’s an excellent point Richard and this was really why I wrote my book A Radically Beneficial World is what I was proposing was that there is a very large pool of workers who don’t have the value system, the ambition, this sort of background perhaps to take on the extreme challenge of learning a bunch of high technology skills sets. And of those people, many of them have other kinds of intelligence. In other words, we need to help people identify where their strengths are. So for instance, some people have great manual intelligence. They can work with very fine machinery, some of which is of course related to robotics.

FRA: Now what can we do about this? Should governments take a role in redeploying or training resources affected by these changes? So that this would be the pool of resources that are unable to be redeployed within the organization or that’s still continued to have an expanded role in their current positions and job functions. So what can government do in this regard? Does it make sense to have government play a role your thoughts?

Charles: That’s a great question Richard and I think we can discern two approaches here. One is direct government spending, like on infrastructure a lot of people think of that, but it’s also the government could streamline a lot of really clunky processes we have now and in it (inaudible 20:21-20:22) both have, you know, a lower-level high school education and also higher education. So there’s opportunities for the government to contribute to the solutions in two ways; simplifying and enhancing processes that’s already involved in and then direct spending.

FRA: What about Reliance on the Invisible Hand of Adam Smith? So you know would that play a role here in terms of inner resources able to self-identify or self-train into other areas of the economy?

Charles: Right, it’s a great question and it’s always an issue I think in a state market economy which describes most of the global economy now right that the government’s around the world are heavily engaged or involved in managing their private sector. And so a lot of people have a sort of Quasi-religious belief that the market can solve everything but there certainly seems to be examples in which government does need to play a role in terms of providing infrastructure for everybody so that everybody has equal opportunity within a society. It’s something that isn’t necessarily profitable for enterprise to supply those things. Sometimes it is, sometimes it isn’t right? The canals in the early of the 18th century in America were privately-funded. But to use the example you mentioned earlier the Apollo Mission to the moon, obviously there was no a market demand for that and so no one was going to put up money or capital because there was no profit to be earned and because there was no market. In my book A Radically Beneficial World, I talk about the community economy as a place where we, the government, could redeploy capital because there’s lot of work to be done in local communities (inaudible 22:47 to 22:48) do the work because it’s just not profitable enough for them. But governments are often heavy handed and there are a lot of programs like job training end up failing. They don’t produce desired results. That’s not a clear answer but I think there’s multiple levels of opportunity for government. Sometimes just providing some infrastructure, sometimes smoothing the path so that work private capital can get to work without a lot of red tape and regulation.

FRA: And what about the lunar Apollo crash program back in the 1960s? There’s estimates that perhaps somewhere between $4 and $8 in economic growth, economic activity was generated for every $1 invested into that program. So maybe could that be considered in terms of doing another crash type of program but in something else that makes sense today like you know nuclear fusion energy development coupled with the electrification of cars for example. Would that make sense it in create jobs not only in the white collar jobs but also blue collar jobs across the entire nation?

Charles: That’s a great question Richard. I think a lot of people are looking to that idea as a major solution. A big government spending program on something that was particularly useful, which would be energy, because we all know we need to transition away from fossil fuels. There’s a cautionary part of that idea and I looked to Japan as an example of the cautionary part. Japan has spent almost 30 years spending a tremendous amount of fiscal stimulus on infrastructure and what they done is mal-invested much of it in bridges to nowhere and high-ways very few people used and this is a result of their political system which gives a lot of power to the construction industry. Sadly, they in my view, they squandered trillions of Yen on infrastructure that really didn’t serve the entire citizenry as well as if they solarize their economy or done something that was more to the common good instead of just kind of make work projects. So we have to be careful here that we’re not just funding make work jobs, we want to leverage some technology that benefits the greater good. One example, and a lot of people talk about this, is upgrading the electrical grid because this is something that is required in order make use of electrical production from solar and wind. It’s increasing right? That grid has to be completely upgraded. So that’s an example of a program that sort of fits those parameters so that it would leverage government investment to the benefit of the private sector as well as to the citizenry. Of course everybody loves the example of the Arpanet, which was the original little government funded program that spawned the entire internet right? That was a really low cost investment and so I think we can talk about that too like it’s easy to talk about spending a trillion dollars, and everybody wants to spend a trillion, but maybe we should start by just trying to see what we could do with smaller sums to leverage new technologies and make them available to a wider range of people like 3D fabrication technology. That could be beneficial if the government invested in spreading that around and that should be a lot less expensive than big trillion-dollar programs.

FRA: Interesting. And finally how do you see all of this playing out in the long-term? Do you see like a combination of government taking a role, the invisible hand of Adam Smith or potential crash programs in the future?

Charles: Right! It’s a very dynamic situation and I would hesitate to make any predictions but I think the potential for disruption is so large that the government itself should be disrupted. In other words, we need to disrupt, to which we apply the technologies that we were discussing. We need to apply them to lower the cost and increase the effectiveness of government itself. And so when we talk about government spending, one of the first places we should invest in is streamlining government because it’s really, and it in so many ways, inefficient and ineffective and it desperately needs to be disrupted in streamlined. So that that might be a first place to start investing taxpayer money.

FRA: Wow, great insight as always Charles. How can our listeners learn more about your work?

Charles: Yeah, please visit me oftwominds.com, and you can read samples of my most recent books.

FRA: Great! Thank you very much for being on the program show for your insights on this very interesting topic.

Charles: Oh yeah, we barely touched the surface. Thank you so much for inviting me on the program!

Disclaimer: The views or opinions expressed in this blog post may or may not be representative of the views or opinions of the Financial Repression Authority.

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Yra & Peter Podcast

By: Tenzin Lekphell

FRA: Hi welcome to FRA’s Roundtable Insight .. Today we have Yra Harris and Peter Boockvar. Yra is a successful hedge fund manager and a global trader in foreign currencies, bonds, commodities, and equities for over 40 years. He was also a CME director from 1997 to 2003. And Peter is Chief Investment Officer for the Bleakley Financial Group and Advisory. He has a newsletter product called the BoockReport.com which has great macro-economic insight and respective with lots of updates of economic indicators. Welcome Gentlemen!

Yra: Hey Richard!

Peter: Hey good afternoon guys!

FRA: Great! I thought we begin with a reflection on the FOMC Minutes today and the observation that you made recently Yra and your blog that Peter Boockvar, Jim Bianco, and the former Bank of India governor, Raghuram Rajan, have all raised concerns about the Feds raising rates while shrinking its balance sheet. This is leading to a rapid rise in borrowing costs for emerging market economies that have high levels of dollars denominated debt. And so what is the consensus today from the FOMC minutes meeting perspective?

Yra: Well I am sure Peter will speak more to the FOMC Minutes. I have read through some and I am sure he’s much more ahead of me on this but you know Peter and Jim and certainly professor Rajan have discussed this and its impact on the ripple effect. You know every central bank because the media is so enamored and the fact the equity market has risen and the central banks all raised the great concept of counter factual wealth we haven’t done this. Well they did do this and I know that Peter and I and Richard you have discussed this for years they have overstayed this hand and did they need Q.E 2 or 3. But the effects of the Bernanke Fed taking this, to me a ridiculous and which prompted the Yishibe and of course The Bank of Japan to take this to ridiculous end, have sent global interest rate to very low levels and I think has enabled, I think that’s the right word, cause when we enable an addiction to this ultra-low interest rate and led this to a huge amount of borrowing because of these low rates. Now that interest rates are moving up as Peter pointed out since he framed the QT or Quantitative tightening, that now liquidity is being withdrawn especially from the world reserve currency, which has greater effects than any other. And it causing some dislocation because interest rates are going up and we feel liquidity is tightening and now this you know, all these people who are borrowed up are now having to paying it back or if they are not paying it back yet, their debt services costs will rise dramatically. So that’s where we sit in the world so I think it has great ramifications but I will leave my voice there and let Peter go on with it.

Peter: Yeah, I agree with Yra’s points and one ironic thing about Monetary Policy is that when you look at that over 20 years ago, each successive cycle saw lower and lower interest rates because the debt build up that has taken over many years meant that we needed lower and lower interest rates not only which encourage the borrowing but meant that higher rates than that would cause a major problems cause of all the debt so here the Feds says I’m going to cover it to zero and I’m going to encourage you guys to go out and borrow and borrow and borrow and now you have taken on a lot of debt now its time to raise interest rates well they can’t raise the interest rates to much because of all the debt that’s accumulated. So we are going to the next recession or down turn whenever that might occur with the fed funds rate well below what it’s been in the past. Likely Europe will go into to the next recession with rates that are negative and Japan will probably do the same. So that’s what going to differentiate the next recession from the previous ones is the inability of central banks to be able deal with it because so many (4:52 Inaudible) have already been expended. So one of the problems there to leave it at that. But with respect to Yra mentioned the Minutes, The Minutes are in a way in addition to FOMC statement, the minutes are not really minutes. When you think of minutes, it’s okay let’s take notes of about what discussed. The fed has turned Minutes into another messaging machine, to be sort of an addendum to the Minutes the actual statements that comes out the day of the meeting. And typically nothing comes of it and I don’t really think nothing really came of it this time but those that think that the Feds are going to be talking about trading and worried about that that there are going to be almost done, well there are plenty of comments within the minutes that talked about company’s having more leverage in raising prices. There is also a great discussion on the yield curve with some saying that we outta to pay attention to the yield curve and we don’t want to invert it. And others have said that you can’t infer economic casualty from some statistics correlation because there global factors that are surpassing long term interest rates such as, as Yra said, very low rates in Europe and Japan. The question is to which side is of that argument is Jay Powell and I’m not sure of that answer.

FRA: Okay and what about the effect of this on the US equities markets Yra you observed that there’s a rallying of the US markets relative to the rest of the world with the (6:32 inaudible) US dollar. Could this be a trend, a change in trend from prior correlation of weak currency and strong equities market?

Yra: Well you know with the algorithmic world and the way we respond to things, can it be a trend? I do not how to define trend anymore. You know it seems 24 hours is a momentum trend so it switches again. So in the big picture, I don’t believe that those fundamental have shifted dramatically and I always find the currency are (7:06 inaudible) interesting because they will roll out, you know I love the different financial media because they will roll out a CEO who when the dollar is rallying or its affecting our outlier that is affecting our profitability of the strong dollar but I yet to hear of a CEO in America who when the dollar is weak and the profits are growing stand up and say, “don’t increase my bonus this year cause its really due to extraordinary circumstances way beyond my control and that’s the dollar is so weak that you couldn’t help but make money”. So the argument about the dollar it’s right now you got both going together because of some theory that the United States is some haven for money flowing in, it’s still the same thing in China with a weak currency but you have a real weak equity market. These are things that we haven’t seen sustain themselves and I don’t believe they will sustain themselves as far as equity markets correlative with currencies that they will have long held view will resurrect itself, But right now we are in a situation where several correlation that we have seen have broken down we also saw oil prices rally with quite a bit with the dollar rally initially. So you know what that’s the thing about correlation they work until they don’t work anymore. But certain along the held relationships we will always reassert themselves. I almost sound like the feds giving enough time (8:56 – 9:01 inaudible)

FRA: And your thoughts Peter?

Peter: Yeah I agree. Even with the European stock markets this year with the recent weakness in the Euro it has done nothing to help the European markets. (Inaudible 9:15) in Germany in which, 40% depended on exports. So and to the point of algorithms, I stopped thinking that equity market was a good discounting mechanism like it used to be and I see it just for responding to events and circumstances that’s smack in the middle of its face and like you take now for example, you see the weakness in overseas economies. Well 40% of the S&P sources goods from overseas but there is not one (Inaudible 9:48) saying that our revenue growth can be clipped here. To think a lot of it does have to do with Algorithms cause in algorithm the input is the data that is out here. It’s not guessing what the data will be. So it’s not saying that China’s growth is falling therefore 6 months from now, it will start to impact the US and I should trim equities today. Its saying, China’s growth is slowing but it hasn’t affected the US and the US is still good therefore buy stocks. So I wouldn’t look at US equity market as a good discounting mechanism just look at 07. The credit markets were literally on fire in the beginning of 07 and the stock market hit an all-time record high in October 2007 because the feds were cutting rates and they thought the feds are here to save us. Buy stocks when they cut rates. In the flipside, buy stocks 2013, 14, 15, don’t fight the feds don’t fight the feds. Well now, you don’t hear anyone talking about, “be careful of feds be careful of feds”. It’s just buy stocks buy stocks things are good! So the narrative always changes and the circle of relationships are difficult to apply now because we never had an experience of negative interest rates. The (inaudible 11:05) 2 years minus 60 basis point historical approximate so don’t give me a seasonal analysis or historical analysis of the yield curve when we are in a rate environment when it’s never been seen in the history of the world before.

Yra: (11:22 inaudible) because you’re in Canada Richard so one of the most interesting things is the flattest yield curve, except outside Iceland which is a different situation, but the Canadian curve is really flat. Flatter than the US. I think its 15 basis points this morning. Which is interesting because they never had a Q.E program. So what is flattening the curve? Is it that the Canadian are now following the US in raising the rates and that the Canadian market a very effective barometer that hey, “you might be wrong here that there are things you ought not to be raising rates in this fashion. I find that very interesting what the Canadian curve is doing and I’m starting to pay attention to it only because it’s a pure view although of course it’s affected by international capital flow which are all affected by the major central banks. But I do find that curve, being as flat as it is, very interesting and something to watch for.

FRA: Yeah could be partly also because on concerns with trade like with NAFTA, with the US and concerns there on discussion on the treaty, revising the terms of the treaty, which could be negative to Canada, and also on real estate, there’s been lot of international capital flow into Canada recently but theres been new measure in terms of taxation or tariffs, penalties imposed on foreign nationals/ foreign entities outside of Canada on the real estate market so it’s no longer as it was before so a lot of jobs recently created due to the real estate boom. So I think maybe those two concerns are bearing on Canada.

Yra: I know it’s worth discussing so you know everybody has ancillary reasons for why this, and what’s interesting because Peter brought it up from the (13:41- 13:42 inaudible) about foreign flow funds are we back to Bernanke argument about the surplus savings. I guess there’s still some people in the feds making that argument for the current state of affairs. That didn’t sit well with me in 2006 and it sits less well with me right now because it fails to take into account the real impact and the damage done by central bank policy but that’s an objective opinion on my part.

FRA: Yeah, exactly. So we talked about the Fed. But what about what about the Japanese central banks. There’s been some potential trends there in terms of the Japanese central bank buying less equities they bought a lot of the in the past and due to changes in the central bank policy, what are your thoughts on that and let’s start with Yra.

Yra: I deferred to Peter and I think he has a better sense of that. So Richard I’ll defer to Peter.

Peter: So what’s most interesting when the Bank of Japan decided to go to Yield curve control, it was there way of saying, “we already broke the Japanese bond market we need to start buying less, lets figure out another way of keeping the rate low. So they went from focusing on the price of money from the quantity of the money they printed. So they said let’s keep the spread the overnight rate and 10 year rate close zero give or take 10 basis points. And that worked in a sense that it allowed them to dramatically cut Q.E. Where they were running at peak 8 trillion yen a month to 50 trillion yen. Problem was that by destroying and flattening the yield curve to nothing, the you damaged profitability of the banking system and if your banking system is your transmission mechanism of your policy, you actually end up tightening via the easing because the banks are reluctant to lend because there’s no yield curve, well you are tightening they are now cutting back on what I’m hearing purchases of stocks. Well when they become dominant holder of Japanese stocks, you actually scare Japanese equity investors because you know it’s not sustainable unless the Japanese want to nationalise the Japanese stock market but I don’t think that’s on the agenda, you actually scare potentially buyers of Japanese stocks because you wonder and fear what’s gonna happen when the Japanese are done buying stocks the markets gonna fall. So their easing becomes into tightening while they still ease and I think that’s why Korota shifted the yield curve control to 20 basis points give or take from 10 but even 20 basis points really isn’t much from 10. So they have a major problem. The end game is somewhat over for the Bank of Japan. I just don’t know how they are gonna figure out a way of getting out of it.

Yra: Yeah I would agree. Peter has that absolutely right. Their QQE, is they refer to it of course, it was quality and quantity as they were buying stocks. I think they have been under buying for a long time that’s why I wasn’t so surprised when they made that announcement in the initial reaction was a quick shutoff of in the equity and a quick reality in the Japanese Yen. So but I don’t think it really was that great of a surprise to the market because they’re not very transparent. It was like watching the Yishibi who would publish where they were at the end of every week and you can kind of follow and map that you knew exactly what they were buying according to the capital keys. The Japanese have really been very secretive here and I think Kuroda has followed. I agree with Peter and I think it’s a terrible policy and I think he was able to do what he was to do because he could do it out of the heels of again Bernanke. I respect Jay Powell and it’s interesting to hear these views but the United states does have a global fiduciary and when it fails, it does things to creates havoc in the system and then everybody else follows as it goes (18:40-18:42 Inaudible) their doing it and (Inaudible) okay I’m going to do this here. So we’ve gone to preposterous measure of central bank activity in the world and I think the first rumblings in the emerging is some of the coming price that’s going to be paid. I can’t tell you when, I wish I could cause then I could retire and then I could do these podcast fulltime. But I think it’s coming to watch out for and I think Peter is picking up on that. With the Bank of Japan, I think they have gotten themselves into a terrible situation.

FRA: Yes and Peter what about the Japanese currency and the last couple of months. It seems to be increasing or strengthening at even faster rate than the US dollar?

Peter: It’s amazing it’s like a conundrum. I mean when you look at the Japanese monetary and fiscal situation you tell yourself, “Why isn’t it 250 instead of a dollar let alone 110 or 112? But I think the recent rally is strictly due to the change in Japanese policy in terms of the yield curve control and continuing to trim Q.E. It’s really as simple as that. Where the end goes from here is, you could flip a coin. As I said on paper, it deserves to be a lot weaker but considering how the US has been handling, its finances. The dollar should be that much stronger than the Yen. So I think what the end results is that printing currency and weakening your currency is not necessarily the pathway to higher inflation. And that was the goal of Bank of Japan was to create 2% inflation even though it’s completely unrealistic benchmark, particularly in a country that had a shrinking population and a growing, aging population that needs to save and really spend less therefore, another reason why you are not going to get the higher inflation. So, here we are with their balance sheet that is almost 100% of their GDP and they are the top 10 holders, 40% of Japanese equities listed on the Nikkei and the CPI number, which comes out tonight, core CPI or core core CPI ex energy and food, is expected to be up all 3/10’s of the year. Astonishing!

FRA: And moving from Japan to China, Yra you referenced the Financial times news item and which it was stated that China’s banking regulator has ordered to boost lending to infrastructure projects and exporter as the government seeks to bolster economic confidence on the eve of a new rounds of trade negotiations with the US. Your thoughts on that?

Yra: Well my thoughts are that is when I wrote that there was a weekend article which I thought was very important article and I did exactly what I thought it would do which is that is coppers and everything that has been down been up all this week. Including everyone was bullish the dollar but this was done to assuage the immediate pressure. I don’t think the Chinese have as much room as they would believe but I thought it was a very interesting switch because they are evidently a little bit nervous about too much slowdown too quickly in the Japanese economy and I know Peter has been watching the Chinese bonds are also approaching are approaching the very low levels they are almost as low as the US ten year. In a country if we believed in numbers, you know over 6% GDP growth. There getting a little worried and their worried about how far Trump’s going to take this Tariff issue? So I thought that was done in way to politically assuage some in the White House and hoping that they would be able to control more of the dialogue between the two and soften some of the rhetoric. It was interesting. Another thing that took place, today or yesterday, the German foreign minister. You know, lets hold off for a bit. Peter you go with China then I will come back with the German foreign minister thing cause he did some interesting things.

Peter: China’s in this tough spot where they acknowledge the success of credit groups that has led to so many imbalances in their economy on top of the massive leverage ratio and that’s why they have been pushing to try to at least bring lending on to bank balance sheets and off the (Inaudible 23:45) outside but at the same time, they don’t want to suffer big decline in GDP growth and they still want the 6.5% type growth and you throw the tariffs in that is a threat to growth which causes another policy conundrum because they want to slow credit growth but they want to speed it up to offset the tariffs. How this plays out is again going to be a mystery because China’s economy overall is a mystery. I think over time, slowing credit growth and trying to maybe privatize is the wrong word but continuing to shift their economy to more private sector dependent area and business’s are a good thing and actually bullish in long term but how they manage this in the next year or two is going to be extraordinarily difficult particularly if Europe is going to slow at the same time because of their own challenges and the end of QE and the Europe is a huge customer there and how they manage further relationships with the US. Now today, delegation comes to US to discuss trade and I’m beginning to now wonder whether China’s saying you know what, we’re not giving in and we’ll wait after the election, the midterm election in the US, because when the democrats takes the house when Trump is going to have less leverage, and maybe we cannot give in as much as he wants us to do. So where the Chinese economy goes is will be how much do they dig in and I think they at least they show some interest in digging in and not giving in to what Trump wants and you throw in this whole Michael Cohen thing and I think that’s kind of irrelevant for the whole US economy and markets and they take this as a sign of vulnerability, which gets them into digging even more. We’ll just have to wait and see.

FRA: Back to the German foreign minister Yra?

YRA: Yesterday, German foreign minister. Hold on one second…It was the only thing I was interested in reading today (Inaudible 26:01- 26:03) it was out and I recently saw this story and nobody really talked about it but discussing it that Europe and others need to break away from the strangle hold of the United States especially office for Foreign Asset Control which is under the US treasury and its ability through sanctions and other mechanisms to control, of course, fund transfers globally which is what the Russians and others, the Iranians, the Turks yelling about, because the US treasury really has the power to affect your ability to move money and the German foreign minister came out and said, they have to be get ready to move beyond this. I thought it was interesting that he came out with that following the Putin and Merkel meeting over the weekend. And Merkel actually this morning came out and supported the article (Inaudible 27:00 27:01) and she came out to supported the foreign minister and those views and it’s really all directed at trying to circumvent the ability of the Swiss system because its price and dollars and the United States has disproportionate amount of power to control a lot of global events because of it. So they want to circumvent it. I think that’s what the Chinese would ultimately like to do and I think that’s what the Russians would really like to get themselves out of which is why I talked about these sanctions they want to remove it is a matter of what negotiating power Putin has with the Trump White House and I’m not talking about the more sorted events, I’m talking about the ability for the Russians to be able to influence and dramatically influence the events in the mid- east. So this is all coming together at an interesting time and I think it’s really a sense of push back against the US “bullying”, as I think the world would say, in regards to foreign exchange flows. This is really nothing new. It really goes back to the 50s and 60s when the French were complaining about the same thing for the different reasons that the US had way to much influence because of dollars rolls reserve currency. But I think this is important and I think it needs to be on everybody’s radar screen to pay attention to.

FRA: Peter any comments on that?

Peter: I agree with Yra, it’s definitely something to watch. All the goings on with the emerging markets right now is important to watch. It’s no coincidence that just within a 6 month time frame that Turkey, Argentina, the time bonding market, the short (Inaudible 28:53) trade is blowing up. The liquidity flow is going the other way and monetary tightening is taking hold and stuff beings to happen and accidents begins to happen and things get more exposed, investors become more discriminating, they become less tolerant to problems. I expect more of these accidents as the months and quarters progress. The questions is how insulated or how (Inaudible 29:18) U.S economy gets impacted by that.

Yra: I think, Richard, that the world is more concerned now because they’ve seen a president or a political leader in the United States who is trying to change the entire narrative of the last 60 years anyway and their going, “wow, we really made our selves sub-servient” because of our needs for dollars but when they see the ability to use this as political leverage, I think the world is very nervous about this important piece of discussion

FRA: Yeah and finally on that relating to the emerging markets, if we look at countries with high risk for currency crisis, like Indonesia, Brazil, Argentina, Turkey, what do you make on Turkey president Erdogan and the possibility of capital controls? Yra?

Yra: Well I think that’s a great possibility. I know everybody you hear all these what I call a (inaudible 30:34) analyst who come out and that’s not going to happen because he’s a rational actor and why would you do that? I would be very careful with Erdogan. First off, he’s very good friends and very close to Mahatir Mohammed, well now he’s was back in prime minister of Malaysia, but back in 1997, 98, during the Asian contagion, Malaysia did put on foreign exchange controls in September, I believe 1998, and it actually aided them and they did it by thumbing their nose at the IMF so everybody else is running to the IMF and dealing with well we’ll borrow money from you but the IMF of course could lend playbook was raise interest rates and cut the spending to reign in the deficit so your basically forcing yourself a severe economic slowdown, Malaysia said no. They went to foreign exchange controls where they tied up money for a longer period of time and if you would do this now, I think first of all, it would cause a lot of havoc in Europe cause so many European banks are involved in Turkey then other banks because of the close ties but the foreign exchange controls are something that this global market really fears because anything that ties up, this whole market is built on the free flow of capital so a country of Turkey size with that much amount of debt, I think that will cause negative reverberation throughout the system and setup a very potential negative feedback loop as far as global liquidity and I think that could really cause problems something that you would have to watch out. Erdogan is, you know, he’s first off foremost curious about Erdogan so I think we should be very attentive to this.

FRA: And Peter?

Peter: I agree with Yra because you can imagine being an emerging market and investor in Turkey and all of a sudden you can’t get your money out. Well you’re going to sell everything you can to offset that so the capital flight from other emerging market could be rather extreme. Now Turkish government has it that there not going to go there but it doesn’t mean they’re not going to change their minds tomorrow. Yra mentioned the precedent that we saw in Malaysia 20 years ago so it would definitely cause a lot of problems and this is all related to excessive leverage, a lot of it at the corporate level, a lot of it dominated in dollar, which is not the currency they collective their revenue in. A classic repeat of this search for yield and okay give me zero interest rates then get me yield. If I can lend money to Turkey for 8%, I’ll take it. Classic search for yield that is now causing a rethink and as I said earlier, a more discriminating view. (Inaudible33:43) Investors when interest rates rise, and monetary tightening picks up.

It’s like we keep repeating this same movie over and over and over again. Just some different colours and different acts the same underlying themes. Over and over and over again in the history of financial markets.

FRA: Yes exactly and we’ll end it there. Great insight as always gentlemen. How can our listener learn more about your work? Yra?

Yra: I blog at the notes from underground and all the podcast I’ve done with Peter, and Financial Repression Authority is a good way to get the discussion out there and I’m very happy to have this opportunity to do this because I think investors needs to hear about these things that you can’t just put on rose coloured glasses and oh earnings are forever and going up and it just doesn’t work that way. Peter just reminded us that things are changing and you have to be attentive to them and whether you agree or disagree, you have to put it into your quiver and at least have the knowledge of it because when these things happen, and it’s not that there not going to happen, it’s just everything else in life is about timing and understanding it. So I just push the idea of understand it so that what you will find in my blog, notes from the underground.

FRA: Yes exactly, and Peter?

Peter: So you may read all my work at the BoockReport.com and if you’re interested in asset management and other financial planning, and you can check us at Bleakley.com.

FRA: Great! Thank you very much gentlemen! Thank you!

Yra: Thank you Richard! Peter good talk with you!

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Disclaimer: The views or opinions expressed in this blog post may or may not be representative of the views or opinions of the Financial Repression Authority.

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FRA: Hi welcome to FRA’s Round Table Insight .. Today, we have Jayant Bhandari. He is constantly travelling the world to look for investment opportunities. Particularly, in the natural resource sector. He advises institutional investors about his findings. He also worked for six years with US global investors in San Antonio, Texas, a boutique natural resource investment firm and, for one year, with KC Resource. He writes a lot of a number of publications including liberty magazine, the MC Institute, KC Research, Acting Man, International Man, Mining Journal, Zero Hedge, Little Rockwell, Frasier Institute and many others. He is contributing editor of the Liberty Magazine. Welcome Jayant.

JAYANT: Thank you very much for having me, Richard.

FRA: Great. I thought today we’d do a focus on the plight of the emerging markets, and you have graciously come up with a number of charts that can help form the basis of the discussion. We’ll make these charts available through the link on the website. But, yeah, I wanted to focus on what’s happening in the emerging markets considering the trends in oil prices, in the US dollar, interest rates and what they have done in terms of investing in energy in particular, what they have not done is probably a better way to put it. Just wondering your initial thoughts on that to get the discussion going.

JAYANT: What happened, Richard, was that from 1995 onwards for almost 20 years, emerging … What are now known as emerging markets did grow very nicely. They have grown by about 100% between 2002 and 2012 according to one of the charts that I sent you. While this growth was an extremely good growth for the emerging markets, from the base that they were starting at, the problem is that the growth rates of the emerging markets have been falling consistently for the last 10 years. Now, if you pay closer attention to what’s happening in sub-Saharan Africa, the growth rate has fallen to only 1.4%. Now, when growth rate … Economic growth rate is only 1.4% and population growth rate is 2.8%, you actually now suddenly end up with a negative growth rate which is -1.4% per capital for sub-Saharan African.

Growth rates in the third world are falling and in case of sub-Saharan Africa it is negative now—while there is still 1.4% GDP growth rate, population growth rate is 2.8%. The net effect is negative growth rate on per capita basis.

Today, US 10-year treasury yields are inching towards around 3%. WTI crude has gone up from US$48 a barrel to US$68 today.

JAYANT: What also happened in the last 10 years was that, a decade back, the western countries adopted very easy money policies which meant that money managers sitting in London and New York suddenly found it very attractive to invest in the third world countries, which were now known as emerging markets despite the fact that the risks of emerging markets were extremely high. They invested a huge amount of money in Africa; particularly money managers sitting in London did that. This money, while superficially was going to generate good returns for them, they did not really take into account the risks associated with investing in sub-Saharan Africa. These people gave a lot of money in US dollar denominated bonds of African countries. They got a much higher interest rate from these countries, but the problem is that Africa suddenly finds itself hugely indebtness. African was indebted by only about 30% in 2005 and now it is more than 50%. The reason it was only 30% 15 years back was that multilateral agencies forgave a lot of debt that African countries owned, and these people have then, again, taken a lot of debt in the last 10, 15 years, and they’re now hugely indebted. What you also find is that a lot of this debt money that African countries raise did not go into investing in capital. A lot of that money went to deal with budgetary deficits. Then, if you pay closer attention to the investments they made in capital, you also see that a lot of that money was not invested properly which means that now that yields on American dollar is starting to increase the currency values of these third world countries are starting to suffer rather badly, and as a result, their stock markets are falling, their currencies are falling and these countries will face problems paying their debts again.

In 2005 the WB, IMF and ADB forgave debts of the heavily indebted poor countries, 30 of which were in Africa. These countries were growing very nicely during the same time. There was actually synchronous growth happening in the third world.

By early this decade, sub-Saharan Africa’s debt to GDP was 30%. This has now gone up to 50%. Given the past failures to pay, African countries pay higher interest rates. Then commodity prices started to suffer, there wasn’t enough revenue to service debts and the pace of borrowing picked up. Interest rates in the West were very low, which made it possible for increased flow of money from the West to Africa.

Fund Managers in Europe invested hugely in Africa, particularly in their bonds those denominated in US$.

Alas, this money went in to deal with budget deficits rather than in capital investment or in infrastructural investments. When money did go into capital investments, it was often squandered.

FRA: You mentioned the money managers in London didn’t look at the risks at that time, what were those risks at that time in terms of the emerging market risks?

JAYANT: The third world has a history of not honoring their debt payments, but every time there is a euphoria about third world countries, money managers in New York and London start thinking that the past is gone and the future is going to be different. Unfortunately, the future continues to be the repetition of the past which means that they keep giving money to countries like Argentina, Venezuela and countries in sub-Saharan Africa, and then the money refuses to return back to the western countries. These people including people in the World Bank, IMF and development banks around the world continue to lose money by giving too much easy money to these third world countries.

FRA: So, you’re saying the loans made during the last 10 years did not go into capital investment or infrastructure investments. It just went to pay yearly budget deficits?

JAYANT: Most of it, yes. If at all that money went into investing in infrastructure, it actually was mal-invested. There was a very interesting case of Mozambique in which a couple of billion dollars of money that was supposedly have gone through invest in government companies actually got mis-invested in good living of people in those companies. Yes, even the capital money that was invested in capital was mal-invested in many of these countries.

FRA: Given how the US dollar trend has been strengthening recently, as you mentioned, these emerging market currencies have been weakening, and so it makes it more difficult to come up with the money, with the dollars to pay US dollar denominated debt, is that what you’re saying?

JAYANT: Absolutely, and not only US dollar is improving, the problem is oil price has also been improving, so some of these countries that do not produce enough oil, actually not only have higher interest to pay on their debt, they also have to pay more money for their oil imports that they’re doing, which means that their currencies are suffering hugely.

The above means that along with falling growth rates, the third world is facing increased interest rates on dollar-denominated borrowings and are also having to pay more for oil, which can be among the biggest imports of the third world. This is happening exactly when the governments and people of the third world were expecting continual improvements in their economies.

JAYANT: I sent you some charts before our conversation started; Indian currency has fallen by more than 5% in the last few months.

The result: Oil importing India’s currency has fallen by 5% y-to-y. As the recent result of increasing yields of US$, foreign institutional investors have been net sellers of Indian stocks and bonds. This will continue exiting going forward as the days of easy money are now gone.

JAYANT: Turkish currency is in a free fall. It has fallen by 33% in the last one year.

Turkish Lira has fallen by 33% y-o-y.

JAYANT: Even Russian Ruble which has fallen fair bit despite that fact that Russia is a net exporter of oil and gas and Brazilian currency, which again, is a country that exports oil and gas fallen about 13% in the last one year. In fact, Brazil is currently facing a huge amount of problems in the country. My Brazilian friend who I was talking with yesterday was telling that his stores do not have supplies anymore, she cannot find gas anymore, she is not driving anymore in the last two weeks because they don’t really have gas at the gas station.

Brazil has lost 13% value of its currency despite that it is an oil exporting country. It is currently facing an emergency situation with truckers on strike. The stores have gone empty, vital supplies are not available, and gas stations have run out of fuel. As we speak Petrobras workers have gone on strike. Michel Temer, the centre-right President is failing to put things right.

Angola and Venezuela are failing to benefit from increase in oil price, as their exports suffer. Angola has aging fields.

As you can see in the currency graphs above, the fall in Argentinean peso, Indian Rupee, Turkish Lira and Brazilian Real has been most significant over the last few weeks exactly when US$ yields have creeped up.

Even the oil-exporting oil countries (Chad, Venezuela, the Middle East, Angola, etc.) can no longer expect oil price to continue to increase, particularly in the long term. They must restructure their economies.

FRA: Wow.

JAYANT: The hospitals have run out of supplies because truckers are on strike which means that nothing really is moving much in the country, and there is a fear psychosis that has gone into the minds of these people despite that this friend of mine is living in gated community in a nice part of Brazil. Now remember, Brazil is an oil exporting country. Despite all that, these countries, in the third world, are continuing to face problems because they did not really invest properly when the oil prices were low. Remember, they were very dependent on oil revenue, so when oil prices fell down, they did not really have money to invest back into the fields. They actually used up the profit of oil companies for other purposes; for their budgetary purposes, and now that the oil prices have gone up, the problem is that oil prices have gone up but they can’t really produce enough to generate the good cash that they were generating when oil prices were higher in the last decade. For example, Angola was producing about 1.5 million barrels of oil every day and now it has fallen quite a bit from that level. I think it’s close to 1.5 million barrels per day or even less than that today.

FRA: We essentially have a double win in terms of the oil price rising and the US dollar currency strengthening. I’ve read estimates there’s as much as 9 or 10 trillion in the corporate based US dollar denominated debt outside of the US. Is that your understanding and what will happen to this? What is the outcome or how do you see it play out?

JAYANT: Well, I don’t have the exact number with me, but the problem with corporate debt is that, if the US dollar continues to be strong and the money continues to leave the stock market of these third world countries, how are these corporate going to actually pay the debt that they owe the western countries? It will become increasingly difficult, and with oil prices increasing, inflation in the third world countries, particularly those third world countries that do not produce oil that actually import oil, inflation will kick in and the profitabilities of these corporations in the third world will suffer. The end result will be that, in my view, a lot of this money is actually not going to return back to the first world. Also, at the same time, and at least I know data of India, foreign institutional investors were huge. Net investor in the Indian stock market between 2017 and 2018, but in the last three months they have pulled out a significant amount of money out of India and the reason is exactly the same. The reason is that now is much nicer for them to invest in US dollar in North America so they’re pulling their money out of India. The consequence is not just that the stock market is losing money in India, but at the same time because India is losing US dollars, Indian currency is falling as well, and as you can see in the chart, it has fallen quite a bit in the last few months.

FRA: How are they going to address their budget deficits? It seems like it’s going to get worse, especially now with interest rates rising? The dollar rising more difficult to make loans.

JAYANT: Absolutely. I don’t know how they’re going to sort out these problems, but this is a traditional problem of the third world countries. They do not plan for tomorrow. They take as much debt as possible today and they use it up without actually worrying about tomorrow, and the western countries all consistently give the third world countries too much money without really understanding the risks involved in giving all that money. The end result is that the first world does not get its money back and the third world countries continue to suffer the problems they have historically suffered.

FRA: Now, recently Argentina ran into that similar problems and they received some guarantees or a bail out by the IMF, I think, of about $30 billion, if I’m not mistaken. Do you see that as the outcome in other emerging markets?

JAYANT: Well, look at Argentinean peso, it has fallen 40% in the last one year despite that fact that their new president is a pro-free market president, and he has been unable to control inflation in the country. He has been unable to control fall in the value of the local currency. You see the same in Brazil, the president of Brazil is a relatively low pro-market president, and the society has gone against him because he has been trying to implement relatively pro-market policies, so yes, you can actually give them a buffer again. The problem is that these societies are relatively socialistic societies; they’re culturally socialistic societies, which means that they have a tendency to always go back to normal, which is, situations in which they cannot actually pay back their debts.

Argentina continues to suffer despite the seemingly pro-freemarket President, Mauricio Macri. Its currency has fallen by 40% y-to-y.

FRA: What about the situation on the energy? You mentioned the money borrowed over the last 10 years could have gone into infrastructure improvements, especially focused on energy but wasn’t. If you can elaborate on that, how is the situation worsening with some of these, particularly oil exporting nations?

JAYANT: Well, look at Chad and Angola; they are two very interesting cases. Both of these countries have been facing fall in the export of their oil, and the reason is that when oil prices fell in the last decade from $150 to $50 per barrel, these countries because they had created government institutions large enough based on higher prices of oil, were unable to sustain the bureaucracy they had created with when the oil prices fell, the end result was that these people were no longer able to invest capital back into the fields that required capital that they must have invested in the oil fields, which means that they cannot actually increase their oil production now that the oil prices have gone up. But at the same time, oil prices are not going to go back to $150 anymore, and these people are structured to live on the basis of $100 per barrel of oil or higher, and the end result is also what you see in the Middle East, a lot of countries in the Middle East, look at Saudi Arabia, they are now in deficit situation consistently because the current price of oil despite being higher than what it was a year back, is unable to give them enough revenue to the government to deal with, to meet the requirements of the government, and they’re having to use up the money that they have saved over the last many years before the oil price fell.

As you can see while costs of wind and solar energy were the highest ten years back, on relative basis they have become cheapest sources of energy.

FRA: Could commodity prices in general go higher considering that oil is at the apex of the commodity stack, if you will? Could that happen even with the rising US dollar?

JAYANT: Absolutely. Commodity prices can certainly rise higher, but commodity exporting countries have basically … Is still not have to feel confident about being able to benefit from higher commodity prices because when commodity prices go up, the cost of producing commodities tend to go up as well because some of the costs of making commodities are costs like oil and other commodities. But also, if you look at what’s been happening in most of Africa, while commodity prices might have gone up, they have actually increased their taxes and they have made it extremely difficult for mining companies to profit from investing in Africa. I’m talking about virtually every country in Africa. The end result is that African countries have become very difficult countries to invest for mining. You see problems in Ghana, you have always seen problems in Zimbabwe, you have increasing problems in South Africa. Unfortunately, even if commodity prices increase, these countries are very likely not going to benefit from that.

FRA: Could we get a situation where with the rise in the interest rates in the US dollar, could we see a potential situation given the plight of the emerging markets whereby there’s an inflow or international capital flows from the emerging markets to the US equity markets in particular given rising interest rates not being good for the bond market. Could we see that similar to what happened in 1927 and 1929 where interest rates also went up and the US stock market also went up? This has been pointed out observers like Martin Armstrong, for example?

JAYANT: I’m not sure what influence it will have on the US equity market, but I certainly see, before our conversation, I was looking at the increase in yields, and it seems to me that part of the reason why US yields have gone up is because the yields have also gone up in the US, which to me is a signal and a symbol that US economy is likely becoming more competitive, and I can see the reasons why it is becoming competitive; regulations are going down in the US, the tax structure and as a result I would not be surprised if equity prices in the US actually continue to improve. If American companies can bring in money from outside the US; if regulations go down and the corporate tax continue to reduce and the filing of tax requirements continue to become less stringent.

FRA: Finally, what are your thoughts on where can investors protect themselves in this environment, or what makes sense in terms of generic asset class for investors?

JAYANT: Richard, I continue to like East Asia: China, Hong Kong, Taiwan, Singapore, Korea, Japan. These are very good stable countries that continue to grow, and there are places where a stock market tend to be rather cheap. I like these countries to invest in. I like gold because the third world countries across the border are suffering and wealthy people in the third world will continue to invest their money in gold. The end result of which is that gold prices will perform going forward. Remember, gold prices have done very well in the last 10 or 15 year timeframe in the last 10 years in US dollar terms, gold has gone up by more than 100%. I continue to feel reasonably good about what’s happening in the US right now.

FRA: Well, great. That’s awesome insight JAYANT, and thank you very much for the charts. How can our listeners learn more about your work?

JAYANT: Everything I do goes on my website, which is Giantbhandari.com.

FRA: Thank you very much Jayant.

JAYANT: Thank you very much for the opportunity, Richard.

Disclaimer: The views or opinions expressed in this blog post may or may not be representative of the views or opinions of the Financial Repression Authority.

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FRA: Hi. Welcome to FRA’s RoundTable Insight .. Today we have Charles Hugh Smith. He is an author and leading global finance blogger and America’s philosopher – we call him. He’s the author of nine books on our Economy and Society including A Radically Beneficial World; Automation, Technology and Creating Jobs for All, Resistance, Revolution, Liberation: A Model for Positive Change and the Nearly Free University in the Emerging Economy. His blog oftwominds.com has logged over 55 million page views and number 7 on CNBC’s top alternative finance sites. Welcome, Charles!

Smith: Thank you, Richard! Always a pleasure to join your program.

FRA: Great. I thought today that we’d do a discussion on what you actually wrote about recently: the tension between the public sector and the private sector. In particular, between public pensioners and the population that pays for that – mainly in the form of property taxes and other fees. This is happening all over North America – this growing tension. Likely to result in a growing pension crisis across the continent and also globally too. This is a global problem as well and just wondering about your thoughts initially on that from your recent writings.

Smith: Right. Thank you, Richard. I think it has been a topic that has that has been suppressed by the mainstream media because there is no easy solution. In other words, the authorities in charge of the pension funds have tended to down-play it by claiming they’re going to make it up from very high returns on capital and other kinds of peen less means but the reality that is now becoming visible is that the public pensions have to be funded at rates that require the cutting of public services. So, there is a seesaw here – that the more money that is put in to the public pension funds to build up their capital to minimum levels then the less money there is available for public services. It is a win-lose situation or a zero-sum game. You can’t find money for both. As the asset bubble economy that we’ve been living in for decade normalizes, or perhaps even declines, then this is really going to be a case where many municipalities and counties are going to be proverbial as time goes out and we’re going to see who is naked.

FRA: Yeah. I mean many of them have built-in assumptions of trying to get 7% to 8% yields in order to make stakeholder obligations but, as you know in financial repression, the repression of interest rates to low values has made it difficult to get yields. A big part of their holdings has been bonds. So, as yields have gone down, it has been made really difficult for the pension funds to meet their yield goals.

Smith: Right. And what has been their response? If you’re one of the fund managers, then you’re piling in to the FANG (Four High-Performing Technology Stocks) stocks, right? Piling into Apple, Facebook, Google and Netflix as the only way to get those kinds of huge returns that are required to keep the funds solvent. We know what happens. These FANG stocks are a tech-bubble that we’ve seen before in 2008. These pension funds are exposing themselves tremendous risks that are way above that of buying a 30-year treasuries or AAA rated corporate bonds, which is as you say, the normal haven for their safe positive return. They’re exposed to a lot more risk so they could end up suffering tremendous draw downs if bond yields continue to rise as we know the value of the existing portfolio on bonds declines accordingly. If the FANG stocks rollover and decline, then that’s going to hit a lot of these pension funds have counted no technology companies to make up for the low yields that you have described.

FRA: Yeah. There are already warnings on that in terms of what could happen otherwise or what could be their response. For example, the Ontario Municipal Employees Retirement System (OMERS), which is actually Canada’s largest defined benefit pension plan with about $95B in net assets. They actually put on their website that deficits will be funded through a combination of contribution rate increases and benefit reductions. They’re already warning that either they’ll be likely much higher property taxes or a cut in benefits to the actual pensioners.

Smith: Right. And maybe we can put some numbers behind these statistics and dynamics that we have been discussing. I have a couple of charts here that I submitted to you before we started recording and the first one shows that the taxpayer contributions into government pensions and that means public sector pensions has more or less doubled in a decade from $60B annually to over $121B and that is skyrocketing. The rate of increase is far above the rate of growth of the economy. In consequence to raise these sums, then municipalities, states and cities are raising property taxes and I have a chart here of King County which is in the Seattle Municipal area.

The property taxes there are up 43% in four years. Anecdotally, I just heard someone report their taxes in the Seattle area went up 26% in one year. That may have been local taxes on top of the other property taxes but 43% in four years, that’s more than 10% annual gain there. Most people’s wages have gone nowhere and I have a chart here that is dated a few years but nothing really has changed and it shows that the bottom of 90% when adjusted for inflation, the bottom 137 million households in the U.S. have lost income when adjusted for inflation.

So, the vast majority of households that are property owners are not making more net income here. They’re having to cut their other spending in order to pay skyrocketing property taxes.

FRA: Yeah. Exactly. You also have some other charts in here as well on how, on the other side of the fence, the government pensioners have been paying themselves very lavish pensions – awarding themselves which actually only makes the whole problem worse.

Smith: Right. This was a chart from a Sacramento article regarding the Sacramento area’s fire department’s highest paid pensioners and a number of these people are earning over $200 000 a year in pensions. A $200 000 income will put you in the top 5% of American households.

In other words, this is an extraordinarily high income and the number of pensioners in the state of California that earn over $100 000 in pensions annually runs into thousands of people. There is a sense here of great injustice. In other words, the majority of people who are paying property taxes have not seen their income soar by these extraordinary increases that these property taxes are going up by nor do they have pensions in a 6-figure range. So, it feels like exploitation to those of us who aren’t looking for $100 000 – $200 000 in guaranteed pensions. What this is doing is creating huge gaps in pension funding. I have a chart that shows an $18B gap in Calpers which is the largest of pension fund in the state of California.

We also see here that we have a chart of New York City pension contributions which soared from about $1B annually around the year 2000 and now it is pushing $10B.

So you’re talking about a tremendous increase and the rate of increase continues. In other words, this isn’t just a one-time bump up and then the pension contributions stabilized. They continue to rise at these rates that are four or five times the growth rate of the economy as a whole and also of wages. Before the program, you mentioned that if we extrapolated these trends, where would we end up?

FRA: Yeah. I mean in your recent writings, you mentioned that the migration to lower tax jurisdictions. Like when somebody is living in Illinois, they may move to Florida. Can you elaborate on that?

Smith: Right. Right. Just to kind of set a context here. The context of what we’re describing is that cities, counties and states are under legal obligations to fund these pensions at the rates that were promised to the pensioners and the only way out of those legal obligations is bankruptcy and many states have unclear laws regarding municipal bankruptcies. In other words, cities and counties in many states do not have a clear pathway to declare bankruptcy and the only way they can raise money to fund the pension plan is to cut public services. You’re hit with the double whammy. In other words, your property taxes and junk fees are rising rapidly. Meanwhile, your library’s hours are being cut, your police departments are being cut and the roads are filled with potholes that can’t be filled unless you pass a special bond. These places that are being crunched by these pension costs – the public is seeing a deterioration in their lifestyle. The local infrastructure is crumbling and there is no money to fund it because all the money has to go to the pensions. I call the people that are stuck in these areas tax donkeys because they’re loaded up with ever higher taxes and it is difficult for them to escape in many cases because of many reasons: kids are in school, family obligations, can’t quit their jobs, etc. So they’re really stuck but there are a very large number of people who tend to be high-income and are mobile. They can leave. They either are childless or their kids have already left home. They work largely in the digital realm so they can work from anywhere. These people are going to migrate and despite the claims of the status quo of politicians in these high-tech states like California, Illinois and New York that people don’t leave. They don’t leave if the services they’re getting keep increasing in quality and quantity every year. In other words, the past is not a good guide to the future because we’ve had an asset bubble based economy for the last decade. So, municipalities have been scoring huge gains in tax revenues which has allowed them to maintain services at a very high level and fund the pensions. Once there is a recession, that goes away then the public services are going to be slashed. So, people like New York City, San Francisco and Seattle but at some point, as homelessness overtakes their neighborhood, homeless encampments show up in their block, crime starts going up, property crime and theft starts going up, and all of that stuff. Good restaurants close because the taxes are too high for them to survive. All these reasons to stay in these high-tech areas vanish. Literally over night. We’re starting to see anecdotally articles from people saying why they’re leaving their cities, for example, Seattle. We’re seeing more and more of these so migration is difficult to track. We know that there is a leakage of population from California and other cities but what is not being captured is the nature of the people who are leaving and I think that if we could dig down those statistics, we’d find that it is the most productive in terms of paying high taxes. It is those people who are leaving because they are the ones caught in the vice. The people who are staying or who are left behind are the less productive or the people who make less money, pay less taxes and absorb more of the government’s services. We can discern a very destructive feedback loops starting now. This feedback loop will only get stronger as we finally get a recession in which the high tax payers are leaving for low tax claims and leaving the people who are depending more and more on the government’s services which are going to be slashed.

FRA: Right. It seems to be an emerging negative feedback loop as you’ve mentioned that is actually non-linear as these more productive citizens leave, then the ones that are left behind are burdened even more to make up for the loss. So it just gets worse in a non-linear way.

Smith: Right. I think that is an excellent observation, Richard. When we think about small-scale entrepreneurs that make cities livable and this includes restaurants, cafes, small theatres and services for the children and elderly and all of these private sector niceties are going to be under tremendous pressure as their customers flee. So they start closing or those people that try to start a new café or restaurant quickly find that they don’t or won’t make enough money to survive as their tax rates go up. I personally am in communication with a lot of people through emails throughout the U.S. where they’re small businesses and they’re noses are just above the waterline. In other words, they’re staying afloat but just barely. There is a huge number of businesses like this that create that non-linear effect that you’re saying. In other words, if property taxes go up another 10% and a recession causes a 5% decline in consumer spending in a city or a county, you’re not going to see a 5% decline in small businesses. You’re going to see a 30-40% decline. That is a huge impact because there are so many people that are right on the borderline. Of course, we can also throw in other factors in which we can be fans of and we can support minimum wage laws and these kinds of things but they’re accumulative. For the small business owner, it is like the property tax, any other junk fees and then the minimum wage increase, and then the higher health care. Each one seems to be something we believe could be absorbed but when you add up 10%, 10% and 10%, then suddenly you’ve got increases of over 40-50% in their fixed expenses and they can’t survive. I think you’re absolutely right that there is going to be an enormous non-linear effects as these feedback loops eke into the class that pays most of the property taxes.

FRA: And the idea that the pension benefits could be cut. What do you think of that? That alone could cause a lot of social unrest, right? – in terms of people not accepting that or not willing to accept those cuts.

Smith: Right. Well, we’ve seen some examples like the city of Detroit where there was a successful municipal bankruptcy and pensions were cut, what was actually sustainable with the existing pension fund? Of course, that created a lot of unhappiness in the pensioners who felt that they have been promised “X’ and were given half of X. On the other side of the coin, in regions like California, Illinois and New York that are dominated by public unions then the war that is heating up would be first from the public tensions and the public employee’s unions versus the tax payers and in the current arrangement, the taxpayers have very little representation in the local government. They don’t really have a voice. The unions have the political influence so they’re going to fight tooth and nail to keep the pension structure as it is. I think it will require a political crisis, either a tax revolt of some kind or the complete disappearance of all cash where the cities and counties simply no longer have any money. Their accounts have been drained and have zero money to pay people. Until that point comes, then I doubt that the status quo would change. I have a chart here based on Peter Turchin’s work about the disintegrative forces and he identifies integrative eras where people find reasons to work together and disintegrative areas where they find reasons to disagree. He plots this on a political stress index. This is what he calls it. So, what we’re talking about here in the public pension and private sector versus the tax donkeys, we can see the three of the key dynamics that Turchin identified at his work: One of is the stagnating real wages. As I said, for 90% of the workforce that is getting nailed with higher property taxes, wages have not gone up in years and maybe decades. Overproduction of parasitic elites and I think that whether you want to call the parasitic elites public or private, I would lump them all together. People pulling down enormous salaries at the expense of other people – that I think, no matter how you want to describe it, I would call that an overproduction of parasitic elites and the deterioration of state finances. We see that counties and cities have and are struggling now in the second longest economic expansion in history. A tremendous expansion in stock markets and housing values and this is the best of all possible times. If we’re seeing cities and counties struggle with budgets now, then you can imagine what happens when we finally get a real recession. Clearly, we’re seeing point 3 to deterioration in state finances. This dynamic that we’re discussing is definitely increasing the political stress index and it is definitely going to create severe structural, social unrest and social discord.

FRA: Yeah. Exactly. This is very interesting on Turchin’s disintegrative forces. There’s also that idea that as property taxes go higher, we begin to wonder whether you own the property and the concept of property rights comes into question. Is it the government owning the property and you’re just renting the property from the government when property taxes get so high? Your thoughts on that?

Smith: Yeah. I think that’s a great topic, Richard! Before we started recording, you mentioned the model that goes back even to the Roman era when Rome suffered these disintegrative forces that Turchin describes in which people simply abandon their properties. They walk away from it because the taxes are higher than they can afford. The property has lost its value because of this tremendous increase in the tax burden. In my view, places like San Francisco, Seattle and New York (Brooklyn) and a lot of other places, people have tolerated these rapidly rising property taxes because their homes have gone up so much in value. In other words, you’re talking about Seattle – a $500k house a few years ago is now $800k and we see these numbers. So, when you feel like you’ve made $300k in five years or less then you feel like you can afford another five thousand dollars a year in property taxes. But if that $800k house drops to $400k in the next recession, then all of those people are going to suddenly start feeling that it is not so easy anymore to make those taxes. Even more recently than the Roman era, there have been times where cities have gone into decay and this feedback loop that we’ve described and Detroit being a famous example, the value of houses fell to zero. Well, that is an extreme or caused by an extreme depopulation and so on but we have to remember that we’re not talking just about the total value of the home, we’re talking about the home owner’s equity. So, if somebody buys a house for a half million dollar and it drops in value into $400k and their entire equity is forty thousand, they’re now under water by twenty grand. They can walk away and they’ve lost nothing. So, it depends on the debt burden that each of these home owners has taken on. That’s how we could see that even these high value cities start having people jingle mail their mortgage because the property taxes are pushed to fifteen and twenty thousand a year. That’s just a standard in Northern California and many other high value places. As you mentioned before we started recording, there was a news report that one of the branches of the federal reserve suggested a one percent wealth tax on all homes in Illinois to resolve their pension crisis.

FRA: Yes. Exactly. Already I know someone in Illinois paying about 3.3% in property taxes. So something about fifteen thousand dollars per year, over a thousand dollars a month on a house that is approximately $450k in value. To add another one percent on that is a suggestion by the Chicago Federal Reserve to add a proposed one percent on property annually for the next thirty years to cover the pension crisis problem in Illinois. That was just recently proposed by the Chicago Federal Reserve.

Smith: Right. So that one percent – the additional $2500 a year – you can imagine as in a recession, there’s even more as we say in tax revenues start drawing up. The public starts rebelling against the cuts in public services then there’ll be another one percent suggested, then another one percent. This is a dynamic that you’ve mentioned earlier program. We can see the feedback loop here that as tax revenues decline in a recession then they have to raise taxes on those people that are remaining who can’t afford to pay those taxes. Another little dynamic here is that rents in places like Seattle are skyrocketing as well and from the property owner’s point of view, if their property taxes are going up by 10-15%, 20-25% a year, then they feel that there is no option but to raise the rents that they’re charging on their properties. It doesn’t just hit property owners. It eventually bleeds over and hits everybody in a municipality: renters and owners alike.

FRA: It’s interesting when you mentioned how the property values in Detroit went towards zero, this is also been observed by Martin Armstrong who sees Illinois following the exact pattern as the fall of the city of Rome during the Roman Empire era. What he mentions is that more and more people just walked away from their property. There was no bid. Illinois is the number one state that now has a net loss of citizens; people that are fleeing the state. Martin Armstrong writes that there absolutely no hope whatsoever in fixing this problem of a pension crisis in Illinois and every solution like the one from the Chicago Federal Reserve we just discussed will fail in the end. Martin mentions that the state also has colas? (30:24) which insanely increase state employee pensions by an automatic 3% annually regardless of the inflation rate. That’s how crazy things have become. Martin also writes that because Illinois does not have its own currency, it is then bound by the national international value of the dollar. Like Greece, if the dollar rises, Illinois is thrown into deflation. Its institutions are broken and will only be remembered by history. When you plot the actual population of Rome when it emerged, it is very interesting and the stock reality that applies to Illinois is that people could no longer afford to live there. They were forced to just walk away from their homes and the value of real estate went to zero. That’s what Martin writes from the analogy of what happened in history with the city of Rome. One thing to think about in that model is that ultimately, every government or state function, whether it be a city, county, state or federal, the government depends on the private sector to generate the jobs and the income that can be taxed to support the state and its employees. As a general rule, the government in the U.S. is surrounded by 20% of the workforce. It depends on the other 80% of the workforce to generate the taxes to pay the 20% state employees. If you strangle your private sector to where it is impossible to make money, it is almost impossible to start a business that is actually profitable. What happens is that you end depending more on a few large employers. The way that Seattle used to depend on Boeing and now it depends on Microsoft and Amazon. What happens is that these large corporations are also mobile. They are the epitome of mobile capital. They don’t need to stay in these high tax areas. They can leave. They can keep a sort of a façade corporate presence but they can move the 90% of their workforce elsewhere in the U.S. or in the world. Once you become dependent on these very large employers and they move, then your city is absolutely gutted. You go down the Detroit path. Detroit became far too dependent on one industry and a handful of corporations and I see this as extremely likely that Seattle and the San Francisco Bay Area are dependent on these leaders in the tech industry. Once they go away or move elsewhere, then the tax base is going to be cut tremendously because those are the companies that are creating the high income jobs that allow people to buy these over priced homes.

FRA: Ultimately, you see sort of a combination of that with brain drain and wealth drain.

Smith: Right. Exactly. The demographic, we didn’t really talk about this much, but as we know, millennials as a generation are already burdened with tremendous student loan debt and compared to previous generations, their earnings in their 20s and 30s is considerably lower than what was achieved by Generation X and the Baby Boomers. That question comes down to whether the millennials want to marry and have children, unless they’re both brain surgeons or CFOs of a company about to go public or somebody earning extraordinary amounts of money like a quarter million dollars each, that dream is not doable anymore in a lot of places. In other words, they can’t marry and have children, have a decent life and buy a house. Generationally, what we’re going to end up with is that we’re hallowing out these very high cost houses and we’re leaving the baby boomers and people that bought their homes long ago with a lot of equity but we’re putting a lot of incentive for younger families and households to leave because that’s the only way they can afford to buy a house and have a family.

FRA: Wow. That is great insight today from Charles on emerging pension crisis and the growing tension between the public sector and the private sector. Charles, how can our listeners learn more about your work?

Smith: Yeah. Please visit me at oftwominds.com and thank you very much, Richard! Always a pleasure

FRA: Great! Excellent. We’ll end it there and do another one next month.

By Karl De La Cruz

karl.delacruz@ryerson.ca

Disclaimer: The views or opinions expressed in this blog post may or may not be representative of the views or opinions of the Financial Repression Authority.

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Disclaimer: The views or opinions expressed in this blog post may or may not be representative of the views or opinions of the Financial Repression Authority.

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FRA: Welcome to FRA’s The Roundtable Insight .. today we have David Rosenberg and Yra Harris. David is Gluskin Sheff’s chief economist and strategist with a focused on providing a top-down prospective to the firm’s investment process and asset mix committee. He received both a bachelor and Master of Arts degree in economics from the University of Toronto. Prior to joining Gluskin Sheff he was chief North American economist at Merrill Lynch in New York for seven years during which he was consistently ranked in the institutional investor all-star analyst rankings. Prior to that he was chief economist and strategies for Merrill Lynch Canada based out of Toronto. He is the author of Breakfast With Dave a daily of distillation of his economic and financial market insights and I think now there’s espresso with David also that’s out. Yra is an independent trader, a successful hedge fund manager, a global macro consultant trading in foreign currencies, bonds, commodities and equities for over 40 years. He was also CME director from 1997 to 2003. Welcome gentleman.
DAVID: Thank you very much.
YRA: thank you Richard, this is a great honor for me, thanks.

FRA: yeah, it’s a great honor for having David on our show, first time and I thought we’d begin with some of David’s recent thoughts. You recently wrote about how Canadian equity markets go higher even US markets go lower as a hedge against inflationary pressures. Can you give us some insight on that?
DAVID: Well sure, it’s not even an opinion it’s a fact in a sense that it’s happened so many times in the past and most recently in 2007 and in 2008 as the US market went down 20% in the opening months of the … market. The Canadian market was up 20% and of course, then the wheels fell off when it turned into a global near depression after AIG and Lehman collapsed. But it’s because the Canadian market being so exposed to the commodity cycle and energy and there are so many other sector correlations with the resource sector and the resource sector is classically psycho value. The SME of 100 is because the classic growth index, Canada doesn’t have much in the way of healthcare exposure, doesn’t have much way in a technology exposure. These are there groppy aspects of the US market that’s kept it alive and well for so long. Either you’re buying on the premise that we are entering into the late cycle, I think there’s a lot of evidence and if it late cycle then it’s value over growth and then if you’re talking about stylistic investing value over growth you have to understand if you look at North America Canada is deep value in terms of sector representation. The US is much more growth oriented. I look at it not just from historical experience in terms of late cycle investing but just looking at evaluations. The Canadian stock market right now trades at a forward multiple of a 14.7 times the coming year’s earnings estimates. In the United States that number is over 16. I look at some other benchmarks as well in terms of valuation matrix and wherever there’s been a day that the Canadian stock market has been this inexpensive relative to the United States.
FRA: Yra have you seen that type of behavior in the financial markets in in your trading?
YRA: It’s interesting to see David and having read his work for so many years. Mine doesn’t take that type of analysis. I will read that and put that into my thought process but then I have to ask, David, about yesterday when to governor Palu speak and his concerns about that their Canadian personal debt levels were elevated and she’s like the bank of Canada is worried about them. How would that play into that scenario? That’s the question that would arise from the way that I would analyze this. I’d like to hear David speak to that.
DAVID: Right. I think that as far as I know the only central banker that is talking insistently about debt exposures and sensitivities and fragility is the Bank of Canada. I guess that’s partly because there’s no real bubble this time around in US household balance sheet. I would argue that even letting out the cash, we have some sort of a bubble in the US corporate balance sheets. Debt worldwide looking at governments, we all own this debt. We can say this … debt in US household balance sheets but the government debt, if we look at corporate debt, household debt. We’re in a situation now where globally outstanding debt in all levels of society is 164 trillion that’s with a T trillion dollars. We’ve already taken out the previous credit bubble peak of 2007 and half that debt and it might not be households in United State system, this time around. We’re get to a government debt bubble I’m sure looking at the future fiscal situation in United States half that debt is in Japan, China and the US. Basically this is a global situation, we just happened to have an honest central banker in Ottawa talking openly about it. He’s basically saying that this is actually one of the risks for the Canadian economy. We have NAFTA risks, we have really an incoherent energy policy to ship the oil out of Canada at the present time. Hopefully that’s going to change. We have divergent tax policies. All that is true. The Canadian economy even with the community boom is destined to underperform the Unites States economy. Of course we don’t have fiscal stimulus in the tax side that the US has so that goes without saying. You see that’s from my economics perspective and then when you put in a strategy a heart, what do you see? Well you’re on the correlations and you’ll see that the Canadian stock market, the TSX does not have that much of a correlation with the Canadian economy, believe it or not. That’s because most of the companies in Canada are truly global in nature. Even the Canadian banks, so you’d been thinking wow the Canadian banks, how much would be exposed. These are giant multinational corporations. You have banks like the bank in Nova Scotia that had a branch in Latin America before they ever had a bunch in Toronto. Going back a century or more. You go along the whole eastern seaboard in United States all you see are those green comfy couches from the Toronto dominion bank. You see what I’m saying basically is that the Canadian stock market has a much more torque to the global economy than it does to the Canadian economy. It doesn’t mean that there’s some special situations or some consumer cyclicals or consumer discretionary stocks that are relayed back into Canadian domestic demand. I will way suggest to stay away from those. I think the energy stocks here, McTaps are priced very attractively and I have nothing to do with the level of Canadian debt on the household site. You have a lot of Canadian companies you see if the bank of Canada hadn’t been keeping interest rates below the US and right now there’s a big negative interest rate spread. Look at where oil prices are right now. The Canadian dollar should be at 85 cents in quotes, should be but it’s not, it’s closer to 78 cents. Well there’s a lot of Canadian companies that have very high at us dollar revenue streams that we’re going to benefit immensely from this ongoing shall we say surreptitious policy in Ottawa to keep their Canadian dollar depressed. Something that doesn’t manage to make it to Donald Trump’s tweets is where the Canadian dollar is relative to the US dollar but that benefits a lot of Canadian exporters.
YRA: You think that that’s an active policy out of Ottawa that’s extended to central … heavily involved in that. Believe me I believe that … Certain as I can look to see what the Australian … When the RBA issued its statement the other night they all target currency whether they do it in the open but when you talk about the strength of your currency and your reason to keep interest rates on a hold … I understand the G40, I understand the G7 but if these are active policy then of course it gives leverage to the Ross Navarro Lighthouse Group about what countries are doing. So you think that that’s an act of policy approach from Ottawa?
DAVID: Well look there’s nobody that … Especially the central bank that’s going to come out and tell you where they would like to see the Canadian dollar. They’re not going to say directly. I think your comment before is right. I think of Steven Mnuchin’s comments in Davos which I believe he made on January the 24th which was like two days before the stock market peaked. Talking openly about the wonders over having a cheap us dollar. The trade weighted US dollar index is dominated by the euro and in the euro really peel back over the course of the past couple of weeks. I never really understood why I thought about 125 to begin with. The reality is that for Canadians what the Australian dollar does if you’re trading aussie currency you do business in Australia that’s obviously important but for Canada over three-quarters of our exports go to the US so that’s what really matters for the Canadian economy and for Canadian profits is that particular relationship. Maybe it is off the radar screen. You can’t have it both ways. If you’re going to have a situation where Donald Trump’s spray team and his NAFTA team creates this air of uncertainty. Nothing has happened yet and maybe we don’t get this solved until later this year if at all. What it does in Canada is it creates this cloud of uncertainty and when you’re uncertain because don’t forget if you’re setting up shop in Canada you’re not really just setting up shop as a business to service 35 million Canadians, you’re doing it the service 300 million Americans south of the border, that’s where the big market is. If you’re going to create a situation in Washington where you’re going to put this cloud of uncertainty over your chief trading partner called Canada you don’t get business investments. Business investment stays in the sidelines. Without business investment you don’t get a lot of growth, you don’t get a lot of employment. Nothing is zero in Canada but the economy is being held back by this air of trade uncertainty that is something that Canadians have imported from the United States. We didn’t start this whole thing, we got to renegotiate NAFTA. What that does is as the Fed raises rates the bank of Canada just says we’re on hold basically because we are frozen in time here for a variety of reasons. Stephen Poloz has mentioned several times that NAFTA uncertainty is part of it. What’s the … going to say? You’re deliberately keeping interest rates below where they are here and they’re artificially depressing the Canadian dollar. The Canadian government will say we’d rather not do that but because you’re creating this air of uncertainty because Canada is a much more intense export-oriented country than the united states is so NAFTA matters infinitely more for our economy than those in the states so naturally we are going to keep rates below and keep the Canadian dollar artificially below until something changes. We successfully renegotiate NAFTA, then that could all change. There is a method behind the madness whether or not it would ever be openly admitted. It’s funny because in the last policy review, the Bank of Canada just came out and lament about Canadian competitiveness. How our non-energy exports have lacked far behind what their models would say. That is code for we’re comfortable actually from a policy perspective having the Canadian dollar trade at competitive levels to make interest rates… or it should be for an extended through a period of time.

YRA: the amazing this is, and I am long term bullish on the Canadian dollar. First of all because, if we go back to the great financial crisis, for lack of a better word. The Canadian banks were certainly low capitalized. They did not suffer because of their lending risk. Their lending practices were so much better than the US banks probably by design. Number two there’s never been a quantitative easy program in Canada. There’s no quantitative easy program as Peter Boockvar would say. You have to go to quantitative tightening. I mean overall the underlying fundamentals to the Canadian financial system, yes I know they got a little bit of a bubble because they’re achieving rates over than it should be by regular market signaling. I think Canada is very well positioned. Once they work through the points that you just raised.

DAVID: I agree with what you said but, I think that we really do have to complete the analysis in this sense because, there are some fundamental reasons why the Canadian economy is being held back. There’s a fundamental reason why a lot of capital investment has been deflected away from Canada. There’s a reason why the Canadian dollar is trading about seven cents below any semblance of equilibrium value. Still on the other side of the equation, we have … You could say well the United States is blowing its brains out on physical policy. Well that might be true. But for the here now, for the first time in decades, the net effect of corporate tax rates in the United States is lower those is in Canada. In Canada being the junior partner and younger brother, we have to have compelling reasons for companies to want to set up shop here. We have to have lower tax rates here. We’re not a price maker on tax policy globally. We’re a price taker not a price maker. It was disappointing that there was no reference outside of one sentence to any response to what happened in the United States. Vis-à-vis at least the corporate tax situation, and then you layer on the accelerated depreciation analysis. If you’re a North American company right now, you’re incentivized to the taxes from right now to book your revenues in the United States which means that’s where the employment and investment are going to be directed towards at the expense of Canada. We have diverging fiscal policies point number one. We don’t have a coherent energy policy which is a very big problem. Hopefully that could change, but that will take a lot of political will, especially at the federal level. On top of that, we do have the situation where consumer balanced sheets are over extended. How that plays out. Of course you do have overextended housing markets in Toronto and Vancouver, which is not 100% of the national market, but it’s still 35% of the national market, and that’s not exactly trivial. I would say that there are some constraints. There’s all this sort of things that is on the bank of Canada’s radar screen, they’ve talked about it. There’s still some I would have to say, you could argue that there are unresolved issues in the United States as well. There’s at least as many if not more can at the current time.

FRA: What do you think of the rising US dollar as a recent trend? Is that going to take place for a longer period of time or … Is it related to the nine trillion and overseas US dollar the nominated corporate then?

DAVID: Well I think that it’s … It’s this classic economics 101. It’s the country that is tightening monetary policy, and the country that is using fiscal policy is usually the country that has the stronger exchange rate. That generally comes through in relative industry differentials. To me the big surprise for the past year, up until the trade weighted dollar starts to really turn around, it’s Back to where it was the first week in January. There was a time where if you looked at the yearly trend in the US dollar, just in the opening months of the year was down roughly 10%. That was really what would go against any macroeconomic textbook would tell you where the currency should be going. Then there was the other side of the argument which is that we have this band of trade protectionist in Washington. You have a president who his whole professional life and now carries it inputs his political life has always made [unintelligible] the current account deficit is his modus operandi. There’s another side, another side to the equation that well, if United States is going to ever want a really balance its deficit, well it’s going to have depreciate it’s currency 10% which is exactly what happened. I think that as this comes down to the old market refrain that you typically get the currency that your president wants. It was no secret that president Trump, would have preferred to have a weak currency that boots exports. I think what’s happening now is this realization. The Fed futures contracts are pricing in more fed. You’re seeing in the UK Mark [unintelligible] is peeled back. The ECB has more less gone quiet. The BOJ is not going to be doing anything. The Bank of Canada the view the beginning of the year was that they were going to raise rates several times. The only central bank it seems right now that’s in play in terms of raising rates is the Fed. I think that’s been part of it. You’ve also seen … Although the data flow in the United States has not been very impressive. I can’t do summersaults over 2.3% GDP growth the same quarter that we got. The fiscal stimulus. Be that as it may it’s the old saying about, in the land of blind the one eyed man is king. I suppose the US with 2% growth is the king, because the data in the UK have been very weak. The data in the Euro zone in particular has been extremely soft over the course of the past few months. I think there is this view on a relative basis that these interest rates differentials are going to work in the US dollars favor. Even more than people thought a couple of months ago. I think that’s a starting to finally come through in the currency markets.

FRA: Yra your thoughts.

YRA: Well, being a currency trader for over 40 years, and I’ve written about it for the last year. … The dollar, there’s fiscal stimulus coupled with interest rates differentials, and how the central bank is raised their rates when nobody else is, sure as David directly says. There’s always been the backup to a stronger currency and where was it. I of course … I agree with it because, I go back to that when Trump was having all the manufacturing, CEOs at the White House back in January February 2017, and Mark Fields who was then the CEO of Ford comes out and immediately calls the currency manipulation the mother of all trade barriers. Well that’s evidently what got discussed at the White house, and that Trump [unintelligible] the euro moved from 106 pretty much history line all the way up to 125, 126. Which bothers one mind because … I’m not one who accepts the European growth story willy-nilly. I think that’s a lot of nonsense to me, I say that for many reasons. The missing dollar really has caused a lot angst to the market, a lot of large hedge funds had miserable years trying to make that trade. I stone cold agree with that. I think now that we’re getting a little more maturity and some more negotiating tactics, there’s no question in my mind that guys like Robert … and Ross Mnuchin, I’m not sure what to make of … Certainly the Navarro they will use the currency as leverage. Trump especially accepts that. It’s interesting David say that the president gets the currency that he wants eventually. I think that’s is true and now I think the market is just … It’s just liquidated in some of the short dollar positions and trying to work through their way through this, this understanding with the dollar differential, the interest rate differentials. Certainly favors the United States and now we saw … with a phenomenally devilish press conference last Thursday. I think the ECB would relish nothing more than the weaker euro. That gets a question I … My favorite train would probably be long gold and short all the fiat currencies, not necessarily the dollar expression because interest rates to the US of course are now … We can argue what are, but they’ve at least going to a real yield. I don’t think there’s anywhere else in the world of the main developed nations where you get a real yield, on your short of interest rates. I think at least the dollar will hold here barring any type of any misstep by the US administration.

DAVID: I’ll just add further that. Look at where the two year note is trading right now at two and a half percent. Then take a look and see where a two year German bond is trading at -0.6. You have over a 300 basis point gap. Not even taking out any real duration risk. Like coming to the front end of the US seal curve compared to we’re in Germany. That spread is widened out, you asked me what’s changed. If that spread is widened out in Americas favor to the tune of 40 basis points just in the past three months. I think that’s really what caught the raider screen a lot of FX traders and why the US dollar starting to come back to life there.

YRA: I agree and plus, in saying that because I know a lot of traders who … They would buy, well when you thought the Euro was going higher, they would do these as unhedged decisions because there wasn’t enough in it. Because if you put your hedges on, by the time you do it wasn’t worth doing. Now, there’s enough meat on that bone to do those things and still being able to hedge a position who wanted to generate a much greater return than you could have as David talks about. That 40% rise in the differential I significant to attract people’s attention.

FRA: In terms of volatility David why do you think markets have been more volatile this year versus last year?

DAVID: Well, where do I begin? I think that we are in a … Last year in some sense was easier from a policy perspective. Yellon … continuity from Ben Bernanke. Markets are very comfortable with her. We didn’t really know what to make of what was going to happen with healthcare reform. Obama care form that didn’t go through. Then moved on tax reform, that gave momentum and the administration of congress at the home run by the end of the year, but that increasingly was getting priced in. I guess that when president Trump talk about how governing can be complicated. I think this year is a lot more complicated. A lot of the good stuff that happened in terms of the deregulation, in terms if the tax release, that’s behind us. What’s ahead of us now are the other parts of the election campaign. Which is more problematic or certainly provides a lot more uncertainty for investors. It relates … We weren’t talking this much about trade policy last year. We weren’t talking … We all knew it was part of the election campaign, but we were told take the president seriously not literally. I think that people didn’t really take it too seriously, maybe they should have. Now we have trade, we have tariffs or the threat of tariffs on steel and on aluminum. And on… dairy farmers. Acrimonious talks at least at the outset of NAFTA. What’s happening on the China side, the European side, exemptions here and none exemptions there. We’re in a much more uncertain global trade environment. Who know when that’s going to get resolved or with the other. DC markets will react at the merchant to not just change but the prospects for change. Because everybody that manages money for a living, is ultimately not just a manager of investments but a manager of risk. The risk on global trade has changed. It’s changed in the way towards cost push inflation, when we’re already late into the cycle. We have that aspect to it. We can talk what heightens your political risks, but …heightens your political risk, they always seem to be around. I think the situation on trade, is fairly serious in terms of what it means for the market multiple. Because the market multiple basically, and that’s the story this year. The story this year wasn’t earning, the story is the fact the multiples has compressed. The multiple is the inverse of uncertainty. Actually I think about the heightened volatility. That’s part and parcel of the inverse of volatility. We have a lot more volatility because we have less liquidity, and we have a more generally uncertain environment. Upon the liquidity for the federal reserve in a second because I think that’s big part of it. Because the fed has to respond all of this. We have policy over here, creates cost push inflation, that’s definitely happening. We saw that in … report before that the Philly Fed survey. We are looking at this hard and soft data. You’re seeing cost push pressures and a lot of it is because of the shift and the trade situation. Look at the fiscal situation too. I don’t think anybody is anticipating, we’re going to go for $500 billion deficits which are high enough as it is to over a trillion dollars. I say that today when the treasury comes out with this free funding announcement. I think the market was speaking about corporate tax reform was a good thing, but they were thinking that the government would lower the rate but broaden the base, and that never happened. The base didn’t get broadened, there’s just more bills and whistles then we cut taxes to households, and then we put an extra few hundred billion dollars on spending just on top of that. I don’t think that investors were looking at trillion plus dollar deficits as far as the eye can see. Of course at a time when the fed is striking its balance sheet. Creates a situation where bond yields go up and interest rates are basically a very powerful valuation determinant for other asset classes. We’re going to interest rates backing up for a variety reasons. One of them is the shift in the fiscal landscape. That’s another reason why we got a more volatile environment. Is because and is reflective of the [vecks] being 60% higher this year on average than last year. Is because of the uncertainty on trade, the uncertainty on fiscal, in terms of deficit finance tax cuts. Not tax cuts funded by spending constraint. It’s funded by higher deficits. The bar market maybe having trouble with that, then that will come back into the stock market as we’re seeing with the lag. Then on top of that … responds. I thought it was actually very interesting. The view back in the fall of last year was that … was going to be just a clone of Janet Yellon, different gender, no Brooklyn accent mind you, but they just … this is a new … Not just the Fed chairman but the whole voting membership of the [FMC] is totally different. It is a more a … fed. You saw it right in front of your eyes. The first meeting, what does [Powel] do? Raises rates. Not just raises rates, raises the growth forecast, raises at the merge and the inflation forecast, raises actually at the margin his estimate of where the neutral funds rate it. That’s all in one meeting, and was already after the stock market had officially collected 10%, and we’re going through tremendous fluctuations and volatility. He doesn’t come out and say, by the way this is going to cause us to take down our forecast and move us to the slide like. It’s quite the contrary. We’re going to actually have to do more at the margin, and we actually raised our forecast. It’s for our firm believer, that the physical boost is coming down the pike even though we somehow missed a good part of another first quarter. He already proved his medal that, he’s not going to come to the investor. He’s not going to come hold your hand because the market rate is 10%. … Bernanke certainly would have done that, Yellon probably would have done that. Here we correct 10% first movers, hike interest rates? I think that for an investor, you don’t have a central bank watching your back than you had in the past of five, 10 or even 20 years. I think this is all being reflected in the shrinkage of the market multiple, to reflect the fact that the times are changing.

FRA: Right, your thoughts Yra also.

YRA: I wrote a large piece where I quoted … My daughter actually works at Bloomberg. She used it in a radio spot that she had done for Bloomberg, that the Greenspan put was kaput. Because you could hear it in the language, when … and others started talking about that … that there was a shift and that Powell had definitely had control over this fed and no others. Because usually you would get some dissonance but there’s been no dissonance. It’s like he wait it out to look it. I can’t be at odds with you there’s certain shifts here, and they all could hide behind the unknown of how that physical stimulus will pay out because we just don’t know. With higher interest rates, will that totally eat whatever benefits were coming from the fiscal stimulus? I’m a big believer and I think J. Paul is much more market oriented. We saw that going back to what David said. If we go back to the late January, early February, there was no, no comment from the fed when the market was down 10, 12 13% in those few days, that they were all worried about it. In fact it was basically stay the course which was what a breath of fresh air that is because, I think the central bank is reacting to markets. At every major reaction is a terrible thing. I thought that back in May, June of 2013, I thought Bernanke made a terrible mistake with the temper tantrum and immediately reacting. He should have stayed there of course. I think we would have been in a much different place and much better place. I was not a …policy to begin with. The more I see and the more that he has more respects for markets the more I respect him and … does have control of the spread at this time. I think David’s point is that …voting change we are getting a more hawkish, even guys like Cash … who’ve been just ridiculously devilish with comments at times are known falling into line even though he doesn’t vote. But it’s amazing I would think that he would think more … speak without a vote. His language is much more leaning towards a heated dichotomy … But certainly not us devilish as he previously was so I think that point is well taken.
FRA: Overall David do you see stagflation in the global economy or in maybe in certain regions?
DAVID: Well I mean I’m seeing notably in the US market and I wrote about it today in my daily and if we are going to define it as rising inflationary pressures and soft growth, I think that we have it. If the ISM yesterday for example, you’re taking a look at the dressing index or was it a price level in 7 years. The past couple of months the vendor delivery delay index which used to be a favorite at the fed going back 20-30 years ago that’s been over 60 now for the past couple of months. Extremely elevated backlogs at a 14-year high. We’re getting some real serious bottlenecks in the economy, there’s worker shortages across number of sectors especially in manufacturing and in transportation related areas of the economy and we’re starting to get some such shortages of materials and that’s one of the things I’m saying that’s caused part and parcel by the growing spectra of trade frictions and tariffs and so on top of what you’re seeing on the energy side which of course is a different story. We are getting a culmination of rising wage pressures, nothing that is dramatically accelerating but moving up and moving up faster than it has been in any other time of the cycle. As we saw last Friday with the employment cost index which is actually once again everybody focuses on average early earnings. The employment cost index I remember the day when that was actually the Fed’s preferred measure, nobody wants to talk about it right now but it’s growing at its fastest rate. Since we’re in the last cycle before the recession so we have rising inflationary pressures on the material side on the labor side and I’m not seeing escape velocity in the economy I think all were going to be left with, with this fiscal stimulus, I’m not talking about the corporate tax reform aspect to it, that was necessary and I was in favor of that. But a blowout on the fiscal side really is going to be … domestic fiscal deficits. Which are going to be a dead weight drag on the economy for years to come. I’m really quite astonished at all the supply siders out there that think that this is actually the fiscal stimulus part to this thing was what we needed. Quite to the contrary, they’ll be a big price to pay in terms of losing fiscal flexibility in the future as a result of what’s happened over the course of the past several months. Congress put that aside though. Yes I’m seeing that the economy disappointed. Look we went into the first quarter, the Atlanta fed was calling for 4% growth we got barely above 2. In our strip out inventories and net exports that GDP number in the first quarter what you call real final sales to domestic purchases which is a real key underlying number on what’s happening to the demand guts of the economy excluding the foreign sector, excluding stockpiling and it was 1.6. I remember the days we got a 1.6 unreal final sales will be talking about around is there recession around the corner? People seem to think that’s a good number today I guessed we’ve readjusted our definition of actually what a good economy is. Then in looking at some of the anecdotal data flow like the ISM index and some other numbers of the sector quarter I’m not seeing much of a list so they view that the first quarter was just a weather report I’m not so sure about that. I’m not seeing the economy right now is growing and my opinion and rather temperedly and we haven’t seen the full impact of the fed rate hikes and the balance seat adjustment hit the wheel side of the economy or the market just fully or at least just not yet. Inflationary pressures are rising. Well people come back to me and say well you’re talking about stagflation yes and then people naturally go back and say what about the 1970s? No we’re not going to go back from where bill buttons were not going to go back and listen to the [Gs] all day long. It doesn’t have to be like the 1970s just like when people … If I talked about a bubble, people say well it’s not the banks and it’s not … it’s not always about the banks it’s not about household balance sheets there’s different accesses. People say they … stag inflation because they think it only happened in the 1970s but a stagflation is strictly defined as soft growth and rising inflationary pressures. We do have that in our hands right now I’d say we have a mild case of stagflation by the way again what is one of the great edges or ways to benefit in that environment is to be really long tooth specific sectors. Energy stocks are a great hedge against the inflationary aspect of it and financials.
FRA: Go ahead Yra.
YRA: With everything that you discussed does the US cover at this time. I know I have to put into the fed because all the signaling mechanisms that we’ve seen over my life in this business. in 41 years and I’ve looked at the yield curve as such an important indicator for so many years I’m not sure what it means in this but with all these consulates of debt, of course rising. We go back to the IMF and the number you … is 164 trillion but especially in the US with growing and I know I know this kind of funded on the short end which I would argue is probably a bigger mistake. But why should this curve be flattening at this time? Is it because the fed is being too … Or the market deems it to be too aggressive or is it still the impact of the QE from whatever the numbers are out of Japan and of course Europe we know those numbers that they actually exceeded it in April. Does that bother you at all David?
DAVID: I think that is … I’ve never really seen a fed tightening cycle fail to tightening the yield curve. Their two-year note is really sensitive to one thing and one thing only and that is fed expectations. You get out the longer end-of-the-year curve, say 10s of 30s and then there’s are confluence of factors between the term premium and real interest rates and replacing expectations. The longer you go in the curve, really the more complicated it is. Inflation expectations certainly have risen but they’re barely more than 2%, they are not rising other control. I mean they have risen. But then again the 10-year no yield is sitting close to 3% it’s not as to war 2 and a half anymore. The fed has already raised rates worth 150 basis points so far. Normally when they raise interest rates and you get towards this more mature phase of the tightening cycle the carb tends to flatten pretty dramatically. I’ve always talked about the yield curve. I’ve been in this business over 30 years and I’ll tell you that I always talked about the yield curve as a great leading indicator. I was screaming from the mountaintop when I was at Merrell back in ‘06 and talking about … Sorry.
YRA: That was great work…
DAVID: The thing is that the question I got … I would bring up the old cards at meetings and I’d talk about the meaning of the inverted yield curve at meetings and I would explain the yield curve at meetings. Today I go to a meeting and the first question I get is what do you think of the yield curve? All the business TV stations all about the yield curve. All the newspapers talked about the yield curve I’m starting to think because I have a real … that may be for the first time in 50 years the yield curve is not going to matter because it comes down to Bob Ferrell’s rule number 9 when all the experts in the forecast agree something else is going to happen. We may end up getting … The first time we get a recession actually without the yield curve having to invert. Remember other things were happening, the Fed where we have large scale deficits they may well be that and I think you’re right. They can’t fund 1.3 trillion dollars of gross new treasury born this year at the front end of the yield curve. Maybe the fact that they flooded the front end is why the yield curve was flat, maybe it re-steepens. I don’t know, it’s hard to really make book especially looking globally at the extent to which the central banks have added on so much duration to the balance sheet. That does the yield curve have the same meaning that it used to. I’ve changed my focus towards more of the general level of interest rates. Does the yield curve really matter? Let’s look at the United States. 47 trillion dollars of outstanding debt at every level of society. At the peak of the last cycle in 2007 it was 30 trillion. It’s gone from 30 to 33 trillion to 47 trillion. We’ve actually just blown out the peak of the debt level that defined the end of the credit cycle of 2007 by multiples. It actually boggles the mind. I actually never would have ever thought it could happen. I thought we were going to go through a real deleveraging cycle and in residential mortgages you could argue we did. We certainly didn’t do it with student loans or subprime models or autos in general certainly corporate balance sheets are extremely bloated. Look at the government sector commercial real estate. You can point your finger but I think it’s going to be more and especially a lot of high yield debt investment-grade debt, the leveraged loans, a lot of the stuff we’re going to be going through a master refinancing campaign in the next couple of years at higher interest rates. I think what happens if we aren’t going to get a default experience we’re going to get rice delinquencies. This isn’t so much a situation as to what it means in the banking sector at large but really the big bubble and this is true in Canada as well as in the non-bank financials that funded this thing. I don’t think the U-curve matters that much. I think the general level of interest rates and the powerful impact it’s going to have on debt servicing cost and the strains that come from that as this mountain of debt rolls over it’s going to be I think the real critical factor and so we might not even have a yield curve inversion putting the economy in recession this time it will just be that interest rates across a spectrum rose and created a tightening in financial conditions along the way.
YRA: Listen if there’s any buyer strike to us debt going on, we need greater premiums. It could happen and that’s why it’s very hard for me as being a … I love the work going back to ’06. I was a client of Merrill Lynch. I had a lot of … at the time. For me so I paid very close attention when you are rent because I’m a big believer in yield curves. I’ve done studying these for … I have a study that … going back 30 years so I pay attention because I’ve got the scars to prove being wrong. I go back to the UK in late 80s early 90s, I sat through 4 interest rate cuts and lost nothing but money I was low on guilts. The guilts keep going lower and shorter. I’m taking about futures prices. They kept going lower. I said how can this be happening? I learnt and bother to study I said I am missing something here. The guilts should have been rallying of course it went the other way and it really made me very aware of how these yield curves can move in ways that you won’t even think about. I’m paying close attention here, I think you added quite a bit. I remember in 2006, 2007 when they had 210 US curve actually voted 26 basis points which was very telling and then of course … Able to really time this what the lug is before when it comes because of course the SMP is one. … New heights. It was really matter. It does matter as you point out. That’s a great discussion I appreciate that.
FRA: Just finally your thoughts David on what have asset classes makes sense. How can the investors position themselves no specific names of companies or securities but generically your thoughts?
DAVID: Well look I think have to … I was saying that the theme for this year was its time to be the students not the teacher. In other words instead of trying to call the market why don’t we just heed the market message and I think that’s really important because the market is giving us a tremendous amount of information, a lot of it came down from when the early question about volatility. The extent of the volatility and the extent of the back-up and interest rates at the very front end of the yield curve is telling you something very important for the coming year. The 2-year not yield is alone a great leading indicator. When you get the … up 60% in this period of time and it sustained tremendous information that we were heading into we were in a transitional market. Basically what’s very important is for everybody to break out of the comfort zone of what works so well that cycle and understand that those trends are shifting. We’re in a transition right now so we are in a transition basically in my opinion in terms of what the markets are telling us that we are classically entering into a period where active investing is going to be far more superior than what’s worked which has been these blindfolded perceive ETF investing. I think that the markets are telling us that we’re going into a period where value is going to be surpassing growth for an extended period of time and I think that what you want to focus on you want to have more cash on hand than you normally do. Whatever your comfort level is. I think that long short strategies in the fixed income market generally speaking. Credit hedge funds good place to be. I’d be focusing on low data stocks with low GDP sensitivities so a little more defensive for a special situation. You want to protect yourself from rising interest rates especially the front end of the yield curve. The Fed is not done just yet so floating rate notes and as I said before the financials within the North American stock market. We actually have been doing quite well being a life insurance company and I think some inflation protection which is why I like the energy stocks. You might like to buy real return bonds or inflation protected securities, I think wouldn’t be a bad place to be. But I think that really morphing in towards that late cycle mindset and that means that if you don’t have commodity exposure in your portfolio you might want to start adding some. It also means by the way the Canadian dollar right now at 77, 78 cents will go to 85 sets if and when the bank of Canada ever closes the negative industry cap and allows the Canadian dollar to trade more with where the end of the line lower prices right now. Something else to keep at the back of your mind is that a North American investor getting some currency exposure in a currency that lagged well behind the US.
FRA: Go ahead Yra.
YRA: I know we’ve been … Everything that David said I find common ground with it. I look at the Mexican peso outside the politics … Because they are really well positioned on their currency basis valuation … That’s why the trump administration is a big part of the equation. Besides that everything that David said is on my radar screen but the issue that … goes back to it and what I followed it through is of course the market exposure to not just a passive trade but the risk purity trade. Everybody talks about … how much they have or AQR but to me the reach in market is not just the massive positions of those to hedge funds but the amount of what I call tail coding. It always goes on. Because one somebody comes up with a formula there’s a lot of copy cats out there and I think that’s why we see volatilities explode. Because there were a lot of people mimicking Bridgewater and others and putting on the same position. I think that they have position on that they have no idea of how they absolutely will eat themselves and explode upon themselves and I view that as a phenomenal risk factor going forward and I don’t know how they escape from it other than going to the central banks and begging them to take their position.
FRA: That’s great insight gentlemen thank you very much for the discussion and just wondering how can our listeners learn more about your work David.
DAVID: Well I produce to dailies as I think you mentioned I produce Espresso with Dave and Breakfast With Dave. So with me it’s always about food. Feel free to email me if you want to get on our trial distribution list for the dailies that I do. My email address is Rosenberg SNB rosenburg@gluskinsheff. So Rosenberg@gluskinsheff.com or call me up at 401-668-188-919 and I’d be happy to facilitate that.
FRA: Great and Yra?
YRA: Okay as usual I’ve got so many things but I keep pushing out the blog that I write is most from underground … and rationalist who can go long. I keep writing there and I’m actively trading some … Always happy to discuss any types of trades that people may have. The discourse that goes on at the blog is really at a high-level. I’ve got a really high readership that … Whack jobs as I called them and we keep it to a very high level. This has been a great honor for me on another financial impression authority ability. I have great respect for Dave Rosenberg over all these years and we didn’t just go negative. Because what I thought about this I said well when we are going to be here because I know from reading David’s stuff and hearing him paying attention when he’s on these things and we wind up in a very doomsday scenario but that’s not it at all. In fact I tongue and cheek so all this is going to be a rendition of … very high level and I appreciate it.
FRA: Great thank you. We’ll end it there.

Disclaimer: The views or opinions expressed in this blog post may or may not be representative of the views or opinions of the Financial Repression Authority.

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FRA:       Hi. Welcome to FRA’s RoundTable Insight .. Today we have Max Horster. He’s the Managing Director and Head of ISS-Ethix Climate Solutions – a unit of Institutional Shareholder Services that enables investors to understand, measure and act upon the implications of climate change on investments. Max developed the industry’s leading methodology to gauge and assess climate impact on investment portfolios, resulting in the world’s largest database of company-level climate change data. He holds a Ph.D. in History from the University of Cambridge. Welcome, Max!

Max:      Hi, Richard. Pleasure to meet you. Thank you.

FRA:       Great. If you could start us with your background? How you got into this field? And your career?

Max:      Sure. You mentioned that my focus used to be in history. After that, I ventured onto asset management. I worked for almost 5 years with a large global asset manager capital group and I was scared. I realized that a topic that’s really close to my heart is climate change which mattered to investors. With that thought in mind, I started a small company in Zurich, Switzerland and operated under the name South Pole Group. We were among the first to look into the topic of investments and climate change. That was 8 years ago. We were a little bit early. So at the time we started, the only investors interested in this topic was (1:49 inaudible). Mr. (1:51 inaudible) invested at the charge investor’s foundation or so – who wanted to understand whether the money that they invested is in line with their mission. But over the years, that changed dramatically and I think about 3 years or so, the topic has really brought mainstream investments.  Mainstream investments come from entirely different angles which is from the risk perspective. So, not so much on how money helping (2:17 inaudible) but how the climate change affects the legislation and potentially affect returns. The market grew tremendously fast. As a leader of this market, we realize that, organically, we couldn’t keep up with the market growth. We were approached by quite a few organizations who were interested in acquiring us. So at some point, around the beginning of last year, beginning of 2017, we decided to enter a process. There was a handful of companies that were interested in acquiring us we’re gracious to be able to choose who we want to partner with and we decided to become a part of ISS (Institutional Shareholder Services Inc.) – which is probably known to this podcast as the largest provider of top government research and services proxy (3:23 inaudible). This is also one of the largest and certainly the fastest growing provider of ESG data (Enviroment Social Government data). Non-financial information. It’s the fastest growing in two ways – by organic growth and by acquisition (3:43 – 3:45 inaudible). Not the latest, I should say. Three weeks ago we added (3:48 – 3:52 inaudible) into our family as well. Since June 2017, we have been a part of ISS. We operate under the name of ISS-Ethix Climate Solutions. We basically do three things. We hep investors understand what climate change means for the investment and what the investments mean for the climate. We help measure (4:14 – 4:23 inaudible). Certainly, we help investors act upon that.

FRA:       So, this is a fascinating topic area. Wondering what your thoughts are on climate change? Do you see global warming? Global cooling? Combination of the both? What industry’s sectors of the economy will be affected by climate change going forth?

Max:      My view of climate change is impacted by the view of the scientific community on climate change. I’m not a climate fan myself. As you’re probably aware, the community of climate sciences is in agreement that … nobody is questioning that the climate is changing anymore I should say. There is still a bit of a debate of what the role of human being is in that – of mankind. Ninety-seven percent of climate fans say that man can play the role different degrees on this scientific event that is happening. Climate change is taking place. The community, policy makers and so on follow the scientific view that mankind is the reason for that – the reason for emitting greenhouse gases. The emittance of how we operate (6:05 inaudible) electricity. Therefore, in order to mimic the effects of climate change and reduce its effects and potentially combat climate change, we need to change as a world, as an economy, as a society. To the second part of the question, it is important to understand what the changes are that comes with climate change. To be clear, we differentiate between – we approach it from the risk perspective – we differentiate between transitional risk and predicted risk. Predictive risk is easily understood. When the climate changes, it can be warming and cooling, depending on what geography you’re at. The global climate is warming. However, there are some geographies where there is cooling because of its rippling effect. In general, when the climate is changing, certain physical effects happen – floods, drought but also heavy rainfall. Long-term changes also impact the economy. These physical effects are obviously impacting (7:58 – 8:02 inaudible). If you are producing fertilizers for southern Europe, due to climate change, agriculture won’t be possible any longer in the south of Europe. Your company might not be really affected by climate change but the market that you cater to is. It could affect the supply for your supply chain. We saw last year that the floods in Southeast Asia that the supply chain (8:30 -8:32 inaudible) were impacted by that. These are physical activity has affected every industry. Then, there are some transitional risks. Transitional risks are that come with the world closing in on climate change and trying to mitigate it. That is, of course, being done by regulators stepping in and saying we need to stop emitting CO2. This is triggered by society and changing the way they behave and the types of cars they drive and so on. This is what we call transitional risks and they’re heavily emit greenhouse gases and industries are impacted. That would be, for example, the oil and gas industry and the utility sector. At least the (9:27 inaudible) part of the utility sector, the energy sector in general. In these industry sectors, you have to differentiate between industries where they have to substitute technology that is kind of climate adjustable and where it isn’t. So, if you think about (9:48 – 9:50 inaudible) produce cars that are emitting less or no greenhouse gas emissions – electric vehicles substitute technologies for the combustion engine. You can also produce electricity through other (10:05 – 10:12 inaudible). Water, wind and solar. There are substitute technologies that means a company (10:20 – 10:21 inaudible) in a specific sector. The company can transition. There are also sectors that cannot transition – the oil company. An oil company is an oil company. If it doesn’t produce oil any longer, it falls into a different sector. This is how they approach looking at different sectors and what affects climate change legislation on one end and the climate change effect on the other end and how they affect those sectors.

FRA:       Does your firm, ISS, advice clients on climate change issues relating to ESG-CSR (Corporate Social Responsibility)?

Max:      Yes. This is the core of what my group and I are doing. We advise and we provide data and screenings that help investors frame the topic of climate change. Then measure where they stand. These are risks that I mentioned; physical and transitional risks. First we would look at what the frame of the topic means. We help organisations that are sometimes very large asset managers or asset owners to understand what the topic of climate change for them and for their specific DNA. To give an example; If you are a government pension plan of the country that is heavily dependent on oil exportation, you might take a very different view on the topic of climate change than a church (?) investor. Or you might take a very different view than an insurance company that not only (12:01 – 12:03 inaudible) but also on the liability side that therefore affects the climate change. So framing the topic is the first step that we help investors with. We come in with our consultants and we help determine what climate change means and creating policies around it. Then, in the second step, we help measure where the client/investor stands. That is typically done by providing the investor with data. We can provide raw data because the investor has the capacity to run themselves where the big risks are and where the opportunities are or where the impact lies. More often the case, especially when an investor stops looking at this topic, they send us their portfolios and we run the analysis on their behalf. There, we create either (13:04 – 13:06) depending on who the stakeholder is and what the aim is. We create reports that point out, almost like a heat seeker, where the risks and where the opportunities are. We also suggest steps that the investors can take to address those.

FRA:       In terms of all the actual tools and methodologies, what are those that the ISS use to assess the investment implications of investment asset classes in firms?

Max:      Typically, what investors start with is called the investor’s carbon footprint. The logic is that you own, let’s say an equity portfolio, you own 0.1% of general electric. The investor’s carbon footprint allocates 0.1% of GE (Greenhouse Gas Emissions) to your portfolio to you first. Then you can do that for other companies and you can calculate your emission exposure. You can understand what your expose is to what amount of CO2. How many tons of CO2 does the company that I own emit? (14:25 – 14:28 inaudible) that against benchmarks. We understand whether you are you below the benchmark or not. The benchmark could also be your own portfolio two years ago (14:36 – 14:39 inaudible). That’s the very first step that an investor takes and is typically a very good one to start with. It has some limitations but it quantifies the topic of climate change that investors can process very well which are numbers. Tons of C02. CO2 in many geographies has a price. You can associate the price with us and you can convert tons of CO2 into, for example, basis points. You can say that the direct costs of greenhouse gas emissions that your investors are responsible for is equivalent to is half a basis point. That is a language that is understood and trusted across an organization. From then on, we analyze, what I mentioned before, the transition risks. These can be risks that can be very sector specific. We would tell you what other companies you are invested in. Let’s say in the oil and gas energy sector have exposure to (15:41 inaudible) or to arctic drilling or other practical steps in the transitioning world might face the risk of being reduced by the regulator block by the regulators. We look at physical risks. So, one of the physical risk exposure achieved in long-term off the company portfolio – when we look at what we would call “scenario analysis”, you might be aware that the world committed in the Paris Agreement to limit global climate change to well below 2 degrees. Keep in mind that we’re geared toward 6 degrees of global warming. So, if we really stick to this 2 degrees’ target which every country in the world signed, and those countries ratified, that means a lot of countries have to change. If we look at what companies in your portfolio can be 2 degree aligned in the future. Will we still have such a business model in such a world that we committed to transition to.

FRA:       Through this work that you have been, how are investment asset classes affected by climate change overall? What have you seen?

Max:      I would differentiate between liquid and non-liquid asset classes. The most important differentiation in our business world is to see why. Because when it comes to physical risks, we’re physically affected by climate change. The increase of floods, droughts, storms and so on and these risks are ten to fifteen years out. They increase over time, but in the liquid asset class, you’ve caused (17:33 inaudible) out of them. I would say physical risks – or let’s say liquid asset classes are very much focused on the transition risk. With the equity portfolio, you are concerned about a government committing to a (17:50 inaudible) tomorrow because at that moment, you might own a company that is larger and the (17:57 inaudible) might tip the share price. You’re not so concerned about the curious perspective but about the physical effect of climate change in ten to fifteen years because at that time, you might not own that company any longer. When you think about non-liquid asset classes, namely real estate and private equity. It’s an entirely different ball game. We see today that in these non-liquid asset classes that physical risks are being taken into consideration in the moment of the investment. In other words, if you build a hotel on the shores of Florida and you realize that the hurricanes are increasing in magnitude in terms of strength and number, that matters to you much more as that what it will look like in ten to fifteen years – how climate change impacts these storms. This is much more for you and for insurance companies on selling you insurance for that hotel.

FRA:       Has the impact to the bottom line then – impact on profitability positive or negative? What classes or firms could be affected by this in terms of profitability? Positive or negative?

Max:      It’s an interesting point. There’s a lot of studies being done on that right now and the question whether the risk of climate change is prized into company valuation already today. You do find a lot of studies that support this view – that companies that have the risks and opportunities that climate change are better under control than others; if you create a basket of them and run them against others’ index, there are studies out there that states that these companies are outperforming their peers. That is also a reason for increasing the amount for low carbon investments strategies that are currently being created or have been created the past few years where asset managers put together portfolios with such promise and (20:26 – 20:29 inaudible) – so that an outperformance is possible.

FRA:       Very interesting. Do you know of any indexes like passive index or smart beta index that currently exists that focuses on firms with a view focusing on climate change?

Max:      Yeah. I would almost turn it around. There is hardly any major index out there that doesn’t have some sort of a climate adjusted index summary. I would say they are at very different levels when it comes to education. The most basic ones are typically indices that either excludes fossil fuel companies – what I would refer to as a divestment approach and would resemble a reference universe without the oil, coal and gas companies – or take out or reduce exposure to companies that have a larger carbon footprint. They basically emit more emissions than their peers for the same output. They are less carbon efficient. This is kind of the first generation of indices and there you find (21:50 – 22:00 inaudible). What I am excited about are (22:06 – 22:07 inaudible) indices that are most sophisticated and try to investment in companies. For example, only companies that have a 2 degree targets and are committed to it. So, companies that are ready to say we are committed to the transition to be in alignment with the climate goal. There a lot of companies out there across all sectors. You invest only in companies with a climate strategy and don’t invest in those that don’t.

FRA:       Interesting. How do institutional investors invest in climate change today and how can retail investors look to investing in climate change?

Max:      I would say that institutional investors, depending on what you’re looking at, the large asset owners in Europe have all started to look into the topic of climate change and the flagship asset owners in the U.S. have as well. The same goes for Australia and Japan. The way that they approach is that they first want to figure out where they stand. So they do kind of a status quo assessment of what is my first climate change today? And then they typically set themselves some sort of either a pathway so they have a climate strategy. Now, more often than not, their strategies might include targets. Their target could be: we commit to bring down the carbon intensity of our portfolio by 20% by 2020 or we want to bring up the companies that have a climate strategy in our portfolio. Another element that would be involved in the ISS would be the topic of (24:10 – 24:13 inaudible). In North America, the number of shareholders on the topic of climate change were at an all time high last year with 89 shareholders that addresses the topic of climate change. This year, now it is April 2018, we are already at the same amount. We expect that this number would be much higher this year and these are the shareholders that ask companies to close greenhouse gas emissions or to get themselves a 2-degree target. These shareholders are increasing its effect by institutional investors who often drive those in some sort of a collective engagement initiative. (25:00 -25:05) New York, California and so on as well. They are getting involved and then they look for products that help them to manage their greenhouse gas emissions or climate impact in general to manage that bound. That’s also a reason why we see increasing investment products popping up in that space. Retail investors, it is a bit of a different story but there are now online platforms available for retail investors where they can basically go online and type in the name of a fund that is available for retail investing and see how the climates affects us. One that we have been building on behalf of the European Union is called Climatrix. Climate Tricks minus waiting.org (I cant find the website). That is a platform where you can look every after 5000 largest retail funds that are registered for sale so it includes some U.S. funds as well and check them for the climate affects. Free of charge. You just go on there and you type in the name of the fund and it tells you whether the fund has one to five (26:36 – 26:40 inaudible) data points that is something easier to digest which is kind of a leaf system. So five leaves is obviously better than four. That is something that retail investors can do invest there and they can, of course, walk into their bank and talk to their advisors and ask for climate adjusted investment product. There is an increasing amount available.

FRA:       Wow! That is interesting. Finally, where can investors find more information on climate change investing and also learn more about your work?

Max:      We produce quite a bit of research as you can probably tell. You can find it at ISSgovernance.com. Where you then can look for climate solutions and mail us or reach us. Other resources that I find useful are thinktanks. There are two in particular that deals with investors about climate change. One is carbon trekker and the other one is called the two-degree investment initiative. Great resources, especially for methodology. Great way to read up on different approaches to investment in climate change.

FRA:       Great insight on the whole industry here and investing in climate change, Max! Thank you very much for coming onto the program show.

Max:      Thank you for having me!

By: Karl De La Cruz

Karl.delacruz@ryerson.ca

Disclaimer: The views or opinions expressed in this blog post may or may not be representative of the views or opinions of the Financial Repression Authority.

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FRA: Hi welcome to FRA’s Roundtable Insight .. Today we have Nomi Prins and Yra Harris. Nomi has worked on Wall Street as a managing director at Goldman Sachs and ran the international analytics group as a senior managing director at [Bear Stearns] in London before becoming an author. Now a journalists, public speaker and media commentator, she’s the author of 6 books. Her writing has been featured in the New York Times, Forbes, Fortune, The Guardian and The Nation among others. Yra as an independent trader, a successful hedge fund manager, global macro consultants training, foreign currencies, bonds, commodities and equities for over 40 years. He was also CME director from 1997 to 2003. Welcome Nomi and Yra.
NOMI: Thank you very much.
YRA: Thanks Richard.
FRA: Well Nomi is coming out with a new book to be released on May 1st. It’s titled Collusion: How Central Bankers Rigged the World. She focuses on five area, Mexico Brazil china japan and Europe and she’s actually scoured the world to write this. Visiting Mexico city, Guadalajara, Monterrey, Rio de Janeiro, Sao Paulo, Brasilia, Porto Alegre, Beijing shanghai, Tokyo, London, berlin and other cities throughout the united states. That’s a lot of traveling Nomi.
NOMI: That sounded like a lot of travelling when you said it Richard. Yes that happened.
FRA: Is that how it came about? Was it through these struggles that you gained this insight how did you get this inside also through your work?
NOMI: The insight itself yes it came from traveling on the ground and that was a result of really watching what happens since the financial crisis in terms of what the federal reserve has done and what other major central banks have done that we know about publicly in terms of advocating and creating and manifesting … Money policy as well as a quantitative easing or asset purchasing policy. It’s asset purchasing of bonds in the US, it’s the ETFs in japan, it’s corporate bonds in Europe are effectively a collaborative process that really had different effects for the major countries versus the more developing countries and also even as it was coming about in the wake of the financial crisis, had a lot of worries and criticisms been brought up about it. What I wanted to do is discover how those words and criticisms impacts on more of the developing countries. We’re part of the results of the Federal Reserve ECB Bank of Japan process of this particular policy. It was a combination of seeing what was going on and wanting to feel it and examine it and research it from the levels of those countries.
FRA: Is this collusion more of a hand off of a baton for example between central banks or is it actually central bank that are more in close coordination with each other?
NOMI: The main central bank that coordinated in the wake of the financial crisis and even before it became public knowledge in the fall of 2008. This was going on in the beginning of 2007 and throughout 2007 is that they worked together to for example have a lot of dollars in the market , in the central bank reserves system to be available in the case of a crisis. They kind of knew in advance what could be happening but to the public of course a particular federal reserve did this through Ben Bernanke. The face was, we’ve got this, there’s no housing crisis, nothing bad is going to happen, everything is fine. In reality central banks the major ones the G7 ones were already starting to work together to mitigate any potential liquidity or money crises that could result from any financial implosions. That was already going on but then once the financial crisis was in a bit of full mode in the fall of 2008 and the spring of 2009 those conversations became much more frequent, the types of coordinated policies amongst these banks became more frequent, the amounts of them more epic in terms of what was swapped between central banks. Like I’ll give you dollars you give Euros and so forth throughout the process to create a global tranquility on the outside that was really fabricated by these central banks. As the years went on different types of timing periods were used to sort of catalyze this type of collusion or group collaboration again. For example in 2012 when there was a more pronounced credit crisis in Europe and so far and it goes on to this day. If the fed raises rates a bit and it hampers the stock markets and all of a sudden there’s a lot of chaos or turbulence and the European central bank as adjusted will step up and say, “We’re are not touching our rates, our rates are good low where they are. We’re going to continue with our quantitative easing or a corporate buy in process so don’t worry.” That’s where the global collusion comes and of course if you’re outside of this main group of these central banks, you’re either acting with them or against them depending on what you need to do for the domestic situation in your own country. For example Brazil when it has high inflation had to do different managers relative to what the fed was doing but that also hurt it politically? A lot of different pools and studs came in that developed countries throughout this process.
FRA: Yra have you seen similar behavior between the central bucks from your observations?
YRA: Are you throwing fuel on my fire on what didn’t know. How do I know? (unintelligible) We’ve known each other 3 or 4 years but I’ve been discussing this with (unintelligible) for years. Nomi can I just ask you a question? Are you familiar with Bernard Connolly?
NOMI: I’m not. It sounds like I should be.
YRA: You ought to be yes. If you’ll give Richard (unintelligible) I’ll send you (unintelligible) We’ll talk about it later but Bernard Connolly who was at AIG London (unintelligible) He wrote a book called The Rotten Heart of Europe. Written in 1995.
NOMI: Wow, okay.
YRA: Everything that has happened. But because he was on the original group that put together the euro currency so what he saw behind the scenes is similar with what you’re discussing. I’ve come to call him a good friend. We talk. He’s kind of disappeared now for a while but he just needed to rest I think. I can’t wait to read your book but Richard you know that answer. The central banks have, as would I would say what’s going on in Europe especially. We saw with droggy this morning that press conference is one of the greatest acts of (unintelligible) Visitation I’ve seen since David Copperfield. He can dance it but you could see it in Europe, there’s basically been a coup d’état in which the ECB is running its monetary and fiscal policy. You can’t escape it and therefore they are all in this and tonight of course will hear from [Kuroda]. Not that they’ll be any change especially with the political problems of Prime Minister Abbey. It’s such a strong word. I’m not used to hearing the word collusion and it’s interesting that you use that word. I always shy away from it because if I can’t prove a conspiracy then I lose some of my credibility so I don’t like (unintelligible) But I love that you do use that word because I do think it is that. It makes me ask you the question Nomi right back to you and do you have some thoughts on the G30?
NOMI: I do and just to maybe circle back to the wording that’s a really good point to bring up because I mean I also shy away in my research and everything I talk about from the idea of conspiracy because to me even though it has lots of different definitions, the implies definition is that it’s something done inside of a dark corner to other outside groups and therefore it’s not out in the light. To me all of this has been pretty public it’s just that nobody is really or a few people you have of course (unintelligible) A few people have connected the dots. The term collusion and of course it’s used now constantly with respect to the US or Russia and the us elections and trump and Putin and whatever might not be going on with that it’s become a constant word in the vernacular and so it’s come to take up on itself more meaning. I think the collusion, the coordination, the collaboration and its parts of all of those things amongst the major central banks definitely it’s not intentionally being negative definitely was the way of artificially creating a veneer in the financial markets and for the banking systems throughout the world and in particular the largest private banks that are codependent upon each other and upon the liquidity that central banks provide them and look to them. As they did in the crisis and continually for support. That is this manipulation of markets by this huge outside fabricated source of capital really does fall under the definition of collusion because it was done in concert and because their perception around what central banks want their behavior to be and the actuality of how artificial it has been for the financial community and markets are at odds with each other.
YRA: Yeah I think (unintelligible) Sorry Richard. I think that’s absolutely perfect. Let me add just 1 piece to that puzzle. This colluding group is absolutely at odds with thee BIS in so many ways. You can go back to Bill White’s work (unintelligible) And how the BIS is taking a different view. Actually two years ago I went to see (unintelligible) Speak in Chicago and I asked him point blank question because being that he (unintelligible) I said now that you’re at the BIS what’s your view on the zero risk waiting for all sovereign debt? I said I understand what you believed when you are at the bank of Spain but has your views changed? He turned right around and said that’s really a good question. Yes I have a different opinion of it. I thought it so clarified the things that you’re exactly talking about. This group is totally at odds with what they BIS is (unintelligible) They are supposed to be the banker’s banker.
NOMI: Right and the BIS as you know has a lot of reports out on this as well as statements that the collusive fabrication over money and the cheaper negative interest rates the major global economies has had a very negative effect on the rest of the world. It’s had the effect of raise in wealth and equality. By raising equity prices and infusing more debt into the world which at some point will need to be paid off. Because equity prices and other assets prices have risen and people who don’t have that same access to them as the wealthier classes and the participants in those markets get left behind. They borrow more money in order to keep themselves afloat. Then their debt burdens are higher but they’re not participating in the outside of quantitative using (unintelligible) And so forth so it creates these chasms for citizens within the age of the countries and as well as between countries amongst the world. What I find the most egregious at odds, to use your term is that for example the Federal Reserve, all 3 of those should have passed chairs. From Ben Bernanke who started it to Janet Yellen to currently Jerome Paul just do not see any problem in what they’ve done. Same thing with the bank of England. They’ll see inequality has risen but they’ll say inequality it rises for lots of different factors. Who can say it’s because of this massively accommodative monetary policy we’ve just imposed for the last 10 years. But the numbers say it. These individuals (unintelligible) As you mentioned, they don’t see that. They put words around their actions that indicate they’re doing this for the greater good and the main economy and GDP and all sorts of other things. But in reality this money goes to the main participants in the asset market and it has the effect of raising those prices and making certain things look really Rosy and positive and it doesn’t go into the main economy. It can’t. It is tied up on the books of these central banks, so how can it possibly go into the main economy?
YRA: Richard (unintelligible) So perfect. If we go back to Jacksonville 2010 when Bernanke laid out what he was going to do with this portfolio balance channel that’s exactly what it was about. You could see it in real time and yet people said no (unintelligible) I was tongue and cheek asked how is this going to trickledown economics? I’m following this through we’re not even going to get trickle down because there is no separate expenditure coming out of this. This is truly asset price inflation and who controls and owns the assets. (unintelligible) In his book basically it was written by Bernanke in …
FRA: And I mean it can we delve into some examples. Nomi, from your book on, like these areas Europe, Japan, China, Brazil, Mexico. Can we go into some of the details that you’ve provided in the book?
NOMI: For example Mexico with each other issues right now, there’s Canada with the united states relative to trade agreement conversations had this issue in the beginning of the financial crisis which words that its economy is doing pretty well and it really was having decent actual growth and actual growth and a decent amount of multiple forms of foreign investment and so forth and it’s not like wedges were perfect but there was a sense of balance to an extent in the few years before the financial crisis hit. Then all of a sudden you have the US. banking system going crazy on toxic assets and fraud and crime and imploding the entire system and its reaction from the fed and so forth. At the time Ortiz who was the head of the central bank in Mexico said I’ve seen this play out in 1994 with a peso crisis. Where these are external movement, there’s a crisis. The currency gets crash. Certain companies that are contingent on trade between various borders get hurt, they fire people, the economy suffers and so forth and he actually went up to Washington and had a meeting with Ben Bernanke. A meeting that isn’t in Ben Bernanke’s memoirs at all. But was covered by the Wall Street journal and they said you really need to do something to install confidence in general. Not within the banking system but from the banking system that’s just done all this outward into the main citizenry because otherwise these ramifications are going to have very long-term effects. Bernanke ignored him and he didn’t write about him and so forth. Ortiz go back and tries to create a policy at the central bank level where he’s critical of what’s going on in the United States. In terms of what they’re doing rates in terms of not restraining the banks that have just caused all of this chaos and as a result he doesn’t get re-nominated to the post of being a central bank leader. It’s taken over by …. Who has this persona outside of Mexico of being more a part of this elite group of central bankers and therefore able to play ball we them. Ortiz goes around the world in particular to US universities and so forth and talks and tries to warn people that these methods are going to ultimately create problems. In particular he’s concerned about regulating the banking system and the derivatives at the heart of the financial crisis going forward because he felt and it’s true that regulators like that central banks aren’t watching them. Which has been true, it is true and it continues and it looks like what the current set of appointees into the fed on what going on around the world will continues to be true. … He tries to basically keep rates to an extent higher in Mexico. They have to be anyway it’s more of an emerging country but not really follow their policies even though he has friends in Washington (unintelligible) rates even though he’s dropping them tight as he possibly can to score of inflationary problems like food prices and so forth that are going on in Mexico. That are going on Brazil and throughout Latin and Central America. As a result he ultimately does come to odds with his leadership there and with the United States and ultimately with president trump and so the critic came in. No he’s at the senior position at the BIS which as we’ve just pointed out before has a more realistic view of artificial fabrication of capital just for the financial markets of banks versus really caring about the ramification toward a real economy. This was a whole decade of a trajectory through these leaders, these two main leaders. No there’s none but two main leaders at the time of the central bank in Mexico that really tried to both keep their independence and also in different ways very different people critique the Fed and one got kicked out and is doing other things and one is at the BIS where again there’s more oven ability to just say what he thinks. That’s the kind of thing that’s happened. Meanwhile in Mexico there were a lot of problems because of our financial crisis in terms of their economy and now there’s other problems related to trade agreements and so forth but that’s really started with our financial crisis this time around.
YRA: Richard can I pick up here more?
FRA: Yeah, sure. Absolutely.
YRA: I love this conversation. It’s like meeting at Starbucks. Nomi let me ask you something. I have a reason for asking I’m not going to tell you why right now. Tell me where you fit the IMF into this colluding process?
NOMI: This is interesting because they are a mess now under (unintelligible) I think have a more (unintelligible) Is most similar to the BIS critique of this whole process. In fact I was at a conference at the Fed in the summer of 2015. They do an annual conference of the IMF, the Fed and the World Bank regulators. We all mean regulator … The regulatory bodies but the main people that are in charge of the regulation of these central bank. I spoke about this very topic, why the money that has been offered to the financial system haven’t made its way down into the main street arena for real. A very quick summary of my talk was I got up in front of them and I said well because you didn’t make them. You did make that money, you had no stipulations on the money that was given as to where it would or should go. As a result why would you even be asking that question? It was around (unintelligible) Janet Yellen they had spoken just before me of (unintelligible) And I had said everything was fine, we’ve passed the regulation in the United States. Some called out Frank under the Obama administration and they basically had the effect of beating down the bench most egregious risky practices and everything was going to be fine. Without addressing anything that the Fed had done and was still doing to provide capital to these and to the asset markets after that there was a luncheon. This is a long answer but I just want to set the stage here. There was a luncheon at which Christine Lagarde was there speaker. This was right after she was having a public media battle with Janet Yellen about not raising rates yet. They hadn’t yet this is the summer of 2015. Because it would negatively impact the emerging economies and countries that were going to be exposed to the dollar and into punitive way. They had borrowed money over these years because they are been under disadvantage because they kept their rates and had to keep their rates higher to fight inflation and other things in their own countries relative to the main countries keeping money down for their financial system. There’s a dislocation that all this debts has accumulated there but if the dollar were to go up because rates were to go up then all of their repayments that had to be done in dollars would be that much more expensive for corporations or for the governments in these emerging countries and that would have a negative effect on those countries. So that’s where she was coming from. Not that she was advocating quantitative easing but she was saying is if you’ve created this mess and you have to understand what the ramifications will be. She didn’t really come up with a solution as to how to do this in a better manner but she certainly warned that the other side could be potentially really dangerous. What you also did was spend a lot of time working with the leader of the people’s bank of china governor Zhou who is not there now he’s just been replaced or he’s just retired. But he had been a long-standing central bank leader and actually he and her had a very good relationship. One of the things that happened in the recent years is that the Chinese … the currency became part of the basket of currencies that the IMF has. The reason for that is I think the IMF was trying to find a way to diversify away from a essentially this us centric, European centric, Japan ancillary contingent because of what has happened over the last decade and to protect the world going forward. I think this whole decade has seen a big shift in the allegiances of the IMF under her. I’m not sure where that will go in the future but that seems to be what has happened.
YRA: I raised the issue because when they chose her of course (unintelligible) Pushed out and I actually had a letter published in the Financial Times suggesting that … Carson I know he was considered for that post but of course he fell back into them overhang. I thought that they should take Trevor Manuel from South Africa, and elevated him because I thought he probably is one of the best finance ministers I’ve ever seen. It’s time to elevate as you rightly talk about non-European non US. Yes I know that their money basically making up the IMF so that. When it’s your gold you get to make the golden rules. It was time to make that shift. I’m not a Lagarde fan I’m not an IMF fan I think that they have a very short … when it comes to certain things like. I’ll always be appalled that they stepped in, in the Greek situation. I have a sense as to why, that they stepped in. But they were just all wrong because if Greece is part of the EU, and the EU is a developed nation with lots of assets. What is the IMF sticking your nose in there for and I know the Chinese were not happy about it, as a lot of the people who work at the IMF at a higher level. Thought that that was a very bad decision. I think they’re going to come and move it after Laggard is gone. When this stuff a lot of gets played out, it will have proven to be a very poor decision. Thank you for answering that.

FRA: What about Japan … Sorry go ahead.

NOMI: This is a great conversation. I agree that there has to be. That was one of the things I noted in China. China chapter in the book is spending time with the heads of a major development bank and the whole idea of even having other consortiums, whether through trade alliances or the development bank alliances that have other countries outside of the main ones that created the IMF and the world bank and control most of the reserve currencies in the world to basically have something else where they have that strength. There’s been a lot of growth. That really doesn’t get covered. I don’t know what it’s like over there. It’s certainly doesn’t get covered in the US the extent to which non developed countries, non G7 or the outside parts of the G30 beyond that are actually working together to be established in a different way and have more power in the world economy.

YRA: It’s a good point. I’ve suggested in my blog for last eight, nine years. The only time the IMF is crying for more money that they suggest issue gold backed bonds and take their hold on gold that they should have and it’s always bothers me.

FRA: Right.

YRA: When real Keynesians will not … It’s just sitting there, and you can leverage it up. You’re from a banking background. I can take that gold and create all the trillion dollars of bond that people around the world who would like a little hard currency or some sense of security whose 20% backed by gold to the demand would be so great and the volume cost. Don’t come asking me for money, you’ve got plenty of money just put it to use.

FRA: I was going to ask on Japan. You have a section in the on Japan Nomi. What is the real story behind the Bank of Japan’s quantitative and qualitative using program which begun in 2013 augmented with a negative interest rate policy for large scale purchases of Japanese government bonds? You go into some detail on the real story behind such actions.

NOMI: Yes so what was going on of course Shinzo Abe the current leader of Japan was also instilling upon a Japan history. Abe economics. Effectively that was an element of stimulus that he brought in. He needed someone at the Bank of Japan that would mirror that, with the kind of policies that the Fed was doing. The Bank of Japan has been involved in dropping rates along this whole period of time, and in quantitative easing. In fact they invented quantitative easing to an extent back in 2001. They basically came on board when Kuroda who’s the current head of the Bank of Japan was selected to lead it. His philosophy was very much in keeping with the feds philosophy and in keeping with Abe’s philosophy that somehow, if there was just watch of capital made available by the central bank, and it could go wherever it needed to go in the economy or in corporations or in the case of the Bank of Japan the actually buy ETFs or exchange trader funds which are collections of basically stocks. Therefore helps elevate the stock market in Japan. This was going to create politically also positive environment for people in Japan to look to this leader and say he’s doing a great job for us. Japan of course has had a very flat economic situation for a long time and this has been a way to consider it stimulus both from a fiscal perspective and the monetary perspective. Even though technically central banks are supposed to … I don’t even know who said they were supposed to. There’s legal boundaries between us central bank and its government in certain countries. The reality is that central banks by virtue of being able to conduct this policies and impact an entire financial system of these countries, are not independent of governments. What Kuroda did was basically give Abe credibility and vice versa, instead of promoting two sets of policies that they could then spin as being positive for the country. There’s also a back story to that which is more relevant now in the age of heighten trade wars. Again I think trade wars or trade re-agreements have been happening very quickly throughout this decade. For Japan had a new agreement with Europe that was penciled not too long ago and forth. They’re also trying to position themselves towards those types of agreements that have more of a leadership role and not just a shadow role to the US and the global economy. By having a central bank that can very liberally conduct these monetary policy moves, it helps their elevation with counterpart as well. They have the capital to do things. That’s a benefit to their overall staff, see what you’ve done as it benefits Abe.

FRA: Go ahead, Yra you wanted to comment.

YRA: No I’m just … Nomi how do I not know you?

NOMI: Because I travel so much, we both travel so much we’re never the same place at the same time.

YRA: It’s amazing because I believe there are things covered in the same way too. In Japan has made a very good … My son it happen to be fluent in Japanese and covers Japan for this male group out of Washington. I have him do my translations for stuff … supposed to stay more in touch with me. I’ve been training for over 40 years, and the Japanese have always been trusted from a currency perspective. What we’ve seen and we can see it. If you go back to the IMF G20 communique in October of 2012 when the Yen really begins its decent from 76, 77, 78 Yen to the dollar to where we presently exist. That was done. You can read the communique because I actually go to blog on the … October 15^th 2012 because they’ve got the … from the IMF that was okay for them to lose the currency to weaken. That’s when Abe … As the democratic head of Japan who had a short run midway while that was placed again by the LDP and it all begins to fit into place. We’re going to see it tonight. The bank … The BOJ is(unintelligible). Now they’ve been very lucky, and I use that word as we might use the collude, they’ve been lucky. They’ve been very fortunate that world has had enough growth to carry them. Anybody who compares Japan to US … I don’t think that’s right, because Japan started from a different place anyway. They started with an enormous school of savings, when the whole stagnation period for over two decades has taken place. They had savings burn off, and number two they had the great luck … I won’t call that luck, but 97% of Japanese debt was owned by Japanese. During the inflationary period, they’re not being punished, they’re being rewarded. We’re speaking on the financial oppression authority podcast. They weren’t being financially repressed because of the deflationary cycle, but Japan they’re not in it anymore. Now they’ll be financially repressed because interest rates are so low. There’s low return on earnings, and now they’re really been … so how long they will be able to continue this. It’s interesting. I believe that Kuroda is a prisoner of this policy. He’s a prisoner of his own success, and I have no idea how they’re going to really make the way out of here.

NOMI: No I think that’s right, that’s probably why they’ve shifted. The one modification he’s made that the other central banks … The central bank has done, but is to buy stocks and that’s very much. Because they’ve gone so low to negative on rates, and they do have such a contain population and a better savings rate and all of that, just philosophy of how they save so forth. There’s nowhere really else to go, as there is nowhere else to go on the rest of the world. But because of this particular situation in Japan accept into the Japanese stock market which is also a very highly owned by the Japanese. The central bank is trying to push off some of the … Again this is politically motivated. To push off some of the problems that could arise when this population of people that really don’t invest outside of the country, have nowhere else to go. They’re helping to pop up the only game in town which is their stock market. That I think is the reason for the modification of quantitative easing relative to the Fed that doesn’t actually buy the stock market here. What the Fed does is it supplies all this cheap money and gives out all of this green lights to the private banks who then lend it out to the corporation and so forth and so buy their own stock. We’re looking at record of the stock by about … Here there’s a step removed whereas I think the central bank is more directly involved in the stock market.

YRA: (unintelligible) and qualitative.

FRA: Perhaps we can end with some examples on European. You have two chapters on that Nomi in the book and a lot of interaction battles between the European central bank and the German Bundesbank. [intelligible] as German chancellor, Wolfgang Schauble German finance minister, and of course droggy. Can you get some examples and insight on that?

NOMI: Sure, so those chapters are actually before droggy. I say before he was head of the European central bank when it was Jean Claude Touche that was during the time where I… I mentioned Greece was being absolutely punished for having been involved in allowing foreign investment into Greece effectively. Then being punished because of the overall decline in the economy and the fact that these bond holders wanted their money back and everyone from this European central bank to the Bundesbank as you mentioned to the IMF, anyone involved in Europe thought it was a really good idea to punish Greece by providing a bailout that really was an extraction of whatever wealth and assets values were left physically in Greece. That was where that problem came in and … came into that environment advocating that but also really advocating more quantitative easing to wash over everybody’s issues. And massively increase the balanced sheet books of European, central bank through that process. He had very strong relationships also with the US. He had come from Goldmans, he had been at the Bank of Italy, which was having a lot of problems. His fortuitous timing of leaving the Bank of Italy to run the European central bank got him out of that situation. As a result not just by his own, but what was going on at the time. From Greece to Italy to Portugal, Spain, all of these countries were being hurt by this new wash of money that was going into the major banks for example in Germany. What’s interesting is that, even though a lot of the money that was made available through the European central bank to the core countries and banks in Europe relative to the more south and eastern countries in Europe as it happened, had the benefit of helping the part of the German banking system that was private. At the same time the Bundesbank because it seeing, it’s getting this help, but it’s also saying that Germany is doing quite well from a growth perspective relative to all the rest of these debt ridden, problematic country. Germany is relative to the rest of Europe really enjoying a strong benefit in general. They do have some inflation, they do want to reduce the reliance and quantitative easing. They do have a fight that emerges between the Bundesbank and the European central bank. Because the European central bank is now all of a sudden setting policy for all Europe and the Bundesbank it’s like we don’t really adhere to that, because we think rate shouldn’t be this low, we actually think they should be higher and there is growth there, there is a inflation here people are doing fine. There’s been this constant fight again between Germany and the European central bank over monetary policy since droggy has been and he always was trouble and so forth because of that. They have a very different situation because they’re factioned in that way. Then you throw into that England, and the Brexit vote which was a direct result of people within the UK being are the people that voted for Brexit being concerned about all of the mess that was going on European … all sorts of other things rather than, their policies of these competing central bank who are ultimately helping their own banks relative to their own people. In England that was just seen on a ground level, and bank of England of course was doing the same policy within England, so quantitative easing, helping it’s a market and helping its banks while wages have been stagnant and so forth. There’s been a little fracture going on throughout Europe on which is manifested and how people low in their economic anxiety and so forth.

FRA: Thought on that? I know you’ve written a lot for the blog site. Yra, yeah.

YRA: First let me … This is my opinion going back to 2011 when droggy gets the nod because that was Sarkozy guessing Merkel. When they put her as the most influential person Europe on Time Magazine I broke into laughter. I was probably laughing for two days. There was no way the French were going to tolerate … who ought to have been the president of the ECB, because I think the Germans would have felt a lot more comfortable with a German at that helm. If you had to go down this path following the US, it be more comfortable. … Of course goes back to when I lost a lot of money in the early 90s thinking that they would break the … After they broke the British pound link to the Deutschmark that the French … Franc would be next. That they would have to go … People forget that … was the head of the Bank of France at the time. The Bank of France was raising overnight rates to spend the speculative tide to 100% for overnight borrowing. Because, in order to be short for French, you had to borrow. …as I would say was more German than the Germans, and you saw it in 2011 when he raised his interest rates twice in the middle of this great financial crisis going on. Because that was him I think really play … the Germans at the time. It was a grave message which of course we get droggy who ensured that France would never, never support a German at their helm. We’re going to see the battle play out again right now, because there’s going to be (unintelligible) I think the Germans are at the point especially the politics in Germany are heating up. Everybody says, well the … was another immigration. You know Richard, and don’t normally speak this. It has more to do with my mind, and take very close attention that German savers, and Germans are savers. They have the lowest home ownership rate … of any developed nation. It’s like 42 or 43%. Germans don’t traditionally borrow, they’re savers. There’s been nobody more financially repressed than the German citizens. I think that gets brushed away too quickly as to what the rising sentiment is in Germany. Merkel has phenomenally weakened. Even the … Can back her into corner in different ways. The rise of political angst in Germany is great. I would argue vehemently that there is much more to do … The fact that inflation Germany is let’s be kind and save 2% and they’re running this whole thing. The two year note in Germany right now is 55 basis, Negative 55 basis point. The people who are getting homes are German savers. You’ve not seen the rush of … is really under the underperform … because that’s what happened in 2000 when the Germans finally convinced (unintelligible) When the other stock market and then of course is a bad combo in tolerating the German market especially (unintelligible) They’ve been reticent so nobody has borne the grip of ECG policy more than the German savers and this is having great political ramifications.
NOMI: Yeah I totally agree with that. I totally agree. They are concerned and that’s where their politicians are arising and some of those areas are having the most impact because you can’t really save money on negative interest rates and so that’s another reason that they are at odds with the ultra-low rate policy of the European central banks.

FRA: Great I guess running out of time but the book is Collusion: How Central Bankers Rigged the World. New book by Nomi Prins. I guess additionally above that how can listeners learn more about your work Nomi?
NOMI: Well they’re welcome to come to my website which I try and update which is www.nomiPrins.com for anything that I might have knew. I’ll post you if I ever come out there but also just basically the book is available I think it’s on amazon.ca and also in different places.

FRA: Yra?
YRA: (unintelligible) Richard you can go to yrahrris.com and Notes From Underground which is my blog pops up I can initiate, you can subscribe to it for free. No advertising on it nothing just a lot of great directive that goes on between the readers over serious issues. As you know we have leadership all over the world so I hear from people who are boots on the ground when we tackle or some of these end I’m glad we did this because now I have to go search Nomi Prins and I’m going to arrange to send her a copy of Bernard Connelly’s book because the fact that Bill Shepard and I Printed 10,000 copies even back in 2013 when the book was out of print. Bernard actually wrote a new forward for … tries to do that to I have many books to spare. I think it’s the most important book. I will say that Nomi’s book is out now and this is an important read for people who felt afraid (unintelligible) Been doing this so I always add a little books of this nature because you need to understand this. These things don’t end well. I haven’t read Nomi’s book but I certainly will order it. I’m sure that’s what goes … They do not end well. It’s not like this is new in history. It’s been done before and it’s in fact the collusion I wanted to get into that if I have a minute of two. We know we talked about that central banks are really (unintelligible) They’re going to lose their independence where they’ve over shot their self-proclaimed mandates I will say we’re self-proclaimed. I know the US congress gave the Fed but I’d …. We’re coming to a very great reflection point that I blogged about the other day which was about everybody better go dust off their knowledge about the 1951 accord between the treasury and the Fed when the treasury forced the Feds prior to that to keep interest rates artificially low because of the huge amount of debt because of World War II. Then the Fed couldn’t take it anymore after inflation got out of hand and (unintelligible) Had to sit down and negotiate and accord. But we are coming to that going to this great inflection point because the fed is now being trapped by this because if interest rates are said to raise the cost of staining the US debt is going to rise and discretionary programs are going to have to be cut dramatically. Here we come.
FRA: Great it’s a nice little discussion based on history financial discussions end economic perspective thank you so much Nomi and Yra.
NOMI: Thank you so much.

Disclaimer: The views or opinions expressed in this blog post may or may not be representative of the views or opinions of the Financial Repression Authority.

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FRA:       Hi. Welcome to FRA’s RoundTable Insight .. Today we have Charles Hugh Smith. He is an author and leading global finance blogger and America’s philosopher – we call him. He’s the author of nine books on our Economy and Society including A Radically Beneficial World; Automation, Technology and Creating Jobs for All, Resistance, Revolution, Liberation: A Model for Positive Change and the Nearly Free University in the Emerging Economy. His blog oftwominds.com has logged over 55 million page views and number 7 on CNBC’s top alternative finance sites. Welcome, Charles!

Smith:   Thank you, Richard! Always a pleasure.

FRA:       I thought today that we’d talk about trade potential for developing trade wars. Where this could ultimately lead and what’s behind it. How have we gotten to this point? We see a lot of, not just in the U.S., but in international trade war issues. This week – Brazil accusing the European Union (EU) of instigating trade wars and threatens World Trade Organization complaint. So, it’s all over the globe now. You recently had a discussion with our co-founder, Gordon T. Long, and I’m just wondering if you can relate that in terms of how financial repression has caused the trade wars.

Smith:   Right! It’s a great topic, Richard, and I’m glad you brought up the issue with Brazil and the EU – showing that this is not just the issue between the U.S. and China which gets a lot of publicity but it is a global phenomenon. But the roots are global as well and at least one of the roots is financial repression which is the major central bank’s policies over the last nine years of recovery to drop interest rates to zero to buy risk assets, to push investors into risk assets and generate a lot of liquidity and credit. One of the results of that is corporations have had an easy time borrowing a lot of money and, of course, some of that have been spent on buying back their own shares and so on. There’s also been a great expansion of capacity, especially in emerging economies like China where the government is explicitly trying to create jobs. There’s been a huge amount of money poured in – generating more capacity. In other words, there are more factories, more production and more mines opening. So, the world is awash in most things. There is too much of everything because of this overcapacity. What that has led to in the private sector is the loss of pricing power. In other words, when there is an over-supply or over-capacity, then you can’t really charge enough to make a good profit. Then, the corporations with global exposure, have to start cutting costs. We’ve seen this lead into sort of an endless cycle where they first offshore production, then they offshore back office, then they slash and burn their payroll and then they move from salary to employees to contract labor. There are all these ways of cutting but eventually, you get through the fat to the meat. Then pretty soon you’re cutting the bone, right? Then you end up with zombie corporations which are still producing and are only surviving because they keep borrowing. In China, that’s the whole model of things. This thing so called SOEs (State Owned Enterprises) which they lose money. The state understands they lose money and they just keep borrowing money so they can keep their payroll. Outside of that sort of government subsidy, it creates a world in which nobody can have enough money to justify their evaluations. So, the national governments start turning to trade wars as a way of getting back pricing power and limiting the over capacity and over supply that’s crushing their domestic economies.

FRA:       Do you think that the trade wars could be implemented by tariffs or by global competitive currency devaluations?

Smith:   That’s a great question, Richard. Because part of what makes every discussion of trade so complicated is because different currencies are the sort of foundation of trade. If a currency is greatly devalued, then those products are cheaper for other buyers and other currencies. If a currency gains in relative value, then that nation’s export becomes expensive and their exports suffer. They talk about competitive devaluation, right? And that’s the policy in which everybody tries to weaken their currency but it’s a zero sum game. We can’t all weaken our currency, right? It’s like if one currency loses its value, it’s against a basket of other currencies. There is some question as to whether that’s really going to work. In other words, if you’re the only country that’s devaluing your currency and everybody else is stable, then you can get away with that and gain an advantage. But if everyone else is starting to play the game, then where would that lead? It’s not really a solution.

FRA:       Let’s dwell a little bit more in detail about the U.S. and the U.S. trade deficit. You’ve graciously provided a number of slides. If you can go through those and provide insight on each?

Smith:   Yeah! Another thing that I find fascinating in trade is that it ties in the global trade economy. We talked about financial repression in central bank policies and how that influences it and how currencies influence trade. In terms of tariffs, I think it is important to mention that many countries such as Japan protect their domestic industries without using tariffs. They just simply use bureaucratic mazes and motes. For example, if you’re going to export something to Japan, you have go through a bunch of different hoops with various ministries and the ministries, of course, are well trained to find some reason to put your application aside for six months and for another six months because have more research we need to do. There is more than one way to protect domestic industries and bureaucratic mazes are actually more effective than tariffs and I think we may get into the political side of this later in the program. But, you know, Trump has announced a bunch of tariffs and then he quickly announces a bunch of exemptions. A bureaucratic maze is actually way more effective way to control or protect your domestic industries. To go through my charts, the first chart is of U.S. based corporate profits.

It is kind of interesting that those profits around 2000 which had shot up a lot as a result of the dotcom boom of the late 90s. They were about $700 billion a year and then China enters the WTO (World Trade Organization) in 2001. Very quickly, the U.S corporate profits basically tripled. That tells you that I don’t think this is a coincidence. That’s a stretch. Clearly, who’s benefitted from the expansion of trade in emerging productive markets like China are the U.S corporations. People that have done research and say,” Oh well, the cost of goods at Wal-Mart are cheap because of the production overseas.” They kind of guesstimated that the American consumers might have saved $200 billion or something like that in the last set number of years. However, if you look at the corporate profits going from $700 billion to $2.4 trillion, the corporations have pocketed trillions. Consumers pocketed nickels. Another chart I have here is the U.S. oil production and has gone up quite a bit as everyone knows because of fracking and other technology since.

This has really relieved the pressure on total U.S. trade deficit and much of which was energy. When the U.S. was importing six to eight million barrels of oil a day, that’s hundreds of billions of dollars’ worth of energy, right? Now that U.S. production has increased, it continues to import energy products and its also exporting some of its oil as well. We know that Canada and Mexico – North American Free Trade Agreement – as a whole is an energy exporter. The U.S., bottom line, has been impacted positively by its oil increase. I have a couple of charts here about breaking down the U.S. trade deficit and it is interesting because we tend to think of it as a national thing, right? What is the trade deficit with China or Germany? This tells us that almost half the goods trade deficit is related to autos and vehicles. That’s an interesting kind of fact. Imports and exports are a really broad part of the economy. In other words, it is not just soy beans and steel or aluminum. It’s a lot of different products from different parts of the world. You can see that the U.S. runs trade deficits with most of the world. Another chart I have here is the trade deficit. It is not mine. It is from somebody else.

The trade deficit used to be extremely modest back in the early post 4 years. Once we got a bubble economy, where the central bank was pouring in tremendous amounts of liquidity into the banking sector and in the economy. Then we get a bubble economy. That’s when our trade deficits sky rocketed. Of course, that is a bit simplistic because oil was a big part of our imports and the strength of the dollar made it convenient to buy other people’s products. When your currency increases in relative value, then it becomes even cheaper for you to buy other nation’s output. There’s a lot going on to add to that huge increase in the national trade deficit there. So the last chart is the IPhone supply chain.

The trade is not calculated with any kind of accuracy. It is very difficult now because of the global supply chain to make sense of what trade really is. This is a good example because if an IPhone is shipped from China and lands at the dock in Longbeach, it is credited as a $500 import from China. But if we look at the components, they’re made in Japan, South Korea, Europe, America, and other nations that as much as $480 of that $500 ‘import’ from China is actually imported from elsewhere. As little as $10 or $20 may actually stay in the Chinese economy. If we calculated trade in that way, some people actually claim that the trade deficit with China basically disappears. So much of what China does is assembling components from elsewhere. That huge trade deficit with China is illusory to some degree.

FRA:       It is somewhat misleading in terms of how we measure trade and that’s leading to misunderstanding as well.

Smith:   Yes. That is right. Much like GDP. It includes a lot of stuff that doesn’t mean the economy is becoming more productive.

FRA:       What about what’s happening in terms of the U.S. Trump administration. Do you think their strategy is to use these trade tariffs and potential trade wars as a bargaining chip for trade treaty organization in order to get the U.S. a better deal?

Smith:   Yeah. I think we see some evidence to support that, Richard. That was one of Trump’s campaign kind of promises – to cut a better deal. It is interesting that when he first announced his trade war sort of policy, then companies like BMW suddenly announced they were expanding their assembly of vehicles in the U.S. It’s an interesting dynamic because if you get a political threat, then corporations don’t really have the luxury of waiting around to see how that policy is implemented.  They see the writing on the wall, they see the political narrative shift and trajectory. It makes sense for them to go ahead and increase their production and assembly in the U.S. In other words, be proactive. Don’t wait around for the trade war to heat up. Just go ahead and move your product line and some assembly to the U.S. ahead of it. Ahead of the curve so to speak. We’re starting to see some of that.

FRA:       Yeah. Speaking of the political angle, there was a recent discussion of placing 25% tariff on U.S. soy beans. Could this be a political ploy by China in order to aggravate the backing of Trump supporters in the U.S. Midwest where a lot of the soy beans are grown?

Smith:   Yeah! It’s a fascinating supposition. I’m glad you brought that up because any kind of announcement regarding trade will have a domestic impact on the companies producing those goods. It’s undoubtedly that the Chinese leadership are trying to undermine Trump’s political support with that. If you’ve ever driven through Iowa, for example, much of the state is soy bean fields, wheat fields and corn fields. The U.S. certainly a bread basket of grain and soy bean producer of global proportions. There was some analysis that came out and said that that sounds nice – the Chinese trying to say they’re going to raise the price of U.S. soy beans but the world does not have an over supply of soy beans. So they can buy some from Brazil which is another major producer but their demand is so large that they’re going to end up buying U.S. soy beans anyway.

FRA:       Yeah. There are 400 million pigs in China that need to be fed. So, without the soy beans, they’re going to run into a lot of problems. There’s only about 14 million tonnes of domestic production in China from my understanding.

Smith:   Yeah, exactly. This is where it is fascinating to drill down because people are saying,” What about rare Earth metals?” This is because China has a monopoly on some of those metals and you can get into some electronic components and chemicals that the Japanese have almost a lock on for relatively modest parts of key industries. It turns out there’s only couple of factories in the world that make these things. That’s why we have to be careful about the sledgehammer to drive attack. Politically, it is also interesting to ask if it is really true that the U.S. has just been a dumping ground for the last 30 years. In other words, everybody else can over produce and just dump over their production into the U.S. market. Maybe it has been unfair. Nobody wants to talk about that but I do wonder if that’s actually a valid perception. As I mentioned earlier about the BMW thing and a lot of the Chinese machinations, people don’t want to lose the U.S. market. It is too big and important. There is no substitute. In a way, Trump has little more leverage than the exporters as far as I can see.

FRA:       Do you think that the U.S. and China will follow through on these plans for tariffs? Do you think that they’ll be pushed back in the market in other countries and economic forces in general?

Smith:   It’s a great topic, Richard. Before we started recording, you sent me an interesting article from the economist Barry Eichengreen – whom I understand you’re going to interview in the near future – he was talking about the fact that China and countries like China with higher export to GDP ratios than the U.S. In other words, these are export dependent mercantilist economies. They don’t really want to encourage a trade war because they’re going to be a much a bigger loser than importing countries.

FRA:       They’re sort of more for free trade than the U.S., ironically.

Smith:   Right! Exactly! To me, it is interesting to look at the model that’s often held up as being remarkably successful since the end of WWII which is the mercantilist model that Japan followed which was to protect domestic industries at all costs and then use government money and power to boost your export sector. Do everything you can to make it easier for corporations to expand their production for selling overseas and that enriches your nation. South Korea followed that model, Asian Tigers and China pursued that model with great success. Now, looking back at what has happened to Japan, after that whole export burst ended in a financial bubble, they’ve been stagnant. Part of why they’ve been stagnant for twenty something years is that when you protect your domestic industry, you protect a bunch of inefficient and unproductive industries. Those companies don’t make enough money to become efficient. They become sort of like a zombie sector. There is some employment but they struggle. Since there is no competition from overseas, to say that that model is successful, it is only successful in the boost phase. But once you get to the point where you’ve protected a bunch of inefficient and unproductive domestic sectors and you run into competition in the global stage with your exports sector, then you get stagnation. Japan’s export sector is still large but look at the profitability problems they’re having. It turns out that big electronic industries like Toshiba and Panasonic, they’re riddled with financial scandals because they’ve been overstating their profits by trillions of yen for years. They’re really not profitable anymore. So much for the mercantilist model. It only works for a while. It is not a permanent successful model. There are blow backs and consequences. To put it another way, trees don’t grow to the sky.

FRA:       Rather than imposing these tariffs, could the U.S administration focus action on intellectual property rights dispute between the U.S. and China on IP (Intellectual Property)? Could that happen?

Smith:   It is important because a lot of what the U.S. exports is software, films, entertainment and all of those things are easily pirated. We all know stories that you could get the DVD of the movie in Hong Kong’s streets before it is even released in theatres. We have a lot of friends in China and they report to us. In general, for the Chinese people, software is like air. Everybody should be free to everybody. It is not considered theft as we would see or it as Microsoft and other companies would see it. Trying to control the theft of intellectual property is very difficult. It is worth doing. You have to make an effort if your export sector is heavily dependent on intellectual property like the U.S. is but I just don’t know how much you can really change that dynamic. It is very difficult to stop thievery except at the official level.

FRA:       Where do you see all of this going in terms of the next phase of trade war discussions? Could this cause inflation in consumer prices because now the U.S. actually have to make the dishwasher or microwave oven here rather than importing it because of the large tariffs. Do you see that potentially happening – much higher inflation?

Smith:   Right. I do wonder about that. People are starting to say,” Oh well, you know, you put tariffs on steel and aluminum and that’s going to ripple through the economy.” We have to start asking. What percentage of our products are basic materials like aluminum, steel and soy beans? If you take a box of cold cereal, it turns out that the grain is something like a nickel or a dime. If we look for inflation, it could be in finished goods, if there’s tariffs on finished goods, that could really hurt like auto parts. If people start slapping 25% tariffs on finished goods, that could have a really big impact. The alternative view is if those producers decide to move their production to the U.S. and go ahead and absorb the higher labor costs and taxes here, it might be awash. In other words, the actual sticker price might not go up that much or there would be benefits in terms of supporting U.S. employment that certain number of higher prices would be offset by bringing the supply chain home, stronger employment here, more taxes being paid and so on.

FRA:       Finally, what are your thoughts on how trade wars could potentially lead to physical wars? If we absorb more labor in the U.S. that would take away labor in China and the ruling party, there is concerned about that – causing social unrest. Could all of this morph into physical wars?

Smith:   There’s a famous quote by a French economist, Bastiat (Frédéric Bastiat), from the 19^th century and I’m just paraphrasing. I don’t have it in front of me but it something like this: If goods don’t go across borders, then soldiers will come across borders. Kind of implying that dynamic you’re mentioning. I think trade is about 10-20% of most major economies – imports and exports together. We have to try and remember the scale. We’re not talking about most countries having 50-60% of their economy based on imports and exports. Trade is a critical sector of every economy but I think that the potential for disruption politically is in those countries that are super dependent on trade. Now, that would include Germany of which about 40% of their GDP is related to trade, as I recall. And China and these mercantilists based economies. They are much more likely to suffer political blowback and domestic turmoil and escalating sort of trade war environment. That domestic political turmoil and disorder is much more likely than a shooting war because trade wars are more relatively controllable compared to an actual combat war – where there is really a high risk where things get out of control. It is more likely that there will be domestic turmoil and that’s what politicians will have to focus on – how to deal with their domestic turmoil as a result of trade being disrupted.

FRA:       Wow. That’s great insight, Charles, on this potential for trade wars. How can our listeners learn more about their work?

Smith:   Please visit me in oftwominds.com. I got three chapters of my most recent books and big archives and come visit me at oftwominds.com.

FRA:       Excellent! Thank you very much, Charles.

Smith:   Ok! Thank you, Richard. My pleasure!

By Karl De La Cruz

karl.delacruz@ryerson.ca

Disclaimer: The views or opinions expressed in this blog post may or may not be representative of the views or opinions of the Financial Repression Authority.