08/10/2018 - The Roundtable Insight: John Browne & Yra Harris See Massive Stress Building In The Financial System
07/25/2018 - The Roundtable Insight – Doug Casey On Precious Metals, Cryptocurrencies and Agriculture
07/12/2018 - The Roundtable Insight: Yra Harris & Peter Boockvar On Escalating Trade Wars & Global Economic Risks
06/07/2018 - The Roundtable Insight: Ronald-Peter Stoeferle And Yra Harris On Gold And The Emerging Chaos In Europe
06/06/2018 - The Roundtable Insight – Jayant Bhandari On The Risks Of A Stronger U.S.$ And Rising Rates On Emerging Markets
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.
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.
05/20/2018 - The Roundtable Insight – Charles Hugh Smith On The Intensifying Pension Crisis
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
05/17/2018 - The Roundtable Insight – Yra Harris And Peter Boockvar On How Credit Cycles Are Being Driven By Monetary Policy
05/02/2018 - The Roundtable Insight: David Rosenberg & Yra Harris On Stagflationary Pressures & Volatility In The Economy & Financial Markets
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.
05/01/2018 - The RoundTable Insight: Max Horster On Investing In Climate Change
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
04/30/2018 - The Roundtable Insight: Nomi Prins & Yra Harris On How Central Bankers Control Markets & Dictate Economic Policy
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.
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 15th 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.
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.
04/23/2018 - The Roundtable Insight – Charles Hugh Smith On The Developing Trade Wars
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 19th 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
04/20/2018 - The Roundtable Insight: UC Berkeley Professor Barry Eichengreen & Yra Harris On The Potential For Trade Wars
03/28/2018 - The Roundtable Insight: Bill Laggner On How Blockchain Will Revolutionize The Economy
03/28/2018 - The Roundtable Insight: Charles Hugh Smith on Automation, Robotics and Universal Basic Income
03/22/2018 - The Roundtable Insight: Yra Harris On The Fed, Trade Tariffs, Italy, Gold & Currencies
FRA: Hi, Welcome to FRA Roundtable Insight .. today we have Yra Harris. Yra is a independent trader, successful hedge fund manager, global macro consultant trading foreign currencies, bonds, commodities and equities for over 40 years, he was also a CME director from 1997 to 2003. Welcome Yra.
Yra: Richard, nice to have you back from Argentina, I haven’t seen you the last time since you were in Singapore so–I cant really follow you. You’re like Waldo.
FRA: Ok, sure. Maybe we could begin with a feedback on what happened on this afternoon, federal reserve, FOMC (Federal Open Market Committee) needing your thoughts on fed share, Jay Powell statement and press conference.
YRA: Yeah—you know, It was interesting that I was just watching the CNBC before we starting going on and Rick Santelli hit it right on target. I’m a fan of Rick, but we don’t always agree. But he had it on target. The one good thing Jay Powell did is he basically said stop relying on (unintelligible]\), because when they go out, the main stream media loves them because it’s an easy way to understand the fed for what they think is understanding… The fed so they can ask questions about it and he basically—you know—These are projections you know—they kept asking about it and asking about and Powell was very (unintelligible) when he said we made a decision today, to (unintelligible) projections and projections you know are just there. projections, they’re not worth the paper that they’re written on and if you follow the fed and their history with their dot plot, they’re a joke and as I wrote last night, you can go back 2006. Our cash in was far better at comprehending where the economy was than those dot plot projections and that’s just our—being, you know all that wisdom. So I just cant stand these dot plots I wrote in the blog last night that he should erase 50 basis points today and put to rest by doing that. Put to rest to dot plots and say yeah you know what we’re going to watch things here. But with raising 50 points and holding until the balance sheet shrunk to $3 trillion. I think he would of done the market to a much greater service because he would of let markets be markets and if there’s one thing that I really like about Jay Powell is that he does have an understanding on the way market works and he seems to be more willing to let markets work and get rid of the theoretical nonsense that fill the air ways with the feds press conference. I do applaud what he did except that I really would of like to see 50 basis points in a whole. Not that I would you know, bullish or bearish the stock I care not about that one way or another cause, I’m going to trade what I see anyway and react accordingly. But it would of put feds note to me a much more interesting position and you know what they got to stop cow toeing to the markets. You know I like what he was doing while the markets were correcting back in February. That he even had Dudley say that 10% drop is small potatoes, so we need to become more market focus than fed focus. That is the end of that story.
FRA: Now instead of the 50 basis point, the raise being only 25, do you think that the fed independence is coming under pressure by the US administration by president Donald trump?
YRA: Not yet, but it will, it will and a lot says about it again is that he talked about it last night and ill expound on it is that, look it. You read every central bank release, whether it is the ECB, Swiss National bank last week was the paradigm of it cause all they talked about was setting policies relative to the currency.
The Australian bank discusses the value of the currency, every central bank (unintelligible) everybody is out there parading this concept of independence of central banks. while they’re all discussing the importance of the currency values when setting their interest rate polices.
Certainly the Japanese, so its all being done so—with the—Donald Trump wanting to turn around the trade deficit, you can’t help but say hey maybe they are actually onto something because they have an independent central bank well—(unintelligible) the independent central bank that goes upon its course based on what its seeing here you know based on domestic economic activity, while everybody else is setting it to international standards then tariffs become the—I guess the alternative especially when the feds is raising the interest rates and they’re the only central bank really raising interest rates… I know… the bank of England went half a basis point, quarter basis point and they are project to go a quarter basis point tomorrow which we will see. But everybody is looking at the international situation and when I read the fed today there wasn’t one statement about it. Of course we did have Powell and little brainer discuss head wins to tail wins which is on the growth of the international economy but everybody goes through currency value when discussing interest policies.
FRA: So with the feds shrinking its balance sheet and raising short term rates—Likely making the US dollar stronger, will that promote tariffs more on the trade tariffs?
YRA: well I think that if the dollar got stronger, you would see much more action… But the dollar hasn’t gotten stronger, so there’s something else or a few other things that are seem to be weighing on the dollar. Now Powell was asked about that and he spoke to—you know—enhance growth, I’m not sure that there’s enhance growth over Europe anyways, I’m not… I need to see a lot more because if that’s the case then the European equity market should be out performing but you know what? They’re way underperforming the worlds equity market. So I’m not quite buying into that argument yet, but you know I’m going to wait and see first. I just need to see more before I go down that road. You know there are many things in play here which we will see which is why we are getting an increase volatility on a global basis.
FRA: And you’ve written recently on thoughts by commerce secretary Wilbur ross in terms that there will be no trade war… Trading partner of the us will compromise on trade treaty, how would that factor in the US dollar, like the potential US dollar devaluation?
YRA: well you know that’s right, that’s what I call the Kudlow dilemma, Kudlow of course when he got into his post, chairman—chief economic advisor to the president, he said you know (unintelligible) dollar and short gold. Well, not so fast Larry. First of all, be very careful about this because if you have king dollar which Kudlow means a strong dollar. Now we all like a strong dollar if its done—If its effected by good policies, but bad policies and a strong dollar, well that’s not such a good thing. You know—I’m not (unintelligible) grow your way out. You may inflate your way out of your debt problem but you’re not going to grow your way out of the debt problem, so let’s get behind that and if the dollar got too strong then the impotence from the white house would be to have more tariffs because they are hell bent on shrinking this trade deficit so when Kudlow discusses that, he ought to be very careful about where he is going because this white house, Peter Navarro and Wilbert Ross will push for a weaker dollar because a weaker dollar is Mnuchin and Wilbert Ross both said in Davos, is sending soldiers to the ramparts in the trade war that exists every day. So, Kudlow, that’s the Kudlow dilemma. It’s going to be interesting to see how he deals with this. But if, you were to get a dollar rally or even what (unintelligible) said and pretty sure wrote in earlier the week when he talked about a possible rip your face off dollar rally. He was quoting what’s his name (unintelligible name) about that. I’d be very very careful with this administration, they will not tolerate a strong dollar at this point in time.
FRA: And if that were to happen what would be the mechanism to effectuate that through monetary policy with the fed with its independence be compromised?
YRA: Yes! That’s a very good question, we don’t know but you would have the treasury secretary just like he said in Davos talking the dollar down which everybody took great umbrage at, but we’ve had that before, you know—One of my issues with Kudlow—(unintelligible) I respect him for his intelligence, he’s been around a long time. He was a Reagan guy, but you know what the Reagan white house lead the battle through James Baker with the Plaza Accord. The Plaza Accord was an orchestrated attempt to drive the dollar down and how is it done? Really—by sitting everybody down in the plaza hotel and reaching this compromise. We’ll pay because the trade deficit are now going to become an issue for wall street in a way that they haven’t in many many years and they are going to start to effect the movements in the market. Not quite ready yet but these algorithms who think that they have factored in every variable that you need and every headline, they are going to be disrupted themselves by the coming impact if the trade deficit continues to grow. This white house will not sit quietly and they made it an issue, and coming into the election this is going to be an important issue for Trump to hold onto his core constituency.
FRA: And thinking globally—how do you see everything playing out in terms of trade. Will Europe introduce measures to protect against Chinese trade and Chinese investments? So you got Europe Asia the U.S., how do you see it playing out?
YRA: well—we’ve seen that already. There was that article FT (Financial Times) earlier in the week that was talking about how Germany is upset that China is targeting some of the corporate jewels of Germany and… believe me the French are the most protectionists trade orientated going back to— (unintelligible) and I don’t care what Macron says because he inherited that it’s a long standing French tradition—so you know what? As the United States leave the battle, you will see that they will all start tail coating… What the white house is trying to accomplish, so while the white house gets beat up today, it gets beat up today because its easy to beat up on the Trump white house for so many missteps that they made. You watch that the European will follow right on top of this, because they have as much with the Chinese and they run. you know—pretty good trade deficit with the Chinese themselves so lets pay attention to what really is going to take place here.
FRA: And ultimately could we then get global competitive currency devaluation—another round?
YRA: Well I think we already have them. You know even with the yen at 103, 104 or 105, the yen is weak and fairly dramatic especially against the euro currency as we’ve talked about for 3 or 4 years already. That has been an interesting play and even I think that the Europeans, especially the Germans have had enough of the weakness in the yen. If you listen to (unintelligible) again, (unintelligible) very upset in January that Mnuchin and Ross, you know—for the D20 agreed not to target their currencies. Well you know what? Who you fooling? Of course, go read the Swiss statement from the release last week when they held their interest rates at negative 75 basis points. It’s all directed against the currency and the Japanese, every time when you listen to (unintelligible) talk, well—we’re not quite ready we need to see inflation. It’s just a nice way of saying we are going to keep our interest rate policy as it is because it keeps pressure on the currency. Come on, let’s call it what it is. They’re all targeting their currency values by using their interest policies for domestic purposes, but you know what? Many variables are in play here which is what is leading to the heightened increased in volatility. And as we’re talking right now, gold is up 23 or 24 dollars and silver is up 45 cents. This is after a fed increase. The dollar is on its lows, stone cold on its lows. What’s going on here in the market is were going to find out. There’s definitely some significant moves and most importantly is that there are two ten yield curve steepened today. Because… of course they changed the dot plot where it seems that there are going to be three rate rises this year so everybody thinks it’s going to be pushed out further and the feds is not going to be as aggressive as previously thought. So the yield curve, the two ten actually steepened out about 3 or 4 basis points as I’m sitting here.
FRA: Hmm.. Do you see president Donald Trump implementing section 301 of the 1974 trade act where the president can impose duties—If there’s like a perceived violation of trade agreements?
YRA: Yeah… that’s a great piece (unintelligible) last week when they were or two weeks ago when they were discussing 232 on the trade expansion act in 1962 under Kennedy which was interesting when it was passed in October of 1962, that was during the Cuban missile crisis. But they put in these—section 301 of the act in 1974. They put them in just because it was the only way they could get these trade agreements through, is that there is leverage against what they deemed at target as unfair traders so in order to get congress to be able to sign onto it there has to be opt outs based on sort of penalties. So yeah, they’re going to vote. We’ve seen it before with the Japanese in the 80s and the 90s was one of the strengths of the Reagan movement to enact 301. They’re going to use whatever they can—like yesterday we saw them soften some of their demands about 50% car parts in US auto—for NAFTA but they soften on that. Of course, and we saw that the peso. The peso reality and the Canadian dollar was really strong today. There are all types of mechanisms in place where they’re sending messages. Hey you better sit down an pay attention, were serious. We put the seal of tariffs down. (unintelligible) yes we backed off a little bit. We have a lot of tools at our command and we are serious about writing some of the wrongs that we have deemed to taken place in over the last 30 or 40 years. You must pay attention to it because, they have shown that they are serious about this, so they are trying to get better negotiating in so Trump can stand tall and say see. See what I did? I over turned some of these past malpractices and it’s going to help us as business returns to the United States.
FRA: will any of this affect U.S. agricultural exports to china?
YRA: well—It will—there is some rattling, we can see hog prices go down, cattle prices go down, some grain prices are holding up pretty well. Even as we are coming into the Brazilian and Argentinian year grind, the south American harvest will bring a lot of supply into the market. Prices are holding up very well, now that the Chinese may threaten the U.S. agriculture and as you know Wilbert Ross strategically laid out—you have to give them credit because they have done their homework and said look it, they’re still going to be buying our soy beans, I’m not buying it but what Wilbert Ross—I think is timing is wrong on the steel and aluminum because the Chinese, there’s so much—Brazil at a record crop this year. The timing wise is bad, we should of waited about two months for the crop to be harvested and for those to be all distributed somewhat and then laid it out because then the Chinese would have less flexibility. Right now they have flexibility because they can buy more Brazilian beans right now and stick it to the US farmers which could really hurt trump in the November elections, because the American farmers are doing very well. This has been a discussion since the China lobby back in the 1940s. the American heart land wants to do business with china, they always wanted to do business with China and when they embargo China, in the 1940s and 50s when Mao came into power, it hurt the American farmers because it took all those businesses with Taiwan versus the peoples Republic of China stunted American export to a billion people. The Chinese number one have to feed their people, end of story and their growth of Chinese purchases of soybeans which is huge because of the diet changes and more protein base especially with higher grades of protein. You have to feed those animals and a lot of soy meals and the Chinese eat a lot of soybeans. So that demand curve goes ever higher, that’s just not going to change… we’re seeing 10 dollar soybeans which is historically pretty high soybean prices and that’s with record supply. You know—agriculture responds very well to capitalism as prices go higher they produce more, but the demand from china and other countries that have now reach much higher per capita income they consume much more protein so prices remain high no matter how many beans come onto the market.
FRA: Yeah. And the soybean meal needed to feed the chickens, there used to be a saying that they only had chicken on Chinese new years but now they have it every day. Finally, your thoughts on Italy, recently you mentioned the markets are underestimating the importance of current Italian political situation and your reference to Picaso dream.
YRA: The market has fallen asleep, they think that there’s going to be some type of center based coalition that everybody (unintelligible) and that the league are going to get tired of trying to deal with five stars—I think it’s a gigantic mistake because 69% of the popular vote in Italy went to the center right including 5 star and if you try to push them out in order to form a coalition that pleases the eurocrats in brussels and status quo in Italy. Well—(unintelligible) I think you’re going to be running into a major problem and I think that the markets are way underestimating the influence of this. And you get again (unintelligible) I can take or leave most days, but he’s been very good with this. In fact, he’s been writing his warning about what’s taken place and you better pay attention to it. It’s no—Its nothing that is insignificant but the market seems to want to downplay it but we’ll continue to watch this. You know, I laugh because we’ve discussed the European financial institution have a severe problem and if you look at the stocks on the European bank, the deutsche bank—(unintelligible) but all the banks are suffering because the amount of non-performing loans have no been resolved, especially in Italy. So they need to really work this out and yet the 5 star and the (unintelligible) really want to push into… you know what we don’t care where the restrictions are coming from—(unintelligible)—budget deficits, we need to get the economy going and the Italian economy even with these ridiculous low interest rates is not showing enough growth and more importantly with these low interest rates, the debt to GDP ratio, it will be sitting around 132% which is enormous with a much lower borrowing cost, so Italy as you know—major problems facing it. (unintelligible) knows and 5 star knows they’re going to get their way because Italy is not Greece, Italy is far too big… far too big and their impact upon the entire global financial system therefore becomes much greater and as it is how to all work out. This is a very interesting time and yet the market is complacent trying to look past it. But I’d be very skeptical about that.
FRA: Wow. Great insight Yra. How can our listeners learn more about your work?
YRA: Well.. You can certainly go to the financial repression authority, we have a treasure trove of discussion but on a daily and weekly basis. I blog from notes underground which you can get and register for free if you go to YraHarris.com you’ll be able to access it and—as much as I write, respondence to the blog are at such a high level of discourse that, that makes it a must go to place because we really discuss very important things and its done at a very high level I’m proud to say.
FRA: Yeah, excellent. Yeah, great, thank you very much Yra, thank you.
YRA: Richard, thank you as for the opportunity as always, we do get into a good look under the hood as we say.
FRA: Yeap, and we’ll do it again another time. Thank you Yra.
03/18/2018 - The Roundtable Insight: Gordon T Long Talks With Dr. Lacy Hunt
03/02/2018 - The Roundtable Insight: Charles Hugh Smith On The Current Conditions In The Financial Markets
02/24/2018 - The Roundtable Insight: Jim Bianco, Yra Harris & Peter Boockvar On Investing Implications Of Volatility & Inflation
FRA: Hi, welcome to FRA’s Roundtable Insight. Today we have Yra Harris, Peter Boockvar and a new guest, Jim Bianco. Jim is President and Macro Strategist at Bianco Research. Since 1990, Jim’s commentary have offered a unique perspective on the global economy and financial markets. Jim’s wide-ranging commentaries have addressed monetary policy, the intersection markets and politics, the role of government in the economy, fund flows and positioning in financial markets. He is a Chartered Market Technician (CMT) and a member of Market Technician’s Association. Yra Harris is an independent trader, successful hedge fund manager, global macro consultant while trading foreign currencies, bonds, commodities and equities for almost 40 years. Yra is also the CME Director from 1997 to 2003. Peter is Chief Investment Officer for the Bleakely Financial Group and Advisory. He has a newsletter product called the Boockreport.com. His great macroeconomic insight and perspective with lots of updates on economic indicators. Welcome gentlemen!
Jim: Thank you!
Peter: Hey Rich!
Yra: Thank you, Richard!
FRA: Great! I thought we’d begin with a discussion on volatility. We did a podcast recently with Chris Whalen about a week before the volatility began in the financial markets; this year volatility to a significant extent. Jim, have you been seeing that as a trend through your research or what are your thoughts on that?
Jim: Not as a trend. Pretty much the opposite. Volatility events like what we’ve seen over the last couple of weeks are not the creation of a trend, they are the exaggeration of a trend. So there was a trend in place already and that trend in place was a turn towards more volatility. The turn towards more volatility was driven by a belief that, for the first time in the post-crisis era, inflation was returning. I’d get technical on you for fifteen seconds. What happened with the volatility event is we caught a short-ball traders on the wrong side of the trade. They did one simple narrow thing; blew up the VIX Market. The volatility measure on the S&P 500 Index option. That’s all they blew up. When we found that that spiked from 12.5 to 50 in two days, we found out how important the VIX is to everybody else. It was their measure of risk. When they saw it go up 400% in two days, they overreacted and the next thing you know, the DOW is down 1600 points. What I want to emphasize is they didn’t create the trend. The trend is towards higher inflation and that higher inflation would bring higher volatility and they got caught in the wrong side of it. All derivative debacles like this are an exaggeration of a new trend that everybody got caught on, not the creation of it.
FRA: And Yra, your thoughts on that?
Yra: You can’t say it better.
Peter: In 2017, we saw a hiccup in the US. The Fed decided to raise rates three times instead of one. Let’s start shrinking our balance sheet. That was overwhelmed by the Bank of Japan and ECB. In early 2018, when rates continued to rise, when the inflation pressure started becoming more evident that this is not a short-term bliss. Maybe this is the beginning a more normalized interest rate trend. One of the analogies that I’ve given in the past is when the central banks are full on easing, it gives investors goggles and it makes everything look perfect. When that starts to change, when that liquidity flow starts to slow and rates start to move then those goggles start to clear up a little bit. Monetary policy became more important. Markets are very reactive nowadays. (5:03 – 5:06 would not play. The audio automatically skips it). All of the sudden it woke people up and said,” Uh oh. This is a big deal. This is twice the level of what it was in the summer of 2016. I better start reassessing my positioning. I better start reassessing my leverage. I better start reassessing what valuation I want to place on the S&P 500. VIX and all these other things became a symptom, of what I call now, a disease of rising inflation and rising interest rates that then caused this explosion in volatility.
Yra: There’s been an argument in the market place that inflation is rising but so what. Higher interest rates is not a bad thing. They take the idea that when it comes to inflation, it is either Zimbabwe and it is really bad or it does not matter but there is a middle ground in there which is critically important. I’ve been saying people to stop talking about the Fed. Central banks as a collective, are the easiest they’ve ever been in the post-crisis era. Their balance sheets are the highest they’ve ever been in the post-crisis era this week. If inflation returns, it puts into jeopardy that we’re gradual. Bernanke said,” We are going to get balance sheet back to $2T to 2.5T and it could take until 2026. He wrote it in 2016. It will take 8 or 10 years to get that. If we have inflation, maybe that 8 to 10 years is now 2 years. By the end of the year, you’re going to have a contraction out of the ECB and the BOJ. That’s where inflation matters. It’s going to force central banks to pull in a lot faster than people thought. One last thing. Wall Street runs into this trap all the time. Somebody points out a risk, everybody looks at their watch and says,” Well, we waited eight minutes. The market has not blown up. I guess that risk does not matter.” There’s a risk from all of this money printing. For the first time in nine years, we have an inflation fear and is now putting doubt in central banks. Now, what’s the first thing that markets do? They have a ___ (7:41 inaudible and the podcast skips it) over that. I think that this inflation fear that makes everybody say,” Bring it on! 3.25 is really good in interest rates.” Be careful what you wish for because that is going to cause a reversal especially in the BOJ. If we continue to see global inflation fears rise, the Fed is already tightening right now, that’s why I said do not talk about central banks. This should be a big deal for markets in 2018 and most people continue to dismiss it.
Peter: Just to add on, with respect to what you said, Jim, on balance sheets being at record highs. The analogy we have given out is that yes, they are at record highs but balloon with the air being central banks easing. There’s still air going into that balloon but there’s less air going in. If there’s less air going into that balloon, that balloon is still going to contract. I think it’s the rate of change that is really changing dramatically in terms of central bank (8:41 podcast skips it – inaudible).
FRA: Could the return of inflation force all central banks to accelerate their exit strategy or just some?
YRA: (9:03 – 9:07 inaudible) was just reappointed with a very (9:08 inaudible) group around him. (9:10 – 9:22 podcast skips it). … stand on fiscal policy is used on the sales tax. Draghi dug himself into a hole. (9:25 – 9:52 some are skipped and inaudible). … How do you get out of this? Peter and Jim are both right. Forget about the Feds. Everybody follows the Bernanke book but they’re stuck in a situation here. To me, that’s really dangerous.
Jim: One quick thing about the ECB. Draghi’s term has a little bit more than a year to go before he’s done. The tradition in the ECB is that the next ECB Chairman will probably be German. It does not have to be a German but probably will be a German. That’s code word for a very hard money person. If you’re going to get inflation and you’re going to get a German to run the ECB, you’re going to get a violent reversal in the next eighteen months. Look at two weeks ago. Two Thursdays ago when the DOW was down 1000 points, what was the catalyst story that everybody said? There’s inflation in the UK and the BOE (Bank of England) might have to double the rate hikes that they’re going with. When was the last time the BOE moved the US stock market? That might’ve been the first time. It’s all because of this idea that central banks is maybe peaking soon and starting to reverse. We haven’t had to deal with that possibility until the last two or three months. It was only in the last two or three months that we’ve only really started to see inflation. What Yra said is right that maybe Japan continues to pump money but they might not be enough to do it. If everybody else is going to reverse, then those global central bank balance sheet will peak. These markets will have a digestion problem with that.
Peter: Just to add on to what Jim said, even the Riksbank in Sweden, which is not necessarily relevant for the global economy, experimented with negative interest rates along with others. It’s a good symbolic gesture. They said they’re going to start the process of getting out of negative interest rates well before the ECB starts. Just going back to zero from negative is going to cost an extraordinary amount of loss. The ripple effect that that’s going to have on the world, I don’t think the people will appreciate it. I like to remind people in terms of the concept of risk happening fast. It was 2015 when, the German 10-year went from 6 basis points to 60 in one month and from 60 to 100 points a month later. This is Germany. Not Greece. Not a third-world country. This is a country that went from a 6 basis points to 100 in less than 2 months.
FRA: How could all of this translate onto a change in basic relationship between stocks and bonds? Jim, you mentioned there would likely be a change on that once again?
Jim: First of all, just as a point of emphasis. One of the things that could change it back another way is that if the doubt of inflationary fears go away. There was a mild form of inflation fears about a year ago and then it went away. The difference between now and a year ago is that we’re finding out that the market, collectively, is a bunch of Phillips Curvers. They’re looking at the stimulus from tax cuts, possibility of infrastructure spending, strong growth and that they’re concluding we’re not going to have inflation after we spend thirty years trying to say that the Phillips Curve does not creation inflation. If it is decided that there is inflation, then there is inflation. That’s where it is coming from. To your question about the stocks and bonds relationship, it changes all the time between the way that stocks and bonds trade together. In 1998 to 2000, it changed. What I used to call is under the inflation mindset. In the 1960s to 2000, the starting point of every discussion was, are we having inflation? If the answer was yes, if bond prices went down then stock prices went down. If the answer was no, the 80s and 90s, were not having inflation, then bond prices went up, interest rates went down went up. Bond prices and stock prices move together. Starting around 1998 to 2000, we switched that dynamic because we were worried about deflation. During the middle of that dynamic, we had long-term capitals, the Asian crisis, the tech bubble, sounds like the derivative thing we’ve been talking about the last few weeks as well. Throughout the 2000s until very recently, we worried about deflation. Are we having deflation? If the answer was yes, equity prices struggle. If there was no deflation, then equity prices went up. So now bond and stock prices move opposite of each other. What we’ve seen in the last few weeks is the decline of bond prices and stock prices together since the financial crisis that they both went down together. The day the DOW was down off 300 points. Up until 60 days ago, if you just randomly told me in the last nine years that the DOW was down 300 points, I would’ve said (16:40 – 16:42 inaudible). That’s the way we traded every single time. I think we’re shifting to an inflation mindset. Now where does that matter? In the last nine years, Wall Street has pushed this idea of a 60:40 portfolio. That it’s the optimal way to invest your money; sixty percent in equities and forty percent in bonds because something is always going up. Either there is no deflation and stocks are going up or there is deflation and bonds are going up. But under the new scenario, either they’re all going up or they’re all going down. Both of them have been falling together. So this idea where you can take a lot of risk with a 60:40 portfolio is going to be blowing up on people’s faces. This means that the relationship between stocks and bonds are transitioning right now. It takes around two years to fully transition it. I don’t know if it will take fully two years now but it will take at least months to do it. There will be periods where it does look like they’re transitioning but I do think that we’ve started that process.
FRA: And Yra, do you see that relationship also changing?
Yra: Yes. This whole risk parity. To me, what people don’t understand, is especially on the issue on how you get of out this. Ray Dalio said you’re going to shed tears if you earn cash. Talking about a coming change. That’s in a two week time period. It scared me. Ray Dalio is a great thinker.
Jim: Just to emphasize something on what Yra said that the single hardest thing to do for anybody that’s investing is to recognize the regime that the old rules stopped working. Most people can’t and they keep pounding away with the old rules until they are out of business. The single hardest thing to do in any type of investing is say that we’re now in a regime shift. If you’re wrong, you get wiped out and if there’s no regime shift and you say it is, you also get wiped out. If there is a regime shift and you don’t adapt, you get wiped out. That’s why we have this volatility and blow ups along the way.
Yra: That’s right. And what I think people fail to understand is not just Dalio’s position. It is everybody that has handled this book and tail-coated it. I know a lot of people in banks or foreign exchange traders who made a fortune and have tail-coated George Soros in the BOE. If BOE reacted like the Bank of France and raised interest rates to 100% and said,” We’re just going to do whatever we have to do and you have to pay the cost.” He wasn’t successful in breaking the (2:38 – 2:40 inaudible)… to exit that train would’ve been an enormous pain for all the people who followed them in. So whatever you think Dalio’s positions are, which I think are enormous is tail-coated and recreated the same trades in many other ways. I think that’s what we’re told in the last two weeks. He’s got a lot of company in this low volatility place.
FRA: And Peter, your thoughts also?
Peter: I also think a lot of people lost perspective on the markets. When you turn on the T.V or the radio or when you read the paper, while earnings are great in the economy’s trade and therefore stocks are going to go up and I just want to point out that that’s from the end of 2012. So the calendar year at the beginning of 2013, the January 26th peak at the S&P, the S&P 500 was up 100%. Earnings since then, assuming 2018 assuming $100 to $150 per share, earnings should be up 60%. So the differences is actually multiple (21: 52 Inaudible). When interest rates rise or when people reassess what central banks are doing, why should people pay eighteen times their earnings? All of a sudden, within a week and a half, they decided let’s pay sixteen times with a one dollar change per earnings per share. Every one-term PE is 155 points (22:15 podcast skips, inaudible) while when we’re talking about two-term PEs, that’s 310 points. I think people need to have perspective that the stock market has ran well ahead of the rise in earnings and the difference is PE multiple expansions. It is now compressing because of the new regime change that we were talking about.
FRA: Could the rising interest rates in the U.S. cause us strengthening in the dollar (22:46)… rising defaults in the U.S dollar denominated debt in emerging markets which is estimated approximately $9T? Could that happen or could it also spur a financial crisis in Europe out of the bond markets? Would that mean that international capital flows coming into the U.S. towards U.S. dollar denominated assets? Just some potential scenarios. Jim, your thoughts?
Jim: I would come down on the idea of ‘no’. Let me explain what I mean by ‘no’. There’s this perception in markets that there’s all this money. There is no money heaven. No one ever loses this their money, it just gets allocated around. When the stock market goes down, but all the money from the bond market will come in to replace the stock market money that went down. I do not think you’re going to see some kind of reallocation where everybody is going to come running into the United States and it’s going to (23:53 podcast skips it, inaudible) the U.S. stock market and it is going to hurt them as well. I think the problem with the dollar, and I’ve been wrong with the dollar for several months now, is that the speculative flows are at record highs for some of them. Everybody is selling the dollar or is shorting the dollar right now. This has been keeping it unnaturally strong. If you wanted me to guess why we’re getting a persistent selling of the dollar, foreigners are basing their investments on who the president of the U.S. is. Sell the dollar. Investors have finally realized that it doesn’t matter. Eventually, that’s going to come back to foreigners and make them realize it matters. Your investments in a political idea might see a strengthening in the dollar. But are you going to see some kind of a wholesale run into the dollar that you were suggesting “no, I don’t think I’m going to see that.”
FRA: Yra, your thoughts?
Yra: I haven’t (25:12 – 25:13 Inaudible) … since Mark Fields’ comments back in 2017. Now, I’m fairly neutral towards it because it’s been a (25:24 inaudible) for people because interest rates in the United States are going up and (25:28 – 25:38 podcast skips it and inaudible). I’m scratching my head. If the deficit scare is real, I think what they did here by blowing the budget apart and the stimulus is that the people are a bit nervous. I don’t disagree with Jim because I’m really neutral with the dollar. If we go to real yields, Peter wrote about it today, the least positive on the short end of the paper rate I’d say is about 40 basis points based on the number that we have. The dollar would get a kick especially if the other central banks are just sitting there complacently because they would like their currencies to weaken anyway. I think Mario Draghi would like the Euro to weaken. I think the Japanese policies are driven by the desire for a weaker yen with the Trump agenda. People are being conscious and would like to see the dollar strengthen in relative to their own currencies. So, I’m going to wait. I don’t really have a good sense to where we go from here.
FRA: And Peter, your thoughts?
Peter: I’m bearish on the dollar in the short-term but considering the moves it has had, I’m definitely more uncertain about the very short-term move. We went into the year saying they’re going to increase the rates three times but then the markets really doubted it and now have the rising inflation that is probably happening. Higher inflation that’s not met by a rising Fed funds rate is typically dollar bearish. The Fed is going to raise three times this year. Take the Fed’s fund rate to a real rate of zero. That, of course, is well above where it is overseas, especially in Europe and Japan. But there is a reality that people still think it’s jamming around 2.0 even though maybe he’s not. But it’s still going to be on its gradual path. So there’s no way the Fed is getting ahead of the curve. They’re still going to be playing catch-up on top of better overseas economies that’s drawing dollars into other areas of the world. There are secular headwinds to the dollar but I’m less certain. I was very certain when the euro was 1.05 but much less certain when the euro is 1.25 in the short-term. I would not be surprised if, within the next two years, we see the euro at 1.40. It would not surprise me at all if we see the pound at 1.60. That’s were eventually heading within the next couple of years.
FRA: Jim, you mentioned this whole environment could be like the 90s when the markets went down and everything else. Where do investors and traders go to?
Jim: That’s the old 60:40 risk. Something is always going up. Yeah, I guess somebody is going to win the lottery today too. If an asset class is going to be rising, the answer is that they’re going to be small. Commodities might be rising but 95% of the money in the world is not in commodities. We’re creating a new asset class; cryptocurrencies. I, personally, think is an outgrowth of the rejection of policy. Inflation pressures financial markets. They go down. Stocks go down. Bonds go down. That was, ask Yra, that was the 1970s. I’m not saying we’re going to have high levels of inflation but what we’re going to have is that the stimulus will give you an appearance of high levels of inflation. So, I think that it’s going to be very hard to find, other than special situations like in the commodities markets, beyond that is going to be very difficult to find ideas where you can profit while returning to an inflationary environment.
FRA: And Yra, your thoughts?
Yra: I agree with Jim. What we’re going to see is (31:01 – 31:08 inaudible). Let’s say that the Phillip’s Curve may be able to get it right for a short period of time. We get higher interest rates. And now (31:27 – 31:30 inaudible)… 60:40 because they are both going to go down. I’m not a Phillip’s Curve advocate but if inflation does that. Those are both detrimental for corporate profits because rising wages with rising interest rates (31:42 – 31:53 inaudible). I just don’t see it. I know Peter has looked at this. (31:01 – 32:07). All these companies that borrowed a lot of money (32:09 – 32:15 inaudible). Take the interest rates expense, it is down to a really low level but we know that’s not going to last because for every one percent rise in the cost in borrowing, it’s going to hit discretionary spending levels dramatically. People are in for a shock here. It is really fascinating that (32:39 – 32:52 inaudible). It really does not make any sense. We’re much more worried about inflation. We know how to deal with inflation. In an interview that he did. So, you’re going to get into a feedback where at 60:40, they’re going to be sorry.
FRA: And Peter?
Peter: Just to quantify on what Yra said in terms of profit margins, lower labor costs and lower interest expense are the two biggest contributors for corporate profit growth from the 09 bottom. Just to quantify, there is about $13.5T of total business debt. So for every 100 basis points of interest cost, is $135B. Now, obviously, a lot of companies have turned down debt. But, generically speaking, in terms of labor costs, companies pay about $7T of labor cost every year. Let’s just combine that. (33:50 – 34:00 skips and inaudible)… higher costs that more than offsets the cut in the corporate tax rate from 35% to 21%. A lot of the estimates that is out there for earnings per share are all else equal analysis. It does not take into account higher labor cost and higher interest cost. When a lot of (34:23 – 34:24 inaudible) come out with their year-end price targets, it doesn’t include a lower PE ratio. It is static analysis. In terms of where to survive here, I would not be surprised if a two-year T-Bill paying 2.25% interest rate outperforms the equity market in a broad basket of corporate credit over the next few years. I think the commodity space is very interesting. I know a lot of people like to look at the demand side in terms of dictating prices but since that 2011 – 2012 peak in commodities, the (35:03 skipped) collapsed. Not only industrial metals, but also energy and particularly agriculture, which I’ve been very bullish on and on my belief on the dollar, I think gold and silver will outperform most equities and certainly fixed income within the next couple of years.
Jim: There’s $13T worth of debt and most of it has been turned out. This means rates goes up now but I’ve got 3 – 5 years to maturity. So I don’t see risk immediately. In the last ten years or so, there’s been a lot of people that have been turning up their debt through derivatives markets. They have been engaged in floating or fixed payments or receiving to take shorter-term debt and turn it out into longer-term debt. That is when you get a spike in volatility. Even that is going to start to come back to this day. Well I’ve got all of this short-term debt. The Fed is going to raise its rates. What am I going to do? I’m going to engage in swaps contracts in order to it mimic a 5-year note or a 10-year note but now it is more expensive to buy that swap contract because volatility is going up. That’s going to start hitting their bottom line too.
FRA: Great! Thank you very much gentlemen for your great insight. Just wondering, how can our listeners learn your work or go around? Jim?
Jim: Probably the easiest way is to follow us on twitter @BiancoResearch.com or at our website BiancoResearch.com
FRA: And Yra?
Yra: At YraHarris.com and the blog is from underground (36:58 – 37:10 inaudible). Food for thought.
FRA: And Peter?
Peter: My twitter is Pboockvar and subscribe to my daily writings at boockreport.com and my managing business is bleakley.com
FRA: Great! Thank you very much gentlemen.
01/26/2018 - The Roundtable Insight: Chris Whalen, Yra Harris & Peter Boockvar On 2018 Trends & The Return Of Volatility
FRA: Hi. Welcome to FRA’s Roundtable Insight .. Today we have Yra Harris, Peter Boockvar and a first time guest, Chris Whalen. Yra is an independent trader, a successful hedge fund manager; global macro consultant trading foreign currencies, bonds commodities in equities for over 40 years. He was also CME director from 1997 to 2003. And Peter is the Chief Investment Officer for the Bleakley Financial Group and Advisory at Bleakley and he has a newsletter product called The Boock Report. BoockReport.com. It offers great macroeconomic insight and perspective with lots of updates on economic indicators. Chris Whalen is an investment banker, author and Chairman of Whalen Global Advisors LLC which focuses on financial services, mortgage finance and technology sectors. He was a Co-founder and Principal of Institutional Risk Analytics from 2003-2013. He has held positions in organizations such as the House Republican Conference Committee…
Christopher Whalen: Yeah, talking about that.. (laughs). That’s okay. Most recently I ran and built up the Financial Institutions Group at Kroll Bond Rating Agency which was a lot of fun. Kroll is really an ABS house, first and foremost, commercial real estate and the rest of it. It’s still very small from competing with giants, but it was a lot of fun.
FRA: Great. And also he was on the board of directors for the Global Interdependence Center (GIC) in Philadelphia.
Christopher Whalen: Yes, that was David Kotok’s little project. You know it’s fun to mix business with pleasure. Fishing, central bankers go fishing.
FRA: Yes, I am actually going next month to the GIC conference in Buenos Aires and going fishing before that. There’s also fishing afterwards, sort of the Camp Kotok in Argentina.
Christopher Whalen: Well, some of them go to Maine. Ramiro Lopez Larroy and his kids will just show which is about 15 hours by plane. It’s a lot of fun. They are great people – A very diverse group at GIC. We’re going to Germany this year, the Bundesbank, so if you like monetary policy that would be a very good trip to go on. I would recommend that.
So, what would you like to talk about this morning?
Peter Boockvar: The Bundesbank has disappointed me for the last few years how they give Draghi the license to do what he has done.
Christopher Whalen: Well, they kind of had no choice. I find it amusing that northern Europe is cranking, and my relatives in Holland are having a great year, and yet southern Europe is not. That dichotomy is ultimately going to be very difficult for them to deal with. The Germans look at southern Europe and they just see more checks to be written. The politics of that is slowly undermining Merkel. It’s very interesting to watch. And then Berlusconi coming back in Italy – Isn’t that great?
Christopher Whalen: I always tell people to read about Berlusconi and you’ll see where America is headed.
Yra Harris: Draghi will be making trips to Italy.
Christopher Whalen: Yeah. Draghi has been trying to keep Europe on ice by pushing debt cost down to zero, but the debt keeps growing. So, what are we really about here? There’s no fiscal discipline anywhere in the Western world and the Chinese don’t care. It doesn’t matter in China – It’s a political issue. That’s why I was writing about H&A recently because ultimately, whether that company survives or not, will be determined by uncle Xi. That’s how it works in China. There is no church and state, there is just the state.
Peter Boockvar: He may want to set an example though.
Christopher Whalen: Yeah, there were a little ostentatious, a little floppy with the parties, pasting their names on the side of office buildings around the world. I think we have 3 of them in New York. It’s quite fascinating.
FRA: A few weeks ago, Chris, you wrote an article, Bank Earnings & Volatility, I thought we could begin with some thoughts there. How have the Federal Reserve and other central banks’ actions affected the credit market, the financial markets and the economy, in general?
Christopher Whalen: Well, what the central banks have done is that they have removed a lot of assets from the market. They’ve gone out with a variety of new money, in the U.S. case: excess bank reserves, and they’ve bought treasury bonds and they’re bought also mortgage bonds. Of recent vintage, Fannie Mae, Freddie Mac, Ginne Mae paper which have 3, 3 ¼ and 3 ½ coupons with very low pre-payment rates. Those bonds are going to be around for a long time. In fact, one thing I remind people of is that about 30% of the market today is the FHA and Ginnie Mae and those loans are assumable so they will stay with the house. And the house will trade and the loan will be conveyed to the new buyer. It could be very interesting, over time, to see how that affects the portfolio. But essentially, the central banks have taken all of this duration out of the market and since they’re end investors, they are basically buying the paper on credit and they don’t hedge it. So the capital markets activity that you used to see around a lot of these positions when they were held by trading firms, banks and other who were going to trade the assets and cared about mark-to-market every quarter has greatly diminished — There’s no hedging. The Fed’s sought out hedging it’s block and it’s a problem now because the Fed is now illiquid. They can’t sell without creating a loss and they dare not do that because it gets them in trouble with the Republicans and the House who don’t understand monetary policy at all, but have a lot of opinions on it. And so you have this weird situation where the Fed essentially has their hands tied. They’re going to wait for the book to run off which they hope is about $20 billion a month. And I think that they could be wrong. I think that they could too wishful in terms of the runoff rate in terms of the mortgage paper. The mortgage companies are going to be around forever and the pre-payment rate is going to be very low, especially if rates continue to move up. That’s kind of what I see. The trading line on Wall Street, the earning will be greatly diminished by this. Then you have the vote to rule. So all of the books, the investment books that the banks use to trade every day, just the value of the assets are passive now. You put those 2 data points together and you will understand why Goldman Sachs and why all of the banks have seen an enormous reduction in their trading buy-ins.
The other issue is that the mortgage market is down so there is less hedging. The forward market for hedges, what’s called the TBA market, has a lot less activity. We’ll do a $1.5 trillion in mortgages this year which is down. The peak was $4.5 trillion during the 2000’s; we don’t want to do that.
Peter Boockvar: Yes and why aren’t we seeing an CNI loan growth?
Christopher Whalen: The banks had to slow down. They had a pretty good run in 2015/2016. We had a little scare from oil which didn’t really materialize. Most U.S. banks did fine on oil credits. There was some restructuring, but the banks we follow like Cadence, which is a small lender that was built to do energy – They have no problems. But now a lot of banks have run up to a regulatory limit on commercial real estate loans, multi-family…there’s a big shtick now for the smaller banks. They’ve essentially run out of customers in certain markets too. The OCC, for example, is forcing regionals to peel back their multi-family exposure because the prices have gone up so much. They just look at that go whoa, wait a minute. And they’re right. Loss rate on these assets, multi-family assets, are negative. So if the loan defaults, you’re going to sell the property for a lot more than the loan and that’s reflected in the ABS numbers too. It’s an interesting time in terms of different asset classes, but I don’t see a lot of growth in the book. I really don’t. BA had a really good quarter at year end, but that was the exception. Most of the big guys were not growing. And of course PMC had a very good quarter and had a nice tax number. I think overall, don’t look for alpha in the banking industry. Between the regulatory changes and just the tenure of the economy you would be in the bond market, right? Anybody could raise money in the bond market in 2016 and part of 2017. So, we had a bull market in fixed income which has driven a lot of strategies and I’m sure Yra has some thoughts on that.
Yra Harris: Let me ask a question in regards to that. I was really taken by it because it was such a good point. With the ECB, BoJ and certainly the Feds, the dynamic hedges are missing from the market, but they are going to resurrect themselves as more paper winds up in the hands of private holdings whether it be by pension funds or insurance companies. But do you think that Jerome Powell…You know I go back and read some of his earlier stuff and of course his initial position as a Fed governor, he had a lot of issues with the massive build-up of the balance sheet. Do you think that he might be quicker to say that we can hold the rate at 2%…Do you think that it’s a possibility?
Christopher Whalen: I think that the snippets from the minutes that have sudden found people’s attention…which is very funny, right? We only pay attention to chairmen. It’s a cult of personality. So here you have Powell saying some very interesting things, very forthright, not an economist, he’s a financial guy, and I’m told he’s fairly decisive although he’s quiet and he listens. He knows how to make decisions. On this he’s got politics because the congress, if you remember years ago, they confiscated the Fed’s surplus to pay for a highway bill. And the idiots in congress, I wrote about this for the American Conservative, keep permittences from the Fed as revenue. They don’t understand that it’s an expense foregone. It’s not revenue. You’re just making the debt go away. Every year they look at this money coming in and the CBO and everyone else say: Oh look, it’s revenue. But it’s a snake eating its tail because the Fed and the treasury are one. It’s like a Hindu god, but in economic terms they are the same. And Bob Eisenbeis, who I interviewed, is wonderful on this issue – He is very funny. I think that Powell is going to be a lot more straight-talking then the others have been and I fault Yellen and Bernanke on this because they should’ve gone out and said to the congress: “No, you can behave like this. This is ridiculous. You don’t go confiscating our surplus.” It was just part of Washington politics, but the Fed didn’t respond. If Paul Volcker was there he would have been up on the hill kicking the shit out of them. And the problem is, these are bureaucrats, they come from academia. They have no money and so they don’t know how to behave in big league politics – It’s a tragedy. I think Powell will be much better. I am very hopeful about his 10-year as chairman. It desperately needed change. We got to get the economists out of the temple, I’m sorry. I love them, but they can’t make financial decisions. You want them on the staff, Yra, you don’t want them trading.
Peter Boockvar: We wish that was the case 10 years ago and now Powell gets to clean up the mess.
Christopher Whalen: Exactly and you know, Volcker cleaned up a lot of messes too. They always clean up other peoples’ messes so it’s a public service.
Peter Boockvar: And this is the biggest mess the world has ever seen.
Christopher Whalen: Oh yeah. No question.
Yra Harris: And with Bernanke he had the courage not to act.
Peter Boockvar: Right. Bailing out people doesn’t take courage. It’s not bailing them out what is courageous.
Christopher Whalen: Well precisely. And the Fed has not said no in a long time. They haven’t said no to accommodating treasury options and they haven’t said no most recently with this lunacy of QE. I mean the first one was fine. They had to reliquify the banking system as Walker Todd put it out to me a while back, but the rest of it was crazy. Selling all the short-dated stuff and loading up the book with long-dated treasuries so they own mortgage backs with an average life of around 12 years now. They have extended a lot, by the way, over the last 18 months. Even if the portfolio gets smaller, the duration has got to go up.
(laughs) How about that?
Peter Boockvar: Chris, what was their thinking in their models with operation twist to say okay, in their models, let’s flatten yield curve and that will be good for growth. And then today they express worries over the flattening yield curve.
Christopher Whalen: Well I know, but this is the point. When you have central banks take all this duration out of the market, nobody is hedging the position; well obviously it’s going to be hard to get those maturities to back up. There is just nobody selling euro/dollars, nobody doing swaps or anything – There’s nothing. So there is market is in stasis and they’re going to push up the short end, but there’s nobody pushing up the long end. So it’s gone up a bit, but I keep wondering…I wrote about it this week. I’m kind of hedged on my bull market 10-year trade, right? But, there is still nobody out there selling it. So I do think you have a flat curve in prospect, I agree. It’s bond market basics. It’s got to be somebody at that table in Washington who understands the bond market and I think Powell does – There’s hope.
Yra Harris: But in understanding the bond market, Chris, do you think that he will move to try and steepen the curve by maybe holding the front end, by saying hey, we don’t have to raise rates. If I get it to 1.75 on the Feds’ fund rate or 2%, I’m basically in a neutral real yield. That’s where I am. That’s probably about neutral on the front end. Maybe the real yield on the front end goes to 50 basis points positive, but I don’t think he goes there. Would it not be in his optimal mindset to say let’s start shrinking the, as Peter would say, quantitative tightening on the longer end on the duration. If the yield curve steepens out to 120-150 basis points it’s not necessarily a bad thing.
Christopher Whalen: I totally agree with you. If the Fed were acting rationally they would be doing all of that. They would have even been hedging a bit of the buck. Just trade it. Go out and hedge on the duration.
Peter Boockvar: Definitely afraid of affecting its bubbling asset prices.
Christopher Whalen: That’s part of it – True.
Peter Boockvar: That’s behind their entire thinking.
Christopher Whalen: But bureaucratically in Washington terms, they don’t want to take a loss because then the remittance to treasury goes away. And believe it or not, in the small minded world of some of these Fed people, that’s what they worry about. So, vector that into your thinking too because he’s absolutely right – They should be trading the book. They should have been doing a lot of things, but they’re not thinking like market people. They are thinking like Keynesian and academic economists and that’s scary — It really is.
FRA: In your article you mention also that this is likely going to result in a volatility returning to the markets that were all short volatility – Can you elaborate on that?
Christopher Whalen: Well that was the comment from Powell. He said at the end of that snippet from 2012 that they were going to unwind their short volatility position. In classical terms, if you buy a portfolio of RMBS it should give you a relatively short position, but in this case I think the other part of it is our perspective, the market. We’re sitting here and he’s got all the duration and we’re buying. Now, all of a sudden, he says that we aren’t going to buy anymore and we’re going to let it run off. So eventually private market participants are going to take up that duration, think of it as the weight that they have to support with capital, and they’ll have to hedge. So you will see market activity return. I think that the Fed has missed an opportunity to get a little bit more of this done quickly and figure out how much the street is willing to support. That’s the thing that we don’t know. The Fed has been supporting everything.
Peter Boockvar: The Fed lost their opportunity. The Fed had a chance to raise 3 times in 2015, 3 times in 2016, now they’re entering a situation where maybe the Fed fund rate tops out at 2-2 ¼. And they have now an issue with this falling dollar and bubbling inflation pressures. Just imagine when we do hit a wall and they start to cut rates and what the dollar is going to do in that scenario.
Christopher Whalen: I think it’s a lot simpler than you put forward which is: go ahead and keep your little quarter point march and if you see spreads start to widen, you stop. It’s the basic Irving Fisher test, right? That was the playbook for Bernanke.
Peter Boockvar: That is too much of a free lunch for me. I think that there is no free lunch in reversing this policy that they have implemented.
Christopher Whalen: So, you think we go to 6%? That’s what Yellen said years ago.
Peter Boockvar: We don’t need to go to 6% to cause a major problem. All the 10-year has to do is go to 3.5%/4% and you’ve got, I believe, a recession on your hands. I think the sensitivity to changes in interest rates is dramatic, as it’s been. You’ve got duration levels that are as high as they’ve ever been globally – That’s where the risk is.
Christopher Whalen: Well you’ll certainly see defaults go up because we’re hiding a lot of defaults with the artificial manipulation.
Peter Boockvar: And it’s not just that. Well you need a zero interest rate to go back to zero and $9 trillion of paper is going to lose a lot of money mark-to-market
Christopher Whalen: Hey, I know that’s why…
Peter Boockvar: Actually, I take that back. It’s more than mark-to-market — It’s real life losses.
Yra Harris: From a trader’s point of view…That position is enormous that they are carrying and more people have synthetically created that. Now you’ve got to realize that all of this volatility selling is all from people who are mimicking that risk parity trick. You can mimic it whatever way…You can recreate this trade synthetically in a million different ways. So when you have to actually start unwinding it, it’s almost like the long-term capital of 1998, we’re not going to be able to get out of that door because a lot of people are going to be racing out that door at the exact same time that you want to go because they have the same position whether you realize it or not.
Christopher Whalen: Well of course. And the VIX is just a popularity contest – There’s no basis for that contract. It’s just a matter of supply and demand. It’s like CDS. There is no basis on the underlying credit anymore.
Peter Boockvar: Well sure, but the VIX is still being determined by a lot of participants placing their bets and puts and calls.
Christopher Whalen: Absolutely. A lot of them weren’t hedging the past few years. Everyone was leaning in one direction.
Peter Boockvar: Of course.
Christopher Whalen: You would see default rates double in Peter’s scenario, easily. I think that’s from latency in the system. If we see the 10-year go up to like 3%, I think the windows will be shaking.
Peter Boockvar: And I read a stat over the weekend that of the roughly 2,000 companies, 40% of the debt is floating rate. And that cost goes up every single day with what LIBOR is doing. Even the 2-year note yield today is up to 2.12.
Christopher Whalen: That’s what I’ve been wondering about is to imagine the reissuance of equity that was bought in by these guys as they desperately try and pay off this debt. That could be a lot of fun.
Peter Boockvar: Yeah. The 1-year bill today is now where the S&P 500 is.
Christopher Whalen: We’ve had 4 years of amazing record bond market activity of each year in terms of new issuance and I would say 1/3 or ½ of it was to fund stock repurchases. It’s been quite something.
Yra Harris: And you know what, there’s another part…When the BoJ and ECB are busy buying corporate assets, there’s no hedging that goes on there either. And there’s also no stock re-lending. Another issue that I’ve raised…
Christopher Whalen: Yeah, that’s true. They may not lend the assets. That’s right. The Asian central banks are very, very conservative on that stuff. They won’t re-hypop.
Yra Harris: Yeah. There’s no rehypothecation of anything so now all of a sudden the game gets even more interesting and the question becomes: Do all the ETFs rehypothecate? Or does that result then with everything in that basket we get way late off the market and make it even more expensive for short sellers. So we’re not getting any short selling for some of these companies that are involved in ETFs are really miserable companies. So the whole dynamic here is shifted. And I don’t know that the players have really shifted.
Christopher Whalen: I don’t know about the ETFs. I would suspect those assets are available, but the central banks are the big thing. When they buy all of this paper and just put it away, you’re right, it doesn’t come out. It doesn’t get loaned. It reduces liquidity – That is, to me, the key thing.
The fascinating part is to look at the Swiss. Swiss National Bank is now buying stocks. Why? Because if they don’t, the currency will appreciate. That is their chronic problem. They just can’t keep the money out and even with penalty rates, they still can’t manage it. So if they stop, it will go up.
Peter Boockvar: That’s what one of the interesting central bank comments this week was from the deputy governor of the Swiss bank in Sweden, who has also gone down that rat hole of negative interest rates, and she said that they are not going to wait for the ECB to start raising rates. They’re going to probably start doing it this year. So I think that there is an end in sight to this negative interest rate experience over the next 2 years.
Christopher Whalen: Well, the whole system has way too much debt and a lot of debt that is mispriced. So like I said, you’ll see the banks start to lean into this too. I think you’ll see provisions gently go up from where they are. I was surprised to see the credit cards up this much this quarter.
The mortgages are still real quiet. And commercial is still really quiet because the collateral values have gone up so much. A loan you made 2 or 3 years ago, the building will get sold easily for the principle on the loan which is typically a 50 LTV (loan-to-value) loan. Look at the equity that has been created in multi-family and commercial real estate over the past 4 or 5 years – It’s ridiculous. And it was all levered up again.
Look at New York. New York is going to be a lot of fun. We have compression underway right now.
Yra Harris: Will the balance bring back foreign buyers to the U.S. market to hold this mark up a little longer?
Christopher Whalen: I don’t know. I’ve been trying to get some good data on that because it depends on a lot of things. There was certainly a gold rush for a while, but then the Chinese shut the door. They changed the rules rather significantly. That’s what H&A is about. I think that for Europeans too, things have calmed down a bit so you don’t have that crazy flight capital that we saw in New York in 2015 and 2016. But the bid for high-end condos, that foreign big is definitely waned. I know a couple of brokers who just do that market and there’s a lot of stuff for sale.
Peter Boockvar: There are a lot of signs that commercial real estate has peaked out in this cycle.
Christopher Whalen: Oh yeah — Definitely. But you know a lot of markets are completely on fire, just look at Denver, downtown Denver…
Peter Boockvar: Yeah, with certain demographics.
Christopher Whalen: Yeah and they’re leasing them.
Peter Boockvar: A lot of population growth.
Christopher Whalen: Yes. That city has exploded. The city has almost reached the airport. And for those of us who remembered when the airport opened, it was really far away.
Peter Boockvar: Yeah, I was at that airport 2 weekends ago.
Christopher Whalen: Yeah, and now (highway) 70 has expanded to the airport. It’s about a 40 minute run. That whole area with Colorado Springs and everything else has just completed exploded in terms of development.
Yra Harris: When they built that airport I said: Why are they taking away the old stable that said, “Stupid”. What vision I had.
Christopher Whalen: Now people are going to start expanding east away from the airport. That’s already happening.
Yra Harris: Wow. It will be in Nebraska.
Christopher Whalen: Exactly. But anyway, markets are going to be very interesting. I think that the fact that the dollar has been trading off the way that it has been is going to make for a very interesting year…
Peter Boockvar: And what we’re seeing in front of our eyes is the air leaking out of the bond bubble. Whether it’s here, whether it’s in Europe with the German 10-year breaking out above this multi-year range. I don’t necessarily know the pace of it from here, but things are changing before our eyes with interest and currencies. If there was going to be a major risk to this whole tranquil environment that it’s perceived to be, it’s the rise in interest rates and certainly a big draw down in the U.S. dollar. I mean commodity prices are at multi-year highs, the CRB printing 200 yesterday and holding them today. I think things are changing and there’s still a lot of nonchalance in the face of that.
Christopher Whalen: Of course. Markets sometime just sort of trade around numbers for a while for no particular reason and then you have an event that wakes everybody up and it moves, like the election. If you look at most charts for the bond market, there’s this big discontinuity around November 2016 and what do you do? Now it’s moved. And it moved again for a variety of reasons. China used to be the excuse, but I don’t think we’ll have that now. It will be a fairly boring inward look at China.
FRA: Chris, on your article you mentioned there could be downward pressure on long-term bond yields as the U.S. treasury concentrates future debt issuance on the short-term majorities.
Christopher Whalen: Yeah, that the schedule. And again, going back to our earlier conversation, you’re the Fed and you see treasury in the market with huge issuance. I can put a lot of pressure on short rates such that they may blow past the targets and keep going. Imagine that. Meanwhile the Fed isn’t going to sell anything outright and they’re not doing anything on the long end. They should be selling the futures at least. You don’t want to sell the cash positions? Fine, but do something because otherwise we’ll flatten just like Peter said. I totally agree with that. And it may happen quickly. It could happen in weeks – Imagine that (laughs).
Peter Boockvar: I still expect a creep higher in long rates.
Christopher Whalen: Yeah, it will bounce up, but it could easily rally. You want to be careful because there is so little paper. If they reopen the old issues which they can do, then you’ll know that somebody is yelling in that building saying, “Hey! You should be issuing longer dated paper.” The pit was planning to take their runoff and invest in the short end stuff the treasury is issuing, right? But their runoff may be so slow that they might not have that much net cash if they want to keep up with that $20 billion decline in the overall portfolio. So, I think it’s a funny situation. It goes to what Peter was saying. We could have a really nasty market environment because the Fed can’t help, the banks can’t help, they’re not allowed to anymore. So the street has no strong hands here that come in and push out a bad auction or push on the dollar if it gets messy. They would just have to intervene.
Yra Harris: And if they were to actually start…If Powell says, “I want to sell off…” to go back to your first point Chris, is that they are going to incur losses. And then they’re going to say, “Hey, we’ve got losses on our books this year because we’re actually taking some losses on the long end stuff that we bought.” So they’re kind of locked in that situation. And the situation on the front end has gotten so interesting that I actually called someone at the CME and said that I think it’s time for them to dust off the old contract and bring it back because it may become useful besides with the euro/dollar.
Christopher Whalen: Well no, this is the thing, the Fed economists in Washington were bragging about the fact that they made money on QE and they don’t understand. To your point though, Yra, what Powell has to do is get up and say, “We’re going to be selling some bits of the portfolio to help accommodate the treasury’s issuance and to rebalance because it’s far too long.” And they can do that in a variety of ways, but then he’s got to look at them square in the eye and say, “By the way, this going to reduce remittances for years.” They have a little account called the negative asset; they came up with it, where they put the losses. The congress capped the Fed’s capital at $40 billion when they confiscated the surplus for highways. So this is the situation you have and they don’t want to be insolvent. If there’s a big number in this contra account and they have $40 billion in equity, people can do the math. That’s the politics of this. It’s very strange. You got to realize that they are central bankers, they are very funny and it’s a big factor.
So, if Powell will change that? That’s a big deal.
Peter Boockvar: I think also a key factor is how much control these central banks can have over their external environment. I am of the belief that markets are going to force their hands. I still believe that cyclical inflation pressures are going to force their hands whether it’s commodity prices, wages or supply chains. I read an article yesterday on the front of the Wall Street Journal on how it’s almost impossible to find a truck to deliver your goods and people are paying hand-over-fist to just try and find drivers. I don’t think it’s necessarily fully in their hands. I mean Powell is going to have to start watching the German 10-year yield every day. Behind the scenes, obviously, a liquidity flow is turning into more of a drip and that all of these central bankers have to look at each other because what one does is really going to influence what the others do both on the upside and downside. When you think about this rise in interest rates, as some of these banks start raising, it gives other central banks cover. So, you’re less inclined to keep rates low if other people are doing it on the upside just as we saw the reverse. Peer pressure cut the rates to nothing and it’s going to do the reverse on the upside. I think that also feeds on itself. I am just amazed at people believing that this is going to be a smooth process and historically it never is.
Christopher Whalen: It’s even worse now because they took cash flow out of the system by forcing rates down. Forcing rates down is a debtor-friendly policy. It’s meant to transfer value from savers to debtors. So now, you have more volatility in the system because it’s less cash flow. People also have very little fat. There’s not a lot of embedded savings in the system from carry because your assets don’t throw off that much cash flow. It’s stunning when you look at Bank of America and the gross yield on their book is 4% — They’re not making money. The whole industry has got a negative risk-adjusted return because the return on assets is so low. In fact, I think that the number for the industry now if 0.75% on earning assets across the board. It used to be over 1.00%. And so the central banks by constantly forcing rates down, they’re taking carry out of the system and it’s not good – It’s deflationary, ultimately.
But I looked at the debt thing, Peter, and I totally agree on it. I’m going to have a lot of fun watching this. I was doing comments today for one of the regulators on whether or not they should allow different credit scores for underwriting loans – What do you guys think? Do you think that’s a good idea to have more than one way of measuring something like that?
Peter Boockvar: It makes sense.
Yra Harris: Yes, it would. I think the whole cycle from a private perspective, you know having my kids go through this stuff, and honestly it’s ridiculous. It’s truly ridiculous in the way that they measure it and they hold everyone accountable to the same standard. I know, it made the banks comfortable with time and there was a need for it, but if I ran a small community bank I would never do business like that. And I know they saddle with them. That’s not how you properly do business.
Christopher Whalen: Well, that’s what I’m telling them Yra. Like you said, the government shouldn’t be in the business of picking one. You let the people who underwrite loans figure this out and then the markets are going to tell them whether they like it or not because they’ll price the pools accordingly. So, I think we can figure this out real fast.
FRA: Just as a final question if you can go around to give your thoughts on where central bank: monetary policy and government fiscal policy is going this year in 2018.
Your thoughts, Chris?
Christopher Whalen: Well, for monetary policy I think that they are going to try and stay on the program as far as rate increases. But you get the 10-year stuck and it keeps moving Fed funds up – You’ll have a flat curve. And I think they’ll have to stop at that point.
Fiscal side: I don’t see any inclination of discipline in Washington – It’s a train wreck. They’re going to have to figure out a way to raise some revenue otherwise we’re staring at some pretty scary deficits. And I think eventually the credibility of the United States will suffer.
FRA: And Peter?
Peter Boockvar: Well, I think the weakness in the dollar is beginning to reflect the worries of those depths and deficits. That maybe we do have a $1 trillion budget deficit again in 2019. Obviously fiscal policies, in terms of tax cuts, are in place. Everyone’s got their fingers crossed that it actually improves economic growth as opposed to just improving earnings per share. We are seeing some wage growth which is a good thing, but one thing that we’ve seen is that the assumption on Wall Street was that the tax cuts all that would flow to the bottom line and we’re seeing that not all that will flow to the bottom line.
Christopher Whalen: Oh yeah. And the repatriation narrative is infantile. I cannot believe that people with PhDs in economics can sit there and go on and on about how cash is going to be brought back and invested in the United States. That’s not the way corporate finance works.
Peter Boockvar: Yeah, and a lot of that cash has been spoken for anyway with all the debt accumulation to buy back stock. So companies have already frontloaded the repatriation by taking on all this debt.
Christopher Whalen: Of course. But if you look at tax shelters like you saw they hit the Goldman because they are the great tax shelter shop. And a lot of that stuff is not going to come to light. You think everybody is going to go to the IRS and turn themselves in? The case with Dow last year that the Supreme Court declined to hear was a big deal. Donald Trump has the same tax lawyers as Dow. Trust me, the IRS now, any corporate they go to sham partnerships with as tax shelters, they basically just have to write a check. They have no appeal. There’s trillions of dollars at stake here. Trust me, these corporates are not going to come forward and say we did this wrong. Nope.
Peter Boockvar: I continue to believe that the other side of the easing mountain is upon and that creates the biggest risk for markets and the economy. People say that we’re not going to have a bear market until the economy goes into a recession and I argue that it’s going to be the rise in interest rates that leads to a decline in stocks that then leads to the recession. A trillion dollars of liquidity coming out from the Fed just in a loan is going to be a big deal as we deeper into the year. That’s what we have to look forward to over the next 2 years. The Fed taking out a trillion in loan the next 2 years after beginning that last year, the ECB ending QE, and that’s a $600 billion reduction in their run rate in 2018. And then the elimination of negative interest rates. So that’s what we have to look forward to over the next 2 years in terms of interest rates and I don’t see risk assets just whistling past that.
Christopher Whalen: Oh no. Look, everything is compressed. The whole curve is going to expand. Yra?
Yra Harris: Yeah, everything that was talked about and then you throw in the infrastructure spending package Trump is going to get through. I mean he’s not only selling the world today. You should watch how he probably hijacked Davos because they couldn’t lick his boots fast enough and he’s disruptive…So he’s got all this more debt coming on. He’s got really got discussions going on, in the United States of course, about financing debt. We are going to find out if his interest rates are going higher. We know the answer to it, but the rate of the world is going to have to find out. You have the ECB who took the Bernanke model and did everything they could to explode it with the amount that he could buy and he’s still…Peter and I know, he’s going to end in September, but it’s going to have a massive amount of assets on that balance sheet in the ECB and with the Germans breathing down their neck…There is nothing good going on there. There is nothing good and it’s going to come back to haunt. Now we have Joe from China and he’s reminding us about Minsky. The Chinese are reminding us about Minsky so we know we are in a very difficult situation and the world is just sleeping through it because you wake up in the morning and you see your stock portfolio is doing a whole lot better so you go, “What’s the difference. We’re all good here.” And they carry on. So, I think it’s going to be this year. I don’t think it’s going to wait for 2019. Some of these issues that people have chosen to pretend don’t exist. And it’s all bound to, we always know it. I think the 3 of us would agree that all crises come up from the debt market. Credit and debt markets determine everything and we’re there. It’s just what’s going to be the actual start that sets it off. I am not sure. I do agree with Peter that it’s going to be central bank oriented and it’s going to come as a change of direction. I think, Christ, you would agree with that too, it’s just how they do it. And Jerome Powell is going to be an interesting guy to see how he reacts to it.
Peter Boockvar: I think a very important question is: Where is the out-of-the-money put strike price right now on the Fed? What level, what percent decline, tells Jerome Powell that he needs to stop his tightening or reverse it? I think that’s going to be an important question.
What’s his tolerance level if these asset markets reverse themselves?
Christopher Whalen: But that’s an important question you’re asking because the tolerance level was very low. In other words, they wouldn’t tolerate any market upset. With Powell, it may be a little different.
Peter Boockvar: Because Powell has more tolerance.
Christopher Whalen: Yeah, I think he does.
Peter Boockvar: I agree.
Yra Harris: …Selloff in the equity markets? I don’t know.
Christopher Whalen: That’s the question Yra.
Yra Harris: Yeah.
Peter Boockvar: The irony is that you get a 20% correction then you’re just back to where you were last year.
Christopher Whalen: Oh, Powell has an easy button on his desk. The question is: Does he push it?
Peter Boockvar: Right.
Yra Harris: Yep, I think that’s absolutely right.
Peter Boockvar: As we speak, interest rates are breaking out today. The 10-year is up to 2.67% now. The 3-year is approaching 2.13%.
Yra Harris: And the Europeans…Today they’re not the catalyst; other times they are the catalysts. I’m interested to see it.
Peter Boockvar: Yeah, the dollar rallied for a couple hours after Trump tried to defend it and went straight back down again.
Yra Harris: And you know what? We didn’t even get into our discussion with the Swiss because they get the alchemy award of the last millennium. The game that they played here and pulled off is unbelievable to me. It tells you about the state of the world…
Christopher Whalen: Well, Peter’s right. They could take a loss on all that corporate exposure that they have. That would be a lot of fun.
Yra Harris: You know what, Richard, they finally admitted now that they are going to be the cryptocurrency capital of the world. They have been the currency capital of the world. But I think that is absolutely right. And it’s interesting, Peter, that is the Yen that turned when Kuroda was speaking at Davos today. The Yen turned very hard.
Peter Boockvar: Yep, it did. He said he’s getting more comfortable as inflation is going to their target.
Yra Harris: Yeah, and I think the Japanese are waking up that the Trump administration is not too happy with the Yen being so relatively weak. And Draghi and Kuroda can pretend all they want…And what was that comment yesterday from that one guy, and I know that they went back to that damn G20 meeting in Washington, which I kind of thought that they would, but he said, “Monetary policies that have a negative effect on currencies, that’s just an effect, that’s not a targeted currency.” Right…And that’s why every central bank when they release the statement about their interest rate intentions cites the level of the currency. Everybody in the United States, that is. Everybody talks about the level of the currency. Everyone discusses the level of their currency as being one variable in determining how they’re going to set interest rates.
FRA: Interesting times and great insight on the credit markets, financial markets and the economy. Thank you very much gentlemen for being on the podcast programmed show.
Yra Harris: I’d love to do this again. This is great.
FRA: Just as a final word for our interested listeners. How can they find more information about your work, Chris?
FRA: Great. And finally, Yra?
Yra Harris: You can find my blog at www.YraGHarris.com and sign up for Notes From Underground which is also free. Whenever I write which is sometimes 4 times a week or sometimes 1 time a week will be sent you. And listen to the FRA podcasts. I think that they are very informative.
FRA: Great, thank you guys and maybe we can all do this together sometime.
Yra, Peter, Chris: Thank you.
Transcript posted by Daniel Valentin
01/26/2018 - The Roundtable Insight: Yra Harris And Peter Boockvar On The 2018 Trends In The Financial Markets
FRA: Hi welcome to FRA’s Roundtable Insight. Today we have Yra Harris and Peter Boockvar. Yra is an independent trader, a successful hedge fund manager; global macro consultant trading foreign currencies, bonds commodities in equities for over 40 years. He was also CME director from 1997 to 2003. And Peter is the Chief Investment Officer for the Bleakley Financial Group and Advisory and he has a newsletter product called The Boock Report. BoockReport.com. It offers great macroeconomic insight and perspective with lots of updates on economic indicators. Welcome gentlemen.
Yra Harris and Peter Boockvar: Thanks, Richard.
FRA: Great! I thought we’d do a view on your thoughts on 2018 in general; where markets are heading, what the trends are, if you see any geopolitical events happening; effects on financial markets and the economy. And so, maybe we begin with the current rally in equities. Do you think it is sustainable? What are causes of this? Where do you see it going? Maybe start with Peter?
Peter Boockvar: So, what we have is enthusiasm, of course, post-US tax reform combined with optimism about global growth. Generally speaking, that is overwhelmed any concerns with central banks and the tightening or less easing of monetary policy. We went from “Don’t fight the FEDs, don’t fight Central Banks” to “who cares about Central Banks” because everything is fine in the economy and there is disbelief that we’re making the transition from a reliance on monetary policy to the benefits of a fiscal policy and synchronized growth. That is what the market currently believes. I think, this year, that thesis will be tested as monetary policy usually dominates fiscal policy in terms of its impact on markets and the economy because interest rates are such a strong lever and in a highly indebted global economy, that becomes even more so the case.
FRA: And Yra, your thoughts?
Yra: I have to stop and say that things Peter and I have done a lot with you Richard and so much of what we discuss is really coming to fruition. In fact, today is the most important day coming out of Davos (World Economic Forum) I hate this time of the year because I’m just not a big fan of what goes on in Davos. I found it, actually, kind of despicable to tell you the truth that these people gather and there’s so many political powerful people that are from central bankers to treasury secretaries to finance ministers discussing things and it’s an expensive ticket. I think its $650,000 to $700,000 and just what are you paying for? And it’s only going to be my problem and of course, there’s a day like today. We got a double blast; from Wilbur Ross and Steve Mnuchin. Mnuchin is a secretary and was talking about “if the dollar goes down, it’s actually good for U.S trade and Wilbur Ross, found to be more incendiary because he said,” …well, there’s trade wars every day. What was the exact phrase that he used? “Now we’re sending soldiers to the rampart”. Well, that’s a very, very incendiary phrase and I was truly bothered by that. So, everything we just talked about, everything Peter speaks to, this is going on. You know, Richard, I think that the 10-year will close out the year at 3.4%. I heard Richard Fisher today pushing about poor rate increases. Maybe. The more I hear what these people or what this administration are talking about, the more concerned I get as to where this is all going. I think I understand why Mnuchin and why they chose Davos to make these statements. That’ll be an issue for other people to think about. It’s very problematic and it does raise some serious issues for the Fed. It’s going to put Jerome Powell in a very difficult position especially if they keep the dollar down. I think we’d probably agree. The reason they keep it down. If you’re going to attack the Trump administration for starting a trade war, the only other alternative is to mark the dollar down. So, it now becomes open season, as far as I am concerned, on the dollar. So, why not? Richard, today you’re talking to two people. I know Peter has certainly been bearish, for what, $1.08 on the euro?
Peter: Yeah, $1.05.
Yra: Yeah, at $1.05 for sure. So I know these discussions have been going on for almost a year. And, Richard you know the many conversations that we’ve had in fact, I know Peter and I totally found commonalities when Mark Fields came out of the White House and talked about currency manipulation being the mother of all trade barriers. So it’s almost like this administration has adopted to that and said,” Hey, you want to go this route? We can play this game too,” and that’s where that leaves us to today.
Peter: It’s a very dangerous slippery slope. Steve Mnuchin is obviously trying to help the manufacturing sector but that’s 10% of the U.S economy. We are a consumer-based economy. So, damaging the purchasing power of a consumer-based economy is very dangerous. You have potential for rising input prices and certainly higher interest rates and I think that will swamp any benefit to multi-nationals. You have commodity prices, say CRB index, which is at the highest level in about two and a half years have rising inflationary pressure, generally speaking, particularly in wages. Now you have the threat of rising interest rates that will only be exacerbated by a weaker dollar. We import more than we export; highly inflationary. Foreigners own a lot more of our assets than we own of their assets and we rely heavily, particularly in the U.S treasury market on foreign buying of our bonds. If you look at last year, one year ago, a European buyer that wanted to pick up some yield bought a U.S treasury; 10-yr at 2.45%. A year later, not only did they lose some principal, since prices are lower, but they lost 15% by owning the dollar. So this is a very dangerous game. The administration should be focused more on currency and dollar stability, not the basement. There’s a very negative slippery slope.
FRA: Could other central banks, outside of the Federal Reserve, take reaction to this? Could there be currency depreciation intentionally done by other central banks? Do you see that?
Peter: We’ll find out tomorrow when we hear from Draghi.
Yra: There’s a lot of people short Yen or long dollar/Yen here who have been comfortable. That is not a comfortable position that you should be in because if there is somebody out there with a target on their back, it’s the Japanese. The BoJ (Bank of Japan) should’ve ended this policy. That doesn’t mean you have to start tightening and I know they’re not buying as much as they say and as the market thinks that they are because they don’t have to. There’s not that much to sell so whatever you have to clean up to keep that yield curve at that position is certainly not nearly as much as it was a year ago. You don’t really know the full amount of buying but with whatever they want to do they step into the equity market anyway people are buying but whatever they want to do. They step into the equity market anyway. It’s a very slippery slope and I think we’re going to hear from Peter’s executive director or from ECB (European Central Bank) about the strength in the euro. Now in some ways, the strength of the euro helps Draghi because it keeps the Germans at bay. It’s interesting that Jens Weidmann, now all of a sudden started talking more and more. So it does give Draghi some leverage. He could certainly go,” Well, we can afford to be more patient.” It’ll be interesting to see in his press conference how much he discusses the recent strength of the euro.
Peter: I actually think in this counter-intuitive that the strength in the euro actually gives Draghi some license to back away from his policy because inflation pressures are building in Europe as well. What the central bankers want, they have to be very careful as with, because if they achieve the inflation they want, interest rates are not going to be where they are. If Draghi gets us 2% inflation, the German 10-yr is not going to be a basis point, it’s going to be multiples of that. We saw in the market data today, talking about prices pressures intensifying. I want to bring up Japan and I’m going to quote Reid from this press release today from market on Japanese manufacturing. It said,” Strikingly output price inflation accelerated to the fastest rate since October 2008 an inch sharper rise to input cost. With a low rate in unemployment and sustained growth in official GDP data, inflation pressures should continue to mount.” Just imagine if they get the inflation they are hoping for, what’s going to happen to these bond markets? So, by having a little rebound in our currency, they can maybe moderate the inflation pressures. At the same time, giving the central banks an out. Now, of course central banks won’t look at it that way. I’m sure Draghi is going to whine about the stronger dollar is making it difficult for him but I think this is a window that’ll give them the opportunity to back away from their policies because I have to believe that they see the same inflation pressures that we do, particularly in the commodity side, with prices continuing to go up every day seemingly.
FRA: So, for this year, do you see a trend towards quantitative tightening by major central banks?
Peter: Well, the Fed is certainly initiating that. The ECB (European Central Bank) and the BoJ are just buying less but buying less is still a form of tightening. If you blow less air in a balloon, there’s still air going in but less air means a contraction of that balloon.
FRA: And Yra?
Yra: Peter and I have little bit of a different view on this because I still think that Draghi is operating, not just prior to his mandate, his self-declared mandate; is of course the preservation of the euro. I still think that his end game is to put so much debt on those books. Not that he doesn’t have it already, he does. He’s going to push for the creation of a Euro bond. Merkel (Angela Merkel), I can’t tell you what she’s thinking right now. She has got some serious issues. She was chirping about some stuff today about globalization, what they need to get done are they going to divide banking authority. There’s a lot of things in the platter in Europe. It’s just not a straight path and I really think that if inflation takes off in Germany, Draghi and a lot of bosses will be happy because it’s a way for them to punish the Germans for being so intransigent towards Greece, Spain and Portugal. And pushing for fiscal austerity even when unemployment is over 20%. You’re going to have to endure this because right now, the most ridiculously priced asset in the world is certainly German debt. It’s preposterous. Peter keeps pushing it and he’s a 100% right. Right now, the interest by any practical measure, the interest should be about 4 %.
Peter: Which should be in line with nominal GDP there.
Yra: Yeah. Maybe 4.5%. It is so preposterous. Let alone all the others but nobody acknowledges that. They all look for reasons. Germany is a land of savers. Every bit as much as the Chinese savers. That’s why the current account surplus is so huge. It’s the largest in the world because Germany saves. They save a lot of money and these savers are being punished because the people who are wrong are not Germans who are investing in the DAX or anything, it’s German pension funds and insurance companies but it’s not individual Germans. They got beat up so bad in the market back in 1999 and 2000. They’re not that invested here. So, most of their money is in fixed income type of instruments — they’re getting killed. We’re speaking on the Financial Repression Authority (FRA), nobody is being as much financially repressed as the German population and that has political notifications.
FRA: Will interest rates tend to rise this year necessarily at different points in the yield curve for yield curves across the major economies? Peter?
Peter: I believe that’s where we’re headed. In the U.S, they keep talking about rising commodity prices and rising wage pressures that are clearly evident everywhere will see whether productivity can offset that or not. The Fed is obviously going to be buying less. You have an enormous amount of supply coming our way as debts and deficits continue to rise. We could have a trillion dollar budget deficit next year. Now, I know the relationships between deficits and interest rates that are somewhat squishy but that was the case in a bull market in bonds. If we’re no longer a bull market in bonds, then the U.S treasury market maybe become more sensitive to U.S debts and deficits. Then you throw in the weaker dollar which can impact foreign purchasing of U.S assets. So I think that interest rates here will continue higher. I think they’ll surprise to the upside. In Europe, I think, interest rates there have only one way to go and that is higher as the ECB will likely end QE (quantitative easing) in September. As they’re currently buying less, or 50% of what they were buying in December and Japan is obviously the wildcard. Actually, before I get to Japan, let’s get back to Europe because this is what bondholders in Europe have to look forward to. Not only do we have a situation where QE is shrinking and going away, but after that they have the end of negative interest rates to look forward to afterwards. So, you had the Riksbank today saying that we’re going to start the path out of negative interest rates even before the ECB starts doing it. So, we are now looking at the barrel of the end of negative interest rates over the next two years. With seven or eight trillion of negative yielding interest rates, there’s going to be a lot of money lost in just getting negative interest rates back to zero. I see only higher interest rates under many different scenarios out of the next couple of years globally.
Yra: I agree wholeheartedly with Peter. I think the 10-yr yield, Peter and I have not discussed targets and I hate choosing targets but when I got pinned down I said,” The 10-yr will be at 3.4% at the end of December of this year. I think I’m going to be low. I think the curve will be back between 130 and 150. I really believe that. If they keep bringing the dollar down, it’s going to come harder and faster as Peter talked about that slippery slope. So, I’m a 100% in agreement and at 2.63 on the 10-year it’s a nice technical level. We could go a lot farther, especially if we have the central bank step back and are not there buying as much.
FRA: Now, one of the economists at Davos we mentioned earlier is Bill White, the former Chief Economist for BIS (Bank for International Settlements). He is now the Head of OECD Review Board. Just wondering on your thoughts, he mentioned because of this rising trend in interest rates, there could be some problems on the horizon due to the problems in servicing debt. So there could be a Central Bank debt trap if you will. Your thoughts on that, Peter?
Peter: Over the last few years, the average duration of credit around the world has gotten to record highs. Which means we’re hugely sensitive to small changes in interest rates. I would have to agree with that. I’ve read some chart from Deutsche Bank saying that,” considering the amount of global debt for every hundred basis points of rise in interest expense or in interest rates, can lead to a loss of 1.2 trillion dollars on paper. We’ve been addicted and accustomed to extraordinarily low interest rates that has dictated behaviour whether it’s the behavior of lending money to a junk credit with almost no covenance to keeping zombie companies alive to buying expensive paintings and hundred million apartments in New York City or buying the S&P 500 at historic valuations compared to 1929 and 2000. Changes in interest rates are higher and it doesn’t have to be a lot higher. It could have dramatic effects on the pricing of a lot of different things because the cost of money is the important price in input to a lot of these things. I think the markets are way too nonchalant with this move in interest rates and this change in behaviour with respect to central banks.
FRA: And Yra?
Yra: You can’t say it better than that. Bill White, whom I have great respect for, as I call him Mr. Lean or Clean because in 2006, he wrote that wonderful paper for BIS talking about the role of central banks and should they be in the business of leaning into spectated bubbles or should they just wait and just clean. He was warning what was coming. We are addicted to this. We’re so addicted to just taking on more debt, more debt, and more debt. What are they using the debt for? To buy back stocks and pay dividends. This is so classic. Ray Dalio, whom I certainly respect as a thinker. I’ve been reading him for almost 35 years and Jeremy Grant also. But it seems to me they’re doing a lot of what I call “chirping” on issues that ought not be discussing such as: if you’re holding cash, you’re going to be sorry. Ok, maybe. But as I think by the time I was down with you, I did something a few weeks ago that I haven’t done in nine years. I took the free cash which is out of my trading account and bought T-bills (Treasury Bills) as my security. My daughter called me and said,” Dad, ninety-day T-bills are 138 basis points.” What am I thinking about? I’m moving and I’m not the only one because Warren Buffett said he’s got a one hundred million in T-bills. These are interesting moments here. I’m not as convinced of this great melt-up as everybody else. I think Peter is getting to where, as usual, things started getting called. We’re very sorry you own a $150 million dollar painting.
FRA: Could there be a slow-down in asset inflation due to the quantitative tightening trend?
Peter: It should. It certainly hasn’t happened yet. The sixty-four thousand dollar question is “when does it matter” and none of us know but I think we’re more confident that it will definitely will matter. I just have to be able to understand that risks are dramatically rising when you have such extreme valuations at the same time you have rising interest rates and a tightening of monetary policy. But again, the question is when does it matter and we won’t know until it does.
Yra: Yeah, and that’s right. People say, if they listen to Peter and I talk, you guys are just crying because you missed it. I have more money in stocks than I ever had. Before the market was at its highest, just by good fortune, started peeling back more. So I’m peeling back into this because I missed the last five percent. I’m not going to be upset because when the break comes, it’s not going to be a five percent break. It may be 15 or even a 20% break. Everybody says,” well that puts you in a bear market.” I don’t know that these rules people really hold in the realm of these Bernanke terminology; zero bond interest rates. I don’t know if any of these old rules hold but we’re going to find out.
FRA: Yeah, exactly.
Peter: We will find out.
FRA: Yeah. If this would’ve happened if they were a significant and fast fall in asset values of asset pricing, could there be a reverse in course by central banks from tightening back to quantitative easing?
Peter: Here is where it gets really difficult for the Fed because they went so extreme and were so slow in removing that accommodation, they left themselves with very little wiggle room. So in the past recessions, they obviously have a lot of bulls to respond. If this selloff is precipitated by higher interest rates, weaker dollar and higher inflation and the Fed decided to start cutting rates that would be a further mess for the U.S dollar and potentially even more inflationary and could lead to even higher long-term interest rates. So then what the Fed is going to do is, they’re potentially really screwed and it also ties hands with QE that could weaken the dollar even more. That gets back to the original discussion on the dollar and the administration wanting a weaker one. It really creates a difficult situation for the Fed if the dollar weakness continues because it completely ties their hands in responding to the next down term here. Because imagine them cutting interest rates with and already weaker dollar, that would be a real mess.
Yra: You know what, if you look at the last the curve steepened out over 180 or 200 baseline, I’m talking about the 210, that was when the second QE2 and everybody was convinced. Now we’re really going to get inflation. So the Fed, of course, wasn’t moving on the long end even though they were buying more. People were selling thinking inflation was really going to take hold. People are smug about the stock market breaking or possibly being negative. The other side of the coin has been where people say,” Where is the inflation?” They started talking about gold but gold is not going to go up because of inflation. Gold is going to go up because the central banks in the world capitulate to the deflationary scare because that is when gold went up the first time. There was no inflation. They would do anything and I mean anything to prevent deflation setting in and that’s what Peter was talking about. If they had to back track here now, look out!
FRA: Did that prompt them to go into extreme negative nominal interest rates so we get real nominal interest rates going into negative territory to an extreme level as if they’re cutting the interest rates on the low end to the same extent they did on the first financial crisis?
Yra: No, that view will certainly have “good friend” on the Fed.
Peter: Yes, no pun intended.
Yra: Pun totally intended. Thank you, Peter
Peter: I’m not convinced we go to negative interest rates. I think you’d blow up the U.S money market industry. I think the banks would go bananas so I don’t see that being a possibility in there. I think that the experiment with Japan and Europe with what they did to the profitability of the banks there. I think there’s a part of negative interest rates that’s been repudiated as a good policy. As the reserve currency of the world, having a negative interest rates, what a disaster that potentially could be.
Yra: I totally agree. I think that point was so well taken. I think Japanese stocks is a safe hiding place for many years. I still hold them. They’re finally starting to move now and they’ve been terrible. It’s like the European banks. Every time I hear people talk about European banks, what Deutsche Bank is trading 19.50? Big deal. They haven’t really responded well. Yeah, they’re well off their lows but that was because there was a question of their sovereignty. Now we’ve got beyond sovereignty at least for a minute until one of the European countries who really have a lot of sovereign debt becomes an issue and our sovereign bond is going to be zero risk rating forever but we’ll get to that question later.
FRA: What are your thoughts on geopolitical risk to the financial markets in the economy, Peter?
Peter: I’m less worried about geopolitical risk. It’s usually more news worthy than economic or market worthy. I don’t think we’re going to war with North Korea. I put that on the backburner, it may happen a day here or a day there. I’m less worried the geopolitics than I am of central banks really screwing this thing up.
FRA: And Yra?
Yra: I couldn’t agree more. To me North Korea, I had trip of my own to North Korea because my son who really knows Japan well. He said,” Look it, as long as the United States isn’t sending air transports and take people out of Seoul, you don’t have to worry about anything because there’s 150,000 Americans living and working in Seoul. We know what happens if the United States were to bomb North Korea. I’m just talking about bunker busters that the retaliation upon Seoul would be so great. There’s nothing going on there. To me, the most dangerous place right now politically is Europe because we have the Italian election coming up and there’s a lot more possible impact coming from there. You can’t show that on television. You can’t take a picture of what’s going on politically in Europe. You can talk about it but it doesn’t have that dramatic effect. The only thing is the Saudi-Russian connection and possibly Turkey but that’s with us at all times. The Mid-East is the Mid-East unfortunately. I don’t see much else.
FRA: What about your thoughts, Peter you recently mentioned, Europe could be the epicentre of the next financial crisis coming out of the European bond market. Do you still feel that way?
Peter: Yeah, we need to remember that the bubble this time around was in central banks and interest rates. Just by having a conversation about negative interest rates tells you the bubble ran because, you know, that’s the epitome of a hot potato market. With Europe flooded with negative interest rates and the ECB reversing themselves, that’s where I think there’s a major, major risk. I think people have to really focus on that. Plenty of risks that could emanate from the U.S but a blow up of the European bond market will have global market interest rate reverberations.
FRA: And Yra, your thoughts on that?
Yra: That says it all. There’s nothing I could possibly add to that.
FRA: Given this view on the horizon, how can investors protect themselves or what asset classes, generically, do you see as making sense in this environment? Peter?
Peter: I remain positive on commodities. Not just initially on the weaker dollar but we’ve seen years of underinvestment. Gold and silver is the way I’m playing the weaker dollar directly. I think that will continue to be a good place to be and I expect much higher prices. I think shorts from bonds, now all of a sudden, pay you something. As Yra said earlier, owning T-bills, you actually get paid in a coupon that is at or above the dividend yield on the S&P 500. Those are two places that is a way to protect yourselves, so to speak, in this kind of environment.
FRA: And Yra?
Yra: Here we are, three sophisticated money people and we’re going to park on T-bills and that’s what I’m doing. We know that real yields are still negative on the short-end but it is far better than where we’ve been. I’m moving more to cash every day. This to me, is one of the greatest gifts we’ve seen. Could it be more rational? Sure, you can. We know that. When the S&P 500 came under pressure today, the break was severe and it actually held at a huge technical level but we still have twenty minutes left and while the S&P’s are hovering at unchanged on the date, it wouldn’t surprise me to see some pressure. Especially Mnuchin and Wilbur Ross, as Peter said, they are on a slippery slope and they are playing in a very dangerous arena here and this isn’t good for equities. The equity markets are much higher ready and as Peter talked about the double-edged sword of a weaker dollar and the impact on corporate properties. It’s not as clear and easy as some people think it is because there is going to be a push back and all you’re going to do is wind up with more uncertainty and disruptions. These are serious disruptions. When you start playing and trying to manipulate financial instruments like currencies, you open up the door to a lot of unintended consequences and we saw it this morning. The first reaction was for the DOW Jones to go up because it’s a large multinational corporation they have been reading this for so long. They see a weaker dollar. “Oh that’s good for you European markets Of course, the European markets never could get up off their behind. In fact, I’m buying DAX this afternoon because they have the DAX under severe pressure but where else are you going to go in Germany? What am I going to buy? Whether the euro goes higher or not, really to me, unless it goes another ten or fifteen percent higher, would I really start to get concerned about it for European corporations. Nothing is going on here. They are playing with, not even dynamite, something that is far more volatile and I’m getting very cautious.
FRA: Great words of wisdom. Thank you very much Yra and Peter. How can I listen more about your work? Peter?
FRA: Great. And Yra?
Yra: Turn into Financial Repression Authority or check out my blog www.YraGHarris.com. It’s a good place where you can get thinking. The good thing is people can really do get some trade ideas that you can really act upon. Peter and I are not offering theoretical analysis. I think there’s really bonafide proof to act upon.
FRA: Thank you very much gentlemen. We’ll end it right here and we’ll do it another time as well in another session.
Peter: Thanks guys. We’ll talk in a few days
Yra: Yeah. See you Friday. Thank you.
Karl De La Cruz