Posted 22nd December 2016
On a recent trip to Berlin I met with the founder of Strategic Intelligence, Jim Rickards.
Away from the conference we were both there to attend, we took some time to sit down and talk about the state of the markets right now.
Below is a transcript of our discussion. I hope you find it interesting.
David Stevenson: Jim, you’ve been an equity bear, well, certainly not bullish about the US equity market for quite a long time, and the S&P just keeps on going up. So has the Fed sort of won in its quest to keep the market going up, or what’s going to turn it down?
Jim Rickards: Well, there’s an old expression, David: be careful what you wish for. I would say, yes, the Fed for 8 years has been propping up the stock market by keeping interest rates low, and of course now we have an expectation with President Trump coming in.
He’ll do what they call the reflation trade or the Trump trade; which is actually not just monetary policy, which we’ve had for 8 years with close to zero rates, but fiscal policy, bigger spending, tax cuts, less regulation.
So, that’s expected. If the Fed accommodates that, that’s expected to produce inflation. Stocks are going up. People look around and say, you know, the United States, well, if you repeal Obamacare, that’s good for pharmaceuticals, and if you repeal Dodd-Frank that’s good for banks, and if you cut taxes there’s more disposable income, it’s good for consumer non-durables, and more defence spending is good for defence: so it’s all good. Everything is going up. Construction is going up. For now.
But the problem is this is going to crash into brick wall reality. The United States has $20 Trillion of debt. We have a debt to GDP ratio of 104%. This is just trying to run the Reagan playbook.
But when Ronald Reagan did this is 1981, our debt to GDP ratio was only 35%. Ronald Reagan had fiscal space, Donald Trump doesn’t.
So while these policies may look good for growth superficially – I’m not saying they’re all bad policies – but I think that we’re going to find very quickly that the US is flirting with a sovereign debt crisis.
A lot of the US debt is owned by foreign countries. It’s owned by China and others, principally China. They have been net sellers of government securities and net buyers of gold. So, some of these trends, as you said, they’re going to get a reality check very quickly.
The problems with stocks is that, sure they’re going up, I understand that. But… they did in the late 1990s, then the NASDAQ crashed 80% in the 2000/2001 bear market. So you can quickly lose 30-40% of your money in the stock market.
DS: Sure. And what about gold, then? That’s kind of gone the opposite way to what you thought of the Trump victory; so what sort of major macroeconomic geopolitical event is going to have to happen to get that fired up again?
JR: Well, again. Gold… people talk about gold; what they’re really talking about is the dollar price of gold. I think of gold by weight. That’s how I understand it in my portfolio.
But the dollar price of gold; it’s a pretty simple story: if the dollar gets stronger the dollar price of gold goes down. If the dollar gets weaker, the dollar price of gold goes up.
So your dollar-gold forecast is simply a dollar forecast. So, what’s the dollar going to do? Right now markets are saying, okay, the Fed’s raising interest rates. Donald Trump is probably going to appoint some hawks. The Congress wants the Taylor rule. The Taylor rule would say the interest rates should be 2 or 4 percentage points higher than they are today.
So, putting all this in play, much higher interest rates, much stronger dollar; that’s a powerful headwind for the dollar price of gold. But where is this leading? If you have a strong dollar, you’re going to import deflation. The Fed says they want inflation.
So think about the up trade here, David. The stock market is talking about the reflation trade, coming inflation. And you’ve got a strong dollar produces deflation. How does that add up? It doesn’t add up.
So these things are going to have to correct and they’re going to crash into each other sooner than later. I would expect one of two things would happen…
The first one is that the Fed actually accommodates the fiscal deficits, the larger deficits; in which case you’re definitely going to get inflation. You have bigger deficits, tax cuts, throw a trillion dollars of debt on top of $20 trillion, keep interest rates low, and that is the reflation trade. That is helicopter money. You’re going to get the inflation and the price will go up.
But let’s say the opposite happens: the Fed leans in, raises interest rates, tightens. That could very well crash the stock market and put the US into a recession. And then gold could go up on a flight to safety, almost a fear trade. And then the Fed has got to flip from Hawkish to Dovish to get the economy moving again. Something that they’ve done eight times in the past six years.
So that’s very positive for gold. So, right now gold’s got some headwinds but that will change.
DS: Okay. So, following on from that, what’s your view on silver? Is that lined to perform any different to gold in the long run?
JR: In the long run, no. People talk about the gold-silver ratio. There really isn’t one. It’s an artefact going back to 1900 when the United States’ silver mining interests insisted on a 16:1 ratio. That was basically to cause inflation in the United States and help the profits in the silver mining industry.
So it has a little bit of history. But in reality gold and silver, in the short run, move in on different vectors. Gold actually isn’t good for anything except money.
It’s the best form of money. But not good for much else. Whereas silver has a lot of industrial uses, so sometimes the price of silver is affected by the business cycle. You know, automobile manufacturing, electronics manufacturing, and other applications.
But in the longer run, sure, silver is a precious metal. I actually recommend it along with gold; it has a place in the portfolio. People say, well, you know what, in an extreme situation, what happens when you have to go out and get some, you know, groceries for your family using precious metals; well, an ounce of gold might be worth a year’s worth of groceries whereas an ounce of silver might be a day or a week’s worth of grocery.
So, silver’s actually… you know, silver coins, American silver eagles, or sovereigns, they’re actually practical in that sense. So… but yes, in the long run silver is going to tag along with gold. There’s no way that gold is going to $5,000 or even $10,000 an ounce, which I expect, without silver going to, you know, $100 an ounce or more.
DS: Sure. Thanks. We’re just switching tack slightly onto US long term interest rates, because they’ve been steadily heading up even before the election results, I think it’s about 2.5% now. How do you think that situation is going to play out over the next couple of years?
JR: Well, I see that reversing. You know, look, there’s been a bear market in bonds globally. US interest rates have gone up. And you’re exactly right, David, it didn’t start with the election, it started really in late September as the market began to, you know, internalise in price for a Fed tightening cycle but they got a big boost after Donald Trump’s election because of this reflation trade that we discussed earlier.
But actually, ten year rates in the United States are not much higher than they were this time last year. And there was a big rally in bonds in December, January, and February of 2016.
So, sure, they were here, the rates came down, there was a bond rally, the rates went up. Bond prices went down. It’s been a little bit of a volatility, but we’re at a point now… how much higher can rates be? You know, real rates are high. Nominal rates are going up. We haven’t seen much sign of inflation. People are expecting inflation, but we haven’t really seen any signs of it. So this is monetary tightening. The Feds are going to exacerbate that with rate hikes and this is going to slow the US economy and then that could be really bullish for bonds.
DS: And the effect on international markets?
JR: Well, likewise. You know, when you look around the world; the US dollar is 60% of the global reserves, 80% of global payments. Everything is affected by the US dollar. So, for now, with the strong dollar you’re actually getting capital outflows from emerging markets. A very dangerous situation.
The problem with a strong dollar and high US dollar interest rates: all the dollars want to come to the United States, but there are 9 trillion dollars of dollar denominated emerging markets corporate debt. How are they going to repay that debt?
The dollar is getting stronger, the real value of the debt is going up. There’s a dollar shortage around the world. So, if interest rates get much higher, the dollar gets much stronger, we could have an emerging markets debt crisis worse than in 1980s.
So again, you know, people look at these things in isolation. They assume that there’s a bear market in bonds, the rates are going up; but if you slow the US economy and import deflation and cause an emerging markets dollar denominated debt crisis, you’re going to have other problems. And then interest rates will come back down very sharply.
DS: Well this is all pretty negative stuff. So, just… to end this on kind of a positive note: you haven’t been particularly bullish so far on the prospects for US infrastructure spending. But I’m guessing that sort of post the Trump triumph you might have a more bullish view on that?
JR: Well again, the numbers don’t add up. So, you know, Trump says, okay, I want infrastructure spending, his principal advisor Steve Bannon wants $1 trillion of infrastructure spending to make America great again.
So they want airports, roads, bridges, ports, etc. But Donald Trump also says he’s very pro-defence, wants defence spending, does not want to cut entitlements, does want to cut taxes.
It all sounds good superficially but how does it add up? It adds up to, you know, more than a trillion dollars worth of debt.
The US is on the path to Italy. You get the US debt to GDP ratio above 110%, with non-sustainable fiscal policy and no ends in sight… Foreigners are already dumping Treasuries, that will accelerate and interest rates will get higher and the US economy will slow down.
So I don’t think you can look at any of these things in isolation, you have to look at them on a macro basis, connect the dots a little bit. So, you know, it’d be nice to rebuild the infrastructure in the United States, but how are we going to pay for it?
DS: Sure. Okay, I understand that. Thanks so much for your insight.
JR: Thanks, David.
DS: Great to talk to you.
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