AIPIS 228 - Asset Inflation and Millennial Investing Habits with Macro Watch's Richard Duncan, Part 1

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I want to welcome back a returning guest. I believe this is his third, maybe fourth time on the show and that is Mr. Richard Duncan. He is an economist. He authors Macrowatch, which is a fantastic website and series of videos about really some interesting views he has on the economy. I just love talking to him. We're going to talk about the dollar crisis causes, consequences and curses, his books and so forth. So let's go ahead and dive in. He was with the World bank and the IMF and just has a tremendous resume. So. Richard Duncan, welcome back. How are you?

Jason? Hi. Thanks.

It's good to have you.

Very well. Thank you for having me back on.

Yeah, the pleasure is all mine. And Richard, you are coming to us from Thailand. So thank you for battling the time zones here in Las Vegas, Nevada. It is about 5pm what time is it there?

It's 8 in the morning.

There you go. Good stuff. Well, my day's winding down as yours is just starting up. I talked to you a little bit about a theory I've been kicking around for a while now and I've shared it with my listeners and I guess I'll just start with this and it'll lead us into many tangents, I'm sure. So my theory is this. We have had relatively low inflation over many years and we both agree that that's a result of globalization. That is deflationary. Because, hey, if you can get things manufactured more inexpensively overseas, you get all the lifestyle benefits of them in the richer countries and there are better prices. Right. There's more to it than that, obviously, but that's the basic idea in a nutshell. And then of course, technology is deflationary. So even as central bankers all over the planet have been pumping money into the economy, we've had, you know, multiple rounds of quantitative easing. These other forces are deflationary. And so it's this constant battle between, well, I would argue bad fiscal and monetary policy and the good benefits of technology and globalization. And so these two forces are at war and whether ultimately we'll have inflation or deflation remains to be seen. But we have definitely had, and no one could argue that we've had pretty massive asset inflation. And the theory I'm working on is this, is that with asset inflation, you get whole classes, whole swaths of people in every country. But we'll talk about the US since it's the biggest economy. Generation Y, the millennial generation, the largest demographic cohort In American history, 80 million strong, slightly bigger than the baby boomers. You know, I think they're going to be largely left out of what I dub the investor class. And so, Richard, when you project that forward 10 years, you know, if you don't enter the investor class as much as prior generations were able to, especially the baby boomer, then, you know, what does that mean when you project it out 10 years, 15 years, 20 years in the future? You know, a lot of these people are just working kind of menial jobs. They're underemployed. They work at Starbucks, they're yoga teachers. They got a little Internet business they're trying to start. You know, it's not the same as it was when I was in my 20s, and I can tell by just a survey of my past girlfriends versus what's out there today. And they were all buying houses when they were 24, 25, 26 years old in nice areas like Irvine, California. I don't see that happening much anymore. This is anecdotal, of course, but what are your thoughts?

No, I think you're. You're entirely correct. The young people can afford to buy houses the way they did in the.

Past and maybe not stocks or any other assets for investment.

Right, right. And I think too many of them have just lost a lot of money on Bitcoin over the last month or so.

Yeah, well, I could have told you that was coming.

So, yes, I mean, that's a real issue now in terms of projecting things out 10, 20, 30 years. That's, of course, that's very far ahead and difficult to see into the future. Yeah, right now that is an issue. And it doesn't look like it's going to go away anytime within the foreseeable future.

It makes me think that, of course, these people will all get the benefit of the deflationary consumer economy. Right. They'll get the nice electric electronics and cars are way better than they used to be. They've got the sharing economy, which is deflationary, too. You know, whether it be Uber or, you know, the bicycles you see all over various cities around the world that you can Share. You don't have to buy your own bike anymore. You don't have to buy your own car. You don't, hey, you know, you can rent an Airbnb place. You know, this is, it's complicated. I mean, there's a lot of complexity.

Sure it is. You know, I've spent the last 30 years or so living in Asia, and if you look at things from an Asian perspective, it's much brighter than it is from a US Perspective. This arrangement whereby the US has run such massive trade deficits with the rest of the world starting in 1980, that's the reason prices have been weak, why inflation has been low in the U.S. the U.S. has been buying things from low wage countries and that's pushed down the inflation rate and that's pushed down the interest rates in the US and there have been lots of benefits of lower interest rates and low cost consumer goods in the US but on the other hand, it's brought about deindustrialization in the US And a loss of manufacturing jobs and a lot of resentment among people who perhaps would have been working in factories had we continued to be an industrialized nation. Now, from an Asian perspective, this arrangement has literally pulled hundreds of millions of people out of poverty over the last couple of decades. So it's been an extraordinary success that has improved the lives of literally hundreds of millions of people around the world. So from their point of view, it's all worked out very well.

Whose point of view? It worked out very well.

For instance, China.

Right.

In 1980, China was a very poor third world country. Now it's the second largest economy in the world and it's just been completely transformed because of China's trade surplus with the United States. Sure, China's trade surplus, but the US is $1 billion a day. A day?

That's mind boggling. That's really staggering. But you know, I kind of wonder, I mean, you got Trump's rhetoric on this and you know, he has some points for sure, but I kind of wonder who's getting the better end of that deal. Is it the US or is it China? I mean, think about it. We ship dollars that we, you know, freshly printed, minted dollars over there and then we can just, you know, inflate them away later. Possibly we get of all the goods over here. Well, I don't know. I guess, you know, we hollow out the American middle class in the process because all those big blue collar manufacturing jobs, they've gone away. But I don't know. What do you think?

I think it's very clear China has gotten the better end of the deal. Although the US Many segments of the US economy have also done well, although there have been losers in the US but just imagine China's getting a third of a trillion dollars every year from the United States as a result of its trade surplus. That money goes into China and has created the greatest economic boom the world has ever seen. It's completely transformed the country from top to bottom. They have first rate infrastructure. Tens of millions, if not hundreds of millions of Chinese people have jobs that they wouldn't have otherwise. An emerging middle class is developing. So the difference between China in 1980 and today.

Oh, it's massive. Yeah.

A million percent.

Yeah.

Whereas the US if anything, is stagnant.

Yeah, fair enough, fair enough. So is Trump's rhetoric about the trade war, is that legit from an American perspective?

Well, of course the American perspective, it depends on which American you're talking about.

Right.

The banks and the corporations have done very well out of this arrangement. The corporations profits have expanded, is they've been able to manufacture things with very low cost labor. So their wage bill has gone down sharply and that's improved corporate profitability and therefore the bonuses of the top senior management across all the corporations. And similarly, this arrangement has required the US going deeper and deeper into debt, which has benefited people who lend money, banks and financial institutions generally. Also it's benefited the US Government in that when China, given that, for instance, China's, as I said, their trade surplus is about $350 billion a year, they sell goods to the U.S. they get paid in dollars, they take those dollars back to China and once they have the dollars, they have to do something with them. And what they do with them is they buy U.S. government bonds. So that makes it much easier for the US Government to finance its very large budget deficits.

And don't forget, they bought a lot of US real estate too.

Real estate too. And so that's pushed up real estate prices in the US and of course and all around the world. Vancouver, Toronto, Sydney, Melbourne, Singapore, Hong Kong, London, Dubai, Dubai. So certain classes in the United States have certainly benefited from this arrangement. However, the middle class and the lower middle class, they have lost out to a large extent because the high paying jobs and relatively high paying jobs in factories that their parents, fathers and grandfathers had now don't exist anymore. So their wages have been at best stagnant since the 70s and they are not pleased. And it's easy to understand why they are not pleased. For a while they were given so much access to credit that they could continue improving their lifestyle. And their home prices were going up so rapidly up until 2008. They could refinance their homes and keep spending even though their wages weren't going.

Up and use it like an ATM machine. And so the credit, I mean, government intervention distorts markets, central banks distort markets, and personal consumer credit distorts your own view of your wealth effect the stock market, you know, and the cryptocurrencies, all these things are distortions. And I wish, Richard, that there was a gauge for, you know, real wealth. I mean, the whole global economy is just built on like smoke and mirrors, isn't it? It's just crazy. And that's what we saw during the Great Recession, you know, when, like if we use the house of cards metaphor instead, maybe that's a better one. You know, you pull one card out and wow, it has a real. Or, you know, or you could use dominoes as well, right? Whatever you want. But when you lever things, the swings are more severe and more pronounced, right?

That's right. And the house of cards certainly came tumbling down in 2008. The credit markets completely froze. And almost every major and minor financial institution in the United States and for that matter globally, was on the brink of failure. But extraordinarily, they managed to reflate the whole bubble and rebuild the house of cards. And now the wealth in the country is something like a third higher than it was in 2007.

Right, but how much of that is real wealth is anybody's guess, you know, or is it levered wealth or is it credit based wealth? It's hard to tell because if you say, okay, all of your real estate portfolio is worth X and all of your other stuff is worth X, but you know, when the destruction of credit occurs, it takes those things down. You know, this is why we don't really like investing in, say, condos, for example, because condos have a. And this is a bit of a tangent, but they have this really scary effect whenever the development gets in trouble, the whole thing, you know, the lenders might not loan in that condo complex. And so when you have a credit based asset, if the financing goes away, the whole thing just, you know, all bets are off. Right? The swing is severe. But everything is based on many forms of credit. The derivatives market, the stock market, you know, there's so many margin accounts, the companies themselves, the asset, you know, that it's backed, they have all sorts of credit facilities. I mean, this whole thing is so complicated. It's just Boggles the mind, it really does. But let's talk about the Fed a little more for a second. You believe that they're tightening more aggressively than people are generally understanding. Right. You know, anybody paying attention knows that Fed has announced they plan to raise interest rates three times this year, two times next year. Of course, we just got a new Fed chair, so maybe that game plan will change a little bit, I guess. Nobody knows yet. But you believe that the tightening is more than most people understand. Tell us about that.

Right? That's right. And just running a little bit longer with your earlier thought about everything being driven by credit and credit expansion. That's absolutely right. For instance, credit has been growing much more rapidly than the economy since 1980. The ratio of total debt in the country as a percentage of GDP, in 1980 it was only 150%, but now it's climbed to 370%. And that's occurred because interest rates have fallen. Back in 1980, the 10 year government bond yield was 15%. It came down to less than 2% in the last couple of years. And so as interest rates became cheaper, that made it possible and affordable for Americans to borrow more. So they borrowed more and spent more and bought more houses, more cars and more everything. Yeah, more everything. And that drove the U.S. economy and the U.S. economy drove the world. But now we're at the point where the Fed has begun tightening. And I'm not just talking about hiking the federal funds rate, which is the overnight rate, the short term rates. It's much more significant what they're doing with the 10 year bond yields, because what they're doing now is reversing quantitative easing. You'll recall that during the crisis there were three rounds of quantitative easing in which the Fed in total created $3.5 trillion from thin air and used it to buy government bonds and bonds issued by Fannie Mae and Freddie Mac. And so as they created money and bought those bonds, that pushed up the bond prices and pushed down the bond yields and that helped reflate the economy. It played a vital role in keeping us from collapsing into depression. But now they're doing the absolute opposite. They are literally destroying money. And as they do, this is going to cause interest rates to rise. Just as quantitative easing, they created money and that caused asset prices to go up. Now they're destroying money and that's going to cause asset prices to go down.

But shouldn't that happen anyway? I mean, is that ne. You say that as though it's a bad thing. Look at the Fed constantly tries to engineer the economy, which I am not in favor of. I think the market should engineer the economy. But you know, maybe I'm just dreaming, maybe it's too complex that we need this elite class doing this, pulling the strings. Right. But don't we always have to have an adjustment? I mean, they're, you know, they admittedly that's a stated thing, that they have to tamp it down a bit. Right. Because it's getting out of hand, or at least they think so. Right. Is this a bad thing?

Well, I think it's right. I do think that they want to slow down the stock market. The stock market was going up too fast for their comfort. They're afraid that asset prices will become so inflated that another bubble will form and then pop and wreck the economy again in another crisis. So yes, they would like to see the stock market stop going up so quickly. On the other hand, the main driver of the US Economy in recent years has been inflating asset prices. As the stock market has gone higher and the property market has gone, people have felt richer, they have spent more and that's boosted consumption and economic growth and job creation. So they don't want it to completely crash. And of course, the people who own stocks and property would prefer that prices don't go down as well.

So the goal of the Fed is always to just have gentle adjustments and swings. Not that they achieve that, but you know, that would be the ideal scenario, right?

That's right. But right now what they've told us they're going to do is starting in October. Last year, they started effectively destroying $10 billion a month in October, November, December. Then starting in January, the Fed started destroying $20 billion a month. And they're going to do that for three months.

Well, they've been criticized for years for putting too much money into the economy. Right.

So some people have criticized them, but most people have, I think, happily enjoyed the stock market boom and property market boom that came about for that reason. Precisely that reason.

Sure, of course.

And so now they're going to tighten at this rate. Starting in April, they'll be destroying 30 billion a month, and then in the next quarter, 40 billion a month. Starting in October, they'll be destroying $50 billion a month. That's sucking $50 billion out of the financial markets and out of the economy. And that's going to make interest rates move significantly higher. If they carry on with this, the 10 year bond yield is going to go significantly higher and therefore the mortgage rates are going to go significantly higher. And if they do. The stock market is going to fall much more than it has so far. And the property market also will probably fall perhaps significantly.

And just on the property thing, I want to ask you an important question in a moment about that. And the question is compared to what? You know. So when you talk about how much money is coming out, let's talk about the total size of the pie to understand how significant that is as a ratio is like a percentage, you know, if we can. But on the properties, I want to get your opinion on this. You know, I divide real estate markets into three types, linear, cyclical and hybrid. And you know that what we do is we recommend the linear, boring markets. And those markets, you know, they're hot, but they're not Los Angeles, Seattle, San Francisco, Miami, any of those expensive northeastern markets. They're not London, Dubai. These aren't crazy markets. They haven't had crazy swings. Do you think it'll be very pronounced in those? I mean, I couldn't agree more that LA needs a correction and probably a pretty decent size correction. You know, whether it be any of these west coast or expensive Eastern markets or other sort of trophy markets around the world, they're just massively overinflated. I mean, we passed the point of fundamentals over way over a year ago, probably. Right. You know, it's, it's just crazy. You know, I kind of don't see that happening much when you're talking about sort of necessity level. Hundred thousand dollar houses in Memphis and Indianapolis haven't really had that kind of massive appreciation. I don't know.

What do you think, going back to your point about what percent is this? How big is this compared to what?

Yeah, how much of the pie? When you say when. Yeah, when 50 billion is coming out of the economy or out of the markets directly, you know, like, what does that mean? You know, I don't know what that means. Right. If there's.

By the end of 2019, given this, the Fed has published its plans on how it intends to reverse quantitative easing. And based on those plans, they are going to shrink the size of their balance sheet by 23%. They're going to destroy a trillion dollars between now and the end of 2019. So that's 23% of their balance sheet. And their balance sheet, in other words, is essentially base money. So they'll be destroying roughly 23% of base money by the end of 2019, which is an enormous amount. And just as the creation of so much money pushed all the asset prices higher, the destruction of this much Money is going to push them lower, it's almost certain, in my opinion.

Oh, yeah, yeah, yeah.

In terms of houses, my family is in Kentucky and they have experienced quite significant house price appreciation in the small town where they live over the. Not, you know, not each year. But if you look back 10 years, 20 years, I mean, prices are certainly very much higher than they were.

Like, can you give us an example? Do you, do you know the metrics? I'm curious. And, and what are you talking about?

Like Lexington or smaller, smaller towns, small cities. All right. But say over 20 years, from 100,000 to 250,000, that's not bad. And they're pretty hot at the moment. Seemingly there are a lot of buyers. So we've got a 10 year government bond yield that is below 3% and therefore mortgage rates are also low. If the 10 year bond yield moves up to 5% or heaven forbid, 6%, this is going to be disastrous.

Oh, it's huge. So won't the Fed make a course correction on the way? Or do you think they're just dead set on really seeing some rate hikes?

I think they will make a course correction if they are very concerned with the stock market. If the stock market falls. As of last night it fell sharply and it's now given up all of its gains. For 2018. It had a very good January, but now it's gone.

Right, Right. But we're only, we're only 41 days into 2018 and that's all days, not just business days or market days, I should say. So it's still pretty early, Right? Or, well, we're not even 41 days in, but whatever.

Yeah, very, very early. And the reason that it fell so sharply is because the 10 year bond yield had moved up from about 2.3% a month ago to almost 2.9% at one point yesterday. And that moved up so quickly because finally this money is being sucked out of the economy and it's pushing interest rates higher. And at the same time, people are beginning to realize that the tax cuts are going to make the budget deficit very much larger, meaning the government will have to borrow more. And the more the government borrows, of course, the more demand for money there is and that pushes up interest rates. Also, we're now talking about a trillion dollar budget deficit this year and next year perhaps. So that is also another factor in addition to the Fed tightening, that will push the interest rates higher across the board.

This will be continued on the next episode.

Thank you for listening and happy investing.

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