Recorded: May 14, 2020
INTERVIEW TRANSCRIPT (EDITED)
Albert Lu: It’s been way too long. How are you?
Michael Pento: I’m doing fine. I hope you’re holding up well, Albert.
AL: I’m very well. You know that discussion we had was over three years ago. It feels like we’re just picking up from where we left off in many ways. What are your thoughts on what’s gone on in the last three years and obviously especially over the last two months?
MP: So, it would take longer than the duration of this interview for me to cover what happened in the past three years, but I’ll tell you what I am concentrated on. Since the breakout of this Wuhan virus, we’ve seen debt levels surge and balance sheets destroyed across the entire planet. You look at the level of negative yielding sovereign debt — that has surged. We started the introduction of the show with that. But not only that. If you look at the run rate, the annualized run rate of corporate debt — which was already in a massive bubble, both in nominal terms and in terms of GDP — corporate debt is increasing at a 25% clip since the Wuhan virus broke out. So what we’ve done is we’ve taken interest rates back to 0%, and I will hasten to remind you and your listeners that the virus did not precipitate a change in central bank monetary policy, Albert. The Federal Reserve was cutting rates in the summer of 2019. The Federal Reserve went back into quantitative easing in the summer of 2019, before anybody heard of a Wuhan virus or COVID-19 or even a coronavirus. So, before Wall Street was aware of one, [of its] existence, though the Federal Reserve is blustering today. I heard that Mr. Powell was saying that we could actually cut back on the stimulus programs in September.
Well, you know, the Federal Reserve went into this extraordinary monetary policy stimulus in the wake of the Great Recession, which ended in June of 2009. And you go all the way to 2019 and what was the central bank interest rate at the breakout of the virus — 1 ¾%? And the Fed did end QE but they went back into QE and every other central bank on the planet — the ECB, the Bank of Japan, Bank of China, you name it. They never could get interest rates to rise and they never ended QE. So, what makes anybody believe that the central bank will be able to cut interest rates and end QE? I’m sorry, raise interest rates and end QE, when this virus dissipates? I don’t think anybody should.
AL: I don’t think they do. They’re pricing in negative rates in December. You know, it’s funny. If I review the discussion we had three and a half years ago. I put up the dot plots back then. And guess what they were forecasting for 2019 and beyond? It wasn’t 0%.
MP: 3 ½%. Am I correct?
AL: Yeah, it was up there. I mean, obviously there’s a range. There was the one guy who wasn’t paying attention that had them down low. Everyone else was up above 2%, I believe.
MP: I think it was [Neel] Kashkari. But everybody else said that interest rates, including Jerome Powell, that the fed funds rate would have to go to 3% and then at least 50 basis points above their r-star — whatever that means — and that would stay above that level for a long period of time, above the natural level of interest rates. Just to make sure we’re back on track. Do you know what the average interest rate has been on the fed funds rate throughout its history? It’s closer to 6%, 5 ½%. It sure as heck isn’t zero, and that’s where we’re stuck and that’s what we will be. And what does a 0% interest rate engender? A 0% interest rate engenders a massive increase in the level of borrowing. You are falsifying interest rates, which is the most predominant indicator in a free market. What is the cost of money? You falsified that. You falsified it for decades, and it will never end. Not in my lifetime.
AL: Michael. I understand the central bank’s desire to protect banks. There’s their central mandate. I also understand how they need to keep lending rates low, borrowing rates low, for the federal government, who’s going to have to issue a lot of debt. But they also seem concerned about junk debt. You’ve got companies, the energy sector, emerging markets. There’s really no limit now to what their mandate is. Why do you think they’re so concerned about all of these other things? Why can’t we just take our medicine and have a recession?
MP: Well, let’s just think. That’s a great question. You know, I can answer that in about an hour. But let’s just try to consolidate it. So, pension plans, Albert, throughout this country, especially in the most stressed cities and states — like Chicago, Illinois, Trenton, New Jersey — their funding of their pensions is down to 20%. So, if you look at their assets divided by their obligations — 20%. So, this is an insolvent situation with pension plans. You think about Social Security, Medicare, Medicaid — $70 trillion underfunded. And now we’re hearing that D.C. wants to cut payroll taxes. So, the whole thing is predicated upon the whole artificial illusion — paper tiger economy, not only United States, but globally — it’s predicated upon perpetual asset bubbles. And they have to get them into the stratosphere, just to hope that they have any semblance of an economy. You know, look at the tax revenues that have been eviscerated since the breakout of the virus. You see I’ve mentioned pension plans are insolvent. There’s 36 ½ million people now who have filed for unemployment claims in the past three months alone. We have a quarterly deficit — not according to Michael Pento, but according to Steven Mnuchin — of $3 trillion in the second quarter of fiscal 2020.
So, you know, there isn’t any tax base on the planet that can service the amount of debt that’s being amassed on the planet right now, because, as you’re adding debt, because you falsified interest rates, you’ve also wiped out the tax base. And this debt that’s being accrued is the most vile and despicable kind of debt, because it’s unproductive in nature. It’s basically universal basic income. It’s helicopter money, with no productive capacity whatsoever. So if you have a national debt that’s $24 trillion, $25 trillion — you have a Fed that is now monetizing all of that $3 trillion debt that I just mentioned — [then] you have an unproductive economy that’s geared and set up for massive, uncontrollable stagflation. That’s my prediction.
After this depression and deflation morphs into its next cyclical phase, it’ll be stagflation in my opinion. And why would you ask that? Why would the stagflation come — it didn’t come in the last crisis, the credit crisis of 2008 and 2009? Because we are no longer just bailing out banks, like you mentioned before. Yes, during 2008 we bought all of the banks’ bad assets, all the mortgage-backed securities, asset-backed securities. We’re doing the same thing now, except now we’re also throwing in corporate debt, junk bonds, CLOs. The Fed is buying everything, [and is] actually making primary loans to businesses. So this is new: The Federal Reserve has never made a loan to a corporation. They bought debt in the secondary market. So, what am I saying?
Via the Fed’s actions and the fiscal policy, which is an end run around banks, you are now sending money directly to consumers and businesses. And that means that the broader monetary aggregates of M1, M2, and M3 will be expanding rapidly. Not just base money supply, not just Fed credit. The broader monetary aggregates will be exploding in size in the context of an economy that is unproductive. That, my friend, is stagflation.
AL: I tend to agree with you, Michael. We’re seeing M2 respond already. It’s just a matter of time until stagflation hits. So you have slow growth, rising prices. That’s going to defeat the purpose of what they’re trying to achieve. I mean, it gets them off the hook, maybe, in terms of them satisfying their pension obligations. But really, the money’s not going to be worth enough for people to live off of.
MP: Well you know it’s a political game in nature, Albert. So, you know, they can say, “Hey, look. I satisfied in nominal terms your pension obligations. Here they are. Here’s your money.” But here’s the thing that investors like you and myself think about: What is your standard of living? What is the purchasing power of your money? I mean, what we all seek as advisors — what you should be seeking — is a real after-inflation tax return, a real after-tax return on your investments. And if you can’t do that, if you don’t know how to do that, you’re in deep doo-doo.
I mean, if you’re in a passively managed fund that has some kind of combination of you know 60/40 — whatever depending on your age, between equities and bonds — what do you think your upside potential is when a U.S. 10-year note has a yield of 0.6% or a Japanese government bond has a yield of negative whatever ten years going out, ten years in duration? So you have insolvent sovereigns borrowing money for basically nothing or getting paid to borrow in the context of inflation? That’s a new phenomenon and that, by the way, Albert, is something that every central bank is dying to achieve. There was a time when central banks were obligated to supply you with a steady fiat currency, OK? A currency that was not depreciating its value at all. But that has somehow morphed into this, you know, heaven-sent 2% inflation rate how they measure it, which is core PCE deflator, as in the case of the United States. So, the core rate of the personal consumption expenditure has to be above 2% [in] the way they measured. And, by the way, the PCE takes out everything that goes up, OK? They sure as heck don’t measure in health care costs accurately [or] home prices, and they sure don’t measure asset prices in terms of equities in there, either.
During the last crash, all of that inflation that they created, that buildup in the monetary base from 800 billion to 4.6 trillion in the wake of the Great Recession, and thereafter, was geared towards what? Wall Street and banks. That’s where all that money went. Didn’t go into the middle class. Didn’t really show up in consumer price inflation. This time around, through various iterations of helicopter money — you know, we just learned that there’s another massive bailout proposed from the Democrats in D.C. I’m not picking on just Democrats because they’re both lovers of debt and monetization. Another $3 trillion, on top of the $3 trillion they already spent.
And, by the way, this particular package also has in it a bailout for the state and municipal governments, which desperately need it. I mean, they are bankrupt. They won’t be able to pay teachers, firefighters, police officers. [They are] bankrupt, without this money. But it also has more of what, Albert? Helicopter money. Direct money sent to your mailbox. So this is why I believe the money supply is going to be growing across the board. Not just base money. We are paying people — this is the worst part of it — we are paying people more money to sit home than to go back to work. So you have unproductive people having money to spend and then the amount of goods and services available for purchase is diminishing.
Now, that’s why I’m worried about stagflation and that’s the real crisis, because that is the Greater Depression recipe. Because when you have an inflationary and insolvency implosion of the bond markets, there is nothing a government can do. They cannot borrow debt, borrow more money, issue more debt to placate a bond market that’s worried about insolvency, and they cannot print more money to mollify a market that is petrified about inflation — taking inflation to the mid-single digits, perhaps even double digits. That’s the real crisis and that’s what I think this market goes down 50% to 80% as it has done in the past.
AL: Michael, I’m going to sneak in one more question about this and then finish with where you think that we should hide out as investors. I had a great question from a viewer. He asked if I thought that some of these states that are holding out opening the economy are doing it because they want to put pressure on Washington for a bailout. I mean, that makes a lot of sense — that a lot of these states would be looking to take a big bath here and blame everything on the virus, all their sins from before, as you alluded, to take a big bath here. Blame everything on the virus and get completely bailed out. What are your thoughts on that?
MP: Yeah, you know, I hate to agree with you because you’d think better of mankind than that. It just so happens that this virus has been politicized, massively politicized on both sides of the aisle. So it’s a great excuse for De Blasio over here in New York to claim he wants a massive bailout, not only just to make the pension plans solvent, but also to take care of all the past sins that he’s done before. And also let me tell you this. It’s also a red and blue phenomenon that I see. The red states want to open up because they want to get the economy going so you can get Trump reelected. And the blue states — I mean, maybe some visceral reactions, you know — there’d be deep-seated feelings here that if we could just retard the growth of the economy, perhaps that will make sure that Trump is not reelected. I mean, why is it so bifurcated between red and blue states as to who’s opening up, who’s not opening up?
AL: That’s true. I doubt it’s about personal liberty, so you’re probably right. OK, I want to finish up with what your thoughts are: This does not seem like typical end-of-cycle behavior here, in terms of what we should be investing in [and] how we should be positioning ourselves. We had big pullback in March. I was hoping that there would be an opportunity to get in some really good names. But [it] turns out those names, if you think about them, like big tech Amazon, Microsoft, these sort of came into favor right at the time when the whole thing was going down. And we didn’t get the opportunity that we wanted. I want to know: What are you looking at? Where’s the opportunity? I don’t think there’s any value per se. Where’s the opportunity?
MP: No, we did very well so far this year, much better than the S&P 500, if I may say. A lot of that was based upon the explosion in the gold mining stocks, which I paired back on a few days ago. I’m trading in and out of there. First of all, for your audience, you have to be an active investor. You cannot be a passively managed investor. I mean, when I said before, when the 10-year note is yielding 0.6%, if it went all the way to zero and even slightly below that, you’re not going to make any money. You’re not going to offset a 30%, 40%, 50% drop in asset prices by a small single-digit gain in your percentage gain. That’s the way duration works. When your 10-year note goes from 0.6% to zero, you’re not going to make a lot of money; it’s not going to offset that loss from your equity. So you have to be an active manager.
We have a lot of cash in the portfolio right now. We have about 50% cash. We are waiting for that pullback. And if you think about how expensive the stock market is. Heading into this virus, Albert, the valuation of equities, the total valuation market cap of equities as a percentage of the underlying economy, which happens to be my favorite indicator and happens to also be Warren Buffett’s favorite indicator — I’m not comparing myself to him but that just happens to make a lot of sense for both of us — you never should have the valuation of equities run in inextricably higher than the underlying income of the economy. That just makes cognitive sense. So we were at one and half times, 150% of the underlying economy — a world record, by the way, right before the virus. Well, now they say we’re at 135% of GDP, market value of equities, but that GDP has a big question mark in front of it, Albert, because you’re looking at trailing 12-month GDP. What’s the GDP really going to be right now, forward GDP?
So, I mean, if you look at the economy, I’m looking at a GDP that might be down 30% globally, and there’s a lot of questions as to how fast we come back. So this is a long way of saying that the market is still massively egregiously expensive right here. And the only reason why it is that case — it probably is more expensive today than even at the record set prior to the breakout of the Wuhan virus — so the question is you have to be very, very defensive. The question is how much higher can stocks go in the context of the fact that the central banks are buying everything on the planet? And in the case of Japan and China, they’re buying actual stocks.
We are not there yet, with the Federal Reserve. We are buying junk bonds, though. So the only thing keeping the stock market levitating here is the fact that we have very active central banks and there’s a lot of optimism about the reopening of the economy. So what I’m myopically focused upon right now is: How successful is the reopening of the economy? How packed are restaurants? How packed are hotels? How packed are airlines? What’s the diminishing factor? What are we multiplying by: point what when it comes to the economy and the capacity in those very key industries? How fast do people get rehired, looking at initial jobless claims, the miserable claims that came out this morning? How deleterious are the effects of a faltering balance sheet both from the public and private sectors? So, those are the things I’m looking at to determine where we go with the economy.
Next, if I’m being overly pessimistic and if it proves that we have a very robust opening and the balance sheet destruction isn’t as bad as I calculate, then perhaps we can buy stocks here, as long as the Federal Reserve keeps on printing money at a pace that it’s going at. But my base case scenario is that it’s not going to go very smoothly. We are going to have a failed opening, unfortunately. I think the virus does make a rebound. If you look at some of these states that are already opening up, they’re having a resurgence of the virus. So, in that context the Fed can’t do anything more than they’re already doing. They’ve already announced unlimited QE and they’re already at zero, and they’ve ruled out negative rates. So other than buying stocks, which by the way hasn’t really helped China and Japan very well — I mean it’s not a panacea — I would say that the base case scenario for a stock market to be more like, I call it, a v-shaped recovery, but the right side of the “v” is going to need Viagra. So, it may be a backward “j” kind of recovery. So the path of least resistance, I think, is to the downside, probably starting sometime in July.
AL: Michael, I’m on the same page with you in terms of being cautious about a failed opening and then the negative consequences of that. Also, holding a lot of cash myself. But what do you think about the idea of stocks now? This new world of investing, where people treat stocks as a defensive, almost bond-like investments, where the Fed is going to provide the put — they’re going to backstop it. And what you’re looking at because you have the consequence of stagflation, meaning you’ve got to protect yourself somehow from inflation. You’ve got maybe a stock market that gives you sort of inflation-protected returns, not very big returns anymore. And maybe you get a dividend. How long are you going to wait and stand on the sidelines before you feel like you have to give in to that mentality?
MP: Okay, very good questions, by the way. Compliment to you. So, yeah, stocks can be a hedge against inflation. But what stocks? That’s the whole purpose behind my inflation-deflation economics cycle model. So do you want to overweight bonds in stagflation? Absolutely not. Bond and bond proxies are probably not going to do very well in a stagflationary environment. I wouldn’t buy banks here. Banks are trading horribly. I wouldn’t be buying any kind of bonds, really, other than TIPS.
What do you want to own? You can get away with utilities, even though they’re sort of a bond proxy. I just contradicted myself, but the reason why I like utilities here is because if an economy is stagflating, it’s not growing very fast. So, you have a chance probably to buy some utilities. You have to buy inflation hedges like energy, farmland, precious metals. They should do absolutely fantastic. So what kind of stocks? You have to ask yourself what kind of stocks to buy. Not high momentum stocks at all. You want to buy stocks that are immune to possibly slightly rising interest rates and stagflation. So if you rigorously back test these cycles, you’ll know what to invest in in stagflationary economies.