Paul Giannamore: We shouldn't rely on the recency bias. We should say, “We are in a new world now, under a new regime. We have a new set of problems.”
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Paul Giannamore: We're recording this on St. Patrick's Day.
Patrick Baldwin: Happy St. Patrick's Day, Paul.
Paul Giannamore: It’s also your birthday. It would've been my mother's birthday today, Patricia. She was born on St. Patty's Day.
Patrick Baldwin: It's a special day. We do have one listener that asked for you to sing heavy birthday to me.
Paul Giannamore: If the Mexican were here today, I'd have him sing. He likes to sing.
Patrick Baldwin: I don't know what he sings in the office.
Paul Giannamore: I'm going to skip the singing today.
Patrick Baldwin: I'm going to go have pastrami brisket to celebrate my birthday at Helberg.
Paul Giannamore: I wish I were joining you.
Patrick Baldwin: I sent you a picture. I did invite you to Helberg but it looks like you're not going to make it.
Paul Giannamore: I got to be honest with you, it's one of my favorite barbecue places. If anything gets me back to Waco, Patrick, I'm sorry to say, it might be Helberg.
Patrick Baldwin: I'll be there also if you choose, got to plan ahead. Paul, It's been a crazy week in the markets. I see Credit Suisse, SVB, and First Republic. Banks are saving banks. Everyone's getting saved except for the US dollar so I've been told. There's nowhere to run, Paul.
Paul Giannamore: Indeed, it's been chaotic. I was watching Janet Yellen, who's the treasury secretary. She was before a congressional committee. It's a maddening discussion. For example, one of the senators from Oklahoma asked Janet Yellen, “You're bailing out all your friends there at SVB. My banks are a lot of community banks in Oklahoma and people are taking their money out, putting a chase, and Citibank. If one of my banks goes under, are you going to fully ensure all my depositors like you did with Silicon Valley Bank?”
If you watched this testimony, you'll walk away saying that if you ever had any doubts, you will not have any doubts that Washington Insider friends get taken care of at the expense of everyone else. She made that extremely clear in this interview. When we talked in January, we talked about the likelihood of a credit event in the United States is extremely high. What we're seeing in the banking system is not a credit event. There will be one, I would imagine. You can't run at negative real interest rates for over a decade and then all of a sudden jack them up and expect there not to be all sorts of problems.
The real question is, what's the Fed going to do? We've got an FOMC meeting coming out so there's another rate decision. The European-centric bank raised by 50 basis points. I had no idea what the Fed will do based on what the ECB has done. I would imagine they'll probably hike again maybe 25 basis points. It's going to be a turbulent year.
What's interesting is I came back from three weeks on the international road and I swung through London, I had some meetings there. I had Dylan. I sat down with Andy Ransom, the CEO of Rentokil. Maybe by the time this episode is published, we'll have published, on Potomac TV, my discussion with Andy, which was extremely entertaining. He's bullish on pest control in general, both on-camera as well as off-camera. He's also pretty certain in his mind that the worst from an economic perspective has already come. I disagree with him wholeheartedly. We're entering phase three here at the bear market. We got some rough waters ahead but I certainly do hope he is right.
Patrick Baldwin: I’d hope so. Did you all record that on camera having this debate?
Paul Giannamore: Yes. It wasn't even a debate. That is on camera. He talks about where his head is in terms of the greater economy as well as what's going on in pest control. Yeah, that's in there.
Patrick Baldwin: Their earnings came out yesterday. I know the video was embargoed for a minute to make sure earnings got through. Rentokil killed it, didn't they? Did you see them?
Paul Giannamore: Yeah. Their stock was up double digits by the end of the day.
Patrick Baldwin: Not bad. The deal got done in October 2022. This is our first full quarter since Terminix.
Paul Giannamore: It was a full-year 2022 result. The Mexican sent it to me. I was surprised, I was quoted, “Can their earnings release an investor deck?”
Patrick Baldwin: What did it say?
Paul Giannamore: It’s something I said in London when I had a meeting. They went ahead and took it and printed it.
Patrick Baldwin: What was it?
Paul Giannamore: We were talking about technology in pest control and we did that transaction in the fall with Ronin in Israel. I said, “This transaction makes Rentokil the world leader in the use of cutting-edge technology and pest control.” It's in the investor deck.
Patrick Baldwin: Look at you, you're famous. Good job, Paul.
Paul Giannamore: Something I never aspired to Patrick but I do appreciate the congratulations.
Patrick Baldwin: Back to the banks, are banks bailing out banks at this point? At some point, this house of cards is going to come crumbling down. At what point does the money get stacked up in Wells Fargo, Chase, Bank of America, and so on but then they get called out?
Paul Giannamore: This whole thing is a confidence game. Here in Puerto Rico, there was a lot of movement. People are taking money out of Banco Popular down here and putting it in other places. We look across the country, two big-to-fail banks brought in tens of billions of dollars in deposit money because people were pulling stuff out of smaller community banks. The main problem here with a lot of banks is that they borrow short and they lend long. When the yield curve is inverted, their long-duration assets are the loans that they make to people who buy a house or invest in a business. Those are usually long term and they're borrowing from creditors or depositors.
We've talked about this on The Buzz before that when you put $100,000 in a bank, that's not your money anymore, you've loaned the bank that money. If you look at the deposit under fractional reserve banking, if you look at the deposit agreement that you signed with your bank in small fine print, it says, “You're effectively loaning us this money and you are now a creditor to the bank.” You are a liability on the bank's balance sheet whereas the asset on the bank’s balance sheet is the loan receivable that they've extended.
When you have a rapidly rising yield environment, if a bank is borrowing short-term and lending long-term, long-term or long-duration debt securities are much more sensitive to interest rates. As the Fed has raised the Fed funds rate and the market has anticipated further rate hikes over the course of the last twelve months, the short end of the curve is spiked, and that's why we have an inverted yield curve. What that means is a lot of those assets on the bank's balance sheet have dramatically fallen in value.
If you're a bank and you do a 30-year fixed mortgage at 3%, and now prevailing interest rates are 5%, the value of that loan or that asset has fallen by 15% or 20%. You have a dramatic decrease in bank capital and the other things that are going on. We lived in a world of quantitative easing where the Federal Reserve has increased effective reserves, bank reserves.
Now we're in an era of quantitative tightening and that's beginning to reverse. It's putting a tremendous amount of stress on the banking system. The Fed came in as per usual and set up a credit facility for the banks to be able to borrow at the discount window. You then have the federal government stepping in through the FDIC and the Department of the Treasury and backstopping creditors. Creditors are people who deposit money in the bank, you and I.
Patrick Baldwin: up to $250,000.
Paul Giannamore: Silicon Valley Bank, all depositors will be made whole.
Patrick Baldwin: How? They're going to get the cash printing machine out again?
Paul Giannamore: What they'll do is they will do a lot of things. They will do special charges on other FDIC member banks. For example, banks in Texas, the community banks, all those banks, for example, will end up footing the bill to bail out depositors at Silicon Valley Bank. I hadn't looked at this for a long time but there were billions of dollars of Chinese investors and companies who deposit money in Silicon Valley Bank. You've got individuals in China who bank at Silicon Valley Bank. Families in Texas will ultimately be bailing them out and making them haul on deposit at Silicon Valley Bank because there'll be special charges and that's how the FDIC system works.
The FDIC, at least under current regs, will insure an account up to $250,000. From time to time, there are bank failures. From time to time, there are a lot of bank failures. At the end of the day, that FDIC money comes from charges that member banks have to pay almost like insurance so they're paying a premium into that system in order to be a member. When you get a massive bank failure like Silicon Valley Bank, that will ultimately be, mark my word, special charges on all member banks within that system to make those depositors whole.
Patrick Baldwin: It might take out smaller community banks.
Paul Giannamore: It's going to complicate things, for sure. This is going to be a prime example of how the government chooses winners and losers, we're seeing this right now. if you were fortunate enough to be a depositor in Silicon Valley Bank, you'll be made whole. As we begin to see more bank failures, some folks won't be as fortunate, unfortunately.
Patrick Baldwin: With the FOMC coming out, this puts the banks in a debacle. They “want” to help out SVB, the members, creditors, or depositors of SVB. If the interest rate goes up, that hurts the banks. By raising interest rates, they're hurting the banks. They want to incentivize the banks to help out other member banks.
Paul Giannamore: It's a complex system. We have a couple of things. We have bank balance sheets and how a rising interest rate environment impacts the value of the assets they hold on their balance sheet, that's number one. We've got quantitative tightening and its impact on bank reserves, that's number two. Even more important, we've got way more than 3 and 4 but we're going to some of the big ones.
Number three is what has happened and I talked about this on Potomac TV when Dylan was down in Puerto Rico back in October 2022 or November 2022. We talked about how, for fifteen years, no one was getting any yield in a bank account. You put money in a bank account. If you got any interest payment at all, you got 25 basis points, almost nothing. That had become the new normal. Everyone's got their money in the bank and they're getting low yield but we had low inflation. A lot of folks were seeking yield in the stock market and so on and so forth.
In one of the videos, I talked about the allocative effect when capital goes into fixed income versus equities. As part of that, what you've seen over the last couple of months is people are finally starting to wake up and say, “Short-term T-bills.” You got treasury security. On the shorter end of the curve, they're called T-Bills, six-month T-Bills, and only one year, for example. If I can get 4.7% or 4.9% by putting in my money, I can go on Treasury Direct, which is the US Treasuries’ website, which allows anyone on the planet to go and buy treasuries or you talk to your financial advisor.
People are saying, “Why am I keeping $1 million in a bank account collecting 25 basis points when I could take that $1 million, which I have no immediate use for right now, and I can put in a short-term T-Bill?” We had begun to see that start to take place in 2022. When I took all my bank reserves out in October 2022, all my US-denominated cash had been moved to short-term treasuries. I did that in the fall. I typically do it in a latter format, meaning I bought durations from three months, maybe I even bought some monthlies, but I bought typically three months out to two years.
In a rising rate environment, I want to be on the short end of the curve. Some go in 30 days, 60 days, 90 days, or all the way up to 2 years. You're getting roughly around 4.7%, which is dramatically higher than what you would get in a bank account. You got $2,000 in a bank account, it doesn't make sense to go out and buy treasuries. If you've got more money in a bank account, it starts to make sense and we started to see that happen over the course of the last 4 or 5 months.
Once we got into 2023, it accelerated so that's what's happening, people were taking money out of bank accounts. You've then got capitalization ratios starting to get wobbly. You had assets on the bank, which were long-duration loans banks had made, and those began to fall in value because we're in an ever-increasing rising yield environment. It makes it increasingly more difficult for banks to pay their current obligations.
Patrick Baldwin: I'm learning, I'm taking it in.
Paul Giannamore: I don't know if this is common knowledge stuff or not.
Patrick Baldwin: No. If I'm common knowledge, I don't know. I always think I'm less than common knowledge.
Paul Giannamore: I wasn't even prepared to talk about this stuff but this is inherently the dramatic risk that you have in a fractional reserve banking system, which is based solely on confidence. Real money doesn't exist anymore, It's fiduciary media, it's Fiat currency so we have that. You talk about confidence, it reminds me of the instant that took place in Japan almost 50 years ago.
You had a bank called Toyokawa. It was in 1973, there was a nasty bank run so businesses and individuals came in and withdrew ¥2 billion. What's interesting about this whole bank run is there were a couple of Japanese girls coming in on a train to Tokyo one day and they were having a discussion about jobs and one of the girls said, “I got a job at Toyokawa Bank.” One of the other kids’ remarks, “Isn't that dangerous?”
Somebody that was sitting in the seat there next to them on the train heard that instead of, “Isn't that dangerous?” Meaning armed robbery or whatever or perhaps a location of the bank assumed that the bank was in danger. That person then got off the train, went to the hair salon, and started talking about it that she overheard three girls on the train, one of which works for Toyokawa Bank, and said that the bank is in danger.
You get the telephone game. It reminds me almost of the pest control industry where rumors are enforced. Somebody starts a rumor or somebody says something and then by the time everyone's heard it from three different people and the source is the same, all of a sudden becomes fact. The nail salon woman was talking to folks, “Does anyone hear that the bank is in danger?” People start talking and there you have it. Ultimately, there was a massive bank run and the state of Japan had to step in to stop that but that was all caused by a misunderstanding on the train.
Patrick Baldwin: That's fascinating. I never knew that.
Paul Giannamore: They used that case study a lot in psychology discussions regarding telephone game-type stuff but there you have it. I don't remember all the details. It was long time ago that I read the case study on Toyokawa Bank but it all was the Japanese financial police investigated and traced it all the way back. I don't know how they did that in 1973 but there you have it.
Patrick Baldwin: Paul, we had an episode a while back and it was asking you about the investments and gave all the disclaimers and all that and chasing yield. It made me think more about de-risk not even looking to get yield but a place in which money can't go away as you have these clients that are walking away with millions of dollars in all cases.
Paul Giannamore: I get calls like that. Tens of millions of dollars, what do I do with it?
Patrick Baldwin: We talked about FDIC insurance. I thought when you exit, can you put $250,000 in this account? You said it to me back then but it was reinstated reading it again that $250,000 per depositor or even per business account maybe.
Paul Giannamore: Tax ID number.
Patrick Baldwin: When you talked about treasury bills, these 1-month, 2-month, 3-month, 6-month, or 2-year T bills, is that de-risk? Do I pull all my money out and put it underneath the bed? Where is a safe haven? Gold?
Paul Giannamore: You raised an interesting proposition because all of 2022, we did Bubble Trouble, we did that in May 2022, and we talked about evaluations in the era of rising yields. A lot of the folks, even people in my own office, said to me, “Paul, what you're saying doesn't make sense because even if the rates go up, there's a ton of money “on the sidelines” that has to go somewhere.” I even hate the term sidelines. There's a tremendous amount of cash that's been created in recent years and it has to go somewhere.
My response has always been that investors will take cash, put it into securities, and reach yield. Until the point in which they have a high likelihood of losing that cash then they become extremely risk averse and they would rather have their money in cash as opposed to equities or alternative investments or anything. If you look at the historical record, that's an asinine argument that the cash has to go somewhere because, at the end of the day, investors prefer not to lose the cash. If assets become overvalued whereby a devaluation of those assets is almost guaranteed, then they will pull money out of that and would rather sit on cash.
Patrick Baldwin: You said that not long ago about private equity and capital calls. People would even take the penalty. It’s like, “Here's the fee.”
Paul Giannamore: We all have a recency bias and we look at like what's gone on in the last month, last three months, or the last couple of years. There are many folks out there that haven't lived through crises. It's hard to imagine a world where it's possible to wake up one day on a Monday morning and on a Sunday night before major banks have been nationalized and there’s bail in. You look at small countries like Iceland, for example. On my trip, I was in the Middle East and I was meeting with a group of Cypriot investors. I had dinner with them in Doha.
Patrick Baldwin: What is a Cypriot?
Paul Giannamore: Cyprus.
Patrick Baldwin: That's the closest I could think of, Cyprus, the country. They're called Cypriots?
Paul Giannamore: That's what I call them. We're having dinner and we were talking about that's a country that faced balance. You always think it can never happen here. None of those people ever thought that. Cypress is a part of the European Union. No one ever expected that.
Patrick Baldwin: What is a bail-in? I've never heard of a bail-in.
Paul Giannamore: A bail-in is a situation where you've got $1 million in the bank and there's an event and the regulators come in and convert your deposits into some security in the bank's capital structure. You loan money to a bank, you deposit, but, in effect, that's what you're doing. You always have to think, “I'm loaning money to a bank.” You don't own that once you deposit it.
You loan money to a bank, you give them $1 million, now they've been reckless, now they have problems, and they have to close down. Sure, that pisses off tens of thousands of depositors. The government steps in and says, “We can't have this.” When there's no money to backstop the creditors or the depositors, a balance comes in a variety of different fashions. A typical balance would be like, “Patrick, you had $1 million in our bank. Now you own $1 million in ABC Bank's stock.” ABC Bank stock at present is worthless because we're almost in receivership. SVB declared bankruptcy.
The last thing you want to be is an equity holder in a bank that's about to go bankrupt. That's bail-in. You find yourself in one of those situations. I don't spend a lot of time studying the US banking system from a solvency perspective so I don't have any opinion on any bank, nor do I have any recommendations as to what individuals should or should not do with their money. I can only talk about what I do with mine.
Patrick Baldwin: Keep talking, I'm listening.
Paul Giannamore: I tend to, for as long as I could, avoid carrying big bank balances because, number one, I'm loaning it to the bank. People always feel good, “There's FDIC insurance.” FDIC insurance causes a lot of moral hazards. Two Christmases ago, were you sitting around with your family saying, “I've been looking at some of the solvency ratios here at our community bank and I'm thinking about moving some money into a bank that's better capitalized or not taking so many risky loans.”
No one in the public at all looks at the levels of risk any bank is taking. They don't look at solvency, they don't look at the balance sheet, no one does, I don't. The reason for that is the US government has created a huge moral hazard where they backstop up to $250,000 and then no one has any reason to take a look at a bank and determine whether or not it should be functioning in a free market society.
All of a sudden, we're back to 2008 where we’re going to socialize a lot of losses. The government will choose winners and losers. I, on the whole, am not worried about the banking system necessarily. I'm worried about a lot of other credit events that could be potentially much worse. As you know, Patrick, I tend to hold real assets, things like gold, and land. Gold is particularly liquid.
It'll be an interesting situation in what happens this 2023 because we've already gotten rates up. The Europeans were raising rates in 2008 and they were raising rates in 2011. We had that European financial crisis. Of course, they're raising rates now. The Fed, from a credibility perspective, is probably going to have to follow suit. My gut tells me it's probably a quarter. Who knows what's going to happen over the weekend?
Patrick Baldwin: I got you away by asking what a bail-in was but what was the conversation with your friends from Cyprus?
Paul Giannamore: We took a stroll down memory lane and I was asking a lot of questions about that era of the disaster there and none of them expected this. A lot of it was, “How could it happen here? We're not Djibouti.” We live in a world where everyone looks at events like that and says, “That's a black swan.” My opinion is if you open your eyes, there's a tremendous amount of risk out there. A lot of these things aren't black swans, we should expect this stuff to happen, I fully do.
The problem everyone has is you can't put a tin hat on and bury your head and not do anything. You got a business to run and you got a family to provide for. Not everyone can move out in the middle of nowhere and live off the land. I get all those things. My opinion is the government is certainly not your friend when it comes to this stuff and those that have the most resources and who are not government connected are going to be the ones that pay for it.
Patrick Baldwin: Since we're talking about your friends from Cyprus, that reminds me of Credit Suisse. Here's a European bank with a long history. How's it getting handled in Europe versus the Stateside?
Paul Giannamore: I worked for Credit Suisse in Zurich years ago, it's an old and storied bank. They bought first Boston in 1987 and it became one of the largest investment banking firms in the United States. As you said, it's an old bank. It has been plagued with a lot of trouble in the last decade or so. They've had a lot of fines for a lot of certain different things. They've had turnover at the top. We see this in the banking industry over the long term banks start as banks and then they get into other lines of services.
Credit Suisse bought Winterthur Group and First Boston. All of a sudden, they're in sales and trading, they're in investment banking advisory, and they expanded into a diversified financial services business and some of those units had some problems. That was one of the whole things about the Glass-Steagall Act that came out during the Depression, which was we need to separate commercial banking from other crazy financial activities advisory-type stuff. That way, banks won't be taking a lot of risks with the depositors’ money.
In Switzerland, most of the banks are continental banks. You have the Continental Bank of Geneva and the Continental Bank of Vaud, which is the state bank. UBS and Credit Suisse are the two largest banking institutions in the country. When I lived in Switzerland, I banked with UBS. UBS is like Chase or Citibank, credit cards, savings accounts, and checking. Credit Suisse had all that stuff too but at least in the area of Switzerland I lived in, UBS was far more prolific. That was everyone's day-to-day bank credit. Suisse had focused more on advisory stuff as well as wealth management. It's a too-big-to-fail bank. The Swiss government bailed them out $254 billion overnight.
Patrick Baldwin: They're backstopping their banking system over there as well. There's no FDIC insurance over there, is there?
Paul Giannamore: I don't know that there is, quite frankly. I can tell you the FDIC is not there for certain. I don't know if there's a Swiss equivalent.
Patrick Baldwin: Without the FDIC or the European version of the FDIC over there, without that backstop, putting my money in a bank, am I looking at it differently? Would I look at the solvency of the bank?
Paul Giannamore: Switzerland is very different from the United States culturally. Switzerland, as we've talked about before on The Buzz, I always view it as probably similar to the United States before it was the United States when it was a Confederacy because it is a Swiss confederation and there are 26 sovereign camps. You naturalize in Switzerland, it takes a long time. Had I become a Swiss citizen, I would've had to naturalize in the Republic of Geneva, which is sovereign under the Swiss Confederation.
Once I became a citizen of the Republic of Geneva, I would've been able to get a Swiss Confederation passport for example. They're not a powerful central state, which is exactly how the United States was. The Swiss, of all the societies on the planet, use cash more than any other society. For example, the Swiss Franc in recent years has been pretty close to parody with the dollar.
For the purposes of this discussion, let's assume one Swiss Franc is a dollar. It is common there to carry around a thousand Frank note. You go to a grocery store in the United States with a $50 and they look at you like you're trying to run some scheme on them. I have gone out with a thousand Frank note and bought ice cream cones from my wife and me from a street vendor and got changed for 995 Francs. I wish I would've gotten 995,000 but no.
It's not uncommon to take a 500 Franc note to the grocery store and buy $50 of groceries and get that change. They use cash for everything. They buy $70,000 cars in cash. By the way, what I was always amazed about Switzerland is I've seen transactions where people are buying vehicles and all sorts of stuff. You can buy a $100,000 truck. Think about it, when you're paying a thousand frank notes, it looks like you're going out to buy groceries, it's not a lot of banknotes.
Whereas in the United States, if you're trying to do that, you got to come in with a duffel bag. That's not how they operate there. If I remember, they still have 5,000. I'm trying to think if they have 5,000 banknotes. I don’t know if those are in circulation but, at one point in time, they did. They are a cash-centric society. It's extremely safe there. The society in Switzerland is quite armed. It's not like the rest of Europe.
You go to Spain, England, and Italy, everyone's a sitting duck. The government is effectively stripped society of most of its weapons. In England, if somebody comes into your house and starts swinging a baseball bat at your wife, if you were to take a gun and shoot the guy, you are now going away for murder even if he's in your own home swinging a bat at your wife. That's how it works in most of Europe.
That's not how it works in Switzerland. You've got a society that is armed, you've got a society that's long been neutral, and you've got a society that believes in privacy and the use of cash and that there should be no central state in your business. There are a lot of folks in Switzerland that have massive cash and gold balance stored away at home and you don't hear or see a lot about their homes being robbed. In Switzerland, people take matters into their own hands. It's a society where they don't want to call the police.
In the United States, if somebody breaks into your house and dangles a deadly weapon, let's say that you shoot them, you're in Texas, you have the right to, you're standing your ground in your own home, that shows up on the news. We always joke in Switzerland, if you do something like that, “What happened to Jim? He's gone. No one has ever heard from him again.” “He broke into somebody's house and got taken care of.”
Patrick Baldwin: Natural selection. It just happens. Carrying all the cash, what does that do to society? Why is that such a big deal over there that people are paying for even large items or $5 ice cream cones in Francs versus here, it's just credit card?
Paul Giannamore: First and foremost is privacy. Anytime you use a check or a credit card or Venmo, anyone that has access to that can see your transactions. The government can see that. Privacy is first and foremost. In Switzerland, like it used to be in the United States, a financial transaction is your own private business, it doesn't matter what it is. There is a distrust in general of the banking system in Switzerland. People like to manage their own affairs. Cash is heavily used.
Patrick Baldwin: It’s interesting. Going back to what you said, this banking event that happened, you said that there are potentially worse credit events that you see as possible or maybe even probable. What are the signs or what would they be?
Paul Giannamore: We're starting to see the signs already. Ultimately, when these things happen, it's a black swan. How could we have imagined this? We are extremely overindebted not only at the consumer level, the corporate level, and the sovereign level. Corporates have used this extremely low-interest rate environment over the last fifteen years to go out. We hear about buybacks all the time.
Elizabeth Warren is on the news talking about, “We need to tax buybacks.” It made a lot of sense. Rentokil could borrow at 50 basis points. Why not go out, take that debt, buy back shares, and return some of that to your shareholders? These things happen. The government blames corporations. At the end of the day, it's the central banks that did this.
When you can set the price of time, ie interest rates, you can do all sorts of perverse things. They've created incentives for companies to go ahead and do that. Lower rates beget more debt. Over the last couple of years, we've lived in this world where government stimulus, all this money that's been conjured, has begun to flow through society. Everyone is getting checks, PPP loans, and all sorts of checks.
At the end of the day, you get this massive boom. Of course, there's going to be a bust and we're going to end up in an earnings recession. I did a Potomac TV discussion where I talked about the operating income of companies over the last couple of years has been literally at an all-time high because there's been a tremendous amount of stimulus that's gone in. We've had high operating margins. At some point, that reverses.
Now we're going into an earnings recession. You've got high leverage and you've got decreasing earnings. The seeds of credit events are not typically liquidity driven, They're usually solvency driven. solvency becomes the point in time where company A can't make its debt payments. We will begin to see that this year in earnest. We'll see credit spreads begin to blow out, which means corporate credit will have to pay increasingly higher interest rates above and beyond what the sovereign pays. From there, that stuff blows out.
When we first started The Buzz back in 2020, I made the comment that in every success of crisis, we kick the can upstairs. We've kicked it from the consumer to the corporate to corporate to now, ultimately, the sovereign. The government will ultimately have this problem. That's what we're beginning to see now. I am long US dollars. I'm long dollars because the whole world is short dollars now. It’s not that I don't think that the long-term trajectory of the dollar is downward.
Remember, I'm not investing here, I'm trading. There's a big difference. In the short term, when you have these crisis situations, I am long gold and I'm long USD, which I was at the first sniff of what was going on with SVB. You saw what happened to gold and you saw what happened to the dollar. Because of the issues that we have in Japan, my cross was short Yen and long dollar. That will go into reverse at some point.
I spent a lot of time in oil-producing countries. I was in Qatar and they pump out and sell more liquified natural gas than any other country on the planet. I met with some of the guys in my YPO there in Doha and had a lot of interesting conversations about what the Russians are trying to do, what the Chinese are trying to do, what the Japanese are trying to do, and what a lot of non-Western countries are trying to do in terms of payment plans and currencies that are outside the USD.
Patrick Baldwin: Which are? What's the plan?
Paul Giannamore: The Saudis, the Emiratis, and the Qataris where you guys accept payment for petroleum products in Renminbi, rubles, or pick the currency anything other than US Dollars.
Patrick Baldwin: They do or they don't?
Paul Giannamore: We're already starting to see those movements. There are a lot of bilateral agreements right now. Look at Russia, Russia has decided they're going to sell oil and Rubles. We're starting to see the de-dollarization happening even with the onset of this whole Russian thing. We talked about the SWIFT system and weaponizing the USD.
I do think we'll start to see the movement away or the de-dollarization begin to accelerate over the coming decade, which will have probably downward pressure on USD exchange rates. What is difficult to determine right now is, in the near term, I'm going to remain bullish from a trade perspective on USD but it's relatively short-lived.
The longer-term trajectory is a down dollar. The down dollar stokes the inflation flames because the US imports a lot and so the dollar goes down. That's one of the benefits that we've had since late 2014 and early 2015 when the dollar began to reverse its fall. Remember in mid-2014, oils start to roll down, it was over $100 a barrel, and it started to fall back.
We had USD begin to climb dramatically and that has helped the inflation situation in the US. That reverses course. It puts the fed in more of a pickle than they're already in because now you get a falling dollar, which is difficult to deal with from an inflationary perspective. There are a lot of musical chairs going on right now, Patrick.
Patrick Baldwin: This is quite the birthday present. Talking about kicking the can up the road and now with the sovereign state, you have a decreasing GDP. We're in this deflationary environment. We've got debt continuing to go up, national debt, where the dollar is going to be on a downward trajectory soon. Where does that put us? I'm thinking about the solvency of the US.
Paul Giannamore: I don't know. I go in and out of dollar-denominated assets. If I'm going to be honest, I'm heavy and I have been heavy in US dollar-denominated assets. In the last couple of years, the dollar has been super strong and that's where I put my money. When you think about the financial world, it's reflexive. George Soros wrote a book called The Alchemy of Finance. Maybe it was in the ‘80s. It is an impossible book to understand. I've thrown this thing against the wall. I've done everything short and lighted it on fire.
He's almost impossible. He talks about the concept of self-reflexivity of markets, which is the only thing that I took out of it. When you think about self-reflective markets, what he's trying to say is that the purchase of an asset in and of itself affects the fundamentals. The change in the valuation of the thing itself ultimately changes the economy or changes the fundamentals behind the asset itself. I'll give you an example.
Patrick Baldwin: Please.
Paul Giannamore: You take the United States and over the course of the last decade, we had a dollar that began to ramp up. We had a lot of quantitative easing and we also had a US stock market that I think anyone that would look at has been on a tariff for at least a decade. A lot of things are impacted in this world by cross-border capital flows. If you look at where Europeans and a lot of Asians and Middle Easterners have put money over the last decade as the US stock market goes up, foreigners buy US-denominated assets. By the fact that they're buying those assets, there's a bit of on USD. Patrick, we're going to make you an Irish investor. You're sitting there in Dublin.
Patrick Baldwin: St. Patrick's Day.
Paul Giannamore: You're in Ireland and you're like, “I've got $1 million I got to deploy.” You're looking around or you're looking at opportunities at home, you're looking at opportunities in Europe, and then you start to look over at the United States and you say, “Not only is the US stock market on a tear but the US dollar continues to go up.” You take your €1 million and you purchase equities in a US stock market.
By exchanging your Euro for a dollar, you've placed a bid into the market for USD because you've got to buy USD in order to buy US stocks. You've caused ever so slightly the USD to go up and then you also made a bid for US stocks. What ends up happening now is as you bid for dollar, you bid for stocks, stocks start to increase, and now asset values go up and asset values are going up and up and they're increasing the wealth effect.
People in the United States have more equity, the value of their homes is going up, the value of their stock portfolios is going, and they're taking some of that money and now they're investing. They're buying things, they're buying businesses, and so on and so forth. That recycles. That's self-reflexive. The fact that the actual assets are going up impacts the real economy, which further impacts the value of those assets. It becomes a cycle. That's self-reflexivity in markets. We're getting extremely deep into this whole discussion.
Patrick Baldwin: This is awesome.
Paul Giannamore: When I think about investing, I'm constantly thinking about reflexivity in markets. Most of my thought processes, both in the short and the long term, are related to cross-border capital flows because this liquidity ultimately is what impacts them. I was in three countries in Europe to all sorts of people that were way smarter than me. They've got a tremendous amount of climate goals. They've got all sorts of stuff going on in Europe that cannot be funded.
The Europeans have a lot of money here still in US dollar-denominated assets. My belief is that will begin to reverse this 2023. You look at the NASDAQ over ten years, I don't know what the percentage increase of the NASDAQ from ten years to the peak was but it's in the thousands of percent. You look at a lot of the European indices and some of them, you would've lost money, they've languished. I believe that we're going to start to see a reversal of that at some point, probably this 2023. The capital flows. When the impacts will ultimately happen in the real economy remains to be seen.
The Europeans are going to have to go through some difficult days ahead. We're going to start to see 40 years of capital flows and interest rate regimes begin to reverse and unwind, which will make it a different investing environment than we've seen historically. What every lawn care owner and pest control operator and HVAC owner has seen both at the personal level as well as the value when it comes to their company is going to be different.
We shouldn't rely on the recency bias. We should say, “We are in a new world now under a new regime.” We have a new set of problems. We've got more activist governments now. It's a different environment. The investing environment, whether I'm talking about investing in stock or investing in your own business, it's going to be different. Patrick, you can't sit around and philosophize about this stuff all day but it is important for people to educate themselves as to what this might mean for the next 10 to 20 years. A lot of people have their retirement and their family's wherewithal, they're banking on this so they need to make sure they understand it.
Patrick Baldwin: In the last few years, I can't imagine a better environment to grow a business or to make money, hence the whole wealth effect. Now what you're saying is a clean break. You can't look back at the last few years and make your plan there. Start fresh knowing you're going to have higher interest rates and probably going to have higher taxes. With everything that's happening with the economy, you've got to make a new plan.
Paul Giannamore: I don't know what's going to happen. I try to look at what's happening today and extrapolate from that. If you're a business owner, let's take pest control, you've been at it for twenty years, back in those days, those companies were selling 5 to 6 times EBITDA and one times revenue. You grew that business over twenty years. We saw multiples go up all the way into the twenties, 20x EBITDA plus 5 times revenue plus.
You shouldn't assume that I'm going to do another 5 or 10 years of work here and I'm going to get 20 times EBITDA or 15 times EBITDA for this business. I talked about this in Bubble Trouble. If you're building a business, you need to assume the historical means from an exit perspective. You can't assume elevated multiples. Assume the median because it's likely ultimately what's going to end up happening.
If you’re basing your exit decisions in the future on what we've seen in the recent past, you might be sorely disappointed. If you look at the historical mean and say, “Paul, I got a $20 million business now today and it's extremely profitable. I'm doing $5 million in EBITDA. What could I get it for today?” Let's say we strike hard and you get super lucky, you get $100 million for it, your $20 million pest control business. Historically, that's a $25 million pest control business but it's dramatically over market.
A lot of guys that we talk to are constantly making the assumption, “They'll fall back but how low can they go?” I don't know. You look through a hundred years of financial history. Going back to mean reversion is where things typically go so I would assume that. I don't know if it's six months from now, I don't know if it's a year, and I don't know if it's five years but I would make those assumptions. Everything else, real estate, we're getting into a higher-yield environment. People are beginning to allocate.
I'm going to be in Turkey and I go to Turkey a lot, Patrick. Turkey has been a train wreck and they have borderline hyperinflation there. In Nisantasi in Istanbul, I have a friend. I looked at some apartments for fun, this was Thanksgiving of 2020, and they were $700,000. I'm not talking about the Turkish lira. I was talking to him last week and he told me, “Paul, you know those apartments in Nisantasi?” I said, “Yeah.” He's like, “Now they're $1.7 million each.”
By the way, it's the Turkish currency that's going to hell in a handbasket. In Turkish currency terms, it's gone up thousands of percent. In the US dollar, it's more than doubled. These are what happens when you get dramatic inflation and you start to see some capital controls and people have to put their money somewhere. Where do they do it? They put it in gold, they put it into real estate, they put it in foreign currencies, they put it into petroleum, and they put it into hard assets.
We're seeing an interesting live case study of what goes on there in Turkey. At a certain point, they go into the equity markets. When you start to get hyperinflation, you can look back through a variety of hyperinflations over the years. You can look back to when Israel had a bad bout of inflation back in the ‘70s and ‘80s. You can look at early Germany in the ‘20s. It's not just company valuations, the question becomes real estate. It becomes stock portfolios, bond portfolios, and the whole nine yards.
It's not 40 years of great moderation, inflation moderating, and not a lot of conflicts. In fact, the world seems to be heading toward more conflict, more geopolitical risk, higher interest rates, higher inflation, slower growth, and more credit issues. Anyway, I don't have any solutions to all this. I didn't even expect to talk about it. At the end of the day, those are the types of things that I think about.
Patrick Baldwin: I love it. Are the T-Bills de-risked? I'm going way back here but as you're putting money there, is that a low risk?
Paul Giannamore: I had an interesting discussion. When I put more money in T-Bills, one of the finance guys was like, “You should put in money in longer duration.” I said, “Why?” He said, “We're dealing with this whole debt ceiling issue in the United States. If they don't raise the debt ceiling, it'll be a short duration. The T-Bills are going to be the ones that get hit first as opposed to long-duration bonds.”
Patrick Baldwin: Hit as in?
Paul Giannamore: If the government can't make a payment on any of its interest-bearing debt, it'll be these short-term treasury bills that will be hit first.
Patrick Baldwin: Do you mean they'll be devalued?
Paul Giannamore: Meaning they won't be able to pay them off. A treasury is a longer-term bond that gets a coupon, it gets a payment, interest payment. Whereas a shorter-term T-bill is a discount, meaning you buy it, you're not getting an interest payment. Do you remember those savings bonds kids would get back in the day? I don't know if they have them anymore in the US. They use them for education. I'm sure a lot of people reading this would know. They're zero-coupon bonds.
You invest $100 at a 5% rate, here's your par value, you're buying it for $95, and you get $100. It’s something like that. I'm not in a world right now where I want to take a duration risk. I don't want to be out ten years on the curve. If we end up having a problem on the short end, where we'll feel it is on the long end. I like to be on a short-term paper. The other argument that he made to me is if we hit a recession, long-term yields will fall.
The value of long-term bonds like a ten-year will increase. You lock into the coupon today, yields ultimately fall, and you get appreciation. I'm not a speculator when it comes to fixed income. Everyone has made a lot of money over the last 40 years. You could lever up. You could take $1 million and buy $50 million in treasuries. You can lever these things up. People were taking not only the coupon payment but they were also taking the appreciation because as interest rates fall, ten-year treasuries start to rise in value so you get a double whammy.
In certain instances, over the last 40 years, fixed income dramatically outperformed equities. We're not in that environment anymore. To answer your question, your short-term US government security is now the risk factor of the sovereign. Is there a dramatic devaluation in USD? This isn’t investment advice. I don't personally think that there'll be a dramatic USD devaluation. It'll be a precipitous fall but it'll be over a longer period of time.
Could the treasury go out and bid for gold at $5,000 an ounce and devalue the USD dramatically overnight? Of course, they can. That's always a risk. I don't think they're going to do it. There's a risk in anything you do, Patrick. There's a risk in buying gold and there's a risk in buying land. The best thing that you can try to attempt to do is to make smart decisions to diversify yourself both from a sovereign perspective as well as a geographic perspective.
We're finally coming into the era, especially for our American friends out there, where you shouldn't want everything to be US dollar-denominated. It's a big world out there. There are a lot of places that are way worse than the US but there are some places that probably have a little bit more promise, at least from a safety perspective.
Patrick Baldwin: I guess I'll be looking. Thanks, Paul. This is a great birthday present.
Paul Giannamore: I'm glad. I won't sing for you. On March 23rd, 2023, this will be published. I want to say on either the 24th or the 25th, we are going to publish the interview that I did with Andy Ransom in Guy Ritchie's Pub in London. Tune into Potomac TV and subscribe for that. We got a couple in England and then we go over to Dublin. PB, I'll be doing some other ones here. I'm going to be hitting the old road.
Patrick Baldwin: I look forward to seeing that
Paul Giannamore: Mr. PB, happy birthday, and have a wonderful Helberg lunch. I'll catch up with you soon.
Patrick Baldwin: Awesome, Paul. We'll see you.
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Dylan Seals: Thank you so much as always for supporting us at The Boardroom Buzz. We know your time is valuable and the fact that you spend 45 minutes or an hour with us means the world. All the media that we put out from Potomac is meant to honor and celebrate you, the service industry owner. As Paul would say, “Yee who toil in the pest control vineyards.”
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The Alchemy of Finance
Potomac TV