Inflation to Deflation
Our overarching investment thesis is that we are at the end of a long economic, social, and market cycle. This framework has allowed us to slowly modify our clients’ portfolios instead of reacting to the wild gyrations in the markets that are a function of uncertainty about the future. It also helps to better understand the decisions being made by central banks and governments around the world that impact the value of clients’ portfolios.
“Men, it has been said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, one by one.” This quote is from Charles Mackay’s seminal work, Extraordinary Popular Delusions and the Madness of Crowds, written in 1841. You would think that humanity would have evolved over the following 181 years but Mackay’s work is as important today as it was when published.
We can see this clearly in the way we treat people with diverging opinions. Where we once offered our opinions and listened intently to our opponents, looking for common ground, today it seems as if we have lost the art of polite discourse. If you disagree with me, you become my enemy! Even our news channels are segmented by political affiliation. Fortunately, this incivility is a function of the aforementioned cycle and we’re already seeing signs that people are slowly turning from such crude behavior.
Including dividends, the S&P500 is down 25% year-to-date, but when you consider how far interest rates have risen from a year ago, being down 25% has been something of a blessing for the equity markets. Based on simple dividend discount models, the jump in interest rates should have resulted in much lower equity markets.
We’ve done quite a bit better than the markets but I’m a little disappointed that we haven’t gotten more of a sell-off in the stocks that we want to rotate the portfolios into for the next cycle. Valuations are still much too high to balance the risk and reward for some of the manufacturing companies we’ve been eyeing for purchase.
In addition, we need a margin of safety in valuations to compensate for the growth risk that will stem from likely economic Depressions in Europe and China. We’ll talk more about this later in the piece but when you consider that most manufacturing companies get some portion of their revenues from outside the US, trouble in other economies can have a significant negative impact on companies whose stock we would like to own.
I’m excited about the prospects of our domestic semiconductor industry in the long term but I was clearly too early with our first position. The more I overlay our economic expectations with the prospects for the industry, the more it seems that the industry’s profit model is going to change dramatically.
With a global economy to sell to, a semiconductor company is able to “payback” its investment in a new chip in about one year. This is because they can sell to companies in the Americas, Europe and Asia, but with Europe and Asia facing massive economic headwinds, the revenue opportunity isn’t there for such a quick payback of the initial investment. Think of it like a pie that is cut into three equal pieces. In the past, semiconductor companies had access to the whole pie but now they are limited to just 1/3rd.
If we extrapolate this change further, we can deduce that product cycles are going to lengthen because companies won’t generate the cash flow to invest in the future as aggressively as in the past twenty years when they could sell to eager buyers in Europe and Asia. We only have a small exposure to the industry but you can see from the chart below that it’s going to take more time before these companies can make money for our clients.
The results of the above analysis won’t impact the global economy equally. Traditional manufacturing industries won’t be overly affected because most of the semiconductor chips they employ are older chips which we now have in abundance. The biggest issue that I see will come in AI or artificial intelligence. If new chips are slower to come to market, the development of this “next phase” will be limited. This could prove to be difficult for companies that are dependent on a fast roll-out of 5G such as Uber, which is losing extraordinary sums of money each year as they attempt to saturate the transportation market ahead of self-driving cars. If self-driving cars are delayed, Uber may not make it.
New Cycle Winners
While it’s far too early to tell which stocks will lead the markets in the future, I think it’s pretty safe to say that it won’t be Google, Amazon, and Microsoft. How can I be so dismissive of such extraordinary winners of the old cycle? The answer is simple; it’s the law of large numbers.
After a sharp decline in 2022, Google still has a market capitalization of $1.3 trillion or 6% of the US Gross Domestic Product (GDP). Over the past twelve months, Google has earned $71.7 billion. Google is a great company as is Microsoft and Amazon but growing off a large base is extraordinarily difficult.
Our slowing domestic economy will be challenging enough but a sharp slowdown in Europe and Asia will make it impossible to grow given their global models. We’ve already gotten confirmation of this difficulty from FedEx shown below.
The winners of the early stages of the next cycle are unlikely to get significant revenues from Europe and China, unless they sell military equipment or food. Instead, they’re going to be companies that benefit from bringing the global supply chain back to the Western Hemisphere. These are the companies I would like to own in the portfolio, if only they can drop a little more…
When I think of the way Europe destroyed its ability to compete in the global economy by allowing a vocal minority of climate change activists to set Europe’s energy policies, I am reminded of Williams Jennings Bryant’s “Cross of Gold” speech at the 1896 Democratic National Convention in Chicago. Bryant was one of the great orators in US history and the Democrats choice to run for President in that year’s election.
In his speech, he said “you shall not press down upon the brow of labor this crown of thorns, you shall not crucify mankind on a cross of gold.” He was referring to the gold standard which governed our domestic money supply at the time which protected creditors at the expense of debtors. The debtors were largely the labor class as opposed to the creditors who were the privileged class.
Thanks to the war in Ukraine, which had been threatened since the annexation of Crimea in 2014, Europe is no longer getting as much Russian natural gas as it had in the past. If this was 2005, it wouldn’t be a problem but due to short-sighted climate change policies, Europe has shut off much of their coal and nuclear capacity such that they’re looking at rationing natural gas and electricity for this upcoming winter. These are typically third world problems.
And despite the trillions of dollars invested in green energy, the world is burning more coal than ever before in 2022 and producing more CO2 than ever before. To apply Bryant’s logic, Europe is being crucified on the cross of climate change.
Meanwhile, India is set to burn 7% more coal in 2022 as it’s grabbing market share in manufacturing industries with both hands, even as the Europeans rapidly shut down their manufacturing plants for want of energy. In one generation, the Europeans have given up the very competitive advantages that made them “first world” nations and doomed subsequent generations to a much lower standard of living.
We can see the effect on the broader European economy by looking at the value of their shared currency, the euro which has lost nearly 40% of its value versus the US dollar. If currencies were measured by hubris of their elected officials, Europe would be just fine.
Economies run on hard work and risk taking, not stultifying rules and endless talk. Europe may remain a federation but I don’t believe that Brussels will be able to maintain a stranglehold on the broader economy for much longer. Europeans are going to be cold and angry this winter and the broad European economy is going to continue to decline.
As bad as things are in Europe, they are 10X worse in China thanks to the Chinese Communist Party (CCP). Not only have they failed to find a vaccine for Covid, they are still locking down cities using the barrel of a gun. This morning we got news that 134 cities are in a Covid lockdown! Do you now see why I expect China to experience economic Depression? Think about how much a short lockdown hurt the US economy. China has been in lockdown off and on for nearly three years.
For now, the global supply chain still largely travels through China but that won’t last long. Companies are quick to move their suppliers to accommodating parts of the globe and China is no longer accommodating as the Communist hardliners exert more control over the economy. Investors are also starting to flee because China no longer represents a place to make money. Below is a chart of the Shanghai Stock Exchange. The market has not appreciated in 15 years even as the companies in the index have piled on debt.
If this performance isn’t bad enough, the CCP has leaked a plan to consolidate Chinese companies into one giant company for each industry so that these hyper-focused companies will be able to control the international markets for inputs such as iron ore, copper, oil, and natural gas while allowing the new companies to enjoy the benefits of both scale and scope. Private companies in China will be “consolidated” into state owned enterprises (SOE’s).
Having studied companies for much of my adult life, I can tell you with some degree of certainty that this is the dumbest idea I have ever seen – and I’ve seen some whoppers! If there is one single thing the Chinese can do to thwart innovation and competitiveness, it would be to follow this plan. This is why I fully expect it to be implemented.
In my last missive, I discussed some of the problems plaguing China such as agriculture, water, disease, demographics, and energy but now we need to add self-immolation to the list. This is why I consider an economic Depression in China to be an easy call. Once the dominoes start to topple in the Middle Kingdom, I expect things to get ugly very quickly and that could lead to supply shocks for the rest of the world.
The US Dollar
People who are invested in the crypto currencies market generally cite the Federal Reserve’s rapid debasement of the US dollar as one of the reasons for wanting to put their capital in alternative currencies. On the surface, this makes sense because the Fed has been creating base money supply at a rapid rate for 15 years.
But analyzing the value of the dollar is nothing like analyzing the euro, the yen, the yuan or the Mexican peso. In fact, there has never been a currency like the dollar ever in the history of mankind which we can study for greater insights. Before the US dollar became the global reserve currency following WWII, the world had been on a gold standard, which is a very different form of currency.
This is why simply looking at the British pound sterling or the Dutch guilder in an historical context fails to yield usable insights, in my opinion. Instead, I believe we need to look at the merits of the United States in comparison to the rest of the world as well as to better understand the way the US dollar, or Eurodollar is used outside the US.
In previous historical periods, the British Royal Navy and the Royal Netherlands Navy protected trade in their respective empires and not the trade of geopolitical competitors. Today, the US Navy protects all global trade, including Chinese and Russian trade because the majority of that trade is conducted in dollars.
This is why the dollar can be paradoxically oversupplied in the US economy and scarce in the international economy. In order for the excess US supply of dollars to move to the global economy, consumers need to either purchase more foreign goods or US investors need to purchase foreign securities. With the US consumer reducing spending and international investors preferring the safety of the US markets, the Eurodollar market, or the market for dollars outside the US banking system, is experiencing scarcity. We can see this from the chart below where the dollar is spiking in value relative to the rest of global currencies.
It’s a bit confusing but when the Federal Reserve prints new base money supply, that money stays in the US. The Fed doesn’t inject new dollars into the Eurodollar market. This is why global central banks want the supply of Eurodollars to increase, not decrease.
The moment a US dollar leaves the US, for all intents and purposes, it becomes a Eurodollar. If you live in Brazil and want to purchase potash from Canada, you can borrow Eurodollars from Banco Santander in Sao Paolo and pay for your shipment. The Canadian potash supplier won’t accept Brazilian real for their products. This is how global trade works.
Nobody really knows how many Eurodollars exist but JP Morgan estimates that it’s roughly the same amount as US domestic money supply. In many respects, dollars and Eurodollars are twins that have been separated like in an old Disney movie – one can move to the US while the other can move to London as both are seemingly interchangeable. The only real difference is that the Fed can’t increase the amount of Eurodollars when necessary like with the dollar.
Because the Eurodollar market has only been around in size since the 1960’s, we don’t know how global central banks will respond to a deflationary economic downturn. Deflation represents the destruction of money such as when a Hong Kong bank lends Eurodollars to a Chinese steel company so that company can purchase steel making equipment from Germany. If that Chinese company fails to earn back the value of their Eurodollar loan by selling steel at a profit, the Hong Kong bank has to take a “write-down” on the value of its loan portfolio and its capital position. The loan is deemed to be worthless and since it was a Eurodollar loan, the number of Eurodollars declines when the bank takes a loss on its balance sheet.
If this deflationary transaction occurs enough times, global trade and the Eurodollar trading system will collapse and that’s when representatives from around the world will need to choose a new global reserve currency. Crypto currency traders believe that it will be because nobody values the dollar due to money creation by the Fed but they are wrong. It will be the result of the opposite effect – the value of the dollar will rise so high that the rest of the world can’t afford it.
The European euro, British pound, Japanese yen, Chinese yuan, and Swiss franc are all collapsing versus the US dollar. There are many factors for this collapse and by next year, I expect Europe and China to be in economic Depressions. I expect global inflation expectations to decline with those two economies.
The Fed has orchestrated a sharp increase in interest rates in the US. Many other nations across the globe are doing the same. You can see the chart below of the 10 year US Treasury Bond and how interest rates have jump from 1.7% in March to 3.90% today.
The idea is to slow the economy down enough so that the supply of goods and services matches the demand for goods and services, where equilibrium of supply/demand ends the price appreciation we know as inflation. In the case of the 10 year Treasury Bond, it correlates to demand for housing in the US which is why we are starting to see initial declines in the value of our housing stock. In addition, when people purchase homes, they tend to increase demand for new appliances, contractors, and other skilled services. Demand for these goods and services have already started to decline.
The risk is that higher interest rates will drive us deeper into recession which means that the Fed will have to orchestrate lower interest rates in the future when they feel that inflation has been tamed. Longer term, there is a huge risk that higher interest rates overwhelm the US government because the US Treasury has to pay interest on all of that debt. Below you’ll see a chart of US federal debt.
With a federal debt of $31 trillion, every 1% increase in the average interest rate on that debt increases the cost to service that debt by $300 billion. The US government collected $4 trillion in tax revenue in 2021 and spent $562 billion servicing that debt. In 2022, thanks to higher interest rates, the government has spent $677 billion servicing debt. Unless the government can keep a cap on interest rates, debt service will begin to “crowd out” other spending, which would then lead to a higher rate of growth in borrowing until the cycle destroys itself.
I don’t see this trend continuing and I don’t expect inflation to remain elevated. Economic weakness in Europe and China is already impairing consumer demand. The European consumer will be spending much of his/her income on energy this winter while Chinese consumers are presently locked up inside their homes.
Government spending in the US is likely to cool after the November elections because a split Congress will mark the end of the conflagration of government spending. This will go a long way towards ending our inflation problem.
Ultimately, the Federal Reserve is orchestrating a potential deflationary bust in the US economy. The Fed’s accommodative interest rate policy from the year 2000 onward has resulted in a massive amount of private and public debt. This sharp reversal of that policy has the potential to cause corporations and regional governments to go bankrupt. This is why we believe the next stage after inflation is deflation. It’s also why we expect interest rates to head back to 0% in the next year.
There has already been some evidence of stress in the global banking system. Credit Suisse, the giant Swiss bank, has been the subject of rumors over the past couple of weeks. As you can see from the chart below, the bank is being priced in the market like it’s going to need a massive bailout before long.
Pension funds in Great Britain have also experienced stress, forcing the Bank of England to intervene in the markets. This stress is going to get worse, perhaps much worse, and that will force the Federal Reserve and other global central banks to revisit 0% interest rates. When things start to get chaotic, we expect our Treasury positions to make a lot of money for clients.
War in Ukraine
Thanks to a large position in defense stocks, our clients have benefited from the companies that provide the goods and services Ukraine needs to defend itself. It’s a good sector for now but who will we be fighting long term? Russia has proven itself to be little more than a regional power with nuclear capabilities. You may recall that we’ve had this assessment for a long time and that our investment thesis for defense stocks has been to counter the growing threat from China, not Russia.
China has more money to spend on weapons but we learned from watching the Russians in Ukraine that you have to be able to get your soldiers and weapons to the battlefield along with the supplies they need to conduct operations. China is deficient in logistics and maintenance, perhaps not as bad as Russia, but bad enough that they don’t pose a serious threat to the US.
It’s great having the latest and greatest technology on the battlefield but soldiers need to train extensively to use the technology in conjunction with battlefield strategies and that is expensive. There is little evidence that Russian soldiers have such training. Chinese soldiers get more training but it appears that advancement in the PLA is based on bribery as opposed to merit. In addition, where US soldiers are lauded for personal initiative, Chinese soldiers need authorization to do just about everything.
If you are the crew chief of a group of technicians that maintain the new F-35 fighter planes for the Air Force, you have extraordinary pressure on you to ensure that each plane is in top condition before it takes off. One mistake in servicing the planes and your Air Force career is over. Similar pressure exists for the other branches of our military and for all types of vehicles.
Contrast this with the broken down tanks and trucks all along the road when Russia invaded Ukraine or news that the Chinese J-20 stealth fighter can’t be washed with water due to issues with corrosion. How much longer will we need to spend extraordinary sums to counter the incompetent militaries of our foes? How long will China be able to keep building weapons when their economy starts to fail?
We still like the industry for the present but if you’re not looking forward and anticipating change before it happens, you’re left to the vagaries of chance.
The day the Covid virus escaped from a lab in Wuhan was the beginning of the end for the economic model known as globalism. This isn’t meant to suggest that each nation will return to a model based on self-sufficiency. The world still needs oil, gas, and coal to provide the energy needed to enjoy a modern lifestyle and that requires trade. Instead, it suggests that the world will no longer use China as the de facto manufacturing hub for global production.
Centralized production was never a sustainable model especially since the Chinese Communist Party (CCP) was always waiting for the right time to reassert control. The ascendency of Xi Jinping to the Presidency in 2012 marked the point where the hardline Communists once again took control.
Multinational companies are now experimenting with moving capacity to other parts of Asia such as Vietnam, Malaysia, and India but none of these countries offer the same low cost dynamics that made China the destination of choice for production. As a result, the disinflationary forces that allowed prices for manufactured goods to remain stable or even drop since the early 1990’s has come to an end.
Global investors continue to look for the next China but they won’t find it and that suggests that the world is set for a period of subdued consumption. This theory runs counter to the expectations of the majority who are either in the inflation camp or the “return to growth” camp. My expectation is that the emerging markets are going to get hammered but with some exceptions such as Israel and Mexico.
Once again, we can turn to copper for a signal and Dr. Copper is telling us that the world economy is definitely slowing, along with inflationary pressures. But it’s not yet warning of a severe decline in economic activity. A break lower and we’ll have a deflationary signal.
The GeoVest Approach
People around the world are starting to learn the true cost of the climate change movement and the war in Ukraine as they struggle with high costs of energy and food. Along with a number of other social and economic variables that are in flux, these changes mark the end of the old economic and social cycle that elevated the world to a standard of living formerly known by only a few.
The easy times are over for the economy and for the markets, but this doesn’t portend rough times for everyone. We are blessed to live in the USA where we have an abundance of energy and food along with a relatively young and intelligent workforce. At GeoVest, we are committed to investing in the companies that are prepared for this new reality.
The old model of benefiting from globalization is over but a new model hasn’t yet replaced the old one. This suggests that we’ll be in a period of transition for some time. Fortunately, there are investments that can benefit from the present climate. Discipline and hard work, plus an open mind are the necessary ingredients for success during this transition period. Thank you and it’s our continued pleasure to serve you.
Philip M. Byrne, CFA
Chief Investment Officer