Barriers to Exit

The great Harvard professor Michael Porter coined the term “barriers to exit” in his groundbreaking book “Competitive Strategy” which taught a generation of young analysts how to analyze industries and companies.  Written in 1980, it is the one book that has influenced my work more than any other. 

“Barriers to exit” refers to conditions that make it impractical or extremely expensive to exit a line of business or industry but I’m using the term in the broader context.  For many people and businesses, it is going to be impossible to make the necessary changes for the next cycle because they are stuck in investments or thinking from the last cycle. 

I chose the term because it can be applied to the capital markets as well as to outdated efforts by today’s policymakers, particularly at the Fed.  As it applies to the markets, it explains why I believe that the Federal Reserve will be slashing interest rates as early as the end of 2023 and throughout 2024.  It’s also why I expect a wild ride in the markets over the next 18 months.

But more than that, I believe the term captures the efforts of policymakers and the banking elite in trying to maintain policies that were appropriate in the past even as it becomes clear that we are moving into a new phase of the post WWII economic, social, and demographic cycles.

The year is not 1990 and we are not at the start of a 33-year market cycle that will bring extraordinary returns to market participants.  We are at the end of that cycle having built out the internet, global supply chains, and technology that would have been unimaginable at the start.  The brilliant people around the globe that brought such extraordinary prosperity are now retiring and looking to spend their golden years enjoying the fruits of their efforts. 

In 1990, China had a large workforce coming into its most productive years, sold on the dreams of a life where they could be rewarded for their hard work.  Today, they are on the brink of economic and social collapse thanks to the negligent policies of the Chinese Communist Party and in particular, a man named Xi. 

The cycle has turned yet our political, financial, and corporate leadership is still fighting the last war or more accurately, they are still trying to benefit from the last cycle.  This is why the next 18 months will catch most people by surprise as it is going to take a reshuffling of our domestic assets to benefit in the next cycle.     

Stock Market

We can see this clearly in the stock market where a handful of large capitalization technology companies have enjoyed an outstanding year while the rest of the stock market has languished.  The chart below is the broadest index of the stock market – the New York Stock Exchange Index as measured in Nasdaq units where the Nasdaq is dominated by a few technology companies.

The average stock is basically flat or down on the year whereas a few stocks such as Nvidia, Tesla, and Meta have done unusually well.  Given the size of their market capitalizations, these stocks have had an outsized effect on the S&P500 and Nasdaq indices year to date.   For different reasons, I don’t like the long-term prospects for any of these three companies yet the market has rewarded them well beyond reason in 2023.  More on this later.

As I’ve said many times, maintaining the level of the US stock market appears to be an integral part of economic policy as strong returns in the stock market imply a strong economy.  I don’t believe we have had real economic growth since 2006 because the economy following the Great Financial Crisis has been dominated by an extraordinary expansion of US and local government debt without a corresponding increase in productive investment.  This should be clear from the chart on the next page.

The point is that policymakers are more focused on perception than an on policies that lead to real capital investment and growth.  This has worked in some ways but the result is a rapid deterioration in US economic fundamentals.  Using 2023 stock market returns to illustrate, we see a handful of large capitalization technology companies experiencing very strong returns in the market even as the average stock languishes.  It’s the same with the US economy.

Remaining on this trend will bring us to a sharp, ugly collapse in the stock market in the future as the terribly overvalued technology stocks are sold aggressively to raise cash. 

The chart measures our annual Gross Domestic Product (GDP) minus our national debt and it’s clear that ALL of the growth in our economy has been a product of unsustainable increases in government debt.  Keep in mind that this chart doesn’t include State and Local debt, nor does it include personal and corporate debt. 

Rounding back to the theme of this newsletter, which is “Barriers to Exit”, the government and the US population by extension, are facing enormous “Barriers to Exit” if we stop increasing debt to keep the economy elevated.  In addition, the policy to keep the stock market elevated also faces enormous “Barriers to Exit” because both the US economy and the stock market would experience a dramatic decline to a more sustainable level for each. 

Our situation is best described as we’re damned if we do and we’re damned if we don’t.  It is what happens when you take the easy route too many times in life.  At some point, you pay the price for never facing up to your troubles.

Wall Street and Corporate America

It is easy to pass judgment on national directives after the fact but there has been a small number of analysts, me included, who have been pointing to the year 1996 and the repeal of the Glass-Steagall Act in Congress as the pivotal event setting us up for our present dilemmas.  For a history refresher, the Glass-Steagall Act was passed during the Great Depression and it was designed to prevent banks from taking part in risky non-banking operations.  I was a young analyst covering banks at the time and even then, I knew the repeal would lead to financial instability at some point in the future.  It was one of the primary reasons we correctly anticipated the Great Financial Crisis of 2008. 

Today, banks are involved in all sorts of risky operations including trading, underwriting derivative products, and securitizing loans.  Perhaps the worst issue is that they trade extensively with large, unregulated financial entities such as hedge funds, special investment vehicles, and highly levered private equity firms whose true risk exposure may not be quantifiable.  A rational industry would not pursue these lines of business but 2008 taught them that regulators are inclined to “socialize the risk”.  In other words, the risk is borne by taxpayers.

The notional amount of all over-the-counter (OTC) derivative contracts is a staggering $620 trillion at the end of 2022.  The vast majority of these simply net out and do nothing to harm the global banking system but this assumption is based on a stable system.  All it takes is one or two big players to experience losses to turn the whole system into cascading dominoes.

We’ll never know for certain but I strongly suspect such a problem occurred a year ago with the giant Swiss bank Credit Suisse where large clients began withdrawing an average of $14 billion per day from the bank in the first half of 2022.  Ultimately, Swiss banking authorities folded CS into the other Swiss banking giants UBS or Union Bank of Switzerland in March of 2023.  Shareholders of CS were wiped out in the transaction.

This is the primary reason I didn’t want to overpay for those few technology stocks that have had a great year, believing that there are some other major banks in similar distress.  In retrospect, I can see why it was imperative for financial authorities and their agents to gun equity markets higher since March in a bid to shape perception.  Mea Culpa.

Meanwhile, Corporate America has done its fair share of adding risk to the global economy by relying on far flung supply chains.  I’ll get into it more later in this piece but China appears to be on the verge of entering her death throes as an economy with its real estate sector starting to collapse. 

During the pandemic, we learned the price of centralizing manufacturing operations in China where we were rewarded with numerous products and industrial inputs becoming scarce.  Unfortunately, I expect ACT II to occur at some point over the next two years.

But Corporate America did something else that worries me; they added to their indebtedness over the past ten years.  Since the Great Financial Crisis, corporations have increased debt from $14 trillion to $26 trillion, a sizable portion of which has gone to fund stock buybacks, an action that makes a company inherently riskier.

I would be disingenuous if I didn’t point out the many benefits we’ve derived as a nation from the above actions of our banking system and our corporate elite.  We’ve gotten higher asset prices to make us feel wealthier, for a time, our standards of living spiked thanks to lower prices for manufactured goods, and our domestic environment became noticeably cleaner.  In addition, corporations were able to dramatically shorten their cycle times for new products knowing that any losses from insufficient time for payback on capital investment would be borne by Chinese savers.  We would be looking forward to the IPhone 10 instead of the IPhone 15. 

Those are the virtuous elements of the latest cycle.  The vicious elements are yet to be felt but will likely include shortages of necessary parts and products, significant losses on foreign investments, and a longer domestic economic downturn due to the need to re-establish parts of our supply chain exported to foreign shores over the past 30 years.  The government may also need to bail out some banks before this is all over.

The Federal Reserve

I’ll start by saying that I don’t blame the Fed for the recent spate of consumer inflation as I believe they are only responsible for inflating asset values.  Yes, they aided and abetted Congress by making it possible to fund that spending but Congress is the primary culprit by sending out checks based on a socialist economic theory known as “Modern Monetary Theory.”  It’s a ridiculous theory put forth by economists who know nothing of history. 

With that said, the more I watch the Fed and listen to their explanations for their actions, the more I conclude that they really don’t know what they are doing.  Alas, I don’t believe anyone really understands our financial system because the level of complexity is too great for such an understanding.  Instead of admitting this lack of understanding, they focus on two highly questionable tools – consumer expectation surveys and their econometric models.

Consumer expectations for inflation is a reasonably good economic variable when used in conjunction with other forward-looking variables.  A strong dollar, ample inventories of motor fuels and agricultural commodities, and a study of national housing price trends gives forecasters quite a thorough look at inflation to support or contrast the survey data but I rarely see these variables cited.

In particular, the Fed seemed to miss the wall of money that hit consumer pockets due to the experiment with “MMT.”  The one big payment during Covid helped to produce some of the “transitory” inflation that we experienced early in the pandemic but it was the subsequent two stimulus plans plus the moratorium on student loans that resulted in the very definition of inflation – too much money chasing too few goods.  Not only that but the amount of steady state transfer payments, which are essentially checks from the government for a variety of reasons, brings the inflation potential higher.

The Fed missed this wall of money because they were not looking forward.  They could not see that putting money into consumers hands would raise the price level because they were focused on their econometric models which are effectively backward looking.  

That’s a lot of money to add to the system without creating competition for goods.  The unvarnished truth is that MMT has been attempted many times through history with the most recent being Venezuela under Hugo Chavez.  By handing out money to the population, he destroyed the economy of Venezuela by igniting inflation.  Ten years later, the economy continues to disintegrate. 

Inflation would have proven transitory if Congress didn’t keep handing out money but they didn’t stop and the Fed missed this important variable.  This is the problem with modern central banking.  The Fed and other central banks around the world have come to rely on econometric models that are very complicated yet consistently miss turning points in economies because they are inherently backward looking.  The most famous failure of the Fed’s model was the Great Financial Crisis where they were caught completely unprepared.

In 1975, British economist Charles Goodhart gave us Goodhart’s Law which states “any observed statistical regularity will tend to collapse once pressure is placed upon it for control purposes.”  Another British economist Jon Danielsson added a corollary to this law by suggesting “a risk model breaks down when used for control purposes.” 

The reason why these models break down is that market participants find ways around the regulations and derivative contracts are at the heart of the complexity, especially derivative contracts traded by unregulated entities.  This is why nobody has the vaguest notion of the true US money supply and especially the Eurodollar money supply, which is outside the US and away from US regulators.   It’s also why the Fed’s use of terms such as “quantitative easing” or “quantitative tightening” is so ludicrous.  The only thing they can measure is the size of their own balance sheet; they have no idea what impact these policies are likely to have. 

The Federal Reserve does the best they can given the extraordinary complexity that is our financial system.  I’ve given them a hard time in preceding paragraphs but nobody has the ability to gauge money supply.  The whole system will need to be re-ordered to make it possible for regulators to do their jobs properly.  I would start with eliminating derivatives except for the most basic uses – buying/selling products forward or hedging simple business risks.  Given the profitability of derivatives and the power of Wall Street, it would take a crisis to enact.

If there is one law of finance that regulators should study it is that risk can NEVER be eliminated, only transferred to someone else.  This brings me to the biggest risk on the planet – China.

China

I’ve chronicled the decline of China about as well as possible over the past ten years.  The population is aging rapidly due to the one child policy from the 1980’s and because it is far too expensive for a couple to have kids today.  The population is also suffering from non-potable drinking water, toxic food, and filthy air to go along with expensive and insufficient health care.  Most of the population still lives in poverty.

The major driver of economic growth over the past ten years has been real estate and it’s presently starting a long decline that could make regional governments and many banks insolvent.  Signature projects such as high-speed rail and semiconductor development have never been profitable and in fact, create heavy annual losses.  Their infrastructure and all other building projects are plagued by shoddy construction, so much so that the economic life of these assets is far shorter than is expected on their financial statements.  In short, the place is a disaster of biblical proportions.

Yet so many people still believe that the Chinese government will be able to embark on a spending plan much like the one that followed the Great Financial Crisis in 2008/2009.  These analysts parse over every word coming from the government looking for anything to suggest a massive stimulus program is forthcoming.  It’s not coming; I can write this with confidence.

Having studied the nation closely for 25 years, there are sometimes pieces of information that stick in the mind more than others.  In this case it was around 2011 and I was trying to understand the inflationary implications of so much “hot money” flowing into China from banks and investors in the form of Eurodollars.  At the time, the People’s Bank of China, their Federal Reserve, was attempting to manage the nation’s money supply for growth without creating inflation as they converted these Eurodollars into yuan for domestic use.

In addition, the PBOC was also trying to manage the value of the yuan in global currency markets so they could maintain a loose peg to the US dollar.  If they were to allow the yuan to appreciate due to all of the money entering China, the yuan would rise versus the dollar in currency markets, making their exports more expensive.  It struck me that China’s efforts to maintain a stable connection between the dollar and the yuan meant that for all intents and purposes, the PBOC had to mimic the policies of the US Federal Reserve.

This piece of information is critical for understanding China’s future because China can’t create a giant stimulus plan to get their economy out of its decline because international investors are pulling money out of China.  It’s the opposite of the situation that followed the Great Financial Crisis of 2008/2009.  We can see this in the chart of the US dollar versus the Chinese yuan in currency markets.

Today it takes 13.7 cents to purchase one Chinese yuan, down from almost 16 cents in early 2022.  That’s a 13% decline and I believe is just the start of a major collapse in the value of the yuan. 

Following the GFC of 2008/2009, the whole world was betting against the US dollar because they believed that the Federal Reserve was trying to devalue the US dollar to save the US economy from the bad investments that led to the GFC.  China took in those dollars and promptly invested in empty cities, redundant industrial capacity, and most of all, a real estate boom beyond the scope of imagination.  China overbuilt China, believing they were destined to supplant the US as the world’s dominant economy.  A decade later much of that investment is worthless.

This is why China is the biggest risk to the global economy and especially the global banking system.  Nobody will admit it but China is in an economic Depression and all of those international banks and investment funds are going to have to write off a significant amount of those investments because China is having trouble paying their US dollar obligations or debt.

China doesn’t have the money to pay for a massive stimulus program.  The collapse of its real estate market means that regional governments have lost 25% of their revenue which is why they are having trouble paying their own bureaucrats.  The national government and the regional governments are out of money and now, nobody in the world trusts the Chinese Communist Party.  We’re close to Game Over in Beijing.

Eurodollars

As I wrote in the last piece, US dollars and Eurodollars are the same currency but where each is deposited makes an enormous difference.  If deposited or domiciled in the US, they are US dollars.   If domiciled or deposited outside the US, they are Eurodollars and no longer subject to US banking regulators.  This is a significant point because the problems in China will impact the Eurodollar system in a huge way but the US dollar banking system much less.

The Chinese economy was built using Eurodollars because suppliers of oil, gas, metals, electronics, and all else demand dollars in trade.  Everything imported to China to build itself had to be purchased using Eurodollars.  This worked great while China was exporting vast amounts of consumer goods to the US, taking back dollars in the process, allowing them to service their international debt. 

When Covid hit, China locked down which made sourcing goods a nightmare for international companies.  Furthermore, China started using a bellicose tone in relations with its trading partners, making threats against Taiwan, and essentially showing the true colors of the Chinese Communist Party.  Now the world is moving manufacturing operations out of China at an aggressive rate.  How will this impact foreign debts?

This is the biggest issue that is overhanging the global economy because it has the potential to wipe out banks in Japan, Hong Kong, Singapore, the Middle East, and Europe.  These banks made a major bet starting 15 years ago that China would continue to grow into the dominant global economy as the US faded into decay.  They assumed that the value of the yuan would one day be higher than the value of the US dollar, allowing them to earn a profit on this movement.  It was the dumbest move of the century because the opposite is happening.  These banks are facing insolvency when the Chinese finally renege on their dollar-denominated debt. Meanwhile, the US dollar keeps spiking higher.  I expect this to continue despite our own economic and banking mistakes.

The dollar is starting to trade at a scarcity premium despite domestic inflation. It takes imports for us to move our domestic dollars into international markets and our weak US consumers are making this more difficult. Despite this, international transactions are using more dollars and fewer European euros in settling trade.

Europe is headed for a MAJOR economic downturn, led by Germany and Italy.  At the start of this year, I anticipated that China would be in a Depression and Europe would be close.  We’ll never get validation for getting this correct because neither the Europeans nor the Chinese will admit the extent of their economic difficulties but we can see it in soft and anecdotal data.  It will be too late to adjust our portfolios when this expectation becomes known by the many which is why it is so important to stick to investments that will thrive as these two regions languish.

BRICS

This is a loose alliance made up of Brazil – Russia – India – China – South Africa – countries perceived to be on the rise ten years ago and ones that favor breaking away from exclusive use of the US dollar in trade.  Many fearful analysts believe there is a risk that these countries will be in position to replace the US dollar in the near future.

I don’t share these fears because I’ve analyzed all of these countries for years and apart from India, they are all facing an ugly future thanks to economic mismanagement.  To keep this discussion brief, below is a long-term chart of the Indian rupee, the strongest economy in the group.  You’ll quickly notice the value has been cut in half versus the US dollar over the past 14 years.  Do you want to hold US dollars in your Reserve Account or Indian rupees?

Russia is a global pariah after invading Ukraine, Brazil is criminally mismanaged and always a currency risk, and the South African government is unable to keep the lights on – literally.  None of these countries has a navy that can project power around the world and in fact, none of these countries possesses the logistics capability to move their armies around the world.   The idea that these nations can form a currency union to compete with the US dollar doesn’t pass a cursory analysis of what it takes to gain the financial confidence of world bankers.

US Economy

The US economy continues to weaken and we still have an inflation problem from past government stimulus plans to go along with some pockets of temporary strength the stimulus produced.  We also have lingering energy cost problems from efforts to fight climate change.  I’ll address climate change a little more later.

We’re in better shape than the rest of the world but we are headed for a downturn in the economy because interest rates are too high and because we won’t get another stimulus plan until a new Congress is elected.  The talk of a soft landing in the economy is just talk to go along with efforts to keep the stock market elevated. 

One variable that is going to hurt consumer spending and is the end of the moratorium on student debt repayment.  People in their 20’s and 30’s have always been major consumers in our economy as they form households and start families yet school debt repayment is strangling the current crop of young people.  As of October 1st, they are required to start paying again after a three-year relief period.  It’s going to hurt consumer spending.

Companies are already anticipating the difficulty.  In the first half of 2023, tonnage at the Port of NY/NJ was down 24% year-over-year.  This figure is reinforced by Chinese trade data where export trade volume was down 11% over the same period.  Factories in Shenzhen and Dongguan, China’s primary export center, are shutting down permanently.

This slowdown is apparent when we look at auto sales shown below.  Around 17 million vehicles per year is a healthy level for the industry, represented by the green line.   Instead, the trend line is pointing lower and repossessions of past sales are growing once again.

We can also see growing weakness in the demand for housing as the rise in interest rates combined with the recent bubble in suburban home prices that was a function of people escaping cities during Covid makes housing affordability too expensive for most. This is reinforced by the second chart that shows the home ownership rate in the US is starting to turn down once again.

It’s going to be EXTREMELY difficult for the Federal Reserve to keep prices for homes, commercial real estate, and stocks elevated without taking interest rates down to 0% once again.  The lingering effects of the last stimulus package from Congress are hiding the damage done to our economy from higher interest rates.  You can see from the chart below that banks and thrifts are hugely levered to commercial real estate.

According to Epiq Bankruptcy, the number of commercial bankruptcies in the US increased 61% during the first nine months of 2023.  Keep in mind that many small and medium sized businesses took advantage of government grants for keeping payroll constant during Covid.  As that money runs out, we can expect commercial bankruptcies to rise until the Federal Reserve loosens financial conditions once again.

Keep in mind that this increase in bankruptcies occurred before people started paying on their student loans again and before this recent spike in the price of oil.  This will undoubtedly add pressure to a deteriorating situation.

Interest Rates

I’ve gotten this call wrong so far in 2023 but I’m confident that our longer dated bond position will turn around quickly before much longer.  The primary reason is what I wrote above about the economy.  As it weakens, the more pressure will build on the Fed to take aggressive action.

Fortunately, I don’t believe cutting interest rates again will spark inflation.  As I wrote earlier, our current bout of inflation is mostly due to government stimulus plans that gave money for no work and secondarily due to efforts to combat climate change. A divided Congress will put the brakes on further stimulus plans.  The chart below is a little dated but reflects the sharp rise in annual interest payments on debt to its current level of $800 billion per year.

The Fed is going to have to engineer interest rates down to 0% again to limit the damage to the government budget from paying interest on the debt.  As it stands, the Treasury is paying roughly 7% of tax receipts to bondholders.

Climate Change and Autos

The Climate Change movement is past its peak as voters have started to accept that zero carbon emissions is both unnecessary and harmful to humanity.  A recent letter stating that the planet is not facing a crisis, signed by 1,600 scientists, including two Nobel Prize winners, is putting minds at ease in developed nations.  Even in Europe, where the Green initiative began, the Green Parties of most European nations are losing voters, replaced by parties that are taking a more pragmatic approach to balancing energy needs with proper stewardship of the environment.

One thing that goes unnoticed is the fact that western economies have already reduced carbon emissions dramatically but get no recognition for the effort.  The two charts below are carbon emissions per capita.  The chart on the left is the US and it goes back to 1970.  The chart on the right is China and goes back to 1990.  I’ve identified the point on the chart of the US that represents 1990.

I’ve been expecting this movement for a few years and its why we are enthusiastic about the long-term prospects for shale oil in the US, we also like companies that allow us to keep older cars on the road for longer such as auto part stores and companies that can re-manufacture used auto parts. 

From the chart on page 13 that shows relatively weak auto sales for new cars and from anecdotal feedback from people in the car business that potential customers are balking at the extremely expensive prices for new cars, we like the prospects for the used car market.  In addition to the price, people don’t seem to like the extreme complexity on new cars to achieve mileage targets set by the Biden Administration.  This complexity has made the cost of service of relatively new cars extremely high and onerous for many drivers because small problems can turn into big and expensive electronic issues.

This is why we’re seeing sharply higher prices for very old cars that are simple to repair and which have characteristics that make them highly sought after for refurbishment.  It’s not quite the situation in Cuba where they’ve been repairing the same vehicles since the late 1950’s but certainly not a good sign for the Big 3 auto companies.  This should be good for our investments in this space.

The chart below shows the rate of inflation for used cars and it’s clear that people are choosing to fix up old cars rather than buying new ones.  When we combine this trend with the very high prices being charged for new cars as well as the relative weakness in the electric efforts of our domestic auto companies, it has me wondering if we’re going to see bankruptcy for at least one auto company in our future.

Increasingly, it seems that electric cars will be relegated to a niche product for urban areas because they’re expensive, inconvenient for long trips and when the weather is extremely hot or cold.  They seem highly suitable for urban environments where they can cover short distances between charging stations, reducing the anxiety of running out of battery power. 

Europe seems well-suited for electric cars where the high-end producers are turning out strong products.  China builds the most electric cars but their quality control is lacking and that spells disaster for electric cars where the lithium batteries explode when in contact with the air.

Tesla remains the leader of the industry but I don’t believe their $800 billion market capitalization level can be maintained for long.  Earnings will fall as they are forced to cut the price of their cars to sell to cash-strapped consumers.

I don’t believe electric cars will experience wide-spread adoption and I fear that the Big 3 US automakers will have to write down the majority of their investments in this space.  Looking at Ford’s balance sheet where debt is 333% of equity, it’s going to be hard-pressed to remain solvent over the next five years. 

War Cycle

A couple of years ago, I introduced the idea that we are entering a war cycle where conflagrations across the globe pick up as people fight over a shrinking piece of the economic pie.  We are all aware of the bloodbath in Ukraine and now we can add Gaza to the list.  There is also continued fighting between Armenia and Azerbaijan.

There is a growing threat of more outbreaks in the area around the South China Sea and the former colonies of France in West Africa.  As such, it’s a good time to be invested in defense companies because business is (unfortunately) thriving.

There is potential for the fighting in Gaza to get much worse as Iran is spoiling for a fight with Israel through its proxy Hezbollah at its northern border in Lebanon.  This should be good for Elbit Systems which is an Israeli defense company.  We purchased the stock years ago because they are outstanding in cyber security but they also benefit from kinetic warfare.

There are some signs that China, Iran, and Russia are behind the militants that started this devastation.  All three would like to see the US lose its position as dominant military and economic power and they know that it takes a world war to make this possible.  There goal is to weaken the US military by supporting fighting across the globe and forcing us to dig deep into our inventories of weapons.

The good news is that all three are on the verge of becoming “failed states” where their internal problems make it impossible for their leaders to concentrate on outside affairs.  Furthermore, the US has weapons systems that we haven’t yet unveiled to the world in the form of cyberwarfare, drone swarms, and interconnectivity of weapons systems across platforms. 

The F-35 fighter jet, made by Lockheed, is rumored to have the ability to destroy electric power grids in hostile regions.  It has also been rumored that the US used cyberwarfare to shut down North Korea’s power grid when they threatened Japan with nuclear missiles.  Undoubtedly, there are many more abilities the US military has kept under wraps.  Just remember how shocked you were when the US attacked Iraq where they unveiled precision munitions and long-range strike capabilities that easily defeated a very formidable Iraqi military. 

On paper, the idea of facing off against Russia, China, and Iran is daunting until you consider that Ukraine has destroyed a significant amount of Russia’s military capability and reflected a Russian military that is poorly led, poorly trained, and unable to handle simple logistics.  China’s military is largely armed with copies of Russian equipment that is more for show than for use.  Like Russia, their military leadership is a mafia-like cadre focused more on extracting wealth than fighting wars. 

As with Elbit, we invested heavily in defense stocks primarily for their cyber security capabilities, with their dominant kinetic warfare businesses as something of an insurance policy against the conditions we presently face.  As such, our clients are well-positioned for the current climate.

Regarding the bigger picture and the continued dominance of the US military, if we stay on the periphery of conflict and limit how much we engage our enemies, time will work against our enemies.  China’s economy is headed for economic disaster and Russia’s economy is already there.  As Napoleon Bonaparte once said “never interrupt your enemy when he is making a mistake.”

Mexico

Enough with negative stuff, let’s talk about something positive.  On the next global upswing, I think Mexico could be a core region for us thanks to its proximity to the US and it’s strong, capable workforce.

Studies I’ve seen suggest that Mexican workers are at least twice as productive as their Chinese counterparts.  Mexico also has oil but their state oil companies lack the technology to exploit their reserves.  This won’t change until the Mexican people change their constitution which outlaws the exploitation of their oil deposits by foreign companies.

The difficult oil beds in Mexico are the perfect companion for the advanced technologies employed by Exxon, Chevron, and Royal Dutch Shell.  In addition, the relatively heavy bitumen oil produced in Mexico is perfect for our Gulf of Mexico refiners that are world leaders in processing lower valued oil.

You can see from the chart below that the Mexican stock market is experiencing weakness, much like the rest of the world.  That’s what I like to see.

Heavy capital investment and a more powerful police force should be enough to overcome their crime cartels.  Crime tends to dominate areas that are starved for capital investment.  Mexico is going to need better rail lines and port facilities but once completed, they should be able to replace a significant amount of China’s manufacturing capacity. 

The biggest issue with Mexico is its mountainous terrain which works against logistics networks, leaving cities as little nations unto themselves given the difficulty of travel between cities.  Modern road building should finally make this untapped region feasible in the next cycle. 

The GeoVest Approach

It’s going to take an extended downturn to break the “Barriers to Exit” but it’s going to happen.  If nothing else, the aging of the Baby Boom generational cohort is going to break some of the momentum that backs extreme consumerism.  Older people require fewer material goods and younger generations are not generating the same level of wealth as the Baby Boom cohort.

Policymakers in Washington continue to try to sustain an unsustainable trend and it’s why we’ve experienced an outbreak of inflation.  Mailing checks to people is one of those enticing policies that resurfaces from time to time and which inevitably leads to inflation.  Whether it continues or not will depend on the will of the people.  I trust the will of the people. 

I’m starting to get the sense that many of the “Barriers to Exit” that have kept our economy in limbo by running up the national credit card since 2009 are starting to break and like everything else in life, the results will be both good and bad depending on how you are affected.  Personally, I’m excited because the US has some extraordinary advantages that have been kept under wraps as Wall Street and Corporate America have exported formerly core US industries abroad.  Oil and natural gas drilling, fuel and chemical refining, metallurgy, agriculture, semiconductor technology, and a host of other competitive advantages are just waiting to be tapped into by young and energetic Americans, Mexicans, and Canadians.  The only thing holding us back is the focus on policies from the last economic cycle.   

At the same time, the extraordinary focus on consumer spending that is behind the success of companies such as Google, Meta, Amazon, and Nvidia seems like is starting to run its course.  The marketing advantages of having computer server farms armed with the latest AI software and hardware dissipate when consumer spending starts to weaken.  Companies that are retrenching don’t need cutting edge information on consumers. 

Things are going to get even muddier when China finally reveals the true state of their economy.  Not only will we see a sharp decline in their consumption of raw materials such as iron ore and oil, their demand for semiconductors and other electronics will be impacted.  This will have a big impact on semiconductor product cycles and profitability.   

Change is coming rapidly and where things have been stable for the past ten years, instability is becoming the norm.  We’re addressing this reality with this longer, more informative newsletter as well as plans to publish more updates in the future.  GeoVest has a new Youtube channel and I hope to start uploading videos over the next week!   Thank you and it is our continued pleasure to serve you.

 Philip M. Byrne, CFA