Red Lining the Economic Engine

A classic television commercial from my youth for motor oil showed the tachometer of a car that was revved up past its red line that subsequently stalled.  The commercial was designed to convince car owners to change their oil more frequently – and to use Quaker State Motor Oil. 

Tachometers measure how hard an internal combustion engine is working.  Automakers put a red line on tachometers to show that it is dangerous to rev up an engine beyond these practical limits.  This is the image that resonates with me when I consider the steps the government is taking to keep the stock market elevated and the economy above the recession threshold.  They’re trying to do too much in front of a contentious election where the main event is a populist reformer running against an establishment mainstay.

It’s a classic mistake that is akin to over-feeding the “goose that lays the golden eggs” so much that the goose succumbs leaving only its liver as residual value in the form of “foie gras”.  Today, the authorities are doing their best to drive the stock market higher by the promise of lower interest rates even as the Biden Administration tries to force feed as much money into the US economy in front of the election to avert a recession. 

Forcing money into the economy is the source of our inflation problem which means that the Federal Reserve won’t be able to cut interest rates even as the “real” economy languishes.  This suggests that the stock market is on very shaky ground because the advance off the November lows has been built on the belief that the Fed will cut rates soon. 

While I still don’t believe the stock market is at risk of a major decline in the next few months, I’m afraid that the overly aggressive strategy of gunning the stock market higher, combined with effectively handing out money to keep the economy elevated, will result in a major crash later this year.  Current economic and market policies are beyond reckless.    

Stock Market

The stock market continues to storm higher, led by the Magnificent Seven sans two.  The good ones are Nvidia, Microsoft, Google, Meta, and Amazon.  You may recall in last quarter’s missive that Apple and Tesla are facing tough times, which is why both lost money in the first quarter.  The remaining five continue to soar thanks to the belief that combining artificial intelligence with cloud computing will result in something spectacular for the economy and those five companies in particular.

The AI/Cloud rally is well past anything resembling reality and as inflation continues to impoverish the US population, the value of the marketing insights derived from data mining the information stored on the Cloud has already started to decline.  For reference, the Cloud is nothing more than giant buildings full of computers that store data for companies and individuals instead of housing that data on company premises.  And data mining represents the programs that rapidly scan the data stored in the Cloud to develop insights into our purchasing patterns.  This information is extremely valuable for anyone selling to consumers or businesses. 

The reason these stocks have done well in the first quarter is because nobody truly understands the potential from AI and Cloud computing, much like the internet revolution 25 years ago.  This makes it relatively easy for Wall Street’s “hype machine” to drive valuations higher.

All five of the remaining “Magnificent” stocks are extremely overvalued.  Additionally, growth stocks are more sensitive to interest rates than value stocks.  A change in interest rates assumptions tends to have a huge impact on their valuations.  With reported inflation coming in higher than expectations, these stocks should run into difficulty because the Fed won’t be able to cut interest rates aggressively.

Like 2023, the big technology companies dominated the first quarter of 2024 but I’ll be surprised if they continue to move higher as investors learn about the limitations for growth each is experiencing.  Along with AI/Cloud, the EV or electric vehicle bubble is starting to burst as people realize that EV’s offer dramatically less value to consumers than comparable ICE (internal combustion energy) vehicles. 

Electric Vehicles

I’ve been quite clear about my disdain for EV’s and vehicle buyers are starting to catch up prompting domestic automakers to slash EV production.  Car dealers don’t want to keep EV’s in inventory because their value depreciates VERY quickly and because the equipment to service EV’s are extremely expensive. 

According to the electric vehicle blog Elektek, Elon Musk sent an internal email to Tesla workers explaining why they are preparing to lay off 10% of their workforce.  Given recent sales numbers, this shouldn’t be a surprise. 

While it’s not widely reported in mainstream media outlets, EV’s pose a significant fire risk when parked in garages or on dealer lots.  It’s so bad that I’ve read where Norwegian Ferry Company now bans electric vehicles on their ferries following some recent disasters.  BYD, the giant Chinese EV maker, recently purchased two ships to transport its vehicles to Europe because auto shippers charge extra for EV’s due to fire risk.  As an aside, BYD electric vehicles are reportedly piling up in European ports, forcing the company to slash production by 43%.

Tesla’s chart tells the story.  Much like Nvidia today, the Wall Street “hype machine” told us that Tesla was cheap at $300 per share and that Tesla would ultimately bring out a $20,000 car for the masses.

What they don’t tell us is that EV cars burn through tires far more rapidly than ICE vehicles thanks to their weight and quicker acceleration.  They also tell us that fast-charging doesn’t harm a battery’s life provided that proper heat discharging steps are followed, otherwise, the excess heat created from fast-charging rapidly degrades the battery and increases the risk of fire.  To maintain a battery long-term, it takes roughly one day to charge which is highly inefficient and impossible for average Americans.

The only way that EV’s will grow from here is if we are forced to abandon ICE vehicles in favor of EV’s.  I don’t expect this to happen for a couple of reasons.  The first is that the weather model that predicted rising global temperatures and melting ice caps has never been accurate.  For over twenty years, this model and its variants that use carbon dioxide in the atmosphere as a key determinant of temperature have been consistently wrong.  This is why people are increasingly tuning out alarmists.

The second reason I don’t expect an end to ICE vehicles is that we are entering a period of economic hardship in the global economy.  Surveys show that people are stratifying their priorities in favor of household well-being and away from discretionary causes such as climate change.  Politicians who want to be elected won’t ignore these types of changes.

There are still a lot of people who feel strongly about climate change even as some scientific heavyweights have become more vocal in opposition to it.   The probability of being forced to accept electric vehicles in the future is still above zero and this is what China is heavily betting on.

Chinese Exports

History won’t be kind to Xi Jinping, the Premier of the Chinese Communist Party (CCP).  For over ten years, he has done his utmost to destroy China’s economy with ridiculous policies reminiscent of Mao.  In truth, it was headed for a major decline anyway but he both hastened the decline and is making it far deeper than it would have been.  Xi is one of the major reasons I believe we’re past the peak of electric vehicles; he’s betting heavily on being able to export them to the West.

BYD is the leading Chinese company in this push to dominate plug-in hybrid electric vehicles (PHEV) and battery electric vehicles (BEV) around the world.  Here’s a chart of their output over the past six years.

For a time in 2023, BYD briefly sold more EV’s than Tesla but that didn’t last long.  It seems that the more Europeans are exposed to BYD’s quality, or lack thereof, the less interested they are in purchasing one.  But that hasn’t stopped Xi from making EV exports China’s top economic goal – and that’s making European and American leaders very angry.

European leaders have been the most vociferous about climate change and many view the shift to green technologies as central to their economic vitality.  China’s dumping of EV’s, solar panels, lithium batteries, and windmills on the world market is drawing sharp criticism from the likes of Emmanuel Macron and Olaf Scholz.  Increased trade tensions could result in a return of widespread trade barriers.

This trade dispute has the potential to put a nail in China’s economic coffin because they reportedly have at least 50% spare capacity in lithium batteries.  Solar panels, steel, cement, aluminum, and EV’s are also believed to have enormous spare capacity that Xi would like to dump on global markets.  With European, South American, and North American economies slowing, leaders around the world are not having it.  Recent data bears this out as Chinese exports declined 8% y-o-y in March as imports declined 2% y-o-y. 

This leaves China in an extreme predicament.  If we were to apply company analysis to China, I would conclude that China is managing for cash – a sign of impending bankruptcy.  Companies in extreme financial danger usually slash advertising, research and development, and all but the most necessary expenses even as they slash prices to customers to get them to pay rapidly.  According to Customs data, in 2023 Chinese steel companies exported 36% more steel in tonnage over 2022 but revenues for their steel declined 8%.  This reflects a HUGE loss on sales.

We can see the results in the chart below of the Chinese yuan relative to the US dollar.  When China’s economy starts to really collapse, I expect the yuan to fall much further against the dollar.  It’s one of my most important indicators.

China represents the single biggest risk to the global economy today.  Their problems are systemic and so pervasive that they can’t avoid an economic collapse even if the rest of the world allowed them to dump exports on the market.  They’re paying the price for not properly respecting capital investment decisions.

The country is broke.  Beijing no longer has the money to induce local governments to follow its directives which means that even good ideas won’t get implemented.  Local governments spend 80% of tax revenues on paying government workers.  With the sharp decline in government revenues, doctors, teachers, police officers, and bus drivers are not getting paid. 

The Chinese Communist Party is doing its utmost to hide damaging data and narratives.  In particular, the content of their foreign currency reserve account is a state secret.  They claim to have $3.2 trillion but that number may include its own currency the yuan, which is virtually worthless in foreign trade.  The implication is that China may not have sufficient dollars/euros/yen in their current account to purchase energy, food, or industrial equipment in a crisis.     Nobody is talking about this risk but I consider it the most significant risk for the world banking system because China would be unable to purchase the necessities for operating an economy.

But it’s not just currency data, we don’t get to see any of this in the West because China no longer distributes useful economic data.  A friend sent me this chart which tells the story. 

We only get data that can be potentially manipulated by the CCP.  The data we get is designed to create a positive impression of China for the world.  China’s rapid decline has already shown up in demand for Apple Iphones, the closing of Western retailers, and the closing of economic consulates across the country.  It’s going to continue to decline as the year progresses and will ultimately start to affect US company bottom lines by year-end.  We may also see forced liquidation of Chinese investments in the US and Europe – mostly in real estate.

Contrarians like to talk about China’s economy bottoming out and rebounding but it’s virtually impossible given China’s consumers are aggressively cutting spending while foreign direct investment has fallen over 80%.  If you know where to look, it’s clear that China is headed for a multi-year economic depression.      

War Cycle and Defense Stocks

Defense companies are still the place to be in 2024 because the potential for widescale military conflict continues to rise everywhere.  Israel and Iran are trading blows.  The Houthis in Yemen continue to attack Red Sea shipping.  China continues to prepare for war in the South China Sea while India is maneuvering to deny Chinese ships access to the Straits of Malacca. 

A new threat has emerged from France which wants to explore increased NATO involvement in Ukraine.  This would make WWIII a possibility along with the use of nuclear weapons. 

Personally, I consider such talk to be beyond dangerous but it helps to know the context around France’s new-found belligerence.  What the mainstream media hasn’t shared is the fact that France is in the position to lose much of its economic influence in Central Africa thanks to efforts by Russia. 

We rarely read about this but France has effectively been a colonial power in Africa for centuries, maintaining much of their influence even as Britain, Belgium, and the Netherlands ceded most of their colonial holding following WWII.  Until recently, they controlled the economies of the Sahel Region of Africa, which is sandwiched between the Sahara Desert to the north and the tropical jungles to the south.  The regions value is in commodities such as uranium and gold which France purchased below market rates for decades thanks to regional currencies being pegged to the French franc and euro.  Now Russian militias such as the infamous Wagner Group are in the region which has created great difficulties for France.  Could this be the reason Emmanuel Macron wants to risk total war in Ukraine?

I’m confident that cooler heads will prevail because Russia has devolved into being more of a geopolitical nuisance than being a major power.  Besides, since the Ukraine war began, Russia lost 2,000 of its best tanks and now is resorting to using tanks built in the 1950’s.  With poor logistics and significant losses of men and material in Ukraine, the Russian army is unlikely to be a threat to the NATO countries. 

The Russian navy has been driven out of most of the Black Sea by Ukraine, which lacks a navy.  Perhaps worse still, Russia is unable to use its air force anywhere but over secure Russian territory for fear of having its planes shot down by Western air defense systems given to Ukraine.  But they still have nuclear weapons…

The Chinese military isn’t much better because their soldiers are mainly armed with weapons copied from Russia or limited blueprints of NATO weapons.  I don’t see a big threat for the US from either China or Russia but the world continues to move towards war and that’s good for the defense business.  More importantly for the near term, these stocks tend to make money when we experience down days in the stock market. 

Economy

In the short run, the US government can report just about any number it wants people to see with the limitation of needing to be somewhat consistent with economic data they don’t control directly.  When you take a deep dive into the way economic data is collected and how it is adjusted for various reasons, it becomes clear that there is a lot of room to fudge data for political reasons.  This has been going on for decades which is why data routinely get “revised” many years after release. 

In an election year, the party in office typically empties the cupboards for potential spending to make the economy appear stronger than its real intrinsic value.  Again, we’ve been doing this for decades.  The problem for the Biden Administration this year is that they’ve been following this path since taking office and it shows in total US debt position as well as in inflation.

Federal debt is $34 trillion, up 21% since Biden took office and I suspect it’s headed much higher as we approach the election; it’s what all incumbents try to do.  The problem is that we’ve reached a saturation point where increases in federal debt is directly leading to inflation.  It’s the mechanism by which Federal Reserve money creation transfers into the economy. 

Every student loan that is forgiven, or handouts given to individual Americans and contested immigrants, directly increases the supply of money relative to the supply of goods and services.  This is basic economics, not political commentary.  Every President that has held office has faced the same trade-off.  Since the Great Financial Crisis (GFC), Presidents have been “buying/creating” economic growth with US debt.  It’s no different than a neighbor running up his/her credit card to give the impression of wealth.  The unique problem for the current administration is that they are in power when this strategy hit the point of diminishing marginal return.

In my estimation, “real” economic growth peaked in 2006 and has been declining since.  Some call it a “Silent Depression” and perhaps this is what the 1930’s would have been like if the Fed turned on the money spigots.  Regardless, we’ve pushed forward the Day of Reckoning.  Unfortunately, each increase in federal debt seems to be increasing inflation – as I said earlier, we’ve reached the saturation point of this strategy. 

Political Economy

I believe the Biden Administration made a tactical error when they chose to force the economy higher instead of allowing the growth rate to trend around 0% in front of the election.  By forcing more money into the economy at saturation point, they are hurting the people needed to win the election.  They also are forcing the Federal Reserve to delay cutting interest rates which is hurting the real economy.

The real economy needs lower interest rates desperately.  Commercial real estate is starting to rapidly decline in value and banks are going to need lower funding rates to carry these problems on their balance sheets.  In addition, the housing market is stalling because young people can’t afford the high prices of homes and high interest rates. 

Continued strength in the stock market is another potential problem because higher interest rates make the cash flows generated by companies less valuable to investors who have less risky options for their capital.  This will prove to be important because the Baby Boom demographic tranche is already in retirement mode and capital preservation becomes increasingly important each year. 

Apart from interest rates, there is a second area of the political economy that bears watching and that is in capital allocation.  In particular, I’m watching the semiconductor space where the US government has given generous grants and loans to Intel, Taiwan Semiconductor, and others to bring semiconductor chip production back to the US.  While I applaud the strategic value of the moves, the reality is going to be dramatic excess capacity in chip production and that implies lower returns for the companies in that space.

The government generally isn’t good at investing with the exceptions of the Erie Canal and the Eisenhower Highway System among others.  They’ll succeed in safeguarding our semiconductor supply line at the expense of semiconductor foundry profitability.  Chip production is a global business and we’ll be bringing huge increases in chip capacity to the market while China, which is the biggest consumer of chips, is being restricted from purchasing these chips.  It’s basic supply and demand. 

Eurodollars

Little known fact – the Eurodollar market was created by the Soviet Union in 1957 when they deposited US dollars, accepted in trade for oil, in a European bank out of fear that they could lose the money if deposited in a US bank.  By depositing dollars in a European bank, the former Communist nation skirted US banking rules and limitations.  Little did they know that they were creating the vehicle for US domination of the global financial system.

Fast forward to today and the US has muscled Russia out of the Western financial system known as SWIFT or Society for Worldwide Interbank Financial Telecommunications following their invasion of Ukraine.  In economic warfare, it’s the equivalent of using nuclear weapons because it makes trading with foreign nations infinitely difficult and expensive.  The Russian economy is suffering mightily as a result.

While I agree with the sentiment, I believe this move will ultimately bring about the loss of the dollar as the dominant global reserve currency because other nations will fear the loss of their financial assets if they disagree with the US in the future.  I consider the move short-sighted although admittedly satisfying to put the screws to Putin.  Once rogue nations such as Russia, China, and Iran find a satisfactory alternative to the SWIFT system, you can bet that other nations will look to use it along with SWIFT.  Necessity is the mother of invention.

Ironically, the strength of the dollar could prove to be a second major driver towards an alternative to the dollar.  As I have mentioned many times over the past five years, the world bet heavily against the dollar from 2009 through 2014.  This was the time where the Federal Reserve was running the printing press to save the global banking system.  Emerging nations starting with China borrowed heavily in dollars in order to fund everything their political classes wanted to build – roads, bridges, airports, dams, ports, and rail to name a few.  They all believed they would be able to pay back their loans with devalued US dollars – wrong!!!!

As you can see, the dollar has been in a secular bull market since 2014 and it’s going to keep going higher even as nations such as China struggle to pay back those dollar bonds.  Just using the chart below, if you borrowed dollars at the beginning of 2010, the appreciation of the dollar has made that debt 40% more expensive to service.  Ouch!!!

Based on the above chart, you may be tempted to conclude that the US really has its financial house in order but that would be the wrong conclusion.  As I have written before, there are two markets for US dollars – domestic and international.  The domestic market has excess dollars as evidenced by the high rate of inflation.  This is the dynamic I discussed above where the excess use of borrowing/spending done by Congress since 2008 has resulted in a saturation of dollars in the economy – or inflation.

The international market is the Eurodollar market and thanks to borrowing and wasting those dollars on stupid investments such as everything China has done over the past fifteen years, there is a scarcity of dollars.  It’s a strange dynamic but it’s possible thanks to the US being a net seller of oil/gas/agriculture.  Every year, we drain dollars from the international market with these critical exports.  Combined this with the destruction of existing Eurodollars from insolvent investments and you get scarcity and a scarcity premium valuation for Eurodollars.

The higher the value of the dollar, the more stress experienced by the global financial system and at 106, the dollar looks poised for another move higher in currency markets.  We may be very close to a meltdown in the emerging markets, starting with China.  Chinese exporters are hoarding dollars in offshore accounts because they expect the Chinese yuan to decline sharply.

Yield Curve Control (YCC)

If you’ve been paying attention, the US Federal Reserve has been following the lead of the Bank of Japan with a thirty-year delay.  The BOJ was the first to give us quantitative easing back in the early 90’s and they gave us YCC or yield curve control starting in September 2016.  I don’t expect that we’ll have to wait another twenty-three years for the Fed to start controlling interest rates from the overnight rate out to thirty years because we are spending a LOT of money on debt service.  The Fed has the capacity to push the entire maturity spectrum of US Treasury debt towards 0%.  I expect to see such a shift to start by the end of the year as the real economy suffers from excess debt and interest rates that are too high. 

The US economy can’t handle long term rates above the red line, particularly the housing market.  Given the fact that Congress is unable to contain its spending urge, I believe the Fed will need to move aggressively by later this year.  We eclipsed $1 trillion on interest payments on federal debt in 2023 and some estimates suggest it could increase above $1.5 trillion by year-end. 

At some point, the Fed will choose to force interest rates lower in a form of financial repression.  They’ll do it because they’ll have no choice to prevent a meltdown worse than 2008.  If there is one thing that is a constant in world history, it’s that excess debt gets devalued when it grows too big.  It’s why gold ultimately makes sense for long term investors.

The GeoVest Approach

We have reached the point where the Goose that lays the Golden Eggs is choking on her food.  The US economy can no longer handle increased federal spending without higher inflation.  The US economy can also no longer handle interest rates that are this high.  Something is starting to break.

People talk about a “re-set” in our financial system all the time to justify bitcoins or technology stocks.  Neither is the answer and that is why we manage our portfolios to benefit from any form of “re-set.”  Our stock and bond selections already incorporate this potential future because nobody knows when it will happen.  We own companies that will benefit from any eventuality, no matter how extreme.

We have been early in this regard but people are starting to appreciate the stocks we own which is why I am confident in our prospects for 2024.  Being ahead of the curve is relatively easy but getting the timing right is always the most challenging aspect of long-term investing.  If you visit our website, www.geovestadvisors.com, I delve into the current environment more deeply.

Thank you and it is our continued pleasure to serve you.

Philip M. Byrne, CFA