Over the last few years, I have used the word “paradox” a lot in my writing mostly because so much simply does not make sense without a ton of digging and consideration. Paradox: a seemingly absurd or self-contradictory statement or proposition that when investigated or explained may prove to be well founded or true. Doesn’t that ring true with a lot of today’s culture?
The first paradox I would like to discuss is the stock market and its sharp advance off the lows of October 2022. How does this happen when the Federal Reserve continues to raise interest rates and the global economy is weakening? This paradox did not need much consideration because we stayed fully invested for a reason – too many investors thought they could make a fortune “shorting” or selling the market. These ill-timed speculators learned that “you can’t fight city hall”.
The global economy may be rapidly weakening but the US economy is only slowly creeping towards an economic downturn. This relatively quiet time created the perfect opportunity for well-funded institutions to take advantage of the overly cautious. Not only did they squeeze short sellers out of positions but they also forced money managers who raised cash to get back into stocks or risk dramatically underperforming the market.
You may recall from last quarter’s newsletter that I suggested that stocks would not crash when so many investors were predicting a crash. If we have learned one thing from the post Great Financial Crisis (GFC) it’s that the stock market is critical for shaping people’s perceptions about our economy which is why it’s essential for the government to ensure that the stock market remains stable. And when so many investors are positioned for a crash, large funds are incentivized to take advantage of the seemingly prudent investors.
Yet amid all the good feelings over the first half rally, the Dow Jones Industrial Average hasn’t budged. It’s because the first half rally has been driven by cyclical companies in the tech space, companies that are more susceptible to an economic downturn than many of the companies in the DJIA. These are the companies that speculators were betting against in the fourth quarter of 2022 and the first quarter of 2023. Those negative speculators lost a LOT of money in the first half of 2023 but I suspect many of those companies to experience losses in the market in the second half of the year for the simple reason that the global economy is moving inexorably towards a very bad recession.
The second paradox of the stock market is that PE’s (or price to earnings ratios) are near all-time highs despite rising interest rates. Because rising interest rates provide alternatives to stocks, rising interest rates normally result in falling PE ratios. Currently, the PE of the S&P500 is around 20X earnings, which is historically VERY high. We’ll discuss this more fully later in this piece.
The US economy is yet another paradox as it is only moving slowly towards a recession where the Federal Reserve’s rapid move to raise short term interest rates would normally have resulted in a sharp economic decline earlier this year. The reason for the temporary respite is that the federal government has been spending like Covid lockdowns are still happening. In fact, when the Democrat leaders in the House and Senate were preparing for the November 2022 election, they anticipated losing one of the houses of Congress and smartly jammed through the Inflation Reduction Act of 2022 which maintained the flow of fiscal cash flow into our economy.
The chart below should explain why our economy has thus far remained “resilient” to the global economic downturn. We jumped on a steeper trend line of fiscal spending following Covid and stayed on that trend line even after Covid was beaten.
A significant part of the previous bills was a provision to compensate small businesses for maintaining employment levels through Covid. This provision was advertised extensively over the summer of 2022 and has allowed small firms to heretofore avoid cutting employment levels due to the slowdown in our economy.
A second provision put a moratorium on student loan payments over the past three years. This moratorium has recently ended and will likely result in a significant bite to consumer spending going forward.
When the government funds run out and the economy has more time to stagger under the pressure of higher interest rates, we will experience a recession. The Federal Reserve even admits to a shallow recession later this year. We can already see a slight decline shaping up in sales of electronics and appliances.
I expect it to be deeper and longer than anything experienced over the past 50 years for the simple reason that our economy will need to move away from a dominant consumption model to a more balanced production/consumption model. We’ve been taught that recessions are akin to a visit from the bogey man but a more productive way to view recessions is as a transition period that brings new opportunity, even as it brings a temporary retrenchment in market values.
As the downturn is still in front of us, made worse by the Fed’s policy to continue raising interest rates, we can expect further downside moves in the stock market. The good news is that we live in the US where we have abundant energy, food, technology, and capital. We only really depend on the rest of the world for imported manufactured goods and that dependence can be reversed within ten years. The rest of the world won’t be as lucky.
Global Economic Crisis
I was hesitant to use the word “crisis” in this newsletter because the term is presently being overused. It seems that in the US, we experience a crisis whenever we do not get exactly what we want when we want it. I wish I was kidding.
It is a word that gets used a lot by politicians to create enough fear to gird us for action to fight for any number of changes their biggest donors want enacted. That said, the US is NOT facing imminent crisis or existential threat that we cannot overcome. But the rest of the world is facing a hefty transition to a much smaller global economy thanks to the decline of China.
The biggest crisis is emanating from the emerging markets as they wrestle with huge dollar-denominated debts even as their own economies whither from falling demand for their exports combined with rising costs for their imports. Argentina, Brazil, South Africa, Pakistan, Egypt, Sri Lanka, Tunisia, Turkey, and Syria are all experiencing extreme economic difficulty. Below is a chart of emerging markets corporate debt. Clearly, investors have soured on it.
Europe is benefiting from supplying the war in Ukraine which has allowed European countries to front load fiscal spending yet Germany, the UK, and France are experiencing varying levels of economic stress that go beyond the rest. Germany is suffering from the loss of cheap Russian natural gas that formerly powered their impressive industrial economy. Natural gas prices in Germany averaged $37.50 per mmbtu in 2022 compared to $16 per mmbtu in 2021. The UK is suffering from a lack of a coherent national economic policy since Brexit three years ago.
France is experiencing major rioting across the country after police shot a 17-year-old North African boy. This follows a decade of importing millions of North Africans without a plan on how to integrate them into society and the economy. The people emigrating to France were looking for a fresh start in life, not second-class status and forced assimilation into French culture. These riots are massive and span the country. Prior to the riots, France experienced major protests over the government’s efforts to raise the retirement age.
It’s not evident yet but China appears to be moving towards a major economic crisis that will dwarf anything presently being experienced around the world. I’ve been chronicling this fall for at least 15 years in this piece and it appears that it has finally arrived.
Economic Black Hole
I find that nature offers a great way to explain economic concepts. In the case of China, it is similar to a “white dwarf star” or a star that had basically burned itself out. Manufacturing moved to China thanks to cheap labor and easy regulations which effectively ended nearly twenty years ago. Chinese labor costs have risen by a factor of 15 since 2006.
Real economic growth effectively ended around 2006, which is the year when their supply of cheap labor reached its peak. Since then, it has remained elevated thanks to massive infrastructure projects ordered by the Communist Party and an equally massive increase in household debt.
Returning to the analogy, as the remaining elements are drawn inward, their compaction releases the remaining energy in the form of a “supernova” which after expelling the remaining energy, collapses into a black hole. This “supernova” is represented by the government driven activity of surplus housing, empty cities, and roads to nowhere. I see China as an economic black hole that will negatively impact the global economy going forward, even as it propelled the global economy over the past twenty years.
Communists are not good at capital management and investment. It was only after the Communists loosened their control did the Chinese economy expand to its present size. The current Chairman of the CCP, Xi Jinping, is a Mao acolyte, which means he’s a staunch Communist. This is why the Chinese economy has progressively moved back to its Communist roots since Xi was elevated in 2012. Like Mao, his goal is to supplant the US as the leader of the world. Unlike the US, his vision does not include inclusivity.
That’s the bad news. The good news is that this wannabe world dictator has screwed up the Chinese economy so bad that it may already be dramatically smaller than current estimates. Following the Great Financial Crisis of 2008/2009, China embarked on the most extraordinary housing and infrastructure bubble ever conceived, building empty cities and roads to nowhere. This is why I liken China to a supernova. You can see this supernova in the chart below that shows how the past ten years of economic activity has been built entirely on debt. Talk about a shaky foundation…
This represents a 400% increase in debt over 10 years – from under $2 trillion to over $8 trillion. The debt is coming due and it’s impossible to pay. Individuals, corporations, and regional governments are all headed to some form of bankruptcy.
This matters for the global economy because China’s insatiable demand for oil, gas, coal, cement, and steel made it the most important aggregate consumer in the world and the primary reason why commodity prices grew to be so expensive from the early part of this century to the present. And now, it’s all starting to collapse like a Black Hole, drawing in emerging nations with it. These are nations that borrowed aggressively from China and which supplied China with natural resources. According to the World Bank, there are 65 emerging nations in financial distress where debts to China represent more than 10% of their outstanding debt.
Below is a chart of the Goldman Sachs Commodity Index. The sharp rise can be attributed to the enormous release of fiscal liquidity following the Covid lockdowns. But now the chart looks like it wants to crash. This is what I mean by China being an economic Black Hole. As their economy sinks into depression, their demand for commodities declines and with it the prices of those commodities.
Besides experiencing weakness in consumer and industrial demand, the Chinese Communist Party is making it impossible for foreign firms to operate in China. Most recently, the CCP passed a new law that went into effect on July 1st that gives the Chinese government extra powers in determining what constitutes espionage. They have also sharply curtailed foreign firms from gathering and disseminating domestic Chinese economic data.
A few months ago, Chinese authorities raided the offices of a number of foreign economic consulting firms causing many to close up their Chinese offices. The problem for the Chinese economy is that foreign companies won’t invest in China without the analyses that emanate from these firms. Along with the investment, foreign firms bring necessary “know how” to Chinese business. Not anymore.
Below are the charts of two former leading Chinese technology companies. Both were leaders in internet services and Baidu claims it is a global leader in Artificial Intelligence. Both stocks are in the dumps because the Chinese Communist Party took control of both companies – and others. Now the world won’t work with either company and both are being run by Communist Cronies. What went wrong?
First of all, the Biden Administration has prohibited western companies from selling leading semiconductor technology to Chinese companies. This means that China has no chance of competing in AI because AI requires ultrafast computer chips. It also means they will fall behind in their defense and space programs. In effect, it represents the death knell in China’s desire to advance into the ranks of modern economies.
But it doesn’t end there. The US has been building a coalition of countries to effectively place a ring around China’s access points to the rest of the world if China tries to take Taiwan by force. Japan, Australia, and Britain have been coordinating naval assets in the region so they can work as one unit if needed to prevent China from expanding beyond the South China Sea. Other nations in the region have supported this effort including South Korea, the Philippines, Taiwan, India, and even Vietnam.
Lastly, nations in Europe have implied that they would be open to sanctions against China like the ones crushing Russia if China invades Taiwan. Given China’s dependence on global trade, China is far more susceptible to such a threat.
The US Dollar
Last quarter I offered you an alternative version of global perceptions of the US dollar. Three months later, I’m even more confident of this thesis. In fact, I believe it was the primary reason that US Treasury Secretary Janet Yellen visited China last week.
You can see from the chart below that the value of the Chinese yuan had been crashing versus the US dollar in currency markets. In late October of 2022, the reversal in the yuan’s crash marked the beginning of the rally in global stock markets. Coincidence? I don’t believe so.
I don’t believe it’s a coincidence that Treasury Secretary Yellen’s visit marked the recent bottom in the yuan’s collapse versus the US dollar. My theory is that her visit allowed for a coordinated support for the yuan in currency markets. In fact, I believe the chart below is the single most important chart to follow when considering the potential for a further decline in the US stock market.
Let’s not forget that Ms. Yellen isn’t just the Treasury Secretary, she’s the former Chair of the Federal Reserve which makes her the most powerful economic regulator in the world. If anyone can coordinate efforts between the US and China, it’s Ms. Yellen.
The greatest risk to the global financial markets is a spike in the value of the US dollar which is why I believe that central bankers around the world are working to prevent the greenback from going higher. As I wrote in the last missive, there is scarcity in the supply of dollars held outside the US which are called Eurodollars. Furthermore, I’m starting to suspect that the Federal Reserve may be raising rates because scarcity of Eurodollars in the global banking system have resulted in higher interest rates due to supply and demand dynamics.
The very last thing the Federal Reserve wants is for the world to learn that Federal Reserve may not be in control after all. It’s entirely possible that the Eurodollar market is setting the price for global money, not the Fed. If this ever came to light, global stock, bond, and currency markets would lose confidence in an instant.
There is one thing that we know is nearly certain and that is that China has squandered trillions of US dollars that it generated in trade and by borrowing in the Eurodollar markets. Every shipment of oil, copper, iron ore, and foreign technology required payment in US dollars and those dollars were invested in projects that do not generate sufficient US dollars to pay back their creditors.
My biggest fear is that as China slips into an economic depression and western banks are forced to write down the value of Eurodollar loans to China and other emerging markets, we’re going to experience a massive decline in global money supply. This is the very definition of deflation and deflation is the biggest and scariest bogey man in the global financial system. This is why China is an “Economic Black Hole.” When they go down the drain, they’re going to drag a significant amount of the global economy with them.
The stock market took off like a rocket from October 2022 to the present but it wasn’t a broad based moved as I showed earlier with the Dow Jones Industrial Average. Instead, it was technology and anything relating to Artificial Intelligence. The move is reminiscent of all the rallies since the GFC but with a 1999 Internet twist.
Amazingly, the Nasdaq is still below its 2021 highs. As I wrote earlier, the economy is slowly weakening and it should be more apparent by the second half of 2023 which is why I expect an end to the rally in tech stocks and a shift back to the stable growth names we prefer. Artificial Intelligence has driven the rally since January yet as I wrote last quarter, AI is interesting but nowhere near being a game changer for the economy. Today, it represents more hype than substance with the obscene valuations applied to AI beneficiaries being far beyond fundamentals.
The value in AI is in taking personnel costs out of the value chain but it only represents an evolutionary move from our present reliance on computer algorithms. The learning aspect of the technology or feedback loop is a relatively mild breakthrough because IT systems have already been learning from experience for decades.
Clever engineers will undoubtedly find some niche uses, but the technology is completely unsuitable for the giant Six Sigma industries ranging from petrochemicals to semiconductors to energy production. These are the companies where 99% quality is far from good enough. AI fails because once a production problem gets past two standard deviations from the average, or two sigma, the technology produces unexpected outcomes. At this point, humans must be called in.
In other words, in industries where producers can’t afford mistakes like working with highly combustible chemicals or semiconductors or other high value/high-cost industries, AI is unsuitable. The real world is simply too complex for programmers to capture all of the possibilities making AI extremely dangerous if used incorrectly. For now, it represents a big opportunity in entertainment and other elements of the on-line experience because it has the potential to replace writers, actors, and other creators of on-line content.
My biggest problem with the whole climate change movement is the extraordinary inconsistencies that exist in our industrial policies. It’s yet another paradox. One simple example is Apple Computer which is in the process of moving manufacturing operations from China to India. The move makes perfect sense for profits but India has 14 out of the world’s top 20 worst cities for air quality. If Apple were truly worried about air quality, they would move operations to either the US or Europe where Clean Air laws are in place.
Apple boasts net profit margins of nearly 25%. A quarter of every dollar spent on Apple products sinks to the bottom line. It would be nothing for them to hold prices constant and allow for lower profits by moving operations to the US or Europe. Their actions speak volumes.
China is the biggest emitter of carbon dioxide on the planet and for the past 30 years, we’ve made China the manufacturing hub for the world. Our companies have closed operations in the US where the EPA enforces emissions standards and outsourced those operations to the worst polluter on the planet – China. Al Gore made his inaugural climate change speech in 1993 – exactly 30 years ago and just as the US was starting to move our manufacturing base to Asia en masse – exactly 3 years after the US Congress updated the Clean Air Act.
And here’s another paradox for you – we’ve been cheering for the growth in the Chinese and emerging market economies for decades even as that growth has directly led to a sharp increase in carbon dioxide emissions. Am I the only person who sees the insanity in this?
It’s been estimated that the world has spent $4 trillion to combat climate change with no return on that investment even as the low hanging fruit of returning manufacturing to the developed world has been ignored. That money could have gone to updating the global electricity grid which is highly inefficient and in desperate need of upgrade. The improvement in efficiency could make a significant impact on how much coal/gas needs to be burned to generate electricity.
This is why I’m not bothered when Exxon and Chevron announced that they will no longer focus on alternative energy and will focus exclusively on fossil fuels. At least their words are consistent with their actions and proof that alternative energy solutions are relatively inefficient.
High Tech Oil
Even as I continue to believe that the price of oil has another leg lower once it becomes obvious that China’s economy is going to contract, I’m starting to look at the oil and oil services sector in a new way. Exxon, Chevron, Schlumberger and the rest have learned to extract oil from fields where much of the oil is trapped in rock such as our shale oil fields.
The market values scarcity and there are very few companies with the ability to extract fossil fuels using horizontal drilling methods in different kinds of rock formations. Companies like Exxon and Chevron and a small number of others have this ability where other oil companies around the world do not. It’s a competitive advantage and I expect it to prove extremely valuable in the long run.
Here are two charts of the price of oil. The chart on the left is West Texas Intermediate Crude while the chart on the right is North Seas Brent Crude, two different charts of oil for two different grades. You’ll notice that Brent Crude trades at a small premium to WTI.
Both grades of oil are considered “light and sweet” which makes them relatively clear and relatively low in sulfur content. This aspect makes them relatively inexpensive to refine into gasoline and other products. Yet West Texas is higher quality and trades at a discount because the US produces a surplus of oil. This represents a massive competitive advantage for the US. We have an abundance of high-quality energy in the form of oil, natural gas, and coal. In addition, we have some of the few regions where solar and wind energy are viable.
I’m hesitant to invest aggressively in this space today because I believe it’s impossible to value oil and gas at this time. The global economic downturn represents an unforecastable variable. As such, countries like Saudi Arabia have been cutting daily output to keep up with the demand destruction from global economic weakness.
Ultimately, when the global economy does turn back up, I believe US oil companies will be able to charge higher prices for their expertise in extracting oil from difficult fields such as the Baku in Azerbaijan and the Siberian fields in Russia.
World War III
I see a lot of talk about how close we are to WWIII thanks to the horrors of the war in Ukraine as well as the threats from China. I’ve been following this risk closely for 30 years and while mistakes are possible, I don’t see either Russia or China being a threat to the US given our extraordinary dominance in military capability.
Russia still fights like it’s 1917 instead of 2023. They continue to use tactics that were first developed during the American Civil War and made infamous by WWI. Their military leadership is among the worst in the world. Their logistics capabilities haven’t improved in 100 years and their ability to maintain and repair their military assets is embarrassing. Throw in the extreme amounts of corruption in their ranks and it is small wonder that Russia was ill-prepared for war in Ukraine.
China isn’t much better as their officer ranks are effectively a Ponzi scheme where promotions come from promises “pay” the officers above in rank. It’s been the case since Deng dramatically slashed military budgets in the 1980’s which prompted the People’s Liberation Army to go into business and to invest in military hardware out of profits.
Neither nation can sustain a global war. Both are dependent on world trade for significant inputs. With Russia, it’s technology and high-end metal products such as ball bearings. With China, it’s technology, food, energy, and high-end metal products. In addition, neither has the logistics capability to project power beyond 1,000 miles.
The only real threat we face is from a cyberwar. China is believed to be able to shut down our electric grid and to cause other problems in critical infrastructure. It’s why we remain heavily invested in defense companies with cyberwarfare capability.
The GeoVest Approach
We are in the very early stages of shifting to a more balanced economy with our competitive advantages in oil/gas/petrochemicals, agriculture, and semiconductors at the core but it’s going to take a long time to complete this transition. The biggest question I have is whether the authorities can keep the stock market elevated until this happens. Nobody knows.
Much will depend on stability in the global economy and this is where I believe that our economic and financial authorities will lose control. I don’t believe people truly understand how bad the situation in China really is. It’s so much more than a negative demographic trend and having a Mao acolyte in power increases the odds that we’re staring at a disastrous outcome.
You’re not going to read any of this in the media. I’ve been piecing this puzzle together for more than 20 years which is why I’m considering writing a separate piece on China. People who prepare for the China hangover should be able to keep their capital intact for the next cycle.
We also need to be prepared for continued government involvement in the private sector of the US economy. I suspect we are quietly living an economic experiment based on Modern Monetary Theory or MMT. The initial returns on MMT proved to be highly inflationary and unpopular among voters but I don’t believe the experiment will end here. This means that we’re going to need to be extremely flexible in our thinking and open to new ideas when allocating capital going forward.
The picture is somewhat cloudy but I can see sunny skies on the horizon. Most of us live in the US which I believe will remain the dominant economic, social, military, and financial leader of the world. Thank you and it is our continued pleasure to serve you.
Philip M. Byrne, CFA