Deus Ex Machina
The title to this piece is a Latin translation from the original ancient Greek which literally means “God in the machine.” The term came into being on the ancient Greek stage as a way to end a play with divine intervention such as a hero being lowered from a rope onto the stage. The lever that bore the actor’s weight being the machine. Today, we use the term to describe something unexpected or implausible that changes a bad situation into a good situation.
In the past 20 years, we have had three “machines” that were going to revive our national economy. It started with “Green Energy” which entailed using extremely expensive but extraordinarily inefficient and unpredictable solar and wind energy, even as we knocked down functioning hydroelectric dams. I did a ton of work early on trying to understand this industry and where sustainable long-term investments could succeed. As we’ve discussed over the years, it has been a failure and the investments will be largely written off over the next 10 years. Good intentions cannot overcome the laws of physics.
The second “deus ex machina” is electric vehicles or EV where Tesla has dominated. Despite grandiose promises of successful new products and unprecedented incentives offered by governments around the world, this industry is rapidly falling out of favor with consumers. When compared to the overall utility of traditional gasoline/diesel vehicles, EV’s come up short.
According to a survey by AAA in June, only 18% of respondents are interested in purchasing an EV while 63% are unlikely or very unlikely to purchase one. EV owners are experiencing rapid depreciation in the values of their cars, rapid declines in charging capacity, and all-around inconvenience. Forced to invest aggressively in the industry by the government, US automakers will eventually write-off these investments in full and may need bankruptcy protection.
Artificial Intelligence or AI is the current form of “deus ex machina.” Nvidia has replaced Tesla as the driver of the stock market as AI is hyped up even as the technology has limited applicability. Based on my calculations, Nvidia is over-priced by a whopping 600%!
Have you noticed the trend yet? Our economy was supposed to be transformed by these three technologies and the hyper-economic activity would allow us to outgrow our sizable debt position. Green Energy is a bust, EV is moving rapidly towards being a bust and AI is only significant for a few applications, most important of which is missile defense where we are already invested.
None of the three has transformed our economy in a positive way while all three are proving to be extremely expensive for tax payers. The only place where companies aligned with these technologies have been successful has been in the stock market but I expect that to prove temporary.
Stock Market
The Magnificent Seven stocks continue their moves higher as all seven are valued at levels that are far beyond their intrinsic values. We’ve seen this type of market many times before starting in the 1970’s, the internet craze of the late 1990’s, and the financial companies before the market crash in 2008. The results are always the same.
A stock market that is benefiting only a few companies is a warning to us that volatility is ahead and the companies likely to be sold most aggressively are these horribly overvalued names. The primary reason is that investors become badly overweighted in these names and they all try to get out of them at the same time.
We can see from the chart below that when all companies are assigned an equal weight in the S&P500 that the market is only up slightly in the last 2.5 years. This is the downside of passive investment such as index buying. A few companies become extraordinarily overvalued while a large number of companies go unnoticed.
Whereas the large technology stocks are overvalued, there are lots of stocks that are undervalued and which have exciting growth prospects in the future – despite a weakening global economy. How about the companies that are using AI to ensure that enemy missiles don’t harm our soldiers or the soldiers of our allies? The same companies are deeply involved with cyberwarfare and security which is an area tailor-made for AI applications. War drums are beating in Europe, the Middle East, and the South China Sea where these companies stand to benefit from increased spending by our allies.
The performance of these large technology companies is very similar to the movements that preceded the Y2K crash yet during that crash, non-technology stocks that had been previously undervalued made money for investors. I expect a similar movement before much longer because none of the technology companies are going to save our economy from a deep downturn.
US Economy
The financial authorities in the US learned from the lessons of the 2008 crash in the financial markets and looking back, I can see the times where they intervened massively to prevent contagion over the past 15 years. As long as they can keep the equity markets elevated, the perception of the economy will stay positive.
The problem they face today is that we’ve experienced so much economic destruction from the Covid years that they can only drive a handful of stocks higher. We can readily see this from CEO interviews of consumer companies ranging from Target to CVS to Hormel. People are struggling and when you consider that our economy gets 70% of its growth from consumer activity, it’s difficult to remain positive.
The US government has completely used up the benefits of dispensing unearned money to consumers. Each new unearned dollar given to consumers results in rising inflation. This should be obvious from the chart below of “transfer payments” which include welfare, Social Security, and student loan grants among others.
Prior to Covid, payments were trending just above $3 trillion. When Covid hit, we received checks to offset some of the economic pain we all experienced. But the government didn’t stop there. We had two more massive giveaways in 2021 followed by a 30% jump in the trend rate of transfer payments to the $4 trillion level. This is the source of our domestic inflation because consumer markets adjusted to this sharp rise in the money supply, effectively negating the economic benefits to consumers. As they say, there is no such thing as a free lunch.
We can also see from the chart that the rate of transfer payments jumped to $4.3 trillion in May of this year. Faced with a contentious election in November while our domestic economy weakens from high interest rates, authorities are trying their utmost to keep the economy positive in order not to be voted out of office. It represents a Hobson’s Choice where both alternatives are equally objectionable. The economy is either going to weaken or inflation will continue to increase. The Administration chose inflation because it’s easier to hide. This suggests that we’ll need to wait a little longer for the Fed to cut interest rates.
As it relates to the title of this piece, “Deus Ex Machina,” Green Energy, EV, and AI were intended to create an investment cycle to transform our economy. The architects envisioned a growing class of technocrats that would raise our standards of living, creating unforeseen growth opportunities for our economy. This is the problem with government-directed economic initiatives. The architects see only what they want to see.
This is why market-driven change is always the best course because it allows people to determine the course of the river, so to speak. Markets create incentives for people to ferret-out what is feasible and what is infeasible. Green Energy, EV, and AI were never feasible for various reasons that the architects chose to ignore.
There is no “Deus Ex Machina” to save our economy from a difficult restructuring. There is no easy way out of our economic dilemma. Capitalism is about trusting people to find the right path and it will always include some periods of restructuring and loss, which tend to be relatively minimal. When the government gets involved like it has over 15 years, small problems become enormous. This is why so many people are confused and frightened about the future and are looking for answers for how to keep the wealth they have accumulated.
Economic downturns are natures way of re-directing people’s efforts from unprofitable activities to profitable activities. Excess government involvement in the economy temporarily negates nature’s efforts but only makes the ultimate restructuring many times more dramatic. We’re headed for some drama in the US economy.
Chinese Economy
The global economy can be can analyzed as a simple regression model where global gdp equals the sum of the US + Europe + China + Japan + Rest of Asia + South America + Africa + Constant Variable. Each of the regional variables has both a weighting and each can be broken into GDP that is both independent and dependent off/on the global economy. Over the past 40 years, each nation has become more dependent on the global economy, commensurate with the rise in global trade and finance.
No country is an island unto itself; each nation is dependent on the global economy to some degree. Over the past 25 years, the global economy has become highly dependent on China both as a source of exports to China and a source of cheap imports from China. Next to the US, China is the most important economy in the world and now China is entering a deep economic depression.
If not for the Chinese Communist Party or CCP, it would be a great time to invest in factories in the Pearl River Delta because there are empty factories, unused machinery, great infrastructure, and people desperate for work. It’s not happening because the CCP has made it difficult for private companies to operate at a profit. Western buyers know this so the factories lie empty and the people languish in the streets.
The CCP is also on a war-footing. Taiwan is harassed day and night by Chinese military assets, constantly threatening to invade. The Philippines is at silent war with China over islands and reefs a short distance off the coast of the island of Palawan. China has also been picking fights with India in the Himalayas, and with Japan around the Senkaku island chain.
China’s worst offense is relatively unknown but which threatens much of East Asia. The CCP is directing the construction of a series of mega-dams on the Tibetan Plateau. This would allow them to control the headwaters of the Mekong, Yellow, Yangtze, Indus and Brahmaputra rivers which are vital to the billions of people.
Furthermore, China has been the main supplier to Russia for the industrial equipment that allows Russia to replace lost weapons in the Ukraine War. There is also growing evidence that China has worked with and possibly supplied Hamas.
Suffice to say, the CCP is losing friends around the world. Nobody wants to invest in China and buyers are scrambling to find suppliers in other parts of the world. As a nation that is dependent on exports, China is digging its own economic grave.
The Chinese people take to capitalism like a duck takes to water. They are superb at capitalizing on opportunity and will work hard to succeed. The only thing holding them down is the CCP which has destroyed their motivation for hard work and risk taking.
The reality in China is that the CCP is systematically destroying private enterprises, even going back 30 years in tax audits to grab the profits from previous years. The government is out of money despite literally “printing” an increase of 15% of the money supply in 2023. The only pool of money left is the profits that private companies and individuals earned over the past 30 years. Given that the private sector employs 90% of Chinese workers, we are looking at an economic disaster of epic proportions.
Returning to the regression model above, the collapse of the Chinese economy will have an extreme negative impact on the global economy. This is happening in real time; the waiting is over. If you would like to read more about what is happening in China, please visit our website at www.geovestadvisors.com. We have a new section called “the second derivative” where I publish the work that determines our top-down decisions. You’ll find a three-part series on China that I believe you will find interesting.
Crisis Investment Strategy
We anticipated the financial crash of 2008 and that allowed us to prevent losses to clients. It’s critical to be prepared ahead of time because nobody is capable of the deep research and planning necessary to prevail while experiencing the extraordinary mental pressure of a market crash.
It will take a flood of new money to accommodate the mountain of debt the world has created over the past 60 years, otherwise, we’ll experience mass bankruptcy – another Hobson’s Choice. This is why so many people are attracted to cryptocurrency, commodities, real estate, and precious metals. It’s because they believe that these asset classes will protect them from the flood of new money; none of these asset classes are certainties but some may have time periods when they can work.
With the mountain of debt in mind, it’s easy to understand why policy makers would try to grow out of the problem with the three “deus ex machinas.” But at the heart of these three attempts at growth is a restriction on humanity and that is part of the reason why all three are failing. You can’t grow an economy by placing limitations on people and forcing them to adopt technology that reduces economic utility. This implies that policymakers will never get us out of the problem of excess debt by organic means. I’ll get into this a little more below because it’s fascinating when you put this into a top-down framework.
Most people are looking for a single asset to purchase and hold as the floodwaters rise but I don’t believe such a strategy will work. Instead, I favor a multi-step process that allows us to be flexible and adjust to the moves made by policymakers, knowing that there is a time to hold certain assets and a time to sell them.
For me, the first step will entail lengthening durations in the bond portfolio and stock portfolios to take advantage of lower interest rates. This will prove difficult in a time when most companies will be reporting weakening earnings which is why we favor more defensive companies that are relatively immune to the broader economy.
Along with the right stocks in the portfolio, we favor US Treasury bonds over corporate bonds and/or portfolios of synthetic credit instruments such as credit receivables. It’s likely that we’re going to get hit with significant credit losses over the next five years and possibly stock market dislocation. When this happens, the flight-to-safety will be US Treasuries, despite dramatic increases in US Treasury debt.
There is a second reason for buying US Treasuries and it’s that Treasury bills, notes, and bonds are the foundation of the financial system because US Treasuries are still the most highly valued collateral in the system. If a financial firm gets into trouble, they can pledge the Treasury securities in their portfolio for immediate loans during a financial meltdown.
We witnessed this during the crash in 2008 where demand for US Treasuries surged, pushing down interest rates and generating strong gains for our clients. When the party gets hopping next time, I expect yields on 10-year Treasury bonds to once again drop below 1%. A drop in interest rates from 4.5% to 1% would bring significant capital gains.
We can see this in the chart below where interest rates were last below 1% at the end of the Covid.
Most investors are comfortable being in a large group of like-minded investors. We’re all inclined to look for safety in numbers but that’s not a solution for market dislocation. Everyone tries to get out at the same time, causing massive reversals in wealth. It’s why I favor stocks that are not broadly held by index funds.
Stage 2 will involve some form of financial repression to ease the burden of excess debt and will probably involve 0% interest rates and heavy government spending. This will be the time to own good long-term businesses that have pricing power and whose products have low elasticity of demand such as precious metals, energy, agriculture, auto parts, defense, and consumer staples.
It will also be a time to rotate out of fixed income or move to extremely short durations combined with an inflation hedge. I expect private equity funds to start liquidating at this time because most are over-burdened with debt. This should bring a ton of great businesses suffering from excess debt to the market.
While I don’t believe cryptocurrency will ultimately work in the US, I suspect there will be opportunities for it outside the US, particularly South America and Africa – perhaps even China and Russia. These regions have always been notorious for destroying their domestic currencies. A lot will depend on the next President of the United States because we are at a crossroads where the old system is no longer optimal. We’ll have to wait to see how the political winds shape the future financial system.
For now, it’s imperative to have a plan for determining when things start to change and we have had our plan in place for a few years. Since we believe that global markets have been heavily controlled by central banks and their agents, we’re looking for signs that government influence has been broken. The first indicator will be a spike in the value of the US dollar in currency markets. We’re not there yet.
The second will be a sharp decline in the value of copper. Copper is used in industrial output, particularly information technology and communications.
The third will be the aforementioned decline in long-term interest rates in the US. This will indicate that investors are seeking out the safety of US Treasury bonds.
In my opinion, a sharp decline in the markets will occur coincident to the broad realization that our economy is in a deep recession. Thanks to intervention in the market by government agents, the stock market no longer offers a signal of oncoming weakness. This is why we won’t move ahead of our important indicators. There is still money to be made – for now.
Geopolitical Model
I create mental models to understand geopolitical trends and events as a way of being prepared for changes in our economy and markets. For the past fifteen years, I’ve experienced some trouble understanding geopolitical trends in the US and Europe particularly as they pertain to the title of this piece. It’s because people are supporting policies that act against their long-term interests. All three movements have struck me as being anti-humanity in that the first two place extreme restrictions on our lives while the third, AI, ultimately leads to relegating humans to the most menial tasks.
Taken together and to their logical conclusion, these three movements lead to a form of neo-feudalism, perhaps even a dystopian form of global governance such as what is happening in China today. For the record, I don’t believe we will experience such an outcome in the US or Europe because of our rich history in blunting any form of centralized authority. The failure of “Green Energy,” EV’s, and the lack of acceptance of AI are indicative of trend reversal. Ultimately, I expect Neil Howe and William Strauss to be proven correct and that we are in the 4th Turning where difficult times will replace our present artificial existence.
Climate Change
The majority of people in the US have come to realize that we are not in a global climate emergency. I’ve delved into the climate change models a bit for fun and as I expected, there is a glaring weakness at the heart of the model that suggests that CO2 in the atmosphere is having an outsized effect on surface temperature. It’s why the models have never been accurate and why researchers changed thousands of thermometer readings across the US for the past 100 years to support the IPCC model.
Dr. John Clauser, winner of the Nobel prize for physics in 2022, is the highest profile “denier” to come forward but he’s not alone. At the age of 81 and being a winner of a Nobel Prize, he’s relatively immune from the backlash of those pushing the disaster message. He and others have noted that the prevailing climate models break the basic laws of thermodynamics. Hermann Harde from the University of Hamburg has proven that the surface temperature multiplier, when CO2 levels double, is only 0.3 kelvin to 0.6 kelvin compared to the climate models which use a multiplier of 3.2 kelvin. In short, they systematically overestimate the impact of CO2 on our weather.
A small difference in a complex model of a complex system plus strong political backing by a powerful few is all it took to create climate hysteria. The good news is that continuing to use fossil fuels won’t bring us to doomsday even though it is true that CO2 emissions have a very small impact on temperature. The bad news is that we have spent trillions of dollars globally on chasing a phantom. The silver lining, in my opinion, is that we have received a loud wake-up call to stop taking the environment for granted. If nothing else, we just need to look at how China has destroyed itself and decide it’s not for us. Lastly, the technology developed should provide unexpected benefits in the future.
War
The pressure for global war is building with China in the background stoking the embers of conflagration so that it can change its relative position in the global power game. Historically, global war is often associated with weakening the prevailing global powers. In this case, the US wields the most power the world has ever witnessed.
China has shown itself to be an ally of Hamas and Fatah, recently hosting some of the remaining leaders of both factions. They are also believed to be supportive of the Houthis in Yemen who are preventing global trade from flowing through the Red Sea to the Suez Canal.
As I mentioned previously, China has been helping Russia and has been a bully in the South China Sea. In addition to China, both Iran and Russia have shown themselves to be global antagonists over the past few years with Iran joining China in the hopes of a global fight. The goal seems to be global conflict in many theaters at once to weaken the US military’s ability to maintain peace across the globe and dramatically reduce US influence on the global economy.
For the most part, I have been pleased with the way the US has managed to stay out of hot military conflicts. People can debate the investment made in Ukraine but the conflict in Ukraine has effectively bankrupted Russia such that I don’t believe they are capable of offensive operations outside of their region. As long as Western European nations avoid getting directly involved in the conflict, I don’t believe they are in any danger from Russia.
If we can keep China and Iran contained without firing shots, the Chinese economy will collapse on its own and will take them out of the “Great Game.” Without help from Russia or China, Iran is effectively neutralized. The US is holding the winning hand at the table. As long as the US avoids further escalation, there will be no WW3 and the US gets to maintain the dollar as global reserve currency for a little longer.
Eurodollars
My favorite quote from the great Japanese strategist, Miyamoto Musashi, is “see that which can’t be seen.” By this he means that when you understand the way the world works, you can anticipate change that others can’t see. Having covered the bank industry in my youth, I understand how money is created and destroyed, as well as how dollars become Eurodollars when they leave the US banking system. This is why I believe that we are uniquely prepared to benefit from what other analysts refer to as the “great re-set” that is soon to take place.
Analysts just look at the amount the US has added to government debt over the past 15 years, which has been extraordinary but this only leads to rising domestic prices. It is believed that there is roughly the same number of dollars outside the US as is inside, the outside dollars being known as Eurodollars. But in truth, all we have are estimates; there is no definitive source for the supply of Eurodollars. Making matters less clear, the Eurodollar market is only lightly regulated, if at all according to the Federal Reserve Bank of Atlanta.
With this in mind, I believe that the Chinese have destroyed at least $1 trillion of Eurodollars, probably more, through investments in their Belt & Road Initiative (BRI) in addition to over-investment on domestic Chinese infrastructure projects. When we look back 20 years from now, I expect that we will view the Chinese economic boom as the biggest waste of capital ever.
But it’s not limited to the Chinese. How about Saudi Arabia’s linear city called Neom? Or “The World” archipelago of man-made islands in the UAE? These are just a couple of the many capital allocation mistakes made over the past 25 years that will ultimately require the write-down of debt which effectively destroys money.
This brings me to what I consider a common mistake made by analysts in regards to the Federal Reserve. Since 2008, the Fed has effectively been replacing bank reserves that have been or would be destroyed in a market sell-off. More than anything, I believe they are “managing asset values” as opposed to conducting traditional monetary policy. The goal is to prevent bank insolvency by maintaining asset values. Federal spending, aided by the Fed, is the source of traditional inflation because it is the only vehicle that puts money directly into consumer hands.
Crisis
I expect a number of negative variables to hit at once starting with the Chinese yuan collapsing versus the dollar. They are already in panic mode where Chinese commercial banks are paying premiums in the Eurodollar market to access dollars because China is rapidly running out of greenbacks. They are paying large premiums because they are a growing credit risk and unless Eurodollar banks are acting as agents for central banks, the losses from lending dollars to China will blow a giant hole in international bank balance sheets.
I’ve been writing extensively about this topic for years so it shouldn’t come as any surprise. China needs dollars to service their dollar-denominated debt as well as to purchase necessary commodities in the global markets since they are no longer generating sufficient dollars in trade.
This is the reason why China is courting the Middle East. They want the Arab states to accept yuan for oil. It’s not going to happen. Arab governments may be mercurial and sometimes volatile but they aren’t dumb.
Japan is throwing everything possible at the currency markets to keep the yen from crashing versus the dollar but it’s only a matter of time. There’s a reason why the Japanese yen and the Chinese yuan charts look similar. Japan and the rest of Asia are pulling business from China and are suffering the consequences of China’s depressionary state.
I expect the US economy to start to decline rapidly from. Yes, there is a ton of US government money flooding the economy but interest rates have been too high for too long. When investors get smacked on top of the head with bad economic data, the equity markets are going to decline sharply, in my opinion. This will exacerbate economic decline.
This is when the credit cycle will hit the world like a ton of bricks. In the US, we’ve got commercial real estate, levered loans, credit receivables, car loans, and mortgage delinquencies on the horizon, much of which has been pushed into pension funds and IRA’s. Banks have done an admirable job of off-loading risk in recent years but the losses will still be booked and banks can’t escape completely, especially smaller banks.
China’s credit situation is a disaster of epic proportions, dwarfing anything ever witnessed before. The world will soon learn the idiocy of the CCP and it’s ridiculous economic policies.
Europe has it’s own credit problem starting with Deutsche Bank and extending throughout the continent and Britain. The green energy movement has been very strong in Europe where they have invested aggressively and will need to write-off this mistake. The war in Ukraine has also increased their cost of energy while diverting funds from social programs to rebuilding their defense capabilities. Europe is going to need to reorganize in a big way.
The result will be a global crisis and it has been building for decades…
The GeoVest Approach
“Deus ex machina” is a fictional approach to ending a story, not a literal one and is certainly not appropriate for economic management of our nation. The government can’t “create” investment booms on their own, particularly when they are asking people to accept a lower standard of living based on these changes.
Relying on economic magic tricks is no alternative to prudent husbandry of our natural resources and the people who rely on them. Now that we’ve reached the point where the tricks are too expensive to continue and the cost of the previous tricks are bearing down on society, we’re close to point where we, as a people, move in a different economic direction. This will entail some economic and financial hardship but also tremendous opportunity by straying from the herd. Now is the time to act.
I started posting the top-down research that shapes our decisions on our website. Not only can you read a more detailed version of this newsletter, there is a new section called “the second derivative” where four pieces have already been posted. I plan to put at least one or two new pieces on per week. And once I master video, those too will follow. Please visit our website, www.geovestadvisors.com, where I hope to make the upcoming events more manageable for our clients. Thank you and it is our continued pleasure to serve you.
Philip M. Byrne, CFA
