The title of this piece is Latin for peace and stability and it follows last quarters piece titled “Deus ex Machina” or Ghost in the Machine. I’ve been finding inspiration in antiquity because much of the chaos we are experiencing has happened before and we are still here. We represent the survivors of past tumultuous periods.
The world has been unnaturally stable over the past 25 years and I’m afraid this period of “pax stabilitas” is over. The world is in grave trouble – Europe, Asia, Africa, and South America are especially challenging. Even the US is experiencing social and political turbulence culminating in the most divisive election of my lifetime. I believe the US will be fine but not the broader world and it will have an impact on the way we live given our dependence on imported products and medicine.
It’s been a great run and while many people are concerned about how the forthcoming rise in volatility will negatively affect their wealth, I see the storm clouds as a great way to build on the gains from the past 25 years. It requires getting in front of change like we did with our War Cycle Thesis. The war clouds that have been threatening for years are now overhead while the old economic cycle has been artificially extended way beyond its expiration date.
From the standpoint of the American standard of living, the benefits of off-shoring much of the industry that allows us to consume seems to have peaked with many of our major suppliers in economic distress. China is close to economic collapse. There is an embryonic trend starting to take hold that promises to bring elements of our supply chain back to the US but those investments will need to weather a global economic downturn before long. It’s why we haven’t been aggressive in pursuing this initial stage.
US Economy
It’s almost become a cliché to say that much of the future economy will depend on the results of the forthcoming election but it’s because voters will be choosing between two different visions for the future. One vision maintains a global focus and a continued shift towards centralized decision-making. The other vision represents more of a national focus and shift away from centralization towards decentralizing decisions back to states and localities. The potential winners and losers of both visions are making a DEAFENING racket in the media to support themselves and denigrate their opponents.
Hopefully framing the situation in this way reduces some of the partisanship and allows us a degree of objectivity for understanding the dynamics in front of us. Regardless of who wins, the next Administration will face the ramifications of a global economic downturn with a concurrent challenge of helping US consumers face the double problem of high prices and high interest rates.
The US economy is largely immune from the global economy but multinational companies, particularly in technology, commodities, and consumer products are at risk of earnings disappointment. The US supply chain is also at risk of dislocation in the event that suppliers in emerging markets such as China and Indonesia unexpectedly go out of business or face social turmoil.
The bigger problem for our economy is that the US is addicted to low interest rates which were raised starting 2.5 years ago. Yes, the impact has been obscured by and caused by the huge increase in federal debt which has concealed underlying fundamentals in national statistics. The result is inflation which forced interest rates higher. In effect, the supposed cure made the problem much worse for Americans.
The cure for high prices is high prices. People change their consumption patterns and focus on the items they really need or they find cheaper substitutes. This is Economics 101 and has been our investment thesis for some time. Stores across the country are reporting that consumers are experiencing stress and are being forced to make difficult choices to reduce spending.
The result seems to be pointing to a permanent reduction in demand. When you consider that the US consumer drives 70% of GDP, or gross domestic product, consumer stress normally results in recession. And while the US is largely immune from the global economy, the global economy is extremely dependent on the US consumer. For this reason, we expect the global economy to continue to get worse – much worse.
We can see the impact of consumer choices very clearly in the auto market. The chart below shows a sharp rise in auto prices. The second chart shows auto sales. On average, auto prices are 20% higher since early 2021. Consumers are unable to afford the higher priced cars yet automakers are forced to amortize their huge increases in costs for electric vehicles and greater fuel economy into the price of each new car.
Housing is another major problem for US consumers. For starters, home affordability is outrageously high thanks to price appreciation for houses and due to high mortgage rates. This leaves rentals as the only option for consumers but these prices have also risen thanks to the need to house the enormous influx of immigrants who also enjoy government stipends for housing. The result is higher prices which is forcing otherwise qualified renters into lower-end housing.
The problem is that it becomes a self-reinforcing cycle. The more the government pays for immigrants to enter the country, the more money enters circulation, the more inflation ramps higher, followed by the inevitable increase in interest rates. The underlying US economy can’t handle higher interest rates.
The chart below is from the CPI or consumer price index which we implicitly accept as our indicator of consumer inflation, despite it being a highly flawed number. The “rent of shelter” portion of the CPI accounts for roughly 36% of the index. This is why the above discussion of the impact from immigrants becomes pertinent.
Actions have consequences but higher consumer inflation is only one part of the picture. The second part is that a decline in spending by existing US citizens is having a negative effect on the broader economy. As mentioned, retail stores are reporting difficulty and this has already led to widespread store closures, with the attendant loss of employment that follows. Ultimately, this will lead to a large jump in vacant buildings and a write-down on real estate loans for banks. This is what we mean by deflation.
The more consumers pull back, the more businesses pull back. We can see this in the recent announcement where Cisco Systems will cut 5,600 jobs. Even Tesla is laying off 10% of its workforce to contend with weak demand for their cars. Microsoft and Amazon have let tens of thousands of workers go over the past couple of years – and these are the successful companies.
The conditions are in place for a sharp downturn in the US economy but I don’t believe it will become obvious until after the upcoming election.
Global Economy
Things are getting difficult in the US economy but the global economy is rapidly weakening, which is EXACTLY what we’ve been anticipating. War in Ukraine and the Middle East is obscuring this weakness but nonetheless, it’s picking up speed. We can see this in updates from McDonald’s where global sales are falling due to rapidly rising prices and weak consumers. For this piece, I’ll limit my discussion to Europe and China but the problems are everywhere.
Europe
The war in Ukraine has been brutal for Europe because much of their energy comes from Russia, particularly natural gas to heat homes and to act as the feedstock for Germany’s enormous chemical industry. You’ll see from the chart below that Germany’s consumer costs experienced a massive increase in 2022 and 2023 that act as a one-time shift in the country’s economic viability. This is because they would need cheap Russian natural gas to reverse the negative effects of 2022 and 2023 and that may not happen for another five years. This means that Germany has become a very expensive place to live.
It's not a coincidence that giant German chemical companies like BASF and Bayer have aggressively shifted production to the US Gulf of Mexico to survive. In addition, Volkswagen just announced a 60,000 reduction in German workers – virtually unheard of before. FedEx is cutting 2,000 jobs in Europe or 4% of their European workforce.
The above chart reflects year-over-year price changes and while they are currently falling, those two years of 3rd World inflation are still in their price structure. We can see how this has affected interest rates in Europe.
Germany went from negative interest rates for a 10-year period to positive 3.9% rates in a short time. I couldn’t imagine how difficult it must have been on business owners and banks having to endure such a massive shift in the cost of business that rapidly. No wonder the country’s economy is in big trouble and if Germany is in trouble, so too is the rest of Europe. It’s why the electorate is getting angry across the continent.
Yet despite these unprecedented challenges, the European stock market is still moving higher. This is why I believe the global stock markets have effectively become nationalized by governments. If a stock market represents the collective discounted cash flow value of corporations in a country, then the drop in earnings combined with higher interest rates should have collapsed the German stock market. Instead, it rallied aggressively.
China
The Chinese stock market just enjoyed a massive rally thanks to promises from the Chinese government to create a new massive stimulus plan. It represents a desperate move in the 11th hour and it’s short on details. I view it as little more than a PowerPoint presentation coupled with wishful thinking. Swimming through the gobbledygook, Beijing plans to borrow roughly $1.4 trillion at the federal government level and distribute that money through local governments to support the value of housing. It represents little more than a sleight of hand and will ultimately fail, in my opinion.
The Chinese are trying to duplicate what the Federal Reserve did in 2009 and what the European Central Bank did in 2012. They are looking to add money to the banking system to replace what has been destroyed by bad investment, particularly in their housing market.
If it works, it buys the Chinese Communist Party a little time to shift the economy away from a burgeoning consumer-based economy to a pure manufacturing power house – even though the rest of the world is against this plan. China wants to export it’s way out of economic trouble just as the rest of the world is entering a global recession. Bad idea, bad timing, and lousy execution is guaranteed to end badly for China.
From the chart below, you can see where we have had a number of these “plans” where the Chinese stock market jumped – most notably 2014. Each time, the market sells off and investors who bought into the hype lost money. This time will be no different.
In 2023, the People’s Bank of China added something akin to 20% of the monetary base to the banking system to prevent a collapse. That’s an extreme move, so why is selling more government bonds going to prove to be the right move today? If we assume that the money, already in the banking system would need to be used to buy these bonds, then banks will need to liquidate some assets to make this purchase. Either that or the People’s Bank of China will need to create more money, deposit that money in Chinese banks like in 2023, so the banks can purchase government bonds. Either way, it’s a repeat of 2023 in some form.
I’ve been forecasting this ending for China for over 20 years because there was only one way this could have gone. When you systematically make bad investments for a generation, deflation or a write-down of the value of those assets is ALWAYS going to happen, particularly when you are facing a demographic cliff like China is facing. China’s working population is retiring yet they can’t find sufficient work for the younger generation entering the workforce.
Once deflation takes hold, central banks have the option of allowing it to run its course or inflating their way out of their mistakes. It’s clear that the CCP, or Chinese Communist Party, is choosing to try to inflate their way out. The result is going to be a massive decline in the value of the Chinese currency – the yuan.
The chart below shows how much a yuan is worth per dollar. In this case, one yuan is worth 0.141 dollars. It’s a bit cumbersome which is why I prefer analyzing currencies using the inverse, or how many yuan to the dollar. In this case, it’s (1/.141) or ¥7.092 to equal a dollar.
Furthermore, I believe that global central banks have been helping China maintain the yuan in currency markets lest we experience dislocation in the global banking system. This is because China claims to have external financial assets worth $9.7 trillion against external financial liabilities of $6.8 trillion for a net positive external financial asset position of $2.9 trillion.
I have chronicled their external financial assets through the years and while some of their assets are invested in safe US Treasury bonds and Eurobonds, much of this amount is invested in their BRI or Belt & Road Initiative where they have built ports, railway lines, airports, roads, bridges, dams and other structures in mostly obscure parts of the world. Think of large empty container ports in places like Sri Lanka and Tanzania. These ports need to generate sufficient volumes in dollars to compensate China for the investment – it’s not happening. It doesn’t look good and it suggests that a significant part of China’s external financial assets are being carried at values well above intrinsic value. It’s entirely possible that China is close to being a net debtor in international markets if their external assets are marked to market.
And since China is unwilling to report what currencies comprise their foreign exchange holdings, it’s possible that they are secretly holding yuan in their reserve account to offset the dollars, euros, yen, and Taiwanese dollars that have been withdrawn from China. Where China was once a destination for foreign investment, foreign multinationals have been pulling out and liquidating their investments over the past few years. It’s just a theory of mine but having followed China closely for over two decades, I won’t be surprised to learn they’ve been fiddling with the value of their foreign exchange reserve account. Otherwise, they would tell us what currencies they hold in it.
This is why the chart of the Chinese yuan versus the US dollar is so important for the GeoVest strategy going forward. If the yuan breaks sharply below 0.138 dollars or it takes more than ¥7.25 yuan to buy a US dollar, it will mean that the Chinese currency is crashing which will make it difficult for China to service its $6.8 trillion of external debt.
Other than war, I consider this to be the biggest risk in the markets. And if China is dumb enough to invade Taiwan, the world will stop buying Chinese products and that would result in a crash in the Chinese yuan, similar to the Russian ruble. Regardless, I believe it’s only a matter of time before the Chinese yuan crashes in global currency markets anyway.
World War III
I see a lot of analysts who consider WWIII to be a viable threat. This is a topic I’ve been considering for the better part of a decade and the reason why we’re invested in defense. For starters, I can see NO good reason for the US to actively participate in global conflicts apart from providing support to our allies with military equipment or shooting hostile missiles out of the sky. There is nothing to be gained and much to lose.
I’m fine with economic sanctions on bad actors like Iran, China, Russia, and North Korea. The less money that flows through their national coffers, the less mayhem they can cause. This is particularly true of Iran which chooses to fund terrorism instead of investing in their own nation.
Regarding China, I’m in favor of keeping them contained to the South China Sea, moving the supply chain away as quickly as possible, and allowing their deepening economic depression to do the work for us. They have a powerful military on paper but not in reality. They are no match for the US on the battlefield.
Russia’s military is badly depleted and little more than a regional power. Ukraine has destroyed many of the aging Soviet era tanks, planes, helicopters, ships, and other equipment along with hundreds of thousands of Russian lives. I agree with calls to end the fighting in Ukraine because there is nothing to be gained. A generation of young Ukrainian men and women have lost their lives keeping the Russian bear contained. That’s a high cost on both sides.
Russia hasn’t been a real threat since 1991. China is more of a threat but are woefully behind the US in terms of logistics, technology, maintenance, and soldier training. But both have nuclear weapons and both will use those weapons if threatened. I see no reason why the US should threaten either one as they’ll both fail before long on their own.
US Dollar
Everything starts and ends with the US dollar. It was the growth of the off-shore dollar market, also knowns as the Eurodollar market, that built the global economy after WWII. This off-shore market is enormous, rivalling our domestic dollar market but it’s also why so many people who have called for the dollar to decline in value keep getting it wrong. Just look at the long-term chart of the US dollar below and tell me that it’s not scarce in global markets.
The dollar is scarce in global markets because international bankers keep destroying the global dollars in circulation by lending money for bad investments such as most emerging market infrastructure projects. If the projects don’t generate sufficient revenues that can be converted into dollars, the loans that funded the projects don’t get paid back. It’s called deflation for a reason and the world is FULL of bad loans just waiting to be written down to zero value.
Let’s talk a little about what Iran does with its oil revenues. Instead of investing in physical capital assets such as factories or infrastructure, they fund Hezbollah, Hamas, and the Houthis. Giving money to a terrorist is the equivalent of burning it because the money is used to destroy, not create. Every time a bomb hits Haifa or Beirut, the value of those buildings gets written down to zero – or less if the clean-up of the sites is considered. This doesn’t even touch the devastating decline in human capital.
Those dollars rarely get invested into projects that generate dollar revenues with which to payback loans. Instead, the money is given to fund destruction. That’s deflationary even if it can’t be quantified on a bank balance sheet.
People keep looking for the inflationary impact of the Federal Reserve printing money but they’re missing the other side of the transaction where that money gets destroyed. Through all of the expansion of the Federal Reserve’s balance sheet, they’ve been adding money to a global banking system with a massive leak in it. The Fed keeps filling the cup while the global banking system keeps cutting holes in the bottom of the cup. In essence, the Fed is allowing screw-ups to keep destroying money. It’s been happening for decades.
The true risk to the dollar as global reserve currency isn’t excess printing, it’s scarcity and that is why the dollar keeps going higher relative to other currencies. The Fed reacts to asset deflation or the threat of asset deflation which is why I expect them to return to QE when the global markets sell-off once again.
Now it’s time for the controversial part; the Fed is presently destroying the global economy with high interest rates and in particular, China. Yes, the Fed is reacting to the inflationary impact of the fiscal policies in the US over the past four years but the result is that they are further starving the global economy for dollars. Like the US economy, the global economy grew addicted to 0% rates in the US. The result is global deflation. We can already see it starting in China and Japan and it’s very contagious.
Bond Market
The bond market looks poised for rates to drop back to 0% once more. This is consistent with deflation. As previously mentioned, much will depend on the outcome of the upcoming election and working through the money that has already been appropriated by Congress. There is too much “free money” floating through the system today to get a materially beneficial impact on consumer prices. In my opinion, if one party wins all three houses, it will likely create the conditions for higher interest rates while giving legislative and executive power to the other party will create the conditions for lower interest rates. I’ll leave it to the reader to assign to guess which party offers inflation versus deflation.
I’m not going to advocate for one party or the other but I will write a piece after the election discussing the implications of the election. With that written, there is the potential for radical change in both directions which suggests opportunity for capital appreciation.
Stock Market
I expect the stock market to continue moving higher at least until we’ve gotten past the election. The good news is that the stocks in our portfolios have done well in the 3rd quarter as investors have sold out of the overvalued, yet popular Magnificent Seven names. Below is a chart of semiconductor giant ASML. It’s the company that makes the equipment that produces the extraordinarily fast chips that make AI possible.
It’s a great company, one which I have discussed before, yet its ability to make money is limited by the extreme difficulty in making the equipment they produce. They can produce 50 machines per year. We didn’t chase the name earlier this year even though I love the company because some simple research indicates that their operating model is limited. So what do you pay for such a company’s stock? Certainly not $1,100 per share.
The broader market is extremely overvalued with the overnight interest rate at 4.81%. The market is clearly anticipating lower interest rates only those lower interest rates will be a function of a sharp decline in the US economy.
Just look at the S&P 500 Bank Index. It’s full of loans that are likely to go bad over the next year or two yet the stock market is driving the group higher. There seems to be a “devil may care” attitude that pervades the stock market. It’s as if nothing can harm these companies so why not invest in them?
History tells us that when investors embrace this kind of attitude, we’re often close to a turning point in the markets. That said, I continue to believe there is money to be made in stocks. We have two primary indicators of future trouble – the Chinese yuan and the price of copper. Neither is flashing a warning sign at the moment, so we wait and we watch…
The GeoVest Approach
“Pax Stabilitis” is over and now we’re probably months away from the investment climate changing to more of an “intrinsic value” market where it will be important to own securities with tangible value at the right price as opposed to the ephemeral value that is currently popular. It’s going to be critical to anticipate that change and invest before the market figures things out.
The world banking system has been trying to expand the global economy for the past 40 years as economic leaders came to realize that the West can no longer grow. The banking system needs the global economy to allow it to outgrow the bad debts on their books. China has been the key to their strategy and now China is close to national insolvency as we’ve discussed in this missive in the past.
The problem was enormous in 2008 but it has grown exponentially since. If the US electorate chooses door number two on November 5th, the US focus will turn inward and the world will be left to deal with this problem themselves. If the US chooses to compete against the world on a level playing field, the US will prosper while the rest of the world craters. Our latent economic fundamentals are that strong.
Regardless of the outcome of November’s election, there will be opportunities to grow our client’s wealth even as volatility increases thanks to preparation. You can see elements of this preparation by visiting www.geovestadvisors.com and reading the pieces filed under the “2nd Derivative with GeoVest” section as well as reading this longer version of the newsletter. Thank you and it is our continued pleasure to serve you.
Philip M. Byrne, CFA
