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Bubble Land

“Everything will be okay in the end. If it’s not okay, it’s not the end.” Thus a quote that’s often attributed to John Lennon, although it was first coined by Fernando Sabino, a Brazilian author. I’m sure we all agree that in today’s environment, few things are okay. Hence, we’re nowhere near the end.

We all have our own way of contextualizing what has changed, what is less wholesome than it used to be. After all, as I’ve often written during the past decade or so, there isn’t a policy construct out there that hasn’t been pushed in the wrong direction for a long way. Whether it’s education, health care, agriculture, social welfare, personal consumption or economics, the systems and habits in place are unsustainable. Worse, they have been unsustainable for decades. The result is that we live in a world of bubbles. If we’re lucky they’ll burst at different times. More likely, a meltdown in one area will spill over into others.

Among the most visible bubbles is the debt dynamic, which is being severely aggravated by a restrictive central bank policy and completely reckless fiscal habits. While the Federal Reserve has been fighting inflation with dramatic rate increases, the U.S. government is fueling inflation by spending at a bizarre rate. The 10-year bond rate is now at over 5% and several of the Treasury’s recent weekly bond auctions have been unsuccessful. Banks are sitting on hundreds of billions in unrealized losses in their securities portfolios. Not surprisingly, their stocks are tanking and deposit outflows are once again accelerating.

Meanwhile, consumers keep spending, despite punishing price increases in key areas such as food, shelter and energy. How can they do that? By tapping deeper into debt facilities. Credit card debt is at sky-high levels, even though interest rates have more than doubled in a very short time. For a reality check, take a look at Forbes’ table of last week’s rates across the whole spectrum of U.S. cards. Once more, as John Lennon used do say, “if it’s not okay, it’s not the end.”

What will give? Will we have another, broader and deeper banking crisis? Will real estate prices finally crack? And how will governments and central banks deal with it—will we be back to the mega-bailouts we last saw in 2008 and will the Fed abandon its fight against inflation? Guessing how exactly it will all unfold is futile, but these are clearly the risks.

Since most of my comments centered on the United States, I should also add the situation in Europe is every bit as precarious. Germany and Britain deserve particular attention—others are in equally bad shape, but are not nearly as consequential. China, as well, is facing serious financial challenges. It’s easy to imagine a nasty contagion scenario.

If I were a banker, I’d be sweating buckets about three key problems:

  1. a rapidly deteriorating loan portfolio, both at the consumer and corporate end;
  2. massive unrealized losses in the institution’s securities holdings;
  3. fast-rising counterparty risk, especially on the derivatives side of the business.

Perhaps that is why JPMorgan CEO Jamie Dimon has decided to dump one million shares of his bank (valued at about $140 million), as last week’s regulatory filings revealed.

The “War Is Good” Bubble

Let me now turn to America’s unsustainable addiction to war. A few days ago, President Biden reminded his nation that weapons manufacturing created jobs, while the new House Speaker, Mike Johnson, told the world that he thought of Russia, China and Iran as the new axis of evil. Perhaps more important than such political babble were the conclusions of the Congress- appointed bi-partisan Strategic Posture Commission. The final statement (notably released before the Hamas attack on Israel) said that “the U.S.-led international order and the values it upholds are at risk from the Chinese and Russian authoritarian regimes,” and that “the United States and its allies must be ready to deter and defeat both adversaries simultaneously.”

Ah, there it is again: the U.S.-led international order and its values. You can’t say that Washington makes any bones about the fact that its post WW2 role must be preserved at all costs. Nor should that surprise anyone. Consider the advantages that have come America’s way: dominance of the International Monetary Fund and the World Bank; de facto control of the UN Security Council and NATO; reserve currency status for the dollar and ownership of the world’s largest trade settlement and payments systems. What escalates the problem is that the U.S. is visibly arranging its military strategy around the goal of perpetuating the country’s hegemonic advantages.

Historically, that is completely normal with waning empires, as is the ability of lesser military powers to defend themselves and, typically via asymmetrical warfare, make life difficult for the dominant power. Thus, in 1315 a bunch of Swiss peasants defeated the mighty Habsburgs, just as Ho Chi Minh’s North Vietnamese guerillas forced America’s hand six and a half centuries later. More recent U.S. interventions in Iraq, Afghanistan or Libya mirror that pattern. All in all, America’s military track record is unimpressive; the sad fact is that the country hasn’t won any notable military conflict for a long time.

For the nations targeted by Washington the outcome is even more horrible: a massive loss of life and infrastructural devastation are commonplace. Meanwhile, for the U.S. not everything turns out negative, despite the embarrassment of defeat and shameful withdrawal. First, while the conflict lasts, untold riches accrue to the U.S. defense industry. And secondly, without exception, the adversary’s region remains completely destabilized, typically for several decades, which perpetuates America’s supremacy.

Perhaps some of America’s European allies are finally waking up to these realities. Having depleted their weapons arsenals during the Ukraine conflict, they’ll now have to reorder armaments to shore up their own military defenses. And who will they turn to? Well, Defense News’ latest statistics on the subject (see our chart) have the kind of detail we all need to know.

Meanwhile, several of Europe’s most powerful nations have done great damage to their economies by siding with the U.S. sanctions agenda. Germany’s decline is the most visible. Commodity shortages and a huge loss of export opportunities have basically annihilated the country’s historical role as Europe’s industrial powerhouse and its high standard of living. Germany’s trade surplus, which stood at 250 billion Euros in 2016, has shrunk to EU80 billion. Not surprisingly, popular support for participation in America’s proxy adventures is tanking in Germany, as it is elsewhere. Notable exceptions are Britain, Japan, Australia and Canada, where U.S. support is still unquestioned.

In the meantime, of course, the Middle East is acting up, which immensely complicates the U.S. agenda. Not only does the Hamas-Israel battle push the U.S. further into strategic overreach mode, but its entire Middle East ambitions are being challenged. Efforts to subdue America’s regional foes by bringing Arab countries like Saudi Arabia, the UAE and Egypt closer to Israel have come at least to a halt. And U.S. ambitions to engage NATO members with its mid-East and perhaps even Asian plans are equally paralyzed. Turkey’s Erdogan, who commands the alliance’s second largest military (1,218,300 active and reserve troops compared with America’s 2,667,500), has openly stated that Hamas “is not a terror organization, but a liberation group, ‘mujahideen’ waging a battle to protect its lands and people.” It’s irrelevant whether anyone agrees with that assessment—what matters is that under such circumstances a NATO role in a wider Middle East conflict is difficult to imagine.

Finally, individual European nations are visibly distancing themselves from any possibility of entanglement. The continent now has a substantial Islamic immigrant presence, which in itself is a result of America’s many interventions in North Africa and the Middle East, all of which unleashed a mass migration to Western Europe.

How Long A Crisis?

What I’m trying to emphasize here is that two macro developments—the debt bubble and the dangerous escalations on the geopolitical front—are creating all by themselves severe imbalances, which will take a decade or longer to unravel. I also suspect that an “unravelling” will be painful and highly disruptive to the lifestyle we are accustomed to. I realize that my views are in stark contrast to the attitude most of today’s economists, money managers and financial journalists hold.

Why is that? For the most part, because the crises they have lived through during their working lives have indeed been short-lived. Invariably, fiscal and monetary authorities forestalled a much-needed restoration of economic efficiencies and instead hosed the system with huge amounts of liquidity. My experience, and that of the generation of financial operatives that are long past retirement age, couldn’t be more different. We witnessed nauseating market declines and sideways movements that lasted for many years. The worst such example saw the S&P500 peak in 1968, then fall dramatically. It took 24 years for the index to recover and eventually surpass its previous high in 1992. Five recessions occurred during that time span.

So, the question for the moment is this. Will the next downturn be short-lived or have central banks and governments run out of options? At this point, it’s a hypothetical debate. What matters is that the possibility of a serious market break is steadily growing. Your portfolio should reflect that.

Portfolio Bubbles

In portfolio land, too, there are bubbles. Some, like the bond market, have already been deflated. If the debt environment were less problematic I’d say that this is an ideal time to re-enter this market, but before doing so I’d like to see some meaningful foreign participation in U.S. Treasury auctions, which may be some time off. For now, we’re sticking to our underinvested position of less than ten percent.

One bubble still in the process of being punctured is real estate. Of course, the coming damage will be concentrated on specific sectors and locations, but in the overall context, things look vulnerable. With interest rates higher for longer, banks will be forced to be very selective in their mortgage renewals.

The stock market is coming under pressure too. Even though interest rates have likely reached a peak, the Fed and other central banks are making it known that inflationary pressures may force them to keep rates at this elevated level. That “higher for longer” narrative is a profound disappointment to equity investors and will be harmful to the economy.

Key indices are reflecting that. European stocks have now been in a nasty downtrend for several months; the same is true of the Australian, Canadian, Chinese, Japanese and emerging economies markets. Last week, U.S. equities finally broke through key support levels as well—a distinct warning sign.

I should add that, even during this year’s mostly positive action in the most important two U.S. indices (the S&P500 and the Nasdaq), the gains were mostly generated by a dozen or so stocks, mostly in technology and communications sector.

Numerous top quality companies have fared poorly—including ones that would qualify for our fairly narrow selection process, which emphasizes a strong and sustainable business model, a solid balance sheet and robust cash flow generation and an attractive dividend. We believe this underperformance of quality and value is temporary, but are nevertheless happy that our market exposure has been low and our cash position substantial.

Finally, a word on gold, which had a tremendous run from around $1200 in 2018 to over $2,000 in 2020—70% in just under two years! Since then, gold has struggled, repeatedly trying to make new highs. In Euros, British Pounds, Yen, Australian and Canadian dollars it has managed to do so, but against a super-strong U.S. dollar held up by a 5.5% Fed funds rate, it sold off, testing the $1,830 level less than a month ago.

That changed dramatically as Israel’s actions in Gaza unfolded. Evidently, the dramatic escalation in geopolitical tension trumped the realities of U.S. dollar strength and high interest rates. Within days, gold once more tested the US$2,000 level, opening the door to new all-time highs. My view now: stay the course. I see absolutely no reason to abandon our 15% portfolio allocation to physical gold.

Still believing that the odds are strong for a multi-year period of stagflation, we are sticking to our allocation targets. Equities 40%, cash 35%, gold 15% and bonds 10%. For now.

With best regards,

Peter Cavelti