Deviations from the Norm – II

In my July 2017 Strategic Update I commented on how few people take note when a major deviation from a long-established norm occurs. I used the comprehensive then-breakdown of IT systems at various major airlines as an example, then turned to the subject of cyber-attacks, which had affected over 70,000 computer systems in close to 100 countries. Nearly four dozen British hospitals were crippled, German trains stopped running, Telefonica users in Spain couldn’t make phone calls, and Fedex deliveries in various parts of the U.S. came to a halt. Russia was one of the worst affected countries, while in China key universities and corporations were hacked.

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What fascinated me was how the mainstream media covered these events. As I reported at the time, “Predictably, media coverage has dwelled on aspects that are not central to the problem. The narrative is that it’s lamentable that thousands of people were stranded at Heathrow, it’s tragic that hackers targeted hospitals and ambulance networks, and so on. Yet little is said about a far more important fact: that sometime in 2017, we started to deviate from the infrastructural norms experienced in recent years, moving from ‘working but in serious need of overhaul’ to ‘prone to comprehensive failure’. If government doesn’t understand the seriousness of this shift and the media complex continues to focus on the fallout rather than the cause, we are destined to live through increasingly more frequent and intense IT failures and hacking incidents.”

Notable Patterns

When I look back at past updates, two things strike me as notable. The first is that key structural problems, whether they are economic, social or geopolitical, can be identified long before they become acute. Over the years, several of my commentaries have warned that the continuous eastward expansion of NATO represented not only a breach of the 1990 agreement between U.S. Secretary of State James Baker and Soviet leader Mikhail Gorbachev, but would lead to outright confrontation once countries actually bordering Russian territory became NATO members. When the Baltic Republics (Estonia, Latvia and Lithuania) joined the alliance, a Russian countermove became in my opinion inevitable. And after the U.S.-inspired and assisted Maidan Revolution I predicted that Ukraine was the logical target. The second thing I notice is that media attention focuses on a given problem only when it indisputably enters crisis-state. And when that happens, the issue is presented in the context of the prevailing government narrative, carelessly ignoring rules of serious analysis.

Shortly after the invasion of Ukraine by Russian troops, I examined the West’s sanctions against Russia in detail, identifying a long list of unintended consequences, many of which would severely aggravate worldwide shortages and price pressures. I also explained why the sanctions would accelerate the transition from an Americentric order to a multi-polar world and why it would destroy Europe’s economy.

Now, a few months later, the senselessness of America’s sanctions regime itself and Europe’s hastily endorsement of it, stand fully exposed. None of what’s happened can be a surprise to any serious analyst: not the failure to subdue Russia by stopping its access to Western payments systems, nor the terrifying increases in fossil fuel and food prices or the massive government bailouts designed to pacify Europe’s and America’s anguished and agitated populations.

So far, almost everything the sanctions achieved represents an undeniable negative to the West. They’ve aggravated inflation, sharply added to fiscal imbalances, evoked what is certain to become broad social unrest, brought Russia and China closer together, and served as a warning to dozens of non-aligned countries to lower their dependence on financial and trade constructs dominated by the U.S. and EU. Worst of all, in conjunction with military support for Ukraine, the sanctions have ensured that the proxy war will go on, causing grave suffering to the Ukrainian people and significantly lowering the standard of living in Europe’s most important economies.

Won’t it materially weaken Russia for decades to come, as well? Of course it will, but at unimaginable cost to the West. Yet the government narrative is still firmly defensive of these misguided policies. As Annalena Baerbock, Germany’s Minister of Foreign Affairs, said recently, “No matter what my German voters think, I want to deliver to the people of Ukraine.” Did the mainstream media take objection to such patent disregard of democratic principles? Not that I noticed.

The bottom line: the outlook for the next 18 months is extremely troubling—politically, socially and economically. Europe is clearly at the center of the storm, with the UK and Germany the most affected, but the chaos emanating from the old continent will be felt everywhere. The situation in China, where the government’s strict Covid-lockdown policy has done serious economic harm (see chart on left), will also matter. Persistent Chinese weakness is bound to affect the global economy and aggravate supply chains.

Supreme Senselessness

Most of us agree that the actions of the world’s key central banks have for several decades been indefensibly misguided. The politicians in charge of most Western nations have done no better. Worse, they’re now aggressively subverting the central bankers’ much overdue quest to counteract inflation. They’re doing it through a variety of subsidies to individuals and businesses, under the guise of “inflation support.” No one argues that households are not in dire need of help, but as Bank of Montreal economist Robert Kavcic put it this week, “Treating a symptom of excess demand with more demand is akin to treating a sugar headache with an O’Henry bar. In other words, direct fiscal transfers as an inflation-support measure are inherently inflationary.”

The bottom line: since the advent of Covid, the actions of Western politicians have been rash and self- serving, and in the wake of the Russia invasion nothing short of idiotic. In the context of Europe, if you had put a committee of geniuses in charge of destroying the economy, undermining the currency and creating social discord, they’d have implemented much the same measures as the leaders of Britain, Germany and other nations have.

The U.S. or Canadian political leadership hasn’t done much better, although the North American continent is uniquely blessed with an abundance of raw materials—an advantage completely absent from Europe or (to use another example of decade-long utter mismanagement) Japan. Not that commodity wealth will keep the standard of living from dropping, but the negative impact on the likes of America, Canada or Australia will be relatively less severe.

Key Asset Classes Remain Overvalued

You will have noticed that, in the analysis of most financial assets, the macro backdrop once again trumps traditional financial and operative fundamentals. Few investments will escape the weightier global forces now in play. Both “black swans” (catalysts that come out of nowhere and derail the status quo) and “grey rhinos” (disequilibria that are well known but have so far been contained) are circling the markets by the dozen. How and when they will impact markets is impossible to say, making the investment outlook extremely tentative. What makes it worse is that all three key asset classes—stocks, bonds and real estate—remain in overvalued territory.

Still, while unprecedented uncertainty (at least in the context of the past half-century) prevails, there are realities that are worth considering:

  • It’s likely that North America’s fixed income and equity markets will outperform those of Europe and Asia.
  • When it comes to currencies, the same may be the case. Even though the dollar’s role as a reserve unit will gradually be diminished, there is even less incentive holding some of the prevailing alternatives, such as the Euro and the Yen.

Considering all this, being prepared for multiple outcomes remains imperative, a reality that is reflected in our model portfolio. We remain significantly underweighted in equities, expecting a retest of the June lows. Stock selection is a key strategic necessity—holding quality companies that have a good chance of generating sustainable cash flow in various monetary and fiscal environments. Gold has been hit hard in dollar terms and is currently retesting the 2021 lows. In most foreign currencies, it’s still doing well, but that is of little consolation to U.S. based investors. Even so, given the metal’s positive fundamentals and its value as a portfolio stabilizer, we are maintaining our sizable core position.

We’ve largely avoided bonds, except for small positions in inflation-protected Treasury securities and short-term high-quality corporate positions. However, we continue to hold a substantial “cash reserve”, mostly in short-term insured term deposits with staggered one-year maturities. These now yield around 3.5% in the U.S. market, 4.25% in Canada.

We will continue to adjust the portfolio mix when warranted by the rapidly changing global situation.

Best wishes,

Peter Cavelti