The Banks, Again

Back in mid-2007 we aggressively cut back our exposure to equities and other financial assets, retreating into cash and gold. A brilliant move, you might say, except for two things. We were a bit too early and we didn’t anticipate the reaction we got from some of our clients, who felt that a less actively managed portfolio shouldn’t earn us our regular fees. Some closed their accounts and went elsewhere, a decision most came to regret.

The Past Weeks: Comparing Financials and Gold

What convinced us that a financial crisis lay ahead? The reckless ‘sub-prime’ lending policies pursued by America’s financial industry were at the center of our fears. But what concerned us even more was the broader derivatives market, which encompassed everything from equities to currencies, commodities and debt instruments, of which mortgage-backed securities were only a small part. By 2008 the size of the derivatives market had reached into the hundreds of trillions.

When in the fall of 2008 the financial system and the economy collapsed in epic fashion, the government stepped in, rescuing America’s brokers and banks, while countless ordinary people lost their homes, their savings and their employment. The Treasury Department’s bailouts and the Fed’s liquidity injections were such that worries about a global meltdown soon died. Markets, adjusting to endless doses of easy money, gradually recovered and, eventually, advanced to new, unimaginable highs.

Here is the problem. While governments, along with central banks, have imposed all kinds of measures to improve bank lending criteria and reporting standards, the derivatives market is as dangerous today as it was fifteen years ago.

The main problem: derivative exposures, which for each of the largest U.S. and international banks are in the trillions of dollars, render credit ratings and other financial metrics irrelevant.

An institution’s positions are essentially intransparent to an outsider and, depending on the extent of leverage used, can quickly impair its liquidity. Even worse, with each derivatives position a bank takes, the identity of the institution that’s taken the other side is unknown. The bottom line: with each derivatives position, there is unidentifiable and potentially toxic counterparty risk.

What are the chances of a worsening banking crisis and a 2008-style meltdown in world stock markets? I’ll explore that further in our investment comments at the end of this update.

Does Anything Ever Change?

Every few years, we build up our hope that dialogue between the major powers will lead to peace. Then comes the next Iraq or Libya or Ukraine. Invariably, the propaganda machine informs us that such calamities are necessary or, to push the narrative toward the preposterous, make for a better world.

Thirty years ago, the United States had more than fifty major firms bidding for defense contracts; now there are five. We all know that monopolies exert undue influence and frequently control government policies, not just in America but the world over. Given these facts, the forever war will continue forever.

The monopolistic dynamic is equally visible outside of the “defense” segment. Whether it’s the airline, telecom, pharma or financial industry we look at, second-tier corporations are disappearing at an alarming rate, while monopolies keep growing.

What’s particularly troubling is that none of the major political parties oppose the trend. Neither America’s Democrats or Republicans nor Canada’s Liberals or Conservatives demand an end to the trend. It’s the same in Europe, where the Greens, the Socialists and the right-wingers vigorously debate fringe issues, but shy away from rocking the monopolist boat.

And why would they oppose what’s going on? After all, the corporate beneficiaries handsomely reward key political players who’ve been voted out of office or tire of their jobs. Former defense officials end up on the boards of armaments producers, while senior operatives of national health authorities are recruited by pharmaceutical concerns. All at highly lucrative compensation packages. And all cheered on by a completely controlled and corrupt legacy media complex. Even worse, a pitifully small portion of the electorate cares. Nearly 70 years ago, the American cultural critic H.L. Mencken noted that the office of president represents the inner soul of the people. He also made a prediction: “On some great and glorious day, the plain folks of the land will reach their heart’s desire at last, and the White House will be adorned by a downright moron.” It appears that, a few years ago, we reached that very point. Nor is the U.S. alone. Canada, Japan, Britain, Germany, France and others have their own resident clowns.

The other day I came across a study on currencies currently in circulation. Intriguingly, over 30% of the world’s banknotes depict monarchs, while nearly 40% feature heads of governments, politicians and military leaders. Another 12% is reserved for poets, revolutionaries and religious leaders—that sounds better, but when you look closely you realize that they’ve been chosen because of their deep linkage to national identities. That leaves less than 20% for scholars, inventors, writers and musicians, people who actually contributed something meaningful to the advancement of humanity.

The question of the day: when it comes to the world’s power structures, how far have we actually advanced from feudal times? Isn’t it undeniable that the scale and reach available to today’s monopolies is far larger than those of kingdoms and even empires that existed a few hundred years ago? Think Lockheed Martin, Pfizer, Amazon, Google or Facebook. Of course, most of us enjoy privileges unimaginable in feudal times but, having said that, it’s evident that our individual rights and freedoms are constantly chipped away at. Are we at risk of becoming serfs of a new class of overlords, this time in the guise of corporate oligarchs? Or are we already there?

When considering the extent of our personal freedom, most of us have a sufficient measure of comparison that we can draw on the context of our lifetime. If we pay any attention at all, we can understand what has happened. But what about the growing portion of society that has never experienced anything other than a world in which large power structures dominate, dictate and manipulate?

The Ukraine War: One Year Later

It’s interesting to review what was said in response to Russia’s invasion of Ukraine and the measures that were implemented by the West. With considerable uniformity we were told by politicians, economists and the media that Russia, as a result of the sanctions imposed by the U.S. and immediately copied by the EU, Britain, Canada and others, would be economically ruined withing months.

Well, that hasn’t happened. So far, despite massive war-related adjustments, the Russian Republic is still in positive growth territory.

Our view was strikingly different. We saw Washington’s reaction as an attempt to perpetuate the post-war American-led world order by a few years, and predicted that in time a Europe facing energy and food inflation would become even more divided, while many of the BRICS nations would distance themselves from the U.S. We also felt that the prospect of continued American hegemony would encourage closer ties between Russia and China.

I suspect that outcome was perfectly apparent to a significant number of senior foreign policy and military advisers. But in their twisted minds, the closer alignment between China and Russia was going to pave the way to the long-promised expansion of NATO and other “defense alliances” into Asia. The most recent AUKUS summit in San Diego, where China was once again singled out as a major threat to the existing world order and where the U.S., the UK and Australia agreed to deploy nuclear submarines to Perth, is a case in point.

Financial Markets: New Tests Ahead

In my last update I questioned the consensus that emerged as 2022 unfolded. It suggested that inflation was cooling off, while the stock market, emboldened by the prospect of an end to interest rate increases and a lower dollar, was set to gain. That, of course, is not how it played out. The dollar started strengthening again, inflation stayed at elevated levels and the Fed promised additional rate hikes as long as the economy refused to tank. That proved too much for the stock market, which experienced another sharp sell-off.

Last week introduced yet another risk element into an already difficult mix: first, three U.S. regional banks needed to be bailed out, then the notoriously mismanaged banking giant Credit Suisse needed to be rescued. As in 2008, treasury officials and central bankers acted swiftly, but the promised support packages leave many questions unanswered and bring up a host of new ones. The trouble is that concerns over the banking system aren’t the only thing that ails financial markets. Home prices have fallen, credit card debt is exploding (see chart) and consumer loan delinquencies are rising—all while job openings are declining. This is eerily reminiscent of 2008. As consumers get hit hard, they lose their ability to service debt, a dynamic which will hit the banks hard. Meanwhile, even given the possibility of more pronounced economic weakness or a recession, equities keep trading at multiples and earnings expectations that are far too optimistic. Unsurprisingly, some seasoned hedge fund managers boldly predict a 25% to 30% decline in key stock indices, a perspective that is sure to be noticed by the Federal Reserve and other central banks.

So, the question of the day is the same that’s been with us for several months. Will the Fed, concerned by slumping markets, abandon its anti-inflationary stance, or will it stay the course? If it’s the former, a period of nasty stagflation will be the result. Personally, I think the odds for such an outcome are very high. However, if the Fed stays restrictive, my forecast would need to be revised. We’d be in a recession within weeks and a severe market decline would become far more likely.

The European Central Bank seems to already have made its decision—on Wednesday it hiked interest rates another 50 basis points despite the Credit Suisse debacle. Note that a pan-European recession would only add to North America’s woes, both in terms of the overall economy and the banking sector.

As I’ve stressed in recent months, unsustainable systems and massive policy errors in major developed nations make for an unpredictable outcome, while social discontent and a highly explosive geopolitical situation add other unknowns. In the end, what we can tell with certainty is only this: massive change is inevitable, but how and when it will manifest is unknown. The adjustments may play out gradually, one sector or region at a time, or they may unravel chaotically, all at once.

How should we prepare for this? In terms of investment management, I think it’s premature to pull the plug as I did in late 2007. But, having said that, it’s imperative to be prepared for multiple outcomes and prudent to bet on areas that have a strong track record of providing flexibility and holding value. We continue to advise a large cash reserve and a strong gold exposure. In my opinion both are underestimated as asset classes that can provide shelter during times of uncertainty. Regarding gold, it’s recent performance has once again demonstrated its virtue as a potent portfolio diversifier and hedge. As we’ve stressed on many occasions, we recommend a 10% to 15% position in physical gold, ideally held outside of the United States.

Bonds have perked up after a long slumber, mainly reflecting fears that a recession scenario will unfold and central banks will have to give up their fight to subdue inflation. Until there is more clarity, we continue to underweight the sector, primarily because we prefer assets that are not someone else’s liability. Some bond holdings are justifiable, provided they are of indisputable quality and short maturity.

In the equity sector, meanwhile, it’s all about selection. We are stressing companies with strong, sustainable cash flow which have a defensive business model and, ideally, compensate investors through a meaningful dividend. Some sectors, like the natural resources sector, have been hit hard—again based on recession fears. We feel that great value can be found there.

Chances are that 2023 will be another challenging year for investors. Our advice: avoid debt, be prepared for multiple outcomes and adjust the portfolio structure as events dictate.

With best regards,

Peter Cavelti