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The Liberal World Order

The rhetoric coming out of Washington is becoming tedious. According to President Biden, “The reason why gas prices are up, is because of Russia—Russia, Russia, Russia. The reason why the food crisis exists, is because of Russia, Russia…” And according to Biden advisor Brian Deese, Americans will have to endure economic hardship for considerable time to come. When asked in an interview about the elevated cost of living, he answered, “This is about the future of the Liberal World Order and we have to stand firm.” Biden himself has echoed that sentiment at numerous recent news conferences.

I wonder—is this the Liberal World Order that accommodates logistical military support and weapons deliveries that make Saudi Arabia’s bombings of Yemeni schools and hospitals possible? Is it the order that converted Libya, admittedly an autocratic but nevertheless functional state, into a place where human trafficking and slavery are now key revenue sources? And what about the Liberal World Order’s adventures in places like Afghanistan, Syria and Iraq? Weren’t they as brutal and destructive as Russia’s assault on Ukraine?

Worse, the kind of statements uttered by Biden, Blinken and a half dozen other front-line U.S. politicians could be coming from the mouths of the EU’s Von der Leyen, Germany’s Olaf Scholtz or Britain’s Boris Johnson. In other words, by now many of Europe’s leaders, along with their counterparts in Japan, Canada and Australia, are fully invested in the U.S.-concocted narrative.

Usually, when politicians can agree on a subject and spout a narrative often enough (with the enthusiastic support of the mainstream media), it’s eventually accepted as truth. This time it may be different. Consider the following dynamics:

-While the U.S. has so far successfully swayed its vassals in Europe and elsewhere, the citizens aren’t on board. In the U.S., critically, domestic support is waning. As a Rasmussen poll found a few days ago, only eleven percent of Americans believe the Biden administration’s narrative that Vladimir Putin is to blame for record high gas prices. The public mood in some parts of Europe indicates similar distrust. I would expect that as the sanctions-induced economic pain continues to spread, the popular disapproval of the Liberal World Order babble will only grow. As I’ve concluded in previous issues, it’s difficult to imagine any outcome to the current political and economic mess that’s not accompanied by widespread social unrest.

-The Liberal World Order’s wrath is directed not only at Moscow, but pretty well any country that doesn’t share its vision for a continuation of the post-war American-led global model. China, according to recently adopted policy documents is now officially the number one threat to U.S. national security.

Not surprisingly, NATO has implemented a virtually identical doctrine through its just released 2022 Strategic Concept. NATO has also made it clear that its next power projection must be eastward, into Asia. The problem, of course, is that China is not alone in resisting America’s dream. Alarmed by the scope of Western sanctions against anything and anyone Russian, the political and business elites in much of the developing world will do anything possible to prevent a similar fate. In practice, that means they’ll lessen their dependence on the dollar as a reserve and trade settlement currency, cut back on using U.S.-based international payments systems, and reduce their exposure to American property.

Of course, none of these and other considerations guarantee that the West will abandon its current stance. But if it doesn’t, Russia will not be the only place that suffers. The latest economic data in the developed world look anything but reassuring. Besides, my guess is that Russia’s capacity for suffering surpasses that of Europe or North America. Even so, from a U.S. government perspective, at least one thing has been achieved: the uni-polar Liberal World Order will be in place for a while longer. What have Europe’s politicians achieved? Absolutely nothing, apart from a crushing pan-continental economic setback, sharply growing divisions within the EU, and hugely increased dependence on America and the U.S.-controlled NATO.

Twin Pivots: Monetary And Fiscal Policy

Much has been said about the ineptitude of our central bankers. Over the years I’ve ridiculed these overpaid technocrats on too many occasions and, what’s remarkable to me, I’ve invariably been right when I called them out. Needless to say, society would be much better served if monetary policy were conducted by a handful of people who actually understand that basic economic principles can’t be defied by mathematical forecasting models.

Yet, having said all of that, the world’s central bankers aren’t the only ones responsible for the mess we’re in. After all, they operate under a set of mandates—such as keeping the economy on track and inflation on target—that are impossible to meet in an environment where politicians can borrow at will. It’s America’s politicians that raised the Debt/GDP ratio from 56% at the beginning of this century to 130% right now. The Fed merely accommodated such folly by gobbling up the Treasury’s offerings, week after week.

As an aside, while U.S. debt creation, when viewed in absolute terms, is nothing short of terrifying, far worse excesses exist elsewhere. Relative to some European nations or Japan, the U.S. national debt looks manageable—at least as long as the dollar remains the world’s primary reserve currency.

High and Low Debt/GDP ratios, 2022

These variations in debt levels have considerable influence on central bank flexibility. The EU’s Christine Lagarde, for example, finds herself stuck in a space where she has to use funds from maturing German and Dutch debt to prop up the prices of Greek, Italian and Portuguese bonds. In Japan the situation is even worse. In the absence of other buyers of newly issued Treasury debt, the central bank is forced to buy them in huge quantities. The result: the Bank of Japan now owns a full 50% of the government’s outstanding debt. The comparable number for the European Central Bank and the U.S. Federal Reserve are 38% and 28%, respectively.

How will central banks and governments move forward? It’s difficult to imagine politicians who won’t do what gets them re-elected, which probably means that an economic setback will be met by even more spending. That will fuel the inflationary dynamic and leave central banks in a historically bad position. In simple terms, if they stick to a tight monetary policy, recessionary pressures will get out of hand. If, on the other hand, they reverse course, they’ll virtually guarantee a decade or more of high inflation.

Confused Markets

Markets reflect this tenuous situation. By now everyone knows that U.S. equity indices had the worst first-half-of-the-year period in 52 years. Moreover, investors found it difficult to find shelter anywhere. Bonds performed dismally, crypto-currencies crashed, cash gave up value to inflation, and even gold lost ground. Real estate is showing signs of weakening too, which is no surprise considering a weakening economy, high debt levels and rapidly rising mortgage rates.

Where will we go from here? While key indices may stay range-bound or even stage a brief rebound, we firmly believe that the bear market has not yet run its course. What is particularly alarming is the breadth of the decline. While the consumer discretionary and tech sectors, along with a few other conspicuous segments, got hit hard early on, even apparent beneficiaries of the new geopolitical realities have sharply corrected in the past few weeks. In other words, negative sentiment is reaching into every corner of the market.

That may change if central banks adjust their rhetoric and step back from their tightening mode. But while such a reversal would stabilize financial markets, a recovery in stock prices would take time— after all, the economy is slowing and corporate earnings are under pressure.

S&P500 Year-To-Date

Despite these conditions, we believe that maintaining an equity position makes sense. Given that the market decline has brought our exposure to stocks from 45% to close to 40%, we may use the weakness to bring our allocation back to target. At this time, we believe the mining, energy, food and fertilizers, health and financial sectors offer decent value. As always, we focus on companies that have demonstrable pricing power and can generate sustainable cash flow.

Meanwhile, our recent 10% bet on short-term bonds, along with our physical gold holding and our robust cash reserve have helped our overall portfolio outperform. The lesson inherent in that is this: in an environment as toxic as this, nothing holds its value. But assets like gold, cash and short-term quality bonds can be potent portfolio stabilizers.

The bottom line: things are moving fast and market narrative can change overnight. We continue to be prepared for multiple outcomes, and will make rapid adjustments as they become necessary.

Best wishes,

Peter Cavelti