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Trouble on All Fronts

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My last comprehensive update was posted on January 11. Its topic: What kind of a world will we experience in 2024 and how will markets be impacted?

The reason I haven’t written anything since is because nothing has fundamentally changed. The trends in place at the beginning of the year are still in place as we approach the end of the first quarter. The debt dynamic is accelerating, social stresses prevail and political tensions keep escalating.

Let’s take a closer look at the most important developments in the United States. Things in other developed economies are in similarly bad shape—I am using the U.S. mainly because what happens there has significant consequences elsewhere.

Fiscal Policy

My June 2023 update was entitled “What Debt Ceiling?” It was a reference to the political process that keeps passing so-called Continuing Resolutions (“CR’s”) in order to avoid government shutdowns. Last year’s summer crisis ended when U.S. lawmakers agreed on a package extending spending to September 30, the fiscal year-end. In the current fiscal year, we’ve already had four more CR’s, each kicking the can further down the road.

The U.S. debt is currently growing at the rate of $1 trillion every 100 days. Interest expenses on the federal debt now exceed both the cost of defense and health.

Monetary Policy

For some time, the Federal Reserve’s hands have been tied. On the one hand, the central bank has kept the debt pyramid from collapsing by buying trillions of dollars of debt issued by the U.S. government—to be exact, $5.238 trillion as of the end of 2023. On the other hand, by issuing more and more debt, the government has clearly complicated one of the Fed’s primary jobs, which is to keep inflation low. Last week’s meeting of the Federal Reserve’s Open Market Committee reflected that: for the fifth time, the central bank’s policy rate was left unchanged.

But that’s where the logic ended. While the committee stuck to its narrative that it would not be appropriate to reduce interest rates until inflation moved toward the 2% level, and Chairman Powell even stated that inflation data for January and February didn’t boost his confidence, the median projection for the federal funds target-range at the end of 2024 was left at 4.625%. That would imply 75 basis points in rate cuts, which market participants promptly translated as three 0.25% cuts later this year.

Will rates really drop 0.75%? I’m skeptical, but then this is an election year and Federal Reserve operatives, while always talking about their independence, are far from politically impartial

The Economy

There are many ways to define a strong economy. One of the most obvious is the ability to consume, which is how most people measure their economic wellbeing. To a large extent the ability to spend depends on personal income, which for most people is generated by their employment earnings. So, what does the employment picture look like?

According to the U.S. government, terrific. But closer examination reveals that the data are grossly misrepresented, if not manipulated. On numerous occasions in recent months, the Bureau of Labor Statistics reported stellar employment numbers, only to later revise them sharply downward. Of course the initial positive report was widely reported, both by financial media and Wall Street, while the subsequent corrections received far less coverage.

The latest report contained yet another surprise. While employment creation looked very positive, it turned out that the private sector economy had lost jobs, while the government had created large numbers of new positions.

Meanwhile, the rosy accounts we receive from the politicians is in stark contrast to the realities workers face. For years now, wealth and income disparity have grown dramatically, a trend that continues unabated. That means countless people at the lower end of the income spectrum source their spending not from personal income, but from any form of available credit. Here, courtesy the New York Fed’s latest “Quarterly Report on Household Debt and Credit”, are the most recent datapoints for credit card debt:

  • A stunning 48% of Americans rely on credit cards to cover essential living expenses;
  • 23% of Americans increase their debt monthly;
  • 40% of Americans have been in credit card debt for over 5 years;
  • Americans’ collective credit card bill currently stands at $1.13 trillion; it rose 4.6% in the fourth quarter of 2023 alone;
  • The average credit card interest rate stands at a staggering 28.15%.

The bottom line: the government is right to say that consumption has been stable, but the only reason is the growing use of debt to finance even essential purchases. To argue that an economy based on such principles is healthy, seems to me a ridiculous judgment.

The Social Dynamic

Faith in the authorities, their allies in the corporate world and a compliant media establishment, is rapidly eroding. Virtually every survey shows that trust in the judicial system, the legislative process and the executive branch is in dramatic decline. When it comes to the media, the readings are even worse. This is particularly true in the U.S., Germany, Britain and Japan, all consequential players in both the political and economic arenas.

One of the most troubling elements in these studies monitoring public confidence is how the constituents of Generation Z feel. Among those aged 18 to 25,  a disturbingly high percentage have virtually no faith in our systems, which has troubling implications for the future.

Why Generation Z? The answer is obvious: basic cultural privileges such as steady employment, food security and affordable housing seem unattainable to many young people. And what are our governments doing about that? Their solution seems two-pronged: fuel the debt bubble even further, rein in what the authorities consider inappropriate expressions, and introduce statutes that punish dissenters.

At this year’s World Economic Forum gathering in Davos, 53% of 1,490 surveyed leaders listed “misinformation/disinformation” as a top global risk for 2024. Societal and political polarization was seen as a top risk by 46%. If the monopolistic Davos crowd sees things this way, it’s a practical given that governments will swiftly implement appropriate measures. Stating our beliefs openly will become increasingly risky.

In the U.S. things are still marginally better than in places like France, Germany and Britain, where the concept of criminal prosecution based on the assumption that someone “is likely to break a law” is already in place. But North America is not far behind. The introductions to the U.S. legislature of the TikTok provisions and of Bill C-63 (the “online Harms Act”) to Canada’s parliament are troubling, as both laws would put the government in charge of deciding what constitutes inappropriate speech. These proposed laws have nothing to do with punishing people who actually disseminate hateful propaganda. Their purpose is to make an example of dissenters and, by doing so, intimidate others into silence.

The grave constitutional violations perpetrated during the Covid pandemic by the likes of Austria, Germany, Britain, Canada, Australia and New Zealand gave us a flavour of how that works. The good thing is that by now, whether the subject is Gaza, “wokeism” or something else, a large part of the population has learned to see through irrationalities and lies dished out by the authorities. But that has disadvantages, too. In the end, profound and widespread distrust in the political establishment always leads to broad social chaos.

Domestic Politics

According to the United Nations, 2024 is the busiest election year ever recorded, with people in 65 nations casting their votes. Among the most widely watched contests will be those in the European Union, Mexico, India and Britain, but none will be more consequential than America’s presidential election.

With U.S. society at its most polarized for many decades, we’re in for an interesting year. Theories of what the next seven months will bring vary widely, but are invariably gloomy. What’s interesting is that the U.S. political complex has by now all the ingredients of a typical banana republic: an incompetent administration, a deeply corrupted legislative and a hopelessly politicized judiciary—along with the unshakable belief that America is the model the world needs. Ouch!

It’s interesting to contemplate how political commentators see the situation. What I read again and again is that the differences in policies between Democrats and Republicans would make for vastly different impacts and risks for the economy. Given that both parties have, from a top-down view, pursued almost identical goals, I find that an amusing perspective.

Isn’t it true that the gradual emasculation of the middle class and the monopolization of corporate America has steadily advanced under the leadership of both political parties? And hasn’t the aggressive application of trade tariffs and sanctions against economic or political rivals consistently escalated under Democrat and Republican administrations? And, finally, when it comes to the preservation of the post-war world order (U.S. effective control of the IMF and the World Bank, reserve currency status, NATO leadership, dominance of international payments systems and vast advantages within the UN Security Council), aren’t both parties committed to do anything in their power to uphold the status quo? And finally, when was the last time either the Democrats or the Republicans opposed the initiation of yet another instalment of the Forever-War? When it comes to the destabilization of another part of the world to America’s advantage, both parties are consistently and enthusiastically on board.

So, will anything change if one side or the other wins? When it comes to fiscal policy, the management of the economy, or trade- related policies, I would say no. In terms of foreign policy, priorities may change, but the pursuit of military interventionism will continue.

Geopolitics

According to Donald Trump, “NATO has to treat the U.S. fairly, because if it’s not for the United States, NATO literally doesn’t even exist.” True enough, but for many Europeans, Trump’s statement raises a question. What would have happened if NATO hadn’t existed?

Arguably, during the Cold War years, NATO served its purpose. But more recently? Would ill-conceived and manifestly non-defensive military campaigns like the ones in Afghanistan  or Libya have occurred? And what about the “defensive alliance’s” continuous eastward expansion, eventually absorbing the Baltic Republics and parking offensive weapons literally at Russia’s doorstep?

The official line of most of America’s European allies is that Russia would have aggressively expanded westward if NATO hadn’t acted this way. But popular sentiments about the alliance are considerably more complex. A frequent criticism is that interventions like NATO’s actions in the former Yugoslavia or in Libya have sent hundreds of thousands of refugees Europe’s way, causing massive social dislocation and economic costs. Similarly, many Europeans complain about the high price their continent keeps paying as a result of two years of war in Ukraine, a conflict that might have been avoided had NATO not pushed as hard. And finally, there are concerns that the alliance is developing into an empire of its own, guided by and accountable to a handful of puppeteers, rather than 32 sovereign member states. Last year’s suggestions by both NATO’s Stoltenberg and U.S. State Department and Defense officials, that an expansion into Asia should be instigated, is particularly disturbing.

Moving the focus onto China is, of course, America’s first objective. Beijing has been labelled as the key threat to the preservation of the “rules-based international order” on numerous occasions and the Western mainstream press has been working overtime to vilify the Chinese regime.

Unfortunately for the U.S., the Hamas terrorist attack on Israel and Israel’s colossal response intervened. What may at any time become a much broader Middle East conflict is severely complicating Washington’s agenda. The Biden administration’s initial unmitigated vocal and financial support now seems to be under review. In retrospect, it was a severe tactical and strategic error. If the Middle East explodes, a dangerously over-stretched U.S. will be weakened on its numerous other fronts and will, most likely, lose its key allies in the Muslim world.

When it comes to geopolitics, the key question for the next ten years is how the U.S. will manage its strategic overreach. If it wants to follow through with its challenge to limit China as an economic, political and military rival, it will have to diminish its operations elsewhere. Of course, Washington’s rhetoric is that its military capacity is unrivalled and that it can handle Russia, the Middle East and China. But as everyone knows, the track record of the U.S. military over the past half century suggests the opposite.

Am I saying that the age of American hegemony is about to end? I’d phrase it differently: I believe the peak of Washington’s capacity to lead is behind us. The descent into a far less influential role for the U.S. may be swift or it could extend over a couple of decades. But no matter what the timelines are, even a more isolationist America would have enormous advantages over potential rivals—just think of the country’s huge raw material wealth, its entrepreneurial culture and its technological leadership. In my opinion, even if the U.S. did step back from its global control agenda, it would be far better off than its close allies. Japan, Britain and key European Union members would be in particular peril.

Basic Investment Rules

How should investors navigate this highly unstable current environment? The short answer is, with enormous humility. When my financial career passed the half-century point, I thought I’d seen everything. Grave geopolitical miscalculations, near-escapes from nuclear showdowns, fiscal and monetary senselessness, financial bubbles and crashes, and highly disruptive social uprisings. Now, a few years later, I accept that I may be destined to witness things I never could have dreamed of. After all, it would be a miracle if the world’s countless systemic shortcomings could be rectified without highly negative disruptions to the life we are used to.

So, again—how to invest as the challenges all around exacerbate or unwind? There is no easy answer to that, but that doesn’t mean that we can’t have a strategy. Mine includes these imperatives:

  • Be pragmatic. Far too many investors stick to firm views of what lies ahead. Almost all of my acquaintances follow a given set of media outlets that spin the same narrative. In other words, they succumb to confirmation bias. Remember, dogmatic thinking is enemy number one.
  • Stay flexible. In today’s environment many buy-and-hold strategies are inappropriate. I can think of countless scenarios where a given company or sector will fall out of favour for some time.
  • Diversify, but don’t over-diversify. Excessive portfolio concentration increases risk, but most managed investment vehicles are over-diversified. In my years of managing mutual funds, pension portfolios and individual accounts I’ve typically held between 12 and 20 selections.
  • Accept that bear markets can be long and painful. Few money managers have lived through protracted bear markets. That is why so many contemporary operators take the view that severe corrections are short-lived and will invariably be followed by a move to new highs. In that context, consider the decline in the Dow Jones from 9,598 in January 1966 to 2,573 in July 1982.
  • Cash and gold are important asset classes. Cash and short-term instruments can be important instruments to build liquidity and provide downside protection when financial markets are overvalued or the economy seems on the verge of recession. Gold, in my opinion, is a superb hedge and a potent portfolio stabilizer.
  • Assets that are someone else’s liability should be underweighted. Be cautious with assets that represent a counterparty’s promise to repay you. When it comes to cash, term deposits, bonds or  derivatives, stick to the very high end of the quality spectrum and to short maturities. Wherever possible, be an owner, not a lender.

Which Asset Class?

Here is a summary of what I currently think of each major assets class:

Last week, when Fed Chairman Powell provided his outlook, the stock market exploded, mainly based on his indication that the central bank could cut interest rates by 0.75% by year-end. Yet the bond market, which should be the primary beneficiary of rate cuts, barely bounced. That in itself should give any analyst pause.

Clearly, the stock market chose to ignore that Powell provided a strong proviso to his rate-reduction scenario: he said that cuts would be administered if inflation showed signs of sustainably moving toward the 2% level. He also added that inflation data for January and February were of concern.

Stocks

Yes, the stock market has moved up too far and too fast and valuations on many equities are excessive. So, a degree of defensiveness is appropriate. Our holdings have mostly tracked the indices, even though we’ve avoided the most fashionable sectors.

Our criteria for stock selection remain unchanged. We look for balance sheet strength, cash flow sustainability and, with our core holdings, attractive dividends. During the first quarter, our natural resource stocks, a significant portion of our holdings, have done exceptionally well.

Still, the market is probably overdue for a small correction. Here is what Warren Buffett had to say in Berkshire Hathaway’s annual report. “There remain only a handful of companies in this country capable of truly moving the needle at Berkshire, and they have been endlessly picked over by us and by others. Some we can value; some we can’t. And, if we can, they have to be attractively priced. Outside the U.S., there are essentially no candidates that are meaningful options for capital deployment at Berkshire. All in all, we have no possibility of eye-popping performance”, he wrote.

Bonds

We continue to be significantly underweight in the bond market. Powell is right: recent developments on the inflation front are not encouraging. Will that mean that the Fed will keep rates where they are or even raise them? I doubt that, mainly because I doubt the Fed’s political independence—this, after all, is a presidential election year.

So, shouldn’t bonds be bought if we assume even one or two small cuts? We’ll reassess as things evolve, but there is a good chance that some stock market sectors (utilities, telcos, pipelines, etc.) will do as well as bonds if we get a moderate decline in interest rates. 

Throughout 2023 I warned that calls for an imminent dollar decline were premature. Even though fewer trade settlements were conducted in the U.S. currency, interest rate differentials remained in the dollar’s favour.

If that changes as a result of U.S. rate cuts, a break in the 100 level in the dollar index (see our chart) would be needed to indicate a major trend change. A falling U.S. currency would be very beneficial to gold.

Gold, Commodities and Bitcoin

As our readers know, I’ve been consistently bullish on gold for the past five years. The five lenses through which I continuously look at the yellow metal are:

Gold as a currency

Gold as a commodity

Gold as a central bank asset

Gold as a portfolio stabilizer 

Gold as an asset of last resort

Analyzing all of these metrics leaves me neither surprised that gold keeps making new highs, nor does it sway me to take some money off the table. In short: the odds are strong that gold will continue to outperform. We continue to recommend physical holdings of the metal, as opposed to vehicles covered by counter-party promises.

The commodities complex, as well, should continue to do well, unless the economy dips into recession.

Some of the natural resource proxies we have high hopes for are uranium and crude oil. former sold off a bit after a serious run and has been building a new base; the latter should benefit from geopolitical developments and the replenishment of America’s Strategic Petroleum Reserve.

A highly interesting contrarian bet is natural gas, which has fallen from $3.81 at the end of October to $1.68 at present.

Finally, a word on Bitcoin, about which several readers have inquired. After its spectacular plunge from around 69,000 to 15,500 in the course of one year, the crypto-currency has staged a remarkable rebound to an all-time high of around 74,000. At its current price of 66,000, Bitcoin remains technically strong. The key reason for its dramatic new bull run is the huge widening of the currency’s demand base, which results from the U.S. authorities January approval of eleven Bitcoin exchange-traded funds. The question, of course, is whether the institutions seeking to acquire even a small holding, have already done so. I don’t have the answer to that, but the competition between the world’s heavily debased fiat currencies and a digital alternative whose algorithm limits supply is now earnestly underway.

One more time:

No matter which asset class you look at, be open to multiple outcomes and be nimble as you adjust to changes.

Best regards,

Peter Cavelti