What Debt Ceiling?

With the U.S. debt-ceiling scare over and the banking crisis resolved, the stock market can only win. Or so we are told. After all, isn’t it true that the much-anticipated recession has been pushed further out? And isn’t it encouraging that Jamie Dimon, the Chairman and CEO of America’s largest bank, reassures us that, “The system is very, very sound?”

Of course, we can also look at things through a different pair of lenses. Dimon, after all, spoke after his bank took over the insolvent First Republic with significant government help and $50 billion in financing from the Federal Deposit Insurance Corporation. I’ll let you draw your own conclusions, but here are some disturbing facts.

Let’s first get some context. The three U.S. sizeable banks that have so far collapsed in 2023 had more assets than all 25 banks that failed in 2008. Meanwhile, bank deposits have been shrinking at the fastest pace since 1934. If this trend continues, banks will struggle to keep their assets and liabilities matched, which means they’ll have to cut back on lending. That will further weaken the consumer economy which, in turn, will add to the pressures on the financial industry.

Another major problem is that the banking industry is sitting on hundreds of billions of unrealized losses (see chart). This is because the recent ramp-up in interest rates has sent fixed income securities tumbling, undermining the banks’ liquidity position.

The bottom line: in my opinion, the global banking crisis is in a temporary state of dormancy, but is far from over.

Next, let me deal with the debt-ceiling theatrics. Obviously, financial markets are relieved that a U.S. default has once more been averted. On the other hand, it’s a huge negative that the current $31.4 trillion federal debt is estimated to swell to around $54 trillion over the next decade. This projection comes from the Congressional Budget Office and, importantly, doesn’t allow for a meaningful recession, continued inflation or elevated interest rates. In short, America’s fiscal crisis is far from over. The only question is how long the proverbial can be kicked down the road. Logic suggests that at some point the debt offered will exceed the amount of debt investors want to purchase.

I should also mention that it’s not only the U.S. government that is hopelessly indebted. Total corporate debt is estimated to be around $25 trillion, while household debt stands at $17 trillion. Moreover, analysts routinely point out that fiscal trends in other developed countries are similarly alarming. However, what’s rarely mentioned is that debt markets in most of the worst offenders are largely financed domestically. The U.S., in contrast, is hugely dependent on foreigners. 24% of all government debt is held abroad.

Take a look at the chart below, which details the ten largest holders of U.S. Treasury securities. Japan, which holds over a trillion dollars, will be under growing pressure to reduce its hoard. Not only does its government have the worst debt profile in the developed world (251% debt-GDP versus America’s 121%), but its corporations owe roughly twice the developed world average. To make things even worse, Japan also faces one of the world’s worst demographic challenges.

The second largest holder of U.S. debt is China, a country that is openly targeted by America as a hostile “coercive power” and has every incentive to unload dollar denominated assets. Spooked by America’s steadily escalating sanctions policy and the seizure of foreign central bank assets, a host of other nations are busy decoupling from the U.S.-dominated financial framework, as well.

In short, the debt-disaster is global and particularly entrenched in the developed world. The transition to a more sustainable model will be messy; it may manifest through successive shocks occurring over a period of time, or it may be compressed into a shorter timeframe and be far more chaotic. Much will depend on how the necessary changes are introduced and what social reactions they invoke.

Recession still likely

Still, with the debt dynamic and the banking crisis temporarily contained, can financial markets look forward to a more constructive period? For the moment, attention is firmly focused on monetary policy and on the widely expected “pivot”—the moment when evidence of a weakening economy will force central banks to abandon the current policy of raising interest rates as a means to contain inflation. In other words, the U.S., along with most major economies, is in a transition zone, which will keep stock and bond markets off balance. I expect more of the same, at least until there is clear evidence that we are in a recession.

In addition to a bumpy monetary environment, there are other factors that can quickly and decisively affect market trends. The geo-political arena remains complex, with a number of European nations now openly questioning their commitment to Ukraine, all while the current U.S. and UK administrations appear to favour further escalation. On the social front, it also promises to be a hot summer, especially in places like the UK, Germany and France, where popular discontent is near extremes. Despite heightened economic pain, North Americans appear less agitated, although the U.S. presidential campaign may soon stoke tensions.

If my cautious economic outlook is correct, the place to be are sectors that have strong pricing power and can survive the coming economic downturn relatively well. Utilities, pipelines, energy and materials are good examples. Some companies in the consumer staples and healthcare space are reasonably valued and pay decent dividends, as well. Above all things, we stress balance sheet quality and sustainability of cash flow. In other words, we believe a rotation from the tech and communications sectors, which have led this year’s performance and whose components (Microsoft, Apple, Nvidia, Meta, Google etc.) are insanely overvalued, will soon unfold.

What about asset classes other than stocks? For considerable time now, we have largely avoided fixed income markets, with the exception of very short-term instruments. In Canada, we can secure yields on GICs with staggered maturities up to one year of just under 5%; in the U.S. the equivalent yield on CDs is above 5%. We view such holdings as a convenient and attractive cash alternative.

I also get asked about currencies a lot. For at least two years, I’ve cautioned that that the displacement of the U.S. dollar as the world’s reserve currency is inevitable, but will evolve gradually. Another point: North Americans tend to be very parochial, focusing on the home front and ignoring what’s going on elsewhere. While things aren’t going well in the U.S. and Canada, it’s a fact that they’re worse in Europe. International capital flows tend to ignore absolutist judgments and head where things are relatively better.

Perhaps the most important drivers of the global currency trade are interest rate differentials. Traders look at both nominal and real interest rates and on both counts, the dollar is more attractive than most other major currencies.

In nominal terms, the U.S. Feds fund rate is 5.25% — a bargain when compared to the central bank rates for the Euro (3.75%), the British Pound (4.5%) or the Japanese Yen (-0.1%). Adjusted for inflation, the U.S. dollar also looks good: it pays 0.32%, while the yields for Euro (-4.9%), Pound (-3.1%) and Yen (- 3.4%) are negative.

In short, while the U.S. currency may trend sideways for the next few months, I believe that a steep decline in the dollar is not imminent.

Finally, a few words on gold—the ultimate hedge against all fiat currencies and the medium of exchange that has incomparable historical legitimacy.

Despite the recent correction of roughly US$100/oz, the yellow metal remains in an uptrend, which I expect to continue. Gradual de-dollarization by central banks (especially among the BRICS nations), a flight to safety as the stock market and real estate take a breather, and geopolitical dislocations should keep gold supported. The introduction of central bank digital currencies could also help. Public surveys, such as the one currently conducted by the Bank of Canada, conclusively show that CBDCs are met by many with apprehension, with privacy concerns topping the list. This doesn’t mean that central banks will hold back (governments and public institutions rarely pay attention to the voting public), but concerned citizens may look for an alternative to a digital platform that allows authorities to monitor every transaction.

In short, I see no reason to abandon our gold position of 15% of invested assets, of which 10% is held in physical, segregated metal. Our gold holding has acted as a reliable portfolio stabilizer during past years, and I’m confident it will do so as we go forward.

With best regards,

Peter Cavelti