Patience is bitter, but its fruit is sweet – Jean-Jacques Rousseau
I would have quoted the Foghat song from 1975 but the lyrics are so non-sensical that I went with Rousseau. With that said, it’s good advice for those who are looking to prosper from a market downturn. The fundamentals may be moving in a negative direction and interest rates may still be high but trying to short this market is akin to storming a heavily fortified position. You can succeed but it’s going to be expensive.
The Treasury and the Fed learned their lessons from 2008 which is why they snuff out any selling pressure before it gains momentum. I developed a theory about ten years ago to explain what’s happening and it revolves around the old football adage “the best defense is a good offense.”
As long as the Fed can inject liquidity into the banking system, the Fed’s agents can run up asset prices. The best way to run up asset prices is to catch speculators short the price of those assets. This has been the story since 2009. The more equity prices rise, the more fixed income is deemed safe based on the relationship of equity being riskier than debt. The wealth-effect provides a stabilizer to economic growth as it gives the consumers fortunate enough to have financial assets a green light to spend on luxury goods.
Owning Nvidia’s stock doesn’t induce shareholders to consume more eggs or other sundries. This is why I blame the Fed for today’s artificially exaggerated equity values and why I largely give them a pass for consumer inflation. Congress and Treasury are to blame for consumer prices while the Fed merely drives the getaway car.
Barriers to Exit
The more panic grows, the more uplifting the image of a man who refuses to bow to the terror – Ernst Junger
The US economy is an absolute mess. The excesses that led to the 2008 “Great Financial Crisis” or GFC were never addressed. Instead, the authorities quadrupled down on the policies that made the system unstable in the first place. The difference is that the worst credit has moved from bank balance sheets to wealth management funds.
Ours is a system built on bad debt, held together by a combination of market manipulation and government credit expansion. It’s the same with all developed economies. Think of the growth in US government debt as economic life support. The Trump Administration has been tasked with restoring the patient’s health. He’s going to have to cut life support first to purge socialism from the system. Socialism represents a frictional cost that inhibits the private sector; the private sector will have enough problems getting going without it.
If successful, the US economy is going to separate from the rest of the world. Europe is beyond broken and behind the curve for change. They won’t recover until Russian gas and oil flow west and south again. China is collapsing – economically, socially, politically, and environmentally. As the marginal buyer of global commodities, China is going to take commodity exporters down with it which roughly means the emerging markets.
People have piled into all manner of inflation hedges because they expect the “great reset” to occur at any moment. We’ll probably get a reset at some point in the future but it won’t happen until after we’ve been struck with a global deflationary depression. I expect those inflation hedges that include commodities, real estate, and crypto to decline in value before we get a reset.
Biggest Risk
If you look at carbon produced per dollar of economic activity, crypto is not a huge outlier – Sam Bankman-Fried
I think of crypto as the overflow container in a car’s cooling system. There is only so many valuable assets in the world today, so crypto was created to absorb excess liquidity much like an overflow container or floodplain. Without crypto, gold would trade at $10,000 per ounce.
The people enamored with it see themselves like Ayn Rand’s productive characters from “Atlas Shrugged” who escaped to “Galt’s Gulch” in the Colorado mountains to toil unencumbered by bureaucrats and socialists. Unfortunately, crypto is a social construct without intrinsic value, subject to the vagaries of the economic cycle. Once asset deflation arrives later this year, I expect that crypto will be one of the biggest losers.
But as Backman-Fried alluded to, crypto is not a big slice of the global asset pie. The biggest asset in the global economy is the US dollar/Eurodollar and I expect dollars to become extremely scarce before much longer. All it will take is a massive drop in asset prices, or deflation. Deflation is the bogeyman that scares central bankers more than Freddy Kruger or Michael Myers.
Therefore, I believe the biggest risk is the rise of the dollar brought on by the collapse of China, to a lesser degree Europe, and the emerging markets. The Fed, by keeping interest rates above 0%, is hastening this move to deflation because the whole world is short the US dollar by virtue of borrowing in the Eurodollar markets. Our high interest rates are making the carrying value of this debt brutally expensive. This is where intervention comes in.
I urge you to read this piece I wrote last year where I share my opinion that China is running out of US dollars. It’s a unique thesis of mine but definitely worth a look. Here’s a link. https://geovestadvisors.com/has-china-run-out-of-dollars/
Yesterday, newly elected German Chancellor Friedrich Merz announced that he’s going “all-in” on fiscal spending to reverse Germany’s economic weakness. Germany is close to a major economic drop because their industry is heavily dependent on cheap Russian energy.
More broadly, there is a reason why Europe has switched from being pacifists to warmongers seemingly overnight. It’s because EU politicians are at risk of losing power thanks to an angry electorate. War is the time-tested method of distracting people from economic policy mistakes. It’s also the reason why China may take a swing at Taiwan despite a badly organized and equipped Chinese military.
Lastly, when we start seeing ridiculous calls for the BRICS currencies to replace the dollar in global trade, it’s because global central bankers are afraid of a spike in the US dollar. The BRICS nations are collectively in horrendous economic condition and their individual currencies at risk of major devaluation. If Trump succeeds in cutting the fat out of Washington and sparking investment in US manufacturing, the dollar WILL spike and destroy the global financial system.
Conclusion
The battlefield is a scene of constant chaos. The winner will be the one who controls that chaos, both his own and the enemy’s – Napoleon Bonaparte
There is nothing straightforward about the coming deflation in the global capital markets except its inevitability and its vague resemblance to Y2K. But amid the chaos, there will be positive returns to be earned. The first step will be to avoid things like AI, luxury goods, high-yield debt, and most commodities.
The obvious strategy is to short some of these sectors in the market but know that the system is designed to destroy short-sellers. Do so at your own risk. Instead of embracing that risk, I like over-looked companies that will likely benefit from lower interest rates – regardless of the economy.
If you’re interested in learning more, visit us at https://geovestadvisors.com/ and ask for Paul Hurley
Philip M. Byrne, CFA
