The markets are caught in an interesting dilemma. On one hand Central Banks have been forced to fight inflation and asset speculation by dialling down the wealth effect to tamper consumer demand.
On the other hand, governments are relying on higher asset prices to provide higher tax receipts. In addition, 23% of the companies in the Russell 3000 are considered Zombie companies. These companies earn just enough money to continue operating and service their debt. Zombie companies have no excess capital to spur growth and are considered close to insolvency.
Today, we are at an interesting crossroads. Continued downward pressure this year in many markets have made this bear market unlike others. For one, both equities, fixed income, and real estate have seen downward price action. However, a more important difference between today and prior bear markets continues to be Federal Reserve monetary policy. During the previous 8 bear markets in the financial markets, the Federal Reserve responded with easy money every time (rate cuts, Quantitative Easing, etc.). This year they’re doing the opposite, hiking rates and starting to shrink their balance sheet. The last time we saw a hawkish Federal Reserve during a bear market was in the early 1980s under Paul Volcker.
U.S. MACROECONOMIC OUTLOOK
The Federal Reserve has reduced their balance by $90 billion however the financial markets have seen as much as $9 Trillion in losses. To say the US markets have become a leveraged casino due to years of money printing is an understatement.
The picture gets much tougher for the markets going into the fall. In addition to the newly passed Inflation Reduction Act that will add $700 billion in more spending, from mid-August through September, the US Treasury Borrowing Advisory Committee (TBAC) is forecasting the US Treasury will issue new Treasury debt of $108 Billion in August and $152 Billion in September. That will coincide with the Federal Reserve increasing Quantitative Tightening (QT) from $47.5 billion in balance sheet reduction or evaporation of money to $95 billion in September. Important to note that QT requires the US Treasury, to raise the cash to repay the Fed by selling new debt in the market. That will add to government bond supply, while subtracting cash from the market. This impact is known as “crowding out”. The government simply demands more money, starving financial markets of liquidity. This occurred in 2008 after the government bailout of $800 billion.
This is where impact on asset prices which effects tax receipts begins to create a doom loop of more government borrowing. Eventually, the playbook is for central banks to begin easing again. In addition, government fiscal policy is used to stimulate the economy. This printing of money which allows for more debt creation simply leverages up a society to a greater degree.
The counter argument or perspective is that the Federal Reserve is willing to be tighter and more restrictive than many investors in the market believe. This is exemplified in numerous surveys and sentiment measures. The CFO Survey shows a collapsing degree of confidence about the US economy as well as their own company outlook. The worry over the US Economy has already surpassed the March 2020 lows and is headed toward the 2008 Crisis.
The University of Michigan survey of consumer sentiment recently took out its lows from the original Volcker era in 1980. This is when consumers experienced gasoline rations and unemployment was on its way to double digit levels. To put some perspective as to how leveraged and sensitive the US economy is to these adjustments to Federal Reserve Policy let’s compare 1974 to today. In 1974 US Deficit was .39% of GDP and today it is 6-7%. In 1974, US debt to GDP was 31% and today it is 125%. Finally in 1974, Government Entitlement outlays were negligible, however today they are running at 70% of US tax receipts and growing 5-10% while tax receipts from inflated asset prices are beginning to fall. These government outlays are one reason for the structural US Government deficits we are seeing every year. As we have seen, the hikes in interest rates that have started since the beginning of 2022 have put enormous pressure on the US financial system. Tightening liquidity has seized up the High Yield market.
Mortgage rates have more than doubled in less than a year, and home buying activity is collapsing with cancellations of sales contracts for new homes rising and price reductions increasing at an alarming rate. Although shortages of key components have hampered the automobile market, inventories of both new and used cars are beginning to increase and layoffs have begun. Auto repos have been accelerating which will continue to add pressure on car prices.
PUT YOURSELF ON A GOLD STANDARD
Inflation in consumer goods, energy, and food added to concerns of consumer household distress for the bottom half of households. Delinquencies and defaults are rising at alarming rates on instalment payments from Amazon purchases to auto loans and direct lending to small businesses. Credit card spending on necessities has also exploded.
For many this is a confusing period to understand. The markets are wanting a deteriorating economy because it will signal to the Federal Reserve that a pause or pivot from monetary tightening will be more supportive of asset prices. This is the issue with central government influence on financial markets for 40 years. We have been conditioned like Pavlov’s dog to expect the Federal Reserve to bailout speculation, malfeasance, leverage, and indebtedness at the first sign of economic pain. If this sounds illogical welcome to the last 20 years of finance.
Unfortunately, this conditioning is imbedded in fiat currency systems. Therefore, I continuously tell clients to put yourself on a gold standard. Global governments will resist this methodology because it limits their ability to spend endlessly. Ultimately, the markets will pull the printing press when confidence in the ability to repay those debts without devaluing the currency is lost.
Currently the best performing asset is US Dollar. There have been many bright analysts discussing the idea that earlier this year Treasury Secretary Yellen wanted a strong dollar for 2 reasons. The first was to promote inflows of capital to US Financial markets as the Federal Reserve began tightening monetary policy. This would allow a buffer of liquidity to support the US Capital Markets. However, this support would come at the expense of many other foreign markets and their respective currencies. This brought us to the second reason. Export inflation and chaos so our strong dollar counters the inflation we are seeing in the USA. Basically, the US Dollar was weaponised. Spiralling inflation in other countries creates instability for their economies whether friendly or adversarial to US interests. The Ukraine invasion along with other geopolitical events created a scenario where monetary policy alone could not fix rising supply issue constraints.
If the US Dollar maintains global currency status, the need for dollars to meet trade and promote growth in global commerce is paramount. Unfortunately, for many countries who realise the power that this reserve currency wields, an old proverb comes to mind, fool me once, shame on you; fool me twice, shame on me. With that said countries around the world are beginning to transact between each other in their local currencies. Although, these transactions are not material yet, the trend is worth watching because the longer-term implications toward funding of US Government debts and US financial markets have much greater longer-term impacts.
This lends us to a conclusion that investor and consumer confidence which has been on a roller coaster the last 2 years will continue to be tested. We are facing challenges many have never seen or modelled for. However, one asset class has stood through declines in empires, world wars, depressions, poorly managed governments, market volatility, etc. This is the precious metals. The rich tradition and benefits of the periodic table provide few resources that do not rely on other’s promises to pay. As the price of the metals have declined recently, the market for physical silver has seen considerable pick up in demand. Investors are weighing the concerns mentioned above and have begun to ask themselves a very simple question. “What is more important, a return on my money or a return of my money?
As volatility and uncertainty continue, historically hard assets become a store of value. The last 2 years have seen high net worth individuals and families begin to accept physical precious metal coins and bars as an alternative to traditional paper investments. Concerns over various risks such as counterparty, systemic, currency, capital controls, and regulatory policy is addressing reasons why physical metals could be part of a diversified portfolio. Especially when one considers that Silver is cheaper today relative to the S&P 500 than it was in the early 1970’s. EG