Category: Macro Posts

Summary- Real Vision interview

Marko Papic and Mike Green — The Next Decade for Geopolitics and Markets

Geopolitical activities will be a cause for concern. But, the major driver is going to be domestic politics in US, China, Europe and around the globe. The reason is low growth, secular stagnation compounded by Covid-19.

The Great financial crisis was not like the great depression as post the depression, debt levels did not fall dramatically now were there high number of defaults. The 2008 seems more like the 1920s where it was a big financial crisis.

Investing based on macro means how would one look at today’s scenario 10 years from now. It all depends on the chart of the year and its directionality. So, we have covid 19 which lead to wartime level spending but no war.

Most important trend is shifting away from the 40 year old Washington consensus. The transition is happening towards a new consensus at a rapid speed. Investors who were bearish thought a great depression was coming. Great Depression was about policy. It was about going into a crisis. As Treasury Secretary Mellon said, liquidating everything. It’s like tightening the screws of pain on the American economy so as to cleanse the system. That was the obsession they had at the time. The recession was tackled with austerity and lowered government spending in the early years of the depression.

But, we have an extraordinary fiscal response which requires a new framework of thinking about politics. We are transitioning from Washington consensus to Buenos Aires consensus.

Washington consensus were about free trade, privatization, central bank independence, fiscal prudence and fiscal policy becoming apolitical.

Buenos Aires consensus is the opposite, it’s about democratizing the institutions related to Washington consensus. It means basically short term gain, long term pain.

Fiscal policy was not in the limelight a lot except for the 2013 fiscal cliff. While the federal reserve monetizing the debt is important whats different this time is that the previous we had a stimulus it was five months into the crisis to the tune of $850 billion and was passed completely along party lines.

After that within 18 months in wake of the 2010 midterm election, we had the tea party revolution where there was talk of usa ending up like Greece. The political revolution was based on fiscal prudence and austerity became the guardrails of monetary stimulus. If you’re going to stimulate fiscally, we’re going to pull back monetary support. You’re going to have huge monetary stimulus, we’re going to pull back fiscal.The reasons we did not have inflation was other than the balance sheet recession , it was the lack of fiscal policy. From 2010 to 2016, US had the most longest and deepest self imposed austerity, basically government was not contributing to GDP growth.

There is a revolt inside the republican party with regards to the tepid $1 trillion package passed. It doesn’t mean that Mitch McConnell or Rand Paul, or Republican senators whose constituencies might be still fiscally conservative, it doesn’t mean that they’re not going to put up a fight, but they’re going to lose.

Nancy Pelosi has sniffed out where the Median voter is in this country which is in favor of left leaning policies. What Nancy Pelosi did is she drove this incredible strategy of just saying more and more stimulus to trump to the extent that we now have trump campaigning against her.

If Mitch McConnell does not allow the stimulus to happen the unrelenting ads against trump regarding him cutting their unemployment benefits will cause him to lose massively.  If Joe Biden wins, he is not going to allow a fiscal cliff to happen as he just now won because of these left leaning policies.

This is the mechanism by which we end up in the new consensus where the size of fiscal stimulus is bid up. The new administration that comes into power next year will say if I stimulated earlier why can’t I stimulate again to avoid a fiscal cliff.

This is why the market is not worried about a blue wave, as a democrat next year would mean that capital gains and corporate taxes are going up. But the market is overlooking the tax and regulatory changes because of its addiction to fiscal policy.

Politicians don’t care about ideals only they just try to win, they feel if they win they can pursue their ideals. Therefore, the median voter is the price maker in the political marketplace and the politician is the price taker.

The great recession in 2008 exacerbated the inequalities, US has a very high median income but middle income as share of total population , but it is very low.

For the first time in history the millennial voter is the median voter and millennials and Gen Z cohort are the ones worst affected by this crisis. Policy makers will simply respond to their policy preferences and if they don’t. They are going to compete against someone who does respond to the policy preferences of the millennial. Last time there was the tea party revolution this time there wont be one.

Now, if US which is the bulwark of the Washington consensus does not back it up, everyone around the world will also abandon it and politicians all around the world are going to surprise us. The fiscal situation is going to last longer than people think and inflationary pressures will build up.

Shifting focus towards Europe , the perception that Europe wants to create a super state to rival US is overblown but so is the narrative that it is going to subjugate the common man to supranational sovereignty. The European union is uniting not out of arrogance or strength but weakness. This is a world in which European countries actually have a geopolitical imperative to continue to integrate. In a world of large states that protect their markets, suddenly scale really does matter. European Union is a protectionist economic bloc that has a geopolitical logic and that logic is strengthening not weakening.

Italy may have a bout of populism in the next 5 to 6 years, which will be an opportunity to buy risk assets as the Italians will renegotiate rather than leave. Long term Europe will stay together, so with china stimulating Europe is ahigh beta play. Euros role as the reserve currency could go from 20% to around 25 to 30%. But EU is not going to be the next global power. Europe is going to do well and one should have a skew towards cyclicals when investing. As Manufacturing shifts from china to Vietnam, Malaysia, Indonesia, East Africa they will need infrastructure and factory building which they will acquire from Europe. Europe probably stands to benefit from deglobalization because it gets to play both sides, and it’s going to be very difficult for the United States to enforce European compliance to its position on China. So, Europe will benefit from Chinese demand or the rewiring of supply chains that will again require some of these cyclical companies to get revenue from the rewiring. Rewiring of supply chains is not all negative for everyone. The last time in 2001-2008, when China entered the WTO, that was hugely beneficial for Europe, emerging markets and other cyclicals and commodities, the industrialization of China and the rewiring of supply chains to include China as a central cog in supply chains. Rewiring of supply chain may hurt S&P 500 as they will have to dip into the revenues profit margins to rewire their own supply chains. That’s not bad for Europe, which could participate in the rewiring.

A lot of countries took the last decade to be the decade of American decline. I think that there is something to say that China moved too quickly. There seems to a policy setting in China to not to respond to the Trump administration with any real increase in tensions. So, while there is the tit for tat policy occurring, its complying as much as it can to the phase one trade deal. China is opening up its domestic economy because it needs foreign investors to go in and professionalized capital markets. If that setting of Chinese policy persists most people will be surprised by how muted Chinese policy will be with respect to united states.

There are red lines like Hong Kong , Taiwan which they are not going to compromise on , but they are opening up to foreign investment. We are in a world that is not going to clearly bifurcate and instead we are entering a 19^th century world where there’s still investment and trade going on between great powers. Most people think in terms of the us vs ussr cold war but that era was different as you had only two clear powers. Instead we are in this multipolar world. That multipolar context has real implications for how the enmity between China and the US will articulate itself from an investment perspective.

After 28 July and Mike Pompeo’s historical speech , the Australian delegation visited and while they were with us on some issues but they will keep trading with china. However, it requires American defense in order to properly protect its sovereignty given its close linkages with China. This is really important, because if America can’t keep its allies in line, it means that they will stab the US in the back in order to get revenues from China, Airbus will pick up the slack that Boeing leaves on the table by pulling out of China. the real critical issue because what we know from history is that when you have this multipolar context, where allies can’t keep each other in line, they capitulate and they trade with the enemy. The one from the 19^th century shows that the United Kingdom traded with Germany right up until the start of World War I. I could have also shown you French trade with Germany, Russian trade with Germany. These were three countries , the triple entendre. They were allied defensively against Germany, and they all expected for 20 years before World War I that there would be a war. But , they still traded because if one partner like UK didn’t protect its commercial interests , then France would pick up the revenue left on the table. It’s going to be very difficult for the US to disentangle from China, because he can’t control its allies the way it did in a bipolar context. However, the probability of conflict in south china sea over Taiwan is a clear threat, but this is going to be a multi decade rivalry and that should not be a reason to stay way from S&P 500. However, because there are chances of conflict one needs to position themselves defensively and be in gold and defense stocks.

Source : Real Vision Interview

There was a moment of panic in markets today ( with EUR/USD down 50 pips, gold down 30 and Dow jones down 150 in minutes ) when US 30 year bond auction result came out. I have attached bloomberg chart for reference

After the stellar, record-sized 3Y and 10Y auctions earlier this week, moments ago the Treasury concluded refunding week with another record auction, this time in the form of an all time high $26BN in 30Y bonds.

However besides the record auction size, today’s 30Y sale had nothing in common with this week’s prior coupon auctions both of which passed with flying colors, as this was without doubt the ugliest 30Y auction in years.

Pricing at a high yield of 1.406%, this was a 2.4bps tail to the 1.382 When Issued – the biggest tail since last July – and well above last month’s 1.357%.

The other metrics were far worse, however, with the Bid to Cover plunging from 2.50 to just 2.136, the lowest since July 2019 and one of the lowest on record.

The internals were even uglier, with Indirects plunging from 72% to 59.8%, the lowest since November and well below the 66.2% six-auction average. And with Directs taking down just 11.9%, it left Dealers holding a whopping 28.3% of the sale, the most since July 2019. 

I believe that investors have started asking for a higher premium to invest in long term US treasuries and today was just a glimpse.

If US treasuries gives market related yields at auction then the yields will blow out

If US treasuries does not want to give higher cutoff yield then Fed will have to buy the bonds by capping the yield curve and Dollar will tank

We are nearing the moment of truth because if Fed does not come to rescue all markets except US dollar will have a meltdown together

The U.S. has four choices in the coming decades for how to deal with the government’s extraordinary debt burden:

• Default on its debt;
• Inflate it away;
• Impose sufficient austerity to slowly pay it down.
• Muddle through economy

We are no more in a normal business cycle and that’s why it becomes important for us to evaluate all these 3 options carefully to choose the right mix of assets allocation in coming years.

Option 1 is unnecessary and politically unacceptable till the time US is a democracy. Democratic govt with right checks and balances on power rarely defaults. If this option is chosen then this is outright bearish US Dollar and can lead to hyperinflation.

Option 2 is the easiest option and can be deployed and is successfully deployed by US previously whenever the debt burden has become large. This will be done by keeping ( artificially suppressing) interest rates below inflation for an extended period of time. This can lead to higher inflation and possibly hyper stagflation but not hyperinflation. This is negative for US dollar but not as much as option 1

Option 3. I don’t think this option is possibility in today’s political environment but having said that if this option is chosen then the only beneficiary is US Dollar and it is extremely negative for EVERY asset on planet except US Treasuries. In this environment US bond yields will decidedly go negative.

Option 4. In this option policy makers get worried about putting too much stimulus and withdraw the easy money at the first sign of inflation. This will lead to periods of strong growth and period of very weak growth. This is the worst environment for investing and in this environment keeping an open mind and becoming opportunistic will be helpful as compared to buy/hold investing. This environment will alter between mild deflation and controlled inflation. This will keep US dollar generally bid as debt/GDP continues to pile up.

In my view we are transitioning from option 4 to option 2

Real Rates (Inflation- Nominal rates) are currently at -1% levels and it seems they may go down even lower. But they have been negative before during the 1940s in the post WW2 Era and in the 1970s STAGFLATION. Decline in real rates sometimes can be a deliberate policy to reduce the Debt burden of govt because the real value of debt falls with rising negative real rates. The policy of negative real rates is always preferred over the bitter pill of allowing companies to go bust .The US policy response post covid has been to print loads to money to reliquify the banking system and avoid defaults. With the rate of US M2 growth reaching 23% , and no chance of increase in policy rates in next couple of years the real rates can fall further in coming years.

When real rates decline, gold’s value tends to go up more because GOLD is a perpetual Zero coupon bond and holding Zero coupon asset with limited supply is better than holding negative real rate asset like US treasury whose supply is unlimited by issuance.Negative real rate also mean that you need to be an asset owner to maintain the purchasing value of depreciating paper currency.

I strongly believe that we are like ( 1942-51 ) headed to -3% to -4% real rates and if that is the expectation on real rates is there a way of mathematically finding the value of GOLD in that environment?

while I was grappling with the question of having an input ( -3 to -4%) value but not the output i.e value of GOLD at that level of negative real rates, there came along an article from the Bloomberg columnist on this subject.

The analysis by Ven Ram(Currency and rates strategist for Bloomberg’s Markets) shows that the duration of gold is 17 when interest rates go up and 20 when yields trend lower, suggesting that the second derivative of the shift in rates is alive and kicking. Back in 2018, Pimco found a duration of almost 30.

Gold has been on a tear this year, having surged 35% in response to a 120-basis point slump in real interest rates. Other catalysts include low global yields; erosion of confidence in global fiat money in general and a weaker dollar in particular; unbridled global monetary and fiscal stimulus; investor purchases through exchange-traded funds in response to uncertainty about the evolution of the pandemic.

However, the outlook for gold gets murky once it goes to around $2,500 an ounce. Beyond that level, it would imply a massive plunge in real rates and an even sharper rally in breakevens than what we have already seen.

Correlations suggest these factors would also imply a big decline in nominal 10-year yields, which currently sit near 0.50%. Such a move would essentially mean the markets are pricing in a depression-like scenario. Should it play out, the study indicates gold may be propelled toward $3,000 should real yields slump to -3.15%.

Given that gold has a longer duration than linkers, the metal offers a balance sheet-economical way to hedge against inflation.

Conclusion

We believe that US is going to have real rates south of -3% and the time period it is analogous to is the 1940s when real rates averaged -3.14%.

On this basis we believe that gold may reach levels of $3000 and go even higher if real rates go below -4%.

The Global Stock Market rally continued through July with the exception of Japan. The EU agreed to a 1.82 Trillion Budget of which 750 billion Euros is Coronavirus Aid, 390 billion Euros is grants & 360 billion euros is loans. Meanwhile US stimulus negotiations seem to yet to result in any deal.

All of this talk of stimulus and investors realizing the gravy train has just begun has led to gold rallying to $2000 an ounce. With more and more trading houses coming out with even more bullish forecasts for gold. The out performer however was Silver which went up 25% in July beating Gold which 9.63%.

We also got to see the impact of lockdowns on the economy. US Q2 GDP declined by a whole 32.9% which is now being considered the worst drop in history with the previous one being in mid-1921.

The Eurozone was no different with the economy contracting by 12.1% in Q2 2020 which is the lowest since 1995. Thus, the impact of lockdowns on GDP become clearer.

Overall S&P Global Ratings forecasts a decline in Global GDP of 3.8%. This is obviously a moving target because of uncertainty related to future coronavirus lockdowns.

The main story of the month is undoubtedly the US dollar Index reaching a low of 92.55 before recovering to 93.35 levels. This is the biggest 1 month drop (-4.15%) in the index in a decade, meanwhile euro rose by 11% from its may levels with its best monthly performance in a decade. This can be the start of the dollar deprecation cycle and thereby lead to rotation of liquidity flows into value from growth and Emerging markets equities from developed world.

Monthly Market Indices

US Reserve Currency status at Risk, as gold surges: Goldman Sachs

As governments are debasing their currencies and real interest rates are reaching all-time lows, gold has had a record-breaking rally.

Goldman Sachs commodity strategist Jeffrey Currie, wrote that “real concerns around the longevity of the US dollar as a reserve currency have started to emerge. “The argument is along the same lines that US Debt to GDP ratio has exceeded 80% which may lead to government, federal reserve allowing inflation to accelerate. Its because inflation allows central banks and governments to reduce accumulated debt burden.

As time progresses and the market realizes the amount of debt racked on by governments worldwide and the unsustainability of it, people will flee even more to asset classes which they consider as stores of wealth.  

With populism on the rise and a future MMT implementation in the works where politicians take control of the money supply. All roads line up to one thing which is inflation and as productivity levels decline due to structural reasons and fail to recover, we might be staring at stagflation. The geopolitical tensions between US and China are rising, with escalatory moves ,de-dollarization  to accelerate which is positive for gold.

The unrest breaking out in many states inside the US is also causing an increase in uncertainty. We have high unemployment rate along with lower median wages and low labor participation rate in an election year, the combination just add to the list of issues.

All of these coupled with plunge in real yields are very bullish for precious metals and real assets. We believe that the rally of gold and silver is in the initial phases and has so much more to go in coming years. Just like 1942-51 we expect real yields to reach -3 to -4% in coming years keeping relentless bid under yellow metal which is nothing but a perpetual Zero coupon bond.

No Pause for Gains in PAWZ

The Proshares Petcare ETF(PAWZ) hit an all time high with a YTD gain of 20%. It is the first and only dedicated pet care and retail ETF.

Almost 67% of families in US have pets and the trend has been accelerated by the pandemic as more families and seniors are looking to pets as a companion. From 2013 to 2018 even while annual incomes increased by 23% pet spending increased by 50%. With Global Pet industry sales forecasted to grow even further PAWZ is good bet to capitalize on this trend.

Are we heading towards Inflation ?

As the federal reserve and congress push efforts to stimulate the economy, M2 growth has reached 23% on YoY basis.

While this is in response to the pandemic, higher money supply growth has been linked to inflation. However, there is an even broader trend of shift of money creation away from central bankers. As pointed out by Morgan Stanley chief U.S. equity strategist Mike Wilson -The “Fed may not be in control of Money Supply growth which means they won’t have control of inflation either, if it gets going,”.

Now we previously had Quantitative easing by the central banks, but it only led to increase in Debt to GDP and did not lead to growth in real GDP as the money did not circulate in the economy.

The power is now shifting from central bankers to governments. Where they are now taking on Contingent Liability and offering to bail out any default on principal which is leading to circulation of money by commercial banks . These bank credit guarantees solve the problem of quantitative easing by directly lending to the real sector.

This mechanism is the real money magic tree and politicians will not relinquish this power. The incentives of the politicians are linked to getting elected and not to any macroeconomic stability related variables like inflation.So, for elected politicians, credit guarantees is a cheap way of funding an economic recovery and green projects.

All these changing trends are already being reflected in assets like gold, silver and cryptocurrencies along with inflation expectations which are increasing rapidly.

Capitalism turning into socialism

Even Mr. Russel Napier, an avowed deflationist for the previous decades has changed his stance. He outlines that “Politicians have gained control of money supply and they will not give up this instrument anytime in near future”. Napier says” In his view, we are at the beginning of a new era of financial repression, in which politicians will make sure that inflation rates remain consistently above government bond yields for years. This is the only way to reduce the crushing levels of debt.”