Citi’s Ed Morse says that supply is growing faster than expected, while demand is contracting as recession fears grow. His base case is that crude will fall to $85 per barrel.
Citi’s Ed Morse says that supply is growing faster than expected, while demand is contracting as recession fears grow. His base case is that crude will fall to $85 per barrel.
Nowadays people know the price of everything and the value of nothing.
~ Oscar Wilde
Without order nothing can exist — without chaos nothing can evolve.
~ Oscar Wilde
“Nowadays people know the price of everything and the value of nothing.” ~ Oscar Wilde
Strong hands are long-term investors, including most institutional investors, who focus on intrinsic value and are insensitive to price.
Weak hands and leveraged investors are highly sensitive to price. They follow the news cycle in an often unsuccessful attempt to to time purchases and sales according to short-term, often random, fluctuations in price.
Weak hands respond emotionally to price movements — making it difficult to be objective in their decisions to buy or sell — while strong hands focus on dividends and other measures of long-term value.
Strong hands recognize that the biggest obstacle to sound investing is their own emotional response to rising or falling prices. Weak hands submit to the psychological pressure, make frequent buy and sell decisions, and find it difficult to be objective. Strong hands detach themselves as far as possible from the price cycle and the emotional pressures that accompany it.
At the peak of the investment cycle, weak hands pay way above fair value for stocks, while strong hands resist the urge to buy when price exceeds their own objective view of long-term fair value.
As confidence decays and prices fall, weak hands are shaken out of their positions. Margin calls force some to liquidate while others sell through through fear — failing to recognize that anxiety is the primary cause of falling prices. Some try to hold on to their positions but eventually succumb to the pressure. The mental anguish of watching their stocks fall often drives them to sell at way below fair value — just to end the pain.
Strong hands are patient, independent of the herd, and unmoved by the wild emotional swings of bull and bear markets. They wait for stock prices to fall to below fair value, when opportunity is at its maximum. Stocks that are gradually recovering from a steep sell-off and scarce retail buyers are signs that a bottom has been reached.
One of the key benefits of years of investing, through several stock market cycles, is the ability to recognize the familiar signs of euphoria in a bull market and despondency in a bear market. When it seems that the bull market will never end, that is normally a sign that risk is elevated. Conversely, opportunity is at its maximum when an air of despair and despondency descends on the investing public.
Price seldom equates to value.
Short-term investors confuse price with value, making them vulnerable to wild price swings which can weaken the resolve of even the most hardened investors.
Long-term investors hold the majority of their investments through several investment cycles, pruning only those stocks where long-term revenue growth or profit margins have been permanently affected and are unlikely to recover.
Many readers are familiar with supply and demand curves from basic economics. For those who are not, here’s a quick refresher:
In a bear market, the supply curve moves to the right as weak hands are influenced by falling prices and a negative media cycle. Note that the bottom end of the curve shifts a lot more than the top — strong hands are relatively unmoved by market sentiment.
Price falls steeply, from P1 to P2, as weak hands increase the quantity available for sale. Volume sold increases from Q1 to Q2.
We need to be careful not to equate the price at P1 or P2 with value. They may reflect the marginal price at which you can acquire new stock (or sell existing holdings) but they do not reflect the price at which strong hands are prepared to sell. That is why takeover offers are normally priced at a substantial premium to the current traded stock price. If you had to increase the quantity that you want to purchase to Q3, you would have to move up the supply curve, to the right, and price increases to P3 in order to attract more sellers2.
Market capitalization, likewise, is simply the number of shares in issue multiplied by the current traded stock price and is not a reflection of the intrinsic value of a company.
Investors need to have a clear idea of their investment time frame and adjust their approach accordingly.
One of the worst possible mistakes is indecision. If undecided, you are likely to be caught between two stools, buying late in an up-trend and selling late in a down-trend.
If you are a weak hand, it is far better to recognize that. Resist buying near the top of the cycle; apply sound money management — position-sizing is vital if you are focused on price; sell early, at the first signs of a bear market; and never, ever trade against the trend.
If you are a strong hand, never confuse price with value. Focus on dividends and other long-term measures of value; stay detached from the herd; and have the patience to wait for opportunity when prices are trading at way below fair value.
“The stock market remains an exceptionally efficient mechanism for the transfer of wealth from the impatient to the patient.”
~ Warren Buffett
Hat tip to RBC Wealth Management for the investment cycle chart to which we added fair value.
Fed Chairman Jerome Powell declared that the Fed’s commitment to taming inflation is “unconditional”:
June 23 (Reuters) – The Federal Reserve’s commitment to reining in 40-year-high inflation is “unconditional,” Powell told lawmakers on Thursday, even as he acknowledged that sharply higher interest rates may push up unemployment.
“We really need to restore price stability … because without that we’re not going to be able to have a sustained period of maximum employment where the benefits are spread very widely,” the Fed Chairman told the U.S. House of Representatives Financial Services Committee.
Under questioning by members of the House panel on Thursday, Powell said there was a risk the Fed’s actions could lead to a rise in unemployment. “We don’t have precision tools,” he said, “so there is a risk that unemployment would move up, from what is historically a low level though. A labor market with 4.1% or 4.3% unemployment is still a very strong labor market.”
He also dismissed cutting interest rates if unemployment were to rise while inflation remained high. “We can’t fail on this: we really have to get inflation down to 2%,” he said.
The Fed chief was also asked about the central bank’s balance sheet, which was built up to around $9 trillion during the pandemic in an effort to ease financial conditions and is now being pared. The Fed aims to get it “roughly in the range of $2.5 or $3 trillion smaller than it is now,” Powell said.
But the bond market isn’t buying it. Treasury yields from 2-year to 30-year are compressed in a narrow band above 3%, indicating a flat yield curve. Expectations are that the Fed can’t go much higher than 3.0% to 3.5%.
The dot plot from the last FOMC meeting similarly projects a 3.4% fed funds rate by the end of 2022, 3.8% by 2023, and lower at 3.4% by the end of 2024.
You cannot cure inflation with a Fed funds rate (FFR) of 3.5%.
CPI is growing at 8.6% YoY, while the FFR target maximum is 1.75%. Another 1.75% just won’t cut it. You have to hike rates above inflation. Positive real interest rates are the best antidote for inflation but the economy, in its current precarious state, could not withstand this.
Paul Volcker killed inflation by hiking the fed funds rate to 20% in 1980, but we live in a different world.
In 1980, federal debt to GDP was less than 50% of GDP. Today it’s 118%.
The Federal deficit was 2.5% of GDP. Now it’s 12%.
Private debt (excluding the financial sector) was 1.35 times GDP in 1980. Now it’s more than double.
Powell can’t hike rates like Volcker. If he tried, he would collapse the economy and the US Treasury would be forced to default on its debt. Collapse of the global reserve asset is about as close as you can get to financial Armageddon.
Instead, the Fed plans to use QT to deflate the asset bubbles in stocks and housing, in the hope that a reverse wealth effect — as households feel poorer — will slow consumer spending and reduce inflation.
So far, the S&P 500 has dropped by 25% and the housing market is likely to follow. The 30-year mortgage rate has climbed to 5.81%, more than double the rate in August last year.
Housing starts and permits are both declining.
Powell talks of a $2.5 to $3.0 trillion reduction in the Fed’s balance sheet. That would increase the supply of Treasuries and MBS in financial markets by an equivalent amount which would be sucked out of the stock market, causing a fall in prices.
The two largest foreign investors in US Treasuries — Japan and China — have also both become net sellers to support their currencies against the rising Dollar. That will further increase the supply of Treasuries, causing an outflow from stocks.
Since 2009, stock market capitalization increased by $47.4 trillion, from $16.9T to $64.3T at the end of Q1. At the same time, the Fed’s balance sheet increased by $7.9 trillion, from $0.9T to $8.8T. Market cap increased by $6T for every $1T increase in the Fed’s balance sheet (QE). The multiplier effect is 6 times (47.4/7.9).
If the Fed were to shrink its balance sheet by $2.5 trillion and net foreign sales of Treasuries amount to another $0.5 trillion, we could expect a similar multiplier effect to cause an $18 trillion fall in market capitalization ($3Tx6). Market cap would fall to $50T or 26.5% from its $68T peak in Q4 of 2021.
That’s just the start.
Nobel prize-winner Milton Friedman argued that long-term increases or decreases in the general price level were caused by changes in the supply of money and not by shortages or surpluses of oil, commodities or labor.
The chart below shows the supply of money (M2) as a percentage of GDP. The economy thrived with M2 below 50% throughout the Dotcom boom of the late 1990s but has since grown bloated with liquidity as the Fed tried to revive the economy from the massive supply shock of China’s admission to the World Trade Organization in 2002 — the introduction of hundreds of millions of workers earning roughly 1/30th of Western-level wages.
The massive supply shock helped to contain prices over the next two decades, perpetuating the myth of the Great Moderation — that the Fed had finally tamed inflation. Fed hubris led them to pursue easier monetary policy with little fear of inflationary consequences.
All illusions eventually come to an end, however, and the 2020 pandemic caused the Fed to purchase trillions of Dollars of securities to support massive government stimulus payments. The MMT experiment failed disastrously, causing a $5 trillion spike in M2 without an accompanying rise in GDP. M2 spiked up from an already bloated 70% of GDP to more than 90%, before GDP recovered slightly to reduce it to the current 89%.
Trade tensions with China, coupled with supply chain disruptions from the 2020 pandemic and a sharp rise in natural gas prices — as industry switched from coal to reduce CO2 emissions — triggered price increases. These were aggravated by Russia’s invasion of Ukraine and resulting sanctions, leading to oil shortages.
Normally, high prices are the cure for high prices. Consumers cut back purchases in response to high prices and demand falls to the point that it matches available supply. Prices then stabilize.
But consumers are sitting on a mountain of cash, as illustrated in the above M2 chart. They continued spending despite higher prices and demand didn’t fall. Investors who have access to cheap debt also, quite rationally, borrow to buy appreciating real assets. Unfortunately cheap leverage is seldom channeled into productive investment and instead fuels expanding asset bubbles in homes and equities.
The Fed is forced to intervene, employing demand destruction, through rate hikes and QT deflate asset bubbles, to reduce consumer spending.
An unwelcome side-effect of demand destruction is that it also destroys jobs. Unemployment rises and eventually the Fed is forced to relent.
Fed Chairman Jerome Powell says that the Fed’s commitment to reining in inflation is “unconditional” but the bond market is pricing in rate hikes peaking between 3.0% and 3.5%, way below the current rate of inflation. The economy is unlikely to be able to withstand more because of precarious levels of debt to GDP and a massive fiscal deficit.
Instead, the Fed plans to shrink their balance sheet by $2.3 to $3 trillion. QT is expected to deflate asset bubbles in stocks and housing and achieve a reverse wealth effect. Households are likely to curb spending as their net worth falls and they feel poorer.
Unfortunately, demand destruction from rate hikes and QT will also cause unemployment, inevitably leading to a recession. The Fed seems to think that the economy is resilient because unemployment is low and job openings outnumber unemployed workers by almost 2 to 1.
But elevated debt levels and rapidly rising credit spreads could precipitate a sharp deleveraging, with crumbling asset prices, rising layoffs and credit defaults.
The Fed may also manage to lower prices through demand destruction but inflation is likely to rear its head again when they start easing. Surging inflation is likely to repeat until the Fed addresses the underlying issue: an excessive supply of money.
Milton Friedman was a scholar of the Great Depression of the 1930s which he attributed to mistakes by the Fed:
“The Fed was largely responsible for converting what might have been a garden-variety recession, although perhaps a fairly severe one, into a major catastrophe. Instead of using its powers to offset the depression, it presided over a decline in the quantity of money by one-third from 1929 to 1933 … Far from the depression being a failure of the free-enterprise system, it was a tragic failure of government.”
Ben Bernanke, another scholar of the Great Depression, acknowledged this during his tenure as Fed Chairman:
“Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton (Friedman) and Anna (Schwarz): Regarding the Great Depression, you’re right. We did it. We’re very sorry. But thanks to you, we won’t do it again.”
Instead the Fed made the opposite mistake. By almost doubling the quantity of money (M2) relative to GDP (output) they have created an entirely different kind of monster.
Slaying the beast of inflation is likely to prove just as difficult as ending the deflationary spiral of the 1930s.
The ASX 200 broke primary support level at 7000, confirming a bear market.
Long-term interest rates are rising, with bond ETFs falling.
A-REITs respected resistance at the former primary support level of 1500, confirming the primary down-trend. Trend Index peaks below zero warn of strong selling pressure.
Financials fell dramatically last week, testing primary support at 6000, as the prospect of falling residential property prices and rising defaults looms. Higher interest rates and wider net interest margins should offset this to some extent. Expect retracement to test resistance at 6000. Follow-through below this level would confirm a primary down-trend and strengthen the overall bear market (Financials have been one of the stronger sectors).
Consumer Discretionary respected resistance at 3000, signaling another decline with a target of 2600 [3000-400]. Trend Index peaks below zero warn of strong selling pressure.
Consumer Staples broke support at 13K, with respect of the new resistance level warning of another test of 12K.
Utilities continue their primary up-trend, rising Trend Index troughs indicating strong buying pressure.
Industrials are headed for another test of support at 6350. Breach would warn of another test of primary support at 6000.
Telecommunications broke support at 1400, signaling a primary down-trend. Trend Index peaks below zero warn of strong selling pressure. Breach of support offers a target of 1200 [1400-200].
Health Care is consolidating below 42.5K. Reversal below 40K would warn of another test of primary support at 37.5K. A Trend Index peak close to zero would warn of fading buyer interest.
Information Technology continues in a primary down-trend, with Trend Index peaks below zero warning of selling pressure. Follow-through below 1400 would offer a target of 1100 [1500-400].
The Energy sector is advancing strongly, while Trend Index troughs above zero signal buying pressure. The prospect of Chinese lockdowns easing is likely to boost demand for oil and gas, sending prices soaring.
Metals & Mining respected resistance at 6250, warning of another test of 5500. Declining Trend Index peaks suggest buyer interest is fading. Respect of support at 5500 would signal that the up-trend is intact but breach seems more likely and would offer a target of the November ’21 low at 4750.
The broad DJ Industrial Metals Index respected resistance at 200, while Trend Index peaks below zero warn of strong selling pressure. Easing of lockdowns in China may increase demand but a bear market remains likely.
Iron ore is also undergoing a correction. Breach of support at 125 would warn of another test of primary support at 90.
The All Ordinaries Gold Index is again testing support at 6000, while Trend Index below zero warns of selling pressure.
The price of Gold in Australian Dollars, however, is trending upwards, with rising Trend Index troughs indicating increased interest from buyers. Expect a test of A$2800 per ounce. Breakout would offer a target of A$3400 [2800 + 600].
ASX 200 broke support at 7200, confirming a bear market. Rising long-term interest rates and a poor global economic outlook are expected to weaken most sectors, while easing of China’s lockdown restrictions should provide some relief to energy and metals.
Our weighting for ASX sectors is:
Larry Summers highlights a paper from the NBER regarding measurement of CPI since the 1980s. Changes in how cost of housing is measured have lowered core CPI relative to the methodology used prior to the early 1980s (blue line below). Applying the current methodology (red line) retrospectively suggests that comparable core CPI is closer to the Volcker era.
“New paper shows past and present CPI inflation are more similar than official data suggests. When correcting for change in how housing inflation is measured, we find a return to target core inflation will require the same disinflation as achieved under Volcker.”
On March 8, 2000, President Bill Clinton made a persuasive pitch to Washington’s foreign policy elite, Congress and the international community, on the merits of China’s accession to the World Trade Organization:
“Membership in the WTO, of course, will not create a free society in China overnight or guarantee that China will play by global rules. But over time, I believe it will move China faster and further in the right direction……..We have a far greater chance of having a positive influence on China’s actions if we welcome China into the world community instead of shutting it out.”
That was little more than a decade after the Beijing government massacred thousands of students participating in pro-democracy demonstrations in Tiananmen Square, June 1989. Twenty years have passed since China’s 2002 accession to the World Trade Organization. Let’s review how that is working out.
Xi Jinping reversed any progress, towards a more open society, made under Hu Jintao. Xi revoked the term limit on his leadership as General Secretary of the Chinese Communist Party; increased censorship and mass surveillance; imprisoned minorities; suppressed news of the COVID outbreak in early 2020, causing a global pandemic; he shredded the one-country-two-systems agreement with the UK and cracked down on the pro-democracy movement in Hong Kong; while threatening democratic Taiwan with invasion.
Rather than opening up China to Western influence, an open Western society proved highly susceptible to Chinese influence operations. Efforts to suppress free speech include infiltration of universities through establishment of Confucius Institutes and research grants; the Belt-and-Road initiative to increase control over fledgling democracies in the Asia-Pacific and Africa; and growing control over appointments in UN bodies. North Korea, for example, has been appointed as the current Chair of the UN Conference on Nuclear Disarmament.
Trade with the West has empowered China’s development of a powerful nuclear ICBM force, including hypersonic weapons; seizure and militarization of disputed shoals in the South China Sea, flouting international conventions; and development of a blue-water navy to expand its influence far beyond its shores.
Ignore the flowery speeches about democracy and freedom from the former President, the primary purpose of China’s admission was to enrich US corporations. When President Clinton described China’s admission as a “win-win”, you can be sure that US multinationals understood this to mean increased profit margins and new markets. China was also meant to benefit economically, to the extent that workers’ standard of living would need to rise so that they could consume more mass-produced Western goods.
It didn’t work out as planned.
Corporate profit margins rose to new highs, post-2002, as employee compensation fell.
The price was destruction of millions of manufacturing jobs as US companies shifted factories to Asia, where labor costs were a fraction of those in the US. Initially the erosion started with low-skill, menial jobs but soon expanded to high technology sectors as China’s industrial base grew.
Industrial production in the US stalled after the 2008 crash, losing an entire decade of growth.
Current account deficits ballooned as Chinese exports flowed into the US, supported by massive capital outflows from China to maintain their currency peg against the US Dollar. Capital outflows prevented the Yuan from appreciating against the Dollar — which would have eroded China’s pricing advantage in international markets.
The US slipped from being a net creditor in the 1980s to the world’s biggest debtor, with a negative net international investment position (NIIP) of more than $18 trillion.
Federal debt climbed to a precarious 128% of GDP in 2021 as the government ran ever-larger deficits to support the economy and offset the massive current account hemorrhage.
The traditional relationship between government deficits and unemployment started to break down in the late 1980s. Unemployment (RHS) is on an inverted scale below, so high unemployment is near the bottom and low figures are near the top of the chart. Before the late 1980s, deficits were relatively small , increasing to between 4% and 6% of GDP when unemployment spiked during a recession. But deficits were kept close to 3% of GDP in the Reagan-Bush (HW) era, even when employment had recovered (blue circle). The hoped-for boost to GDP failed to materialize but the experiment was nevertheless repeated, even more aggressively, by Trump in 2016-2020, cutting corporate taxes in the hope that this would boost growth. But GDP growth again remained low.
The Fed started expanding its balance sheet after the 2008 global financial crisis, in order to support a massive fiscal deficit of 10% of GDP, and an even larger 15% deficit in 2020. The effect was self-reinforcing as QE discouraged foreign investors from purchasing Treasuries — out of fear that the Dollar was being debased — forcing the Fed to inject ever-larger amounts of QE to make up for the absence of foreign funding. Money supply (M2) spiked upwards as a percentage of GDP, adding to debasement fears.
There was one win, however, from globalization that the Fed was quick to claim. Low inflation is mistakenly attributed to Fed skill in managing the economy rather than the real reason: erosion of the US industrial base which undermined wages growth, particularly in the manufacturing sector.
Admission of China to the World Trade Organization in 2002 was an unmitigated disaster, unleashing a massive deflationary shock that destabilized the global financial system. Despite being a developing economy, China become a major exporter of capital, as well as goods, upsetting the level playing field of international exchange rates. This helped to suppress the Yuan, giving Chinese manufacturers an advantage over Western competitors, and caused the loss of millions of manufacturing jobs in the West. The Western response was to run larger deficits, causing public debt to balloon to precarious levels, while central banks efforts to support growing fiscal debt destabilized the global financial system.
The recent surge in inflation exposed central banks inability to protect their currencies, without causing a global recession, undermined by precarious public debt levels and bloated central bank balance sheets.
Sir James Goldsmith — interviewed here in 1994 by Charlie Rose — was on the money when he referred to breach of the social contract between capital and labor, that ensured political stability in the West, and the betrayal of trust between political leaders and their electorate.
The present course is unsustainable in the long run and we anticipate an era of de-globalization as nations on-shore critical supply chains. There is no other currency that can compete with the Dollar’s status as global reserve currency but the system is likely to evolve towards a multi-polar world, with several separate trading/currency systems backed by commodities such as Gold, Silver and Base Metals. Oil would be ideal, as energy is central to the global economy, but storage is cumbersome; so a fixed exchange rate between oil and gold/base metals is more likely.
Interesting audio interview with Stephen Kotkin in Foreign Affairs.
“We tend to exaggerate the influence that our policies have in Russian behavior, Iranian behavior, Chinese behavior….They’re ancient civilizations that preexist the United States by many, many centuries. And there are internal dynamics there that are deep, profound…. It’s not to say that there weren’t major policy mistakes. Of course there were policy mistakes. In retrospect one can criticize many things that the West did. You just can’t get that to be the prime driver or explanation for where we are with Russia today…”
“In many ways, systems select for leaders. You can get into power randomly through some accident, if you’re appointed, or there’s a death—you name the cases where there’s an accidental rise to power of a figure. But you can’t stay in power for 20 plus years accidentally. You actually have to sustain yourself in power, and that’s much harder, more complex. And so the random characters who might get in are not there 20 years later. But then they’re transformed by being in that position.
The argument of Stalin….. is that he wasn’t a fully formed personality before he got to the position of being the despot of the Kremlin. It was being in that position that made him the figure that we know. Something happened to Putin as well…..”
Our continued addiction to fossil fuels is bolstering Vladimir Putin’s petrodictatorship and creating a situation where we in the West are — yes, say it with me now — funding both sides of the war. We fund our military aid to Ukraine with our tax dollars and some of America’s allies fund Putin’s military with purchases of his oil and gas exports.
~ Thomas L Friedman, NY Times, May 17, 2022