True Start to U.S. vs. China Trade War

Doug Nolan


Let’s begin with the markets. Ten-year Treasury yields dropped eight bps this week to 2.39%, nearing the March 27th low (2.37%). Two-year yields fell seven bps to 2.20%, a 13-month low. German bund yields declined six bps to negative 0.10%, the low closing yield going back to September 2016. German two-year yields dipped another three bps to negative 0.65%. Swiss 10-year yields declined four bps to negative 0.40%, and Japanese 10-year yields slipped a basis point to negative 0.06%. Spanish 10-year yields at 0.88% and Portuguese yields at 1.05% make no sense whatsoever unless huge new ECB QE programs are in the offing. The market now prices a 75% probability of a Fed rate cut by December, up from the previous week’s 59%.

China’s renminbi dropped 1.38% versus the dollar this week to 6.9179, the low since November 30th (offshore renminbi at all-time lows). It’s worth noting that the renminbi is now only 1.2% from breaching the key psychological 7.00 level versus the dollar. Currencies were under pressure throughout Asia. The South Korean won declined 1.5%, the Singapore dollar 1.1%, the Taiwanese dollar 1.0%, the Philippine peso 1.0% and the Indonesian rupiah 0.9%. Weakness spread into EM more generally. The Brazilian real fell 3.5%, the South African ran 1.8%, the Hungarian forint 1.5%, the Chilean peso 1.5%, and the Colombian peso 1.0%.

For the most part, EM bond market calm endured. Problem child Lebanon saw local bond yields surged 24 bps to an almost five-month high 10.65%, with yields up 87 bps so far this month. More concerning, Brazil’s local (real) yields surged 31 bps to 9.09%, the highest level since March.

After somewhat stabilizing (courtesy of “national team” buying), Chinese equities this week resumed their descent. The Shanghai Composite dropped 1.9%, with the CSI Financials index down 2.7% and the ChiNext Index sinking 3.6%. Hong Kong’s Hang Seng Index declined 1.3%, led lower by a 2.1% drop in the Hang Seng China Financials index. Stocks were down 2.5% in South Korea, 6.2% in Indonesia, 3.1% in Taiwan, 2.5% in Thailand and 1.3% in the Philippines. Brazil’s Ibovespa index sank 4.5%.

Though major U.S. equities indices ended the week down less than 1%, there’s a story to tell. Monday trading saw the S&P500 sink 2.4% (DJIA down 617 pts). The President began the morning with a tweet: “China should not retaliate - will only get worse! I say openly to President Xi & all of my many friends in China that China will be hurt very badly if you don’t make a deal because companies will be forced to leave China for other countries.” Less than two hours later, Beijing announced retaliatory tariffs on $60 billion of U.S. goods.

Markets rallied on Tuesday, nerves calmed by the President’s comment that the trade war with China was a mere “little squabble;” “We have a good dialogue going. It will always continue.” “When the time is right we will make a deal with China. It will all happen, and much faster than people think!” A Chinese Foreign Ministry spokesperson said that China and the U.S. had agreed to continue “pursuing relevant discussions.” Treasury Secretary Mnuchin suggested he was planning for a trip to China to resume negotiations.

May 15 – Associated Press (Yanan Wang and Sam McNeil): “What do tilapia, Jane Austen and Chinese revolutionary poster art have in common? All have been used to rally public support around China’s position in its trade dispute with the U.S., as the ruling Communist Party takes a more aggressive approach — projecting stability and stirring up nationalistic sentiment in the process. ‘If you want to negotiate, the door is open,’ anchor Kang Hui said Monday on state broadcaster CCTV. ‘If you want a trade war,’ however, he added, ‘we’ll fight you until the end.’ ‘After 5,000 years of wind and rain, what hasn’t the Chinese nation weathered?’ Kang said. The toughly-worded monologue on the banner evening news program followed days of muted official responses to President Donald Trump’s decision to hike tariffs…”

May 14 – Bloomberg: “Chinese President Xi Jinping denounced as ‘foolish’ foreign efforts to reshape other nations as he pushes back against U.S. trade demands. ‘To think that one’s own race and civilization are superior to others, and to insist on transforming or even replacing other civilizations, is foolish in understanding and disastrous in practice,’ Xi said… at the opening ceremony of the Conference on Dialogue of Asian Civilizations in Beijing… ‘The Chinese people’s beliefs are united and their determination as strong as a rock to safeguard national unity and territorial integrity, and defend national interests and dignity,’ Xi said Tuesday when meeting with visiting Greek President Prokopis Pavlopoulos.”

By Wednesday morning, it was becoming increasingly clear that the “little squabble” was more than a little fib. China’s vice-premier Liu He had stated that China (negotiators and the Chinese people) would never “flinch” in the face of tariffs. After showing restraint over recent weeks, the Chinese media was unleashed. State media declared that China would “never surrender” to external pressure. And from the communist party’s People’s Daily: “At no time will China forfeit the country’s respect, and no one should expect China to swallow bitter fruit that harms its core interests.” CCTV’s “If you want a trade war, we’ll fight you until the end” video (from above) was quickly viewed more than 3.3 billion times.

U.S equities markets opened poorly Wednesday morning, quickly giving back much of Tuesday’s recovery. If Monday’s lows were to have been taken out, market technicals could have quickly turned problematic. Especially after the previous week’s instability, there were large quantities of put options outstanding in the marketplace. Had the markets weakened going into Friday’s expiration, there was a distinct possibility of intense self-reinforcing derivatives-related selling.

About 40 minutes after Wednesday’s open, Bloomberg reported that President Trump was preparing to offer the EU and Japan a six-month window to “limit or restrict” auto exports to the U.S. before imposing new tariffs. The S&P500 jumped as much as 1.4%, a rally that carried into Thursday’s session.

The auto tariff news came at a critical market juncture. Whether it was or wasn’t a coincidence hardly matters. At this point, markets have become quite enamored with the notion of Quadruple Puts – the Fed, Trump, Xi/Beijing and corporate buybacks. When historians look back at this period, they will surely be baffled by the markets’ capacity for disregarding major risks and negative developments. We’re at the stage of a historic - and especially protracted -cycle where it has repeatedly paid to ignore risk. Over time, the successful risk ignorers and dip buyers have ascended to the top. Risk-takers systematically rewarded; the cautious banished. And, once again, those that had recently purchased put options to hedge market risk were left unsatisfied.

The official announcement of the six-month delay in auto tariffs came Friday, along with news that the President was lifting tariffs on Canadian and Mexican steel and aluminum imports. The FT headline: “Trump Eases Trade Conflicts with US Allies.” Rallying markets were receptive to seemingly positive news – that is until a Friday afternoon report from CNBC (Kayla Tausche and Jacob Pramuk): “Negotiations between the U.S. and China appear to have stalled as both sides dig in after disagreements earlier this month. Scheduling for the next round of negotiations is ‘in flux’ because it is unclear what the two sides would negotiate…” One can assume the administration is now working to generate some positive news flow as it hunkers down for a tough fight with the Chinese.

The U.S./Chinese relationship was never going to end well. The lone superpower versus the rising superpower. Vastly different systems, cultures and values. And it would be such a different world these days if not for a decade (or three) of unprecedented global monetary stimulus – cheap (i.e. nearly free) finance that allowed the U.S. to run endless huge Current Account Deficits coupled with easy finance that bestowed upon the Chinese (the curse of) unlimited monetary resources for the most outrageous Credit and investment booms in history. I always expected markets would at some point put a kibosh to this perilous dynamic. It was instead the embittered U.S. electorate and the architect of “Make America Great Again.”

It sure appears as if the Rubicon has been crossed. Beijing has called out the dogs (i.e. state-controlled media) – and public anti-U.S. sentiments have been inflamed. I’ll assume they’re now executing a contingency plan some time in the making: Trump is the unreasonable and disrespectful bully. China will never again be disrespected and pushed around. President Xi - general secretary of the Communist Party, President of the People's Republic of China, chairman of the Central Military Commission, China's ‘Paramount Leader’ and revered ‘Core Leader’ – is precisely the great commander to confront the U.S. hegemon determined to repress China’s strength, advancement and rightful standing in the world.

It’s become difficult to envisage Trump and Xi exchanging pleasantries and doing beaming photo ops next month at the G-20 summit (June 28-29) in Osaka, Japan. President Trump has often touted his close personal relationship with China’s Xi, and the U.S. side seems to believe that a private meeting between the congenial leaders can get talks back on track (worked in Argentina!). Let’s ignore U.S. freedom of navigation voyages through the South China Sea; the administration cozying up with Taiwan; Secretary Pompeo meeting this Thursday with a pro-democracy leader in Hong Kong, etc. Let’s disregard the trail of condescending tweets. And Huawei.

May 16 – Bloomberg: “The Trump administration is pulling out the big guns in its push to slow China’s rise, with potentially devastating consequences for the rest of the world. The White House on Wednesday initiated a two-pronged assault on China: barring companies deemed a national security threat from selling to the U.S., and threatening to blacklist Huawei Technologies Co. from buying essential components. If it follows through, the move could cripple China’s largest technology company, depress the business of American chip giants from Qualcomm Inc. to Micron Technology Inc., and potentially disrupt the rollout of critical 5G wireless networks around the world.”

From CNBC: “Reacting to U.S actions on Huawei, China’s Commerce Ministry said in a statement, ‘We firmly oppose the act of any country to impose unilateral sanctions on Chinese entities based on its domestic laws, and to abuse export control measures while making ‘national security’ a catch-all phrase. We urge the US to stop its wrong practices.’”

My view is that China is adamantly opposed to the U.S.’s use of “unilateral sanctions.” The administration’s insistence on a sanction enforcement regime as integral to the trade deal was a red line the Chinese refused to cross. The U.S. doubled-down with sanctions on Huawei – and until proven otherwise I’ll assume both China’s and the U.S.’s positions have further hardened.

This is a critical juncture for China’s faltering Bubble. Fragilities are acute. The assumption is that China will now move aggressively with additional fiscal and monetary stimulus. Conversely, it’s not an inopportune time for Beijing to take some pain. They have a scapegoat – a villainous foreigner determined to contain China’s rising power. For Beijing, the greatest risk is that its population loses trust in the phenomenal communist party meritocracy.

As noted above, the Chinese renminbi dropped 1.4% this week versus the dollar – and is now just a little over 1% away from the key psychological 7.00 level. “China’s Central Bank Won’t Let Yuan Weaken Past 7 to the Dollar (Reuters’ Zheng Li and Kevin Yao): ’At present, rest assured they will certainly not let it break 7,’ a source told Reuters. A defense of the 7 level could help boost confidence in the currency and soothe investor fears about a sharp depreciation in the yuan… ‘Breaking 7 is beneficial to China because it can reduce some of the effects of tariff increases, but the impact on our renminbi confidence is negative and funds will flow out,’ the source said.”

“At present, rest assured…” Excluding its massive surplus with the U.S., China runs a significant trade deficit with the rest of the world. There’s a scenario where President Trump places hefty tariffs on all Chinese imports into the U.S., levies that over time would be expected to significantly reduce demand for Chinese goods. At the same time, a weakening renminbi would see China expend more for much of its imports. Keep in mind, as well, that Beijing’s current stimulus measures are further fueling its apartment Bubble and resulting consumption boom. It’s possible that China’s trade position is poised to radically deteriorate.

Let’s assume the PBOC does move to defend the 7.0 level (renminbi vs. $). Markets will instinctively test this support – while closely monitoring for indications of the scope of reserves (and forward contracts) expended in the process. And China (and the world) better hope reserves prove more resilient than back in 2015, when they proceeded to collapse by $580 billion over a twelve-month period. If China’s reserves begin to rapidly deplete, expect stringent capital control and other measures to stem outflows. And while everyone believes China will resort to fiscal and monetary stimulus until the cows come home, EM Crisis Dynamics invariably force authorities to tighten conditions to bolster currency and financial system stability.

Friday’s report on University of Michigan Consumer Confidence had consumer sentiment at a 15-year high. Consumer Expectations surged almost nine points to 96 (up from January’s 79.9), to the highest reading since January 2004 – and the second strongest reading going back to November 2000. With stock prices recently (May 1st) hitting record highs and the unemployment rate at 50-year lows, consumer optimism is not unreasonable.

Increasingly, it appears as if the respite from Q4 global market instability has about run its course. As an economy – from governments to corporations to households – I can’t imagine a more poorly prepared system for the gathering storm. I know: fundamentals are “sound” and the banking system is “well capitalized.” Besides, there’s the Quadruple Puts – a deeply entrenched market misperception that really concerns me. Complacency is pervasive – epically so. Ignore fundamental developments, while placing faith in the power of politicians and central bankers (and corporations forever enjoying access to cheap finance to fund buybacks). Such a backdrop creates extraordinary risk for an abrupt change in perceptions and resulting crisis of confidence – in policymakers and the markets.

We started with the markets and will end with the markets. At this point, I don’t see great contradictions between the markets: Safe haven bonds and the risk markets are not actually telling wildly different stories. Seeing low market yields, loose financial conditions, seemingly great underlying U.S. economic fundamentals and Quadruple Puts, highly speculative (trend-following and performance-chasing) markets have been behaving about as one would expect near the end of a historic cycle: an intense, overarching short-term focus on speculative market gains. The safe havens, much less concerned with timing, see speculative Bubbles primed for bursting. Treasuries, bunds, JGBs, Swiss bonds, etc. see an acutely fragile global market structure.

May 14 – Bloomberg (Steve Matthews): “Federal Reserve Bank of Kansas City President Esther George said she’s opposed to cutting interest rates in order to raise inflation to the central bank’s 2% target, warning that could lead to asset-price bubbles and ultimately an economic downturn. ‘Lower interest rates might fuel asset price bubbles, create financial imbalances, and ultimately a recession,’ George… said… ‘In current circumstances, with an unemployment rate well below its projected longer-run level, I see little reason to be concerned about inflation running a bit below its longer-run objective.’”

Markets are not pricing in a 75% probability for a rate cut by December because of current Fed thinking. Chairman Powell is joined by sound thinkers including Esther George that recognize the risks associated with even looser monetary conditions. Markets are instead discerning the high probability of a market dislocation that would so significantly tighten financial conditions that the Fed and global central bankers will have no option other than cutting rates and resorting to more QE.

The breakdown in China/U.S. trade talks provides the initial catalyst. The 3.3% one-month decline in the renminbi (offshore renminbi down 3.9%) is indicative of acute vulnerability in the Chinese currency. And if PBOC support fails to stabilize the market, a crisis of confidence and run on Chinese assets cannot be ruled out. I don’t think one can overstate the financial, economic and geopolitical ramifications of China succumbing to Crisis Dynamics. The world becomes a much more uncertain place. Deleveraging in China would surely equate to global de-risking/deleveraging and highly destabilized global financial flows.

And for the crowd that these days harbors delusions of U.S. markets and economic activity largely immune to global issues, I pose the question: How do U.S. markets perform in the event of illiquidity and a “seizing up” of global markets? As I’ve posited before, the U.S. economy is extremely vulnerable to a dramatic market-induced tightening of financial conditions. What would markets look like if the marketplace turns against negative cash-flow enterprises? How would the U.S. economy function in the event of if debt market illiquidity?

The Powell U-turn granted markets four months of fun and games – and only greater systemic vulnerability. Now comes the downside, with a Fed that just might prove somewhat slower to come to the markets’ rescue than everyone presumes. This week marked the True Start to the U.S. vs. China Trade War. The degree of cluelessness is shocking.

Brutal Gold Futures Action Explains Last Week’s Big Price Decline

Just when it looked like gold futures — which still, unfortunately, dictate the price of physical precious metals — were ready to turn bullish, last week’s commitment of traders report (COT) revealed that commercial traders (usually right at big turns) had gone massively short while speculators (usually wrong at turning points) went aggressively long.

gold COT brutal gold futures

That kind of action usually precedes a price drop, and this time was no exception. On Thursday and Friday, gold fell from $1,294 to $1,277.

godl price brutal gold futures


Presumably, this flushed a bit of the bearish imbalance out of the futures market by forcing some speculator longs to cut their losses and allowing some commercial shorts to book profits. But it probably didn’t send the structure of the market all the way back to bullish. That will take another couple of weeks like the last one.

Meanwhile, gold seasonality has another couple of negative months to run. The following chart shows the average price action by month from 1975 through 2013. Note that June is the third weakest month, but that in July the trend turns positive and stays that way through February, mostly thanks to Asians buying precious metals for Spring wedding gifts.

gold seasonality brutal gold futures


So assuming no external shocks – admittedly a big assumption in a world of trade war with China and possible shooting wars in Iran, Syria, and Venezuela – history predicts at least one more boring month for gold.

Which is another way of saying June might offer some good entry points for precious metals and oversold mining stocks. The following table shows some high-quality miners and streaming companies getting cheaper in the past few months. They might become cheaper still in June:

gold stock prices brutal gold futures


The story, by the way, was pretty much the same at this time last year. See When Will Gold’s “Summer Doldrums” End? History Says Pretty Soon

Trade is just an opening shot in a wider US-China conflict

The current standoff is part of a struggle for global pre-eminence

Philip Stephens




The unnerving thing about America’s trade war against China is that it is just the start. Donald Trump is fixated on trade balances and tariffs. The US president hankers for the 1950s, when US industry swept aside all before it. Among the swelling community of China hawks in Washington, however, resetting the terms of trade is only an opening shot.

While American and Chinese negotiators were trying and failing to reach a trade deal last week, Mike Pompeo, the US secretary of state, was visiting London. His message to Theresa May’s government? Allow China’s Huawei to build any of Britain’s next generation, or 5G, communications network and you can say goodbye to the special relationship.

Back in Washington, Mr Trump announced new measures to effectively ban Huawei from selling technology into the American market and may also prevent it from buying US semiconductors that are crucial for its production.

Six thousand miles away, US warships were steaming through the South China Sea. At the head of a small flotilla of Japanese, Philippine and Indian vessels, the US navy raised another banner. As much as China turns disputed rocks into military outposts to stake its claim to the waters, the US will respond with more freedom of navigation patrols.

Prominent Republicans, meanwhile, were lending support to a new anti-Beijing lobby group. The Committee on the Present Danger: China invokes the cold war against the Soviet Union. The Texan senator Ted Cruz, his colleague Marco Rubio from Florida, and Newt Gingrich, the former Speaker of the House of Representatives, are among those echoing its warnings that China has started a new arms race.

Mr Trump says he hopes to patch something up on trade with Chinese president Xi Jinping when the two meet at the G20 summit in Japan next month. The China hawks have moved on from tariffs. They want essentially to decouple the two nations’ economies.

The president has leaned in this direction with tighter controls on Chinese investment in sensitive sectors of the US economy and new restrictions on Chinese students at US universities. Mr Trump’s answer to complaints that high tariffs are hitting US companies with plants in China is straightforward. Bring the production home. Disentangling American and Chinese supply chains would restore national independence.

Until quite recently, China was viewed as an economic competitor playing an unfair game. It cheated the system by manipulating trade and investment rules, forcing technology transfer from western partners and stealing intellectual property. In the US, the anger at such practices has been widely shared by Democrats as well as Republicans. Europeans have voiced the same irritation with China’s restrictive investment conditions and asymmetric trade rules.

The trade narrative is now being subsumed into a much more alarming one. Economics has merged with geopolitics. China, you can hear on almost every corner in sight of the White House and Congress, is not just a dangerous economic competitor but a looming existential threat. Beijing may not have the same ideological ambitions as the Soviet Union, but it does threaten US primacy. It needs more than a level playing field for trade to confront this challenge.

The shift was foreshadowed in Mr Trump’s National Security Strategy and in the National Defence Strategy produced by the Pentagon. “China is using economic inducements and penalties, influence operations, and implied military threats to persuade other states to heed its political and security agenda,” the first document says. As for the South China Sea: “China has mounted a rapid military modernisation campaign designed to limit US access to the region and provide China a freer hand there.”

The defence strategy aims to dispel any doubt. “For decades, US policy was rooted in the belief that support for China’s rise and for its integration into the postwar international order would liberalise China. Contrary to our hopes, China expanded its power at the expense of the sovereignty of others. China . . . is building the most capable and well-funded military in the world, after our own”. The goal, the Pentagon says, is, “Indo-Pacific regional hegemony in the near-term and displacement of the United States to achieve global pre-eminence in the future”.

The irony is that Mr Trump’s focus on the nuts and bolts of trade during 11 rounds of talks between Washington and Beijing, and his habit of showering compliments on Mr Xi, has obscured this profound shift in US policy.

Nothing stirs US neuralgia so much as technology. Beyond the temporary jolt delivered by losing the space race to the Soviet Union during the 1950s, the US has been consistently confident of its technological lead over adversaries.

No longer. At a recent gathering of US policymakers and experts, speaker after speaker took to the podium to voice fears that China is stealing a march in harnessing 5G digital technology and artificial intelligence applications to its military ambitions.

The danger in all this speaks for itself. Treating China as a certain enemy is a sure way to persuade Beijing that it should behave as such. Mistrust begets mistrust, which in turn could provide the spark for open conflict.

China is no innocent — witness the ever present cyber attacks on western militaries and vital infrastructure. But demonising everything it does simply opens up the path from a trade war to something much rougher. What the two nations need above all are common rules of the road to avoid escalation. Otherwise we are heading towards an altogether hotter war.


Long-term investing is a necessity as much as a choice

The long bull market and QE have led to a drastic change in thinking

Amin Rajan


Aston Martin executives celebrate the car group’s trading debut in October. The number of IPOs is falling in the UK and US (Luke MacGregor/Bloomberg)


John Maynard Keynes said: “When the facts change, I change my mind. What do you do?” The current late-cycle phase of the markets has led many pension plans to do likewise with regard to investment periods.

These funds have always been long-term investors with liabilities spanning many decades but the risk-on/risk-off cycles seen in the early 2010s elevated the sequence of returns risk — the time taken by a portfolio to recover after a big hit.

Since asset prices went up step by step but came down in the lift in that period, it was no longer possible to ignore large short-term losses just at a time when ageing memberships meant pension liabilities were fast maturing.

However, the fresh highs scored by the markets have turned the tables by increasing regret risk: sadness at missing out on what is the longest bull market in history with no reversal in sight.

Time in the market is now more important than timing the market. It necessarily means riding it out while the going is good but being prepared to extend holding periods to recover losses when the bears finally arrive.

Such an extension is evident in both the passive and active space, according to my recent surveys. Currently, 80 per cent of pension plans hold their traditional indexed funds for more than two years as part of their core portfolio. The corresponding figure for exchange traded funds is 45 per cent.

Similarly, 63 per cent of pension plans have a holding period of more than five years for their total equity portfolio and 64 per cent for their total bond portfolio. In all cases, the numbers are up lately and expected to rise over the next three years.

They range from pragmatists at one end, who think they have to accept today’s investing as it is, to believers at the other, who opine that it’s time to go back to basics. Indeed, on that spectrum sit four groups.

The first comprises momentum investors who hold that central banks’ quantitative easing has overinflated asset values by borrowing against future returns. It seems wise to go after juicy returns while they last and let time heal all wounds.

The second group is made up of long-suffering value investors who say that current asset valuations, distorted by QE, appear to be defying gravity. With or without policy unwinding, mean reversion will kick in, if history is a guide. The question is not if but when. The third comprises those keen to minimise that most silent of portfolio killer: implementation leakage. It has become all too clear that how asset allocation works on paper is one thing, what it delivers is quite another; the ex post returns rarely match the ex ante promises.

The implied leakage is due to a variety of factors, including style drift that results in unintended exposures, fees and charges that put a drag on returns, and overtrading that creates all manner of hidden costs and inefficiencies.

The problem is exacerbated by the fact that simulations at the portfolio construction stage concentrate on asset choices. They do not take into account how investors’ own actions and reactions introduce new risks, as do the reactions of other investors as they weigh up new situations. Such feedback loops are nigh impossible to unravel, except perhaps in hindsight.

The final group comprises pension plans with strong governance and skillsets that have embraced long-term investing as a part of a new mantra: active ownership. Their view was recently articulated by Stuart Dunbar, the Baillie Gifford partner, in a provocative paper. According to Dunbar, “what passes for active management is simply the second-order trading of existing assets, with the main focus being to try to anticipate the behaviour of other investors. This has little to do with actual investing”.

Thus, equity markets are no longer conduits between savers planning for a decent nest-egg and borrowers who deploy savings to create wealth, jobs and skills. Mr Dunbar’s view is not only supported by the falling number of initial public offerings in the UK and US, but also by the fact that most of those that come to market aim primarily to help owners to cash out rather than raise capital for future growth.

The EU’s second Shareholder Rights Directive, effective from June, seeks to remedy the situation by strengthening the role of shareholders, enabling them to act like active owners rather than passive holders of paper assets. It promotes a new form of stewardship that is free of fads and clichés. Long-term investing is an idea whose time has come. It remains to be seen how it develops from now.


Amin Rajan is chief executive of Create-Research and a member of The 300 Club

Iran Threat Debate Is Set Off by Images of Missiles at Sea

Secretary of State Mike Pompeo at the United States Embassy in Baghdad earlier this year. The order for a partial evacuation of the embassy adds to the rising tensions between the United States and Iran.

By Julian E. Barnes, Eric Schmitt, Nicholas Fandos and Edward Wong


Secretary of State Mike Pompeo at the United States Embassy in Baghdad earlier this year. The order for a partial evacuation of the embassy adds to the rising tensions between the United States and Iran.CreditCreditAndrew Caballero-Reynolds/Agence France-Presse — Getty Images


WASHINGTON — The intelligence that caused the White House to escalate its warnings about a threat from Iran came from photographs of missiles on small boats in the Persian Gulf that were put on board by Iranian paramilitary forces, three American officials said.

Overhead imagery showed fully assembled missiles, stoking fears that the Islamic Revolutionary Guards Corps would fire them at United States naval ships. Additional pieces of intelligence picked up threats against commercial shipping and potential attacks by Arab militias with Iran ties on American troops in Iraq.

But just how alarmed the Trump administration should be over the new intelligence is a subject of fierce debate among the White House, the Pentagon, the C.I.A. and America’s allies.

The photographs presented a different kind of threat than previously seen from Iran, said the three officials, who spoke on the condition of anonymity because they were not authorized to talk about it publicly. Taken with the other intelligence, the photographs could indicate that Iran is preparing to attack United States forces. That is the view of John R. Bolton, President Trump’s hard-line national security adviser, and Secretary of State Mike Pompeo.

But other officials — including Europeans, Iraqis, members of both parties in Congress and some senior officials within the Trump administration — said Iran’s moves might mostly be defensive against what Tehran believes are provocative acts by Washington.

Either way, the questions about the underlying intelligence, and complaints by lawmakers that they had not been briefed on it, reflect a deep mistrust of Mr. Trump’s national security team.
Working off the new intelligence, the State Department on Wednesday ordered a partial evacuation of the United States Embassy in Baghdad and a consulate in Iraqi Kurdistan, a move that one senior American official said was an overreaction to the intelligence and could possibly do more to endanger diplomats than to keep them safe.

Speaker Nancy Pelosi of California, in a closed-door meeting of House Democrats, criticized the administration’s lack of transparency on the intelligence, according to a Democratic aide. Ms. Pelosi also said that the administration must consult Congress before taking any action.


Speaker Nancy Pelosi and Senator Chuck Schumer both raised concerns over the lack of transparency from the Trump administration about the new threats from Iran.CreditErin Schaff/The New York Times


Ms. Pelosi spoke hours after the evacuation of embassy personnel was ordered by Mr. Pompeo, who as a congressman was one of the fiercest critics of the Obama administration’s handling of the 2012 attacks on the American diplomatic mission and annex in Benghazi, Libya.

But the senior American official said Mr. Pompeo was overreacting, and Iraqi officials said the threat level portrayed in the intelligence was not urgent enough.

Intelligence officials are set to meet on Thursday with senior congressional leaders for a briefing on the new intelligence about Iran. Nine American national security and congressional officials discussed the intelligence and the closed-door talks about it on the condition of anonymity because they were not authorized to speak about them publicly.

Until recently, American government officials had said that Iran was continuing its usual support to Arab militias in the region, but was not seeking a fight.

That shifted with the new intelligence on May 3, changing the Pentagon’s assessment of the immediacy of the threat. Reacting to that information, the military’s Central Command asked that an aircraft carrier and bombers be sent to the Persian Gulf, rebuilding a show of deterrent force that some officials believed had been eroded by recent troop drawdowns.

On May 5, the White House sent Mr. Bolton to announce that the aircraft carrier Abraham Lincoln would sail to the gulf sooner than expected. Choosing Mr. Bolton, who is a longtime advocate of regime change in Iran, to deliver that message fueled skepticism among allies and congressional Democrats.

As military officials struggled to show that the threat from Iran was growing, intelligence officials declassified a photograph of one of the small boats, called dhows, carrying what was described as a functional Iranian missile.

The Pentagon has not released the photograph. On its own, two American officials said, the photograph was not compelling enough to convince the American public and lawmakers, or foreign allies, of the new Iranian threat. But releasing other supporting images could compromise secret sources and methods of collecting intelligence, the officials said.


Mohammad Bagheri, a commander of the Islamic Revolutionary Guards Corps, and President Hassan Rouhani of Iran last month in Tehran.CreditAbedin Taherkenareh/EPA, via Shutterstock


The other photographs, which remain classified, show the Revolutionary Guards loading missiles onto the boats at several Iranian ports, the two American officials said. It is believed the boats are under the Revolutionary Guards’s control.

CNN first reported that Iranian missiles were being moved onto ships last week. But new details have emerged in recent days, and American officials have concluded that Iran did not intend to transfer the weapons to a foreign militia.

Combined with other intelligence, the photographs signaled a troubling Iranian mobilization of forces that officials said put American ships, bases and commercial vessels at risk.

Adding to that concern, the United States recently learned of conversations between the Revolutionary Guards and foreign militias discussing attacks on American troops and diplomats in Iraq. The conversations themselves are nothing new, but the recent discussions were held with unusual frequency and included specifics about strikes on American targets.

American officials said they have also collected intelligence about Iran targeting commercial shipping, prompting a warning to mariners issued last Friday. That was one of the reasons that led American officials to suspect Iran was behind this week’s sabotage of four tankers off the coast of the United Arab Emirates. The officials said they do not have conclusive forensic analysis that shows Iran was to blame.

A Message from the CEO

Why We Need Gold

BY Peter Grosskopf

 
It has been nearly a decade since I made a career change from investment dealer to asset management. Throughout that time, the asset management industry has continued to change dramatically, bringing many benefits to investors. These include overall fee compression, the ability to own almost every conceivable segment of the market through ETFs, some increased participation in "alternative" investment strategies, much-improved access to information and risk disclosure and the proliferation of fee-based accounts providing tailored investment advice.

The markets have delivered strong overall returns globally and those who have not been fully invested have been punished as asset classes of all descriptions rose in tandem, fueled by reasonably strong economies and low-interest rates.

That backdrop underpins the advice of almost all conventional asset managers today — to allocate capital mostly to broad, liquid equity and bond indices, with perhaps some participation in real estate and other dividend-paying asset classes. The global giants in our industry are no longer active investment managers; rather they resemble operators of licensed technology platforms that offer computer-generated models, packaging this robotic advice to their clients in easy-to-swallow bites.

The Cinderella Story Will End

There are ominous signs that dangers lie ahead for this Cinderella story, which has worked for investors lately but will not last forever. For one thing, all of the strategies described above have become increasingly correlated and have benefited from once-in-a-lifetime interest rate reductions. For another, global debt levels are at record levels and can no longer be serviced by the productive engines of the economy and normal tax levels. Many pensions and entitlement programs are past the point of broken and government deficits are out of control. A spate of recent IPOs based on ludicrous price-to-sales valuation multiples are eerily reminiscent of the dot-com bubble of 2000.

From a top-down perspective, there is no question that the combination of the increasing polarization of classes and politics will drive governments globally to adapt populist-leaning policies, rather than those that require moderation. It is clear to me that these dovish policies will now require financing through the hand-in-hand partners of massive deficits and direct currency printing, as justified by some version of Modern Monetary Theory (i.e., "helicopter money"). While inflation, as calculated by the misleading CPI (consumer price index) measure, is currently seen as low, there is simply no precedent by which to predict what might occur as this macroeconomic thriller plays out. An apt summary is that all of the above can be described as a tightly coiled spring which is becoming more loaded every year.

We understand that it is hard to resist the siren song of the solid track record that has been created by the investment industry in the past ten years, and the three decades which preceded it as the boomer generation propelled the markets and the economy. There is also ample logic to suggest that when helicopter money drops one must have some allocation to solid growth and value stocks, as well as dividend-paying real assets. These positions should broadly benefit from the growth and inflation that is initially generated as governments print more money.

Time to Add Portfolio Protection?

A reasonable question to ask is what happens if investors cool to Treasuries, or lose confidence in the purchasing power of their cash, or start to price in the multiple risks that appear to be lurking on the edges of "consensus" expectations? The crowded trade is to do nothing but that is yet another harbinger that the right thing to do is to begin to add some portfolio protection. As we see them, the existing liquid alternatives for insurance would, with U.S. Treasuries losing much of their appeal, be limited to (a) moving to cash; (b) purchasing portfolio protection options or moving to market-neutral funds; or, (c) buying gold or gold equities.     

On the personal side, I accepted the position as CEO of Sprott because I felt, after more than 30 years of experience financing the mining industry, there was an opportunity to establish an industry-leading investment firm specializing in precious metals. I believe that investors will require our expertise as protection against a highly probable pullback in the markets. Lately, my patience has been tested by the markets’ resilient faith in government monetary policies and their proxies — the paper currencies.

Gold is Unmatched as a Diversification Tool

Most investors do not realize that gold is one of the world’s most liquid currencies and assets, trading with volumes equivalent to those of the euro or U.S. Treasury bond benchmarks. Although similar in philosophy, gold blows Bitcoin away on any measure by which the two can be compared. Gold bullion is easy to purchase and the principal risks are timing, fees and expenses. There are significant new developments in vaulting, ETFs and the digitization of gold, which are helping to improve access for all investors.

The digitization of gold is particularly important because it has ushered in the technology and platforms that address the final frontier for gold: allowing gold to be used within the financial system as a viable household-level payment currency which can credibly replace cash. Put yourself in the headspace of a citizen of most countries and you can understand why gold is immediately superior to holding local currency-denominated cash at the bank, which is an almost guaranteed loser of principal value over time. All of this underpins the conclusion that gold is a must-own cash diversification tool that provides a defense against fiat currency devaluation. Gold should be held in the account of every investor at some appropriate percentage. Sprott is exceptionally well qualified and able to assist individual and institutional investors in executing this allocation.

Investing in Gold Equities

In contrast to gold bullion, investing in gold mining companies has been difficult given that metals producers are notoriously tough to value. The last several years have exposed these pitfalls and punished investors as mining companies over-bought, over-built and over-promised, and the quest to uncover value suffered due to the ebbing tide of investor sentiment and the corresponding flows to the sector. Partially because of the weak performance record and partly due to pervasive indexation, gold equities are currently suffering from a severe lack of buying interest and many notable specialist funds have been closed or downsized.

This leaves Sprott in the position of being stock-picking specialists in an underserved, poorly understood market — in other words, smack in the sweet spot of a contrarian investor. Sprott has developed a solid track record in project lending and our equities team has a sound approach to selecting a focused portfolio of the next tier of successful producers.

Perhaps now is finally the time for investors to benefit from a “life preserver” while others enjoy the card game on the decks of the central bank-piloted Titanic.
 

 

Get Ready for the Next Financial Crisis: Gold Provides Proven Portfolio Protection
Gold vs the S&P500

Source: Tocqueville Asset Management. Dates used: 1987 Crash: 8/25/87-10/19/87; Iraq Invades Kuwait: 7/17/90-10/12/90; Asia Crisis: 10/7/97-10/28/97; Russia/LTCM Crisis: 7/20/98-10/8/98; 9/11: 9/10/01-10/11/02; Global Financial Crisis: 10/11/07-3/6/09; Eurozone Crisis: 4/20/10-7/1/10; U.S. Sovereign Debt Downgrade: 7/25/11-8/9/11; Taper Tantrum: 5/22/13-6/24/13; China Worries: 8/18/15-2/11/16; Fed Rate Hike & China Trade War: 9/20/18-12/24/18.

Doing the Haka

Despite the furor that rages, the world appears to be quietly moving along.

By George Friedman


In New Zealand, the Maoris have a ceremonial dance called the haka. Today it’s performed at rugby matches and consists of the New Zealanders making stylized threatening gestures, including sticking out their tongues at their competitors, crouching, jumping and chanting. It is deeply rooted in Maori history, but for all its energy and passion, it does not do what it is intended to do, which is frighten their opponents, and the rugby match goes on.

The political history of humankind is filled with the haka and the violence that was meant to come next. Even at the great turning points, the deepest agonies of humanity, life went on. This was no comfort to those caught in the moment. They died, but in the end, so did everyone. That is of course too Olympian a perspective for most of us, and certainly for those of us with children and grandchildren, but there is a terrible truth to it.

On a lesser level, there are moments when the haka goes on, when all sides are determined to frighten each other and frighten the world, yet it means no more than what it means at a rugby match. Coming back down to earth, we seem to be at a moment like that. The furor rages, but the world appears to be quietly moving along.

The Americans and the Chinese have been locked in a “trade war.” There has been great anticipation of catastrophe for both sides, yet the world remains unchanged save for the noise.

The North Koreans have nuclear weapons. The Americans don’t want them to. Each meeting is greeted with the expectation that something will happen. Apart from each side pulling frightening faces, nothing does.

Russia continues to lick its wounds after the collapse of the Soviet Union and the loss of Ukraine. Threatening gestures are made in places that hardly matter to Moscow, like Syria, and Russia struggles with the price of oil, but little of substance takes place.

On the Continent, there are those who regard the European Union as the source of Europe’s redemption, others who see it as a necessary evil, and still others who see it merely as evil. Each faction has utter contempt for the other and makes frightening faces, but nothing comes of it.

In the Middle East, the lines shift as Arabs and Israelis face the Iranians in a battle never really joined. The Kurds and the Palestinians demand statehood, but both are still far from reaching their goal.

And in the United States, Donald Trump is president and the Democrats despise him. Each day, each side invents a new way to hurl contempt, and the viewers are enthralled by the venom. But at the end of the day, Trump sleeps in the White House and those who feel this is outrageous demonstrate their outrage.

There are, of course, places where terrible things are happening, and they must not be dismissed. But such dreadful things have been going on for a long while and will likely continue beyond our time.

This is not the normal condition of the world. Think of the 2008 financial crisis and the great movement of global power that it incited, with China staggering economically and Europe fragmenting politically. These are not moments but rather unfolding trends. Nothing is settled, even when things come to a standstill, as they appear to be now. Nothing is leading to anywhere. Trade wars continue without coming to a head, nuclear talks lead nowhere, gestures of power remain gestures, and ancient animosities continue to show themselves. And the politics of the time plod on, resembling a haka more than any great historical moment.

In one sense, it has always been this way, the blood and fury flowing while humanity goes on.

At other moments, they are the signs of a period that has exhausted itself. That is what our current moment looks like. What 2008 created has run its course, and the world is waiting for the next act in the never-ending drama. But such moments of meaningless paralysis can continue a long time; in retrospect, they are good times, but in the moment, they frustrate those who aspire to great things. It is a moment of mediocrity, in which the haka challenges the course of history, but it does not capture the moment that is coming.

The problem is that once the haka has been danced, eventually the game begins. We seem to be in the haka interlude, with dances meant to inspire terror being performed and onlookers seeing the performance as merely odd. But the period of gestures will end. Where the future war will break out is truly unclear. At the moment, none of these hakas warrant war. But wars never seem to warrant violence until they are underway.

The world, as always, is filled with genuine issues that affect nations profoundly. In due course, the gestures end and the issues are settled. Some of the lesser issues can be resolved with calm discussion. It is the most significant ones that transit from the gesture to the conflict. It is rare that all explode at once. But equally rare that none explode at all.

Taiwan: More Than a US Friend of Convenience

U.S. assurances to Taiwan are intentionally vague. U.S. interests in Taiwan are crystal clear.

By Phillip Orchard


Last Wednesday marked the 40th anniversary of the Taiwan Relations Act – the U.S. law shaping de facto diplomatic relations between Washington and Taipei. Taiwanese President Tsai Ing-wen celebrated the occasion by doing what most of her predecessors have often found themselves having to do: exhorting the U.S. to prove that it still “considers the security of Taiwan vital to the defense of democracy.” This comes amid Taipei’s latest push for a tangible demonstration of U.S. commitment to Taiwanese security, this time by approving the sale of more than 60 F-16 fighter jets to the self-ruled island, which China considers a renegade province.

Taiwan hasn’t lacked for attention under the Trump administration. Two months before Donald Trump even took office, he took an infamous phone call from the Taiwanese leader, violating decades of protocol and antagonizing Beijing, but effectively acknowledging that the game of diplomatic make-believe around the issue of Taiwan had become rather silly. In early 2018, the U.S. Congress passed legislation allowing the resumption of high-level official visits between Washington and Taipei that became taboo after 1979. In March, a U.S. warship sailed through the Taiwan Strait for the fifth time in six months. 




(click to enlarge)


Yet, with the balance of power between Taiwan and China shifting dramatically in the latter’s favor, and with Beijing repeatedly declaring its intent to reunify (by force, if necessary), Taipei’s perpetual unease is understandable. After all, Washington designed the Taiwan Relations Act to give itself ample flexibility to reinterpret the law if changes in the broader strategic environment necessitated it. Forty years later, in other words, Taiwan’s fate is still tied firmly to a superpower an ocean away that Taipei suspects could someday conclude that it has bigger fish to fry. But that day won’t arrive anytime soon.

A Diplomatic Dilemma

The Taiwan Relations Act was an inelegant but effective fix to a diplomatic dilemma that started with President Richard Nixon’s landmark trip to China in 1972. At the time, the strategic interests of Beijing and Washington were converging. The U.S. wanted China to stop meddling in Vietnam and, more important, to cooperate against the Soviets. China, which had fought a major battle with the Soviets along the Siberian border a decade earlier and feared additional attacks, was inclined to coordinate with Washington against the Soviets.

But Washington struggled to appease both China and Taiwan, and so the normalization process with Beijing dragged on for another seven years as the U.S. tried to come up with a way to let both sides save face and preserve the cross-strait status quo. Since China was too weak to retake Taiwan by force – and since Beijing was demanding few substantive changes to U.S.-Taiwanese defense or trade ties – Washington was happy to endorse the “one China” policy and shift diplomatic recognition to Beijing. It was easy enough to close its embassy in Taiwan and reopen it as the American Institute in Taiwan, a nongovernmental organization that happened to be manned by U.S. diplomats (and, since 2005, U.S. military personnel).

Somewhat more problematic, Washington also had to formally pull out of the 1954 Sino-American Mutual Defense Treaty, which meant that it needed a mechanism to maintain military ties with a government in Taipei it no longer recognized as legitimate. The solution, introduced in Congress less than two months after U.S. diplomatic ties shifted to the mainland, was the Taiwan Relations Act.

The act includes two key passages. Both are notably vague in keeping with the U.S. principle of “strategic ambiguity,” which allows the U.S. to avoid military entanglements not of its choosing. (Formal U.S. mutual defense treaties are likewise imbued with this principle.)

The first passage describes how the U.S. would respond to an attack on Taiwan: “[The U.S. will] consider any effort to determine the future of Taiwan by other than peaceful means, including by boycotts or embargoes, a threat to the peace and security of the Western Pacific area and of grave concern to the United States.” This isn’t exactly an ironclad commitment.

Every U.S. administration since President Jimmy Carter has sought to augment this clause with various clarifications and promises intended to reassure Taipei, but its ambiguity continues to make Taiwan uneasy.

For the U.S., however, balance and flexibility have remained the priorities. President Ronald Reagan, for example, gave Taipei his “Six Assurances,” promising, among other things, to continue arming Taipei without asking first for permission from Beijing. But he also committed in the “Third Communique” with Beijing to gradually reduce arms sales to Taiwan. The Clinton administration, focused firmly on boosting economic ties with Beijing, reinterpreted the act to allow for further international isolation of Taiwan, and then sent a carrier group into the Taiwan Strait in 1996, humiliating Beijing, in response to a series of Chinese drills simulating an invasion.

The second key passage in the act is intended, in part, to avoid ever having to decide whether to come to Taiwan’s rescue in the first place: “The United States will make available to Taiwan such defense articles and defense services in such quantity as may be necessary to enable Taiwan to maintain a sufficient self-defense capability.” Since 1979, the U.S. has sold Taiwan more than $25 billion in arms. Still, what’s sufficient for Taiwanese self-defense is open to interpretation. What Taipei thinks Taiwan needs and what Washington thinks Taiwan needs have, at times, differed widely. Ultimately, it’s up to Congress and the White House to make that determination. And the U.S. inevitably has myriad factors to look at when considering an arms sale to the self-ruled island. The U.S. is wary, for example, of giving Taipei cutting-edge technology because of Taiwan’s extreme vulnerability to Chinese espionage. More broadly, the U.S. is constantly either at odds with Beijing or in need of Chinese cooperation on one issue or another. Reagan’s assurances notwithstanding, the timing and scope of arms sales to Taiwan will inevitably be seen as something of a U.S. bargaining chip with Beijing – especially in an environment where a Chinese invasion appears a pipe dream.

Island Bliss

Taiwan has geography on its side, and it’s a technological powerhouse in its own right. So it doesn’t need the full weight of U.S. power on its side to keep China at bay. (Early on, in fact, the U.S. was worried about giving Taiwan too much, lest Chiang Kai-shek and the Kuomintang try to restart the Chinese civil war.) A Chinese invasion of Taiwan would be exceedingly difficult. It doesn’t matter how many troops, arms and supplies the Chinese army can amass on the shores of Fujian province across the Taiwan Strait. To invade Taiwan, China would need the bulk of its forces to get into boats and make an eight-hour voyage into the teeth of Taiwanese firepower coming from well-entrenched, well-supplied onshore positions. They would be funneled into just a handful of acceptable landing zones and met by as many as 2.5 million well-armed troops and thousands of armored fighting vehicles and self-propelled artillery. China’s army is almost entirely bereft of experience with amphibious operations in a modern combat environment. Amphibious war requires extraordinarily complex coordination between air, land and sea forces, especially with logistics. An enormous number of things must go right for China to succeed, and the political risks of failure would be sky high.

Still, for Beijing, reunification is a matter of when, not if. Politically, Taiwan is a perpetual scar on the Communist Party’s narratives about the communist victory in the Chinese civil war, and the party routinely nurtures grievances about foreign meddling in Taipei to curry nationalist support for its right to rule. Strategically, so long as the U.S. can pair its superior naval and aerial capabilities with bases and allied support along what’s known as the first island chain – Japan, Taiwan, the Philippines and Indonesia – it poses a threat to block sea lanes that are critical to China’s export-dependent economy. And more than any other island in this chain, Taiwan could be used by a foreign power to threaten the Chinese mainland itself. Retaking Taiwan would blow a hole in the U.S. containment strategy – and put China in a more enviable position to threaten Japan’s southwestern islands.


(click to enlarge)


Thus, the possibility that the U.S. (along with allies like Japan) may, in fact, intervene on Taiwan’s behalf is, more than anything else, preserving the status quo. And Taiwan does have some reason to question the continued willingness of the U.S. to do so. While China may still be incapable of mounting an invasion with an acceptable chance of success, much less going toe-to-toe with the U.S. in open waters, it is developing the capabilities to make it increasingly costly for the U.S. to go to battle closer to the mainland. Unlike other U.S. allies like the Philippines and Japan, Taiwan is located well within range of China’s growing “fortress fleet” of onshore anti-ship missiles, air power and swarming maritime forces.

But the fact remains: Control of the Pacific is important enough to the U.S. that Taiwan can neither be left to its own devices nor bargained away. Strategic ambiguity cuts both ways; the U.S. doesn’t have to convince Beijing that it will intervene, just that it might and that it can.

And for the time being, at least, the U.S. can defend Taiwan without putting its surface ships at risk, much less bringing its own amphibious forces into the fray. U.S. missiles and air power could pick off amphibious forces like sitting ducks and impose severe retaliatory costs on the mainland, while the vastly superior U.S. (and Japanese) submarine fleets thwart a Chinese blockade.

Ultimately, to take Taiwan, China has to think it’s ready to take the entire Western Pacific.

China does not think it will be ready for this for decades to come. Until then, it’ll be stuck fruitlessly trying to coerce Taipei back into the fold via economic and political coercion. Thus, Taipei is largely in the same situation it was in 1979: anxious, isolated and comfortably secure.

Time to Become a Hindu

By Jeff Thomas





For centuries, East Indians have regarded gold as the primary source of wealth. All Indians own gold if they can afford to. They keep it as close as possible, sometimes in coin form, but often as jewellery, since “wearing wealth” means that it can be kept very close. They’re often especially reluctant to trust banks to hold their gold.

Hindus make up 80% of India’s population and, to Hindus, gold is sacred. Lakshmi (pictured above) is the Hindu goddess of purity, prosperity and good fortune. Her symbol is gold, so gold plays an important part in Hindu ceremonial occasions and Hindus donate large amounts of gold to the temples in Lakshmi’s name.

In recent years, the Indian government has tried one ploy after another to gain control of the temples’ gold. The most recent ploy was a programme whereby the temples could deposit the parishioners’ gifts to Lakshmi in banks. The gold would then be melted down and the temples would be given cash in an amount that would exceed the value of the gold.

Sounds pretty good. In many countries, the average individual would be shortsighted enough to go for it, thinking that he would have a few extra rupees. Internationally, even some Prime Ministers have thought it a good idea. UK PM Gordon Brown sold England’s gold at the bottom of the market between 1999 and 2002. More recently, Canadian PM Justin Trudeau sold off all of Canada’s gold during a major downward correction as soon as he took office. (Two excellent examples of proof that it’s possible to be elected the leader of a major country and still be an imbecile.)

But, returning to India, those running the temples tend to be distrustful of governments. Most are also distrustful of bank storage, although some do store gold in banks. The majority of the gold that they hold, however, remains in the temples.

The Indian government has also attempted to tax the gold in the temples, but the temples, quite rightly, have stated that they don’t actually own the gold. They hold it in trust for Lakshmi. (Good luck trying to tax Lakshmi.)

Governments have no problem telling people what to believe, except when it has to do with religious belief. Then they get quite skittish. So, to date, the Hindu religion has been a major deterrent to governmental success in getting Indians to part with their gold. And will continue to be. (I don't think that, in my lifetime, they'll have significant success. If God says wealth and prosperity are to be respected, it's hard for the government and media to counter that belief. And Lakshmi continues to be rather firm as to God’s take on the subject.)

Elsewhere in the world, governments of most western countries have succeeded in convincing roughly half of their populations that wealth is evil and shameful. It’s okay for a rapper to wear several pounds of gold jewellery, but it’s immoral for the average person to have a few eagles or maple leafs stored for a rainy day.

That means that the average man’s wealth is at greater risk. Governments tend to be parasitic creatures with no moral compass whatever. They’ll do whatever they can to diminish the power of the individual and to separate him from his wealth. The system of taxation is essentially a shakedown operation.

The only limiting factor in any government taking everything you have is that political leaders do worry about their image. They want to appear to serve the electorate so that they can be re-elected. So, they have to tread lightly. They can even force their citizens to pay tax on income derived from another country by implying that if tax is not paid, the income must have been gained through money-laundering.

They can take your possessions through civil asset forfeiture if they can imply that you are suspected of having committed a crime. And they can take away your “inalienable” rights if they can suggest that you might be suspected of terrorism connections.

Likewise, they can take away your gold. All they need do is convince the majority of people in your country that your ownership of it is somehow evil. To date, no country has fully succeeded in doing this.

But, recently in the West, this idea has been growing some legs. The socialist ideal has been blossoming in the EU, US, Canada and elsewhere in the former Free World and, along with it, the irrational concept that “earned wealth is evil” has been taking root.

Pop stars and sports figures can have monetary reward heaped upon them without being in any danger of social persecution. And politicians can have expenses that run into the millions annually, plus a host of benefits that are unknown in the private sector.

Yet, the owner of a business, however small, is looked upon as someone who has somehow looted the populace if he sells a good or service for the purpose of profit.

This is, of course, an astonishingly irrational position for anyone to take. As Thomas Sowell has observed,

“I have never understood why it is greed to want to keep the money you have earned but not greed to want to take somebody else's money.”

And that astute observation is from an academic (not a businessman) who grew up in Harlem.

What this means is that, for each of the jurisdictions above, those who have lived responsibly – those who produce more than they consume and save the difference - are in for a rude awakening.

In order for their governments to pay for the new socialism that’s on the way, they’re going to have to balance the equation by taking from someone and that someone will be the guy who has retained wealth (however great or small.)

His wealth will be taken from him for “the greater good.”

As every Indian - even those of limited means – understands, the greatest protection from such looting by governments is to liquidate assets and convert the proceeds into precious metals.

It’s unlikely that the average westerner will become a Hindu, but, if he’s wise, he’ll acquire his own personal Lakshmi in the form of precious metals storage and he’ll do so outside of his home jurisdiction, in order to have even greater insurance against confiscation.

What Donald Trump gets right about the US economy

The president understands monetary policy has done more for the markets than Main Street

Rana Foroohar




It is amazing how adept Donald Trump is at identifying something important in the felt experience of the American public and then exploiting it for his own gain. So it has been with his suggestion that businessman and former presidential aspirant Herman Cain should be on the board of the US Federal Reserve. Just when we thought it couldn’t get any worse than pundit Stephen Moore, Mr Trump presents the Pizza King.

It is easy to dismiss the suggestion as the latest example of the president’s economic cluelessness — as four Republican senators have done this week, making it unlikely that Mr Cain will secure a seat on the Fed board.

But we shouldn’t be dismissive. It is true that Mr Cain has no idea how financial markets work. This is a man who, along with Trump nominee Mr Moore, wanted interest rates to rise right after the 2008 crisis. But the president’s defence of Mr Cain is that he is not a policy wonk, but rather a job creator who understands Main Street. Mr Trump cares only about packing the Fed with political lackeys. However, he has nevertheless hit on an important truth — that monetary policy over the past decade has done much more for the markets than the real economy.

Consider that since the beginning of 2010, real hourly wages in the US have grown by only 6 per cent, while real housing prices have grown by over 20 per cent and inflation-adjusted stock market valuations have doubled. Household incomes have grown quicker than wages, thanks to employment growth. They are up 10 per cent from 2010 to 2017, though they still lag behind asset price growth. Meanwhile, the period 2007 to 2016 saw the largest increase in wealth inequality in the US on record.

This, along with record levels of corporate indebtedness relative to gross domestic product, were unintended consequences of the Fed’s efforts. The central bank could bolster asset prices, but couldn’t remove the principal drags on the economy. These do not stem from a lack of money, but from deeper challenges that monetary policy can’t solve — from a skills and jobs mismatch, through an ageing workforce, declining geographic mobility and greater corporate concentration, to technology-driven labour market disruptions.

You can’t fix those things with low interest rates and quantitative easing alone. You need fiscal policy decided on by elected officials, not technocrats. But polarised governments cannot deliver it. This is a conundrum not only for the US, but also in Europe, where arguments rage about the effectiveness of the European Central Bank’s monetary firepower and the merits of a co-ordinated programme of fiscal easing across the eurozone.

I worry a lot about this overdependence on central bankers. It amazes me that many of the same people who worried about too much easy money causing hyperinflation after the crisis (Messrs Moore and Cain among them) now argue for lower rates — not because they care about ordinary people particularly, but because it suits their political aims. We should call this exactly what it is: buck-passing — the kind that has happened many times before when presidents have wanted to paper over their problems with cheap debt.

It is not only Republicans who want to have it both ways, either. The current popularity on the left of “modern monetary theory,” or MMT, is driven by the idea that it holds out the prospect of a “people’s QE” of the sort proposed in 2015 by Jeremy Corbyn, the leader of Britain’s Labour party. The belief among some Democrats in the US is that they could circumvent contentious political debates over tax and spending by empowering the Fed to use its balance sheet to fund not financial asset inflation but real growth-creating investments in education and infrastructure.

The success of such a scheme would depend on low interest rates, low inflation and relatively sanguine credit markets. Whether or not you believe those conditions will remain, MMT would also politicise the Fed by making it appear that the central bank was being used to accomplish specific policy goals outside the democratic process. This, of course, is exactly what Mr Trump is doing, albeit to very different ends, right now.

The bottom line is that we are exactly where we were in 2008 — with politicians looking to central bankers to do what they can’t. But why would we ever believe that the Fed (or the ECB) could somehow magically change the fact that we have a bifurcated economy and a looming skills gap? Central banks can’t create growth by themselves. They can only funnel money around.

Mr Trump wants to disrupt the Fed for his own gain. But the Fed is already disrupting itself. The US central bank has recently embarked on a major review of its monetary policy framework, including a listening tour in which regional governors will be talking to people outside their ivory tower — business leaders, mortgage borrowers, pensioners, millennials, labourers and entrepreneurs. The idea is to consider the ways in which the real economy has changed over the past several decades, and think about whether monetary policy should evolve too. Perhaps by the time they finish, we’ll also have an administration and a Congress ready and able to play their part.


A Deep Dive Into U.S. Liquidity

by: Trading Places Research

 
Summary
 
- Since the crisis, the real money supply has inflected above the historical trend, the result of Fed actions and the lack of inflation that has typically accompanied money supply growth.

- While the Fed has been successful in inflating the money supply, they have been less successful at juicing nominal GDP growth.

- Historically, the nominal money supply and asset prices are tightly correlated, but this has become unglued in the last 2 years.

- The major risks here are a version of the liquidity trap, and systemic liquidity risk.

- The experience of Japan is instructive: low population growth, low economic growth, low inflation, low interest rates. This is not a recipe for a dynamic economy.
 
 
 
Why I Read The Comments, Against Everyone’s Sage Advice
 
In my recent Q2 Outlook, here’s how I framed recent trends in US equities:

There is a tug-of-war happening right now. The fundamentals are souring everywhere you look at the beginning of 2019, yet equities surged globally in response to increased central bank liquidity, and what people believe that means.  
But as we saw up top, these valuations are not justified by the growth of the economy generally or corporate profits specifically. 
The entire point of increased central bank liquidity is to reduce the cost of capital so that marginal or high risk/reward investments go from thumbs down to thumbs up.  
But that’s not what’s happening. Outside of IP investment, fixed investment growth and productivity growth have been moderate at best. 
So where is all this capital going? First, to the tune of an additional $1.25 trillion in 2018, it is going to fund the federal debt at rates barely above inflation. That should tell you what investors think about other opportunities. Second, at least for the S&P 500 companies, the increased cash flows they are generating from all this liquidity is going back to shareholders. Some companies are even issuing debt to return cash to shareholders, raiding their own balance sheets, because long term rates are so low.  
Again, there doesn’t seem to be much interest in investing in new capacity. Finally, with the increased savings rate, consumers put an extra $300 billion in the bank during December and January compared what they would have at the old rate. 
So right now we are floating on a sea of global central bank liquidity, but soon, like Japan, we may start drowning in it.
A commenter, awesomely named DorkVader, brought up the money supply, which has been a little softer than it had been. I realized that I had left a large part of the story on US liquidity out, which I intend to rectify now. Thanks Vader! (Did I just type that?)
 
Defining What We Mean By Liquidity
 
“Liquidity” is a word that is used to mean different things in different contexts. There is accounting liquidity, and market liquidity, and systemic macro liquidity. But they have one thing in common: cash is king.
 
Take a simple example. You want to buy a new car that costs $30k. If you have $30k cash in your house, you can walk down to the dealer and make a deal right there. If that $30k is in a checking or savings account, you may have to get a bank check before you get your car. If that $30k is in stocks, you will have to sell them first, and you don’t get to choose your price, so you may have to wait, or take less than $30k. Each of these things is progressively more illiquid, because they take longer to turn into cash and subsequently a new car.
 
But what if your money is tied up in your one-of-a-kind collection of potato chips shaped like famous people’s heads, which you value at $30k? Needless to say, the barter possibilities with the auto dealer are doubtful.
 
So you have to hop on eBay (NASDAQ:EBAY) and auction them off, which will take time, and the market for novelty potato chips may not be as, um, liquid, as you thought it was, so you may have to wait a long time, or take less than $30k.
 
The point here is that cash is king and assets can be converted to cash easily at acceptable prices when there is a lot of systemic liquidity - cash in readily available places. The potato chip example is what happens when market liquidity dries up, like it did in 2007-8. The mortgage-backed assets that everyone thought were worth something turned out about as valuable as those potato chips, and no one wanted to exchange cash for them.
 
This brings us to…
 
 
Systemic Liquidity Risk: These Potato Chips Are Worthless!
Suppose you really want that new car, but also don’t want to sell those potato chips, which you believe will only increase in value with time. So you take out a loan to finance the car, thinking if something goes wrong, you can always sell the chips.
 
This is called the wealth effect. You look at what you think the value of your potato chips is, and think you have $30k to consume, when in actuality, you just have some potato chips. So now you are in debt to a bank, and making monthly payments.
 
But then the economy sours, and you are no longer able to make those monthly payments. When you go to sell the chips, you find that people have begun to prefer cash and cash-equivalent government bills to riskier assets and aren’t willing to part with it. The auction goes poorly, and you are forced to default on the loan, losing the car and declaring bankruptcy.
 
The bank gets the car, but its value doesn’t nearly cover the outstanding loan amount. Also, it turns out that there were quite a few people besides you who were goaded into new purchases by the wealth effect, who also just defaulted on their car loans. The bank, which valued these loans as pretty good risks, then packaged them and sold them to buyers, just blew a huge hole in its balance sheet.
 
But it’s not just the bank. All those buyers, many of whom are other banks chasing yield, also had to reprice those assets, and now they have a huge hole in their balance sheets. Credit freezes up - even though there’s plenty of cash in the system - because of some improperly valued potato chips. This is the unusual situation where systemic liquidity does not translate into market liquidity.
 
So having enough liquidity is important for price stability and it keeps credit flowing during normal times. But when everything is headed downhill, the central bank has to step in and use its full suite of tools to restore order. Most notably, this is the Fed Funds rate and federal debt purchased by the Fed, i.e., quantitative easing. In 2009, they also bought a lot of worthless potato chips at inflated prices.

But the trend over the last 20 years, pretty much everywhere, is that even when restoring order, the increased liquidity in the system is not going to investment that improves GDP growth, but into asset-price inflation, while goods and services price inflation remains muted. The old economic “truism” that Savings = Investment no longer holds, unless you count $1.25 trillion in new federal debt in 2018 as an “investment."
 
Fifty years of supply-side thinking have made everyone forget that demand exists. Without demand, the beneficiaries of increased systemic liquidity have no reason to invest in new capacity, and all of a sudden a 5-year Treasury bond 14 bps below Fed Funds sounds pretty good.
 
Liquidity: You’re Soaking In It
 
Who knew Admiral Ackbar knew so much about macroeconomics?
 
 
The thing that I underestimated coming into 2019 is how much the sea of liquidity we have been soaking in over the past decade has affected sentiment. The only news that seems to interest investors these days is central bank liquidity, and how much they can fill up on.
 
As is typical at the end of cycles, sentiment has become divorced from fundamentals. In the past, it has usually been investors chasing growth, like in 1999, or yield, like in 2006. Now everyone chases any signs of liquidity in the system, whether they understand what that means or not. Demand for US Treasuries remains very high despite all-time record supply, because many investors see an interest rate just above inflation as the best use of their capital. No amount of added liquidity is going to change that.
 
The surge in buybacks is clear evidence that companies don’t believe investing in new capacity with all this liquidity is a very good bet. They have generated record amounts of cash, and are returning all of it to investors. Some companies are even taking out debt at historically low rates to do buybacks, essentially raiding their own balance sheets.

In 2018, the S&P 500 companies returned over 99% of GAAP earnings to shareholders. To put this in context, all US companies spent an additional $251 billion in nominal dollars over 2017 on all fixed investment in all of 2018. Instead of adding to that, just the S&P 500 companies chose to return $1.26 trillion to shareholders, a $324 billion increase over 2017, the previous record year. This should tell you everything you need to know about how corporate leadership view organic earnings growth prospects.
 
This is a version of the Liquidity Trap that Keynes originally described. In his telling, when interest rates hit the lower bound, investors prefer cash to bonds and stop buying, driving rates back up when the central bank is trying to keep them low.
 
In this version, let’s call it LT2.0, the system is awash with liquidity, but the growth in the system doesn’t seem as attractive as a 6-month bill at 2.45% yield, or a 3-year bond at 2.26%, or the 10-year Bund at 0.07%, or buying your own shares. So the central bank loses the ability to juice the real economy with cuts to the lower bound, and only inflates asset prices.
 
Just How Awash Are We?
 
Lounging in a sea of liquidity. Itamar Grinberg for the Israeli Ministry of Tourism.
 
 
Pretty awash, but not like we were going under. Yet.
 
There are two primary measurements of liquidity: the M1 and M2. M1 is currency and checking accounts, whereas M2 includes savings accounts, money market funds and small short-timed deposits like short-maturity CDs. We’re only going to be talking about M2, the broader measure.
 
All money supply measurements come from Fed Table H.6 "Money Stock and Debt Measures.”
 
First let’s look how the money supply has grown in nominal dollars
 
As we should expect, the money supply grows exponentially, but we have been well below trend since 2004, with the inflection happening in the early 1980s after a bulge in the late 70s. What we are seeing is the effect of inflation, or the lack thereof, on the nominal money supply and vice-versa.
 
 
 
 
Since the peaks in the 70s, inflation has remained tamed. At first, the policies of the Volker Fed broke the back of inflation and brought it back to more reasonable levels in the 3-5% range. But after the 90s recession, inflation began dropping into its current range of 1.5-2.5% without any significant Fed policy driving it. Since then, inflation has remained historically low, and the Fed has not had big inflationary cues to raise the Fed Funds rate. As investors became convinced that the new low-inflation regime was not going anywhere, long term rates, as represented by the 10-year Treasury, have been dropping steadily over this long period.
 
So let’s get rid of inflation and look at real M2, using a 2012 chained-price deflator.
 
 
So this changes the picture radically. Even subtracting inflation, M2 grows exponentially. But now we see that real M2 has been well above trend since 2011, with the inflection happening at the financial crisis, and the Fed’s dramatic actions in its wake to reflate the economy.

In the past, nominal M2 growth over time has more or less been the same as nominal GDP growth (real GDP growth plus inflation). But since the recession, they have become divorced by Fed actions.
 
 
 
 
The blue line is the annual spread between nominal M2 growth and nominal GDP growth. In the pre-2008 period, the average YoY change was -0.21% (red line), basically zero. But since 2008, the average has been 2.94% (green line). This is the effect of the Fed actions. They have inflated the money supply, but not the economy nearly as much. Both real GDP growth and inflation remain muted.
 
While the low Fed Funds rate had a lot to do with this, there are diminishing returns to rate cuts as you approach the lower bound, so the Fed began quantitative easing, or buying US government debt at scale, as well as worthless mortgage-backed securities at inflated prices.
 
The Fed has always kept some US debt on the balance sheet, both for the same reasons all banks do, but also to fill small holes in Treasury market liquidity as they arise at auction.
 
Leading up to the recession, they held about half a trillion dollars in US debt, which had very little effect on the money supply.
 
But someone had the bright idea that if they bought small amounts of debt to fill small holes in liquidity, if needed, they could buy large amounts of debt to fill large holes in liquidity. So if we look at the M2 and subtract the liquidity the Fed has added with its balance sheet, we can see the huge gap that opened up. We’ll call this new measure M2-FED. To be clear, this is nominal M2 minus the sum of Fed holdings of US Treasuries, federal agency debt and mortgage-backed securities (from Fed Table H.4.1), then deflated with the 2012 chained-price index.
 
 
The red line approximates what would have happened to M2 had the Fed not stepped in and you see it is not pretty. We can clearly see the effects of the sequester (AKA, The Dumbest Bill Ever) on the reduction of M2-FED in 2013-2014, which forced the Fed to step in with more QE to keep M2 growing. Since 2015, the M2-FED has been growing at a very nice clip, but the balance sheet remains, and they will begin backdoor QE4 this fall. In the media, you have likely heard this referred to as “printing money,” or “monetizing the debt.” Both are accurate characterizations.
 
To be clear, monetizing the debt is a good thing in crisis times, but not so much at the end of the cycle.
 
So to sum up:
  • Over time, nominal M2 grows exponentially. Its growth historically has mirrored the growth of nominal GDP.
  • Since the last recession, real M2 has inflected above the historical trend. This is the result of Fed actions, particularly quantitative easing, and the lack of inflation that has typically accompanied increases in the money supply.
  • While the Fed has been successful in inflating the money supply, they have been less successful at juicing nominal GDP growth. On average, there is a 3% per year spread in the growth rates since the crisis.
  • Without Fed actions, the money supply would have been a hugely disastrous situation in the early recovery years.
  • Instead of juicing nominal GDP growth, the Fed-sponsored M2 growth has gone to asset price inflation.

M2 and the S&P: A Love Story

 
Let’s dig a little deeper on asset price inflation. I will be using the S&P 500 as a proxy, but you could use the Case-Shiller home price index, or any other asset price index, and the results are similar. Since the S&P is nominal, we will be using nominal M2.
 
Stats 101 caveat! Correlation does not equal causation. You have been warned.
 
Starting with the historical data going back to 1959, we can see that in this long period, M2 and the S&P are highly linearly correlated.
 
 
But since 1994, in the period of low interest rates and low inflation, the two have become much less correlated, as the relatively low Fed Funds has produced more exogenous factors affecting the S&P.
 
 
 
But to get back to where we started all this, since the crisis the S&P has become even more tightly correlated to the money supply than ever before. As we saw above, much of the growth in the M2 in this period is Fed-sponsored QE, made possible by the US deficit, so all four are correlated.
 
 
 
But since 2017, the promise and then reality of late-cycle stimulus from the federal budget left the two unmoored from each other.
 

I’m not a shrink, but I play one on Seeking Alpha. Seriously, I do spend a lot of time thinking and reading about market psychology, because I believe this is the most underappreciated aspect of analysis.
 
The experience of the post-crisis era (“Staying Together for the Kids”) has created an expectation that asset price growth will be even more closely tied to liquidity growth than ever.
 
Much of this growth in liquidity came courtesy of the federal deficit and the Fed, not nominal GDP growth, but this has not seemed to matter to investors. When this broke in 2017 due to the expectation of late-cycle federal stimulus, it was to the upside and no one spent too much time worrying about it.
 
But then December happened. The 1-year effects of the stimulus were fading, and Fed-sponsored money supply inflation was fading, both via Fed Funds increases and balance sheet “normalization.”
 
Even though M2 continued to rise through December at a fast clip, the Fed saw credit tightening and spreads collapsing - systemic liquidity was not translating to market liquidity.
 
Thus, the double-pivot to radically reshape expectations.
 
But the Fed’s actions and signaling of possible future easing did not have the intended effect on the money supply which was down significantly in January and February (QT continues through the fall), recovering in March, but still below previous growth trajectories.
 
Market participants have begun to anticipate easing from the Fed, and sooner rather than later - sometime around 6 months, if the yield curve is to be believed.
 
 
 
The 6-month bill is flat or inverted all the way to the 7-year bond. The 3- and 5-year maturities have been below Fed Funds for some time now, going as low as 2.16% just a couple of weeks ago. This tells us bond investors are anticipating that rates will start falling in the 6-12 month window, probably closer to 6 months at this point. Maybe in the fall when the Fed starts buying Treasuries again.
So we are back to 2017 again, hoping to return to that post-crisis ultra-tight correlation of liquidity and asset prices. But instead of market participants anticipating added liquidity from federal stimulus, they are anticipating added liquidity from the Fed. Since the Christmas Eve bottom, the relationship between M2 and the S&P has been shattered.
 
 
Small sample size, but it’s all over the map here. Again, so long as it’s to the upside, no one’s going to worry too much.
 
So, to sum up:
  • Historically, nominal money supply and the S&P 500 are tightly linearly correlated.
  • In the period of 1994 to the present, the relationship between the two became strained as permalow interest rates and inflation have added more exogenous factors.
  • But the post-crisis period is characterized by an even tighter relationship between the money supply and the S&P than in the historical data. Much of the money supply growth in this period was sponsored by the federal deficit and the Fed’s balance sheet, not nominal GDP growth, as had previously been the case. The Fed’s actions have been much more successful in inflating the money supply and asset prices than nominal GDP.
  • Since 2017, the money supply and S&P have become divorced from each other, especially recently. End-of-cycle psychology has taken hold, but instead of chasing growth like in 1999, or yield, like in 2007, based on the experience on the last 10 years, investors are chasing liquidity from the federal budget and the Fed.

Why You Should Care

 
There are two possible outcomes from this delicate balance that should worry you. The LT2.0 situation and systemic liquidity risk, both described above. Let’s dig down on these concepts.
 
We are living in a house of cards that has taken decades and three cycles to build. The muting of inflation post-1990 has led the Fed to keep Fed Funds unusually low, and when recessions have come, they have had progressively less and less ammo in their bandoliers to combat it.
 
This is one of the reasons I believe the Fed should switch from inflation targeting to nominal GDP targeting.
 
Year of RecessionPeak Fed Funds of Cycle
19709.20%
197412.92%
198119.10%
19909.84%
20016.51%
20075.25%
Current2.40%

 
 
As we have seen, rate cuts have diminishing returns to the real economy near the lower bound. In 2007, the Fed had 525 bps to zero, and that was obviously not enough. If 240 winds up being the peak of this cycle, there will be little the Fed can do with interest rates and we will need more QE. A lot more.
 
Meanwhile, with a trillion dollar structural deficit that is only growing, there is very little hope for fiscal stimulus to fill a liquidity hole.
 
Japan is the first country where this happened, so let’s look at them and see where this can end up:
 
 
 
At the end of 2018:
  • Overnight rate: 0.30%
  • Real YoY GDP growth: 0.25%, with a 20-year CAGR of 0.8%
  • 10-year government bond: 0.068%
Not pretty. This is all in a period where the overnight rate was close to zero almost the entire time.
 
Let’s look at Germany, where this also seems to be happening:
 
 
 
At the end of 2018:
  • Overnight rate: -0.36% (negative since 2015)
  • Real YoY GDP growth: 0.64% with a 1.4% 20-year CAGR
  • 10-year government bond: 0.19%
This can all be ours if we’re not careful. The US numbers at the end of 2018:
  • Fed Funds: 2.4%
  • Real YoY GDP growth: 2.97% with a 20-year CAGR of 2.14%
  • 10-year Treasury: 2.69%

Much better than the other two countries, but still well below historical norms on all accounts.
 
The most under-appreciated aspect of all this is working-age population growth, which is highly correlated to GDP growth in advanced economies. The 10-year CAGRs:
 
 
 
 
That US number doesn’t look so bad by comparison, until I tell you that the 50-year US CAGR is 1.20%, over double the 10-year. Working age population growth has been decelerating rapidly for a number of demographic reasons, and restricting the immigration of working-age people will not help this.
 
So we are obviously not there yet, but the next recession could easily tip us into LT2.0.
 
But what may tip us into recession? This is where the danger of systemic liquidity risk comes in, and gets us back to market psychology. The experience of the last financial crisis is instructive here.
 
There were large numbers of empty subdivisions all over the country in places no one wanted to live in. Like our novelty potato chip example, these were only worth something so long as people thought they were worth something.
 
The “value” of these houses never changed - they were the same houses in the same places in 2008 as they were before. What was different was that everyone woke up one day and realized that, while the day before they thought they owned shares of a tranche of low-risk paying US mortgages, today they owned some worthless potato chips.
 
We are already in a pretax earnings recession in 2018, and without the growth in durables inventories that no one seems interested in buying, real GDP growth was very weak in H2 2018 - 0.59% annualized. The Atlanta Fed just upped their 2019 Q1 GDPNow estimate to 2.3% from a low of 0.3% at the beginning of March, largely on the back of, gulp, investment in inventories. Good God.

Meanwhile, GDPNow estimates of personal consumption expenditures growth plunged from 1.6% annualized (already well below the 2.8% annual growth of the past 2 years) to 0.7%. No one wants this stuff.
 
So will companies wake up one day and realize these inventories are just so many potato chips?
 
What day is that? I would definitely like to know.
 
But inventories are just but one risk from assets that may be currently vastly overvalued by their owners:
  • Student loans: $1.5 trillion.
  • Credit card debt: $1 trillion.
  • Auto loans: $1.25 trillion.
  • US Equities: The ratio of the Wilshire 5000 to GDP is near the all-time highs of the dot-com bubble. Same for the S&P 500.
  • US Mortgages: Again. The ratio of the Case-Shiller home price index to GDP is approaching the pre-crisis high.
This is just what I could come up with off the top of my head. Ask yourself: how many people were focusing on the systemic risk emanating from the US mortgage market in 2007? Very few.
 
There may be risks hiding in plain sight that we do not even see. The “unknown unknowns” are the most troubling.
 
Summing Up
 
 
  • Over time, nominal M2 grows exponentially. Its growth historically has mirrored the growth of nominal GDP.
  • Since the last recession, real M2 has inflected above the historical trend. This is the result of Fed actions, particularly quantitative easing, and the lack of inflation that has typically accompanied increases in the nominal money supply.
  • While the Fed has been successful in inflating the money supply, they have been less successful at juicing nominal GDP growth. On average, there is a 3% per year spread in the growth rates since the crisis.
  • Without Fed actions, the money supply would have been a disaster in the early recovery years.
  • Instead of juicing nominal GDP growth, the Fed-sponsored M2 growth has gone to asset price inflation.
  • Historically, nominal money supply and asset prices as represented by the S&P 500 are tightly linearly correlated.
  • In the period of 1994 to the present, the relationship between the two became strained as permalow interest rates and inflation have added more exogenous factors.
  • But the post-crisis period is characterized by an even tighter relationship between the money supply and the S&P than in the historical data. Much of the money supply growth in this period was sponsored by the federal deficit and the Fed’s balance sheet, not nominal GDP growth, as had previously been the case. The Fed’s actions have been much more successful in inflating the money supply and asset prices than nominal GDP.
  • Since 2017, the money supply and S&P have become divorced from each other, especially recently. End-of-cycle psychology has taken hold, but instead of chasing growth like in 1999, or yield, like in 2007, investors are chasing liquidity from the federal budget and the Fed.
  • The major risks here are LT2.0 and systemic liquidity risk.
  • With the Fed Funds at 2.4%, the Fed will have very little ammo to combat the next recession.
  • With trillion dollar structural deficits as far the eye can see, the hope for fiscal stimulus to fill liquidity holes is slim.
  • The experience of Japan is instructive: low population growth, low economic growth, low inflation, low interest rates. This is not a recipe for a dynamic economy.
  • There are many asset classes that may be overvalued by their owners.
So where does that leave us? So long as everyone believes that the Fed will continue to provide liquidity absent nominal GDP growth, and that this will inflate asset prices, not nominal GDP, assets will be the thing to own.
 
My portfolio. Evan-Amos
 
 
But one day, everyone may wake up and realize they own a bag of potato chips. Again, I would like to know what day that is.
 
Remember, Wile E. Coyote stays aloft, until he looks down.