What the hell is happening? July 2023
From a recession narrative to a recovery narrative. Real Assets Vs Fixed Assets. What to do? Price is what you pay, value is what you get. China+
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One year ago, in the July 2022 version of WTHIH we talked about the Fed’s goal to bring down inflation, regardless of the price the economy or the stock market would pay.
The Fed’s main aim was to anchor inflation expectations or else the Treasury market would suffer a serious decline — endangering the U.S. Treasury’s ability to refinance its debt at beneficial terms. Imagine having to refinance sovereign debt at 7, 8 or even higher rates. I talked about the virtuous cycle the US of A has benefited from here and how I see cracks.
A quote from last year’s WTHIH.
“Drastic times call for drastic measures. The Fed aims to bring down inflation even if it brings down the economy with it. It doesn’t matter if monetary policy can’t influence supply-chain disruptions or the price of energy via geopolitical events.
The Fed’s mandate is for maximum employment and price stability - and they aren’t ready to fail on the latter.
We have been in a two month sell off where seemingly nothing is safe, and Fed officials are piling on the hawkish messages on top.”
This fast and drastic rate hike cycle made most market participants believe in the certainty of a recession, and they positioned themselves accordingly.
Don’t fight the Fed, you say?
I warned about putting too much trust on investment adages like “Don’t fight the Fed” here and rather recommended a more sane path to long-term investing here.
Shadows & Traps
I hinted on the trap of conflating news and sentiment to individual stocks and market indices in the conclusion to WTHIH August 2022, and I quote.
“A few more words on the stock market rally…
I see many being annoyed from this rally. “Nothing has changed!”, they cry out.
Nothing has changed from what exactly? Why do you think the economy is equal to the stock market with a 100% relationship?
When people look to economic figures or the general macro picture - they think they can use all that to make predictions on the stock market’s direction. We also like to use historical analogies to prove our predictions or expectations…
But reality is elusive, what happened before is something else, what is happening now is something different.
And looking to economic data to tell you what will happen in the stock market is like looking to shadows to try and understand objects.”
I doubt they heeded my calls and so I proceed to write another mindset essay, titled Shadows & Traps, where I used Plato’s Allegory of the Cave as an analogy to the financial markets. ESSAY.
I can get a risk-free ~5% on my money…
Many seem to be avoiding high-quality, well-run businesses selling for good prices simply because of the psychology of a good return on their money. They feel nominal rates are the same as real rates.
No matter the level of investor or experience, he keeps falling in this trap. I recently wrote a piece explaining how not all yields are made the same, using the example of a business like Apple.
Yes, inflation is coming down (relatively to where it was), so does that mean inflation is actually coming down or is it year to year changes that are reducing?
The point is, inflation is still eroding the purchasing power of fiat currencies. Your money is worth-less over time. A 5% nominal rate could mean 0% in real terms, don’t be stupid!
Benign Environments, Inflation & Yields
Investors seem to believe inflation will go back to ~0%, simply because it was there before. I think inflation was low because post-2009 the environment was so benign and in reflation mode (after the GFC bust) without many problems.
The Fed wanted to keep inflation at 2% at least — and moved rates as low as needed to keep the inflation-target narrative alive. Because how can you inflate the debt if inflation moves below 2%?!
But is this the environment we are in today? Why should cash holders lend out their capital today for such low prices? In fact I think sovereign bond yield curves should move up in most Western economies (US, UK, Germany + EU etc.)
I expect a repricing event where sovereign yields will move up rather suddenly, in a process of price discovery. I think yields are lower than they should be (as per current fundamentals) because there are forced buyers buying those bonds.
Retail investors, financial institutions like banks and insurance companies, major corporates etc. spent too many years basically earning nothing; that they now feel compelled to lock in some good rates across the curve — and make a spread on the deposit balances they hold, which are making much less than the curve.
Banks seem to be enjoying this party because profitability is at a high. The bonds they hold aren’t breaking (down) and the rates they pay out are significantly lower — this is the headwind they needed. i.e. The carry trade is working brilliantly!
Meanwhile, what if inflation re-accelerates?
The Fed’s drastic-times rate-hike strategy managed to lower inflation, as we touched upon in last May’s WTHIH. But is that it? The environment is not benign this time around.
Tit for Tat
The war between the West and the East, driven by its main players the US and China begun long ago. The US has been trying to stop the rapid ascent of China with all sorts of protectionism and barriers.
But now, China is pushing back — recently applying export curbs on Gallium and Geranium, vital metals for electric vehicles and certain electric devices.
Excerpt from Peak American Empire.
Biden recently went all out against China and its semiconductor industry by tightening the noose and aiming to drain them of intellectual property and know-how. Chances are this will not work and will result in unintended consequences — the Chinese will adapt to this reality and end up building their own.
The technological advantage that the US had for so many decades is tightening. Globalisation comes with side effects! The US doesn’t control the world anymore, even though they are surely trying.
You see, the West wants to use Chinese labour and resources but doesn’t want to allow China to have a say in how the world is run. And Russia is seen as an extension of China and its ascendance.
China
Post-Zero Covid Policy, the Chinese economy has been lagging. There were calls for the CCP Politburo to announce stimulus measures to support the economy — but it seems the CCP isn’t ready to bring out the bazooka just yet.
The Chinese understand that their economy is now at a state where they can’t just overstimulate and hope for the best. They need more sustainable growth and more measures on economic structure and competitiveness rather than budget deficits and rising total debt.
On July 14th they came out with a 31-point announcement on how they will help the economy, which I outlined here:
In my opinion, this is what China needs going forward. On July 24th they came out again with pledges on boosting domestic demand:
"Currently, China's economy is facing new difficulties and challenges, which mainly arise from insufficient domestic demand, difficulties in the operation of some enterprises, risks and hidden dangers in key areas, as well as a grim and complex external environment," Xinhua quoted the Politburo as saying, after a meeting chaired by President Xi Jinping.
China will implement its macro adjustments "in a precise and forceful manner" and strengthen counter-cyclical adjustments, as the government sticks with a prudent monetary policy and pro-active fiscal policy, the Politburo was quoted as saying.
Next Steps for China
I don’t expect massive stimulus from China this time around, rather I expect the next level of growth and development in China to be borne by market reforms, increased competitiveness, further de-regulation, an international opening up of the Chinese economy and for the state to start intervening less into the economy.
State-owned enterprises (SOEs) which represent a staggering 40% of the Chinese economy’s GDP seem to be the low hanging fruit of reforms and restructuring — to be used as the spearhead for the economic recovery.
Efforts will be made to expand returns on State-owned capital and enhance the strength, quality and size of SOEs, with improving their core competitiveness and functions being a priority. Solid steps will be taken to build a more resilient industrial chain and promote more technological advances in key areas, he added.
SOE reforms will be pushed forward on an ongoing basis to keep pace with world-class, industry-leading enterprises, Zhang said.
But besides extracting the fruits of more efficient SOEs, the Chinese still place a serious weight on free markets.
Guided by Xi Jinping Thought on Socialism with Chinese Characteristics for a New Era, thoroughly implement the spirit of the 20th National Congress of the Communist Party of China, adhere to the general tone of the work of seeking progress while maintaining stability, fully, accurately and comprehensively implement the new development concept, accelerate the construction of a new development pattern, and strive to promote high-quality Development, adhere to the direction of reform of the socialist market economy, adhere to the "two unwavering", accelerate the creation of a market-oriented, law-based, and international first-class business environment, optimize the environment for the development of the private economy, and protect the property rights of private enterprises and the rights and interests of entrepreneurs in accordance with the law. Comprehensively build a pro-Qing political and business relationship, so that various ownership economies can equally use production factors in accordance with the law, participate in market competition fairly, and be equally protected by the law, guide private enterprises to continuously improve the quality of development through their own reform and development, compliance management, transformation and upgrading, and promote the private economy. To be bigger, better and stronger, to make positive contributions in the new journey of building a modern socialist country in an all-round way, to shoulder a greater mission, shoulder greater responsibilities, and play a greater role in the historical process of the great rejuvenation of the Chinese nation.
More Themes I am following
The war in Ukraine and its effects on European politics.
British politics, Rishi’s future and the UK economy.
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Sincerely,
Philo 🦉