Making Hay Monday - Guest Article

Thank you, Charles Gave!

Jun 19, 2023

“People do stupid things. When you have free money for 11 years, people do really stupid things.” -Stan Druckenmiller in a May 9th, 2023, interview.

For our many new subscribers, including around 500 over the last few days (thank you, by the way!), some explanations are in order. The “Gave” in my firm’s name, Evergreen Gavekal, to which I devote most of my time, is primarily a function of two individuals, Charles and Louis Gave. They are father and son, with the former turning 80 in a few months. Despite that, he’s still very much involved in his firm’s research activities. This includes a considerable amount of writing and speaking. Suffice to say, there are very few members of the professional financial community with Charles’ 50-plus years of experience.

Typically, I personally write our Making Hay Monday (MHM) editions, but I’m trying to carve out some time to rewrite a chapter in my book, Bubble 3.0. As many longer-term Haymaker subscribers know, we digitally published that in early 2022 via this same platform, Substack. The chapter I’m recreating is one of the most important: How to protect your investments from the bursting of what I believe was the biggest investment bubble in human history. (We plan to share portions of this with you in the near future.) This break is also giving me the chance to provide our readers with a sample of Charles’ unique economic musings.

In this guest version of our MHM, Charles goes into a number of reasons why he sees trouble ahead. Both of us have been around long enough not to be dissuaded by frothy market conditions, such as now, when we believe the underlying conditions are concerning… if not downright dangerous.

Admittedly, this is a longer note but for those who want the “Reader’s Digest” condensed version, you can skip to his conclusions at the end. However, the article itself is almost a short course on economics that draws on the lessons he’s learned over his long career. Thus, for any serious investors it contains a trove of valuable information and observations.

A couple of explanatory notes are in order. First, Charles is a big believer in the theories of a long deceased Swedish economist, Knut Wicksell. He held that improperly set interest rates — either too high or too low — lead to economic and financial market dislocations. Of course, for many years central bankers in the rich world have been intervening with regard to interest rates in unprecedented ways. (Along similar lines, Joseph Schumpeter, an Austrian economist who died in 1950, popularized the theory of creative destruction; David Ricardo was a 19th century British economist most famous for his work on free trade and comparative advantages. As you’ll soon see, Charles refers to both of them.)

Both Charles and I believe this interest-rate manipulation has produced the series of bubbles we’ve seen, particularly over the last 25 years. Clearly, the legendary Stan Druckenmiller agrees (see above) and feels the experience since the Global Financial Crisis has been epic in that regard.

Again, I’d highly recommend you take the time to carefully read this article, as I believe it is brimming with valuable insights. In my mind, many of these have vital investment implications, such as his comments on energy and indexing. (With the former, Charles believes we remain in an energy crisis despite the recent declines in oil and natural gas, as do I. The sudden price eruption in European gas prices last week underscores the present supply/demand situation’s precariousness.)

Don’t be shy in sharing your thoughts and questions on the many crucial points he discusses!

- David “The Haymaker” Hay

To learn more about Evergreen Gavekal, where the Haymaker himself serves as Co-CIO, click below.

Private Wealth Management

Note: The below material was originally published by Gavekal Research on June 12th. We have applied text/formatting changes, removed links to premium content, and made minor corrections as necessary.

What I Have Learned Since 1971: Beyond The Reserve Currency - Charles Gave

The core premise of the argument made in the first two parts of this series is that two different systems must coexist within any market economy. To use a computer analogy, the production system can be thought of as the hardware responsible for creating real goods and services, while the monetary system acts like a Windows or iOS operating system which allows users to run applications such as transaction settlement and accounting for the time value of money.

Problems emerge in the production system when at least two serious economic maladies develop

On this basis, three types of problem can develop within our economic systems that can be deemed to be systemically critical:

1) A problem within the production system

2) A problem within the monetary/operating system

3) A problem in the link connecting the production and operating systems

In my experience, trouble in the production system starts when at least two of the following maladies affect activity:

• War

• Protectionism

• A significant increase in taxes on productive assets

• A large increase in energy prices

• Price controls

• An explosion of regulations

All these factors lead to a decrease in the return on invested capital, and from there to recession—even depression—and a bear market. These conditions are all present in the eurozone, they are emerging in the United States and are nowhere to be seen in the “global south”.

The monetary/operating system can be thought of as working on two basic axes: the currency exchange rate acts to intermediate geography, while interest rates act to provide a pricing mechanism for the passage of time.

Problems emerge in the operating system when exchange rates and interest rates are unduly manipulated

Origins of problems in the operating system

The first malady stems from efforts to fix, or to manipulate, exchange rates. Such policy errors tend to create balance-of-payments crises as happened in Asia in the late 1990s and in the eurozone in 2011-12. The second malady arises from manipulations that keep the market rate of interest high relative to the Wicksellian natural rate of interest—as with France’s costly “strong franc” policy in the early 1990s—or too low relative to the natural rate, as has occurred in the US and Europe for most of the last 15 years.

As I tried to show in the first two parts of this series, I do believe that most problems in the real economic sphere currently stem from mismanagement of the international operating system’s US-controlled time axis.

The mismanagement of the geographical axis that mostly affected the eurozone was due to European Central Bank actions. I will limit my coverage of that issue in this paper, as it is one I have often covered in the last 20 years.

At the outset, I would also note that problems arise when the international operating system falls under the control of one nation which starts to exclude other nations. At such a point, the system stops being an international system and a new version must be adopted. This is where we are today.

A little bit of history is needed at this point to explain the working of the operating system, as it was from 1945 to 2022. Every nation had its own monetary system, its own currency, and its own approach to dealing with time (interest rates) or geography (exchange rates). Having an “independent” operating system is in fact what defines a nation financially.

After World War II, the issue was how best to organize the relationships between different national operating systems. After all, some countries had free capital flows, while others did not; some had gold reserves, while others did not; some had structural current account surpluses and others had structural current accounts deficits. The solution was that international trade in goods, services and energy would be settled in US dollars, while US long rates acted to fix the cost of capital for the world.

Since 1945, the challenge for policymakers can be seen as choosing how to organize different operating systems

The US dollar as a link between operating systems

This situation caused the US dollar to become a link allowing users to toggle between domestic operating systems. International trade moved from a pre-Depression-era situation—in which anyone could trade with anyone using gold to settle their accounts—to a world in which everyone had to go through the US dollar to reach the rest of the world.

Strangely, it meant that while there were plenty of national operating systems, there was only one international operating system, which happened to be based on a national currency. So, to trade internationally, countries had to “buy their way” to become a member of the club: first, they had to acquire, or borrow, US dollars; second, they had to build up enough US dollar reserves to handle rainy days when dollars were in short supply.

The double benefit of the US dollar became known as the “imperial privilege”

Imperial privilege

Having acquired these US reserves by various means, countries’ monetary policymakers had little choice but to invest them in US treasuries, which meant that US budget deficits were financed via the US current account deficit. These were settled by the US importing goods and exporting little pieces of green paper. This double benefit of the dollar became known as the “imperial privilege”.

In practical terms, the US central bank thus had to provide liquidity not only for the US economy, but also for other countries to trade with each other, and with the US. At first, this international liquidity was provided by capital flows; from 1945 to 1971 it involved US banks lending abroad and US multinationals making investments. When an international liquidity crisis arose in this period, the International Monetary Fund was called in to save those US banks that had lent imprudently to poor countries.

After 1971—with the link between gold and the US dollar broken—we moved to a new system, which I have dubbed the dollar/oil/US bond market standard. The idea was that dollars obtained from US current account deficits were reinvested by their holders in US treasuries. The system worked so long as the total return of US long bonds allowed users to buy the same quantity of oil, or more, at the end of a 10-year investing period as at the start. This worked from 1980 to 2009.

The US’s dual role meant that its managers would eventually have to chose between domestic priorities and foreign needs

This dual role created the risk that one day the US government would have to choose between its domestic needs and the requirements of international users. In such an event, close observers always knew that US authorities would favor the domestic system over the international one. Such tipping points arose after the September 11, 2001 attacks and after the global financial crisis seven years later.

The non-US part of the international operating system began to break down about a decade ago when the US authorities decided that US laws would apply to all transactions using the dollar as a medium of exchange. This was an unacceptable loss of sovereignty for most nations.

The pattern became even more obvious when the US decided to weaponize both US dollar usage and the worldwide dollar payment system. This excluded countries that the US government does not like, with the first victim being Iran and later Russia. In 2022, an even more dramatic action saw both the Federal Reserve and ECB freeze Russian foreign currency reserves.

The key factor undermining the imperial dollar system has been the pursuit of excessively low US interest rates

Still, the key factor to threaten the imperial dollar system was a domestically-focused US central bank lowering interest rates to very low levels at a time when US budget deficits were super high, such that foreign holders of US dollars are now refusing to play the game.

And then, inflation came back with a vengeance and the price of gold started to rise, indicating that imperial privilege was on the wane. Not only has the US bond market stopped being a credible reserve of value for those needing US dollar reserves to buy oil; it has also became clear that sellers of oil have a waning interest in selling oil and gas for dollars. It has become safer for them to be paid in a currency that supports a proper bond market.

As a result, countries with an energy deficit and yet a current account surplus are increasingly not building foreign exchange reserves in US dollars for reinvesting in the US bond market. Those nations sporting both an energy surplus and a current account surplus are investing less of their excess savings in treasuries. And third-party nations are trading less with each other using the US dollar as a medium of exchange. There is no compelling reason for a Singapore firm to bill its Japanese, Thai or Chinese clients in US dollars. Such transactions will increasingly occur in the currencies of the transacting parties, ending the US dollar’s role as the main trade currency.

I conclude this historical review by noting that the forced use of the US dollar to trade internationally, or to buy energy, has broken down. And there is no possible return to the old situation since trust has been lost.

Most people at this point ask me: what will replace the US dollar as the global reserve currency? My answer is that this new world will not need a reserve currency.

The move to a more decentralized system of international finance should be seen as a good thing

To extend the operating system metaphor, albeit anachronistically, think of the US dollar as a 1970s IBM mainframe computer sitting at the center of a network. Now, computing developments in the following decades saw dispersed networks develop that had many independent nodes and no center.

In the same way as computing changed, I expect settlements for international transactions to morph from a centralized system that is highly efficient yet fragile, to one that is decentralized—and probably much less efficient—but anti-fragile in nature. This should be seen as good news.

I could stop there, since no one can seriously forecast how this new system is likely to work. Still, I will beg the reader’s indulgence to go a step further.

For the sake of simplicity, I will analyze likely developments in zones around the three main currency areas: the US dollar and its satellites; the euro and its satellites; the Chinese renminbi and its satellites.

I will deploy my trusty Wicksellian tools to express these views, even though the findings will be more intuitively logical than deeply researched.

1) In the renminbi zone, the market rate of interest is going to fall and the natural rate is going to rise.

2) In the US zone, the market rate is going to rise, while the natural rate could go one of two ways: (i) stay stable if the US remains the chief repository of “Schumpeterian” growth, or (ii) fall, if this is not the case.

3) In the European zone, the market rate will rise and the natural rate will fall. It will become impossible to finance the usual social transfers.

The Asian monetary zone is best placed to manage in this new financial order

1) The Asian monetary zone

Louis and I have written extensively on the emergence of an Asian monetary block centered around the renminbi.

If this research was any good, the countries in this area are best prepared for the changes that are now taking place. Asian economies chose to live within their means in the last 25 years as their aim was to never again need an IMF bailout, as in 1997-98. To achieve this goal, they had to generate massive excess savings. These funds—measurable by increases in Asian central banks’ foreign exchange reserves—have been invested in US treasuries or European government bonds. This meant that the market rates of interest in their own countries were too high, and those in the US and Europe were too low.

In the new system, these countries will invest their excess savings to earn the highest marginal ROIC, not where the safest dollar return can be found, as they already have too many dollars. And this could very well be in the economies surrounding the Indian Ocean. The market rate for the region will thus go down but the natural rate will go up.

As a result, the Asian zone will go through a massive period of Ricardian growth like Europe after the Treaty of Rome in 1957, with personal consumption unleashed to grow at least as fast as the underlying local economy.

It is in this zone that one should own bonds and long-duration assets since it is about to enter a “triple merit scenario” of rising exchange rates, falling interest rates and rising equity values.

The US government will be forced to pare back its spending in the new era

2) The US monetary zone

As Asian savings start to avoid the US dollar, this should lead to a sharp rise in the market rate of interest in the dollar zone with real rates rising. As the cost of servicing its large stock of debt rises sharply, the US government will have to cut some of its spending, notably on defense.

The US economy maintained its citizens’ living standards in the last 20 years by borrowing abroad to maintain consumption at home. This situation was facilitated by excess Asian savings being invested in the US, thereby creating artificially low interest rates and an artificially high US dollar exchange rate.

The US consumer bought cheap foreign goods with money borrowed from the producers of these goods, while using domestically earned money to buy expensive goods produced in the US, in sectors not facing foreign competition like housing, education, health, and weapons.

The loss of imperial dollar privilege will mean that the US goes through a serious economic restructuring

As this vendor financing is withdrawn by foreign producers, US consumption will fall to a level dictated by domestically-earned funds. The natural rate will rise in those sectors that now face less foreign competition (reindustrialization in the US should begin, as firms start to raise their prices), but the natural rate will decline in the protected sectors, as demand for these items craters.

A special case should be made for “Schumpeterian sectors” in the US, which earn a very high natural rate of interest. If the US succeeds in dominating artificial intelligence and nuclear fusion as it has dominated the technology sectors for the last 50 years, then a decline in the US standard of living could perhaps be avoided.

Europe faces a debt-trap set of dynamics

3) The European monetary zone

In Europe, the natural rate of interest is declining in the face of the full panoply of negative factors outlined at the start of this report: war, protectionism, more regulation, rising energy costs, price controls and higher taxation.

In addition, European economies have poorly-working operating systems and a dysfunctional relationship between these systems and their underlying economies. The effect of this dysfunction is an effectively failed European banking system that has been sacrificed on the altar of the euro project.

As excess savings from Asia dry up, the worry must be that Europe faces a rising market rate of interest, which further impedes growth. In good Wicksellian theory, if the market rate moves above the natural rate of interest, then economies like France, Italy and Spain will move into a debt trap, with national governments’ budget deficits exploding to the point that social services and transfers get cut. After all, the eurozone represents 20% of global GDP and 60% of its social expenditure. If this were to happen, I would expect the euro to either collapse, or be abandoned.

Investors should be very choosy in buying assets of European-zone entities

The only European assets that investors should own are shares of multinational companies producing everywhere and selling everywhere. There are quite a few such companies quoted on the French stock market. I would avoid those firms that manufacture in one zone and sell everywhere.

The damage to Switzerland, Sweden—and perhaps the UK—should be more limited than in the eurozone, as they have far lower government debt (except for the UK), independent central banks and freely-floating exchange rates.

In the new world, trade between the main currency zones will be protected

Conclusion: building a portfolio fit for the new world

1) In a world comprising three currency zones, each area will likely have free trade arrangements, with heavy protection between zones. The collapse of the unipolar US dollar implies the end of free capital flows between zones, with capital made unavailable to investors outside of the zones.

Gold will be the key instrument for settling trade between currency zones

2) Within each zone, trade will be settled using the dominant currency of that area, or the local units of member economies. Gold will emerge as the main currency for transacting between zones. The currency of the main surplus zone could also play that intermediary role for material periods of time. But in the longer run, no zone will get to run perpetual current account deficits. In fact, any zone running a deficit will face pressure to sell its gold, or engineer a return to some kind of equilibrium versus the others. For investors, this means there will no longer be one dominant economic/financial cycle—as has been the case since 1945 through the US dollar system—but three different cycles. As a result, international diversification as an investment strategy, which has been useless since around 2012, is going to come back with a vengeance.

There will be a rebalancing of global equity values to reflect economic realities

3) For the last 20 years or so, the US and Europe accounted for no more than 50% of global GDP and less than 20% of global growth, yet they have represented at least 80% of world stock market value, and around 90% of world bond market value. Now, if readers think that profits made by “old West” companies in the next 20 years will grow at four times the rate of those in the “new South”—as is implied by market pricing—I have a bridge to sell them in New York.

To be more succinct, the next bear market will occur in indexed portfolios. Anyone who defines risk as the tracking error of a portfolio versus an index is going to be massacred, as occurred when Japan made up more than 50% of the global index, with Japanese banks alone having a 25% weighting.

The big risks today are to be found in indexes whose levels are not based on realistic assumptions about future earnings but faulty assumptions built into the old US dollar system. Indexation is really just a structured form of momentum buying, which has always produced massive bubbles followed by gigantic crashes. The current bubble was created by money printing in the old West and will deflate as soon as it stops, which is unavoidable given current account deficits in the US dollar zone, which will have to disappear.

Seldom in my career have I seen such a discrepancy between the reality of future economic growth and equity indexes whose job is to passively capture that growth for investors. This is even more true in bond markets where, to be honest, the notion of index investing is asinine.

Investors should seek out dominant bond markets of the new South

In the next decade, global bond and equity indexes that represent “false values” in the old West may crash, while a massive bull market unfolds in the equities, currencies and bond markets behind growth in the new South.

Latin American bonds should be in the offensive part of their portfolio, along with other well-positioned risk assets

I maintain the view that investors should avoid the currencies, bond markets and shares of firms that are a play on consumers in the old West, or firms that have a privileged relationship with local states in the old West.

• The defensive portfolio should be organized around gold (20%) and the dominant bond markets of the new South.

• The offensive portfolio should be deployed into illiquid new-South bond markets such as Latin America’s with funds removed from corporate bonds in the West. Commodities should be embraced when centered on energy firms that are profitable on their own merit. The same goes for genuinely multinational firms, and investment in infrastructure and productivity-enhancing ventures.

The point is that a good number of these investment vehicles can be found in the old West, even if the locus of their activity is in the new South.

Haymaker