The Next Big Short, Part II
In The Ring - November 19th, 2022
Image: Shutterstock
“Sometimes the weekend gets hijacked by work, but as my mother would say, this is the right problem.” -Julian Fellowes, creator of Netflix’s mega-hit series, Downton Abbey.
Yesterday’s The Next Big Short, Part I ended on the topic of the “Curse of the Cover Story”. As shown then, Fortune’s ultra-close-up photo cover of Sam Bankman-Fried, who might not be free much longer, is the odds-on favorite to be the worst example of misplaced media hagiography ever seen (displacing Elizabeth Holmes was no mean feat). To further enhance those odds, the Fortune cover subtitle asked if he was the next Warren Buffett. Instead, it should have wondered if he was the new Bernie Madoff; you know, the fellow who made off with billions of investors’ dollars by faking high and steady returns through all kinds of market conditions.
There is a kind of poetic justice in this year’s crypto crash. One reason for the meteoric rise of Bitcoin and its myriad wannabes in 2020 and 2021 was a New Age distrust of the U.S. dollar (USD) and its reserve currency status. The USD’s dramatic surge this year and the at least somewhat-related meltdown in cryptos could be seen as the revenge of the Old Order, the one that held that there is no viable substitute for the dollar. For now, a victory lap by the greenback bulls is certainly in order, but there are a number of reasons to question the sustainability of its recent remarkable strength.
The inverse of the curse of the cover story was an extremely well-timed article by the chair of Rockefeller International, Ruchir Sharma. Perhaps that’s because it was on page 17 of the Financial Times (FT) instead of the front page. He didn’t quite hit the peak in the dollar, but he came within about a month, assuming the high is in. Writing in an August 29th FT article titled A post-dollar world is coming, he made several compelling points justifying said title:
“When a current account deficit runs persistently above 5% of gross domestic product, it is a reliable signal of financial trouble to come.” He went on to note the U.S. is now close to that threshold.
“The US currently owes the world a net $18 trillion, or 73% of US GDP, far beyond the 50% threshold that has often foretold past currency crises.”
“Since the 15th century, the last five global empires have issued the world’s reserve currency—the one most often used by other countries—for 94 years on average. The dollar has held reserve status for more than 100 years, so its reign is older than most.”
“The dollar share of foreign exchange is currently at 59%, the lowest since 1995.”
In my mind, the first two are the most compelling along with numerous countries beginning to settle their trading accounts in their own currencies versus USDs (a point somewhat related to his last bullet). It’s also telling that overseas central bank purchases of gold have spiked 400% year-over-year. This is eye-opening considering the USD’s strength and also the allure of much higher interest rates.
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Some are speculating that we’re on the verge of a new Bretton Woods. This refers to the agreement that sealed the dollar’s supremacy for the post-WWII era. It held from 1944 until 1971 when Richard Nixon took America off the gold standard. That action ushered in what has been referred to as Bretton Woods II.
It’s a growing possibility that Bretton Woods III is unfolding today, and it will lead to the demise of fiat currencies. Instead of merely being backed by government edict, there is a rising possibility paper money will need to have hard-asset backing, perhaps by a basket of commodities. Naturally, gold would play a critical role in this potential new monetary system, but energy is likely to be included, as well. A catalyst for this transition could be further dysfunction in the world's most important market, that of U.S. Treasury debt, which is already flashing warning signs.
One of my biggest fears for next year is how the U.S. government can possibly finance its deficits. These are likely to erupt to towering heights should a severe recession occur, along with the swelling tsunami of increasingly unfunded entitlements. (Payments into Social Security and Medicare are falling short of payouts at an accelerating rate; as I’ve often noted in past newsletters, no actual investments are in those trusts funds, other than more unserviceable government IOUs.) There is also the reality of Quantitative Tightening (QT) where the Fed is selling, rather than buying treasuries (QE). Accordingly, a fiscal funding crisis in the U.S. next year is a considerable risk.
It's my belief U.S. policymakers should review the playbook Germany used after it got itself into an even worse financial position after WWI (losing a world war will do that to a country). This unleashed the Weimar Republic’s infamous hyperinflation. The way it created a new currency, one that restored its citizens’ faith in what became the Rentenmark, was by backing it with government-owned land. (The Rentenmark was replaced in 1924 by the Reichsmark and was legal tender backed by gold; the former fiat Papiermark was exchanged for the hard-asset-backed marks at a ratio of one trillion to one!)
Fortunately, America is not facing hyperinflation and the U.S. government has a formidable array of assets with which to back its currency, including immense holdings of real estate. Further, it also still has an enviable store of gold. The even bigger asset it possesses, though squandered right now, is the ability to institute an effective estate tax on the tens of trillions of Baby Boomer-owned assets. Those will be shifting to the next generation over the next 20 years, a process that has already begun.
As I’ve written before, a workable estate tax needs to have a fairly low tax rate — way below what it is today — but without the plethora of loopholes and dodges. Trillions of additional tax revenues are very feasible with the right structure as the largest asset transfer in history continues to occur. Estate taxes also don’t disincentivize hard work and entrepreneurship, particularly if set at a non-confiscatory rate like 30% (and much lower for smaller estates). In over 43 years of working with high-net-worth, and ultra-high-net-worth clients, I’ve never heard any of them say they didn’t want to make more money because of estate taxes.
Despite those impressive attributes, the days of the supremacy of the fiat dollar looked numbered to me. The fact that right now it trades as richly as it does makes it extremely vulnerable and, in my mind, worthy of representing The Next Big Short. Because shorting the dollar using the main index means, in essence, going long the inherently feeble euro, pound, and yen, that’s a suboptimal way to benefit from its eventual nosedive.
A far better approach, in my opinion, is to have meaningful exposure to those assets that might go into that commodity-backed currency basket. This would include oil, natural gas, gold, silver, copper, uranium, aluminum, palladium, and potash, to name a few of the obvious beneficiaries of a shift to a hard dollar versus the increasingly flimsy one we have today.
Fortuitously, all of these have undergone fairly substantial corrections from their peaks earlier this year, even oil and natural gas, where supply shortages are becoming more acute on an almost daily basis. (The U.S. Northeast is likely to painfully experience the gas deficit this winter.) It’s also nice that there are equity ways to play these resources, both with shares in the producers thereof and ETFs that hold the physical commodities. While I’m partial to the former — like Apache, Shell, Freeport and Norsk Hydro, among many others owned by most Evergreen Gavekal clients and the Haymaker personally — ETFs like the Sprott Uranium Trust (SRUUF) strike me as attractive, as well. These hard assets also have drivers such as the immense need for copper in the Great Green Energy Transition — such as for electric vehicles (EVs) — and the resurgence of nuclear energy.
To learn more about Evergreen Gavekal, where the Haymaker himself serves as Co-CIO, click below.
One of the worst recommendations, at least thus far, from my book Bubble 3.0 was my touting of developing-world debt funds like the Templeton Emerging Market Income fund (TEI). The dollar rally of this year has been an extremely strong headwind for its share performance. This is despite the fact that many emerging market currencies and bond markets have produced solid performance. In many cases, their returns have been far better than badly battered U.S. Treasury bonds, as noted in yesterday’s Part I. Once the dollar has decisively peaked, closed-end funds like TEI should come roaring back. In the meantime, you collect an SEC yield (i.e., not overstated) of 10%.
We’ll wrap up this two-parter with some summary thoughts. First, the refinancing risk next year is formidable and it’s not just a U.S. government headache. While close to 30% of Treasury debt matures over the next year or so — close to a $10 trillion Mt. Everest of borrowing that needs to be funded — there is also $1.6 trillion of investment-grade corporate debt that must find buyers, as well. For sure, there is maturing debt that will likely be recycled back into treasuries and “govies” but it’s still a staggering sum of money. Then, there is the much higher rate of interest that needs to be paid on these many trillions of maturing IOUs.
On top of that is the high probability of erupting federal deficits in a recession. Next up is the increasing reluctance of foreign central banks to buy Treasury debt. Louis Gave and I both believe the Fed now has a stealth mandate to fund the U.S. government in the event buyers refuse to show up, at least at yields the Treasury can afford. Frankly, that’s not much above zero, and certainly not 5%.
Let’s end on a note of caution for USD bears: last week’s exceedingly candid presentation by former NY Fed president Bill Dudley was high-def clear that additional tightening is coming. In fact, he suggested the fed funds rate could hit as high as 7%. His base case is 6%. Along these lines, I expect Jay Powell to hold another “Dirty Harry Callahan-type” press conference next month.
The USD is already off about 7% from its late-September spikey peak. More macho talk from Mr. Powell could easily trigger a move back up to around that level. Consequently, move slowly in putting on anti-USD positions for now. As I’ve written recently, when it comes to energy, for those of you who have been following my suggestions to be overweight this sector, taking some profits is prudent.
However, sometime in the second half of next year, I believe the economic damage will be so severe that Powell & Co will have little choice but to cut rates and, probably, suspend their balance sheet shrinkage (QT). As noted before, this is a very rare instance of the Fed in double-tightening mode. It’s also an extremely rare situation where it is aggressively turning the monetary screws into a bear market in stocks and mounting evidence of a global recession, not to mention the third energy crisis of the last 50 years. For now, that can still be dollar supportive — though anything but for the stock market. Santa Claus rallies do usually happen around now, but the odds are high that Mr. Powell will be the “Grinch who Stole Christmas” in 2022. Perhaps for this year’s stock market bulls, it was Christmas in October.
Social security is easily fixed. Just remove the salary cap. That would bring in so much money that the percentage we pay could be cut. That is a tax cut for the low and middle class. Think about it.
Deficits are solved w/ 4-5% inflation for a decade - which is likely what we'll see once we get past the disinflation of the global recession forthcoming in 2023.