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Q1'2023: Pick your Poison

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By: Jack Schibli

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Today, we explore the left (deflation) and right (inflation) tail outcomes for the economy and what they might mean for markets.

TLDR – “too long; didn’t read”. We recognize our posts can be lengthy and challenging to digest, so here’s our executive summary.

  • The recent interest rate increases have yet to circulate through the economy, as most outstanding debt was financed at low interest rates.
  • As debt matures and new debt is financed at prevailing higher interest rates, the cost of servicing debt will crowd out spending in the private sector. This will begin the deleveraging process, which is inherently deflationary. The U.S. economy is currently on this trajectory.
  • The above scenario assumes no fiscal or monetary interventions, which history tells us is unrealistic. We expect yet another liquidity injection to meet an incoming crisis (SVB response is a prelude), but importantly something must “break” first to warrant such action.
  • Meanwhile, Western governments have three top priorities: 1) re-shoring manufacturing, 2) re-arming national defense 3) effecting the energy transition to reduce carbon emissions.
  • All the above are national security matters (not optional) and require heavy government spending. We suspect this will necessitate continued currency debasement (i.e., inflation) relative to hard assets, particularly the commodities needed to achieve the energy transition.
  • It’s a future full of tail events, and if we are correct, both deflation and inflation will come to fruition in that order.

Shh, the "R" word 🤐

These days we are often asked our thoughts on a pending recession. First, we must define recession, which most economists refer to as two consecutive quarters of declining real GDP. Technically, the U.S. economy experienced a shallow recession in Q1 and Q2 of 2022, where real GDP fell quarter over quarter at 1.6% and 0.6%, respectively1. However, the declines were so modest, and the employment data non-confirming, that even the White House ignored it.

Looking ahead, we see a recession, as defined above, as near certainty unless the government deploys fiscal or monetary intervention in anticipation. Our confidence comes back to basic concepts of the credit cycle. The extension of credit pulls forward spending, which is precisely why cycles are so predictable, as the debt must always be paid back at some point in the future. It’s just math. In recent decades, we have had the benefit of falling interest rates, where the persistent decrease of the cost to carry $1 of debt has enabled ever higher debt loads. The below diagram illustrates how the extension of credit, spending, and growth is reflexive.

For Illustrative Purposes Only

 To explain, we’ve employed OpenAI’s ChatGPT to create a (hopefully) digestible analogy:

Imagine a community of farmers with low levels of debt at the beginning of the farming season. They all decide to borrow seeds (money) to plant larger fields. This increases their overall harvests (spending), which in turn raises their collective incomes. The more bountiful harvests they produce, the more successful their farms appear to the seed lenders (creditors) and others in the community.
As the farmers' incomes grow, the seed lenders consider them more creditworthy and are willing to lend them even more seeds. This enables the farmers to expand their fields further, which in turn leads to higher spending, more income, and eventually an increase in the value of their lands and assets (collateral). With higher collateral values, the farmers appear even more creditworthy, leading to more borrowing, spending, and so on.
This virtuous cycle continues throughout the community of farmers until the cost of servicing their debts starts to put a strain on their finances. As the interest payments on the borrowed seeds become a burden, the farmers have less money to spend on maintaining their fields, buying fertilizer, or investing in new equipment. This results in a decline in their harvests (spending) and collective income.
As the farmers' incomes fall, so do the values of their assets, including their lands, which in turn reduces their creditworthiness. With the decline in creditworthiness, they can no longer borrow as many seeds, causing a further decrease in spending, income, and asset prices. This downward spiral continues throughout the community until the farmers take steps to reverse the cycle, such as reducing their debt burdens or finding new ways to increase their farms' productivity. In this way, the entire economy, represented by the community of farmers, is impacted by the credit cycle.

Not bad for a robot in 3 seconds.

The impact of rising interest rates on consumer spending remains to be seen since most existing private debt was financed at low rates. For example, the median mortgage in the U.S. is financed at 3.1%2. These fortunate Americans are in no hurry to sell their home to take on a new mortgage at the prevailing 6% rate. As a result, existing home sales are down 23% versus last year3. However, a new home buyer’s carrying cost for the same mortgage amount has doubled. The same math applies to car loans. As debt in the economy matures, and new debt begins to constitute a more significant portion of outstanding debt, the increased cost of servicing new debt will impede the spending power of both individuals and corporations who employ those individuals. This is the beginning of the deleveraging process. Recall that when debt is paid back, money is destroyed. The credit cycle will work equally as reflexively on the way down, and this process is deflationary.

We would be remiss not to mention the banking sector amidst the Silicon Valley Bank (SVB) implosion during the quarter. Unfortunately, many banks hold the other side of those coveted 3% mortgages we discussed. As interest rates have risen, the value of those mortgages (usually pooled into mortgage-backed securities - MBS) held by banks have declined significantly. SVB was heavily exposed to these long-duration securities purchased at low interest rates, which became problematic as their tech-startup heavy clientele drained cash (SVB deposits) amidst the 2022 drought in venture capital (VC) funding. To make matters worse, the financial decisions of a large percentage of SVB customers were heavily influenced by what was likely a dozen or so VC funds. Thanks to this concentration of power, with a few clicks of the iPhone, $42B left SVB on March 9th and an additional $100B was queued for withdrawal by the following morning when regulators seized the bank4. That’s $142B in 24 hours, roughly 85x faster than the previous fastest bank run on record, which occurred at Washington Mutual Bank in 2008 at the rate of $16.7B in 10 days5.

Unsurprisingly, it was a government bailout to the rescue yet again. In the aftermath of SVB, regional banks remain most at risk, particularly those with outsized exposure to commercial real estate. This sector, flipped upside down by the pandemic-driven work-from-home movement, is sitting on assets now worth materially less in the higher interest rate environment and cannot economically roll their debt at these new rates. We expect to see several defaults, which would also impair banks with high exposure in their loan books. These same banks are likely to rein in lending and increase credit standards, which will have a chain reaction effect on spending and incomes, as illustrated in the previous diagram. 

For Illustrative Purposes Only

 Our regular readers will know we are firmly in the inflation camp for the next decade. Why? Despite everything we discussed above being incredibly deflationary, history tells us the government’s response to this economic fire will be a fire hose of liquidity (fiscal and monetary stimulus), each instance typically magnitudes larger than the last.

Cycles: Debt, Power & Commodities 🌀

Over the last twelve months, we have been actively cataloging what we believe to be the most implicative and investable theme of the decade: the end of the long-term sovereign debt cycle.

Ray Dalio has done extensive work on cycles in his books Big Debt Crises and The Changing World Order. His historical research has identified consistent economic and social patterns leading to long-term debt cycles (like the farmer analogy above), which take place over 75 to 100 years and often correlate to the rise and fall of empires via what we will call “power cycles”. Using Dalio’s framework, we believe we are in the final stages of the U.S. long-term debt cycle coinciding with the late-stage power cycle, meaning its days as undisputed global superpower may be numbered. We highly recommend watching the following video by Ray Dalio for a simple and high-level overview of the power cycle (at 2x speed).

Today, the United States shows many signs of a declining power. We are amidst significant internal strife. Increasing wealth inequality has driven populism, and the politicization of social issues, exacerbated by the pandemic, has resulted in growing extremism. Domestic conflict and the later stages of the long-term debt cycle open the door for international conflict, as global powers recognize weakness as their time to strike.  

We wrote last quarter that the world was already at war, albeit a non-militant, political, economic, informational, and financial war. The first quarter of 2023 brought many signposts of heightened conflict, which coalesced around de-dollarization and a growing sense of alliance in the East. The tea leaves are beginning to pile up. Here are a few that caught our eye:

  • March 11: China brokers a peace deal between Saudi Arabia and Iran, a recognition by the Middle East that China is the desired power player in the region, not the United States. As a result, the Yemen war may come to a close.
  • March 21: Chinese President Xi spends three days meeting with Putin, signifying a growing alliance.
  • March 27: Saudi Aramco takes a $3.6B stake in a Chinese oil refinery, expanding its presence with the word’s largest importer.
  • March 28: Saudi Arabia joins the Shanghai Cooperation Organization, a political and security union led by China, India, and Russia.
  • March 29: Xi Jinping announces he is preparing China for war at the annual parliament meeting.
  • April 14: Saudi Arabia cuts diplomacy deal with Syria, signifying another regional peacetime development.

 The growing stratification between East and West could not be any clearer.

We are investors, after all. We seek to protect and grow purchasing power and we believe the result of the inflecting long-term debt cycle and power cycle will be the emergence of a commodity cycle. Investors must recognize the next decade will look markedly different than the last several, particularly the period since 2008. The geopolitical aspect is just one of several elements which sway us toward commodities.

Following the 2008 Financial Crisis, the world was awash with cheap commodities, cheap labor, and cheap credit. Commodities were oversupplied following a heavy investment cycle from the turn of the millennium as demand was driven by China’s emergence as a global manufacturing powerhouse. Labor was widely available, as unemployment remained high in the wake of the global recession, and outsourced manufacturing labor in the East (China) was significantly cheaper than in the West. Lastly, interest rates were brought the zero bound by central banks in an effort to stimulate the economy. These factors made for efficient and cheap supply chains, which meant inflation was nowhere to be found, despite rising Western consumer demand and inflating asset prices.

Today, none of these factors are present. Instead, the combination of pandemic fiscal and monetary stimulus during a period of supply chain restrictions let the inflation genie out of the bottle. As a result, inflation has increased wages (cost of labor) and interest rates (cost of capital). Meanwhile, most commodities markets experienced little to no investment in supply during the 2010s, which has left commodity markets undersupplied for the upcoming decade. This imbalance is amplified by the three core priorities of the Western G7 nations: 1) re-shore manufacturing, 2) re-arm national defense 3) complete the energy transition. The combination of all three is a step change in commodity demand into markets that are already supply constrained. Importantly, all three agendas are matters of national security, given the increasing polarization of global superpowers, meaning they are not optional.

Fiscal spending will be the name of the game. The U.S. CHIPS and Inflation Reduction Act are a precursor to more spending on domestic supply chains and clean energy initiatives. Similarly, military spending is on the rise. Japan announced it will double defense spending from 1% of GDP to 2% over the next five years and, following his recent announcement, French President Macron will have doubled military spending by 2030 since he took office in 2017. However, the real kicker for commodities is the energy transition. A glance at the following charts is all you need to see.  

First, the concentration of mining and processing in China for minerals and metals needed for clean energy technologies should jump off the page, particularly considering the multipolar nature of today’s geopolitics. Chile, also featured prominently, just nationalized its lithium industry.

For Illustrative Purposes Only

 Next – the projected necessary growth in supply to meet energy transition demand. 

For Illustrative Purpose Only

 The exponential growth in demand is shocking. The International Energy Agency estimates that the combination of existing mines and those under construction will generate just 50% of project lithium and cobalt requirements and 80% of copper needs by 2030 (CITE). Worse, their historical analysis suggests it takes 16.5 years on average to move a mining project from discovery to first production (CITE).

This is setting the stage for major supply/demand imbalances for many commodities, exacerbated by the potential for trade limitations amongst competing powers, all of which bodes favorably for commodity prices. We believe the hard asset renaissance amidst global fiat currency debasement will turn heads. Let’s see. 

Innovation Spotlight 🔍

We must highlight OpenAI’s ChatGPT, which marks the world’s most advanced artificial intelligence (AI) development. We are in awe of AI capabilities and are still working on grasping its vast implications. We believe, not insincerely, that AI is the most transformative human invention of all time, and we will have lots more to say in upcoming posts.

AI undoubtedly represents a step change in human productivity, which will significantly affect economic growth. Perhaps, that pesty debt issue we can’t stop talking about may be partially alleviated by AI-driven growth. Goldman Sachs estimates a $7 Trillion increase in global GDP, which equates to a 1.5% increase in growth rates over the next ten years. However, if history’s assessment of the human ability to grasp exponential growth is any guide, these assumptions will drastically underestimate AI’s impact.  

AI is making headlines daily, and among the most mind-boggling we’ve seen is the below output from AI Researcher Brian Roemmele. He trained an AI on a dataset of every U.S. patent ever filed and asked the AI to generate new patent ideas. He claims to have hundreds of these generated in just a “few days.” 

For Illustrative Purposes Only

Thanks for reading!


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All financial data is sourced from Refinitiv unless otherwise noted.

1  Bureau of Economic Analysis. BEA Data: U.S. Real GDP (Quarterly)

2 Boesel, Molly.  "Higher Mortgage Rates Lead to Strong Lock-In Effect". CoreLogic. November 2022. 

3 National Association of Realtors. Existing Home Sales. March 2023

4 Puzzanghera, Jim. "Silicon Valley Bank Collapsed at Unprecedented Speed: Can Washington Prevent Another Viral Bank Run?".  Boston Globe. April 2023. 

5 Salmon, Felix. "The Largest Bank Run in History". Axios. March 2023.