Q1'24: Haves and Have-Nots

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

Inflation has been above “target” (2%) for nearly 38 months, and recent trends suggest it may be increasing again.
As we have repeatedly written, inflation dynamics are structural, not just cyclical. Therefore, we expect inflation to remain elevated through cycles, likely in the 4-5% range over time.
The structural reasons are many, but the causal chain goes something like this: China (manufacturing center of the world + U.S. Treasury buyer) + Federal Reserve Quantitative Easing ➡️ created an artificially low-interest-rate environment (cost of capital < growth) ➡️ ballooned a debt and asset bubble ➡️ dramatically widened wealth inequality ➡️ gave rise to populism in America ➡️ favored unchecked government spending ➡️ moved baseline inflation higher.
Inflation rates greater than the interest the government pays on its debt help deleverage the federal balance sheet; inflation is their friend not their enemy.
Scarce assets (gold and Bitcoin) are on the move, perhaps a signpost of a changing global monetary system, growing concerns around government deficits, and a broadening acknowledgement of forthcoming currency debasement.

The American Barbell 🏋️

Inflation is sticky – that’s what many investors and policymakers are currently learning, but readers of this blog will find it no surprise that CPI has stopped coming down and looks to be heading higher from its most recent 3.5% year-over-year reading in March. The confluence of factors supporting long-term inflation are structural, not cyclical.

The world is exiting what Russell Napier calls “the Age of Debt” – a global monetary system supported by China’s rapid economic growth over the last thirty years. By pegging their currency in 1994, China kept the Yuan artificially low, making manufacturing in China even cheaper on a relative basis. This structural advantage helped Chinese GDP increase 31.5x from 1994 to 2023, all while running massive trade surpluses, which were then sent back to the U.S. in exchange for U.S. Treasury bonds. China’s holdings of U.S. Treasuries peaked at $1.3 trillion in 2013 (when trillions meant something), up from virtually zero at the turn of the century ^[1]. The combination of cheap goods exported to the U.S. and the depression of sovereign bond yields in the West created a deflationary impulse, which central banks would go on to fight with inflation-targeting policies, Napier argues ^[2]. The decision to conduct quantitative easing (central bank bond purchases) following the wake of the GFC further contributed to artificially suppressed yields. The consequences of the unnaturally low-interest rate environment ballooned global debt loads simply because debt was so cheap – why not borrow at 0%?

The Cantillon effect, first theorized by Richard Cantillon in the 18th century, describes how the injection point of new money supply in an economy creates uneven effects, benefiting those who receive the money first. Through QE, our central bank provided a near-zero cost of capital directly to the investor class, which forced them further out on the risk curve in search of yield, subsequently inflating asset values in the financialized economy – stocks, bonds, and real estate. Since 1994, when Russell Napier believes the Chinese currency peg altered the global monetary system, the cyclically adjusted PE ratio (Shiller PE) has reached a permanently higher plateau, averaging 28x vs. the prior 135-year average of 14.5x. Asset gains have generated substantial wealth creation, but in a highly uneven fashion, thus worsening wealth inequality. Corporations (larger the better) were also beneficiaries of cheap capital, which most used to maximize profits by driving costs lower through the exportation of manufacturing to China. This hollowed out the American middle class, further perpetuating modern America’s societal barbell: the haves, who own assets, and have-nots, who do not.

For Illustrative Purposes Only

Here are a few more statistics that JP Morgan CEO Jamie Dimon called out in his annual letter to shareholders:

“From 1979 to 2019, the wage growth of the top 10% was nearly 10x that of the bottom 10% - which, basically, had not increased at all”.
“Of the 160 million Americans working today, approximately 40 million are paid less than $15 per hour”.
“Nearly 40% of Americans don’t have $400 in savings to deal with unexpected expenses, such as medical bills or car repairs”.

This level of inequality tends to breed populism – a political ideology in which leaders appeal to the common man in their struggle against the elite establishment – which is alive and well on both sides of the aisle today. Populism is not just a domestic phenomenon, as it has gained appeal across many Western democracies. Driven largely by European nations, the share of independent countries with a populist government is at all-time highs.

For Illustrative Purposes Only

Critically, populism is a key contributor to structural inflation. Populist policies are typically nationalistic, favor trade restrictions, and liberal use of fiscal and monetary expansions to close the inequality gap. The United States experienced this firsthand in the wake of the pandemic, as total government spending packages total nearly $6.7 trillion or 31% of 2019 U.S. GDP – Trump Covid Relief Plans (combined $2.4 trillion), Biden American Rescue Plan ($1.9 trillion), Biden Bipartisan Infrastructure Law ($1.2 trillion), Biden Chip Act + Inflation Reduction Act ($1.17 trillion). This rivals the scale of FDR’s New Deal programs during the Great Depression, which totaled $41 billion (now a rounding error!) or nearly 40% of 1929 GDP ^[3]. In a review of recent bills, we think McKinsey (inadvertently) perfectly captures the populist agenda: “Equity matters. The BIL, CHIPS, and IRA seek to redress long-standing inequalities by laying a stronger foundation for sustainable, inclusive growth”. A recent study of Latin American countries empirically found populist regimes ignited far higher inflation rates than non-populist regimes.

For Illustrative Purposes Only

Through government spending, particularly the Covid-era direct-to-citizen fiscal transfers, the U.S. has continuously stoked demand. Meanwhile, the supply side has struggled through shutdowns, shortages, higher interest rates and is now prioritizing geopolitical concerns. No longer is the incremental manufacturing dollar spent in China. As a result, the decades-long deflationary impulse stemming from China has reversed into an inflationary impulse driven by the return of manufacturing to the West. We have several times called out what we believe are the three driving factors of inflation this decade – the Western agenda to 1) re-arm (military), 2) re-shore (manufacturing), and 3) re-energize (facilitate energy transition). We’ll add a fourth – to re-distribute wealth. In the U.S., all four commitments are funded by a government with spiraling deficits.

The time-tested strategy for governments to deleverage is to inflate their way out by making tomorrow’s debts worth less. Balance sheet progress is made when inflation exceeds the interest rates on government debt, so next time you hear policymakers talk about fighting inflation, remember that behind closed doors, inflation is on their team.

Pet Rocks Breathe Life 🪨

How can investors protect themselves in this era of elevated structural inflation and currency debasement? We believe scarce assets like gold are a good place to start. Since the February 2022 sanction of Russian U.S. dollar reserves, we have been opining on a new global monetary system in which gold has a far more central role as a neutral reserve asset. Historically, gold, which pays no interest, has traded in tight inverse correlation to real interest rates (nominal yields minus inflation). When real rates rise, gold usually falls due to its higher opportunity cost and vice versa. Yet, throughout the global central bank rate hiking cycle, gold remained steadfast and has recently broken out to new highs – perhaps something is different this time.

For Illustrative Purposes Only

The last time gold rose with interest rates was in the late 1970s when inflation and government spending drove yields, the U.S. dollar, and gold in the same direction – up. Gold went on to jump from ~$100 in 1976 to ~$800 four years later. We believe gold remains the most explicit expression of protection against the runaway government deficits the U.S. is currently experiencing. Foreign central banks, specifically BRICS+ nations, seem to feel the same. Since 2020, these central banks have increased gold tonnage by 16% (538 tons, roughly half purchased by China), while G7 nations haven’t budged (cumulatively +0.71% driven exclusively by Japan). This only accounts for “officially” reported purchases – some estimates put China’s total holdings at 5,538 tons, well above their officially disclosed level of 2,250. It’s not just China’s central bank buying gold – it’s their private sector, too. Chinese consumers are aggressively stockpiling gold while their real estate and stock markets suffer. In effect, the Chinese capital account, which has historically been closed, appears to be open on a limited basis via gold – perhaps an important signpost.

China has been the architect of de-dollarized oil trade, whereby China now buys oil in Yuan from the Middle East, which is redeemable for gold at the Shanghai Gold Exchange. As the price of gold rises in Yuan, China’s marginal barrel of oil purchase becomes cheaper. Thus, we would expect gold to be flowing to China, where it effectively buys more oil. Indeed, physical gold appears to be flowing East, as bullion held by Western ETFs continues to decline, and the LBMA (London Bullion Metals Association) reports vault holdings 11% lower than their peak in 2021, representing 1,156 tons in outflows ^[4]. The combination of Chinese central bank purchases and private sector demand marks a monumental shift whereby physical gold prices are now being set in China, not in London or New York.

For Illustrative Purposes Only

We view this as a defining change in the structure of global gold markets. As mentioned in a previous post, some estimates put the paper gold market (claims on rehypothecated gold) at 20-30x larger than the physical market ^[5]. In the past, spikes in the gold price were often tampered out by the expansion of (false) supply in the paper markets. However, China’s preference for physical bullion is draining Western stockpiles, and we believe only a matter of time until paper markets experience a run on physical gold. Interestingly, Western investors have been nothing but net sellers since the gold price began moving higher. Perhaps gold bugs have been converted to crypto bugs and are swapping their gold ETFs for the recently approved Bitcoin ETF – more on that shortly. We can’t be sure, but the dramatic rise in gold despite Western selling is noteworthy. We don’t foresee Chinese demand slowing, and with enough momentum, Western investors (who have less than a 3% allocation to gold) may flip from sellers to buyers, likely accelerating price gains.

We also hypothesize that the lack of Western investors’ interest in gold is one of the root causes of the lagging performance of gold miners relative to the shiny metal they dig up. Other contributing factors include higher cost estimates (inflation), jurisdictional risk (Barrick might lose their Mali mine, 12% of output, to nationalization), and, in the case of some very large mining companies, massive reclamation costs on their balance sheet thanks to decades of mining environmental impact. Not all miners are created equal, and we believe non-legacy miners with strong management teams operating in jurisdictions that abide by the rule of law will see significant interest as spot gold price increases mostly fall to their bottom line.

For Illustrative Purposes Only

Lastly, we highlight Bitcoin – the younger generation’s (digital) pet rock – which shares and improves upon many characteristics that make gold “sound” money. You can read our original Bitcoin piece here, which details Bitcoin’s origin, key properties of money, and network mechanics. In 2024, Bitcoin has set a new all-time high following the SEC’s approval of Bitcoin ETFs in January. This has made the asset far more accessible to institutional investors, fast-tracking adoption. BlackRock’s Bitcoin ETF (Ticker: IBIT) has been its most successful ETF launch of all time and has taken in new funds every single day since approval – an astounding statistic in our view ^[6].

Like any asset, supply and demand drives price. Following the Bitcoin bear market in 2022, long-term holders of Bitcoin only increased. The percentage of Bitcoin that hasn’t moved in over a year is nearly 70%, representing long-term investors. As this metric increases, so does the inelasticity of supply (the responsiveness of supply to an increase in price), which is why net inflows on the scale of tens of billions have driven the market cap of Bitcoin up hundreds of billions.

A key source of supply to the market is Bitcoin sold by miners. Miners receive freshly minted Bitcoin as a reward for expending computing power to verify each block. The reward per block halves roughly every four years, and as of April 19th, 2024, has decreased from 6.25 Bitcoin per block to 3.125 Bitcoin per block. Since miners typically sell mined Bitcoin on the open market to fund their operations, the market must absorb their daily selling activity. On average, there are 144 blocks mined per day, meaning that daily new issuance is now 450 Bitcoin (down from 900), which is assumed to be sold by miners. By contrast, ETFs have swallowed up an average of over 5,000 coins per day. While the ETF accumulation rate may slow, we believe the flow dynamics will likely remain very positive.

Thanks to their scarcity value and monetary characteristics, both gold and Bitcoin stand to benefit from continued currency debasement and an evolving global monetary landscape. We believe both have important roles in investor portfolios.

Disclaimers

The information provided is for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status, or investment horizon. You should consult your attorney or tax advisor.

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Investments involving Bitcoin present unique risks. Consider these risks when evaluating investments involving Bitcoin:

Not insured. While securities accounts at U.S. brokerage firms are often insured by the Securities Investor Protection Corporation (SIPC) and bank accounts at U.S. banks are often insured by the Federal Deposit Insurance Corporation (FDIC), bitcoins held in a digital wallet or Bitcoin exchange currently do not have similar protections.
History of volatility. The exchange rate of Bitcoin historically has been very volatile and the exchange rate of Bitcoin could drastically decline. For example, the exchange rate of Bitcoin has dropped more than 50% in a single day. Bitcoin-related investments may be affected by such volatility.
Government regulation. Bitcoins are not legal tender. Federal, state or foreign governments may restrict the use and exchange of Bitcoin.
Security concerns. Bitcoin exchanges may stop operating or permanently shut down due to fraud, technical glitches, hackers or malware. Bitcoins also may be stolen by hackers.
New and developing. As a recent invention, Bitcoin does not have an established track record of credibility and trust. Bitcoin and other virtual currencies are evolving.

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Sources:

All financial data is sourced from Refinitiv Data or Federal Reserve Economic Data (FRED) unless otherwise noted.

^[1] Treasury.gov – Major Foreign Holders of U.S. Treasury Securities.

^[2] Russell Napier – The Rise and Fall of the Age of Debt. Forward Guidance Podcast. March 26, 2024.

^[3] Dupor, Bill. Federal Reserve Bank of St. Louis. How Recent Fiscal Interventions Compare with the New Deal. July 13, 2021.

^[4] London Bullion Metals Association. London Vault Data. March 2024.

^[5] Nemethy and Scalabrini. An Upcoming Paper Gold Crisis? 2020.

^[6] www.theblock.co. Data. Spot Bitcoin ETF Flows.