Q4'22: A World at War
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As we enter 2023, we remain focused on the confluence of rising geopolitical tensions, buoyant sovereign debt loads in the West, and inflation. These factors are forming an investing paradigm structurally distinct from that which markets have been accustomed to for the last fifty years. We wrote in early 2022 that U.S. dollar hegemony might be under siege, driven by the increasing polarization between East and West, which would have significant implications for U.S. sovereign debt (Treasuries) and, consequently, asset allocation frameworks.
TLDR – "too long; didn’t read." We recognize our posts can be lengthy and challenging to digest, so here’s our executive summary:
- We are in a new era of power struggles between East and West. This war is non-militant but political, informational, economic, and financial.
- The U.S. fiscal position (debts and deficits) is our kryptonite. We cannot afford a war, nor these sustained higher interest rates, without adequate buyers of our Treasuries. Therefore, the Federal Reserve will fill the void by soon restarting asset purchases (Q.E.).
- A multipolar world is a world built for resiliency, not efficiency. Reverse globalization will have several effects, culminating in increased economic costs, further contributing to inflation.
- Inflation is not linear, so while 2023 may print some relatively low year-over-year inflation readings after last year's surge, we believe this will be a temporary reprieve.
- Bank lending, a.k.a. money creation, has soared despite rising interest rates. This is yet another factor that will contribute to structural inflation.
- Bottom line: macro uncertainty and inflation are sticking around; this likely means a volatility-prone equity environment with high dispersion of returns across sectors.
The Silent War 🔕
World War III is upon us, and most are oblivious, primarily because this world war looks nothing like the former two. The modern battleground is no longer purely physical nor fought by men. Warfare, just like every industry, is digitizing. Pippa Malmgren, economist, and former Presidential advisor, first asserted the start of WWIII in October 2021. She writes, "the focus of applied methods of conflict has altered in the direction of the broad use of political, economic, informational, humanitarian, and other nonmilitary measures – applied in coordination with the protest potential of the population1." WWIII is fought in space, cyberspace, underwater, through social media, the weaponization of supply chains, and, most notably for investors, financially. Historian and professor Arthur Waldron reminds us, "the Chinese esteem most those victories achieved without fighting; they abhor long-term, attritional war2."
Here are a few examples of silent warfare that caught our attention over the last year:
- The Swedish government concluded the Nord Stream pipeline, which carries gas from Russia to Europe, was sabotaged by a state actor but won't reveal its suspect.
- Russian spies are being caught across Europe at an accelerated pace, particularly in Norway.
- TikTok, the viral social media app that has long been thought of as an espionage tool for the Chinese state, admits to tracking journalists. Note TikTok has the proven ability to track users' every move when browsing within the app, including keystrokes, text inputs, and screen taps (careful with those passwords and credit card numbers, Gen Z).
- In October, the Biden administration imposed sweeping restrictions on semiconductor and chip-manufacturing equipment exports to China to slow and limit their access to advanced technologies.
- Chinese tracking devices were found embedded in U.K. government officials' cars. Due to warranties and commercial agreements, Chinese car parts are often outfitted without being opened or inspected.
- Underwater network cables were mysteriously cut, causing widespread internet outages on separate occasions in Egypt, Southern France, and Norway.
If we are engaged in some form of non-militant war, we should recognize that the United States' weakest link is the ballooning debt load and widening deficit. The rising "Eastern" coalition of BRIC+ nations (Brazil, Russia, India, China, and more recently, Turkey, Saudi Arabia, and Argentina) is seeking to weaponize our deficit through de-dollarization and the subsequent loss of U.S. Treasury buyers. We have described this tactic before, but it goes something like this: less international trade in U.S. dollars ➡ less foreign demand for U.S. Treasuries ➡ inability for the U.S. to finance deficit/debts without central bank printing ➡ Federal Reserve forced to print into inflation ➡ more inflation, more populism, more domestic unrest. A compelling playbook if you're Xi Jinping or Vladimir Putin. If we cannot effectively finance ourselves, we cannot fight a war.
De-dollarization is just one vector of attack, and the second related vector is inflation. It is well documented that war is exceptionally inflationary, as it increases the propensity of governments to increase spending, driving an increase in aggregate demand for commodities, all while shuttering and hamstringing physical supply and global trade. Credit Suisse macro strategist Zoltan Poszar writes our "low inflation world stood on three pillars: first, cheap immigrant labor keeping service sector wages stagnant in the U.S.; second, cheap goods from China raising living standards amid stagnant wages; third, cheap Russian gas powering German industry and the E.U. more broadly. U.S. consumers were soaking up all the cheap stuff the world had to offer: the asset rich, benefiting from decades of Q.E., bought high-end stuff from Europe produced using cheap Russian gas, and lower-income households bought all the cheap stuff coming from China. All this has worked for decades until nativism, protectionism, and geopolitics destabilized the low inflation world 3."
The latest IMF (International Monetary Fund) paper coins the term geoeconomic fragmentation (GEF), where the authors explore the potential economic ramifications of reverse globalization. We have previously emphasized the realignment of global superpowers more distinctly on an East vs. West axis. This growing multipolarity will transform many tailwinds of the last few decades into headwinds.
- The transition from a singular supply chain designed for global efficiency to duplicate supply chains designed for regional resiliency will make goods scarce and, thus, more costly. This will disproportionately impact low-income countries and low-income consumers in developed countries.
- Immigration restrictions will limit the flow of labor and intellectual capital to Western countries, compounding poor demographics and decreasing output capacity.
- Reduced capital flow and foreign direct investment will constrain technological diffusion, the process by which innovation spreads within and across economies.
- Erosion of the U.S. dollar system will diversify sovereign reserve assets away from the U.S. dollar, creating more financial volatility.
The IMF finds that GEF could negatively impact global GDP by "0.2% (in a limited fragmentation / low-cost adjustment scenario) to up to 7 percent of GDP (in a severe fragmentation / high-cost adjustment scenario). With the addition of technological decoupling, the loss in output could reach 8 to 12 percent in some countries4." These are significant impacts on the global economy, which will have equally significant implications for investors who have enjoyed nearly 80 years of increasing globalization.
Bank Credit Growth = Inflation Fuel ⛽Commercial banks create money when issuing new loans, increasing the broad money supply. Commercial banks are only required to hold a certain percentage of deposits in reserve, so the only restraining factor to lending is the reserve requirement ratio, which has historically been 10%.
Let's say Alice applies for a $100 loan at 5% interest. If approved, the bank then digitally credits her account with $100. Suddenly, there is an additional $100 in the economy, and the bank only needs $10 in reserves to make the loan. Alice is obligated to pay back the $100 plus $5 in interest at the end of the term. If new loans create money, then repaying a loan destroys money.
Banks had little interest in lending during the low-interest rate environment, as they did not feel adequately compensated for credit risk with 2% interest. However, given today's rising interest rate environment, banks have rediscovered their lending appetite and are in a financially sound position to do so.
Roughly $1.2 trillion of loans were made in 2022, nearly three times higher than the prior 3-year average5. We believe demand for loans will remain strong so long as inflation persists well in excess of interest rates. Bank credit growth increases the broad money supply, and is a direct cash infusion to the economy, much like fiscal stimulus. Ironically, the Federal Reserve is trying unabashedly to quash demand, yet we expect this bank credit growth to support demand and, therefore, inflation. We also note that should a rebirthing of the U.S. manufacturing sector occur in response to the growing global multipolarity and fragility of current supply chains, bank credit growth will only accelerate to meet domestic investment needs.
This sets the stage for corporate earnings and, subsequently, equity market valuations. If, as we believe, a structurally inflationary environment persists, then corporations will grow profits nominally as price increases generate higher sales. However, we expect profit margins to decline slowly in aggregate as higher costs are not fully passed on. Yet, there will be pockets within equities growing both earnings and margins. This environment is distinct from any other recent recessionary period, all of which have been deflationary recessions that brought into question the solvency of the financial system and manifested significant earnings declines.
The Year Ahead 🔮
Viewing the market as a function of earnings and the price market participants are willing to pay for those earnings (Price/Earnings – P/E) gives us a decent roadmap. 2022 was a year of valuation multiple compression whereby markets were willing to pay less for earnings because interest rates rose dramatically. Thanks to rate hikes, investors could achieve greater yields in U.S. Treasuries, which demanded an increase in equity yields (as yields are the inverse of price, this meant equity prices declined).
Looking into 2023, we believe interest rates will not end the year significantly higher, primarily because, as we constantly remind readers, the government cannot afford them! Thus, the majority of multiple compression is likely behind us (P in P/E). As for earnings (E in P/E), we described above that nominal profit dollars (not adjusted for inflation) are likely to increase slightly or, in the event of a significant recession, decrease marginally. This sets the stage for a rather muted year in equities at the aggregate index level from point to point. Yet, we expect the path to get there to be sprinkled with continued bouts of volatility and high dispersion of returns across sectors. We remain focused on identifying sectors and companies well suited to perform in this environment. Here are just a few areas of interest:
- Best-in-Class Software
- Technology companies were disproportionately affected by multiple compression. These growth companies typically carry higher valuations because their expected cash flows are heavily weighted to years further out in the future. Hence, investors are willing to pay a premium today. Enterprises are focused on prioritizing software spending and consolidating solutions that drive the highest cost efficiencies. These best-in-class platforms will continue to see healthy demand. Meanwhile, software companies are focused on cutting expenses, starting with their workforce. At Twitter, Elon Musk, love him or hate him, has proven to Silicon Valley CEOs that you can indeed do more with less.
- Aerospace & Defense
- The Silent War is driving increased investment in aerospace and defense by sovereigns. Not only is space the next military frontier, but it's also the source of valuable intelligence for on-earth activities. While we expect makers of traditional weapons and jets to perform admirably, superior intelligence will be key to winning this, so far, non-militant war.
- Fossil Fuels
- The stubbornness of politicians with respect to energy policy continues to dumbfound us. The refusal to support increased fossil fuel production has led to structurally tight supply globally. Objectively, additional oil and gas are needed before we can successfully transition to clean and sustainable energy sources. While companies in the exploration and production phase have had significant runs in the last two years, we believe they will continue to generate record profits. Typically, these profits would be reinvested in further production projects, but today, these companies are returning the bulk of earnings to shareholders. We find offshore drillers a particularly well-positioned sub-sector.
- Precious Metal Miners
- Gold and silver are hard monies. Given a world of consistent and predictable fiat currency debasement and increasingly unstable geopolitics – has there ever been a better setup for gold? After nearly two years of price consolidation, we believe 2023 might be a breakout year and prefer to own the miners, whose profits grow exponentially relative to increases in the spot price of gold.
We leave readers with the wise words of Ludwig von Mises - "the most important thing to remember is that inflation is not an act of God, that inflation is not a catastrophe of the elements or a disease that comes like the plague. Inflation is a policy"6. We'll go as far as to say good policy if you're seeking to reign in a sovereign debt bubble.
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1 Malmgren, Pippa. A Hot War in Cold Places. Dec. 3, 2021.
2 Waldren, Arthur. Naval War College Review. The Hundred-Year Marathon: China's Secret Strategy to Replace America as the Global Superpower, by Michael Pillsbury. 2015.
3 Poszar, Zoltan. Credit Suisse Research. War and Interest Rates. August 1, 2022.
4 Aiyar, Chen, et al. International Monetary Fund. Geoeconomic Fragmentation and the Future of Multilateralism. January 2023.
5 Wang, Joesph. FedGuy.com. Credit Boom. January 2023.
6 von Mises, Ludwig. Economic Policy: Thoughts for Today and Tomorrow. 1979.