June 3, 2022
By Steve Blumenthal

“The Fed is attempting to regain its credibility.
There is a big risk that inflationary psychology becomes embedded.”
– Felix Zulauf, Owner and President, Zulauf Asset Management

“I was wrong about the path inflation would take,” Treasury Secretary Janet Yellen said in a CNN interview with Wolf Blitzer Tuesday night. St. Louis Fed President James Bullard on Wednesday piled on, “I think we’re on the precipice of losing control of inflation expectations.” Fed Chairman Jerome Powell said this week that inflation is not the Fed’s fault. One can try to duck under the cover of Covid and supply chain issues but printing 50% of all dollars ever created, in just the last two years, is the big elephant in the room. Too much money chasing too few goods. Thank you, Chairman Powell.

That goes on the Fed. Experts see little chance of the Fed pausing rate hikes in September. The fight is on. Inflationary psychology is embedded.

After our pause last week, let’s dive back into a selection of my summary notes from the Mauldin Economics 2022 Strategic Investment Conference.

Grab your coffee and find your favorite chair. I’ve broken my notes into several sections and provided links to previous posts. Being able to watch and rewatch the replays has been tremendously valuable. You really should consider signing up for next year’s conference. I’m biased of course due to my relationship with Mauldin, but in my view, he and his Mauldin Economics team put together the best collection of thinkers in the investment world. By the way, if you are not reading Mauldin’s free weekly Thoughts From the Frontline e-letter, it’s excellent (you can sign up here).

If you are not signed up to receive the free weekly On My Radar letter,
you can sign up here.

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A Short Selection of Previously Shared OMR Notes

From Felix Zulauf

• Nothing is linear. Things progress cyclically, as determined by greed and fear. There is a business cycle up-wave, then a bear market down-cycle.
• QT is the reduction of liquidity, and we will get a liquidity crisis at some point. Will the blow-up this time be in Turkey or Hong Kong? We don’t know.
• He believes there is more room on the downside. We will see a big bull run in equities if the Fed U-turns.
• He sees more upside in yields and the dollar and expects inflation to continue into the mid-2020s.
• He expects a rollercoaster ride in the markets over the next 10 years and says, “you must be aligned with the main trend and the trend is bearish.”

From Dr. Lacy Hunt

• “We are in pre-recession, we are going into recession and where the Fed goes from there I’m not sure.” (You’ll find more from Lacy below.)

From Howard Marks

• The last 13‒14 years have been unusual in that we have not had a substantial number of defaults in distressed debt. He sees more bankruptcies over the next two years and noted that cheap money has kept zombie companies alive.
• The Fed game is basically over. He does not see another round of stimulus in the years ahead.
• The Fed should ignore the markets and focus on inflation.
• A soft landing will be hard to achieve.
• He sees the Fed Funds rate reaching 3–4% within 18 to 24 months.
• He was asked what he thought Powell is going to do and answered, “Powell doesn’t know what he is going to do so why should we?”
• Adding (importantly), “We must have political cooperation to solve coming problems like Social Security, Medicare, and immigration.”

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The Gavekal Team 

From Anatole Kaletsky 

• According to Kaletsky, the economic outlook changed significantly because of the war in Ukraine, sparking a long-term state of high inflation.
• He turned bullish after the 2008 great financial crisis due to the tremendous level of monetary stimulus (easy money) and low-interest-rate policies around the world.
• This created underlying preconditions for higher inflation. “You can’t have inflation without monetary expansion, but you can have monetary expansion without inflation, at least for very long periods,” Kaletsky said.
• He said, “Instead of buying on dips, the new correct policy is to sell the rallies.”

From Charles Gave

• The thing to understand is that we are in a new economic/financial environment.
• You don’t make money in an inflation period; you have to try to stay rich since financial assets and bond markets will go down.
• You need tactical asset allocation; the period of putting some money in stocks and bonds and waiting 30 years is finished.
• You need cash, but be careful where you put your cash (some currencies will be very good cash receivers, others won’t).
• The inflationary cycle ends with an inflationary bust and/or a liquidity crisis.
• An inflationary environment means the death of the index fund.
• Every inflationary period leads to deglobalization, the reemergence of capital control, price control, and foreign exchange controls.
• When reserves decline year over year, there has always been some financial crisis outside the U.S.
• Reserves are declining, meaning the start of a shortage of dollars outside the U.S.
• Then, the dollar will go up before going belly-up. Gave believes an early liquidity crisis has started.
• The markets are moving closer to a state of panic, in which the correlation rate with assets will go to one.
• The future state of Europe: Gave thinks we might be arriving at the end of social democracy in Europe. He added, “There is no philosophical difference between the economics of social democracy and communism.”
• With inflation and increased money supply, Gave asks, “Is this crisis the final crisis of social democracy?”
• This implies European currencies would collapse, which he says would present opportunities for European companies and entrepreneurs to make tons of money.
• In terms of investment portfolios: He thinks you need 50% of your assets in anti-fragile assets to resist a coming crisis. He says you should own energy 75% of the time where you don’t make money in energy and 25% of the time where you make tons of money (like right now!)
• On European Banks: He says Germany is bankrupt, and people don’t understand that. Its economy is very one-dimensional: “They make cars and machine tools to make cars….What they do is that they make combustion engine cars that are the best in the world, but nobody’s going to use combustion engine car ten years down the road.”

From Louis Gave 

• He believes we are moving to a world in which savings won’t go as global as before. Chinese savings stay in China, Japanese savings in Japan, European savings in Europe, and so on.
• Gave believes the Fed is bluffing on tightening due to a large amount of government debt that needs to be paid off (inflation would make it easier for the government to pay that off).
• We need a fall in all prices or a recession in the U.S. to have a meaningful rollover in inflation.
• He doesn’t expect any interest rate increases in Europe because politicians are trying to do everything to keep Europe from self-destructing. If they do increase rates, it’ll be a very marginal rate increase.

Kaletsky and Charles and Louis Gave agree we are in a permanent state of higher inflation—a new era.

SB Here: This got me thinking about Louis Gave’s presentation from a year ago, so I went back into the OMR archive and found the following (not a recommendation to buy or sell any security, but it’s worth a discussion). From May 14, 2021’s On My Radar: SIC2021 – Deflation? Inflation? Transitory? Define It?:  “A declining dollar is inflationary for the US, and if this is the regime we are moving into, you need to totally rethink your portfolio allocations.” In a picture the playbook looks like this, courtesy of Louis Gave:

A reader wrote me this week asking what breaks first in a liquidity crisis. I really don’t know, but my best guess is the Euro, due to the amount of outstanding sovereign debt it has and the misconstruction of its monetary union. It’s usually a smaller country, but this time maybe not… it really could be any of the following (focus on debt as a percentage of GDP; historically, anything above 100% is a problem for growth):

Source: Ned Davis Research

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Dr. Lacy Hunt’s Interview with Bill White

Mauldin wrote in his missive last week:

On Day five, we started pulling the pieces together. Bill White, the former chief economist at the Bank for International Settlements and, before that, a top Bank of Canada official, knows central banking and monetary policy from the inside out. I have often said that Bill is my favorite central banker. Right now, it would be an understatement to say he’s concerned.

During the SIC, Lacy Hunt interviewed Bill White, adeptly drawing out a reality we would rather not hear about. A few key points:

• The core problem that central banks aren’t recognizing is that the global economy faces multiple serious supply shocks. It’s not just COVID. We were having supply chain problems even before the pandemic. China has major issues. The whole world has demographic challenges. White thinks climate change is an economic problem, whether the answer is to adapt to it or mitigate it. All of these problems generate inflation pressure in various ways.
• Bill’s top fear is that the Federal Reserve may get so far behind the curve that it can’t ever catch up. This could happen if inflation rises faster than the Fed hikes. In that case, real interest rates would actually be moving lower. That’s when people start fleeing a currency. Then inflation gets very high, and things get worse. He didn’t predict this, but thinks it is possible. This isn’t just a U.S. problem. It is potentially even worse in Europe and much of Asia.
• Lacy asked about reports that the Fed waited to tighten because it wasn’t clear if the president would nominate Powell for another term as Fed chair. Bill carefully said he didn’t know their motivations. He noted Powell is a wealthy man who doesn’t need the Fed job. It shouldn’t have been a barrier to doing what needed to be done if that’s what they saw.

Following are several of my bullet-point notes from my review of the session.

The Fed and Bringing Down Inflation

• According to Bill White: There are lots of negative supply shocks coming down the road, and the Fed has a tough job of bringing down inflation.
• The supply shocks are a result of bad resource misallocations before the pandemic, Chinese COVID lockdowns, climate change, and deglobalization.
• He was critical of ultra-easy monetary policy and says it has created imbalances that may cause a big fall in the economy. The Fed is clearly behind the curve in moving to fight inflation. Bill believes a deep recession is in the future… “not just in the US, but the whole global economy into recession, and perhaps a quite deep recession.”
• Political problems will impede policy response.
• Low investment leads to low productivity growth. Overvalued asset prices and low growth lead to financial market problems, and liquidity concerns.
• He noted that Powell’s waiting to taper and raise rates while waiting for of his reappointment was “totally inappropriate.”

White’s Views on Central Banker Philosophy

• White said that maybe central bankers are wrong in their beliefs.
• Central bankers may have made the economy seem too simple and stable, compared to reality. The truth is the economy is very complex.
• The ultra-easy monetary policy encourages a buildup of debt, limiting economic growth.
• This leads to misallocations of real resources and slows down the aggregate supply.
• White believes that “all of the central banks have really not put as much emphasis on the aggregate supply questions as they should have done.”

The Fed and Liquidity

• Fed doesn’t have the financial sector included in the models they use (except for short-term/long-term interest rate) à they overlook these things
• Believes “we should be putting more emphasis on things like that [money aggregates] than the Central Banks tend to do”
• We’ve had very slow growth in investment, and very slow growth in productivity for ages and ages. We’ve got asset prices that are way above numbers that can be reconciled with underlying fundamentals, we’ve got problems in the financial markets.
• There is renewed concern about liquidity in the treasury market, the most important market in the world.
• We’ve got all examples of excess and fraud and all the stuff that you see right at the end of the cycle. So I think we’re set up here for what could be a fairly deep recession. And I worry that we no longer have the ammunition to deal with it.
• You look at monetary policy and say, “If things come unstuck, what are they going to do?”
• We really spent a huge bundle of money, not just in the US, but in all of the advanced countries. Sovereign debt levels are now at record highs in many countries. So you’ve got some problems there. Do you bail out the banks once again?
• And the question becomes what’s the political fallout. Liquidity on the international side, will the Fed provide swaps to all the people that need them? Will Congress let them do it? Political problems exist under the surface virtually everywhere, which will be impeding a good policy response.
• So I guess what I see as I look forward is that the Fed is behind the curve, they will continue to be behind the curve and the implications of that could be quite dangerous. And that leads you on, in the limit to something like debt deflation. There is, however, another strand to this and that is about longer-run structural stuff.  The other strand to it is that some combination of easy money against a backdrop of a difficult fiscal situation could lead you into concerns about fiscal dominance. To the kind of concerns that we’ve seen play out in many emerging markets in the past.
• I don’t think that is likely, but it can’t be ruled out that the Fed in effect gets so far behind the curve of inflation, that they can’t ever really catch up. And so that inflation is always moving higher, the real rates of interest are actually moving lower, and in the end, you get a flight from money, flight from the currency, and then you’re into a very different world that goes from debt deflation, into a world of very high inflation and all the destruction that goes on that side.

China

• China is trying to shift away from the Japanese growth strategy (financial repression, wage repression, and a low exchange rate, which leads to more investment and then more exports).
• He says China doesn’t have the courage to shift away, because they’re scared of periods of low economic growth.
• China has problems right now (real estate and other large debt overhangs, COVID lockdowns).

Lacy Hunt’s Insights

• There is indebtedness among the four major economies (US, China, Japan, and Europe), and it’s a drag on growth.
• Hunt thinks China is more over-indebted than Europe when Chinese economic data is adjusted for errors/overstatements.
• Japan is even more over-indebted than China, but China’s indebtedness is increasing much faster than others.
• List of indebtedness (from most to least): Japan, China, Europe, U.S.
• This reduces the probability of China overtaking the U.S. as a global reserve currency.
• Lacy likes to look at real GDP per capita growth (and levels of real GDP per capita), indebtedness, and demographics.
• Overall, the U.S. has higher real GDP per capita; it’s not as old as Europe, Japan, and China, and not as indebted.
• He doesn’t see China replacing the U.S. as a reserve currency anytime soon

From Bill White 

• Central banking relationships are good globally, everyone is cooperating—though he is not sure if their objectives are the right ones.
• He sees two problems the international community faces: Debt and a lack of people in charge within the global community to deal with a crisis (such as a liquidity shortage).
• He concluded, “There is no easy way to restructure debt in the international community.”

SB here: One Manhattan on the rocks please; light on the vermouth.

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Trade Signals: “Brace Yourself For Economic Hurricane”

June 1, 2022

Market Commentary 

Notable this week:

JPMorgan’s CEO, Jamie Dimon says ‘brace yourself for an economic hurricane caused by the Fed and Ukraine war. From CNBC Wednesday, June 1, 2022:

• There are two main factors that have Dimon worried: So-called quantitative tightening, or QT, is scheduled to begin this month and will ramp up to $95 billion a month in reduced bond holdings.
• The other large factor worrying Dimon is the Ukraine war and its impact on commodities, including food and fuel. Oil could hit $150 or $175 a barrel, he said.
• “You’d better brace yourself,” Dimon told the roomful of analysts and investors. “JPMorgan is bracing ourselves and we’re going to be very conservative with our balance sheet.

Dimon’s comments follow Wells Fargo’s CEO warning this morning that higher interest rates mean the economy has to slow, and that a soft-landing scenario was hard to achieve.

High yield moved to a buy signal. Yields in the 7% range are far more attractive than in the mid-4 % range. However, while I could be wrong, I suspect the signal to be short-lived. Stop-loss rules remain in place. The Zweig Bond Model also moved to a buy signal. The 10-year weekly MACD remains on a sell. All of the equity market trend signals are signaling risk-off with the exception of the S&P 500 Index Daily MACD Indicator. Investor sentiment remains “Extremely Pessimistic” which is also short-term bullish for equities. My two cents remain to sell the rallies and/or hedge your equity exposure. Don’t buy the dips. It’s not often you get an “economic hurricane” warning from Wall Streets’ most trusted banker.

The Dashboard follows next. More red than green. Yellow arrows indicate a nearing change in signal.

Not a recommendation for you to buy or sell any security.  For information purposes only.  Please talk with your advisor about needs, goals, time horizon, and risk tolerances.

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Personal Note –  In Need of a Hero

When I was growing up, my mom hung a plaque on the kitchen wall. It read, “Make new friends, but keep the old, one is silver and the other is gold.” For a young child—and us older people—the message is beautifully simple. I thought about it this morning, along with my mom. But I struggled to find my smile. The world feels far more complicated today.

This morning, Susan read to me a WSJ Opinion piece from Peggy Noonan about The Uvalde Police Scandal. You and I now know the police stood outside for almost an hour. It was not only a horrific tragedy, but also an inconceivable failure of duty. “The great shock is what the police did—their incompetence on the scene and apparent lies afterward. This aspect has rocked the American people….It was their job to go in. If you can’t cut it, then don’t join and get the badge, the gun and the pension.” Noonan wrote. She concludes her opinion piece with her assessment of the larger state of play—which is not good—and advocated that we deal with this now. Sadly, I think she is right.

She wrote:

I’ll close with a thought tugging around my brain. I think I am seeing a broad and general decline in professionalism in America, a deterioration of our pride in concepts like rigor and excellence. Jan. 6 comes and law enforcement agencies are weak and unprepared and the U.S. Capitol falls to a small army of mooks. Afghanistan and the departure that was really a collapse, all traceable to the incompetence of diplomatic and military leadership. It’s like everyone’s forgotten the mission.

I’m not saying, “Oh, America was once so wonderful and now it’s not.” I’m saying we are losing old habits of discipline and pride in expertise—of peerlessness. There was a kind of American gleam. If the world called on us—in business, the arts, the military, diplomacy, science—they knew they were going to get help. The grown-ups had arrived, with their deep competence.

America now feels more like people who took the Expedited Three Month Training Course and got the security badge and went to work and formed an affinity group to advocate for change. A people who love to talk, endlessly, about sensitivity, yet aren’t sensitive enough to save the children bleeding out on the other side of the door.

I fear that as a people we’re becoming not only increasingly unimpressive but increasingly unlovable.

My God, I’ve never seen a country so in need of a hero.

I’ve been driving into Philadelphia once a week for physical therapy. I’ve been a dream patient over the years for orthopedics (two hips, an ACL, and torn Achilles). It’s the result of years of sports, but as my dad would say, “the prize is worth the price.” No complaints. One doctor, in particular, orthopedic surgeon Dr. David has become a friend. His brother and I coached our daughters together in soccer more than 20 years ago.

My last call for help was in 2016, “Marty,” I said, “can you call your brother? I think I just blew out my ACL.” Recently, Dr. David repaired Brianna’s left ACL and I joined her for one of her post-surgery visits. When David was done with Brie, I asked him about the repetitive pain I’ve been having in my lower back when I finish my golf swing. David reached behind him, and wrote me a script. He said, “Go see Joe Zarett.”  Joe isn’t the first physical therapist I’ve been to for the issue, but he is the only one that has fixed me.

I visited Joe and his team a few days ago. When our session was over, Joe and I talked. Many years ago, he immigrated from Russia and built a successful PT business here in Philadelphia. One of his comments struck me, “Steve, I left Russia because of the lack of freedom and communism. I was lucky to come to the greatest country in the world.  Never would I have imagined I’d see our United States becoming more and more like Russia.” Think about that.

I am not coming at this from a political perspective though I do believe there is a leadership void on both sides. We’ve grown soft and intolerant of others. We can do better. We must do better.

I’m going to write about the 2022SIC closing panel that included John Mauldin, Felix Zulauf, Bill White, and Tom Hoenig next week.  I’ll conclude with my summary thoughts and share a few ideas about how to invest in the current environment. I know I’m recommending a stiff drink but really the impact on your wealth depends on how you position yourself. There are investment opportunities. I just don’t see traditional cap-weighted index fund investing as one of them. That day will present again. It’s just not today. Inflationary psychology is embedded. We are in a different ball game.

Here is a toast to making new friends, cherishing our old friends, and being there for each other.  Hold that glass up high: “To friendship!”  Let’s be a hero. Ever forward.

Wishing you a great week,

Steve

Stephen B. Blumenthal
Executive Chairman & CIO
CMG Capital Management Group, Inc.

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Stephen Blumenthal founded CMG Capital Management Group in 1992 and serves today as its Executive Chairman and CIO. Steve authors a free weekly e-letter entitled, “On My Radar.” Steve shares his views on macroeconomic research, valuations, portfolio construction, asset allocation and risk management.

Follow Steve on Twitter @SBlumenthalCMG and LinkedIn.

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