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On My Radar: The Queen’s Gambit

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May 12, 2023
By Steve Blumenthal

“If we get into a hard landing, are we finally going to allow creative destruction and Capitalism to do it’s thing? I think if we do, we’ll have a chance and what’s made America great for 200 years could possibly revive.“

– Stanley Druckenmiller, Presenting at the Sohn 2023 Investment Conference May 10, 2023

The Queen’s Gambit is Netflix’s most-watched miniseries—named after one of the oldest and most common opening chess moves. Released in 2020, the series is a 1950s American coming-of-age story, based on the 1983 novel of the same name by Walter Tevis, that follows a fictional orphan, Beth Harmon, as she prodigiously rises to the top of the chess world all the while struggling with drug and alcohol dependency.

As anyone who has watched the series—or, better yet, played chess themselves—knows, chess is a game of foresight and planning between two opponents. It requires players to analyze the current state of the game, evaluate the strengths and weaknesses of their own pieces and their opponent’s pieces, and make decisions that will lead to favorable positions or advantageous exchanges. Players need to consider not only the immediate consequences of their moves but also their long-term implications.

This includes factors like piece development, control of the center, king safety, pawn structure, and piece coordination.

As players progress in skill level, they encounter more advanced concepts such as positional understanding, opening theory, middlegame strategies, endgame techniques, and the art of combinations and sacrifices. Improving as a chess player requires continuous learning, practice, and experience.

To me, investing is a version of a chess match, except with more than two players at the chess board attempting to win the game of growing and defending wealth—the grandest (and most addictive) game of them all.

Mauldin Economics’ “Queen’s Gambit” (a.k.a. their 2023 Strategic Investment Conference) kicked off with David Rosenberg on the first of five days of virtual presentations that played out over two weeks, concluding this past Wednesday, May 10.

There was so much information to take in, reflect on, and organize as I tried to understand best how the current pieces on the board are positioned and which moves are the best to make next. I  found myself both mentally stimulated and somewhat exhausted.

Where are interest rates heading? Inflation or deflation? Exactly where do we currently sit in the economic cycle? Recession, yes, when? Where are rates heading? Higher or lower? What will be the impact on currencies, equities, commodities (hard and soft), and real estate? Internal and external conflicts? International trade relationships? Peace or war?

We live in a multi-dimensional, global chess game with many skilled (and some not-so-skilled) players sitting at the table. As Stan Druckenmiller said recently:

“I’m sitting here staring in the face of the biggest and probably the broadest asset bubble…forget ‘that I’ve ever seen,’ but that I’ve ever studied.”

(Click here for a six-minute education from one of the great investments grand masters, Stan Druckenmiller. And you’ll find the full link below in the Random Tweets section.)

Last week, we highlighted David “Rosie” Rosenberg’s excellent presentation. When organizing today’s OMR, I went to the conference’s host, John Mauldin, for his thoughts. With permission, I’ve pulled a few highlights from what John wrote in his “Thoughts from the Frontline” letter last week. And stay tuned: I’m going to be recording a podcast episode with John next week to get his high-level takeaways from the 2023 SIC.

From John:

Rosie thinks this week’s rate hike will be the last, and the Fed will begin cutting rates soon. He says 500 basis points won’t surprise him and would be typical based on past recessions. I realize that’s hard to imagine right now. A return to near-zero rates is certainly quite different from my own thinking. But I’ve learned not to discount Rosie’s forecasts. They are often “out of consensus,” but the consensus is often wrong, too.

I read Rosie almost every day. He excels at seeing the right direction, if not the actual destination. Will the Fed eventually cut rates? Absolutely. Will it be 500 basis points? I don’t think so, but it’ll be closer to that than 50 basis points.

Rosie went on to talk about what this will mean for the stock and bond markets. I won’t share that here, but you can register and watch his whole presentation.

(SB here: Please note I am not affiliated with Mauldin Economics in any way. There is a cost to their service, to which I personally subscribe, but I do not get compensated in any way).

Another longtime SIC fixture is Lacy Hunt, the chief economist at Hoisington Investment Management. His outlook is more long-term than Rosie’s but consistent with it. You can look at Lacy’s presentation as the theoretical basis for the patterns Rosie describes. None of this is accidental or random. It happens for specific reasons, which Lacy outlined clearly and eloquently.

In Lacy’s view, the “business cycle” we discuss is actually three different waves occurring in a specific order. The financial cycle comes first, followed by a GDP cycle, and then a price/labor cycle. They peak and trough in that sequence. He illustrated it with this graph showing how one wave leads to another.

The financial cycle comes first, with monetary policy (the Fed) heavily influencing its movement. Loose credit unleashes both inflation and excessive risk-taking. These push GDP up and, later, make wages and prices rise. Then the financial cycle peaks, falls, and the others fall as well.

Again, this isn’t new. Lacy talked about the long history of economists going back to David Hume in 1752, all describing the same basic process. Each generation gained a little more understanding of it. Knut Wicksell first described the “natural rate of interest” concept in 1898. That is an interest rate that neither slows nor accelerates economic activity. In other words, it’s what we would have if central banks weren’t constantly interfering. (It is more complicated than that, as markets can temporarily get out of balance as well.)

However good the intent of central banks, this activity is what causes booms and busts. Central banks can control the money supply, but the amount of money isn’t the only factor. The speed at which it moves through the economy (the “velocity of money”) matters, too. Creating more money has little effect if people don’t use it.

As Lacy’s chart shows, velocity right now is even lower than it was in the Great Depression. I have been following Lacy for almost two decades, and we have become close friends. Lacy was predicting the velocity of money would slow to this level well over 10 years ago, from my memory. And probably before then. This is a serious problem for the Federal Reserve’s attempts to stimulate growth.

 

Note how velocity has actually been falling since the 1990s, with only a few brief interruptions. The decline intensified in 2007‒2009 as the Fed fought the financial crisis with zero interest rates and quantitative easing. Then it fell even more vertically with the 2020 COVID stimulus policies. Force-feeding liquidity into an economy without good uses for it doesn’t seem to work very well.

Lacy tracks this with what he calls the “marginal revenue product of debt.” That’s the amount of GDP growth generated by each additional dollar of debt. That has been falling for years and is set to fall even more as higher rates divert a bigger part of the revenue from debt-funded projects to interest payments, instead of more productive uses. Although I have been writing that I expect to see large US interest payments on the government debt, it still makes me shudder to see that interest payments on the US debt will be over $1 trillion. When interest payments are more than defense spending, something is radically out of balance.

The bottom line: Monetary policy is losing its ability to stimulate growth. We used to call this “pushing on a string,” but Lacy says that metaphor is no longer sufficient. Just as that cycle chart shows, this peak in the financial cycle will be followed by a peak in GDP growth, then peak wages and prices (i.e., inflation). We’re already past that point, and it is downhill from here, consistent with the recession Rosie expects.

These are bleak outlooks even in today’s negative environment. Before you despair, let me remind you: We will get through this. Not to say it will be easy, but we at least have the advantage of forewarning. We have time to prepare.

(By the way, these charts above are from the decks Rosie and Lacy prepared for SIC. Attendees can download the full decks to see the wealth of graphic data included.)

That concludes what I wanted to share with you from John. The opening move has been made. Let’s advance the game.

Grab your coffee and find your favorite chair. Hunt and Boockvar are next.

Here are the sections in this week’s On My Radar:

  • Dr. Lacy Hunt and Peter Boockvar
  • Random Tweets – Stan Druckenmiller
  • Trade Signals: Private Market Commentary for Clients and Subscribers Only
  • Personal Note: Football is Life

(Reminder: This is not a recommendation to buy or sell any security. My views may change at any time. The information is for discussion purposes only.)

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

Dr. Lacy Hunt and Peter Boockvar

My bullet point notes of Dr. Lacy Hunt’s economic presentation at the annual Mauldin Strategic Investment Conference:

  • The business cycle consists of three separate cycles: the financial cycle, the GDP cycle, and the price/labor cycle.
  • The peak and trough of the financial cycle are determined by factors such as monetary increase, debt accumulation, low real interest rates, and excessive risk-taking.
  • Forward guidance from the Federal Reserve has become an additional factor in determining the financial cycle.
  • Extreme fluctuations in financial conditions do not benefit the economy in the long run, leading to high inflation, excessive risk-taking, and offsetting damage.
  • The economy is falling further behind the trend rate of growth, and monetary swings and fiscal policy accumulation of debt contribute to this decline.
  • Historical thinkers like David Hume, Knut Wicksell, Irving Fisher, and others recognized the negative effects of extreme monetary policy and debt accumulation.
  • Loose monetary policy (low-interest rates and QE) leads to increased risk-taking, overaccumulation of debt, and financial instability.
  • Several contemporary researchers have found empirical evidence supporting the link between loose monetary policy, increased risk-taking, and financial fragility.
  • The recent extreme looseness of monetary policy in 2020 and 2021 has led to an unprecedented decline in monetary aggregates.

A quick aside: Monetary aggregates refer to various measures of the money supply within an economy. (ie: MO, M1, M2 and M3). They represent the total amount of money in circulation or held in financial institutions, which includes both physical currency and deposits. These aggregates are important indicators for analyzing the state of an economy and assessing monetary policy. The categorization and specific components of monetary aggregates may vary slightly between countries and central banks. These aggregates help central banks, and economists monitor the money supply growth, understand the liquidity in the economy, and make informed decisions regarding monetary policy, interest rates, and financial stability.

Now back to the notes: 

  • Bank credit tends to turn negative during recessions, but the recent contraction in other deposit liabilities suggests a decline in bank credit even without a recession.
  • The velocity of money, a lagging indicator, is influenced by the marginal revenue product of debt and the loan-to-deposit ratio.
  • The marginal revenue product of debt is expected to decline due to the refinancing of debt at higher costs, while the loan-to-deposit ratio is likely to fall as the economy weakens.
  • The labor market may appear resilient, but declining productivity and average real weekly earnings suggest underlying fragility and the need for labor force rationalization.
  • Inflation disproportionately affects modest and moderate-income households, particularly through price increases in necessities like food, fuel, and shelter.
  • Excessive risk-taking and economic instability pose further risks to these households.

Summary of Dr. Lacy Hunt’s presentation continued:

  • The trend rate of growth in the standard of living is falling below the long-term trend, indicating significant pressure for many people.
  • Loan delinquencies are increasing on various types of bank loans, reflecting the income situation and higher lending rates.
  • Fiscal policy (tax rates, rescue packages, legislatively approved goodies) plays a major role, and high levels of debt can have a deleterious impact on economic growth.
  • Research by Reinhardt and Rogoff suggests that when debt exceeds a certain threshold, economic growth falls below the trend, and real interest rates tend to be lower.
  • France, Italy, and Japan are significantly more overindebted than the United States, but high indebtedness policies lead to erosion of economic performance rather than an immediate crisis.
  • The United States has outperformed Europe and Japan in terms of real per capita income, but the policies exacerbate income and wealth inequality (SB here: evident are increasing internal conflicts).
  • The volume of world trade, when adjusted for currency and price effects, has been negative even before the pandemic, indicating a global economic downturn.
  • Prior to the pandemic, the US and Europe were experiencing faltering growth rates, debt overhangs, and over-dependence on the US.
  • Monetary policy results have cons that are still not fully determined.

Peter Boockvar entered the discussion and was tasked with questioning Lacy. Following are summary bullet points:

  • The financialization of the economy has led to the emergence of credit cycles, where the expansion and contraction of credit play a significant role in economic dynamics.
  • The current budget deficit stands at approximately 7% of GDP, a high level even before entering a recession. In previous recessions, the deficit typically bottomed around 5%. (Bold emphasis mine)
  • Financing the large deficit requires finding buyers for US treasuries, including the Federal Reserve, foreign investors, banks, pension funds, and retail investors. Lacy believes there will be buyers of additional Treasury Bills, Notes and Bonds.
  • The government’s increasing share of economic activity crowds out the private sector, leading to a weaker economy overall.
  • Bank credit traditionally turns negative during a recession as existing loan books deteriorate, leading banks to limit the extension of new loans.
  • However, the current slowdown in bank credit is occurring before the recession due to banks’ exposure to low-interest rates and investments in treasuries without hedging interest rate risk.
  • Bank failures and the slowdown in bank credit before the recession are consequences of the duration mismatch between low deposit rates and investments in long-term treasuries.
  • The government’s expansionary policies, combined with loose monetary conditions, have created a severe dilemma for banks. The Federal Reserve’s guidance and easy money policies encouraged banks to take on risks and invest in treasuries, contributing to the current situation.
  • The prospect of financing the deficit relies on several factors, including the Federal Reserve ceasing to liquidate securities from its portfolio, foreign central banks becoming net buyers of treasuries, and potentially lower interest rates.
  • However, the government sector’s increased presence in the economy weakens overall economic performance. The private sector has a positive multiplier effect on the economy, while the government sector has a negative multiplier effect.
  • The coordination between monetary and fiscal policy can lead to inflationary pressures, as observed in the early 1970s. It is crucial to avoid further coordination between the Fed and the Treasury to maintain a healthy separation between the Federal Reserve and the U.S. Treasury.
  • The Federal Reserve may resort to cutting interest rates back to zero and implementing quantitative easing (QE) as a response to the upcoming recession. However, these measures have shown transitory benefits and do not address the underlying issues.
  • Over the past 25 years, the Fed’s monetary policy has been characterized by instability, with interest rates fluctuating significantly. This instability has contributed to the current economic situation.
  • Monetary policy only alters the timing of economic activity without enlarging it, while fiscal policy (more government involvement) has a tendency to lower economic activity.
  • The trend rate of economic growth remains unchanged despite monetary policy interventions, leaving a significant portion of the population behind.
  • It is important to find ways to break the cycle of excessive monetary and fiscal policy and seek sustainable solutions that promote long-term economic growth.

Here are the additional points:

  • Lacy Hunt expressed concern about being stuck on a treadmill and the difficulty of finding a way to get off it. The reliance on expanding monetary and fiscal policies as a response to economic challenges perpetuates a cycle that fails to produce satisfactory results.
  • The Federal Reserve’s policy can be described as creating “boom booms and slump slumps.” While their actions may provide temporary benefits or alleviate downturns, they do not fundamentally change the trend rate of economic growth.
  • Over the past 25 years, the Federal Reserve’s interest rate adjustments have been characterized by instability, ranging from high rates to near zero and back again. This instability has contributed to the current economic situation.
  • Monetary policy interventions, such as interest rate cuts and quantitative easing, may have short-term impacts on economic activity but do not lead to sustained enlargement of the economy.
  • Fiscal policy, on the other hand, tends to lower economic activity.

In the conversation, Dr. Lacy Hunt and Peter Boockvar expressed concerns about the current situation created by Fed and government policies. While they did not provide specific solutions, they discussed some key points regarding the way forward:

  • Lacy Hunt emphasized the need to avoid further coordination between monetary and fiscal policy. He pointed out that excessive coordination in the past led to inflation and long-lasting consequences. He suggested that it is important to let the Federal Reserve handle inflation battles while avoiding excessive intervention from fiscal policymakers.
  • Both Hunt and Boockvar highlighted the unsatisfactory results of discretionary monetary and fiscal policies. They agreed that simply expanding these policies on a grander scale would not lead to better outcomes.
  • There was recognition that the current monetary policy cycle, characterized by boom-bust cycles and unstable interest rate adjustments, needs to be addressed to create more stable and sustainable economic growth.
  • While specific solutions were not proposed, the conversation indicated a need for a reassessment of the existing policy framework and a shift away from reliance on excessive monetary and fiscal measures. This suggests a call for exploring alternative approaches that promote long-term stability and avoid the negative consequences associated with current policy patterns.
SB Conclusion: 
  • I really liked the treadmill analogy. Peter asked Lacy if he saw a way out, and Lacy said, unfortunately, he does not know how we get off the treadmill. (Slamming on the breaks – aggressively hiking rates, then slamming on the accelerator – aggressively lowering rates. Wash, rinse, repeat.)
  • “We’re caught in a trap; I can’t walk out, Because I love you too much, baby… Why can’t you see, What you’re doing to me, When you don’t believe a word I say? We can’t go on together, With suspicious minds (suspicious minds), And we can’t build our dreams, On suspicious minds…” – Elvis Presley 
  • How do we get off the treadmill? I can’t help but think of Stan’s quote I shared with you in the OMR intro above: “If we get into a hard landing, are we finally going to allow creative destruction and Capitalism to do it’s thing? I think if we do, we’ll have a chance and what’s made America great for 200 years could possibly revive.”

(Reminder: This is not a recommendation to buy or sell any security. My views may change at any time. The information is for discussion purposes only.)

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

Random Tweets – Stan Druckenmiller

Stan Druckenmiller at Sohn 2023: “I’m sitting here staring in the face of the face of the biggest and probably the broadest asset bubble, forget that I’ve ever seen, but that I’ve every studied.” Click on the photo for the short six-minute interview.

Stan Druckenmiller at Sohn 2023: “We are absolutely going to cut entitlements in this country. It is a lie and it’s a fantasy to say we don’t have to cut entitlements. We either cut them now or we’re going to cut them later on. But if we cut them later, it will be much worse.” “They say how bad it would be for current seniors if we were to do something on entitlements. Well what about future seniors? Why should current seniors get a $1.00, or 100% of the loaf, and future seniors get zero? It makes no sense to me.”

Click on the photo.

Here is the link to the full one-hour interview…

 

(Reminder: This is not a recommendation to buy or sell any security. My views may change at any time. The information is for discussion purposes only.)

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

Trade Signals: Private Market Commentary for Clients and Subscribers Only

One of the advantages of making Trade Signals a client subscription site is that I’m able to provide information that I am not able to share publically. There is no pressure to join. OMR will always be a free letter. If you are interested in learning more, give Trade Signals a try. 

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Trade Signals provides a weekly snapshot of current stock, bond, currency, and gold market trends. We provide a summary of technical indicators to help you identify where we sit in short, intermediate, and long-term cycles. We track important valuation metrics to determine the probability of future returns (i.e. when return opportunity is best/least). Trade Signals also tracks investor sentiment indicators and economic and select recession watch indicators. Trade Signals is now a low-cost subscription service, about the cost of two Starbucks lattes every month. You can find the archive of weekly Trade Signals posts (2008 through 2-15-23) by clicking here.

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Personal Note: Football is Life

“I’m very different from your parents because your parents don’t want you to fail and be uncomfortable. They do everything in their power to make sure you don’t fell the pain that they felt growing up. And it’s probably their biggest mistake because you are going to fail. I love you enough to allow you to fail.”

– Dawn Staley, A Coache’s Diary

Reflecting on my years and experiences as an athlete with several great coaches, a few not-so-great coaches, many great teammates, and a few not-so-great ones, I think about how much I gained from having them all in my life. The best coaches encourage you to take chances, fail, pick yourself up, and fail again. It’s in the failing that you improve and grow.

It’s now tryout season for Susan’s travel soccer teams. She is, of course, my very favorite coach. Susan coaches several 14- to 16-year-old teams. Cuts have been made—as have the hard calls with players and parents that come with them. Those are hard calls for everyone on the line. Far too many these days are different than years past; they’re just ugly.

When our youngest got cut from a top team years ago, we hated to see him hurt, but it turned out to be good for him. He worked harder on his own, dug in, and found his way back to the team two years later. Often, failure is a great motivator. Some parents think there are “politics” involved with player selection. That is probably true here and there but not in Susan’s club. She’s a coach at the same club her son got cut from (though she did not coach his team). Her involvement with the club had no impact on the decision. This year, Susan’s fellow coach’s son was also dropped to a lower-level team. Let’s just say that his father is not taking it so well. No politics there, either. Lessons for both are in play.

The platform of sports (or other areas—dance, theatre, chess, and more) creates a wonderful place for young people to learn and grow. In the end, I sure want to work with people with passion who are not afraid to fail. It’s part of life; failure is going to happen, and boy, does it make the moments of victory, when they come (and they will come), feel that much better.

“I love you enough to allow you to fail.” What a great coach… preparing young people for a successful journey through life. It’s a lesson that applies to all things—not just in sports, but in science, in business, in engineering, in everything.

Temperatures are running hot these days, and we seem to have grown OK with being uncivil and rude to each other. Perhaps it’s part of the growing internal divide. But we won’t be able to avoid confronting the pickle we’ve put ourselves in. One way or another, we’ve got to solve the divide so that we can solve our greatest problems. For us to do that, we really need great coaches (leaders) to step up and show the way. After all, we are better together than we are apart.

My confidence sits high, though, because there is an abundance of good people. In that direction, if you are not watching Ted Lasso on Apple TV (and you probably are), it’s a gigantic happy pill. As they say in the show, “Football is Life.”

Lastly, I am a fan of the Admired Leadership Fieldnotes. I must admit I don’t read everyone that hits my inbox, but I very much enjoyed the following discussion with US National Team player Carlie Overback. Put your sneakers on, plug your earbuds in, and get out for a nice walk. Click on the photo to listen to a great discussion on coaching and leadership.

Thanks for indulging me. I so love great coaches, and one of my favorites is waiting for me to join her for some red wine—time to sign off and wish you a wonderful week.

Kind regards,

Steve

Stephen B. Blumenthal
Executive Chairman & CIO
CMG Capital Management Group, Inc.
Private Wealth Client Website – www.cmgprivatewealth.com
TAMP Advisor Client Webiste – www.cmgwealth.com

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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.

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