Aug 12, 2022
By Steve Blumenthal
“U.S. consumers were soaking up all the cheap stuff the world had to offer: the asset rich, benefiting from decades of QE, 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…”
– Zoltan Pozsar, Global Head of Short-term Interest Rate Strategy, Credit Suisse
Zoltan Pozsar has become a global macroeconomic cult hero. A deep thinker and an excellent writer, he believes we are on the path to a new world (monetary) order centered around commodity-based currencies in the East that will likely weaken the Eurodollar system and contribute to inflationary forces in the West. Pozsar calls it “Bretton Woods III .”
This is something I think about quite a bit. And Pozsar ups the ante on that thinking. Most are playing economic checkers; this guy is playing economic chess.
Who is this cult hero? Pozsar is the New York-based Investment Strategist at Credit Suisse. He was a senior adviser to the US Department of the Treasury, where he advised the Office of Debt Management and the Office of Financial Research, and served as the Treasury’s liaison to the Financial Stability Board on matters of financial innovation. He joined the Federal Reserve Bank of New York in August 2008, and was in charge of market intelligence for securitized credit markets. He also served as the point person on market developments for senior Federal Reserve, US Treasury, and White House officials throughout the great financial crisis.
He played an instrumental role in building the structure to backstop the Asset-Backed Securities (ABS) market and pioneered the mapping of the shadow banking system, which inspired the Financial Stability Board’s effort to monitor and regulate shadow banking globally. Later, at the IMF, he was involved in framing the Fund’s official position on shadow banking and consulted G-20 working groups. He consulted G-7 policymakers, central banks, and finance ministries on global macro-financial developments. He is also a founding member of the Shadow Banking Colloquium of the Institute for New Economic Thinking, and a former adviser on European affairs.
Smart, experienced, and well-connected, whenever he publishes research, Twitter explodes with the latest from #Zoltan. What’s his strategy? We can look to another quote from the man himself: “When you stick your neck out with a view you don’t know if it’s going to happen. But you kind of feel it’s going to happen, because you think logically it has to happen, and then you hopefully see it in the numbers. If you wait until the data shows it, it’s too late.”
Let’s take look at his latest piece today. Here is the introduction:
War and Interest Rates, by Zoltan Poznar, August 1, 2022
War is inflationary.
Wars come in many different shapes and forms. There are hot wars, cold wars, and what Pippa Malmgren calls hot wars in cold places – cyberspace, space, and deep underwater (see here). We would also add to the list of cold places “corridors of power” in Washington, Beijing, and Moscow, where great powers are waging hot wars involving the flow of technologies, goods, and commodities – hot economic wars – which have been major contributors to inflation recently.
Inflation did not start with the hot war in Ukraine…
…but the war did fan the inflationary currents that had been underway already: understanding today’s inflation as the result of an escalating economic war, and a lingering pandemic is important for if war and zero-Covid policies stay, the view that inflation is mostly cyclical, driven by excessive stimulus, is wrong.
After visiting over 150 clients in eight European capitals over six weeks, my impression is that the expected path of Western policy rates rests on two hopes: first, that inflation is about to peak; second, that we are near peak hawkishness.
Obviously, if the first view is right, the second view is right too. But the risk with the first view is that it assumes a stable world with no geopolitical risk premia where demand management is more powerful than issues related to supply, when in fact, we live in an unstable world where geopolitical risk premia are rising and where supply-side issues are more powerful than demand management.
It follows that if the first view is wrong (inflation is driven by the economic war, not stimulus), the second view is wrong, too (we are not at peak hawkishness).
The aim of today’s dispatch is to highlight risks to the peak hawkishness view. We won’t be forecasting. We’ll be observing. And you’ll draw your conclusions.
Thus, with slight exaggeration, the 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 EU more broadly.
U.S. consumers were soaking up all the cheap stuff the world had to offer: the asset rich, benefiting from decades of QE, 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…
Let’s jump to Zoltan’s conclusion.
As a quick aside, when I was struggling with accounting classes in college, I’d go to my father for help. Dad was a CPA. He always took me to the conclusion first with the belief that if I understood where we are going, I’d be able to better see the pieces come together on our way to the conclusion. Kind of like the WAZE app on your phone, plug in the destination, look at the full map, and then press go and follow the turns step by step to get to your destination. So, let’s get to the conclusion, and see if we can find our way back to it.
With a hat tip to my old man, the following is Zoltan’s conclusion (bold emphasis mine):
- Zoltan believes inflation is going to be with us for some time.
- Figuring out where inflation goes from here is basically a matter of perspective: do you see inflation as cyclical (a messy re-opening after Covid, exacerbated by excessive stimulus) or structural (a messy transition to a multipolar world order, where two great powers are challenging the might and hegemony of the U.S.). If it’s the former, inflation has peaked. If it’s the latter, inflation has barely started, and could actually be understood as an outright instrument of war, for, as Lenin said, “the best way to destabilize the capitalist system [is] to debauch the currency.
- It’s time to think outside the box and to appreciate the pattern: the Fed went from transitory to not transitory; no hikes to hikes; hikes to a string of rate hikes; a string of 25 bps to a string of 50 bps; a string of 50 bps to a string of 75 bps; a string of 75 bps with forward guidance to the same without any comments…
- Bill Dudley and Larry Summers are having a Volcker moment in a “spot” sense, but they are not in charge, and they don’t have to navigate the political aspects of interest rate hikes. Jay Powell has too, and that is why he is moving slower. But moving he is, and he is quietly having his Volcker moment in a rolling, “forward” sense: look at the pattern above; listen to him when he says that “there will be pain”; listen to him when he says, “we’ll cut when inflation is dead” – we are paraphrasing Powell only on the last bit but are not exaggerating…
- This is not the growth-sensitive Fed of the post-Great Financial Crisis era.
- This is not the stocks-sensitive Fed of the post-Greenspan era.
- This is not the unipolar world order the Fed’s been operating in since WWII.
- This is a different ballgame…
- …and if you think that the peak of tightening is 3.5% because inflation peaked, and that cuts are coming next year because a recession is nigh and stocks are now at the cusp of a bear market (maybe not, because we need a recession, and lower asset prices are the path to a recession), you might be terribly wrong. Bill Dudley and Larry Summers are right about the direction of travel (more from here, not less), but Jay Powell sets the pace…
…because he is accountable to Congress; Dudley and Summers are not. But make no mistake about it: the risk of the Fed hiking to 5% or 6% is very real, and ditto the risk of rates cresting there despite economic and asset price pain. The market and the Fed’s Summary of Economic Projections (SEP) (perhaps the market, because of the Fed’s SEP) is telling us that we will curb the biggest outbreak of inflation in fifty years with a “hiking cycle,” where the peak of the “hiking cycle” next year corresponds to negative real interest rates… unless you think that inflation moderates to target, that is 2%, by next year. If that is true, I am going to re-take Economics 101.
- What could I be missing?
- Is Jay Powell a dark horse who is more political than serious about inflation? I do not think so.
- Once you go down the path of invoking Paul Volcker’s legacy, you can’t avoid making good on that promise: if you do, you damage the Fed’s reputation irreparably. The risks are such that Powell will try his very best to curb inflation, even at the cost of a “depression” and not getting reappointed…
- Between a deep recession and damaging the Fed’s reputation as an institution, a deep recession is the lesser of two evils. The former is public service, and the latter is a public disservice. The former is a central banker’s clear conscience, and the latter is a life-long burden.
- Whether Jay Powell will succeed in slaying inflation is not the question; in the context of economic war, we can doubt that. Rather, the question is whether he’ll try his best to slay it. There I have no doubts.
- In our next dispatch, we’ll start thinking about “what’s next”: if we are right about the nature of inflation and the need for an “L”-shaped path for the economy, how will we ever ramp up from the “_” part of the “L” without generating inflation? If the East holds the key to the supply side, and economic war means that the supply side is held back, the West will have to develop its own supply of things such that “L” becomes “L/.” And much like the current hiking cycle is not a cycle but a tightening campaign, that recovery won’t be a recovery driven by rate cuts but by fiscally funded industrial policy…
…which we will discuss in detail in our next dispatch.
SB here: L shape means a sharp economic decline, then we stay there in recession for a longer period of time. No quick economic recovery like the “V” shape 2008/09 recovery fueled by massive government stimulus. We had a “U” shape recovery from 2000–2002. The big challenge this time is the Fed is dealing with a rate of inflation not seen in 50 years. Looks like “L” to me.
“Fiscally funded industrial policy.” Keep that in the back of your mind when the next crisis creates the motivation for the next set of handouts, aka The Inflation Recovery Act. I agree… more is coming.
I’ve shared a great quote from William White several times over the last few years: “In the end, there will be inflation.” We are in that end phase now. I see it going up and down and up again over the balance of this decade until we hit the end of the road and default on the debt and let the system clear. I do think we will reach that point. This is not an inflation forever story, but it is a challenge for the next five years or so. Of course, I could be wrong. I like out Zoltan put it, “When you stick your neck out with a view you don’t know if it’s going to happen. But you kind of feel it’s going to happen, because you think logically it has to happen, and then you hopefully see it in the numbers. If you wait until the data shows it, it’s too late.” Our job is to make sure we are not too late. For new readers, William White joined the Bank of International Settlements (BIS) in 1994 as Manager in the Monetary and Economic Department, and was Economic Adviser and Head of the Monetary and Economic Department from May 1995 to June 2008. Think of the BIS as the central bankers’ central bank.
You can read the full Zoltan here. I’ll leave it to you to WAZE your way to the end conclusion shared above.
Grab your coffee and find your favorite chair. As Dalio points out next, the “Tit-For-Tat Escalations Are Very Dangerous.” You will also find an excellent interview with my friend Jonathan Ward. Jonathan wrote the best-selling book, China’s Vision of Victory. We met at the Bangor, Maine, airport in 2018 and drove north together for the two-hour ride to Grand Lake Stream. We were both attending David Kotok’s annual Camp Kotok fishing/shadow Fed meeting. It was on that ride that my eyes opened wide to China’s mission. We all have our eyes wide open today. On the economic front, the restructuring/restoring/regionalizing of supply chains is a national emergency. Think about what that means in terms of input cost pressures, wage pressures, etc. Head up, stay positive, ever forward!
The US-China Tit-For-Tat Escalations Are Very Dangerous
By Ray Dalio
Unfortunately, what is happening now between the US and China over Taiwan is following the classic path to war laid out in my book “Principles for Dealing with the Changing World Order.” If events continue to follow this path, this conflict will have a much larger global impact than the Russia-Ukraine war because it is between the world’s leading superpowers that are economically much larger and much more intertwined.
For reasons previously explained, the Russia-Ukraine war is minor by comparison, though the two conflicts are related and the Russia-Ukraine war, like all wars, is having terrible consequences. For example, consider that China’s share of world trade is over seven times larger than Russia’s [1] and constitutes about 19% of all American manufactured goods imports. [2] Imagine if importing goods from China and doing business with China became the same as they are with Russia now. Imagine what the supply chain and economic impacts on the world would be. Imagine what sanctions on China would be like for the world. Supply chains would collapse, economic activity would dive, and inflation would soar. And that’s just what would happen to economies due to economic warfare which would pale in comparison to the impact that military warfare, which we are obviously dangerously close to, would have.
For reasons explained in my book, the situation that now exists between the United States and China is very similar to that which existed between powers immediately prior to World Wars I and II and many other immediate prewar periods. The chart below shows my US-China conflict gauge since 2000. As you can see, the readings for conflict between the US and China are the highest ever.
This index is composed of many indicators such as changes in military spending, personnel, and deployment; sentiment of each country’s people about the other country; media attention given to the conflict, etc. The combination of military spending and attitudes toward each rival country has been particularly indicative. The chart below shows the shares of global military spending for the US and China which significantly understates China’s military spending because much government spending that supports the military is not included as direct military spending. Also, American military spending covers the world while Chinese military spending is more focused in the region. Knowledgeable parties tell me that China has significant military superiority around Taiwan.
The chart below plots recent Gallop poll data and shows that 80% of Americans now have an unfavorable view of China—which is now on par with how Americans view Russia (and is up meaningfully over the past few years).
To put the existing level of conflict between China and the US in perspective the table below compares the current US-China conflict gauge reading to past readings of other great conflicts. As shown, the current reading for the US and China is nearly 1.2 standard deviations above the average, which is a reading in the high end of the range of major conflicts. While this conveys a high level and risk of conflict, it should not be misinterpreted to mean that a worsening is to come. Sometimes, these moments of heightened conflict are followed by a stepping back from war. For example, the period leading into the Cuban Missile Crisis had a relatively high reading of 0.9, but wise heads prevailed so a potential disaster was avoided.
There are many more measures that convey the changing picture that are explained in my book which I don’t have the space to show you here but will continue to plot along with the historical analogies I outlined in the book. I will use them to paint as accurate a picture as I can about what’s happening and put it into a historical context. The dot plot will speak for itself as to which path we are on.
As for what’s now happening, the Chinese are responding to Nancy Pelosi’s visit by cutting off most relations and demonstrating that they can militarily control the area around Taiwan, which implies that China could shut Taiwan off from the rest of the world. Imagine that and its implications — e.g., imagine if semiconductor chips couldn’t get out of Taiwan. China is also displaying its military power and it is crossing previously uncrossed lines of demarcation, thus closing in on Taiwan. [7]
Pelosi’s visit was perceived by China as a move in favor of Taiwan’s independence rather than toward one China with Taiwan part of China, and it is essentially challenging the US to stop it from doing what it is doing. The question is whether the US will respond with another escalation that will prompt another Chinese response, in the classic tit-for-tat acceleration into war, or if the sides will step back.
To gain a picture of the past and the forces that are driving the evolution of the US and China toward war (i.e., the Big Cycle) I suggest that you review Chapter 13 “US-China Relations and Wars.” I suggest that you pay particular attention to my explanation of previous Taiwan Straits crises and why I said I would worry if we had a “Fourth Taiwan Crisis” which is the crisis that we are now having. To understand what is happening you must understand these things.
As I summarized on page 455 of that Chapter in the section “The Risk of Unnecessary War”: Stupid wars often happen as a result of a tit-for-tat escalation process in which responding to even small actions of an adversary is more important than being perceived as weak, especially when those on both sides don’t really understand the motivations of those on the other side. History shows us that this is especially a problem for declining empires, which tend to fight more than is logical because any retreat is seen as a defeat. Take the issue of Taiwan. Even though the US fighting to defend Taiwan would seem to be illogical, not fighting a Chinese attack on Taiwan might be perceived as being a big loss of stature and power over other countries that won’t support the US if it doesn’t fight and win for its allies. Additionally, such defeats can make leaders look weak to their own people, which can cost them the political support they need to remain in power. And, of course, miscalculations due to misunderstandings when conflicts are transpiring quickly are dangerous. All these dynamics create strong pulls toward wars accelerating even though such mutually destructive wars are so much worse than cooperating and competing in more peaceful ways. There is also risk of untruthful, emotional rhetoric taking hold in both the US and China, creating an atmosphere for escalation.
While the power of the forces behind the Big Cycle explained in “Principles for Dealing with the Changing World Order” can be overwhelming, people still have choices that will affect the outcomes. This conflict is still a low-grade military conflict (which I call a Category 2 military conflict) because 1) it has not yet produced an exchange of bloodshed of people from the two major sides (i.e., Chinese and/or Americans) and 2) it is not taking place on either country’s homeland (though the Chinese would say Taiwan is part of their homeland even though it’s not part of mainland China). If either of these were to change, that would be the next big step up toward unimaginable all-out war which I still consider improbable.
A good thing is that sensible people on both sides are scared of war even though they don’t want to look like they are. A bad thing is that some people on both sides want to intensify the fight because to not do so in the face of the provocation would be perceived as a sign of weakness. That dynamic of upping the ante to avoid looking like one is backing down has throughout history been shown to be a very dangerous dynamic. We have seen many historic cases which have led to terrible wars because neither side wanted to back down and only few in which sensible people stepped back from the brink when faced with the prospect of unacceptable destruction.
My hope is that China’s escalation will not lead to the next US escalation which will lead to the next Chinese escalation which, despite the strong desire of sensible people on both sides to avoid war, would lead to a war. But hope is not a strategy so I will try to be as realistic as possible, navigate accordingly, and communicate well with you.
Footnotes
[1] China accounts for roughly 15% of global exports while Russia accounts for less than 2%. For example, see https://www.statista.com/topics/5947/trade-in-russia/ and https://unctad.org/news/china-rise-trade-titan
[2] https://ustr.gov/countries-regions/china-mongolia-taiwan/peoples-republic-china
[3] Note conflict gauge readings are shown as number of standard deviations from the average.
[4] Based on internal calculations using data from SIPRI (https://www.sipri.org/databases/milex)
[5] Source: Gallup (https://news.gallup.com/poll/1624/perceptions-foreign-countries.aspx)
[6] Note conflict gauge readings are shown as number of standard deviations from the average.
[7] For more detailed coverage of recent Chinese responses to Pelosi’s visit see https://www.ft.com/content/be6eca07-0f57-4aa4-a6af-58cc8bdc683f
For discussion purposes only. Talk with your investment advisor. Not a recommendation to buy or sell any security.
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Jonathan Ward
Trade Signals: The July CPI Surprise
Market Commentary
August 11, 2022
S&P 500 Index — 4,207
Notable this week:
On the inflation front, things finally look a little more temperate. A big part of it is simply falling gasoline prices, but if you look at July’s CPI (Consumer Price Index), there are some hints that the worst may be behind us in terms of the pace of Fed interest rate hikes. And that has the stock market in an upbeat mood. Overall CPI was down 0.02%. Core inflation, excluding food and energy, rose 0.3%. Note the breakdown by color in the following chart.
The probability of a 75 bps rate hike dropped to 50%.
I remember when the probability of a 50 bps rate hike spooked the market. The reality is that one month does not make a trend.
Over the prior 12 months, headline CPI is up 8.5%, and core inflation is up 5.9%. The hope is the slowing this month vs the last two will prompt the Fed to be less aggressive. Finally, inflation eased primarily because of the 7.7% drop in gas prices.
Interestingly, the “Don’t Fight the Tape or the Fed” indicator moved to a bullish +1 score this week. The Zweig Bond Model continues to signal a bullish trend in high-grade bonds and the 10-year Treasury Weekly MACD remains in a bullish buy signal (suggesting lower interest rates). Also, the two-year vs. 10-year Treasury yield curve has continued to invert to its lowest level since the height of the tech bubble. Recession anyone?
On the equity market front, the NDR Daily Investor Sentiment indicator shows “extreme optimism,” which is short-term bearish for equities. The S&P 500 Index Daily MACD model remains in a buy signal, but the move is aged with the moving averages higher than any time in the last year (red circle in the lower right corner of the following chart). Both the Daily Investor Sentiment and Daily MACD are signaling caution. As you’ll see farther below, the intermediate-term trend signals for equities remain bearish.
The short-term trend in the high-yield bond market turned bearish this week. Further, the weekly technical pattern in HY continues to show a bearish trend of lower lows and lower highs. If we are indeed heading into a recession, it will spell trouble for the high-yield bond market… and opportunity in HY bonds on the other side of the recession.
Gold is back above $1,800. A bullish intermediate trend buy signal looks to be near. My personal long-term view on gold remains bullish. Of course, no guarantees; I could be wrong.
Click HERE to see the Dashboard of Indicators and all the updated charts in Wednesday’s Trade Signals post.
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Personal Note – Golf, A Lobster Bake, and Cape May
“If you don’t do it this year, you’ll be one year older when you do.”
– Warren Miller, Ski and Snowboarding Filmmaker
I’ve been getting updated emails and following tweets from this year’s Camp Kotok. Post-Covid, David Kotok made the event two weeks. I planned to attend week one but had a conflict. And it wasn’t golf 😊.
I miss the lake, the fishing, the food, and my friends. Though, what I miss most is what I learn there. The dinners are excellent, and David sets the topic for discussion. The room is filled with money managers, economists, geopolitical experts, and former Fed officials. Most of what is discussed stay private. That creates an open and honest space for shared views and thoughtful debate. David is an excellent host, and as you can see, he can fish! Wish I were with you, David.
David Kotok, Grand Lake Stream, Maine, with dinner
Susan and I are planning to head to Cape May for a few days next week. Step-son Tyler sent us a nice note this morning and a photo of his discharge papers. Today is his last day of active service in the Military. A big congratulations party is in our new future. Proud, of course… We can’t wait to see him.
Golf with Kyle is planned for tomorrow afternoon at Stonewall, to be immediately followed by a lobster bake cookout. As much as I try, I haven’t been able to pull Conner and Kieran into the game of golf. I try, they smile… the dance continues. But food is another thing, and tomorrow is Stonewall’s annual Lobster Bake dinner, and the reservation is set. Susan is teaching a soccer licensing course in Connecticut and is unlikely to be back home in time. One Lobster to go, please!
Detroit is coming up on August 23 and 24, and then the big one, Salmon and Halibut fishing off the coast of British Columbia, August 27-31. I’m meeting Mauldin in Vancouver. He’ll be flying in from Puerto Rico. I’m told we will see Alaska when we are out in the ocean. And whales, and eagles… John, no speedos in BC.
The year is shaping up to be a good “Bucket List” year. Hard work, fun play. No complaints. Happy. Sending you my kind wishes in hopes that you are checking a bucket list box or two or three.
As the great Warren Miller once said, “If you don’t do it this year, you’ll be one year older when you do.” Pick something really fun to do and go for it. Life’s too short.
All the best!
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.
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