HyperNormalTimes

Written by our Director of Equity Advisory, Jeremy McKeown, the HyperNormalTimes provides in-depth and considered long-term commentary on major macroeconomic and market-shaping themes.

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May 6, 2024

All Getting Very Real

Why Real Assets Are Preferable to Bonds

Tank,Made,Of,Money

Reality Strikes

Wishful thinking, however well-intentioned, cannot defy the laws of physics or the fundamental economic problem of satisfying infinite wants from bounded resources. During this year of elections, the tectonic plates of political fantasy and physical and economic reality are colliding. The inconvenient reality is that electorates are also consumers who sense that things can’t continue as they are. The make-believe is unravelling, revealing a reality of misallocated capital that threatens the fabric of our financial system.

Zero Chance

Consider Humza Yousaf’s recent decision to resign as Scotland’s First Minister after his coalition partners, the Scottish Green Party, withdrew its support. The Greens took this step after the Climate Change Commission (CCC) reported on Scotland’s progress towards its 2030 emissions targets. The CCC concluded that for it to achieve its stated goal of reducing its emissions by 75% of the 1990 level by the decade’s end, the devolved government must, among other things, triple EV charge point installation, reduce car traffic by 20%, increase heat pump installation by a factor of thirteen, double onshore wind capacity, and significantly reduce air traffic via higher airport departure taxes.

Term Ending

Whatever we might think of the need for action on climate change—and, trigger warning, opinions do vary—the reality of the CCC report is that Scotland has zero chance of meeting its objective. If it were an end-of-term report, which technically for Mr Yousaf it was, the Scottish government would have received an F. The SNP’s reaction was to blame Westminster for lack of funding, but this didn’t wash with the Greens, who weren’t prepared to “do a Clegg,” removed their support, and left Mr Yousaf hanging by a thread.

Over There

Alternatively, take the matter of Europe’s listed oil companies. Shell and Total Energie CEOs have separately suggested that seeking a listing in the US could be in their shareholders’ best interests. The maths behind the European oil majors’ statements is undeniable. US investors would almost certainly value Shell and Total more highly, potentially by 50% more. The fact that these oil bosses can publicly admit that ESG has costs is a refreshing breath of realism, but the fund manager Barry Norris made the case more forcefully. The choice, as far as he is concerned, is stark.

Many European companies are choosing to list in the US, where ESG reporting requirements are less onerous. Smaller companies will not go public due to the extra compliance costs, while profitable old-economy companies—shunned by public markets—will go private. We can have thriving European capital markets, or we can have ESG. 

Caring Too Much

Matthew Syed has voiced concern for our mindless compassion built on years of prosperity that stretches across the way we do politics, healthcare, social justice, and economics. In his Sunday Times article, he said that,

A visitor from the time of the agricultural revolution would be astonished by our wondrous technology but perhaps even more so by triple-locked pensions for all, observing that in late-stage regimes, social entitlements have a tendency to become uncoupled from the material conditions required to finance them. 

Economic Cost

It isn’t a debate between right and left but realism and denial. All choices have costs; as Chicago economist and social commentator Thomas Sowell put it, the reality of policymaking is that there are no solutions, only trade-offsToday, as interest rates remain higher for longer, decisions are more real; they exist in the here and now, and this reality is causing problems.

Tolerating Intolerance

Today, the US and Europe have run up national debt to GDP levels similar to those in the 1940s. The main difference is that we haven’t had to fight a world war, at least not yet, and far from being united in the face of a common enemy, we are radically divided. Matthew Syed has written of the need to recalibrate what we mean by compassion in a world of rising military conflict. In The Open Society and Its Enemies after witnessing the Nazi destruction of pre-war Vienna’s fertile intellectual cultureKarl Popper said,

If we extend unlimited tolerance even to those who are intolerant, if we are not prepared to defend a tolerant society against the onslaught of the intolerant, then the tolerant will be destroyed, and tolerance with them.

Change Through Trade

European defence spending was long ago de-prioritised in favour of what Germany championed as Wandel durch Handel (change through trade). Yet, favouring the abundant supply of cheap Russian energy above national security has proven costly. The Russian government’s behaviour was never considered an ESG issue before February 2022, ddespite its long-running human rights abuses. Today, buying shares in BAE is blessed by the government as worthy. As Europe faces previously unimagined geopolitical challenges, its two largest listed companies make weight loss drugs and handbags. One suspects the new reality will change things.

Step Aside Mr Powell

Meanwhile, in the US, a more dovish monetary subtext lurked beneath last week’s FOMC headlines of unchanged rates. The unexpected slowing of the Fed’s balance sheet contraction was another reminder that we are in a world of fiscal dominance, where monetary policy plays second fiddle to the Treasury’s requirements.

Some Are More Equal

As Liz Truss demonstrated, not all governments are equally blessed with the ability to deficit-spend their way to growth like the fiscally privileged US with its reserve currency and the world’s deepest capital pool. In contrast, Argentina reached a stage last year when its president was elected on a platform to blow its financial system up and start again; its Peronist fiscal irresponsibility had failed too many times.

Debt is Money

A recent paper by Chen Zhao of Alpine Research, entitled What Debt Crisis? pointed out that central banks acting as credible buyers of government debt can counter turmoil in bond markets. However, high inflation or a falling currency are the limiting factors for such an intervention – i.e., the Bank of Japan today.

But, Zhao went on to say that:

In the end, money and government debt are the same thing. The only differences are that they have different maturities, and holders of government paper are paid interest.

Fiscal Stimmy

Today’s debt borrows from the future, perfectly describing the US’s fiscally driven sticky inflation problem. By paying nearly a trillion dollars annually in interest on its debt, the US Treasury provides its cash-rich bondholders (wealthy boomers, Alphabet, Apple, and others) with a healthy stimulus at a time when the economy is running hot, and its average Federal borrowing cost remains only 3.2%.

Who’s In Charge?

Fiscal dominance occurs when the interest bill stimulus from Treasury debt exceeds the monetary headwind of higher rates, and evidence suggests the US may have reached such a tipping point. How does this recipe turn out? Like all good cooking programmes, we prepared one earlier.

Oven Ready

Japan, which started its QE programme years before the US and Europe and continues with it to this day, is way past its fiscal tipping point. Japan pays 30% of its tax revenue on interest payments, despite the average rate it pays still approximates zero. It cannot contemplate a world where it pays “normal” rates on its sovereign debt. Finance Minister Suzuki no doubt gave Treasury Secretary Yellen the heads up on this during his recent visit to Washington. As existing US and European national debts mature and new debt issued, their sovereign borrowing costs will rise, too. It is unclear which currency will be out of the oven next, but further currency volatility can be expected.

$5 Milkshake

Such a world of financial chaos is the event-driven scenario of  Brent Johnson’s Dollar Milkshake Theory, in which the dollar (DXY) and gold price can rise together. This has played out in markets since March as the world seeks safety from the risk of currency debasement in Japan, China, Europe, and elsewhere.

Further, Johnson says:

We are at a point where all these overseas economies have gotten over their skis and exhausted the things they can do regarding monetary and fiscal policy. We are reaching a situation where all fiat currencies are being debased relative to gold; initially, the dollar will rise further than any other currency, but gold is rising faster than all of them.  

Short Abundance

As Investment Strategist Lyn Alden put it in her recent public newsletter:

Most successful investing can be summed up as “go short abundant things and go long scarce things.” In an era of fiscal dominance, bonds are among the most abundant things around. The Congressional Budget Office forecasts that there will be $20 trillion worth of cumulative fiscal deficits over the next decade, and their assumptions are that interest rates will be lower than they are currently and also that no recessions will occur. In comparison, at current production rates and prices, somewhere in the ballpark of $2.5 trillion worth of refined gold will likely be mined and minted over the next decade. Similarly, at current prices about $70 billion worth of Bitcoin will be produced over the next decade.

Alden and Johnson highlight the risks of the 60/40 portfolio in periods of structurally higher inflation and growing sovereign debt burdens. Allocating to real assets rather than bonds provides significantly greater protection in such scenarios.

Fiat Folly

Finally, if you think our politicians must be aware of all this and will get their advisers and agents to manage the situation on our behalf and save the world from financial chaos, you might be disappointed.

Joe Biden explains inflation:

I’m sick of this stuff.

A leading monetarist disagreed:

Inflation is made in Washington.

But if you think the President’s advisers will save him from his lack of grasp of monetary economics, then watch this from the Chairman of his Council of Economic Advisers, Jared Bernstein, being asked about why the government borrows when it can print dollars:

Um, MMT is difficult.

However, the idea that Donald Trump might save the day is even less credible if the recent story about his plans to oust the Fed Chairman is true. As the Telegraph and others reported, he plans to set interest rates directly.

What could possibly go wrong?

It is enough to make you go all in on real assets. The reality is that gold has broken out into new all-time highs, BHP has started an expected +£30bn bidding war to own Anglo American’s real copper assets, and the Bitcoin price has risen 10% in the last 48 hours; it’s all probably just nothing.

Jeremy

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