Geo-Political & Currency Risk

2022 was a correction year in the markets. The cause of the correction was Inflation and the Fed aggressively raising interest rates having thought inflation would pass after supply chain disruptions passed following the Covid-19 pandemic.

Looking forward into 2023 the consensus of economists forecast is for a Recession. We have already had 2 back-to-back quarters of negative GDP growth (the standard definition of Recession) but strong employment has delayed an official announcement of Recession despite many big technology companies laying off thousands of workers.

The Fed intends to keep raising interest rates to stabilize prices until the economy reaches a balance where prices and wages in the economy works for everyone. With short term debt yielding more than long term debt (inverted yield curve) and negative real returns (negative investment returns after inflation) this means inflation must fall below the Fed’s 2.0% target by using the blunt force of higher interest to right size the economy until prices come down. It will be painful for highly indebted and unprofitable companies needing operating capital and it is likely bankruptcies will follow and layoffs rise.

Obviously, this means a recession is probable, but the big question is will we have a soft or hard landing? Currently the market is pricing in a mild recession and most think the Fed will have to make rate cuts in the second half of this year to rescue the economy. With stock and bond prices off their highs and abundant employment opportunities many investors believe a soft landing is likely.

The ‘hard landing’ camp thinks we are at the end of a long-term debt cycle where high sovereign debt levels and rising interest rates will cause something to break. They see the potential of banking and/or sovereign debt defaults turning into a potential domino-event. In any case, they foresee a crisis in currencies and point to Japan with 250-300 percent debt to GDP. They argue Japan cannot continue to both hold interest rates low and the Japanese Yen high. Japan has been buying its own bonds for twenty years and now owns 50% of all JPGs. They think Japan’s Yield Curve Control (interest rate manipulation) depressing 10 Year JGP’s interest rate to 0% to .50% is not sustainable and that at mere 2.0% rates Japan would not be able to service their debt without printing more money stoking inflation and exacerbating a weaker Yen. The ‘hard landing’ camp sees the same possibility of something breaking in Italy, Spain Greece and Portugal and foresees rising sovereign debt levels causing monetary destabilization, public unrest, and a pivot back to more QE which will lead to financial crisis and hyper-inflation.

Our assessment is that money has been cheap for too long and excessive leverage has been utilized to pull growth forward. We agree with the ‘soft landing’ camp that given the nearly $3 trillion in stimulus spending readied for infrastructure investment, reshoring of tech manufacturing, and the transition to electric vehicles a US recession could be mild. We disagree that the 2022 selloff shields stocks and bonds from going lower.

Likewise, we agree with the ‘hard landing’ camp that sovereign debt levels now aggregating to hundreds of trillions of dollars worldwide are starting to compound at higher interest rates posing a broad market threat. There has to be a limit to open end stimulus and with nations now seeming less willing to own low yielding, questionable quality debt like JPGs which pay only .50%, when safer bonds pay more, it may be that Japan is nearing a tipping point. As the largest owner of US Treasuries Japan is likely to sell their US Treasuries to buy JPGs to prop up their currency and maintain below-market yields. Japan’s trillion dollars of treasury bonds suddenly hitting the market would likely cause China and the Netherlands to sell their treasuries as well to cut their losses as yield rise. The Fed of course could intervene and buy the Treasuries adding to US debt pile (QE) or they could have a proxy ally do so. The point is monetary risk levels have risen and are a concern to watch and be cautious about.

In our judgement then, there are different potential outcomes that may unfold. (1) The Fed could hike interest rates to 5.0% and hold them there for a prolonged period of time and assess what happens. (2) Some financial event may erupt in the world that forces the Fed to reverse course and cut rates because not doing so may make things worse. (3) Higher global interest rates and a strong dollar could push our allies’ monetary systems to a breaking point, crushing trade, and leading to an unstainable political environment including war.

In one sense, these are all the same scenario that foretell a similar chain of events. Raising interest rates to stop inflation is necessary but leads to slower growth and an economic downturn while higher debt service can lead to default that causes panic. While the US is not likely to default on its debt, other countries or their banks may and any default on national debt could cause a ripple effect to counterparties not being able to pay and so on, and so on. This could cause a return to Quantitative Easing (QE) and perhaps even negative interest rates because no other solution to keep things going is available.

Condensing these scenarios into probable outcomes requires planning for the worst and watching data and events attentively. As we mentioned in our last commentary, the world is moving towards a multi-reserve currency world—the US Dollar and a new Asian Central Bank Digital Currency backed by Gold, Commodities and Oil. The Fed is draining dollars from the international payments system and raising interest rates not just to squash inflation but also as a counter move to strengthen dollar demand. These actions will cause pain at home but shore up Dollar attractiveness backstopping wholesale moves to the new currency.

Perhaps the most unsettling concern we have is seeing the underlying structural defects not being addressed as deficit spending continues and higher debt levels increase strain and vulnerability. The US can control many things but not others—like what currency nations use to settle trade. Shunted by a post 2008 US foreign policy attacking China industry and trade, China has gone to the Middle East and proposed a new trade cooperation paradigm where it would import large quantities of crude oil on a long-term basis from GCC countries and purchase more LNG. With the proceeds from oil & gas sales China has proposed it would bring engineering and materials to build upstream storage, transportation, chemical, and refinery capacity to the GCC countries offering its Shanghai Petroleum and Natural Gas Exchange for trade settlement in Yuan, not Dollars. Because Saudi Arabia needed a new market for their oil since the US has become an independent producer, the Saudis have recently cut a deal with China to buy their oil and China will build them middle east a shipping port and a high-tech Silicon Valley like tech hub while the parties trade will be done in Renminbi (Chinese Yuan), not US Dollars. This of course, diminishes the power of the “Petro Dollar” and sets the stage for multi-lateral trade with other nations who want to avoid the potential of reserve confiscation by the West as Russia has experienced.

Navigating the financial markets requires monitoring macro-economic events as well as domestic economic policies. Clearly Europe, the US and Japan are caught in a “catch-22” dilemma now having to raise interest rates on themselves to combat inflation which increases debt service, debt levels, and global confidence in their currencies. The Russia/Ukraine war is a wrecking ball event further threatening political and economic stability particularly in Europe. This year and next the US and Europe must refinance some eleven trillion in debt at much higher yields. According to the Congressional Budget Office, US debt service will rise from $442 billion to $700 billion in 2023, and $1.2 trillion in ten years. All these tumultuous headwinds increase the risk of some black swan event, so we continue to hedge portfolio risk and favor holdings which offer certainty of income and return over uncertain growth.

We have identified sectors that offer long-term innovation and growth, but remain concerned that revenues and earnings may yet fall further and until that potential is priced in, we will continue to pursue a conservative strategy of getting paid while we wait.

Please understand this commentary was not meant as a negative, bleak outlook, but as a realistic one informing you of what factors we consider in making investment decisions. As a Total Return manager, we strive to keep money compounding and that means managing costs, portfolio valuations, and market risk. In fact, “Managing Market Risk” is what differentiates ProActive from other advisory firms as we monitor account performance striving to avoid big setbacks as much as keeping performance top notch. Please pass along this commentary to any friends or family that have suffered losses this past year as we’d love to help them. Thank you for your continued confidence and trust.