Out of Road
Right now, investors are correct in feeling the economic sands moving beneath their feet. After 14 long years of kicking the can down the road, Western bureaucrats are out of road and have moved to sand – deep sand. Times are changing rapidly. Investors would be wise to assess their allocation of scarce investment resources accordingly.
Key risks we’ve been warning about in these notes for some time are all happening now, at the same time.
- Inflation/stagflation
- De-dollarization
- Systemic Financial Risk
On the matter of de-dollarization, the pace at which many countries excluding US, Europe, Japan and allies have been moving away from USD settlements in all sorts of commodities over the past few months has been shocking. It seems many countries really did worry about “who’s next” when the US sanctioned Russian Central Bank assets. Even France surrendered to the BRICS+ party last week, with the LNG sale by French company to China, in Renminbi instead of USD.
On the inflation front, the de-dollarization story matters little to the Western bureaucratic echo chamber as inflation will continue to be the poison of choice for said bureaucrats on the basis that they know no other way than to try and print their way out of any crisis.
So, as the de-dollarization and inflation trains build steam, systemic risk looms large for investors, as the March bank failures showed us.
What does this mean? It means we’re dusting off the old Lehman 2008 favourites. Mark to Market, Collateral Calls, Write Downs, Margin Calls, Credit Derivative Risk, Bail Outs, Bail Ins and (our favourite although we never got any when we applied) Troubled Asset Relief Programs.
The systemic risk, bank failure party started thanks to the very remedy Central Banks have been using (other than manipulating the numbers) to combat inflation – rising interest rates. Combating the inflation that Central Banks bought upon us!! They (CB’s) were always going to raise rates until something broke, it’s an established pattern. In this case it’s the “somethings”; Cryptoland, Silicon Valley Bank (plus few others in the US) and the most amazing, Credit Suisse. In the case of Credit Suisse one should be quite impressed (or fearful) with the way Credit Suisse existed one week, then over one weekend, before Asian markets opened Monday morning, it was part of UBS with all the muscle the Swiss National Bank required. POOF, and it’s gone.
Let’s look at the root of all things systemic risk, aside from the obvious fractional reserve issue. We’ll start with a very simple explanation. With all due respect to the journalist that penned the article that contained the extract below, we wonder if the full impact of a disfunctional Credit Derivative is properly understood.
“Deutsche’s five-year credit default swaps – a derivative instrument that insures investors against a bank failing to make payments on its bonds – have blown out from 134 basis points on Wednesday to more than 200 points on Friday, a four-year high”. – Australian Financial Review: 25/3/2023 (emphasis added)
The creation of an entire system that allows financial institutions to create products that allow fellow institutions to take on any risk they like, as the risk can be hived off using “swaps”, was part of the “deregulation” of the banking system in 1998. Many thanks to the deregulation sponsors, the Clinton administration’s senior economic advisers Larry Summers and Robert Rubin (both have remained as key administration economic “advisers”). Even today, in a post “Lehman” world, if one questions a world chock-full of derivative risk the smartest heads in the room will politely raise their eyebrows as if to say, “so you don’t know it all nets out”?
Dismissing counterparty risk in this financial system is a fatal flaw. Lehman was a counterparty failure and central banks have been bailing the system out one stimulus package at a time ever since.
There have been feeble attempts to “normalise rates” in line with inflationary pressures that have all been reversed at the first sign of trouble, just like we’ve seen on the last few weeks post the bail out of Silicon Valley, not the bank, all of the Valley (systemically important?).
Don’t believe us? Let the chart below tell a few trillion stories, a chart that first came to our attention in 2015. We’ve not seen an updated version; numbers will have changed but the size proportions of the towers are unlikely to have changed much. The DB below refers to Deutsche Bank.
(Source: Bloomberg)
The market is correct to look at DB, long time coming, most certainly, too big to fail and possibly too big to bail. But it’s not just DB, it’s systemic! So, they keep plugging holes with fresh printing.
So, now we wait for the next weekend of bailouts, although with the reintroduction of QE, things may have calmed, for now.
(Source: Bloomberg)
There are Spigots open for those in need (not you).
(Source: Grant Williams)
How long before rates start coming down? Not long.
This beacon of instability is probably nothing.
One needs to use the this pause in proceedings to assess how they feel about their investments at this stage of the cycle. Recent banking turmoil, central bank induced inflation and a market expectation of rate cuts in coming months has rendered “cash” as an unattractive investment to many. We do endorse a decent cash allocation as a means to take on new investment opportunities, particularly in a proper SHTF situation, when high quality assets are being sold down aggressively because investors are panicking and have to sell. Enter the Margin Calls!!
However, this could also be the time one could maintain full faith in our bureaucracies to continue to do whatever it takes to retain status quo, including money printing, telling you inflation is contained, War or anything else needed to extend the “show”. But something tells us this time is different. A general balanced approach was a losing strategy in 2022 so it should be clear investors need to be more strategic.
With systemic risk in US, European and Japanese banking systems accelerating, international trade settlement is moving away from fiat dollars into domestic currencies and safer havens. What safer havens could there be other than the USD?
One asset class clearly has the attention of investors post a stellar first quarter – precious metals, specifically Gold. It’s ironic that it has been the BRICS+ nations, particularly China and Russia that have been openly championing Gold as an important investment stabilizer to any portfolio for a number of years, as it has been for many a millennia. More Central Banks seem to be catching on!
Net Central Bank Gold Purchases
(Source: Incrementum)
And with the party just starting in our view, it’s time to recall, there’s no rush like a Gold rush!
(Source: Katusa Research)
We’ve enjoyed the re-emergence of sensible thesis on the effect of a meaningful Gold revaluation to reinstate it to its proper role as some type of Fiscal Bedrock. $15,000 is a recurring number of some analysts for reasons relating to money supply ratios, story for another day, time will tell.
So, how does an average investor allocate to Gold? The answer is, most don’t. Gold and associated precious metals have not been more under owned in 100 years. Relative to the overall asset pool, Gold makes up less than 1% of investable assets. If one did want to consider owning precious metals as part of an investment strategy then we’ve these opinions (NOT ADVICE) to pen from experience:
- The Real Metal, nothing like it, in your hand, no one else’s liability and the right weight can make a useful doorstop.
- Large cap, low cost Gold producers in Tier 1 jurisdictions with little to no debt and low costs of production, you virtually get the ounces in the ground for free.
- Well managed mid cap producers with no debt and low costs in Tier 1 jurisdictions for more risk and more upside potential in some cases.
- Emerging producers with proven management and excellent resources. There has been much cost mismanagement and business failures in this space in recent times, investors are rightfully nervous.
- Explorers with high potential of discovery, the highest risk with high reward/loss potential. Fortunately, there is 0, zilch, no love for these companies from investors right now so maybe a small allocation could go a long way.
- Some Gold ETFs are unlikely of offer anything more than a derivative style price tracking experience, be aware of what your claim is when you buy any “reputable” Gold tracking ETF with promises of conversion to metal at any time.
Overall, excluding Precious Metals, the commodity space in general has been a very rewarding investing experience for some over the last few years. The search for Copper, Lithium and other critical minerals if definitely hot right now. Economic cyclical risk remains higher (in our view) for base and battery metals than precious metals but one could do worse than apply the notes on Gold above to any of these metals, particularly Copper.
Overall, away from metals, we’d describe the current macroeconomic set up as very, very 2008. There were many signs through 2007, early 2008 before the eventual Lehman moment. One should heed the lessons history stores for us.
Finally, we leave you with this to ponder:
Science fiction author Robert Heinlein (1907–1988) wrote in Stranger in a Strange Land, “Government! Three fourths parasitic and the other fourth stupid fumbling.”
Peace.
