On Target Newsletter
In this issue:
- Stagflation threat,
- America torpedoes its dollar dominance,
- Spreading your risks,
- Tech’s momentum switch,
- Ukraine war sanctions.
Investors Face a World of Stagflation
The world is adjusting to the unpleasant consequences of one madness after another.
First there was the climate change lunacy, which has driven the prices of fossil fuels to new highs. The ironical consequence has been a mad scramble to get more of them – natural gas, oil, even coal. Then came the panic over superflu, combining savage business disruption with a cash-and-credit explosion. Now we have a war in Europe, with international sanctions producing the ejection of Russia, the world’s only full-spectrum commodity superpower, from the global financial system.
So far stock markets have been amazingly resilient. Although European markets were initially clobbered because of their proximity to Ukraine, they have rebounded. They and the S&P 500 index are only down about one-seventh from their recent peaks; the Shanghai market is down just 6 per cent, London even less.
But I fear that investors generally are too optimistic.
In the US inflation is too high, the central bank is very cautious about tightening credit, and economic growth is sluggish – it looks like being a year for stagflation (inflation combined with sluggish economic growth). A shambolic administration headed by a president whose mental acuity is clearly fading seems destined for a hammering in the November elections.
In Europe the obsession with climate change has increased energy dependence on Russian gas imports at the worst possible time. Germany is closing its remaining nuclear power stations while policy is focused on wrong priorities — wind and solar supply that is unreliable and unprofitable. Investors in renewables in companies such as Siemens Energy and Vestas are being devastated financially. GE’s wind unit booked a $312 million loss in the last quarter.
Poor countries face a food supply crisis because of disappointing harvests in key grain exporting countries such as Canada, and now comes the European war. Ukraine is called “the breadbasket of Europe” and many countries in the Mideast and Africa are heavily reliant on it for wheat supplies. Russia and Ukraine together account for a third of the world’s wheat exports, a fifth of its
corn trade and almost 80 per cent of sunflower oil production.
With Black Sea ports closed by the war, their inventories cannot be shipped while fighting goes on. And if Ukrainean farmers don’t plant substantial quantities of corn soon, the supply crunch will be “very severe,” says Rabobank.
A worldwide fertilizer shortage threatens food production everywhere. Nitrogenous fertilizer is mainly made from natural gas, which is now so expensive that many plants have shut down. The plant food has soared from $200 to $1,000 per ton. Russia and Belarus account for a third of the world’s exports of potash and a tenth of phosphates.
“The whole production chain for food is under pressure from every side” says Abdolreza Abbassian, ex-head of agro markets at the UN Food & Agriculture Organization. “I have never seen anything like it in 30 years; I fear that prices are going to go much higher in the 2022-23 season.”
The world faces a commodity supply and price avalanche encompassing a gamut of primary resources: oil, gas, coal, fertilizers, grains, vegetable oils, are all spiralling together, with metals catching up fast. Inventories of tradeable materials are critically low. It’s a systemic stagnation shock that threatens, and it will be an intractable problem for central bankers to deal with. Inflation argues for tightening credit, but threats to economic growth countenance the opposite.
Unlike the West, China prepared for the crisis. It has bought enormous quantities of soy in recent weeks and has been stocking up commodities for months. It currently holds 84 per cent of the world’s copper reserves, 70 per cent of its corn and 51 per cent of its wheat.
How the crisis plays out could prove harder to predict than the 2008 financial collapse. Then, risks were mostly contained in the banking sector. This time banks are much sounder apart from those relating to Russia. But risks are much wider, more diverse, and threaten many of the fundamentals of global economic growth.
How should investors react to this developing situation combining war in Ukraine, inflation and supply crises? With more than usual caution. Gold and other natural resources are likely to continue doing well. I suspect most shares have more downside ahead. Possibly much more.
Replacing SWIFT and Dollar Dominance
The freezing of almost half of Russia’s $643 billion foreign reserves by central banks of America and its allies, and the partial exclusion of Russian banks from the SWIFT international messaging system, has been celebrated as a huge success for the effectiveness of the US-led financial sanctions to punish Russia for invading Ukraine. But consider the long-term implications…
How do some countries that have accumulated large foreign exchange reserves now view the risks of their dependence on the goodwill of one nation, America, for the safety and liquidity of their international assets? Autocracies own half the world’s $20 trillion pile of international reserves and sovereign wealth asset. China has forex reserves of $3.2 trillion, India of $632 billion, Saudi Arabia of $447 billion. Both China and India have already refused to submit to American pressure by abstaining from the United Nations’ vote demanding that Russia end its military operations in Ukraine.
The fierce anti-Russian sanctions have highlighted the risks for all countries that they could in future be targeted by the US because of their dependence on assets held in dollars, and excluded from making transfers in the currency, which accounts for an overwhelming majority of international trade.
There are three implications, says Morgan Stanley’s James Lord:
► Identifying the safest asset in which to hold wealth. The dollar and US government-backed securities may still be the safest. The latest sanctions involved a broad range of government authorities acting in concert. But managers of national foreign reserves and sovereign wealth fund investors can be expected in future to be less certain about the dollar, readier to resort to a diversity of assets.
One reason Russia has not been crippled by the sanctions, harsh as they are, is because it wisely planned to reduce holdings in dollars and maximize other currencies, particularly the Chinese yuan, and physical gold.
► Political alliances could be key. The sanctions demonstrate that relations between different states can play an important role in the safety of reserve assets. While the dollar might be a safe asset for strong allies of the US, its adversaries could see things differently. To put the dollar’s dominance in the international financial system at serious risk, would-be challengers of the system would need to build strategic alliances with other large economies.
► Onshoring foreign exchange assets will also be a consideration. Recent sanctions have crystallized the fact that there is a big difference between a forex deposit in a foreign bank account under the jurisdiction of a foreign government and a forex deposit that you physically own on your home ground. While both might be considered ‘cash,’ they are not equivalent in accessibility or safety.
Reserve managers may opt to keep forex assets on-shore. One way of doing this is to buy physical gold and store it safely within one’s home jurisdiction. Another is to have holdings of banknotes in currencies such as dollars, euros or yuan.
A monetary earthquake
Credit Suisse’s Zoltan Poszar says the Ukraine war has precipitated a monetary earthquake, a revolution in international financial crisis as significant as President Richard Nixon’s scrapping of the gold backing for the dollar in 1971. ‘After this war is over ‘money’ will never be the same again,” he says. We can expect the dollar to be much weaker. And the Chinese renminbi/yuan, backed by real assets such as gold, to be much stronger.
For years China has been working on seeking to make the renminbi/yuan an international reserve currency challenging the dollar, the most potent symbol of America’s global dominance. It has been encouraging global trade in natural resources, usually denominated in dollars, to instead use the yuan, introducing future contracts in commodities and gold. It has made great strides in invoicing its foreign trade in its own currency.
The security/geopolitical rationale for holding assets in yuan has become stronger through measures such as financing the Belt and Road initiative. And China has been opening its markets to foreign investors. Non-residents can more easily buy and sell stocks and bonds on the mainland’s markets. Saudi Arabia is in talks with Beijing to price some of its oil sales to China in yuan instead of dollars.
While China has been seeking to internationalize its currency the US has been moving in the opposite direction. It has weaponized the dollar, using its dominance as a trading currency to punish enemies and force its allies to comply with geopolitical sanctions. This is very effective, but incentivizes countries to reduce dependence on dollar assets.
Anti-Russian sanctions are the most dramatic example of this development. The Ukraine war has accelerated plans to develop an alternative system of international finance outside the dollar and therefore beyond American control.
The Russian parliament has established the New Development Bank with a $100 billion pool to be used for transactions among the BRICS organization of the world’s five leading emerging economies (Brazil, Russia, India, China and South Africa).
They will contribute equally to its funding. It will be based in Shanghai, India will serve as its first five-year rotating president, and the first chairman of the board of directors will come from Brazil. The first chief executive is likely to be Russian finance minister Anton Siluanov. Its currency is expected to be the Chinese yuan.
A key component of the three-nation alliance being negotiated between Russia, China and Iran will be a Eurasian clearing network to compete with SWIFT, the global messaging system among banks. The main question will be to choose the standard currency. The most likely choice will be the Chinese yuan.
Spread the Risks to your Wealth and Lifestyle
A common misconception is that there isn’t really anything you can do about diversifying your affairs internationally. But that isn’t true, Jeff Thomas writes in International Man…
Some countries are in decline but others are on the rise. Wealth is not destroyed; it just changes hands, flowing from one country to another.
Choose countries to relocate to, if you can, and in which to hold your assets. Ones that have a history of being welcome to people in your situation; ones that stay out of conflicts and don’t take sides in wars.
Seek minimal economic dependence on declining countries – as measured by their growth… or lack of it. Look for people who welcome foreigners, who share the same core values that you do. For a country that can supply your basic needs – job, schooling, medical facilities, diet and so on. Pick one that you feel would be the happiest place for you and your family, based on needs and personal likes and dislikes.
If you can, it’s very advisable to take on another citizenship or two. Several European countries – Austria, Cyprus, Malta – and Caribbean island-nations, offer investment citizenship. You deploy some of your capital; your reward is a second or third passport.
A cheaper route is to acquire citizenship by living in a country. Many offer this after residence as short as two years.
You can protect your savings against confiscation by governments. This can be as simple as opening a bank account in a foreign jurisdiction. Invest in precious metals stored in a jurisdiction safer than your own.
How do you identify a safe and appropriate foreign jurisdiction? You’ve probably already have heard of them – Singapore, Switzerland, the Cayman Islands.
In searching for one appropriate for your needs, look for the following:
► No direct taxation. No capital gains or inheritance taxes. None that apply to the purchase, ownership, storage or sales of precious metals.
► A world-class local financial system to provide auxiliary services.
► Stable government, with a consistent history of economic stability that caters to international investors.
► Minimal wealth legislation and regulation.
Is there a safe way to store wealth outside of financial institutions other than in precious metals?
Yes. The safest is in overseas real estate. Choose a jurisdiction meeting the above criteria. Ideally, you’ll want one with little or no property tax. Buy in a country where you wouldn’t mind living, and one that’s likely to grow economically, rather than decline, in a crisis (this ensures that property prices will rise).
Real estate may even be safer than precious metals as a store of wealth. But metals have the advantage of being far more liquid and more divisible.
There are no guaranteed safe havens. However, you can make yourself and your wealth difficult to target.
Political leaders of a country facing economic collapse will always make a last-ditch effort to grab as much as they can as they go down. You can make it as difficult as possible to be a victim. You may emerge from any period of crisis intact, or possibly in a better position than before. The key is to choose one or more jurisdictions where the tide isn’t going out, but coming in.
Momentum Switches from Tech to Commodities
This year tech stocks are the worst-performing group, while the best are old-fashioned physical commodities such as metals and energy.
Many commentators attribute these moves to rising interest rates, which tend to hurt growth and help value stocks such as commodities, magnified by the Ukraine war. But something more fundamental is going on, argues Ruchir Sharma of Rockefeller International.
Tech shares became overhyped and overvalued. In contrast, commodities are just coming off a record low of barely 5 per cent of US market cap and are experiencing a strong run.
Tech manias tend to lose steam when investors realize they have been pouring money into increasingly improbable and unprofitable ideas. In the US the market cap of unprofitable companies is now $2.6 trillion; 85 per cent of that total is accounted for by tech firms.
Many tech stocks have been falling as investors begin to scrutinize their prospects more closely. At the other end of the spectrum, prices for all things physical have been rising, including houses, cars, cargo and the materials and energy required to build and power them.
The once fashionable idea that younger “digital natives” would live for experiences rather than stuff is evaporating. Worldwide, prices for housing rose last year at the fastest pace since 1980, driven by younger buyers. It turns out that digital natives need physical shelter too – and they need wheels once they move to the suburbs. Millenials are driving new demand for cars.
Green politics has made it unfashionable, even unsavoury, to invest in new oilfields, mines or smelters. Last year, for the first time since 1988, energy companies spent less on new supply than they wrote off to depreciation. Now could be a good time to invest.
The War: Sanctions and Counter-Sanctions
We have not even begun to feel the blowback for the aerospace and semiconductor industries should Russia retaliate against global sanctions by exploiting its lockhold over the global supply chains for titanium, palladium, neon and C4F6 gas, says The Telegraph’s Ambrose Evans-Pritchard.
Nine-tenths of the world supply of neon – a rare gas used for microchip lithography – comes from Russia and Ukraine. Two-thirds of this is purified for the global market by one company in Odessa. Palladium is used for sensors, plating material and computer memory chips. Almost half the supply comes from Russia. The world’s biggest producer of titanium is based in Siberia. The metal is a component of alloys used in aircraft engines and frames.
Russia has been doing what China did earlier with rare earth minerals – establishing a lockhold on global markets by selling below cost and knocking out Western supply chains. The US Bureau of Industry & Security said in a recent report that America relies on supply of materials from hostile state-controlled entities to build its fighter jets, rockets, submarines, helicopters, satellites and advanced weaponry.
Russia has said that it will cut off exports of important chemicals, metals and processed gases to any nation applying sanctions over the Ukraine conflict. These exports are indispensable to manufacturing processes in several major industries, including semiconductors, automobiles and farming. However, it hasn’t yet implemented such retaliatory sanctions.
Inflation: It’s still rising in America. In February the CPI rate reached 7.9 per cent, the highest figure for 40 years.
The Federal Reserve has started raising interest rates. Futures suggest there will be three more increases this year, and some policymakers expect as many as seven rises. Eoin Treacy, the well-known technical analyst, has a strongly contrary view. The Fed will have “an extraordinarily difficult time raising rates,” he says. If it increases rates seven times, that would make a recession inevitable. That’s fantasy. But even three increases would mean the chances of a recession would be better than even. The one increase already announced could be all that happens; it “sounds about right to me.”
The Atlanta Fed says the American economy’s growth rate has already fallen to 1.3 per cent. Financial conditions are tightening, liquidity measures are signalling caution, high-yield bond ETFs are accelerating lower.
China: The government’s ban on the $100 billion private education industry has had a devastating impact on businesses offering tutoring services. Tai Education reported a $1 billion loss for the first months following the clampdown, compared to a profit of $53 million for the previous comparable period. Competitor New Oriental has disclosed losses of $876 million after being forced to close its school-age tutoring. The government acted to stamp out expensive childhood extracurriculars blamed for exacerbating social inequality.
China is notorious for its corruption, but following the advice given to foreign businessmen operating in the country to stay “clean” doesn’t always work. The bureaucracy actually prefers entrepreneurs to be “dirty” as they are more easily controlled. FT editors Edward White and Victor Mallet say that China’s secretive justice system is “famous for arbitrary detention, torture, forced confessions and a near-100 per cent conviction rate.”
Coal: Investors have been told by almost all advisers to stay away from the dirty stuff. It has no future, they said. But once again, conventional advice has been wrong. Investors who have stayed away from coal have missed some big profits.
Far from declining, coal use globally surged to record levels of the winter. In the US coal-fired power generation has been higher under Joe Biden, its enemy, than it was under Donald Trump, its friend. Europe experienced an 18 per cent rise in coal use last year.
The Ukraine war has sent coal consumers in Europe and Asia scouring the markets for supply and pushing up prices, which hit $400 a ton this month compared to about $82 a year ago.
The anti-carbon mania is throttling production. “Nobody is building new coal mines; no one is getting funding for new mines; but there continues to be a healthy appetite for coal” says Glencore’s chief executive Gary Nagle.
Germany: Its electricity is the costliest in Europe – 70 per cent pricier than France’s — thanks to extreme climate change policies, but its new federal government has been forced into retreat by supply shortages and soaring prices. Robert Habeck, the Green leader who is vice-chancellor, says the government is considering scrapping the long-planned phasing out of nuclear energy, leaving on line three power stations due to be closed at the end of this year and switching back on three that were closed in January. That will be enough to replace 11 billion cubic metres of natural gas a year, or one-eighth of current energy needs. Germany is also increasing its consumption of coal, the dirtiest fossil fuel, after years of cutting back.
Incidentally I see that half of the cost of the Nord Stream 2 gas pipeline under the Baltic that Germany has refused to allow to operate will be lost by five European energy firms.
Defensive investing: The golden rule of investing – diversify – applies more than ever when the world is turbulent, says Tom Stevenson in The Telegraph. Harry Markowitz, the father of modern portfolio theory, called it “the only free lunch in finance.”
The three most important ways to diversify a portfolio are across individual shares, asset classes and geographies.
Evidence suggests that most individuals’ portfolios are far too focused. A study of accounts at a large American brokerage a few years back showed that the average holding was just four stocks, with younger and less sophisticated investors holding the most concentrated portfolios. Since 1926 it’s been the stellar performance of just a small number of shares that have accounted for all the gains achieved. The more concentrated your portfolio is, the less likely you are to have an exposure to that handful of top performers.
Risks in global finance: Two dangers stand out, says The Economist. One is leverage hidden in shadow banks and investment funds. Total borrowings and deposit-like liabilities of hedge funds, property trusts and money market funds have risen to 43 per cent of GDP. Firms can rack up huge debts without anyone noticing. Archegos, an obscure family investment office, defaulted last year, imposing $10 billion of losses on its lenders.
The second danger is that the system still relies on transactions being channelled through a few nodes that could be overwhelmed by volatility. Exchange traded funds, for example, with $10 trillion in assets, rely on a few small market-making firms to ensure that the prices of funds accurately track the underlying assets they own. Trillions of dollars of derivatives contracts are routed through just five clearing houses.
Electric cars: Americans have been less enthusiastic about switching to electric vehicles than drivers in other big markets because of smaller government subsidies, long driving distances and a lack of options beyond Tesla luxury models. Drivers are still fretting about whether electric vehicles work efficiently in cold weather – although this doesn’t appear to be a problem in Norway, the country where the switch to electric has gone furthest.
Last year sales of electric models in the US more than doubled, but still added up to less than 5 per cent of new passenger vehicles, compared to about 14 per cent in both China and Europe.
Renewables: What countries that expand solar- and wind-generating capacity fairly quickly discover is that the marginal benefit of installing more of it rapidly decreases as more capacity is installed, Prof. Anton van der Merwe writes in the FT. This is because they are intermittent and there is no affordable and scalable way of storing this power. It is not clear when affordable storage will become available. Until this problem is solved, we will continue to rely on fossil fuels to back up renewables.
A better answer, he suggests, would be to use nuclear power as back-up. (But we know that is expensive, controversial, and the facilities take a long time to construct).
Safe havens: Wealthy Russians fleeing from international sanctions are heading for places in the half of the world that refuses to apply them… and are benefiting from the international conflict.
One of the most successful is the United Arab Emirates. There are already an estimated 40,000 Russians living in the country, whose government has taken a neutral position on the Ukraine issue. Many wealthy Russians have established businesses there. Others have bought residence. Investment of $200,000 gives the right to live there for three years; larger amounts can secure longer-term “golden” visas.
Australia: It’s doing well out of the commodities boom. Natural gas, oil and wheat account for 18 per cent of exports; coal for another 14 per cent.
The other positive feature about the economy is the potential for a domestic consumption boom as 25 million Australians emerge from lockdown with household deposits at A$249 billion – 25 per cent high than prior to Covid.
A general election is due in May. The opposition Labor Party is five to ten percentage points ahead in the polls.
The pandemic: Vaccines don’t stop people from become infected and they don’t stop the spread of the virus by those who are infected, argues the Daily Reckoning’s Jim Rickards. The data shows that the fully vaccinated are more likely to catch the Omicron variant than the unvaccinated.
Extensive evidence is emerging that the mRNA vaccines produce myocarditis (heart failure) in men under 40, and particularly those in the 16- to 25-year range.
Anti-greenery campaigner: Britain’s best-known populist politician, Nigel Farage, has launched a movement to torpedo the country’s net zero emissions policy by campaigning for a referendum on the issue. Farage is credited with achieving Brexit, a policy almost no one expected would be achieved when he started campaigning for it as it was overwhelmingly opposed by the nation’s ruling elite.
Relocating to Latin America: American commentator Doug Casey says he would put Panama at the top of his list as a place to live. It’s very international, very urban (in Panama city), and very sophisticated. His second choice would be Belize. It’s English-speaking; more a part of the Caribbean, ethnically and culturally, than of Latin America. Casey was long a fan of Costa Rica but says it’s now overrun with Americans and very expensive.
Crazy policies: After years of using fierce sanctions to prevent Iran and Venezuela from selling their oil, the Americans have reversed their policies. They now want them to sell lots of the stuff. And after years of preaching about the evils of fossil fuels, they want allies such as Saudi Arabia to pump more. Quickly.
Vaccine deaths: According to the European Medicines Agency, 3.7 million suspected adverse drug reactions to the Pfizer-BioNTech, Moderna, AstraZeneca and Janssen anti-Covid vaccines, which resulted in 40,788 deaths, were reported to the end of last month. I leave you to guess why this readily-available public information isn’t reported by mainstream media.
Tobacco: It is easily the most profitable of China’s state-owned enterprises, and therefore escapes the robust anti-smoking policies imposed elsewhere in the world on the industry. The China National Tobacco Corporation monopoly makes and sells four out of every ten cigarettes smoked in the world.
Electrification for climate change: Implementing this will require enormous quantities of materials such as copper, nickel, manganese, lithium, and more common metals such as steel and aluminium. How’s it going to be paid for? No one seems to have a credible answer.
Windmills: The newest batch of offshore wind turbines are the largest rotating machines ever built. They keep getting bigger because there is a 45 per cent increase in generating capacity for a 19 per cent rise in diameter.
On Target is a free, private newsletter for Martin Spring’s worldwide circle of friends and contacts.