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More of the Same in 2023?

US Deficit Spending

Congress once again demonstrated a remarkable lack of fiscal discipline.  The 2023 Omnibus Bill, which consisted of 4,155 pages, was passed on December 23.  Projected federal spending for the fiscal year ending September 30, 2023 is $5.9 trillion.  Tax revenue is expected to be $1.0 trillion less than the spending authorized by the bill, adding to the current $31.3 trillion of federal debt outstanding as of December 28 (https://fiscaldata.treasury.gov/datasets/debt-to-the-penny/debt-to-the-penny).

The Omnibus Bill included $47 billion in emergency assistance to Ukraine.  It also included $16 billion for 7,510 “earmark” projects in lawmakers’ districts.  The earmark projects are usually local projects that should be paid for by state or local governments.  However, as Adam Andrzejewski, CEO and Founder of OpenTheBooks.com, wrote in an opinion, “earmarks are legal bribes doled out to members of Congress in exchange for their support of these large, irresponsible spending bills that are rushed through without much scrutiny.”

International Monetary System

Zoltan Pozsar received some attention from his December commentary on oil, gold, and changes to the international financial settlements system.  Pozsar is an analyst at Credit Suisse and previously worked at the Federal Reserve and the US Treasury Department.  He is one of the leading experts on the inner workings of the world’s financial system.  Pozsar believes that the sanctions on Russia marked the end of what he calls “Bretton Woods II” or the use of the US dollar for trade settlement.

The original Bretton Woods Agreement (or Bretton Woods I) was negotiated in July 1944 when representatives of 44 countries met in Bretton Woods, New Hampshire and agreed that US dollars could be redeemed by central banks for gold at an exchange rate of $35 per ounce.  Other currencies pegged their value to the US dollar with narrow trading ranges but adjustments to the exchange rates were sometimes required to restore balance to trade between countries.  Bretton Woods I ended in 1971 when President Nixon took the US off the gold standard and foreign central banks could no longer redeem US dollars for gold at the fixed exchange rate.

What Pozsar calls “Bretton Woods III” is still in the process of development.  While the United States is a staunch defender of a unipolar world, many countries now appear to prefer a multipolar arrangement, involving shared power and an international monetary framework that does not rely on the US dollar and G-7 currencies.  Pozsar expects the emerging monetary framework to involve international reserves for settlement that consist of gold, oil, and other commodities with some inherent value.  The Eurodollar system (US dollar financial assets and liabilities outside US boundaries) will contract and contribute to inflationary forces in the West.

At the 2022 St. Petersburg International Economic Forum, Russian President Vladimir Putin’s speech included comments entirely consistent with Pozsar’s comments:

Caught in the inflationary storm, many nations are asking, why bother exchanging goods for dollars and euros when they are losing value right before our eyes?  Indeed, the economy of imaginary wealth is being inevitably replaced by the economy of real, valuable, and hard assets.

According to the IMF, today’s global foreign currency reserves contain 7.1 trillion dollars and 2.5 trillion euros.  And this money is depreciating at an annual rate of about 8%.  Moreover, it can be confiscated or stolen at the whim of the US if it disapproves of something in a country’s policy.

I think this has become a very real threat for many countries that keep their gold and foreign exchange reserves in these currencies.  According to objective expert analysis, in the coming years a conversion process of global reserves will get underway.  Reserves will be converted from weakening currencies into tangible resources like food, energy, commodities, and other raw materials.  Clearly, this process will further fuel global dollar inflation.

The potential for change to the international system is reflected in central banks’ demand for gold.  Central banks around the world added nearly 400 tons of gold in the third quarter, the largest quarterly increase in central bank gold reserves since the World Gold Council started keeping records in 2000.  The World Gold Council reports that demand “has outstripped any annual amount in the past 55 years.  Last month’s estimates are also far larger than central banks’ official reported figures, sparking speculation in the industry over the identity of the buyers and their motivations.”

US/Ukraine/Russia Conflict

There does not appear to be any resolution to the conflict between the United States/Ukraine and Russia anytime soon.  The continuation of the war will, of course, pose problems for economic activity in Europe and international trade.  David Collum, Professor of Chemistry and Chemical Biology at Cornell University, writes an annual review blog at the end of each year and has developed a following.  He dedicated Part 2 of his commentary this year to the war in Ukraine.  His commentary is lengthy but full of interesting facts and quotes.  https://www.zerohedge.com/geopolitical/dave-collums-2022-year-review-part-2-war-ukraine-how-does-it-end

Economic and Financial Market Outlook

Vanguard published their economic and market outlook for 2023.  Among their expectations:

  • Rapid monetary tightening will eventually succeed in reducing inflation.
  • There is likely to be a global recession due to a deterioration in financial conditions, increased policy rates, energy concerns, and declining trade volumes.
  • Central banks will continue their aggressive monetary tightening in early 2023 before pausing as inflation falls and job losses increase.
  • Equity markets have yet to drop materially below their fair-value range, which they have historically done during recessions. However, their global equity outlook is improving because of lower valuations.
  • Over the next 10 years, they expect annualized returns of high single digits for foreign equity markets and mid-single digits for US equity markets.

I agree with Vanguard’s comments with two caveats.  First, their comments do not reflect the impact on stock returns of lower corporate profits associated with recessions.  Second, like most US investment firms, there is little consideration given to changes in the international monetary framework, which I believe are becoming increasingly likely to happen.

As we enter 2023, asset allocations in client portfolios will continue to reflect a conservative stance, with a significant allocation to precious metals.

Best Wishes for the New Year!  If you have any questions or comments, please contact me.

Sincerely,
Robert G. Kahl
CFA, CPA, MBA

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The Inflation Inflection Point

There was a positive reaction by the financial markets to Federal Reserve Chairman Powell’s comments on Wednesday this week.  He said, “The time for moderating the pace of rate increases may come as soon as the December meeting.” The last four rate hikes to the fed funds rate have been 75 basis points (0.75%), so he is indicating a rate hike of 50 or 25 basis points at the conclusion of the Federal Open Market Committee meeting on December 14.  The current fed funds rate target is 3.75-4.0%.

The financial markets paid less attention to Chairman Powell’s other remarks, which reflect the Federal Reserve’s concern of reducing inflation.  After his comment about the December rate hike, he said, “History cautions strongly against prematurely loosening policy.  We will stay the course until the job is done.”

Goldman Sachs strategists are forecasting a peak federal funds rate of 5.25% in May following a 50 basis point hike on December 14 and three more 25 basis point hikes next year.  Most economists expect inflation to trend lower as interest rates peak and supply constraints ease.

Rob Arnott, Partner and Chair of Research Affiliates and his partner, Omid Shakernia, recently published an article, “History Lessons: How ‘Transitory’ Is Inflation?”  The full article is located here: https://www.researchaffiliates.com/publications/articles/965-history-lessons.  Their conclusion is contrary to the consensus.  They cite a meta-analysis of 67 published studies on global inflation and monetary policy by Havranek and Ruskan (2013) which found that across 198 instances of policy rate hikes of 1% or more in developed economies, the average lag until a 1% decrease in inflation was achieved was roughly 2 to 4 years.

Arnott and Shakernia conducted their own study and examined all cases where inflation surged above 4% in 14 OECD developed economy countries from January 1970 through September 2022.  Their study focused on the level and trend of inflation.  Their conclusion had the following key points:

  • The US Federal Reserve Bank’s expectations for the speed of reverting to 2% inflation levels remains dangerously optimistic.

  • An inflation jump to 4% is often temporary, but when inflation crosses 8%, it proceeds to higher levels over 70% of the time.

  • If inflation is cresting, inflation levels of 4 or 6% revert by half in about a year. If inflation is accelerating, 6% inflation reverts to 3% in a median of about seven years, threatening an extended period of high inflation.

  • Reverting to 3% inflation, which we view as the upper bound for benign sustained inflation, is easy from 4%, hard from 6%, and very hard from 8% or more. Above 8%, reverting to 3% usually takes 6 to 20 years, with a median of over 10 years.

Arnott and Shakernia believe that the consensus view that a short “transitory” period of high inflation will soon pass places too high a probability on the best case and ignores economic history.

If you have any questions or comments, please contact me.

Sincerely,
Robert G. Kahl
CFA, CPA, MBA

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Next Moves for the Fed and BRICS+

The Federal Reserve’s Open Market Committee (FOMC) meets Tuesday and Wednesday of this week.  The FOMC meets approximately every 6 weeks and releases their policy statement at the end of their two-day meetings.  The consensus expectation is that the FOMC will announce an increase in the fed funds target rate of 75 basis points this week.

When Chairman Jerome Powell gave testimony to Congress on June 23, he noted that inflation remained “well above our longer-run goal of 2 percent” while the “labor market has remained extremely tight.”  Not much has changed during the last four months regarding both inflation and employment.  The rationale for higher interest rates remains in place for now.  Interest rates remain far below the level of inflation as measured by the government.  However, in the future, there are limits to how much the Fed can raise rates.

As of September 30, 2022, the US Treasury has $30.9 trillion of debt outstanding, reflecting a debt/GDP ratio of 123%.  In December 1980, when Fed Chairman Paul Volcker raised the fed funds rate as high as 22%, the US Government had $908 billion in debt, which represented 32% of GDP.  Since the US debt to GDP ratio has nearly quadrupled during the last 42 years, the Fed will eventually have to consider the impact of higher interest rates on the interest expense of the US Government, as well as businesses and households.  Higher interest rates raise the risk of debt defaults.  It remains to be seen where the tipping point of financial pain is due to higher interest rates.

Meanwhile, in the rest of the world, the dynamics of international relations are changing rapidly and the United States is losing its leadership role.  ZeroHedge described the recent protests in Europe:

Tens of thousands of people have marched across metro areas in France, Belgium, the Czech Republic, Hungary, and Germany – many of them are fed up with sanctions on Russia that have sparked economic ruin for many households and businesses – but also very surprising, support for NATO’s involvement in Ukraine is waning.

There has been increasing awareness and dissent among Europeans about their countries’ leaders prioritizing NATO’s ambitions in Ukraine over their own citizens.  The prioritization has been in the form of sanctions against Moscow, sparking energy hyperinflation and supplying weapons to Ukraine, which has made Moscow displeased with any country that does so.  Some Europeans are now demanding NATO negotiate with Moscow to end the war so that economic turmoil can abate.

There is also increased interest by many countries in joining BRICS+ (an economic alliance started by Brazil, Russia, India, China, and South Africa).  The original five BRICS countries seek to expand their influence by establishing principles of “inclusive and equal cooperation” for international trade and financial regulation.  Among the countries being considered for admission to BRICS+ are Argentina, Egypt, Indonesia, Iran, Kazakhstan, Kenya, Mexico, Nigeria, Saudi Arabia, Senegal, Tajikistan, Thailand, Turkey, and United Arab Emirates.

Saudi Arabia’s intention to join BRICS+ is significant.  Mohammed al-Hamed, President of the Saudi Elite Group in Riyadh, told Newsweek: “China’s invitation to the Kingdom of Saudi Arabia to join the BRICS confirms that the Kingdom has a major role in building the new world and became an important and essential player in global trade and economics.  Saudi Arabia’s Vision 2030 is moving forward at a confident and global pace in all fields and sectors.”  Thus, Saudi Arabia’s snubs of President Biden are no surprise as the country realigns its economic and geopolitical interests.

As Saudi Arabia is the largest exporter of oil in the world, there is serious doubt about the longevity of the “petrodollar” (use of the dollar for payment of oil deliveries).  Fed Chairman Jerome Powell acknowledged this in June when he said, “rapid changes are taking place in the global monetary system that may affect the international role of the dollar.”

If you have any questions or comments, please contact me.

Sincerely,
Robert G. Kahl
CFA, CPA, MBA