Category: Financial Markets Commentary

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