The Fed's Wrecking Ball

Stress testing Tom Dyson's investment strategy, tech earnings turn ugly and America's coming winter catastrophe...

(Source: Getty Images)

Dan Denning, checking in today from Laramie, Wyoming…

Everyone’s talking about the 40-year lows in America’s Strategic Petroleum Reserve. At 20 million barrels per day in consumption, if we couldn’t import any oil, the 400 million barrels left in the Reserve would last about 20 days. And did you know the US has just 25 days supply of diesel fuel? I’ll come back to both in a moment–and a follow up on the train wreck that was tech earnings yesterday.

America and Europe face a ‘Winter Nightmare’ if they don’t get their energy house in order, according to our founder Bill Bonner. It may already be too late to prevent some real hardship in 2023. As a reminder, Bill is hard at work in Florida over the next two weeks trying to get our message out to as many investors and Americans as we can. He’ll be back soon.

In the meantime, we continue our look behind the scenes showing you the big ideas published this year by our Investment Director Tom Dyson. One of the most important ideas is that investors underestimate the damage to stock prices that will be done by Quantitative Tightening (QT). Forget how high interest rates eventually go (the ‘terminal’ rate). It’s QT that will wreck portfolios, says Tom.

A quick note about yesterday’s price action before we get to Tom’s research. It was ugly. Both Microsoft and Google fell by around six per cent in after hours trading. Earnings were disappointing for both firms, but for separate reasons.

For Microsoft, growth in its cloud computing business (Azure) is slowing down (from 40% to 30% in the most recent quarter). As a reminder, the ‘cloud’ is not a place in the sky where data goes to live and die. It’s someone else’s computer. And that computer is usually in a big warehouse that requires energy for power and cooling so you can doom scroll your way through Twitter or watch cat videos on YouTube.

And speaking of YouTube, Google’s stock price fell when it reported that ad revenues at YouTube fell by 1.9% in the third quarter and missed analyst expectations. Advertisers are dialing back budgets and deciding whether the spending is worth it. As a subscriber to YouTube TV, I can tell you I’ve never once clicked on an ad there and skip them as soon as the algorithm will allow me.

Facebook (META) reports today. And then we get Apple and Amazon tomorrow (Thursday). All of these companies have been amazing growth businesses. In the bull market, investors and institutional funds rewarded their stock prices with a huge growth ‘premium.’ And now?

It feels like June again. The market got ahead of itself ‘pricing’ in a Fed pivot and more easy money. Growth beat value and animal spirits were high. But inflation never went away. And the Fed kept hiking. And here we are today–closer to the ‘terminal’ rate, but not sure of the impact of a 2023 recession on earnings.

That’s the key point–one Investment Director Tom Dyson made in the Monthly Report that goes out to subscribers in 24 hours. The first 20% drawdown in the S&P 500 was a valuation reset. 

Stocks were overpriced relative to all historic valuation metrics. But that was then.

The next drawdown–the one that could generate ‘the big loss’ for investors we’re trying to avoid–comes when stocks are repriced for lower earnings in 2023 (a recession). If Big Tech is slowing down, what do you think is happening in the real economy, where food, energy, and housing costs are breaking the back of the Middle Class? The Fed’s Wrecking Ball is doing damage. See below.

Dan

P.S. There are a million barrels of emergency diesel fuel in the Northeast Home Heating Oil Reserve, according to the Energy Information Administration. But the US transportation sector–the backbone of the system that moves food, goods, and supplies across the country–uses 128 million gallons a day. The national average price of a gallon of diesel fuel is $5.34 gallon. 

If you think chicken and eggs and meat cost a lot now, what do you think would happen in a real diesel emergency? I’m ordering more frozen beef today from a local ranch that delivers straight to my front door. You should think about it too.

Finally, it’s true that it’s hard to imagine a situation where the US could import no oil and would have to consume all the oil left in the Strategic Petroleum Reserve. But you have to wonder if it’s wise to run down an emergency supply of oil in order to try and lower gas prices before the mid-term elections so your party can control both Houses of Congress. Seems pretty shortsighted. 

Saudi Oil Minister Abdulaziz bin Salman agrees. Yesterday he told a conference that, ‘People are depleting their emergency stocks, had depleted it, using it as a mechanism to manipulate markets while its profound purpose was to mitigate shortage of supply. However, it is my profound duty to make it clear to the world that losing emergency stock may become painful in the months to come.’

It’s a little on the nose for a member of the world’s largest oil cartel to complain about market manipulation. But his point is well taken. Deplete your emergency oil stocks heading into winter, while picking a fight with two of the world’s three largest oil producers? We’ll be lucky if it’s only a nightmare and not a real catastrophe. 

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The Fed’s Wrecking Ball

Originally published Wednesday, April 6th, 2022
Chiswick, West London
By Tom Dyson, Investment Director

Today I want to bring your attention to a new potential threat to your wealth. This is probably the last thing you would expect me to worry about. And it's also the one possibility we've spent the least time considering.

But as Investment Director, it’s my job to notice all the changes that are happening in the world, handicap all the different pathways the world might take no matter how unlikely they seem, and distill everything into an investment strategy that preserves our wealth.

It’s not easy. Things are moving quickly. And the penalties for being wrong could be enormous. But I spend every waking moment of my day working on it.

Thirty years of experimental monetary policy are about to come crashing down

Our core hypothesis is that overactive central banks have inflated history’s greatest credit bubble. Now, the big national governments, including the United States, are effectively bankrupt. The only way out of this predicament – without causing a worldwide depression – is through a globally synchronized currency devaluation (and we still may get the worldwide depression anyway.)

It’s already started. The inflation we’re seeing? That’s it. The inflation is a deliberate policy of reducing the amount of debt these governments must pay off (it’s called Financial Repression).

We expect debasement to continue on and off for many years, until the major currencies have collectively lost as much as 75% of their value against gold, just like they did in the aftermath of World War I, the last time there was a collapse in globalization and a sovereign debt crisis.

(Source: Financial Times)

All year, we’ve repeated the same advice: hold lots of cash, lots of hard assets, a few select deep value shipping stocks and stay away from bonds and stocks in general. It’s been the right advice. The news from this week confirms it.

Here are some of the headlines I’ve seen this week so far: “S&P suffers biggest quarterly drop in two years”, “Bond Market Suffers Worst Quarter in Decades”, “Commodities Finish Best Quarter in 32 Years”, “Inflation hits new 40-year high, surging 7.9%”, “World may be on cusp of new inflationary era”,  “Bond Traders Ring Recession Alarm on Imminent Curve Inversion.” 

The chart below shows the returns of the major asset classes over the last three months. With commodities and gold up and bonds and equities down, we’ve had the right mix for our goal of maximum safety and avoiding the big loss. While we’ll continue to look at speculative chances to make more short-term gains (especially food/inflation/commodity themed), loss aversion is our main focus, at least until we get some further clarity about the Fed’s reaction path.

Also remember, the BIG opportunity–a once in a generation opportunity that your children and grandchildren may relish–will come when we switch from gold back to stocks. But when we do that is determined by the action of the Gold/Dow ratio. New readers can read our research on how that works in our Gold Report. 

(Source: Bonner Private Research)

Stress testing your investment beliefs

One exercise I like to do periodically is re-examine our basic assumptions to make sure we haven't missed something important, something that may have changed. I think of it as 'stress testing' our position. It’s a good way of keeping yourself honest, or from losing awareness of your own biases. 

We're already positioned for a situation where inflation continues to “run hot” and currencies get weaker (incrementally or exponentially). War, de-globalization, onshoring, ESG politics… these are all structurally inflationary long term trends. By ‘Structurally’ I mean they will bake inflation into the economic cake for years to come. 

We’re also prepared for a situation where something breaks, like the stock market, which is at the peak of a massive bubble. In this kind of crisis, the Fed quickly pivots back to money printing (Quantitative Easing) and negative interest rates. It’s what the Fed has done in every crisis since 1998. The only question is how big the crisis has to get first. Or as options traders wonder, where the Fed Put lies.

In this second scenario, it’s deflation of financial assets you want to look for. Record leverage, illiquid credit markets, sky high asset valuations, unfavorable demographics, rising cost of living expense (which reduces consumer spending)–these are all structurally deflationary forces. They indicate a contraction in credit growth, speculation, and spending, all of which mean lower financial asset prices. These are the kind of triggers that usually get the Fed quickly pivoting back to debasing the currency.  

But is there a third scenario? Something not in the playbook already? Some scenario which we may have missed which catches investors off guard and represents a new direction or outcome we should be ready for? 

The following recent headlines caught my attention. This from Monday:

“JP Morgan chief Jamie Dimon warns of 'drastically higher' US rates”

Then yesterday, I noticed this one:

“Fed to make ‘rapid’ cuts to balance sheet next month, says top official”

And earlier today, this one:

“If stocks don’t fall, the Fed needs to force them: Bill Dudley” 

Bill Dudley was the president of the New York Fed from 2009-2018. Add these remarks with Jerome Powell’s recent hawkish “do whatever it takes to restore price stability” commentary, and I wonder, are we about to see a sort of Paul Volcker-esque hard money Fed? Is our core hypothesis wrong? 

I call this third scenario “the Fed wrecking ball.” 

As I said, because so few are expecting this, it’s probably worth considering. In financial markets, it’s the thing that no one is looking at that you should be paying the most attention. This goes for risks as well as opportunities. Let’s try imagining a hard money Fed…

The Fed Wrecking Ball

With the world economy so leveraged and the U.S. economy so sensitive to higher interest rates, especially the US government, a Volcker-esque Fed would stick investors, creditors and homeowners with a bill for losses measured in trillions. 

By the way, for readers not familiar with financial history, I say ‘Volcker-esque’ in reference to former Federal Reserve Chairman Paul Volcker. Volcker was Fed Chair during the big inflationary shock of the 1970s. To stamp it out, he raised the Fed’s target interest rate (the price of money) to almost 19%. That’s what it took to stamp out inflation. It also caused two back-to-back recessions (which set the stage for the beginning of the Great Bull Market of 1982-2000). 

If the Fed raised rates today to whatever level is necessary to crush inflation, the consequences would be the same (or worse) than in the late 1970s. Many businesses would go bankrupt. We’d see a wave of bond defaults. There’d be a deep recession or a series of recessions. The government would have to embrace austerity and cut its spending on the military and maybe even Social Security.

On the other hand, higher interest rates would wash away all the zombie companies and restore some slack in the labor markets (unemployment would rise, wages stabilize or fall) and supply chains. That’s a good thing for the economy. Right now, employers aren’t able to fill job vacancies and restock shelves in time. Millions of businesses in the United States cannot operate at full capacity due to labor shortages and inventory problems. 

Here’s another benefit of a hard dollar: lower commodity prices. Lower commodity prices would destroy the Russian economy and make sanctions much more effective. Right now, sanctions seem to be hurting Europe the most (paying higher energy prices) while Russian trade is booming in dollar terms. The politicians in Washington can’t be happy about this. 

What about the great green energy transition politicians want to make? Impossible, with commodities soaring. This week, I even heard Germany suggesting it would return to burning coal. A hard dollar could help this. 

With higher interest rates and a harder dollar, worldwide energy consumption would fall and lower the cost of raw materials for electrification like copper and nickel. I’m not saying this is a good thing. I’m saying politicians might see a depression as a political solution to reducing carbon emissions. 

Finally, a hard dollar would squeeze leveraged speculation out of markets and the shadow banking system and restore equilibrium to market prices and interest rates. It’d also make housing more affordable. Pocketbook concerns like rent, mortgage payments, groceries, and gas are not trivial going into elections this fall (when both the House and the Senate are up for grabs). 

Harsh medicine, for sure, and very unlikely but it’s an outcome we need to think through. How would we know it was coming? How would we position ourselves for it in our strategy?

Just to reiterate, I’m not forecasting a Fed wrecking ball–much higher official rates than anyone expects and a stronger US dollar. I’m just keeping aware of all potential threats to our wealth. 

We’ve got plenty of gold and silver, in case inflation gets out of control or there’s a run on the dollar. We’ve got essential infrastructure investments we bought at cheap prices that generate safe, consistent cash flow. And we’ve got plenty of cash in case the “Fed wrecking ball” shows up.

And just to repeat, even though I’m a long term bear on the stock market, especially profitless tech stocks and highly leveraged zombie companies, I’m not going to add any short positions to our idea list. The best way for us to hedge a falling stock market is simply to hold cash and gold.

Regards,

Tom Dyson
Investment Director, Bonner Private Research

[ED note: This research note was first published in early April. Tom’s been updating the Fed Wrecking Ball story regularly since then. Send your questions about it to research@bonnerprivateresearch.com. Tom will be answering questions next week, after we’ve published the October Monthly Report for subscribers later this week]