The Price of a Supply Shock

“Our indicators tell us, we’re very close to a Lehman-like drawdown,” argues Larry McDonald, a former strategist at Société Générale who now runs The Bear Traps report.

Financial Times, February 20, 2020

*The Bear Traps Report’s institutional client flatform includes; financial advisors, family offices, RIAs, CTAs, hedge funds, mutual funds, and pension funds.

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This is Part II of our Cobra Effect Series.

What are Commodities Pricing In?

The Price of Gold

Days to reach Round Numbers

$1900-$2000: 7  (All-Time record achieved Aug 4, 2020)
$1800-$1900: 5
$1700-$1800: 121
$1600-$1700: 61
$1500-$1600: 155
$1400-$1500: 43
$1300-$1400: 1228

Bloomberg data

Breaking: “Fed Weighs Abandoning Pre-Emptive Rate Moves to Curb Inflation” WSJ, Sunday, August 2, 2020

“The Federal Reserve is preparing to effectively abandon its strategy of pre-emptively lifting interest rates to head off higher inflation, a practice it has followed for more than three decades. Instead, Fed officials would take a more relaxed view by allowing for periods in which inflation would run slightly above the central bank’s 2% target, to make up for past episodes in which inflation ran below the target.” – WSJ

Our Larry McDonald: “Since mid-May, we have stressed to clients, this type of policy action is coming. This is a historic adjustment for the Fed. They’re all in the Larry Summers’ Camp now, ‘don’t hike interest rates until you see the whites of inflation’s eyes’ is the thinking – laid out publicly by the former, Sr. Clinton Administration Treasury official. Larry is now on the OUTSIDE looking in – and VERY loud doing so. It’s a far-more social justice focused central bank now. The push-back the Fed has received on the “inequality” front is at all times highs. It’s a heavy topic of conversation around Capitol Hill. Make NO mistake about it, politics’ heavy hand in central bank policy is entering a whole new level.”

Stagflation Triggers on the Rise

The probability of stagflation is soaring, its impact on asset prices and your portfolio will be profound. Let us explore.

The week we learned, Bank of America’s private client wealth hedges using precious metals are surging. More and more investors feel uncomfortable with extremely low bond yields – sky-high bond prices, they’re looking at a risk-parity conundrum (we address this dynamic below). In 2011, these protective measures reached a 9.6% allocation. Today, it’s down at 2.5% and moving NORTH from 1.3% last year. Their strategist Harnett has referenced 20-25% exposure.

See our bullish note on the commodities sector here. 

Supply shocks rear their ugly head when governments institute policies that slow down the economy while dramatically increasing the money supply. Both of these events transpired in 2020. First, January’s shut down of China’s $13T economy was a wake-up call for the planet, creating a colossal supply shock. Total nonfarm employment there – much of it manufacturing – is 580 million, almost four times the U.S.’s labor force. Then in March, the West instituted lockdowns while dramatically increasing the money supply. The causes of stagflation are well known and have been thoroughly studied by economists for decades. We can tell you with certainty, more than a half-century of economic theory will be upended if stagflation doesn’t arrive in fierce force in the 2020-2022 period.

Stagflation vs. Depression

The spread between the U.S. ten year Treasury bond yield and the S&P 500’s dividend yield is Grand Canyon Esque, near 60-year wides. Central banks are forcing capital into very strange places. Investors have fewer and fewer choices each day. The thinking? Stagflation beats depression all day long, see our Cobra Effect here.

Uncle Sam Needs a Loan

On Monday, the U.S. Treasury said it needs to raise nearly $950B in the three months through September to fund COLOSSAL deficit spending, that’s $270B more than they projected in May. One large problem, the Treasuries average weighted maturity across its portfolio is down to 63 months, that’s the shortest window since 2012. Look for the U.S. Treasury to seel a large bundle of longer-dated bonds this month and next.

Distorting the True Cost of Capital, COMES with A PRICE

As central bankers distort the true cost of capital, the side effects are mathematically incalculable. We’ll never know how many Bernie Madoffs maybe sipping mint juleps on the Hamptons this summer? If Lehman didn’t fail, would Bernie have ever been caught? Failure is a good thing, a cleansing thing and so is a “true cost of capital” which the free-market used to forge each day, but NO more. Many people think Keynes was a lower interest rates kind of guy, using the cost of capital – monetary policy – to stimulate an economy. That part is true, but it just might be the most significant half-truth coming out of the last 100 years of modern economics. Above all, he was a believer in the natural rate of interest. When you juice fiscal policy in a short period of time by $5T and hit the monetary policy accelerator at the same time by $3T, the spread between the true cost of capital and the artificial, or the central bank suppression rate – is COLOSSAL.  Today, by our calculation – over 85% of the planet’s bonds yield less than 2%, just two years ago this number was 36%, using the Bloomberg terminal. Keynes even warned against distortions/side effects of lowering the cost of capital BELOW a market-driven, natural rate. Keynes might be considered a right-wing radical today, complete with an Antifa mob on his front doorstep every morning. We delve into the explosive side effects here in the Cobra Effect.  

Will the Real John Maynard Keynes Please Stand Up

The U.S. recession of 1973-1975 marked the end of the post-WWII expansion and was considered unusual in having both high unemployment and high inflation. However, the term “stagflation” was invented in the UK by British politician Ian Macleod back in 1965, again in 1970, and again in 1973. John Maynard Keynes actually outlined how the components of unemployment and inflation could co-exist in his writings. Sadly, important parts of Keynes’ body of work were ignored by many establishment economists during that era and beyond. The point is – Keynes was very nuanced and complex. The following generation dumbed and pared him down. For instance, he wrote that if interest rates were too low for too long, financial interest rates would flow to financial assets (stocks, bonds, real estate) and be diverted away from labor, which explains the slow employment growth and financial asset boom during the post-Lehman failure years, circa 2008-2016. We argue large chunks of Keynes’ writings have been ignored by the modern economic establishment. Keynes was redefined and simplified such that the critiques of the simplified Keynes often used ideas that later economists had purged from. There are passages in the original Keynes doctrine that a neo-Keynesian would find horrifying. Pure comedy indeed. From the dominant economic theory from the end of World War II to the early 1980s was really a Keynesians-for-dummies policy wherein recession and inflation were mutually exclusive, a view symbolized in the now debunked, Phillips curve.

Death of the Phillips Curve**

Being a single-equation economic model, the Phillips curve was readily embraced by politicians, because it was so simple, even a politician could understand it. A rare accomplishment, bravo. Phillips argued increased employment causes increased wages i.e. follow-on inflation. Ironically, Phillips himself viewed this as a trivial observation. It was Milton Friedman who destroyed it on theoretical grounds and who correctly predicted the 1973-1975 recession. Unfortunately, in the 2015-2020 economic regime, the Phillips Curve has thoroughly embarrassed scores of economists globally.  Employment gains, NOT only didn’t lead to inflation pressures but also fueled disinflation. Economists spent far too much time focused on economic theory and not enough on economic risks tied to a runaway U.S. dollar which proved to be HIGHLY deflationary, exponentially so.

**The Phillips curve is an economic theory developed by A. W. Phillips stating that inflation and unemployment have a stable and inverse relationship. The theory claims that economic growth comes inflation, which in turn should lead to more jobs and less unemployment.

Beware of Economists too Deep on the Weeds

It was in Manhattan, February 2015. As I stepped out of a cab, freezing cold ice-water filled up my right shoe. The dreaded pothole got me again.  Late for a meeting, I scurried up the 36 marble stairs leading to the entrance of 245 Park. Moving into the crowded elevator, a few minutes later, 22 of us were in the conference room on the 28th floor. The topic of discussion; the Phillips curve and 8-10 rate hikes our Soc Gen economists saw coming over the next 24 months. Their conviction was on a high perch that day and I brought just two questions. First, why and how could the Fed hike rates 8 times -heading into the 2016 Presidential election? Second, wouldn’t the side effects from a strong dollar cut the Fed off at the knees as they tried to hike rates 8x – while the rest of the developed world was easing monetary policy? In a world filled with far more dollar-denominated debt, each rate hike in 2015 carried the power of 3 rates hikes in the 1990s. Financial conditions would tighten dramatically I argued. Economists would hear NONE of it, their Phillips curve had all the answers. By the end of 2016, the Fed hiked rates just two times and the Phillips curve sent a busload of the Street’s economists into temporary retirement. The lesson?  Economists should spend far more time focused on leverage and risk metrics, than out-dated models.

Major US Pension Fund

Risk-Free Rate vs. Risk-Adjusted Return Target

2020: 0.55% vs. 7.0%
2010: 4.00% vs. 8.5%

*So, a decade later – US ten year Treasuries are yielding 3.5% less, but pension funds are still targeting 7%. How’s that work? Risk-Parity Conundrum or nightmare?

Colossal Complacency equals Danger

As a global investment community, our recent experience with this economic theory train wreck coming out of the Phillips Curve’s demise is the foundation for today’s rich complacency around the prospects of stagflation and or inflation. You can’t cut it with a knife – it’s that thick – downright dangerous. The Risk-Parity Conundrum: We now have over $110T of the planet’s wealth yielding less than 1.50% (a few years ago this number was less than $25T). Up until a month ago, everyone trusted risk-parity modeling in protecting their hard-earned capital. Some more hard-earned than others! Faith is risk-parity is in full retreat today with metals up 30-40% in Q2, see our bullish note on the commodities sector here. 

In the UK of the 1960s and 1970s, the relationship between inflation and the money supply was not understood by the government. The money supply grew untethered, resulting in inflation. Every trick in the book was used to combat inflation except for reigning in money supply growth. The result was a slower economy with higher prices.

Stagflation and Money Supply
Many people forget, from 1971 to 1974, gold was 325% higher, while everyone remembers the 475% surge from 1977 to 1980. The U.S., stagflation commenced after an egregious expansion of the money supply was initiated to counter the precipitous increase in oil prices caused by the October 1973 oil embargo announced by the Organization of Arab Petroleum Exporting Companies to punish those countries that had supported Israel in the Yom Kippur war which lasted from October 6th to October 25th, 1973, led by Egypt and Syria against Israel. Oil prices initially increased by 17%, but at its peak, prices shot up 400%.

Bretton Woods

The groundwork for the subsequent expansion of the money supply was laid once the US had its adjustment during the Bretton Woods Agreement on August 15th, 1971 (the United States halted the conversion of dollars into gold and devalued the dollar by 10%. One catalyst, France was aggressively redeeming its dollars for gold, which helped precipitate the emergency move by U.S. President Richard Nixon). The expansion in the money supply caused a classic price/wage spiral, wherein price increases driven by the oil shock caused wage increases allowed by the expansion of the money supply which of course was in turn allowed now that the US was no longer on the gold standard strictures under Breton Woods. “Wages chase prices and prices chase wages”, as the saying goes. This is the genesis of the Fed’s continuous blather about inflation expectations, which now virtually has been laid to rest by the current pandemic.

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Supply Shocks

Current Keynesians argue that monetary and fiscal policies are effective against adverse variations in demand but wholly useless in adverse variations in supply. There are several ways to cause a supply shock, but one way is for the government to severely restrict production, as of course is happening now! By our calculation, entering Q2, over 415 – gold, silver, copper, iron, coal, and uranium mining, development, and exploration assets across the globe have ceased or scaled back production (meaning operating stockpiles and with limited workforce).

The standard Keynesian model tells us supply increases as price increases. However, when supply is artificially restricted, that relationship breaks down. Instead, inflation jumps as production collapses. An updated view would add that as money is created to give to those out of work, inflation is later inevitable.

The question is, why don’t we see inflation? The answer is: you don’t have to see inflation initially simultaneously but subsequently before economic recovery. In other words, we aren’t there yet, but metals are predicting we soon will be.

“Lenin is said to have declared that the best way to destroy the Capitalist System was to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some. […] Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.”

John Maynard Keynes, 1938

The sad fact is, if Keynes was alive today, he would NOT be considered a Keynesian. We know because we have lived through it, that an increase in money supply alone doesn’t cause inflation. But an artificially restricted economy, by the government, by fears of Covid-19, have set the table for stagflation. Society cannot possibly quantify the unintended consequences, silver is screaming this fact. It’s NOT every month you see a 35% surge in silver – unless your names are Sonny and Cher. 

And by the way, not all firms lose during stagflation. It is a well-observed phenomenon that the largest firms have the greatest pricing power.

Oddly enough, the largely Keynesian analysis above is not intellectually inconsistent with the Austrian school view that an increase in money supply benefits most of the initial recipients of the money, at least not under the circumstances we see currently. The producers receive the money later, thus benefit less. Traditionally, this has been viewed as anti-Keynesian, at least by members of the Austrian school. But as in so many other examples, they overlap more than the proponents care to admit.

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“The increase in the money supply rate of growth coupled with the slowdown in the rate of growth of goods produced is what the increase in the rate of price inflation is all about. (Note that a price is the amount of money paid for a unit of a good.) What we have here is a faster increase in price inflation and a decline in the rate of growth in the production of goods. But this is exactly what stagflation is all about, i.e., an increase in price inflation and a fall in real economic growth. Popular opinion is that stagflation is totally made up. It seems therefore that the phenomenon of stagflation is the normal outcome of loose monetary policy. This is in agreement with [Phelps and Friedman (PF)]. Contrary to PF, however, we maintain that stagflation is not caused by the fact that in the short run people are fooled by the central bank. Stagflation is the natural result of monetary pumping which weakens the pace of economic growth and at the same time raises the rate of increase in the prices of goods and services.”

Frank Shostak, Austrian School Economist

Many may well conclude that supply disruption coupled with monetary expansion combined should lead to stagflation since either one alone might.  How long does it take? About a year. 2021 will see inflation outpace GDP, and noticeably. That is to say, stagflation.

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