While many global equity markets have bounced off their February and March lows, we strongly believe it’s a bull trap. We think February was only the beginning of a bear market that has much more to play out in our favor on the short side.
The almost-certain biggest asset bubble in the world today, the rhino in the room, is the Chinese credit market, and the yuan by extension. The US stock market is also in an historic valuation bubble. We have thoroughly documented the extent of these bubbles in our past several quarterly letters.
Fed tightening has been a reliable catalyst for the bursting of asset bubbles globally as the chart above illustrates. This time will almost certainly be no different. Thus, we remain net short global equities in our hedge funds.
We must consider a wide range of possible macro environments playing out. The current late cycle overheating risks point to rising inflation, with “cost push” forces becoming more apparent. If history repeats itself, the Fed is likely to tighten until asset bubbles burst (stocks, corporate credit, real estate perhaps). Then we have to be concerned about deflationary pressures emerging. If they do, the Fed should and would likely move substantially and quickly back to QE, shifting our concerns back to rising inflation. Under this situation worries of stagflation arise, or even hyperinflation at the extreme. Those kind of macro markets are real but have been left for dead for some time. They could easily re-emerge to surprise the vast majority of investors since that is what highly imbalanced markets tend to do at major inflection points. Somewhere along that spectrum is a 1973-74 kind of bear market with rising inflation, declining bonds, and plunging stocks.
Whether inflation really takes root all boils down to inflation expectations. Inflation expectations are drawn from surveys and hard data, but they are often driven by human behavior. People begin to believe and act as though inflation is coming then it becomes self-reinforcing, causing money velocity to rise and pushing investors into inflation hedge assets. We worry that some investors might still be fighting the last war and thinking the next downturn will play out again like 2008, i.e. deflationary. While that is a possibility, the increasing concerns over inflation make these arguments very convoluted. Rather than making a major call on inflation versus deflation at this point in the business cycle, we choose instead to focus on shorting Chinese stocks, the yuan, and US stocks which can win big in either a deflationary or inflationary downturn.
Gold remains an excellent long hedge for us under the ultimate inflationary scenario that we see playing out. Gold is also a haven asset with deep-value properties for added protection in the deflation scenario. Looking at the crisis periods highlighted in the first chart, gold vastly outperformed the broad market and treasuries during inflationary bust periods on an average annualized basis. Gold also held up very well during crises characterized by declining inflation, dropping by only 1% on an average annualized basis during those periods.
Inflationary vs. Disinflationary Forces
Whether the next downturn will be stagflationary or deflationary is a big debate. Considering all the compelling arguments for each side that we list below, it’s difficult to build too strong of a conviction on one side or the other at this time.
The report is 11 pages long and well worth a closer look.
I like the notion that Fed tightening cycles "coincide" with asset bubble burstings, but it's important to note that hike cycles do not "cause" problems.
Fed policies (central bank policies in general) sow the seeds of their own destruction.
Inflation expectations are mostly meaningless as I have pointed out on numerous occasions.
People can fill up their gas tank, but no more. A freezer holds only so much food. If rent soars, people will not rent a second house nor will they buy a third toaster or phone.
The only time this breaks down is in cases of hyperinflation. People will literally buy anything to avoid currency becoming worthless.
Velocity Does Not Have an Independent Existence
Yes, Velocity is ticking up. So what?
Contrary to mainstream economics, velocity does not have a “life of its own.” It is not an independent entity–it is always value of transactions P(T) divided into money M, i.e., P(T/M). On this Rothbard wrote: “But it is absurd to dignify any quantity with a place in an equation unless it can be defined independently of the other terms in the equation.” (Man, Economy, and State, p. 735)
Since V is P(T/M), it follows that the equation of exchange is reduced to M(PxT)/M = P(T), which is reduced to P(T) = P(T), and this is not a very interesting truism. It is like stating that $10=$10, and this tautology conveys no new knowledge of economic facts.
As I See Crescat's Graphic
The Taylor rule, velocity, inflation expectations, and breakeven rates are all mostly nonsense if not complete nonsense.
- What's left on the inflation side is mostly what's happening right now: Late stage inflation.
- What's left on the deflation side is mostly long-term secular deflationary forces.
- Asset bubble burstings are deflationary by definition.
Gold vs Faith in Central Banks
Gold primarily moves with faith in central banks, not inflation expectations. Note that gold fell from over $800 to $250 between 1980 and 2000 with inflation every step of the way.
Regardless of why there will be a downturn, it's pretty clear the Fed will react to it in the usual way.
Thus, I wholeheartedly agree with Crescat's thesis that gold is likely to be a winner.
Mike "Mish" Shedlock