If you watched the popular series "Game of Thrones" you will recognize the warning. It cautioned that when winter comes to Westeros, it is unspeakably brutal and denizens must be prepared if they have any hope of surviving.  This is periodically true in the investment world.  Markets move in both short and long-term cycles. An investment strategy that is successful during the bull (summer) phase of a long term cycle is unlikely to be suitable for the bear (winter) phase of the cycle.  While all winters (down cycles) are tough, some are horrific. 

Market Cycles
    No one knows with certainty what the market will do today, tomorrow, next week or next month. That "no one" includes us, you, your investment advisor, market pundits on television, investment letter writers, central bankers, and politicians.  This suggests that investing is a crap-shoot - and in the short term that is true.  How often have you made a thoughtful investment only to have it quickly drop in value on unexpected news?  But in the long term it is not true.  
    As price inflation began to rise over 2%, Jay Powell, chairman of the Federal Reserve Bank kept insisting that it was "transitory."  He maintained that position as inflation rose to 3%, then 4% and beyond.  We do not know whether he actually believed it was transitory or knew that it was not but said so hoping to deflate "inflation expectations." 

    Our guess is that he was genuinely clueless and had no understanding that sluicing $8T into the economy and keeping real interest rates in negative territory for fourteen years would cause prices to rise dramatically.  In the end, it is unimportant what he believed or hoped to accomplish.  What is important is that investors could have reasonably foreseen that what the Fed and Congress were doing in the US and the European Central Bank was doing in Europe from the housing bust in 2008 through the Covid shutdowns and into 2022 (printing trillions in currencies and forcing real interest rates to negative figures) was certain to lead to problems.  It was only a matter of time.  Armed with that knowledge, investors could have begun to take defensive measures such as reducing their equity holdings over time, raising cash and beginning to hedge some of their positions.

    As inflation continued to rise, it was also foreseeable that central banks would eventually be forced to raise interest rates.  Like deer in the headlights, central bankers initially froze, failed to act and inflation quickly surged out of control.  The Fed was the first to timidly raise rates, the Bank of England and European Central Bank did not.  That development foreshadowed yet another outcome: foreign money would begin to flow into US dollars which would rise in value while foreign currencies fell.  

    The reason is simple.  If you were British, French, German or Japanese and could only earn 0.2% interest on your cash at home, you would be sorely tempted to buy short-term US Treasuries. They pay a far higher rate of interest and the dollar is rising in value against your local currency.  Other central banks still lag behind the Fed's rate increases, so the dollar appears to be rising.  The reality is their currencies are simply weakening.  This proves the financial adage that "money goes where it is treated best."  To be sure, the dollar is no prize: 4% interest does not offset 8.3% inflation but that 4.3% loss is far better than 10 to 20% loss of value in your home currency and 25% loss in the stock market.  As Stan Druckenmiller reminds us, it is less important what you make in rising markets and more important what you lose in falling markets.

The US Economy Shrinks

    While politicians claim that the economy is recovering, the facts suggest otherwise. Housing, a huge part of the US economy, is clearly suffering.  Sales are down and falling fast.


And sellers are having to resort to price reductions in an effort to entice buyers.  


All other things being equal, price reductions would stimulate sales.  But these reductions are necessary because mortgage rates have more than doubled from 3% at the beginning of the year to 7% causing monthly mortgage payments to soar.  This makes housing less affordable to an ever growing portion of the population and has raised the numbers of foreclosures by over 130% year over year.

Besides the economy shrinking, so too is much of what you buy. John Mauldin recently identified some products for which you pay the same price, or more, but now get less.
Folgers' coffee: 51 ounces to 43.5
Walmart Paper Towels: 168 sheets per roll to 120
Crest 3D White Radiant Mint toothpaste: 4.1 to 3.8 ounces
Most “Party Size” Chips: 18 to 15.5 ounces
Chobani Flips yogurts: 5.3 ounces to 4.5
Burger King chicken nuggets: 10 to 8
Bounty Triples: 165 sheets to 147
Hefty's mega pack: 90 bags to 80
Pantene Pro-V Curl Perfection conditioner: 12 ounces to 10.4
Angel Soft bathroom tissue: 425 sheets per roll to 320

Europe Faces Fiscal and Climatic Winter 

   With the end of Russian supplied gas, euro nations are facing the quadruple whammy of industrial slow-downs, layoffs, soaring natural gas prices and home heating rationing.  They also face electrical power shortages.  Germans thought it was a great idea to close down the nuclear power plants that supplied a large part of their base-load electrical capacity before they developed sufficient replacement energy sources.  That was done with much fanfare and political back-patting amongst the green lobby but the pain flowing from that decision is now being felt acutely. Claudio Grass describes the continent's dire situation,

In August, eurozone inflation hit another record high at 9.1 percent, with no sign of abating and projections growing more and more confident that it will surpass 10 percent in the coming months. In the UK, the situation is even more dire, with Goldman Sachs warning that it could exceed 22 percent in January. And the most worrying part of it all is that these record price jumps are only the tip of the iceberg. They are calculated using extremely biased and inaccurate formulae, heavily skewed to underestimate real inflation, the financial pain people actually feel in their daily lives. The reality on the ground is much worse.

In Germany, where inflation climbed to a forty-year high of 8.8 percent in August, nearly three million children now live in poverty, a number that soared since last spring, according to children’s charity Arche. As its founder, Bernd Siggelkow, pointed out, in Europe’s economic powerhouse, “more and more people are coming to us, asking for support. It seems that nobody will do anything until a child dies of hunger in Germany.”

In Italy, more and more bars and restaurants are putting their gas and electricity bills on public display, to show customers the stress they have been under, and the choices they are facing between hiking their own prices or going out of business. In Greece, where inflation now stands at a twenty-nine-year high, rent has climbed to levels that already threaten many families with homelessness. Also, efforts to restart long-demonized nuclear power plants have been largely insufficient. After years of cutting funds and attempting a premature transition to “green energy,” which couldn’t begin to cover the needs of the population, politicians are slowly recognizing that power plants don’t have “on/off” switches one can simply flick when they realize they made a mistake.

Businesses already have been warned they might have to halt operations in the winter because of expected shortages and households are already making daily sacrifices in food and other necessities to be able to afford heating over the coming months. These pressures appear primed to translate to political and social tensions. As we can see already from the UK leadership race, the main topic of public interest is the cost-of-living crisis.

The UK's New Prime Minister's Plan  

    Liz Truss' proposed "mini-budget" called for large tax reductions coupled with massive new expenditures to cap energy costs.  The Bank of England cautioned that such fiscal imbalances would threaten a new bout of inflation.  

    In an unprecedented move, the IMF cautioned her to withdraw the tax cuts and Moody's and Fitch (bond rating agencies) warned that the UK's bond rating was in danger of being lowered.  That would cause yet more pain for the UK Treasury as interest rates on UK bonds (gilts) would rise further, thereby increasing the deficit and driving down the value of the pound sterling.   Ambrose Evans-Pritchard at the Telegraph summed up Truss' dilemma.     

The UK has a structural current account deficit of 4pc of GDP, a net international investment position of minus £740bn, and needs constant inflows of foreign capital to fund an unsustainable lifestyle. The IMF’s objection to the mini-budget is not just that monetary and fiscal policy are at cross purposes, but also that the package is skewed to the wealthy and is aggravating a crisis of inequality.

It is obvious what needs to be done. The Chancellor [of the Exchequer] must take all cuts in income tax off the table until the public finances have recovered. He must stop talking about further cuts. He must return to the core message of supply-side reform.

Ray Dalio, founder of the biggest global hedge fund Bridgewater, has long warned that the post-War social contract is breaking down, and that the liberal democracies are heading for civil war and revolution unless they restore solidarity. Talk of scalping welfare to fund tax cuts is not going to assuage the likes of Dalio. It is not tenable to extend a comprehensive energy subsidy for the affluent lasting two years at an unknown cost.

Liz Truss faces an invidious choice. She can beat a hasty retreat and ditch unfunded tax cuts with the least supply-side justification, and which most alarm global investors.

Or she can persist, leaving it to the Bank of England to defend sterling, and to cope with the inflationary consequence of raw demand stimulus in an economy already operating at capacity constraints. The latter course means a house price crash, and an avalanche of business bankruptcies. It risks a self-feeding downward spiral…. There is scant recognition that the British nation is already living beyond its means. (Emphasis added)

 The pound crashed on news of the tax cuts and energy caps and interest rates soared.


    The BOE felt forced to launch a bailout of pension and hedge funds that had huge derivative bets that interest rates would not rise. Instead of proceeding with its previously announced QT program of selling off its large hoard of bonds, the BOE announced that it was prepared to devote 65 billion pounds to buying bonds to keep interest rates from rising farther. Truss reversed course and will not seek to reduce the 45% tax on incomes over 150,000 pounds to 40%.  (One hundred fifty thousand pounds is not a princely sum. Some high school teachers in our area make that much.  Having to forfeit 45% of ones income to the state is unconscionable. It amounts to governmental peonage.)

     David Stockman (former economic advisor to President Ronald Reagan) takes a dim view of the BOE bailing out the pension and hedge funds.  He argues that those who take out-sized, high-risk bets should pay the piper when their ill-considered trades move against them and that cost should not be foisted onto the public through the central bank.

The repeated refrain since the BOE’s Wednesday intervention is that the gilt market had gone “bid-less”. But, no, it hadn’t because markets are never bidless: At some price, there is always a buyer and seller.

Markets do gap up or down badly, however, when startling or unexpected new information hits the trading pits. In those instances, like occurred recently in the gilt market owing to the Truss mini-budget, the bid-ask spread widens substantially as the process of price discovery does its work, even if painful for parties on the wrong end of the trade.

In today’s world of serial central bank bailouts, that’s when the smart operators who end up in the loser’s column start whining loudly about bid-less markets, financial seizures and the imminent collapse of the financial system. And when central banks respond, the bid/ask gaps narrow and the losers are not forced to crystalize their losses.

Now, if interest rates were set by honest markets and the continuous clearance of supply and demand, they would tend to be random over any material span of time. Holders of interest rate swaps, therefore, would not make or lose from interest rate movements; just perhaps sleep better in the knowledge that their long-term liabilities were properly and continuously hedged.

Alas, we do not have free and honest financial markets. Instead, for the past several decades central banks have relentlessly pushed interest rates lower in their misguided attempts to goose GDP growth and full-employment.
    The central banks that created world-wide inflation by falsifying interest rates and massive money printing are now forced to raise rates to reverse that inflation. Sweden's Riksbank raised rates 100 basis points (a full 1%), the Philippines, Indonesia, Switzerland, Norway, and South Africa raised rates 50-75 bps. Japan alone has refused to raise rates. As a result, the Japanese yen recently tanked from 146 to the dollar to 115. This forced the BOJ to sell dollars from its reserves and buy yen in an effort to raise the value of its falling currency.

Saying the Rights Things but Doing the Wrong Things

    Fed Chairman Jay Powell recently claimed that, 

Price stability is the responsibility of the Federal Reserve and serves as the bedrock of our economy. Without price stability, the economy does not work for anyone. In particular, without price stability, we will not achieve a sustained period of strong labor market conditions that benefit all.

Had you been at that press conference you might have asked him, "Was that not the case when inflation was over 2%, then 3%, 4%, 5%, and 6%? Why did you fail to take action for so long?"  The reason is that price stability was not his primary concern at the time.  That was getting reappointed to the Fed chairmanship.  To accomplish that he could not antagonize President Biden who nominates the candidate for the position.  Had Powell started raising interest rates earlier causing the markets to suffer, he likely would not have gotten the nod.  He personally benefited; now we suffer price inflation.

    This chart shows that the Fed is still imposing a negative real interest rate on 10 year Treasuries.


And this shows still negative real Federal Fund rates.


Thus, interest rates are still extremely accommodative and continue to pressure price inflation upward.  What is the price we are paying for fourteen years of monetary manipulations? Dan Denning explains,
When you distort [the interest rate] (lower it to zero) you distort the values of all other assets (making it very difficult to figure out what to pay today for future cash flows). By mis-pricing the cost of capital, you distort capitalism itself.

Thus, our currrent misery is not an aberration.  It is the direct and foreseeable consequence of the actions taken by central bankers.  

What Might the Future Hold?  

    Several writers have offered their takes on this issue.  Kirshner's "First Law" proposes,

When a self-governing people confer upon their government the power to take money from some and give it to others, the process will not stop until the last bone of the last taxpayer is picked bare.

 G. Edward Griffin adds,

When it is possible for people to vote on issues involving the transfer of wealth to themselves from others, the ballot box becomes a weapon with which the majority plunders the minority. That is the point of no return, the point where the doomsday mechanism begins to accelerate until the system self-destructs. The plundered grow weary of carrying the load and eventually join the plunderers. The productive base of the economy diminishes further and further until only the state remains.

    Alexis de Tocqueville, French aristocrat, political philosopher and historian, visited the US in the 1830's and went home to write a two volume work called "Democracy in America." He observed that every democracy eventually fails when the masses discover they can vote themselves largess at the expense of others.

So, Are We Doomed?        

      We have no compelling evidence to refute these grim prognostications but do not believe we are there yet.  To right the ship of state and steer her away from the destructive shoals of populism we must remember why our capitalistic system succeeded so spectacularly.  From the dawn of humankind to the very recent past, the few lived off the labor of the many: few nobles, many serfs/peasants/tenant farmers.  These conditions persisted for thousands of years and did not lead to any meaningful advancement in the human condition.  

     It was not until the industrial revolution that today's western society became possible.  Putting fossil fuels to use as an "energy enhancer," a worker could produce a prodigious amount of goods, at reduced costs, for the betterment of all.  Worker's standards of living rose spectacularly.  From living in hovels on their lord's land, workers live in heated homes with hot and cold running water, a sewer system to carry away waste, central heat, they own and drive reliable cars, and use electricity to light the night and entertain themselves with television.  They have far greater creature comforts than former kings ever did.  

    What aided this surge?  It was not government bureaucrats, or their edicts and 5-year plans.  Countries that tried that system fell rapidly behind and the living standards of their citizens suffered badly.  Into the 1980's, throughout the vast USSR, shops had long lines of customers waiting to enter, were lightly stocked and the goods available were of poor quality.  The East German Trabant (1957-91) is an example.  It was a small, poorly made, unreliable car and it was all that was available to the working people.  It was derisively referred to as "a spark plug with a roof."  Of course, communist party leaders (the insider elite) drove imported cars, bought imported goods and did not wait in lines.

    Why did the Communist system fail?  According to a popular joke at the time, "workers pretended to work and the state pretended to pay them."  The critical fact is that there were no incentives for anyone to improve the quality of products or increase productivity.  The goal of every factory manager was to meet his production quota established by a government bureaucrat who was likely unfamiliar with the industry.  The quality of the product did not matter, only the quantity did. The workers' goal was to work just hard enough to keep from being fired. Thus, life behind the "Iron Curtain" progressively deteriorated.  

    To be sure, capitalism is not nirvana and has its warts, but it has worked far better than any other system tried to date.  It has lifted hundreds of millions of people out of poverty and vastly improved the quality of their lives. The reason it works is simple. Financial incentives encourage people to innovate and work hard. It gives them "skin in the game." Competition stimulates increased productivity that results in more and better goods at cheaper prices.  That makes it a "win-win" for everyone. However, as soon as government begins to reduce these financial incentives through onerous taxation, regulation, and pay-for-no-work, the goose that lays the golden egg begins to sicken.   

When Did the Goose Take Ill?

     It started in 1913 with the introduction of the Federal Reserve Bank.   J. Cortez at Mises.org explains.

In 1913, Congress created the Federal Reserve System (which has since served to devalue the Federal Reserve Note more than 97 percent, despite its mandate to maintain price stability). Then came an income tax, gold confiscation in 1933 by executive order, the abrogation of gold clause contracts, and ultimately the complete severance of any tie between gold and the Federal Reserve Note in 1971.

What came next surprises no one: An explosion of government spending brings us to our present situation. Biden administration bureaucrats face no constraints on their borrowing and bailout schemes. America is now well down the road to financial insolvency, shouldering more than $30 trillion in debt [now $31T].

History teaches us no government can ultimately escape the consequences of removing sound money from its monetary system. Absent the constraints on ever-expanding fiat money supply imposed by gold and silver, the current inflation problem can only worsen.

History confirms this truth.  Everywhere there is a central bank the result is the same.  The Canadian dollar has lost 94% of its value, the Swedish krona 96%, the US dollar 97% and the British pound is down nearly 98%.  It used to be said that "the power to tax is the power to destroy." To that, we must add that "the power to print money is the power to destroy."   Cortez continues:
Sound money has two simple value propositions. The first is that [it] protects capital and creates stability. People can accumulate savings and transmit value over time, allowing them to better plan, save, and invest for the future. The second is that sound money acts as a defense against excess debt accumulation and an ever-growing government.

The current system of fiat money issued by central banks enables unlimited deficit spending by government. Inflation allows the costs to be socialized across all holders of the currency by slowly and steadily stealing everyone’s purchasing power. From decade-long wars to wasteful domestic programs, the ability to create currency endlessly has empowered the government to spend in ways that it would not be able to if not for a printing press.
    So long as your money is being methodically debased by your central bank, it is not possible for your economy to thrive.  Every dollar, pound or euro that Joe Biden, Liz Truss, Emmanuel Macron and Olaf Scholz propose to spend must come from one of three sources: tax revenues (from you), bond proceeds (with the interest and principal to be repaid from future taxes on you) or money printing by the central bank (with future inflation to be suffered by you).  There is no free lunch – you pay for everything sooner or later – so you should care deeply about the feckless promises made by politicians to buy votes - with your money.  Politicians like to say that corporations will pay the lion’s share of taxes but that is a palpable lie. Who consumes their products and services? You do.  Therefore, you pay all the costs associated with those goods and services:  labor, materials - and their taxes.  As they say in the world of poker, if you do not know who the sucker is at the gaming table, it is you. 

Food for Thought

     Consider: over the same 100 years that the Fed was busy destroying the value of your money by 97%, the price of silver rose more than 3000% and the price of gold rose over 8500%.  Fiat currencies are not stores of value and never will be.  They are designed to be certificates of confiscation and they have served that purpose with distinction.

Important Message: The foregoing is not a recommendation to purchase or sell any security or asset, or to employ any particular investment strategy.  Only you, in consultation with your trusted investment advisor, can select the strategy that meets your unique circumstances, investment objectives and risk tolerance.  © All rights reserved 2022