"WHAT'S PAST IS PROLOGUE"


                          

    So said Antonio in Shakespeare's The Tempest, to his co-conspirator Sebastian, to justify the murderous act they were about to commit. Today the phrase is used less ominously to mean that history sets the stage for what happens next. About that there can be little doubt. The present is necessarily built on the foundations of what has come before. This leads us to believe that our future will be an extension of the present. In the world of psychology, this is known as "recency bias." However, the future often plays out very differently than expected because we have misinterpreted what has actually happened and ignored obvious risks.  

    Recent examples of unexpected futures were governments shutting down the world's economies for more than two years in response to a virus and flooding the world with liquidity for fourteen years (2008-2022). Both actions were deemed essential by politicians and "government experts" and were opposed by numerous independent experts. Both events had severe consequences which were readily foreseeable but ignored at the time. We cannot "rerun" history to test alternative government actions, but with regard to Covid we have the benefit of Sweden's response: no shut down of its economy or education system, with a far better outcome. Government officials and their media flacks never revisit these decisions because doing so will require abject apologies and result in lost elections. In the realm of politics the rule is: "Never reflect, never apologize."  

What Surprises Might 2023 Have In Store? 

    At the start of each new year many people feel compelled to predict what will come next, particularly in the realm of politics and the economy. Most of these predictions (guesses) widely miss the mark. Dan Ferris counsels: "Don't predict. Prepare." His thesis is that no-one can reliably predict the future and if you are wrong-footed by your efforts at doing so you will pay a heavy price. With that in mind let us review last year.

    The last twelve months were very painful for most investors.  Stocks tanked, bonds tanked, and many other asset classes suffered with them. The NASDAQ was down almost 33%, US Treasuries (20+ yr.) were down 31%, tech was down 30%, the Russell 2000 was down 20%, the S&P was down 18% and the Dow Jones was down 7%. Foreign markets took it on the chin as well (MSCI World Growth -29%) with the FTSE 100 being the surprise exception (+5%). It seemed as if there was nowhere to hide. But that was wrong. There were several bright spots: commodities were up 24% and energy was up nearly 59%.

    In addition to the markets taking hits, Russia's brutal war on Ukraine continued, European energy supplies from Russia were shut off causing gas prices to soar, and supply chains fought to come back to life following two years of government mandated Covid shut-downs. Mid-term elections in the US resulted in a split Congress foretelling much conflict to come. Many people consider that a big win as neither party will be able to push through more ill-considered, debt increasing legislation.

    Investors fervently hope that the Fed's rate increases will quickly bring down price inflation to a level that will allow it to lower rates and then add new liquidity so the glory days of soaring stock markets will return.  Jay Powell has repeatedly said that rates will continue to rise in 2023 and that he will not "pivot" to monetary ease until price inflation falls to his 2% goal.  We admire his rhetoric but are not persuaded that he will follow through.  We suspect that if there is a big "credit event" (large corporate or bank failure) he will wilt like a flower on a hot day and flood the economy with more "stimulus" (cheap money).  That is because his biggest concern is not that inflation stays elevated and continues to impoverish the working classes, but that equity markets crash impoverishing the elite who own the vast majority of the stocks.

    Despite the fact that the Fed has raised rates substantially, "real" interest rates (net of inflation) are still in negative territory. Thus, the Fed is still being monetarily "accommodative." Historically, real rates have been in the positive 2% range.  They have a long way to go to get back to that level.

                      

    We have previously noted that government supplied inflation statistics are a joke. Shadow Government Statistics tracks the rate of price inflation the way the government did until 1980 when inflation became so high that the government needed a way to keep that bad news from the voters. So it started making "adjustments" to the way inflation was calculated which always results in a lower reported rate. Calculated the way it was previously done, price inflation today is near 15%. Thus, real Fed fund rates are over 10% negative. Real negative rates are what drove price inflation to forty-year highs last year. The Fed grew the money supply (monetary inflation) much faster than the growth of goods and services resulting in rising prices (price inflation). It is very slowly reducing its obscenely bloated balance sheet of government bonds and mortgage backed securities that it bought with newly printed money. Chairman Powell hopes to overcome decades of Congressional and Fed fiscal and monetary profligacy without causing anyone any pain. 

    The honest way to overcome an economic contraction is to recognize and liquidate past mistakes so that the healthy portion of the economy can grow, unencumbered by the ongoing costs of supporting failing businesses. It is estimated that 20% of the Russell 5000 companies are "zombies" - meaning they do not make enough money to pay the interest on their loans much less ever repay them. That is one out of five or 1000 companies! If the banking system continues to supply financing to them, that financing is not available for the healthy businesses that are the best hope for the future. Banks are not eager to write off those bad loans as they will then have less reserves, less money to lend, lower net interest income and most importantly, smaller bonuses for bank executives. Not doing so ensures a future banking crisis with the Fed called upon to ride to their rescue once again - with you, the taxpayer, footing the bill. 

    The self-correcting nature of capitalism solves the problems of mal-investment and incompetent management. Failing companies close their doors. This allows the nation's limited resources (financial, raw materials and labor) to realign with the stronger, better managed companies. This process is what economist Joseph Schumpeter called "creative destruction." The fit and successful businesses survive and the weak and incompetently managed ones fail. This strengthens the economy for the long-term betterment of all. When the government or central bank intercedes to support failing, politically-favored businesses, the economy necessarily suffers to the detriment of all. 

    As the Fed became more active in trying to "manage" the US economy (a preposterous notion), that economy has predictably gotten weaker. The US had an annual GDP growth rate of over 3% in the 1960's. In the 1990's it was over 2%. Today it is less than 1%. It is noteworthy that prior to the sub-prime crisis in 2008 with its massive government interventions, the US had less than $10 trillion in public debt amounting to 63% of GDP. Today that debt exceeds $31 trillion, amounts to 120% of GDP and is expected to rise to $45 trillion in ten years. Our bet? It will not take that long. The pressing question that should be front and center on the minds of our elected officials is: What is the plan to address this staggering debt?  Sadly, the answer is: There is no plan. No politician has any genuine interest in seriously addressing the debt.  Thus, the US bumps up against its debt ceiling once again. What will happen? After much bluff and bluster, it will be raised again at the last moment. It has been raised over seventy times since 1940 and twenty times since 2001. Why? Because both political parties want to spend ever more money. Their only dispute is on what to spend it.

    The Fed believes that it can manage every economic downturn by adding more "stimulus" to the economy - i.e., printing money and lowering interest rates. That flood of cheap money is what directly caused today's price inflation. It is self-evident that the solution to the problems caused by excessive money printing is to stop printing more of it. Since the creation of the Fed, the dollar has lost 97% of its purchasing power. This more than one-hundred year trend is something you ignore at your own risk.  It will continue until the financial house of cards collapses. It will continue because there is zero political appetite to reverse it (return to a sound dollar). Of course, the dollar is not alone in this debacle. Compared to the price of gold (historic money), every fiat currency has failed to maintain its purchasing power. The yen has lost 99.98% of its purchasing power. (Note: this is a logarithmic scale. If represented arithmetically, all three currencies would look like a waterfall drop to near zero.) 

                     Source: Weiss Ratings, Resource Trader  

    Data is useful because it helps us visualize the negative consequences when the government tries to "manage" a giant, infinitely complex, modern economy.  The chart below shows the index of total US industrial production and manufacturing from 1954 to 2007.  Note the steady growth of both over time despite small set-backs during recessions that are indicated by the gray bars.

                   

    The next chart shows the same index for the last fifteen years. Note the absence of any growth. Constant government interventions in the economy have not promoted growth but have hindered it. Without continuing growth a nation first stagnates and then rapidly falls into decline. As Henry Ford famously said, "The business of America is business." By that he meant that business is the lifeblood of the economy and the nation. More government meddling is not the answer.  


 
Britain As An Object Lesson

    England was a great nation and the UK was a mighty global empire. As all empires do, it eventually disintegrated. Today it is suffering from a weakened currency, rising taxes, high energy prices, energy shortages, government debt to GDP over 100%, is racked by strikes of rail workers, nurses, ambulance drivers, teachers, border patrol, and it suffers political gridlock. The country has a rich history of rule of law, innovation, hard work, premier schools, and great minds. Why are the wheels falling off? There are many contributors to its decline but the underlying forces are the same that brought down the fabled Roman Empire.  

    Rome fell due to its inability to pay for the defense of its vastly expanded borders and its failure to placate an increasingly resentful public with "bread and circuses." The bread consisted of social welfare benefits and the circuses were offered to keep the people entertained and passive. When money ran out for both, the government collapsed. Britain's "bread" is its National Health Service, underfunded pensions, wage supports, energy subsidies, government supported radio and television and endless other "social benefits." Each benefit is justified in its own right but there is never an honest discussion about how together they negatively affect the economy or how to pay for them. Its circuses are debating the issue of who is a woman and the never-ending Harry and Meghan melodrama. 

    The social benefits are consuming an ever greater portion of Britain's GDP so taxes must be raised to nose-bleed levels and the currency is devalued in desperate efforts to come up with money to pay for them. Doing so predictably drives away the most successful people and businesses to less oppressive environments. No politician ever gets elected promising fewer public benefits so no politician ever runs on that platform or votes for cuts in the increasingly unaffordable but popular benefits. One thing is certain, over time the nation will sink beneath the waves of its ever-growing personal and public debt. This scenario has played out multiple times throughout history - a history from which no one ever seems to learn anything. Daily Telegraph economic editor Ambrose Evans-Pritchard has been a voice in the wilderness warning that the nation has been living beyond its means for decades and must stop doing so to avoid an existential crisis.

    As British wages lose purchasing power there are, of course, demands for wage increases. Thus, the current wave of strikes by essential government service workers. Inflation is currently running at a stiff 10%. It is likely that the government will give in to most of these demands in order to get the workers to return to their jobs. The result is predictable. Higher wages will increase the cost of the goods and services produced by these workers, driving consumer prices ever higher, resulting in further wage demands. As with post-war German hyper inflation, the only cure for a wage-price inflationary spiral is returning the pound sterling to a sound currency. When a nation's currency retains its purchasing power there are few wage demands. Unfortunately, this will not happen until "The Final Crisis" arrives because the immediate price for a sound currency is great and neither the public nor the politicians are willing to pay that price.

The US Follows The Same Degenerate Path

    Between 2008 and the present, Congress and the Fed shoveled trillions of new "stimulus" dollars into the economy with the result that "official" inflation soared to 9%.  Today US inflation is said to be 6.5%.  This means that "real" (net of inflation) wages for US workers have been negative for twenty-one months in a row despite nominal wage increases averaging 5%. Using a more realistic calculation of US inflation, workers are incurring close to 10% real annualized wage cuts.  Investors should not assume they will continue to suffer in silence.  

    As in Britain, US wage demands will increase. That will have a negative impact on both future earnings and price inflation. As stock prices are premised on anticipated future earnings, those prices are in jeopardy. Another certainty is that Congress will continue to spend ever more on social benefits to buy votes and grant more subsidies to favored industries to buy political donations. Budget deficits will continue and the national debt will soar. In all respects, the US is following in the footsteps of Britain (and Rome). The US deludes itself by thinking that it will remain forever on top because "we are an exceptional/indispensable nation."  It has many good qualities but do not the British, German, French, Chinese and Russian people also consider themselves to be "exceptional?" What would be truly exceptional is for them to get their financial houses in order and enter the world of monetary and fiscal sanity. Like being a good parent that requires one to sometimes say "no." 

    Politicians and many economists insist that the US economy is rebounding from "supply chain disruptions" (the current all-purpose excuse for a weak economy) and we are looking at the promised "soft landing." We have no crystal ball and decline to predict what will come to pass. However, if we examine the data we can draw some reasonable conclusions. Look at recently announced layoffs: Amazon, 18,000; Alphabet, 12,000; Microsoft, 10,000; Meta, 10,000; as well as thousands of workers at Zillo, Twitter, Uber, Lyft, Peloton, Cisco, 3M, Carvana, Goldman Sachs and Netflix.  Some 200,000 tech workers were let go in 2022. Do these facts suggest that the US economy is on the cusp of a resurgence? These executives, who actually run successful businesses, apparently do not see it that way. Of course they could all be wrong and the politicians could be right - but we would not bet the ranch on that being the case.

    Inflation is said to have fallen from 9% to 6.5%. Yet, “food at home” (your grocery bill)—was up 10.4 percent in December over the previous year, energy services were up 15.6 percent and shelter was up by 7.5 percent. The Fed assures us that it intends to return price inflation to its "2% goal." We are supposed to be grateful for this news but then are reminded of the adage that when a great injustice is about to be inflicted on us, we happily accept a lesser injustice as a victory.  How would you feel if your banker secretly drained 2% from your savings and investment accounts every year? You would expect him to go to jail. But the Fed wants you to be OK with it embezzling 2% of your wages, savings and retirement account every year (causing your savings to be cut in half in thirty-six years). That is, it pretends to be your friend while it continuously picks your pocket. The chart below shows the ever-declining purchasing power of the dollar. The working classes suffer the most from this decline as they spend a far greater percent of their income on food, energy and shelter.  

                       

    The Fed justifies this ongoing theft from Americans workers (and foreign investors) with the argument that deflation (falling prices) must be avoided at all costs. It argues that if prices are allowed to fall, people will hold off making purchases until prices fall further and this will destroy the economy, cause businesses to fail and lead to soaring unemployment. Therefore, it must act to keep prices from falling (hence, its goal of 2% inflation). This is its cover-story to justify the ongoing debasement of your currency.  
    
    Consider this: when Sony's first large screen plasma TV came out it cost $10,000.  Now you can buy one for less than $300 - despite rampant price inflation in the meantime. How did that come to pass?  Sony's competitors worked feverishly to develop their own products, improve their designs, and increase their productivity. Prices fell dramatically. Now nearly every home in America has one. This is the magic of free market capitalism. If those TV's were built exclusively in the socialist workers paradise of the old USSR, they would still cost a fortune, be unreliable and in short supply. Competition among companies is what causes growth in the economy to our collective benefit.  Despite what the Fed says, falling prices are not an evil. They are the natural result of a healthy, free market.   

    The Fed has distorted the US economy for decades and especially since the sub-prime mortgage crisis (which it brought about by forcing mortgage rates to absurd lows). It has become an ever-larger and dangerous force in the US economy. In 1986 the Fed had a balance sheet equal to 5.9% of GDP.  Following the mortgage crisis its balance sheet grew to 15.3% of GDP. It now amounts to a shocking 37% of US GDP.  It was never designed to play a leading role in the economy and its history conclusively proves that it is not competent to do so. It has no power to predict the future and makes all of its policy decisions looking at data reports. These reports provide information about what has already happened - sometimes with a lag of many months. Trying to steer the giant US economy forward based on often-questionable data is like to trying to drive a large bus through central Paris during rush hour while looking out the rear window of the bus at where you have been. The process is absurd and explains the Fed's persistent policy errors. 

The Travails of the EU

    The EU has an intractable problem with no solution. It is made up of wildly disparate nations that must be treated as equals. While there is no serious problem with the differing cultures, there is a fundamental problem with their differing economies.  Germany agreed to join the EU based on the explicit promise that it would not become a "transfer union." It saw the handwriting on the wall: German taxpayers were going to end up supporting all the lagging economies but-for the promise that each nation would financially stand on its own. While Germany has a strong economy that supports its government expenses, the southern nations, especially Italy do not. EU rules forbid the European Central Bank (ECB) from lending disproportionately to any of the member states. Thus, the ECB could not keep buying Italian bonds to keep its bond rate low and the government afloat during the Covid crisis.  Similarly, it cannot charge more favorable rates for loans to Italy simply because that nation cannot afford the going rate.  

    The ECB's "solution" was to charge zero interest rates for its loans so that Italy could afford them. It has been buying Italian bonds since 2015 protecting that market from natural market rate forces. That stopped in June 2022.  To prevent the inevitable crisis, it started rolling over German bonds in favor of Italian bonds but that drew much criticism and has stopped. Professor Ken Rogoff observes that,
The glue that has been holding the eurozone together is the world of zero real interest rates. So long as they stayed at zero [the ECB] could use QE as a transfer subsidy from the North to the South, and it didn't seem to cost anything.  The underlying problem was never resolved. The one-size-fits-all rate is patently stupid - a rate that is suitable for Germany is not good for Italy - one suffers needlessly.

    The risk is that German taxpayers will once again haul their government before the German Constitutional Court seeking an order on the German government to cease supplying money to the EU for these increasingly obvious transfer payments to Italy.

    France too has huge fiscal problems. It is racked by fierce opposition to the proposed increase in the state pension retirement age from sixty-two to sixty-four. As with the US's Social Security System, when the retirement age was originally set, the average life span was in the high sixties.  That meant that the retirement system only had to take in enough money from each future beneficiary to support him or her for some six years. Today the average life span in France is about seventy-six meaning that monies collected to date are woefully inadequate to pay the promised benefits.

    There are several solutions. The first is the one proposed by Macron: raise the retirement age.  His suggested two-year increase was undoubtedly chosen to reduce worker push-back but it is clearly inadequate to solve the problem. The second solution is to significantly raise the workers' contribution rates. The third is to reduce benefits to match the available funds. The workers can strike and march all they want but these, individually or in combination, are the only honest solutions. That leaves the dishonest (politically preferable) solution of printing money to pay the benefits. Of course, that will inevitably generate price inflation effectively reducing the benefits. Politicians hope workers will not figure that out.

    All western nations are confronted with the same problem: underfunded pension promises that will continue to consume an ever-growing part of each nation's GDP.

China's Recovery

    When Xi Jinping imposed his zero-covid, full lockdown on the nation, he assumed the virus would quickly abate. He was wrong. After enforcing draconian lockdowns for nearly three years (sometimes welding the doors of apartment complexes shut so tenants could not leave) he abruptly reversed course. Did he do so because he finally admitted the stupidity of the policy?  Not likely. Did he do so because he feared an insurrection by 1.4 billion Chinese following unexpected mass marches and calls for his removal? Perhaps. Clearly, a motivating reason was the rapid decline in GDP growth - undoubtedly far greater that official Chinese statistics report. The slowing economy, rising unemployment and collapsing real estate market could have triggered a call for regime change. Will his sudden reopening of the economy trigger a massive Covid outbreak, a high death toll and re-shutting of the economy?  Stay tuned.

    China has another very serious problem: rapid population decline. The government-imposed one-child policy that forced tens of millions of women to have abortions and sterilizations had its intended effect, fewer births. What was not anticipated was parental preference for boys who could support their aging parents. Female fetuses were aborted en mass. The result is a shortage of women for marriage and a disinclination of working women to have children. As they say: be very careful what you ask for. The result is a steadily declining population of young workers who are necessary to support the increasingly large elderly population. Here are two charts depicting the problem. The first shows Chinese and Indian population growth by age group. The second shows a comparison of the two populations into the future. India is expected to take over as the most populous nation this year. We note that Japan's population has been in decline since 2008.




Africa's population growth rate remains the highest, but it too is slowing. Twenty years ago, a woman was likely to have as many as six children but is now more likely to have four. As populations move up the economic ladder, they have fewer children. This results from many factors but three are: reduced childhood mortality, the increased cost of raising a child, and less need for child workers on the family farm. It is said that "demographics are destiny." Changing demographics around the world will pose very difficult pension and health care funding problems for which there are no easy solutions.




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