The Almighty U.S. Dollar

 Unless you were born more than 80 years ago, you have never lived during a time when the United States dollar was not the undisputed dominant currency in the world. The Bretton Woods Agreement entered by the major economies in July 1944 formally acknowledged what was already generally accepted - the dollar would serve as the world's principal reserve currency. Furthermore, it would be the currency of choice for most countries to utilize when transacting international trade. 

Per the Bretton Woods Agreement, the dollar was convertible to gold at the fixed rate of $35 per ounce. The majority of countries in turn pegged their currency valuation to the U.S. dollar. This monetary system dissolved in 1971 when President Richard Nixon terminated the convertibility of the U.S. dollar to gold. From 1971 henceforth, the dollar and other major currencies have experienced a floating exchange rate. This is a system where the currency price of a nation is set by the foreign exchange market based on supply and demand relative to other currencies.

The dollar was and remains the obvious candidate to serve as the world's primary reserve currency. Similar to the end of the Second World War, the American capital markets continue to be deep, open to the world, and highly liquid. In addition, there is a track record of stability supported by investor protections and the rule of law. The U.S. represents practically 25% of the world's $115 trillion (annual) economy. Foreign governments and central banks around the world hold dollar-denominated assets, usually U.S. Treasury securities, as reserves to manage the foreign exchange value of their currencies or to weather economic shocks. Dollar assets comprise about 60% of global foreign currency reserves, down from 70% in 2000. The next highest reserve holdings would currently be the euro at 20% of the total.

Very few Americans truly grasp the benefits and significance of the dollar serving as the world's primary reserve currency. The dominant dollar has been called an "exorbitant privilege." And it is that, and more. A generous supply of dollars combined with strong global demand allows the U.S. to borrow money at a lower cost than if the dollar was not the world's principal reserve currency. A dollar at the top of the food chain reduces the cost of imports paid by American consumers. A strong dollar induces foreign direct investment in the United States. Long-term investment in businesses and property has been significant. The dollar's reserve status allows the U.S. to export inflation to a certain extent. While domestic consumers receive vast amounts of physical products of substance, in exchange foreign exporters receive vast levels of fiat money that has a history and future of debasement. The dollar has lost 98% of its purchasing power over the past century.

History tells us the U.S. dollar will ultimately be displaced as the world's dominant currency. Since the demise of the Roman Empire, there have been more than a dozen different currencies that sat at the top of the heap for varying tenures. The Dutch guilder succeeded Spain's silver dollar and dominated for the 17th and 18th centuries,. The United Kingdom's pound sterling was the primary reserve currency of much of the world in the 19th century and first half of the 20th century before being bumped off its throne by the U.S. dollar. There is no question that the dollar will eventually be replaced as the kingpin by either a different currency or an entirely new monetary system. The only question is when - will it be in two years, twenty years, or 200 years? I would lean toward the twenty-year scenario and I'll proceed to defend my thesis below.

Myself and many others predicted the imminent demise of the dollar in the past couple of years due to reckless, undisciplined fiscal policies and continued abuse of economic sanctions leveled on other nations by the U.S. It is time to eat some crow. I was wrong, and so were many others. We were caught-up in all the hub-bub surrounding proclamations that the BRICS' nations were about to unleash their own currency backed by a basket of commodities including gold. This may eventually transpire, but it probably is a ways off. I also failed to take into account higher interest rates in the U.S. and a robust stock market over the past two years. This induced foreign capital inflows which further supported the dollar. The fact of the matter is, currently there aren't any viable reserve-currency alternatives. The euro, Japanese yen, or Chinese renminbi are not in a position to replace the dollar. The dollar remains the cleanest shirt in a drawer full of dirty shirts.

However, over the next decade or two, unless something dramatically changes, I foresee the dollar gradually declining both in purchasing power and global importance. It may be the last man standing, but if powerful current trends continue on an unabated path, it too will tumble. Since leaving the gold standard over a half-century ago, the dollar has been kept aloft by the tax-generating ability of a growing, productive economy and a defense structure that has safeguarded the economy's strength. Cracks are beginning to widen in the foundation of the dollar. Central banks across the world have been de-dollarizing and aggressively increasing their gold reserves. Investors, both domestic and foreign, will continue to purchase U.S. Treasury debt as long as they believe they'll get their money back and that money has successfully navigated the storm of unrelenting debasement. Since I harbor little or no trust in our federal government, I suggest hedging in the form of hard assets and quality equities. If the United States moves to the point where the preferred policy is one of financial repression that allows  inflating the debt away, the market will consider and pursue alternatives to the dollar as a store of value.

The timing of a policy shift to financial repression is difficult, if not impossible, to predict. I expect it will be implemented over time in different phases. Along with financial repression, I foresee the Federal Reserve Bank pursuing and implementing a central bank digital currency (CBDC). There is no stopping the digital train. We are heading toward a cashless society. Most governmental parties claim CBDC will work as a supplement to fiat money with cash still allowed as an option in the payment system. I don't believe this for a minute. Central bank digital currencies will allow governments to exert more control over their citizens and facilitate complete oversight over all financial transactions.

Before I wander off on that tangent and go on a rant, I should tie a bow on this blog posting and speculate as to the probable successor to the U.S. dollar. At some point, there will be a global financial meltdown that will make the Great Financial Crisis (GFC) look like a Sunday school picnic. The major economies - United States, China, Europe, Japan - will gather somewhere and eventually agree on a new monetary system. The U.S. will no longer be a hegemon; the world will be multipolar; and globalization will be on the upswing again. At that point, I see the establishment of an international digital currency. Of course, I've been wrong before in the arena of making predictions.

A Political Pivot, And Where The Economy Goes Next

 "It's the economy, stupid" is a phrase widely associated with Democratic strategist James Carville in 1992 in the run-up to Bill Clinton's successful 1992 presidential election against Republican incumbent, George H.W. Bush. As is often the case, the condition of the U.S. economy in 1992 (recession) was the primary reason Bush was not re-elected. Although immigration no doubt played a role in the 2024 election cycle, the Republican Party's sweep of the White House and Congress can for the most part be attributed to a surge in inflation and an economy that was portrayed as strong but was extremely weak below the surface. It's a well-worn adage, but people do tend to "vote with their wallets."

The Biden Administration and their co-conspirators in the mainstream media consistently presented the economy as a vibrant juggernaut hitting on all cylinders. This political spin could not have been further from the truth. Both inflation and unemployment rates were significantly higher (by 30%-50%) than the numbers reported by the Bureau of Labor Statistics (BLS). The antiquated models and inaccurate surveys used for determining those statistics are seriously flawed with subjective assumptions superseding objective facts. The cumulative inflation (at least 25%) that accrued between January 2021 and December 2023 especially took a toll on the family budgets of low and middle-income earners, and they have yet to recover. Besides a massive revision (downward) of 818,000 new jobs created in the 3rd and 4th quarter of 2023 and 1st quarter of 2024, the trend lines showed ongoing declines in full-time jobs in the private sector. The only job growth was an increase in part-time and government jobs. These are not signs of a healthy economy.

The U.S. economy was widely predicted to fall into recession in 2023. When this didn't come to fruition, many predictors claimed their timing was off a bit but that it would happen in 2024. It appears that  recession call was erroneous as well. So what happened? Why has the economy remained in growth, chugging along like the Energizer Bunny? There are two primary reasons that explain this surprising growth in the economy. The first one is the sheer abundance of liquidity that has been sloshing around the financial system for practically two years now. Although the Fed claims to have tightened conditions via boosting the Fed Funds rate in 2022 and 2023, and by implementing Quantitative Tightening (QT), the data and facts paint a different picture. The National Financial Conditions Index (NFCI) generated by the Federal Reserve Bank of Chicago shows non-stop, increasing levels of liquidity from March 2023 through the current point in time.

The other main reason triggering unexpected growth in the economy was unprecedented fiscal stimulus. The federal deficit in 2023 was $1.7 trillion, equal to 6.3% of Gross Domestic Product. The federal deficit for fiscal year 2024 was $1.8 trillion, equal to 6.4% of GDP. Deficits at this level traditionally are only seen during periods of war and economic recession. Simply stated, they are unsustainable and a threat to the long-term viability of the United States economy. Federal spending as a percent of GDP has also skyrocketed. For fiscal year 2024, government spending represented almost 35% of GDP. This binge of spending goosed the economy with many cynics believing it was done for political reasons.

Trump's victory in the recent presidential election, combined with the Republicans taking back the Senate and retaining a slim majority in the House, has seemingly revitalized the optimism and even animal spirits in the business and investment communities. While it is possible that the new administration and Congress will be able to thread the needle in terms of policy decisions, I do not share a high degree of optimism. I believe Trump is walking into an economic shitstorm and his proposed policies for the economy will only serve to exacerbate the problems.

Like traditional Republicans, Trump is always looking to lower taxes. Unlike traditional Republicans, Trump never appears to be overly concerned with the level of government spending as evidenced by an increase in the national debt of $8 trillion during his first term. Besides a continuation of the 2017 tax cuts, Trump has proposed lowering the corporate income tax rate (to 15% from 21%) and eliminating certain types of income subject to personal income taxes (overtime pay, tips, Social Security benefits). While I can live with an extension of the 2017 tax cuts, the other reductions mentioned make no sense whatsoever when the national debt is at $36 trillion with projected $2 trillion annual deficits. For those believing Messrs. Musk and Ramaswamy will save the day by finding ways to significantly reduce government expenditures - I wish them well but they have an almost impossible nut to crack due to the preponderance of non-discretionary budget items. The Department of Government Efficiency, an obvious oxymoron, will garner numerous headlines and possibly even save $200 billion - $400 billion per annum with their recommendations. However, those savings will be more than offset by increased interest payments on the national debt. Insofar as actually reducing spending, please wake me up when Congress decides to tackle entitlement reform (Social Security, Medicare, Medicaid).

At this point, I'm sure the reader can discern that I have little faith in the Trump 2.0 administration and Congress being able to slow down the runaway debt train. I see annual deficits being roughly the same for the next few years with the potential for even bigger deficits in the event we experience economic contraction. While the stock market is giddy with Trump and his policies coming on board, the bond market's response has been totally the opposite. The bond market sees inflation and problems for the economy on the horizon. Since 9/18/24, the Fed has lowered the Fed Funds rate by 75 basis points (.75%). However, the current yield on 10-Year Treasuries has increased by 60 basis points (.60%) since the Fed started lowering. Basically, the bond market was telling Trump and Kamala Harris, and now just Trump, that their respective economic platforms were inflationary in nature. Thus, investors in the bond market were/are demanding more term premium before they would assume the greater risk posed by potential future inflation on longer duration U.S. Treasury securities.

There are a couple other potential economic pitfalls lurking in the weeds if Trump elects to pursue certain major policy positions espoused in his campaign rhetoric. Massive deportation of illegal aliens is one such risk to the economy. If the estimates of 10-12 million illegals in the country are accurate, large-scale deportation would be a daunting and expensive task. It also would have the potential to harm the U.S. economy. With an aging population combined with below replacement level birth rates, immigration provides an obvious solution to keep the economy in growth and provide jobs for employers. The Immigration Reform and Control Act of 1986 provides a good blueprint for offering a path to citizenship for many of the immigrants who are in the country illegally. 

The imposition of tariffs on a large scale could also potentially cause more harm than benefits to the majority of American citizens. Economists and other free trade advocates absolutely hate tariffs. And for good reason. Contrary to the claims of the President-elect, rather than hurting foreign exporters, it is American firms and consumers who are the hardest hit by tariffs on imports. While the initial bill for a tariff is paid by the importer, the financial burden shifts to businesses and consumers in the form of increased prices. In other words, tariffs are considered inflationary. It should also be noted that China appears to be the target of Trump's most severe tariffs. Is it wise to start a trade war with a competitor that is arguably on equal footing with you both economically and militarily?

My pessimism in the new Trump Administration being capable of addressing the nation's economic challenges is grounded in math. For the first time ever the U.S. government spent more than $1 trillion this year on interest payments for the national debt. Twenty cents on every dollar spent by the federal government goes to debt service. The Congressional Budget Office (CBO) projects that annual interest payments will rise rapidly throughout the next decade and exceed $2 trillion by 2034. I see nothing to question the CBO's prediction. The cumulative probability of tax revenues exploding and Congress setting aside its spendthrift ways is about 2%.

The debt problem is not a political problem that can be easily resolved. It is an arithmetic problem. Whether it be in Trump's tenure, or his successor's tenure, I predict that the government through its central bank will resort to the playbook used during the Great Financial Crisis (2008-2009). The Fed will reintroduce Quantitative Easing (QE) to expand the money supply to buy U.S. government bills, notes, and bonds. This most likely will cause a spike in interest rates as investors demand higher yields to compensate themselves for the government's balance sheet risk. This leads me to further predict the government will then implement financial repression to cap interest rates and channel funds from the private sector to itself to facilitate debt reduction. Savers will earn at rates below the rate of inflation. Also, look for the government to require banks, insurance companies, and pension plans to hold significantly larger amounts of government debt than is necessary for prudential purposes. The picture I paint is not pretty. Look to hold hard assets for some protection from the continuation of the debasement of the value of our currency.

 

 

Short Selling Stock

 This blog will start the same way it ends - with a warning concerning the subject matter: Short selling is not for the inexperienced and faint-hearted investor.

Fundamentally, short selling is a way to invest so that you profit when the price of a security declines. Rather than buying a stock (called going "long") and then selling later, going short reverses that order. A short seller borrows stock from a broker and sells that into the market. Later, they hope to buy back that stock at a cheaper price and return the borrowed stock in an effort to profit on the difference in prices.

For those electing to take the plunge, the first step is to establish a margin account on your brokerage account. This will allow you to borrow money to short a stock. There needs to be enough margin capacity to support the loan, on which you'll pay interest. In addition, there's a fee paid to the broker for the service of finding stock to sell short. Lastly, you're on the hook for any dividends paid by the company. The interest cost, fee, and dividends are all rolled into your margin balance.

Probably the most important aspect of the process is selecting the right stock to short. This should only be done after extensive research and analysis. There should be powerful fundamental reasons why you are placing a bet in anticipation of a company's stock declining. To short a stock, you'll place an order to sell stock that you don't own. The short position will typically show up in your account as a negative number of shares (e.g., - 100 shares of XYZ stock). Ideally, the stock you shorted will decline in value, if not outright take a severe swoon. As the investor, you'll have to decide when to close the position and at what price. When you're ready to push the button, you buy the stock. This will automatically close out the negative short position. The difference in your sell and buy prices is your profit (or loss).

Short selling can offer some positives. First and foremost, an astute investor can make money when they discover an overvalued stock that comes back to earth in terms of valuation. It provides another tool in the investor's tool kit. Short selling also helps keep fraudulent companies from ripping off investors. Because of the intense research involved, short sellers can at times dig up financial information and data overlooked by long/passive buyers. Markets tend to be more orderly and function better when short sellers are in the mix. Besides providing liquidity for buyers, long-term investors can buy at more stable prices and amass stakes at lower prices. Lastly, shorting offers excellent hedging opportunities. Investors can sell their profitable positions for cash in a market drop, and then add to their long positions at lower prices.

Of course, short selling has its share of detractors and disadvantages. Since the stock market as a whole tends to go up over time, short sellers face a situation that's already stacked against them in the long run. Another potential hurdle is the fact that you can experience unlimited losses in the event the stock you've shorted keeps rising. You could lose more than you put into the trade since your risk is theoretically uncapped. Also, as mentioned earlier, there are ancillary costs involved with the short selling process. Lastly, and it primarily comes from less than knowledgeable investors, but there's often skepticism, animosity, and unfavorable stigma associated with short sellers. America admires success, and short sellers are betting against success.

I would be remiss if I didn't touch on a recent notorious "short squeeze" scenario. Specifically, the situation involving video game retailer GameStop in early 2021. A short squeeze occurs when the stock rises rapidly, forcing short sellers to close their position. As the short squeeze hurts more and more short sellers, they are forced to buy stock at any price, pushing the price still higher. This nightmare played out for short sellers of GameStop stock in 2021. Led by a basement-dwelling cretin known on the Internet as "Roaring Kitty," masses of small, novice investors put the screws to some hedge funds who had wisely shorted GameStop. There was no fundamental financial reason to bid up the price of GameStop. I found the whole incident disgusting. These small investors, if you can even call them that, were not heroes. They were nothing more than idiotic "pumpers and dumpers."

Personally, or as a fiduciary, I've never technically sold a stock short. I harbor no philosophical reservations about doing so, however. Lack of doing so is primarily attributable to a reluctance to establish a margin account and the various costs associated with the short selling process. That said, I have "effectively" shorted certain stocks and indexes by purchasing put options - with mixed results. One challenge, as mentioned previously, and it's especially been the case during this long-running bull market, is that stocks can stay irrationally overvalued for a surprisingly extended period. Long enough to test the solvency and patience of many investors taking a short position. My advice would be to favor put options over short selling, favor indexes over individual stocks, and to place short bets exclusively for hedging purposes. As promised at the onset, I end with this reminder: pure short selling is not for the inexperienced and faint-hearted investor.

A 150 (degree) Pivot on Bitcoin

 Note: The following blog on Bitcoin was drafted in March 2024 with subsequent posting in September 2024.

At the start of this particular blog, I feel it necessary to devour some metaphorical crow. Not the entire bird, but a significant portion of Corvus corone. I believe I was premature in expressing extreme skepticism as concerns Bitcoin, and even relegating it to the dustbin of history. My initial error was a common one, especially among old coots like myself. I cast judgment on Bitcoin before taking the time and expending the energy to understand Bitcoin. In particular, I failed to research the pros and cons insofar as to whether or not it can be both a monetary vehicle and a long-term store of value. That was a mistake. It should be noted that my newfound positivity for Bitcoin does not extend to any of the other 13,217 cryptocurrencies currently in existence.

In 1984, Nobel laureate and Austrian School economist, Friedrich Hayek, was quoted as saying: "I don't believe that we shall ever have a good money again before we take the thing out of the hands of government. Since we can't take them violently out of the hands of government, all we can do is by some sly roundabout way introduce something they can't stop." Congress created the Federal Reserve Bank in 1913. Since that year (1913), we have experienced a cumulative rate of inflation of 3,035%. An item purchased in 1913 for $1.00 would cost $31.35 in 2024. The primary reason for this dramatic debasement of our currency and the subsequent loss of purchasing power has been a gross over-expansion of the country's base and broad money supplies. For this, we can place blame firmly on the shoulders of the Federal Reserve's consistently loose monetary policies and the total abdication of the U.S. Congress in performing their fiscal responsibilities.

The current global monetary system came into existence in 1971 when Tricky Dick Nixon brought an end to the Bretton Woods System and ended U.S. dollar convertibility to gold. In fairness to Nixon, he had no choice in the matter. Foreign nations and their central banks were rapidly draining America's gold reserves. From 1971 to date, our monetary system has been exclusively based on fiat money and a network of constantly increasing levels of debt. Fiat money is described as a government-issued currency that is not backed by a physical commodity. In other words, the U.S. dollar is only backed and supported by nothing more than the full faith, credit, and trust in the United States government. In my humble opinion, after a half-century of relentless currency debasement and accruing an unsustainable level of debt, the fiat system will soon (within a decade) be either replaced or reset in a dramatic fashion. And that is the main reason for me developing a certain fondness for Bitcoin. I simply no longer trust the government to do the right thing in terms of retaining long-term prosperity for the American public.

Unlike banks, central banks, and fiat currency financial systems, there is no entity that can unilaterally debase the Bitcoin ledger. Bitcoin is an open, decentralized, and widely distributed public ledger. Anyone with a basic laptop and internet connection can participate in the network as a node operator by running a free and open-source software application, and doing so allows them to send and receive transactions without the permission of any centralized entity. Bitcoin closes the speed gap between transactions and settlements. It represents the first significant way to settle scarce value at the speed of light. The number of bitcoins is capped at 21 million coins. As of now, about 95% of this total has already been created. Much like physical gold, Bitcoin is not someone else's liability. The ability to quickly move a non-liability asset over long distances is something the world has never had before.

Another similarity to gold is that Bitcoin can serve as "insurance" for an investment portfolio, Runaway inflation or a severe financial crisis will garner interest in these types of bearer assets. Bottom line is that Bitcoin represents a portable, self-custodial, supply-capped, censorship-resistant form of global money. Nobody knows for certain Bitcoin's long-term fate, in particular its pecuniary value, if any. Currently, there is approximately $500 trillion in global assets. Of this total, market capitalization for gold is about $10 trillion and Bitcoin comes in just over $1 trillion. Consider this possible scenario for a moment. Over the next few years, the Bitcoin network manages to capture 1% of the world's assets, which translates into a market cap of $5 trillion. Five trillion dollars divided by 21 million coins equals $238,000 per coin. Furthermore, at a mature stage for the Bitcoin network, people around the world might on average want multiple percentage points of their assets in that form of money.

The road to Bitcoin riches is obviously laden with myriad roadblocks, pot holes, and hurdles. There is probably a 55% probability that the valuation per coin will eventually go to zero, with an additional 25% probability that the value will never exceed what it is at the time of this writing ($64,000). People are bothered by Bitcoin's volatility, and that is understandable. Much of that volatility is due to the fact it monetized from zero to more than a $1 trillion market capitalization within its first 15 years of existence. Bitcoin is almost guaranteed to be very cyclical (high highs and low lows) along the way. Only once it is closer to its addressable market, with extremely high levels of liquidity and user adoption, can its notorious price volatility realistically diminish.

A couple of minor risks to Bitcoin's future would be software bugs and arbitrary changes to the rules of the network. For the most part, these two risks can be easily dismissed. Previous software issues have been competently and expeditiously resolved. Also, the extensive decentralization of the network precludes an individual or minority of participants from unilaterally making changes to the system. A more feasible threat in my opinion would be the saturation of different cryptocurrencies. Although there will only be 21 million bitcoins, the concept can experience supply inflation and dilution by the countless new blockchain monies. If the market share becomes and remains highly fragmented between an excessive number of blockchains, then perhaps none of them will persistently maintain any significant purchasing power, liquidity, or security. Bitcoin currently stands alone with over 90% of market value of all proof-of-work blockchains.

The biggest threat, the threat that would probably keep me up at night, would be the federal government imposing a ban on the ownership of Bitcoin. There is precedent for this action. Between the early 1930s and the early 1970s it was illegal for Americans to own gold. Fortunately, the law was not strictly enforced. The penalties were quite severe. As mentioned previously, I have little or no trust in our government as the powers that be slowly but surely increase government involvement in our respective lives at the expense of our individual freedoms. To make matters worse, as fiat currency loses value, expect blame to ultimately be placed on Bitcoin users, as though they somehow caused the existing monetary systems to become destabilized.

A legislative effort to ban Bitcoin would tell us a lot about the condition of our nation. A country with a robust currency, strong property rights, and where capital wants to be, is unlikely to ban Bitcoin. Whereas a country dealing with severe mismanagement of its public ledger is more likely to try to ban Bitcoin, or at least add a lot of friction to it. If Bitcoin ultimately ends up in the crosshairs of Congress or a government agency, I expect it to happen sooner rather than later. Young people look at Bitcoin more favorably than their parents and grandparents. As Baby Boomers exit the stage, in theory, Bitcoin should gain interest and strength. Even now it is estimated that 46 million Americans (roughly 22% of the adult population) own a share of Bitcoin. That figure was before the SEC approved Bitcoin spot ETFs a couple of months ago. The art of investing does not incorporate avoiding risk, it involves managing an acceptable risk/reward matrix. Perhaps I should join those American investors who have taken the Bitcoin plunge and put my money where my mouth is.

 

The Paramount Relevance of Liquidity

 Note: Although posted on or about 9/15/24, this blog was actually drafted in February 2024 before the blog originated. I thought the timeliness and relevancy of the subject matter were important enough to see the light of day on "Mark's Macro Musings."

Like many active investors who closely follow the capital markets, I fully expected the American economy to enter a recession in 2023 with a corresponding dive in the stock market. The most expected recession in history never arrived in 2023 and the S&P 500 Index appreciated by 24% last year (2023).What the heck happened? In my opinion, there were two primary reasons for this surprise. The first one, and by far the least important of the two, is the customary lag period (6mo.-18mo.) between interest rate changes and their impact on the economy. The Fed Funds rate went up by 5.00% between March 2022 and year-end 2023. A significant increase with seemingly little effect on the economy. There is another factor that trumps interest rates - liquidity. While interest rate levels capture most, if not all, of the attention, the real story of liquidity levels escaped the scrutiny of almost everybody. This is a mistake, a profound one.

Before proceeding, it would be wise to establish a definition for liquidity when used in the context of the financial markets. Liquidity would be a combination of all liquid assets and the availability of credit to borrowers. Liquid assets are further defined as all such assets that can be exchanged for money, at any time, at short notice, and at a relatively small transaction cost. Obtaining credit or having debt is self-explanatory. It should be noted that the debt portion of the equation is probably more important in the determination of market liquidity. The credit availability factor is also more volatile and usually the source of financial crises.

We live in a credit-based world - leverage is what drives the boom-bust cycle and liquidity sets the stage for the debt cycle. When leverage is cheap (low interest rates), people borrow profusely and bid up riskier assets - pushing prices higher (the boom phase). Following the Great Financial Crisis in 2007-2009, the Federal Reserve Bank effectively adopted a program of keeping interest rates artificially low and flooded the system with monies via Quantitative Easing (QE). Those monetary stimulants went into hyperdrive when the Covid-19 pandemic hit in 2020. The result is that the Fed has managed to simultaneously drive debt (government, corporate, individual) levels to historic highs while creating a massive asset bubble, particularly in the equity and real estate markets.

The flip side of the boom phase is of course the bust phase. When leverage is expensive (higher interest rates), people borrow less - and even liquidate riskier assets to pay back debts - pushing asset values lower. As mentioned previously, the Fed started aggressively raising interest rates in March 2022. Late in 2023, they effectively pivoted with indications that either in the 1st Quarter or 2nd Quarter of 2024, they would begin reducing interest rates. Starting in June 2022, the Fed began gradually reducing its Balance Sheet via Quantitative Tightening (QT). This will no doubt come to an end at some point in 2024 since they have messaged rate cuts are coming in 2024.

Ironically, despite the Fed's rate hikes and Quantitative Tightening over practically two years, monetary conditions are still considered "loose." The reasons are multiple. Banks still had trillions worth of excess reserves from the Fed's QE years. Plus, slowing growth and calamity in Europe, Emerging Markets, and Asian economies have pushed investors to put cash in the United States. The U.S. and U.S. dollar is still considered a safe haven for parking money. This has given banks even more excess money.

By this point, the reader is probably thinking..."Now where can I find information and data concerning the present and past liquidity levels?" The ideal mechanism to track and measure liquidity in the financial system is the National Financial Conditions Index (NFCI). The NFCI tracks what is going on in money, debt, equity markets, and even the "shadow banking" system. This information and valuable tool is generated and posted by the Chicago Federal Reserve Bank. The index is neutral at zero. A number below zero is considered "loose" conditions. The more below zero, the "looser." A number above zero is considered "tight" conditions. The more above zero, the "tighter." When the NFCI has spiked dramatically above zero, harsh bear markets and economic recessions have occurred.

It is only a matter of time before another leak springs in the financial system due to unprecedented (500 basis points) interest rate increases in the past couple of years. A little under a year ago the Fed had to extinguish a fire when regional banks such as Silicon Valley Bank and First Republic Bank imploded. A strong candidate for the next potential crisis would be the corporate debt sector. Corporate debt as a share of GDP is now at an all-time high. Firms took advantage of the ample liquidity and low rates to bring on debt. Approximately 40% of the companies in the Russell 2000 are losing money. These are companies that rely on credit to stay afloat. Over the next 2-3 years, a whopping $3.5 trillion of corporate bonds are set to mature. Companies will be forced to roll over debt and add new debt when the cost to borrow will no doubt be much higher. Markets will be in a fragile position if liquidity dries up.

In the process of reading a book and various articles on the subject matter of this blog, I stumbled upon a statistic that switched on a light bulb in the cognitive portion of my brain. Per an economist and author named Michael Howell, over the past 40 years, new factors have evolved to displace earnings power as the main driver of stock prices. He goes on to postulate that only about 20% of equity gains can be attributed to increased corporate earnings. I assume that figure is net of inflation -which was up a little over 200% between 1982 and 2023. The S&P 500 Index, on the other hand, increased by a mind-boggling 3,300% (from 140.64 to 4,769.83) between 1982 and 2023. So why did investors move away from safe assets like bonds and seek riskier assets like equities? A strong argument can be made that enhanced and elevated global liquidity is the answer.

The Net National Savings Rate Takes A Swoon

The net national savings rate measures the amount of income that households, businesses, and governments save. It is an economic indicator tracked by the U.S. Commerce Department's Bureau of Economic Analysis (BEA). Although not considered one of the "prime time" leading economic indicators, the savings data is relevant and has implications for all businesses and investors. A disturbing fact is that the net savings as a percentage of gross national income has been negative since the first quarter of 2023 after starting a decline in the fourth quarter of 2020. The current period of negative net savings is only the third time that net savings slipped into negative territory in the last 75 years. The only other time net savings has gone negative is in the lead-up to the Great Recession (2007-2009) and during the brief Covid-19 recession (2020). A rapid drop in the net savings rate virtually always indicates the U.S. economy has either entered a recession or will soon enter one. It would not surprise me to ultimately learn that we are in recession as I write this blog. A lag for announcing a recession is not unusual. For example, the National Bureau of Economic Research (NBER) declared in December 2008 that the United States economy entered a recession in December 2007.

The primary culprit for the slide into negative territory in terms of the national savings rate would of course be Uncle Sam. The federal government has been operating at a fiscal deficit for over a quarter century now. The past few years have been particularly disconcerting as the government went on a spending binge while tax revenues remain weak. The Covid-19 pandemic and the development of the "green" economy serve as excuses for our government to accumulate limitless debt. The percent of disposable income saved by Americans has likewise reached disturbing levels. The personal saving rate in the U.S. averaged 8.45% between the years 1959 and 2024. The rate currently stands at 2.90%. Consumer spending has been robust and this has kept the economy plugging along. The American consumer is about to hit the wall, however.

Soaring inflation in the wake of the pandemic makes it harder for lower and middle-income earners to make ends meet. The cost of goods and services has increased a minimum of 25% since January 2020. Income has not kept pace. Everyday expenses are being funded by dwindling cash reserves and increased levels of personal debt. Credit card debt stands at an all-time high of $1.14 trillion (average interest rate of 21%) as individuals use cards to fill in budget gaps. Delinquencies and bankruptcies are steadily increasing. Due to reduced savings, most Americans won't have as much at their fingertips come a downturn or a shock that leaves them more financially vulnerable. Because of the precedent set by direct distribution of checks to most Americans during the early days of the pandemic, I expect they may be expecting and looking for a bailout when the economy tanks.

Next, we'll look at the long-term ramifications of a low or negative national saving rate. Spoiler alert - there is nothing positive about a scenario of that nature. The purpose of savings is to allow a country to finance its investment needs with its own resources. Investments are generated through savings. Household savings can be a source of borrowing for government to provide funds for public works and infrastructure improvements. Any deficiency in net national savings must be filled by foreign capital to make up the difference between net U.S. investment and net U.S. domestic savings. At negative net national savings, the United States is eating into its capital stock instead of adding to it. This cannot go on for long without putting the American economy at the mercy of the international capital markets. But here's the catch - where will all of the capital come from? Investors from China are no longer welcome on American soil. At present, Europe lacks sufficient savings to replace China as a source of capital.

Wrapping things up, it should be reiterated that an economy is dependent upon savings to grow, be vital, and provide prosperity for the participants of a nation's economy. Another financial crisis, perhaps equal or worse than the Great Recession (2007-2009) will eventually enfold on the U.S. economic landscape. History tells us that the countries with the highest savings rates before this nasty recession, were also the ones that were less affected by it. I anticipate this particular correlation will repeat.

 

    

Gold - A Barbarous Relic?

 One hundred years ago, in 1924, the seminal macro-economist, John Maynard Keynes, called the gold standard (and by proxy gold) "a barbarous relic." That said, with a 6,000-year history of stored value and cross-cultural popularity, gold remains relevant to this day and the foreseeable future. Due to the unprecedented fiscal irresponsibility of the major sovereign nations, especially over the past score years, the future importance and pecuniary value of gold may increase at an exponential rate. For historical context, it should be noted that the basis for our current global monetary system was established near the end of World War II in 1944 under the terms of the Bretton Woods Agreement. The most important provision of this Agreement was the United States dollar becoming the world's reserve currency. Other currencies were in turn pegged to the U.S. dollar, which in turn was backed by gold. The gold backing was discarded in 1971 when President Richard Nixon ended the direct convertibility of the U.S. dollar to gold. With the collapse of the gold standard, the reign of fiat currencies began.

Why is gold valuable? First and foremost, it is rare. Extremely rare. It's estimated that the amount of mined gold in the history of the world comes in just under 200,000 tons, with the majority of that total being unearthed since 1950. All of the world's mined gold would make up: "one cube with dimensions of 20.5 meters. If it was all melted, it would fit within the confines of an Olympic-sized swimming pool." On average, the global supply of gold increases by between 1.0% and 2.0% per year. It is difficult to discern the amount of gold remaining in the earth's crust that will eventually be mined. Obviously, there is a finite supply of gold. We do know that the easiest and least costly extraction of gold is nearing the end. Production from the known big geologic formations has "hit the wall" in recent years. People in the industry believe "peak" gold production is either at hand or will occur in the next 10 years. Based on known reserves, estimates suggest that gold mining could reach the point of being economically unfeasible by 2050. If demand continues to rise while available supply stagnates, the basic economic theory of supply and demand would suggest that prices will rise substantially in the future. Besides rarity, gold is durable. It does not corrode, atrophy, or deteriorate. For these reasons and others, gold has commercial applications in such areas as jewelry, electronics, aerospace, dentistry, and mobile phones.

The spot price for gold recently (8/16/24) closed above $2,500 (per ounce) for the first time ever - closing at $2,509.65. At that price, the value of all the gold in the world approximates $16 trillion. Central banks have been hoarding gold for the past few years - buying gold at a record pace - adding 1,037 tons in 2023 and 1,082 tons in 2022. For the first quarter of 2024 - global official gold reserves increased by 290 tons, the largest quarterly increase since 2000. Central banks are attracted to gold because of its safety, liquidity, and return characteristics. They also see it as a way to diversify away from the U.S. dollar, which has historically made up the majority of their reserves. Foreign central banks are wary of the United States weaponizing the dollar and our financial system to achieve adherence to U.S. foreign policy objectives. That is especially the case after the imposition of severe economic sanctions on Russia after it invaded Ukraine. At the individual retail level, Americans have been net sellers of gold in the past few years. That has not been the case in Asia where investors, particularly in China and India, have aggressively been buyers of gold.

There are powerful reasons why an investor would be wise to allocate a portion of their investment portfolio to gold. Under the principle of extra portfolio diversification, it makes sense to spread the value of one's portfolio across various asset classes. This allows you to minimize losses, as it's unlikely every asset will suffer from the same market conditions. Historically, gold has consistently provided a good hedge against inflation. When the inflation genie escapes from his bottle, the dollar's purchasing power goes down, sometimes precipitously. It is unsettling to an economy and a society when it takes more dollars to buy the same level of goods and services. Gold is considered a safe-haven asset. A war in the Mideast or another sensitive area in the world can elicit buying demand for gold and send the price for this commodity soaring. Investors often buy gold to protect their savings in the event of a market crash. They seek portfolio "insurance" in the event an overvalued equities market gets whacked 30%-50% in a bear market (something that happens on average every 7-10 years). It would be unbalanced not to mention a couple of drawbacks concerning gold ownership. Unlike bonds, real estate, and dividend-paying stocks, gold does not generate a stream of income. The only way to make money investing in gold is through price appreciation. There can also be storage or holding costs if physical gold is held by a third party.

There are fundamentally three different ways to invest in gold. One way is to own physical gold either in the form of coins or bars. Depending on the amount of gold, it can either be held in a bank safety deposit box, a safe in the investor's primary residence, or with a business providing safekeeping services. Some investors prefer to indirectly own gold via investing in ETFs or mutual funds that hold physical gold. The value of these investment vehicles is directly correlated with the market price of gold. Another play on gold, a riskier one, is to purchase stock in gold mining companies. The price volatility and management quality of these companies can pose problems for risk-averse investors. However, when conditions are favorable, outsized capital gains can be realized on gold mining stocks.

Next, we'll take a look at how gold performed compared to some of its competing asset classes over the past half-century. Between 1971 and 2024, gold returned 7.98% per annum, while the stock market garnered an annual return of 10.70%. However, if you look at the period from 2000-2024, gold has outperformed the returns of both stocks and bonds. Gold has had a good run over the past 12 months - returning 33.18% vs. the Nasdaq at 32.44% and the S&P 500 at 27.47%. The average American investor holds 1% of their investment portfolio in gold. Some investment advisors recommend an allocation of gold in the 5% - 10% range. I would be in that camp, advocating an allocation of 8%. That would be further divided as follows: 4% in physical one-ounce gold coins (American Eagles) and 2% each in the common stocks of Newmont Corporation (NEM) and Franco-Nevada Corporation (FNV).

What's in store for gold in the future, in particular, the value of gold as measured in U.S. dollars? Since gold is real money, hard money, in contrast to every fiat currency in the world, including the dollar, gold's reign as the ultimate currency for thousands of years will continue. Gold will keep appreciating as the various fiat currencies in the world depreciate. I believe the possibility exists that some governments may eventually incorporate gold confiscation programs. Between 1934 and 1974 it was illegal for U.S. citizens to own gold. In 1934 the Gold Reserve Act gave the United States government title to all of the gold coins in circulation and ended the minting of new gold coins. Forty years later in 1974 during the Ford Administration, Congress passed legislation to once again allow Americans to legally own gold. Led by the U.S. and its wayward fiscal and monetary policies, we are witnessing a train (global economy) wreck unfold. It may take another 8-12 years, and the dollar may be the last man standing, but the train and the current international monetary system (fiat money) is heading toward a violent derailment. Post-crisis, much like Bretton Woods in 1944, the major economies will meet somewhere and hammer out a new monetary system. We are not going back to the gold standard, but I believe gold will be in a basket of commodities that will back the new system. Making financial predictions 10 years out can be a fool's game. Since I at times qualify to play that game, I'm going to end this blog with a prediction that in a decade hence, the value of one ounce of gold will be closer to $15,000 than zero.