Pro Perspectives 8/4/22

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August 4, 2022

Don't underestimate the significance of the events of last Wednesday (last week).
 
Heading into that Fed meeting, we had made the case that with another rate hike, we may have reached the end of the tightening cycle.
 
Indeed, Jay Powell delivered reasons to believe that might be the case. 
 
He said they had reached neutral on rates (not accommodative nor restrictive of economic activity).  And he said they would no longer "guide" on policy, but take things meeting by meeting, dependent on the data.
 
Then, hours later, Congress approved nearly a quarter trillion dollars of fiscal spending, and then immediately disclosed that the Build Back Better agenda would be funded too.  Congress pulled out the bazooka, in the face of forty-year high inflation.
 
Now, let's assume that the Fed was fully privy to this government spending bazooka that was being loaded to fire.  And still, they told us explicitly that a "neutral" Fed Funds rate is more than 600 basis points below the most recent inflation reading.
 
If you didn't believe me when I said the Fed was using "tough talk" (and "forward guidance") all along, with no intention of aggressively fighting inflation, the sequence of events last week should give you plenty of pause. 
 
The Fed has been bluffing.  It's all been talk, no meaningful action.  They don't have the appetite (given the debt servicing conundrum) to combat inflation.
 
With that, if we look back through history, major turning points in markets have often been the result of some form of intervention (i.e. policy action or adjustment). 
 
This one-two punch of monetary and fiscal (in the same day!) would fit the description.  
 
With Congress's foot on the pedal, and the Fed foot coming off of the brake, we should be in for persistent inflation, but also high growth.  Asset prices, UP.  Dollar, down. 
 
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Pro Perspectives 8/3/22

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August 3, 2022

Yesterday we talked about the noise surrounding Pelosi's trip to Taiwan.
 
What was the geopolitical strategy behind it?  
 
Beyond all of the speculation about the signaling involved, there was good reason to believe there was a practical purpose to the trip.  
 
Again, it came on the heels of the passage of the Chips Act (which came just this past Thursday). 
 
And who is the most important chip producer in the world?  Taiwan Semiconductor (symbol TSM).  
 
Given the timing of it, we discussed the likelihood that this trip could mostly be about negotiating the building of more productive capacity, of the world's most advanced microchips, in the U.S. (via U.S. government subsidies).
 
Indeed, it was reported by Nikkei news that Pelosi met with both the founder and Chairman of TSM.  
 
Why does the U.S. government care so much about a Taiwanese chip maker that they would send the number three person in government, under the threat of Chinese aggression, to (likely) offer them (more) direct U.S. taxpayer money?
 
Because TSM has become critical to U.S. economic and national security.  Equally, it is critical to China's economic and national security. 
 
TSM is the world's chip manufacturer.  They manufacture 90% of the world's "advanced" microchips, which power the cutting edge digital technology, critical infrastructure and weaponry used today.  Most of the chip makers we know by name, have over the years become just designers, and have outsourced manufacturing to TSM.
 
That makes everyone vulnerable.  Thus, the Chips Act.  And thus the importance of protecting the global supply coming from Taiwan, until manufacturing and the technological leadership can be diversified (i.e. onshored to the U.S.).
 
TSM is already building manufacturing in Arizona.  And Intel is making strides to catch up to the sophistication level of TSM chips, while also making big investments to build manufacturing, including foundry business (where they produce competitor chips, too).
 
With the above in mind, most of the key chip stocks are down more than 30% on the year, yet are in the pipeline to get significant government money.  Institutional money tends to follow government money.
 
We own the cheapest (by far) of these chip stocks in our Billionaire's Portfolio, yet one that may be the biggest beneficiary of government subsidies.  It's among the highest conviction positions in the portfolios of two of the best value investors of all-time (both self-made billionaires).
 
If you're a reader of these daily notes and you have not yet subscribed to our member's only portfolio service, if you do so now, I'll send over all of the details on this chip stock.  Just click here, subscribe and join us.  

Pro Perspectives 8/2/22

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August 2, 2022

In late June, we stepped through the events that came out of a week of G7 and NATO meetings.
 
The week was littered with World War 3 flashpoints.
 
The U.S. and G7 allies banned imports of gold from Russia.  That was soon followed by a Russian debt default, forced by the asset freeze and banking sanctions (transactional restrictions) placed on Russia from the Western world.  
 
Next, NATO announced plans to increase “troops on high-readiness” from 40,000 to 300,000. 
 
Then the the G7 included in its communique that they would phase out Russian oil, and in the meantime, threatened price caps on Russian oil imports (which would only further limit global supply, and increase prices).   
 
Then Finland and Sweden signed an agreement paving the way to join NATO. 
 
Putin had already warned that he would respond (in kind) if NATO were to deploy military and infrastructure in these bordering countries (Finnish land border, and Swedish maritime border.  Biden then announced that the U.S. will ramp military presence in Europe by opening a permanent army base in the Poland (formerly controlled by Russia and flashpoint of WW2).
 
So, with all of this, we asked, is this flexing a position of strength to deter or to provoke?
 
Now we have this Pelosi trip to Taiwan. 
 
With all of the noise surrounding it, there hasn’t been a stated purpose for the trip.  Of course, Xi has warned that a visit by Pelosi would be playing with fire.  
 
So, again, is this a move to expose China’s bluff/tough talk, or is it to provoke some retaliatory response?
 
Keep in mind, this is an administration that has refused to call the Chinese government an enemy, instead calling it a “tough competitor.” 
 
What’s the plan?   
 
The timing:  This comes on the heels of the quick emergence and advancement through Congress of the coveted the democrat agenda (Build Back Better) late last week.  Within a new government spending deluge is the Chips Act, which includes $52 billion for chip makers.  Taiwan Semiconductor is already in the process of building chip manufacturing in Arizona, with the view of this money coming down the pike.
 
With TSM producing 90% of the world’s “advanced” microchips, Taiwan has been critical to the economic and national security of both the U.S. and China. 
 
Is Pelosi there to offer more incentives to move more TSM production to the United States?  Maybe.
 
With that in mind, here’s a look at the chart on TSM …  
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Pro Perspectives 8/1/22

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August 1, 2022

We head into August with a bear market for stocks behind us. 
 
That bear market was pricing in a Fed tightening campaign, which included the Fed’s threat of reversing QE (i.e. extracting liquidity from the system). 
 
And that tightening campaign, along with a bear market in stocks, produced a technical recession (two consecutive quarters of negative GDP growth). 
 
All of this delivered the justification the democrat-led Congress needed to push through more government spending, in the name of “inflation relief.”  As we discussed last week, and was admitted by the President, this is their coveted Build Back Better plan, now on path to be funded.
 
In short, the plan that created inflation (through policy-driven supply destruction of commodities, including labor), is now going to be super-charged under the label of the “Inflation Reduction Act.”
 
What should we expect?  Inflation.
 
And we should expect the Fed to do nothing to counter it.  
 
They’ve intentionally remained well behind the curve on inflation.  The last year-over-year inflation reading was 9.1%.  And yet Jerome Powell just told us that an effective Fed Funds rate of 2.3% is neutral.  They told us they would be shrinking the balance sheet by $95 billion at this point (two months into their quantitative tightening plan).  They’ve done just a third of that plan. 
 
So, we should expect inflation to persist, just without the headwinds of idle threats to contain it, from the Fed. And with nearly a trillion dollars of new government spending coming down the pike, on economically transformative spending, the economy will be hot.  The question is, will this tailwind of spending be enough for growth to outpace inflation (i.e. will it produce meaningful ‘real’ economic growth)? 
 
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Pro Perspectives 7/28/22

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July 28, 2022

Stocks continue to respond to a massive fiscal spend, that bubbled up very quickly, to combine with a Fed that appears to be signaling a continued low rate environment. 
 
As we discussed over the past two days, the advancement of these spending packages had "Build Back Better" written all over it.  It has been justified by a high inflation and (manufactured) negative growth first half. 
 
Biden couldn't help himself but to admit it (that it's BBB) in a speech this afternoon.
 
Like it or not, this is more fuel on the fire. 
 
This is a green light for a resumption of the rise in asset prices.
 
Below is a look at stocks. 
 
This trendline representing the decline since March (when the Fed started rate liftoff) has broken.
And the combination of more fiscal spending and less monetary tightening should mean pain for the dollar (i.e. lower).
A falling dollar should resume the bull market in commodity prices …
Welcome to the high growth, high inflation environment.
 
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Pro Perspectives 7/27/22

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July 27, 2022

The Fed delivered on expectations today, with another 75 basis point hike.
 
We've discussed the case for this possibly being the end of this tightening cycle. 
 
Jay Powell opened the door to that scenario today in the press conference.  He called the (now) Fed Funds rate of 2.25%-2.50% neutral (i.e. not accommodative nor restrictive of economic activity).  And he said they would no longer "guide" on policy, but take things meeting by meeting, dependent on the data.
 
Remember, if we look back at the last tightening cycle, this level on the Fed Funds rate is right around where the Fed was forced to stop and reverse on their tightening campaign.  Without repeating the entire case, the bottom line is, the domestic economy can't handle higher rates, nor can the global economy (mostly due to highly rate sensitive/unsustainable global credit markets). 
 
And as we discussed yesterday, simultaneously (and contradictorily), Congress is pouring more fuel on the fire. 
 
No sooner did the Senate finish a vote today, approving another $280 billion in government spending (of which $228 billion looks like climate and energy transformation, masked as a "China competitiveness" bill), than was the controlling party of Congress already announcing a reconciliation process to ram home the remainder needed to fund the "Build Back Better" agenda — with yet another $669 billion spend.
 
Remember, "Build Back Better" is the cornerstone of the global (G7) agenda, of which, the U.S. administration is in full, explicit cooperation to execute.  It's rooted in energy and social transformational policies, and it doesn't get done in the most important constituent country (the U.S.), if the democrats lose control of Congress in November.  As I said earlier this month, what will they do to ensure it gets done?  "Whatever it takes."  It looks like it will get done. 
 
With all of the above in mind …
 
I posed this question (and answer) last week:  "What will stocks do when the realization finally sets in that the Fed (and major global central banks) can't and won't do anything meaningful with interest rates?  Answer:  Stocks will soar."
 
Add to this, my closing statement from yesterday's note:  More fiscal spending, with monetary policy tools exhausting, is a formula for higher asset prices. 
 
Today looks like the realization day. 
 
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Pro Perspectives 7/26/22

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July 26, 2022

The interest rate market has a 75 basis point rate hike priced in for tomorrow's Fed meeting.
 
Let's revisit the Fed's projections from their June meeting. 
 
They revised down their 2022 estimates on GDP growth by more than a percentage point (to 1.7%).  They revised UP unemployment (but still well under 4%).  And they revised UP inflation.  
 
So, slower growth, higher inflation.  
 
We've seen it. 
 
Back in June, they also revised UP, dramatically, their projection for where the Fed Funds rate would sit at year end — to 3.4%.  
 
If they follow through with a 75 basis point hike tomorrow, in line with expectations, they will get the Fed Funds rate up to 2.25%-2.50%.
 
But remember, as we discussed yesterday, this will put the Fed Funds rate very close to where the Fed was forced to stop and reverse it's tightening campaign in 2019. 
 
Why did they stop and reverse? 
 
Things started breaking in the financial system.  And emerging markets were under the stress of capital outflows, driven by rising U.S. interest rates (threatening a global sovereign debt crisis).
 
Not only did they cut rates in July of 2019, they quietly stopped shrinking the balance sheet and restarted QE by late summer. 
 
With all of the above in mind, despite the continued jawboning and "guidance" the Fed continues to promote, we've discussed the likelihood that tomorrow's hike could/should be the last in this tightening cycle — for no other reason than the financial system and global debt markets can't withstand higher rates. 
 
Now, consider this …
 
We still have $6 trillion of money supply growth in the U.S. economy over the past two years.  That's an increase in the money supply by one-third.  It's ten years of money supply growth in two years.  The result?  A reset in prices higher (i.e. a devaluation of money in your pocket). 
 
Still, fiscal policymakers are so (not) concerned about this rate/inflation conundrum that they (the Senate) have just approved another $280 billion fiscal spend. 
 
This is the "Chips Act," of which only 19% goes directly toward subsidies for chip makers. 
 
That leaves $228 billion worth of handouts allocated in the name of "research."   The section-by-section summary at senate.gov is littered with money for "energy."  This looks like Build Back Better lite.
 
More fiscal spending, with monetary policy tools exhausting, is a formula for higher asset prices.   
 
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Pro Perspectives 7/25/22

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July 25, 2022

We’ve talked about the set up for a good second half.
 
This Wednesday, we should get another 75 basis points of tightening by the Fed.  And on Thursday, we should get confirmation from the
BEA’s advanced Q2 GDP report, that the economy was indeed in recession through the first half of the year (a second consecutive quarter of contraction in GDP).
 
The rate cycle is cause, and the recession is effect. 
 
It was the signaling from the Fed (on rates) that killed the animal spirits in the economy.  It was signaling from the Fed (on rates) that led to the inversion of the yield curve in early April (an historic predictor of recession).  And it was the signaling from the Fed (on rates) that led to the discounting of recession in the stock market.
 
That all resulted in the worst first half for stocks in more than 50 years.
 
So, how does this set up for a good second half? 
 
As we’ve discussed, there are good reasons to believe this week’s move by the Fed could/should be the last move in this tightening cycle.
 
That would be a positive catalyst for stocks and the economy. 
 
It would leave the Fed Funds rate at 2.25-2.50%.
 
It would put the effective Fed Funds rate right around where the Fed stopped and reversed in July of 2019. 
 
Of course, we’ve already talked about the Fed’s clear lack of appetite to make any meaningful adjustment higher to interest rates, in this current tightening cycle. 
 
It can’t because it exacerbates the domestic debt burden.  And it can’t because higher U.S. rates creates a flood of capital out of all parts of the world, and into the U.S. dollar.  
 
Both become problems for domestic and global economic stability. 
 
On that note, both debt and the global capital flight conditions are worse today, than in 2019, when the Fed pulled the plug on its tightening campaign:   The domestic debt burden relative to GDP is about 25% higher today, and the dollar is about 8% stronger today, compared to the summer of 2019.
 
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Pro Perspectives 7/22/22

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July 22, 2022

Standard and Poor’s published its Purchasing Managers’ Index report this morning.  This is a “flash report” projecting the way July private sector output is tracking.
 
It wasn’t good.  The index fell from 52 to 47 (weighed down by services, not manufacturing).  
 
Below 50 is considered to be contraction in activity, which tends to be consistent with a contraction in the economy. 
 
This has people taking about “possible” recession.
 
But as we’ve discussed here in my daily notes, the economy has very likely already been in recession — for the first half of the year. It’s old news.  
 
Remember, the official GDP contracted in Q1 by 1.6%.  And a model the Atlanta Fed uses, to track all of the inputs used by the BEA to calculate the official GDP number, has been projecting a negative number for Q2 since late June. 
 
That projection now stands at -1.6%, and we only have a few data points for the month of June yet to be incorporated.  That data will come next week.   
 
With that, by Thursday of next week, we will get the first look at Q2 GDP.  It will very likely be negative.  Two consecutive quarters of negative GDP is by definition, a recession.
 
This is technical recession, driven by high inflation (which is driven by both policy and pandemic driven supply deficits). 
 
But what does this technical recession really say about the health of demand? 
 
If we look at the nominal rate of economic growth it’s running hot — better than seven percent annualized based on the Atlanta Fed model.
 
For perspective, take a look at the past seventy years of nominal GDP growth.  This nominal growth rate is “rare air” for the U.S. economy, only seen in times of high inflation (which we are experiencing).   

Of course, when we subtract a 9.1% year-over-year inflation rate, we get negative “real” GDP (i.e. after the effects of inflation).
 
But that’s all in the rear-view mirror, and aligns with a stock market that quickly discounted such a first half. 
 
More importantly, what’s in store for the second half of the year?
 
Heading into the first half of the year, the Fed was clearly going to embark on a new tightening cycle.  A rising rates environment is a recipe for lower P/Es (lower valuation on stocks).  The P/E on the broad market has indeed fallen, from well north of 30 (ttm) to around 20.   
 
Heading into the second half, there is a fair case to be made that this tightening cycle is near the end — perhaps as early as next week (with one more hike).
 
Add to this, the job market remains strong.  And consumers and business balance sheets remain strong (as just confirmed in bank earnings reports).
 
This sets up for a good second half. 
 
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Pro Perspectives 7/21/22

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July 21, 2022

The European Central Bank raised rates this morning for the first time in eleven years.  They surprised markets with a 50 basis point hike (market was expecting a quarter point). 
 
This takes the benchmark short-term lending rate in Europe to a whopping zero percent. 
 
Yes, after watching print after print of record high eurozone inflation (eight consecutive months of new, higher record inflation – resulting the chart below), the ECB is so interested in becoming inflation fighters that they have just now decided to exit negative interest rate policy.
If you somehow believed the lip service the Fed has been giving us, about alleged intentions to "expeditiously" raise interest rates, this view of Europe should set you straight.
 
The Fed has done a lot of talking, and yet has set (deliberately) the effective Fed Funds rate at 750 basis points UNDER the rate of inflation. 
 
In Europe, the ECB is 860 basis points UNDER the rate of inflation.
 
What tools do the central banks have to kill inflation?  Rates.  What does it take, historically, to kill inflation.  It takes moving the short-term rate ABOVE the rate of inflation.
 
Neither have done it.  And though they've done a lot of talking, they haven't even taken a "shot across the bow" with a big and bold rate move.  Remember, as Bernanke said, after launching QE to respond to the Great Financial Crisis, "we could raise rates in 15 minutes" to combat any concerning inflationary consequence.  
 
Bottom line:  As we've discussed often in these daily notes, even if the U.S. economy could withstand the pain of higher interest rates (which includes our government's ability to service its debt), the rest of the world can't.
 
Sticking with Europe, what would happen if the ECB were to really take on the inflation fight with higher rates?  The fiscally fragile countries of Europe would quickly become insolvent, unable to sustain on higher borrowing costs.  And the dominoes in Europe would begin to fall, which would lead to sovereign debt dominoes falling around the world.   
 
On that note, what did the ECB incorporate into today's decision?  A newly branded asset purchase plan.  On the one hand, they are telling the world they are "tightening" policy to curtail inflation, and on the other hand, they are restarting QE (reopening the liquidity spigot they just closed on July 1st). 
 
This new iteration of ECB QE, called the Transmission Protection Instrument (TPI), is a plan/threat to be the buyer of last resort of the sovereign debt of these weak eurozone countries, to keep a lid on their borrowing rates. 
 
What does it all mean? 
 
We can look to the interest rate market behavior today for the answer. 
 
After the first rate hike in Europe in eleven years, at a market surprising 50 basis points, key global interest rates moved lower on the day (that includes German and U.S. rates).
 
What will stocks do when the realization finally sets in that the Fed (and major global central banks) can't and won't do anything meaningful with interest rates?  Answer:  Stocks will soar.  
 
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