Nowhere To Hide
MWM Q2 2022 Tactical Short Conference Call
July 21, 2022
David McAlvany: It’s great to be with you today. This is David McAlvany, and I’m joined by Doug Noland to discuss the second quarter for Tactical Short. The presentation today is “Nowhere to Hide.”
Glad you could join us today. Want to remind you of some valuable resources that are at your disposal each week. Many of you are familiar with Credit Bubble Bulletin. If you’re not, it’s an invaluable read. I would start your weekend with a strong cup of coffee and a thorough reading of the Credit Bubble Bulletin, where Doug can share with you insights from the week and performance in various markets.
An incredibly valuable daily service that you’ll find is the curation of articles. I would encourage you to be joining us on the website daily, and again it’s in the Credit Bubble Bulletin section, but Doug does a masterful job of curating articles of interest from 20 or 30 different news sources. So if you’re looking for a significant time saving device as you’re trying to understand what’s happening in the world on a daily basis, a weekly basis, et cetera, that is a great place to visit.
So on a daily basis in the Credit Bubble Bulletin section on our website, mwealthm.com, you’ll find the curated news. Saturday morning, you’ll find the Credit Bubble Bulletin. If you’re also interested, of course, we have the Hard Assets Insights, which is a weekly summary of the markets as it relates to tangibles, and the Weekly Commentary, which is now in its 15th year as a podcast. This is a unique offering as well, what we do here on a quarterly basis. We hope that it is of value to you to get a macro overview and an insight into performance for our Tactical Short product.
So I just want to start with a special thanks to our valued account holders. We greatly value our client relationships, and are glad that you’ve joined us today.
I’m going to cover performance and then transition to Doug’s comments, and then we’ll both come back around to the Q&A. As a reminder, many of you submitted questions ahead of time. If you are on the website, M as in McAlvany, wealth, and then M as in management, so mwealthm.com, bottom right hand corner of the front page, there’s a place for you to submit questions. So if there’s something that you want us to expand on, clarify, or are generally curious about, then we’ll do our best to throw those questions in at the end of the long list of questions which have already been submitted.
So again, on our website, if you want to add another question, we look forward to addressing that towards the tail end of the presentation. So without further ado, let’s dive in.
I know there’s a number first time listeners on the call today, so we’ll begin with some general information for those who are unfamiliar with Tactical Short. Of course, you can get more detailed information that’s available at mwealthm.com/tacticalshort.
The objective of Tactical Short is to provide a professionally managed product that reduces the overall risk in a client’s total investment portfolio while providing downside protection in a global market backdrop with extraordinary uncertainty and extreme risk. This strategy is designed for separately managed accounts, is very investor friendly, with full transparency, with flexibility, with reasonable fees, and with no lockup. We have the flexibility to short stocks and ETFs. We also plan on occasion to buy liquid listed put options. Shorting entails a very unique set of risks, and we’re set apart both by our analytical framework and by an uncompromising focus on identifying and managing risk.
The Tactical Short strategy began the quarter with short exposure targeted at 77%. That is the highest level in the history of the strategy. The target remained steady during the period due to the highly elevated risk environment for shorting. We focused on the S&P 500 ETF. That was our only short position during the quarter. We’re not proponents of aggressive market bets, including against the stock market. As we stress in every call, remaining 100% short all of the time, as most short products are—that’s how they’re structured—that’s what we would define as risk indifference.
While aggressive shorting has been rewarded recently, the market rally over recent years has inflicted huge losses on the short side for those who are indifferent to risk. We continue to believe a disciplined risk management approach is absolutely essential for long-term success. We’ve structured Tactical Short to ensure the flexibility to navigate through even the most challenging market conditions.
So let me give you an update on performance. Tactical Short accounts after fees returned 13.61% during the second quarter. The S&P 500 returned -16.11 for the quarter. So for that timeframe, Tactical Short accounts returned 85% of the S&P’s return. Again, we returned 85% of the S&P’s return. As for one-year performance, Tactical Short after fees returned 6.29 versus the -10.64 for the S&P 500. That’s over a 12-month period.
We regularly track Tactical Short performance versus the three actively managed short fund competitors. First, Grizzly. Grizzly Short Fund returned 22.21% during the second quarter, and over the past year, 27.96%. Ranger Equity Bear Fund, another fund we keep track of, returned 31% for the quarter, 39.47% over four quarters. Federated Prudent Bear returned 18.77 during Q2 and 4.67 over the four quarters or for the full year.
While we underperformed this quarter, Tactical Short has significantly outperformed each of the bear funds since inception. As I mentioned earlier, a number of the rallies that we’ve seen with these funds being 100% exposed has left them with deep holes to dig themselves out of. So from April 7th, 2017 inception through the end of September, Tactical Short returned negative 33.58% versus 76% positive return of the S&P 500. On average, that outperformance, compared to our competitors, that outperformance measures up to 2,570 basis points.
There are also popular passive short index products. There is the ProShares Short S&P500 ETF, which returned 17% for the quarter and 7.21 over the past year. The Rydex Inverse S&P 500 Fund returned 16.72 during Q2, 6.61 over the four quarters. Last but not least, there’s the PIMCO StocksPLUS Short Fund, which returned 15.58 for the quarter and 6.56 for a full year.
Brief comments on performance. Tactical Short definitely lagged the riskier strategies during the quarter and over the past year. In periods where the high beta and short stocks get crushed, we will underperform. We understand that. But it’s worth repeating that we still have significantly outperformed on a longer-term basis. The riskier strategies dug really big holes, and they’re still climbing out of those holes. So in fact, two of our competitor short funds had 30% drawdowns, 30% losses, during an individual quarter. One of those funds had two quarters of at least 30% losses. The way it works: Most investors in the short side suffered huge losses, typically likely abandoned those short products, and were not positioned to recoup losses during this downdraft.
It’s worth noting that Tactical Short’s one-year performance was similar to the three lower-risk short strategies, even though Tactical Short took less risk over the same period of time. Again, less risk because we were not 100% short versus the S&P. These other strategies rebalance their short exposure back to 100%, and they do that on a daily basis. Tactical Short approaches rebalancing, as it says in the name, more tactically. We specifically don’t rebalance daily, and allow short exposure to fluctuate within a band around our target.
Moreover, we lean heavily on a broad mosaic of indicators to provide an edge for the timing of the rebalancing of those trades while striving to be opportunistic in our rebalance trading effort. This approach on the margin helped performance relative to the indexed short fund products. There were periods of market weakness where we didn’t add short exposure to get back to target, and then we’re able to do some rebalancing trades during market rallies that on the margin benefited performance. Candidly, we were looking for opportunities to increase our short target during the quarter, but we didn’t pull the trigger.
There were several instances where we were prepared to boost the target, but then international developments would lead to big gap down openings in our markets, and we backed away from raising the target, choosing to wait for a better opportunity. We can always look at these things in hindsight, and in hindsight we should have been more aggressive in raising the target to 80%, but our strategy is to err on the side of caution in highly volatile and unstable market environments.
That’s the beginning of our time together. Doug, I feel, will share some comments with us, and again, we’ll come back to Q&A towards the tail end.
Doug Noland: Thanks, David. Good afternoon, everyone, and many thanks for being part of today’s call.
We certainly recognize these are trying times. Few of us have been spared from what has been an all-encompassing market decline. What I hope to do today is to focus on an overarching mission of informing and educating. This is such an extraordinary and confounding environment. There’s no doubt about that. My objective is to further expound on an analytical framework that hopefully sheds some light on such a macro backdrop. It’s not a positive message, and I apologize for that. I would prefer not to be the messenger in such circumstances.
With Q2 validating my analytical framework and thesis, my commitment to analytical integrity compels today’s cautionary message. With that said, let’s cut to the chase: nowhere to hide. Stocks were hammered. Fixed income fared only somewhat better. Treasurys—and I’ll use the iShares Treasury Bond ETF for return purposes—returned negative 12.6% during the quarter, and is down 20% year to date. The iShares Investment Grade Corporate Bond ETF returned negative 8.4% for the quarter. The iShares High Yield ETF returned negative 9.48.
Through mid-June, commodities had offered a refuge from the pounding being taken by financial assets. At its June high, the Bloomberg Commodity Index was sporting a 15.3% quarter to date gain. Crude traded up to almost $124 a barrel. Natural gas surged to a 44% quarter to date gain. But then commodities reversed sharply lower during the final couple weeks of the quarter. The Bloomberg Commodities Index ended Q2 with a 5.9% decline, with most of crude’s advance gone—and natural gas actually ended the quarter lower. Even gold and silver, that had been safe havens, reversed sharply lower and posted Q2 losses. With global yield surging along with the dollar, losses continued to mount in the emerging markets and their currencies or stocks and bonds.
Meanwhile, one of history’s great manias collapsed in spectacular fashion. Cryptocurrencies suffered catastrophic losses with withdrawal suspensions, insolvencies, panic runs—in general, chaos engulfing the entire sector. Bitcoin sank 59% during the quarter to 18,700, with prices down 73% from November 2021 highs. Most of the other cryptocurrencies were hit with even larger losses. In short, the so-called everything bubble transitioned to bubbles bursting everywhere. The backdrop beckons, at least in my eyes, for some credit and bubble analysis.
Bubbles are a monetary phenomenon. There is invariably an underlying source of credit expansion driving a, in quotes here, “self-reinforcing but inevitably unsustainable inflation.” That’s my bubble definition. As I am fond of explaining, a bubble fueled by junk bonds might turn a little crazy, but it would not be expected to pose major systemic risk. Because of the elevated riskiness of the underlying credit, a junk bond issuance boom will reach a point where apprehensive buyers say, “No more junk. No more junk. I’ve got enough,” and this point of risk aversion ensures the bubble doesn’t inflate year upon year, thereby inflicting deep structural damage.
A bubble fueled by money, credit instruments perceived as safe liquid stores of value, well, that’s a completely different animal. Unlike junk bonds, money enjoys insatiable demand. We literally can never get enough of it. Bubbles fueled by money-like instruments can inflate for years, in the process imparting deep structural maladjustment to market, financial, and economic structures. For real life examples, think of the late ’90s dot-com bubble, fueled by a boom in telecom and corporate debt along with ample speculative leverage.
It was certainly spectacular, but excess for the most part was contained within the technology arena. Its bursting caused ample market pain and some economic hardship, but not being systemic, aggressive Fed stimulus rather quickly reflated the system, certainly boosted by the strong inflationary bias that had developed in housing. The mortgage finance bubble here in the U.S. was significantly more systemic, fueled by AAA money-like mortgage securities. This more prolonged bubble went to gross excess, with associated major structural maladjustment. Accordingly, the bursting episode was much more destabilizing for the markets, the financial system, and overall economy—the so-called great financial crisis. Even with an unprecedented one trillion of QE, it took years for even radical monetary inflation to generate system-wide reflation. With that theoretical backdrop, let’s delve into the everything bubble.
Appraising the Fed’s post bubble analytical and policy framework, I began warning of the potential for the global government finance bubble back in 2009—what I called the granddaddy of all bubbles. With the introduction of QE in conjunction with massive fiscal deficits, the expansive bubble, it had finally made it to the very foundation of finance—central bank credit and government debt. From my analytical perspective, it was the worst-case scenario. The bubble was being fueled by an egregious inflation of money, and it was all enveloping the world.
I also introduced the concept of moneyness of risk assets, and that’s an expansion of my moneyness of credit tenet from the mortgage finance bubble era. Basically, the Bernanke Fed was using zero rates and inflating market prices to coerce savers into stocks and bonds, and then aggressive monetary stimulus was employed to backstop the markets, thus promoting the perception of safety and liquidity. Stocks, they always go up. It was all reckless inflationism that was clearly fueling dangerous asset and speculative bubbles.
Sure, there were some serious bouts of instability along the way, 2012, 2013, 2018, 2019, and March of 2020. In each instance, the Fed and global central bank community adopted the ever more radical monetary inflation necessary to sustain bubbles. It all culminated during the pandemic, with five trillion from the Fed and similar amounts from the ECB and BOJ. There were trillions more from central banks everywhere. It was monetary and fiscal stimulus—inflationism—on a global basis, the likes of which the world had never experienced.
Importantly, the bubble inflated for an incredible 13 years. History teaches that things can get very crazy at the end of bubbles. We witnessed some of the craziest things ever. I think readers far into the future will ponder this era as we do the tulip bulb mania and John Law’s Mississippi bubble. Most, unfortunately, it’s all coming home to roost.
David: Doug, of course, the commentary on inflation was first dismissive, leaning heavily on the word transitory. Now, you’ve got Fed officials who have leaned, again more recently, on the idea of peak inflation, trying to put the worst in a historical context—it was bad instead of a present tense is. I think it’s fair to assume that the extremely low levels of inflation from recent decades are what actually fit that past tense. Maybe we aren’t flirting with double digits going forward, but how realistic is that quick return to 2%?
Doug: Sure. Yeah. Excellent question. Last quarter, during that call, I discussed the unfolding new cycle, and we believe inflation dynamics have fundamentally changed. I doubt inflation will stay above 9% for long, but I do believe the Fed will be challenged to get and to keep inflation under control. There were some anomalies that played major roles in keeping consumer price inflation relatively contained throughout the previous cycle. Technological innovation, globalization, and the historic development in China and the emerging markets. That’s just to name the most obvious.
I don’t see any of these factors playing the same type of role in the new cycle. Also, and this is a key point, financial assets, they have lost the huge advantage they enjoyed over real assets throughout the previous financial boom cycle. Now, with consumer prices having been unleashed and inflation psychology altered, a chasing Fed and global central bank community have begun to adjust their doctrines now to stress resolve and containing inflation. This is a secular sea change. During the previous cycle, the relatively benign consumer inflation, it nurtured monetary policy drift to a securities market focus.
This created a self-reinforcing dynamic whereby liquidity injected during QE operations, it specifically gravitated right to the financial assets, in the process stoking speculative bubbles while having limited inflationary effect on general consumer prices. The way it works, liquidity always inherently flows in the direction of the strongest inflationary biases. During the previous cycle, that was financial assets. But we don’t expect this dynamic to hold sway going forward. I don’t think we can overstate the significance of the so-called Fed put during the previous cycle. This liquidity backdrop that morphed over time into whatever it takes, zero rates, and trillions of QE created the perception of moneyness throughout the financial markets.
Stocks became a “can’t lose,” corporate debt the same, and even the cryptocurrencies. The same can be said for derivatives in the Wall Street area of structured finance, private equity, and venture capital where it can’t lose. You couldn’t lose with hedge funds and leveraged speculation. This central bank-induced moneyness of everything stoked a historic period of myriad synchronized bubbles across the globe. History offers nothing remotely comparable. But the game has changed, and this lies at the heart of the unfolding new cycle.
The central bank liquidity backstop has turned problematic and ambiguous. In the end, I do believe central banks will have no alternative than to use QE to counter the forces of bursting asset and credit bubbles. But inflation’s resurgence suggests the halcyon money free-for-all days—they’re behind us. We’ll return to the new cycle theme, but let’s address a few of these bursting bubbles. In this regard, I find the periphery and core instability analytical framework particularly helpful in these kinds of environments.
As the cycle begins to turn, risk aversion takes hold first out at the periphery, with the more fringe regions, countries, markets, sectors, and companies. When finance is loose, it’s the fringe that sees the greatest impact from risk embracement and liquidity excess, offering enticing speculative opportunities. But when the cycle inevitably turns, the maladjusted periphery is vulnerable to even subtle shifts in risk tolerance and financial conditions, losses, de-risking/de-leveraging, and waning liquidity gain momentum, leading to contagion effects that over time gravitate from the periphery to the core.
This dynamic attained robust momentum during Q2, powerful de-risking/de-leveraging took hold throughout the emerging markets, with currencies and bond markets under heavy liquidation. The unwind of levered EM carry trades fuel the self-reinforcing dynamic of dollar strength, waning liquidity, and intensifying de-risking/de-leveraging. To support their faltering currencies, EM central banks resorted to aggressive rate hikes along with the sales of treasuries and other international reserve holdings.
It all fed a dramatic tightening of global financial conditions for a world that until recently had the semblance of endless liquidity abundance. China’s international reserves dropped $116 billion during Q2, suggesting significant capital flight. China’s currency lost 5.4% versus the dollar.
David: I think this is a pretty critical point to make. A number of people have asked us, curious—on the one hand, China has $3 trillion in reserves, which means maybe 116 billion is just a drop in the bucket. But on the other hand, we don’t know precisely the composition of those reserves. There may be less latitude than you might assume with such a large number. We do know that markets often extrapolate trends. So if the declines in international reserves persist, or if they grow in size going forward, there can be a point that market operators get concerned. So that move in the RMB is pretty critical to keep an eye on.
Doug: Yeah. Excellent point. Thank you, David. Yeah. China’s bubble collapse, it’s recently taken a turn for the worse—perhaps a decisive turn. Recall that China faced heightened instability late in Q1. Its developer bond market crisis had jumped from the periphery to the core, with Country Garden, China’s largest developer, seeing bond yield spike from 6½% to surpassed 30%. Predictably, Beijing moved forward with a series of aggressive stimulus measures that temporarily calmed the developer bond market while spurring a pretty decent stock market rally.
There were Covid outbreaks, including an extended crippling lockdown in Shanghai. Beijing announced more stimulus measures, including plans for massive infrastructure spending. Then something very important transpired. Despite all of Beijing’s measures, developer bond yields began rising again. The crisis deepened. China’s apartment bubble is one of history’s greatest bubbles. Its collapse comes with momentous ramifications for China’s economy and financial system, along with the global economy and the global financial system. There are clear geopolitical repercussions.
Crisis dynamics often move at a glacial pace, only to suddenly accelerate at seemingly lightning speed. Crisis dynamics can appear manageable for some time, only to reach a point where fear takes hold that they might be uncontainable. China’s crisis is on such a trajectory. Last week, a movement caught fire where owners of uncompleted apartment units decided to stop making mortgage payments. Within a few days, developments in a hundred cities were impacted.
We might look back at last week and see it as a critical juncture in the crisis, a point where crisis dynamics began to turn systemic. Keep in mind that this is new territory for China’s households, developers, banks, regulators, and Beijing officials, all experiencing their first housing mortgage finance bust. It’s worth noting that consumer—in China that’s chiefly mortgage—consumer borrowing has almost doubled over the past five years, and was up fourfold in 10 years to almost 11 trillion. Chinese bank assets—and by the way, they were up almost 2 trillion just during Q1—surged 50% over the past five years, 200% in 10 years to an astronomical 53 trillion.
Country Garden saw its bond yield surge a full 11½ percentage points last week to a record 41%. These bonds were yielding 3¼ in September. Another top-five developer, Longfor, their bond yields spiked 23 percentage points in eight sessions to 126%. Sunac jumped to 117%, Evergrande yields to 141%. Vanke, another top developer—and they’re worth special attention here—it’s considered the financially strongest of the major private sector developers. Its bonds were yielding 3% in September, with its credit default swaps priced at below a hundred basis points. Well, Vanke yields have surged to 10%, with its CDS surpassing 550 basis points. The market is saying China’s apartment bubble has made it to the strongest, to the core. If Vanke is now in trouble, I believe China’s bubble collapse is quickly approaching the point of no return. And we’re talking about an industry with trillions of liabilities.
David: Doug, so there’s the global economy and the global financial system, which, if you’re considering the domino effect, is certainly a part of this issue—the Chinese economy and the financial system, and the weaknesses here. But I think we can sometimes lose perspective on large numbers. We tend to lose track of the importance of certain statistics when scale scrambles the brain. Yes, these developers are in real trouble. And you brought this up in this week’s weekly meeting, they have obligations they can’t fulfill. As an example, Country Garden, as you shared this week, it’s just one company, they need $50 billion to complete their existing projects. 50 billion. That’s on par with the combined capitalization of all the big US developers. The debt markets are looking and saying it’s a real issue. Country Garden, and a lot of these other companies, they just don’t have a lot of value, even in liquidation. Debt trading at 13 cents on the dollar for Longfor, Kaisa at 10 cents on the dollar, Sunac, 12 cents on the dollar, Sunshine, 7 cents on the dollar. So, I hope that we don’t lose perspective when trillions are referenced. We’re talking about something that ultimately has systemic concerns globally, can’t be ignored, and really, containment is a challenge because of the scale.
Doug: Yeah, and it’s a historic credit collapse unfolding. And not many people are paying enough attention to it.
Corroborating the thesis that China’s crisis has turned systemic, Chinese bank stocks sank almost 8% last week as China’s bank CDS spiked higher, blowing past the highs from that March instability period. Notably, China Construction bank CDS jumped 25 basis points last week to 123 basis points. And these numbers don’t mean much to most of us. It surpassed the March 2020 pandemic crisis spike. But this is a bank with over $4 trillion of assets, one of the largest banks in the world. And you see a spike in nervousness in the marketplace like that. Of China’s other big four, Bank of China’s CDS surged to a high last week going back to 2014, China Development Bank and Industrial and Commercial bank, their CDS rose to highs back to 2017.
And we could call it the Beijing put. China’s historic credit and apartment bubbles, they’re unmitigated disasters. And we can talk about these big numbers and the ramifications, yet markets have been content to look the other way while renewing its faith in the almighty Beijing meritocracy. No issue is too big to be resolved by the communist leadership, no amount of debt too excessive, no bubble too big, no degree of structural maladjustment too deep for Beijing stimulus. And apparently there’s no economic downturn that won’t be countered by boundless Beijing-directed lending and spending.
Well, I remember the mantra from mid-1998, the West will never allow Russia to collapse. And then, in 2006-07, Washington will never allow a housing bust. Today it’s Beijing won’t allow financial and economic crisis, it won’t tolerate fallout from bursting bubbles, not with its global superpower status on the line. And this is precisely the mindset that sets the stage for destabilizing crisis. First, faith in government control underpins sustained credit and speculative excess and associated maladjustment. The [inaudible] would had given up on Chinese banks years ago if they didn’t believe that they would be bail bailed out by Beijing.
Bouts of instability resolved by government actions over the course of a cycle only emboldened risk taking. With everyone well conditioned, confidence is sustained for a while, even as bubbles begin to deflate, as we’re witnessing. Importantly, however, there reaches a critical juncture where speculative de-risking/de-leveraging attains a certain momentum where resulting instability forces markets to begin questioning whether policymakers actually do have things under control. I refer to the “Holy crap!” moment. In 1998, this dynamic revealed egregious leverage at long term capital management and elsewhere. In 2008, it was with Lehman and Wall Street finance. The unraveling process commenced last week in China, the movement to halt mortgage payments was on the heels of some protests by depositors of failed banks. I believe there’s growing recognition that the Chinese people are being pushed to their breaking point. A most protracted bubble inflated many things, including expectations.
The Chinese have been willing to tolerate increasingly brazen government repression because of confidence that a highly effective Beijing would continue to improve standards of living. This trust is being shattered. There is heightened recognition that Beijing has seriously mismanaged economic development. Zero Covid is seen by many as terribly misguided government overreach. And I would imagine there are, these days, many questioning China’s partner without limits alliance with Putin’s Russia. If not already, the bloom is at least coming off the rose for Beijing. Inflating bubbles create genius, while bubble deflation spawns blunders and incompetence. From my perspective, a crisis of confidence is unavoidable. The degree of mismanagement—especially in regard to credit and speculative excess, its banking system—has been shocking. And with Beijing now forcing aggressive crisis lending, including to insolvent developers, how long can confidence be maintained in China’s bloated banking system?
But here’s what has me really worried. It’s not just Beijing that is facing a crisis of confidence. Right now, the emerging markets confront sinking currencies, de-risking/de-leveraging, hot money outflows, and a dramatic tightening of financial conditions. And it’s anything but clear what reverses these dynamics. I’ve witnessed a number of EM crises during my career, but never has there been such a setup like today’s dominoes, all lined up across the globe. In Europe, the ECB raised rates 50 basis points today for the first hike in 11 years. And even its main policy rate hasn’t even made it to positive yet. The troubled European periphery is already under acute stress. Highly indebted and dysfunctional Italy is in the crosshairs. Mario Draghi resigned earlier today, Italian parliament was dissolved, and there will be at least two months of uncertainty with elections now scheduled for September 25th.
Crisis dynamics engulfed European periphery bonds last month with destabilizing yield spikes in Italy and Greece. The ECB responded with a pledge to create a so-called anti-fragmentation tool, which essentially means more QE directed at Italian and periphery bonds to thwart bond market collapse. A vague outline of this program was announced today. Not surprisingly, the Germans, Austrians, and others are opposed to printing more money to support fiscally irresponsible governments. After all, the ECB’s balance sheet has inflated 5 trillion over recent years, and now Europe faces a serious inflation problem to go along with an energy crisis and economic stagnation.
It should be obvious by now that money printing will not resolve Europe’s issues. I’ve argued that at the end of the day, don’t expect the Germans and Italians to share a common currency. And that’s why the ECB and global markets turn so anxious when European periphery yields spike. It poses nothing short of an existential threat to European monetary integration. The ECB faces a crisis of confidence. They’re concocting a liquidity backstop mechanism for the eurozone’s periphery that, truth be told, they really hope they don’t have to use. When they are forced to employ bond support operations, and its efficacy is questioned, they will then face the very real prospect of a serious run on periphery bond markets, and even the euro currency.
And speaking of runs on bond markets, I fear the Bank of Japan is also facing a crisis of confidence. The Bank of Japan has been creating and spending hundreds of billions to maintain its 25 basis point ceiling on Japanese ten-year yields. This was a crazy bad idea to begin with, and these days, with inflation spiking globally along with yields, it has become untenable. The yen has sunk to 20-year lows versus the dollar, and confidence in the yen and monetary management has taken a big hit. When their misguided yield peg breaks, there will be serious risk of a major bond market dislocation and currency turmoil.
Let’s now turn our focus homeward, away from the periphery and more to the core. Inflation surpassing 9%, bursting bubbles, a sour public mood, economic fragility, and a central bank facing a very serious crisis of confidence of its own. Contemplating the extraordinary backdrop, it’s critical to think secular rather than cyclical. Unfolding financial and economic crises are decades in the making. Recently, J.P. Morgan’s Jamie Dimon warned of a potential hurricane. A PIMCO manager last week said he expects more of a shower.
I am reminded of a passage from a book I read years ago analyzing the late ’20s. It said, “Everyone was prepared to hold their ground, but the ground gave way.” There’s an incredible amount of complacency these days, especially considering the environment. Ominous developments at the global periphery are easily disregarded. This is typical. The dollar is exceptionally strong, commodity prices have reversed sharply lower, and bond yields are lower. And some see the Fed winding down its tightening cycle in the not-too-distant future. And all of this, yeah, it supports the narrative that peak inflation has passed and market lows have been established. Meanwhile, global de-risking/de-leveraging, illiquidity, and contagion are bearing down on the core. And we’ve already witnessed serious stress unfold at our own periphery. The crypto bubble is collapsing, revealing a lot of leverage, a lot of shenanigans. The corporate debt market has also taken a hit, the junk bond market has been largely shut to new issuance for weeks now. And even the investment grade marketplace has experienced a dramatic change in the liquidity backdrop.
This equates to destabilizing, tightening conditions. Tighter financial conditions at our periphery after years of the loosest financial conditions imaginable. And this is a major structural issue for an economy that, over recent years, has been driven by a proliferation of negative cash flow and uneconomic businesses. The shakeout, it has begun, with some of the clearest evidence of this dynamic unfolding in the technology arena. We’ve seen some layoffs, but we’re really early. Before this is over, I expect massive restructurings and bankruptcies. This is going to be quite an arduous adjustment to a new market policy, financial, and economic environment. New realities.
Markets are extraordinarily vulnerable here, that’s stocks, bonds, housing, private equity, commercial real estate, and so on. We’re so early in the adjustment process. There are two interrelated critical dynamics at play in the markets. Financial conditions have tightened meaningfully, which imperils the solvency of many companies, while pressuring household and business spending. Meanwhile, it’s a critical issue that the Fed put has turned ambiguous. Market faith in Fed liquidity and that backstop has crystallized over three decades, becoming deeply embedded in market perceptions, prices, and speculative dynamics. In the market’s eyes, it has been the most consequential facet of contemporary monetary policy doctrine. The Fed liquidity backdrop has been integral to trillions flowing into perceived safe and liquid ETFs. It’s been key to trillions into hedge funds and speculative leverage generally, it has been crucial for risk taking overall, it has been absolutely fundamental to multi-hundreds of trillions in the derivatives complex. And there is today uncertainty as to how the Federal Reserve will now respond to crisis dynamics.
I’m on record forecasting a much larger Fed balance sheet. There is no alternative to central bank liquidity in the event of serious de-risking/de-leveraging. I also believe newfound inflation persistence will preclude the Fed from their singular focus on market stability. I expect another round of QE, but it seems likely that this liquidity comes later and in narrower scope than markets have grown accustomed to. And later and smaller will not suffice.
Recall the portentous dynamic from March 2020. The Fed hastily responded to de-risking/de-leveraging and market dislocation by announcing a major QE program. Yet, market dislocations only worsened. An increasingly desperate Fed repeatedly boosted its crisis policy response until the prospect of trillions of QE finally reversed de-risking/de-leveraging, and halted the run on some ETFs. The Fed’s most recent 5 trillion QE onslaught pushed leverage and speculative excess to unprecedented extremes. When serious de-risking takes hold at the core, it would take trillions of additional liquidity to rejuvenate risk taking and leveraged speculation. And at this point, with inflation raging and bond markets fragile, such a massive QE program would pose great risk to inflation and bond market stability, not to mention Federal Reserve credibility.
Fundamentally, altered inflation dynamics, they’re a prominent aspect of the new cycle. The era of endless cheap imports from China and Asia has largely run its course, and Russia’s invasion of Ukraine and the new Iron Curtain solidified the end of a multi-decade period of integration and globalization. And while commodity prices have retreated over recent weeks, we believe the new cycle will be in the era of hard asset outperformance versus financial assets. And this dynamic will change so many things, including raising the risk that QE injections feed directly into commodity prices and general inflation. The job of a central banker has become incredibly more challenging.
David: You know, Doug, you mentioned earlier the difference between secular markets and cyclical, and I think this point of a multi-decade period of integration and globalization coming to an end is really critical. Globalization, and alluding to the end of the Cold War, that was our launching point for significant increases in trade and capital flows. And of course, along with that came labor arbitrage and the opportunity to lower the cost of consumer goods, which— Wasn’t that a shot in the arm for consumers globally? But these are unique circumstances. If you look back at what was changing geopolitically, they gave birth to a particular cycle, and suggesting that the cycle we’ve just completed, it wasn’t normal, it was a bit of an aberration. So we’ve had a globalization cycle, there are also de-globalization cycles, and it’s not clear that we can simply choose a fresh round of globalization. It may be outside of the control of all policymakers. And in this sense, maybe we’re overestimating the potency of monetary policy on its own.
Doug: Yeah, I definitely believe that’s the case, David. Cogent comments. Markets, they can no longer take for granted that the Fed is willing and able to ensure the perpetual bull market. Late and limited QE will not thwart financial crisis. And this new dynamic implies significantly higher market and economic uncertainty. Markets are riskier now, speculation is riskier, leverage is riskier. The cost of market protection, it is higher.
And let me summarize some key aspects of the new cycle that will profoundly impact the markets. Consumer prices will have a stronger and sustained inflationary bias, central banks will be forced back to a traditional inflation focus rather than the past cycle’s experimental market-centric approach, policy rates will be higher, and QE will be relegated to a crisis-fighting tool. Financial conditions will be significantly tighter on a more sustained basis. The liquidity and policymaking backdrops will be much less conducive to leveraged speculation and risk taking more generally. The so-called Fed put will remain nebulous, with QE employed more unpredictably and sparingly.
I believe we’re in the early part of the process here of markets adjusting to new cycle realities. Markets are highly volatile, it’s cycle inflection points, we know this from history. And we’ve been experiencing this phenomenon. I expect even more volatility. The fundamental tightening of financial conditions is currently having its greatest impact at the periphery. And while our markets have retreated, the core is currently benefiting from the strong dollar and generally low market yields. This creates a mirage of liquid and sound markets. There has been meaningful tightening at the core’s periphery though, with waning liquidity and market losses in US corporate debt, and we’ll continue to watch that closely. But a much more perilous storm is approaching, and we need to ponder the possibility that there will be nowhere to hide, that the unfolding crisis is global, deeply systemic, and uncontrollable for the global central bank community. I worry about a crisis of confidence in policymaking, in the markets, and in finance more generally. It’s all one big crisis of confidence. As I’ve said many times, contemporary finance appears almost miraculous so long as it’s expanding, as it did in historic fashion over the previous cycle.
It’s not clear to me how existing market and financial structures continue to operate effectively in the new cycle. How does contemporary finance expand with financial conditions much tighter? With the central community’s newfound stinginess with liquidity, with significantly reduced leverage speculation, and much less faith in forever-rising security prices. And in closing, I fear there is nowhere to hide from escalating geopolitical risk. And I’ll again underscore a most pertinent psychodynamic. During the up-cycle boom, the economic pie’s perceived as robust and expansive. Cooperation, integration, and strong alliances are viewed as beneficial, both individually and collectively. But as the cycle ages, strains mount, and insecurity increasingly takes hold. Eventually the backdrop is viewed more in terms of a shrinking pie, with a newfound zero-sum game calculus. The downside of the cycle heralds a period of fragmentation, animus, and conflict.
We’re now five months into the tragic war in Ukraine. The West is determined that Russia cannot be allowed to win. Putin seems as determined as ever to ensure Russia doesn’t lose. And the more munitions that arrive from the West, the more it appears that Putin is adopting a scorched earth strategy of destruction in the South and terrorizing missile strikes in population centers across the whole of Ukraine. At this point, a return to the previous world order appears impossible. From this perspective, the world appears into the transition to a new perilous down-cycle dynamic. Last week, Putin referred to the Ukraine conflict as, and I’ll quote here, “The beginning of a radical breakdown of the American world order. The beginning of the transition from the liberal globalist American egocentrism to a truly multipolar world.”
And there’s little doubt that China has aligned with Putin’s Russia to form an anti-US alliance. An altered and much less hospitable world order is fundamental to the new cycle. I fear a scenario where the West has to significantly ramp up support to preserve Ukraine as an independent nation. I’ve worried for a while now that bursting Chinese bubbles could spur a Beijing move on Taiwan. US-Chinese tensions are on a troubling trajectory. It’s difficult to imagine a backdrop with greater uncertainty and greater risk, market policy, economic, political, and geopolitical. I’m a broken record on this, but it’s time to hunker down and prepare for tumultuous times. I sincerely hope my analysis proves way too pessimistic. David, back to you.
David: Thanks, Doug. This is why we have this product. The objective is to provide a reduction of volatility, and to provide downside protection in a global market backdrop with extraordinary uncertainty and extreme risk. It’s why we have this product, and it’s why it is meaningful to engage with it now.
Let’s go to the questions, and there’s a few more topics still to discuss, and we’ll kind of unlock those in the questions. Doug, I’ll start with the first one to you. “Assuming the known box that the central bankers have trapped themselves within, does a hyper-stagflationary depression make sense? Assuming the high rates of inflation, the recession we’re entering, and the recognition that the central banks will have no choice but to print in order to reduce debt-to-GDP levels.”
Doug: I’m definitely in the camp that believes central banks are trapped, no doubt about that. I’ve written that repeatedly. The issue of trying to inflate away unmanageable debt, that’s a major issue. But it’s the so-called “buyer of last resort” role of central banks that I believe is today probably more pressing. There’s not much transparency at all on this, but I hold the view that there are literally tens of trillions of leveraged speculative holdings around the world, in emerging markets, our markets, all the markets, leveraged speculation everywhere. There are hundreds of trillions of notional value of derivative contracts out there. In a serious de-risking/de-leveraging crisis and panic, with massive derivatives-related selling, there is no one with the wherewithal to provide liquidity during collapsing markets outside of the Fed and the central bank community. So, they will be forced to inject trillions of additional liquidity, liquidity that risks a very dangerous inflationary spiral. I think this time that the liquidity, as I mentioned earlier, it’s not going to flow the same way it flowed before. We have different dynamics now.
So, we risk a very dangerous inflationary environment. I think the value of the dollar will have a major impact on the inflationary backdrop. I feel a collapse in the dollar would be increasingly likely under such a scenario of another round of massive QE. That would boost the likelihood of the inflationary backdrop. But the dollar has very weak and unsound competitors. We’re watching it this year, the euro, the yen, the renminbi in particular. So, there’s great uncertainty with regard to relative currency performance over time.
At the same time, however, a crisis in credit market dislocation, they could unleash some deflationary forces. There’s no doubt about that, especially in the asset markets. And there is certainly the issue of China’s bursting bubble and how their policy responses play out over time. And as I mentioned just a few minutes ago, there are these very serious geopolitical issues. So, after all these years, the bottom line is I’m still in the camp that we have to keep an open mind in the inflation/deflation debate over the longer term, just follow developments closely, but thank you very much for your question.
David: I’ll take the next part, which is kind of a second subset of that question. “If so, we know gold performs well in stagflation, but how would it perform in a hyper-stagflationary depression lasting a decade? The same question regarding silver.” I learned a lot from the Summers-Barsky thesis, and I would encourage you to go back and read it. Larry Summers put it together in the ’80s, and it’s something of a framework for when and how gold outperforms and the thresholds at which it no longer is as attractive in the marketplace. So, going back to the Summers-Barsky thesis, gold does well in an environment where other assets are not doing well on a real return basis.
So, you take your asset class performance, whether it’s stocks or bonds, and then subtract out the inflation rate, and it gives you an idea of what could be considered greener pastures, greener grass, a place that investors would rather put money than gold. So when those options narrow, when growth is alternatively disappointing, and inflation is further pressuring returns towards the negative, then gold attracts an audience. So this is where I think, to the point of the question, it’s a question of how many people are in line to buy an asset. Like any asset class, there’s a question, how many buyers are still in line to purchase the asset and further push the price higher? It seems reasonable to me that in an extended period of stagnant economic growth and high levels of inflation that the audience for gold continues to grow.
The challenge with any sort of depressionary scenario, inflationary or otherwise, is to what degree does that negatively impact the consumer and demand for consumer goods that use a commodity as a production component? So, silver’s a bit of a different deal. Silver always has a higher-risk profile than gold, and I would simply say that while the industrial uses of silver add a layer of complexity for its performance in the short run, over a longer period of time, what you can see, what you might see is investor demand coming in and ultimately offsetting that loss of industrial demand.
But as an investor, you could look and say, “Gold is doing its job. Why isn’t silver moving in lockstep with gold?” It is the sort of lag effect because of the loss of industrial demand and the waiting for investor demand to make up for that. So, that’s what I would suggest, is a lag in performance for silver, certainly, temporary frustration for an investor looking at it as a pure inflation hedge. To your point, Doug, I think it is important to not necessarily judge things in as bifurcated a way. Either we’re moving towards hyperinflation on the one hand or deflation on the other because what you described are the forced buying, the central bank being the buyer of last resort. What that suggests is that they’re trying to prevent a collapse in pricing for particular assets.
So, there can be this price deflation, if you will, price deflation, which they try to avoid. So, you can have pockets of deflation at the same time you have pockets of inflation. At the same time, you may ultimately, as a result of massive balance sheet expansion, end up seeing even more exaggerated expressions of inflation. So, it’s tricky. It’s not one or the other. It’s some blend of the two, so that’s what I would say in regards to the gold and silver in a hyper-stagflationary or depressionary environment lasting over a period of time.
The next question also relates to gold and silver, so I’ll just address that quickly as well. “When can silver reach a triple digit?” That’s a good question. Again, frameworks like the Summers-Barsky adds some insight into how people view gold as opposed to other assets. I think when you’re looking at silver, it’s helpful to know how it’s trading in relation to things, so how it relates to gold is important. The gold/silver ratio would suggest that you need a $3,000 gold price and a return to ratio of 30 to one to break into triple digits. That’s not unrealistic. We had 31 to one on the ratio as recently as 2011. 40 is perhaps more realistic.
You get to see those numbers a little bit more often. The lower the number, the more of a rarity it is, and so at a 40 to one, if you wanted to see triple-digit silver, you’re talking about adding $1,000 to the gold price. I don’t know the timeframe for when. When can silver reach a triple digit? I don’t have a timeframe for when, but I do have the conditions for when triple digits are a possibility. At extremes, the ratio has gone to 15. I’m not counting on that. By the ratio of 15 to one, I mean $1,500 gold, 15 to one, there’s your $100 silver.
What I think is very realistic is, in an aggressive bull market where gold is attractive to investors for a variety of reasons, either market instability or dollar instability— We’re seeing a tremendous amount of retail demand for gold at present because people don’t like the idea of dollar reserves sitting in a bank, losing 9% or more on an annual basis. So, they’re just opting for gold. I think an aggressive bull market in gold will drive small investor demand ultimately for silver, so probably more realistic just to see, say, $3,000 gold and that 30-to-one ratio. For perspective, we’re at 90 to one today, so significant outperformance at some point, at some point, on the silver side. But as we talked about earlier, there can be that lag because of the demand destruction from a slowing economy and the industrial uses.
Doug, to you, “What is your strategy to capitalize on the expected volatility of a Fed pivot at some time against the backdrop of geopolitical headwinds leading probably to bouts of inflation, disinflation, and deflation in the next 18 to 30 months?”
Doug: Sure. Maybe I’ve been on the short side too long because I can still have nightmares of the great 1991 short squeeze. So, candidly, when I think of volatility on the short side, I think first about the risk of quickly losing money. I don’t generally think of volatility as a friend on the short side, and I know for some aggressive traders that’s a different dynamic, but generally, managing short exposure is a challenging and volatile environment. We keep our short exposure in a relatively tight range around our target, so volatility generally increases our rebalancing and risk management challenges.
I would prefer not to trade the market, especially in environments with such extraordinary uncertainty. That said, as the question states here, there will be a pivot, another significant market development that I sure hope we can use to our advantage. It would be advantageous for performance to be able to reduce short exposure and somewhat mitigate losses in the event of a significant policy-induced rally. I’ve seen them throughout my career, and it can really help performance if you can navigate around those.
The issue on the short side is that bear market rallies tend to reverse abruptly, and if you try to be too cute with trading, you often don’t fully capitalize on these big downdrafts that can come quickly and tend to catch the market unprepared, or on the short side people say, “Okay. I’ll just cut back and short at a better level,” and all of a sudden you take a big leg down, and you missed out. So, our strategy to this point has been specifically to keep short exposure at a level where we can withstand volatility and not get shaken out of our short position.
Q2 didn’t have significant bear market rallies. It was unusual for that. But I do believe that that would be an exception. We’re already seeing here at the beginning of Q3 a pretty notable short squeeze, notable short squeeze just this week. So, anyway, we’ll come in one day at a time, and I’m hoping for an environment of less volatility where I feel that I have more flexibility. Thank you for the question.
David: It’s been interesting to see the dynamics as we transition from the last quarter to this one. Late summer, we could look to see a rally in the equities markets. The rally attempts so far over the last several weeks have petered out and haven’t carried through, but in a thinly traded summer environment, anything can happen.
The next question, Doug, “Is the S&P a better short than the Wilshire 5000, and is the S&P a better short than the Russell 2000?” So looking at a couple of different indexes?
Doug: Sure. Just to make this a little bit more complicated— Let’s start out with the question, what makes a good short? Many believe that the best short is the stock, the sector, or the index that has the potential to go down the most. Fair enough, but that approach disregards risk, and often the stocks with the greatest potential to decline are also subject to much greater volatility, with the potential to post significant gains, and often get caught in these short squeezes where stocks can double, triple, and do crazy things. So, I always approach shorting focused on risk versus reward.
What is the potential that I have to cover a short, have to reverse it, have to reverse my decision by buying back that security at a loss, and how big might that loss be? No matter what the potential reward is, if there is a high probability of a loss in that position, I want to avoid that. I’ll add, however, that if we’re playing with profits, I will accept a higher degree of risk, a higher likelihood of loss. Since we went through a very difficult period and have holes to fill, I’m still compelled to maintain a key focus on risk management. I’m not backing away from that yet.
Let me make a comment on the S&P 500 index also. The question here is the S&P versus, basically, an index of all of the stocks. This is not granddad’s or even dad’s, for that matter, S&P 500. Some of the big S&P losers for the quarter included Royal Caribbean Cruises, Netflix, Expedia, Align Technology, Nvidia. Tesla is in the S&P 500. Meta, Facebook, Etsy, PayPal, Zebra Technologies, I can go on, there are a lot of extremely pricey growth stocks that have made their way into the S&P 500, and info tech has the largest weighting in the S&P 500 at almost 28%. Consumer discretionary is third at about 11%. Also, the S&P 500 has significant exposure to the global economy.
So, there are definitely things to like about the S&P 500 as a short. For most people, it doesn’t give them enough bang for the buck. For me, there’s enough bang there. Moreover, we’ve seen enormous flows into the S&P 500 ETFs. These flows have had little appreciation for the risk involved. So, from my perspective, shorting the S&P 500 has offered just a phenomenal risk versus reward opportunity. Phenomenal. Is the S&P 500 a better short than the Russell 2000? This analysis is somewhat related to this, to my comments here. Year to date, the Russell 2000 is down about 18%—that’s as of yesterday’s close—versus the 16.2% decline for the S&P 500.
So I guess it seems clear that the small cap has been a slightly better short, but if one factors in risk, from my perspective, it was not necessarily, even in hindsight, necessarily a better short. It was certainly riskier, more volatile. And just this week, at least through yesterday, the Russell 2000 had gained 4.8% in three days, almost double the S&P 500’s gain. So, if you were short the Russell and the market is going against you like that, you have a decision to make. Do you do nothing and allow your short exposure to rise rapidly, or do you buy back that Russell 2000 short during a price spike to ensure your short position doesn’t rise? Keep in mind how this works.
If you’re 100% short the Russell 2000 coming in Monday, and it moves 4.8% against you in three sessions, your short position is up to 104.8%, 104.8%, the gain in the index, while your account value declines to 95.2. It started at 100%, it declines by 4.8%, so you get to 95.2, and I apologize for these numbers. The bottom line is, in three days your short position, you went from being 100% short to 110% short, 104.8 divided by 95.2. Some managers will let their short exposure rise and take risks that it keeps rising without imposing risk control. We won’t. We won’t. I don’t want to see my short exposure jump from 100% to 110% in three sessions.
If it did that, I would impose risk control and get exposure back down closer to our target, especially when I know the environment is highly volatile with extraordinary uncertainty. I prefer to position with lower volatility. I don’t want to be buying the Russell 2000 today after a three-day spike to get my exposure down. That really hurts performance. The other— people that do the high beta, a lot of times they won’t reduce exposure back to target, and that’s just kind of a risky game, Russian Roulette. It’s only a matter of time until you get hit. My overriding objective has been no accidents, and that’s why, in a high-risk environment, our short default is the S&P 500. Very long-winded answer there, just to provide some of the nuance of how we think about risk management and positioning. Thank you for the question.
David: That’s with indexes, indices— I mean, there’s other assets to short. Seeing the collapse in cryptocurrencies and NFTs, looking at the exchanges that trade cryptocurrencies, Coinbase, the further question that’s asked is about banks. Australian banks looking like leveraged REITs, Canadian banks. There’s individual places to go to short as opposed to an index. I mean, maybe you answered that question already in terms of risk versus reward, but any comments on shorting crypto, Coinbase, NFT, banks, what have you?
Doug: Sure. All very, very reasonable, good questions. I’m not aware of a way to short NFTs, the non-fungible tokens. If there were ways, I’m assuming that these vehicles, they would not be very liquid. For Tactical Short, we prefer positions and instruments that are highly liquid. Liquid instruments tend to be less volatile. If I want to get out, I’m going to get out. If something came up in Tactical Short, we could get out immediately if something dramatic came up. The last thing I ever want to do is deal with illiquid shorts in a squeeze environment. Again, I’ve lived through that experience early in my career. No fun whatsoever.
So, I don’t even look. I don’t even explore the possibility of shorting NFTs or cryptocurrencies or the like. I can be called a coward or whatever. I’m not going there. Australian banks, well, there was a day when I analyzed banks and financial institutions. Australia has been— They’ve experienced a protracted exceptional real estate bubble. I’m not today familiar with the composition of Australian bank assets. For some, I can imagine they would be an enticing short. More generally, I’m cautious on global banks and financial stocks. They’re poorly positioned for the change in environment, the new cycle, tighter financial conditions. All the policy uncertainty, fragilities, due political risk, all of that, I wouldn’t want to own bank stocks globally.
That’s Canadian bank stocks, Australian bank stocks, US bank stocks. Now, I short them today. They can tend to be very challenging instruments. Canada, they’ve had their own real estate bubble, maybe not as spectacular as Australia, but it’s been formidable. But generally, financial stocks, they can move in mysterious ways. All of a sudden, the market narrative is, higher interest rates are good for financial stocks, so then every time bond yields go up, bank stocks go up. We dealt with that for months, and you scratch your head, but if that’s the way the market wants to play financial stocks, they can. Their earnings are difficult to predict. They can be challenging shorts. I certainly don’t fault anyone that short them today, however. Thank you for your question.
David: The next question is, “I’m curious to know if David and Doug believe whether gold or Bitcoin are currently more attractive at current levels than just holding and rolling over short-term Treasury bills.” We can share this. I’ll give you my opinion, and then you can correct my errors, Doug. It’s both/and, in my opinion, in terms of the gold and short-term Treasury bills. As rates have risen, yields more attractive, on the other hand, the vulnerability currency exposure you have there, gold offsets some currency risk, so I prefer a combination of the two. Bitcoin doesn’t make the cut as an asset preservation tool. It doesn’t make the cut as a repository of wealth, and it doesn’t make the cut as a liquidity substitute. It does, however, pass muster as a speculation, and a wild one at that, but it’s not attractive in the same way that those other two assets mentioned would be. That’s what I would say.
Doug: Yeah, David. I’ll just briefly— I’m sure everyone’s sick of hearing my voice, but now I’ll just briefly say how our family, we employ our savings. We hold gold and T-bills, no Bitcoin. We’ve never owned cryptocurrencies. I can’t see a scenario where they fall within our risk guidelines. As you said, David, they’re highly speculative vehicles, and especially in this environment, we are avoiding speculation.
David: You may have covered this some to degree. We’ve talked about the S&P 500, but the— “Which index would you short to protect your long portfolio, and when and where would you cover?” We’ve covered the S&P 500. Maybe you can cover the last part of that question. Where would you cover?
Doug: Sure. Maybe I’ll take a little different angle on this. First of all, as David said at the onset there, we don’t recommend shorting by individual investors. To create a hedge for a specific long portfolio, that requires some detailed information, analysis, a lot of discussion, contemplation. For example, a high-risk portfolio that includes, say, high-beta technology stocks, high-yield corporate credit, that would require a different hedging strategy than a low-risk portfolio heavy on short-term government debt, lower-risk equities, and precious metals. I mean, those are two completely different hedging challenges there.
So, I’m not going to be much help here, and when to cover, oh, geez. It’s over 30 years. I’m still trying to figure that one. When to cover, it’s a big challenge, and that will demand intense daily focus. That’s the only way I can put it. Of developments in the markets, policymaking, along with all these other factors, certainly geopolitical, but I’ll also throw out, it’s generally not an on/off switch, at least how I think of it. It’s more a matter of trying to have timely reductions in hedges, focused on analyzing changing risk/reward dynamics, and a lot goes into this analysis. It’s a real challenge, but thank you for the question.
David: The next question is, “How close is the dollar to losing reserve currency status, and what’ll this mean for investors?” I would say we’re a long way down the list of problem currencies. You mentioned earlier, Doug, that we’re not in a great position, but all things are measured in a relative basis in the world of fiat, so as a friend of ours used to say, we do happen to be the best looking horse in the glue factory. So, not a great place to be, but we’re better than others on a relative basis. I think as it relates to losing reserve currency status, you’ve probably heard it says that power abhors a vacuum.
Well, the substitute for the dollar would first have to be a reality, and for a number of years there was the possibility that the euro would be that. You started to see central bank reserves increase their exposure to the euro as it decreased their allocation to US dollars, but in a world where the euro’s under fire and the RMB struggles to improve its international footprint, it’s kind of unclear what the substitute for the dollar would be. So I would say we’re a long way off from losing reserve currency status as the world is today. That’s having commented on the currency role.
Reserve status is one part currency, one part power projection from a military, and one part importance to global trade. In my mind, we still dominate all three. There’s a huge reconstruction of the world in terms of global trade, and again, I look at the military projection of power. It’s something we still have a grip on. The other thing that I think is important to keep in mind is that reserve currency status is not all good, and it’s not all bad. The groups that seem to benefit the most from maintaining reserve currency status are probably Wall Street and the military-industrial complex.
So, something would have to change dramatically where Wall Street’s no longer in the seat to benefit, because keep in mind, having reserve currency status allows us to run these massive trade deficits. You run trade deficits, it creates surplus dollars elsewhere that end up being recycled into US dollar assets. Wall Street loves the fact that there is a constant demand for US dollar assets, stocks, bonds, what have you. So, slightly different benefit in terms of the military-industrial complex, but those two would have to be upset, removed, their interests neglected for us to see much of a shift there.
Anyways, I know it’s long been a concern, and our readers, listeners have assumed that that’s going to happen. It’s harder to see happen than you would think—not that it can’t. I mean, look. Every reserve currency has lasted roughly— no more than 200 years. So, if you’re going back through history, the history books are littered with those who have been the reserve currency. So, I’m not saying that we can’t or won’t lose it at some point, but the world would have to be turned inside out pretty thoroughly for us to lose it.
So, “views on short-term macro, long-term macro in relation to,” this is the next question, “views on short-term macro and long-term macro in relation to the equity indexes, precious metals, commodities, and bonds.” You want to take that one first, and then I’ll add something?
Doug: Yeah. Hopefully, I’ve covered that area pretty thoroughly, but over the longer term, I just don’t see how precious metals and commodities don’t perform well, certainly outperforming financial assets, bonds, and equities. The short-term is always more volatile, but as I spent a lot of time on my thoughts on the new cycle unfolding here, and I think that certainly favors the precious metals and commodities.
David: Yeah. I think the long cycle is what we have in mind. And as you mentioned in your comments, 20, 30 minutes ago, Doug, there’s this long-term migration to hard assets from financial assets because the conditions that drive the greatest success within financial assets, they are changing. And so, that’s a hard road ahead for most of your indices. Alternatively, it’s a fairly intriguing one for commodities and metals. And I throw bonds into the financial asset categories as having headwinds, considerable secular headwinds. The caveat on commodities is we’re concerned about the China play and the demand structure for most of your industrial commodities. So, you’ve got this general category of commodities, but you’ve got all these subs, which are more or less vulnerable, whether it’s your soft commodities, your industrial commodities, your energy commodities, your precious metals, and they all have different demand components. Supply for your commodity structure is really pretty tight today.
And so, the vulnerability comes in on the demand side, at least in the short run, where China can gut the copper market and the iron ore market. Those are factors that have to be considered. So, one of the things that we do in our hard asset strategies in complement to Tactical Short, is to manage that kind of risk and continually ask the question, where do we need more exposure or less exposure? Again, weighing risk and reward. And in a broad stroke, we can say, yes, we’re interested in commodities in this next cycle and hard assets as opposed to financial assets, but we are still going to, like an accordion, shrink or expand particular areas within the commodity space given the potential for demand destruction, given the upset to a particular commodities profile. So always risk management in mind.
Next question is, “Inflation fears seem to have reached a fever pitch. Isn’t it deflation we should be worried about?”
Doug: Sure. Following up on the previous question, there is risk of a deflationary scenario, but for now, I would tend to view this risk as being more isolated to asset markets. I expect bursting asset bubbles across the globe, which would have dis-inflationary ramifications. But as we’ve been discussing here, central bankers won’t have any alternative than to inject multi trillions into an already high inflation backdrop. And, we expect this liquidity to gravitate to real things, commodities and such, working to sustain inflationary forces in key areas, especially food and energy, key areas of where folks spend their hard earned money.
So I expect ongoing supply chain issues, severe climate impacts, and geopolitical conflicts that will also underpin inflationary dynamics. But the future, it’s certainly not preordained, so I’m determined to come in every day and analyze this extraordinary global backdrop to try to recognize developments as early as we can. I tend to not think inflation, or inflation versus deflation, but instead to expect wild price instability and extreme relative price divergences and divergences between financial assets and hard assets, for example. I think that could be the key inflationary dynamic to focus on in this unfolding new cycle. If central bankers lose control and global financial collapse unfolds, deflationary pressures would surely expand significantly beyond asset markets, and we’ll be watching for those dynamics. And thank you for your excellent question.
David: “Who coined the term, the Tactical Short?” You want to add anything to this, feel free, Doug. It comes out of a reflection that the markets— you can have a short product which is one hundred percent short all of the time, and that fails to address the biggest concern with being short—exposure to theoretically infinite losses. To tactically reduce exposure on the short side is a part of the value-add. To be able to, as Doug talked about earlier, look at market trading dynamics and not automatically, but on a very considered basis, either move towards the target or wait, having that flexibility to be tactical with the exposure. That’s what we wanted. That’s why we named it Tactical Short, as opposed to what you find more commonly in the marketplace.
Doug: Well said.
David: “Why do the masses continue to have a confidence in the most inept institution on the planet, also known as the Federal Reserve?” That’s an interesting question just from the standpoint of how we view knowledge and how we prioritize those who are in authority within our culture today. You could go back as far as the Enlightenment and the transitions to science being prioritized and rationality being prioritized. And over time, we’ve actually migrated to really the only value is something that is mathematically in the construct of a proof. If you look at economic textbooks today versus even economic textbooks 50 or 100 years ago, today it’s math, it’s equations and the value. You’re only considered a legitimate economist if you’re doing math because of the priority of math science and the soft sciences being less and less relevant.
So there’s this transition to what we prioritize, specialized knowledge refined through PhD research, that now sits much higher on the knowledge ladder, if you will, than perhaps common sense analysis. And so, yeah, I look at the Federal Reserve, and like so many economists, they’ve tried to take what is really an art and turn it into a science. What that implies, what that conveys to observers, is that there are some sort of rules that they’re operating within. There’s laws within the financial universe which they’re observing and operating according to. And so who are we to question these laws of nature, when in fact it’s really not that clean and neat. There is much more art to it. That fantastic interview with William White, who was the Chief Economist at the Bank of International Settlements a number of years ago, was on this particular point.
“We are treated as scientists,” he would say, “When in fact we are, in our best day, merely artists.” And so why do we have confidence? Because there’s a lot of people who don’t know what’s going on. They don’t know and have not engaged the complexity of the financial and economic universe. And if somebody has a PhD, who are we to challenge someone who has greater refined scientific mathematical knowledge? That’s basically why I think we continue to put a tremendous amount of confidence in the Federal Reserve. And it’s not just one PhD. You realize, on staff they’ve got 600 PhDs. 600 of them. So we have confidence in a construct. We have confidence in a construct. And I think that’s one of the reasons why we tend to like gold, because we understand that this is nothing more than a confidence game, and when that game founders, when confidence is called into question, then all of a sudden you’re talking about a system that’s revealed to be not as scientifically robust as you thought, not with these masters of the universe moving so many levers and pushing so many buttons to determine certain outcomes.
But in fact, they’re holding on for dear life. They have no idea what’s going on, and they’re hoping for the best, like the rest of us. So, the confidence that is conveyed from the Federal Reserve is really nothing more than a bluff, and they’ve continued to maintain that bluff. I don’t think they can maintain it indefinitely, but they’ve done a darn good job of it. And so long as there’s enough people to have faith in the bluff, they win the day.
Next question kind of complements it. “What’s the best way to short the Federal Reserve?” I gave the answer already. I would say own gold. It’s stupidity insurance, which is not to say that the Fed or those 600 PhDs I just mentioned are stupid, but it is to say that smart people can be given to pride. Obviously, you look at accomplishments or you look at where they went to school, et cetera, et cetera, smart people can be given to pride. They can overestimate their abilities, and they can make very stupid mistakes. So own gold as stupidity insurance.
Doug, the next question is— it relates to bond portfolios. I can answer this, or if you want to, “What should you do with a bond portfolio, municipal bonds, highly rated?” I mean, I think my advice is limited to just the practical issues of, maybe this is a good time to seek alternatives for income. If you must focus on munis, prioritize general obligation versus revenue bonds, and of course, ladder them sufficiently to reduce interest rate exposure and improve over time your income profile. What are your thoughts on muni bonds, even if they’re high rated beyond those general priorities?
Doug: Yeah, David, I agree with your general priorities. I would add that I would be cautious with the insured bonds, the credit insured bonds. A lot of munis are— they receive a high rating because of this insurance. In a significant crisis environment, like an ’08 type of environment, that insurance may not provide you the protection that people expect of the protection embedded in that highly rated instrument.
David: Yeah. Doug, when a car stinks, you can get those little things at an O’Reilly’s or an auto parts dealer store. You throw them under the seat and it makes the car smell better. You know what I’m talking about?
Doug: Right. Right.
David: That’s your insurance on the bond. It’s like something has been covered over. It masks— insurance can mask the larger issues. Couple more questions. “If the dam breaks on the underpinnings of the Western financial ecosystem, are we looking at a fall-of-Rome scenario in the US and elsewhere?”
Doug: I always walk a fine line. I’m a devoted serious macro analyst, but with my focus on credit and bubbles, going on three decades, I’m often associated with the so-called lunatic fringe. So, I don’t use that fall-of-Rome comparison because I’ll just be viewed as a wacko, but I do worry about the Western financial ecosystem and the consequences of collapse. I absolutely do. And I hopefully made myself clear in my earlier presentation. I’m increasingly worried of the dam breaking scenario. I worry about a series of collapses, and we have all these bubbles, these fragile economic systems. I worry about social geopolitical cohesion.
And as I mentioned earlier, from my framework here, this has all followed a worse-case scenario. And I only get more worried every quarter, because I just see more confirmation of the thesis. I see this, unfortunately, starting to come to fruition. So I’ll say again, it’s time to take precautions and be prepared for challenging times. I look at it, I just don’t see the downside of being as prepared as we possibly can be today. Why wouldn’t we want to do that? Because if nothing else, because of the uncertainty. So thank you for your question.
David: “How do you see the ramifications playing out for the US dollar as OPEC and emerging market or BRIC countries shift away from the US dollar? When and how severe? What kind of ripple effects?” I think this comes back to what I was talking about earlier, about dollar recycling. We had the petrodollar recycling. Then we had the tradable goods recycling, and obviously, as we run big deficits, trade deficits, and you’ve got countries like China with trade surpluses, no surprise to see them buying US dollar assets. What happens if that comes to an end?
Think about the rate structure. If you lose someone who’s buying $50, 100, 200 billion a year in US Treasurys, and that buyer goes away, arguably that puts upward pressure on interest rates. They’ve been encouraged to accumulate US dollar assets, and to some degree that is shifting.
You can even look at the Russia/Ukraine events of recent months. Go back to February, March, April, and to Doug’s point on social and geopolitical cohesion being in reverse, we have sanctions on Russia, and all of a sudden you’ve got even more reasons for small countries to look and say, wow, there’s some vulnerabilities in having that recycling process in US dollar terms. Maybe we need to start creating reserves in other currencies. Maybe we need to create currency swap relationships with China, and that’s happening. So countries are creating Plan Bs. They’re creating alternatives to the dollar. It still takes a long time. I mean, global trade is immense. The dollar’s role in it is primary. And to undo the trade system that’s in place is not something that happens overnight.
So, when? I think it’s still a long fuse issue. It’s still a long fuse issue, but I think it goes to Doug’s larger point, which is we’re looking at things that are shifting that have up to this point been very supportive of the expansion of credit and the kind of inflationary tendencies that are coming into play in the financial markets today. Why are we moving into a new cycle? This is a part of the de-globalization theme. This is one aspect of the de-globalization theme, and it’s a slow evolution, but it’s something that does change the attractiveness of financial assets and makes them less attractive, and makes hard assets more attractive over time. These are themes that will play out.
“What is the level of inflation,” Doug, “where the Fed loses control and inflation moves into the next stage?”
Doug: I don’t really see a particular level, but this is also my focus on crisis dynamics and the likelihood of more QE coming, and the likelihood that that QE comes in an environment where we already have highly elevated inflation, and this bias where I think liquidity will gravitate towards real things rather than financial assets. That scenario is very problematic. If the Fed announces a big QE program, and it looks like it’s going to fuel another leg higher in inflation, how would the bond market react? And I think at the end of the day, the bond market, that will be the key market that holds a potential to discipline the Fed. The Fed hasn’t been in a situation where they’ve had to contemplate additional QE in the face of a bond market crisis, but that would be a real turning point for the Fed, potentially for inflation. So that’s the dynamic that I look to as a key dynamic, rather than an actual level of inflation. If 9% doesn’t do it— 9% is pretty high, so we’ll see.
David: “If the IMF for other countries established a tokenized and audited gold backed digital currency, would that be enough to reestablish confidence in currencies of the markets?” I would say maybe, but they won’t do it moving in the direction of a gold backed currency if they don’t have to. Think of fiat money and deficit spending without limits, what we’ve had for a good many decades. It’s really tough to close that chapter. And when you look at the dysfunctions of our body politic, a lot of that is driven off of the opportunity of spending beyond natural limits and an opportunity to offer to constituents what they want regardless of the price that’s paid for it. And so to rewrite the political playbook, that’s implicit in moving to a currency, even if it’s a digital currency, if it’s backed by gold. It means that there’s limits on what politicians do. There’s limits on what can be spent.
And that’s a big decision. That’s a big decision. I don’t think you get that unless we’ve already gone past a stage of social and political unraveling, and have gone through the pitchforks and torches stage, if we were ever to have something like that. You have to have complete social destabilization for politicians to consider, or to put that on the table again. They’re not going to put it on the table otherwise. It’s just— it’s not— we’re— yeah.
I think of even the Germans who preferred backing the German mark with all the land in the country. The rentenmark was their first attempt after the hyperinflation of 1919 and 1924 and it was a version of backing the currency with something real, and even that only worked for, I think, less than a year. And they ultimately, had to go back to a gold backed currency. But you’re talking about a devastated environment. Complete devastation. I think that’s what you’d have to see before you have a political will, and even then, politicians are still looking for an alternative. So last question to you, Doug. This goes back to 2019. This goes back to overnight rates. “If the overnight rates blow out again as they did, hitting 10% in 2019, liquidity dries up similar to 2008, do you foresee a bank freeze?”
Doug: Well, illiquidity. I worry a lot about illiquidity. Any event that led to a precipitous surge in short term borrowing costs would be really problematic for a system as levered as ours. There should be no doubt about that. Obviously, if the interbank lending market freezes up, that creates all kinds of serious issues for the banking system, for the markets, for the real economy. At the same time, however, I believe the banking system, illiquidity there, in a crisis backdrop, is something the Fed can likely manage. At least it’s within their policy and regulatory purview. They can add liquidity into the system, or they could directly fund individual banks. So in that scenario, I tend to think of a more problematic situation of illiquidity and dislocation in the securities markets. And that’s the story of the last cycle, the last 30 years. It’s this movement towards market-based finance, market-based credit, market-based finance.
So that’s where, to me, the biggest fragilities are lying in wait. The questionnaire mentioned BlackRock. So it’s not clear to me how the Fed would respond to market dislocation and a run on ETF shares with BlackRock and Vanguard managing ETFs with trillions of assets. And even in the event that regulators had to get involved with these operations, I’m not sure the mechanism the Fed would employ to provide liquidity to redeeming shareholders if there’s a run. And of course, the Fed could just become big buyers in equity and fixed ETFs and mutual fund shares, but that comes with all kinds of issues and problems. Anyway, we’ll be paying particularly close attention to liquidity dynamics, and that’s the interbank market, that’s ETFs, that’s corporate credit, that’s a broad look at liquidity throughout the markets in the financial system, globally and here at home.
David: Doug, actually, one more question on volatility index. “Why hasn’t volatility, why hasn’t VIX been increasing as the market has become more unsettled?”
Doug: Yeah, that’s a good question. First of all, I think there is complacency. There is still the view that if the Fed has to reverse course, they will. The Fed will do whatever it takes to keep the markets liquid and sound. So there’s complacency. But I also think this global periphery to core dynamic plays a role in this, an interesting role in that the more unstable things become globally—China, the emerging markets, Europe, the periphery in Europe, the stronger the dollar, downward pressure on Treasury yields, market yields, commodity prices, more belief that the Fed tightening cycle will be over sooner. I think this all feeds into this complacency, and the VIX will be— it’s around 25 now. It’s going to be around 25, and then all of a sudden something will happen and it’ll be at 40. So to me it’s not that big of a surprise that it’s acting curiously. I’ll put it that way.
David: Well, we’re at the end of our questions at the end of Q2’s summary for Tactical Short. We look forward to engaging with you in the next few weeks with interest in the product and with ways that we can best serve your family, your institutions. And please feel free to send us questions in the interim, or to book some time on the phone. Doug would love to visit with you. I would love to visit with you and pursue a meaningful engagement in risk mitigation. These are very curious times and fascinating markets to participate in, but definitely not a time to be complacent. So if there’s a way that we can help you, reach out and let us know how we can be involved in that process. So we thank you very much for your time today in your engagement. And for our existing clients, thank you very much for the trust and confidence you put in us. We work diligently every day to honor that.
Doug: Thanks so much everyone for putting in the time to be with us today on our call and good luck everyone. Thank you.