Market Commentary for July 2020

"Confused, the Fed, inflation and Gold... "

By Alan Hull

This commentary is in part or entirely created using extracts and comments from my weekly Blue Chip Report. For more information about the Blue Chip Report, including subscription details and a recent sample report, go to Blue Chip Report

Last month I said that I was bullish in the short term and bearish over the longer term. A month on and I am now confused in the short term and still bearish over the longer term. Fundamentally markets are overvalued, a second wave of COVID-19 is developing and central banks are throwing even more stimulus into the works. And the major global index charts are telling me that I'm not the only confused investor.

Markets are up one day and down the next...the end result being that nearly all the major world Stockmarkets haven't moved anywhere during the month of June. But what did happen during June is the U.S. Federal Reserve (the Fed) took the unprecedented step of providing credit to U.S. Corporations, announcing they were going to buy up to $750 Billion in corporate Bonds. So they have now gone well beyond ensuring liquidity to markets, to actually providing a source of credit.

Stockmarkets around the world rallied on the news, but now they don’t seem to know what to do. The only thing I am not confused about in the short term is that we are moving in lockstep with the U.S. markets. And this is not a good thing when U.S. markets are at the whim of the Fed. So we are not dealing with 'Free' markets at the moment. Not until this latest stimulus washes through the system, as it ultimately will.

Central banks around the world have become addicted to stimulus and none more so than the Fed, who are trend setters in the use (or maybe that should be 'abuse') of Keynesian economic practices. They got to this point by deviating from their original mandate, incrementally over the past 100 years. Their original mandate being price stability and guaranteeing supply to the banking system, to prevent bank runs.

This mandate was then extended to employment, supporting market liquidity and being the lender of last resort for the U.S. government. And being the lender of last resort is a bit of a farce as the Fed is the government’s first option. The U.S. government always favours issuing treasury Bonds (which the Fed buys if no one else will) over raising taxes. Hence the constant raising of the debt ceiling every year, which actually led to a government shutdown in 2013.

Whilst this system of getting freshly printed money into government coffers prevents the open market from setting interest rates, confusing liquidity with credit is another very large step away from free markets. Of course the Fed employs 200 PhDs in the Washington DC area alone and so I doubt there is any confusion on this. They have now moved from ensuring liquidity to directly propping up asset markets.

The Fed has been buying and selling Bonds for a long time, where these have typically been treasury or mortgage Bonds, not corporate Bonds. In the past 8 months the Fed has supported liquidity to Wall Street by providing ‘repo’ loans (about 6 Trillion USD) which are short term secured loans against high grade paper assets. This being a valid way of ensuring liquidity.

But buying corporate debt in the form of Bonds, is providing credit. So like the banks have done for a long time, corporations can borrow at ridiculously low interest rates and then buy stocks in other corporations which end up on their balance sheet as assets. The Stockmarket goes up and this boosts their bottom line and then other companies buy their stock. Sound like a Ponzi scheme?

It is and it is the same type of Ponzi scheme that sent the Japanese Stockmarket skyrocketing in the late 1980s, prior to it’s twenty year long bear market. Panasonic bought Mitsubishi, who bought Fuji, who bought Panasonic. It brings to mind the saying, ‘Those who ignore history are doomed to repeat it’. The best investment in the U.S. is their Stockmarkets…and that’s where any easy money goes.

But at its core, this is simply a further abuse of the printing press that the Fed has in its basement. They are now totally addicted to printing money…also known as quantitative easing or boosting the Fed’s balance sheet or easing monetary policy or increasing liquidity. (They've also come up with a lot of euphemisms for it) However they are running out of bullets as a Trillion dollars of stimulus isn’t what it used to be. Printing money ultimately causes inflation, or even hyperinflation.

Under a fiat monetary system a sovereign power has the right to print money, but an abuse of this power leads to monetary failures like Germany in the early 1920s. A loaf of bread in Berlin that cost 160 Marks at the end of 1922, cost 200 Billion Marks by late 1923. In fact there is no instance in history where a non-tangibly backed currency has succeeded. They always end up being abused by the sovereign power that controls them. Good in theory..but it simply doesn't work in practice.

Hence the U.S. have been expanding their money supply ever since they came off the Gold standard in August 1971. During this period they have effectively devalued the U.S. dollar by approximately 97% and most of this has occurred in the last 2 decades as the U.S. money supply and U.S. government debt have been increasing exponentially. You can see in the following charts of the money supply and U.S. government debt how the acceleration of their curvatures began from about the 1970s onwards…

This is what happens when a sovereign power is allowed to print money and expand their monetary system. So the question on your mind now is…why aren’t we seeing this in the inflation figures if it’s such a problem? And that’s because we look at the annual inflation figures instead of the cumulative impact of inflation. Thus 2 to 3% per annum inflation adds up…

Again, you can see how the above chart accelerated rapidly from 1970 when the U.S. went off the Gold standard. What’s more, local inflation in most western countries is being masked by imported deflation (cheap goods) from places like China. But I like to picture inflation in terms of potato cakes. I paid 2 cents for a potato cake in the early ‘70s and today they cost around $1.00. Now think about how Stockmarkets have increased in value over the past decade.

The most stark example is the NASDAQ which has risen from 1,500 to 10,000 points over 11 years! So it takes a lot more stimulus to support it today than it did 11 years ago. In fact it takes nearly 7 times more! So the Fed is playing a finite game by printing money. Mind you, it may be academic if a second wave of COVID-19 infections destroys the U.S. economy before inflation does. Hence the Fed can't control the spread of COVID-19.

So free market forces are going to have the last say, one way or the other. And the last question is...isn't Australia doing the same thing by printing money to pay for stimulus? Aren't we going down the same road? Not based on our track record. This is why it is imperative that we responsibly manage our national debt (unlike the U.S. who keep increasing it).

If the RBA prints money against a debt (like government Bonds) and uses the money to expand our money supply, then we have to repay this debt which means taking the money back out of the money supply. Think of it as printing money to make a loan and then the money that's paid back is then burnt in an incinerator. The government pays the RBA back the money for the Bonds, which the RBA burns in an incinerator. The Bonds are effectively an IOU from the government, which then get torn up...or thrown into the incinerator along with the money.

Monetary expansion is a common practice in extreme circumstances like war and economic depressions, not to mention worldwide pandemics. And it's a good medicine if it's not it has been in recent decades by central banks. The problem for us as investors is that the U.S. dollar is the world's monetary standard and so we are not immune from it. Inflation won't stop at the border. So we need some way of protecting ourselves and the answer is a single word...Gold.

Gold becomes an alternate form of money (chosen by the marketplace) when a synthetic monetary system fails because it is a safe store of value. Imagine discovering a chest full of Gold on a thousand year old wreck, at the bottom of the ocean. Happy days! But if you discovered a chest full of paper money from the same period, inflation would have destroyed its value and that's assuming it's still in use today. I'll take the Gold...thanks.

And you can get ready for Gold with my Bear subscription as I am launching my new Gold portfolio from July. Right now Gold is an insurance policy against monetary weakness but I'm pretty confident it's going to outperform in the not too distant future. And there's a couple of really good reasons why you should buy shares in Gold producers and not physical Gold or derivatives over Gold. But that's a story for next time.