Month: July 2023

Welcome to “The Week Ahead” with Tony Nash, where we discuss the latest market trends and forecasts for the upcoming week with a panel of experts including Blake Morrow, Tracy Shuchart, and Albert Marko.

They begin with Blake by examining the strength of the dollar in relation to the euro, Japanese yen, and the resurgence of commodities. The conversation highlights the Fed’s indication of keeping rates high, the dovish stance of the European Central Bank, and the inflationary environment in Europe and the United States.

The focus then shifts to the Bank of Japan and the potential changes in their yield curve control policy. The speakers discuss the challenges the BOJ faces in moving away from ultra-loose policy, and the impact it may have on the Japanese yen’s depreciation and potential future appreciation.

The episode also covers China’s economy and the challenges it faces in shifting towards a consumer-based model. The speakers mention the potential devaluation of the yuan to boost exports, as well as the appreciation of the Mexican peso and the rally in commodities driven by a weak US dollar and China’s stimulus.

Tracy touches on the energy sector and the United States’ oil demand. The conversation explores the implications of rising energy costs on inflation and the global economy, as well as the slowing growth in margins for S&P 500 companies. They discuss the impact on luxury brands and high-end consumers, as well as the current status of AI in the tech industry, mainly with Albert.

Lastly, the experts discuss the role of large language models in improving search efficiency and potentially replacing low-level analyst jobs. They acknowledge the transformative effect of AI advancements in search capabilities, but caution about the accuracy of information provided by AI, especially in legal contexts.

Key themes:

1. Dollah! (& EUR, JPY, CNY)
2. Commodity Resurgence
3. Earnings

This is the 73rd episode of The Week Ahead, where experts talk about the week that just happened and what will most likely happen in the coming week.

Follow The Week Ahead panel on Twitter:
Tony: https://twitter.com/TonyNashNerd
Blake: https://twitter.com/PipCzar
Albert: https://twitter.com/amlivemon
Tracy: https://twitter.com/chigrl

Transcript:

Tony

Hi. And welcome to the Week Ahead. I’m Tony Nash, and today we’re joined by Blake Morrow, Tracy Shuchart, and Albert Marko. Thanks, guys, for joining us. Today, we’ve got a few key themes. The first is the dollar, and we’re going to talk about the dollar in relation to the euro, Japanese Yen, CY. We’re also talking about commodity resurgence and earnings.

Tony

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Tony

Guys, thanks so much for being here. I really appreciate the time as always. Blake, it’s your first time here. Thank you so much. I appreciate it. I’ve heard great things about you and I follow you on Twitter. I want to start by talking about the dollar. We do see another, of course, another 25 basis point move by the Fed and the ECB this week. And after a couple of months of hearing about the dollar’s demise, which Albert and Tracy and I have laughed at every time we hear it, yesterday on Wednesday, we’re looking for strength to return the dollar. And we saw that Thursday this morning after the ECB meeting. Can you walk us through your case for dollar strength?

Blake

Yeah, sure thing. And by the way, thanks for having me here. It’s first time and hopefully not the last time. It’s really an honor to be here with you guys. This week was a unique week because we had the Fed, ECB, and the B2B OJ is happening tonight. And we just had some headlines come out less than an hour ago that’s really moving the markets. But it’s rare when you can get these central banks, you have a good understanding from a macro micro point of view, fundamental point of view, what to expect. And in this case, we had the Fed that… I think we’re all coming to the realization that the Fed, even though they’ve said this many a time for months and months and months, rates are going to stay high for probably a long period of time. And something they said yesterday that really caught my eye or caught my ear, rather, was that their internal economists aren’t even forecasting a recession, which means that if you were thinking thinking when we get in a recession, the Fed is going to eventually cut rates, they’re not going to. So that automatically, I was assuming that they would message that they were going to keep rates higher for longer and try to drill that in.

Blake

I didn’t think it would come out in that way. However, I also figured the ECB, which came out this morning, and if you saw Christine Le Gard, I almost thought her shoulders were really slumped over. She looked really not so optimistic, and she was very dovish, more so than I’ve ever seen her in over the last 12 months. I figured that was going to be the case because the European data has been really deteriorating. And so I figured that she would be somewhat dovish and maybe not lead us down the path that we’re going to get another rate hike, which I think that was the case today. So it just so happened that it worked out the way that I anticipated. But let me be the first to say, Tony, that doesn’t always happen by no stretch of the means. It did really work out according to the way I planned it this week.

Tony

Hey, take the win.

Blake

I’ll take it this time. I take plenty of losses, so I’ll take the win.

Tony

With Powell yesterday, one of the things that I noted that he said is he said policy is not restrictive enough or for long enough to have its full intended effect. And so that the hire for longer is just all baked into that sentence, right? And surely after that, he said, we have a long way to go. And so I think there were some people who walked away from that press conference thinking it was Dovish, and I just didn’t hear that at all. Did you hear Dovish comments out of the press conference?

Blake

No, I think it was pretty well balanced, but the higher for longer, I think it’s starting to resonate with the markets. But between that and between the ECB and now the BOJ, I think the markets are starting to understand, and really you’re taking the Bank of Japan, which is the last G10 central bank that has ultra loose policy, that might actually get removed or start the other direction as of tonight or tomorrow morning in Asia. And I think the markets might be getting the hint now. And I think we’re starting to see signs of it actually today would be the first day that we are.

Tony

And then ECB made comments about end of cycle. So she really wanted wants to be at the end of her rate rise cycle, right?

Blake

She does. And I think she’s probably feeling a lot of pressure from Germany. If you’ve looked at the German, especially the manufacturing PMIs just earlier this week, they’re horrendous. And when Germany is the growth engine, if you will, of the Eurozone, if you will, and they have plenty of seats in the ECB Board of Governors, she’s probably feeling a lot of pressure from Germany specifically. And so, yeah, I think she wants this cycle to be over. I think everybody does. But the problem that we’re all facing, and I think the best case or I shouldn’t say the best case, the best example of a stagflationary environment is what’s happening in the UK with persistently high inflation. But now you have growth that may actually go negative and then they’ve got a real big problem. I think Europe is facing that as well.

Tony

Europe, I think we’re hitting up against some energy derived base effects over the next few months where I think people may be declaring victory over inflation and the battle may not be over. But we saw, especially gas, really rise Q3 Q4 of last year. And so they’ll be measuring inflation against that. I’m not sure that is going to be the battle is won type of environment for Europe.

Blake

I want to defer to Tracy and Albert as well. But Tracy, you follow a lot of these commodities. I was really, really carefully watching cotton over the course of the last couple of weeks. It had been basing since I want to say, the fall of last year of 2022. And it just broke out of a base, literally this week. And when you see these commodities percolate, that’s going to make life a little tough, especially when you have certain financial conditions are looser than they should be with equities where they’re at with the trickle down effect. You got people feeling a little wealthier. Their housing their houses or their multiple homes haven’t really lost a lot in value yet. And then you throw that type of spending on top of commodities staying very perky. I think this last leg of getting inflation from 3 % to 2 % is like running the 22nd to 26th mile of a marathon. And that’s where they’re at. It’s not going to be the easiest part.

Albert

Yeah. What we really should look at is the core CPI. That’s still raging hot. All the points that you made were absolutely correct. We’ve discussed this for many months now, Tony and with Tracy that Europe is just a zombie economy. And the moment they start taking up in any which way, inflation starts to rage again. And then energy inflation is gaining steam, not only there, but also in the United States. And we have a problem. I mean, the chairleaders of… We’ve solved inflation because they have a three handle, which is a little bit silly and way premature in my opinion.

Tony

Let’s circle back, Blake, for just a minute to talk about BOJ. I know we’re going to talk about a lot of the commodity stuff in the next section with Tracy, but let’s circle back to BOJ. There are some stories out today on Thursday about the BoJ tweaking yield curve control to cap it by 0.5 %. So that is a pretty massive change.

I know they just changed their BoJ chair about three or four months ago, so he didn’t want to make any changes right away. But it sounds like he’s really starting to talk about some incremental changes. This is a pretty small change, but it’s actually a pretty big change. Can you talk to us about that a little bit?

Blake

Well, I think it is a big change because it would be a step in the direction that the markets don’t want to see. The last time Bank of Japan tried to move off the zero bound was just pre GFC, the financial crisis in 2008. So here they are again trying to move off the zero bound first starting with yield curve control tweaks. Now the BOJ, we have a new governor, BOJ Ueta, which is really interesting is he had been so in his academic papers that he’s written over the last couple of decades, how critical he’s been of the BOJ and where they’re at. He jumps into the BOJ driver’s seat and he ends up being just pretty much the same as Kuroda. Probably from a political standpoint, not wanting to rock the boat too much.

Blake

However, he also pulled a very similar move to Kuroda this last week where they leaked out from official sources to Reuters, probably every journalist from Vogue to who knows what, The Economist, saying that they weren’t going to tweak yield curve control. We saw move in the Yen move lower. So people like myself that were pre positioned waiting for this yield curve control leak, we got stopped out. I took some losses last week because of it. And then here goes today from the Nikkei paper suggesting that tonight or tomorrow morning in Japan, they’re actually going to make the tweak and move the band so they can allow it to trade up to 0.5 %. Now, that in itself is that tweak of that yield curve controller allowing it to move is basically step one of probably many steps of trying to normalize their monetary policy. But if you think about that, that’s the last central bank that we have that really is keeping ultra loose policy. And that’s I think the takeaway that the markets need to start looking at, especially equity markets globally.

Tony

Right. Very hard for them to continue importing inflation, but also very hard for them to fight against demographics in terms of the productivity value add in their economy. So they’re in a really rough place. So can we look at a number of currencies? I have a chart up now on several currencies. I want to just walk through some things with you as we look at where we are. First, on the top and blue, we’ve got Japanese Yen, which we’ve seen real depreciation since 2022. Can we talk about within the context of the dollar, if this BOJ policy really does go through, do we expect marginal appreciation in JPY or do you think it’ll really come back down to say 120 or something like that?

Blake

That’s a great question. I think over time, depending on how aggressive the BOJ has to be, I think 120 would be probably a realistic expectation from a technical point of view because you’d be looking at an equal leg move from the highs down to the lows that we put in in January of this year. So that would probably take us in the range of 120. And it’s not going to happen overnight, but it’s baby steps for the Bank of Japan. And I think that the first real key is going to be what I saw as channel support, which it would be around the 136 level. We start trading below 136, 135. I think a lot of longer term yen shorts might be looking to exit those positions at that point.

Tony

Okay. And then looking at CNY, China’s economy is in a really bad real tough spot and we’ve seen some devaluation there. What’s your expectation with CNY, CNH? Do you expect to see continued devaluation there, or are we in that zone where the monetary guys in China are comfortable?

Blake

Well, I don’t think they’re comfortable at all. And that’s a great question. And it’s a really, as you pointed out, it’s a really complex situation that China is dealing with. They thought their opening would be great. The issue that China has, and if you’ve watched China over the last 20 to 30 years, trying to shift their economy to a consumer based economy, hasn’t They’ve made a lot of billionaires and millionaires as you could imagine, but still a majority of their country is not in that situation yet. Yes, I get to eat five bowls of rice today versus 10 years ago, and they had three bowls of rice. Maybe that’s the difference for a lot of their population. But the fact of the matter is, is they’re really trying to rely on domestic demand, and they just said it in the Politburo meetings this week that they are struggling with that particular issue. So they have a few levers that they can pull, stimulus levers, reserve ratio requirements. They can try to spur domestic loan demand, but the real estate markets are a little iffie at best because a lot of Chinese, they have multiple properties that they own.

Blake

So trying to get them to leverage up and borrow a little bit more. It’s a hard or a tough ask for the Chinese people. So China’s got a few levers left and one of them happens to be with the C&H. And the C&H and the C&Y. Trying to get the Wan or the Renminbi lower to spur more demand from Europe, from the US, make their goods cheaper. But it’s hard for the the PBOC to pull that lever without looking too obvious, right? Because we know they have the lever, we know they can pull the lever, but we know politically it’ll be frowned upon. So I eventually expect the US dollar C&H to break above 730 and maybe even go towards 750. And that would be signaling to us as investors in capital markets globally that China is really feeling the heat. So can the US dollar C&H continue to dip, maybe down towards the 200 day moving average around 7? Sure. Do I think it’s probably a buy down there? I don’t trade it, but I think people that do are probably looking at that level as an attractive level to be on the long side.

Tony

Okay, yeah. I think one of the key things that I look at when I look, especially at Northeast Asian currency is you have this movement with the BOJ, which will likely appreciate JPY.

You have the Korean won that’s appreciating. China’s domestic economy is a mess and they really need to goose exports so they can use that industry to further develop domest. Given all the troubles they have at home, that might be an easy decision for them to make to devalue just a bit to goose some exports, especially as more industries move off of the Chinese mainland for a lot of political reasons. In terms of moving industries, I want to also talk about the Mexican Pesso. We had a viewer question about the Mexican Pesso, and we’ve seen the Mexican Pesso appreciate pretty nicely against US dollar over the last, say, nine months or something. Can you help us talk through and understand why the Mexican Pesso is moving in that direction?

Blake

Yeah, you bet. This has been the darling of the FX market. By the way, going back to China, I just want to say I’m not the best China expert. I have some European members in the forex analytics team that trade the US dollar C&Y and C&H quite aggressively. So they’re better. I just take from them what I can. But as far as the Mexican Peso, it is something that I trade quite actively and aggressively at that. It’s been the darling of the FX market as a carry trade. When you can carry the Mexico’s higher rates over anything else, especially the euro, the yen, the Mexican, M XN, JPY, the euro, M XN, dollar and Mexican Peso. The Mexican Peso has been the star. And the reason why is because the rates are extremely high and FX institutions will park their money in Pesos and they’ll sell other currencies. And that’s great in a market where stocks are rising, we see that volatility is low. Those we call carry trades. That is the carry trade. It’s like the yin of the mid 2004 to 2005 era. The Mexican Pesso is in that situation. The risk at this point is that we’re starting to see other LATAM currencies l ike…

Blake

Oh, I always forget the central bank. The Chilean Central Bank, BCCH, is that what it is? Anyway, they’re about ready to embark on a rate cut campaign. Now, Chile is not Mexico, but it is a La Tène currency, and you’re starting to see some of these emerging market currencies, banks go stop raising rates as well. Will they start cutting rates? If they do, that the margin that you’re going to get on that carries a little bit less. Then if you start to see equity markets really come under pressure, like let’s say the and P trades from 40, it’s trading around 4,500, 4550 right now. We trade down to 4400 or 4,300, you’re going to see the air come out of the Mexican pay zone. You’re going to start to see the dollar outperform, the yen outperform as the BOJ adjusts their policies. Even the EuroMexican Peso is probably going to recover after having such a big slide. So I’d be careful with the Mexican Peso as it trades below 17. I think if it trades back above 17, 1705, especially 1750, we’re probably looking at a squeeze well over 18 again.

Tony

Okay, great. Thanks. We don’t talk about Mexico a lot, so this is really interesting.

Albert

I like the Mexican pace, though, simply because the trade has increased tremendously between Mexico and the United States.

Blake

I cannot disagree with that. And I think Mexico is the US is China. And specifically when I played a couple of rounds of golf with a gentleman that he has a chip company that he’s actually migrated his employees from China to Mexico over the last three, four years because of cost, labor cost. And so I am actually a Mexican pesos bowl. People that know me know that I believe the dollar Mexican pesos is eventually going to be trading in the lower teens over the course of the next couple of years. But right now, the specific risk is that we trade back to 18 before 15. How about that? Maybe that makes sense.

Albert

Yeah, I’ll leave the forex stuff in the levels of the U.

Tracy

And that was the exact question I was going to ask. I was going to say, does it have to do with trade with the United States as we’re seeing a lot of manufacturing, which was big in, say, the 80s in Mexico, now returning to Mexico with trade to the United States or say US companies moving their manufacturing to Mexico rather than China per se.

Blake

Yeah. And Tracy, I gave you that one example. It’s anecdotal evidence, right? It’s not like something I’d hang my hat on. But I think that is a trend that we will see in the years ahead is as China’s labor force shrinks and it costs more to produce in China, the rest of the world is going to search for alternatives. Most of them, like a lot of Europe, is going to go to India. We’ll go to India. But Mexico is our next door neighbor and labor is still cheap there. So we will find alternatives and I think the rest of the world will away from China. That’s one of the issues that Tony, you brought up about China. They got issues. You try to change your whole demographic of your entire ginormous country, there will be repercussions. And this is one of them, I think.

Tony

And it’ll happen. It’ll start slowly and then people will realize it and it’ll hit heart pretty quickly at some point. So I think looking at CNY, CNH right now is really important because I think we’re in the early days of something larger happening over the next few years.

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Tony

So Tracy, let’s talk about resources for a minute, I know that’s where you live every day. So we’ve seen strength in commodities over the last three months. I’ve got a chart up on copper, WTI and net gas up on the screen right now.

So why are we seeing a rally in commodities now? Is this really on the back of a week or dollar or is there something more to it?

Tracy

Well, I think we need to look at each one of these separately, to be honest. Just for example, Blake brought up the cotton issue and why is cotton starting to rally off the lows now. And that’s a China stimulus story right now because they have a lot of manufacturing to make a lot of cotton T shirts, etc. I think it’s really hard to lump all of the commodities together. So I would like to look at… I think we should look at oil or the energy sector in particular separately from, say, the metal sector, separately from, say, the softs.

Tracy

I think if you’re looking at the energy sector in particular, you are looking at a week or dollar. That always helps. And that all ends suddenly signs of life from China, meaning people are starting to believe China’s stimulus matters. Whether it’s come true or not, we really haven’t seen them say a whole lot until the last couple of weeks. You can even look at the hang saying on this in which we’re down 5 % on the year. And over the last weeks, it’s surging right away. Goldman just put out a note on Wednesday that said funds are piling back into China at the fastest pace in nine months over the last week, which is huge based on what they have said over the last week. It happened.

Tracy

Whether you believe them or not, the markets believe them at this point. And then as far as energy is concerned, we still have that supply demand issue. We have Russian S exports down. We have voluntary cuts filtering into global markets right now. And we are also seeing recession fears seeming to subside a bit because markets are seeming to starting to believe in this soft landing, or at least the commodities markets are.

Tracy

The equities markets, that’s a whole another story. And then if you look at the metals, again, I think if you look at the metals, this is again a China story. Suddenly, everybody’s believing China stimulus at this point. Again, I don’t know what exactly changed and what exactly changed the market’s mind, but I think it was helping a little bit of the property sector, which is definitely not enough, in my opinion, as well as the tech sector, the couple of announcements that they put out over the last two weeks. And so I think that’s really what we’re looking at right now. And again, a lot of it is the China story.

Tony

Right. So we’ve got Europe dead. We’ve got China dead with some commitment to them to maybe get stimulus, and we’ve got the US slowing down into the end of the year.

Tracy

Well, if we’re talking about the energy sector in particular with the United States, we have implied demand over the last several weeks has risen from 19 million barrels a day to 21.7 million barrels a day, which is huge. That’s over 2019 levels. And so we’re not really seeing And implied demand, you can take in different ways, but that is what product supply is implied demand. That’s what everybody takes it to be. So we’re not really seeing demand being lowered in the United States. We are also looking at a place in August where we’re going to see a lot of exports to China because Russian oil is getting to be more expensive right now. We’re above that price cap. And so we’re seeing China has put a lot of orders in for the United States, for WTI, Midland, for August deliveries. So we will see a reans here in the United States as far as inventories are concerned. And we still haven’t seen China overall. I mean, over this whole period that everybody’s thinking China is imploding, which they may or may not be. They’ve been buying oil hand over fist. And perhaps, yes, that’s a lot of it is going into storage.

Tracy

They can build storage out. But a lot of it, if you look at the refinery runs, are also huge.

Tony

I’m so glad you didn’t say China is talking up to go to war because I’m so tired of that.

Tracy

No, I don’t think China likes cheap oil, let’s be real. So they can get a huge discount from Russia, right? And get this price cap. And so at the time, it was $23, $20 below the price cap. Of course, who’s not going to stock up? India stocked up. Everybody’s going to stock up at that point, right? You’re going to buy high end over this. Actually, the best thing that the United States could are the best thing the West could hope for is that Russian oil is trading over that price cap because you know why? That doesn’t make it as desirable anymore. Nobody’s going to buy as much anymore. I think it’s short sighted thinking to say, Oh, my God. They’re trading over the price cap. Well, great. That means it’s not as desirable anymore. Why would I deal with the hassle of buying with them if it’s only a few dollars discount?

Blake

Do you mind if I interject and ask a question?

Tony

Yeah, absolutely, yes.

Blake

Okay. And Tracy, this is something I think about quite a bit just because we’re having this discussion or we’re having this discussion about crude oil and inflation, going back to the inflation question. It’s interesting. You watch crude oil rally and everybody cheers like, Oh, things must be getting better. But there’s always that inflection point, and I’m not sure where it is in crude or R Bob or whatever you’re looking at, but at what point do these higher energy costs really start to translate to, Oh, my God, that’s going to bite the consumer here in US globally, wherever you’re talking about. And crude going higher is not a good thing. There is that inflection point. I don’t know where it’s at. I don’t know if it’s at 80, 85 at 100. Do you have any thoughts on that?

Tracy

I think it really depends on the state of the economy and where we’re at. Our I think at $70, we’re still in that 70 to 80 range.

Blake

And I think that’s… Goldilocks, right? Goldilocks? That’s comfortable.

Tracy

It’s very comfortable, right? You’re not seeing $5 oil or gasoline prices at the pump. Not saying that’s a very comfortable position for oil to be in at this juncture. If we start to see oil prices spike higher than that, of course, that’s going to matter. And of course, this is all going to filter into energy runs the economy. You can’t do anything without energy. You can’t run a business because you have to keep the lights on. You can’t grow food because you need energy to grow food. So energy runs the economy. So at some point, yes, it’s going to matter. It’s going to filter in. It’s going to make prices higher. And I don’t think we’re going to see 2 % inflation anytime soon. In fact, even Powell doesn’t think we’re going to see 2 % inflation anytime soon. He said yesterday we’re not going to see this to 2025. I tend to think that ambitious goal because I think that no matter what we do at this point, if we’re looking at energy transition and we’re looking at all of these policies we want to put forward, we’re still lacking a lot of these materials, we’re still lacking a lot of energy for this.

Tracy

And this is going to be a huge problem that central banks just cannot counteract no matter… They may try. Actually, Peter Bookfire brought up a really good point yesterday when I was interviewing him. He said it’s easy to bring inflation down quickly with high rates. It’s harder to keep it down.

Albert

Tony, who told you that the more they rally this market, the more inflation is going to be a problem?

Tony

You did, Albert. You said it a long time ago. You said it.

Albert

Why people think that as they rally this market in silly, silly stratospheric levels, that they didn’t think that commodities in oil and wheat and cotton and every other thing is not going to run? Of course it is. Their problem is they’re running out of room now for rate hikes. So what they get, the only other option that I can see that they’re going to use is the US dollar. That’s the only thing they can do is take the dollar back up to the 108, 109 area just before you start breaking Europe and the rest of the world to try to team inflation because they don’t want to see 6, 7 % CPI prints going into an election year. That’s just ridiculous.

Blake

Isn’t it crazy, Albert, how the dollar can be weaponized? And it really can be, I believe.

Albert

Of course it’s going to be weaponized. It’s a reserve currency and Janet Yellen controls the policy. She’s going to do what she needs to do whenever she wants to do it. Unfortunately, that’s just the reality. It’s just the reality of the situation. And as I was saying, rate hike runway is pretty much ending. So the dollars is the only thing that they’re going to be able to use.

Tony

So your thesis is that US rates will top out at 6 %, and that’s going to crush China. Is that right?

Albert

Oh, yeah. China was never prepared for 6 % rates. Absolutely.

Tony

And again, tell us why? I want to make sure everyone understands.

Albert

Well, it’s just the debt level, the amount of debt that they had and the way they funded their debt. No one was, I don’t think anybody on Earth was thinking that 6 % % Fed Fund rate was coming. But here we are at 550 almost with probably another two hikes to go.

Tony

So we hit 6 % now. Now, China has been evergreening debt since 2009. They have all that debt for 20 years ago. They’ve continued to evergreen because they haven’t been able to pay it off and so on and so forth. Fed funds hit 6 % and the Chinese are practically begging the US not to raise anymore. Is that fair to say?

Albert

Oh, absolutely. And it’s funny because Yellen was just over there and then coincidentally, the dollar tanked underneath 100. As soon as she left for a day or two.

Tony

Total coincidence, Albert.

Albert

Total coincidence. Total coincidence.

Tracy

I tweeted that out. I tweeted that out. Absolutely.

Blake

Her getting psychedelics was total coincidence as well.

Tracy

That was the best part of the whole…

Albert

But I agree with Tracy wholeheartedly. I think 65 is the floor for oil, and I think probably 85 is probably a top for oil. It’s a comfortable zone that they’re willing to deal for the next whatever year or so.

Tony

Great. Let’s move on to earnings, Albert. I just want to cover a little bit on earnings here. What are your thoughts on future earnings? So far, we’ve seen S&P 500 companies report the slowest growth in margins since Q4 of 2020.

So over the last probably year, year and a half, we’ve talked about the pricing power that companies have had since about Q2 ’22 where they were able to continue to expand their margins and raise prices on customers and customers would just accept it. That seems to have come to an end at least a bit. So is that what’s driving this margin compression? I’ve got a chart from faxing on the screen showing the margins of companies coming down to right around 11 %.

Albert

It’s not just that. We talked about this maybe six months ago saying that this is probably going to end up happening where margins are going to start ticking down second half of the year. And that’s exactly what we’re seeing. The issue is, labor rates are still advancing. Their fake CPI is still a little bit of tailwind for earnings, but that’s slowing down too. So they don’t have that inflationary tailwind to jump up prices as demand is starting to take down. Consumers at this moment are a little bit more price sensitive. They don’t really need a Rolex watch or a secondary home or a third boat and whatnot. So as that money is starting to dry up, margins are starting to dry up too. I think that it’s going to be a bigger problem for Q4 However, if I’m right and inflation is ticking back up, there might be a little bit of earnings tailwind into mid 2024 again. Of course.

Blake

Albert, since you and I just met for the very first time today, it sounds like you’re obviously following earnings pretty closely. How do you feel about the Reishmont group last week and then Louis Vuitton this week? What does that tell you about the high end stuff and the high end global consumer consumer.

Albert

The high end global consumer, I’ve always watched to see when they start retracting spending is when I start to get nervous. Whenever the big homes in Naples, Florida stop selling and Louis Vuitton start getting worried about their demand, that’s always problematic. Now, I personally love Brunello Cucinelli. That’s my brand. I’ve watched them for years, seen their stock price go from 38 to 80. And as recently this last couple of weeks, I’ve been noticing their ticker trending downward. And I looked at their sales and their stores are not getting as many people in. Their online stuff is going more to outlet than it is into the stores and out to top consumers. So yeah, I think the top consumers are about to pause. If not paused already, they’re about to start pausing in Q4.

Blake

Yeah. The Reishmont group, I think last week they were down 10 % in European trade. And Tony, that goes back to your point about China and they decided to solve the Chinese high end consumer. They’re the problem.

Albert

Yeah, they say that. But that’s more than just that. The Chinese high end consumer is one component of it, probably a real big one. But the Middle East is probably showing the same little drawbacks. North America and Europe is obviously going to have falling sales in the luxury market. So they can blame China, but it’s a lot bigger than that.

Blake

Yeah, right. Cool.

Tony

I want to talk for a second about tech, Howard, because I know you love to beat on AI, even though I run an AI company. I don’t take it personally. So on tech, I thought it was really interesting that Microsoft’s growth for Azure hit 25 %, but AI was only about one and a half % of that growth. So I think some real questions have come. People have really started to think about AI. If Microsoft can’t get money out of AI because they’re effectively the owner of Open AI, right? So if they can’t make money out of AI, who can? We’ve seen for the past two, or at least earning calls, AI is mentioned dozens of times on so many earnings calls, right? So when do you think we’ll start to see that? Or do you think AI is just a feature in larger products that just help people retain and marginally grow?

Albert

Yeah, I think that’s correct. I think that’s just the feature and the larger products. The only AI that I would be excited about is whatever comes out of Apple.

Tony

And Complete Intelligence, of course.

Albert

Of course, Complete Intelligence. Truly dollar money maker right here.

Albert

But as a stock that’s actually traded, Apple would be my number one for AI. From what I hear, they have a working AI internally that’s just off the chain. But Apple is really smart. They wait years to perfect something before they start releasing things. So I just think that AI is a little bit too premature, and I don’t really like the marketing talk by some people. It just throwing AI around as if it’s some godlike feature on an app. It’s not. So I think we got a ways to go for that.

Tony

Yeah. My view is large language models like JMP and all the stuff that Microsoft is starting to do is really just a synthesized search engine. It makes your search a lot smarter. It’s all it does. It’ll take out some low level analyst jobs to write some papers for you. It’ll make your searches better, that thing. But we’re not to the point where those LLMs are real money makers right now. They make those applications more useful. Does that make sense?

Tracy

Anecdotally, wasn’t there just an article out that saying AI is getting dumber?

Albert

Well, it’s garbage in, garbage out. I think you’re talking about where chat GPT was answering 98 % of math problems correctly, and then just recently it dropped down to 2 %.

Tony

It answered 2 % correctly?

Albert

Yeah, 2 % correctly. It’s just garbage in, garbage out.

Tony

I’m going to look that up.

Albert

Yeah, I posted it.

Tracy

He posted it. I actually read it before he posted it. It’s true.

Tony

Because I don’t need AI to do those problems. I can get 98 % of them.

Albert

That’s the thing, Tony. I always tell people, whether it’s technological or political, social, things happen. Things happen incrementally. There’s never some jackpot trade or technology that comes out that changes the world like we’ve never seen before. It’s just things happen in stages.

Tony

But to OpenAI’s credit, AI, I think, was a really far off imaginary word to a lot of people until chat tipit e was brought to market. And then I think people went, Oh, my gosh, this really changes things. And I think it did. I think it’s the biggest change to search that we’ve seen in 20 years. I completely agree. It’s made it a lot easier.

Tracy

You just have to make sure it’s correct, right? Because you hear these stories, some lawyer used this for a brief and they brought in a whole bunch of…

Albert

Legal trouble. Yeah, you got.

Tracy

To say it. It didn’t really happen.

Blake

Yeah. It’s definitely like an assistant and you have to go back and double check the work. I look at AI as the Google Glass of today. Yes. I’m sure at some point we’ll all be wearing weird things on our heads. Whether it’s…

Tony

I hope not.

Blake

Not. Whatever. Well, just wake me up when Ex-Machina actually happens, and then I’m going to go run for the Hills.

Tony

Right, exactly. Just circling back to earnings for a minute, Albert, as we finish out this earnings season, are you looking for… Are we recapturing earnings momentum, say, later this quarter or into the next quarter, or do you see things continuing to gradually deteriorate?

Albert

I think we’re going to gradually deteriorate into the end of the year with probably earnings starting to tick back up Q1 Q2 of next year in the run up to the election. Obviously, tech earnings, it’s the fabulous five of Microsoft, Google, Apple, NVIDia, so on and so forth. Those are the ones driving the market. So that’s the ones that I would be watching.

Tony

Very good. Guys, thank you so much for your time. This has been excellent. Blake, thanks for joining us for the first time. Albert, Tracy, thank you your time as always. Have a great week ahead. Thank you. Thank you.

Tracy

Thank you.

Blake

Thank you all. Thank you.

In this episode of the Week Ahead, Tony Nash moderates a panel discussion with Brent Johnson, Albert Marko, and Michael Green, covering various key themes in the market.

The panelists address the uncertainty surrounding market direction, with predictions varying among experts. A correction is expected in the next 3-6 months, and while a crash is possible, monetary authorities may intervene to counteract it.

Factors such as the Federal Reserve’s tightening measures and rising interest rates are anticipated to impact market performance. Government responses to market downturns also play a role in stabilizing and stimulating the economy. The historical trend suggests that assets tend to trend upward in the long term.

Market sentiment is currently high, but positioning is no longer extremely bullish. Earnings are expected to decline in Q3, influenced by slowing demand and decreasing inflation. Large companies like Samsung, Ford, and GM may experience significant earnings declines. The limited ability to raise prices puts pressure on corporations’ bottom line, and lower volatility enables consumers to engage in comparison shopping.

The panelists discuss the complexities of inflation calculations and emphasize the influence of perception on market dynamics. Understanding the gap between the Fed’s reaction and the market’s perception is crucial for informed trading.

China’s challenges with inflation, manufacturing, debt loads, and demographics are highlighted. The struggles faced by the Chinese yuan (CNY) and the need for devaluation to enhance competitiveness are explored. The panelists also touched on China’s risk of collapsing due to demographics and limited consumption growth.

The discussion shifts to the interplay between the US and China, emphasizing the preference for economic fights over geopolitical or war fights. The strained relations between the two countries and the potential for unintended consequences are examined. The US dollar’s role as a tool in geopolitical events and its impact on asset prices and credit quality are discussed.

Chapter 11 bankruptcies in the US have surged despite tightening credit conditions, indicating market fragility. The broken relationship between bankruptcies and credit spreads is analyzed. Mechanisms such as preventing market clearing events and refinancing avoidance are examined. The potential for a severe correction, investment opportunities in defense companies, and the struggle of levered companies are also discussed. Overall, the panelists provide valuable insights into the evolving market dynamics and potential risks moving forward.

Key themes:
1. Epic crash or correction
2. Chinadestruct.exe
3. Credit divergence

This is the 72nd episode of The Week Ahead, where experts talk about the week that just happened and what will most likely happen in the coming week.

Follow The Week Ahead panel on Twitter:
Tony: https://twitter.com/TonyNashNerd
Brent: https://twitter.com/santiagoaufund
Albert: https://twitter.com/amlivemon
Mike: https://twitter.com/profplum99

Transcript

Tony

Hi, everyone, and welcome to the Week Ahead. I’m Tony Nash. Today, we’re joined by Brent Johnson, Albert Marko, and Michael Green. We’ve got three of the smartest guys on Twitter with us today and we’re really happy about it. We’ve got a few key themes we’re looking at. Brent will talk to us about an epic crash or a correction or what’s next in markets. Albert’s going to talk to us about a little program he calls Chinadestruct.exe, which we’ll get into. And then Mike’s going to talk us through credit divergence.

Tony

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Tony

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Tony

Brent, I want to start out with the survey you took in January, showing that you were brilliant followers thought gold would outperform the S&P 500 for the first half of 2023.

I love surveys like this. I do this stuff all the time. I have one running myself right now about whether it will be inflation, deflation or stagflation in 2024, and I run it once a month just to see how those opinions track. So I love this stuff. You followed this with an actual performance showing that the S&P 500 outperformed anything in your survey, gold, TLT, and so on.

We’re at a place where a lot of people are confused about market direction. I’m confused, honestly. It’s really hard to look too far out given where some of the data is and it’s a little bit mixed. Without looking too far ahead, because I think it’s easy to predict extremes, where do you think we’re heading in the next, say, 3 to 6 months? Are we heading for a continued bull market? Do you see an epic crash or mild correction or something else? Can you walk us through that a little bit?

Brent

Yeah. I’m happy to tell you what I think it’s going to happen. But I’m going to preface this by saying that I don’t know. It’s confusing for me as well. And I think that one of the… And I’ve talked about this a lot. I’ve probably talked about it with you before, Tony, but one of the most amazing things to me is in this environment, I talk to so many people who think they have it all figured out. And I don’t have it all figured out. And I’ve been doing this for 25 years. And I talk to other really smart people who have been super successful and they don’t have it figured out. So when I do talk to people who are so certain to me, it comes off as a little too much. And I don’t think this is the type of environment to be certain about anything. Now, having said that, my base case is that we are going to get a correction sometime in Q3 or maybe in Q4, but sometime in the second half of the year. As of right now, I think it’ll be a correction. I don’t think it will be an epic crash.

Brent

I understand the arguments for the epic crash, and I won’t rule that out. There’s a number of factors that could lead to that, but that’s not my base case. My base case is that we will get some a correction. The rest of the world, I think, will feel it more than the United States will. But I think that the tailwinds that the markets had for the first half of the year are gone, and there are a number of headwinds now. Now, again, whether those headwinds lead to a crash, I’m not sure about that, but I do think there are their headwinds. I don’t think the going will be as easy in the second half as it was in the first half. We had a lot of stuff happen in the first half, and I think the reason it is confusing is not all of it was good. Some of it was bad. I think since 2008, there’s this predilection for people to want to predict the crash. And I think part of it is, I know we’ve talked about this before, part of it is this, they want to see it happen. They almost feel like the US deserves to have this happen to them.

Brent

And as a result, because the US deserves to have it happen, it’s going to happen. And again, I understand the arguments for that. But the reality is if you look at a long term chart of assets, they trend up into the right. They tend to do that, and they tend to do that because Fiat tends to lose value over time. And even though that upward into the right graph over time is punctuated by draw downs, usually there is some a monetary response or government response to get it back on track of up and to the right. And so I’ve always managed money with that in mind. I want to be long assets because Fiat loses value and assets trend up, but I almost always have some hedge or some cash on the sideline in order to be ready for those draw downs that will inevitably come and then try to take advantage of whatever government response comes as a result of those draw downs. Now, the tailwinds that we’ve had for the last, let’s call it nine months, eight or nine months is that we had bumped up against the debt ceiling. So while then in 2022, Powell hiked like crazy, yelling, wanted a stronger dollar.

Brent

And so through October of last year, early November, that happened. But since then, even though Powell continued to tighten, his tone changed, his pace, the race and the pace of change slowed, and he spoke not as hawkish. And so a lot of people have assumed that we are at the end of the tightening cycle, and they’ve front ran that. Now, in addition to that, what we had was as we bumped up against the debt ceiling, the treasury could no longer issue bonds. And so typically what is happening is while the government is spending a lot of money into the economy, they’re typically draining it from the economy simultaneously by issuing treasury bonds. They give the public treasury bonds, the public gives them cash. They’re spending money in the economy, but they’re also pulling it out in order to fund their own operations. But as they bumped up against the debt ceiling, they couldn’t issue those bonds anymore. But they were still spending money. They were spending money out of their TGA account. And so that was providing tailwind of liquidity to markets at the same time that Powell was slowing rate hikes. And so that provided, in my opinion, an extra boost of liquidity that otherwise wouldn’t have been there had we not been up against the debt ceiling.

Brent

Well, now they’ve raised the debt ceiling and Powell, I think, continues to raise. And until markets force him to turn, I don’t think he’s going to turn. I think he’s going to raise. Now, he’s not going to start doing 1 % hikes again and he’s not going to do five of them in a row. But I think his proclivity is to continue to tighten. So that will, in my opinion, pull some liquidity out. The treasury will continue to issue bonds. So that’s no longer a tailwind. It’s now a headwind. We have the student loan forbearance that I think in sometime in October or sometime between August and October. So that would be a headwind. And not only that, but think about all the rate hikes we have had in the last 15 months. Oftentimes it takes anywhere from 12 to 18 months for rate hikes to show up in the real economy as old loans or old credit lines come due and they get refined nanced at the now higher rate. Those are going to start getting refinanced at a higher rate. And I think that will be a tailwind look to liquidity. And so it’s for all those reasons that I expect us to have a pull back or a correction.

Brent

The reason I don’t yet think we’re going to have a full on crash, like many are predicting, is because I think monetary authorities will counteract that, or at least will try to counteract that. And I know there’s people out there saying, Well, markets are bigger than governments. And you’re absolutely right, they will. They are. And eventually that will happen. But I am not someone who believes that the Fed is out of bullets. I think there is a lot of things that the central banks can still do. I think there’s a lot of things that the monetary authorities can do. Whether they should do them or not, that’s an entirely different conversation. But I think they will. And so I think right now, to me, it’s a fairly easy decision for me to be hedged. I’m actually neutral to even maybe slightly net short right now based on the number of hedges that we have. And to me, it’s a fairly easy decision right now because sentiment is pretty high, not as high as it was a couple of weeks ago, but it’s pretty high. Positioning is no longer super bullish and we no longer have the tailwind.

Brent

Where I think it gets really hard, Tony, is if we do get a 10 % correction, then what do you do? Is that dip that you buy or is that where you really get careful because the crash is coming? And again, I don’t know the answer to it, but I’m happy to be neutral to net short right now and just wait and see what happens over the next month or two. That was a very long, rambling answer to your question. Hope that explained it.

Albert

I agree with Brent. I don’t really see a crash coming. They’ve repeatedly said that they’re looking at a soft landing and performing that when the market is performing that way. Another thing that I want to touch on is inflation had a lot of inflated earnings for corporations, so it just kept rallying the market over and over again. And I think that’s probably coming to an end in Q3 and Q4. Fed funds rate, I think it’s probably going to 6 %. That’s going to be another headwind that Brent was talking about. But the Fed does it. They’re certainly not out of tools. They can use a VIX crush. They can use zero day trades. They can text stocks rallying repeatedly. I mean, like, AMD or Apple in any given day goes up 5 %, 6 %. I don’t see a crash coming just like Brent was talking about.

Tony

It’s interesting, but Brent noted that 10 %. Is that the marker? Is that the number? Is it 10 %, 20 %? When does the Fed get…

Brent

I don’t think it is. I think they would have to go back to the levels we saw last September or potentially even lower for the Fed to fully reverse. Now, it’s not to say that they wouldn’t come out and jawbone or talk about slowing paces or say we have tools to reuse this, but I don’t see them going back to QE unless we get at least back to where we were last September. And here’s why I think this is that when they started their rate hiking cycle 15 months ago, very few people thought that they could pull it off or at least pull it off to the extent that they have. But they have. They have taken rates from a half a % to five and a half % on their way to 6 %. And markets are within what, 3 or 4 or 5 % of their all time highs? If you would have told Powell 15 months ago that he could take rates from 50 basis points to 6 % and markets would be within 5 or 10 % of their all time highs, I think he would have said done. Thank you very much.

Brent

I love that solution. Yeah. Now, I think that they’re going to be surprised. I think things are going to deteriorate quicker than they think it’s going to, but I don’t think they’re going to react until it does deteriorate. And I know that if it deteriorates bad enough, they will react because that’s literally their job is to go in there and react and be the lender of last resort or save the system, however you want to define that. But I don’t think that their be upset with asset prices 10 % lower than here. I mean, we were basically there last November and it didn’t really stop them.

Tony

Right. Brent, it’s interesting when you talk about them coming in and job owning and the Fed job owning and saying, don’t force us to support markets. I mean, how hard could that be? It’s not like it’s punitive, right? And so Albert mentioned earnings. Albert, can you talk a little bit about where you see earnings going in Q3? Because we’re starting up soon.

Albert

I don’t think they’re going to be good at all. I think we’re going to start looking at earnings starting to come back down. There’s no tailwinds of inflation to help out these inflated prices that a lot of the corporations are reporting. Demand is certainly slowing no matter what data they spit out. Their demand is slowing. Inflation is coming down. Certainly it’s coming down. But I don’t see how corporations are going to be able to make up all that in their earnings with their reporting in Q1 and Q2. I just don’t see it continuing.

Tony

Well, we saw Samsung report earlier today with a 96 % decline in their earnings or something like that. Of course, they’re not American company, they’re a Korean company, and it’s a specific industry issue. But when we start to see very large companies with those type of prints, I think it really does start to raise some eyebrows.

Albert

Yeah, you’re going to see Ford and GM do the same thing. Those EV sales are slow and lackluster and recalls keep coming in. I just think the earnings are just going to take an absolute nosedive.

Tony

Right. And we also, I think for a year or so, we talked about how companies, whether it’s restaurants or consumer goods, would raise price and they wouldn’t really see their volume decline. But that’s changed pretty dramatically over the last, say, four or five months. And so companies don’t have the ability to continue to raise price to grow their bottom line. Yeah.

Mike

I was just going to add to that. I mean, the General Mills report is obviously the one that everybody responds to on that where they have limited ability of indicated that there’s limited ability to raise prices further. And I do think it’s funny, people have used this term greedflation, and they’ve used it in both directions. There’s a lot of people who I think take it quite seriously. I m among them. There’s also people that treat it quite dismissively and say something along the lines of, Oh, surprise. Corporations are greedy. They’re in search of profits. That’s not actually what the message was. The message was that what we were seeing is corporations were taking advantage of the volatility of price data to raise prices whenever they could. Saying to their customers, It’s not really our fault. You understand, inflation, things are crazy. That created the opportunity for them to raise prices. But as the inflation, as Albert is pointing out, has retreated, and more importantly, the volatility of that inflation has retreated, it’s becoming easier and easier for people to, again, comparison shop, make the articulation, I’m not going to buy these eggs at 7.99 because I see them next to another pack cheaper at 2.99. Suddenly, that is happening again.

Mike

That ability for consumers, both on the institutional side, supply chain managers and on the retail side, the consumer themselves to actually start to do the process of comparison shop again in a lower volatility environment is putting tremendous pressure on these types of prices.

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Tony

It seems to me that July and August, say, CPI prints may reflect a bit of a slowdown and potentially disinflation based on some of the base effects we had last summer around crude and the secondary tertiary impacts of crude. Is that a fair assertion to make? And do you think in two months time, we’ll declare victory over inflation?

Mike

I don’t think that we’re going to declare victory over inflation in two months time, in part because I think that we’ve actually created some of our own inflation. And so this has been an area that I’ve spent a lot of time trying to educate people on. Many of the components of what’s called the super core services, actually, crazily enough, have interest rates embedded in them. The most extreme one I can give is the cost of banking services. The cost of banking services in the CPI is defined as the spread between the risk free rate on government bonds and the interest rate you’re receiving on your deposit. Jp Morgan, for example, it’s perceived that their banking services have risen in price dramatically and that people value them so deeply because they’re paying effectively 500 basis points, 5 % for a bank service that they used to get for 25 basis points. Now, there’s been no change to the services cost. There’s been no articulation of an actual price change, but that’s what’s showing up in the CPI suddenly. Likewise, I know that you guys are active in financial markets. You’d be very surprised to discover that mutual fund fees have exploded.

Mike

The cost to investors of mutual funds, of financial services management has exploded. Why? Because the cost of securities lending has risen so much because it’s tied to the financing rate. So again, these silly things show up auto leases. Same dynamic where the actual cost of financing is now actually showing up in the cost of the auto lease. All of these are things that are feedback loops in inflation, and the Fed seems very unwilling to actually engage in discussions around that. I’m with Brent that says, one, I think it’s going to be very hard to get them to reverse. I don’t think it’s actually tied to the equity market s at all. I think it’s tied to the credit markets. I think within the credit markets, they’re going to be extremely slow to react because this is a general mantra that we saw take hold with Silicon Valley Bank and First Republic of, Oh, it’s their fault. They shouldn’t have been so greedy and stupid. So we’ll see stress begin to emerge there. And I think it’s only really when you begin to see the unemployment kick up in a violent way that they’re really going to feel any real pressure.

Tony

Okay. So on that first, I’m shocked to hear that not everyone at Silicon Valley Bank was stupid. Kidding. But we saw the employment report today. It was obviously not as aggressive as ADP earlier this week, but still very strong.

Mike

Just as a quick modifier on that observation, though, remember that the birth death on average on a seasonally adjusted number, which is what we saw, is adding about 100,000 jobs to the private sector. That’s all it does.

Tony

Every month.

Mike

Every month. So right now, we’re running on an annual average about 108 to 120,000 jobs per month that are being created using this, what I would describe as fictitious model of birth depth. That 144, in my math, was 32,000, basically.

Tony

Yes. That’s one of my bigger points that I try to hammer home on Twitter all the time. The least trustworthy data that I’ve found are jobs data, inflation data, and retail or consumer spending data because these are what get headlines in media and you always have to wait for the late revisions to really understand what’s going on. So that’s a great point. Mike, so.

Brent

Can I jump in real quick? I want to say something on that because this is where I think markets get really interesting. And this is why I think I’d be interested to hear what Albert and Mike think about this. But it’s also why I think markets will trend in a certain direction before they typically gap is that you’ve got to play what the fundamentals actually are, but you also have to play the common knowledge game. If you and I and Marco or Albert and Mike, if we know that the inflation numbers or the way they’re calculated are a little off and the jobs numbers are calculated a little off, that’s fine. But if nobody else knows it and everybody else goes off of the headline, then the markets are going to react to the headline. Now, eventually the fundamentals will catch up to the headlines and eventually you’ll hit the wall and you’ll get this hard draw down. But I think this is a mistake a lot of people make in the markets is they will try to look through the data, which is good. I’m not saying it’s a bad thing to look through the data, but you also have to understand I’ll talk to so many people say, Well, the CPI data, they don’t calculate it the way they used to.

Brent

If they calculated it the way they did in 1982, it would be much higher. Okay, that’s fine. And it’s good to know that. But markets react off of the way it’s priced right now. And so eventually, maybe those fundamentals will catch up with it, and we will have an epic reversal because the Fed also ignores how it used to be done. Mike just said the Fed is reluctant to look into this or engage with it any deeper. And so that’s why and with all the work Marcus, Mike has done with the structure of markets with passive investing, it’s really hard to change the trend. But when the trend does finally change, then it can move really quickly in the other direction. So anyway, I think to me, that’s one of the more interesting parts of markets.

Albert

Yeah, I agree with Brent. I mean, the BLS number, as Mike just pointed out, it was changed, I think under Obama and then Trump railed against it, but he kept it. And the way they calculated it is now even more inflated than it was previously. But even knowing that Brent’s right, perception is reality at the end. And that’s just the way the market is working. If they’re going to come out there with Fed speakers trying to rally the market and these employment and CPI prints rally the market, then it is what it is and you just have to react to it. Even I know this market is just full of crap at the moment. But, I’m forced to take five tech stocks and hedge against all my puts because I know what the game is at the moment.

Mike

I’m going to actually say, first, obviously, I agree. At the end of the day, markets are right, whether regardless of your analysis, price goes up, you have to mark your book. It is a luxury that private equity doesn’t have, for example. And we know that, but there is also a reality associated with this dynamic of transactions or forced behavior. The only reason I care about that data is because I actually am trying to understand what’s really going on, effectively identifying the alligator jobs that are opening up between what the Fed is reacting to and what market they’re reacting to. And what I’m seeing is the underlying phenomenon. That’s really all you can do. I agree with what Marco is saying and what Brent is saying. You have to trade the market. But at the same time, it is a variant. I think one of the most misunderstood statements was Chuck Prince, when the music’s playing, you got to keep dancing. Everybody universally shit on that coming out of the global financial crisis because we all had the hindsight to look at that. But he was right. It’s the same thing we’re experiencing right now.

Brent

That’s exactly right. That’s exactly right.

Tony

Hey, speaking of keeping dancing, let’s move on to China. These are great guys. We could talk for hours on this stuff. Let’s move on to China. Albert, you posted something a couple of weeks ago on June 29 talking about this Chinadestruct.exe when US rates go to 6 %. Really interesting. And a viewer asked us to talk about this on the show.

So can you talk to us about how rates approaching 6 % impact China? Also, we’ve seen some real pressure on CNY. So our view is that we’ll continue to see pressure through the end of the year.

But why is CNY struggling? Can you talk us through that stuff? And obviously everyone join in. But, Albert, if you don’t mind, if you can start on your Chinadistract.exe, that would be fascinating.

Albert

Well, it’s predicated on the notion that it’s better to face China and stress them in the economic markets rather than face them globally on a geopolitical level or in a military conflict or any one of those different variables that people like to talk about in the doomsday preppers. But China was never ready for 6 % Fed funders. They’re not ready for it. It was out of their calculations. They didn’t think it would ever go up that high. They’re just simply not prepared for it. And that’s going to take a significant chunk out of their purchasing power. They got debt issues or the dollar debt issues. They have issues all over the place. 4.5 % on the ten year for Asia and whole, that’s really problematic from what I was told. I think we’re just discussing it off camera that just takes a lot of the inflows back into the US dollar and the US markets. And Yellen knows this. Yellen knows this. Right before she goes to visit China, the DXY is still elevated at 103, 104. So she’s over there lecturing the Chinese on what she thinks needs to be done and whatnot. But it’s clear as day at the moment that the United States has a policy within, whether it’s the treasury or the Biden administration, to keep a cap on China’s ability to stimulate the economy and potentially launch another round of inflation globally.

Tony

So why haven’t they, in your view, why haven’t hasn’t China really focused on stimulating their domestic economy?

Albert

Well, they got an inflation problem themselves right now, currently with commodities all over the world just being elevated. Their manufacturing sector is still a little bit… It’s not running on full cylinders at the moment. They’re not in a good place, put it that way.

Tony

They’re a little bit stagflationary. I wouldn’t say fully, but a little bit it seems.

Albert

Yeah, they got a demographics problem, as many people have pointed out on Twitter and everywhere else in the media. But they’re just… He has so many problems economically and politically that for him to even talk about devaluing the RMMB is almost a non starter. But the reality is that that’s probably what’s going to have to happen at some point.

Tony

Well, they have to. You’ve got a depreciated JPY, you’ve got a depreciated KRW. Those guys in Taiwan are the major competitors for exports. So if China is going to raise dollars, they’re going to have to do something to make their export. I mean, it’s an overly simplified argument, but at some point they’re going to have to do value because they’re still carrying debt loads from pre 2008.

Albert

Yeah, their debt loads. Their debt is anywhere between 500 and 700 to the GDP. So it’s not really… The reported debt loads that they have is probably three times as much.

Tony

I want to go back to that because you said their debt loads are between five and seven times GDP. What we typically hear is something like 230 %. So can you talk us through a little bit of your assertions there?

Albert

Well, even the Chinese have started to talk about being able to identify the debt within the country in the real estate sector and the commodity sector. I knew people in China that would look at a pile of copper and inquire about it, and they were told it’s been leveraged already five, six times. So it’s like all this hidden debt in China is still relatively unknown.

Tony

Okay, interesting. Brent, do you have any thoughts on C&Y and what’s going to happen there?

Brent

Yeah. I sent you a chart before we started that goes back, I don’t know, maybe 10 years, and it shows the mini deval they did in 2015.

And if people remember, just that small little deval caused, at least for a couple of months, a little bit of chaos in the markets back then. And now C&Y is significantly weaker since then. And to me, it’s a function of the US being in a place where they are better able to raise rates than the rest of the world. For all the people who say that the US cannot get away with keep raising rates, I completely understand the argument they’re making. But the US can get away with it better than everybody else. And as a result, the yield differential between a US Treasury and a C&Y Treasury, but you get to hold the dollar rather than holding C&Y, just more money flows into the dollar and makes the dollar stronger. And then they have a lot of dollar debt and it’s now getting refinanced at higher levels. They’ve got a slowing real estate market, which they’ve been dealing with for a number of years now, and they’ve been able to plug those holes, but it’s just becoming harder and harder to do.

Brent

And I think they’re getting it. The C&Y has gotten fairly weak this year. My guess, if I just had to guess on what will happen is, they will do something in the next month or so to strengthen it in order to show they’re tough on it, in order to scare anybody who wants to short it. But I think by the time we get into the second half of the second half, I think the C&Y is significantly weaker than it is right now because I just think that they have too many problems, in my opinion. And if they lower rates or they stimulate, then that causes their inflationary problems to pick up internally, which causes social problems internally. But if they don’t do that, then their real estate market comes under pressure. And I think ultimately that they will sacrifice the currency.

Tony

Well, I think what a lot of people underestimate is, of course, fiat currency is a faith based activity. And your currency is only as good as your central bank. And the amount that people understand about the PBOC is almost nothing. And the transparency of the PBOC is almost nonexistent. I’ve said this several times and I’ll say it again, PBOC management borders on numerology. At some point, it is literally numerology when they make policy changes. So for people who claim that the CNY is the globe’s next reserve currency, or that it’s credible, or whatever, they obviously don’t watch the PBOC very hard because there’s some very weird moves that they make.

Brent

I know Mike’s done work on this as well and be curious to hear his thoughts. But it’s just one of these things, and I know I’ve harped on this for years now, and I would encourage any of the listeners who have taken a hard look at the US and have come to the conclusion that the US is in so much trouble because we have all these problems, do that same level analysis on these other countries. And you’ll realize that they have all the same problems, but they don’t have nearly the same advantages as the US. So this is not to scapegoat the US. It’s not to say that we are immune. It’s not to say that we won’t eventually feel the pain. We will. But on a relative basis, the US it still looks much better in my opinion in the rest of the world. And the other thing is, we talked about rates earlier, but real rates, I think the US has, I think, has the highest real rates in the world right now. That is a magnet for capital as well. Money will go where it’s treated best. And even though we have problems here with rates where they are and inflation coming down, the real rates are positive and getting more positive, at least for now. That can change very quickly, but at least for now.

Tony

Sure. It could. Mike, do you have any thoughts on that?

Mike

Well, so I would hit on a couple of things. One is, first, I agree with a lot of what you guys are saying. I do think that it’s important to recognize that the US, while it has tremendous resource advantages and has well documented advantages in terms of navigable rivers, separation from the rest of the world. We effectively have two somewhat friendly countries on our borders. We don’t really have to worry about hostile competitors in the same way that others do.

Mike

The problem for the US is social cohesion. Are we actually one country now? Are we two countries? Are we three countries split into two various flyover regimes with a standout group in the middle? We just don’t know yet. And that I think is really part of what we need to be very aware of. If we pull together and we behave as a cohesive unit, you can’t fight us. We can’t be stopped, at least not within the normal framework. But that is the key risk for us is the social cohesion dynamic. For China, they have a totally different one, which is that they have built up the productive capacity to serve the world. The rest of the world is suddenly saying, Hey, we don’t really trust you, China, to do that. And we certainly don’t want to take more of your excess production as we’re struggling with demand dynamics at home. And as a result, China is now facing risk of collapsing due to demographics and inability to grow faster than the rest of the world on the productive side at the same time that they just can’t grow their consumption. So you’re potentially looking at a true collapse.

Mike

It’s not dissimilar to what happened to Japan. It’s just they’re starting from a much lower point, which means there’s a very real risk that it turns into something really ugly.

Tony

And every Chinese economic planner’s nightmare is becoming Japan. And every Chinese, and they swear it’ll never happen.

Mike

Well, and the problem is for them to become Japan, they have to do what Japan did actually in 1989, which is roll over, expose their belly and say, Please, America, protect us. And this is something that I’ve said for going on explicitly with Europe. I’ve said it for Japan for 20 years. These places are… Europe and Japan have rolled over effectively and said, We are subservient to the United States. They may not acknowledge that yet. That’s much harder for Europe to engage in. Germany was Eastern European and Chinese flirtatious for an extended period of time. That honeymoon is beginning to break. And the problem is that if they want to rely on us to protect them, they have to actually be a little bit nicer to us, I guess, the way that I would describe it and stop talking so much smack. If I look at China, to me, the really critical relationships that I’m watching in the currency space are much less tied to the US, China, which I agree has the potential for a meaningful devaluation and would highlight that it’s had a much more significant devaluation than the mini one in 2015.

Mike

I actually think the much more interesting one is the within Asia relationships. So if I look at the Singapore dollar versus the Chinese one, to me, that’s just a very clear indication of capital flight out of China. You’re effectively seeing everyone who can get money out go to Singapore in one way or another or to other areas around the region. That is really concerning because I would actually turn around and say, I know that the crypto bros and Bitcoiners have gotten this world where we’re told that Fiat is faith based. That’s actually not what it is. It is force based. It is your ability to force your citizens to exclusively transact and pay taxes in your local currency. And when you have capital flight like we’re describing, where the money is actually taking every opportunity it can to get out of China, not return to China, and instead go to safe havens like Singapore, that’s telling you that the force based character of China is getting weaker and weaker.

Tony

Yes, and that should be terrifying for them.

Mike

I agree.

Tony

Going back to what Albert said at the very beginning, I would much rather we fight economic fights than fight genetic geopolitical political or war fights. It’s so much more desirable to do this. And the other part about that, Mike, when you talk about Europe and Japan rolling over, they’re not bad places to be. And the US is not a harsh, I guess, master. I hate to put it that way, but the US is not a harsh party to bail someone out. Japan is a great place to be. Europe is a great place to be. So for China to become more accommodative to US support and US guidance, I don’t think that’s necessarily a bad thing for them. It will take a lot for the TCP leadership to acknowledge that. So I think there’ll be more suffering at home before they’re ready to acknowledge that.

Mike

Unfortunately, I think that’s correct. I think that the key issue is that we are facing conflict with the TCP, not necessarily the Chinese people. How we choose to interact, how they choose to interact in that process is going to define a lot of it. And in many ways, the US has squandered a lot of the goodwill that was created. We remember Pepsi and McDonald’s going into Russia or the USSR, and all the goodwill that existed there. That’s now largely been squandered. There’s a very real risk that we go through similar dynamics with China. I would argue that we’re actually well on our way to that where the Chinese domestic narrative is turning to this century of humiliation at the hands of Westerners, and we have to act to preserve our rising and recentency.

Mike

All the language that’s there is used by every externally focused authoritarian government in history, from North Korea through Germany, through various bad guys as we view them in history in Europe and elsewhere. So I just think that’s unfortunately the case. I would also say, though, that even when you do have the economic competition as compared to the kinetic competition of a war, obviously, I would prefer to have the economic competition as well, but it’s foolish to think that there are not important ramifications associated with that.

Mike

So just like it takes resources for us to go and fight a war, it’s going to take resources for us to go off and fight economically. What I don’t know, and this is Albert and many others are more connected to this stuff, I don’t see the actual awareness of using US interest rate policy to fight against the Chinese. I think it is an unintended benefit, but I don’t think that there’s actually a fully intentional process associated with this. I really do think that this is mostly about domestic concerns, but it has the unintended benefit of behaving like John Connolly. It’s our currency, your problem. The problem is, do we get to the point when I sent you guys an email that shows the history of the DOW versus gold.

One of the things that’s really interesting about what happens is when you start to see these unanticipated reversals, it’s almost always tied to some form of breaking point that’s happened in a geopolitical and economic framework, whether that’s the Sino Japanese War in the 1930s, the Mexican Peso and British pound devaluations in the 1970s. I don’t know what it is this time, but that is absolutely the way it feels is that somebody out there is preparing to break.

Mike

And I can’t help but look around at the few remaining pegged currencies to the US dollar, and I’m just like, why? I mean, the Middle East, Saudi Arabia is playing a terrible game in terms of aligning itself with the United States, is doing everything that every small, potent, a dictator does in history to basically tick us off. And it’s playing a a very dangerous game in my view. Hong Kong, it’s literally, if we were to just decide that we’re going to sever some banking relationships which are increasingly irrelevant, that currency has to collapse against the US dollar. So we have all these characteristics that are sitting out there and some of these things. I think those are going to be very interesting potential shocks to the system.

Albert

Yeah, you have a lot of political risk there. People within the White House and the State Department acting a fool and forcing one of these issues to break and causing economic calamities around the world. So I agree with Mike on that one. It’s one of those things where there’s no competitor to the United States right now economically. So it gives us benefits, but it also gives us a lot of room to make mistakes.

Mike

We are an elephant in a tea shop. It’s really easy to unintentionally break stuff.

Brent

Yeah, I would just say that I tend to agree with Mike that the US does not lead with the dollar as a weapon, but I think that they are fully aware that it is one and they know how to use it if they choose to do so. I don’t think that they actively do so on a regular basis, but I think they know they have the capability to use it if they want to. And so I think that is why we could have a similar break. As we’re talking, I’m looking at this chart you just sent, and I could see some a break similar to these other geopolitical events in which the dollar would be used as a tool to do that.

Mike

Well, that’s what the chart… Again, Tony, if you want to put it up, you’re welcome to. Yeah, it’s going to be up.

Mike

The point that I would emphasize is just that when this is going down, we usually think about this as the dynamic of the US dollar weakening against gold. So this is just showing the ratio of DOW and gold. But what’s really happening in a lot of these situations is that the dollar becomes impossibly strong in a manner that effectively causes chaos. That in turn causes people to recognize that that can’t continue. So they begin moving into gold, allowing gold to appreciate at the same time that the dollars appreciating against everything. This is Brent’s dollar milk shake.

Tony

Yeah.

Mike

That unanticipated strengthening of the dollar hits assets that are from the private sector and designed to deliver dollars in the future, which is all common equities and corporate bonds and household mortgages, etc, are, they are instruments that are designed to return dollars in the future. If you spike the price of the dollar, they have to fall in price and the credit quality has to deteriorate because it becomes more uncertain that you’re going to be able to meet those commitments. Is.

Brent

Yeah, and I think that’s absolutely right. And the point I just want to make, because I think a lot of times when people hear me say this or you say this is the milk shake theory is that they automatically think that because I think the dollar gets stronger and the US is best on a relative basis, that this is a good thing for the United States. I don’t necessarily think that. It could be these unintended consequences. It could be a really bad thing for the US, but I just think it would be even worse for everybody else. So I don’t think that this is a situation where the US is having a picnic and the rest of the world is in flames. It’s just on a relative basis, if you’re holding the sword, you typically tend to be the one that’s better off.

Albert

Yeah. No, I agree. We saw the dollar get up to the Dixie, get up to like 112, 113, 114. And I mean, Europe was on the verge of breaking.

Mike

Yeah, that’s another chart that I’ve shared. I put it on Twitter the other day. I put it in our tier one note earlier today, which is this dynamic of everyone’s pointing to the Dixie and saying it can’t get out of its own way. It’s like, guys, wait a second. You understand what happened last time last year was the Euro got killed on a terms of trade deal where they suddenly had to buy our super expensive oil and gas. That caused Europe to move into a structural trade deficit as long as oil and gas prices remained that high. They’ve now unwind that. And now we’re looking at the interest rate differential story. Unless, of course, the US output in terms of oil and gas continues to depreciate sharply. But I just think that’s really hard from here. So a very temporary relationship, Kip, and I put it into a Twitter chart saying, this is the source of so much macro confusion where the euro, which traditionally trades with oil because it tends to be an anti dollar trade, suddenly completely reversed. That was just terms of trade. And within FX, it’s very rare that major developed market currencies trade on a terms of trade basis because they tend not to move that radically, but this was truly unique.

Tony

Yeah. Hey, guys, speaking of breaking things, let’s talk about credit for a little while. Mike, we were talking yesterday about credit divergence, and data were released earlier this week by Epiq showing that Chapter 11 bankruptcies in the US have surged by 68 % year on year in the first half. So we’re not seeing that in high-yield credit spreads.

We would expect to see this in a very loose credit environment, but not with the tightening we’re seeing with the Fed and regional banks, meaning the low credits. So what’s wrong and what are we missing here? You sent me a great chart showing bankruptcies and credit spreads and how that’s a bit broken. Can you walk us through this chart?

Mike

Sure. So the chart I believe that I sent you is one that shows the actual bankruptcy is rolling four week average.

So it’s not looking at that percentage change which can be colored by coming off a very low level. So we’re currently seeing levels of bankruptcies that are similar to COVID, similar to 2008. What we’re not seeing is credit spreads react to that. And there’s two reasons that I think that that’s happening. And by the way, the other chart that’s on there is my credit model, which perfectly matches the bankruptcies. It’s just not showing up in market pricing yet. Part of the reason why I think that’s happening is the same thing that happened going into the global financial crisis, which is as everybody recognizes that their portfolio is increasingly marked not on a fundamental basis, but on a relative value basis, they do everything they can to prevent the transaction from occurring that exposes that the actual value has fallen, causing everything on a relative value basis to be marked lower. We’re seeing this action, particularly in commercial real estate, but also within corporations. The Bye Bye Baby story today, I thought was fantastic on hitting this, where we’re doing everything we can to prevent the transaction from actually being a market clearing event.

Mike

If you read the headlines on what’s happening in commercial real estate, they’re handing the keys back to the lenders without even trying to sell it. Why? Why would you do that? Well, the answer is because you already know you’re under water and if you actually execute a market transaction, the rest of your book may get better.

Brent

Everything else goes, yeah.

Mike

So we’re seeing almost no transactions within high yield. There is a story, and I was just listening to Bruce Karsch highlight this, and I think there’s some truth to this, that within high yield, we’re seeing relatively higher quality credits. But those higher quality credits are only higher quality because their current debt levels, their current interest rate levels are so low. If you actually see the refinancing wall ahead of us in 24, 25 for those high yield credits and they repriced to the current levels of interest rates, the profitability of the entire high yield universe collapses and everybody gets downgraded. So everybody is trying not to refinance because the minute that they put this new stuff on, people do the calculations on debt to EBITDA or interest coverage expense. They’re like, Wait, now you’re a terrible credit. And nobody wants to do that. And so what we’re seeing within credit is only a few high quality credits are trading. The actual volume of transactions is way down. And I just think that very similar to the dynamics that led into the global financial crisis, we’re in this, let’s pretend nothing is actually happening in the hopes that nothing really does.

Tony

But that doesn’t really work out, right?

Mike

It can. Right, it can. This is part of the irony. People are constantly saying, slamming people in the financial markets and saying, Oh, you’re a bag holder and you’re just trying to get the Fed to pivot to save you from your positions being marked down. Like, Man, I’m running net short right now and suffering from it. So I’m sitting there like, Oh, man, they want to keep interest rates higher. I would absolutely love that. So that dynamic of the pivot, the begging and pleading is isn’t actually happening from financial market participants. I think they’ve largely come to terms with it. The begging and pleading is actually starting to happen in the real economy where businesses are constantly filing for bankruptcy. Businesses are basically being forced to hand over the keys and say, We can’t do it. And because those businesses in many situations are owned by private equity or players who have multiple properties, they’re just doing everything they can to prevent the thing from clearing. And it should tell people so much look at what just happened with Bed Bath & Beyond. The prime piece of property that they supposedly owned that justified all the valuation that everyone thought and the potential for this thing to survive even as it was selling six week old roasted peanuts and its checkout lines.

Mike

The underlying dynamic was this bye bye baby was a crown jewel. No bids, nobody wanted it. That tells you so much.

Tony

So what happens, Mike? In this type of cycle, when do people start recognizing that it’s a pretend game?

Mike

Well, I think this is going to be the real question because it is very much like the housing bubble in 2006, 2007, where it’s when the for sale occurred. And the ability to hold that off, you’re actually seeing the Fed guide lenders to negotiate gently. Let’s try to work constructively, etc. I think they’re increasingly aware of this, but the problem is, once it breaks, it’s like Humpty Dumpty. How do you put it back together again?

Tony

So that’s the credit that we’re looking for, and that may be the excuse that Brent’s looking for or mentioned for the.

Mike

Fed to come in and get that. I would just describe the market. To me, so many parts of the market have this characteristic where they are inherently stable within a small range. But if you move out side of that range, they become incredibly unstable. It’s fragility in the market as compared to any other reasonable expression of it.

Brent

Hey, Tony, I actually got to jump in a minute, but I wanted to make one point related to this that, again, I think is, to me, it’s very interesting. And I think a lot of people just miss it. And it leads to what Mike’s talking about is everything goes along until it goes out of bounds and then it changes very quickly is that there is a positive aspect of the higher rates too. So far, we’ve talked a lot about how there’s these negative aspects of rates, and eventually it’s going to catch up and it’s going to cause this downturn. But in the short term, until you hit the wall, the higher rates are somewhat stimulative because the government is putting more and more money into people’s accounts. Even money market funds are paying much higher than they were a year ago. So people who have asset balances are getting paid more. And so the government is putting more money into the economy through that channel. That helps to push prices higher. It helps the economy to go on longer. And then in a weird way, paying higher rates allows the Fed to raise again, potentially because of this tailwind.

Brent

But then it’s also why when you eventually do hit that wall, when you eventually do go out of bounds and things have to get priced, people have to mark their books, it’s the elevator shaft down.

Tony

Yeah. And guys, is this something typically that is… Are we going to wait two or three years for this to happen, or is this something that happens within a matter of months? How long does it take people to recognize these things?

Mike

It’s not a recognize. I just want to emphasize that. As Brent is highlighting, it’s an actual realization. The reason why commercial real estate is happening faster than other areas is because the financing there tends to be variable. They’re already experiencing these dynamics. There was another transaction that just occurred where the keys were literally just handed over. The reason that you do this, it’s not that the facility it’s not that the units were vacant or anything else. It’s just the cost of actually servicing the new or higher levels of debt meant that you had no prospect. The cap rate that you were earning on the rents, effectively, were so far below your financing costs. It’s like, Fine, give it to the bank. There’s nothing we can do here.

Mike

We’re seeing that in commercial real estate. The corporate sector, we’re starting to see it in many of the companies that were bought by private equity. I gave the example in one of my pieces on my sub stack talking about the difference between Veritas, which is an enterprise software company whose high yield… I’m sorry, whose first lean term loan, which is a variable rate, is now yielding 18 % against SAP, which is a direct competitor that’s trading in 100 times earnings. You just do the math on those two costs of capital and like, Wait a second, that doesn’t make any sense whatsoever. The spread between those two is so absurd. That dynamic, those who are in the variable rate are moving fast. They’re starting to hit already. Those who are in the fixed rate space have more time claim, and they’re praying to God that the Fed is forced to turn before their business deteriorates to the point that the operations start to hammer them. And that’s the last thing I would just hit on this, which is chump tax reform in 2017 took a step to try to get rid of excess leverage in the corporate space.

Mike

You may remember this. They moved to requirements that you’re any interest above 30 % of EBITDA was no longer tax deductible. So basically three times EBITDA to interest expense, which is highly levered. In 2022, that changed to 30 % of EBITDA. That’s a much more restrictive model because depreciation and amortization tends to be one of the tools that you actually use to conceal profitability in a variety of ways. As a private equity business, you simply fail to replace the capital. You can generate the cash flow that’s used to generate and pay down debt or to return dividends in the form of dividend recapitalizations. That change means that combined with a much higher interest expense, tons of companies are going to be moving into an environment in which their interest is no longer tax deductible. That’s a huge increase in the effective cost of interest rate. It then goes a step further, the same tax rules change so that you can no longer use losses to claim against prior tax payments. So tax benefits no longer extend back to prior profits. They can only be used going forward. That’s a huge diminution of the value of those tax laws carry forward.

Mike

This is hitting it all at the same time. So we’ve got this perfect storm for levered companies, and it’s crazy, but this is part of the reason why you’re seeing the Russell struggle. But across the universe of relatively highly levered companies, they’re not reflecting any of this. I see most of them as bankrupt. Wow. It’s pretty crazy.

Albert

We could go on for hours on this one. Just the sectors, the auto sector is one of my concerns because of the job layoffs that would be coming pretty soon afterwards if they blew up in the credit cycle. So it’s very interesting.

Tony

So, Brent, before you go, do you still think it’s going to be a correction rather than a big washout?

Brent

My answer right now, I think it could be a pretty severe correction. I don’t think that we have this crash and we’re in a depression for three or four years. I’m not willing to necessarily put a percentage on the correction. I don’t think that this is the crash and we’re in another Great Depression until 2032 or something like that. The last thing I’d say is before I got to jump is I know somebody asked on Twitter, you asked what questions asked and somebody asked about investing in defense companies or whatever. If this is going to lead to military engagement at some point of the geopolitical situation, wouldn’t that be a good place to invest? And I would tend to say yes. I own defense contractors. I think that’s probably an area that will get more funding in the years ahead as opposed to less. If you look at the top 10 defense contractors, I think seven or eight of them are public and a lot of them pay between a two and a three % dividend. And with my idea that the US will get flows anyway and then probably get funding from the government, though, I think those are perfectly legitimate companies to be looking at if you’re looking to buy the dip and equities.

Brent

With that, I will say…

Tony

Brent, thank you. I’m just going to thank all of you guys. This has been a long discussion. Albert, Brent, Mike, I just want to thank you guys for your time. I want to thank you for your thoughts and just have a great weekend and have a great week ahead. Thank you.

Mike

Thanks a lot. Thank you very much, guys. 

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Join host Tony Nash and experts Michael Gayed of  @leadlagreport , Adem Tumerkan  @AdemTumerkan , and Leo Nelissen in this latest episode of The Week Ahead. They discuss pressing economic topics, providing valuable insights into global markets.

Michael Gayed explains the looming credit event, highlighting widening credit spreads and underperformance of high-yield junk debt. Leo Nelissen shares European market trends and inflation concerns.

The panel discusses deflation and reaccelerating inflation in the US. Michael suggests deflation risks while considering a potential surge in money velocity that could reignite inflation, challenging the Federal Reserve’s target. Adapting views based on evolving information is crucial amid uncertainties. Tony presents a hypothesis on deflation followed by reaccelerating inflation. Michael draws parallels to past deflation pulses, like the 1987 crisis.

Adem discusses China’s lack of an opening boost and the prevailing deflationary atmosphere. The US banking system’s challenges, including declining borrowing and impact on net interest margins (NIMs), are explained. Concerns arise over banks’ heavy borrowing and the implications of an inverted yield curve. China’s economic challenges are examined, including its net exporter status and low consumer demand leading to a deflationary environment. The high savings rate, excessive household debt ratios, and declining consumer confidence are discussed. Parallels with Japan’s balance sheet recession caution against China’s potential trap. Housing sales decline, reserve hoarding, and hidden debts exacerbate challenges, emphasizing the need for debt restructuring and a shift to a household sector focus.

Germany’s negative prints and prevailing pessimism are explored as it serves as Europe’s manufacturing hub. Long-standing issues, such as deindustrialization and nuclear reactor shutdowns, impact the economy. Declining demand and China’s automotive dominance pose challenges. The quality of Chinese exports and outsourcing of chemical production are scrutinized. Germany’s anemic consumer base and low-interest rates impact consumer confidence. A comparison between Europe and the US underscores the role of the Federal Reserve and the potential for deflation followed by inflation.

Key themes:
1. Looming credit event
2. China weakness
3. German pessimism

This is the 71st episode of The Week Ahead, where experts talk about the week that just happened and what will most likely happen in the coming week.

Follow The Week Ahead panel on Twitter:
Tony: https://twitter.com/TonyNashNerd
Michael: https://twitter.com/leadlagreport
Adem: https://twitter.com/RadicalAdem
Leo: https://twitter.com/Growth_Value_

Transcript

Tony

Hi everyone. And welcome to the Week Ahead. I’m Tony Nash. Today, we’re joined by Michael Gayed, Adem Tumerkan, and Leo Nelissen. Guys, thanks so much for being here. I really appreciate your time. I know it’s been a pretty hectic week and we’re headed into, at least in the US here, we’re headed into a holiday weekend.

Tony

Today we’re going to talk about a looming credit event. Michael’s been on this for probably seven, eight months, maybe longer. I really want to dig into that. Adem has been talking about China weakness, and we’ve all seen that over the last six months. That’s something that we can dig deeper into as we’re starting to see that really get some traction. And then Leo is going to talk to us about Germany. So I think that’ll be really exciting.

Tony

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Tony

So guys, thanks again for joining us. Michael, let’s start with you if you don’t mind. I’d like to talk about this credit event that you’ve been tweeting about. You posted this very diplomatic tweet this week about the melt up, which you were early on board with that, and this looming credit event.

You’ve been on this and the deflationary bus for quite a while, as I’ve said. Can you talk us through your view? Why is this important right now?

Michael

First of all, I think we have it just to define what the credit event means. Credit event means a sequence whereby credit spreads widen, high yield junk debt ends up performing significantly worse for a moment in time than higher quality Triple A bond paper. And that tends to coincide with a fixed spike. And most fixed spikes tend to mark the end of a major volatility swing. So I’ve said many times before, I believe, oddly enough, we’re probably still in a bear market, which is not a popular opinion, but we can go through some of those reasoning. And the bear market probably ends in that fashion. Now, to your point, I’ve been saying that for a year now. Back in June of last year, I said every duration crisis eventually becomes a credit crisis. Now, there are lags, and it can take time to play out as we know. But that’s I think the major point. Now, the fact that you have a lot of these loans rolling over next year and the year after. A lot of these companies are going to be suddenly faced with higher financing costs on the rollover of their existing debt, which were at low rates post COVID.

Michael

They roll over that debt, that may not be able to survive. If they don’t survive, that’s when you end up having a lot of stress. Now, the thing is, if you’re going to have a lot of refinancing of loans next year, the stock and bond markets have to respond off of it this year because it’s a discounting mechanism of the future. So I think if I’m right that there is a crisis coming and it’s going to be around the debt rollovers of next year, this is going to be a year that a lot of people are going to be surprised by for like, what do you say?

Tony

What comes first is it do we start to see deflation appear first? Do we start to see equity market action first? So that VIX spike. What really comes first? Because if that refinancing is next year, and is not refinancing. I know there’s a number of questions here and apologies for that. Is that refinance commercial? Is it residential? Is it corporate? First of all, what are those refinance things you’re talking about next year? Then let’s get into the other.

Michael

Yeah, it’s primarily on the corporate loan side. We’re having to even touched the commercial real estate risks, housing risks, which I think are still out there. But just to be clear, I’m not like a firm or bear. Actually, I would argue that I’ve been wrong on the Melta this year. Okay, so early October last year, I said, I made that point, the end of the world is at hand. That’s why stocks are about to have a Melta. And I said that word because at the time, the speed with which yields were rising would have suggested that in a month, mortgage rates would have been like 20 %. So you can’t bet on that. So you might as well bet on stabilization of the bomber, which causes the move higher in equities. December, I said there’s a risk of a crash. You didn’t have a crash. 50 % of it was December in history. And then early January, I said back to melt up. But I think I’ve been wrong in the sense that if you look at what’s happened in terms of leadership, it’s not a broad melt up. It’s a melt up really just a select number of stocks which are driving the market at weighted averages.

Michael

You play at retailers, they’re not a melt up. You look at dividend stocks, they’re not a melt up. You look at merging markets are not a melt up. You look at small caps are not a melt up. So it’s like in Europe, in some parts it might be in a melt up. But for the most part, as I’m sure we’ll get into, right? Not so much. So my point is, people are focusing on the wrong thing. The market is already not following the pre election year script. And all that means to me is nobody knows what the hell is going to happen next. A lot of people are pulled up. It could very well be that everyone’s going to get surprised at the downside.

Tony

I have people ask me regularly, so what’s going to happen? And I can honestly say right now I can make a case for anything happening. We really are in one of those environments. And that type of environment to me is a little bit scary because I can normally look at a market and go, Okay, X is going to happen, then Y, then Z. And generally, it’s pretty straightforward. But right now, you can really make a case either way. I like that you said the point that you’re not a perma bear because it’s easy to… Because you’ve said this for a while, it’s easy for people to say, Oh, Michael’s a Pro of error. Let’s just dismiss what he says. But you do… First of all, I watch you change your outlook regularly. You calibrate it, of course. You don’t change it 180 degrees.

Michael

I flip flopped, is what people say, which is like…

Tony

Sorry?

Michael

People say I flip flopped. My answer is, you’re supposed to flip flopped. When there’s a new information, you’re supposed to adjust.

Tony

Your assumptions change. The context changes. You have to change with that. And so okay, so what happens first? Deflationary indicators? Is it equity markets changing? Is it more on the debt side and treasury side? What do you see changing first?

Michael

The bond markets that you’d see a more aggressive in credit spreads. Actually, I pushed the question to Leo, just bring Leo in because I think if you’re going to talk about the parallel of what comes first, you’re seeing it already happening in Europe. The ESB has to keep on hiking rates. You saw UK inflation brutal.

Leo

Oh, it’s brutal. Core inflation is a mess. I think it was today, coin inflation is actually up again in June. It’s an incredible mess. I think Spain inflation is below 2 %, but that’s only because of government measures. So that’s not sustainable. Not once, as you already said, credit, especially in commercial real estate, there are some incredible risk brewing over here, actually, because I’m in Europe. But yeah, that’s an issue. We have on one side weakness and on the other side high inflation, which is so keen on fighting. So it’s a trickier situation.

Tony

So do you see inflation reasserting itself in the US, Michael?

Michael

No. Well, let me put it that way. It’s all about probabilities. So I would argue that you’re much more likely to have left tail deflation risk for moment in time. And by the way, if you believe that the Fed is going to be effective in reaching the average of 2 %, you have to believe in a period of outright deflation. Because if you’re going to have an average of 2 %, you have to go past 2 %, given how high inflation was to smooth it out. So I don’t think it’s actually inconsistent from the way people think about it. But let’s talk about the other side for a second, though. There is a possibility that really what surprises people is exactly what happened in Europe. It happens in the US, meaning inflation reaccelerates. And what would cause that? It will be the thing nobody’s paying attention to anymore, which is the velocity of money, which has been in its downtrend for a really long time. Remember, inflation is more than just money supply, it’s transactions. So if you end up having conceivably a bottoming and picking up in the velocity of money, that’s going to be scary.

Michael

It’s not a base case, but that’s where it’s like, this is where we get.

Tony

Out of it. A pickup in the velocity of money is scary. Is that what you’re saying?

Michael

Yes. It would be against the backdrop of what the Fed has already done, hiking rates.

Tony

Okay. So let me just put a hypothesis out there. Last summer, a year ago, we saw crude spike, we saw inflation really start to pick up, other things. Now, we’re seeing a lot of downward pressure on crude. And of course, there’s the secondary and tertiary impacts of crude markets. So is it possible that we start to see that deflationary impact permanently? And then once that passes, we start to see a re pickup of inflation, meaning, say, late Q3, early Q4, we start to see a reacceleration of inflation. Is that a plausible, say, path for the next, say, six months?

Michael

Every credit crisis is a deflation pulse. That would make sense, actually, from a sequencing perspective, which is why I keep saying, for all you know, this year could play out a bit like 1987, where you had DAO up 38 % towards the peak, then a crash, then a Fed pivot all in one year, and all in a pre election year. So if that sequence is about now, that’s a good transition I’d argue to Adem because the part of this equation is what the PBOC and the fiscal side on China does. Perfect. Given that inflation has been actually much the opposite of everybody else. China reopened and inflation just is not trending up at all. The reopening trade is nowhere near looked like everyone else’s experience.

Tony

Yeah, a lot of slack in the market. Before we go on to Adem, Michael, I think it’s a huge factor that it is the year before an election here in the US. And I don’t think that should be discounted by anybody. The election cycles are major factors in the economy and in Fed policy here in the US. I like that you raised that and I like that you put that forward. With that, Adem, good morning. It’s pretty early where Adem is this morning, so I’m grateful that he got up to have the discussion. Good morning, Adem. Let’s start talking about China because what Michael raises is a good point. We obviously haven’t seen that China opening boost, and that’s obviously a lot of people have talked about that. You’ve posted some great stuff on Chinese incomes and house values this past week.

Can you talk us through some of that? And within the context of the deflationary vibe that we’re getting in China?

Adem

Yeah. And just before we go on to China, I just wanted to add to what Michael was saying. Also in the US banking system right now with the credit risk and deflation, we’ve seen bank lending pretty much grind to a halt over the last few months. And in a credit-driven economy, which is like the 1980s world at this point, that’s pretty deflationary. You’re having more debt being repaid than new loans, and that will probably weigh down growth, the prices and increase bank instability. The Fed stress tests yesterday pretty much showed how they’re all borrowing from the federal home loan banks and BTP at very costly rates. So as the NIMS gets spread, I think it’s going to be pretty deflationary in the US. But sorry, back to China.

Tony

Sorry, before you move on, there was a lot that you just said. When you talk about the NIMS, you’re talking about net interest margin, right? So could you talk to us, first of all, about the magnitude of the fall of borrowing, and then can you talk us through net interest margins a little bit?

Adem

Sure. Yeah, net interest margins is basically how a bank makes money. They make a loan, which is an asset for them, and then the equivalent deposit is the liability. And like we saw with SVB, they had pretty good assets. But the problem is, once you have capital flight.

Leo

Or.

Adem

Etc. Come in, you have to persuade depositors to stay. And we can see how a liquidity crisis can start and happen extremely quickly and wipe out bank capital ratios, which usually hover around 10 %, capital ratios for anyone that’s basically bank equity. Once you have non-performing loans or asset prices drop 10 % in aggregate on the balance sheet of the bank, they’re essentially insolvent. And then you have to liquidate assets to meet the liabilities, which pushes the loans below their book value. And once you get below insolvency or wipe out that 10 %, you can’t lend anymore. I don’t think banks are done. We saw the recent stress test. They tested or they looked at 84 banks under the analysis, and Bloomberg did a good piece on this. And they showed that banks have been borrowing heavily from the federal home loan banks. Federal home loan banks are basically government-sponsored enterprises in the US. They don’t have access to the interest on excess reserve market, so they arbitrage their money, like they lend to other banks, and then they can park it as reserves, collect it from the Fed, or lend out. But it’s costly right now.

Adem

It’s about 5 %. So the end of the yield curve right now is what? I mean, it’s inverted, essentially. So banks are finding it very costly to hold this money. And we actually just saw for the first time in eight years at least, banks now in the last quarter paid more in net interest income… I’m sorry, net interest than they made in quarterly profits. And yeah, I’d imagine that. And this was pre SVB or right up to that late March. And this is when they’re already borrowing heavily from the federal home loan banks and the BTP. So I’m assuming that it’s going to probably get worse in the coming quarters because nothing’s fundamentally changed.

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Tony

Great. With that train over, let’s move on to China.

Adem

Yeah, China’s stuck. I know a lot of people thought… I actually remember being in a space with Michael a few months back, and everyone was talking about inflation, and they were saying when the China reopening happened, and me and Michael were the only people saying, That’s going to be deflationary just because China is structurally in balance at the point that they’re a net exporter. They have no demand in that economy. So when you see everyone say like, Oh, when they reopen, there’s going to be a big consumption boom. The problem is they don’t really have the buying capacity that the US… For the second largest economy in the world, China’s revealed GDP per capita, it’s about 12,000. It’s very small and their gross savings rate is a % of GDP. It’s 45 %. It’s excessively high. To put it in context, Japan’s and Germany, which also have anemic consumers, they’re about 30 %. Saudi Arabia is 30 %. South Korea is around 30 %. So you can see a trend. All these net surplus running countries have very high savings rate. So China now has a crisis of confidence in the consumer, and their solution is, Let’s cut interest rates.

Adem

And we’ve seen the Yuan get obliterated over the last few months. And that’s going to make things worse for the Chinese consumer because a weaker currency is a tax on imports. And that’s exactly China’s problem right now. So they’re trying to get exports to grow their way out of whatever situation there is of slowing growth. But how much more can you depend on the rest of the world to absorb your excess if you can’t fund it domest? And Germany, same thing. All these other countries are in the same boat. South Korea, etc. Japan. So China now is in a thing, in my opinion, called a balance sheet recession and a balance sheet recession, BSR. It’s a term by Richard Kueh. He’s the head of macro analyst at Nomura. He wrote a great book on this called Escaping the Balance Sheet Trap about a decade ago. He was looking at Japan and he was seeing how basically in Japan in 1990, you had very high, the late 80s, household debt soared in Japan. Their currency, the Yen, appreciated about 40 %. It effectively popped their asset bubble. Their exports to GDP dropped from about it was about 12 %, 15 %, it dropped to about eight.

Adem

And that was after the Plaus Accord basically Ray in and told Japan and Germany, hey, we’re running deficits. You need to let your currency appreciate our dollars way too strong right now. Kind of like what Trump was doing with China. So you could see it’s very cyclical with these countries when they start absorbing their surplus, it means you have to run a deficit. So China, the whole theory behind China in the early 2000s, like you were talking about earlier is, they were very under invested back then when they entered the WTO. So savings flowed into the country. It made sense. The investment returns, the infrastructure was needed. But now they’ve hit that law of diminishing returns and you can see it in their debt ratios. If the amount of debt they were spending on these infrastructure projects and investment were matching growth, the debt ratios wouldn’t be exploding. Clearly, they’re putting more debt to get less returns, hence the ratio is widening significantly. China’s macro leverage to GDP, not even including local governments, is already 300 % of GDP. Household debt went from about 28 % in a way. Now it’s about 63 %. To put it in context, the US is about 73 %.

Adem

So they’re already right behind the US’s household debt to GDP for their entire economy, but their buying power is essentially one sixth of the US. And that’s troubling for China because if they cut interest rates here, and this is where the balance sheet recession comes in, they’re falling right behind Japan. Because if you cut interest rates, the idea is it will stimulate growth. In macro theory, it’s, oh, cut interest rates, it allows the production to go further out. You’ll have investment, more consumption in a rational market. But in a balance sheet recession, it’s when the consumer’s confidence is shaken and they stop borrowing. When you stop borrowing, interest rates and deflation… I’m sorry, inflation sinks, interest rates sink to zero until you find equilibrium. So China is cutting interest rates to effectively try to spur consumption and investment. But the business side, the private side of China’s investment is way down. And it makes sense because if you have a weak consumer, why are you going to invest domestically? That was the same problem Japan had. If you have no consumption in your economy or it’s very weak, you’re not going to keep investing in your own private business.

Adem

So we’ve seen that state own enterprises in China stepping up. But the government subsidies are very high there. The investment to GDP is very high there. They would have to reverse that entire balance of their entire economy to the household sector. And I don’t think China wants to do that. Or it’ll be very painful to do it because you’d have to let GDP fall and let household incomes rise for multiple years. And that’s a painful process. And yeah, so the Chinese consumer is a big saver right now, clearly, and they don’t have safety nets. So cutting interest rates will probably aggravate the problem, like in Japan, because they have a huge demographic problem coming up. They need to save for retirement. Home prices are essentially there… I think home prices in China are the world’s largest asset class. It’s about two plus times bigger than the US’s, and they are depending on that for future investment. You retire, you sell your home, you have the cash. Now, if home prices are falling and they can’t get confidence back up, we’ve seen mortgage loans taken out in China, just they’ve collapsed. It used to be about 10 %, 15 % per year.

Adem

It’s zero now. It’s actually literally dropped over the last six months all the way to zero. So they’re just not borrowing. I mean, if you look at China’s household debt to GDP, it’s been flat, essentially flat for three years. And if you don’t have new credit coming out, I don’t see how cutting interest rates is going to fix that. And they’re just flying to the same trap Japan did.

Tony

Yeah. If you talk to any Chinese leader or senior bureaucrat, there are two things that they’ll say is, first, they will not become the Soviet Union politically, and they will not become Japan economically. They are paranoid about those two things. And so the case you lay out for China becoming Japan… In Asia, you have these four demographic waves. First was Japan, then was Taiwan, then was South Korea, and now is China, where they’re just aging so fast that it’s really hard to keep up the growth rates and the monetary and fiscal policies that they had when you had such a large working group and you had such a young, large young group that you could balance out those costs across age groups. And they just can’t do that anymore. They don’t have the growth of income, they don’t have the growth of foreign investment, they don’t have the growth of exports. As other markets get older, Europe and other places get older, their consumption goes down too. So it’s a huge problem for them. And so in the balance sheet recession in 2009, first of all, before we get to that, can we talk a little bit about housing sales?

Tony

You sent a couple charts across on housing sales. I want to make sure I know you discuss these generally, but I want to talk about these a little more specifically where you say there’s no signs of a pickup in housing sales.

Leo

The.

Tony

Income’s dropping, where do you derive the Chinese income’s dropping from that chart?

Adem

So yeah, the PBOC or the MBS, they do a survey on household wealth and confidence. And the latest one showed that it did below 50. I think it’s the first time it’s done that in a few years, actually. And it was one sixth of surveyed. And granted, it’s a survey, so keep it with a grain of salt. But they were saying that their incomes have actually been declining in China, which makes sense. The yuans been battered.

Tony

And it will get even more battered, right?

Adem

Yeah, I agree. It’s interesting, the PBOC is essentially letting it fall because they could step in. They have what, 3 plus trillion in reserves.

Tony

Supposedly.

Adem

Yeah. I think they have at least five or six trillion. I mean, if you look at the current account balance of trade, they’ve had 3 trillion for It’s been what, like a decade? It’s just been flat. But they’ve been running current account surpluses since then. I’m assuming they’re offloading it to the state banks or like a shadow banking with their reserves because they have way more than three trillion, which is a problem too, obviously, because they’re just hoarding the money. They’re just sitting on it. They’re not.

Tony

Investing it. Let’s look at that for a minute, though, because after the financial crisis, they had all these loans that they continued to evergreen and pass across to other banks. They’ve had to really pay off some of those loans. So all of these dollars that China has, they’re not necessarily being stashed away, they’re being used to offset those loans that have been evergreen for the last decade plus. Yeah, that’s true. There’s this global assumption that China has all of these dollars, but they have all of this debt that’s 20 plus years old that has needed to be offset on those bank balance sheets. So do they have all of the dollars that they claim to have? Maybe. Maybe they do, maybe they don’t. But that’s how they dealt with their balance sheet recession previously, was just evergreening these loans. And so this time around, they’ll likely have to evergreen these residential and commercial real estate loans at those lower rates. Does that make sense? Yeah. And so those new dollars that come in are going to have to have to be used on evergreening those Chinese real estate loans that have taken place over just the last 10 years.

Tony

That says nothing about the ones that are over 10 years old. Is that does that make sense?

Adem

Yeah. Well, that’s also a problem in China. I agree with you because they’re cutting rates is essentially just going to let these big toxic debt piles be rolled over. Banks in China now, their nims are below 2 %. I think it’s the first time it’s actually been below 2 %, it’s like 1.9 % right now. So they’re getting squeezed pretty hard. Nonperforming loans already up to about two and a half percentage points on a $52 trillion or one y ou on a banking system. So even if they have the dollar reserves, the local government debts, which are the real problems in China right now, no one knows what they really have. But I’ve seen estimates. They’re not going to be looked at it’s about 4 trillion, but they said hidden debts are another 6. So let’s say it’s 10.

Tony

It’s 10 trillion.

Adem

Yeah. So that’s 50 % of their GDP, if not more at this point. So we’ve had to see them now they’ve been doing big fees. And this is a structural problem with China is that they’re taking more away from households, which is exactly the opposite problem. As the local governments now are straining under land sales and property values, we’ve seen record fines and taxes right now actually happening in China. There was some restaurants that their fines for serving a certain dish away, they got fined like $700 US dollars or something because they’re trying any way they can to raise capital at this point. But the thing is, when you’re taking money away from… I mean, it’s a subsidy to the government, right? And that’s the problem. You’re taking the money out of the consumer and you’re moving it back to the state.

Tony

And.

Adem

Then what does the state use it for? To roll over debt, use it on wasteful investment. So everything China is doing now is just making the anemic consumer worse. And that’s why the last six months I’ve just looked at it and I’ve just said there’s no way that you’re not going to see a booming economy with this imbalance. They have to rebalance.

Tony

And this is why it’s important to have the bad bank, right? I mean, the old archetypal, I guess, bad bank, it started, I guess, here in the S&L crisis, and Korea did it pretty successfully. And you’ve got to have a bad bank to take all those debts and then offload that onto the public so the value can be discounted so that those loans can come to some conclusion, right? Otherwise, they continue to be carried by the government. And in a.

Adem

Central crowded state… You need some restructuring.

Tony

And in a central planning state as government, if there isn’t really an actual value of money, this is why the C&Y, at least for now, can’t be a global currency because there is no actual market to market value of loans, of financial instruments, of the currency and other things. Great. I love the chart that you put up on mortgage borrowing as well. As that becomes more anemic, what that says to me is not only are people afraid of the economy, but they don’t really trust the institutions around homes generally, banks, even the real estate companies, and so on and so forth. That’s where a lot of the wealth is kept, retirement wealth and other wealth is kept is in real estate.

Adem

Yeah. The confidence is very shaken in China consumer, and that’s going to be a big problem for them.

Tony

Well, and that’s a great point. Confidence is, once the flow slows down, you can’t play musical chairs anymore. That’s the real problem with mortgages in China because you can’t the Ponsy has to stop once the flow stops. Great. Okay, so I’m really pessimistic on China now. Thanks, Adem. I really appreciate that. Let’s go to Germany, where I think we’ve had some really negative prints, and sentiment prints, Leo, over the past week. One is on business expectations and the other is on manufacturing export expectations. Leo, why are these two prints so important? First and second, what is driving that pessimism?

Leo

Well, they’re so important because Germany is essentially the manufacturing hub, actually the manufacturing hub of Europe. Just the other day, I saw that Dutch politicians were saying, Germany is struggling and that’s going to have a big impact on us as well, whether it’s transportation or services. The economies are so well connected. What I find so interesting about these indicators, I said, they just tell a story. I was just googling the other day the IFO index that you are referring to, EFO. I googled it and I saw that multiple news articles from 2019 and 2018 already said, Germany is actually headed for a recession. They’re obviously in a recession right now and it’s self inflicted. So all these issues, everyone is talking about deindustrialisation, they are right, and all these issues that Germany has, but none of these issues started after the pandemic. I think they started in 2011 after Fukoshima when Merkel decided to take these nuclear reactors offline. And that’s when it started very slowly. I think Germany peaked in 2017 when automotive production peaked. And since then, things have gone downhill quite rapidly, especially after the pandemic. I noticed in late 2020, early 2021, everyone was talking about pent up demand, which was right.

Leo

There was a lot of pent up demand. And sentiments started to come down because of the weakening economy. And everyone said, Yeah, but that’s not an issue because supply chains are easing supply chain bottlenecks. So that’s good for Germany. I was always a bit skeptical because yes, supply chains are getting healthier, much healthier, but demand is struggling right now. So I actually looked it up from the EFN and they said backlogs are a huge issue. So demand is basically gone at this point for cars, chemicals, and that’s what they’re saying. So chemicals in a very bad place, machinery, which is essentially 50 % of Germany’s export chemicals, machinery, and stuff related to this. And then transportation and logistics are struggling right now. So Germany was, especially after the Euro crisis, one of the strongest players in Europe. And now it’s the only G7 nation with negative growth expectations for this year. So that’s a big problem. And now you’re seeing export weakness again, which is triggered because of China weakness and in general, the global economy is quite bad, or it’s weakening. What I need to add as well is Germany has rapid population growth.

Leo

Last year, population grew by 1.4 %. Obviously, a lot of refugees, Ukraine, Syria and refugees and everything, but Germany isn’t handling these things quite well. Most of these people are unemployed. The government is basically paying people to be unemployed. There are no incentives for people to get into work. Germany right now is a structural mess. It’s incredible. And then China now, we’re talking about China, China is getting stronger in automotive. Essentially, Germany helped China grow after the 1970s. They saw a nation wanted to grow with manufacturing. They needed machinery for construction and everything. And then once China’s middle class started to grow, Germany saw an opportunity to sell cars, Volkswagen and luxury cars like Mercedes and BMW and whatnot. But now China is saying, Hey, we want to take this market back. So especially in electric segment, the test drive is quite a big player, but the vast majority of cars are Chinese that are sold right now in the EV space. And China controls EV related commodities. So the Europeans actually, in another problem, they’re just now pushing for EVs. I think they want to ban fossil fuel cars after 2035 or something. Not entirely sure on that one.

Leo

But they would essentially now give China more power and harm their own economies because China is now starting to export cars. I looked it up the other day and it’s just wild. Germany is now exporting fewer cars than China. Last year, Germany exported 2.6 million cars and China exported 500,000 cars more than Germany. And that’s almost 400 % growth in the past seven, eight years, China. These developments are just incredibly bad for Germany.

Tony

It’s easy for people to go, Yeah, but those China exports are low value, low quality exports, and German exports are high quality, high value exports. I think that’s the knee jerk reaction to that. Is that the case?

Leo

In general, a lot of products from China have inferior quality. German companies already said for over decades, we want to work with the Chinese, but the workforce and the equipment we get, I want to work with what we need for our production. Quality has always been a Chinese issue and I expect it to continue. But in EVs, China is actually doing quite well. There are a few brands that I never heard of that just came popping up in the past few years that are now flooding. Growth is high, but they’re not dominant right now. But the quality of these cars is great. People actually, great reviews and everything. That’s a big problem. The EV quality is great and that’s the thing that hurts. Then chemical production is going overseas as well. That’s one thing that really started to accelerate after the invasion of Ukraine. Big companies as BISF, they are just outsourcing now. They made crystal clear, we’re not going to invest in Germany anymore. So production, I think BISF is accelerating investment in Texas, Louisiana, in China. That’s a big issue, especially because chemicals are so important in pretty much every supply chain. That’s probably coming from structural inflation.

Tony

Yeah.

Adem

Go.

Tony

Ahead, Adem, sorry.

Adem

I was just going to ask Leo, a lot of people call the UK the sick man of Europe, but I’ve actually argued that post 2000, Germany has been the sick man of Europe because their consumer is so anemic. Their current account surplus is… I don’t know if you guys have seen that chart after the Hartz reforms in Germany, early 2000s. It’s enormous how much they’ve been excess dumping their savings and unconsumed goods abroad. So I was just curious what you thought about that.

Leo

Yeah, I think that was one of the things that I think some Germans actually enjoyed when the UK went pretty much south after Brexit vote. I always so argue that the UK is somewhat of a mess right now. But yeah, Germany is a stick man. I mean, the UK has become way more flexible when it comes to international trade deals and geopolitical play. Uk is quite dominant and Germany is lacking all of these things. And just another number that I looked up, outside investments in Germany last year were actually 11 billion. And German companies invested more than close to 150 billion outside of Germany. And add to this, as you said, the consumer is in a pretty bad spot because not just because of inflation and higher rents and everything, but because of low interest rates after the Great Financial Crisis. People just spend it all. Germans, just like us Dutch, we barely spend. We are very frugal, but still, people spend a lot. And everyone was saying, Yeah, it’s because rates are so low. That’s one of the things that’s now hitting us in the back. That’s really stinging. If you look at consumer confidence, it has bounced a bit, but I think it’s close to or even below the 2020 pandemic laws right now.

Tony

Right now.

Leo

In Germany? Yeah, right now in Germany.

Tony

So business confidence and consumer confidence are? Consumer confidence is the thing that’s the difference. I wasn’t aware of.

Leo

Consumer confidence.

Tony

What’s inflation in Germany right now?

Leo

I don’t know the numbers on top of my head, but I had to look it up. But core inflation is actually coming up again. I mean, food inflation is high. Energy inflation is down everywhere, but I don’t know the numbers exactly, but it’s way above where the ECB wanted to be.

Tony

Hearing Michael’s views at the start, and he pointed to Europe as a leading edge of what could happen here in the US, do you see that happening in Europe right now, particularly in Germany?

Leo

It’s tricky. I think because a lot of what’s going on depends on the Fed. I think they’re way more powerful than ECB. The ECB now, they’re way more reactionary. Europe is different because we have a lot of structural issues. Right now, Italy and Spain, they’re just complaining about high rates, obviously. And still, a lot of the debt issues, they have just been massed by cheap money prior to the hiking cycle. I think it’s a difficult situation to compare. But overall, I think it’s similar. If you get a situation where deflation were to occur, I think it could, but it would be a very short period because it would probably be followed by quantitative easing, rapid rate cutting, and that would be unwind some of the structural issues, especially in energy. So I think you would get a second wave of inflation very quickly, even if deflation were to happen, both in Europe and in the US.

Tony

Interesting. Okay, very interesting show today, guys. I really appreciate this. Thank you so much for your time. I really appreciate it. Have a great weekend and have a great week ahead.

Leo

Thank you very much, guys. Thanks for having me.

Adem

Yeah, thank you. Bye. bye..