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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. 

Be a more intelligent trader/investor with CI Markets. AI-powered market forecasts. Transparent error rates.

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

Before we get started, I want to take a second to talk about our subscription product called CI Markets. CI Markets is our AI platform that forecasts stocks, ETFs, commodities, currencies, and economics on a weekly and monthly basis. Stocks include the S&P 500, Nasdaq, FTSE, Nikkei, and others, as well as the top 50 US ETFs. We forecast over a 12-month horizon and we show you our one-month and three-month error rates so you understand the likely risk associated with our forecast data. Subscriptions to CI Markets start at $20 a month and you can find out more at completeintel.com.

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..

“The Week Ahead” episode combines the wisdom of Tracy Shuchart, Chris Berry, and Corey Lavinsky, as they explore peak oil, battery technology, and biofuels. Tracy shares insights from the recent IEA study, predicting peak oil around 2028. Though oil demand may decline, it won’t vanish entirely. The talk shifts to electric vehicles (EVs) and Tracy’s reminder that their power source in China is still primarily coal, underscoring the significance of considering the energy mix behind EVs.

Transitioning to EVs poses challenges, particularly with grid infrastructure. Tracy stresses the need for substantial investment in grid systems, particularly in the United States, to support the surging demand for EVs. China and India boast differing grid systems with potential for growth, albeit with their respective hurdles.

Chris Berry adds his perspective, emphasizing the crucial role of raw materials in battery production. Securing a sustainable supply of lithium, cobalt, and graphite becomes vital to meet the surging demand for EV batteries. The hurdles of domestic sourcing and the time required for new mining operations are discussed.

The episode unravels the complexities surrounding the energy transition and the multitude of factors shaping the energy sector’s future. It highlights the need for a holistic approach that encompasses technological advancements alongside infrastructure, grid systems, and raw material supply chains, all critical for sustainable energy solutions.

The episode further delves into battery metals’ impact on battery affordability and supply chains. Chris discusses the price volatility of battery metals, particularly lithium, and their limited influence on battery economics. Lithium prices fluctuate significantly but constitute a small portion of the overall battery cost. However, the concern lies in potential price hikes of metals like nickel, which could disrupt supply chains and pose challenges for automakers and battery manufacturers. Managing price volatility necessitates battery chemistry innovation and metal substitution.

Regarding lithium sources, Chris clarifies that lithium is not scarce and can be found in multiple locations, including North America. However, refining processes, mainly conducted in China, pose supply chain bottlenecks. The urgency to secure raw material access surfaces, exemplified by General Motors and Ford investing heavily in lithium projects. Partnerships between American and Chinese companies underscore automakers’ concerns about potential supply shortages and the need to secure critical metals for battery production.

The discussion discusses the conflict between climate goals and the North American mining permitting process. Tracy highlights the protracted and burdensome permitting process, hindering climate goal attainment. Chris raises the issue of coal’s use in nickel production for EV batteries, contributing to carbon footprints. Environmental impact considerations extend to mining, refining, and transportation within the supply chain. Alternative solutions like lithium-ion battery recycling and direct lithium extraction are explored, yet acknowledging their own CO2 footprints.

Shifting gears, the dialogue focuses on refining’s role in corporate mining investments. While Liontown concentrates on mining, Lithium America’s plans include refining. Presently, China dominates the lithium refining industry, with most raw materials sent there. Chris mentions upcoming lithium refineries in the United States, aiming to lessen reliance on China. The discussion culminates with Tony suggesting using biofuels for transporting lithium, potentially mitigating the CO2 footprint.

In another segment, Tony engages Corey in a conversation about biofuels and the recent EPA announcement on biofuel mandates. Corey reveals that biofuels are derived from biomass or organic matter, predominantly ethanol in the United States. Biofuel sources range from corn, sorghum, and sugar cane to biodiesel derived from fats and recycled oils. While biofuels presently represent a small fraction of diesel and aviation fuel markets, their growth prospects are promising.

The dialogue explores biofuels’ potential in aviation and the challenges posed by electric-powered long-haul flights. Corey highlights biofuels’ remarkable growth in the United States, propelled by the Renewable Fuel Standard program, which has fostered ethanol and biodiesel production expansion.

The EPA’s biofuel mandates encompass various categories like renewable fuels, biomass-based diesel, advanced biofuels, and cellulosic fuels. Corey discusses the reduction in proposed mandates for corn-based ethanol, causing discontent among biofuel companies. Biomass-based diesel mandates exhibit sluggish growth, despite substantial investments in renewable diesel and sustainable aviation fuel facilities.

The episode delves into biofuels’ current state and future prospects, specifically focusing on ethanol and sustainable aviation fuel (SAF). Tony initiates the conversation, underscoring conventional fuel production’s plateau and potential Midwest disappointment due to sluggish biofuel requirements. Corey envisions a reduced demand for ethanol in gasoline-powered vehicles due to increased electric vehicle adoption. However, he views SAF production as a promising opportunity for the industry. Corey highlights ethanol’s potential as a SAF feedstock, enabling aviation decarbonization. Tracy raises concerns about SAF’s cost for consumers, prompting Corey to mention existing SAF mandates in Europe and planned future mandates in the United States. Limited SAF availability stems from technological development and the absence of past SAF mandates. Corey predicts increased SAF production as airlines enter offtake agreements with renewable fuel producers.

Lastly, Tony moderates a discussion with Chris, Corey, and Tracy on near-term opportunities in battery metals, biofuels, and oil. Chris emphasizes battery technology advancements, specifically advancements in cathode and anode formulations. He spotlights the intriguing investment potential in the refining aspect of the battery supply chain. Corey accentuates ethanol’s utility as a sustainable aviation fuel (SAF) feedstock and outlines federal and state incentives propelling SAF facility advancements. Tracy highlights how some traditional oil refining companies invest in biofuels, noting that oil and gas industries differ from mining metals, oil, and gas. She reveals that many oil companies remain unaware of alternative energy sector developments, allocating funds to avoid falling behind. Chris adds that historically, oil and gas companies hesitated to invest in battery metals due to the limited market size, but changing political dynamics are now driving exploration into such opportunities.

Key themes:

1. Peak Oil in 2028

2. Batteries

3. Biofuels

This is the 70th 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
Tracy: https://twitter.com/chigrl
Chris: https://twitter.com/cberry1
Corey: https://twitter.com/biofuelslaw

Transcript

Tony

Hi everyone, and welcome to The Week Ahead. I’m Tony Nash, and today, we’re joined by Tracy Schucart from Hilltower Resource Advisors, Chris Berry from House Mountain Partners and Corey Lavinsky from S&P Global.

Tony

I want to take the opportunity really to talk about energy. We’re going to talk about peak oil with Tracy. We’re going to talk about battery technology and battery minerals, metals with Chris Berry, and then we’re going to talk about biofuels with Corey. So really excited about this show so we can get really deep in one sector.

Tony

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Tony

So guys, thanks. I’m really excited about this show.

Tony

Tracy, I want to talk a little bit about peak oil. There was this IEA note that came out last week saying that we’ll see peak oil around 2028.

They said demand for the chemicals industry will continue to drive oil demand, but demand for transports will shrivel. That was their wording. So 2028 is pretty soon, and it seems like a really quick time frame to change oil consumption. So can you talk to us a little bit about this IEA study and just tell us what some of the key takeaways are?

Tracy

Yeah, absolutely. So first, IEA estimates that global demand reaches 105.7 million barrels per day in 2028. That’s up 5.9 million barrels a day compared with 2022 levels. But really what they said is growth is to flow from there, not decrease. So it’s just the rate of change or the rate of growth is to decline is what they are saying. So they’re not actually saying that peak oil demand. That said, like all of the other forecasts, I do think this is wishful thinking more than anything. And they did, as you are correct, they did include a caveat which included biofuels, petrochemical feedstocks and other non energy uses, which is up to a broad interpretation really, if you kind of work through this report, the only expected growth decline is in Europe and the United States and with increases elsewhere led by China and India. And given that if we look at this study, europe has 742,000,000 people, that’s 9.27% of the global population. North America has six, 4 million. That’s 7.55 million portion of a global population. So really that’s not a lot as a whole, considering there are 8 million people on the planet and many of which are in emerging economies where fossil fuels are necessary to reach levels above poverty.

Tracy

I mean, if we look at Africa, for instance, we have 600 million people alone in that country without electricity, and they’re going to need fossil fuels for a very long time. In addition, again, I can bring up China and India because both of them are expected to increase their consumption. Even if, adding in renewables, their consumption is set to increase together, their population is much larger than Europe or the United States.

Tony

Okay, great. So it sounds like it’s really a both, and it’s not just kind of fossil fuels or, say, renewables, it’s a both and kind of way going forward. But it doesn’t sound like oil is going to collapse in 2029 or anything like that.

Tracy

Correct.

Tony

Okay, so they talked a bit about transports and how much are EVs impacting the expectations around Ice vehicles. So you talk about India and China as being the big growth vehicle. So are EVs, let’s say, in India, going to displace ice cars?

Tracy

Not at this juncture. Not even close. And yes, in China, it’s huge growing industry. However, that’s not their main driver, because if you look at what is powering, their ice vehicles is coal because coal is their main power source. And so you have to take that into account when you’re looking at these things. Oh, yeah, China is the biggest growth in EVs. But what is powering the EVs? Where does that electricity come from? That electricity is basically still coming from coal, along with a mix of hydro, natural gas and crude oil. If we look at the United States, as far as feasibility is concerned, biden administration says he wants 50% of US EVs by 2030. We’re currently at 12%, and we don’t even have the chargers or the grid to even support this. So I have to still go ahead and say a lot of these initiatives are fantastic, but realistically, in seven years, it’s just physically impossible to get to 50% EVs even if people were forced to buy them. Right.

Tony

So we look at guys like Ford who’ve talked about losing billions of dollars this year, and they lose tens of thousands of dollars on every vehicle. And Chris, I want to get into this a bit with you in a second, but we’re not close to that goal yet and it seems very difficult. I want to go back just a second and talk about grids. So, Tracy, again, you talked about India and China. And can their grids sustain the EV growth that’s expected in those countries? Because we have difficulties with grids here in the US. Right. Sustaining. EV. Plugins. So is it first of all, can we hit that here in the US by 2035? 50% just on the grid alone? Second of all, what about India and China? Do they have the grid that can sustain EV growth?

Tracy

Well, we’re talking about two different grid systems, right? If we’re talking about the US. Or we can even include EU in this scenario is that we have particularly aging grid system, right? So really, to realize the goals and I’ll just use the United States as an example, to transition, we’re going to need to build we’re going to need to add over a million miles of transition lines, which first of all, there’s no money in the budget for that. Nobody wants to do that. We’re already hitting over 70% of our current lines are more than 25 years old, and the rest are well into their 50 year timeline. So we have to completely redo our grid system to meet these 20 30, 20, 35, 20 50 goals. And simply no government wants to spend that. And it’s just not in the budget for that right now. So, realistically, it’s just impossible for us to really get there. Now when we go to China and India, right, they’re more of, well, India is an emerging market. I can argue that China may or may not be anymore, but that’s besides the point. But they can grow their grid system because it’s not as advanced or not as mature as our grid systems are.

Tracy

And so, sure, they can add a lot of capacity as far as renewables is concerned, but that doesn’t mean that they’re giving up their power mix. I mean, coal is still really huge in India and China, so it’s natural gas. Hydro is really big in China, which is renewable. It’s easier to transform a country’s grid that is just not aging like ours are.

Tony

Yeah, I would add that I think a lot of the regulatory environment here in the US. Makes grid build out a little more difficult. Maybe Chris or Corey, you guys know more about that. But in China, it’s pretty straightforward. I think they can really build their grids out wherever they want in India, actually, from a regulatory perspective, really complicated. So I think it’s not that easy in India to build out new power lines, to take new real estate to make that more robust. So some of these things, I think, are going to be difficult. I think people will innovate the way around it. I don’t know how they’ll do it, but I think it’s going to be difficult to build out that infrastructure in some of these places. Chris, do you have any thoughts on that?

Chris

Not so much on the infrastructure side. I mean, I certainly agree that that is a limiting factor when we talk about electrification. Whether or not it’s a million miles or whatever it is you use, just from an EV perspective. I mean you use four times as much copper in a single electric vehicle that you do in a traditional or comparable internal combustion engine car. And so my angle on all of this really comes a little bit less from not so much the policy side of the infrastructure side, but where are all these raw materials going to come from? The lithium, the cobalt, the graphite and I’m happy to get into that here in a couple of minutes. I know that’s kind of the topic here, but the infrastructure is certainly, maybe, in my view, a secondary limiting factor or a lack of the infrastructure. But in my view, before we even start thinking about, okay, where are we going to build these lines or the charging stations, or what have you? Where are we going to get the millions of tons of lithium or millions of tons of copper. If we’re talking from a domestic perspective here, when it takes ten plus years to build a brand new mine in the United States, So those, I think, are some of the initial issues.

Chris

And again, we can get into some of those details for sure.

Tony

Great. Okay, let’s do that. Let’s jump there. Tracy. Thanks for that, by the way. Chris, obviously, batteries are a growing share of energy for transports, and you talk about the availability. I also want to talk about the affordability of some of those battery metals. So can you talk us through where, I guess prices first, before we talk about supply, where have those prices been? We have a chart showing nickel, copper, coal, and lithium.

Where have those prices been? How does that impact the overall battery prices? And I guess most importantly, what’s impacting the way companies are investing in their supply chain? So I guess let’s talk about price and availability at the same time. That would be really interesting.

Chris

Sure. I think when you think about the price impacts of the battery metals on lithiumion batteries, it’s a relative discussion. In other words, you sort of need to think about what has gone on with lithium, what has gone on with copper, nickel, cobalt, manganese, graphite, sort of the big Six, as I like to call them. And in the chart that I had sent over from Bloomberg, basically what it does is it looks at what I call the Big Four. Big four battery metals. And I stretched the chart back to early 2018, and the reason why I did that was that was the peak of the last battery metals cycle. And so it just gives you, as the viewer here today, an idea of what I think we’re just seeing, the tip of the iceberg of which is battery metals, price volatility. And there are a number of reasons for that that we’ll get into. But I think, again, we could spend all day long talking about specific metals. Lithium is clearly the bell of the ball, for lack of a better phrase. That’s the one that gets all the press. And there are reasons why you have seen so much lithium pricing volatility.

Chris

Again, back in early 2018, what we call battery-grade lithium carbonate hit a price of around $24,000 a ton, up from historically, around $6,000 a ton. And then things kind of went to sleep. The cycle ended in 2019. COVID came and sort of froze everything or allowed everything to restart, I guess, depending upon how you think about it. And then, as you can see from the chart, things have absolutely exploded. Lithium went from about $8,000 a ton to a peak of about $85,000 a ton, and then crashed down to around 22. And now it’s sort of on its way back up. It’s at about $45,000 a ton on a spot price basis today in China.

So to your point, Tony, what exactly does that do? Okay, well, the interesting to battery economics, the interesting response there is with respect to lithium, it really doesn’t affect battery economics all that much. Okay? The price of lithium in a full electric vehicle battery, really, even at a price of around $80,000 a ton, was about maybe twelve or 13% of the cost of that battery. So not enough to really make these automotive manufacturers say, wait a second, this isn’t affordable, or this is unaffordable.

Chris

The issue is, and this is what purchasing managers at Ford and General Motors and Tesla and BMW are all worried about. The issue is what happens when lithium price goes crazy. Nickel price goes to $100,000 a ton. Everything sort of goes up in the air. It’s very, very difficult to manage. So what that has forced automotive manufacturers and battery manufacturers to do is really innovate, I should say, around battery chemistries, and think through, okay, what is truly irreplaceable, what can be substituted, and quite frankly, the only metal here that can’t be substituted without making some very, I guess, significant issues with respect to performance is lithium. Okay? You can use less nickel, you can use zero cobalt again, et cetera, et cetera. And so, from the standpoint of mobility, again, whether or not we’re talking about cars, trucks, buses, scooters, I don’t think anything is going to challenge lithiumion from a market share perspective for the next ten to 15 years. Okay? It’s a much more interesting conversation when you think about what we call long duration energy storage. So putting batteries in with solar farms and so on and so forth, there’s a lot of competition over there, and again, a lot of it has to do with price and performance.

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Chris

Go ahead. Sorry.

Tony

Yeah. With lithium, we hear maybe I’m misunderstanding, but like China and Chile or something, are the two big sources of lithium. Is lithium in other places? And what other places are there? There’s this perception that it can only be sourced from a limited number of places. What are the bottlenecks there?

Chris

So the bottlenecks are in the upstream, in the mining and the refining. And so lithium can be found either in traditional hard rock sources, primarily in Western Australia. There’s a lot of it in Africa, too, and then traditional Brine sources. You may have heard of the Lithium Triangle, which is, if you’re looking at a map of South America, where Bolivia, Chile, and Argentina sort of converge, there’s an awful lot of lithium. About 50% of global lithium comes from that part of the world. So the interesting thing about lithium is that it’s not rare at all. Again, you could actually extract lithium from seawater if you wanted to. I wouldn’t recommend it because it’s very difficult and costly. But my point is, lithium is not rare. The issue with China, and China isn’t even a major lithium mining source at all. They only produce around 13% or mine, I should say around 13% of lithium globally. And just for the sake of perspective, today lithium is about a 900,000 ton per year market, okay? So compare that to copper at 24, 25,000 tons a year. Excuse me, but the issue is the refining. In other words, taking that raw material, whether or not it’s in the form of liquid Brine or the hard rock concentrate and producing, converting it into what we call battery grade lithium salts, either carbonate or hydroxide.

Chris

Now, about 65% of that happens in China, okay? And then as you go further down the supply chain, when you think about the cathode of the battery, so nickel, manganese, cobalt, lithium, iron phosphate, these different chemical formulations, about 65% to 70% of cathode is produced in China, about close to 100% of the anode. The other side of the grephidic side of the battery is produced in China, and they also have a lock on battery production, overall cell and pack production. So this is one of the things that I think the Inflation Reduction Act is designed to try to counteract over the course of the coming years. But again, coming back to my original point, if we do want to compete with China and sort of level the playing field, the one thing that really isn’t addressed in all this legislation is where will the raw material come from? There is no sort of streamlining of mining permitting or anything like that in the Inflation Reduction Act, and that is one pretty significant limitation, quite frankly.

Tony

So are there lithium sources in North America? I mean, would it be possible to mine it in North America, 100%?

Chris

Absolutely. Again, lithium is not rare. I live in Washington, DC. Now. I used to joke when I lived in New York, I could get a shovel and go to Central Park and start digging, and eventually I would find trace elements of lithium.

Here’s a perfect example. And this is maybe a good way to tie in what corporate America or the OEMs are doing. And so, look, the automotive manufacturers, Ford, General Motors, just to use them as an example, finally woke up, I think, and realized, okay, we are going to have to produce electric vehicles whether we want to or not, regardless of the economics, to Tracy’s point. And so they should have been making multimillion or multibillion dollar investments in supply chain development 5, 6, 10 years ago. And so they’re just doing that now. And got a couple of examples. So General Motors has agreed to invest about $650,000,000 in, I should say, a development stage lithium project out in Nevada run by a company called Lithium Americas.

And so, again, I’ll just cut right to the chase. The bottom line is the lithium that is being produced today is pretty much spoken for. Okay? The question becomes, if we are going to get to 50% EV penetration or anything even remotely close to that by 2030, you need to be making those upstream mining investments today to try to accelerate that.

Chris

And so the interesting thing about that General Motors example is that that mine probably won’t even be in production before 2026. And so it just, I think, speaks to the desperation on the part of General Motors to say, listen, we are willing to pay a very large sum today in this high risk mining environment for the chance to negotiate for offtake by 2025 or 2026.

Tony

Okay, so looking at this graphic, you’ve got Ford with Lion Town. I guess that’s a lithium investment as well.

Chris

Yeah, Liontown is a development stage hard rock lithium mining company development, meaning they’re not in production yet. But again, I think it just speaks to maybe I don’t want too much hyperbole here, but the desperation or the focus on the part of these automotive manufacturers, they finally woke up, probably again, five years too late, and realized, hey, we have a raw material problem. We can get our hands on the intellectual property to build batteries or build gigafactories or what have you. And of course, you’ve got the Department of Energy and the Inflation Reduction Act providing a pretty strong tailwind there. But what good is building a gigafactory or a recycling facility if you don’t have the feedstock for it? And so, again, there are nuances here that we can get into in terms of accessing that feedstock. But all of these players that you see on the screen, again, see a lot of General Motors and Ford and LG Chem there. They’re just very concerned right now about raw material access. And again, it goes beyond lithium. I mean, you can see in the lower right hand corner there ford Valet and Hawaiia Cobalt. Interestingly enough, you’ve got an American automotive manufacturer entering into a multibillion dollar nickel sourcing deal with one of the largest Chinese cobalt players in the world.

Chris

So it just, again, is a sign of, I think, how worried these OEMs are about. They see the tea leaves or the winds shifting or whatever the phrase is, and they don’t want to get left behind.

Tony

Right.

Tracy

I had a question.

Chris

Sure.

Tracy

Okay, so we already know that we have a permitting process problem here in North America. It’s not only in the United States. Canada is facing that same issue as well, where it takes ten years to even get the permit, basically. And so in what ways or how do you think that climate goals are in conflict with sort of this process? Right? We already know we need these metals. We already have this red tape that already existed before. This is like an old problem. Right. And so now we have these climate goals, which is adding to the problem. How do you see this panning out?

Tony

Basically?

Chris

Yeah, no, it’s not a comfortable conversation, quite frankly. And I’ll just give you a perfect example. I mean, when you had talked earlier about China and coal growth to feed the grid, indonesia is going to be one of the largest nickel producers. They already are one of the largest raw nickel ore producers in the world today. They’re expanding capacity there dramatically. And in terms of what is the energy source to build these mines and operate these mines, it’s coal. So all of this nickel that is going to go into these millions and millions and millions of electric vehicle batteries is going to be coal fired. And so you have to take to your point with respect to climate goals and thinking about how green the process is. You have to take that into account. And that’s kind of the uncomfortable part of the conversation. And so a lot of my inbound calls coming from investors are, we understand, like, there’s commodity price risk, there’s ESG risk with mining. Mining industry, quite frankly, doesn’t have a sterling reputation when it comes to hitting things on budget and on time. And so what else is out there?

Chris

What else could feed or should say plug any kind of structural gap in metals demands, number one. And number two, do so in such a way that you hit these ESG goals, which again, are very, I think, fluid in some ways. And so I do a lot of work in lithiumion battery recycling and do a lot of work in a certain type of lithium extraction called direct lithium extraction. Again, don’t want to get too much into the weeds today, but even those processes have their own CO2 footprints. And so, at the end of the day, I sort of look at this as, like, the paradox of green growth, which is everybody wants to decarbonize, and we want to have clean cars or a clean grid or whatever. It is. But there is a price to be paid to get there in the first place, and you’re just not going to do it through recycling or innovating with battery technologies. It’s going to take a lot more raw material, and that is going to have kind of a basic carbon footprint that needs to be accounted for.

Tony

Hey, Chris, before we move on, when you talk about these corporate investments and supply chain investments, it looks like a lot of this stuff is on the mining side. Are these say lithium America’s. Lion town. Are they refining as well, or are they only mining?

Chris

Excellent question. Liontown’s intention is just to mine. Okay. Lithium america. It’s an interesting question because neither of them are in production today. And so we just have to rely on their feasibility study and their stated plans. So lion town is a hard rock asset, or they’re developing a hard rock asset in Western Australia. Their initial intention is just to mine the concentrate, the hard rock concentrate. Where will that go to be refined into battery grade salts? It’s going to go to China, probably.

Tony

At least initially, like we’re going to mine it here, ship it to China, have it refined and send it back.

Chris

This is the issue with well, again, the fact of the matter is the Chinese has spent the last ten or 15 years building a consolidated lithiumion supply chain. I’m not saying it’s going to take us ten or 15 years, but we have the mining issue to think about. We have the refining issue. And to be honest, you could get a lithium refinery here in the United States. And there are actually perfect example, tesla and Corpus Christi, they’re building a lithium refinery company here on the slide, piedmont Lithium. They’re actually building two lithium refineries, one in Tennessee. Again, the source of the feedstock is kind of an open question there, but nevertheless, these companies are going to build these refineries in the next three or four years. It’s much easier to permit midstream to downstream portions of the supply chain than it is the mine. But, yeah, again, think about a lithium molecule, right. Maybe it comes it’s mined in Western Australia, it’s concentrated there. It goes to China, where it’s turned into battery grade salts. Maybe it then ends up in Japan, where it’s turned into cathode. Maybe then it goes to Fremont, California, where it’s put into a Tesla.

Chris

I mean, the journey of a lithium molecule has a rather significant CO2 footprint associated with it. And again, this is, I think, what, the inflation reduction act. And a lot of this legislation, this kind of near shoring or friend shoring legislation is designed to do is to minimize the CO2 footprint. But, yeah, it’s kind of a long winded answer saying some of these guys are going to refine and some of them aren’t. But at the end of the day, for the foreseeable future, everything’s going to go through China.

Tony

But if that lithium was transported with biofuels, Corey, it would really help that CO2 footprint.

Corey

Right. Nice segue, the same thing.

Tony

Thanks, Chris. Thank you. I really appreciate it.

Tracy

That segue was excellent.

Tony

Corey, hey, thanks for joining us. There was a big EPA announcement on biofuels this week, and I want to understand what all of that means. I’m not an expert here at all. So can you please tell us what is a biofuel?

Corey

Sure. A biofuel is a fuel that’s derived from biomass or organic matter. The most common ones in the United States are ethanol. Ethanol is about 98% of the gasoline in the United States has ethanol in it. It’s mostly made from corn or sorghum. In the United States, it is made from corn and wheat. In Canada, it’s made from sugar cane. In Brazil and other areas of the world. Other biofuels that are common are biodiesel and renewable diesel, which are substitutes for diesel as well as sustainable aviation fuel, which is a substitute for jet fuel.

Tony

Okay, so when we hear the words biomass, what does that mean?

Corey

Once again, I’m just re saying organic material, organic plants. Biodiesel is also made from fats, recycled oils and greases. Those are the soybean oil, veggie oil. So that’s kind of what we’re talking about.

Tony

Okay, great. So when you talk about things like biodiesel or aviation biofuels, how much of, say, biodiesel in, say, North America or Europe, or how much of diesel in, say, North America or Europe is biodiesel?

Corey

I would say about five to 7% of the total diesel pool is biodiesel. Renewable diesel. It is a growing percentage primarily because with this EPA announcement, there’s mandates that require refiners and importers to use the fuel, as well as states with low carbon fuel standards that have increasing targets that require increased uses of these fuels.

Tony

Okay. And aviation fuel, bioaviation fuel, how much of the market is biofuel?

Corey

Next to nothing. And that’s where the big opportunity is. I think right now it’s like less than one 10th of 1% of the total jet fuel pool is sustainable aviation pool. And I think production in the United States was less than 16 million gallons last year. When we’re talking about targets of like 3 billion by 2030 and 35 billion by 2050, we’re talking minuscule mounts at this time.

Tony

Okay. I think it’d be much more comfortable in a biofuel powered jet than an electric powered jet at this point. I don’t want to get to that 300 miles limit and have the jet engine just stop.

Corey

That’s very common. I don’t think anybody wants to fly from Los Angeles to Singapore in an electric jet, but maybe if you’re hopping from island to island, then you would be comfortable with those smaller ranges.

Tony

Okay, so can you also tell us on these general segments that you’ve talked about in terms of biofuels, how quickly are they expected to grow? Generally like 400% a year or 20% a year.

Corey

No, I mean, the renewable fuel standard is what jump started the industry. Right? So ethanol was used as an oxygen for gasoline was basically like a 4 billion gallon per year. Industry in the United States. Then the Renewable Fuel Standard came out 2005. It’s been around for around 15 years or so or active. And during that time ethanol has gone from 4 billion gallon industry to a 17 billion gallon industry. So there’s already been the extensive growth for ethanol and biodiesel. Right now there seems to be a transition where more of the construction is going into renewable diesel and SAF. Those fuels can be produced from the same facilities. Like you said, it’s such a small percentage of the total jet fuel market that there’s an increased focus now on decarbonizing it. So if we have over 10% of the gasoline pool that has ethanol, around 5% to 7% of the diesel pool has biodiesel and renewable diesel. Now we’re just kind of making that transition of why is such a small percentage in aviation. And so the Biden administration has had setting these goals of production targets as well. As I know that Chris mentioned the Inflation Reduction Act a few times, that there are incentives for SAF that are better than some of the other fuels.

Corey

There’s higher blending credits for sustainable aviation fuel. And then in 2025, when there’s a new clean Fuel production credit in the Inflation Reduction Act, SAF has preferential treatment as well, where it gets a higher credit. So that’s the tool being used by the government to jump start SAF, just like ethanol and biodiesel were jump started with the onset of the Renewable Fuel Standard program.

Tony

Okay, great. So I understand those are all basic questions and most viewers are probably way beyond me in their understanding biofuel. So thanks for doing that. Can we walk through some of the EPA information that came out yesterday? You sent this great table, and if you could walk us through what that stuff means, I’d appreciate it.

Corey

Sure. Okay, so the intent of Congress was for refiners and importers to use a growing amount of biofuels each year. And there’s four separate categories that are depicted on the chart to the left that they need to blend a certain amount of renewable fuels, they need to blend a certain amount of what’s called biomass based diesel, which are the diesel replacements, a certain amount of advanced biofuels and a certain amount of cellulosic fuels. And what Congress did is that they would set a mandate and every year EPA would look at it and adjust it based on the available domestic supply. The mandates were set by Congress through 2022. And this has really been the first set of mandates where the EPA was setting mandates without the guidance of Congress. And essentially the only guideline that they had was try to keep up with the congressional intent. And essentially the congressional intent was for mandates to get higher and more stringent every year. So if we look at the chart, you can see how volumes are constantly going up a little bit. If we focus on this table, one of the takeaways from the announcement was a lot of biofuel companies were unhappy with it.

Corey

There was a proposal in December of last year followed by a public comment period and taking them about six months in order to finalize these mandates. The ethanol industry got a number less than what was proposed in December. So if we look at the conventional biofuels column of that table, we can see that about 15 billion gallons was basically reserved of a category that corn based ethanol can satisfy. The proposed volume was 15.25 billion and it was reduced to 15 for 2024 and 2025. So the ethanol industry is very upset about that. The higher the mandate is, the more than the greater likelihood there would be higher blending. The ethanol industry wants to move up from the standard of E Ten. The vast majority of the fuel in the country is E Ten, and they are pushing to have more E 15, E 85 and other higher grades. And part of the Inflation Reduction Act too was giving half a billion dollars in order for service stations to update their equipment, update their infrastructure, to enable them to sell more E 15. In terms of the biomass based diesel column, that’s something that you can see that it gets progressively higher each year for the mandates that were set for 2023, 2024 and 2025.

Corey

But it’s growing at a very slow pace and it doesn’t mirror the amount of investment that has been going into the sector. There’s already enough reduction right now to satisfy the mandates in 2025 and hundreds of millions of dollars are going into converting existing oil refineries to produce renewables. So we have renewable diesel facilities being constructed, we have sustainable aviation fuel facilities being constructed, and the actual capacity is going to be way higher than these biomass based diesel mandates, which has upset a lot of companies because historically, the EPA usually has looked at the availability of supply as the guide for setting these mandates. And when these mandates are considerably less than what they expect supply to be, then that has upset a lot of people. And the cellulosic biofuels, there was going to be a really big change in 2023, 2024 and 2025. The EPA was going to include EVs in this renewable fuel standard program. EVs do reduce emissions and they aren’t allowed to generate compliance credits like all these other fuels. And they had proposed a system or proposed regulations that would allow EVs to generate credits under the Renewable Fuel Standard and they were quite complicated.

Corey

The only companies that would be able to generate these valuable Rins are valuable credits known as Rins were EV manufacturers and there was just great opposition to it during the public common period. So the EPA punted having EVs generate these types of credits. So the cellulosic fuels are basically very small amounts of liquid biofuels coupled with biogas.

Tony

Interesting. Okay, so you covered this already, but I’m very interested to see that 15 billion gallons of conventional fuels just kind of plateau. And there must be a lot of disappointed people in the Midwest of the US. About that. And it does look like things are slowing down in terms of biofuel requirements. Maybe too much is strong. But is there more capacity than needed today, or is it just the investment that’s going in? Is planning to have more capacity than is outlined in these regs?

Corey

Well, it depends what type of capacity you’re looking at. If you look at just individual fuels, ethanol, if you kind of look ahead, if you look in the medium term and we’ve been talking about EVs during this discussion, that it’s clear that the increased penetration of EVs is going to take a lot of gasoline powered vehicles off the road. And when you take millions of gasoline powered vehicles off the road, there’s going to be less on road demand for fuel ethanol. So we’re going to reach that stage of what are you going to do with all that ethanol. We have about 17 billion gallons of capacity. So this is where sustainable aviation fuel is a godsend to the industry because one of the technologies that’s being developed to produce SAF is using ethanol as a feedstock for SAF. We talked at the beginning of how veggie oils can be used for biodiesel and corn and sorghum and wheat can be used to make ethanol. Right now they’re developing technology where actually ethanol itself can be used as a feedstock for staff. And once again, when there’s going to be massively declining demand for on road ethanol, the prospect of using ethanol to make something that could help decarbonize the aviation sector is extraordinarily exciting for the industry.

Corey

And also, it’s not a one to one ratio. It takes about 1.7 gallons of ethanol to make one gallon of SAF due to density issues. And so SAP is really opening up a tremendous opportunity for domestic and domestic ethanol producers and also imported fuel.

Tony

Go ahead, Tracy.

Tracy

Sorry, I had a question. So we’ve seen a lot of the aviation industry kind of push back on this state, saying that we can’t do this right now. This is going to cost us a lot of money. We’re going to have to pass these costs on to the consumer. So how do you look at this as far as I mean, obviously this is in the invancy stage, but how do you see this panning out? How long do you think this is going to take until this becomes like a viable fuel for aviation where it doesn’t cost us another $200 per flight to pay for?

Corey

Well, look, there’s already countries that mandate SAF in Europe. France mandates AF Norway and Sweden mandatesf. Already the EU directive is going to institute mandates starting in 2025. So it’s a real thing in Europe right now. Right now, once again, construction is going on. We have very minimal SAF production right now there’s a SAF producer called Montana Renewables in Montana that’s operating. And we have a lot of big facilities that are going to be coming up soon in California, in Georgia, and elsewhere. I’m seeing differently. We’re talking with airlines and more. The public press releases, they say they’re excited about it. They’ve entered into offtake agreements with these renewable fuel producers. They’re part of airline associations that have specific targets. Many of them have targets of 10% SAF by 2030. Whether or not anybody believes that’s Achievable, they may say something as the time comes closer where perhaps they take the position that it’s not feasible because staff is too expensive and consumers are unwilling to bear the added expense. But I think that many airlines are looking towards decarbonization efforts and they’re waiting for the staff to be produced. It’s behind schedule. There’s supposed to be a lot more availability of sustainable staff by now, but they’re waiting for it and they have offtake agreements for when it comes.

Tony

Why is the availability not there?

Corey

The development of technology. And frankly, when we look at the mandates, when I said, hey, there’s mandates for advanced biofuels and biomass based diesel and ethanol can satisfy one of the categories. There isn’t a mandate for SAF. Had there been a mandate for SAF when the Renewable Fuel Standard was amended in 2007, then we would have seen technology being kick started. And back then there’s been over ten years of trials and testing and test flights. Everything would have been accelerated had SAF been a mandated fuel. So right now the Biden administration, they have a target. They have what they call a grand challenge for a certain amount of production. 3 billion gallons of production by 2030. And once again, they’ve had provisions in the Inflation Reduction Act which will support this program, such as blending credits and cleanfield production credits that are pro staff.

Tony

Tracy, I’m sorry, I didn’t mean to interrupt you. You were starting to ask a question.

Tracy

No, you actually almost asked my same question, just rephrased a little bit differently.

Tony

Okay, very good. So in Corey, it also sounds to me like on some level, and I don’t think this is fully level, but it almost sounds to me like biofuels is kind of seeding, say automotive to EVs. Is that fair to say or not?

Corey

There’s no seeding going along.

Tony

Okay.

Corey

SAP is like perhaps a backup plan or the way they’re looking at the future. The ethanol industry right now is trying to make sure that fuels have higher blends. And actually last year there was record sales of E 15. There’s record sales of E 85. Ethanol has been selling at a lower price point than petroleum based fuels. So when you blend, there’s a better economic incentive to blend. So E 15 was selling at a much cheaper price point last year, and E 85 in California was selling up to like $2.50 less a gallon than the normal E ten. So a lot of people, when times are tough and the economy was bad, a lot of people saying, look, I heard that my car can accept E 15. I could fill up my tank for $6 less. And they gave it a shot and the cars didn’t fall apart on the side of the road. So you had essentially a lot of millions of new customers who tried these higher blends for a first time because they didn’t really understand them that well. They saved some money and now we got some new adopters of this fuel.

Tony

Okay, interesting. I’m going to ask both you and Chris the same question about your respective areas of expertise. So what should we be looking for when evaluating companies that are well positioned in biofuels? And Chris, I’ll ask you the same thing about battery metals, but what should we be looking for with those companies?

Corey

The companies are leading the carbonization efforts. One thing I didn’t really focus on is a lot of the new renewable diesel and SAF producers are going to be traditional oil refiners, refiners like Marathon and Chevron and Philips 66 and CVR and HF Sinclair. These are companies that are taking existing facilities and converting them to start processing renewable feedstock in order to produce renewable fuels. They’re making this transition from the old oil stuff and they’re producing these new fuels. And now they could use and they could blend these fuels into their existing petroleum based products. But that’s what we’re seeing. We’re seeing decarbonization efforts and a lot of these big oil refiners that are doing the energy transition and moving towards renewables.

Tony

Great. Chris, how about you? What should we be looking for when evaluating companies that are well positioned in battery metals? What are the main things that you’re seeing?

Chris

Yeah, I mean, look on the upstream with respect to the raw material. I think as I look at specific companies, the whole lithiumion supply chain discussion has this huge geopolitical component to it now. And so when I think about assets, mining assets in particular, I think what I’m looking for first are companies that have what I would call geographic and geologic diversity. Companies that may have lithium assets in Western Australia and in Chile or just different parts of the world. That way if you have an asset in a country and all of a sudden they wake up one morning, the government says, hey, you know what, we’re going to look at those royalty numbers again. Or no more exporting of raw. Well, look at Indonesia, right? I mean, twice in the last eight years they’ve banned raw exports of nickel anyway. So geologic and geographic diversity, number one. And then number two, producing battery metals, in other words, hitting that spec. I’ve talked a couple of times about battery grade lithium carbonate or cobalt sulfate or whatever it is. That is not something that’s easy to do. And while the know how is out there.

Chris

You want to find those management teams that I always like to say they have the right blend of sort of financial markets, acumen, how to raise the capital and manage the balance sheet and manage the capital structure, but also how to produce these chemicals. Because what we’re going to be doing if we are going to get to 50% Ed penetration or whatever the number is in the future, we’re going to be going after lower grade, lower quality assets. And those are more problematic in terms of hitting that battery grade spec. So, again, it’s geologic and geographic diversity, number one. And number two, it’s just management teams that have that technical capability to produce these materials of scale.

Tony

Yes. And I’ll ask you both the same question as well. What do you see as the best near term opportunity, Chris, around battery metals, around that supply chain? What’s the biggest near term, say, three to five year opportunity in that area?

Chris

I think from a higher risk tolerance perspective, I look a lot at battery technologies and so innovations around different cathode formulations. In other words, either using an equivalent amount of lithium or nickel or what have you, and increasing energy density. So I look at a lot of different cathode and anode technologies on the anode side of the battery, really interested in what we call silicon anode technology, which is effectively doping that anode with silicon. And that can increase the energy density up to around 30%. Okay. So you can drive 30% further, charge a little bit faster. So I look at a lot of those types of opportunities. Again, kind of alluding to or going back to what we talked about earlier, the refining aspect of this whole theme and this whole thesis. I mean, Elon Musk will tell you that he thinks that the bottleneck is in refining of these materials, and I think he’s partially right. I think, again, it’s also just getting your hands on the feedstock in general. So building out that refining capacity again, to your point, over the next three to five years is a really interesting place to be as well.

Tony

Right, okay. Corey, how about you in biofuels? What is the biggest opportunity in the next three to five years?

Corey

I’ve already mentioned it. The biggest opportunity is the use of ethanol as a feedstock for SAP.

Tony

For aviation fuel.

Corey

Yes, I’m sorry, I’ve been saying SAP. SAP is short for sustainable aviation fuel. That seems to be a great opportunity. We have once again, they generate Rin credits that can be used for the federal Renewable Fuel standard. They’re beneficial for these state low carbon fuel standard programs like in California, Washington and Oregon, and they’re developing state credits that are incentivizing it as well. So if you there’s a SAF purchase credit in Washington state and Illinois now where they’re adding on tacking on additional incentives to sell staff into those states. So I think ethanol to SAF and the advancement of the construction of these facilities is quite exciting to the industry.

Tony

Okay, thank you. And Tracy, let’s end up where we started out on oil. We’ve talked over the years about the lack of investment in the upstream, in oil and in the downstream in oil and gas. Right. And it sounds like battery metals and biofuels are getting a lot of investment. So are these large energy firms, are they taking funds that could be put into the upstream and substituting them into biofuels and battery materials? Or is it not substitutional? Are they just not doing that capex on energy upstream and they see this as a completely different thing?

Tracy

Well, there are two totally different things when we’re talking about mining for metals and mining for oil and gas. But if we look at the biofuel side of it, of course there are a lot of refiners that have allotted a lot of money to changing over, particularly California to changing over. Some of their refineries to include biofuels. Marathon is one, valero is one for a couple to look up. I definitely think that this industry is they’re not aware of what is happening and where this industry is going. And so, again, like I said, in particular, if we were looking at the refining industry, there are a lot of traditional oil refining companies that have already allotted a lot of money into biofuel technology and refining biofuels because they don’t want to get left behind.

Tony

Great.

Chris

Sorry, Tony. Just as an example of an oil and gas company looking at the battery metals is exxon. There was a story in the Journal a couple of weeks ago about how they’re looking at getting into the lithium production business and the smackover formation in Arkansas. The reason I think why a lot of these oil and gas players have shied away from battery metals or diversifying away from their business from a capex perspective is quite simply because most of the battery metals markets are too small. I mean, I mentioned that lithium is a 900,000 ton a year market that’s I don’t even know at elevated prices, is it 20 billion a year or something like that in revenues? I mean, that’s probably the capex budget for one of these super majors in a specific year. So the battery metals have never really moved the needle from a financial perspective for these guys and that’s one of the reasons why they’ve steered clear of it. But again, with the way the political winds are shifting, you’re starting to see the exxons of the world say, hey, we’ll give this a closer look. So I don’t know what’s going to come of it, but it’s something that is interesting.

Tony

Great. Okay, guys, this has been really helpful for me, really educational, informative for me. So thank you so much for spending your time. Thanks so much for helping us out with this. Have a great weekend and have a great week.

Corey

Ahead.

Tony

Thank you.

Tracy

Thank you.

Chris

Thanks you me out.

In this latest episode of “The Week Ahead,” Tony Nash hosts David Cervantes, Albert Marko, and Tracy Shuchart to provide valuable insights on a range of topics, including recession indicators, China’s economic challenges, the natural gas market, and Europe’s energy supply problems.

Challenging Prevailing Narratives

David Cervantes sets the stage by reflecting on his accurate recession call made several months ago and his process of questioning prevailing narratives. He emphasizes the importance of construction activity and employment data when analyzing the correlation between the housing market and recessions. His research process involves independent replication of economists’ work to understand the underlying factors and ensure a comprehensive perspective.

Commercial Real Estate and Economic Impact

The panelists discuss the role of commercial real estate in the broader economy. David explains why it is not a major factor in the economic cycle, highlighting the strength of the construction industry and the scarcity of contractors. By shedding light on the limited impact of commercial real estate, the conversation emphasizes the need for a holistic approach when assessing economic trends and potential risks.

Tech Job Losses and Economic Outlook

Tony and David explore the current state of tech job losses and its implications for the overall economic outlook. David counters concerns with data, citing payroll and continuing claims data that do not support the narrative of significant job losses. The conversation also touches on the trend of individuals turning to do-it-yourself solutions for home repairs, adapting to tasks they would otherwise hire professionals for.

Factors Affecting Hypotheses

While acknowledging the potential risks to his recession hypothesis, David dismisses concerns about a credit contraction in the banking sector. Structural changes implemented after the global financial crisis provide safeguards against such an event. The conversation also explores the possibility of energy shocks and their potential impact. Falling oil and gas prices are seen as beneficial, but the panelists discuss how energy shocks could still play a role in shaping future economic scenarios.

China’s Economic Challenges

The discussion shifts to China’s current state, its economic challenges, and the implications of US economic officials’ actions. Panelists express concerns about China’s lack of movement politically and economically, despite slight retail sales growth. They delve into the influence of interest rates, inflation, and China’s desire to avoid becoming like the Soviet Union or Japan. The participants draw parallels between China’s situation and Japan’s experience in the 1980s, highlighting the complexities and geopolitical considerations at play.

Geopolitics, Governance, and Natural Gas

The panelists delve into geopolitics, governance, and the natural gas market. They discuss China’s fear and arrogance regarding its future and Japan’s bureaucrats apprehensive about following the path of the Soviet Union or China. The conversation also touches on China’s challenges, including demographics, environmental issues, and water scarcity. Differences between the US and European markets are highlighted, with a focus on Europe’s energy dependence, climate concerns, and political decisions impacting market volatility.

Europe’s Energy Supply Problems

The discussion highlights the supply problems in Europe related to air conditioning demand during summer. While Europe is not a major consumer of air conditioning compared to the US, increasing temperatures lead to energy supply drawdowns. The panelists highlight the impact of low water levels in rivers like the Rhine, causing difficulties in transporting crude and gas products to Europe. The water scarcity issue extends beyond northern Europe, affecting the Mediterranean region as well.

Energy Costs and Industrial Dynamics in Europe

The conversation explores the impact of high energy costs and environmental policies on European industries. The participants discuss the relocation of companies to countries like China and the US, which offer lower energy costs and potential incentives. Deindustrialization in Germany and other EU countries leads to the loss of market share. The participants also touch upon Europe’s approach to energy policies and the potential regrets that may arise in the future.

The latest episode of “The Week Ahead” provides invaluable insights into key economic topics shaping our world. The discussions on recession indicators, China’s economic challenges, the natural gas market, and Europe’s energy supply problems offer a comprehensive understanding of the complex dynamics at play. By challenging prevailing narratives and encouraging critical analysis of data and methodologies, this episode serves as a guiding light for navigating the ever-changing economic landscape. Stay tuned for more thought-provoking conversations that empower us to make informed decisions in an interconnected world.

This is the 69th 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
David: https://twitter.com/pinebrookcap
Albert: https://twitter.com/amlivemon
Tracy: https://twitter.com/chigrl

Trascript

Tony

Hi, and welcome to the week ahead. I’m Tony Nash. Today we’re joined by David Cervantes, Albert Marko, and Tracy Shuchart. Guys, thanks so much for joining us. Been a really interesting week with the Fed meeting and with it seemed like a reacceleration of markets.

Tony

One of the things I really wanted to talk about and I’m so pleased to have David today is his no recession call, or at least not right now call. This is something he did six, seven, eight months ago, and he’s been very consistent since then. So I want to dig into that. I also want to talk about China. We’ve had a lot going on in China with the upcoming blinken trip and some Chinese economic data and other things. So I want to talk with Albert about that. And then we want to talk a little bit about Nat Gas. We’ve seen a bounce in Nat Gas over the past couple of days, and Tracy’s obviously the expert there, so I want to get her thoughts on that as well. David, thanks for joining us. I know this is your first time, and and I promise you’ll, you’ll emerge unscathed afterwards.

Tony

We’re were you called a recession back in on November 14 of 2022. I couldn’t find an earlier time that you did that. But if you look at the tweets we’ve got from the 14th, you went into kind of a fair bit of detail on why you called that.

And you’ve been very consistent since then, as we’re showing, kind of in this first series of tweets, you’re talking about really, as you say, in plain English, why you changed your view, and then you reinforced this on January 6, and then you’ve been very consistent since then, despite a lot of pushback. ‘

And so I really admire that. And I think all of us here have some pretty non consensus calls pretty regularly. So I think that’s a great call. But what I really want to learn about is your process because we have a lot of kind of retail investors who watch us. And so can you talk to us a little bit about your process and how that process fed into this recession call? Because I think people underestimate having a consistent process.

David

Yeah, sure. Well, first of all, thanks for having me. Really excited to be here. I’ve been following your work for a while, you and Albert and Tracy, the rest of the whole team. So I’m really pleased to be here. Just getting back to the question of the process. Look, we’re all reading the same information, have access to the same media set and tools. So the question is, how do you step out of that and develop views that may run counter to that? And if they do, are they right or are they wrong? So just as a general matter, I like to just question the implicit and explicit assumptions that underlie the thesis or the dominant narrative. So it’s not so much drilling into the numbers as it is to understanding the argument, the logic, and just kicking the tires and seeing if it makes sense. So back in October, I don’t know if you saw this tweet, but back in October I said, hey, I’m going on a recession watch. One of my indicators flipped yellow, and that indicator is the, I call it Wrap real average weekly payrolls for non managerial employees, basically the vast majority of W two wage earners.

David

So that kicked off in October. And the indicator rule is as long as we’ve stayed positive year over year, we’ve never gone into recession. It’s an indicator that has a 100% batting average in the post war period. So that flip yellow. And at that point, recession hysteria was kind of peak. The 210 yield curve inverted back in July in October, 3 month ten year, which is kind of the gold standard that inverted as well. And oh my God, we’re going to go into recession. But as with anything, I had to check what was the dominant narrative that was feeding this. Well, the big narrative obviously was the rate hikes. But housing, it was like all of a sudden the bull market and housing came to a stop. House price appreciation stopped, sales volumes tapered off and then eventually being a turn down. So a little light bulb, my head went off and it was, oh my God, it’s housing. So I started digging in. Look at Ed Lemur’s work. He’s an economist who coined the phrase the housing cycle is the business cycle. Read his work and then I basically replicated his work doing it.

David

I did it myself. So instead of just taking what he said as a fed out complete, I said, you know what, I’m going to rebuild this model on my own and really get into the weeds and see if it clicks. And it did. We don’t have to go into the model process. But what I came to learn was that seven out of eleven post war recessions originated in the housing market, okay? And specifically, it wasn’t just house prices or house sales volume. It was construction activity and construction employment. And it wasn’t just the employment at a level, it was the volatility of that economic activity. So I basically wrote this paper for myself just as a thought exercise, and I basically had a predetermined thesis. The housing market will once again be ground zero for a recession. And as I was going through that process, I was looking at the data, I had an insight, and it’s no the housing market. If we have a recession, it won’t be because of the housing market. And the reason was housing construction and housing employment were very robust for a variety of reasons. One was all the stimulus money that got pumped into the system, people were still buying houses, rates were obviously on the move up.

David

But when you need a home given the structural home shortage in this country, you make whatever trade off you have to make to house your family. Even if you move somewhere else, you buy less house, pay more interest and buy less house. Whatever you got to do. You need a roof over your head, and you’ll do it. So I didn’t see the typical causes of a housing downturn to be in the works. And then we got the big inflation pullback in the November report of the October data. And if you recall, after that report came out, we had a huge short squeeze. We were up, I think, 2% on that day. And that raised took my yellow flag on the wrap, real aggregate payrolls back to a green. So between the inflation story supporting aggregate payrolls and coming to the conclusion that the housing sector would in fact not be the cause of a recession, the ODS were that we would not have a recession. When you have a seven out of ten being in the housing market I’m sorry, seven out of eleven and the remaining four well, if it’s not from housing, then your ODS are just less.

David

And between my indicator and I use a variety of indicators, but that was the one that was most prominent between that indicator and what I saw going on in the weeds of a housing market, not sales, not volume, but an actual economic activity that rolls into GDP accounts, if you recall. Prices and sales don’t. They might benefit the buyer and seller, but they don’t roll into GDP accounting. Construction activity does. Employment activity does. And that was moonshotting. That was doing great. So I said to myself, we’re not having a recession. Obviously, I continued to monitor the data, but that was the basis of the call.

Tony

Great. I love you understand the initial conditions. You understand the prevailing narrative. You understand the data I see regularly on your feed where you kind of question the data. You understand the details of the data. You did more research on your own to identify where we actually are, and then you changed your view. So I think it’s easy for us on Finn, Twitter, whatever, to see what the prevailing narrative is and be panicky about. We have to position a certain way because of where the narrative is. But I like the way you kind of pulled apart from that and you really looked at the underlying data and then came up with your own hypothesis. It’s fantastic. And I like the way you continually re change that. We don’t talk about that enough. We’re kind of talking about what are people doing in markets, what’s happening in markets? But going back to these principles and coming up with your view and having that being a rolling view, right? You’re not stuck in that. Sure, of course. No, you’re checking your views as new data come out.

David

I’m sorry, Tracy. Go ahead.

Tracy

I wanted to ask you about what your thoughts were on commercial real estate, because literally, if you go on FinTwit right now, everything is you are all going to die. Commercial real estate is going to crash. We have nobody going back to work in office buildings. New York. You’ve got New York. Even you’ve got San Francisco. That’s a whole different story. So what are your thoughts on that as far as how it factors into this real estate narrative?

David

In terms of the economic cycle, I really don’t pay a whole lot of attention to the commercial real estate part. And here’s why. The construction activity of the actual building of a construction of a building does feed into GDP accounting, but what we’re seeing now is a collapse in commercial real estate prices. And some people are going to take their lump. There will be some tiers, there will be some PNL losses. As long as it doesn’t feed into the credit markets and into the broader economy. As far as the cycle goes, I think it’s for the most part, not an issue. Investors will get burned, someone will get hurt. But in terms of GDP accounting, I just don’t see it really being a factor. Now, again, I mentioned actual construction. So fine, maybe new building development takes a pause, but we have record amount of money going into other types of non residential construction. Back in May, we got some data for the April release on non residential construction, and these numbers were completely off the charts. I have some threads up. I can’t recall them right now. But the idea was that with the Onshoring and the IRA, the Inflation Reduction Act, we’re going to see a lot of infrastructure, a lot of money pumped into infrastructure development.

David

And I think that’ll fill the hole that’s being left by any development in the commercial real estate space.

Albert

That’s interesting because a while ago we noted that when we’re talking about layoffs, one of the most robust sectors was the construction industry, specifically housing. We mentioned that verbatim. We’re like, where are all these layoffs? If we’re going to a recession, where are the layoffs in that sector? They just weren’t coming.

David

That’s right. So one of my recessionary indicators is the thumb rule where you basically get a 1% I’m sorry, I believe it’s a 0.5% increase in U three within six months of its most recent peak. And then there’s other recessionary studies, but my basic metric is 1%. If we see a 1% loss of non farm payrolls and employment, basically 1.6 million jobs, that’s where you start getting recession. Not just recession vibes, but it’s pretty much you’re into recession because history has shown it doesn’t stop at 1%. Once you have 1% job losses, it keeps going. But the question in my mind is what’s going to trigger this employment extinction event? What’s the economic media that’s going to come out here? Have you tried hiring a contractor? Have you tried getting someone to fix anything? Good luck. I’m looking personally. We’ve got three bathrooms to do. In our best case scenario, they’re going to be done in the spring. Okay? That’s our best case scenario. Between backlogs and supplies and just bodies that can hold a hammer and use a drill, they’re just not there. The bodies aren’t there. So what’s going to trigger the employment extinction event?

David

It’s not going to come out of construction. It’s not going to come out of any other sector that would have that much of an impact.

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Tony

So when we hear about tech job losses, you’re not really all that worried about that.

David

Just on the numbers alone. The answer is no. If you go back to weekly payrolls, you go back to continuing claims. It’s just not there. It might make it for a great headline, but we’re not seeing the numbers. Obviously, weekly payrolls have softened a little bit, but the four week moving average is still well within my comfort zone. My comfort zone is when we see the four week moving average break at 330,000 and we’re, I think right now at 245 or something like that. So we’ve got a while to go.

Tony

And your answer on hiring contractor David is I’ve been watching a lot of YouTube videos, so for anybody who follows me on Twitter, I replaced my wife’s brakes last weekend. So that’s an incredible amount of trust from her to allow me to do that. But I think people are coping. They’re trying to cope to figure out how to do things for home repairs and for their car and other things when you can’t find I kind of joke about the brakes thing. I was just more curious about how to do it. But I think a lot of people are trying to figure out how to do it on their own because they don’t want to wait for seven to nine months to get something done right. And mean, that’s just that.

David

But I mean that’s for planned things. But you also have unscheduled things. What if you have a broken window or you need locksmith? I think is pretty easy. But something that happens and your HVAC goes down in the middle of winter, your heating goes down, what do you do?

Tony

Yes, very expensive. Okay. So if you just take a different position and let’s say there were something to happen in the next, say, three to six months to break down your thesis, what could some of those things be? Because a lot of people out there going, oh, this can’t continue to happen, it’s not this strong, things are going to break down. What could it be to break down your hypothesis in the next, say, three to six months?

David

I think the problems that we saw in the banking sector, if they were to expand and roll over into the general economy and really cause a credit contraction, but we’re just not there. I mean, part of that is just structural. After the global financial crisis, all the rules were rewritten the banking system and the economy had somewhat of an existential moment. The adults in the room said, never again, we’re just not going to allow this. We’re going to rewrite the rules. So now you’ve got the two big to fail banks that control most of the credit in radiation. A lot of some credit is local, particularly construction. Construction lending, real estate lending is very local. But for the most part, the credit flows that drive the economy come from the g SIBs. They’re too big to fill banks. So it’s out there as a possibility, but I see that more of as an economic meteor. Can it happen? Yes, likely. I don’t place high odds in it right now, is the answer. Okay, so that’s one area of concern though. Things did get a little dicey back in March, but it seemed like it’s contained for now.

David

I know that’s a four letter word after 2008, contained, but I think that’s where we are now.

Tony

Okay, so we could see a gradual deterioration in economy, but you’re not really seeing any near term shocks. That’s a question statement. Yeah.

David

I think the other shock could be obviously an energy shock because that energy is very inflation is very energy sensitive, and Headline in particular. So if you recall back to 2008, we were looking at $140 a barrel oil. That was, I think, the primary catalyst for a policy mistake with the ECB when Trisha raised through Europe into a double dip recession. I’m sorry, not double dip. First step was in 2008, the second was in 2011. But oil was really the catalyst. So we’ve been lucky where if you look at the price of oil and gas, they’ve come down significantly. I know Core is separate from that, but headline has been helped tremendously by a fall in gas. So if we have some geopolitical event or some kind of energy disruption, that could be another factor, I think.

Tony

Yeah, I think you’re right. I mean, geopolitical events, these are things that really can’t predict. Even geopolitical forecasters, it’s really hard for them to predict this stuff. Right. Except Albert, of course, because he’s got a great record. But I don’t know of anybody else who really predicts them as well as Albert. Okay, David. Thanks so much. For that. It’s an incredible call you made. You’ve stuck with it even when it was really not popular. And so I really wanted to highlight that and really underscore, how did you come up with this? And I think I’m hoping people look at that and really kind of check their initial conditions and look at their assumptions and then really run their own data, because we can’t take it from social media. We can’t take the narrative from other people. We have to check this stuff out on our own.

David

I think that’s absolutely right. I could have taken the Lemur study at face value and just gone with it. I think forcing myself to replicate the study made me get into the weeds and understand everything that I had to understand to make the call.

Tony

And every time you dig into methodologies, you find flaws and you find things where in some cases, it’s more detailed and effective than you assume. I love tearing apart methodologies so you understand that stuff. So that’s great.

Tracy

Okay.

Tony

Thank you for that. Hey, Albert. Let’s move on to China. China kind of seems to be in a little bit of kind of an inertia state. I mean, there’s just not a lot of movement. There’s not a lot of movement politically. There’s not a lot of movement economically. We saw the kind of sputtering restart in Q One. They’re still kind of not moving that much, although we saw retail sales grow, like, 14% or something like that. Although, admittedly, it’s on a closed economy. But we have things like youth unemployment over 20%, which should terrify the Central Committee. And we have this Blinken trip coming up this weekend, which I don’t really understand the point of this. And we have things like China’s foreign minister. We’ve got a story on screen where China’s foreign minister pretty much spanked Blinken on Wednesday before the trip, saying that the US.

Needs to change and other things. So, first of all, I know there’s a lot to cover here, including the plunging CNY. But first of all, is there a point to Blinken’s trip to Beijing this weekend?

Albert

I mean, in Blinken’s mind, there might be, but not in anybody else’s. He’s not going to be meeting with anyone of significance. I mean, she certainly will meet with him, and I don’t even think the foreign minister might meet with him. They might give him to, like, a third or fourth string official just for photo ops, but that’s about it. Blinking has shown that in the foreign affairs world that he is a lightweight and destructive to the United States interest. So I don’t care, and I don’t think anyone else in the world cares about Blinken’s visit to China.

Tony

Right. And I just want to kind of direct people back to, say, 2021, when he went to Anchorage and we were talking about this, and he really didn’t look strong in that meeting. He really didn’t look like he was carrying a potent message then and again, the the foreign minister kind of spanked him in front of everybody, and he really hasn’t come back from that. He’s tried to take a hard line on things like Taiwan and other things, but he’s really looked more like an academic than a secretary of state.

Albert

Is that fair to yeah, that was intentional. I mean, the Chinese tested him and he failed, and he never recovered, and nor will he recover. He’s failed pretty much everyone in the world. So, like I said, besides Blanking, there’s a lot of things going on in China right now.

Tony

He’s done well in Europe, though.

Albert

Yeah, well, I mean, it hasn’t blown up yet, so I guess that’s okay to say.

Tony

Right? We don’t know. Right? Exactly. Okay. So I wanted to cover that off really quick, just in terms of what to expect from the blinken trip. Maybe there’s some surprise, but I don’t have huge expectations because I don’t think the purpose is clear, really, to anybody. As we look at China on the economic front, they’re desperately trying to get things back on track after that slow reopening. And we spoke in December and agreed that it would kind of sputter, and that’s what we’ve seen happen. As I said, retail sales came in strong. Youth unemployment is pretty terrifying, and we see the PBOC coming in with kind of a small loosening.

But why has China been so slow to act? And what moves do you think Xi’s regime can do to accelerate things?

Albert

Well, they’re right now facing an economic warfare against the United States. The Federal Reserve, with Powell and Yellen at the treasury and some of the blinking officials, along with Wall Street, have a concerted effort to push China down for political and economic reasons. How are they doing? Well, because they’re keeping rates up so high right now, 4.5% on the tenure is game over in China. I’ve been told by analysts in China and Singapore that it’s game over. They certainly weren’t ready for 6% Fed Funds rate, which everybody in Wall Street is talking about right now. And I think that’s absolutely coming. We’ve talked about it on this, that 6% should probably be where they stop, and it looks like it’s going to right now. The Federal Reserve with Yellen can keep us here at 5% rates for the long run, maybe two years, keep the economy between zero and half percent growth, and maintain where we are right now. And hats off to David that saw this data well ahead of anybody else in terms of keeping a recession away from the political scene here in the US.

David

Can I jump in there on your point, Albert, about the US. Economy? The strength, I think, is being underestimated, underappreciated. So going back to the housing call, I looked at fixed residential. I went to the GDP, national accounts line by line, and fixed residential investment was the catalyst for it. Was net GDP subtracted from GDP in 2022 in late winter early spring I did a thread discussing fixed residential investment. My hypothesis was that we didn’t need it to get better. We needed to get less bad. And if it got less bad, given the resilience of the economy, that could potentially moonshot. Things fair enough. Q one GDP comes out. We were expecting I believe -0.6 subtraction GDP and we got -0.4 so there was a marginal less bad, marginal improvement and I think that’s going to continue. And if that continues, I do think that this whole idea we’re going to cut rates that gets kicked out farther than we think. So I’m just trying to go back to your point that this economy is going to run a lot hotter than people think rates will stay higher and that’s going to put the pressure on that you were discussing.

Albert

Yeah. Let’s be clear here. Four and a half percent on the ten year and 6% Fed fund rates means that all the money in Asia is going to come right back into the United States, which is bullish for equities. And we can discuss about what that really means for the market, I mean, for the economy overall, but that’s what’s going to end up happening. And from their perspective, it’s better for China to defend themselves from going over in the abyss than actually take on the United States globally. And that’s the general thinking right now. When it comes to inflation, they got it somewhat handled because they have a team that deals with commodity inflation in the futures market.

Tony

Chinese or the American?

Albert

No. The US. Has a team of like two dozen guys that handle this in terms of commodities in the futures market. And it’s under the whole national defense sort of mantra. But with inflation somewhat in the four and 5% area and wage inflation gaining steam, that keeps the populace at least at bay and not have pitchforks and torches coming for congressional members.

Tony

When you say economic warfare, is that intentionally against China or is it something where US. Economic officials are really just trying to keep the job market in a good position and put a damper on inflation? And then a secondary effect is the impact on China.

Albert

I’m 50 50 on that one. Right, because it’s certainly directed towards China. But Yellen knows that if you attack China and Asia in general, all that money comes right back into the US. Economy and the US. Market. It’s a little bit of 50 50 from my perspective.

Tony

Okay so from your perspective what can China do to all these headlines over the past couple of weeks talking about China needs to rally they need to circle the wagons and figure out what they’re going to do with their economy. What can they do just spend more money domestically build more bridges and high speed rail and all that stuff or.

Albert

Devalue the one that’s the only option to do it. That comes with other ramifications that a little bit over my pay grade, but that’s their only option is to devalue.

Tony

Well, it’s domestic inflation in China. Right? So they’re going to goose their exports to compete with Japan and Taiwan and Korea. But that comes with more inflation at home. Is that fair?

Albert

Yeah, it is. But inflation there is kind of tame. They have control over the economy more so than anybody else does. So they can tame inflation, at least on a numbers basis of what they put out, because we all know that data. That data is all the time inflation.

Tony

Data in every country. There is no country inflation data is accurate.

Albert

Yeah, of course. Even in the United States. I mean, they manipulate things with unemployment, inflation data and CPI all the time. But it’s interesting you mentioned Japan. This is eerily similar of what Japan went through in the 80s.

Tony

Tell us more about that.

Albert

No, I’m just relaying what I’ve been discussing with clients and friends in Wall Street, and this is exactly what the Japanese had gone through in the they’re pushing it onto the Chinese. The Chinese could have an inflation problem. Their growth is stagnant at the moment. Their demographics is not that great, and they’re fighting against the juggernaut in the United States.

David

China looks at the past 25, 30 years and they see two things that they don’t want to be. They don’t want to be the Soviet Union and they don’t want to be Japan. And I think both those things terrify them for a host of reasons. But those two things are the third row that they want to stay away from.

Albert

Yeah, that’s exactly right. And that’s why I’ve always dismissed any kind of Taiwan invasion, because that bring back the Soviet mentality of taking on the United States geopolitically. They don’t have the money for it. Let’s just be honest. They don’t have the money or even the nerve to do something like that. And when it comes to the Japan comparison, they really don’t want an economic collapse of their manufacturing sector.

Tony

Right.

David

David. What?

Tony

You mentioned about the Soviet Union in Japan. That’s absolutely true. They’re terrified of that. But when you talk to their bureaucrats, particularly, they’re also somewhat arrogant about we won’t be that because we’re different. And so there’s kind of both arrogance and fear about becoming either one or both of those. And it’s kind of weird because they’re moving in the direction of both. They’re going to fight really hard not to become one or the other. And I’m not saying they will, but I think that the possibility of that is becoming more real by the quarter, let’s say.

David

I think that’s right. China’s biggest problems are problems that they can’t resolve through war or through geopolitics, whether it’s their demographics and their birth rate that’s falling off a cliff, whether it’s water, their environmental issues are horrific. The Gobi desert. Continued when I was in Beijing, back when I was in graduate school, living in Singapore. Took a couple of trips to Beijing. There are always sandstorms in Beijing because the Gobi Desert is encroaching upon Beijing. It’s just one environmental catastrophe after another, going back to water. This is why they got their eyes on the Himalayas, for that Himalayan clean water source, which, aside from food, you also need for manufacturing. And I think this is where the United States has a huge geopolitical edge. We are very geographically advantaged versus most of the world, if not the entire world. Our water resources. We got the Great Lakes. We have the watershed that goes through the Appalachian Mountains, the watershed that runs through the Rockies. We have all these massive watersheds that we could leverage off of for both food and for manufacturing. China does not have that, not even close.

Tony

Well, and as China tries to take the Himalayo Mountain watershed, they’re upsetting everyone in India. And all of those tensions taken together are just a nightmare for China. China as a governance subject is incredibly difficult. I think most people on this side of the world look at China and believe it’s this monolithic government, and Xi Jinping makes a decision, and then it happens. It’s not that way at all. It’s just chaotic. And so, given all of these challenges they have, as well as the challenges within governance, it’s incredibly, incredibly difficult for them to tackle one of these, much less the gamut of all the challenges.

David

They have their governance. Really, the basis of governance in China is patronage, whether that patronage is family or whether it’s friends or political cronies, but it’s patronage. So the things that make governance good, such as competitive politics, don’t really exist in China. Obviously, the Communist Party’s monopoly on political power. But without that kind of competition, you have a lot of patronage favor occurring that might not lead to optimal outcomes. And then you magnify that across the country, different levels municipal, provincial, national it’s just like a real cluster bomb of bad governance and bad incentives.

Tony

Oh, it’s a competitive political environment, all right. But if you lose, you die. Like, literally.

Albert

I’m glad David pointed out all those things. Very few people actually in the financial sector actually take into consideration all these other things like water, fresh food, defense, and all these other components that make a superpower what a superpower is. I mean, all we’ve been hearing is that China is the next superpower. It’s taken on the United States, ABC and D reasons and so on and so forth, but they completely forget that they don’t have any kind of arable land at the moment to feed themselves. They’re in a battle with India, which is a nuclear power, for God’s sakes, for water that supplies a billion people on one side and a billion people on the other side. And these things are not to be taken lightly. I mean, you can’t just gloss over these things and say, oh, well, China is just going to take over Taiwan and US can’t do anything about it, and so on, and they’re going to move into Africa and South America and this and that. It’s far more complex and the details that they but actually pointed out, it’s spot on.

Tony

Great. Okay, guys, thanks for that. Tracy, let’s move on to natgas because we’ve seen some real interesting activity in natgas over the last couple of days. We’ve seen an interesting bounce. And so you put out a tweet on China’s natgas traders this week, surprised by the bounce in the market. So that’s very interesting to me. It looks like they were caught off guard.

We saw natgas up 9% this week.

But if we put that in context, that’s kind of a slight rise. It’s not like it’s completely market changing. What are your thoughts on this? And are we finally seeing some strength come back into the Nat gas market?

Tracy

Well, I mean, to be honest, this is a non sequitur for the US. Market. At this juncture. We’re going to have to see major drawdowns in either Asia or Europe to really get this market going. Yes, we saw a bounce, but if you look over the long term out to the US nat gas futures markets when this contract started, we’re still in that same long term trend that we have started in since 1996, when this contract started. So we’re still in that very comfortable zone in the US. Where we’re one dollars, $3. We have seen spikes over the last 30 years, but we’re still in a very comfortable zone just because of the amount of natural gas we produced. Yes, we did see a spike in prices in the TTF contract, which is the European contract that was due to Norway. Norway had to shut down one of their processing plants. And then we also had that news that the Netherlands was shutting down their largest natural gas field, but we did see price rise 70%, but it came back down 20%. I think that altogether, if we look at this Nat gas situation altogether, I just don’t see still at this juncture where we’re going to see natural gas prices rise.

Tracy

The United States, if that’s where we’ll be looking at Nest, has nothing to do in the immediate term. Let’s just say that because we’re just still producing a lot of natural gas, and even though we’re exporting to other countries, we still don’t have those long term contracts. We still are spending money building out export facilities in the Gulf. The United States in particular is a very different situation than we would see perhaps in Europe right now. And so I think looking at their particular situation, we’re going to see higher volatility in those kind of markets. Because if production goes down in one country or is mitigated in one country, they’re going to see a price spike. Unlike the United States, if we see, say, the permian doesn’t produce as much as they usually do on one week, that’s really not going to change the overall situation in the United States just because of the amount of natural gas reproduces the whole. So if you’re looking for this bump in natural gas prices in Europe and in Asia, I don’t think that’s really going to manifest itself exactly right now in the US.

Tony

Okay, so let me go back to something you said. Why are the Dutch shutting down the largest field in Europe?

Tracy

Well, because without I don’t want to.

Tony

Make no, just be yourself.

Tracy

Say what the situation is. The climate activists are saying this is causing earthquakes and everybody’s dying. And we all know kind of where the Netherlands is kind of down as far as if we look at the farmers and what they’re looking at as far as shutting down farming and fertilizer production, ammonia, et cetera. So I think this is, again, without upsetting anybody, I think that this is just another step where we see a little bit of hysteria that kind of causes a backlash as far as what we’re looking at as far as energy security is concerned. And actually, if you go to Hilltower Resource Advisors, one of our analysts just posted a great post on that.

Tony

Okay, great. Hill Tower Resources. Advisors. Right.

Albert

Yeah. These are just born from bad political decisions for politicians in Europe trying to safeguard their seats and their parliament. That’s all it is. They cater to the Green parties and they come up with bad economic policies.

Tony

Okay, go ahead.

Tracy

Sorry. What I’m thinking is I’m addressing this towards you, Albert, actually, because you just brought this up, is that if we’re talking about do you think that with elections coming up, that we’re going to start seeing a backlash? Because we just saw like, say, the Green Party in Germany fall from 22% to 14% over a very short period of time. So do you think with upcoming elections we’re going to see sort of a change in stature of these parties because they’re going to lose votes?

Albert

It depends. It depends on the country and the situation and the parliamentary makeup of each of the countries. Let’s just take Holland, for instance, one of my non favorite countries in the world. But Root has a liberal majority in his parliament. For him to stay in power, he needs that liberal majority. So in order to keep those seats, he’s going to have to cater to those people, and that means more Green initiatives to the extreme. Now, of course, if the economy starts to tank and inflation takes hold in Europe and the banking sector starts to falter, those are scenarios where, yeah, it could tip a lot of elections over back to the right. But the problem is the European elections and the way they do their government is a parliamentary system. So they don’t necessarily need to win the majority for their party. They just need to have a coalition that takes a majority.

David

Albert, what impact do you think going on? What Tracy mentioned and this whole topic of Green politics with the war in Ukraine and Russia, I think it’s the energy dependence that Germany in particular saddled itself with with respect to Russia that just kind of blew up in their face. And that has implications for a lot of the Green policies that were championed, namely getting rid of nuclear. So do you have any insight on how the war is impacting? Is there going to be a revisit of these green policies to maybe not repeat the same geopolitical mistake or experience?

Albert

Well, that’s going to really depend on what happens in the winter of this year. They had a mild winter, so it kind of eased up on the pressure that the European politicians had to deal with. But let’s just be clear that Europe is, like I’ve said, for weeks now in a zombie state in terms of their industrial output. Right now, they’re not really working. There’s not very many things being built over there. They have a drought that’s still pretty significant in Europe and actually getting worse. So that’s going to affect the shipping, like Tracy mentioned, I think, like six months ago up the river of the Rhine. They can’t ship materials back and forth because the water levels are too low. So there’s a lot of things that have to be taken into account. So it’s not really, let’s wait and see how the winter goes and then we can readdress what policies they’ll probably have to look into concerning green initiatives.

Tracy

We’re already seeing problems as far as supply is concerned with summer coming along. Right. Although Europe is not a big consumer of air conditioning like the United States is, we’re still seeing a large drawdown because temperatures are over 20 C there. We laugh in the US. I know, but that’s a big deal for them. We’re seeing this in the UK, we’re seeing this in summer is just really starting. And again, I think I mentioned this and everybody was skeptical about it. I mentioned this on this podcast months ago, that we should look to summer because air conditioning would be a big drawdown for this. And I saw a lot of the comments saying, but they don’t have a lot of air conditioning. It’s not like the US. But yet we are seeing this happening. So I think we need to pay close attention to this. I think right now, especially again, we’re seeing a drought again. So from Rotterdam to Germany, we’re going to have a problem on the Rhine again this year that’s going to mitigate heavy vessels that carry crude and gas products to Europe. People don’t understand when water levels are low, you can’t have those heavy vessels coming.

Tracy

So this is what we had. This is part of the problem that we had summer of 2022. And this looks like this might be a problem again.

David

I was visiting family in southern France last summer. I was in Provence just outside of Avignon, and the Roan was really low. There are parts of the Roan where you could basically flatbed looking some boats that were just on their side. So this water crisis is not just in northern Europe, but it’s also on the more Mediterranean south as well.

Albert

Italy’s had a big problem, too, with water levels. I think the Pole was showing, like, historical markers from, like, four or 500 years ago of droughts. It’s a problem. And the mild weather kind of mitigated how much pressure the Russians could really enact on the energy market. But they get a cold winter and the Russians want to get nasty. Look out for Europe.

Tony

Yes. So, Tracy, if they can’t transport product by river, do they transport it by rail or truck or do they just not transport it?

Tracy

Well, what they do is they have to take that product and put it into lighter vessels. In other words, through there you can’t get an apple. You got to go the smallest. They start taking that product, they’re not going to let people go without energy. So what you have to do is you just have to start putting that project into smaller vessels that can transverse that river.

Tony

Okay.

Albert

If it’s not lighter vessels, it’s actually one third of the cargo capacity to keep the boat lighter and afloat higher. But that increases the cost of shipping.

Tracy

Which increases inflation, which also creates another problem. Exactly.

Tony

Okay, then just kind of final question is I’m really interested in this closing of the field in Holland. And I know that sounds a little bit pedantic, but it kind of reminds me of the reactionary close of the nuclear stations in Germany in 2012. So are we watching Europeans do things that they may regret in 5678 years and then reverse trend on this stuff?

Tracy

Well, absolutely. All you have to look at is the deindustrialization that is happening exactly right now in Germany and then take that model and place that across every country in the EU that is following those exact same protocols. Right. And we’re seeing that we’re seeing chemical production flee to China.

Tony

Yeah, you’ve talked about BASF and other.

Tracy

Companies that have so we’re seeing all these people go to other countries that are much more amenable to this kind of business because it’s too expensive.

Tony

So when you talk about these guys moving, is it the access to energy? Is it the kind of environmental arbitrage they can go and do things in China environmentally, is it a number of things. Is it wages?

Tracy

It’s a number of things. It’s the cost of doing business as far as energy is concerned because obviously, industrial manufacturing, et cetera, is very energy intensive. So it’s the cost of doing business. They asked companies to limit their energy use 15% last winter. That hasn’t been lifted yet. And it’s costing them ten times the amount that they were paying before. So of course, they’re leaving to other countries that may incentivize them. And that’s not only China. This is what Europe is also worried about is that industry is going to move to the US. Even, right?

Tony

The Inflation Reduction Act.

Tracy

Well, yes, which is reduction, which is not reducing any sort of inflation, but it does provide incentives to companies to move over to the United States if they want to because they get a bunch of tax credits. Now, that doesn’t influence us as taxpayers. But as far as business is concerned, if you’re looking to pay less, your options are China and the US. Mexico mexico is great, but that’s a whole nother subject.

Tony

Love to dig into that at some point. So let me ask one final question of all you guys. Albert talked about how us Officials, Fed, treasury are either directly or indirectly conducting economic warfare on China. But as we’ve talked about with Europe, they’re a little bit handicapped with their drought and their electricity prices and power and all sorts of things. And we have the economic policies of the US. Is that same kind of economic warfare kind of activity is that also impacting Europe in either a direct or indirect way? And how do the Europeans feel about that?

Albert

Of course it is. I mean, the Europeans, let’s be clear, it’s really Germany and France and maybe Holland, but they’re the economic engines of Europe. And right now they’re so blinded to where they think that China is the only emerging market share that they have available to them, which is just incorrect. But that’s their goal right now, is to safeguard that market share in China by any means necessary. And that means it’s going against the United States, which they’ve been clearly vocal on for the past six months or so.

Tony

David, what do you think about that?

David

Yeah, I don’t have any real insights into that. It’s kind of above my pay grade.

Tracy

I don’t want to speak for the people. And all I can say is what we’re seeing in companies within countries is that we are seeing transverse from obviously we’re seeing industry move from Europe to China and to the United States. Again, I don’t know how these people in these countries feel about this. I can only speak to what we are seeing business wise and trends.

Tony

We are seeing great guys, thank you so much. This has been really fantastic. David, thanks for joining us for the first time. I appreciate that. Hope we can ask you back. And Albert, Tracy, guys, thank you very much.

Albert

Have a great week and a great weekend.

David

Thank you. Thanks for having me. Take care. Have a good weekend. Bye.