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
Before we get started, I’d like to let you know about a promotion we’re doing for CI Markets, our forecasting platform for stocks, ETFs, indices, commodities, currencies, forex, and economics. For the next two weeks, we’ll buy the first month of CI Markets for you. Go to the link to find out more. At checkout, use the code 25OFF. That’s the number two, the number five, and the letters O, F, F. This will give you the first month free when you subscribe to our $20 or $25 a month plans.
Get fresh market forecasts every week, accountable forecasts where CI discloses our error rates, and a growing set of capabilities.
Tony
We’ve just launched the top 50 US ETFs, Nasdaq 100, Nikkei 100, Fuzzi 100, and so on. Check out CI markets today and use the promo code 25off. Thank you.
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.
AI
Great news, traders and investors. CI Markets has expanded its coverage to include stocks from the S&P 500, Nasdaq, Nikkei, FTSE 100, and the top 50 ETFs. With more than 1,500 forecasted assets, our AI-powered platform provides highly accurate forecasts. Join our community of successful investors who rely on CI Market’s insights to make informed decisions. Subscribe now for as low as $20 per month and unlock the power of comprehensive forecasting. To learn more or book a demo, visit completeintel.com markets.
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.