December 2023 Monthly
The Middle East Keeps Burning, Milei Is For Real!, Checking In On Banks, Fed Pivots
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*Not financial advice, merely pointing out political trends*
Financial markets had a decent December performance, with the S&P 500 up around 4%. The much-anticipated Fed pivot appears to have arrived, with the Fed’s projections now showing three rate cuts in 2024. Gold cleared $2,000 on the news but has not been able to sustain a rally.
The Middle East conflict had a slight pause, but continues to burn. Israel continually attacks Gaza and Lebanon. Iranian backed militia groups continue to hit US bases- they’ve attacked US bases in Syria and Iraq over a hundred times now. More worrisome is the fact that Houthis in Yemen have entered the fray. Armed with ballistic missiles, they’ve attacked commercial ships and shut down the Red Sea /Suez shipping route. As of now, markets don’t care, but it’s only a matter of time before this conflict gathers steam and they do care.
We are at an unusual juncture, and it’s beginning to look like 2000-2002 all over again. Commodity and International stocks are absurdly cheap. Energy names all trade at 1-2x EBITDA and have huge free cash flow yields. Miners are at record low valuations. Gold is getting ready to break from a nearly 15 year base. The Fed is about to start rate cuts. War drums are being banged and conflicts are growing in strength.
On the other hand, international investors are heavily concentrated in large cap US stocks, especially big cap tech. These stocks are priced for perfection, and arguably are totally ignoring any risk of further trade disputes with China or conflict over Taiwan. All the historical recession signals abound in the US, but everyone predicts a soft landing.
This era resolved itself with a huge rally in 2002 and 2003 for international stocks, after a beating in 2000 and 2001. But US stocks got killed 2000-2002 and then slowly recovered in 2003-7, before again crashing in the Global Financial crisis. We are not predicting a crash in US shares. But we are predicting a long period of underperformance for large caps and the tech sector against international stocks and commodity names. And even if there is a US bear market, those names can start to decouple. Our base case would be that US indices are flat to down in 2024, but that international indices and commodity indices are comfortably higher next year.
Themes are below. The one change is taking a victory lap and removing ‘Avoid Fixed Income’. We still think that credit spreads are too low and that the Fed is not yet ‘easing’ by any means. But with a 50% fall in long term bond prices these past two years, and a Fed pivot upon us, the juice has been squeezed out of the trade. The other minor change is the title of the Argentina theme- Milei is For Real!
1. Middle East Keeps Burning, Ukraine Running Out of Steam
2. Milei is For Real!
3. The Fed Has Pivoted
4. Checking In On Banks
5. Chinese Gold Buying Update
1) Middle East Keeps Burning, RICs Coalition Ups the Pressure
Late November saw a few days pause in the conflict in Gaza for swapping hostages. But the war goes on and we are now up to 20,000 dead in Gaza and well over 1,000 Israelis dead. Israel continues to fight in Lebanon, Gaza and Syria. US bases in Syria and Iraq have been shelled well over 100 times now by Iranian backed militias.
Now the conflict is about to enter a more serious strategic phase. Israel is threatening to invade Lebanon up to the Litani river, which is more than 50 miles from the Israeli border. Iranian backed Houthi rebels in Yemen have stepped into the conflict. They have already sent missiles aimed at Israel. But now they are shooting at targets closer to home, having hit several commercial ships over the past few weeks. As a result, ships are avoiding the Red Sea and Suez Canal all together. Ships have been redirected to sail around Africa. The US Navy and others have formed a coalition to contain the Houthis, and restore safety.
There have been 37 incidents in the last month according to Axios:
Reports have come out that the Houthis are firing ballistic missiles, marking the first time that ballistic missiles have been used to hit ships. The missiles were Chinese made. And Iranian naval and intelligence assets have been heavily in the planning and target selection. That is in addition to their assistance to Hamas, to Hizballah, and to numerous militias in Syria. And the Russians assistance to the Syrians.
We have written before about the obvious military strategy of the Russia-Iran-China (RIC) coalition, which is here acting together against the US and NATO interests, and to a lesser extent Israeli ones. The West is being bled financially, with higher inflation and economic stagnation which this shipping shut down will exacerbate. The West is being tied down militarily in several locations, which is by design. The RIC leadership wants US forces and military support spread out so much that they lose their maximum effectiveness. Ukraine is a good example - the US’s assistance has been strong, but not enough to unwind the Russian territorial gains. Introducing new theaters of conflict is going to keep happening until the US breaks and withdraws back to North America. Ukraine was first. Then Gaza. Then Lebanon. Then Syria. Then US assets in Iraq. Now the Red Sea. Soon it will be the Persian Gulf. Then eventually Taiwan and a couple of other spots in the Pacific theater. With US troops and military support tied down in almost a dozen locations, stopping this coalition eventually becomes impossible.
The US is currently moving naval assets to the Red Sea, the Eastern Mediterranean, and away from East Asia and the Persian Gulf. The conflict here is also far more expensive for the West: US destroyer missiles cost $500,000 and have limited production. Iranian drones can be rapidly built and cost a few thousand dollars, meaning they can soon swarm the US navy without a capacity to counter.
Over Christmas weekend, Israel did a decapitation strike, taking out a top Iranian Revolutionary Guard official who was in Western Syria. Iran has vowed respond to with a host of attacks on US and Israeli assets, perhaps even Israel itself. Iran has moved up thousand of its troops in Syria close to the Israeli border. In addition, we saw a massive Iranian backed group attack a US base in Erbil. The US responded with large air strikes on these forces, killing several. We are not yet at the point where the US and Iran are bombing each other. Nor where Israeli and Iran forces attack each other directly in large numbers. But these incidents represent the first direct shots fired between the two major powers, and there is a risk of an escalation spiral.
We don’t want to be alarmist here. But we have to point out that since the initial October 7th attack on Israel, this has morphed from an Israel versus Hamas fight to a very complex regional conflict. The number of combat zones continues to expand, as does the severity of the attacks. Situations like this usually only require one trip wire to be accidentally or intentionally tripped for an even bigger conflict to follow. Ukraine is a perfect example, where the refusal of Ukraine to withdraw from Luhansk saw the Russians respond with a full invasion. We can also cite conflicts like Lebanon in the 1980’s or Vietnam in the 1960’s and 1970’s as other examples of an ever-widening mess.
The markets don’t care about this simmering multi-front conflict now, apart from a few shipping stocks. And that’s right- it’s not a big deal as of now. But as this continues to burn and grow, it will at some point matter to everyone. We will try to identify the inflection point as soon as it happens.
We think it’s inevitable that the RIC coalition will go for bigger objectives, and that the US will have to get involved directly somehow. With the US Navy pulled away from East Asia and concentrated around the Arabian peninsula, we can be sure that China’s potential Taiwan invasion has better chances of succeeding now compared to six months ago. Xi told Biden point blank at their recent meeting that retaking Taiwan is going to happen. The when is the only question.
The fact that China has a large naval base just across the water in Djibouti is something most journalists have not mentioned. But if the RICs coalition’ desire is to shut down Red Sea commerce, they can easily fully enforce this from both sides. Or protect the RIC assets and harm others.
2) Milei Is For Real!
Milei and team introducing the DNU reforms
Argentina’s new President, Javier Milei, took office on December 10th. In the weeks leading up to this inauguration, people speculated what his first moves would be (we of course knew very well and told you what would happen). Would he be able to work with Congress? Was he serious about all of his mega campaign promises? Would he actually be able to defuse the peso and banking sector ticking time bombs?
Well, after two weeks, the answers are pretty clear: Milei is for real! Far from just repeating libertarian economic talking points, he has begun the world’s first real time libertarian lab experiment. The outlook is quite promising for his political prospects and for the country’s economy. The right in Argentina had identified that the gradualism other center-right presidents in the past practiced did not work. This time, they needed to do major reform starting on day one.
Investors clearly love the program. Starting from the day before Milei’s win, Argentine bonds have nearly doubled. Key stocks like YPF and Banco Galicia are up 60-80%.
Milei has done a breathtaking amount of reform in just two weeks, taking his promised chainsaw to government spending. A review of the spending and program cuts announced thus far:
· Cutting the number of ministries from 18 to 9
· Firing roughly a third of secretaries, sub-secretaries, and ministers
· Suspending all new programs and public works
· Elimination of subsidies for energy, electricity and innumerable state owned enterprises
· State workers’ wages had been growing above inflation for years under Kirchners, now he is having government employees’ salaries grow well below inflation
· Terminating 7,000 government employees’ contracts, with another 45,000 under review
· Innumerable little spending cuts and eliminations of public waste
Projections now indicate that the government deficit should go from a deficit of 6% of GDP in 2023 to a balanced budget or a small surplus next year. Our favorite anecdote is the catering company that was billing the President’s office for 1600 ham and cheese sandwiches per day- but only delivering 200 and pocketing the difference. The contract has been renegotiated.
At the same time, Milei has managed to liberalize the exchange rate regime. Argentina has multiple exchange rates and regimes for converting pesos to dollars. The day of the election, the ‘official’ rate was 350 pesos to the dollars, versus a 1,000 informal rate. This represented a windfall to politicians and their friends who could access the official window, and then arbitrage it with the unofficial rate, as you could essentially triple your peso balance. The different exchange rate regimes for importers and exporters are going to be eliminated. Under Milei, the exchange rate gap has already narrowed to an official rate of 850 versus a 950 unofficial, and it should fully merge in 2024. Milei’s reforms also now allow people to contract in the currency of their choice (pesos, dollars, bitcoin, yuan etc) which will likely lead to the withering away of the peso, to be replaced by stronger currencies. This will, coupled with the shrinking money supply and structural reforms, cause inflation to crash in Milei’s first two years. We wouldn’t be surprised if Argentina enters a deflationary period as competition picks up in every industry.
The central bank has managed to build $2bn of reserves in the first two weeks, and at this pace, should have than enough dollars to handle the international payments due in 2024. The central bank also stopped printing money and ran down all of the LELIQs (central bank notes) that the government had stuffed for years into banks to finance itself. A major obstacle to banking stability and dollarization is gone in a week, whereas we were worried it would require months.
All of these reforms would be impressive under any government. All of these reforms, in just two weeks, is very impressive. But perhaps the most impressive part of this is his massive structural reform package called the DNU. It’s a decree now, but the Congress and Senate have indicated they will not block it, so it will become law after 90 days.
This shock therapy will completely unshackle the private sector from its decades long stagnation. For context, one must understand that almost every industry in Argentina exists with a phalanx of anti-competitive rules that protect it. This system rolls on because 40% of the country gets a handout. Those people, along with union members and government employees who get special benefits, constitute a majority who kept voting for this, until Milei. Politically connected businessmen work hand in with a very corrupt political class for special contracts and benefits, and to keep out new competition. The average person gets screwed with the resulting high prices, high taxes, high inflation, and poor real wage and productivity growth. The caste perpetuates itself.
One big rule is the ‘buy Argentina’ rule that exists for industrial products. If the product is made domestically, anything from concrete to steel to ball bearings, you have to buy from an Argentine supplier. Even if the German steel is 10x better or the Brazilian version is one third the price, you don’t have the choice. This especially hurts businesses in border towns, who could buy cheaply from across the river in Uruguay but instead have to truck something from hundreds of miles away in Argentina. This has kept a host of inefficient companies in business- and their union laborers voting Peronist. But it hampers the rest of the country.
On an individual industry level, there are a host of regulations that thwart competitors entering the market. Supermarkets have a dizzying array of price controls and advertising requirements impossible for small groups to keep up with. Monopoly grants exist on a host of assets and industries, like electricity and tourism agencies- yes, each province has a state-owned monopoly tourism agency which contracts with its best buddies. Banking is regulated to an enormous degree, so that there are essentially five major national banks and no foreign competitors. Fees are high, service is trash, and there is very little lending to the private sector. Magically, senior politicians end up on these boards after their time in office.
Now, all of the little cliques, mafias, and politically connected companies that dominate Argentine industry are vulnerable to disruption. This will create massive growth in almost every major industry from supermarkets to energy to Internet to wine. The expansion of the supply side is going to cause increased productivity and likely even a period of deflation for the country. We think that the increased investment from the private sector will likely offset the rapid tightening of monetary and fiscal conditions.
We won’t list the 30 full points of his DNU, you can read them here (in English). But to see how much this will improve outcomes for everyone, let’s look at the airline sector as an example. First, the government has been subsidizing losses at state owned Aerolines Argentinas for years- $8bn in the past fifteen years. That will end. Its ownership has been transferred to the employees, who now will be responsible for management and for making it competitive, and will eliminate possible political interference. The government has ended the company’s monopoly on flights within Argentina, and is allowing foreign airlines to enter the market and operate . Previously, any company operating within Argentina was required to have majority Argentine ownership. Cargo transport will be open to any operator now, giving consumers more choices. Restrictions on flights into and out of Argentina to foreign countries are lifted, so that tourists and business travelers will have more options. Price controls and fees that were in place, and led to very high ticket prices relative to its neighbors, will be eliminated. As airports are already mostly privatized in Argentina, they will be able to expand capacity to meet this coming wave of demand. Expect this whole new policy to lead to a boom in foreign travel and a shift away from the long bus rides between cities that Argentines currently endure.
And this is just one industry folks. As we said, similar sweeping reforms at the industry level have been enacted in nearly every industry, including very important ones like energy, banking, and agriculture. Reforms of the major anti-business laws that impact all businesses, like Argentine’s very hostile labor laws, are an additional boost.
Lastly, Milei has announced an agenda to privatize (story in Spanish) all the state owned assets he can. Right now that is a list of 33 companies employing 100,000 people. This agenda will contribute to easing the fiscal burden and improving the country’s overall productivity in sectors like post and packages, trains, cargo, etc. Some of these are going to take a long time to fix- the train company for example spends 10x its current revenue. Argentina’s Mendoza to Buenos Aires train currently takes eleven hours longer than it did when it first opened – in 1895! To say that this will take the future buyers time to turn around is an understatement. But at the same time, if Argentina eventually moves these sectors up to regional or international standards, the gains will be enormous.
Polls show strong support for this, over 70%. That will give Milei a tailwind for the near term and a cushion for the austerity to come. If reforms succeed in lowering inflation significantly, then he could ride 70-80% approvals by the time the midterms roll around in two years.
Milei has proven he is for real, readers. And we still have four more years of reforms coming! Milei could end up being one of the few world leaders able to rip out socialism before a country’s total economic and political collapse. Do not underestimate how major this shift is! Decades of monetary chaos and low productivity are now turning into what will be one or two decades of private sector growth, investment, competition and price stability. This has rarely been seen in economic history, with perhaps the reforms of Eastern Europe in the 1990s and Thatcher’s Britain of the 1980’s being the best comparisons. The Czech Republic, as an example, went from having a GDP per capita of $2,000 in the early 1990s to $27,000 currently. But even if Argentina’s economy ‘only’ performs as well as Brazil after the Plano Real, or Mexico post-1994, it will still represent a sea change for investors and business owners. Book a (soon to be more numerous) flight to Buenos Aires before everyone else does and start to identify the best opportunities.
And we recommend you follow our friend @BowTiedMara on Twitter for the latest and greatest news on Argentina.
3) Checking in on Banks
We wanted to circle back on the banking data and see what was the latest. We see a stagnant data series for deposits and bank credit. While not deteriorating at that pace they did over the summer, they have not yet begun to recover. The stress is still in the system, and it’s driven by the total mess in the real estate market. Every day news comes out about CRE deals being at half the prior price of ten years ago. And the dam has not yet burst from all the high vacancies and higher interest rates working their way through the pipeline.
The major sign that stress is not yet out of the system is the ‘emergency’ plan the Fed put in place after the news of Silicon Valley Bank blowing up. This program, the Bank Term Funding Program (BTFP) has reached new levels of usage, $130bn. More worrisome is that the program is set to expire in March, after one year. Will the Fed renew it? Or force banks into other programs which are not as generous on securities lending?
This rise in usage is AFTER the rescues of a) Silicon Valley b) First Republic c) Signature d) PacWest. If all the problem banks have been swallowed by bigger groups and therefore don’t need emergency funding- then who are the new problem banks? The Fed does not divulge this data. We strongly suspect that Citizens and PNC bank are on the list. After Q4 results are released, we will again go through individual bank deposit data to see who is losing share and is the most vulnerable.
BTFP Usage
Deposits
Deposits in the system, after a large outflow in Q1/2, remain steady
Bank Credit
Bank credit has staged a rebound after contracting all year long
RRP
We wrote at length last month on the RRP data. The reverse repo allows groups with cash to pledge cash at the Fed and get securities. It reached $2.5tn in usage at peak. It has fallen in the past year to $700bn, and this liquidity injection into the market has largely driven the past 12 months stock rally. We think that the RRP led rally continues into likely late January or February, at which point the facility will probably reach its lowest usage, if not zero. Then we expect the problems to start with bank reserves at low levels and the liquidity injections over.
Another issue that had dogged banks in 2023 was the huge pile of unrealized losses on their balance sheets. According to the FDIC, this number reached almost $700bn at the end of Q3:
Unrealized Losses on Securities Increased From the Prior Quarter: Unrealized losses on securities totaled $683.9 billion in the third quarter, up $125.5 billion (22.5 percent) from the prior quarter. Unrealized losses on held-to-maturity securities totaled $390.5 billion in the third quarter, while unrealized losses on available-for-sale securities totaled $293.5 billion.
This number has probably improved somewhat with the Q4 rally. But still, this amount represents ¼ of banking system capital. Should banks realize this in a deposit outflow scenario, the losses would be scary. Keep an eye on these figures.
Finally, we want to discuss the fact that even if the Fed cuts rates once or twice, that this does not mean the Fed is actually easing. How is that, Decoding? We remind you, the Fed research indicates roughly each $1tn of balance sheet contraction is equivalent to 25bps of hikes. The Fed balance sheet is down $1.3tn since its peak, and at current pace, should be down by $2tn by mid-summer. If the BTFP is not renewed, that’s another $130bn rolling off. The Fed would have to end QT and to cut over 100bps to truly be considered in easing mode. While stocks have rallied on the expectation of no more hikes, they will do nowhere near enough in order to get a true ‘Fed easing bull market’ like in 2003, 2009, 2019 or 2020.
4) The Fed Pivots
The Fed’s December 13th meeting saw them keep interest rates unchanged. Rates have been unchanged for the past six months. The Fed was talking hawkish previously and suggesting that their next move would still be rate hikes. But the long-anticipated Fed pause (and upcoming Fed pivot to lower rates) has finally arrived, with Fed members suggesting their next likely moves are cuts not hikes from the current 5.25% level.
Each quarter, Fed staff and FOMC members prepare what’s called the “Summary of Economic Projections” (SEP) where each member puts down their projections for various economic variables. The most watched of these is The Fed’s ‘dot plot’, which shows members’ belief on the future level of interest rates. First the time, ten out of twelve members are in favor of rate cuts in 2024, with many wanting 100bps or more. Powell’s comments at the press conference of December 13th, however, indicate it’s still a long way before inflation sustainably hits the Fed’s 2% target.
Based on the Consumer Price Index and other data, we estimate that total PCE prices rose 2.6 percent over the 12 months ending in November; and that, excluding the volatile food and energy categories, core PCE prices rose 3.1 percent. The lower inflation readings over the past several months are welcome, but we will need to see further evidence to build confidence that inflation is moving down sustainably toward our goal. Longer-term inflation expectations appear to remain well anchored, as reflected in a broad range of surveys of households, businesses, and forecasters, as well as measures from financial markets. As is evident from the SEP, we anticipate that the process of getting inflation all the way to 2 percent will take some time. The median projection in the SEP is 2.8 percent this year, falls to 2.4 percent next year, and reaches 2 percent in 2026.
We think that this language takes off the table a large cutting cycle of 100bps or more. Several commodities have begun to perk up recently, and remain over their year ago levels. That, plus some moves in other categories, will keep core inflation sticky around 3%. We think, absent an economic crisis, we only see two or three small 25bps adjustments lower in 2024. Too many investors out there have been conditioned by the 2002-2020 Fed. They believe in the event of any problem, the Fed will take rates to 0 or 1% and dramatically expand the balance sheet. We think that given the higher for longer inflation we have seen, and the deteriorating fiscal picture in Washington, the Fed will be far more cautious about responding to a recession with aggressive easing.
However, we acknowledge that this Fed pivot is real and likely to last into 2025. As a result, we removed our “Avoid Fixed Income” theme. We don’t suggest owning long duration bonds and we think you should avoid anything with credit risk. But it’s probably okay to own out to five years here without much risk. Real rates are now positive and the absolute yield is healthy relative to the earnings yield on mainstream blue-chip stocks.
The yield curve, a measure of how restrictive policy is, still shows the curve heavily inverted- the most since the early 1980s, when we had a double-dip recession and 15% interest rates. This implies that the Fed is trying to wring inflation out of the system, even though it all but guarantees a recession. Every time this indicator hit zero or went negative, a recession followed, which are the grey columns on the chart. It is near a certainty that we will see a recession next year, just a question of severity. The only variable is how much that recession can reduce inflation and allow the Fed to cut.
Since we first wrote about it in December 2021, the ETF representing long term US Treasury bonds, TLT, fell from 148 to 83, and currently sits at 98. By comparison, anyone owning cash over that time period or stocks is sitting on breakeven or a small gain.
Just like in the 1970’s, as we have written before, we expect another major wave of inflation to come, likely driven by war or severe shortages. We hope to notify readers near that inflection point. Then, we would not be surprised to see TLT fall from say 110 or 120 to the 50-60 range. The fiscal issues are not yet pressing, but will become more so with each passing year.
5) Chinese Gold Buying Update
In our May piece “BRICS of Gold” we highlighted that the BRICS were allocating their reserves to gold and would push the market higher. Russia was the first to act, but now the 800lb gorilla China was ramping up purchases. They have increased gold holdings twelve months in a row.
Since the start of the year, China has added around 240 metric tonnes, a 12% increase in its total holdings. This represents about 8.5m ounces, or 10% of global production. But in dollar terms, it is still relatively small: it’s only $17bn, a fraction of their $3tn plus in foreign exchange reserves.
China’s Gold Holdings, tonnes
Yet even this small amount has managed to push gold higher this year by about 13% (using GLD). If China continues to divest Treasuries and to purchase gold, then we can expect similar buying and similar performance by gold for years to come.