Vijay Kumar Gaba

For many weeks, global markets have been behaving in a very desynchronized manner. Non-congruence is conspicuous even in the behavior of the same investor/trader operating in different market segments, e.g., equities, bonds, commodities, currencies, cryptocurrencies, etc.

For example, until a month ago an investor with a balanced 50:50 debt-equity asset allocation invested in bonds as if a soft landing was imminent leading to a series of policy rate cuts over the 12-15 months. The same investor invested in equities believing that earnings growth would surpass the estimates and stocks of top technology companies would continue with their dream run. The investor was content investing in USD assets assuming green greenback would strengthen and at the same time he was buying bitcoins expecting the demise of the extant monetary system by independent crypto or digital currencies.

Last week in the US, equities reached their all-time high levels as if all is well in political, geopolitical, climate, economic, and financial spheres. It felt that the Fed was about to begin a sharp rate cycle, earnings growth had rebounded, Sino-US relations had normalized, the Gaza ceasefire had been announced, and El Nino had ended. However, across the street, the bond market was selling off as if prices were going out of control forcing the Fed to push the rate cuts to 2025. Back street, the bullion market announced that a recession was imminent. Across the Ocean, crude prices were rising as if a war was imminent with Iran threatening to escalate. In dark streets, crypto traders were laughing at conventional investors/traders rushing to bullion markets to hedge against recessionary weakness in USD.

Back home, last week equity indices reached their all-time high. Nifty Small Cap 100 gained over 7%. Commodity stocks rallied as if a bullish commodities cycle was imminent. Ignoring RBI's concerns over prices and credit, bond prices corrected only marginally. No one bothered to care about political manifestoes which are promising fiscal profligacy of gigantic proportion. USDINR appreciated marginally ruling out any pressure on the current account and balance of payment due to the sharp spike in energy & gold prices (two major imports of India) and FPI flow reversal due to the narrowing yield differential between India and developed market yields. People are also rushing to buy Silver (up 10% last week) to make some quick gains.

One of the largest asset management companies is running equities weight close to the lowest permissible in their balanced fund. It has also restricted flows to their smallcap fund. The top fund manager at this AMC is one of the most respectable names in the industry. Considering that the Smallcap index was up 7% last week against the 0.8% rise in Nifty, it seems, no one is listening to his sane advice.

We have all heard the story of an elephant and six blind men. It goes like this.

Once upon a time, there lived six blind men in a village. One day the villagers told them, "Hey, there is an elephant in the village today."

They had no idea what an elephant is. They decided, "Even though we would not be able to see it, let us go and feel it anyway." All of them went where the elephant was. Every one of them touched the elephant.

"Hey, the elephant is a pillar," said the first man who touched his leg.

"Oh, no! it is like a rope," said the second man who touched the tail.

"Oh, no! it is like a thick branch of a tree," said the third man who touched the trunk of the elephant.

"It is like a big hand fan" said the fourth man who touched the ear of the elephant.

"It is like a huge wall," said the fifth man who touched the belly of the elephant.

"It is like a solid pipe," Said the sixth man who touched the elephant's tusk.

They began to argue about the elephant and every one of them insisted that he was right. A wise man was passing by and he saw this. He stopped and asked them, "What is the matter?" They said, "We cannot agree on what the elephant is like." Each one of them told what he thought the elephant was like. The wise man calmly explained to them, "All of you are right. The reason every one of you is telling it differently is because each one of you touched a different part of the elephant. So, the elephant has all those features that you all said."

"Oh!" everyone said. There was no more fight. They felt happy that they were all right.

The story's moral is that there may be some truth to what someone says. Sometimes we can see that truth and sometimes not because they may have different perspectives which we may not agree to.

But I am witnessing a different phenomenon. No six blindfolded men are feeling different parts of an elephant this time. It is only one person who sees different parts of an elephant with open eyes and is not able to tell that it is an elephant.

I have been tracking the news flow and experts’ opinions regarding the developments in global commodities markets for the past couple of years. Of course, I am a novice in matters of global economics, trade, and finance; but the commodities markets are particularly something I could never understand.

From my elementary understanding of economics and human behavior, I understand that aging demography, deeper & wider penetration of dematerialization & digitalization in human lives, rising awareness about climate change, and deteriorating growth potential of the developed economies, and perhaps China also, definitely do not augur well for the commodities’ demand in the long term (10-15yrs). However, the opinion of experts is overwhelmingly in favor of a bull market in commodities in the short term (2-5yrs).

The key arguments presented by experts in favor of a bull market in commodities could be summarized as follows:

(a)   Energy prices have corrected back to the pre-covid period. European power prices, US gas prices, natural gas prices, coal prices, and crude oil prices are back to more “normal” levels. The latest inventory, consumption, and production forecasts for 2024 and 2025 are indicating further easing in energy prices over the next couple of years. Energy being one of the major costs in the production of commodities, lower energy costs and adequate supply is a bullish argument for commodities.

(b)   Focus on the use of clean energy, particularly for mobility and electricity production, is changing the demand mix for metals. The demand for metals like copper, aluminum, lithium etc. is rising much faster than the supply. The stockpiles are diminishing fast.

(c)   Commodity producers, mostly emerging economies, are getting stronger in global strategic balance. The expansion of BRICS to include more commodity producers in the emerging market alliance is just one instance. These economies are now in a much better position in determining the terms of trade, which are dominated by the financialized developed world in the extant global order.

(d)   The geopolitical conditions are worsening. Presently, two fronts (Palestine and Ukraine) are witnessing open war. The fear is that more fronts could open in the next couple of years as the political stands are hardening and no one is showing signs of backing out. Wars have been traditionally bullish arguments for commodities as demand for war equipment and reconstruction work need more metals and building materials.

(e)   There is not much consensus on this point, but a strong view is that USD as a global currency may have peaked and could potentially see a steady decline over the next many years. The share of global trade invoiced in USD terms and USD reserves of global central bankers have witnessed a consistent decline in recent years. Moreover, the cross-border flow of funds from the US has witnessed a sharp rise in 2023. Unsustainable US public debt has led to a downgrade of the US sovereign rating outlook. Besides, the trade conflict with China has led to a conspicuous shift of technological advantage from the US to China. These trends may consolidate the position of commodity-producing emerging economies enabling them to seek favorable terms of trade.

(f) Bloomberg Commodity Index is presently at the same level it was in November 1995.

I have avoided investment in commodity producers for a few years now. I think more study of trends in the commodities market, and a review of investment strategy is due.

 One of the major trends in the post global financial crisis (GFC) world is the weakening of the United States of America’s (USA) clout as an undisputed global economic and strategic leader. In the past 15 years, the US administration has consistently failed in achieving its economic, financial, technological, and strategic objectives.

The economic performance of the US has been below par in the past decade. The handling of the pandemic has been highly questionable. Both monetary and fiscal policies have not yielded the stated objectives of price stability (inflation has been persistently high and rates have become growth restrictive) and financial stability (many regional banks have failed, delinquencies are rising and capital adequacy & reserves of banks have deteriorated, particularly in the past couple of years). Fiscal profligacy has benefited the rich much more than the poor.

The efforts to restrict the benefits of advanced technological innovations flowing to China through tariff and non-tariff means have mostly failed. In fact, these efforts have led to a greater focus on China to successfully develop indigenous technology, forge new alliances, and diversify its market and vendors. The Sino-Arab technoscientific alliance is one prominent example.

The exit of the US forces from Afghanistan and the installation of the Taliban government; failure to prevent Russian invasion in Ukraine and protracted (21st months) conflict there; continued ISIS aggression in Syria and alienation of Turkey; virtual failure to reign Iran’s nuclear ambitions; and now escalation of hostilities between Israel and Palestine are only some recent examples of the strategic failures of the US.

To make things worse, the demography of the US started to worsen. In 2022, the US population grew a meager 0.4% and is estimated to shrink in 2023. Whereas the number of homeless and jobless may be rising.

Consistent deterioration in the quality of political leadership; sharp rise in income and wealth inequalities leading to a conspicuous rise in domestic unrest and violence; unmindful fiscal profligacy; the emergence of an alliance of nations having quasi, pseudo, and non-democratic regimes led by key adversaries China, Russia & Iran and including key allies like Saudi Arabia is seriously undermining the US supremacy.

The education and skill standards of the average US youth are deteriorating fast, raising the reliance on immigrant workers for jobs requiring high skills. The political rhetoric, even from the likes of Vivek Ramaswamy who himself comes from a family of immigrants, further explains the goal incongruence in the US policy.

In my view, it might be a matter of years, not decades, when the fabled “US Consumer” diminishes. The average American household becomes spendthrift; the social security system collapses and fiscal profligacy is forced to reverse the course. An entire global ecosystem that is based mostly on the indulgent US consumer could potentially come down crashing. Also, while most money managers and businesses in India are talking about the “China+1” opportunity, I have not heard anyone talking about “China is number 1” in new technologies including 7G, 8G, AI, smart chips etc.

As an investor, I would like to build these probabilities into my strategy. I am keen to filter my investments for the US consumer and technology dependence.

 Last year, while discussing this subject, I mentioned, “it is a debate that will continue for many more years and no one will remain unaffected by it. Almost everyone who transacts in money or is part of the global economic system will need to deal with it at some point in time.”

I note that the debate is intensifying, widening, and deepening. Moreover, it is becoming more balanced with many conventional money managers, regulators, bankers, and administrators coming in support of digital currencies as an alternative to fiat currencies.

A few days ago, Larry Fink, the Chief Executive Officer of BlackRock, one of the most influential financial firms globally, commented in a TV interview that under the current circumstances “Crypto will play a role as flight to quality”. He was reported to have said, “Bitcoin is a hedge against the devaluation of your currency”. This comment is in total contrast to his comments in 2017 when he had emphatically condemned the idea of cryptocurrencies, saying “Crypto is an index of money laundering”.

Last month, a leading German Bank (Bank) reportedly entered into a partnership with Swiss trading firm Taurus to offer custody services for institutional clients' cryptocurrencies and tokenized assets. In 2018, Deutsche Bank's chief investment strategist Ulrich Stephan criticized crypto for being "too volatile and not regulated enough." Standard Chartered (A leading British Bank) also made a bold forecast predicting that “Bitcoin prices will climb to $100,000 by the end of 2024.”

Earlier this summer, Hong Kong’s Securities and Future Commission proposed guidelines to enable Chinese users to invest in Bitcoin and some other large-cap cryptocurrencies on registered platforms. This is in total contrast to the stance of the mainland Chinese authorities.

In the meantime, several smaller African and Latin American countries, like the Central African Republic, Uganda, Zimbabwe, El Salvadore, Paraguay, Venezuela, etc. have continued to adopt cryptocurrencies in their monetary system, some even declaring bitcoin as legal tender. Last year, even Ukraine created a ministry of digital transformation with an aim to become one of the foremost authorities on crypto. (see here)  Cryptocurrencies are now legal in many countries/regions like the EU, US, Mexico, Brazil, Israel, etc.

There are speculations that the ardent crypto hater Warren Buffet may also be having a slight change of heart in recent months. In an apparent change of traditional policy, Berkshire Hathway has invested as much as US$600 in two fintech firms - PayTM of India and StoneCo of Brazil. This has led to market speculation that the firm may change its long-held stance on digital assets including crypto.

India’s regulatory thought process on crypto has also travelled a long way in the past five years. The Reserve Bank of India started with a blanket ban on the sale or purchase of cryptocurrency for entities regulated by RBI (all scheduled commercial banks and NBFCs) in 2018. The RBI governor “equated crypto trading with gambling”. The ban was declared untenable by the Supreme Court. Presently, the legal position on dealings in crypto in India is ambiguous. It is neither explicitly unlawful nor a regulated asset. However, last week RBI governor reiterated his stance on the cryptocurrency ban, saying there has been no change in the central bank’s position.

No surprise that Bitcoin has weathered all the pessimism and sharply outperformed gold and equities in the past five years. Since October 2018, Bitcoin has gained over 400%, as compared to ~63% for gold (in USD terms) and ~47% for S&P500.

Continuing from yesterday (see here).

I am convinced that the current global monetary and fiscal conditions will have an enduring impact on the global financial system, trade, businesses, and markets. We may feel comfortable with the resilient performance of the Indian economy and markets in the past couple of years, but it would not harm if we factor in the global conditions and trends in our investment strategy. In particular, household investors with relatively smaller portfolios need to exercise due precautions to protect their portfolios from a negative shock.

I have negligible knowledge of global economics, financial systems, and markets. I therefore usually approach these larger issues with common sense and my elementary understanding of the basic concepts of economics. History, of course, always provides some useful support.

I usually study the historical behavior of economies and markets to anticipate the likely actions and reactions of the current set of market participants and policymakers. It is my strong belief that the reaction of investors and fund managers in their 30s or early 40s, who have never experienced borrowing costs in high single or double-digit; policymakers who have not governed through prolonged periods of war, human misery, uncertainty, lack of information, and are not particularly committed to ethics, ideologies, and standards seen during crisis during would react the same way as their predecessors acted/reacted during 1920-1940; 1950-1960, 1970-1980, and even 1990s.

I may be wrong here, but I believe that the policymakers today are governed by the principle of SoS (Save our Souls first). Their natural tendency is to protract the inevitable decision (kick the can) as long as possible rather than make hard decisions that provide sustainable solutions. Similarly, the market participants are also influenced by their inexperience. To me, this implies that the global policymakers and market participants are not adequately prepared to face a material event (credit, geopolitical, natural); and may panic easily and excessively if such an event were to occur. We have seen glimpses of such panic during the outbreak of the Covid-19 pandemic in the year 2020.

Considering that the present global economic, financial, and geopolitical conditions are much more fragile as compared to the summer of 2020, the contagion will spread much faster, wider, and deeper. Therefore, hiding under the shelter of the assumption that India shall mostly remain immune to the impending global crisis may not be a good idea for smaller investors for the simple fact that their capital is much more precious (much higher marginal utility) as compared to the larger or institutional investors.

With this background, I may now share my views about the five points I mentioned yesterday:

1.    Whether the Fed is done with hiking: In my view, this question is not important as of now. A 25bps hike in the next meeting would not make much of a difference, as the previous hikes are still permeating through the financial system. The lending rates may continue to rise even if the Fed does not hike any further.

2.    Will the rates stay higher for longer: In my view, yes. I believe higher rates are arguably the most effective method to bring down the indebtedness of the US government. The federal bond prices have already fallen by 25-40% in the past year, from their recent highs. A 2% rise in yields would shave off another 20 to 30% in bond values. In the meantime, the Fed is creating leverage (through QT) to buy back bonds at half the face value. Large corporations with tons of cash parked in treasuries, hedge funds with leverage positions in treasuries, and the US trade partners with a surplus (China, etc.) would bear much of the losses. Pension funds etc. which hold most securities till maturity may not suffer much. Savers may enjoy higher rates offered by the fresh issuances. Since most new issuances would be at a much higher coupon rate, these may automatically enforce fiscal discipline over the next 2-3 years.

In the interim, however, we may see severe pain in the financial markets as the excesses of the past two decades are obliterated.

3.    Hard landing or soft landing: In my view, it would most likely be a growth recession – a prolonged phase of low or no real growth, as the US economy adjusts to a normalized monetary and fiscal policy mechanism and the USD is freed of onerous responsibility of being the only global reserve currency.

4.    Impact of higher rates on USD: In my view, the normalized interest rates would eventually result in a much less volatile and stronger USD.

5.    Impact of a softer US economy on the global economy: A softer US economy now would be bad news for the global economy and therefore markets. However, over the medium term, a fiscally disciplined US economy (with higher domestic saving rates, positive current account balance, and refurbished infrastructure) could provide strong support to the global economy, especially the emerging economies, much in the same way it did in the 1950s and 1990s.

How do I build this in my investment strategy…will share as I figure it out.

Post the latest meeting of the US Federal Open Market Committee (FOMC), the market narrative is primarily focused on the following five points –

(i)      Whether the Fed is done hiking rates or it may hike once more in 2023.

A larger section of market participants believes that the Fed may hike another 25bps by the end of 2023 and then pause for 6-9 months before cutting the rates from 4Q2024. Another section is however of the view that the economic conditions are too tight to tolerate another hike. This section believes that the hiking cycle of the Fed may well be over and we may see rate cuts from 2Q2024 itself.

(ii)     Whether the treasury yields and other lending rates in the US economy will stay “higher for longer”, as forecast by the US Fed, or we shall see a faster decline, as the economic conditions deteriorate.

The higher rates have already started to reflect a slowdown in the US housing market. The rate of bankruptcy filings has also reportedly reached the 2008 levels. We have already witnessed one round of trouble in the regional banks, which was contained by the Fed support; but the fragility of smaller banks and pension funds remains pronounced.

(iii)   Would the US economy witness a gradual bottoming out (soft landing) or will it contract quickly into recession (hard landing) as the higher rates permeate through the economy?

The US Fed has reduced its balance sheet by over US$940bn since April 2022, while the US public debt has increased by ~10% to US$33trn in this period. A recession may prompt the Fed to unleash another round of quantitative easing (QE) through balance sheet expansion; whereas a controlled slowdown may permit it to further contract its balance sheet (QT).

(iv)    How would the “higher for longer” rates impact the US dollar?

In recent quarters, we have witnessed a tendency to reduce the USD treasury holdings amongst some of the major holders of the US treasury, e.g., China, Japan, and Saudi Arab. Besides, the percentage of USD invoicing in global trade has also come down. Some central bankers have increased their holding of gold, and cryptocurrencies have also gained larger acceptance. The question therefore is whether we are likely to witness a prolonged phase of USD weakness.

(v)     How would a softer US economy or a US recession impact the overall global economy?

The growth rate in the Chinese economy has been slowing down for the past many quarters despite frequent attempts to stimulate growth. Despite showing promise, the Japanese economy has not been able to accelerate its growth. Most major European economies are struggling to avoid recession. Some emerging economies, like India and Indonesia etc., have shown resilience; but a slower US economy could potentially have a more severe impact on the overall global economy, as compared to the global financial crisis period (2009-2010) when growth in emerging economies like China and India sustained at much higher rates.

I am too small an insect to comment on these larger global issues. Nonetheless, I retain the right to assess the impact of outcomes on my tiny portfolio of investments. I shall be happy to share my naïve thoughts on these issues that I will take into consideration in the next couple of years…more on this tomorrow.

One of the several global trends that have been developing in the past decade, in particular, is the dissipation of the US dominance in the game of Lawn Tennis. The game that was dominated by US players for several decades does not have any commonly recognizable US players. The list of top 10 rank players in the ATP Men ranking has only two US names – Taylor Fritz (9) and Frances Tiafoe (10); while the rest eight are all European players. In women ranking also only two US names – Jessica Pegula (4) and Coco Gauff (7) – appear in the top 10 lists. Within Europe also, players from Eastern Europe are dominating the court, versus Germany, the UK, and France which had a significant presence in the game for decades.

It would be interesting to study if there is a correlation between losing dominance on the Tennis court and losing dominance on the mint streets (economic muscle) and battlefields (strategic power).

In the past decade, the US has ceded significant economic power to China. For example, consider the following three data points:

·         The share of Yuan in global cross-border payments is inching closer to 3%.

·         The share of the USD in global reserves has declined below 60% from a high of 72%, two decades ago.

·        China has become the largest trade partner of almost 75% of the countries globally, within two decades of its admission to WTO.

On the technology front also, the US has been steadily losing its edge over China in the past couple of decades. In 2020, China filed 2.5x more patents than the US and was granted 50% more patents than the US. In particular, China led the patents in the field of Biotechnology and Energy. (see here)

Maybe equity investors are taking cognizance of these trends and are de-rating the US stocks. The current risk premium for US equities is the lowest since 2004.

On an unrelated note, the pattern of rains in Rajasthan has been changing noticeably for the past decade or so. As per the IMD statistics, the normal level of average rainfall in western Rajasthan has increased by 32 percent since 2010, while in eastern Rajasthan, it has increased by 14 percent. There have been frequent instances of floods in Rajasthan over the past decade.

“A 2013 research by the Max Planck Institute tried to explain and define the effects of climate change in recent years with the help of high-resolution multimodality. The average level of rainfall in west Rajasthan will increase by 20-35 percent and east Rajasthan will increase by 5-20 percent in 2020-2049, compared with 1970-1999 data.” (see more details here)

If this trend sustains, we shall see some dramatic changes in the economy, demography, and ecology of the state. Real Estate enthusiasts might want to further explore this trend.

The response for my post yesterday (This summer don’t go nowhere) is overwhelming; though not fully surprising.

Notwithstanding the fiscal and monetary profligacy of the Fed and US government, the USD has endured its strength relative to most emerging market currencies. The broken supply chains across the world due to the pandemic led to severe shortages of everything leading to very high inflation worldwide. The suffering in most emerging economies due to inflation created a sentiment against US dominance on the global economy.

A strong US economic response to the Russian aggression in Ukraine since early 2022, including freezing USD assets of many Russian businesses, further exacerbated this sentiment. Russia and its allies like China and Iran; and major trade partners like India have shown interest in development of a non-USD trading mechanism. The traditional US allies like Saudi Arabia, Mexico, Brazil and even France have raised questions on continuing US dominance over global economic order, besides showing interest in non-USD trading mechanism.

Though the details of a non-USD global trade mechanism are still sketchy, the debate is intense. Maybe like many previous occasions, this debate would also subside as inflation peaks out; US Fed and government embark on a credible course correction; Russia withdraws its forces from Ukraine and a sense of normalcy returns to the Sino-US trade relations.

Or maybe over the course of next decade, we shall see the emergence of a neutral currency that may act as the medium of exchange for international trade not involving the US or its close allies, while the trade with the US continues to be done in using USD.

Or maybe we shall see multiple trade blocks using non-USD currencies to settle trades within their respective blocks; while using USD or some other acceptable currency for trades outside their block.

All these conjectures are presently predicated on the premise that the US as a global power is declining in terms of its technological edge; financial strength and geopolitical supremacy. There is evidence of economies like China and India gaining technological edge; and the US losing its geopolitical supremacy. In the past one decade, both India and China have shown remarkable progress in digitization of their economies and space program to back faster and superior digitization. The complete failure of the US led alliance in resolving Russia-Ukraine conflict; China bringing Saudi Arabia and Iran closer; and Afghan Taliban pursuing a foreign policy independent from the US and its ally Pakistan influence are some signs of declining US geopolitical supremacy. It however remains to be seen if this decline is structural or is just a reflection of poor confidence of the global community in the present US leadership.

I posses no competence to comment on sustainability of the USD as global reserve currency for long. Therefore, it would be preposterous on my part to speak about impact on the global economy, should USD lose its only “global currency” status. Nonetheless, I must say that this will be a major global event, no less than a world war. And in a war like situation strong leadership is what matters the most.

In the US, banking panic started at regional level in 1930, with many smaller regional banks faced crisis. However, as Great Britain decided to leave the gold standard for GBP on 21 September 1931, the panic spread throughout the country. Foreigners became concerned that the US may also follow Great Britain and end gold convertibility of USD. There was a rush to convert USD into gold. The collateral was that depositors became concerned about the safety of their money and started withdrawing currency from their accounts. A global rush to convert USD into gold and an internal rush to withdraw currency from banks drained out the banking system reserves and choked the money supply – exacerbating the deflation and propagating the great depression. There was a spate of bank failures in the US during 1931-1933.

The Federal Reserve Bank of New York responded to the situation by hiking rates in October 1931, to encourage investors to deposit money in the US banks or buy US bonds. There was an immediate relief, but that did not last long. The Fed started buying bonds from the market in 1932 and hiked the rates again in February 1933. It did not help much in restoring the confidence of investors in USD. In March 1933, the Federal Reserve Board suspended the gold standard for USD; President Roosevelt announced a national bank holiday and suspended all outbound gold shipments. The provisions that allowed the holders of specific treasury bonds to convert their bonds into gold were also revoked (many commentators have implied this action to be a sovereign default by the US).

1931 was the first year in recorded history of the US when both US Treasury Bonds and US Stocks yielded negative returns in the same year. The following two years marked a watershed in the history of the US financial system.

Bretton Wood agreement of 1944, established USD as the reserve currency of the world. The agreement, inter alia, provided that all the participating nations would allow free conversion of their own currencies into USD at all times; and the US will allow conversion of USD into gold at a fixed exchange rate of USD35 per troy ounce of gold. At that time the US manufactured over half of the total global production, as most of Europe and Japan lay shattered due to WWII. Obviously no one objected to the reserve currency status of the USD.

In the next 25yrs, Germany and Japan made substantial progress. The US share in global GDP fell from 35% to 27% during 1950-1969. The US participation in the Vietnam war (1964-1970) took a significant toll on the US economy. Besides, other political efforts like “Great Society” etc., also weakened the US economy. The “reserve USD” became highly overvalued, impacting US exports and causing a sharp rise in trade deficit. The US was forced to print more USD to keep its obligation under the Bretton Wood agreement. This led to a sharp decline in the gold coverage ratio of the USD. The inflation also shot up sharply.

To stem the run on US banks, the Fed had increased its key policy rate to 9.75% by October 1969.

1969 was the second time in recorded history of the US when both US Treasury Bonds and US Stocks yielded negative returns in the same year. Two years later, in August 1971, president Nixon unilaterally abandoned USD peg to gold, hence rescinding the 27yr old Bretton Wood agreement. For other participants in the agreement, it was a virtual default on the part of the US. However, the advent of “petro dollar” a few years later sustained the reserve currency status of USD.

Presently, the USD is arguably highly overvalued. The Fed is hiking rates and reducing money supply. Inflation is high. The economy is on the verge of recession. Trade deficit is rising. Fiscal deficit is at an unsustainable level. The US share in the global economy is shrinking. Large trade partners of the US, like China, OPEC, Japan, etc. are exploring non-USD trade with other trade partners. The US is incurring huge costs in the Ukraine war. And 2022 is the third time in history when both US treasury bonds and stocks have yielded a negative return in the same year.

If history rhymes, we could see some material developments in the US and, perhaps the global, financial system. A sharp USD devaluation, replacement (or supplement) of USD with a new digital currency, end of petrodollar regime (and hence reserve status of USD) are some of the wild guesses I could make.

 Thirty seven years ago, on 22^nd September of 1985, the representatives from the now defunct G-5 met at Plaza Hotel, New York to discuss one of the most remarkable currency manipulation plans. On that afternoon, the US, France, Germany, UK, and Japan signed the Plaza Accord to weaken the US dollar to help the US reduce its burgeoning trade deficit.

As part of the accord, the US agreed to cut its fiscal deficit materially; while Germany and Japan consented to boost their domestic demand by cutting taxes. All parties agreed to actively “manage” their currency markets to “correct” their current account imbalances.

In backdrop to the Plaza Accord, the US Dollar had appreciated about 48% during 1980-1985, primarily induced by the sharp hikes in the policy rates by the US Federal Reserve, led by the Paul Volcker; pressurizing the US manufacturing by making (i) imports from Japan and Germany more competitive and (ii) exports to other countries less competitive. This was the time when US manufacturing giants like IBM and Caterpillar were facing severe stress and lobbying the US Congress for relief.

The US Dollar (USD) depreciated over 25% against Japanese Yen (JPY) and German Mark (DEM) in the two years following the Plaza Accord. The plan worked with limited success but not without material collateral damage. The US-Japan trade sustained as Japanese automobile and Electronic products continued to overwhelm the US consumers. US-Germany trade imbalance corrected materially. A stronger JPY however resulted in severe deflationary conditions in the Japanese economy, resulting in the famous “lost decade”.

Paul Volcker retirement from US Federal Reserve and appointment of Alan Greenspan was heralded by Black Monday, 19^th October 1987. The stock markets crashed the world over and the limitation of the Plaza Accord stood exposed. The era of “Greenspan Put” that started in 1987 has continued till recently, with few short interspersed breaks; though the nomenclatures are now more generic like “Fed Put”, “ECB Put”, “BoJ Put” etc.

The current situation in the US is no different from the early 1980s. Inflation is persistently high. Rates are rising. The USD is strengthening. The trade deficit is now with China, instead of Germany and Japan then. The growth has slowed down materially. But the stock market implied volatility is impudently low. The only plausible explanation for this in my view is that the markets have strong belief in the central bankers’ put. The markets appeared assured by the reckless support extended by the central bankers post Lehman Collapse and in the wake of Covid pandemic. The belief that a “black Monday will not be repeated” is too strong at this point in time.

In this context, the latest presentation of Fidelity International on “2023 Investment Outlook” makes an interesting reading. Outlining one of the three key themes for 2023, the presentation, inter alia, highlights the following:

·         Interest rate differentials have driven the dollar ever higher, creating headwinds for countries dependent on trade, with large external debt burdens, and/or maintaining a currency peg. Vulnerability is highest among emerging markets.

·         We see chances for a Plaza 2.0 type global accord on controlling the dollar as low in the absence of a full-blown currency crisis. In the meantime, central banks including the BOJ and HKMA must ramp up efforts to defend currencies.

 One of the most important and fundamental principles of economics is that “in a ‘free market’ current price of anything having an economic value is a function of demand and supply of such things at that particular point in time.” Of course there could be multiple factors that may impact the demand and supply of a thing; but usually nothing impacts the “price” directly other than the factors demand and supply.

In a ‘controlled and/or manipulated market’ the prices of things are fixed by the controlling authorities (or forces); regardless of the demand and supply for such things. In such markets, usually demand and supply of things are controlled and/or manipulated; or demand and supply duly get adjusted to the fixed/manipulated prices.

If we apply this core principle of economics to the world around us, we may discover that a significantly large part of global markets is presently either controlled or manipulated. The free market may only be prevalent in textbooks, policy documents and political speeches.

In the modern world, money is arguably the largest factor of production in the world. The price of money (interest rate) should ideally be a function of demand and supply of money. In case of excess supply the interest rates should be lower and vice versa.

In the past three years (2020-2022), nominal world GDP is estimated to have grown by less than 19%; whereas the money supply has increased by more than 50%. In spite of recent marginal contraction in money supply, the supply must be exceeding demand. Thus, there is no economic case for rise in interest rates; but it is happening. Obviously the money market is a controlled/manipulated market where central bankers and other major lenders may be controlling/manipulating the price of money to meet their other economic, political and/or geopolitical goals. (I refuse to accept the argument that money supply manipulation is happening to control inflation. There is no evidence of money supply impacting inflation in the past 15years at least. Else we should have 10% CPI inflation in 2010-12.) 

This distortion in the price of money has material repercussions in the market for goods and services across the world. It is impacting demand and supply (and therefore prices) of almost everything.

A significant part of the global trade is priced in terms of US dollar (USD). In a free market the price of USD (exchange rate) should also be a function of its demand and supply. In the past 33 months the supply of USD (M2) has increased by more than 50%, from $15.5trn at the end of 2020 to 21.7trn at the end of September 2022. In this period, we have seen global demand for USD diminishing, as reflected by the fall in global forex reserves. As per IMF the demand for USD by global central bankers is down to 25yr low. (see here) 

Under these circumstances the price (exchange rate) of USD must fall materially. To the contrary it has strengthened against most currencies. Obviously, the price of USD and some other dominant currencies is also manipulated.

Same argument could be extended to the prices of energy, gold, travel, wages in many jurisdictions, communication, education etc.

Under these circumstances I do not find it hard to believe that in the extant global order, ‘free market’ is a myth; and if we earnestly accept this premise, few things will remain the same insofar as the investment strategy and valuation methods are concerned.

I believe that we might soon need to adjust valuation models and investment strategy to factor in probabilities of frequent and strong state interventions; diminishing competition; radical policy shifts and sudden collapses.

This summer Americans drove less than the summer of 2020 when many office goers were working from home and the economy was partially shut down. The situation is no better in Europe. Higher fuel and food cost is driving the cost of living higher in most of the world, significantly disturbing the household budgets.

Many emerging and underdeveloped markets were struggling with higher inflation even before the pandemic. But pandemic and adverse weather conditions in the past two and half years have made the situation worse.

Whereas many emerging markets, especially in Africa and Latin America, have been struggling with higher inflation and rise in the cost of living for a couple of decades, it is a relatively new phenomenon for the post 1980s developed western economies. The present generation in these economies had gotten used to cheap and easily available money and marginal food and fuel inflation in the past two decades. For them this sudden and sharp rise in basic cost of living is nothing less than a major shock. Most of them may not be financially sufficient, economically trained, socially skilled and/or mentally prepared to deal with this problem.

On the other hand, the modern asset pricing models may also not be suitable to the situation where interest rates are rising at record pace. Many valuation models used for making investments in "startups" - having very long payback period in terms of conventional asset pricing techniques; not differentiating between revenue and capital cashflows for operating purposes; usually funded by professional private equity investors with little own skin in the game; and having high leverage debt as the ultimate source of funding – may not work at all in a scenario where USD is depreciating and cost of USD borrowing is running in excess of 6%.

The current spike and persistence of inflation has been attributed to the logistic constraints due to the pandemic; adverse weather conditions; Russia-Ukraine war and fiscal support extended by various governments to mitigate the hardships faced by the citizens. Initially most central bankers believed that the inflation is transitory and will wane as these conditions change. However, in the past six months a realization seems to be dawning upon them that the trillions of dollars in new money, printed over the course of the past 2yrs, may also have a key role to play in this episode of high inflation. Apparently, it took 215yrs for the US government debt to reach US$7trn. It has added the same amount in just the past 27months.

Inarguably, the problem of inflation has many more dimensions. Hiking rates and withdrawing quantitative tightening will take more than 25yrs to reach a sustainable level of debt. Manufacturing a recession by sharp hikes will only destroy demand for various commodities and weaken the inflation. However, the inflationary forces will keep coming back, much stronger than now, as and when the growth begins to revive.

A sharp USD and EUR devaluation could perhaps be one of the more viable solutions left to (i) reduce the public debt materially in a short period of time; (ii) complete restructuring of the global terms of trade; (iii) rationalization of the global commodity prices especially energy; (iv) catalyze a new investment cycle led by US and European exports.

The investors in USD denominated assets would obviously suffer tremendous losses. No wonder large investors like the Chinese government have materially reduced their holdings of US treasury and USD. India is also trying hard to diversify its trade to include other currencies like Ruble, Riyal and Yuan, to contain its exposure to USD.

The questions that beg answer are:

(a)   What shall be the safe haven in case of a sudden USD decline. Whether it would be the traditional asset like Gold; a new age asset like digital currencies or traditional safe havens like CHF, CNY, SGD etc.?

(b)   Is there any actionable for a small investor, if this speculation does come true?

 In the past one month, the bond yields in most of the developed world have risen sharply, devastating the bond portfolios, especially the leveraged portfolios. Even most emerging markets have seen their bonds declining in value. Consequently, the global currency markets have also seen high volatility. The USD index has reached the highest level in two decades, as JPY, EUR and GBP have declined to lowest levels in decades. Even PoBC is cutting the reference range for CNY sharply and USDINR is at historic lows.

The sharp rate hikes in most parts of the world, and tighter money markets have so far not been able to rein the runaway inflation. It is expected that the central banker may continue hiking aggressively for another quarter at least. Accordingly, the forecast of a severe recession in 2023 in most parts of the western world on both sides of the Atlantic is fast becoming a consensus.

Poor demand outlook due to recessionary conditions is causing severe correction in the commodities markets. Industrial metals and crude oil have corrected sharply. The shipping container rates have also collapsed. Even if we normalize the commodity prices and container rates for the Covid related abnormalities, we are heading towards prices lower than the average of 2018-19.

In all this global turmoil, the most puzzling piece is precious metals. Both gold and silver have not behaved in the expected manner. Traditionally, during periods of high inflation, geopolitical uncertainties, war, money-debasement (due to quantitative easing or hyperinflation) etc. gold and silver had provided a safe haven, protecting the wealth of investors. In the latest episode of crises, precious metals have actually belied their safe haven status.

Despite, inflation ruling at four decade high level; Russia-Ukraine war; tension in the China Sea; and massive money debasement (US Fed alone printing US$7trn in the past 30months), international gold prices have actually fallen over 10% since January 2021 in nominal USD terms. In real terms, the losses are even more. Though, in GBP and EUR terms gold prices are higher, but certainly not commensurate with the circumstances and historical trends.

The trend in gold prices becomes even more intriguing, when we factor in the requirements under Basel III regulations that may require much higher holdings of physical gold by the global central banks. In fact a number of central banks like Bundesbank, PoBC, Central Bank of Russian Federation, RBI, etc. have increased their holdings of physical gold in the past 4years.

A few months ago, I had expressed my apprehension that yellow metal might be losing its luster (see here). The recent trend further strengthens my fear that in the new global order that is emerging post the pandemic, Gold may not be a key component. Declining consumption demand (the share of gold & silver ornaments has fallen below 1% in Indian household savings, from 1.7% just 5yrs ago, see here); competition from digital currencies; higher security risk and higher cost of security; and rising cost of production etc. are some factors that seem to be working against the gold.

Nonetheless, I am inclined to believe that we may get a very good trading opportunity in gold sometime in the next twelve months. I shall look to allocate some tactical money towards gold, if it falls another 8-10%.