Is It Nailed Down?

TLDR:

1. China and Russia announce Yuan settlements for oil
2. Hard Assets outperform
3. Labor Data Softens

If not, buy it. This was our call a few weeks ago, and the trend continues. Clearly despite the Fed’s assurances to the contrary, the market believes that the Fed will ease shortly. And with more easing, comes more financial leverage which means buy anything that’s not nailed down. Case in point from this chart:

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Since the failure of SVB, anything that moves has gone up. Stocks, Bonds, FX, Gold, and the star of the show…Bitcoin. 

The magnitude of the Bitcoin outperformance gives you a hint that this time, it’s different. Of course, Bitcoin barely existed in the great financial crisis, but last time, there was a flight to safety and the US Dollar. This time however, it has not played out (see dollar index above DXY). Why?

Part of this stems from the fact that this time around it is inherently a liquidity and not a solvency crisis. There are calculations that the unrealized losses could eventually lead them to insolvency, but with the Fed’s Bank Term Funding Program (BTFP), those outcomes have now been pushed back at the very least for another year.

The other development that has caused a lot of chatter recently is the de-dollarization of international trade. The death of the USD is greatly exaggerated. However, the trend has begun in earnest as…

China and Russia Announce Yuan Settlements for Oil

This has been quickly followed by similar announcements from China and Brazil, as well as news of a Yuan settled liquified natural gas trade with the UAE.

Many of these developments have been in the works for years. China has been pushing the Yuan for quite a long time with modest traction until recently. But things have accelerated greatly after US sanctions on Russia. The freezing of its central bank assets has sent shockwaves through the international community. Governments everywhere have taken note. 

It is akin to the diplomatic immunity that countries afford their counterparts, there’s no international “law” explicitly dictating such procedures, but everyone assumed central bank deposits would be off limits despite regional conflicts.

This custom has been broken and we are now searching for alternatives to the USD to serve as the Global Reserve Currency (GRC). Unfortunately there isn’t even a close second. The Euro is not widely used throughout the world since Europe does 90% of its trade internally, and they… already use the Euro.

Eurozone area growth has been anemic at best, coming in at an even 0% for the last quarter of 2022.

Meanwhile, China’s Yuan is not free floating, nor have Chinese courts developed a deep case history of settling international trade disputes. Such institutional knowledge and experience takes time to build and will be an ongoing obstacle for the Yuan to achieve GRC status.

Outside national currencies, the alternative is to go “old school” and settle in gold. 

Hard Assets Outperform

The narrative has been that gold and Bitcoin are diversifiers when people no longer trust fiat. Why not another currency? Developed countries have all used the same playbook in the last couple decades, which usually meant a massive boost in liquidity whenever there were signs of stress.

However, giving away candy is much harder than taking it away. And like a doting parent, why let your children suffer when you can inflate the problem away?

Global central banks are weary of exactly that, but it takes time, so they have been diversifying away from the USD and back into gold ever since 2008.

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Despite the increase, the share of reserves in gold has diminished significantly across the decades.

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Which means that if the de-dollarization trend will continue, there will be a multi year bid in hard assets simply to get back to the historical average.

Bitcoin has also benefited from this dynamic as a digital alternative to gold. The track record on this has not been stellar however as the only country that has bought Bitcoin (El Salvador) has suffered 30%+ losses.

It will take a while for de-dollarization to come to fruition, but as investors, it’s always about where the puck is going, not where it is now. Speaking of investments, we’ve finally seen real pressure in the real economy.

Labor Data Softens JOLTS below 10mm, NFP 235k

The combination of data from both JOLTS and NFP this week affirms that indeed the labor market is softening. So unfortunately we are unlikely to see 500k prints in NFP in the coming months, but given that the numbers are neutral or slightly weaker than expectations, we expect the softening to continue.

In particular, as we discussed from last week, the ensuing credit contraction as central banks choose to inflate problems away instead of deleveraging will mean lending drops like a rock. It will take a while to play out as capital expenditures get delayed or abandoned, but it surely will feed through the economy soon enough.

A case in point is the $70B Blackstone REIT. It again limited redemptions from its fund in March. It honored only 15% of the $4.5B redemptions it received. You can imagine this could go on for a long while until situations stabilize.

This won’t be nearly as dramatic as in ’08 where everything was melting down. So as we watch the slow train wreck flow through in terms of poor bank earnings, a strong labor market should continue to support asset prices.

Ivan’s Take

My views have been largely one sided on the long side this year. This outlook hasn’t changed yet, but it’s important to step back and understand what scenarios could change the outlook.

In the next few months, we should see:

1. Labor data will overrule inflation data. This is because of various base effects already built into inflation data, everyone expects it to come down unconditionally. Weaker labor will be supportive of asset prices and vice versa.
2. The banking crisis is not over. Regular blips and anemic earnings will trickle in, perhaps this means a controlled consolidation of smaller banks. The worse bank earnings are, more liquidity will be injected into the banking system. Capital heavy firms lose, capital light firms win. Have you seen tech stocks lately?
3. Commercial credit losses. Post COVID occupancy dropped like a rock. The shoe hasn’t dropped on this sector yet, but the cracks are glaring. Prices are still higher than pre-COVID, I don’t see it rebounding. It’s structural, they need to rezone!
4. De-Dollarization. It’s a process that takes decades, the structures will not fall into place in a few months, but asset prices are very forward looking (dollar index down a lot). If such trends accelerate, I expect hard assets such as gold (at all time highs), crypto and real estate to do well.

In the first scenario, it’s a buy or sell everything play. In the other 2, investors can potentially beat the market being underweight structural sectors in the stock market. In the last scenario, crazy does well. 

My hunch is that labor continues to be healthy, banks and commercial real estate continue to struggle, and the de-dollarization narrative gets louder. Remember, you don’t have to be right to win, let the narrative do its thing. See you next week!