Past
Commentaries
07/25/2024
Current Commentary
Dear Friends,
Recently I attended a two-day due diligence retreat in Newport, RI with approximately 70 other qualified institutional investors. It was a good opportunity to network and share ideas. Some of the topics covered, either by presentation, panel discussion or breakout tables, were the outlook for global markets, alternative investments, crypto, real estate issues and outlook, emerging markets, portfolio construction, private equity, and credit markets – corporate and private.
The Global Outlook panel discussion quickly turned to American debt and de-dollarization, subjects about which many of you have expressed concern, including me. Coincidently I had just finished re-reading Niall Ferguson’s book, The Ascent of Money – A Financial History of The World (Penguin Books, New York, 2008). The Spanish philosopher George Santayana said those who cannot remember the past are condemned to repeat it. Mark Twain said history doesn’t repeat, it rhymes. So I turned to Ferguson looking for patterns. And therein I found some.
The thirty years prior to World War One were a period of general global financial harmony. Many intellectuals and progressive thinkers – left and right - even declared the end of war, because of the advances in devastating war machinery, because of the interdependence on credit- based finance, and because the richest nations had the most to lose. The borders of the six great European nations seemed finally settled among their genetically related royals.
Those peaceful fantasies were suddenly extinguished with the onset of the Great War in 1914, triggered by the assassination of Archduke Ferdinand, heir to the Austrian throne, by a Serb in Belgrade. Austria issued an ultimatum demanding entrance into Serbia to investigate Belgrade’s complicity in the killing. It triggered an immediate selloff of stocks and bonds as investors sought liquidity. Exchange rates “went haywire” as cross-border creditors tried to repatriate their money. Dollars and rubles collapsed; francs and sterling surged. Within a month securities markets were in free fall globally. Many closed for extended periods. New York closed July 31, not to reopen fully until April 1, 1915. Everywhere the government reactions to the liquidity crises were the same: print more currency.
Only after the guns started firing in August 1914 did “American liberals grasp that secret diplomacy and the tangle of European alliances were the principal causes of conflict.” Abundant liquidity, 44 years of uninterrupted peace, global integration and financial innovation made the world seem safer to investors than it was.
What followed WWI for the twenty years up to WW2 was a continuous series of global financial calamities. China declared bankruptcy. Bunds defaulted. Extended bank holidays were regular and commonplace. Everywhere central banks were plugging dikes or putting out fires financially, doing anything they could to sustain or create some liquidity in the system. Sterling would never re-establish its preeminence as world reserve currency. Stock market losses of 50% and more were exacerbated by out-of-control inflation rates.
When the American stock market crashed in 1929 the great, worldwide depression ensued. Global capital mobility became impossible as more and more nations imposed exchange and capital controls, tariffs and trade restrictions in an effort to preserve national wealth. “It was a story repeated all over the world, from Shanghai to Santiago, from Moscow to Mexico City.”
American policies at the time could not have been more anti-global. The nation was the largest global manufacturer and exporter and yet passed the Fordney-McCumber Act of 1922 imposing import tariffs of 40% on foreign goods. It was followed by 20% increases in the Smoot Hawley tariffs of 1930. Stock market regulations were weak and ineffectual, inviting speculation and eventual disaster. And at a time when the U.S. should have printed money to provide liquidity, it didn’t. Hindsight is 20-20.
“The first era of financial globalization took at least a generation to achieve. But it was blown apart in a matter of days. And it would take more than two generations to repair the damage done…” It was only interrupted by the wartime economics of World War 2. The globe remained fragmented financially until Bretton Woods in 1947 which – as a result of American predominance - established the dollar as the universal reserve currency. For the next 70 years most of the world moved steadily toward globalization and integration.
Now the cycle is reversing: deglobalization and de-dollarization; the former due to increasing mercantilism – economic nationalism – the latter due to Modern Monetary Theory (MMT) and the enormous American advantage of the dollar reserve currency.
China has an objective of manufacturing everything, every product, by 2025. By trading with China, the West is subsidizing a totalitarian, communist gulag, many of which products are manufactured by indentured or slave labor, without regard to American OSHA or EPA standards, which treats the environment like a toilet, without regard to climate change. The concept of tariffs is obnoxious because they continue to allow trade at a higher price with revenues accruing to the government. There has to be a moral standard to capitalism. If China seeks autarchy (complete self-reliance) it should (and will) fail as others resort to the same strategy.
MMT is the gift by Professor Stephanie Kelton of Stony Brook University to taxers and spenders everywhere of a license to print money without limit. This has earned her celebrity status among the power elite in Washington. Her best-selling book is “The Deficit Myth: Modern Monetary Theory and The Birth of The People’s Economy.” The thesis: deficits don’t matter because the U.S. can print money endlessly as the world’s reserve currency. It doesn’t say what happens when it is not. Other nations are working assiduously to disadvantage the U.S. by avoiding dollar exchanges and creating their own trading protocols absent dollars. Yet there is an MMT cadaver for economic forensics: the Soviet Union, which ran their People’s Economy for 70 years without an accounting system, “force balancing” everything.
The U.S. federal debt now exceeds $35 trillion. The interest on the debt is larger than the defense budget. The largest employer in America is the federal government. The largest owner of U.S. debt is the Federal Reserve. The debt in 1946 reached an all-time high of 106% of GDP, debt incurred to finance a world war. Debt is now at 100% of GDP - in peacetime. It is projected to exceed 106% by 2029.
Important people, of both political parties, who manage trillions for depositors and investors have been warning of an imminent debt calamity without corrective action, to no avail. Too many politicians have become power drunk, unaccountable and intransigent. The size of government is obviously too big and is out of control. It is dividing the nation. The Washington establishment steals money from future generations to make political bribes to its pet constituencies. To indenture future generations for expenditures they did not make is terribly wrong. I used to say, “when there’s no solution, there’s no problem,” but this is an inescapable, glaring problem and there are solutions.
Artificial Intelligence
In his book “Fundamentals,” (Penguin Press, New York, 2021) Nobel Prize winner Frank Wilczek discusses the speed of thought (among many other things). The latency of electrical pulses between neurons limits their frequency to “a few tens or hundreds per second” depending on the neuron type. In 2021, when the book was published, the “clock rate” of a CPU was approaching 10 gigahertz, about 10 billion operations per second.
In a recent interview, Jensen Huang, CEO of Nvidia, stated that their chips processing speeds were currently at trillions per second and in the near future would be processing at rates of quadrillions (one thousand trillions) per second. From this perspective one can begin to appreciate the potential of artificial intelligence that processes data a trillion times faster than natural intelligence.
I think of manufacturing, process control equipment, critical transactions processing, medical and health diagnostics, telemetry. The applications are endless. AI will contribute enormously to productivity and earnings. The cover story of IBD Weekly June 24th is “Can AI Outrun The Deficit?” making the case that huge productivity growth is the only prophylaxis for the out-of-control federal debt that threatens the economy. And the growth of AI will put enormous stress on a power grid that needs a minimum of 10 years upgrading. An AI search can consume ten times the electricity of a standard query. Bitcoin mining already consumes over 2% of total U.S. electricity. Data Centers consume huge quantities of water, for cooling. Consider all the externalities, like the effects on emissions and climate change.
Interest rates, Recession and Earnings
The markets have priced in at least one rate cut, as early as September. But a glut of Treasury securities, and a dearth of international buyers could keep longer-term rates higher, with dire debt-service consequences for the deficit. The recession that hasn’t come still awaits. We are still suffering Covid after-effects. The trillions that were distributed (much for political gain) show signs of being spent. Savings have fallen, credit card spending and defaults are rising, consumer confidence is waning, leading indicators - while slightly positive - have fallen for 3 months in a row. The monthly employment numbers look sanguine at first but look closer: every month this year the largest growth in new employment is the health care sector, followed closely behind by the federal government. It’s estimated that government activity is responsible for over 1% of GDP, which is estimated to be less than 2 ½% this year.
Corporate earnings are sanguine and improving. S&P 500 earnings growth should be double digits this year and next. Manufacturing construction is booming. Baby boomers are requiring more health care, and consuming instead of saving. Defense spending is up as global threats multiply. AI is the driver for this super-cycle of chip manufacturing.
Our latest position build was GE. Larry Culp, having split the company in three, gotten margins where they should be, and moved the best (GE Aerospace) to Cincinnati, is running a jet engine money machine. We want to own it. There is a bright future there.
So?
If the world collapsed financially, in a worst-case scenario, I would have to keep enough cash to get by, minimizing inflation exposure. But even if market values declined by half, I would continue to hold shares of quality corporations, especially manufacturers. Governments – and warring nations - can’t survive without them.
Peace,
Dennis M. O’Connor
