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Data Update 2 for 2023: A Rocky Year for Equities!

It is the nature of stocks that you have good years and bad ones, and much as we like to forget about the latter during market booms, they recur at regular…

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It is the nature of stocks that you have good years and bad ones, and much as we like to forget about the latter during market booms, they recur at regular intervals, if for no other reason than to remind us that risk is not an abstraction, and that stocks don't always win, even in the long term. In 2022, we needed that reminder more than ever before, especially after markets came roaring back from the COVID drop in 2020 and 2021. While there are many events during 2022, some political and some economic, that one can point to as the reason for poor stock returns, it is undeniable that inflation was the driving force behind the market correction. In this post, I will begin by chronicling the damage done to equities during 2022, before putting the year in historical context, and then examine how developments during the year have affected expectations for the future. I will follow up by looking at the mechanics that connect stock prices to inflation, and examine why the damage from higher inflation can vary across companies and sectors. 

Stocks: The What?

We invest in equities expecting to earn more than we can make on risk free or guaranteed investments, but the risk in equities is that actual returns can deviate from expectations. In some years, those deviations work to our benefit and in others, it can hurt us, and 2022, unfortunately, fell into the latter column. In this section, I will begin with a deconstruction of stock returns in 2022 and the year's place in stock market history. I will then provide a template for estimating expected returns on equities, and examine how expected returns changed during the course of the year.

Actual Returns

Your returns on equities come in one of two forms. The first is the dividends you receive, while you hold stocks, a cash flow stream that provides a measure of stability to investors who seek it. The other, and less predictable component, is the price change, which in good years adds to the return as a price appreciation, and in bad years, often  overwhelms dividends to deliver negative returns.

The Year in Review

At the start of 2022, the S&P 500 was at 4766.18, up from 3756.07 at the start of that year. During the course of 2022, the index was staggered by political events, with Russia's invasion of Ukraine upending global economies, and by inflation, which entered the year high, and continued on that path through the course of the year. The graph below shows the S&P 500 at the end of each month, from December 31, 2021 to December 31, 2022, and the resulting monthly returns:

Aggregating over the entire year, the index declined 19.42% in 2022, and while the dividends during the course of the year rose, the dividend yield of 1.41% provided only a minor offset, resulting in total returns of -18.01% on the S&P 500 for the year:

I know that this is US-centric and large-cap oriented and I will cover returns in other geographies and across broader classes of stocks in my next few posts, but suffice to say, that in this year, there were no sectors or geographies that were spared.

And in historical context

    It is undeniable that 2022 was a bad year for stocks, but in historical context, how bad  a year was it? I maintain a database of historical returns on stocks, bonds, bills and other asset classes on my webpage, and I looked at the annual returns, by year, starting in 1928 through 2022 for US stocks. In the graph below, I look at the distribution of annual returns over those 95 years, paying special attention to the negative years:

S&P 500 officially came into existence in 1957, but we filled in earlier years using stock return data

As you can see, it is not uncommon for stocks to have negative years, but the returns in 2022 of -18.01% put them at the tail end of the historical distribution. In the table below, I look at how 2022 ranks in terms of bad years over the 1928 - 2022 time period:

In nominal terms, i.e., before taking into account inflation, 2022 ranks as the seventh worst year, over the 95-year time period, and in real terms, it moves up to being the sixth worst year, with real returns of -23.48%. No matter how you slice it, there is no denying that 2022 was the worst year for US equity investors since 2008, and the magnitude of the damage is even more staggering, if you consider it in market value terms. During the course of 2022, US equities collectively lost $11.6 trillion in market capitalization, but for balance, it is also worth noting that US equities are still holding on to a gain of $6.9 trillion on their market capitalization at the end of 2019. Given that we endured a pandemic, multiple political crises and wars in the three years since, that is almost a miracle.

Expected Returns

    Markets are driven by expectations, and while expectations for the future can be affected by what has happened in the past, they are still worth exploring. After a year of being pummeled by markets, what are investors pricing stocks to make in 2023 and beyond? And will they be disappointed or delighted by what the year delivers? Those are the questions that investors have to answer today and I will try to provide my perspective in this section.

Actual vs Expected Returns

    As you saw in the previous section, actual returns on stocks can be negative, and significantly negative, in some periods, and those negative returns can sometimes extend into decades. Those who invested in the Nikkei at its peak on December 29, 1989, have spent the decades since trying to get back to that level. The notion that stocks always win in the long term is a dangerous one, and while those pushing it claim to have the data on their side, it is worth remembering that the use of US data to make this case is statistically flawed. The US was one of the most successful of global equity markets of the twentieth century, and to use its historical record as the basis for all equity investment in the future strikes me as wrong headed.

    That said, when investors buy equities, it would be both irrational and illogical to settle for expected returns that are less than what you can earn on risk free or guaranteed investments, though behavioral finance suggests that both irrationality and illogic are persistent human traits. The premium that investors demand over and above the risk free rate is the equity risk premium, and practitioners in finance have wrestled with how best to estimate that number, since it is not easily observable (unlike the expected return on a bond which manifests as a current market interest rate). 

a. Historical Equity Risk Premium

    The conventional wisdom, at least as taught in business schools and practiced by appraisers, is that the only practice way to estimate equity risk premiums for the future is to use equity risk premiums earned in the past. Thus, historical risk premiums are viewed as the best estimates for the future, though analysts disagree not only about how far back in time they should go, whether to compare stock returns to T.Bill or T.Bond returns and even on how to compute the historical average return (arithmetic versus geometric averages). The graph and table below provide my estimates of the historical equity risk premiums in the US market:

As you can see, I arrive at premiums ranging from 4.12% to 13.08%, depending upon my estimation choices on time period, treasury rate used and averaging approach, but I don't use any of these numbers as my estimate for the future for two reasons. The first is that the use of historical risk premiums is predicated on the belief that the future will look like the past, and the world, in all its dimensions, has changed dramatically over the last few decades. The second is that even if you are comfortable with assuming mean reversion, the estimates from the past are extremely noisy (have large standard errors), with the premium from 1928 to 2022 having a standard error of 2.15%. In effect, even with that long period, the best I can offer, if you are looking for an equity risk premium for stocks over T.Bonds is a range so wide (2.34% - 10.94%, i.e., the average plus or minus two standard errors) that it is not useful

Implied Expected Returns

    There is another approach to estimating expected returns on stocks, and equity risk premiums, and it is forward-looking. It too requires estimate for inputs, but the range of error is magnitudes smaller than with historical premiums. In this approach, I draw on a technique used to compute the yield to maturity on a bond, the discount rate that makes the present value of cash flows on the bond (coupons and face value) equal to the price of the bond, and extend it to equities. To illustrate, I estimate this implied equity risk premium for the S&P 500 at the start of 2023, using the index level as the price that I pay on the index and using market estimates of earnings and dividends/buybacks on the index for the next five years and beyond. 


As with the yield to maturity for a bond, I solve for the discount rate (IRR) that makes the present value of cashflows on the index equal to the level of the index. At the start of 2023, by my calculations and with analyst estimates of earnings, I estimate an expected return of 9.82%. which when you net out the T.Bond rate that day results in an implied equity risk premium of 5.94%. There are clearly input estimates that you can take issue with, especially on earnings and cashflows. Thus, if you assume that analysts are over estimating earnings and/or that companies will return less of these earnings to investors in the form of dividends and buybacks, the estimated equity risk premium will decrease, and if you assume that growth will be stronger than forecast, the equity risk premium will rise. In this spreadsheet, you can see that making different assumptions on these fronts yields equity risk premiums ranging from 4.83% to about 6%, a much narrower range than from historical risk premiums.

In historical context

   In my first data post, I noted the increase in equity risk premiums during 2022 from 4.24% at the start of 2022 to 5.94% at the start of 2023. I posited that any debate about whether the market, as it stands now, is fairly, under or over valued is really one about whether the equity risk premium at the start of 2023 is too high (in which case, the market is under valued) or too low (in which case, it is overvalued). To answer that question, and address the question of where the expected return of 9.82% stands in historical context, I report the expected returns and equity risk premiums for the S&P 500 from 1960 to 2022:

At 5.94%, the implied equity risk premium is closer to top of the range of historical risk premiums, but the most striking feature of 2022 is that the expected return on stocks, at 9.82%, is now at its highest level since 1995. 

Stocks: The So What?

    It is worth noting that in valuation, demanding a higher expected return depresses value today, and the increase in expected returns over 2022 is therefore consistent with the decline in stock prices during the year. In fact, the drop in stock prices of 20% is mild, given the surge in expected returns during the course of the year.  There is another reading of this expected return that ties into investment and growth, where the expected return on stocks is the cost of equity that companies need to clear to make investments. In short, an average-risk project with a return on equity of 7%, which would have passed the investment test at the start of 2022, because it was greater than the cost of equity of 5.75%, prevailing at the time, would not pass muster at the start of 2023. 

    The effects of a higher equity risk premium are also not uniform across all stocks, with higher risk stocks seeing much greater rises in their costs of equity than lower risk stocks. The table below provides the cost of equity distribution across US companies at the start of 2023:

Note that, for the first time in a decade, more US firms have double digit costs of equity than single digit values, and while that may seem shocking to younger analysts, it is a return to what used to be normal in the pre-2008 market.

Stocks: The What Next?

    To close this post, I revisited my valuation of the S&P 500 on September 23, 2022, and since much of last year's changes to the risk free rate, earnings expectations and the equity risk premium had happened by then, my value of the index has not changed much. In fact, if you view the current treasury bond rate as reflective of the market consensus on future inflation and rates, and assume that analyst estimates of earning already incorporate the effects of an economic slowdown in 2023 and 2024, the index value comes in at almost the current index level:

Download spreadsheet

In sum, with analyst estimates of earnings for the next two years powering earnings expectations, and an desired equity risk premium of 5% (close to the average premium in the post-2008 time period), stocks started the new year closer to fair value than being under or over valued.

    The market consensus can be wrong, and as the last year has shown, markets can change their minds, and especially so on two variables. The first is inflation, and whether it will recede to pre-pandemic levels or stay elevated, with consequences for both interest rates, nominal earnings growth in the long term and reinvestment. The second is the economy, where talk of recession fills the air but where a whole range of outcomes is possible from no recession to a steep drop off in economic indicators. 

Download spreadsheets: Low inflation & no recession, Low inflation & steep recession, High inflation & no recession, High inflation & steep recession

As you can see, the most favorable scenario for the market is one where inflation subsides quickly to pre-pandemic levels (1-2%), bringing down the treasury bond rate, and the economy escapes a recession, leaving corporate earnings unscathed; in this scenario, the index value is 4311, about 10% higher than the current level (in January 2023). In the least favorable scenario, inflation stays high, pushing interest rates further up,  and the economy enters a steep recession, with earnings dropping 20% (10%) from analyst estimates for 2023 and 2024; in this scenario, the index value is 3212, leaving the market over valued by almost 20%. Note that I am not calling it the worst case scenario, because that depends on how high  inflation gets, with the higher the inflation, the more dire the outcomes for stocks, as well as how bad a recession is, with worse economic outcomes lowering value more.

Summing up
    One of the rituals that start the market year is for market strategists at investment banks to make their best predictions for where they see markets going over the course of the year. While this exercise has zero predictive power, and perhaps even a perverse relationship with actual returns, it does offer some insights into how much strategists are in agreement or disagreement about the year to come. At the start of 2023, here are the predictions from strategists for the year:

What should you do with these forecasts? Absolutely nothing, but the wide divergence in forecasts comes from different expectations of how the inflation/real economy story will play out. Rather than adopt one of their outlooks, or mine, you should, as an investor, find your point of view and let it drive your investment actions for the year. The first step in being a good investor is to take ownership of your investment decisions, and I hope that my framework/spreadsheet helps you on that path.

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Pfizer Responds After Director Says Company Is Developing Ways To Mutate COVID-19

Pfizer Responds After Director Says Company Is Developing Ways To Mutate COVID-19

Authored by Zachary Stieber via The Epoch Times (emphasis…

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Pfizer Responds After Director Says Company Is Developing Ways To Mutate COVID-19

Authored by Zachary Stieber via The Epoch Times (emphasis ours),

Pfizer late Jan. 28 responded to comments from a director at the company about exploring ways to mutate COVID-19 as a method to “preemptively develop new vaccines.”

“In the ongoing development of the Pfizer-BioNTech COVID-19 vaccine, Pfizer has not conducted gain of function or directed evolution research,” Pfizer said in a lengthy written statement after days of ignoring queries from The Epoch Times and other outlets.

A sign for Pfizer is displayed in New York in a file photograph. (Timothy A. Clary/AFP via Getty Images)

Pfizer did say that it has conducted research “where the original SARS-CoV-2 virus has been used to express the spike protein from new variants of concern.”

“This work is undertaken once a new variant of concern has been identified by public health authorities. This research provides a way for us to rapidly assess the ability of an existing vaccine to induce antibodies that neutralize a newly identified variant of concern. We then make this data available through peer reviewed scientific journals and use it as one of the steps to determine whether a vaccine update is required,” the company added.

Pfizer did say it has conducted experiments in a level 3 laboratory.

Pfizer said, in its work developing a treatment for COVID-19, it has “engineered” the COVID-19 virus “to enable the assessment of antiviral activity in cells.”

“In addition, in vitro resistance selection experiments are undertaken in cells incubated with SARS-CoV-2 and nirmatrelvir in our secure Biosafety level 3 (BSL3) laboratory to assess whether the main protease can mutate to yield resistant strains of the virus,” Pfizer said. “It is important to note that these studies are required by U.S. and global regulators for all antiviral products and are carried out by many companies and academic institutions in the U.S. and around the world.”

Pfizer produces a COVID-19 treatment called Paxlovid, or nirmatrelvir that is authorized in the United States and some other countries.

In its statement, Pfizer did not dispute that Dr. Jordon Walker, who told a Project Veritas journalist that Pfizer is exploring how to “mutate” the COVID-19 virus, was or is a Pfizer employee.

Professional profiles for Walker, which have since been taken down, listed him as a director of messenger RNA research at the company. Pfizer’s COVID-19 vaccine utilizes messenger RNA. The profiles also listed a Pfizer email address, and an email sent to that address did not bounce back. A receptionist at Pfizer on Thursday also told The Epoch Times that Walker had an internal company profile, but a different receptionist on Friday said there was no listing for the doctor, indicating he might have been terminated after the comments were made public.

Malone

Dr. Robert Malone, who helped develop the messenger RNA technology, said that the experiments Pfizer described met the definition of “gain of function.”

Pfizer is basically acknowledging that they are doing the same type of gain of function research that Boston University was caught doing, but they are denying that it is gain of function or directed evolution,” Malone wrote on Twitter.

Malone pointed to Pfizer’s comment about taking the original SARS-CoV-2 virus and using it “to express the spike protein from new variants of concern.”

Gain of function generally describes experiments that aim to increase functions of a virus such as transmissibility and virulence. Walker had said in his comments that the work he was describing was not gain of function, but “directed evolution.”

Researchers with Boston University revealed in 2022 that they had developed a strain of COVID-19 that killed 80 percent of mice infected with it.

The U.S. National Institutes of Health (NIH) is supposed to oversee risky research conducted in or funded by the United States but has faced criticism for only reviewing a handful of projects—none since 2019—under the oversight system.

The NIH funded gain of function experiments at the Wuhan laboratory situated near where the first COVID-19 cases were identified, and officials have promised to keep funding research in China.

Sen. Marco Rubio (R-Fla.) had written a letter to Pfizer CEO Albert Bourla referring to Walker’s remarks and questioning whether the company has or is planning to mutate the COVID-19 virus.

Walker’s comments “are alarming,” Rubio wrote in the Jan. 26 missive.

YouTube Takes Down Video

In a notice sent to Project Veritas, YouTube cited its medical misinformation policy, which bars “claims about COVID-19 vaccination that contradict expert consensus from local health authorities or the World Health Organization (WHO).”

It wasn’t clear which authorities specifically YouTube was relying upon to rebut the video.

YouTube, which is owned by Google, did not respond to a request for comment.

O’Keefe noted that the claims in the video were made by a Pfizer director.

Project Veritas was given a “strike,” which prevents the organization from taking actions like uploading new videos for one week. A second strike would block such actions for two weeks and a third strike in a 90-day period would result in a permanent removal of the group’s account, YouTube warned.

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Tyler Durden Sat, 01/28/2023 - 14:30

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Von Greyerz: As West, Debt, & Stocks Implode; East, Gold, & Oil Explode

Von Greyerz: As West, Debt, & Stocks Implode; East, Gold, & Oil Explode

Authored by Egon von Greyerz via GoldSwitzerland.com,

“The…

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Von Greyerz: As West, Debt, & Stocks Implode; East, Gold, & Oil Explode

Authored by Egon von Greyerz via GoldSwitzerland.com,

“The risk of over-tightening by the European Central Bank is nothing less than catastrophic” says Prof Kenneth Rogoff .

At Davos he also said:

Italy is extremely vulnerable. But this could pop anywhere. Global debt has gone up massively since the pandemic: public debt, corporate debt, everything.”

Rogoff believes that it is a miracle that the world averted a financial crisis in 2022, but the odds of a major accident are shortening as the delayed effects of past tightening feed through.

As Rogoff said: 

“We were very fortunate that we didn’t have a global systemic event in 2022, and we can count our blessings for that, but rates are still going higher and the risk keeps rising.”

But lurking in the murkiness is also the global financial assets/liabilities which is almost $500 trillion including the shadow banking system at 46% of the total. The shadow banking sector includes  pension funds, hedge funds and other financial institutions which are largely unregulated.

Shadow banking is not subject to the normal mark-to-market rules. Thus no one knows what the real position or losses are. This means that central banks are in the dark when it comes to evaluation of the real risks of the system.

Clearly, I am not the only one harping on about the catastrophic global debt/liability situation.

And no one knows the extent of total global derivatives. But if they have grown in line with debt and also with the shadow banking system, they could easily be in excess of $3 quadrillion.

Cultures don’t die overnight, but the US has been in decline since at least the Vietnam war in the 1960s. Interestingly, the US has not had a real Budget surplus since the early 1930s with a handful of years of exception.

But when you, like the US, live on borrowed time and borrowed money, it becomes increasingly difficult to keep up appearances. In 1971, the pressures on the US economy and currency became too great.  Thus Nixon closed the Gold Window with the dollar having lost over 98% in real terms since then. This is of course a total catastrophe and a guarantee that the remaining 2% fall to ZERO will come in the near term future, whether it takes 5 or 10 years for the dollar to reach oblivion. Remember that the final 2% is 100% from today!

The US, EU and Japan have now reached the stage when no one wants their debt. So sovereign debt of these nations is no longer a question of “passing the parcel” but keeping the parcel. When every third party holder of these debts is a seller, who will buy?

These three countries will end up holding their own debt. Japan already holds over 50% of its debt. Before the Western Ponzi scheme comes to an end, these three nations will virtually hold 100% of their own debt. At that point, the bonds will be worthless and interest rates will have reached infinity. Not a pretty prospect!

US – PERFECT RECIPE FOR DISASTER

The final phase of all empires always includes excessive deficits and debts, inflation, a collapsing currency, decadence and war. And the US qualifies perfectly in all those categories.

Ernest Hemingway stated it superbly:

The first panacea of a mismanaged nation is inflation of the currency; the second is war.
Both bring temporary prosperity;
both bring a permanent ruin.
But both are the refuge of political
and economic opportunists. 

The US has failed in every war since the Vietnam war, including the Yugoslav Wars, Afghanistan, Iraq, Syria and Libya. The results have been massive casualties and destruction of the countries, often leading to economic misery, anarchy and terrorism.

The Ukrainian war is not between Ukraine and Russia but between the US and Russia as I discussed in a previous article (Link). The clear proof that there is no desire for peace from the US is that they are sending money and weapons to Ukraine in the $100s of billions and “encouraging” an increasingly suffering Europe to do the same. But they are not sending any peace negotiators to Russia in an attempt to end the war. This is very ominous.

The geopolitical situation is now on a knife edge with two major nuclear powers fighting about a relatively insignificant country. This is how major wars normally start.

Let us hope that the current conflict does not lead to a major nuclear war since that would be the end of the world. Thus not worth to speculate about the outcome of this high risk scenario.

But the economic war and the collapse of the US dominated financial system is not just  inevitable but also catastrophic for the Western economies.

A COMMODITY DOMINATED WORLD

As the hegemony of the US is coming to an end, the dominance of the decadent West is moving quickly to the East and South. Commodity based countries like the enlarged BRICS will dominate for the next few decades and probably longer. Oil and gas will form the base of this shift but also many other commodities including gold which is now starting a new era.

It is likely that 2023 will be the first year of many when we will see a strong rise in gold just like 2000 – 2011 which saw a 7.5X gain.

The end of the Western debt based cycle and the rise of the Eastern and Southern commodity cycle is well illustrated in the graph below

OIL, GOLD TO GO UP > 9X AGAINST STOCKS

The S&P Commodity Index relative to Stocks has recently made a 50 year low. Just to return to the mean, the index would need to go up 4X. But when long term cycles turn up from a historical low, they tend to trend higher and longer than anyone expects. So a move past the 1990 high of 9 is very likely. This would mean that commodities, and especially oil and gold, relative to stocks would move up more than 9X!

This  9X move  would obviously involve a combination of falling stocks and rising commodity prices.

The expected move of the index confirms the shift from the West, based on an unsound and debt infested system, to the East & South, based on commodities.

Much of this move is based on the fossil fuels of the countries involved – to the chagrin of the climate movement zealots.

In today’s woke world, there is a tendency to believe that we can change all the laws of nature and science. This is the case both in the economy and climate.  Bankers and governments are confident that they can create permanent prosperity by printing worthless pieces of paper believing that these represent real and lasting value and wealth.

Well surprise, surprise, these people will soon have the shock of a lifetime as all that printed money returns to its intrinsic value of ZERO.

A debt based economy eventually becomes a self-fulfilling prophecy.

The higher the debt, the more the debt needs to grow in a never ending vicious circle. In the end the debt cycle becomes a perpetual motion Ponzi scheme……. UNTIL IT ALL CRASHES!

The debt feeds on itself and the more that is issued, the more needs to be issued. As inflation rises, the escalating interest cost on the debt leads to more debt. Next is defaults, both private and foreign. Then the $2-3 quadrillion derivatives, a great part of which is in the shadow banking system, comes under pressure. This leads to massive further debt creation by the Fed and other central banks, desperately trying to save the system.

This will eventually lead to what von Mises called:  “…. a final and total catastrophe of the currency system involved.”

But remember that we are here talking about the Western financial system. The economic sun in the East will rise strongly and eventually be the guiding light for the world economy.

The debt based US and West will to quote Hemingway decline “first gradually and then suddenly.”  So due to the $2+ quadrillion size of the problem, the biggest part of the decline is unlikely to take more than 10 years and it could be a lot faster, especially at the end.

But the climate zealots

 will have to wait to 2050 to learn that through their actions they didn’t manage to limit the increase in temperature to 1.5 degrees. But with a lot of luck, climate cycles might be on their side and make the weather much colder.

Personally I believe that cycles determine the climate and not humans.

The climate cycle graph below covering 11,000 years shows that there has been numerous periods with warmer temperatures than currently. At the peak of the Roman Empire 2000 years ago, Rome had a tropical climate.

Fossil fuels produce 83% of the world’s energy today. According to forecasts this percentage is unlikely to come down significantly in the next 50 years.

Partly due to the increased cost of producing energy, fossil fuel production will fall by 26% by 2048. Increases in nuclear and renewables will not compensate for this decline.

If the world stops using fossil fuels, the world economy would totally collapse. Sadly the climate activist movement does not seem to worry about such disastrous consequences.

So it seems fairly clear that for a very long time, the world will be dependent on fossil fuels in order for the economy and population not to collapse.

For the above reasons, the commodity based countries will soon dominate the world and that for a very long time.

The constellations of commodity rich nations are forming rapidly.

Firstly we have the BRICS countries which currently consist of Brazil, Russia, India, China and South Africa. Many countries are in the process of joining BRICS including Saudi Arabia, Iran, Algeria, Argentina and Turkey.

It is the enlarged BRICS aim to bypass the dollar and create their own trading currency.

Many talk about the Petroyuan replacing the Petrodollar but what would everyone do with the Chinese currency since it isn’t freely convertible. Better then to have a currency linked to several commodity countries like Special Drawing Rights. This would create more stability and usability. The Credit Suisse analyst Pozsar calls this Bretton Woods III.

There is also the EAEU or Eurasia Economic Union with Russia leading plus China, India, Iran, Turkey and UAE involved.

The SCO – the Shanghai Cooperation Organisation headquartered in China is also an important force. The SCO is a political, economic, international security and defence organisation. It includes many Eurasian nations like China, Russia, Uzbekistan, Kazakhstan etc.

All the economies involved in this important development are commodity based. For example, commodities are 30% of Russian GDP. Their target is to expand gold mining to 3% of GDP and become the biggest gold producer in the world.

Russia has the world’s largest commodity reserves at $75 trillion and produces 11 million barrels of oil per day. Russian friendly provinces produce another 14M totalling 25M. China produces 5m barrels and the Middle East Oil going through the Strait of Hormuz is 22M barrels.  So in a conflict with the US, Russia, China and Iran  could decide to close the Strait of Hormuz which means they would have control over 50% of global oil supply. As Goldman Sachs has stated, oil would then be in the $1000s.

If we take Russia, Iran and Venezuela, they control 40% of the global oil supply.

The point I am making is that these various constellations of commodity countries will be the dominant economic power of the future as the US and Europe decline.

So for Russia, gold and oil are two strategic commodities which will play an important role not just for Russia but for all of these Eastern/Southern countries.

And no one should believe that the US and European sanctions are working. Russia and Iran are selling oil and gas to China at a discount. China then exports this, including refined products, to Europe at premium.

So the sanctions are a farce which totally kills the European economy.

Interestingly, the relationship between yellow gold and black gold has been stable for decades as this chart shows:

GOLD / OIL RATIO 1950 – 2023

GOLD – THE VITAL WEALTH PRESERVATION ASSET FOR 2023 AND BEYOND

Gold was the best performing asset class in 2022 but the investment world didn’t notice since it is hanging on to the declining bubble assets of stocks, bonds and property.

Let’s look at gold’s performance in various currencies in 2022:

The chart shows gold up 15% against Swedish Kroner on the right and for example up 11.6% in pounds, 6% in Euros and virtually unchanged in US$.

Bearing in mind that most asset markets, including bonds, have fallen by 20-30%, this is an outstanding performance by gold.

But no one must believe that gold is going up. All gold does it to reflect the total mismanagement of most economies. The chart above should be turned upside down to reflect the loss of purchasing power of all paper money.

As has been the case since 1971, this trend of falling currencies will continue but not at the same steady pace.

With the debt infested Western economies collapsing, their currencies will implode one after the other.

So please firstly acquire as much physical gold as you can afford and then some more.

And when you own your gold, don’t measure the value in collapsing currencies. Just measure your gold in ounces, kilos or grammes.

Also please don’t keep it in the country where you live, especially if that country has a tendency to grab assets. I don’t need to tell you which countries you can’t trust. The problem is, there are not many you can trust.

BEWARE – A GOLD CUSTODIAN DISAPPEARED WITH CLIENTS’ METALS

Also if you store your gold with a gold custodian, ensure that only you can release it by having the Warehouse Receipt in your name. A custodian gold company disappeared last year with the major customer assets in spite of the gold being stored with a major vault company. The weakness was that the gold company could release the gold without the client’s approval. This is not an acceptable way to store your wealth preservation asset. 

Finally remember that gold is not just your most important wealth preservation asset but can also be beautiful.

TUTANKHAMUN’S DEATH MASK 1327 BC

Tyler Durden Sat, 01/28/2023 - 11:30

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Week Ahead Alchemy: Can Powell Turn a Quarter-Point Move into a Hawkish Hike?

The new year is still young, but the week ahead may be one of the most important weeks of the year. The divergence that the market has been anticipating…

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The new year is still young, but the week ahead may be one of the most important weeks of the year. The divergence that the market has been anticipating will materialize. The Federal Reserve will most likely hike by 25 bp on Wednesday, followed by half-point moves by the European Central Bank and the Bank of England the following day. On Friday, February 3, the US will report its January employment situation. It could be the slowest job creation since the end of 2020. The Bureau of Labor Statistics also will release the preliminary estimate of its annual benchmark revisions. 

The markets' reaction may be less a function of what is done than what is communicated. The challenge for Fed Chair Powell is to slow the pace of hiking while pushing against the premature easing of financial conditions. In December, ECB President Lagarde pre-committed to a 50 bp hike in February and hinted that another half-point move was possible in March. With the hawks showing their talons in recent days, will she pre-commit again? Amid a historic cost-of-living squeeze that has already kneecapped households, can Bank of England Governor Bailey deliver another 50 bp rate hike and sell the idea that it is for the good of Britain, for which the central bank does not expect growth to return until next year?

United States: The Federal Reserve has a nuanced message to convey. It wants to slow the pace of hikes, as even the hawkish Governor Waller endorsed, but at the same time, persuade the market that tighter financial conditions are necessary to ensure a times convergence of price pressures to the target. Indeed, Fed Chair Powell may warn investors that if it continues to undo the Fed's work, more tightening may be necessary. The market has heard this essentially before and is not impressed. Financial conditions have eased. Consider that the 2-year yield is down 20 bp this year, and the 10-year yield has fallen twice as much. The trade-weighted dollar is off by more than 1.5%. The S&P 500 is up 4.6% after a 7% rally in Q4 22. The Russell 200 has gained nearly 7% this month, on top of the 5.8% in the last three months of 2022.  

Last year, Powell drew attention to the 18-month forward of the three-month T-bill yield compared to the cash 3-month bill as a recession tell. It has been inverted for over two months and traded below -100 bp last week, the most inverted since the tech bubble popped over two decades ago. The market seems more convinced that inflation will fall sharply in the coming months. The monetary variables and real economy data, including retail sales, industrial production, and the leading economic indicators, suggest a dramatic weakening of the economy. Yet just like most looked through the contraction in H1 22, seeing it as primarily a quirk of inventory and trade, the 2.9% growth reported in Q4 22 does not change many minds that the US economy is still headed for weaker growth, leaving aside the fuzzy definition of a recession.

The median forecast in Bloomberg's survey is for a 188k rise in January nonfarm payrolls. If accurate, it would be seen as concrete evidence that the jobs market is slowing. This is also clear by looking at averages for this volatile series. For example, in the last three months of 2022, the US created an average of 247k jobs a month. In the first nine months of the year, nonfarm payrolls rose by an average of 418k a month. Average hourly earnings growth also is moderating. A 0.3% rise on the month will see the year-over-year pace slow to 4.3%. That matches the slowest since June 2021. The decline in the work week in December to 34.3 hours spurred narratives about how businesses, hoarding labor, would cut hours before headcount. Yet, we suspect it was partly weather-related, and that the average work week returned to 34.4 hours, which is around where it was pre-Covid. 

Benchmark revisions are usually of more interest to economists than the market, but last month's report by the Philadelphia Fed raised the stakes.  It looked more closely at the April-June 2022 jobs data. After adjusting for updated data from the Quarterly Census on Employment and Wages, it concluded that job growth was nearly flat in Q2 22. It estimated that only 10,500 net new jobs were created, a far cry from the 1.05 mln jobs estimated by the Bureau of Labor Statistics. The Business Employment Dynamics Summary (released last week) was starker still. It points to a job loss of nearly 290k. Lastly, we note that US auto sales are expected to have recovered from the unexpected almost 6% decline (SAAR) in December. However, the 14.1 mln unit pace would still represent a 6% decline from January 2022, when sales spiked to 15.04 mln.  

The Dollar Index continues to hover around 102, corresponding to the (50%) retracement of the rally recorded from January 2021 through September 2022. It has not closed above the 20-day moving average (now ~102.80) since January 3. It remains in the range set on January 18, when it was reported that December retail sales and manufacturing output fell by more than 1%. That range was about 101.50-102.90. Although we are more inclined to see it as a base, the prolonged sideways movement last month saw new lows this month. That said, the next retracement target (61.8%) is near 99.00.

Eurozone:  The ECB rarely pre-commits to a policy move, precisely what ECB President Lagarde did last month. Apparently, as part of the compromise with members who at first advocated another 75 bp hike in December, an agreement to raise rates by 50 bp was accompanied by an agreement to hike by another 50 on February 2 and explicitly not rule out another half-point move in March. There was a weak effort to soften the March forward guidance, but the hawks pushed back firmly. The swaps market has about a 70% chance of a 50 bp hike in March rather than a 25 bp move. 

The ECB's deposit rate stands at 2.00%, and the swaps market is pricing 125 bp of hikes in the first half of the year. In contrast, the Fed is expected to raise the Fed funds target range by 50 bp. This has been reflected in the two-year interest rate differential between the US and Germany, falling from about 275 bp last August to around 160 bp now. We had anticipated the US premium would peak before the dollar, and there is a lag of almost two months. The direction and change of the interest rate differential often seem more important than the level. In late 2019, before Covid struck, the US premium was near 220 bp, and the euro was a little below $1.12.

There has been a significant shift in sentiment toward the eurozone. The downside risks that seemed so dominant have been reduced. A milder-than-anticipated winter, the drop in natural gas prices, and successful conservation and conversion (to other energy sources) lifted the outlook. Some hopeful economists now think that the recession that seemed inevitable may be avoided. The preliminary January CPI will be published a day before the ECB meets. The monthly pace fell in both November and December. The year-over-year rate is expected to ease to 5.1% from 5.2%, while the core rate slips to 5.1% from 5.2%. The base effect suggests a sharp decline is likely here in Q1, but divergences may become more evident in the euro area. This could see a reversal of the narrowing of core-periphery interest rate spreads. 

The EU's ban on refined Russian oil products (e.g., diesel and fuel oil) will be implemented on February 5. It is considering imposing a price cap as it did with crude oil. Diesel trades at a premium to crude, while fuel oil sells at a discount. There have been reports of European utilities boosting purchases from Russia ahead of the embargo. Separately, reports suggest that the EU was still the largest importer of Russian oil in December when pipeline and oil products were included. However, at the end of December, Germany stopped importing Russia's oil delivered through pipelines. This does not count oil and refined producers that first go to a third country, such as India, before being shipped to Europe.  

Pullbacks in the euro have been shallow and brief. Most pullbacks since the low was recorded last September, except the first, have mostly been less than two cents. That would suggest a pullback toward the $1.0730 area, but buyers may re-emerge in front of that, maybe around $1.0775. On the top side, the $1.0940 is the (50%) retracement of the euro's losses since January 2021. The euro rose marginally last week, even though it slipped by around 0.2% in the last two session. It has risen in eight of the past 10 weeks.   

UK: Without some forward guidance that stopped short of a pre-commitment, the market is nearly as confident that the Bank of England will deliver another half-point hike in the cycle to lift the base rate to 4.0%. The BOE was among the first of the G10 countries to begin the interest rate normalization process and raised the base rate in December 2021 from the 0.10% it had been reduced to during the pandemic. The swaps market projects the peak between 4.25% and 4.50%, with the lower rate seen as slightly more likely.

High inflation readings and strong wage growth appear to outweigh the economic slump. The BOE's forecasts see the economy contracting 1.5% year-over-year this year and output falling another 1% in 2024. The market is not as pessimistic. The monthly Bloomberg survey (51 economists) founds a median forecast for a 0.9% contraction this year and an expansion of the same magnitude next year. The survey now sees only a 0.2% quarterly contraction in Q4 22 rather than -0.4% in the previous survey. The median forecast for the current quarter was unchanged at -0.4%. 

Sterling continues to encounter resistance in front of $1.2450, which it first approached in mid-December. Although marginal new highs have been recorded, like the euro, it has been mainly confined to the range set on January 18 (~$1.2255-$1.2435). We are inclined to see this sideways movement as a topping pattern rather than a base, but it likely requires a break of the 1.2225 area to confirm.

Japan:  After contracting in Q3 22, the Japanese economy is expected to have rebounded in Q4 (~3.0% annualized pace). Reports on last month's labor market, retail sales, and industrial production will help fine-tune expectations. This month's rise in the flash composite PMI moved back above 50, pointing to some momentum. Still, Tokyo's higher-than-expected January CPI warns of upside risk to the national figure due offers good insight into the national figure, which may draw the most attention. We expect Japanese inflation to peak soon. The combination of government subsidies, the decline in energy prices, including the natural gas it gets from Russia, and the stronger yen (which bottomed in October) will help dampen price pressures. We look for a peak here in Q1 23. 

Last week, the dollar moved broadly sideways against the yen as it continued to straddle the JPY130 area. It repeatedly toyed with the 20-day moving average (~130.40) last week but has yet to close above this moving average for more than two months. Rising US and European yields may encourage the market to challenge the 50 bp cap on Japan's 10-year bond. A break of the JPY128.80 area may spur a test on the JPY128.00 area. However, the market seems to lack near-term conviction.

China:   Mainland markets re-open after the week-long Lunar New Year holiday. There may be two drivers. The first is catch-up. Equity markets in the region rose. The MSCI Asia Pacific Index rose every session last week and moved higher for the fifth consecutive week. The JP Morgan Emerging Market Currency Index rose about 0.40% last week and is trading near its best level since mid-2022. The euro and yen were little changed last week (+/- <0.20%). The second driver is new news--about Covid and holiday consumption. The PMI is due on January 31, and the median forecast in the Bloomberg survey is for improvement. It has the manufacturing PMI rising to 49.9 from 47.0 and the service PMI jumping to 51.5 from 41.6.  The offshore yuan edged up 0.3% last week, suggesting an upside bias to the onshore yuan, against which the dollar settled at CNY6.7845 ahead of the holiday. 

Canada:  After the Bank of Canada's decision last week, the FOMC meeting, and US employment data in the days ahead, Canada is out of the limelight. It reports November GDP figures and the January manufacturing PMI. Neither are likely to be market movers. The Bank of Canada is the first of the G7 central banks to announce a pause (conditional on the economy evolving like the central bank anticipates) with a target rate of 4.50%. The central bank sees the economy expanding by 1% this year and 1.8% next. It suggests that the underlying inflation rate has peaked and, by the end of the year, may slow to around 2.6%. The swaps market has 50 bp of cut discounted in the second half of the year. 

The Canadian dollar held its own last week, rising by about 0.5%, which was second only to the high-flying Australian dollar. The greenback approached CAD1.3300, its lowest level since last November when it traded around CAD1.3225. Quietly, the Canadian dollar has strung together a six-week advance, and since its start in mid-December, it has been the third-best performer in the G10 behind the yen (~6.2%) and the Australian dollar (~6.1%). We are more inclined to see the greenback bounce toward CAD1.3400 before those November lows are re-tested. 

Australia:  The market's optimism about China recovering from the Covid surge, with the help of government support and attempts to help the property market, has been reflected in the strength of the Australian dollar, which leads the G10 currencies with around a 4.4% gain this year. Yet, changes in the exchange rate and Chinese stocks are not highly correlated in the short- or medium-term. The surge of inflation at the end of last year, reported last week, lent greater credence to our view that the Reserve Bank of Australia will lift the cash target rate by 25 bp when it meets on February 7. In the week ahead, Australia reports December retail sales, private sector credit, and some housing sector data, along with the final PMI readings. The momentum indicators are stretched after a 2.5-cent rally from the low on January 19. It is at risk of a pullback and suggests a break of $0.7080 may be the first indication that it is at hand. We see potential initially toward $0.7000-$0.7040.

Mexico:  After falling by nearly 5.25% in the first part of the month against the Mexican peso, the dollar is consolidating. The underlying case for peso exposure remains, but there are two mitigating conditions. First, surveys of real money accounts suggest many are already overweight. Second, the dollar met key target levels in it late-2019 (~MXN18.80), even if not to the February 2020 low (slightly below MXN18.53). On January 31, Mexico reports Q4 GDP. The economy is expected to have expanded by 0.5% after 0.9% quarter-over-quarter growth in Q3 22. Growth is expected to slow further in Q1 23 before grinding to a halt in the middle two quarters. The following day, Mexico reports December worker remittances. These have been a strong source of capital inflows in Mexico. Remittances have a strong seasonal pattern of rising in December from November, which sees remittances slow. However, after surging for the last couple of years, they appear to have begun stabilizing. Also, the optimism around China is understood to be more supportive of Brazil and Chile, for example, than Mexico.  

We do not have a very satisfying explanation for the two-day jump in the dollar from about MXN18.5670 to MXN19.11 (January 18-19) outside of market positioning and the possibility of some large hedge working its way through. Still, it seemed like a transaction-related flow rather than a change in the underlying situation. The greenback has trended lower since then and has fallen in five of the last six sessions. It fell to nearly MXN18.7165 ahead of the weekend. Latam currencies, in general, did well, with the top two emerging market currencies coming from there (Brazil and Chile). The Mexican peso rose about 0.4% last week.   Last week, the Argentine peso's loss of almost 1.2% gave it the dubious honor of the worst performer among emerging market currencies. It is now off nearly 4.6% for this month. Mexican stocks and bonds extended their rallies. A firmer dollar ahead of the February 1 conclusion of the FOMC meeting may see the peso consolidate its recent gains.

 


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