Introduction

There is a lot happening in the geo-political world that are impacting the macro-economic environment which has its own issues, e.g., collateral shortage. In this newsletter we will bring together some of these issues in the context to our changing macro-economic world.

Key geo-political events with macro-economic implications

Prior to the Ukraine war we were all aware of the growing tensions between the US and China. Simply, a rising power (China) challenging the existing global power (US).

Issues such as Taiwan sovereignty, US claims of intellectual property theft by China, each spying on the other and China’s military build-up continue to fuel tensions. Some commentators and politicians call for China to be contained with more trade sanctions and de-globalisation. We do not know how any country or group of countries can contain China? It is the world’s second most populus country, it has a large and growing military, and is the second largest economy in the world, whose manufacturing sector is the economic engine of the world. It holds billions of USD dollars and has supported the global economy for many years. Much of the world’s recent economic growth can be attributed to China.

Just recently, China has also stepped out for the first time in a major way in the diplomatic world by facilitating a de-escalation of relations between Iran and Saudi Arabia. Both Muslim countries are in a constant struggle for leadership of the Muslim world. Iran is Shia and Saudi is Sunni. They have agreed to re-instate diplomatic relations and appoint ambassadors to their embassies, as well as find a solution to the Yemen war where they are supporting opposing factions.

Putting aside for one moment the terrible loss of life of the Ukraine war there has been a number of important macro-economic consequences. As we have written about in newsletters for some time, the US through sanctions has weaponised the USD and this has severely impacted Afghanistan, the Balkans, Belarus, Burma, Central African Republic, Cuba, Democratic Republic of Congo, Ethiopia, Hong Kong, Iran, Iraq, Lebanon, Libya, Mali, Nicaragua, North Korea, Russia, Somalia, Sudan, South Sudan, Syria, Ukraine, Venezuela, Yemen, and Zimbabwe. With the Ukraine war, the US increased sanctions on Russia and froze its reserves held outside of Russia. Energy, particularly oil is critical to all nations’ economic growth and across the globe many countries economic development has been hamstrung because 40% of the world’s oil producing countries are under US sanctions. These countries include Venezuela, Iran, Iraq, Libya and now Russia. China that is energy deficient is now buying cheap oil from Russia and Iran, and has seized the opportunity to hasten down a path it has been travelling for some time, i.e., de-dollarisation that Russia has similarly been moving down that direction.

Significant change to the macro-economic world is in the wind. It will not happen overnight but rather ever so slowly unless the current geo-political tensions between an emerging power (China supported by Russia and others) and the existing dominant country (US and ‘the west’) blows over into war. We hope cooler heads prevail.

Is this end of the Petro-dollar?

The US and Saudi after World War 2 entered into an agreement where the Saudis would sell oil only in USDs and the US would guarantee its security. Over recent years this agreement has been strained for a variety of reasons and the final straw that appears to have “broken the camel’s back” was the attack on Saudi oil facilities by Houthi rebels in a possible expansion of the war beyond Yemen’s borders. The Saudi’s at that time thought the US would come to their defence as per the petro-dollar agreement. The US did not. This combined with earlier factors, including watching the US exit Afghanistan, the Saudis wondered about the US’s commitment to their security, thus the détente with Iran mentioned above.

The Saudis have agreed to sell oil to China in renminbi (RMB), also called Yuan. Iraq has been selling oil in Euros prior to the first Gulf war and other countries are set to follow suite and sell oil in either their own currency or the buying countries currency, but outside the US payment system, e.g., SWIFT.

At the same time Brazil, Russia, India, China and South Africa (BRICS) are working toward a solution to trade and transact where possible outside the US controlled monetary system. The solutions being explored include a new currency (weighted basket), or a currency like the International Monetary Fund (IMF) Special Drawing Rights, or a currency backed by commodities or gold and finally possibly have trade imbalances settled in gold. This movement is gaining steam. We have dismissed the currency backed by commodities as it is too difficult with no substantial historical precedence. Given gold’s 3000 year history as a currency it trumps all other solutions as it is globally acceptable. Thus, we believe it will play some role. Gold is unlike fiat currency which is an IOU and there is no counterparty risk with gold.

Consistent with the gold argument we have seen central banks globally go on a gold buying spree, and we believe this will continue. We are also seeing countries queuing up to join the BRICS, including UAE, Algeria, Argentina, Venezuela, Iran, Egypt, Turkey and Indonesia.  Some of these countries have traditionally been more aligned with the US, e.g. UAE, Turkey and Indonesia, than with China which demonstrates a loss of US influence as traditionally the US would apply pressure on those countries to fall into line.

Recent Macro-economic Events

Below we consider some of the macro-economic developments impacting us all.

Electronic Money and Ledger Systems

The failures of Credit Swisse and Silicon Valley Bank have been in the news headlines. The reasons mentioned in the press for the failures do not consider the more fundamental problems in the global monetary system.

Thirty years ago, if a customer wanted to withdraw a million dollars from a bank they could turn up at a branch (after giving some notice to the branch) and collect a million dollars in cash and walk out the door with it. You could not do this today, as the bank would report you to Austrac (Anti-money laundering body) prior to you even turning up and banks no longer carry large amounts of cash. Armed bank robberies are rare events these days unlike before 2000s. Physical cash is disappearing from the monetary system. The world is moving to a full ledger based monetary system which has been around for many years and in time there will be Central Bank Digital Currency (CBDC) that will replace all cash. China is leading the charge on this.

The most important distributed global ledger monetary system is the Eurodollar system, i.e., USDs outside the jurisdiction of the US Federal Reserve. This monetary system is many times larger than the US domestic monetary system and interest rates (medium to long end of the yield curve) are determined by the market. Remember that central banks can only control the short end (cash rate) of the yield curve impacting demand by increasing/(decreasing) it as economic conditions dictate.

What does this have to do with Credit Swisse and Silicon Valley Bank ?

The US in 2020, in response to the Covid pandemic, repealed the requirement for banks to hold reserves and back in 2009 in response to the Global Financial Crisis (GFC) Rule 157 was repealed.  This rule required banks to “mark-to-market” their assets, e.g., bonds, and this repealing meant that many banks held their bonds at cost on their balance sheet and they assumed they would hold them to maturity which did not occur because of the run-on deposits. They were forced to sell the bonds at a loss to meet withdrawals. If these requirements had remained in place the issues that brought down Silicon Valley Bank would have been identified early and corrective action could have been taken.

It's all about liquidity!

The US Federal Reserve through higher interest rates and Quantitative Tightening (QT) is withdrawing money from the system, i.e., reduction in M2 which is in conflict with the increasing demands for more USDs coming from the Eurodollar market (See Newsletter 45 Triffen’s dilemma) because of rising debt servicing costs in USDs. Market participants want more USDs and they want it secured by collateral (USD treasuries being considered the most pristine collateral available), and there is a shortage of US treasury bills. Lack of liquidity leads to insolvency.

Days of easy investment returns are over!

As outlined for over 12 months now the days of easy returns are over. We just experienced a 30 year period of falling interest rates, down from 20% to 0.10% which fuelled asset price increases. We are in a new economic paradigm which will take some time, possibly years to find a “new normal”. This adjustment period will be characterised by greater volatility, stagflation because of the high levels of debt, intermittent supply shortages and wage push inflation. We expect the Consumer Price Index (CPI) will remain stubbornly above the Reserve Bank of Australia (RBA) target range of 2-3% for some time, unless the RBA crashes the economy which they are trying not to do from the pause in interest rate rises on 4 April 2023.

As outlined in previous newsletters, we do continue to see opportunities in the store value area. Please feel free to reach out and discuss.

Happy Easter!