“The reason a lot of people do not recognize opportunity is because it usually goes around wearing overalls looking like hard work.” ― Thomas Edison
“The most important lesson I’ve learned is to understand and to trust abstractions. If you can learn both to see and to believe in life’s underlying patterns, you can make highly informed decisions every day.” ― Nathan Myhrvold, former Chief Technology Officer of Microsoft
Confusing the Cyclical with the Secular
We have, since late last year, been bullishly positioned in precious metals and have reiterated this view on several occasions over the course of this year. That being said, however, we are not of the view that precious metals have entered a new secular bull market and will be making a run for new highs, in US dollar terms, in the near term.
Similarly, in last week’s piece, we highlighted cyclical factors indicating that long-term US bond yields were likely to rise, in the near-term, as opposed to going even lower. Once again, this is a cyclical, not a secular, view.
Below we share two passages that provide a framework for understanding the conditions that would lead to a bond market rout and a new secular bull market in precious metals.
The following passage in an excerpt from The Invisible Hands: Top Hedge Fund Traders on Bubbles, Crashes, and Real Money on the discussion between the author, Steven Drobny, and his (unrelated) colleague at Drobny Global Advisors, Dr. Andres Drobny (emphasis added):
Many people think there is a limit on public debt, but I am not so sure. Apart from a country constrained by a gold standard or fixed exchange rate, the only scenario where the government might bot be able to fund its debt is an inflationary scenario. However, the scenario only seems likely to emerge after the policies succeed in promoting growth. One of the reasons that a much-anticipated financing problem has never materialized in Japan is that reflationary policies failed to stimulate a sustained rebound and a return of inflation. Interest rates have remained low and fund the deficit has been surprisingly easy.
Consider what happens if the public debt and financing fears prove correct and bond markets start to tank. This is an issue that came up during a debate at our recent conference in London. Without inflation, rising nominal bond yields push up real yields and deflate the economy; bonds become more attractive again and buyers bring yields back down. Without inflation, it is hard to get a bond rout. It is only when inflation rises that government financing becomes a real and sustained problem for bond markets. That is when bonds no longer get cheaper as they sell off and nominal yields rise, which is when you get a real bond crisis.
The key takeaway from the above passage is that a secular turn in the bond market will only occur when rising nominal yields do not translate into rising real yields, that is when the rate of inflation outpaces the increase in nominal yields.
In the 1960’s and from the mid-1970’s through the early 1980’s, rising nominal yields in the US coincided with sharply declining real yields. Until such a disconnect begins to manifest, the secular bull market in bonds is intact.
The following passage in an excerpt from Peter Warburton’s essay The debasement of world currency: It’s inflation but not as we know it (emphasis added):
An excessive expansion of credit can create an environment where the factors of production — land, capital and labour services — appear to be in infinite supply. If sufficient (borrowed) financial resources are made available, then sterile, parched and polluted land can be fertilized, irrigated, cleaned up and turned to productive use. Similarly, more factories, kilns, assembly lines, steel mills, semiconductor plants and so on can be built using state-of-the-art technology. Idle and untrained workforces can be mobilized and organized into productive units. A rich country, with plenty of collateral assets against which to borrow, can indeed face a supply curve that is seemingly infinitely elastic. I can assure you that consumer price inflation will not be a problem for such an economy.
The United States still has plenty of collateral assets to borrow against. The US dollar hegemony may be on its last legs but there is no credible alternative making it still too early to bet against it.
In the chart above, the magenta line is a custom index tracking the relative performance of US liquid assets (equities and investment grade bonds) to that of global liquid assets ex-US. The orange line is the Bloomberg Dollar Index ― the index is broader than $DXY, which is just a proxy for the EURUSD cross.
The continued out performance of US capital markets relative to the capital markets of the rest of the world is supportive of the US dollar and indicative of the superiority of US collateral relative to ex-US collateral.
The Iran-China Comprehensive Strategic Partnership
Speaking of the end of the US dollar hegemony, it was reported last week that Iran’s foreign minister Mohammad Zarif paid a visit to his Chinese counterpart Wang Li at the end of August to present a road map for the China-Iran comprehensive strategic partnership, signed in 2016.
As part of the deal, China will invest US dollars 280 billion in developing Iran’s oil, gas and petrochemicals sectors. There will be a further US dollars 120 billion of investments made by China in upgrading Iran’s transport and manufacturing infrastructure. Notably, the deal also includes “5,000 Chinese security personnel on the ground in Iran to protect Chinese projects, and […] additional personnel and material available to protect the eventual transit of oil, gas and petchems supply from Iran to China, where necessary, including through the Persian Gulf,” according to Iranian sources.
According to reports, the deal also includes a long-term commitment by China to buy Iranian oil. Based on these reports, Iran has agreed to sell its oil and gas to China at a guaranteed discount to prevailing market prices of at least 12 per cent, plus a further discount of up to 8 per cent to account for the risk ― presumably of a backlash from the US. China, of course, will pay for the oil in renminbi.
The benefits of the deal for Iran are obvious. It receives much-needed foreign direct investment. It secures a market for its hydrocarbon output. And secures a deterrent against possible military strikes by Israel or Saudi Arabia and its allies. Iran, though, does not simply want to be China’s discount oil dealer. It wants more, it wants a strategic alliance. Iranian foreign minister Mohammad Zarif penned an op-ed in the Global Times clearly articulating what Iran wants. It is unclear, however, if they will get it by “looking east”.
The benefits to China are somewhat mixed. Cheaper energy imports paid for not in US dollars but in local currency eases China’s dependence on the greenback and furthers its ambitions to form an independent monetary bloc. Buying Iranian oil and defying of US sanctions, on the other, is only likely to infuriate President Trump and further complicate ongoing trade negotiations.We see China’s willingness to defy US sanctions as a signal that its leadership is unwilling to do a deal with President Trump that it does not deem to be fair. By agreeing to buy Iranian oil, China is either hedging itself and preparing for a new economic reality or it is posturing to show strength in its negotiations with the US.
Aside from trade, the most interesting near term takeaway from China’s agreement to buy Iranian oil is that it did not lead to sharp pullback in the price of oil. Rather oil has moved higher, suggesting oil could move higher still.
This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.