Uncontrollable Events
To be clear, in HAI‘s view, the ongoing closure of the Strait of Hormuz is undoubtedly the epicenter of a rapidly growing risk for a potential global crisis.
The size of the disruption of global oil supplies is already orders of magnitude larger than any other major disruption in over 50 years. Despite that, very few investors seem to realize the implications of having this oil disruption occur at an unprecedented level of U.S. Federal debt and deficits relative to GDP. The fact is, this oil disruption is far larger than anything seen in recent history, and it’s happening within far more fragile U.S. and global financial systems.
To underscore the point, the Strait of Hormuz shut-down (20% of global oil exports) amounts to a loss of global oil supply roughly three times larger than the 1973 Arab oil embargo. At that time, U.S. debt/GDP was 32% versus 122% today. Similarly, in 1973, the U.S. deficit relative to GDP was 1% while it’s well north of 6% today.
The point is, in 1973, there was effectively no combination of higher oil prices, higher inflation, and resulting higher global bond yields that would trigger a debilitating U.S and global sovereign debt spiral. Today, the combination of higher oil prices, higher inflation, and resulting higher global bond yields is almost certain to trigger a catastrophic debt spiral if the Strait of Hormuz is not opened almost immediately or if policymakers don’t implement a massive yield curve control program (or it’s functional equivalent) equally soon.
That said, the rapidly growing concern now is both that policymakers (given extremely high debt/GDP and deficits/GDP) may initially be far more constrained in reacting to crisis than in Covid, and that the Strait of Hormuz may not be open anytime soon.
This week, in a Bloomberg article titled “Gopinath Warns Fiscal Space ‘Depleted’ for Long-Lasting Iran War,” former IMF chief economist Gita Gopinath underscored concerns over the possible constraints to policymaker reaction functions. Gopinath said the world “does not have the capacity” to respond to a major crisis, and that “It has absolutely depleted policy space, compared to the start of the pandemic.”
Now that doesn’t mean policymakers won’t react to the crisis, but it may mean the reaction will come late and almost certainly have a very outsized negative impact to the currency relative to past interventions.
As far as the Strait of Hormuz staying closed for an extended period, this week a Bloomberg article titled, “Iran’s attack drones and missiles put US military under unexpected strain,” points toward the increasing risk that Iran could manage to keep the Strait closed for long enough to cause massive chaos.
According to Bloomberg, “when the first cruise missiles began detonating inside Iran, the strikes had all the hallmarks of previous successful US military campaigns — unstoppable, overwhelming force delivered without warning.”
“But as the conflict extends toward a third week, the US war effort is showing unexpected signs of strain against an adversary whose military budget is smaller than the GDP of Vermont — but which has an arsenal of missiles and drones unlike anything the US has ever faced.”
Maybe U.S. forces open the Strait tomorrow, or maybe a peace deal is struck imminently. Certainly possible. But given reports of Iran beginning to mine the Strait, of dwindling U.S. munitions stockpiles, of the U.S. having to redeploy THAAD anti-missile systems from South Korea to the Middle East, and an inability of U.S. forces to open the Strait so far after two-weeks of engagement, the balance of evidence is shifting towards a prolonged conflict with a prolonged closure of the Strait of Hormuz—and all the negatives that follow.
If the Strait of Hormuz stays closed for much longer, oil (and fertilizer, then food) is likely to spike even higher, inflation expectations (and eventually actual inflation) are likely to spike higher, 10-year U.S. Treasury yields are likely going to spike higher, U.S. and global equity markets are likely to drop considerably, the global economy (and credit markets) will take a big hit, and the combo of higher rates, lower tax receipts, higher deficits, more debt issuance, and the resultant still-higher bond yields will all very likely spark a U.S. and global debt spiral.
That spiral is already beginning to unfold. This week, S&P Global warned that the downstream effects from the escalating Middle East conflict are beginning to “strain credit channels” across multiple sectors, and they described the situation as moving from a high-risk scenario to “severe.” Perversely, the only short-term solution might be for the Fed to print even more money to delay that vicious cycle by stimulating the economy, papering over credit cracks, and buying Treasuries to artificially cap yields—into a preexisting oil and inflation spike.
That’s all a mouthful and a mindful, but, in HAI‘s view, it simply means that all roads lead to gold and that the end of the fiat era and start of the hard asset era (led by gold as the tip of the spear) is not a question of if, but rather just how soon.
The only way that might not be the case is if the U.S. puts on a massive display of military dominance sufficient to utterly compel the rest of the world right back into the tight confines of the post-1971 dollar system. That does not appear to be what is happening—at all. Rather, the way this conflict is playing out so far, the events in Iran appear far more likely to convince the world of the practical limits of U.S. economic and military power. That is almost certain to be a dramatic accelerant of the precious metals bull thesis already playing out for years.
In HAI‘s view, the reasons for the weakness in the precious metals sector since the war broke out are likely two-fold. First, the precious metals were already in a technical correction. Their prices are continuing to consolidate prior big moves in preparation for moving higher. Second, weakness in precious metals may also be a short-term signal of mounting broad market global liquidity pressure. That may be a signal that all assets face short-term pressure. However, it’s not a long-term statement contra to the longer-term bullish precious metals fundamentals.
Again, HAI is confident that the fundamentals stemming from this geopolitical conflict are ultimately very likely overwhelmingly precious metals positive. If the worst case unfolds, and the Strait remains closed for a month or more, global liquidity pressures could hit all assets (including the precious metals). Even in that scenario, however, the ultimate policy response is likely to trigger a previously unseen—and definitive—run to gold and hard assets that will mark the start of a new hard asset era.
Two weeks ago, the U.S. got itself into this Iran conflict. Right now, it remains to be seen how, and on what terms, the U.S. gets out of it. In regard to that question, the stakes are very high.
Speaking to House of Commons on November 12, 1936, Winston Churchill warned, “Never, never, never believe any war will be smooth and easy, or that anyone who embarks on that strange voyage can measure the tides and hurricanes he will encounter. The Statesman who yields to war fever must realize that once the signal is given, he is no longer the master of policy but the slave of unforeseeable and uncontrollable events.”
We are now dealing with the full fog of war, and HAI doesn’t know how this conflict will play out from here. This author certainly hopes for the very best possible outcome. That said, given recent events, caution is warranted. At least in the short-term, it seems time to consider the possibility that we may be slave to “uncontrollable events.” The risk that we may have to contend with a prolonged closure of the Strait of Hormuz is growing. By extension, so is the risk of everything that follows.
What is foreseeable, however, in HAI‘s view, is that at some point—fairly soon—the precious metals bull market is going to reassert itself—most likely with a massive extra spring in its step.
Weekly performance: The S&P 500 was off 1.6%. Gold was down 2.37%, silver was off by 4.33%, platinum was down 5.92%, and palladium was off 5.79%. The HUI gold miners index was creamed by 7.30%. The IFRA iShares US Infrastructure ETF was off 1.44%. Energy commodities were volatile and mixed on the week. WTI crude oil gained 9.25%, while natural gas lost 1.57%. The CRB Commodity Index was up by 3.88%. Copper was down 2.88%. The Dow Jones US Specialty Real Estate Investment Trust Index was down 0.37%. The Vanguard Utilities ETF was up 0.49%. The dollar index was up 1.53% to close the week at 100.50. The yield on the 10-yr U.S. Treasury was up 15 bps on the week, closing at 4.28%.
Have a wonderful weekend!
Morgan Lewis
Investment Strategist & Co-Portfolio Manager
MWM LLC
