Energy and the Controlled Fiscal Demolition
It is a great frustration for HAI to constantly survey the investment landscape for opportunity and repeatedly find that only one risk-adjusted investment theme motivates great enthusiasm. It’s not the impressive investment case for precious metals that is the problem, but rather the lack of great additional alternatives. What makes gold a unique investment at present is that it’s an economically insensitive store of value that’s free of counterparty risk.
These attributes are perfectly matched with the dynamic array of risks and price drivers currently exerting the most prominent force on global asset prices. Further, these attributes are likely to be in much higher demand as the current set-up of global risk dynamics domino toward a new era. Our current era has attained relative Goldilocks characteristics in economic, financial, and market conditions. As it increasingly unravels, gold will be the obvious recipient of global capital inflows due to its economically insensitive nature.
The existing structure of global institutional capital allocation is entirely dependent upon near-Goldilocks conditions. It’s a massive and precarious structure intricately built upon the sands of unwarranted confidence in policymakers’ ability to deliver a government-sponsored perpetual Goldilocks future. As the confidence bubble bursts, the yellow metal will stand to benefit from a disproportionate reallocation of the existing capital investment structure.
To be clear, HAI’s highest-conviction outlook is that the Goldilocks era is over—one way or another. And to reiterate to prevent any confusion, Goldilocks conditions are a simultaneous combination of maintained economic growth, low-interest rates, low government interest expense, fiscal sustainability, low inflation, and stable bond and currency markets.
It was the initial condition of relative Goldilocks that first allowed policymakers the flexibility to use activist and radical policy tools to unnaturally maintain the ephemeral condition every time it began to fall apart. Increasingly over time, those policymakers used their activist policy tools to support the economic growth component of the Goldilocks equation each time it faltered.
After many years of the habitual use of radical activist policy measures, the policy of maintaining Goldilocks has undone itself. We now have an inflation problem, a fiscal sustainability problem, a government interest expense problem, and a higher interest rate problem (in response to the inflation problem) that is threatening economic growth for the rate-sensitive private sector. In aiming to control and contort natural economic law by habitual use of unnatural and radical activist policy measures, policymakers have destroyed the conditions that make Goldilocks possible in the first place.
Nevertheless, hope dies hard. Despite the degenerative, self-defeating effects rapidly accumulating because of intensified policy malpractice, global institutional assets are still allocated according to confidence. Investors believe that policymakers will reconstitute Goldilocks again—and soon—through the use of even more radical policy alchemy.
HAI strongly disagrees, and is convinced that the Goldilocks era has already transitioned into a new era of Whac-A-Mole (at best), in which policymakers will have to choose to support certain vital economic variables by ignoring (if not sacrificing) other vital economic variables. In other words, we are past the point of being able to direct policy towards manifesting optimal economic outcomes (Goldilocks). We are left instead with only the ability to direct policy towards what is determined to be the least-bad outcome.
As previously discussed, regardless of exactly how policymakers prioritize economic variables and outcomes, gold is best positioned to benefit from the breakdown of Goldilocks. That said, the specific nature of new policy priorities amid a breakdown of Goldilocks becomes a larger issue for the outlook of other asset classes. The $64,000 question is, are we approaching a degree of clarity as to exactly how Goldilocks will unravel that permits us to increase risk in investments outside of precious metals? Perhaps.
This week, lets examine some recent clues as to how Goldilocks might break down, and tease out some implications for non-precious metal assets.
Let’s start with the latest US federal budget deficit data out this week. In its monthly budget review, the Congressional Budget Office (CBO) this week estimated that the fiscal first quarter budget deficit increased 20%, or $87 billion, from the year-earlier period. After adjusting for special factors affecting the timing of payments and receipts, the CBO’s adjusted deficit was actually $94 billion more than the year-ago quarter. These latest quarterly numbers now project at least a $2.2 trillion annualized deficit.
Alarmingly, this 20%+ increase in the quarterly deficit occurred despite the fact that tax revenues reported for the period were up 8%. While it’s good news for the growing fiscal crisis that revenues were up, it’s decidedly bad news that government outlays needed to assist the economy and stock market in generating higher government tax receipts were up even more. The government increased outlays by 12% in order to generate an 8% increase in tax receipts. That’s seriously bad deficit-busting math, and a sure-fire road to consequential fiscal ruin.
Given the latest budget numbers, this fiscal crisis/debt doom-loop dynamic appears firmly established at this point. If the government doesn’t deficit spend aggressively right now to keep GDP humming along, tax receipts will crater—as they always do in the recession that typically soon follows—and the deficit also blows out (rather than a 20% increase in the deficit, a recession could trigger a 100%, 200%, or greater increase in the deficit), as it always does in a recession.
Given that we are already at crisis-level deficits, however, doubling or more the deficit from here while digging out from a recessionary spiral would almost certainly escalate an insolvency emergency. It would smash the Treasury market and the currency, and usher in an acute sovereign debt crisis with potentially unthinkable negative consequences.
So, it appears that the government is now trapped in a spend-or-die predicament in which it increases outlays to avoid a crippling fall in receipts, but continues to fatten the deficit in the process. This, in essence, represents the slow path to insolvency as opposed to the explosive recessionary fast track. Given the latest budget data, HAI is willing to speculate that, at least through the election, government policymakers will continue to err on the side of a “controlled fiscal demolition” and the slow path to insolvency as apposed to risking the fast track.
Confirmation of an overall fiscal and monetary policy setting biased in that direction may come if, in addition to massive deficit spending and despite still-elevated levels of inflation, Jay Powell and the Federal Reserve do in fact proceed with rate cuts this year, as currently expected. Such a Fed policy pivot, if actualized, would provide strong confirmation that an inflationary “slow walk to insolvency” is the new policy. The pivot would indicate that the Fed is prioritizing the addressing of a worsening fiscal crisis over its official mandate of price stability.
If we assume that inflation (price stability) is the chosen sacrificial lamb, then the easiest way for policymakers to maintain economic growth—and by extension support tax receipts while also reducing government spending outlays—is for the Fed to cut rates. Lowering rates would stimulate the private sector economy that’s now struggling under higher rates, while at the same time reducing the interest component of government debt that is now over $1 trillion. In Whac-A-Mole fashion, however, sacrificing price stability would logically and likely entail re-accelerating inflation.
Make no mistake, letting inflation run hot is by no means an inconsequential decision at this point. Consider findings this week from the Federal Reserve Bank of New York. The NY branch reported that due to the high cost of living a record number of Americans are trapped in a credit card debt spiral. As more Americans are forced to turn to plastic to pay bills, simultaneously, a dwindling number are actually able to pay their credit card bills in full at the end of the month. As card balances total a new record of $1.08 trillion according to the latest quarterly report from the NY Fed, 49% of credit card holders carry debt from month to month, up from 46% last year according to a new report by Bankrate. If inflation is the first casualty of a breakdown of Goldilocks, expect this already unsustainable dynamic of more debt and less debt payment to accelerate dramatically, and economic instability to substantially accelerate right along with it.
Speaking of inflation, the latest Consumer Price Index (CPI) release on Thursday indicated that inflation is still well above the 2% target. For December, headline CPI was hotter than expected and rose by 0.3% versus the expected 0.2%. Annually, headline CPI came in at 3.4%, a result also hotter than the expected 3.2% increase. Excluding volatile food and energy prices, core CPI additionally came in hot. Core rose by 0.3% for the month and at a 3.9% year-over-year rate, compared with estimates for 0.3% and 3.8% respectively.
In short, CPI data remains stubbornly above target. That fact alone is of significant concern for the inflation outlook if the government continues the deficit spending binge and the Fed proceeds to cut rates. What’s even more concerning, however, is the recognition that CPI data remains stubbornly above target even as WTI crude oil prices have declined from over $95 per barrel in September to near multi-year lows under $73 per barrel today.
As HAI has long warned, energy prices are the great inflation force multiplier. If inflation remains stubbornly elevated today while energy prices are a disinflationary tailwind, expect a significant reacceleration higher in CPI when energy prices rebound. They will likely do so given the prospect of more deficit spending to prop up GDP, along with rate cuts to additionally stimulate the economy. A developing trend towards increasingly bullish oil price fundamentals could also soon contribute to further exacerbating that non-cooperative inflation variable.
While a turning tide towards bullish supply/demand fundamentals in the oil patch may be bad for inflation, it could present HAI with a much-hoped-for opportunity to increase investment allocations outside of the precious metals sector.
In HAI’s view, the long-term oil supply/demand fundamentals have been, and remain, exceptionally bullish compared to market expectations. This dynamic has been in place post-Covid amid chronic underinvestment in supply and overestimation of the success and speed of the green energy transition. The question for oil-related investments has been the potential short-term implications of a possible recessionary demand hit, along with any over-performance of short-term supply.
As Goldilocks breaks down, if government officials choose inflation as the lesser of two evils, we can expect short-term oil demand to hold up better than current market expectations. Simultaneously, the supply picture might also be set to underwhelm expectations. If so, we could be at a critical juncture in the energy market, and near a tradable bottom in energy investments.
For the last decade, shale oil production has been responsible for about 90% of global oil production growth. In 2023, oil supply from shale surprised to the upside. Energy analyst James West at Evercore ISI attributes the better-than-expected shale production to the lagged impact of higher rig counts in late 2022 and 2023, and a 19% year-over-year increase in spending. But with prices down considerably from 2022 and near the lows of 2023, West expects spending to remain flat in 2024 while the rig count has already fallen by 20% from year-ago levels. Meanwhile shale production decline rates are trending increasingly negative, including at the all-important Permian basin in West Texas.
According to geologist and oil market expert Art Berman this week, Permian and Eagle Ford shale recoveries have both fallen by 30%, and the Bakken has declined by almost 20% from peak. Combined, according to Berman, those shale plays accounted for two-thirds of U.S. oil output in 2023. As Berman put it, “That means that U.S. production will decline at some point in the relatively near-future… The wells are burning out. Oil supply—like life—is a marathon, not a sprint.”
Shale decline rates can be offset by aggressive investment in production, but if 2024 spending is flat, as James West anticipates, increasingly negative productivity decline rates will bite and crimp supply output.
If policymakers spend and cut rates in 2024 to stave-off recession, the demand variable is also likely to positively surprise versus current expectations. When higher-than-expected demand meets lower-than-expected supply in the context of a hostile OPEC+ and a geopolitical powder keg in the Middle East, we have potentially the most constructive energy market outlook since before Russia’s invasion of the Ukraine.
In the very short term, oil prices could continue to weaken as unfolding international dynamics risk a backup of U.S. energy exports that could flood domestic supply. If prices fall into the $60s per barrel range on these short-term oversupply concerns, however, it would likely represent a great buying opportunity in the energy sector. It could present an opportunity for portfolios to position in choice energy names expected to thrive as long as policymakers pull the inflationary policy lever.
If policymakers sacrifice the inflation factor, at least through the election, perhaps economic growth will continue to be supported in an attempt to slow-walk the fiscal crisis and deficit doom-loop dynamics now taking hold. This would be the path HAI has long described as inflationary fire. It’s a trajectory toward early-stage Austrian crack-up-boom dynamics, where, when it is well understood that higher inflation is policy, capital will seek alternatives to rapidly depreciating currency in the form of scarce hard assets with real value.
If the deficit spending spigot continues to blast full-bore at a $2.2 trillion annualized rate or more, and the Fed cuts interest rates despite inflation remaining well above target, we will know, almost definitively, that inflation is the poison policymakers have picked. If that scenario is confirmed in 2024, then perhaps we can press beyond gold as the only attractive investment at present, and discuss the potential of a meaningful and investable bottom in the works on the oil patch.
Weekly performance: The S&P 500 gained 1.84%. Gold was up 0.09%. Silver was almost unchanged, up 0.04%. Platinum dropped 5.22%, and palladium was down 5.65%. The HUI gold miners index was modestly higher, up 0.10%. The IFRA iShares US Infrastructure ETF was lower by 1.16%. Energy commodities were volatile and mixed on the week. WTI crude oil lost 1.53%, while natural gas surged 14.52%. The CRB Commodity Index was off by 0.58%, and copper was down 1.84%. The Dow Jones US Specialty Real Estate Investment Trust Index was up 0.25%. The Vanguard Utilities ETF was down 1.85%. The dollar index was nearly flat, up 0.02% to close the week at 102.15. The yield on the 10-yr U.S. Treasury lost 9 bps to end the week at 3.96%.
Have a wonderful weekend!
Best Regards,
Morgan Lewis
Investment Strategist & Co-Portfolio Manager
MWM LLC
