Basepoint's Chief Investment Officer (CIO) W. Allen Wallace presents valuable insights on the real-life scenario playing out right now in our global economy. The amount of liquidity that has been created by both monetary and fiscal policy is staggering throughout the world. Gain more knowledge on how Basepoint is positioned and why.
“Liquidity is important, but there is such a thing as too much liquidity,”
-Paul Volcker
Dear Family, Friends, and Clients,
Imagine playing Monopoly with a group of friends following a looser set of rules that allows negotiated transactions between players, but someone has brought 10 extra game sets and included all the additional money to be integrated into the game. In addition, one player has designated herself the right to take money arbitrarily from some players and give it arbitrarily to other players. Further, the property squares can be divided into infinite parts, and a small share of Boardwalk can be had for almost nothing. What do you imagine would happen to property and rental prices under these conditions? Let’s take this a step further and assume that 10 other games are playing simultaneously with varying amounts of money, and money from one game can be converted into another to buy assets on a neighboring game board. The conversion factors fluctuate frequently, and some currencies are very cheap, and other currencies are very expensive. The interest earned/paid on cheap currencies is low, and the interest earned/paid on expensive currencies is high. What do you think the consequences of this type of game would be, and what strategies would be most effective?
A real-life version of this scenario is playing out right now in our global economy, and the amount of liquidity that has been created by both monetary and fiscal policy is staggering throughout the world. If the amount of stuff available to buy remains relatively consistent, there is only one potential lever for creating equilibrium between a stable amount of stuff and substantially more money: higher prices. If increased liquidity can cause asset prices to rise significantly, it should be obvious what happens when this liquidity evaporates.
Market volatility has recently increased, and this article is an attempt to explain what is going on, and what the dangers are that may be unseen.
Our central bank sets short-term interest rates in an attempt to control both inflation and employment. They also use open-market operations to influence longer-term interest rates by buying and selling bonds in the open market, which controls the supply of money. This activity is called monetary policy, and over the past 111 years the Federal Reserve has been the lender of last resort in the United States. Other countries have their own central banks that independently try to manage the monetary policy of their countries, and in some cases, conflict can arise when economies are diametrically opposed to each other.
The most common measure of money in our economy is M2. M2 is comprised of cash, checking, savings and CDs, all of which can be easily converted into spendable currency on short notice.
As can be seen in the chart above, money supply has been steadily increasing since 1980, and had a very large spike during the Covid pandemic, and started declining when the Federal reserve began raising interest rates and stopped purchasing bonds in the open market. Note that the drop in M2 coincides with the 2022 market correction that caused a large decline in the price of long-term bonds. The point is that a steady perpetual increase in liquidity has stopped, and reversed, and liquidity is becoming harder to find, especially when interest rates are much higher than before.
You may have heard the term “carry trade” going back as far as 1990. A carry trade is when you borrow money in a cheap/low interest rate currency, and then buy assets in a strong/higher interest rate currency. Many times, this activity is performed by selling government bonds short to generate cash, and then converting the short currency into the long currency in FX markets, which is where traders exchange currencies.
For many years Japan has had very low rates and in some years deflation. This has caused a massive carry trade to accumulate with hedge funds and other large investors selling Japanese government bonds and then converting Yen into other currencies where high interest can be earned. Like many things that last for decades, investors became complacent, and did not pay enough attention to the risks involved in their strategies.
Last week the Japanese Central Bank raised rates for the first time in 17 years. This caused the interest cost on Japanese debt to increase and caused the Yen to rise against other currencies. This is a double-edged sword since not only is the cost to maintain the trade higher, the currency required to cover the cost is also more expensive. This is exacerbated when the trades also utilize large amounts of leverage in order to magnify profits.
It is estimated that more than $20 trillion is currently engaged in various carry trades throughout the globe. It is impossible to measure exactly since no official statistics are reported on this type of activity. The rising cost of the carry trade has forced some participants to sell assets in non-Yen currency and convert cash back into Yen in order to pay off Yen denominated liabilities.
This selling of assets in strong currencies to buy Yen creates a problem for carry traders. The demand for Yen causes further price appreciation, which causes more sales and subsequent Yen purchases. It is a self-fueling process that creates a feedback loop if not controlled. We are seeing this happen now as global assets sell off and previously strong currencies depreciate in relation to the Yen.
It is further impossible to know what exact securities carry traders bought with their converted Yen. It is highly likely that emerging market debt, stocks, and cryptocurrency are among the majority of assets involved in these trades. Cryptocurrency only requires a single leg currency conversion since crypto can be directly converted into Yen instead of having to pass through another currency in the process. Emerging market debt is characterized by high yielding coupons, and much of it is dollar-denominated, which is a reserve currency, has been very strong lately, and is highly liquid. Stocks are very long duration assets and have been appreciating significantly for years. It is likely that some of the artificial intelligence boom, especially the rise of NVIDIA, has been fueled by carry traders.
The Fed and carry traders are in a precarious position because it is an election year, and because the stock market is incredibly high and very concentrated.
At the end of 2023, 27% of the S&P 500 was concentrated in 10 stocks, the majority of which are highly dependent on Artificial Intelligence. In mid-2024, this concentration reached almost 35%. This is a very dangerous position for 401(k) investors who have very limited choices in how they allocate their assets, and to the 55% of investors who are currently utilizing passive investment strategies. If this unwind of carry trade positions continues, we may see large losses in EM debt, US Large Stocks, and Cryptocurrency.
There will be calls for the Federal Reserve to cut interest rates to stem market declines. Unfortunately, this may be the worst thing to do because this will weaken the Dollar in relation to the Yen and will perpetuate the unwinding. It is possible that a rate increase would be necessary to stop the unwind, but the political climate will most likely not allow this, and it will further put pressure on asset prices. It is also completely possible that this blows over in a couple of days and we all forget about it until the next time. It is way too early to make any changes based on these limited fluctuations over the past week, but the circumstances are definitely present for this to greatly increase in magnitude. We are continuing to monitor the situation, and we are positioned in a way to profit from large dislocations, if they occur.
How does this impact portfolios managed by Basepoint:
The portfolios managed by Basepoint have lower equity exposure than normal due to market conditions, and we have very high cash positions. We have very little exposure to large technology stocks, and we do not utilize the S&P 500 in our portfolios. We have positions across the capitalization spectrum, and we do not suffer from the large concentration that most portfolios see where 35% of their equity allocation is in 7 holdings. We increased our fixed income duration over the past year so a decline in interest rates would be helpful. We have very limited credit exposure, and defaults or expansion in credit spreads will cause little damage to our results, but we would see spread expansion as an opportunity to increase yields. We have increased international exposure, but have continued to limit emerging markets equities, and we have no exposure to emerging markets debt or high yield debt.
We continue to hold gold and silver, which may be negatively impacted over the short-term by carry trade unwinding.
We are currently maintaining our positions. If equity prices fall significantly, we will deploy cash into stocks. We will not base purchases on percentage of decline, we will base equity purchases on earnings yield in relation to the 10-year treasury bond. We will be looking to almost double the 10-year yield before significantly increasing equity exposure. We will have our eyes on the large cap technology space and will look to deploy capital here if compelling prices present themselves over the next few months.
We are ready for this type of volatility, and it is when our discipline shines. The more prices drop, the better our future returns will be, but we will not be cavalier with your money, and we favor patience over bravery, and logic over emotion. We have been through this before, and it will happen again. Almost everything that we own generates real cash flow, and cash is king when liquidity evaporates.
As always, if you have any questions, or want to see where you stand, do not hesitate to reach out to your wealth advisor, or me personally.
Warm Regards,
Allen
This article is for informational and educational purposes only and is not an offer to sell or a solicitation of an offer to buy the securities or instruments named or described in this report. The charts, graphs, and formulas included are not intended to be used by themselves to determine which securities to buy or sell, or when to buy or sell them. Such charts and graphs offer limited information and should not be used on their own to make investment decisions. Decisions to buy or sell a position should be based on an investor's investment objectives and risk tolerance and should not rely solely on this report. Investments involve risk and unless otherwise stated, are not guaranteed. Be sure to first consult a qualified financial adviser before implementing any strategy discussed. Supporting information related to the recommendation, if any, made in the research report is available upon request. Past performance may not be indicative of future performance.
The information in this report has been obtained from sources believed by Basepoint Wealth, LLC to be reliable and accurate. We cannot guarantee its accuracy, completeness, and validity and cannot be held liable for any errors or omissions. Any opinions or estimates contained in this report represent the judgment of Basepoint Wealth, LLC at this time and are subject to change without notice.
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