The world is a very volatile place right now, both socially, geo-politically, financially and with the added flavor of a virus pandemic. It is difficult to keep a clear head in the moment which is not helped by the continual cycle of fake news and misinformed emotional opinions.

It is very difficult to actually verify everything you hear and read about, but this is the reality of the situation we find ourselves in. If you spend the time to build your own market thesis, it will generally serve you well, so long as you invest the time and effort to be thorough. However we all have a time problem and thus a full understanding is hard to come by.

What I have always hoped for in my time working with RSC is to provide you with my honest distilled thoughts about on what is going on. We can never know if these ideas are right until it plays out but I certainly try my best to understand the realities so as to provide a rational insight and ideally a useful input to your own mental models.

Today I want to provide you with my current thinking about how I am position myself for the current market conditions and some high level theories I have running through my head. Remember that you must take this as my personal opinion only and not any form of advice. I am not trained in markets and despite my best efforts, I can and will be wrong.

Where are we?

We are currently in a period of consolidation / relief rally after the dramatic sell off in global markets. This particular sell-off has been the fastest of any recession in modern history, eclipsing the pace of the 1929 Great Depression.

One reality that I am considering as my base case is that the immediate future is more likely to be 1929 style than 2008 style. I strongly base this opinion from the work by the clever folks over at Real Vision who also consider this the more likely outcome.

The chart below shows an overlay of the current market compared to the 1929 for the Dow Jones index. History doesn’t repeat buy it often rhymes. If you subscribe to this model, the trend has just started.

This is a scary prospect and as a result, my approach is to plan for the worst, hope for the best. I consider job security as a new and uncertain variable for many and thus all actions must be conservative as the next 12 months are a great unknown for us all.

The opportunity cost of being on the wrong side of history and being over leveraged and having your capital destroyed by continued sell off is not a desirable outcome. I view it as better to sit on the sidelines and miss any ‘relief rally gains’ in order to preserve capital until a trend is re-established.

What is driving this market behaviour?

There are a few drivers behind this with the following forming dominant parts of my thesis:

The virus – This one is obvious as it has disrupted both supply and demand lines and put global economies into stasis. Different jurisdictions are taking different approaches to managing the virus with a common theme of closing down business, physical contact and essentially reducing consumption to zero. This is compounded by lack of quality information and conflicting perspectives. It leads to pure uncertainty which is now being priced in.

Initial Deflationary shock – As markets break free from suppressed volatility bull markets and ‘all is good’ sentiment, there is a flee to safety in cash. In particular the USD as the fear of not being able to pay back debts which are denominated in USD becomes the driving factor. When credit is paid back, money is effectively destroyed (a feature of fractional reserve banking). USD is also the currency that commodities are priced in being the global reserve asset. Thus we see all other currencies sell off in favor of the USD.

This leads to a deflationary pressure, particularly on assets which lose significant value against the dollar. The Dollar index (Ticker DXY) is the best way to track this phenomenon as a gauges for risk on/off in a macro sense and coincides with the inverse of drops in the equities markets.

Deleveraging of debt – Interest rates have been effectively zero since 2008. Money is cheap and risk is plentiful. Companies borrowed extraordinary sums, bought back stocks, enriched the board and investors and are now seeking bail outs. Governments have established running deficits that exceed production by extraordinary levels and Central Banks are unable to reduce their balance sheets without tanking markets.

There is literally no breathing room left. We are saturated in debt and it is impossible to pay it back. The only option left is devalue the currency and print the debt smaller. Long term this is almost guaranteed to result in widespread inflation.

Whilst the virus is the pin that popped the bubble and potentially shifted this from a recession to a depression, corporate debt is the real bombshell. In 2008, it was household debt that imploded. This time, it is corporate debt on a much larger scale as a result of a decade of cheap money.

I believe the market has now priced in the virus. Markets know that supply and demand lines are disrupted and that the world is now working from home. What I do not believe has been priced in is the collapse of business as a result of debt obligations and the need to pay the piper. Many business models (especially early VC startups) are destined to collapse (WeWork comes to mind) which further deleverages their creditors. Debts are written off, jobs are lost and creditors come under increased pressure. This to me feels like the catalyst for the next leg down. The domino effect of who owes who as defaults start to roll in. Combined with massive derivatives, options and insurance knock on effects, we (the world) have no idea how far reaching and deep the impact will be.

Stimulus packages – The central banking solution. We are rapidly moving into a world of Modern Monetary Theory (MMT) which now feels inevitable. The volume of currency being printed is literally in the multiple-trillions on an almost weekly basis. We have just seen over $6Trillion approved for injection into the US markets with claims to do ‘whatever it takes’ and calls for the Fed to exercise its infinite balance sheet. This is the approach across much of the western world with central banks following suit in most major currencies.

The East may be dropping the USD

In last weeks article we looked at the amount of gold being accumulated by China and Russia in particular whilst the West is largely selling off their gold. China is also the top global producer with Russia coming up close third. There is also reports that China and Russia are now net sellers of US treasury bills as their reserve asset, swapping T-bills for gold bars.

Check out this video below on the progression of top gold producers since 1900. Snips below show how China and Russia have grown from rank  3 and 7 to rank 1 and 3 respectively since 2002.

I personally speculate that the East is attempting a long standing and coordinated drop of the USD as the global reserve currency. There are three key assets in the world as part of this game of chess:

Gold: Historically the soundest money, converged on by every society through to recent history. It is the original decentralised, sound money, just not as immutable for the average individual as Bitcoin.

Oil: This is the means of production. It underpins modern industry, transport and manufacturing. Russia recently strong armed OPEC and initiated an oil price war which also put USA shale oil (a debt riddled industry) into unprofitable territory.

Credit/Money: The USD global reserve and access to credit markets. This is Americas biggest export, access to financial markets, money and leverage. The cost of doing business is the Triffin dilemma where managing demand for credit both domestically and internationally eventually tears the reserve currency apart.

The chart below shows the history of the global reserve currency since the 1400’s as it shifts through Portugal, Spain, Netherlands, France, UK and finally to USA. Each lasts around 80 to 100years, the USD, at 110 years young, has potentially reached expiry.

If the East succeeds in deploying a new gold standard and the USA continues on its almost guaranteed path of MMT printing, the East can just sit tight and watch gold explode higher. No gold suppression scheme will contain its price and we already see Bullion markets drying up globally.

Under a theoretical Eastern gold standard currency, USD denominated debts will be paid back at a fraction of their present value. It would fundamentally undermine the USAs primary export, credit money. This makes me extremely bullish on gold but also extremely concerned with what the side effects of this are. In a perfect world, we end up back on the gold standard of sound money. In reality, I do not expect the USD will go down without a fight.

I believe gold should be a hedge in everyone portfolio right now, it certainly helps me sleep at night as a store of value with immense liquidity and network effects.