What’s Next

Yet something alerted him; he pricked up his ears and stopped, rooted to the spot, feeling a vague sense of unease.

Faithful Ruslan, Vladimov, 1979

THIS IS NOT INVESTMENT ADVICE. INVESTING IS RISKY AND OFTEN PAINFUL. DO YOUR OWN RESEARCH.

The Fed is now on a path to get ahead of the building economic weakness. We are on the cusp of one of the bigger monetary easings since Volcker. That’s good for assets and I am long.

I am tracking the rate at which the economy slows against the rate at which the stimulus works. This dynamic will play out against the backdrop of a US election and an unnerving geopolitical backdrop, both of which can swing markets meaningfully. While the press this week was understandably focused on exploding pagers, I am watching the gradual worsening of the internal situation in Russia and China. A good portfolio needs to balance all of these risks.

Here is what I imagine happens next.

1. US growth stabilizes, unemployment rises, Fed cuts a lot. Now that the Fed is easing, we watch the dials on the dashboard—growth, inflation, unemployment. The key variable in the equation—what is the right rate of interest—is unknown and unknowable. Think about that. The most important interest rate in the financial system (the rate that balances supply and demand) can’t be precisely measured. It could be 1%, it could be 3%. It’s priced now to be 3% but can easily be lower. We know a 3% real yield (5.3% policy rate and 2% inflation) was too high, high enough to asphyxiate parts of the economy–real estate, small business lending, the IPO market–and  drive up unemployment. Because the Fed moved quickly, the economy probably doesn’t slow much and the private sector is responsive to easing. I suspect 12 months from now stocks are higher and real yields lower.

2. Harris wins.   The Fed decision was driven by economic conditions, not politics. It is however true that the cut is favorable to Harris. The election will come down to a few tens of thousands of voters in swing states and the polls basically say “toss-up.”  My prediction of a Harris victory is based on the fact that a) Harris has moved (a little unconvincingly) to the center on energy, Israel and diversity b) abortion is a clear dividing line, with Harris and the majority of the American public on one side and the Rs on the other and c) she is new (though not really) and Trump is old and novelty is worth something. The differences between them in terms of a) tax policy and b) foreign policy mean that financial markets will swing on the outcome.   (Yields up under Trump and down under Harris).

3. No major policy changes.  If Harris wins, she will try to raise taxes on the rich. This would be bond bullish, particularly if AI and outsourcing of service jobs (accountants, admins, software engineers, designers) globally is as deflationary as I think it will be. As I said, inflation could sink quite a bit lower. However, polling data suggests R majorities in both the House and the Senate. If Harris is President and Congress is R, little gets done. That means the government keeps borrowing at 5% of GDP and Fed cuts stimulate the private sector. If Trump wins and there is R control of Congress, there could be a meaningful tax cut, deficit widening and sharp rise in bond yields. In sum, lower bond yields, with real yields lower and discounted inflation a little higher. That’s positive for inflation linked bonds.
4. Taiwan gets dangerously murky. A Harris victory increases the odds of a confrontation with China. In part this is because the two leaders will have trouble finding a common language—one is a young (relatively), female Californian lawyer, the other is a male septuagenarian faux-Maoist Princeling.  If you pay attention, Xi’s playbook for China borrows from Putin’s for Russia. I took note that Xi forbade foreign adoptions, just like Putin. I’ve seen Russian and Chinese orphanages first-hand; forbidding the adoption of these kids is cruel, plain and simple.

The basic Putin/Xi plan is:

• concentrate power by focusing on an outside enemy, the West and “corrupt” people at home
• bathe the domestic population in propaganda
• eviscerate local opposition, be it political or in the business community
• launch a foreign war to consolidate a, b and c, then repeat.

How does Xi do “d”? Fights with the Philippines over unoccupied reefs might be a dress rehearsal for Taiwan. Perhaps a blockade of Taiwan conducted by commercial Chinese fishing vessels and unarmed Coast Guard? This would disrupt the tech supply chain and cause a global crisis. I suspect China is studying Ukraine and trying to figure out how to force Taiwan to give up their sovereignty without resorting to the economic self-immolation Russia is undergoing.  An outright, D-Day style landing seems unlikely. Russia once looked down on China. Now China looks down on Russia. Changing fortunes.

5. Russia closes its borders. Russia is now un-investible for Westerners, but the economy still matters because that is what feeds the war machine and a bad enough economy risks a descent into disorder inside Russia, which will rattle global markets. Weak oil prices—courtesy of China’s de-leveraging—are a problem for Russia, as is the fact that perhaps as much as 1% of the Russian population has died or been injured fighting in Ukraine. The manpower shortage combined with a surge in defense spending is resulting in high (9%) inflation and a central bank that cranked up interest rate to a cool 19%. Think about how much damage 5% policy rates did in the US.

Businesspeople are both starved for capital and even the middle-aged are being summoned to the local draft board and having to bribe their way out of going to the front. The nation’s talent fled in 2022, the day after the invasion.  Stashes of dollars are as valuable now as gold was in 1930s Germany.

If the economy is frozen and thousands of Russians are dying at the front each day, the only way for Putin to maintain control is to further tighten control. He is already locking up anyone who even makes a social media post about the war and arresting nomenklatura for alleged corruption (note the playbook I mentioned early on). He likely needs to tighten control even more, perhaps by closing the border to any but “reliable” citizens, a softer version of the Soviet Union.

The US and Britain have not given permission to Ukraine to use their missiles to bomb deep inside Russia, which continues a theme—dating all the way to George W Bush turning a blind eye on Russia’s 2008 seizure of northern Georgia—of reluctance to directly confront Putin. The West is trying to give just enough aid to Ukraine to stop Russia, but not enough to cause nuclear war. Sanctions are a part of that and, like monetary policy, they work with a lag. Putin is banking on a paralyzed US Congress that can not agree on further aid.

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