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Podcasts from Confluence Investment Management LLC, featuring the periodic Confluence of Ideas series, as well as two bi-weekly series: the Asset Allocation Bi-Weekly and the Bi-Weekly Geopolitical Report (new episodes posted on alternating Mondays).
Welcome to the Confluence Investment Management biweekly geopolitical report. I'm Phil Adler. Are Trump tariffs working as the administration expected? Confluence advisory director Bill O'Grady joins us today to unpack the Trump strategy and give us some advice about dealing with extreme market volatility and risk. Bill, you've titled your report the Besant Gambit, referring to the treasury secretary, and I imagine the word gambit was carefully chosen.
Phil Adler:It suggests a strategy to suffer present losses to achieve ultimate gains. Are you saying that what seems chaotic to us now, the pain caused by tariffs, government cutbacks, the aggressive foreign policy, these are all creating volatility in the markets but are part of a well reasoned plan.
Bill O'Grady:Yes. Although I would say there's a difference between well reasoned and well executed. I think the administration has a definite end goal they're trying to achieve, which is fundamental restructuring of the global financial system. Getting to that end point is going to cause some degree of volatility, and that is clearly being signaled by the administration. There is an element of sequencing here that is important.
Bill O'Grady:If one isn't careful, you trigger outcomes you don't want because you didn't enact policies in the best order. But to be fair, knowing how to create an order for policy that you can politically do is difficult.
Phil Adler:Well, Gambit also does suggest risk, even the risk of losing everything. Is that accurate in this instance?
Bill O'Grady:Well, it's possible. In fact, the changes to the underlying structures always entail significant risk. When Nixon closed the gold window in 1971, it was thought at the time that the dollar would no longer hold its reserve currency status, and the chaos that emerged would never get resolved. And to be fair, it took over a decade to resolve the end of Bretton Woods. But in the end, The US created a new global financial system that's arguably fostered the strongest growth in global trade in human history.
Bill O'Grady:But success is not inevitable. Hindsight suggests there were numerous mistakes during that period that were made. This may be the key, however. When Nixon hit in Bretton Woods, it became clear that the system in place was unsustainable, and so something had to be done. The political turmoil in The US suggests to me that we're at a similar juncture.
Bill O'Grady:However, we would note that whether or not the time for making changes is short or not isn't obvious. I believe that 02/2008 was a clear signal that we needed to address the issues of debt, the global financial system, and hegemony. Clearly, subsequent administrations didn't agree with me as none really moved to address the problem. But when the interest on your debt exceeds your defense budget, it's probably a good sign that the problem needs to be addressed.
Phil Adler:So, Bill, is debt then the key issue that Bessent and the Trump administration have identified that warrants all these new policies that have been so disruptive?
Bill O'Grady:I think there is a difference between what is advertised and what is perhaps the core issue. I have identified US debt as what is unsustainable. That debt growth is, I believe, a direct result of the US dollar being the reserve currency and even more importantly, US treasuries and to a lesser extent other US debt being held as the reserve asset. Foreign nations were given an incentive to structure their economies to under consume and oversave and use that resulting excess goods and services to export to US to acquire the reserve currency and the reserve asset. Foreigners did this for a number of reasons.
Bill O'Grady:In some cases, they wanted to industrialize and they wanted the domestic saving to build this investment. In other cases, they were scarred by events such as the Asian financial crisis and wanted a backstop of foreign reserves to prevent another crisis. But in any case, this has led to unsustainable level of debt in The US. It has also led to American deindustrialization, which is a serious risk in a world where geopolitical tensions are rising. So to fix the debt problem, The US needs to fix the reserve asset issue.
Phil Adler:Well, is there something sharply different about this debt situation today compared to times in the past when The United States had to wrestle with this issue?
Bill O'Grady:Well, some things are different while others are similar. What's different is the origins as I discussed before, but all debt overhangs are resolved with some party bearing the cost of resolution. What Bissent is crafting, it appears, is to reduce debt growth by changing the incentives for foreign governments to undersave. And to deal with the current debt overhang, Bassent tends to levy the costs on foreigners.
Phil Adler:Bill, you spent a good deal of time in your report exploring the origins of the debt problem, and you narrow the causes to two factors. One is income inequality. It looks right now that the middle and lower income consumers are hurt most by tariffs and higher prices. How might tariffs address income inequality?
Bill O'Grady:Well, if more production returns to The US economy, labor demand will rise. It will also quite likely reduce profitability. So in the short run, there's a risk that price levels will rise due to the tariffs and other trade impediments. In the long run, if production returns to The US, this negative factor could be offset by stronger labor markets. Another issue that we're watching carefully is the potential for a secular decline in profitability.
Bill O'Grady:If labor is advantaged, either consumer inflation must rise a lot or profitability will fall. Unless, of course, Basen is successful in getting foreigners to bear the burden. We note that there have been headlines suggesting major US retailers are telling their foreign suppliers to absorb the tariffs, meaning they are actually paying the cost of the tariffs.
Phil Adler:The second factor you identify is the role of the dollar in treasury securities in the international finance system, which you've already discussed in part. In your report, you spent some time explaining how we arrived at the present situation where the dollar is the world's reserve currency, and countries who export to The US buy US treasuries with the dollars they accumulate. This has created an ongoing trade deficit. Now are tariffs meant to weaken the dollar and unwind this process?
Bill O'Grady:Well, tariffs are designed to reduce imports. Although the usual explanation is that tariffs raise the cost of imports and that reduces the trade deficit. In reality, tariffs should reduce consumption with less domestic savings. The dollar is a different issue. Often tariffs lead to a stronger currency as foreign governments engage in policies to weaken their currencies and thus offset the tariff.
Bill O'Grady:But that isn't always how it works. As we noted in the last question, we could see tariffs reduce profits, which would tend to weaken the dollar. A weaker dollar would accelerate this process.
Phil Adler:Are tariffs also meant to reduce US consumption to the extent that a recession might be a necessary part of the Besant gambit?
Bill O'Grady:Well, they are designed to reduce consumption, but a recession isn't a foregone conclusion. Investment could rise, and that could help The US avoid a downturn. But it does appear the administration is prepared to accept a recession if necessary.
Phil Adler:Bill, another part of the Bessent plan may include creating a long duration bond with very low interest rates that foreign countries would be directed to buy to avoid higher tariffs. We have discussed this possibility in prior Confluence podcasts. Do you think it is still part of the overall plan?
Bill O'Grady:Oh, very much so. Remember, foreign governments want to acquire dollars in their reserve asset, which is treasuries. The century bonds are designed to make that activity less attractive.
Phil Adler:Another part of the plan may be to revalue gold assets held by the treasury that are now valued, your report says, at $42.22 an ounce. Revaluing that to present day levels over $3,000, would make our debt situation look a lot better, good enough perhaps to support further tax cuts. Is there a danger to doing this?
Bill O'Grady:Well, strictly speaking, no. The asset is held on the treasury's balance sheet and simply recognizing the gain as an accounting measure. But it would buy some time for the administration to reduce treasury borrowing and likely lower long duration interest rates.
Phil Adler:Well, looking at the Trump Bessent plan in its entirety, what are the major risks?
Bill O'Grady:Well, being a glass half empty guy and one who also notes the glass is often dirty too, I think a lot about this. Here are some of the potential pitfalls. Foreign governments may balk at the century bonds and try to maintain the current system. This may force other measures such as taxing foreign buying of treasuries. Exchange rates are driven by sentiment.
Bill O'Grady:If the administration is successful in weakening the dollar, it could become too successful and trigger a reflexive downtrend that could become difficult to control. Inflation, I think, is a major risk. Globalization has been a key in reducing inflation over the past three decades. Unwinding globalization will almost certainly lead to higher price levels. Now it's important to recognize that this low inflation came at the cost of deindustrialization.
Bill O'Grady:So the inflation is a policy choice in rebuilding America. And finally, there may be unexpected follow on policies. What brought a new reserve system after Britton Woods was Paul Volcker's type monetary policy that was unanticipated. What could come out of this new policy? Well, we don't know either, but I wouldn't be surprised to see capital controls be implemented or the Fed be forced into yield curve control.
Phil Adler:Markets do not like uncertainty, neither do corporations which must invest for the long term. Do you think the Trump administration might suffer from a credibility challenge that would increase uncertainty and stifle the economy?
Bill O'Grady:Well, this would fall into the previous question, but from the standpoint of execution, uncertainty raises the risk that firms reduce capital projects and consumers delay major purchases. It's not necessarily result of the policies themselves, but in their execution. In other words, if the administration isn't completely sure what they want from tariffs, that could be a problem. It's kinda like this. If you want terrorists to act as a revenue source, then you really don't necessarily want trade to decline.
Bill O'Grady:An example of unexpected consequences we note is the situation state governments found themselves when they started sharing benefits from the tobacco companies as part of the legal settlement. Suddenly, they realized that they needed smokers to continue their bad habit to continue to receive the funds from the tobacco companies. If tariffs are designed to reduce the trade deficit, then they probably don't raise as much revenue and almost certainly will be inflationary. If you want tariffs to give you leverage in negotiating foreign defense spending or in trade policies toward China, then tariffs might be seen as a threat or merely as temporary. We have seen all these reasons rolled out, but my sense is that the administration isn't completely clear on what they actually want.
Bill O'Grady:In earlier podcasts, you might remember the Tinbergen problem, which states that you need an equal number of policy tools for an equal number of policy problems. One major risk is that the administration seems fixated on one tool to to fix many problems.
Phil Adler:Bill, do you think that economic pain, which may be caused by the tariffs, could be sufficient to defeat Republicans at the polls before any of the potential benefits could be felt?
Bill O'Grady:Well, it's clearly a risk, which probably explains why the administration is moving so quickly. What Reagan proved is that if you're going to have a recession, have it early in your first term.
Phil Adler:You do address investment implications in the face of all this uncertainty in your report. Should we expect at the very least a weaker stock market and rising inflation?
Bill O'Grady:Well, inflation is my primary concern. The equity situation is complicated. If a recession develops, we'll almost certainly see a weaker stock market. One future risk is that the restructuring of the economy and the global financial system could result in a secular decline in profits. On the other hand, as we discussed in last s allocation biweekly, equities have proven to be a good store of value, and thus, we can't count out a good stock market with rising price levels.
Bill O'Grady:And then there are the effects of uncertainty on actual physical investment. If policy is going to lurch violently from administration to administration, firms really can't make long term investment decisions easily. That could harm the economy over time.
Phil Adler:For investors, are treasuries a good alternative?
Bill O'Grady:Well, it probably depends on the duration. With recession risks elevated, long bonds have a certain appeal. If century bonds are well received, we could see long duration yields decline significantly. But for inflation protection, shorter duration treasuries are probably a better long term alternative.
Phil Adler:Bill, you suggest cash and gold are effective hedges this time around. Confluence has been advocating gold for quite a while. I remember back when gold was around $1,700 an ounce. So that recommendation certainly looks good now. But my question is, is gold now simply at a level where future gains will probably be minimal?
Bill O'Grady:Well, cash is always attractive because it buys an investor optionality. It gives one the wherewithal to buy when asset values decline. Gold, on the other hand, is a different matter. As we discussed last year, the factors that traditionally were used to value gold no longer work. If there is part of the world that's going to leave the dollar treasury reserve system, gold is likely going to be the reserve asset.
Bill O'Grady:If that's what's evolving for nations outside The US block, gold probably has more upside. I'm thinking that's actually what we're seeing evolve. You also continue to favor foreign defense stocks, and that recommendation also looks wise. Confluence made it well before this year's healthy rally in these stocks. Does it look like there are more gains yet to come?
Bill O'Grady:Well, I think so. The rapid commitment by European nations to boost defense spending looks like it's just getting started.
Phil Adler:Are there any other groups of stocks you feel good about?
Bill O'Grady:We will be taking a serious look at overseas stocks in general along with smaller capitalization stocks domestically. These areas have lagged large cap growth stocks for years, but we may be finally getting to the point where they have the makings of a sustainable rally.
Phil Adler:Finally, Bill, is there a way to frame this entire situation with useful guideposts for investors?
Bill O'Grady:Although there are a number of potential historical analogs, the one that might fit best is Nixon's end of Bretton Woods. The US was in a difficult spot, and the solution could change everything. Investors in the nineteen seventies struggled to figure out how to adjust their portfolios. What worked in the sixties didn't work at all in the nineteen seventies. And chair Volker's response to dramatically tight monetary policy was completely unexpected.
Bill O'Grady:Thus, investors should exercise care. We are in a period of high uncertainty.
Phil Adler:Thank you, Bill. This week's report is titled the Besant Gambit, and you can find a link to the written report on the Confluence webpage, conflenceinvestment.com. Today's discussion is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. Also, this information does not constitute a solicitation or an offer to buy or sell any security.
Phil Adler:Our audio engineer is Dane Stoll. I'm Phil Adler.