Key Takeaways:

• AI continues to drive markets, but current valuations may be difficult to justify over the long term.
• Rising interest rates remain the primary risk to markets, making diversification and disciplined portfolio management more important than ever.
• Our focus remains on preserving recent gains while positioning portfolios for sustainable long-term growth.

I’ve written in these pages before about the K shaped economy and how 70% of the US GDP is consumer spending.  Of that spending, the lion’s share is the upper crust—among them, Camelotta clients—who are able to own and participate in the financial markets.  It’s easy for us to be complacent and forget that the norm for most in the economy looks flat or worse if we inflation adjust it—the downward leg of the K.  If the AI trade fizzles out or slows down, then you might see this elite consumer group pull back on spending which would have a major impact on US and global economic growth.

We want a horse in the race, but we also don’t want to have only one way to make money. Our response is not to abandon innovation or attempt to call a market top. Instead, we are broadening portfolio exposure, reducing concentration risk where valuations have become extreme, and maintaining the flexibility to participate in future opportunities without becoming dependent on a single investment thesis. 

Last quarter our international holdings performed just as well as the S&P 500.  I see more potential for future profits in terms of the cheapness of the companies (compare their price to revenue multiple of 2 to SpaceX at 100), the types of businesses, and the continual weakening of the dollar.  You may have noticed how popular Japan has become as a vacation destination.  This is because the Yen is the weakest it has been since 1986.  Given that they have one of the most severe baby shortages in the world, they have swaths of unoccupied housing.  All of this means you will likely start hearing about people moving to Japan as a retirement plan!

The biggest threat to the current success of stocks is the specter of higher interest rates.  The new Fed chair indicated that they are biasing more towards raising rates before the end of the year.  In addition, there is weak demand for US Treasuries.  During Covid, the US budget deficit ballooned more rapidly than ever before.  To finance it, the Treasury borrowed enormous amounts in short duration bonds.  Interest on the debt balance is now the largest expense paid by the US government; more than defense.  The Covid bonds are coming due and, rather than pay them off, the US intends to refinance them with more bonds.  Anyone who refinanced a house during 2021/2022 knows that the interest rates available then are impossible to obtain now.  Tariffs, sanctions, and protectionism have led foreign governments to store funds in other currencies.  The petrodollar agreement no longer exists; to entice buyers, new bonds will need to offer much higher interest rates. It’s sobering to imagine the tax rate it would take to compensate for the higher cost to refinance this debt.

Adding to the pressure, the Iran war could also raise rates.  There are countries locked behind the Strait of Hormuz who have not been able to ship oil and gas.  Still other consumers of hydrocarbons are paying higher prices and dip into savings to buy it.  These savings are held in US Treasuries and what oil producers and consumers have in common is a need to sell US Treasury bonds for Dollars and when bond prices go down due to selling, the interest rates to reissue the bonds go higher.

The first domino to fall was the United Arab Emirates. Rather than deal with the interest rate spike from a major central bank selling US treasuries, the US extended a swap line enabling them to borrow Dollars in lieu of selling bonds.  This instance alone is fine however it sets a precedent.  Qatar is next in a line of countries asking for the same credit facility.  In doing so the US government itself is essentially borrowing to extend these dollars to them.

Who can we find to purchase US Treasuries?  This market is giant: 10 times larger than the stock market.  This leaves one major pool of money large enough to make an impact: Chinese savers - they have a large savings glut caused by a collapse in their real estate market a medical system that is problematic and has strained local budgets.  The problem facing a Chinese saver is that they have limited real estate investment options and, moreover, there is a legitimate risk of capital confiscation.  Therefore, many would love to push their money outside of the country however it is illegal to transfer more than about $50,000 per year outside of China.

Trump made a very strange and hastily put together trip to China during Q2.  Not only that, but he also took some of the most prominent American business leaders with him.  This was not simply to demonstrate American financial success, but rather to solicit these Chinese investors to put money into the United States. You might ask, how can they do that if it is illegal?  Well, the answer is a new financial construct called Stablecoin.  These are like Bitcoin with the added feature that they are backed by US Treasuries. 

The Chinese government seems to be looking the other way when residents purchase stablecoins.  If this remains true, then, in theory we have a mechanism linking Chinese savings to the US Treasury market.  It’s no coincidence that they recently passed the law in the United States that a major stablecoin offerings must be secured with US Treasury bonds.

The upshot is that we need to keep an eye on the oil price.  As this crisis wanes and oil prices drop, the pressure on US Treasuries should ease.  However, if oil sticks at high levels and countries continue to have trouble funding their fuel budgets then you could see increasing pressure on the bond market.  This could pose a serious risk similar to 2022 where all assets sold off—the worst market in a century for asset allocators.  I would say that this is a tail case and it’s not likely to become a major issue.  Outside of this, we will increasingly hear stories about this Treasury funding failure and the efforts by the US government to fix it.  We have a very workable game plan, should this play out.

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