Crises & Bailouts

We started the year bullish. It seemed to us that it would be difficult to have a recession with wholesale gasoline below $2 per gallon and interest rate cuts along the way. We did note one caveat at the end:

Stagflation is the big concern that we see. If the economy is weak and inflation is high, things can get very ugly. The Fed can't come to the rescue by printing. Perhaps that is what Warren Buffett is thinking about, the 1970s stagflation parallels. But it is hard to have stagflation with a plummeting oil price! 

We now have the opposite of a plummeting oil price, and interest rate cuts are no longer in the cards. In fact, we are on the verge of stagflation.

Trump is begging Iran for a deal to reopen the Strait of Hormuz and Iran is refusing. They have him cornered. By closing the strait they are forcing the world to burn through several million barrels per day of reserves. Trump threatens but doesn't dare attack Iran any further because of the damage Iran can do by retaliating against the Gulf states' energy infrastructure. 

We have not had a credit cycle or financial crisis since 2008. It seems to be the case that you can prevent something like 2008 if you are willing and able to do bailouts.

In 2008 the government was caught off guard by the real estate speculation and how that interacted with opaque mortgage securitizations. There was also a false sense of security because real estate prices had never declined on a nationwide basis. (We had a variant view because we had a front row seat to the excesses of the sunbelt real estate bubble.) So, the government was "unwilling" to bailout, but mainly because they did not realize how bad it was at first. Ultimately they nationalized the problem with the Fed balance sheet.

Now the government is certainly willing; look at Powell's bailout of the economy in 2020. Trump & Co. would happily run the printing press even to prevent a 5% market decline. But you can reach a point where the bailout that is needed cannot be delivered because of its size in relation to GDP. The U.S. debt/GDP has doubled since the GFC (60% -> 120%).

One of the things that stays with us from Trillion Dollar Triage was the head of the NY Fed's market desk saying that what was "most frightening" during Covid was that "Treasury yields were spiking higher at the same time that equity markets were plummeting."

The warning sign for another financial crisis would be if bad things happening (whether geopolitical or equity market declines) made bonds go down.

We are seeing some of that with the Iran war. The ten year bond yield (TNX) had fallen below 4% prior to the Iran war, and is now 4.62%. On Friday (May 15th), the S&P was down 1.2% and the ten year yield was up 8.5 bps. (Bond price down almost 1%.)

Our guess of Buffett's thinking is that he has been predicting stagflation. Inflation-beneficiary "croupier" businesses at 30x earnings will not work if higher interest rates cause their valuation multiples to get cut in half.