The Beginning of the End Part II: The Return of Inflation

…the use of money in the capital markets is a potential repository of inflationary potential. Monetary inflation invariably makes itself felt first in capital markets, most conspicuously as a stock market boom… Virtually all, and not merely a proportionate part, of the excess money demand created by a monetary inflation goes temporarily into the capital markets… A boom in capital prices which exceeds the growth of real capital values and is not accompanied by falling prices in national product is an inflationary danger signal of the first order.” Jens O. Parrson, Dying of Money

Investors are giddy again with delight at the markets’ performance this year in the face of an aggressive Fed tightening cycle. The current belief, in contrast to last year, is that there will be no recession, inflation is going away, a new bull market in stocks has begun, and the Fed will eventually pivot and begin to cut interest rates. If there is a recession it will be mild and brief so the markets can only go up from here.

This bullishness is reflected in capital flows into stock funds, bond funds, and ETFs. According to a recent WSJ article, “America’s Retirees Are Investing More Like 30-Year-Olds,” older Americans keep rolling the dice in the stock market, ignoring conventional wisdom to protect their nest eggs. Vanguard reports that investors age 55 and older have 70% of their portfolios in stocks, and one-fifth of investors 85 and older have nearly all their money in the market. Money is also pouring into bond funds with investors ignoring duration risk or the lack of risk premiums in bond yields. Money is flowing into passive index funds and day trading is making a comeback. In the words of one investor quoted in the same article, “I don’t like cash and I don’t like bonds. Both are losers’ games when it comes to inflation.” Investors remain blissfully unaware of the inflationary depository they are helping to fuel and the risks that lie below the surface. What the markets don’t expect and are not prepared for is the return of inflation.

Upon its creation, money can follow one of three paths. It can be held as cash, channeled into investments, or used to purchase goods and services. For inflation to occur, three factors come into play. The first is the amount of money produced by the Federal Reserve and the banking system. The second is the velocity of money, or the speed at which money is spent and circulates in the economy. The third is the supply of goods or tangible assets. Among these three factors, only one is directly manageable by the government. If inflation emerges in the other two areas, a corresponding adjustment in the money supply is necessary to prevent inflation from escalating.

As Milton Friedman observed, inflation is always and everywhere a monetary phenomenon, a pattern that has held true throughout history. Not only is the government one of the main causes of inflation, but also stands as its principal beneficiary.

I would now like to present my reasons for predicting the resurgence of inflation. In my view, there are seven key factors that will pave the way for a significant increase in inflation. These factors include:

  1. Fiscal policy
  2. Monetary policy
  3. The war economy
  4. Resource scarcity, especially in oil and base metals
  5. Reshoring and reindustrialization
  6. BANANA greens & ESG
  7. De-dollarization and resource encumbrance

Fiscal Policy

What we are witnessing across the globe is fiscal spending and debt issuance by governments at an unprecedented level. As demonstrated by the chart below, there has been a substantial surge in government debt issuance and spending since the onset of the Covid pandemic.

us national debt
Source: U.S. Department of the Treasury. St Louis Fed (annotations added by FSWM)

As of this writing, we have now already surpassed $32 trillion and will likely end the year over $33 trillion. The pace of debt accumulation we are currently seeing is astonishing but makes sense when you look at the spending bills over the last several years listed below (note: cost estimates may vary based on methodology and assumptions):

  1. CARES Act, March 2020: $2.2 trillion
  2. Consolidated Appropriations Act, December 2020: $900 billion
  3. American Rescue Plan Act, March 2021: $1.9 trillion
  4. Consolidated Appropriations Act (Part 2), December 2021: $1.4 trillion
  5. American Rescue Plan Act (Part 2), March 2022: $1.9 trillion
  6. Inflation Reduction Act, August 2022: $500 billion

Additional spending and supplemental bills:

  • FY 2022 Omnibus Bill: $625 billion
  • Infrastructure Law: $370 billion
  • Honoring our PACT Act: $280 billion
  • Snap (Food Stamps): $280 billion
  • Health-Related Executive Orders: $175 billion
  • CHIPS and Science Act: $80 billion
  • Ukraine Supplements: $55 billion
  • Student Debt Relief: $700 billion

The nation’s national debt stood at $22.7 trillion in 2019. It has risen by $9.7 trillion since that time to $32.4 trillion in just a few short years. In addition to spending, we must now add interest on that debt which is now greater than spending on our entire military. As the Fed continues hiking interest rates, government interest expense will rise and become a larger portion of the government’s budget. Trillion-dollar interest expense will be upon us soon as nearly one-third of government debt comes due in the next 18 months. Given the big jump in interest rates, US debt that was previously issued at historically low rates between 0.10-0.50% will now be rolling over at rates ranging between 4-6%. With $32.4 trillion in debt, and quickly rising, you can see the dilemma the government faces over the next several years.

When considering the above, rising debt and interest rates will likely bring to the fore “fiscal dominance and the return of zero-interest bank reserve requirements.” This is according to a recent research paper published by the St. Louis Federal Reserve. It states:

Under current policy and based on this report’s assumptions [government debt relative to GDP] is projected to reach 566% by 2097. The projected continuous rise of the debt-to-GDP ratio indicates that the current policy is unsustainable…

The essence of fiscal dominance is the need for the government to fund its deficits on the margin with non-interest bearing debts. The use of non-interest-bearing debt as a means of funding is also known as “inflation taxation.” Fiscal dominance leads government to rely on inflation taxation by printing money.

The paper outlines how this could be brought about by a failed Treasury auction where there are no offers to buy the government’s debt. This then forces the Fed to resort to printing money as an alternative. This is highly inflationary and lies directly in front of us.

Monetary Policy

One of the main factors besides fiscal spending that has brought about the return of inflation is monetary policy. As shown in the graph below, the Fed’s balance sheet exploded with the onset of Covid. The Fed’s balance sheet grew from $3.8 trillion in 2019 to a peak of $8.965 trillion by April of 2022, an increase of 136% in just three years. In addition to a growing balance sheet was the fact that the Fed kept interest rates at 0% on the Fed funds rate from September of 2008 to April of 2022, with a brief blip between 2016 and 2019 when Yellen and Powell tried to normalize interest rates. Low interest rates and moderating inflation, called the “Great Moderation,” fueled the bull market over the last decade and was responsible for the heady market returns during the Covid lockdown as the government and the Fed spent trillions into the economy.

fed balance sheet
Source: Fed Board of Governors

The Fed will once again be forced to do the same—lower interest rates and print money—once fiscal dominance becomes the only way left for the government to finance burgeoning deficits, all of which will be highly inflationary.

Foreigners basically stopped financing US debt in 2014 which brought about regulatory changes that year to the banking system and money market funds, making it more favorable to hold government debt as reserves. This is one reason banks are sitting on hundreds of billions of losses in their bond portfolios which caused the bank runs and failures of several banks this year. Yellen herself predicts more bank consolidations are likely ahead of us.

Deficits are now running at a $2-3 trillion annual rate and with the global financial system moving away from a dollar-based system it will become more difficult for the Treasury to finance government debt, which will usher in fiscal dominance with the Fed basically financing government deficits.

The War Economy

Let’s now move onto the global stage. The low inflation world of the last decade was largely due to three factors:

  1. Cheap immigrant labor keeping service sector wages low
  2. Cheap goods from China
  3. Cheap energy

That has now ended with a shortage of workers, which is keeping the unemployment rate low and leading to upward pressure on wages. Energy prices, I believe, are likely to remain high and rising, and are no longer cheap for Europe or the US. The emerging trade wars with China and reshoring will lead to higher costs in the production and manufacturing of goods as countries diversify from China as the lowest cost provider.

In his War and Industrial Policy report, Zoltan Pozsar eloquently expresses that the current state of affairs between the West and the East can be best described as a combination of a "Cold" and "Hot" war. The "Hot" war can be exemplified by the conflict in Ukraine, while the "Cold" war primarily manifests as an economic battle. Pozsar argues that this scenario will necessitate significant financial investments from the West in order to emerge victorious in economic warfare. This will involve re-arming (to defend the current world order), reshoring (to get around potential chokepoints and blockades), restocking (expanding production in key commodities), and rewiring the grid as we move through an energy transition.

Pozsar’s four themes will become the defining aims of industrial policy which will be implemented over the balance of this decade. These themes are:

  1. Commodity intensive
  2. Capital intensive
  3. Interest rate sensitive
  4. Uninvestable for the East

These themes possess inflationary tendencies and, in accordance with my beliefs and the perspectives of others, are likely to contribute to what is commonly referred to as a new "Commodity Super Cycle," driven by resource scarcity where demand consistently outpaces supplies. This cycle is expected to exert a significant influence on investment trends throughout the entirety of this decade.

Resource Scarcity

As mentioned above, rearming, reshoring, restocking and rewiring all require resources to build and maintain. This will be occurring while natural resources and critical minerals will be in short supply due to resource depletion, lack of investment, falling inventories, and ESG and BANANA (Build Absolutely Nothing Anywhere Near Anybody) Green policies that make it difficult to mine or explore for oil. There simply aren’t enough natural resources to accomplish all these goals.


In the realm of energy, productivity in shale basins is experiencing a decline, with major basins in the United States already reaching their peak and only the Permian basin remaining, albeit with decreasing well productivity as producers shift to less productive tier 2 wells. Experts predict that the Permian basin is nearing its peak within the next two years. This situation is of utmost importance considering that US shale has been responsible for 90% of global oil production growth over the past decade.

Among the 55 oil-producing countries or regions worldwide, 46 have already surpassed their peak production by more than five years. Consequently, only nine countries remain to compensate for the declining production and meet the future demand for energy, which is necessary for economic growth. It is crucial to acknowledge that this impending scarcity of energy will result in a substantial increase in costs throughout this decade and beyond.

Depletion and Discoveries

As a result of ESG and BANANA Green policies, mining and energy companies have pulled back considerably from investing and exploring for oil and minerals. Furthermore, major discoveries in key minerals as well as oil and gas have been declining each decade. As the graph below illustrates, the majority of the world’s oil discoveries occurred during the 50s and 60s with a brief spike in the 80s with North Sea and Alaskan oil.

oil discoveries by decade
Source: ASPO

Since that time there has been a dearth of new discoveries with very few elephant-sized oil field discoveries since the early 80s. This also holds true for key metals needed for the green energy transition from copper, silver, to nickel.

As S&P Global recently stated, “Elevated copper exploration budgets over the past several years has not led to a meaningful increase in the number of recent major discoveries… With copper demand expected to outpace refined copper production, the industry is not making enough new, high-quality discoveries to support the long-term pipeline.”

Copper and Nickel Inventories at Multi-Decade Lows

Copper nickel inventories
Source: Bloomberg, Financial Sense Wealth Management

Silver Inventories at Multi-Year Lows

silver inventories
Source: Bloomberg, Financial Sense Wealth Management

The green transition will require more energy to mine the required minerals for manufacturing Electric Vehicles (EVs), wind turbines, solar panels, and for the expansion of the electricity grid. Those minerals will be in short supply, and in many cases, there simply won’t be enough to meet the demand needed to make this transition. I will cover this topic in depth in my next article.

Suffice to say for now, inventory levels from copper, nickel, silver to cobalt and lithium are in short supply. This will translate into higher energy and mineral costs which will only add to the inflationary impulses working their way through our economy.

Reshoring and Reindustrialization

One lesson learned from the lockdowns was the risk of depending too heavily on a single nation such as China for global manufacturing. Since the beginning of the 21st century, China has established itself as factory of the world and nearly monopolizes the production of vital minerals, like rare earths, which are essential for the green transition.

“More than 95 percent of rare-earth materials or metals come from, or are processed in, China. There is no alternative,” defense giant Raytheon chief Greg Hayes warned this week. “If we had to pull out of China, it would take us many, many years to reestablish that capability either domestically or in other friendly countries.” (Source)

Western countries have experienced higher costs and supply disruptions in everything from appliances, computer chips, to pharmaceuticals. Consequently, Western nations are currently undergoing a reshoring or nearshoring shift, whereby manufacturing operations are being returned or moved closer to home. It began with the Chips & Science Act of $80 billion to spur chip manufacturing here rather than rely on Taiwan, the primary manufacturer of critical chips used in a vast array of products ranging from missiles and cars to refrigerators, iPads, and iPhones.

In April, Jake Sullivan, Biden’s national security advisor, laid out plans for a new industrial policy that would invest public funds in sectors essential to economic innovation and national security –such as semiconductors, critical minerals, and energy—alongside public goods like infrastructure. The reshoring process was initiated with the enactment of the following legislative bills (note: cost estimates vary slightly according to methodology and assumptions):

  • Inflation Reduction Act (Green New Deal): $500 billion
  • Infrastructure Law: $370 billion
  • CHIPS and Science Act: $80 billion

Unfortunately, a government directed industrial policy is fraught with political opportunism, corruption, waste, and inefficiencies, which will only drive up costs more. It was tried in the 1970s and failed. Regardless of how this plays out, the US and the West will have to rebuild their industrial base and start making things at home. It will cost more to make things here due to higher labor rates, much stricter environmental laws, and misguided energy policies. However, reshoring is necessary, and will be a part of the ongoing economic war now being waged between the US and China. This will add one more factor that is going to drive up costs and inflation.

BANANA Greens and ESG

Another factor driving up costs and inflation is environmental policies, which through regulation and policy mandates is making it difficult to drill for oil and natural gas, mine strategic metals or build out a reliable grid necessary to power the green transition. Instead of mining the necessary resources to reindustrialize and transition away from fossil fuels, the US is consistently banning or halting mining projects across the country.

From the federal Administration to governors of blue states, laws are being enacted that obstruct the extraction of vital resources. At the same time, mandates are being issued in states like California, where I reside, that prohibit the sale of gasoline-engine cars by 2035, while also decommissioning nuclear, coal, and natural gas power plants that furnish the crucial baseload power for a dependable electrical grid. The focus is being shifted solely onto intermittent power sources like wind and solar, which is increasingly burdening the grid.

It should not be a surprise then that California utility rates and gasoline prices are among the most expensive in the nation. Not to mention, the numerous power outs in California and elsewhere as reliable electricity is being replaced with intermittent and less reliable power from weather dependent sources.

Efforts to establish a new mine, conduct exploration and drilling for oil and natural gas, or construct a new nuclear power plant often face timeframes spanning 10 to 20 years, if they are permitted to proceed at all. While our leaders emphasize the existential threat posed by climate change, by inhibiting drilling and mining domestically, we are essentially outsourcing our green transition to China and OPEC. By preventing the mining of crucial minerals, the drilling for new oil and gas, and the construction of nuclear power plants, we are delaying our green transition and driving up costs. The regulatory obstacles, delays, and bans on resource extraction will only increase our dependency on countries with whom we are in competitive conflict.

De-Dollarization and Resource Encumbrance

For many years, the BRICS (Brazil, Russia, India, China, and South Africa) have held discussions around the creation of a new BRICS-led currency, possibly even linked to gold, which could act as an alternative to the US dollar in trade. Moves along these lines were accelerated in 2022 when Russia invaded Ukraine and the West responded with heavy sanctions and cutting Russia off from international finance.

The BRICS countries are now set to meet a little over a month away in August 22nd at a major summit in South Africa where they will be taking up this topic. There is much speculation as to whether any official announcement will be made—some members saying that this is more of a medium to long-term ambition vs. an imminent development—but it is clear that the winds are shifting in this direction.

There are a few reasons why a BRICS-led currency is becoming more widely discussed. First, the collective amount of resources and land mass between these countries is massive. Second, is economic weight: BRICS countries now represent a much larger share of global GDP than in years prior with some measures showing that they have now overtaken developed economies. Third, the increasing geopolitical rivalry and conflict between the US and China—and particularly as it relates to the Russia-Ukraine war at present—bolsters the case for alternative trading networks immune to any potential disruptions.

Outside of currencies, there is another element to the growing influence of the BRICS-led coalition, which is resource encumbrance. China is strategically securing the resources it needs via long-term trading contracts with Gulf state producers, which means that oil will no longer be available for the West at low prices. In exchange for these resources, China is investing hundreds of billions in development in Gulf state economies replacing the US policy of “oil for arms” with “oil for development,” which fits in perfectly with the Belt and Road Initiative and Saudi Arabia’s goals of moving beyond crude oil to more advanced petrochemicals.

If this new coalition is successful, it will encumber 80% of the world’s oil reserves with Russia, Iran, and Venezuela accounting for 40% of the world’s oil reserves with the remaining 40% in OPEC.

Whether it’s oil, gasoline, diesel, jet fuel, or petrochemicals, the West will be paying more for energy. This is going to make oil more inelastic as China—the world’s second largest economy—will get more of OPEC oil at a discount, and OPEC and China will be exporting more downstream products made from oil earning higher margins on oil resources.

This is one of the largest macro developments I can think of in our lifetime. Not since August of 1971 has anything of this consequence taken place in global financial markets. When Nixon took the dollar off gold backing, eventually leading to the petrodollar, the US was in a position to dominate global markets and trade with the dollar as the world’s reserve currency. It has been up until now a unipolar world. If we inflated or depreciated the dollar, other countries had to deal with the problem. Before the US could say, “The dollar is our currency, but it’s your problem.” But now, according to Pozsar, the BRICS countries are quickly replacing this by saying, “Our commodity, your problem. Our commodity, our emancipation.”

What will this mean? Geopolitics is now highly inflationary and the stage is set for a series of non-linear shocks to the financial system. All of this, I believe, is strongly bullish for commodities as an investment this decade. It is my belief, and that of my firm, we are about to witness the commodity bull market of our lifetimes. This is, in my opinion, the next macro megatrend in investments that will dominate this decade. The good news for investors is that it is still in its early stages, and very few see it coming. Full disclosure: we are long inflation and commodities.

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