Getting A Grip On Geopolitics

Summary

• Long-term geopolitical trends matter for investors.
• Tom Luongo paints with all the colors of the geopolitical landscape. It's a potentially bleak picture, but there are opportunities if you know where to look.
• Like Russia, which has a lot going for it, as Tom points out.

Mr. McGuire: I just want to say one word to you. Just one word.

Benjamin: Yes, sir.

Mr. McGuire: Are you listening?

Benjamin: Yes, I am.

Mr. McGuire: Plastics.

--"The Graduate"

In the iconic film, "The Graduate," Mr. McGuire, a family friend, drops this famous piece of investing advice at Benjamin's college graduation party with all the confidence of Floyd Mayweather in the boxing ring. Now, we don't know if Mr. McGuire actually knew what he was talking about, and no one can predict with any certainty what the "next big thing" will be, but we can theorize and hope to make some money on our ideas.

Ask Tom Luongo, an ardent watcher of geopolitics, gold, silver, world banks and currencies, and he'll tell you he believes Russia is rife with opportunities for investors. Yes, Russia. We won't give away the whole punch line, but stick with us til the end of the interview, and find out why Tom is such a strong believer, like Mr. McGuire was in plastics.

The author of Stocks, Shocks & Rocks, Tom gives us the lay of the geopolitical land and the world economy; discusses where gold, silver and currencies are telling us the market is headed; offers his take on the Qatar crisis in the Gulf; and shares what's keeping him up at night from a geopolitical standpoint.

Seeking Alpha: Oil continues to struggle, even as bulls like those at Barron’s call for $60/barrel prices or higher. You cover energy from a macro geopolitical perspective. From your standpoint, what’s impacting energy and the stocks you cover today, and what is most crucial for investors to pay attention to in terms of how those factors may help or hinder their strategies?

Tom Luongo, author of Stocks, Shocks & Rocks: The first thing to consider with respect to oil (and gold, copper, silver) is that deflation is still the order of the day. The central banks can only prop up asset prices for so long by ever more unconventional means. The ECB has become the BoJ, the buyer of last resort of sovereign debt. They are running out of debt to buy, much like the Fed did during QE III/IV. They had to stop buying because they’d nearly reached their statutory limit. The ECB is in the same boat now, and will either have to change the rules, again, or end the bond buying. My guess is they will change the rules to widen their net, but that will be a signal to the market that they don’t have an answer to the problem. They don’t have an answer, but the market still believes it does… for now.

So, Barron’s is crazy to think we can have $60 per barrel oil when clearly, we are dealing with increasing supply growth and slowing demand growth.

Oil, in particular, is suffering on the supply side from the double-whammy of new technology in both fracking and offshore lowering extraction costs along with lower financialization costs of properties that have been sold for a fraction of their previous price, which is deflationary, and lowering the break-even price for many wells into the $30s.

Add to that the existential need for countries like Saudi Arabia to pump to keep their revenues up as they continue to pour money into the abyss of their primary budget deficit. In opposition, Iran can and will expand output, especially if the Saudis keep making aggressive noises. Russia holds cards there as well.

And, as I’ve covered in recent articles on Seeking Alpha both for my subscribers and publicly, this current drop in oil prices has happened against the backdrop of a falling US dollar. We’re looking at the beginnings of the next up-leg in the dollar bull market, which will only add to deflationary forces, not just because the Fed will attempt to shrink its balance sheet and raise interest rates, but because of the insane amount of foreign owned dollar-denominated debt out there, at last count over $10 trillion (BIS quarterly review), that will have to be serviced at effectively higher prices as the dollar rises.

Do you really think the global economy will be able to grow with that kind of drag on it? Because that’s what it will take to send oil over $60 per barrel. I can see a path to a boom, but I’ll address it in a later question.

SA: Qatar and the Gulf are obviously a hotbed of crisis. Do you see any imminent resolution to that? Again, how are the difficulties there impacting energy stocks, and what risks does this present for investors? Any ideas on how investors can mitigate some of these risks?

TL: No, I don’t see an imminent solution to the situation in Qatar, despite Sec. of State Tillerson going over there Monday July 10th to try and pressure a solution. As I wrote in a public article for S/A, Crown Prince Mohammed bin Salman is the key figure and he is the architect of the Saudis’ aggressive foreign policy. To see what he will do in Qatar, look to Yemen. The war there was his idea. It’s a disaster.

The Saudis can’t afford that war, but bin Salman refuses to sue for peace.

I also don’t see this situation affecting anything supply-wise short of a shooting war in the near term, but neither the U.S. nor Russia want that and bin Salman exists at our sufferance at this point. So, he’s not going to invade Qatar to wrest control of the North Dome/South Pars gas field as some have suggested.

Instead, he will continue to pressure the rest of the GCC to isolate Qatar. But the longer this goes on, the more opportunity Qatar will have to wiggle out from underneath the effects of the sanctions. Notice how the 13-point ultimatum was ignored by Qatar and then nothing of note happened after the deadline?

Bin Salman’s position along with the House of Saud becomes more tenuous the longer this goes on without them getting what they want from Qatar. Loss of prestige within the GCC, due to shoddy leadership, may see the knives come out. This may hasten the collapse of the Saudi government, but I wouldn’t put that on 2017’s calendar. As economic conditions worsen thanks to political and financial unrest in Europe, oil prices will continue to slide and that, along with his multiple blunders, could bring about regime change sometime in 2018, however.

For now, energy stocks are nonplussed by the situation. They have a supply and demand mismatch that is far more important.

If the situation does not change for the better and the U.S. does not materially help Qatar avoid the worst of the financial blockade by the GCC, then expect Qatar to de-peg the riyal from the U.S. dollar if only to ensure that can diversify its reserves to reflect its future business. If that were to happen under duress due to the U.S. backing the Saudis’ play, which is less likely today than last month, then I would consider a long on the MSCI Qatar ETF (QAT).

SA: Is there anything else keeping you up at night from a geopolitical impact on investing standpoint?

TL: Yes. Where to start? It centers around European and U.S. politics as it pertains to Russia. My read on geopolitics is not in alignment with that of the U.S. press and Washington D.C. think tanks. So, salt my response here to your taste.

We have made mistake after mistake in attempting to destabilize the Russian Federation through regime change (Ukraine) and proxy wars (Syria). Putin has countered them all and, like the judo master he is, reversed the aggression to weaken our position in Eastern Europe, Central Asia and the Middle East.

With every little victory that Putin has notched up, the U.S. foreign policy establishment has upped the stakes. Trump understands a lot of this but, to what extent, I don’t know. Trump has his work cut out for him. Vladimir Putin may wind up being his most valuable ally in his attempt to right the ship of the U.S. state. And their meeting the other day at the G-20 was, indeed, a great start.

Russia is only our enemy because we make it out to be so. Putin is fighting a war of attrition against an American Empire that is up to its eyes in debt. He would rather not fight us, but work with us. The problem is to fix what’s wrong with the U.S. government means upending the power structure in D.C. and Wall St. and that’s not going to happen easily, if at all.

My worry is that Trump fails to get control of the inner workings of his administration and is betrayed both by his own impetuousness and his political enemies, which puts us on a collision course with Russia.

The Obama/Clinton policy was designed to push Russia to the brink of nuclear war and then get Putin to submit out of common decency. This is what would finally win them a gas pipeline into southern Europe, break up the BRICS, and eventually gut the Russian Federation.

Yes, I really believe that. And it is what keeps me up at night.

Because a staunch nationalist like Putin sees this more clearly than I do and will be pushed only so far before responding. The war of attrition Putin is playing is designed to wear the U.S. out and allow it to collapse on its own.

Trump is trying to broker for us the best deal he can, geopolitically, while figuring out a path to a Grand Peace Bargain for the Middle East with Putin. Both men understand that the U.S. and Russia have to be the guarantors of peace to get the secondary players – Israel, Iran, Turkey, Saudi Arabia, Hamas – to behave and allow tension to dissipate.

Germany’s Angela Merkel is caught between these two men trying to hold together an EU that is fundamentally flawed thanks to the euro, and is rapidly approaching its crisis point. Unfortunately, Merkel is the wrong person for this job.

So from an investing standpoint, one needs to realize the long-term trends are in place (short of all-out war with Russia, in which case, I suggest toilet paper and antibiotics). Gazprom (OTCPK:OGZPY) will continue to gain market share in Europe while supplying immense amounts to China.

The Russian economy will boom in 2018 and beyond regardless (or because) of U.S. sanctions. Along with Iran and Turkey, they will begin looking east to Central Asia as they back China’s desire to stabilize the region from the former Soviet ‘Stans to Pakistan through its One Belt, One Road project. Putin and Xinping are thinking 50 years ahead.

Our time horizons have shrunk to early next year.

So, there are tons of opportunities in this region from Kazakhstan to Pakistan. The EU is trapped and the euro is doomed because of its flawed structure. We’re seeing panic buying in the euro now after a couple of major bank failures. That will likely fade before the summer is over, if it hasn’t already.

I think investors should be hedging this uncertainty with a sizeable cash/cash-equivalent position. Cash-equivalents are gold, silver to a lesser extent, cryptocurrencies like Bitcoin/Ethereum.

For foreign investors, I can only tell you, buy dollars while you can still get them cheap.

SA: You also cover precious metals and currencies. What opportunities are you currently watching in those sectors, and why? Again, from a macro perspective, what are the cautionary flags investors should watch out for?

TL: In short, I think we are in the lull period before the storm. The ECB can’t continue to play games and it began a panic stampede into the euro. All year the central banks have been talking down the dollar while the Fed raises rates. It’s bizarre.

But it makes sense if there is a mountain of debt that cannot afford a rising dollar along with favorable moves in yield spreads between U.S. dollar and local currency debt. For this reason, foreign central banks have been loading up on U.S. Treasuries held in reserve, liquid, with the Fed.

The U.S. dollar has been sold, in my opinion, far too much this year. The euro is overvalued, so is the pound. German pensions are collapsing, just like in Illinois and Connecticut. Demographics are catching up with government promises.

And that’s the signal for the next crisis to unfold - a loss of confidence in government institutions designed to keep everything running.

Gold, silver and oil are signaling deflation is still the dominant theme and the market is finally realizing the Fed is serious about raising interest rates.

This all plays into a thesis of a market terrified of dollar liquidity concerns.

The U.S. yield curve is widening since the last Fed rate hike. The 2/10 spread has moved 21 basis points in two weeks. I feel we are getting close to a bottom in the USDX.

What I’m expecting is a sharp reversal in all of these markets in the next few weeks. Gold and silver may be in the process of bottoming here, but could still collapse if the dollar spikes. The euro is topping. I’ve made no bones about being short the euro. The recent run up in the pound has that looking vulnerable. So is the Canadian dollar.

SA: We’ve had two rate hikes so far this year, and the Fed forecasts one more in 2017 and 3 in 2018. Do you expect the Fed to stick to the plan, and either way, what’s the impact on gold in your view? Which currencies are you watching closest as we enter (potentially) a tightening cycle?

TL: I do expect the Fed to stick to their plan because they 1) do not want to be blamed for an equity bubble, 2) because they want to have room to cut rates when the economy turns down thanks to a stronger dollar and 3) they need to shore up the pension systems domestically with higher yields.

Do I think they should stick to that plan? As an Austrian-style economist, yes. Because I want bond yields to reflect real risk assessment and 2.4% on the 10-year U.S. note is not adequate compensation. But, compared to German Bunds, it’s a steal. And that’s the point.

This will put sincere upward pressure on the dollar unless the Fed stops paying interest on excess reserves, around $2.2 trillion. But that is the main way the Fed is recapitalizing the banks still dealing with issues from the 2008 crisis. They haven’t fixed any of that. There’s still $1.76 trillion in worthless mortgage-backed securities on the Fed’s balance sheet.

Gold will get caught in the backlash, if it isn’t already, of collapsing dollar liquidity for all of the reasons I outlined earlier. But really, I feel the macro-picture is bleaker than I’ve painted it so far. Gold needs another collapse in price to take out the rest of the bulls who can’t see what I’m talking about.

In a liquidity crunch gold gets sold first because it trades in the forex markets without discount, you know, because gold is still money.

But along with a collapse in dollar liquidity will be a real debt crisis. And that will puncture what’s left of the faith in central banks and government promises. And at that point, Gold and Silver will take off like a shot, just like they did in 2009 when the Fed embarked on QE.

We are rapidly approaching an inflection point. We just need a catalyst to set things in motion. But right now, gold and silver are telling us something is definitely not right.

SA: You represent your areas of focus this way in your profile: “...publishing my thoughts on where markets, central banks, gold and geopolitics meet and explode.” Can you explain what that means, and how it applies to your work on Seeking Alpha, and in particular, within your Marketplace service, "Stocks, Shocks & Rocks"? What can readers expect from you? How do you go about “decrypting” the news for subscribers, and how does your input add value for investors?

TL: The world is awash in information. Everyone speaks but very few people actually say anything of importance. Geopolitics, central banks and gold are all joined at the hip of the grand confidence game that is modern banking. By mixing an Austrian economist perspective on the distortions made by central banks and government to markets with a pragmatic look at the changes in the geopolitical landscape happening with ever-increasing frequency, I try to lay out for investors what these changes mean and why they should or should not worry.

To be honest, the Austrian Business Cycle Theory mixed with geopolitics makes for a very powerful investment tool. It helps decode the geopolitics into expected policy measures. We’ve had deflation since 2007. Nothing’s changed because the Fed refuses to allow the money it printed to flow. M2 Money Velocity is at an all-time low. And it won’t improve unless the Fed unlocks the $2.2 trillion in excess reserves by no longer paying interest on it.

If it does that, it risks a massive inflationary event that Mises would call a “Crack-Up Boom.”

From an investing perspective, my job is to de-stress my subscribers by giving them insights into these events and relate them directly to my investing theses. For example, I identified back in 2014 that Russia reacted to its currency crisis perfectly. For my previous subscriber base at Resolute Wealth, I put them in the Van Eck Russia ETF (BATS:RSX) at the bottom of that crisis. I also doubled down on Gazprom (OTCPK:OGZPY).

After that, it was a matter of explaining the geopolitical maneuvers as either bullish or bearish for them. But I also did this with the understanding that they would own these stocks for the next 10 years or more. Geopolitical events like that make for big investing decisions.

When the next gold bull market starts the same thing will occur. We’ll buy the very best exploration stocks where my track record is north of 80% and we’ll ride them up the bull market to insane returns.

But at the same time buying perfectly-placed blue-chips, like Gazprom and Royal Dutch Shell (RDS.A), to pay substantial yields and give you the option of deploying the cash to reinvest or take a speculative bet on a penny gold stock is the right way to build a portfolio.

Cash in a crisis is what makes you brave. It keeps your stress low and your options high.

SA: On somewhat of a personal side note: You have a penchant for coming up with clever names. Your Marketplace service is called “Shocks, Stocks & Rocks,” and your Patreon-sponsored monthly newsletter is called “Gold, Goats n’ Guns.” Those don’t sound like your run-of-the-mill finance-focused publications. What was the impetus behind these interesting monikers, and do you have a hidden history in advertising or marketing we don’t know about?

TL: I don’t have a hidden history in advertising, but I am a professional writer first and financial analyst second. Both names come from a bit of advice I was given in a college poetry workshop by one of the great poets of the 20th Century, Donald Justice, who said that all good lists are three items long.

I’m an iconoclast and a contrarian and a lover of language. I raise dairy goats and am a libertarian politically. Gold Goats ‘n Guns is a metaphor for being your own central bank. Gold represents your savings, your “pool of real savings/wealth.” Goats are the metaphor for your industry, how you deploy savings to build wealth and then save more. Guns are the metaphor for how you protect your savings and your investments.

Stocks, Shocks & Rocks is what I do at Seeking Alpha. I look for stocks while navigating the shocks to the financial system and feel the best way to make money doing that is through commodities and precious metals, since they are the markets most directly affected by big changes in geopolitics.

SA: What’s your top investing idea right now, and what’s the story behind it?

TL: One word. Russia. Putin has built Russia the way I would have. Low taxes, shrinking bureaucracy, low debt and a focus on building an internally strong and diverse economy not reliant on cross-border currency flows. Russia imports very little and exports its excess commodities. The ruble will become an important regional currency for the Eurasian Economic Union.

The Russians have de-dollarized their economy to a great extent and have the means by which to survive any global financial crisis. They won’t go through it unscathed but they are in a better position than many to weather the storm.

The Russian economy is moving into a new generational bull market. The Bank of Russia has been too conservative in lowering interest rates and that is why the yield curve is a mess. Expect interest rates to be down near 7% by year-end.

There is also so little Russian debt on the market, the spreads are high.

Expect a concerted effort to professionalize the banking system and deepen Russian financial markets over the next five years. Putin is serious about eliminating bureaucratic corruption and his interest in using Ethereum blockchain technology to remove the petty bribery and unaccountability within the Russian bureaucracy is real.

In the event of a crisis, expect Russia to be a haven for some international capital flow from Europe and Japan. Credit expansion in Russia is entering the virtuous portion of the cycle so the timing is right alongside an EU sovereign debt crisis. Most of the money will flow to the U.S. and Switzerland, but some will leak away to Russia because of its strong political position, improving rule of law and low capital start-up costs. A weak ruble/USD pair will only help these things.

Lastly, Russian diplomacy is ascendant. Putin and his Foreign Minister Sergei Lavrov are putting on a two-man show of Dale Carnegie’s “How to Win Friends and Influence People.” That will pay the Russian people and, by extension, the economy major dividends well past the time either man is still alive.

This thesis only gets stronger if Trump and Putin figure out the Grand Bargain for Middle East Peace.

***

Thanks to Tom for joining the Marketplace Roundtable. You can read his work on his profile, or check out Stocks, Shocks & Rocks on a two-week free trial, and only $349 a year if you decide to sign up.

Sign up for the SA Marketplace Roundtable above or below to get all of our roundtables in your inbox. We have authors launching new services weekly, and we are going to explore a few other interesting topics and formats over coming months. Plus, it's a great way to stay on top of Marketplace developments.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Tom Luongo owns physical gold and silver, and is invested in EUO.