David R. Kotok, August 25, 2024

(The following was published on The Kotok Report website and via LISTSERV. For details, visit https://kotokreport.com/.)

Bill Kennedy is a regular invitee in Maine and the Chair of the Global Interdependence Center (https://www.interdependence.org/). He published this excellent summary of our gathering in Maine. I thank him for permission to share it with readers. Here’s Bill Kennedy about his experience in Maine.

Postcard from Maine

Bill Kennedy

I drove the rental car from Bangor airport through the Down East Lake Region, arriving in Grand Lake Stream in just over two hours. “It’s up there,” I thought before a glance at the map confirmed I was still a four-and-a-half-hour drive from Estcourt Station, the northernmost point in the U.S. east of the Great Lakes.

As I spotted the “Welcome to Camp Kotok” sign, I turned down the two-mile dirt road, anticipating five days with some of the brightest minds in economics and finance. Driving through the towering pines, I was transported to a familiar world far removed from the hustle of Wall Street.

Camp Kotok is an invitation-only gathering of prominent economists, strategists, asset allocators, analysts, legal experts, scientists, policymakers, and journalists. The event is best described as a mashup of an economics conference and adult summer camp. It is hosted at Leen’s Lodge and brings new and old friends together for great fishing, food, and fellowship. This marked Camp Kotok’s 21st year (excluding 2020 due to the Covid pandemic).

Each day starts with a question over breakfast. Then, two campers and a highly skilled guide spend several hours traversing lakes in a canoe. As lines are cast, conversations drift to pressing economic and market issues.

One of my favorite traditions at Camp Kotok is the fireside lunch, where canoes and campers convene for freshly caught fish grilled by the guides. These informal conversations provide the perfect backdrop for freewheeling discussions and heated debates on topics as diverse as global growth and inflation, deglobalization, national defense, the nature of curiosity, the brain’s hemispheric impulses, and breeding habits of the browntail moth. As the sun sets over West Grand Lake, attendees gather on the lodge’s deck for continued conversation. Ideas flow freely, encouraged by the Campers’ carefully curated wine selections. Some of the most insightful and unexpected connections are made “out on the deck.”

Seeking Answers

I arrived at Camp Kotok with a handful of pressing investment questions.

Question #1: RiskBridge expects a downturn regime, marked by decelerating growth and lower inflation. Is there a divergent view?

Findings:  70% of Campers surveyed anticipate the Federal Reserve will reduce policy rates from the current 5.5% to below 5.0% by the end of this year. The consensus view aligns with expectations for a potential economic slowdown and declining inflation in the second half of 2024.

Nearly 20% of the survey respondents expect policy rates to finish this year and next above 5.0%. I was surprised by this divergent view. Several conversations focused on the likelihood of increased debt-financed fiscal stimulus, whether from Democratic fiscal spending or Republican tax cuts. For what it’s worth, two-thirds of Campers thought Harris would win the White House. We believe uncertainty regarding future inflation and Fed rate policies may impact investor psychology. So, too, would a forced change in FOMC leadership.

Question #2:  No one is positioned for a 10-year Treasury yield of 5.0% or higher. Why? Could this change?

Findings:  The 10-year Treasury yield is currently 3.8%, reflecting expectations about future growth. The Fed funds rate is the short-term policy rate the Fed uses to influence monetary policy and reflects expectations about future inflation. The current upper bound target for Fed funds is 5.5%. Since 1970, the spread between the 10-year Yield and the Fed funds has been a positive 1.06% (source: Bloomberg). Today’s spread is a negative 1.70%.

A negative spread could mean several things. It may signal investor expectations for an economic slowdown, confirming our downturn regime thesis. It could also be that the Fed’s policy-setting is too tight, explaining why market participants are hyperventilating about multiple rate cuts for later this year. It could also reflect the unanticipated consequences of unconventional monetary policies unleashed by the Fed in response to the pandemic and the temporary closure of the U.S. and worldwide economies. Like most things, there is rarely one cause or answer. We believe multiple forces may be causing the inverted yield curve. In the same way, there may be multiple paths to normalizing the curve. For example, maybe the Fed cuts rates by 100 basis points to 4.50%, and 10-year yields rise to 5.50% on the back of faster-than-expected growth or a more normal term premium embedded in Treasury yields. Time will reveal the answer, but few investors are positioned or prepared for higher (more normal) Treasury yields.

Question #3:  Do rising deficits and debt really matter?

Findings:  The U.S. government spends $6 trillion annually and takes in $4.6 trillion in income. As a percentage of GDP, the Federal deficit is about 6%, and the Federal Debt is approximately 122% (source: Trading Economics). In my lifetime, the deficit as a percentage of GDP has been at current levels or higher under the Reagan, George W. Bush, Obama, and Trump Administrations. Since the pandemic, many commentators have warned that U.S. fiscal imprudence risks a buyer strike on U.S. Treasury bonds. What if no one is willing to buy U.S. debt securities? Perhaps this argument has been debunked since U.S. Treasury prices spiked higher and yields collapsed from 5.0% to 3.8%. Some Campers argued that the size of U.S. deficits and debt don’t matter given the extraordinary privilege of its status as the world’s reserve currency.

Moral hazard refers to the tendency for individuals or government agents to take on more risk or behave less cautiously when they are protected from the consequences of their actions. Given the U.S.’s unique military and economic dominance, some argue moral hazard doesn’t apply. I suspect similar words were spoken by the Athenians, the Romans, and the British before their empires collapsed. The most intellectually honest answer to this question came from a seasoned Camper who responded, “I just don’t know.”

Question #4:  How will the Supreme Court’s overturning of the Chevron deference doctrine impact the Fed’s ability to implement monetary policy during the next financial crisis?

Findings:  This topic is not on anyone’s radar. Few understand it. The Chevron deference doctrine was an administrative principle requiring federal courts to defer to a federal agency’s interpretation of an ambiguous statute that the agency was charged with administering. In other words, the regulators got to interpret the regulations. However, on June 28, 2024, the U.S. Supreme Court overturned this long-standing doctrine in the cases of Loper Bright Enterprises v. Raimondo and Relentless, Inc. v. Department of Commerce.

SCOTUS overturned the Chevron doctrine, claiming courts should decide all relevant questions of law. The perception was that the doctrine gave too much power to executive agencies at the expense of the judiciary. The change is expected to affect financial, environmental, and employment regulations significantly. Yet, given the recency of the change, the issue is not fully understood by market agents. One Camper, well versed in the law and the current state of the judiciary, suggested that a few legal cases must be tested and adjudicated to establish precedence in this new regulatory regime. In our opinion, if the wheels of justice move slowly, so will future financial regulation, which may include the Fed’s ability to implement expansive monetary policies.

Question #5:  Geopolitics: Where to from here?

Findings:  The Department of Defense (DoD) has vastly underestimated the number of munitions needed to deal with multi-theater conflicts. With their 2024 budget request, the DoD requested multiyear procurement authorities for several priority weapons to defeat “aggression in the Indo-Pacific” and strengthen production lines. The DoD was addressing critical gaps in maritime strike and air defense weapons. The fiscal 2025 budget request does not build on last year’s progress. Spending levels for key conventional precision munitions are down, and congressionally imposed fiscal caps forced the Pentagon to make hard choices in this budget. Munitions became the billpayer. 

While the Russo-Ukrainian War started in 2014, the current leg has lasted more than 900 days (the Korean conflict lasted 1128 days). Ukraine’s surprising offensive maneuvers into Russia’s Kursk region suggest, according to one Camper, that the fighting and destruction of life and property will continue for the foreseeable future. Zelenskyy has poked the bear. We will see how the bear responds.

One geopolitical expert argued the U.S. is not even prepared to fight in one theater, much less three (Ukraine, Israel, Taiwan).  My bottom-line conclusion is that investors will have to live with geopolitical uncertainty for the next decade. It may get incrementally better, but first, it is likely to get worse. We remind readers that academic research shows that war has positive effects on the economy and markets, as government spending and defense production tend to accelerate economic activity, reduce economic vulnerability, and increase corporate earnings.

Finding New Questions

One of the most striking insights I gained was the perspective of lead camp counselor David Kotok, who led the Sunday night discussion on the lodge’s deck. David and his co-authors have written a book looking at a 4000-year history of how pandemics, epidemics, and plagues impact asset prices, interest rates, inflation, wages, and economic growth. Interested Kindle readers may pre-order the book here, which is due to be published in early 2025.

David combines his passion for history and economic research to form a data-driven, long-term view that offers enlightening but sobering insights about the current state of economic and geopolitical trends.

Currency and money have played pivotal roles in the rise and fall of the great empires of Athens, Rome, and the United Kingdom. Central to the dollar’s global reserve currency status is the concept of trust, which is rooted in America’s economic might, military power, and political stability. Are the actions of our political and policy leaders instilling or destroying trust? Looking ahead, factors such as military and economic dominance, national defense strategy, and the actions of political and policy leaders will be essential in evaluating this experiment that is the United States.

Conclusion

As I departed from Leen’s Lodge, I grappled with questions far more profound than those I had arrived with. Camp Kotok has once again proven its value in providing answers and reshaping the questions we ask to help clients build wealth and navigate the complex interdependencies of history, economics, and geopolitics that shape our world.

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