Dancing on Thin Ice

If you are going to walk on thin ice, you might as well dance – Jesse Winchester

The S&P500 is close to new all-time highs despite war, tariffs, mass deportations, inflationary pressures, deflationary pressures, civil unrest, and high interest rates.  Is it the dawn of a new age or just another day in Bizaro World? https://geovestadvisors.com/bizaro-world/

I’m reminded of the phrase: “and the band played on.”  It doesn’t matter that we just struck an iceberg because the band is playing our favorite tune.  At this point, the only thing we can do is have a laugh before getting back to the serious work of preparing for economic and financial dislocation.   

As discussed in my Bizaro World piece, there is something other than fundamentals at work in the global capital markets because the Fed continues to shrink its balance sheet since its peak in late 2022.  The break in the previous correlation between the Fed’s balance sheet and capital markets forces us to look elsewhere for causation.   

I suspect it’s the AI bubble more than anything because AI represents the existential life raft for the technology cycle.  All the major tech companies are spending boatloads of cash to figure prominently when the HAL9000 goes live.  Movie buffs will remember the Hal9000 as the sentient computer that went rogue in 2001: A Space Odyssey.    I think it’s going to prove the hill the Magnificent Seven dies on but more on that another time.  One thing that I learned from 2008 is that massive change does not favor the crowd. Popular trades get destroyed amidst chaos. 

Now we get to add the Iranian turmoil into the models.  Do we have a cease-fire?  Are we headed for WWIII?  While I believe Iran is virtually defeated, the region is in a state of flux.  Normally, this wouldn’t be good for equities but in Bizaro World, it’s justification for a rally.

The China Syndrome

There are legitimate concerns long term, in my view, about nuclear war and policy and stuff like that.  But the world has become a better place every 20 years for the last 2,000 years – Jamie Dimon

China buys 90% of Iran’s oil exports and it represents an important source of crude for small, independent refiners in China’s Shandong region. In fact, most of China’s oil imports pass through the Strait of Hormuz, suggesting that China would be the biggest loser if Iran opts to attempt to close this maritime chokepoint.

Money talks and BS walks; China is in bad shape and they can’t afford to add oil supply issues to their list of troubles.  In addition, Iran gets paid yuan for their oil and since they are locked out of the global financial system, they are forced to exchange their oil revenues for Chinese manufactured goods.  For all intents, they are a captive state of China much like the Sahel was controlled by France for 100 years.

Regime change in Iran would be hugely negative for China because Iran could follow Syria back onto the SWIFT system.  Might this prove to be the final nail in Xi Jinping’s political coffin?  I think it’s inevitable just like I don’t believe Xi will make it past October as Party Secretary.  Persians are tired of the Islamic theocracy and the Chinese are tired of Communism. 

Where some see WWIII as inevitable, I assign it a low probability < 10%.  I believe the US has already won because Iran is effectively vanquished, Russia is heavily depleted both of manpower and equipment, and China has always been a poser on the battlefield.  Prevent them from stealing military secrets and their R&D yields no advancements.

China is using special bond issuances to create subsidies to replace cars, appliances, and electronics.  They used $41 billion in late 2024 and again in the first half of 2025 with another $90 billion slated for the third and fourth quarters of this year.  It sounds voluntary but it’s not.

Local government officials visit apartments to inventory the model number and age of appliances so they can pressure the owners to “upgrade.”  Official government auto inspection centers fail perfectly good cars to force upgrades.  Think of it as “cash for clunkers” with a gun to your head.  This represents the spending that is supposedly driving China’s consumption numbers because otherwise, China is in the grip of the “Paradox of Thrift.”  Think of it as economic life-support, not growth. 

The Paradox of Thrift is a Keynesian concept whereby an increase in savings by consumers reduces aggregate demand such that demand, production, and employment all fall into a vicious cycle.  This is exactly what we are witnessing in China today and why exports are critical for keeping the lights on at China Inc.  Unfortunately, the rest of the world can’t afford to subsidize China’s lack of organic consumption.

China’s economy is deflating.  Their domestic market is insufficient to absorb China’s excess domestic production.  The People’s Bank of China added roughly 20% to money in circulation in 2023 yet that wasn’t enough to pull them out of this deflationary spiral.  Now, the China Syndrome is being exported to the rest of the world.

Deflation is Coming…

The way you create deflation is you create an asset bubble – Stanley Druckenmiller

If we return to the dark days of the first quarter of 2009, policymakers had two options for dealing with the global financial meltdown.  The first was that they could choose to manage the deflation of over-priced assets while recapitalizing the banking system through bankruptcy and bailouts.  That would have been painful in the short run but ultimately would have set the global economy back on a sustainable course.

Instead, they chose to systematically inflate assets to create “artificial” profits in the banking system that effectively recapitalized those shaky institutions.  It worked even as it has led to extraordinary levels of US government debt and a generational misallocation of capital.

Fiscal policies to counter the economic destruction that accompanied Covid led investors to discount hyperinflation, resulting in over-investment in housing by professional investors.  Residential housing is a relatively illiquid asset class where booms and busts are the most pronounced. 

The cracks started in 2024 in the southeast but were hidden by the FHA under the COVID-19 Recovery Modification program where missed mortgage payments are capitalized onto the loan.  In 2025, the cracks are getting larger as institutional investors look to dump underwater properties into an illiquid market.

Commercial real estate is also experiencing weakness in the office and retail space, particularly in large cities.  This trend is likely to worsen as consumers continue to tighten family budgets and as federal Covid relief appropriations roll-off.

The stock market is the last bastion of strength – the last line of defense.  It’s currently running on the vapors of the “short-squeeze” off the April bottoms and the utopian promises of artificial intelligence.  Neither is permanent.     

The Federal Reserve no longer manages US money supply because technology and regulatory laxness has turned money into something of a Frankenstein’s monster.  It is far too complicated to measure let alone manage its supply.  The dirty secret is that the Fed has no idea how many US dollars exist and it’s the same with euros, yen, and yuan. 

Instead of managing the nation’s money supply, the Fed manages the perception of our nation’s banks and asset markets.  They also attempt to make us believe that their policies can control inflation – they can’t for the same reason the Fed can’t measure money supply.  The system is too complex.

The Fed’s one superpower is that they can control short-term interest rates which has a major effect on our financial system.  Short-term interest rates are currently much too high for a US economy that is addicted to 0% interest rates and the result is a slow deterioration of the underlying economy.    

The longer interest rates remain this elevated, the more damage is being done to the underlying US economy.  By the time Chairman Powell figures this out, confidence will be too weak for the Fed’s propaganda machine to reverse.  Powell is a modern Nero plucking his fiddle from the Eccles Building.

Policymakers chose the easy route in 2009 and unleashed fiscal decadence on the country.  Decadence always leads to decay and in this case, that decay means deflation in asset prices. 

Exporting the Pain

Power has only one duty – to secure the social welfare of the people – Benjamin Disraeli

Tariffs and Iran are important considerations but not in the way they are popularly depicted.  Instead, they represent a US that is finally willing to flex its muscles for the first time since the end of WWII and the world is responding with obeisance despite domestic resistance.

The US is going to return industrial, medical, and electronic production back to the states and the result will be a vacuum of economic activity away from developed and developing countries alike.  It won’t be the entire supply chain but it will be the value-added parts in addition to petrochemical derivatives where the US has an unassailable cost advantage. 

China is already the biggest loser.  As mentioned above, they are barely holding it together by forcing people to trade in cars and appliances.  That won’t last long because salary cuts and unpaid wages are making it difficult for Chinese workers to afford necessities, let alone luxuries such as cars.

In addition, it’s becoming clearer by the day that Xi Jinping’s power has been checked by party elders and that limits China’s ability to act decisively in an emergency.  This means Taiwan is safe for now.

Furthermore, China’s technological “resurgence” is little more than a façade.  They can make 3 nanometer chips but not in scale nor can they design chips competitive with western chips.  They will never lead in AI but Deepseek proves that they can copy and debase existing programs.  Lastly, the ease at which Israeli and US F-35’s tore through Chinese-made Iranian air defense systems is testament to being several generations behind on defense technology.

China still has a place in the global economy long term and once Xi is deposed, the Pearl and Yangtze River delta regions will become unfettered by Xi’s redistribution policies.  Xi’s policies moved significant tax revenue from prosperous, export-oriented regions to poor interior regions, making the southern provinces poor in the process.

US Ascendancy

Come and listen to my story ‘bout a man named Jed, a poor mountaineer barely kept his family fed.  And then one day he was shootin’ at some food, and up through the ground came a-bubblin’ crude.  Oil that is, black gold – Texas tea   – The Beverly Hillbillies

Despite the troubles facing us, the US is entering a period of ascendancy in the world thanks to our unrivalled military, the mis-steps of China and Russia, and due to the natural advantages of our nation.  The current administration is going to de-regulate and empower private industry, allowing unfettered competition with Europe, Asia, and South America. 

In effect, the global economic pie is getting smaller even as the US grabs a much bigger slice of the pie.  As written, it will come at the expense of China, Europe and our other major trading partners.

But this is going to take time and we’ll have to manage through an asset deflation along the way.  Our first step is to manage through this setback while planning to take advantage of long-term US market share gains.  As I’ve been writing for years, we’ll know the asset deflation cycle is starting when the US dollar spikes and the price of copper falls.

We’re not there yet.  The hedge funds that got slaughtered in the second quarter by being short the market were too early and too aggressive.  The same is going to happen to those short the dollar much the way they got clobbered in 2014 – the year Uncle Jed shot the well and sprung a gusher of shale oil! 

Let’s be clear about one thing.  A spike in the US dollar will bankrupt the world thanks to the excess dollar-denominated debt they all have on their books. When imports start to drop due to domestic manufacturing production, US dollar liquidity will dry up in the global banking system exactly the way it did when our domestic shale oil fields became viable.   

Conclusion

Those who cannot remember the past are condemned to repeat it – George Santayana

We reached those April lows partly because professional investors started betting against the markets by buying put options and using short sales on stocks.  Collective movements can work to the upside but not the downside.  The post-2008 market rally was built on the short-squeeze.

It’s much the same amongst those who are betting against the US, believing the US empire is in decline – far from it.  The post-WWII US empire was a kind, benevolent master which allowed its trading partners to partake of the ever-increasing bounty at the expense of the US.  Pax-Americana is over, the global economy is shrinking and now the US is poised to get lean, mean, and aggressive in trade.

Furthermore, those who believe they can make money in indexes because they’ve done so well over the past fifteen years are in for an awakening.  Investing money is anything but easy when intervention loses its effectiveness.  The great asset deflation is starting in the residential real estate market and it’s going to spread.

Tomorrow’s winners are going to need to avoid the crowded trades and zero in on the changing economic and financial landscape.  Remember, at turning points, crowded trades get slaughtered.  AI will be no different but those are thoughts for another day.   

If you’re interested in learning more, visit us at https://geovestadvisors.com/ and contact Paul Hurley. 

Philip M. Byrne, CFA