What's the baseline for the US economy? That's a central question. Everything flows from that. And the one word answer is stagflation. And the biggest problem markets will have is intellectually, very few Americans have lived through this, but the ‘flation’ is going to make you ignore the stag. But it is a very potentially recessionary scenario. That's the biggest challenge. Now you could say, why do I care about this? Well, you care about it because it gets at the heart of revenues versus earnings, right? If you care about stocks.

And a lot of what's happening in the US economy is a squeeze of the consumer through higher input prices or you know commodity prices, food and energy, but also tougher financing, not just higher rates, but more competition for consumer loans. Why lend to a consumer when you can lend to an AI company?

Why EM Debt Looks Better Than DM Right Now

Very few Americans have experienced this, which is why the 40 that they have in their fixed income has performed so poorly. The EMs have the opposite conditions largely. Obviously, there are many different ones, but these countries generally have low debt and an independent central bank that maintains high real rates, and the low inflation that normally comes with it. So they're in many ways in the opposite situation as EMs and so arguably EMs are in much better shape than the developed markets.

Two Risks Markets Are Ignoring

The market's not pricing two key risks, war and midterms. The market went into May thinking, what are people going to see in September? And the thought in May was, midterms, I have no opinion, don't think about them at all. And the two wars, they're going fine.

And they come back to September thinking midterms really do matter, and that there are now three wars with more refinery destruction. Three wars gain theoretically is much trickier, much more uncertain, harder to predict than two wars. So midterms have to be a major challenge to the AI trade.

Is it bad for the dollar? Whenever I get that question, my first is which dollar?

The mic drop chart of the year is Chinese government bonds up 7% year to date with treasuries down, probably 2% year to date now. That's the mic drop moment. So clearly something is winning.

We've been writing about China, we can get into the reasons, or you can read our pieces, but the Chinese currency is acting like a reserve currency. So not bad for dollar CNY. Generally speaking, Japan, Europe, UK are more vulnerable than the US. And that is how most people define the dollar, namely DXY or Dixie. But China and many EMs that are exporters are also have been winners and should continue to be winners.

The Eurozone's Structural Problem

At this stage, unless peace breaks out on all three war fronts, the basic line has to be the Fed is going to hike until something breaks. and the other thing to watch, speaking of overindebted countries whose central banks might not have been able to focus slowly on inflation, France. Now that's not a proper description of the Eurozone. The issue with the Eurozone is that it's suboptimal, that it's one money and many fiscals and many financials, many banking systems inside it, and many fiscal situations.

But the structure is the problem, right? Boons could rally and France CDS can sell off. The most striking thing about my visits in the last few years is the impossibility of having a normal discussion about the asset price implications of obvious political developments.

French and German elections, where Europeans just really can't have a conversation on the asset price implications. Why not privates and their links to insurance companies? There are a number of these.

One thing I want to emphasize, I mentioned France and CDS, credit default swaps. We had mentioned this in Oracle several months ago when the spreads were much lower. You don't need to be right to make money on these views. Sub-100 CDS, under 50, you know, 50 basis point CDS when it was that. Your only standard is, this may work out, because you can find plenty of things that are 50 over or 75 over to go against it.

So France CDS is an easy catch-all for that dynamic as well. And it's very consistent with DMs having the problems and commodity prices going higher being one of the results, and that benefiting many EMs.

I mentioned midterms in the AI trade, right? That is competing for finance. That’s one that the market's going to pay attention to. Simple commodities being higher and creating recession risks. That's a basic one.

Where the Opportunities Are

So we've got what seems to many to be a scary scenario of stagflation, geopolitical risk, questions around the dollar. I'd step back and say, why do you think that's scary? You think that's scary because you're an American or a European or an advanced Asian. and maybe it is bad for you. So do something about it. The main thing you can do is not have your most of your bond exposure in your own country where the yields are too low relative to the risks.

Usefully, there are real winners in this situation. Obviously, if commodity prices are rising, countries that produce them and tax them and grow on the basis of them are going to be winners. But also there are very defensive countries, China being the most obvious, that are slowly replacing the dollar as a reserve asset. The dollar's status as a reserve asset began being questioned after 2008 under fiscal dominance, but sanctioning the central bank reserves doesn't challenge that, it accelerates that. So other central banks are looking to Chinese and let's and Malaysian government bonds as a defensive asset. So there are a lot of winners from these implications in It's just that most of the folks that we talk to, particularly if they're very US focused, are naturally exposed to their own markets, and they think that that applies to all bonds in the world and it doesn't.