Climate change drought risks global unrest

Plus inflation & interest split, Ethiopia’s famine, El Salvador’s scam, G7’s mess

Hey everyone, welcome to another week of Contention! We hope you get good insight from these eight minutes of dissident business news. We cover:

  1. Inflation, interest head in different directions 

  2. Climate change drought risks global unrest

  3. Rapid Round: Ethiopia sells out and starves, El Salvador launders millions, G7 bungles Belt alternative

These are tough times, and we fear they are only getting tougher. If you think we help clarify some of the confusion, please share Contention with others who might appreciate it too.


Inflation, interest head in different directions 

U.S. equity markets ended last week with mixed results, the Dow losing 0.8% but the S&P 500 gaining 0.4% and the Nasdaq up 1.9%.

Unexpected contradictions in major indicators helped drive ambiguity in the indexes, the latest round of data from an economy nobody has ever seen before.

A dropping Dow and rising Nasdaq almost always means a rotation into growth stocks like the tech companies concentrated on the Nasdaq and out of the value names in the Dow. Plunging interest rates drove the impulse, with yields on 10-Year Treasuries falling the most for any week since June 2020.

All of that makes sense. What does not make sense is that these rapid declines in rates would come the same week as the worst inflation data in decades.

Thursday saw the release of May consumer price index (CPI) numbers, with a 5% year-over-year gain beating analyst expectations for 4.7% -- the largest annual jump since 2008. Core CPI -- which strips out food and fuel costs to minimize volatility -- was up 3.8%, the most since 1992.

This isn’t just base effects: month-over-month prices rose at an annualized 8% rate over the last three months, the biggest three-month spike since 1982.

Bond investors should react to news like this by insisting on a higher yield to cover the eroded value of their investments over time, but last week they did the exact opposite. We are now seeing the largest gap between 10-Year yields and CPI since 1980. In only 10 months over the last 70 years has the gap been wider, all during the stagflation crises of the 1970s.

So what is going on? There are at least three likely explanations. The first: the cash glut currently drowning short-term interest rates. Interest rates are the price of money, and with an oversupply of cash you would expect prices to slide. Thursday saw a new record for the Federal Reserve’s reverse repo operation, with 54 counterparties parking an incredible $535 billion with the central bank overnight.

Cash deposits have carrying costs, returning the holders less than zero. Free market repo rates are likewise negative right now, but the Fed has put a floor under the market, paying exactly zero. Treasury bonds return more than zero (before inflation, at least), and this demand for anything over zero has pushed bond prices up and yields down.

The second reason: a short squeeze in the bond market. Earlier this year, bond investors bet on big inflation numbers forcing a selloff. Now that rates have reversed -- driving up prices -- they are scrambling to cover their positions, creating the same sort of feedback loop we’ve seen in meme stocks. 

Also at play in the squeeze: looming new bond demand from pension funds. The stock market surge over the last year has put retirement plans into a nearly fully-funded position (98.8%) for the first time since the 2008 crisis. As recently as July of last year, pensions were only 82% funded, forcing them to play stocks in order to try and catch up. 

Now that they are back at par, the funds will pursue a “liability-matching” strategy, moving out of stocks and into annuities and corporate bonds that will pay out at the same time retirees start drawing benefits. Bond shorts need to cover before this trend begins in earnest.

Note that both of these explanations arise from the Fed’s extraordinary market interventions in recent years. Crises erupt, forcing state action to save markets, creating new dislocations which the state -- led by its least democratic, most capital-oriented institutions -- has to try and fix. 

This then gives rise to the third possible explanation for last week’s weirdness: markets actually do expect lower inflation because they expect economic growth to stall out.

Inflation is running away in part because rich country governments supported consumer demand through deficit-driven fiscal stimulus. With no more stimulus on the way and deficit bills coming due, the future is likely to see lower growth with deflation -- falling prices. 

Last week saw new indications that inflation is already starting to stem growth. The new University of Michigan consumer sentiment survey found spontaneous references to home, vehicle, and durable good price increases the highest since 1974. Buying intentions for homes and vehicles have now plummeted to the lowest level since 1982

When inflation arises from insufficient supply meeting excess demand, the fastest solution is a withdrawal of demand. This is the best case scenario for investors; otherwise market distortions have forced capital into money-losing negative yield investments. Either way, markets are betting that the good times will not roll that much longer. 

Climate change drought risks global unrest

The western United States is now officially in what may be the worst drought in at least 125 years, with all western states experiencing their driest or second driest year since 1895 -- when record-keeping began. Nearly three-quarters of the region has reached “severe” drought stage just ahead of wildfire season.

The dry spell isn’t limited to the United States, however, with climate change already forcing up food prices and raising the risks of geopolitical instability worldwide. Governments everywhere are exploring new ways to navigate and take advantage of the growing chaos.

The U.S. drought is settling in just two years after California officially ended its last one, a brutal seven-year stretch of insufficient rain. Some scientists argue that the last drought never actually ended, and new evidence indicates that California and much of the west is now experiencing a “megadrought” -- two decades of dry conditions arising in large part from climate change. 

A 2020 paper in the journal Science takes the claim even further, using tree-ring data to estimate the period from 2000 to 2018 as the second driest period during the last 1,200 years, with only a stretch at the end of the 16th century worse. The impact has reached beyond California and across the western half of the country

Understanding the different kinds of droughts points to climate change’s role in the crisis. 

  • Meteorological droughts occur when it doesn’t rain or snow enough. 

  • Agricultural droughts happen when elevated air temperatures dry out soils, meaning that even increased precipitation won’t restore moisture levels. 

  • This usually also leads to a hydrological drought, water shortages in rivers, lakes, and streams. 

Climate change has raised temperatures across the west, reducing soil moisture by 40% over and on top of normal dry conditions. This puts increased pressure on reservoirs, leading to hydrological drought. Less surface water means less water evaporation, raising air temperatures even more. This “anthropogenic drought” is riddled with feedback loops that threaten to make things even worse.

The most significant impact for business: food prices. California alone accounts for 25% of the U.S. food supply, and the drought is forcing desperate agricultural decisions like uprooting almond trees, plowing under vegetable crops, and leaving hundreds of thousands of acres unplanted. Beyond the west, soaring grass and feed prices in North Dakota and other beef producing states are forcing mass herd culling, thinning out future supply and threatening even more inflation. 

This is bad for U.S. consumers, but in developing countries similar droughts threaten to starve millions. The dry spell in South America has been especially acute, with Brazil losing at least 14% of its expected corn crop and soybean, sugar, and coffee yields falling across the region.  

Making matters worse: this reduced supply is experiencing extraordinary demand. Diverting crops into biodiesel production has raised vegetable oil prices 124% year-over-year. At the same time, Chinese demand for corn, soy, wheat, and other animal feed crops has exploded as the country replenishes hog stocks depleted by a wave of African swine flu. Corn futures have doubled in the wake of the move.

Altogether, food prices have gone up 38% since the beginning of 2020, with the World Bank’s index rising 12 months in a row -- surging 5% just in May. The World Food Program warns that acute malnutrition has doubled in the 79 countries where it works. 

Similar dynamics in 2008-2011 led to food riots in dozens of countries and sparked the Arab Spring, a series of conflicts still ongoing in Syria, Libya, and Yemen today. History may be repeating itself now in Colombia, where a wave of demonstrations and blockades have buffeted the government for weeks, further raising food prices

The message of the last year: you never know where the initial chaos will start -- deforestation setting the stage for a pandemic, factory farms causing swine epidemics, drought killing off food crops -- but we know that more is sure to come. The drought reminds us that the institutions in place today cannot possibly solve any of them.

Rapid Round

Ethiopia starves Tigray, sells telecom

The United Nations’ top humanitarian official accused the Eritrean and Ethiopian governments last week of causing the world’s worst famine in 10 years in Ethiopia’s war-torn Tigray state. An estimated 350,000 people are now in the worst “catastrophe” stage of famine with nearly 1.8 million more in the second-worst “emergency” stage. Officials fear as many as 300,000 children alone may starve to death in the coming months.

Ethiopian forces and Eritrean military allies forced Tigrayan farmers off their land just before harvest last year and are killing those who attempt to plant this year. Military forces have also intercepted international food aid, reminiscent of Ethiopia’s notorious 1980s-era conflict-driven famine which killed more than one million people.

As we reported last year, the war is the culmination of widespread ethnic conflict following Prime Minister Abiy Ahmed’s market-based “Homegrown Economic Reform Program.” The previous Tigray-led government used state-led development to reduce poverty by half in 16 years, but Ahmed promised widespread privatization in return for $2.9 billion in IMF loans. Ahmed won the Nobel Peace Prize in 2019. 

Last month also saw the long-awaited breakup of Ethiopia’s telecom monopoly with an $850 million auction granting licenses to an international consortium led by British firms Vodafone and CDC, Kenya’s Safaricom, and Japan’s Sujimoto. The U.S. International Development Finance Corporation provided a $500 million loan to help finance the deal

New sanctions in response to the famine may threaten the loan, but analysts have assured investors that the license award is not in jeopardy. 

El Salvador’s crypto scam

El Salvador became the first country to accept bitcoin as legal currency as the Legislative Assembly approved a proposal from right-wing Pres. Nayib Bukele. The law signed last Tuesday requires "every economic agent" to accept bitcoin as payment as "unrestricted legal tender with liberating power, unlimited in any transaction, and to any title that public or private natural or legal persons require carrying out."

The country currently uses the U.S. dollar as its currency, setting up a system where “fake dollars go in, real dollars leak out," crypto journalist David Gerard wrote. El Salvador will work with crypto payment network Strike, which relies upon tether “stablecoins” to complete its transactions. 

Tether was supposedly backed 1:1 by dollars, but recent disclosures indicate that this is far from true. Dollars transmitted to El Salvador via Strike will automatically convert into tethers, which Salvadorans will only be able to cash out at one of two bitcoin ATMs in the entire country. 

Bitcoins entering the country will also go through Strike, which will buy them with dollars and then sell them for tethers. Those dollars will come from a $150 million trust set up by the national development bank BANDESAL. “That is: El Salvador will launder $150 million of bitcoins,” Gerard added.

In the meantime, El Salvador has sought a $1 billion bailout from the IMF, a deal complicated by a May power grab when Bukele fired five Supreme Court judges and the attorney general.

Group of Seven meet ends with bluster

On Sunday, The G7 group of western countries wrapped up their first in-person meeting since the start of the pandemic. The exclamation point of the summit: a declaration to counter Chinese and Russian influence via a working group to design a competitor to Beijing's Belt and Road Initiative called "Build Back Better World."

The group failed to clarify the project's funding. E.U. and British leaders also apparently couldn't even agree on whether Northern Ireland was still in the United Kingdom -- as a post-Brexit protocol now only requires checks on goods when they come from Britain, not the Republic of Ireland, an E.U. member.

The G7 pledged to send 870 million vaccines to the developing world over the next year -- short of a one-billion-dose goal set in February. China, a major provider of global vaccines, meanwhile criticized the G7. "The days when global decisions were dictated by a small group of countries are long gone," the Chinese government said in a statement.


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