Friday, 24th of August 2018
August is shutting down. Traffic in the city is increasing, parking places are becoming scarce again, and even temperatures are dipping. Other than these usual changes, we broke a new record this week – the longest ever equity bull market run… Well, this is the headline, but there are so many ways to measure this… Does a fall of 19.5% along the way break the record into two stretches? Or must the “correction” along the way be above 20% to qualify? Either way, we are in the midst of a Goldilocks environment (notwithstanding the Big Bad T Wolf huffing and Tweeting at our door). Interest rates remain stubbornly low with the 10-year US benchmark at 2.83%, German Bunds at 0.34% and Japanese yields at 0.09% on the JGB. And corporate earning just about everywhere is running ahead of expectations, growing some 20% quarter-on-quarter in the US…
It feels like Disneyland for investors. But then again, even though we like to say that Disneyland is fake, we touch those castle walls and they are really there! This long run in equities was engineered by the Federal Reserve, affectionately known as The Fed. In bringing down long-term interest rates via their QE, Twist Operations, and other high-wire acts, they were squeezing the toothpaste tube, pushing us investors away from bonds and towards the only viable alternative – equities. Many investors didn’t get the hint from the Fed and rode the Bond rally and watched the equities roar on the side, with even the most conservative investor making money. Base reference term-rates came down as central banks swept up all decent bonds, forcing the pension plans and other institutional portfolios to allocate rising amounts to lower credit standings, causing a collapse in credit-risk spreads. But the porridge bowl is about to empty and our friendly Fed and brethren say that there is no more cooking on the stove. Yes, we have been saying this for over a year now – the bond markets’ rally is probably over. This doesn’t mean that bond yields will rise dramatically and their prices fall. We had predicted a slow rise in short dated rates, causing a flattening of the yield curves. Effectively, bond positions have not caused losses as prices remain as stable as term yields have. With inflation data quite tame (a one-month spike is meaningless), there is hardly a coupon-cloud over our Disneyland. Hold your bonds if you must, but ask yourself if it really makes sense? True, there is little risk of big losses here, but what is the upside? The 10-year Treasury at a 3% yield gives about 2% after 35% withholding tax. Meanwhile, the Fed is telling us loud-and-clear that they want inflation at 2%, which will give you a Zero real rate of return on your bonds… Not a very enticing risk/reward equation, with potentially low risk but certainly low rewards. Well, some people like oysters, others don’t…
We remain in the camp that believes the central banks have primed the pumps, with everything ticking along quite well across geopolitical frontiers and many industries, but we are watchful on the ongoing disintermediation process in the broad economy. Yes, there was a blip with Target which surprised most with good results and rising sales but there are always exceptions to rules. We say that disintermediation is still in its infancy and huge disruptions are coming. Many analysts have been pushing investors into bank stocks since early 2017. We remain on the side-lines as, at the end of the day, JP Morgan and Walmart are the same animal, caught in the headlights of the internet – both are intermediaries, buying “wholesale” and reselling “retail”, albeit goods at Walmart or money at the banks. But all businesses which are not based on intermediation are doing well and looking good heading into the growing world economy.
Goldman Sachs economists are reiterating their plea to keep calm and carry on after a widely followed recession signal flashed brighter. The gap between 2 and 10-year Treasury yields shrank to as little as 21.8 basis points on Wednesday, reaching the narrowest spread since August 2007, a year that also marked the last time an inversion of the curve happened. The contraction has prompted traders and Federal Reserve officials to warn of the ominous risks to America’s growth outlook. While the spread moving below zero has many times preceded recessions, the Goldman Sachs Group Inc. economists say it’s not a great predictive tool now for a number of reasons, including the fact that central bank debt purchases have crushed term premium (the usual compensation investors demand to hold longer-term bonds). “The historical correlation between yield curve inversion and recession is impressive,” wrote Goldman’s David Mericle and Daan Struyven, in a note. “But it can be misleading,” they said, adding that they see the risk of a U.S. recession as only “moderate for now.” Goldman forecasts the unemployment rate will fall to 3 percent by early 2020 and say inflation and trend unit labour costs will remain a touch below 2% with inflation expectations holding on the softer side.
U.S. central bankers are ready to raise interest rates again so long as the economy stays healthy, according to a record of the Federal Reserve’s most recent policy meeting. Powell may update his outlook when he gives a speech today on “Monetary Policy in a Changing Economy” at the Kansas City Fed’s annual forum in Jackson Hole, Wyoming.
The S&P 500 hit an all-time high on Tuesday and tied the record for the longest bull market ever as investors bet that the strengthening economy and booming corporate profits seen under President Donald Trump’s first two years would continue, despite recent trade battles. How wrong is the market? Quarterly earnings have grown at least 10% in five of the past six quarters, according to FactSet. This year, quarterly profits have risen at least 20% in the first two quarters. Meanwhile, the U.S. economy expanded by 4.1% in the first quarter, its best pace since 2014. Remember that Bull markets don’t die of old age; they die of euphoria and we’re nowhere near euphoria!
How does the Dollar-weighted capital see the world? Clearly through pink-tinted goggles – the VIX is quiet at about 12, Gold is steady under $1’200/Oz, and bond yields are steady on the low-side of recent ranges. The USD, the ultimate refuge from turmoil, has been drifting down (nothing dramatic mind you!) with the DXY index at 95.50. We still believe that the Dollar ought to rise by a good bit, not as a refuge but as a classic “carry play”…
Things are looking good everywhere… well, not quite so good if you are living in Venezuela or Turkey. For most of us who live in neither of these two troubled economies, it would be worth keeping a watchful eye on both – we could see a massive exodus from Venezuela into its neighbours and re-live the European refugee crises in Central America. On this side of the puddle, Erdogan’s stubborn response to Turkey’s economic meltdown has resembled the populist playbook of Venezuelan President Nicolás Maduro, rather than the market-friendly posturing of Argentinian President Mauricio Macri. Turkey, unlike Argentina, does not seem poised to turn to the International Monetary Fund to stave off financial collapse, nor to mend relations with Washington. If anything, the Turkish President looks to be doubling down in challenging the US and the global financial markets – two formidable opponents. As that process unfolds, it will likely undermine Erdogan’s domestic appeal, even among his most committed ideological supporters, and unleash political instability in its wake. Regardless of whoever ends up leading the country, a wounded Turkey would most likely seek to shift the centre of gravity away from the West and toward Russia, Iran and Eurasia. Not so nice… Be watchful as an axis Turkey/Russia/Iran is not to be taken lightly.
But here is one light-hearted observation on BREXIT – Theresa May’s Conservative Party received twice as much money from dead people as it did from dues paid by members last year. In this context, maybe Theresa May ought to read some Ayn Rand: “The question isn’t who is going to let me; it’s who is going to stop me”.
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