Three perspectives: one direction
As we are at a very significant juncture this month, the likes of which has been seen by very few current market participants, some of whom are in careers that began less than 10 years ago, we are going to look at the actions of the market through three different lenses.
The first of these, supplied by John Williams of ShadowStats, accomplishes the important task of establishing context. Williams has been interrogating the official economic data, for a long time, highlighting discrepancies within the “rosy glow” provided by, among others, the Federal Reserve, the Bureau for Labor Statistics, the Census Bureau, and the Bureau for Economic Analysis. The main thrust of his argument is that inflation is consistently under-reported with the unemployment rate being equally flawed.
In his current outlook, provided at www.shadowstats.com, Williams believes that both intensified selling of the US Dollar and negative stock market turmoil remain in situ. In the context of deteriorating fiscal circumstances in Washington, D.C., given the latest budget package, and especially in light of the worsening economic prospects, the US dollar is particularly vulnerable to heavy selling. Put simply, the headline economic boom that helped to drive the major US stock indices to recent all-time highs, has begun to fall apart.
This process should accelerate over the next several weeks, as underlying economic detail increasingly re-stabilizes at lower levels, of down-trending activity, as evidenced by February Retail Sales reporting, and also indicated in unfolding, first-quarter quarterly contractions in New Orders for Durable Goods and New- and Existing-Home Sales. Williams goes on to say that with headline numbers faltering anew, selling of the US dollar should also intensify, with both factors likely to begin turning stock prices lower. Given the strong likelihood of a fully-fledged panic in the selling of dollars, stock prices would be expected to tank in tandem, as investors both foreign and domestic increasingly sought safer havens in other currencies.
While natural disaster-recovery activity boosted economic numbers in late 2017, the system has begun to re-stabilize: towards a prior non-recovery mode characterized by an intensifying downturn. The fundamental and increasing disconnect, between sanguine hype in both the media and financial markets, alongside the Fed’s FOMC pronouncements as to a rapidly expanding US economy, and the underlying reality, of broad US economic activity never having recovered its pre-recession 2007 peak, is a scenario which promises to disrupt both FOMC policy and financial market-tranquillity in the months ahead.
In summary, Williams concludes that over the next quarter imminent economic data will create a pointedly high risk-environment. In response to likely renewed liquidity stresses from an “unexpected” economic downturn, it still remains probable that the FOMC will abandon its current path of policy tightening, so as to reach instead for a renewed and expanded QE program in order to bolster an increasingly liquidity-challenged domestic banking system. The market response to, or anticipation of, such a shift in policy, should also pummel the value of the US dollar in the global markets, spiking gold, silver and oil prices. Again, in turn, domestic equity and credit-market prices should fall sharply, as significant capital flees the US’s weakening currency and its domestic markets. Holding physical gold and silver remain the ultimate hedges — stores of wealth — for preserving purchasing power.
Another seasoned commentator, John Hussman, provides our second lens, and forwards the belief that we have entered the bubble phase, also concurring with Williams, in thinking that ultimately the market still has significant downside. Hussman adds to our picture by noting that the collapse of major bubbles is often preceded by the collapse of smaller bubbles: representing “fringe” speculations. Such early wipe outs constituting canaries in the coalmine.
Using July 2000, as an example, the Wall Street Journal reflected at the time on the “arrogance, greed, and optimism” which had preceded the collapse of dot-com stocks. A pertinent quotation from the cited article, entitled, What were we thinking? tellingly reads, “Now we know better. Why didn’t they see it coming?” The piece had the misfortune of being published at a point where the Nasdaq still had an 80% loss (not a typo) ahead of it. Similarly, in July 2007, two Bear Stearns hedge funds, heavily invested in sub-prime loans, suddenly became nearly worthless. This occurred almost three months before the S&P 500 peaked, in October, which was followed by the implosion that would take it down by more than 55%.
In observing the sudden collapses of fringe bubbles, today, including inverse volatility funds and Bitcoin, my impression is that we are witnessing the early signs of risk-aversion and selectivity among investors. The speculation in Bitcoin, despite issues of scalability and breath-taking inefficiency, was striking enough. The willingness of investors to short market volatility, even at historical all-time low levels, was nevertheless mathematically disturbing.
Through our final lens we should permit Albert Edwards, at SocGen, to have the last word. “Once again, the Fed has built up the illusion of economic prosperity on a mountain of debt, fuelled by monetary steroids that have inflated asset values way beyond their sustainable level. As markets begin to slide, this wealth is now being eviscerated as quickly as it was created, and it threatens this increasingly anaemic and very aged recovery. Unlike the 2008 financial crisis,” he adds, “this time I expect it is the Fed that will be held responsible for yet another debt crisis. Do not expect their independence to survive.” One can only hope.
The UK is no exception to the change in the pattern of equity markets in front of us. The long-running bull market may yet have another twist in store, but an initial correction down to 1900 would only retrace 50% of the move up, from the lows of 2016.
Hardly the end of the world, given that in 2009 the index was below 1100. UK equities have been the worst performers among Western markets, in sterling terms, so a retracement to the 200-day moving average is not unlikely. Sharp falls and aggressive rallies, followed by further falls, are the hallmarks of bear markets.
The correction barely registers on this chart, using a log scale, and has bounced off the 200 day moving average; suggested as a minimum retracement by us for some time. So far so good, but we still find US markets egregiously expensive and the pattern-change also suggests lower prices.
Having first lead it up, the German market is now leading the European bourses back down again. One of the key shares to watch is Deutsche Bank, which has huge exposure to interest rate derivatives that are suffering from a lack of inter bank liquidity, on top of the incipient upward trend in rates generally. It looks to be testing the 2016 lows, hence we anticipate significant intervention from the ECB if it breaches. The Italians have yet to form a government, subsequent their elections in early March, but in line with our prediction last month it looks increasingly likely that it will have an anti-EU flavour.
We have seen the pull back, to the 200-day moving average, that we were anticipating. The index is also back above the psychologically important 21000 level, as shown overleaf. The very strongly held consensus view (not shared by John Williams) is that the US dollar will regain its strength, which of course helps Japanese exporters; not something with which Mr Trump will likely put up with, for very long. If Japan is to regain its former status, however, the Yen may well be the currency to own, along with domestic companies.
Asia Pacific and Emerging Markets
A correction of sorts, but not yet back to the 200 day MAV. Both market sectors are heavily influenced by the moves in the US dollar index, and, as has already been alluded, the consensus is that the US dollar will strengthen. In the short term this may be the case, which will provide an opportunity to add exposure on a market pull back. Long term the demographics of this region are the big positive. The Asia Pacfic markets’ chart shows a very similar pattern of still being significanlty overbought, in the short term.
Commodities and Gold
Gold had a strong year in 2017, also helped by the relative weakness of the dollar. If the consensus view on the greenback fails to materialise then it could be a very good 2018 too; particularly for mining stocks, which still languish at lows relative to the gold price – the green line on the chart.
Like some equity markets the oil price is becoming very over-extended to the upside but could reach resistance at $70 before a more meaningful correction. The implications for the global economy in the short term are highly inflationary and this is coming through in rising transportation costs, which feel the immediate impact of higher pump prices.
Commodities in general have been out of favour for some time as the chart of the GS Commodity index relative to the S&P 500 clearly shows. A rising line indicates commodities outperforming the S&P and vice-versa. Given our views on the US equity markets and the bullish potential for gold and oil, this trend could be about to change. Commodity plays are good providers of portfolio diversification.
Without doubt the proverbial canary in the coal mine is the bond market. Some of us, getting on for 40 years, have been watching its relentless rise beginning with yields peaking at 16% in the early 80s. With the Fed in tightening mode and three more rate rises to come in 2018 being highly probable, on top of more Treasury issuance to fund the Trump tax bill, it is little wonder that 10-year yields are on their way up.
Last month we said that “the perceived wisdom is that if rates reach 3%, a number to which we are very close, buyers will return to shore up the market.” So far this has panned out but with so many derivative positions currently “betting” that 3% is the limit, any surge through such a ceiling would very quickly turn into a rout.
Bonds of most flavours are off the menu, apart from index-linkers, floating rate notes, and some of the very best credit funds with asset backing. There are also some good absolute return bond funds that are worth considering, as proxies for the “run of the mill” corporate bond and sovereign debt funds, where liquidity in a sell off is also becoming an issue.
In the short-term any equity market weakness could well induce some risk-off buying of bonds, and should the Fed’s rate rises tip the US into recession, then they have hinted at negative interest rates, which would keep the bond bull market going for a while. However, buying paper with a built in negative real return is the current definition of insanity.
Central bank rhetoric has changed, and options for withdrawing QE are on the table while rate rises in the States are rising apace. As usual central bankers caveat their prognostications, and are likely to return with further accommodation if asset markets show any serious weakness. We doubt that such an outcome would be as well received as the central banks anticipate…
- Government bonds are heroically expensive – the trend in rates appears to be on the turn.
- Spreads on corporate bonds are still tight and several European issues are trading on negative redemption yields. On that basis, they are ridiculously expensive and default risk can only rise from here, also making high yield potentially less attractive. Is the yield premium adequate? It would appear not, given the increasing level of selling seen in this sector. There is also significant concern over liquidity risk, despite central bank buying (Europe and Japan) and regulatory stress testing.
- Western equity markets are long overdue a correction; have we had it? The jury is still out.
- Property is attractive, as a real asset offering a higher spread against most fixed interest markets, but with the gating of many UK bricks and mortar funds in 2016, due to large redemptions, their attractiveness is now questionable. REITs are equities in disguise.
- Conventional wisdom says that ECB QE should be beneficial for financial assets, but the Greek issue and the recapitalisation of European banks are yet to be fully resolved, plus, Draghi has threatened to start removing the QE punch bowl. It is unlikely, however, that the ECB would allow things to get out of hand: but how well will any response be executed? The Nikkei index has pulled back to the 21,000 region and looks poised to move higher; domestic issues are preferred. Emerging and Asia Pacific markets are not overly expensive as a long-term position, but will continue to be volatile and affected by dollar machinations and Chinese economic weakness.
- Demand for the physical metal continues to be strong, and sentiment is returning with new gold markets having opened in Shanghai and Dubai, mindful of the world contemplating the latest North Korean threat. Mining shares are not unattractive.
- Commodities have potentially reached a bottom relative to equity markets.
- The central banks have a significant unknown variable to contend with; the US President. Sovereign bond yields are rising on expectations of higher interest rates; not for the first time in recent history. Global economies are still fragile and any shock to the system is likely to be met with further central bank “largesse”. We observe closely for signs of success… or failure.
Clive Hale – 1 April 2018
© 2018 Albemarle Street Partners Ltd. All Rights Reserved.
The information, data, analyses, and opinions contained herein (1) include the proprietary information of Albemarle Street Partners, (2) may not be copied or redistributed without prior permission, (3) do not constitute investment advice offered by Albemarle Street Partners, (4) are provided solely for informational purposes and therefore are not an offer to buy or sell a security, and (5) are not warranted to be correct, complete, or accurate. Albemarle Street Partners shall not be responsible for any trading decisions, damages, or other losses resulting from, or related to, this information, data, analyses, or opinions or their use.
Albemarle Street Partners is a trading name of Thornbridge Investment Management LLP,
which is authorised and regulated by the Financial Conduct Authority (“FCA”)