20/20 vision of future market action would be nice to have, but unfortunately like other investors, we must use judgement and analysis to have a sense of the market’s future direction. Our outlook on the markets and the various asset classes has changed over the course of the last few months.
Back in September/October we were increasingly taking the view that it made sense to be defensively positioned – economic data was weakening and the trade war was heating up. We considered adding duration to bond exposure, but ultimately took a ‘wait and see’ attitude. Bond yields were already so low and on the short term there was room for yields to increase.
Our concern that yields would increase was vindicated in the 4th quarter, driven by three events: 1) the Fed indicated very clearly in their October meeting that they wouldn’t be raising rates until inflation was well above target of 2%; 2) the Repo market broke and the Fed stepped in aggressively to keep overnight rates manageable and 3) there was talk of increasing fiscal spend in many economies.
- The Fed’s October statement that they would only increase rates if inflation was well ahead of the targeted 2%, is a very clear indication that the Fed has the equity market’s back. At least for the moment. Their stance was again emphasized in the December meeting. With rates set at 1.5 -1.75%, inflation running at just over 2%, unemployment rates at all-time lows, and the US equity market at all-time highs, one has to question why the Fed is so preoccupied with providing easy policy. Negative real rates are a massive incentive for investors to keep on piling into risk assets, and the Fed has now clearly told us that they will be very slow to raise. All of which is supportive to risk assets, such as equities, but potentially negative for bonds, at least on the short term.
- The second key driver to impact our earlier conservative view was the Fed’s reaction to the stresses in the repo market, where overnight rates spiraled higher to around 10%. The Fed stepped in aggressively to reduce the overnight rate and indicated the willingness to pump in over USD400bn of liquidity into this market, over a little more than a few months – The Fed is still active in the repo market as at the time of writing. Such a liquidity injection is inherently a form of Quantitative Easing. Remember, it wasn’t so long ago that the Fed was in Quantitative Tightening mode, reducing the size of its balance sheet. What a difference a few months make. This QE will, as we have seen in prior episodes, feed into higher asset prices – as reflected by the market strong run in December.
- Lastly, talk of increased fiscal spend is inherently supportive of risk assets. Both the UK and Japan, as well as others, are implementing modest plans to increase fiscal spend and ECB President Christine Lagarde is pushing for this in Europe. Again, though, it’s worth making the point here that these policies are being considered/implemented at a time when most governments are running significant deficits already and total debt/GDP levels are significantly higher than they were back in 2007.
So, going forward, how has this impacted our view of the Equity, Bond and Precious Metals markets?
In the short-term, we take the view that the continued Central Bank and Government largesse will be supportive of risk assets such as equities and that the risk of an economic recession is lower today than it was a quarter back. Inflation remains low and the goldilocks period, I hate to say it, seems likely to have been extended. The long-end of the curve is still well behaved and the cost of capital is low. Risk assets should continue to do well in such an environment.
Bonds though, are likely to languish as the improved economic data, at least on the short term, will be supportive of yields. So, we don’t plan to add to the current allocations. If anything, we may cut back a little on the short-term, expecting bond yields may be pushed slightly higher.
The actions though, of the Fed and other central banks and the potential of higher fiscal spending has though, given support to our positive view on Precious Metals. The Fed has told us, is that the value of the USD is under threat as they will be slow to raise rates if inflation picks up – so we will continue marginally adding as and when we consider it prudent. We continue to have a preference for Silver, as the metal is trading at a relative discount to Gold on a historical basis, a gap we feel will narrow over time.
While we see Central Bank and government largesse as being supportive to risk assets, such as equities, on the short term, we remain cautious further out – for two reasons:
- The equity market is due a correction of at least 5% in the short-term, based on being overbought technically. Any correction may well occur as the Fed’s temporary repo operations come to an end, sometime in the first or second quarter of 2020. Also, we take the view that earnings growth is likely going to disappoint in 2020, relative to current consensus and this will be a headwind.
Secondly, our intermediate and longer-term view remains unchanged, namely that we will see a weaker economy and weakness in risk assets, regardless of Central bank action.
- The Macro data is weak and we believe will likely weaken later in the year.
- The Business cycle is now very extended. Its one of the longest on record.
- The trade deal is a bit of a ‘non-event’ and trade unlikely to rebound.
- Valuations are increasingly stretched.
- The piper will need to be paid. There will be a fallout from all the Central Bank largesse. All the Mal-investment, driven higher on the back of easy money, will eventually implode.
Indeed, recent CB action is far from being a panacea. It has rather just further entrapped the Fed into a policy of easy money and higher inflation on the longer-term. Potentially, much higher inflation a decade or two out.
Global debt is also already at record levels and continues to increase. Increased fiscal spend and government and corporate borrowing are pushing these levels ever higher and, when the dam does eventually break, managing the ‘water fall’ sell-off will be all but impossible. At least without extreme measures. And that, I believe, is what the central banks are now prepared to do – to lower rates to negative and be the buyer of last resort. Do whatever it takes to keep the system afloat – but this won’t necessarily equate directly into a stronger economy or higher equity prices..
Thus, while our Macro Outlook is that we expect continued short-term modest economic ‘strength’, or recovery, we do expect an eventual slowdown later in the year or next, which will likely be offset by aggressive central bank and fiscal response.
Should this come about we expect we could easily see the Fed rates at parity with counterparts in Europe at around 0%, if not marginally negative. They will, as done in the past, also be large buyers of bonds to keep yields low across the curve. Longer-term we would expect policies such as MMT and also for real yields to remain in negative territory.
In terms of our outlook for the asset Classes:
- While yields may rise on the short-term, we expect them to fall later in the year or next as the slowdown bites. The Central Banks are likely also to buy across the yield curve. High quality Bonds, will rally with falling yields. At that stage, we would look to lighten up exposure towards the trough of the cycle. Until we reach this point though, we will continue to patiently hold exposure to US Sovereign Debt or other quality exposure.
- We would expect Precious Metals to shine coming out of the economic trough – which may be a year or two further out. They will be driven higher by the market’s expectation that central bank policy will have a negative devaluing impact on the value of fiat currency. Expected inflation will likely rise at a far higher pace than bond yields, as central bank policy would likely manipulate yields lower. We expect the PM market to be relatively supported as an increasing number of investors come to the same view we have and start adding to holdings.
- Equities may rally a little further on the short-term, but as economic data weakens, as we have no doubt it will, and sentiment changes we expect equities will come under pressure. Particularly if stock buybacks are curtailed, which is likely to be the case in the event of an economic slowdown.
So, in summary, on the short term we remain cautiously constructive on Equities and Precious Metals, a little less constructive on Bonds.
On the medium and longer-term though, we see bonds providing an excellent hedge and potentially strong returns, should the economy eventually weaken.
We see Precious Metals increasingly as a core essential holding, in a world where the value of fiat currency is being destroyed by central banks.
2019 was an excellent year for us – we strive to continue generating strong returns for our clients, but with a very keen focus on the potential risks in the market. As always, we appreciate your support and will be doing our very best for you in 2020.