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Views from the twilight zone

Views from the twilight zone

The world’s a pretty strange place right now. 

The financial market:

  • There are over USD12trl dollars’ worth of bonds that are negative yielding. A number which is likely going to increase over the next few years. Austria’s 100yr bond has a yield of below 1.5%. Dwell on that for a moment.
  • We have an equity market which is increasingly reactionary – reacting to every tweet, seconds after they are released. No fact checking, more than often no thought. 
  • The US stock market is at record highs and unemployment at record lows and yet the Fed has quickly flipped from a contractionary stance, to one of cutting. 
  • Central banks in the developed world have been, and will likely be for a long while, the largest single buyers of their country’s debt. This is likely to extend to equities in the next recession.

Trade wars:

  • We have a ‘trade war’ going on between the world’s two largest superpowers, each playing tit for tat. A ‘war’ neither party will win. There may be a ceasefire for the moment, but this is only the start of a much larger shift in power from West to East. These trade tensions will widen out, as China and others increasingly, but gradually, shift away from the US dollar. Won’t happen? – read history. There are many cases of empires diminishing. Just takes time and it’s during these periods that tensions will rise, as the old superpower starts to wane.  

Bipolar irrationality:

  • We live in a very bipolar dystopian world. Twitter and other new media facilities encourage this. Have a view? You can now reach out to millions and drive it. There is no fact checking. No assessment of whether the tweet drives an agenda or not. 
  • Rational people, and I would argue the silent majority, are pushing back. But they are still largely silent. The voice of reason just doesn’t catch the headlines.

Conflict concerns:

  • There are conflicts across many states of the Middle East and now Iran is in the firing line. This is an extremely dangerous place to be, especially when Trump includes words like ‘obliteration’ in a text on Iran. For any leader to include this in any form of message, is cause for concern. I suggest everybody reading this, spend some time on Twitter – do a search on Iran. It’s a fascinating insight into the views of so many – so many that have probably never been to the Middle East or indeed Iran. 
  • The hostilities in the Middle East continues, with certain nations driving the agenda there and creating an environment that will only ever breed greater hostility. 

Brexit: 

  • A nation held to ransom by a few outspoken narrators. The UK has it good in Europe. It can determine the value of its own currency. And yet, three years later of failed negotiations, there is still talk about a ‘Hard Brexit’ and that it is ‘not democratic’ to hold another referendum on the subject. Wait until the next slowdown to see Greece/Italy/Portugal/France all want a weaker Euro, or the power to control their own currency. 

Quite a state of affairs. Thankfully, we can focus our attention purely on the Financial markets where at least history is more than often a guide. 

Any outlook should take all the above and more into consideration. Certainly, there are many unknowns in the market and, with the increasingly flippant comments and polarization of the populous, we should be increasing considering the irrational as the most likely outcome. 

Outlook for the Financial Markets:

I give this Outlook over a much longer timeframe than normal. It is in order of timeline:

  • We are, in our view, entering a period of slower growth and the current business cycle in the US is getting stale. Trade, Iran and the rest, just reinforce the slowdown but don’t necessarily cause it. Markets and economies, in general, move in cycles. Up and down – it’s the law of nature. 
  • The Fed and others will do what they only know how – lower rates and print. They have said as much already. Rates may go further into negative territory in the EU and the US will likely be chasing them lower.
    • The market is already factoring in a rate cut or two this year.
    • The ECB will likely do more Quantitative Easing. 
  • Economic data though, will likely deteriorate further, as CB action usually takes a number of quarters to be effective. 
  • There will be a continuation of the war against holding cash. Rates in Europe are already negative and may go further into negative territory. Lower rates will pull short and mid duration yields lower, pushing bonds further into stratospheric price levels. 
  • Risk assets will likely decline on the back of weaker economic data – through a process of deleveraging and a desire to get out ahead of the pack. Lower markets will drive a further sell off, as momentum traders will sell out. We saw how quickly markets can move in late 2018. 
  • This time round though, central banks and governments will probably want to be ahead of the curve, so trying to determine how deep any slowdown, or sell off, will be difficult.  
  • Central banks will react aggressively. The war on cash will deepen. Sovereign bonds will at some point start to come under pressure as the market prices in higher inflation and yields. 
  • Fiscal spending is likely to also increase. This may happen sooner rather than later, with worrying indicators of increasingly socialistic polices such as the Green New Deal (GND) coined by AOC and the rise of the Green Party in Germany. 
  • Central banks will start aggressively buying bonds across the yield curve to keep borrowing costs low. In their minds, there will be an absolute need to keep all the mal-investment of the last few years from imploding. 
  • CB actions of negative rates and low yield will eventually drive investors back into risk assets (equities) and we will start to see the market bottom. Not unlike 2009 – perhaps a shallower overall equity sell-off, but perhaps just as scary. 
  • Central banks then likely truly commit to driving inflation. The farce will likely be revealed – that fiat money is not worth as much as promised. At some stage in the next decade, central banks may potentially, we would argue will, cancel government liabilities. There will likely be debt forgiveness across the board. 
  • Government Debt/GDP will fall and fiscal spend will increase. Inflation will rear its ugly head. Not driven by demand but rather by the devaluation of fiat currency. 
  • Cash may, for many years, likely earn no real return. There will be open support by policy markets to manipulate yields, to protect the fragile economy and to stabilize the underlying. 
  • Inflation targets will be higher. 3%, 4%, 5% – anything to drive real debt levels down. 
  • Eventually, debt will have reached levels that allow the central banks to start increasing rates to put a hold on inflation. 

This is of course all speculation and these events may take a long while to play out. 

We may have a few more years ahead of us of improved growth. Markets may rally higher. The cycle can always continue for a little/lot longer and it’s tough for anybody to depict the exact turning point. 2007/08 is a great example of this –  the indicators were all flashing red, a major bank had just gone under, Bear Stearns, and yet the markets kept on going, until they didn’t.

Good things though, always come to end. That’s just the way it is. Try and prevent it, or ignore that truth, and the eventual collapse will be that much worse. Something the majority of Central Bankers have failed to understand.   

So how does one invest around this?

  • Gold & Silver: If anything, like the above plays out, Gold and Silver should do well. Negative cash rates will be the catalyst. Investors will be looking for safe haven assets and having to pay to hold fiat currency may not be that appealing. FX is also key though, particularly the USDJPY rate. A stronger dollar, regardless of rates, may not equate to higher gold. So, we ideally need to see negative rates with a weaker USD against the JPY. 
  • Bonds: Mid-duration US Sovereign debt should continue to do well. But at some point, they will likely be the worst of investments in real terms. So, taking exposure before and into any slowdown will likely work well, but there will be a time to cut back. 
  • Risk assets: During the initial stages of our outlook, assets such as Equities will likely come under pressure. So, capital preservation will be key. 
    • In this regard, we are focusing on companies with strong cash flows and attractive valuations – there still are a few – and defensive characteristics. So, HealthCare will be an area we have a larger than normal allocation to. We will also use our various indicators to reduce exposure, as and when we think prudent. 
    • With central banks wanting to be ahead of the curve, risk assets may not decline as sharply as we have seen in prior sell-offs. Furthermore, the point of holding Equities is to have exposure to longer term forward cash flows and we see excellent growth opportunities ahead in the areas of Healthcare and Technologies related to Autonomous Vehicles, AI, Internet of Things, 5G, Robotics and the like. 
    • Equites should, we would envisage, still be a better investment over the next decade, than negative yielding 10yr Sov. bonds that are guaranteed to give you a….wait for it …. negative return.  
  • Real estate: Our view is that investors need to be selective. The majority of real estate is leveraged. As we have seen in countless cycles, when the slowdown hits and rents dry up, there is a sudden rush for the exit. Prices thus decline. So, having exposure to un-leveraged real estate, or that where the demand and rentals will be fairly constant or growing, will likely pay off through the cycle. 
    • Farm land could be a great investment over the longer term and many smart wealthy investors have already taken exposure here (with global warming/cooling entering the mix this is one area we wish to focus more energy on).
    • Other areas that benefit from demographics, will also do fine.  
  • Private equity: unless the fund is designed to benefit from the above scenario or has some real interesting catalysts, it’s not a great idea giving up liquidity at this time in the cycle. I have started to see a worrying trend of Private Equity Funds investing in private equity firms. If the smartest of the investment pack are selling out, what does that tell you?

Timing one’s allocation as these potential events unfold, will be critical to preserve the real value of capital. The collapse in the US market late 2018 is a great example of this. It was unexpected and caught a lot of investors off guard. 

The events described above will unfold in their own time and the market will likely be reactionary. While investors and commentators generally will always respond with shock and awe, some of these events are not that difficult to foresee. 

The critical element of a successful investment policy though, is to be prepared and understand what may, or may not, come down the pike. And then trade around it. Get it wrong, get out fast. 

We all have views on the market, but history is littered with those that failed to see the errors of their outlook and traded against the market. We hope we are more right than wrong and want to be prepared for any eventuality. 

So, there you have it. Our base case outlook over the next few years. 

Bloomberg Interview Expecting a sell-off in Equities