Axel Merk, Merk Investments
September 4, 2014
One reason markets tend to get a little nervous in September is that it’s time for investors to ponder about their asset allocation for the remainder of the year and beyond. With the markets at or near record highs and the US dollar on a roll, what could possibly go wrong? Let’s look at what’s next for the dollar, gold, and currencies.
A couple of highlights:
- Equity markets are at or near record highs;
- Measures of complacency are near record levels (for example, the VIX index, a measure of implied stock market volatility, is near historical lows).
- 10 Year U.S. Treasuries are yielding around 2.4%, near record lows.
The theory is that with the U.S. pulling ahead, the greenback must win. A couple of caveats to this theory:
- The U.S. recovery might not be as healthy as it appears: the housing market remains vulnerable; many retailers have challenges; inventory stuffing might be happening at some tech firms; and how can the U.S. recover when Europe and parts of emerging markets are slowing down?
- U.S. real interest rates are increasingly more negative than Eurozone real interest rates. With the Fed all but promising to be late in raising rates, odds are that the differential will increase. In this context, the notion of an exit appears absurd.
- There is no historical correlation between a rising interest rate environment and a stronger dollar. That’s because U.S. Treasuries might lose in value as rates rise, providing a disincentive for foreigners to hold the greenback.
- In our analysis, the Fed’s actions have made risky assets appear, well, less risky, causing everything from stock prices to junk bonds to be more expensive. This is referred to as a compression of risk premia. We go as far as arguing that our recovery is based on asset price inflation. As such, should the Fed truly pursue an “exit”, risk premia might expand once again, putting not only asset prices, but the entire recovery at risk. As a result, we have warned investors about a potential crash.
Yet, it’s clear that the euro has been underperforming of late. Why? In our assessment, the euro’s weakness is not due to interest rate differentials, not because of monetary policy. Instead, the tit-for-tat sanctions between Russia and the European Union are causing a serious blow to both confidence and economic activity. As an investor, you might say you don’t care why a particular security or currency is down, but it does matter in terms of assessing the outlook more broadly. Market participants scream for more easy money from the European Central Bank (ECB), but printing money won’t ease tensions with Russia. In recent years in particular, a lot of emphasis has been on the ECB, as the ECB is the one body in Europe that can decisively act. But while we will mince every word of ECB head Draghi, we might be watching the wrong spectacle.
There have always been loud euro bears. The euro bulls, yours truly included, have held the upper hand while pointing out how ineffective monetary policy is in weakening the euro. But when other factors – i.e., the Ukrainian crisis – set the tone, the euro bulls are stepping aside, allowing the bears to pile in. And boy have they piled in, with short positions the largest since the peak of the Eurozone debt crisis. That in and of itself can, of course, create the dynamics for a bounce back in the euro. But for the euro to resume its ascent, the Ukrainian crisis must be resolved. And that’s a challenge, as Russia’s President Putin might have an interest in perpetual instability in the region. The situation isn’t helped by the fact that Europe historically outsources its foreign policy to the U.S., with a U.S. President that takes what looks to be a more European approach to foreign policy. The only “good news” is that markets tend to get used to any environment. In the short-term, though, the euro appears to be bouncing around based on a mix of rumors and action coming out of Russia and Ukraine. Like everything else in Europe, the process is a messy one. Incidentally, Putin understands Europe much better than Europe understands Russia. For him, sanctions may be a low price to pay to re-assert Russia’s influence over Eastern Ukraine.
And why is gold down if geopolitical tensions are high and rising interest rates aren’t real (pardon the pun in a negative real interest rate environment)?. Well, as of this writing, even with recent drops in the price of gold, the shiny metal is up over 5.5% in dollar terms year-to-date. We can pick other horizons over which it is down (such as over the past 12 months) and yet others over which it is up. We don’t like to buy gold because of geopolitical tensions, as such tensions – more often than not – tend to be short-lived. We like gold long-term because we don’t think we can afford positive real interest rates. A Newport Beach based portfolio manager places interest rates in the “new normal” environment at about 2%. We sympathize with that view, but would like to add that this may well mean that we will live in a persistent state of financial repression, meaning real interest rates may be negative as far as the eye can see. For those more inclined to look at the short to medium term, let’s keep in mind that many of speculators in gold have been shaken out of the market and would like to argue that the remaining holders of gold are reasonably “strong hands” these days, i.e., those buying gold actually like gold. That’s in stark contrast to buyers of many other assets, including the S&P, where buyers merely buy the stock market to keep up. On the Nasdaq in particular we have started to see some excesses that are rather reminiscent of the dot-com bubble.
So which currency should you invest in? Some might say the Swiss franc, as the Swiss are conveniently not joining sanctions against Russia; Swiss cheese exports are surging as Russians love foreign cheese, but can’t get French or other European cheeses anymore (no offense meant, but they don’t miss American cheese). Indeed, the Swiss franc has outperformed the Euro of late. But let’s not forget that the Swiss National Bank has put in a ceiling on the Swiss franc versus the Euro; betting against that might be an uphill battle.
Instead, we have long suggested investors look a little bit off the main stage, notably Australia. Many wrote off Australia as a tumbling mining sector and a threat of a Chinese hard landing, amongst others, caused headwinds to the Australian dollar. But as happens all too often, that’s exactly where there is value to be found. In the major currency space, the Australian dollar is the best performing currency year-to-date. And while the Chinese Yuan is down year-to-date, it’s only behind the Brazilian Real in the emerging market space over the past three months.
On Tuesday, September 16, 2014, please join me for a “fireside chat.” We will make most of the hour available for you to ask questions. Please register to participate. We no longer record our webinars (the regulatory overhead is too much hassle), so join live to get answers to the questions you always wanted to ask.
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Axel Merk is President and Chief Investment Officer, Merk Investments,
Manager of the Merk Funds.
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