Axel Merk, Merk Investments
December 2, 2015
Up! Buy the dips! What could possibly go wrong? A hell of a lot, actually, so investors might want to take precautions before, rather after, bad things happen to one’s portfolio. We take a stab at where one may find opportunities in 2016.
In an early August Merk Insight entitled Coming Out - As a Bear!, we argued rising “risk premia” could create headwinds to the stock market (and other so-called risk assets) for at least eighteen months, if not years. To understand what this means, consider that central banks have - in our view - taken fear out of the market, as evidenced by low yielding junk bonds and low volatility in the stock market, amongst others. The lack of fear in risky assets is another way of saying that risk premia have been low, or as we also like to put it, that complacency has been high. Not fully appreciative of this inherent risk, it seems many investors have refrained from rebalancing their portfolios, and bought the dips instead. We believe the Fed’s efforts to engineer an exit from its ultra-low monetary policy should get risk premia to rise once again, that if fear should come back to the market, volatility should rise, creating headwinds to ‘risky’ assets, including equities. That said, this isn’t an overnight process, as the ‘buy the dip’ mentality has taken years to be established. Conversely, it may take months, if not years, for investors to shift focus to capital preservation, i.e. to sell into rallies instead.
When we talk with retail and institutional investors alike, we hear that many like neither stocks nor bonds, but that they haven’t changed their investment strategies. The fear of losing out on the next rally appears to still be high. Yet, when we look at other parameters in the market, we can’t help but be pessimistic:
- In the most recent earnings season, the majority of corporations did not meet revenue targets. Conveniently, the strong dollar is frequently blamed (if it’s the currency, management is not at fault).
- Share buybacks, in our view, a key driver of the market rally, become less attractive as interest rates rise.
- We see classic symptoms of a stock market top, including a lack of breadth (few companies participating in rallies).
It’s no secret that the U.S. economy has not been firing on all cylinders; the global slowdown appears to have hit the U.S. as well, as we see, amongst other factors:
- A clear slowdown in the technology sector;
- Sluggish retail sales;
- A housing market in the Bay Area that, to us at least, resembles that of 2000. New home listings in hot markets are priced at ever-higher levels, but an increasing number don’t appear to be selling.
All of this unfolds despite low energy prices that, theoretically, should boost consumer spending. As ‘risky assets’ (most notably the equity markets, but also the high yield fixed income market, amongst others) in general have benefited from the low interest rate environment, those may be most at risk. When it comes to ‘systemic fallout’, i.e. the collapse of an institution, we don’t expect a major bank to fail. However, while regulations in recent years have coerced banks to take on less risk, such risk has moved to the shadow-banking sector. And while regulators have made the financial system more robust against some shocks they can imagine, we imagine any shock is more likely to come from places were we don’t expect it; more importantly, it may come from a place where the Fed might not be able to provide relief. Market jitters a few months ago because of losses at Glencore PLC, an Anglo-Swiss trading and mining company, come to mind as a possible candidate for turmoil in the market. Turmoil in a Chinese brokerage firm or some other obscure place could also be a source for trouble in the markets.
It wouldn’t be the first time that the Fed is raising rates into a slowing economy. So where should investors hide, or better yet, make money? First, let me mention that there’s no assurance that risky assets may indeed plunge. The buy the dip mentality has proven profitable for many investors, and it may well continue. But even investors that are very optimistic about the market may want to do a thorough stress test on their portfolio. At a recent conference, an “investment coach” explained how investors are diversified across tens of thousands of stocks with a global stock portfolio, suggesting nothing could possibly go wrong. We beg to differ. We see diversification as creating a portfolio with underlying assets that aren’t highly correlated with one another. That’s no small feat in an environment where the prices of so many assets have moved up in tandem.
Investors may want to look at investment strategies that, by design, have a low correlation to traditional investments. The challenge to overcome with such strategies is that some of them are difficult to understand or may be difficult to implement in a volatile market environment.
Take a long/short equity strategy, for example. Such a strategy, if well executed, may deliver just what the doctor ordered. However, in such a strategy, the portfolio manager can also be wrong on both the long and the short side, so no assurance can be given that it will deliver.
The same applies to long/short currency strategies. Buying the Australian dollar versus the New Zealand dollar (or vice versa) is all but certain to generate returns that have a low correlation to other assets, but it provides no assurance that gains will be generated.
Let’s get more specific about some areas:
It’s one of the reasons why we often mention gold. Gold is special because it isn’t so special: it’s a shiny brick that doesn’t pay a dividend and doesn’t change. It’s the world around it that changes. Because it has less industrial use than other commodities, we believe its price dynamics are less prone to the ups and downs of the economy and, overall, less complex. As we pointed out in our October Merk Insight, Gold for a Bear Market?, gold has been a profitable diversifier in each bear market since 1971, except for the one induced by Paul Volcker in 1980. We don’t think we are about to experience massively positive real interest rates as Volcker imposed at the time, but of course there’s no assurance that a) there will be a bear market; and b) that the price of gold will perform well.
The classic zero correlation asset for the bear case is cash. We like cash, but we think the U.S. dollar may be at risk - more on that in a bit.
Let’s talk dollar...
So we have been told the Fed will hike rates, and that there’s nowhere for the U.S. dollar to go up. Yet, we observe that the greenback has been rallying in tandem with the stock market during many rallies of late (at least the last 18 months). Conventional wisdom, however, has it that the dollar benefits from a “flight to safety”, i.e. when the stock market is performing poorly. Instead, during down days - and the turmoil in August is a case in point - the dollar has been selling off. Importantly, when we look at how speculators are positioned (based on recent “Commitment of Traders Reports”), we see extreme optimism reflected in positions favoring the U.S. dollar versus other currencies (and gold). And who can blame them given Mr. Draghi’s threat to further deploy the ECB’s bazooka. Yet we would not be surprised to see some “selling on the news” when the Fed finally starts raising rates.
What about that euro?
Mr. Draghi, the head of the ECB, appears to be hell-bent on reaching a 2% inflation target; more importantly, he has surprised markets in the past. As the ECB meets this Thursday, whatever Mr. Draghi announces, we expect him to add that there is more the ECB can and will do should it be necessary. With that threat, how can the euro not go down? To us it means that there will be few daring souls buying the euro before Draghi’s off the hip shooting of the bazooka, as they don’t want to be caught in the fire. We call it off the hip shooting because, with due respect, we believe his policy is inappropriate, even irresponsible. The Wall Street Journal (WSJ) recently published an excellent article as to why Finland’s problem (the laggard in growth in the Eurozone) is not the euro. Notably, while the country has kept its finances in order (Finland continues to enjoy a AAA rating), the government is responsible for 56% of GDP and its labor markets are one of the most rigid in the world. That is, Finland has not engaged in structural reform; money printing won’t fix that.[Cite to WSJ article]
Similarly, as the European Banking Authority (EBA) points out in a recent report, European banks continue to carry €1 trillion of non-performing loans, holding back their ability to lend. Again, printing money won’t fix that.
In the aftermath of the terror attacks in France, the Vice Chair at the ECB indicated monetary policy could be used to combat the economic fallout, if there is to be one. We aren’t convinced that a bazooka of fiat money can effectively be deployed to fight hard bullets.
The reason - or excuse - to keep rates low is low inflation. Just be aware that a key reason why inflation is so low is because of the plunge in commodity prices. That plunge accelerated after OPEC’s surprise announcement not to cut production on Thanksgiving Day in 2014. That’s just over a year ago, suggesting that the year-over-year comparisons on commodity prices may not much longer reflect a steep decline. That is, a key argument for Mr. Draghi’s strategy may fizzle out.
We mention all this because we think it is unsustainable. Mr. Draghi is deploying not only the wrong medicine for the disease, we believe he is trying to coerce the euro lower to help boost exports. Never mind that the key beneficiary is Germany, an economy that’s not in need of further stimulus. More importantly, we believe it’s rather difficult to coerce a currency backed by an economy with a current account surplus lower through monetary policy.
We have noted that the euro has incidentally performed very well in risk-off environments. Our explanation is that the currency is used as a funding currency, i.e. when investors feel good, they borrow money in euros; conversely, they reduce their leverage when volatility rises, thereby pushing the euro higher as positions are unwound. It’s doubtful the euro can thrive merely on short-covering rallies, but there’s a limit as to how long the euro can be suppressed.
We have to mention Sweden in this context: highly correlated to the euro, Sweden has good economic growth and low unemployment; the housing market is hot, but inflation is low. The central bank has been using the latter as a reason to drive rates further into negative territory. We believe Sweden will run out of excuses to keep rates low sooner than the Eurozone. Indeed, the central bank has now indicated that the influx of refugees might drive up inflation, possibly a face-saving way for them to initiate a U-turn in what we believe is an absurd monetary policy.
While the markets’ focus on the euro, we have noted the Australian dollar has had a remarkable rally of late. Maybe it’s that China’s economy isn’t all that bad after all (the further one is away from China, the more pessimistic appears to be the outlook on China); or maybe it’s that there’s a bottom in the commodity sector (although jobs may not come back anytime soon); or maybe it’s just that all this money printing has to go somewhere and it goes to the one place that’s perceived not to be overpriced (the U.S) or where policy is not too absurd (Europe). In any case, an uptick in commodity currencies may foreshadow a regime shift in currency dynamics.
What about implications of the IMF’s decision to declare the Chinese yuan a ‘reserve currency? Well, to continue this discussion, please register for the Merk 2016 Outlook Webinar on Thursday, December 10. If you haven’t already done so, ensure you don’t miss it by signing up to receive Merk Insights. If you believe this analysis might be of value to your friends, please share it with them.
Axel Merk is President & CIO of Merk Investments
Manager of the Merk Funds
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