10 October 2019
Triple A advisors b.v.b.a. Mr. R. Barge 27-09-2019
When we take a step back from the daily deafening noise in the markets and media, we see that financial markets, be it Risk Assets or so-called Safe Assets, like Sovereign bonds and Gold, have rallied enormously after the Christmas 2018 trog in the markets. And what it took was a FED turn from being hawkish and hikish and promising to continue to do so ("We are on autopilot") to recognizing that they had over hiked and that they were moving to a dovish stance. Once the FED performed this 180° turn, the Central Bank Put was back and the party could continue.
But the FED turn also validated the real global economy weakening, and this was the Bad news. But for the markets, bad news was good news again, in the sense that the bad news meant that the Central banks would loosen more. So, more rate cuts, and eventually also a resumption of increasing liquidity by way of QE and Central Bank Swap interventions. Thus, this meant game on for both the Equity markets as well as the Fixed Income markets and Gold and Silver.
And that is what we have seen happening YTD. Asset markets are expensive again; close to all-time highs again. YTD our benchmark, consisting of 5-35-60 cash-fixed income-public equity, stands at 15.4% per 01-09-2019
Where do we go from here?
We are seeing a couple of important changes in the markets that we believe will have consequences:
The Global economy is slowing down, and the drive to globalization is inversing. Contrary to previous global slowdowns the world can no longer count on super large Chinese stimuli coming to the rescue. The Chinese economy is also slowing down and the Government seems to understand that, in order not to become unsustainably unsound on a financial level, it should not embark on the road of a new round of capital investments in public works and housing. In how far this restraint will hold will depend on the depth of the Chinese slowdown, but so far it seems likely to hold.
The US president has changed the geopolitical landscape from a win-win negation game, into a win-lose arm wrestling game. This is having almost all countries and trade blocks turn more and more into a me-first stance.
Recession comes nearer as the August job growth turns negative in China, the USA and India collectively
The business cycle is at a very late stage, and that means that earnings growth is receding and will continue to recede and could even risk becoming negative. Labor wants its share and growth is falling, with a lot of spare capacity, meaning that the higher costs of production cannot be (fully) passed on to the consumer.
With earnings receding it is also doubtful if the Stock Buy Backs can stay the driving force holding the stock markets high (they represent close to 80% of the buying volume in the USA today).
The world is full of insecurities, both geopolitical (Trade Wars, Oil Attacks, etc.), as well as on the level of national politics (Populism, Climate legislation, etc.). This has the effect of people delaying their larger investment and consumption decisions (Capex, housing and other big-ticket consumption items).
This lowers growth, and it also lowers productivity growth to a fraction of what would be needed to compensate for the higher input costs.
Specifically, in the US, which is the consumption force of the world, the equity market and the housing market need to keep on growing for the consumer to be able to continue spending. Presently the lower savings rates are allowing consumption to hold strong, but that is an unsustainable support over time. For the equity and housing markets to continue to rise, they need a lower US Dollar. This could mean that the FED must become even more dovish, around 75 to 100 basepoints in further cuts would most likely outgun the ECB and the BOJ, which are out of monetary ammo, with their nominal interest rates already being in negative territory.
The world is suffering from a US Dollar shortage. The combination of lower oil prices, higher US shale oil production and thus lower US import volumes, lower trade surpluses in Asia, which is actually enforced by the ongoing trade war, an ongoing trend of paying for commodity imports in other currencies than the US Dollar, and a huge increasing US government deficit, leading to an increasing issuance of US Treasuries that have to be financed somehow, is leading to a US Dollar shortage.
This Dollar Squeeze is manifesting itself on the international or Euro Dollar Markets firstly and such leads to liquidity squeezes around the world, and mainly in the emerging markets, where much is financed in US Dollars. This liquidity squeeze sees its consequences in a very low, and too low, monetary growth in for instance China, thus handicapping its efforts to prevent a hard landing for the Chinese economy.
China is doing its utmost to prevent this by rushing to solidify its commodity imports in other currencies than the US Dollar. Only last week it has closed a 25 year $400Bn+ strategic deal with Iran which allows it to have the right of first refusal to all stalled or new developments in Iranian Oil, Gas and Chemical projects, including the provision of technology, systems, and personnel. It can buy any oil, gas and petrochemical products at a total discount of between 18% and 20%, and pay in soft currencies for this, meaning mostly African currencies, which represents another 8% to 12% discount, thus totaling a discount of up to 32% and they can delay payments for up to 2 years post-purchase.
The Chinese were already paying for Russian oil and gas in Yuan's or Rubles, and with this Iranian contract on top of that, it is almost impossible for China to run into a USD shortage because China's non-commodity trade surplus is around $700 Billion per year.
But on top of these "international US Dollar squeeze effects, from mid-October 2018 onwards, the liquidity squeeze is increasingly also manifesting itself in the US domestic money markets. Late October 2018, the US regulator instructed the US commercial banks to lower their exposure towards US Dollar hedging contracts that were in their eyes insufficiently paid for by the institutional international UST investors hedging out their USD exposure via these contracts that were offered to them by the US commercial bank sector. Following this, the Swap rates went up with 30 bp's for the USD-EUR and with 50bp's for the USD-YEN currency hedge contracts. This had as an immediate effect that it made investing in fully currency hedged UST positions negatively yielding and thus much less attractive for the Non-US investors to hold. Following this, the large issuance of US Treasuries has now to be bought primarily by the Americans themselves. And the US Government deficit is crowding out the financing available for the private sector. This process risks bringing a recession closer.
Monetary policies are getting closer and closer to becoming powerless. More and more signs of Central banks pushing on a string are manifesting themselves. In the US where we have the most monetary ammunition left, we are seeing little follow-through in the Housing markets although the Fed has now lowered rates two times in a row. In Europe, we are seeing the ECB running into a brick wall with negative rates for the German Bund on the entire duration curve, and with short term policy rates now so negative that it had to come up with a diversified interest rate for the too big to fail European banks. Such does however not protect the savers, pensions and Insurance companies included. What do you do when you earn less on your savings when you are approaching your pension age? You save more, thus spend less. When the economy is burdened with very high debt levels and when interest rates are already so low, a monetary policy of lowering interest rates even further risk become counterproductive (see, the extraordinary public statements of many Northern European Central bankers protesting and objecting to the latest ECB policy as implemented by a departing ECB president Mr. Draghi).
Central bankers are more and more urging the politicians to have fiscal stimulus take over from monetary stimuli.
Politicians are less and less afraid of government debt, less afraid of the bond vigilantes, and thus the need for austerity, for them, is gone or at least fading very fast. Old wine in new bottles, like MMT, Modern monetary theory, (or the Magical Money Tree), are surfacing and are getting more and more political traction.
Even serious people like Ray Dalio, are now speaking about Monetary Policy 3, where Monetary policy 1 was lowering interest rates to stimulate economies, and Monetary policy 2 was QE in the sense as we know it now, i.e. buying financial assets, mostly bonds, from the banks.
With Monetary policy 3, the aim is to have fiscal policy, i.e. state spending, and the Central Bank money printing to go hand in hand, to inject liquidity, “free money”, into the markets. But this time not to the banks, who would then lend it out to the economy, but to the people directly. This is thus the direct monetization of fiscal expenditures. This is the Walhalla for politicians, they can then spend and hand out goodies to their voters and they do not even have to raise taxes to do so.
BUT, liquidity injections directly to the public are inflationary as many regimes have showed repeatedly. History has NO exceptions and it always ends in currency depreciation, i.e. the real value of money, or the spending power of money, going down. Once this process gets going it will get going faster and faster and a way out is a very painful one, including many bankruptcies and many people finding out that they own far less than what they thought they owned.
HOWEVER, this Inflation will come with a time lag and an important one. The time lag has in history been as long as up to 6 years. (1942-45 to 1949).
So, politicians, who are short term oriented anyhow, will love this new MMT or Monetary policy 3 toolbox and they will go for it. And for a while, and possibly for a few years, it will seem to work very well. So, the risk is that politicians will dole out this “Free Money” even more.
Already the fiscal situation is very tricky with the CBO forecast of future deficit levels to increase further substantially and up to the point where tax receipts will not even cover the mandatory outlays of the Federal Government.
In conclusion, we seem to have two conflicting forces
On the one hand, a late-cycle and seriously slowing economy with forecastable lower corporate earnings and following lower tax receipts.
And on the other hand, authorities that will do everything to keep the game going and that will move from monetary stimuli to fiscal stimuli which will need to be financed by freshly produced money out of thin air.
And on top of this the USA in its role of dominant economic, financial, and military player and the US Dollar's status as a global reserve currency, are under pressure.
What will be the effects?
Since we are so deep into uncharted territory nobody can be sure.
But our view on things is as follows:
We have a risk that a late-stage slowing economy bumps into a dollar liquidity crunch, which could undermine the trust of the market participants and which would thus risk becoming self-re-enforcing downwards cycle, setting off a recession.
In the Short term
We do believe that a lot will hinge on how fast and how accommodative the FED will want to be. It needs to come through with preferably two more rate cuts before the end of the year and with one to two more in 2020.
Even more importantly, to stave off the increasing US Dollar liquidity squeeze also in the USA itself already for a longer time with IOER rates moving above Fed Fund Rates, but even more strongly and much more acutely manifesting itself in the Repo system the last week of September.
The Repo market, where Repo rates shot up to 10% from the usual rates of around 2%.
The Repo market is a very important if not the most important market where the banks and other large financial institutions meet to balance their books and to assure enough liquidity. These are overnight contracts whereby one party sells very secure assets, mostly UST’’s, to another party who pre-agrees to buy them back, mostly on the next day, at a given price.
The difference in the selling and buying prices is the interest that can be gained by selling these assets in the overnight money markets.
The spiking interest on these repurchase agreements between banks strongly indicates an increasing difficulty for the financial system to find the needed liquidity.
What exactly is the main source of the problem is not truly clear. The FED is citing smaller and temporarily technical issues but we believe that this is signaling much more serious and lasting problems that could be a combination of the increasingly high issuance of US Treasuries which the US banking systems, the prime brokerage banks, need to take up, the lack of liquidity in the money markets, the fear of risks that leads these prime brokerage banks not wanting to sell these safe assets, these UST’s, into the repo market, not even at 10%.
This week the Fed has used some band-aid by coming into the repo market on a day to day basis with repo assets up to a value of $75Bn a day. But the markets wanted even more. And the FED did not seem to be prepared for this at all. Their computer system did not work properly on the first day that they intervened, and they have had to increase their amount daily.
To us, this indicates that the FED needs to start providing liquidity to the system, very soon, and that such will risk being in vastly increasing amounts over time.
Now it has started to do so by providing large repo’s to calm the repo markets but we believe that it will have to start QE and with ever-increasing amounts very soon.
So far it seems that the Fed will only come in as per their October meeting, with a more structured form of QE-Light, focused only on resolving the liquidity problems in the Repo market, but we fear that such will not be enough to calm the markets and that a move to more full-scale QE is going to be on the agenda. As the ECB has already decided to do in their last September meeting. The ECB will come into the markets with 20Bn Euro of asset buying per month, and they also lowered their prime rate to NEGATIVE -0.5%.
The FED must also bring the US dollar down enough for corporate profits to stay up, and go even higher, and for the foreign buyers of “save assets” to be willing to buy US Treasuries again, thus alleviating the present pressure on the US banking system which is required to buy them in the absence of foreign buyers.
In case that the FED does do these things fast the recession can be held off until 2020 leaving enough time for the politicians to start coming around with Fiscal stimuli.
We believe these to be no longer limited to adhering to sound financing levels of Government debt and we believe that the politicians will go for the “free” money. They will start to do so on a relatively sound basis only investing into project that they believe will be enhancing the future productivity of their country, i.e. in infrastructure, education and alike, but over time and in our fear very quickly this will end up in spending on the hobbies of the politicians in power, which will be mostly to favor as much as possible their own, constituencies.
This brings us to the Longer-term
With Fiscal largesse being combined with monetizing deficits and with the inflationary reaction to such policies being highly inflationary but with an important time lag before they kick in, we believe that the risks for the long term are inflationary. But this will happen well after we have passed through a period with stronger growth and with further inflating asset prices.
The conclusions for us are
In the short term; it looks like everything will be hinging on the FED, and the US Dollar, when these two issues are properly managed by producing enough liquidity, structurally and convincingly, we believe that we will not have to go into recession yet.
In such a scenario, as described here above, we would expect even stronger risk asset markets but with a less positive outlook for fixed income; without them going into a tailspin. An such could very well be neutral to even negative for gold and silver, depending on how big the fear of inflation will be as a result of these policy changes and how far the US Dollar will correct downwards.
We see no reason to sell Equity, (both public and private), nor commodities at this point, but we would continue to be more careful with Fixed Income exposure. We will be watching the US Dollar very carefully, being ready to hedge as of the moment that the Fed will resort to true QE. We will, of course, be holding on to our Gold and Silver exposure.
As an indicator of what could be coming we believe that we will have to watch the volatility in the Credit markets attentively (The ML MOVE index), since this will indicate if the present funding problems in the short term money markets are spilling over in the more longer duration credit markets or not. If so then we risk this self-re-enforcing spiral of lower and lower trust in the financial markets, leading to less and less liquidity being available, and thus into a much larger risk for a serious economic recession.
In the longer term: say as off 2021-2024 we fear that inflationary pressures could become bigger and thus we fear that Fixed Income markets could have a more serious problem. Politicians and Central banks might try to counter this and resort to even more buying of these assets to distort prices downwards. This would resemble the Japan scenario with Central Banks owning most of the float in the Fixed Asset markets. Successful or not, we would not want to own these assets to front-run the Central Banks buying.
This longer-term outlook is for us the reason to hold on to our exposure to Gold and Silver and their related miners.
The tech debt bubble of 2000 was kicked upstairs to the banking system via a housing bubble that burst in 2007. That bubble was kicked upstairs to the sovereign debt level, when the government bond bubble bursts, where can we kick that up to? The only answer can be to the currency level. Thus, we believe Gold to be the right asset to protect us from the coming blow-up of the paper currencies.
We prefer to continue our underweighting of Fixed income, and to continue our large allocation to Gold and Silver and their related miners, while not yet starting to steer to a lower exposure level for equity. This last point would change when we would see the present unrest on the money markets spill over into the credit markets.
Concerning our underlying currency exposure, we presently have an overexposure to the USD, and the CAD as well as an undervaluation to the Euro. We have always indicated to stay long USD until the moment that the FED would turn to full-scale QE, which is not YET the case, but it seems to be approaching now.
However, wanting to be out of the USD, because we could see its valuation fall, where do we go to? In what currencies will we go? The ECB is even more, and much more, aggressive in their monetary policies, with full swing QE and nominally negative interest rates. The USD is the only DM currency with a positive yield. Forward selling of USD’s into Euro’s would mean that we would have to make a currency gain of the Euro vs. the USD of at least 2.5% on an annual basis. The Euro today buys, 1.10 USD’s and thus that would need to go to 1.13 just to stay equal. Goldman Sachs believes that the real fundamental value of the USD vs. the Euro is around 1.20, which would mean a depreciation of the USD vs. the euro of 9%. So, it might still be worthwhile to hedge some USD risk into the Euro. But we would also prefer to hedge away some USD risk into other currencies that might have less aggressive supportive monetary policies and that could gain in a market environment where the liquidity support generated by global QE policies would drive up their economies and currencies, like the Norwegian Krone, and others alike. We like gold best as our alternative currency to hedge our US Dollar exposure into.
Time-wise we do believe that with the acute level of the ongoing Dollar liquidity squeeze it is not YET time to start this USD hedging policy. Thus far we have a high exposure to precious metals and their related miners as well as to the US Dollar.
We prefer to wait it out some more and to then slide more into these hedges in incremental portions of around one-third of our underlying dollar exposure.
In our opinion, the key is if the central bankers and the politicians will be able to maintain the common belief that they have it all under control and they can and will successfully have the investors backs in case that a recession would encroach.
Do we keep on believing that they can re-inflate the bubble and that they can do this without blowing up the whole financial, economic and social system?
Can we believe that the Central Banks and especially the Fed and the Chinese government can reflate the world economy back to new highs again?
After ten years of QE and ZIRP or even NIRP and to times a huge reflationary effort out of China we have an economy that is on a slow-growing path and although we have financial asset inflation, real assets have increased in value much less. This is the slowest post-recession recovery ever and it has taken more debt more money creation and lower interest rates than ever before.
A clear example of decreasing bang for your buck. The velocity of money has collapsed and is continuing to do so.
We believe that the trust in the almighty Central banks is already waning.
This means that we do believe that the next trick to be holding these markets up will have to be Monetary policy 3, which is the combination of Fiscal support financed by the Central banks printing the money for it.
In Monetary policy 3 central banks and politicians will work hand in hand but politicians will be calling the shots much more so than the Central bankers which is a big change vs. the situation of today, where the Central Bankers believe to be in the lead. And we believe that such will make the world and the financial markets even more unstable.
With so many insecurities, and unknowns it is even more important to have sufficient liquidity otherwise we do risk a recession coming faster as that we are expecting still today.
Liquidity is the oxygen tent for risk assets? And it is still evaporating, monetary growth is stagnating.
It will all depend on the speed and the volume of CB injected liquidity, AND to how the public will react to this. If the public refuses to believe the CB put for a second time than the velocity of money will go down further and sharper taking out all potential punch of the fresh liquidity pumped into the markets. Then, it will be clear to everyone that the Central bankers are pushing on a string, and that they are powerless.
Corporate profit margins are starting to feel the squeeze, with the fiscal stimulus of the Trump tax cuts petering out. We fear that stock buyback volumes will have to follow downwards, which will take a huge pillar of support away for the US equity markets.
So, new tax cuts are needed, and they will come. It is likely to be done to hold up the markets across the period leading up the US presidential elections and the Chinese communist party anniversary.
Finally, we believe that the real economic growth picture will stay relatively low, and that interest rates will also stay very low for a sustained period, and thus that future inflationary pressures will be very slow to manifest themselves, but impossible to evade in the very end of this long cycle.
We have strong secular trends in place that will keep inflation subdued, barring overly wild monetizing of vast amounts of government debt.
Thus, we believe that inflation will in time move up, but that it will take a lot of “Free” Government money spending first.
For the shorter term, where does this lead us to?
We, unfortunately, have to repeat our outlook for lower returns across most asset classes over the coming decade(s).
These signal returns over the coming 10 years of around 3 to 5 percent for a moderate risk portfolio, with 2019 and possibly 2020 and 2021 being still a relatively OK and above average years.
Recent GMO Asset Class return outlook for the next 7 years out.
Recent Goldman Sachs Asset Class return outlook for the next 5 years out.
For the longer term, where does this lead us to?
We stay convinced that we are very late-cycle in an aging bull market and that we will face a prolonged period with lower highs and lower lows, with a lot of volatility.
Given this longer-term time frame that is full of increasing risks we feel comfortable with our portfolio and believe that it houses a lot of elements that should be generating outperformance in case of a downturn.
We do however recognize that our portfolio is penalized with an underperformance vs. the publicly quoted markets in case that all assets continue to be pumped up by monetary and fiscal largesse. The move from a purely monetary largesse, or monetary policy 2, to a more fiscally driven form of largesse, monetary policy 3, will be more supportive for our Private Equity part of the portfolio, which might very well keep in step with the public equity markets in such an environment.
We have built up a portfolio of many different defensive elements, and these include a long USD position, a good exposure to n Precious metals and their mines, and exposure to defensive Hedge Fund strategies, that are often countercyclical. Our risk exposure has pivoted already from being mainly public equity-driven to being driven by private assets mostly bought with low levels of financial leverage. These Private assets through our focus on the small end of the market are often bought at very reasonable prices, giving us a margin of safety.
Now in a real crisis all correlations will go to one, and everybody will be selling what they can sell just to create the liquidity, so we would prefer to have more free cash, which is something we plan to be building up by way of not re-investing all cashflows out of our illiquid asset portfolio’s. Illiquidity risk is also a real, certainly in a more prolonged and deep liquidity-driven crisis. But although It is not something to be neglected, we momentarily feel more at ease with that type of liquidity risk in assets with low levels of leverage than that we would be feeling owning many public assets driven up to very high valuations and full of duration mismatches, and credit risks.
We wish you all the very best and we are looking into the future mindful of the risks AND the opportunities.