Premium Content Archives - Page 5 of 10

The Cyclical and the Secular

“By searching the sky now, me and other asteroid hunters hope to give us the early warning – ideally decades – that we need. But that strategy of focused searching hasn’t stopped people from thinking about what we might do if an asteroid was on its way toward us.” ― Carrie Nugent

This week’s piece is both a bit short and important. In the second half of the piece, we share a critical identity in understanding the fundamental drivers of the US yield curve.

We have put in much time and thought into better understanding the economic fundamentals driving the yield curve and put forth a seemingly straightforward identity that, we hope, can better explain shifts in the yield curve.

OECD Leading Indicators and the Cyclical Trend

The below chart is that of the year-over-year change in the OECD Leading Indicator Index for major economies and that of the yield on the US 10-year Treasury bonds lagged by 3 months.

OECD LI vs 10Y Yield

The leading indicators index tends to lead long-term yields by, approximately, three months.

In 2018, long-term yields over shot to the upside based on the leading indicators index. Today, the index is signaling that yields are too low and on a cyclical basis economic activity in the major economies has bottomed and is turning up.

The below chart is that of the leading indicators index versus the the MSCI All Cap World Index excluding US stocks lagged by nine months. Global stocks, excluding the US, tend to lag the leading indicators index by six to nine months.

ACWI ex Us vs OECD LI.png

The leading indicators index suggests that non-US stocks are close to bottoming on a cyclical basis.

The Secular Trend Behind the Yield Curve

In the below chart, the orange line is the 10Y – 2Y US Treasury yield curve and the magenta line represents US private savings less US private investment.

US Savings Less Investment vs Yield Curve.png

Private savings less private investment approximates the shape of the yield. Given, however, the fractional reserve system of banking, the private savings surplus or deficit has some slippage that does not capture excess credit creation by the banking system. Nonetheless, it is a good enough proxy for the purposes of approximating the direction of the yield curve.

What does a private savings surplus or deficit have to do with yield curve?

At the start of an economic expansion, private savings are plentiful, having been replenished following a recession as households and corporations repair their balance sheets by increasing savings and scaling back investments. As private sector balance sheets are repaired, confidence slowly returns and a new investment cycle commences.

With plentiful savings, in the form of deposits and cash like holdings, short-term interest rates are pressured lower. Reduced appetite to invest in longer maturity assets following a recession pushes up longer-term interest rates to entice savers to invest in longer duration assets. With an upward sloping yield curve, the banking system is incentivised to undertake maturity transformation by borrowing short and lending long.

As savings are drawn down, the declining supply of capital at the short end of the yield curve places upward pressure on short-term interest rates. At the same time as capital moves towards longer duration assets, the increased supply pushes down interest rates at the long-end. The continued maturity transformation undertaken by banks by borrowing short and lending long eventually leads to a flattening of the yield curve.

The yield curve inverts when increasing investments have exhausted private sector savings and the competition for marginal capital available at the short-end pushes up short-term interest rates.

The yield curve eventually steepens as appetite for longer duration investments collapses and an increasing number of investments made during the expansion become impaired. Impairments are caused by (1) investments no longer being profitable (on a net present value basis) due to the higher short-term rates; or (2) revelations of misallocation of capital into speculative or ponzi investments that sustained only because of the abundance of capital.

The drop in capital investments precipitates a recession and the economy once again has to enter a phase of balance sheet repair before the economy re-enter an expansionary phase.

Economic Identities

(1) GDP (Y) = Consumption (C) + Government Spending (G) + Investment (I) + Exports (EX) – Imports (IM)

(2) Y – C – Tax (T) = G – T + I + EX – IM

(3) Private Savings (PS) = Y – C – T.

(4) PS = G – T + I + EX – IM

Current Account (CA) = EX – IM

(5) Savings of the Government (SG) = T – G

(6) PS = I + CA – SG

Putting It Altogether

Private sector savings in the US can be replenished by (1) increased foreign investment into the US, (2) the current account going from a deficit to a surplus or (3) the government increasing its spending.

If we assume, the current account deficit remains around current levels, private savings will only be replenished through increased (foreign) investment or increased government spending.

Loosely, government spending and foreign investment are two sides of the same coin. The US has historically financed its fiscal deficits with the capital foreigners have invested in US Treasury securities. Foreign investors, however, may be unable or unwilling to finance the US government for a wide variety of reasons including:

(1) a US dollar shortage leading to stress or turmoil in their local economies;

(2) protectionist policies of the Trump Administration; or

(3) the unfavourable risk-to-reward profile of financing ever increasing deficits at record low interest rates.

If all foreign investors want or need is higher carry, the yield curve will simply steepen as it has done in the past. In the no-longer remote chance that foreigners are unable or unwilling to finance growing US deficits for reasons other than higher carry, however, what then is the release valve that will enable private sector savings to be replenished?

Should we be surprised that modern monetary theory (MMT) has become part of the broader economic policy discussions and no longer a fringe theory?

MMT is a whole other can of worms and deserves a discussion on its own that we will return to at a more opportune time.

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

Safe Haven Bid: Ahead of Itself?

Marilyn: Thank you for coming over, Mr. Baer. Welcome back and forgive me if I wade right in, but forgetting for a second your bureaucratic checklist, I’m trying to get undigested information, so if you could give me a reading of the temperature over there?

India is now our ally. Russia is our ally. Even China will be an ally. Everybody between Morocco and Pakistan is the problem. Failed states and failed economies, but Iran is a natural cultural ally of the U.S. The Persians do not want to roll back the clock to the 8th century.

I see students marching in the streets. I hear Khatami making the right sounds. And what I’d like to know is if we keep embargoing them on energy, then someday soon are we going to get a nice, secular, pro-Western, pro-business government?

Bob: It’s possible. It’s complicated.

Marilyn: Of course it is, Mr. Baer. Thank you for your time.

Intelligence is the misnomer of the century.

Bob: They let young people march in the street and then the next day shut down fifty newspapers. They have a few satellite dishes up on roofs, let ’em have My Two Dads, but that doesn’t mean the Ayatollahs have relinquished one iota of control over that nation.

Distinguished Gentlemen: Mr. Baer, the reform movement in Iran is one of the President’s great hopes for the region and crucial to the petroleum security of the United States.

Terry George: These gentlemen are with the CLI.

Distinguished Gentlemen: The Committee for the Liberation of Iran, Mr. Baer

Bob: We’ve had Iran in embargo for almost thirty years, we backed their neighbor, a neighbor we invaded twice, in a ten year war against them, we’re hanging on by a thread with a massive occupation force, so I got news for you… Thomas Jefferson just ain’t that popular over there right now.

― Syriana (2005)

Iranian foreign minister, Javad Zarif, made a surprise visit Sunday to the the Group of Seven summit, meeting with a delegation including French President, Emmanuel Macron, as leaders grappled with how to defuse tensions and salvage the landmark nuclear deal after a US pullout.

Mr Javad Zarif did not meet with the US delegation in Biarritz, France, although President Trump has indicated that he is open to meeting Iranian officials without preconditions.

The narrative in the noughties when oil was rallying and the spectre of peak oil (supply not demand) was of popular concern ― the BBC even produced a film titled The Crude Awakening: The Oil Crash in 2007 to warn of the end of life as we know it because the world was running out of oil ― was that of the US’s need to ensure hydrocarbon security. Today, the narrative is that the world is awash with oil and the US is energy independent, affording President Trump the luxury to scrap the deal with Iran and to re-impose economic sanctions.

As it relates to oil, the truth lies somewhere in between the fears over peak demand and peak supply but almost never, barring a energy paradigm changing supply- or demand-shock, at the extremes.

As it relates to geopolitics, should oil prices rise sufficiently, driven by a flurry of bankruptcies in the US shale patch or US shale production plateauing, it would be of no surprise to see the US either return to the negotiating table with Iran or to ease sanctions.

The overarching consensus for oil appears to be that of lower oil prices. With some even calling for a crash to below the US dollars 30 per barrel level, that would lead to global deflationary bust. In our opinion, these calls seem premature. Rather, if anything, we see the greater risk being to the upside.

We often use the 48-month moving average, for commodities and major currency crosses, to guide our trading strategy. For now, WTI crude prices remain above the moving average, albeit just barely. Given the proximity of the current price to the moving average, the best course of action may be to be on the sidelines. That being said, as long as prices do not meaningfully breach the 48-month moving average, our bias is to be long in expectation of prices climbing the ‘Wall of Worry’ over the next 6 to 12 months.

USCRWTIC Index (US Crude Oil WTI 2019-08-26.png

Has the Safe Haven Bid Got Ahead of Itself?

In the below chart, the magenta line is the ratio of the price of gold to the Merrill Lynch 10-year Treasury Total Return Index. The orange line is that of core price index.

XAU Curncy (Gold Spot $_Oz) GL 2019-08-26 11-47-07

The US dollar price of gold, loosely an inflation hedge, rising relative to the 10-year Treasury index generally coincides with rising core inflation. There, of course, are periods that the ratio over- or under-shoots core inflation but over time the roughly coincident movement of core inflation and the gold-to-ten-year Treasury index tends to reassert itself.

In recent months we have seen safe haven assets, government bonds and precious metals, get bid up. Notably, gold has outperformed 10-year Treasury bonds in 2019 even as core inflation has witnessed a sharp drop. Between early 2017 and early 2018 we saw a similar dynamic play out, when long-term bond yields rallied (long bonds sold off) and gold remained steady while at the same time core inflation moved sharply lower.

In 2018, core inflation eventually moved higher and caught up with the gold-to-Treasuries ratio. Suggesting that markets had correctly anticipated the move higher in core inflation.

We will know in time if the markets have got it right again or not. If core inflation does not move higher, it is likely that the safe haven bid, specifically in gold and other precious metals, has gotten ahead of itself and investors are better off owning government bonds over precious metals.

With long-term bond yields near all-time lows, it is difficult to make a strong case for bonds, however.

The below chart is that of WTI crude (magenta) and gold (orange). The two commodity prices tend to, over the long-term, have the same directional move. Oil does not have the safe haven characteristics of gold and therefore has stronger moves than gold both to the up and down sides.

USCRWTIC Index XAU (US Crude Oil WTI 2019-08-26.png

Much like the relation between the gold-to-Treasuries ratio and core inflation, a gap has opened up between the price of gold and that of oil, much like it did in 2017. In 2018, the gap was closed with oil moving higher. Will that also be the case this time around?

Finally, the last chart in this week’s piece. This one compares the price of oil to core inflation.

USCRWTIC Index PCE.png

The price of oil is one of the primary drivers of core inflation, albeit with a lag. Should oil prices move higher from here, core inflation will be higher 6 to 12 months down-the-line; justifying the move higher in gold and likely proving the current rally in government bonds to be a bull trap.

On the other hand, if oil prices make new lows, gold should be sold in favour of government bonds.

The price of oil is probably the most important price in capital markets today. The next move in oil will drive many of key tactical decisions for asset allocators.

If oil moves higher, portfolios will be found to be lacking allocations to assets that do well in periods of rising inflation ― resource and mining companies, resource rich emerging markets, high yield credit and precious metals ―and over exposed to high duration assets such as loss-making technology companies as well as utilities and long-terms bonds.

If oil moves lower, the stampede into developed market government bonds, technology stocks and utilities is likely to continue unabated.

We will be following the oil price ever so closely hereon out.

An Unconventional Inflation Gauge | What Have We Learnt?

“The first lesson of economics is scarcity: There is never enough of anything to satisfy all those who want it. The first lesson of politics is to disregard the first lesson of economics.” ― Thomas Sowell

An Unconventional Inflation Gauge

In the below monthly chart the magenta line is the ratio of silver to the S&P 500 Index. A rising magenta line means that silver is rising relative to the S&P 500 Index.

The black line is the 5-year (or 60 month) moving average of the silver-to-S&P 500 Index ratio.

The orange line is core consumer price inflation in the US.

Ideally the impact of geopolitical events, such as the spike in the oil price following Sadaam Hussain’s invasion of Kuwait, and the sharp swings in inflation in the immediate aftermath of the Global Financial Crisis due to base effects should be ironed out of the core inflation series.

XAG Curncy (Silver Spot $_Oz) S 2019-08-09 18-01-00

The silver-to-S&P 500 Index ratio has led the disinflation / deflation curve in the US over the course of the last 30+ years. As a general rule, the periods during which the ratio has been below its 60-month moving average, inflation has receded. When the ratio has moved above its 60-month moving average and remains above it for some time, inflation has tended to pick-up on a cyclical basis.

The silver-to-S&P 500 ratio is approaching its 60-month moving average and it just maybe that a breach of the moving average coincides with cyclical inflationary pressures picking up in the US once again. Mathematically, barring very sharp moves in either silver (up) or the S&P 500 (down), the series will take some months yet to crossover, if at all. Therefore, it might well pay to monitor the series and its moving average for any signal for a pick up in core inflation.

Notably, the Atlanta Fed’s Wage Growth Tracker has shown an uptick during the past several months. The 12-month average reached 3.7 per cent in June, up from 3.2 percent last year. If wage inflation continues to remain for 3 per cent, its only a matter of time that we see core inflation pick up.

Trade Wars: What Have We Learnt?

With an additional US dollars 300 billion of Chinese exports to the US to incur tariffs and the proverbial line in the sand of 7 on the USDCNY cross having been breached, what have we learnt?

First, the battle lines have been drawn and Beijing has clearly decided that it is not willing to make a deal on purely US terms. If a ‘beautiful deal’ is to be struck, it will now require some concessions from the Trump Administration ― the tough talking China hawks will need to back off, even if a little. Otherwise, China will tough it out and hope that the 2020 election will deliver an adversary other than Trump.

Second, President Trump has run out of Chinese imports to tariff. He could ratchet up tariffs to 25 per cent from the proposed 10 per cent but such a move risks a severe loss of business confidence; and gives China added impetus to let the renminbi depreciate further and stabilise its own economy, at the expense of everyone else’s.

What is seemingly working in President Trump’s favour is the half-life of the impact of his tariff tweets on the US equity market is declining. This may have more to do with liquidity than investor apathy.

The below chart is the year-over-year increase in commercial bank deposits in the US.

ALNLDEPO Index (US Commercial Ba 2019-08-09 18-51-12.jpg

Using commercial deposits as a proxy for US system-wide liquidity, liquidity has been in a cyclical contraction since 2013. Since November last year, system-wide liquidity has been picking up. If US commercial bank deposits can continue expanding, the US economy and equity market are likely to remain resilient for the time being.

Given this resilience, President Trump could continue to ratchet up tariffs and assume economic and market damage can be contained, especially if he can bully the Federal Reserve into loosening the purse string. If the Fed plays hardball, however, and markets and the economy have an almighty wobble, President Trump will have a ready scapegoat.

This might or might not be a successful strategy to get re-elected. It will not, however, bring China back to the negotiating table. Instead, Beijing is likely to let the renminbi depreciate gradually in an effort to shore up its economy. And central banks of nations with close economic ties with China are likely to respond by cutting rates to stabilise their respective currencies to the renminbi, much like what we saw happen in New Zealand this week.

It is worth noting that since the breakdown of the trade talks in early May, the Chinese negotiating position has been quite clear, and unaffected by the pressure tactics applied by the Trump Administration. Statements in May by senior Chinese officials, including chief negotiator and vice-premier Liu He, demanded that any trade deal meet three conditions: the list of US goods to be purchased by China to cut the trade deficit must be reasonable and not subject to capricious change; existing tariffs must be substantially reduced or eliminated; and the text of the agreement must “respect China’s dignity”.

The latest tariff threat by President Trump, despite virtually all his advisors objecting to it, achieved very little except giving China an excuse to let the renminbi depreciate. For now, the US-China negotiations are a stalemate. The choice President Trump makes will determine whether China returns to the negotiating table or not.

Dislocation

“Neutrality is at times a graver sin than belligerence.” – Louis D. Brandeis

In May, an escalation in the US-China trade dispute and President Trump’s reversal on the trade pact with Mexico, albeit short-lived, damaged business confidence and sufficiently raised uncertainty to cause corporations to re-think their investment plans.

No surprise then that business investment in the US fell by four-fifths of a percentage point, on a quarter-over-quarter basis, during the second quarter and was a major drag on US GDP growth.

President Trump, having raised hopes of an amicable solution to the trade dispute following the G20 meeting in Osaka, once again threw a spanner in the works yesterday. He tweeted that the US will be imposing, starting 1 September, a 10 per cent tariff on the remaining US dollars 300 billion of Chinese imports that hitherto had not been subject to tariffs.

President Trump’s tweets sent Twittersphere into a frenzy and caused stocks to sell off, oil to crater and gold to, well, behave like a safe-haven. And probably delayed corporate investment plans further.

Given the context, may be everyone should be long bonds and it makes sense that:

Over US dollars 13 trillion of global bonds trading with negative yields;
Bonds of sub-investment grade issuers in Europe trading with negative yields;
The German and Swiss yield curves are negative out to more than 20- and 30-years, respectively; and that
Austria sold a century bond with a yield of just 1.2 per cent.

Or it might be that global bonds trading at record low yields is a signal that either a global recession is underway, which the data will confirm sooner rather than later, or that the world will enter a recession sometime between now and late 2020. An imminent global recession appears to be the consensus view.

In our humble opinion, global bonds trading at record low yields are just as much a signal that a recession is imminent and that inflation is dead as technology stocks trading at market capitalisations of double- and triple-digital multiples of their hypothetical five-year revenues at the height of the tech bubble were of the internet ushering in a new business paradigm.

Sometimes the price is just wrong. Often because of a technicality.

A Digression

Up until 18 March 2005 the S&P 500 Index was a market capitalisation weighted index. That is, the weight of a stock in the index was equal to its market capitalisation divided by the sum of the market capitalisation of all stocks in the index. After 18 March 2005, the S&P 500 Index became a float adjusted capitalisation weighted index. That is, a stock’s weight in the index is equal to its free float market capitalisation – the stock price multiplied by the number of its shares freely available to trade, i.e., all shares excluding those held by insiders, locked-in as part of incentive programmes, held by the government or the promoters – divided by the sum of the free float market capitalisation of all stocks in the index.

The S&P 500 Index weighting calculation being agnostic to the free float and being based purely on a market capitalisation had an unintended consequence. That unintended consequence was the tech bubble.

All else being equal, a stock with fewer freely available shares to trade is less liquid, or illiquid, relative to a stock with more freely available shares to trade. Illiquid stocks tend to have more exaggerated price moves, up or down, than a liquid stock for the same value of buy or sell orders.

During the tech bubble, the market direction was just one way – up. So the upward price moves in illiquid stocks, in general, were greater than those of liquid stocks. And with each passing day, as a result, illiquid stocks started comprising a greater and greater portion of the S&P 500 Index. As their weight in the index grew, the demand for these illiquid stocks grew from (i) passive strategies that allocate based on index weightings and (ii) active managers reducing their tracking error and benchmark risk. The growth in demand for these illiquid stocks was not met with a commensurate increase in the quantity of stock freely available to trade. Rather, the opposite occurred. Those that held the illiquid stocks became averse to trading them. Setting off a vicious spiral that required bubble-like prices for the market to clear. Of course, when the market was ready to clear, nobody wanted the illiquid stocks anymore.

The Bond Technicality

Rather than go through an exhaustive list of technicalities that force bond buying, the below are examples of rules and regulations that have created price insensitive buyers of bonds:

OECD countries, such as Japan, France, Belgium, Portugal and Denmark, impose a minimum allocation to public sector bonds on their respective pensions plans. The minimum allocations range from 15 to 50 per cent of pension assets.

Basel III, a set of banking regulations developed by the Bank for International Settlements, increased the ‘Tier 1’ capital ratio – roughly the amount of ‘equity’ banks need to hold as a percentage of risk-weighted assets – and put a zero risk-weight on government bonds. To comply with the more stringent requirements banks have a choice to maintain risk-weight by increasing capital or reduce risk-weight by investing more in government bonds. Most banks chose the latter.

Quantitative easing. Just as an example, the European Central Bank bought over euros 1.9 trillion of government bonds, roughly 90 per cent of the bonds issued by European governments, over the 45-month period the quantitative easing programme was running.

The global bond prices are not right. It is a technicality. That does not mean you bonds should be shorted, either.

What Does Trump Want?

President Trump is nothing if not belligerent. He will try to get what he wants by any means necessary. But what is it that he wants other than being re-elected for a second term?

Lower Interest Rates, More Spending

The last four US presidents not to be re-elected all oversaw struggling domestic economies going into their re-election campaign. President Trump is undoubtedly aware of this and does not want a tight monetary policy or higher, than needed, interest rates to derail his campaign.

Lower interest rates, moreover, may make it easier for the Trump Administration to continue playing hardball with China. After all, the US economy is far less reliant on trade than most and it is the health of the consumer that tends to determine to fate of the US economy. Lower rates are simply put better for the US consumer.

In this instance investors should be long short-term interest rates. Equity investors should be long high quality consumer packaged companies with a decent yield such as Campbell Soup $CPB.

A Weaker Dollar

A weaker US dollar is generally stimulative for the global economy but also reduces China’s ability to meaningfully weaken its currency to offset any tariffs. Getting a weaker US dollar, at a time when most central banks are cutting rates and easing monetary policy, is not easy. The Fed, of course, is the one central bank that has the capacity to manufacture a weaker US dollar.

In this instance, investors should be long gold and other precious metals.

In neither instance do we think is buying long-term bonds the answer because a world with a weaker US dollar and / or lower interest rates is unlikely to enter a recession.

More importantly, businesses will eventually have to invest and they are most likely to invest in the US – the trade uncertainty is not going to go away anytime soon whether President Trump gets re-elected or not. The US has tight production capacities and low unemployment. Save a new immigration drive, a meaningful increase in business investment in the US or a large government led fiscal spending programme is likely to kindle inflationary forces and precipitate a sell-off in long-term bonds.

China Gold & Equities | Silver Update | Yield Curve

“An open, competitive, and liberalised financial market can effectively allocate scarce resources in a manner that promotes stability and prosperity far better than governmental intervention.” ― Henry Paulson

The irony of the above quote is rather obvious: Henry Paulson was a driving force behind the Troubled Asset Relief Program (TARP), which freed the United States government to purchase toxic assets and equity from financial institutions to strengthen its financial sector. That does not, however, mean the message is incorrect.

XAUCNY and the Chinese Equity Market

Earlier this year and late last year there was much debate around an implicit peg that seem to have formed between the renminbi and gold. More recently, the seven handle on the USDCNY cross has gathered much intrigue as the line in the sand for China.

We, too, have been following the price of gold in renminbi terms. Rather than signaling an impending currency devaluation, however, we think the pair can signal potential dislocations between the Chinese equity market and the economic realities on the ground.

Gold / CNY vs. CSI 300 Index (Inverted)

XAUCNY CSI300

Source: Bloomberg

The chart above plots the price of gold in renminbi versus the Shanghai Shenzhen CSI 300 Index (inverted).

Gold strengthened between 2010 and 2012 as the equity market faltered. Then weakened well ahead of the sharp Chinese market rally of 2014/15. Notably, the bottom in gold in renminbi terms almost coincided with the peak in the Chinese equity market.

More recently, the draw down in Chinese stocks following the sharp rally at the start of the year has coincided with strengthening gold. Gold has since continued to strengthen while stocks have traded sideways, portending more bad news for equity investors.

According to a paper authored by researchers at the Japan Center of Economics Research “(1) the gold return rises significantly if stock returns fall sharply; (2) it rises as the stock market volatility increases; (3) it also rises when general financial market conditions tighten”. The quoted study focuses on the US equity market. Assuming, however, that the findings are just as applicable in China, the continued rise in gold in renminbi terms may be signalling a sharp tightening of financial conditions on the mainland.

The below chart plots the Citi Early Warning Index for China (magenta) versus the XAUCNY cross.

CEWSCNY Index (Citi Early Warnin 2019-07-26 12-12-46.jpg

The above too suggests that the renminbi price of gold can act as a less volatile signal for the stresses building up in China.

Silver Updates

The below are updated versions of charts we have shared previously.

XAG Curncy (Silver Spot $_Oz) 4 2019-07-24

Silver has moved above its 48-month moving average. If it can continue to stay above the moving average, silver could sharply move higher.

SPX Index (S&P 500 Index) spx si 2019-07-24 10-00-21

The S&P 500 Index in silver terms in struggling around key levels. Making a silver a suitbable hedge for any US equity market weakness henceforth.

Reading Too Much into the Treasury Yield Curve

The below is a chart of the yield differential between US 10 year and 3 month Treasury securities.

USGG10YR Index (US Generic Govt 2019-07-25

Starting July, US yield curve is no longer inverted. A sharp steepening of the yield curve over following an inversion caused by a series of Federal Reserve interest rate hikes has been characteristic of the early stages of the last four US recessions. We think, however, commentators and investors may be reading too much into it. In the prior instances, a recession was signaled by a bull steepening, with the short end of the curve falling faster than the long end. This time, though, long end has been rising faster than the short end ― a bear steepening

Several factors have contributed to the reversal of the US yield curve’s inversion over the last couple of weeks. On one hand, Fed chairman Jay Powell confirmed market expectations of a near term rate cut in his testimony to Congress last week. On the other, both the New York Fed’s survey of one-year ahead consumer inflation expectations and the 10-year breakeven inflation rate signaled a pick-up in inflation expectations. As a result, the bond market has begun to price in the possible effects of firmer future inflation on future Fed policy. With the short end of the yield curve anchored by the Fed’s current dovishness and the labour market tight, any liquidity-driven improvement in the US growth outlook is likely to feed through into a further steepening of the US yield curve over the second half of this year.

The current iteration of an inversion followed by steepening resembles 1998 and not the last four recessions. In 1998, the Fed cut interest rates in response to global economic weakness following the Asian Financial Crisis and the collapse of Long Term Capital Management, resulting in a bear steepening. Between 1998 and 2000, US equities, specifically tech stocks, went parabolic.

Now is not the time to sell US equities in fear of a recession. It is the time to wait and see if we get a parabolic move higher and to gradually reduce equity exposure as markets move higher.

A Fear & Greed Gauge

“I listened very, very carefully to the world around me to pick up the signals of when trouble was coming. Not that I could stop it. But it made me observant. That was helpful when I became a lawyer, because I knew how to read people’s signals.” ― Sonia Sotomayor, Associate Justice of the Supreme Court of the United States

“Remember always that everything you know, and everything everyone knows, is only a model. Get your model out there where it can be viewed. Invite others to challenge your assumptions and add their own.” ―Donella H. Meadows, lead author of The Limits to Growth and Thinking in Systems: a Primer

As the US stock market has rallied and reached new heights, we have been trying to develop a framework that can provide a timely signal to reduce exposure. At the same time, we also want said framework to provide a timely signal to increase exposure following a draw down in the market.

In today’s piece we share one tool that we hope will, eventually, form part of a larger market timing framework. This piece is word light, chart heavy with the same tool being applied to major indices, select sector ETFs, and individual securities to provide indicative buy and sell levels can help us preempt sharp draw downs and avoid missing out on sharp rallies.

If you would like us to apply the tool to any additional securities just email us and we would be happy to do so.

Greed & Fear Gauge

The tool is really quite simple. It is a leading indicator created by deducting the 100-week moving average from weekly close prices and then identifying key buy and sell levels based on the indicator.

The key buy and sell levels are meant to act as guide, allowing some room for discretionary judgement if one prefers, rather than exact levels to trigger decisions. While there is some friction from whipsawing around key levels, a non-discretionary approach to the key levels can work well too, in our opinion.

In each of the charts presented below, there are twenty-five, the magenta line is the indicator and the orange line is the weekly close prices of the index / ETF / security in question.

Major Indices

S&P 500 Index

SPX Index (S&P 500 Index) Fear a 2019-07-22 09-57-22

The key levels are indicated using the black horizontal lines on the chart above.

The upper bound should be used as follows:

If the index has a weekly close at or more than 350 points above the 100-week moving average for the index, the sell trigger is a weekly close that is less than 350 points above the 100-week moving average.

If the index recovers the 350 points threshold on a weekly close at a later day, long positions should be re-established.

The lower bound should be used as follows:

If the index has a weekly close below the 100-week moving average of the index, any remaining long positions should be closed out.

If the index moves back above the 100-week moving average, new long positions should be initiated.

For the remaining charts we will identify the upper and lower bound levels and the same explanation as above will apply but replacing the respective upper and lower bounds for the ones for the S&P 500 Index.

Nasdaq 100 Index

NDX Index (NASDAQ 100 Stock Inde 2019-07-22 10-33-15

Upper bound: A weekly close 1,000 points above the 100-week moving average.

Lower bound: A weekly close below the 100-week moving average.

Nasdaq Index (Broader)

CCMP Index (NASDAQ Composite Ind 2019-07-22 09-57-45

Upper bound: A weekly close 1,000 points above the 100-week moving average.

Lower bound: A weekly close below the 100-week moving average.

MSCI ACWI

MXWD Index (MSCI ACWI Index) Fea 2019-07-22 14-41-28.png

Upper bound: A weekly close 50 points above the 100-week moving average.

Lower bound: A weekly close 25 points below the 100-week moving average.

Emerging Markets $EEM

EEM US Equity (iShares MSCI Emer 2019-07-22 10-59-31

Upper bound: A weekly close $10 above the 100-week moving average.

Lower bound: A weekly close $5 below the 100-week moving average.

Nikkei 225

NKY Index (Nikkei 225) Fear and 2019-07-22 11-19-22

Upper bound: A weekly close 3,000 points above the 100-week moving average.

Lower bound: A weekly close 150 points below the 100-week moving average.

MOEX Russia Index

INDEXCF Index (MOEX Russia Index 2019-07-22 11-19-50

Upper bound: A weekly close 400 points above the 100-week moving average.

Lower bound: A weekly close below 100 points above the 100-week moving average.

Sectors

PHLX Semiconductor Sector $SOX

SOX Index (Philadelphia Stock Ex 2019-07-22 10-24-22

Upper bound: A weekly close 100 points above the 100-week moving average.

Lower bound: A weekly close 35 points below the 100-week moving average.

Energy $XLE

XLE US Equity (Energy Select Sec 2019-07-22 11-49-30

Upper bound: A weekly close $5 above the 100-week moving average.

Lower bound: A weekly close $10 below the 100-week moving average.

Utilities $XLU

XLU US Equity (Utilities Select 2019-07-22 12-03-59

Upper bound: A weekly close $5 above the 100-week moving average.

Lower bound: A weekly close below the 100-week moving average.

Pharmaceuticals $XPH

XPH US Equity (SPDR S&P Pharmace 2019-07-22 12-10-28

Upper bound: A weekly close $5 above the 100-week moving average.

Lower bound: A weekly close $5 below the 100-week moving average.

Retail $XRT

XRT US Equity (SPDR S&P Retail E 2019-07-22 12-12-39

Upper bound: A weekly close $3 above the 100-week moving average.

Lower bound: A weekly close $1.25 below the 100-week moving average.

Consumer Staples $XLP

XLP US Equity (Consumer Staples 2019-07-22 13-24-22

Upper bound: A weekly close $5 above the 100-week moving average.

Lower bound: A weekly close below the 100-week moving average.

Healthcare $XLV

XLV US Equity (Health Care Selec 2019-07-22 13-26-42

Upper bound: A weekly close $12 above the 100-week moving average.

Lower bound: A weekly close below the 100-week moving average.

Biotech $IBB

IBB US Equity (iShares Nasdaq Bi 2019-07-22 13-29-00

Upper bound: A weekly close $10 above the 100-week moving average.

Lower bound: A weekly close $5 below the 100-week moving average.

Individual Stocks

$AAPL

AAPL US Equity (Apple Inc) Fear 2019-07-22 10-16-02

Upper bound: A weekly close $30 above the 100-week moving average.

Lower bound: A weekly close below the 100-week moving average.

$MSFT

MSFT US Equity (Microsoft Corp) 2019-07-22 10-45-46

Upper bound: A weekly close $30 above the 100-week moving average.

Lower bound: A weekly close below $10 above the 100-week moving average.

$SBUX

SBUX US Equity (Starbucks Corp) 2019-07-22 10-43-16

Upper bound: A weekly close $10 above the 100-week moving average. Given the strongly rally recently, however, we add $20 above the moving average as a profit-taking trigger.

Lower bound: A weekly close below the 100-week moving average.

$GOOG

GOOG US Equity (Alphabet Inc) Fe 2019-07-22 09-59-49

Upper bound: A weekly close $225 above the 100-week moving average.

Lower bound: A weekly close below $50 above the 100-week moving average.

$NKE

NKE US Equity (NIKE Inc) Fear an 2019-07-22 10-48-10

Upper bound: A weekly close $18 above the 100-week moving average.

Lower bound: A weekly close below $5 above the 100-week moving average.

$AMZN

AMZN US Equity (Amazon.com Inc) 2019-07-22 10-05-05

This is a difficult one given the strength of the rally in the last three years and probably provides a weak signal.

Upper bound: A weekly close $600 above the 100-week moving average.

Lower bound: A weekly close below $200 above the 100-week moving average.

Micron $MU

MU US Equity (Micron Technology 2019-07-22 10-55-54

Upper bound: A weekly close $15 above the 100-week moving average.

Lower bound: A weekly close $5 below the 100-week moving average.

Precious Metals

Gold

Upper bound: A weekly close $250 above the 100-week moving average.

Lower bound: A weekly close below the 100-week moving average.

Silver

XAG Curncy (Silver Spot $_Oz) F 2019-07-22 11-27-11

Upper bound: A weekly close $5 above the 100-week moving average.

Lower bound: A weekly close $1 below the 100-week moving average.

Bitcoin

XBTUSD Curncy (XBT-USD Cross Rat 2019-07-22 11-31-24

Upper bound: A weekly close $5,000 above the 100-week moving average.

Lower bound: A weekly close below $1,000 above the 100-week moving average.

Osaka: From Trade to Tech

“Decisions in a modern state tend to be made by the interaction, not of Congress and the executive, but of public opinion and the executive.” ―Walter Lippman, The Basic Problem of Democracy, 1919

Before going on to this week’s commentary, we wanted to share a passage from These Truths: A History of the United States by Jill Lepore:

Progressivism had roots in late nineteenth-century populism; Progressivism was the middle-class version: indoors, quiet, passionless. Populists raised hell; Progressives read pamphlets. Populists had argued that the federal government’s complicity in the consolidation of power in the hands of big banks, big railroads, and big businesses had betrayed both the nation’s founding principles and the will of the people, and that the government itself was riddled with corruption. “The People’s Party in the protest of the plundered against the plunderers―of the victim against the robbers,” said one organizer at the founding of the People’s Party in 1892. “A vast conspiracy against mankind has been organized on two continents and is rapidly taking possession of the world,” said another. Progressives championed the same causes as Populists, and took their side in railing against big business, but while Populists generally wanted less government, Progressives wanted more, seeking solutions in reform legislation and in the establishment of bureaucracies, especially government agencies.

Populists believed that the system was broken; Progressives believed that the government could fix it. Conservatives who happened to dominate the Supreme Court, didn’t believe that there was anything to fix but believed that, if there was, the market would fix it. Notwithstanding conservatives’ influence in the judiciary, Progressivism spanned both parties.

The United States of America has been here before.

We will be sharing passages from Jill Lepore’s magnum opus over the coming weeks and months in the run up to the Democratic primary battle for 2020 Presidential Election.

Osaka: From Trade to Tech

From The Wall Street Journal:

Some money managers are bracing for a potential resurgence in trade tensions after President Trump’s meeting with Chinese President Xi Jinping this weekend by hedging their bets with currencies and options.

Strategies include a short on the Australian dollar and other currencies as well as bearish put options on the iShares China Large-Cap exchange-traded fund. Money managers including Russell Investments have pared their exposure to U.S. stocks, favoring more-attractively-valued shares of emerging-market companies.

How those moves pan out largely depends on what happens in Osaka, Japan, this weekend, when Messrs. Trump and Xi meet Saturday on the sidelines of the Group of 20 summit. There is no clear consensus among investors on whether the U.S. and China can reach a deal. Trade-policy uncertainty remains at elevated levels, according to data compiled by Wells Fargo Investment Institute.

Rather than being left flat-footed, investors are taking precautions in case talks lead to an impasse or, worse, a full-blown escalation in tensions. The S&P 500 slumped 6.6% in May following the unexpected implementation of additional tariffs on China’s products.

With one trading day remaining before President Trump and President Xi are expected to meet at the sidelines of the G-20 summit in Osaka, the S&P 500 Index is down 69 basis points while the Philadelphia Stock Exchange Semiconductor Index is up 317 basis points. Huawei is likely to be part of any potential trade deal, the recent strength in semiconductors could well reflect some optimism for trade negotiations taking a turn for the better following the meeting between Messrs. Trump and Xi.

While we are somewhat optimistic with progress being made on trade negotiations, more on that anon, we are concerned the economic hostilities between the US and China gradually shifting from being centered around trade to being increasingly focused on enabling technologies, such as semiconductors, and core technology infrastructure, such as telecommunication networks. For that reason, we would use any trade optimism related rallies in semiconductor stocks to further reduce exposure or add short positions.

Trade Optimism

The noise out of Washington suggests that there is a more than even chance that the talks between the leaders of the largest economies in the world will result in a deal in the next few months. It may well also be that the US and China negotiate a truce on Huawei, although any deal relating to the Chinese telecommunication changed could be torpedoes by Congress.

Our view is predicated on President Trump, not the trade hawks in his administration, wanting a deal rather than applying further tariffs on US dollar 325 billion of Chinese imports that he threatened to impose as early as next month.

We expect the two leaders to announce, following their meeting, that trade talks will resume and they expect a deal to be hammered out before the end of the year. The hawks on the Chinese side are likely to agitate for all tariffs to be eliminated with immediate effect. While the hawks in the Trump Administration will continue to insist that China enshrine its commitments in law.

Beijing has already made changes to its laws by passing a new Foreign Investment Law in March, and making amendments to its intellectual property-related laws and regulations. Changes to the intellectual property laws and regulations offer, accord to experts we have spoken to, significantly stronger protection for foreign intellectual property rights and limit Chinese corporations ability to coerce technology transfer. More action is likely to be required China, but at least there appears to be meaningful progress on this front.

Putting China’s Technological Progress in Check

Among the preconditions for a trade agreement put forth by China is the requirement for the US to remove its ban on the sale of US technology Huawei. This will be a tricky matter to resolve. The Trump Administration has for months been drumming up anti-Huawei sentiment in Washington that any attempt to compromise will be seen as selling out national security for monetary gains. Senator Mitt Romney is already working on legislation that would prevent the President from removing Huawei from the export ban list.

Of the few bipartisan issues in Washington is the desire to put China’s technological progress in check, particularly its development of semiconductor and defense industries. Therefore, in our opinion, any trade deal is likely to skirt around the Huawei and technology transfer issues. These issues are then likely to manifest through alternative channels after a trade deal has been struck. One possibility is for a compromise allowing Huawei to resume buying components from US suppliers, in exchange for some restrictions on Huawei building out telecommunication networks US-friendly jurisdictions.

The technology-led US equity bull market might not die of old age but may die because the power players in Washington decide that the no amount of lost revenue is worth salvaging in its bid to slow the rise of China.

Trading the Thin Zone | Healthcare Follow Through

“If history repeats itself, and the unexpected always happens, how incapable must Man be of learning from experience.” ― George Bernard Shaw

Goldbugs are gloating. Dollar bulls are hurting. Ellioticians are cursing. This, we hope, is not one of those pieces.

Trading in the Thin Zone

Actions speak louder than words. Well, except for the Federal Reserve. They talked a big game, did very little yet markets popped. None more so than precious metals.

Rather than discussing the what and why of the latest Fed meeting, we discuss our thoughts about trading strategies for the US dollar, gold and silver.

Before we explain, the summary:

The critical level for US dollar bears is around 92 on the $DXY or US dollars 24 for the Invesco DB US Dollar Index Bullish Fund $UUP;

Above US dollars 1,375 per ounce for gold; and

Around US dollars 17.50 per ounce for silver.

In the price charts below, we overlay the volume around each price level to identify what may be called “thin zones” ― areas where prices can move quickly and where positioning should be biased in favour of the shorter-term trend. The investment instruments we chart are ones we deem suitable proxies for the US dollar, gold and silver.

Thin zones are price levels where there has been relatively little buying or selling. Making them areas where there should be little to no support or resistance and so prices can move quickly through them.

These thin zones are typically preceded by, from above or below, price levels where there has been a lot of volume both on the way up and on the way down. These price levels are likely where institutional buying or selling has been heaviest in the past and where there are been a lot of push and pull between bulls and bears. And therefore the breach of such price levels can cause one set of market participants immense amount of pain while reap handsome rewards for the other set of participants.

Winners are unlikely to suppress a favourable move and instead may add fuel to the fire by increasing their positions and heaping yet more pain on those on the other side. The losers, except the most stubborn, are likely to cover adding yet more fuel to the move. With demand being almost unidirectional, prices can spike on very little volume ― making it profitable to position at the edges of thin zones.

Using $GLD as a proxy, gold given the recent sharp move higher is right at the very edge of the thin zone and any continuation of the move higher should be used to add to longs.

Based on $UUP, the US dollar is still someway from getting to the thin zone on the downside but is close to one on the upside. It is still too early to have a full short position in the US dollar and if the current move down is a head fake, shorts should close out positions and even look to go long.

We suspect, 92 on the $DXY is close to the pain threshold for foreign pools of capital holding US Treasury securities without hedging foreign currency risk. If the US dollar breaks 92, it will be time to put on a full short position in the greenback.

UUP

Silver has a lot of work to do before it too can get closer to the thin zone. Gold is probably the better instrument to trade if you want to be long precious metals at present. If, however, silver moves through US dollars 17.50 per ounce, all bets are off and gold longs should be rotated into silver.

slv

Another proxy for silver is to watch for a sustained move above its 48 month moving average.

XAG Curncy (Silver Spot $_Oz) 4 2019-06-20 12-54-14.png

Healthcare Follow Through

A few weeks ago we highlighted the sharp recovery in healthcare stocks and started thinking about the sector as hunting ground for new long ideas. Since then we have witnessed a follow through with the SPDR Health Care Select Sector ETF $XLV continuing to push higher, particularly on the back of mergers and acquisitions activity in the biotechnology space.

The sector has been a laggard year-to-date but a leader in the last month. If the current iteration of the US bull market still has legs, we expect healthcare to continue going from strength-to-strength.

XLV US Equity (Health Care Selec 2019-06-20 11-27-42.png

We remain long Repligen Corp $RGEN and Novocure $NVCR and identify two additional names as long ideas in the healthcare sector. (A long in $AbbVie has still not been triggered.)

RGEN US Equity (Repligen Corp) H 2019-06-20 12-07-54.png

Medtronic $MEDT

Medtronic is the world’s largest medical devices company that infamously acquired Ireland-based Covidien to enable Medtronic to shift its legal headquarters from the US to Ireland to benefit from the favourable tax-regime in Ireland.

We will look to enter a long position should the stock close above US dollars 100.

MDT US Equity (Medtronic PLC) He 2019-06-20 12-10-26

Edwards Lifesciences Corp $EW

Edwards Lifesciences is another medical equipment company. It specialises in artificial heart valves and hemodynamic monitoring.

We are long here.

EW US Equity (Edwards Lifescienc 2019-06-20 13-12-18.png

Thank you for being a subscriber!

Charts, Ideas and the Euro

“There is nothing more deceptive than an obvious fact.” ― The Boscombe Valley Mystery by Arthur Conan Doyle

Gold vs. US 10 Year Treasury Real Yield

Source: Bloomberg

The above chart compares the year-over-year change in the US dollar price of gold versus the year-over-year change (inverted) in the real yield on US 10-year Treasury Securities. (The deflator used to calculate real yields is core inflation.)

Ever since the gold-bubble popped in 2011, the year-over-year change in its price has been negatively correlated with real 10-year yields. Intuitively, this makes sense given gold is a non-yielding asset and the lower the real yield on bonds the more attractive a non-yielding asset becomes on a relative basis.

Real yields can, of course, decline either due to nominal yields in bonds declining or by inflation picking up. In either case, if the relationship between gold prices and real yields holds, gold prices should move higher. With little seeming desire on the part of the Federal Reserve to jawbone rates higher — especially with a Twitter-happy president and global trade uncertainties rising — precious metals, other than their customary volatility, could be primed to move much higher. Our conviction will be increased if see gold take out its 2016 highs of around US dollars 1375 per troy ounce.

Thinking About the Euro

Try and go back to the start of the year and imagine:

(1) the trade dispute between the US and China escalating;

(2) global risk aversion — measured using the BNP Paribas Global Risk Premium Index — reaching levels last witnessed at the start of 2016;

(3) Italian bond yields blowing out;

(4) economic data coming out of Germany deteriorating;

(5) systemically important European banks, such as Deutsche Bank, crashing to new lows; and

(6) the positive carry (higher interest rate) for the US dollar over the euro sustaining.

Given the above scenario, most investors would want to be long the US dollar and short the Euro. And, indeed, positioning in futures markets suggests that investors are indeed long the greenback and short the euro. Yet, the US dollar is not moving higher. What gives?

EURUSD Curncy (EUR-USD X-RATE) 2019-06-07 18-06-14.jpg

The above is a monthly chart of the Euro US dollar cross. If we get follow through in the recent move higher in the euro by the end of this month, the probability is the euro strengthens from here at least to 1.20 and possibly higher. If, however, the recent move fails and the US dollar strengthens, then we may well get the doomer scenario of a US dollar that is too strong for the rest of the world to handle.

Our base case view is that a weakening greenback finally gets us the blow-off top or ‘market melt-up’ in US equity markets that many have been waiting for.

Watch the euro-US dollar cross and position yourself in stocks accordingly.

The ECB: Not Doing Enough to Prevent the Worst

At this week’s governing council meeting, the European Central Bank (ECB) left the deposit rate at -0.4 per cent and extended forward guidance into 2020, with rates expected “to remain at their present levels at least through the first half of 2020”.

The ECB also confirmed that the proceeds from maturing bonds in its portfolio will be reinvested to keep the stock of assets steady. Details of a third Targeted Longer-Term Refinancing Operation were also revealed: it will be held quarterly from September at interest rates as high as main refinancing operation rate (currently at 0 per cent) + 10 basis points and as low as the deposit rate + 10 basis points. The precise rate will depend on banks hitting their lending targets.

The ECB’s measures should support the European economy and potentially slow down the upward pressure on the euro from an increasingly dovish Fed. However, we do not think the ECB has gone far enough to address the challenges faced by its banks and a further deterioration in global trade activity. It might be that Mr Mario Draghi is passing the buck onto his yet to be named successor but we think the ECB may have at least one trick left up its sleeve: Open Monetary Transactions.

The Open Monetary Transactions (OMT) facility, established during the European crisis, has never been utilised. Currently, the ECB can only buy government bonds according to member states share of its capital. Under an OMT program, however, it would have the power to buy bonds of a specific member state if said member’s government accepts conditionality along the lines demanded by the International Monetary Fund for countries in its funding programs.

If the ECB eventually, albeit reluctantly, comes through with an OMT like programme or another measure to reduce the burden of negative interest rates on European banks, that too could push global stocks much higher.

Sharp Recovery in Healthcare Stocks

Take a look at the relative chart of the SPDR Health Care Select Sector ETF $XLV to the S&P 500 in the second panel below. After a more than four-moth period of drastic under performance by the healthcare sector, we have witnessed a sharp recovery in recent weeks.

We think healthcare stocks might be ripe ground for stock pickers.

XLV US Equity (Health Care Selec 2019-06-07 18-21-02

Some of the names we are tracking closely in the space are highlighted below.

Novocure $NCVR

Research and development company focused on developing cancer treatments with a market capitalisation of US dollars 5.3 billion. We recommend a small position here with a view of adding if it breaks to new highs, above US dollars 56.67.

NVCR US Equity (Novocure Ltd) VE 2019-06-07 18-44-57.jpg

AbbVie Inc $ABBV

Pharmaceutical behemoth $ABBV is starting to looking interesting to us at current levels. A move up US dollars 81.50 and we would be buyers. We recommend buy stops at the level.

ABBV US Equity (AbbVie Inc) VEEV 2019-06-07 18-50-15.jpg

Repligen Corp $RGEN

Massachusetts based $RGEN is engaged in the development and production of materials used in the manufacture of biological drugs ― substances made from a living organisms or its products and used in the prevention, diagnosis, or treatment of cancer and other diseases.

We are long here.

RGEN US Equity (Repligen Corp) V 2019-06-07 19-18-03.jpg

Charts and Comments

“During the 1970s, inflation expectations rose markedly because the Federal Reserve allowed actual inflation to ratchet up persistently in response to economic disruptions — a development that made it more difficult to stabilize both inflation and employment.” — Janet Yellen

Japanese Banks

On a price-to-book basis Japanese banks look cheap (top panel). Adjusting the price-to-book ratio for return on equity, Japanese banks are trading at their long-term average. (bottom panel).

TPNBNK Index (Tokyo Stock Exchan 2019-05-27 11-10-57.png

The Semiconductor to Software Flip

The below chart is the ratio of S&P Software GICS Level 3 Index to the Philadelphia Stock Exchange Semiconductors Index.

A potential trade to hedge out some risks from a further escalation in the trade dispute would be to be long software short semiconductors.

S5SOFT Index (S&P 500 Software I 2019-05-29 13-58-25.png

US REIT Spreads to 10 Year Treasury Yields

The top panel in the below chart is the absolute gross yield of the S&P US REITs Index and the bottom panel is the yield spread relative 10-year US Treasury Securities. REITs are not benefiting from the recent drop in bond yields but yield spreads are not showing any real signs of concern (unlike in 2016).

SREIUS Index (S&P USA REIT USD I 2019-05-31 13-35-13.jpg

If there is a deterioration in US economic activity yield spreads on REITs could spike. Alternatively, if inflation expectations pick up absolute yields could pick up.

An inflation neutral, US economic deterioration hedge could be long US 10-year Treasury Securities short US REITs. The negative carry, i.e. the higher yield on REITs means that the payout of coupons on the short side relative to the receipt of coupons on the long side, might make it a difficult trade to hold on to.

The Long Run S&P 500 to Silver Ratio

The below chart is the very long-run ratio of the S&P 500 Index to the dollar price of silver. (We did not use gold as the dollar was pegged to the barbarous relic for prolonged periods of time during the twentieth century.)

As the chart below suggests, we are getting close to bubble territory in terms of the value of the S&P 500 relative to silver. (Bubble territory being two-standard deviations above the long run average — the very top orthogonal line in the chart.)

SPX Index (S&P 500 Index) spx si 2019-05-31 14-17-08

The below chart, a bit messier one than the above, includes the year-over-year change in the US urban consumers price index (CPI) and the and the 4-year moving average of CPI.

SPX Index (S&P 500 Index) spx si 2019-05-31 14-48-16.jpg

The periods of benign or sharply declining inflation have generally been favourable for stocks relative to precious metals. While periods of sharply rising or persistently high rates of inflation have been

Members of the Federal Reserve have, in recent months, been talking up a monetary policy framework called average inflation targeting, which would entail accepting overshoots of the targeted two per cent price goal to make up for times when inflation was too low.

The concern we have, taking inspiration from the Janet Yellen quote above, is that a change in the monetary policy framework by the Fed causes “actual inflation to ratchet up persistently in response to economic disruptions”. The yield curve is sending a signal that the world will be unable to escape from the current deflationary / low-inflation trap that it has been stuck in. And the consensus view seems to be that trade wars are deflationary.

What if, however, the ongoing trade war between the US and China is about to cause an economic disruption that leads to a persistent ratcheting up of inflation?

Globalisation has been a deflationary force over the last three to four decades. The accession of China to the World Trade Organization (WTO), in particular, allowed 750 million workers, whose wages were estimated be as little as 10 percent to those of workers in developed markets, to enter the global trade system. The central bank policy response to the deflationary wave of globalisation and the abundant availability of low cost workers in China was that of lowering interest rates.

Low interest rates and juicy returns on investments made in China, and emerging markets in general, created a positive feedback loop.

Large US Corporations borrowed at low interest rates -> invested the capital in emerging markets and reduced capacities in developed markets -> developed market consumers benefited from lower prices -> central banks lowered interest rates -> rinse repeat.

Low interest rates beget lower interest rates. That is, until the capital being invested starts to get impaired and the cost to corporations is not just interest but also loss of principal. The victory of the Trump Administration in deterring the flow of capital into China by multinational corporations has been that, unlike previously, there is real concern now about loss of principal. And when corporations are sufficiently worried about loss of principal they do not invest.

Businesses, however, can only postpone investing for so long. A prolonged trade dispute is going to result in capital being invested in jurisdictions other than China. Executives and company boards, however, are likely to be sufficiently worried about other jurisdictions being targeted by the Trump Administration’s protectionist push. And so a portion, a significant one, of corporate investment budgets is going to be allocated to the US.

Labour markets in the US are tight. While capacities are not constrained, there is little slack. What if protectionism is the economic disruption that causes “inflation to ratchet up persistently”?