tHE FIRST SHOE IS NOW DROPPING

We appreciate that it’s a rear-mirror view but end December data from our friends at CrossBorder shows unequivocally that investors have moved to being risk-off.  Their World Risk Exposure* index moved from approximately neutral to -37 (‘normal’ range -50 to +50), or approximately two standard deviations below trend.  We would suggest that a capitulation of this scale is a necessary pre-condition to a new bull market but we don’t believe that it is yet sufficiently sustained to send a buy signal.  Long experience tells us that bear markets rarely end in a single sell-off, though there are exceptions such as 1987. Our reasoning is primarily that funding liquidity globally remains at a level (16 on a range of 0 to 100) which is predicting recession.  No surprises that the US Federal Reserve is the biggest drag but it is worrying that the People’s Bank of China, until now the least tight major central bank, has shown signs of tightening.  It may only be a temporary phenomenon ahead of the Chinese New Year, but given that central banks are in our view far too tight in their policy already, it is not helpful.  The ECB, perhaps with the possibility of a no-deal BREXIT in its head, is now the loosest major central bank. We continue to think an economic downturn is almost inevitable and a global recession likely.   However, for investors trying to time when to dial up their risk exposure again, the first shoe is now dropping.  The second shoe will be an upturn in funding liquidity.  We’d expect that to happen in the second half of 2019. *Risk Exposure data measure the % of the global portfolio held in risk assets as against ‘safe’ assets such as cash and bonds.   

Too early to put the pedal to the metal in Japan?

We’ve had our feet off the pedal on Japan for much of 2018, as regular readers will know.  It’s not that things were going wrong with the economy, more that stockmarket investors - or was it really buying by the authorities for political rather than investment reasons – had gotten ahead of themselves. We pointed out in 2018 that there was a structural change for the better in profit margins and that the very low level of leverage meant that could be boosted significantly by borrowing.  We also pointed out that Japanese valuation disparity was relatively greater than other major markets, indicating an inefficient market.  Add in Prime Minister Abe’s seemingly secure tenure and relatively looser monetary policy in both Japan and China, and the combination should have made a profitable hunting-ground for active investors. It didn’t turn out that way and we now have the added weight of the Nissan saga - casting doubts on corporate governance improvements in Japan - as well as a sharp increase in the yen.  We are not surprised that on Christmas Eve the Nikkei index fell to a bear market territory reading of more than 20% below its 2018 high. We are still refraining from treading hard on the metal but our reasons are more macro than micro.  Our biggest concern is that investors will use the yen as a safe haven if global markets take another leg down.  Currency volatility has been suppressed over the past few years and investors are probably underestimating the risks. The positive story on Japanese earnings is still very much in place, notwithstanding the gloss may have come off governance.  Active investors will probably enjoy good profits from Japan over the next couple of years but our hunch is that there will be a better entry point coming up quite soon. To find out more about our specialism in Japan please click here.​

​Linchpin 2019 Inflation Update

William Bourne has since 2012 written an annual update on the long-term outlook for inflation by monitoring shifts in a varied range of inflation indicators.  Last year for the first time the consensus tipped towards inflation: we agreed on the direction of travel but argued significant rises were not yet imminent.  One year on, austerity has clearly been abandoned, and protectionism is on the march: we consider both to be inflationary.  On the other hand, the US Federal Reserve’s determination to cap inflation will in our view lead to an economic slowdown, which is deflationary. A year ago we concluded that deflationary forces had after 25 years finally been outweighed by more inflationary ones.  Behind this lay secular indebtedness, shifts in relative power between capital and labour in the West, and a cyclical upswing in Emerging Markets economies.  We argued that higher inflation is inevitable eventually but placed more emphasis on market indicators suggesting not quite yet. Headline numbers in 2018 have continued to rise gently to around 2% in most of the world.  Japan is an outlier below this number and the US an outlier above. The final abandonment of fiscal austerity by most developed countries is clearly inflationary in the long term.  Not only does it build up government debt level, but by adding to demand it increases pressures in areas such as labour costs.  It confirms our view that western money will ultimately be debased.   Under the traditional model, new demand would be filled first from spare capacity.  Today the output gap is minimal in most countries, and the new demand is often in different industries and areas to where excess supply lies.  We have not changed the indicator for the output gap, but we have for deleveraging - really it is now a case of leveraging. In 2017 commodity prices rose by 8% and we marked them as Inflationary.  In 2018 non-energy prices were not greatly changed but oil prices rose by around 25%, so we have maintained this measure as Inflationary.The growth in trade friction is another factor leaning towards inflation, both prima facie as tariffs are added to goods but also in the longer term as competitive pricing pressures reduce.  We have moved the Costs indicator (re-named from Labour Costs) to Inflationary. Last year it was the market indicators, and primarily bond yields, that made us hesitate about predicting an immediate rise in inflation.  A year later, US bond yields have risen decisively, with 10-year bond yields categorically breaking up through 3% before falling back.  Other sovereign bond yields have not risen by much in 2018 suggesting that, outside the US, inflationary pressures are likely to remain muted.  We have therefore retained bond yields at Neutral. Monetary policy is very tight around the world except for China. The US Federal Reserve is in our view on the verge of making a policy error by over-focusing on inflation concerns.  This is how most recessions are caused, and we now expect at best a slow-down, at worst a recession.   Having said this, the Federal Reserve has softened its tone: while it is still talking further interest rate rises, Fed. Chairman Powell’s latest speech clearly prepares the ground for some backtracking.  Notwithstanding, we have moved this indicator to Deflationary.In summary, government fiscal policy seems inevitably to lead to higher inflation, but it is only coming through in some market and financial indicators.  Our 13 indicators have moved in different directions, with two (cost pressures and deleveraging) indicating more inflation and two (lower growth and monetary policy) signalling lower. Table showing direction of travel for inflation  Current market estimates of inflation The current IMF forecasts for Advanced Economies are little changed, whether in the short term or five years out, at 1.9% (deflator measure, 1.8% twelve months ago) and 2.0% five years out (end period CPI, 1.9% twelve months ago).  Estimates for Emerging Markets over the next five years average out at 4.2% end period CPI at the same time, compared to 3.9% 12 months ago.  US consumer inflation, as measured by the Personal Core Expenditure (ie. ex food and energy) was 2.2% in November 2018 (2.1% a year ago).  It peaked mid-year at 2.9% and has been falling back since. Conclusion In our view the final ditching of fiscal austerity, combined with the levels of debt in the West and an increased level of political dysfunction, bakes in higher inflation in the longer term.  However, in the short term the forces may actually be pulling in the other direction: we believe that the ECB and the Federal Reserve are on the verge of making a policy error by running too tight a monetary policy and economic growth has probably peaked this cycle.  That may be what market indicators, and particularly bond yields, are telling us. If you would like to discuss anything in this article with the author, please contact us.​

What will 2019 bring? We're going on a bear hunt

Any reader with children will be familiar with Michael Rosen and Helen Oxenbury’s delightful book of a bear hunt which ends with the bear pursuing the adventurers back to their bed at much greater speed. We see parallels in today’s markets.  Investors risk appetite is still quite elevated, particularly in the US.  ‘We’re going on a bear-hunt.  We’re not scared.’  At the same time the environment, and particularly the lack of liquidity, is highly unfriendly.  The main cause is central banks withdrawing liquidity, which on a range of 0 to 100 sat at 18.5 overall at end November.  ‘Uh-uh!  A forest! A big dark forest. We can't go over it. We can't go under it. Oh no! We've got to go through it! Stumble trip! Stumble trip! Stumble trip!’ Our view is that central banks have tightened too far against a still quite fragile world economy.  The US Federal Reserve is showing some signs of realising this, but the ECB is at maximum tightness and is on course for a major policy mistake.  We have for some time had a recession pencilled in for 2019 and we expect markets to wake up to that in the next six months.  ‘WHAT’S THAT!  One shiny wet nose! Two big furry ears! Two big goggly eyes! IT’S A BEAR!’ Equity markets may no longer be expensive but they are not cheap either.  And many investors are too young to have seen what happens in a traditional bear market, especially when political risk is elevated as now and there are structural debt problems.  ‘In to the bed.  Under the covers.  I’m not going on a bear hunt again.’    In fact, of course, bear markets throw up opportunities for canny investors.  We’d guess that the best ones are likely to come up in Asia because that is where liquidity is strongest.  The People’s Bank of China is relatively less tight, risk appetite is lower (ie. a better starting point for a new bull market) and cross-border flows continue to move away from Developed Markets. But it’s a story for late 2019.  In the first half, under the bedcovers is a sensible place to hide from the prowling bear.  We wish we could end 2018 on a merrier and happier note. To find out more, please contact us. .  

End October liquidity data

Regular readers of this blog will be aware that the overall liquidity picture is the weakest since just before the Global Financial Crisis - and before then 1989.  The most recent end October data remains at levels which normally herald a recession.  A major factor behind this is, of course, central bank tightening.  Over 70% of central banks are running ‘tight’ policies and only the People’s Bank of China is still officially easing. It’s no surprise that, when the financial tide is running out, marginal borrowers are the first to be exposed.  Hence Emerging Markets economies are weakening faster, while the ‘core’ US remains relatively resilient.Our friends at CrossBorder who produce this liquidity data also see signs from the bond market that an economic slow-down is on its way.  Yield curves have flattened and for the real technos the position of the curvature peak within them is contracting too.   With this background, perhaps the intriguing question which has not yet been asked is whether we are coming towards the end of the current tightening cycle?  It’s probably a little early but it seems to me most unlikely that even the Federal Reserve is going to be able to follow through on its promised track of interest rate rises.So, while I confidently expect another leg down in markets, we can also see some seeds of recovery beyond that – albeit probably at the cost of inflation. To learn more about CrossBorder’s research on liquidity please click here. ​

William Bourne and Mukesh Malhotra attend Investing with Impact Summit

On 21st November 2018 William chaired a Panel at the Investing with Impact Summit on implementing an impact investment.  Mukesh also attended the event which was held in London.

Is corporate america going to eat all of our lunches?

I intended to write a blog this week on the UK Budget, but there’s really not much to say.  It’s almost as if it was written by a Shadow Chancellor who can promise what he wants, knowing he probably won’t be there to deliver it.    Instead I’m going to ask whether perhaps the negative Linchpin view on the United States and its equity market is wrong.  As regular readers of this column will know, we think the combination of a sharply tightening Federal Reserve, overstated US earnings growth and a relatively strong dollar is pretty toxic.  Let alone President Trump’s willingness to upset his allies and enemies alike in his determination to get a fairer deal for the US on trade and defence. I am prompted by a conversation I had with a West Coast friend of mine.  Two years ago he voted for Trump, while admitting it was a gamble.  Today he reckons that the United States is going to eat the rest of the world’s lunch.  He sees it as the living proof of capitalism’s success in contrast to regulated and socialist Europe.  US companies dominate key industries, and Trump’s policies are providing financial dividends as Europe shares a greater part of the defence burden and China is forced to open up. He would agree with me that market returns are going to be lower in the next 10 years than they have been in the last but he reckons that the rate of US economic growth, albeit maybe not at 2018’s 4% clip, will be sufficient to deliver reasonable returns to equities. Part of his argument is what he sees as the failure of other economies to follow the successful model of the US.  We might disagree exactly what success means but no-one can deny that the large US companies are leaps ahead in terms of global reach. I still believe that the recent setback is not yet the ‘big one’ which we – because of such a poor financial environment – believe is inevitable.  I continue to think that over-aggressive tightening by the Federal Reserve is likely to be the catalyst.  But I will admit that my conviction has weakened. Find out more here.​

Central bank liquidity at lowest since early 1980s

At the end of August, central bank liquidity was at its lowest level since the early 1980s, according to the data which our friends at CrossBorder Capital monitor.  The index stands at 13.8 (range 0 to 100) and only the People’s Bank of China is still following a relatively loose policy. We shouldn’t perhaps be surprised by this, coming after nearly ten years of Quantitative Easing (QE).  But an environment of tight money undoubtedly heightens the risk that someone somewhere is unable to pay their bills and the first domino falls. In contrast investors are relatively sanguine and ‘risk-on’ in aggregate.  CrossBorder’s measure of this metric is at +33 on a scale of -50 to +50, which is consistent with what we hear on the street.  Many professional investors are preferring to remain invested for the time being. Although there are pockets of light in the liquidity environment (China and, surprisingly, the UK where corporate cashflow is strong), at Linchpin we would argue strongly for a defensive ‘risk-off’ stance.  The overall levels of liquidity are pointing unambiguously to, at best, soft economic growth and, at worst, a recession if Central Banks tighten further.  Given investors’ positioning, that is unlikely to end well for those exposed to too much risk.To learn more about CrossBorder’s research on liquidity please click here.  

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