Despite headlines about US bond yields, William Bourne, albeit reluctantly, is staying ‘risk on’​

Investors have begun 2018 much as 2017 ended – with a high appetite for risk (call that complacency if you will) and a willingness to ignore politics in the hunt for return of any kind.  Hence arises the conundrum we have regularly referred to – ie. that market volatility remains stubbornly low while political risk appears to be high.     Global liquidity at end December, as measured by our colleagues at CrossBorder, was 51 on a scale of 100.  This provides some justification since it is not at a level which predicts any kind of financial crisis.  However, when there is a consensus, one has to ask the question: what could possibly go wrong? Well, there are the obvious geo-political risks but they would have to be of a cataclysmic scale to burst investors’ complacency.  In the Linchpin view of the world, all market setbacks involve some form of financial crisis where one entity can’t pay its debts to another.  Think back to the UK in the 1970s, Latin America in the 1980s, Russia in 1998, Enron in 2002 or banks in 2008.  We can only see a few plausible candidates here, principally in the US and China. Today’s headlines feature a technical break of the US two year bond yield downward trendline, with comments that they are for, the first time in ten years, close to 2008 levels.  If this does signal an end of the bull market in bonds and a normalisation of the ‘price’ of money, that has the potential to impact investor complacency, simply because of the level of debt in the western economy.    Investors should also keep an eye on the US$ since cross-border flows out of the US are accelerating.  If currency weakness is gentle, investor confidence will probably be maintained; however a sudden lurch could be sufficient (as in 1987) to burst confidence, and lead to a further rise in bond yields and downward repricing of equities. China is another possible candidate, though the level of state control in the financial system means that any financial crisis would be the result of deliberate state intervention rather than market forces.  We are more optimistic about China than the consensus in the short term but are also aware that at some point the People’s Bank of China will need to turn off the monetary taps, as it did in 2015, to control excessive domestic credit growth.  This is not a 2018 story but if it is done in a clumsy way, so that there are major defaults, the domino effect may take over. All that said, despite the jitters in US bond markets, we are not predicting an imminent correction, simply because the gross level of cross-border flows remains healthy (currently 66 on a scale of 1 to 100) at the end of December.  It is when they turn sharply down that we should be afraid.  So we will be watching them closely in 2018 and until then will retain a reluctant ‘risk-on’ mindset. Information on how to purchase CrossBorder's research can be found here.​

Liquidity to ward off the bears in 2018?

The growling of bears seems to be growing louder, despite the fact that markets have so far been remarkably calm in the face of unsettling political news on a range of fronts.  I very much doubt we have seen the end of history, as Francis Fukuyama’s celebrated 1992 book postulated when liberal democracy seemed to win over all other political systems, but we have to ask why the bears have been wrong so far. The latest piece from our colleagues at CrossBorder starts off: ‘Does Global Liquidity Warn of a Bear Market in 2018?’  From a liquidity perspective, the answer is pretty clearly ‘no’.  At the end of November, global liquidity stood at 48, just below neutral.  They argue that the world is focusing too much on Developed Market central banks withdrawing liquidity and not sufficiently on what is going on in Emerging Markets, where liquidity is loose and the sums are - surprising though it may be - significantly larger.  The implication is that what’s going on in China, in particular, will be sufficient, at least for the time being, to stop the world catching a cold if America sneezes. In their experience, sharp and accelerating falls in cross border flows are also a valuable signpost to an impending market crisis.  The aggregate today stands at 58 (scale 0-100), compared to 88 six months ago but the trend is not speeding up, which should give investors some reassurance.   We see the US as late in its economic cycle, Europe as mid-cycle, and China and the Asian bloc as early cycle.  It can be seen most clearly in private sector liquidity flows, where Europe is strongest at 88 and the US weakest at 34.  This underpins our view that when economic trouble comes it is most likely to come out of the US.  But, unless history reasserts itself through a geo-political jolt, probably not in 2018.  We would advise investors to watch the upswing in China just as much as the downturn in the US. Information on how to purchase CrossBorder's research can be found here.​

The end of austerity - but not yet?

The Chancellor’s budget has a clear theme of extra spending.  I was waiting until the end for the hammer-blow of more taxation somewhere to make up for all the goodies but it never came.  As it happens, I believe his approach is the right thing to do when gilt yields are so low, but I do note from the Treasury’s detailed documents that the fiscal loosening doesn’t really kick in till 2019-20 and there’s actually a small fiscal tightening compared to March 2017’s forecasts in the next two years.   It will all be very convenient if this Government lasts the full five years but could backfire if it falls after, say, two. I’d applaud a number of the micro measures the Chancellor is proposing: to allow councils to charge 100% premium on the council tax for unoccupied properties and to remove the transitional arrangements for taxing carried interest (designed to ensure that tax is paid on the full economic benefit of a partnership’s activities) immediately, to take two tiny examples.  As always, however, the Budget is long on headlines and I am cynical about how much of them will really make it into legislation, particularly given the weakness of this Government. I will highlight a couple of the details I found interesting: he is making £1bn available for local authorities to finance local infrastructure at a rate of Gilts +60bps.  I wish he would make more use of this - effectively allowing them to borrow.  On the other hand, there is a mention of a new long term strategy for the asset management industry, ensuring it continues to ‘thrive and deliver the best possible outcome for investors and the UK economy.’  That could be taken as code for making them pay for some of the infrastructure improvements he wants to bring about. All in all, I would give the Budget a thumbs-up, though with the caveat that all these detailed measures may never happen.  Ending austerity must be the right thing to do, with the BREXIT risk looming, and the Chancellor was absolutely right to talk up Britain’s strengths rather than falling prey to the gloom everywhere.

November update on global liquidity

As regular readers of the Linchpin blog will know, I am presently upbeat about China’s prospects and consequently for other economies in Southeast Asia.  Our friends at CrossBorder Capital have released end October data on money and credit flows, which corroborates this picture.  While global liquidity is still about neutral (48 on a scale of 0 to 100), and China’s a bit higher than average, capital flows are heavily skewed towards China and Southeast Asia.  We think this is safe haven money which fled in 2015/6, and is now being invested into these economies as returns on investments improve again.  The combination of adequate liquidity and strong capital flows is quite bullish for these equity markets, at least for the time being. Other trends remain in place: the Eurozone and the UK are at the top of the liquidity cycle while the US looks very late in the cycle.  Given domestic Japanese liquidity remains low, the strength of the Japanese stockmarket seems to be because it is increasingly in the Chinese orbit.  However, we are less positive about the Japanese market than some commentators right now, particularly after its post-election rise. If you would like to read CrossBorder’s update, which represents the most timely macro-economic data available, it is available for purchase here. ​

Investors, watch the People's Bank of China!

At 31 trillion renminbi the People’s Bank of China (PBOC) is now the largest central bank in the world by some margin.  It also operates differently to other banks in one crucial respect - it sets domestic banks overnight reserve targets rather than operating through reserve maintenance windows which allow some flexibility.  This gives it more direct control over domestic credit, as can be seen by the fact that over the last 40 years the credit multiplier (ie. the ratio between the total pool of credit, including shadow banks, and the PBOC’s balance sheet) has remained almost unchanged at about five times.  In contrast, both the US and the Eurozone’s equivalent numbers have varied by about 400%, demonstrating that the Federal and the Reserve and the ECB have more limited control over their economies. An important consequence of this is that interest rates and bond yields, which we have always seen as the ‘price’ of money’ rather than a policy tool anyway, do not give any signals about the PBOC’s policy stance.  The clearest signal of domestic monetary policy is given simply by the size of the balance sheet. In 2015, there was a 15% tightening, both in order to ensure the Chinese currency was included in the IMF’s SDR basket and also as part of an anti-corruption drive.  This resulted in a sharp contraction in the economic growth rate, capital outflows, and sharp falls in equity markets both in China and other Emerging Markets.    Today the balance sheet is growing at a 12% annualised rate.  In our view, this is clear evidence of easier monetary policy, which will in turn lead to a faster growing Chinese economy.  As well as Chinese markets, other Emerging Markets and Japan and commodity prices can be expected to benefit.   Some commentators are misled by rising bond yields, currently 4%, believing this is a signal of tighter monetary policy and a faltering economy.  In contrast, we see this simply as a higher ‘price’ of money as economic confidence returns and appetite for safe assets declines. It is not all good news: if the PBOC has more control over its domestic economy than western banks, it has the ability to turn the taps off as well as on.  The next major financial crisis may well emanate from this source.  That is why we say all investors need to watch the Chinese central bank. Our data comes from our friends at CrossBorder Capital, who have published a more detailed analysis on this subject and have for many years kept a careful eye on Chinese monetary policy.  If you would like to purchase their report, please email us on research@linchpin.uk.com. ​

Should investors be worrying that a bear market is about to descend on us?

The big disconnect today is between the undoubted geopolitical stresses round the world and markets still hovering at close to record levels.  A number of investors whom I greatly respect have in recent weeks told me they believe that the next market movement has to be downwards.  Valuations of many asset classes are higher than has ever been sustained for long, central banks are loudly announcing their intention to withdraw the monetary stimulus we are hooked on and, although economic growth seems to be stable, there is no shortage of things to worry about.  And yet, unless there is a major geopolitical or financial 'event' to cause a crash in investor confidence, I am not sure we are on the brink of  a bear market.  It will come eventually, I agree, but I'm only seeing trouble ahead in the distance. There is no doubt that investors are holding high levels of cash, which suggests that buyers will come in if there is a price dip.  And our friends at CrossBorder's end-September liquidity data does not suggest anything disastrous is about to happen.  Yes, global levels are below average and the US, in particular, is looking vulnerable.  On the other hand Europe and the UK are seeing strong liquidity flows, and China and Emerging Markets, while lower than recently, are still high.  CrossBorder (the clue is in the name!) pay close attention to cross border flows because a sharp fall in them is often the harbinger of a market fall.  These are currently at all time highs, which means there is only way they can go, but we aren't seeing falls yet.  I also note that bond markets and volatility indices, both usually leading indicators of trouble ahead, are calm. With the remains of hurricane Ophelia approaching Ireland, I am aware of the danger of repeating Michael Fish's claim to fame when I suggest that a bear market is not about to descend on us.  Markets will fall one day: that is certain.  My point is that, unless there is an obvious event which causes investors' risk appetite to nosedive,  I believe we are still several quarters, and possibly years, away.      If you would like to purchase CrossBorder's latest major markets update with end September liquidity and cross border flows data, please find out more here. ​

What are the prospects for gold?

Gold has not been particularly fashionable as an investment since the heady days of 2013 when the price reached nearly US$2,000 per ounce.  The undoubted heightening of political risk (think superpower jostling, demographic challenges, European constitutional uncertainty and terrorism) might lead one to expect the price to approach that level again.  It has risen about 25% from its low in late 2015, but either investors are not worried by events or they do not see gold as the ‘go to’ safe haven. We like to think of gold as being a measure of the overall demand for fiat money, almost the inverse of its price.  The price of paper money increases if investors are confident enough to want to invest more (ie. demand rises) and goes down if central banks print more (ie. supply rises).  Demand for gold - whether bullion, jewellery or whatever - is simply the other side of that economic equation. It is gratifying that the data from our friends at CrossBorder Capital backs this up.  They measure the price of gold inverted against net demand for paper money and there is a strong correlation between the two.  No surprises that is the case during QE2; however the measure has picked up most of the major changes since the 1980s.   Today the data signals limited upside for gold, which should not be much of a surprise given that at least some of the central banks are beginning to withdraw QE.  Of course, there is always a case for holding gold as insurance against a major geo-political crisis but we would suggest there is likely to be an opportunity cost attached. For more on Linchpin IFM and asset allocation please click here.​

Latest liquidity data - steady as she goes?

End of August data on money and credit flows showed little overall change from a month earlier: the overall index stands at 43 on a scale of 0 to 100, below average but emphatically not suggesting a major slowdown.  This is not inconsistent with the general Quantitative Tightening and reflation story which seems to be the current market consensus, but it does suggest that is not the major influence on markets today.  Investors’ risk appetite stands at almost a peak level, which is less positive (because there’s only one way for it to go), but is not signalling immediate problems.  Beneath this headline calm, as we have suggested before, there is more to the picture.  Europe is at the top of the cycle, which would normally suggest equity markets can continue to go up for another nine months or so, Asia is on the upswing, and US liquidity is weak both in quantity (index 25) and quality (private sector contraction faster than public). The story we are watching more closely is cross border flows.  In size, these are much smaller than either central bank or private sector credit creation but they can at times be the marginal swing factor.  There has been a three month fall in this index at a global level from 90 to 60 since May, which we think is driven by repatriation of Chinese money from safe havens as their own economy recovers.  We would suggest that this is the strongest driver of market movements in the short-term – for example, it is probably behind the Chinese authorities’ more relaxed attitude to the renminbi level in recent days. We would also note that, right now, UK liquidity is top of the pack at over 90.  Some of this is associated with Europe’s general strength, as the economies are closely linked.  But, if you like to follow the money, it also suggests that the business world is taking a less jaundiced view on BREXIT than the UK media and Jean-Claude Juncker.  Generally, we see bond and equity markets continuing ‘as is’ unless there is a major political jolt.  The major risk in our view continues to be the US, where corporate cashflow continues to deteriorate.  Equity markets are likely to go sideways at best, with significant potential downside if things go wrong, and the US$, which any unhedged global investor is likely to be around 60% exposed to, is distinctly vulnerable to further falls.  Serious trouble ahead will be signalled through increased bond market volatility in the first instance. CrossBorder’s full article is available for purchase here.​

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