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.​

​THE US DOLLAR WILL BE WEAK, BUT NOT BECAUSE OF TRUMP

At Linchpin, on the back of the work at our colleagues from CrossBorder Capital, we have been gently but consistently bearish on the US$ for a number of months now.  We have been eyeing the deterioration in the quality of US capital flows, both domestic and overseas, in particular because  this is always a harbinger of a weaker currency eventually, regardless of interest rate differentials and The Federal Reserve’s policy statements.We see two major trends leading to a weaker dollar.  The first is the cash piles held by US corporates outside the US.  US banks have since 2012 increasingly re- lent these back into the US and borrowed Eurodollars against them.  The effect has been to boost US cashflow, effectively hiding the deterioration in cash generation from operations,  and to leverage the US corporate sector.  Today, these flows are drying up and we believe the effect will be to expose the shortage of operational cashflow from the corporate sector.  The effect on US eps growth can be hidden for a while but not for ever. The second major element is the flood of ‘safe haven’ money flowing out of US Treasuries, in particular into China, Europe and Japan as their economies recover.  Our friends at CrossBorder Capital calculate around US$3 trillion, or 5% of total US liquidity creation in this period, went in the direction of the US in 2014 and 2015, but since early 2016 the tide has been setting in the other direction. So we would argue that the US$ has in recent years been the beneficiary of two temporary flows of capital, both of which are slowing and reversing.  Against this is the Federal Reserve’s gradual tightening of monetary policy over the past two years, which economics 1.01 tells us should act as lower US$ supply and therefore a higher 'price'.  We would expect the US$ to be significantly weaker over the next 12 months.  Note we haven’t even mentioned the vagaries of Trump politics! A weaker US$ is both good and bad for investors.  It will act as a further boost for Emerging Markets, a Linchpin theme for some time.  However investors who use global equity managers or index funds will have over 50%, perhaps even 60%, of their assets held in US$.  If we are right, that is a major risk to performance.

Are capital flows behind US$ weakness?

Investors today seem to be fixated on the process of the Federal Reserve and other central banks unwinding nearly nine years of Quantitative Easing (“QE”).  Given the levels of consumer debt in some countries, they are understandably worrying whether interest rates can be risen and funding withdrawn from the system without dire consequences.  The result has been a lot of talking and, so far, only hesitant action. We would not deny the importance of this Quantitative Tightening (“QT”) but we think there is an elephant in the room which too many investors are ignoring.  It is the Great Unwind, as investors from countries such as China and Russia, but also Europe, seek to repatriate money placed in funk-holes (mainly government bond markets in the US and Japan).  As their economies recover from the shocks of the last five years, investors have - over the last twelve months - started to reverse these flows. Our friends at CrossBorder Capital (the clue is in their name!) monitor these flows.  They estimate US$3.5 trillion left China and the Eurozone since 2011, and that it is now flowing back fast.  By comparison, Central Banks probably created around US$5.5 trillion of money above normal requirements since 2008 through QE and are expected to remove US$1-2 trillion of that over the next three to five years through QT.  CrossBorder reckon twice that amount of capital flows could quit the US dollar and Treasuries over the same period. What does this mean for markets?  There is a bit of a two way pull at the moment for government bond markets and the US$, but capital flows explain the ‘weak’ US dollar and we would expect to see it continue to fall modestly while bond yields rise, perhaps more sharply.  If you are interested, the full CrossBorder Capital article is available for purchase via the Liquidity tab on the left.

Are we finally at peak sentiment?

Our monthly update from CrossBorder on global liquidity conditions has got clear signs of the change from QE to QT (Quantitative Tightening) happening.  Overall liquidity is a bit below average at 43.8, but there is clearer evidence that major Central Banks are quantitatively tightening, that capital flows have reached a high, and that overall Risk Appetite is also at a peak, consistent with this.  Markets thrive on strong liquidity and rising risk appetite among investors, but both are becoming scarcer and more localised.  Effectively we are at, or just over, Peak Sentiment.  This says nothing about the pace of its future decline but does warn that investment returns are coming under downward pressure.  Emerging Markets and Europe look strongest and, indeed, Emerging Market risk appetite is on a big upswing everywhere.  It may not be time to sell quite yet but we think that's where investors should concentrate their firepower.​ CrossBorder's full article is available for purchase here.  

The next major policy error brewing?

We are all aware that Central Bank Balance Sheets have been pumped up by QE over the past nine years and at some point there has to be a reckoning.  Some believe their size could fall by as much as one-third over the next few years and have labelled this the ‘Great Unwind’.  This is unlikely to happen without significant fall-out, but the questions are where will the impact be and when will it happen.   In the view of our friends at CrossBorder, it may not be immediate, but the clearest adverse impact is on both the US dollar and the US credit markets. In particular, if ‘real’ term premia on US Treasuries return to normal levels, we can expect 10 year yields to rise by something in the order of 100bp. Equities will be an indirect casualty of negative QE via its effect on the other markets, particularly credits, which appear unambiguously at risk.  Overall, in CrossBorder’s view, systemic risks are rising and another major policy error may be brewing.​ CrossBorder's full article is available for purchase here.​   

A look at whether there really is an equity bubble yet

It is a commonplace today that equities are expensive by most historic standards. Whether the criterion be price to earnings, longer term Schiller ratios or the recently popular market cap to GDP measures, Developed Market equities are either at, or close to, all-time highs. The only precedent was the end of the 1990s and the eventual dotcom bubble. The explanation usually given to justify valuations, and one I would happily subscribe to, is the nine years of easy money which we have enjoyed since the last financial crisis. Because industry has found it hard to find profitable ways to employ this money in the real economy, much of it has flowed over into investment assets including financial ones. Prices of bonds, equities and property have all gone up. We have lacked, however, a way of quantifying how far prices have gone up relative to the level of liquidity – ie. how far the bubble has inflated. A recent article from CrossBorder Capital aims to do precisely that by looking at stock market capitalisation relative to the pool of available financial assets. It is effectively a measure of the size of the equity weighting within investors’ entire financial asset portfolio. In theory, much as with any portfolio, if the ratio becomes too high investors should react to reduce it. CrossBorder’s conclusions are that generally, on this market cap to liquidity basis, global equity valuations are at around the middle of the range pertaining since 2000 and well below the dotcom bubble peak. Even the US looks no more than a tad expensive while Emerging Markets, and to an extent Japan, look cheap. This is not an argument for complacency. There is clearly scope for a sharp fall in equity prices if the authorities choose to take liquidity, the ultimate denominator of this measure, out of the market by tighter monetary policy. But it does suggest that we are not really in a bubble yet and that if - admittedly a big ‘if’, given the noises coming out of the Federal Reserve - the level of cheap money is broadly sustained, valuation levels alone will not prevent equities from rising further.     CrossBorder's full article is available to purchase here.

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