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.   

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. .  

Hold on to Your hats!

I make no apologies for returning to the major question all investors have first and foremost today:  will October’s downturn become a real bear market?  I mean by that a fall in markets of 25% or more, with all the second order consequences that brings.  In my opinion the odds are now more than 90% that it will. The core reason behind this view remains the fact that funding liquidity (ie. the money and credit available to pay debts) is close to rock bottom in the West.  Only in China is the picture at all different.     The evidence is a further decline in western central banks’ liquidity position, now at 10.7 (range 0 to 100) combined with three other signals which have historically been strongly predictive.  On their own, none of them are conclusive but together they are just about as strong a signal as can be.  The first is that investors’ risk appetite, as measured by our friends at CrossBorder Capital, is high, albeit not sky-high, and a long, long way above the capitulation levels which normally signal bear market turning points; the second is similarly high levels of speculative cross border flows; the third is the flattening yield curves, long seen as a predictor of recessions. What could derail this on-rushing train?  Events evolve every day but an abrupt policy about-turn by central banks is the one which could change its direction.  China is easing, which may ameliorate some of the worst effects, but the key is the currently hawkish US Federal Reserve.  Unfortunately, the US today seems to be permeated by super-optimism and a sudden change of heart looks highly unlikely.  So our advice is to don your steel helmets and hold on to them. Find out more by contacting us at research@linchpin.uk.com.

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. ​

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.​

Have we turned into a lemming?

Earlier this year, I found myself in a spat in the FT comment columns because I offered some investor sentiment data (as usual from my friends at CrossBorder Capital) which was at odds with the Bank of America (BoA) Fund Managers’ survey. As a reminder, BoA’s is a subjective survey of 174 (this month) large institutional investors’ investing intentions, whereas the data we use at Linchpin is an objective measurement of all financial assets.  We don’t know who owns them but if the aggregate held in equities is a relatively high weighting (for example) we’d expect that to revert to the mean in due course, much as a portfolio manager overweight in equities relative to his/her benchmark will find a way to bring it back in line. Today the main sentiment messages from both data sets are more similar: risk appetite is declining but investors are still overweight equities and underweight bonds.  They are weighted towards US equities, Japan is also favoured, and there is convergence in the expectation that economies will slow down and that US treasury yields are expected to rise further. At Linchpin we share the sober view about the economic outlook and are likewise concerned about rising bond yields.  We are probably not far from the consensus in our view that equities need to go through a market correction of some sort in the near future.   As natural contrarians, however, we are not particularly comfortable being with the masses.  We begin to think that our fears or hopes are already discounted.  Having said this - unlike many - we are firmly of the view that Emerging Markets are likely to be the best performers over the next downturn.  It is an interesting reflection that over the 2008 Global Financial Crunch that was also the case, at least until central banks i) succeeded in stabilising the financial system and ii) continued to print money.  We’d expect the same to happen this time round. If you think we are turning into another lemming, please tell us.  If you would like to find out more about CrossBorder’s investor sentiment data, please click here.​

China smelling of roses?

One of our themes over the past few years has been to pay more attention to China when trying to predict the future market environment and less to the USA.  That’s not just because the Chinese economy is now 70% the size of the US (compared to just 11% in 1997) and its central bank’s balance sheet is 1/3 bigger than the Federal Reserve.  China has also been extending its hegemony across the world in many ways, from its Belt and Road infrastructure vision across western Asia to its policy of encouraging use of the yuan rather than the US$ for global trade contracts. The contrast between the monetary policies of the two countries is particularly stark right now.  The Federal Reserve, followed by most ‘western’ nations, is running very tight policy, whereas the People’s Bank of China and most Emerging Markets (EM) are relatively loose.  In data terms, provided by our friends at CrossBorder Capital Limited as at 30th September, the DM index is at 6.5 (range 0-100) whereas the EM is at 54.7. For markets this has a strong implication that the US$ is likely to strengthen against the Chinese yuan, because other things being equal central bank easing equates to more supply.  We’d expect the Japanese yen to move somewhere in between the two, as another long-held thesis of ours is that Japan’s orbit is now at least as much influenced by China as America. It is also a much more positive background for EM.  Many commentators assume that the strong US$ will continue to be a negative for them, but we’d comment that yuan weakness will be a just as large, if not larger, positive for them (and incidentally Japan).  We also note that crossborder flows into EM have rebounded sharply since the low point in June 2018, suggesting greater confidence than newspapers would lead readers to believe. Given the dire liquidity background just now, we continue to expect a more substantial correction in markets than we saw last week.  If China continues its current loose monetary policy, those countries connected to it economically may just come out smelling of roses, at least in market performance terms. To learn more about CrossBorder’s research on liquidity please click 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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