Let’s take a bet on what happens now financial markets have experienced a recovery since the distress experienced by banks and other financial institutions in 2008. Ten years later, what’s going on?
Things are getting back to normal in the vernacular of people participating in the market. Normalisation, to turn a noun into a verb, has begun. People who have been in the market for the last few years have probably succeeded in growing their wealth. Let’s Compare Bets’ tips have done pretty well to.
People with money to plough into financial markets may be scratching their heads wondering what should I do…. advice, bank account, premium bonds (in the United Kingdom), under the mattress, start a business, travel around the world, or, have a craic and wager some of this money personally into financial markets.
Other posts in this series have gone into detail about what’s happened in the past and some predictions about what’s going to happen in the future. In the context of full disclosure, we’re not messiahs at Let’s Compare Bets, in so far as you won’t find any messianic prophecies here and there will be no mention of the apocalypse. What you will find is some ideas about where to place your bets: which have been cobbled together using some voices in the market that have had interesting things to say. Sources have been named at the end of the post in the tradition of scientific publication (but there won’t be individual citations because this a post about betting. Let’s Compare Bets doesn’t want to reinvent the wheel!). After you listen to a various voices in the market you also get a feel for who you trust and who you don’t. Trust is a dynamic and complex concept and changes constantly. After listening to voices in the market a bit of objectivity about who you trust allows you to filter out different people and sources of information. Rather than deciding if the person or organisation was likeable: you know, what sports do they like, are they idiosyncratic, aggressive, or arrogant etc , it’s possible to be objective about the process. In the process of learning a bit about the economy and financial markets, bits and pieces from sources perceived trustworthy have been cobbled together here so that readers can make better bets.
Previous posts in the series can be accessed from links at the end of the post. Among other things we’ve spoken about how to frame your view of investing in the context of world wide trends and how to bet your funds now the current economic expansion is maturing. To illustrate certain points about financial markets and relative returns exchange traded funds or ETFs will be used in this post. Also there will be some candid pithy comments from the Author to spice things up a bit, and the odd anecdote.
Let’s condense some major trends first, then look at where to place your bets in the context of the current cycle (debt cycle and business cycle). Unfortunately this isn’t a short post. It is difficult to get everything in and it be a short post.
Technology is accelerating and will increase productivity of the economy (it doesn’t necessarily mean jobs losses in aggregate over the long term if productivity can keep up, but it’ll be your kids or kids kids who’ll really benefit). Talking about reinventing the wheel, as an aside point, readers might like to check out how Goodyear is doing just that with their Eagle 360 spherical tire. Technological advancement is said to reach inflection points that allow human endeavour to progress in leaps and bounds. Amazing how the internet has reached so many people and allowed information to reach curious minds. Having visited the Roman Forum recently, knelt at the foot of the Temple of Saturn staring up at the preserved pediment restored for the senate and the people of Rome (wishing I could read Latin) with the low December sun warming my face it struck me like a bolt of lightening from Jupiter’s very hand (or should I say Zeus)……. the Plebs have never had it so good! That’s down to technology and access to information. It’s no wonder the combined market cap of Google and Microsoft is higher than the GDP of Spain.
Debt. We’re past the bottom of the long term debt cycle; in terms of interest rates, the bottom is when central bank interest rates go to zero in some countries and negative in others (and are currently still negative in some countries). Now interest rates are going back up, but, they may bump along the bottom first. Biblical amounts of debt, and when the total aggregate amount of debt gets biblical it leads to change.
Change. Change in politics, structural changes to economies and increased geopolitical activity or realpolitik. Bringing us nicely into the last major trend that’ll be shared with readers for this post….
A rise in the number of inquisitive minds inspiring creativity, and more technological advancement.
Where are we now?
In a nutshell interest rates have started to go back up. This has hammered some sectors of the equity market and with the benefit of hindsight this makes total sense. Equities which have provided a consistent and reliable source of return in the form or dividends and capital appreciation in the form of stock buy backs have experienced a correction. Not that these are bad companies or the industry they are in is doomed but because they’ve gone up so much in price: pension funds and insurance companies have been ‘chasing yield’ pushing prices up and dividend yields down. Companies with the highest debt burdens or those that have made major acquisitions at too high a price have been punished. United States stock market indices are still making new highs although, the highs are being led by fewer and fewer sectors and companies. Market breadth is said to be low.
Why has this happened? Money managers have been able to earn income from parking cash in lower risk investments like short term treasuries and cash: denominated in dollars. This is one indication that the current business and credit cycle is nearing an end. Money has moved into cash like assets and safe currencies waiting for the market to turn. Readers with an inquisitive mind may want to learn more about the concept of opportunity cost or alternative cost regarding this phenomenon.
As interest rates increase money will start to flow out of all equities and bonds because the attractiveness to money managers of future cash flow from companies and certain government bonds goes down when compared to alternative investments like short term treasuries. What does this mean to the Laymen?
Recession / slow down and opportunity
As interest rates go back to what is considered normal using the previous x something number of years. Stocks and bonds go down, enabling a nimble financial gambler to place his or her bets… but, when? And there’s the million dollar (or currency equivalent) question. Not just when but how…
Luckily JP Morgan Chase and Bridgewater Associated have provided a couple of suggestions about how and when. Admittedly these players are a two names in a sea of opinions and voices competing for the attention of market participants: they are big names and should be listened to, not least because they move around large amounts of money and influence other players who move around large amounts of money like pension funds.
Take the following image. It is a way of visualising who you can trust and how information peculates through the system. A simplified representation of how Google uses ranking algorithms to decide which websites to serve up to web surfers hungry for information.
Each circle represents a person or organisation and the size of the circle indicates how much trust you assign to them. In reality this would be dynamic so the size of the circles (or the numbers inside) would be constantly changing. Individuals could assign parameters to dictate who they trust the most. In reality the size of the circles would be influenced by an endless number of variables, but, for the purpose of this post Bridgewater associates and Morgan Stanley (caveat emptor not withstanding) can be put into circle B. Circle C could be the honourable US Government.
Again, a side point for inquisitive minds. The more you see people listening to a particular voice in the market the more it’s worth questioning why it is that you trust that voice. Blindly following people you trust may cost you big time. Anyway, how do Bridgewater Associates and Morgan Stanley think it’s gunna pan out (no pun intended)?
In the event of the next economic recession which would be caused by interest rates increasing here are some predictions.
JP Morgan September 2018
US stock slide 20%
Interest rates will go down in the next recession to stimulate the economy
Corporate bond yield spreads to widen
35% decline in energy prices and 29% decline in base metals
2.79% point widening in spreads on emerging nation government debt
48% slide in emerging market stock, and a 14.4% drop in emerging currencies
Bridgewater September 2018
30% fall in the value of the dollar
slow decline in stocks and longer grinding in value
Closer to the bottom in emerging markets or 2/3 of the way through
There’s a lot to talk about there. If each of those statements was like a horse in the 12.50 at Sandown or the Kentucky Derby, where do you place your bets?
Well, let’s start with JP Morgan’s…
“2.79% point widening in spreads on emerging nation government debt”
“48% slide in emerging market stock, and a 14.4% drop in emerging currencies”
These two have already happened depending on how you measure it. Emerging markets equities and currencies have dropped significantly.
“US stock slide 20%”. Some sectors have already seen declines exceeding this, but, it’s not fed through to the technology sector, other growth stocks or the broader market indices in the USA, Europe and UK.
“Interest rates will go down in the next recession to stimulate the economy”. This will be one that causes more geopolitical consternation.
“Closer to the bottom in emerging markets or 2/3 of the way through” – this is happening now with emerging markets.
“30% fall in the value of the dollar”. The value of the dollar has gone up as money has moved from Emerging Markets into lower risk dollar denominated assets. A 30% fall in the context of recent dollar strength would be absorbed relatively easily. A fall in the dollar would be linked to reduced short term interest rates.
Interestingly there’s no mention of more Quantitative Easing (QE). Last time it was to give systemically important banks more liquidity (increase reserves) to allow them to carry on lending. What indications are there that QE is going to happen again?
Other information worth mentioning from JP Morgan from the reports and information released at the time includes the following. During the next recession they expect; “shorted dated treasury yields to decline as the market anticipates the nest easing cycle of the US Federal Reserve Bank FED funds rate. Ten year treasury yields are expected to fall by half from a possible peak of 3.5% to 1.75%”: looking at the last 6 US recessions and subsequent interest rate cycle the spread between short dated treasuries and 10 year treasuries was 2.8%. Indicating that if the 10 year yield drops to 1.75% the FED funds rate will be at the lower bound again (or near zero). In previous posts we concluded that it’s extremely unlikely the FED is going to allow a serious deflationary depression to occur and policy is going to produce stimulus to help global aggregate demand find an equilibrium with global aggregate supply.
What could cause them to need to do more QE?
It’s the deficit stupid..
“Making America Great Again” is going to cost money. More money than is being received in taxes. Deficit spending is set to grow quite a lot.
Normally spending is financed by selling treasuries, notes and bonds to investors either at home (pension funds and other institutional investors like systemically important banks) or globally to private and a state investors.
To finance deficit spending with the help of the global community is going to be harder and involve realpolitik. Interest rates need to find a price point where global investors are happy to buy. In view of the situation with the tariff negotiations finding buyers is going to be somewhat more difficult, and may involve what commentators describe as tariff wars becoming shooting wars.
Also there is a current account deficit where more goods and services are imported than exported, also affecting the dynamic of trade negotiations.
This is going to involve a catch 22 situation for the FED when adjusting the yield curve (the rates paid to investors across various note and bond maturities). Here’s why?
Asking the global financial community to lend money may involve raising rates higher than the economy would like. In the past voices at the extreme or edge of the discussion say rates should have been and needed to be a lot higher. Interestingly this view is now taking centre stage particularly regarding having to finance new deficit spending. Larry Fink chairman and chief exec of BlackRock acknowledges this: something he mentioned at the Bloomberg Business Forum 2018. Here’s a link to the coverage. What’s more Ray Dalio of Bridgewater Associates thinks likewise. Refreshing to see elites of the financial system opining on the matter. BlackRock is another organisation that can be tucked away in circle B above: not least due to their positive contribution to the USA’s ongoing gun debate and other positive uses of shareholder power. Talking about creativity and innovation BlackRock is injecting some life into the music business, which could help counter the deflationary effects of the internet on the music industry, using BlackRock’s alternative investments.
Either way rates going up will end up causing a recession or slow down depending on how fast and by how much they go up. What’s going to affect how much and the speed that rates increase?
1)Overcapacity. Overcapacity exists in the world economy and structural changes are happening as a result. Raising rates before the prescribed structural changes have time to take affect would be deflationary. As such, increasing rates too much would cause a deflationary death spiral and would require more QE.
2)If overcapacity is removed, for instance a reduction in manufacturing capacity in China, then China may start exporting inflation to the USA. Fair to say that’s how the economy should work. China’s prosperity increases, it’s workers get pay rises that are larger than inflation and the Renminbi increases in value compared to trading partners currency. Balance is returned to the system, and the USA gets the kind of inflation required. If China exports inflation to the USA interest rates would need to rise faster than currently expected.
If inflation is imported to the USA and rates rise this may help fund deficit spending, but, as suggested in previous posts the missing jigsaw piece is US wages. If US wages (and it’s a similar situation in the UK) do not rise faster than inflation there will not be real economic growth. The result is decelerating or no growth and rising inflation.
As mentioned in previous posts wage increases above consumer price inflation will require unemployed and under employed people to enter the market and for the velocity of money to increase. Factors that are affected by psychology and the madness of crowds, which will take some time yet to occur. This scenario provides a catch 22 within a catch 22. Inflation increasing so you should be raising rates, but, growth is decreasing so you should also be lowering rates.
Damned if you do and damned if you don’t.
Don’t raise rates enough = reduced ability to fund deficits and the need to resort to QE.
Do raise rates enough = reduced or negative economic growth and the need to resort to QE. Raise them as much as some think they should you get the end of an epoch in the financial system (Apocalypse).
Get it just right = the need to do less QE and everyone else (participants in the global economy) are kept relatively happy.
Either way interest rates are likely to go down.
When will there be a slowdown or recession?
There is a consensus about 2020 being the year the next US economic recession will reveal itself. Accumulative effects of central bank monetary tightening are expected to percolate through to the real economy during 2020. US Federal Reserve tightening of monetary policy has been going on for years now and is being capped off with quantitative tightening, the Bank of Japan has already made tentative steps to tighten, and the European Central Bank is set to follow in 2019. Resulting in higher borrowing costs for companies which will slow down economic activity. Who knows some central banks may also reduce the amount of normal financial assets they are buying as well, but there’s not a lot of transparency on this score. You never now there could be some big defaults as well and debt swapped for equity. How bad the recession gets will be determined by the will and level of cooperation between central banks.
Financial markets tend to forecast events before they happen. So when might these moves be felt in financial markets?
Canaries in the coal mine (indicators that a US, UK, and Europe economic slow down and financial market correction are coming)?
Bitcoin peaked in December 2017 and dropped by a significant amount. The most speculative part of the global financial markets. The fact it hasn’t gone to zero indicates that perhaps large stakeholders expect more money printing.
Emerging markets peaked in January 2018 illustrated by the MSCI emerging Markets ETF.
Emerging markets that have government spending financed with a larger proportion of dollar denominated debt have dropped in price the most, namely, Turkey and Argentina. Emerging market currencies have dropped in step with the equity markets.
Problems in the banking sector. Speculation abound about how Deutsche Bank will be unwound in September 2018. Deutsche bank is too big to fail, mainly due to the size of it’s derivative book. In my opinion it is unlikely there will be a big reduction in equity markets as a whole until Deutsche Bank is either merged with another bank or nationalised (something the German Government has said that they won’t do). That would be a bitter pill to swallow for Germany.
Turning to the USA. The housing market is slowing caused by rising mortgage rates. ishares U.S. Home Construction ETF is down by 21% from it’s peak in January 2018.
Indicators of consumer sentiment are turning down. Take the car market, it is effected by both interest rates and structural economic reforms such as trade tariffs. Ford Motor Company’s share price has fallen by 29% since the recent peak in January 2018. Ford stated recently that the inflationary impact of trade tariffs on their suppliers of steal and aluminium will reduce net profit by 1 billion dollars. Also a large part of the market for new cars is fuelled by credit agreements, so increasing financing rates will also hurt.
Icelandair not able to secure long term funding reported on BBC radio October 1st 2018.
Ok, so there are some good indicators of a maturing economic expansion. Financial markets tend to price themselves based on predicted future events. Some assets have already responded and equity markets will probably respond sometime in early 2019 (approximately 12 months before an economic recession or slow down is acknowledged).
How does this information play out into choosing how to invest?
Time to balance one’s portfolio. Put simply sell some of the investments that have gone up in price compared to whatever asset allocations have been set. Something that has been discussed before. Deploy some of that cash into alternative investments and leave some in cash. After listening to lots of gurus recently and tit bits of advice, something I’ve not heard anyone say is that investing is a bit like comedy. It’s all about timing. Get it wrong and you are insulted, harangued and booed off stage. Get it right and everyone is laughing with you, not at you, and all is well.
Alternative investments, going from high to low risk.
Emerging markets have gone down in price a lot since the start of 2018 characterised by falling currencies, falling stock markets, reduced investment from foreigners, and turbulent politics. Are they worth considering? Yes and worth watching, except possibly the higher risk emerging markets like Turkey and Argentina which will take longer for the political situation to evolve.
Brazil looks interesting. I have also made a suggestion for China later on.
Brazil looks good for the following macro economic reasons.
They have resources giving them strong links with China. They are closer to the USA than China giving them closer links with the USA.
Brazil has tools to manage the volatility in their currency including $382 billion dollars of foreign exchange reserves, and they use of currency swaps. Currency swaps indicate good relationships with counterparties. The central bank and treasury are coordinating response to volatility in the currency.
Current account deficit is trending down
This will encourage foreign direct investment especially when the US FED stops
increasing interest rates.
The Brazillian Reais to US Dollar exchange rate is stabilising
They have a real rate of interest with central bank interest rates above consumer price inflation, which should encourage foreign direct investment.
Inflation has surged in Summer 2018 due to a truckers strike caused by high fuel prizes. High fuel prices have been caused by the increase in the value of the dollar. As oil is traded in dollars and the value of the Brazilian currency has fallen it’s caused serious pricing issues. If the value of dollar falls as expected it would help ease inflationary pressures enabling the Brazilian central bank to lower interest rates. This would be positive for the stock and bond market.
Exports and manufacturing should also have received a boost from lower currency valuations.
Uncertainty about the up coming elections and political landscape going forward.
Uncertainty about the how the situation in the USA will pan out.
Ok, so let’s nail down some investment ideas.
Securities, from higher risk to lower risk.
First up is Telefonica Brasil. More consumers are moving into the middle classes and want access to fast broadband and the ability to buy stuff. The balance sheet looks alright. Maturities on corporate debt don’t look bad. Net profits consistently reported. Interest and dividend cover look okay. Free cash flow will drop due to their capital expenditure plans through 2020. Spending is on growing fast broadband penetration, so investing in assets, which should provide a good return. Based on the dividends paid so far in 2018 the estimated yield for 2018 at the current share price is around 12%. Not bad if cash flow can fund capital expenditures, interest costs, and dividend payments.
VanEck Vectors Brazil Small-Cap ETF. Yield 6.23%.
Smaller companies in Brazil are likely to benefit from improvements in the economy to a greater extent. Again performance will be correlated to what happens to interest rates in the united states.
VanEck Vectors J.P. Morgan EM Local Currency Bond ETF. Yield 6.55%
The yield has increased from a low of 4.10% in August 2016 to 6.91% recently. Compare this to the yield on economically developed market (DM) bonds using the Ishares International Treasury ETF. The spread has already increased by over 2.5%. JP Morgan’s call on emerging nation debt looks spot on. Interestingly there has been more volatility in the yield on the DM bond ETF than the emerging market local currency bond.
If you expect US interest rates to fall then this EM local currency play looks good. It’s not Brazil specific but it includes Brazil in the top ten holdings. Higher risk local currency debt of countries like Turkey form a low percentage of holdings. What’s more investing in this product increases direct foreign investment in these countries and helps restore balance to their funding requirements.
iShares J.P. Morgan USD Emerging Markets Bond ETF 4.6%. A lower yield than the local currency ETF but includes higher percentage holdings in Turkey.
Invesco Chinese Yuan Dim Sum Bond Portfolio ETF. Yield 4.11%. Relatively good yield for the risk. The currency has experienced a correction vs the dollar which effectively negates a large portion of the trade tariffs. They have lots of foreign exchange reserves, trade surpluses, and full control over the currency.
iShares 20+ Year Treasury Bond ETF. Considered a safe heaven in times or financial turmoil. These securities have lots of domestic buyers in the form of pension funds, so liquidity is never in question. Currently in a down trend and waiting for a trigger, which would be the top in the US rate tightening cycle.
When deciding when to enter these investments it’s worth considering if it’s worth waiting for a correction in US stock financial market. Prices could be more attractive after the event. One solution is to take the funds that where earmarked for investment and buy a third now and two thirds later. When the US market corrects equity markets globally could also sell off and to a lesser extent fixed income.
Previous posts have discussed a phenomenon called a Minsky Moment. This would be one of the biggest risks during the next recession. Personally, I think the chances of a Minsky moment (discussed in previous posts) in the next slow down or US recession are limited. A Minsky moment is where the price of lots of assets become correlated to a larger extend, or in other words, the prices all go down at once. Money rushes to safe havens. In 2008 this was king dollar and monetary commodities and their miners.
Why is a Minsky moment not expected: this time round the housing market is not in a bubble. The aggregate value of real estate is massive and thus makes it a systemically important part of the global financial system. Currently mortgage loans do no make up a dangerously high proportion of total real estate value and there are no ridiculously loose lending standards. Readers may remember or may have benefited from Liar loans available in the run up to the 2007/08 financial crisis. That’s right no job, no income or assets to speak off…. no problem sir! We’ll lend you $500000 (or currency equivalent) to buy a large house in the country with a swimming pool, or condos in Florida, or whatever.
As an aside point, I would be interested how many people had the foresight to stock up on liar loans sell their properties at the peak, buy gold Sovereigns or American Eagles, and bury them somewhere in your back garden (yard). X marks the spot me hearties. Get enough like minded people and you’ve got the makings of a banking cartel. By the way, nothing in this post can be considered financial advice. As always do your own research and that was just a joke.
So where have we got to so far? To consolidate some important conclusions from previous posts first.
1. Capitalism is not going to consume itself any time soon. Hence gambling one’s life savings to secure a comfortable retirement is not a crazy as it sounds. Theresa May’s free market capitalism speech was well timed and well founded. Capitalism is also the best way to inspire people through collective competitiveness to push the boundaries of technology. Ironic that this phenomenon will end up replacing capitalism one day far off with some other system.
2. Left to their own devices central banks could engineer a balance between inflationary and deflationary deleveraging in systemically important countries like the USA and China. With the will of western central banks erring on the side of inflation.
Onto this post.
3. Interest rates up, dollar up. Impending slow down or recession equals dollar down and interest rates down.
4. Investments for now. Emerging markets with a preference towards fixed income first and then into equities.
Other factors to consider.
Interest rates in the USA relative to Europe which also has a reserve currency. The spread between the two is statistically large. To revert to mean either US interest rates need to come down or European rates need to increase. In view of what’s going on in Europe namely, Brexit, Italy’s proposed budget, anti European sentiment, and Duetsche Bank, US interest rates are likely to fall more than EU rates will increase.
Exchange rate risk between USD which some of these assets are priced in and the currency you use normally. As well as the exchange rate risk between the emerging market and USD which is affect by many things.
What to watch?
Company earnings and the 4th Quarter 2018 and 1st Quarter 2019 GDP numbers for the USA.
A template for understanding big debt crisis by Ray Dalio.
Gerald Celente – pushing the boundaries of the 1st Amendment and helping make ‘America Great Again’, not that it was anything other than great off course depending on how you define great. Also offering a publication nicely juxtaposed to the Economist or Time (both of which have always been a great read whenever I’ve picked them up).
Perter Schiff. Gold expert.
Steve Keen. Economist. Mr Keen has provided insight into economies work. Most recently his thoughts on what’s happening and what’s going to happen in the economy in the future have been useful. Not so much for answering the question of where to place your bets in the next two years, but, how to place your bets with you children and grand children in mind. For instance, he mentioned recently how he thinks the system of credit growth and accumulation of Government debt with turn out in the end; what will force agreement on the global stage between central banks, governments and international institutions (and it would be nice to think that global multinational companies or corps would have a focus on this to) is taking action on climate change. In my opinion this will either be by choice,which would be good, or it’s going to be forced by mother nature, which would be bad (due to the big demographic adjustments this would cause).
Other posts in this series.