Thursday, July 21, 2016

Get "Real" on Gold Fever - Revisited

Throughout the year I’ve referenced the chart below, which now reflects a large performance differential between the banks and the gold miners, as yields – both nominal and real - have fallen. Although the banks have had a difficult time performing in this environment, gold mining stocks have done exceptionally well, as gold has benefited robustly from both safe-haven demand and from the retracement in real yields, which has made it attractive again from a real return perspective.


Not surprisingly, banks have strongly underperformed even the equity market indexes, as exceptionally low yields reflect the contentious business environment for the banks, and more importantly – their customers. Bank profits are inherently hurt in the current market environment through the compression in net interest margins and more broadly through weaker demand for banking services and products – as demonstrated by investors willingness to accept certain exceptionally low and even negative returns, rather than the prospect of potentially much larger and uncertain losses. The later also reflects greater deflationary expectations by investors, as exceptionally low and negative bond yields can still produce positive real returns – if, inflation remains below said bond yields.

Essentially, even though the S&P 500 made an all-time high yesterday, the performance in the banking sector and the bond market do not reflect long-term confidence or investment in growth  even as the economic data in the US remains firm, inflation appears to be on an uptrend and the prospects for a recession are low. Moreover, these dynamics have created a feedback loop in the fixed income market that could/has sustained market inertias longer than even we had suspected. And while we were open to the possibility going into this summer that the Treasury market could break down, that window appears to have closed with the Brexit vote – moderating policy expectations that once again have buttressed bonds. That said, from our point of view, there’s still a much greater probability that real yields will fall further over the next year, as inflation continues to rise – which ultimately is a loosing proposition for those fixed income investors seeking a positive real return from these more “safe-haven” positions.

One of our long-standing suspicions has been that the 2011 cycle lows for real yields would eventually be broken on the next leg down. This belief has largely maintained our interest in the precious metals sector that exhibits a strong inverse correlation to real yields. From our perspective, the probability that inflation would eventually outstrip the reach of nominal yields – was more likely, than a continuation of the atypical market dynamics engendered by the Fed during the taper-tantrum, where real yields spiked on greatly overblown fears of higher rates – but inflation wilted on the vine. In a more typical and “organic” market environment where monetary policy was not enacted at ZIRP or after extended periods of large-scale quantitative easings, real rates begin to rise when benchmarks and expectations of improving growth is followed by tighter policy and a decline in inflation expectations. At secular cycle lows, real rates surge as the inflation cycle crests and retreats – and after nominal yields remain supported.

Our outlook for new lows in real yields has also been guided by our historic studies of the long-term yield cycle (see Here), that shares similarities with the last time yields fell and formed the protracted trough of the cycle through the 1940’s. As frequently mentioned in previous notes, this time period also shares a certain likeness with the last time the Fed and Treasury extended extraordinary support to the markets between 1942 and 1946, with large-scale asset purchases aimed to prop up the financial system, as markets and participants recovered from the long tail of the Great Depression and the colossal price tag of World War II.

Ultimately, there were latent effects from the historic accommodations extended, as participants and regulators struggled with normalizing policy, as strong pulses of inflation worked through the system, while investors remained concerned that another deflationary tide of the Great Depression was about to unfold. As such, investors didn't flee the bond market as if inflation would maintain its trajectory higher, but took shelter in the perceived safe-haven of the Treasury market, likely because of what they had lived through over the past two decades.
“Despite the extent to which the public and government officials were exercised about inflation, the public acted from 1946 to 1948 as if it expected deflation.” - Milton Friedman and Anna Schwartz, A Monetary History of the United States, 1963
Sound familiar?

In essence, policy makers might have succeeded at supporting the markets through considerable attenuating circumstances in the economy, but broader market psychologies were still entrenched and impaired from what participants had been through in the Great Depression. The net effect was a collapse in real yields that eventually made a cycle low in 1947; a year after nominal long-term yields retested the lows from 1941 and began to stabilize through 1946. Although the upswing in inflation did not upset the Treasury market – as policy makers refrained from tightening, equities went nowhere between 1946 and 1950, until investor confidence returned and monetary conditions broadly normalized and reset with the Fed and Treasury Accord in 1951.

Overall, we remain steadfast bulls on precious metals and expect the performance gap over equities to continue to widen, as real rates target the 2011 lows next year. Over the short-term, it wouldn’t surprise us to see the global rally in equities resume into August. However, the performance in the financials over the past year does not support those expectations of a material breakout – that ultimately requires the banks leadership as testament of greater investment confidence in the economy. Similar to the last time yields scraped the trough of the long-term cycle in the mid 1940’s, market participants do not appear ready to invest in the next secular growth cycle – even if the economy could structurally support it. Unfortunately, you can’t have one without the other, or as the great philosopher Yogi famously framed – it’s ninety percent mental and the other half is physical. We’ll get there eventually, just not quite yet.
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For our earlier thoughts on real yields and precious metals, see Here.

Thursday, June 30, 2016

Silver Linings

Last Thursday, as I was coaching my son’s little league team on their improbable quest to Williamsport… I glanced at the headlines rapidly breaking in Britain: the vote was swelling towards the Brexit. My first thought was to discount the panic tone of the initial reports, as it was still early in the tally with much of the vote outstanding. In retrospect, my instinct to qualify the hyperbole spoke to a larger fallacy at play. In truth, the writing had been on the walls for some time.

As investors, we’ve all been influenced by the range of emotions that can lead you to and from the trough, with greatly varying results. With experience, you typically become more pragmatic when it comes to sizing up the markets, as seeking returns influenced from more idealistic persuasions is often a costly trip down an uncharted rabid hole. Although there have been a few sizable global brush fires since the financial crisis peaked in 2009, central banks have largely succeeded at mitigating widespread collateral damages in the markets, primarily by enacting aggressive monetary policy where private industry and public markets had been heavily impacted. And while a dystopian haze has remained hanging on the horizon over the past seven years, by and large, central banks have overrode the worst-case forecasts by intervening in concerted and extraordinary ways.

The crux, however, is aggressive monetary policy has not addressed – and arguably even worsened the public’s perception of the widening chasm between the halves and the have nots. From this perspective, the free lunch went squarely to the wealthiest at the expense of the taxpayers. Here in the US, it was the Fed and Treasury’s Hobson’s choice – a pragmatic prescription aimed primarily to save the system during the throes of the crisis.

One of the few silver linings of the Great Depression was the enormous gap in income inequality leading up to the peak in 29’, was narrowed by the massive public works programs that infused earnings to what eventually became a broad and sturdy middle class. Moreover, those wealthy had their influence hobbled through lightened pocketbooks, because markets did not rebound nearly as spritely as they did this time around. That said, in Bernanke’s calculus – and as he articulated years before the crisis, central banks helped cause the Great Depression by not acting swiftly and magnanimously in easing monetary policy in the wake of the crash. From his perspective, you bail out the banks and you bail out everyone by saving the system. Without functioning markets, the health of the middle class is greatly endangered, and before long  you have the same global economic instabilities that contributed to the social upheaval that made nations turn inward, brought fascism to power in Europe and war to shores worldwide.  

The rub today is that while the system was saved during the crisis and markets rebounded strongly, wealth and income inequality has greatly expanded – mostly at the expense of public trust. No public trust – no political capital to govern and enact responsible fiscal policy. No real fiscal policy and the health of the economy and public markets are left primarily to the broad and imperfect influence of the central bank. In this environment, where there’s widespread perception that the government has mostly failed its citizens and only served the wealthiest and most powerful parts of society, the natural tendency for the nation is to collectively turn inwards and towards those political ideologues pointing out the obvious flaws in the system, with at times incendiary solutions.

- Enter the likes of Donald Trump, Bernie Sanders, Nigel Farage, Boris Johnson, Marine Le Pen, Pedro Sanchez, Pablo Iglesias, Frauke Petry ... etc. 

Although they certainly don’t fall on the same side of the political continuum or share similar ambitions, what they all collectively tap into is the tangible rage in the middle class that has felt abandoned by their respective governments in the wake of the financial crisis. What happened last Thursday was the ideologues triumphed over the pragmatists. And while the counterfactual arguments of how the financial crisis was handled will go on in perpetuity – just as they have for generations since the Great Depression, the reality is last Thursday’s results will not be the last victory for the ideologues and is testament of the dangers that inevitably will impact markets with unknown consequences. Considering that Britain was a relative outlier to the broader economic travails within Europe, it also suggests that even if the vote had failed or comes to pass without them leaving the EU, participants (myself included) have underestimated the underlying political frictions that have been butting up against the limitations of central banks worldwide.
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Postscripts

From an intermediate-term perspective, the market reaction from the British referendum may provide a discerning catalyst for commodities and those markets tangentially correlated. As nominal yields likely remain suppressed at or near historic lows and the post-Brexit market environment gives greater cover from future rate hikes, real rates that began moving lower subsequent to the Fed’s initial rate hike in December – should continue to trend down.

Despite some renewed deflationary concerns from the Brexit punditry, the silver:gold ratio – that we follow as another reflationary barometer, has recouped the initial retracement decline from the Brexit vote and continues to trend higher. As we pointed out towards the end of last year, the rare positive momentum signal in the ratio bodes bullish towards the long-term prospects of precious metals and commodities, as well as those assets that benefit from rising inflation.
While the referendum did generate immediate disinflationary pressures that supported the dollar, we believe those forces will be greatly curtailed by the weakening appetite for further rate hikes by the Fed this year and the loosening of credit conditions that supports the positive domestic trend in inflation. All things considered, we expect the reflationary trend that began in gold last December and broadened throughout the commodity sector this year – to continue.
Should the dollar resurrect its dormant uptrend from last year, all bets are off with commodities; which might also suggest a more severe market dislocation is a foot. For now, we continue to closely watch the dollar and its relative performance to gold, for indications that our buy-the-rumor (taper) and sell-the-news (rate hike) suspicions towards the dollar is misplaced or adversely impacted by the recent events in Britain. 

What’s interesting to note, is in the chart that we constructed at the beginning of the year to frame our bullish gold/bearish dollar thesis, gold is now seasonally trading around the same level from 2014, despite the dollar (USDX) strengthening by nearly 20 percent. This isn’t that surprising to us, however, since major lows in gold have typically led pivots in the dollar, which we have speculated is on the back side of completing a cyclical high last year. While over the near-term it wouldn’t surprise us to see the shine come off precious metals and on to other commodities like oil (i.e. similar to March), underlying market conditions continue to support the trend higher.

Sizing up the move in gold relative to the US equity markets, you continue to see that gold has not only led the broader reflationary trend, but pivots in the equity markets as well. We’ve speculated, however, that a principal distinction in longer-term market structure is as commodities have put in a cyclical low with inflation, US equities are distributing across a now broad cyclical top.

That said, this week’s strong rally in equities continues to follow the leading footprints in gold, which may suggest that the SPX would again test the top of its broad two-year range.

Thursday, June 16, 2016

Starring Down the Long Dark Tunnel

Like an oak slowly growing in a stand of pines, the outgrowth of sentiment extremes become visible through major market inflection points. The irony, however, is seeing them. This is because on both sides of a market cycle there is a natural tendency for conditions otherwise thought abnormal to become commonplace. As much as we try to anchor our baseline expectations with history, inevitably, paradigm creep sets in as markets and sentiment slowly become stretched beyond more rational assumptions. 

They couldn’t see the trees for the forest – until the forest caught fire.

In the late 1990’s as venture capital was seeding manic entrepreneurs with otherwise outrageous business plans, perspective was forsaken for the chance to become the next internet giant. A short time down that road, the pursuit of Amazon quickly gave way to the likes of Clickmango, your one-stop shop for all of your succulent produce desires and LifeJacketStore.com – well, for your many recreation flotation demands…

Fast-forward a decade later and the opposite side of the continuum, the raging fires of the financial crisis warped investors expectations into believing that a steady state of chaos would erode markets for the foreseeable future. So powerful were these kinetic events that the same anxieties still haunt participants today, even as economic conditions here in the US and abroad have little resemblance to that time and their unfounded fears over the past seven years have largely remained unrealized.

We’ve come along way when it comes to market expectations of historically low yields.  Before the financial crisis hit in 2008, the lower range for the 10-year Treasury yield was around 150 bps below at just above 3 percent. When it plunged to around 2 percent in the bowels of the financial crisis, the thought of an even deeper slide below that threshold was inconceivable – even as the threat of deflation was at its height. In fact, at that time conventional wisdom believed inflation was the next risk for the economy and markets as the Fed led the world and began applying extraordinary monetary accommodations to bridge the gap across the crisis.

Simply put, on both sides of the continuum, our collective behavior is often realized in the markets with a latent reflexive chase down a dark tunnel with an oncoming train. Today, we’d argue that participants gamble down the tunnel has been darkened by the now universally accepted exceptionally low yield market environment and that the train approaching is inflation. In this analogy, the sentiment extreme that has brought nearly half of the global government bond market to negative yields is an inverse equivalent of the speculative mania during the dotcom era that ushered in companies like Clickmango and LifeJacketStore.com – right before the bubble burst in 2000. One period was propelled with exuberance and the other by fear. Another distinction is that the immediate risk in the market is largely institutionally (both public – central banks & private – pensions, insurance companies and banks) held today, whereas, in 2000 retail investors became the bag holders of last resort.

With a reasonable chance that core CPI in the US will make a push above 2.5 percent later this year, who in sound mind would expect even a positive intermediate return on Treasuries, no less a longer duration note like the 10-year. But alas, the relative attraction to Treasuries here in the US where the 10-year still yields around 160 bps above German bunds is enough for most "conservative" investors. Just keep in mind that the US introduced the deflationary threat by igniting the fires in housing and is leading the way out – as the inflation data continues to suggest. As always, Fed policy has lagged on both sides of the cycle, but the notion that bonds remain attractive today because of disinflation and deflationary conditions/concerns is as reasonable as shorting them was directly in the wake of the financial crisis with fears of hyperinflation.

The reality is it's been a “Costanza” market since that time and we see no reason to believe conventional wisdom will get it right today.


George: “My life is the complete opposite of everything I want it to be. Every instinct I have in every aspect of life, be it something to wear, something to eat… It’s often wrong.”
Jerry:  ”If every instinct you have is wrong, then the opposite would have to be right.” 
                                                              - Seinfeld, "The Opposite" (1994) 


Do we expect a return to "normal" where the 10-year yields over 4 percent or the fed funds rate is materially above 2 percent? No. Expectations were pushed too high over the past two years and as seen yesterday with the Fed’s new dot-plot projections for June, have continued to drift lower as expected. Moreover – and as shown below with our comparative profile of the last time yields fell into the long-term cycle trough in the 1930’s and 1940’s, they still have a ways to go in aligning expectations with reality. 
The twist, however, is long-term yields have now been pushed to the bottom of the range by the latent reflexive move. Our best guess  and an opinion we have held since the end of 2013, is that the 10-year yield will remain range bound between 1.5 and 3 percent for the foreseeable future, as markets and economies work across the transitional divide to the next major secular growth cycle. 

With precious metals continuing to lead the move higher in the commodity sector this year and with the US dollar poised to fall further (see Here), the inflation vane continues to points higher – despite the Costanza concerns with disinflation and deflation today. All things considered (see Here), we would conservatively speculate that the 10-year yield will snap back to the return profile of the long-term cycle around 2.25 percent.     


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Postscripts

The British are coming! The British are coming! The British are coming!

With the Brexit vote on tap for next Thursday, we see a resolution for the markets heightened anxieties and not a revolution to leave the EU. Over the past few weeks, concerns have snowballed that Britain will choose to leave. Our best guesstimate is they're widely off the mark, and expect a strong snap-back reaction to develop in the markets next week. Broad brush, over the short-term this would likely be bullish for equities and bearish for bonds and gold.

Taking a speculative swing with potentially longer-term opportunities, we cautiously like the prospects for higher beta equity markets over the short-term, such as Spain's IBEX. Moreover, our momentum comparative that we've followed over the past three years for the IBEX points towards an interim low, with the possibility that its cyclical decline has run its course. With the euro finding a foothold in today's session, we like the iShares MSCI Spain ETF - EWP, that would also benefit from a stronger euro. For potential longer-term investors, the ETF pays a hefty 4.25 percent dividend.  













The US dollar index, which we had expected to retrace lower coming into June, continues to flirt with the bottom of the range (~93) of the broad top it has traded in over the past two years. Should the vote in Britain fail next week, we'd expect the euro to find strength and the US dollar index to weaken. Our dollar index comparative from 2009 also points towards further weakness and a breakdown below support of its broad top. 
Although gold may have reached another interim high this week, we are still long-term bulls on both gold and silver and point towards further weakness in the dollar in tempering their potential retracement declines. Moreover, the silver-gold ratio's rare positive momentum cross remains broadly bullish towards the reflationary trend that gold had led initially this past December. Should the trend in inflation step higher through the end of the year, we expect silver will continue to outperform.

Thursday, June 2, 2016

The Long & Short of it...

Long-term Treasuries are throwing caution to the wind this week - or more appropriately, seeding caution to the wind, with strong follow-up strength into tomorrow morning's US jobs report. And as much as anticipating a short-term prospective catalyst is a murky Game of Unknowns endeavor to trade on, we still like the risk profile over the intermediate-term from the short side of long-term Treasuries.

As outlined in a note a few weeks back (see Here), long-term Treasuries have been trading in a broad descending range from their February highs that in the past has presaged a subsequent trend shift lower. Coupled with our historical study of how a similar disinflationary market environment exhausted and reversed course, the jobs report appears near a coincident comparative pivot. 

From our perspective, a short in long-term Treasuries (30 Year or iShares 20+ Year Treasury ETF - TLT) is asymmetrically defined by the upside risk (<2%) above the previous highs this February and a prospective breakdown below support extending from the lows from late December 2013. While we don't trade futures, we do like the ProShares UltraShort 20+ Year Treasury ETF - TBT, that is again revisiting levels around $35.60.