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.
