‘The End Game’
February 2019 Investment Report
Summary
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The US Dollar has an 8 and 16 year cycle which is likely to see a trough in 2024, supporting an increase in inflation, Index Linked Gilts, Commodities, Precious Metals and possibly emerging markets.
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Research from Incrementum shows that during periods when US inflation exceeds 3% per annum, Gold provides an average return of 8% per annum above the rate of inflation.
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Stock Market Warnings.
The US Dollar Index
The following chart is of the US Dollar Index since 1990. Clear trends can be identified and on closer inspection a 16-year trend. The US Dollar Index peaked in 2001 and again in 2017. The Index troughed in 1992 and again in 2008. We can therefore assume that the US Dollar Index is likely to reach a new low point in 2024 (a date that I have often cited as the likely end of the cycle for other markets (peaks for gold and troughs for stock markets)).
It would be complacent to assume a continuation of this trend just because it has existed in the past and we therefore have to consider the fundamental background for the US Dollar Index. The US Budget and Current Account Deficits are a good 18-month lead indicator for the US Dollar. The US Current Account Deficit has been increasing for the last five years and the budget deficit has been rising for four years. We therefore have fundamental evidence to suggest that the US Dollar will fall for at least the next eighteen months. Should the US enter a recession, the budget deficit would increase further and consequently put further downward pressure on the US Dollar.
In addition, the US needs to sell $12tn of bonds over the next decade, most of which occurs by 2025. As with anything that one attempts to sell a lot of, the price tends to fall in order to attract buyers.
The US Dollar Index (Source: Stockcharts)
This is important for financial markets as a falling US Dollar tends to cause rising inflation for two reasons. The US is the worlds largest consumer nation and as the US Dollar falls in value, the cost of foreign goods that they consume rises. Furthermore, commodities (oil and metals) which are priced in US Dollars become cheaper and the largest consumers of these commodities (emerging markets) tend to purchase more of these commodities thus pushing up the price and consequently inflation.
This is evidenced in the following chart of the UK Inflation Rate which peaked in 1991/2 and 2008 as the US Dollar Index troughed and the UK Inflation Rate troughed in 2000 and 2015/16 when the US Dollar Index peaked. We can therefore postulate from these two charts that inflation is likely to attain a cyclical peak in 2024.
Again, we have a couple of underlying indicators which suggest that inflation will be rising: -
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Global liquidity and the G4 yield curve currently indicate rising inflation for at least two to three years;
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The Output Gap is still rising and inflation would normally peak around two years after it has begun to decline.
UK Inflation Rate (source: Trading Economics)
It is also noticeable that the rate of acceleration in inflation since 2016 is far greater than the acceleration that occurred from the year 2000.
What Impact Would Rising Inflation Have on Asset Prices?
The following chart demonstrates the historical return from different asset classes in different inflation regimes. Looking at the rising inflation environment, Equities provide losses of 10.3% per annum adjusted for inflation, Index Linked Bonds (US TIPS) and Energy Equities provide positive returns above inflation and mining equities, precious metals and commodities provide significant returns above the rate of inflation.
Research from Incrementum also shows that during periods when US inflation exceeds 3% per annum, Gold provides an average return of 8% per annum above the rate of inflation.
Emerging markets should also benefit from these conditions as developed economies lose their technological advantage. However, emerging markets may see falls of around 25% before rising. China may be the exception, where the market has already fallen 50%. The Chinese stock market offers very good long-term value and we are now recommending exposure to clients who have that risk tolerance.
Henry Sanderson, FT – ‘The physical demand for Copper in China, the worlds largest consumer, is strong. That sentiment is shared by the largest copper miners such as Freeport-McMoran and Antofagasta, which say that demand for copper from their customers remains strong.’
Stock Market Warnings
Last year, I released research that showed 27% of FTSE 100 companies to be tangibly insolvent. That figure has now risen to 32%. The figure for the US S&P 500 is 29%. It is worth noting that in the event of insolvency, assets are generally written down by 40%. Now think about 32% of companies writing down their assets by 40% and the impact that would have on the remaining 68%, a large portion of which are financial services companies and you will realise that you would lose most of your money in these markets. However, as I have said before, rather than allowing companies to go bust en masse, I believe that governments and central banks will inflate the problem away.
The percentage of US Companies that are recording negative earnings before interest and tax (profits) has risen to the same levels as the peaks of 2000 and 2007. This has not been reflected in an increase in default rates which are below 4% compared to over 10% in 2002 and 2009. This brings us back to the resolution of the overall debt problem. Central Banks didn’t provide liquidity in the 2007/8 financial crisis until it was too late. This time they are reacting as liquidity becomes restricted. In other words, they are easing monetary conditions so that money can continue to circulate. This action extends the financial problem and does not resolve it. The consequence should be a rise in inflation and a revaluation of assets which are currently priced for a prolonged period of low inflation.
Global Real M1 is shrinking and according to Nordea this could lead to corporate earnings (profits) falling by up to 25% in the next ten months. Whereas their GDP minus wages model suggests that the fall could be as much as 40%.
An indicator that is highly correlated with the stock market (Stock market capitalisation to GDP adjusted for demographics) currently suggests that the US stock market total return could fall by 4.1% per annum (-49.5%) adjusted for inflation over the next ten years.
Mark Carney, the Governor of the Bank of England has warned that there has been a build up of $30tn of assets held in funds, which are supposed to offer daily liquidity to investors but are heavily in underlying assets that are not liquid. These assets are hard to sell in good times and even harder to sell in bad times. Mr Carney has been part of the architecture that has allowed this problem to develop. He has been Chair of the Financial Stability Board since 2011, a central banker since 2003 and prior to that spent thirteen years at Goldman Sachs. I find it galling that he has the temerity to warn us of these problems.
The US leveraged loan market is now almost twice as large as in 2008. Covenant-light (with few guarantees) issuance has risen from virtually nothing in 2010 to 9% in 2018.
Ambrose Evans Pritchard, The Telegraph – ‘The BIS (Bank for international Settlements) fears a waterfall effect. ‘The bulge of BBB corporate debt, just above junk status, hovers like a dark cloud over investors. Should this debt be downgraded, if and when the economy weakened, it is bound to put pressure on a market that is already quite illiquid’ said Claudio Borio’.
Russell Napier an independent market strategist – ‘While many investors are fretting over what stage of the business cycle we are in, the global monetary system is collapsing – with a whimper initially, but ultimately a bang. The whimper is causing losses for equity investors. The bang will impact global asset prices as much as the end of the Bretton-Woods system or the end of the gold standard (1971). For 10 years the growth of debt has outstripped growth in broad money and nominal GDP. Central bankers have bought growth by sacrificing financial stability. China will probably move to a flexible exchange rate, thus creating the freedom to grow and inflate away these debts. It is that exchange-rate adjustment that will destroy the current global monetary system.’
Crispin Odey, Odey Asset Management – ‘My own predictions for 2019 are that the world will start to see the effects of years of depleting resources on the cheap – fracking being the latest example, but also factory farming that relies upon antibiotics to allow such closely confined living. Cars that are only cheap because interest rates are low and full employment that has concealed natural levels of default. At the same time wage inflation appears to be taking hold in the UK, japan and the USA. Central banks may have little leeway. Excessive credit creation will bring headaches in many unforeseen places. Governments will show themselves to be vulnerable, especially where the political class are not representative remotely of their own constituents. Stock markets will be good for traders but bad for investors. A poor 2018 will be followed by a poor 2019.’
Mitchell Neale
Director
The views reflected herein are those of Vertis Private Wealth Management Limited and should not be regarded as a recommendation to invest in any one product or service; before investing you should always consider personal investment advice.
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