The Big Picture Issue 7

How could I have been so mistaken as to have trusted the experts?

John F. Kennedy – after the Bay of Pigs fiasco.


As I wrote in a recent client note, it is too early to dismiss the stock market adage of ‘sell in May and go away’ However with US stocks recovering from last year’s correction in December to reach all-time highs, gaining 16% this year, investors who have missed the rally will be frustrated and may be tempted to ‘ride’ the bull. Market history shows us that the last leg of a Bull Market prices can increase by 40- 50%. Most Bull market gains come in the last third of the market.

This is the most hated Bull Market in history. So where is the buying coming from? We will examine this later in this newsletter. Bull markets do not die of old age but on euphoria to quote the late Sir John Templeton,’ Bull Markets are born on pessimism, grow on scepticism, mature on optimism and die on euphoria’. The US market has reached an all-time high and European developed markets have also made double digit gains this year but no sign of euphoria indeed the opposite. So, what are investors to make of this?

US Treasury Bonds have once again confounded the so called ‘Gurus’ and proved most forecasters and experts Wong. The much ‘trumpeted’ economic growth in the US and Europe has not materialised despite aggressive monetary policy and fiscal stimulus. The Federal Reserve and the European Central Bank have both been taking their feet off the interest rates pedal seeking not to kill off what little growth there is by easing rates rather than raising again. Despite the increasing trade tensions with China and the threat of US protectionist tariffs, the Bull market has trampled underfoot any thought of economic consequences. Aggressive use of trade tariffs was last used by the Smoot Hawley Act in 1930 which imposed tariffs on 27,000 imported goods to support US agriculture and resulted in prices rising in the US 40- 50%. Global trade decreased by 65% as other countries retaliated against the US.

The Bond market with the US 10-year yield falling to 2.0% and German Bunds returning to negative real yields is reflecting a disinflationary environment (prices move inversely with interest rates). As I commented in last quarter’s newsletter the dilemma facing central banks is how to keep their powder dry for the next recession? The only tool that they have is to lower interest rates and authorise the treasury to print money. I% move in interest rates makes a substantial effect to GDP and inflation. (the Taylor Rule).

Low rates for longer do not help ordinary people who have their savings in interest bearing and deposits and savings bonds. As the stock market continues to climb this only continues to fuel the income divide. Central Bank’s monetary policy is becoming increasingly restrictive to growth. People are losing trust with professional opinions. Forecasting is consistently proved wrong. The speculative game played by CEO’s of forward stock earnings driving PE ratios to boost stock options and share buybacks together with Central Banks forward guidance, is inevitably revised downwards.

Gold has broken out of its 5-year trading range and has tested $1,400 an ounce last reached in April 2013. Unloved for several years speculators are once again placing Gold on their radar as the Fed’s change of interest rate policy could result in a weaker dollar. The Gold price moves inversely to the USD. Aggression from Iran and increased ‘sabre rattling’, meetings between China and Russia and threats of more global trade tariffs have increased geopolitical tension which has also been supportive of the gold price.


Things are seldom what they seem, Skim milk masquerades as cream

Gilbert and Sullivan – HMS Pinafore


The S&P 500 index of US stocks reached an all-time high on June 21st. This index, comprising the largest 500 US companies by capitalization, whilst commonly used as a benchmark by many US equity fund managers is not representative of US business as a whole as the index is dominated by the giant technology companies. The New York composite index with 1, 900 stocks including stocks from 30 different countries listed in the US is more representative of the US economy.

Why most hated market?

In the last 40 years we have added so much leverage that the average US company’s debt is rated as ‘junk’ (a high risk of default). I am old enough to remember when in the late 1980s the structured finance market was born. Before this we did not have a credit market. We have had three credit booms and busts in recent decades. 1991 – 2000 Collapse of the Long-Term Capital Management hedge fund (LTCM), Enron, WorldCom et al. 2004 – 2007. Sub Prime crisis. 2009 – now. Pension funds were 60% of GDP 1984 and now are 120% of GDP. Pension funds are now the dominant global investor. On average they are 30% underfunded and they need to make 7.5% pa to cover the gap between government legislation plus what is promised to government workers. Boards of pension funds are forced to think short term and deploy capital into the leveraged credit market not equities which are a much longer-term investment. The world has changed so much in the last 3 decades the flow of money into the market from private investors, has remained net flat. Money has moved from mutual funds to ETFs and from active to passive. The new money has come from Pension Funds deploying tax dollars with aggressively leveraged credit.

We have had 35 sharp declines in the recovery since 2007 and the market has always bounced back. The stock market has outpaced the real economy leaving average taxpayers worse off. The selloff of December 2018 was a good example. The credit market shut down when risk assets sold off only to buy again aggressively once price had dropped 20%. The financial engineering from pension funds with taxpayers’ dollars coupled with share buybacks allows them to leverage their return. This has been the main force driving this equity Bull Market, impeding price discovery and frustrating active managers. The market is hated as it is disconnected from the real economy. Funded through tax dollars deployed with aggressive leverage in an effort to achieve the 7.5% return pa Pension Funds buying short term to meet pension funding gaps. Credit cycles end in a severe crisis with a bang not a whimper. When pension funds are forced to sell through a run on the ‘shadow banking system’ which is the financial engineering from Pension funds the music will stop! We now have the opposite of Euphoria. Stocks are in the main disliked. Leveraged credit is the main driver. If this is true, then this Bull Market still has legs to run. Investors must guard against confusing a ‘bull market’ with ‘Brains’. Scrutiny of Investment Managers should be made in times of ‘lack’ not in times of plenty’.


The EU has again revised growth forecasts downwards. It is difficult to see how the ECB can raise rates with no growth and core inflation at 1% pa way short of the target of 2%. As with the US Monetary policy restricting growth and spending, so too in Europe unfunded pensions liabilities and the insidious increasing indebtedness is undermining growth. The ‘Damocles sword’ of Brexit still hangs over the Union but this is not the reason for a decade long lack of consumer demand. The Dax Index reflecting German stocks is up 16% this year 5% coming in the last quarter. The broader European index has gained around 16% in euro terms. The political federalist experiment by forcing EU member states with vastly different economies into a single currency has resulted in the southern group of countries having to depreciate their currency dramatically against the Euro subsequently ‘gorging’ on cheap debt. This debt overhang is still having to be serviced at a much higher rate which coupled with unfunded pension and social security benefits is undermining consumer spending and growth and increasing credit. All EU countries are carrying high and increasing debt to GDP in other words spending much more than they earn. The US debt although high and increasing has a lower debt to GDP burden than Europe.

Emerging Markets

The Pacific Rim economies by 2050 will have some 60% of global middle class disposable income. (Barclays Global Survey). Emerging economies equities markets have risen by 13% this year as investors again begin again to buy into this asset class. Weak inflation in the US and a reluctance for the Fed to raise interest rates ( emerging growth economies hold relatively large tranches of US Dollar denominated debt which has to be paid in local currency ) is supportive coupled with strong economic fundamentals and increased market share as they seek to gain trade from China during the US – China trade hostilities In addition to China facing US trade tariffs GDP growth is low. The Chinese economy is highly leveraged through government debt. The corporate sector is borrowing to pay off debt. China now has a higher debt to GDP ratio than the US which is 360%.


Total US debt, public and private, is 360% of GDP. Some $53 Trillion outstanding with $15 Trillion of income. This is the 4th period of extreme over indebtedness since the 18th century during the time of the railroads. Each period including the 1920s all ended badly. This time the Federal Reserve has not been unable to ‘shrink its balance sheet’ as it had wished by buying back or letting mature the bonds that it issued to try and stimulate economic growth and is now caught with an increasing debt liability made worse with an increasing cost to service the debt if it raises interest rates further. The Fed can’t raise taxes it can only raise rates.

The Fed raised rates 9 times during the last 10 years of the recovery with little increase in consumer spending or economic growth. Central Bank’s monetary policy is becoming increasingly restrictive to growth. Consumer spending and productivity has remained largely flat. Many analysts point to Japan as an economic model to avoid as they have failed over two decades to stimulate consumer spending and economic growth. Given the huge and increasing level of government unfunded debt liabilities this may also be the future direction of US and European economies? There is however one fundamental difference between the Japanese economy and the US. Japan owns her own debt. Some 30% of US government debt is owned by China. The Yen is considered by global investors as a safe haven currency along with the US Dollar. The ECB is without a treasury and euro credit is a disparate assortment of economic players with political disagreement, no fiscal leverage and differing indebted economic models, with the exception of Germany whose Bundesbank drives European fiscal policy (see Is the Euro Really the Deutschmark?) In 1989 Japan’s government debt to GDP was 60% in 1998 80% it 2018 it was 500%. They have experienced 4 recessions in the last 10 years. In a recession all asset classes fall except treasury bonds as investors sell risk assets and move into safe havens. Japanese Government Bonds yield less than zero but with inflation trending under 1% Investors in Europe fare worse. That investors are prepared to pay a premium to receive a discounted capital value shows their fear to buy risky assets.

With US and European companies highly leveraged on cheap money much corporate paper is mispriced and poorly rated. There was a time when we called High Yield Bonds ‘Junk’ for a reason. Today some 46% of investment grade corporate paper in the US if market to market would be rated ‘junk’. As with Freddy and Fanny in 2008 which were rated AAA when the music stops investors will be crushed rushing for the exits realising too late that they are holding ‘junk’ Students of market history know that credit markets unwind violently with a ‘bang’ not a ‘whimper’. Sensible investors will have an equity bias in their portfolios and have a firm safe haven anchor to windward.


Gold has broken out of its 5-year trading rage and has tested $1,400 an ounce last reached in April 2013. Unloved for several years speculators are once again placing Gold on their radar as the Fed’s change of interest rate policy could result in a weaker dollar. The Gold price moves inversely to the USD. Aggression from Iran and increased sabre rattling, meetings between China and Russia and threats of more global trade tariffs have increased geopolitical tension which has also been supportive of Gold. For technical chartists $ 1,350 represents an important long-term resistance level. Breaking through this is a bullish signal for Gold. Sensible investors hold gold in their portfolio as an asset class diversifier. Physical Gold is the only asset which is not someone else’s liability and has zero counterparty risk which was what brought the final panic into the US in the crash of 2008-9. This is not true for investors who hold a paper claim to gold through a fund or an equity participation.


The US Dollar has weakened against the Euro since 23 May and fell most during June as the US imposed an additional 25% on $ 200 Bn of Chinese goods to bring Beijing to heel during bilateral trade talks. This and the threat of other tariffs on the largest trading partners of the US has produced flows out of the USD. As both sides dig their heels in with another summit as I write this, it is hard to see where the USD goes from here in the short term. The Fed change of policy towards interest rate hikes wrong footed traders. The US Dollar should weaken further if they cut interest rates from here. Against this is that the world needs US Dollars. The Dollar is 50% of the world’s reserves, 65% of world trade and 100% of oil. The deepest most liquid market in the world. In a trade war nobody wins as the result of the Smoot Hawley Act showed. The US should win in the short term as China exports far more to the US than she imports, and other Asian countries are desperate to compete. On the other hand, China holds some 30% of US Treasury debt the so called ‘nuclear’ option is they redeem or threaten to redeem part of this debt. China sold off $20 Billion of US Treasuries in March of this year which moved the US Dollar. China also accounts for 80% of the worlds rare earth uses in the manufacturer of cell phones and computers.

Sterling has been falling against the USD since 13 April 2018 to a current low of 1.27. The all-time low was 1.22 on November 10th, 2017. Brexit uncertainty is the main driver of sterling. The market does not want an exit from the EU without a negotiated trade deal. October the 31st will be an important milestone for sterling. The Euro has weakened against Sterling since December 2018 05 May high of 0.90 to a low of 0.80 in May and has since strengthened since May 2019. The currency pair fluctuate as much as votes in the parliament in Westminster.


The quarter has seen heightened tension between the US and Iran and increasing tension in trade between the US and China. The dispute with China over territorial claims in the South China sea has again surfaced as the Philippines is putting pressure on the US to act in their defence.

An incident in the Straits of Hormuz between Iran and Oman through which 60% of shipped oil moves is an escalation and threatens all the oil exporting countries in the region. A global choke point it is vital that it is kept open to international shipping. Increased rhetoric from Iran to increase their production of uranium in breach of their previous agreement has infuriated an already hostile US and Israel. The Iranian economy is feeling the pinch. US sanctions are biting into Iran’s economy, since they were ‘kicked out of the SWIFT payment system which is the ‘spinal cord’ of the global financial trading system. Israel will not allow Iran to develop a nuclear weapon. The US fear is a nuclear arms race in the middle east if Iran’s nuclear ambitions cannot be thwarted.

Russia China Iran and Turkey are aligned to trade outside of the USD the world reserve currency to try and circumvent using the US Dollar and be vulnerable to US sanctions. Russia has dumped most of its holding of US Treasury Bonds. Trade between these countries is backed by Gold. Russia has tripled its Gold reserves in the last 10 years and China is now the world’s largest producer and importer of Gold. Turkey used its Gold to intervene in its own currency markets when the Lira dropped some 50% against the US Dollar in 2018.

Jeremy Blatch TEP
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