We have been highlighting, for a number of weeks, the prospect of higher bond yields and suggesting that equities should eventually adjust to the downside in such an outcome. And for weeks, we looked like idiotic naysayers. As the old Keynesian saying goes “the market can remain irrational far longer than we can remain solvent”, and even noted bears were opening up to the idea of a market “melt up” – which we noted in early January, if it were to occur, would take market valuations to bubble peaks; not impossible, but certainly extraordinary.
Finally, the rise in bond yields seems to be getting noticed in the equity markets, and the swings in currency markets are also causing some confusion. Europe and the UK seem to be bearing the brunt of the equity nervousness so far. This may be partly because of their currency strength so far this year, but perhaps also because bond investors are on the cusp of pricing in a regime change in European monetary policy.
Chart 1 below shows the weekly FTSE 100 chart since early 2014. At the end of 2017, the flagship UK index appeared to be breaking out of a bullish triangle pattern that had been at least 6 months in the making. However, the price deterioration in recent weeks now gives the look of a failed breakout. We think there is a good possibility that this index will test support in the 7100 area, which is both the initiation of the triangle pattern and significant structural support (all the way back to the December 1999 peak). We also think it is worth pointing out that this index has now made zero progress since March 2017 or nearly 10 months – hardly the sign of a roaring bull market. And for those that like to use the FTSE 250 as a benchmark, this index has made zero progress since June 2017.
Chart 1 – Weekly chart of FTSE 100 Index
In Europe, the EuroStoxx 600 Index is yet again testing structural resistance in the 400 to 415 range. Any further deterioration in the weeks ahead will leave the impression that the current test of this resistance zone is failing.
Chart 2 – Monthly chart of EuroStoxx 600 Index
The US equity market has benefitted from a weaker Dollar over the last 12 months or so, but even here, the S&P 500 suffered its worst week in 2 years or so.
Chart 3 – Weekly S&P 500 Index
Our base case remains that equity markets are extremely overvalued and that a very nasty bear market lies out there somewhere in the not too distant future. The global economy is growing at a decent clip at the moment, inflation is picking up especially in the US, and central banks are either exiting the extraordinary policies pursued in recent years, or are well on the way to normalisation. Global bond markets are badly mis-priced and higher yields lie ahead of us which will ultimately impact highly leveraged economies and risky assets.
And yet, we are not sure that nasty bear market is in the immediate future. Not only do markets go through a topping process that usually takes months, but it feels like too much bearishness is creeping into bond markets in the short term, and we do not expect yields to move up in a straight line.
Furthermore, although a weaker Dollar is usually beneficial, if it is too weak or the decline is too rapid, then that can cause its own problems. And in recent weeks, perhaps the decline in the Dollar was becoming too much, and actually a threat to markets.
So, if we were to try and build a roadmap for the weeks/months ahead, we expect the declines in equity markets to extend a bit more in the short term, but the buy the dip crowd are surely in the wings waiting. Perhaps they will be encouraged by some soothing words from central bankers if equity and bond prices fall too quickly? We do not, however, expect any significant bond market rally and think that the trajectory is lower for prices in the months ahead. As for equities, we think that a multi month topping process may have begun, although a new highs are likely in some indices, perhaps most of them.
The Dollar is interesting too. In the very short term, the Dollar is oversold, and we would not be at all surprised if it were to rally in the weeks ahead. In the long term, however, the odds that the Dollar is in a structural decline are rising. The Federal deficit is set to rise dramatically and the US is on a course towards more isolationism rather than globalism. In the years ahead, global reserve managers are likely to diversify further away from the Dollar as Europe’s existential crisis remains elusive and China’s influence grows.
There is little doubt in our mind that the weakness in the Dollar in the last 12 months has been mostly as a result of reserve managers selling Dollars. Chart 4 below shows the performance of the US Dollar index alongside the share of global reserves held in US Dollars (as measured by the IMF). Unless there is some sort of global upheaval or upset in Europe and or China in the quarters ahead, we think that reserve managers will be reducing their exposure to Dollars further, perhaps significantly.
Chart 4 – The US Dollar Index and the share of global reserves held in US Dollars
As noted above, historically a weaker Dollar was generally seen as a positive unless the decline became too rapid or even disorderly. However, we are beginning to wonder whether things could be different in the future. Last week, we noted that the end of the Dollar Standard could be a big deal SEE OUR REPORT ON 28/01/18. A natural outcome from the end of the Dollar Standard is higher US interest rates, which as we have said many times would at some point act as a drag on the highly indebted US economy.
Another worry for the US is that, for the first time ever, the US budget deficit is deteriorating even before a recession starts. The usual sequence of events in a recession is that unemployment starts to rise causing the deficit to widen as automatic stabilisers kick in. Chart 5 below shows the US Federal deficit as a per cent of GDP alongside the unemployment rate. Recessions are shown by the shaded areas. As can be clearly seen, the deficit is already widening well before any deterioration in either the unemployment rate or the economy. Furthermore, the deficit is set to widen significantly as a result of the recent tax reform bill.
We are beginning to worry a lot about how bad the US deficit will be in the next economic downturn. Who will fund deficits of well over US$1 trillion each year, as well as replacing the funding gap that the Fed will leave due to its quantitative tightening at a time when the US is moving to a more isolationist position and losing the benefit of being the global reserve currency?
Chart 5 – US Federal deficit alongside the unemployment rate
So to try and wrap up this week, our structural concerns over valuations in both equity and bond markets remain, and frankly, we still strongly believe that a nasty bear market lies in the not too distant future. We are greatly concerned about structural problems like too much debt, stretched consumers and now a potential deterioration in US Government finances at a time when global reserve standards are changing and even before the next US recession starts.
That said, nasty bear markets usually only happen after multi month topping patterns. Bonds may well have completed such patterns, and we think that yields are generally headed higher. Equity markets may be beginning their topping patterns now, or perhaps after some more marginal highs in the months ahead. Ultimately, we expect any more short term weakness in equities to be seen as an opportunity for the buy the dip crowd to step in, and the question is whether this happens after say another 5% decline from here, or perhaps only a couple of per cent.
But the big message we want to leave here is that structural problems are close to the surface, and the markets after months/quarters of uninterrupted gains, appear to be changing character. We have long made the case that returns for buy and hold investors will be around zero for the next 10 to 12 years. We appear to be in the process of entering this lengthy period of poor returns, and we expect that this will be more obvious by year end, and mostly likely quite a bit before.
RMG Wealth Management