Q4 2019 Review. 3 levels of Crisis.
If there is a better long term record by an investment manager than that of Stan Druckenmiller then I’d like to see it. So we are fortunate whenever we get an update on his views.
I believe that the most important message from this interview is his conviction about the link between policy, bubbles, and financial crisis.
Q4 2019 Review. 3 levels of Crisis. The Faster You Can Move The Less You Have To Predict.
I believe the list of unprecedented investment metrics has continued to accelerate into year end with the extraordinary behaviour of the Federal Reserve, and other central banks. I hope I can bring some clarity and understanding to the latest events by breaking this down into 3 separate but interrelated perspectives:
1. The internal central bank crisis
2. The long term crisis this creates outside the central banks
3. The investment prospective return crisis
The internal central bank crisis
Superficially, the central banks tend to say that all is well under their supervision. However, you don’t have to dig very deep into their own publications, the BIS annual review for example, to see that they do indeed see a crisis in their own policy.
The chart below shows that it’s really hard to miss the epic failure of economic policy over the last 10 years. Despite record intervention by central banks over the last decade, both world trade volume and industrial production are negative, still declining and at their worst levels since 2009.
The unfortunate conclusion from the BIS link above, is that central banks just intend to do more of everything that hasn’t been working for the last 10 years. What exactly that means is now becoming clearer.
Central banks are cutting rates at the fastest rate since 2009.
The Fed’s balance sheet reversal is simply astonishing. Yet still Fed chair Powell claims this is not QE!
If central banks were confident about what they were doing would they be accelerating their gold buying rate to new multi decade highs?
There is little doubt that the central banks are indeed operating as if we are in a crisis, and are trying to preempt further economic deterioration. The unanswered question is how effective will their latest efforts be? Also, has the best possible outcome already been discounted?
As shown in the chart below, the S&P 500 has already fully priced in the strongest rebound in the global economy since the financial crisis… and yet the actual global PMI remains on the verge of contraction.
The long term crisis this creates outside the central banks
It was just a fantasy that the central bank “rescue” in 2008/09 would be a one off event. The Fed’s attempt to shrink the balance sheet back to “normal” could never work, as I wrote in May 2018.
The Fed should have known better.
The chart below shows that the financial system since 1968/1970 depends on ever accelerating debt relative to income.
At some point this system can only survive on ever increasing rescues, which have to become permanent and exponential. That is where we are today. Now it seems likely, in my opinion, that the system increasingly depends on debt monetization.
The scale of intervention now means that:
‘Markets have nothing to do with fundamentals anymore …. Insane but it’s going to carry on’
It seems that the Fed wants stocks higher and has trillions of dollars they can create at will. Participants are coming to believe that the Fed is the market. However, it’s no longer a market of price discovery with healthy and productive feedback. Decision making at all levels across the economic spectrum is becoming increasingly impaired.
Understanding the dynamics and the distance between price and value are becoming increasingly essential. Also consider where the economy could really be without massive intervention.
By 2008 growth had already become dependent on ever accelerating debt. The chart below shows that the US economy ex Federal Debt is in a 12 year collapse.
This may be the real reason why intervention and debt keeps accelerating to new extremes. Without constant intervention the system would likely fail.
Central banks are overwhelming markets with supportive action and liquidity, which creates low volatility and rising markets in the short term.
However, in doing so they have broken the normal relationships that markets have historically had with real economic data.
The chart above shows that since the explosion in the Fed’s balance sheet in September, the weekly direction of the S&P 500 has a perfect correlation with the Fed’s balance sheet change. At the same time the direction of the S&P 500 has had a negative correlation in 2019 with equity fundamentals, earnings growth, and the direction of YOY GDP growth.
It seems probable, in my opinion, that the central banks have just dug themselves deeper into supporting an out of control system that requires ever more “support”. This would mean that all they are doing is increasing longer term instability, and impairing economic efficiency through distortions in market function.
The investment prospective return crisis
The 60% Equity, 40% bond portfolio has had an exceptional decade as central banks have gone into constant rescue mode. However, investors may be better served to consider this as forward payment for the next decade’s return too. The math of prospective return does not seem to add up.
The best estimate of expected return for the next 20 years is shown below, with its multi decade track record. It has just gone below the low of 1929!
Investors should keep a firm grip on core principles and durable strategies in an increasingly unstable environment.
Manipulated markets are a mile wide and an inch deep and can turn on a dime. Liquidity and positions swing wildly as fundamentals increasingly conflict with interventions. I believe this instability will most likely continue to increase.
If the fundamentals were really healthy there would be no need for intervention. If intervention was really working it would not need to continue accelerating!
No one knows how long the current dynamic can continue. However, it is important to understand that we continue to see new all time historical records reached or exceeded in a range of investment metrics. It is only this dynamic of extreme intervention which is producing prices at otherwise unprecedented levels.
Unprecedented, because investors across the developed world are now presented with multiple assets classes which, in my opinion, mathematically offer the high probability of zero or even negative future real long term returns. This is what the chart above is signalling.
Negative interest rates, are the most obvious example of taking policy concepts too far in my opinion. The chart below shows that, as best we can tell, negative interest rates have not been needed for the last 5000 years.
European Banks CEOs can’t see how negative rates work. The CEO of Deutsche Bank says “In the long run, negative rates ruin the financial system,”
European Banks stocks are lower than when negative rates were introduced in 2015.
It seems that finally negative interest rates are losing credibility even in central bank circles. The central bank of sweden has already decided to end this experiment.
However, the world is still awash in negative interest rates, so a full normalization would potentially cause significant damage to bond markets worldwide. For German government bond yields to return to the neighborhood of current nominal GDP the move could involve well over 1% higher in 10 year yields.
In any case the outlook for bonds remains very poor in terms of the zero bound, and even at very low inflation rates worldwide, negative real yields are typically the norm. Here is the chart for US government bonds.
Investors are reaching for yield in corporate credits but the spreads here are historically low to US government bonds. So risk is significant, even leaving aside our prior notes on the quality challenges within the corporate bond market.
Overall bonds represent amongst the worst prospective long term returns in history, unless intervention takes over. Over the next decade from current levels I would anticipate poor, and potentially negative real returns. My favorite exposure in bonds is short dated Treasury Inflation Protected Securities, which offer low risk positive real returns.
US equities have just made new all time highs relative to GDP.
This is Warren Buffett’s stated measure of overvaluation for US equities, and Warren Buffet has record levels of cash in Berkshire Hathaway.
Most investors, however, do not respond to valuation like Warren Buffett. It seems that natural behaviour for most investors is to set their equity asset allocation according to the recent return trend. Much of the time this is can be an effective strategy, but over a full cycle, and particular at clear extremes, it is apparently difficult for most investors to be proactive with an effective sell or rotation strategy.
The chart below shows how closely household stock allocation follows the last 10 year returns of the S&P 500. Allocations peak near prior bubble highs at 2000 for example, and then reach their low in 2008/9.
This is why most households consistently underperform over the long term. The data below the chart shows that average household return is very negatively correlated with the highest levels of household stock allocation.
All the data above suggests that investors must use measures other than, or in addition to, past return to select their optimal equity allocation. The metrics shown above suggest this is a good time for a review.
Two sectors which may reward further investigation as an alternative to stocks and bonds are gold and commodities. The charts below speak for themselves as regards the upside potential from current levels, and relative attraction compared to US equities.
The Faster You Can Move The Less You Have To Predict.
I believe that we are in a time of unprecedented instability and uncertainty. Central bank policy has continued to expand over the last ten years, and significantly in 2019. The BIS 2019 annual report, in my view, signals desperation and policy extremism, which is not backed by any evidence I have been able to find or consider credible in the long term.
The central banks are clearly acting as if we are already in a crisis as shown above.
Investors need to consider the efficacy of central bank policy, which has now become so dominant both to markets and the economy.
I strongly prefer not relying on any prediction or static allocation, when underlying conditions are increasingly unstable, and prospective returns in the major asset classes are at or near historic extremes.
Passive investors have enjoyed a windfall gain in equities and bonds in recent decades. However, the math of prospective returns, as shown above, is no longer supportive of either equity or bond long term allocations.
I believe full cycle investing will outperform passive equity and bond allocations over the coming decade, and with far lower volatility.
I feel confident that Stan Druckenmiller is right about the link between easy money, bubbles and crisis.
Objectively, stocks and bonds are now above the levels of any previous bubble on the measures shown above.
Just because central banks are intervening to push markets into ever higher valuation levels and boosting returns in the short term does not mean that we are not already in a crisis.
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