Strategy Monthly
Are We Still
In A Bull Market?
October 2018
It all seemed so reasonable at the time…
At the beginning of 2018, my outlook was straightforward:
• The US expansion was in a late phase, while younger
expansions in EM, Japan and Europe had longer to run.
• Trump’s tax cuts would: widen the US budget deficit; add fuel to
the global expansion; and support energy, materials and EM.
• Easier US fiscal policy would: steepen yield curves; encourage
the ECB and BoJ to stop easing; and weaken the US dollar.
• With higher rates and a steeper yield curve:
¾ Value, financials and emerging markets would outperform
¾ Growth, technology and developed markets would underperform
• A “left tail risk” was that China would accelerate its efforts to
promote the renminbi as a reserve currency. With the dollar
under pressure, an obvious hedge was to buy gold/gold miners.
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…but markets have a way of ripping up the best laid plans
Needless to say, pretty
much everything in this
outlook proved to be off-
target.
The year started with a
bang for most asset
classes, but after January
things got much tougher.
Aside from US equities, no
major asset classes have
outperformed US$ cash
in the past seven months.
If most assets can’t beat
cash, it seems reasonable
to pose the question: are
we still in a bull market?
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The breakdown occurred around mid-May
The outperformance of the US equity market has been Consensus holds that the main cause of this shift was a
relentless… and extreme since May. From a cross- stronger dollar, which caused problems everywhere else.
correlation rate of 0.9x between EAFE/EM and the US that But looking closer, the issue seems to be less a strong
prevailed in the past three years, the correlation rate dollar than a weak renminbi.
suddenly shifted gear to -0.6x!
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The renminbi, not the US dollar, was the key factor
For all the talk of the “strong dollar,” the recent rise in the The renminbi plunged by almost -10% against the dollar
US dollar index was modest—far less than the jump in between April and August. This had several impacts:
2014. The dollar is trading about where it was a year ago, • Puts downward pressure on commodity prices and
and is bang on its 2-year moving average. inflation expectations.
It’s hard to see how such a small move in the dollar could • Lower inflation expectations flatten the yield curve.
trigger such a big market reaction. In reality, the currency • Flatter yield curve pushes investors into growth stocks.
that did move big-time this summer was the renminbi. Looking ahead, we need to ask: why did the renminbi fall
so much? And where does it go from here?
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The renminbi depreciation: causes, implications, consequences
Option 1: China is bracing Bad news for Yields, commodities,
for a long slowdown in global growth and deep cyclicals and
domestic/global growth inflation emerging markets will
stay under pressure
Option 2: China hopes
A US-China deal All beaten-up asset
that letting its currency
will soon be done classes will rebound
fall by -10% can set the
and the trade-war strongly at the first
stage for a later +15%
panic will end sign of a coming deal
bounce—letting Trump
declare victory
Stimulus will boost Big rotation from
Option 3: China is
commodity prices growth to value and
slowing but will stimulate
and inflation; from US to EM
fairly soon
steepen yield curves
Option 4: China is biding its time— Perhaps the biggest
but still aims to de-dollarize Asia Long-term bearish “tail risk” out there: that
and commodity markets. Renminbi UST, US growth runaway US budget
could strengthen when markets stocks & US dollar deficits upend the
decide US deficits are untenable. global system
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Something to watch: renminbi pricing of gold and oil
An interesting side note to the renminbi: it fell sharply this What is the connection? Swapping the renminbi for the
summer not only against the dollar, but against the CFETS dollar in commodities trading carries a risk for Beijing: loss
trade-weighted basket that is supposedly the target of of control over its exchange rate. By linking the renminbi
PBOC policy. Yet it barely moved against gold. to gold, even if loosely, it can create an alternative for
This could be a coincidence. Or it could be evidence of international payments, without losing control of its
Beijing’s long-term plan to de-dollarize commodity prices. currency (see Does Beijing Really Manage The RMB
More evidence: the Shanghai RMB oil futures contract, Against A Basket?).
which has picked up market share from Brent and WTI.
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US yields and looming deficits point to a dollar shortage
One anomaly of this summer’s sell-off is that emerging And the dollar shortage is only likely to get worse, as US
market indexes tanked, but there was no corresponding budget deficits inexorably expand and the Treasury has to
flight to safety in US treasuries pushing yields down. The ramp up its issuance of bonds.
10y yield stayed stubbornly flat at around 2.8%-2.9%,
and then cracked above 3% once EMs stabilized.
Along with various other indicators (including a fall in
central bank reserves held at the Federal Reserve), this
suggests that there just aren’t a lot of dollars around.
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US dollar liquidity squeezes typically end with one of three events
Oil prices collapse China stimulates Fed injects liquidity
For Against For China Against China For Fed Against Fed
lower oil lower oil stimulus stimulus easing easing
¾ Likely China/ ¾ Tight supply- ¾ Leadership ¾ Xi Jinping ¾ An Italian ¾ The Fed is not
EM slowdown demand won’t want would lose crisis? in this frame of
¾ Possible ¾ Little capex in to risk debt hard-won mind
deflation policy ¾ US housing &
repeat of EMU recent years &
credibility US autos roll ¾ By resisting
crisis (Italy…) high wear/tear
over Trump
¾ Saudi pumps with fracking ¾ Could trigger pressure for
to squeeze ¾ Iran sanctions another wave easing, the Fed
Iran of capital safeguards its
flight independence
Does the liquidity squeeze have to get worse
before it gets better?
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A final factor: financial engineering in the US
S&P 500 share buybacks hit a record of US$194bn in Q118, But there are limits to financial engineering. US corporate
and matched that in Q2. Buybacks now equate to more debt relative to GDP is already at a levels seen only in
than 3% of the US market cap. No other market is above recessions. Once borrowing costs start to rise, it will be
1.5%. harder for companies to buy back shares.
It may be that US equity outperformance simply reflects So far, the spreads on corporate bonds have stayed tight,
the steady reduction of equity available to buy. Another and there are no danger signals. But once spreads start to
indicator: the number of listed firms in the US has shrunk rise, equities could be in trouble.
by half since 1996, from 8,070 to 4,330 in 2017.
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Conclusion: The question investors need to answer
Adding it all up, investors need to ask if the sell-off was due to:
• Trump “speaking loudly and carrying a small stick”?
¾ The US and China will make a deal, previously beaten-down assets will
bounce back, and the US dollar may sell off (this is Anatole’s view).
• Rising expectations of a US-China economic cold war?
¾ Most risk assets will continue to suffer, except perhaps energy and
gold, as Beijing will likely stock up on both.
• Disappointing growth in Europe and China?
¾ With Europe structurally weak and China loath to stimulate, no relief
in sight. ROW problems will eventually hit US earnings and stock
prices, unless financial engineering keeps boosting US equities?
• A US dollar liquidity squeeze?
¾ Bad for risk assets everywhere, unless the oil price collapses or the Fed
makes a volte-face—both pretty unlikely in the immediate future.
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Falling back on certainties
Much now depends on hard-to-predict policy moves (trade wars,
renminbi policy) or corporate decisions (buybacks). Yet we can pick
out a few certain guideposts:
• Momentum has shifted to defensive/non-cyclical sectors.
¾ Defensives are much less richly valued than the previous momentum
kings (tech and consumer discretionary). Tech and consumer need a
big growth or inflation pickup to recover. It pays to stay defensive.
• There are value opportunities in EM and parts of Europe.
¾ Asia is oversold, and the GBP, CHF and SEK are very undervalued. The
question is what will be the catalyst for gains in these markets?
• There are no obvious sources of policy stimulus.
¾ For the past decade, markets have been assisted by easy monetary
and fiscal policies. Over the next six months, no such assists are likely.
Markets are on their own.
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