EM Currency Stability Set to Continue Near Term

  • Emerging markets are experiencing steady capital inflows and currency appreciation on a broad basis, with a few exceptions.
  • Fears of rapid US interest rate hikes due to sharp increases in economic growth and inflation expectations have subsided due to political dysfunction in the US once again. The new Republican led government has been unable to pass major reforms in healthcare, taxation, regulation, or infrastructure.
  • A period of EM stability is set to continue other than politically inspired turbulence in the Middle East over Qatar and global energy oversupply risk.
  • Value can still be found in broad EM FX vs. USD, CHF, and JPY. Expect supportive trend continuation in CNY, ILS, MXN, ZAR, RUB, and COP.
  • Spain’s troubled Banco Popular was acquired by Santander in what is being viewed as a successful ECB assisted bailout. This has relieved some near term banking system stress in the European periphery. Although Banco Popular common equity and junior debt holders were wiped out, senior debt holders were spared. This reinforces what is theoretically supposed to happen with various investor risk segments in the capital structure, although central bank involvement is not ideal.

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Inadequate Historical Valuation Measures and What Comes Next in This Monetary Bubble Investing Frontier

  • Market analysts far and wide continue to pound their fists on the table daily about overstretched equity valuations (and many other assets for that matter) putting risk markets in dangerous territory ripe for an imminent sizable correction, or worse.
  • Indeed, global risk markets are tremendously overvalued by almost any historical measure. It takes a heroic effort of wishful thinking to believe otherwise.
  • If we take a look at the S&P500 as one prime example, 18 out of 20 of the most widely followed valuation measures are flashing “overbought” with red blinking lights. Four of the measures indicate an S&P500 at least 50% overvalued, historically speaking.

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  • Therein lies the problems with historical valuation analysis: first, it is based on backward looking data only. Additionally, valuation alone has proven to be an inadequate timing mechanism.
  • Assist FX does not see the historically overstretched valuations currently witnessed in global equities, real estate, and bonds imminently leading to a near term risk-off crash as the base case, although that is always a possibility. Valuations will likely become even more stretched first. Additionally, the current bubble investing environment might lead to a different ultimate resolution than the traditional risk-off market correction/crash many are accustomed to witnessing. We see a different range of scenarios playing out involving capital eventually being less attracted to paper/fiat based financial assets and more attracted to physical-based assets and decentralized stores of value. Imbalances may very well be resolved via asset depreciation in real terms rather than in nominal terms. An occurrence of this nature is not likely to materialize for some time, but risks are building daily as global debt pressures become less and less reversible.
  • Key question: Is this time really different? Answer: yes and no. There has never been another time in history where global central banks have been this supportive of asset prices all at once. During a time marked by real estate bidding wars and new all time highs in global stock indexes, central banks still feel the need to create more than $200 billion dollars per month from thin air to buy mortgage bonds, stock ETFs, and government bonds. Markets are rigged, but they are actually rigged to rise in order to supposedly create a self fulfilling “wealth effect” of unrealized asset gains fueling greater economic activity and confidence.
  • You can’t skirt the basic laws of market supply and demand forever. Reference Venezuela as one of hundreds/thousands of unfortunate examples involving central planners throwing a grand party on borrowed time that ends in widespread misery as soon as the bill comes due. Today’s advanced economies are not being operated with the same extreme mismanagement as in Venezuela, but less severe policy errors are impossible to ignore when cumulatively compounded over time.
  • Current state of global monetary policy: The Fed, ECB, BOJ, PBOC, BOC, SNB, RBA, RBNZ, and other central banks have enabled massive asset price inflation to grow unchecked across several asset classes, particularly in real estate and equities. They do this in the name of fighting a phantom crisis of consumer price deflation which only seems to exist in heavily adjusted inflation index data conjured up by statisticians who know the entire political and industrial complex desires the lowest official readings possible. The appearance of low inflation makes GDP look higher, wages look stronger, and government transfer payments linked to inflation indexes lower. Understated inflation indexes are to politicians and executives what Photoshop editing is to swimsuit models.
  • What many well-meaning analysts have been getting wrong is just how long this type of central planning charade can go on before supply and demand imbalances are aggressively shocked back to reality in a reversion to the mean event. That is because this is not only a function of economic mathematics but also of mass psychology. Dispassionate valuation modeling alone is not enough for a prudent money manager. One must also have their finger on the pulse of market psychology to know when the music has stopped and isn’t coming back on for a very long time during the metaphorical musical chairs game also known as investing in a bubble environment. Assist FX research indicates the music isn’t quite ready to stop–we aren’t there yet. But don’t pile into expensive asset classes with huge leverage either. Stay vigilant and nimble.

Bottom Line: Assist FX has believed for some time, and continues to believe, that central banks have “doubled down” on a quasi commitment to keep asset prices elevated by doing “whatever it takes” as their primary strategy to minimize the onset and severity of cyclical recessions. This improves the appearance of macro economic activity in the near term while adding to dangerous systemic risks longer term. It is difficult for financial markets continually pumped with newly created money and ultra low interest rates to simultaneously crash and stay down. It tends to materialize with earnings multiple expansions in stocks, cap rate contractions in real estate, and overall suppressed volatility, making nearly all asset classes appear “overvalued” for a much longer period of time than many market observers believe can occur.

Make no mistake. We are in yet another central bank inspired asset bubble that was engineered to “fix” the aftermath of the last two central bank inspired asset bubbles. The imbalances grow more pronounced with each reflated bubble because instead of having moderate, occasional recessions where the most unproductive debt is reset via bankruptcies, you have massive unproductive debt imbalances augmented much further by artificially cheap credit and financial engineering. This dramatically increases systemic risk associated with major financial crises, economic meltdowns, and complete monetary system resets. Yet, bubble environments can exist for very protracted periods of time.

Nearly everyone who thinks about these types of economic topics knows at some level, whether more conscious or subconscious, that the current central bank driven free-lunch asset holders are enjoying today are creating the types of systemic risks that endanger the global monetary system tomorrow. This will push private citizens worldwide to increasingly seek alternative stores of value for their savings. That is why demand for decentralized, alternative stores of value such as block-chain technology-based digital currencies is set to accelerate. The block-chain trend is just getting started. As for traditional financial markets, we see a continuation of the type of slow grind, nearly dead volatility asset price levitation to continue for the time being.

USD Soft Patch to Set the Stage for Another Grind Higher in Asset Prices and Interest Rates

  • Bullish USD sentiment clearly became overly reliant on the Trump Administration’s desired agenda of tax cuts, deregulation, and infrastructure.
  • Due to the host of potential political scandals plaguing the Administration, as well as general political dysfunction in the US Congress, expectations of a pro-growth agenda being enacted this year have been significantly muted, though not completely discounted by Assist FX.
  • Assist FX still sees passage of a lighter version of market-friendly reforms in 4Q2017/1Q2018 limping past the finish line in what is becoming a non-consensus call. Sparring blocs within the Republican party will increase cooperation as political viability becomes increasingly threatened for the 2018 midterm elections.
  • In the near term, USD will struggle to stage sustainable rallies as political uncertainty takes its toll.
  • As financial asset prices in equities, real estate, and alternatives continue to inflate further into historically stretched valuation territory, it will place pressure on the Fed to remain on track for gradual rate hikes approximately once per quarter.
  • Long duration USTs will be pressured by lower real yields, lifting rates at the long end of the curve. This will contribute to moderate firming in USD in the medium term 3-6 month outlook.
  • Top risks to this view include a pronounced spillover effect from China’s debt deleveraging efforts resulting in global financial market instability, as well as any number of potential Trump Administration scandals escalating to such severity that the blow-back shifts the political landscape in favor of left leaning populists for 2018 and beyond. While these risks are currently underappreciated by markets, they are not our base case.

China’s Controlled Deleveraging

  • China has decided it is time to pull away the punch bowl for a little while.
  • There is a coordinated series of moves by China’s leadership to slow down the risk buildup posed by excess leverage.
  • The correction in both Chinese bonds and equities has thus far been met primarily with utter disinterest by advanced economy risk markets. Volatility levels are still crawling near historic lows across major asset classes and new all time highs are regularly being surpassed.
  • Still, if there is anything posing an out-sized share of global systemic risk it is China’s massive debt load.
  • Keep an eye on raw commodity prices in China as a leading proxy for  inflationary/deflationary asset price impulses. Iron ore specifically has had difficulties stabilizing as the Q4 2016 run up is moving closer to being fully erased on the way back down.
  • My base case is that China is not yet ready to unravel and this is a healthy process of mild deleveraging. However, it won’t take many more risk off days in China before it begins to spill over into developed markets elsewhere. If this situation does not materialize with increased stabilization by the middle of next week, there will be a tradable risk off wave. Stay tuned.

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Why Market Volatility Is in Secular Decline and How to Adjust to It

VIX and other “fear index” measures of market volatility are in secular decline. Markets are driven less by human emotion and more by automated trading programs and data dependent monetary policy than they used to be. These forces are proven volatility crushers.

Automated trading programs (AT, HFT, robots, etc.) dominate trading volumes in nearly all public, liquidly traded financial markets. Morgan Stanley estimated up to 84% of all orders placed on US stock exchanges originate from automated trading programs. Aite Group LLC, a Boston-based consulting group that analyzed Bank of International Settlements (BIS) data on spot foreign exchange dealing, estimates 81% of FX trading will be automated by next year.

By design, automated trading is designed to remove the weakest link in trading performance: human emotion. That means these programs are less likely to produce an outsized emotional reaction to incoming market data and are more likely to engage in the type of “range crunching” strategies that strangle volatility.

Humans are prone to overestimating the importance of each data point, whereas robots merely attempt to assign a statistically significant weighting. Let’s face it–most of the data points hitting markets each day are just noise. Only a few items really matter. One Global Dairy Trade auction probably shouldn’t move the New Zealand dollar by 2% in a rational market, though any trader loves to see irrational volatility they can seize upon. Automated trading programs are typically designed to fade overreactions rather than pile into them.

Additionally, monetary policy in the post Great Financial Crisis (GFC) era increasingly aims to lower market volatility. It does this by reacting to sizable asset price moves with counter actions–when equities fall sharply on fear, in comes your friendly neighborhood central banker hinting at fresh stimulus to stop the bleeding via monetary policy loosening channels. When risk markets are melting up, it is just a matter of time before a slightly less dovish central banker attempts to sprinkle in a shred of reality with hints of higher interest rates down the road.

Even during a potential future crisis, VIX will probably be muted somewhat compared to where it would have been in a similar magnitude of crisis had it occurred years ago. This is not a cyclical phenomenon; it is secular and structural. You need to accept this as a trader and adjust to it rather than thinking you identified a temporary anomaly of markets underpricing risk as most financial publications have erroneously suggested.

How should traders adjust to the “new world order” of low vol? First, stop chasing momentum. Trend following momentum strategies are not worth risking one’s capital unless the VIX (or comparable vol index) is above 20. Second, lengthen your holding time frame. Trying to rapid fire market orders in a “watching paint dry” market is a good way to chop yourself right into the margin call poor house. Finally, and most importantly, financial assets can trade at seemingly grossly overpriced valuation levels longer than you can stay solvent shorting “expensive markets.” That is because the volatility risk premium is diminished when VIX is crawling on the floor around a 10 handle. Lower volatility means higher asset prices, all else equal.

Bottom Line: Traders and investors should expect volatility to remain below historic norms. Central banks are long past a day where they will or even can allow true price discovery by fully letting the air out of the asset bubbles they created. That, along with increased trading automation and counter cyclical  monetary policy could allow elevated asset prices with low volatility to persist for much longer than many analysts estimate.

French Elections This Weekend Unlikely to Produce Destabilizing Outcome

  • Out-sized market attention has been placed on the French general election this weekend on Sunday, April 23. This is due to the significant geopolitical risk posed by one of the more extreme candidates destabilizing Europe should they somehow pull off an upset victory.
  • This risk is far overblown. Populist right victories in 2016 by the UK Brexit campaign and Donald Trump created a misplaced fear bias for something similar happening in France or elsewhere in Europe. Trust in political polling is understandably low.
  • While the first round election on April 23 is somewhat of a close call, the second round runoff on May 7 will not be. The margin of error for Emmanual Macron (Independent) beating Marine Le Pen (Front National) or Jean-Luc Mélenchon (Unbowed France) in the second round is more than 20 points. That is far beyond the margin of error at this time before both the UK referendum and US presidential election. Not even close.
  • The main risk to keep an eye on at this point is both Le Pen and Mélenchon beating out the field in the first round of elections this weekend, meaning one of them would be the ultimate victor after round 2 since the threat of one of the more mainstream candidates would be removed. Stranger things have happened, but the probability of this is perhaps about 10%.
  • If the first round results indicate almost any outcome other than that posed by the point above, the euro should rally, French bonds should recover, and a global equity relief rally should ensue early next week, all else equal. It is difficult to support the opposing view with 10% odds at best per my analysis.

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Sky Is the Limit for Gold but Correction Risk Grows

  • Gold raged $50 per troy oz. higher after the last note posted on this site 27 March. Sitting on gold longs was my preferable strategy during the past few weeks as most other asset classes had difficulties finding their footing in either direction.
  • The long distance gold marathon higher is far from over, but it is time for traders to lock in some gains on partial positions and/or raise stops per prudent risk management.
  • Chatter builds surrounding Republican plans to revive healthcare, tax, infrastructure, and regulatory reform efforts. While there is a serious lack of budgetary space to enact the more ambitious elements of the Trump growth agenda, negative sentiment towards said reforms may have peaked for now.
  • Geopolitical risks in France of a Le Pen victory are far overblown.
  • The Korean peninsula is still a wild card but constructive developments in recent US-China relations will be sufficient to keep North Korea out of the top headline spot now that the 105 year Kim-Il anniversary has passed. The Trump Administration decision to not label China a currency manipulator is not unrelated.

Bottom line: long term gold investors should stay long and strong in their positions while shorter term traders should be more cautious by protecting recent gains in case there is a bull market correction.

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