Being Fearful While Others are Greedy
Looking around global markets today, uncertainty is rife. After coaxing the market to price in interest rate hikes last week, the Bank of England’s Monetary Policy Committee (MPC) decided to leave rates unchanged at 0.1%. Governor Andrew Bailey confirmed that he can do little to influence the current supply shocks and therefore acknowledged that inflation will remain higher for longer (expected to reach 5% by Spring 2022). The markets expected the MPC to do the right thing, reigning in exuberant spending and showing some attempt to tame inflation. Bailey’s decision undermines his own trustworthiness, and after his announcement he suggested he is not at the beckon call of the markets. Your bond purchases suggest otherwise Mr. Bailey!
Although loose monetary policy continues, fiscal policy is starting to tighten. Rishi Sunak released his budget several weeks ago, and raising taxes was at the top of his agenda. This, alongside higher inflation, will add to the squeeze on corporate profits. Sunak also conceded in his statement that the UK public finances are twice as sensitive to rates as before the pandemic, with a 1% rise in interest rates costing the government an additional £23bn. By raising taxes at a time when supply shocks and labour shortages are still widespread, Sunak is playing a dangerous game, and investors are starting to wake up to this (more on this below). Labour shortages cost Amazon $2bn this quarter.
Across the pond, after months of ‘talking about, talking about tapering’, the US Federal Reserve (Fed) finally started reducing its bond purchases, by $15bn per month. Unlike Andrew Bailey, Fed Chair Jerome Powell at least recognises his responsibility in asset pricing and his role as subservient to the stock market – but then again, I suppose he has to be when his friends in the Federal Open Market Committee (FOMC) are profiting from his decisions. Along with his tapering decision, Mr. Powell continues to promote the ‘transitory’ inflation narrative and has confirmed that monetary policy will have little effect on the inflationary pressures currently faced. At what point does transitory become permanent? Who knows, but we are now 10 months deep into the transitory narrative.
Both the US and UK central banks are waiting on further improvement in the labour market before they confirm further monetary tightening. The US economy is now 4.2m jobs short of pre-covid levels and could reach full employment by the end of 2022. This is a tall order, but we could get several large job prints once Covid subsides and pandemic savings are spent, leading those sitting on the sidelines to re-join the workforce.
Novice investors would be right to question market actions of late. Every time there is bad jobs data markets rally. Equity markets have become hooked on the central bank’s stimulus since the Financial Crisis of 2008 and therefore bad news is interpreted as good news, as it means central banks will keep the money taps loose. Also, 82% of S&P companies that reported earnings so far have beaten expectations, but many stock prices still fell, another contradicting action from markets. This is the problem with richly valued companies – and why The Spark is avoiding them at present. Markets are pricing in huge earnings beats and monumental growth, so if a company does not deliver, its share price falls. Peloton’s recent 50% drop is testament to this.
Following Jerome Powell’s speech, a relief rally ensued, and the US stock market once again screamed to new all-time highs. However, a big shock to the system came on Wednesday in the form of a 6.2% inflation reading. This was certainly headline-grabbing, being the highest figure since 1990. Even without volatile food & energy components, core inflation rose 4.2% Year over year (YoY). This caused precious metals to explode higher and we saw the market’s 5-year breakeven inflation rates climb to new heights (see below).
US 5-Year breakeven inflation expectations, Source: Bloomberg
Ultra-easy monetary policy is engulfing us. Several hawkish members of the European Central Bank (ECB) have informed us that European markets are ahead of themselves by pricing in two rate hikes in 2022. Down under, the Reserve Bank of Australia has also played down a rate hike next year. This is stoking inflation globally.
Cracks are appearing everywhere
Further east, Japan has seen its highest Producer Price Index (PPI) reading in 40 years and China’s Factory gate Inflation (cost at which wholesalers buy materials from producers) hit its highest in 26 years at 13.5%. Once again, rapidly rising commodity prices, power shortages, and supply chain disruptions are to blame for price increases, but such costs are now being passed on to consumers and will flow into CPI readings around the world.
Investors are cautious about taking on risk in emerging markets at present due to fears over a taper tantrum much like that of 2013. The faltering property market in China is also causing concerns of a global (and especially emerging market) slowdown and potential contagion risk, as around 70% of the Chinese population’s wealth is held in property assets. Slower vaccine rollouts and higher energy prices are also dragging on growth. If China slows, many other markets will follow suit.
Supply bottlenecks have dampened demand, which in turn is weakening growth. The US economy expanded by 0.5% in the three months to September, down from 1.6% in the previous quarter. It is a similar story in other economies, with German manufacturing PMI falling to 57.8 in October. Global economies are slowing around the world, and the bond market is waking up.
Listening to the bond market
Around the world, breakeven inflation is at multi-year highs, and the spread between the 10yr and 2yr yield is falling. This is worrying. The spread between the two and ten year is a good indication of banks profitability (their net interest margin) from loans - they borrow on the short end (2yr) from central banks and lend to us on the long end (10yr). When this ratio is falling, banks are less inclined to lend as the loans are less profitable, therefore liquidity in the economy falls. This is coming at a time when liquidity is already falling due to tapering.
US 10yr minus 2yr spread, Source: Bloomberg
As I explained a few weeks ago, bonds are an extremely unattractive investment at present. Over 50% of bonds in Europe are still negative in real terms, and this seems set to last with recent comments (above). It is a similar story around the world. Bonds are now negative-yielding assets, but prices continue to push higher (maybe it’s credit markets and not equity markets that are in a bubble). This is what is driving equities. Relative to bonds, equities continue to look attractive due to both their capital appreciation and dividend yield creating a positive real return. A similar analogy can be used in China, where the property market was full of negative-yielding assets, but prices continued to rise so people kept buying until the bubble was pricked by CCP regulation which forced many property developers into liquidation.
While the stock market continues to thrive off the high of the central banks drug of choice (loose monetary policy), our friends in the bond market are not so convinced of a happily ever after. Cracks are now appearing.
The US and UK yield curves are starting to turn down, which is a worrying sign. The yield curve shows the yield (coupon payment) on bonds of differing maturity (2,5,10yr etc). In an expanding economy, the yield curve should slope upwards, as investors are rewarded for holding a bond for longer, due to heightened risks of inflation and interest rate changes. However, when the yield curve starts to flatten or invert, it suggests investors are worried about the future, selling long bonds and buying short-dated ones. They prefer safety (liquidity) over capital gain.
US (Orange line) and UK (Blue line) 30yr minus 2yr spread, Source: Bloomberg
Protecting Capital
Inflation is red hot and yields are now falling. Investors are worried and seeking safety. Precious metals have a proven track record of capital preservation and protection of purchasing power for hundreds of years. I have already outlined my reasons for holding precious metals here, but I am going to add to my exposure further, as I believe the bond market is telling us that times ahead will be tough. With inflation continuing to rise and yields now falling, real rates (Interest rate minus inflation) are set to remain negative. This is the ideal environment for precious metals and therefore I am increasing my exposure to silver and adding Fresnillo to the portfolio.
Fresnillo is a silver miner based in Mexico. Their flagship project is a silver mine located in the state of Zacatecas. Silver is often referred to as gold’s schizophrenic sister. It moves more rapidly up than gold in bull markets but also feels more pain when investors’ perceptions of precious metals change. Fresnillo is trading at its cheapest valuation since 2009, has a strong balance sheet, and should produce excellent returns for The Spark’s portfolio should my predictions for inflation and interest rates materialise.
I am adding 1.4% exposure to WisdomTree Physical Silver (PHSP) at £17.52 (to a total position size of 4.8%) and a 4% position in Fresnillo PLC (FRES) at 972p. Prices are taken from close of business on Friday.
Until next time,
Peter
Disclaimer
This communication is for informational and educational purposes only and should not be taken nor used as investment advice, as a personal recommendation, or solicitation to buy or sell any financial instrument. This material has been prepared without considering any particular recipient’s investment objectives or financial situation and has not been prepared in accordance with the legal and regulatory requirements to promote independent research. Any references to past or future performance of a financial instrument, index or structured product are not, and should not be taken as, a reliable indicator of future performance. I assume no liability as to the accuracy or completeness of the content of this publication.