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By Stewart Richardson on 26/03/17 | Category - U.S

To view a PDF copy of this report, click here.

After an extraordinary week in US politics, let's take a step back here and try and assess what's going on. At the recent peak in the S&P 500, the index had risen about 15% from the low point before the US election. So not only were forecasts of looming disaster in the event of a Trump victory proved completely wrong, the equity market has risen in expectation of widespread positive changes to the US economy ranging from deregulation, tax reform and infrastructure spending. After the healthcare debacle, is it time to rethink the efficacy of the Trump reflation trade?

Chart 1 - The S&P 500 Index

We are by no means experts on the US healthcare industry. Our simple view about Obamacare was that; yes, it's great in that it increased the number of insured, however, this came at a large cost to many US taxpayers. Insurance premiums had risen way too fast in recent years and the out of pocket expenses were prohibitive for many. From our distant, disinterested vantage point, Obamacare needed significant reform. 

With the Republicans controlling all branches of Government, and having been fierce critics of Obamacare for years, surely they would be able to cobble together a reasonable plan that would improve Obamacare. The fact that the plan seemed to harm many of the people who probably voted for Trump, and was viewed by so many in the GOP as not worth voting for, leaves us a bit dumbfounded. Frankly it makes the Trump administration look pretty inept in our opinion. Furthermore, with Obamacare as we know it crumbling, what is plan C? If the US healthcare system is at risk of not functioning adequately then it cannot be good for America.

As can be seen in chart 1 above, the S&P 500 Index had been tracking broadly sideways for nearly two years into the US election. This period of no performance coincided with the Fed beginning to normalise policy and the economy was mired in a stop-go period where corporate earnings actually declined (mostly because of the energy sector). Then along comes Trump and the equity market buys into the reflation narrative completely. The bullish narrative is that growth will be energised by a combination of deregulation, tax cuts and infrastructure spending.

In the weeks post the election, we repeatedly talked about how the reflationary Trump narrative could be either elegantly played out or not. We also voiced concerns that he would fail to generate a sustained increase in the growth rate of the US economy. So far, we have seen nothing that is elegant from the Trump administration, and we now wonder whether the healthcare failure is indicative of what may befall all of his main policy proposals.

The optimists out there will say that we should just put this healthcare defeat behind us, and focus on the tax cuts that are coming. Well, surely there is an equally valid opinion that tax reform will be just as difficult to achieve after the healthcare failure. Furthermore, it is our view that financial deregulation will garner a lot of opposition and the infrastructure spending plans, because they look like they will be via tax credits relying on private sector investment, will be less effective in boosting the economy than many believe.

We think that whether you are an optimist or a pessimist on the Trump administration, the events of last week have to bring into question just how successful Trump will be in boosting the US economy. If, after sober analysis, an investor can say that they truly believe that the Trump administration has a high probability of success, then they will be comfortable in owning equities even after the 15% advance since the elections. Anyone who is now questioning whether Trump will be able to make any of the big changes he promised, then surely they will have to look at the recent market rally and the current valuations matching previous bubble peaks (depending which valuation measure) as an opportunity to take profits and move to the side lines.

Will the healthcare debacle have an impact on sentiment in the US? We have all read how the survey (or soft) data was outpacing the hard data since the US election. The question was really whether the survey data was "leading" the hard data or getting ahead of itself. Last week, Markit released their preliminary ISMs for February and the US survey was a disappointment. In fact, the services and composite ISMs are at levels seen in January 2016 at the height of the financial market's concerns over China. This survey was taken before the political events of last week. We suspect that business and consumer sentiment may deteriorate in the weeks ahead so that we see the soft data fall back to levels consistent with the hard data.

Chart 2 - Markit Composite PMIs for US and Eurozone
If like us, you do not believe that these events simply bring the bullish tax cuts closer, then not only should you be thinking cautiously on US equities but also the US Dollar as well as being constructive on high quality fixed income (owning some gold may not be a bad idea either). In terms of the Dollar, we are detecting that, whereas US economic data may be beginning to miss elevated expectations, European data remains very robust. Chart 2 above shows the composite PMIs for the US and Eurozone, and although it is not right to directly compare the actual levels, it is clear that the US business community is becoming less optimistic in the last two months whereas in Europe, business leaders continue to become more confident.

At the same time, the talk around whether the ECB will change policy later this year only gets louder. The talk is of a potential rise in the deposit rate and a change to the monthly level of QE. We think this may all be a bit premature, but we do expect the Euro to strengthen markedly as and when the ECB properly moves to the exit and if the recent divergence between US and European data continues in the short term, the Euro could be stronger than many believed just a few weeks ago when it was testing 1.0/1.05 to the Dollar.

As for the federal reserve, we and everyone else has noted in recent weeks, that they have tried to become just a shade more hawkish. If Trump's policies risk getting completely bogged down, then there is every chance that Fed rate rises will be curtailed no matter how bullish Fed speakers are (another busy week ahead on this front). As we have pointed out recently, the Dollar has taken a back seat in recent weeks, and we think that this will continue. This will help high quality bonds.

To sum up, we think that last week's events in Washington should cause investors in to a reality check. After the majority of investors were wrong footed by Brexit, the Trump election victory and the Italian referendum, making these sorts of market calls is open to failure these days. However, and as pointed out a couple of weeks ago in our report "Charts that make you go hmmm" (LINK HERE), bubble like valuations coupled with an equity market losing momentum are usually decent indicators that it is right to reduce risk. 

By Stewart Richardson on 12/11/16 | Category - U.S

To view a PDF copy of this report, click here.

Last week in "Peering past the election", we outlined a potential reflationary period ahead that could either be elegant or disorderly. Clearly the market views Trump as more reflationary than Clinton would have been, judging by the reaction in bonds last week. We think that the Trump victory is a potentially very important event for financial markets and by extension the global economy. For the record, we are making no comment about the man himself, we'll leave that for others to thrash out. Our comments below are focused on the global financial markets and economic trends.

We said last week that with US growth and inflation nudging higher, bond yields were set to rise (a theme we have been discussing for some time). From a pure policy perspective, Trump is rightly seen as reflationary by the markets, and this should exaggerate the moves in bond markets in the period ahead; let's call that 3 to 6 months for the moment. Trump has told us that he will increase spending on infrastructure (by issuing new debt) and will cut taxes quite aggressively. Furthermore, there is talk of reversing recent financial regulation and paving the way for the repatriation of trillions of Dollars held abroad by US companies. If Trump is serious about these policies, and able to make them happen, then this really should be quite inflationary.

We have noted several times of late (including last week) that after months and months of investors reaching for yield, sometimes employing leverage to do so, the exit was getting much smaller. The action last week seems to be following that script. Chart 1 below shows US ten year yields alongside the 5s/30s yield curve and 5 year 5 year forward inflation rates. They all jumped very smartly post the Trump win, illustrating not only the inflationary policies that Trump is likely to pursue, but also the lack of bids in a market where far too many are looking to sell at the same time.

Chart 1 - US Yields and market based inflation expectations all jumped smartly post the Trump win

Now, for a short period of time in the hours after the Trump victory was declared, the "elegant reflation" narrative seemed to be at work, whereby bond yields, US equities and the US Dollar rose on the prospect of stronger economic growth. However, and as noted last week, it is very difficult to predict whether markets follow the elegant reflation path or a "darker" reflation path. This darker path is towards rising yields, a stronger Dollar and a disorderly exit from those yield assets that have been bid up to extremely expensive valuations in the pervasive reach for yield. For most of Thursday and Friday, the darker reflation was the order of the day, as yield sensitive assets such Emerging Market assets, sold off quite aggressively. In fact, this darker reflation puts at risk any asset which is over-owned, as the wobble in Nasdaq and recent high flying tech stocks late last week illustrates. 
Chart 2 below shows the performance of an Emerging Market Bond ETF (in white) that tracks the performance of an index of bonds priced in US Dollars. As can be seen, the share price has fallen rapidly in the last few days. We show this chart to illustrate how quickly popular trades can come unstuck. The red line on the chart shows the number of shares outstanding which rose rapidly from the low in February as risk assets rose generally post the China wobble seen at the time. The worry here is that the selling has barely begun and the selling that has taken place has hammered the share price. 
Chart 2 - Emerging Market (US$) Bond ETF with shares outstanding
We also chose to illustrate an Emerging Market asset, as Emerging Markets would appear to be the most vulnerable in a Trump world. Not only will higher US bond yields and a stronger Dollar make life more difficult for Emerging Markets, but Trump's focus on doing what's right for America and forget about the rest of the world is a new policy. Reneging on trade deals and imposing trade tariffs are poor policies from a global growth perspective, and with some of these policies aimed directly at selected Emerging Markets, we have to think that EM assets will generally under-perform. A look at chart 3 below shows that Emerging Market equities have turned lower from a formidable zone of resistance, and have broken a well-defined uptrend that has been in place since earlier this year. 

Chart 3 - Emerging Market Equity ETF
Another intriguing aspect of the Trump victory and the reflation policies that are now being discussed is that this is very different from the current European landscape. Not only will French and German elections dictate that big decisions on any important European matter will be delayed, but the ECB's Negative Interest Rate Policy (NIRP) is at risk of being seen as deflationary. Surely a successful reflation story goes hand in hand with rising interest rates, both short term and long term. This was certainly the case between 2003 and 2007, as can be seen in chart 4 below showing the US equity market and the Fed Funds Rate.

Chart 4 - The US Equity Market and the Fed Funds Rate 1999 to 2009
Unfortunately, the ECB has a potentially huge problem in this cycle now. NIRP is not working, and yet they cannot (or will not) raise interest rates until well after the end of QE. Currently, QE is scheduled to end in March next year, but Draghi told us at the last meeting that QE would not end abruptly. It would appear that his plan is to extend QE, which only delays the normalisation of interest rates, which is so desperately required for a true reflationary process to begin. Frankly, we doubt that the ECB will get anywhere close to raising interest rates for a long time to come, and any illusion of an inflationary pulse will be just that; an illusion. Indeed, the inability of European equities to overcome well established resistance, as seen in chart 5 below, is a worry and may well be indicative that Europe simply cannot unshackle itself from structural problems whereas the US is now focused on reflating its economy, and may well have some success, at least in the next couple of quarters or so.

Chart 5 - The European Equity Market continues to respect well defined resistance
So, if European and Emerging Market equities are set to under-perform, or even decline, what of the US. Can we really see the elegant reflation noted at the beginning whereby bond yields, interest rates, the US Dollar and equities all rise together? At this particular juncture, we simply don't have a strong opinion. We think that US equities in aggregate are extremely expensive (as they have been for two or three years), but we can see the logic of the reflation narrative and broad equity indices remain near the top end of recent ranges. That said, underneath the surface, we suspect there will be some quite violent sector shifts with money fleeing defensive income type stocks and looking to buy cyclical stocks including Banking stocks if the yield curve continues to steepen.

So, to try and wrap up for this week. What do we have highest conviction in? Well, as we have been saying for some time, bond yields appear to be heading higher as growth and inflation nudge higher. This reflation impulse will gather momentum if Trump follows through on some of the policies he has outlined. We are therefore comfortable in looking for higher bond yields and a stronger Dollar. Also, given Trump's insular view of let's do what's best for America, we think that Emerging Market assets are vulnerable. For the time being, we are somewhat ambivalent on US equities, but we will be avoiding anything too defensive or income oriented as well as anything that has massively outperformed in recent months.
We end on a familiar note, but one which we think is only strengthened by Trump's victory. We strongly feel that buy and hold strategies will be disappointing over the next 5 to 10 years, and may well generate close to zero returns. The US is set to follow a very different course now, and one that may well disadvantage many emerging markets, and even illustrate the structural problems that continue to afflict Europe. In a world of very low returns from mainstream assets, and a world of political divergence (perhaps even central bank divergence as well), we believe that trading/active strategies will offer not only the chance of positive returns but also a level of diversification that is so hard to find today in any mainstream asset.

By Stewart Richardson on 05/11/16 | Category - U.S

To view a PDF copy of this report, click here.

To the relief of many, the US election should be over by this time next week. Not only will the US have a new President, but we will know who controls Congress and the Senate. Clearly markets have been ruffled by the Trump resurgence post the FBI investigation news from a week or so ago. As with the Brexit experience, life will settle down whoever wins and we now need to think about what the next few months will bring. For what it's worth, if Trump does win, we think equity markets drop and we will look to buy into that weakness to benefit from a post trauma bounce (not unlike Brexit). If Clinton wins, equities should rally modestly but we look to sell that rally as HRC represents the status quo, of which we are bearish. We see less sensitivity to either outcome in the FX and bond markets.

So, trying to look past the election, we see a relatively short cyclical pick-up in growth and inflation. This is partly down to a low base effect from the oil price which will help at least through February 2017. Yet, reading some of the recent business survey commentaries, there is a feeling of some actual improvement in general conditions as well. With both growth and inflation nudging upwards, and the Fed telling us that the case for a rate hike has strengthened since September, we fully expect a second rate rise in December assuming the equity market behaves itself (more on that later!).

Chart 1 - The Fed Funds Rate and the Shadow rate over the last few cycles

This all has a feel of a classic late cycle phase, where the central bank continues to tighten policy as growth and inflation nudges higher. The current recovery is 89 month old now, the third longest in the post WWII period, and according to a policy adjusted model, the Fed has been tightening quite a lot in the last couple of years. Chart 1 above shows both the Fed Funds rates and a "shadow" rate developed to measure the policy rate adjusted for the unorthodox policies employed since the financial crisis. 

What's interesting looking at Fed policy through this lens is that policy has already been tightened by about 3% which is comparable to the 4% tightening periods seen prior to the last three recessions. As can also be seen by looking at real GDP, growth has shifted into a lower gear post the financial crisis, and it is very possible that the tightening implied by the shadow rate, along with a modest increase the Fed Funds rate, may be enough to tip the economy into recession next year.

We have a roadmap in mind which sees growth and inflation move higher over the next 3 to 6 months. This will not only encourage the Fed to raise rates, but should also lift bond yields, a theme we have been talking about for some time now.

Now here is where we can visualise two outcomes. We have explained before how we think fixed income investors have stretched themselves in the search for yield, through a combination of duration, credit exposure and even leverage. There is a distinct possibility that a continuing bond sell off will become disorderly which could impact the financial markets generally and also the real economy. There is also a possibility of what we would call an elegant reflation, whereby yields rise ever so gently whilst risk assets celebrate better growth and inflation.

Whereas the disorderly sell off scenario is immediately bearish of both financial markets and the economy (and would surely keep the Fed on the sidelines), the elegant reflation buys a couple of quarters of time for markets to perform before the larger maturity of the business cycle kicks in, and recession risks rise anew.

There does remain an elephant in the room and that is the equity market that remains grossly overvalued. In chart 2 below, we show the performance of the equity market and corporate profits (as measured in the national accounts) alongside the total number of employed persons. Historically, and as should be expected, profits and stock prices are quite closely correlated, and employment follows with a bit of a lag. Our overriding concern remains that an equity bear market will simply encourage CEOs to cut jobs and capex which would undoubtedly push the economy into recession.

Chart 2 - The stock market with corporate profits and total employment

If the current deterioration in the equity market gathers strength, then our cyclical uplift thesis will be obsolete and there will certainly not be any elegant reflation. When we have such diverging market outcomes as realistic possibilities, we need to maintain a very flexible approach to markets, and of course we cannot ignore the possibility that global central banks will fight any market weakness with even more stimulus.

If it feels like we are leaving a lot of loose ends this week, that is because the short term outlook is so uncertain on many fronts. What we remain comfortable with is that the likely returns over the long term will be low single digits for most mainstream assets, and investors will be both disappointed and vulnerable to periods of intense volatility. At a minimum, our flexible approach allows us to sidestep these periods and hopefully benefit from rising volatility and a degree of directionality that has been sorely missing in recent months.


By Stewart Richardson on 04/06/16 | Category - U.S
Two weeks ago in our note titled "Markets have to adjust as Fed alters course", we said the following; "...The Fed is continuously worried about upsetting financial markets if they remove the punch bowl. They are also now worried about Dollar strength, vulnerable global growth, low commodity prices and political  uncertainties. Despite the rally in asset prices in the last two months or so, none of these uncertainties have actually been resolved, and so it is unclear why the Fed have altered their narrative this week..."
A few days later, Janet Yellen spoke, and although she was not as specific as many of her colleagues in calling for two or three rate rises this year, she did say that a "rate hike in coming months may be appropriate" with the usual caveat of data dependency. The key point for us at the time was that at the beginning of May, there was no pressure on the Fed to raise rates at all. The recent re-pricing in the market was entirely due to communications from the Fed.
Fast forward two weeks to today, and after a truly disappointing US employment report, the market has priced out any rate hike in coming months, with only slightly more than a 50% probability of one rate rise by year end. In our opinion, Janet Yellen has always been a lot more dovish than a number of her colleagues and will not want to raise rates now. So, either the Fed ignores the poor US employment report (and the continuing weakness in the manufacturing sector and corporate profitability) and raise rates anyway, thereby risking upsetting the financial markets. Or, they shift back to a more dovish narrative, risking their credibility.
Now, we have definitely been on the more bearish economic case for a good few quarters, primarily because of the slowdown and then decline in corporate profits and the leading indicator qualities this has historically held. So, a poor employment report at some point had been due. However, before we get too enthusiastic about positioning our portfolios for a world where the Fed is on the sidelines, we need to consider the case for a strong whiff of stagflation in the latter part of this year.
The chart below that we showed a few weeks ago shows the potential trajectory for inflation in selected countries assuming the price of oil stays at $45. What is clear is that inflation is likely to be heading demonstrably higher by late summer, and with the Fed's employment mandate basically now achieved, rising inflation should lead the Fed to rate normalisation. Will the Fed really be able to stand pat with both their mandates being met, even if growth is slow?
Chart 1 - The potential trajectory of inflation in selected countries
Back to our report from two weeks ago. We finished by saying that "The altered Fed policy makes for a very interesting period ahead, quite possibly an increased level of global volatility and difficult markets... Confidence in markets, policymakers and the outlook for the global economy is pretty fragile, and it only takes one or two small upsets in this sort of environment to really throw a spanner in the works...[we are] watching the Fed very carefully for any backtracking from their new found hawkish bias."

In terms of our big picture thinking, we are comfortable with the stagflation scenario for later this year. Our view is that if the Fed do raise rates as they articulated in recent weeks, then this will flatten the yield curve, strengthen the Dollar and likely be part of the tapestry of indicators we look for when thinking of imminent recession. So, the big question is can the Fed keep rates low enough to help enable modest growth and inflation, alongside stable to rising financial markets and sufficient jobs and wages growth to neutralise the wealth/income inequality debate during the US election campaign? Quite a task considering the Fed's forecasting track record.

As noted above, the performance of corporate profits is a good leading indicator for the economy. In the chart below, we compare corporate profits with total employment (lagged by 12 months) and the US stock market.

Chart 2 - Corporate profits versus total employment and the US stock market
Corporate profits peaked in Q3 2014 and are expected to decline again in the second quarter of this year. It would appear after the poor employment report that total employment may very well be close to peaking, just about bang on schedule. In this analysis, the next shoe to drop will be the US equity market, which appears to be running on fumes. The chart below shows the US equity market and a composite indicator of 5 financial conditions indicators. If the US equity market starts going down, and drags credit spreads higher as is usually the case, the financial conditions will deteriorate. We continue to strongly believe that an equity bear market will be final nail in the coffin for this economic expansion.
Chart 3 - The US equity market with broad financial conditions index
So again, the only way financial conditions can remain stable is for the prices of corporate assets to remain steady or higher, despite extremely stretched valuations, declining corporate profits, aggressive use of leverage for buybacks and M&A and the growing acceptance of central banking impotence.

Our main scenario remains that there are any number of ticking time bombs around the world ready to explode at any time. Policymakers have somehow managed to keep the investment community happy with extremely unorthodox policies forcing a record hunt for yield and mis-allocation of capital. However, growth remains too low and insufficient to generate the cash flows necessary to service both outstanding debt and equity holders.

Central bankers probably do not have sufficient firepower to prevent the next global recession when one of the ticking time bombs explodes. Yes, they will do all they can which means that the day of reckoning could be delayed for longer than the bears would like. However, the basic laws of finance and economics cannot be repealed forever. The poor US employment report is a sign that US growth is simply not as strong as the Fed would have us believe, and they have no ammunition in the event of a recession. If they choose to ignore the slow growth, and raise rates because inflation is picking up, then they will likely be making a large policy error from which they will struggle to recover their credibility.  

By Stewart Richardson on 21/05/16 | Category - U.S
The Fed's normalisation process has been a tortuous on/off affair primarily because their focus has been almost entirely on not upsetting the financial markets rather than doing the right thing for the long term health of the US economy. This week, the Federal Reserve machine cranked into action to persuade markets that they want to raise rates before the Summer and again before year end. So far, the reaction has been quite muted, but it is far from certain that this calm veneer will continue. Let's dive in and think about what the Fed are doing and what this means for markets.
We have little doubt that a truly independent Fed would realise that their policy setting is just plain wrong in terms of the domestic economy. It has been wrong for years now, and we know why this is so. The Fed is continuously worried about upsetting financial markets if they remove the punch bowl. They are also now worried about Dollar strength, vulnerable global growth, low commodity prices and political  uncertainties. Despite the rally in asset prices in the last two months or so, none of these uncertainties have actually been resolved, and so it is unclear why the Fed have altered their narrative this week, especially ahead of the G7 meeting next weekend.
Whatever the reasoning for the alteration in policy, more rate rises than previously expected by markets will have an effect on prices. The most sensitive to faster rate rises will be the front end of the US yield curve, and probably the US Dollar as policy divergence becomes more obvious again. Chart 1 below plots the Fed Funds mid point versus 3 month Libor and the two year Government bond yield. What is clear is that prior to the rate rise in December, US interest rates were already rising in anticipation. At the moment, the market has barely begun to price in a second rate rise, never mind a third or fourth. We expect short end US rates to rise assuming the Fed can deliver on rate rises.

Chart 1 - Short end US interest rates versus Fed Funds
Perhaps the largest impact in markets will be the value of the US Dollar. The key here is that further rates rises demonstrate the clear divergence in global policy as all other central banks remain committed to maintaining extremely easy policies, or even moving further into uncharted extremes. If we assume that US 2 year yields rise back above 1% and German yields remain mired around current levels of minus -0.50%, then the yield differential will widen well past 150 basis points in favour of the US. We illustrate the yield differential in chart 2 below alongside the EUR/USD exchange rate. On this basis, it is possible to envisage the EUR/USD exchange rate going down to test this year's lows near 1.08 and even last year's lows around 1.05.
Chart 2 - EUR/USD exchange rate versus 2 year yield differential
Having warmed to the Dollar at the end of April and moving to outright bullish in early May, the more hawkish Fed posture and the resulting broad Dollar strength is very welcome for us. Nothing moves in a straight line, but unless the Fed now reverses course and fails to raise rates at either the June or July meeting, we expect to remain bullish of the Dollar across the board, with an emphasis on being bearish Emerging Market and commodity currencies. This is best seen in the RMG FX Strategy UCITS fund.
In the bond markets, our key takeaway is how the yield curve continues to flatten as short end rates rise faster than longer dated bond yields. The difference between ten year and two year yields is around 0.95%, down from nearly 1.10% just a few weeks ago and 1.45% last November before the first US rate rise. We believe that this flattening of the yield curve is extremely important. First, a flattening of the yield curve historically indicates weak or weaker economic growth ahead. Secondly, if the curve actually inverts, this is historically one of THE single best recession indicators known to mankind.
Chart 3 below shows the year on year real growth rate of the US economy, and the US yield curve advanced by 8 quarters. It is clear that movements in the yield curve have a reasonable correlation with future growth. It is also clear that once the yield curve has inverted, the economy is at real risk of recession. The only time when US growth exceeded that predicted by the yield curve was in the late 1990s when demographics, globalisation, productivity and financial liberalisation were fantastic tailwinds.
Chart 3 - US real growth versus the 10/2's yield curve
With the structural headwinds that we have discussed in recent months, we strongly believe that the yield curve will flatten further if the Fed continues to raise interest rates. Will the curve actually invert in the months ahead? Possibly, although the Fed will most likely refrain from being too aggressive if trouble erupts again in markets. At the very least, we expect economic growth to remain low, and with policy ridiculously easy in other developed economies encouraging a global search for safe yield, US ten year bond yields should remain fairly well anchored around current levels just below 2%.
As for equities, the reflation trade that began in February has clearly stalled in the last few weeks, with emerging markets displaying the most immediate vulnerability. We continue to believe that developed equity markets are vulnerable as well, and although the change in tone at the Fed has not led to an immediate sell off, we are sticking to our bearish thesis. US equities continue to be egregiously overvalued but also continue to outperform in the very short term. This is a pattern we have seen before the sharp sell offs in October 2015, August 2015 and January this year. We are thinking something similar may happen again soon.
To try and wrap things up for this week, it appears that the Fed have made an active decision to change the market's outlook for rate rises and become more hawkish than expected. They didn't have to do this, and so unless there is a market sell off (quite possible in our opinion) or global event, we have to expect the Fed to raise rates before the Summer and maintain a slightly hawkish bias. We believe that this will be bullish for the Dollar, bearish for global equities and neutral for longer dated bonds.
The altered Fed policy makes for a very interesting period ahead, quite possibly an increased level of global volatility and difficult markets at a time when most investors are struggling to make money over the last 12 months and year to date. Confidence in markets, policymakers and the outlook for the global economy is pretty fragile, and it only takes one or two small upsets in this sort of environment to really throw a spanner in the works. Defensive and tactical investment approaches continue to offer attractive options for the current time period and likely for some time to come. For our part, we are bullish the Dollar and bearish on equity markets whilst watching the Fed very carefully for any backtracking from their new found hawkish bias.

By Stewart Richardson on 26/03/16 | Category - U.S
Although markets seemed to really quieten down ahead of the long Easter weekend, there was still enough happening and enough on the near horizon to keep us on our toes. Rather than dive into a long essay like we did last week, we will just have a look at a couple of things that have caught our eye.

First, the third revision to fourth quarter US GDP was released on Friday, and with that came the calculation of corporate profits, as measured on a national accounts basis. As expected, corporate profits on this measure were horrible, falling more than 11% year on year. We have said many times that declining corporate profits leads the US into recession as shown in chart 1 below. The only major false signal in the last 45 years was in 1986, which interestingly was the last time that the oil price collapsed at a time when US oil production was close to current levels.

Chart 1 - US Corporate profits (year on year % change) and Real GDP
Companies' own pro forma results are expected to decline by about 9%, year on year, in the first quarter of 2016 so we will just have to wait and see whether the corporate sector finally starts dragging the economy into recession or whether the consumer (who is still keeping the US economic engine sputtering along) will be strong enough to keep the US just above stall speed. The start of the US quarterly results season is only a couple of weeks away, and it feels like it could be a very important quarter for US companies, particularly the message they give to investors about the outlook for the year ahead.
Second, we came across an analysis from Horseman Capital linking the performance of the Japanese equity market to the US. The thought process is that the US has run a persistent current account deficit in recent decades, and this needs to be funded by someone else's capital. The world's biggest saver continues to be Japan who has been funding the US for years. Of course, all current account deficits will be funded, but at what price? In the words of Horseman Capital, "My view is that the Japanese are the world's biggest net savers and investors, and it is the movement of Japanese investments that cause the biggest moves in currencies and equities."
The point of the notes is to illustrate that the Japanese equity market has peaked 3 to 6 months ahead of the S&P 500 at the last two peaks in 2000 and 2007, as can be seen in chart 2 below.
Chart 2 - The US and Japanese equity markets
The chart also shows that the Japanese equity market peaked last summer. So far, this looks to be coincident with the peak in the US although clearly Japan has underperformed in recent months, perhaps leading the way as in 2000 and 2007?

This begs questions over capital flows in general, and the increasingly disappointing performance of Japanese equities despite massive QE from the Bank of Japan (same for European equities after a year of QE from the ECB). To keep this note short this week, we won't delve into this any further; simply leaving this out there as an interesting thought. We would point out that we have looked at global liquidity in recent weeks and in particular the change in global FX reserves and how they rise and fall with asset prices. Needless to say, when global FX reserves are falling, and domestic asset prices of the world's largest savers (Japan and Germany) are falling, then perhaps it's only a matter of time before even the mighty US equity market stumbles.

For many months now, we have been trying to articulate how we feel that equity markets, the US in particular, are overvalued. With corporate earnings now declining, economic growth stalling, central bank credibility falling and global liquidity tightening, we find it very difficult to be bullish and all too easy to be bearish. Add in geopolitical concerns and structural headwinds like demographics (Japan and Europe in particular), poor productivity and high and rising inequality and our bearishness only increases. 


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RMG Wealth Management LLP is authorised and regulated by the Financial Conduct Authority (FCA). These reports are for general information purposes only and do not take into account the specific financial objectives, financial situation or particular needs of any particular person. It is not a personal recommendation and it should not be regarded as a solicitation or an offer to buy or sell any securities or instruments mentioned in it. This report is based upon public information that RMG considers reliable but RMG does not represent that the information contained herein is accurate or complete. The price and value of investments mentioned in this report and income arising from them may fluctuate. Past performance is not a guide to future performance and future returns are not guaranteed.