I cannot count the amount of times that I have recently heard “oh you are in finance, I heard right now is a terrible time to invest!” Certainly, this is not the type of euphoric sentiment characteristic of a bull market blow-off top. Statements such as the above characterize the unusual investing environment that we see today; relatively high equity valuations, slowing global growth, low and declining interest rates, and defensive sentiment among investors comprise a unique investing backdrop. I still see upside in both US equities and Treasury bills over the next one to two years. While being long Treasuries conforms to the consensus and increasing numbers of investors, including myself, see an unsustainable bubble forming, I still believe that yields have further to fall to form that expected top in the bond market. However, my more unique thesis favors being simultaneously long US equities to take advantage of a squeeze to new highs in the S&P 500.
Back in late April, I was concerned about US equities as fitting many characteristics of a bubble. Slowing GDP growth domestically, inflation below targets, and terrible Eurozone economic data certainly did not justify S&P 500 p/e multiples north of 20. Most frightening was hedge funds’ huge levered purchases of equities into a market with a very light offer, seeming to me as F.O.M.O./career insurance against underperformance versus low fee index funds. This raises concern over a self-reinforcing cycle of margin call liquidations to the downside triggered by a significant pull-back. However, a pull-back came in the form of a rough May, but June and July rate cut hopes took us back within reach of and eventually to new all-time highs, putting concerns of equity market leverage on hold. Although this validates my now equity bull thesis, I find this extremely concerning from a moral hazard perspective as it seems that we have entered a paradigm shift where financial markets affect the Fed more than the Fed can affect financial markets. Trump jaw bones fund futures to price in a rate cut, equities take the hint, and the Fed obliges in order to prevent investors from being disappointed and selling the market to a level more in line with the global macro outlook. The Fed is clearly signaling investors that it is very worried about the impact of a negative wealth effect brought about by a potential decline in equity prices to more reasonable levels. Thus, comprising the first and most general part of my equity bull thesis, global investors feel assured that the Fed has their back, significantly reducing perceived risk, even at these likely higher than justifiable valuations. Moving on to the heart of my thesis, U.S. equities present a good alternative opportunity for foreign pension fund and sovereign wealth fund managers. Looking across developed, liquid, global asset markets, U.S. equities look relatively attractive and will continue to look more attractive. Increasingly negative yielding sovereign bonds across the Eurozone and Japan present themselves as truly imprudent investments. A manager could certainly do better by shifting those ridiculously-priced bond holdings into higher yielding U.S. equities which are backed by the Fed’s quasi third mandate guarantee and the underrated strength still demonstrated by the American consumer. Thirdly, U.S. equities provide foreigners great dollar exposure in a manner diversified from Treasury Bills. As the global dollar liquidity squeeze is still alive, as demonstrated by recent Repo market abnormalities, foreigners will continue to pile into dollar-denominated assets to speculate on further appreciation. Finally, from a trader’s perspective inside the markets, August saw many SPY traders aggressively selling short into the small rallies to the low 290’s. Although most of them are underwater as I write this and many may have trimmed their positions as a good risk management practice, the current high is not so far away as to have completely wiped-out their positions. This sets the stage for an increased magnitude price move on the back of the above fundamental catalysts.
Different from equity sentiment, U.S. Treasury bulls represent the crowded side of the trade, having seen huge appreciation in the past twelve months. Although textbooks teach a traditional inverse correlation between bond and equity markets, my fundamental thesis for equities rests in an environment where both can rise together. Deep negative-yielding European sovereigns, an underrated but strong domestic consumer, a dovish Fed, and demand for exposure to dollar appreciation produce this environment. While likely we are entering a bubble phase for both asset classes, both still have room to run. Just as in equities, investors should still buy dips in Treasuries. Until inflation returns (which it certainly will eventually), the reality is that the Fed has unlimited ability to do quantitative easing. As difficult as it is to comprehend, there is even talk of a permanent expansion of the Fed’s balance sheet. This essentially means the proliferation of the bond bull market until inflation jolts fixed income investors out of their forty-year fairy tale. However, until this happens, and as the global economic picture continues to get gloomier, the flight to quality will continue pushing down yields. Still, this does not even account for the fact that the dollar remains the global reserve currency, perpetuating a structural demand for Treasuries. At the very least, there is little concern of fire sales of these FX reserves as in many cases they compose a large portion of the foreign central bank’s asset side of the balance sheet; meaning that their sale would lead to a local currency appreciation, effectively functioning as a monetary tightening at a time when many of these countries are in danger of recession. This kind of deflationary shock would be disastrous for countries such as China, who are in the midst of huge credit bubbles. Therefore, I see the greatest short-term risk in bond markets stemming from my equity market breakout thesis. While I believe both can and should rise together, there is always the possibility that an equity rally, even as a liquidity event, would choke-out investor demand for Treasuries. So certainly, investors should pay close attention to bonds’ reaction to an equity breakout and prepare appropriate risk management.
Although I tell a bullish story in multiple asset classes, one must remember that these theses do not stem from an optimistic global economic outlook. It is quite the opposite, as I speak of frightening times to come which will in the short-term be positive for U.S. markets as a haven of safety and liquidity. However, beyond obvious negative ramifications of an eventual recession, long-term, U.S. Treasuries, equities, and especially the currency itself will face a very painful day of reckoning. Although it’s currently seemingly nonexistent, I believe that we are nearing the end of the long-term inflation cycle. Seeing magazine headlines such as “Inflation Is Officially Dead Forever” really make the astute contrarian perk-up. That is the first “It’s different this time” warning sign of the unsustainability of the current cycle. Honestly, there is no way to predict when high inflation will return, as many gold investors learned during the Fed’s unprecedented quantitative easing. When it does return though, it will likely cause the next global financial and economic crisis. Pension funds and IRAs who have known nothing but appreciation of U.S. Treasuries will get decimated. Equities will decline in real currency terms and consumer buying power will vanish. Given the ever-rising U.S. government debt and deficits and the resulting unsustainability of the dollar’s privileged status as the global reserve currency, high inflation certainly seems inevitable eventually. This is not to mention possible experimentation with Modern Monetary Theory if U.S. politics were to swing to the left in 2020. Perhaps this will be the event triggering high inflation’s return, but an investor can never be overly certain. For now, I will position myself in line with my short-term theses and listen to what the market is telling me. At the same time, gold will remain on my radar as the obvious expression of my inflation thesis. Yet from both a short-term fundamental and technical standpoint, I believe we will see better buying opportunities to come after my above theses come to fruition.
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