A bi-polar world

There is much talk in the media of a multipolar world, with the split between the West and the BRICS, led by China & Russia. That may be relevant in the long-term but the immediate challenge for investors is a bi-polar world, where some markets are rallying strongly while others are collapsing. Even within the US market, we have some sectors rallying while others are collapsing.

The S&P 500 is still in a bear market but the index has rallied to test resistance between 4200 and 4300. Breakout would confirm the bull signal from 250-day Rate of Change crossing to above zero.

S&P 500

The big 5 technology stocks — Apple, Amazon, Alphabet (GOOGL), Meta Platforms, and Microsoft — have all rallied strongly since the start of 2023.

Big 5 Technology Companies

Volatility is elevated but declining peaks on Twiggs Volatility (21-day) suggest that this is easing.

S&P 500 & Twiggs Volatility

However, the rally is concentrated in big tech stocks, with small caps struggling to hold above support. The Russell 2000 iShares ETF (IWM) is testing the band of support between 164 and 170. Breach of support would signal a second downward leg in the bear market.

Russell 2000 ETF (IWM)

The Treasury yield curve is also inverted, with the ever-reliable 10-Year minus 3-Month spread at its lowest level (-1.49%) since 1981. Recessions tend to only occur after the spread recovers above zero — when the Fed starts cutting short term rates — which tells us that the recession is only likely to arrive in 2024.

Treasury Yield Spread: 10-Year minus 3-Month

The longer than usual lag may be the result of the “pig in the python” — a massive surge in liquidity injected into financial markets during the pandemic.

Commercial Bank Deposits/GDP

We are already seeing cracks in the dyke as liquidity starts to recede. Regional banks are in crisis, caused by the sharp hike in interest rates and the collapse in value of their “most secure” assets. Risk-weighted capital ratios are meaningless when bank investments in Treasury and Agency securities — which enjoy the lowest risk weighting — fall sharply in value. True levels of leverage are exposed and threaten bank solvency.

The S&P Composite 1500 Regional Banks Index ($XPBC) is testing support at 75 after a sharp decline. Not only do regional banks have solvency problems, caused by losses on Treasury and Agency investments, many are also over-exposed to commercial real estate (CRE) which faces a major fall in value, primarily in the office sector as demand for office space shrinks due to the shift to work-from-home after the pandemic.

S&P Composite 1500 Regional Banks Index ($XPBC)

There is always more than one cockroach — as Doug Kass would say — and regional banks are also threatened by a margin squeeze. Short-term rates have surged to higher than long-term rates, pressuring net interest margins. Banks are funded at the short-end and invest (and lend) at the long-end of the yield curve.

The Fed is unlikely to solve the regional bank problem easily, especially with the political impasse in Congress — needed to support any increase in deposit guarantees.

Commodities

Falling commodity prices warn that the global economy is contracting.

Brent crude is in a bear market, testing support at $70 per barrel. But US cude purchases — to re-stock their strategic petroleum reserve (SPR) — may strengthen support at this level.

Brent Crude

Copper broke support at $8500/tonne, signaling another test of $7000. Sometimes referred to as “Dr Copper” because of its “PhD in economics”, the metal has an uncanny ability to predict the direction of the global economy.

Copper

We use the broader Dow Jones Industrial Metals Index ($BIM) to confirm signals from Copper. The base metals index breached secondary support, at 167, warning of a test of primary support at 150.

Dow Jones Industrial Metals Index ($BIM)

Iron ore has also retraced, testing support at $100/tonne. Breach would warn of another test of $80.

Iron Ore

Dollar & Gold

The Dollar is also in a bear trend, testing support at 101. The recent rally in our view is simply a “dead cat bounce”, with another test of support likely. Breach would warn of another primary decline in the Dollar.

Dollar Index

Gold is in a bull market as the Dollar weakens. Dollar Index breach of 101 would likely cause a surge in demand for Gold, with breakout above $2050 signaling another primary advance — with a medium-term target of $2400 per ounce.

Spot Gold

Australia

The ASX 200 recent (medium-term) bull trend is losing steam, with the index ranging in a narrow band between 7200 and 7400 since April.

ASX 200

Breakout from that narrow band will provide a strong indication of future direction. Breach of 7200 is, in our view, far more likely — because of weakness in global commodity prices — and would warn of another test of primary support between 6900 and 7000.

ASX 200

The All Ordinaries Gold Index (XGD), however, is in a strong bull trend. Respect of support between 6900 and 7000 would strengthen the signal, while breakout above the band of resistance (7500 – 7700) would signal another primary advance, with a medium-term target of 8200.

All Ordinaries Gold Index

Conclusion

The US market is bi-polar, with large technology stocks leading a rally, while small caps and regional banks are struggling. The lag between an inverted yield curve and subsequent recession may be longer than usual because of the “pig in the python” — large injections of liquidity into financial markets during the pandemic.

Commodities are in a bear market, with falling crude and base metals warning of a global recession.

The Dollar is weakening and we expect a primary advance in Gold — with a medium-term target of $2400 per ounce — if the Dollar Index breaks support at 101.

The ASX medium-term rally is weakening and breach of 7200 would warn of another test of primary support. Two major influences are global commodity prices and major Wall Street indices.

Our outlook remains bearish despite the rally in the US technology sector. We are underweight in growth, cyclical and real estate sectors and overweight in gold, silver, defensive stocks, critical materials, cash, money market funds and short-term interest-bearing securities.

ASX double-bottom breakout

The ASX 200 completed a double-bottom reversal with breakout above 7100, suggesting another test of resistance at 7600. The signal is strengthened by subsequent retracement that respected the new support level at 7100, as well as 100-day Momentum crossover above zero.

ASX 200

Australian Bond ETFs are forming a base, signaling that expectations of long-term interest rates have plateaued.

Australian Bond ETFs

A-REITs rallied off support at 1200, penetrating the descending trendline which suggests that a base is forming. However, the move has not been confirmed by 100-day Momentum which remains well below zero.

ASX 200 REITs

Financials have made a stronger recovery, breaking above their August high, with Momentum crossing above zero. We expect a test of 7000.

ASX 200 Financials

Housing price growth is slowing as the RBA hikes interest rates.

Housing

But low unemployment keeps bank loan impairments down.

Unemployment

Net interest margins remain under pressure, however, as liquidity tightens.

Net Interest Margins

Consumer Discretionary continues to test resistance at 3000 but respect remains likely, which would warn of further consolidation.

ASX 200 Discretionary

Staples rallied off long-term support at 12000 but Momentum remains below zero. Breakout above resistance at 13000 would signal another test of 14000.

ASX 200 Staples

A higher trough on Health Care and 100-day Momentum cross to above zero are bullish signs. Breakout above 44K would signal another advance, with a target of 49K (44K + 44K – 39K).

ASX 200 Health Care

Information Technology remains weak, with 100-day Momentum deep below zero. Expect another test of 1250.

ASX 200 Information Technology

Utilities broke resistance at 8400, signaling an advance. Momentum crossover to above zero strengthens the bull signal..

ASX 200 Utilities

Industrials are headed for another test of resistance at 6700. But further ranging between 6000 and 6750 remains likely.

ASX 200 Industrials

Telecommunications are slowly edging towards resistance at 1500 but Momentum below zero indicates weakness.

ASX 200 Telecommunications

Energy remains in a long-term up-trend, testing resistance at 12000. Retracement that respects support at 11000 would strengthen the bull signal.

ASX 200 Energy

The ASX 300 Metals & Mining index broke resistance at 5650, signaling an up-trend. Retracement that respected the new support level and 100-day Momentum cross to above zero both strengthen the bull signal.

ASX 300 Metals & Mining

But weakness in major metal groups makes us wary. Declining iron ore prices are testing support at 90. Breach would signal a test of $50/tonne

Iron Ore

Base metals are similarly testing support at 150. Breach would warn of another test of 100.

DJ Industrial Metals Index

The All Ordinaries Gold Index broke through resistance at 5500, with retracement respecting the new support level to confirm the breakout. But 100-day Momentum is a long way below zero, warning buyers to be wary. Expect further tests of the new support level.

All Ordinaries Gold Index

The Australian Dollar is ranging between A$2500 and A$2700 with no clear direction at present.

Gold in Australian Dollars

Conclusion

Growth in Australia is slowing but recession is unlikely unless there is a sharp rise in unemployment — and fall in the housing market — or a global recession.

ASX 200 completed a double-bottom reversal, offering a target of 7600, but we do not believe this to be the start of a bull market. A negative yield curve in the US, warning of a recession next year, makes a bull market unlikely. Respect of resistance at 7600 would confirm that we are still in a bear market.

Our weighting for ASX sectors (ST = short-term, LT = long-term):

  • A-REITs: ST underweight, LT overweight in industrial REITs
  • Financials: overweight
  • Staples: overweight
  • Discretionary: ST underweight, LT neutral
  • Utilities: overweight
  • Industrials: neutral
  • Telecommunications: neutral
  • Health Care: overweight
  • Information Technology: underweight
  • Energy: overweight
  • Iron ore & Base Metals: ST underweight, LT neutral
  • Critical Materials: heavily overweight
  • Gold: ST neutral, LT overweight

Bond market: No place to hide

Advance retail sales were flat in September, reflecting slowing growth, but remain well above their pre-pandemic trend. So far, Fed rate hikes have failed to make a dent in consumer spending.

Advance Retail Sales

Even adjusted for inflation, real retail sales are well above the pre-pandemic trend.

Advance Real Retail Sales

The culprit is M2 money supply. While M2 has stopped growing, there has been no real contraction to bring money supply in line with the long-term trend. A fall of that magnitude would have a devastating effect on inflated asset prices.

M2 excluding Time Deposits

Inflation is proving persistent, with CPI hardly budging in September. Hourly earnings growth is slowing but remains a long way above the Fed’s 2.0% inflation target.

CPI & Hourly Earnings Growth

Treasury yields have broken their forty year down-trend, with the 10-year testing resistance at 4.0%. Stubborn inflation is expected to lift yields even higher.

10-Year Treasury Yield

Inflation is forcing the Fed to raise interest rates, ending the forty-year expansion in debt levels (relative to GDP). Cheap debt supports elevated asset prices, so a decline in debt levels would cause a similar decline in asset prices.

Non-Financial Debt/GDP

A decline of that magnitude is likely to involve more pain than the political establishment can bear, leaving yield curve control (YCC) as the only viable alternative. The Fed would act as buyer of last resort for federal debt, while suppressing long-term yields. The same playbook was used in the 1950s and ’60s to drive down the debt to GDP ratio, allowing rapid growth in GDP while inflation eroded the real value of public debt.

Federal Debt/GDP

Conclusion

We are fast approaching a turning point, where the Fed cannot hike rates further without collapsing the bond market. In the short-term, while asset prices fall, cash is king. But in the long-term investors should beware of financial securities because inflation is expected to eat your lunch. Our strategy is to invest in real assets, including gold, critical materials and defensive stocks.

No soft landing

10-Year Treasury yields have climbed in response to the December FOMC minutes which suggest a faster taper of QE purchases and faster rate hikes. Breakout above 1.75% would offer a medium-term target of 2.3% (projecting the trough of 1.2% above resistance at 1.75%).

10-Year Treasury Yield

The Dollar Index retreated below short-term support at 96, warning of a correction despite rising LT yields.

Dollar Index

Do the latest FOMC minutes mean that the Fed is serious about fighting inflation? The short answer: NO. If they were serious, they would not taper but halt Treasury and MBS purchases. Instead of discussing rate hikes later in the year, they would hike rates now. The Fed are trying to slow the economy by talking rather than doing — and will be largely ignored until they slam on the brakes.

Average hourly earnings growth — 5.8% for the 2021 calendar year — is likely to remain high.

Hourly Wage Rate

A widening labor shortage — with job openings exceeding total unemployment by more than 4 million — is likely to drive wages even higher, eating into profit margins.

Job Openings & Unemployment

The S&P 500 continues to climb without any significant corrections over the past 18 months.

S&P 500

Rising earnings have lowered the expected December 2020 PE ratio (of highest trailing earnings) for the S&P 500 to a still-high 24.56.

S&P 500/Highest Trailing Earnings (PEmax)

But wide profit margins from supply chain shortages are unsustainable in the long-term and are likely to reverse, creating a headwind for stocks.

Warren Buffett’s long-term indicator of market value avoids fluctuating profit margins by comparing market cap to GDP as a surrogate for LT earnings. The ratio is at an extreme 2.7 (Q3 2020), having doubled since the Fed stated to expand its balance sheet (QE) after the 2008 global financial crisis.

Market Cap/GDP

Stock prices only adjust to fundamental values in the long-term. In the short-term, prices are driven by ebbs and flows of liquidity.

We are still witnessing a spectacular rise in the M2 money stock in relation to GDP, caused by Fed QE. The rise is only likely to halt when the taper ends in March 2022 — but there is no date yet set for quantitative tightening (QT) which would reverse the flow.

M2/GDP

Gold continues to range between $1725 and $1830 per ounce with no sign of a breakout.

Spot Gold

Conclusion

Expect a turbulent year ahead, driven by the pandemic, geopolitics, and Fed monetary policy. Rising inflation continues to be a major threat and we maintain our overweight positions in Gold and defensive stocks. A soft landing is unlikely — the Fed could easily lose control  — and we are underweight highly-priced growth stocks and cyclicals, while avoiding bonds completely.

Gold breaks $1850 per ounce

10-Year Treasury yields remain soft despite the recent CPI spike. The Fed is weighting purchases more to the long end of the yield curve. Breakout above 1.75% (green line) would signal a fresh advance.

10-Year Treasury Yield

10-Year TIPS yield sits at -0.78%, unaffected by the $369bn in overnight Fed reverse repurchase agreements which remove liquidity but mainly affect short-term interest rates.

10-Year TIPS Yield & Fed RRP

Gold broke through resistance at $1850/ounce. A rising Trend Index indicates medium-term buying pressure. Long tails on the last three daily candles indicate retracement to test the new support level; respect signals a test of $1950/ounce.

Spot Gold

Silver is testing resistance at $28/ounce. Rising Trend Index indicates medium-term buying pressure. Breakout above $28 is likely and would offer a target of $30/ounce in the short/medium-term.

Spot Silver

The Dollar index is testing primary support between 89 and 90. Rising Trend Index (below zero) suggests another test of the descending trendline. Respect is likely and breach of primary support would offer a medium/long-term target of 851.
Dollar Index

From Luke Gromen at FFTT:

When you are an externally-financed twin deficit nation with insufficient external funding (as Druckenmiller pointed out), there are three potential release valves:

  1. Higher unemployment.
  2. Higher interest rates.
  3. Lower currency (inflation.)

With US debt/GDP at 130%, Options #1 and #2 aren’t an option……

Conclusion

We expect long-term Treasury yields to remain low while inflation rises, causing the US Dollar to sink and Gold and Silver to advance.

Our long-term target for Gold of $3,000 per troy ounce2.

Notes

  1. Dollar Index (DXY) target of 85 is calculated as the peak of 93 extended below support at 89.
  2. Gold LT target calculation: base price of $1840/ounce + [TIPS yield of -0.87% – (nominal Treasury yield of 1.64% – real inflation rate of 5.30%)] * $400/ounce = $2956/ounce

Inflation is baked into the cake

Inflation is a hot topic at the moment. For good reason: higher inflation would drive up interest rates, affecting both bond and equity prices, as well as commodities and precious metals.

March CPI jumped to 2.64% but the increase is partly attributable to the low base from March 2020. Core CPI (excluding food and energy) came in at a more modest 1.65%. The main difference between CPI and core CPI is rising energy and food costs.

CPI & Core CPI

The annual inflation rate in the US ……is the highest reading since August of 2018 with main upward pressure coming from energy (13.2% vs 3.7% in February), namely gasoline (22.5% vs 1.6%), electricity (2.5% vs 2.3%) and utility gas service (9.8% vs 6.7%). Prices also accelerated for used cars and trucks (9.4% vs 9.3%), shelter (1.7% vs 1.5%) and new vehicles (1.5% vs 1.2%) while inflation slowed for medical care services (2.7% vs 3%) and food (3.5% vs 3.6%). Cost of apparel continued to fall (-2.5% vs -3.6%)……..a jump in commodities and material costs, coupled with supply constraints, are pushing producer prices up and some companies are passing those costs to clients. (Reuters)

10-year Treasury yields eased to 1.62% with the breakeven inflation rate at 2.33% — weakening the real 10-year yield to -0.71%.

10-Year Treasury Yield & Breakeven Inflation Rate

Inflation and the Money Supply

Milton Friedman famously said, “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.”

CPI & M2 Money Supply

But experience since the 1980s shows several surges in money supply growth without a corresponding rise in inflation. While an increase in money supply may be a prerequisite for a spike in inflation, it is not the cause.

More direct causes of inflation are increases in input costs for suppliers of goods and services. The two largest input costs are commodities and wages. Rises in commodity prices will mostly affect the manufacturing sector, while increases in wage rates impacts on all employers. Also, commodity prices tend to be cyclical, so price fluctuations will be more readily absorbed, while wage increases tend to be permanent and more likely to be passed on to customers.

The chart below shows a much closer correlation between hourly wage rates and CPI since the 1970s, with surges in hourly earnings accompanied by a rise in inflation.

CPI & Hourly Manufacturing Wages

Conclusion

Rising commodity prices are driving higher inflation at present. While some of the pressures may be transitory, due to supply interruptions, underinvestment in new production over the last decade is likely to act as a supply constraint for both energy and base metals. Rising demand fueled by short-term stimulus and longer-term infrastructure investment would act as an accelerant.

Wage rate increases are so far restrained, but that is likely to change as the economy recovers, boosted by decoupling from China and on-shoring of critical supply chains. Shortages of skilled labor are expected to drive up wage rates, maintaining upward pressure on inflation in the longer-term. Training and education of suitable staff will take time.

We have all the ingredients for an inflation spike. A massive boost in the money supply, accompanied by record stimulus payments, much of which has been channeled into savings. This will help to fuel increased demand in the longer term, while restricted supply will drive up commodity prices and wage rates for skilled labor.

Gold versus Bitcoin

Interesting question from Steve:

Bitcoin has broken through $50k, so there is now some USD940 billion in circulation. What would be the impact on the Gold price? It seems to me that many Bitcoin purchasers are buying as an alternative to buying Gold as a store of assets.

Bitcoin may be diverting some investors from gold but we believe this is marginal. Global gold reserves ($9.6T according to Perth Mint) are still 10 times the size of Bitcoin.

If we look at 2018, when Bitcoin fell from $19,000 to $3,200….

Bitcoin

There was little benefit to Gold which also fell for most of the year.

Gold in 2018

Again in 2020, when Gold peaked at the beginning of August….

Gold in 2020/21

Bitcoin remained flat for 3 months before commencing an up-trend in November 2020. And broke $20,000 on Dec 17th, while Gold was rallying.

Bitcoin in 2020/21

Conclusion

The rise in Bitcoin is not the cause of recent weakness in Gold.

We see Bitcoin as speculative and would not hold it as a store of value — any more than Dutch tulips.

Gold has served as a store of value for thousands of years and this is unlikely to change.