As much as things change, they seem to remain the same. Headlines are screaming that the Almighty Dollar is once again breaking new records and re-ascending its throne. Commodities, after staging a mixed but encouraging recovery, have resumed their pullback mode, much to the detriment of emerging markets across the globe. Is this déjà vu all over again? With election risk behind us, is this one last stretch of a strong USD on parade? Will Trump press the envelope enough to create inflation and the possible deflation of global stock markets? Too many questions and far too few answers…
The recent “Trump Rally” has surprised quite a few analysts in the investor community. An earnings recession had put a pall on markets for the better part of the last two years, but the current earnings season has been anything but negative. With 85% of S&P 500 participants reporting, 71% of that distinguished group has beaten earning expectations. The prevailing forecast beforehand had been for a 2.2% drop from the comparable quarter from twelve months back, but, to the consternation of all, the so-called earnings recession came to an abrupt halt, powered by 2.7% earnings growth.
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Consequently, the Fed will have little reason for postponing a rate hike in December. As a result, the U.S. Dollar has busted through its index ceiling of 100. Here is a chart:
After the election results were announced, financial markets went into a slow boil, gyrating to and fro until a new consensus began to emerge. A Trump Presidency might actually be good for business in the short term, especially if you discounted the long-term impacts of potential trade re-negotiations. The Dollar quickly jumped from its lethargic state, leapt upward above 100, and settled in at 101 and above. In two brief weeks, the Yen weakened from 102 to 112, and the Euro fell from 1.13 down to 1.05. Even gold bullion felt the heat and depreciated by nearly 10%.
Amidst these conditions, analysts are questioning whether this historic Bull market can keep going. With valuations topping out at “25X” multiples of trailing earnings, many wonder if the good times are behind us. Cheap money has fueled this fire, but the writing may be clearly on the wall. As one analyst noted, “There are good reasons to think that this bull-run is running on its last legs: Stocks are expensive; Monetary policy has run its course; Bonds are falling; The dollar is rising; The recovery might stall; Earnings could stall; Buybacks could retreat; Labor’s power could increase, and we have not even factored in the possibility of gray or black swan events.”
Black swans by definition are unknown, but the gray ones already proliferate the investment landscape. In anticipation of impending inflation, there has been a large sell off in the bond market. No one wants to be left holding an empty bag when the defaults start to ramp up. Forget Greece, Italian debt is the next in line for grief, as are emerging market countries that depend upon revenues from commodity sales and will cave at the first sign of U.S. and European protectionism. Banks in Germany also hold the largest book in debt derivatives and high-risk loans. One major hit could send ripples across the planet. Cheap money has created an artifice that is shaky by any measure.
How have commodities reacted to these changing tides?
While “Trump-phoria” has driven stock markets to new record highs and boosted the Dollar, commodity prices have moved unevenly in financial futures markets, primarily due to their inverse relationship to fluctuations in USD valuations. Commodity prices are traditionally priced in Dollars, and, in order to decipher what is truly transpiring in this sector of the market, adjustments for the vicissitudes of the greenback must be factored into the equation. As for commodity prices in general, the responses have been mixed. Some fell, some rose, and some stayed the same. Here is a brief rundown:
Oil: OPEC meetings in the coming weeks hold the promise that production cuts could actually become a reality. Crude has bounced over $48 a barrel in anticipation of good news, but there is no guarantee that Iran will capitulate with the Saudis. Low prices have been good for businesses and consumers this year, but, as most analysts had forecasted, oil prices have gradually increased above the $50 mark by April and stayed within a $43-$50 range since that time. The experts have expected demand to catch up with supply in the near term, but a cut in production could lead to a price spike. The original Saudi strategy was to keep prices well below the $50 range, the breakeven point for other higher-cost related types of crude oil. As a result, note defaults have been more prevalent in the energy sector, as high-cost producers continue to hang on for dear life.
Gold, Silver, and other Precious Metals: Election day jitters drove Gold, Silver and their other precious brethren to new highs, while stocks initially tanked and uncertainty reigned. Once the final results were announced and analysts had a bit of time to reach a consensus, the unthinkable happened. Markets reversed with reckless abandon. Stock markets recorded new highs, while the precious metal sector took it in the shorts. Gold hit $1338, then fell to $1201. Silver rose to $19.01, then dropped to $16.43. Platinum topped out at $1023, then declined down to $916. These new lows passed right through the recovery highs that were established after the Brexit referendum took place in June. It was carnage in the streets, except for Palladium, which behaved more in line with industrial metals and rallied 13.5% in the past two weeks to rest at $719. The upbeat mood that had prevailed obviously made some precious metals less precious.
Industrial Metals: Copper, Iron, and Zinc had been on upward swings for months, buoyed by favorable industrial data coming out of China. Combine this positive support with Trump’s promise to spend broadly on infrastructure projects and you have basic fundamentals that the market could not ignore. Copper, the bellwether leading indicator for increasing industrial demand, shot up nearly 12% from its stagnation ranging value from July. The sudden spike has retreated a bit, some 3.6%, with iron and zinc following on its coattails, brought about by a strengthening Dollar and a forecast that Chinese demand will slacken over time. Goldman Sachs has already proclaimed that the rally in Copper was too much, too fast, and foresees a slight pull back by yearend.
Will this current trend keep repeating? The near-term picture may be rocky, but the long term is another story according to one expert: “Right now, the threat of rising rates has traders punishing the gold and silver markets. But in the months ahead, the perceived threat could shift to that of inflation and the Fed being behind the curve. Precious metals tend to thrive in that sort of environment. When inflation outpaces rate increases, then rates are trending in a negative direction in real terms. Negative real interest rates are bullish for hard assets, regardless of whether nominal rates are heading up or down.”
What is the economic scenario for the next twelve months?
Unfortunately, it has been déjà vu all over again in emerging markets. Any tick up in treasury rates reverses their capital flow overnight. This sector had been an above average performer in 2016 up until the election. Emerging market indices plummeted on the Trump news, a harbinger of trade wars and forex volatility to come. As one group noted, “Coupled with the protectionist bias of president-elect Trump, investors are becoming increasingly concerned about the future prospects of emerging markets. The worry is that stronger U.S. growth will have a smaller impact than previously on emerging market growth under a protectionist president.”
Financial markets are currently wrestling with finding a plausible consensus for how the coming year will play out. The curve ball at the moment is Trump: “By the time Donald Trump is sworn in as president, the total national debt will exceed $20 trillion. Given his promises to not touch entitlements, to rebuild the military, and to spend big on infrastructure, there is no reason to expect the budget deficits to close. The only thing Trump might be able to do is make the debt more manageable by growing the economy.” The logical question then becomes where will this growth come from?
The growth will not come from consumers. American households remain heavily indebted. Mortgage applications are declining, as well, while new home starts are rising, another indication that the real estate market may be in for a severe collapse in prices. At present, the Trump growth plan demands huge deficit spending for infrastructure and military expenditures. Repatriation of foreign corporate profits, some $2.5 trillion, could wreak havoc on global capital flows, and there is no guarantee that businesses will invest the funds in domestic activities and jobs. During the Bush/Cheney era, a test program failed to deliver on its promises. Repatriated funds went to pay dividends, bonuses, and stock buyback programs. Whatever amounts went to M&A activity resulted in net job losses, as is typically the case.
The concern is that higher deficits will put more pressure on the bond market. Trade wars will increase import prices, leading to more domestic inflation, and then the only way out is to have an accommodative central bank that keeps interest rates low, the exact opposite of what the Fed’s current interest rate normalization plan entails. A conundrum exists with no easy solution forthcoming.
One cautious analyst quipped, “It’s a very, very bad situation that I think short-term exists for the bond market. And if I’m right, by the way, the 10-year note’s yield went from 1.83% the night before the election to 2.3% in the wake just a few days after the election. Now if that kind of trend even remotely continues, Mr. Trump unfortunately is going to be welcomed in – as so many other of his predecessors – with a recession, and maybe a very steep one.”
A repeating pattern is occurring in our financial markets, one that is not sustainable in the long run. At some point, something has got to give. All eyes are focused on Trump and his team of advisors. What policies will they put in place to deliver growth and the jobs that were promised during the campaign, without putting too much pressure on bond prices? Change is coming, but it may wear many disguises in the days to come.
Stay cautious, and keep your powder dry.