LOW YIELDS FOREVER?...WHY THE FEDERAL RESERVE DOESN T MATTER ANYMORE

Transcription

1 SWISS INFINITY INVESTMENT UDPATE OCTOBER 2015 ECHO FROM THE ALPS LOW YIELDS FOREVER?...WHY THE FEDERAL RESERVE DOESN T MATTER ANYMORE There is an intense debate going on about the Federal Reserve and when it will start to hike U.S. interest rates. The discussion and the speculation about the timing of an eventual move by the Fed is keeping markets on hold and has created a great deal of uncertainty and volatility in the last few months. Of course, there were and are other factors that add to this uncertainty but it is rather surprising how much confusion the rate discussion has been creating. The other big discussion topic at the moment is the slowdown of the Chinese economy and its impact on the global economy. Recent economic indicators and statistics clearly paint a mixed picture about the Chinese economy. What is clear is that there is a slowdown, no doubt about that and it might be even more severe than the official statistics show. The Chinese government still aims for GDP growth of approximately 7%, however, it looks like China is currently growing below this target growth rate. In fact trade statistics suggest that the true growth rate might even be below 6% at the moment. The tide is turning; after several years of recovery, the U.S. Dollar might soon be heading lower again These two factors, the debate about the Fed policy and the China slowdown, have been the main cause of volatility and negative sentiment in financial markets in the past few weeks. The concern about Europe and a possible Grexit (Greece leaving the Euro) are almost a non event these days. Also, nobody talks about the Ukraine conflict anymore and the unsolved problems between the Ukraine and Russia. We are indeed living in a fast moving world and the big story of today could be old news by tomorrow; even if the problem still exists. While the future of Federal Reserve policy and the China slowdown are 1 P age

2 economic questions, the main geopolitical hotspot right now is the situation in Syria. This situation continues to pose heightened conflict potential. However, it forces countries like the U.S., Russia, Europe and even local players like Iran, Iraq, Saudi Arabia and others to talk and find common ground for a solution or at least a strategy. This might not be bad, in fact, it might even create a situation of constructive dialogue and with it a chance to improve relations. This is especially true for Russia that wants to play a more important role again globally and to move out of the isolated position that it created in the last few years; especially due to the conflict with the Ukraine. The Syria conflict is something that all major countries should be concerned with. Having improved stability in the region is important for everybody. Right now, the ones that are suffering the most are the people of Syria that are trapped amidst the fights between the IS, various rebel groups and the troops of President Al Assad. The consequences of this ongoing conflict can be felt globally as waves of refugees flee the area trying to find shelter and stability in Europe and other places that offer them at least the chance for a better life. While this flood of refugees is creating short term challenges, especially for Europe, it would be naïve to think that this is only an isolated problem. A recent study shows that globally more than 200 million people are moving or are looking to move to other countries to flee from conflicts or to simply look for a better life for their families. Who can blame them? This makes also clear that this is a far bigger trend that goes way beyond the current situation with Syria. The developed world will face large challenges in coming years as it will get harder and harder to control borders and deal with millions of people who look to move away from their home countries. But back to financial markets and the recent developments there. After months and months of speculation about the Federal Reserve and their future interest rate policy, we know that they decided not to hike rates at their September meeting. They left the door open for a hike in December but given the recent headwinds for the global economy and some disappointing U.S. economic indicators (especially the job numbers in early October), a hike in December looks unlikely. It now looks like even a rate hike in 2016 looks less likely. No matter what the course of U.S. rate policy is going to be, global markets are too much focused on this and it looks like most have not yet understood what the real message behind all of this is. Unlike in previous economic recoveries, there is absolutely no way that we are going to see a series of interest rate hikes happening in Maybe we get a hike in December and maybe another one in 6 12 months but this is in sharp contrast to previous economic cycles. Depending on how one looks at it, we are currently in the eighth year of recovery and we are still far away from having a vibrant global economy. This will not change any time soon. That does not necessarily mean that things are bad, just slower from a global perspective. Oil prices have fallen by around 60% in two years and most commodity prices have fallen by roughly the same and this will of course have a deflationary effect. So a sluggish global economy, significant deflationary forces and a very competitive global market place are all factors that make it very unlikely for us to see any increase in interest rates in major financial markets any time soon. It looks very likely that this situation in not going to change in the foreseeable future. Now what does this mean for investors going forward? The implications are far reaching and, despite the outlook for slow global growth that continues, we feel that the changes and developments for financial markets will be very significant. Investors need to be aware of these coming changes as they will have a big impact on investment returns. Let s review the most important factors by starting with currencies and then look at equities, bonds and eventually precious metals. 2 P age

3 GLOBAL CURRENCIES: 10 5, 10 5, 10?? The most important story in the global currency market is the recovery of the U.S. Dollar in the last five years, after reaching an all time low in 2010/11, the greenback is up by almost 40% versus most major currencies. The current Dollar rally is the third major Dollar spike in the last 40 years, however, the major long term trend for the Dollar continues to move lower. Shorter periods (5 years on average) and longer periods of decline (10 years on average) followed each other in a surprisingly regular pattern over the last 40 years. The chart below shows the long term U.S. Dollar cycle and these changes over time. There are usually various factors at work when the Dollar moves up but in sharp contrast to the rally in the 80 s or the late 90 s, the current rally is not only driven by domestic factors such as GDP growth or the discussion about the Federal Reserve hiking interest rates, but equally by external factors given the various concerns such as the slow down in China or geopolitical problems in the Middle East or Russia/Ukraine. By all standards, the current valuation of the U.S. Dollar looks rather unsustainable. This is especially so given the anticipated changes in the global currency system, especially with the Chinese Yuan likely being awarded official reserve currency status in the coming months. The main question is what is going to drive the Dollar once the debate about the Federal Reserve and its future policy is over and everybody realizes that rates will not move much beyond a possible 25bps points hike? It would take a further, much stronger improvement in economic momentum in the U.S. alone as well as continued global turmoil to push more money into the U.S. Dollar. While this can t be ruled out short term, the longer term outlook makes it more likely that at some point the Dollar will move lower again. From an investment point of view, one of the biggest risks over the coming years is a potential correction in the U.S. Dollar similar to the corrections in previous cycles. 3 P age

4 INTEREST RATES: LOWER FOR LONGER MUCH LONGER U.S. bond markets are going to be very unattractive, at least by historical standards, for a long time to come. This does not necessarily mean that the bond market is in a bubble, but it is hard to believe that rates would move higher in the coming years. What can be observed in the U.S. can also be seen in a lot of other places in the world. There is a long and very powerful trend for yields to move lower, whereas interest rate hikes or cuts by the central banks can have an impact on yields at the shorter end of the curve, long term yields have been in steady decline for more than 35 (!!) years. So there is obviously a bigger trend/story driving long term rates. The deflationary forces in the global economy are significant, even before the recent sharp decline in energy and commodity prices. A global economy that has created a very competitive market with intense pricing pressure makes it almost impossible for prices to move higher. Another good example is the recent recovery in the U.S. jobs market, despite fewer workers out of work, salaries have not gone up; in fact they are lower than before. This is confirmed by the lower household income that the average family has. With the global economy still being relatively slow, it is simply impossible that upward pressure for prices is developing. It is probably very realistic to assume that at some point commodity prices and energy prices will move slightly higher again, but there is so much excess capacity that any increase in prices will be small and only temporary. So where can opportunities still be found in global bonds? In our view, investors need to have a closer look at global bonds denominated in foreign currencies. The currency component of those bonds is probably more significant than the interest income. This is especially the case for U.S. Dollar based investors that want to diversify some of their exposure into global currencies. While the strong Dollar has caused problems for these bonds in the last five years, the future might look very bright, especially should the Dollar indeed reverse its course and head lower. 4 P age

5 GLOBAL EQUITY MARKETS: ARE OLD VALUATION MODELS STILL APPLICABLE? There are many reasons why investors can argue that the current level of equity markets is either overor undervalued. Depending on the method of valuation that is used, there can be enough reasons found to justify most opinions and outlooks. We have witnessed some rather strange moves in global equity markets in recent years and it is obvious that there are different forces driving markets. While we believe that some of the common valuation methods are still valid, we feel that certain dynamics in the market have changed in recent years and these changes need to be addressed in valuation. An often heard argument today is that the stock market is expensive and at some point has to correct toward its fair value. There are many different views what the fair value is, but generally pricing measures such as P/E, Shiller P/E or PEG are being used to justify a certain view. While the U.S. market currently looks a bit expensive based on this view, most global markets look 10 20% undervalued; some even more. In the U.S. the current P/E of the market is about 15% above its long term average. Is this really expensive and does it really imply that there must be a correction somewhere down the road? Not at all, at least in our view because many different valuation methods need to be applied to figure out whether a market is over, fairly or under priced. The most extreme valuations we have seen were in the late 90 s with the overall stock market in the U.S. trading at almost twice the P/E we have now and this at a time when interest rates were significantly higher. Our view regarding global equity markets is that they are still very attractive today with maybe a few exceptions such as the U.S. where the market is clearly trading at a premium. At least in theory, future profits should deserve a higher premium, especially given the fact that interest rates are so low (these rates are used to discount future cash flows and therefore result in a higher present value of those cash flows). Despite the slow global economy, companies today are generally very lean and efficient and many of them face slowing costs due to lower energy and commodity prices. With labour prices also growing much slower than in the past, most companies have been able to generate some very decent profit growth in recent years. These profits, that are generated for the shareholders, deserve an even higher premium because in a world with ultra low interest rates (and therefore no easy returns for investors), people should be willing to pay more for these much wanted (and scarce profits). So there is a clear case to be made that equity markets have further upside from here. It seems that there has been more negative sentiment in the market and it was therefore not very surprising to see the increased volatility in recent weeks. However, this does not mean that this will last for very long. A strong year end rally is still absolutely possible and between the last quarter and next spring it is still possible that global equity markets move up by 10 20%. Historically equity investments during early November and the end of April have proven to be much more attractive. The market moves in the last few years clearly seem to confirm this as market corrections or at least soft patches usually happened between early summer and mid autumn. While we continue to feel optimistic on global equity prices going forward, we want to clearly point out a few risks that need to be managed properly. One thing that seems to have changed is that markets, especially short term, can experience sharp spikes in negative volatility and with it a sharp price correction. As long as the market corrects only by a few percent, a well diversified portfolio can certainly handle this. We see the big risk today that at some point the market could experience a very major correction (20%+) simply because everybody is watching the same news and wants to exit the room through the same door when the house is on fire. Markets are very fast moving and with the increasingly popular automated trading in global markets, short term trends and price movements seem to be stronger these days. This is the reason why investors should take a disciplined approach when it comes to hedging and protecting portfolios. Equities still tend to go up over longer periods of time, but 5 P age

6 the returns are severely diminished if the portfolio takes a full hit during times of sharp market corrections. PRECIOUS METALS: WHEN WILL GOLD SHINE AGAIN? This is a very hard call with complex dynamics and we don t know the exact answer to this question. We were admittedly surprised by the sharp decline of gold and silver prices in recent years. While part of that is a direct consequence of the strong Dollar and the liquidation of speculative holdings, prices are now at a level that make precious metals look very attractive again for the long term investor. So when are prices coming back to life again? The situation at the moment seems rather bizarre. While major gold producers with the most productive mines are currently having all in production costs of around USD 1 000, the current market price is only slightly higher, around USD as per the end of September. With prices being so low, many of the producers are not making any money at all and that is why we foresee a further decline in global production for the next two years. While physical demand (except for investment purposes) has remained very solid and even saw stronger demand in certain markets, investment and speculative demand has seen a sharp decline in recent years. Our opinion is that gold and silver prices are at a bottom or at least not far away from it but unless financial demand for gold is increasing again, there might not be any renewed positive sentiment. In sharp contrast to the paper market for gold and silver, the actual physical market seems to be very strong as most refiners are confirming. Some of them even consider the current situation as being extraordinary as suppliers are very tight. So if that is the case and prices in the futures market are flat, what is causing this disparity between these two markets? In our view there are two main factors to consider here. First of all, after a strong decline in prices in recent years, the market has failed to develop a new and more positive trend, that can be seen with the current prices going sideways at best. So due to the lack of positive sentiment, no new long positions were taken in the futures markets, at least not yet. Also, when looking closer at the investment demand for gold, it is interesting to see that a lot of large funds that invest in gold are not pure gold funds but actually are investing in a broad range of commodities including base metals and even soft commodities. So with most commodities having moved significantly lower, investors pulled out a lot of money and therefore these funds needed to liquidate their positions, including the precious metals. The selling pressure arising from this source will only decrease when commodities in general are starting to stabilize. 6 P age

7 SUMMARY Despite the negative volatility in markets the past few weeks, we continue to see equity markets moving higher over the next 1 2 years. While profit growth might be relatively slow, the premium that investors are willing to pay will continue to increase. The U.S. market looks more expensive and thus we see more opportunities in international markets. After a strong recovery in the last five years, the U.S. Dollar finally shows signs of peaking and moving lower in the coming years. While the exact timing is uncertain, it is hard to believe that the overvalued Dollar can keep these levels for much longer. For U.S. investors this might represent a once in a decade opportunity to diversify some of the currency risk. With good fixed income investments being harder and harder to find, it might make more sense to either keep higher levels of cash or park some of that money in precious metals for the time being. Gold and silver, in our view, have bottomed out and are now looking very attractive for the long term minded investor. With this short summary, we finish this update and are looking forward to hearing back from you. Should you have any questions we are happy to help, please do not hesitate to contact us. Kind regards from Switzerland, Daniel Zurbruegg CFA DISCLAIMER: This communication including any attached or linked appendices is provided for information purposes only. It is not offered as advice nor as an offer of any products or services. The content while believed to be accurate at the time of presentation is not guaranteed and any opinions are those of the writer(s). Swiss Infinity Global Investments GmbH disclaims any warranty or liability related to this communication. This information should not be used by parties not legally entitled to use it. This information should not be relied upon for making any investment decisions. You should seek personalised professional advice before making any investment decisions. Please contact us with any questions Swiss Infinity Global Investments GmbH is a registered Investment Adviser. Registration with the United States Securities and Exchange Commission or any state securities authority does not imply a certain level of skill or training. Additional information about Swiss Infinity Global Investments GmbH is available on the SEC s website at 7 P age