Why the “Bond King” Has Never Been More Bearish

Justin Spittler


The bond “super bubble” is coming to an end.

For the last three decades, U.S. bond prices have been in a steady uptrend. This epic bond bull market survived three recessions, the dot-com crash, and the 2008–2009 financial crisis.

Because of this, bonds have become very popular with investors. You can see why in the chart below, which shows the Dow Jones Equal Weight U.S. Corporate Bond Index since 1997. This index tracks the performance of U.S. corporate bonds.

As you can see, a $100,000 investment in corporate bonds 20 years ago would now be worth more than $360,000. What’s more, corporate bonds did relatively well during the violent stock selloffs that occurred in 2000–2002 and 2007–2009.



Many investors have gotten used to making safe and steady returns in bonds.

But it looks like those days are over…

• Over the last few months, bond yields have skyrocketed…

A bond’s yield rises when its price falls.

The yield on the U.S. 10-year Treasury has jumped from a record low of 1.37% in July to 2.23% today. We’ve seen similar spikes in two-years all the way up to 30-years.

The same thing is happening overseas. Yields on French, Italian, and British government bonds have all hit multi-month highs over the last few days.

This is a huge deal. Just four months ago, MarketWatch reported that global interest rates reached the lowest level in 5,000 years.

• Still, you might not be worried about this if you don’t own any bonds…

But you must understand that the bond market is a cornerstone of the global financial system.

If it unwinds, it’s going to impact everything from stocks to the economy at large. We’ll explain what could happen in a minute.

But first, let's look at what some of the world’s smartest investors have to say about this.

• Ray Dalio thinks bond prices have peaked…

You've probably heard of Dalio. He manages more tan $150 billion at Bridgewater Associates, the world’s largest hedge fund.

Yesterday, Dalio explained why he thinks the bond market’s topped out:

[W]e think that there's a significant likelihood that we have made the 30-year top in bond prices. We probably have made both the secular low in inflation and the secular low in bond yields relative to inflation.

In the investing world, secular means long-term. In other words, Dalio’s saying bond yields and inflation rates have bottomed.

Now, we know higher bond yields are bad for bond prices. But rising inflation is also bad for bonds.

Inflation measures how fast prices for everyday goods and services rise. The higher the inflation rate, the faster everyday prices rise.

High inflation is obviously bad for the average person. It means the money in their wallet doesn’t go as far. It’s also bad for people who own bonds. That’s because inflation eats away at a bond’s future payments.

• If Dalio’s call sounds familiar, it’s because we’ve been saying the same thing for weeks…

On October 19, we told you that bondholders could take heavy losses if inflation keeps rising.

More recently, we've shown you plenty of reasons why inflation is likely headed higher.

This is clearly bad news for bonds. Unfortunately, many people are still on the wrong side of this trade. Dalio wrote yesterday:

When reversals of major moves (like a 30-year bull market) happen, there are many market participants who have skewed their positions (often not knowingly) to be stung and shaken out of them by the move, making the move self-reinforcing until they are shaken out.

• Jeffrey Gundlach also thinks the 30-year bull market in bonds is over…

Like Dalio, Gundlach is a world-class investor. He runs DoubleLine Capital, an investment firm that oversees more than $100 billion. He’s also one of the world’s leading bond investors.

He’s known on Wall Street as the “Bond King.”

According to Barron’s, Gundlach turned bearish on bonds months ago:

Gundlach says, he turned “maximum negative” on bonds on July 6, two days before the 10-year Treasury yield hit a multidecade closing low of 1.366%. He predicted shortly thereafter that the 10-year yield would top 2% by year end.

Gundlach’s prediction was spot-on. Remember, the U.S. 10-year currently yields 2.23%.

Since the election, Gundlach’s become even more bearish. Barron’s reported over the weekend:

Trump’s pro-business agenda is inherently “unfriendly” to bonds, Gundlach says, as it could to lead to stronger economic growth and renewed inflation. Gundlach expects President-elect Trump to “amp up the deficit” to pay for infrastructure projects and other programs. That could produce an inflation rate of 3% and nominal growth of 4% to 6% in gross domestic product. “If nominal GDP pushes toward 4%, 5%, or even 6%, there is no way you are going to get bond yields to stay below 2%,” he says.

In a way, this is good news. After all, what American wouldn’t want the economy to grow faster?

• Unfortunately, Trump’s pro-growth policies could come at a steep price…

For one, inflation could take off. We could also see more deficit spending, more debt, and more currency debasement.

Plus, problems in the bond market could spill over into other assets, like stocks. Dalio wrote yesterday:

The question will be when will this move short-circuit itself—i.e., when will the rise in nominal (and, more importantly, real) bond yields and risk premiums start hurting other asset prices.

Gundlach is also worried about the side effects of rising yields. Barron’s reported:

“[T]he structure of the U.S. economy and the pricing of the stock market are predicated on 1.5% Treasury yields and zero short-term interest rates.” Rising rates would hurt the U.S. housing market and possibly dent corporate stock-buyback programs. Buybacks helped boost share prices in recent years and were funded, in many cases, with borrowed money.

A buyback is when a company buys its own shares off the marketplace.

Since the financial crisis, Corporate America has borrowed enormous sums of money to pay for buybacks. As we’ve explained many times, buybacks are a big reason stocks have kept rising even though earnings have been falling.

If rates keep rising, it will become much more expensive for companies to borrow money…and that could kill the buyback craze. In short, the stock market could lose one of its biggest sources of demand.

• To be clear, we aren’t saying higher rates will kill the buyback craze overnight…

But it’s something we’re going to keep a very close eye on. It’s also something to think about before diving headfirst back into stocks.

Chart of the Day

Dividend-paying stocks are getting crushed…

Today’s chart shows the performance of telecom stocks, real estate stocks, and utility stocks over the past month. All three of these sectors are known for paying steady, often generous dividends.

When bond yields are low or falling, many investors like to own these stocks. When yields are high or likely to rise, investors don’t like these stocks as much. That’s because it's easier for them to earn decent income in other assets, like bonds.

Over the past month, telecom stocks are down 7.5%. Real estate stocks are down 4.2%. Utilities have fallen 4%. According to MarketWatch, these are the three worst-performing sectors in the S&P 500 over that stretch.

If rates keep climbing, these stocks should continue to lag the market. Keep this in mind if you own stocks in these sectors, or any stock that you bought mainly for its dividend.




sábado, noviembre 26, 2016

EGYPT AS A REGIONAL NON-POWER / GEOPOLITICAL FUTURES

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Egypt as a Regional Non-Power

Domestic political and economic problems have constrained the country's influence over other Arab states.


Summary
After long being the center of the Arab cultural and political world, Egypt’s power and influence has declined in recent decades. Since the 2011 Arab Spring uprising, which was led by the urban middle class, the country’s regional status has taken a major hit. Furthermore, domestic political and economic issues now constrain Egypt’s once-dominant position. Cairo is no longer able to fend for its own political economy – a situation that is unlikely to be reversed in the foreseeable future.
  • Once the leader of the Arab world and a major player in the Middle East, Egypt now struggles to maintain domestic stability in large part due to a struggling economy.
  • The current government faces no challenges from any opposition movement; however, the regime is a threat to itself. For decades, the authoritarian republic’s stability kept chronic economic woes in check; now, they are getting out of hand in the wake of autocratic meltdown.
  • While Egypt won’t collapse, it is unlikely to improve its domestic political economy anytime soon – much less project power beyond its borders.
Introduction

Many of our readers have noticed that we do not include Egypt among the four powers of the Middle East (Turkey, Israel, Iran and Saudi Arabia). Some have written to inquire about our rationale for this assessment. It is a reasonable inquiry given that the country has long represented the intellectual core of the Arab world and remains its largest nation by population. Egypt also maintains the largest Arab military (the 12th largest military in the world).


Egypt and Major Powers of the Middle East

Despite these factors, Egypt has been losing its ability to shape the Middle East since the 1980s due to a number of domestic security and economic issues. Even so, it managed to chug along. For many years, the authoritarian state’s growing internal weakness was masked by its ability to suppress dissent at home. However, that veneer was shattered in early 2011 with the Arab Spring uprising, which led to the ouster of former President Hosni Mubarak.

 

Top 20 Military Budgets

In many ways, the underlying factors shaping Egypt’s current crisis were present even before Mubarak’s removal but were exacerbated by the Arab Spring. It is important to note that although the military-dominated regime was not overthrown in 2011, the political system was jolted enough that the state has struggled to maintain stability. In the five years since mass unrest erupted on Jan. 25, 2011, instability has weakened Egypt to the point that it needs massive external financial assistance to manage its own political economy. Even though the regime has thus far succeeded in quelling dissent, Cairo has become increasingly dependent on Saudi Arabia and the other energy-rich Gulf Cooperation Council (GCC) allies to pay its bills.

Egypt and Surrounding Area

 
The Dismal Economic Picture

To understand why Egypt’s power and influence have declined, it is necessary to examine its economy, which has significantly weakened since the July 2013 coup during which military chief Abdel-Fattah el-Sissi took power from President Mohammed Morsi. Morsi was the country’s first democratically elected president and a member of the Muslim Brotherhood (the largest group on the Islamist side of Egypt’s political spectrum); el-Sissi was elected president in 2014.

In an unprecedented move last week, and in order to meet conditions for a $16 billion loan from the International Monetary Fund (IMF), the Central Bank of Egypt devalued the Egyptian pound from 8.8 to 13 on the dollar and then floated it. Since then, the dollar has been fetching around 18 pounds on the open market. As a result, the prices of goods imported to Egypt will increase by about 45 percent. At the same time, gas prices will increase by 30-47 percent depending on the type. Additionally, Egypt’s fuel subsidy cut also came into effect last week as part of a plan to slash its total subsidy bill by 14 percent.

Cairo has resisted subsidy cuts for years, but its hand has now been forced by the devalued and floated currency – something Egyptian Prime Minister Sherif Ismail acknowledged when he told journalists on Nov. 4, “today, we don’t have the luxury to postpone these decisions; today, we can’t take painkiller decisions.” These changes come at a time when Egyptians are still adjusting to government subsidy cuts that increased electricity prices by up to 40 percent from August. A 13 percent value-added tax also approved by parliament in August is now being phased in.

As part of the agreement with the IMF, Egypt needed to secure as much as $6 billion in additional financial support from other countries. Egypt received $2 billion from Saudi Arabia and $1 billion from the United Arab Emirates, and a Central Bank official said on Oct. 30 that the country had reached a currency-swap deal with China valued at $2.7 billion. Thus far, however, only 60 percent of the bilateral financing has been secured and Cairo is still working toward securing the remaining 40 percent. Tarek Amer, the head of the Central Bank of Egypt, warned that the expected economic benefits resulting from the recent changes will not be seen until 2018.

Egypt spends as much as 10 percent of its annual GDP on subsidies, with fuel subsidies accounting for two-thirds of that amount. Since the government has decided to float its currency, Egypt – which relies on imports to meet its energy needs – will now face higher costs for gasoline and other oil products. Egyptians will see rising costs also because of the government’s subsidy cuts.

Meanwhile, the Saudis informed the Egyptians last month that they would halt supplies of refined oil products despite Riyadh agreeing earlier this year to provide Cairo with 700,000 tons of refined oil products per month for five years. The arrangement was valued at about $20 billion. Egyptian Oil Ministry spokesman Hamdi Abdel-Aziz said the kingdom gave no reason for the stoppage, nor did it provide a timetable for when it would occur. The Saudi decision adds more strain for the Egyptians, who will have to search for alternative (and potentially more expensive) sources of refined oil products and will potentially have to spend more.

In addition to economic pressure from increased petroleum costs, proceeds from tourism, a major source of revenue for Egypt, declined by 15 percent in 2015. Only 1 million tourists visited Egypt in 2015 compared to 1.7 million in 2014 and 1.4 million in 2013.

Another factor in Egypt’s dismal economic picture is its unemployment rate. Of Egypt’s population of nearly 90 million, roughly 40 percent are between 10 and 20 years old. Overall youth unemployment in Egypt stands at 30 percent, which is more than double the national unemployment rate of 12.8 percent. Furthermore, the unemployment rate for university graduates is 34 percent, compared to just 2.4 percent for youth who have only a primary level education. These statistics are of particular concern because young people can create mass unrest in hard economic conditions.

 
Egypt's Dismal Economic Picture, 2016

In addition, Egypt’s national inflation rate has reached double digits since last April and is currently estimated at 15.5 percent. The government faces large budget and current-account deficits – some 12 percent and 7 percent of GDP, respectively. At the time of the 2011 uprising, foreign exchange reserves stood at $36 billion but dropped to $15.5 billion last July. They currently stand at $19.6 billion – but only after a fresh influx of money from the GCC states. These numbers underscore that it will be extremely difficult for Cairo to fix the national economy.
The Regime Poses a Threat to Itself
Egypt’s severely declining economic conditions have destroyed the massive political capital that el-Sissi enjoyed when, backed by popular demand, he took power and was seen as the nation’s savior. (Indeed, tens of millions of people took to the streets during the July 3, 2013 putsch to force out the Muslim Brotherhood’s short-lived and unpopular government.) El-Sissi’s government was successful in part because it was able to quickly suppress any dissent from Brotherhood supporters; this was possible largely because the state’s security apparatuses retained their coercive capabilities through the 2011 upheaval. Neutralizing political opposition, however, does not help Cairo on the economic front.
El-Sissi has benefited from the fragmented nature of Egypt’s political landscape; as long as the country’s political opponents are divided, the regime can play them off of one another. This holds true for both sides of the Islamist-secularist ideological divide. On the secular end of the political spectrum are multiple small entities that lack broad popular appeal. On the Islamist side, the Brotherhood (the largest of the Islamist movements) faces challenges from rival groups, especially the largest Salafist party, Hizb al-Nour, which has been supportive of el-Sissi.

The threat from Egyptian jihadis has also helped el-Sissi consolidate his government. Cairo has been able to use the threat of the Islamic State along with the fate of Libya, Syria, Iraq and Yemen to prevent insurrectionist Islamist forces from making too many inroads. This has been accomplished by exploiting public fears of anarchy; el-Sissi has warned that unrest will benefit IS and could potentially lead to situations similar to those abroad. Although Egypt saw a series of attacks from jihadis pledging allegiance to IS shortly after el-Sissi came to power, the state’s intelligence apparatus appears to have largely neutralized the threat and limited it to the Sinai Peninsula.

The regime faces no threat from any organized movement, whether peaceful or violent. Therefore, the current order is unlikely to be overthrown by an opposition group. Instead, the challenge to the el-Sissi government comes from within, including its greatest threat, the highly turbulent economy. On this front, it encounters massive constraints – partly because it inherited many of the problems that emerged after the Arab Spring. The regime faces numerous ongoing structural problems that cannot be resolved in the short term, a situation that is complicated by the state’s lack of resources.

To a great extent, many of the country’s economic woes are chronic and thus hardwired into its society. For instance, despite having a large population, Egypt has very few resources. Although it has some natural gas reserves, it has gone from being a natural gas exporter to an importer, which has had a further negative impact on the economy. Additionally, most of the population resides along the Nile River Valley, creating problems associated with population density and limiting the area where economic activity takes place. Any government would be unable to change these fundamental ground realities.

 

Egypt's Gas Consumption

 

The nature of the regime further limits its options for combating economic issues. The modern Egyptian republic, founded in 1952 when Gamal Abdel Nasser led a group of army officers to oust the monarchy, was designed with the military at its center. Every president since (with the exception of Morsi during his one-year rule following the Arab Spring) has been a former military commander. The armed forces remain the country’s only coherent institution and have controlled large swathes of the economy since the republic was founded, leaving very little room for private Enterprise.    
     
The Fall of the Once Mighty 
     
The 1952 coup was as much a domestic revolution as it was a regional one, resulting in Egypt leading pan-Arabism under the Nasser regime. Then, during the 1950s and ’60s, the Egyptians led the drive towards secular republicanism; they did this against the traditional monarchical regimes led by the Saudis. Egypt’s influence spread throughout North Africa, the Levant, the Arabian Peninsula and even Mesopotamia. Through short-lived initiatives, Egypt also formed a unified polity with Syria in 1958 to establish the United Arab Republic, which formed a loose confederation with the Mutawakkilite Kingdom of Yemen (also known as North Yemen). This confederation was called the United Arab States.

Nation-state-based nationalism held sway over pan-Arab form, and both of these entities dissolved in 1961. Egypt, however, continued to lead the Arab world even after its shocking defeat in the 1967 war against Israel. It launched another war against Israel in 1973, and although Egypt failed to win, it negotiated a peace treaty with Israel in 1978 and remained the undisputed heart of the Arab world until the early 1980s. However, its failure to establish a viable political economic system limited its success thereafter.

While the military was prevented from having direct involvement in politics during the Nasser era, genuine civilianization of politics has failed to take root because the military has continued to dominate the system and created a single-party regime with an autocratic nature. Nasser founded the Arab Socialist Union (ASU) as a civilian vehicle to oversee governance while the military ruled from behind the scenes. Nasser’s successor, Anwar Sadat, then replaced the ASU with the National Democratic Party (NDP). After Sadat’s assassination in 1981, Mubarak led the NDP for three decades. His 30-year dictatorship created resentment among the masses, which erupted in 2011 and resulted in his own ouster in the wake of the Arab Spring.

Further weakening Egypt’s influence, the NDP was disbanded when the military took direct control of the government after Mubarak was forced to step down. This move created a problem that the military has not yet been able to solve: the lack of a political vehicle through which to control the polity. When the Brotherhood won parliamentary and presidential elections in 2012, the military briefly moved to establish a modus vivendi with the Islamist movement, which was evident from the fact that the constitution crafted during the short Brotherhood reign gave massive authority to the armed forces. The Brotherhood appeared able to establish a working relationship with the military regime, as has been the case with the Islamist movement’s counterparts in Tunisia and Morocco.

However, the Brotherhood’s strategy of trying to placate the armed forces while pushing out competing political groups (secular as well as Islamist) backfired.
Meanwhile, even as it tried to forge an arrangement with the Egyptian military, the Brotherhood faced opposition from other parts of the establishment as well as from civil society groups. It resulted in the uprising that was led by the Tamarod movement on June 30, 2013. The resulting gridlock, with Morsi refusing to step down, created a situation where the military had to once again hit the reset button.

Egyptian opposition protesters chant during a demonstration in Tahrir Square as part of the "Tamarod" campaign on June 30, 2013 in Cairo, Egypt. Crowds of pro- and anti-Morsi protesters gathered in locations across Egypt on June 30, the day of a series of nationwide mass demonstrations entitled "Tamarod" or "Rebel," planned to take place on the first anniversary of Morsi's election. Ed Giles/Getty Images
 



When establishing the new government, the military chief – el-Sissi – hung up his uniform to become elected as a civilian president. El-Sissi was popular with the masses because they believed he could stabilize the country; the regime hoped this popularity would buy time to improve economic conditions so that the people would not return to Tahrir Square, the site of both the 2011 uprising and the 2013 coup. However, those hopes have not materialized, as is evident from the economy’s continued downward slide despite an influx of billions of dollars.

The regime is incapable of engaging in the kind of economic reforms that are needed to reverse the current economic trend. For instance, the Egyptian citizenry is accustomed to its subsidies, and eliminating them could lead to much larger protests than those associated with the Arab Spring. Furthermore, IMF officials have reportedly described Cairo’s changes to secure the IMF loan as cosmetic. The changes have likely been cosmetic because the regime fears that large-scale reform measures could spark the very unrest that it is hoping to avoid. For instance, the prime minister acknowledged the risk during a Nov. 3 press conference by recalling the 1977 Bread Riots that erupted over austerity measures (including subsidy cuts), forcing Sadat to cancel the measures.

Conclusión

The post-Arab Spring climate is far more volatile than Egypt’s climate was during the Bread Riots. However, caught in a very difficult situation, the regime has no choice but to secure IMF funding to prevent the economy from further declining. This is especially true since Saudi Arabia and the other Gulf states are unable to assist Egypt given the plunge in oil prices and the rise in their domestic and foreign expenses due to regional turmoil. Should the economic situation get particularly dicey and people take to the streets, el-Sissi will become the regime’s scapegoat. The generals will be forced to once again open up the political system, removing the president and allowing another round of democratic elections in order to weather the economic storm.

In addition, Egypt lacks the resources to deal with regional conflicts outside its borders despite having a large military force and no external challengers. For example, it has refrained from playing much of a role in neighboring Libya, where
a complex civil war is underway. Even regarding the Palestinian conflict, with which Egypt has been heavily involved in the past, Cairo has not been able to do much. It stands to reason, therefore, that Egypt will also be unable to play a role in Syria and the war against IS. Regardless of how Egypt attempts to muddle through its deep economic malaise, it is clear that the country will continue to struggle on the domestic front for quite some time. Moreover, it will not regain its ability to be a major influencer in the Arab world.
 


Turkey’s Erdogan threatens to let 3m refugees into Europe

Turkish president responds angrily to parliament vote to suspend membership talks

by: Laura Pitel in Ankara and Arthur Beesley in Brussels


© Reuters



Turkey’s president Recep Tayyip Erdogan warned Brussels on Friday he would allow 3m refugees to cross over to Europe unless the EU softened its criticism of Ankara.

The Turkish leader lashed out a day after the European Parliament called for a pause in Turkey’s EU accession talks in protest at Ankara’s “repressive” and “disproportionate” response to a violent coup attempt earlier this year.

Mr Erdogan, who has previously warned that he could put refugees “on buses” to Europe, hit out angrily in response to the non-binding vote.
“We are the ones who feed 3m-3.5m refugees in this country,” he said. “You have betrayed your promises. If you go any further those border gates will be opened.”

The EU struck a crucial but controversial immigration deal with Turkey in March after hundreds of thousands of people crossed illegally from Turkey to Greece last year.

In exchange for a series of promises, including accelerated membership talks and steps towards visa-free travel for Turkish citizens to the EU’s Schengen zone, Turkey agreed to crack down on smugglers and to accept migrants and refugees returned from Greece.

The agreement and other measures have dramatically reduced the numbers crossing the Mediterranean, but it has been complicated by growing anti-EU sentiment in Turkey and fears of increasing authoritarianism that have only deepened since July’s aborted coup attempt.

​​Mr Erdogan’s remarks met a chilly response in Brussels, where officials insist Europe is upholding its side of the migrant deal.

“Rhetorical threats are absolutely unhelpful and should not be the standard tone between partners,” said a senior EU official. “This will not help Turkey’s credibility in the eyes of European citizens. Europe will not be blackmailed.”
But Ankara argues that Brussels has failed to uphold its end of the bargain. European leaders, meanwhile, have been alarmed by warnings that Mr Erdogan is using the failed putsch, which left 241 people dead, as cover to pursue not only those connected to the plot but also academics, journalists, Kurdish opposition politicians and other critical voices.

The Turkish president has also threatened repeatedly to respond to popular demand to bring back the death penalty, a move the EU has warned would instantly put an end to Turkey’s longstanding accession bid.

The vote by the European Parliament reflects growing frustration and hostility on both sides of the Turkey-EU partnership but is non-binding. Only European governments have the power to put a formal end to Turkey’s accession talks.

While Austria has called for a halt to the process, Germany, France and most other EU states support continued engagement. They see Turkey, the world’s largest host of refugees, as a difficult but vital partner for tackling the migration crisis and maintaining the cohesion and stability of the bloc.

Ankara is also an important security partner in the battle against Isis, intercepting foreign jihadist fighters seeking to reach Syria or Iraq from its territory.

Some analysts have questioned whether Mr Erdogan would follow through on his ultimatum to open up the borders, given that the Turkish authorities have imposed travel restrictions on large numbers of Turkish citizens.

Several alleged leaders of the July coup attempt are reportedly on the run, while many other people have been subjected to travel restrictions since the coup, as the government has sacked 125,000 people from the military, police and the public sector.

sábado, noviembre 26, 2016

GOLD: WHAT´S NEXT? / SAFE HAVEN

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Gold: What's Next?

By: Axel Merk


After an initial surge in the hours after Donald Trump's election, the price of gold has been under pressure. To gauge what's ahead for the yellow metal, we dissect the forces that may be at play.
Gold Cartoon
 
 
We have argued in the past that for investors to consider any investment, including gold, in their portfolio, it needs to satisfy two conditions: it needs to exhibit low correlation to their existing investments; and there should be an expectation of a positive return. Let's evaluate the changing investment landscape for gold in the context of the election:
 
Gold as a diversifier?

 Since 1971, the price of gold has had a zero correlation to the S&P 500 index based on our analysis (-0.016 based on daily returns, to be precise). From that point of view, gold may be a long-term diversifier. That said, there are times when the correlation is positive; others when it is negative:
 
Gold versus S&P500 1970-2016
 
 
The traditional way to look at a portfolio is one that contains both equities and bonds. As such, let's also look at the correlation of gold versus bonds: since 1971, that correlation is 0.024, i.e. also quite low. However, if you look at the chart below, you will see that the correlation to bonds has been at historical highs of late:
 
Gold versus US Treasuries 1970-2016
 
 
We will talk more about bonds below when we discuss fundamental drivers, but as far as whether the relatively high correlation to bonds of late will persist - if history is any guide, it may well fizzle out rather soon.
 
Differently said, when it comes to gold as a diversifier, we believe the long-term case is strong, but some investors may not appreciate it when correlations to equities or bonds flares up.
 
In the past, we have said gold may well be one of the 'easiest' diversifiers, meaning gold is easier to wrap one's head around than, say, a long/short equity or currency strategy that, by design, may also have a near zero correlation to other asset classes. But that 'easy' diversification comes with a price: the low correlation isn't stable, and there are times when correlation can be elevated.
 
Gold in a market downturn

Staying on the theme of gold as a potential diversifier, the price of gold has had a positive return in each bear market in equities since 1971, with the notable exception of what I might call the Volcker-induced bear market when interest rates were rose substantially:
 
S&P500 versus Gold 1971-2016
 
 
We will talk about interest rates in a second, but let me explain a fundamental reason why gold might have performed well in each of these bear markets: in an era where "risk premia" are compressed, i.e. where prices of risky assets - be that junk bonds or equity prices - are elevated, we believe those prices are vulnerable should risk premia rise once again. That is, if for whatever reason, the market is allowing risk once again to be priced more highly into assets, it could provide major headwinds to both stocks and bonds. As a result, gold, with its low correlation to risk assets, might shine in a bear market.
 
Gold to provide positive returns?

While investors may appreciate diversification, they may appreciate positive returns even more. We have had a notable selloff in bonds since the election; and, as one can see from above, the price of gold has, of late, been correlated to those of bonds. So what is going on?
 
We have often argued that the biggest competitor to gold is cash: if investors get properly compensated for holding cash, the case to hold gold, an unproductive asset, is reduced. A "proper" compensation for cash may be an acceptable real interest rate on cash.
 
Currently, real interest rates, i.e. interest rates net of inflation, are close to zero (let's sidestep the discussion whether any particular metric of inflation fully reflects cost of living increases).
 
The question then is to what extent will a Trump presidency change that. Two of the major themes that come to mind are infrastructure spending and less regulation:
  • Infrastructure spending. We believe a) Trump will get at least some infrastructure spending done, and b) that it will be inflationary. Trump is a deal maker, so he may well promise some Senator their favorite bridge to nowhere if he will let him build his wall. This is a simplified way of saying that in Washington, it should be possible to spend money by making promises across the aisle, even if budget conscious Republicans object. In an environment where unemployment is already low, we believe this will induce wage inflation. Last time we checked, the government is usually not the most efficient in allocating resources, i.e. a fiscal spending program may foremost increase the deficit. Incidentally, we observe that currencies of countries where inflation ticks up often rise versus peers; while that may sound counter-intuitive, the reason is that investors assume central banks will counter inflationary pressures with higher interest rates. As such, if one believes the Fed will be "ahead of the curve", i.e. hike interest rates before inflation picks up, that would be a negative for gold. If, however, investors believe that the Fed will fall further "behind the curve," we believe there's a good chance gold will do well, even as nominal rates move higher.
  • Even if Congress doesn't pass legislation a President Trump proposes, he should have substantial influence on how agencies are run, suggesting that he should be able to execute on his promise to reduce the regulatory burden on business. If history is any guide, the pendulum is unlikely to swing quite as much as hoped for (or feared - depending on where one stands on this debate); however, on the margin, this should be a positive for investments. One of the reasons the long-term bonds have yielded so little is because businesses have preferred to purchase financial assets (e.g., share buybacks) rather than invest in real business. As such, to the extent that the selloff in the bond market reflects that businesses would now rather invest in new ventures (rather than the prospect of higher inflation), we believe it is negative for the price of gold.
There's also the proposed tax cut; we'll have to see to what extent what is on the drawing board can be implemented, but any simplification of the tax code might also encourage investment.

We have not seen Trump propose any serious fix to what may be the soaring cost of entitlements.

That is, even before additional fiscal spending proposed by President-elect Trump, deficits may balloon in a few years.

What we haven't mentioned is the potential impact of a trade war. At this stage, the market appears to suggest that Trump might back off from his anti-trade rhetoric. The reason we think so is because we think the dollar is vulnerable in a trade war; that's because we need foreigners to finance U.S. deficits; the U.K. is the latest example of a country that relies on financing from abroad to have seen its currency suffer when trade barriers have risen (a vote for "Brexit" suggests the introduction of trade barriers). The dollar might not decline versus the Mexican peso or other emerging market currencies, but it may well decline versus major currencies and gold.

So what will happen to the price of gold?

We expect to see a battle of the various forces discussed above. For now, the market may be pricing in stronger real growth through less regulation, with a Fed able to raise interest rates as the economy strengthens. In many ways, we have seen this movie before, with the market anticipating a rate hike due to improving fundamentals.

The problem is that we have such a leveraged economy, that higher bond yields and the anticipation of higher rates may well cause risk premia to rise, i.e. volatility in the market to increase, possibly toppling over equity prices. The associated volatility may cause 'financial conditions to deteriorate' as the Fed likes to put it, causing them to back off from any hawkish plans. That is, the anticipation of higher real rates may fizzle out yet again, providing support for the price of gold.

And aside from higher rates being a source of market volatility, it may well be that Trump policies themselves, such as the introduction of trade barriers, may cause volatility to rise and gold to benefit.

In short, if investors believe the future is bright, with businesses increasing investments and with the Fed's magic wand doing wonders to keep inflationary pressures just right without causing too much of a stir, gold might not rise in value.

If however, investors believe that this tug of war between the different forces will ultimately get the Fed to be 'behind the curve,' i.e. inflationary pressures to increase; or if investors believe the stock market might experience another bear market, then gold may continue to be a worthy diversifier.

For those who believe that this will be a repeat of Reaganomics, we would like to caution that Reagan came into office when unemployment was much higher and with a most hawkish Federal Reserve Chair.

Finally, in addition to all of the above, the Fed continues to sit on a huge balance sheet; that balance sheet hasn't been a problem with lackluster growth; but we see major challenges ahead for both stocks and bonds if indeed we get significant growth out of the Trump policies. We shall dive into these risks more in a future analysis.

We don't have a crystal ball, but we believe in prudent risk management. As such, we encourage investors to assess the risks of certain scenarios unfolding. If we then add to that the fact that gold has a low correlation to bonds and equities, we believe investors may want to consider including gold in a prudent asset allocation.


Barack and Angela’s Tragic Romance

The American president and the German chancellor will share a legacy as long-term thinkers, advocates of openness — and, perhaps, as the last of their kind.

By Joerg Forbrig

Barack and Angela’s Tragic Romance


On what is his last tour of Europe this week, and what is likely to be his last major tour abroad, outgoing U.S. President Barack Obama has reserved a full two days for Berlin. This unusually long visit to the German capital is not a coincidence. It is here that he first became a figure of global importance when, in July 2008, the then-candidate mesmerized a crowd of 200,000 Berliners. It is here that he developed his strongest rapport with any world leader: German Chancellor Angela Merkel. Most importantly, however, it is here that his foreign-policy legacy now has its strongest, if not last, line of defense.

That Obama would develop this level of political and personal intimacy with the country was hardly obvious eight years ago. In character alone, Obama and Merkel made for something of an odd couple.

The charismatic orator met understatement personified. The public intellectual outshined the reclusive scientist. His biography spans the globe; she hails from provincial East Germany. The one roused sky-high expectations; the other was eternally underestimated. And if Obama’s attention was drawn to the rising powers of Asia, Merkel was focused on keeping the Old Continent afloat. It seemed improbable back then that the two leaders would form any bond beyond the polite and profesional.


Joerg Forbrig is a senior transatlantic fellow with the German Marshall Fund of the United States in Berlin.