Jay Powell’s challenge at the Fed

He must work out how to achieve growth that is adequate and financially sustainable

Lawrence Summers

If the Fed raises rates sufficiently to assure financial stability, there is the risk the US economy will slow too much © Bloomberg

Janet Yellen has completed her term as chair of the US Federal Reserve with unemployment much lower than it was when she began, inflation low and closer to target than when she began, and with the financial system better capitalised and more liquid than the one she inherited. What more can anyone ask from a Fed chair?

Ms Yellen’s success is a tribute to her judgment and thoughtfulness. Importantly, though, like Alan Greenspan in the 1990s, she recognised quickly a major structural change in the economy and adjusted policy away from where traditional models would guide it. In Mr Greenspan’s case the structural change was the acceleration of productivity growth. In Ms Yellen’s, it was the decline in the neutral rate of interest — the rate of interest at which saving and investment would balance without either a major acceleration or deceleration in growth.

The fashionable view at the Fed and elsewhere when Ms Yellen took office in 2014 was that growth was slow despite very low interest rates because of “headwinds” — transitory factors associated with the financial crisis that would soon recede. When the headwinds receded, it would be possible for the economy to enjoy sustained growth with the “normal” 4 per cent federal funds rate. On this view, the near zero rate policy in place was highly expansionary and risked dangerous inflation.

By 2014, after five years of financial repair, the headwinds theory was losing credibility. Estimates of the neutral rate were starting to come in suggesting that it had been trending down for a long time. More straightforwardly, despite near zero rates and the completion of financial repair as measured by credit spreads in 2009, growth remained very slow. That is why I sought to resurrect the secular stagnation theory — the idea that the economy, except at moments of financial excess, was likely to suffer from an excess of saving over investment and be prone to sluggishness and insufficient inflation.

Without endorsing the idea of secular stagnation, Ms Yellen led the Fed gradually but firmly to the recognition that the neutral rate had declined significantly, and to the corollary conclusion that policy was not as expansionary as was generally supposed. Her instincts were corroborated, and even proved to have been if anything too cautious as growth and inflation generally fell short of the Fed’s expectations during her tenure — even as interest rates were kept lower than expected and federal deficits increased more than expected.

It is fortunate for the American economy that Ms Yellen recognised changes in its structure and deviated from models and policy rules derived from historical experience. Had she followed such models we quite likely would be in recession right now. Yet it must be acknowledged that growth in recent years associated with low interest rates would not have been as great as it was without the stock market increasing at a manifestly abnormal rate and without increases in borrowing that far outstripped growth in incomes.

Thus the first challenge facing the estimable Jay Powell as Fed chairman is working out how to achieve growth that is both adequate and financially sustainable. Even with very low interest rates, the normal level of private saving consistently and substantially exceeds the normal level of private investment in the US. And the differential is magnified by inflows of foreign capital. This creates a deflationary tendency that can be offset only by budget deficits or financial conditions that artificially depress saving and increase investment.

Asset values and levels of borrowing cannot indefinitely grow faster than gross domestic product, even though their ability to do so for a time has contributed to economic success over the past few years. If the Fed raises rates sufficiently to assure financial stability, there is the risk that the economy will slow too much. If it focuses on maintaining the growth necessary to meet its inflation target, there is the risk of further increases in leverage and asset prices setting the stage for trouble down the road.

There is a very difficult balance to be struck. Except in the aftermath of recessions it has been a long time since the US economy grew well with a stable financial foundation. History will judge how stable the financial conditions of recent years have been. Prior to that we were in recovery from the 2008-09 recession. That in turn was preceded by a period of financial excess in housing and other markets. Prior to that came the 2001 recession and recovery, which in turn was preceded by the internet and stock market bubbles of the late 1990s.

So it has been a generation since the US economy enjoyed stable, financially sustainable growth from a position of strength. Good luck Mr Chairman.

The writer is Charles W Eliot university professor at Harvard and a former US Treasury Secretary


The dollar keeps weakening. Is that good news for the world?

It all depends on the reasons for the greenback’s lack of fizz

AT THE start of 2017, just before Donald Trump was inaugurated as president, a survey of fund managers by Bank of America Merrill Lynch (BAML) found they believed that being positive on the dollar was “the most crowded trade”. It turned out they were right to be cautious. On a trade-weighted basis, the currency has fallen by 9% against other major currencies in the past year.

It is not clear what the Trump administration thinks about this. At the recent World Economic Forum in Davos, Steven Mnuchin, the treasury secretary, said: “Obviously a weak dollar is good for us as it relates to trade and opportunities.” Although the rest of his statement was more nuanced, it is unusual for anyone in his position to depart from a “strong dollar” line.

The greenback duly fell in price.

Mr Trump then followed up with a statement in favour of a strong dollar in the long term, which caused a rebound. Since it was only last April that the president talked about the dollar being “too strong”, the markets can be forgiven for being confused. Never mind singing from the same hymn-sheet, the American authorities are using different tonal systems.

Adding to the puzzle is the administration’s focus on eliminating the trade deficit. The recent package of tax cuts, by boosting demand, is likely to suck in imports and widen the deficit. The trade deficit tends to fall during a recession, but that is not a desirable outcome. So it may need a big decline in the value of the dollar to bring about a cut in the deficit, while keeping the economy buoyant.

If the dollar is poised to experience one of its long periods of weakness, as in the late 1980s or the early 2000s (see chart), what would that mean for the financial markets? Much may depend on the reason the dollar is weak. If the weakness is related to bad news about the American economy, then that is usually bad for equities and good for government bonds. The reverse applies if the weakness reflects a boom in emerging markets; that would be a sign of investors taking advantage of exciting opportunities elsewhere.

Current dollar weakness seems to be linked to a rebound in the global economy. That also helps explain why stockmarkets have started 2018 in a buoyant mood. A weaker dollar helps American multinationals, as Mr Mnuchin suggested. Not only does it make their exports more competitive, but their overseas earnings are also worth more in dollar terms. BAML says that, in the fourth quarter, 68% of companies with high foreign sales beat analysts’ forecasts of profits and sales. Only 39% of companies with no foreign exposure managed to do so.

Although equities have been performing strongly, Treasury-bond prices have been falling (in other words, yields have been rising). This may suggest that foreign investors need a higher return to persuade them to put their money in a depreciating currency. Another explanation is that American bond investors think stronger economic growth will eventually lead to higher inflation and are demanding higher yields to compensate (see article).

What about the rest of the world? A weak dollar means a strong euro and thus, all else being equal, tighter financial conditions in Europe. Mario Draghi, the president of the European Central Bank, made some pointed remarks on January 25th about disorderly movements in exchange rates, and their adverse implications for financial and economic stability. He took a more doveish tone on monetary policy than investors expected; the ECB will not want the euro to rise too far. Government-bond yields in Europe have also been rising, so financial conditions are already tightening.

Life tends to be easier for economic policymakers in developing countries when the dollar is falling than when it is rising. The Asian financial crisis, for example, occurred during the dollar surge of the late 1990s. Many countries peg their currencies, formally or informally, to the greenback; if the dollar is rising, they may be forced to tighten monetary policy in order to maintain the link. A weaker dollar gives countries scope to cut interest rates, boosting growth.

Of course, all these trends may go into reverse if they go too far. If a lot of money flows into emerging markets, economies can overheat and an overvalued currency can make exporters uncompetitive, leading to an eventual crisis. If Treasury-bond yields rise far enough, that will prompt capital to flow back into the dollar. Furthermore, a sharp rise in bond yields will put the squeeze on economic growth. Investors do not mind a bit of dollar weakness; they just don’t want too much of it.

Australia Weighs Its Relationships With the US, China

By Allison Fedirka


Mixed messages have been coming out of Australia this week regarding Canberra’s threat perception of China. The defense minister, for example, changed her position on the threat from Beijing overnight. Initially, she said that Australia shared similar concerns as the U.S. National Security Strategy – which points to China’s expanding military as a top security priority. Later, she backtracked, saying Australia doesn’t see China as a threat. Prime Minister Malcolm Turnbull and Foreign Minister Julie Bishop also chimed in, saying China does not pose a military threat to Australia. This was soon followed by the deputy director of the Australian Security Intelligence Organization, claiming that China posed an extreme threat to Australia, particularly in the area of espionage. The rhetorical back and forth is nothing new and is symptomatic of how Australia’s immediate economic needs can be at odds with its longer-term strategic objectives.

Canberra is questioning whether it should shift its focus from the United States to Asia. The pull Australia feels between China and the U.S. was captured in the government’s 2017 Foreign Policy White Paper. In the document, the Australian government identifies the U.S.-China relationship and its effects on the Pacific region as the source of Canberra’s main challenges. Australia’s main goal, and challenge, is to protect global shipping lanes so that the island nation’s imports and exports can move freely throughout the world. Located in the Southern Hemisphere, the country is on the periphery of major maritime trade routes. It has a small population – especially compared to its landmass – and a very long coastline, which limits the country’s military capabilities.
Australia, as a whole, is an inhospitable environment for large-scale human settlement and is therefore unable to meet all its needs domestically. It has always relied on outside powers for this – both to secure sea routes and to spur economic activity through trade. It is here that U.S.-Chinese relations intersect with Australia’s international interests. It needs strong trade and business partners as well as a strong military alliance to protect  trade flows. The current dilemma for Australia arises from the fact that its top trading partner, China, is locked in an intensifying rivalry with the United States, Australia’s security patron. The conflicting statements from Australian officials reflects this uneasiness about needing to work closely yet separately with two countries that are increasingly distrustful of one another.

The question over which side Australia should align itself with has been simmering for a couple of years. Much of Australia’s media and many politicians have raised questions about Chinese immigration, influence and espionage. Turnbull and other political leaders have gradually become more hawkish in their position against Chinese influence in Australia, particularly after reports of Chinese money being used to sway Australian political campaigns and policy. There has also been a clampdown on Chinese investments in Australian real estate, ports and farmland.

In the past year, the administration of U.S. President Donald Trump has cast doubt on the U.S. commitment to the region. After mere days in office, Trump threatened to renege on a deal the U.S. government had with Australia to resettle Syrian refugees. Shortly after, Washington pulled out of the Trans-Pacific Partnership, a 12-nation trade deal that included Australia. The situation in North Korea – its nuclear weapons program and the threat that poses to the U.S. – also gives Australia pause since a major military conflict could compromise Washington’s ability to honor its security commitments. The U.S. still needs Australia to maintain a strong foothold in the region and is by no means turning its back on it. But domestic issues have made U.S. foreign policy erratic, and that makes an ally like Australia uncomfortable.
Two Strategies
To help manage its relationships with China and the United States, the Australian government is pursuing two strategies. Regarding China, Canberra is keeping the focus heavily on business ties. China’s economy requires massive amounts of commodities to stay running, and Australia’s coal and iron ore exports (among others) have largely benefited from this. During and after the 2008 financial crisis, Australia pulled back from antagonizing China. Since then, Canberra has seen the value of keeping the focus on wealth generation and maintaining a steady relationship with Beijing.

As for the United States, the Australian government has demonstrated a willingness to expand its security relationship with the U.S. to include regional allies such as Japan and India. Some of the most recent examples include Australia’s support for reviving the Quadrilateral Security Dialogue, an informal coalition involving the U.S., Australia, Japan and India, and a bilateral agreement between Japan and Australia that significantly enhances the transfer of military hardware between the countries and the training of Japanese troops in Darwin. Such moves show commitment to the United States while at the same time strengthening defense ties with other nations. The government’s labeling in the Foreign Policy White Paper of its “neighborhood” as the Indo-Pacific region reflects the emphasis Canberra places on its on ties with Japan and India to help secure its interests in the Pacific. As Beijing continues to encroach on the South China Sea – which Australia is less reliant on due to its geographic position – Australia needs to maintain open trade flows and therefore must have a security alliance capable of ensuring sea lanes remain accessible. That means it still needs the United States, but it is increasingly also looking to regional allies for support, should U.S. engagement in the region wane.

For Australia, the dilemma ultimately comes down to the fact that its key security partner is at odds with its top economic partner. This is a relatively new scenario for Australia, since up until 2007 its top trade partners were also aligned with its top security partners. From the early 1900s through the first half of the 1960s, the United Kingdom was Australia’s top trade partner. Then, from about 1965, Japan replaced the U.K. as the leading trade partner. In 2007, China assumed the title. All the while, the United States ranked as Australia’s second- or third-largest trade partner. (It’s currently a close second.) On the security side, Australia initially used its colonial ties to rely on the U.K. After World War II, the United States became Australia’s top security partner (and Japan came under the U.S. security blanket as well). The U.S. and the U.K.’s long-standing alliance with Australia is seen through their involvement in organizations such as the Five Eyes, an intelligence-sharing program that also includes Canada and New Zealand, and coordinated, international military missions in places such as Afghanistan and Syria.
Security vs. Economy
It is not uncommon to see nations re-evaluate their partnerships to make sure national interests are still being served by them. At this point, Australia is looking at the possibility of choosing between security and economy. Ultimately, it will side with the United States for two reasons. First, when a country is forced to choose between the two, security will trump economy. This is particularly true for Australia, where security plays an integral role in ensuring the health of the economy. The other reason is that while China plays a major role in Australia’s economy, Canberra has the world’s top economy (U.S.), and third- and fifth-largest economies (Japan and the U.K.) to fall back on, not to mention the budding security relationship with India, whose economy ranks seventh. Australia’s uneasiness with this new dynamic is understandable even if it does not pose an existential threat.

Radical Gold Underinvestment

by: Adam Hamilton

- Global investors are radically underinvested in gold today.  Years of relentless stock-market rallying to endless new record highs has left prudent portfolio diversification with counter-moving gold deeply out of favor.

- But the same central banks that fueled this extraordinary stock bull are now reversing to massive and unprecedented tightening this year, which will inevitably force stock markets to roll over.

- As stocks sell off in what is almost certain to become the long-overdue next major bear, gold investment demand will make a glorious renaissance.  Investors will flock back to gold.

Global investors are radically underinvested in gold today. Years of relentless stock-market rallying to endless new record highs have left this classic alternative investment deeply out of favor. But this gold-demand ebb is ending. The same central banks that fueled these extreme stock markets through epic easing are reversing to massive and unprecedented tightening. As stocks roll over, gold investment will return.

Gold is a unique asset class established over millennia that should play a critical role in every investment portfolio. Unlike virtually everything else, gold generally rallies when stock markets inevitably suffer their periodic major selloffs. That effectively makes gold the anti-stock trade. A substantial gold allocation is essential and necessary to diversify and protect stock-heavy portfolios, moderating their overall volatility.

But late in major stock bulls after years of rallying on balance, complacent investors mostly forget about gold. If stocks apparently do nothing but rally indefinitely, then why bother with counter-moving gold? Thus their collective gold allocations gradually slump to unsustainable lows as stock euphoria mounts. The lack of gold investment demand leaves it languishing at relatively-low prices, deeply out of favor like today.

Like nearly everything else in the global markets, gold prices are heavily dependent on investment capital flows. When investors are buying gold in a meaningful way, demand exceeds supply which drives gold’s price higher. When they’re materially selling, supply trumps demand thus gold’s price naturally retreats. This past year or so has been stuck in the middle, with gold investment flows generally neutral on balance.

The definitive arbiter of global gold supply and demand is the World Gold Council. It publishes quarterly Gold Demand Trends reports with the best gold fundamental data available. As these typically come out 5 to 6 weeks after quarter-ends, the Q4’17 GDT hasn’t been released as of this writing. But 2017’s world gold investment demand current to the end of Q3 still reveals the radical underinvestment in gold these days.

During the first three quarters of 2017, global gold investment demand ran 935.0 metric tons. That was down sharply year-over-year, collapsing 32.6% or 451.4t from the comparable 9 months of 2016! This plunging gold investment demand was more than responsible for the entire 388.1t drop in overall total gold demand in that span. Investment demand is further split out into traditional bars and coins and new ETFs.

Physical-bar-and-coin demand actually proved strong in the first 3/4ths of 2017, rising 13.0% or 87.1t to 755.3t. But ETF demand cratered a catastrophic 75.0% or 538.5t YoY! Due to their ease of trading and trivial commissions compared to physical gold, ETFs have become the gold vehicle of choice for stock investors. And with stock markets surging extraordinarily on taxphoria last year, gold was largely shunned.

Gold exchange-traded funds act as conduits enabling vast amounts of stock-market capital to slosh into and out of physical gold bullion. These big changes in collective buying or selling really move gold. Since the gold ETFs seek to mirror the underlying gold price, they have to shunt excess ETF-share supply or demand directly into actual gold bars. There’s no other way for gold ETFs to successfully track their metal.

The world’s leading and dominant gold ETF is the venerable American GLD SPDR Gold Shares (GLD). Every quarter the World Gold Council also ranks the world’s top-ten gold ETFs. At the end of Q3, GLD alone accounted for a whopping 36.9% of their total gold-bullion holdings! GLD was 3.8x larger than its next biggest competitor, which is the American IAU iShares Gold Trust. GLD is the behemoth of the gold-ETF world.

The supply and demand of GLD shares, and all gold ETFs, are totally independent from underlying gold’s own supply and demand. So when stock investors buy GLD shares faster than gold is being bought, the GLD share price starts decoupling from gold to the upside. That is unacceptable, as GLD would fail its mission to track gold. So GLD’s managers must vent this differential buying pressure directly into gold.

They do this by issuing sufficient new GLD shares to meet the excess demand. All the money raised by these GLD-share sales is then plowed into physical gold bars that very day. This mechanism enables stock-market capital to flow into physical gold. Of course this is a double-edged sword, as excess GLD-share selling pressure forces this ETF to sell real gold bars to raise the capital to buy back its share oversupply.

What American stock investors are doing with GLD shares is the primary driver of gold’s trends! GLD has grown massive since its launch back in November 2004, and acts as a direct pipeline into gold for the vast pools of stock-market capital. Nothing is more important for gold prices now than GLD inflows and outflows. These are very transparent, as GLD reports its physical-gold-bullion holdings daily in great detail.

I call stock-market capital inflows into GLD as evidenced by rising holdings builds, and outflows as seen by falling holdings draws. In recent years there have been plenty of quarters where GLD builds and draws alone accounted for the entire global change in gold demand! Rather incredibly, GLD has grown into the monster tail that wags the global-gold-price dog.

American stock investors dominate gold’s fortunes.

Amazingly many if not most investors still don’t grasp GLD’s critical role in gold price trends.

They attempt to understand today’s gold’s price action in historical pre-gold-ETF-era terms. But for better or for worse, the gold world is radically different now. GLD, and to a lesser extent the other large gold ETFs trading in foreign stock markets, changed everything. Gold investors ignoring GLD’s holdings are flying blind.

This chart drives home this critical point. It superimposes GLD’s daily physical-gold-bullion holdings in blue over the gold price in red. Carved into calendar quarters, gold’s performance in each one is noted above GLD’s quarterly holdings changes in both percentage and absolute terms. The correlation between GLD’s physical-gold-bullion holdings and gold prices is very strong. GLD capital flows explain much for gold.

Rising GLD holdings reveal stock-market capital is flowing into gold bullion via GLD, due to differential GLD-share demand. Conversely falling GLD holdings show stock-market capital coming back out of gold, thanks to differential GLD-share selling. When American stock investors are either buying or selling GLD shares at much-faster rates than gold is moving, their collective capital flows greatly impact its price.

This is readily evident in strategic and tactical terms. GLD’s holdings are highly correlated with gold price levels. American stock investors sold down GLD’s holdings in 2015, and gold fell in lockstep. But that all reversed sharply in early 2016, when stock investors flooded back into GLD which catapulted gold into a new bull. Gold kept surging as long as differential GLD-share demand persisted, then stalled when it abated.

After Trump’s surprise election win in November 2016, stock investors dumped GLD shares at dizzying rates and gold plunged. Then GLD’s holdings stabilized and largely drifted sideways on balance in 2017, so gold did too. GLD capital flows and gold prices are joined at the hip. What American stock investors are collectively doing and likely to do with GLD shares is critical for gaming where gold is likely heading next.

Thus the key question for gold investors today is what motivates stock investors to buy or sell GLD shares en masse? The answer is simple, stock-market fortunes. Gold is effectively the anti-stock trade since it tends to move counter to stock markets. So gold investment demand via GLD shares surges as stock markets suffer major selloffs, and withers when stock markets rally to lofty euphoria-generating heights.

The entire reason gold investment demand has stalled out over the past year, which left gold drifting, is the extreme euphoria in US stock markets. Wall Street constantly claims there’s no euphoria, but that’s not true. The words “euphoria” and “mania” are often confused. Mania means “an excessively intense enthusiasm, interest, or desire”. In the stock markets, manias are associated with bubbles at bull-market tops.

Euphoria is a milder term meaning “a strong feeling of happiness, confidence, or well-being”.

There’s no doubt investors have been euphoric on hopes for big tax cuts soon since Trump won the election. And since those Republican corporate tax cuts actually became law in late December, stock markets have arguably entered the mania phase. This is readily evident on fundamental, technical, and sentimental fronts.

The flagship S&P 500 broad-market stock index is starting 2018 with its elite component stocks trading literally at bubble valuations. The simple-average trailing-twelve-month price-to-earnings ratio of these 500 stocks was running 31.8x at the end of January! That’s above the 28x historical bubble threshold, or double the 14x fair value over the past century and a quarter. These stock markets are dangerously expensive.

Despite that, fear of missing out fueled extreme capital inflows in the opening weeks of 2018 as investors rushed to buy stocks high. In this year’s first 18 trading days, the S&P 500 rocketed 7.5% higher which annualizes to an absurd 104% pace of gains! That stretched this leading stock index as much as 14.0% above its 200-day moving average, making for some of the most-overbought conditions ever witnessed.

Sentiment indicators were universally crazy in January too, revealing the most-extreme herd bullishness, optimism, and greed seen since soon before huge past selloffs. Those included late 2007 leading into a 56.8% S&P 500 bear market, early 2000 ahead of the previous 49.1% S&P 500 bear, and even 1987 prior to October’s infamous Black Monday crash where the S&P 500 plummeted 20.5% in a single trading day!

With virtually everyone totally convinced these euphoric, bubble stock markets can keep surging forever, it’s no surprise gold has fallen out of favor. Investors are so caught up in this irrationally-exuberant late-bull psychology that they don’t perceive any meaningful downside risk. So there’s little motivation to prudently diversify stock-heavy portfolios at all, let alone with gold. That’s driven radical underinvestment in it.

This is actually measurable to some extent using GLD’s physical-gold-bullion holdings held in trust for its shareholders. Since American stock investors’ gold capital flows via GLD shares often dominate gold’s fortunes, the value of its holdings approximates overall gold investment. Looking at the ratio of that to the total market capitalization of all the S&P 500 companies reveals rough gold investment levels over time.

This ratio between the amount of capital invested in GLD and the total value of the S&P 500 is rendered below in red. That’s superimposed over GLD’s total gold holdings in metric tons in blue.

Once this ETF ramped up past its initial early-adoption years, this metric revealed relative baseline gold investment levels for American stock investors. And gold investment has been very low during the recent taxphoria surge.

American stock investors’ gold portfolio allocations as measured by this GLD/SPX value ratio have been extremely low throughout the entire taxphoria rally since Trump’s victory. The amount of capital invested in GLD shares has been running around just 0.14% the amount invested in S&P 500 companies! Gold really can’t get much more out of favor than an implied portfolio allocation of a trivial 1/7th of one percent.

The last quasi-normal years in the markets came between 2009 to 2012. That was sandwiched between the first stock panic in a century and the Fed’s extreme open-ended money printing in QE3 that wildly distorted the markets ever since. During that span, gold investment was much higher. The capital invested in GLD shares averaged 0.475% of the collective market cap of the S&P 500, nearly half of one percent.

That implies American stock investors’ gold portfolio allocations are well under a third of normal levels by recent standards! They would have to soar 3.4x merely to mean revert, not even overshoot which is very likely after such anomalous lows. While getting back near a 0.5% gold allocation would require massive capital inflows into GLD for years catapulting gold prices far higher, that level of gold investment remains conservative.

For centuries most of the world’s smartest and most-successful investors have recommended portfolio gold allocations of at least 5% to 10% for every investor. One recent example came from Ray Dalio, the universally-respected founder of the world’s largest hedge fund Bridgewater Associates. With his $17b net worth, when Dalio talks Wall Street listens. Back in August he wrote an essay echoing this classic advice today.

Dalio was warning about the serious downside risks in these lofty stock markets. On gold he said, “We can also say that if the above things go badly, it would seem that gold (more than other safe haven assets like the dollar, yen and treasuries) would benefit, so if you don’t have 5-10% of your assets in gold as a hedge, we’d suggest you relook at this.” That wasn’t just idle talk, as Bridgewater’s Q3’17 investing proved.

Funds have to report their holdings to the SEC in quarterly 13F reports. Bridgewater was buying GLD shares hand over fist as Ray Dalio advised building 5%-to-10% portfolio gold allocations. In Q3 alone its GLD holdings skyrocketed a staggering 575% quarter-on-quarter to 3.9m shares! Bridgewater’s $474m in GLD shares was its fourth-largest position, making this hedge fund the eighth-largest GLD shareholder.

As these insane mania stock markets inevitably roll over into their long-overdue bear, other investors will follow Dalio’s lead. The last time the stock markets corrected, fell more than 10%, was early 2016. That followed an extraordinary 3.6-year correction-less span thanks to extreme Fed quantitative easing, one of the longest on record. So gold was languishing near a deep 6.1-year secular low before stock markets fell.

The S&P 500 merely dropped 13.3% over 3.3 months leading into early 2016, relatively minor as far as major corrections go. Yet gold investment demand turned on a dime as volatility returning awoke stock investors from their complacent slumber. As the first chart showed, in Q4’15 gold fell 4.9% on a 6.6% or 45.1t GLD draw. With stock markets very high and euphoric, investors wanted nothing to do with gold.

Yet in Q1’16 after that modest stock-market correction, gold surged 16.1% higher on a gigantic 27.5% or 176.9t GLD build! Once investors realized stock markets could fall too, they rushed to diversify a little of their capital into gold. Provocatively that GLD build alone accounted for 95.2% of the total jump in world gold demand per the latest WGC data! Gold was catapulted into a new bull market on a mere stock correction.

That big gold investment buying continued in Q2’16, where gold rallied another 7.4% on another 16.0% or 130.8t GLD build. The only reason this trend stalled in Q3’16 was the S&P 500 surged back to its first new record highs in 13.7 months. The catalyst was hopes for more central-bank easing following that UK vote where the British people decided to leave the European Union. Record stock markets kill gold demand.

It’s going to explode again like in early 2016 the next time these euphoric bubble-valued stock markets sell off materially. Given the extreme fundamentals, technicals, and sentiment rampant today, it’s hard to imagine the overdue and coming major selloff not at least testing the upper limits of corrections. That’s a selloff approaching 20%, probably the best-case scenario for the bulls.

Anything beyond 20% is a new bear.

Unfortunately that new-bear scenario is far more likely. As of late January this S&P 500 bull has soared an extreme 324.6% in 8.9 years, making for the third-largest and second-longest stock bull in all of US history! Much of those gains were fueled by epic central-bank easing far beyond anything ever before seen in world history. This year both the Federal Reserve and European Central Bank are slamming on the brakes.

The Fed just started its first-ever quantitative-tightening campaign in Q4’17 to unwind years and trillions of dollars of quantitative easing. QT is going to gradually ramp up in 2018 to a powerful $50b-per-month pace starting in Q4 this year. Per the Fed’s schedule, it will effectively destroy $420b of capital in 2018 by letting QE-purchased bonds roll off its balance sheet. Nothing remotely close has ever happened before!

On top of that the ECB just slashed in half its own QE campaign in January to a €30b monthly pace, with a targeted QE end date of September. That means ECB QE will collapse from €720b in 2017 to just €270b in 2018, a radical 5/8ths plunge. Between the Fed’s QT and ECB’s QE tapering, there will be the equivalent of $950b more tightening and less easing in 2018 compared to 2017! That’s going to leave a mark.

The Fed and ECB will literally strangle this stock bull by unwinding and slowing the QE that grew it. And this isn’t just a 2018 thing. In 2019 the Fed and ECB are on track to have another $1450b of tightening compared to 2017. So these stock markets are in real trouble with central-bank liquidity being pulled regardless of their extreme overvaluations and overboughtness. 2018 sure ain’t gonna look like 2017 at all!

Bear markets ultimately tend to cut stock prices in half, literal 50% losses in the SPX. The last couple bears that started in March 2000 and October 2007 saw the SPX drop 49.1% in 2.6 years and 56.8% in 1.4 years! Bear markets are exceedingly dangerous and not to be trifled with. They also tend to grow in size in proportion to their preceding bulls, so the next bear should be bigger than usual after such a massive bull.

When stock markets start materially weakening, investors return to gold. Gold is the ultimate portfolio diversifier because it tends to move counter to stock markets. Gold is forgotten when stock markets are high and euphoria and complacency abound. But once major selloffs inevitably follow major rallies, gold demand explodes as investors rush to diversify their stock-heavy portfolios. Gold is effectively the anti-stock trade.

Given the radical gold underinvestment following this extreme stock bull, investors will likely have to do big gold buying for years to reestablish normal portfolio allocations. That will continue to fuel this young gold bull born in late 2015 in the last stock-market correction. At best gold was only up 29.9% so far as of mid-2016, nothing yet. The last gold bull powered 638.2% higher over 10.4 years ending August 2011!

While investors can ride the coming gold bull in GLD shares, far better gains will be won in the stocks of its leading miners. They tend to amplify underlying gold gains by 2x to 3x due to their profits leverage to gold. With gold so out of favor, the gold stocks are deeply undervalued today. That gives them huge upside as gold mean reverts higher, dwarfing everything else in all the stock markets. Fortunes will be won.

The bottom line is global investors are radically underinvested in gold today. Years of relentless stock-market rallying to endless new record highs has left prudent portfolio diversification with counter-moving gold deeply out of favor. But the same central banks that fueled this extraordinary stock bull are now reversing to massive and unprecedented tightening this year, which will inevitably force stock markets to roll over.

As stocks sell off in what is almost certain to become the long-overdue next major bear, gold investment demand will make a glorious renaissance. Investors will flock back to gold to stabilize their bleeding stock-heavy portfolios, catapulting its price much higher. It will likely take years of gold investment buying to restore overall gold portfolio allocations to reasonable historic norms. That’s super-bullish for gold!

Dancing with danger

Europe’s populists are waltzing into the mainstream

They and their ideas are both being picked up by established parties

ON AN icy January morning, twinkly lights and the glow from chic cafés illuminate Hässleholm’s tidy streets. The employment office opens its doors to a queue of one. Posters in shop windows invite locals to coffee mornings with immigrants asking: “What will you do to make Sweden more open?” At first glance, this small town fulfils every stereotype about the country: prosperous, comfortable, liberal. But last year it became the centre of a political storm.

Mainstream Swedish politicians have refused to co-operate in any way with the Sweden Democrats (SD), a right-wing populist party with extremist roots, since it was formed in 1988. In 2015 Fredrik Reinfeldt, a former prime minister and then still leader of the centre-right Moderates, described the SD’s leadership as “racists and the stiffly xenophobic”. But a year ago the Moderates used SD support to oust Hässleholm’s centre-left local government and elect Patrik Jönsson, the SD’s regional leader, vice-chair of the new council. In November the council adopted an SD budget that would cut spending on education and social care for immigrants and build a new swimming pool for locals instead. “We just want to shut Hässleholm’s doors,” announced Mr Jönsson. Per Ohlsson, a columnist on Sydsvenskan, the local newspaper, is alarmed: “I get a growing feeling that liberal democracy is something we have taken for granted for too long.”

Some European politicians saw 2017 as a welcome setback to the rise of populism across the continent. After a 2016 in which support for parties like the SD hit record highs, and England and Wales voted for Brexit, polls showed the populists’ popularity falling (see chart). Marine Le Pen of the Front National (FN) lost the French presidential election to Emmanuel Macron; her party fared poorly in the subsequent elections for the National Assembly. The Alternative for Germany (AfD) made it into the Bundestag for the first time, but not to a degree that truly threatened moderate politics. Two far-right “Freedom” parties, the PVV in the Netherlands and the FPÖ in Austria, did worse than expected in their national elections.

The continuing rise of populism, though, is something to measure decade by decade, not year by year. The financial crisis and the large influx of refugees contributed to a spike, but Euro-populism has been growing quite steadily since the 1980s. According to a new study by Yascha Mounk of Harvard University and others for the Tony Blair Institute, the populist vote in an EU state was, on average, 8.5% in 2000. In 2017 it was 24.1%. This quantitative increase is producing qualitative shifts in the continent’s politics. As Hässleholm shows, populists are no longer shunned by the democratic mainstream as a matter of course; they are increasingly called into coalitions, co-opted and copied.

Defining populism is notoriously subjective, but political science provides some guidelines. Jan-Werner Müller of Princeton University singles out its exclusive claim to represent a “morally pure and fully unified people” betrayed by “elites who are deemed corrupt or in some other way morally inferior”. Populism attacks judges, journalists and bureaucrats it deems not on the side of the people. It speaks the language of silent majorities, national humiliations, rigged systems; of “We are the people” (Germany’s anti-Islam PEGIDA movement), “Take back control” (Brexiteers), “This is our country” (the FN)—and, elsewhere, “Make America great again”.

Cas Mudde of the University of Georgia notes that populism is a “thin” ideology. It can have hosts on the left as well as the right and even create hybrids of its own, such as the Five Star Movement (M5S) which is topping Italian opinion polls in the run-up to the general election in March. It can also be practised by politicians whose parties are not avowedly populist. Such politicians can subscribe to a more or less monolithic and exclusive vision of “the people”; they can defend minority groups, the judiciary and the free press to a greater or lesser extent; they can choose honesty about policy trade-offs over convenient scapegoats more or less frequently. Their parties can inch along the spectrum over time. So can whole societies.

Take Hungary. The Fidesz party led by Viktor Orbán, the country’s authoritarian prime minister, grew out of the anti-communist movement and governed the country as a fairly conventional conservative party around the turn of the century. But partly under pressure from Jobbik, an extreme right-wing party founded in 2003, and increasingly citing “the will of the people”, Mr Orban has taken to demonising immigrants and minorities (particularly Muslims), attacking the judiciary and disenfranchising sources of dissent. He is demanding that, at the parliamentary election to be held in April, the voters give him a mandate to take on George Soros, the Hungarian-born, America-based billionaire who founded the Central European University in Budapest and who, Mr Orbán claims, has a secret plan to flood the country with Muslims.

Most political scientists now consider Fidesz a full-blown populist outfit. Elsewhere the entangling of mainstream parties with populist policies and the populist style takes place in subtler ways. The options open to Sweden’s Moderates illustrate the dynamics at play.

The slow growth of the SD has not been enough for it to form a government, as Fidesz, Syriza, a far-left party in Greece, and the Law and Justice party in Poland have done. But by 2014 it was big enough to make it hard for the established parties to form stable centre-left or centre-right coalitions, as was long their wont.

The Moderates might have joined a stodgily broad government of the centre right and left. Such governments have become much more common across the continent as the growth of populist parties, along with wider political fragmentation, has made more ideologically coherent coalitions harder to pull off. Today Germany, Italy, the Netherlands and Spain offer variations on this muddled-middle theme, some of them formal coalitions, some looser toleration agreements. Such arrangements are unappealing for ambitious politicians. They also pep up populist rhetoric by proving that the political class is indeed all in it together.

The other two options available to the Moderates were to co-opt the populists or to try to steal their voters. Last March Anna Kinberg Batra, Mr Reinfeldt’s successor as leader, leant towards co-option, announcing that after next September’s election she might try to form a government with SD support. This prompted furious arguments which led to her resignation. Ulf Kristersson, the new leader, moved the party towards option two: “In Sweden we speak Swedish,” he declared pointedly in his Christmas message. But an SD-backed Moderate government is still possible.

Such possibilities do more than anything to normalise parties like SD. Austria, Bulgaria, Denmark, Finland, Latvia, the Netherlands and Norway have all now seen mainstream parties govern with the formal or informal support of populist parties. In Slovakia a government led by the centre left has a similar arrangement. The number of European governments with populists in their cabinets has risen from seven to 14 since 2000. Their ranks may soon be joined by the Czech Republic and Denmark, where the centre-right Venstre party says it might invite the right-populist Danish People’s Party (DPP), now propping it up in government, to become a full partner after the next election, which has to be held by July 2019.

The left is looking at new alliances, too. Last year, for the first time, Germany’s Social Democrats (SPD) went into a general election without ruling out a coalition with Die Linke, a left-populist party descended from the East German communists. Similarly, Spain’s centre-left Socialists have flirted with a deal with Podemos, a movement which grew out of anti-austerity street protests.

This all suggests the populist tide will continue to rise. Through analysing 296 post-1945 European elections, Joost van Spanje of the University of Amsterdam has found that, in general, welcoming formerly ostracised parties into the mainstream tends not to reduce their support.

The sincerest flattery

Going hand in hand with normalisation-by-coalition—in part its cause and in part its effect—is a growing professionalism and a professed moderation among the populists. In their early days they were often closely associated with frank racism, as with the anti-Semitism of the FN in the days of Ms Le Pen’s father; such sentiments are now increasingly kept at arms length (though in the case of Mr Orbán’s attacks on Mr Soros not very convincingly). They were also chaotic and split-prone. Some, like the UK Independence Party (UKIP), still are. Others, tasting or scenting power, have been getting their act together. The FPÖ in Austria is an example. It was shambolic during its previous turn in government, from 2000 to 2007, but it returned to ministerial power last December with a more sober image, having made efforts to distance itself from the right-wing Austrian social networks known as “fraternities”. “I expect the FPÖ to be much more disciplined and effective this time,” says Mr Mudde.

Part of this sprucing up involves tailoring policies to broaden support, which normally comes from the working class. While voters for Podemos, M5S and Syriza tend to be more educated than average, and also younger, the best predictor of support for the right-populists of the north is usually how early an individual left formal schooling. Winning over more bourgeois voters means tempering their message in some ways. Thus the FPÖ is less stridently anti-EU than it was. The same is true of the FN—which now presents itself as a staunchly pro-Israel bulwark against Islamism—the Danish DPP and the AfD.

Another part is experience gained in state governments and running municipalities like Wels, near Linz; subnational politics offers a good way to gain acceptability. City government in the north of Italy has helped the populists of the Northern League; in Spain mayors allied to Podemos in Madrid and Barcelona have given the party a stronger national profile. But local power is not always a plus. Corruption scandals and piles of rubbish in the streets of Rome under mayor Virginia Raggi have damaged M5S.

Austria’s new government also exemplifies the second sort of populist-mainstream accommodation: copying the populists’ ideas. In the election campaign the established Austrian People’s Party (ÖVP)—now the senior party in the coalition—shamelessly ripped off FPÖ policies, such as a burqa ban and reduced social-security rights for migrants. A cartoon in the Kurier, a newspaper, showed Heinz-Christian Strache, the FPÖ’s leader, naked in a police station: “They took everything!”

This “contagion”, as political scientists put it, is visible across the continent. Mark Rutte, the liberal-conservative Dutch prime minister, has pioneered a style of politics he distinguishes from “the wrong kind of populism”. Before last year’s election his party, pressed by the PVV and the Forum for Democracy, a new nationalist-populist party, ran dog-whistle adverts in newspapers telling foreigners to “behave normally or go away”. In 2016 Theresa May, his British counterpart, rallied her party by attacking “citizens of nowhere” who “find your patriotism distasteful, your concerns about immigration parochial, your views about crime illiberal, your attachment to your job security inconvenient” in a speech that could have come from UKIP. In December France’s Republicans chose as their leader Laurent Wauquiez, a Eurosceptic opposed to gay marriage who wants immigration reduced to “a strict minimum” and plans to make his party “truly right-wing”. New Democracy in Greece and GERB in Bulgaria, facing competition from the extreme-right Golden Dawn and Zankina parties respectively, have taken tougher lines on immigrants and other out groups.

In Germany the notionally liberal Free Democrats have called for most refugees to be sent back eventually. In Angela Merkel’s Christian Democrats (CDU) there is talk of a more assertive German “lead culture” and a stronger sense of “homeland”, which may indicate the party’s direction when Mrs Merkel steps down. At the annual gathering in January of the Christian Social Union, the CDU’s Bavarian sister party, Mr Orbán was a guest of honour. Alexander Dobrindt, a CSU grandee, demanded a “conservative revolution” against Germany’s metropolitan minority.

One rationale for such cosying up is that it denies the populists exclusive ownership of sensitive issues such as identity, thus allowing reasonable voters to whom such issues matter an alternative not tinged with extremism. But in “The European Mainstream and the Populist Radical Right”, a new book, Pontus Odmalm and Eve Hepburn of the University of Edinburgh conclude that there is “no immediate pattern” suggesting that the availability of mainstream alternatives to the populist right weakens the latter's electoral performance.

Mr van Spanje’s analysis suggests that imitating populist insurgents only weakens them in the rare cases where they are also ostracised. Pointing to the dynamic between UKIP and Britain’s Conservatives before the Brexit referendum, Tim Bale of Queen Mary University of London observes that “the centre right often primes the electorate for the radical right’s message...helping it to take off and then, in an attempt to counter its appeal by talking even tougher, simply makes that message even more salient and further boosts its appeal.”

Meanwhile, on the left, social democratic parties are adopting what John Judis, an American journalist, calls “dyadic populism”. Insurgent populism often boasts three ideological players: the people, the elite, and the “other” (foreigners, immigrants, welfare spongers and the like) to whom the elite has sold the people out. Thus it is “triadic”. The dyadic version has no nefarious third party, just an us-and-them world where a corrupt capitalist political caste has betrayed the proletariat for its own benefit. Under Jeremy Corbyn, a 68-year-old from the party’s hard left, Britain’s Labour Party went into the 2017 election calling British politics a “cosy cartel” and a “rigged system set up by the wealth extractors, for the wealth extractors”. Martin Schulz, the SPD’s centrist leader, sought to protect his working-class flank in last year’s election by railing against bankers in “mirrored skyscrapers”.

Another way to get populist politics and policies without populist governments is to hold referendums. In 2013 Dutch populists keenly supported a law enabling any piece of primary legislation to be put directly to the country’s 12.9m voters if 300,000 of them demanded it. In Greece the Syriza government used a referendum to reject the conditions of a bail-out by international institutions. In Britain the referendum on Brexit—the fulfilment of a long-standing UKIP demand—compelled almost the entire political class to adopt a policy confined until recently to its populist fringes. Austria’s coalition agreement opens the door to more plebiscites; so, more tentatively, does the preliminary blueprint for a new CDU/SPD coalition in Germany. In Italy the M5S manifesto promises to give the people opportunities to vote on which laws to scrap.

Trilingualism against the triadics

Not all mainstreamers are parroting populist positions. The surge of what Mr Müller calls “illiberal democracy” has produced a backlash. The confidently pro-European, pluralist politics of Mr Macron and his En Marche! party is one instance. Another is the centrist Ciudadanos (“Citizens”) party now leading the polls in Spain. Its leader’s slogan is “Catalonia is my land, Spain my country and Europe is our future”—the first phrase spoken in Catalan, the second in Spanish, the third in English. Other new parties—Modern in Poland, Momentum in Hungary and NEOS in Austria—match the populists’ enterprise and presentational swagger while fighting their world view. As yet, though, they remain small.

It looks likely they will grow, but so will the sway of the populists. For a glimpse of what that may mean look at the continent’s last generation of political entrants: Green parties. Originally scrappy, over time they became more professional and started to join local and sometimes even national governments. None has ever led a European country alone, but their influence is felt in the attention now paid to green transport, recycling, renewable energy and certain civic liberties (particularly sexual freedoms).

What if the populists are as successful in the next few years? One might expect more authoritarian law-and-order policies, burqa bans, greater opposition to multilateral bodies like the EU, NATO and the WTO, and greater sympathy for Russia (an affection held across the populist spectrum, from Syriza to Fidesz by way of M5S). Expect, too, frequent referendums, less well integrated immigrants, more polarised political debates and more demagogic leaders emoting directly to and on behalf of their devoted voters.

Populists do not need to win elections to enact their policies and spread their style of politics.

They can do so through the very mainstream parties whose votes they threaten to take; infecting them and living off their political blood. “Eventually,” warns Mr Bale, “the parasite may end up consuming the host.”