i gave an interview to Ventura Securities and thought about sharing it with you all
Nobody knows what the world is going to look like after the Corona episode ends. However, as capital markets are forward looking, investors need to stay ahead of time in analysing the investment climate and taking informed decisions. During such phases, experience comes into play.
For the benefit of our readers and the entire investor community, we recently interacted with one of India’s best fund managers and mutual fund CIOs, Mr Ritesh Jain. We highly appreciate him sharing his thoughts at this time of uncertainty.
In his investing career of over 20 years, he assumed senior roles which includes CIO—BNP Paribas Mutual Fund and Tata Mutual Fund—wherein he managed USD 1.2 billion and USD 6.0 billion, respectively.
Amongst many national and international awards he won as a fund manager, CRISIL CNBC TV18 Award, Business World Debt fund manager of the year award in 2011 and Lipper Best Bond Fund of the year (4 years in a row) are noteworthy.
A blogger himself (http://worldoutofwhack.com/), Mr Jain is now a trend watcher and global macro investor. His mantra is to Make sense out of chaos.
We share with you here his candid perspectives and hope it enables you to take well informed decisions after doing your own analysis.
The Fed’s effective nationalization of the financial markets in the past week has spiked gold prices. It does appear the first phase of the bear market and bursting of multiple asset bubble is almost complete. Phase 1, an initial massive deleveraging, brought gold down 15 percent from its recent high before the big spike over the past two days as the Fed announced it will print “whatever it takes.”
Gold is now our highest conviction trade and fully expect the 1704 recent high to be taken out very soon, clearing the way to take out the September 2011 all-time high at 1920.80, which is only 15.6 percent higher. A chip shot on the gold yardage card.
What We’re Watching
There are two things we are focused on like a laser.
Bond Auctions
We are watching the Treasury auctions with the 5-year and 7-year note to scheduled to take place in the next two days. The budget deficit is exploding higher and the Treasury near-term funding requirements are growing exponentially. How much the markets are willing to finance and how much will the Fed be forced to monetize will determine the slope of gold’s trajectory.
Our back of the envelope estimate with both the decline in tax revenues and increase in spending will put the effective budget deficit well north of $4.5 trillion for the year, which is almost a 25 percent increase in the federal debt held by the public. We may not see that number due to window dressing, however.
We don’t know but suspect the Fed will have to directly credit the Treasury’s operating cash held at the Federal Reserve but not sure if the law allows it, which will have to be changed. Risking a series ugly auctions would strike another blow to confidence.
Dollar
Trouble with the auctions and accelerated down move in the dollar index below 88.23 will fuel gold’s rally and signal a bigger problem. The dollar index spiked 8.81 percent during the recent collapse and has started to sell off after the Fed’ big announcement to print “whatever it takes” earlier in this week. Watch this space.
MMT is finally about to get its big test. We are open to be converted and do hope they are right.
Stop losses über alles. As always, we reserve the right to wrong.
It’s said that you want to buy when others are fearful. It sure seems that investors are currently losing their minds. Look, I get it, there’s a virus and there’s a good chance that a lot of us will get it. There’s conflicting data about the overall mortality rate which makes it all worse; especially as its origins in China are terrifying. All sorts of businesses are shuttering operations while the Federal Government seems hopelessly incompetent at fighting this thing. Meanwhile, local governments have created a dysfunctional patchwork of mandatory quarantines and arbitrary rules which will harm businesses and do little to fight the virus as people who don’t follow the quarantines will keep infecting those staying indoors (Full Disclosure: I’ve been staying home, eating my canned tuna and whiskey rations). It’s a complete mess and it is almost certain that economic conditions will get worse before they get better. I get all of that, in fact, it’s been pounded into my head every few minutes by just about everyone I know—which means they all get it as well. At some point, this gets priced in.
The Russell 2000 is now down 40% in a month and is currently at 2013 levels. How is it not getting priced in?
Various companies that I track are down by more than half since the start of the year and many are down by more than 80%. The selling is indiscriminate and it is clear that many large funds are getting liquidated. To me, this all spells opportunity. Sure, you won’t get the low tick, but if you aren’t buying stock down here, you’re simply doing it all wrong.
Investing is about looking forward a few years into a business’s future and figuring out if you’re getting a bargain. I promise you, for most companies, the next quarter or two will be awful. Who cares? I’m buying the next 5 years of earnings. Why do I care about the next two quarters if I get the subsequent 18 quarters at a MASSIVE discount?
Why am I so sure that the next 18 quarters will be so strong? Behind the scenes, all sorts of crazy schemes to prop up the economy are getting worked out. Lobbyists are calling in favors from their favorite congressmen. These things take time and right now, they can’t do much as we’re all told to stay indoors and stop spending. I promise you, by the fall, they’ll be rolling out a scheme a day as we head into the election.
Meanwhile, the big bazookas are owned by the Federal Reserve. Every day last week, friends looked at the tape and told me that QE doesn’t work on a virus. Of course, it doesn’t. You can’t solve a pandemic by printing money. You’re stupid if you thought that. However, the money is now out there. Eventually it will find its way into financial assets—it always does. My friends keep telling me the Fed shot its gun and is out of bullets. Are you kidding me? They own the bullet factory. They’ll come back in a few days with a bigger gun. The history of investing since 2008 is that the Fed will keep throwing solutions at the market and eventually, they’ll find the right combination of tools to arrest the market’s decline—then the market will take off as all that liquidity is out there, looking for a home. The Fed is in the bubble-blowing business. They’ll figure this one out and create a bubble to dwarf all others.
But Kuppy; isn’t the economy going to be in tatters all summer?
Who cares? Venezuela’s economy is in chaos and their market has gone vertical (they don’t have toilet paper either). If you print enough money and target it at the stock market, assets values will increase, regardless of economic conditions.
Who says you need a functioning economy to have a bull market?
But Kuppy; how do you know it won’t go lower first?
I don’t know anything. I know that I’m buying businesses at a fraction of fair value because people have panic sold them. I see no solvency risk in my holdings and I accept the fact that they may drop a lot more first. I also know that once this thing turns, it’s going to be too hard to get on-board the freight train because I’m not the sort of guy who buys something that’s up 10% on the day and we’re going to be up 10% a day for weeks at a time.
But Kuppy; isn’t fiscal stimulus slow because it takes a long time to permit infrastructure programs?
Who said anything about infrastructure? That doesn’t get anyone’s votes. They’re going to do something akin to giving everyone a $5,000 Visa debit card with an October 1 expiration date.
I’ve now heard every reason not to be long. I haven’t seen palpable fear like this in ages. Everyone is sure that half the population will get this thing and a million people will die. Let’s say that is unfortunately the eventual outcome. In 2019, 2.8 million Americans died and the vast majority of them died from pre-existing conditions. Guess what the number one marker for mortality with COVID is? Pre-existing conditions. If 1 million Americans die, the vast majority of those individuals will be those who were likely to die at a different time from their pre-existing conditions. Now, I don’t mean to belittle death and suffering. Rather, I want to say that if the worst-case outcome occurs, I don’t think we’ll be more than a few hundred thousand deaths off trend-line in terms of overall mortality in America—COVID-19 probably won’t even be a 1-sigma event. It’s horribly unfortunate if it’s you, but it won’t change the economic situation here in America.
The only thing that can change the economy is government induced chaos. I suspect that we’ll get a few more weeks of that, but as a result, the rate of infection will slow and go negative—just like in every other country where they’ve eventually figured out how to “flatten the curve.” Then people will go on with their lives, right as the stimulus programs kick in. The ensuing recovery will lead to the biggest bull market run of my career. Now, you can be in the fetal position or you can front-run that. I don’t know what date the market bottoms, no one does. However, I’m pretty damn sure that once it gets going, you’re going to want to be at maximum exposure. I’ve spent the past few days buying stocks. I have the most exposure that I’ve had in years. A month ago, I wrote to warn you to take something off. Now is time to buy everything you always wanted to own, but for a fraction of the cost in January.
I’m not saying to be reckless; make sure the debt is termed out, make sure there’s plenty of excess liquidity, make sure your companies can make it through a lower for longer scenario. However, you don’t get bargains like this during a benign environment. You have to take on a bit of event risk.
I’m buying. My main theme is that deflation is dead—get long inflation. Remember, in investing, your only edge is your ability to cycle capital into something cheaper and take advantage of someone getting liquidated. If you have positions that have done well (bonds for instance), you really ought to be cycling into companies that are down a bunch. If you can’t figure out what to own, just buy gold–Powell intends to launch it to Pluto.
On a final note, I’m by no means saying you need to go “all-in” here. In fact, going “all-in” is what gets people into trouble. What I am saying is that this is the time to be buying, not selling. I took some off a few weeks ago and I put it to work in the past few trading sessions. I was a bit early, but I don’t regret it. As they turn on the fire hose of liquidity, we’re going to have one epic bull market in risk assets. I want exposure to that.
The last time I had a similar message to “buy shares,” was at the lows in 2018. I was about a week early, but the market subsequently rallied 40% over the next year. Back then, we didn’t know where the Fed stood on interest rates. Now we know they’ll do “whatever it takes” to prop up the market. In fact, every day we learn of a different alphabet soup of acronyms designed to prop up the market. I feel pretty confident that they’ll dramatically overshoot the mark this time. It’s time to buy shares, accepting that I may be a bit early once again. I intend to ignore the incredible volatility over the next few weeks and remain confident that a tidal wave of liquidity is coming behind me. The bull market of the second half of 2020 will stun people. I intend to ride it.
Disclosure: Funds that I control are long a whole lotta exposure including gold
I’ve been dreading this. In the midst of all the policy responses to the collapse of the mortgage finance Bubble, I recall writing something to the effect: “I understand we can’t allow the system to collapse, but please don’t inflate another Bubble.” It was obvious early on that policymakers had every intention to reflate Bubbles.
There was a failure to grasp the most critical lessons from that terrible boom and bust episode: Aggressive monetary stimulus foments market distortions, while promoting risk-taking, leveraged speculation and latent risk intermediation dysfunction. Years of deranged finance ensured unprecedented economic imbalances and deep structural impairment. There was no predicting a global pandemic. Yet today’s acute financial and economic fragility – and the risk of financial collapse – are directly traceable to years of negligent monetary management.
I have to adjust my message for today’s post-Bubble backdrop: I understand we can’t allow the system to collapse, but Please Don’t Completely Destroy the Soundness of Central Bank Credit and Government Debt. Does anyone realize what’s at stake?
I don’t see another Bubble on the horizon. Each reflationary Bubble must be greater in scope than the last. Mortgage finance was used for post-“tech” Bubble reflation. Policymakers unleashed the “global government finance Bubble” during post-mortgage finance Bubble reflation. Massive international inflation of central bank Credit and sovereign debt went to the heart of global finance – the very foundation of “money” and Credit.
There is no greater Bubble waiting in the wings to reflate the collapsing one. We are instead left with desperate measures to expand central bank “money” and government borrowings that will surely appear absolutely reckless in hindsight.
Let’s touch upon prospects for Bubble reflation. There was an abundance of positive spin coming out of the previous bust period. “If only the Fed hadn’t incompetently failed to bail out Lehman, crisis could have – should have – been avoided.” Reckless home lending caused the crisis, and regulators will never tolerate a replay. Prudent “macro-prudential” policies and an abundantly capitalized banking sector ensure stability. From the crisis experience, central bankers learned to move early and aggressively to nip market instability in the bud.
The previous crisis was labeled “the 100-year flood.” Onward and upward, with enlightened central banking both leading the way and ensuring a smooth ride.
With assurances of central bank liquidity and market backstops, an unprecedented Bubble inflated throughout global leveraged speculation. Popular “carry trades,” foreign-exchange “swaps,” myriad derivatives (incorporating leverage) and such morphed during this cycle into a colossal self-reinforcing Credit Bubble. The resulting liquidity became a prominent fuel source for asset and economic Bubbles, reminiscent of the late-twenties.
Can’t a massive expansion of central bank Credit (securities purchases, lending facilities, swap lines, etc.) now reflate the Bubble? I seriously doubt it. Risks associated with various strategies have been revealed. Leverage in its many forms has been, once again, shown to be a serious problem. Rather than the proverbial “100-year flood,” for the second time in less than 12 years the world is facing the worst financial crisis since the Great Depression. Burn me once, shame on you. Fool me twice…
It’s not hyperbole today to use “depression” to describe the unfolding deep global economic downturn. Coronavirus uncertainty makes it impossible to forecast the length and severity of the economic collapse. In the best case, the rapidly expanding outbreak in Europe and the U.S. subsides over the coming weeks. Even so, economies around the world will take huge hits. And prospects for the coronavirus to reemerge next winter (and emerge more powerfully during the southern hemisphere’s approaching winter season) will keep risk-taking well-contained for many months to come.
Coming out of the previous crisis, the global economy had the benefit of a powerful “locomotive” of accelerating expansions in China and the emerging markets more generally. Importantly, post-Bubble reflationary measures came as those fledgling Bubbles were attaining powerful momentum. Beijing pushed through an unprecedented $600 billion stimulus package, while aggressive monetary policy stoked EM booms generally. Keep in mind that total Chinese banking system assets inflated from about $7 TN to $40 TN since the crisis.
Looking ahead, the global economy is without “locomotives.” It evolved into one massive global financial Bubble financing a precarious synchronized global economic expansion. And I believe speculative finance became a prevailing source of Global Bubble Finance.
Here’s where I could be wrong. I seriously doubt this Bubble is revivable. The unwind will likely unfold over weeks and months. Extraordinary central bank measures will spur rallies and hopes for recovery. At times, it will appear that liquidity is returning. Yet the Bubble will not be reflated.
Confidence has been shattered. Faith that central banks have everything well under control has been broken. Myriad fallacies have been exposed. Central banks can’t guarantee liquid markets, especially in a Bubble-induced highly levered speculative environment. The entire derivatives universe has been operating on the specious assumption of liquid and continuous markets. History is unambiguous: markets experience bouts of illiquidity, dislocation and panicked crashes. The fantasy that contemporary central bank monetary management abrogates illiquidity and market discontinuity risks is being debunked. The mania in finance has, finally, run its course.
Leverage has to come down – and I believe it will stay down for years to come. A month ago risk could be disregarded – had to be disregarded. Market, financial, economic, social and geopolitical risks matter tremendously now, and they will matter going forward. In the best-case scenario, the coronavirus peaks over the coming weeks. I don’t want to ponder the worst-case.
A Friday-evening Zerohedge headline says it all: “Stocks Suffer Worst Week Since Lehman Despite Biggest Fed Bailout Ever.” In last week’s CBB, I wrote that we “saw more than a glimpse of what the beginning of financial collapse looks like”. This week’s sequel was how global financial collapse gains momentum – especially Wednesday. I watched the ’87 stock market crash on a Quotron machine. I’ve witnessed scores of bursting Bubbles and collapses – including bonds in ’94, Mexico ’95, SE Asia ‘97, Russia/LTCM in ’98, “tech” in 2000, 9/11, the spectacular 2008 collapse and 2012’s near melt-down. None of those previous crises were as alarming as current market dynamics.
The dollar index surged 4.1% this week, in a perilous market dislocation. The Mexican peso sank 10.2%, and the Russian ruble fell 9.2%. The South African rand dropped 7.6%, the Czech koruna 7.5%, the Indonesian rupiah 7.4%, the Hungarian forint 7.0% and the Brazilian real 4.5%. Massive “carry trade” losses (i.e. borrow in dollars to lever in higher-yielding EM bonds) were compounded by collapsing EM bond prices (surging yields). Even with Friday’s bond rally (yield decline), yields this week surged 96 bps in Peru, 82 bps in South Africa, 70 bps in Turkey, 44 bps in Indonesia, and 39 bps in Thailand.
Ominously, the rout was even more pronounced in dollar-denominated EM bonds. This market rallied sharply Friday after the announcement of enhanced central bank swap facilities. Mexican yields sank 44 bps Friday but were still up 72 bps for the week. Brazilian yields surged 68 bps this week, even after Friday’s 34 bps decline. For the week, dollar-denominated yields were up 152 bps in Ukraine, 131 bps in Qatar, 97 bps in Chile, 92 bps in Philippines, 92 bps in Turkey, and 74 bps in Indonesia. This type of dislocation in highly levered markets signals global markets are “seizing up.”
Market dislocation went much beyond the emerging markets. Crude oil’s 29% collapse was behind the Norwegian krone’s stunning 13.9% decline. The Australian dollar fell 6.7%, the Swedish krona 6.6%, the New Zealand dollar 5.9%, the British pound 5.3%, the Canadian dollar 3.9%, the euro 3.8%, the Swiss franc 3.6%, and the Japanese yen 3.0%. Mayhem.
Pointing to acute systemic risk, “developed” nation bond markets also dislocated. After beginning the week at 1.85%, Italian yields spiked to 2.99% in panicked Wednesday trading. Greek yield began the week at 2.10% (up from 0.96% on Feb. 21) and traded as high as 4.09% Wednesday. Portuguese yields were at 0.86% in early-Monday trading before spiking to 1.61% by mid-week. Spanish yields surged from 0.66% to 1.38%. Even German 10-year bund yields rose from Monday’s negative 0.59% to Wednesday’s negative 0.24%.
Wednesday’s meltdown spurred the ECB into emergency action, announcing a new $800 billion QE plan. ECB buying was surely behind the big end-of-week rallies in euro zone periphery bonds.
March 15 – Financial Times (Martin Arnold): “Christine Lagarde has apologised to other members of the European Central Bank’s governing council for her botched communication about its new monetary policy strategy which triggered a bond market sell-off last week. Speaking to the ECB’s top decision-making body in a call on Friday, the central bank’s president said she was sorry for comments that led to the biggest single-day fall in Italian government bonds in a decade… In Thursday’s press conference Ms Lagarde said it was not the ECB’s role to ‘close the spread’ in sovereign debt markets…”
Lagarde’s “gaff” was ridiculed by market pundits, with comparisons to communication blunders early in Powell’s chairmanship. Yet it should never have become the ECB’s role to narrow borrowing spreads, or for the Fed and global central bankers to kowtow and backstop the securities markets. Years of central bank cultivation of risk-taking and leveraged speculation are coming home to roost in the a very bad way.
Evidence of acute financial instability made it to U.S. shores this week. “Short-Term Bond Market Roiled by Panic Selling;” “Government Bonds Buckle as Investors Dump Haven Assets for Cash;” and “How a Little Known Trade Upended the U.S. Treasury Market.” It was the nightmare scenario for highly levered contemporary finance: Illiquidity and rising safe haven yields, rapidly widening Credit spreads, surging CDS prices, de-risking/deleveraging, general market illiquidity and dislocation. The definitive recipe for devastating outcomes. Even more alarming, systemic dislocation unfolded not long after the Fed announced a new $700bn QE program.
March 15 – Wall Street Journal (Nick Timiraos): “The Federal Reserve slashed its benchmark interest rate to near zero Sunday and said it would buy $700 billion in Treasury and mortgage-backed securities in an urgent response to the new coronavirus pandemic. The Fed’s rate-setting committee, which delivered an unprecedented second emergency rate cut in as many weeks, said it would hold rates at the new, low level ‘until it is confident that the economy has weathered recent events and is on track’ to achieve its goals of stable prices and strong employment. ‘We have responded very strongly not just with interest rates but also with liquidity measures today,’ Fed Chairman Jerome Powell said during a press conference Sunday evening…”
As the week unfolded, it was full-fledged financial crisis. It was difficult to keep track of the various emergency measures.
March 17 – Bloomberg (Christopher Condon, Craig Torres, and Matthew Boesler): “The Federal Reserve unleashed two emergency lending programs on Tuesday to help keep credit flowing to the U.S. economy amid strain in financial markets… The central bank is using emergency authorities to establish a Commercial Paper Funding Facility with the approval of the Treasury secretary… The Treasury will provide $10 billion of credit protection from its Exchange Stabilization Fund. Later in the day it announced a Primary Dealer Credit Facility, also with backing from Treasury. The moves follow mounting pressure to act after the Fed’s Sunday evening emergency interest-rate cut to nearly zero and other measures failed to stem market stress as investors reacted to the risk that the virus will tip the U.S. and global economy into a recession.”
March 18 – Reuters (Howard Schneider and Megan Davies): “The U.S. Federal Reserve rolled out its third emergency credit program in two days to battle the fallout from the virus crisis, this one aimed at keeping the $3.8 trillion money market mutual fund industry functioning if investors make rapid withdrawals. The Money Market Mutual Fund Liquidity Facility unveiled on Wednesday will make up to 1-year loans to financial institutions that pledge as collateral high quality assets like U.S. Treasury bonds that they have purchased from money market mutual funds. The Fed is in effect encouraging banks to buy assets from those mutual funds, insulating the funds from having to sell assets at a discount if they come under pressure from households or firms wanting to withdraw money.”
Despite it all, U.S. markets convulsed uncontrollably. U.S. equities were bludgeoned (S&P500 down 15.0% and Nasdaq falling 12.6%). Yet the more alarming developments were within the Credit market. Dislocation was deep and broad-based – Treasuries, investment-grade corporates, high-yield, municipal debt, MBS, commercial paper, CDOs and derivatives. A popular investment-grade corporate ETF (LQD) collapsed 13% in three sessions (Tuesday through Thursday). Perceived safe and liquid (“money-like”) instruments were crushed in a panic (see “Market Instability Watch” below). ETF problems turned acute, as “investors” ran for the exits.
March 19 – Financial Times (Robin Wigglesworth): “When financial markets were rattled across the board last week, some investors and analysts thought they knew where to point the finger. ‘The risk parity kraken has finally been unleashed,’ one tweeted. Risk parity is a strategy pioneered by Bridgewater’s Ray Dalio. His pioneering fund, All Weather, has been hit hard in the recent turmoil, sliding 12% this year. That is quite a fall, for a strategy designed to function well in almost any market environment, by seeking to find a perfect balance of different asset classes such as stocks and bonds. Some analysts say such funds are not just succumbing to the wider turmoil but exacerbating it — especially the freakish sight of both supposedly defensive government bonds and risky equities selling off at the same time. ‘These moves suggest a rapid unwind of leveraged strategies like risk parity,’ said Alberto Gallo, a fund manager at Algebris Investments.”
With Treasuries these days providing minimal upside, losses escalated for myriad levered strategies. The global leveraged speculating community is hemorrhaging. The derivatives complex is in chaos. Goldman Sachs Credit default swap (5-yr CDS) prices surged 66 to 223 bps, the high since the 2012 European crisis. Bank of America CDS jumped 63 to 199 bps; Citigroup 60 to 214 bps; Wells Fargo 59 to 192 bps; Morgan Stanley 57 to 211 bps; and JPMorgan 53 bps to 176 bps. Ominously, the big U.S. financial institutions were at the top of the global bank CDS leaderboard this week.
If financial collapse can be avoided, an altered financial world awaits. The old scheme doesn’t work any longer. The era of cheap money financing massive stock buybacks has ended. Leveraged speculation creating self-reinforcing liquidity abundance and asset inflation – over. Buy and hold and disregard risk has been discredited. Blindly plowing savings into perceived safe and liquid ETFs is a thing of the past. In the new financial landscape, can derivatives be trusted? How about the private equity Bubble? The age of endless cheap finance for virtually any borrower and equity issuer (irrespective of cash flow or earnings) has reached its conclusion.
Meanwhile, “helicopter money” has arrived. Seemingly outrageous on Monday, Senator Schumer’s proposal for a $750 billion stimulus package was small potatoes compared to spending plans contemplated by week’s end. Federal Reserve Assets surged $356 billion the past week to a record $4.668 TN. Fed Assets were up $907 billion over the past 28 weeks, as it becomes clear a $10 TN balance sheet will unfold more quickly than I have anticipated.
The inexhaustible inflationists and eager MMT adherents see their opening. “Please Don’t Completely Destroy…” will haunt me – and the world. In a crisis, no one was willing to stand up to Bernanke. Today, “Helicopter Ben” looks fainthearted compared to what today’s central bankers are about to attempt. The experiment has gone terribly wrong, just as foolhardy bouts of inflationism have throughout history.
If they actually believe the massive inflation of central bank and government Credit will reflate markets and economies, they will be grievously disappointed. Government debt and central bank balance sheets have commenced what will be a frightening buildup. The inflationary consequences are today unclear. What is clear is it will be anything but confidence inspiring. The desperate inflation of perceive money-like Credit will not encourage the leverage speculating community to re-leverage. It will not entice burned investors back into perceived money-like ETFs. It will not stabilize currency markets. However, it does risk a bond market debacle.
History’s greatest Bubble is nearing the end of the line. It’s all left to central bank Credit and sovereign debt – the massive inflation of Credit at the very foundation of global finance. This experimental strategy is so fraught with peril that it is difficult to believe that risk will be disregarded – that things can somehow stabilize and return to normal. Confidence in central banks’ capacity to control global markets has been irreversibly damaged – and a long overdue market reassessment of the value of financial instruments has commenced.
Truth is stranger than fiction. The world’s weakened superpower cracks down, initiating a trade war with the aspiring superpower. Relations sour. Then, shortly after a watered-down compromise agreement is signed, a virus outbreak erupts in the aspiring country that leads to a global pandemic and major crisis in the superpower country. The aspiring nation’s dictatorial government, seeking a scapegoat to pacify its shaken populace, blames the superpower for the virus and its collapsing Bubble. The superpower government, in an election year, points blame at the aspiring nation’s government. Two strongmen leaders face off. The American Virus vs. the Chinese Virus, with consequences that are chilling to contemplate.
Two strongmen leaders face off – in the oil market. Why all the strongmen? No coincidence. A decade (or two) of booms and busts and resulting heightened global insecurity has led to this critical juncture. Strongman heads of state, uncontrollable monetary inflation, and epic bursting Bubbles make for a perilous geopolitical backdrop. Covid-19 has let the genie out of the bottle.
The oil price collapse is a bad omen for much worse things to follow. The global contagion is impacting the U.S. economy and the domestic oil industry far greater than I realized just two weeks ago. As I try to allow my analysis to “Catch Up” to the gravity of the situation, my new forecast of the U.S. economy and oil industry is quite dire indeed.
I don’t say this to panic anyone, but to provide a more “realistic and pragmatic” view of where we go from here over the next few weeks and months. The rapid collapse in the U.S. oil price suggests BIG TROUBLE ahead for the domestic shale oil industry. While the low oil price is causing havoc in the shale industry, it’s only one component of the overall equation.
Today, oil consumption in the United States has already declined significantly due to the lockdown of many cities and areas in the country. However, this is just the first stage of the crisis. My gut tells me that U.S. oil consumption is likely down 25-30% already… maybe more. But, as state and federal governments continue to lockdown additional cities, we may see upwards of 40-50% drop-off in oil consumption. It sounds outlandish, but we have to start considering the FACTS.
Last summer I wrote about a mispricing in the bond market in 2008 and wondered if we’d ever see something like it again.
As of March 20th, markets are (once again) giving away inflation protection for next to nothing.
The chart below shows the breakeven inflation rate. This is the level of inflation where Treasuries and Treasury inflation-protected securities (TIPS) will earn identical returns:
If future inflation is higher than the starting breakeven rate, TIPS will outperform Treasuries. With the breakeven rate near an all-time low, TIPS are extremely cheap. TIPS are different than a regular bond in two ways:
The principal value is adjusted higher with inflation.
Coupons are based on this adjusted principal.
If you buy a regular bond for $1,000 with a 1% yield, you’ll earn $10 per year in interest and $1,000 back at maturity. But let’s say you buy a TIPS bond and inflation is 2% in the first year. The principal will increase to $1,020. And if the bond yields 0.5%, then you’ll earn $5.10 in interest.
Given current breakevens, a 10-year TIPS bond will outperform a 10-year Treasury if inflation is higher than 0.5% per year over the next decade. The last time this happened was during the Great Depression:
Even if things do get that bad, TIPS have a built-in deflation floor.
TIPS have significantly outperformed Treasuries following periods of low breakeven rates. When breakevens were below 1.75%, over the next year TIPS went on to outperform Treasuries by 3.6% on average:
Disclosures
TIPS and Treasury performance data uses TIP and VIPSX for TIPS (VIPSX when data for TIP is unavailable) and IEF for regular Treasuries. These are all intermediate-term bond ETFs with similar durations. Data includes reinvested bond interest. All returns shown are hypothetical, simulated, and are not an indicator of future results.
The biggest misconception about TIPS is that they’re only worth investing in when inflation is high. As the above chart shows, the main thing that matters is the starting breakeven rate.
Inflation protection is chronically missing in most portfolios I review. If you don’t have TIPS, now is a great time to buy them. Especially in an environment where governments are willing to spend whatever it takes to save the economy:
I personally own Vanguard’s VTIP ETF and it makes up half of bond exposure in all client accounts.
Summary
Inflation protection is extremely cheap.
The 10-year breakeven inflation rate is 0.5% and inflation hasn’t been that low since the 1930s.
TIPS have historically outperformed Treasuries after starting breakevens were at current levels.
Are you looking for securities to buy to take advantage of the carnage in the financial markets from the coronavirus? Baron Rothschild, the 18th-century British banker advised that “The time to buy is when there’s blood in the streets, even if it is your own.” He made a fortune buying government bonds in the panic that followed the Battle of Waterloo against Napoleon. But it’s not sovereign debt of the world’s superpowers that is on sale today; it’s not the S&P 500 or Dow either.
US government bonds already had their biggest year-over-year rally ever, and at record low yields, they are no bargain. As for US stocks, it’s only the first month after what we believe was a historic market top. The problem is that the pandemic just so happened to strike at the time of the most over-valued US stock market ever based on a composite of eight valuation indicators tracked by Crescat, even higher than 1929 and 2000. It also hit after a record long bull market and economic expansion. The stock market was already ripe for a major downturn based on an onslaught of deteriorating macro and fundamental data even before the global health emergency.
As we show in the chart above, we believe there is much more downside still ahead for US stocks as a major global recession from nosebleed debt-to-GDP levels has only just begun. Corporate earnings are now poised to plunge and unemployment to surge. These things are perfectly normal. There is a business cycle after all. It must play out as always to purge the economy and markets of their sins and prepare the way for the next growth phase. From the February top for large cap stocks, it would take a 56% selloff just to get to long term mean valuations, a 74% decline to get to one standard deviation below that. In the worst bear markets, valuations get to two standard deviations below the mean. Such realities happened at the depth of the Great Depression, the 1973-4 bear market, and the 1982 double-dip recession. 1932 was an 89% drop from the peak. The initial decline in this market so far is comparable to 1929 in speed and magnitude. There will certainly be bounces, but even after an almost 30% fall in the S&P 500 through yesterday’s close, we are not even close to the “blood in the street” valuations that should mark the bottom for stocks in the current global recession that has only just begun to unfold.
But value investors do not have to despair today. There is one area of the stock market that already offers historic low valuations and an incredible buying opportunity right now. Small cap gold and silver mining companies just retested the lows of a 9-year bear market. Last Friday, they were down 84% from their last bull market peak in December 2010! This was a double-bottom retest at a likely higher low compared to the January 2016 low when they were down 87%. Now that is what we call mass murder! In the chart below, we show that precious metals juniors reached record low valuations last Friday relative to gold which is still up 18% year-over-year. Mad value. Look at that beautiful divergence and base. The baby was thrown out with the bathwater in a mass margin call. Last time the ratio was in this vicinity, junior gold and silver miners rallied 200% in 8 months. Crescat owns a portfolio of premier, hand-picked juniors as part of our precious metals SMA and in both hedge funds where clients can gain exposure today. We significantly increased our exposure in our hedge funds amidst the massacre last week.
The entire precious metals group was a casualty of a liquidity crisis, the forced margin call selling for stocks and corporate credit at large in the precipitous market decline. But it was also a victim of a meltdown in dubious levered gold and silver ETF products. These produces such as JNUG and NUGT already had a horrific tracking error. Nobody should have ever been investing in them in the first place. Gold stocks are volatile enough on an unlevered basis. But when it comes to the precious metals mining stocks, we are convinced this was a margin call on Wall Street at large and in particular for these levered ETF products.
The chief culprit in the ETF space last week was the $3 billion leveraged assets, Direxion Daily Jr. Gold Bull 3x ETF. It absolutely imploded, dropping 95% through last Friday from its recent high on February 21. The fiasco in JNUG was insult to injury for long-time precious metals investors, especially those invested in silver and in junior miners. It was also an incredible buying opportunity that Crescat took advantage of, especially in its hedge funds, where the profits from our short positions at large allowed us to step up. Last week’s action may have marked a major bottom for precious metals mining stocks and ideally a bottom for battered silver this week. As of Friday, miners were on track for their worst quarter ever as we show below.
The gold and silver stock selloff has exposed enormous free cash flow yields today among precious metals mining producers of 10, 20, 30, 40, even 50%. This is completely opposite the stock market at large. Meanwhile, the pure-play junior mining explorers have some of the world’s most attractive gold and silver deposits that can be bought at historic low valuations to proven reserves and resources in the ground. These companies are the beneficiaries of underinvestment in exploration and development by the senior producers over the entire precious metals bear market. That rebound may have started yesterday in the mining stocks especially the juniors. It is a historic setup right now for the entire precious metals complex. Central banks are coming in, guns blazing.
Meanwhile, the fundamentals have never been better for gold and silver prices to rise making the discounted present value of these companies even better. Global central bank money printing is poised to explode which is important because the world fiat monetary base is the biggest single macro driver of gold prices. Gold itself is already undervalued relative to global central bank assets which targets gold at $2400 an ounce today.
At the same time, the price of gold is the biggest macro driver of the price of silver, which is gold on steroids. Silver today is the absolute cheapest it has ever been relative to gold and represents an incredible bargain. We think silver is poised to skyrocket along with mining stocks in what should be one of the biggest V-shaped recoveries in the entire financial markets in the near term.
As we have shown in our prior letters, when the yield curve first inverts by 70% or more, there is a high probability of a recession and bear market. At that point, historically it has paid to buy gold and sell stocks for the next 2 years. We went above 70% inversions in August 2019. At Crescat, we continue to express both sides of this trade in our hedge funds and our firm at large. The gold-to-S&P 500 ratio is up 28% since last August. The first part of the move was mostly driven by the rise in gold. Since February 19, its been driven by the decline in stocks. Now we’re at the place where historically both legs start to work in tandem, and yesterday that was evident with one of our best days ever in both Crescat hedge funds.
The Fed has not exhausted all its bullets. It has many forms of monetary stimulus. It can print more money and take interest rates into negative territory if need be. As the downturn in the business cycle becomes more pronounced, these policies will become increasingly called upon. That’s precisely what we are seeing today. Rate cuts everywhere, QE announcements, even forms of helicopter money are being implemented. It won’t save the economic cycle from its normal course, instead, it should only invigorate the reasons for owning precious metals. Central bank money printing and inflationary fiscal policy will almost certainly intensify. This is incredibly bullish for precious metals. We are in a global synchronized debasement environment. Gold has already been appreciating in all major fiat currencies in the world over the last year.
While yields continue to make historic lows worldwide, in real terms they have reached even more extreme levels. For instance, the US 10-year yield is now almost 2 percentage points below inflation. This just further strengthens our precious metals’ long thesis.
Even investment grade (IG) bonds are now blowing up. Implied volatility for IG bonds is surging! It’s now at its highest level since the Great Recession. Last week, the LQD (ETF) plunged 8% in 3 days, which is equivalent to a 10 standard deviation move. Declines as such only happened one other time in history, September 2008. We believe the corporate debt market crisis has just begun.
Stocks are acting like it’s the Great Depression again and we believe a recession has already begun. The probability for a US recession, as measure by this Bloomberg indicator, just surged above 50%. It’s currently at its highest level since the global financial crisis. This indicator leads changes in unemployment by 5 months with a 0.81 correlation. It suggests that the labor market has peaked.
We have also recently noted that the number of full-time employed people is now contracting. This was already rolling over in January. With the recent impacts from the virus outbreak, we believe this number will be plunging imminently.
Macro Trade of the Century
Crescat’s “Macro Trade of the Century” has been working phenomenally well since the market top. We believe our in-depth analysis looking at the history of economic cycles and the development of macro models is paying off tremendously. This is just the beginning of this three-legged trade. The global economy has just entered a recession and the fundamental damage of the virus outbreak on an already over-leveraged economy will be greater than anything we have ever seen. We have massive underfunded pensions with governments and corporations record indebted, while wealth inequality is at an extreme across the globe. It is not the ideal mix for asset prices that remain grossly overvalued worldwide.
When investors ask us if our macro themes to position for the downturn have already played out, the answer is absolutely not. There is so much more to go. We explain it in three ways:
1) The bursting of China’s credit bubble, the largest we’ve seen in history, has yet to materialize in its most brutal manner. As macro imbalances unfold worldwide, the Chinese current account should only continue to shrink and exacerbate its dollar shortage problem. We expect that a large devaluation in its currency versus USD is coming soon. We haven’t seen anything yet. We remain positioned for this in an asymmetric way through put options in our global macro fund in the yuan and the Hong Kong dollar.
2) Except for last year, gold, silver, and the precious metals’ miners haven’t yet performed in the way we think they will. Instead they have recoiled in a major way YTD. Meanwhile, central banks are clearly losing control of financial markets and further monetary stimulus appears unavoidable. The entire precious metals’ industry should benefit from this macro backdrop. The near- and medium-term upside opportunity in the entire precious metals complex has never looked more attractive than it does today.
3) Equity markets remain about 30% above their median valuations throughout history. The coming downturn is one that will likely not stop at the median. As we showed above, we believe there is much more downside ahead for stocks at large before we reach the trough of the current global recession.
In our hedge funds, we added significantly to our precious metals positions with gains from our short sales late last week. We have also recently been harvesting profits in some of the most beaten down of our shorts. We remain net short global equities but much less so than a month ago and with less gross exposure overall. As a value-oriented global macro asset management firm, we believe there is so much more to play out as the economic cycle has only just begun to turn down. We are not perma-bears, but we are determined to capitalize on this downturn.
I wanted to share my input. I’ve been watching what is going on in markets and my conclusion was that Risk Parity has blown up and Citadel and Millennium are in deep trouble. I just received a call from an old GS friend who now runs a large part of a Japanese bank balance sheet in the US and he was highly agitated…
His observation is that Bridgewater has faced massive redemptions from Saudi and others and that is what is caused some of the more dramatic moves last week (gold, bonds, equities and FX). He thinks AQR and 2 Sigma are in the same boat. There is massive forced liquidation of risk parity. All of them run leverage in the strategy, sometimes significant. Sovereign wealth, he thinks, is running for the hills as are others.
As you all know, I think Bridgewater goes under for reason not involving this but the exposure of massive fraud but this will force it.
My friend explained that due to the Volker rules, now that vol has risen, we has to cut risk limits by 80% in many areas – to put it in perspective his Dollar Mex position limit has gone from 200m to 12m. Thus, just when he was supposed to prove liquidity, he has to reduce it. His hands are tied. Even worse, he has to hedge counterparty risk with corp borrowers and that is adding to the tail spin of selling. There is no liquidity from the banks.
The same VAR issue, he claims, is hitting Citadel and Millennium but with a twist. He, along with all the banks, is jacking up lending rates to counterparties from Libor +35 to Libor +90 and he has a $1.5trn balance sheet. The funding stress is forcing banks to reduce lending risk. The issue is that the funding stress is coming from Citadel and Millennium it seems. They rely on repo but via the banks but the transmission mechanism is broken (regulation). It appears that Bernanke probably called Powell and asked him to flood with liquidity at repo but instead of $500bn being drawn, only $78 was drawn. The banks don’t need the cash and don’t want to lend to counterparties. And there in lies the problem – a full credit crunch.
With rates going up, all the relative value trades have blown up. Nothing works any more as they were making 12bps in illiquid stuff on massive leverage (off the runs, etc). As funding goes up they instantly go wildly unprofitable and are stuck either begging for repo funding or having to unwind and realize massive losses. There is no funding. This is big trouble.
These guys are short vol (VAR), short liquidity and short rates. The perfect fucking storm.
Then on top of that, my friend who was almost yelling to me about it, says he cannot take any risk and therefore cannot provide liquidity. His hands are tied.
COVID makes it even worse and liquidity is going to massively dry up next week and for the next few weeks. You see under Series 24 of FINRA, a trader cannot make markets from home. It is illegal. So everyone is getting sent home but the traders. The problem is the traders are now falling ill – JPM and CS are the two I’ve heard thus far. They will have to go home and each day more do, or decide they want to, the lower liquidity gets. No one can make markets.
Also, in the corp credit markets things are equally fucked up. Credit, due to the liquidity issues, has stopped trading. That is causing IG etc to blow out. When banks lend to corps, a separate desk (CVA or CPM desk) shorts the stock or buys the CDS etc as a hedge (regulations again) and if the loan is still on the books (they are not allowed to own the bonds but can lend to counterparties, bizarrely) they continues to do that as stocks fall or CDS widens. Essentially, they are short gamma, creating a lob sided market. Everyone is a seller and no one is a buyer. The banks have made money on the hedges while the debt markets get worse.
This is causing the equity value of many firms such as Haliburton, to fall below the debt levels. Whether these borrowers have cash on balance sheet or not is irrelevant because of the falling equity value in this market and from the CVA hedging. That is causing spreads to blow out and it will cause downgrades, thus creating a doom loop. > > So, we have a total shit storm if vol stays here for any period of time. I do not see vol falling yet and that is going to cause a really big issue with Citadel, Millennium, all the risk parity unwinds, all the risker credit that is being shorted for hedging and the repo that no one wants in the banks but their counterparties desperately needs. Every day this situation continues, the more dangerous it is going to get….
We have a big fucking margin call under way.
In my friends opinion, the only way to stop this is to remove the Volker rule under the emergency powers act ( to allow banks to provide liquidity), the Fed to cut to zero and for them to buy corporate bonds. All the banks have been talking to FINRA and they have said go to the government. Problem is Jamie Dimon is in bed. They need him to run the US Treasury as he is the only person who understands all of this and can navigate it through the politics.
This is likely the fix that needs to happen. What happens to Citadel, Millennium, Bridgewater, AQR, 2 Sigma and the corp bond market until they pull that trigger, I have no idea.
Today, I’m not going to go through all the country-by-country details of the ongoing coronavirus pandemic. My team and I are working diligently – franticly – to assimilate a huge amount of ever-changing information. As soon as we have some preliminary conclusions, we will share them. But for now we just don’t have enough hard data.
That will change soon.
This coming week (March 23-28) the South Koreans will be in the fifth week of their epidemic. To be blunt it is what I’ve been waiting for. The “typical” coronavirus experience for someone who requires hospitalization and survives is about 25 days end-to-end; five weeks is about what we need to get some good data.
Why the Koreans? The South Koreans are technically minded, they have a top-notch health care system, they are culturally wired for quick responses, their first instinct isn’t to lie about everything, and they believe in math. They will soon provide the world with the best and most holistic information about all aspects of the virus. If coronavirus had first erupted in South Korea, I have zero doubt it would have been contained, squashed, and we’d not be discussing it at all, much less living under self-imposed quarantine.
Until I have that information, however, I think our time is best served discussing the ongoing panic. In particular, the (I’m not sure this is quite the right word) positive aspects of the panic. There is more to American panic than toilet paper shortages.
The American geography is by far the best on the planet. The Greater Midwest is the largest chunk of temperate zone, high-quality arable land in the world, and it is overlain by the world’s largest internal navigable waterway network. Development and industrialization is the cheapest there of anywhere in the world. Barren deserts, rugged mountains, dense forests, giant lakes and ocean moats make for a nigh invasion-proof homeland. For five generations the United States experienced greater development, rising standards of living, easy financial access, minimal health concerns, rising economic growth, all in an environment of almost perfect security.
This has many, many outcomes. Three are worth highlighting:
First, considering its riches, its low development costs and its security, the U.S. economy is geographically set up for massive success. It isn’t about policy or governance or ideology. It is about place. That cannot be copied. The American system has exited every decade in a stronger position than it was in when it entered, including the decade periods of the Great Depression and Great Recession. It came thru the 1920s Spanish flu epidemic (a far more deadly pathogen than coronavirus) just fine. It will come through this one.
Second, the United States isn’t very good at national governance. When geography takes care of all the big issues, there is little need for a large, overarching, competent, national government. And it shows. The U.S. isn’t Germany or Korea, countries that live in geographic pressure cookers and so governance has to be top notch to ensure survival. This isn’t Russia which is paranoid for good reason and so must excel and intelligence operations. This isn’t Brazil where the terrain and climate are hostile to development and so excellence at infrastructure policy is essential. America’s lack of federal competence means that when there is a crisis it all comes down to the personality, skill and contacts of the person at the top. America’s initial reaction to the coronavirus isn’t its first failure of presidential leadership. But America’s sublime geography means the country will survive this failure to have others down the road.
