2017 has been an amazing year in the financial markets and although there is another month to go before the year-end, we feel it is right to outline here our views and investment strategy for 2018.
Our Model Portfolio recorded + 30 % for the first 11 months of the year and the AZUR ASIAN EQUITY FUND that we advise is up 22 % year to date net of fees, outperforming most of its benchmark and many competitors.
Yesterday, US equity markets recorded new all-time highs and Asian equity markets surpassed their 2007 peak for the first time. Some equity markets and sectors have gone into vertical acceleration recently and are showing trend-ending patterns.
As our readers know, we have been raising cash and initiated hedges in our model portfolios, while increasing our exposure to precious metals as an additional hedge.
But equities are not the only asset class to have risen strongly. Bitcoins are in a frenzy with all the hallmarks of an investment bubble and real estate markets have been strong almost everywhere apart from the high-end UK market which was affected by the consequences of BREXIT.
In fact, the global rise in risky assets confirms what we have been saying all along:
Central Banks kept loose monetary policies, maintained negative real interest rates and injected massive liquidity in the financial markets through massive bond purchases for way too long.
This is about to end and 2018 will mark the global shift in Central Bank policies from extremely accommodative monetary policies to a global tightening to control accelerating and coincident inflation.
The consequences on asset markets could be significant !
Here’s our outlook for the year ahead even if some of our views could be vindicated even before the end of 2017.
Key Call # 1: INFLATION IS BACK
Central Banks have always had a tendency to look into the back mirror rather than predicting the future.
This is the natural and intrinsic bias of a process that is based on analyzing past and actual data and where the risk of making policy mistakes based on predictive models that could be off the mark cannot be afforded.
The 2008 global financial crisis – the worst since the other US-induced crisis of 1927 – was a phenomenal trauma for central bankers around the world and they resorted to extraordinary measures to stabilize the banking systems, the economies and get the world back on track.
And indeed they succeeded ! Today the world economy is growing again and fears of a systemic deflation à la Japan are receding.
2017 was remarkable in so much as economic growth increased globally towards 3 %, inflation rose towards 2 % – the actual target of most of the world central banks – but central bankers and bond market participants are still worried about a loss of momentum ahead, as testified by the minutes of the Fed meeting released yesterday and the extraordinary flattening of the US yield curve in the past few weeks.
In yesterday’s released minutes the Federal Reserve acknowledges that the US labor market had continued to strengthen and that economic activity had been rising solidly despite hurricane-related disruptions but several policymakers still consider that inflation remains persistently low and worry about the FED tightening too much too quickly.
European Central Bank President Mario Draghi repeatedly says the same and Japan’s Kuroda San has clearly indicated that Japan’s monetary policy will remain extremely accommodative for years to come to deflate the massive stock of debt accumulated by Japan over the lost decades.
But economic laws are economic laws and inflation is a deep undercurrent that moves very slowly, with a lag, and is very difficult to tame it one way or another. Inflationary cycles are both cyclical and structural and our readers know that we are of the view that the world ended a 30 year structural deflation phase in 2013.
We are now starting a new 30 year structural inflationary cycle.
From a more cyclical standpoint, with US unemployment at a record low of 4.1 % and decreasing, it is just a matter of time for wage pressure to start appearing, and as always, central bankers will start worrying only when they appear.
Unfortunately, by then, it will be too late as their momentum will be well entrenched.
The charts below show the future trends of inflation and we expect US inflation to rise markedly above 2 % in the second half of 2018 and the same to happen in Europe and Japan.
Key Call # 2: BOND MARKETS ARE HIGHLY RISKY
As global investors and macro-economic asset allocators since 1984, we started our career and lived most of it through this massive structural deflationary trend that started in 1982 with Paul Volcker at the helm of the FED.
US interest rates were at 18 % then and most of our career was done investing in bonds and arbitraging these markets.
Since 2013, and for the first time in our career we have been avoiding fixed rate bonds and see them today as the most dangerous asset class of all.
Our analysis an conclusions are based on two significant factors :
One is that inflation is coming back and that the current near-zero interest rate policies, flat yield curves and negative long term interest rates are not discounting what is bound to happen when inflation re-surfaces; a massive re-rating in bond yields, particularly at the long end of the curve, and an acceleration of the pace of interest rates normalization at the short end of the curve as inflation and wage pressures become ascertained and a reality to deal with.
Two, that the trillions of fixed rate bonds accumulated by the various central banks in the past ten years have created an artificially-biased bond market by limiting supply and that this phenomenon is about to reverse as testified by the decision of the FED to start offloading their bond portfolio gradually. When this artificial purchasing phenomenon dries out, bond markets will re-rate downwards.
Investors must keep in mind that the NEGATIVE bond yields that we experienced over the past few years are EXTREMELY EXCEPTIONAL and actually never happened in history apart form the case of Switzerland when its currency was seen as a political refuge by global investors.
Long-Dated bond yields will not stay in negative or at zero as is the case in Europe and Japan for long.
Finally, the above phenomenon has forced pension funds who are obliged to guarantee income on their portfolios to go way longer on the curve than they should have, in search of that incremental yield needed to service their liabilities.
This in turn explains the abnormally flat yield curves in the three largest economic zones, and a significant correction in fixed rate bonds will have the effect of triggering massive stop losses and a one-way market in bonds.
Another worry we have is that the global stock of debt has increased enormously in the past ten years and is now way higher than it was in 2007 before the financial crisis. Today, global debt represents 325 % of world GDP, more than doubling since the peak of 2007.
The size of global bond markets has equally doubled over the period as can be seen from chart 4 below.
Ultra-low interest rates have enticed Governments, corporations and individuals to borrow massively and re-leverage using rising assets as collateral.
When interest rates start to rise, the cost of servicing this debt will shoot up and default rates will explode, making investors demand higher yield premiums to lend.
There are numerous indicators flashing orange and red lights in the markets, and the recent breakout of high yield and junk bond spreads is one that should not be neglected by bond investors and global investors for that matter.
In our view, global investors should avoid fixed rate bonds altogether or stay at the very short end of the curve at this stage.
They should rather privilege inflation linked bonds or Floating rate notes and stick to high credit ratings.
Key Call # 3: THE US DOLLAR AND THE CHINESE YUAN WILL RISE
Currency markets are hard to predict and the precise timing of the calls are even more difficult to make.
However, currency levels are relative values of the medium of payment that reflects a particular economy and are either function of interest rate differentials or of systemic shifts in the importance of an economy relative to other economies.
The two phenomena will be at play in 2018.
As discussed above, we expect inflation to come back and interest rates to rise in the three major economic blocks of the world ahead, but the USA are well ahead in terms of timing in the economic cycle and they will raise rates much faster than Europe or Japan, creating not only a nominal interest rate differential in favor of the US Dollar, but even a real interest rate differential that will entice global investors to shift their liquidity to the US Dollar in search of higher yields.
This timing differential is already visible. The FED is actively debating its next increases in interest rates, the next one probably happening in the next two weeks and the entire debate is about when the next ones will take place.
In Europe, the central bank is adamant that it will not raise rates for at least another year and Japan has not even set any target date for a potential increase in interest rates.
Indeed, contrary to the situation of the USA where unemployment rates are recording new lows after new lows and are now at or below what is considered to be the Natural Rate of Unemployment below which an economy cannot function, Europe still has to deal with high unemployment in many parts of the European Union and will keep rates low until this unemployment starts falling decisively.
Structural reforms such as the one being implemented in France will obviously be key, but still, Europe’s growth rate must accelerate markedly to trigger more employment.
Japan has different reasons for keeping interest rates ultra low for almost ever. Japan has now close to 250 % public debt-to-gdp in an aging economy and the only way for Japan to tame its debt and reduce it in real terms is to actually deflate it through high inflation.
Although the BOJ continues to state that 2 % is its target inflation, Japan probably needs inflation running at 4 to 5 % to really bring back its finances under control.
2018 will therefore be the year where interest rate differentials between the US and the rest of the world will be the greatest and we expect the US Dollar to start appreciating strongly after the current bout of weakness.
THE CHINESE YUAN
Currency levels also reflect structural changes in the relative importance of economies in the world and their impact on the global financial and economic scene.
This is currently happening in China and the Chinese Yuan is about to embark on a structural appreciation phase.
China has become the world second largest economy in less than three decades through a model of cheap exports and me-too technologies that made it the manufacturing centre of almost everything on the planet.
This was made possible by the combination of a skilled labor kept extremely cheap by pro-active policies of maintaining the Chinese currency at low levels for several decades. This in turn explains how China accumulated in excess of 4 trillion of Foreign exchange reserves.
The competition from cheap Chinese labor had a substantial structural deflationary impact on the rest of the world and triggered high unemployment levels almost everywhere.
But It allowed China to create hundreds of millions of jobs in industry and services and shift hundreds of millions Chinese from the countryside to urban centers. By the same token, these policies have allowed the development of the world’s largest middle class that is now becoming the world’s largest consumer.
China is transforming itself from an export-led economy to a consumer-led economy and the secular phase of urbanisation and high job creation is over.
The need for China to keep an artificially low currency is no longer there and, on the contrary, an appreciation of its currency will make its consumers’ disposable income much higher in relative terms.
Moreover, the opening up of its financial markets to foreign investors will trigger substantial rebalancings of global portfolios that are still extremely underweighted Chinese assets and bonds in particular.
We believe that the Chinese Yuan started in 2017 a long-lasting structural phase of appreciation that will take it much higher even if the rise is gradual and controlled as is always the case in China.
Expect the Yuan to rise steadily in 2018, probably to 5.5 in 2018.
Key Call # 4: EQUITY MARKETS WILL PEAK IN 2018
We are less enthusiastic about equities heading into 2018 – we do not see much upside in the world major equity targets for the next 12 months and the liquidity conditions that have fueled equity markets upwards in 2017 are set to turn in 2018.
Moreover, from a cyclical standpoint, Corporate Earnings growth have will probably peaked in the first quarter of 2018 as higher interest rates and higher wage costs start cutting into profits.
As can be seen from the charts below, equity markets had a spectacular run since the bottom of 2009 with the World Equity Index delivering a 200 % increase in 8 years, the US SP500 rising by 290 %, and Europe lagging seriously behind with only a 110 % increase.
In Asia, the MSCI Asia Pacific Index delivered a +147 % performance, Japan adding +223 %, China’s domestic stocks rising by 105 % only and Hong Kong listed Chinese shares rising by 153 %.
We expect stretched valuations and rising bond yields to limit equity index performances in 2018 and the prospect of a potential US economic slowdown in 2020 to further cramp returns in 2019.
We also raise some concerns about the quantity of shorts on volatility, which could potentially strongly deteriorate the risk reward profile of equity markets. US equities at their fair value – The S&P 500 has already surpassed our target for the end of this cycle and is now entering expensive territory.
Indeed, on all the metrics, US equities are trading at levels only seen during the late – 90s bubble. Since Trump’s election, the US equity market has risen 24%, but only half of this came from earnings growth. The other half has been driven by P/E expansion.
The US equity market is already pricing in potential tax reform. The rise in bond yields and Fed repricing should be headwinds against further US equity rerating. Technology stocks are particularly expensive and we would rather stick to defensive, mining and cyclical stocks.
Technically, we see a short but sharp correction in December 2017, a last rally but not much higher than current levels in the first quarter of 2018 before a much more severe end to the bull phase later in the year.
We would not chase this market higher as many political events could take place.
We use NASDAQ shorts to hedge global equity portfolios.
The eurozone recovery is now well under way and a well-known story but European equity markets seriously underperformed in 2017 because of the strong EURO.
Equity valuations are still fair in Europe and are in line with their historical averages.
A stronger economy would support corporate earnings, unless the EUR were to continue to strengthen as it would constitute a headwind to profit growth. But we are not of the view that the EUR will rise much from current levels. On the contrary. If the EUR starts depreciating as we expect, then European equity markets would become a major BUY.
We favor core markets over peripherals markets and UK equities – The French and German equity markets are amongst our preferred markets together with Switzerland.
Political uncertainty should continue to weigh on peripheral markets in 2018: elections in Italy and the issue of Catalonia in Spain. We also recommend staying away from the UK as Brexit negotiations are accelerating and several scenarios are possible: only a soft Brexit would be supportive for the FTSE 100.
In Europe we favor financials, cyclicals, healthcare, distribution and consumer discretionary products.
ASIAN EQUITY MARKETS
Asian equities are clearly overbought short term and are testing their previous 2007 peak surpassed only yesterday. A correction is likely, but Asia remains, and by far, the most attractive region to invest in today.
Economic growth will remain strong in China, India, Vietnam and South East Asia in general and the coming to age of the Chinese consumer is going to boost this part of the world considerably.
Japan had a phenomenal run since March 2016 and the landslide victory of Mr. ABE in October sent the market sky-rocketing. Corporate earnings are the best they have been in more than twenty years and ultra-low nominal rates are propelling stocks higher.
The only headwind at the moment is the strength of the Japanese Yen, but we expect this strength to be short-lived.
Beyond a short term correction, we see the Nikkei Index reaching 25’000 before 2018 is over and prefer consumer stocks, real estate, financials and technology stocks.
CHINA remains by far our preferred equity market in terms of valuation, economic growth, corporate earnings and flows of funds.
Domestic Chinese equities have lagged considerably the rest of the world having risen only 105 % since 2009 and they still trade 60 % below their 2015 peak.
The Chinese authorities attempt in 2014 to liberalise the markets created a major up move form 2000 to 5000 and the subsequent correction.. It also triggered massive flows of domestic funds outside of the Yuan which led to the 2016 depreciation of the Yuan.
But the Chinese have learned from their mistakes and will keep the market under control and volatility low. The Government has ample pockets to intervene in both equity and foreign exchange markets and the steady rising trend of the index since February 2016 is expected to continue.
The Hong Kong-listed Chinese shares HSCEI has risen more than the domestic index, but remains cheaper in terms of valuation because of the underweighting of technology stocks and overweighting of more cyclical industries.
Foreign investors worry about the substantial increase in total Chinese debt but we have written at length about this issue and the need to analyse it within the context of High Capital formation and extremely high savings.
The Government efforts to tame credit growth and corporate indebtedness are bearing their fruits and individuals indebtedness remains low by international standards.
The big story in China will be the consumer and the high-flying stocks are technology stocks.
We would not chase the Tencents and Weibo of this world too far and prefer online retailers, banks, financials, insurance, pharmaceuticals and healthcare as well as the big theme of electric cars in China as the Government is determined to fighting pollution as a strategic goals for the next five years.
We also privilege clean power generation and would avoid real estate.
We cannot exclude the possibility of a correction in the short term, but it should be taken as an opportunity to increase positions.
Key Call # 5: PRECIOUS METALS SET TO SHINE
Beyond a positive economic backdrop for global commodities due to strong coincident economic growth and rising inflation, Precious Metals are gently but surely carving a very nice base for a strong rally in 2018.
Inflationary fears, sharply lower bond markets and a peak in global equity markets will set the stage for a substantial flight to quality into Gold which, as can be seen from the chart below, is carving a magnificent cup configuration.
A Break of the 1375 level on the upside will mark the beginning of the rise and the move could be quite rapid.
Silver is in an even better position and the chart looks even more promising.
Investors imagination may start being captured by the important use of Silver in solar panels and Electric Vehicles as both products should see considerable growth ahead.
When taking into consideration the fact that there has not been any new major discovery of Silver deposits for almost 40 years and that peak supply is expected to take place between 2023 and 2029, Silver could rise very sharply and even outperform Gold significantly.
Silver recycling is certainly an important component of supply but recovery costs are currently well above US$ 17.
We expect Silver to trade towards 22 and then, once 22 is broken, the sky is the limit.
Oil has been strong lately on OPEC resolve and inventory data from the US. However, the problem remains the same and we do not see much upside for OIL in 2018, barring a major armed conflict in the Middle East, a probability that we do not exclude.
Oil will probably touch US$ 60 – impacting inflation by the way – before succumbing to the twin effects of more shale oil production and the spreading of Electric Cars and Hybrid vehicles world wide. Moreover, Solar panels are becoming much cheaper and much more efficient and we would not be surprised to see another bumper year in terms of investment in renewable energy generation plants in 2018.
All this to say that we do not expect the current rally in Oil to last very long and maintain our long-held target of a price of 10 to 20 Dollars per barrel of Oil in the coming few years.
Key Call # 6: VOLATILITY WILL BE BACK in 2018
Maybe the least difficult call to make but the most difficult to time is the return of volatility of the financial markets in 2018.
The past 18 months have been characterized by the lowest volatility on record ever and the longest string of new highs in equity markets without corrections.
The VIX charts below show that we are trading a record lows and at levels that led to major spikes in volatility afterwards. The second chart indicates that the open position in Volatility contracts is at levels never reached before as investors have been shorting volatility continuously over the past few years and particularly since 2016.
The very tame behaviour of the financial markets is actually not limited to equity markets but it has also been a hallmark of the bond markets.
We explain this extremely low volatility by the extraordinary monetary stimulus and extremely low levels of nominal interest rates, which drove investors to buy any pullback when they had a chance to.
But there again, the world in changing in 2018 and liquidity will be taken out of the markets as if someone had been pulling the rug from under their feet.
A breakdown in bond markets following nasty inflation figures or a much more hawkish tone at the FED could do the job and the departure of Janet Yellen does not bode well for continuity.
If our timing is right, we expect a short spike in volatility in December and much more pronounced rise at the end of the first quarter 2018.
Considering that the long term average of the VIX index is 18 and that it currently trades at less than 10, there is definitely value in buying it now, but the question is how long will one have to hold positions to make money on the trade.
The 2016 correction brought the VIX to 50 if one had caught the top, but a more conservative assumption would be to expect volatility to trade above 25 in the coming 6 months. Probably worth the trade.
Key Call # 7; POLITICAL RISK HAS SHIFTED TO THE MENA
2017 was a year with high tensions originating from the Korean peninsula, the Syrian war and Radical Islam terrorism.
The first two are now out of the way in our view as China has taken responsibility for peace in North East Asia and Russia has taken control of the process to end the Syrian war.
The consecration of Xi Jing Ping at China’s CNPCC in October and his subsequent meeting with Donald Trump at the beginning of November have allowed China’s New Emperor to make commitments and take responsibility for Peace on the Korean Peninsula.
One of the most contentious issue, the deployment of the US THAAD missile anti-ballistic system in South Korea was solved by a mutual agreement between China and South Korea and since then the North Korean Leader has been far less vocal in his attacks against the US.
We have always argued that the rise of China as a world, if not THE world, superpower was not only economic but also political and XI Jing Ping is definitely en route to take control of the fate of the Asia Pacific region.
China has, by nature, a culture of peace and stability and its expansionary views are far more directed at economic dominance than at military domination. Its rise in might is a good sign for the world peace and we believe that the North Korean issue will be dealt with gradually and without major conflicts from now on.
One cannot exclude some significant changes in North korea in the coming years, maybe even starting in 2018.
In Syria, the decisive military intervention of Russia allowed the remaining in power of Syrian President Bashar Al Assad and the military victory of the Government forces and allies over Daesh and the remains of the Syrian opposition.
The Peace process is engaged and last week’s meeting of Turkey, Iran and Russia in Sochi was organised to outline the format of the peace process whether in Astana or in Geneva.
Nevertheless, Syria will not come out of this war as a unified and peaceful country and the fundamental issues at stake have not been resolved. Guerrilla warfare will probably continue for many months until a viable political solution is found, and that may not include Assad remaining in power. But these will be insignificant as far as the global financial markets are concerned.
Radical Islam is definitely on the mend, at lest from the Sunni side.
The tectonic shifts taking place in Saudi Arabia are about the realization that the policy of financing and nurturing a radical vision of Islam since the second oil shock in 1979 only led the two muslim leaders, Saudi Arabia and Iran, to a religious war with devastating consequences.
Even more damaging, it has made the Arabs and the Muslim World the pariahs of the world.
The nomination of a 32-year old prince, Mohammad Bin Salman, as heir to the Saudi throne is a sign that his mission is to reform Saudi Arabia profoundly, and the task will take at least a generation. MBS could stay in power for decades if history of the Saudi Kingdom is any guide.
And MBS is in a hurry. His drastic reforms vis a vis women’s rights, new lifestyles and cleaning up the internal affairs of the Kingdom have taken everybody but surprise, but one would be foolish to assume that MBS is acting the way he is without having the very solid backing of his father the King and of a large segment of the Saudi Royal family, let alone the people itself.
Saudi Arabia is a nation of young people and they all want more freedom and rights.
The defeats of Daesh, Al Qaeda and Al Nusra are also other signs that the fight against radical Islam is coming to an end and that it will now be much more difficult for these groups to benefit from financing and resources.
The rapport de force between Qatar and the rest of the Gulf States is an indication of that, the main criticism from the Arabs towards Qatar being their involvement in financing radical Islam.
So this is good news for the rest of the world, but it is only one side of the equation.
And the other side is the Islamic Republic of Iran, which contrary to Saudi Arabia is not a Kingdom ruled by a family with the support of clerics, but a country where the clerics themselves rule the country and they are facing major challenges at home to make the Islamic Republic a success. From the 1990 Iran-Iraq war to the international sanctions, Iran actually never had a period of real peace and prosperity since the Islamic Republic was established in 1979.
For the past forty years, Iran has gone backwards economically and in terms of personal freedoms. The violent repression of 2009 shows that the Iranian people are contesting the system they are living in. Indeed, international sanctions have fed the downturn, but the fact of the matter is that the Iranian clerics cannot do what MBS is doing in Saudi Arabia without losing their grip on power.
Over the past decade, Iran shifted its focus on exporting its model outside of its borders and position itself as the leader of the shiite world, a world that represents 18 % of the entire Muslim population.
And to do so it financed and encouraged radical islam in countries that are not Persian or Caspian Sea countries but in the Arab world, a world that has, for thousands of years been a natural enemy of Persia. The devastating Iran-Iraq war of the 1990s is a reminder of how difficult integrating Arab countries – be they Shias as well – into an Iranian-led political conglomerate will be.
Iran is today at the forefront of the next political tensions as testified by the Lebanese crisis that started on November 4th and we expect political and military tensions to rise considerably in the Middle East in 2018.
The possibility of a new war cannot be excluded.
For the first time since the creation of the State of Israel in 1948, the interests of the Arab World – Saudi Arabia and the Arab League – of Israel and of the USA are converging and for the first time since 1948 a two-state solution in the Israeli-Palestinian conflict has become a real possibility as the PLO and the Fatah recognized earlier this year the right of Israel to exist as a State in peace.
The only remaining threat to any peace process is the presence of the 100’000-or-so offensive missiles deployed by Hezbollah in Lebanon under the guidance and instructions of Iran.
The recent heightening of tensions in Lebanon, home to Hizbollah, shows that Saudi Arabia has decided to deal with the problem and force Iran to back-off from the Arab world.
Could that lead to a war ? One can certainly not exclude that possibility considering the way MBS did not hesitate to engage Saudi troops and air forces in the Yamani conflict.
The fact of the matter is that the weapons of Hezbollah have become the crucial issue on the International scene and that it will either be solved by a unilateral and peaceful withdrawal from Iran or by a very destructive war that could involve Saudi Arabia and Israel at the same time.
Political risks have shifted from the Asia Pacific region to the Middle East….
And wars in that region have never been good for the markets.
Also published on Medium.