Credit Cover Photo. Joseph Chan – Unsplash.com
As we predicted, 2018 was a year of turning points : turning points in inflation, monetary policies and equity markets.
We were amongst the few to predict the end of the secular bull market in US equities and 2018 ended-up being the worst year in equities since the 2008 financial crisis.
Equity markets lost -10 % on average while Asian equities and Emerging Markets lost -15 %. Chinese equities were by far the worst performers losing – 25 %.
Our Model Portfolio recorded + 17.59 % for the year, the fifth consecutive year of double-digit positive performances and a remarkable achievement considering the global environment.
Our outperformance came primarily from our ability to predict the global trends successfully at the end of 2017.
(see OUR SEVEN INVESTMENT CALLS FOR 2018 )
Amongst many other things, in 2018, we successfully predicted :
. The return of inflation
. The fall in bond markets
. The peak of equities and the end of the 2009 – 2018 secular bull market
. The return of Volatility
. The Strength of the US Dollar
. The End of Technology, and
. The collapse in crypto-currencies
However, we did not forecast the outbreak of the US – China Trade war in February and our worries about a military conflict in the Middle East were misplaced. Our call on precious metals was also too early.
We are now ready to share our vision for 2019
OUR SEVEN INVESTMENT CALLS FOR 2019
Macro-economic trends determine monetary policies which determine the liquidity environment, which, in turn, and together with investors psychology, determine the behavior of asset classes and the trends in valuation expansion or contraction.
We are entering 2019 with EXACTLY THE OPPOSITE situation we were at at the beginning of 2018.
In January 2018, Donald Trump’s tax cuts were delivering a growth and earnings shot in an already red hot US economy, while equity markets had a phenomenal year which culminated in a vertical acceleration between the 1st and the 24th of January 2018.
At the beginning of 2019, we just had the worst quarter in equities of the past 10 years, fear has reached extremes and economists are pondering the likelihood of the next recession.
Key Call # 1: DEFLATION SCARE
2018 was the year of the return of inflation. Last year, we made that call against a consensus that was largely worried about deflation. But during the year, inflation turned up in almost every region of the world apart form Japan.
Economists, strategists and bond investors all espoused the return of inflation theme and the best illustration of that was the decision of the European Central Bank to announce the end of its quantitative easing despite sputtering growth in the Euro zone.
2017 was the year where the world economy had finally regained a strong footing with coincident growth in various parts of the world feeding on each other.
It was also the year where the exceptional monetary policies implemented since the 2008 crisis were reversed.
America increased interest rates four times and ended its bond buying program as the lowest unemployment rate in four decades ended up fueling wage inflation.
Although economic growth has been uneven, the underlying inflationary trends have been clear and the behavior of the world bond markets up till November 2018 were clearly the result of an Inflation scare.
In 2019 we are going to have a Deflation scare instead !
Inflation could and should have continued to rise in a coincident way.
But the Trade Wars launched by Donald Trump in February, against Canada, Mexico and then China had a significant effect on global growth.
The final effects on the 4th quarter GDP numbers are still to be seen, but we already have signs that China slowed down significantly, that Germany is on the verge of a recession and that US corporations have been severely impacted.
The Trade Wars caused major uncertainties for CEOs in every part of the world and they suddenly shelved all the plans they had for future expansion.
The brutal slowdown in Investments was visible in almost every major economy in the fourth quarter of 2018, and Tim Cook’s recent profit warning was a strong reminder to Donald Trump that the first casualty of the Trade War would be American corporation’s sales and profits.
The Chinese do not like to be attacked and the Government does not need to give instructions or even send messages for Chinese consumers to boycott American products. This is what happened to Apple in the last two quarters of the year and what he had predicted would happen back in February.
Moreover, US$ 5 Trillion of wealth vanished in American equities in the 4th quarter and the same amount was wiped out in other equity markets.
The negative wealth effect induced by the fall in global equities will be considerable as consumers and savers feel that much poorer and therefore pull back on consumption and borrowings.
We expect a significant slowdown in the major economies of the world in the first half of the year.
The most likely scenario is one where global growth remains relatively solid in the first quarter, building on its past momentum, but starts slowing down sharply in the second quarter.
This economic slowdown, combined with the base effect of the 2018 collapse in oil prices will translate into lower inflation numbers.
BY THE SUMMER, THE BUZZ WORD OF ECONOMIST WILL BE DEFLATION.
In the second half of 2019, we will experiment a DEFLATION SCARE with significant consequences on the various asset classes.
Investors will worry about a coming recession and a fall in inflation towards zero and way below the targets set by Central Banks.
The FED will slow the pace of interest rate increases and may even lower rates at the beginning of 2020
But economic laws are economic laws and inflation is a deep undercurrent phenomenon that moves very slowly and with a lag.
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 started a new 30 year structural inflationary cycle in 2016 and the 2019 deflation. scare will only be a “scare”, a temporary lapse in an otherwise structural uptrend in inflation that will resume its course in 2020.
Economists will fear recessions and Central Banks will have to put any ideas of monetary tightening on hold for a few quarters, but the world economy should avoid recession and start growing again in 2020.
The key to the global economy will be China that is in the midst of a slowdown that will probably end by the middle of 2019 as economic stimulus starts to kick-in.
Key Call # 2: EQUITY MARKETS WILL COMPLETE THEIR CYCLICAL BEAR MARKET
Global equity markets started a cyclical bear market in 2018. Cyclical bear markets are deep corrections within a secular bull phase. They tend to last for 400 days and prices tend to fall by 38 % if one uses the averages recorded since 1900.
Cyclical Bear markets unfold in three phases ( A-B-C ) with two down legs ( A & C ) and one up leg (B ), the bear market rally. Each DOWN leg tends to last 4 to 6 months while the UP leg ( Baer Market Rally ) is usually shorter ( 3 to 4 months on average )
Bear phases are themselves made of 5 legs, 3 down and 2 up, while the up leg is made of three (A-B-C)
The MSCI World equity index peaked on the 29th January 2018 and fell 20.2 % in the first leg of the bear market. Most equity markets peaked in January as well, save for the US equity market
The US markets made new highs later in the year, propelled by the strong earnings coming from Donald Trump’s tax cuts, indeed, US corporate earnings have been spectacular in 2018 with grown exceeding 22 %, and the massive share buybacks made possible by the unexpected cash flow left by the tax cuts.
The US Dow Jones Industrial Index peaked on October 3rd 2018, after a rally that started on March 31st 2009, the longest in the history if the US stock market and saw the value of the index more than treble, delivering an average of 16.12% per annum over the nine and a half years it lasted.
At the time of writing, and focusing on the US equity indexes, we have now completed 4 of the 5 legs of the A phase of the secular bear market.
What this means is that the strong rebound of the beginning of January is the 4th leg and that the bottom recorded on the 26th December 2018 is NOT the final bottom of the A leg of the cyclical bear market in US equities.
Equally, the 11 % rebound of January has probably run its course and we should see some volatility in the last two weeks of January before we start the fifth a final leg down of the A Phase in February/March with an ultimate target on the SP500 at around 2’200.
The Bear Market Rally should start by the end of March beginning of April and last until June / July of 2019 with a target of between 2650 and 2700, a significant and highly tradable rebound of about 20 % from the 2200 level.
The last leg ( C ) of the Cyclical Bear Market should then unfold over the summer in 5 different sub-legs and end either in December 2019 or at the very beginning of 2020 at a level of 2070 – 2080, or the full 38 % decline from the top.
This scenario is in tune with the macro-economic environment that is to be expected. Wave A of the bear market is pricing an economic cool down – what we are in now – while Wave C will be pricing in a recession and the deflation scare.
An Alternative scenario is that we are in a melt-down similar to 2008 where high yield credit risk becomes a systematic scare and poor market liquidity triggers an irrational undershooting similar to the one we saw in the last three weeks of December.
If this is the case, January’s rebound should be followed by a sharp fall in February /March and the final low of the cyclical bear market would be in April of this year.
If this is the case, then 2019 could end up being a positive year after all.
European equites have been underperforming for more than 10 years and framed in a massive triangle since their 2000 peak. The rally that started in 2009 peaked in April 2015 after a 117 % appreciation and again in November 2017.
The outlook for European equities is therefore very different from the one of the US and European stocks are in a secular sideways trading range that has not experienced any of the sentiment or valuation excesses of their US counterparts.
In 2019, we see less downside for European stocks ( target for the low at 2600 on the EUROSTOXX 50 ) but do not see the factors that would trigger a massive advance either, despite the ultra low interest rate environment.
Europe needs a political drive for more integration and economic efficiency. A successful BREXIT will be one step forward, but good news must come out of Greece, Italy and Spain and more political leadership out of France and Germany before Europe outperforms.
Asian / Emerging Markets
Emerging Markets peaked ahead of all other equity markets in January 2018 and fell much more than European or American equities. The MSCI Emerging market index and the the MSCI Asia Pacific lost 26 % and 25 % of their value respectively since January.
Asia and China bottomed out in October and showed relative outperformance in December, a positive sign as far as a first half rebound is concerned.
Beyond the first quarter / half bear market rally, we see Emerging / Asian equity markets falling in the second half of the year in tune with Us equities and marking a final low in December 2019 / early 2020.
This final low will constitute a VERY IMPORTANT LONG TERM BUYING OPPORTUNITY for Chinese stocks as their next phase will be a structural and long-lasting bull market.
India, Australia and New Zealand should have a negative 2019 marked by sharp falls.
Key Call # 3: THE US DOLLAR TO WEAKEN FIRST AND THEN COMPLETE ITS STRUCTURAL BULL MARKET
Currency markets are hard to predict and the precise timing of the calls are even more difficult to make. We had extremely good calls in 2018, timing the top of the EUR at 1.255 and of the Japanese Yen at 106.5.
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.
2018 break down in equity markets and collapse in oil prices will take its toll on global growth and refrain monetary policies normalization.
In 2019 we see the action much more on the Yuan and Emerging market currencies than on the major pairs.
As our readers know, we have seen the Us currency in a major secular advance since 2008.
Although we expect a bout of weakness and the EUR rising to 1.18 in the first half of 2019, another leg up in the US dollar is needed to complete the entire secular bull market.
The next leg up will take the US currency at least to re-test the 2016 highs or even higher.
Indeed, the interest play between the US dollar and Europe is now frozen with less and less hopes for higher US rates but even less hopes for Euro rate increases.
Speculation will take over and make the pair move sharply one way or another around the current pivot rate.
Japan has many 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.
For the time being, Japanese inflation has barely reached 1 % with very little momentum. The stock market weakness of the 4th quarter of 2018 has created a self-feeding deflationary push of the Japanese Yen higher.
For years now the Japanese Yen has been in a long term triangle that was broken in 2018, opening the way to a major move down towards 120 and 125.
The JPYUSD sharp move from 114 to 104.74 in January 2018 brought it back on the other side of the triangle and, if not negated quickly, points to more strength of the Japanese Yen ahead.
THE CHINESE YUAN
The 2018 Trade War had a significant impact on China and the Chinese currency.
China was and is in the middle of a transition in its economic model form an export-led model to a consumption led model. This transition is well advanced and last year Chinese consumption represented 78 % of the GDP when compared to 56 % the year before.
It is also quickly becoming a service economy.
Nevertheless, 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.
However, China is still a massive exporting machine and the Chinese Government has been holding off and preventing a yuan revaluation for as long as they could to keep growth and job creation humming.
China’s fast transformation into a consumer-led economy means that 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.
However, Donald Trump’s trade War changed the situation completely in 2018
As soon as it was announced the Yuan paltered and starting to fall, with investors betting that China would counter the effects of the US tariffs through a competitive devaluation.
China and America both know that the only solution to China’s Trade Surpluses is a sharp and lasting revaluation of the Chinese currency. Donald Trump has voiced that request several times in the past few months.
Both parties now need a quick resolution to the Trade War and the positive tone of the negotiations in January 2019 led to a sharp appreciation of the Chinese currency.
From there, two scenarios are possible :
. Either the Trade War continues and the bear market in global equities extends until the end of 2019 /beginning of 2020 and the Yuan then depreciates towards 7.20 / 7.25 until a clear bottom is made in equities
. The two parties really want to solve the Trade War issue and equity markets make a significant and final bottom in Q2 2019 and the Yuan starts appreciating structurally towards 5 or below.
The choice is very much in the hands of the Chinese themselves and their willingness to commit to a Yuan appreciation to solve the Trade issue.
Interestingly enough, in a very unusual way, the annual meetings of many regional and provincial Communist Party cells that were scheduled to take place in December and January have been postponed until February.
This usually indicates that some major strategic decisions are being discussed and will be announced in February.
Key Call # 4: A Major Breakout in GOLD and SILVER
We made that call in 2018 and we got it wrong. We had called a major bottom in Gold in December 2015 and were waiting for a confirmation of the change of secular trend in Gold and Silver.
We expected the breakout to take place in 2018 and be caused by the return of inflation, but instead, Gold failed to break above the horizontal resistance and tested the uptrend of the triangle.
Silver even broke down of its very long term triangle to re-test its 2015long term low at 14 US$.
In fact, the base for precious metals to rise is still being build-up and the trigger for the rise will not be inflationary fears but the deflationary scare and the fear of investors about equity markets.
Deflationary fears, sharply lower bond and equity markets will set the stage for a substantial flight to quality into Gold which, as can be seen from the chart above, is recording higher lows after higher lows.
A Break of the 1375 level on the upside will mark the beginning of a substantial rise and the move could be quite rapid.
Inflationary fears, sharply lower bond markets and a peak in global equity markets will set the stage for a substantial flight to quality into Gold which, as can be seen from the chart below, is carving a magnificent cup configuration.
A Break of the 1375 level on the upside will mark the beginning of the rise and the move could be both rapid and substantial.
Silver has just recorded an important double bottom at 14 and should climb back above the long term triangle.
Investors imagination may start being captured by the important use of Silver in solar panels and Electric Vehicles as both products should see considerable growth ahead.
When taking into consideration the fact that there has not been any new major discovery of Silver deposits for almost 40 years and that peak supply is expected to take place between 2023 and 2029, Silver could rise very sharply and even outperform Gold significantly.
Silver recycling is certainly an important component of supply but recovery costs are currently well above US$ 17.
We expect Silver to trade towards 22 and then, once 22 is broken, the sky is the limit.
2019 could also be the year of Gold and Silver mines, a sector that has been devastated in 2018.
Key Call # 5: COMMODITIES TO REMAIN IN A BEAR MARKET
Secular bear markets in commodities tend to last between 8 and 16 years and this one started in 2011. In Q1 2016, Oil and metals made a cyclical bottom within this secular bear market and the bear market rally lasted until September 2018, as investors expected a return of coincident growth and inflation.
The turning point in equities, oil and commodities in the 4th quarter of 2018 indicates te beginning of the last leg of the 2011 secular bear market.
Deflation fears will take metals and soft commodities lower until global equity markets complete their bear market, either in April 2019 or in December 2019 / January 2020.
The last and final leg of the CRB Index will probably take it to 140 /150 for a final bottom of the cycle and the beginning of a new secular up cycle, driven by China’s economic growth.
This bottom will take place at the end of 2019 or in early 2020.
Oil has roller coaster year in 2018, rising 30 % in the first nine month of the year and ending the year 20 % lower than where it started.
Its gyration’s impact on inflation and interest rates have been non-negligeable and will continue to affect the macroeconomic picture in 2019.
Longer term however, Oil prices will ultimately succumb to the twin effects of more shale oil production and the fast deployment of Solar farms and Electric Vehicles world wide.
We expect Oil demand to peak in 2020 and it could even weaken earlier if the world economy slows faster than we expect.
From a technical standpoint, Oil started 2018 extremely oversold and a bounce has started already. It is likely to continue well into the beginning of the summer and could take oil prices up to US$ 60.
However, we expect Oil to fall again in the second half of the year and to reach 30 -35 $ by December 2019
Key Call # 6: IF ANY, THE NEXT CRISIS WILL COME FROM CORPORATE BONDS
The current environment is not favorable for corporate credit.
In 2018, the tax windfall was used by CEO’s primarily to buy back their shares, something they ended up doing at the top of valuations and of the market.
Unfortunately very few have felt the urge to pay back debt, quite the contrary as still low nominal rates and almost negative real interest rates have made borrowing extremely cheap.
Even worse, several companies have borrowed money to buy back their own shares at the top of the cycle.
Yield spreads remained relatively tame until the summer of 2018 and then corporate bonds collapsed in the fourth quarter as equities were sold off.
Using the iShare Iboxx High yield ETF as a proxy, the picture looks like this.
An extremely sharp rebound took place in the first two weeks of January but we would not trust this rebound and, on the contrary would take it as an opportunity to offload high yield corporate bonds.
Corporate America has been once again breeding an orgy of debt issuance and the world stock of debt has increase extraordinarily in the past few years.
Global debt has hit another high in 2018, climbing to $260 trillion in the third quarter of 2018, of which the non-financial sector accounted for almost $196 trillion.
The debt-to-gross domestic product (GDP) ratio has exceeded 325 percent amid record levels of corporate and household debt in many mature markets.
The unprecedented debt load is probably the most worrying factors on the horizon with the impacts of a trade war.
The corporate sector is highly leveraged and is bound to be very vulnerable to higher interest rates. Corporate debt-to-GDP is at record highs thanks to interest rates being historically low due to quantitative easing and forward guidance.
The inherent instability of debt over equity financing suggests that the next downturn will hit investment spending unusually hard and we have had signs that this has already started in the fourth quarter of 2018.
It is probably too early to worry about a systemic risk and normally the next economic downturn should be mild, but if one risk deserves to be monitored closely, this is it !
Key Call # 7: BITCOINS AND MOST CRYPTO CURRENCIES WILL GO TO ZERO
Although we had not include Crypto-currencies in our SEVEN INVESTMENT CALLS for 2018, our readers know that we had been shorting Bitcoins at 19’000 on December 19th 2017.
We kept that short position all along 2018 and are still short Bitcoins, even if prices have fallen from 19’000 to 3’500 in December 2018, losing 81.5 % of their value.
We have advocated all along that the whole infatuation of the milleniums with crypto-currencies was a speculative bubble and that crypto-currencies had none of the characteristics of currencies.
They were simply a supply-demand Ponzi scheme that was bound to meet its end and leave many investors much poorer.
The Blockchain technology itself is now being questioned as the cost of maintaining, managing and servicing distributive ledgers is prohibitive and that the same levels of security and unforgettability can be achieved through other and much cheaper technologies.
Another interesting development is that sovereign States such as China are working on plans to issue their own digital currencies with a view to replace cash, cheques and even credit cards.
One thing is ure though is that they will use neither the existing crypto-currencies nor will they use the distinctive distributed ledger technology used by the blockchain.
When it comes to Bitcoins and the remaining crypto-currencies, there is no rationale for anyone wanting to buy them or hold them and ultimately the remaining stock of code in existence will be sold by holders wanting to get at least some cash out of them.
3’500 was an important technical level for Bitcoins and the Cryptocurrency did rebound on it, but it will soon go through that support ad fall to the ground.
14th January 2019