Where Investors Should Allocate Capital

James Juliano Insights

Financial markets were calm and economic news coverage slow this week as US families celebrated Thanksgiving. Given that many holiday conversations may involve the “state of the world,” below is a high level overview of the big five asset classes (US Equities, Fixed Income, Foreign Equities, Commodities and Real Estate) to help guide your discussions. The bottom line is that investors continue to reward US dollar based assets while punishing non-dollar assets like foreign equities and commodities.

US Equities

We said in the beginning of 2015 that US policies had been steadily improving towards pro-growth with the GOP capture of the House (2010), the fiscal cliff/sequester deal (2012), and the 2014 GOP capture of the Senate. US equity markets celebrated these developments by steadily advancing through mid-2015. In early August we began cautioning that “policy uncertainty” was creeping into markets largely due to fears that the Federal Reserve could engage in a deflationary monetary policy error. Coupled with severe anti-growth comments from the leading Democratic presidential candidate, Hilary Clinton, markets declined sharply and quickly in the last few weeks of summer. We reminded clients not to panic in our August 24th Reading the World newsletter edition. While US equities entered a policy “yellow zone” after three years of uninterrupted “green zone” status we did not observe much underlying economic weakness warranting another recession. In fact, leading economic indicators like swap spreads remained at historically calm levels, and they still do. Barring a major monetary policy error, we believed then as we do now that US equities would remain the best place for global capital. We are happy to report that no monetary policy error occurred.

Importantly, US equities may have much to celebrate from future policy developments. A monetary policy interest rate hike is now on the table for December and would be great news for US equity investors. Additional pro- growth policy developments like a gold standard and lower tax rates are being positioned by GOP presidential candidates as credible economic solutions. These ideas stand in stark contrast to the growth killing ideas presented by all Democratic presidential candidates in their first debate weeks ago. The trajectory of US equity prices over the next year will largely be driven by 2016 presidential election politics. Will pro-growth ideas continue to gain traction among GOP candidates? Will voters continue to favor those over the failed redistributionist ideas promoted by Democratic candidates? If so, our optimism about the US economy and US equity prices will remain high. A pro-growth monetary, tax and regulatory policy plan in 2016 will unleash a US equity bull market not seen since the 18X stock market advance during the 80s and 90s. US equities are in favor because it is an asset class that thrives when economic growth is improving and the dollar is strong (gold is down.) We think recent political outcomes bolster the odds of both trends continuing.

Fixed Income

US Treasury bonds continue to be a risky asset class despite their reputation as being safe, low risk investments. The US bond market is pricing in extremely low growth rates under 0.60% over the next 10 years. Any future reset higher in real growth rates will have an enormous negative impact on bond prices. Bond prices will fall 30-50% if nominal yields just return back to average levels around 4-5%. We have been making this claim for two years. We were correct in 2012 when bond prices collapsed but were obviously wrong in 2014 when bonds rallied. Recent bond weakness may be the beginning of the bond bubble popping we have been expecting. Bond yields can rise much further as growth picks up, and bond prices will fall further accordingly. Future increases in bond yields have plenty of room to run given the correct set of government economic policies.

We remind you that we are currently at the tail end of a 30-year bull market in bond prices. Treasury yields peaked in 1982 over 15%. Since then the bond market has enjoyed a multi-decade bull market as interest rates declined to current sub 2% levels. It is almost impossible for interest rates to fall again in the same fashion from current levels. A pro-growth policy shift in the 2016 US presidential elections will once and for all pop the US bond market bubble as interest rates rise to reflect higher growth rates. The zero rate on Treasury bills will not persist. As rates normalize, bonds are a risky asset class.

Foreign Equity

Policies that seemed to be improving in Europe just a few quarters ago now seem to be faltering again. From 2012 to mid-2014 Europe seemed to be turning the policy corner. Failing austerity plans were being abandoned in speeches by EU leaders, and the Euro currency was strong and stable. Pro-growth policies were only talk, but at least they were being discussed. That optimism gave way to reality in mid-2014 when EU policymakers failed to deliver any tangible growth agendas. In many countries, policy continued to worsen down the higher tax/higher government spending paths.

In early 2015 European policies began to turn back towards positive, but recent talk about increasing the ECB’s quantitative easing program is not good news. Rising Euro gold prices signal that Europe needs less, not more, supply of Euros to match demand. This monetary policy error coupled with increasing demographic and immigration risk across the Eurozone puts European equities in a dangerous “yellow/red zone.” Emerging markets are in an even more dangerous “red zone” and have been there for several years.

Commodities

The US dollar has been strong since 2012 and is continuing to strengthen. This makes commodities a dangerous place to invest, and we don’t just mean investing in metals. Commodity linked equity sectors like energy as well as commodity linked countries like Brazil and Russia are bad places to invest capital when the US dollar is strengthening (i.e., gold prices are flat or falling.) These assets have lost tremendous value as the US dollar rose over 35% since 2012, and there is no policy reason to expect the US dollar to stop strengthening any time soon. The chart below shows the power of policy and knowing which direction it is shifting.

Russian equities, Brazilian equities and energy sector equities have suffered as gold prices fell (US$ rose) over 35% since 2013. Note how much better broad US equities in the S&P500 did over this time period, rising 45%. Brazil and Russia couldn’t be more different as countries, and only one of them has been involved in warlike geopolitical situations in recent years. The energy sector is comprised of hundreds of different energy companies around the globe. But there is one fact binding these assets together and resulting in all three dramatically underperforming broad US equities since 2013. Brazil, Russia and energy companies are all levered to a weak US dollar. When the US dollar is strong they must be avoided.

commod

Real Estate

US commercial real estate is levered to stronger US economic growth and is historically stable when the US dollar is strong. Both conditions are happening now and could vastly improve with a pro-growth policy shift in 2016.

Summary

Our big theme for 2015, and now 2016, is under optimism in the US economy and stock market. US bond and equity markets continue to both be priced for a modest future at a time when the “death of liberalism” is approaching in the political spectrum.  We believe it is increasingly possible to get an upside surprise in US growth that will accelerate the US stock/real estate markets and deflate the US bond bubble. Recent market turbulence and violent price declines this summer injected some caution into our viewpoint, but has not derailed it. In fact, recent policy developments are extremely pro-growth and have been driving US stock prices toward new nominal highs.

Our investment process is to identify government economic policy headwinds/tailwinds and invest accordingly. When one looks around the world there are few, if any, geographic regions in a policy “green zone” except the US. This results in US dollar based assets being in favor while weak dollar assets, especially commodities, continue to decline.

The last three years, like numerous multi-year periods throughout history, are a clear example that diversification is a “fool’s game” in that it allows one to reach mediocre results from whichever side one starts. We do not believe in diversified portfolios. Contrary to conventional investment wisdom, diversification is what you do when you don’t know what to do. To successfully invest you must avoid policy “red zones” and tilt capital towards policy “green zones.”

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