Outlook on the Dollar, Currency And Markets: Look Out Below! by Axel Merk, Merk Investments

The FIFA World Cup and market predictions have in common that we are tempted to create a world of make-believe when it comes to predicting outcomes. While others ponder about the meaning of a round ball, we’ll focus on the implications of a make-believe world comprised of ever-higher asset prices. Our caution: look out below.

Investors have a tendency to ignore the hidden risks in their investments, even if those risks may be hiding in plain sight. You may recall the references to a “goldilocks” economy in the run-up to the 2008 credit crisis. Similarly, in the 1990s, what could possibly go wrong investing in tech stocks? What these episodes have in common is that the downside volatility of asset prices was unusually low. The pessimists warn of pending collapse, yet are ignored.

As an optimist, I agree with the pessimists. Not because I think the world will come to an end, but because the path from euphoric to normal is a rough one. When low asset price volatility lulls investors into believing the markets have become safer than they really are, folks take risks that they are bound to regret. Those that pile into the equity markets on the backdrop of ever shorter corrections, of ever higher asset prices, of historically low volatility, may be running for the exit fast when they realize they had no business being over-exposed to the equity markets in the first place.

Some laugh at gold investors that saw the price of gold drop sharply in 2013. What many fail to realize is that the very same can happen in the equity markets just as easily. When an asset (gold in this case) rises for 12 years in a row, there will be those taking out a loan to invest in the yellow metal. Similarly, investors have taken out ever more debt to buy stocks. For such euphoria to end, we don’t need a crisis, all we need is fear levels to return to “normal.”

Liquidity is dead

The low volatility environment has been accompanied by what is historically low volume. When liquidity in the market is low, it provides fertile ground for more abrupt price moves. One reason why liquidity may be low is due to the Dodd–Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”). Dodd-Frank, with its good intentions, has banished a lot of risk taking by financial institutions. That may be a good thing in some ways, but it has also curtailed major liquidity providers. The next sharp correction in the markets may well be an indication of whether the dearth of market participants is a problem.

Other markets infected

The above symptoms don’t just affect the equity markets. In the fixed-income markets, our analysis shows:

  • Volatility has been rather low of late;
  • Liquidity is sharply reduced as banks have sharply reduced their trading activities (due to Dodd-Frank);
  • Investors chase yield (mostly by chasing “credit”, i.e. lower quality debt instruments; but some also take on more interest rate risk by investing in longer-dated debt securities).
  • Investors increasingly embrace what we call creative bond funds that brag about holdings in Master-Limited Partnerships (“MLPs”) and ultimately have big exposure to dividend paying emerging market equity securities.

Currency markets have also experienced extraordinarily low volatility of late. Having said that, we have not seen leverage increase much in this market, as folks abstain rather than take huge positions.

Policy makers concerned

Folks at the Fed have started to talk about complacency, with New York Fed President Dudley saying, “Volatility in the markets is unusually low.” At a dinner of the Hoover Institution I attended, Kansas City Fed President George mentioned in a speech: “The incentives to reach for yield extend to smaller financial institutions as well… If longer-term interest rates were to suddenly move higher, these institutions could face heavy losses.”

Should you be concerned?

If you are not concerned, you are not paying attention. The reason I say this is because when the masses are complacent, it is my assessment that it is prudent to be fearful. The time to prepare for the next correction is now. And you don’t need to think a crash is imminent to endorse the idea that it might be a good idea to rebalance a portfolio when equity securities have taken on a greater portion of one’s portfolio.

Do I think a crash may be coming our way soon? Yes. What can trigger such a crash? Nothing in particular, yet anything can, given the high degree of complacency we see in the markets. Could I be wrong? Certainly.

What can you do about it?

First, if the equity exposure in your portfolio has grown, consider rebalancing in the context of your longer-term goals. This is a prudent exercise no matter what your long-term outlook is. Beyond that, to the extent you want to be invested in equities:

  • Consider an enhanced, hedged or market neutral strategy. There are many flavors out there of equity strategies, each of them have their own set of risks and opportunities. You’ll have to do your homework to be comfortable with them.
  • There will always be some sector in the market outperforming. Rather than chasing the winners, consider looking at areas that have underperformed.

Even these types of strategies may experience negative returns in a down market, but you may consider yourself a winner with many of these strategies if you lose less than the market.

Second, diversify. As already eluded to with the reference to different types of equity strategies, key to thriving when equity returns sour is to have assets that produce a return stream with low or even negative correlation to the equity markets:

Currenciy Market chart

As one can see from the illustration, bonds have historically been powerful diversifiers for equity portfolios. Trouble is that investors not only want low correlation, but they also like positive performance. And while bonds have historically done just fine with regard to performance, many investors, including yours truly, aren’t so sure that this will be the case going forward. However, rather than finding an incarnation of a “new generation” fixed income fund that engages in what may be unnecessarily risky bets or masks an emerging market equity strategy as a fixed income play (because those stocks pay a dividend), we prefer to look elsewhere.

As many of our readers know, we have increasingly been looking at gold as a long-term diversifier as we think real interest rates, i.e. interest rates after inflation, may be negative for a long time. Today, we take it a step further, focusing on our currency outlook for the second half of the year. We like the currency market for a couple of reasons, including: