Merk Outlook on Dollar, Currencies & Gold by Axel Merk, Merk Investments
Who would have predicted oil prices in the sixty-dollar range a year ago? Something is not right about these markets. Our take: don’t get burned when markets add fuel to the fire. Here’s what to watch out for as we head into 2015; ignore at your own peril.
Adding Fuel to the Fire
The world isn’t running out of oil, but out of cheap oil. Therefore the fundamentals don’t support oil trading in the $60s. As oil prices have plunged from over $100 to just over $60 a barrel, it appears to us the market is driven by a combination of the following:
- The global economy is experiencing a severe slowdown;
- Major liquidity providers have left the market; and/or
- Technicals rather than fundamentals are in charge
Europe can’t get back on its feet with sanctions imposed on Russia (hint to European Central Bank head Draghi: printing money can’t fix this). China’s economy is in transition with significant headwinds coming from a housing bubble that’s deflating. In the U.S., we are made to believe our recovery is getting ever stronger; the energy markets appear to disagree.
The large moves we have seen in some markets of late – most notably in oil futures – may well also be a reflection that banks are no longer “risk takers” in these markets; the law of unintended consequences has removed these very large liquidity providers. Investors shouldn’t be surprised that moves have become more volatile.
The media attributes the drastic drop in oil prices to OPEC’s decision not to limit production. OPEC’s meeting last week might have been a catalyst, but fundamentals did not change radically enough to justify the dramatic decline. Some say commodity prices tend to be driven more by technicals, and we don’t disagree. We take it a step further, though, arguing all markets are ever more removed from fundamentals.
Ready to Ignite?
What’s happening in the oil markets is a symptom of what’s happening in all markets. Our long-term readers know that we have been most concerned about complacency in the markets: complacency is the absence of fear. In the equity markets, the VIX index measuring volatility is a good barometer of complacency. In our analysis, complacency on the backdrop of rising asset prices is a problem. It’s a problem because investors bidding up such asset prices are not appreciative of the inherent risks they are taking on. As fear comes back into the market, such investors can be gone in a heartbeat, as they suddenly realize their investments expose them to greater risk than they bargained for. In our assessment, an equity market that has relentlessly risen on the backdrop of low volatility is a box of tinder waiting to be lit.
Volatility has crept back into the markets, although casual observers might not have noticed. First, there was the equity market that briefly acted up in late September / early October. Pundits write this episode off as old history. Indeed, even we said a possible market crash is put on hold after Japan announced its $1.2 trillion pension fund would invest hundreds of billions in foreign equity markets. As we wrote in a recent Merk Insight, this policy may only provide short-lived support to the markets and be ultimately a net negative for Japanese investors.
Since then, other markets have thrown mini-tantrums. Be that in the currency markets where we’ve seen big swings in select currencies to the commodity markets. But while the Russian ruble has been on a nosedive and other commodity currencies have suffered in the most recent bout, the spikes in volatility have not always been in the most obvious places. To us this suggests not all is well in the markets.
And then came the rout in commodities, at first also pulling down gold. But gold – at least as of this writing – is staging a furious comeback.
And conspicuously absent: a correction in the S&P. To understand why, consider that the global storyline has been that the U.S. is the one place in the world that’s recovering. Investors around the globe see the glass half empty, but have been told that there’s this one place where the glass is half full. And sure enough, they buy US equities, pushing up the U.S. dollar in the process. And why not, the Fed is the one central bank that’s embarking on a tightening course.
Except that we think foreign investors are the new retail. Retail investors have long left this market; some say we can’t have a market top if they haven’t joined the frenzy.
Trouble is, they have no money to join the frenzy. But foreign investors were not only late in gobbling up toxic Asset Backed Securities (ABS) in 2007, they have bought into conventional wisdom, driving U.S. equity prices higher in recent months.
What to do?
Here are 9 things to consider as 2015 unfolds:
1. As volatility is making the rounds in currency and commodity markets, it may only be a matter of time before it reaches equity markets. When it happens, brace yourself, as the long overdue correction may finally take place. The longer it goes the more likely a correction turns into a crash.
2. The Fed has already been back peddling on its hawkish talk. In the meantime, forward inflation indicators have plunged – including those that ought to be less sensitive to changes in commodity prices.
While some pundits will interpret any less hawkish tone from the Fed as another rallying cry to buy more equities, if you agree to what we have outlined above, don’t bet your house on it.
Quite the contrary:
3. The U.S. was the only major country that was expected to tighten. If this needs to be re-priced, it could bring the dollar back to earth.
4. Note that in recent months, higher equity prices have been correlated with a stronger dollar. Conversely, do not count on the dollar playing “safe haven” currency if the equity market tumbles.
5. The ECB is now aggressively talking about QE now that forward inflation expectations have come down. Trouble is that even if the ECB were to buy sovereign bonds, it is doubtful that it will be enough to increase those inflation expectations. What Draghi needs is to have fewer geopolitical headwinds. Those may well come as German chancellor Merkel has made some first comments that appear to be aimed at diffusing the standoff in Ukraine. Aside from lackluster demand, European banks continue to have some challenges; Super Mario (Draghi) can help, but not work miracles.
6. Gold has had a low correlation to equity markets in the long-term. We continue to believe investors may want to consider gold as a diversifier in an era when real interest rates are negative and may well continue to be negative for some time. In fact, we have repeatedly said we don’t think the U.S. can afford positive real interest rates for an extended period – not now, and not a decade from now. Negative real interest rates are supportive to the price of gold, as the shiny brick pays no interest – which may be better than losing money on a real basis holding the greenback.