July 1, 2016
By Steve Blumenthal
“We recognize that our EU policies aren’t working for everybody. That’s okay. We just have to figure out how to make sure that everybody gets what they need, even if it means less control from Brussels.”
-European Union’s founding members: Belgium, France, Germany, Italy, Luxembourg and the Netherlands
On Tuesday, I tweeted out a piece titled, Brexit Bombshell: EU Capitulates. Geopolitical analyst George Friedman links the Brexit vote with the world’s growing class division and growing anger. George is an internationally recognized geopolitical forecaster and strategist on international affairs. The elites capitulated.
On my risk watch is the potential for a sovereign debt crisis originating in Europe. The debt-to-GDP ratios are staggering, entitlements are unmanageable and unemployment is high. The economic chasm between the northern haves and the southern have nots is blatantly clear. The people have had enough. The UK exit is the start not the finish.
All of this dysfunctionality wrapped together in incomplete and growingly divided political structure. The surprise capitulation reeks of desperation by the elites to hold it all together. So we step forward and watch with keen interest. George’s insights are worth the read. I share it with you below.
This morning the 10-year Treasury Note touched 1.38% overnight. As I write, it is yielding 1.43%. The 30-Year Treasury Bond is yielding 2.22%. Why? Bonds are rallying globally as the UK vote to leave the European Union raises speculation that the decision will curb economic growth. Money is escaping to the Treasury market.
Take a look at the following chart. It shows the year-to-date down move in the 10-Year yield from 2.25% to 1.43%. At the start of the year, few Wall Street analysts and none of the Fed officials, were predicting declining rates. Again, a big miss. What we are seeing is that growth remains subdued and debt continues to have a choke hold on the global economy.
To this end, I have been on record saying that interest rates will remain lower for longer. I certainly didn’t expect a drop of 75 bps in six short months. Remember back in December that the Fed had just raised the Fed funds rate by 25 bps and the call was for three to four more rate increases in 2016.
The Zweig Bond Model has kept me correctly positioned, invested in long term high quality bonds. It is a Trade Signals model which is largely based on trend analysis. It continues to remain bullish on high quality bonds. Not perfect, no guarantees, but it has kept us in the right spots over the last few years. I’ll change course when the model signals higher rates.
See Trade Signal’s post below or click here. You’ll find the chart near the bottom of each week’s post and this is something you can track on your own.
Let’s pause for a moment and take a step away from the daily noise. What concerns me over the intermediate term is that equity market valuations remain high and forward 10-year returns likely remain low. Grantham sees -2.3% real returns for U.S. large cap equities over the coming seven years (with a forecast number lower than where it was in December 1999).
Median PE, which I will share with you next week, points to a 2% to 4% annualized 10-year return for the coming ten years (that’s 0% to 2% real or after inflation). So it is hard to get excited about equities. That day will come though the timing remains elusive.
Combine the low equity returns with a 1.43% 10-year treasury and you can see how hard it will be for pensions to meet their nominal 7 ½% annual bogies. Not going to happen! For now, patience is required. Include in your portfolios other, less constrained, return drivers.
I remain in the 30/30/40 allocation camp. Reduce exposure to equities (hedged), 30% to fixed income (tactically managed, trend analysis) and 40% to tactical and liquid alternatives (seasoned managed futures and global macro managers).
As a quick aside: See my white paper titled, The Total Portfolio Solution. In it I take an in-depth look at what valuations tell us about probable future returns. You’ll see that returns are best and risk lowest when equities are attractively valued and the opposite being true when equites are expensively priced. The paper builds on traditional Modern Portfolio Theory in two ways – it adds liquid alternative investments as a third asset class to stocks and bonds and it employs “strategic tilts” that increase equity exposure when stocks are attractively priced and decreases the equity exposure when they’re expensively priced. It is free and you can find it here.
As we begin the second half of the year, my outlook remains unchanged. This is what I wrote on December 31:
2016 Outlook: neutral on equities and neutral on fixed income. Nothing exciting there, but like the Fed, I’ll hedge and say it is “data dependent.” Following are the significant risks I see:
- Global Recession – Likely underway
- U.S. Recession – Possible in 2016. Probable in 2017. The largest market declines come during periods of economic recession.
- High-yield bond defaults – Rising in 2016, peaking in 2017 (tactically trade HY)
- European sovereign debt crisis – The EU banks are loaded up on that debt (shorting EU banks or buying out-of-the-money put options may be a good equity hedge).
- Emerging Market dollar denominated debt crisis
- Watch the Fed, ECB, JCB and Chinese central bankers
- Tax and structural reform would be a positive for the markets, but unlikely in 2016
Further, I currently believe the Fed is unlikely to raise rates this year and it is believed more central bank stimulus lies in our immediate future. The risk on mood seems to have returned. It is tied to the prospects for more central bank QE but the deeper implications remain. The Fed remains “Data Dependent.” The market appears to remain “Fed Dependent.” For now…
Next week, we’ll take a look at June month-end data on valuations, forward returns and I’ll share with you my favorite recession probability charts.
Wishing you and your family a wonderful holiday weekend!
Click the orange link below for this week’s OMR. I hope you find it helpful in your work with your clients.
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Included in this week’s On My Radar:
- The EU Capitulates, by George Friedman
- A Bit More On Brexit: From Bridgewater Associates – Daily Observations
- Business Loan Delinquencies & Job Creation
- Trade Signals – Oversold, Extreme Pessimism ST Bullish, Risk High
The EU Capitulates, by George Friedman
“Today, foreign ministers from the European Union’s six founding member states issued an extraordinary statement, declaring that they will “recognize different levels of ambition amongst Member States when it comes to the project of European integration.” This was a landmark capitulation by the major European powers, accepting the idea that uniformity across the bloc is impossible and nations can choose the terms of membership.
The ministers – representing Belgium, France, Germany, Italy, Luxembourg and the Netherlands – publicly recognized that there is discontent across the bloc. The statement said that they will “focus our common efforts on those