Capital Allocation For 2016: Capital Seems To Be Flowing Back To The Center Of The Capitalist System

Includes: DIA, IVV, QQQ, SPY
by: Nelson Alves


The European Union ineptitude to deal with the myriad of crisis affecting its political project, is the starting point for my asset allocation for 2016.

The Emerging markets seem to be on the bust part of a boom-and-bust cycle.

There is strong evidence that the money is flowing back from the periphery to the center of the capitalist system: the U.S.

How the European Incapacity to Govern Itself Is the Starting Point for the 2016 Asset Allocation

From Europe with love

The European project as it is, negatively influences the EU members' economies. Since the beginning, the EU has always been an insufficient project prone to the occurrence of periodical crisis. What kept the project going was the ability to address the main problems by moving one step forward each crisis.

Now, the main issue is that the EU has just run into a roadblock during the sovereign debt crisis. Germany is blocking the way with its status quo preference. The recurrent argument that the German tax payers won't allow this or that is an inversion of the hierarchy in politics. The voters choose a government to lead them, and after the election, the government leads until the mandate is over. Not the other way around. The problem with the current German government is that it doesn't lead. The population of stable countries has always been afraid of uncertainty, which is often confused with fear of change. The job of a government is to choose areas where it feels to be necessary the mobilization of the population towards a new goal. However, the previous idea won't happen if governments use polls to take their decisions. Basically, if the current generation of German policy makers were in charge in the 1950's we wouldn't have an European Union in the first place.

Europe do not exhibit signs of changing the current status quo. In the article The guide to understand why European banks are underperforming U.S. banks, I expose many indicators that reveal why the European economy is most likely going to underperform the U.S. New politics that address some of the issues raised in that article should be seen as indicators for investors to reevaluate the European economy. Right now, I do not see any improvements underway. Actually, I just see the same European ineptitude to deal with the current refugee crisis.

The bottom line is: Europe is not at a crossroad, it is on the wrong path. If it keeps going this way, Europe will disintegrate. If Germany decides to adopt a sort of fiscal union, things might get better and Europe might be safe but this won't happen overnight. All in all, I believe it might be wise to keep most of your funds out of Europe.

The Emerging markets have lost the allure

So, if Europe is not the right answer in terms of asset allocation for 2016, maybe the Emerging markets have the answer we are looking for. Looking at the performance in the currency markets, the emerging markets are on the bust part of a boom-and-bust cycle.

Right now, it is hard to evaluate whether the current economic downtrend in the emerging economies is going to aggravate or if it is reaching a bottom. What we know is that the market is testing several emergent countries.

Graph 1 - MSCI Emerging Market Index 2013 to Present (Source: Financial Times)

Let's put some context on the emerging economies. Basically, the U.S.'s quantitative easing (QE) acted as steroids on emerging markets, lightning up the commodity prices. Since 2009 until the beginning of 2014, the commodity markets enjoyed a prolonged bull-market that is now coming to an end. The bull-market occurred mainly because part of the QE money had to go somewhere, it couldn't just stay on a stagnant economy like the U.S. back in 2009. Additionally, the rise in consumption of raw materials in China and in other emerging countries acted as the fuel to ignite a sustained rise in prices. Both the QE and the consumption acted together, self-reinforcing this cycle. The higher prices attracted more capital and the extra demand encouraged extra supply.

Graph 2 - Commodity Market Performance (Source: IMF)

The previous cycle is expressed in the Graph 2. The end of the bull-market came when two things happened: the FED started to unwind the QE and the market started to notice the huge supply base built during the commodity bull-market. The lower commodity prices became self-reinforcing, since the capital was already leaving, the lower prices increased the velocity of the capital outflow. This resulted in a downslide much faster than the preceding bull-market. In my opinion, the oil price is now far away from balance but we can't say that it will be returning closer to balance any time soon.

Ok, so what can we expect, now? The current downslide is going to test the credit market for several emergent countries. Some countries have debt pegged to the USD, which means that the current weakness in their currencies will increase the debt burden. There are some emerging countries in a good position to face this challenge while there are other countries, clearly, more exposed to a possible debt crisis.

Table 1 - Total Reserves as % of Total Debt for Selected Countries (Source: World Bank)

Click to enlarge

Looking at Table 1 figures, we can see that China seems well positioned in terms of currency reserves to face a possible financial turmoil. Nevertheless, the downward trend in the Chinese is not a tranquilizing fact. On the other hand, Brazil will most likely feel much more pressure and its currency reserves have already started to wear off.

Summing up, the current crisis in the emerging economies is nothing more than the after waves of the 2007 crisis. The market mechanisms are self-reinforcing by nature which means more turbulence. The emerging countries are now facing a wave of turbulence, which means that I'll stay put in emerging markets during the following months.

The American Way

By exclusion, we are left with the U.S. The American economy won't be immune to the current turmoil in financial markets, but so far the current losses in the equity markets have been correcting a long-lived bull-market which might not be bad at all.

However, we can never be sure, the self-reinforcing market mechanism can turn what seemed a healthy correction in equities into a deeper recession on the whole economy. However, right now, the money seems to flowing from the periphery into the center of the capitalist system. This means that at first, during the panic phase, safe-haven type of assets will most-likely perform better (Gold, German Bonds, Swiss Franc, etc…). After the panic phase, the money will pursuit the best opportunities in productive assets within the center of the capitalist system and this is why I believe investors should keep monitoring possible opportunities in the S&P 500 (NYSEARCA:SPY) during the following months.

I'll keep focused in equity markets in the U.S. In the following months, I expect to provide analysis on company offering good investment opportunities. Right now, high quality companies like Disney (NYSE:DIS), Nike (NYSE:NKE) and Wells Fargo (NYSE:WFC) are on the most attractive levels in a long time.

Disclaimer: The previous text develops a set of insights based on a very complex reality. Some or even several of the probable outcomes identified in this text might not materialize which might compromize the success of the suggested investments. Each investor is the solely responsible for the evaluation of the risk of adopting any of the views present in this article.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in DIS, NKE, WFC over the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.