The Fed's dovish pivot may have precipitated a historic rise in equities, but history suggests that a slowing economy and inversion of the yield curve are likely a portent of a stock market correction. In lieu of contracting manufacturing PMI levels, less aggregate capital expenditures, and slowing global growth, the late stages of the business cycle are likely upon us--and I believe that it will take aggressive monetary stimulus to keep the U.S bull market alive. With less ammunition than his predecessors, Fed Chairman Jerome Powell will likely revert back to quantitative easing (after interest rates hit zero or even turn negative). For reasons I will articulate below, I believe that such measures will generate unsustainable levels of inflation, conducive to economic stagnation. This article operates under this premise, and aims to identify specific investment vehicles that may perform well in such an environment: gold (GLD) and the Yen (short USD/JPY).
My aim is not to predict the timing of a recession (impossible even for the best investors), but simply to portend its probabilistic likelihood, which I believe has markedly increased. The first glaring warning sign is that the U.S. yield curve has inverted - meaning that the yields of longer term bonds have fallen below those of bonds with shorter maturities. This phenomenon is anomalous because in normal economic conditions investors would require higher yields for longer term bonds because of the additional risk incurred and higher expected opportunity costs of other investments. When the yield curve inverts, the bond market implies that growth will decline, inflation will be lower, and the Fed will likely have to cut rates in the future, driving up the prices of those bonds. The recent inversion between the 3-month and 10-year treasuries is especially significant - this particular phenomenon has preceded every recession since 1967 (with an average of 14 months lead-time).
Furthermore, key data metrics are pointing to a slowing economy. U.S. manufacturing PMI recently fell to the lowest level in ten years and below the pivotal 50 threshold--a leading indicator for economic contraction (in China and across much of Europe PMI has also already fallen below 50). Additionally, capital expenditures (CAPEX) peaked in mid 2018 and have been falling since. Historically, declining CAPEX levels and less business investment have been remedies for economic slowdowns. Consumer Confidence also fell considerably last month. Lastly, GDP growth also peaked in 2018 and has declined since, with consumer spending (the largest input at roughly 70%) especially lagging. It is worth noting, however, that unemployment has remained strong, at record lows, and the services PMI has held relatively steady--a figure that some feel better characterizes the modern economy than the manufacturing data. Nonetheless, the aforementioned indicators coupled with trade uncertainty paint a much bleaker picture--that the longest U.S. economic expansion in history is likely running out of steam.
The rapid pace at which PMI is declining tends to precede recessions. Source: Created by author using data from Bloomberg and the St. Louis Fed
Quantitative Easing Will Induce Inflationary Pressures
Central banks ran out of interest rate stimulus in the years after '08, an the ensuing government intervention in the markets via the printing of money and buying of financial assets (i.e. quantitative easing, or QE) will likely have various adverse effects in the long run (for a comprehensive explanation of QE, click here). Firstly, I believe it to be likely that QE has pushed the economy beyond its natural production capacity and widened the wealth gap between rich and poor - since wealthier people tend to own the financial assets that the government has been buying up. Most importantly, QE combined with increased government budget deficits (debt-to-GDP ratios globally are highest since before the financial crisis) will likely result in a significant currency devaluation because governments are far more likely to simply print money than pass measures to cut spending. Social Security, the biggest drain on government spending, will likely run out of money soon as the baby boomer generation continues to age and life expectancy improves. When debt payments and liabilities come due, the only foreseeable solution is to print a considerable amount of money.
Further, in a political climate where both major parties have adopted big government and spending policies, voters are much less likely to vote for less benefits via a spending cut in order to balance the budget. The best characterization of this is the boiling frog analogy. If thrown suddenly into a pot of boiling water (cut spending immediately), a frog will get agitated and jump out; however, if it is put in temperate water and brought to a boil slowly, it will not perceive any imminent harm and will be boiled to death. The slow boil is analogous to the attrition of currency - the printing of money over time to sustain bloated spending and debt levels, thereby diminishing the purchasing power of U.S. citizens. The people will suffer all the same—inflation is merely more indirect and less conspicuous. In short, the artificial stimulus of QE coupled with large deficits that will need to be monetized could likely result in a period of stagflation, where gold would outperform most asset classes. For a more detailed analysis on QE and its potential long-term effects, I strongly encourage reading Ray Dalio's Paradigm Shifts.
The Japanese Yen is considered a safe-haven currency, and thus should perform well in the type of environment that I have described. Though the Japanese economy has lagged far behind the U.S. for some time, a key reason for its safe haven status is its large surplus in current account balance--the idea being that consistent, large cash inflows signify stability. Japan has the 2nd largest surplus in the world, which increases the demand for its currency especially in flights to quality. Another key reason why the Yen outperforms during times of economic turmoil is the carry trade. Essentially, investors borrow at near-zero Japanese interest rates, convert the money to higher yielding currencies, buy those higher yielding bonds, then finally convert back to the Yen. For instance, if JPY interest rates are 1% and Australia 5%, and nothing changes or goes awry in the world, investors are essentially looking at a 4% dividend yield by putting on the carry trade with the Ozzie Dollar (which can be highly levered to generate better returns). This seems like a great scheme until an economic downturn hits, whereby less developed or emerging markets countries (generally with higher interest rates) suffer most, traders quickly attempt to unwind their currency trades, and money floods back into the Yen. This is precisely what happened in '08.
Further, the idea of a purchasing power parity (PPP) equilibrium is simple - a basket of goods should cost the same in two similar, developed countries when adjusted for exchange rate and inflation. In the short run, this idea has little effect on the foreign exchange markets. However, in the long run, economic theory and basic intuition provide that a currency exchange rate should revert or converge to its PPP equilibrium (or zero). The PPP of the Japanese Yen vs. the US Dollar suggests that the Yen is currently 38% undervalued; the data since 2000 is shown on the chart below. It is not logical that one could move from Oregon to Tokyo and spend 38% less than what he or she spends in the U.S. on common goods. Over time, the logic holds that the Yen should appreciate in value to price out this inefficiency--given that both economies maintain their high GDP levels.
Source: The Economist
The case for bullion is fairy straightforward. In times of economic instability, investors tend to flee to safe haven assets - such as gold. For one reason or another (color, brightness, chemical properties, etc.), people have regarded it to be of significant material value since the dawn of man. Thus, gold can serve as a great hedge against inflation; when the Dollar is worth much less tomorrow, one ingot of gold today is still equal to one ingot of gold tomorrow. Gold may also act as a hedge against deflation, which would likely occur first if a recession is in the near future. It is, in effect, a hedge against central bank lunacy in general. Additionally, gold has historically had low to slightly negative correlations with equities, which promotes portfolio diversification. Also, in times of geopolitical uncertainty, gold tends to perform well. For reasons that I will outline in the risks section, gold may currently be overbought and suffer in the short-run (especially if a market correction is drawing near, wherein every asset class tends to sell off); however, its ability to immunize the effects of inflation on an investment portfolio is sound logic for a bullish long-term outlook.
Risks and Conclusion
Whenever one bets against the economy, there are always massive downside risks because most everyone wants the opposite scenario to play out. Timing is chiefly important. I am certainly no advocate for technical analysis, and I am of the belief that anyone who relies solely on technicals will consistently lose out to someone relying on pure fundamentals over time. However, because people believe it to work or exist, it sometimes does - a self-fulfilling prophecy of sorts. So, I will concede that while technicals should never tell you what to buy, they may sometimes help in figuring out when to buy - once you already have a strong fundamental case for the underlying security. Because of my general apathy for the practice as well as its highly subjective nature, I will not delve into technical analysis specifics here, but I will leave the matter open for interpretation and for readers to conduct research themselves. Based on my own analysis, however, certain signals point to gold being overbought in the short run; I would likely wait for a market selloff to initiate a position.
The largest risk to my thesis is a potential last-ditch effort from Trump to save the economy and the financial markets through aggressive fiscal or monetary stimulus. In this scenario, markets would likely rally in the short run, but this rally would provide an opportune time to initiate positions in Gold and the Yen should the fundamental reasons To me, this seems fairly likely since one of the only positives from his administration has been the economy. Many feel that Trump may do whatever it takes to stave off a market downturn or recession. He even tweeted about this once before, attributing his success to record highs in the stock market.
Another risk is the massive under-reporting of inflation by governments. After all, governments benefit from under-reporting these figures because things like social security payouts (the largest government expenditure) and Treasury Inflation Protected Security payouts are linked to their reported figure. Actual prices have risen much faster than the mere sub-2% rates that governments report - many believe them to be above 5%. I highly suggest reading the linked article, as the reader may see for his or herself how the methodology of reporting inflation is structurally flawed. One key example is that technological advances resulting in higher prices are not accounted for in the government's calculation of inflation, even if the aggregate price for that good rises. A misrepresentation of inflation in the U.S. could strengthen the greenback more than it should be and distort market perception--both would weaken the case for bullion and the Yen.
Nonetheless, the fundamentals behind the reasoning for both the Yen and gold are sound, and in the long run should be conducive to out-performance. However, as with any investment idea, the individual investor should make a decision based on his or her own reasoning and logic - using this piece as merely a guide or a way to elucidate a potential opportunity.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in USD/JPY 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.