While the weight of the evidence says that the equity market has formed your textbook, classic bubble, the Fed still has room to move interest rates notably lower to catch down to the rest of the world, and seems more than willing to increase the size of its massive balance sheet ever-further, despite the risk, and despite the history of bubbles and of its propensity for expanding them at their later stages.
In addition to the Fed’s, as well as other countries’ central banks’ monetary stimulus, there is tremendous incentive for governments the world over to apply fiscal stimulus to their respective economies -- to the extent they can.
Despite the record budget deficit, and now record national debt, the U.S. Administration is promising to push through yet more tax reform (cuts). As for the rest of the world, one country in particular indeed has legitimate fiscal firepower; Germany has been running budget surpluses and has a notably lower debt-to-GDP ratio than most other nations. While Germany’s positive fiscal picture has resulted from discipline in the face of a world of eagerly-spending politicians, macro reality virtually demands that it embark on a fiscal stimulus/spending package of its own. That could be big for its equity market, as well as the rest of Eurozone equity markets for awhile going forward.
While of course trying to time these things is a fool's errand, I’ll give it 50/50 odds that all of this global stimulus will delay the next recession and full-on bear market in equities -- and what I view as a virtually unavoidable explosion in the corporate debt market -- into 2021; possibly beyond for the coming corporate debt debacle.
I also see a very good chance that the Fed will cut interest rates sooner than they otherwise would have as the economic impact of the coronavirus begins to show up in data releases in February and in March (bodes quite well for gold). While we will indeed come to the inflection point where monetary stimulus no longer does the trick for financial markets -- it has already lost its punch when it comes to the real economy -- I can’t make that call at this point given the sheer eagerness of traders to still buy every hint of stimulus by the Fed, or any other central bank (read China) for that matter, regardless of general conditions or the circumstances under which the stimulus is occurring (classic bubble behavior).
In terms of our core allocation; while we’ll absolutely remain more defensive than we’ve been in a decade, we’ll actively tweak around the edges to keep our risk/reward profile consistent with our view of present conditions. For example, this morning we’re slightly cutting our short junk bond trade to a still-healthy 7.5% of overall exposure, and using the proceeds to increase our international exposure. We’ll bias Europe (per the above) with the proceeds, but we’ll add a bit to our Asian exposure as well; for, as it stands, Asian equities trade at their cheapest valuation ever relative to U.S. equities (speaks to how historically-expensive U.S. stocks are presently). Barring a near-term global recession, there’s a decent chance Asian equities will close that gap during the course of this year.
Bottom line: Risk remains markedly elevated, and without a positive resolution to the many stressors underlying the global economy, whether the next recession occurs this year, next, or whenever, the character of the corporate debt market and the dramatic departure of equity prices from the underlying fundamentals (in the U.S. in particular) virtually assures that the accompanying bear market in asset prices will rival modern history’s worst. In the meantime, it won’t surprise me to see stocks, on balance (i.e., with some serious volatility along the way), meander higher.
Our core allocation allows us to capture some, if not all (depending on how our non-correlated positions perform), of whatever upside this year may have in store -- while providing meaningful downside protection (the non-correlated positions along with the out-of-the-money put) in the event of a major equity market selloff.
Thanks for reading!