Between the Lines: This Week's Message: With Clarity Comes Opportunity, But Patience Is Key...

I'm taking this week's main message from an entry to our internal log that I penned last weekend (adapted/edited to be featured herein).

While, in it, I pull no punches, I want to be careful not to leave you with an all-hope-is-lost feeling.

First, we should recognize that, while I effort mightily to stay data driven and empirical, the following are the musings of a money manager (which I distinguish from a "financial services professional", which would define my early career) who's seen a few things during his tenure (which began on August 1, 1984). And who, like all humans, is no doubt influenced by his personal experiences. Understanding this, as I look into the proverbial mirror, I absolutely know that -- deep research aside -- I am as prone to getting it wrong as the next guy/gal who does what I do.

Embracing that last sentence, and pounding it home to everyone at PWA, I actually believe gives us a serious edge, so to speak.

Again, the following will not inspire the reader to back up the truck to the stock market, unless, that is, to perhaps empty it, but make no mistake, as you'll also gather below, with clarity comes opportunity!

10/18/2020 GLOBAL GENERAL CONDITIONS

If I had to pick one overriding long-term macro theme to focus on going forward it would be the fact that OECD countries plus China possess very poor demographics, making for tough general conditions for years to come…

As for the moment:

Fiscal “stimulus” so far has served as support, not stimulus. There is of course some serious "stimulus" to come, much of it targeted to infrastructure. Although it’ll take utterly huge commitments to make a sustainable economic difference, while in the process pushing already high government debt loads even higher. In the U.S., government spending this year is pushing nearly 40% of GDP… In Europe it's 50%... Hmm...

Essentially, the world economy has become for the most part a planned economy. The price discovery mechanism in debt markets (Greece 10-year sovereign debt fetches nearly what 10-year treasuries fetch [unbelievable!]) has been severely hamstrung, if not gone altogether. The impact of the Fed's foray into corporate bonds has tightened credit spreads (the difference in yield between riskier corporate bonds and safe treasury bonds) to levels that would have signaled, pre-March 2020, that all's well in the U.S. economy. Well, 11 million folks on unemployment, and record corporate bankruptcies and bond defaults, suggest otherwise...

One might think that such a scenario (the high government spending part) would ultimately spawn some seriously high inflation. Thing is, demographics make that tough, and a severe, sure-to-be-long-lasting, output gap (GDP running far below potential), is deflationary by definition. But, then again, I do believe that inflation is indeed to some degree on the horizon, given the level of government spending about to hit the global economy -- as central banks revert to essentially monetizing sovereign debt issuance as (they deem) needed, while maintaining, as best they can, interest rates at rock bottom lows.

Central bank digital currencies appear to be on the horizon… That’ll pave the way for further monetary reform… a topic for another day for sure...

Higher tax regimes are inevitable…

Deglobalization/populism is the growing global theme… Protectionist policies, immigration controls, etc., will serve to exacerbate demographic headwinds, and, should present trends persist, dangerous geopolitical risks will continue to heighten...

Socialist redistribution policies are likely to grow exponentially…

In the meantime, huge government spending along with ultra-easy monetary policy will, ironically, provide some level of support for global stock markets...

Real assets -- post recession -- are likely to outperform for years going forward…

Short-term forecasting is exceedingly difficult these days as securities markets rest at historically-high valuations amid exceedingly weak fundamentals, while, via government and central bank intervention, there’s ample liquidity to push prices higher on headlines. I.e., presently, liquidity and momentum rule, fundamentals simply do not matter… Historically-speaking, that’s toppy phenomena...

A mood shift -- introducing the hoard of inexperienced traders to declining share and options prices -- from these high and concentrated levels could easily gain momentum and ultimately see equities, at a minimum, testing the March 23rd low in the not too distant future. Present sentiment and market structures/internals smack of the conditions that led to similar events past...

The implications for financial assets if central banks happen to lose their hold on bonds (if yields notably rise), or the dollar, going forward is ominous…

Longer-term, commodities and dividend-paying large cap equities in developed markets, along with emerging market equities (where demographics are favorable), will likely dominate our portfolio exposures. Over the next year+ infrastructure-related equities will be an area we'll no doubt be looking to exploit...

Bonds have enjoyed a multi-year secular bull market that has, virtually by definition (record low interest rates), ended. Risk is clearly to the downside (yields higher), however, central banks will bring much to bear to mitigate what is huge risk going forward. That said, we will seek out safe opportunities in areas such as very short-duration investment grade corporates to gain better than money market yields on our core fixed income allocation.

In summary:

Decades of government and central bank intervention into markets has brought us to the proverbial point of no return. No return, that is, to the market dynamics that define capitalism.

So, do you think -- by making such a declaration -- that I've taken it too far this time? Well, you tell me which statement best defines where we presently find ourselves:

"Capitalism is based on individual initiative and favors market mechanisms over government intervention, while socialism is based on government planning and limitations on private control of resources." -- Investopedia

Any narrative that supports rising inflation going forward flies in the face of burdensome demographics, extreme debt levels, present political and geopolitical trends, etc. -- as those are all arguably deflationary phenomena. Thing is, we are about to experience an utterly massive government spending campaign (arguably inflationary), plus, there’s what they call stagflation -- inflation that occurs during a period of economic malaise. I.e., stagflation has more to do with capacity constraints (I know, there's that "output gap") than it does growing demand, and higher interest rates under such circumstances has much to do with the need to issue debt (again, the US govt is now 40% of GDP) that exceeds the market’s capacity/willingness to absorb it (at record low interest rates, that is). Of course the Fed has a plan for the latter.

As for markets, ironically, a weak dollar, low interest rate, high government spending environment, by itself is bullish for equity markets. And I firmly believe we'll discover opportunities therein to exploit going forward. However, without a true market-clearing bear market bringing valuations down to fundamental reality, prudence will demand that we employ smart hedging strategies well into the foreseeable future.

That's a setup that's also bullish for commodities; many of which that are not coming off of longest-ever bull markets (like U.S. stocks). Quite the opposite in fact.

Here's the 10-year chart of our ag commodities ETF: