Thursday, December 28, 2023

PWA 2023 Year-End Letter, Part 6: What's Next?

Once again, the next cycle will be rich with macro investment opportunities, once we're through whatever's left in the current one.

Now that we've sufficiently (and some) expressed our view that there's more left to play out in the present cycle, we'll finish up this year's year-end message with a look at the next cycle's investment prospects.

Recall that we're bearish, on a trend basis, the dollar, once we get past the present cycle (see Part 4)... Which makes for some serious tailwinds for certain investment themes.

For starters, let's track the US dollar index (dxy) all the way back to when the US abandoned the gold standard for good -- August 15, 1971:

Note the multi-year trends:
08/15/1971 to 10/31/1978 - down (29%)
10/31/1978 to 02/28/1985 - up (93%)
02/28/1985 to 08/31/1992 - down (51%)
08/31/1992 to 01/31/2002 - up (52%)
01/31/2002 to 03/31/2008 - down (40%)
03/31/2008 to current        - up (41%)

Now we'll explore the results for US and foreign equities, commodities and gold (which, at times, needs distinguishing [from other commodities] due to its currency properties) during those stints, and see if we can sniff out any consistencies... I'll bold (to emphasize impressive gains) and color code the returns accordingly:

08/15/1971 to 10/31/1978 (dollar down)
US Stocks (S&P 500 Index): down 6%
Foreign Developed Nation Stocks (MSCI EAFE Index): up 78%
Commodities (Bloomberg Commodity Index): up 390%
Gold: up 468%

10/31/1978 to 02/28/1985 (dollar up)
US Stocks (S&P 500 Index): up 95%
Foreign Developed Nation Stocks (MSCI EAFE Index): up 34%
Commodities (Bloomberg Commodity Index): down 18%
Gold: up 19%

02/28/1985 to 08/31/1992 (dollar down)
US Stocks (S&P 500 Index): up 128%
Foreign Developed Nation Stocks (MSCI EAFE Index): up 228%
Foreign Emerging Mkt Stocks (MSCI EM Indx beg '87): up 193%
Commodities (Bloomberg Commodity Index): up 23%
Gold: up 19%

08/31/1992 to 01/31/2002 (dollar up)
US Stocks (S&P 500 Index): up 173%
Foreign Developed Nation Stocks (MSCI EAFE Index): up 37%
Foreign Emerging Mkt Stocks (MSCI EM Indx beg '87): up 12%
Commodities (Bloomberg Commodity Index): down 4%
Gold: down 18%

01/31/2002 to 03/31/2008 (dollar down)
US Stocks (S&P 500 Index): up 17%
Foreign Developed Nation Stocks (MSCI EAFE Index): up 87%
Foreign Emerging Mkt Stocks (MSCI EM Indx beg '87): up 237%
Commodities (Bloomberg Commodity Index): up 128%
Gold: up 225%

03/31/2008 to current (dollar up)
US Stocks (S&P 500 Index): up 261%
Foreign Developed Nation Stocks (MSCI EAFE Index): up 9%
Foreign Emerging Mkt Stocks (MSCI EM Indx beg '87): down 10%
Commodities (Bloomberg Commodity Index): down 50%
Gold: up 126% (not impressive given the time frame)

So, what can we glean from the above?

Tallying up the strong-dollar periods:
US Stocks (S&P 500 Index): up 529%
Foreign Developed Nation Stocks (MSCI EAFE Index): up 80%
Foreign Emerging Mkt Stocks (MSCI EM Indx beg '87): up 2%*
Commodities (Bloomberg Commodity Index): down 72%
Gold: up 127%**

Tallying up the weak-dollar periods:
US Stocks (S&P 500 Index): up 139%
Foreign Developed Nation Stocks (MSCI EAFE Index): up 393%
Foreign Emerging Mkt Stocks (MSCI EM Indx beg '87): up 430%*
Commodities (Bloomberg Commodity Index): up 541%
Gold: up 712%**

*Emerging Mkt Equity Index captures fewer periods, as it wasn't around during the the first two cycles.

**Gold captures the 468% bounce when the peg was suspended in 1971.

So, without exception, there has been significant outperformance on the part of foreign over US equities when the dollar's trended lower... And vice versa when it's moved higher.

As for commodities and gold, clearly, the time to own them is when the dollar is weak.

Now, beyond the prospects for the dollar, when we consider where the long-term opportunities lie in global equity markets, valuations come into play (green = US, blue = developed foreign nations, orange = emerging foreign nations).

Price to Earnings Ratios:

Price to sales:

Price to book value:

Yep, compared to the rest of the world, US stocks are historically-expensive overall (i.e., there are nevertheless values to be found, even now, amid certain US sectors)... Or, more opportunistically put, foreign stocks look historically-cheap!

And what about dividend income?

Per the below, it's more than doubly better outside the US:

When we're talking regions, given the go-forward setup, commodity producing areas of the world will have a distinct advantage over commodity consumers.

For example, we're bullish on Brazil... And despite it's recent runup, its equities still trade at a cheap 10 times earnings and sport an attractive 5% dividend... I.e., we believe the best is yet to come.

Here's our EWZ (Brazil Index ETF) position year-to-date:

Mexico (EWW) has been special of late as well, but that's been more about strong capital investment into the country, building out its manufacturing capacity... We're maintaining a more modest position there, as Mexico's economy is intimately tied to the fate of the US consumer, and we see potential weakness there in the months to come.

EWW year-to-date:

But of course it's not just stocks that have our attention!

As illustrated, commodities stand to perform handsomely as the next cycle gets underway... However, as with equities, we need to approach the near-term with caution... I.e., while industrial commodity prices stand to rise in a not small way as global capex (traditional and energy transition) serves to fuel the next expansion, should the economy, as we expect, slow further into the second half of next year — which, in a recession scenario, would likely put upward pressure on the dollar — the commodities, and their global producers, that we long-term want to own will likely come at notably lower prices.

That last paragraph said, one might make an earlier case for industrial metals, copper in particular, if indeed China -- as we expect -- pulls out more stops to recover from what has been an overall ugly year (relatively-speaking) for the world's second largest economy, and its markets... A scenario that, by the way, could in fact temper the overall economic hit if indeed the global economy sees recession in the coming months.

And what about market technicals? Of course that's forever a moving target... So rather than saddle this last section with a dozen more charts, I'll simply ask you to tune in to our twice/week video updates going forward.

Lastly, what are the prospects for bonds going forward? Glad you asked!

This chart of the 10-year US Treasury yield tells quite a story:

That was a 40-year downtrend that has become etched into investor mindset to the extent that it makes it hard, if not impossible, for some (the "it's transitory camp I reference below") to actually believe that when it's all said and done, inflation above the Fed's random 2% target will ever be sustainable... Don't sweat it, they proclaim, things, including super-low yields, will get back to "normal" -- that, they promise!

And, you know, the latest inflation trend hasn't hurt their argument.


But of course a notable decline in inflation was an absolute foregone conclusion, as I stated back in 2021:
"...before we settle into that structurally rising inflation scenario (if indeed that's where we're headed), I look for a notable calming of the thrust we're presently experiencing -- as the worst of the production bottlenecks subside -- inspiring a chorus of I-TOLD-YOU-SOs from the "it's transitory" camp."

And as the red-shaded areas (recessions) in the above chart prove -- inflation declines when the economy does. 

Allow me to express our long-term inflation view one last time.. This is worth pounding home!

"...amid what may be a period of relatively low velocity of money, heavy debt burdens, and, we presume, further technological advancement -- I see increasing odds that we're at long last on the cusp of something meaningful (but not 1970s meaningful, mind you) with regard to structural inflation risk:
  • Increasing populism (a serious headwind for global trade -- in both goods and in labor).
  • A continual stimulating of the economy via fiscal policy (facilitated by easy monetary policy) -- demanded by a politically-powerful populist movement.
  • China maturing into a service-oriented, consumer-driven economy (while moving away from providing cheap labor and goods to the outside world).
  • The Fed's fear of bursting present asset and debt bubbles were it to implement traditional inflation-fighting measures -- thus willing to fall notably behind the inflation curve well into the foreseeable future. In fact, I personally place better than 50/50 odds that if indeed a long-term trend of rising inflation emerges, that the Fed will revert to yield curve control (buying up the price (down the yield) of longer-term treasuries) to control lending rates that, were they allowed to rise, would themselves produce a headwind to rising inflation.
  • The trillions of dollar-denominated debt sitting on foreign corporate balance sheets inspiring an active campaign by the Fed to keep the dollar at bay, in an effort to avert what could otherwise turn into very messy global currency crises.
  • The reticence of producers in the metals space to aggressively expand capacity despite rising prices: Speaks to the devastation they experienced post the ‘08 to ‘11 China building boom.
  • The political/environmental headwinds for fossil fuel producers to expand capacity.
  • Inflation being the US’s historically-preferred mechanism to reduce heavy federal debt burdens.
Now, all that said, before we settle into that structurally rising inflation scenario (if indeed that's where we're headed), I look for a notable calming of the thrust we're presently experiencing -- as the worst of the production bottlenecks subside -- inspiring a chorus of I-TOLD-YOU-SOs from the "it's transitory" camp.

Thereafter I suspect we'll see inflation settle into a steadily rising structural trend, and in the process fuel what will likely turn out to be the next longer-term commodity supercycle."
Okay, back to bonds.

After what had been an utter disaster in 2022 (I believe the worst year on record), and given the economic strains we see developing into next year, it's probably safe to dip your toe into the deep end of the pool (the long end of the curve)... Although we are going there very gingerly right here.

We currently hold two modest positions, one in long-term treasuries and one in long-term TIPs (inflation protected treasuries)... Both will do exceedingly well in a recession scenario (as rates are plunging)... But, again, despite our weak economy view, we are reticent to go there in size right here.

You see, virtually nothing in markets -- save for crashes and blow-off tops  -- goes in a straight line, and if we happen to see a pickup in the data over the coming weeks -- our PWA Index [tracks general conditions], for example, jumped 6 points last week -- we would likely see a backup in rates/selloff in bond prices that, frankly, wouldn't sit well with equities either.

So we remain patient, and openminded, as we meander into 2024.

As for the corporate bond space, we're not exposed there at this point, it's too easy just to go treasuries right here and avoid the credit risk associated with corporates... Now, on the other side of recession (if we get one), we will be seriously looking to grab yield from the corporate debt space -- the higher yielding issues tend to perform fabulously during early-stage expansions.

And, lastly, we do see value in the non-US bond space, emerging markets in particular.

Check out the green-shaded yields and rates in the far-right columns in Bespoke's Dashboard below... The higher the rate the more the potential (assuming no severe cracks form for any issuing sovereign one's exposed to) bond price appreciation amid a slowing macro backdrop... A weaker dollar is big in this context as well:

As with treasuries, we presently have modest exposure to EM bonds.

Now, as I'm sure you've gathered, I can ramble on for far longer than anyone should have to endure... And as I think about other setups, etc., that we haven't explored in this year's final message, I find myself yearning for a sufficient way to bring it all to a close.

One such, very interesting and potentially-important, setup revolves around the Japanese yen... I could also expand big-time on our gold thesis -- given the prospects for low real (inflation-adjusted) yields [as the federal govt wrestles with its long-term debt prospects], and, not to mention, the US's newfound will for weaponizing the dollar, which has inspired quite the accumulation of gold reserves among foreign central banks, and so on.

So, in searching past posts for something I could copy and paste on the yen, I came across our November 3rd video commentary (reposted below)… And, thankfully, it turns out to be a perfect close to this year's message.

In it I made the case for a strong year-end rally in stocks, while putting it in its proper long-term perspective... I also pretty well covered the general gist of the overall go-forward message herein, while touching briefly on the setup for the Yen as well.

PLEASE be sure and watch this one start-to-finish!  And also note the links to parts 1 through 5 at the very bottom.

Folks, sincerely, we here at PWA simply can't express enough how blessed we feel to be working for such a truly great group of people! Sincerely!!

Wishing you and yours the very happiest New Year!!!!

Concerts, Child Care, YOLO, Yen, the Dollar and a Rally Right on Cue (video)

Once playing, click the icon in the lower right corner for full screen. Focus should occur after a few seconds; if not, click the wheel to the left of the YouTube icon to adjust:

Attention Non-Client subscribers: Nothing in this video should be construed as investment advice. The examples expressed relate to portfolio management we perform on behalf of our clients, and, again, under no circumstances are they to be considered recommendations to the viewer.

Links to Parts 1 through 5:

PWA 2023 Year-End Letter, Part 1: If A Blizzard Hits, Characteristics of The Best Portfolio Managers, and An Invaluable, Timely, Quote-Fest

PWA 2023 Year-End Letter, Part 2: The Economy and the Stock Market

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