Follow the Money!
As macro-traders, we are mainly interested in the long-term trend: where we are in the trend, and how long it will continue. This is true not just for particular trading products, or monetary policy, but for geopolitical trends and capital allocation trends. In fact, the interdependency between these and other factors are what make the financial markets resemble what Paul Tudor Jones coined a “3-dimensional chess game”. Today, let’s look at the current market scenario through the lens of geopolitical and demographic trends to see what capital allocation trends might occur in the next 10 years.
Back in the 70’s and 80’s, investing was far more straightforward and as almost anyone will tell you, easier: find a company that had a good business model, a high ROE, low PE, and sit on it, or play the range because you knew it would come back, usually. Today, considering the pace of technology, the ease of business model disruption, the mobility of capital, and the virtual disappearance of the individual trader from the marketplace, we have a very different animal.
If one looks at the most successful companies of the past 10-15 years (the FANG stocks) they all banked on the idea of reaching a large mass audience and incurring losses until they had cornered their market. The business development strategy was markedly different from adveryour success through profitability, and today, startup companies are marketing themselves to be the next unicorn. Whether this approach will succeed going forward is another matter. IPOs like Uber have no real moat around their business. Investing in them is very different from investing in something like Google or Amazon at their inception. What is happening now is reminiscent of the late 90's where all one had to do was put a .com behind their name to attract investors. I would bet against companies like Uber whose model is easily replicated. This is one trend that may have seen it's apex. Time will tell, no predictions. Logic and the bottom line prevail over the long term, so I would be very surprised to see companies with no real moat and no profitability being able to attract investors too much longer.
There is a geopolitical trend developing now which I believe will influence investment in the next 5 to 10 years. In fact, it has already begun to influence capital flows. But first, let's look at some other key trends that are influencing the financial markets.
1) Active investment funds are dying a slow death because they simply can’t beat alpha – most of the time. See #2 below to understand why this is the case (in part anyway).
2) Algorithmic trading has completely dominated trading volumes. This typically means holding times for any trade have been cut significantly. There is more market ‘noise’, which makes short term trading strategies less successful for the most part.
3) A global trade war: what nation-state needs to threat launching ICBMS when they can simply threaten to redeem their bond holdings? The issue is more complex than this of course, but you get the point: it has become increasingly difficult for nations to maintain independent monetary and fiscal policy. As a result, we will see capital going to nation states which do have suitable control over this - Japan and Switzerland remaining 2 case examples. Capital will continue to be highly mobile, and political instability will increase. The European Union is likely to destabilize further.
4) Global ‘Quantitative Easing. It’s all about jobs; after all, that is what wins votes in any election. Governments need to keep rates low to spur investment in capex (and hopefully more employment). But productivity and earnings don’t come from hiring more people, they come from hiring more robots. (note: robots don’t pay income tax rates of 35% to 50%.)
5) Demographics (Aging): The Western world (cashing out and getting sick) / Emerging markets (getting richer and not old and sick yet).
Key takeaways from all the above:
i) More strain on infrastructure and the government finding new clever ways to reduce pension commitments . (Think more QE).
ii) Increased productivity through innovation (not employment). GDP figures becoming less meaningful than they already are. One should focus on companies with legitimate innovations rather than old-world products. Consider stocks like Ubiquiti Networks (UBNT) rather than Proctor and Gamble (P&G). (We will discuss this in a future blog post).
iii) Interest rates are not headed higher without due cause (inflation), and there can be no inflation when the disposable income of the middle class continues to erode.
iv) Capital moving to emerging markets where capitalism is alive and well.
v) Capital Flight due to the introduction of estate/inheritance taxes. These taxes are high in countries such as Japan, Korea, The UK, and France, but not in countries like Canada and Australia. It is primarily because of export growth and tax contributions from immigration that these latter countries have not resorted to stealing from financially successful families, not yet anyway. How long this trend will continue is anyone's guess, but the current government in Canada is already tabling this idea. If this comes into being we can expect some capital flight, and perhaps greater growth in the underground economy.
So, to summarize, we suggest that you keep a strong cash position for episodes of high volatility ahead, don't bet on seeing a unicorn IPO securing your retirement, and avoid investing in fixed income (since official inflation figures which affect these investments are more or less meaningless). One should look at a mix of gold bullion to preserve their capital, emerging markets - especially in countries with secure governments (as in East Europe), and companies with a solid moat around them (think Visa or Mastercard). As well, keep an eye out for trends in our favourite leading indicator commodities, such as lumber and copper. As everyone should know, the economic cycle is highly influenced by the credit cycle, which in turn is influenced by housing demand, and to a lesser degree, auto demand. Copper and lumber, being 2 of the primary inputs of these sectors need to be monitored. At the same time, the big issue in the shorter term remains China. Their growth may be slowing but they are in a position, as is the USA, to introduce more dovish monetary policy; that would bode well for gold bullion, but less so for gold stocks which tend to decline significantly when people shift assets to growth stocks. Most of all, be nimble, and don't be greedy as this bull market is very long in the tooth.
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First a little background: in the wake of the financial crisis in 2008-2009, the ECB had been compelled to cut interest rates to negative; they currently sit at -0.4 %. The intent of negative rates is to encourage institutions to lend money rather than park it at the ECB. If euro banks aren’t lending, then they are forced to pay the ECB to sit on their cash, or take greater risks in their lending practices. This has been hurting EU bank profits for quite some time, as the chart below indicates.
Well, some relief may be on the way for EU banks, but this doesn’t necessarily bode well for anyone who is long the EURO.
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