Are you seeing the Forest from the Trees?

We never see it coming

We are all fairly familiar at this stage with the primary villain of the recent market volatility - the so-called yen carry trade. Briefly, this investment strategy involves borrowing in a low interest rate currency (yen) and purchasing higher yielding assets (including US equities). Currency divergence also added to the strategies appeal via a declining yen and rising US dollar. All was well until the Bank Of Japan decided to raise interest rates. This narrowed the return spread on offer and more importantly triggered in-house hedge fund risk models leading to serious market volatility. The one puzzling thing for me is not the mechanics of the carry trade for as long as there are interest rate differential’s, ?carry trades will exist. What is surprising is that in all the reports, articles, news opinions I’ve read in recent years, there wasn’t one mention of the yen carry trade.

One last point - they say the “marginal investor” moves the market so it may be important not to overstate this carry trade event. Japanese investors are selling their US stocks and bringing their yen home. At the margin, that may have been enough. Whilst the recovery was sharp and noteworthy, the market was looking for a reason to sell off and its had plenty - weaker economic data, reality check re AI hype, Iran-Israel escalation, uncertain US election, frothy stock markets….The key Q now is whether the “unwind” is done or has more legs….

Follow Powell’s “why” not his what

The US Federal Reserve Chairman Jerome Powell will likely reduce the effective federal funds target rate this week. Much of the focus has been centered upon whether the target rate is reduced by 0.25% or 0.5%. I think this misses the key point that getting out of the blocks is more important that the actual quantum of cuts. For two years we have been writing about “good news being bad news” for the stock market as the concerns about inflationary pressures were slow to ease. With inflation clearly receding, the focus has shifted back to growth and concerns for employment. An important angle to all this is “how will investors perceive the rate cuts”. If the perception is that the FED is cutting in response to a weaker economy (remember the US payroll numbers in August) then the market will sell off. On the other hand, if the perception is that inflation is no longer a concern and a “soft landing” can be manufactured by lowering the cost of capital to fuel economic demand (and growth) then the market should like it. Perception is key as well as the yarn that Powell gives us.

What happens to GOLD when retail investors fall back in love with it

Its fair to say that gold prices have been on a tear for the last three or four years. What has been extraordinary is the environment in which the precious metal has continued to soar - higher interest rates and declining retail investor fund flows. As gold is (with some justification) viewed as a currency, higher “real” rates should be negative for gold as should an appreciating US dollar. However gold has continued to rise higher in an environment of rising rates. Falling interest rates and a declining USD should support further price appreciation. The chart above is complements of incrementum asset management. The red trend line (top right hand corner) illustrates the decline in Gold EFT flows across all regions since 2020. Its hard to believe that gold has rallied so well even without retail investor support (i.e. the ETF flows are reducing as per the red line trend). So what is supporting the price? Asian private markets and Central Bankers. I wrote a post in mid 2021 that Central Banks would be major purchasers of gold arising from the US decision to confiscate Russian holdings of US treasuries in a strategic response to Putin’s aggression. It appears that global (EM) central banks are now pursuing their own policy shift - one which encompasses gold as a “strategic reserve asset”.

“So far, we aren’t experiencing a weaker consumer overall.”

The weak employment report and increase in the unemployment rate in the United States in July along with weaker manufacturing PMI’s spooked markets. However we believe that Hurricane Beryl had a distorting impact on the July employment report. On August 15th the US unemployment insurance claims validated this view with both initial and continuing claims declining by 7,000 to 227,000 and 1.864m respectively. We expect a lot of attention to focus on the August payroll employment report as a barometer of the health of the US economy. The consumer also appears solid with retail sales rising by 1% m/m in July. We know that manufacturing and the goods-producing sector is weak and this has been the primary driver in the “false positive” signals or recession warnings from the composite leading indicators.

But dont take our word for it. Walmart CEO Doug McMillon says the US consumer remains resilient. Walmart is the largest retailer in the US and may be considered an accurate bellwether for the US consumer. Therefore when its CEO says “so far, we aren’t experiencing a weaker consumer overall.”, we should take notice.

24 hour 150km challenge to keep children safe

My daughter turned 7 recently. I am very conscience of the issue of smart phones, online safety and cyber-bullying. CyberSafe Kids is an Irish registered charity who’s mission is to keep children safe online. Jim and I are participating in the Tom Crean Dingle Challenge (for CyberSafe Kids) which encompasses running, cycling, hiking and kayaking 150km over a non-stop 24 hour period. The CyberSafe Kids team is pictured above and also includes Mike Murphy from Galway and the well known family psychotherapist Dr Richard Hogan. I know that some of you have already supported our fundraising drive and we really appreciate it. All funds raised will go to supporting the vital work of the CyberSafe Kids team including physically going into schools and delivering ?online safety programmes. We would really appreciate your support. The GoFundMe link is including below.

Sincere Thanks.

Alan & Jim

CyberSafe Kids GoFundMe Page

Stock market is way too optimistic…again

We wrote in the December 2023 edition of this newsletter that the market was way too optimistic pricing in 6/7 interest rate cuts in 2024. This followed a “dovish” or market friendly press conference whereby Jerome Powell signaled “mission accomplished” with regards to inflation. What happened? Nothing! No interest rate cuts to date 8 months into 2024. What is happening today? Again the market is getting ahead of itself pricing in multiple rate cuts with some commentators forecasting 200bps in cuts inside the next 6 months. This is madness unless you think that we are headed for a nasty recession. If that economic scenario is your base case then 200bps could happen and easily. We dont think the economic data points to that type of weakness. On the flipside, the market looks to be already discounting multiple rate cuts and a perceived “slower rate cutting cycle” may generate market volatility.

Sobering view on Debt

The CBO or Congressional Budget Office in the US produces independent analyses of budgetary and economic issues to support the Congressional budget process. As illustrated in the chart above, they project that debt interest payments will total $892 billion in fiscal year 2024 and rise rapidly throughout the next decade — climbing from $1 trillion in 2025 to $1.7 trillion in 2034. This is a staggering projection and raises the fundamental question of sustainability of US debt financing. Important to remember that the US is running a fiscal deficit of 7% of GDP in an environment of historically low unemployment - what happens to that fiscal deficit in a recession? I dont exactly hear “fiscal restraint” from Kamala Harris either by the way - $25,000 cheques for first time buyers. Europe is not without its debt issues either by the way. For instance spreads between French government bonds and German bunds have widened noticeably given French public debt has now reached €3.1tn or 110 per cent of GDP, while the budget deficit last year was €154bn or 5.5 per cent of GDP.

The elephant in the room is taking up more space!!

Timely wisdom from the great Mr. Templeton

Sir John Templeton was asked what drives financial markets. His quote below captures the unquestionable link between market dynamics and human psychology. Legendary investors like Templeton have a contrarian approach which involves doing what is often uncomfortable but tends to be rewarded.

"Bull markets are born on pessimism, they grow on skepticism, they mature on optimism and they die on euphoria."

Sir John Templeton

So what happens next?

We can mind-map what “may” happen next as follows. The consumer remains resilient in the US despite the doom and gloom from the “glass-half empty brigade”. Inflation continues to trend lower (and stabilize) thereby providing the FED with headroom to commence interest rate cuts. A strong consumer and improving sentiment keeps a lid on the unemployment rate leading to more rate cuts and the stock market continues to trend higher.

But what if we are wrong?

I am reminded of Bob Farrell’s famous 10 market rules of investing and number 9 in particular:

“When all the experts and forecasts agree—something else is going to happen”.

A healthy dose of caution remains warranted given the elevated valuations, extreme geopolitical risk and US presidential election uncertainty.

Thank you for reading