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Investment Strategy Journal Volume 45 • February 2016
________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
ETM Global Strategy Letter – 1st Quarter 2016 Showdown: King Dollar vs. Emperor Gold
"How did you go bankrupt?" "Two ways, gradually and
then suddenly." – E. Hemingway, The Sun Also Rises
Hemingway’s literary quip got so famous because it
tapped into a visceral truth in economic and financial
affairs: things are fine right up until they’re not. It’s
roughly the opposite of the famous old military saying
“hurry up and wait.” When big macro cycles unfold, it
often feels like a case of wait, then hurry up.
Consider how oblivious volatility was in 2014 to
what was just around the corner – a commodity crash,
equity bear market, EM currency thrashing, and China
potentially spinning out of control. This deflation
phase is a result of the great dupe that is money print-
ing. How quickly the illusion can unravel
when the taps are turned off.
At ETM, we’ve maintained throughout
the post-GFC period that not only was the
global financial and economic system not
repaired by radical monetary and fiscal
activism, but also it was probably made
much more fragile by it. We got extend-
and-pretend instead of real free market
reforms - the proverbial kicking of the can,
finger in the dyke etc.
For those who take their cue from
stock markets, it seemed to have worked.
But rising stock markets over time are al-
ways just a sign of cheap and easy lever-
age and inflation and with it the inevitable
flipside, bankruptcy and deflation.
Few countries exhibit these phenomena quite as
vividly as China. We think China is tremendously frag-
ile. The debt orgy by Chinese crony corporations and
regional state fiefdoms, indulged by the roaring ex-
pansion of bank balance sheets and endorsed by Bei-
jing’s god-complex politburos, has created perhaps
the largest unsustainable business cycle ever seen.
China’s equity and currency market remind us that the
façade fades gradually and then suddenly. As Beijing
deploys its big policy guns to save face, it’s hard to
see this ending well for the renminbi.
We continue to emphasise the importance of the
dollar liquidity cycle (adjacent chart). The season is
winter, and a dollar bull market winter (at least to
date) at that, which is a one-two sucker punch for the
gigantic QE-funded carry trade. Global financial win-
ters are indeed seasons for portfolio
defensiveness. But they are also
times of opportunity. After all, some-
times the best form of defence is
attack.
Russell Lamberti
MD & Strategist, ETM IS
60
80
100
120
140
160
180
0%
20%
40%
60%
80%
100%
Dollar Liquidity CycleUS Money Supply (AMS) 5-year %ch v Dollar Index (DXY)
Winter Winter+$ Bull Mkt Summer
Source: St. Louis Fed; Michael Pollaro; ETM Analytics
US
recession
Latam Crisis
Commodity
slump
US/Japan
Debt & Stock
Mkt Booms
S&L Crisis
US recession
EM & Tech
Boom
Asian
Crisis LTCM/Russian Crisis
Dotcom crash
Global Real Estate
& Stock Bubbles
Sub-
prime
GFCEU Debt
Crisis
Global
Stock Mkt
BoomCommodity
Boom China
Debt
Boom
Arab
Spring
Commodity
bust
--- AMS ←
--- DXY →
ETM Global Strategy Letter • FEBRUARY 16 2016
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OUR AUGUST ’15 VIEWS
HAVE HELD UP WELL IN
A DEEPENING DOLLAR
WINTER
US BOND BULL AND
CURVE-FLATTENER
PLAYING OUT STRONGLY
DOLLAR BULL TREND
HAS SLOWED
STILL BEARISH FRENCH
SOVEREIGN DEBT
Recap from the August 2015 letter In our August 2015 global strategy letter, we made the case for why we
thought the dollar bull market would extend well into 2016. We looked
at some short term market dynamics in gold, and also highlighted the
looming threats emanating from China and renminbi devaluation risk.
In this letter, we revisit the dollar question and explain why the case for
gold ownership is again very compelling.
What we got right in August 2015
- We reiterated our long-held view that US stocks would experience a
10-15% correction before year-end, a move which materialised al-
most immediately after publication. The S&P 500 was down 13% off
the May 2015 highs by January 2016.
- Bullish US 10-year bond and US curve flattener. 10yr-2yr yield
spread down from 142bp to 103 and 10-year yield down to 1.70%.
- We thought dollar gains would slow in Q3 and Q4, particularly vs the
majors, but we were more bullish tactically and strategically vs. EMs.
DXY is up only 1.8% and the major trade-weighted index up 2.7%.
- We favoured going tactically and strategically short/underweight
European banks. EURO STOXX Banks ETF down 30%.
- Strategically short/underweight UK property. UK listed real estate
companies and REITS ETF (UCITS) down 15%.
- We continued to warn of China risk, massive PBoC stimulus, and
RMB devaluation. The RMB has fallen 1.7% against the dollar.
- We warned of EM equity risk. $EEM is down 11%.
- We liked being tactically underweight gold (in dollars), but strategi-
cally neutral with an OTM call hedge at a $1255 strike. Gold quickly
fell 9% but subsequently rallied 20% to $1260.
…what we got wrong
- Pound Sterling proved less resilient in the near term than we ex-
pected (GBP-USD down 8%). Our strategically bearish call is in play,
though.
- Asian currency basket has proved more resilient in the near term
than majors ex-dollar (DXY up 1.8% while ADXY down 0.9%). RMB
risk still a bearish threat to ADXY basket in 2016 though.
…and where the jury’s still out?
- Dollar bull market for much of 2016 and DXY target of 110.
- Strategically bearish French sovereign debt view. France/US 10-
year yield spread shaping to narrow while French 5-year benchmark
CDS spread has widened, but both not conclusively enough yet. We
nonetheless strengthen our conviction in being short France/US
yield spreads and long French CDS.
- EM rate hike risk. Some big EMs (Chile, Mexico, S.Africa, Colombia,
Egypt, Peru) have hiked since August 2015, as expected, but not
hard and fast enough yet to fit snuggly with our EM repricing thesis.
60
70
80
90
100
110
120
130
140
150
160
60
70
80
90
100
110
Key Market Developments Base 100 on 21 August
Source: Bloomberg, ETM
August 2015
Strategy Letter Now
DXY
CNYUSD
EURO STOXX
Banks
$EEM
GoldS&P500
US 10y/2y
spread
UK
Property
Russell 2000
ETM Global Strategy Letter • FEBRUARY 16 2016
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BEARISH DOLLAR CHO-
RUS GETTING LOUDER
FED EASING DOES NOT
ALWAYS WEAKEN THE
DOLLAR
…BUT TENDS TO WHEN
EASING INTO DOLLAR
OVERVALUATION
…& AFTER THE FED’S
BEEN MUCH TIGHTER
THAN PEERS
Is the dollar bull market over? Clients know that we’ve been a proponent of the dollar bull market
thesis since early 2014. But for most of the past year, the dollar largely
stagnated against the other majors. Through that sideways trend, we’ve
argued the dollar was setting up for another leg higher. While this has
been frustrated on the DXY, the trade-weighted dollar against major
trading partners has indeed broken out into another bullish phase.
But there is a growing bearish dollar chorus. According to this view, the
market priced in much stronger US growth and much tighter US policy
compared to the rest of the world than is materialising. As perception
aligns with reality and US growth expectations and Fed hawkishness
are downgraded, so the dollar bull thesis collapses. On top of this, it is
asserted that ‘long dollar’ is a “crowded trade.”
While compelling and plausible, one should consider the following:
1. Does Fed easing (or chickening out on hawkishness) necessarily
weaken the dollar?
2. How does the dollar behave in liquidity winters and recessions?
3. Does a bull market have to be predicated on just one bull thesis?
FED EASING & THE DOLLAR: Fed easing is no guarantee of dollar
weakness. When the Fed eased from cheap dollar valuations, after
tightening, and during a time of ex-US macro risk, the dollar
strengthened (the early 80s, late 90s & early 10s). When it eased from
cheap dollar valuations and through recessions, the dollar was neutral
(the early 90s & GFC). Easing from cyclically high valuations in boom
cycles to counter equity market bear risks weakened the dollar (the
mid-80s & early 2000s).
So Fed easing doesn’t automatically mean dollar weakness. However,
after an already mature dollar bull cycle (nearly five years and +40%)
and potentially a lot of pain already priced into EM, decisive Fed easing
could reverse the bull market. There’s been a long stock market boom
cycle turning into a nasty bear market, and a dollar cyclically
overvalued. If the Fed eases into this, it could well be “green zone”
easing as per the adjacent chart (the mid-80s & early 2000s).
But if a “green zone” period lurks, then we should also note that the
previous two green zone easing cycles first saw the dollar gain ~10%
before peaking and embarking on a big bear cycle.
Blue zone easing (dollar bull) seems less likely. While there is
potentially a lot more ex-US macro risk still to manifest, sitting
anywhere from European banks to China, to the EM carry trade unwind,
the dollar is not undervalued like at the start of previous blue zone
easing cycles (the early 80s, late 90s & early 10s).
Regarding the other major central banks (peers), in blue zone Fed
easing (dollar bull), US rates tend to be higher than peer rates and fall
slower than peer rates. In grey zone (dollar neutral) Fed easing, US
rates tend to fall sooner, faster and below peer rates, and they tend to
fall sooner and faster in green zone Fed easing (dollar bear).
-10%
-5%
0%
5%
10%
15%
20%
70
80
90
100
110
120
130
140
Hu
nd
red
s
Fed easing doesn't simply = $ weaknessReal trade-weighted $ (major) during easy money phases
TW $ Major (left) Fed funds/Shadow short rate Money Supply y/y%ch
Source: St. Louis Fed, ETM Analytics
$ weakness$ strength $ neutral
$ Avg
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FED HAS TO MAKE
LARGE ABOUT-TURN TO
SPARK EASING CYCLE
…BUT THEN PEERS MAY
ALSO EASE SHARPLY,
NEGATING THE $ EFFECT
DOLLAR BEARS NEED
ANOTHER LIQUIDITY
SUMMER CYCLE
THE DOLLAR TENDS TO
DO WELL IN RECES-
SIONS & RISK-OFF
If the Fed is near to making a dramatic about-turn in monetary policy, it
could spark further easing among the other central banks, but arguably
not as much at the margin (barring perhaps the BoE). This policy would
be more consistent with green zone (dollar bear) easing. That would
probably have to involve more QE to provide the monetary catalyst
needed since bank lending won’t provide the necessary stimulus. If the
Fed is just going to pause on rate hikes or cut back to zero and hold
there, or even dip into negative rates, at best that constitutes blue zone
easing (dollar bull) since this won’t spark enough bank credit stimulus.
Neither of these outcomes necessitates dollar weakness whereas each
is associated historically with at least short-term dollar gains.
WINTER, RECESSIONS & THE DOLLAR: Though dollar liquidity cycles we
find that the dollar is either strong or neutral during winters and neutral
or weaker during summers, depending on valuation and relative
monetary policy. The dollar may only weaken in the next liquidity
summer, which may take a new and gigantic Fed QE programme.
In recessions, we typically see the greenback appreciate into or through
the period. The main exception to this was the 1991 recession. The
dollar benefits from global demand for cash and liquidity. To the extent
that recession risk is rising for 2016/17, the historical record suggests
the dollar is likely to trade bullishly through such a phase.
MORE THAN ONE BULL THESIS: Basing the rationale for the end of the
dollar bull market on the end of the strong growth/hawkish Fed thesis
assumes there could only be one rationale for a bull market. The
previous two bull markets exhibited more than one bull thesis. In the
80s, the dollar rallied on a liquidity-tightening recession period and
then because US growth was outperforming. In the 90s, it rallied
because of tighter monetary policy and EM risk, and then on domestic
financial risk. The present cycle could easily exhibit a similar shift from
one bull thesis to another; from strong growth/tight Fed to growth risks,
financial risks, and a clamouring for dollar liquidity.
-10%
-5%
0%
5%
10%
15%
20%
Hu
nd
red
s
Fed Easing v Other Central BanksMain Policy rates/Shadow Short Rates
UK Discount/SSR
Fed funds/Shadow short rate
EZ Discount/SSR
Japan Discount/SSR
Source: St. Louis Fed, Krippner, ETM
$ strength
$ neutral
$ weakness SSR
→
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DOLLAR BULL CYCLE IS
MATURE
…BUT SIGNS OF IMMI-
NENT BEAR MARKET
ARE UNCONVINCING
RISK: AGGRESSIVE QE
THAT SHATTERS FED
CREDIBILITY
10-15% HIGHER DOLLAR
PLAUSIBLE
BOTTOM LINE: The dollar is clearly in a mature stage of its bull cycle,
having rallied for nearly five years and 40% off its cyclical low in mid-
2011. The Fed is apparently being forced to rethink its tightening plans
as per our long-held view that QE4 was more likely than a 1% Fed funds
rate. Equally, though, the Fed can’t change the liquidity season from
summer to winter without a large, aggressive QE programme,
something it may only be willing to do after a series of rate cuts to ZIRP
and maybe NIRP. The liquidity winter is therefore still firmly in play and
recession signals, while mixed and atypical, are, at a minimum, flagging
significant growth dislocations. The stock market is falling and haven
demand is firmly on the up. Some big central banks are easing hard.
On balance we remain unconvinced the dollar bull trend is over,
although 2016 may well be shaping up as a turning-point year.
RISK: If Fed credibility shatters in the coming months as rapidly
deteriorating financial conditions force it into an ultra-aggressive QE4,
or possibly even a “QE4ThePeople” Zimbabwe-style debt monetisation,
the “clamour for dollar cash thesis” could be overrun by the “new dollar
carry trade” thesis.
INVESTMENT IMPLICATION: How much more can dollar bulls squeeze
out of the dollar’s run? On balance, another 10-15% remains plausible.
We’ve made a case for more upside tactically, but gains from here start
to spring-load the next bear market which could be every bit as
ferocious as the bull cycle. The better strategic trade may be to plan to
position for the next phase when the dollar bear re-emerges.
SOME CURRENCY CHARTS
Japanese negative rates have met with a yen bid. Markets are now
speculating that the BoJ will have to introduce another surge in QQE to
counter yen bull forces. The short term chart pattern is yen bullish and
may feed into an aggressive BoJ response. However in 2014, the JPY
broke above a 25-year trend line. It’s quite plausible the market will
retest that trend around 105 in the short term. If that holds the pattern
may stay bullish JPY (bearish yen). For now, it’s hard to see dollar gains
coming from yen losses.
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1.15 STILL A KEY LEVEL
ON THE EURO
…BUT MAY YET NEED TO
RECKON WITH PARITY
STERLING LOOKING
BEARISH
YUAN RISKS LURKING
DESPITE PBOC TRYING
TO KEEP IT FIRM
Euro consolidating in a well-worn range with 1.15 still a key level to
watch. If 1.15 is broken is may jeopardise the dollar bull outlook.
…but the euro may still need to reckon with long term trend support
around parity and a longer bear cycle.
Meanwhile, Sterling appears to have capitulated below long term trend
resistance and may have 12-18 months left in this bear cycle.
Markets are also increasingly speculating against China’s yuan.
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GOLD’S RECENT GAINS
ARE TELLING IN A DE-
FLATIONARY WINTER
HAS THE SHARP RALLY
BROKEN THE BEAR?
GOLD TRADING LIKE
THERE’S RISING FEAR
WHAT IS GOLD?
IT’S THE TRANSCENDENT
STORE OF VALUE
Why Gold is a Portfolio Necessity As 2016 shifts into top gear, one of the most important trends is the
resilience of gold amid many falling prices around it. Gold’s already
done a lot of its falling since 2011, and in a dollar liquidity winter that
exerts strong deflationary tendencies, gold’s recent gains are telling.
The yellow metal had around four bear market rallies from mid-2013
and none of them were able to break the bear trend. But the fifth one
may have. Last week’s breakout, as Janet Yellen mused over negative
interest rates, may be very significant.
At a time when sellers are pounding commodities, stocks, junk bonds
and various currencies, gold’s recent resilience is impressive. It sug-
gests the weaker hands on the long gold trade may have mostly been
flushed out and it points to an underlying monetary system and central
bank credibility risk amid a global business cycle slump.
We highlighted this theme in a video to clients in September 2015. You
can click on the image “Gold De-Coded” to watch it (8 minutes).
WHAT IS GOLD?
It is not surprising that most don’t understand gold as a monetary store
of value. There are two main reasons why. The first is because there is
no one alive who can remember what life was like when households
and commercial banks held and traded in gold as money. Even under
Bretton Woods, gold was far removed from the ordinary man and
boarded up in the esoteric world of central bank reserves. There is al-
most no-one with an experiential knowledge of gold as a monetary
store of value. The second reason is propaganda. For a fiduciary fiat
currency system to work, other financial media have to be discredited,
hence the constant mainstream gold bashing – “barbarous relic”,
“yellow worthless lump” etc.
A view on gold fundamentally hinges off what you think gold is. If you
believe that it’s a useless piece of metal, then you won’t own it. If you
think it’s a commodity like copper or coal, then you might sometimes
own it, and sometimes not. If you believe that it is a monetary store of
value, then you’ll probably own it permanently in some quantity that
might vary depending on your circumstances.
To us, gold is undoubtedly a monetary store of value. In fact, it is fun-
damentally the transcendent store of value. Every other discussion on
gold is ancillary to this.
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GOLD'S VALUE TRANS-
CENDS TIME & PLACE
GOLD DOES WELL
THROUGH ‘TRANSITION
NODES.'
GLOBE CLEARLY IN A
MAJOR & UNCERTAIN
TRANSITION PHASE
HAVING GOLD IN A
PORTFOLIO IS PRUDENT
In a study of 750 years of gold and inflation data we conclude that:
Gold protects value against monetary debasement and inflation.
Gold stores value through systemic political change, regime
change, wars and social upheaval.
Gold preserves value through systemic economic change,
technological change, repeated business cycles, corporate and
sovereign bankruptcies.
In short, gold's value transcends time and place. Its value does not fall
to zero as companies, sovereign securities or fiat currencies often do.
Its universal acceptance and portability mean it transcends geography.
Companies may trade globally, but they operate in specific locations.
Sovereign debt securities are tied to individual governments of
particular territories. Real estate is inherently geographic. Nationalised
fiat currency has jurisdictional restrictions.
Gold bullion is therefore at the rarefied intersection of being a liquid,
transcendent store of value with no counterparty risk (although non-
trivial confiscation or theft risk). It can also be linked into digital pay-
ment systems yet is wholly physical. These properties are rare.
TRANSITION OR STABILITY?
In stable systems or complacent periods, the need for the services ren-
dered by gold is quite small. By contrast, there will tend to be signifi-
cant spikes in gold demand into and through major transition periods.
If one accepts this, then it is worth considering the following questions:
1. Is the world/your country in a transitional or upheaval period?
2. Is any human lifespan likely or unlikely to experience a transitional
or upheaval period?
Asking Question 1 another way, is the monetary order and economic
and political balance of power stabilising or transitioning?
In our view, the international system is unambiguously in a state of
transition rather than stabilisation. This transition is increasingly at risk
of being a disorderly one. QE and NIRP are undermining the structural
integrity of the financial system. The West has arrived in a fiscal cul-de-
sac. Much the G20 faces peak debt. Nation states are losing power to
non-state actors. This dynamic mix of transitory forces is already result-
ing in social unrest and profound political instability, combined with
state desperation, increased regulation, taxation and stagnation. It is,
in essence, a giant tug of war between the nation-state-centric forces of
centralisation, and non-state forces of devolution, embodied in EU poli-
tics.
The answer to Question 2 is that the likelihood of anyone living an en-
tire lifespan without experiencing a systemic transition period is ex-
tremely remote. Whether it be war, political system change, financial
and economic crisis, monetary regime change, sovereign bankruptcy,
hyperinflation, or disruptive technological shifts, it’s almost sure that
every human being will live through one or more systemic transitions in
their lifetime. So even if the answer to 1 is “no”, holding gold in a bal-
anced wealth portfolio would remain a profoundly necessary, prudent
long-term strategy.
GOLD IS A PERMANENT PORTFOLIO NECESSITY
We remain convinced that gold is a permanent necessity in a balanced
wealth portfolio. While this might range from 5% to 50% depending on
time horizon and trading and risk appetite, the idea of not having any
allocation to physical gold must be considered grossly imprudent. Gold
should form a permanent part of cash allocation, and gold miners a
cyclical component of equity allocation.
With gold having sold off nearly 50% from its highs in 2011, currently
bucking the commodity broader selloff, and offering a haven during a
time of potentially unravelling central bank credibility, we are strategi-
cally bullish the metal. Tactically, a final dollar bull leg could keep a cap
on gold although it doesn’t have to. Gold and the dollar can rise at the
same time.
Short term trading action can be deceptive, but the action this past
week may be indicative of a process of shifting from bear to bull market.
Therefore, in establishing strategic gold exposure, we favour moving
into a firmly overweight gold allocation.
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FURTHER DOLLAR
GAINS SPRING-LOAD
THE NEXT BEAR MKT
WE ARE STRATEGICALLY
BULLISH GOLD
DOLLAR AND GOLD MAY
BE POISED TO RISE IN
AN EPIC FACEOFF
WE REMAIN HIGH CON-
VICTION ON LONG US
BONDS & A FLATTENING
YIELD CURVE
Investment Implications ~ Dollar: Fed rate cuts this year appear to have become a majority (or
near-majority) view. But until the Fed throws more QE at the issue,
it’s not clear that this alone undercuts the dollar bull theme. Even if
the Fed gets more aggressively loose through NIRP and/or QE, the
reasons for this would be a global panic which could feed into
tactical gains. But further dollar gains, particularly in a panicked QE
scenario, stretch the dollar to extreme overvaluation and would
present an opportunity for the coming short dollar trade.
Positioning: Tactically bullish dollar; strategically neutral to bearish.
~ Gold: There are negative central bank rates and bond yields across
much of the developed world. To pass negative rates through to
consumers you need to ban cash. European banks are under stress,
and sovereigns pose a bail-in risk – money in the bank is risky. Who
backstops the banks? The central banks; but they’re running into
the cul-de-sac of their grand monetary experiment. This should be a
sparkling cocktail for gold, and it’s no surprise the metal is resilient.
Gold markets will probably be choppy along with much else in the
near term, but this looks like an excellent strategic opportunity for
gold bullion and arguably even better for heavily unloved silver.
Positioning: Tactically bullish, strategically bullish gold and silver.
~ Gold miners: As the globe moves deeper into an equity bear market
and dollar liquidity winter, it’s plausible we witness gold and the
dollar rising in tandem. These periods are usually short-lived, but
they are very bullish gold in EM currency.
Positioning: Tactically bullish gold miners with exceptionally high
leverage to the local-currency gold price.
~ US bonds: Until the Fed fights a panic with big QE, we remain bullish
US long bonds, and we also still favour a US curve flattener. The US
10yr-2yr yield spread broke below a key support level last week.
Position: long US 10-year bond; target 50bp on 10yr-2yr spread;
strategic long US 10yr/short French 10yr.
~ The Fed: We’ll deal with Fed policy in more detail soon, but a quick
comment here is that the market is turning far more dovish in its
expectations. Whether this is a short-term overreaction remains to
be seen, but strategically we still think markets don’t fully
appreciate the structural imperative for ultra-loose, ultra-activist Fed
policy. QE-NIRP is highly plausible but markets (Eurodollar futures et
al) are not priced for such aggressive policy action through the cycle.
Positioning: Favour lower rates across the curve and assets poised
to make reflationary comebacks like inflation-linked bonds.
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Investment Strategy Journal ©
Russell Lamberti
MD & Strategist
SOUTH AFRICA
Tel: +2711-8758556
Block 5, Fourways Golf Park
Roos Street
Johannesburg
South Africa (2055)
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