BLOG

The Sleep of Reason Produces Monsters- Francisco Goya, 1799

Investors enter the fourth quarter with elevated and asymmetrical downside risk until after the elections, likely subsequent interest rate hike, and probable market shakeout. There will be ample opportunity to reinvest at lower levels.

The U.S. election should be seen as binary, as the outcome is still uncertain despite any outrageous recent findings about the candidates. The financial risks of a Trump presidency are large, and Wall Street is underestimating the influence of the anti-establishment sentiment which may not be reflected in the polls. If Trump wins, there be sharp adverse effects on the stock market due to:

• His attitude about “negotiating” with creditors concerning U.S. Treasury debt.
• His intention to add trillions of dollars to US long term obligations while implementing the largest income and corporate tax cut in U.S. history, which, according to the nonpartisan Committee for a Responsible Federal Budget, will boost the national debt by $11.5 trillion over the next ten years.
• His intention to deport immigrants will drain economic growth, as population loss equals economic shrinkage.
• His intention to impose import tariffs would lead to decreased economic growth.

It is clear that higher rates by the Federal Reserve will impact stock prices. The market now perceives that the Fed is waiting to do so until after the elections. The options market is implying a market move during election week of only 1.6%. The perception of risk remains low into some potentially market moving events. Aside from higher rates and the U.S. elections, the Italian Referendum in December could also prove extremely destabilizing and hand over power to the anti-establishment (and anti-Euro) party.

There are many other reasons for concern. Risks to the European financial system are sharply increasing. Deutsche Bank is in deep trouble, representing the “canary in the coal mine” of European banks. Non-performing loans are rampant throughout European banks, which have not succeeded like their U.S. counterparts in increasing their capital base adequately since 2008. Deutsche Bank has been in the news because the US Department of Justice fined it $14 billion over its mortgage security misdemeanors leading up to 2008. This is not its only litigation risk, as Deutsche Bank is also guilty of laundering Russian money and will be liable for an estimated $1bln-4bln more. But these misdemeanors are masking the real reasons behind Deutsche Bank’s stock trading at a 20 year low, or its extremely low valuation. Deutsche Bank is one of the world’s ten largest banks, and has one of the largest derivatives books in the world, valued at a notional amount of $50 trillion. As the viability of the bank is called further into question, Deutsche Bank’s clients have already begun pulling money out and unwinding derivative contracts. In a recent IMF report, Deutsche Bank was named as the riskiest bank globally. Counterparty risk with Deutsche Bank is present on all continents, meaning that if Deutsche Bank were to go bankrupt, there would be a contagion of negative impacts at other banks and companies, including American ones.

Germany’s Chancellor Angela Merkel has ruled out state aid to the bank, while the default risk on it has been surging as measured by the credit default swap market. So Deutsche bank either needs to raise capital, which will further depress its stock price, pursue a “bail in”, meaning that it could seize depositors money (and cause a full blown bank run), or appeal to the European Central Bank for a bridge loan (which will spook international markets). If Merkel changes her mind and decides to provide a state bailout, it will likely sink her political career.

There is a global movement toward political “strongmen/populists” which will have disturbing implications for investors. Vladimir Putin (Russia), Donald Trump (USA), Recip Erdogan (Turkey), Victor Orban (Hungary), Marine Le Pen (France), Frauke Petry (Germany), Rodrigo Duterte (Philippines), Narendra Modi (India), Abdel Al-Sisi (Egypt), Benjamin Netanyahu (Israel), Geert Wilders (Netherlands) Jimmie Akesson (Sweden), Siv Jensen (Norway), Jaroslaw Kaczynski (Poland), and Norbert Hofer (Austria) all have something in common; right-wing authoritarianism reminiscent of the 1930’s.

As investors, we should expect three consequences:
1) Less political cooperation and more volatility between nations.
2) Less coordinated central bank moves, hence more currency volatility.
3) Even less liquidity in an already illiquid bond market.

The new U.K. Prime Minister, Theresa May, has signaled that she will invoke “Article 50” and begin the U.K.’s withdrawal from the European Union by March of 2017. This would initiate the 2 year Brexit process. As a consequence, the British Pound has lost 20% of its value over the past year. It should be noted that Theresa May, announced plans to have all companies list non-UK nationals who work for them in an effort to dissuade companies from hiring foreigners. Banks and landlords who knowingly do business with illegal immigrants would face prison under the proposal.

In Japan, the Bank of Japan has announced another desperate effort to stimulate the economy through “yield curve control” which attempts to keep the yield of the ten year Japanese bond at zero, “no matter what”. While the bond market in Japan is completely distorted by Central Bank purchases, so is the Japanese stock market. The BOJ decided on July 29 to expand their stock market stimulus by increasing its annual purchases of ETFs to 6 trillion yen ($60 billion) from 3.3 trillion yen. This is achieved entirely with printed money. The Federal Reserve in the U.S. is not allowed to buy stocks, and the Congress is unlikely to support doing so. But the ability of Japanese, European, or U.S. central banks to stimulate growth is diminishing.

The following chart might support that argument:

This chart is disturbing because it suggests that real investors are fleeing the Japanese stock market even as the Japanese government is buying it, which lends to the argument that central bank buying is no longer working.

In the U.S., there are significant outflows taking place in the stock market. Total mutual fund outflows amounted to $156 billion so far this year, twice the amount of 2015. In fact, all categories of investors (ETF’s, mutual funds, life insurers, pension funds, foreign investors) are expected to be net sellers this year except two: households and corporations.
Generally speaking, households are not where the smart money is usually located, meaning that smaller investors are often the least well informed and often left “holding the bag” into stock market selloffs. As for corporations, who are on track to buy some $450 billion of their own stock this year, they have propping up their own stock with borrowed money, instead of investing in their own future. Simultaneously, “insider” sales of stock by corporate directors has been surging. Evidence suggests that stock buybacks are now increasingly ineffective at raising stock prices.

The IMF published its World Economic Outlook last week and downgraded forecasts for advanced economies from 1.8% in July to just 1.6%, much lower than the 2.2% predicted a year ago. The IMF also downgraded 2016 growth projections for the U.S. from 2.2% in July to now just 1.6% due mostly to falling business investment and inventory drawdowns.

If capitalism is about allocating resources efficiently, the world’s central bank policies have been doing a great disservice. Zero interest rate policies have decimated savers worldwide, and created the income inequalities which lead to populist government. The role of “price discovery” is fundamental to any market, and when central banks buy their own stocks and bonds with printed money, they undermine price discovery with distortions which have now become flagrant.
Furthermore, these zero interest rate policies are damaging banks at a time when they are under increasing pressure by regulators to increase capital. While Main Street loves to hate banks, most people would seek to avoid another banking crisis.

Markets have been conditioned to think that any volatility, or selloffs, will be rescued immediately with more central bank buying, but central banks have become less effective in doing so, and will soon become less willing to do so.

For the first quarter of 2016, the S&P 500 was up 6.1%, the Dow was up 5.07%, and the Nasdaq was up 6.08%.

Grant Rogers

Global Disclaimer
This report has been prepared by Metis Capital Management LLC. This report is for distribution only under such circumstances as may be permitted by applicable law. It has no regard to the specific investment objectives, financial situation or particular needs of any specific recipient. It is published solely for informational purposes and is not to be construed as a solicitation or an offer to buy or sell any securities or related financial instruments. No representation or warranty, either express or implied, is provided in relation to the accuracy, completeness or reliability of the information contained herein, nor is it intended to be a complete statement or summary of the securities, markets or developments referred to in the report. The report should not be regarded by recipients as a substitute for the exercise of their own judgment. Any opinions expressed in this report are subject to change without notice. The analysis contained herein is based on numerous assumptions. Different assumptions could result in materially different results. The analyst responsible for the preparation of this report may interact with trading desk personnel, sales personnel, other analysts, journalists, and other constituencies for the purpose of gathering, synthesizing and interpreting market information. Metis Capital Management LLC is under no obligation to update or keep current the information contained herein. The securities described herein may not be eligible for sale in all jurisdictions or to certain categories of investors. Options, derivative products and futures are not suitable for all investors, and trading in these instruments is considered risky. Mortgage and asset-backed securities may involve a high degree of risk and may be highly volatile in response to fluctuations in interest rates and other market conditions. Past performance is not necessarily indicative of future results. Foreign currency rates of exchange may adversely affect the value, price or income of any security or related instrument mentioned in this report. Metis Capital Management LLC accepts no liability for any loss or damage arising out of the use of all or any part of this report. Certain of the information contained in this presentation is based upon forward-looking statements, information and opinions, including descriptions of anticipated market changes and expectations of future activity. Metis believes that such statements, information, and opinions are based upon reasonable estimates and assumptions. However, forward-looking statements, information and opinions are inherently uncertain and actual events or results may differ materially from those reflected in the forward-looking statements. Therefore, undue reliance should not be placed on such forward-looking statements, information and opinions.