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Things are a bit confusing right now.
The bond market is shrieking “recession”. Equities remain reluctant to shed their perennial “glass half-full” take on things, but they’re eyeing the door.
And yet economic data in both the UK and the US yesterday was better than expected. Consumers are out there buying stuff – it’s almost as though full employment offsets vague fears about political arguments.
In any case, if you’re wondering what’s going on, I read a very interesting research note from Charles Gave at Gavekal, one of the more thought-provoking research providers out there, this morning.
His conclusion about the state of markets right now?
“We’re in a panic”…
Panic is never a good idea, but in this case, it’s understandable
Charles Gave makes an interesting point on portfolio construction in his latest piece. He notes that long-dated US government bonds tend to be negatively correlated with gold. In other words, when one goes up, the other usually goes down.
Why’s that? Loosely, if people are buying bonds (and so bond yields are going down), it suggests that they aren’t concerned about inflation. If they’re not concerned about inflation, they’re not typically in the market for gold.
But this is not the case right now. Both US Treasuries and gold are shooting higher. So Gave had a look at previous occasions in which this has happened. He came up with five. And every single one was associated with events you’ll probably remember, because everyone was terrified at the time.
There was the start of the financial crisis; then the end of the financial crisis; then the “whatever it takes” bit near the end of the eurozone crisis; and then the last devaluation of the yuan back in 2015.
Today, the reasons to panic are not as stand-out obvious as they were before. But there are lots of individual “stories” to be very worried about.
As I mentioned earlier in the week, Hong Kong is one potential problem. I really hope that the situation in Hong Kong has as peaceful a resolution as you could expect (and hopefully that’s still on the cards). But if something bad happened, then clearly there’s the potential for a major global financial centre to effectively shut down overnight.
There’s the whole issue of a Chinese devaluation. The yuan seems to be behaving itself at the moment but we have no idea how long that might continue or what could persuade China that a weaker currency is the way forward.
Or there’s the eurozone banks. I’ve generally been sanguine about the eurozone banks because we know what the playbook is for a bankrupt bank – the central bank steps in to save it.
But that is a much trickier thing to do within the eurozone than elsewhere, due to the toxic mix of supranational organisations clashing with perceived national interest. And now that the euro maestro, Mario Draghi, is on his way out of the European Central Bank, investors could be forgiven for feeling jittery.
At the moment, negative interest rates make it hard for the banks to make profits. And rules introduced since the eurozone crisis ironically might make bank runs more rather than less likely, because big depositors know that they might get “bailed in” (in other words, they’ll lose their deposits) if things go wrong.
Here’s why investors are buying gold and bonds at the same time
In all, there are quite a few bits of the economy that could “break” with unclear but negative consequences. So people don’t know what’s going to happen next but they think that it won’t be very nice.
As a result, they are piling into bonds as a “safe haven”. (And also a massive momentum trade, but let’s stick with the “safe haven” argument for now.)
So, what about gold? Well, there are two main reasons to buy gold. One is because you think that inflation will rise faster than interest rates. If “real” interest rates are falling, gold tends to go up.
Long story short, that’s because an asset with a 0% yield and an index-linked price becomes steadily more appealing as rates turn more and more negative. (On this point, it’s worth noting that gold is not an inflation hedge as such. It’s not about inflation on its own – it’s about the interaction between inflation and interest rates.)
Two, is because you are worried about the integrity of the financial system. If the financial system blows up, gold is one of the very few assets that is not dependent on someone else’s solvency – it has no counterparty, in the City jargon. Gold is just gold.
Today, there are reasons to buy on both fronts. Firstly, real interest rates are falling (bond yields are sliding even although inflation in both the US and the UK is sitting at or above their target levels). Secondly, investors are clearly worried that something might break in the financial system.
Gave favours gold over bonds at the moment, “since bondholders are most likely to be the victims of the next crisis.” Other than that he suggests raising cash and sticking with high-quality equities, among other things.
My own view? Like I’ve been saying all week, don’t panic. It’s always a bad idea, but it’s especially bad when everyone else is too. If you don’t have a plan, get one. If you have a plan, stick to it.
Something else I’d note – panics don’t always resolve in disasters. Three of the panics Gave cites above were resolved by massive central bank action. I am concerned that this is getting harder now, but a flailing Fed that cuts by 0.5% or even 0.75% at the next meeting would be hard for markets to ignore.
Who knows? My point is this – we can’t know the outcome. All we can do is try to make sure that our portfolios are built to last, and don’t depend on perfection. To my mind, that rules out a fair few assets right now.
Anyway, we’ll be debating all this a lot more at the MoneyWeek Wealth Summit in November – get your ticket here. I’d like to see you there!