INSIGHTS

On December 05, 2016

AAM Viewpoints – Multi-Year Trend Lines Broken

These Long-Term Charts Spell Very Different Expectations for Future Economic Growth

Looking back at market occurrences since the U.S. presidential election, one has to be impressed at the prolific strength in the equity market, as well as the rise in yields (drop in price) of the bond market. However, looking at a few long-term charts, we note that several long-term trend lines have been shattered. Interestingly, the changes did not start after the election, but were firmly in place much earlier. The U.S. election only seems to have accelerated their movement as many investors found themselves possibly positioned incorrectly for the election results.  

Since the financial collapse of 2008/2009, global central banks have been targeting the creation of global inflation by lowering interest rates as well as making large purchases of assets, also known as quantitative easing (QE). In fact, efforts by several central banks over the past seven years have caused interest rates to drop to historic lows and for aggregate demand to remain positive albeit weak. Although asset prices have recovered since 2008, there has been little hint of accelerating economic growth and the term “lower for longer” has been the mantra of the interest rate market (with one exception in 2013 when a short-lived rate spike would later become known as the “taper tantrum”).

Two charts that have significantly reversed trend and snapped long-term resistance are that of copper prices and interest rates. What has piqued our interest is that both of these multi-year/multi-decade price charts have simultaneously snapped and that the move began well before the U.S. elections. Many market followers know that copper is often referred to as “Dr. Copper” since its price tends to move ahead of – and in correlation with – global economic growth. When copper is moving upward, we tend to see a coincident growth in global economies. Further, rising interest rates tend to indicate that inflation pressures may be mounting and higher aggregate demand may support rising rates.  Therefore we believe that we are in for a change in both the rate of economic growth and global inflation.

First Long-Term Trend Broken - Bond Prices Down and Yields Up

First, let’s look at longer-term interest rates. Highly regarded commodity strategist, Dennis Gartman, published the below chart in his 11/21/16 letter noting that the multi-decade trend line in 10-year Treasury futures had been snapped. He aptly noted that this is a major trend reversal for the bond market, which likely means that the trend for rates in the future is higher. Does that mean straight up? Most likely not, but it seems that the “lower for longer” interest rate consensus may be at risk. Remember, one of our most revered investment tenants is to “Never fight the Fed” and the Federal Reserve has wanted to increase economic growth and employment since the Great Recession.  We suspect they now, more than ever, want to normalize interest rates by raising them.

In the past, the interest rate market generally moved in advance of the Fed. Now, it appears the market is finally signaling to the Fed that it is ready for higher rates.

Source – The Gartman Letter 11-21-16

In addition, we have often noted the long-term correlation between interest rates and inflation. Interestingly, we point to the chart below showing the Fed’s five-year forward break-even rate that shows a “reversal” of the prior trend.  This chart shows that the rate of change in inflation began mid-year 2016 and has been steadily moving higher ever since. We would also point to the fact that interest rates globally have been moving up in tandem as well.

Source – Bloomberg L.P.

Second Long-Term Trend Broken – Copper Prices Higher

Ok, so now that we have looked at interest rates and have illustrated why we expect continued inflationary pressure, why do we expect a significant bump up in global economic demand? Simply put, upward pressure on prices tends to indicate increasing demand on the supply of goods and services. The chart below shows copper futures prices over the past couple decades.  More recently, starting in mid-2016, we can see a sharp rise in copper prices that has clearly snapped the trend (white line) to the upside. We note that copper is known for being a great economic predictor and we think this time is no different.  We expect global economic growth to translate into higher demand in the next few years. In our opinion, we are at the beginning of a multi-year cycle, not the end.

Source – Bloomberg L.P.

We noted a general bottoming in commodity prices earlier this year, as demand collapsed globally. Since the beginning of 2016, we have witnessed a very rounded bottom forming in most commodities – coal, iron ore, copper, gold, silver and other base materials. We believe this is the end to a very long bear market in these commodities.

In addition, we should point out that during times of rising inflationary pressures, stocks have tended to do well while bonds are often challenged. Tangible assets generally outperform intangibles, as rising global demand overcomes the limited amount of supply available. In short, as demand overtakes supply, prices typically rise. Remember, during commodity bear markets, demand wanes. Capital that would normally be used to find more of a depleting asset is not available for new mines and wells. Thus the available supply dwindles as current stocks are depleted. Only a reversal in demand and price can cause capital to be resupplied and new mines and wells developed.

Market Timing Fails Once Again

Finally, one of the biggest lessons of 2016 is the fate of the market timer. We know that it is generally very hazardous to attempt to “time” the market and by trying to do so you increase your odds of failure by having to make two decisions accurately (when to sell and – more importantly – when to buy to get back in) rather than only one.  This year we have seen a miserable failure of both market timers and pollsters. Several big name firms that have plenty of brilliant strategists were shouting this past quarter that investors should pare back their equity exposure as their charts were screaming of an inevitable selloff. Firms such as Goldman Sachs, Merrill Lynch, Barclay’s and HSBC publicly told investors to sell stocks and go to the sidelines. Headlines like the one below filled the pre-election financial news. They called it a “red alert.”

Jane Bryant Quinn once aptly noted, “The market timers’ hall of fame has no one in it.” Time and time again we see the pitfalls in trying to time the market. We believe investors should view the markets on a long-term basis. Emotion is the greatest enemy of capital growth. We now know that the equity markets didn’t crash but actually spiked upward leaving those who “heeded” the warnings trying to get back in. The better way, in our opinion, is to let “time in the market” triumph over “timing the market.”

Oh Yes, We Almost Forgot To Address the Dollar – Likely Goes Lower Not Higher

We can’t complete our analysis without addressing the worry of U.S. dollar strength. Many strategists warn that a stronger U.S. dollar could dampen U.S. economic growth. Jim Paulsen, Chief Investment Strategist at Wells Capital Management, noted in a recent CNBC interview that, “There [have] been five major increases in the [Fed] funds rate since the 1970s, and every one of them, when the Fed raised rates, the dollar came down.” (Source CNBC Interview 11/21/16). We would expect that as global economic growth materializes, foreign currencies will strengthen as well. We would not plan our investment thesis on trying to play currencies directionally.

What Does All This Mean?

Overall, we believe you can expect better global growth and increasing inflationary pressures into 2017.

What does this mean for your asset allocation mix? Well, for the value investor we note that at times such as these energy, financials, industrials, consumer discretionary and materials have tended to lead. Interest rate-sensitive sectors such as utilities, REITs (Real Estate Investment Trusts), and consumer staples have tended to lag.

Inflation is an enemy to long-term bond holders and this time might be worse than usual. Yields have been the lowest in history and any reversion to the long-term mean could be painful. We believe you should consider taking higher credit risk and less duration risk to hit your yield requirement.

Finally, we suggest that global markets might be more generous in returns than U.S. equity markets. We note that U.S. markets already reflect the fact that our economy is further along in its recovery. This year has not only witnessed a reversal in commodity prices, but also in the economies that benefit from the production of them.  We believe emerging markets, Europe, China and Japan should follow the United States.  Overall, their markets are significantly cheaper on a price/earnings basis than the United States. Recent leading indicators including Purchasing Managers Indices have turned higher in places like Europe and China indicating that those economies may be beginning to gain upward momentum. We like these global choices.

Multi-year trends can be your friend until they aren’t. We believe that the breaking of long-term trends in interest rates and copper prices tells us that there is change in the air regarding global economic growth and inflation expectations. We look for higher GDP (gross domestic product) and earnings growth in 2017 and beyond. We think that the trends have changed - likely for many years to come – and believe investors should take appropriate action in their asset allocation strategies.  What we don’t suggest is trying to time your market exposure.

CRN: 2016-1205-5669 R

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.