The first few weeks of the new decade already introduced a new level of investor anxiety in the markets, the likes of which we haven’t seen in a long time. Perpetual optimism, overconfidence and widespread complacency have caused many investors, analysts and market observers to assume that the historic bull market in US equities was unstoppable. By the end of 2019, almost all major central banks had returned to the easing path, interest rates were negative or ultra-low across the board, and QE had also made a decisive comeback. The trade war had de-escalated, the future looked bright and even the impeachment moves against the US President failed to make a dent on market euphoria.
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Despite the warnings of conservative analysts and economists over the many systemic risks, such as over-indebtedness and monetary overreach, most mainstream investors and speculators preferred to focus on short-term rewards and ignore the bigger picture. And yet, recent events seem to have effectively refocused their attention on the urgent need for downside protection. The sudden escalation of the tensions between the US and Iran, the threat of a coronavirus epidemic out of China, as well as a number of worrying economic reports out of major economies, have given serious pause to stock investors.
While we do recognize the considerable risks of a potential military conflict or a contagion scenario, as well as the massive ripple effects on the global economy, we still think it is a mistake to focus solely on these developments and to assume these are the only threats to investors going forward. Even if worst-case scenarios prevail, they would not cause an economic or market downturn: they would merely trigger it. Instead, the real cause would likely be found among the underlying and preexisting pressures at work that have been ignored and underestimated for too long.
As was expected, the worrying news was accompanied by a measurable increase in investor anxiety. This was clearly demonstrated by the market sell off and the volatility spike in the days immediately following the news of the US drone strike that killed General Soleimani. The VIX, the main market volatility gauge, saw a 17% surge, while oil prices climbed to a three-month high. Of course, precious metals also saw significant gains: Gold rose to $1,590.90, its highest level in nearly seven years, and silver reached $18.55.
However, it is useful to remember that recession fears have actually been on the rise for quite some time already – something we’ve covered in our Q4 Digger - long before the death of the Iranian general or the spread of the Chinese coronavirus. While US stock markets were still breaking records almost on a daily basis, many investors were already seeing trouble ahead. According to last quarter’s Big Money Poll by Barron’s, only 27% of money managers were bullish about the market’s outlook for the next 12 months, the lowest percentage in over 20 years. This figure, that stood at almost 60% in the same survey a year ago, accurately reflects a wider shift in sentiment and has been echoed by multiple similar polls over the last six months.
There are very good reasons for this gradually spreading skepticism. For one thing, the performance of US stocks over the last year increasingly appeared divorced from the economic realities on the ground and from official data. It is also becoming easier to support the argument that stock valuations are really not at all what they seem. Years of ultra-low interest rates have encouraged reckless corporate borrowing and massive stock buybacks that have artificially inflated equity prices. U.S. corporate debt has increased by 50% over the past decade and now stands near $10 trillion. The cracks are already beginning to show. According to S&P data, 2019 saw the most credit ratings downgrades relative to upgrades since 2009. And this trend is all but certain to continue in 2020.
Risks out of Europe
For months already, reports and economic figures from key EU economies have been consistently flashing warning signs. Germany is in serious trouble, as an avalanche of worrying data has sparked concerns of a recession. The latest manufacturing figures, published in December, showed an output drop of 5.3%, as the country’s industrial sector suffers its steepest decline in a decade. We could see further weakness ahead in the economic engine of the EU, as Andrew Kenningham at Capital Economics warned, “far from bottoming out, Germany’s industrial recession may be getting worse. The latest data supports our view that a recession is still more likely than not in the coming quarters”.
Source: International Monetary Fund, German Federal Statistical Office
Meanwhile, Italy continues to be the problem child of the Union. Apart from its huge debt levels and ailing banking sector that still pose a severe threat to the entire bloc, its reignited political tensions have caused fresh headaches in Brussels. The current coalition government, headed by Prime Minister Giuseppe Conte, has managed to assuage the fears of an “Italexit” scenario, raised by the previous coalition that included right-wing populist and Eurosceptic, Matteo Salvini, and his Lega party. However, this latest coalition now seems to be on the brink of collapse, rife with internal frictions and external attacks. Salvini might have he lost his position in the government, but he did retain his popularity and threatens to destabilize the fragile governing alliance.
All of this is very important in the context of the ongoing financial reform efforts in the country. PM Conte has agreed to the conditions set by European Stability Mechanism (ESM) in order to extend much-needed credit to the country. These include measures and legal changes that will make debt restructuring and bailouts much easier. Given the dire condition of the nation’s biggest lenders, many Italians fear that their savings, bond holdings, and shares will be used to pay the banks’ bills.
Last, but most definitely not least, we have the risks coming out of the UK and Brexit. Although it’s been a long time coming and there has been plenty of time for investors and businesses to adapt and plan ahead, we are still not sure what the future will look like for an EU without Britain. The departure of the island nation, one of the bloc’s largest contributors and key trading partner, is bound to have a considerable impact on its labor market and on its exports. Apart from Ireland, Germany is likely to be hit the hardest, as newly established tariffs would inflict serious damage on the country’s already struggling auto sector.
Global protests and political shifts
The new year brings with it a lot of baggage and unfinished business from 2019. The massive wave of protests that swept almost every continent on the planet in the past few months still casts a very long shadow over many major economies and threatens fragile alliances and international relations. In Latin America, Chile, Colombia, Argentina, Ecuador, and Bolivia all saw their fair share of protests and intense public discontent with the status quo, with citizens demanding radical changes and political accountability. Venezuela continues to devolve into a failed-state status, with a crippled economy and ongoing demonstrations that often end in violence by government forces.
The Arabic world already had the Lebanon crisis to contend with, an issue we examined in great detail in our Special Report in early January, but now the tensions between Iran and the US are fueling further uncertainty in the region. The situation in Hong Kong continues to be unstable and it’s too early to tell whether the recent appointment of a new Beijing envoy will help pacify the protest-ravaged city.
Back in Europe, France continues to be paralyzed by strikes and demonstrations that have never really stopped since the Yellow Vests movement emerged in October 2018. Spain is also gripped by public unrest. The aftershocks of the Catalan referendum are still intensely felt, as separatists continue to fight for independence and to protest their leaders' imprisonment. Violent clashes with police are becoming increasingly common. In December, thousands marched in Poland in protest against reforms that they say systematically erode the independence of the justice system and place it under the government’s control. As their demands remain unmet, fresh demonstrations are planned for 2020.
As for the US, 2020 is a particularly important election year. The Trump presidency has been characterized so far by controversy and a deep division in the nation. With radical agendas like that of Elisabeth Warren and Bernie Sanders gaining traction, these divisions could get a lot worse as we get closer to November, depending on who wins the Democratic nomination.
Trump does have the incumbent advantage and a lead in some of the early polls. However, if his original 2016 victory taught us anything, it is to be very wary of pollsters and their forecasts. It would be foolish to even attempt to predict the outcome this early in the race. An economic downturn or a severe market correction could change everything, and so could starting another war, or having the trade deal collapse again.
On the monetary policy front, there is nothing to suggest that the easing trend that began last year will be reversed anytime soon. The Fed has been increasingly dovish and its still ongoing repo market cash injections are by now widely seen as just another, more subtle way of delivering QE. As for its interest rate policy outlook, at this stage it appears the only way is down, a scenario that’s reinforced by the current geopolitical tensions.
It can also be argued that keeping rates close to zero is no longer just a policy choice, but perhaps a necessity, as any increase could risk setting off a game of corporate debt default dominoes. The Fed seems to be acutely aware of this threat, as the minutes from its December meeting clearly show. Some members openly expressed fears of a corporate debt bubble that could make the next recession considerably worse. In addition to this, the central bank also went to great lengths to highlight the dangers of spiraling corporate debt in its latest Financial Stability Report. As the report stated, “Business debt levels are high compared with either business assets or GDP, with the riskiest firms accounting for most of the increase in debt in recent years”, adding that “in an economic downturn, widespread downgrades of bonds to speculative-grade ratings could lead investors to sell the downgraded bonds rapidly, increasing market illiquidity and downward price pressures in a segment of the corporate bond market known already to exhibit relatively low liquidity."
Source: Bloomberg, "Peak Greed" Fuels Record Junk Bond Sales in Europe
As far as the ECB is concerned, the policy outlook is even clearer. The central bank’s new President, Christine Lagarde, has already announced her intentions to follow her predecessor’s footsteps and maintain the extremely loose policies set by Mario Draghi. In other words, negative interest rates are here to stay, as is QE. The bank, after restarting its asset purchasing program last November, is set on a course to keep buying €20 billion worth of bonds every month, a policy that is projected to last at least another year. The only obstacle to an infinite extension of this program appears to be the central bank’s self-imposed limitations, which specify it can only own up to a third of any eurozone country’s bond market. The ECB is dangerously close to these limits for Germany, the Netherlands and Finland, which explains why officials are reportedly already exploring options to change the regulations and lift those restrictions.
Overall, by enforcing consistently loose monetary policies, central bankers have painted themselves into a corner, while they have already depleted their arsenal before the next recession has even begun. As a result, fears of a possible “Japanification” of the European and even of the US economy have spread over the last few months. The term, based on Japan’s monetary and economic experience over the last 30 years, describes a situation where deflation and weak growth continue to plague an economy, despite extraordinarily aggressive monetary and fiscal stimulus efforts. Instead of reviving growth, these measures just fuel negative yields, even as debt burdens explode. Now, with 12 trillion worth of bonds trading with subzero yields, many economists fear that this malaise is spreading to the West and could eventually become a global phenomenon and a chronic disease
Precious metals expectations
Gold and silver have already shown considerable strength going into the new year, which is hardly surprising, given all the risk factors we’ve outlined above. 2020 definitely looks like a very promising year for precious metals investors. From a fundamental perspective, there are many good reasons for mainstream investors to turn to a more risk-off strategy, as doubts spread over the replicability of the 2019 equities performance. The wider sentiment is slowly but surely turning sour, defensive sectors are beginning to look increasingly attractive, and demand for time-tested safe havens like precious metals has been building up for months.
Source: Bloomberg, Gold's Rally Helps Miners Delay The Inevitable
At Global Gold, we are optimistic about the prospects of gold and silver in the new year. Nevertheless, over the last decade, we also have learned never to underestimate the lengths to which central bankers are willing to go in order to postpone the inevitable.
We assume that the huge wave of fresh liquidity that has been injected in the global economy in 2019 will continue, as will the NIRP and ZIRP policies. We wouldn’t be surprised if these efforts were redoubled in the face of a more pronounced economic slowdown or stock market correction. Of course, this could keep markets afloat for a little longer. However, we believe it will eventually prove too little too late and we see physical gold and silver as the safest possible bet for the long-term investor.
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