Monday, June 20, 2016

Depreciation, Fed, and Brexit

Investors,

 The currency depreciation story has been gaining steam, leading to a surge in my favorite investments of gold (+23% YTD) and bitcoin (+77% YTD). Neither has a great correlation to inflation, they're more like psychological bets that investors will try to ditch their government-issued currency. I expect both to continue doing well, and I'm maintaining my large exposure to each. If you don't own any cryptocurrency, I'd still strongly suggest buying some (mostly Bitcoin, a little Ethereum and DASH). You haven't missed the boat. This is just the start of the birth of a new asset class. The crypto world is a complex beast for the uninitiated - I'm happy to chat about it if you'd like more information.

 Last week's Federal Reserve meeting had a few major surprises. While the interest rate was (unsurprisingly) unchanged, the Fed issued very pessimistic forward guidance on the economy, and substantially reduced their expectation of future rate hikes. Additionally, the St. Louis Fed. led by James Bullard, released an entirely new policy framework for how to think about the economy and how the Fed should manage interest rates. To oversimplify - rather than focusing on a single base case economic scenario, Bullard thinks the Fed should focus on a range of possible outcomes and the uncertainty around them. In other words, just because unemployment is very low today, he advocates dovish policy because of things that could go wrong in the future. This shift towards dovish Fed policy will further support the currency depreciation theme.

 While the "inflation hedging" assets have rallied strongly, actual inflation expectations (represented by the inflation swap market) are only up slightly. Unemployment has fallen to 4.7% and money printing continues in most countries, but investors feel that deflationary forces are even stronger. That strong unemployment number hides a falling labor force participation rate. Even China is starting to replace human labor with robots on a massive scale. Long-term we'll continue seeing deflation in commodities and input prices, and inflation in the cost of final goods as a result of currency depreciation. I think that in the next year we'll see a moderate jump in inflation expectations back to more historical norms, although it might be short-lived. Speaking of equities, US stocks are near all-time highs, while European and Emerging equities are still far from it. For technical reasons I think US equities might have a strong 6-12 months ahead, but valuations are terrible. Expected returns for US equities over the next 7 years are barely above zero. I've sold the last of my very small US equity holdings and am currently leaving the proceeds in cash. I still very much like holding emerging market equity, and that makes up about 1/3 of my portfolio.

 The Brexit (Britain's vote to leave the European Union) is on June 23rd. The odds implied by the market are currently about 33% that Britain will leave. If so, the pound will fall and volatility will rise. Beyond that, I can only guess. I think Britain's departure may be the first domino in the dissolution of the EU. The Eurozone never solved their problems from 2008. All of the issues remain - from heavily overlevered banks to labor productivity disparities that cause low-productivity countries like Portugal to constantly accumulate debt to high-productivity countries like Germany. If Britain leaves, the electorates in many other countries will start talking about following.

 Conclusion: I like gold, cryptocurrency, and emerging market equities. US equities are overvalued, but may have a strong 6 months ahead (after which, I would likely put on S&P 500 shorts.)