The numbers this week show a mostly quiet state of affairs, with a bias towards inflationary conditions. Energy is slightly stronger than commodities and notably, the VIX has sold off.
Whether it’s the capital flows or narrative that comes first, it’s often the case that a theme takes over in capital markets and dominates capital flows, often to the exclusion of other – sometimes very juicy – investment and trading opportunities.
Since the Coronavirus related crash in March we have seen a general recovery in asset prices ( a recovery while priced in USD – but no recovery at all (as we think it should be) when priced in stable store of value – Gold, which we will go into further below), and with high interest taken in technological assets. This emerged as the dominant trade until the S&P500 hit a significant level and the NASDAQ peaked the same time last week, something we discussed recently.
It makes sense that in flux, tech companies will attract more support (capital, political, perhaps even friendly waitresses) and do more sophisticated problem solving than established, cumbersome and political corporations. But there is always a limit to capital flows and narrative virility, especially as more focus goes towards the single theme, eventually falling over, hoisted by its own petard.
This time around a slight correction has improved the market structure (it was a top-heavy market at the high of buyers in profit, leveraged buyers over committed to risk and potential profit-taking being taken) and investors are more fully-invested – but nobody is really being forced to do anything further.
The most significant factor in preventing further selling is the Fed put, which makes aggressive selling highly unlikely without fairly specific events that contribute to systematic financial risk or de-leveraging/reducing the monetary supply to push risk assets lower.
So if we can presume that these risk assets will also struggle to break their highs in a hurry, but also that committed selling is highly unlikely it seems that the obvious thing to do is sell volatility as the market likely has an extended period of consolidation as those late to the game buy the high and take profit by selling the low looking for a break-out that is unlikely to emerge for the reasons we have detailed.
So if that is the case we are now onto deciphering where the next capital flows should emerge and the macro-picture suggests that the answer is in a discussion of deflation vs inflation (which we also covered recently).
Without intervention, coronavirus as an economic event should create defaults in debt with a high chance of those defaults rolling into creating more bad-debt in a financial bad-debt contagion – the event was not priced in, the potential for contagion was not priced in and risk is tightened in decision-making.
The backdrop of this was an environment that had hit maximum global capacity (very diminished return on the marginal dollar of debt), a capacity constricting since 2018 with the US/China trade war and related geo-political frictions on global trade. There is also discussion of moving manufacturing – especially strategically important manufacturing – back home in many places. Where low interest rates are supposed to encourage capital expenditure, low interest rates caused by this set of circumstances presents a far more pathetic outlook for future growth (and inflation).
But, the US Fed has recently made it clear that they would pursue a policy of inflation. With inflation they can essentially inflate their way out of debt ($100 of debt owed today is equivalent to $90 in a year if inflation is at 10%) through monetary intervention in which they can avoid the scenario of bad-debt contagion in favour of what is essentially a haircut of debt (which they do not say in such words).
It is not certain whether this policy needs a clear trigger or not. As it stands, there is less fiscal expenditure in the US than the market expected (more political disagreement than presumed on the amount of fiscal expenditure, holding a deal up altogether) and there are fiscal/monetary cliffs globally as stimulus from earlier in the year ends or reduces its impact on assets (with the potential exception of China which appears to be going for broke this year in expanding debt).
The fiscal cliffs should be deflationary, however markets can never really make a proper move on deflation (risk assets sell, USD appreciates, Gold:Silver appreciates and commodities sell) due to the fact that everybody knows that the U.S. Fed has implied a backstop to risk assets and is also targeting higher inflation.
So for now, there is likely to be zombification of markets.
With all of this intervention it is difficult to appraise the actual state of the global economy. The stock-market as it is, represented in U.S. dollars is not a measure of future expected economic activity, consumer behaviour and the decisions of capitalists anymore, it is a measure of expected future policy responses from central banks and their political controllers.
Because of the relationship between USD and risk assets (they are correlated in complex ways) it is hard to see the true impact of reality using changes in asset prices priced in USD.
But with this underlying truth – of markets as expectations of policy and a complex USD/risk asset correlation and relationship, to take an accurate reading of the state of risk assets we can use a tool – gold – to properly represent economic reality as a stable store of value.
(Bitcoin must have more significant adoption rates institutionally and strategically to be a fair comparison – because it is still gaining acceptance its price action as money – compared to alternatives – should be heavily skewed to the upside for some time).
If we want to price true economic activity with a true asset value we need a source of value which is as neutral as possible to changes in asset prices and USD supply given the broad impact of policy responses and complex relationship between asset prices and policy responses – which is why we are pricing the S&P500 in gold.
We can trust gold as a stable store of value to tell the story accurately. We can’t trust USD because it is in a complex correlation with the assets it is used to price – and is also increasing in supply in a pro-cyclical way.
Here we can see the S&P500 peak in the year that global capacity signalled it would peak – when the US/China trade war became permanent in 2018. The coronavirus selloff had a dead-cat bounce before selling off into an environment of lower economic activity. The asset broke out of the trend-channel during the equity blow-off bubble high.
To understand the role that gold is playing we must think systematically rather than linearly. Gold is an un-leveraged store of value outside of the global financial system and should hold its value relative to the global set of investable assets. However gold is also in competition with the global financial system and can change its relative value on that basis – it appreciates relative to the global set of investable assets during increasing systemic risk and depreciates during decreasing systemic risk.
As the keystone to the global financial system, this relationship is especially important with respect to the U.S. dollar.
As mentioned at the beginning of the newsletter, markets can often only focus on a single theme at a time and with the blow-off top in risk assets, with US Fed interventionist behaviour to stop a process that would otherwise be de-leveraging (in the USD Fed announcing a plan that effectively gives debt holders a haircut with the policy of inflation) the path of least resistance in which the global set of assets accurately reflects the economic reality of the global economy, we think the focus will now shift to gold – buying gold.
There is no de-leveraging event coming in which the amount of debt reverses itself as reduced economic activity creates default of bad debt. Politically connected companies will survive as their debt is supported with central bank policy. Or fiscal expenditure and direct payments to citizens will be monetised by the central banks.
It doesn’t matter – it’s all the same thing. More cash to take on a cascading wave of otherwise de-leveraging, deflationary events and absorb the risk and devalue the debt through expanding the money supply and creating inflation.
So why did this not occur with Japanese monetary policy over the last 2 decades? We suggest this is different because the Yen was never the money of the global financial system where the U.S. dollar has been the final settlement layer of monetary value that the system relied upon as a source of truth. What is occuring now is far more significant as a form of global systemic risk and this is what gold is optimised for.
In this situation inflation pays gold (deflation might as well), the haircut of USD debt pays gold, the Fed put in equities pays gold, the real state of the global economy favours gold, the increase in systemic risk pays gold through increased adoption in strategic and institutional portfolios, low and negative interest rates pay gold and as gold gains momentum the potential for hedging risk assets in gold increases.
With this last point the fed inflation policy and actions will likely encourage a scenario where speculators purchase risk assets AND gold in a pro-cyclical reflexive cycle.
On all of that, when we take a look at recent trends in Bitcoin/Gold correlation we can see that things could become very interesting for both assets shortly, if the above thesis is correct. Although we had been looking for Bitcoin strength for the last 2 months with little luck, perhaps the gold correlation and market narrative timing has been required.
We have seen digital assets trade around in volatile fashion during this week, with several promising starts and finishes in many assets.
Assets that outperformed in recovered included
Energy Web Token
Bitcoin has still done very little in markets, with potential in the gold price as described. The chart shows room to move to the downside, perhaps with the opportunity to push long positions out below the long-term trend-line.
BTC/USD Chart: Daily
The BTC/USD chart shows that the asset has further to go to the downside before hitting its major up-trend. Investors with capital should consider bidding on the break of that trend-line, and will know quickly whether they should hold the position.
Volume has been low for the week.
Sentiment has been poor in digital assets, swinging around quite wildly from being significantly positive sentiment a couple of weeks ago.
BTC dominance is ambiguous, with some technical information suggesting a low but room to move to the downside.
We had been quite certain at one point that a lower USD was on its way after the break of the support line in blue. However with deflation creeping in and the risk assets hitting a high have turned the USD around for now.
Our technical view of gold gives the asset 2 weeks to trade back to its trend-line, potentially making it’s final touch before performing a parabolic move. The alternative is a serious move to the downside.