[00:00:05] With many markets distorted by the heavy hand of central banks, are there any assets which could perform well, regardless of the outcome of the US Election? That’s The Big Conversation.

Last week we looked at currency volatility as a way of hedging against some of the risks through to the end of the year. Bond volatility has been suppressed by central bank intervention, whilst equity volatility in the US is being elevated into the November election. The spread between the VIX October and November futures contract (that’s the volatility index on the S&P500) is at its widest level though we have seen the difference between the first and second month contracts reach wider levels earlier this month when September was still the live first contract. The hump in the VIX curve peaks with the futures contract expiring on November the 18th, two weeks after election day. If this is going to be a contested election result, then the uncertainty will probably last into December, making the November to December spread still look attractive despite having tightened a bit over the last three weeks. The 2000 election took over 30 days to resolve and we should expect that hump in implied volatility to be pushed out if this occurred again. If the election reaches a swift conclusion, then both the November and December contract should fall. When I was at Deutsche Bank in the run up to the 2016 election, the Chief Strategist Binky Chadha noted that the S&P500 tended to move sideways into a closely contested election, but once resolved there tended to be a relief rally regardless of the outcome. This would favor a decline in volatility, especially if actual volatility of the underlying index stays close to its current level of 20. The spread between the implied volatility of the VIX and the actual volatility of the index should begin to narrow. Whilst the short term uncertainty remains, it is perhaps the post-election landscape that is of greater interest. How can investors position themselves now for something that remains highly uncertain? I interviewed Julian Brigden of MI2 Partners about the longer-term outlook for US policy. Julian outlined why he thought that the US was at a major inflection point and that this outcome was likely regardless of who wins the race for the White House. Julian points out that there has been an enormous hit to US GDP. Whilst we are seeing a recovery in many measures of sentiment, the absolute hit to the economy is far deeper than was experienced during the great financial crash of 2008. Now there may be a rapid rebound off the lows, but how long will it take to fully recover the previous levels? Whilst many sentiment-based indicators of US growth have rebounded to extremely high levels, such as the ISM non-manufacturing index, this does not reflect absolute levels of growth. The US Economic Surprise index reached record levels but is now rolling over as the latest data sets start to disappoint versus expectations. The rebound in the data had been beating expectations largely due to the size and speed of both the monetary and fiscal response and the unique rebound of the US equity market. Very few other global equity markets are performing as impressively. Other data suggest that the recovery could be prolonged. The COVID crisis has seen a hollowing out of the service sector. After a rebound that briefly returned to 80% , restaurant footfall is now around only 50% of last year’s levels. With furlough schemes rolling off and uncertainty about further fiscal support this year, jobs within leisure and hospitality, which saw by far the largest losses of any sector, are unlikely to rapidly rebound. The US jobs market took a much bigger hit than many other regions because US policy makers chose to provide income support, rather than jobs support. In Europe, policy makers chose schemes that kept workers on the payroll. US domestic airline passenger numbers have recovered but not anywhere near their former levels and the mass readoption of airline travel is unlikely whilst COVID remains a threat. Even if a vaccine were found, the nature of business travel has been permanently changed. The rebound in international flights is even shallower. Companies that have managed to operate with fewer employees will be reluctant to rehire, turning many of the temporary job losses into permanent redundancies. There have been bright spots within the US economy. New Home sales have continued to beat expectations, buoyed by cheaper mortgages, though these are only really available to those who can already afford them and are not a reflection of improved demand from lower income households. But this is not organic growth and would not exist without the huge levels of fiscal and monetary support. And the commercial real estate sector could soon be under pressure. Accounting trickery has allowed deferred rents (that may never be realized) to be accrued as if they have been paid as normal. These policies may be extended beyond year end, but it is unlikely that commercial real estate will ever return to pre-COVID levels because of profound changes in the work and retail space. The Dow Jones REIT index is still well below the pre COVID highs, versus the S&P500 which has exceeded them. It is clear that the real economy is still in trouble, even if the financial economy has been buoyed by monetary policy. Where the real economy has been supported by fiscal policy, the distribution has been extremely uneven. Therefore the likely response from both parties after the election is that they will double down on the huge fiscal and monetary support that has already been meted on so far this year. We don’t need to have a firm view about the outcome of the election or even a strong political preference. Both sides are going to spend and both sides are going to ask the US Federal Reserve to help monetize that spending. This doesn’t mean that Modern Monetary Theory is coming…yet. Both sides will be aware that this will blow out the deficits and push debt to GDP ratios even higher. It should mean that the risk to government bond yields is higher, but as we saw last week, bond yields have largely been stuck in ranges. Bond volatility, as denoted by the MOVE index has recently touched an all-time low. Bond issuance may be picking up, but the threat of QE and Yield Curve Control but is keeping a lid on yields. The front end is anchored by a rates policy that is on hold until 2023. Price discovery in the bond market is facing a death by a thousand cuts. counterintuitively maybe, but bonds are not the place to be playing excessive fiscal support. So what about the currency? The US dollar should come under pressure if the Fed is going to turn on the taps. But then every other region is going to do the same. German inflation has again dropped below zero. Policy makers will not want to tolerate deflation within the Eurozone for long. Will the Fed’s monetary and fiscal support be greater than the combined support of the ECB, the BOJ, the PBOC and to a lesser extent the BoE, RBA and RBC? The Fed is not acting in isolation, even if its policies are catching down to the rest of the world. So far dollar weakness has been mainly versus G10 countries. The US dollar is still strong against many of the major emerging market currencies such as the Brazilian Real, where USD-REAL looks set for another upside break in the near future. If bonds look dead in the water whilst the dollar short is now something of a consensus, how else can we play a rapid fiscal and monetary expansion in the US? The obvious area would be precious metals which have recently experienced a bit of a pull back. The most recent run up in gold and silver had coincided with US dollar weakness, but for much of the previous two years, both gold and the dollar had rallied together. Recent dollar weakness was a nice kicker, but not a pre-requisite. The uncertainty about which country will inject the largest levels of fiscal and monetary stimulus may matter for the US dollar, but precious metals will benefit if all regions are debasing their currency.

Falling bond yields and in particular falling real bond yields have benefitted the gold price. On this chart we can clearly see the relationship in which gold has risen when real bond yields fall. What should we expect from real bond yields going forward? The Fed has changed its targeting to allow inflation to overrun the 2% level. If inflation and inflation expectations are allowed to run hot, then bond yields, particularly at the longer end, would be expected to rise. But rising bond yields would be crippling given the current levels of government and corporate debt. The Fed have already embarked on QE infinity. If yields start to rise, then the Fed can also announce yield curve control (QE is where they buy a specific amount of bonds per month, whereas yield curve control is where they target a specific level of yield). The upshot of this is that real yields can fall further, because nominal (or actual yields) will be locked by central banks, whilst fiscal policy will try to push inflation higher. If policy makers get their way, then real yields on the 10 year could fall toward -2% from -1% today. The biggest risk is that policy makers and the current consensus for inflation are once again wrong footed by persistent disinflation. But, in those circumstances, policy makers will again double down on policies that support precious metals. Whilst there are no foregone conclusions, precious metals still look like one of the best placed assets for an election outcome in which monetary and fiscal policy will be similar, regardless of which party wins. Positioning in precious metals is not the extreme, but that could very quickly change if the pension juggernauts turn their oversized attention to these undersized markets. 

Over the last decade, the hunt for yield became an investment mantra of the times, driven as it was by the crushing impact that quantitative easing was having on global yields, which has spilled over from the government sector into the corporate sector and beyond. Despite the squeeze on interest income, share buybacks and dividends had kept cash flowing into the coffers of the insurance and pension fund industries over that period, with buybacks in particular looking set to make a new record until the COVID pandemic struck. Since then, the focus has been on the rebound in the US equity market, bolstered by that influx of younger investors using cheap mobile-based platforms and social media to share tips. Other regions such as Brazil and Korea have also seen a rise in retail investors who have engaged across the asset classes. But has the rebound in the equity market helped longer term investors such as pension funds? Obviously, the rebound doesn’t hurt, but it has only recouped the losses year to date in the US.  At last week’s lows, the S&P500 was back to flat for the year. If we remove the tech sector, plus Amazon and Netflix, the S&P500 was down nearly 10%. Institutional investors will be spreading their risk and will not have concentrated their positions in the few stocks which have been global leaders. This concentration of performance can be seen here where the top five names make up 25% of the S&P500 and 13% of the world’s listed equity market. For global pension funds, the equity outlook is even trickier. Not only will pension funds in Europe carry less equity, they will not have the same concentration of US exposure, never mind specifically in those mega cap names. Many of the European equity indices are still carving out bear market bounces as can been seen on the UK’s FTSE 100. European pension funds will skew their equity exposure toward domestic stocks. But the real pain for pension funds and pensioners in particular, who have switched into income bearing assets for retirement, is the decline in income opportunities from bond yields and dividends. Savings rates have shot up, partly because of furloughed cash payments and fewer outgoings during lockdown. But it also reflects a need to save more in order to generate the hoped-for future income in a world of suppressed yields.

Major central bank policy rates are currently locked at or below zero. The Fed have signaled that they are unlikely to raise rates for the next couple of years and the Bank of England has recently been discussing the potential for negative interest rates. This will lock bond yields at the front end of the yield curve. US two year and five-year yields have been flatlining for the last few months. It’s hard to see where these go if central banks are on hold. Yields are more likely to go down than up, because the upside could be capped by the threat of yield curve control. Longer dated yields would normally move higher if inflation expectations are on the rise. The US Fed has been buying inflation protected bonds (called TIPS) at an incredible pace this year. It looks like they want investors to believe that inflation is coming by distorting the price of this part of the market. But, with QE in place and that threat of yield curve control, they will prevent long dated nominal bond yields from rising, giving inconsistent signals to investors.

The 30-year yields has moved higher when compared to the 2 year yield, but they won’t want the long dated part of the curve from moving aggressively higher because it would then have an impact on mortgages. Whilst central banks have been suppressing income opportunities since 2008, the COVID crisis has also now taken a scalpel to dividends. Global dividends are forecast to fall by over $250 billion from last year, with the worst-case forecast expecting them to fall to levels last seen seven years ago. The 12-month IBES dividend forecast for Europe and the US expects these declines to persist. It took four years for dividends to bounce back after the great Financial Crash of 2008. Unlike then, however, the cash flow constraints are spread across most sectors of the economy and not just concentrated in the financial sector. Once the cure was found in 2008, the healing was able to begin. Today, consumers are again taking cover as another wave of infections hit many regions such as Europe. Dividend futures are already pricing in a very weak recovery for the rest of the decade, particularly in Europe. Although there is an element of pricing the present into the future during a time of little visibility, these contracts will still be used to facilitate mark-to-market operations, again depressing the outlook for income. Now given this back-drop of yield suppression and income destruction, some pension funds have openly stated that they will buy the dips in equity markets and even using leverage to try and achieve their goals. There is a hope that in doing this on mass, they can drive up the price of equity markets and replace lost income with capital gains.

But obviously this increases the existential threat if central banks lose control. It may seem like a last throw of the dice, but the pension fund and asset management industry maybe too big to fail – as witnessed by the sharp response of central banks in mid-March when rules-based portfolios had started to unwind during the liquidity crunch. But as discussed in the last section, pension funds may increasingly turn to precious metals if declining real yields and equity income continue to make the carry cost of holding physical gold look more and more attractive. 

Over the last few weeks, the non-commercial which are often called ‘speculative’ short positions on the Nasdaq e-mini have surged. The increase in short positions, represented by the falling line on this chart, is quite dramatic. The last time we saw short positions of this magnitude was back in the bull run of 2005 to 2007, but those built up over a couple of years. This time around, it has been a relatively sudden surge. On the face of it, this could open the door for another short squeeze in the NASDAQ, which could fuel another rally and see the index make yet another new high on the ratio versus the S&P 500. This short position does stand out versus positioning on other indices. The non-commercial positions on the S&P500 e-mini contract is in neutral territory, having just nudged back into a net long position. Shares outstanding on an ETF is the measure of assets under management – or at least, the total number of shares that have been created for trading and investing purposes. It’s a bit like open interest on a futures contract.  For the two leading ETFs, the SPYDER on the S&P500 and the triple Q on the NASDAQ, we can see that demand for exposure on the triple Q has been rising, which is in stark contrast to the rise in short NASDAQ futures positions. The shares outstanding for the SPYDER ETF have been falling. We can see that over the last few months, the shares outstanding for the triple Q and the SPYDER are a mirror image. It maybe that investors have been switching from the S&P500 exposure to NASDAQ exposure, chasing the relative outperformance of the tech sector. And this maybe a clue to the surge in Nasdaq shorts. Rather than this representing a huge increase in outright bearish bets, it may reflect an attempt by hedge funds to capture some of the tech outperformance. Hedge funds have largely lagged the surge of interest by retail investors but they were increasingly getting involved over the summer. They may be buying the bigger names that have been driving the outperformance and then selling Nasdaq futures against them, to reduce the net exposure and capture some of the retail trends that have been at the very core of the Nasdaq’s recent performance.

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