July 1, 2016
By Steve Blumenthal
“We recognize that our EU policies aren’t working for everybody. That’s okay. We just have to figure out how to make sure that everybody gets what they need, even if it means less control from Brussels.”
-European Union’s founding members: Belgium, France, Germany, Italy, Luxembourg and the Netherlands
On Tuesday, I tweeted out a piece titled, Brexit Bombshell: EU Capitulates. Geopolitical analyst George Friedman links the Brexit vote with the world’s growing class division and growing anger. George is an internationally recognized geopolitical forecaster and strategist on international affairs. The elites capitulated.
On my risk watch is the potential for a sovereign debt crisis originating in Europe. The debt-to-GDP ratios are staggering, entitlements are unmanageable and unemployment is high. The economic chasm between the northern haves and the southern have nots is blatantly clear. The people have had enough. The UK exit is the start not the finish.
All of this dysfunctionality wrapped together in incomplete and growingly divided political structure. The surprise capitulation reeks of desperation by the elites to hold it all together. So we step forward and watch with keen interest. George’s insights are worth the read. I share it with you below.
This morning the 10-year Treasury Note touched 1.38% overnight. As I write, it is yielding 1.43%. The 30-Year Treasury Bond is yielding 2.22%. Why? Bonds are rallying globally as the UK vote to leave the European Union raises speculation that the decision will curb economic growth. Money is escaping to the Treasury market.
Take a look at the following chart. It shows the year-to-date down move in the 10-Year yield from 2.25% to 1.43%. At the start of the year, few Wall Street analysts and none of the Fed officials, were predicting declining rates. Again, a big miss. What we are seeing is that growth remains subdued and debt continues to have a choke hold on the global economy.
To this end, I have been on record saying that interest rates will remain lower for longer. I certainly didn’t expect a drop of 75 bps in six short months. Remember back in December that the Fed had just raised the Fed funds rate by 25 bps and the call was for three to four more rate increases in 2016.
The Zweig Bond Model has kept me correctly positioned, invested in long term high quality bonds. It is a Trade Signals model which is largely based on trend analysis. It continues to remain bullish on high quality bonds. Not perfect, no guarantees, but it has kept us in the right spots over the last few years. I’ll change course when the model signals higher rates.
See Trade Signal’s post below or click here. You’ll find the chart near the bottom of each week’s post and this is something you can track on your own.
Let’s pause for a moment and take a step away from the daily noise. What concerns me over the intermediate term is that equity market valuations remain high and forward 10-year returns likely remain low. Grantham sees -2.3% real returns for U.S. large cap equities over the coming seven years (with a forecast number lower than where it was in December 1999).
Median PE, which I will share with you next week, points to a 2% to 4% annualized 10-year return for the coming ten years (that’s 0% to 2% real or after inflation). So it is hard to get excited about equities. That day will come though the timing remains elusive.
Combine the low equity returns with a 1.43% 10-year treasury and you can see how hard it will be for pensions to meet their nominal 7 ½% annual bogies. Not going to happen! For now, patience is required. Include in your portfolios other, less constrained, return drivers.
I remain in the 30/30/40 allocation camp. Reduce exposure to equities (hedged), 30% to fixed income (tactically managed, trend analysis) and 40% to tactical and liquid alternatives (seasoned managed futures and global macro managers).
As a quick aside: See my white paper titled, The Total Portfolio Solution. In it I take an in-depth look at what valuations tell us about probable future returns. You’ll see that returns are best and risk lowest when equities are attractively valued and the opposite being true when equites are expensively priced. The paper builds on traditional Modern Portfolio Theory in two ways – it adds liquid alternative investments as a third asset class to stocks and bonds and it employs “strategic tilts” that increase equity exposure when stocks are attractively priced and decreases the equity exposure when they’re expensively priced. It is free and you can find it here.
As we begin the second half of the year, my outlook remains unchanged. This is what I wrote on December 31:
2016 Outlook: neutral on equities and neutral on fixed income. Nothing exciting there, but like the Fed, I’ll hedge and say it is “data dependent.” Following are the significant risks I see:
- Global Recession – Likely underway
- U.S. Recession – Possible in 2016. Probable in 2017. The largest market declines come during periods of economic recession.
- High-yield bond defaults – Rising in 2016, peaking in 2017 (tactically trade HY)
- European sovereign debt crisis – The EU banks are loaded up on that debt (shorting EU banks or buying out-of-the-money put options may be a good equity hedge).
- Emerging Market dollar denominated debt crisis
- Watch the Fed, ECB, JCB and Chinese central bankers
- Tax and structural reform would be a positive for the markets, but unlikely in 2016
Further, I currently believe the Fed is unlikely to raise rates this year and it is believed more central bank stimulus lies in our immediate future. The risk on mood seems to have returned. It is tied to the prospects for more central bank QE but the deeper implications remain. The Fed remains “Data Dependent.” The market appears to remain “Fed Dependent.” For now…
Next week, we’ll take a look at June month-end data on valuations, forward returns and I’ll share with you my favorite recession probability charts.
Wishing you and your family a wonderful holiday weekend!
Click the orange link below for this week’s OMR. I hope you find it helpful in your work with your clients.
♦ If you are not signed up to receive my weekly On My Radar e-newsletter, you can subscribe here. ♦
Included in this week’s On My Radar:
- The EU Capitulates, by George Friedman
- A Bit More On Brexit: From Bridgewater Associates – Daily Observations
- Business Loan Delinquencies & Job Creation
- Trade Signals – Oversold, Extreme Pessimism ST Bullish, Risk High
The EU Capitulates, by George Friedman
“Today, foreign ministers from the European Union’s six founding member states issued an extraordinary statement, declaring that they will “recognize different levels of ambition amongst Member States when it comes to the project of European integration.” This was a landmark capitulation by the major European powers, accepting the idea that uniformity across the bloc is impossible and nations can choose the terms of membership.
The ministers – representing Belgium, France, Germany, Italy, Luxembourg and the Netherlands – publicly recognized that there is discontent across the bloc. The statement said that they will “focus our common efforts on those challenges which can only be addressed by common European answers, while leaving other tasks to national or regional levels.”
This response to the decision of British voters to leave the bloc marks a profound change in the EU’s formal goals and could signal a transformation in the EU’s role. Until today, the EU — and many of its member states’ governments — were formally committed to boosting integration. From banking regulations to refugee policies to everyday matters like cellphone fees, Brussels was moving toward greater interconnectivity and uniformity across the Continent.
On paper, the EU has sought to limit states’ ability to bail out banks, cap fiscal deficits and set up a quota system for distributing newly arrived refugees, among other goals. And yet, the failure to respond effectively first to the financial crisis and then to the refugee crisis gave momentum to nationalist forces. The gap between the EU’s formal aims and the preferences of some national-level governments has been widening as a result.
But successive crises and the diverging interests of member states led to fatigue with Brussels and, in some cases, active opposition to the bloc’s policies. Some countries, like Hungary and Poland, began to ignore EU rules, with few consequences.
The EU warned countries like Spain and Portugal time and again over their excessive budget deficits but failed to impose any meaningful repercussions. European officials, however, ignored growing signals that the bloc’s formal aims and the realities in member states were growing further apart.
The decision of a major European economy to leave the bloc has led European leaders to recognize that anti-establishment and anti-EU forces are gaining ground, and that as a result the bloc could be moving toward irrelevance.
The type of EU today’s statement describes would ultimately reduce the bloc to a free trade zone. Given Germany’s hyper-dependence on exports, this was an urgent and desperate retreat to the one thing the Germans had to have: access to the European market.
Germany, more than any other European country, is dependent on the EU, and its signature on this statement is an attempt to safeguard the country’s economic interests in the wake of Britain’s decision to leave. (Emphasis mine). With anti-establishment parties gaining ground in Germany, France, Italy and beyond, incumbent governments are also seeking to appease their voters, who are becoming more and more skeptical of Brussels.
Today’s statement is thus a capitulation and a recognition that much of the European public does not share Brussels’ enthusiasm for further integration. The EU has accepted that, if the bloc is to survive, each member will pursue its own policies and different levels of integration in the future.” Source
I encourage you to click through the source link and read the full piece. You’ll also find a piece titled, The Surprise at Brexit and the Social Crisis Behind It and some commentary from John Mauldin. I believe you will find it worth your time.
A Bit More On Brexit: From Bridgewater Associates – Daily Observations
Next I share a few bullet points from a recent piece from Bridgewater Associates. BA is the firm founded and run by Ray Dalio. He and his team manage the world’s largest hedge fund. $170 billion doesn’t find its way to you unless you are really smart.
- The UK voting to leave the EU is a clear warning signal that the rise in populist/separatist positions has reached levels that they can change the status quo significantly. Many voters across Europe are looking for their own referendum, and it seems reasonably likely that with time some will get their chance (although many centrist politicians will probably learn from Cameron’s disaster and try to avoid a referendum).
- All in all, on a global scale the UK leaving the European Union was a rather modest political outcome, yet the fear of it led to 10% swings in global equity markets (in light of this outcome, we have attached our June 22, 2016 Observations: “The Options Facing the UK and Europe If Brexit Wins”).
- This is a reflection of the tight coupling of the global financial system, a risk that would be significantly higher if a major Eurozone country were seriously considering leaving.
- The global economy and financial system relies on the euro and the ECB, and the continued existence of the euro depends on the cooperation of the Eurozone countries.
- If the UK leaving the EU caused a 10% swing, what would a set of political events that raised questions about the future functioning of the ECB cause? Managing this risk seems to us to be an important part of managing money in this secular environment.
- Given how easy it is to move capital within the Eurozone, any rise in risk of a country leaving could easily cause a pickup in capital outflows that could threaten the country’s banking system (as we saw during the sovereign debt crisis).
- And this could extend to other countries perceived as potentially vulnerable to leaving as well.
- The ECB would then be faced with the choice of whether to step in (increasing its exposure to a country that might walk away from the liabilities) or institute capital controls like in Greece last year.
- The prospect of such pain and disruption lowers the probability of such an event occurring. But even given the low probability, it looks to us like markets are under-discounting the risk.
- The global economy and financial system relies on the euro and the ECB, and the continued existence of the euro depends on the cooperation of the Eurozone countries.
- If the UK leaving the EU caused a 10% swing, what would a set of political events that raised questions about the future functioning of the ECB cause?
- Managing this risk seems to us to be an important part of managing money in this secular environment. Sources here and here.
Business Loan Delinquencies & Job Creation
Commercial and Industrial (C&I) loan delinquency rates have a strong historical
correlation to net job creation. This makes sense: companies that can’t make their
loan payments probably aren’t hiring new workers and may well be shedding them in layoffs.
Based on the historical correlation and the sharp growth in C&I loan delinquencies recently, it is conceivable that employment drops abruptly over the next six months.
“The chart above shows the inverted C&I delinquency rate (orange) plotted against
the monthly BLS employment change (blue). It shows how they moved together in the recessions of 1991, 2000 and 2009. Now the C&I delinquency rate is moving again, but jobs haven’t yet followed. If history repeats itself, they will—and probably very soon.”
– Patrick Watson, co-editor of Macro Growth & Income Alert
“Over the last 50 years, the U.S. was either in recession or just recovering from one every time three-month job growth went negative (below zero on the graph). In fact, on average a recession began when the three-month average of job growth was still well above zero at 104,000.
Currently, the three-month average sits at 116,000. If next month’s report shows fewer than 151,000 jobs created, the three-month average will fall below 104,000.”
“A monthly reading above 50 signifies that a majority of those surveyed believe employment conditions are improving. A reading below 50 denotes the majority think employment conditions are worsening. The most recent reading was 49.7 but the three-month average of the ISM Non-Manufacturing
Employment index has yet to break below 50. Historically, each time it has dropped below 50, the U.S. was already in a recession. That said, the three-month average of 51.0 is currently below the three-month average the last two times the U.S. economy entered a recession.” Source 720Global
I’ll share my favorite recession timing chart with you next week. Why the obsession with recessions? It is because the markets decline 30%, 40%, 50% or more during recessions.
Trade Signals – Oversold, Extreme Pessimism ST Bullish, Risk High
Click through to find the most recent trade signals. My favorite weight of evidence indicator, The CMG NDR Large Cap Momentum Index, remains in a sell signal. Trades Signals is posted each Wednesday. Here is a link to the Trade Signals blog page.
“August 15, 2016 will mark the 45th anniversary of President Nixon’s decision to close the gold window. U.S. citizens and the government are now beholden to the consequences of years of accumulated debt and weak productivity growth that have occurred since that day.
Now, seven years after the end of the financial crisis and recession, these consequences are in plain sight. The Fed finds themselves crippled under an imprudent zero interest rate policy and unable to raise interest rates due fear of stoking another crisis. Worse, other central banks, in a similar quest to keep prior debt serviceable and generate even more debt induced economic growth, have pushed beyond the realm of reality into negative interest rates. In fact, an astonishing $10 trillion worth (SB here: now $11.5 trillion post Brexit) of sovereign bonds now trade with a negative yield.
The evidence of these failed policies is apparent. However one must consider the basic facts and peer beyond the narrative being fed to the public by the central bankers, Wall Street, and politicians. There is nothing normal about any of this.
It therefore goes without saying, but we will say it anyway – investment strategies based on historic norms should be carefully reconsidered.” Source 720Global
Enough said… if you are reading this on Friday evening, go grab a cold beer or a nice glass of wine and share it with those you love the most! If it is morning time, forget that beer else we really start to worry.
Dana Point and most of coastal California for that matter is blow away beautiful. PIMCO’s Jerome Schneider’s presentation didn’t disappoint. Referencing the global economy he sees it as “stable but not secure.” He believes QE is having a diminishing effect and believes that needed is fiscal stimulus and infrastructure spend. However, he, too, sees it as unlikely in the current political environment. I’m on record believing we’ll get it but it will only come in crisis. I’ll share more in greater detail next week as it will weave in well when we take a look at the recession probability charts.
Chicago follows on July 20-22 for a large advisor client conference. I’m looking forward to seeing a number of good friends. August slows down with a week at the beach mid-month. Pre-season soccer for the boys starts immediately following the beach and, of course, school soon after. In September, I’ll be speaking at the Morningstar ETF Conference about portfolio construction.
I dropped Susan’s youngest son, Kieran, off this morning on my way to work. He is heading into ninth grade and switching to a new school. Required is a month of prep work. As he walked in front of the car, I watched him and just couldn’t believe how much he has grown. A nice young man. Time is going by way too fast.
Tomorrow, Kieran, Matthew and I are playing in a family golf tournament. It is a scramble format. Several weeks ago Kieran swore he’d never play golf again. He’s 14. How many times have I left the course with that same thought? But love is love so back at it we go. I’m really looking forward to the long weekend. I hope you have some fun plans lined up!.
If you find the On My Radar weekly research letter helpful, please tell a friend … they can sign up for the letter by clicking the “subscribe here” link that follows:
♦ If you are not signed up to receive my weekly On My Radar e-newsletter, you can subscribe here. ♦
On My Radar is a free weekly letter from Steve Blumenthal. Steve shares his views on macroeconomic research, valuations, portfolio construction, asset allocation and risk management.
The objective of the letter is to provide our investment advisors clients and professional investment managers with unique and relevant information that can be incorporated into their investment process to enhance performance and client communication.
Wishing you a wonderful Fourth of July weekend!
With kind regards,
Stephen B. Blumenthal
Chairman & CEO
CMG Capital Management Group, Inc.
Stephen Blumenthal founded CMG Capital Management Group in 1992 and serves today as its Chairman and CEO. Steve authors a free weekly e-letter entitled, On My Radar. The letter is designed to bring clarity on the economy, interest rates, valuations and market trend and what that all means in regards to investment opportunities and portfolio positioning. Click here to receive his free weekly e-letter.
Social Media Links:
CMG is committed to setting a high standard for ETF strategists. And we’re passionate about educating advisors and investors about tactical investing. We launched CMG AdvisorCentral a year ago to share our knowledge of tactical investing and managing a successful advisory practice.
AdvisorCentral is being updated with new educational resources we look forward to sharing with you. You can always connect with CMG on Twitter at @askcmg and follow our LinkedIn Showcase page devoted to tactical investing.
A Note on Investment Process:
From an investment management perspective, I’ve followed, managed and written about trend following and investor sentiment for many years. I find that reviewing various sentiment, trend and other historically valuable rules-based indicators each week helps me to stay balanced and disciplined in allocating to the various risk sets that are included within a broadly diversified total portfolio solution.
My objective is to position in line with the equity and fixed income market’s primary trends. I believe risk management is paramount in a long-term investment process. When to hedge, when to become more aggressive, etc.
Trade Signals History:
Trade Signals started after a colleague asked me if I could share my thoughts (Trade Signals) with him. A number of years ago, I found that putting pen to paper has really helped me in my investment management process and I hope that this research is of value to you in your investment process.
Following are several links to learn more about the use of options:
For hedging, I favor a collared option approach (writing out-of-the-money covered calls and buying out-of-the-money put options) as a relatively inexpensive way to risk protect your long-term focused equity portfolio exposure. Also, consider buying deep out-of-the-money put options for risk protection.
Please note the comments at the bottom of Trade Signals discussing a collared option strategy to hedge equity exposure using investor sentiment extremes is a guide to entry and exit. Go to www.CBOE.com to learn more. Hire an experienced advisor to help you. Never write naked option positions. We do not offer options strategies at CMG.
Several other links:
IMPORTANT DISCLOSURE INFORMATION
Past performance is no guarantee of future results. Different types of investments involve varying degrees of risk. Therefore, it should not be assumed that future performance of any specific investment or investment strategy (including the investments and/or investment strategies recommended and/or undertaken by CMG Capital Management Group, Inc. (or any of its related entities, together “CMG”) will be profitable, equal any historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. No portion of the content should be construed as an offer or solicitation for the purchase or sale of any security. References to specific securities, investment programs or funds are for illustrative purposes only and are not intended to be, and should not be interpreted as recommendations to purchase or sell such securities.
Certain portions of the content may contain a discussion of, and/or provide access to, opinions and/or recommendations of CMG (and those of other investment and non-investment professionals) as of a specific prior date. Due to various factors, including changing market conditions, such discussion may no longer be reflective of current recommendations or opinions. Derivatives and options strategies are not suitable for every investor, may involve a high degree of risk, and may be appropriate investments only for sophisticated investors who are capable of understanding and assuming the risks involved. Moreover, you should not assume that any discussion or information contained herein serves as the receipt of, or as a substitute for, personalized investment advice from CMG or the professional advisors of your choosing. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisors of his/her choosing. CMG is neither a law firm nor a certified public accounting firm and no portion of the newsletter content should be construed as legal or accounting advice.
This presentation does not discuss, directly or indirectly, the amount of the profits or losses, realized or unrealized, by any CMG client from any specific funds or securities. Please note: In the event that CMG references performance results for an actual CMG portfolio, the results are reported net of advisory fees and inclusive of dividends. The performance referenced is that as determined and/or provided directly by the referenced funds and/or publishers, have not been independently verified, and do not reflect the performance of any specific CMG client. CMG clients may have experienced materially different performance based upon various factors during the corresponding time periods. Mutual funds involve risk including possible loss of principal. An investor should consider the fund’s investment objective, risks, charges, and expenses carefully before investing. This and other information about the CMG Tactical All Asset Strategy FundTM, CMG Global Equity FundTM, CMG Tactical Bond FundTM, CMG Global Macro Strategy FundTM and the CMG Long/Short FundTM is contained in each fund’s prospectus, which can be obtained by calling 1-866-CMG-9456 (1-866-264-9456). Please read the prospectus carefully before investing. The CMG Tactical All Asset Strategy FundTM, CMG Global Equity FundTM, CMG Tactical Bond FundTM, CMG Global Macro Strategy FundTM and the CMG Long/Short FundTM are distributed by Northern Lights Distributors, LLC, Member FINRA.
NOT FDIC INSURED. MAY LOSE VALUE. NO BANK GUARANTEE.
Hypothetical Presentations: To the extent that any portion of the content reflects hypothetical results that were achieved by means of the retroactive application of a back-tested model, such results have inherent limitations, including: (1) the model results do not reflect the results of actual trading using client assets, but were achieved by means of the retroactive application of the referenced models, certain aspects of which may have been designed with the benefit of hindsight; (2) back-tested performance may not reflect the impact that any material market or economic factors might have had on the adviser’s use of the model if the model had been used during the period to actually manage client assets; and (3) CMG’s clients may have experienced investment results during the corresponding time periods that were materially different from those portrayed in the model. Please Also Note: Past performance may not be indicative of future results. Therefore, no current or prospective client should assume that future performance will be profitable, or equal to any corresponding historical index. (e.g., S&P 500® Total Return or Dow Jones Wilshire U.S. 5000 Total Market Index) is also disclosed. For example, the S&P 500® Total Return Index (the “S&P 500®”) is a market capitalization-weighted index of 500 widely held stocks often used as a proxy for the stock market. S&P Dow Jones chooses the member companies for the S&P 500® based on market size, liquidity, and industry group representation. Included are the common stocks of industrial, financial, utility, and transportation companies. The historical performance results of the S&P 500® (and those of or all indices) and the model results do not reflect the deduction of transaction and custodial charges, nor the deduction of an investment management fee, the incurrence of which would have the effect of decreasing indicated historical performance results. For example, the deduction combined annual advisory and transaction fees of 1.00% over a 10-year period would decrease a 10% gross return to an 8.9% net return. The S&P 500® is not an index into which an investor can directly invest. The historical S&P 500® performance results (and those of all other indices) are provided exclusively for comparison purposes only, so as to provide general comparative information to assist an individual in determining whether the performance of a specific portfolio or model meets, or continues to meet, his/her investment objective(s). A corresponding description of the other comparative indices, are available from CMG upon request. It should not be assumed that any CMG holdings will correspond directly to any such comparative index. The model and indices performance results do not reflect the impact of taxes. CMG portfolios may be more or less volatile than the reflective indices and/or models.
In the event that there has been a change in an individual’s investment objective or financial situation, he/she is encouraged to consult with his/her investment professional.
Written Disclosure Statement. CMG is an SEC-registered investment adviser located in King of Prussia, Pennsylvania. Stephen B. Blumenthal is CMG’s founder and CEO. Please note: The above views are those of CMG and its CEO, Stephen Blumenthal, and do not reflect those of any sub-advisor that CMG may engage to manage any CMG strategy. A copy of CMG’s current written disclosure statement discussing advisory services and fees is available upon request or via CMG’s internet web site at www.cmgwealth.com/disclosures.