This note was originally published at 8am on June 27, 2013 for Hedgeye subscribers.
“There is thy gold, worse poison to men’s souls,
Doing more murder in this loathsome world,
Than these poor compounds that thou mayst not sell.”
My colleagues and I ventured up to Toronto (nicknamed Hogtown due to the vast pork processing plants that used to call Toronto home) yesterday to meet with some old clients and some new prospects. The first prospect’s office we strode into had a massive solid gold coin and paintings from French Impressionists on the walls. Clearly, the commodity, and in particular gold, boom, has been good to Canadian investment managers.
As we made our rounds yesterday, it became increasingly obvious that Canadian money managers were also doing their utmost to diversify from this commodity heritage and in the short run that means diversifying more into U.S. equities. In part, this was actually due to a perception of potential strength in the U.S. dollar, a theme which is very near and dear to our hearts, of course.
One manager actually made a very interesting point on gold companies, which was that as the majors were being increasingly forced to hedge out gold prices, they put their company at even greater risk in the future if, and when, gold prices and operating costs increased. His view is that intrinsic value of many major Canadian gold companies is substantially lower than where Mr. Market is currently valuing them.
Given how much fun we’ve had analyzing the hedging strategies of LINN Energy, the Canadian gold sector may be an interesting short research project to work on next. But as always, while you can marry your longs, it’s highly recommended to only date your shorts.
Back to the global macro grind . . .
Despite a little bit of a market freak out last week, global markets are seemingly stabilizing. An important tell for us on this front is sovereign debt markets in Europe where, logically, risk capital seems to flee first. After peaking over 5% on Monday, Spanish 10-year bonds are back down well below 5% and on their way back to 4.5%.
Admittedly, though, even as some of the risk has decreased over the past couple of days, the low volume price recovery in many key markets has been uninspiring. In Asia, the bounce has been very uninspired with China down small over night and Hong Kong only up 0.5% for the second day of its bounce. In Europe, Greece is back in crash mode as is down -2.7% this morning.
Speaking of yields, the future direction of yields on U.S. Treasuries is one of the topics our international clients are increasingly focused on, which is no surprise given the blood bath that has occurred in the U.S. government debt market over the last thirty days. But, where will yields go from here?
Many bond experts had been adamant that the Federal Reserve would defend the 2% line on the 10-year. Clearly, that was about as defendable as a Canadian Football League offense against a NFL defense. In the Chart of the Day, we look at the yield on the 10-year going back ten years. On a basic level, if the market truly begins to price in the end of quantitative easing, the blood bath in the bond market is likely in early days.
Conversely, as interest rates go up in the U.S., this should bode well for the U.S. dollar especially given the positive relative position versus the Yen and the Euro. In Japan, to generate anywhere close to 2% inflation will require substantially more quantitative easing. Meanwhile in Europe, the continued economic bifurcation between countries makes it unlikely the ECB will tighten anytime soon. On the last point, the best example of this is like the gap in unemployment rate of Germany at 6.8% and the rest of the Euro zone at 12.2%.
Another key theme that will continue to play out if rates in the U.S. increase and the U.S. dollar naturally strengthens is Emerging Markets outflows. In fact, in the strong dollar era from 1995 to 2001, the SP500 CAGR was 15.8% and the CAGR of the MSCI EM Index was -5.3%. Conversely, in the weak dollar period of 2001 to 2011, the SP500 CAGR was 1.4% and the MSCI EM Index returned 14.5%. Now clearly, there were and are other factors at play, but the U.S. dollar will continue to be one of the most influential.
As it relates to interest rates, today’s jobless claims print will be the most important data we will get through the end of the week. If claims are better than expected, then interest rates are likely to continue their ascent. So far, equities have not acted well with interest rates breaking out to the upside, though that could change if a stabilizing economy becomes increasingly evident.
The global markets are having a difficult time finding their identity. As Shakespeare wrote:
“All the world’s a stage, and all the men and women merely players: they have their exits and their entrances; and one man in his time plays many parts, his acts being seven ages.”
Indeed, we are all stock market players. The key is to make sure, whether it is gold, U.S. treasuries, or LINN Energy, that we are not the last players to exit.
Our immediate-term TRADE Risk Ranges are now (TREND bullish or bearish in brackets):
UST 10yr 2.39%-2.74% (bullish)
SPX 1558-1618 (neutral)
DAX 7606-8096 (bearish)
Nikkei 12,578-13449 (bearish)
VIX 15.17-20.97 (bullish)
USD 82.27-83.67 (bullish)
Euro 1.29-1.31 (bearish)
Yen 96.41-99.53 (bearish)
Oil 98.98-103.36 (bearish)
NatGas 3.64-3.89 (bearish)
Gold 1207-1316 (bearish)
Copper 2.98-3.12 (bearish)
Keep your head up and stick on the ice,
Daryl G. Jones
Director of Research