05/19/2017 - The Roundtable Insight: Peter Boockvar and Alasdair Macleod On The Risks Of Central Bank Policies To The Financial Markets

FRA is joined by Alasdair Macleod and Peter Boockvar in a discussion of geopolitics, central bank monetary trends, and their impact on the global economy and markets.

Alasdair Macleod writes for Goldmoney. He has been a celebrated stockbroker and Member of the London Stock Exchange for over four decades. His experience encompasses equity and bond markets, fund management, corporate finance and investment strategy.

Prior to joining The Lindsey Group, Peter spent a brief time at Omega Advisors, a New York based hedge fund, as a macro analyst and portfolio manager. Before this, he was an employee and partner at Miller Tabak + Co for 18 years where he was recently the equity strategist and a portfolio manager with Miller Tabak Advisors. He joined Donaldson, Lufkin and Jenrette in 1992 in their corporate bond research department as a junior analyst. He is also president of OCLI, LLC and OCLI2, LLC, farmland real estate investment funds. He is a CNBC contributor and appears regularly on their network. Peter graduated Magna Cum Laude with a B.B.A. in Finance from George Washington University. Check out Peter’s new newsletter service at www.boockreport.com.

THE TRUMP FACTOR

Up until recently, the market was laser focused on tax reform, health reform, and policies. But Trump’s behavior in his tweets crossed a line that the market couldn’t ignore it any longer. The market knows that he needs all the credibility and stature in order to get the tax reform that the market has been anticipating. The market has been solely focused on tax reform and not paying attention to central banks pulling back and the issues with the US economy and mediocre growth. It’s all been chips on the table of ‘Trump’s going to make things great with tax reform and I don’t care about anything else’, and this is a gigantic wake-up call that the belief that everything is going to go smoothly was incredibly naïve.

This is much more than a one-day event. Now you have a dark cloud over the Trump agenda. You take that away at the same time the Fed is raising interest rates, the US economy is mediocre at best, and the yield curve keeps flattening? There’s no room for error in terms of valuations, and it’s that kind of cocktail that gives us a sell-off like we’re having today.

Trump’s problem is that there’s a turf war raging in the White House. On one side you’ve got established security and on the other you’ve got Trump and his men. The central point about this is that you’ve got the McCain type faction hell bent on continuing to wage a cold war against Russia and China, and you’ve got Trump coming in as a peacenik. He’s turned into someone who’s started quite a few actions around the world. What’s interesting is that President Shi came over, and the result now is that there’s a dialogue between him and Trump. Trump wants to do the same with Putin, but he’s being prevented because there’s so many leaks accusing him of leaking things to Russia, or appointing someone who’s said the wrong things to Russia, etc. The unfortunate thing about it is that it’s moved away from that into the public domain, and now it’s become an issue and they’re talking about impeachment. The fallout from the turf war is starting to destabilize things, and it’s likely that Trump has lines of communication with Shi and Putin, which in the final analysis is going to be very good for all of us. Continuing with the cold war is fundamentally a mistake.

THE EFFECTS ON INTEREST RATE POLICIES

Rate hike odds have gone down, but at the end of the day the Fed is still going to focus on the numbers that they see, and in their eyes they’ve reached their ‘mandates’ in terms of employment and inflation and they’re going to raise interest rates. It’s going to be interesting to see how they manage the political landscape verses what they should be doing on the economy because even if Trump gets impeached, Mike Pence will just carry out what Trump did. The Fed should not be focssed on politics and focus more on what policies will come this year and next. Even so, the Fed seems intent on raising a few more times and shrinking their balance sheet.

The possibility of impeachment does throw into the air when tax reform and health care reform is going to be done. The policy people working on tax and health care reform are going to do that regardless of what shows up in the newspaper and on TV. As Trump is losing credibility, everyone has to ask the question of what moral suasion is he going to have on this process to get something passed. If he doesn’t get this passed and it bleeds into next year, that’s going to have economic implications because corporate CEOs and CFOs are going to freeze some decision making on capital spending or anything else. That’s what the market is questioning; they couldn’t care less about whether Trump is president, they’re just worried about what happens to his agenda.

The basic job of the Fed is to try and manage monetary policy in the context of what the economy is actually doing. Having driven interest rates down to zero, there comes a point where the Fed should try and normalize. Unemployment and employment statistics have come back to target, and that means interest rates should be normalized. The problem the Fed has is that there’s so much debt in the US economy that to raise interest rates very much would destabilize the situation. This is why they’re being very cautious about the rate at which they increase interest rates. If they raise the Fed fund’s rate to 2.5%, they could bring on the next credit crisis. The Fed is very much aware of the debt situation and they don’t want to raise rates like they did in 2006/2007. Assuming that people in the Fed have a sort of inkling, that’s as far as they’re willing to go.

NORTH AMERICA’S EFFECT ON EUROPE

They’ve been beating to a different drummer. While we have political challenges with Trump, their political situation has actually gotten cleaned up with the elections in Austria, the Netherlands, and France. Then we have Italy next year, but the political worries that were becoming widespread have calmed down. We’re seeing better economic activity, and at the same time there’s a growing pressure on Mario Draghi to further taper. Europe is enjoying some calm, but it’s going to be the European central bank and Draghi that completely disrupts that sometime this year and certainly into next year.

There is growing antagonism in Europe about the whole of the EU project. The real problem the ECB has is that it has completely mispriced the bond markets. The prices are way overinflated, but under Basel II and Basel III, these debts are risk free as far as the regulators are concerned. They’re not risk free. The problem now is that as things begin to normalize in the EU, what’s going to happen is that substantial losses are going to appear in the bond market. This could be better absorbed in the US banking system, but not the European banking system. The banks are horribly weak: their balance sheets are rubbish, dressed up to look good for regulators. If you dig down, most of those banks are barely solvent and they cannot afford to take the losses on the bond market which accompany an economic recovery. That is going to be the big, big problem.

Moving on, we’ve got the Brexit negations and the general election. There’s little doubt that Theresa May will have a strong mandate to negotiate as she sees fit with the EU. The EU does want to get a settlement done because they’ve got other problems. The potential Brexit offers the UK is absolutely enormous. If interest rates start rising in the US, there is going to be a tendency for the Euro to be weak. Sterling could also recover against the Dollar are people begin to understand that Britain’s position in negotiating Brexit is actually pretty good, and an agreement is going to be achieved.

The only other currency that needs to be considered in this context is the Yen. Japan is beginning to move, joining the Asian Infrastructure Investment Bank for example, which indicates that business in Japan is starting to drive the government in a different direction from the pockets of the US. There’s lots of change going on, but the big danger is raising interest rates in the EU, which is going to be difficult to do without casualties in the banking sector.

The Fed is going to create policies here irrespective of what goes on overseas. They’re not going to run out of things to buy, but you run into restraints where you start to break the market. The Bank of Japan has certainly broken the JGB market, and the more ETFs they’re going to buy the more they break the stock market. You do reach a natural wall, and that’s not even talking about the limits they reached in terms of the inflation they’re creating and the goals that they’ve met. The level of central bank activity for the sole reason of 2% inflation is a scorched earth monetary policy, and now they have to live with the consequence that they can’t reverse themselves. It’s going to be a nightmare to get out; look at the Fed: here we are in the ninth year of the expansion and the balance sheet hasn’t shrunk one Dollar after raising three times.

OVERALL EFFECTS ON GOLD AND LONG END OF BOND MARKET

The Dollar Index has given back the entire Trump trade; it’s gone back to where it was on Election Day. Now you have the yield curve below where it was on Election Day. Half of that is the Fed raising interest rates and people worried about the economic implications, but at the same time we’re seeing a drop in long yields because they were worried about US growth and the Trump reform not happening. The only real outlier here is the stock market, that’s really on a different planet in terms of its perception of the macro economy and what Trump can do.

The reason that the stock market is so overvalued is that no one is valuing anything in the stock market anymore. The vast majority of investors today are just buying ETFs. It sort of insulates them from reality, but at some stage the market will turn and you’re going to get an awful lot of liquidation. You can’t say the stock market is overvalued; it’s just not valued.

China has tried to take a lot of speculation out of the wealth management products because they’ve been frontrunning the Chinese government’s purchases of commodities. Everyone in China knows the government is stockpiling commodities for its plan to industrialize the whole of Asia. She’s easing down her US Treasuries in order to buy commodities. Basically China’s shaken this out and that process is coming to an end. This is an important signal in gold and silver today. This year so far, silver has risen less than gold, likely because of China unwinding these wealth management products. If you put together the thought that this liquidation in the commodity holdings in the wealth management products, plus the weakness in the Dollar, the potential for gold to rise is pretty good. Base metals and precious metals will move up from there, possibly extended to mid-year. The background for gold and other precious metals is looking pretty good.

The Dollar’s been nothing like a safe haven, so people have found a different save haven. The whole thing with geopolitics is that usually it has a very short impact on markets. It still comes down to what affects markets over a longer period time than currencies, commodities, and fixed income: monetary policy and economic growth. That’s what people should focus on the most.

The Dollar will continue to weaken in the short term, because the rallies we’ve seen in both the Euro and Sterling aren’t over yet. Measuring the Dollar against a basket of commodities, you get a different situation: the Dollar is fundamentally weak against the major commodities and raw materials. Energy is interesting because it refuses to weaken, the purchasing power of the Dollar measured in oil will tend to go down.

FINAL THOUGHTS

This is the first year that all five central banks are either raising rates, ending QE, shrinking their balance sheet, or tightening liquidity. The only reason this market is trading is because of central bank policy. The second concern is what Trump is going to be able to pass, assuming he remains in office, because obsession with tax reform and regulatory relief has blinded people to other growing risks. These are the two things people should focus on the most, instead of geopolitics. People have to understand that we have credit cycles, not business cycles. If central banks didn’t exist, we wouldn’t have these cycles at all! We’re getting quite close to the crisis phase in the cycle, and this time around this crisis could even be bigger than the great financial crisis 8-9 years ago.

Abstract by: Annie Zhou <a2zhou@ryerson.ca>