Below are the titles of the posts we have issued during October (but not posted to the website):

  • Oct 01: Econ 101: How to Grow Tax Receipts and Lower the Deficit
  • Oct 02: The King of Currencies
  • Oct 05: Aussie Consumers Feeling the Pinch
  • Oct 06: Bulls in Full Control
  • Oct 08: US Capital Growth” v’s “Aussie Dividend”
  • Oct 09: Are US Households Set to Spend?
  • Oct 10: Goldies Break from Fiat Wolf Pack
  • Oct 11: Watching Oil Continue its Bullish Trend
  • Oct 12: Crypto: The 3 Big Challenges Ahead
  • Oct 14: RBA Blow Horn on Housing / Fed to Hike
  • Oct 15: Weekly Macro Charts – It’s Earnings Season
  • Oct 16: Aussie Bitcoin Push & Global Finance Chiefs Warn
  • Oct 17: Why The XJO Caught a Bid
  • Oct 18: Again, this Market is not Exuberant
  • Oct 21: Weekly Charts: S&P 500, XJO and USD Index
  • Oct 22: Bullish on US Bansks
  • Oct 23: Gold Reverses on Stronger USD / Economy
  • Oct 24: NBN: Why Failure was Inevitable
  • Oct 27: Blockchain Trumps Bitcoin
  • Oct 28: The Weekly Close – Tech Surges on Earnings
  • Oct 29: Market Not Optimistic on Growth – But Very Mindful of Rates 

For access to all the posts I issued over the past month – feel free to join. It’s free. 

The most read post was “Aussie Bitcoin Push & Global Finance Chiefs Warn”.

It would appear that readers are very interested in crypto… not surprising given the “Bitcoin mania”.

We are less enthusiastic about ‘bitcoin’ specifically (ie many coins out there have more speculative upside) – but super bullish on blockchain. 

In fact, we shared examples of who is investing in blockchain (and how) this week with Blockchain Trumps Bitcoin”

Today I am going to share my most recent post “Market Not Optimistic on Growth – But Very Mindful of Rates”

You would think that with stocks hitting all new highs at the time of writing – the market is pricing in greater growth.

Not necessarily.

In fact, my argument is the market not that optimistic on growth of more than 2-3% the next few years.

We also talk more to what to expect from Congress and tax reform. For example, if it fails – will it materially impact equities? We don’t think so.

However, this is not the biggest issue on the table… 

Preface 

  • 5-Year TIPS Proxy for Growth
  • Will Trump’s Tax Reform See Upside?
  • Watching the 10-Year Yield for Clues

Stocks are hitting record highs.

Ultra-low rates combined with strong earnings are seeing investors revise expectations to the upside.

However, many are of the view that valuations are stretched; eg being quick to cite (poor) indicators like Shiller’s CAPE ratio.

We argue the opposite; ie it’s fairly priced at a forward PE of ~17.7x given what we see with interest rates.

Warren Buffett made the same point recently – saying if there is just one thing he would like to know in 5 or 10 years time – it was interest rates.

The other thing we like to point out is the market is not that optimistic about forward looking growth. And if it were, the market would be several magnitudes higher.

For example, one of the best proxies for growth is what we see with the 5-Year Treasury Inflation Protected Securities (TIPS).

Yield on 5-Year Treasury Inflation Protected Securities

This chart is extremely useful as it gives us real-time knowledge of the market’s expectation for risk-free, inflation-adjusted returns.

For those not familiar, TIPS pay a real rate of interest in addition to whatever the inflation rate happens to be. The price of TIPS varies inversely with the market level of the real yield on TIPS.

What’s key here is real yields on TIPS tend to track the economy’s real growth rate.

For example, when economic growth was booming in the late 1990s, TIPS paid a real rate of interest of about 4%, since they had to compete with the market’s expectation for 4-5% real economic growth.

But with the trend rate of growth having now slowed to just over 2%, the real rate of interest on TIPS is low; ie: 0.2% for the next 5 years

Here’s the thing:

If the market were optimistic on say 3%+ growth — then it’s likely the real yield on 5-yr TIPS would be in closer to 2% (if not higher).

Which brings us to optimism around tax reform… and the (potential) impact on equities.

Will Failed Tax Reform Punish Equities?

If the Republicans can achieve anything – tax reform is perhaps the lowest hanging fruit.

We argued a year ago that of all the “battles” Trump chooses to fight in Washington (and there are many) – he should start with tax reform.

Tax reform will likely lead to growth and investment – greater government income – paving the way for other bills.

Health on the other hand was never going to be easy. This is always at the heart of any left-winged campaign (with many choosing to see it as a “basic human right”)

Anyway, a year later here we are finally focusing on tax (a year too late in my view).

The question is whether tax reform will get through Congress?

I ask that because let’s say the Democrats filibuster significant, growth-friendly tax reform (ie via prolonged speech that obstructs progress while not technically contravening the required procedures) – then what?

From mine, this would result in some downside to the current market rally – but not significant downside. However, should they be successful — we could see major upside.

Put another way, the risk to equities (from mine) is not so much what we see with tax reform. What matters more is what we see with interest rates (eg as the likes of Warren Buffett, Bill Gross, Larry Fink and Ray Dalio have all said recently)

If rates were to rise faster than expected — this would obviously hit bond prices.

In turn, this would see the market lower the market’s PE ratio (which is the inverse of the earnings yield on equities) thus limiting further gains in equity prices to a rate lower than its earnings.

That’s the major risk to this 8.5 year bull.

Higher than expected rates is what the world is watching now (and to a degree – less about things like tax reform).

So Where are Rates?

In short, they remain historically low. For example, below is the yield on the 10-year treasury (Buffett’s preferred metric)

US 10-Year Treasury Yield

In real terms (ie when adjusted for inflation) – the 10-year is still yielding below 1%.

As such, this is extremely conducive for higher equity prices. However, should bond prices fall, then we can expect these rates to shoot higher (triggering a sell-off in equities).

Let’s take a look:

10-Year Treasury Prices – Weekly

We are currently bearish on the 10-year note (ie we expect yields to rise) in the weekly timeframe.

However, prices have been traded in a tight range after their large fall from June last year. Not surprisingly, they found good support in the 61.8% zone – which saw yields peak around 2.5%

2.50% has been comfortable for equities however some have argued that if yields ~3.0% – things may be a different story.

In the situation the risk-free rate is competing with the yield on risk assets.

For example, if we assess the 10-year using the monthly view, we get a better perspective of how far they could potentially fall:

10-Year Treasury – How Far will Prices Fall / Yields Rise?

In December of last year – we saw the first trend shift in this chart in 18 years.

For almost two decades, bond prices have traded consistently higher sending the yield on the 10-year (and interest rates) lower. In turn, this has been an enabler for risk assets.

But now that (bond) tide has turned.

The question is how far (and how fast) bond prices will fall?

The market is of the view that is yields rise to something around 3.50% — then it will most likely send equity prices lower.

As I explained above, this would see the market lower PE ratios for risk assets (which is the inverse of the earnings yield) thus limitings gains to a rate lower than its earnings.

Putting it All Together… 

With respect to economic growth – the market is not overly optimistic.

For example, the current yield on TIPS is pricing in growth “muddling through” at somewhere between 2% and 3% (at most).

With respect to tax reform – if it fails to get through Congress – I doubt we will see any meaningful downside (eg perhaps no more than 5%). However, if the Republicans are successful, then we could see large upside.

Above all else, when it comes to risk assets and their direction, the most important variable are interest rates (and specifically what we see with the US 10-Year Treasury yield).

If there is a bond exodus (and I am not expecting one) – this will see yields rise faster than expect and we should expect a repricing of stocks (as PE ratios are adjusted).

But for now, things are priced fairly. Keep a close eye on the 10-year yield.

Regards,
Adrian Tout

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