Rate cuts and RMB Depreciation – What next for Singapore investors?

What a week it has been! Or rather, what a momentous 10 days in the financial markets!

Basics: What happened the past 2 weeks?

It’s been an absolute roller coaster the past 10 days, so I’ll just summarise the key bits here:

1. US Federal Reserve cuts rates 25bps. Jerome Powell indicates this is not the start of a rate cutting cycle, but rather a “mid-cycle adjustment”
2. Literally the next day, Trump proposes 10% tariffs on the remainder of China’s exports to US
3. China retaliates the following week by allowing the yuan to depreciate below the psychological 7 barrier
4. US brands China a “currency manipulate”
5. New Zealand, India and Thailand all cut rates, with New Zealand surprising with a 50 bps rate cut
6. At the same time, global yields drop to new lows, while safehaven assets like gold makes new highs

Now it’s never wise to make predictions about what happens next in financial markets, but I did want to share some of my thoughts on the broad trends that I expect to play out in the coming 12 to 24 months.

Of course, I could be completely wrong here, so as always, do take the time out to critically evaluate and decide if you agree with my opinion.

What happens next? – Short Term

In the short term (say 6 months, but the exact pace in which things play out will depend on investor actions and central banks/governments):

USD to strengthen

I believe the USD will strengthen relative to most major currencies. It’s all about relative strength of the economies, and the US economy is the lone bright star in the world today.

Chart Credits: Bloomberg, Raoul Pal 

Asian Currencies to weaken

It’s kinda like the Asian Financial Crisis style situation (very loosely) here. The Asian/EM economies are weaker than the US, so they’ll need to weaken their currencies to boost exports and stimulate the slowing economy.

The recent round of rate cuts by Thailand, New Zealand, India, and of course China, already hint at the start of this.

I don’t know if this will degenerate into a race to the bottom style competitive devaluation, but if it does, things could turn ugly very quickly.

High quality bonds and high quality fixed income proxy (eg. Blue Chip REITs) to strengthen

High quality bonds such as US treasuries will strengthen (bond yields fall) as global central banks start cutting rates.

Ultra high quality fixed income proxies such as stable, blue chip REITs could benefit as well as a way to bet on falling yields.

Global PMI and manufacturing continue to weaken 

Of course, the underlying cause here, is the global manufacturing recession set off by the US-China trade war.

The chart below is a great one that shows how global PMIs have gradually deteriorated from 2018 till now. In the absence of a resolution on the trade tariffs, I don’t expect this to change.

Certain export driven economies such as Germany already have negative Q2 GDPs, so a technical recession for those countries is possible in Q3.

Uncertain – US stocks are a question mark. 

Stocks are always a tough one to predict, because of their volatility. It’s also why I don’t recommend going out and shorting the S&P500 or the STI, because a vicious rally in stocks can easily get you stopped out, and they are close to impossible to predict. In times like this, the real money is made in the fixed income / Eurodollars markets if you were so inclined.

That said, short term, I think that emerging market (EM) stocks underperform, while US stocks outperform, because of the relative strength of the US economy.

All that money flowing out of the rest of the world into the US will go into either bonds or stocks, and this should at least boost US stocks in the short term. Don’t forget that back during the Asian Financial Crisis in 1997, US stocks continued going up for a year or two even after Asia was in turmoil, simply because all that money being pulled out had to go somewhere.

What happens next? – Mid term

Global slowdown worsens

In the medium term, barring any major intervention from central banks (eg. a drastic 50 bps cut from the Feds), or a resolution on the US-China trade war (we’ve been over this in a previous article, I think it’s looking very unlikely), I think the global manufacturing slowdown will continue, and this will gradually spread into the rest of the real economy.

I’m hearing more and more companies that are not directly related to manufacturing cite that they are pushing back capex / investment plans because of the global uncertainties. If enough companies start doing so, the recession will become self-fulfilling.

We may or may not see a technical recession in Singapore in 2020, I think the jury is still out on that one, it depends on how things play out over the next 12 months.

USD will depreciate as the US economy weakens in the medium term

Short term the USD goes up, and it will cause turmoil in EM.

In the medium term the Feds will probably cut as the global slowdown impacts the US economy, and they will de facto weaken the USD to save the rest of the world (or y’know, to appease Trump).

Unconventional monetary and fiscal policies from global central banks and governments to stimulate the economy

What happens when you have a recession with German 10 year Bunds at negative 0.556%, 10 year JGBs (Japan) at negative 0.191%, and US 10 year Treasuries at 1.71%?

You cut to zero (if you still can), then you start bringing out the crazy stuff.

The US and the UK are probably the only large, developed economies left here with any firepower left in monetary policy. I expect them to have to cut to zero in the medium term. After that, it’s going to be the crazier stuff like more QE, infrastructure spending, debt reliefs, helicopter money etc.

Remember all that talk about Modern Monetary Theory (see definition below)?

Modern Monetary Theory (MMT) is a heterodox macroeconomic framework that says monetarily sovereign countries like the U.S., U.K., Japan and Canada are not operationally constrained by revenues when it comes to federal government spending. In other words, such governments do not need taxes or borrowing for spending since they can print as much as they need and are the monopoly issuers of the currency.

Well, applied to the US, MMT basically says that Trump should spend as much as he wants building highways and roads and infrastructure, without having to worry about the debt. In fact, MMT says that he should do, and is obliged to do it.

It’s pretty crazy stuff, but I expect more of such talk going forward, to justify the massive fiscal policies needed to pull the world out of the slowdown. Trump is no idiot, and he knows this as well, hence he’s been calling for huge rate hikes from the Federal Reserve, so that he can issue more debt.

European banks are screwed

The big elephant in the room here, is going to be European banks.

Taking a step back, we need to understand how banks make money from lending. What they do, is that they borrow short term, and they lend long term, and they earn the spread. So they may borrow 1 year debt at 3%, and lend over 10 years at 5%, so they earn a nice spread of 2%. That’s how things work in the normal world.

Now imagine what happens when short term borrowings are at -0.5%, and you’re lending long term at 0.5%. Surprise surprise, the bank actually makes no money on this trade, because its cost of funding is effectively 0.5%, and the 0.5% it earns from lending the money out offsets what the bank has to pay to borrow that amount.

Throw in capital adequacy ratios that require European banks to hold a certain amount of European bonds which are negative yielding, and you start getting an idea of how batshit crazy things are in Europe this days.

This has been playing out in Europe over the past 10 years, and as rates go further negative in the coming years, I’m pretty worried about how this all ends.

The 30 year chart of the European banking index below is horrendous, and I wouldn’t rule out the need for European governments to have to step in to rescue their national banks.

More populism

I think we’re already seeing this play out. It started with Trump, spread to brexit (and Boris Johnson), yellow vests, and more recently in Hong Kong.

People are unhappy because they feel that the current political system isn’t working for them. It used to be that if you worked hard, you could get a decent job with decent wages, and you could buy a nice house and start a family.

Over the past 10 years has changed that drastically. An era of quantitative easing and easy money has pushed up global asset prices, to the point where houses are prohibitively expensive for young people to own. At the same time, education costs have gone up, translating into more student debt, while wages have remained somewhat stagnant.

The other understated point here to me, is the rise of technology. As it turns out, technology was massive because it created an era of new startups with business models that disrupted existing industries. Just think of the impact that Amazon has had on retail, and multiply that across all other industires.

And because these new wave of companies are built from the ground up to leverage technology, the need for manpower is not as large as the old school industries they are disrupting. So that’s created a situation where the net demand for highly skilled labour these days is not as high as it used to, resulting in less highly paid jobs.

So I think a lot of young people these days are graduating into the economy where the perceived prospects for job and wage growth isn’t as strong as it used to be 10 or 20 years ago, and this coincides with sky high housing prices and student debt. Whether that’s actually true or not is immaterial, what matters is people’s perception of reality. And if enough people believe this narrative, you start seeing populism.

The same dynamic plays out for older folks, and the lower skilled portion of the workforce, but it’s more acute for young people.

Personally, I expect to see more of such populist movements going forward, as people look to create a system that distributes wealth more equally throughout society. It’s happened all throughout history. Whenever inequality reaches a certain point, pressure starts building in the system, and unless the underlying problem is remedied by the prevailing ruling class, the pressure will eventually build to a breaking point.

What is good?

So what kind of investments are good in such a climate?

Gold

To quote Freddie (StashAway CIO) in the FH Podcast, Gold is a “supercycle” investment. I absolutely agree.

I genuinely think that as the dynamic described above plays out over the next 24 months, gold price may skyrocket, as it’s the only safe haven / hard currency that cannot be depreciated away or printed by any government.

And just to show that I’m putting money where my mouth is, over 10% of my own net worth is held in the form of gold, as all Patron members will know.

Such volatile times are exactly what gold is built for.

US Treasuries

US Treasuries have had a monster rally. The US TLT ETF is up almost 20% this year.

My personal thinking, is that this continues to play out going forward.

In the medium term, the Feds will probably cut rates much further, and 10 year yields may go to zero, and 2 year yields may even go negative. The Eurodollar futures may be another good way to play this trend.

Closing Thoughts

I know this is a bit of a doom and gloom post from me today.

But don’t get me wrong, everything I described above is on a short to medium term basis.

In the longer term, I have absolute certainty that the world will pull through stronger. I think 5, 10 years out, the economy is going to be way stronger than it is today, and we’ll be regretting all the opportunities that we failed to take back in the “2020 crisis”.

So despite all the short term volatility, don’t forget that this is exactly what this is. Short term volatility.

If you’re a long term investor with an “all weather” style portfolio, there’s really nothing required for you to do here, because the bond/gold component of your portfolio will do what it’s supposed to do. You can focus on your day job, your family, and the more important stuff in life.

If you’re a trader or short term guy, then I think there’s going to be massive movements in financial markets coming, and if you get on the right side of the trade, there could be plenty of money to be made here.

And just in case you guys missed it, the Financial Horse Complete Guide to Investing for Singapore Investors launched yesterday! I’ve spent the last 9 months compiling everything I know about investing into this guide, and it’s all available to you now. Check it out here!

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