Negative interest rates, positive investment returns?

I wrote in January that it was time to look at the resource sector. Since then energy, materials and precious metals producers have provided double digit returns. And this is likely only the beginning.

Negative rates are the new normal.

Major changes are occurring in the global picture. Changes that may appear to be disorienting.  Such as today’s ECB rate cut and QE extension causing a massive near 2% rally in the Euro, defying all expectations.

Or the Bank of Japan’s negative interest rate program boosting the Yen.

This may be a sign of something much more critical to resource sector stocks: a beginning of the end for the US dollar rally.

I wrote last year that the US dollar rally was stalling. Since then the dollar has stalled, moving up and down, but having a very hard time making a decisive continuation of its short term uptrend — or its long term downtrend.  Instead it has been consolidating with a more downward bias as of late.

This to me is suggestive that the US dollar rally is in a phase where the next trend is being decided by the conviction of buyers and sellers and the global economic picture as it changes.  And it is changing — rapidly.

There is no doubt that the US economy has made some progress since the depths of the crisis in 2008-2009, but it is not the level of progress that the stock market would suggest or that the unemployment rate seems to portend.

Instead we’ve enjoyed a very slow, very weak recovery that has mostly created part time, low paying jobs. And this is not as much of a political issue as it is a monetary policy issue.

QE, low interest rates and bail outs have transferred wealth from the working class, and shrinking middle class to the wealthy.

This actually hurts the economy. Slowing consumption, reducing confidence and shrinking the job market. Reality is setting in. Federal Reserve policy makers seem to be realizing that their hawkish hopes of hiking interest rates may be just that. We may even see negative interest rates before we see a 1% Federal Reserve interest rate again.

Such a development is very positive for those traditional inflation hedges.  Which is why I will continue to circle various components of the resource sector in pursuit of misunderstood or undervalued companies which could be valuable investments for the long term.

Now is the time to look at the resource sector

The streets are red with the blood of disemboweled investors. Just the sort of situation that is ripe with opportunity. When emotions run high logic is a distant second.

What’s wrong with this picture?

Enormous allocations of capital have gone in to a variety of companies, including social media, discretionary technology and biotechnology that are speculative at best. Yet they have achieved lofty valuations as money rushes anywhere it may find a return.

Meanwhile, companies in the real world that have viable businesses  are languishing in the current commodity bear market.  Many trading at attractive valuations. What’s the deal?

Now is the time to look at the resource sector.

The backwards logic of QE’s supposed wealth effect

The Federal Reserve has recently admitted, through various policy speeches and interviews, that quantitative easing’s primary goal was to foster a wealth effect by raising asset prices across the board.

If that’s true, then why did the middle class largely evaporate over the same period?  Because the middle class does not own large amounts of financial assets.

Numbers don’t lie

Income inequality and wealth inequality are significant issues. The problem is growing and will continue to do so because the monetary policies enacted thus far have exacerbated the underlying imbalances in the economy.  Growing the wealth of the wealthy at the expense of the rest of the population is not only counterproductive, it’s actually dangerous.

The primary driver of US economic activity is consumption.  That means that a prosperous middle class is critical to a flourishing US economy.  Spenders that have an increased sense of wealth and rising incomes will buy larger homes, make more discretionary purchases, be better equipped to support larger families and ultimately that adds to our GDP.

Economic sanity must be restored

Favoring the wealthy and large corporations has created the problems that our economy will face in the future.  Adding to that, the enormous student debt owed by today’s generation of new entrants to a workforce with less high paying jobs will significantly hinder their ability to buy a home, car or make large discretionary purchases.  Thus robbing future demand from the economy.

This is a significant headwind for the US economy as we move forward in to a future that has been defined by the actions of today.  The only means of reaching an escape velocity whereby the middle class can thrive again is to re-examine the current economic paradigm with a focus on the future.  And I don’t mean in terms of 4 years or the next election cycle.

We can decide our destiny

The future of our country can be a wonderful one should we so choose to exert the effort necessary to make it so.  But that will mean difficult choices about spending priorities, it will mean forgiving large amounts of student debt and favoring the individual over the interests of the corporation (as a change).  It will mean bringing back regulation that strengthens oversight of Wall Street and banks (Glass-Steagall would be a good start).

Most importantly, though, we need to focus on our country.  Minimizing participation in global conflict and putting forward programs to rebuild our nation’s infrastructure.  Our roads, trains, power lines, water pipes and broadband delivery systems can all use a massive investment to bring the US back to being a global leader. A position we have earned, but have failed to maintain.

Seesaw market creates opportunities in volatility

There is a lot of emotion charging the market, creating exaggerated moves both up and down.  One day everything is fixed, the next everything is broken.  Manic depression wouldn’t even begin to describe the back and fourth being witnessed.

But with chaos comes opportunity.  And the opportunity here is finding beaten up, misunderstood and frankly cheap assets.  Right now the areas that seem to be most attractive are commodities, commodities companies, energy and energy companies.

The global markets are pricing in worldwide depressed demand.  Oil producers are pumping at frantic rates, more concerned about the flow of cash than the margin on each sale.  This has created a glut of energy supply — and with little demand oil prices have crashed below $30.00 to about $28.00 a barrel for West Texas Intermediate Crude (WTIC).

Consider the following opportunity: The US dollar has had a rally which induced a de facto tightening even before the US Federal Reserve raised interest rates.  As such, one can reasonably expect that the actual pace of interest rate tightening, with the backdrop of a softening US economy, will likely be subdued.

Markets have priced in a more aggressive interest rate hiking cycle, which is putting pressure on everything that’s priced in dollars.  Even stocks.

I think that we’re getting ahead of ourselves here.  The Federal Reserve is unlikely to let this situation turn in to a full blown 2008 panic again, unless there is a desire to bring back all the calls to audit the Fed and the political upheaval that protests and social unrest would bring.  Instead, especially given that it’s a critical election year, I believe the Fed will tap the breaks and ease off the gas, leaving interest rates at 0.25% and possibly cutting them to negative levels if the global slowdown increases in momentum.

Energy falls, stocks mauled

There’s a deflationary wind that’s been blowing this way since late 2014. It’s been strengthening since the August 24th intraday market crash in the US. And now I think it is really picking up.

What comes of this brewing storm has yet to be realized in equity markets, but energy prices (and the companies vulnerable to lower profits) have tumbled. As have the prices of mining companies and the materials they extract.

The weakness in China coupled with a slowing US and EU consumer portends to a long-term deflationary headwind.

And don’t look now, but the Japanese Nikkei market seems to be crashing…

Gold’s 2015 performance in various currencies (chart)

The Brazilian Real was walloped and the dollar was clearly a standout winner. Gold’s relative underperformance shows against US dollars that the US dollar is still seen as a safe haven currency.

Until that changes gold will underperform as measured by US dollars. I think we’re closer a that point in time when we see positive price action then we were a year ago, but I can’t say for certain if the markets will agree until stocks move in to a bear market.

As seen in the start of 2016, when stocks were out of favor, gold caught a bid and moved higher each day stocks were sold off. Now that stocks are catching a bid, gold is selling off.

Whether or not 2016 is the year that stocks enter a bear market remains in question. I am inclined to think that we have only seen a prelude for the downside in stocks that could occur this year.