Bond market tells us it will take much longer to return to normalcy

The markets could slow down after the election as people are in a wait-and-watch mode in terms of stimulus and the rise of Covid over the winter will keep economic growth subdued., says Raoul Pal, CEO & Co-founder, Real Vision Group.

When we last spoke a year ago, you had cautioned against a big event which could turn the world upside down and in 2020 that has happened. Are you surprised at the pace and the manner in which the global markets have reacted?
Everybody is surprised that we had the biggest economic event in our lifetimes and the markets have basically shaken it off as a short term thing. In some respects, it has to do with the flow of funds and how people invest but there is a belief that this was a short sharp shock and not something lingering. I am not sure that is true.

In your report you had described the three phases of unfolding panic, hope and insolvency. In which phase are we in and what is the road ahead?
We are transitioning from the hope phase into the insolvency phase. The hope phase is when everybody believes everything is going to be okay and the economic events and in this case Covid will go away relatively fast and things will return to normal.

Insolvency is another spin on this and it seems that Covid is not going away and the economic event can drag on. In Europe, we are seeing the signs of further lockdowns and economic restrictions. It will be the same in the United States and in India. Even though the virus is starting to slow, things will continue longer and the economic disruption will go on longer but in the investment world, what it leads to is a bifurcation. The companies that have plenty of cash flow are fine but companies that do not will suffer. What is happening right now is year-on-year GDP growth is not recovering above zero and is unlikely to do for this year and maybe for a large part of next year. If that is the case, then companies that do not have access to capital markets, companies with higher debts --be it small companies or even households -- start running into problems.

Now, when the fiscal stimulus is fading, it is getting more dangerous because these companies will start defaulting on their ability to pay their debts or go under. That makes unemployment stickier and that in itself lowers demand and drags on the economic episode longer than expected. We can see that in many of the banking stocks around the world that have been very subdued versus the main indices, particularly the tech companies that have no debt and are all cash-generative businesses and have been less hit in an online world than in a bricks and mortar world.

So a big bifurcation is going on. We have seen it in all sorts of things like gold miners that at one point were outperforming the banks by 85% in the first 7-8 months of this year. I have never seen a bifurcation of that sort before and it is giving me alarm signals. We also see it in the bond market which never really recovered. Yields stayed very low globally and they do not seem to also price in a big recovery.

I call the bond market the market of truth because bonds tell the truth, they are very macro and are priced off inflation and GDP growth and that is what they look at. They are telling us things are not going to return to normal for much longer than most people are expecting.

How do you see the US elections playing out and the kind of impact that they would have on the markets?
I am cautious and I would reduce equity holdings right now. The markets have come a long way and it is now a prove me situation where we need to see some economic growth. In terms of the US elections, I do not think there will be a positive or negative impact on markets. I know people like to if Democrats win taxes will get worse. I do think tech companies will come under closer scrutiny for regulations and potentially higher taxes but the markets are already trying to price in some of this and we have seen some of these tech stocks not moving forward for a while now.

What is also interesting is if it is a Democrat victory, the marginal propensity of a Biden administration to undertake more restrictive measures to get Covid under control is higher than the markets perceive. If that is the case, then we will see what is happening in Europe get repeated in the US, which is a slowdown of economic growth. Again, it is not a collapse but it is a general slowdown which drives into my insolvency thesis.

We expect a stimulus package but I am not sure we will get one done before the election. If it does not come till January, there is a big air pocket for markets that could be a little bit complicated. But really I do not think the big fiscal stimulus comes till much later once we have seen further economic weakness, it is very difficult for the Democrats to try and pass a big new deal if we do not see much more economic weakness. And I think it will be the same if Trump is re-elected. Republicans are not super keen to do much more stimulus either. Overall, the markets could slow down after the election as people are in a wait-and-watch mode in terms of stimulus and the rise of Covid over the winter keeps economic growth subdued.

Which are the sunrise and sunset sectors in your view?
I am more orientated to be underweight on banks right now because of solvency. I understand that they have massively underperformed the market and the risk is that my view would be wrong and in which case those would play catch up but I do not think that is the case yet. The insolvency event is larger than that. I do like things like gold miners, precious metals, crypto currencies, things that we are seeing because of more and more printing of money by the governments and central banks and more stimulus. Gold miners traded sideways for an extended period and have been correcting. I would imagine they would be good performers going into the end of the year and next year. I like that sector and now many people are looking at the commodity sector overall but I am not a big believer in a global cyclical pickup yet.

As for tech stocks themselves, I am not entirely comfortable with the arguments but they are very expensive and there is a lot of speculation in the names. I would rather be underweighting those and underweighting the markets in general.

You have maintained that the bond market tells you the future outcomes, commodities tell you the present. What are they whispering to you now?
Well the bond market is telling us as I said before that the things are not good but they are not deteriorating yet. Once you start seeing that breaking higher above 170, that is telling us things are changed. My personal opinion is that interest rates in the United States are going to go negative. So we will have another move coming in the bond market as the market starts to realise that economic growth is not coming back as fast as they would like it to and that economic stimulus is a false economic hope in terms of the effect it will have on the economy.

I am waiting for that signal, I am waiting to see two-year rates go negative. Do not forget we have just seen that happen in the United Kingdom. Most of Europe is now negative, Denmark, Sweden, Switzerland, they are all negative. We have seen New Zealand flow with negative rates and I think we will see that overall.

For Indian investors, I still think the Indian bond market offers opportunities. It offers a decent yield and over time, bond yields will drift lower in India. The asset allocation I prefer is heavier weighted towards bonds than equities. Also, speculators’ short positions in 30-year bonds in the US is an all time record. People are heavily betting on rates rising and when everybody is on one side of the boat, it is often better to explore the other side of the boat for better returns.

Are you still convinced though that the dollar is king and that the world needs Bitcoin?
The dollar has been stuck for months and months in a sideways range. I still think the dollar strength pattern is in but let us wait and see if price will be the final arbitrator of the truth within that. If it is a debt cycle, then most debt is denominated in dollars and that tends to drive the dollar higher. If I am wrong and we are back to growth, then the dollar will weaken over time. Bitcoin has been going up a lot since I suggested it and it will continue to rise because in inflation and deflation Bitcoin rises.

In inflation it rises because the value of hard assets goes up. In deflation, it rises because the only answer the central banks and the government have is to do more and that tends to weaken currencies and overall that makes Bitcoin very attractive. Bitcoin is the hardest asset that there is. It has a fixed supply and that supply eventually runs out. It is a truly extraordinary opportunity if you are able to own it.

At what point do you think this thesis needs to be revisited?
The dollar has been only a part of the thesis but I must admit it is a large part of the thesis. I would not be comfortable saying that DXY, the dollar index below 90 would make me start changing my view. I have long-term views and I have been long on dollar for almost a decade now. It has been a very long term and very good trade for me but I agree things could be changing and I am always open to changing my opinion.

If the dollar does change, that offers lots of opportunities like emerging markets. If the dollar starts falling, then emerging markets do particularly well. Countries like India will be net beneficiaries and that sets us up with lots of investment opportunities, right here and right now. With the dollar trading sideways those opportunities are less clear.