Inflated asset prices, investor complacency and brewing crisis that could trip up the current happy equilibrium are the backdrop for Axel Merk’s warning that it is time for investors to start “taking chips off the table.”
But the key difficulty for the Merk Investments founder and portfolio manager in his latest investment analysis is where to hide in an environment in which “instability may be the new normal.”
To answer that question, Merk first locates tracks the market’s current state as one of complacency — which is the third of three states in a market crisis.
Typically, he says, equity markets sell off in a crisis; as that crisis evolves, markets tend to differentiate: For example, when Cyprus blew up, Spanish bonds were undisturbed. In the third and current stage of a crisis, risk seems manageable.
“When a Portuguese company didn’t pay its loans on time, the markets barely blinked,” Merk writes.
It is at this stage that pundits typically advise not to sell but rather to buy the dips.
And this approach is vindicated by central bank easy-money policies that have the effect of compressing risk premiums.
European Central Bank chief “Mario Draghi has promised to do ‘whatever it takes.’ So why shouldn’t investors chase yields in the weaker Eurozone countries?” Merk asks.
The currency portfolio manager similarly critiques Fed chair Janet Yellen, whom he assesses as having “all but promised … to be late in raising rates.” What’s more, he thinks any nominal rate increases will be meaningless, because of inflation, such that he expects real rates to remain the same.
The trouble lurking in this low rate, high complacency environment is the danger that risk premia will suddenly and unexpectedly rise.
And while the source of this shift could be as subtle as a change of perception (“the glass is suddenly half empty”) or a result of the Fed seeking to engineer an exit, Merk devotes much of his analysis to growing social and geopolitical disorder.
In the social sphere, central bank easy-money policies are destroying society’s social fabric because asset holders are benefiting disproportionately, thus enlarging the wealth gap.
“I would argue policies of the Fed have a far greater impact on wealth distribution than the policies of Republicans or Democrats,” writes Merk. “Those that know how to deal with easy money, such as hedge funds, can do great in this environment; however, those that don’t know how to deal with debt easily fall through the cracks, unable to recover.”
The result is a deep erosion in purchasing power that fuels populist movements such as the Tea Party and Occupy Wall Street; Japanese Prime Minister Shinzo Abe’s populist policies; uprisings in the Middle East; and the ascendency of populist parties in Europe of late.
In this light, Ukraine’s essential problem is its inability to balance its books, thus turning initially to Russia and now to the European Union for subsidies.
Noting that World War II was preceded by the Great Depression, Merk says that “the aftermath of a credit bust is a fertile environment for the sort of dynamics that can lead to armed conflict. Russia has an interest in an unstable Ukraine; Japan might ramp up military spending to boost domestic growth, to name but two sources of instability.”
While not predicting World War III, Merk continues that “the U.S., a superpower no longer able to finance all of its commitments, is not exactly a source of stability, either: the biggest threat to U.S. national security may not be China or Russia, it’s the national debt.”
Merk is pessimistic about the possibility of dealing with the debt through entitlement reform in an environment of rising populism, for which reason he is convinced that real rates will have to remain low lest U.S. debt servicing costs rise by $1 trillion or more a year with a rise in rates.
So with asset prices at or near record levels and volatility at record lows, combined with rising world and domestic instability, investors should try to steer their portfolios away from risk.
Merk thinks bonds will be among the worst performers in the coming decade, and besides, are too risky to short because of the requirement to pay interest; he does not see the dollar as a safe haven with real interest rates in negative territory; and buying equities now means coming “late to the party.”
Investing in gold makes sense, he says, “as low to negative real interest rates may make the shiny metal that pays no interest (but cannot be easily ‘printed’) a formidable asset.”
Investors might also “diversify to baskets of currerncies” and “possibly be tactical in an effort to stay a step ahead as currency wars may be raging.”
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