The stock and bonds markets are up, the dollar is trading high, fourth-quarter growth was robust and there is a general expectation that the heavens are starting to rain down their abundance on the U.S. economy.
But think again, warns Axel Merk, founder and manager of gold and currency-based portfolios bearing his name.
“Substantial economic growth is the biggest threat to the U.S. economy right now” — for which reason it’s not going to happen, not now and not for many years to come, Merk tells ThinkAdvisor in a wide-ranging and provocative interview.
“In 10 years from now, I don’t think we’ll be able to afford positive real interest rates,” Merk says. “If we had gangbuster growth, if we went back to historical average [rates] of financing deficits, we’d be spending $1 trillion a year to finance our deficits.”
That means that the U.S. has a built-in bias toward keeping rates low, and the currency funds manager and frequent financial commentator is not by any stretch speaking merely of the distant future when few will bother to verify his forecast. His warning about today's central bank is equally bracing:
“The FOMC [Federal Open Market Committee, which sets the Fed’s policy rates] is going to chicken out and be late in raising rates,” Merk said.
“People think there’s going to be a gangbuster exit in the U.S.,” he continued. “It’s not going to happen. Workers with high-paying jobs in the shale industry are being laid off. Can you raise rates in that sort of environment?"
Under these fiscal and monetary constraints, the fund manager urges investors to rethink their model and its investment implications.
A good place to start this reframing is with expectations for the dollar, which has been strengthening for more than six months now.
“Right now, the rest of the world is perceived to be in a horrible state; the U.S. is perceived to be in a fabulous state,” and it is this short-term perspective that is driving the rally. But Merk warns against the commonly held view that the dollar will be protective — the so-called “flight to safety” — in a market reversal.
“You can actually measure these things,” he says, citing the VIX index of market volatility as an example. “In recent months, the dollar has been rising when people have felt good; but in a risk-off environment, when the market has been plunging, the dollar has plunged.
“Foreigners are the new retail [class] pushing markets to new highs,” Merk continues. “The flip side is that when there’s a correction in the market, don’t count on the dollar being a quote-unquote safe haven.”
Merk’s dissent on the dollar does not enamor him of the euro, at least not for now. While the currency manager is long-term bullish on the euro, he remains on the sidelines, concerned about European Central Bank president Mario Draghi’s plans to undertake large-scale U.S.-style bond buying starting next week.
“Why on earth would the eurozone need quantitative easing?” Merk asks. “It needs structural reform rather than just printed money. The cost of money has [already] plunged. What you need is stronger banks; you need demand.”
Merk considers the planned move a grave error because it fails to take cognizance of differences that exist between today and the previous eurozone crisis.
“The problem is you can’t just park cash, you pay for it … There was no negative deposit rate in 2012. That’s not the case today,” he says of the negative interest rates depositers are facing.
So Merk believes the world’s central banks are behaving badly — with the Fed pretending it will get out of QE (though inflation expectations are plunging) while the ECB is seeking to get into QE (while Europe is already awash in liquidity).
What does the world’s zero-bound financial straitjacket mean for investors?
“There is no safe asset anymore,” Merk says. “Cash is not safe anymore. When governments penalize you for holding cash, you cannot call cash safe anymore. When interest is not making up for inflation, that is called financial repression.”
That leaves bond investors in the unenviable position of choosing between risky Greek bonds that yield something versus an outright negative real rate on the short-term bonds of Switzerland, Germany or other stable economies.
Yet going long five or 10 years is no solution either — that will get you zero or 54 basis points respectively in German bunds.
“Are investors going to stick around for five years? Inflation could take off, entitlements could blow up … I wouldn’t touch bonds with a broomstick,” he puts it colorfully.
But Merk is no more sanguine about equities:
“When volatility rises, asset prices have to reprice lower,” he says, noting that “most investors today are skewed toward very risky portfolios. What the hell do you do?” he colorfully asks.
“You take chips off the table,” is his answer. You do what [former Fed chairman Ben] Bernanke does. You have a toolbox.”
By "toolbox," Merk means the pursuit of a diversified strategy, but a unique strategy at a time when investors should take no comfort from stocks, bonds or cash.
“We use a long-short strategy as a diversifier,” he says of his Merk Absolute Return Currency Fund, currently his most popular in terms of investment flows.
“It’s an alternative to bonds that enables you to reduce the risk profile of your portfolio,” he says, adding that the fund would, for example, buy the New Zealand dollar and sell the Australian dollar. “The returns you generate hold a low correlation with other asset classes in your portfolio” and, further, currencies managed this way are not very volatile despite their reputation, he says.
That requires entering the "gray box" of active management, he says. For those lacking such courage, Merk calls gold “the easy answer…It’s a no brainer in a world of financial repression over the next few years. [Merk runs currency mutual funds and a gold ETF].
“Are you willing to buy this brick that pays you nothing?” he asks. “Nothing is a lot more than the negative return” among the Treasury rates of the world’s major economies, he adds.
But these are unique times.
“For the first time in history, both U.S. consumers and the U.S. government have too much debt,” he says. “The folks that own the debt are foreigners who don’t have a vote, and your [advisors’] clients are holding the other side of the trade.”
The results of this profligacy include “capital misallocations” (asset bubbles) and increasingly “convoluted” policy guidance from the Fed and other central banks that control the money-printing presses and are desperately trying to “manage where things are going.”
Another foreseeable outcome Merk warns of is social unrest.
“Governments never blame themselves — it’s always bankers, foreigners and others,” he laments.
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