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A Turning Point with many Question Marks
In our last edition of our BFI InSights, we looked at the new role gold is playing as an anchor in today’s global financial system. We made the case why precious metals in general have a promising outlook for the months and years to come. Over the course of the summer, gold has moved decisively higher, pushing through some very important resistance points and currently prices are trading around USD 2’615, so in recent weeks there has been a more than 10% gain for the yellow metal. However, as explained in our last update, the action in the gold market can’t be seen as isolated from all the other ongoing developments around the world.
While our focus was on precious metals last time, we now want to look at currency markets and the US dollar in particular. While gold has been breaking out to higher and higher levels, the greenback has shown some weakness in recent weeks and is currently trading just slightly above the psychologically important support level of USD 100 points in the dollar index.
After many months of speculation, we recently saw the first rate cut in the US, with the Federal Reserve reducing the Fed Funds rate to 5.0% from 5.5%. The Fed waited for quite some time before it enacted this first cut, but finally the central bank decided it was time to adjust interest rates to reflect the current economic reality. The reality is that growth is currently expanding by less than 2% and inflation has also returned to levels close to those seen prior to the pandemic. This suggests that the current 5% interest rate level is still quite far from “fair value” and that there are several more rate cuts in the pipeline.
Despite the fact that this move was widely expected, it was certainly not a non-event for financial markets. Equity markets, after a rough patch during July and August, have finally started to recover and move higher again. While generally falling interest rates should be positive for equity markets, the correlation is not always clear. In the current situation, however, it seems obvious that this is a very important turning point, not only for interest rates, but probably for financial markets in general.
We are currently seeing some very interesting developments, and even though some of them are not widely discussed, we believe they are highly relevant for the coming months and maybe even years. Investors need to understand that all areas of financial markets and the economy are interconnected. When we discussed the outlook for gold in our last edition of the InSights, we showed how this is related to global geopolitics and the changing world order. The world is moving to a multi-polar global order, with more competition and friction among the various blocs. While we believe the current impressive upward trend in precious metals is driven largely by global geopolitics, we believe that currency markets are also starting to show early indications of wider changes to come, especially for the dollar.
Since 2008, which marked the all-time low for the USD, the greenback has been able to recover against almost all major currencies. In recent years, it has been holding up primarily because of higher interest rates, which were a reaction to the rapid increase of inflation post-pandemic. The incentive for investors to hold higher yielding US dollars was certainly clear, but they now need to realize that the fundamentals for the dollar have become even more negative in recent years. Once again, we are at an important turning point which is somewhat comparable to previous dollar cycles with peaks in the 80s and 2001/2002.
An important difference today is that the economy is not in a recession and despite some indicators suggesting a slowdown in the coming months, the risk for a severe downturn in the US does not seem to be very high. However, it is important to recognize that the country’s deficit and government debt continue to pose a serious problem with no solution in sight. US assets, especially equities, are currently trading at very stretched valuations compared to their international counterparts. In addition to that, as described in our last update, the world is increasingly trying to move away from a US-centric global financial system.
Figure 1: Federal Funds Target Rate
It would be too simplistic to expect a decline in the USD solely because of falling interest rates, but the fact remains that higher rates have certainly been a very important support for the currency in recent years, a support that now seems to be fading away, especially relative to other countries and currencies. At the point that we are right now, investing more globally, and with it, reducing the dependence on the dollar and US markets, looks like a very attractive strategic move. Selling high-valued dollars and US assets and diversifying into international investments with the possibility of not only getting higher future returns from asset appreciation, but also excess returns from the relative appreciation of foreign currencies, certainly makes sense in the present climate.
While the price appreciation in precious metals and the increasing volatility in currency markets might be obvious, we are also seeing some other interesting developments in financial markets. Specifically, we want to mention the increasing price momentum in mining stocks as well as emerging markets. China is showing attractive potential for a return to promising growth, especially after Beijing recently unveiled a broad package of stimulus measures, signaling the government’s willingness to intervene more decisively to support the economy. After years of underperformance, Chinese share prices jumped as a result of the announcement, perhaps indicating an important turnaround, not only for China itself but also for other interconnected markets.
For investors, this means that we could be on the verge of a promising entry opportunity in the emerging markets. With attractive valuations and western economies being stuck in an environment of only moderate growth, these markets might now benefit from falling interest rates, a weaker dollar and superior growth relative to western markets. Recent pricing data suggests that there is indeed rising momentum among emerging markets and commodities (as seen with mining stocks).
Financial assets relative to commodities are currently way too expensive, or put differently, commodities are way too cheap relative to financial assets. Readers of our publications are familiar with our outlook for the coming years: we believe that we are entering a new era that will require a different investment strategy with a focus on tangibles (such as precious metals and commodities) and investments in sectors, themes and trends that promise superior value creation. We have already discussed some of these investment themes (cybersecurity, defense & security, commodities, etc.) in detail in previous editions of this publication.
Financial markets move in cycles and prices tend to revert to the mean, especially over long periods of time. Commodities might be offering a once-in-two-decade entry opportunity, as we might be in the early phase of a relative price appreciation versus equities.
It is important to note, however, that this does not imply a large correction for equity markets; it simply means that the future expected returns might be higher in commodities relative to stocks. The key with equity investments is to be very selective in terms of sector/market allocation. US equities have been primarily driven by the performance of a small group of outperformers called the “magnificent seven” (Nvidia, Tesla, META, etc.). While the current valuations for these stocks look very stretched, it does not automatically mean we are going to see a large correction, but rather lower performance going forward. Based on today’s rich valuations it is fair to assume that the future expected rate of return might be below average.
In our last edition of the InSights, we made a strong case for risk management. While we have always emphasized the importance of risk management, we believe it is particularly necessary in today’s environment of increasing systemic risks, such as those related to geopolitics, politics or the financial system. On the other hand, it is also important to note that global equity markets are seeing increasing buying pressure coming from large amounts of liquidity and the pressure of mostly institutional buyers that have no other choice but to put said excess liquidity to work in a timely manner.
This becomes increasingly evident with large pension funds that have clear guidelines and policies about how much cash they can hold, but generally these investors have less and less flexibility and are therefore in a position where they have to buy the dip. This became obvious again in the last couple of weeks when global equity markets came under pressure because of increasing recession fears. Most major market indices saw prices fall by 5-10%, however, this correction was very short-lived, and soon thereafter large investors were again entering the market, making use of lower entry prices which not only supported markets, but started to drive them back up to the levels from where the correction had started.
In our view, the current turning point in interest rates has far-reaching consequences and coupled with other factors such as the additional stimulus in China, we are already seeing an impact on currency markets, commodities and emerging market securities. These developments offer attractive investment opportunities. At BFI Infinity, we build global investment portfolios, and we identify themes and trends in order to select our investments. Also, we don’t simply benchmark our portfolios because we are convinced that the optimal portfolio for the future needs to include allocations to precious metals and commodities, as well as take into account trends and themes that promise to be value-enhancing in the years and maybe decades to come. We diversify our portfolios, but never at the expense of conviction. We would like to encourage our readers to review the Special Report that we issued four years ago, where we describe how investors should be primed for the New Era; the core points and themes we outline in this report are today more relevant than ever.
Don’t hesitate to reach out to us to discuss any questions that you might have.
To access the full BFI Infinity InSights and read more about the second article in it, click here.