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Happy New Year! I’d like to start 2019 on an upbeat note, but as I’m reviewing what happened last year, that’s not a realistic aspiration.
2018 was tough for investors.
Depending on the figures you use, the key US market, the S&P 500, narrowly avoided falling into technical bear market territory (from its closing high in September to its closing low on Christmas Eve, it shed 19.8%).
But the slide in the last third of the year was faster and more brutal than a similar slide in 2011.
In all, it was the hardest year investors have experienced since quantitative easing (QE) was launched in 2009.
It was also the year that saw the launch of quantitative tightening, the reversal of QE.
Somehow, I don’t think that’s a coincidence.
There’s no dark secret underlying 2018’s struggles
One hangover from the 2008 financial crisis is that when markets fall, everyone starts to look for something that’s set to “blow up”.
Markets can’t fall for relatively ordinary reasons. There has to be the equivalent of a Lehman Brothers moment lurking behind every dip and tumble in global stocks. You might not be able to see it, but it’s there.
Yet you don’t have to have a near-apocalyptic financial collapse to send stockmarkets lower. Other factors do play a part sometimes. Not every bear market is caused by a banking crisis.
In the case of 2018’s turmoil, the cause is pretty clear. You don’t need Robert Peston or Evan Davis to come on the BBC news and explain the inner workings of a subprime mortgage with the aid of sticky-backed plastic and old washing-up bottles.
You just need to look at what was different in 2018 to every other year since the financial crisis. The big change was that QE – money printing – went into reverse. It became QT – money burning.
Why does that matter? Because unless you believe that QE had no effect on asset prices whatsoever (some people do indeed think that, but I’d suggest it’s an ideological stance), it means that any premium that asset prices generated from QE now has to be worked off.
QE worked by forcing investors to take more risk if they wanted to achieve what they considered to be acceptable returns. When investors are forced to take more risk, that means there is more money available for flakier assets and projects, such as trophy assets such as collectables, and novel assets such as bitcoin.
QT means that support for these flakier assets and businesses is withdrawn. But it also means that investors no longer need to take as much risk to generate acceptable returns.
For example, in the US, you can get about 2.5% interest on short-term bonds now. It’s not revolutionary, but it’s higher than the dividend yield on the S&P 500, and if you can get that on an ultra-safe asset, then returns on other assets have to be a lot more appealing before you’ll consider them.
In short, if money gets tighter, investors have to become pickier. That’s good news for efficient capital allocation and productivity. But it also means that a lot of investment opportunities need to be repriced – some of them rather more brutally than others.
The most interesting price in markets right now
What does this mean for investors in 2019?
A focus on fundamentals matters more than ever. Hope is no longer a viable strategy. If you are looking at individual companies, you need to be able to understand what a company does and how it does it, and then get a realistic idea of how much money it will make, and therefore, what it’s worth today. And then build in a decent margin of safety.
If you’re looking at entire markets, you want to buy them cheaply, particularly as today’s earnings are likely to be close to peak earnings (which means that non-cyclically-adjusted price/earnings ratios are probably artificially low).
But what happens if the Fed backs down and the market shifts tack again? From that point of view, the most interesting price to me right now is that of the US dollar, as measured by the dollar index. This measures the value of the dollar against a basket of its biggest trading partners. The euro dominates the basket, but there are several other currencies in there too.
I’ve mentioned this a few times in recent months, and I’m going to keep doing so, simply because it’s the most obvious signal of just how tight global monetary policy is at any given point.
In short, the dollar is the world’s reserve currency – everybody needs US dollars. So when they are expensive, money is tight. When they are cheap, money is loose. That’s a gross over-simplification, but it works as a broad-brush indicator of the macroeconomic background.
If the US dollar is getting weaker, global monetary policy is looser, and it’s a good sign for risk assets. If the US dollar is rising, the opposite is happening.
A good example is to consider the sharp contrast between 2017 and 2018. In 2017, US stockmarkets floated serenely higher with barely a glitch. It was an exceptional year in terms of the lack of volatility.
That same year, the US dollar spent most of its time falling, as Federal Reserve chair Janet Yellen continued to undershoot market expectations on interest rate rises.
In 2018, US markets peaked, then fell, then peaked, then fell again. Meanwhile, the US dollar picked up strongly from mid-April as investors started to realise that the Fed under Jerome Powell was much more aggressive than Yellen had ever been.
In the last few weeks, the dollar has shown signs of turning around. The index has fallen from a recent high of above 97 towards the 95 mark.
Could this be good news for risk assets? Possibly, if the Fed starts to back down on the pace of QT. But it would certainly be good news for gold and precious metals, which ended last year on a bit of a tear. If you don’t have any in your portfolio, it’s probably a good time to get hold of some, just in case.