Regime Shift

In addition to the normal deluge of 2018 forecasts and 2017 year-in-review commentaries, last week we were swamped with interest rate decisions from central bankers all over the globe.

Rather than channeling Miss Cleo and guessing where the S&P 500 will be sitting on December 31, 2018, I’m going to cover some data-dependent intel that will actually prove useful to your portfolio as we look ahead to next year.

For those of you who are new to Vague Destination, my investment process is based on the belief that the most important variables impacting asset prices are economic conditions and how central banks respond to those conditions. I ground every investment decision in my Gravitational Investing Framework, which evaluates the three most critical forces, or gravities, that impact asset prices: fundamental, quantitative, and behavioral.

So, despite this being a time of year when most people in finance merely go through the motions, last week was a very important week. All the big boys announced their latest policy decisions: The Fed, ECB, PBOC, BOE, and SNB, among others.

The announcements confirmed that there is a regime shift occurring in all three gravities for both long-dated U.S. Treasuries and gold, and this shift is getting very little airtime.

 

The Tailwinds

Fundamentally, both long-dated U.S. Treasuries and gold have two bullish tailwinds working in their favor.

First, U.S. economic growth has been accelerating for 17 months, which is a duration that is very meaningful.

Since 2009, we have experienced three phases of U.S. growth accelerating and three phases of growth slowing. The previous three growth-accelerating phases averaged 14 months, and the three growth-slowing phases had the same average duration. Symmetry, anyone?

From that historical perspective, the current regime has overstayed its welcome, having hung around about 25% longer than previous growth-accelerating economic regimes. The bottom line is that a growth-slowing regime is just around the corner.

Second, we’ve just had our fifth Fed rate hike in the last twenty-four months. The previous four were announced on December 15, 2015; December 14, 2016; March 15, 2017; and June 14, 2017.

This is a critical fundamental development for every market that is overly sensitive to the direction of U.S. yields, including U.S. Treasuries and gold.

There is a common misconception that Fed rate hikes push yields higher, which should be bearish for gold and Treasuries. However, history shows us that exactly the opposite occurs in the immediate aftermath of a hike in U.S. interest rates, and that yields typically fall.

 

U.S. Treasuries

Quantitatively, when U.S. growth slows, it’s bullish for long-dated U.S. Treasuries because, like Shakira’s hips, the historical performance doesn’t lie.

During the regimes since 2009 when U.S. growth has slowed, the relative outperformance of long-dated U.S. Treasuries has been very favorable, averaging a +15.5% return, versus just a +8.6% return for the S&P 500.

Similarly, in the six months following each of the previous four hikes, the reward-to-risk statistics for long-dated Treasuries have been very bullish, gaining an average of +7.9%, with an average drawdown of just −4.5%.

That’s nearly two times as much upside potential as downside risk. That’s not bad for just six months of work!

Behaviorally, investors have yanked close to $1B from the four largest Treasury exchange traded funds in the last four months. In fact, the iShares Barclays 20+ Year Treasury Bond ETF (TLT), has seen outflows over $500MM in the last month alone. In futures markets, investors are outright short both 2 and 5-year Treasuries, while being just slightly long 10 and 30-year bonds.

 

Gold

What’s good for the goose is good for the gander: the barbarous relic also performs well in a growth-slowing U.S. economic environment.

During each of the growth-slowing periods since 2009, gold has nearly doubled the average return of the S&P 500. It’s gained an average of +15.1%, versus just a +8.6% return for the S&P 500.

Similarly, it tends to perform well in the aftermath of a Fed rate hike because nothing drives the risk and return of gold more forcefully than the trajectory of U.S. yields.

In the six months following each of the previous Fed rate hikes cited above, gold has gained an average of +9.5%, while experiencing an average drawdown of just −6.5%.

That’s nearly 1.5 times as much upside potential as downside risk over a six-month period.

Behaviorally, investors have been taking money from gold-inspired exchanged traded funds for months now. In fact, the SPDR Gold Trust ETF (GLD) has seen outflows over $800MM in the last three months alone. In the futures markets, investors are slightly long gold, but they’re still well below the long positions they held just three to six months ago. They simply aren’t bullish enough given the environment we are likely to encounter in early 2018.

Collision Course

Both markets perform well in either a growth-slowing or post-Fed rate hike scenario. How do you think they’ll do when both scenarios collide?

Well, the last time we experienced the combo platter of slowing U.S. growth and a Fed rate hike was the first six months of 2016.

During this time frame, long-dated U.S. Treasuries gained +16.3% while experiencing a −4.6% drawdown. Gold gained +24.7% while experiencing a −6.5% drawdown. And everyone’s favorite benchmark, the S&P 500, gained a whopping +3.8%, while experiencing a −10.3% drawdown.

Now for the $64,000 question: would you rather be invested in an asset class where the reward-to-risk characteristics are skewed four-to-one in your favor? Or would you prefer a market that has typically exhibited three times as much downside risk as upside potential?

 

The Bottom Line

Two things are being made abundantly clear by the behavioral gravity of both the long-dated U.S. Treasuries and gold markets.

First, investors are blissfully unaware that this current U.S. growth cycle is long in the tooth and will likely reverse itself during 2018. Second, investors are still buying the misconception that a Fed rate hike pushes U.S. yields higher.

I know it’s easy to get distracted by the latest forecast promising perfect clarity into the financial markets for months ahead. But remember, you can only gain insights other investors miss if you remain data dependent, process driven and risk conscious.

The very best investing opportunities come when a market’s fundamental gravity diverges from its behavioral gravity; in other words, when the underlying economic conditions change, and investors do not position themselves accordingly. This is the exact divergence we are seeing right now in both long-dated Treasuries and gold.