Get ready for the cliff-edge. Be maximum long duration of nominal government bonds in safe haven markets. This means the U.S., the UK and Germany, in that order, and perhaps others. Be long gold. Think the unthinkable – we always do, and you should ask yourself why the consensus refuses to do so, and seems perpetually on the ‘everything is ok’ side of events. If I was any more bond bullish we would explode. This is identical to 2008, including the incredible complacent (and we believe wrong) consensus. Words: 1382
So says RBS in an article* presented by The Pragmatic Capitalist (pragcap.com
RBS is sounding the alarm on risk assets with a call that markets are at risk of falling off the edge of the cliff – by as much as 60-70%! They refer to equity investors as the “worst cult in history….which has no basis in fact, or history, but yet seems universally accepted.” They believe the current downturn could very well “destroy” this “cult”. They’re not just bullish on treasuries –they are super bulls with a 2% target on 10 year yields, saying:
A Cliff-edge Just Around the Corner
Get ready for sub 2% on 10-yr USTs; sub 2% on 10-yr bunds; and 2.5% on UK 10-yr Gilts. Our long held US$2000 gold view as a trade for the breakdown of the financial system looks increasingly ok.
We cannot stress enough how strongly we believe that a cliff-edge may be around the corner, for the global banking system (particularly in Europe), and for the global economy (particularly in the US/Europe). We have been wrong before, but we think the risks associated with us being wrong are low (i.e., [that] rates just stay where they are [or that] yields back up a little bit – after all we are not about to enter a new global economic upswing!). The risks associated with us being right are >10% returns in 10-yr USTs at the same time that equities/commodities will collapse far beyond what even some equity bears anticipate.
Today’s Stock Valuations Are Very Unattractive
For a counter consensus look at just how rich equities actually are if we are right about the economy, and how far they can fall. [L]ook at Robert Shiller’s 10-yr real adjusted P/E ratio on the S&P500, which uses ten year smoothed earnings. We have used this as our marker for proper (unbiased) long-term valuations for many years (it is freely available to all investors to look for themselves on his Yale website) and it sits at 20.0.
One pillar of our framework is that sometimes it is right to buy equity; sometimes it is right to sell equity. [C]all us old fashioned, but we will buy at low PEs, and sell at high PEs [s]o a PE now of 20 sits very uncomfortably right at the TOP of its range if we take out the pre-first great depression spike in 1929 and Nasdaq 2000 spike. We argued in [the] 2007/08 pre-crunch that we would buy equities again when they looked cheap, which would be at 6-8 PE on this metric. That is an equity fall of 60-70% from here. [C]all us mad with such big numbers if you desire, and say we will miss the big equity rally on a structural view – what rally? [The] S&P500 total return since 1Jan2000 is actually -8.1%! – [but] an investment in 30yr USTs has returned you +126%! [While] you do not have to see -60-70% off risk assets to be cautious here, we are just suggesting this is what the numbers say are attainable if certain circumstances prevail, using a 120 year snapshot.
The End-game Approaches
This all sounds somewhat doomsdayish, so we should update how the real economy/banking is panning out for us. It is saying that the end-game approaches [and there are 3 causes:]
1. The U.S. housing market
The trigger [will be] the U.S. housing market. The last of the U.S. fiscal easings, the first time homebuyer tax credit, [has ended and now] investors [must] get ready for [a] violent turn down. The NAHB housing index has dipped; housing starts [are down) 10% m-o-m (6.3% under consensus); building permits [are down] 5.9% m-o-m (8.4% under consensus); existing home sales [are down] 2.2% (8.2% under consensus); new home sales [are down] 32.7% m-o-m (14% under consensus); there is a surplus of 1.75m housing units built since 2006 and even with normal household creation, this will take two years to remove. [This] weak housing theme should now pollute its way into consumers and kickstart the rebuilding of the savings rate [which is] just 3.6% [having been] delayed from rebuilding by the fiscal/monetary shock and awe.
2. The European banking system
The European banking system faces problems [with] downgrades continuing in Europe… We are amazed there is not now immense market & media focus on the new letters that will bring forward the end-game and worsen it: 2a-7.
3. The SEC rule 2a-7
[The implementation of the SEC rule 2a-7 could well be what pushes us off the edge of the cliff!] It forces US money market funds – up to now the provider of USD liquidity to those who need it – to become ‘safer’. The SEC puts it thus: ‘The amendments tighten the risk-limiting conditions imposed on tax exempt money market funds by rule 2a-7… [and] are designed to reduce the likelihood that a tax exempt fund will not be able to maintain a stable net asset value.’ [source: SEC] The US$2.8trn of 2a-7 funds now have to a) own 30%, not 5%, of assets in sub 7 day liquid paper; b) weighted average maturity of fund has to fall to 60 from 90 days. We can all see the logic – the sovereign defaults from EMU have the power to hit EMU banks badly, and the USA does not want to repeat the calamitous ‘breaking the buck’ problem when in 2008 Reserve Primary Fund wrote down its Lehman assets, took its net asset value sub $1, caused a run on money funds which then forced them to sell their assets, cutting NAV for other funds, etc., i.e., contagion.
From what we can see, the USA is basically pulling up the drawbridge and retreating into its fortress, trying to protect its financial system from coming European banking problems – but the consequence is clear. Banking is about confidence. If you are reliant on markets to fund yourself and that confidence wanes, a total stop can occur immediately/within days…Once we apply 2a-7 (and the ability of U.S. money funds to ‘put’ their EMU bank assets back to the issuer EMU banks within 7 days on signs of trouble, since the U.S. money funds will from now on increasingly own 1yr securities with a 7 day put) to our economic slowdown/deflation themes, this means one thing. If there is a slowdown and sovereign trouble, the problems facing EMU banking have, through this rule, potentially become a whole lot worse. This worsens – and brings forward – the ‘cliff edge’ potential.
“Monster” Quantitative Easing is Coming
With fiscal policy off the agenda the next shock and awe will be in the form of large scale more monster QME (quantitative monetary easing) but with one massive difference – it [probably] will be focused on lowering yields, not expanding money supply. As such, do not be surprised if the next QME is about guaranteeing yields at, say, 2% 10-yr US, or lower. Even if it is a vanilla buying programme as before, expect it to focus along the curve and bring all yields down in a monster bull flattener (you cannot bring down 5s and not 30s because that just changes savings’ maturity preference, it does not deter saving)…
We are getting more bond bullish, not less.