BlackRock, the largest asset manager in the world and one of the big beneficiaries of the Fed’s policies, and of similar policies by other central banks, is in a bullish mood.
In its 2015 Investment Outlook, BlackRock is gung-ho about the US economy. Dominant among the forces behind that miracle is the Fed’s “ultra-loose monetary policy” that has “inflated US equity and home values.” Monetary policy will likely “remain highly stimulatory.” And “even if the Fed were to hike by a full percentage point, real short-term interest rates would still be negative.” So savers would continue to get annihilated, at least until they entrust their money to BlackRock.
BlackRock is a fan of Abenomics and the Bank of Japan which has taken over where the Fed left off. The BoJ monetizes the entire deficit of the government. Japanese institutions, including the huge Government Investment Pension Fund, have been pressed to sell their JGBs to the BoJ and plow this money into stocks and other assets, expressly to inflate their values. BlackRock is licking its chops.
And it’s looking with fond expectations to the ECB, which has essentially promised, despite German opposition, a big load of QE starting in 2015, on top of the negative deposit rates it is already inflicting on banks and increasingly their depositors.
Under these glorious circumstances, for an asset manager that depends on assets being constantly inflated, nothing could possibly go wrong in 2015. Or so it would seem. But in its 2015 Investment Outlook, BlackRock sees quirks of reality that could royally muck up the rosy central-bank-decreed scenario.
Turns out, financial markets and economies in most countries are “diverging.” The financial cycle, pushed to the max by central banks, has moved much faster then the economic cycle. So the US may be “closer to the end of the financial cycle than the economic cycle.” That is, even if the economy hums along, turmoil could break out in the financial markets.
But the economy may not hum along either: That hoped-for growth in the US is at risk if “weak global demand and the strong dollar” hurt exports; ballooning student loan burdens are a “drag on consumption and home buying”; and a “liquidity crunch” leads to “financial instability.” Even the Fed is using that term.
It’s a euphemism for “crash.”
In corporate America, “operational leverage” is an issue, and there have already been “five or six different events where companies stretched too far.”
And valuations of US equities are lofty. If something looks “cheap,” it’s “only because everything else is so expensive.” Turns out, the “low-hanging fruit” has been picked, and now investors are “high up on an increasingly shaky ladder, reaching for the remainder. It is an accident waiting to happen.” These valuations have been aided by “robust profit growth.” Alas, this growth is a result of….
“Financial wizardry” and stretching accounting principles:
Corporate earnings are a key risk. Analysts predict double-digit growth in 2015, yet such high expectations will be tough to meet. Companies have picked the low-hanging fruit by slashing costs since the financial crisis. How do you generate 10% earnings-per-share growth when nominal GDP growth is just 4%?
It becomes tempting to take on too much leverage, use financial wizardry to reward shareholders or even stretch accounting principles. S&P 500 profits are 86% higher than they would be if accounting standards of the national accounts were used, Pelham Smithers Associates notes. And the gap between the two measures is widening, the research firm finds.
Junk bonds are a “a canary in the coal mine.”
Because defaults “bite” them first, their performance should be “company specific and varied.” But they’ve all boomed, well, at least until June. “If you are not getting dispersed returns in this asset class, something is wrong: Investors are too complacent…. Our complacency gauge once again is flashing red.”
Thanks to the Fed’s policies which have “suppressed volatility and pushed up asset prices across the board” – the policies that BlackRock so adores – many investors “have taken on more risk than they would normally do to compensate for low yields. Many are out of their comfort zones and ready to quickly pull the plug.”
The result: Short bursts of volatility, worsened by poor liquidity in popular markets such as corporate bonds…. We had two wake-up calls in 2014: the spring sell-off in US Internet and biotech stocks and the global risk-off move in October on growth fears.
Many assume these volatility bursts will quickly subside and be great buying opportunities, just as they were in 2014. They could be right; and therefore it is smart to keep dry powder to exploit these opportunities. (Cash will do just fine.) Yet volatility may not calm down. Market swings can range from a temporary 10% sell-off to a prolonged and disastrous 50% loss—and the difference is hard to tell as events unfold.
But there has been a nerve-racking twist in the second half: Large-cap stocks, small-cap stocks, and junk bonds all fell in lockstep. While large-caps more than recovered, small-caps did not fully recover, and junk bonds – the canary in the coal mine – continued to get hammered. Which could be a “glimpse of the future.”
And the “voodoo-like belief in momentum”…
… will lead investors to react in the same way when the selling starts. “This makes for sudden stops when the driver hits the brakes.” And it raises the “cost of mistakes.” But traditional diversification might not work as a hedge because “stocks and bonds could fall in lock step.”
Risks abound elsewhere as well, even in the current and future QE paradises: the Eurozone is “bound to either integrate deeper over time – or break up.” But that won’t happen for a few years. Meanwhile, “the Eurozone is a low-flying plane that constantly hits air pockets. This causes both occasional lifts and near-death experiences.”
And in Japan, the BoJ is “playing with fire” with its mega-QE. If structural reforms go no nowhere, and foreign investors, who make up 60% of the volume on the Tokyo Stock Exchange, lose confidence, the whole thing will “likely end in tears.”
And so, smooth sailing in 2015.
Gold – which interestingly didn’t make it into BlackRock’s report – is the most maligned asset, if you listen to the Fed, the ECB, and other central banks. But why? I asked the CEO of Goldbroker.com. Read… Gold “Terrifies” the International Monetary System
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It’s funny, but a couple of years ago I heard Larry Fink say the following: Bill Gross was wrong for betting that interest rate would increase (Larry was proven right), and the Fed would be CRAZY to continue QE beyond the second one. Blackrock the company would no doubt continue to generate non sense, but I’ve always had the feeling that management is really smart and knows how to protect themselves. Heck, Aladdin is a piece of crap, but they managed to spin a business out of it anyways. Kudos.
While visiting family in Belvedere-Tiburon (north of San Francisco) over the holidays, I met a fixed income money manager who had retired as a partner in the Bear Stearns San Francisco office around 2002.
Without hesitation, he agreed with my own assessment that the world economy is much weaker than it looks, and that interest rates on US Government notes and bonds are more likely to fall than to rise. Specifically, my rate prediction was that we are more likely to see the 30-year US treasury bond yielding less than 2% than we are to see it yielding 4%…
To your point Vegasbob, the end of 2014 feels eerily similar to how 2013 ended. Increasingly it would seem that investors are convicted that this is the year that the Fed will raise rates. Speculative positioning is now shorter treasury bonds than it was at the end of 2013, and we know how that movie played out. I think the elephant in the room is the strength of the US Dollar and the return of capital to US assets from the emeting markets complex. I believe that this carry trade unwind will be the biggest story of 2015 and the big risk that few are really focussed upon…for me the right place to be given all the potential headwinds, is short EM and long US treasury bonds. Good luck all for 2015
I encourage everyone to buy and read “The Reigning Error: The Crisis of World Inflation” by William Rees-Mogg. It was written in 1974, and is an excellent examination of governments’ war against gold.
I have been punished for buying gold stocks for several years now, but I just keep buying more. I just view every share as a share I’m buying on sale. I’m just not the kind of person that would buy something like Target at a PE of 31. Revenues are barely growing. Their operating margin is currently 4.5%; for 10 years it had always been 7% or higher. To get there they have a debt equity ratio of 1.4 with ultra low interest rates. There’s no further way to milk profits out of them with further leverage or lower rates, and PE multiples are at nosebleed levels.
Meanwhile, gold is hated here while being gobbled up by the East, and it’s being sold at around its cost of production. Target is receiving max love, while gold gets max hate. I will continue to buy gold and gold stocks in this environment.
Had a very long discussion with my son over what is coming. He told me all the reasons that the collapse is 5-20 years in the future, why a computer collapse could have happened in the ’90s but not now. I pointed out that even if it only took a couple of weeks to get back up and running there is only about a 3 day supply of necessities in the warehouses of any particular city and a breakdown in infrastructure would cause food riots that would make Ferguson look like a wiener roast. As is his want he is contemplating what I said. Is 2015 the year? I have no idea. We are getting closer to some sort of detente but I think because of his age and his desire not to believe how fast the crash can happen, and his analytical mind, my gut instinct is a hard sell. But we are closing in on a rapprochement.