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    Gavekal Research

    Making Sense Of The Rally In Cyclicals

    By all accounts, 2016 has so far proved to be a challenging year for “market neutral” funds, and “smart beta” strategies, along with various quant funds. Before we have even reached the seasonally-challenging part of the year—sell in May and go away, and all that—a quick glance at year-to-date returns for “low volatility” hedge funds illustrates that the pain is pretty widespread. In a sense, this is surprising; after all, spreads are tighter...

    2
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    Gavekal Research

    Vertigo And The US Economy

    Regular readers will be familiar with my contention that persistently low interest rates lead not to economic growth and sunlit uplands, but instead to a structural decline in the growth rate and stagnation. Based on this analysis, I have for a while expected a US economic contraction. That one has not yet materialized means there is, however, an obligation to check whether I have been barking up the wrong tree.

    3
  • Gavekal Research

    NIRP: Machiavellian Design Or A Policy Mistake?

    In order to make money, Starbucks has little choice but to sell coffee. Ford must sell cars if it hopes to stay open. And Lockheed Martin better get orders for bombs, missiles and planes if it is to remain relevant. But banks do not need to make loans (their stated purpose) in order to make payrolls and pay shareholders a dividend, at least at certain points in the cycle. When the yield curve is steep, banks can borrow money cheaply at the...

    3
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    Gavekal Research

    The Sum Of All Fears

    As “China implosion” and renminbi devaluation fears have faded, risk assets around the world have enjoyed a sustained a rally led by “China sensitive” assets such as commodities, Asian equities and emerging market high-yield debt. In short, all the assets that were priced for a scenario just short of Armageddon. But following this rebound, what next? The most obvious point is that, with the pick-up in fiscal stimulus, the rebound in construction...

    0
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    Gavekal Research

    Rebalance Away From US Equities

    Yesterday the S&P 500 closed at a year-to-date high of 2,094, up 14.5% from its February 11 low. Now comes the real test of investor confidence. At its current level the index is just 1.7% below its all-time high, set on May 21 last year. Since then the market has tried and failed on four occasions to surpass that level, in June and July, and then following the summer’s sell-off, in November and December. With the market apparently poised...

    0
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    Gavekal Research

    Oil’s Busted Flush

    Buoyant expectations that the world’s major oil producers could agree a production freeze when they meet in Doha on Sunday have helped push the price of crude to a four-month high this week. The international Brent blend benchmark reached just shy of US$45/bbl, up 66% from its late January low of US$27, with at least some brokerage houses predicting the price could breach US$50 in the event of a deal. Maybe—but forecasts that the crude price...

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  • Gavekal Research

    Is US Manufacturing A Leading Indicator?

    There is a commonly held belief that US manufacturing leads the rest of the economy, so it is surely a worry that factory output has been flat since late 2014. And yet the broad economy kept growing—with GDP up 2% YoY in 4Q15, consumption up 2.7% YoY, and home construction by almost 10%. One explanation for this apparent decoupling is the US’s shift to a more service-intensive “knowledge economy” which has rendered metal bashing and more...

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  • Gavekal Research

    Updating The US Recession Indicator

    In January last year I penned a piece whose simple thesis was clear from the title (see Towards An OECD Recession In 2015). The idea was that each time the rentier owner of capital made more money than the entrepreneur (on a worldwide basis) in the previous 12 months, a recession in the OECD materialized some time in the next 12 months. Returns for the rentier were computed using the 12-month total return of 10-year treasuries and those for...

    1
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    Gavekal Research

    The Slowdown In Services

    Both the main leading indicators of activity in the US services sector—the ISM services PMI and the Markit services PMI—staged modest rebounds in March. But on the face of it, the pick-up in the headline numbers offers little encouragement for investors. At 54.5 for the ISM and 51.3 for Markit, both measures remain substantially below their 2015 averages of 57.2 and 55.9 respectively. Considering that services make up 70% to 80% of the US...

    0
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    Gavekal Research

    Why US Imports Are Disappointing

    Given the strength of the dollar, it is not surprising that 2015 generally saw US exports contracting, US imports growing, and the trade balance widening. What is more perplexing is that import growth has started to look shaky in the first part of this year. What gives?

    0
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    Gavekal Research

    Fade The Emerging Market Rally

    In defiance of conventional wisdom the oil price has tumbled -10% in the last two weeks despite a weak US dollar. For emerging markets investors, the breakdown of this correlation raises tricky questions.

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  • Gavekal Research

    Things Fall Apart

    Over the past century periods of social breakdown have swung the pendulum of power from markets to governments and back. Each crisis ended with a transformation in economic and political thinking. Today, voter anger is a response to the 2008 breakdown of deregulated capitalism. This time, argues Anatole, politicians must reconsider the market fundamentalism that has prevailed in recent decades and design a new system of checks and balances to...

    12
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    Gavekal Research

    The China Factor In The Fed’s Equation

    Janet Yellen yesterday confirmed that uncertainty over the global outlook was why the Federal Reserve scaled back expected interest rate hikes. But just what happened in the world to change her mind? Rather than slightly weaker global growth prospects, market turbulence is the more likely culprit—in particular the stress over China’s currency.

    0
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    Gavekal Research

    Returns On Capital Are Deteriorating

    The rate of return on capital invested in the US has taken another step down. While not terribly surprising, this does bring the world’s largest economy one step closer to the next recession and a full-scale bear market. Nevertheless, the day of reckoning remains some way off; the current cycle is not about to reach the end of its road just yet.

    0
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    Gavekal Research

    US Housing: From Great To Good

    The US housing recovery properly kickedoff in 2011 as a confluence of benign factors converged to favor the sector. Yet while housing continues to provide a much-needed positive contribution to US economic growth, recent data points to reduced momentum. After a weak January, homes sales for February, released yesterday, ticked a little higher. Yet over the last year, sales have been choppy and generally flat. The NAHB index also shows...

    2
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    Gavekal Research

    The Fed’s Price Keeping Operation

    The US equity market is a constant source of surprise, but what really amazes Charles is any suggestion that it is “trying to tell us something”. Between algorithms, indexation, regulations, exchange traded funds, structured products, trackers, negative interest rates and of course massive central bank intervention, “Mr. Market” probably has little to say, save that he is hopelessly lost.

    1
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    Gavekal Research

    Dollar Liquidity And Its Dependents

    One of our long-standing rules of thumb has been that a deteriorating US trade balance is good news for the rest of the world, and especially for emerging markets. It is thus a positive sign that the ex-energy, ex-China trade balance shifted from surplus to a deficit in 2015, sending US$150bn to the world outside of China and the oil exporters. The overall trade balance is likely to continue worsening through late 2017, thanks to the lagged...

    5
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    Gavekal Research

    We Are Killing The Wrong Pig

    Lord Keynes, who was a lot smarter than most Keynesians, argued strongly in favor of the euthanasia of the rentier. I see the logic. The rentier has almost by definition a huge preference for liquidity (to use the Keynesian terminology), which leads automatically to a very low velocity of money, and from there to recession. So the idea is to force the rentier into a lower preference for liquidity, which should lead to a higher velocity of money....

    6
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    Gavekal Research

    The Fed Is Falling Behind The Curve

    The Federal Reserve surprised no one yesterday when it decided to remain on hold. But the downward shift in its projection of year-end inflation from 1.6% to 1.2%—and the consequent revision of its dot plot to show two, rather than four, rate hikes in 2016—should have raised a few eyebrows. By adopting such a dovish stance, the Fed is in increasing danger of falling behind the curve on inflation, which in turn implies that the risk of sharper...

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  • Gavekal Research

    The Bloodhound And The Swedish Economist

    After more than 10 years of researching the theories of 19th century radical bourgeois economist Knut Wicksell, Charles concludes that Keynesian monetary policy, which holds market interests down relative to the “natural rate”, leads to slower growth, a more volatile economy, less reliable price signals, and falling P/E ratios. Unfortunately, that is exactly what the US is facing today.

    7
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    Gavekal Research

    A Diagnostic Tool For Bear Markets

    One of the most vexing moments in a money manager’s career comes when one of the team—usually the young intern—asks the question: “So, are we in a bear market or not?” Immediately, everybody on the investment committee jumps into the discussion, and without fail everyone has a strong opinion on the matter. A vigorous debate ensues, and when everything is said and done, a lot more has been said than done—and neither the intern nor anyone else on...

    7
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    Gavekal Research

    The State Of US Profits

    With the US earnings season for 4Q15 done and dusted it is clear that the glory days of this cycle are long gone: aggregate sales for S&P 500 firms fell -4.0% YoY, profits tumbled -7.5% and margins for the period (not the trailing measure) compressed by -2.2pp to 6.5%. The big drivers of profits were (i) the oil price collapse, (ii) the strong US dollar and its crimping of exporters, and (iii) the tendency for rising wages to erode margins....

    0
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    Gavekal Research

    Reality Check In Brazil

    After a year of terrible news, Brazilian markets rallied last week on the surprise news that former president Lula Ignacio da Silva had been forcibly hauled in for questioning by investigators plumbing a vast and fetid corruption scandal. On the hope that Lula’s brief detention presaged his arrest and the fall of his hand-picked successor, the widely despised president Dilma Rousseff, equities gained 8% in two days and the beaten-down real...

    1
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    Gavekal Research

    Dissolving The People

    Populist movements are being greeted with horror by political elites across the Western world. For Charles this is not surprising for such movements threaten the self-perpetuating and self-interested economic structures which our elites have constructed.

    9
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    Gavekal Research

    Not Yet The Buy Of A Lifetime

    With emerging market equities up 13% over the last three weeks, and outstripping developed markets over the year to date, the notion is gaining traction that after four years of underperformance emerging markets are now “the buy of a lifetime”. Investors should be cautious. While it is indeed possible that emerging markets could continue to rally over the next few months as the US dollar tops out and commodity prices stabilize, the longer term...

    2
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    Gavekal Research

    Back To Climbing The Wall Of Worry

    Just three weeks ago markets were in full-blown panic mode. The S&P 500 was down -10% YTD, 10-year treasury yields were down to just 1.6%, and credit spreads were close to their cyclical highs. Dark clouds seemed to be rolling in on every front—from China, Brazil, Europe, banks, and the energy sector, all compounded by fears the Federal Reserve had made a grievous policy error. Since then, the skies haven’t exactly cleared, yet the S&P...

    0
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    Gavekal Research

    Video: On Wicksellian Theory

    0
  • Gavekal Research

    A New Forex Driver?

    Foreign exchange markets are serial monogamists. The currency exchange rate between two economies can be driven by factors such as differences in their respective interest rates, monetary policies, purchasing parity levels, return on invested capital, current account deficits, trade balances and inflation rates. But at any point in time, only one single factor is likely to be the primary driver of performance, which is why currency markets tend...

    3
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    Gavekal Research

    No More Curve To Roll Down

    Since the Bank of Japan introduced a negative deposit rate on January 30, Japanese bank shares have collapsed, falling -21% in yen terms and -15% in US dollars. The first question to ask is this: why were Japanese bank shares derated so dramatically after the policy change? Here are a few explanations, which are not mutually exclusive:

    4
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    Gavekal Research

    Housing And Deflation

    As regular readers will know, I have been warning for some months that the US economy is on the verge of a deflationary bust, which is by far the most dangerous part of any economic cycle (see Four Quadrants: The Growth Question or The Typology Of A Deflationary Bust). So the question readers are probably asking now is this: did the January data released last Friday, which showed US consumer price index inflation accelerating to 1.4% with core...

    3
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    Gavekal Research

    Deflation Deferred

    In the context of weak earnings, weak growth and weak inflation numbers, Beijing delivers another blow to confidence by devaluing its currency. Markets swiftly drive down the prices of equities, commodities and high-risk bonds. Anyone still expecting the US Federal Reserve to follow through with rate hikes must be completely out-of-touch with reality...

    2
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    Gavekal Research

    The Dollar That Didn’t Bark

    Sherlock Holmes would have loved it. In trying to unravel the unsolved mystery of how US$20trn suddenly vanished from the vaults of international investors in early 2016, the most intriguing clue was the dog that didn’t bark. When the Federal Reserve started its hiking cycle back on December 16, 2015, a rampantly-rising US dollar was generally considered to be among the biggest risks to the global financial outlook. Two months later, the dollar...

    0
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    Gavekal Research

    Having Your Cake, And Eating It

    Is the world really facing a 2008-style economic and market meltdown all over again? If it is, then the prescription for investors is clear: load up on long-dated US treasuries in expectation of a continued slide in yields, leaven your portfolio with exposure to gold, and prepare for the apocalypse. But what if the end of days is not imminent? In that case, investors face a trickier call.

    0
  • Gavekal Research

    Crisis? What Crisis?

    Two weeks ago I published an article dissenting from the near-universal view among my Gavekal colleagues, and also probably among our clients, that the global equity markets had entered a severe bear market (see Is Wall Street In A “Bear Market”?). Since I expressed this relatively optimistic view on January 27, the S&P 500 has fallen another -2.7%, the world MSCI-ex US by -3% and the Nikkei by a whopping -8.5% in yen terms. It may therefore...

    4
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    Gavekal Research

    No More Shock Absorbers?

    Things have come to a pretty pass when the heads of two of the world’s three leading central banks come out with all guns blazing in an attempt to persuade markets that they will do whatever it takes and more to ease policy—and their currencies promptly strengthen by two big figures. Yet that is exactly what has happened this week. On Monday Mario Draghi dropped a heavy hint that the European Central Bank is preparing to push interest rates even...

    2
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    Gavekal Research

    Tools Or Jewels?

    An asset can have value for reasons of scarcity (a jewel, or gold), or because it is useful and productive, and so over time generates positive cash flows (a tool). In the long run, tools tend to go up more in value than jewels like gold. Tools also have a terrific advantage in that projecting their future productivity and discounting their future cash-flows allows them to be objectively valued. By contrast, valuing jewels like gold is a...

    13
  • Gavekal Research

    Red Herrings, Margin Calls And Heart Attacks

    Most recent commentary we have read suggests that January’s turmoil can be blamed on either the slowdown in China or the fear of an impending US recession. But let us suggest an alternative: these are red herrings which only distract from the real analytical challenges faced by investors.

    4
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    Gavekal Research

    Anatomy Of The Bear

    I wish I shared Anatole’s degree of conviction. In yesterday’s Daily he set out his belief that the current sell-off in financial markets is not the start of “a structural ‘bear market’, still less a structural Ursus Magnus likely to last for many years” (see Is Wall Street In A ‘Bear Market’). I am not so sure. I suspect that what we are witnessing may indeed be the emergence of an Ursus Magnus, the sort of bear market so deep and prolonged...

    2
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    Gavekal Research

    Is Wall Street In A “Bear Market”?

    Charles has boldly defined a serious bear market as a downtrend in which investors who buy at the top do not recover their money for four years or more. By contrast, he dismissed a -15% to -20% decline lasting less than 18 months as a mere bear cub that could equally well be described as a “pause that refreshes”. In my view the present decline it looks rather more like “cub” than an Ursus Magnus.

    4
  • Gavekal Research

    Who Is The Marginal Buyer?

    Notwithstanding yesterday’s equity market rally (carried over into the Asian morning), the behavior of risk assets over the past month begs the question of whether a big financial actor is seriously “sick”. The constant plunge in commodities, the relentless rise in spreads and an inability of all major equity markets to hold on to a rally suggests that someone, somewhere, is just “puking” a massive portfolio (as AIG did in 2008).

    3
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    Gavekal Research

    Here Comes Daddy Bear

    For the last few months I have been concerned that a bear market was likely to unfold. It is my considered opinion that we are now on such a trajectory. Of course the next question has to be what kind of bear market, for history suggests that such episodes come in two distinct extremes.

    2
  • Gavekal Research

    Four Quadrants: The Growth Question

    Charles has been on a near 40 year quest to find a rules-based solution to the most basic of economic questions “what is the current situation?”. He has long used his Four Quadrants methodology which categorizes an economy as being in either an inflationary boom or bust, or alternatively a disinflationary boom or bust. In the first part of this series he proposed a framework to show whether the US was in the inflationary or disinflationary part...

    0
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    Gavekal Research

    Keep Calm And Rebalance Into Equities

    The investment environment has not fundamentally changed since December. Then as now, the situation neither justifies being “all in” nor “all out”. Since the economic situation is worsening, a balanced portfolio of some type makes sense—unless there's evidence of a looming US recession. In my view, that time has not yet come.

    3
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    Gavekal Research

    Looking For The Bright Side

    By most measures, the first two weeks of 2016 have been the worst-ever start of the year for risk assets. With the MSCI All-Countries index down nearly -20% from last May’s high, we are now in a global bear market.

    1
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    Gavekal Research

    High Yield Worries

    Attention may have focused yesterday on the oil price collapse and its knock-on to US equities, but there was also grim price action in the sub-investment grade debt markets—the high yield master index fell back towards its December low, while the CCC-rated index breached that threshold. This pain can be attributed to worsening conditions in the energy sector, where the chance of large scale defaults increases with each lurch lower in the crude...

    2
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    Gavekal Research

    It’s About The Dollar, Not The Renminbi

    In my 50 year career working in financial markets, I have never seen the money supply of one country move across the border to another country. Hence I must confess to being perplexed when reading recent commentary fretting about “capital flight” from China. Never mind that China’s highest denomination bill is RMB100, meaning that a fleet of trucks would be needed to move any meaningful sums into Hong Kong, but the country still has foreign...

    1
  • Gavekal Research

    Four Quadrants: A Wicksellian Analysis

    In 1978, when still young and creative, I produced my first four quadrants chart. The idea was that there are four basic investment environments depending if economic activity is expanding or contracting, and whether prices are rising or falling. It was usually obvious which state we had just left—for example the UK having suffered an inflationary bust in 1977—but far harder to judge what state we had entered. Being able to make such a call in...

    1
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    Gavekal Research

    US Risks

    While China grabs the headlines (Trading halted before 10am after a quick -7% drop, renminbi devaluation fears at fever pitch!...), we will leave those issues for a later report and focus on a question that looms larger for most investors: what is happening in the US economy, and what are the key risks facing the world’s biggest market in 2016?

    0
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    Gavekal Research

    The Last Holdout Of US Value

    Some readers have expressed surprise at my contention that the US stock market is “not that expensive” as their direct experience suggests otherwise. The objection is reasonable, so I have conducted a review of my US equity valuation model. I like to compare equities to a long-dated US zero coupon bond because it has the same annual volatility as the US stock market. Hence, the chart below compares the S&P 500 with the price index of a zero...

    0
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    Gavekal Research

    The Day One Carnage

    “Well, that was an oddly timed report,” one of our long-suffering clients remarked yesterday, with justice. Right after we pressed send on our outlook for the year ahead, assuring readers that China fears and commodity prices would not play as big a role in markets in 2016 as they did last year, the Shanghai index collapsed by -7%, and oil prices had a volatile ride thanks to growing tensions between Iran and Saudi Arabia. Have we been proved...

    0
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