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...there are reasons to believe the current equity sell-off will be relatively short-lived. Moreover, heightened fears suggest a near-term bottom may be close. As a result, investors might consider taking some profits on hedge positions in the Vix. Once a decline in realized volatility confirms a market bottom, they should rebalance back into US equities, preferring large-cap value stocks, especially banks, to minimize the drag from higher yields (see US Equity Transitions). Beyond this, however, they should continue to maintain hedges, as monetary tightening and narrowing budget deficits suggest heightened volatility will be more common in the medium term. Vix futures remain the preferred hedge
For the first time in a long time, we agree with Jeremy Grantham – equities likely need to correct quite significantly. Here are some simple mental models. The cyclically-adjusted Shiller price-earnings (p/e) ratio is sitting at 37 times compared to its long-run mean of 17 times and median of 16 times. The only time in the last 150 years it has been higher was just before the 50 per cent drop in US equities during the ‘‘tech wreck’’, which resulted in the Shiller p/e falling from 44 to 21 times.
If we suppose that it is reasonable for US shares to normalise back to their pre-pandemic peak on the basis that investors incorrectly extrapolated ultra-low inflation and 10-year bond yields in perpetuity, stocks would need to adjust downwards by 28 per cent.
If we consider a more serious downside scenario whereby equities mean-revert to their December 2018 level (which is when the Fed last had its cash rate at a ‘‘neutral’’ level of 2.5 per cent), shares would have to drop 48 per cent. There are many shortcomings with this analysis. One of the biggest is that this time is different to the recent past in so many ways. Unfortunately, that point of difference implies even greater downside risk.
When was the last time you can remember a US president egging on the Fed to crush inflation and raise interest rates? When do you last recall inflation being a major US political issue? The post-GFC period has been defined by politicians trying to strong-arm central banks into easier, not tighter, policy settings.
Of course, President Xi Jinping is begging the Fed not to hike interest rates given his currency is pegged to the US dollar. Further, China is, like the US, home to hordes of ‘‘zombie’’ companies. In the US, zombies represent roughly 15-20 per cent of all listed firms. These are entities that do not have enough money to service the interest repayments on their debt using existing earnings. Heaven help them if rates rise sharply, as they are now doing. In China, the state has been the primary backer of many of these entities, which can only survive with access to this artificially cheap public sector funding.
China’s latest economic challenges were on display this week with the release of its annual economic snapshot for the year just ended.... headline 2021 GDP growth rate of 8.1 per cent beat forecastsPeople’s Bank of China’s (PBOC) surprise interest cuts on two key lending rates. While flagged by policy-makers late last year,China and the United States are not only moving in opposite directions in the way they manage the pandemic, but they are now at odds over monetary policy.‘‘The Fed and the PBOC are very likely going to be moving in opposite directions in 2022, and that in itself is pretty remarkable,’’ Bloomberg’s chief economist, Tom Orlik, predicted in a December podcast. He notes that the Chinese yuan was historically tied to the US dollar, which meant the PBOC had to raise or lower rates when the Fed did, regardless of economic conditions.‘‘Now, after a decade of careful, painstaking reforms, the renminbi is much closer to a free-floating currency and that has given China’s central bank a new degree of freedom on how it manages monetary policy. We already see them using it,’’ Orlik says in comments that resonated this week.China is the world largest producer of gold, and the worlds smallest seller of goldBut this week Xi was back before Davos, held online for the second straight year because of the pandemic, with a new message. This time he was positioning China as a leader in global monetary policy. In an unprecedented move, he told the United States and other rich Western countries they should not raise interest rates when developing countries were saddled with huge debt...which they cannot repay. Same old game by the west, so smart to offer a better game for the developing countries, which is what China has been doing for a decade or more now.The global financial system does sadly need more rigour and structure and the US, which is near in civil war with a President who has one of the lowest public press conferences for a president (thank goodness), has shown they are not up to the job, to proceed.We live in velly interesting times? I am again! expecting good times for gold.the gnomeps lets not mention the shenaikans going on in the Ukraine?