Higher Rates And Market Risks Require Active, Careful Investment Management

February 7, 2019

Mike Gleason: It is my privilege now to welcome Axel Merk President and Chief investment officer of Merk Investment and author of the book Sustainable Wealth. Axel is a well-known market commentator and money manager and is a highly sought-after guest at financial conferences and on news outlets throughout the world and it's always great to have him back on with us.

Axel it's always a pleasure and thanks for joining us again.

Axel Merk: My pleasure.

Mike Gleason: Well Axel, we want to get your thoughts here as the market seemed to be in a bit of flux. A few months ago, pretty much everyone was looking at three or four rate hikes and for Quantitative Tightening – the reduction of the central banks bond holdings – to continue, but then the higher rates and prospects of further tightening finally caught up to the equity markets. We had three months of sustained selling in stocks late last year and suddenly Fed officials are singing a very different tune. Today they are signaling a much more dovish policy, however we've seen a big rally in stocks, it isn't clear what to expect. Since the equity market seems to be a major factor when it comes to FOMC policy. Tell us what you're expecting here and before we get too much into Fed policy, moving forward which I'll ask you about in a moment, tell us is the selling we saw in the fourth quarter all behind us or is this a bit of a sucker's rally in stocks.

Axel Merk: Sure. Well, I think you're timing is right talking about the expectations we had the end of the third quarter last year about a lot of tightening and to talk market terms, there were very substantial positions on short treasuries, short bonds betting on higher rates. And as investors then looked out towards this year, 2019, they repositioned. Or you can say there was a short squeeze, and you had a significant rally in treasuries. Suddenly this took on a life of its own and the media is never afraid of putting a story into market a move and say "Oh my God! The world is falling apart!" And sure enough, the scare made it all the way to the Fed and our Mr. Powell, who was walking in his dark room and said "Alright, alright. The market once had it a certain way and now it doesn't" and then the moment that switched the market then started on rallying.

A few things here, the U.S. consumer is doing just fine. Maybe they’re going to fall off a cliff, we don't see that yet. Inflation impressions are increasing no matter what everybody is telling you, wages are going up, not just for the C.O. (level), but all the way down the corporate ladder. Yes there are issues in the rest of the world and yes we are late in the economic cycle. And so, what all of that means is that higher rates to me automatically translates to more volatility. So, the high volatility is just natural. Obviously, it may have been exasperated, you can blame the algos, whatever you want, but yes higher volatility is with us. Historically, we don't have a bear market, most of the time anyway, unless there is a recession and I just said I don't think the recession is imminent.

Now that doesn't mean there isn't a risk of one, that doesn't mean volatility isn't high, it doesn't mean investments aren't going to diversify but certainly long in the tooth on this expansion and so everybody may well be prudent to kind of trim things back on their risk exposure and that’s exactly what's been happening. But for the time being, I do think this economic cycle is not over yet. We are late in it. I also happen to think, I mentioned inflationary prices, the Fed is not done tightening. We've gone overboard on that and I think we will likely see two more rate hikes later this year.

So, this back and forth is likely going to continue and it's going to be a bit of a rollercoaster because also, I mentioned higher wages. That obviously hits corporate earnings. Corporate America is exposed internationally, so yes they'll have some headwinds but in the meantime, the consumer seems to be spending happily. Maybe not on housing but on many other things.

Mike Gleason: As we're talking here on Wednesday afternoon, Fed chair Powell just came out with his statement. Tell us what you took from that. Sounds like you're still expecting that we are going to see a couple more rate hikes this year… talk about Fed policy a bit more.

Axel Merk: Well yeah, that was my view and of course my view doesn't matter. It matters what Mr. Powell thinks because he is the one who calls the shots, right? It's not me. I just have my thoughts here. Obviously, Powell has backpedaled quite substantially and they're two things. There is the rate path and then there's this wonderful thing called Quantitative Tightening you refer to. And maybe let's talk about that first.

Remember when Yellen talked about paint drying on a wall when they started on this journey. Basically, they decided the Fed balance sheet is too large, they want to get down but that's about all they decided. They didn't make up their mind of where that journey is going to take them. In my view, they thought that they had until the end of this year or so before they can actually decide how low they want to take the balance sheet so sure enough the market threw a tantrum and Powell said "Okay I get it we got to do something" and at the FOMC meeting he kind of said "we still don't have a clue". He didn't use those words but "yeah we might consider doing something" and that really shows that the Fed doesn't have a plan with Quantitative Tightening. They're in so called 'uncharted territory' and there's no academic framework, no past of framework other than listening to the markets and that's really dangerous because it’s the Fed that's supposed to set what the risk-free asset is. The regulatory risk free asset treasuries. And so, when the Fed just says "hey let the market dictate that" it creates an interesting unstable back and forth. I'm not suggesting that wouldn’t be better if he market did everything but with the Fed in there with a bazooka that kind of creates odd dynamics.

On the other side of it with regard to raise. Remember we are still only just about maybe in “neutral.” Yet unemployment has been going down and wage prices have been going up. At some point, that's not going to work anymore, and I think that'll have to take the foot further off the accelerator. I happen to think that's still on there. Even though we've had hiccups in the emerging markets, where it matters accessibility to loans, financial conditions are just fine in the U.S. and the whole point of hiking is to tighten financial conditions. That hasn't happened unless you’re in emerging markets, unless you're in some bad areas or from a junk area a little bit. But for mainstream America, financial conditions have not tightened and that's why I think they will change their view later this year. Possibly as early as this summer and if you just take what the Fed said, that's part of what markets rallied, that's why metals rallied is because rate hikes are off the table for now and God speed for you. People are thinking "maybe the economy is going to ease up some point.”

Mike Gleason: Yeah happy days are here again I guess at least in the short term. One of the reasons it's great to have you on is that we know you're always keeping a close eye on international markets as well. There's a lot going on in both Europe and China. The Chinese economy appears to be slowing and any serious recession there will have big impacts for all of us and the political turmoil in Europe may also drive markets. What do you see as the biggest developing story internationally that will impact investors her in the U.S. Axel?

Axel Merk: The biggest story may not always be what the biggest impact is. You rightfully mentioned China first. China is just so much bigger so what happens in China matters. China clearly has had a slowdown. They have all kinds of incentives along the way to try to boost that. They’re trying not to actually lower rates so they're actually lowering most of the reserve requirements and have tax cuts. They don't like to lower rates because they don't like to mess with the exchange rates too much. They like to keep that reasonably stable, whatever that means these days with the yuan. And so, there is some slowing down. If they quote unquote 'panic' it means they'll open the floodgates of stimulus but for the time being they're reasonably confident that the stimulus will work its way through. The quote unquote 'bigger story' may well be Brexit even Powell referred to it keep in mind, the good old great empire is about less than 3% of world GDP these days. So yes Brexit matters but it doesn't matter as much as some other things out there.

Similarly, Italy that was the sideshow, mostly a show, and sure there are going to be elections in the European Union and sure the populists are going to get more votes but none of that really changes the global dynamics. Obviously, what does happen on global scale are the trade discussions. The general perception is: there are solutions. They're not going to happen there tomorrow and if you listen to Draghi the head of the European Central Bank, he says “Oh, we downgraded our outlook, but it’s not that we think that we going to be negative outcomes to these many risk scenarios.” That’s what Draghi said, he actually thinks there’s going to be positive outcomes to most of them but because of the uncertainty, the sentiment has been impacted so that's dragging on things and obviously the sentiment is impacted, and that's the same danger with the U.S. consumer of course, is that that might actually then induce slower growth.

All these risks that are out there they're solvable. Brexit most people believe we're not going to haunt Brexit to kick the can down the road. Heard that term before. That's what strong leaders are best at it seems. The world will be around tomorrow in the meantime, American consumers are happily spending.

Mike Gleason: Let’s get your thoughts on what all of this might mean for precious metals. Can you give us a quick summary of what you're expecting in the metals market as we move through the year?

Axel Merk: Yes sure. On gold which is kind of the easiest because of the least industrial influence that's difficult enough to prognosticate about. You've got these two forces. On the one end I see rising inflationary pressures, that's a positive. I see at some point rates are going to go down as a discounting mechanism. The market seems to be giving a boost here to precious metals. Now with that said, I do think rates will move higher later this year. The main buyer in gold that I see these days is one that buys for diversification. When you have higher volatility cash flow gets discounted more. That means the risk assets, stock market in particular, is under pressure potentially but gold historically does well when the stock market doesn't do well. There are exceptions like the early 80's, bear market and that's when real interest rates went up to through the roof. But it is for diversification because gold is really one of the easiest diversifiers… I say easier rather than best necessarily because it has the zero correlation to stocks and it’s far easier to do than some long-short strategy that gives you an uncorrelated return otherwise.

If you go to other metals and other commodities of course the dynamics are far more complex, that's why I really try to stick to gold, especially on a brief analysis.

Mike Gleason: My guest last week talked about how gold is hitting all-time highs in many different currencies. Talk about the currency side of things, the dollar, what you're expecting there because obviously gold is trading in reverse correlation to the dollar in many situations, not always but in many situations. Give us your thoughts there.

Axel Merk: Well, on the day we're talking the dollar index is plunging. Other currencies are rising versus the dollar because of this very dovish commentary and statement by the Fed. And the question really is, and the world was divided on that and that's great because we make the market, where's it going to be heading from here. We've had years of dollar going up. The U.S. was the cleanest of the dirty shirts and what not and it increasingly appears that the market is looking forward to the next easing cycle, whereas the other parts of the world, and I include the Eurozone here, they're still thinking we're on the hiking cycle. We have Sweden who also negative rates for example other than the Eurozone, they hiked rates. Draghi is retiring at the end of this year out of the ECB. I happen to think that as both Yellen and Bernanke were more hawkish towards the end of their terms so will Draghi be and Draghi is actually quite positive in a medium term. The successor to Draghi cannot be as dovish in my view as Draghi is.

And then I happen to think the glass is half full on some of these inflation metrics. On that note by the way, we have low oil prices at the end of last year. If oil prices are not depressed any of this year, the year-over-year effects will show quite significant headline inflation. In the Eurozone, by the way, headline inflation is the mandate. In the U.S. it’s core inflation. But if you look at longer term inflation expectations, they happen to be very correlated to the price of oil. It may not make much sense because obviously in the long-run the price of oil of today doesn't really matter. But as those changes are filtering through, I think inflation expectations will rise. Wage prices will lead to higher wages inflation expectations. So, all of that will get other leaders around also to be a tad more hawkish and it appears to be that is in favor of world currencies versus the dollar that just had such a great ride for several years and so it appears to me that this long bull run in the dollar might be over.

Mike Gleason: Well, as we begin to wrap up her Axel give us any final thoughts that you may have for us today or maybe touch on anything else that you may be focusing on that perhaps we didn't get to already and then ultimately what kind of year do you envision 2019 is going to be for investors? Expand on any or all of that as we begin to close please.

Axel Merk: Well the short of it is higher volatility. Higher rates warrant higher volatility and at the risk if using a technical term that means higher dispersion of risk. Let me expand on that just briefly. When you have Quantitative Easing, the perceived risk was taken out of the market. So, you invested in junk barns and it was quote unquote 'not risky' because the Fed took care of it. Now fear is back and the good news of that is that it matters where you put your money. That means active management will come back, that means the making a choice is actually going to prove you're right or wrong whereas before you just bought the index and everything was great. That doesn't mean that suddenly all the money will go back to active managers. I think that's going to be a long process, but I would not be surprised of this year active managers are going to significantly outperform the industry simply because of greater opportunities there with the greater volatility. Reference the sharks, but I just look at interest rates because when interest rates are higher there will be more opportunities, I think, for the active manager.

Mike Gleason: Well we'll leave it there. Thanks as always Axel. We certainly appreciate your getting your very studied insights and greatly appreciate your time coming on with us once again. Now before we let you go like we always do please tell folks a little bit more about you and your firm and then also how they can follow you more closely.

Axel Merk: Sure. Come to MerkInvestments.com. We publish research charts on the Fed on all kinds of things. We do have some investment products including a gold product. Look around on our site we do a lot of work on currencies. If you want to get my up to date commentaries, feel free to follow me on Twitter or LinkedIn or whatever your favorite social media site is. We're there to help and we can even devise some specialized strategies to take a position on interest rates if that's something somebody's interested in. We do a great deal of things. Also we got a mandate the other day to manage a precious mining fund and that's still subject to shareholder approval but if and when so, we'll be talking a lot more about the specific mining companies down the road as well.

Mike Gleason: Yeah, I think many folks here would be interested in that. Well excellent, Axel. Thanks so much for your time. We look forward to checking back with you before we're long and dissecting the state of the markets again with you soon. Until then take care and enjoy your weekend, thanks for joining us.

Axel Merk: My pleasure take care.

Mike Gleason: Well, that'll do it for this week. Thanks, again, to Axel Merk, President and Chief Investment Officer of Merk Investments, Manager of the Merk Funds. For more information, be sure to check out MerkInvestments.com.

And check back here next Friday for our next weekly Weekly Market Wrap Podcast. Until then, this has been Mike Gleason with Money Metals Exchange, thanks for listening and have a great weekend everybody.


Spanish Conquistadores invaded the Inca Empire in 1528 to steal their silver and gold.

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