Monetary madness and the world of 'Alice in Wonderland' economics

James Marlay

Livewire Markets

Everything going on is nuts. Greek bonds are yielding less that Australian bonds, QE is on the cards from the RBA and the S&P500 is trading on a lofty 18 times forward price to earnings ratio. It would appear that many of the ingredients for a market meltdown are in place.

Chris Watling from Longview Economics has a different view and reckons market euphoria is only six and a half out of ten, he says growth stocks have further to run and that there’s plenty of reasons to believe that 2020 can be another bumper year for equities.

Watling is not afraid to make counter consensus calls and was one of the first economists to correctly call the RBAs rate cutting cycle over the past 3 years. In this interview, he outlines his current perspective on navigating investment markets in a time of monetary madness.

Image: Chris Watling, Chief Investment Officer, Longview Economics

How would you describe the backdrop setting for markets at the moment? Is it still the central bankers at the decks keeping everyone spinning?

Yeah, I think they are keeping everything spinning. I mean Jerome Powell, his comments in December were quite significant when he, at the committee meeting, said that he thought inflation needed to be significant and persistently above target before they were even going to sniff a thought of a rate hike. That was huge.

I think that was liquidity, central bank largesse, that was just a green light to load up. And quite a lot of hedge funds switched their positions on the back of that from short to long. And we had that whoosh up in December and to January.

They're not the only part of the rally in the equity market, but they are a key part. Absolutely.

What are the other parts?

Well, the other part is the fact that we've got a global economy re-accelerating. Coronavirus is a bit of a hiccup, sure, but the trend is absolutely up.

People get confused because they expect China to do a huge stimulus like they did in 2016, and this is not China's turn to drive the global economy. 

There's really three engines; America, Europe and China. China doesn't always participate in the sort of mini cycle upswings. 

We had one after the Euro crisis, mini cycle upswing globally. We had one after 15/16, and now we're in our third one since then. And of course, after the Euro crisis, it wasn't about China. They were trying to deleverage they were muddling along. You may remember they were absent. '16 they were there, now they're absent.

It's about the Western consumer, the American consumer, and indeed the European consumer more than people realise, are driving this global recovery.

If there's a mini upswing in place, being driven by largely Western consumers, how far into it are we, and what's the evidence to support that that's what's taking place?

I like to think of these mini-cycles as sort of roughly three years. Don't get too precise on it. But, we're in year two. Last year was year one, the classic year one in the mini cycle as the central banks get going. They turn around, they cut, earnings don't really grow, the economy is still slow, but the central banks are providing liquidity.

Year two is really the case for the global growth story upswing becomes more convincing.

What's the evidence? Tonnes of it. US housing cycle, look at housing starts and housing permits, just taking off. They’ve been flat for three years, last few months taking off. The rule of thumb is, if you get housing right, you get the US consumer, right and you broadly get the US economy right. That's good.

We've had an inventory cycle in the States, which is de-stocking and has largely run out. Now we're going to get a restocking, and the labour market in the US remains robust.

It's all pretty good over in the States. Bits and pieces of that in Europe, although it's not as obvious.

2019 was a bumper year. Should we expect another bumper year?

Yeah, for sure. It always makes me laugh because people love the idea, if you had a big year, you're going to have a bad year or an average year. But actually, there's been five years when the S&P has done 30% or more in the last sort of 40 odd, and almost always afterwards it's a plus 15 plus 20. Just because the S&P has gone up 30 doesn't mean it doesn't go up 15 the next year. In fact, we're already up about five or so and we're not far into the year.

Where do you think the value is, or where you want to be positioned at the moment?

Well, I think where the value is always a dangerous concept if you're sort of thinking about the next 12 months, because there's little correlation between valuation and returns.

In fact, that is something that people need to bear in mind. It's zero correlation actually between the S&P PE ratio and the next 12 months returns. Ironically, there's actually zero correlation between earnings expectations for the S&P, and the next 12 months returns.

I think the best value... There may be a little bit of a trade in emerging market equities, a bit of a cyclical bounce globally as China comes back from coronavirus. But, that is a trade not an investment.

I think the main action is in developed market equities and probably in US equities. Because I think the growth stocks, the tech stocks, have got more to go for.

People worry a lot about where they are already. They've gone up a lot in the last six months, the likes of Amazon, Apple... Or less Amazon, but Apple, Google, Microsoft and so on. If you look at the way they behaved in 1999, or in the run up to the NIFTY 50 peak in the mid 1970s, which is when growth stocks were were really strong the last two times, the stocks get to average PE ratio is 60, 70, 80, 90.

Today they are about 29 on average. There's a lot of upside on that metric.

What are the risks that you’re seeing?

Well, what I worry about is bull markets end when the punchball is taken away, when the central banks tighten up money. And at the moment, they're not doing any of that as we know. What worries me is as we get into next year there'll be more signs of inflation and we'll see central banks starting to think about removing the punchball.

Are you seeing any evidence, and then what are things that you think support a case for a potential tick up in inflation?

I think that the case for a potential tick up is absolutely there. If you look at all the data, what we've seen is a tightening labour market really for five years. It sort of ebbs and flows in a tightening trend and it ebbs a bit where the global economy slows down and then it comes back.

You can do some quite clever things. You can strip down the labour market and really look at what's going on under the surface, and you can see that trend much clearer.

I'd say over the last five years, the labour market has really tightened up in America and in the UK and in parts of the West. You can see that in the underlying wage inflation.

The wage inflation trend is up. Now, productivity may come through and masks that, and therefore companies can get away with it. If they're more productive then they don't have to worry about wage inflation so much. That's why it's difficult to know whether it's a one-year trade, a five-year trade. But we can watch that as it comes through. Then there's a real risk that wage inflation starts to influence consumer price inflation, and then the Fed starts to act.

Are there any lead indicators that you find are really great and reliable, and accurate predictor of a tick up in inflation?

The tightness of labour market is interesting. It's not necessarily the best, but it's a good one. I like to strip out consumer price inflation into cyclical indicators and non-cyclical. And if you look at the trend in the cyclical that is trending up, clearly when bank lending starts to accelerate, that's a sign there's a bit of euphoria coming into activity. And that means people are spending more money than they're earning, they're borrowing money. That's a great indicator of inflation.

Those sorts of things are some of the things we look for. Global economy re-accelerating is clearly part of it, and so on.

What's your perspective on Australia right now?

I think Australia's done a lot in the last 12, 18 months to support its economy, and we'll see a smallish bounce because I think the household cashflow will look a little bit better over the next 12, 18, 24 months.

That's kind of good. But what troubles me is I still think there's a couple of underlying trends where the deterioration has continued. It's almost like the confidence in housing has gone. I know the house prices have bounced. Activity hasn't picked up as much as you would've thought. It's had a sort of initial relief rally.

The thing that worries me the most is ute sales. I always think of pickup trucks as a great indicator of what you guys talk of as tradies.

I think when confidence in the housing market's under pressure, you lose a lot of the construction workers on the edge, and the tradies who are involved in that sort of activity. It just worries me that those trucks sales are going down. It's an expression of less confidence, you might see otherwise.

I can see a muddle through with support from a bit more monetary support perhaps post Corona. It might give the RBA cover to do one more cut. Maybe some fiscal support. I know that the governor is nudging the government to do some. And that all helps, but I just think a lot of the oomph in the economy has gone, and it's a bit of a sort of dribble through growth story if you like.

You did say at one stage you thought rates in Australia would go to zero. Is that still on the cards?

Well, effective zero. There's an effective zero bound. We're not far off. The debate was whether it's 50 or 25, and it seems it's now 25 your effective zero, so you're not far. You'll get there in the end and I think you'll end up with QE at some stage for sure.

How will that impact asset prices in Australia? 

Well, what QE really does, first and foremost, is stop prices from going down more. It acts as a counter to deflation. And potentially it then adds some oomph to asset prices as well. What would be most impacted? Probably the currency. It's not good for the currency.

I know the currency is already very low, and I'm not sure I'd go out and short the currency today, but I do think QE would add some downside to the currency from there.

Over the next 12 months, growth versus value, where do you want to have your money and why?

I think growth. I think maybe value gets a bit of a few months pick up trade. It's a nice little trade. But really you want growth stocks because I think we're moving into potentially the kind of slightly euphoric part of the market. People say it was quite euphoric last year, but really a lot of that was catch up, and the last part of the year was perhaps a little bit strong if you like.

I think if you look at late 1998 into March, 2000, the market went up dramatically in certain growth stocks. The tech stocks at the time went up five times in the likes of Cisco, Qualcomm went up 15 times in 18 months, and they ended up with extraordinary high PEs. I think we could potentially be moving to that sort of phase.

If you measure markets on a scale of one to ten for euphoria, where would you put the scale right now?

Right now, on a one to ten reading, and ten is obviously euphoric, one is not. I would probably say we’re on a six. Maybe six and a half. 

When it's six and a half people would look at the valuation and say, well hold on, the S&P is on 19 times forward earnings. It's only ever been higher during the TMT bubble. 

And that's true.

But then you know, if you listened to Alan Greenspan in 1996, he made his famous comment about the markets being irrationally exuberant. And I remember it very well. They sold 3% off on one day and then promptly turned around and went up for four years, and they went up a lot.

It's very easy to look at a valuation and say it's very frothy. But I'd say we're six and a half, I think we could easily have a very good 12, 18 months.

Are government bonds the most expensive asset class? I saw Greek debts yielding less than Aussie debt at the moment, isn't that ridiculous?

Look, you've got to think about cyclical and structural. We live in the world of Alice in Wonderland economics. Where I call it sort of ‘monetary madness’.

Everything going on is nuts.

If you print a lot of money, and retire assets from the public markets onto central bank balance sheets, I call it economics 102 because they don't teach this stuff at university, but it's very simple. It's supply and demand. The supply of assets is going down, and the demand hasn't changed or indeed is going up. People still want to buy stuff, so everything becomes expensive.

Valuation doesn't tell you about timing anything, but it tells you when stuff's expensive, and it's all expensive.

So Greek bonds don't look like they're good value at the moment?

Well, that's not hard to conclude that they're not good value. When they're trading at 1% or less. With a debt pile there was no way the Greeks can pay back, or service really realistically. Stick another recession on top of Greece, or another European recession on the Greek numbers, there's all sorts of trouble.

Then, who's buying Greek bonds?

Well, this is the point. The whole thing is manipulated, isn't it? You withdraw assets by printing money, you create an artificial market. The financial markets, I like to say, they've become the sort of slave of socialism.

There's no proper price discovery in financial markets today, there's manipulation by central banks, by money creation.

The Swiss national bank famously owns ... Is one of the big owners of US tech stocks, and they bought it all with a newly created Swiss francs.

They want to stop the Swiss Franc appreciating so they print Swiss francs, sell them into the market, so the more you print supply, the more you keep the price down. Get dollars, and they wonder what to do with them. They buy Facebook.

This is an extraordinary world. It is Alice in Wonderland economics. It's the White Queen, she can believe six impossible things before breakfast. 

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James Marlay
Co Founder
Livewire Markets

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