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View from Toronto: Betting on Quantitative Tightening Breaking-Bad

01/10/2018 3:44 pm EST


Ziad Jasani

Managing Director and Partner, Independent Investor Institute

How actions in the U.S. affect Canadian markets, where over 75% of Canadian GDP is linked to the U.S. More on global markets fromZiad Jasani of the Independent Investor Institute, writing on Jan. 1.

Q1 2018 Begins with the global economy pointed up on the backs of biblical levels of debt-creation, and with Equity Markets at the top end of uptrend channels.

Can this rally keep going? Yes. However, we should be prepared in case it doesn’t. To that end here are some thoughts on what may take place south of the border that can affect our Canadian markets (never forget ~75% of Canadian GDP is linked to the U.S. and 70% of U.S. GDP is all about consumption.)

Betting on Quantitative Tightening breaking-bad

Global Equity Markets are transitioning to another experimental policy from Central Bankers in 2018: Quantitative Tightening (QT) and interest-rate-normalization. Think of this venture as a polar-opposite-force to the last ~decade of Quantitative Easing (QE) and crisis-level-monetary-policies (ZIRP, NIRP). 

The natural questions into this global-transition are:

  • Will QT will be as negative for Global Equities as QE was positive?
  • Will the Federal Reserve break the bond market by raising rates while wages persistently stagnate?
  • Or, has economic growth reached escape-velocity, such that the addict (Equity Markets) no longer needs their drugs (monetary-policy-stimulus)?’

Equity Markets have arguably “priced-in” the benefit of reform and have likely discounted most of 2018’s upside within the current price-valuation structure. How does that figure when all indicators are pointed up? 

Evidence of this lies in comparing the S&P 500’s P/E ratio to historical norms. Currently, the S&P 500 P/E ratio of ~26 is at a 65% premium to the long-term average of 15.6 (1871 – 2017); and at an 83% premium to the average from 1871 to 1997 of 14, but at the average from 1998 to 2017 of 25.7. Further multiple expansion may be temporarily bolstered (one or two quarters) by the re-patriation and utilization of capital from abroad via share buy-backs or dividend bump-ups; but domestic demand growth (revenue) is a less likely outcome.

Why? Rising interest rates off of historic lows usually mean a slowdown in corporate-credit-creation, especially in the High-Yield Bond (HYG) or Junk Bond Markets (JNK), which are presently grossly overvalued.

This, in turn, leads to lowered business investment, leading to slower growth. Couple this theme with rising rates leading to a stronger USD (UUP) which invariably pressures Emerging Markets (EEM), as they are net-debtors to the U.S. (i.e. they have to convert lower values of local currencies gained from trade to U.S. dollars to repay their debts).

Add to this protectionistic trade policies emerging from the populist-uprisings we’ve seen from Brexit to Trump, all pointing to slower credit-creation, contraction of global-trade and a stronger USD, which usually equal economic stagnation or contraction, not expansion.

Momentum (MTUM) & Growth-Based-Spaces (IVW), anchored by Technology (XLK, IYW, QQQ), have led this bull market. However, these spaces have already started to sell-the-tax-reform-news and pass the baton to Value-Based-Spaces (IVE). 

The rub is that Technology & Momentum-Plays are a significantly bigger market-cap-weight within US markets (~60%) vs. Value-Plays (~40%); making it harder for Mr. Market to sustain new highs without a correction that brings fresh-blood back into the game.

Furthermore, the U.S. citizens are facing highly inflated costs of living (housing, rent), medical care and transportation, while wages remain persistently stagnant for the foreseeable future.


As central bankers pull-liquidity-out and attempt to push-interest-rates-up, U.S. families are less likely to consume the potential ~$3,000 per household in tax-reform savings, but more likely to spend it managing their growing debt-repayment obligations.

As the Fed takes rates up, the U.S. government will likely face higher debt financing costs and deepening fiscal deficits and companies are less likely to pay higher wages as they trade-off labor for AI & robots. 

If the majority of folks aren’t getting paid more, as rates rise, how are they going to consume more with tighter credit conditions?

Prices for goods and services would naturally have to come down, and that usually means margin-compression and lower equity valuations. QT and rate-normalization suggest that toplines (revenue) struggle in “keeping-the-party-going” throughout 2018, which in turn lowers the growth outlook and leads to multiple-compression.

Many would argue that the central banker synchronized growth story has come a little too late in a maturing bull market. The average bull market lasts 9 years going back to 1926 data, and we’re about to complete year 9 in March of 2018.

However, secular bull markets have lasted as long as 15.1 years, but were underpinned by major geopolitical transformation (i.e. Bretton Woods after WW II) or technological innovations (i.e. 80s & 90s microchip, PC, internet). Our current Bull-Market has been funded by biblical levels of stimulus, also known as debt-creation and/or money-printing, all layered onto the taxpayers’ shoulders.

But the growing trend towards populism/nationalism/anti-establishment is likely to curtail further burdens placed on the taxpayer. Furthermore, QE is now transitioning to QT, and Equity Markets are priced-for-perfection heading into this transition.

The Bull remains intact into Q1 2018 as inflation - according to the Federal Reserve - is subdued and stimulus is being pulled at a gradual rate.

But as we approach March 21, 2018 - the next target date for another 0.25% rate hike - we’re expecting trouble for equities and likely bonds.

It’s all about the pace at which the Federal Reserve, ECB, BOE, SNB, PBOC, etc. push rates up and/or reduce their balance sheets, in reaction to inflation picking up. Any sign of back-tracking to QE or lower-rates is likely to raise a “crisis in confidence” for economic growth, invert the yield curve and depress the U.S. dollar.

Temporarily this may be good for Investors especially in commodity-laden markets but bad for Main Street’s purchasing power. However, tightening too fast is likely to break-bad with Equity Markets.

Canada's bank regulator is introducing fresh capital rules.

The Bottom Line: How can we capitalize on this transition to QT (Quantitative Tightening) and rate-normalization?

We expect Equity Markets to remain in their uptrend channels (starting November 2016) through Q1 2018 with a -3% to -5% pull-back closer to the beginning of the quarter. We remain long equities overall, SPY (SPDR S&P 500 ETF) and Value Plays (IVE S&P 500 Value ETF) but temper these holdings with TLT (20+ Year Treasury Bond) and UUP (Powershares DB U.S. Dollar Index Bullish) through most of Q1.

On approach to March 21, 2018 (into Q2) we intend to transition to short equities via SH (Proshares Short S&P 500), EUM (Proshares Short MSCI Emerging Markets), and if credit-creation slows against the Central-Banker-Quantitative-Tightening-Back-Drop, we’ll be shorting High Yield Junk Bonds via SJB (Proshares Short High Yield Bonds) and the U.S. Long-Bond via TBT (Ultrashort 20+ Year Treasury Bond).

If we’re wrong, and credit-creation does not slow down, and inflation remains at bay, and consumers continue to leverage debt to consume more, and companies present optimistic growth projections, we’ll be focused on accumulating Big-Pharma (XPH), Bio-Tech (XBI), Consumer Discretionaries (XLY) and potentially Energy Producers (XLE) & Miners (XME, GDX, SIL); on the Canadian side we’re then likely to be long Energy (XEG) and Materials (XMA), while maintaining holdings in defensive sectors (Telco’s, REITs, Staples, Utilities).

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