Evan Harp sat down with Eric Biegeleisen, deputy chief investment officer at 3EDGE Asset Management to discuss the last few weeks of the market, the bank crisis, and more.
Evan Harp: Obvious we’ve had a busy few weeks in the market. What’s the signal here and what’s the noise?
Eric Biegeleisen: On the heels of 2022 we are no doubt in a volatile environment that is in our opinion entirely orchestrated by the worlds major central banks — particularly our own US Federal Reserve. They were slow to act when inflation was initially elevated and believed they could jawbone their way out of it — classifying it as ‘transitory.’ Instead, inflation took root and then they had to play catchup by aggressively raising rates, the speed and magnitude of which we haven’t seen before. We are potentially just now beginning to witness the effects from this aggressive monetary tightening. Tightening credit conditions, banks unwilling or unable to lend, skittish depositors pulling money from banks — the banks who’ve invested in longer duration/maturity bonds, layoffs, rising unemployment, rising mortgage rates, and more. We also have a debt ceiling that is fast approaching and will no doubt be a flashpoint for political negotiations and brinksmanship in DC.
Given this backdrop, it seems like market participants have not been able to make good sense of things — we have a US equity market that has been fairly range bound since May of last year when the S&P 500 broke down below 4200, and bottomed in early Q4 at 3600. There have been pockets of performers in there though, namely China in Q4, Europe at the start of this year, and gold starting here in March.
Evan Harp: How has 3EDGE navigated all of this?
Eric Biegeleisen: We entered 2022 with an outlook that most equities were overvalued, particularly large cap US equities, like the S&P 500. We also saw flattening and inverting yield curve measures for many economies as we calculate them — this only increased further when the worlds major central bankers began raising rates to fight their own inflation problems — which still persist today. This sets up an environment that isn’t particularly conducive to growth and generating profits — hence our model output was directing us towards minimal equity allocations, and more towards commodities, gold, and for fixed income in short-duration, high quality and inflation-protected Treasury securities while avoiding credit.
Beyond the small pockets of opportunity with China and Europe that I already mentioned, we have dry powder (earning a nice yield finally) and waiting for the opportunity to reinvest, but the conditions or catalysts just aren’t there as we see it currently to invest more into equities at this time.
Evan Harp: Do you see this has a momentary bout of turbulence, or are we about to hit a long patch of truly rough air?
Eric Biegeleisen: While any number of future outcomes are possible based on the actions of central bankers, incoming data, etc., our base case is that the Fed (and most likely other of the worlds major central bankers) will continue to fight inflation by continuing monetary tightening policies by using interest rates increases… But perhaps at a slower cadence and in smaller steps (like the 25 bps they just did) alongside balance sheet reduction — though sidebar: the bank-run maelstrom we just experienced, resulted in the Fed undoing half of their run off since they started last year in just one week! (Peak, 8.9 T in April 2022, 8.3 on Mar 8, 8.6 on Mar 15). This just demonstrates just how difficult it is for our economy to get off the intravenous drug of monetary stimulus that we’ve grown so accustomed to.
In any event, we believe this continued tightening alongside the aggressive tightening from last year may lead to further equity market declines as earnings are likely to disappoint and credit conditions tighten further making it more difficult for consumers and businesses to take out new loans and/or refinance existing ones.
This includes mortgages whose spread over the 10yr has just reached near all-time highs. Unemployment is likely to tick up more and inflation is likely to not reach the Feds preferred 2% target — leaving them in a true rock and hard place conundrum — continuing raising rates to bring inflation down recognizing monetary policy maybe isn’t capable of doing so and potentially tipping the US and/or global economy into a deep recession or depression; or reverse course by lowering rates and expanding the balance sheet to provide relief to firms, increased liquidity, and cheaper financing to get folks back to work, and the economy humming again even in the face of elevated inflation. We don’t envy Chair Powell’s position.
We believe we are well positioned for a Fed that is continuing the fight against inflation. If and when that position changes, we’ll need to adapt to the new environment. Our analysis of the global capital markets dates back to 1870, a good 4 decades before the Fed existed — so we’ve seen a few interest rate cycles!
Evan Harp: What are your biggest concerns and where do you see opportunity?
Eric Biegeleisen: Based on how I’ve laid things out here, I suppose one of our biggest risks shorter-term is that the market finds some renewed optimism that the banking system is fine — nothing to see here, that the Fed will engineer a soft landing with slow/mild growth, not a huge uptick in unemployment, and all while bringing inflation right back down to their 2% target. In this scenario, presumably the Fed would be able to ease up on monetary tightening, and we’d likely see equity markets breakout of this current range to the upside.
As long as inflation continues to fall in Europe, we’ll likely continue to find some level of attractiveness there — however, there are increasingly negative signals coming out of the region too that we must be mindful of and watch for their negative contribution as it may over take the positives from the declining inflation. This is largely focused around the inverted yield curve measure we calculate for the region which continues to invert further as the ECB continues to raise rates at the short-end and while their longer-term bond yields stay somewhat anchored.
Another potential outperformer may be gold. We find real yields move inversely to gold prices and with real yields topping out in Q4 last year, and somewhat range bound since, there may be an overall downward trend here which would be a positive for gold. We‘ve seen quite a bit of gold buying by central banks of late, and just this month gold has broken out of a critical range and breaching $2000 briefly a few days ago on March 20.
Addressing Market Woes
Evan Harp: Do you think anyone has learned their lessons here or is there a systemic failure that has yet to be addressed?
Eric Biegeleisen: I think we’ve seen a cousin of this movie before. The risks that banks took that put them in this position was entirely orchestrated by the regulations that were set for them. It isn’t the banks fault per se that the rules suggest long duration/maturity Treasuries are considered zero risk capital and can be labeled as ‘held to maturity’ such that they don’t have to value the bonds each day. Now a human risk manager within a firm like this would hopefully identify the risk here, and presumably there are better risk managers at many of the other banks out there (in fact, I’m told that the risk manager position at SVB was vacant for some period of time recently). Ultimately, I expect more regulation which will likely make lending even tougher down the road but potentially make the banks safer — at least from this type of failure — and of course may lead to unintended consequences elsewhere within the banking system. But to answer your question — this does seem systemic and the longer the yield curve in many economies remains inverted the higher the likelihood of more bank troubles ahead. Depositors will move money to higher yielding money market funds leaving bank balance sheets with little liquidity and forced to reduce longer-term holdings at losses.
Evan Harp: What’s your worst-case scenario, and how is 3EDGE planning for that?
Eric Biegeleisen: I suppose a worst case scenario for the economy is a market that has lost confidence in the Feds ability to bring inflation in check while not causing a recession or worse. If they continue to raise rates or even pause and hold for a bit; and inflation doesn’t budge or even ticks up, they have a real problem on their hands. If unemployment ticks up in a meaningful way while inflation continues to be elevated, they have a real problem on their hands. In a more dire circumstance perhaps, their aggressive rate hikes à deflation
Evan Harp: What’s the best-case scenario, and how likely are things to break that way?
Eric Biegeleisen: In a best case scenario for markets, the Fed gets the job done or close to done all while we muddle through with slower but maybe still positive growth, maybe flat-ish earnings. They slowly lower their interest rate towards a long-term call it 2 to 2.5% while reducing the balance sheet slowly and the market takes off to new highs! We are not particularly optimistic on this scenario, but its no doubt a non-zero probability. And maybe Russia leaves Ukraine; China leaves Taiwan alone; and Israel and Iran patch things up! Non-zero probability, but not particularly likely.
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