Welcome to 2017.
Expect market volatility to creep higher into the New Year as investors take profit. I am positioned for a rise in long-duration Treasury bonds, which appear extremely oversold near a support zone. My current holdings are starting to reflect the base-case of complacency along a cycle shift. I begin with a look at the implied market risk premium, which was mentioned by Bundesbank VP Claudia Buch in a November '16 interview. Buch stated that a low ERP reflects a false sense of security that is tied to a period of prolonged monetary easing. The combination of stretched U.S. equity valuations and several indicators of complacency results in a bullish outlook on Gold and international equities vs. government bonds.
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Markets do not reflect underlying risk
The decline in equity risk premium reflects a false sense of security. The ERP measures the expected return that equity investors demand over and above a risk-free rate. Some argue the Federal Reserve engineered a declining ERP; enhanced by prior deflationary forces such as the decline in both commodity prices and government bond yields. Such complacency will likely trigger a greater risk premium as Western economies shift from a period of monetary easing to monetary tightening.
For example, long maturity loans issued by European banks at such low rates is a concern. Banks will have to pay higher funding costs as short-term rates rise, which narrows the interest margin. The observation by Bundesbank VP Claudia Buch helps us understand the shifting rate cycle, which could be the starting point of a significant unwind of risk.
U.S. Equity valuations are stretched
A high level of complacency is also reflected in stretched valuation levels. The Shiller P/E ratio is around 60% higher than fair value, and recently exceeded 2007 levels. Shiller P/E is a valuation metric calculated by price dividend over an average of the past ten years of earnings, adjusted for inflation. Stretched valuation levels suggests a low to negative implied future annual return for U.S. equities.
Treasury bonds oversold as yields hit resistance
'Equity Bulls' and 'Bond Bears' will continue to take profit into the new year. Investors should come to terms with long-term impacts of a shifting monetary cycle. A rally in long duration Treasury bonds from extreme oversold levels should slow the spike in yields. The chart below shows the 10-year Treasury yield at a key resistance zone.
U.S. Equities preferred vs. long-duration Treasury bonds
A short-term rise in bond prices does not warrant a sudden shift away from equities. The breakout in the S&P 500 relative to long-duration Treasuries will likely re-test support at the start of 2017 and continue an uptrend.
Hedge with Gold - further upside ahead
The final result is a bullish outlook for Gold. An expected rise in market risk premium will trigger a re-pricing of risk assets into a cycle shift. Gold provides an alternative as both bonds and equities remain distorted from a prolonged period of monetary easing. The chart below shows the Gold price positioned at a key support level. If confirmed, a strong upside wave will follow. This is expected as the U.S. Dollar begins a downside corrective phase. With gold as a hedge, the hunt for attractive equity valuation will begin abroad.