11:14 EST / Nov 24

Fed officials are taking care to leave a smidgen of doubt about the outcome of the mid-December Federal Open Market Committee. But markets will be shocked if the FOMC does not go through with an initial interest rate hike this time after the rhetorical buildup they’ve heard.

Numerous officials have given strong indications that they are ready to support a Dec. 16 rate hike. Others have talked about going into the meeting with an open mind, as one would expect them to do, but they too have indicated they are prepared to raise the funds rate on the seventh anniversary of the zero lower bound.

Fed Chair Janet Yellen, who not long ago told Congress a Dec. 16 move is “a live possibility” which the FOMC is “actively considering,” kept the ball rolling Monday in a letter to consumerist Ralph Nader. She said she and her colleagues “all hope and expect that the economy will continue to expand, that the jobs market will continue to make progress, and that inflation will move toward our 2 percent price stability objective. If that is the case, my colleagues and I have indicated it will be appropriate to begin to normalize interest rates.”

San Francisco Fed President John Williams, Yellen’s top advisor when she ran that Bank, professed open-mindedness in a Saturday session with reporters, saying he is “going to go into that meeting with views, with analysis in my hands, listen to my colleagues and come to a conclusion based on our discussion.”

But Williams, an FOMC voter, said the FOMC’s Oct. 28 decision to stay on hold was “a close call” and strongly suggested that data since then meet the Committee’s liftoff conditions. “The data, I think, have been overall encouraging, especially in the labor market. The data show that the hiccup we saw in a couple of Labor reports has reversed. We’ve seen other signs that the economy is on a good track. And I would say the inflation data have been consistent with inflation — core measures of inflation — having stabilized and maybe even starting to firm up. So I think these are all encouraging signs. And assuming we continue to get good data on the economy, continue to get signs that we’re moving closer to achieving our goals and gaining confidence in getting back to 2% inflation over the next couple of years, then I think…if that continues to happen there is a strong case to be made in December to raise rates.”

At a San Francisco Fed conference last Thursday, Fed Vice Chairman Stanley Fischer did not flatly predict a Dec. 16 rate hike, but dropped plenty of hints that liftoff is probable on that date. at that time is a strong possibility. “In the relatively near future probably some major central banks will begin gradually moving away from near-zero interest rates,” he said. “While we continue to scrutinize incoming data, and no final decisions have been made, we at the Fed have done everything we can to avoid surprising the markets and governments when we move…”

Indeed, Fischer noted, “several emerging market (and other) central bankers have, for some time, been telling the Fed to ‘just do it.’” He said “we don’t take orders form other places, but we have to listen.” And he said the fact that other countries are saying “just do it” is “an important indicator they’ve made their preparations.”

Fischer cracked that when he first joined the Fed Board of Governors in May 2014, he had trouble “getting excited” about talking about interest rates at each FOMC meeting, “but now it’s getting exciting and interesting.”

Even dovish Fed Governor Daniel Tarullo may be having a change of heart. Ahead of the Oct. 28 meeting, he “wouldn’t expect it would be appropriate to raise rates” this year. He did not say he now favors a rate hike before the end of the year Monday, but neither did he vocally oppose it as he did last month.

Tarullo simply declined to say whether he would support a rate hike in December when he appeared on Bloomberg TV. “I think it is a mixed picture,” he said of the economic outlook. “We have seen continued improvement in the labor market, but the environment for inflation is still one where there is a lot of uncertainty.”

Tarullo conceded that economic conditions have improved and downside risks lessened. He said there now is “a fair amount of balance and the data goes both ways.” By contrast, in September there was “some sense” the economy could slow further, but “what we have seen since then … is not the realization of some of the fears that exist in September.” The economy “has shown, by the latest jobs report, to still be chugging along with modestly above trend growth,” he said.

“It is hard to overlook the fact that both market-based measures of inflation compensation and survey-based measures of inflation expectations are sort of near historic lows,” Tarullo said. “We are not meeting the Fed’s own stated inflation target.”

But, of course, inflation does not have to be at target for the FOMC to begin normalizing interest rates. Policymakers need only be “reasonably confident” inflation will reach 2% “over the medium term,” i.e. in two years or more.

Begging off saying when the FOMC should lift off, Tarullo said, “there has been an awful lot of talk about specific months over the last year … . There is probably too much attention being paid to particular months and meetings,” he said, “and not enough attention paid to what is going to be the trajectory of rates.” He did not sound much like a man who would dissent against a rate hike if that’s what Yellen wants.

Bloomberg News
November 18, 2015 — 10:00 AM AEDT

The high-drama highway arrest of a prominent hedge fund manager. Seizures of computers and phones at Chinese mutual funds. The investigations of the president of Citic Securities Co. and at least six other employees. Now, add the probe of China’s former gatekeeper of the IPO process himself.
The arrests or investigations targeting the finance industry in the aftermath of China’s summer market crash have intensified in recent weeks, creating a climate of fear among China’s finance firms and chilling their investment strategies. At least 16 people have been arrested, are being investigated or have been taken away from their job duties to assist authorities, according to statements and announcements compiled by Bloomberg News.

The authorities’ goal is to root out practices such as insider trading as part of China’s anti-corruption campaign, and a desire by “some in the political leadership to find scapegoats to blame” for the market crash, according to Barry Naughton, a professor of Chinese economy at the University of California in San Diego.
“Together these are creating uncertainty and anxiety that can only undermine the effort to make these markets work better,” he said by e-mail.
New Products
Chinese authorities have long encouraged funds and brokerages to create new investment products to keep the finance industry along a development path. Now that’s been halted by regulators’ raids, arrests by police and anti-corruption investigations of even regulators themselves by the Communist Party’s disciplinary committee. JPMorgan Chase & Co. and Credit Suisse Group AG have scaled back products that allowed foreign investors to bet on stock declines. At least one Chinese research firm has withdrawn information it used to provide to the market, calling it “too sensitive.”
The government’s response to the market crash was intervention: state-directed purchases of shares, a ban on initial public offerings and restrictions on previously allowed practices, such as short selling and trading in stock-index futures. Next, high-ranking industry figures came under scrutiny as officials investigated trading strategies, decried “malicious short sellers” and vowed to “purify” the market.
Policy makers say “now we’re innovating, so you can all come in — using high-frequency trading, hedging, whatever — to play in our markets,” Gao Xiqing, a former vice chairman of the China Securities Regulatory Commission, told a forum in Beijing on Nov. 6. “A few days later, you say no, the rules we made are not right, there are problems with your trading, and we’re putting you in jail for a while first.”
‘Hardly Predictable’
“That makes our markets hardly predictable — such rules won’t bring stability,” said Gao, who later led China’s sovereign wealth fund and now teaches at Beijing-based Tsinghua University.
The products scaled back by Credit Suisse and JPMorgan are called synthetic shorts, which enabled clients to indirectly wager against Chinese stocks through Hong Kong’s stock exchange link with Shanghai, according to a memo to investors seen in September and people with knowledge of the matter. A scarcity of stocks that could be used for synthetic shorting led to limited usage of the product, said one of the people. The banks scaled back the offerings, which were legal, after Chinese authorities restricted short-selling and trading in index futures. Spokeswomen at both firms declined to comment at the time and again when contacted this week.
Stopped Trading
About a third of China’s futures-focused hedge funds had to stop trading as regulators restricted practices such as short-selling. Howbuy Investment Management Co. in September said it stopped providing data on premature fund liquidations because the information was too sensitive. The Shanghai-based fund research firm had previously said almost 1,300 hedge funds closed this year amid the stock rout.

In the latest probe announced last week, Yao Gang, a vice chairman at the CSRC, is under investigation for “alleged serious disciplinary violations,” the Communist Party’s Central Commission for Discipline Inspection said. Known as China’s “King of IPOs,” he supervised China’s initial public offerings until earlier this year, when he changed to approve bonds and futures, according to Caixin magazine. He joins two other CSRC officials being investigated, one of whom, Zhang Yujun, was formerly the general manager of the Shanghai and Shenzhen stock exchanges.
Unannounced Inspections
The securities regulator carried out unannounced inspections of several Chinese investment firms including Harvest Fund Management earlier this month, taking away hard drives and mobile phones, according to people familiar with the seizures. Police in Shanghai also confiscated computers and froze $1 billion of shares in listed companies connected to Xu Xiang, the manager of Zexi Investment known as “hedge fund brother No. 1,” who was arrested Nov. 1 on a highway between Shanghai and Ningbo.
Among Xu’s fellow money managers who performed well this year, anxiety has been palpable following his arrest, according to hedge fund manager Lu Weidong, chairman of Xinhong Investment based in China’s southern city of Dongguan. Lu’s Fuguo No. 1 fund was the best-performer among the 236 Chinese multi-strategy hedge funds from June to August, according to Shenzhen Rongzhi Investment Consultant Co., which tracks the data.
It isn’t uncommon for Chinese money managers to trade on unpublished information, according to Lu. Everybody that ever traded on such tips would “restrain themselves a bit” going forward, Lu said by phone.
“People are worried,” he said.

While Zexi Investment’s Xu kept such a low profile that few knew what he looked like until a photo of him in handcuffs when he was arrested as part of a probe of alleged insider trading went viral on the Internet, he has long attracted attention for his funds’ exceptional performance, which had been “an outlier from a statistical point of view,” according to Yan Hong, Shanghai-based director of China Hedge Fund Research Center.
Amid tumult in China’s stock market, five funds managed by Xu yielded an “astonishing” 249 percent on average this year through September, according to Shenzhen Rongzhi data. The Shanghai Composite Index fell 5.6 percent in the same period, after a 41 percent market plunge since June 12 wiped out earlier gains. His returns prompted speculation about the methods and strategies he used, according to analysts including Hao Hong, chief China strategist at Bocom International Holdings Co. in Hong Kong.
Surpassed Expectations
“The extent of this round of clampdown in the financial industry has surpassed everybody’s expectations,” he said. “Over the longer term, the clampdown on corruption in the financial industry will level the playing field in the market for smaller investors.”
Others caught up in the probes include executives at trading firms Yishidun International Trading and Huaxin Futures, who were arrested after police alleged Yishidun made 2 billion yuan ($316 million) in “illegal profit,” according to a report by the Xinhua News Agency, citing the Ministry of Public Security.
Bloomberg News hasn’t been able to contact any of the 16 individuals through their firms, the CSRC or public records to get their responses to the allegations at any time since the announcement of their arrests or investigations. Officials at all of the companies either declined to comment or couldn’t be contacted. Citic Securities has repeatedly declined to comment on the cases of its employees.
‘It’s Unprecedented’
“We’ve never seen anything like it in the past,” said Fraser Howie, a co-author of “Red Capitalism,” a book on China’s financial system, referring to the scale and scope of the probes. “Without question, it’s unprecedented.”
There have been no shortage of bad practices over the past 20 years, including manipulation and offenses such as insider trading, for the authorities to investigate — had they chosen to do so, Howie said. “It begs the question: where were the investigations in past years?”
Trading volume of China’s CSI 300 Index and CSI 500 Index futures have plunged after authorities in early September raised margin requirements, tightened position limits and started a police investigation into bearish bets. A total of 181 futures funds suspended trading in October amid liquidity scarcity, up from 165 in September and accounting for 34 percent of all funds tracked by Shenzhen Rongzhi, which provides the data monthly.
China entered a bull market this month as investors began returning to stocks. The Shanghai Composite Index has risen 23 percent from its Aug. 26 low.
“Everybody knows that insider trading and market manipulation is something that repeated crackdowns have failed to eradicate in China’s stock market,” China Hedge Fund Research’s Yan said by phone. “It could be just the tip of the iceberg. For this market to grow to a relatively mature level, like the U.S., we still have a fairly long way to go.”

News headline story
By Shuli Ren
According to Bank of America Merrill Lynch, the Chinese government spent at least 1.5 trillion yuan ($234 billion) in the third-quarter alone, buying shares in at least 1,365 stocks – or 49% of the total number of listed shares – to shore up its stock markets. It has since covered most of its losses.
Merrill derived these numbers based on top-10 shareholder information disclosed by companies. It looked at holdings by China Securities Financial Corp. (the official bailout fund), domestic sovereign fund Huijin, the broker-funded Stabilization Fund, as well as the five mutual funds funded by the securities regulator CSFC. Merrill also included in its estimates the 120 billion yuan ETF bought by the CSFC – this number is based on local media reports.
Beijing seems to have recuperated most of its losses. While the government agencies have lost an estimated 224 billion yuan as of the end of September, by November 11, they collectively gathered 44 billion yuan in capital gains – or about 3% – according to strategist David Cui.
The Shanghai Composite Index dipped to a year-to-date low of 2965 at the end of August but was trading at 3563 recently.
To be sure, Merrill’s China bear Cui is not feeling bullish. “Given the potential damage to the PBoC’s and RMB’s reputation, economic growth and long-term financial system stability, we think it unlikely that the government has the resolve to keep buying if heavy selling pressure in the A-share market resumes at certain point,” wrote Cui. Last Friday after the market close, China’s two stock exchanges doubled their margin requirements to 100%. Beijing certainly does not want another multi-billion dollar bailout for liquidity-inspired bull run.
The Shanghai Composite Index pared back earlier losses, down only 0.5% by noon break. The ChiNext Index was up 0.8%.
Month-to-date, the iShares China Large-Cap ETF ( FXI) fell 3%, the iShares MSCI China ETF ( MCHI) fell 2.3%, the Deutsche X-Trackers Harvest CSI 300 China A-Shares Fund ( ASHR) gained 1.9%, the Market Vectors China ChiNext ETF ( CNXT) rose 3.5%.
More at Barron’s Asia Stocks to Watch blog, http://blogs.barrons.com/asiastocks/
(END) Dow Jones Newswires
November 15, 2015 23:43 ET (04:43 GMT)
Copyright (c) 2015 Dow Jones & Company, Inc.

MICHAEL TURNER, STRATEGIST AT RBC CAPITAL MARKETS

“Our first take of the statement is that there is nothing suggesting an urgency for a December cut. December is not any more likely than today. A December cut? Maybe maybe not, our forecast is still for a move early next year.”

ANNETTE BEACHER, HEAD OF ASIA-PAC RESEARCH, TD SECURITIES

“We have a clear easing bias, but the Australian dollar is particularly unmoved and bond yields are also unmoved. So we are wondering why that is the case. To me this it the shift that doves were looking for. But by definition, there is a small disappointment trait, given that 12 out of 29 were looking for a cut so there is that initial disappointment.

“They have left a clear easing bias on the table. The outlook for inflation affords scope so we should see downgrades to inflation on Friday in its statement on monetary policy.

“They decided that the next move is likely to be down. From our perspective, we are leaving the cash rate on hold for December but that meeting is live, just like the [Federal Open Market Committee]. At this stage, we are not calling for a cut until I read the statement to see whether they are balanced or more dovish.”

TOM KENNEDY, ECONOMIST, JP MORGAN, SYDNEY

“They’ve left the cash rates steady but have put an easing bias into the statement. That means there is scope for further easing of policy should that be appropriate.

“They’re saying dollar is adjusting to developments in the commodities market so all is fine on that front.”

JASMIN ARGYROU, SENIOR INVESTMENT MANAGER, ABERDEEN ASSET MANAGEMENT:

“Economic conditions remain stable enough to justify keeping the cash rate on hold, although the RBA has kept open the possibility of future cuts if conditions deteriorate. We think this is the right call for now.

“While the recent surprise increases in home loan rates by the major banks have increased the cost of some loans, this is not the case for all loans. At the same time, a weaker Australian dollar continues to support the economy by making life easier for businesses relying on the sale of goods overseas.”

JAMES MCINTYRE, MACQUARIE BANK

Following RBA decision to leave cash rate unchanged today, Macquarie chief economist James McIntyre now expects the RBA to cut in February.

He, however, thinks that the decision to keep rates on hold in November has increased the prospects that the RBA ultimately cuts the cash rate to 1.50% in first half of 2016. “Ultimately, we remain of the view that the mix of challenges – both internal and external – confronting the economy at present and over the year ahead requires a significantly undervalued currency. Until the A$ pushes into the US$0.60-0.65 cent range, and remains there for an extended period, the risk of further policy support (monetary and fiscal) remains elevated.”

High frequency traders shift to futures markets

High frequency traders are moving more trading to bond and equity futures markets, according to the ASIC’s latest review. Bloomberg

Read more: http://www.afr.com/markets/high-frequency-traders-shift-to-futures-markets-20151025-gki8pq#ixzz3piiGqCDk
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By Tim Cole

Barwon MDA

Investment and finance industry articles often seem to be primarily produced by marketing departments or spin doctors. It is quite a challenge for most of us to sort out truth from fiction at the best of times, let alone when we are bombarded by the likes of Industry Super Fund advertising and similar marketing posing as education.
I mention this as Australia looks to Asia for its future growth, as historically Australia has been focused on all things USD, JPY or GBP. I remind the reader that the premise of the GFIN Barwon MDA investment models is based on capital flow into and out of the US Dollar (USD). Despite impending free trading agreements (FTA) our financial markets are inextricably linked to the USD.

The USA has huge budget and current account deficits, but the world remains highly US dollar centric. Many international currencies are linked to it, and even when people question the AUD strength it is relative to the USD. Of 1,785 active commodities futures contracts, 1,133 are denominated in US dollars. Nearly 90% of the more than $5.3 trillion a day in foreign exchange transactions involve the USD, the same as 25 years ago. More than 80% of trade finance is done in USD, and 60% of foreign currency reserves of the world’s central banks are in USD.

Summarising, there are three good reasons the USD is not about to lose its status as the world’s reserve currency:
1. The greenback is the world’s safe haven. The U.S. government has a long history of honouring its obligations. Rightly or wrongly USA Treasury securities are regarded as the world’s safest investment, and the Federal Reserve is the world’s primary central bank.
2. The size of the market for USD denominated debt securities is unparalleled. No country’s bond markets offer comparable depth and transparency. Therefore, finance markets have thin bid/ask spreads, and large numbers of instruments to hedge USD exchange rate risk.
3. There are no realistic alternatives. What would replace the USD as the reserve currency? Certainly not the Euro, a political experiment between prosperous large countries and profligate smaller ones that still threaten to come apart at the seams. Not the Japanese Yen, the currency of a country that has fought a debilitating two decade fight with deflation and whose budget deficit as a percentage of GDP is more than twice as large as the USA. The Chinese Yuan is not easily tradable and is still government controlled. Switzerland with its Franc is an example of fiscal responsibility but its economy is too small.

Historically, global investors have flocked to the USD in times of crisis, and it’s easy to understand why. The United States is the world’s richest country and is the world’s largest economy and its share of global GDP is growing. Despite forecasts of growth in China and India economies no nation as yet seriously challenges the USA dominance.
During the market turmoil of 2008 the effects of this USD dominance was playing out before our eyes. Call it “risk on/risk off” or “flight to fantasy”, when things are rocky the USD is at the centre of the game.

Pink Floyd’s The Wall is a musical milestone unlike any other. The album’s highly acclaimed release in 1979 was followed by an imaginative tour in 1980-81 and a visually intriguing movie in 1982 of the same name.

The songs trace the tortured life of Pink, a fictional protagonist modeled on band members Syd Barrett and Roger Waters. The storyline begins with his fatherless childhood, domineering mother, and abusive school teachers. Events lead him to become a rock star, only to feel jaded by the superficiality of stardom.

To live free from life’s emotional pain, Pink begins to build a mental wall between himself and the world. Every personal wound is another brick in his wall of exile. As his wall nears completion, spurred by the revelation of his wife’s infidelity, he convinces himself that his self-imposed isolation is a desirable thing.

At first, the gathering of bricks seemed fairly innocent. Now, all that’s left is a giant wall that encloses him from all sides. Pink, unable to arrest his frenzied mind, spirals into insanity.

Tell me,
Is there anybody out there?

Never thought that I would end up all alone,
Everyday I’m feeling further away from home,
I can’t catch my breath,
But I’m holding on.
In the wake of emotional destruction, the gravity of his life’s choices sets in.

Source: Pink Floyd

This has been a tremendous bull market in stocks.

Yet, people still remember what happened during the early 2000s and 2008. Having lived through that period, most of us fear a repeat and will do everything possible to avoid it. In this “avoidance process,” we built a wall of mental detachment to cope with bear market-inflicted wounds.

While the wall helped temper our emotions to the market’s gyrations, it further severed our understanding of the rapidly changing investment environment. In the last six years, the common investor (let’s also call him “Pink”) has missed a lot of opportunities as a result.

With the self-deluding rationale that this time is different, the metaphor of “the wall” makes its first appearance after the spectacular tech crash in 2000. The wall is a defense mechanism that renders Pink comfortably numb to his own mistakes. With bitter satisfaction, he continues his hopeful journey.

It was just before dawn,
One miserable morning in black September ‘08.
Dick Fuld was told to sit tight,
When he asked that his bank be bailed out.
The Fed gave thanks, as the other banks,
Held back the enemy tanks for a while.
And Lehman Brothers was held for the price,
Of a few thousand ordinary lives.

It was dark all around,
There was frost in the ground,
When the tigers broke free,
And no one survived.

The 2008 meltdown etches an indelible mark on Pink. He resigns from the cruel investment world, watching with skepticism and disdain as the market is rescued by the central bankers’ dirty tricks. You can hear him yell out from a lonely bend, “Hey! Central Banker! Leave the markets alone!”

All in all, it just leads to another brick in the wall.

The US housing bust, European sovereign debt crisis, Japan’s deflation demon, China’s hard landing, the commodity crash, and currency wars are all bricks in his ever-growing wall. Every financial wound leads him to drift farther from reality. The more he blocks out the world and retreats into his own ideological biases, the worse off he becomes.

Years of oppression lead to full revolt against manipulated markets. He rebukes central bankers, who he blames for molding freethinking investors into mindless followers. He is eventually typecast in the role of the fear mongerer.

His wall looms so high that it blocks sight of the macro landscape. He can only see the ominous writing on the wall, because the bricks are constant reminders of the kind of pain that markets can inflict.

Pink is left desolate, still waiting for retribution, and completely cut off from the investment world. He feels abandoned by the stock market (too little, too late)…

People keep thinking that we are stuck in a secular bear market and that another lurch down into the abyss is just around the corner. This “availability heuristic” helps explain the abnormally large “wall of worry” that still persists.

The lesson here: we can’t run our portfolio as if a repeat of 2008 is all but certain. Those who did missed this wonderful bull market.

And investors who remain fixated on the ghosts of the deflationary past can’t embrace the possibility of a major secular change.

Tear down the wall!
Tear down the wall!
Tear down the wall!

Investment Observations

It has been my experience that a standard obstacle to maintaining an objective investment stance occurs when we inflexibly adopt a preconceived idea of where the market is headed. This happens all the time. People are slow to change an established view. Everywhere we see signs of confirmation bias – investors overweighting evidence that confirms their prior notions and underweighting evidence that contradicts it.

With Stray Reflections, my trick is simple. I try not to take my eye off the bigger picture and take advantage of the fact that others have. With eyes wide shut, most investors simply don’t expect to see what they are not looking for. I want so much to open your eyes. As per Helen Keller, the only thing worse than being blind is having sight but no vision.

In this Outside The Box, I present my investment outlook and key asset allocation recommendations. I sense a wave of skepticism about the global macro landscape, leading people to underestimate the gains and overestimate the risks.

Riding Out The Deflation Scare

The recent market volatility has been disconcerting, but it does not impact the big picture or my pro-growth investment stance on a 6- to 12-month horizon. It is important to stay focused on the macro themes that are likely to prove durable.

There are compelling signs that we are nearing the end of a valuation-driven correction rather than morphing into a prolonged bear market. While the technical damage has been severe, most markets have maintained uptrends and are still holding above key support levels. I am encouraged by the market’s basing action since the August 24^thvolatility spike, and suspect the correction lows are already in place.

The late-September decline had all the hallmarks of a successful retest, which is defined by positive divergences (new lows in some benchmarks not confirmed by others) and less selling pressure (lower volume and volatility during the retest). Even if we were to see more downside near-term, I feel confident that the worst of the correction is behind us. The NYSE short interest is at the 2^nd highest level ever, which implies that any further selling will be contained.

Source: Barchart.com

Much ink has been spilled over the merits and impact of a Fed rate hike on global markets and the world economy. To my great chagrin, the warnings by some luminaries have bordered on fear mongering, with a chorus among them even calling for QE4.

I find myself in vehement disagreement with this policy prescription. I firmly believe economic conditions in the US, as well as globally, necessitate a December rate hike. The world doesn’t need further stimulus. It needs leadership.

We have reached the point in the investment cycle where the Fed must inspire investor confidence by normalizing policy. Growth conditions are becoming increasingly self-reinforcing, and do not require ultra-accommodative monetary policy.

The household debt-to-income ratio is back to its 2002 level; business confidence has healed; credit is growing at a healthy pace; auto sales are at 10-year highs; construction spending is rising at the fastest pace since 2006; and unemployment claims recently hit a 42-year low.

A Fed rate hike should reinforce the signal that the US economy is in a durable expansion and that macro risks are diminishing rather than intensifying. If Yellen keeps delaying the rate hiking cycle, the equity correction will worsen. Fed dovishness is no longer a reason to be bullish on stocks.

Historically, US stocks have corrected about 10% around the start of the last three Fed-tightening cycles (1994, 1999, and 2004). In our current experience, the correction looks front-loaded, with the S&P 500 down 13% ahead of the Fed’s lift-off.

I am convinced the much-anticipated Fed rate hiking cycle will prove to be bullish for global stocks. The most-discussed risks are often not the ones that end up being influential.

Once the US leads the global policy rate cycle, the discussion and pressure to dial back central bank aggression will emerge in even more countries. That said, major central banks would lag behind the growth curve and maintain a reflationary bias, which is ultimately beneficial for stocks, to the detriment of government bonds in general. The global stock-to-bond ratio should rise as a result.

A Whole New World

There is no shortage of things to worry about, but global growth conditions are currently improving rather than deteriorating. While the manufacturing sector has been uninspiring, it is worth noting that global services PMIs are still expanding. The services industry is far more important to the health of the world economy as it represents around 75% of GDP in the US, Europe, and Japan. Even in China it has now become the major driver of growth and accounts for a record half of GDP. The global economic recovery may pale by historical standards, but it is now on a much better footing than in previous years.

Source: J. P. Morgan

Europe’s economic turnaround is still in its early phase. The combination of a weaker euro, increased bank lending to the private sector, less fiscal austerity, and lower oil prices should yield a positive growth surprise over the coming year. The improvement in the credit cycle will also feed through to core inflation and unemployment, with a lag. Although the euro area unemployment rate is at 11%, hiring growth has been strong and employment posted the largest rise in four years during the second quarter.

German unemployment is around post-reunification lows, and real wages are growing at the fastest pace in more than 20 years. This is an essential part of euro area rebalancing that should support growth in neighboring countries by way of a competitive boost. The Spanish labor market has enjoyed its best year since 2007.

A spate of recent economic data has once again raised the specter of Japan falling through the deflationary trapdoor. Missed in the reporting is that core inflation (which excludes both food and energy) is still accelerating, reaching 0.8% in August. The broadest measure of inflation, the GDP deflator, has been positive for the past five quarters. This has not happened for 20 years. I believe deflation is in the process of ending in Japan.

For Abenomics to deliver on its promise in the long run, there must also be a sustainable transfer of wealth from the corporate sector to the household sector. There are some indications this may happen. The 3.4% jobless rate is the lowest since 1996, while the job offers to applicants ratio is at its highest since 1992. Although recent wage gains have slowed, such labor market tightness suggests this will only be temporary.

The consensus view that Chinese growth has cratered, which set off the surprise currency “devaluation,” is wide of the mark. Although China’s manufacturing PMI has steadily worsened, hard data from industry does not point to a deeper crisis. In fact, Chinese economic activity should strengthen in response to past easing and growth-friendly initiatives. The property market is already rebounding and fiscal stimulus is picking up. Despite the prevailing market narrative – with Chinese hard landing fears at an all- time high – consumer confidence in China continues to rise.

China’s slowdown is nothing new and should be taken as a sign of success, not angst. China’s per capita income (at around $12,000) has reached a level similar to Japan’s in the 1970s and Korea’s in the 1990s, after which both countries saw their growth rates gradually but steadily come down. As China gets richer and the economy rebalances toward services and consumption, its growth will also keep slowing. That said, even at a much slower growth rate, China’s contribution to global growth (at around 1%) will remain the same as during its heady days in the early 2000s because it’s own economy is so much bigger.

The Fed is also not a real threat to emerging markets (EM). EM risk assets have typically faced a major setback when the Fed is actually cutting rates, not hiking. Rather than Fed policy, it is shifting domestic fundamentals that largely explain the fluctuations in EM stocks, bonds, and currencies in the medium and long term.

As there is little indication that policymakers are prepared to introduce the pro-market reforms necessary to reverse the secular decline in productivity and potential GDP growth, EM economies will continue to suffer and defaults will inevitably rise. That said, I don’t expect financial stress in the emerging world to snowball and threaten the global economy and financial system as it did in the past.

EM currencies have been in a downtrend for over four years, investors have shunned EM stocks since 2013, and global banks that have made loans face far tougher regulations and are generally better capitalized. A Fed rate hike will not lead to a disorderly carry trade unwind, an EM debt crisis, and another global recession. Although EM external debt is back to mid-1990 levels, it has declined as a share of GDP, and EMs are less exposed to currency mismatch risks than they were in the 1990s.

Previous Fed rate-hike cycles (1994, 1999, and 2004) have also coincided with an improvement in global trade flows. As the trade cycle regains strength, EM risk assets should recover.

Why So Bearish?

Many investors and commentators view the sharp decline in commodity prices, particularly copper and oil, as evidence that the global economy is about to enter a recession. I disagree with this simplistic analysis and lean firmly on the side of better global growth conditions in the year ahead. The latest deflation scare does not endanger what I consider to be a more durable economic expansion.

According to Anatole Kaletsky, falling oil prices have never correctly predicted an economic downturn. On all recent occasions when the oil price was cut in half (1982-1983, 1985-1986, 1992-1993, 1997-1998, and 2001-2002), faster global growth followed. Conversely, every global recession in the past 50 years was preceded by a sharp increase in oil prices.

The maximum reflationary impact for the global economy from the collapse in oil prices is yet to be felt. IMF estimates suggest that the level of global real GDP rises by about 0.4-0.8% for every 20% decline in oil prices. As oil prices have fallen over 60% in the last 12 months, this implies they could add at least 1% to global growth in each of the next two years.

The US dollar strength in the past year makes the world economy look much worse than it actually is. As the drag from the energy sector diminishes and the base effects from the strong dollar wear off, I expect stocks will be bailed out by a robust recovery in a variety of economic and market-based indicators, including corporate profits. Contrary to widespread speculation, the earnings backdrop will improve markedly in the coming year.

Source: Bank of America Merrill Lynch

Investing in a Post-Apocalyptic World

While risks to my forecast have risen, I remain optimistic that the path of least resistance for stocks will continue to be higher. Two vicious bear markets in under a decade has effectively created a cult of bears, which makes the bullish case even more resolute.

Despite double-digit annual returns in the last six years, investors are filled with pessimism, unwilling to accept that economic growth is attainable or that margins and earnings are sustainable. They seem to have lost faith in the global macro landscape and believe stocks are rising for only one reason: central bankers have artificially induced the rally.

It is amazing how many investors cling to falsehoods even when so many truthful arguments are within our reach.The truth is that the equity bull market is built on profits – not QE. Despite the severity of the 2008 crisis, US corporate profits rose back to record levels just three years after the recession ended.

Unmoved by this impressive development, most investors usually follow up the QE lament by saying that profits are juiced by record share buybacks. Before you buy into this dogma, I encourage you to look at the chart below, which shows total US corporate profits as a share of GDP and the S&P 500. There is no manipulation or financial engineering going on here.

Source: Yardeni Research

According to S&P’s old-timer Howard Silverblatt, buybacks do not increase the S&P 500 earnings per share (EPS). The S&P index weighting methodology negates most of the share count change and reduces the impact on EPS.

At the secular trough in 2009, the trailing 12-month EPS for S&P 500 fell to $40. It has now risen to $108. That’s a gain of 170%. The S&P 500 has increased 200% over the same period. What is so artificial about the market rally? I anticipate further earnings growth (and multiple expansion) before we near the end of this economic cycle.

That said, it is perfectly normal to “hate” the early stage of a secular bull market, where the economy is just emerging from a difficult period. Not until much later – when recognition of an improving economic outlook grows – will people feel confident in greater stock ownership.

In the coming years, I see the potential for larger equity inflows from investors who have distrusted the secular bull market and are likely to eventually capitulate. They will not be able to ignore the frequency of new highs in major indices. I expect global participation to rise and the advance into record territory to broaden further.

Perspectives on Valuation And Strategy

According to BCA Research, stocks are far from the bubble conditions expected at the end of a secular bull market, when secular bear influences take over:

To test whether US equities are in a bubble, we adopted a commonly used statistical technique of price momentum, observing deviations from a ten-year moving average of real prices. A more than two standard deviation divergence was identified as being in bubble territory. The rationale is that the fundamentals might be driving a rapid appreciation in the real price of an asset captured by the moving average. Speculation will drive bubbles beyond the normal distribution around the trend. On this basis, US equities are not yet in bubble territory, and neither are any of the other major markets. Equities were not unduly extended at an overall index level and no sector looked extended relative to their ten- or twenty- year real moving averages. This is in contrast to 2007, when oil and gas failed the test and the end of the 1990s, when almost every sector was in bubble territory.

Source: BCA Research

I see no evidence of dangerous levels of complacency today. Credit spreads – the difference between Moody’s Baa bond yield and the long-term Treasury yield – remain well above the levels reached before the important highs of 1966, 2000, and 2007, when euphoric optimism (and excessive market speculation) was implicit in the narrow spreads.Considering the current low-yield environment, the US equity risk premium remains fairly generous.

The only “bubble” is in the use of the word.

At present, all stock markets are under downward pressure, but this is only a short-term problem in the course of long-term progress. The current risk-off phase should be viewed as an exceptional opportunity to increase exposure to stocks at the expense of government bonds.

The Bond Bull Market Is Over

With many pundits claiming the stock bull market is over, it is surprising how few realize that the bond bull market already ended in Q1. The global meltdown in interest rates is over.

Government bond markets in the developed world have enjoyed their longest and biggest bull market in history. The secular bull cycle began in 1981, and the peak to trough decline in yields is a stunning 91%. The 34-year trend in bond prices has almost been straight up. This has bred an entire generation of real money investors conditioned to buy any dip (in search for yield) and remain invested for the long term.

That said, evidence mounts that we are near the natural end of the secular bull market in bonds.We have completed the long-term journey from one sentiment extreme to the other.

I find cultural mindsets today are exactly opposite to those that prevailed at the end of the great inflationary spiral in the early 1980s. Between 1977 and 1980, the Fed hiked rates from 4.75% to 17.5%, ultimately setting off the secular bull market in bonds. Just as the Fed declared war against inflation in the 1970s, the global focus today is on fighting deflation. Major central banks have dropped interest rates to zero and bought $15 trillion of financial assets.

After more than three decades of disinflation, investors today are obsessed with the potential for a deflationary spiral. They have loaded up on government bonds with complete disregard for the consequences to bond prices if interest rates moved higher. By March of this year, negative-yielding bonds accounted for €1.5 trillion of debt issued by euro area governments, equivalent to 30% of the total outstanding. Half of global government bonds were yielding less than 1%.

Meanwhile, consider that core inflation in Europe has been stable at 1% since late 2013. In the US, the annual core inflation rate has held above 1.5%. What will it take to get rid of the deflationary mindset that has taken hold among investors?

I have warned readers since February that bond yields in much of the developed world have fallen to unjustifiably depressed levels, and that owning government bonds carries major revaluation risk at this stage of the investment cycle.

The US 30-year Treasury yield hit an all-time low of 2.23% on January 30th, 2015. It is at 2.85% now. The German 10-year bund yield reached a record low of 0.05% in April, and is 0.55% today. The US 10-year yield made a higherlow in 2015 at 1.65% (the all-time low of 1.39% was on June 1^st, 2012). It is presently consolidating near 2%.

My base-case assessment is that bond yields will not revisit the lows this year. Even after (1) a 30% plunge in oil since May, (2) China’s surprise “devaluation,” and (3) a vicious selloff in global stocks, the US 30-year yield isstill 30% higher than its January level.

It is notable that government bonds have essentially produced flat returns in 2015 despite the generally risk-off environment. The muted bond market reaction (compared to previous deflation shocks) implies the world economy is more resilient than scary headlines or the persistent dire warnings from pundits would suggest.

Many expect deflation pressures to persist and believe the US economy is on the verge of a recession. We think both fears are exaggerated. As deflation concerns fade and market expectations adjust to a more rosy global growth scenario, yields will climb significantly higher.

On a one-year horizon, the US 10-year Treasury yield should work back toward equilibrium, which we think is above 3%. The US economy is growing at a 2% annualized pace, and inflation should gradually approach the Fed’s 2% target. If Europe experiences mild price inflation next year, say 0.5%, and the euro area economy is able to grow at 1%, the fair value for the German 10-year bund yield is around 1.5%.

The outlook for government bonds remains poor, with current yields pricing in an extraordinarily bearish economic and inflation outcome.

Source: Nordea Markets

As the Fed rate hike nears, we want to be short bonds, not equities.

Since 2009, inflows to bond funds were $1.2 trillion (despite the minimal yields) versus $573 billion to equity funds. According to Bank of America Merrill Lynch, net inflows into bond funds over this period represent a staggering 66% of their total assets under management compared to just 6% for equity funds.

We expect bond outflows to gather pace in the coming months. The inflation cycle has already turned, and it is all but certain that the rate cycle will soon turn higher as well. Treasuries have not done well in monetary tightening regimes, with yields rising in each of the last nine tightening cycles.

Therefore, I see no reason to change our bearish stance on government bonds from a cyclical vantage point.

Source: Ned Davis Research

Bond investors continue to fight the Fed.

Round one of the bond bear market lasted from February 2^nd to June 26^th, when the US 10-year yield rose from a low of 1.65% to 2.52%. Round two of the bond bear may be upon us, with a start date of August 24^th. That day’s mini-panic sent the 10-year yield to 1.9% intraday, before ending the session close to 2%.

Yields will now transition to a sideways range, ahead of an eventual move higher. The Fed tightening cycle, improving global growth conditions, and a repricing of deflation fears will drive the next cyclical upleg in yields. The bond bull market is over.

I anticipate a sustained move in bond yields above the 200-day moving average (currently at 2.18% on the 10-year and 2.92% on the 30-year) as confirmation of our investment stance. Should the 10-year yield break below 1.8% instead, I will need to reevaluate my investment thesis and positioning. The breakdown would stoke fears of a global recession, and lead to an acceleration in risk aversion.

In any case, the prospective return from owning government bonds is not commensurate with the risk. Shown in the table below, a 100-basis-point increase in yields would, on average, deliver an 8.6% loss in 10-year bond prices. In 30-year bonds, the same increase in yields would lead to an 18% loss.

Source: Dan Koh (Bloomberg)

Final Word

Stocks and bonds have risen for six straight years to all-time highs. Yet, I believe both are in dramatically different stages of their secular lifecycles.

Stocks are recovering from their worst decade in history and should see many more years of relatively strong returns. Meanwhile, the era of high bond returns is over, and bond yields are likely in a secular bottoming process that will last many years. The corollary is that the global stock-to-bond ratio will continue to climb.

For exceptional returns in the coming year, it is not enough to just be bullish on stocks, you must also avoid (or short) government bonds.