LOOK OUT- yield curve inverting! Falling stock prices ahead? A golden opportunity?

If interest rates are like gravity that pulls stock prices lower, then earnings growth is like a rope to haul them higher. When interest rates are on the rise the difficulty is in determining which will out match the other. This has caused the market to lurch forward then backward as traders find an equilibrium. After starting the year off with a strong upward trend, the market dropped sharply at the end of January then rose again in February and dropped in March. Each time the market rose and fell by a little less as it found purchase on the underlying earnings growth as the Federal Reserve raised interest rates. Interpreting signals from the market, the Fed slowed its pace in March and put off another increase. The "second order effect" of rate policy or the "rate of change of the rate of change" was undermining the good earnings outlook. The Fed was clearly paying attention. Now that earnings growth has caught up the Fed may start moving rates higher again, inflation is on the move.

The CPI (Consumer Price index) has steadily increased over the last six months and has moved noticeably above the FED target rate of 2.0%. At the start of 2018 the year over year CPI rate was just 1.7%. It has risen month by month to an annual rate of 2.8% in June. At the current rate of change the CPI will reach 4% by year end, a rate not seen since 2012. As inflation increases it puts a downward pressure on the buying power of the dollar in the US, but strangely, since May the dollar has risen roughly 5% in value against foreign currencies. The US has approximately $10.5 trillion dollars of currency outstanding, of which $1.2 trillion is located outside the US. A simplistic calculation would suggest that over the course of one year a 3% inflation rate would diminish dollar buying power in US terms by $280 billion. Meanwhile, a 5% increase in the relative value on the foreign exchange would increase external buying power by $465 billion. This at least partially explains the reduction in the balance of trade deficit. Also, no doubt, you have noticed that the foreign index ETFs that I recommend have gotten cheaper in the last few months. Mostly this is due to what has happened to the Chinese currency (the renminbi) and its stock markets. Which leads me to the odd behavior of the price of gold and how it has historically behaved during periods of inflation.

Gold is considered by some to be a haven for wealth because it has tended to maintain its value over long periods of time relative to fiat currencies. More recently it seems to have done just the opposite. To understand why we must step back 10+ years and look at who the largest buyers and producers of gold have been. World production of gold peaked in 2000 and fell for 8 years, during which time its price doubled, due to diminishing supply and the raising demand of China's reserve bank. Since 2008 world gold production has increased by nearly 50% and the price has tapered, down 30% due to the greater supply. China is still one of the largest buyers, and not surprisingly, is now one of the world's largest producers. China produced roughly 50% more gold in 2017 than the US and 30% more than Australia. China's reserves are still just a fraction of the world's total supply. Fort Knox holds as much gold as Germany, Italy, and France combined and over 4 times as much as China. China's high production rate has taken a lot of the pressure off the price of gold, and interestingly, over the last year the renminbi/dollar exchange rate has started to behave a lot like the price of gold.

It seems, because of the threat of a US-lead trade war, many diversified international ETFs are down for the year due to their exposure to Chinese stocks. The Chinese stock market is down roughly 12% and the renminbi (and gold) is down about 7% (in dollar terms) over the last three months. Vanguards All World ex-US index ETF (ticker: VEU) is a perfect example of this exposure. Because of this, in April, I did something I have done very rarely in the 10 years I have been running my index ETF model. I made a change. I swapped out the Vanguard All World ex-US ETF for Vanguard's Developed All world ex-US index ETF (ticker: VDU). There was too much overlap between the VEU and the Vanguard's Emerging Market ETF (ticker: VWO). Both ETFs have exposure to the same big Chinese tech stocks, and while their contribution was small at first, China has grown, and companies such as Alibaba (ticker: BABA) and Ten Cents Holdings (ticker: TCTZF) have become significant. Rather then try to straddle the fence with two ETFs holding the same stocks I chose to concentrate the effect in one, the VWO, while retaining the same international exposure through the VDU. Over the long run this will provide better performance from the ratcheting action of re-balancing. No one likes the idea of a trade war. Trying to guess how policy makers are gaming out the various trade tariffs to figure out where the bottom of the market will be is fruitless. The VWO has 36% of its investments in the Chinese market making it one of the most volatile in the model. BUT, much of the worlds growth is coming from that side of the planet, and the average stock in the VWO is trading 13 times earnings and growing at 12%. The power of compounding will eventually drive these shares higher. Use your stronger dollar to buy while its relatively cheap and take advantage of its volatility to rebalance when it moves higher. If you already have a long position, consider accumulating a few more shares in the $42 or better range and trimming your position when it moves closer to $48 or better. This ETF has performed poorly relative to it US counterparts over the last five years, but its volatility (50% more than the broad US market) has added performance through the ratcheting action of re-balancing. Buy low, sell higher, buy low, sell higher. Just the simple act of re-balancing can make a poor performer add value, and it chucks off a dividend while you wait. That is better than gold!

Something to consider

Unlike the US many of the worlds developed nations have a consumption tax, or a VAT(value add tax). Consider that with the income tax cut the administration can offset the revenue loss with import tariffs. The US imports of the order of $2.3 trillion of goods and services. A 10% across the board tariff on all imports would effectively be the same as a VAT that collected $230 billion a year.