I’ve never been known to be a gold bug. But even I can see that, in this climate, it makes sense to buy a bit of gold, or even build on your position.
You see, all signs are pointing to a market correction.
And while gold has lost some of its luster in terms of serving the role of a safe haven, it’s still an asset class that investors can turn to during market upheavals.
In fact, gold has actually been performing fairly well over the last few weeks, holding above $1,200 per ounce as concerns in the markets grow. And those worries will only get stronger in the weeks ahead…
So, what is the nature of this unsteady market we’re all in?
Big Crowd in a Small Room
Well, for one, there are fears of an illiquid bond market.
Fixed-income markets are jittery over headlines warning investors about a looming liquidity shortage in corporate bonds and the credit markets in general.
Should a liquidity dearth materialize to any measurable degree, the stakes will be high for traditional asset managers who are buying up new issues, many of whom are jaded, as they recognize a liquidity shortage, but have yet to feel its effects.
New bond issues have also been rising at a rapid rate.
The current $7.8-trillion corporate bond market is 65% larger than it was in 2008, according to the TABB Group. At the same time, the amount of liquidity that dealers can provide to secondary market makers in U.S. investment-grade and high-yield bonds is approximately 21% lower.
The capacity to absorb investor selling has shrunk significantly, too. Dealers have reduced the number of counterparties that they transact with, and many buy-side firms are holding similar corporate bonds in a classic, crowded-trade scenario.
Sure, there are a number of new e-trading bond platforms and liquidity pools, but those platforms will likely be consolidated as it becomes more difficult to survive.
Furthermore, the U.S. bond markets continue to sell off as yields climb.
This Tuesday, the yield on the benchmark 10-year Treasury note rose to a year-to-date high of 2.303%. Meanwhile, the long, 30-year bond yield was also up five basis points at around 3.07%. Yields, however, pared some losses on Wednesday after the Fed minutes indicated no rush to raise rates.
So, will a rate hike trigger massive selling in a crowded room full of bonds exiting through a very narrow door?
Potential for Correction
Currently there’s a huge disconnect in the stock market.
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You see, over the last number of weeks, U.S. equity funds have shown massive outflows, while the stock market has continued to climb to record highs.
According to Bank of America (BAC), U.S. equity funds have suffered $100 billion in outflows in 2015, tumbling to levels not seen since January 2008. More fund managers are trimming their equity holdings to be underweight as confidence in corporate profits dwindles.
It begs the question, if money is flowing out of U.S. equities, then where is it going? And furthermore, who is propping up the stock market?
The first answer is European, Shanghai, and Japanese equities. Money is pouring into these equities because the marketplace sees a greater return there due to ongoing government stimulus on both sides of the continent.
Secondly, support of U.S. equity indices appears to be coming from large asset managers – like pension funds, sovereign wealth funds, and central banks – whose portfolio managers don’t concern themselves with weekly data and other market “noise.”
It’s likely that the allocation models of these asset managers will dictate that a hefty percent of their portfolios should stay in U.S. equities because market indicators, while not great, are still okay. Plus, there’s very little yield available in fixed income.
To add fuel to this market disconnect, a sharp drop in U.S. consumer confidence in early May underscored a lackluster economic picture for the United States. This drop was highly unexpected by the markets, predicting a reading of 96.
The actual number was 88.6.
Truly, it seems the equity market disconnect, along with softening consumer confidence, looks to be a big red flag. This means our prized 18,000 Dow Jones level may break yet again on the downside.
Rate Hike Spotted Through Clouds
U.S. interest rates have remained at rock bottom, and have been exacerbated by foreign buyers who have been suppressing the yield curve.
But, by now, we all know that tightening is somewhere in Janet Yellen’s cards, even though the actual date remains a big mystery.
One thing is likely, though – when it happens, it’ll probably be only 25 basis points. Still, this will cause market volatility, despite its already being priced into the markets.
Lastly, Tuesday’s news of a surge in housing starts to a seven-year high was yet another sign of a potential tightening by the Fed.
So what should you own if bond holders run for the fire door, the stock market sees a major correction, and the Fed’s tightening finally come about?
Gold, at least for the near term, makes a lot of sense.