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InnOvation Capital & Management, LLC

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SEPTEMBER 21, 2016

Contact Richard Power with comments or questions. IntelDigest is intended for the use of our clients and colleagues.  Material may not be reproduced, forwarded or shared without express permission.

In this issue of IntelDigest, we focus on an update of “Brexit.”  The separation of Britain from the apparatus of the European Union is a major development, affecting world economies outside the geographical boundaries of Europe.

For economic and political reasons, the United Kingdom and the European Union will want to maintain close ties.  The U.K. is still a major European power, and a major trading partner of most of the countries in the European Union.  Approximately 44% of U.K. exports go to members of the E.U., and 53% of its imports come from the European Union.

There are three existing frameworks for relations between the European Union and non-E.U. neighbors, referred to as the “Norwegian” model, the “Swiss” model, and a more open free trade agreement.  All of these are on the table as the United Kingdom negotiates its withdrawal from the Union, while at the same time establishing a framework going forward.  The final resolution may be a different framework entirely, reflecting the special standing of the U.K. in Europe.

The Norwegian Model

Under the Norwegian model, Britain could preserve its membership in the European Economic Area, which allows the free movement of goods, services, people and capital within the E.U. single market.  The U.K. would have to join Norway, Iceland, Switzerland and Liechtenstein in the European Free Trade Association (EFTA).  Such an arrangement would offer many of the advantages of E.U. membership without requiring the United Kingdom to participate in the E.U. Common Agriculture and Fisheries policies, or prohibiting it from signing free trade agreements with outside countries.

Adopting the Norwegian model could be the most expedient and least disruptive action.  It is unlikely that it would result in any punitive tariffs between the parties, and many services, including financial services, could continue unabated.  This “soft landing” would also ease concerns in Scotland and Northern Ireland, where the majority voted to have the U.K. “remain” in the European Union.

However, there are negative factors.  One sticking point … at least for those who voted to “leave” because of immigration concerns … is that this resolution would require Britain to continue to accept E.U. workers.  In addition, EFTA member states are required to contribute to certain parts of the E.U. budget, without having a say on E.U. policy.  Being forced to accept rules that it cannot influence while contributing to a budget that it can’t reform … these were reasons for the Brexit vote in the first place.

The Swiss Model

Switzerland is not a member of the European Union, but it has over 100 bilateral agreements with the E.U. and its member states, so it has ready access to the E.U. single market.  These agreements have been negotiated over decades.

But, this access comes with a trade-off … Switzerland must accept E.U. workers. This is a hot issue. The Swiss public voted in a 2014 referendum to limit immigration from the European Union. The vote specified that the Swiss government must implement the changes by February, 2017.

The Swiss parliament is now trying to prepare legislation that would honor the referendum results without violating the E.U. deal.  The proposed laws would give priority to hiring Swiss citizens for jobs in Switzerland, but impose no rigid limits on immigration.  However, there is stiff opposition in parliament.  And, the European Union is adamantly against such quotas.

The European Union will likely strike a hard bargain with Switzerland on these points, so as not to encourage such concessions in its upcoming negotiations on the U.K. withdrawal.

Free Trade Agreement

A free trade agreement with the European Union would address many of the issues central to the Brexit campaign, giving the United Kingdom full control of its immigration policy and greater control of its foreign policy, eliminating its financial contributions to E.U. structures, and restoring full parliamentary sovereignty.

However, negotiating free trade agreements tends to be a lengthy undertaking, often taking 5-10 years to come to fruition.  In the meantime, trade between the European Union and United Kingdom could suffer … both parties would likely introduce tariffs during any interlude between the U.K. withdrawal and adoption of new agreements.

Also, free trade agreements are easier to negotiate for goods than they are for services.  And services comprise a significant percentage of the British economy.

The Migration Issue

The free movement of people within the European Union has become a hot issue across the Continent, and anti-immigration parties in several E.U. member states continue to lobby for Withdrawal Referenda in their homelands.  This will likely make the European Union wary of granting the United Kingdom access to the single market, while allowing the U.K. to reject E.U. workers.  This would set a provocative precedent for other members.

The Brexit Agreement

Finding a balance between migration policies and market access will be the priority for the European Union in negotiating the Brexit.  Because of the size, relevance, and importance of the United Kingdom in Europe, the resulting settlement will most likely be unique.

The settlement will be shaped by national economic interests on each side of the negotiating table.  France and Germany hope to attract financial services operations relocating to the Continent from London.  The Swedish government recently warned that the U.K. suggestion to entice investors by reducing corporate taxes could complicate its negotiations with the E.U.

On the other hand, countries with strong economic links to the United Kingdom, such as Ireland, will advocate for the broadest possible deal with London.

Negotiations will probably far exceed the two-year period established by E.U. rules.  But, the resulting agreement will probably reflect the “special status” that Britain has retained for generations.

 

 

InnOvation Capital & Management, LLC

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September 14, 2016

Contact Richard Power with comments or questions.  IntelDigest is intended for the use of our clients and colleagues.   Material may not be reproduced, forwarded or shared without express permission.

Over the last three weeks, IntelDigest has focused on The Federal Reserve and its policies … and the similar policies of central banks around the world … because these policies have had an enormous impact on the world economy.

In effect, the central banks have been fighting a futile battle against the business cycle … amounting to not much more than a Holding Action … but the outcome will most likely be extremely negative for lots of people. The Human Cost has already been too high for people who have worked hard all their lives and made sensible financial decisions, but now find themselves falling behind.

In this issue, we will summarize the effects of ultra-low and negative interest rates. In coming weeks, we will discuss asset management, allocation, and diversification; the International Monetary Fund and significant developments in currencies; free trade and protectionism; updates on “Brexit” and related developments; and a variety of topics dealing with finance, markets, government policies, and legal issues.

The primary result of central banks’ creating ultra-low interest rates has been to shift wealth … from savers and retirees to borrowers, and from middle class workers to upper-income investors. In fact, the primary beneficiaries of ultra-low interest rates are governments, which can continue to run massive deficits and continue to borrow at ultra-low rates to fund those deficits.

If only we had some sort of legislative body in this country tasked with oversight of government spending and other fiscal matters!!!

Let’s focus on The Federal Reserve. The stated mission of the “The Fed” is to manage monetary policy “… in pursuit of maximum employment, stable prices, and moderate long-term interest rates.” Over the last eight years, the primary method employed was pushing short-term rates down to levels never before seen, creating a number of serious problems in our economy.

Has this stimulated the economy?

As we wrote in the August 24 issue of IntelDigest

“Interest rates are near Zero or Negative in many places around the world. Central bankers postulated that reducing rates would encourage spending and produce inflation; instead, low and negative rates appear to induce more saving (to compensate for lost interest) and deferred spending (in anticipation of lower prices due to deflation).”

Short-term interest rates are at their lowest point in recorded history! But, lower interest rates did NOT stimulate demand. They did NOT create higher demand for goods and services. Instead, they seem to have reduced demand, as people save more and spend less.

For example, many retirees (for generations) have tried to live off the interest earned on savings and super-safe investments. That is not possible in a low-interestrate environment. In order to earn income, the retiree has to take on more risk in stocks and bonds. He or she would then compensate for the increased risk by trying to save more … to have a bigger savings cushion. This reduces spending, which reduces demand.

Similarly, low rates have a depressing effect on household incomes of consumers and savers. Their savings accounts and pensions are stagnant. Even in relatively wealthy economies, people have to contend with rising healthcare costs, increasing longevity, and uncertainty over pension funding. Households likely respond to lower income by trying to save more.

At the same time, lower interest rates seem NOT to spur corporate investment. Sure, many corporations have borrowed (at very low interest rates) Billions of Dollars to buy back their own stock in the marketplace, but have low rates spurred investment in operations? Investment decisions have financial consequences over many years, and are more influenced by attitudes about risk and calculations of future growth … not so much by interest rates set by central banks.

In fact, some very successful companies have been hoarding cash … for example, some giant tech companies, including Apple and Microsoft, have Billions stashed outside the country for tax reasons. But, even if those tax disadvantages went away, such companies would probably still keep much of that money in cash.

If they determine that they have no good places to spend or invest that money, then the ultra-low interest rates are stimulating nothing.

Has monetary policy been well managed by The Fed?

Arguably, no. In 2008 the whole financial system was on the verge of collapse. The Chairman of The Fed, Ben Bernanke, fought that collapse with a number of tools, including cutting short-term interest rates and adding liquidity. That certainly made sense, under the circumstances, but there is less justification for continuing to reduce rates, year after year after year, until they are close to Zero.

Many central bankers are devotees of John Maynard Keynes. Even Keynes acknowledged that interest rates needed to reflect reality, that they could not be set so low that they inhibited business. Could the central bankers not see that low rates would punish savers and inhibit business?

As Walter Bagehot noted, the purpose of a central bank is to provide liquidity at a price in the middle of a crisis. (Bagehot … pronounced “Badge-it” … was a 19th Century British economist and editor of The Economist). In his influential 1873 book, Lombard Street: A Description of the Money Market, he described the “lender of last resort” function of the Bank of England, a model embraced by The Fed and other central banks. He said that, when necessary, the BoE should lend freely, at a high rate of interest, with good collateral.

In today’s world, central bankers certainly follow the “lend freely” part, but have ignored the rest. Bagehot said last-resort loans should impose a “heavy fine on unreasonable timidity” and deter borrowing by institutions that did not really need to borrow. Instead, central bankers around the world simply prop up banks by lending low-interest taxpayer money, even when management has made bad decisions.

In 2008, The Fed acted in contradiction to Bagehot’s rule, spraying money in all directions, charged practically nothing for it, and accepting almost anything as collateral.

Does The Fed have a plan, going forward?

The Fed .. over the last 15 years, but particularly since the 2008 financial crisis … seems to have been overly concerned with propping up the stock market (NOT in its mandate) and avoiding the recessions which come with the normal business cycle (also, NOT in its mandate).

However, restoring short-term rates to normal and reasonable levels will inevitably slam the stock markets and bring on recession, unless The Fed raises rates gradually over 5-6 years. Is this in the plan? Who knows?

How can Insurance Companies and Pension Funds survive?

Insurers make a profit by taking your money and turning it into long-term loans. They use the money they make, along with your premiums, to cover your insurance risk in the event of need.

Pension funds generate profits from long-term loans to grow the money they need, along with your contributions, in order to pay for your retirement. They have built into their models a reasonable long-term return (from a historical perspective) on bonds and the stock market.

This model can fall apart very quickly in a very-low-interest-rate environment. The returns insurers and pension plans make on their investments no longer adequately fund the promises they have made.

InnOvation Capital & Management, LLC

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INFORMATION FOR THE ENTERPRISE AND INVESTOR

September 7, 2016

Contact Richard Power with comments or questions.  IntelDigest is intended for the use of our clients and colleagues.   Material may not be reproduced, forwarded or shared without express permission.

This week in IntelDigest is a time to pause and reassess, specifically with respect to stock investments. To use a baseball analogy, we are in the 9th Inning of an investment ball game that began in 2009, as the economy began its “recovery” from the last major financial crisis.

I place “recovery” in quotes because the increases in value of stocks and other assets are attributable more to manipulation by the Federal Reserve and other central banks than actual increases in productivity, earnings from operations, or other legitimate business activities.

So, as we enter the 9th Inning, we pause to try to determine if the bull market of the last seven years will come to an end next year …. or next week!

Looking Up?

On the Plus Side (from the standpoint of the stock market), we remain in a historically low interest rate environment, which could remain for quite some time, even if the Federal Reserve raises rates slightly after the Election.

This has encouraged investors to search for Yield in equities, rather than more traditional vehicles. You cannot remain a Fixed Income investor when bank savings accounts and certificates of deposit pay practically Zero and the 10-year U.S. Treasury earns only 1.50%.

Another Plus is that American corporations have been running aggressive and unprecedented stock buyback programs because they can borrow cash at ultra-low rates to fund buybacks. This has buoyed stock prices, and could continue to do so.

You could call this a “Goldilocks economy” … growth is not great, but the economy is growing … interest rates are ultra-low and not expected to go significantly higher for another few years …. inflation is low.

Equities could remain high for several more months

Looking Down!

On the other hand … there are plenty of Red Flags waving, indicating problems in the marketplace:

•   five consecutive quarters of declining overall corporate earnings

•   Bloomberg reported that cash and cash equivalents for S&P 500 companies dropped to a median $860 million last quarter – a three-year low

•   the top 50 companies in the S&P 500 accounted for more than half of that total

•   the remaining 90% of S&P 500 companies have fast-falling cash balances

•   much of that cash has gone to stock buybacks and dividends, but buybacks are slowing, as is growth of dividends

•   as cash balances decrease, companies can still borrow at low rates to keep up buybacks and dividends, but that increases their debt burden

•   Standard & Poors has reported that global corporate debt has already hit three times earnings before interest, taxes, depreciation, and amortization (EBITDA), the highest level since 2003, and nearly three times higher than last year

•   wages are stagnant, and low interest rates make it difficult to save for retirement

•   stock prices of many companies are at All-Time Highs, even as the company fundamentals continue to deteriorate

Add in other disruptions around the world:

•   the U.K. leaving the European Union, and the possibility of other countries following

•   aging populations in the developed world

•   political tensions involving war and migration

•   seemingly-clueless central bankers with enormous power

•   a truly wild presidential election cycle

•   an impending change in International Monetary Fund Special Drawing Rights (SDRs) which could have a severe impact on the U.S. Dollar within the next few years (we’ll discuss this, in more detail, in a late-
September issue)

Re-assess and re-evaluate

So, what do you do? Liquidate everything and go to Cash? Last week … in our discussion of Yield … we set out various investment possibilities, including real estate, gold & silver, and stock options. We will expand on these and other alternative investments … convertible bonds, preferred stocks, art, collectibles, et al … in the near future.

You should take the time now to reassess your investment goals and your portfolio. Are your goals and your holdings aligned? On track? Is your portfolio diversified for balance and safety?

Volatility will surely increase in the coming weeks. What is your comfort level? Can you endure losses in your accounts? Are you nearing retirement?

If you are more comfortable in traditional equities … stocks, ETFs, managed mutual funds, index funds … understand that now is not the time to be holding over-priced stocks with declining fundamentals. Expect to see your fellow investors in a general rotation into more defensive stocks in the coming weeks (this has already begun).

You would want to hold stock (either directly or through a fund) of the highest-quality companies with strong and improving fundamentals. You should look for consistent sales and earnings growth, strong support from institutional investors, and a history of paying and raising dividends.

Historically, regular dividend payments account for 40% of total stock market returns. Even when a general stock market downturn temporarily lops 15-20% off the stock values in your portfolio, regular dividends offset some paper losses and instill confidence that the company is strong enough to come back, and prosper again, in the near future.

Sell companies which do not reflect such strong fundamentals.

Act sooner, rather than later, to avoid a panic situation weeks or months down the road. It is time to plan for the inevitable downturn … if you haven’t already … and implement changes as soon as possible.

We will be writing every week about the problems that we see on the horizon, and possible solutions. We discuss finance, markets, government policies, and legal issues.

If you would care to call, we can discuss solutions which we are implementing for ourselves and for our clients. We would like to help you.

InnOvation Capital & Management, LLC

LAW  –  POLICY  –  FINANCE  –  MARKETS

INFORMATION FOR THE ENTERPRISE AND INVESTOR

JULY 26, 2016

Contact Richard Power with comments or questions.  IntelDigest is intended for the use of our clients and colleagues.   Material may not be reproduced, forwarded or shared without express permission.

Today, we will discuss Gold as an investment, and the timing for this column is fortuitous. As we present the reasoning for increased investment in gold (and silver), this happens to coincide with a temporary pullback in the price of precious metals, probably lasting until the end of Summer.

In other words, the next few weeks present an excellent buying opportunity to increase allocations of gold and silver in our portfolios. Both gold and silver are up by approximately 25% in 2016, and we believe that they will go much higher in 2017 and 2018.

The standard advice of major investors and investment advisers, in “normal” investment climates, is to keep up to 5% of one’s portfolio in precious metals, particularly gold and silver. As we mentioned last week in IntelDigest, the “smart money” has been betting on gold this year. Several highly-regarded stock investors and hedge fund managers have gone to 10-15% of precious metals in their portfolios.

There are certain “fundamental forces” which would continue to propel the current rally in both gold and silver, and the most important are (1) extremely low, and turning negative, interest rates, and (2) weakening fundamentals in the world economy. Only a strong U.S. Dollar has kept the value of gold and silver from rocketing higher this year. When the Dollar declines, the price of gold will shoot over $2,000 per ounce.

Historically, gold has done well when “real” interest rates have fallen. “Real” interest rates refers to the return one can receive when inflation is factored in. For example, in the 1970s and 2000s, inflation was high, essentially wiping out any return from normal interest rates on fixed income investments, as well as yields on equities. Gold performed very well then, because the return from normal investments dropped to zero or went negative.

In the current economic climate, inflation is very low, but so are interest rates, which have gone negative in many places around the world. Inflation is approximately 1.4%, while the average short-term interest rates are 0.3%, and heading lower. Even with a Zero Yield, gold beats out investments with a negative yield.

“Real” interest rates are now negative, so gold and silver should do very well.

We discussed the matter of weakening economies last week; we mentioned a recent report from the Bank for International Settlements, the central bankers’ bank. It warned of the “risk trinity” of conditions looming over the global economy, including (1) productivity growth which is unusually low, (2) global debt levels which are historically high, and (3) central banks with fewer options and little room to maneuver in addressing these problems.

The world is awash in debt, and economic data is pointing to a recession, no matter how hard the Federal Reserve and other central banks work to stave off recession through manipulation of interest rates and the money supply. U.S. industrial production is down, and U.S. exports have been declining for close to two years.

Global trade is similarly in decline, especially in China, where exports are closely correlated to the country’s gross domestic product. While the formerly fantastic Chinese growth engine slows to a pedestrian pace, the weight of debt will slow it more. No market, not even the U.S., has added more debt to its economy since 2008 than China. China’s total debt has tripled over that time, to $30 trillion, with the most growth occurring in corporate obligations.

Brazil, Russia, and other economies which are driven by exports are all in trouble. Large multinational banks which have significant exposure to these export economies …. Deutsche Bank, Citigroup, HSBC, Mitsubishi UFJ Financial Group, as examples …. have seen their stock prices fall by at least 25% in the last twelve months. Deutsche Bank alone is down over 50%.

So, we have the fundamental forces at work … negative interest rates and weakening economies. Most investors are familiar with the traditional arguments for gold … it can be a hedge against inflation and a currency hedge, it performs well in a low-interest environment, and it is considered a store of value in times of uncertainty.

Gold is a traditional safe haven in times of insecurity; it can provide insurance against cyber and political risks. And, there are good, old-fashioned fundamentals at work …. demand for gold is growing in the marketplace, from Russia and China to western markets, while supply has been dormant because new mining projects were delayed or closed down over the last few years, when the gold price was receding from its 2011 highs.

All of these factors argue in favor of much higher gold prices.

Not everyone agrees with this thesis. We have been stuck in a deflationary environment since the 2008 banking crisis, and some believe that this will continue into the future. Even seven years of lower and lower interest rates has not produced the inflation that the central bankers thought would generate economic growth.

Some well-known economists, such as Harry Dent and Gary Shilling, believe that the deflationary forces in the world economy are too strong, that low growth will continue well into the future, and the price of gold will fall below $1,000.

But, many believe that, despite the deflationary forces, governments will succeed in forcing inflation, primarily because they have no choice. Deflation makes the real value of debt go up. Deflation destroys tax collections … when prices and wages go down in deflation, governments collect less tax. If the value of debt goes up and tax collections go down, then economies collapse.

Governments can’t allow that. So, they will do whatever they can to produce inflation. Some economists posit a theory that governments will be forced to go to an extreme to produce inflation, and do so by setting the price of gold at $5,000 per ounce, or even higher. The gold market has been manipulated for several years to keep the price of gold down; it would be easy to change direction and manipulate the price up!

If major countries around the world continue to implement negative interest
rates in attempts to spur growth ….

If the Fed continues to shy away from raising U.S. interest rates for fear of
damaging the economy further ….

If weak economies take too long to come back ….

If governments and central banks manipulate the gold price up ….

Any combination of these events amounts to a compelling case for owning
gold and silver. If you’d like to know where we have made investments in gold and silver, feel free to give us a call.

InnOvation Capital & Management, LLC

LAW  –  POLICY  –  FINANCE  –  MARKETS

INFORMATION FOR THE ENTERPRISE AND INVESTOR

JULY 19, 2016

Contact Richard Power with comments or questions.  IntelDigest is intended for the use of our clients and colleagues.   Material may not be reproduced, forwarded or shared without express permission.

WARNING: the following discussion is neither pleasant nor uplifting.

As we wrote last week, debt is the biggest economic problem in the world, and has been for more than ten years;  the global economy is drowning in debt.  Corporate debt in emerging markets has jumped five-fold over the past decade, and companies in the U.S., Europe, and Japan have been taking advantage of ultra-low interest rates to amass TRILLIONS of dollars of new debt.   U.S. corporations are carrying twice as much debt on their books as they did six years ago.

Somebody owns that debt …  you and I, and everyone that we know.   That debt shows up, primarily in the form of bonds, in our own investment portfolios, as well as investments by our banks and pension plans and insurers.   Corporations, non-profit foundations, governments all invest or park their cash in money market and investment funds loaded with bonds and other debt instruments.   That debt permeates all of our lives.

The Federal Reserve and other major central banks …  in the U.K., European Union, Japan, and China …  have encouraged the amassing of debt.   The global economy is being propped up by the easy-money policies of central banks, whose leaders believe that they can simply paper over any fiscal or monetary problem by printing more currency.   Because they believe that they can “print growth,” every major central bank in the world has gone overboard with easy money.

Do you know how this will play out?   Neither do we, and neither do the central bankers.   Economic growth and prosperity does not come from creating currency out of thin air, and the world has never seen so much bad debt.   But, central bankers are intent on printing money and cutting interest rates, which only makes the problems worse.

How will currencies be valued when they offer no yield?   What prosperity will come from highly leveraged companies?   How much upside remains in equities which have been artificially inflated?

Since the 2008 financial crisis, central banks around the world have cut interest rates hundreds of times, cumulatively, and created $12 trillion of new currency, this according to MarketWatch.    We believe that this course will, eventually, destroy the paper currencies which the central bankers are supposed to be defending.

(Later in the Summer, the Federal Reserve will be the primary topic of one or two issues of  IntelDigest.   For purposes of this discussion, The Fed is just one of the several major central banks from around the world which have piloted their economies  into dire straits.)

The Bank for International Settlements is, essentially, the central bankers’  bank.   Based in Basel, Switzerland, the BIS is the oldest international financial organization in the world;  over 60 central banks are its members, and its mission is to serve the central banks in “their pursuit of monetary and financial stability.”

A recent BIS report warned of the “risk trinity” of conditions looming over the global economy.  These include (1) productivity growth which is unusually low, (2) global debt levels which are historically high, and (3) central banks with fewer options and little room to maneuver in addressing these problems.

Financial markets are fragile, and interest rates have gone negative around the world.   Are you annoyed that your bank deposits pay interest of less than one percent?   In many countries, citizens now have to pay the bank for the pleasure of depositing money into their accounts.

Central banks and their governments have painted themselves into a corner, and they are unlikely to find the way out because they are stuck in their fundamental  presuppositions about monetary policy, which many say are fundamentally wrong.   They have manipulated the system, and created a world where savers are penalized and companies are paid to buy their competition rather than compete.   They intended to create inflation and growth by continually cutting interest rates, but only select financial assets have appreciated while economies have stagnated.

It is likely that the world economy will be stuck in neutral for the next two years.

As a result, the “smart money” has been betting on gold.   Next week,  IntelDigest  will present a more-detailed examination of Gold as an investment for the next few years.   In the meantime, we’ll just point out that many highly-regarded stock investors and hedge fund managers ..  Stanley Druckenmiller, David Einhorn of Greenlight Capital, George Soros, as examples …  have increased their investments in gold significantly in the last year, and are holding historically high proportions of their respective assets in gold ETFs and gold mining companies.   More on this topic next week.

In the very short term, there is still money to be made in U.S. markets.  As we wrote last week, U.S. equities, fixed investments, and real estate are continuing to benefit from low interest rates and the influx of capital from around the world …  from investors whose home economies are in worse shape than the American economy.

This dynamic may continue through the end of the year, as the long bull market in equities sputters to its end.

However, the fundamental problem of debt is expected to drag down markets in the coming years.   Our national debt is now at $20 trillion.   Those are current government liabilities.   Unfunded future liabilities are much greater.   There will come a day when this debt will become impossible to finance, with a resulting devaluation of the U.S. Dollar.

The amassing of debt continues unabated.   Government spending in the U.S. (Federal, state, and local) is now $7 trillion per year, making up 38% of the total economy.  Add in medical spending, which is directly or indirectly financed by government, and the total government spending as a percentage of the American economy is over 50%.

(At the same time,  the private debt of Americans …. mortgages, credit cards, student loans, etc. … now totals $17.5 trillion.)

Nothing is limiting the growth of government spending.   When legislators face a fiscal crisis, their options are to raise taxes, cut the cost of government, or inflate the currency.   The U.S. Congress of the last two decades has been unwilling to either raise taxes or reduce government spending, so no progress can be expected there.

Therefore, it is left to the Federal Reserve to create inflation; the Fed has a target of 2% inflation per year.   But, even if it is successful in breaking the economy out of the current deflationary environment, there is the danger that the Fed will overshoot its target.   Massive money printing is most likely to lead to runaway inflation.

Runaway inflation is a form of “stealth taxation” in that it devalues the dollars in our pockets.  Devaluing the currency favors debtors, such as the federal government, which is the biggest debtor in the land.

So, here in the U.S., we can look forward to “progressing” from our current low-interest-rate environment, possibly into a negative-interest-rate environment, and onward to a highly inflationary economy.

Whichever way it goes, it’s not good for savers.

Well, that’s enough for this depressing column.   However, you will be better prepared to face and plan for the future if you know what’s really happening in the economy.   In the next several issues, we will discuss positive strategies which you can use in managing your assets in the coming years.

InnOvation Capital & Management, LLC

LAW  –  POLICY  –  FINANCE  –  MARKETS

INFORMATION FOR THE ENTERPRISE AND INVESTOR

JULY 12, 2016

Contact Richard Power with comments or questions.  IntelDigest is intended for the use of our clients and colleagues.   Material may not be reproduced, forwarded or shared without express permission.

Last week, we discussed political aspects of the “Brexit,” the prospective divorce of the U.K. from the European Union.   Today, we’ll discuss finance and markets.   Later in July,  IntelDigest  will have global Debt on the agenda, as well the prospects for Gold.

Uncertainty is the primary product thus far of the U.K. vote to leave the European Union.   Investors hate uncertainty!   In the immediate aftermath of the referendum, global equity markets and the British Pound Sterling took giant steps down; the Euro and related currencies fell; many investors fled to the supposed “safe havens” of precious metals and U.S. treasuries.   Gold and silver, in particular, rallied by more than 5% in two days.

In the following week, markets settled down and many equities regained their previous footings.   But, gold and silver have not retraced, and Sterling remains down more than 10%, at its lowest level in decades.   Gold and silver are likely to continue making great gains over the next two years, while the British Pound is likely to continue lower.

In the U.K., six fund managers have halted redemptions from their U.K. property funds in the last two weeks.  This is stifling almost 50% of the real property markets.   The  fund managers fear that sellers will overwhelm the market, forcing fire sales of U.K.  property.

The market uncertainty hastened by the Brexit vote will have long-lasting ramifications, but that does NOT necessarily mean a market crash, or even a bear market, IN THE SHORT TERM.   There is a high probability that central banks around the world will move to counter downturns in the markets with new rounds of monetary easing.

The Bank of England, European Central Bank, and the People’s Bank of China have all indicated that they are ready to provide liquidity, if needed, to ensure global market stability.   The Federal Reserve stated that it is  “carefully monitoring developments in global financial markets, in cooperation with other central banks, following the results of the U.K. referendum on membership in the European Union.” And, it is “prepared to provide dollar liquidity through its existing swap lines with central banks, as necessary, to address pressures in global funding markets, which could have adverse implications for the U.S. economy.”

Impact on the U.K.

It is likely that Brexit will lead to lower GDP growth in both the U.K. and the E.U. over the next two years as the separation progresses.

The long-term outlook for the U.K. economy is actually better, once it is free from E.U. regulations and has completed new trade agreements with the E.U. and the rest of Europe.   The old saying is that “capital goes where it is treated best,” and a nimble, re-formed U.K. economy should make the country appealing to investment capital.   However, that is a couple of years down the road.

In the meantime, the British economy is fragile, whether it leaves the European Union or not.   The United Kingdom has a high chance of plunging into a recession, and the Bank of England would be left with a difficult choice.   The BOE could lower interest rates in an attempt to mitigate the risk of recession, which would hurt its currency even more and create inflation concerns.   Or, it could raise rates to support the currency, thereby choking choke off growth.

Impact on the E.U.

The European economies have more to lose from the Brexit.   For example, consider that Britain is Ireland’s largest trade partner,  accounting for roughly 14 percent of Irish exports.   Depreciation of the British Pound will make it more difficult for Irish exporters to sell goods to Britain.   The Netherlands, Luxembourg, and Belgium send 9% of their respective exports to the U.K.   All E.U. economies will be at a disadvantage versus a depreciated British Pound.

A large part of the problem pre-dates the Brexit vote; even before the referendum, Debt has been the biggest economic problem in the world;  this will be the primary topic of  IntelDigest  next week.   The global economy is drowning in debt.  Corporate debt in emerging markets has jumped five-fold over the past decade, and companies in the U.S., Europe, and Japan have been taking advantage of ultra-low interest rates to amass TRILLIONS of dollars of new debt.   U.S. corporations are carrying twice as much debt on their books as they did six years ago.

The situation is worse in Europe, where the banking system never fully recovered from the 2008 financial crisis.   Brexit will severely test the banks of Europe, placing greater constraints on the already fragile union, which will lose financial  support from Britain, which may then be in a position to operate in a more nimble and dynamic fashion as it competes against the union.

 Impact on the U.S.

The oasis in the desert of the world economies has been American dividend-paying stocks, mostly in the utility, telecom, specialty REIT, and consumer staples sectors.    Fear and upheaval drive investors to essential and basic goods and services offering reasonable yields (3-5%).   As noted above, capital will go to where it is treated best.

This is the reason that there is less probability of a bear market or recession in the U.S. during this year.   Capital flees from upheaval and uncertainty, and cash from around the world continues to prop up U.S. stock markets.

Looking Forward

The economic consequences of the Brexit will play out over time.  The financial crises of 1998 and 2008 actually started over a year before the Crisis Dates, so the Brexit consequences could ramp up to a Crisis Date over a year or more in the future.

We are likely to see more spirited intervention by central banks, opening the  floodgates of Easy Money even wider.   Although the quantitative easing programs of the Federal Reserve ended two years ago, the Fed could come up with QE4 if a recession looms.   The European Central Bank buys $90 billion per month of both government bonds and corporate debt in order to keep Europe afloat.   And, the Bank of Japan has become the largest shareholder in just about all Japanese companies, and will probably begin buying American equities soon.

We must be cognizant of the potential for another financial crisis in 2017 or 2018.   Financial systems around the world are still fragile after the 2008 crisis, and have been propped up by massive interventions by central banks.  The level of debt all over the world is unprecedented.  And, both the U.K. and European Union will likely be at their weakest as they progress through the separation process over the next two years.

IntelDigest  will continue to address these issues and many others, on a weekly basis, as we go forward.

InnOvation Capital & Management, LLC

LAW  –  POLICY  –  FINANCE  –  MARKETS

INFORMATION FOR THE ENTERPRISE AND INVESTOR

JULY 5, 2016

Contact Richard Power with comments or questions.  IntelDigest is intended for the use of our clients and colleagues.   Material may not be reproduced, forwarded or shared without express permission.

One of the most important Current Events of the year has been the referendum in the United Kingdom with respect to its membership in the European Union.   We will devote significant space this month to the topic of the “Brexit.”  IntelDigest will review the political aspects of the event this week.  In the coming weeks, we will concentrate on finance, trade and economies.   We will finish July with a discussion of Debt around the world, and how that is expected to influence our investment decisions going forward.

First, the politics … we believe that the issue which pushed voters “over the edge” is the perception that unelected bureaucrats had too much influence over citizens’ lives.   The European Union has become the “United States of Europe,” with similar dysfunction in governance.   What began as a common market for trade evolved into a “federal” system, with bureaucrats in Brussels implementing trade and immigration policies having significant effect on businesses and individuals throughout the 28 member nations.

Too many people have been feeling left out economically in a globalized world.  Foreign leaders in Brussels … having different customs, cultures and priorities … regulate  domestic policies.   There is widespread resentment of the elites who manage the financial system or who benefit from globalization.   And, the influx of immigrants from alien cultures was the impetus for many “Leave” votes.

It is possible that the leaders of the member states, collectively called the European Council, may have realized the enormity of the problem which they had created, and the need for a different approach.  After the Brexit vote, the foreign ministers of the “EU 6” original members  (France, Germany, Netherlands, Belgium, Luxembourg and Italy)  issued an unusual joint statement, recognizing “…. different levels of ambition amongst Member States when it comes to the project of European integration …. we have to find better ways of dealing with these different levels of ambition so as to ensure that Europe delivers better on the expectations of all European citizens.”

A few days later, the full European Council met, and stated, among other things, that:

“…. The outcome of the UK referendum creates a new situation for the European Union. We are determined to remain united and work in the framework of the EU to deal with the challenges of the 21st century and find solutions in the interest of our nations and peoples…

…. The European Union is a historic achievement of peace, prosperity and security on the European continent and remains our common framework. At the same time many people express dissatisfaction with the current state of affairs, be it at the European or national level. Europeans expect us to do better when it comes to providing security, jobs and growth, as well as hope for a better future. We need to deliver on this, in a way that unites us, not least in the interest of the young.

…. This is why we are starting today a political reflection to give an impulse to further reforms, in line with our Strategic Agenda, and to the development of the EU with 27 Member States ….”

“Better late than never.”   The European Council seems to understand that the Brexit vote is a VERY BIG DEAL.   There is a significant level of disillusionment throughout the member nations on the subject of globalization.   Wages are flat and jobs are scarce.   Many people have tired of waiting for the “trickle down” effects in the economies of interconnected modern societies.

If the U.K. leaves the E.U., other members may try to follow the Brits out the door.   With more referenda in member states which are in far worse economic shape than the U.K., there is a very real danger that the E.U. could break into smaller blocs.

Although a Brexit may have positive outcomes for the U.K. in the long term, all parties are likely to be hurt over the next two years.   The reality is that the U.K. needs the E.U., and the E.U. needs a vibrant and strong U.K. as a partner.   Trade among the E.U. members is very important;  remember that the idea of the E.U. began as a common market for trade.

For example, Germany must maintain free trade with both the U.K. and the other E.U. member states.   Exports account for half of Germany’s GDP.   Economic  weakness has already reduced sales to China and the rest of the E.U.   If significant barriers to trade with the U.K. are adopted at the same time that the world is slipping into recession, the strongest economy in the European Union will be hit hard.

Some potential problems:

• rising unemployment and falling tax revenue in Germany
• rising unemployment among Germany’s trading partners
• an influx of foreign workers to Germany

Other areas of concern:

We are already seeing political instability in the U.K. in the wake of the Brexit referendum;  if other  E.U. members are forced by popular sentiment to hold Exit votes, you can multiply that instability.

Just as the Pound Sterling has had a precipitous 10% drop, the Euro will likely recede over the coming year.   Trade agreements among all the European countries would have to be negotiated anew if the Netherlands, Italy, France or others decide to follow the path of the U.K.

The status of E.U. citizens living abroad becomes a major issue.   There are many Brits living and working across the European Union, and millions of E.U. citizens … from all across the bloc, but mostly from newer E.U. members Poland and Lithuania … living and working in the U.K.

The European Union is one of the largest oil markets in the world.   Should a recession in Europe follow the Brexit, demand for oil will fall.  The U.K. is an integral part of the E.U. energy market, and a member of the European Energy Community.  What would its status be after the divorce?

China does a lot of business with the European markets today … over 15% of  China’s total exports.   A recession in the U.K. would likely spread to continental Europe, taking a toll on China exports.

Finally, let’s not forget the Russians.   The European Union has been able to successfully negotiate trade and oil/gas deals with Russia, and has maintained sanctions against Russia for two years because of its aggression against Ukraine.    Russia would enjoy negotiating with a weaker European Union.   And, a divided Europe will also present a less coherent response to future Russian aggression.