Author: DigestAdmin

InnOvation Capital & Management, LLC

IntelDigest

LAW – POLICY – FINANCE – MARKETS
INFORMATION FOR THE ENTERPRISE AND INVESTOR

NOVEMBER 30, 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, we continue the discussion of likely economic effects of the election results, both short-term and over the course of the next four years.  In coming issues, we will look at the theory behind Trump economic proposals, review some measures put out there by others, and make some policy proposals which we think the new government should consider.

 

As we wrote last week, the Dollar and stock markets have rallied ..

“… on the expectation that a Trump presidency will be good for business. The President-Elect has vowed to lower taxes (especially on corporations), commit Hundreds of Billions of Dollars to infrastructure spending, and reduce government regulation.”

 

Having given equity markets a short-term lift, the rallies show signs of petering out already.  At the same time, the retreat by gold and silver can be attributed to an expectation of higher interest rates … starting with a December rate hike by The Federal Reserve … and continued strength of the U.S. Dollar.

Looking forward to the new year … 2017, 2018 and beyond … the biggest questions for financial markets revolve around the actions of the President and The Federal Reserve.  What sort of President will Donald Trump be?  Will he act and speak (and tweet) in the same manner as he did on the campaign trail?  Will his policies help or hurt the economy? What stance will the Fed take?  What of the results (or consequences) of Fed actions?

 
The Federal Reserve
.
If The Fed is accommodative to massive spending programs and higher federal deficits, we can expect much higher inflation in the near future and exacerbation of the Debt Crisis.  Gold investments should perform well in this environment.

 
On the other hand, if The Fed raises interest rates too much and too often, to keep ahead of inflation, it would probably set off a stock market fall and a recession in the U.S.  This would be damaging to all asset classes and spread into a global recession.  Followed by a major debt default by emerging markets;  followed by a global liquidity panic.

We have written several times over the last six months about going into the new year with large positions (10-15% of your portfolio) in Gold, and cashing out some of your stocks and bonds.  We believe that Gold and Cash act as excellent portfolio insurance against the uncertainties of both the Trump Administration and Federal Reserve policy.

We believe that Gold will do well in both the inflationary and deflationary scenarios discussed above  (more about Inflation vs Deflation, below).

 
The Bond Market

We have also discussed the Bond Market at length, and have concluded that Bond values are on their way down.  Understand that the Bond Market is much bigger than the Stock Market (about twice the size of the equity markets), and is a cornerstone of the global financial system.  The market includes … theoretically … all public and private debt in the world. As the Bond Market unwinds, it will have massive effects on all other asset classes.

Fund manager Ray Dalio runs the largest hedge fund in the world, Bridgewater Associates.  He believes that bond prices have peaked.  He recently wrote:

“… [W]e think that there’s a significant likelihood that we have made the 30-year top in bond prices.  We probably have made both the secular low in inflation and the secular low in bond yields relative to inflation.”

Secular means long-term.  Dalio is saying that bond yields and inflation rates have bottomed.

Both rising inflation and higher bond yields will depress bond prices. With respect to the bonds held in your portfolio, inflation eats away at the future payments on the bond.  As inflation and interest rates rise, the value of your bond investments goes through the floor!

Donald Trump’s pro-business agenda … strong economic growth, increasing inflation, mushrooming Federal Deficit … will destroy your Bond portfolio!

A diversified portfolio including Bond investments is usually the hallmark of a safe and stable portfolio.  We believe that such a strategy will NOT be profitable over the next two years.  We have been selling bonds from our portfolio;  we are, in fact, “shorting” corporate bonds (more on that in a later issue).

We believe that we are at the top of the housing market (for awhile), and that real returns on fixed income securities will erode over the next two years.

 

 

Inflation vs Deflation

Likely results of pro-growth policies in the new administration would be: climbing inflation, higher Federal deficit spending, growing Federal Debt. This would normally be a recipe for currency debasement.  However, with most other countries around the world in a similar (probably more leaky) boat, it is unclear when the U.S. Dollar will feel the effects of our massive Federal Debt.

But, as we wrote at the beginning of this letter, Uncertainty for the new year prevails.  Depending on the implementation of Trump Administration policies, and the reaction of The Fed thereto, the odds of an Inflationary scenario versus a Deflationary scenario are slightly better than 50-50.

 
Inflationary Scenario

The President-Elect’s massive public-works spending will add to a Federal Debt which is already at record levels, and will probably require The Fed to print Billions of Dollars to pay for it.  Team Trump contends that increased spending would be financed by higher growth resulting from tax cuts and reduced Federal regulation.

This is the Laffer Curve come back to life … i.e., the Federal deficit will not be blown out because economic growth will be strong enough to generate more tax revenue.  Can anyone say “supply side economics?”

There may be nothing wrong with this theory, except that (1) conditions are quite different now than they were in the 1980s, when “supply side” morphed into Reaganomics, and (2) recent implementations of the theory have had disastrous consequences.

The 2001 and 2003 tax cuts were supposed to generate so much growth and tax receipts that we wouldn’t have to worry about the cost of the Iraq War or the Medicare prescription-drug program.  In reality, the Bush/Cheney Administration doubled the national debt to $10 Trillion and consumer prices roared higher … until they came to a crashing halt during the Panic of 2008.

We still pay the price for that error, as the Obama Administration and the Congress kept the Deficit Train on the same track.

More recently, in 2012, Governor Sam Brownback of Kansas used these same arguments to pass large cuts in state tax rates.  As a result, the state treasury went from surplus to deficit, necessitating emergency cuts in spending on infrastructure and education.

More likely, growth resulting from the Trump plan will NOT counter an explosion in the Federal Deficit.  Remember that higher deficits are already in the cards because of expected retirement claims (Social Security and Medicare) by the large Baby Boom generation.

 

Also arguing in favor of the Inflationary scenario is the track record of The Federal Reserve.  The Fed has, thus far, been unable to sustain short-term interest rates at a reasonable level, and it has lost all credibility with its forecasts of interest rate hikes which do not come to pass.

If The Fed accommodates higher deficits with easy money and continued low interest rates … referred to as helicopter money … inflation is assured.

 
Deflationary Scenario

As mentioned earlier, The Fed could try to keep ahead of inflation and deficit increases.  In the Deflationary scenario, The Fed could try to maintain “positive real rates” by regularly raising short-term interest rates (when interest rates are above the rate of inflation, real interest rates are positive).  If the Fed reacts to deficits with high real rates, the U.S. economy will probably tip into a recession.

These facts argue in favor of the Deflationary scenario:  (1) the Dollar is at a 13-year high, and looking stronger,  (2) The Fed has recently reiterated plans for an interest rate increase “relatively soon,” and  (3) there are already strong deflationary forces in the world arising from debt deleveraging, a dollar shortage, technology, and demographics (we will discuss Technology in a December issue of  IntelDigest).

A strong Dollar resulting from higher rates will increase the foreign exchange value of the Dollar and make Dollar-denominated debt owed by emerging markets unpayable.  This could lead to an emerging-market debt default crisis worse than the 1980s crisis in Latin America.

 
Looking Forward

As there is Uncertainty ahead, we believe that investors should hold BOTH inflation- and deflation-protection in their portfolios, and a high percentage of Cash to offset volatility.  We have already mentioned that Gold should do well in either scenario.

Inflation-protection includes hard, tangible assets such as gold, silver, natural resources, land, fine art.  Deflation-protection would be U.S. government bonds and notes, such as the 10-year U.S. Treasury note.
We are here, every week, to review and update the situation in the markets.  We write about 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’d be happy to help you.

 

 

 

InnOvation Capital & Management, LLC

IntelDigest

LAW – POLICY – FINANCE – MARKETS
INFORMATION FOR THE ENTERPRISE AND INVESTOR

NOVEMBER 23, 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, we will review the market reactions to the election surprise, and the short-term prospects for several asset classes. Over the next three weeks, we’ll take a closer look at the theory behind the Trump economic proposals, speculate on the likely economic future for the United States during the next presidential administration, and make some policy proposals which we think the new government should consider.

 
Reaction

To most people, the Trump victory was a surprise and a shock.  As we wrote on the afternoon after Election Day:

“Most foreign markets dropped immediately by 2-4%, and U.S. stock futures fell by up to 4% overnight (when U.S. markets were closed). However, by the time that U.S. markets opened this morning, things were already returning to normal.  It is likely that markets around the world will calm down and return to (relative) normal within a day or two.”
Indeed, the broad markets have rallied in the short-term … and will probably do so into early next year … on the expectation that a Trump presidency will be good for business.  The President-Elect has vowed to lower taxes (especially on corporations), commit Hundreds of Billions of Dollars to infrastructure spending, and reduce government regulation. Investors are encouraged, and have piled into equities since Election Day; some sectors have performed better than others (which we discuss on page two).

 

Corporate tax reform is at the center of the Trump agenda.  For years, U.S. multinational companies have parked significant sums (now amounting to $2.5 Trillion Dollars, by some estimates) in offshore tax havens, in order to avoid U.S. corporate income taxes, which can be as high as 35%.
During the campaign, Trump proposed reducing the tax rate to 10% on cash which companies would repatriate from overseas.  When Trump assumes office, he will be working with a Republican-controlled Congress, and an incoming Senate Minority Leader, Chuck Schumer, who has expressed a desire to get corporate tax reform done.

 

If anything like this proposal becomes law, giant U.S. multinationals will be flush with the repatriated cash, and their shareholders can expect significant increases in dividend payments.

 

A commitment of the U.S. government to massive infrastructure spending … on roads, bridges, ports, airports, et al … would obviously boost corporations in the construction sector, while cutting government regulations is bound to help businesses across the board.

 
Early Winners

Three sectors have enjoyed immediate benefits in the two weeks since the election.  The stocks of Industrials have increased more than 6% in that short time.  Many companies in this sector would benefit directly from infrastructure spending.

 

Shares of Financial Institutions have skyrocketed, having increased by more than 11% over two weeks.  The President-Elect wants to dismantle the Dodd-Frank law, which was enacted in the wake of the 2008 financial crisis and places strict regulations on the banks and other financial companies which were at the center of the crisis.  Reversing that regulation would reduce compliance costs and boost bank earnings.

 

Also reaping the benefits of the election results is the Defense Industry, with shares up by more than 8% since Election Day.  The Trump Administration is intent on increasing military spending at least $500 Billion, and perhaps as much as a Trillion Dollars.

 
Impact on the Bond Market

The yield on the 10-year Treasury bond has jumped 22% since the election.  Trump is expected to pursue an aggressive fiscal policy.  So, investors think that the combination of higher spending and tax cuts could lead to a soaring U.S. deficit, which would push the federal debt even higher in the long term.

 

The yield on the 10-year bond is up to 2.355%, its highest level in 16 months.    This is important because higher yields impact every area of the market.

Utilities, for example, are sensitive to higher interest rates.  Many investors own these stocks specifically for their stable dividends.  When interest rates are high or likely to rise, they lose some of their appeal because investors can get decent income from other assets, such as bonds.

Utilities have lost ground since the election, and will probably lose more over the next couple of months as yields continue to rise.
Higher yields can be expected with Increased infrastructure spending by the new administration.  Trump campaigned heavily on this issue, he has experience with construction, and it will likely be the centerpiece of his domestic policy.

To fund these projects, the government will likely sell more bonds.  A greater supply of Treasury bonds should push prices lower and yields higher.  If Trump pressures the Federal Reserve to raise interest rates … which is likely considering his campaign rhetoric … that’s another point for lower bond prices and higher yields.

 
The Dollar Rules

The jump in Treasury yields has boosted the U.S. Dollar  …  which has moved up against the Euro and other currencies in recent days  …  and knocked down both precious metals and emerging market stocks.  The new administration’s bias toward fiscal expansion is stoking inflation fears, and some investors expect the Federal Reserve to respond by accelerating the pace of interest rate hikes in the new year.

Reuters explained how the spike in Treasury yields affects the emerging markets:

“The most volatile trading on Friday was across emerging markets, as investors bet that Trump’s fiscal policies will be inflationary, push U.S. rates up, and drive investors into dollar-based assets.”

The anticipation of higher interest rates also hurts precious metals in the short-term.  Gold has retreated by almost 8% since the election, in spite of expectations for higher inflation.

 
Short-Term Expectations

So far, the U.S. Dollar and the stock market are the short-term beneficiaries of the surprise election results, while bonds and precious metals have suffered.  These trends should continue into the new year and up to inauguration day.

Where will the trends lead thereafter?  If inflation expectations continue to increase, will investors resume buying gold as an inflation hedge?  If inflation rises faster than the Fed interest rate hikes, will gold overshoot its recent highs?

Precious metals tend to do well in times of uncertainty.  Will Donald Trump be the same wild card as President as he was on the campaign trail?  Will his policies work to rein in the national debt, or make things worse?

We will address these questions over the next few issues.

Happy Thanksgiving to all!!

 

 

 

InnOvation Capital & Management, LLC

 
IntelDigest

LAW – POLICY – FINANCE – MARKETS
INFORMATION FOR THE ENTERPRISE AND INVESTOR

NOVEMBER 16, 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, we address a major policy issue which had a significant impact on the election of the next President of the United States.  That issue is  Trade Policy, but voters often focus only on certain economic provisions, referred to as  Free Trade.

Arguably, the election turned on this very issue, as formerly “Blue” states in the Rust Belt were won … by narrow margins … by Donald Trump. These states had been solidly-Democratic, but Trump’s argument … that Free Trade had taken away millions of American jobs … resonated with enough voters to turn the tide.

Enmity focused on:  (1) a dated trade agreement, the North American Free Trade Agreement (NAFTA), which was negotiated in 1993;  and (2) a proposed agreement, the Trans Pacific Partnership (TPP), which would go into effect by 2018 if ratified by all the parties.

While job losses over the last twenty years have resulted as much from technology, automation, and productivity gains as from Trade Policy, the detrimental effects of foreign competition have been unmistakable.

 

 
Trade Agreements

Trade Agreements are vital factors in relations among nations.  Although many people see them as strictly economic agreements, the fact is that they form the basis of economic, political, and strategic relationships. Trade Agreements are often primarily diplomatic accords, with economic details secondary.

The central economic feature in such agreements is usually referred to as Free Trade, meaning that goods and services may be sold between countries without any sort of tariffs, quotas, or other prohibitions. However, these agreements can cover a wide variety of issues, including labor and workers’ rights, currency manipulation, regulatory compatibility, movement of capital, data transfer, protection of intellectual property, bribery and corruption, environmental concerns, et al.

 

The importance of such agreements is greater than ever before, because … whether we like it or not … the world has been growing increasingly interdependent.  We are living in the age of Globalization, where advances in communications and transportation have facilitated the world-wide exchange of products, ideas, capital, and cultures.

 

 
Development of Free Trade

Protectionism had been the way of the world, from the Industrial Revolution and throughout the 19th Century and into the 20th.  In the U.S., tariffs were regularly imposed in order to protect this industry or that from foreign competition, and to help their proponents win re-election.  However, the theory of  Free Trade took hold in the 20th Century, especially after World War II.

Open markets between countries would give people wider access to goods at lower prices, and spur economic growth.  In the second half of the 20th Century, hundreds of bilateral and multilateral trade deals were negotiated and ratified, affecting every country on the planet.

However, there are practical difficulties which can offset the theoretical advantages of  Free Trade in many economies.  In order to trade, a country must make products which others need.  If its markets are not protected, more advanced countries will offer products at lower prices and better quality.  As a result, the country will be unable to fully develop its industry, and will be unable to purchase even low-cost goods, thus perpetuating underdevelopment and poverty.

The theory of  Free Trade has been attacked from both ends of the political spectrum.  One argument, from the Left, is that protectionist measures early in the industrial development of a country are necessary to allow that country to enter into competition with other nations.  Free Trade agreements can lock out economies struggling to develop, and lock in advantages to established economies.

The argument from the Right is that Free Trade doesn’t work when successful emerging economies, such as China, take advantage of temporary low wages and their own formal or informal protectionism. Lower wages in the emerging economy can devastate important sectors of a competing advanced economy, while keeping out exports that could compete in other sectors of the emerging economy.  In other words, developing countries can use Free Trade to destroy some sectors of economies in advanced countries.

The argument FOR Free Trade is that, over time, the dislocations caused by open markets will lead to tremendous benefits that will be equitably distributed among all parties.  But, the issue is:  how much time?  For devastated industries and displaced former employees in a particular country, it may take a generation for the benefits of increased national wealth to create new industries based on new inventions.  While that is not a long time for a country, it is a very long time for an individual.

A middle-aged worker who loses his job to foreign competition may find that learning the skills needed for a new industry is impossibly expensive and takes too long.  That worker may never be employed in a job that supports him as he had lived before.  This creates a personal disaster that could affect large numbers of people.

In the short term,  Free Trade can devastate a particular economic segment.  This may balance out, in the long run, but time and the unequal distribution of benefits pose a political problem.

 

 
Globalization and Its Consequences

Dani Rodrik, a professor of economics at the John F. Kennedy School of Government at Harvard University, has argued that “unmanaged globalization” is undermining democracy.

“The promise of free trade is undeniable:  Everybody likes those everyday low prices.  But the consequences of the differential distribution of the benefits of globalization are becoming disturbingly clear:  For the upper classes, the world is their oyster.  For the lower classes, the world is their competitor.”

Those who can take advantage of the global economy can benefit from Globalization, while those who don’t have the resources and skills are left behind.

Because of the uneven distribution of the “fruits” of Globalization, wedges are driven between upper and lower classes in the developed economies. As a result, there is a disconnect between the lower classes in developed economies and the citizens of other nations, who are painted as enemies by populist demagogues.

The fundamental problem is that economic globalization is having a distorting effect on politics all over the world.  In the U.S., resentment over the ill effects of trade has been manifest for almost 15 years.  In areas hard hit by job losses caused by trade with China, voters have been electing more extreme legislators, exacerbating the polarization that has made Congress so dysfunctional.

By its uneven distribution of gains, economic globalization is fostering undemocratic tendencies.  This has been illustrated in the Brexit vote and the results of the U.S. election, and will most likely manifest itself in voting in Italy and other European countries in the coming months.

 

 
Possible Solutions

It is incumbent on economies around the world, including here in the U.S., to pay greater attention to education, re-training, and “trade adjustment assistance” for workers who are displaced when industries are disrupted by  Free Trade.

This is not a new idea;  in fact, it has been a component in the party platforms of both the Democrats and Republicans for years.  But, it has never been addressed seriously;  rather, it has been reduced to a platitude.  Now, it is a moral imperative.

 

 

 

InnOvation Capital & Management, LLC

IntelDigest

LAW – POLICY – FINANCE – MARKETS
INFORMATION FOR THE ENTERPRISE AND INVESTOR

NOVEMBER 9, 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.

 

 

The long presidential election campaign is finally over, and world markets began roiling last night by midnight.  As expected, the elevation of Donald Trump to President-Elect reverberates both domestically and internationally.

Most foreign markets dropped immediately by 2-4%, and U.S. stock futures fell by up to 4% overnight (when U.S. markets were closed). However, by the time that U.S. markets opened this morning, things were already returning to normal.  It is likely that markets around the world will calm down and return to (relative) normal within a day or two.

That includes the Gold market, which is up roughly 5% as a reaction to Mr. Trump’s election, but will likely pull back this week.

At  IntelDigest, we try to have a long view, so we go forward with our discussion of the Gold market in the coming year, as we promised in our last issue.  There are very important developments coming in the Gold market, which convinces us to continue accumulation of Gold and Gold-related investments going forward.

 
Fundamentals

We have previously discussed the “fundamental forces” which drive the Gold markets;  you can review the archive copy of the July 26 issue of IntelDigest for a detailed discussion of the issues.  Weak economic fundamentals in many countries around the world, ultra-low … even negative … interest rates, and enormous amounts of public and private Debt, all propel investments in Gold.

As we stated in that issue:

“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.”

 
Looking To The New Year

Now, we look at three important international developments in the Gold market, which argue in favor of increasing investments in Gold by the end of this year.

 

The first is the Shanghai Gold Exchange.

China is the top consumer, importer, and producer of Gold in the world. China probably has the largest Gold reserves of any country, as it has acquired massive amounts of Gold in the last decade, much of it secretly. But, government actions are opaque, so outsiders can only make estimates of the reserves.

Existing Gold markets are centered in the London exchange, and Gold prices are controlled by participating banks … mostly Western banks, but also including the Bank of China.  Many believe that these banks manipulate the price of Gold at the behest of their (Western) governments and for their own purposes.

We won’t get into the full conspiracy theory re: Gold pricing (perhaps in a later issue).  But, remember this significant fact:  the LIBOR and COMEX exchanges price Gold based on futures contracts, and there are currently 252 ounces of Gold claims FOR EVERY OUNCE OF DELIVERABLE GOLD!

China is set on dominating the Gold market.  It established the Shanghai Gold Exchange in 2002, and would now like to make it the center of Gold trading and pricing for the world.  China has proposed that the Shanghai market would set the price on the basis of ACTUAL PHYSICAL GOLD, not on paper futures contracts.

Increased activity in the Shanghai Gold Exchange would be a significant factor in propelling growth in the Gold market.

 
The second development is a change in Islamic law which would allow massive investments in Gold by Muslims around the world, who number 1.6 Billion.

Some interpretations of Islamic law prevent Muslims from investing in trades considered “immoral,” such as alcohol and tobacco;  this ban has included investment in Gold bullion as a tradeable commodity for the last few decades.
As a result, approximately 23% of the population of the world has stayed out of the Gold market.  Now, however, the Accounting and Auditing Organization for Islamic Financial Institutions is working with the World Gold Council to set a standard allowing Gold trading by Muslims.

If the pent-up demand by this group of investors is unleashed, Trillions of Dollars could soon pile into the Gold market!

 
Finally, the last important development in the Gold market is Peak Gold, the theory that the production of new Gold is shrinking around the world. Declines in new Gold discoveries have coincided with a surge in the costs of mining exploration.  This has resulted in a reduction in mining operations and a steady decrease in Gold production.

Goldman Sachs has warned that there are “only 20 years of known mineable gold reserves.”  Blackrock, the largest asset manager in the world, has also warned about “Peak Gold,” and asserts that Gold production is likely to decline by 20% per year for the foreseeable future.

There is no way to predict if Peak Gold is a concept which will last for years, or if new technologies or discoveries will change the dynamic.  But, for now, the production of Gold is decreasing at the same time that Gold demand is about to soar!

 
A New Bull Market

Based on these three pivotal factors, a new, strong bull market in Gold is likely in the New Year.  We see the opportunities in Gold as yielding high Returns on Investment going forward, so we are applying our research efforts to finding the best prospects in this sector.

 

 

InnOvation Capital & Management, LLC

IntelDigest

LAW – POLICY – FINANCE – MARKETS
INFORMATION FOR THE ENTERPRISE AND INVESTOR

NOVEMBER 2, 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, we will discuss the financial markets … looking at expectations for the near term, as well as prospects for 2017.

In coming weeks, we will go into detail on the highlights of this discussion … examining the causes of an expected Bond Market downturn, and specific reasons for the expected surge in the Gold Market.  We will also dive into discussions of Free Trade, and Technological Development, as well as outline Medicare regulations and requirements for those of our clients approaching retirement age.

Let’s start with The Election … we do not discuss politics in  IntelDigest, but the results of an election have a major impact on the markets … at least in the near term … so we will discuss the impact of the November 8 results.

 
Election of a New President

It is generally expected that the election of Hillary Clinton has been assumed by market participants, and would result in a temporary lift in stocks.  However, the FBI Director’s letter to Congress has roiled the markets over the last few days, causing uncertainty among investors.  As we have stated several times in past issues, investors and companies HATE uncertainty, so stocks are in a defensive posture until the vote has been completed.

On the other hand, a win by Donald Trump will most likely cause an immediate downturn, perhaps as much as 10% in U.S. markets within a day or two.  If foreign markets follow this downward path, the aftermath of a Trump election could reverberate around the globe and turn a 10% slide into a 15-20% global decline.

If that happens, The Federal Reserve would probably cancel the small interest rate increase which it has targeted for December.

 

 

Looking Forward to a New Year

After the dust settles and we move into 2017, certain economic themes are expected to play out, no matter who is elected President.  One example is Gold.  James Steel, chief precious metals analyst at HSBC Bank, believes that Gold is the only sure winner in the election.  The spot price of Gold today is $1,307;  Mr. Steel expects the price to end the year over $1,400 if Clinton is elected, and over $1,500 if Trump is President-Elect.

As reported in BloombergMarkets, “… both candidates have espoused trade policies that could stimulate demand, with gold offering a potential “protection against protectionism …”  Both candidates are also on record as supporting significant stimulus programs.  A Democratic sweep would almost certainly result in a large increase in federal spending.  An increase in the federal deficit would underline a surge in the value of Gold.

Another 2017 theme is the danger in the Bond Market.  There has been incredible movement into bond funds and ETFs (exchange-traded funds) this year.  Inflows into Bond Funds/ETFs through the first nine months of 2016 have totaled $123 Billion … 4X the previous year … and much of that investment came out of Equity Funds and Money Market Funds.

The risk in Bond Funds … particularly the possibility of default … will be higher in the coming years than it has been in decades.  Liquidity is a major issue for companies who have taken on vast amounts of Debt in the low-interest environment of the last seven years.  Profits are decreasing across the board.

Bonds have sold off recently as interest rates rose, and many investors began dumping bond funds.  The Wall Street Journal reported this week that investors pulled $2.2 billion from all junk bond ETFs last week.  Nearly half of that sum came from just one ETF on a single day:  $998 million flowed out of the iShares iBoxx High Yield Corporate Bond ETF (HYG).  High-grade bonds were also affected;  $1.7 billion was pulled from the iShares iBoxx Investment Grade Corporate Bond ETF (LQD), the biggest weekly outflow since inception.

A serious bond-market decline is expected in the coming year, and these recent outflows could be the first sign of much bigger problems to come.

You should be especially wary of junk bonds, or funds containing such bonds.  The danger is that some combination of rising defaults and higher interest rates will trigger a bond-market panic.  The risk of default is just too great!

 
Return of Inflation

Inflation is making a comeback, and that has a deleterious effect on Bonds.  According to The Wall Street Journal, “… data released on Friday showed that core inflation, which excludes food and energy, hit a two-year high of 1.7%” last quarter.

Inflation is rising in Europe, and soaring in the U.K.  The National Institute of Economic and Social Research (NIESR), a British think tank, warned that inflation could quadruple in the second half of next year.

As we know, higher prices are not good for the average person;  for the Bond investor, inflation is disastrous!  The typical Bond pays a fixed annual interest rate;  as inflation goes higher, it eats into the “real” return on investment.  If inflation leads to higher interest rates, then the market value of the Bond decreases.

Investors in long-term bonds are most at risk;  the future payments of long-term bonds are more vulnerable to rising inflation and interest rates than bonds with shorter durations.  Because they are riskier, long-term bonds pay higher yields.   For example, the 30-year U.S. Treasury has yielded almost twice as much as the five-year U.S. Treasury over the last 10 years.

Investors have loaded up on long-term bonds in recent years because short-term bonds have paid next to nothing.  As Bloomberg has reported, “… Investors seeking relief from central banks’ zero-interest-rate policies have poured into government debt due in a decade or more, swelling the amount worldwide by a record $733 billion this year.  It’s more than doubled since 2009 to about $6 trillion, data compiled by Bloomberg and Bank of America Corp. show.”

Now, with inflation rising, many investors are fleeing from long-term bonds.   As an example, the iShares 20+ Year Treasury Bond ETF (TLT), which tracks the performance of long-term U.S. Treasuries, is down 9% since July.

 
Things To Do Now

It’s time to sell (or stay away from) long-term bonds.  If inflation keeps climbing, investors will sell more bonds, pushing yields higher, which could trigger even more selling.  The global bond market is a $100 trillion market;  these early signs of trouble have already spread to the stock market.

As the Wall Street Journal reported on Monday, “… the Dow Jones Industrial Average fell for a third consecutive month, its longest stretch of declines since 2011.  The S&P 500 recorded its worst month since January, and the Nasdaq Composite snapped a three-month winning streak.”

It is also time to go to Cash;  portfolio managers at several large institutions are recommending Cash right now, including Mohamed El-Erian of Allianz, one of the world’s biggest insurance companies.  Among the reasons to cultivate Cash now:  uncertainty about the election, overvaluation of equities, and falling bond prices as interest rates rise around the world.

Cash also allows you to avoid losses on positions which have declined, reduces the volatility of a portfolio, and maximizes “optionality” (choices) to enter and exit positions, and search for bargains, without having to worry about price.

Having more Cash than other investors allows you to shop for bargains when others are desperate to sell.

 

InnOvation Capital & Management, LLC

IntelDigest

LAW – POLICY – FINANCE – MARKETS

INFORMATION FOR THE ENTERPRISE AND INVESTOR

OCTOBER 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.

 

This week in IntelDigest, we will discuss China, the world’s second-largest economy and greatest enigma.  Unlike Las Vegas, “What Happens In China” tends to affect the rest of the world, so it is in our best interests to understand that potential … for good or for ill … so that we can make informed investment choices over the coming years.

This is a country whose economy has grown at an Average Annual Rate of 10% over the last 25 years, whose currency continues to grow in stature, and whose influence around the world is approaching that of the United States.  China is the largest exporter in the world, the second-largest importer of goods and services, and an early adopter of new technologies

However, as investors, we have to determine how much we can rely on continued growth, or trust the data put out by the government and Chinese corporations, or sidestep significant problems involving the credit and real estate markets in China.
Argument FOR Investing in China

It is possible that, in 5-10 years, the largest and most profitable companies in the world could be from China … Baidu (the Google of China), Alibaba (like Amazon, an online retailer), TenCent, owner of the wildly-popular messaging app, WeChat.

These companies are leaders in “The New China” … businesses which are not affiliated with state-owned enterprises like banking, energy, and telecom.

You may be surprised to learn that Alibaba is already the largest retailer in the world.  Its gross merchandise volume has reached $500 Billion in the last year, passing Wal-Mart.  Yet, it is still entirely an online business, like Amazon.com.

 

Alibaba controls 80% of online retailing in China.  And, Baidu has a larger share of the Internet Search market in China than Google has in the U.S.  Both companies have had a tenfold increase in sales over the last five years!

The potential growth in a country as large as China is incredible, as existing customers increase use of these services and hundreds of millions of new customers are still to come on line.

Another leader in the technological revolution in China is a company called TenCent, which owns WeChat.  This app has transformed the way most people in major Chinese cities communicate and conduct financial transactions.  It’s like having Facebook, Paypal, a telephone, and text messaging all in one app.  WeChat is a platform which contains Ten Million third-party apps, and participating companies can easily add apps to the platform to facilitate transactions with customers.

Many Chinese communicate primarily through the text messaging functions of WeChat, rather than making voice phone calls.  Rather than carry cash or credit cards, they make their purchases with a swipe of their smartphones.  They can check the news, hail a cab, or manage their credit card bills within the main app.

This technological revolution has occurred in just the last three years!

The WeChat functionality is ahead of companies like Facebook;  and, WeChat has a virtual monopoly in the most populous country in the world.  TenCent, the owner of WeChat, is also one of the world leaders in mobile gaming.

As investors, we certainly want to participate in the growth potential of the leaders of “The New China.”
IMF Special Drawing Rights

Another advance for China was the recent inclusion of its currency, the renminbi (commonly referred to as the “yuan”) in the Special Drawing Rights (SDR) of the International Monetary Fund (IMF).  The IMF created SDRs with the aim of providing a future global reserve currency … in fact, as a future replacement of the U.S. Dollar as the reserve currency for the world.  The yuan is now included in the basket of currencies which will be used to determine the value of the SDR.

We will discuss Special Drawing Rights in a future issue of  IntelDigest; for now, we can tell you that a SDR is valued using these five currencies:  U.S. Dollar (41.3%), Euro (30.93%), China Yuan (10.92%), Japan Yen (8.33%), and U.K. Pound (8.09%).

 

 

Argument AGAINST Investing in China

We should all be aware, however, that there is trouble brewing in China, which could trigger the next recession around the world.

The Bank for International Settlements (BIS) and the IMF have raised warnings this year about the level of debt in China.  Outstanding loans in China have been rising rapidly over the last eight years, and the debt has reached $28 Trillion. Corporate debt is 171% of the GDP of China;  total debt is 255% of GDP.

A recent BIS report pegs the “credit to GDP gap” in China as 30-to-1, meaning that the credit bubble in China far surpasses any other country in the history of such metrics.

Plus, China has committed itself to Trillions of Dollars in infrastructure projects. The New Silk Road project, which is meant to connect China to European markets via a series of modern roads, ports, railroads and pipelines, is estimated at One Trillion Dollars (before cost overruns).  The leadership has also promised massive spending in the interior to raise the standard of living of hundreds of millions of its citizens.

We have previously discussed in  IntelDigest  the fragile state of economies around the world.  From Zero- and Negative-Interest Rate policies, and massive bond purchases by central banks, and historically low bond yields … to decreasing corporate profits while stocks are at historical highs.

The danger is that, if China loses control of its over-extended debt situation, it could cause a shiver in these fragile economies which would result in a stock market crash and a Greater Recession.

 
Caution is Warranted

We believe that caution is warranted in investing in China, especially in more traditional industries which may be burdened by some of the massive debt referred to above.  For our part, our investments in China are mainly in the technology area, where there is room for explosive growth in the coming decade.

In either case, investors should be expecting a stock market shock in the coming months, and pay proper attention to their positions in Chinese assets, as well as other markets.

 

 

InnOvation Capital & Management, LLC

IntelDigest

LAW – POLICY – FINANCE – MARKETS
INFORMATION FOR THE ENTERPRISE AND INVESTOR

OCTOBER 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.

 

We have previously published in IntelDigest several discussions of short-term interest rates around the world, and the consequences for millions of people affected by the actions of The Federal Reserve and other central banks in forcing such rates down.  Short-term rates have fallen to almost-Zero … below-Zero in some countries … over the last seven years.

Today, we’ll discuss a commonly-used interest rate that has risen by 44% so far this year, and the central banks have little or nothing to do with it.  We’re talking about LIBOR, the London Interbank Offered Rate.

LIBOR is a benchmark interbank rate which many leading banks use to charge each other for short-term loans.  It is often the foundation, or first step, in calculating rates for millions of loans around the world … in all likelihood, your own home mortgage loan is calculated using LIBOR.

We won’t go into a technical description of LIBOR;  instead, we’ll discuss why it is rising so fast while other rates are stuck.

According to Bloomberg Markets, $7 Trillion of debt … corporate bonds, student loans, mortgages, et al … are based on LIBOR rates.  The 3-month U.S. Dollar LIBOR rate has gone from 0.61% to 0.88% in just over nine months, and is expected to keep rising.  This initial increase will raise interest costs on the outstanding loans by Billions of Dollars!

This is setting the stage for a possible credit crisis within the next 2-3 years.

 

 

Securities and Exchange Commission Rules

Why is this happening now?  LIBOR has not made a significant move since 2008.  Many analysts believe that it is a response to new SEC regulations which have gone into effect this month.  The regs apply specifically to money-market funds … an attempt to reinforce an industry which was in the middle of the 2008 financial crisis.

As reported in Bloomberg Markets, the new rules require prime money-market funds … an important source of short-term funding for banks and businesses … to “build up liquidity buffers, install redemption gates, and use ‘floating’ net asset values (NAV) instead of a fixed $1-per-share price.”

The NAV requirement does NOT apply to government and retail money-market funds, which can still offer stable net asset values.  But, it DOES APPLY to funds which invest in short-term debt securities and work with retirement plan sponsors . Such institutions now have to allow their prices to fluctuate daily based on the market value of their holdings.

The “redemption gates” and “liquidity buffers” apply to both institutional and retail money-market funds, but NOT government funds.  These provisions allow some funds to temporarily suspend redemptions or impose liquidity fees on investors who try to withdraw money during volatile periods.

 
Stresses in the Banking System

Bloomberg Markets has recently reported that $1 Trillion have been shifted from prime money-market funds to government funds over the last year (the new rules were published last Fall).  The competition among banks to replace these lost Dollars would seem to be a cause for LIBOR rates to spike.  Rates last spiked like this in September, 2008 when Lehman Brothers filed for bankruptcy.

When there is high uncertainty or panic in the banking system, banks charge each other very high LIBOR interest rates.

 
Stresses in the Economy

In previous issues of  IntelDigest, we have discussed many of the strains on our economy, which include decreasing corporate earnings, especially at the banks, increasing corporate defaults on debt, and massive borrowing by U.S. corporations at low interest rates.

Corporate profits have NOT kept up with borrowing.  As LIBOR rises, interest costs increase for all borrowers.  At the same time that corporate earnings are headed down, debts are becoming more expensive.  This is a problem for our economy!

 
Addressing the New Money-Market Rules

Money-market funds have traditionally been a safe haven in times of market stress, but you may have to avoid such funds in future.

Money-market funds may no longer be an option in many retirement plans, or you may choose not to live with the possibility of having to pay a penalty for withdrawals during volatile periods.

You, as the investor/retiree, will have to decide how best to invest monies which had been held in cash or cash equivalents in the past.  The safest, but lowest-yield, alternative is usually a government money fund investing in short-term U.S. treasury bonds.  Financial institutions may also offer money-fund replacements such as stable-value funds, short-duration bonds, guaranteed investment contracts, or certificates of deposit.

 
Recognition of Danger in the Economy

Rising LIBOR rates will have a profound effect on the economy, and there is little that The Federal Reserve can do to change the situation.  Market forces are in control.

The first step is to recognize the problems:

Be aware that the economy is slipping into recession

Be aware that the stock and bond markets are in danger of sharp corrections in the coming months

Be aware that, if LIBOR rates continue rising over the next two years, a serious credit crunch will hit in 2018-19

 
Steps to Take Now

We repeat the analysis published in the August 31 issue of IntelDigest:

1. All investors should analyze their portfolios to determine if the dividend is sustainable in each of their dividend stocks. A sure sign of trouble is a company which pays more in dividends than it earns in profits.

2. Look for companies with proven dividend track records. For example, if a company has increased its dividend for more than 10 years in a row, you know it can manage its dividend through ups and downs of the business cycle. Those are the companies that we want to hold for the long haul.

3. Try to avoid companies with significant indebtedness. If there are serious problems in the economy over the next year or two, many companies will struggle to make money. Companies with too much debt may have to cut their dividend, or stop paying dividends entirely, in order to pay their debts.

4. In these “unusual” times, investors should have positions in gold, and should consider holding 10% to 15% of their money in gold. This small position could protect against catastrophic losses if stocks plunge.

 

InnOvation Capital & Management, LLC

IntelDigest

LAW – POLICY – FINANCE – MARKETS
INFORMATION FOR THE ENTERPRISE AND INVESTOR

OCTOBER 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.

In several issues of IntelDigest, we have been critical of The Federal Reserve and its monetary policies over the last fifteen years, during both the Bush and Obama administrations.  Fed policies and manipulations of short-term interest rates have perverted the normal business cycle.  Here’s another perspective.

Over the two-term presidency of George W. Bush, the cumulative (federal government) National Debt level doubled;  the National Debt has doubled again over the two-term presidency of Barack Obama.  The Great Recession of 2008 straddled the two administrations.  Things started going badly under Bush in 2007 and the stock markets hit bottom under Obama in 2009.

As the Obama Administration now draws to a close, the official cumulative National Debt approaches Twenty Trillion Dollars ($20,000,000,000,000).

The debt of corporations also stands at record levels.  In the U.S., the amount of corporate bond obligations is at an all-time high relative to Gross Domestic Product (GDP) … just over 45%.  The situation is worse in other parts of the world.  Corporate obligations in China have soared from practically nothing eight years ago to more than 120% of GDP today.  The International Monetary Fund has reported that global debt is now equal to 225% of global GDP.

Given the steady increases in government debt and debt securities over those few years, one would have expected bond prices to fall, rising interest rates, and lots of inflation.

In actuality, bond prices continued upward, and interest rates have been driven down so low that they are now negative in several countries.
.
The expectations of most economists would have been that massive increases to credit and money supply would have caused a great expansion of consumption, resulting in high inflation and high interest rates.

But, this did not happen.

 

 

Multiplier Effect

Most economists (especially Keynesians) over the last four or five generations have posited that government borrowing and spending would produce a positive multiplier for an economy.  They have thought of government spending as “priming the pump.”  The theory goes that if, for example, the government borrows money to build new roads, then private industry would be spurred to build new houses along the roads and build new businesses to serve those houses, etc.

However, some recent research turns that theory on its head.  There is a new postulation that the multiplier effect for government spending is actually negative, and reduces economic growth.

The research finds that too much of the capital borrowed by governments and invested in public projects goes to waste.  As debt-to-GDP levels surpass 80% of GDP, economic growth suffers, and gets increasingly worse as debt and spending increase.

The data show that our economy is likely to experience big declines in GDP growth as the federal government continues to borrow more and more and spend more and more in an effort to reverse the declining economy.

If this is accurate, it will hurt overall productivity, corporate profits, industrial production, employment, consumer spending, and wealth creation.

 
Imagining “Free” Markets

Since the Great Recession, the U.S. government has created approximately Ten Trillion Dollars of new debt.  Central banks around the world have driven interest rates down to nothing, so the interest on that Ten Trillion Dollars is very low.

Imagine what interest could have been earned on that new debt without central bank intervention.  What economic activity could have been produced?

Long-established data-supported economic theory indicates that interest rates should be roughly equal to annual GDP growth, plus a nominal return above the inflation rate.  If growth is 2.5% and inflation is 2%, we should see short-term government bonds trading around 4.5%, with longer-dated bonds trading closer to 6%.

Ten Trillion Dollars earning 6% would have put an extra $600 billion per year into the hands of investors.  The full National Debt ($20 Trillion) earning 6% would provide $1.2 trillion per year of capital to private investors and savers.

One point of view is that the Federal Reserve manipulations took so much money out of the hands of private citizens, where it could have been used for
consumption and investment, and put it into government programs bedeviled by waste and malinvestment and disincentive.

This is the essence of a negative multiplier.

 

As we set out in the August 24 issue of IntelDigest:

“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).”

So, after massive increases to credit and money supply (and printing Trillions of Dollars out of thin air), the central bankers counteracted their own strategy by forcing interest rates to Zero.  Consumption has fallen markedly, and the expected consumer price inflation has not developed (except in specific areas).

The primary result of central bank manipulation has been asset price inflation, including the artificial inflating of stock prices.  Instead of chasing goods, investors have been chasing yield.

Persistent low interest rates have caused asset bubbles which could pop and unleash a fresh financial panic at any time.

 
A Better Way?

Perhaps there could be a better mechanism for setting short-term interest rates.  As we explained in the August 24 issue, the Federal Open Market Committee (FOMC) of The Federal Reserve has the power to set interest rates and monetary policy.  The FOMC has a standing membership of twelve voting members, comprised of seven members of the Fed Board of Governors in Washington and five presidents of regional reserve banks.

Unfortunately, this “elite” group of twelve men and women has, in recent years, prioritized the interests of the stock market above the interests of savers and retirees and pension funds.  They have clung to a notion for several years that the stock market is the indicator of the health of our economy, and declined any move to normalize rates for fear of a stock market downturn.

Could there be a pure market mechanism for setting rates?  Or, at least, a committee or congress of people from around the country and from a variety of industries (not just banking) who would represent a broader macrocosm of our citizenry?  People who could bring different perspectives  …  rather than the current insular viewpoint of “the 12″ …  to a matter of utmost importance to us all?

How much better would our economy be today if the FOMC had begun to normalize rates on a timely basis?  If it had starting raising rates by 2012, our economy and stock markets would likely be in good shape today;  savers and retirees could be getting decent returns on bank deposits;  banks, insurance companies, and pension funds would be able to rely on a stable basic return of 4% or more.

And, with higher interest rates on government debt, governments would be forced to maintain better control of their budgets and deficits.

 

 

 

 

 

InnOvation Capital & Management, LLC

IntelDigest

LAW – POLICY – FINANCE – MARKETS
INFORMATION FOR THE ENTERPRISE AND INVESTOR

OCTOBER 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.

In this issue of  IntelDigest, we will discuss federal taxation of investors.  This will not be a policy discussion or speculation of tax law changes in the next president’s administration … that can wait until after the election.  We will set out the current tax rules and how they affect particular kinds of investments. We have made several suggestions regarding various asset classes in recent issues, and you should know how such investments will be taxed.

Before beginning that discussion, we have a few words about the consequences of a December interest rate hike by the Federal Reserve.

It is likely that The Fed will make a token rate hike in December, perhaps as much as 50 basis points (0.50%), or perhaps just 25 basis points (0.25%) like last December.  So, how will such a move affect your investments in bonds, stocks, and gold?
Bonds

A general rule of thumb regarding bonds is that the value of a bond will come down as short-term interest rates rise;  and, the amount that the value comes down correlates to the duration of the bond.  For example, if interest rates rise by 100 basis points (1%), the value of a long bond with eight years left to maturity will generally come down by 8%.  This is NOT a hard-and-fast rule, and there are exceptions.  But, as an investor, you should expect such an impact on your bond investments when interest rates rise.

Expecting a modest rise in short-term rates, as indicated above, would most likely result in a modest decline in the value of your bonds.  Of course, holding onto your bonds until the maturity dates … whether months or years into the future … allows you to collect the full par value of the bonds.  In the meantime, be aware that the values of your bonds can fluctuate as short-term interest rates change..

This applies to corporate bonds as well as Treasuries.
Stocks

The impact on equities of a rise in short-term interest rates depends on how artful the Federal Reserve governors are in presenting the case for higher rates.  We have argued that The Fed can “schedule” a number of rises in advance … for example, announce that rates will rise by 50 basis points each December for the next three or four years.

Everyone in business hates uncertainty!!  We believe that stocks will fall for only a few days or weeks after the announcement.  After that, the expected increases would be “baked into the cake” of asset prices going forward;  the markets would likely recover quickly and even march higher IF the economy improves.

Business tends to do well when there is a level of certainty in the marketplace.
Gold

Traditionally, gold prices have tended to go down when interest rates go up, mainly due to carrying costs.  Gold pays no interest, so it has a negative carry. Compared to bonds, money market funds, and dividend-paying stocks … which have traditionally paid out a return of 4-5% or more … Gold was at a disadvantage.

However, we are in an environment where bond and money market yields are close to Zero.  Many government bonds around the world now trade at Negative interest rates;  taking inflation into account, Cash has a negative interest rate as well.

For the first time in history, Gold has a positive carry compared to cash and government bonds.  Central banks, investment banks, and large money managers have bought significant amounts of Gold over the last few years, pushing up the prices of Gold, gold funds, and mining companies.

Gold prices have corrected over the last two months;  but, if The Fed keeps interest rates low, and the US Dollar maintains its current level, the gold price should resume its rise.

Even if The Fed raises short-term rates, we expect that Gold will rise even faster!  Any hike of U.S. interest rates will attract hundreds of billions of Dollars from foreign investors seeking yield;  this money will likely flood into U.S. bonds.

As the U.S. bonds are bid up, their yields will come right back down again. And, as these yields go lower, the positive carry of Gold will become more pronounced, likely leading to a rally in Gold into 2017.

The same thing happened last December after a Fed hike of 25 basis points.

 

Taxation of Investments

Bonds and other Short-Term Holdings (including most options trades) have similar tax treatment.  Interest income is treated as ordinary income and is taxed in the highest tax bracket of the taxpayer.  If the bond or option is held for one year or less, then it is a short-term holding and is treated as ordinary income.  You can save taxes by making such investments inside a tax-advantage account, such as an IRA or other qualified retirement account. (Note that distributions from IRAs and other retirement accounts are treated as fully-taxed ordinary income).

On the other hand, municipal bonds typically pay tax-exempt interest, so it makes sense to hold municipals in a standard (taxable) investment account.

Dividends from publicly-traded equities are usually classified as qualified dividends, which allows them to be taxed at 20% or less, which is lower than the rate on ordinary income paid by most investors, and approximately half of the top ordinary tax rate.  For an individual with taxable income below $415,050 ($466,951 for married filing joint), the tax rate on qualified dividends is only 15%;  if your taxable income is more, you still pay only 20% tax.  Taxpayers in the lower tax brackets could have a tax rate on qualified dividends as low as Zero!

Long-term capital gains (on stocks and other assets) are taxed similarly, so it can make sense to hold publicly-traded stocks in a standard (taxable) account because of the built-in tax benefits.

Preferred Shares of publicly-traded stocks offer special dividends which are practically guaranteed and are paid out before any common shareholders get theirs.  One must review the prospectus of any preferred offering to determine whether these dividends are treated as qualified dividends or fully-taxed ordinary income.

Real Estate Investment Trusts (REITs) are required to distribute 90% of taxable income to unit holders to avoid paying corporate taxes.  The payouts from REITs are then taxed to investors as ordinary income, which could be as high as 39.6%, depending on each investor’s top tax bracket.

Note that if you wish to reduce your tax on a REIT by holding it in a tax-advantaged account, such as an IRA, you could run afoul of the rules on Unrelated Business Taxable Income (UBTI), which could jeopardize the tax-exempt status of your IRA.  Remember that if the income from a REIT is classified as UBTI of $1,000 or more, the investment is inappropriate for an IRA.

Master Limited Partnerships (MLPs) are similar to REITs in their tax treatment.  Typically, some of the payout is treated as ordinary income in the current year, and much of the payout is classified as a tax-deferred return of capital in the current year.  Most of that return of capital will be taxed, eventually, as ordinary income in the year that the asset is sold.

Like REITs, Business Development Companies (BDCs) avoid corporate taxes if they pay out 90% of earnings to the shareholders.  Distributions typically include tax-advantaged qualified dividends, fully-taxable ordinary income, and tax-deferred return of capital (like MLPs, above).  As distributions usually include a large amount of ordinary income, these investments usually work best in your tax-advantaged IRA.

 

InnOvation Capital & Management, LLC

IntelDigest

LAW – POLICY – FINANCE – MARKETS
INFORMATION FOR THE ENTERPRISE AND INVESTOR

SEPTEMBER 28, 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 the National Debt, its consequences, and steps which you can take to protect yourselves from the likely 2017 recession.  In reality, we have been in a recessionary environment for many months, but the artificial buoying of the stock market has clouded the perception of many investors.

We can start with the state of our official National Debt, which stands at approximately $20 Trillion.  Additional future unfunded government liabilities … Social Security, Medicare, Medicaid … would increase the true National Debt to hundreds of Trillions of Dollars over the coming decades.

The official Debt can only increase, as the federal government continues to spend much more than it brings in.  Boston University professor Laurence Kottlikoff has written that over 90% of federal tax revenues go to cover entitlement programs plus interest on the Debt.  ALL other federal government expenditures … including the cost of the largest military in the history of the world … has to be funded from the remaining 8-9% of revenues, PLUS more and more borrowing.

Interest rates are expected to rise … VERY SLOWLY … beginning in December. Considering the state of the public debt, imagine what would happen if short-term interest rates rose to more “normal” levels, such as 4%.  Sure, we would all be able to earn a reasonable return on our bank deposits.  But, the federal government would have to spend more than $500 Billion per year on interest payments alone.

So, unless the Congress and president (both current and future) suddenly “get religion” and decide to make serious attempts at cutting and balancing the Federal Budget, don’t expect the Federal Reserve to raise interest rates with any speed or decisiveness.  The Fed will also move very slowly in raising rates because of a general fear that moving too quickly will result in a stock market crash.
As we discussed in our August 24 issue:

“The Fed’s efforts to avoid small, cyclical recessions have created bubbles in the debt and equity markets, skewed the economy, encouraged consumers and investors to engage in extremely risky behaviors, and resulted in larger, more dangerous recessions, such as 2008.  There is a high probability that a recession in the next year will dwarf the 2008 downturn.”

We also wrote that “… interest rates are not just the cost of borrowing liquid capital; ultimately, interest rates are the “price” of money.”  The Federal Reserve and other major central banks tried to stimulate the world economy … mainly through interest rate cuts … and failed.  Lowering the “price of money” to Zero, and printing “money” out of thin air, have done nothing to increase value or wealth.

The central banks’ actions created Trillions of Dollars worth of “credit” around the world, which is becoming a credit “bubble.”  Many people see the flood of credit and confuse it with wealth, which it is NOT.  It is “fake” money, which is not backed up by production or tangible assets.
The Current Situation
Negative Interest Rates are becoming more prevalent around the world. In major economies … Germany, Japan, France, Italy … 10-year bonds are already Under Zero. Other countries … United Kingdom, Switzerland, South Korea, India … are intervening in currency markets and lowering interest rates to Zero or Negative in attempts to fight deflation.

Here in the U.S., we are left with an artificially-inflated stock market … which is in danger of a severe fall in the coming year … and the inability to earn anything on traditionally-safe assets such as bank deposits.  There is huge risk in the bond market, especially as interest rates begin to inch up, which will probably begin in December.

Many investors have already moved money to safer assets:

– U.S. Treasuries (as U.S. interest rates are still positive and the 10-year U.S. Treasury earns around 1.50–1.60%)

– raw land and rental real estate

– municipal bonds

– dividend-paying stocks (the dividend yield on the S&P 500 stocks is 25% higher than the 10-year U.S. Treasury)

 

Time To Take Care

Increased investments in dividend-paying stocks have driven certain sectors, such as Utilities and Telecom, to extreme highs, so investors should be wary of putting new money into shares which may be overvalued.

Increased investments in dividend-paying Real Estate Investment Trusts (REIT) and Master Limited Partnerships (MLP) have also driven these sectors higher, and there are dangers in these investments.  In the most recent quarter, a substantial number of REITs have paid out dividends which EXCEED their net income; this is not sustainable.  Be wary of investments in commercial real estate (growing bubble in this sector) and commercial REITs, as well as REITs heavily involved in mortgages and loans;  a small rise in interest rates can stunt their profits.
In our August 31 issue, we set out the following advice:

Steps to Take Now

1.  All investors should analyze their portfolios to determine if the dividend is sustainable in each of their dividend stocks.  A sure sign of trouble is a company which pays more in dividends than it earns in profits.

2.  Look for companies with proven dividend track records.  For example, if a company has increased its dividend for more than 10 years in a row, you know it can manage its dividend through ups and downs of the business cycle.  Those are the companies that we want to hold for the long haul.

3.  Try to avoid companies with significant indebtedness.  If there are serious problems in the economy over the next year or two, many companies will struggle to make money.  Companies with too much debt may have to cut their dividend, or stop paying dividends entirely, in order to pay their debts.

4.  In these “unusual” times, investors should have positions in gold, and should consider holding 10% to 15% of their money in gold.  This small position could protect against catastrophic losses if stocks plunge.
As we enter 2017, we will “crash-proof” our portfolios.  We will cut back our investments in companies which need a growing economy to make money … airlines, retailers, restaurants … anything which relies on consumer discretionary spending.  We will hold more cash, so that we can employ it AFTER the stock market downturn to buy shares of the best businesses at lower prices.

We expect the values of gold and silver to rise substantially, so we will hold gold and silver … both in shares and in physical form … as well as shares of mining companies.

Finally, we will take a close look at the underlying investments in our money market accounts and mutual funds to be sure that we are not invested in dangerous instruments unknowingly.