Month: October 2016

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.
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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.