Month: December 2016

InnOvation Capital & Management, LLC

IntelDigest

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

DECEMBER 14 , 2016

 

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

 

 

As expected, The Federal Reserve acted today to raise the federal funds rate by one-quarter of one percent (0.25%), and expects to make similar gradual increases over the coming year.  The immediate response from stock markets was a mild selloff, and it remains to be seen if there will be further ramifications in the coming weeks.

This was a rather tepid move by The Fed, and is well short of any sort of normalization in interest rates.  But, it was a move in the right direction.

The next major news event will be the vote of the Electoral College, which should put a final exclamation point on an unprecedented election cycle.
In the meantime, we will address a few issues which could prove to be major obstacles for the new President in bolstering the American economy.  We refer to stagflation, systemic risk in the banking system, and a credit-default crisis.

Stagflation, a remnant of the 1970s, refers to the combination of a stagnant economy and rising prices.  Although not generally considered a threat today, there are elements of it on the horizon.  The economy has been growing at an extremely slow rate over the last few years, and three primary measures of economic output are still weak:   retail sales, industrial production, and capacity utilization.

At the same time, wholesale prices leapt higher last month.  If the next President initiates major federal spending programs, this would likely be inflationary.

As we stated in the November 30 issue of  IntelDigest, the reaction of The Federal Reserve will be crucial.  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.”

Inflation without accompanying growth in economic output results in stagflation.

 

 

The systemic risk in the banking system has been pushed onto the back burner by most Americans  If a new Republican administration makes good on threats to “gut” the Dodd-Frank Act and drastically reduce other banking regulations, the problems of the 2008 Panic will come back to the fore.

The facts are that the banking system is even more dangerous today, the
“too-big-to-fail” banks are bigger than ever, they hold a larger percentage of the total assets of the banking system, and their use of derivatives is greater!

Can anyone doubt that there is still a serious risk of a global liquidity crisis or market panic?   Consider some possible triggers of such a crisis:

In addition to a serious natural disaster, one could imagine a few catalysts, starting with the failure of Deutsche Bank.  The German bank is undercapitalized and faces Billions of Dollars in fines by U.S. regulators. Its business is interconnected with dozens of other financial institutions, including several in Italy which are facing imminent bankruptcy.  And, Deutsche Bank has one of the largest “derivatives books” in the world, making its exposure to danger significant.

We have also discussed manipulations in the Gold market in previous issues.  A failure by any institution … Deutsche Bank, for example … to deliver physical Gold on demand would trigger a crisis.

One can also imagine global problems stemming from a Dollar-denominated debt crisis in some emerging markets, or a credit-default crisis in the U.S.  We will devote the rest of this issue to the latter.

 
The Bond Market

 

In numerous issues of  IntelDigest, we have discussed the dangers in the Bond Market:  the likelihood that bond values are on their way down, the vast amounts of Debt which many companies have taken on in the low-interest environment of the last eight years, declining corporate liquidity, and the growing risk of default.

U.S. corporations now carry on their balance sheets the highest level of financial risk in our history.  Companies took advantage of the historically-low interest rates served up by The Federal Reserve and other central banks, and borrowed unprecedented amounts of money.  In every year from 2010 through 2015, U.S. corporations borrowed at least a Trillion Dollars.

Did this borrowing spur growth in the economy?  It did not.  Many companies used the funds to buy back shares rather than increase capital expenditures, productivity and sales.

Servicing this amount of debt as interest rates rise will be impossible for many companies.  The soundness of the corporate bond market has been diminished, so that the threat of default is higher, and potential losses more severe.

 

 

Historically, U.S. corporate debt has been predominantly high-grade. However, quality has diminished.  During the 2010-2015 buying spree, high-yield (or “junk”) bonds comprised approximately 20% of the issues. This is a much greater percentage of corporate debt than is usual or prudent.  The only time this has happened before was in 1997-98, and it ended in disaster when the Dot.Com Bubble burst, leading to defaults in 2001-02.

The default rate on high-yield U.S. corporate bonds rose to more than 5% in August.  This has started a new credit-default cycle;  some believe that the default rate could rise to 10-15% over the next two-to-three years.

Credit quality of investment-grade debt has also diminished.  The lowest quality of investment-grade debt is rated “BBB” … which has increased from a norm of 10% of total investment-grade debt to more than 30% today.

This quality of debt is less likely to default;  however, if defaults rise from a normal level of 1% to a level of 3-4%, there will be very large losses at the major financial institutions.  Dollar losses on defaults of combined high-yield and investment-grade debt could easily reach into several Hundreds of Billions, which would dwarf the 2008 mortgage loan crisis.

Rising interest rates … inability to service debt … leading to rising defaults … will erase profits entirely in some industries which rely on low interest rates.

As defaults grow, lenders across all industries will become more cautious. Credit will tighten;  refinancing will become more expensive for some, impossible for others.

 
These are the dangers of a Credit-Default Cycle.  However, there are possible investment opportunities in this environment.

We have identified sectors which are particularly susceptible to default within the next couple of years … where companies are enduring a fatal combination of falling asset prices, too much debt, and a growing inability to service the debt.  We are actively “shorting” several of these companies in our accounts and in client accounts.

Feel free to contact us for more information.

 

 

 

 

InnOvation Capital & Management, LLC

IntelDigest

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

DECEMBER 7 , 2016

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

 

 

This week in  IntelDigest, we discuss various policy proposals for the consideration of the incoming administration.

Before getting to policy matters, we’d like to start with a brief discussion of the markets, which we will cover in more detail next week.  However, a monetary event will likely take place next Wednesday before our weekly issue is published;  that event could have a significant impact on the markets.

Equities have been surging since Election Day, on the expectation that a Trump presidency will be good for business … less regulation, lower taxes, and Billions of Dollars in infrastructure spending by the government.

The Trump election rally would normally feed into a December “Santa Claus Rally” lasting into January.  And, it may still do so.  However, we have stated on several occasions that we expect The Federal Reserve to raise short-term interest rates in December, and we still believe so.  The Federal Open Market Committee meets next week, and will likely announce a rate hike next Wednesday.

One year ago, a Fed hike of 25 basis points (1/4 of 1%) led to an 11% fall in equities over the following two months.  Now, there were other monetary events happening at that time (a Chinese devaluation of the Yuan, for example) which also impacted the markets.

However, a prudent investor may reasonably determine that cashing-in some profits before The Fed rate hike next week is justified.

 

 

 

The Starting Point

To set the stage for policy recommendations, we must establish the overriding truth which the new administration MUST face when it takes office.  The U.S. national debt will likely stand at approximately 20 Trillion Dollars as of Inauguration Day.  Combined state and local government debt will be at least 3 Trillion Dollars.
Therefore, total government debt in the United States will be north of 23 Trillion Dollars.  Gross Domestic Product of the U.S. will barely reach 19 Trillion Dollars by the end of this year.  So, the U.S. debt-to-GDP ratio will be over 121%.

The new administration MUST prioritize getting the national debt and annual deficit under control.  It doesn’t have to be done immediately;  the process can stretch over several years or even a decade.  But, there must be a process in place to show The American People that this dangerous situation is being addressed.

This will require a committed President and Congress to work together to craft budget compromises, government reorganization, deficit reduction, balanced budgets, and reform of both entitlement programs and the culture of the military.  All of these approaches will be necessary to avoid a fiscal disaster which awaits us because of mismanagement … by both Republicans and Democrats, in both The Congress and the Presidential Administrations … over the last 16 years.

Allowing the Debt to grow further will just make it harder for our economy to grow out of the problem.  Since the Financial Panic of 2008, the American economy has been growing at a rate of 2% per year (after inflation);  but, the Debt increase has grown at DOUBLE the rate of the economy!  These trends must be reversed, at minimum.

 

 

 

A New Culture

The basic goal is to find a process which will provide for the financial needs of the country while also putting the federal budget on the road to being balanced.  We have been (justifiably) extremely critical of Congress in these weekly letters.  We believe that the esteemed Members of Congress who have served over the course of the last two presidencies have totally abdicated their responsibility in managing the budget.  They have consistently put partisan agendas, special interests, and their own “sacred cows” ahead of crafting fair and balanced federal budgets.

The new President and Congress must agree that reduction of the national debt is an undeniable Priority, as is fiscal responsibility in every annual budget and proposed law.  Achieving debt reduction may require increased tax revenue;  it certainly requires decreases in federal spending … in all departments, including the Pentagon.

So, considering that taxpayers WANT THE GOVERNMENT TO SPEND in order to provide healthcare and Social Security benefits and other necessary government services, such as defense.  And, considering that we have the large Baby Boom generation entering retirement years.  And, considering that growing the economy out of our Debt problems would be extremely difficult … after all, unlike the 1980s, we don’t have low stock prices and low market capitalizations and a falling interest rate environment and favorable demographics to facilitate the process.

A new “corporate culture” is needed in governing, both in terms of management processes and government policies.  It’s time to go bold and innovative, and completely re-make the fiscal side of government.

 

 

What Steps to Take?

 

Considering only those areas which come under the financial and economic bailiwick of  IntelDigest, we propose the following;

1. Corporate Tax Reform

Reduce corporate income taxes – either to a flat percentage for all businesses (perhaps 15%), or a progressive tax schedule that tops out at 20%

Allow a lower tax rate (perhaps 10%) for cash repatriated from foreign shores

Eliminate most deductions, credits, net operating losses, et al, to eliminate loopholes and other financial planning mischief

By significantly reforming the corporate tax process, companies should all pay their fair share of income taxes.  By lowering corporate tax rates (from the current top rate of 35%) … i.e., emulating competitive countries such as Ireland … this would provide incentive to multinational companies to keep, or move, their operations to the United States.  This would mean more jobs, in both manufacturing and services, in the U.S. Even with lowered rates, corporate tax receipts by the government should be higher in the first year, and grow as more companies re-locate to our shores from year to year.

2. Social Security and Medicare Reform

Reform Social Security Eligibility – including, raising retirement age to a minimum of age 70

Raise the taxable wage base on Social Security taxes so that more higher-paid employees are paying into the system

Government insurance and healthcare systems must be allowed to use their bulk buying power to negotiate lower costs on all drugs, devices, and medical services

When Social Security was instituted in the 1930s, average life expectancy was less than 65 years.  Since the origins of the program, average life expectancy has increased by at least 20 years, but little has been done to change the retirement age.  That has to change immediately in order to save and extend the retirement system.

Retirement and healthcare are the most expensive parts of the federal budget, and costs continue to skyrocket.  The President and Congress will either have to find ways to find ever-increasing funding for these programs, or reform the programs themselves so that they become less of a drain on the economy.  And, they will have to stand up to the “special interests” (pharmaceutical and other healthcare companies, insurers, et al) and their lobbyists.

We have seen a proposal to eliminate the existing taxes which provide for Social Security and Medicare, and replace the funding scheme with a 15% Value-Added Tax dedicated to all retirement and healthcare.  Although an interesting idea, VAT tax schemes are highly regressive;  we would improve the existing system.

3. Infrastructure Programs

Encourage local and municipal governments to undertake infrastructure improvements and capital construction in their local areas, utilizing local labor and public/private partnerships

Establish a new type of Infrastructure Bond – federal government guarantee, interest rate equivalent to 30-year Treasury Bonds – to support the local projects

Federal program (like the federal highway system) to build out national projects

Most infrastructure projects are inherently local, such as roads, bridges, water systems . These should be handled locally, with little interference from the federal and state government.  Some projects are more regional, such as ports and airports, and may require state or multi-state action.

Then there are truly national infrastructure projects, such as establishing a coordinated electrical grid.  This country should have a technologically-advanced, EMP-hardened, secure SmartGrid.

 

 
General (Common Sense) Rules of Governing

Finally, here are two rules to apply to all levels of government:

 

Compliance — All levels of government (federal, state, and municipal) must comply with all laws promulgated by their legislatures … retroactive application to laws already on the books.  There will be no more regulations on citizens or businesses unless the government (including the legislature) is required to comply equally.

 

Congressional Legislation — Before the House or Senate can vote on a bill, the members must have a minimum amount of time to read and consider its provisions … let’s say a legislator has to have one day for every page of the legislation.  Perhaps this would eliminate legislation of several hundred pages being rammed through Congress in 24 hours!

 

This list is a cursory first attempt to “think outside the box” … to consider alternative methods of governing and changing the culture of government.  We welcome input from our clients and colleagues … what would you do to improve government?  We will have more suggestions … and will reprint your comments … in future issues.

 

 

 

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.