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
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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.