IntelDigest

InnOvation Capital & Management, LLC

IntelDigest

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

MARCH 1 , 2017

 

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

 

 

Over the last few issues of  IntelDigest, we have set out our analysis of the investment markets going forward.  Our forecast for 2017 can be summarized as follows:

 

Small-cap stocks will benefit … over the course of this year … from an expectation that the Trump Administration and Congress will succeed in lowering business taxes, reducing government regulation, and increasing federal spending on infrastructure

The U.S. economy will continue to expand … as it has over the last eight years … but at a stronger pace;  if Trump and the Congress succeed, the expansion could approach three percent (3%) per year

Fundamentals are improving in Emerging Markets, and the BRICs countries (Brazil, Russia, India, China) should do well this year

Precious Metals (particularly Gold and Silver) are expected to rise, and should be a staple (up to ten percent (10%)) of an investor’s portfolio

Historically low Interest Rates are the dominant factor in the U.S. Equities Bull Market … stock prices are reasonable when low interest rates are factored in;  even though three modest rate increases are expected from The Federal Reserve this year, rates will still be extremely low, supporting a continued rise in stock prices

U.S. Real Estate remains a very attractive investment while interest rates are at such low levels

Excellent opportunities still exist in some mature foreign markets, such as Japanese equities

These are the precepts supporting an optimistic viewpoint, at least as far as this year is concerned.  Stock markets will have occasional spurts up, such as the increases today following the President’s address to Congress last night. And, there will likely be corrections … where equities slide by 5-10%.  However, the basic assumption of a rising stock market should hold for 2017.

Taking a Cautious Stance

Having an optimistic outlook does NOT mean that we should keep our eyes closed to potential problems.  And, it does NOT mean that ALL investments will do well in the current environment.

In the weeks prior to the Election, we warned investors that the value of corporate bonds will fall as The Federal Reserve raises rates;  that the stocks of companies with substantial indebtedness or unsustainable dividends should be culled from portfolios.

An investor who has reduced exposure to bonds and the stocks of problem companies should be left with a strong core of equities (both American and international), precious metals, and U.S. tangible property.  Owning such formidable assets should carry you through 2017.

Update on Short-Term Interest Rates

Mohamed El-Erian is the Chief Economic Advisor at Allianz, and a former officer at PIMCO investments.  Writing in Bloomberg, El-Erian sees a likelihood of a modest rise in interest rates in March, and a possible change in “tactics” by The Federal Reserve going forward.

The Fed is more likely to raise rates in March if the February jobs report is strong.  El-Erian believes that “… a green light from the wage data would do more than significantly increase the probability of a March rate hike. It also would allow the Fed to slowly evolve away from its tactical posture and toward one that involves more strategic consideration.”

After the 2008 Financial Crisis, The Fed had adopted a “data-dependent” approach to policymaking, with poor results.  Not only were the experts at The Fed surprised by the crisis, their analytical modeling was insufficient or out-of-date, and the policy of dragging short-term rates down to ultra-low levels has been a catastrophe for Main Street.

El-Erian believes that a positive jobs report will motivate The Fed to step up in March, and return with confidence to its historical proactive strategic stance … one which will be necessary moving forward, as policy battles between Congress and the Trump Administration threaten to derail the expansion of the American economy.

 

 

The “Goldilocks Market”

Louis Navallier, famed investment advisor, has a different take on rate hikes.

Navallier describes the current economic conditions as a “Goldilocks” environment … meaning that the economy is running at exactly the right temperature.  There is sustainable growth, but it’s not so “hot” that The Fed will be compelled to raise interest rates by much.

He believes that The Fed Open Market Committee will NOT likely raise rates at its March meeting because inflation remains in check.  He asserts that The Fed has a 2% inflation target;  if it exceeds that level, it’ll likely raise interest rates.  As it stands, the Fed’s inflation measure is running at 1.7%.

In recent testimony before the Senate Banking Committee, Fed Chair Janet Yellen implied that the FOMC will gradually raise key interest rates at its upcoming meetings.  Fed Vice Chair Stanley Fischer later reiterated Yellen’s comments … that The Fed is noting the strengthening economy and that it “is a little more confident about where we’re going and how soon we’ll get to full employment with stable prices.”

Translated from “Fed speak”, Fischer is hinting that the data-dependent Fed will most likely raise key interest rates at its June FOMC meeting. There is a small chance of a rate hike at the March FOMC meeting, but based on market rates, a June hike is much more likely.

The Strength of the Stock Market

Navallier believes that the accommodative policies of The Federal Reserve will continue, and will push down the yield on corporate bonds. If Congress passes corporate tax reform which includes an incentive for multinational corporations to repatriate Billions of Dollars held in foreign countries, Navallier believes that this would lower bond yields even further.

This goes against our own view of bond yields, so we will keep a close watch on these developments.

Navallier has a theory for the “persistent strength” of high-quality U.S. stocks:

“Between the stock buyback activity and the lackluster IPO market, the stock market is actually shrinking. So as money pours into the stock market, it flows into fewer shares.”

Looking at the short term, March and April tend to be seasonally-strong months in the markets as significant amounts of pension funding occur at this time. So, we expect the markets to continue performing well in the coming weeks.

Next week, we will update developments in the three major policy debates which will impact all our fortunes in the coming months … the Debt Ceiling, Tax Reform, and Infrastructure Spending.

 

 

 

 

InnOvation Capital & Management, LLC

IntelDigest

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

FEBRUARY 22 , 2017

 

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 recent issues of  IntelDigest, we have published economic analysis as it relates to the current market environment for Investment.

 

We have posited that small-cap stocks will do well this year, as primary beneficiaries of Administration and Congressional policies aimed at lowering business taxes, reducing government regulation, and increasing federal spending on infrastructure.  This would be supported by a continued expansion of the U.S. economy, which has been happening at a gradual pace for the last several years.

 

We have noted that global inflation has been rising of late … at a faster pace than expected … and that fundamentals have been improving in the Emerging Markets sector.  We believe that the BRICs markets (Brazil, Russia, India, China) are positioned to do very well in the next year or two, and we pointed to a BRIC investment fund where we have invested.

 

We have repeated our analysis that the fundamentals for Gold (and Silver) investment are positive, and that such Precious Metals should have a place in every portfolio … investors should consider Precious Metals for approximately ten percent (10%) of total holdings.

 

We have also warned of a Credit-Default Crisis on the horizon for 2018-2019.

 

 

Today, we will begin with a few more words on Gold, then move on to an analysis of The Long Bull Market, and why it still has legs in 2017.  Finally, we will discuss the looming Credit-Default Crisis of 2018-19, and what we can do to prepare for it.

 

 

 

More Gold Talk

In addition to the Gold fundamentals which we have set out in prior issues, there are a few more points to consider.

 

Inflation in the economy and a weakening of the U.S. Dollar are primary stimulants of the price of Gold.  The looming battle between the Trump Administration and The Federal Reserve over Inflation will take center stage in the coming months.

 

The Fed will want to keep Inflation in check;  typically, The Fed will opt to raise interest rates fast enough to moderate Inflation, which adds strength to the U.S. Dollar.  The Administration, on the other hand, wants a weaker dollar to help U.S. exports and create U.S. export-related jobs.  Donald Trump has railed against several of our trading partners … China, Germany, Japan … assailing them for using cheap currencies to hurt U.S. workers.  He is determined to fight back with a weaker U.S. Dollar.

 

A weaker Dollar will translate to Higher Gold Prices.  Gold is both a Hard Asset and a form of money, like the Dollar, Yen, Euro, Chinese Yuan.  When the Dollar is weak, the price of Gold (as measured in Dollars) rises.

 

How will Trump “trump” The Federal Reserve?  He will be in a position this year to appoint up to four of the seven members of the Federal Reserve Open Market Committee.  It is a sure bet that the “reconstituted” Open Market Committee will side with the President.

 

The resulting weakening of the Dollar will be good for Gold investments.

We also look to the actions of one of the top investors in the United States, Stanley Druckenmiller, for another sign of Gold strength this year.  Druckenmiller held extraordinary amounts of Gold investment in 2015-16, then sold much of it on the day after the presidential election.  However, he renewed buying in December.

 

When asked why he was buying Gold again, in the middle of the Trump Rally, he stated that he wanted to own some currency, but “… no country wants its currency to strengthen … Gold was down a lot, so I bought it.”

 

His reasons had nothing to do with fears of a recession or a stock market crash;  he bought Gold because (1) it’s cheap, and (2) central bankers are weakening paper currencies.

 

Gold should be considered a core holding in one’s portfolio, to be held for the long-term.

The Long Bull Market

Ultra-low Interest Rates are the dominant factor in the U.S. Equities Bull Market which has continued since the end of the 2008 Financial Crisis.  Although the Bull Market seems “long in the tooth,” and the National Debt is a gargantuan problem to overcome, the simple fact is that Interest Rates will remain low for some time to come.

 

That provides continued support for Investment in Stocks this year.
By many traditional metrics, equities are expensive. However, when the ultra-low Interest Rates are factored in, stock prices are reasonable.  With many markets and individual stocks hitting new all-time highs in the last few weeks, we expect that the Bull will run longer, probably through most of 2017.  Historical data supports the notion that assets which attain long-term highs will keep running higher.

 

Investors have a choice in the current marketplace, between earning no interest in the bank, or taking risks in stocks … guaranteed safe returns vs. the risks of the stock market.  Today, the guaranteed safe returns don’t exist.

 

So, to understand if stocks are a good deal, you have to consider whether they’re a good deal relative to interest rates.  You must consider both stock valuations and interest rates when analyzing the true value of the investment.

Outside of the U.S., we believe that some of the best investment opportunities come from Japan, where the head of the central bank has taken extraordinary measures to get Japan’s struggling economy growing again.  The Japanese government is actively buying Japanese stocks, and is expected to continue money-printing.  The results should be (1) falling Yen, and (2) surging stock prices.

 

We are invested in the WisdomTree Japan Hedged Equity Fund (NYSE: DXJ), which will allow us to profit from the rise in stock prices without exposure to a falling Yen.

Investing in Real Estate

Don’t think that discussions of Gold and Emerging Markets and small-caps, et al, indicate that we are overlooking Real Estate.  Real estate in the U.S. is still a highly-valued asset class, and mortgage rates are still close to all-time low levels.

 

We would imagine that the Real-Estate-Mogul-in-Chief will work to keep the tax and investment climate supportive of real estate owners for years to come.

Credit-Default

In numerous issues of  IntelDigest, we have discussed the dangers in the Bond Market, and the crisis looming in 2018-19.  Consider 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.

 

 

 

Servicing this amount of debt as interest rates rise next year 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.

 

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.

Looking ahead to 2018-19, when Interest Rates will likely rise as the economy grows, this will likely lead to inability to service debt … leading to rising defaults … erasing 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.

 

We have identified possible investment opportunities in this environment, in sectors which are particularly susceptible to default within the next couple of years, including shopping malls, car rental fleets, and some companies in the oil patch.  Here, companies will endure a fatal combination of falling asset prices, too much debt, and a growing inability to service the debt.

 

The opportunity is in “shorting” several companies in these sectors, starting this year and continuing through 2018.

We would be pleased to discuss strategies for managing and protecting your assets in the current environment, and going forward.

 

 

 

 

InnOvation Capital & Management, LLC

IntelDigest

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

FEBRUARY 15 , 2017

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 continue our focus, in this issue of IntelDigest, on The Economy and Investing in the “New World Order.”  Today, we discuss the prospects for Gold this year. Next week, we will concentrate on Equity investing for 2017, and discuss preparing our portfolios for the 2018-19 Credit Crisis.

We have written on the case for Gold on several occasions in the past year, and the basic premise has not changed, despite the election surprise.

 
Fundamentals

We addressed the fundamentals of Gold investment in both the July 26 and November 9 issues.  Feel free to review the archive copies of those issues on our websites.

The basic arguments are:

1. 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.

2. Gold is a traditional safe haven in times of insecurity;  it can provide insurance against cyber and political risks.

3. 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.

 

 

4. Only a strong U.S. Dollar has kept the value of Gold and Silver from rocketing higher in the last two years.  When the Dollar declines … and the Trump Administration is in favor of a softer Dollar … the price of Gold could shoot over $2,000 per ounce.

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

International Factors

We have also looked at three important international developments in the Gold market, which should propel the Gold Market 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.

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 third  international 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!

Political Factors

As we discussed in the November 30 issue of  IntelDigest, the Gold Market in 2017 will hinge on the actions of the new President and The Federal Reserve.  We wondered what type of President would reside in the Oval Office, and the early indications are that it is the same Donald Trump who slashed his way across the country over an 18-month-long campaign.

The uncertain nature of Administration actions and policies will push many people into further Gold investment.

What of Trump’s legislative agenda, i.e., significant tax cuts and Federal spending on  Infrastructure?  If The Federal Reserve 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 push the Dollar higher and set off a stock market fall and a recession in the U.S.  Raising rates would make U.S. goods and services less competitive, resulting in lower profits and damaging our long, slow economic recovery.

This is NOT what The Fed intends, so it will NOT be able to raise interest rates very much or very quickly.  Many long-term investors realize this, and continue to buy Gold to protect their wealth.

We believe that Gold and Cash act as excellent portfolio insurance against the uncertainties of both the Trump Administration and Federal Reserve policy.

 

 

 

 

InnOvation Capital & Management, LLC

IntelDigest

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

FEBRUARY 8 , 2017

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 continue our focus, in this issue of IntelDigest, on The Economy and Investing in the “New World Order.”  Today, we discuss new opportunities in Emerging Markets, Infrastructure proposals in the United States, inflation and interest rates.  Next week, we will revisit Gold, and explain its resurgence in the new year.

As we pointed out last week, we expect small-cap stocks to outshine multinational corporations this year.  Small-caps would benefit from increased earnings produced by reduced government regulation and lowered corporate income tax rates.  Most small-caps should be generally unaffected by conflicts over trade policy.

 

Several sectors which rallied following the election … including multinational corporations in financials, industrials, materials, and energy … will likely underperform in 2017.  These sectors have been characterized by lackluster or negative earnings and sales growth … investors can see that these companies don’t have the fundamentals to support the year-end surge.

 

These sectors have already experienced a pullback from their frothy market highs post-election, as investors see extreme contentiousness from the new Administration, and reluctance in Congress to dive head-first into the Trump Agenda.  Markets have been spooked by potential bottlenecks on tax reform, healthcare reform, and the vaunted Infrastructure spending spree (which we discuss later in this issue).

 

Combined with concerns about the fundamentals in these sectors, investors have taken profits on the year-end market surge.

Emerging Markets

We believe that one of the best opportunities in the markets is to look overseas.  Emerging Markets have lagged American markets since the 2008 Financial Crisis, but fundamentals are improving and the situation looks promising for 2017.

 

Emerging Market fundamentals are illustrated by the Purchasing Managers Index (PMI) for the Eurozone, which recently rose to its highest level in nearly six years. Manufacturing growth is up in Germany, France, and Italy; this is a good indicator that the long battle against deflation in Europe is coming to an end.

Inflation is now rising faster than expected for the first time in years.  The “Global Inflation Surprise Index” at Citigroup has been surging higher in recent months, along with consumer prices.  The index compares actual consumer price data with market expectations, and has been in positive territory in the last few months.

After years of falling short of analyst expectations, global inflation is suddenly moving much faster than predicted, which should be bullish for equities (in the short-term) and precious metals (in the long-term).

BRICs

Like the rest of the Emerging Markets, the BRICs markets (Brazil, Russia, India, China) are due for a rebound from the Financial Crisis, and they have significant advantages over other countries.  The BRICs are the four largest Emerging Markets, and have the potential to be among the largest economies on the planet in future decades.  Their stock markets soared in the early years of this century;  a moderate recovery in these markets now would be profitable for investors.

China is now the second largest economy in the world, behind only the U.S.   India is seventh largest, and Brazil is number nine.  Even Russia, with all its financial troubles and the decline in the oil market, is the twelfth largest economy in the world.

The BRICs Bull Market in the early-2000s followed a decade of underperformance compared with the U.S. in the 1990s. During that Bull Market, the the MSCI BRIC Index rose 745% from its low in 2002 to its high in 2007.

We believe that this year will be good for The BRICs, so we have invested in the iShares MSCI BRIC Fund (BKF) which tracks that Index.

Infrastructure Projects in the U.S.

Both the Trump Administration and the Democratic opposition have new Infrastructure Proposals on the table, so it is relatively certain that Billions of Dollars will be spent on Infrastructure over the next four years.

The Administration has published its “Priority List: Emergency & National Security Projects,” which lists 50 projects to be tackled early in Trump’s Presidency (originally put out by the Transition Office).  Total federal spending would exceed $137 Billion Dollars, and The Administration would encourage the private sector to add a similar amount for vital national projects.

The paper and its details can easily be found on the Internet.  Highlights of the Plan include: road and bridge repair and replacement; updating and expansion of the electric grid; energy storage projects; upgrades to airports in St. Louis, Seattle, and Kansas City; modernizing the Air Traffic Control System from radar to satellite-based tracking; rail and transit projects, including the Washington-New York corridor; reinstatement of the Keystone and Dakota Access pipelines; addition of the Atlantic Coast Pipeline from the Marcellus Shale in Pennsylvania to utilities in Virginia and North Carolina; and various other projects, including dams, waterways, et al.

The Democrats’ Plan is set out in the “Blueprint to Rebuild America’s Infrastructure,” which would spend A Trillion Dollars on the Trump projects and many more.

Infrastructure spending obviously has support from both parties.  Whatever combination of projects comes out of Congress later this year, Billions of Dollars will be spent and many jobs will be created.  We will discuss possible investment opportunities later this year as the Plan begins to take shape.

Long-term Credit Problems

As we have written in several issues, a long-term Credit Crisis looms over the horizon, which will make investing very challenging in 2018 and 2019.

The Wall Street Journal recently published an interesting analysis of The Federal Reserve, highlighting an unusual consequence of the Fed’s Quantitative Easing (QE).  Recall that, in the wake of the 2008 Financial Crisis, the QE program involved The Federal Reserve buying up Trillions of Dollars of bonds (mostly government securities) in an attempt to lower interest rates and increase the money supply to spur the economy.

The program did not achieve the stated goals, but some would argue that it stopped the world economy from plunging further into crisis.

The Fed stopped buying new debt in 2014, but it still holds more than $4 Trillion in debt, including nearly $2.5 Trillion in U.S. Treasury securities.  The Fed holds mostly longer-term debt, meaning relatively little of this debt has matured.  The Fed has been reinvesting the cash from maturing bonds back into new Treasury debt.

The Journal notes that the average duration of the Fed’s Treasury holdings has fallen from nearly eight years in 2014 to just six years today.  In other words, the Fed has been reinvesting in shorter-term debt than it had been.  And this has helped push interest rates higher.
Janet Yellen, the current Fed Chair, asserts that this has had the same impact as if the Fed had raised short-term rates two additional times.

According to the Journal, The Fed now intends to cut the size of its bond portfolio … it will stop reinvesting the cash from maturing bonds back into Treasuries.  This would put even more upward pressure on rates.

Moreover, much of The Fed’s Treasury debt is set to mature over the next five years.

Long-term rates will soar higher as inflation begins to stir for the first time in years and the Bull Market in bonds rolls over.  This would result in much higher borrowing costs in the next few years.  High-grade borrowers would be forced to pay unusually high rates;  many firms will be unable to borrow at all

Expect the benchmark 10-year Treasury to rise from 2.35% to 6% over 2-3 years.

Next week, we’ll address this problem in more detail … the time frame for onset of such a crisis … steps to be taken ahead of time to protect our assets.

 

 

 

 

InnOvation Capital & Management, LLC

 
IntelDigest

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

FEBRUARY 1 , 2017

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, and for the next few weeks, we will focus on The Economy and Investing in the “New World Order.”  We will start with a general overview today, and analyze specific sectors in the coming weeks.

Most market analysts expect that the Trump economic program will be positive for the American economy, in general.  A particular beneficiary of Trump policies would be small-cap stocks, primarily because the Trump Administration intends to continue challenging other nations on the subject of “fair trade,” which could upset some trade relationships and invite retaliation against American multinational companies trying to do business in various countries.

 

Small-caps will have two advantages in the new environment:  (1) they generally earn a larger percentage of their income in the United States, compared to larger companies and multinationals, and would be injured less by trade-related controversies; and  (2) small-caps are less likely to be impacted by Trump-inspired U.S. laws aimed at large U.S. companies which have moved operations and jobs overseas.

Then there is the intention of Trump and the Republican-controlled Congress to lower corporate income taxes.  This is another initiative which should be a greater benefit for small-cap stocks … small-caps have been paying higher U.S. tax rates for years compared to certain multinationals which could hide profits in foreign countries and avoid U.S. corporate income taxes.

Lower taxes will certainly improve earnings of small-caps, with an expected stock market boom as a result.

These factors, plus Trump’s commitment to reducing government regulation, have already spurred a rally in small-cap shares since the election.  Investors are anticipating lower taxes, more favorable trade deals, less regulation, and pro-U.S. business policies which should be favorable for American companies.

 

 

 

Even before the anticipated corporate tax cuts, companies in the S&P 500 are expected to see earnings rise by up to 8% in 2017.  With the tax cuts, forecasted earnings growth could be as high as 20%!  Add to that the expectation that new tax legislation will give multinationals the opportunity to repatriate Billions of Dollars of profits at a low rate, and the outlook for U.S. corporations is looking positive for the next few years.

Economic optimism is now widespread, even if the new administration will likely be embroiled in political controversy for an extended period of time.  Even so, American influence in global financial matters has not abated, Wall Street indices are close to all-time highs, and consumer confidence is at its highest point in 12 years.

At least from an economic standpoint, the uncertainty which accompanied Trump’s surprise election has gradually abated.

The International Monetary Fund (IMF) expects the U.S. economy to grow 2.3% in 2017, and 2.5% in 2018 … higher than its previous forecasts.

Other economic metrics support favorable growth forecasts.  Inflation stands at just over The Federal Reserve’s target (2% per year), and crude oil prices are stabilizing.  December housing starts jumped 11.3% to an annual pace of 1.23 million homes … for the year, housing starts rose 5.7%, the second-highest annual pace since 2008.  Existing home sales rose 4.0% in 2016, and the supply of existing homes is now at a 17-year low.

The housing market should remain strong as long as interest rates remain relatively low.

 

 

On the negative side, not all sectors have a rosy outlook, and there are other areas of concern.

Several sectors rallied following the election, including multinational corporations in financials, industrials, and materials.  These sectors have been characterized by lackluster or negative earnings and sales growth.  Investors need to be wary about these sectors, and will have to work hard to extract the few diamonds from the mass of overvalued companies.

The strength of the U.S. Dollar over the last three years has cut into the bottom line of most U.S. companies doing significant business overseas.  Even with the pullback in the Dollar this week, the stocks of the aforementioned financials, industrials, and materials are likely to be hurt as investors see that these companies don’t have the fundamentals to support the year-end surge.

 

There are serious concerns that the Trump controversies in non-economic areas could easily disrupt the financial world.

Both Chancellor Angela Merkel of Germany and China’s President Xi Jinping have openly warned the U.S. against pursuing protectionist policies.  Clearly, big exporters like China and Germany want to protect their current trade surpluses

Trump’s aggressive first ten days in office have created more uncertainties which have halted the rise in interest rates and Treasury yields (now 2.48% on the 10-year).

Analysts have downgraded some multinationals, such as Coca-Cola (KO) and Procter & Gamble (PG), which were both downgraded to a “sell” rating by Goldman Sachs.  We would expect downgrades of most multinationals in the coming weeks.

 

Then there is the daily barrage of extreme nonsense from the White House which is likely to put investors and business owners in a state of unease going forward.
For example, is the U.S. going to build a multi-billion Dollar wall at the Mexican border?  The Mexican government claims that it won’t pay for such a thing, so the Administration put out a plan involving a border tax, which would ultimately put the American consumer on the hook for the cost.

From a Republican retreat which brought together the President and
Congressional Republicans, The Wall Street Journal reported that the executive and legislative branches “struggle to understand each other.”

 

 

The downside of such spectacles is that they can quickly erode the confidence of Corporate America … will business owners go forward to hire more workers and expand their businesses in such an environment?

By the way, a major impediment to economic growth could occur in March when the Congress and President have to seriously consider raising the Debt Ceiling … that promises to be a donnybrook for the ages!

 

The bottom line is that the economy is looking up, at least for certain stocks in certain sectors, but there is a high probability of confusion and controversy in the next 90 days.  It is a stock picker’s market, so we’ll use a good deal of digital ink in the next few issues to discuss the areas where opportunities lie in the immediate future.

 

 

 

 

 

 

InnOvation Capital & Management, LLC

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JANUARY 25 , 2017

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After the discussion last week of the “Trump Doctrine,” we continue with matters of ideology in this issue of IntelDigest.  Next week, and for the ensuing few issues, we will return our focus to The Economy and Investing in the “New World Order.”

Today, we will tackle Nationalism.  Most people see the successes of the Brexit and Trump campaigns as Nationalist victories.  But, what does that mean?  How did we get to this point?  Where are we headed?

 

 

The simple explanation for the rise of Nationalism in the United States is this:   economic dysfunction has political consequences.

 

 

In the wake of the 2008 financial crisis, long-held support for Internationalism … which has held sway since the end of World War II … has crumbled among the middle classes. Economic stagnation has persisted in most advanced industrial nations, while instability and insecurity are widespread in export-dependent countries.

Internationalism begat Globalization and Free Trade.  We discussed Trade Policy in our November 16 issue, which you can access in the IntelDigest Archive on our websites. Free Trade, as a world-wide policy, gained prevalence in the decades following the carnage of World War II;  traditional Protectionism now gains momentum.

The balance between Free Trade and Protectionism has been a point of contention throughout the history of the United States.  Today, exports account for only 12-13% of our Gross Domestic Product, so it is less of an issue in our country than in others.  However, the financial crisis has brought the subject to center stage, and opened the door to re-evaluation of our trade policy.

Controversy over trade policy ties into complaints over declining purchasing power and standard of living, job losses, stagnant wages, and loss of market share for U.S. products.
Political debate in the U.S. still revolves around the dichotomy of Left  vs.  Right, Liberal  vs.  Conservative. However, around the world, the political divide is more often Internationalist vs. Nationalist … those who deem essential the system of  alliances, mutual responsibility, free trade, and transcultural life which has developed since World War II   vs.   those who abhor the globalist perspective and prefer to hold dear their nation, culture, class.

 
Post World War II

Most would acknowledge that Internationalism was largely successful in the decades following World War II.  The world had been ravaged by conflict, the origins of which included the rise of Nationalism in Germany, exacerbated by the pre-war economic crisis.  The Great Depression featured the collapse of international trade because of Protectionism, represented in the United States by the Smoot-Hawley tariffs.

Post-war economic development depended on economic cooperation and opening up trade among the affected nations.  The United States encouraged European integration and free trade, and led the formation of the International Monetary Fund and World Bank.

The dangers of Nationalism and the necessity of international cooperation were the lessons which came out of World War II.  The result was an Internationalist system moving toward increased political, military, and economic integration in the West.  The collapse of the Soviet Union only validated this thinking;  the West had defeated the Soviets because of superior military and economic systems produced by international integration.

This encouraged world leaders to expand the Internationalist ideology.  Greater interdependence among nations would foster common interests and reduce the chance of conflict.  Greater integration would lead to greater prosperity.  More prosperous nations would encourage liberal democracy and respect for human rights.

Conservative advocates of free markets and liberal advocates of social justice embraced Internationalism;  one group seeing it as a path to prosperity through trade, and the other seeing rising standards of living and liberalization of political behavior.

 
Unequal Benefits

Internationalism has been largely successful around the world, but Nationalists charge that only part of the population has enjoyed the wealth, while cultural identity has suffered in many places.  Some would acknowledge that Internationalism is hostile (or, at least, tone-deaf) to cultural identity, and that is a weakness which has become more prevalent since the 2008 financial crisis.

 

 

 

Vulnerabilities

Interdependence can also be the Achilles Heel of Internationalism.  In a Nationalist environment, the barriers between nations … tariffs, currencies … act as moderating forces when a financial crisis hits another country.  But, the 2008 financial crisis was felt around the world like a contagion.  The integrated world banking system … which had been designed to facilitate the free flow of capital … instead quickly spread the financial virus everywhere.

Because of the high level of financial integration and the vast network of trade relationships among nations, significant damage was done to American finance and Chinese exporting and European markets, which, in turn, has undermined the oil market.

But, even the prior successes of Internationalism had been sowing seeds of discontent in some quarters, as economic growth increasingly benefited certain classes at the expense of others, and vast interrelated systems caused individuals to feel that they, and their native countries, had lost control of their own destinies.  Economic Elites could be satisfied with following capital around the world, but the homeland mattered to the Common Man.

This problem became more prevalent after 2008.  It became clear that middle classes in some countries were hurt when companies moved production overseas to take advantage of lower wages.  While people with wealth or position still had freedom of movement, many people, especially among the middle- and lower-classes, weren’t going anywhere, in both literal and metaphorical senses.

 
Rise of Nationalism Overseas

The breaking point was immigration.  Many in the middle- and lower-classes … in countries around the world … felt imperiled by an influx of thousands of immigrants or migrants, threatening their cultural foundations and their ability to earn a living.  They saw their own government as indifferent to their plight and complicit in disrupting their world.  They saw immigration as a burden placed particularly on them.

Nationalism is more prevalent in Europe than the U.S.  The European Union (E.U.) had put forward regulations and policies which prioritized the success of the E.U. at the expense of national interests.  This created conflicts within the bloc and among the member states.  This was exacerbated by the 2008 financial crisis, when member states experienced an economic crash while their hands were tied by the E.U. apparatus in Brussels.

 

 

 

Nationalism in America

In the United States, the defining economic problems today are decline in the purchasing power and living standard of the middle class.  One of the key affected groups is the white working class.  While it remains the single largest ethnic and social group in the U.S., many white workers felt disenfranchised, and were ready to turn on the party in power, the Democrats.

Donald Trump astutely tuned in to this demographic, and used it as his base to win the election.  Any of the other candidates … either Democrat or Republican … would have had a strong candidacy if they had addressed the issues important to this group.  Only Bernie Sanders came close.
Has Nationalism Reached Its Zenith?

Many people … in many countries … have turned to Nationalism after suffering through the 2008 crisis, because they came to view Globalization and Free Trade and Internationalism as ineffectual in solving the political and security and economic crises around the world.  People will seek the path providing the best advantage, and, today, Nationalism looks increasingly attractive.

However, it is still unlikely that nationalist parties will win majorities in any European countries.  The greatest concern in Europe is the threat of E.U. members attempting their own Exit from the Union;  the jury is still out on this question.  We will write more about the European Union in the Spring.
The situation is quite different in the U.S., and American Nationalism may have reached its high point.  There is significant push-back against the nationalist policies of the Trump Administration, and soul-searching among Democrats (and other Internationalists around the world).

The Brexit and Trump earthquakes of 2016 are likely to spur renewed efforts in 2017 to attend to disenfranchised groups, especially in the U.S., and reinvent international institutions to smooth out disparities in the global economy.

 

 

 

InnOvation Capital & Management, LLC

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JANUARY 18 , 2017

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Is there a “Trump Doctrine” on foreign relations?  If so, does anyone know what it is?

We look abroad in this issue of  IntelDigest.  On the eve of a presidential inaugural, we try to divine the outline of a foreign policy in the new administration.  Does the incoming president have a sense of where he wants to take the country internationally?  Or, will this be a “seat-of-the-pants” operation?  Is Donald Trump’s “unconventional” behavior a carefully-considered stratagem meant to keep allies and competitors overseas “on their toes?”  Or, is he simply feeling his way in an area where he has no prior experience?

Will The Trump Doctrine be based on economic nationalism?  Or militarism?  Or a rejection of liberal internationalism?  Or, will Donald Trump and his team simply react to international events?

 
Points of View

There is actually a parallel to Barack Obama’s assumption of office eight years ago.  Obama, too, had very little foreign policy experience.  However, the demeanor and personality of the president-elect is such a polar opposite to President Obama that the parallel ends there.

Barack Obama, as president, has been a realist.  He understood that his victory in the 2008 Election was attributable, in great measure, to his campaign promise to bring home American military men and women who were engaged in extended Middle East conflicts.  He considered it his mission to re-balance the projection of American power, and reduce our involvement in wars in the Islamic world.

The Obama philosophy of foreign affairs was characterized primarily by Restraint and Civility, and he took the long view.  He pivoted the U.S. focus toward the Far East, where the U.S. now has more economic interest than in the Middle East.  And, he has tried to re-boot the long-standing strife with Cuba and Iran in order to set our relationships with those countries on a more productive path going forward.

 

 

President Obama has been a forward-thinking Internationalist.  Although he encouraged our allies to pay a greater share of the costs of security, he never threatened to take away the U.S. security umbrella.

To Obama, foreign trade was a means of building alliances and containing conflicts;  however, when protectionist measures were required, the U.S. led G-20 countries in carrying out discriminatory-trade measures on certain industries, such as metals.  He saw that technology was changing the world, upsetting familiar manufacturing practices and taking away jobs everywhere.  He understood that companies had to change their business operations in order to survive;  workers would be left behind unless they adapted and upgraded their technological understanding.

For Obama, the long-term impact of climate change was a much more existential threat to this country than short-term threats posed by the Islamic State.

Barack Obama took the long view.  It may have been to his own detriment, and that of his party.  But, that didn’t make him wrong.

 
By contrast, Donald Trump presents himself as a Nationalist.

Based on data drawn from his campaign rhetoric, his post-election Twitter posts, and his Cabinet nominations, we have a preliminary picture of his views on foreign affairs.

Trump’s narrower, more nationalistic viewpoint may tend to be more myopic in assessing threats from overseas.  He has expressed a disdain for long-held collective security arrangements, such as the North Atlantic Treaty Organization (NATO).  He seems to be more interested in bilateral, rather than multi-lateral, treaties and trade deals.

His proposed solution for displaced American labor is to punish foreign trade partners, rather than to retool the U.S. workforce to adapt to demographic and technological change.  Climate change concerns will certainly take a back seat to more immediate desires to ease regulations on business.

His negative comments on China trade and currency, along with the kerfuffle over relations with Taiwan, indicate an intent to deal harshly with China.  Meanwhile, his “bromance” with Vladimir Putin and staunch defense of Russia against U.S. intelligence agencies indicate that he has strong views on relations with Russia.

Perhaps he sees the One-China policy and contentiousness with Russia to be relics of the Cold War, and he intends to turn those situations on their heads.

Most Americans would welcome better relations with Russia, especially on our terms.  However, one may be concerned that short-term conflicts with Beijing over trade and Taiwan could cost the U.S. a much bigger strategic advantage with respect to greater China issues, such as cyberspace and open sea lanes.

 

 

Negotiation As Strategy

Evidently, Trump sees Russia more as a business competitor than as a dangerous enemy requiring Cold War-era collective security commitments.  And, he may have a point (notwithstanding Russia’s 7,000 nuclear warheads).

Russia is far-removed from the Soviet empire trying to spread a Communist ideology around the world.  Instead, Moscow is focused on basic tasks:  forging a national identity in a very large land mass encompassing hundreds of disparate cultures and ethnicities;  insulating the state and its borderlands from Western encroachment, such as the Euromaidan revolution in Ukraine;  maintaining pension, social welfare, and military salary payments in an economy in severe recession;  anticipating greater domestic turmoil in its far-flung provinces over these issues.

The incoming administration sees an opening to develop a new understanding with Moscow, settle the issues in Crimea and eastern Ukraine, and work together with respect to Syria and the Islamic State.  Perhaps a new relationship would lead to the end of sanctions against Russia, new investment in Russia, and a new nuclear arms treaty.

 
Keeping the World on Its Toes

Donald Trump’s biggest advantage is his unpredictability.  He makes people uncomfortable, and generates a feeling of chaos.

Whereas President Obama had been criticized as overly cautious in his foreign policy, and thus too much of a known entity for U.S. adversaries;  Donald Trump gives the impression that he is willing to throw caution to the wind and rely on instinct in shaping foreign policy.

This may have the effect of keeping both our allies and adversaries “on their toes.”  At the beginning of the Trump Administration, there could be value in keeping others off-balance, at least until the government can settle in and craft a cogent strategy and foreign policy.

 
Trump’s Core Beliefs

Perhaps we can discern The Trump Doctrine by looking at the President-Elect’s core beliefs, as far as we can identify them:

Trump prizes business acumen and a “killer” instinct for managing affairs

Trump believes in tough deal-making – identifying sources of leverage and showing a willingness to use them

Trump sees Nationalism as the natural and rightful path for every country, including the United States, in protecting its interests.

Trump believes that the United States is losing its competitiveness, and blames that on globalism and Obama’s Internationalist foreign policy

Trump believes that U.S. foreign policy has become too predictable, stuck in a quagmire of international diplomacy

Trump believes that it is better to “tell it like it is” — and call out institutions and conventions that have outlived their usefulness.

 
Foreign Policy Options

So, The Trump Doctrine could go one of several ways.  It could be a doctrine of Militarism.  This would probably be the choice of General Flynn, the incoming National Security Advisor, who sees the Islamic State as an existential threat to the United States.  Flynn would urge a Global Crusade against Radical Islam.  But, Trump the Deal-Maker would not be inclined to go this way.

It could be a doctrine of Isolationism — America First.  This would certainly be agreeable to Trump, but contrary to his deal-making tendencies.

We expect that The Trump Doctrine would be one of Economic Nationalism, where President Trump can be Businessman Trump with enormous amounts of power.  Trump would want the opportunity to flex his negotiation muscles on a larger stage — to “Get the Best Deal” for the country.

As a businessman, Trump has lived by certain maxims:  Maximize Options;  Eliminate Costly Competition;  Use Leverage against adversaries and to motivate allies.

We believe that Economic Nationalism is a doctrine which is most in keeping with the espoused beliefs of the incoming President, and one which he would be excited to apply on a global stage.

 

 

 

 

InnOvation Capital & Management, LLC

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JANUARY 11 , 2017

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We begin a New Year at  IntelDigest, a year of new challenges and opportunities in the global economy.  Old problems persist into 2017;  are there new solutions to these problems?  We will see if new policies of a unified Republican government can overcome long-standing economic trends which threaten to plunge America into recession, or worse.

Ours is still the leading economy in the world.  We may no longer dominate the world economy as we did in the post-war (WWII) years, but American business and industry still leads, and the American government still carries the greatest influence around the world.  For all their economic strength, China and Japan and the European Union stand in second place to the United States.

The performance of the American economy in the next few years has the potential to “lift all boats” in the global economy, or allow Moby Debt to sink the fleet.   (Too dark?).

Today, we discuss the transition from the Old to the New.  In coming weeks, we will delve into the myriad issues facing our country and our society:

Policy Issues, such as Tax Reform, Infrastructure Development, Trade Policy and Offshoring, healthcare and retirement, a Trump Doctrine in foreign affairs, the National Debt, Fiscal Responsibility

Societal Issues, such as Nationalism, The Future of Work, survival of the American Middle Class, Technological Advances and their impact on productivity and employment, Fake News and Fake Economics

Geopolitics, such as our relations with our allies around the world and with China and Russia, the status of the European Union, struggles in the Islamic world

Investment in Gold and Silver, the Trump Trade, direction of the markets, investing in China, robotics and automation, a rebound in commodities

As they say in Television, stay tuned …..

 

 

Transition

For much of the last 15 years, world economies have been dominated by monetary policies of The Federal Reserve and other major central banks. These policies can most kindly be referred to as “experimental.”  In the most radical experiment ever undertaken by central banks, interest rates were brought lower and lower until they hit Zero (and below).

By manipulating the “price of money” to unheard-of levels, the central banks have altered all the global economies and distorted prices and values.  This manipulation has encouraged massive borrowing, by both governments and corporations.  As explained in the December 14 issue of IntelDigest:

 

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.

 

Individuals have had their savings accounts devastated by this manipulation.  Although some have taken advantage of ultra-low rates to borrow for real estate speculation and personal expenditures, the vast majority of individuals and families have endured stagnant savings while reaping no benefit in the credit markets.

It is telling that … despite the lowest cost of borrowing in history … the home ownership rate in the U.S. is at its lowest level in 45 years!

 

 

With a new administration about to take office, it now appears that monetary policy will share the spotlight with some aggressive new fiscal policies.

Opinions on Donald Trump are as divided as the American electorate, and it is difficult to predict what policies and pronouncements may come from The White House (via Twitter) after Inauguration Day.  However, it is likely that an unorthodox presidency will “shake things up” in the federal government and the economy.

As we discussed in the November 23 issue of IntelDigest:

 

…. 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.

 
A unified Republican government is already seen as pro-business, which should continue to buoy the markets in the short-term.  Aggressive fiscal policies … if the President-Elect and Congress follow through on promises … would be viewed as a welcome change of pace from the years of domination and experimentation by the Federal Reserve.

Indeed, lowering corporate tax rates and encouraging repatriation of profits from overseas is likely to be near the top of the agenda for the new administration.  This is a policy which can pass the Congress with less controversy than other proposals likely to come up in the first 100 days.

The Trump Agenda also focuses on substantial … some would say “dramatic” … public works and infrastructure projects, taking advantage of the historically-low interest rates to rebuild roads, bridges, ports, airports, et al.

Democrats have long favored such a program, but the Republican-controlled House and Senate blocked Obama Administration proposals. The Trump Administration will probably be able to push at least $500 Billion of projects through Congress.

From an investor’s viewpoint, Infrastructure spending would favor industrial companies, the construction sector, and materials.  While corporate tax reforms would provide a boost across most markets.  Market movement in the Spring and Summer of this year will be tied to the success or failure of the new administration.

Will Trump and the Republicans succeed in pushing such an agenda forward?  If they do, will it actually help to grow the economy faster and start to work off our vast National Debt?  Will The Fed throw a monkey wrench into the works?

 

 

In upcoming issues of  IntelDigest, we will survey those new policy proposals which are likely to become law, and examine their impact on the economy and markets.  We will discuss the “Trump Trade,” which is expected to be inflationary, and follow the reactions of the Federal Reserve to the economic initiatives of the Congress and the President.

There will be much to discuss over the course of this New Year, and we hope that you will find value in our work.

 

 

 

 

InnOvation Capital & Management, LLC

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DECEMBER 14 , 2016

 

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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

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DECEMBER 7 , 2016

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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.