On 12/31/15 the S&P 500 closed at 2044, resulting in a total return of 1.38% for the year. After a year of increasing volatility, the S&P 500 ended with a slight loss. The major uncertainty was whether the Fed would hike the policy rate to .25%. The most recent (and decreasing) Fed estimate of that rate is: 1.4% by the end of 2016 and 2.4% by the end of 2017. Taken by itself, this present estimate is not unreasonable because the real rate of interest, with 2% inflation, is still negative to low.
The Fed's projected interest rate increases are likely appropriate for the real economy, for the financial system (where bubbles of speculation are becoming evident in the high-yield bond market) but not for the general financial markets where 2016 and 2017 promise losses in long-term treasuries and likely the stock market as well. Bond portfolios are being hedged (at a cost); some calculations follow in the next paragraph.
Most U.S. financial assets are priced off the Fed policy rate; here we assume a parallel shift in the bond yield curve attendant to continued moderate economic growth. This means that the 10 year treasury yield - priced roughly at the Fed funds rate + 2% - will be 3.40% by the end of 2016 and 4.40% by the end of 2017. (That bond is currently priced at 2.25%.) To compensate investors for equity business risk, we then add another 4% to the treasury rate to get a required return on equity of 7.40% by the end of 2016 and 8.40% by the end of 2017. The actual implementation of Fed fund rate increases will be "conditions dependent," but the direction of this analysis does not bode well for the S&P 500 over the next two years because the present calculated return of the S&P 500 is only 5.8%.
The alternative to moderate economic growth in the U.S, is worldwide stagnation at equilibrium; where S&P 500 earnings continue to drop (down 6.6% in 2015). In the 12/28/15 Barron's, the Harvard historian, Niall Ferguson, describes three general possiblities abroad:
1) More troubles in the oil-producing Mideast, with Saudi Arabia the most susceptible due to its social divisions.
2) Policy errors in China.
3) Political problems in Europe, due to the Mideast.
Seven years of interest rates at the zero bound have caused a three-fold rally in the S&P 500, generating returns that will now have to be (partially) given back due to the inhibitors of higher interest rates or stagnant growth. We think our portfolio strategy of maintaining somewhere around 50% in high-quality medium-term bonds and 50% in cash, to take advantage of stock valuation opportunities, is appropriate - as the Fed's likely goal is to keep the economy growing at a moderate pace.
On the first trading day of 2016, the S&P 500 dropped 1.7% to 2009. Niall Ferguson mentioned three general possibilities that we thought lay in the intermediate future. They were, in fact, just around the corner (which is usually what happens).
1) The Shanghai stock market fell by 7%, in response to a manufacturing index that confirmed deaccelerating economic growth.
2) Sunni Saudi Arabia executed an Shia cleric, thus triggering a major crisis with Iran, whose intensification would affect the world's oil supply.
3) The Washington Post writes, "As Europe's crises have mutiplied over the past year, the once-overwhelming share of British voters who favor staying inside the E.U. have dwindled - with some polls showing the contest dead-even. And the "out" campaign has room to grow if Europe's problems persist, as most analysts expect they will." A referendum to decide this will likely occur in 2016. A Brexit would affect the EU's prospects.
Globalization causes widespread economic and social changes, that need to be modulated. The international economic system has to benefit a large number of people; or it will break down. Such a breakdown lead to W.W. II. Since the current form of social organization is the nation state, achieving a healthy dynamic balance among its constituents is a worthy goal. In the January/February 2016 issue of Foreign Affairs, Danielle Allen specifically writes, "We need a virtuous circle in which political equality supports institutions that, in turn, support social and economic equality."
The world-wide market rout that began in China continues. At its opening, the S&P 500 dropped 1.79% from its previous close. We could, but will not, comment upon the contradiction beween China's centralized political system and the free market; because that contradiction isn't the major cause of this market crisis (we note that the 2008 market crash in the U.S. nearly vaporized the world's economic system).
The major cause of this downturn is Mr. Market, an equal opportunity disrupter. In "Manias, Panics, and Crashes," the late economist Charles Kindleberger (2011 ed.) wrote, "The specific signal that precipitates the crisis may be the failure of a bank or of a firm, the revelation of a swindle or defalcation by an investor who sought to escape distress by dishonest means, or a sharp fall in the price of a security or a commodity. The rush is on...'Overtrading', 'revulsion', and 'discredit' have a musty, old-fashioned flavor; they convey a graphic picture of the decline in investor optimism. Revulsion and discredit may lead to panic (or as the Germans put it, Torschlusspanik, 'door-shut-panic') as investors crowd to get through the door before it slams shut. The panic feeds on itself until prices have become so low that (value) investors are tempted to buy the less liquid assets, or until the trade in assets is stopped (e.g. as in China at least for this day) ...or because a lender of last resort succeeds in convincing investors that money will be available to meet the demand for cash. (p.p. 32, 33)"
You can see from these discussions that the market process, changing the world, continually generates interesting new questions and answers. This process needs to be channeled, at least somewhat. Otherwise, people may become insecure and behave badly.
Since our readers have undoubtedly secured their portfolios, they will likely go about their business in a relaxed frame of mind. Our next discussion, requiring an unconcentrated mind, will be about the predictability of market crashes, statistically analyzing Kindleberger's data.
We think the present U.S. stock market is caught between the Scylla of economic growth (thus enabling the Fed, as is appropriate - to slowly normalize the policy rate) and the Charybdis of economic slowdown abroad. Between the two, something is going to happen. When it does, we will keep in mind a comment about last summer's correction, "Longer term, this (error) correction will be a good thing. It will bring financial markets closer to what is justified by fundamentals."
But consider the following, the possibility of a slow market correction lasting a few years. The 1/8/16 Bloomberg noted that John Williams, President of the San Francisco Fed, expects inflation will be at or near the 2% goal by the end of 2017. This implies, according to the median of the Fed's Open Market Committee 12/15 estimate, a 2.4% Fed funds rate. Repeating the above: assuming a parallel shift in the bond yield curve, this implies a 4.4% 10 year treasury rate and an 8.4% annual return on the S&P 500. This implies a rather large drop in the S&P 500 because the present return is only around 5.8%.
The good news is that investors will finally start earning something on their money market funds. The bad news is that it will be likely quite a while before the market bottoms and values appear. Investors should therefore conserve their capital for the next two or maybe three years. (This stock rally lasted more than seven years.)
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The S&P 500 dropped to 1859 on 1/20/16. Market values are now determined by the globalized financial system rather than by the Fed. To use a polite word, the world's (now closely correlated) financial markets are exhibiting "volatility." The one pipeline stock that we own has dropped by 23.6% since the beginning of the year, but it mainly distributes refined petroleum products to the Northeast and has oil terminals operating at capacity. We don't see how the current drop in Brent crude to $27.91/bbl adversely affects its fundamentals. Its dividend should therefore be secure.
This a good time to talk about volatility, that is losses in a down market. By temperament or training, you should be either a momentum investor or a value investor, but not both. If you try to be both, you will mess up in the market and likely your life as well. The market is now approaching a panic mode due to the confluence of events that set both its context and trend:
2) Oil prices.
4) And, as always, the Mideast.
There are two major investment strategies in a down market. Conventional financial planning counsels:
1) Stick to your plan.
2) Slightly rebalance your portfolio by buying more stock.
Value investing, on the other hand:
1) Simply buys stocks when they become value.
Because there is (somewhere) a floor on stock prices, the planning approach will produce much greater losses in a down market than the value approach, which will conversely give up some of the momentum based upside. Speaking qualitatively, both require a tolerance for losses. A value investor might buy a stock at target; but Mr. Market (that is the collective panic) might carry its price down further. Which boils down to this: If you don't like any losses, you should be in cash or short-term bonds; but then you will pay the long-term price.
There is no such thing as painless gain. A financial analyst once said, "The stock market is like life." We're in the process of assembling a list of the stocks to buy; add: but its going to take time for them to become value stocks.
2/9/16 - The continued resilience of world oil production, in excess of consumption, is responsible for continually decreasing oil prices. The following also illustrates how markets function, very small changes in production and consumption produce large swings in spot prices.
........................................................................Daily Surplus World Crude Oil and Liquid Fuels Supply Over Demand
|MM Bls/Day||Q1||Q2||Q3||Q4||Q1 (E)|
|OECD (incl. US)||26.64||26.42||26.80||26.89||26.54|
Source: Energy Information Administration, February 9, 2016 forecast.
U.S. shale oil is a major contributor to OECD production. Its unexpected resilience to low oil prices is due to technological advances and low marginal production costs. In the meantime, the price of West Texas Intermediate has dropped from a 2015 average of $48.66/bbl to a present price around $28.46/bbl. EIA currently expects market equilibrium between supply and demand, in one year, towards the beginning of 2017. In the meantime, we would expect the continuing inventory build to to be symptomatic of decreased world economic activity leading also to decreased stock prices. Saudi Arabia continues its price war against shale oil and Iran, absent other political factors.
2/14/16 - Our pipeline stock reported the results for the fiscal year 2015. The following also discusses value investing.
The large decrease in the price of crude has created havoc in the U.S. petroleum industry. Despite plunging oil prices, 2015 operating results improved substantially:
|EBITDA- Plant *||$683,427,000||$768,445,000||+12.4%|
* Earnings before interest, taxes, depreciation and amortization - plant maintenance expenditures
This improvement was due mainly to the growth of global marine terminal capacity utilization from 85% the previous year to 96% and the increased throughput of gasoline, both benefits of lower oil prices. Since the beginning of this year, however, the price of of this investment dropped by 17%. What happened to rationality?
What happened to investor rationality was investor panic, the following events likely: 1) Investment managers have to go before their committees to justify their portfolios. 2) To avoid criticism and to raise liquidity, they dump all their oil-related investments despite a yield on this one of 6.8%.
This lemming-like behavior gives value investors the opportunity to sort through the rubble to find the gems. Why didn't we sell this investment? 1) There are complicated tax consequences. 2) In spite of volatility, it will very likely continue to be a dependable source of growing future income. 3) We like it.
We would not take the last lightly. Investors should like the companies in their stock portfolios. If you know what you own, the present price quote really matters only at the extremes. Otherwise, it is possible to invest in stocks through a S&P 500 index fund when it is not overvalued. We will comment on that index in the future, from both financial theory and practice, because it has merit as an all-purpose investment.
After 2008, the Fed flooded the financial system with money, averting a total collapse of the world's economy. However, due to continuing economic imbalances * and the absence of fiscal policy, it has been unable to create rapid growth.
An expansive monetary policy is supposed to cause rapid private growth, but it hasn't had much effect. Instead years of low interest rates distorted the financial economy, overpricing almost all financial assets, as commodity prices in the real economy have plunged. Goldman Sachs estimates that the energy sector had its first decline in operating earnings per share in 48 years. The S&P's operating earnings have therefore declined from $113.01/share in 2014 to $100.88/share in 2015, a drop of -10.7%.
Given the slowdown abroad and the possibility of adverse events, we think the best investment strategy is to bide one's time until opportunities appear.
* Resulting from the obvious, the location of factories abroad and the debts here.
The Atlantic journalist, James Fallows, went on a road trip by a light aircraft. In "How America is Putting Itself Back Together," he reports on the country's reinvention and renewal. San Bernadino, California was a troubled town even before the shootings that, "...combine(d) nearly every destructive economic, political, and social trend of the country as a whole. He was surprised, "...how wide a range of people, of different generations and races and political outlooks, believed the city was on the upswing, and that their own effects could help speed that trend." A prosperous Air Force veteran turned aerospace engineer ran for the school board and helped the city's troubled, low-scoring schools turn around. With a colleague, he then set up a non profit technical school for unskilled locals, "...training them on real machines, with real national-level certification, for good real-world jobs that really exist." More than 400 students have passed through the school, "right into the high-tech manufacturing world."
A professor said, "In scores of ways, Americans are figuring out how to take advantage of the opportunities of this era, often through bypassing or ignoring the dismal national conversation."
Duluth, Minnesota, "...has become one of the country's aerospace centers largely because the two brothers who founded Cirrus Design, "...decided that they wanted to spend their working lives amid the same Upper Midwest landscape and outdoor opportunities with which they had grown up...And now another generation of entrepreneurs is choosing Duluth."
Redlands, California used to rely on the orange growing business and the neighboring Norton Air Force Base. The city is being transformed by a high-tech company, Esri, which is a world leader in geographic information systems, or GIS. The company has 10,000 employees worldwide, and 2,500 in Redlands. The founder developed his ideas at Harvard.
Holland, Michigan posesses an important agricultural industry and strong manufacturing and design companies. The public school population is mainly nonwhite. In 2010, the superintendent of the public schools, Brian Davis, "... began a campaign to get major new bond funding.... in the depth of the financial collapse...Davis was asking the mainly white electorate, most of whom did not have children in the public schools, to refinance the schools. And they did. The new programs and facilities paid for by the bond...helped reverse a decline in public confidence in the schools."
Fallows ends this article, waiting for reforms to happen again, as they did at the end of the first Gilded Age. He considers three necessary elements for those to occur:
1) A national shock...that galvinizes the effort.
2) The ability of political power to control strictly economic forces. "Otherwise you're talking about a nationwide corporation, not a country."
3) Fertile experimentation with new approaches and possibilities.
The national mood, Fallows suggests, "...will change again. When it does, a new set of ideas and plans will be at hand...Until the country's mood does change, the people who have been reweaving the national fabric will be more effective if they realize how many other people are working toward the same end."
On 3/16/16 the Fed decreased its 2016 estimate of the December Fed funds rate from 1.4% in December to 0.9%; the market rallied on that news. The number of likely Fed rate hikes this year decreased from 4 to 2. This new estimate, concurrent with lower U.S. economic growth, seems to us reasonable.
|Est Fed Funds||.9||1.9||3.0|
The Fed's January projection for the policy rate likely indicates what kind of stock market investors can expect this year. The lesser number of 1/4% rate hikes will likely result in a U.S. stock market that has a greater number of trading rallies; but the overall Fed policy rate (conditions depending) is projected to increase to 1.9% by the end of 2017, to match the Fed's inflation target which is likely to be met.
If historical financial risk premiums hold, the required equity rate of return at the end of 2017 will be around 8%.* That required rate of return will result in a large drop of the S&P 500, as on 3/18/16 the estimated rate of return was only 5.75%, measured by the present value of distributable cash flow model, and 6.25% measured by the financial market risk premium model below.
The analysis above assumes an eventual logical investment pricing. Years of interest rates at the zero bound have distorted financial markets. We suspect the normalization of interest rates will not occur without some turbulence, whether caused by the financial markets themselves or by Fed policy. In his new book, "The Only Game in Town," Mohamed El-Erian (2016) writes:
"The global financial crisis...gave way to a frustrating 'new normal' of low growth, rising inequality...and...social tensions...For those caring to look, signs of distress are mutiplying - so much so that the path the global economy is on is likely to end soon...Already there is unusual consensus among economists on the components of a durable solution. All it takes is for our politicians to step up to their national, regional, and global responsibilities...and for the private sector to respond to a more enabling environment **, including deploying more of its accumulated cash into productive activities....The bad news is..."
* Fed funds = 1.9%, say 2%.
Fed funds + 2% = the 10 year treasury.
10 year treasury + 4% = the required rate of return of the S&P 500 - which is the riskiest investment here priced.
** Michael Spence (2011) says essentially the same thing in, "The Next Convergence."
Washington requires steady and experienced leadership to obtain the necessary cooperation from local authorities - and from other countries - to develop policy and to manage events and their causes. The United States must lead an interrelated world system, which is not simple.
Restoring wide-spread economic growth is not just a matter of negotiating better trade deals or going after the capitalists, who are needed to create more jobs in the U.S.
The late Andrew Grove was a founder of Intel and, for many years, its Chairman and CEO. He was known for his direct style. In 2010, he wrote, "How America Can Create Jobs." We quote extensively from this notable 7/1/10 Bloomberg Businessweek article:
1. The underlying problem isn't simply lower Asian costs. It's our own misplaced faith in startups to create U.S. jobs.
2. What matters for U.S. job growth is what happens after the concept has been developed in the Silicon Valley garage. The technology has to go from prototype to mass production, when companies scale up. They work out design details, figure out how to make things affordable and hire people by the thousands. Scaling is hard work, but necessary to make innovation matter. *
3. The scaling process is no longer happening in the U.S. As long as that's the case, plowing capital into young companies that build their factories elsewhere will continue to yield a bad return in terms of American jobs. Scaling used to work well in Silicon Valley. At Intel, we had to build factories, hire train and retrain employees, establish relationships with suppliers, and sort out a million other things ** before Intel could become a billion-dollar company.
4. Many companies died along the way, but each survivor added to the complex technological ecosystem that came to be called Silicon Valley. (Economic activity is not just individual atoms of self-interest interacting in a market medium. It occurs like a living, complex biological system where structure - "spillovers" and innovation clusters - matters.)
5. (In 2010) manufacturing employment in the U.S. computer industry is about 166,000 lower than it was before the first PC. Meanwhile, a very effective computer manufacturing industry has emerged in Asia, employing about 1.5 million workers. Apple has about 25,000 employees in the U.S. That means for every Apple worker in the U.S., there are 10 people in China working on iMacs, IPods, and iPhones. The roughly 10-to-1 relationship holds for other U.S. tech companies.
6. You can say, as many do, that shipping jobs overseas is no big deal because the high-value work - and much of the profits - remain in the U.S. That may well be so. But what kind of society are we going to have if it consists of highly paid people doing high-value-added work - and masses of unemployed?
7. The job machine breakdown isn't just in computers. Consider alternative energy: photovoltaic panels and advanced batteries. There is more at stake than exported jobs. With some technologies, both scaling and innovation take place overseas.
8. Scaling isn't easy. The investments required are much higher than in the invention phase. And funds need to be committed early. Another example from Intel: The investment to build a silicon manufacturing plant in the '70s was a few million dollars. By the '90s the cost of the factories that would be able to produce the new Pentium chips in volume rose to several billion dollars. The decision to build these plants needed to be made years before we knew whether the Pentium chip would work or whether the market would be interested in it. Lessons we learned from previous missteps helped us. Some years earlier, when Intel's business consisted of making memory chips, we hesitated to add manufacturing capacity...Our Japanese competitors didn't hesitate: They built plants. When the demand for memory chips exploded, the Japanese roared into the U.S. market and Intel began its descent as a memory chip supplier.
(As Keynes wrote, investors' short-term market orientation greatly discourages long-term investment. This is the problem with an economy built mainly around finance. ***)
9. How could the U.S. have forgotten? I believe that answer has to do with a general undervaluing of manufacturing - the idea that as long as "knowledge work" stays in the U.S., it doesn't matter what happens to factory jobs. (Many economists say, export commodity production abroad.) I disagree. Not only did we lose an untold number of jobs, we broke the chain of experience that is so important in technological evolution. As happened with batteries, abandoning today's "commodity" manufacturing can lock you out of tomorrow's emerging industry. (As Elkus put it, "...future technology will find its basis in what exists today - nothing comes out of the ether.")
10. Our fundamental economic beliefs, which we have elevated from a
conviction based on observation to an unquestioned truism, is that the free
market is the best of all economic systems - the freer the better. Our
generation has seen the decisive victory of free-market principles over planned
economies. So we stick with this belief, largely oblivious to emerging evidence
that while free markets beat planned economies, there
may be (is) room
for a modification that is even better.
11. (This really matters.) Such evidence stares at us from the performance of several Asian countries in the past decades. These countries seem to understand that job creation must be the No. 1 objective of state economic policy. The government plays a strategic role in setting the priorities and arraying the forces and organization necessary to achieve this goal. (This was also true in the United States when Alexander Hamilton advocated that government policy foster growth and industry. Economics is not only a matter of land, labor and capital - with labor just a factor of production.)
12. By transferring manufacturing and a great deal of engineering out of the country, (we have) hindered our ability to bring innovations to scale at home. Without scaling, we don't just lose jobs - we lose our hold on new technologies. Losing the ability to scale will ultimately damage our capacity to innovate.
13. The first task is to rebuild our industrial commons. We should develop a system of financial incentives; levy an extra tax on the product of offshored labor. If the result is a trade war, treat it like other wars - fight to win. Keep that money separate...make it available to companies that will scale their American operations. Such a system would be a daily reminder that while pursuing our company goals, all of us in business have a responsibility to maintain the industrial base on which we depend and the society whose adaptability - and stability - we may have taken for granted. (Two candidates in the 2016 Presidential campaign now advocate revolution. U.S. economic problems adversely affect the political process.)
14. Growing up in the Soviet bloc, I witnessed first-hand the perils of both government overreach and a stratified population. But, most Americans probably aren't aware that there was a time in this country when tanks and cavalry were massed on Pennsylvania Avenue to chase away the unemployed. It was 1932...Unemployment is corrosive. If what I'm suggesting sounds protectionist, so be it. ****
* In, "Winner Take All," Richard Elkus (2008), former division manager of Ampex, described how the company, which invented video recording, was not able to take advantage of its technology because, "...(it) never created the kind of engineering and manufacturing structure that would enable it to take advantage of the market potential inherent in those technological concepts...it never (assembled)...the resources needed to advance from a small business with limited manufacturing expertise to a corporation that could meet the challenges presented by the potential for audio and video recording." Akio Morita, who co-founded Sony, was obviously able to do this.
** Manufacturing is very detailed.
*** The 4/4/16 Time writes, "Experts including Adair Turner, the former head of financial regulation in the U.K., estimate only about 15% of all capital flows within America's financial system end up making their way into the real economy."
**** For the United States, appropriate tariffs to reduce the trade deficit would be an improvement.
Dartmouth economist Douglas Irwin defends free trade in usual terms, on the 3/8/16 NPR. "...trade does destroy jobs in import-competing sectors, such as apparel and furniture. But so does technological change. And it also has to be pointed out trade creates jobs in export-oriented sectors, such as aircraft and high tech (too general, the article above is by an actual job creator). So trade doesn't affect the number of jobs in the United States so much as it affects the composition of jobs (that is the salaries companies can afford to pay). And unfortunately, some of those jobs are located in Ohio and Michigan, where heavy industry has traditionally been."
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The natural rate of interest is the real fed funds rate that neither expands nor contracts the economy. As the graph above shows, peaking shortly after the recession of 2000-2001, that rate has steady declined to zero, providing no long-run incentive for savers to save. A capitalist sysem that relies on interest rates to allocate investment can obviously not function in this way; not to mention the U.S. pension system that continues to assume a rate of return of around 7-8% on assets, with equities obviously much higher.
Why do businesses, all around the world, have no incentive to invest and thus demand capital? It is possible to blame the demographics in the developed world or a lull in technological innovation since the digital revolution of the 1990s. We think the most likely reason is imbalances that have been allowed to develop. In short, the factories and income are in Asia, but the debt and spending are in the developed world.
The trade imbalance, and the resulting lack of opportunities in the developed world, has resulted in capital markets that do not serve the needs of society. What is supposed to be a market that matches savings with investment has turned into a casino. It has resulted in risk-seeking investor behavior, levering up or buying subprime mortgage obligations just to get some extra income. It has resulted in corporations that further fail to invest in the United States.
Since the mild recession of 2000, the growth potential of the U.S. economy has slipped from 3%+ to around 2%. There are likely three main causes:
1) As mentioned above, the U.S. trade imbalances have developed over a period of many years, affecting the structure of the economy.
2) In a globalized world, the economic law of one price means that a worker abroad will be paid the same as a comparable worker in the U.S.
3) Both globalization and technological change have eroded the earnings of the U.S. middle class, which has decreased by 4% since 2000.
Technological change may increase the labor productivity (GDP / labor costs) of an industry, but it also reduces the work opportunities for more and more Americans. Martin Ford (2009) notes, "The free market economy...simply cannot work without a viable labor market. Jobs are the primary mechanism through which income - and, therefore, purchasing power - is distributed to the people who consume everything the economy produces." This erosion is now becoming increasingly obvious in the service industries, and will be a major challenge to Washington in the future. The economic solution of compensating people who have lost their jobs does not answer the other half of the problem - what do people do?
The U.S. is a very large market. The obvious temptation, particularly in this political year, is to put "America First," seal our borders and live happily ever after, cultivating our own garden. Except, that is impossible:
First, to prevent a world war from happening again, the U.S. created the system of international organizations to stabilize the foreign environment. In a sense, the international environment is the United States, which the country cannot retreat from. The U.S. cannot isolate itself from foreign wars, climate change or nuclear proliferation.
Second, in a now interconnected world, foreign discord can easily reach the U.S. To cite just two examples, one obvious and one not. Problems in the Mideast are boiling over into Europe and the U.S., to bad effect. A main goal of the U.S. is to keep the sea lanes open in the South China seas. A retreat from that effort would allow China to establish hegemony in Asia, as it is trying to - thus increasing discord with its neighbors, Japan and possibly Korea. This discord would affect the United States, which is a major trading partner with all.
The U.S. must remain engaged with the world and handle the international system well. A major goal for the U.S. should not be, "America First." A major goal should be to achieve a healthier balance among the domestic and international factors we have mentioned, finding ways to reduce our trade deficit. The late MIT economist, Charles Kindleberger, noted that the complex financial system requires a lender of last resort (central bank) to maintain stability. The same is true for the international system, where the United States is the balance wheel.
The goal of max [Profit] is way too simple, for what matters is what people say and do within the context of their societies and their histories.
The inclusive unity of the United States is a major political resource. In reaffirming this unity, words matter - in fact they matter very much, because it is also from these words that people infer attitude and intention. These negative Republican testimonials suggest that the insulting Donald Trump is simply not qualified to lead his party and to be president.
In a 5/3/16 NYT article titled, "Trump and the Lord's Work, Thomas Friedman suggests that the developer's candidacy might put the radicalized Republican party out of its misery. Mr. Friedman essentially says the nation now needs a center-right partner for the Democratic party to accomplish overdue reforms in:
c) Social Security, Medicare and Obamacare
d) A capitalism driven more by machines and robots
"Every one of these challenges can be met....For this to happen, though, this version of the Republican Party ha(s) to be destroyed, so a thinking center-right party can emerge." This is as it should be, for change is inevitable. British statesman, Edmund Burke (1790) wrote, "A state without the means of some change is without the means of its conservation." The United States requires the hope of steady reform, rather than trust in the whirlwind that everyone will reap.
A 5/12/16 NYT article headlines, "Donald Trump, Bucking Calls to Unite, Claims 'Mandate' to be Provocative." This is his real estate deal style; it will likely also become his political style of "pitchfork populism." The broad electorate will likely see that he is out of his element; but there is precedent for his kind of confrontational politics in revolutionary France of 1789 and in Germany of the 1930s, both societies undergoing traumatic change.
Why consider history? Professor Jeremi Suri, of the University of Texas, recently gave an excellent lecture. He noted that historical knowledge is useful because it situates you in the complexity of the world:
1) It provides a context, describing where you are relative to others.
2) Provides a laboratory of human experience illuminating, as good history does, both the roads taken and the roads not taken.
3) Provides comfort and connection to past human experience.
4) Is a source of empathy, which is not sympathy, placing you in the shoes of your opponent. (This is the main lesson that Robert McNamara learned in Vietnam.)
Considering relevant history will result in better policies for societies and organizations.
The French Revolution of 1789 began with the hope of compromise. The later descent of the Revolution into chaos and violence resulted from the unwilligness of Louis XVI to become a constitutional monarch and the inability of France to reform its finances. In 1989, Simon Schama wrote, "Citizens," likely the definitive chronicle of the French Revolution:
"The creation of a political alternative to aristocratic conservatism occured not outside but inside the elite...Those on the radical side of that division were not only ready but eager to use popular force and the polarizing language of patriotism and treason to empower their ideology.
What was that ideology? In the first place its radicalism can be measured by what it was not. It repudiated historicity and the sanction of the past. This itself was a shock of departure from the hallowed language of opposition to absolutism since the reign of Louis XV. It emphasized that a constitution was to be built anew, not simply rescued from atrophy. The criteria for this new constitution were to be rational and patriotic...
Rationality, however, did not have a monpoly of utterance in 1788 and 1789. The kind of eloquence needed to mobilize popular anger to the point at which it could be used as a lever of power was not cool but hot. And the stokers of revolutionary heat were not prepared to allow it to cool off for the benefit of moderate institutional change (our note). They were guided neither by rationality nor by modernity but by passion and virtue....The prospect of satisfaction - in the eighteenth-century sense of redress - was what pulled ordinary Frenchmen into politics for the first time. And it was their participation that turned a political crisis into a full-blooded revolution." *
The Revolution destabilized France, that went through another monarchy and four republics until its politics was finally stabilized by Charles de Gaulle in 1958.
Concerning Germany's Weimar Republic of the 1930s, we note that Hitler rose to power on inflammatory rhetoric designed to make legislative compromise impossible.
add: In democracies, steadiness at the helm and principled
compromise are necessary; otherwise the result will be a lack of progress,
frustration by all and finally a descent into the malestrom. There is a lot at
stake in this election. Does the U.S. really want to make an Atlantic City
casino bet on its future? This 4/8/16 Washington Post article
indicates that the art of the real estate
deal transaction is not like
the art of democratic government.
* Simon Schama; "Citizens"; Knopf; N.Y., New York; 1989; p.p. 290-292.
We don't recall ever agreeing with conservative columnist Robert Kagan. However, his 5/18/16 Washington Post article, "This is how fascism comes to America" is incisive.
Why are countries misgoverned? This U.S. campaign season shows how terribly easy it is to slip. All it takes is for a democratic electorate to abandon reason, that established the political framework for the Enlightenment inspired United States.
The U.S. does not need an ideology or a strongman to place blame on others (just look at the Mideast), but could use credible solutions that mobilize everyone to address some real problems.
With the world's largest economy (measured in U.S. dollars) and military, the U.S. is appropriately a conservative power. Since the international system was essentially its creation after W.W. II, the U.S. keeps it running by maintaining international order. This is strategy appropriate to the fact.
So, where in this does the Donald's disruptive Fascism fit? The answer, it doesn't. Fascism is a 19th century political movement, a reaction to severe social turmoil that relied on the will of one man. In "The Roots of Romanticism," Isaiah Berlin wrote:
"Fascism...is an inheritor of romanticism, not because it is irrational - plenty of movements have been that - not because of a belief in elites - plenty of movements have held that belief. The reason why Fascism owes something to romanticism is, again, because of the notion of the unpredictible will either of a man or of a group, which forges forward in some fashion that is impossible to organize, impossible to predict, impossible to rationalise. That is the whole heart of Fascism: what the leader will say tomorrow, how the spirit will move us, where we shall go, what we shall do - that cannot be foretold. The hysterical self-assertion and the nihlistic destruction of existing institutions because they confine the unlimited will, which is the only thing which counts for human beings; the superior person who crushes the inferior because his will is stronger; these are a direct inheritance - in an extremely distorted and garbled form, no doubt, but still an inheritance - from the romantic movement..." *
At best, the U.S. under the Donald would lurch to who knows where. At worst, he would have the nuclear codes. A rational decisionmaker will ask, what's the upside and what's the downside.
* Isaiah Berlin; "The Roots of Romanticism"; Princeton University Press; 1999; p. 145.
We find this comment from NBC's 5/22/16 Meet the Press by a Republican strategist disturbing:
"Folks are desperately wanting change in this election....they think we are...at a terminal moment if this country drifts in the direction of European socialism....The center does not hold. We want strength." *
This comment shows what the Republican party is now rallying around, Europe in the 1930s - which (to say the least) wasn't together.
*The show's transcript edits out the underlined. For the center to hold, it is necessary to make a principled compromise on goals according to a common set of facts.
The Fed's April 26-27 Open Market Committee Minutes start off mentioning, "...the possibility of using monetary policy to address financial stability risks," (asset bubbles on the upside and institutional failures on the downside). It notes the macroprudential tools (net worth requirements and other banking regulations) could be, "...ineffective at mitigating those risks (at times)." This statement combined with four references to the possibility of raising rates at the Fed's June meeting lead us to conclude that the Fed would like to raise interest rates.
But, U.S. monetary policy now also considers foreign financial conditions (which are improving slightly) and domestic conditions (where the housing sector has improved further, business fixed investment and net exports have fallen, and strong job gains point towards additional strengthening of the labor market). The U.S. economy is growing slowly and steadily; but, "...inflation continuing to run below the Committee's 2 percent longer-run objective..."
This is key, "Members also continued to expect inflation to remain low in the near term...but to rise to 2% over the medium term as the transitory effects of declines in energy and import prices dissipated and the labor market strengthened further." This means that over the medium term (the conditions-dependent Fed is appropriately vague as to what that means, although it projects that rate by the end of 2017), short-term interest rates will also begin to approach 2%, then equity returns will increase from around 6% to 8%. This does not bode well for stock market prices over the medium term.
There are the additional international possibilities of a Brexit, a Grexit and possible financial problems in China.
If our readers note many complications and contingencies in the conduct of monetary policy, they are right. Our general conclusion from all of the above is that there is a Fed bias to higher rates, and that the realization of these rates depends upon the ability of U.S. economy (and now somewhat the world economy) to withstand these hikes. What the Fed cannot do is to allow inflation to get out of control, for that will badly impact the values of all negative interest rate bonds (which are now 29% + of the Bloomberg Global Developed Sovereign Bond Index) and surely panic investors.
Do we want an angry and divisive president?
Donald Trump is angry at those who oppose his will. This 5/27/16 NYT article cites 224 people, places and things he has demeaned. His many unvarnished words signal what he would really do with the powers of the presidency.
He is fundamentally divisive. The Great Seal of the United States (also on the dollar bill) expresses the values and goals of the Founders. It carries the motto, "E Pluribus Unum"; out of many one. The United States accomplishes this by respect for the rule of an impartial law and respect for the judiciary. By going after Judge Curiel, he threatens the rule of that law, the separation of powers and the constitutional checks and balances that guarantee our freedoms.
Donald Trump should not reach the presidency, bringing to it his underlying anger and divisiveness. In spite of Party attempts to add a veneer of restraint, the more his political success, the worse his behavior. It is now possible to see, unfolding in excruciating detail, how democracy can be lost; that requires but one vote, one time. We hope the electorate will be careful what it wishes for because anger could cause him to fire the American people if they disappoint. This is the time to stop him.
In an interrelated world, the way to improve America is not to get angry; but to get smart by fine-tuning the industrial, not the deal, economy. The 2015 U.S. trade deficit was 2.7% of GDP; it was not 27%. But we are now suffering the structural effects of decades of deficits, now causing the same intense political reaction in many other developed countries. This excellent 6/7/16 WSJ article lists detailed proposals to improve U.S. manufacturing. These require present investment to obtain a better future - in spite of the present earnings that short-term financial markets demand. Government adds to the economic mix, long-term economic perspectives and incentives.
In a political crisis (or when investing in markets), acting solely out of emotion practically guarantees doing the wrong thing. For example, Al Quaeda purposely bombed the Shiite mosque at Samarra in 2006, setting Shiites and Sunnis violently against each other. Iraq then fell apart. After the tragic Orlando killings, Donald Trump advocated a (temporary) ban on all Muslim immigrating to the U.S. and allowing licensed owners to carry guns into bars.
Policies oblivious to the facts on the ground and to the values of society will not be effective. U.S. born citizens, acting alone, were responsible for the killings in San Bernadino, Fort Hood and Orlando. As for guns in bars...
At its open on 5/24/16, the S&P 500 dropped 2.63%, 55 points to 2057. Due to the complexity of the modern international economy, the British vote to leave the European Union is highly problematic. One of the major causes of the Great Depression was that economic cooperation in Europe ceased after W.W. I. The prospect of a very difficult two years of negotiation to implement Brexit promises a great deal of market turmoil as everyone tries to reassess their relationships to the international economy and to each other. Impacted in major ways will be:
1) The banks. London is a major world financial center. British banks, including the subsidiaries of U.S. banks, may no longer have free access to the markets of the Continent. The British treasury estimates that Brexit will cost the economy between 3.4%-9.5% of GDP by 2030, due to lower trade and foreign direct investment - into a much smaller market.
2) The loss of the world's fifth largest economy could call into question the entire European project.
The European Brexit negotiators will be very unhappy. A MP of Chancellor Merkel's party wrote, "There cannot be any special treatment. Leave means leave." add: The press reports, after the vote, more than a few British voters are now expressing regret at their advisory referendum to leave, because the many costs - including the possible dissolution of the United Kingdom - will be staggering. The EU has said it will be patient.
3) A decrease in international trade will cause the Asian economies to slow still further.
The investment implication of this is likely a considerable delay in the normalization of interest rates. add: This merits calling an exception to normal value investing, increasing our purchase of some stocks for more secure income. The EU situation might be "fluid," but we think that adding somewhat to income stocks would be a good idea - anyway. This is decisionmaking under uncertainty.
Mohamed El-Erian commented, "(The Brexit adds) to global economic instability that's already being fueled by negative interest rates, policy uncertainty in China and political populism in the U.S...." Former London mayor, Boris Johnson, cites "independence" as a benefit of Brexit. Without thinking through its economic implications, the emotional British voters may have jumped from the frying pan into the fire. We hope the U.S. electorate does not make a similar mistake.
Speaking from Scotland on a business trip, Donald Trump said, "It's an amazing vote because the voters are angry...They took back their country and that's a great thing." He hopes to profit from the Brexit. As Britain unfortunately steps aside from the world, the U.S. cannot do so. The stability of the post W.W. II international order is now at stake:
1) Russia is recalcitrant, conflicting with Eastern Europe.
2) China is becoming a significant geopolitical competitor, possibly conflicting with Japan and the rest of Asia.
3) The Mideast continues to spread its problems, conflicting with everyone else.
It is remarkable that Brent Scowcroft, national security adviser to George H.W. Bush; and Richard Armitage, deputy secretary of state to George W. Bush, have endorsed Hillary Clinton. During an inevitable foreign policy crisis, being quick to anger is a very dangerous reaction.
Further, in a 6/24/16 Washington Post article, former Republican treasury secretary and Goldman Sachs CEO, Henry Paulson, writes about Trump's attempts to play Monopoly in the Atlantic City casino business. "The tactics he has used in running his businesses wouldn't work in running a truly successful company, let alone the most powerful nation on Earth....He excels at scorched-earth tactics in negotiations during bankruptcy proceedings. Here, the "Art of the Deal" businessman is a master at advantaging himself over his fellow stakeholders and partners. In essence, he takes imprudent risks and when his businesses fail, disavows his debts." He would obviously be an irresponsible president.
Donald Trump is backed by the angry base of the Republican party, a toxic combination. There is little that can be done to allay that anger before November elections. But the vast majority of the U.S. electorate can simply make a level-headed decision and thoroughly consider whether to hire him as president of the United States.
Effective economic policies, doing the right things, will (in time) reduce those adversities that still afflict the economy and Trump's supporters. There is no silver bullet. We wondered why the United States did not dissolve into social chaos and authoritarian government (or worse) during the Great Depression. Its liberal political values and progressive reforms were the reasons why.
The Republicans currently have no solutions beyond building a wall, cutting taxes and expenses. The electorate should give the Democrats a chance to reform the education system, worker training, the tax system, also investing in infrastructure and research - to make our economy more competitive in globalization. These are real measures that can secure us an improved future.
After years of increasing discord, the first era of globalization ended with W.W. I. In "The Wrath of Nations (1993)," William Pfaff writes, "The modern western nation is a practical affair. It provides defense, civil order, a system of justice, an economic structure...It demands solidarity among its citizens which means their willingness to accept the moral and legal norms of the collectivity...Citizenship is a matter of obligation and reciprocal benefits, although it nearly always has an emotional colortion as well, often intense - attachment to country, patrie, or "fatherland" that repeatedly has caused people to disregard others' claims to justice, or to disregard reason, or a common morality. This national feeling, which is not a practical commitment but a matter of passions, has consistently overridden principles of international solidarity..." In short, the nation-state provides people with a secure home, the perceived trespass of which can cause violent and extreme behavior, an acting out.
There is an inherent conflict between national sovereignty (democracy, if you will) and the market forces of economic globalization. Under conditions of conflict, it is natural for proponents to vigorously argue their cases. To prevent enthusiastic conflict from descending into the law of the jungle, in the U.S., there is a predominant common sense and a legal system to realise a rule-based justice, and the judgment of judges to reasonably apply the law to each unique individual case.
The application of economic or political theory to present circumstances requires the judgment to design (or directionally evolve) an economic system that is both globally efficient and meets the needs of the nation.
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On 7/22/16, the S&P 500 closed at a record high of 2175. The reason is long-term interest rates still remain low, at 1.56% for the U.S. 10 year treasury. The Financial Times notes that even some companies, and of course some nations, are able to borrow at negative rates. This means that you have to pay them to take your money. The key question for the future U.S. stock market is how long the Fed will keep the fed funds rate close to zero. As the following graph illustrates, the nominal (effective) fed funds rate has been abnormally low since 2009.
Eventually the Fed will normalize fed funds to the present 2% inflation target rate. This means the ten year treasury rate will begin to approach 4%. This implies a required S&P return of 8%. The S&P is currently priced to return around 5.5% - 6%.
Fed rate increases have been stayed by the expected financial dislocations the Brexit is causing; thus a 2% fed funds rate might be delayed beyond the end of 2017, the current Fed projection. However, when the Fed starts raising rates, the U.S. stock market's mind will again be concentrated. A trader noted that there is no sense in tripling your money, then to lose 90% of it in a large downturn. (Traders deal with numbers like that.)
Donald Trump’s political strategy consists of name-calling and divisiveness because he has no real program to restore economic growth and thus, “Make America Great” again. But since politics, like markets, can be both logical and subjective; we discuss both aspects of his candidacy:
He comes from real estate development, that is short-term project and deal oriented. Real estate development has almost nothing in common with long-term process oriented manufacturing, that mainly values continued efficiency: Output/Expenses. Unlike the development of real estate, industrial production is evolutionary, its products continually engineered and evolved.
Ignoring his business tactics, the idea that Trump’s reputed prosperity translates into national prosperity is too simple. There are no major companies both in real estate and manufacturing. The fields are too different. GE dropped its finance businesses (that include real-estate) to make it more consistent and to de-risk the company.
As FDR’s New Deal illustrated, a general government experience will be much more effective to reform the national economy. Mr. Trump’s prior experience in real estate does not support his candidacy for the presidency.
By valuing the community, conservatism at its best aims to conserve it. A specialist in demolition, creative or otherwise, Donald Trump offers no solutions to build and adapt communities to economic change. The present constituency of the Republican party is susceptible to his messages of populism and isolationism. But “law and order” utterances do not translate into real jobs and communities. All the venting in the world will not unify a Republican party that is fractured between a Darwinian economic ideology that favors elites * and fervent economic complaints from the base. Then there is that raft of divisive cultural issues.
The riven Republican party has not much positive to say about itself or the country; all it can do is denounce the opposition in hyperbolic terms. If the Republicans can’t govern themselves, how can they govern the nation?
Everyone has both unique and common perceptions of the world, based upon nature and experience. Donald Trump’s unique perception is from the specialized, Dawinian deal business. It is not appropriate in politics (polis) which involves community and, yes if necessary, sacrifice. Not everything is a dollar and a deal, just ask Senator McCain or our NATO allies **.We don’t think Trump’s perceptions have much in common with the shared reality in which most people live. He’s a very bad bet.
* The main ideology of the party has been free markets and very limited government. However, as London School of Economics political philosopher, John Gray (1998) writes, “Laissez-faire came about in England through a conjunction of favorable historical circumstances with the unchecked power of a Parliament in which most people were unrepresented….But the free market lasted in England for barely a generation. From the 1870s onwards, it was gradually legislated out of existence….Now and in the past, in virtually every society, the market has been curbed so that it does not thwart too severely vital human needs for stability and security (n.b.).”
The American ideology of very limited government has its roots in the English and colonial histories before the Revolution. It is not universal, but rooted in unique historical circumstances that, of course, change. In 1790, British conservative legislator Edmund Burke wrote, “A state without the means of some change, is without the means of its conservation.”
** This 7/24/16 NYT article relates that the Democratic National Committee's e-mails were hacked by Russian state actors, likely to aid Donald Trump who advocates the reduction of the U.S. commitment to NATO. add: This 6/17/16 Washington Post article indicates that the Trump organization has received investments from Russia and tried to do business there. Will Trump stand up to Putin when he tries to re-establish the Russian empire?
Donald Trump's reaction to the DNC hacks shows he is utterly unaware of the larger issues involved. He thinks only about himself and will therefore make big mistakes. The 7/27/16 CNN reports that he said, "Russia, if you're listening, I hope you're able to find the 30,000 (Clinton personal) e-mails that are missing." He is inviting Russia to intervene in the U.S. elections on his behalf. House Speaker Paul Ryan said, "Russia is a global menace led by a devious thug. Putin should stay out of this election."
The U.S. recognizes that society ultimately exists for the benefit of its members. Periodic government intervention is therefore necessary to even the playing field, enabling the economy to respond to new challenges:
In 1901, Theodore Roosevelt, a progressive Republican, broke up the abusive monopolies of the trusts.
In 1933, FDR, another Roosevelt, established the social safety nets of the New Deal.
The Obama administration led the recovery from the Financial Crisis of 2008 and reformed the financial system; further economic reforms are necessary to meet the wide challenges of globalization and technological change. In the election of 2016, the American people will decide whether these challenges will be met by the crude response of building a wall * and classifying an ever widening group of people as the guilty Other; or by a set of credible and focused programs to reform the economy, so it will again benefit the American people.
* This 7/23/16 NYT article reports that the Arizona ranchers say, "Intensive, round-the-clock patrols along the border are required for a fence or wall to work; otherwise, those determined to cross will always find a way. But, they argue, if you have boots on the ground, you will have no need for anything so beautiful as the Great Wall of Trump."
On NBC's 5/22/16 Meet the Press, a Republican strategist said:
"Folks are desperately wanting change in this election....they think we are...at a terminal moment if this country drifts in the direction of European socialism....The center does not hold. We want strength." This leads to the central question of this campaign, are the American people going to vote for democracy or autocracy? If democracy, they will work together to build a better country. If autocracy, they will follow a "strong" leader.
At the 2016 Democratic convention, President Obama said, "...(Donald Trump is) selling the American people short. We are not a fragile or frightful people. Our power doesn't come from some self-declared savior promising that he alone can restore order. We don't look to be ruled....We, the people, can form a more perfect union."
At the Republican convention, Donald Trump said, "Nobody knows the system better than me, which is why I alone can fix it." * At the Democratic convention, Hillary Clinton replied, "Isn't he forgetting troops on the front lines, police officers and firefighters who run toward danger, doctors and nurses who care for us, teachers who change lives, entrepreneurs who see possibilities in every problem...?...Americans don't say 'I alone can fix it.' We say 'we'll fix it together.'" She then outlined a progressive economic agenda for the first 100 days, which is in accord with the nature of the American people and the circumstances we face.
* A problem with autocracy, of course, is without the attention of the autocrat, nothing happens. When it does, without checks and balances, it can easily result in the wrong policies. Take Donald Trump on ISIS, "I know more about ISIS than the generals do, believe me...I would bomb the (expletive deleted) out of them." This guy is dangerous, and a vote for him is not just a protest vote. The vote in this election will choose what kind of government America will have. An autocrat, not respecting our system of government, will simply ignore the checks and balances of the Constitution (or worse).
The Negativity of Donald Trump:
His answers to questions often contain distracting, negative emotional triggers such as "disaster," "lose," "worthless," or "hypocrite." Whenever he utters a negative, discount it and what's left is the substance of his answer (or lack thereof). Try this way of understanding him.
If you are negatively emotional this election, realize that he is logically manipulating your emotions to close the deal in his favor.
8/10/16 - Then there is the person. Almost every other day, Donald Trump utters a new outrage against national security, minorities, most recently against law and order. Donald Trump better fits the ecology of the zero sum real estate deal business. In politics, the government of the community, his reflexes are all wrong. This is the basic problem. This is why he has to correct himself after, "Letting Donald be Donald." He's literally maladroit add: and his heart is in the wrong place.
We hope the electorate will reform the Republican Party - defeating him and removing the doctrinaire Tea Party.
Long-term bond investors invest for income (that is secure yield). Stock investors invest for the prosperity of their companies (that is earnings growth). But what if earnings growth is absent due to the many imbalances * that inhibit current investment and force bond yields accordingly low, there being a low demand for capital? Betting that these imbalances will continue and interest rates will remain low, traders have bid stocks to historic highs. According to the Gordon dividend model, stock prices will become infinite if the required equity return approaches the dividend growth rate.
In markets and politics, there are countervailing forces. Trends therefore continue until they don't. The first spoiler is the most obvious, overvalued assets can cause markets to crash as investors take more and more risk to reach for yield - for instance investing only in stocks that produce "income." The second is structural, interest rates at the zero bound will eventually result in banks, insurance companies and pension funds that can't meet their expenses and promises. The third is political, the U.S. elections of 2016 and the Brexit have revealed that years of slow economic growth have created social discontent, possibly imperiling liberal democracy itself. At such times, the U.S. has been able to cooperatively reform itself, in a way that is best for the country.
Congress should stimulate demand by fiscal policy, digging not holes (as Keynes joked), but laying the foundations for future economic growth by tending both to the economy's supply and demand sides. (Ideology will focus only on one side.) On the supply side, repairing and developing necessary infrastructure, reforming trade policy, advancing exportable green energy technology, and educating people to deal successfully with 21st century opportunities. On the demand side, begin by raising the minimm wage, reforming the tax system, and fine-tuning healthcare. These measures will start to move economic growth and interest rates toward more normal levels. It should also be possible to measure their total medium-term financial effect. Reason and perseverance are necessary to navigate a complex 21st century world that needs the stability the U.S. provides.
* To mention a few: The demand is here, but the factories are there; U.S. real median household incomes have been stagnant for almost two decades (1996: $53,345 2014: $53,657); and demographic trends are not favorable.
We have discussed the causes of low interest rates above. The effect of low interest rates on our portfolio strategy is as follows: We seek to preserve optionality by overweighting cash; to preserve capital, we are invested in medium to short-term corporates; for some income, we are invested in utilities and a real estate stock.
Add: There are different kinds of risks - Some bonds, and we do note some bank loans, default because their margins of safety were clearly inadequate at inception, but were booked anyway. Equities, a step below on the balance sheet, don't default. But they can remain at the same price for long periods of time or decrease. This is why truly secure dividend income matters. For investment horizons of ten years or longer, the income component of U.S. equity returns becomes larger than the capital appreciation component.
We'll leave that at this.
In a 8/26/16 speech, Fed Chair Janet Yellen, noted in spite of very low interest rates, the U.S. economy remains controllable mainly by the continuation of extraordinary measures such as paying interest on bank reserves, to raise the Fed funds rate and by asset purchases, to lower it. Although the U.S. economy remains controllable, there is a price to pay - continued low growth and low interest rates due to structural issues.
In theory, a reliance upon monetary policy expands the private sector; and a reliance on fiscal policy expands the role of government. Since monetary policy has obvious reached its limit, it is necessary to use fiscal policy to effect the necessary structural reforms mentioned above. Indeed, Ms. Yellen notes, "Beyond monetary policy, fiscal policy has traditionally played an important role in dealing with severe economic downturns. A wide range of possible fiscal policy tools and approaches could enhance the cyclical stability of the economy....As always, it would be important to ensure that any fiscal policy changes did not compromise long-run fiscal sustainability."
Fiscal policy, i.e. government spending, is the responsibility of the legislature; and here Ms. Yellen treads lightly. There is also a developing consensus outside the Fed that the legislature must begin to spend money well. It makes no sense to insist out of ideology that all government spending, outside of war, is bad. That belief flies in the face of U.S. history, beginning with Alexander Hamilton.
In "A Cautious Return to Fiscal Stimulus," the 8/22/16 Bloomberg Business Week writes, "With economies all over the world growing too slowly and little scope left for new monetary stimulus, governments are turning their attention back to fiscal policy. This shift in thinking is overdue. In many countries, though not all, fiscal expansion is not only possible, but also necessary. A resumption of budget activism won't be riskless, so caution will be needed. A stubborn commitment to fiscal austerity, however, would be riskier still."
In a 9/7/16 WSJ article, "The Way Trump Talks," columnist Daniel Henninger discusses the current right-brained (emotional) mood of American politics:
"For years, politicians have been oh-so-careful with their words. In part, this is the language of constituencies and coalition building, the constant calibrating of support. But it is also because in our time the media has made politicians pay a price for saying anything that risks harming this or that collection of political sensibilities....It's ridiculous but real. No straighter jacket exists in politics today than language....Scrupulous exactitude in politics may be a good thing, but it's also dull.
The problem today is that fear of offending or losing votes has so blanded out the political class that many of these politicians and the American electorate are no longer speaking the same language....Into this void flopped a couple of rhetorical throwbacks - Donald Trump and Bernie Sanders. Though both lacked eloquence people everywhere responded to their blunt language, to the point of being oblivious to the content.* It was the way they talked that connected with voters. Messrs. Trump and Sanders liberated their audiences from normal politics, because normal politics had become suspect.
Something else in the culture elevated this new political language. It isn't exactly truth-telling, because so much what those two said remained obscure....It seemed - or sounded - so real. Many people today think food isn't real unless the label tells them it is organic or artisinal. TV commercials announce, 'Not actors, real people.' Politics has no immunity from these new intepretations of what's real. Just the feeling of authenticity for many has become more powerful than understanding the grubby realities of political limits Many voters don't want to hear established politicians talking about the political process....What they want is a fighter, a valiant gesture. The Trump and Sanders detractors thought they were hearing a fascist or a socialist wingnut. Their supporters were hearing Sir Galahad, a knight to the rescue.
Still, the now-evident limitation of this new emotive political language is that none of its speakers or hearers knows what to do next (our note). What comes after the words remains a uncharted frontier. Bernie fell short. The current Trump campaign looks like a game of Twister, covering the blank spots."
In politics and stock market investing, reason and emotion should be aligned, resulting in effective programs and actions. The truly complex problems of global warming, economic growth, and the provision of health care can be solved only by a cautious reason. As history and markets show, to ignore reason in favor of pure emotion is not a good idea.
* We think this is unfair to Bernie Sanders. The political program of the extreme left is derived from the hyper-Enlightenment. But Sanders articulates goals that enable people, as individuals, to develop in their societies. The political attitude of the exteme right, anywhere, is illogical, resulting from highly stressed communities.
A 9/9/16 NYT article about Paris, Kentucky says why people support Donald Trump, in spite of the possibilities of a new economy - built around agriculture, ecotourism, education, renewable energy and small-scale manufacture. Trump wants to restore the past, in spite of the fact that coal wasn't going to last forever anyway. (It is also human nature to be short-term, as markets demonstrate.):
"Far from the metropolitan hubs inhabited by the main beneficiaries of globalization's churn, many people feel disenfranchised from both main political parties, angry at stagnant wages and growing inequality...
'I love Trump...He shoots from the hip.'
'But, I ask, isn't that dangerous?'
'I don't care. After all we've been through (economically), I just don't care.'"
These two paths lead to hope or despair. We will further discuss how economic growth necessarily proceeds from economic structure.
The fact-challenged Donald Trump accuses other people what he is guilty of, egregious "lying," which shows no respect for the electorate and is very dangerous in a president. But real governing is about dealing with facts as they exist and about convincing people.
This is an apparently theoretical point, but we think ultimately substantive. For most of human history, people have lived in command and control societies, motivated by their basic need for physical protection or a simple fear of power, consider feudal Europe, monarchies or all dictatorships. The appeal of command and control societies is very simple. Trust a leader, or a group of leaders, obey orders and in return receive some freedom from fear and benefits such as, "Make American Great Again." Forget about institutions and civil society.
The Enlightenment of the 18th century and the modern world assumes that people are reasonable and free. They therefore have rights and institutions to protect themselves from arbitrary state power and can, with the use of reason - communicate, convince and compromise with each other - forming societies for their general benefit.
This election revolves around the issue of trust, but trust in a leader to do what? We don't think there can be trust in a leader to achieve a vague and symbolic slogan with platitudes and mendacity. Rather than escaping to or recalling an idealized past, we remember an America almost always facing problems such as nuclear annihilation, Vietnam, OPEC and now the Mideast. This election has to be about trust in a leader to achieve practical and specific goals in a complex, globalized environment such as repairing infrastructure, encouraging entrepreneurship, improving health care and education. Such a program relies on an optimistic (and self-fulfilling) belief in other people. This is the modern world, with all its problems and promises.
Nearly eight years of low interest rates have driven world-wide financial asset prices up, creating a difficult dilemma for investors. According to the 9/25/16 WSJ, the dilemma facing the German Allianz insurance company and the Swiss Zurich Insurance Group is the same; but their investment policies differ. "Analysts said dwindling yields have yet to cut into insurers' profitability in a significant way.' (But) the question is whether this industry is going to be over the next five to 10 years.' "
In search of higher yields, Allianz has invested in a military garrison for the U.K.'s Parachute Regiment, a Texas wind farm and a 16-mile sewer tunnel in London. They have also invested in New York real estate. "Analysts said that helps to make Allianz emblematic of an element of the industry seekng to get more creative (watch that word in finance) with investments, while Zurich Insurance repesents the opposite end of the spectrum. Zurich Insurance Chief Financial Officer...cautioned that getting creative might bolster insurers temporarily, but it also could cause fallout when conditions change. 'The music stops, and you find yourself at peak asset risk,' ...'As a sector, we really have to try and avoid that.'"
Our investment strategy is obviously more like the latter because conditions may soon change:
1) The 9/26/16 Bloomberg writes, "...central banks (are) questioning the benefits of pumping billions of dollars of free money into the pockets of investors every month with little to show for it in the way of economic growth, share valuations approaching record highs and the role increasing for computerized funds that use voltality as a trading signal."
2) Rates need to be raised in the near future to create (at least) a psychological headroom to lower them when necessary, rather than to slip into a regime of negative U.S. rates, which is not capitalism.
3) The reason inflation has stayed so low these many years is that fiscal policy has been absent. The return of an appropriate fiscal policy will cause rates to rise, at least somewhat.
The present market expectation that the Fed policy rate needs to be raised once this year (by .25%) and similarly twice next year (to a total of 1.25%) is likely correct. This could cause the markets to readjust over time rather than to crash (see below).
Reason considers the consequences of an action. Reason says do not support Donald Trump to be president. In the first 9/27/16 debate, the named and responsible fact checkers of the NYT found that the fact-challenged Donald Trump told 20 partial or outright lies, that is one every 4.8 minutes of the debate, or approximately one every 2.4 minutes he was speaking. A person who continually lies to others will surely lie to himself. A president unable to see the truth and who lives in a "reality warp" is extremely dangerous.
Reason also says he is too emotional. According to this 9/26/16 Washington Post article, "...starting around the 11-minute mark in the 95 minute event, Trump's cool began to melt. He started to shout through Clinton's answers, gripping the sides of the lectern until his hands turned red. 'That's called business, by the way,'...as Clinton accused him of rooting for the housing collapse. (He is obviously incapable of perceiving the public interest. He's running for president?) 'I did not! I did not! I do not say that,' he shouted as Clinton accused him of calling climate change a hoax, which he has said on numerous occasions. 'Facts!' he yelled as Clinton began to question the accuracy of his assertions."
Reason and emotion should pull in the same direction. What if they do not? If your reason says do not vote for Mr. Trump, but your emotions says do; vote on November 8 for the broader future of your family and your country. If you follow only your emotions, look back in history to see what happened to those who allowed themselves to be misled. As this book review notes about you-know-who, all Americans should watch out for an abetting "willfull blindness", "bottomless mendacity" and "a turning away from reason."
10/8/16 - The ancient Greeks had a saying, "Character is destiny." Donald Trump has a noxious character. With his offensive comments and fabulations, he would lead the country to a very bad future. Why did the Republican party recommend him to the American people to be president, thus threatening our democracy?
After a finance minister conference, Larry Summers wrote in the 10/9/16 Washington Post, "The specter of secular stagnation and inadequate economic growth on the one hand, and ascendent populism...has caused widespread apprehension." To counter future stagnation in the U.S., the 10/14/16 WSJ reports, Fed Chair Janet Yellen discussed possible Fed policy beyond December, "...temporarily running a 'high-pressure economy,' with robust aggregate demand and a tight labor market."
Slightly delaying future rate hikes will likely sustain the U.S. economy in the short-run; but cutting interest rates from a higher level (with inflation still under control) will be necessary to counter the next recession. Monetary policy has simply reached its effective limit.
Appropriate fiscal policy is now necessary to improve the economy's performance and to establish a higher level of rates for future cuts. The Republican party has stood in the way of fiscal policy. For many reasons, it needs reform.
This over-the-top election year has plumbed new depths. On 10/17/16, NYT columnist Charles Blow described Donald Trump."He has mocked, whined, chided, bemoaned and belittled. It's as if the man is on a mission to demonstrate to voters the staggering magnitude of his social vulgarity and emotional ineptitude."
Why did the Republican party nominate such a candidate? They gave in to the chaotic authoritarian impulses from the pre-Enlightenment, pre-democratic world. As has been noted:
1) The Republican party allowed years of self-reinforcing crazy talk to mount opposition to whatever the Obama administration was trying to do. In other words, the party leadership licensed negative and irrational political behavior by "the base" and Tea Party until the two finally nominated Mr. Trump, who would have destroyed the social trust upon which U.S. democracy crucially depends. But the riven Republican party cannot even govern itself, not to say the nation.
2) They allowed untruth, that is disregard for the facts.
The Republican party is now the irrational American political party led by an irrational political leader, who will "totally" accept the election results, "if I win."
Hillary Clinton has the steadiness and experience to keep America secure, improve the economy by investing in the country and its skills, and uphold our democratic system of government. These will grow the economy from the middle out, benefiting all.
There is a call in the press for Trump to be decisively defeated this election, which is correct. What has to be defeated is a political idea new to the U.S.
The 10/17/16 Bloomberg Business Week writes:
"Trump is part of a global phenomenon. Around the world, in wealthier nations and developing ones, democratic values and traditions are in decline. A broad swath of 'elected autocrats' and candidates with authoritarian tendencies has come to dominate many political systems...Often, these political systems collapsed after elected autocrats won power and then destroyed democracy.* In many cases, these politicians launched vicious attacks on institutions even before winning office. Thailand's Thaksin Shinawatra threatened the independence of the judiciary during his first prime ministerial campaign; Italy's Silvio Berlusconi attacked supposedly elitist judges; and Trump has suggested that, as president, he could impose new restrictions on the media and federal judges...
Many elected autocrats have...radically transformed political norms..."
*Quoting the Volker Ullrich review again. After being chosen as chancellor in 1933 by a combination of, "...pressure from the party grass roots combining effectively with pseudo-legal measures," Hitler destroyed the system of local German rights in but five months. Those who fervently wave their copies of the Constitution in the House ought to reflect that it is that easy to destroy democracy, if you nominate and elect the wrong executive. Really. Then forget about such niceties as the Second Amendment and a balancing Supreme Court.
On 11/8/16, the American people elected Donald Trump the next president of the United States. Like all revolutions, the Trumpian revolution will have unintended consequences.
World financial markets dropped on the news.
Donald Trump and a compliant Republican congress will likely enact large tax cuts for the top 1% and accelerate infrastructure spending, increasing deficits and supplying a large stimulus to an economy that is approaching full capacity. Anticipating higher inflation, 30 year treasury yields have increased by .3% since the election. Its price decreased 6.3%. The price of the S&P 500 will likely drop later as treasury yields continue to increase.
In the Federalist Papers (1787), Madison and Hamilton designed the U.S. government to realize the value of Freedom in a progressively diverse society (even then). But Freedom requires the general concepts of citizenship and rights. These are the banisters of civilization anchored in economic security and civility.
But globalized markets bring change and insecurity. In 2016, Donald Trump's supporters elected him president because he promised them security. Economic security can be best realized by appropriately growing the economy for all, both city and country, and by restoring civility - that is, social trust.
Donald Trump has created his own mass movement. Hoping for the best means hoping that the U.S. does not reap the whirlwind. Getting Amtrak to run on time and repairing I-80 will not be enough.
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Buoyed by the hope of tax cuts and infrastructure spending, the S&P 500 reached 2213 on 11/25/16, a record high. But the yield of the 10 year treasury also reached a one year high as the bond market immediately saw increased inflation from increased infrastructure spending and tax cuts, with the economy near capacity.
In 2009, some investors expected the Fed's high monetary creation would create rapid inflation. But that money remained within the banking system, resulting in high bank reserves, low interest rates but only slow economic growth. With the election of Donald Trump, and a suddenly compliant Congress, the erstwhile economic conservatives will likely approve large infrastructure spending and tax cuts. Legislative overspending is the traditional cause of inflation.
|Est Fed Funds||.6||1.1||1.9|
This pre-election Fed forecast, predicting a 1.9% Fed Funds rate by 12/2018, will likely be met or exceeded. It will cause a large downward readjustment in stock prices, but it is difficult to say when; other than to suggest that this will now occur sooner rather than later. *
It is a useful time to discuss investment philosophy. Short-term momentum investors are jumping right in, buying cyclical companies in a stock market priced to impeccable perfection. This has to be a short-term play. Value investors have a long-term investment horizon.
* In a 10/17/16 speech to the Economic Club of New York, Fed Vice Chair, Stanley Fischer, noted that expansionary fiscal policies will raise equilibrium interest rates. According to the Fed/US model (and others show a similar directional effect), the effect of higher government spending equal to 1% of GDP will raise interest rates by about 0.5%. Lower taxes equal to 1% of GDP will raise rates by another 0.4%. These are major effects.
Since the two variables are substantially independent, their effects are likely to be additive. If we add these to the median Fed 2019 September estimate, made before the elections, we get a 2019 increase in the Fed funds rate level from 1.9% to 2.8%, a not unreasonble rate given its past history shown here.
This would imply a required S&P 500 risk-adjusted return of 8.8% (rather than approximately 6% now). We would be very careful.
Monetary and fiscal policies are shorter-term measures to boost the economy. Mr. Fischer also outlined long-term government measures that could boost growth.
"Government policies that boost the economy's long-run growth rate would be an even better means of raising the equlibrium interest rate. This is a point I have also made in the past. While there is disagreement about what the most effective policies would be, some combination of more encouragement of private investment, improving public infrastructure, better education, and more effective regulation is likely to promote faster growth of productivity and living standards--and also to reduce the probability that the economy and, particularly, the central bank will in the future have to contend with the effective lower bound."
At this time, effecting appropriate economic and social policies is like repairing a watch, requiring knowledge and expertise. But the United States elected a political novice to the presidency. He won by employing the competitive business strategy of FUD, spreading fear, uncertainty and doubt, throughout the nation and then promised security saying, "...I alone can fix (the system)," rather than by presenting the American people with a clear and credible program for economic reconstruction, allowing informed choice.
How do oligarchs seek and maintain political and economic power in a democracy? The answer is simple. Feed the base cultural and political placebos, while reducing the real effects of taxes and government on themselves.
The kind of governance we will get over the next four years might be like a Trump deal, not based much on fact; combined with the decisions of his chosen cabinet. The articles on this site essentially say that free markets, left totally to themselves, lead to high and likely intolerable social instability. To allocate society's resources, the alternative is some government action; but it must be carefully considered. The 2007 documentary, No End in Sight, recounts how the chaos of Iraq resulted from trying to "wing it" without detailed plans.
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