Don't Look Down!

When climbing a mountain or standing on the edge of a precipice the old axiom "Don't look down holds water."  This apparently also works in children's cartoons where the character pursuing, in this case Wiley E Coyote, is fine until he looks down and realizes that there is no floor.  Only then does he plummet to the bottom of the canyon.

The same can be said of the market.  The first quarter GDP numbers were terrible.  Having initially estimated growth of 0.1% it was revised to show a decline of 1%.  Worse still corporate profits fell 9.8% which was the worst decline since the Great Recession began.  It really did not matter where you looked on the corporate profit side as both domestic and foreign sourced profits were weak in both financial and non-financial sectors.  There was no hiding but for some reason the market continued higher with the S&P 500 printing new all time highs.  It appears that either the coyote is standing on an invisible platform or the market has not yet looked down so which is it?

Looking at this in some more detail it appears that the market is betting on a resurgence in the second quarter.  Economists across the board (including the Federal Reserve) expect that GDP will accelerate in the second quarter.  Estimates as high as 4% are being touted and the market has bought into these estimates.  The view is that the cold winter kept people away from buying and that this pent up demand will be reflected in the second quarter GDP growth.  So is this plausible?

Well so far the second quarter is not living up to its hype.  Housing sales (the one area that economists firmly placed their bets) has not rebounded.  What has remained strong is spending on health care which grew by 9.1% (so much for savings in the health care sector associated with Obamacare) and this trend is likely to continue. The squeeze is on and consumers are feeling the pain.  On top of that oil continues to move higher breaking above its 52 week high and the follow on in gasoline prices is hurting consumers further.  This is having a direct correlation to spending which while higher is being poured into health care, food and gasoline rather than housing, technology and other consumer items.

So to me once again the market is being promised something (4% GDP growth) that is not there.  I would be surprised to see GDP above 2% in the second quarter.  Anything below 2% would be a huge disappointment and would send the markets reeling but there is one last caveat - the Federal Reserve.  If I am right and GDP is weak in the second quarter it would be equally surprising to see the Federal Reserve continue to cut their purchases.  This is the second hope of the market.  The bulls believe that they will be rescued regardless of what happens so they are relying on the invisible platform and are not looking down.  I on the other hand have decided to stand well back from the ledge's edge and suggest that you do the same.

A Geopolitical Perspective

"Most Americans are close to total ignorance about the world.  They are ignorant.  That is an unhealthy condition in a country in which foreign policy has to be endorsed by the people if it is to be pursued.  And it makes it much more difficult for any president to pursue an intelligent policy that does justice to the complexity of the world." - Zbigniew Brezezinski 

Zbigniew is a Polish American who served as National Security Adviser to President Carter in the 70s.  I have to say that since then American geopolitical views have matured considerably but are still well behind the rest of the world for the simple reason that geopolitics is not something that Americans have to deal with on a daily basis.  Unlike Europe, Russia, Africa, the Middle East and Asia (including China and India), America for all of its economic muscle really has little daily interaction with the rest of the world.  Yes it is a global economic power house that sells products around the world, exports its political agendas and tries to secure its energy providers through a combination of political strategy, economic opportunities and military might, but its citizens are mostly insulated from the rest of world.  The only borders it has it shares with two friendly nations, Canada and Mexico and on either side it has vast ocean expanses buffering it from all other countries.  In comparison most other nations are bordered by or are in very close proximity to nations that disagree with their political point of view.  They operate under the veil of secrecy and mistrust and this feeds daily into their citizen's minds etching a geopolitical point of view that dictates the countries economic and political futures.  Welcome to investing through a Geopolitical Perspective!

When investing it is imperative to take these geopolitical ideals into mind to give you a better understanding of future trends within countries and how these trends will impact future growth prospects.  The trends are all extremely long term or secular as the views are deeply rooted having taken decades to evolve and will take decades to change. This form of analysis includes a look at a country's geography, its culture and history (or a look at the history that shaped the country's culture) and the country's needs and expectations.  Once you have a clear understanding of each of these pieces of the puzzle it is a lot easier to determine a forecast for future policies and thereby a road map to industries and companies that will benefit from this scenario.

So as an example let's compare China to the United States.  As I have already mentioned the United States is protected on all sides by either friendly neighbors or vast oceans.  The closest islands on the east are the Bahamas and the threat of Cuba has been alleviated with that country's demise.  On the west the nation is protected by a massive naval port in Hawaii.  The remaining threat is from Russia in Alaska but that has always been seen as a very minor threat in that the weather and the distance from the rest of the country is vast.  The country's culture is made up of a vast array of nations that all emigrated to the new frontier and it still to this day conveys a sense of the wild west.  Mineral wealth abounds and its vast educational backbone drives its technological advances.  It is one of the world's energy giants and has vast plains that easily feed its citizens.  All in all it is protected throughout so it should not be surprising that most of its policies look inward rather than outside hence the supposed naivety in geopolitics..

China on the other hand is bordered by Russia, Mongolia, Pakistan, India, Burma (Myanmar), Vietnam and Korea.  It only has access to the ocean on its east coast and this is surrounded by Japan, Taiwan and Indonesia, all United States allies.  It has limited energy wealth outside of coal and has a vast population of unskilled and uneducated people.  Its infrastructure is in dire need of improving but it requires massive imports of raw materials to accomplish this.  It has used its vast unskilled and poorly educated masses to climb into the second spot (some argue that they are already the top spot) in terms of global economic wealth and it is using this economic might to strengthen its military and economic presence around the world as it seeks to secure its energy sources.  It is no wonder that they are fearful of the West's intentions and seek to protect their borders and the Strait of Malacca as these are vital to their prosperity.  Therefore it should come as no surprise if there is conflict in the strait particularly if the United States continues to send warships that way.

Now by no stretch of the imagination is this an exhaustive analysis, in fact I have barely scratched the surface but the example was to show you how important it is to take a more geopolitical approach to your investment analysis as this will give you a better understanding of policies that will shape the direction of economic growth within the borders of the country in which you invest,  This in turn should allow you to take advantage of secular trends improving your overall returns.

A Study of Inflation

"The first panacea for a mismanaged nation is inflation of the currency, the second is war.  Both bring a temporary prosperity; both bring a permanent ruin.  But both are the refuge of political and economic opportunists." - Ernest Hemingway

The United States, Europe and Japan are all reporting low inflationary numbers.  In fact Europe is trying to fend off Japan style deflation while the United States considers inflation benign at 1.5%.  The average consumer can argue all day long that the inflation rate is accelerating as the cost of everything from food to gasoline to insurance to health care to school fees to ... I could go on and on but you get the picture.  Furthermore stock markets around the world have produced double digit returns for the past number of years and assets such as housing, art, diamonds and other exotic style investments are seeing prices never before witnessed.  So why is there such a dichotomy between what the Federal Reserve reports and what is really happening in the world and how could this affect the investment landscape in the years to come?

The problem is that the measure used by the Federal Reserve to calculate increases in prices excludes the increase in asset prices and strips out oil and food price spikes.  So when the stock market rallies or house prices increase or the cost of a diamond soars, these price increases are not added to the inflation gauge used at the central bank.  Back in time inflation was calculated by determining the amount of money that was added to the market relative to a quantity of gold.  Adding more money meant that the value of the currency would decline unless more gold was added to the reserves.  Devaluing the currency resulted in things costing more per dollar and thus inflation was calculated.  When the world left the gold standard and printed money at will this valuation metric was dropped and a new measure of price increases was used.

In a way this was understandable as the complexity of new financial products made it very difficult to operate on a standard as simple as the gold standard but the increased complexity has brought with it the problem that it is impossible to calculate the actual money supply or the total currency in circulation and therefore there is no way to accurately calculate inflation.  For this reason the Federal Reserve and central bankers around the world use some form of price increases to estimate the inflation rate.  In the United States added complexities are put into the equation like the perceived benefits associated with technological and medical advances.  These benefits are handled through adjustments to the actual numbers.  So what you really have is a concocted number (I can see them brewing up the next one in their laboratories now) rather than a real understanding of inflation and this is why the central bankers of the world are continually caught with their pants down when their readings finally register inflation.

So how much have currencies depreciated (or inflation increased) over time.  Well if you take one metric which is to compare the value of a dollar to the price of gold, a dollar purchased 1/250th of an ounce of gold in 2000 and today it buys 1/1,300th of an ounce.  This equates to an inflation rate of over 500% during that time frame.  Another metric is to Look at the Federal Reserve balance sheet which has expanded from $800 billion to $4 trillion in five years.  This equates to an inflation rate of 500% in five years rather than 14 years calculated using gold.  Either way you can quickly get the idea that the expansionary policies followed by the central bankers of the world have decimated the currency and pushed inflation into orbit, all the while reporting modest to no inflation. In the past when inflation has run amok like this trouble brews and so it is imperative that you find investments that will protect you.

As I mentioned earlier the authorities will not act on an inflationary signal until it appears in their data.  Until that point in time they will continue with their inflationary programs thinking that they can quickly deal with the problem.  This has never happened in the past because as we have seen they are not monitoring the real inflation rate, so the chances of them catching it early this time have already passed.  Fortunately they are slowly reducing the monthly buy but it is too little too late as normal.

In an inflationary environment like the one we had here in the 70's it is imperative to own assets, and by assets I mean hard assets like real estate, gold, oil, diamonds and the like.  Stocks do not normally perform well as their value is based on a future cash flow stream and if that stream of cash is seen to devalue due to high inflation they can often lag the appreciation of real assets.  So look at your portfolio and ensure that you have some allocation to these investments as the sooner you do the better off you will be when the Federal Reserve finally wakes up to what you and I already know.

A Secular Trend Worth Noting

Secular - Occurring once every century or similarly long period.  Definition from the Oxford English Dictionary

As the Federal Reserve and central bankers around the world try to kick start growth there is a long term indicator that points to slow growth for many years to come – birth rates.  Not since the Great Depression have birth rates been so low.  This low birth rate is having a profound impact on long term economic growth rates but unfortunately the authorities continue to ignore this important piece of economic input and continue to provide overly optimistic forecasts. 

The Federal Reserve continues to project that the economy will grow at a rate of 3.0% or greater for the next three years and then they expect it to slow to 2.3%.  This is the same growth rate that they have predicted for the past few years and each year these forecasts are slowly ratcheted down during the year to 2.5% or lower by year end.  Whether they actually believe these forecasts or are just trying to sell hope is anyone’s guess but looking at one of the main economic drivers, birth rates, it is clear that regardless of what they predict slow growth will be with us for years to come. 

Throughout the developed world birth rates are below historic norms and below 2.1, the rate required to maintain a population.  A number below 2.1 means the population is contracting and above 2.1 it is growing.  In Germany, France, United States, Japan and the United Kingdom, the birth rate is 1.7.  Furthermore the number of people in the labor pool in Germany, France and Italy has already started to shrink.  So not only is the current labor pool not growing but the trend will worsen.

Part of the reason for this lack of growth is the financial crisis.  Couples who would normally have had a few children are now having one or sometimes none for the simple reason that the financial crisis had such an impact on their nest egg that it made them reconsider the financial impact of having a large family.  Not only did millions lose their houses but many more lost their income so the thought of adding another mouth to feed, clothe and school was just too much to bear.  Economists had expected that this phenomenon would quickly resolve itself but the deepness of the downturn and the slow recovery have left couples wondering if they will ever have the financial fortitude to have a large family.

While this may be a temporary issue, the longer it continues the larger the impact on the economic outlook.  Demographic trends are secular trends, in that they last for an extended or secular period.  So looking forward with the loss of workforce participants economic growth will be muted.  While some of this can be offset with productivity gains there is still a smaller pool of consumers and this is where the impact is really felt.  Everything from electronics to homes is affected and this ripples through the economy.  Slower growth means lower profits and this feeds into stocks and other investments that retirees rely on to live.  In this scenario low interest rates become the norm and markets are beaten down on a regular basis.

On the flip side global population growth caused concerns regarding the ability of the globe’s food stocks to support this enormous population so relief from this will be a good thing.  The problem is that the countries where the slowing is occurring will soon be overtaken in population size by poorer economies, notably Africa, where there are already too many problems to mention.   So while the developed nations struggle with slowing birth rates the developing world is growing at a feverish pace.  This is why more and more of the profits of global businesses are coming from outside of the developed nations and this is a trend set to continue.

In Japan there are more adult diapers sold than baby diapers, in Germany and Italy small towns are emptying and in South Korea where births have fallen 11% in a decade 121 primary schools are vacant.  The issues facing the developed world are great and this trend is not quickly resolved by printing money.  It appears therefore that the slow growth that we are currently dealing with may be here for a much longer period than any central banker will admit.

How Low Can They Go?

"How low can you go? 
I could go low, (go low) lower than you know,
Go low (go low) lower than you know
Go low (go low) lower than you know
Go low (go low) lower than you know
Go low (go low) lower than you know" - Lyrics from the song How Low Can You Go by Ludacris

Low interest rates are a source of frustration for retirees and joy for investors.  On one side of the coin you have those trying to live off interest payments and on the other you have the people borrowing money.  The first group (mainly retirees) have seen their livelihood evaporate while home buyers, businesses and others borrowing money have seen the cost of borrowing fall to record lows.  In the United States you can buy a house with a mortgage rate of less than 3.5% which makes home ownership very affordable, but try living on interest income of less than 3%!  Take as an example of a person with $1 million in retirement savings who was expecting to earn 6% or $60,000 a year.  This income has now fallen to less than a third and means that this person will have to dig into their principle eroding future income all the while losing to inflation.  This person's retirement plans are being destroyed. 

Now while we could go into options available to them the question that most people are asking is how much longer can interest rates remain low and I will argue that not only with they remain low for years to come, but there is a high probability that they could go a lot lower.  The reasons for my outlook are numerous but I will expound on a few main points in this blog starting with the Federal Reserve's desire to keep them low. 

While the Federal Reserve does not have complete control over market forces they can influence them significantly and through continued stimulus and by holding bank rates down they have effectively managed to keep the lid on any increases.  Furthermore with their share of market debt rising significantly and congresses lack of ability to balance the budget they have a huge incentive to keep borrowing costs down. To take the example above and place it into the context of the Federal Reserve and Washington (and I will use a round number of $20 trillion as it looks like we will be there sooner rather than later) if you pay interest on $20 trillion at around 3% versus 6% you are saving $600 billion a year.  Now that might not seem like a lot in terms of the nominal value of the debt but if you put it into the context of balancing the budget it makes a huge difference.  Right now we run a $600 billion deficit, add the increased payment of $600 billion and suddenly the budget deficit doubles!  Certainly a huge incentive to keep the lid on interest rates as long as possible.

The next area to look to is the market.  The market is made up of banks and institutions and foreign governments.  Looking abroad at Europe and Japan and the picture becomes very interesting.  I looked at the 10 year rates around the world and it is truly eye opening.  The rate in the United States is approximately 2.60%.  In comparison, Japan is 0.60%, Switzerland is 0.80%, Germany 1.45%, Netherlands 1.77% and France at 1.92% all of which are substantially lower than the United States.  In fact Italy at 3.04% and Spain at 2.97% are pretty much in line with the United States and Mexico at 3.67% and Portugal at 3.60% are not a lot higher.  If I were surveying the investment scene around the world to place a large amount of money I would be hard pressed not to invest in the United States as the security offered for one of the best rates in the globe makes it a compelling alternative.  More investment means prices of bonds go up and this then keeps the lid on rates and can force them lower.

The final piece to this puzzle is inflation.  Without inflation there is no requirement to raise rates so it is very interesting to note that one of the reasons the European rates are so low is that due to their austerity they are now staring at deflation.  If they enter a deflationary spiral similar to the one that has plagued Japan for decades we could easily see a world where rates remain muted for a very long time regardless of what the Federal Reserve does. 

This will have a huge impact on your retirement and investment outlook so make sure that you factor this into your portfolio as the odds are high that interest rates fall further from here even though ( and maybe because of the fact that) consensus tells you otherwise.  This is why I repeated the lines in the quote four times (like they do in the song) just to remind you that lower is possible.