Gluttony

"Gluttony might be innocuous were it not for the fact that gluttons tend to disregard whether their self-serving behaviors harm anyone else.  We don't need to look far and wide to find examples of gluttonous behavior, as they are numerous throughout the history of capital." - Simon Mainwaring

Reading article after article on the amount of debt being printed daily by the central bankers around the world is like listening to a stuck record (for those of you too young to know, in the good old days music was played on vinyl records that would sometimes hit a scratch and repeat themselves continually until you got up and moved the playing arm past the problem).  As I have mentioned before the Keynesian school of economics, which seems to be being practiced across the globe in some form or another, relies on heavy government spending, lower tax rates and low interest rates to stimulate spending.  A side effect of this is that large influxes of capital lower a country's currency value when measured against a basket of other currencies.  Lowering a currency's value stimulates exports and local consumption allowing a country to recover from an economic downturn. Furthermore increased spending from the government should result in stimulus and the result is economic growth.

Looking around the world today and it appears that the central bankers of the world have become gluttons of their own debt.  While Keynes was for stimulating I have to believe that even he would be shaking his head at this gluttony as $60 trillion of increased global debt has barely had any economic impact.  Each day billions is spent buying debt created by the governments.  Everyone it seems is awash with their own newly created debt but the results are not stimulus but a burgeoning debt level.  It is thought that unless more stimulus is added the world will fall into a massive recession so the only option is to print more money.  Stop printing and your currency appreciates making you open to a recession.  Raise interest rates and who knows where the currency will appreciate to and how far the economy will tumble!

Already we are seeing the effects of the slow down in stimulus from the Federal Reserve on the dollar.  As Japan is the largest glutton in the globe their currency has fallen the furthest against the dollar diving more than 30% in 30 months.  Britain and Europe have also seen their currencies fall against the dollar but not by as much as Japan,  Looking at the Euro/Yen exchange rate over the past two years shows only a 5% movement during the past two years as the two economic blocks fight for currency depreciation against the dollar.  With this lack of currency depreciation has come limited economic growth for either of these two areas while in America the stronger dollar is causing fits for American companies as their earnings and sales are tumbling.

As I mentioned in a previous blog it appears that this currency race to zero is not having the desired effect and in fact may be the cause of the globe's tussle with deflation.  Cheaper currencies mean cheaper exports leading to lower prices in the purchasing country resulting in an export of depreciation.  As one of the expectations from all of the stimulus is to see inflation resume it may be that the massive global debt is creating the very thing that everyone is trying to avoid.

In the United States where quantitative easing was officially stopped almost a year ago there is the expectation that the poor numbers from the first half of the year will be magically replaced by economic growth robust enough to require the Federal Reserve to raise interest rates.  Based on the above argument it seems almost impossible to imagine this happening as any further appreciation in the dollar will surely put a bullet in the heart of any economic growth and force the Federal Reserve to not only ratchet down the interest rates but to resume its quantitative easing program repeating a cycle that has produced no results.

As with most if not all gluttons it is not the starting that is the problem it is the stopping and this is the problem.  How the world of gluttonous central bankers weens their way off this quantitative easing cycle is beyond me but at some point, like all gluttons, the madness has to end and it is never pretty.

Surprise, Surprise - NOT

"Humor is a spontaneous, wonderful bit of outburst that just comes.   It's unbridled, it's unplanned, it's full of surprises." - Erma Bombeck

"How ridiculous and how strange to be surprised at anything that happens in life." - Marcus Aurelius

This week the Federal Reserve left interest rates at their previous record low levels.  During their press release they once again sat firmly on the fence of caution and optimism leaving the markets guessing as to their next step.  Consensus still expects an interest rate increase later in the year, possibly as early as September.  The market reacted as if the decision to leave interest rates alone was surprising but readers of this blog should not have thought it strange at all.  In fact I found it strange that the market actually responded positively to the news as clearly the Federal Reserve still considers the economy too weak to handle even a 1/4 point move higher.  Furthermore it is clear that the market is still firmly drinking from the fire hose that is low interest rates and that any move higher will stick a knife right through its heart.

It almost seems like the record is stuck as once again the growth projections were ratcheted down from a range of 2.3% to 2.7% to a range of 1.8% to 2.0%.  I would not be surprised if this range is lowered further later in the year.  Certainly there has not been much if any of an economic uptick in the data through the end of May.  Consumption dropped in March and April, both months with no cold weather impacts, and industrial production has now fallen for five months straight.  For these reasons some economists argue that the United States is in a "secular stagnation".  Secular stagnation refers to the economic theory where savers do not invest their proceeds into the economy and so the economy stagnates.

Looking at America it seems hard to push the economy malfunctions into the secular stagnation box although as has previously been written in this blog the inequality of earnings is now at its highest level since 1928.  High earners are more likely to save rather than invest so this may point to some of the problem but companies are borrowing money at greater rates than at any time in the past and margin debt is also at a record high.

To me the problem is the access to capital.  Large corporations have access to as much capital as they can or are willing to acquire while small growth companies are unable to access capital regardless of their outlook.  These large companies compete on the world stage which is really struggling and does not create much demand at home.  Now of course this is a very broad brush but in the main it holds true.  In addition while the unemployment rate has dropped the middle class continues to be squeezed and this uneasiness closes wallets.  In my sphere it is rare to hear of a small business owner who is truly optimistic about the future.  They are still on edge and have been since 2008.  To them nothing has really changed.  Sure the economy has not imploded again but it certainly does not feel like it has come even close to recovering.

With this outlook it is no wonder that the economy continues to splutter.  If more were done to free up capital and level the playing field to assist the small business owner I firmly believe that this economy would be flying.  Instead the world sits watching the Federal Reserve play games with interest rates and soon we will be barraged with a bunch of horse manure from the potential presidential candidates as to how they are going to grow the economy by magically finding jobs and cutting taxes.  Until they wake up to the fact that the economy needs a complete revision to the rules of the game we will continue to splutter along and will probably waste another decade.  During this time it should be no surprise to my readers if the Federal Reserve keeps interests rates low far longer than anyone can imagine as they really have no metric to hang their higher interest rate hats on.  They will continue to blow hot air around their stuffy conference room but unfortunately this will not result in a humorous outburst - surprise, surprise; NOT.

Ignorance is Bliss

"Ignorance is bliss. I wish I still had some."  - Adam Pascal

Sometimes while I am reading economic reports over a quiet lunch the chatter of happily ignorant people reaches me and I have to wonder what it must be like to go through life with the ignorant belief that someone, somewhere, the "theys" of modern society (I still have no idea who "they" are but apparently "they" are always looking out for everyone's best interest and will come to the rescue in our hours of need), is looking out for our well being.  There is no need to plan for retirement or worry about any future market turmoil as it will all work itself out and that magically, when it comes time to retire, the nest egg will suddenly lay itself and will produce a smooth 8% year over year return that will more than satisfy their needs.

As I am sitting at my table surrounded by economic inputs showing increasingly poor numbers that the Federal Reserve believes can be rectified with ever more debt, it is completely clear to me that this bubble that the majority of people live in will soon be popped.  Not that I am predicting a popping tomorrow or even next week as that would be absurd to place a date or time on something that is unknown but with every fiber of my body and with more than 30 years of experience under my belt it is crystal clear that the policies followed by the central bankers of the world are leading us to a bitter end.

Some of the numbers that I look at show company GAAP earnings falling more than 8% year over year while GDP growth declined 0.7% in the first quarter.  Furthermore US corporate revenues are declining while price to earnings ratios reach levels not attained outside of 1929, 2000 and 2007.  The stock bulls believe that everything will once again return to growth magically in the second half of the year but there is little evidence to show that their expectations will be met.  In the meantime citizens live like turkeys, ignorant that Thanksgiving is around the corner.

So for those of us who have lost our ignorance virginity the solution is to minimize risk or, better still, become antifragile.  In his book "Antifragile", Nassim Taleb describes that in order to benefit from the expected collapse that one's portfolio needs to be convex.  A convex portfolio has limited losses but large profits which is contrary to the current state of the market where there is minimal upside or profits with the potential for large losses, in other words concave results.  The way to detect whether your portfolio is concave or convex is to determine the acceleration of harm (or benefit).  This is critically important and will determine whether you should remain in an investment or exit.

Now not everyone is a statistical genius as he is but we can all run some simple models that can extrapolate results.  These results may not even be accurate but, assuming that you have done a half way decent job of capturing the larger variables, then changing the inputs will quickly show you whether your investment is convex or concave.  As an example if the Federal Reserve has added (which they have) $4 trillion dollars and the result is a mediocre increase in GDP then adding more debt should show limited returns.  This is called the utility function in economics where every additional dollar has less of an impact.  However, if interest rates spike then the downside to this investment is huge.  So limited upside but massive downside is a seriously concave investment and is being replicated throughout the world by all of the central bankers.  In essence they have created the mother of all concave investments.

Hopefully you have a chance to take a good rational look at your investment portfolio and ensure that it is smiling rather than frowning and if it is not then take this time to turn that frown around so that you are not let down when everything else is.  Make sense of that last sentence if you can but I am sorry to say that if you have read this far then you too have lost your ignorance so it is now time to spring into action!

Human Capital is the Key

"The worth of a human being lies in the ability to extend oneself, to go outside oneself, to exist in and for other people." - Milan Kundera

Human capital is a very interesting economic concept and one that is not brought up in the normal course of investment strategies but this is a mistake.  Human capital is the inherent ability that we as individuals have to make money.  Each of us has a certain amount of human capital which we use up as we get older.  By the time that we retire the majority of our human capital is used and we are then reliant almost exclusively on our investments to support us.  So over time the idea is to maximize your human capital and turn as much of it into an investment pool as possible which can then be used to provide a good retirement.

Taking this at face value it can quickly be seen that an investment in your human capital is not only of utmost importance but should be continued throughout your career.  To some this would mean that a university education is of utmost importance but as I have argued in a previous blog there comes a point where the cost of the education obtained exceeds the benefit to human capital.  In these cases it would be more beneficial to learn through an apprentice program but the point is that education and learning are key ingredients to maximizing human capital.  Looking at the world as a whole just getting everyone a high school education would lift the globe's total human capital enormously and would lift the GDPs of numerous countries significantly.  It would seem like a no brainer for governments to provide this education at a minimum but power and politics can unfortunately often get in the way.  Why educate the masses when they may then not vote for you once educated and you lose your cheap labor pool?  As shameful as these policies are the other side of the equation is where the long hand of politics and government reaches into the university market and drives the cost of education through the roof.  Worse still is the amount of interest charged to students by the government entities providing the loans.  All of these policies limit human capital and therefore GDP growth.

Outside of education another way that human capital can be enhanced is through productivity growth.  Looking back in time the benefits to this can be seen in the mid to late 1990s as the "miracle that is productivity growth" (Alan Greenspan) drove GDP growth through the roof.  Since then there has been a slowdown in the acceleration of productivity growth   This can be seen clearly in the graph below and is one of the main reasons that growth has stagnated in the United States.

Combining this productivity slowdown with the lowest labor participation rate in decades and you can clearly see why the United States and other countries around the globe are struggling with expanding their GDP.  As amazing as it is then the Federal Reserve and other central bankers still believe that this problem can be repaired by throwing money at banks and lowering interest rates.  Still more confounding is that economists continue to expect a recovery in the second half of the year driven by consumer spending!  Until human capital growth resumes itself the globe will be stuck with slow GDP growth and the consumer will not be the driver of growth.

Hopefully the consumer is spending their money on developing new skill sets to grow their human capital rather than invest in the stock market as this will provide a far greater return on capital than the alternative and will allow the world to move out of its stagnation cycle and into a new era of economic growth.

Deflation at the Gate

"Let's call this NFL game balls for dummies.  Oh, don't take offense. Up until a few days ago, when the Deflategate "scandal" broke, we were all dummies when it came to the esoterica of NFL ball rules. Hell, let's be honest; we were imbeciles.  Now, we're learning all sorts of fancy things about the league's regulations and how teams and referees handle footballs before and during a game. For instance, did you know the ball must be a "prolate spheroid"? And did you know that before today, the term "prolate spheroid" had appeared on CNN.com only four times in its history? - Blog posted by Eliott McLaughlin of CNN

It seems that we finally have Deflategate in the rear view mirror.  Despite the scandal the Patriots retained their crown so in all honesty it was once again a media frenzy that resulted in nothing.  So with nothing but blue skies ahead of the NFL I thought I would turn to the actual Deflategate issue that is front and center; "Deflation at the Gate."  

Not a day goes by without some talk about raising interest rates so I thought I would do a review of the global markets to get a sense of what is happening in the world.  My data points to something far from an increase in interest rates in the near future.  Rather it shows alarming signs of a potential global deflationary spiral.  Reviewing data from the Economist magazine shows that of the 41 countries listed in their economic indicators page, 12 or almost 30% have printed a negative number in the inflation column (this includes the United States).  A total of 19 or nearly 50% of all major economies in the globe have inflation running below 0.5%.  This is hardly the type of market where interest rates should start to climb!  Looking at the countries with double digit inflation and you have only 3, Russia, Venezuela and Egypt; none of these are world economic leaders and all have serious structural economic issues that will not vanish overnight.

Taking a look at interest rates and specifically each country's 10-year note and using the United States as the benchmark for risk free debt shows 20 of the 38 countries that have data with interest rates below the United States' 2.24% rate.  So more than 50% of the globe have rates lower than the United States and most of them have far worse economic problems than the United States.  No wonder the dollar is gaining strength almost daily!  Should the United States raise interest rates the dollar would explode higher and growth would dive even more dramatically than it is currently.  Furthermore with oil and most raw materials priced in dollars, prices would fall precipitously across the board driving prices even lower and causing a global deflationary spiral.

So I took the liberty to research the last time the globe as a unit was gripped by deflation and not surprisingly there has not been a time in history where all major economies have simultaneously struggled with deflation.  A lot of countries have had spates with the issue but never globally.  The data certainly shows me that global deflation is more than a vague probability but could very easily take hold.  Raising interest rates at this stage in the game might be the catalyst to cause the global outbreak and while I am no Federal Reserve fan I have to believe that even they have worked this one out.  As such I think that this talk is just that and the reality is low interest rates are here for at least the next twelve to 24 months.

The Debt Debate

"Am I in debt?  I'm a true American." - Balki Bartokomus

"Slight was the thing I bought,
Small was the debt I thought,
Poor was the loan at best -
God! But the interest." - A poem by Paul Laurence Dunbar

As the levels of global debt increase a debate that has raged for many years is growing in volume.  Currently total global debt stands at almost three times total global GDP.  This is a staggering number and one that is not getting any smaller.  With many governments around the world awash with debt and businesses and consumers seemingly hooked on it, the prospects for debt levels decreasing any time soon seems dim.  This is worrying most economists due to the expectation that interest rates will start to rise at some point in the future and when they do, servicing this massive debt burden will have a large negative drag on economic growth.  Furthermore with seemingly ever person, company and government agency up to their eyeballs in debt not only will the impact be felt by consumers and businesses but governments will find a massive hole blown in their budget plans.

Interestingly though most first world economies treat debt with reverence in that debt payments receive a subsidy in the form of tax relief.  While a lot of advocates harp on the loopholes in tax law or farming and oil subsidies few discuss the subsidy that is the ability to deduct interest payments as a pre-tax expense.  This benefit is not only provided to companies who can deduct interest as an expense before tax but consumers can deduct the interest paid on their mortgages from their income earned.  It is estimated that this subsidy drains roughly  $800 billion a year in lost tax revenues from the United States Treasury alone.  This is more than the amount spent on defense each year.  As the current budget deficit is roughly that number, removing this subsidy would almost instantly balance the budget.  Furthermore studies have shown that the main beneficiaries from this subsidy are the wealthy as they are more than likely to have a loan (or the ability to obtain one), so in effect this $800 billion is a large cause of the inequality gap being seen across the globe.

One of the main proponents of the subsidy is to encourage home ownership.  It is argued that without this subsidy home ownership in the United States would fall precipitously.  This would drag down home prices and impact the entire home industry from DIY stores to Realtors to builders.  The impact is expected to be so large that it is almost unthinkable to remove the subsidy.  Taking a look at economies that do not provide this subsidy have shown that while there would be an initial sell off, home prices would only fall roughly 10% and subsequently recover.  The study found that not only do people naturally wish to own their home but that once prices fall to a certain level investors snap up the inventory and create a rental portfolio of properties. Therefore it is thought that the impact of removing this subsidy would be less dire than once thought and would be temporary.

Removing the luxury of deducting interest from company income statements would result in a restructuring of many companies balance sheets particularly the balance sheets of banks.  As interest is currently a pre-tax deduction, moving it below the tax line would remove the luster.  Companies might view debt very different as suddenly the thought of adding debt or issuing equity becomes a more evenly debated topic.  As a company can stop paying dividends without being forced into bankruptcy it is thought that many would curtail borrowing in favor of issuing equity.  The risk of adding more debt, which is less forgiving than equity, would push companies to add more equity rather than debt reducing the probability of another financial crisis.

As an example during the popping of the NASDAQ bubble more than $4 trillion of wealth evaporated.  In comparison the banks lost $2 trillion during the 2008 crisis and we are still trying to recover from that problem whereas the lost equity, while devastating to a lot of people, did not create the same economic after shocks as the financial crisis has.  Transferring the risk of investments from the banks and governments onto the equity investor seems like a lost art as every year since the Great Recession less and less money has been raised through the stock markets while the preferred funding source of debt spirals higher.  Changing this course seems to make sense but it will only happen once the subsidy is removed.

Against this positive effect is the cry that a number of companies would be driven out of business due to this lost benefit.  Furthermore many mergers and acquisitions not to mention leveraged buy outs would suffer.  While some of these deals do create value the majority result in a large payout to the funds putting the deal together with little benefit to the company and their employees so to me this is an argument with limited merit.

So while all may be well it is a sure thing that problems will arise from the debt gluttony once interest rates start to rise.  As it appears that interest rates will remain low for a while it could be a good time for governments around the world to quietly remove some or all of these subsidies.  Not only will this have the lowest level of impact right now but it will provide the safety net against another debt lead crisis.  Leaving the subsidy in place will have the double effect once interest rates rise of not only reducing government tax revenues due to the increased subsidy given to companies and consumers bu their deficits will spiral out of control as they will be required to service their gargantuan debt levels with ever larger amounts of borrowed money!  Lower tax revenues and higher deficits at a time when no government has the ability to handle any more financial stress, sounds like a great plan and one we are surely stuck with.  So while it may seem like a small bridge to cross for a large payoff there is no politician on earth that would try to push that policy through parliament until it is too late.  Pity as we could use a safety net rather than more interest.

Up, Up and Away

"Would you like to ride, in my beautiful balloon .... Up, up and away, in my beautiful balloon" - words from the song Up, Up and Away, written by Jimmy Webb

It is really amusing to me to see that once again it is a Friday and once again we are breaking through to new highs.  It seems like every Friday afternoon the market magically recovers from the slump of Monday and Tuesday to end the week on a positive note.  In fact the last 5 of 6 Fridays were good for the market; not that you should trade this statistic as it is certainly not a trend that can be maintained but it is remarkable.

Enough of trivia and turning my attention to the markets it has been a pretty rocky rode for government bonds around the world.  After reaching record low yields traders suddenly seemed to decide that enough was enough and that the hot coal could no longer be passed to the next chump so they dumped bonds en masse driving yields higher.  This was then followed by a surge in buying which has stabilized the yields but did not return them to their former lows.

It is interesting to note that during this frenzy world stock markets followed in the same path, first turning down and then resuming their meteoric rise.  Not all of them have acted as well as the S&P 500 but they have recovered from the sell off.  It is not often that you see bond prices moving in lock step with stock prices so this is a clear indication that the markets around the world are currently heavily reliant on cheap money to fuel their rise. It is also clear from the recovery in bonds that the world continues to believe that low interest rates are here for an extended period.  It also shows that any spike in yields will be met by huge demand as the world is desperate for higher interest on their savings and investments.

It was also interesting to watch the silver and gold markets which appear to have broken out of their trading range, jumping higher and breaching their 200 day moving averages.  This is interesting as typically these commodities run on fear or inflation so could these be signalling a move away from the slow growth and low inflation environment of the past years and into a more frenetic period of higher growth and inflation?  With oil prices above $60 a barrel and well above their lows recorded only a few months ago, there is a chance that inflation could be creeping back into the picture but it is far too early to say for certain.

If inflation is making a come back, which undoubtedly it will at some point in time, will it remain under control or take off like wild fire?  I have to believe that at least for the remainder of the year there is little chance of runaway inflation.  Unemployment is far too weak and oil prices are still miles from their peak but, if the consumer is forced to spend more on goods and services caused by higher prices there may be a small boost in spending and this might surprise a few economists and possibly the Federal Reserve.  Should this occur, the chance of the Federal Reserve raising rates increases and, as I believe that this would be a premature move, should they fall for the false signal it would put a bullet right through the heart of the market much like popping a balloon.  Would you like to ride in my beautiful balloon?