Liquidity Trade

Doug Nolan

It’s not quite 1999 at this point, but it’s been moving in that direction. In about five months’ time, the Nasdaq 100 (NDX) has posted a gain of 20.5%. NDX stocks with greater than 50% y-t-d gains include Vertex Pharmaceuticals (74%), Activision (64%), Tesla (60%), JD.com (58%), Wynn Resorts (54%), CSX (53%), Autodesk (52%), Liberty Ventures (51%) and Lam Research (50%). Amazon’s 34% 2017 rise has increased market capitalization to $481bn (P/E 189). Apple’s 33% gain pushed its market cap to $806bn. Facebook has gained 33% y-t-d, Google 26%, and Netflix 32%.

There’s an interesting similarity to the 1999 backdrop: A Federal Reserve (and global central bank community) way too timid in implementing a “tightening cycle” despite bubbling asset markets. Fed funds began 1999 at 4.75%, after rates were slashed 75 bps late in 1998 in response to the Russia/LTCM financial crisis. Despite clearly overheated securities markets, rates ended 1999 at 5.5% - the same level they were for much of 1998. The Fed was content to let the speculative Bubble run, with memories of the previous year’s near financial meltdown clear in their minds. Moreover, Y2K uncertainties provided a convenient excuse to accommodate the raging Bubble.

There’s at least one huge difference to 1999. The 10-year Treasury yield began ‘99 at 4.65% and ended the year at 6.44%. Ten-year yields ended Friday’s session at 2.16%, down 29 bps for 2017 and near lows since the election. Astounding amounts of government debt have been issued globally since 1999. Radical central bank measures ensured prices of these securities inflated to unprecedented levels (even in the face of endless supply). Historically low yields are a global phenomenon. German bund yields closed the week at 27 bps and French yields closed at 71 bps. It’s worth noting some current 10-year sovereign debt yields: negative 27 bps in Switzerland, 31 bps in Finland, 40 bps in Sweden, 48 bps in Netherlands, 53 bps in Denmark, 54 bps in Austria and 64 bps in Belgium.

MSCI's all-country world stock index ended the week at a record high. Both the UK FTSE (up 5.7% y-t-d) and German DAX (up 11.7%) equities indices traded Friday at new highs. European equities have been powering higher. The French CAC 40 has gained 9.9% y-t-d, Spain’s IBEX 35 16.6%, and Italy’s MIB 8.8%.

June 2 – Bloomberg (Katherine Chiglinsky): “Mohamed El-Erian, Allianz SE’s chief economic adviser, said the rally in stocks and high-yield bonds is part of a ‘liquidity trade,’ based on optimism that central bank stimulus efforts and the accumulation of corporate profits will sustain market gains. ‘That is what you’re betting on,’ El-Erian said Friday in an interview on Bloomberg Television. ‘You’re not betting on the Trump rally anymore. You’re not betting on the reflation trade anymore.’”

The “Trump Trade” provided convenient cover for what has been for some time a strengthening speculative Liquidity Trade. The histrionic bond market reaction to the weaker payroll data was telling. The long-bond surged a full point, with yields dropping five bps to the lows since November. If the issue were a weakening economy, one was challenged to see it in the reaction within the risk markets. Investment-grade corporate debt (LQD) gained about 0.5% Friday to trade to the high since November. Even junk debt (HYG) posted a small gain to trade to an almost 18-month high. The NDX jumped 1.1% Friday, with the Nasdaq Composite up 1.0% - both to record highs. The Semiconductors gained 1.0% (near year-2000 highs), and the Morgan Stanley High Tech index rose almost 1% to an all-time high. The Biotechs rose 1.9% to a 2017 high (up 20% y-t-d).

It’s worth noting that gold gained 1% on Liquidity Trade Friday, increasing 2017 gains to a notable 11%. Crude’s 1.5% Friday decline (down 4.3% for the week) was not inconsistent with Liquidity Trade dynamics. Shale exploration and extraction are thriving on easy “money.” And when it comes to Liquidity analysis, Bitcoin has earned a place at the table. Bitcoin rose $160 this week to $2,430, boosting its y-t-d gain to a remarkable 155%.

A Friday ZeroHedge article asked the relevant question: “BoJ, ECB Balance Sheets Exceed the Fed’s For First Time Ever - What Happens Next?” The over $1.0 TN global QE injections during the first four months of the year argue for “Peak QE.” The ZeroHedge article includes a chart of the G3 (Fed, BOJ, ECB) balance sheet that correlates closely with U.S. stocks going back to 2009. It’s worth noting that G3 balance sheets will soon reach $14.0 TN, up from less than $6.0 TN in early-2009 (after initial crisis-period QE). “Now what?”, indeed. Near zero rates and unprecedented “money printing” have inflated asset price Bubbles around the globe. 
 
What happens when stimulus is removed? This is by now a conspicuous problem, though markets are confident that central bankers have no stomach for finding out how big of a problem. The Liquidity Trade is premised on global central bankers being trapped in ultra-easy “money” (including ongoing printing).

May 30 – Bloomberg (Jeanna Smialek and Matthew Boesler): “Federal Reserve Governor Lael Brainard said soft inflation could cause her to reassess the path forward for monetary policy should it linger, even as the global economic outlook brightens and U.S. growth looks poised to rebound. ‘If the soft inflation data persist, that would be concerning and, ultimately, could lead me to reassess the appropriate path of policy,’ Brainard said… ‘I see some tension between signs that the economy is in the neighborhood of full employment and indications that the tentative progress we had seen on inflation may be slowing,’ Brainard said. ‘If the tension between the progress on employment and the lack of progress on inflation persists, it may lead me to reassess the expected path of the federal funds rate in the future, although it is premature to make that call today.”

This is exactly the type of dovish diffidence that feeds market speculation. The Fed needs to find a backbone and move forward in the direction of normalization without reacting to the normal ebb and flow of securities markets, inflation data and economic performance. 
 
Moreover, central bankers should jettison this notion of no tolerance for recessions or bear markets – both precious Capitalistic system cleansing mechanisms. Clearly, central bankers have come to exert profound effects on securities and asset prices. Recent history has as well demonstrated that their capacity to manipulate an index of consumer prices is suspect at best. 
 
Prolonging ultra-easy money will surely exacerbate global overcapacity (i.e. additional Chinese overcapacity and U.S. shale investment).

Especially after Friday’s weaker-than-expected payroll data, the markets will question whether the Fed is about to flinch. Expectations are growing that the FOMC will pull back from an already incredibly cautious rate hike cycle – one that to this point has completely failed to “tighten” financial conditions. Indeed, conditions have further loosened.

I’ve read and listened to analyses warning against the Fed committing a major policy error by tightening into a weakening economy. Yet their mistake was waiting way too long to commence the normalization process. At this point, there is great risk in the Fed accommodating late-cycle excesses - including the global securities markets’ Liquidity Trade. Only a meaningful amount of pain will impact what has become a major inflationary/speculative psychology enveloping global securities markets. The Fed needs to bite the bullet and push rates higher.

Discussions continue regarding the Federal Reserve’s decision to shrink its balance sheet. 
 
Similar to rate discussions, the markets (for good reason) believe the Fed will refrain from measures that actually tighten financial conditions and impinge booming securities markets. If queried, most sophisticated market professionals would likely respond that they expect the next major change in the Fed’s holdings to be on the upside (another round of QE). Some Fed officials see selling some assets as a positive measure that would help reduce excessive monetary accommodation. At this point, balance sheet discussions appear to be backfiring. Believing the Fed will likely pause rate increases while reducing assets both slowly and very modestly, the markets now see potential Fed balance sheet operations as a bullish development that ensures no actual tightening of financial conditions for many months to come.

Next Thursday’s ECB meeting is widely expected to see a contentious debate as to the process for winding down extraordinary QE and rate measures. Euro zone economies and inflation trends have bounced back. Ultra-loose financial conditions have worked their magic, although Draghi does not want any change in ECB stimulus to upset the Liquidity Trade. The Germans and others have long ago seen enough and seek to establish a timeline for winding down QE.

The markets assume Draghi will, once again, win the day. This week also saw happenings in China that embolden those believing that Beijing will also continue to win the day, month and year.

May 31 – Bloomberg: “The offshore yuan jumped the most in four months as funding costs surged amid speculation policy makers were supporting the currency in the wake of a surprise sovereign rating downgrade… ‘The sharp gain in the offshore yuan is partially due to the unwinding of short yuan positions because the high offshore yuan funding cost has made the currency too expensive to short,’ said Stephen Innes, senior Asia-Pacific currency trader at Oanda Corp… ‘Bears with short yuan positions would need to cut their exposure.’ The overnight yuan interbank rate in Hong Kong, known as Hibor, surged 15.7 percentage points on Wednesday to 21.08%, the highest since Jan. 6, while the offshore yuan’s overnight deposit rate jumped to 60%.”

May 31 – Bloomberg: “China is dishing out a tough lesson to currency traders and strategists alike: don’t bet against the yuan. The currency jumped its highest level in seven months offshore, extending Wednesday’s gain of 1.2%, despite analyst forecasts for declines this quarter. Surging interbank rates are squeezing bears by driving up the cost of short positions. The rally, which broke months of calm against the dollar, comes as a rebuke to Moody’s…, which downgraded China’s sovereign debt rating last week. The government has made its displeasure clear, calling the move ‘absolutely groundless.’”

On the back of the People’s Bank of China’s forceful interventions, the renminbi traded this week to the strongest level since November. Speculative markets have come to welcome heavy-handed Chinese intervention. The assumption is that Chinese officials are absolutely determined to hold bursting Bubble dynamics at bay.

China is not the only macro worry. Italian bank stocks were hit 4.3% this week. Talk of early elections also pressured Italian bonds. With yields rising 16 bps, the Italian to bund yield spread widened a notable 22 bps this week to a six-week high. It’s also worth mentioning the 4.3% fall in crude and the 9.4% drubbing in natural gas. And there’s the ongoing strength in the yen. The Japanese currency rose 0.8% this week (up 5.9% y-t-d) and has been notably resilient in the face of advancing equities and risk markets. I tend to believe that various macro risks continue to play a prevailing role in stubbornly low global bond yields, a backdrop that along with timid central bankers fuels dangerously speculative risk markets across the globe.


US consumers’ trust deficit is permanent
    
Our behaviour is altered by seismic events — Americans now save more and spend less
     
by: Rana Foroohar



There is a paradox at the heart of the US’s lacklustre economy these days. Consumers in America are, according to much-watched numbers like the University of Michigan consumer survey, more “confident” than they have been in years. And yet they are spending less than they have since the Great Recession.

They are also increasingly skittish. As Starbucks’ executive chairman and former CEO Howard Schultz has told me, consumer spending can collapse at a moment’s notice, particularly on disturbing economic or political news (anything from race riots to terror attacks to populist electoral battles). Sales will eventually rebound as events move on. But as he and other retailers have told me, the US consumer today is “fragile”, likely to close up their wallet more quickly, and open it more slowly, than in the past.

The missing metric that explains all this isn’t economic, but social — it’s about trust. Or more notably, the lack of trust among the general population in what the future will look like, and the ability of elites to manage it. While the Michigan survey tallies with how people feel right here, right now (something that is typically correlated with stock prices), there are other more forward-looking surveys, like the Gallup US Economic Confidence Index, which measure not only how people feel in the moment, but what their expectations are of the future.

Those numbers are significantly more negative, and that’s important, since expectations about the future matter a lot in terms of big-ticket private sector spending. Businesses doing big capital investments, as well as consumers buying homes and cars, are thinking about multiyear time horizons, not the momentary level of the markets.

That’s probably a big reason why the average private sector financial surplus from the end of 2008 until now is 5.31 per cent — a whopping 1134 per cent higher than it was in the five years before the financial crisis. That cash cushion may reflect the imprinting of the crisis itself; as research shows, it’s not only rational to fear such events once you’ve been through them, but consumer behaviour is permanently altered by seismic events — think of the economic optimism of the Baby Boomers, or the children of the Depression, forever reusing tea bags.

No wonder Millennials are saving more as a percentage of income than their parents, and taking longer to make their first home purchases. Not only did they come of age during the financial crisis and Great Recession, but they have to deal with its aftermath in the form of a student debt bubble, decreased wealth prospects (young people who enter the job market in a recession never make up the lost income), and rising rents in the best job markets.

But there’s a broader anxiety about the future, not just on the part of Millennials. Economists such as Robert Shiller have speculated that decreased demand in the economy reflects “vague fears” about long-term employability, given frequent news stories about the robots taking our work (the McKinsey Global Institute estimates that 60 per cent of us will see 30 per cent of our work disrupted by technology in the next 10 years). Many other progressive economists believe that the failures of the neoliberal system itself (which have been chronicled by even the IMF) have created a broad-based existential angst reflected in the new propensity of Americans to save rather than spend.

Like Chinese consumers, whose high savings rates are a reaction to things such as having lived through huge social upheaval, and coping with an inadequate social safety net, Americans seem less sure of the political economy in which they live.

They have plenty of reason to be suspicious, not only because the recently proposed Trump administration budget and healthcare “reform” bill would do away with what little safety net the most vulnerable Americans have. Consider a recent Roosevelt Institute paper showing the stark effect of money on politics, even on the left: for every $100,000 that Democratic representatives received from finance, the odds that they would break with the party’s majority support for the Dodd-Frank legislation increased 13.9 per cent.

As Allianz’s chief economic adviser Mohamed El-Erian puts it: “You cannot underestimate the economic and political effects of the profound loss of trust that the public has had in the core managers of the global system.” Rebuilding that trust would be the best kind of fiscal stimulus.

But it will require heavy lifting, and not just in the US. French president Emmanuel Macron, for example, will have to prove that he’s not a business-as-usual neoliberal if he wants to avoid another populist challenge once Europe’s cyclical recovery wanes.

Angela Merkel will have to convince Germans that they should become less German in order to preserve the economic union that has enriched them more than any other EU nation.

Economists and policymakers everywhere will have to figure out how to incorporate voters’ understandable concern about the demise of the nation state, the rise of corporate power, and their own economic vulnerability. Indeed, growth itself may depend upon it.


The Case Against Subsidizing Housing Debt

Jeffrey Frankel
. houses for sale

 

SINGAPORE – At the end of the first quarter, according to the Federal Reserve Bank of New York, American consumer debt for the first time exceeded its previous peak (in dollars), reached in the third quarter of 2008, just as the global financial crisis erupted. Although car loans and student debt have been rising especially rapidly, housing debt remains more than two-thirds of the $12.7 trillion total.
 
As a share of income, household debt is nothing like the threat to the national economy that it was ten years ago. But the new statistic is a reminder that American households don’t save enough.
 
Some would attribute Americans’ tendency to spend – while Asians, for example, tend to save – to cultural factors. But there is an important policy component as well. US government policy is designed as if to encourage Americans to take on as much housing debt as possible.
 
Economists hesitate to explain to people that they should borrow less. The advice sounds too schoolmarmish. It seems to lack empathy for those whose incomes are not keeping up with the standard of living that historical trends had led them to expect. But it does no one any favors to encourage over-indebtedness as a matter of policy, as the millions who lost their homes in the aftermath of the 2008 crisis discovered.
 
Owning your own home is said to be an essential part of the American dream. There is nothing wrong with dreaming. But there is nothing wrong with renting, either. Buying a house is typically a consequence, not a cause, of a family’s prosperity.
 
Advocates of an “ownership society” argue that homeowners take better care of their property than renters, with positive externalities for the neighborhood. But public encouragement of homeownership also weakens labor mobility. In the last US recession, many who lost their jobs could not move to other parts of the country where jobs were more plentiful, because they couldn’t sell their homes. There is good evidence that the housing crisis boxed in job seekers.

Encouraging home ownership isn’t cheap. The overall effective annual subsidy to US housing debt has been estimated at roughly 1% of national income. The largest component of this subsidy is the tax deductibility of home mortgage interest, which costs a lot of revenue and is hard to justify on distributive grounds: the benefit goes only to those with incomes high enough to itemize deductions.
 
If US President Donald Trump manages to get any economic legislation passed at all in the coming year, it is likely to be a tax cut. Congressional Republicans say they want revenue-neutral, efficiency-enhancing tax reform, which is properly defined as lowering marginal tax rates but simultaneously eliminating distortionary deductions, thereby keeping revenues and the budget deficit stable. In that case, the deductibility of home mortgage interest should be among the first targets for reform. Yet the Trump administration has explicitly ruled out curtailing it.
 
Particularly suspicious in the case of Trump is his support for giveaways in the tax code that benefit only real-estate developers like him. One such loophole lets developers deduct losses that exceed their investments. Another is the use of “like-kind exchanges” to avoid capital gains tax.
 
But the problem goes well beyond Trump or the Republicans. The policies that favor mortgage debt are extremely popular. Virtually all politicians of both major political parties have long supported them, taking the goal of maximizing homeownership as self-evident.
 
Beyond the deductibility of home mortgage interest, borrowers are permitted to make down payments of as little as 5% (or even less) of the value of the house they buy, rather than the more standard 20%. Many other countries, such as Korea and Singapore, have regulations – loan-to-value ratios, for example – limiting how much households can borrow. They even manage to tighten the loan limits or tax measures counter-cyclically, which is the recommended way to help stabilize the housing cycle.
 
But the US is not the only country with measures that tilt toward excessive housing debt. In the United Kingdom, for example, the Help to Buy initiative has subsidized home purchases with down payments of only 5%.
 
Another way the US has long subsidized housing debt is through the huge quasi-government mortgage underwriters Fannie Mae and Freddie Mac. Both were privately owned but had an implicit government guarantee from taxpayers, a classic case of moral hazard. Sure enough, they were put in federal conservatorship in 2008. Congress could easily repeat the mistake of privatizing them while failing to eliminate the implicit guarantee. Their capital standards should be raised, just as regulators have appropriately forced banks to do.
 
The Dodd-Frank financial reform bill, signed into law by President Barack Obama in 2010, contained many provisions to reduce the chances of another big financial crisis. But the law would have moved the financial system further in the right direction if many in Congress had not spent the last seven years chipping away at it.
 
Here is one example. The Dodd-Frank law wisely required banks and other mortgage originators to retain on their books at least 5% of the housing loans they made, rather than repackaging every last one for resale to others. The loan originators need to have “skin in the game,” in order to have an incentive to verify borrowers’ creditworthiness. Under heavy pressure from Congress, that requirement was gutted in 2014.
 
Ironically, the encouragement of housing debt in the US doesn’t even succeed in raising homeownership rates relative to other countries: even at the peak of the housing boom, the subsidies drove up the price of housing more than the quantity. Homeownership was no higher than in many countries with more sensible mortgage policies (no tax deductibility), like Canada. The 2007-09 crisis lowered it from 69% to 63%. And of course the housing debt distortion was itself a key contributor to the crash.
 
Most economists have long frowned on US policies that subsidize homeownership. But most held their tongues. And now many Americans no longer want to hear from experts. When did that loss of faith happen? Wasn’t it when the economy was hit by a housing and financial crisis, which economists were supposed to predict?
 
 

Demographics, Debt & Devices - A Series of Deflationary Events

Dear Reader,
 
Over the course of this week, we will be sharing key insights from the 2017 Strategic Investment Conference exclusively with Mauldin Economics readers.
 
A topic covered by speakers like Mark Yusko, David Rosenberg, Dr. Lacy Hunt, and Raoul Pal at the SIC was US economic growth and the reasons it will stay low for decades to come.
 
Demographics Are Destiny
 
Dr. Lacy Hunt, former senior economist at the Federal Reserve and EVP of Hoisington Investment Management, said the single best economic indicator is nominal GDP growth as it measures all the changes in market prices that have occurred during a given year.
 
And this indicator suggests the US is in trouble.
 
Despite a surge in optimism post-election, nominal GDP growth in 2016 was just 2.95%—making it the fifth worst year on record since 1948.
 
What does this have to do with demographics?
 
Mark Yusko, founder and CIO of Morgan Creek Capital Management told us...
 
Growth in the working-age population has been a leading indicator of nominal GDP for decades.
 
Chart
 
 
And the future looks bleak.
 
According to the CDC, the fertility rate is at its lowest level since records began in 1909.
 
This, coupled with the fact that 10,000 people turn 65 each and every day in the US, means growth in the working-age population will remain at record lows... thus weighing on any economic expansion.
 
More Debt, Less Growth
 
David Rosenberg, chief economist and strategist at Gluskin Sheff, dissected another trend hurting growth: DEBT.
 
As these statistics from the Bank for International Settlements and Haver Analytics show, higher debt levels coincide with lower growth.
 
 
Chart
 
 
While the total debt/GDP ratio is 248% today, the non-partisan Congressional Budget Office projects it will rise to 280% by 2027... and that’s assuming nominal GDP grows at 4% per annum.
 
This huge debt burden also means interest rates must stay low to keep service costs down... Dr. Lacy Hunt pointed out that a 1% increase in interest rates would mean an extra $200 billion in Federal debt repayments per annum.
 
Devices Equal Lower Prices
 
Another deflationary trend discussed at the SIC 2017 is the rise of automation and technology.
 
Findings from the Brookings Institute show rising productivity in manufacturing has led to a decline in employment in the sector.
 
Chart
 
 
By removing labor costs, automation is driving down the price of core goods, as David Rosenberg detailed.
 
Chart
 
 
But no longer is this just in manufacturing. In a recent study, PriceWaterhouseCooper found that 38% of US jobs will be automated by 2030, which means more deflationary pressures.
 
And these pressures have serious implications for your portfolio...
With US equities trading at all-time highs, should you invest in them with little chance of earnings growth?... With inflation likely to remain low, are Treasuries a buy at 2.2?


A Trans-Atlantic Turning Point

What Was Merkel Thinking?

By Annett Meiritz, Anna Reimann and Severin Weiland

 German Chancellor Angela Merkel at the Bavarian beer tent where she made her comments on Sunday
German Chancellor Angela Merkel at the Bavarian beer tent where she made her comments on Sunday
 

An historical turning point or mere campaign bluster? Chancellor Angela Merkel's Sunday speech on relations with Donald Trump's America has raised eyebrows the world over. What did she mean?

A "potentially seismic shift" wrote the New York Times . A "new chapter in U.S.-European relations," proclaimed the Washington Post. German Chancellor Angela Merkel's comments made in a beer tent in Munich on Sunday have made headlines around the world. It was the kind of appearance the likes of which she will make hundreds of times ahead of Sept. 24 parliamentary elections in Germany. But in this speech, she clearly distanced herself from U.S. President Donald Trump. And she urged Europe to prepare for a future in which it has to be much more self-reliant.

"The times in which we could completely rely on others are over to a certain extent. That is what I experienced in the last few days," Merkel said. "That is why I can only say: We Europeans must really take our fate into our own hands."

She went on to say: "Of course in friendship with the United States of America." She emphasized friendship with the U.S. on a few other occasions in her remarks as well. But then said: "We have to fight for our own future, as Europeans, for our destiny."

Merkel's comments were unusual on several levels. It's not just what she had to say that was interesting, but also why and when: at a folk festival following a series of summits during which she spent extensive amounts of time with Trump. The chancellor made direct reference to her strenuous week, during which the U.S. president managed to alienate his partners on several occasions.

Despite the directness of Merkel's Sunday speech, however, there are several open questions that need to be answered:

1. Why did her comments cause such a stir around the world?

On the eve of Trump's trip to Saudi Arabia, Israel and Europe, heads of state and government around the world were eager to put on a veneer of harmony. That effort, though, is over -- and Merkel is one significant reason why. Since Trump's victory last November, many see the German chancellor as the leader of the free world and her appearance on Sunday was a sharp break with the careful Trump-related rhetoric she had thus far employed. To be sure, she reminded him in her congratulatory message after he won the election of the values that form the basis for the trans-Atlantic relationship, but she had nevertheless consistently sought to emphasize commonalities rather than divisions.

Merkel's comments on Sunday are a turning point because she cast doubt on past convictions -- and provided a clear indication that she is losing hope that she can ever work constructively together with Trump. Or -- a slightly different interpretation -- she is now willing to express those doubts that have been building for some time. Either way, she did so in a manner which was, for her, unusually blunt.

2. Why did Merkel choose the words she chose?

Trump's credo is "America First." For Merkel, that consequentially means that Europe must take on a greater role. Trump's policies make it necessary to redefine European interests: That is something of which both Merkel and Foreign Minister Sigmar Gabriel, a senior member of the Social Democrats (SPD), are convinced. Much of the discussion has recently centered around increasing Germany's defense spending, which is a highly controversial issue in the country. Trump may have watered down his criticism of NATO in a recent tweet, but he is still demanding that most European countries spend more on defense. One outcome of the NATO summit last week is that all alliance member states are to demonstrate annually how much progress they have made toward the NATO goal of spending 2 percent of gross domestic product on defense. Thus far, only the U.S. and a couple of European countries meet this target, while Germany lags behind at 1.2 percent.

As such, Merkel's comments aren't just reflective of the state of the trans-Atlantic relationship.

They are also an appeal to the Germans, and to Europeans more broadly, to shoulder more responsibility - and to confront even such emotionally charged proposals as the establishment of joint European defense and security policy.

3. To what degree were Merkel's comments part of the German campaign?

Merkel's appearance was the clearest indication yet that foreign policy and the future of the European Union will be vital issues in the campaign. The SPD had been hoping that it could score points against Merkel on the basis of her erstwhile even-handed approach to Trump. But now, Merkel has positioned herself more clearly than ever before as Europe's defender in the face of the Trump challenge -- a role that her SPD challenger Martin Schulz had been hoping to play. The SPD can do little more than agree with the chancellor. On Monday, Schulz tweeted "the best response to Donald Trump is a strong Europe" -- which is essentially exactly what Merkel said.

4. What are the consequences of Merkel's comments?

While there are no immediate consequences, the chancellor will have to substantiate her comments in the coming days and weeks. Otherwise, the SPD and other parties will be able accuse her of empty politicking. Already, though, Merkel has sharpened her focus on France, saying that she and President Emmanuel Macron have agreed on a "new push" in Franco-German cooperation and that the two countries intend to present a "roadmap" for desired reforms. Foreign Minster Gabriel, for his part, has presented a more concrete plan. In addition to strengthening the eurozone, it sketches out possible joint German-French investments, a joint defense fund and more intense cooperation on foreign policy.

Efforts at strengthening Europe, in other words, are on the way -- and Merkel's comments are an expression of that. They have also triggered a debate that Germans have historically found to be extremely uncomfortable: How much should Germany and Europe spend on their own defense? And how large should Germany's role be in that defense. They are questions that promise to be a significant ones in the years to come.


How to Retire on 2% Returns

By Patrick Watson


Does the past predict the future? If you work in the regulated financial industry, you can only answer that question two ways. Your acceptable answers are:

  • No

  • Not necessarily

When I used to write commodity and hedge fund marketing materials, I typed the official phrase, “Past results are not necessarily indicative of future results” so often, I finally gave it a hotkey on my computer.

That’s not to say the past is irrelevant. It can tell us a lot.



If you can identify a pattern in economic cycles or market activity and have enough observations to make your observation statistically significant, it raises your odds of success.

The fact that most people do this badly doesn’t mean it can’t be done at all.

Talent exists; it’s just hard to find.

That’s why John Mauldin’s Strategic Investment Conference is such a boon.

Last week, he gathered some of the world’s most brilliant investment thinkers in one place and let them speak their minds.

Better yet, he turned the experts loose on each other by grouping them in panels. Those discussions were pure gold.
 
I heard some things I didn’t especially like, but there is no true bliss in ignorance, no matter what the folk wisdom says. Today, I’ll tell you about one of speakers and what I learned from him.
 
Slow Growth Ahead

I started reading Martin Barnes probably 25 years ago when I worked at ProFutures. My boss, Gary Halbert, was a big fan and let me read his copies of the very expensive Bank Credit Analyst, which Barnes edited for many years.

BCA doesn’t always catch short-term moves, but its long-range macro outlook has been reliable. I was thrilled to finally meet Martin in person last year at the Camp Kotok economists’ retreat—and this year, I got to hear him speak at the SIC.

Martin believes the current slow economic expansion will continue. He showed this slide comparing the length and magnitude of past US growth cycles.


 
The bottom yellow line represents the current recovery, which has produced less GDP growth than prior cycles. But in terms of length, it is now tied for third place, surpassed only by the 1961–69 and 1991–2000 expansions.

If it lasts two more years, it will be the longest on record.

Martin thinks it could happen: “Expansions are typically assassinated. They don’t die of old age,” he said. In most cases, the assassin is monetary policy.

The good news this time is that Martin doesn’t see the kind of imbalances that would make the Fed go overboard. With inflation relatively subdued, he thinks the tightening won’t be too tough.

He also noted that President Trump’s tax cuts and stimulus spending plans would have overheated the economy and probably led to a 2019 recession. With gridlock winning, he sees this as a minor risk.

The bigger problem is that other macro trends aren’t helping. Worker productivity and working-age population are problematic already, and they will likely get worse.


 
This being the case, Martin thinks we can’t expect the kind of investment results seen in prior expansions. Over long periods, stock market growth has to track economic growth. Market gains since 2009 reflect good news that hasn’t actually happened yet.

Which brings us to the bad news I mentioned.

Martin thinks the 2% average real GDP growth of this expansion will likely continue for the next decade—and in the long run, stock benchmarks can’t grow more than the economy in which they operate. That means net investment returns will stay around 2% as well.

Here’s what BCA expects, broken down by asset clases.


 
From 1982 to 2016, a static stock/bond portfolio delivered real (after inflation) returns around 7%. US equities alone averaged 11.2%.

Consider those the “good old times,” though, because Martin Barnes doesn’t expect any more of it.

This is a big problem for investors who are planning their retirement on the assumption that they will earn inflation-adjusted returns well above 2% and are saving and investing accordingly.

Worse, many public pension funds still assume their portfolios will earn 7–8% nominal returns and make promises to workers based on that assumption. If Martin is right, this is not going to end well for either workers or taxpayers.

What can you do?
 
Overestimate Your Enemy

Also at the SIC was George Friedman of Geopolitical Futures. He said something in an entirely different context that fits here too.

In discussing the United States’ response to North Korea’s recent missile launches, George said, “It’s important to always overestimate your enemy.”

To George, this means the US has to assume North Korea’s nuclear capabilities are real, and act accordingly.

To investors, it means we shouldn’t assume 7% real returns will continue.

Maybe Martin is wrong and the market will zoom higher in the next decade—but your retirement plan shouldn’t bet on it.

In other words, keep your expectations conservative. Better to be surprised by a windfall than a shortfall.

Specifically, you can start by tempering your retirement lifestyle plans. That could mean pushing back your planned retirement age, living in a less expensive home, or renting out part of your house to lower expenses.

You could also save more aggressively for retirement, which might require reducing your current spending plans. You’ll be glad you did later.

Finally, reconsider your investment strategy.

You‘ll notice in the BCA forecast that they expect the highest future returns to come from emerging-market (EM) equities. I agree—which is one reason I recently recommended a reduced-volatility emerging market ETF to Yield Shark subscribers. It’s up almost 3% so far but still has plenty of room to grow.

What you absolutely shouldn’t do is assume the future will look like the past.

But while you can’t predict the future, you can still control your response to it.

Make sure your strategy won’t disappoint you.

See you at the top,