The Questions for the Coming Year

By Louis-Vincent Gave, Gavekal Research



Like obscenity and modern art, bitcoin price charts will mean different things to different people. Take for example this recent tweet from the Federal Reserve board’s “uber-dove”, Neel Kashkari.


 
This tweet startled me for various reasons, namely:

a) Central bankers really do embrace their role as party-poopers whose mission is to take away the punch bowl before things really hot up (note, there will be no central bankers at my annual Christmas Eve party, so if you happen to be in Whistler, you should come along!).

b) The above was tweeted by the most dovish Fed governor, so if Kashkari is scratching his head over bitcoin developments more hawkish governors are presumably pulling their hair out.

c) And if dovish policymakers in the US are publicly pondering the impact of crypto-currency speculation, central bankers in markets where such activity is rampant must be properly concerned.

Indeed, a recent Bloomberg article noted that 40% of bitcoins are owned by around 1,000 or so individuals who mostly reside in the greater San Francisco Bay area (the early adopters). Sitting in Asia, it feels as if at least another 40% must be Chinese investors (looking to skirt capital controls), and Korean and Japanese momentum traders. After all, the general rule of thumb in Asia is that when things go up, investors should buy more.

Asia’s fondness for chasing rising asset prices means that it tends to have the best bubbles. To this day, nothing has topped the late 1980s Taiwanese bubble, although perhaps, left to its own devices, the bitcoin bubble may take on a truly Asian flavor and outstrip them all? Already in Japan, some 1mn individuals are thought to day-trade bitcoins, while 300,000 shops reportedly have the capacity to accept them for payment. In South Korea, which accounts for about 20% of daily volume in bitcoin and has three of the largest exchanges, bitcoin futures have now been banned. For its part, Korea’s justice ministry is considering legislation that would ban payments in bitcoin all together.

At the very least, it sounds like the Bank of Korea’s recent 25bp interest rate hike was not enough to tame Korean animal spirits. So will the unfolding bitcoin bubble trigger a change of policy from the BoK and, much more importantly, from the Bank of Japan in 2018?

The aim of this paper is to look at this and other important questions whose answers may have a significant impact on the price of financial assets over the coming quarters.
 
1 — Will the BoJ change course in 2018?

In recent years, the BoJ has been the most aggressive central bank, causing government bond yields to stay anchored close to zero across the curve, while acting as a “buyer of last resort” for equities by scooping up roughly three quarters of Japanese ETF shares.

Yet, while equities have loved this intervention, Japanese insurers and banks have had a tougher time. Indeed, a chorus of voices is now calling for the BoJ to let the long end of the yield curve rise, if only to stop regional banks hitting the wall.


 
So could the BoJ tighten monetary policy in 2018? This may be more of an open question than the market assumes. Indeed, the “short yen” trade is popular on the premise that the BoJ will be the last central bank to stop quantitative easing. But what if this isn’t the case? There are, after all, pros and cons to keeping an uber-easy monetary policy, as shown below.
 


 
So all in all, we seem to be on a knife edge, and any number of events in the coming months may force the BoJ’s hand.
 
2 — Will inflation surprise on the upside?

From the very first Gavekal paper to the first book we wrote up to my more recent offerings, we, as a firm, have taken a broadly deflationary view of the world. A key factor for this over the past 15 years has been excess manufacturing added by China, together with millions of workers leaving the countryside year after year to try their luck in cities. In a sense, spending the past 15 years talking about deflation had less to do with being visionary than simply being observant.

But is the situation now changing? In a recent piece, I asked what would happen to companies whose sole purpose is to optimize excess capacity (i.e. half of the world’s unicorns) if and when that excess capacity is used up. Again, simply by being observant rather than visionary, we know that:

a) Migrant workers are no longer pouring into Chinese cities. With about 60% of China’s citizens now living in urban areas, urbanization growth was always bound to slow. Combine that with China’s aging population and the fact that a rising share of rural residents are over 40 (and so less likely to move), and it seems clear that the deflationary pressure arising from China’s urban migration is set to abate.

b) Reduced excess capacity in China is real: from restrictions on coal mines, to the shuttering of shipyards and steel mills, Xi Jinping’s supply-side reforms have bitten. At the very least, some 10mn industrial workers have lost their jobs since Xi’s took office (note: there are roughly 12.5m manufacturing workers in the US today!).



 
To say that most “excess investment” China unleashed with its 2015-16 monetary and regulatory policy stimulus went into domestic real estate is only a mild exaggeration. Very little went into manufacturing capacity, which may explain why the price of goods exports from China has, after a five-year period, shown signs of breaking out on the upside. Another part of the puzzle is that Chinese producer prices are also rising, so it is perhaps not surprising that export prices have followed suit. The point is, if China’s export prices do rise in a concerted manner, it will happen when inflation data in the likes of Japan, the US and Germany are moving northward.
 



Indeed, for all the talk about how inflation is harder to find than morals in a movie production company, a sizable chunk of the recent inflation data is starting to point towards a creep higher in a number of prices.
 
3 — Why does inflation matter?

Forget the fact that higher inflation typically leads to lower P/E ratios (as firms are forced to keep more inventory, thereby exposing themselves to the economic cycle), while lower inflation tends to lead to higher P/Es. Forget also that equity market valuations around the world, but especially in the US, are decently high by any historical gage, and thus arguably discounting a low inflation/low interest rate environment for years to come. The real reason I worry about inflation today is that inflation has the potential to seriously disrupt the happy policy status quo that has underpinned markets since the February 2016 Shanghai G20 meeting. And here, a historical parallel may be relevant.

Back in the early 1980s, foreign exchange volatility wreaked havoc on business spending plans and countries’ ability to repay foreign currency debt. To remedy this situation, the world’s key financial policymakers got together, first at the Plaza Hotel in New York in late 1985 and then in early 1987 in Paris to agree on a plan for coordinating monetary policies. The idea was to reduce currency volatility and so limit the scope for financial shocks. And so were born the “Plaza accords” and the “Louvre accords”.

Unsurprisingly, global investors loved the idea that they would no longer get sucker-punched by large currency swings. Almost all risk assets ripped higher. Gold and silver miners were especially big winners as silver prices more than doubled between the summers of 1986 and 1987 (today, bitcoin has that easily beat!). Deep cyclicals rallied hard, as did emerging markets (Hong Kong equities more than doubled in the period, while Taiwan (where 10% of adults were day-trading) started to redefine what a bubble looked like. These go-go years came to an abrupt halt after a rise in bond yields through the summer of 1987. In response, the Bundesbank (which back then was a genuine inflation hawk) panicked and in October 1987 raised short rates. US Treasury Secretary James Baker responded: “We will not sit back in this country and watch surplus countries jack up their interest rates and squeeze growth worldwide on the expectation that the United States somehow will follow by raising its interest rates”.

This statement made on a Sunday morning television show made it clear that the Louvre Accord was dead and buried. The next day, the Dow Jones Industrials opened down 27%.
 
So why re-hash ancient history?

Because careful readers will have noticed that for the past 18 months, I have espoused the idea that, after a big rise in foreign exchange uncertainty – triggered mostly by China with its summer 2015 devaluation, but also by Japan and its talk of helicopter money, and by the violent devaluation of the euro that followed the eurozone crisis – the big financial powers acted to calm foreign exchange markets after the February 2016 meeting of the G20 in Shanghai.

Since then, markets have lived under the calming influence of the “Shanghai agreement” (such an agreement may or may not exist, but the fact that market participants think it does has minimized the required intervention!). And, as in the post-Louvre accord quarters, risk assets have broadly rallied hard. It’s all felt wonderful, if not quite as care-free as the mid-1980s. And as long as we live under this Shanghai accord, perhaps we should not look a gift horse in the mouth and continue to pile on risk?

This brings me to the nagging worry of “what if the Shanghai agreement comes to a brutal end as in 1987?” (back then, the Hong Kong stock exchange closed for a week as it could not handle a tsunami of sell orders).

For that to happen, one would need someone to play the role of Karl Otto Pohl who headed the Bundesbank through the 1980s. Now today, Mario Draghi is about as well suited to play that role as Ben Affleck is to play Batman. And frankly, in spite of the concerns expressed above about regional Japanese banks, Haruhiko Kuroda at the BoJ is also unlikely to upset the Shanghai understanding. So it is easy to conclude that, with everyone now happy to be on the back foot against inflation, there is no risk of a 1987 denouement of the established international order.

Except that this overlooks the single most important economy: China (let’s face it: the last two upswings in global growth, namely 2009 and 2016, were triggered by China more than the US). Indeed, the People’s Bank of China may well be the new Bundesbank for the simple reason that most technocrats roaming the halls of power in Beijing were brought up in the Marxist church. And the first tenet of the Marxist faith is that historical events are shaped by economic forces, with inflation being the most powerful of these.

From Marx’s perspective, Louis XVI would have kept his head, and his throne, had it not been for rapid food price inflation the years that preceded the French Revolution. And for a Chinese technocrat, the Tiananmen uprising of 1989 only happened because food price inflation was running at above 20%. For this reason, the one central bank that can be counted on to be decently hawkish against rising inflation, or at least more hawkish then others, is the PBoC.

And this is why a rise in inflation could end up dealing the markets a triple body blow.

First, rising inflation would lead to lower valuations for most asset prices. Secondly, higher inflation would likely trigger a tighter monetary and fiscal policy in China. Thirdly, a tighter China threatens the cozy “Shanghai Agreement” which has prevailed since 2016. And how can one hedge against this threat? In 1987, bunds ended the year among the world’s best performing asset classes. Of course, history never repeats itself; but if it ends up rhyming, owning short-dated renminbi-denominated bonds may be an obvious “portfolio cushion”.
 
4 — What will the Fed do?

Answering this question has always been an important driver of performance, yet this year the general level of “stress” regarding the Fed’s upcoming decisions has been remarkably low. Almost every conversation I have had on the topic has been a version of the following:

a) The differences between incoming chair Jerome Powell and departing chair Janet Yellen are marginal.

b) In any event, Powell’s policy choices in the near term are constrained by the “dot-plot” and the path that Yellen has traced out. For Powell to depart from the plan would require significant upside/downside surprise for the economy and markets.

c) So bottom line, unless there is a shock to the system, we will just have more of the same.

d) And more of the same seems fine, thank you very much!

Needless to say, the above makes ample sense; and indeed, the path that Powell will follow is likely that offered by Yellen, and so discounted by the market. Yet, imagine a parallel universe, such that within a few months of being sworn in, Powell faces a US economy where:

  • Unemployment is close to record lows and government debt stands at record highs, yet the federal government embarks on an oddly timed fiscal stimulus through across-the-board tax cuts.

  • Shortly afterwards, the government further compounds this stimulus with a large infrastructure spending bill.

  • As inflationary pressures intensify around the world (partly due to this US stimulus), the PBoC, BoJ and ECB adopt more hawkish positions than have been discounted by the market.

  • The unexpected tightening by non-US central banks leads other currencies higher, and the US dollar lower.

  • The combination of low interest rates, expansionary fiscal policy and a weaker dollar causes the US economy to properly overheat, forcing the Fed to tighten more aggressively than expected.

The base case must remain that the Fed will follow broadly the path that it has set for itself. That said, the above scenario does not look far-fetched. Which means that looking into 2018, four scenarios seem most likely.

In the first scenario, events unfold fairly predictably and the Fed stays on its promised path. In this case, global currency volatility stays muted. In the second scenario, the US embarks on a huge stimulus, prompting the Fed to tighten monetary policy aggressively. Meanwhile, other central banks continue to sit on their hands. is triggers big capital inflows from the rest of the world into the US and pushes the dollar higher. The third scenario sees the world experience some kind of shock (take your pick from a bad Italian election, a bank crisis in China, a Saudi-Iran war, a North Korea war or a political crisis in the US) and the Fed responds with more QE. Finally, the fourth scenario sees the Fed deliver the promised monetary policy tightening, but inflation accelerates and the rest of the world tightens more aggressively than expected.

In the first two scenarios, the US dollar will likely rise, either a little, or a lot. In the latter two scenarios, the dollar would likely be very weak. So if this analysis is broadly correct, shorting the dollar should be a good “tail risk” policy. If the global economy rolls over and/or a shock appears, the dollar will weaken. And if global nominal GDP growth accelerates further from here, the dollar will also likely weaken. Being long the dollar is a bet that the current investment environment is sustained.
 
5 — The other threat to the current environment: oil prices

For ease of math, assume that the world consumes 100mn barrels of oil a day (the real number is around 97mn bpd). Then further assume that about 100 days of inventory is kept “in the system”, whether in pipelines, boats or reservoirs. Now, funding these inventories takes money, which is how a US$20/barrel move in the oil price can have a big impact on the global liquidity situation. After all, if the price of oil is US$60/bbl, then oil inventories will immobilize around US$600bn in working capital. But if the price drops to US$40/bbl, then the working capital needs of the broader energy industry drops by US$200bn.

The point is that an environment of rising oil prices and tightening Fed policy is usually bad for financial assets. Simply put, the more money the Fed sucks out of the system, and the more that is tied up in the energy complex, the less is available to push up asset prices. On this score, it should be noted that excess money supply in the US is decelerating (see chart below).


Should oil prices continue to rise, the resulting change in the liquidity situation could leave markets vulnerable. It follows that energy stocks may be a decent hedge for portfolios. To be sure, if oil prices head lower, then energy stocks will underperform, as the freed-up excess liquidity will flow into the likes of tech, emerging markets and bitcoin. But if oil prices do creep higher – or worse still, some kind of supply shock unfolds due to a Saudi-Iran confrontation or perhaps another collapse in Venezuela’s output – then energy stocks will provide a buttressing effect against a very different investment environment.
 
Conclusion

To many investors’ surprise, the past year was characterized by:

a) Massive outperformance of growth vs value

b) Massive outperformance of tech

c) Solid globally synchronized growth with low inflation

d) Low equity market volatility

e) Low bond market volatility

f) Low foreign exchange market volatility

g) Oil mostly range-traded, though breaking out on the upside towards the end of the year

h) Yield curves flattened/stayed flat
 
What are the odds that 2018 produces more of the same?

When I was a boy, I went to Jesuit school in France. And there, I was taught to answer every question with another question. Or better yet, with several questions (if only to ensure that one’s conversation partner ends up too confused to press a point). So the quandary of whether 2018 will unleash “more of the same” to me comes down to five questions:

1) Is the recent oil price breakout a sign of more strength to come? My fear is that the recent upside stems from strong, global, synchronized growth and a lack of investment in the past few years. This lack of investment is important, as the energy industry has become far more capital-intensive in recent years due to the rapid depletion of fracking wells compared to traditional wells and the associated faster wear and tear of equipment. Thus, I am inclined to own energy stocks as a hedge against a further rise in oil prices; a rise which will suck up excess liquidity and so cap gains in hitherto “hot” asset classes. I also like energy stocks as a hedge against a big geopolitical shock as I worry that Saudi and Iran are one big terrorist event away from going at each other’s throats.

2) Will inflation surprise on the upside in 2018? There is little doubt that most of the world’s structural trends (the digitalization of everything, robotics and population aging) are deeply deflationary. Yet, what strikes me as odd is that everyone in every investment committee meeting these days is a deflationist. Gone are the days when at least one or two people may argue that central bank printing would lead us down the path of Zimbabwe or Weimar Germany. The inflationists have either been fired, or beaten into silence and submission. Which probably means that the “deflation forever” thesis is, by now, most likely fully baked into most asset prices? So much so that, even as inflation data around the world start to rebound, no-one seems to care! It should also be acknowledged that since the eurozone crisis of 2011-12 few modern economies have added much productive investment capacity. Sure, real estate has been on fire almost everywhere and it is hard to go to a major city and not see a number of large construction cranes scar the skyline. But beyond real estate, and beyond tech, where have the marginal investment dollars gone? Not into steel mills, petrochemical plants, oil refineries, cement factories, or new tankers; not even in China, Korea or Japan (which could usually be counted to invest regardless!). So if global growth continues on its current synchronized path, isn’t the risk that this lack of investment in new capacity ends up causing demand to outstrip supply? If so, then a sell-off in global bond markets is likely, along with all long- dated assets (especially growth stocks with limited profits). Fortunately, hedging against such an event is fairly easy as financials around the world should, in this eventuality, see steeper yield curves rapidly translate into better profits.

(3) Will China tighten more aggressively in 2018? The main reason I am worried about inflation is that this would likely trigger a far tighter stance from Chinese policymakers. And let’s face it, the world is more fun when China steps on the accelerator than when it steps on the brakes. At the very least, it is easier to make money when China steps on the gas. Now this doesn’t mean we can’t cushion portfolios against a tighter China. And today, the most obvious hedge would be Chinese government bonds, denominated in renminbi, yielding 4%. In case of further Chinese tightening, such bonds may be as useful to portfolios as bunds were in 1987. As Charles often likes to highlight, he came into October 1987 with 30% of the portfolio he managed (against the World MSCI) invested in long-dated German bunds. In early October 87, he thought this might be too much. By late October 87, he had realized it wasn’t enough.

(4) Will Japan tighten monetary policy? The lack of inflation in Japan makes this seem a fringe possibility. Yet, there are three reasons why a policy change may occur. Firstly, at some point policymakers will need to be seen doing “something” in response to the bitcoin mania. The second is that Japan tends to play ball with American requests and [though] a mercantilist president wants wins on trade, that won’t be easy with an under-valued yen. The third is that regional banks are starting to really struggle, with the simplest fix being a yield curve steepening. Thus, while a change in monetary policy is not likely, it is a risk for the coming year and one that is currently “unpriced”. With that in mind, investors who, like me, fear a BoJ policy reversal should (i) remove yen hedges/short positions, (ii) rotate equity portfolios from high flying exporters to long-suffering domestic financials and (iii) press bets on Japanese domestic real estate.

(5) Will the Fed continue to tighten monetary policy? It has been said that Keynesians think governments should expand their balance sheets when an economy heads south, and shrink it once an expansion is under way. Meanwhile, Republicans think the government should expand its balance sheet when a Republican is president and shrink it when a democrat is president. I used to take this adage in jest, but today, the joke is on us as the GOP seems intent on proving the premise with gusto.

Concretely, this means that the US investment environment may be set to change. Specifically, between 2010 (when the GOP took over the House) and 2016, the US experienced a tight fiscal and loose monetary policy. As Charles has shown over the years, this is the best combination for equity markets, as tight fiscal policy and loose money almost invariably leads to far higher P/E ratios. Alas, the opposite is true for the reverse: loose fiscal policy and tight money typically trigger a de-rating of equity markets. And this is the policy mix we seem to be heading towards.

So pulling it together, investors who responded “no” to all five of the above questions with confidence should stick with the winners of recent years. In this eventuality, the investment environment in 2018 should not prove too different from the one that prevailed in 2017. However, investors who answered yes to the above questions may want to start building cushions in their portfolios against shocks. These cushions may be a greater exposure to energy stocks, financial stocks, renminbi bonds, the yen, rotating away from US growth stocks and towards value stocks, or simply buying puts on US equities.


The Man Who Is Laying the Foundations for a New Economics

By John Mauldin

Flawed from its foundation, economics has failed to improve much with time. As it both ossified into an academic establishment and mutated into mathematics, [it] became an illusion of determinism in a world of human actions. Economists became preoccupied with mechanical models of markets and uninterested in the willful people who inhabit them. 
—George Gilder

Knowledge and Power is one of the most fascinating examinations of how wealth is created in a very long time. It makes the moral dimension of entrepreneurship more visible in this age of decreasing confidence in the virtues of wealth creation. Gilder's ideas are new, yet so compelling that they simply cannot be ignored. 
—Reverend Johannes Jacobse

One of the most important concepts that my mentors have drilled into my head is this simple statement: Ideas have consequences. As a corollary to that, bad ideas have bad consequences.

Let me offer a somewhat controversial statement: Economics is populated by a lot of bad ideas.

Many of which have come to be accepted as the correct interpretation of how the economy functions, and thus have become the basis for economic and monetary policy.

The chief bad idea in economics today is that most economists regard the discipline as a “pure science.” Economists have succumbed to what I call physics envy: They want their less-than-precise discipline to be considered a hard science, too. Unfortunately, economics—which concerns itself with unpredictable human behavior—is fundamentally incompatible with science.

Hard science, like physics, has rules you can’t break. The law of gravity makes for very specific physical behavior that can be mathematically modeled. Economists want us to believe that their own models are as reliable as the law of gravity. But the real world is a complex, dynamic, out-of-balance mess that doesn’t fit inside anyone’s model. You can’t model a system that is as chaotic and unpredictable as an economy in an Excel spreadsheet or even in the latest and greatest statistical software.

You may say, this is all well and good, but it’s just economic theory. How does that matter to my investment portfolio? The direct answer is that these models drive the policies of central banks and determines the price of money. And the price of money is fundamental to the prices of all our assets.

Further, using models to determine policy has damaged the economy in many ways, including:
  • Dysfunctional and counterproductive tax/regulatory/entitlement/trade policies
  • Private-sector credit growth encouraged by central bank mismanagement, and
  • A massive expansion of Federal Government power and spending

Worse again, these models are all backward looking and measure only that which has already happened. But the economy, and its millions of economic actors, are forward looking, striving to create and do things which have never happened before. Yet another reason why the models we rely on are incompatible with how the economy functions.

This is why I believe it is time for a new economics. An economics which focuses not on mechanistic models, but on the creations and innovations which have driven economic progress since the beginning of time.

The brave man who has taken on the task of crafting a new economics is my good friend George Gilder. For those who don’t know, George wrote the seminal work Wealth and Poverty, back in the early '80s, selling over one million copies and influencing a generation. He was Ronald Reagan’s most-quoted living author.

He has written many books since then, but Knowledge and Power is, in my opinion, the most important. I did not simply read this book, I thought through it, as the core premise is truly pivotal for my own thought process.

In Knowledge and Power, George attempts with some success to turn economics on its ear. His great insights are that entrepreneurial creations are the keys to understanding economic progress, and that accumulated knowledge is wealth.

Now, entrepreneurial creativity and innovations are not going to make it into any models that economists can concoct. Because we simply do not have the tools to model that kind of complexity.

Let’s dive into George’s theory of “an economics of disorder and surprise that could measure the contributions of entrepreneurs,” and extrapolate out what it means for us.

Identifying the key driver of economic progress

In Knowledge and Power, George lays the groundwork for a new economics:
Capitalism is not chiefly an incentive system but an information system. The key to economic growth is not acquisition of things by the pursuit of monetary rewards, but the expansion of wealth through learning and discovery. The economy grows by accumulating surprising knowledge through the conduct of the falsifiable experiments of free enterprises.

Conventional economics holds that it is incentives—carrots and sticks—which drive individual economic actors to do what they do, and thus leads to economic growth. Although incentives are important, they are not the main driver of growth. The Neanderthal in his cave had the same incentive to eat and access to the same raw materials as we do today. Yet, our economy is vastly more advanced, why?

George says that it is accumulated knowledge, brought about by entrepreneurial efforts, that creates growth and prosperity. I agree. Whether it’s the discovery of penicillin, the creation of the automobile or the printing press, all the “things” which make our lives better and create wealth originate in the mind of the entrepreneur.

Thus, the economy is driven not by “centralized” institutions wielding rewards and punishments, but by an ever-growing pool of knowledge. This knowledge, in a real sense, is the source of wealth: wealth that is ultimately distributed throughout an economy.

But here’s a crucial point: Entrepreneurial creations—the source of wealth—are unpredictable and always come as a surprise. George often quotes former Princeton economist Albert Hirshman on this: “Creativity always comes as a surprise to us. If it didn’t, we would not need it; we could plan it.”

So, if we recognize that entrepreneurial creations are the key driver of growth, but that economic models cannot measure or predict these “surprises,” then we must recognize that traditional economics is useless at measuring the true wealth of the economy.

Thankfully, George has a better way to measure the contributions of entrepreneurs and demonstrate how economics works in the real world.

The foundation of the internet, and a new economics

With traditional economics incapable of measuring how an economy grows, George has applied the principals of information theory to create a new economics:
[A] new economics—the information theory of capitalism—is already at work. Concealed behind an elaborate apparatus, the theory drives the most powerful machines and networks of the era. Information theory treats human creations as transmissions through a channel—whether a wire or the world—in the face of noise, and gauges the outcomes by their surprise. Now it is ready to transform economics as it has already transformed the world.
Developed in 1948 by Claude Shannon, information theory is the basis for all telecommunications and the internet. At its core, it is complex and mathematical, but its implications for economics can be expressed by how it defines information.

The fundamental principal of information theory is that all information is surprise; only surprise qualifies as information. Sound familiar? George recognized the tie between entrepreneurial surprise and information theory: “Claude Shannon defined information as surprise, and Albert Hirshman defined entrepreneurship as surprise. Here we have a crucial tie between the economy and information theory. For the first time, it became possible to create an economics that could capture the surprising creativity of entrepreneurs.

Let’s flesh out how George applies the principals of information theory to economics. At its root, information theory is about distinguishing signal from noise. In technology, a signal goes down a telephone line or through a fiber-optic cable. The challenge is to sort out the actual signal from the noise that accompanies it.

Since communications can be business ideas, information theory is applicable to anything transmitted over time and space—including entrepreneurial creations. In the economy, the entrepreneur has to distinguish amidst the noise, a signal that a particular good or service is needed. But if some force—a government or central bank—distorts the signal by adding “noise to the line,” the entrepreneur could have difficulty interpreting the signal.

It is vitally important that the entrepreneur be able to separate the “signal from the noise,” as processed information leads to knowledge. And as we established above, knowledge is wealth. If the signal cannot be separated from the noise, then no new wealth can be created.

Admittedly, it took me a while to take in the full effects of George’s information theory of economics. I really had to think through the core ideas, and the more I did, the more “a-ha” moments I got.

George lays the groundwork for an economics which places entrepreneurial creativity—the creator of prosperity—at the heart of the economy. It is an economics that appreciates the powerful connection between chaos and creativity, between the disorder and surprise which engender growth. This recognition is the first step toward changing the policies that govern our nation and affect entrepreneurs and investors.

While the information theory of economics is concerned with the forces that create growth, it is also focused on those which hinder it.

Can low-entropy carriers make America entrepreneurial again?

While the information theory of economics recognizes that entrepreneurial creations drive economic growth, it places equal importance on the environment in which they operate:
One fundamental principal of information theory distills that the transmission of a high-entropy, surprising product requires a low-entropy, unsurprising channel largely free of interference.
Another concept George borrows from information theory is entropy, which is defined as “a measure of surprise, disorder, noise, and complexity.” I think of entropy as a spectrum:
  • The low end: Predictable and stable carriers. In technology, a fiber-optic cable is an example of a low-entropy carrier: a system which is largely free of interference and doesn’t cause distortions of the all-important signal it is carrying.
  • The high end: Surprising and unexpected signals. In economics, new creations and inventions by entrepreneurs are examples of high-entropy signals: these signals are disorderly, always come as a surprise, and inject new knowledge into the system.
While “high entropy” signals create knowledge and drive economic growth, they cannot do so without the existence of a “low-entropy” environment or channel.

For example, the success of a radio or internet signal depends on the existence of a low-entropy channel that does not change substantially during the course of communication. If there is “noise on the line,” then the communication may be distorted.

Likewise, the entrepreneur needs low-entropy “channels” to turn the idea in his mind into a product or service. George defines these predictable carriers as “The rule of law, the maintenance of order, the defense of property rights, the reliability and restraint of regulation, the transparency of accounts, the stability of money, and a level of taxation commensurate with a predictable role of government.”

For me, this is the most important part of George’s new economics. The entrepreneur must know that if his product or service succeeds at the market, it won’t be regulated out of existence. And the profits will not be taxed away. If he doesn’t have that assurance, the likelihood of turning his idea into a product or service is greatly diminished. That results in less entrepreneurial creations, which means less knowledge and wealth in the economy.

I would argue, as George does, that the business environment in the US has moved away from being a “low entropy” carrier in the past few decades. The tens of thousands of pages in The Code of Federal Regulations and Tax Code speak to that.

In order for innovation to thrive, and living standards to rise over the coming decades, we must return to a “low-entropy" legal, regulatory, tax, and monetary policy. Too much noisy interference from governments and central banks distorts market signals. They also increase the hassles of doing business, which stifles innovation and discourages entrepreneurship. Ultimately, this makes the country less wealthy and prosperous.

Identifying both the drivers and destroyers of economic growth is what George does so well with his information theory of economics. It has changed how I think about the economy, and what policies we should pursue going forward.

My hope is that President Trump will read Knowledge and Power and give a copy to all cabinet members—as Ronald Reagan did with Wealth and Poverty. Maybe I’m too optimistic, but if we began basing economic and monetary policy on George’s information theory of economics, I believe there would be a complete revitalization of the American entrepreneurial spirit.

If this can happen, I have great hope for the future. That’s because knowledge and wealth originate in the minds of entrepreneurs. As George once said to me, “An economy is a noosphere, and it can be transformed as rapidly as human minds and knowledge can change.”

I often say that every great thinker has one “big idea.” George’s information theory of economics certainly qualifies as one of those. You’ve likely heard me mention how important exposing yourself to these big, powerful ideas is. Well, that’s exactly what I aim to do with my Strategic Investment Conference. I have invited George to speak at the SIC 2018 in San Diego, this coming March.
What a great conference it was this year: great organization and amazing speakers! I was really enthusiastic about it when I came back to the office and now I think my other colleagues want to go as well next year.” 
—Herman G. (past SIC attendee)
George is well versed in several areas, so I’m sure we will get into many intense discussions on topics ranging from technology to finance to economics. Yet, George is only one of the speakers that attendees will get to hear and meet. I really hope you can be there to experience it in person, with me. If you’re ready to learn more about the SIC 2018, and the other speakers who will be there, you can do so, here.

That does it for the second installment in this five-part series. Next, you’ll get my insights into Karen Harris’ pioneering work into the declining cost of distance, and the life changing effects this trend is going to have on our lives.

Your hoping Washington adopts this new economics analyst,

 John Mauldin


The Missing Ingredients of Growth

Michael Spence , Karen Karniol-Tambour

 Businessmen and shoppers walk along Madison Avenue

MILAN/NEW YORK – Most of the global economy is now subject to positive economic trends: unemployment is falling, output gaps are closing, growth is picking up, and, for reasons that are not yet clear, inflation remains below the major central banks’ targets. On the other hand, productivity growth remains weak, income inequality is increasing, and less educated workers are struggling to find attractive employment opportunities.

After eight years of aggressive stimulus, developed economies are emerging from an extended deleveraging phase that naturally suppressed growth from the demand side. As the level and composition of debt has been shifted, deleveraging pressures have been reduced, allowing for a synchronized global expansion.

Still, in time, the primary determinant of GDP growth – and the inclusivity of growth patterns – will be gains in productivity. Yet, as things stand, there is ample reason to doubt that productivity will pick up on its own. There are several important items missing from the policy mix that cast a shadow over the realization of both full-scale productivity growth and a shift to more inclusive growth patterns.

First, growth potential can’t be realized without sufficient human capital. This lesson is apparent in the experience of developing countries, but it applies to developed economies, too. Unfortunately, across most economies, skills and capabilities do not seem to be keeping pace with rapid structural shifts in labor markets. Governments have proved either unwilling or unable to act aggressively in terms of education and skills retraining or in redistributing income. And in countries like the United States, the distribution of income and wealth is so skewed that lower-income households cannot afford to invest in measures to adapt to rapidly changing employment conditions.

Second, most job markets have a large information gap that will need to be closed. Workers know that change is coming, but they do not know how skills requirements are evolving, and thus cannot base their choices on concrete data. Governments, educational institutions, and businesses have not come anywhere close to providing adequate guidance on this front.

Third, firms and individuals tend to go where opportunities are expanding, the costs of doing business are low, prospects for recruiting workers are good, and the quality of life is high. Environmental factors and infrastructure are critical for creating such dynamic, competitive conditions. Infrastructure, for example, lowers the cost and improves the quality of connectivity. Most arguments in favor of infrastructure investment focus on the negative: collapsing bridges, congested highways, second-rate air travel, and so forth. But policymakers should look beyond the need to catch up on deferred maintenance. The aspiration should be to invest in infrastructure that will create entirely new opportunities for private-sector investment and innovation.

PS. In Theory: Economic Growth

CLICK HERE

Fourth, publicly funded research in science, technology, and biomedicine is vital for driving innovation over the long term. By contributing to public knowledge, basic research opens up new areas for private-sector innovation. And wherever research is conducted, it produces spillover effects within the surrounding local economy.

Almost none of these four considerations is a significant feature of the policy framework that currently prevails in most developed countries. In the US, for example, Congress has passed a tax-reform package that may produce an additional increment in private investment, but will do little to reduce inequality, restore and redeploy human capital, improve infrastructure, or expand scientific and technological knowledge. In other words, the package ignores the very ingredients needed to lay the groundwork for balanced and sustainable future growth patterns, characterized by high economic and social productivity trajectories supported by both the supply side and the demand side (including investment).

Ray Dalio describes a path featuring investment in human capital, infrastructure, and the scientific base of the economy as path A. The alternative is path B, characterized by a lack of investment in areas that will directly boost productivity, such as infrastructure and education. Though economies are currently favoring path B, it is path A that would produce higher, more inclusive, and more sustainable growth, while also ameliorating the lingering debt overhangs associated with large sovereign debt and non-debt liabilities in areas like pensions, social security, and publicly funded health care.

It may be wishful thinking, but our hope for the new year is that governments will make a more concerted effort to chart a new course from Dalio’s path B to path A.


Michael Spence, a Nobel laureate in economics, is Professor of Economics at NYU’s Stern School of Business, Distinguished Visiting Fellow at the Council on Foreign Relations, Senior Fellow at the Hoover Institution at Stanford University, Advisory Board Co-Chair of the Asia Global Institute in Hong Kong, and Chair of the World Economic Forum Global Agenda Council on New Growth Models. He was the chairman of the independent Commission on Growth and Development, an international body that from 2006-2010 analyzed opportunities for global economic growth, and is the author of The Next Convergence – The Future of Economic Growth in a Multispeed World.


Karen Karniol-Tambour is Head of Investment Research at Bridgewater Associates.


Central Banks: The New Alchemists

By Randall W. Forsyth
  

    Photo: Getty Images 


Medieval alchemists dreamt of turning lead into gold. Today’s speculators seemingly have achieved much the same with bitcoin, turning the ones and zeroes of computer code into billions, at least for now.

But they are both outdone by modern central bankers, who have been able to conjure billions in wealth without the benefit of either ancient alchemy or modern mining of cryptocurrencies.

And the most brilliant among them has been the Swiss National Bank, which last year made $55 billion from its $800 billion portfolio of stocks and bonds.

That’s more than Apple (ticker: AAPL) earns in a year, The Wall Street Journal reported Wednesday. By comparison, the Federal Reserve earned $100 billion, less than twice as much as its Swiss counterpart, on assets worth five times as much as the SNB.

The difference is that while the Fed’s assets are made up of U.S. Treasuries and agency mortgage-backed securities, the Swiss own foreign stocks and bonds with much higher returns.

And those returns are enhanced by the rise in the value of the currencies in which those securities are denominated relative to the Swiss franc.

In other words, the SNB has become like a giant hedge fund—with one huge difference. As a central bank, it can issue liabilities—in this case, Swiss francs—with a computer keystroke, with which it can acquire assets. For most central banks, those assets typically are government bonds, which are the highest-quality and most liquid investments.

Since the financial crisis, global central banks have purchased an estimated $14 trillion of assets, which has had the effect of lowering interest rates—to below zero percent, in some cases.

That raises the prices of bonds and, in turn, stocks. It is no accident that central banks’ balance sheets and equity values have risen in tandem since the bull market began almost nine years ago.

For the Swiss National Bank, the linkage has been more direct. In order to keep the Swiss franc from rising excessively—and hurting the export-dependent Swiss economy—the SNB buys foreign bonds and stocks and sells francs, some 760 billion francs ($776 billion), according to the Journal.

Those francs literally cost nothing to produce, but global holders of dollars or euros happily exchange them for the Swiss currency. The SNB uses those foreign currencies to buy stocks, which have appreciated in the global bull market and even more so in Swiss franc terms, since the SNB has been successful in capping its currency’s value.

The bank held equities worth over $87 billion as of Sept. 30, according to its most recent 13F filing with the U.S. Securities and Exchange Commission. The portfolio looks a lot like the Standard & Poor’s 500 index: Apple is the No. 1 holding, with 19.2 million shares, followed by 17.3 million shares of Microsoft (MSFT), 8.9 million shares of Facebook (FB), 1.5 million shares of Amazon.com (AMZN), and 2.25 million shares of Alphabet’s two classes—1.15 million shares of class C (GOOG) and 1.1 million class A shares (GOOGL).

Conspicuous in their absence are big financial stocks, notably JPMorgan Chase (JPM), Bank of America (BAC), Wells Fargo (WFC), and Berkshire Hathaway (BRK.A), all in the top 12 S&P 500 market caps but whose Swiss operations may be regulated by the SNB.

If central banks have helped to boost values of assets such as equities by their unprecedented expansion of liquidity and suppression of interest rates, shouldn’t those central banks join in the benefits?

Had the Fed earned a return on its assets comparable to what the SNB earned (relative to the size of the U.S. economy versus the Swiss economy), the U.S. Treasury would have seen a windfall of $1.5 trillion, the Journal notes. (In the case of the Swiss institution, investors can actually buy shares in the SNB, which trade “by appointment.”)

Could it really be that easy? Central banks can create money out of thin air to purchase stocks, which are claims on the stream of earnings and dividends of real businesses, and inflate their values. Not in the wildest imaginations of ancient alchemists was such a feat possible.

Obviously there is a limit to such money printing, as feckless regimes from Argentina to Zimbabwe have demonstrated repeatedly. The Swiss can do it because they have shown historically they care deeply about their franc, which means the SNB has to expand the supply to keep up with demand—the opposite of other central banks that have debased their currencies.

The question now before markets is what happens when the major central banks cease to perform this magic of conjuring wealth through their quantitative easing. The Fed has begun to pare its balance sheet, while the European Central Bank is reducing the pace of its purchases, as is the Bank of Japan. As the Fed reduces its holdings, the Treasury is stepping up its issuance to cover the deficit expanded by tax cuts, leaving less excess liquidity to bid up risk assets.

What happens when the magic stops?


Sword Of Damocles: Unintended Consequences Of Federal Tax Reform And Monetary Policy

by: Howard Wiener




- Fed Forcing Removal of Liquidity.

- Real Issue: Solvency.

- Tax Bill Less Bang for the Buck.

- Gold Set to Shine.
 

The big economic events that just took place were the passage of the Trump tax cut, the rate hike of 0.25% by the Fed with projections to make three more next year, and the ramping up of balance sheet reduction at the Fed. All will have either a dramatic new impact or will add dramatically to prior actions. On the one hand, we have added liquidity into our economy, and on the other hand we have reduced liquidity. It’s like a game of tug of war where both sides are have Americans pulling, and in the middle the loser falls into a pit of fire. Like the Sword of Damocles, there is imminent danger here that is clouded by other circumstances, obscuring our view of the real dangers at hand. And it is being further complicated by the ECB and BoE tightening actions as well.
 
I hope this blog posting will continue to challenge your notions of the Trump bump, employment, GDP growth (R&D is now part of investment in GDP calculations, even though businesses expense it), asset appreciation... the whole economy. You’ve probably heard in the financial media about the everything bubble and small corrections being overdue and other such notions. Those ideas are the understatement of the century, and what I fear is coming I think will make The Great Depression, Weimar Germany, Argentina, Zimbabwe, and Hungary combined look like child’s play.
 
Before I get into my comments, I want to take a moment to thank Bruce Hurwitz of Hurwitz Strategic Staffing. I was featured in his podcast on December 26, 2017, and we spoke about the Fed. A little history, the Fed’s role, the power of speech at the Fed, interest rates and other monetary policy tools, and more. To listen please click here. I’ll be grateful and I am sure Bruce will be grateful too. I must also thank my high school classmate, Professor Cox, for helping me sort out some of the provisions in the tax bill and organize my thoughts. Conversations with her were instrumental to that process.
2008
 
If we look back at the financial crisis a decade ago, the basic story line is that banks wildly lent to unworthy borrowers, their adjustable mortgage rates started moving up, they defaulted, and this all caused a break down in the entire banking system leading to widespread defaults and economic collapse.
 
In swoops the Fed and Treasury to the rescue, first with $787 billion, then QE1, QE2, Operation twist, and many desperate measures in an attempt to support an ailing economy with heavy doses of liquidity.
 
Unfortunately for Wall St., Main St., and everyone else in between, the problem was not liquidity. Therefore, injecting liquidity was not the right solution. It was like seeing a patient with the recurring heartburn caused by h-pylori, but instead of giving the LAC Antibiotic regimen and some pepto to the infected patient, the doctor gives water and Alka Seltzer, and wishes the patient luck. It’s sorta the right thing and may help for a while, but in the end the patient is still sick with the virus.
 
The real problem in 2008 was not liquidity. Rather, it was solvency. Banks became insolvent.
 
Let’s use fictitious bank names to illustrate the point, instead of poking fun of landmarks like “Bailout Ballpark” here in NYC (That’s where the Mets play, and yes, I am a fan of their arch rival).
 
Bank A makes a contract with Bank B to sell short Investment I. Bank B then says, “We like the idea, and since we are already long on Investment I, it makes sense to hedge that by going short on the same investment, just in case.” So Bank B goes to Bank C and makes a new contract to go short on Investment I with Bank C. Bank C then turns around and says “Hey wait a sec, our position in Investment II looks like it could be a risk as well, so let’s go to Bank D and make a contract to short Investment II.” And so on and so forth.
 
It’s really not as complicated as I make it sound. All of these positions were done on margin (borrowed cash), and the banks all netted out their long and short positions. By netting everything to zero, they thought they were safe. But there’s a really big BUT here. The problem was two-fold. First, no one knew anyone else’s positions, so rather than measuring net at risk, the banks should have measured gross at risk.

The second problem compounds the first and causes the over riding issue at hand, which again was solvency, not liquidity. That problem was the margin debt that was used to stake out positions in all these investments. Leverage of putting down $1 cash for every $100 or more in a position. If Bank A had $1000 in assets bought with $10 cash plus leverage, and therefore if they had $990 of liabilities, a loss of value of just 1% in the asset value renders Bank A insolvent. As long as the asset continues to rise in value, there is no problem. But G-d forbid it falls and the banks are forced to recognize the market value of the asset rather than the par value price at the point of purchase, and we have a system wide crisis of insolvency.
 
Like the heartburn patient in the analogy, the problem was not properly addressed. The liquidity that was injected only helped so much. And now everyone thinks that if the same thing happens all we have to do is inject more liquidity. It’s not so simple and that’s the wrong solution.
 
I’m sorry to tell you that not only did the wrong course of action prevent a proper cure the first time, it will prevent it again, and the problem is actually worse now. The reason it is worse is that the financial system is much larger now than it was in 2008. As the scale of a complex system grows linearly, the risks to the system grow exponentially…scale up by 100% and the risk more than doubles, perhaps to 3x, 4x, or 10x. It’s a fundamental principal of Bayesian theory of complexity, but it must be applied to our financial system instead of physics or chemistry. The scale of the financial system is now much larger than 2008, over $70 trillion of debt larger, in fact.
 
The fundamental issue at hand is not liquidity, it is solvency. However, liquidity will be blamed, and it will cause a cascading snow ball effect that will expose the financial system’s problem of solvency for what it is. It will go all the way up to the highest echelons: CEOs of the biggest banks in the world as well as central banks including our own Fed, the ECB, BoE, BoJ, and others. Make no mistake, the bankers of the world are likely to give the wrong diagnosis and the wrong cure, and we’ll see much more than we saw in the aftermath of the last crisis. We may see much more QE than ever contrived, helicopter cash, universal basic income, negative interest rates, bail ins, bail outs, and much more.

It’s important to remember what Mike Maloney says, that “on the opposite side of every crisis lies and opportunity.” Our job is to see the crisis coming long before hand, and find the opportunities that await us before, during, and after the crisis. Wealth will be transferred, and the question is if you will let it pass you by, will the wealth be transferred out of your hands, or will it be transferred into your hands. If you position yourself correctly, you can build and protect long-lasting, generational wealth.
None of the experts or leaders or talking heads knew what was coming. I’m guessing most of you still don’t really know what happened…But there were some who saw it coming. While the whole world was having a big old party, a few outsiders and weirdos saw what no one else could…the giant lie at the heart of the economy. And they saw it by doing something the rest of the suckers never thought to do. They looked. [emphasis added] -The Big Short (movie)
The Fed
 
A lot is going on at the Fed these days…New chairman, rate hikes, balance sheet reductions, and more. Let’s start with the new chairman, Jerome Powell, keeping in mind that Trump picked him to succeed Janet Yellen in February 2018. There’s a lot of talk about Powell not being a PhD economist, and instead he is a markets guy. That sounds great and it’s a welcome change. In fact, the Fed has seen much better people at the helm who were bankers and businessmen with real world experience, in contrast with the academics we’ve had in the chairman’s seat more recently.
 
But for all the talk, Powell will probably follow in the footsteps of Janet Yellen. He has made numerous public statements indicating as such. At least in the first 6-12 months he’ll likely not deviate from Yellen’s plan of rate hikes, especially since the infamous dot-plot is telling the Fed to make 3 more hikes in 2018. He has also indicated that the planned balance sheet reduction may be too much. At first it seems contradictory to keeping Yellen’s rate hike schedule. Upon further examination we may conclude that not only will he be likely to slow the pace and the amount of reductions to the Fed balance sheet, but he is also ready to lower interest rates again at the first sign of trouble. For now, though, it will be steady as she goes.

Raising Rates – We just saw a quarter point hike, and we are likely to see 3 more next year, according to the Fed itself. Anyone with a variable rate debt or anyone taking on new debt will have higher payments with each rate hike at the Fed, translating into less discretionary spending money.
 
Less for savings. Less for anything and everything, and even though there are some preliminary reports to the contrary I think this holiday season will be worse than expected. If it’s not the holiday season itself, it will be in the first quarter next year when the holiday spending bill comes due to everyone who bought their holiday cheer on credit cards. And yes, I know MasterCard (MA) reported record transactions. Remember though that we now live in a world of Amazon and other online retail stores. Internet shopping may be growing, but let’s wait and see how much total shopping is done this holiday season.
 
Along with consumers being squeezed, businesses with variable rate loans or who are getting ready to take on new debt are seeing higher rates, translating into less cash on hand for expanding the business, making new capital investments, hiring more employees, and anything else they might do with capital. Like a slow leak in the backyard swimming pool, their cash is slowly being diverted to debt service instead of conducting business. The recent announcement by 14 companies that they are giving extra bonuses because of the tax plan likely will turn into a one-time bonus by CEO’s who want to move the public narrative towards favoring tax cuts. I doubt we’ll see permanent pay raises.
 
Quantitative Tightening – Currently, this is the sale of treasuries and mortgage backed securities as well as not rolling over treasuries, though in the future it may include other measures. Trimming the Fed balance sheet will make a double whammy in conjunction with rate hikes because it puts further upward pressure on rates. As the Fed sells treasuries and MBS’s, there won’t be enough buyers to soak up the additional supply being added back into markets. And that’s in addition to any new treasuries that Treasury will be selling.
It’s a massive opening of the flood gates that will overwhelm demand in the markets for these securities, and as long as there is selling pressure to bring the price down, there will be an opposing pressure to bring rates up naturally through market forces. It was only $7 billion in the first month, but by October 2018 this will be in full swing to the tune of over $50 billion per month, and the cumulative total will be over $1.25 trillion by the end of 2019.
 
Other Central Banks are now doing the same as well. The Bank of England (BOE) recently raised their rates by 25 basis points, and the ECB is tapering its own QE program which should be grinding to a complete halt also by the fall, 2018. It makes two more central banks that are removing liquidity both directly (ECB) through tapering its purchases and indirectly (BOE) by raising rates and making it more difficult to pay debts and diverting more cash towards those debts.
 
Yield Curve – The spread we are interested in is the spread between the interest rates at the ten-year treasury versus the two-year treasury. We want to see a spread of around 250-300 basis points (2.5-3% difference) in a healthy economic environment. If the curve tightens, or flattens, it can be caused by a reduction in the long term rate, an increase in the short term rate, or both. And it could be either in real terms or relative to each other as well.
 
Flattening indicates either concerns for the macro-economic picture, or it indicates rising stress in the banking system. Stress for banks because banks want to borrow at the shorter term rates but then lend out at the longer term rates. If the spread is too close there is too much risk and banks don’t want to take on that risk in exchange for the minimal return they’ll earn on the loans. If the spread inverts so that short term rates are higher than long term rates, banks will completely close their lending facilities until further notice. And make no mistake, inversion of the yield curve has never failed to precede an official recession by about 12 months or so.
As of this writing the yield curve is now hovering in the 50-55 bps range, and it implies that the Fed has just two rate hikes to go at 25 bps each, before it intentionally flattens or inverts the spread in the yield curve.
 
Because of the flattening there is no longer any profit in prime lending to borrowers with full documentation of income, assets, and employment. Banks have already loosened their lending standards for primary residence mortgages. Remember those 100%+ LTV loans, NINJA loans, option ARM loans? They’re slowly coming back. And subprime lending as well as riskier credit, such as revolving balances, are the only place left that banks can earn profits in their core business.
 
Even though the riskier loans are where the profit is located now, these loans are becoming increasingly difficult for borrowers to obtain. Outside of the proper context it doesn’t make sense that a business with cash flow should have difficulty borrowing. But I have spoken to business owners in a wide range of industries, including restaurants, grocery stores, importers, laundromats, auto repairs, and more. They all complain that they have tremendous difficulty obtaining funds. Look no further than the charts I posted here in July 2017, and in November 2017, reposted updated versions here. It is my opinion that these difficulties have arisen because there is too much risk for banks to lend with such a small spread between their borrowing cost and their lending return. This is another indicator that the necessary liquidity is not making its way into markets and the economy.
 
Removing Liquidity – Let’s look at another analogy. Imagine that you are sitting in driver’s seat getting ready to turn the key and start the car. After a minute or two, you put the car in gear, and as you are driving you see some smoke coming from the engine. Luckily there is a service station one block away, and as you pull in the engine grinds to a halt. When the mechanic opens the hood and the smoke clears, he tells you, “It’s obvious, there’s no oil! When was the last time you checked the oil?”
Motor oil is to the engine just as liquidity is to the economy. Without liquidity, transactions cannot be completed. The Fed and other central banks are removing the motor oil of the economy, which we call cash. Without cash, the economy will come to a grinding halt like a car engine without motor oil.
 
Yes, the Fed and other central banks are removing liquidity in highly dramatic fashion. And this is the point of all this. With all of these unprecedented central bank moves that we are seeing now, in the US, in England, and in the EU, removing liquidity is deflationary, which is the death knell of central banking. They are removing cash from circulation. How this is happening is because they are both selling bonds and other securities as well as raising rates. If they sell and collectively we buy, the Fed retains all that cash in its vaults. This will be highly deflationary because cash will be moving out of circulation and into the Fed’s vault. As low as the velocity of money is now, it will sink even lower. It’s similar to removing the bid for shares stock. If there is no bid, the ask price must fall until a bid exists.
 
Inflation/deflation in the form of rising/falling prices only happens when three factors all work in tandem, which are the velocity of money or circulation, addition or removal of money into or from the system such as printing, and perception which is what everyone thinks is going to happen to prices…all three must work together for us to see inflation or deflation of prices of things like beef, potatoes, and gas at the pump. The deflation I see coming will not happen at first because The Street is euphoric like a frat boy wearing his first pair of beer goggles.
 
Fed officials may think that this pull back in liquidity will cause the remaining currency to circulate faster, but they are mistaken. The circulation rate will take too long to increase and catch up to the removal rate. The reaction on The Street will be slow at first, but even as I write this, people are catching on. They just don’t realize why yet.

The balance sheet reduction at the Fed is looking like it will be over $1.25 trillion. Also, if the Fed is hiking rates, as noted, more and more cash will be diverted by businesses and households to pay off debt. Banks will NOT relend that cash back out because it is just too risky (and becoming more risky as the yield curve flattens further and eventually inverts), and there is no return on that capital for banks. I’ll borrow a phrase from resource sector legend Rick Rule here, and call this type of lending return free risk. Banks are in the business of getting paid back whatever they lend, and making a profit on those loans.
 
As all this cash comes out of our collective pockets and into bank vaults, that cash will stay on the sidelines and put massive deflationary pressure on everything…houses, stocks, bonds, commodities, Da Vinci paintings, collectables, and anything else you can think of. Prices are set to fall like a rock in a pond. Just like the rock falls, so too prices will fall, but remember there is also a ripple effect when the rock hits the surface of the water, which I’ll get to soon. For now, it suffices to say that 2008 will literally look like a picnic compared to what’s coming.
 
Lending
 
This brings me to lending. I’ve already mentioned a few points above, but it needs more attention to detail. As we’ll see, the situation is much worse than I’ve already stated. I can’t emphasize enough that central banks around the world are removing liquidity from the economy, which will lead to a ripple effect in the banking sector as well as anything that banks have a hand in. This leverage will cause a massive insolvency, the likes of which we have never seen, making every other economic downturn combined in the history of the country look like child’s play.
 
Charts – Lending is falling. Really a free fall, and it will get worse. I first published a series of charts from FRED of the St Louis Fed in July and reexamined the same charts last month (both articles are linked above). In dollar amounts, lending is increasing. But we aren’t interested so much in whether or not banks are making more loans. We are more interested to know if the amount of loans they made in the last 12 months is more, the same, or less, than the 12 months before that.
The best way to examine this is in the year-over-year percent change. If the banks lent out, for example, $1, that means they increased loans. But if the prior 12 months saw loans of $10, then that means that even though they increased the amount of loans, they are actually decreasing lending activity. And that is a crucial distinction that a lot of people are missing. Bankers, economists, asset managers, financial media, and more are all missing this critical point. The list of charts includes bank credit, commercial and industrial loans, real estate loans, consumer loans, revolving credit…this is all anathema to anything you hear from the financial talking heads or anything you hear on the nightly news.
 
I also included charts showing stock buybacks are continuing to drive stock prices, because in another chart we see that stock valuations are going up. That diverges completely from the earnings which may be rising on a per share basis. And yet, total company earnings are falling.
 
As the yield curve continues to flatten and eventually invert, lending will crash to zero and that event is likely to happen before the inversion. If the Fed continues to hike and flood the market with bonds and MBS, the lending spigot will be turned off. It’s all but guaranteed, and it’s not a matter of if, rather, a matter of when. The infamous dot plot is telling the Fed to hike three more times next year, but there is only about 50 basis points (2 hikes) to go before the curve is flat! If the Fed hikes three times, they’ll force it to invert.
 
Defaults will begin to rise precipitously, and they are already rising in both Emerging Markets and subprime auto loans. With a more than 100% rise in defaults in the last two months, home equity lines and loans are next. When this all hits, it will hit particularly hard on all banks that lent to emerging market economies with loans denominated in dollars.
 
You see, as the Fed raises interest rates, in the short term that will help strengthen the dollar.
 
Any company who earns its profits in a currency that is weakening against the dollar, but has to pay back loans in dollars, will have a more and more difficult time as the payments increase.
 
The dollar amount won’t change, but the peso, yuan, rand, or reál amount will steadily increase as those currencies weaken. On top of that, as rates rise, some of those loans which are variable rate loans, will see their interest payments rise along with a weakening currency. So that will be a double whammy for EM loans made in USD. Banks that have lent in this manner will see very high levels of defaults.

The biggest banks (by assets), according to Bankrate, are Chase, BofA, Wells, Citi, Goldman Sachs, Morgan Stanley, US Bancorp, PNC, TD, and Capital 1. To give a little perspective, if you took all the assets of Cap1 ($348.55 billion) and laid it out in $100 bills end to end, you’d make a trip to the moon and almost half way back. If you own shares in any of these banks, or if you own shares of an ETF or fund that has a large position in any of these banks, it would be prescient to watch very carefully, and pay particular attention to their EM loan defaults.
 
Personally, I would call into the next earnings conference call and ask about it, and I would go a step further and challenge the speaker when s/he blows off your question.
 
In addition to EM loans, credit cards are beginning to see a large uptick in defaults. Since the October of 2013, defaults have been holding steady around 2.75%. In December 2015 with the first rate hike by the Fed, the default rate on credit cards bottomed out at 2.49%. There has been a steady rise since then and we’re now over 3.25% default rate. The last time default rates on credit cards rose to this level was right before the 2007/2008 crisis.
 
I have mentioned only a few areas of lending here where I see defaults rising and I predict they will continue to rise. I suspect, though, that this issue will spread through the entire banking sector very quickly, and not just the banks, but also private placements, VC, PE, “Shark Tank” style lenders, peer to peer lenders, and anyone else who is in the business of lending. Defaults are set to rise rapidly and the pace will accelerate as the Fed sells securities and hikes rates.
 
Housing
 
This sector is going to experience a second round of hard hits. It’s Fed monetary policy combined with some of the new tax laws affecting high tax states like NY, CT, and CA. According to the St Louis Regional Fed, the national median home price peaked in 2007 at $262,600. (The National Association of Realtors has the peak in July 2006 at $230,400.) According the StL Fed, September this year was $324,900, for an increase of 23.7%. Its off by about $12,000 for November (December not out yet as of this writing), but remember nothing goes straight up. There has only been 5 times since January 2000 that the price went up two months in a row, and 4 of the five times was $1500 or less. To be fair there has been only 4-5 times that it went down two months in a row as well.
 
Otherwise, in the last 18 years, it has always been one up and one down.

The Case-Shiller home price index is also close to pre-crisis levels on the 20-city composite. It’s now at 203.50, just 1.46% shy of the peak of 206.52 in July 2006. For the ten largest, the index is currently at 217.69, and the June 2006 peak was 226.29. The 10-city composite is off by just 3.8%.
 
Nationally, the difference is more pronounced at almost 6.0% higher than the prior peak in July 2006.
 
Some cities are down still, like Atlanta and Cleveland. Some are flat like New York, but there are other cities that are disturbingly higher. Charlotte is up 11.1%, SF is up 18.5%, Portland is 20.2%, Boston comes to mind at 21% higher. Dallas is 42.3% higher. Denver is 44.7%. Interestingly the areas that we might expect to seriously skyrocket…Vegas, Phoenix, southern Florida, NYC, Los Angeles, Chicago…these areas are at or below their 2008 peak.
 
Dallas has skyrocketed, and I suspect that is because of favorable tax laws in Texas that favor entrepreneurship, business, and low taxes, instead of social welfare entitlements and high, repressive taxes like NY, Chicago, or California. And that gap is about to widen with the Trump tax bill passage, because as we know, people who already pay high real estate taxes and high state income taxes have been hurt with being limited in their deductions on their tax return in those categories.
 
Defaults – Case Shiller also tracks defaults, and they show similar results to other sources, that primary home loan defaults are falling. But the canary in the coal mine for mortgages is second or subordinate loans, which is home equity loans and lines of credit. In 2007 it was subprime.
 
Now we only see rising defaults in second mortgages. From June 2012 until now, it’s been steady as she goes in a range of 0.50%-0.75%. But from September 2017 through November 2017, the index has spiked from 0.53% up to 1.08%. And I get it, 1.08% is not too bad of a default rate at all. It’s certainly better than the post crisis range of 3.5%-4.5%, but what we are looking at is 104% increase in the default rate in just two months. That’s a figure I’ll be keeping my eye on, and it will be interesting to find out where the defaults may be concentrated and why.
Defaults on primary home loans are in a range of 0.65%-0.75%, and if we see this rising, which I suspect it will, it will spell trouble as the default rate begins to move past 2% and up to 3%. I also suspect that as subprime lending standards continue to loosen (I’m already seeing adverts for 100% financing with low or no credit), as home purchase prices continue to rise, and as adjustable mortgages come into vogue again, subprime defaults will accelerate past second mortgages. These are the least qualified borrowers, and we already see it in subprime auto-lending with some loans going into default as soon as the car leaves the lot with the very first payment being missed.
 
One more important point is defaults on loans of all types, and leases too for that matter, defaults are a lagging indicator of economic stress. If it stays in a range, I wouldn’t worry about small upticks within that range. But once it moves assertively and significantly out of its established range, warning bells begin to ring. If we already see defaults rising, it means that the economy is already doing worse than we thought.
 
Spikes in loan defaults are more common just before official recessions are declared. So if we see defaults rising in the last three months, it could mean that the economy has been more sluggish than we think for 6 or more months. Therefore, if the trend continues upwards, we know what is coming…the widespread realization of what is already here.
 
Stock and Bond Markets
 
I’ve been through stocks and bonds with every article, and I don’t want to rehash what I’ve already stated in those postings or above in this one. It’s just beating a dead horse. I will add a couple summarizing comments, though.
 
By all measures stocks are completely over valued at this time. Warren Buffet’s favorite metric is stock market total market cap to GDP ratio, which is 143%. The historic average is around 50%. And worldwide the current ratio of total stock market cap to total world GDP is in excess of 350%!!! All other measures are also in the stratosphere.
Truthfully, the ratio should be higher because the denominator, GDP, was recently changed. Under GAAP accounting rules, any company that has a budget for research and development writes off cost as an expense. The government now adds R&D into the investment part of the GDP equation. Until recently that was never included because it is not a final product or service. So the ratio should have a smaller denominator, and hence, a larger ratio of stock market value to GDP.
 
Because S&P companies have very strong balance sheets and profitability is very strong as well, there is some staying power here for stocks, and I emphasize some. As such I am adjusting my perspective to say that I can see the stock market taking itself another 5-7% higher based on the tax cut expectations and current momentum. That puts the DOW, which had 71 new all-time highs in 2017, at a range of 26,080-26,580 based on its high of 24,837.51 on December 28, and the S&P’s high of 2690.16 on December 18 may go to a range of 2825-2880.
 
However, as I’ve noted already, as interest rates rise, balance sheets, income statements, and the staying power of such will deteriorate. Also, as interest rates rise, government bonds of all types may become more attractive, which will cheapen the value of dividends being paid. That’s because if you’re an income investor and you’ll be able to de-risk your current 1.8% S&P dividend (another historic record, a record low) by purchasing treasuries or munis, you might give strong consideration to do just that. It will cause equity prices to come down with selling pressure.
 
The historical mean for the S&P 500 dividend yield is 4.37%. Believe me if something hits the fan on our economy, the current dividend will fall precipitously along with the index, even as the dividend yield rises. That means that if the current dividend reverts to the mean dividend yield, we’ll see the S&P 500 below 1100. If the dividend falls, which is likely to happen, the S&P 500 will fall even lower for the dividend yield to revert to the mean. Usually what happens, based on the historical chart linked here, dating back to the late 1800’s, the stock market will grossly overshoot. If that happens again, you’ll probably be able to pick up the index with a dividend yield north of 7%.

In addition to central banks paring back QE or selling bonds and MBS, there is a very high level of bond fund outflows as well. As the funds sell, that will add even more selling pressure which translates into falling prices. Of course, if the price of a bond falls, you guessed it, the interest rate on that issue must commensurately rise.
 
For junk bonds, which is non-investment grade, Reuters says the week ending November 15th saw the fourth largest outflows on record since 1992 when the statistic began. Marketwatch has the same period, ending November 17th, as the 3rd largest outflow on record. And Lipper shows the trend has continued through the end of the year. Several billion in outflows from bond funds, and in weeks of buying, inflows are shrinking. Over the same period, there has been several more billion in outflows from bond ETFs as well.
 
When compared to the total US bond market of over $40 trillion it doesn’t sound like much, but if you consider that in the context of rate hikes and Fed sales, institutional and retail investors are worried that their principal investment is going to fall in value, and they’re 100% right. I don’t attribute it to tax selling because the fever pitch of tax selling is typically the very last week of December. This selling was in November.
 
The last three weeks of December saw bond fund and bond ETF outflows in excess of $10 billion combined. The Financial Times reported on 12/22 that the prior week saw the highest outflows since Trump became president. Bond funds in developed markets lost $4.1 billion. Bond funds are generally for one purpose: income. If investors are pulling out of bond funds, it means they think that either there are better opportunities for income, or they are protecting against loss.
 
Along with the outflow from funds and ETFs, we don’t see a commensurate inflow to stock dividend/income funds, high yield funds, or emerging markets bond funds. The catch here is that we know interest rates are in a rising environment, so investors might be pulling out now to protect their principal, and waiting for that anticipated third rate hike next year to go back in at higher yields.

It’s just not clear at this time where they are parking the cash because money market funds are also seeing net outflows that are outpacing bond fund/ETF outflows and equity fund/ETF inflows in all categories of funds and ETFs. That tells me investors are completely pulling cash out of their brokerage accounts to pay for stuff. Further, the savings rate is now at a paltry 2.9%, which was last seen before the last recession. I’ve mentioned previously that I think people are paring their brokerage accounts, preferring to pay down their margin debt (even though margin debt is at all time highs), variable debt like credit cards, pay for living expenses, and make holiday purchases. And I reiterate that now, in light of this new research I’ve done.
 
As noted many times, bonds work in an inverse relationship between the rate and the price. If the rate goes up, then the price must go down. Rates have not begun to rise in earnest yet, but mark my words by next fall we are likely to see a dramatic turn of events in bonds. As noted, the Fed is in the middle of rate hikes. As the rate rises the price of bonds must fall. They are also in the midst of ramping up sales without commensurate buying to mop up the supply. As the price falls the rate must rise. The government runs a budget deficit of over $650 billion and rising, and that will add even more supply to a market that is beginning to flood.
 
Taxes
 
I’m not a big fan of the tax bill. There are some great provisions, for sure, but overall I am not a fan. I made some of my own tax reform suggestions here, in case you are interested. You can see a good summary of some of the bills’ winners and losers here. Let’s have a little bit of a look.
 
On personal returns the average American will receive over $1600 on their tax cut (about 55% of Americans pay no taxes at all so you can’t cut taxes from 0), and the standard deduction was doubled as was the child tax credit. But real estate taxes on your primary residence plus state and local taxes now have a maximum tax advantage of $10,000 combined. That will hurt anyone who lives in states like New York, CT, NJ, IL, and CA where there is a very high level of social welfare entitlements and high taxes. Places like TX and FL won’t be hurt so much because they have low real estate taxes and low state and local taxes. Some people will pay more, but most will either continue to pay nothing or get a reduced tax bill by an average of $1600. And the more you pay in taxes now, the more you are likely to save on your tax bill in the future.
The $1600 figure comes from the CBO, and the Tax Policy Center is saying about 143 million tax payers will pay less versus about 8.5 million tax payers who will see an increase. Congress’ own Joint Committee on Taxation is crunching similar numbers to the CBO and TPC.
 
Another big line item in the bill was 529 college savings plans may now be used to pay for K-12 private school tuitions. That is very big for anyone sending their kids to Catholic School, Yeshiva, Friends Schools, Medras, or any other private primary/secondary educational institution. It will be a big deal for those institutions too.
 
The big problem is that the same agencies mentioned above are finding that cutting taxes will take away about $2 trillion in tax receipts over the next 10 years, while the projected GDP increase will bring back only $400 billion in new tax collections. On net balance, over the next ten years, prior CBO projections of no less than $600 billion in budget deficits every year and growing by no less than $50 billion each year, will have to add $140 billion per annum for an additional $1.4 trillion added to the bonded debt of the USA. We’re talking over $10 trillion being added to the national debt in 10 years, just because of budget deficits. At what point do our creditors say enough is enough and pull the plug on continuing to fund deficit spending, knowing they’ll never get paid back in full, and if they do it will be with worthless dollars?
 
In addition to the provisions I’ve mentioned, there is something else that I have been talking out with people. Everyone who will listen, in fact, cause this is a biggie. Quite a few people have said to me, “Holy cow, why didn’t I think of that?!” In fact, the only other person I know of who has mentioned this issue is Michael Pento of Pento Portfolio Strategies, who mentioned it for the first time this week in his weekly podcast. He said he is the first to mention it to the public, which could be true. But he is not the only person to think of it, and once I mention it to people they have the epiphany.

The issue is the individual mandate was repealed, leaving two problems for health insurance providers. I am not going to talk about the moral or ethical construct of the issue. I am only concerned with the economics here. There are other forums for the ethical and moral discussions, and I kindly ask to keep those discussions in those forums, not here.
 
One issue is that young healthy people who don’t utilize their insurance will self-terminate their coverage. Insurance companies won’t collect their premiums to offset the costs of really sick people. And that’s the second point is that people with pre-existing conditions like heart disease and cancer can’t be denied coverage. Those people are very sick and have very expensive medical bills because of procedures and medications. Heart transplant surgery, for example, could be in excess of $1 million, bypass surgery over $350K, and cranial malignant tumors could be over $750K. Just for the surgery.
 
If you remember, Obama promised us that our premiums would drop from $12,500 to $10,000 with the enactment of the Affordable Care Act. You can also read about that here. But realistically premiums doubled or more in most cases. And that includes healthy people paying premiums for insurance that they under utilize or don’t use at all. All those underutilized premiums are about to disappear, and if you think the premiums got expensive in the last 8 years, think again. That will look cheap on election day in 2020, and what looks expensive in 2020 will look like a fire sale in 2024.
 
Here’s why premiums will go up. I already mentioned that young healthy people who under utilize their insurance will just drop their policies. That takes out a large pool of cash from the insurance companies, which is normally used to invest in the insurance company itself or to make investments in the markets. The goal of all that investing is to turn a larger profit. The premiums being paid in will come from sick people and families with young children. These groups typically over utilize their coverage, meaning that the insurance companies will pay out more cash in claims than they can raise in premiums. Insurance companies are not in business to lose money, so they’ll have to raise premiums to make up the difference. If your premiums went up when the individual mandate was included, a fortiori they’ll go up without it!

It’s not just families that will be hurt by this. Companies made out good on this tax bill because corporate taxes are dropping from 35% down to 21%. By the way, taxes are an expense, and all corporate expenses are built into the final price of goods and services at the point of sale. So companies really don’t pay taxes. The consumer that buys their stuff really pays the taxes.
 
In any case, the big “but” on that corporate tax reduction is that, like individuals and families, companies that offer and pay for medical benefits to full time employees will see those premiums rise very quickly, even with discounted group costs. Insurance companies know that people will be dropping coverage, and they know the risks that accompany the remaining people who are sick. They can calculate the risk and mitigate it mathematically. But there is a big uncertainty and that is how many people will drop coverage and how many new people will apply. And what are the costs going to be for all those new people? And more importantly, what are the uncertainties that lie ahead in the healthcare arena’s regulatory environment?
 
Chances are that more people will drop than anticipated, and more sick people will apply for coverage than anticipated. And chances are that the costs for the new applicants will be higher than we expect.
 
You know, agree with the president or not, vote for him or not, Trump is a smart guy, and it could be that he has a plan for the fiasco he just created. It could be that his plan is to show everyone how economically unfeasible the ACA really is, and thereby the people will clamor for real and lasting structural change in the health care insurance industry. When that happens, we’ll see Trump open the doors to a more competitive atmosphere, for example, by allowing companies to sell across state lines.
 
I am sure that other innovations will take place in the health insurance industry as well. For example if your religious beliefs preclude you from certain procedures or medications, you may be able to opt out of those. Maybe women who’ve reached menopause won’t have to pay for birth control medications or procedures. Many other innovations may appear as well.

While there are some positive developments of the tax bill, I think the negatives will exert too much downward pressure on the economy. It will leave GDP growth projections of 5-6% in fantasy land, and the high expectations will be short lived.
 
National Debt
 
The national debt is a very big issue, and it probably should be near the beginning of this article.
 
Also, more attention should be given to it in the media. And you, dear reader, should pay more attention as well. Here’s why. The current level of bonded debt (think treasuries) is $20.62 trillion.
 
The current level of future liabilities that are not yet bonded, but for which the government must borrow in order to pay for those liabilities is estimated at an additional $80-$100 trillion total for each and every person now living in the USA. What that amounts to is future promises to pay social security benefits, Medicaid, Medicare, and any other benefit that has been promised by law.
 
As noted many times, the current annual budget deficit is over $600 billion, and that is set to grow by no less than $50 billion per year. Also, those $80-$100 trillion are not line items in the budget. They are items that are not included in the budget, meaning that if there is a budget deficit of $650 billion this year, the government has to borrow that amount plus more to pay for its welfare obligations. It is for this reason that you can see a budget deficit of $650 billion, but the national debt rose by significantly more.
 
I have seen study after study showing how nations with a national debt exceeding 90% of GDP will be guaranteed to have a day of reckoning on their debt. Whether by blatant default or restructuring, either way the creditors of those nations will have to take the proverbial haircut. National debt in excess of 100%, that day of reckoning will be both sooner and more harsh, and this is considered the point of no return.
 
As I write this, America is now at 104.99% debt-to-GDP ratio. So where is all the clamoring for restructuring, why isn’t Wall Street crying over losses, and why aren’t insurance companies changing the structures of their annuities and life insurance policies? Why isn’t anything happening on this front? Where are the academics who wrote those studies about the debt to GDP ratio?

Here’s the rub. The debt to GDP ratio is important, but it is not the only component of that equation. To understand, here’s an analogy. Imagine a recent CPA candidate just landed his first job at one of the big accounting firms, and they are paying him $70,000. Then he goes and buys a condo on Central Park West for $10 million, with an interest rate of 0.00%. He doesn’t have to do anything to service the loan because no interest is due at any time. But what if the rate suddenly rises to 0.1%? His interest payment is now $10,000 per year. Still affordable, though he might consider paying off his student loans and some other debts, and he may also reconsider which restaurants he dines at with his girlfriend. What if his interest rate rises to 0.7%? All of a sudden, all of his income must be used to pay the interest on his mortgage, and he has nothing left to pay for anything else.
 
This is the same situation that the USA finds itself in. The national debt is currently sustainable. But as interest rates rise, either by Federal Reserve policy, by market forces, or by both, the debt will become less and less sustainable. Eventually America’s creditors will realize that they are not going to get paid back in full, and there will be a rush to the exits.
 
According to treasurydirect.gov, the current interest rate for all marketable and nonmarketable treasury debt (does not include TIPS or floating rate notes) is 2.293%, which comes out to $472.6 billion of interest payments per year. That is just over 14% of total tax revenue (which is set to drop, see above). As the national debt and the interest rate on that debt both rise, it will eat up more and more of the federal tax revenue. That’s because federal tax revenue will not continue to increase as fast as the debt service payments.
 
And what do you think the government will have to do to make up the difference? That’s right, it will issue more treasury debt, it will print, and it will commence more monetary policy moves that will have a negative impact in the long run, even if emergency measures provide temporary help in the short run. Everyone around the world will have to recognize the truth of the situation, that the full faith and credit of the US government can’t coexist with the insolvency of the US government.

The situation is currently sustainable, but as interest rates rise, as the debt rises, and as tax revenue falls, a tremendous amount of pressure will inevitably be exerted in this area. The end of this particular saga will not be good, and everyday Americans will be hit hardest. As the value of the dollar falls, everything we import will become more and more expensive, and that will cause domestic goods to rise in price as well.
 
Bitcoin
 
I don’t know where Bitcoin ends. Or any other crypto currency for that matter. It could be $100,000, it could be $1.0 million, or it could be $150. It could even be zero. What I can tell you is that the blockchain technology behind it is here to stay. Well, until we find something better. But for now it’s here to stay, regardless of what happens with the crypto currencies. Just don’t let the crypto currency story become kryptonite to your portfolio.
 
I also think that this cryptomania is indicative of what the concerns are with fiat currency. People are looking for a real store of value, which fiat currency is not. And they are also looking for something which forces the government to butt out. Fiat sorta does that, but it sorta doesn’t. Crypto is actually a nightmare scenario if you are a flaming libertarian or anyone else who can’t stand governments poking around your personal business like the school nurse looking for lice before allowing your kid to come to class. In the end the cryptomania bodes well for other assets, such as gold, silver, and the mining shares.
 
I have several concerns with Bitcoin and all other cryptos, though, including hackable (it’s been done several times already with several cryptos including Bitcoin), it’s multipliable (over 1200 cryptos and counting, and each coin brand can be increased in total number), it’s not widely accepted yet, and it’s not physically transportable so if your power goes out you may lose access, and many other problems.
 
The biggest problem in the cryptosphere is the uncertainty of governments and their propensity for sweeping intervention. China and Russia have already announced they’ll be introducing a national crypto currency, and Israel announced last week that they’re beginning to look into the matter. Several countries have also made it more difficult to use the currencies in their markets, with the latest being South Korea. Other nations will follow very quickly.
Here in America the problems with the government are many. I work in the financial services industry, and we have several regulations in anti money-laundering, know your customer, bank secrecy, FATCA, suspicious activity reporting, the Patriot Act, and more. Ever try to deposit a few thousand in cash? The teller calls over the branch manager and they start questioning you like FBI agents. Behind your back they’ll file mandatory reports after you leave. Last time I deposited a couple thousand I just said, “My tax refund finally came in and I have to make a mortgage payment, so I took cash out of my account at the other bank to deposit here for immediate availability.” It was true, but they gave me a weird look for that one, like if I was hiding money for Al Capone.
 
Cryptos fly in the face of all of these regulations. The regulatory climate in the banking and financial industries has been designed to help track down drug dealers, terrorists, mobsters, and others with foul intentions for society. None of the regulations are being kept in the crystosphere, and believe it when I say the US government is ready to swoop in. They are just waiting for the most opportune moment, and meanwhile they get a front row seat to observe the latest innovations as well as public sentiment.
 
What it means is that if we have a FedCoin (or whatever they’ll call it), all transactions can be traced, no more tax evasion, no more cash, it will be an invasion of privacy of the highest order by law enforcement agencies, and we all lose freedoms. I am not a conspiracy theorist by any means, but the history of government involvement in money and currency leads me to believe that this time will not be different. Only the currency will have a different name and a different picture on it, but the story will remain the same…government takes on too much debt, government can’t pay debt, government debases currency, government defaults and monetary revolution ensues.
 
The United States and other countries are just waiting to see how the crypto story plays out. The private sector is in the midst of perfecting the next phase of currency history, and governments will take over soon enough. As soon as Uncle Sam comes in, FedCoin will be the only legally accepted cryptocurrency in the country, rendering all others useless and valueless.
In relation to gold, there are two points to ponder. One is that crypto is not a substitute for gold, even though some people may claim it is. It doesn’t share all the same properties as gold, even though it shares some, and it will be traceable by governments, whereas gold is not. In the short term, individuals may play the crypto market and make a killing on it or they may get killed on it.
 
The second point is that even though gold has temporarily lost its luster, the cryptosphere is indicative of what is coming for gold, as noted above. A growing number of people understand the complete farce of fiat currency systems, and that gold is the only true world currency alternative that outlasts everything. Afterall, there is over 5000 years of written historical record attesting to gold’s utility as both a currency and a store of wealth.
 
Gold
 
Back in May 2017, I laid out the case for owning gold. When I posted that blog it was 19 pages single spaced. We clearly don’t have the time for that much here, so I’ll just touch on the major points. If you want to see it, just click the link.
 
Ok, so gold has an economic function as both a commercial/industrial metal and the more important function as real money. It’s used in electronics, satellites, jewelry, life-saving medical equipment, and much more. As money it is the only store of value that doubles as currency, and stands the tests of both time and geography. If you price anything in gold rather than your local currency, the value of everything in the world remains relatively constant for looong periods of time. Also, it is the one true safe haven asset in times of uncertainty and worse, during hyperinflation and war.
 
Next, gold does not pay dividends, and that is not why you own gold. Though I know of a hedge fund that now specializes in owning gold and receiving a return on your gold in more ounces. You own gold because 1) it hedges against inflation, and 2) it acts as portfolio insurance. Most importantly it functions as an asset to which there is no third party counter risk such as banks, stock exchanges, or governments. Also, gold is the only international currency because no matter where you go in the world, one ounce of pure gold retains the same value in all places and at all times.

Next is that gold can’t be printed like the cash in your pocket. There are costs to bring it out of the ground which are rising, and the world gold supply increases each year at about the same pace as population growth... 1.5-2.0%. Not only that but nearly the entire supply of gold ever mined is still in existence and still in use somewhere in the world, unlike other metals that typically end up in the garbage dump, such as copper, zinc, plastics, fabrics, and others.
 
At this time central banks around the world are becoming net buyers of gold…Russia, China, Turkey, India, and several other EM nations and Asian nations. This is because all the other central banks of the world, especially Western central banks, are in a race to the bottom to devalue their currency, hence, the reason asset prices in all categories have exploded in the last decade. See, if your unit of measurement becomes smaller and smaller, then you need more and more of those units to measure the same value of an asset like an ounce of gold, a single family home, farmland, or a painting. In addition to central banks becoming net buyers, the most reputable investors around the world are buying as well... George Soros, Li Ka-shing, University of Texas endowment fund, and many more.
 
And then there are several economic cycles all coming together at once, including the rise and fall of all fiat currencies including the dollar, the lifecycle of baby boomers, Kitchin waves, Juglar waves, the wealth distribution cycle, the stock market cycle, Kondratiev waves, and the East-West grand super cycle.
 
My prediction for gold in 2018 is to test its 2011 high of $1948 per ounce, and silver will test $50. In the next 3-5 years, we could see $3000-$4000 per ounce with silver reaching $125+, and in 5-7 years, we are likely to see $8000-10,000 per ounce of gold and $300+ per ounce of silver.
 
This will happen because the Fed has failed to bring rates high enough and fast enough. They should have started rate hikes much sooner, and it should have been much faster. Remember that in the last two easing cycles, rates came down by 5% or more to restart the economy.
 
When interest rates in the market hit 4.5%-5.0% on the 10-year treasury this coming fall, the Fed will have no choice but to immediately drop the Fed Funds rate from 2.0-2.25% back to zero and go -2.5% to -3.0%, and reengage QE. As that unfolds the dollar will also tank, which bodes well for PMs.
Energy
 
Oil and gas are becoming more difficult and more expensive to bring out of the ground, and the price to do so per barrel of oil is currently around $60. If the price per barrel is below that, companies will only tolerate losing money for so long before low prices are cured by more low prices. What will happen is we’ll start to see more and more exploration funding getting cut off, and more oil well closures. We’ll also see consolidation in the industry. So eventually prices will rise and companies will outperform expectations.
 
Even though the Trump tax package opens up ANWR, that will still require years of further exploration, preliminary economic assessments, permitting, and building of wells in one of the most difficult drilling regions on the planet. It will also require the infrastructure buildout, because it’s not so easy to just drill a well and carry several million barrels of oil equivalents across the frozen tundras of Alaska and Canada.
 
In addition to oil and gas, there is the issue of uranium. We are at a juncture whereby the choice is either continue mining uranium and using it for reactors, and building more reactors, or the lights go out. I suspect the world will choose the former over the latter, because all the other sources of energy, such as solar and wind, are just not efficient enough and aren’t cost effective enough to be viable on the scale that is needed to replace nuclear energy.
 
The rebound in nuclear energy will be a function of Japan coming back on line with its nuclear facilities as well as more plants opening around the world. In fact, the first nuclear power plant in several decades in the US was just approved in Georgia. We’ll begin to see more of that as old plants close and the need for energy grows with the population, power hungry gadgets, and electric cars.
 
Also, China has over 400 reactors either in the planning stages or are already under construction.
 
The spot price of uranium is currently about 60% below the cost to bring it out of the ground. Like oil, that will change and uranium companies, with such perversely low expectations right now, will both outperform expectations and also positively surprise Wall St. In addition, in the last 4 weeks or so, we saw Cameco (CCJ) close one of the largest mines in the world, which effectively cut 10% of world production! In addition to the Cameco cut, the state owned uranium company in Kazakhstan, Kazatomprom, will close one of their largest mines as of January 2018. That mine alone is 20% of the company’s production.

The combined world production between these two closures is well over 25%, and that is why uranium prices moved higher by 20% in the days following those announcements. Expect to see more closures, more consolidation, and more streamlining of business models. We are now seeing the beginning of a capitulation by the professionals in the industry, and as we see more of this, this subsector of the energy domain will begin to do very well.
 
Recommendations
 
Everyone reading probably wants to know what to do.
 
The single most important thing to invest in is your own financial education. People who do so tend to be better off financially, and they know when to question the “wisdom” of the Street. I like Robert Kiyosaki’s Rich Dad Poor Dad. It’s a fantastic book and it’s the best selling personal finance book of all time. I also like Mike Maloney’s Guide to Investing in Gold and Silver. Mike is the foremost expert in the world in the big picture of the gold and precious metals arena. I also recommend his YouTube video series called “The Hidden Secrets of Money”, which is a primer on how the entire financial and banking system works.
 
Before you even buy these books, let alone read them or watch the YouTube videos, you must, must, must call your stock broker if you still use one, and ask that person “How will the current climate of rate hikes and Fed balance sheet reduction affect my portfolio?” Your money manager should welcome this question for two reasons. One it makes his job easier because he doesn’t have to prioritize if he should call you. But more importantly it sends a message that you care about what happens to your money, and he should too.
 
The answer to that question should be “I’m glad you called, and many clients like you have similar concerns. That is why we are taking a proactive approach to make sure you’ll be able to protect what you have and hopefully grow it a little bit too. When can we get together to discuss it in the next week?”
 
If your money manager doesn’t welcome your phone call and the question, and instead blows you off in any way at all, perhaps the next question you should be asking yourself is if your money manager is the right guy for the job. Is he fulfilling his fiduciary responsibility first, before he thinks about making his wife’s Mercedes payment?
Beyond that I have some bold recommendations of what you can do right now with your portfolio. First is that as I said in November, gold ownership is now mandatory. You better get in while it’s still cheap! You can buy bullion coins and bars from many different places, but I would not recommend most of them. Especially not the companies that have big radio and TV advertising budgets.
 
There are several companies of good repute, like Schiff Gold, GoldSilver.com, and Miles Franklin (not paid endorsements). How much physical gold bullion you own depends on your situation, but investors would do well with a 10% position in bullion (and that is 10% of total investable assets), and build a position in mining companies after that. Investors should avoid numismatics, they aren’t worth the price and they don’t serve the same function as bullion.
 
Also, it’s important to avoid the gold ETFs like IAU or GLD. You just aren’t entitled to redeem your shares for real gold, and the ETFs dilute your value. It says as much in their prospectus, usually between pages 5-8.
 
Also, if you didn’t read my article on owning gold, go read it, and pay attention to the scams and shams to avoid. Schiff Gold has an excellent pamphlet on the scams and shams too, and they’ll give it to you for free if you are willing to give them your email address.
 
The second half of the gold story is in the mining companies. It’s important to do your own research. If you don’t know how to do that, you can buy an ETF or mutual fund, and some are much better than others. Personally I am in the EuroPac Gold Fund (EPGFX), and both the ALPS ETF/Sprott Gold Miners (SGDM), and ALPS ETF/Sprott Jr Gold Miners (SGDJ). Precious metal streaming companies will also outperform, and my favorites are Franco Nevada (FNV) and Wheaton Precious Metals (WPM). WPM is formerly Silver Wheaton.
 
All three funds are selective of which miners they buy, paying careful attention to who runs the companies as well as some other fundamental metrics. These funds don’t just spread out their umbrella over the mining industry and buy whatever fits in. They also have small positions in both silver mining companies and platinum metals group miners. These guys are set to outperform gold miners, but the main focus of the funds is gold. Outside of precious metals, the base metal zinc is already warming up, and copper looks good too.
I also like the energy sector, I’m starting to warm up to it here for the reasons above. I think it’s still a little early, but that doesn’t mean you can’t find excellent companies, priced at a discount, and poised for several solid years ahead as the underlying commodities rise in price. Uranium companies will do well, but if you want a more direct play on the metal you can go Uranium Participation Corp (OTCPK:URPTF). The major oil producers will handily perform for you as well, streaming companies such as Freehold Royalties (OTCPK:FRHLF) will also give you handsome returns with a fat dividend, and some of the midstream and servicing companies will also do well and pay dividends.
 
Another very big recommendation right now, perhaps the biggest, is to pay off all your margin debt and get into cash. If you have the cash to pay it then that is the best way. If not, sell something at a profit and pay the taxes if you have to (speak to your CPA as well). If there is a crash like 2008, and if you have a high level of margin debt against your account, you’ll be toast. Don’t think twice, just pay it off and don’t look back. Sell for profit and pay the taxes because the losses in a crash will be higher than the taxes on the gains if you don’t.
 
Not only paying off margin, but I also recommend very high levels of cash, starting with at least 25-30% of your investment portfolio. First of all, I’d rather miss out on the next 3%-5% upward move rather than suffer 50% or more in losses. Secondly, when it all does hit the fan, there will be tremendous opportunities on the other side of this crisis to pick up companies like Apple (AAPL), Starbucks (SBUX), General Electric (GE) at extreme fire sale prices. Apple, for example, in 2008 was well over $200 per share, and at the bottom in 2009 you could pick up shares for around $60. Starbucks bottomed around $5-$6. GE more than quadrupled from its March 2009 low of $7 to its recent 2016 peak over $30. Like Johnny and Baby in Dirty Dancing, we’ll surely see companies like these doing dips again.
I really don’t like banking stocks right now, and I wouldn’t touch them with a 10 foot pole.
 
Especially those US banks that have lent to EM companies denominated in USD. Yeah, I know, the Street is in love with banks, but all the analysts work for banks. Go figure. Investors might consider a small short position in the banking sector to hedge against general stock market losses. You can accomplish this with an ETF like the Financial Select Sector SPDR Fund (XLF) or the Vanguard Financials ETF (VFH). I have nothing against these two ETFs, and they are just examples of vehicles that you may or may not choose to employ.
 
A small hedge against the broad stock market with a short position in US stocks might make sense too. If you don’t sell and take profits, and rather stay all in, when it hits the fan you’ll be able to recoup some of that if you short the market. The most popular ETF probably would be the SPDR S&P 500 ETF Trust (SPY), but any index ETF will do.
 
The single most obvious short is treasuries, because the Fed is hiking and selling, and the yield curve is only 50-60 basis points from inverting. Again, if the yield is rising, the price MUST be falling. You can use any treasury bond ETF such as iShares US Treasury Bond ETF (GOVT). the short end of treasury durations makes the most sense here. 30-year treasuries fell by 30 basis points in 2017. 10-year treasuries fell by a mere 3 basis points, but since just September the yield has risen 37 bps. And 2-year treasuries have risen by 70 bps. Because of this trend, iShares 1-3 Year Treasury Bond ETF (SHY) might be a better short position than GOVT.
 
Aside from energy, precious metals, and cash, I also like selected defense stocks. One thing not considered by the financial mainstream group stinkers is war in either North Korea or the Middle East. Regardless of the North Korean softened stance in the last couple days, I am more concerned with North Korea right now, but there are rumblings in the Arabian Peninsula too.
 
If Trump makes any comments that lead us to believe he will move in either arena, companies like Northrup Grumman (NOC) and Lockheed Martin (LMT) will benefit handsomely. Again, you must, must, must do your own research here.
But it’s not just NK tensions, Iranian nuclear ambitions, or Saudi shakeups, it’s also the fact that Trump campaigned on ramping back up on military strength. And it shows in his budget proposals. I believe him when he says he’ll spend on the military, because many of the things he said he will do in his campaign he is already done with or in the midst of doing.
 
Aside from defense stocks, defensive plays are also good positions, like electric companies, water companies, and staples like food and beverages. Do your homework and don’t just buy anything with a pulse.
 
One final area to keep a watchful eye on is cannabis. Weed. Pot. Marijuana. Mary Jane. Grass.
Reefer. Joint. Texas Tea. Pakalolo. Hashish. Ganja. Skunk. Boo. Call it whatever the hell you want, I don’t care. Medical marijuana is in full bloom, and recreational is blossoming. It’s a multibillion dollar industry set for massive growth, and California is only the latest state to add it to the list of legal substances. As other states see the tax revenue being enjoyed on the left coast, they’ll clamor to join. In the next 3-5 years, it will likely be legal across the nation, and you won’t have to fly to the Netherlands anymore just to smoke without concern of arrest. Just a word of caution here... stay off the pump and dumps, and stay away from their stock pimps.
 
All these moves I am suggesting will probably protect your portfolio and add cash dividends, but the real growth with come from gold and gold mining companies. Like I said I think gold will test its 2011 high of $1948, and if the Fed reverses its sales of treasuries and MBS, and instead goes to more quantitative easing, bail ins, bail outs, helicopter money, universal base income, negative interest rates, and whatever else they can do, we’re in for massive inflation like we haven’t seen in America since long before the 1970’s. we’ll see a hyperinflation that will have “it ain’t worth a continental” written all over it. We’ve had four rebirths of our currency just since 1913, and it can and will happen again. I don’t know if 2018 is the year. It’s just not a matter of if, but rather when. What I do see is that by October of next year, like I said gold could be testing its 2011 nominal all time high and we could see the ten-year treasury bond at 4.5%-5.0%.