O, O, O, It's Magic

by: Brad Thomas


- All triple-net REITs grow earnings by utilizing spread investing.

- The higher the multiple, the lower the costs of capital, and that translates into BIGGER MARGINS.

- The low cost of capital (high equity multiple) is the most important competitive advantage in the net lease industry.

This article is one in a sequence of articles that I refer to as “If I Had To Own Just One REIT” series. As you may recall, I recently wrote on the Healthcare REIT sector and I selected Ventas, Inc. (VTR) as my top pick. I summed up my BUY recommendation as follows:
VTR is my favorite Healthcare REIT and one of the best managed REITs overall. While I don't consider the shares anywhere near bargain-pricing levels, I consider the stock soundly valued and worthy of an entry position. For a deep value investor, I would wait on a pullback, but I have no problem recommending shares at the current price point.
I also wrote on the Shopping Center REIT sector and I explained that “after surveying the list of vetted retail REITs and considering which of the companies are worthy of ownership, I find Retail Opportunity Investments Corp. (ROIC) one of the best REITs to own.”
Given the more recent news and powerfully disruptive force in the retail sector – Amazon (AMZN), it’s critical that investors focus on QUALITY. As I explained in a recent Forbes article,
The best quality real estate with the highest sales productivity should thrive as successful retailers want to drive sales and inventory turnover..., Amazon is recognizing that to build a successful mousetrap, the blueprint must include REAL ESTATE.
In other words, it’s now more critical than ever to own Retail REITs that have the highest quality assets. There is no reason to be cute, hoping to capture outsized returns by investing a REIT like Spirit Realty (SRC) that leases to Shopko and formerly invested in a struggling grocer, Hagen. I summarized my thoughts in a recent article,
The cream always rises to the top, and today REIT investors have an opportunity to pick up shares in a stalwart REIT that has a superior low cost of capital advantage. It’s critical to always examine the underlying revenue generators of a REIT and remember that “quality is not free.
Now it’s time to continue the “If I Had To Own Just One REIT” series and today I’m writing on the Net Lease REIT sector. I’m sure you already know the company but in case you don’t here’s a clue…. O, O, O, It’s Magic.
The Basic Net Lease REIT Overview
Before I start on the discussion of Realty Income (O), let’s begin with a general overview of the Net Lease REIT sector. Net Lease REITs are different from Shopping Center REITs because their lease structure and growth drivers support a predictable revenue stream relative to other forms of retail real estate. This snapshot below compares Realty Income (and Net Lease REITs) with Shopping Center/Mall REITs:
One of the most important differentiators for Net Lease REITs is that they drive growth through acquisitions. When is the last time you saw a Mall REIT acquire a Mall? Net Lease REITs like Realty Income have a large pool to fish in – the sector is highly fragmented and there are opportunities to invest in practically every state in the U.S. (Realty Income owns properties in 49 states).
Here is a snapshot comparing Realty Income’s market capitalization with the Net Lease REIT peers:
Over the years, Realty Income has evolved into a massive Net Lease REIT with 4,980 properties located in 49 states and Puerto Rico. As you can see below, the company has a highly diversified portfolio spanning 49 states (not in HI):
It’s hard to fathom how much Realty Income has grown over the years, from one Taco Bell site to over 4,900 properties. The company now has incredible scale, well diversified by tenant, industry, geography, and to a certain extent, property type.
No tenant represents more than 6.8% of revenue as Realty Income has 250 commercial tenants, 45% are investment-grade rated (including 9 of the top 20 tenants):
As you can see, Whole Foods is not on the list of Top 20 tenants. During the first quarter, Realty Income added Kroger (NYSE:KR) to its top 20 tenants, representing 1.2% of annualized rental revenue. But more importantly, the top 15 tenants represent higher quality credit, less cyclical industries and greater diversification vs. 2009:
No industry represents more than 11.1% of rent and the company has considerable exposure to defensive industries: Top 10 industries represent strong diversification, significant exposure to non-discretionary, low price point, service-oriented industries:
Realty Income’s roots are in retail with growing exposure to mission-critical industrial properties:
Realty Income’s management team is highly experienced at sourcing deals and when the company invests in retail it seeks strong unit-level cash flow coverage (specific to each industry). The company seeks tenants with service, non-discretionary and/or low price point components to their business with favorable sales and demographic trends.
Keep in mind, there have been 13 retail bankruptcies in 2017 and 12 of them were related to apparel, electronics, and general merchandise. Realty Income has little exposure to these categories: 5 apparel BKs and O has 1.8% of ABR in apparel, 3 sporting goods BKs and O has 1.3% of ABR in sporting goods, and O has .30% exposure in electronics, 1.7% in general merchandise, and just .65% exposure in shoes (i.e. Payless BK).
Also, Realty Income has 3.67% exposure (based on ABR) to the grocery sector. The company has Wal-Mart and Kroger as Top 10 tenants. As I said earlier, it’s critical to invest in quality retail and that means avoid REITs that have exposure to weaker chains like Shopko (i.e. SRC) and Bi-Lo (i.e. WHLR).

What about Rite Aid (RAD)?
Of all of Realty Income’s tenants, Rite Aid is, in my opinion, the biggest watch list candidate. There is doubt regarding the Walgreen merger and RAD is highly leveraged (rated B by S&P). Realty Income has 69 RAD stores but I don’t consider this dire news given the fact that Realty Income has cherry-picked the real estate and the pharmacy sector is growing.
Who knows, maybe the RAD leases become Amazon leases… I’ll save that article for another day…
Realty Income remains comfortable with the momentum in the drugstore industry and continues to view the exposure favorably given the industry’s attractive demographic tailwinds, non-discretionary nature and continued growth from in-store pharmacy pickup.
Additionally, Walgreens and CVS (the top two drugstore tenants) have generated 15 consecutive quarters of positive same-store pharmacy sales growth.
Most importantly, over 90% of Realty Income’s retail portfolio has service, non-discretionary and/or low price point components. The Non-Retail-focused investments are Fortune 1000, primarily investment-grade rated companies.
The Magic Starts Right Here
All triple-net REITs grow earnings by utilizing spread investing; this simple formula is described as follows:
Cap Rate - Cost of Capital = Spread
By using this example, assume a triple-net REIT acquires standalone buildings at a 7% cap rate, and then, after subtracting the cost of capital (~5%), arrives at a spread (that's the profit margin) of ~2% (or 200 bps).
Over the years, I have been reading many articles on Seeking Alpha and other investing websites, and I'm amazed that most analysts miss the "most important thing" when it comes to net lease investing:
The Low Cost of Capital Advantage.
Let's consider the equity details related to spread investing.
To arrive at the earnings yield, one must divide the P/FFO ratio into 100. For example, a P/FFO of 21x divided by 100 is a 4.7% earnings yield. Since assuming Wall Street charges around 6.5% for equity, the earnings yield after issuance costs is .935 (100% - 6.5% = 93.5%).
So, the Nominal Cost of Equity is arrived at by dividing the 4.7% earnings yield by .935, or 5%.
With a 7% cap rate (on a purchase), the 5% NCE is equal to 2.0%. Thus, on a $100 million investment, there is $2 million in new profits for all shareholders. The same thing at 25x P/FFO equals a 4.27% NCE that translates into around $2.73 million (in profits) on a $100 million acquisition.
So, very simply, the higher the multiple, the lower the costs of capital, and that translates into BIGGER MARGINS.
AFFO yield = Annualized 2017 estimated AFFO ($3.06) divided by $56.67 stock price = 5.39%
Estimated cost of 10-year debt = 3.60%
Nominal Cost of Free Cash Flow = 0%
66% equity = 5.39% * (0.66) = 3.56%
34% debt = 3.60% * (.33) = 1.22%
WACC = 3.56% +1.22% = 4.78%
(In reality, it's actually lower than that, because O uses free cash flow instead of equity. Cash has a 0% nominal cost.)
Realty Income’s investment spreads relative to its weighted average cost of capital remained healthy in the first quarter, averaging 170 bps, which were well above the historical averages. Realty Income defined investment spreads as initial cash yield less the nominal first year weighted average cost of capital.
As illustrated below, the low cost of capital (high equity multiple) is the most important competitive advantage in the net lease industry:
Low cost of capital allows Realty Income to acquire the highest quality assets and leases in the net lease industry:
Realty Income avoids lease structures with above-market rents, which can often inflate initial cap rates:
Assuming identical real estate portfolio, consider two different lease structure scenarios...
Realty Income’s cost of capital advantage drives ability to source, fund, close on accretive M&A deals, like the ARCT transaction that closed in 2013:
Large, diversified portfolio offers capacity to absorb co-mingled portfolio opportunities, like the Inland portfolio that closed in 2014:
Realty Income’s property diversification, cost of capital, and willingness to acquire $250mm+ transactions with diverse property types provides unique growth opportunities in addition to traditional single-asset or retail sale-leaseback pipeline.
The Fortress Balance Sheet
In the first quarter, Realty Income issued approximately $800 million in common equity at an average price to investors of approximately $62 per share (trading at $53.76 now).
Realty Income has the highest credit rating in the net lease sector, the company issued $700 million in fixed rate unsecured debt with a weighted average term of 18.3 years and a yield of 4.1%.
The company’s credit spreads remain among the lowest in the REIT industry and leverage continues to decline with net debt to total market cap of approximately 26% and debt to EBITDA of approximately 5.5x. Realty Income currently has approximately $1.5 billion available on its $2 billion line of credit. This provides ample liquidity and flexibility as the company continues to grow.
The company is rated BBB+ by all three major rating agencies (Moody's, S&P, and Fitch), and is likely to become an A- rated REIT soon. Key metrics include: 93% fixed-rate debt, weighted average rate of 4.15% on debt, staggered maturities (8.1 year on average), and ample liquidity ($1.68 available on revolver (L+90bps) with $120 million (annually) of free cash flow.
O, O, O, It’s Magic
What company would copyright the name, “the monthly dividend company” if they did not intend to generate reliable monthly dividends?
As you can see, Realty Income has had Zero dividend cuts in 22 years as a public company:
The “Magic” of Rising Dividends: Yield on Cost, Dividend Payback long term, yield-oriented investors have been rewarded with consistent income. There are potential benefits to investing long term in a company that regularly increases its dividend. The longer you hold your shares, the higher the yield you will receive on your original investment, assuming dividends increase over time. Additionally, the compounding of reinvested dividends could generate increased investment returns over time.
Investors who have elected to reinvest their dividends have enjoyed the following returns over time (as of 3/31/2017):
Buy, Sell, or Hold?
Keep in mind, Realty Income’s share price (of $72.00) is down considerably over the last 11 months.
The dividend yield has compressed by 230 bps, representing a cushion for investors (Note: I had a “Trim” on shares at $72.00).
Let’s examine Realty Income’s dividend yield, compared with the peers:
Now let’s examine the AFFO Payout Ratio:
Realty Income's Payout Ratio is higher than most peers, but the company does not have considerable office exposure and the quality of the income stream justifies the low 80% ratio. Now let’s examine the P/FFO multiple:
As you see, Realty Income trades at the highest P/FFO multiple in the Net Lease REIT sector, but that does not mean shares are expensive. I would argue that shares are now “soundly” valued and that the premium valuation (relative to the peers) is warranted based on management’s skillful strategy for managing risk. Obviously, I would encourage investors to buy Realty Income if the price drops, but I consider fundamentals sound and I’m maintaining my BUY recommendation.
Although the Amazon/Whole Foods deal was a surprise last week, it should be no surprise that Realty Income has been able to successfully manage risk for more than two decades. The fact that Amazon is betting on brick and mortar serves to validate the argument that real estate is an essential asset class for delivering goods and Realty Income remains in an enviable position to be the dominant Net Lease consolidator.
In conclusion, if I had to buy just one Net Lease REIT, it would be Realty Income... O, O, O, it's magic!
AFFO per Share Forecaster (powered by FAST Graphs):
Author's note: Join me at the DIY Investor Summit where I share detailed tips on my core investment strategies, top advice for DIY investors, and specific ways I'm positioning for the second half of 2017.
Brad Thomas is a Wall Street writer, and that means he is not always right with his predictions or recommendations. That also applies to his grammar. Please excuse any typos, and be assured that he will do his best to correct any errors, if they are overlooked.
Finally, this article is free, and the sole purpose for writing it is to assist with research, while also providing a forum for second-level thinking. If you have not followed him, please take five seconds and click his name above (top of the page).
Sources: FAST Graph and O Investor Presentation.

Argentina’s 100-year bond cannot defy EM playbook forever

If the Fed is proved right on growth and inflation, then EM assets are likely to suffer

by: Jonathan Wheatley

Gauchos: saddle up. Argentina, one of the world’s most notorious serial defaulters, came to market on Monday with a 100-year sovereign bond, and investors snapped it up with all the macho bravado of the legendary horsemen of the pampas.

Really? A dollar-denominated bond that pays back 100 years from now, from a junk-rated country that has barely managed to stay solvent for more than half that time in its entire history as a creditor?

While there is certainly an investment case for taking part, several analysts warn that this issue is a classic sign of a market getting ahead of itself.

The point, though, is not the 100 years. The complexities of bond maths mean that, once maturities go beyond 30 years, the investment case barely changes. Barring default, with a yield of nearly 8 per cent, the bond will repay investors in full in about 12 years, all else (such as inflation) being equal — and that’s leaving aside its resale value. Many investors will have much shorter horizons.
In a world starved of yield, the 7.91 per cent on offer proved to be quite a pull and the bond attracted orders of $9.75bn for the $2.75bn issued. “People are looking out over the next 12 to 24 months and see a pretty positive outlook [for Argentina],” says David Robbins, head of emerging markets at TCW in New York. “Duration in high yield is something they are more comfortable with.” Argentina, he notes, is in effect selling equity in its economic recovery.

With so much else priced to perfection on global markets, this may seem to go with the territory. But others warn that we have been here before.

Sérgio Trigo Paz, head of emerging market fixed income portfolio management at BlackRock, says the rationale and the pricing are all good. But, he adds: “When you put it into perspective, it gives you a sense of déjà vu.”

Argentina’s is not the only noteworthy sale this week. Russia reportedly attracted demand of more than $6bn for 10-year and 30-year eurobonds expected to be priced later on Tuesday at yields of about 4.25 per cent and 5.25 per cent respectively.

This is happening just as the US Federal Reserve has embarked on “quantitative tightening”, raising interest rates last week for the second time this year and preparing markets for an announcement on how it will begin shrinking its supersized balance sheet later in the year.

It is not hard to see parallels between today and 2013, when the Fed announced the approaching end of quantitative easing just as investors were piling with enthusiasm into a series of high-profile eurobond issues by African governments. Some of those went badly wrong as investors fled emerging markets in the subsequent “taper tantrum”.

Investors may feel Argentina is less vulnerable this year to the dangers of “original sin” — issuing debt in dollars that must be serviced from revenues in your own, potentially weakening currency.

Last year’s dollar strength has faded and the peso has weakened against it by only about 1.5 per cent this year.

While a repeat of the taper tantrum is not expected, Mr Trigo Paz is among those warning that we are nevertheless at an inflection point.

He sees two scenarios. In one, the Fed is right about inflation and rates will continue to rise.

This would turn the Argentine bond into “a bad experience”. In the other, markets are right, US inflation and payrolls will disappoint and we will be back in a low rate environment, which will be good for the bonds — until deflation rears its head again, hurting the Argentine economy and its ability to pay.

In the meantime, he says, there is a “Goldilocks” middle ground in which investors can suck up an 8 per cent coupon. Beyond that: “It doesn’t look good either way — which is why you get an inflection point.”

Jim Barrineau, co-head of EM debt at Schroders, agrees. “Issuance like this will be the most volatile when the market cracks,” he says. “You do well until you don’t.”

At bottom, the question is whether the strong flows into EM assets this year, more than $35bn into EM bond funds alone, will continue to cushion investors from upsets down the road. It may be that the sheer quantity of money in search of yield will overpower events.

“You’re getting a ton of inflows, including passive inflows, compression of yields and compression of default risk,” says Mr Barrineau. “And people need to put money to work.”

However, he added: “History shows in EM that this type of environment doesn’t last for ever.

“This is the type of thing that when the tide turns is just poised to underperform. We’d rather pass on issues that appear to be the product of a frothy market.”

Britain’s Deepening Confusión

Robert Skidelsky
. theresa may

LONDON – “Enough is enough,” proclaimed British Prime Minister Theresa May after the terrorist attack on London Bridge. Now, it is clear, almost half of those who voted in the United Kingdom’s general election on June 8 have had enough of May, whose Conservative majority was wiped out at the polls, producing a hung parliament (with no majority for any party).

Whether it is “enough immigrants” or “enough austerity,” Britain’s voters certainly have had enough of a lot.
But the election has left Britain confusingly split. Last year’s Brexit referendum on European Union membership suggested a Leave-Remain divide, with the Brexiteers narrowly ahead. This year’s general election superimposed on this a more traditional left-right split, with a resurgent Labour Party capitalizing on voter discontent with Conservative budget cuts.
To see the resulting political terrain, imagine a two-by-two table, with the four quadrants occupied by Remainers and Budget Cutters; Remainers and Economic Expansionists; Brexiteers and Budget Cutters; and Brexiteers and Economic Expansionists. The four quadrants don’t add up to coherent halves, so it’s not possible to make out what voters thought they were voting for.
But it is possible to make out what voters were rejecting. There are two certain casualties. The first is austerity, which even the Conservatives have signaled they will abandon. Cutting public spending to balance the budget was based on the wrong theory and has failed in practice. The most telling indicator was the inability of George Osborne, Chancellor of the Exchequer from 2010 to 2016, to achieve any of his budget targets. The deficit was to have vanished by 2015, then by 2017, then by 2020-2021. Now, no government will commit to any date at all.
The targets were based on the idea that a “credible” deficit-reduction program would create sufficient business confidence to overcome the depressing effects on activity of the cuts themselves. Some say the targets were never credible enough. The truth is that they never could be: the deficit cannot come down unless the economy grows, and budget cuts, real and anticipated, hinder growth. The consensus now is that austerity delayed recovery for almost three years, depressing real earnings and leaving key public services like local government, health care, and education palpably damaged.
So expect the ridiculous obsession with balancing the budget to be scrapped. From now on, the deficit will be left to adjust to the state of the economy.
The second casualty is unrestricted immigration from the EU. The Brexiteers’ demand to “control our borders” was directed against the uncontrolled influx of economic migrants from Eastern Europe. This demand will have to be met in some way.
Migration within Europe was negligible when the EU was mainly West European. This changed when the EU began incorporating the low-wage ex-communist countries. The ensuing migration eased labor shortages in host countries like the UK and Germany, and increased the earnings of the migrants themselves. But such benefits do not apply to unrestricted migration.
Studies by Harvard University’s George J. Borjas and others suggest that net immigration lowers the wages of competing domestic labor. Borjas’s most famous study shows the depressive impact of “Marielitos” – Cubans who immigrated en masse to Miami in 1980 – on domestic working-class wages.
These fears have long underpinned sovereign states’ insistence on the right to control immigration. The case for control is strengthened when host countries have a labor surplus, as has been true of much of Western Europe since the crisis of 2008. Support for Brexit is essentially a demand for the restoration of sovereignty over the UK’s borders.
The crux of the issue is political legitimacy. Until modern times, markets were largely local, and heavily protected against outsiders, even from neighboring towns. National markets were achieved only with the advent of modern states. But the completely unrestricted movement of goods, capital, and labor within sovereign states became possible only when two conditions were met: the growth of national identity and the emergence of national authorities able to provide security in the face of adversity.
The European Union fulfills neither condition. Its peoples are citizens of their nation-states first. And the contract between citizens and states on which national economies depend cannot be reproduced at the European level, because there is no European state with which to conclude the deal. The EU’s insistence on free movement of labor as a condition of membership of a non-state is premature, at best. It will need to be qualified, not just as part of the UK’s Brexit deal, but for the whole of the EU.
So how will the shambolic results of the British general election play out? May will not last long as Prime Minister. Osborne has called her a “dead woman walking” (of course without acknowledging that his austerity policies helped to seal her demise).
The most sensible outcome is currently a political non-starter: a Conservative-Labour coalition government, with (say) Boris Johnson as Prime Minister and Jeremy Corbyn as his deputy.

The government would adopt a two-year program consisting of only two items: the conclusion of a “soft” Brexit deal with the EU and a big public investment program in housing, infrastructure, and green energy.
The rationale for the investment program is that a rising tide will lift all boats. And an added benefit of a thriving economy will be lower hostility to immigration, making it easier for Britain to negotiate sensible regulation of migrant flows.
And who knows: if the negotiations force the EU to re-cast its own commitment to free labor movement, Brexit may turn out to be a matter less of British exit than of an overhaul of the terms of European membership.

 Is Amazon/Whole Foods This Cycle’s AOL/Time Warner – A Sign That The Party’s Over?  

Towards the end of the 1990s tech stock bubble, “new media” – i.e., the Internet — was ascendant and old media like magazines, newspapers and broadcast TV were yesterday’s news.

This was reflected in relative stock valuations, which gave Internet pioneer AOL the ability to buy venerable media giant Time Warner for what looked (accurately in retrospect) like an insane amount of money.

Now fast forward to 2017. Online retailing is crushing bricks-and-mortar, giving Amazon all the high-powered stock it needs to do whatever it wants. And what does it want? Apparently to run grocery stores and pharmacies via the acquisition of Whole Foods, the iconic upscale-healthy food chain.

The two deals’ similarities are striking, but before considering them here’s a quick AOL/Time Warner post-mortem:

15 years later, lessons from the failed AOL-Time Warner merger
(Fortune) – The landscape of mergers and acquisitions is littered with business flops, some catastrophic, highly visible disasters that were often hugely hyped before their eventual doom. Today marks the 15th anniversary of one such calamity when media giants AOL and Time Warner combined their businesses in what is usually described as the worst merger of all time. But what happened then will happen again, and ironically for the exact same reasons. 
A lot of people thought that the merger was a brilliant move and worried that their own companies would be left behind. At the time, the dot-coms could do no wrong, and AOL (AOL) was at the head of the pack as the ‘dominant’ player. Its sky-high stock market valuation, bid up by investors looking for a windfall, made the young company more valuable in market cap terms than many blue chips. Then CEO Steve Case was already shopping around before the Time Warner opportunity came up. 
On the other side, Time Warner anxiously tried, and failed, to establish an online presence before the merger. And here, in one fell swoop, was a solution. The strategy sounded compelling. Time Warner (TWC), via AOL, would now have a footprint of tens of millions of new subscribers. AOL, in turn, would benefit from access to Time Warner’s cable network as well as to the content, adding its layer of so-called ‘user friendly’ interfaces on top of the pipes. The whole thing was “transformative” (a word that gets really old really fast when reading about this period). Had these initial assumptions been borne out, we might be talking today about what a visionary deal it was. 
Merging the cultures of the combined companies was problematic from the get go. Certainly the lawyers and professionals involved with the merger did the conventional due diligence on the numbers. What also needed to happen, and evidently didn’t, was due diligence on the culture. The aggressive and, many said, arrogant AOL people “horrified” the more staid and corporate Time Warner side. Cooperation and promised synergies failed to materialize as mutual disrespect came to color their relationships. 

A few scant months after the deal closed, the dot com bubble burst and the economy went into recession. Advertising dollars evaporated, and AOL was forced to take a goodwill write-off of nearly $99 billion in 2002, an astonishing sum that shook even the business-hardened writers of the Wall Street Journal. AOL was also losing subscribers and subscription revenue. The total value of AOL stock subsequently went from $226 billion to about $20 billion.

Now back to Amazon/Whole Foods. Amazon is going to apply its advanced technology – online ordering, fast delivery, drones, autonomous cars, whatever – to the quintessentially meatspace business of selling groceries. And it’s paying $13 billion to find out if this is a good idea.

Whether it is or isn’t is less important than what this type of M&A says about the mindset of a given cycle’s favored companies. When undreamed-of amounts of money start pouring in (as with the dot-coms of old and today’s Big Tech) it changes the perception of risk. $13 billion is a terrifying amount of money to bet on a new and untested idea – except in the context of a near-trillion dollar market cap, where it seems downright modest.

When the next bear market hits, though, that kind of money might seem a bit hubristic.

As with so many other extraordinary recent market events (record-high stock prices combined with record-low volatility, negative yields on government bonds, soaring debt/GDP combined with falling inflation), Amazon/Whole Foods might or might not be the bell that rings at the top. But when the history of this time is written, there’s a good chance that it will be somewhere on the list.

Mad Hawk Disease Strikes Federal Reserve

“A serious writer may be a hawk or a buzzard or even a popinjay, but a solemn writer is always a bloody owl.”

– Ernest Hemingway

Image: Magalle L’Abbe via Flickr


Longtime readers know I am not the Federal Reserve’s #1 fan. I can’t recall ever resting easy, confident that the Fed was ably looking out for our economy and banking system. However, I have experienced varying degrees of skepticism and distrust. I must also acknowledge that we are all still here despite the Fed’s many mistakes.

Once or twice a year the Fed rekindles my frustration and concern with a particularly boneheaded statement or policy change. Last summer, the Fed’s annual Jackson Hole Economic Policy Symposium outraged and saddened me at the same time – which, given my emotional makeup, is quite an accomplishment. I shared my rage with readers in “Monetary Mountain Madness.” Feel free to read it again if you enjoy a good rant. I would have been even more depressed if I had known that one of the academic presenters there, Marvin Goodfriend of Carnegie Mellon University, an unabashed cheerleader for NIRP, would appear on the short list of candidates for Donald Trump’s first two appointments to the Fed.

Goodfriend is nominally a monetarist, but he doesn’t quack or waddle like any monetarist I know. The session that he presented was entitled “Negative Nominal Interest Rates.” In the first paragraph of the first section of his paper, he says that “[M]y current paper makes the case for unencumbering interest rate policy so that negative nominal interest rates can be made freely available and fully effective as a realistic policy option in a future crisis.”

So the first appointment to the Fed that Donald Trump will reportedly make is an unabashed advocate of negative interest rates as a policy option. It doesn’t sound like Trump wants a Fed that is modeled on the far more disciplined principles of a Richard Fisher or a Kevin Warsh.

While my rant last summer was about the Fed’s apparent willingness to embrace negative rates, we now face the opposite risk. Janet Yellen & Co. are asserting that inflation is such a serious threat that they must tighten policy with a two-pronged approach. They are already raising the federal funds rate and will soon begin reducing the massive bond portfolio accumulated in the QE years.

I don’t think these moves will create a crisis on their own. Rather, I think the mentality that they reveal may lead to much bigger mistakes when the next recession arrives.

The mistakes may already be unfolding.

Here’s my key question: Is the Fed really as “data-dependent” as Yellen and others say, or do other factors influence them? I think the latter. You’ll see the other factors in a little bit.

Inflation Fail

That the previously dovish Janet Yellen took the Fed chair when she did is almost comedic. Ben Bernanke had uttered that word taper in 2013, signaling that quantitative easing’s days were numbered. No one knew how the Fed would extricate itself from years of QE and near-zero rates. But, to her credit, Yellen accepted the challenge in late 2013.

Having tapered the Fed’s bond buying down to zero (except for reinvestment of dividends and maturity rollovers) and begun the rate-hike cycle, Yellen has accomplished a few things; but normalizing interest rates under a Democratic president was not one of them.

Another objective Yellen hasn’t been able to achieve is to create enough inflation. Yes, you read that right. It is part of the Federal Reserve’s job to keep inflation at an acceptable level, which it defines as 2%. This mandate is articulated in the Federal Open Market Committee’s “Statement on Longer-Run Goals and Monetary Policy Strategy.” The boldface is mine.

The inflation rate over the longer run is primarily determined by monetary policy, and hence the Committee has the ability to specify a longer-run goal for inflation. The Committee reaffirms its judgment that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve’s statutory mandate.

The Fed itself says monetary policy determines the inflation rate. The Fed determines monetary policy, so inflation (or lack thereof) falls squarely in their laps.

That is actually quite a startling statement, if you think about it. The Fed doesn’t just regulate inflation; the Fed causes inflation, not as a side effect of something else but because they think it is desirable. And they admit doing so, right in their own documents.

 But wait, there’s more.

The Committee would be concerned if inflation were running persistently above or below this objective.

PCE inflation has lagged persistently below 2% for years now. The Committee reminds us at every meeting that it is, in fact, concerned about this. But its concern has not stopped it from plowing ahead with policies that produce everything but inflation.

Personally, I think low inflation is preferable to high. It preserves the purchasing power of our currency. The point here is that, by its own self-imposed goals and definitions, the Fed has failed to accomplish a key part of its mission. It wants 2% inflation. It says its policies can create inflation, but those policies haven’t. This is failure by any definition of the word.

Let me comment on the section that I bolded above: “The inflation rate over the longer run is primarily determined by monetary policy….”

Really? If inflation or deflation is primarily determined by monetary policy, why is there no inflation in Japan today, and why hasn’t there been for 25 years? With the most massive quantitative easing and extraordinarily low interest rates ever seen, Japan has been trying as hard as it can to create inflation; but Japan has been pushing on a string, and I think some of the same conditions (demographic and market) that have foiled Japan are beginning to apply in the US and Europe. And I suspect the Fed’s efforts will be as futile as the Bank of Japan’s have been.

When a person or an organization fails – and of course we all do – the best response is to show some humility, identify the problem, and modify the strategy. The Fed is doing the opposite.

Ignoring the Market

FOMC members customarily enter a “quiet period” before each policy meeting. That means we get a heavy dose of speeches and interviews the week after they meet. Last week was that week, and it kicked off with New York Fed President William Dudley.

Speaking at a Business Roundtable event, Dudley reportedly expressed great confidence in both the economy and the Fed’s policy moves. (I’m relying on press reports here because the NY Fed did not release Dudley’s prepared remarks, if he had any.)

The Financial Times’ account captured it best:

Despite some jitters among investors, Mr Dudley reckons continued progress in the jobs market will push wages higher at a more rapid clip, something that would be expected to boost inflation closer to the Fed’s targets.

The policymaker added that stopping rate increases at this point could be dangerous for the economy. His stance echoes that of other senior central bankers who worry that with the jobless rate near levels seen as natural in a properly functioning economy, there is a rising risk of inflation overshoots.

I see zero indication that Dudley is even slightly concerned about the Fed’s overshooting with its rate hikes. However, he is supremely confident that inflation will overshoot if the Fed doesn’t tighten policy. Perhaps more disturbing, a MarketWatch story says that Dudley remarked that he “is not paying much attention to signals of concern from the bond market.”

Read that again. If someone has his exact quote, I’d love to see it, because this is astonishing. The NY Fed’s president is a permanent FOMC member precisely because he is closest to the bond market and is responsible for executing the Fed’s trades. Yet by his own admission he is ignoring the market’s concerns.

Could that be because Dudley doesn’t like the markets’ message? Futures prices show that traders do not believe the Fed will raise rates as aggressively as the FOMC’s dot plots say it will. That’s kind of an important signal. Dudley’s job is to listen to it. If he’s not listening, why not?

I have a theory.

Great Fed Rotation

All this is happening as the Fed is on the cusp of drastic change.

The Federal Reserve System has a seven-member Board of Governors. Three of those seven seats are currently vacant. President Trump has not nominated anyone yet, although two names have been floated in the press (including NIRP lover Goodfriend). Even if Trump were to nominate them tomorrow, they would still have to go through Senate confirmation, and the Senators have a lot on their plates.

Meanwhile, Janet Yellen’s term in the chair expires on February 8, 2018, and Vice-Chair Stanley Fischer’s term ends in June 2018. Their board terms are separate, so both could theoretically remain governors after their leadership terms expire, but most observers expect them to retire. Their staying would not be without precedent (I think there was one exception), but it certainly would be an eye-opener. So, if things go as expected, Trump will have two more seats to fill.

So, we are potentially one year away from a Board of Governors with at least five of the seven being Trump appointees. And it seems highly likely that Lael Brainard will not stick around much longer after Yellen leaves, and then the only question remaining is whether Jerome Powell steps down. I know nothing of his plans, but it could happen. Is his ideal career move to remain on the FOMC as the odd man out?

The seven Fed governors – when there are that many – all sit on the Federal Open Market Committee, which sets interest rates and makes other monetary policy. Also voting on the FOMC are the New York Fed’s president and a rotating cast of four other regional Fed presidents.

President Trump does not appoint the regional Fed bank presidents. They answer to their own boards, which comprise bankers from their regions. So the FOMC has both political appointees and commercial bank representatives. It was set up that way on purpose. But it’s also no accident that the political appointees constitute a majority – or will when more Trump appointees take their seats.

The FOMC works by consensus. Most of its decisions are unanimous or almost unanimous. Fed chairs strive mightily to get everyone on the same page, which I’m sure is tough, on the level of herding cats or getting Republicans in the House to agree. It’s also important – banks and private businesses want to see stability.

Enter Donald Trump, for whom stability is a lesser priority.

The FOMC members must see what is coming. Their beloved unity is in danger, and I doubt they are pleased. I believe a faction on the FOMC wants to cement its own preferred policies in place and make it difficult or impossible for a new majority to change course in 2018 or thereafter. Yellen, Fischer, and Dudley all seem to be of that mind, and they are now taking a hawkish approach to monetary policy. That’s why they don’t want to do the otherwise sensible thing, which is to wait for more evidence that inflation is a problem before tightening further, especially so late in the recovery cycle.

Note also that Yellen and Fischer can further complicate the situation by staying on the board next year. Yellen won’t be chair unless Trump reappoints her, but her board term runs through 2024. Fischer is likewise on the board until 2020.

Can Trump fire Fed governors, like he did the FBI director? Maybe. The Federal Reserve Act says governors can be “removed for cause by the president.” He could certainly find cause if he wished to do so. But firing Fed governors would send a horrible signal to markets. Far better to give them incentives to resign, which could be done quietly. And frankly, I think those around him would let him know that firing would be a really bad idea. Just not done. Independence of the Fed and all that…

In any case, right now we have a Fed that is arguably letting its own parochial political concerns seep into its policy decisions. By raising rates when inflation is nowhere near problematic, they risk tipping the economy into recession. We’re overdue for a recession anyway, and I get that they want to have room to cut rates if necessary. But that will be cold comfort if their own actions trigger the recession. But it even goes further than that…

Bitter Enemies

Division on the FOMC is a microcosm of a much broader problem: the increasingly bitter division within American society. I know many people blame the split on Donald Trump, but it was already well underway before he ran for office. I think Trump is a symptom, not a cause.

The survey data is stark and horrifying. This is from a June 15 New York Times story titled “How We Became Bitter Political Enemies.”

“If you go back to the days of the Civil War, one can find cases in American political history where there was far more rancor and violence,” said Shanto Iyengar, a Stanford political scientist. “But in the modern era, there are no ‘ifs’ and ‘buts’ – partisan animus is at an all-time high.”

Mr. Iyengar doesn’t mean that the typical Democratic or Republican voter has adopted more extreme ideological views (although it is the case that elected officials in Congress have moved further apart). Rather, Democrats and Republicans truly think worse of each other, a trend that isn’t really about policy preferences. Members of the two parties are more likely today to describe each other unfavorably, as selfish, as threats to the nation, even as unsuitable marriage material.

This isn’t just party loyalty. A sizable majority of Americans of both parties now see the other political party as not just mistaken, but as close-minded, immoral, and dangerous, clueless on policy and the correct way to run the country. Again, that’s on both sides. The animus is also clearly visible in the disdain that party elites feel for the members of their own party – no matter what they say when they’re up at the podium.

The current split is even wider than what we think of as more divisive issues like race or gender identification. Regardless of which side you are on, this ought to be terrifying. How can we ever come to a national consensus on crucial issues when this is the underlying environment? More from the NYT story:

Mr. Iyengar also points out that Americans are willing to impugn members of the other party in ways that aren’t publicly acceptable with other groups, like minorities, women or gays. There simply aren’t strong social norms holding partisans back.

This is a terrible state of affairs, and I see no good way out of it. It’s going to manifest itself in many ways, in every institution and corner of society; and in many cases it already has – including at the Federal Reserve. That means it is affecting the economy.

Let me be clear: I am not trying to convert anyone to my own side of the aisle or assert that my side is morally superior. This is a bipartisan problem with plenty of blame to go around. Pretending it doesn’t exist helps no one. I write this because I must hold out hope that we can somehow restore a civic space where we can have adult conversations and somehow recover our lost national unity.

Like it or not, politics is not separate from our private and business lives. It has real-world consequences that affect everyone’s well-being.

And that brings me back to the Fed and their current actions. The following is speculation on my part and will be vigorously denied by anyone associated with the Fed.

I think there is a mixture of political bias and legacy-building that is driving Federal Reserve policy.

The simple fact of the matter is that the Fed should have been normalizing interest rates starting in 2013. Fifty basis points a year and we would be at 2% now. That is not exactly a torrid rate-hike path. It cannot be seen as putting your foot on the brakes; it’s simply moving to normalize a situation that everybody realizes is abnormal. I think that everyone on the FOMC recognizes that rates do have to be normalized, and they don’t want to leave the Committee with rates sub-1% as their legacy.

But when these governors walk into an FOMC meeting, try as they might, they can’t leave their biases in the anteroom. It’s a simple fact that for four years during a Democratic administration they basically refused to raise rates. They said their actions were data-dependent and that the data was telling them it was too early to tighten. Then Donald Trump gets elected, and all of a sudden the data is telling them it’s time to raise rates.

After they have blown a series of bubbles with their low rates, in housing, stocks, all sorts of debt instruments, the automobile market, markets of all sorts, now somehow the data is different, and we have to raise rates.

No two ways about it: There is no significant difference in the data today from that of four years ago – except that four years ago we didn’t have all the bubbles I ticked off above. And we are already late in the cycle. And – the elephant in the room – we now have a Republican president. Who is not going to reappoint these governors.

Let’s look at the data. Unemployment was low four years ago, and it is lower now. The Fed keeps talking about wage inflation, but there is no evidence of it. Further, the Fed’s models are backward-looking and based on historical economic trends and patterns that no longer exist.

In a future letter I’m going to write in depth about the difference between the service class and the working class. The working class generally makes stuff, working at trades and manufacturing jobs. The service class works in the retail sector, in stores and restaurants, and represeents the bulk of the country’s employees. The skill sets are entirely different. There may be in fact some wage pressure in the working class due to a lack of qualified and trained employees (welders, carpenters, and other craftsmen), but that is not the case for the service class. (There are indeed other classes of workers who are more information-oriented or who are professionals. But that is for another letter.)

When Sears goes bankrupt the next time, up to 160,000 people will be joining the unemployment rolls and looking for other service jobs. Ditto for all the other retail jobs that Amazon is gobbling up. There will be millions of such workers in the service industry looking to find jobs – not exactly the stuff that wage inflation in the service job market is made of.

According to a Merrill Lynch study, auto production is going to drop from the projected 17.9 million for this year to 13.8 million in 2021, due to lease roll-offs and other pressures. That dramatic dip in production is going to make a huge dent in the need for workers in the working class. This is not the stuff of wage-pressure-induced inflation.

Subprime auto loan defaults are rising, as are student loan defaults. There are signs everywhere that we are much closer to the end of this business cycle than we were in 2012. There are so many data points that seem to be rolling over. We are not at the end yet, but we’re a lot closer.

The FOMC members are now coming to the realization that leaving the Committee without normalizing rates is going to be disastrous for their legacy, whatever that is. And so they are embarked on a tightening cycle. And they no longer have to worry about creating a recession during a Democratic administration. How convenient. Although they would aggressively deny that any such thing would be ever part of their decision-making process.

And intellectually, I think they are being totally honest. But our emotional biases are not part of our intellectual makeup: This fact of life is basically behavioral psychology 101. Our biases cause us to look at situations (and economic data) in ways that are not always entirely rational. Overcoming our own personal biases is one of the single most difficult things humans can do. So I am not really criticizing the members of the FOMC; I’m just making some observations and freely admitting that I am chief among sinners when it comes to allowing biases to influence thinking.

As David Rosenberg has pointed out, Fed tightening cycles always end with a US market crash or an emerging-market crash or both (but usually just a US market crash). The Fed keeps tightening until we get an unpleasant event.

You really can’t ignore the fact that the FOMC is telling you they are going to raise rates at least once more this year. I know that the two-year bond doesn’t believe that, but I think you need to take it very, very seriously. And I would bet on a January rate hike, in the last month of Yellen’s chairmanship. Doesn’t quite get us to 2% rates but… close enough for government work.

They are hoping that by raising rates slowly they won’t push the economy into a slowdown before they can abandon ship. Then the next chairman and the Fed can deal with it.

One last thought: I want to reiterate that the potential appointment of Marvin Goodfriend is disturbing to me. I’m sure he’s a good guy and a brilliant economist; but it all boils down to this: If you can wrap your head around negative interest rates, I don’t want you anywhere near the policy steering wheel.

If the Goodfriend choice is part of a trend and Mnuchin or whoever is advising the president on these choices, that suggests to me that the Trump team is not looking to appoint a hawkish, less activist FOMC. That means we are not going to get a Kevin Warsh or a Richard Fisher as chairman. We’re certainly not going to get a Volcker. I truly, deeply, sincerely hope I am wrong. I hope I have to eat those words.

Thinking the unthinkable: Could we see a return to QE before the end of Trump’s first term? It’s way too early to tell, and maybe somebody will get with the president and discuss the dynamics of Federal Reserve policy and the problems of quantitative easing and NIRP or zero boundary rates. A recent Princeton study (pointed out to me by Lyric Hughes Hale) suggests that when rates fall below 2% there is no real stimulative value and, in fact, rates that low hurt the economy.

We need a new mindset at the Fed. If we don’t not change the underlying philosophical posture that 12 people can sit around a table and set the price of the most important item in the world, money, and do that better than the market can, we will continue to flounder. If, after all the new appointments, we still end up with an activist FOMC that believes in its own models, which have been preposterously wrong for 30 years and that will continue to blow a series of bubbles in all markets, which will eventually crash, then we are destined to a wash, rinse, and repeat series of financial crises.

This Fed has already engineered the next crisis, just as Greenspan kept rates too low for too long, ignored his regulatory responsibility, and engineered the housing bubble and subprime crisis. If you can’t see this next crisis coming, you’re not paying the right kind of attention. The Trump Fed is going to have to deal with that crisis, but we still have many questions as to what a Trump Fed will actually look like or do.

But make no mistake, whomever Trump puts on the FOMC, it will be an FOMC that he will have to take full ownership of, no matter what they do. Very few other presidents have ever had the opportunity to reshape the FOMC as completely as Trump will do.

And make no mistake, if we plunge into a recession and the market drops 50%, ardent pleas will issue from all points of the world to give us more quantitative easing. Just give us one more fix, the market will beg. “This time we promise not to get too irrationally exuberant again. Just give us a few more rounds of even more massive QE….”

With each passing quarter, the Great Reset is coming nearer. You need to think hard about how you’re positioned in the markets and in your own personal life and businesses, in order to weather the crisis that’s coming as skillfully as posible.
Getting Married on St. Thomas, Omaha, San Francisco, and Freedom Fest in Las Vegas

Shane and I are leaving today for St. Thomas in the US Virgin Islands and will be married on some beautiful beach on June 26, her birthday. Then I actually intend to relax for a week, enjoying time with my new bride and reading books with no redeeming social value (also known as science fiction/fantasy). I will begin final writing on my new book when I come back. I am finally really ready to attack the topic of what the world will look like in 20 years.

I have a quick trip to Omaha in the middle of June; then I’ll head directly on to San Francisco and Palo Alto for speaking engagements (and have dinner with my good friends Andy Kessler and Rich Karlgaard). I will be speaking the next day, Thursday July 13, in San Francisco at the S&P Dow Jones Indexing Conference at the Omni Hotel from 12 till 4. Here’s a PDF of the agenda. If you are an advisor or broker, you can attend for free. I look forward to meeting you there.

Afterward, I’ll come home to Dallas, recover for a few days, and then fly with Shane to Las Vegas for the Freedom Fest. It has become one of the largest libertarian gatherings in the world, and I have so many good friends who go that it’s really a lot of fun for me. And while I am not much of a gambler (as in I suck at it and hate losing money to people who are much richer than I am), I really do like the shows. And dinners with friends.

That covers July, and August is, of course, the annual Maine fishing trip; but right now the rest of August looks to be pretty wide open. If I can figure it out, I may go somewhere that has a much cooler climate than Texas does in August and relax and write.

It’s time to hit the send button – the driver will be here in a few minutes. I’ve been officially informed that calories do not count on St. Thomas and that if you’re on your honeymoon they are actually negative. I’m going to test that theory. Personally, I think it’s about as reliable as Fed models are; but like the Fed, sometimes you do something just because you have a theory about how the world works and the theory makes you feel good. I think I see a serious diet in July…

(Update: Flights have been delayed, so we will be getting into St. Thomas a day late. Extra time in airports is so much fun. And now they are talking about rain on Monday. But I confidently predict that the sun will come out when we get married.)

Your out of here analyst,

John Mauldin