What Could Go Wrong?

By John Mauldin


“Experience is simply the name we give our mistakes.”

– Oscar Wilde

“Mistakes are the usual bridge between inexperience and wisdom.”

– Phyllis Theroux

“Economists are often asked to predict what the economy is going to do. But economic predictions require predicting what politicians are going to do – and nothing is more unpredictable.”

– Thomas Sowell
We’ve reached that wonderful time of year when financial pundits pull out their forecaster hats and take a crack at the future. This time the exercise is particularly interesting because we’re at several turning points. Any one of them could remake the entire year overnight. I should probably say up front that I am actually somewhat optimistic about 2017 – optimistic, meaning I think we Muddle Through – but that’s a lot better outcome than I was expecting five months ago. And since my annual forecast has been “Muddle Through” for about six years now (which has been turned out to be the correct forecast), then, given all the speed bumps in front of us, this could be the year where I’m spectacularly wrong. Midcourse corrections may be warranted.

I’ll have my own specific predictions later this month, along with a review of others that I find instructive. Today’s letter, though, will preface that discussion. Instead of trying to answer questions about the future, I’ll try to list those we should be asking as 2017 opens.
These are the things that I sit and meditate about when I consider the future of economics, markets, and investing. Today’s economy is something like an old-fashioned Swiss watch.  
It’s a thing of beauty when all those delicate little gears mesh just right. If you ever take the time to actually study the inner workings of the marvelous manifestations of human ingenuity that keep us all alive, it is difficult not to come away awestruck by the ability of the human mind to craft such complexity. But if any of the gears get just a little out of whack, the entire contraption can grind to a halt.

Now, if your watch stops working, it isn’t the end of the world. You can know roughly what time it is just by looking out the window. The global economy is another matter – we can’t afford for any of its major components to break down; so it’s smart to ask, “Where are the weak points.” That’s what we’ll do today: We’ll poke at the economic mechanism as it grinds along here on New Year’s Eve 2017; then I’ll get more specific in my forecast issue.

Before we begin, let me briefly mention that our most exclusive service of all, the Mauldin Alpha Society, is currently open to new members.

Now, let’s look under the hood at 2017.
Trumping DC
The biggest change will happen in Washington when Donald Trump takes office. Aside from the changes he can make on his own authority, he’ll be in position to approve the many Republican initiatives that President Obama blocked. Here are some items I’m watching.

Tax Reform: Our monstrosity of a tax system needs major reconstruction. I’ve described what I think would be ideal: a reduction and simplification of corporate taxes, a significant reduction of the individual income tax, and replacement of the Social Security tax with a VAT-like consumption tax. What will come out of the House is still unknown. If you look at House Ways and Means Chairman Kevin Brady’s bill, he uses the word tariffs, but his proposal looks suspiciously similar to the VAT that I’m suggesting, except that Republicans aren’t allowed to say “VAT” saying “I’m against it” in the same sentence. Or at least they couldn’t until both Rand Paul and Ted Cruz basically suggested a VAT. I will admit to discussing the topic with both of them, but their versions are an amalgam of ideas.

My sources are telling me House members want to pass an initial tax cut quickly and defer the more complicated changes for later in the year. The easy initial tax cut is to remove the Obamacare tax when they repeal Obamacare (the Affordable Care Act), which it appears they will do early in the session. It won’t be an immediate repeal but rather a slow, orderly retreat. But getting agreement on a replacement system is going to be contentious. The problem is the Medicare taxes don’t kick in until about $250,000 of income.

While the tax outcome could be nice for some of us, I’m afraid of the political perception problem if the first tax cuts go mainly to high-income taxpayers. Democrats will cry foul and try to force a split between the GOP’s business wing and its new populist elements. More to the point, a tax cut for the wealthy won’t stimulate the economy enough.

So I very much hope the first tax cuts either target middle- and low-income taxpayers or at least somehow encourage beneficiaries to reinvest their tax savings back into the economy. Lack of capital is not our problem; we need to stimulate demand – and tax policy can help.

Final thoughts on taxes: What Kevin Brady is saying basically sounds good, as he acknowledges that some industries will suffer massive impacts if you slap tariffs on incoming goods. Further, putting a high tariff on products that are sold at Walmart and Costco and on Amazon is massively inflationary to those shoppers (and that’s most of us).
Look at the immediate and one-time negative effect on inflation in Japan when they increased their sales tax a few years ago. These policies can be tricky, and the consequences can have a big impact on consumer confidence.

You have to be very careful about applying tariffs to raw commodities that we need as inputs to our own manufacturing but that we can’t produce in sufficient quantities here at home. We don’t want our manufacturers to be hamstrung because we load them up with increased costs for their input materials, like iron ore, heavy crude, or rare earths. Those materials are in a different category than processed goods. Like I said, it’s tricky. Changes as massive as the ones being contemplated simply cannot be good for everybody. Somebody’s ox is going to get gored.

If I have one suggestion, it would be to implement the large changes over three or four years and let businesses adjust.

Energy: The Obama administration’s heavy-handed environmental regulations are a major impediment to US energy independence. Trump can change many of them quickly, because they came in the form of executive orders and rulemaking that doesn’t require congressional approval. I’ll be watching to see if the new administration approves more natural gas export terminals and pipelines, which will both create jobs and help reduce the trade deficit.

Trump can also approve some of the Arctic and offshore drilling projects that Obama would not consider. I am told that there are some $50 billion worth of oil-production projects that are ready to go, which would be a massive source of high-paying jobs.

If he wants to play hardball with OPEC, Trump could even impose a tariff on imported petroleum products that we can produce here (as opposed to the raw crude, especially heavy crudes, that we currently don’t produce). That would give domestic producers and refiners a further boost. It would also aggravate the rest of the world’s oil glut.

Sidebar: I read this week from a reliable source that in 2017 it will be 20% cheaper than it was in 2016 to drill the same well in West Texas. I keep telling you that oil production is now a technology business. I’m going to do a special letter on that subject at some point, because it is difficult to grasp just how much big data and new drilling technologies have impacted the business. It is not impossible to envision a future in which, not that many years from now, a $30 a barrel oil well will be considered profitable, especially if you can capture the attendant natural gas and ship it around the world.

With the continued improvement in vehicle gas mileage and the overall reduction in the use of oil in the US (which is an ongoing trend), energy independence is no longer a pipe dream.

Economic stimulus: The bond-financed infrastructure program I’ve advocated doesn’t seem to be on anyone’s radar, unfortunately. What I hear is mainly a tax-credit privatization program. I suppose that would help, but it won’t accomplish the same goals.
And it will necessarily be smaller in scope.

We have plenty of shovel-ready projects, or could create them in short order, that would create jobs and simplify trade and travel. Some will not be very profitable in the short run, so they may not happen under a tax-credit scheme. Investors will want to finance toll roads and the like – projects that will generate predictable cash flows.

Trade: Import-dependent businesses are on pins and needles right now, hoping the Trump administration doesn’t turn toward the kind of protectionism some of the new appointees have advocated in the past. We’ll see. The president has considerable latitude in this area, so almost anything is posible.

China is the main point of contention. We already see Trump trying to use Taiwan as a bargaining chip. Beijing isn’t at all happy about that, but their options are limited. I feel sure we will see some kind of new US-China trade arrangement, but I really don’t know what to expect. The stakes here are enormous, so the situation bears close watching.

The appointment of Peter Navarro to oversee American trade and industrial policy has made more than a few of us a little nervous. I simply do not agree with his analysis of the impact of imports on GDP. I think it would make a lot of us on the free/fair trade side of the fence a lot more comfortable if somebody like Larry Kudlow is appointed chairman of the Council of Economic Advisors. He has been rumored for the job for about three weeks, but Trump has not pulled the trigger. (I know, I know, Larry does not have a PhD. But he is more than qualified. But if not him then somebody who has the same views, as a balance to Navarro.)

For the record, I explicitly agree with Stephen Mnuchin, who says he prefers to do bilateral rather than regional trade agreements. Trump should appoint 25 trade specialists and assign them to different countries and put them on planes within a few weeks of his inauguration. Trying to get agreement from 14 to 20 countries that all have competing interests makes any trade document so unwieldy that it ends up looking more like managed trade than free trade or fair trade. Not every country will want to get involved, but I’ll bet you a lot will.

Obama threatened the United Kingdom that if it left the EU it would fall to the back of the line as far as US is concerned in trade deals. Trump and Mnuchin say the UK will always be at the front of the line. Negotiations on a new trade agreement should start now so that it can be ready to sign as soon as possible.

Banking: One reason the stock market has gone bananas since the election is the prospect of banking deregulation. Wall Street has been chafing under the Dodd-Frank Act’s requirements and restrictions. The Volcker Rule on proprietary trading has clearly worsened bond market liquidity and taken a major revenue center away from the banks. I am not so worried about the revenue source, but there will always be another crisis in the future. Right now, liquidity in the bond markets can dry up in a Wall Street second – much faster than it would have done in the past. The banks really did provide liquidity, which is a useful item (as opposed to high-speed trading, which should be reined in as soon as possible).

Worse, the Dodd-Frank Act as presently constructed could actually aggravate matters if we find ourselves in another financial crisis. Dodd-Frank prevents the Federal Reserve from stepping in with liquidity and instead says that the FDIC should “resolve” any failing banks. I see the point, but the main reason we have a central bank is to provide a lender of last resort to the banking system. The FDIC simply can’t act fast enough, nor does it have the ability or the cash to act effectively in a crisis. Congress needs to fix this soon.

Finally, Dodd-Frank puts our regional and small community banks at a massive disadvantage. They get all of the costs and are restricted from their normal activities.
Hardly a week goes by that I don’t see some fixed-income equivalent return in the high single digits or/low double digits from private businesses looking for cash. These are the types of deals that banks used to do to their considerable profit, and now regulators are restricting what they can do. The deals still get done, or now they are just done in the private sector. I am not complaining about that because I am part of the private sector and from time to time get to take advantage. But the greater good really does require small community banks to be able to function properly. Overhauling Dodd-Frank will be a big boon to entrepreneurs and small businesses and will create jobs.

I am all for serious restrictions on too-big-to-fail banks. I would prefer that they have to increase their capital reserves. But that doesn’t describe 99% of the banks in this country, yet we have written rules to make sure the 1%, the largest banks, don’t put taxpayers at risk (even while those rules make it more likely that they will be at risk in some future crisis).

Federal Reserve: We should also see at least two nominees to the Fed’s Board of Governors soon after Trump takes office. He may get a third one if Daniel Tarullo leaves, as some observers expect. He will get to nominate both the chair and vice chair next year, and it is likely that the remaining members will think about leaving as well when Yellen departs. But the early nominees will tell us a lot about Trump’s priorities and long-term plans – hopefully for the better. (I do hope that Richard Fisher is on the very short list for Fed chair and that Dr. Lacy Hunt is in line for one of those board seats.)

Meanwhile, the Fed is in the middle of a long-overdue policy turn. There’s still a risk that they will find they started tightening just in time for a recession, which is also long overdue. I was convinced last summer that they would push rates negative in that scenario. Negative rates could yet happen, but I think they will be less likely if the FOMC abides by their dot plots and raises rates three times this year. And I find it difficult to believe that a Trump-appointed Fed would take us into negative rates.
We are going to have to find more creative ways to do things.

Wall Street is actually fine with higher rates, by the way. Yes, hiking at the short end raises their cost of funds a bit, but long-term rates have jumped even more. That results in a steeper yield curve and makes lending more profitable for banks.

Surprises: Black swans aren’t a risk limited to the world of finance; they happen in politics, too. George W. Bush had no idea that September 11 would hit less than eight months into his presidency. God forbid we get something like that again, but a similarly unforeseen crisis is possible and maybe even likely in 2017. Such an event could push aside all the best-laid plans and change everything.

Canadian Bubble
Our neighbors to the north are at their own turning point. The Canadian economy was riding high in the commodity boom but has run into problems after two years of sharply lower oil prices. Since then Canada has avoided recession but has not enjoyed much growth, much like the US. I should point out that Canada is by far our biggest trading partner.

Canada also has a housing bubble that looks increasingly ready to pop. (Then again, I’ve been saying that for three or four years.) Home prices in Vancouver are unbelievable, and Toronto is not far behind. These prices have little to do with oil and everything to do with Hong Kong Chinese and other Chinese buying property.
Wealthy Chinese, eager to evade their own country’s capital controls, are buying homes as offshore savings accounts. What look like astronomical prices to us are still attractive to Chinese buyers, especially if they believe (and I think with good reason) that their own currency is likely to drop relative to the US dollar over the coming years .

What happens in Canada will tell us something important about China and vice versa.
Anything that keeps Chinese money from leaving the country will raise the odds of Canada’s bubble popping.

US energy policy matters to Canada, too. The country’s huge oil sands deposits would help its export balance, but in some cases the best access requires pipelines through the US, like the Keystone that Obama has held up. Trump can help Canada by letting that project go forward. We should find out fairly soon if he will.

Crowded Exits in Europe
I thought there was a good chance the Italian bank crisis would come to a head in 2016.
The Italians seem to have yet again delayed the inevitable. Reality hasn’t fundamentally changed, though. Monte dei Paschi and the other troubled institutions are not going to get better on their own, nor is the new government going to miraculously gain public confidence.

Monte dei Paschi has at least 36% of its loan portfolio in the nonperforming category. The Italians have raised €20 billion for a bank bailout fund, but there is serious doubt that will be enough to cover Monte dei Paschi alone. My friend George Friedman says Goldman Sachs estimates that successful recapitalization would require €38 billion, while a senior market analyst at London Capital Group suggests the number might be closer to €52 billion. And that is just one bank.

Saving Italian banks will take multiple hundreds of billions of euros, which Italy does not have, nor do they technically even have the legal right to unilaterally bail these banks out.
They would have to utilize an ECB facility that does not now exist to get that much money, and such a measure would require German approval. By the way, individual Italian investors and savers have invested at least $200 billion in junior, well-subordinated debt that paid a higher yield than bank savings accounts do; and they were told the investment was safe. Think about what would happen if $1 trillion disappeared from the savings of retirees in the US, and then double that number and you’ll be getting close to what the equivalent impact would be. Think that’s politically posible?

I keep telling you that Italy is the most dangerous economic issue on the world front. Attention must be paid.

That said, Europe is quite capable of staving off disaster. They are professionals at that. They can do it again this time if nothing else goes wrong. That’s a big if.

In the “something else” category, start with political pressures. France and Germany will both hold elections in 2017, with populist parties itching to take charge. I don’t think they will succeed in either country, but the price of holding them off could be high. Merkel may have to surrender her wish to accept more Middle East refugees. The refugee flow will not stop, though. People will instead pile up in Italy, Greece, and Turkey, all of which have their own serious problems.
And Merkel is not going to want to acquiesce to Italian demands for relief on its banking issues prior to the German election in September.

Further north, it looks like the UK will formally begin the Brexit process in 2017.  
Implementation will consume energy and resources that the EU really needs to devote elsewhere. Also, the closer the UK gets to actual withdrawal, the more pressure other countries will face from their own anti-EU parties. The arguments against EU withdrawal will weaken considerably once the UK pulls the trigger without world-ending consequences.

Then there’s NATO. The defense alliance partially overlaps with the EU but also includes Turkey. Trump wants the other member states to increase their defense spending. He says, correctly, that they aren’t paying their fair share and has openly questioned whether the US would come to their aid in an attack. The Baltic countries and Poland are very concerned, as they are the most exposed to potential Russian aggression.
Does Putin intend to attack and try to occupy one of those countries? Think Afghanistan. I really rather doubt he will, but he can cause all kinds of problems without attacking. Fear alone is sufficiently troublesome. Meanwhile we have President Obama, despite his being on the way out the door, imposing new sanctions on Russia for alleged hacking activity.
And we see Russia and Turkey actually growing closer after the assassination of the Russian ambassador in Ankara last month.

As with Italy, though, fear has consequences. Leaders can juggle only so much. When too many things happen at once, the risk rises that someone will drop a ball. 
Asian Angst
Relationships within Asia are in flux, to say the least. Trump’s phone call with the Taiwanese president and subsequent comments show he’s willing to roll back prior commitments in order to get better ones. Beijing was not pleased, to put it mildly, but I don’t see this as a crisis. I suspect Trump intermediaries are already working quietly on new deals with China. We could see some major changes in 2017.

China has other problems, too. They are holding the domestic economy together with astonishing amounts of debt. New liquidity can’t leave the country due to capital controls, but it has to go somewhere. The result is rolling asset bubbles that make even Vancouver housing prices look flat.

The transition from an economy driven by exports to one led by domestic demand is probably going as well as it can, but that’s not saying much. The process may accelerate if Trump has his way. This is one area where I fully expect him to follow through on the rhetoric. It will look crazy, but crazy with a purpose. The hard part will be giving the Chinese leaders a face-saving way to accept the demands without causing domestic instability. I am not sure Trump fully appreciates that side of it. Either side could miscalculate and set off a bad reaction.

Over in Japan, something interesting is happening. The job market is unbelievably tight. I saw in a Wall Street Journal report last week that each available worker has two job offers on average. The unemployment rate is historically low. In a normal market, you would expect employers to compete for workers by raising wages, right? But it isn’t happening. Wages are flat or even falling.

Japan’s culture and some unique labor policies partly explain this, but I think the situation really shows how hard it is to escape a deflationary spiral. Deflation has changed the psychology for two generations of workers and managers. Employees are afraid to demand more, and companies are afraid to pay more.

It’s also a potentially ominous sign for the US. The Fed and many others are watching labor markets closely for signs of wage inflation. Rising wages are one of the factors that would justify tighter interest-rate policies. Yet Japan shows that unemployment can stay low for years without necessarily causing wage inflation.
The BOJ would probably love to see some, but they aren’t getting it.
Japan is another potential target of Trump’s trade policy. Unlike China, Japan really is devaluing its currency. The policy is working, too, in terms of promoting exports. But those exports don’t all go to the United States. Japan sells China much of its industrial equipment and technology, demand for which will presumably drop if Trump succeeds in reducing Chinese exports.

(And while we are talking about currencies that are devaluing against the dollar, let’s note that the British pound is down 40% and the euro is down about 35%, and I don’t think it will be much longer before the euro is at parity with the USD. Are we going to declare those countries currency manipulators? China’s small currency drop is meaningless by comparison. And if China were to float its currency? My bet is the renminbi would drop by another 25 to 30% almost immediately. So much for free markets…)

While we’re talking about Asia, I have to mention India’s paper-money crackdown. Prime Minister Narendra Modi has been trying hard to control the country’s very large underground economy. In November they did an overnight cancellation of the two largest-denomination paper bills, giving people until Dec. 30 to deposit them in a bank account before the paper became worthless.

The problem, of course, is that hundreds of millions of Indian workers don’t have bank accounts. The result, at least according to news reports, has been nothing short of chaos in some places. Normal commerce simply ground to a halt. People have been existing on barter and IOUs. The debacle may cost India a point or two or more of GDP growth, according to some estimates.

Worse, it may not have even accomplished the original goal. The theory was that people hoarding large amounts of cash would be afraid to turn it in, and it would simply become worthless. That would teach them, Modi must have thought. But now it appears that almost all of the cash returned to the banking system. That means the black market was not as large as the government thought, or people found other ways to launder their cash.

I explain all that to make an important point. Government mistakes are a top risk factor now. I think Modi had good intent. I’m sure the government planned the operation as well as it could. They were attacking what they thought was a real problem with what seemed like a reasonable plan (at least to them). But it still didn’t work and might even have caused additional damage.

Imagine the damage a similar-scale policy error could cause in the US. We have an incoming government that will likely try things no one has ever tried before. We have a Federal Reserve that needs both to raise interest rates and to reduce its bloated balance sheet. We have all kinds of international challenges. I haven’t even mentioned Africa, the Middle East, Australia or Latin America. They all hold potential problems for the global economy, too.

We enter 2017 with more question marks than I can count. Even if all the policymakers are competent and have good intentions, stuff happens. Things go wrong. People don’t react the way you think they will. You end up causing more problems for the people and businesses you wanted to help.

I have full confidence in the ability of US business to produce quality products and services at fair prices. Ditto for many other countries. Their decisions are not what we need to worry about. Now more than ever, economic risk around the world emanates from our governments and central banks.

I was with Steve Forbes the other night in New York. He asked me how I was feeling and gave me a list of about seven adjectives. I told him that I was skeptically optimistic. He laughed and said that’s probably the right position. I have not been happy with the bulk of what has come out of Washington DC for the last 16 years.

Trump has the traditional 100 days to deliver something to keep the optimism going.
Hopefully, a Congress that is nominally Republican controlled can agree on important measures and move more quickly than we have seen it move in quite a while. But then New Year’s Day is a moment for optimism and hope. That’s how we’ll end this letter; and next year – that is, next week – I’ll have my own economic and market forecast for 2017 for you.
DC, Florida, the Caymans, and a Few Final 2016
Tonight I will celebrate New Year’s Eve with close friend David Tice of Prudent Bear fame, who is getting married to his new wife Sophia in a few hours. It should be quite the New Year’s Eve party. Then Shane and I will be in Washington, DC, for the inauguration. I am on the board of a public company called Ashford Inc., which manages hotel REITS, among other things. We own several hotels in DC, including the Capital Hilton, and our chairman and my good friend, Monty Bennett, decided we would move our board meeting up a few weeks and hold it in Washington during the inauguration. I will get to see a lot of friends and of course will be at the huge Texas inaugural ball, called Black Tie and Boots, on Thursday night (if you are there or in DC, let’s meet) and am still looking for tickets for an inaugural ball on Friday night.

We will go straight from DC to the Inside ETFs Conference in Hollywood, Florida, January 22–25. If you are in the industry and coming to that conference, make a point to meet with me. Mauldin Solutions (my investment advisor firm) will have a booth at the conference, where I will try to hang out some. If you are an independent broker advisor in the area, make a point to come by and see me. I will be making some big announcements at the conference. Then I'll be at the Orlando Money Show February 8–11 at the Omni in Orlando. Registration is free. I am also scheduled to speak at a large hedge fund conference in the Cayman Islands February 14 to 18.

During the last week of the year, I always end up thinking about what my next five years will look like. I’ve been doing that since I was 22 and leaving Rice University with a freshly printed sheepskin. I have had 45 opportunities since to analyze how effective and accurate my five-year planning is. So far I’m 0 for 45. That’s right. A guy who makes his living as an analyst and forecaster has never been able to accurately predict his own life, the one thing that he theoretically has under control. Not even once! I actually get the general direction right about half the time, which I suppose is not too bad. Well, and that’s with a pretty broad definition of direction. That said, while I would have preferred to avoid a few bumps, I am pretty happy with where I am. Not too bad for a poor country boy from Bridgeport, Texas.

There have been only a few times when I was not optimistic about the coming year, and thankfully this is again one of the optimistic times. I’m actually as pumped as I have been in a long time. I have been hinting that I will have a new portfolio construction concept ready to share with readers for some time – always at some vague time in the future – but now I can begin to narrow the date when everything should be ready for prime time to sometime in the middle of March. I have quietly been assembling an all-star cast of partners and team members.

I have lost some good friends this year. Age and disease can be a bitch. These people were all planning to keep working for a long time; then things changed. That has made me a little more reflective, but it is not changing my attitude. At 67 I am launching a business that will require at least a 10-year commitment to my partners and future clients.
It will require even more travel time than I put in now. I was in the gym this morning with The Beast, trying to keep this body together and working. I say this every year at this time, but this year I mean it: I am honest to God going to get in real shape this year. I am already starting to change my lifestyle a little bit, acknowledging that perhaps I can’t do some of the things that I did when I was 30 and 40. But that doesn’t mean I can’t do everything I can do today and more tomorrow with what I have. I know that more than a few of my readers share that attitude. We are just having too #$%$ much fun to want to go sit on the porch and watch the world go by.

A little tease: I think core portfolios, the way they are designed today, are going to be in for very difficult 5–7–10 years, so my partners and I have been rethinking a better and smarter way to do core portfolios. Cheaper, better, faster-acting and reacting. Something that can work not only for accredited investors but for average investors and for those who are overseas as well. The problem, from my standpoint, is that I have to be ready to handle all the responses to our program, and do so efficiently and capably, from day one. The user experience must work seamlessly. That doesn’t happen without a lot of planning and a very experienced team.

What we are doing with portfolios today was not even possible five years ago, and what we are planning to do in five years is not yet possible today. This will not be your father’s portfolio construction model. Going to the sidelines is not an option, because you can’t grow your portfolio if you’re not involved in the markets. But nobody says you have to endure massive bear markets and huge changes in asset classes passively.

2016 has been a year of major surprises. Frankly, I think 2017 has the potential to offer even more challenges than 2016 did. When I sit with my friend George Friedman and talk about the geopolitical changes that are brewing, I realize that politicians are getting ready to be bigger players in the market than they should be.
But we don’t get to choose the times in which we live. Our choice is how we live them.

One thing I can predict: Barring some physical challenge, I will still be writing this letter for free for a long time to come. It is my passion and joy. I feel a connection with each and every reader every time I hit the send button or when I meet you and we talk and share our lives. I try to read every comment that comes back and answer some of them directly, and some questions and comments become topics for letters. My partners tell me we have some 70,000 new email addresses this year, so welcome to the family. And feel free to tell others to join us. The next 20 years are going to be the most hellaciously fun time of any period in history. And we are all going to have a front-center-row seat. To paraphrase another media outlet: I write. You decide.

Thanks for being with me and making 2016 such a great year. I will be traveling a lot more this next year, hopefully to a city near you where we can share a few thoughts. Let me give you my sincere and heartfelt wish for a wonderful and happy new year!

Your raring to start the new year analyst,

John Mauldin

Bush Trumps Reagan

By: Peter Schiff  

The optimism that has followed the election of Donald Trump has pushed the Dow Jones Industrial Average to the threshold of 20,000, a level that will be both a nominal record and a symbolic milestone. Although this is not the way most observers had predicted that 2016 would play out, most on Wall Street have become extremely reluctant to look a gift horse in the mouth…or to even look at him at all. The impulse is to jump on and ride, and only ask questions if it pulls up lame. But if this year has proven one thing, it is that predictions made by the consensus should not be trusted.
Back in the earlier part of 2016 the mood was decidedly darker. At that point most people believed that the Federal Reserve would be raising rates throughout the course of the year.

While such hikes had been anticipated (and delayed) for years, most took comfort in the belief that the economy would be expanding nicely by the time the Fed actually pulled the trigger. But in late 2015, the already tepid GDP growth seen in the prior two years seemed to be decelerating. Investors also concluded that Hilary Clinton was a lock to win the election, thereby assuring that the anti-growth policies of the Obama years would continue. Many looked at these developments and concluded that the sins of the past decade, in which the Government and the Federal Reserve had used unprecedented levels of fiscal and monetary stimulus to prop up the economy and the stock market, had finally caught up with us. As a result, the Dow Jones shed more than seven per cent in the first two weeks of the year, its worst start on record.
But the year comes to an end amid a cloud of Trump-fueled bullishness. The markets fully embrace an unapologetic capitalist, and his team of billionaires, who promises to cut taxes, rewrite trade deals in America’s favor, take a machete to anti-growth regulations, repeal Obamacare, and return America to its former industrial might. Many are making parallels to the Reagan Revolution in which a maverick anti-establishment Republican took charge in Washington and ignited an economic boom, a stock market rally and a surge in the dollar. But to make this comparison, boosters must jump over a more telling comparison to the last Republican president elected, George W. Bush.
The parallels to W. are striking. Both lost the popular vote, and will have taken office following the tenure of a two-term Democrat who had presided over a furious stock market bubble and a surging dollar. In the 4 years prior to Bush's election, the Dow Jones had surged approximately 60% and the dollar index had risen approximately 19% (1/2/97 to 12/29/2000). For Trump, the numbers are 48% and 24% (1/2/13 to 12/21/16). Then, as now, the U.S. was seen by investors as the only game in town. Clinton's second term was rife with global crises that both created safe-haven flows into the dollar and caused the Fed to backstop U.S. financial markets with cheap money (at least cheap by the standard that existed at the time). Both will have come into office promising tax cuts and regulatory relief following eight years of Democratic reign. As a result, the market gains of the Clinton and Obama years were expected to continue under their Republican successors.
But the optimists did not anticipate that the big, fat, ugly bubble that inflated during Clinton’s second term, would burst early in Bush’s first term (although the air started coming out of that bubble while Clinton was still in office). Given the ensuing recession of 2001, it can be argued that the only reason Bush was reelected in 2004 was that the Fed was able to inflate an even bigger, fatter, and uglier bubble in housing that postponed the pain until the financial crisis of 2008. That is where the similarities will likely end, as Trump will likely not be that lucky.
One of the pillars of dollar strength under Clinton was eight straight years of deficit reductions, culminating with a massive $236 billion budget surplus in 2000 (Congressional Budget Office).

While the surplus did require some accounting smoke and mirrors and a stock market bubble to create, it nonetheless marked a significant achievement. At that point, many economists had assumed that the U.S. debt problem had largely been solved and that the country would ride a wave of permanent surplus. The only problem most could envision was a shortage of Treasury bonds once the national debt was fully repaid. No one is to worried about that “problem” now.
Similarly, Trump is taking charge at a time when official budget deficits have fallen consistently since 2009 (albeit from astronomically high levels). But 2016 is projected to be the first year since 2009 in which the deficit will have risen, significantly, from the prior year. The Congressional Budget Office sees a return to perpetual $1 trillion plus annual deficits in the early part of the next decade (The Budget and Economic Outlook: 2016 to 2026 report, January 2016), even if we have no tax cuts, spending increases or recessions over that entire time. Under the Trump presidency, we are likely to get all three.
If a recession comes early in Trump’s presidency, it will be no more his fault than the 2001 recession can be blamed on Bush. A sharp pullback has been years in the making. Firstly, there is simply the issue of timing. On average, the U.S. has experienced a recession every 60 months or so since WW II (based on data from National Bureau of Economic Research and Bureau of Labor Statistics). The current expansion is already 90 months old, or 50% longer than average.

Sooner, rather than later, it will have an end date. Recessions completely reshuffle the budgetary deck, causing government outlays to rise and revenues to fall simultaneously. The swings can be dramatic. The 1981-1982 recession resulted in a 61% increase in Federal red ink.

The recession of 2001 turned a $236 billion surplus in 2000 into a $377 billion deficit in 2003 (then a record). The Great Recession of 2008-2009 caused the $458 billion deficit in 2008 to more than triple to $1.4 trillion in 2009. Rest assured, the next recession can cause a similar catastrophe to the government’s finances.
Trump’s election was predicated on his intention to buck traditional Republican policy of fiscal restraint. He has promised tax cuts for people and corporations and massive $1 trillion plus spending binges on infrastructure and the military. Of course the argument goes that these moves will stimulate growth thereby raising tax revenue to pay for both the cuts and the spending. The same arguments were made by George W. Bush in 2001 when he cut taxes, increased spending, and pushed through a temporary tax holiday to encourage corporations to repatriate money held overseas. Deficits soared anyway. The only real question is will the recession arrive before or after Trump’s fiscal policies kick in. If the events happen simultaneously, the budgetary implications will be hard to fathom.
Investors who are basking in the Trump victory should take a hard look at what happened to the markets during the Bush presidency. In mid-2008 (just a few months before the financial crisis sent stocks plummeting), the S&P 500 was just 17% above the level when Bush was elected nearly eight years earlier. The dollar, in particular, took a beating under Bush. In August 2008 (right before the dollar rallied temporarily as a result of the panic), the dollar index had fallen by 19% since his election. The opposite occurred in gold. In November of 2000, gold was at about $370 per ounce, close to a 20 plus year low. In August 2008, it was more than $920, down significantly from it's high of almost $1,100 hit earlier that year.
Also, for all the optimism about the U.S. stock market and pessimism abroad, it was foreign markets that delivered for investors. From Bush’s election to mid-2008, just before the global financial crisis sent stocks reeling around the globe, developed foreign markets were up 80% (priced in U.S. dollars) while emerging markets were up a staggering 300% (priced in U.S. dollars). Even if you include the huge losses in the back half of 2008, by the time Obama was sworn in, developed markets were down less than 3% from the time of Bush’s election, and emerging markets were still up about 80%. (In contrast, the S&P 500 was down almost 27%).
The 2001 Recession, which was triggered by the bursting of the dotcom bubble and the September 11 attacks, came very early in Bush’s first term. Fortunately for W., the Federal Reserve was able to support the economy by bringing rates down from more than 6% to just 1% (Federal Reserve Bank of St. Louis) (which helps explain the swift collapse of the dollar). As a result, the 2001 recession was the shortest and mildest on record. In doing so, however, the Fed blew up an even bigger bubble in real estate, the bursting of which created a far bigger recession in 2008, propelling Obama into the White House.
But can the Fed ride to the rescue this time around? Given that rates are practically zero and the Fed is choking on trillions of dollars of assets that are permanently held on its balance sheet, the answer is clearly no. All the Fed will be able to do is launch the mother of all QE programs, perhaps in the form of a massive helicopter drop. But the bad news for Trump fans is that the result will not be a housing bubble like the one that bailed out Bush, but a wave of stagflation that will make Trump a one-termer. The nightmare scenario is that once again tax cuts and deregulation take the blame, allowing Bernie Sanders or a socialist candidate to ride another populist wave, only this one headed far left, into the White House of 2020.

Inflation, Interest Rates and ‘the Politics of Rage’


Donald Trump will soon be sworn in as president after promising less regulation, tougher trade policies and more government spending on things like infrastructure, which could spur growth.

But coupled with tax cuts, such moves could also expand government debt. At the same time, populist pressure similar to what put Trump in office is afoot in England and some European countries, pressing governments to turn inward and spend for the benefit of people who have felt left out by globalization.

Taken together, it looks like a formula that would lead to higher inflation, which in most developed countries has languished at below-average levels since the financial crisis.

In the U.S., a strengthening economy is already leading The Federal Reserve to pledge to continue to raise interest rates. The Fed is targeting an inflation rate of  2% — it’s currently about 1.7% and has been even lower in recent years. This month, the Commerce Department revised up GDP numbers for the third quarter – from 3.2% to 3.5% (annualized) — pointing to faster-than-expected growth.  

The Fed’s hawkish stance is a sea change from only a few months ago, when there was much wringing of hands about growth and inflation being too low, says Wharton finance professor Itay Goldstein. “All of a sudden people are talking about infrastructure [spending] and cutting taxes and things that could lead to new growth and growing inflation.”

Politics and Inflation

Mark Zandi, chief economist at Moody’s Analytics, has predicted higher inflation and interest rates, more government debt and slower economic growth under Trump policies, and some other experts warn about the dangers of rejecting trade and international cooperation if the so-called “politics of rage” persist.

While most everyone wants stronger economic growth, some observers worry that anger among voters in various countries about the benefits of globalization could cause some developed countries to turn inward in ways that could hinder economic progress. They point to parallels between Trump’s win and the British vote last June to leave the European union, as well as movements in several European countries that signify disfavor with open trade and immigration policies, and a preference for protectionism and populism.

“Suddenly people are talking about infrastructure [spending], cutting taxes and things that could lead to new growth and growing inflation.” –Itay Goldstein

“Both the Trump and Brexit campaigns evoked fear and anger at immigration, free trade, and globalization and multi-cultureness more generally,” says Dan Kselman, academic director of the IE School of International Relations in Madrid, adding that, “both represent not so much the victory of a political party or a clear political platform, but rather rejection of the status quo political elite from both major parties, seen as corrupt and disconnected.”

If the result of that rejection is policies that favor more government spending on programs popular with the public, economies could grow. But Trump-style policies could be damaging as well, some economists say.

Wharton professor Kent Smetters has said that Trump has talked of reducing tax rates, especially for higher-income people — but also  for businesses – that would stimulate the economy in the short run. The Penn Wharton Budget Model shows the impact of various assumptions. “In the short run, it creates some stimulus, but over the long run, you lose a lot of revenue,” said Smetters, a Wharton professor of business economics and public policy, of Trump’s business tax cut proposals.

The risk to the U.S. economy is that the tax cuts will lead the government to increase borrowing and thus further balloon public debt, which could compete with private capital for household savings and international capital flows, depending on whether the overall economy is at full capacity. In the Penn Wharton Budget Model, the short-term gains turn negative over time, and in fact become “very negative” over 10 years, Smetters noted.

Goldstein sees some of the same political and social trends in Europe that won Trump the election in the U.S., with many people thinking globalization has gone too far and that it puts international interests ahead of national ones. “I certainly think it’s a broad phenomenon. It’s not just the U.S. and U.K.,” he says. “There is clearly a backlash.”

Kselman adds, “Donald Trump has promised to repeal the Affordable Care Act, which gave millions of lower class and lower-middle class Americans access to health insurance. He has pledged to adopt traditional trickle-down economic policies, such as the reduction of corporate taxation, that have contributed to increasing American budget deficits, increasing international debt, and the increasing marginalization of the American industrial working class.”

As such, Kselman continues, “Donald Trump’s economic policies are not likely to help the working-class whites who carried him to office.”
Protectionism Backlash

A report by Cleveland-based Victory Capital, an asset management firm, warns that, “The possibility of massive deficit spending has the potential to devalue the dollar and re-price inflation expectations.”

The report continues: “The key question is whether President-elect Donald Trump will legitimately pursue an isolationist agenda. He has been outspoken on the North Amer­ican Free Trade Agreement (NAFTA) and the Trans-Pacific Partnership (TPP), and his language has been combative on the topics of trade, tariffs and immigration.

“From our perspective, the key risks facing global equity markets are threats of greater protectionism, including unilateral tariffs and re­writing of trade agreements. These actions could boost inflation and act as a brake on the global economy. … Depending upon how the legislation proceeds, we may need to revise that expectation higher.”

Wharton finance professor Richard J. Herring says he detected signs of reduced international cooperation in a recent meeting in Chile of the Basel Committee, which sets international banking regulations, when German and American representatives failed to agree on key standards to control bank risks, sticking with positions they felt would benefit their own countries.

“It’s another example where countries seem intent on going their own way,” Herring said. He adds that public anger in various developed countries will continue to grow, forcing governments to respond to people who feel left behind. In the U.S. and some other countries, he says, there has been too little attention to strategies like retraining workers who lose their jobs to globalization, making it unlikely disaffected workers will be mollified by simply ramping up government spending.

The worst outcome, he says, would be a period of stagflation, or poor growth and rising inflation at the same time. “That can lead to a complete disintegration of the economy,” he says, recalling the 1970s.

“You might see a world that is less open. You might see less trade. You might see less immigration,” Goldstein says. “You might see less cooperation on the global level, on global warming and things like that.” He thinks that, generally, trade and globalization are good for the world economy, and it would be a shame to see those trends widely rejected. “I would like to see a world that is continuing with globalization and openness and cooperation, but maybe being more careful to see that the benefits are shared by everyone and not just a few people.”

The Benefits of Government Spending

Though big spending on things like infrastructure improvements could increase inflation in the U.S., Goldstein believes it would be worthwhile to fix worn roads, bridges and airports. “I think this country’s economy would do much better with infrastructure [spending].” Stock market gains since the election reflect investors’ belief that growth will accelerate, he says. He suggests that worries about inflation are overdone and that any rate below 4% is probably tolerable.

“Four percent sounds to me like the number above which you have to start worrying.”

Many experts, while concerned about public rejection of international involvement, think the situation is far from dire.

Wharton finance professor Jeremy Siegel sees some positive international trends, which in his view include such things as Latin American nations turning away from leftist policies that have stunted growth. Commodity prices, meantime, often a signal for inflation to come, have stabilized, he adds.

Going from 20 trillion to 30 trillion in debt could be manageable — “10 trillion is a lot of debt, but I don’t see that as a threat over the next few years.” –Jeremy Siegel

Europe, which has lagged the U.S. in recovering from the Great Recession, may find conditions less stressful going forward, Siegel says. “There are signs of nascent expansion in Europe. I’m not going to call it a boom, but definitely expansion. Japan’s economy is also strengthening a bit, he notes.

He believes the British vote to leave the European Union will not cause others dominoes to fall.

“No one’s leaving the European Union no matter what happens in Italy, so we don’t have to worry about that,” he said before Italian voters rejected their prime minister’s proposed reform package in early December. The vote signaled some displeasure in the public with the EU, but most political experts think it unlikely Italy will ever pull out.

More generally regarding inflation, few experts predict the kind of deadly inflation of the 1970s and 1980s, and many point out that inflation at more normal levels would be a good thing, making debt loads more manageable and signifying stronger economic growth.

Goldstein, for example, doesn’t expect massive, inflation-fueling government spending in Europe despite public clamoring for more inward-focusing policies. “Maybe there will be more spending on economic growth, but I don’t see it coming very quickly.”

Still, some analysts do caution against complacency, warning that inflation could drift too high even if it does not become extreme. Siegel believes Trump’s plan to increase spending on things like roads and bridges and the military could spur economic growth and lift inflation, especially as unemployment has fallen to the “full employment” level of about 4.6%.

“Clearly, if spending increases you are going to get shortages and some labor [cost] increases, and some of those are going to have to be passed along [in higher prices], without question,” Siegel says, though he does not think inflation will get too high anytime soon. In his view, inflation can go to 3% without causing much harm, though he supports the Fed’s 2% target.

The Fed, he says, has plenty of ammunition in its inflation-fighting arsenal — it can raise rates to slow the economy if prices start to rise too fast. “You’ve got to stand against inflation,” Siegel says, “but not prematurely.”

Higher inflation typically comes hand in hand with higher interest rates, and yields on the 10-year U.S. Treasury note have already gone to about 2.6% from 1.6% last summer.  Most experts think rates on mortgages and other loans will go up as well, though loan rates and bond yields remain low by historical standards.

“You’ve got to stand against inflation, but not prematurely.” –Jeremy Siegel

Trump’s plans to spend big on infrastructure and the military would likely increase the deficit and national debt if Congress goes along, Siegel says. By some estimates, debt, currently near $20 trillion, could grow by another $10 trillion in a decade or so. But the U.S. could handle that, Siegel says.

“Ten trillion is a lot of debt, but I don’t see that as a threat over the next few years.”

For the financial markets, much depends on whether Washington opts for the tight-purse string policies of the Republican Party or the heavier government spending advocated by Trump, Siegel adds.

“The stock market likes the Republican agenda. It’s very popular,” Siegel notes, attributing the big stock gains since the election to investors focusing on the best-case of tax cuts and reduced regulation. A cut in corporate taxes, for instance, would boost earnings, driving stock prices up.

But stocks could be hurt if Trump pressures companies to do things they don’t want to do, like pass up chances to move production to cheaper countries, he adds.

Siegel notes further that bond yields have gone up in anticipation of greater government borrowing if Trump gets his way and spends heavily while cutting taxes. To borrow more, the government would have to pay higher interest rates. Higher borrowing costs from rising interest rates could damage corporate earnings, hurting stock prices.

For now, though, the stock market is focusing on the good things that could come, not the bad, Siegel says. “This is the rose-colored glasses that the market is now looking through,” he noted in early December. “And one cannot say at this point it is not justified.”

We Have Not Seen This Happen In Gold Since 2004

by: Hebba Investments


- Net speculative gold positions dropped for the seventh straight week.

- Gold ETFs finally added to physical gold holdings after 33 days of sales which Bloomberg data says was the longest streak since 2004.

- Negative sentiment abounds in the speculative gold market, thus for investors that see value in gold, now makes a good contrarian time to buy.

After starting the year with a bang, the last Commitment of Traders (COT) report shows gold ends 2016 with a muffle, as for a seventh straight week, speculative traders lowered their gold positions. But despite the trader negativity, gold rose on the week, which is not unheard of - but it usually portends a short-term turnaround for the metal.
Also, we saw something else very interesting last week as gold ETF holdings broke its 33-day losing streak, the longest since 2004, as ETFs finally increased physical gold holdings.
We will give our view and will get a little more into some of these details, but before that let us give investors a quick overview into the COT report for those who are not familiar with it.
About the COT Report
The COT report is issued by the CFTC every Friday to provide market participants a breakdown of each Tuesday's open interest for markets in which 20 or more traders hold positions equal to or above the reporting levels established by the CFTC. In plain English, this is a report that shows what positions major traders are taking in a number of financial and commodity markets.
Though there is never one report or tool that can give you certainty about where prices are headed in the future, the COT report does allow the small investors a way to see what larger traders are doing and to possibly position their positions accordingly. For example, if there is a large managed money short interest in gold, that is often an indicator that a rally may be coming because the market is overly pessimistic and saturated with shorts - so you may want to take a long position.
The big disadvantage to the COT report is that it is issued on Friday but only contains Tuesday's data - so there is a three-day lag between the report and the actual positioning of traders. This is an eternity by short-term investing standards, and by the time the new report is issued, it has already missed a large amount of trading activity.

There are many different ways to read the COT report, and there are many analysts that focus specifically on this report (we are not one of them) so we won't claim to be the experts on it. What we focus on in this report is the "Managed Money" positions and total open interest as it gives us an idea of how much interest there is in the gold market and how the short-term players are positioned.
This Week's Gold COT Report

This week's report showed a drop in speculative gold positions for a seventh straight week, as longs decreased their positions by a chunky 6,017 contracts on the week. On the other side, speculative shorts increased their own positions by 6,647 contracts on the week.
Moving on, the net position of all gold traders can be seen below:
The red line represents the net speculative gold positions of money managers (the biggest category of speculative trader), and as investors can see, the decline in speculative traders continues.
As we said last week, we are now at some of the lowest speculative levels of the past decade, though we haven't yet hit the lows we saw at the end of 2015 before gold's spectacular rise earlier this year.
Sentiment wise, speculators want nothing to do with gold and are stampeding out. Money managers are only net long 41,000 contracts, while producers and merchants are steadily increasing their positions.

As for silver, the week's action looked like the following:
The red line, which represents the net speculative positions of money managers, showed a drop in speculative positions for the week which should be no surprise since silver tends to track gold.
Silver speculative positions remain relatively high compared to gold speculative positions while producers/merchants have not been increasing their own positions nearly as much as those same entities on the gold side. This suggests to us that, at least per the COT report, gold remains much more oversold than silver. We still like silver for other reasons, but silver speculative trader positions remain relatively high compared to their gold counterparts.
Gold ETF Holdings Finally Rise
For more than a month, ETF gold holdings have been sold off, and according to Bloomberg, experienced their longest gold disbursement streak since 2004.
  Source: Bloomberg
Our data is a bit more inclusive than Bloomberg's as we include mutual funds and gold repositories, but it shows the same massive decline in gold holdings.
The correlation with gold ETF holdings is very clear from the chart above, and even though it is not a major increase over the last week, it is something for gold bulls to monitor as transparent gold holdings increased.
Our Take and What This Means for Investors
We are working on our "Gold Looking Forward" piece to detail why we think gold is an excellent investment as we close 2016, but strictly based on the COT report gold looks extremely oversold after seven consecutive weeks of speculative traders lowering their net long position. With speculative traders holding a little over 41,000 net long gold contracts, we are at some of our lowest levels since early February - gold has truly retraced most of its 2016 gains.
Additionally, when compared to the net speculative position over the last 10 years, we are close to some of the lowest net speculative long levels that we have seen in gold.
This makes it simple when it comes to gold because if you are an investor who believes that any of the following could occur in 2017:
  • Rising interest rates could cause a crisis with over-levered governments, companies, or individuals.
  • Donald Trump's policies may not pan out as optimistically predicted by stock markets.
  • The reversal of globalization continues as per populist political rhetoric and nations enact protectionist policies that hurt global trade.
  • The European Union begins to fall apart as the UK, Italy, France, or others elect anti-EU parties.
  • The rift between the US and China grows and causes China to continue to sell US Treasury holdings.
  • The rift between the US and Saudi Arabia grows and causes Saudi Arabia to sell US Treasury holdings.
  • The market turns its attention to the US fiscal picture and realizes that with $1 trillion of new debt accumulated in 2016 and trillions more of entitlements moving forward, the picture does not look good.
  • All the quantitative easing enacted by global central banks reignites inflation.
Then now makes an excellent time to buy gold as speculators are at some of their lowest net long levels over the past decade.

We believe much of these are not priced in by markets, and if one or more of these things occur, then gold should have another good year in 2017. Thus, based on the extremely negative sentiment by gold speculators, this makes it a very good time to buy gold strictly based on it unpopularity.
Contrarian investors should seek to accumulate gold and the ETFs such as the SPDR Gold Trust ETF (NYSEARCA:GLD), the ETFS Physical Swiss Gold Trust ETF (NYSEARCA:SGOL), the iShares Silver Trust (NYSEARCA:SLV), and quality precious metals miners and explorers.