Angst in America, Part 5: The Crisis We Can’t Muddle Through

“The ship of democracy, which has weathered all storms, may sink through the mutiny of those on board.”

– Grover Cleveland, the 22nd and 24th president of the United States

“It is your concern when your neighbor’s wall is on fire.”

– Horace

“The biggest mistake investors make is to believe that what happened in the recent past is likely to persist. They assume that something that was a good investment in the recent past is still a good investment. Typically, high past returns simply imply that an asset has become more expensive and is a poorer, not better, investment.

– Ray Dalio, Founder, Bridgewater Associates

When you spend a couple of decades writing weekly letters to hundreds of thousands of people you think of as friends, your readers naturally come to associate you with a few key ideas. I have certainly become known for at least one. My longtime regular readers think of me as the “Muddle Through” guy. That’s not an image I have tried to cultivate, but I have it anyway.

I have to confess that it’s usually accurate. In a typical letter I will describe some sort of potentially scary problem, explain what might happen, then conclude that we’ll probably avoid the worst and muddle through. That has almost always been the right call. The worst doesn’t happen, and we all survive. “Muddle Through” can mean widely varying outcomes for individuals, but for the world at large, things generally work out OK.

As a statistical matter, this stance makes sense. The extreme tails of any distribution curve comprise outcomes that almost certainly won’t occur. The most probable outcomes cluster around the fat middle.

Yet there is one problem that is very definitely coming our way that I really don’t think we can Muddle Through and where even the middle-of-the-road scenarios are terrible, and that’s the public pension crisis. I really see no way it can end well. It’s going to hurt just about everyone.

“But wait,” my Canadian and German friends will say, “that’s an American problem. Leave us out of it.”

I wish I could. The sad fact is that the US is the big fish in the global economic pond. One way or another, our problems affect everyone. You catch cold when we sneeze. The “Disappearing Pensions” crisis I described last week will hurt you, too. The only question is which transmission mechanism will bring it to you. Further, most developed countries have their own version of the pension crisis in the form of government promises that can’t be kept. Same song, different verse.

Today I want to delve a little deeper and explain why pension angst is completely reasonable and not at all overblown. If anything, it has been understated.

No Magic Rainbows

Most pension fund analysis focuses on funding levels, i.e., the assets a plan actually has versus how much it should have at a given point, based on actuarial analysis of future liabilities and assumptions about future contributions and investment returns.

Funding levels are important. They are a useful canary in the coal mine – but only to the extent that the responsible parties pay attention to them and respond correctly. No such thing is happening. Worse, the assumptions that are being made mean that funding levels probably understate the coming disaster.

Yes, disaster. I use that word because I don’t have a stronger one that I can use in a family-friendly letter.

Let’s make this simple. The “defined benefits” that any DB plan will eventually pay its beneficiaries come from two sources:

1. Cash contributions, mostly from the employers but often from workers, too

2. Interest, dividends, and capital gains earned on the investments into which those cash contributions are placed.

That’s it. There is no pot of gold at the end of the rainbow. There’s not even a rainbow. Every penny that every retiree receives from every DB plan comes from those two sources. Unlike the federal government, cities and states can’t mint currency by fiat. No magical ponies will come pulling carts full of cash to bail out the pension plans. (We do that only for banks.)

The problem is that, with few exceptions, neither source is producing at the level necessary to deliver the promised benefits. In many cases there is a vanishingly small chance they ever will produce enough. And the longer we go without fixing the problem, the smaller the chance becomes.

In each municipality and state, a few hardy souls are jumping up and down and screaming about the coming crisis in their locales. But when politicians do pay attention, the required actions are so painful that they conclude there is very little chance of anything substantive being done. And so they do nothing. The sad fact is that even actions that would fix part of the problem are often pushed away.

There is a perverse logic to this failure to act, and it has to do with the Merciless Math of Loss.

Squeezing Too Hard

We’ll start with contributions. The amount a city or state agency must donate to its pension plan(s) is a function of the promises made to its workers, typically in union-negotiated contracts.

The unions naturally want as much as possible. The employer wants to contribute as little as possible. Fair negotiations should produce a number acceptable to both sides – but that assumes negotiations are fair. Often, they aren’t.

Here we must recognize a practical distinction between public and private. In theory, a city council is responsible to its voters just as a corporate board is responsible to shareholders. Yet the relationships are quite different.

Corporate board members are generally themselves shareholders, who share in the gains or losses their choices cause the company, and there is actually quite a bit of legal liability attached to being on a corporate board. The more happy and productive the board can keep the workers, the more valuable their shares will be. City council members, while residents in the communities they represent, don’t gain or lose monetarily from the contracts they approve. Their incentive is to garner political support that leads to re-election or advancement to higher office.

So public worker contract negotiations are a competition between highly organized and motivated workers on one side and diffuse and often disinterested voters on the other. Elected officials may nominally answer to the voters, but the unions have more immediate influence, so the elected officials may not negotiate as zealously as they should, especially when the city, police, fire, and school workers tend to vote en masse for the candidate that is the most favorable to the unions. And in most municipal elections such workers may represent a high percentage of voters: Turnout for elections is generally less than 20%, and in many cities it is less than 10%. In the last mayoral election in my hometown of Dallas, only 6.1% of eligible voters actually participated.

On the other side of the equation, workers have every incentive to demand higher retirement benefits. To them, a pension is substitute compensation for cash the agency doesn’t have to put in their paychecks today. They accept the promise of future retirement benefits in lieu of higher pay. And the elected officials have every incentive to promise those benefits, because the immediate cost of doing so is much smaller than the perceived value they give to workers, and they get the votes and cooperation of the workers. The problems that come down the road will be dealt with by other politicians.

The immediate cost, though smaller, is not zero. Government agencies have to make annual pension contributions, and the amounts of those contributions are a function both of the benefits politicians promised and other factors, like market returns, life expectancies, etc.

The fatal flaw here is that required annual pension contributions are an easily gamed number. A city council can shop around for a consultant who gives them whatever number they desire, and they frequently do just that. But the game gets harder to play as time passes and the bogus numbers get bigger and bigger.

Repeated rounds of this process lead to funding ratios like these in Massachusetts:

As I said, these funding ratios depend on assumptions that are often far too optimistic. Yet most pension experts will tell you that there is no bouncing back, no restoring the ratio to a healthy level once it has dropped below 50%. Almost all the entities in the table above are in or near that zone. City of Springfield retirees are in deep trouble, and the rest not far behind.

What, realistically, can retirees expect from government agencies like these? Very little, frankly. I repeat: Benefits come from plan contributions and investment gains. I don’t know the situation in these specific communities, but it’s highly unlikely that elected officials can raise taxes or cut other spending enough to make the kind of contributions required to make up these shortfalls. It can’t happen, which means it won’t happen.

I’ve said this before, but it bears repeating: City limits are static, but the tax base is not. People can move away. Companies can relocate. Both will happen if local officials push too hard. That is what ultimately forced Detroit into bankruptcy. The city was depopulating, but its expenses didn’t fall accordingly.

Nonexistent Dollars Don’t Grow

The table above came to me via Marc Faber, who in turn got it from pension expert Frederick Sheehan. The title of Sheehan’s report is good advice:

“Public Pension Recipients: Start Saving. You Are on Your Own.”

That falls into the category of “advice no one wants to hear,” but it is nonetheless correct. Many, perhaps most, current city and state workers simply aren’t going to get anything like the pension benefits they have been led to expect. Sheehan puts it this way.

“We are promised...” is the haphazard refrain often encountered when the reduction of pension claims is mentioned. Promised or not, one distinguishing feature of non-federal government spending commitments stands out: only the United States has a printing press. States cannot print money. They can earn returns on their pensions’ invested assets, they can sell city hall, lay off the public works department, and tax, but an underfunded pension plan can only pay claims with dollars that exist.

This list of options is actually too generous. Sell city hall? That presumes someone will buy it. Lay off the public works department? Not good for property values. Raise taxes? Right, on all the people in those houses without sewage service.

Repeat Sheehan’s last line and burn it into your brain: “An underfunded pension plan can only pay claims with dollars that exist.” No one gets anything if the money isn’t there, and in a disturbing number of places it isn’t.

Keep in mind, those horrifyingly low funding levels would be far lower still if they didn’t assume investment returns that are, in fact, unrealistically rosy. Between 7½% and 8% is typical now. Exactly how is that going to happen?

We know that pension plans typically have only 40–50% of their assets in equities, something like 40% in bonds, and the rest in real estate and alternative asset classes. How do you get 8% from that mix? Keeping 40% in bonds at 3% (if you’re lucky) means everything else has to make 15%.

Do you really want to bet that stock returns will average 15% over the next decade? If you actually think that is your future reality, then all I can say is that the ’60s were probably pretty good for you, and you may still be living in a drug-induced hallucination. If you are a public pension beneficiary, that may be your best shot: just pretend. Good luck with that.

Marc Faber, who is even better at scaring people than I am, points out something that should be obvious but apparently is not: Pension plan funding ratios have been declining even as financial markets have posted impressive gains:

I find the deteriorating funding levels of pension funds remarkable because post-March 2009 (S&P 500 at 666) stocks around the world rebounded strongly and many markets (including the US stock market) made new highs. Furthermore, government bonds were rallying strongly after 2006 as interest rates continued to decline sharply.

In fact, if I look at the total return of both equities and bonds (including interest for bonds and dividends for equities) over the last ten years (ending August 31, 2016), I note that the return levels exceeded the expected asset return of almost 8% a year.

My point is this: If, despite these truly mouth-watering returns of financial assets over the last ten years, the unfunded liabilities have increased, what will happen once these returns diminish or completely disappear? After all, it is almost certain that the returns of pension funds (as well as other financial institutions) will diminish. Consider pension funds that have increased their allocation to bonds, and now (in the case of S&P 500 companies) exceed the equity allocation.

Now consider the following. Ten-year US Treasuries yield 1.74% and 30-year US Treasuries 2.48%. In Europe and Japan, government bond yields are frequently negative. How will it be possible with these low yields to achieve, in the long term, returns that even come close to the expected return of 8%?

Marc wrote that in October 2016, so those yields are a bit higher now; but you get his point. Yields are nowhere near high enough to deliver the kind of returns pension trustees are assuming. It just won’t happen.

Worse, even if return assumptions are fulfilled for a while, as unlikely as that may be, those good years will not be enough if a bear market strikes at the wrong time. Sheehan quotes a study by Steven Malanga in City Journal last year. The State of Utah’s pension plan lost 22.3% of its assets in 2008. It gained back 13% in 2009. A good start to recovery, right?

No, not right. Utah determined that its investment returns would have to compound at over 10% annually for the next 20 years just to recoup that 2008 loss. Why is that? Because while the portfolio was down, workers were continuing to earn new retirement credits. You have one set of people trying to fill the hole while another group digs it deeper. So just making back what you lost is not enough. You also have to make back the additional obligations you took on while you were trying to recover.


The word serendipity was introduced to the English lexicon in 1754 by Horace Walpole as luck that takes the form of finding valuable or pleasant things that are not looked for. Let me introduce you to a new word. In 1998 William Boyd coined the term zemblanity to mean basically the opposite of serendipity. The Urban Dictionary defines zemblanity as the inevitable discovery of what we would rather not know. If you are or have been the parent of teenage kids, you have had some of those zemblanity moments. 

America is going to be experiencing its own zemblanity moment during the next financial crisis when it discovers that many of its municipal and state pensions have crossed the threshold from merely difficult situations to almost impossible-to-fix ones. We are going to do a little math here, but I promise you it will be rather elementary. No calculus required. Seriously, this is so simple that even a politician could understand it. If you could get one to sit down and really think about it, much less do anything.

The Merciless Math of Loss

My friend Steve Blumenthal wrote a little essay called “The Merciless Math of Loss.”
He opens by quoting Ned Davis:

“It’s a little-known but startling fact: The average buy-and-hold stock market investor spends 74% of his or her time recovering from cyclical downturns in the market (from 1900–May 2015).” (Ned Davis Research)

That’s according to well-respected Ned Davis Research, Inc., in Venice, Florida. It raises a big question: How is it possible that investors spend three quarters of their time just getting back to the starting line?

The answer is explained by the unforgiving mathematics of loss: When investments lose ground, they must make up more ground, percentage-wise, just to get back to even.

Say you invest $10,000 and your account takes a 10% loss over six months. You’re down to a $9,000 balance. Because of your reduced capital base, you will have to earn 11% to recoup your losses. The steeper the losses, the higher the hurdle becomes for breaking even. For example: Recovering a loss of 30% requires a 42.9% gain; a 50% loss requires a 100% gain. To recover from a loss of 75%, a 300% gain is required.

Getting back to even can eat up precious time. Take that 10% loss over six months. Earning a steady 4% annually after that, you will still need two and three-quarter years just to get back to where you started. That time would be much better spent accumulating new money. Remember, the idea is to grow your money, not just regain lost capital.

You can see the required recovery levels more graphically in this chart from my friend Ed Easterling at Crestmont Research:

A 50% loss requires a 100% return to get back to breakeven. Add just another 10% loss for a total loss of 60%, and it takes 150% to get back to breakeven. The mathematics get uglier the bigger the loss.

Let’s look at two charts of the S&P 500. The first shows straightforward index levels since 1977. If you click on the link above or the chart below, you can bring up an interactive version of the chart. Click on “max” and then run your cursor back and forth to see where the index was on various dates. Note that it took 13 years to recover from the peak of 2000 (not including the very temporary peak of 2007). Since 2000, the market has risen roughly 50%. A 50% return over 17 years is not exactly what people thought they were going to get back in 2000 – it’s a little less than 3% a year on a compounded basis.

But that’s not really a fair way to look at it. While the NASDAQ and other indexes have small dividend payouts relative to the size of their indexes, the S&P 500 actually has reasonable dividends compounding over time. So this next chart shows the level of the S&P 500, including dividends, since 1988. And yes, while it did take almost 13 years for the market, including dividend returns, to fully recover from the top in 2000, since that time it has actually more than doubled with the help of dividends. That slightly-larger-than-2% dividend has compounded nicely over time.

That pleasant result has lulled pension plan managers and other investors into believing that this period is somehow normal. And it has convinced them that their pensions must be recovering lost ground. The problem is, that’s an illusion.

I read recently that the average pension fund in the United States expects its investment prowess to bring home returns of 7.69% in the future. A number of funds still use 8% as their target. Seriously.

Now let’s do some math based on the rule of 72. The rule of 72 is basically (according to Investopedia) a simplified way to determine how long an investment will take to double, given a fixed annual rate of interest. By dividing 72 by the annual rate of return, investors can get a rough estimate of how many years it will take for the initial investment to duplicate itself. Investopedia even provides this handy table:

Let me reiterate that the biggest portion of the money that will be used to pay retirees from a pension fund comes from actual returns on investments and not from the original contributions. That means that if there is a portion of the pension fund that is currently unfunded, those (nonexistent) dollars can’t grow so that they can be redeemed 30 years later by the retirees.

Further, the amount by which a pension plan is underfunded is determined by the assumptions on returns that the fund makes. These next few paragraphs will drive the actuaries and math nerds among my readers crazy, but I am going to simplify here to make a point.

If you project returns of 8%, then you expect your assets to double every nine years. Thus in 27 years, $1 that is sitting in the fund today will have become $8.

But what if your returns grow at only 5%? Looking at the handy chart above, we see that it takes 14.2 years to double your assets, so that in 28 years $1 will have grown to only $4. That is only about half of the dollars that your actuaries and consultants have assumed would be there.

If you project 5% returns for the next 30 years, then you have to almost double the current level of contributions to have the necessary assets in 30 years. So basically, any pension fund that is assuming 8% compound returns and is falling significantly short of that level now, will turn out to be massively underfunded, far more so than funds are telling their retirees or the public.

I understand that the actuaries actually calculate the underfunding for each year, not just 30 years out. That makes the math far more complex, but the principle is the same. The lower you make your return assumptions, the more you are required to fund current pension balance sheets. And that funding comes from only two sources, taxpayers and current workers. Of course, you could go to your current retirees and tell them they are going to get less money, starting right away, but how popular will you be then? (And how illegal would that be?)

What happens if Jeremy Grantham is right (and he has been right 97% of the time with his seven-year projections), and total market returns are less than 1% over the next seven years?

Then not only will pension funds have to grow returns much faster in subsequent years to catch up, they will also have to go to their respective states, cities, or schools and say, “You need to give us more money, because we’re becoming more underfunded each year.”

Let’s just make this pension data analysis even more fun. During the Great Recession, the market fell 58%. A 50% drop in the stock market during a recession is not unusual. What is the probability that we will not have a recession in the next four years? Pensions are making a huge wager on that proposition, so it is not a trivial question.

An Ugly Picture

The more I look at the situation with pensions, the more clearly I see that there is no practical way out. We know three things with near certainty:

1. Public pension plans are nowhere near able to meet their obligations.

2. Most cities and states can’t possibly contribute enough to cover the gaps without serious budget upheaval or increased taxes.

3. Plan investments won’t achieve projected returns, let alone earn enough to cover the contribution gaps.

I suppose in a different flavor of quantum universe where math works differently, it might be possible to make these pension plans work. Here in our universe, not so much. Not going to happen.

What does that mean?

It means several million more people are not going to have the kind of retirement they envisioned. If you’re one of them, you need to aggressively start saving every penny you can, right now.

Further complicating the situation is that in many places, state and local workers don’t participate in the Social Security system. They won’t even have that minimal amount to cushion the blow.

All these unexpectedly uncomfortable retirees will affect the economy. Their added savings will serve to keep interest rates low for everyone. Their consumer spending will be lower, reducing demand for many goods and services. They may have to sell their homes and move to more economical locations, thereby depressing property values.

None of this is built into anyone’s economic projections, which are often not so good in the first place. I’d like to point out a silver lining, but I just don’t see one. All I see are clouds: dark, ugly clouds threatening to rain on us all.

Will we Muddle Through? Most of us will. But I am 100% confident that this pension debacle is going to end very badly for many millions of state and local public workers. And we haven’t even talked about the social impacts.

You think the 2016 presidential campaign was ugly and divisive? Wait until your local elections turn on whether or not to cut your neighbor’s pension in half. The arguments are going to be up close and personal. What kind of person will run for local office in those conditions? Probably people who shouldn’t. Which will only make it all worse.

Like state and local pension obligations, US federal government pension obligations are also basically unfunded. They are expected to come from future tax revenues. Those obligations are the bulk of the over $100 trillion in unfunded liabilities that show up in the estimates of how much the United States is really in debt. That money is going to have to come from somewhere. But just as the United States will never default on its actual debt, I truly don’t believe we will default on US government pension obligations.

Future politicians are going to be faced with some very uncomfortable choices, one of which will be how much money to ask the Federal Reserve print in order to honor those obligations. Or should they cut future pension payouts, or maybe even current ones?

When Illinois or any other state finds itself unable to pay its pensioners, I think it is unlikely that the federal government will ride to the rescue. And the other states will look at each other and say, “Not my monkey, not my circus.”

But what happens when a majority of the states and citizens in those states begin to demand that something be done to help the poor public service workers whose lives are being seriously impaired? We can say that in today’s political environment it is unlikely that the federal government would rescue states and cities. But in a future political environment? Hard to say. The pressure to “do something” is going to be huge. And it’s going to be coming from seemingly everywhere.

If you aren’t already angst-ridden, consider this letter your ticket to the club. It’s going to hurt to belong; but we’re all in this together, one way and another.

Sonoma, Orlando, and Washington DC

Last week we had a bit of an “oops” moment. I mentally knew that I had committed myself to an investment speaking engagement in Sonoma sometime in April or May, but for whatever reason that event did not make it onto my calendar. I have actually had conversations about the event with the host organizers, Brian Lockhart and Geoff Eliason of Peak Capital Management, but somehow the event never got firmed up here on my end, which of course meant that no one had actually booked airline tickets. I got an email on Wednesday asking me to confirm a time for a conference call about next week’s event. I immediately got on the phone to confirm the details and then asked my new executive assistant, Tammi Cole, to look into last-minute airline reservations and so on. Turns out there were seats available, and Shane and I will be in Sonoma on time Monday afternoon. Then, if I haven’t missed putting anything else on my calendar, my next trip wi ll be to the Strategic Investment Conference May 22–25 in Orlando. On the 26th Shane and I fly up to Washington DC to be with Neil Howe and bride Gisela at their wedding. I’m particularly honored that he would be willing to speak at SIC on Thursday morning and then fly back to get married! But then, what are friends for?

This past week has was filled with an endless array of meetings, conference calls, and research and writing, with my number one goal of working on next week’s letter somehow slipping until today, so I now find myself writing Sunday afternoon in an effort to get ahead of next week so that I can actually spend some time with my friends in Sonoma, rather than stay in my room writing. I don’t want to say that I’m running fast, but my shadow has started to complain about having to keep up.

Who knows, in Northern California I might even have to borrow some golf clubs and play a few holes to see if my back is up to it. I have been feeling a bit looser lately. I think the best idea might be to buy six balls and play until I lose them. Surely I can last a few holes.

You have a great week.

Your hearing the gym call my name because it misses me analyst,

John Mauldin

How the Washington blob swallowed Donald Trump

The US foreign policy establishment should be careful what it wishes for
by: Gideon Rachman

News that the US has launched missile strikes in the Middle East is not normally a cause for celebration. But there was no disguising the relief and pleasure with which the US foreign policy establishment greeted last week’s decision by the Trump administration to unleash a volley of cruise missiles on Syria. Liberal newspaper columnists, hawkish senators and allied ambassadors were united in their approval.

Their reaction reflected a widespread revulsion at the Assad regime’s use of chemical weapons on civilians and children. But a crucial underlying reason for the buzz of satisfaction in Washington is the hope that President Donald Trump’s actions prove that the world’s policeman is back on the beat.

The Washington foreign policy establishment, a group derisively labelled as “the blob” in Barack Obama’s White House, is united by the belief that the willingness to use military power is crucial both to America’s global standing and to the stability of the world order. Mr Obama’s failure to use force to back up an American “red line” over the use of chemical weapons in Syria in 2013 created widespread unease in the blob. And Mr Trump’s isolationist election rhetoric led to something closer to despair and fears of a complete abdication of US power.

So the sudden conversion of the Trump White House to military intervention in Syria has been hailed as a turning point. Mr Trump’s most ardent nationalist defenders meanwhile are appalled. Ann Coulter, author of In Trump We Trust, tweeted her dismay, asking: “Why get involved in another Muslim catastrophe?”

The Syria strikes have crystallised a growing sense that the foreign and security policies pursued by the Trump administration may ultimately turn out to be more conventional than his critics feared, and his nationalist supporters hoped.

In recent weeks, the signs of a shift towards conventional thinking have accumulated. Mr Trump has conspicuously failed to follow through on some of his most radical foreign policy pledges. He has not ripped up the Iran nuclear deal. He has not moved the US embassy in Israel to Jerusalem. He has switched from open hostility towards the EU to cautious support. He has not held a bromantic summit with Vladimir Putin.

Just a couple of days before the Syria strikes, it was announced that Steve Bannon, the president’s chief strategist and the main advocate of “America first” nationalism in the White House, had lost his seat on the National Security Council. General Michael Flynn, who shared many of Mr Bannon’s radical instincts, was sacked as head of the NSC in February. He has been replaced by Lieutenant General HR McMaster, a man who is revered by the blob. Some of the lower-level appointments at the NSC also sent an interesting message. The newly installed director for Russia and Europe at the NSC is Fiona Hill, a noted critic of Mr Putin, who has been plucked out of the Brookings Institution, a centrist think-tank.

The Syrian strikes took place as Mr Trump was playing host to Xi Jinping, his Chinese counterpart.

The outcome of the first US-Chinese summit of the Trump years was, once again, much more conventional than Mr Trump’s campaign rhetoric. During the election, candidate Mr Trump accused China of “raping” America and threatened to raise punitive tariffs on Chinese goods.

He promised that he would not treat Chinese leaders to fancy meals but instead would take them to McDonald's. In the event, Mr Trump offered Mr Xi pan-seared Dover sole with champagne sauce at Mar-a-Lago and emerged from the summit purring about the marvellous rapport he had established with the Chinese leader. Talk of tariffs and confrontations on the high seas had given way to the usual bland, blob-like commitments to joint dialogue and study groups. The Chinese had reason to be pleased, if a little baffled.

Some in the Washington establishment are nonetheless hopeful that the coincidence of the Syria strikes and the Xi summit might serve a useful purpose, sending the message to North Korea, Russia, China and others that the US once again has a leader who is comfortable using military force.

But foreign policy traditionalists should be careful about celebrating Mr Trump’s apparent conversion. The Syria strikes could yet be a turning point — in the wrong direction. Three particular risks present themselves. First, Mr Trump’s about-face on the Assad regime demonstrates his volatility. If he can chuck out a year’s worth of rhetoric on Syria in 24 hours, he could easily reverse himself again in response to the next shocking event.

Second, there is a risk that the president, who is obsessed with his poll ratings, notices that military strikes have boosted his popularity and develops a taste for this sort of thing. But later uses of force, in North Korea or elsewhere, could be a lot riskier than lobbing a few cruise missiles on to a Syrian air force base.

Finally, there is the obvious danger of escalation in the Middle East. There is little sign that Mr Trump has thought about the steps after the cruise missile attack. But the risks and contradictions of military action in Syria are evident, and range from a Russian military response to gains for the jihadis of Isis. The blob should put the champagne back in the fridge and stay tuned.

Major Choke Points in the Persian Gulf and East Asia

By George Friedman and Cheyenne Ligon

The flow of international trade has always been subject to geopolitical risk and conflicts. At all stages of the supply chain, trade inherently faces challenges posed by the geopolitical realities along a given route.

Some routes are more perilous and harder to navigate than others. One such trade route is the maritime path for delivering oil from Persian Gulf producers to East Asian consumers. It faces two critical choke points that are unavoidable given geographic constraints.

The Persian Gulf is a leading oil-producing region, accounting for 30% of global supply. Meanwhile, East Asia is a major oil-consuming region and accounts for 85% of the Persian Gulf’s exports, according to the Energy Information Administration (EIA). The most common route for oil deliveries between these two regions is through the Strait of Hormuz, into the Indian Ocean, and through the Strait of Malacca.

The two straits are geopolitical choke points because geographic limitations and political competition threaten access to these routes.

Strait of Hormuz

The Strait of Hormuz is the primary maritime route through which Persian Gulf exporters—namely Bahrain, Iran, Iraq, Kuwait, Qatar, Saudi Arabia, and the United Arab Emirates—ship their oil to external markets. Only Iran and Saudi Arabia have alternative access routes to maritime shipping lanes. The strait is 21 miles wide at its narrowest point, bordered by Iran and Oman. The EIA estimates that approximately 17 million barrels of oil per day—about 35% of all seaborne oil exports—pass through the strait. This path is also the most efficient and cost-effective route through which these producers can transport their oil to consumers in East Asia.

Persian Gulf countries depend heavily on revenue from these exports. For this reason, passage through the Strait of Hormuz is both an economic and a security issue for countries in the region. Disruptions in the strait would impede the timely shipment of oil: Exporters risk losing significant revenue and importers could face supply shortages and higher costs. The longer the disruption lasts, the greater the losses.

Disruptions could take place when Sunni and Shiite countries threaten to deny each other passage through the strait. Blocking access is a way to inflict financial damages on countries that depend on exporting goods through this area. Shiite-majority Iran has threatened to close the strait and plant naval mines to assert its power over Saudi Arabia and other Sunni states. Saudi Arabia and its allies have conducted naval drills to demonstrate their willingness and ability to retaliate should Iran follow through.

Given their financial dependence on oil revenue, Persian Gulf countries have tried to mitigate the risk associated with passing precious exports through the strait in two ways. First, they have established alternative export routes. Saudi Arabia built a pipeline that carries oil from fields in the east to refineries in the west. From there, it is shipped out through the Red Sea. Similarly, the United Arab Emirates built the Abu Dhabi Crude Oil Pipeline to bypass the Strait of Hormuz and export directly from Fujairah Port. In both cases, the pipeline capacity is not enough to relieve dependence on the Strait of Hormuz.

Second, Persian Gulf countries have built security alliances with countries that have a vested interest in keeping the strait open. These security alliances often involve a partnership with the United States. In 2016, the US received 18% of its oil imports from the Persian Gulf. Therefore, it wants to maintain safe passage of exports through the strait. The US also has the most powerful naval fleet in the world. These forces can be rapidly deployed to deter a potential blockage of the strait, since other navies in the area could not compete directly with the US Navy in a confrontation.
Strait of Malacca

The Strait of Malacca is the shortest sea route to move goods from the Persian Gulf to Asian markets. It is over  one-third shorter than the closest alternative sea-based route. This added distance would make the oil more expensive for consumers. Roughly a quarter of all oil transported by sea (more than 15 million barrels per day) passes through the Strait of Malacca, making it second only to the Strait of Hormuz in oil transport by volume.

The Strait of Malacca is 550 miles long and runs past Indonesia, Malaysia, and Singapore. At its narrowest point, the strait is a mere 1.5 miles wide. Its narrowness makes ships more susceptible to piracy (which is prevalent in the area) and blockades.

Both Japan and China’s national economies rely heavily on oil imports that pass through the Strait of Malacca. Therefore, open access through the strait is key to their economic security. Over 80% of China’s oil imports (by sea) and around 60% of Japan’s total oil imports currently pass through the strait. These two countries have a long history of animosity and war as they competed with one another to be the dominant geopolitical power in the region. 

However, attempting to block the strait would be a double-edged sword for these regional powers. On one hand, restricting trade flow through the strait could be a way of inflicting economic pain on a rival. This could lead to an economic downturn and subsequent domestic political problems for the rival. On the other hand, initiating a blockade could set a precedent for other countries to vie for control of the strait. This could put either country’s access at risk.

To secure their economic stability, Japan and China have pursued means to guarantee safe passage of oil through the strait. Like Persian Gulf countries, Japan relies on its alliance with the United States to guarantee free navigation of goods by sea. The US Pacific Coast conducts a significant amount of trade with East Asia, and Washington relies heavily on its alliance with Tokyo to offset China’s power and any other potential threats in the region.

China’s strategy involves strengthening its military and political ties in the region. Beijing has forged strong political and economic relations with the countries that surround the Strait of Malacca, particularly Indonesia. It is also in the process of building a large navy with the goal of gaining more control of its surrounding seas.  

For both Persian Gulf exporters and East Asian consumers, the free passage of oil shipments is essential. However, these shipments must pass through two geopolitical choke points. In the Strait of Hormuz, the main risk derives from the conflict between Sunni and Shiite powers in the region. In the Strait of Malacca, it is the regional rivalry between China and Japan.

All of these countries must take measures to mitigate their risk and secure free passage through the respective straits as the effects of a blockade would be devastating to local economies. Geopolitics not only explains why such measures are necessary, but also which measures are most suitable for the countries involved.

The Market Churn Before The Storm?

by: Orange Peel Investments

- Markets held together nicely last week, despite geopolitical tensions and an ugly jobs number.

- The market appears to be consolidating, leading us to believe volatility is eventually on its way.

- We think the market can go any which way, except much higher.
What a week, and what a market reaction. To recap last week, here are a few headlines.
North Korea.
Non-farm payrolls.
Doesn't exactly seem like the type of environment where markets should be trading sideways, does it? Although it is no surprise to us, that is exactly what markets did over the last week even on news that the United States was bombing Syria, reviewing options to deal unilaterally with North Korea and posting a jobs number that missed estimates horribly. Yet, for the most part, the markets remain resilient.
^DJI Chart
^DJI data by YCharts
In fact, markets finished the week as though nothing had happened.
If you want to know why this hasn't been too much of a surprise to us, you should read an article that we posted last week talking about why the Federal Reserve might prevent a crash from ever happening again and why the market, during the next recession, could actually just trade sideways for several years to come. You can read that entire article here, but the gist of it was,

"...we do think that there is a real case for stocks simply trading sideways over the next few quarters and maybe even over the next few years. The equity market trading sideways while earnings ostensibly continue to increase would almost be the equivalent of a bear market, as valuations would compress, but the optics of the scenario wouldn't be as bad as a full-scale recession. This is the situation we think that the Federal Reserve might actually allowed to happen. 
We continue to have numerous events globally that could cause volatility, but the markets just simply don't seem concerned. The continued investigations into the Trump administration regarding Russia and new conflict arising with North Korea don't seem to be of any concern to equity markets. We are not sure what it will take to create some volatility in the markets, and there's part of us that doesn't even want to know what this point."
The point of this article today is to point out that things happening in the world do not seem to fall in line with what equity markets are doing and we think that this is eventually going to cause a stir in US equity markets. Make no doubt about it: although it may not be a massive recession, we do think markets are eventually going to make a move lower, before perhaps parking themselves at about 19,000 or under 20,000 where they may trade sideways for several quarters.
Escalating geopolitical tensions continue to have no affect on the market. While equity futures sold off slightly on the news that President Trump had launched missiles into Syria, those futures were hastily bid back up heading into the trading session on Friday, where the market eventually finished near unchanged. In addition to this, Friday morning's nonfarm payrolls miss also had Dow futures down about 50 or 60 points, but they too were eventually bid back up before the opening of trading. We don't really want to speculate as to the cause of this constant dip buying, but we do want to point out that the more the surrounding environment changes while the market stays the same, the more chance there is going to be of some stormy weather coming at some point in the future.

For every day that goes by that the markets don't react somewhat sensibly to news that should be causing some volatility, we believe it is just getting worse for when the straw that breaks the camel's back finally arrives. Just like what happened in 2008, we didn't know there was a problem until it was too late. This adage could be used not only for the state of our global economy, but also for the state of geopolitical tensions. It appears as though our conflict with Syria will continue. It appears the administration is set on dealing with North Korea unilaterally. It appears as though consumer credit is overextended. And finally, on top of all of this, interest rates are set to continue ticking higher.
With a market that has rallied significantly over the last eight years due to interest rates being low and the geopolitical tensions being almost completely eliminated, we now a step into a new era.
Except, instead of changing, the market simply continues to think that it is OK to keep moving higher. While the market will definitely move higher over the very long term, as earnings rise and inflation occurs, right now we believe there is a disconnect between what is happening in the world and how the public markets are responding.
This, of course, creates opportunity and we continue to be carefully positioned at about 60% long and 40% short heading into the middle of 2017. We would encourage market participants to review a little bit of history and look at the effects on markets in the past due to interest rate hikes and heightened geopolitical tensions. As a reminder, the rally that has taken place under the watchful eye of the current administration took place in anticipation of tax reform. Not only has tax reform not happened yet, but the Trump administration has been unable to put forth any type of meaningful legislation or healthcare reform. That is not to say that won't happen in the future, it's just to say that on top of ignoring current events, the rally that the market has had over the last four months may in fact also be a fallacy.
^SPX Chart
^SPX data by YCharts
As you can see from the above chart, the market simply continues to churn sideways over the last month. Technicians know that when a stock or an index consolidates like this, a large move usually comes out of it eventually. What direction this move is going to be in and when it is going to happen, if ever, remains to be seen. One thing is for sure though, we don't see the market moving higher from here. Given the geopolitical tensions worldwide and the slowing of growth and in the United States, combined with rising interest rates, we see the market as potentially staying sideways or eventually pulling back up to 10% over the coming quarters.
We have prepared ourselves accordingly.

Trump, China, and the Art of Easy Promises

Chinese officials can afford to make assurances about reducing the trade surplus—as long as things are going well back home

By Nathaniel Taplin

Donald Trump’s summit with Chinese President Xi Jinping this weekend may have passed calmly, but one comment should make investors sit up: Chinese officials expressed an interest in reducing the country’s trade surplus.

Given how hard the U.S. has been pressing on this subject—arguing that the gap is the product of unfair trade practices—this looks like great news for investors hoping the two sides can head off a trade war.

China has good reasons to want a narrower surplus. When its exporters sell their dollar earnings for yuan, the increase in the domestic money can stoke inflation—a headache the central bank had to deal with for much of the 2000s. Domestic inflation is already on the rise, thanks to massive credit-fueled stimulus in 2015 and 2016 and tighter capital controls that keep more money in the country. Lower export earnings might help subdue inflationary pressures.

The problem is that higher inflation may not last. When Chinese prices stop rising so quickly—and tighter credit starts pressuring heavily indebted corporations—assurances given on trade now will be harder to keep.

As recently as the third quarter of 2016, Chinese exports were contracting rapidly—down 7% from a year earlier—and capital was streaming out of the country. Factory-gate inflation was persistently negative, in part because the central bank’s efforts to support the currency by selling dollars and buying yuan were pressuring domestic money supply.

Those conditions could return easily. The main domestic drivers of inflation—easy money and real estate—are already showing signs of reversing. Commodity prices are losing momentum, and industrial overcapacity remains severe, making a sustained pickup in domestic inflation unlikely.

When, as seems likely, prices at home lose momentum, Chinese policy makers may welcome the money-supply boost that healthy export earnings provide. That is when investors will see whether this weekend’s cordiality has truly changed Chinese trade policy in a meaningful way.

Safety last

How to manage the computer-security threat

The incentives for software firms to take security seriously are too weak
COMPUTER security is a contradiction in terms. Consider the past year alone: cyberthieves stole $81m from the central bank of Bangladesh; the $4.8bn takeover of Yahoo, an internet firm, by Verizon, a telecoms firm, was nearly derailed by two enormous data breaches; and Russian hackers interfered in the American presidential election.

Away from the headlines, a black market in computerised extortion, hacking-for-hire and stolen digital goods is booming. The problem is about to get worse. Computers increasingly deal not just with abstract data like credit-card details and databases, but also with the real world of physical objects and vulnerable human bodies. A modern car is a computer on wheels; an aeroplane is a computer with wings. The arrival of the “Internet of Things” will see computers baked into everything from road signs and MRI scanners to prosthetics and insulin pumps.

There is little evidence that these gadgets will be any more trustworthy than their desktop counterparts. Hackers have already proved that they can take remote control of connected cars and pacemakers.

It is tempting to believe that the security problem can be solved with yet more technical wizardry and a call for heightened vigilance. And it is certainly true that many firms still fail to take security seriously enough. That requires a kind of cultivated paranoia which does not come naturally to non-tech firms. Companies of all stripes should embrace initiatives like “bug bounty” programmes, whereby firms reward ethical hackers for discovering flaws so that they can be fixed before they are taken advantage of.

But there is no way to make computers completely safe. Software is hugely complex. Across its products, Google must manage around 2bn lines of source code—errors are inevitable. The average program has 14 separate vulnerabilities, each of them a potential point of illicit entry.

Such weaknesses are compounded by the history of the internet, in which security was an afterthought.

Leaving the windows open
This is not a counsel of despair. The risk from fraud, car accidents and the weather can never be eliminated completely either. But societies have developed ways of managing such risk—from government regulation to the use of legal liability and insurance to create incentives for safer behaviour.

Start with regulation. Governments’ first priority is to refrain from making the situation worse.

Terrorist attacks, like the recent ones in St Petersburg and London, often spark calls for encryption to be weakened so that the security services can better monitor what individuals are up to. But it is impossible to weaken encryption for terrorists alone. The same protection that guards messaging programs like WhatsApp also guards bank transactions and online identities.

Computer security is best served by encryption that is strong for everyone.
The next priority is setting basic product regulations. A lack of expertise will always hamper the ability of users of computers to protect themselves. So governments should promote “public health” for computing. They could insist that internet-connected gizmos be updated with fixes when flaws are found. They could force users to change default usernames and passwords.

Reporting laws, already in force in some American states, can oblige companies to disclose when they or their products are hacked. That encourages them to fix a problem instead of burying it.

Go a bit slower and fix things
But setting minimum standards still gets you only so far. Users’ failure to protect themselves is just one instance of the general problem with computer security—that the incentives to take it seriously are too weak. Often, the harm from hackers is not to the owner of a compromised device. Think of botnets, networks of computers, from desktops to routers to “smart” light bulbs, that are infected with malware and attack other targets.

Most important, the software industry has for decades disclaimed liability for the harm when its products go wrong. Such an approach has its benefits. Silicon Valley’s fruitful “go fast and break things” style of innovation is possible only if firms have relatively free rein to put out new products while they still need perfecting. But this point will soon be moot. As computers spread to products covered by established liability arrangements, such as cars or domestic goods, the industry’s disclaimers will increasingly butt up against existing laws.

Firms should recognise that, if the courts do not force the liability issue, public opinion will. Many computer-security experts draw comparisons to the American car industry in the 1960s, which had ignored safety for decades. In 1965 Ralph Nader published “Unsafe at Any Speed”, a bestselling book that exposed and excoriated the industry’s lax attitude. The following year the government came down hard with rules on seat belts, headrests and the like. Now imagine the clamour for legislation after the first child fatality involving self-driving cars.

Fortunately, the small but growing market in cyber-security insurance offers a way to protect consumers while preserving the computing industry’s ability to innovate. A firm whose products do not work properly, or are repeatedly hacked, will find its premiums rising, prodding it to solve the problem. A firm that takes reasonable steps to make things safe, but which is compromised nevertheless, will have recourse to an insurance payout that will stop it from going bankrupt. It is here that some carve-outs from liability could perhaps be negotiated.

Once again, there are precedents: when excessive claims against American light-aircraft firms threatened to bankrupt the industry in the 1980s, the government changed the law, limiting their liability for old products.

One reason computer security is so bad today is that few people were taking it seriously yesterday. When the internet was new, that was forgivable. Now that the consequences are known, and the risks posed by bugs and hacking are large and growing, there is no excuse for repeating the mistake. But changing attitudes and behaviour will require economic tools, not just technical ones.