May 2016 Commentary and Opinion May 16, 2016


(Artist: PepperAna, used with permission)

The economic landscape has become extremely complex, beyond the understanding of even many famous economists, so I will attempt in this letter to keep things very simple and brief.

The Federal Reserve and most other central banks have spurred an unparalleled rise in borrowing since 2009, and the debt has been used for unproductive purposes such as stock buybacks and mergers instead of research, development, and capital expenditures.

This is true in the U.S., Europe, Japan, and China.

As a result of these central bank policies, we have negative real interest rates in much of the developed world, which is without historical precedent, even going back to Biblical times. (“Well then, you should have put my money on deposit with the bankers, so that when I returned I would have received it back with interest”: Matthew 25:27).
This observation alone is good reason to believe that we are not experiencing a “normal” investment landscape.
There is a stubbornness persisting in defensive posturing which in the context of the rally off the February lows has many investors confused. There seems to be something bothering the stock market.
Central banks have printed trillions of dollars around the world in order to support asset prices.
Those asset prices, be they stocks or bonds, are now historically expensive, and with no more ammunition left for central banks to cut interest rates any further, are poised for a pullback. The only reason why they haven’t yet is because of more central bank intervention, but this will not last forever.
I have elaborated in the past why caution is currently advised for both stocks and bonds. There has been tremendous volatility in the world financial markets this year. After a 20% selloff in January, stocks rallied back to an unchanged level due to central bank intervention. But US stocks are largely in the same place since the end of 2014, and European, Chinese, and Japanese stocks are lower.
The debt level of the Unites States now stands at $19.3 trillion and goes up by $500 billion per year. Unfortunately, things are not better abroad. This morning the Chinese Communist party’s biggest newspaper The
People’s Daily published an unusual front page interview with an “authoritative figure” who warned that China’s soaring debt levels could lead to “systemic financial risks”. China’s debt level is now at 237 percent of GDP and climbing. “A tree cannot reach the sky” he said. “Any mishandling will lead to systemic financial risks, negative economic growth and evaporate people’s savings. That’s deadly”. The source of these quotes is rumored to be none other than the head of the People’s Bank of China, as a warning to certain members of the government.
This global debt is one of the primary reasons why your portfolio has grown nicely over the past ten years. However, it could also be the reason why your portfolio will decline in value unless it is handled defensively. We have all become accustomed to stock market performance, but should be mindful of the 15 year period between 1968 and 1983 when the stock market was unchanged, and in real terms, negative. This, was a period of “stagflation”, or economic stagnation combined with inflation.

If the U.S. was spending only what it earned, or seen another way, if its citizens and companies were taxed at a level equal to government spending, the U.S. stock market and the bond market would be considerably lower.
Now that we are facing higher rates ahead as a protective measure against inflation, we are approaching a shift in perceptions about the future.
A 1% rise in U.S. interest rates will mean a $1.3 trillion rise in interest costs for the U.S. government. It is not difficult to imagine what this would mean if rates needed to climb more than that. When these interest costs rise, governments have less to “spend” on stimulus. Taxes go up, and consumers and businesses have less money to spend on goods and services. Company revenues and profits begin to grow at a slower rate.
Consumers represent 70% of the U.S. economy. Since the middle of last year, personal consumption as a percentage of income has been declining, while personal saving is at a 3.5 year high, at 5.4%. These higher saving rates end up as excess reserves at banks, which are not filtered back into the economy via higher levels of investment. Subsequently GDP growth in the U.S. is weak; in the last quarter of 2015 it was only 1.4% and in the first quarter of 2016 it was only 0.5%.
Yet because of central bank intervention, stock valuations are unrealistically high. The price-to-earnings ratio of the S&P 500 is now at 23.6, whereas its historic average is 15.6. If the stock market were simply to return to its “average” valuation level, it would need to drop 33%. What is worse, however, are the distortions in this ratio created by over $2 trillion of stock buybacks since 2009 by publicly quoted companies. When a company borrows inexpensively in order to purchase back its own shares, it artificially reduces P/E levels, since the “E” in P/E stands for earnings “per share”. With fewer shares, this makes earnings per share figures higher and thus Price-to Earnings ratios lower. Without these record buybacks, the P/E ratio of the S&P 500 would be even more over-valued. This practice amounts to converting stock into debt in order to elevate stock prices with an aim to avoid “options dilution”. Top executives of publicly quoted companies make most of their compensation with stock and stock options, so it is in their interest to keep stock prices elevated as long as possible.


The above chart is a 20 year graph of the Volatility Index. When it is low, investors are complacent. When it is high, investors are panicky. Right now, it is low, too low when taking into account the Brexit vote on June 23rd, the Federal Reserve Bank meeting on June 16-17, and the strangest political climate the U.S. has seen in a lifetime which could produce a “toxic” U.S. President. There is very little liquidity in the stock market right now, meaning that it is subject to over-reaction.


It may seem contradictory to worry about inflation while expecting a stock market pullback. But this is precisely the moment to begin thinking about it, while unusually low oil prices are suppressing inflation expectations.
Recall that the 1970’s was a period marked by low growth and simultaneous inflation.
I believe that there are incipient signs of inflation in the U.S. economy right now, and that later this year when the 12 month “lookback” on oil goes positive, inflation will be discussed a lot more. There are already signs of wage inflation appearing in the U.S.

I am not alone in this view. Federal Reserve Board members Fisher, Brainerd, Lacker, Williams, and Bullard have made similar comments recently.

The output gap, or difference between the actual output of the US economy and its potential output, is far narrower in the US that it is in Europe or Japan. It has been steadily narrowing since 2009. The growth in the US labor force has finally exceeded population growth. Combined with rising US wages, a low unemployment rate, and rising unit labor costs, the risk is now that the US will experience some inflationary wage growth.

Traditionally, when a business cycle extends into what is known as "late-cycle", it moves past its peak rate of economic growth. In this phase of the business cycle, rising inflation can cause profit margins and earnings growth to decelerate. While input prices have remained subdued because of the collapse in commodities, this is not likely to be the case for much longer. Rising inventories relative to sales are another indication of the end of the business cycle. The following chart indicates that the inventory to sales ratio is at a seven year high.


Rising interest rates and tightness in the employment market are two other signs of a late stage business cycle. During this phase of the business cycle, stock returns are typically less reliable and assets that resist inflation tend to outperform. These might include Treasury Inflation Protected Securities, gold, commodities, and stocks related to commodities. In the near-term there may be continued volatility in the global commodity markets. But as we move forward and commodities and oil establish a floor, there will be an increased focus on the risks of inflation. This view contradicts the widely held notion that world economies are headed for further deflation.

Profit Margins:

As a business cycle moves into “late stage” and the labor market tightens, workers gain more bargaining power and demand higher wages. When firms resort to price increases to protect their profit margins, inflationary pressure causes the Fed to hike interest rates, which can move the economy into recession. I expect that wages in the U.S.will accelerate more quickly than prices and that firms’ profits are likely to decline as a share of national output.
A glance on the following chart may emphasize why this is important:


Note that every time there is a drop in profit margins, a recession usually follows (in grey).
Accordingly, I expect a lower stock market this year. Specifically, I expect the market to drop and bottom out sometime toward late October.

Donald Trump:

At the time of this writing, Hillary Clinton is leading Donald Trump in the U.S. polls by only 1%, 41% to 40% (Reuters/Ipsos poll, May 11th).

I can say in no uncertain terms that a Donald Trump Presidency would be catastrophic for the global stock and bond markets.

Mr. Trump has now declared bankruptcy four times in his career. On Thursday the 5th of May, he was asked about whether he felt that the United States needed to pay 100 cents on the dollar of that debt, or if he thought there were ways to renegotiate that debt.

His response?

“I've borrowed knowing that you can pay back with discounts. And I've done very well with debt. Now of course I was swashbuckling, and it did well for me, and it was good for me and all of that. And you know debt was always sort of interesting to me. Now we're in a different situation with a country, but I would borrow knowing that if the economy crashed you could make a deal. And if the economy was good it was good so therefore you can't lose. It's like you make a deal before you go into a poker game. And your odds are much better.”

The entire world financial system is built around United States Treasury Bonds being risk free. If they are suddenly no longer risk free, it defies the imagination to understand the consequences. It can be argued that the
U.S. Congress would prevent him from any concrete action as President, but the words alone are unsettling enough to cause tremors in an already nervous world of investors. Publicly held U.S. debt amounts to some $13.8 trillion.

He is militaristic towards the Middle East, and wants to ban Muslims from entering the United States which will inflame jihadi groups and lead to terrorism on American soil.

A Washington based policy institute estimates that immediately and fully enforcing current immigration law, as Trump has suggested, would cost the federal government from $400 billion to $600 billion and shrink the labor force by 11 million workers, reducing the real GDP by $1.6 trillion and taking 20 years to complete. Economists know that immigration is a source of economic growth, so Trump’s immigration proposals are obviously negative for growth.

Industries that depend on cheap immigrant labor would be harmed immeasurably. There would be a fall in farm income and a spike in food prices. There would be a loss of jobs at the level of local and small businesses who service immigrants. There would be wage inflation.

Trump wants to reduce taxes for companies and individuals, which could be considered pro-growth. Except that the cost of doing so would drive the United States off a fiscal cliff, reducing tax revenues by over $10 trillion.

Trump has a hostile attitude to free trade, and will continue to alienate and bully Mexico and China which could result in a trade war. He is in favor of “up to” 35% trade tariffs. Tariffs are a disaster for global trade, and thus would be negative for Asian countries that depend upon global trade, like China, South Korea, Taiwan, Vietnam, and Malaysia.

The Tariff Act of 1930 was enacted by the U.S. Congress to protect American jobs and farmers from foreign competition despite a petition signed by 1,028 economists pleading the U.S. President Hoover to overturn the law. This law imposed tariffs on over 20,000 goods being imported into the U.S. Students of history know what happened next; retaliation by 23 countries led to a decrease in imports of 66%, a decrease in exports of 61%, a contraction of 46% in national output over the next four years, and a doubling of the unemployment rate from 8% to 16%.

So is Donald Trump dangerous to the world economy, and by extension to your stock portfolio? In a word, yes.

Specific Recommendations:

1) TIPS are U.S. Treasury bonds, whose coupon is simply the global American CPI, or Consumer Price Index. TIPS are compared with traditional Treasury bonds. The narrower the yield spread between the two, the cheaper TIPS are on a relative basis. Currently, the spread is 1.51 percentage points for 10-year TIPS versus 10-year Treasuries, which is the tightest the spread has been in years. The spread is also known as the “break-even inflation rate,” meaning that inflation only has to exceed 1.51% for TIPS to beat Treasuries—a relatively low hurdle.
TIPS are slightly more complicated than they seem, as they have two components: their coupons, which pay income like any other bond, and their inflation adjustment, which is added twice a year to the bonds’ principal based on movements in the consumer-price The bond component, like any other bond, can go down in price if bond yields go up. The longer the duration of a TIP bond, the more sensitive it is to increases in interest rates. And rates generally rise with inflation.
I have initiated a position for my managed clients in the Vanguard Short Term Inflation Protected Securities ETF, which consists of only short term TIPS. Its average duration is 2.6 years.
This security is, for me, a cash alternative which should make around 4% this year of principal appreciation.
TIPS are one of the least loved asset classes because inflation has been a one way bet, downwards, since TIPS were first issued in 1997. I have chosen the short maturity TIPS fund to reduce interest rate risk, as I feel long end bond yields will begin moving up in the coming years. For now, the coupon on this TIPS fund is minimal….Seven basis points. It is a play on price appreciation and an increasing coupon as inflation begins to move upward, with very limited downside risk. Despite the risks outlined above under a Donald Trump Presidency, short dated Treasury bonds are still a relatively secure investment.

2) The oil sector is still full of risks. The most notable risk is the next OPEC meeting on June 2nd, in less than three weeks. At this meeting, two producers who ideologically detest each other, Iran and Saudi Arabia, will once again face off. Saudi Arabia wants Iran to cut production and drive prices up. Iranian mullahs need income after years of economic sanctions, and may decide to increase their production instead, driving down prices. Both countries desperately need higher prices to pay their bills, but there is also a regional proxy war being fought between them in Syria, Iraq, and Yemen. It is difficult to predict the outcome.
There is also the problem of US fracking companies and their “Drilled, Uncompleted Wells” or DUC’s. According to the Director of the U.S. State Department’s Bureau of Energy Resources, these uncompleted wells could begin producing 500,000 barrels of oil more per day when oil is art $45 or higher. There is very little concrete analysis that can be made from the politics of the Middle East. However, in the U.S., output is at its lowest level since October of 2014. Drillers have cut more than 190 drilling rigs from service just this year to the least amount of active machines since 2009.
It would be a shame to miss a rally in oil, which is bound to come at some point, but impossible to say when. Last June, US oil output surged to a weekly record as drillers returned rigs into service after crude oil climbed to over
$60 a barrel from $45. This rally was short lived however. As the stockpile of oil grew, prices fell to $37 by year end, and $27 by January of 2016.
Nonetheless, U.S. oil companies are so behind on their investing that it’s likely they will need to engage oil service companies to catch up, particularly if oil goes above $50, which is possible if Iran and Saudi Arabia decide to put their differences aside in order to generate some cash. Accordingly, I suggest beginning to build positions in Schlumberger, the world’s largest oilfield services company.

I am positioning portfolios very conservatively at the moment as a consequence of the cautious view described in this letter.

This blog, and this website, are now available in French, German, and Mandarin as well. Language options are found at the top right pull-down menu on the home page.

Grant Rogers

Global Disclaimer

This report has been prepared by Metis Capital Management LLC. This report is for distribution only under such circumstances as may be permitted by applicable law. It has no regard to the specific investment objectives, financial situation or particular needs of any specific recipient. It is published solely for informational purposes and is not to be construed as a solicitation or an offer to buy or sell any securities or related financial instruments. No representation or warranty, either express or implied, is provided in relation to the accuracy, completeness or reliability of the information contained herein, nor is it intended to be a complete statement or summary of the securities, markets or developments referred to in the report. The report should not be regarded by recipients as a substitute for the exercise of their own judgment. Any opinions expressed in this report are subject to change without notice. The analysis contained herein is based on numerous assumptions. Different assumptions could result in materially different results. The analyst responsible for the preparation of this report may interact with trading desk personnel, sales personnel, other analysts, journalists, and other constituencies for the purpose of gathering, synthesizing and interpreting market information. Metis Capital Management LLC is under no obligation to update or keep current the information contained herein. The securities described herein may not be eligible for sale in all jurisdictions or to certain categories of investors. Options, derivative products and futures are not suitable for all investors, and trading in these instruments is considered risky. Mortgage and asset-backed securities may involve a high degree of risk and may be highly volatile in response to fluctuations in interest rates and other market conditions. Past performance is not necessarily indicative of future results. Foreign currency rates of exchange may adversely affect the value, price or income of any security or related instrument mentioned in this report. Metis Capital Management LLC accepts no liability for any loss or damage arising out of the use of all or any part of this report. Certain of the information contained in this presentation is based upon forward-looking statements, information and opinions, including descriptions of anticipated market changes and expectations of future activity. Metis believes that such statements, information, and opinions are based upon reasonable estimates and assumptions. However, forward-looking statements, information and opinions are inherently uncertain and actual events or results may differ materially from those reflected in the forward-looking statements. Therefore, undue reliance should not be placed on such forward-looking statements, information and opinions.


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