The economy may make a significant shift in 2017. The Trump administration and Republican Congress will reshape economic policy. They face the same mega-trend headwinds that all other recent governments have. Their goal is to overcome those headwinds and stimulate growth without creating massive debt.
In our Annual Letter we discuss the major turning points in the markets and the economy. We began this letter earlier with our Financial Year in Review. The topics in that piece dovetail with the ideas presented here. We suggest you read that before continuing.
The Power of Tactical Thinking
As we discuss often, we use a process called “tactical asset allocation” when managing money. This approach is designed to help reduce risk while participating in the best parts of the markets for making returns. While there is complicated mathematics underlying this investment management approach, there is a simple, but powerful, idea behind it all.
Throughout life, we observe situations that cause us to question. Often something that seems quite easily fixed or dealt with, is not dealt with successfully. Other times we see problems that seem so insurmountable, that when people overcome those dilemmas we are amazed.
The difference between those who overcome and thrive can be measured in one key quality: their ability to adapt to situations and make good choices. While we acknowledge and understand the power of circumstance, the choices we make line our path.
The ability to adjust as circumstances change is at the heart of tactical decision making. Businesses, the military and people of every stripe are faced with changing circumstances every day. How they adjust to those changes is what causes them to succeed or fail over time. Those who can effectively tweak their approach to handling a changing world, tend to do better – bad luck notwithstanding.
In life, and in managing money, we seek to adjust to changing circumstances by making a series of good tactical decisions. We make those decisions based upon the what is going on today and likely to happen tomorrow. Over time, people who think tactically and are willing to make occasional positive changes, succeed.
A New Era
The election of Donald J. Trump to the U.S. Presidency was the biggest news of 2016. In 2017, the Trump administration will begin a process of “upgrading” the American economy. We’re calling it upgrading because, despite the U.S. economy reaching better footing following the financial crisis, about half of Americans are not participating in the nation’s aggregate success. The economy needs to be upgraded so that far more people can lead better lives.
The process of upgrading won’t be easy. The Trump team, and Republican Congress, will face mega-trend headwinds: aging demographics and overwhelming global debt.
Each quarterly letter, and many columns, touches upon the challenges of dealing with an aging global population. This is not just a challenge for the United States, it also affects the next three largest economies as well: China, Europe and Japan.
Populations with increasing average age pose a significant problem for governments. The “old age dependency ratio” is the number of people age 65 and over divided by the working age population. It is an approximation of how many people that the working population is helping to support. That support come in the form of healthcare and retirement benefits.
Globally, the old age dependency ratio is steadily increasing. Currently about 13% of people are 65 years-old or older. That is an increase from under 7% fifty years ago. The percentage of working people to support the aging in just two generations has roughly doubled.
In the United States the ratio is even more dramatic. However, the issue is the most challenging in Europe and Japan.
The projections are imposing as well. Economists demonstrate that helping our senior citizens becomes very difficult once the percentage is over the middle teens. We are at that percentage globally and exceed it in the 3 of the 4 largest economies today.
In China, which has been leading the world in growth in recent decades, there is a large uptick as well due to the previous “one child” policy. The old-age dependency ratio in China is expected to double in the next twenty years according to the U.N.
Old-age Dependency is a Huge Challenge and Growth is the Only Solution
The issue of old-age dependency is huge. It is likely the most pressing economic challenge we face. Already, nations are borrowing trillions of dollars to address their needs. How long can the global economy continue to print money, kick the can down the road until we collapse under a mountain of debt?
The key to addressing debt is REAL economic growth. In America, incoming President Trump hopes to grow the economy at nearly double the current rate by creating the pro-growth policies necessary to incite American business to have the confidence to grow. Innovation will be at the heart of finding new ways to deal with an aging workforce while providing opportunity for younger workers the freedom to innovate for the next generation.
The Small Business Index recently reported that since the election, confidence in the future is at the highest level since 1980. Small businesses are looking forward that the next four years will give the regulatory and tax relief needed to put capital and labor to work again.
At Global View, we strive to uncover the drivers of growth and innovation so that our investors can participate in that growth for the future.
Debt is at epic proportions. As one of our core research providers Ned Davis Research states:
“According to our recent calculations, global non-financial debt has climbed to a record high 233% of global GDP. Although emerging markets encompass a smaller share of the global debt burden, they are surely catching up, as total non-financial debt climbed to a record 171% of GDP. Private debt in the emerging world is reaching developed-market proportions, jumping to a record high 148% of GDP. Much of this is due to China, not only due to its size, but also its level, as its private debt is the highest in the emerging world, at 209%. South Korea and Chile aren’t far behind, at 196% and 148%, respectively (see table below).”
Many point to the potential “hard landing” scenario in China as a catalyst for a large debt and currency market correction. With the Yuan gaining some traction as an international currency, it is easier for the Chinese to monetize internal debt. This would be done in a similar fashion as the U.S. Federal Reserve has done for America.
Debt in Europe & Japan is Out of Control
The debt in Europe has reached unsustainable levels and the people know it. As we have discussed, Europe has several key elections in 2017. If the E.U. frays and the ECB weakens, the risk of a major banking and sovereign debt crisis in Europe increases. With Greece set to receive more aid, if that were disrupted, it is easy to see a waterfall of problems developing.
In Japan debt is a whopping 233% of GDP. That is far in excess of even Greece’s debt overhang. Combined with their demographic issues, any disruption to global economics would likely hit an exporting nation like Japan very hard.
If Europe & Japan do not instill pro-growth fiscal policies, the domino effect in global debt markets could be tremendous. While central banks maintain the ability to print money and government helicopter money is possible, there is a growing awareness that monetary policies have reached their limit.
At Global View, we are underweight in Europe & Japan, however for the small allocation we do have, we utilize ETFs that specialize in hedging currency-risk as their currencies depreciate against the U.S. dollar.
The World Trade Organization has documented that global trade has remained subdued for five years. Their projection for 2016, is under 2% trade growth.
Some fear that rising protectionist ideas across the globe threaten to harm trade and history has proven that it can. However, we understand the temptation of protectionism.
China uses our intellectual capital, subsidizes its steelmakers, and often forces our companies to work with local firms when working within THEIR country. For example, as discussed on Bloomberg radio, just this week, China imposed a 53% tariff on aluminum while increasing its own aluminum production in an effort to increase global supply, drive down global prices, which in turn, is causing extreme harm to US aluminum producers. The Obama administration has filed a complaint with the World Trade Organization for these illegal acts, but perhaps the threat of protectionism will get them to stop these practices.
Americans are waking up to these kinds of practices and are calling to reverse the globalization practices that have moved jobs to countries with lower labor costs and taxes. By inciting the captains of American business to move operations back to the US if they want unfettered access to the US consumer may be the kind of steps necessary to grow our economy.
Rising tensions, caused by economic stress, appear to be rising across the world. The possibility of confrontations seem high. While negotiation can often lead to win-win situations, confrontation rarely does. President Trump, by virtue of being the American President will be at the center of many negotiations and possibly confrontations.
In today’s confirmation hearing for Defense Secretary, Ret. Gen. James “Mad Dog” Mattis when asked by Senator John McCain if America is prepared for the rising global risks, said, “the US is under it’s biggest attack since WWII; from Russia, from terrorists groups and from China in what their doing in the South China Sea.” When questioned by Senator McCain if our military was prepared for these threats, he answered, “sir, no we are not.”
Our approach to investing since 9/11 has been the ability to take aggressive defensive action during extreme geopolitical events to protect the hard won capital of our investors by employing a defensive mandate to move high risk assets to the sidelines in either bonds and/or cash.
Since the 2008 Financial Crisis, Central Banks around the world invoked some of the most extreme money printing schemes in history to fight deflation. The US alone has created more debt in the last 8 years than all of its 225 history. In addition, central banks have pushed yields to almost 50% of global sovereign debt into negative rates. This is lunacy! Central Banks have finally admitted that without pro-growth fiscal policies from governments that their current monetary policies will do more harm than good.
In our opinion, 2017 will mark a major turning point for inflation. That turning point will consist of a confirmed shift in market expectations from the fear of deflation to the expectation of inflation.
That initial shift began in Q4-2016 after the Trump presidential election win. At that point we witnessed a sudden spike in inflation expectations.
At Global View we track the ratio between U.S. equities and commodities. There is a recent spike in agricultural commodities and gold, but we would be looking for a follow-through from the broad-based commodity indexes.
Valuations Are Still High
As covered in our 2016 3rd Quarter Letter (RISK IN THE GLOBAL ECONOMY AND ASSET MARKETS IS NEAR 2007 LEVELS) stock market valuations are high. Not the highest on record, but near the top. Implying that the 20-30% stock market correction is a real possibility. There is a wildcard to this equation though.
According to Bloomberg, most stock prices have been driven by share buy backs which may be a continuing trend. If there is corporate tax reform, that will be hugely bullish for stocks because it increases profitability, leading to a continued rise in stock prices.
The possibility of a tax holiday or some sort of deal for repatriating corporate profits from off-shore tax havens is also likely. American multinational companies will benefit the most from that. Companies in the Nasdaq 100 (tech companies) control about 80% of the two trillion or more dollars American corporations have overseas.
A fast growing economy could continue to support stock prices. Growth and inflation would likely push stock prices even further up. Our models show that under those circumstances there is still room for a significant rally.
Another scenario is that in the short-run a correction occurs, only to grow out of it quickly. That has happened a few times in the past several years. To handle this, we employ a multitude of tactical approaches for managing high volatility on a short-term, intermediate-term and long-term basis, allowing us the flexibility to adjust to such shifts.
As discussed at the outset to this quarterly letter, we are tactical investors at Global View Capital. We believe there will be an inevitable correction to markets, but do not predict when. Those who attempt to predict the next correction, recession or collapse are generally wrong and miss substantial gains. So, rather than tell the markets when to correct, we simply follow what the markets do.
Right now our models are cautiously optimistic and overweight to US equities. Foreign direct investment and buybacks are offsetting domestic selling by aging Baby Boomers. If earnings are decent in the next month, then we would expect that to continue. But, if earnings do not come in well, then we could see a change in trend.
In our opinion inflation will return. We have been using a hard asset rotation fund to offset some inflationary pressures. Owning hard assets such as gold, energy assets and real estate in your asset allocation to offset inflation could be important when protecting and growing your financial freedom.
As managers, we stick to our disciplines, report weekly analysis and find the asset classes that are doing well to participate in and do our best to avoid the weak asset classes. This discipline helps us to manage risk ongoing.
Tactical Closing Thoughts
As we navigate a changing world economy, we expect more volatility in coming years than since the Financial Crisis when Central Banks were repressing volatility. When the market returns to normal volatility, we see that as positive because without the heavy-hand of Central Bank intervention, we can have free markets again.
These are indeed interesting times. If it is up to all of us help push through to the brighter side. Since the Dark Ages, man has in fact done that.
We would like to take a moment to remind people about America’s greatness as we witness the inauguration of a new President. To remind ourselves how blessed we are to live in a country that allows for ALL ideas to be expressed freely.
This country was founded on the principals of freedom, faith in our fellow man and God. The United States has continually pushed forward over time, even if there are some stumbles and we expect that to continue. Our children will gradually live better than us, although we may sacrifice for a time. As Warren Buffett has stated: “It’s never paid to bet against America. We come through things, but it’s not always a smooth ride.”
It’s not always a smooth ride, we would remind you, take a tactical approach to investing. Have a plan, but be flexible enough to adapt to changing circumstances. That is our plan and we’re sticking to it.
The Global View Team