Welcome to The Global View Outlook, and our first quarterly newsletter. There are many reasons why we have added our voice to the litany of voices flooding the internet on this free website. We feel that the web has become a double-edged sword; while information is widely available, it is often nearly impossible to determine the worthwhile from the worthless. We plan to add wisdom to the discussion. Doing this is our way of giving back to the country that has given us so much.
If we saw the world as an easy place, we might have passed on this site and simply spent more time on hobbies. We have seen the world change a lot during the past few decades; some of these changes are positive, some are negative. As the rate of change is still increasing, it makes it even more difficult for people to determine how to live the best life possible. We hope that by sharing our thoughts, experience and analysis, we can help people find the lives they dream of. By doing this, we will truly feel that we have completed our mission to Design, Grow and Protect the Personal Economy of Families from all over the World.
Ultimately, life is about happiness and meaning. While money doesn’t buy happiness, having financial success and stability can take the stress away from living, allowing for the pursuit of happiness and the ability to embark on a meaningful life.
The July 2016 Quarterly Letter
All of our letters, will follow a simple format that should help create a useful narrative to follow over time. We will recap topics which happened in the previous quarter, but will also provide a macroeconomic analysis, review the macroeconomic investment landscape, discuss the most important asset allocation trends and wrap it up with what we are watching going forward. Then briefly touch on how we might react under different scenarios.
Our quarterly letters will form the foundation of the topics that we write about throughout the quarter. For example, aging demographics is an important mega-trend that we will discuss today and pay attention to going forward.
We are not trying to write a novel. Your time is valuable. We aim to keep these letters short, but still focus on providing useful information. With that, let’s begin our story.
All the King’s Men
The biggest news of the second quarter of 2016 was the vote in the United Kingdom (U.K.) to leave the European Union (E.U.). The so-called Brexit was widely expected to lose at the polls; however, it was won by a convincing margin of nearly 4 points, due to massive voter turnout. Within minutes of the recognition that the U.K. had voted to leave the E.U., capital markets around the world began to plunge.
Many pundits predicted that the U.K. vote would be a massive disruption to the global economy and markets. Ben Hunt, author of the Epsilon Theory blog, called it a “Bear Stearns Moment,” comparing it to the precursor event that triggered the financial crisis in 2008.
Hunt points out the short-term risk of Brexit is a liquidity shock that could lead to a flash crash. We agree with Ben. However, central banks ride to the rescue to mitigate that risk. We wonder if that could manifest into a rolling correction, the sort we have seen hitting sequential sectors. If a rolling correction plays out, then a tactical approach to managing asset allocation could do very well.
Whether a “Bear Stearns Moment” or not, if Brexit triggers a scramble for high-end capital in European banks, then we are on our way to another financial crisis. If the market believes that central banks can back-stop events coming from Europe, then stock markets might not have peaked, commodity markets may have room to run coming off a four- year bear market and the global economy could be further from recession than many predict. If time is moving faster than humans can comprehend, we could move in a flash to a “Bear Stearns Moment.” So far, what is clear is that risk and volatility are on the rise in a fragile global economy with plenty of potential Humpty-Dumpty catalysts.
In early July, seven U.K. real estate funds halted redemptions as they cannot keep up due to illiquidity in the underlying real estate holdings. This is what can happen when funds that are supposed to have daily liquidity hold semi-illiquid investments. Collectively the funds hold $32 billion of value, however, that valuation may fall substantially as the London real estate market adjusts to expectations about the future values. For a value manager, this presents a buying opportunity.
So far, no large hedge funds have signaled that they’re in trouble. If one or more does signal, that could be the so-called “Bear Stearns Moment.” We’ll continue to monitor the credit markets and the trading trends in ETFs to look for signals of underlying instability.
Regardless of where we are in time and what the future ultimately holds, the Humpty Dumpty analogy is fitting with Brexit. Without sound fiscal policies to create real growth, risk in financial markets will continue to be high. Central banks have enabled dysfunction within governments, leading to delays in governing with sound fiscal policies.
The biggest long-term risk of Brexit is a disruption of the E.U. causing global recession and massive financial fallout. The immediate risk of Brexit is other nations follow the U.K. out of the E.U.. Should that happen, then the intertwined nature of the global economy could be hit by whatever slowdown emanates out of Europe as a result.
If the E.U. punishes the U.K. – which E.U. President Jean-Claude Juncker (he has a Twitter account @junckereu) wants, we could see the long-term risk of Brexit play out. There are alternative approaches that could work.
We believe the economic slowdown from a break-up of the E.U. would be substantial as the old continent is already very delicate economically. Dismantling the E.U., which might not produce any long-term or short-term economic benefits for those nations staying or leaving, could cause global financial fallout due to the connected nature of the global economy. SCARY!
Polling data shows nationalist movements in several countries having enough support to potentially lead them out of the E.U.. To avoid that situation, it seems the E.U. must impose harsh consequences.
The E.U. must negotiate a firm deal with the U.K. which doesn’t cut either side off at the knees, nor inflame political passions. The E.U. must make clear the material consequences of leaving. The E.U. wants and needs to send a message that any other nation electing to “Leave” will be a colossal error, so the E.U.’s voice will become strong and clear.
The anti-globalization and anti-immigration movements are in a strange yet strong alliance capable of moving nations and markets. Make no mistake about it, there’s a war between Globalization and Nationalism and it has legs. When the madness of crowds is sweeping the globe, we don’t forecast.
With a two year process for the U.K. to leave the E.U., there is plenty of time to salvage the E.U. With Theresa May, a “remain” candidate, coronated as the U.K.’s new Prime Minister, the E.U. may have a chance to keep political and banking interests in place.
Perhaps a preemptive move against a non-compliant nation would be the European Community’s best bet at letting other countries know they need to get their ships in order and their minds right. Any “failure to communicate” properly could lead to a lot of eggs cracking – homage to Cool Hand Luke.
In the meantime, it is likely that markets become more volatile and that could give tactical managers more room to generate alpha. Keep in mind the U.K. is not tied to one set of trading partners. We’ll keep a sharp eye on the U.K.’s relationship with Russia, China, and the U.S..
The U.K. recently joined the Chinese-led Asian Infrastructure Investment Bank (AIIB) which is setting up to be a very important international financial institution long-term. It is likely that the U.K. may try to make an end-around Europe in negotiating with China.
While President Obama suggested that Brexit would put the U.K. at the back of the line for trade agreements with the U.S., history doesn’t support that at all. Consider that NAFTA, which is U.S. led, and includes Canada and Mexico, could expand. Who’s to say that it couldn’t become the North American and Atlantic Free Trade Agreement – NAAFTA (it even sounds the same) with the U.K. as a member?
It’s important to realize that the global wheels in motion are very complex. We don’t want to get caught playing checkers in a 3-dimensional game of chess. It may become very important to be tactical in your investment strategy as Brexit and other factors play out.
The Macro Global View
Typically, this section will focus on changes in the macroeconomic environment; however, as this is our inaugural issue, we want to discuss three secular mega-trends that WILL have major economic, financial and personal impacts for the next several decades. From these three tsunami sized secular (long-term) super-trends, we believe all other cyclical trends will be derived from for a very long time.
The first of the super-trends is “aging demographics.” The aging of the planet’s population is an unchangeable trend with a massive impact on everything from economic growth to government budgets and social welfare.
Aging demographics cannot be reversed in the short-term, and probably only slowed long-term. It cannot be legislated away. There is no cure for it because it is not a disease. It just is.
Aging demographics refers to the fact that the average age of people on the planet is increasing. For many people that sounds like a statement of the blatantly obvious, most do not realize that until recently, the planet was adding babies at a rate faster than people were dying. As such, the average age wasn’t rising fast despite people living longer lives. The primary impact of aging demographics is the “old-age dependency ratio.” This ratio shows the number of dependents over age 60, against the number of people working.
Old-age dependency is best understood as the number of working people who are contributing to economic resources versus retired people who are drawing from economic resources. In the United States, we think of Medicare and Social Security as economic resources that are starting to have more withdrawn from than contributed to. We are also seeing for the first time that individual retirement plans are having more money withdrawn than added to.
This problem has already hit Japan and Europe. Surprisingly, the U.S. is almost net neutral on aging demographics. This chart from Business Insider shows the trend lines in both developed and developing economies:
The above charts show just how much the global population is changing for the aging. Not only is there a rising tide of older people, but there are fewer younger people to ultimately join the workforce and fund resources to support the retired.
Direct from the UN Department of Economic and Social Affairs, old-age dependency in the world looks like this through the end of the century:
The chart above demonstrates just how explosive of an expense problem the aging population is going to be for governments. There is little potential to level off the increase in expenses until at least the middle of the century. Governments are going to be very strained to find the resources to support all of these people.
Ultimately, the private sector will have to play a larger role in offsetting the impact of an aging global population. Technology could help a relatively smaller workforce provide for a growing retired community. Healthcare will have to become more affordable, particularly biotech, which despite massive advances is still expensive.
Investors, must be diligent in following emerging trends. Our goal as portfolio managers will be to mitigate the economic and financial risks of an aging population, but also to take advantage of what will surely be some wonderful opportunities. Following our strict rules for building tactical strategies, combined with an understanding of this central theme, could give managers an edge over time.
In 2008 total global government debt stood at about $30 trillion, today it is about $60 trillion dollars (Economist Intelligence). However, that $30 trillion in additional public debt only brought global GDP from $62.9 trillion to about $80 trillion today, that’s less than 25% (St. Louis Federal Reserve) .
Monetary history has shown us that it’s not the level of debt, but the velocity in its growth relative to GDP that spells trouble. When the growth of debt goes hyperbolic, as it has since 2008, relative to the growth in the underlying “real economy,” the result is a high concentration of wealth in the hands of the few. Printing Money is not wealth creation, it is wealth transfer. We could write volumes on this subject!
So, central banks have exasperated the income inequality gap. What this has led to are populist movements like Brexit. It’s not the first time in history when the masses revolt, demand sovereignty and take their freedom back. This year, globalization is waking up the masses and many countries are in election cycles.
In addition to massive government debt; total household, corporate and bank debt is up about 40% since 2007 to nearly $200 trillion (McKinsey Global Institute). Global wages are growing at about half the compound rate as debt (International Labor Organization). Monetary history shows that this leads to a state of Nationalism.
The central bankers of the world have created trillions of dollars of debt through stimulus programs. The United States Federal Reserve has taken trillions of dollars of debt onto their balance sheet, much of it bad loans from banks, and replaced it with new U.S. Treasury debt. In effect, socializing many of the bad loans of the banks. While this has been good for the stock and bond markets, it is increases our national debt load on everyone, but especially the younger generations. A colleague once called it, fiscal child abuse.
As central banks print money, it’s booked as part of the national debt. The chart below demonstrates that the U.S. debt outstanding has consistently increased since the 1980’s. In just the past 8 years, the U.S. debt has exploded 46% (recently crossing $19 trillion). How long can this last if GDP growth doesn’t accelerate for a prolonged period? What are the ramifications?
Ostensibly, central banks and governments of the world have been trying to preserve people’s standard of living and help create economic growth. In a recent testimony before Congress, Fed Chair Janet Yellen, admitted that she believes there might be structural issues preventing growth from accelerating – demographics anybody?
We would also point out that the continued use of emergency measures – near zero and negative interest rates – not only creates more unsustainable debt, but undermines the confidence of businesses, banks and investors.
We believe this reduction in confidence has a direct impact on capital spending by businesses and saving by investors, both of which are at very low rates by historical measures. Sadly, that has thwarted the very growth that central banks and governments want.
Monetary history has proven that central bank easy money and government overspending eventually leads to inflation. While we acknowledge there are severe deflationary pressures, we are beginning to see a duplicitous type of inflation/deflation hybrid similar to stagflation. In other words, extreme deflation LEADS to extreme inflation eventually. Like gravity in physics, its a universal law of economics.
Commodity prices are impacting the standard of living as they approach all-time highs. We are seeing a split developing between the prices of real assets and the service economy. Financial assets are at all-time highs, especially precious metals, but wages have risen about half as fast as necessary to keep up with cost of living increases. In other words, the income inequality gap is widening, not narrowing.
One thing that we do at Global View Capital Management, Ltd. is consider the motives of the various central banks. The one overriding motive they all seem to have is to keep interest rates low. It seems to us that most central bank activities have to do with keeping interest rates low to service debt, not to create growth.
Regardless of timing, the biggest risk to the global financial markets and economy will someday be the unwinding of asset prices when monetary policy can no longer support the debts created.
Usually left out of the debt discussion are bond vigilantes. In short, a bond vigilante is someone who sells bonds in protest over something, usually low-interest rates or policy that might damage the quality of the bond. The impact of massive bond selling would be governments and corporations no longer being able to finance their debts cheaply. If that occurs and interest rates rise too rapidly, that could trigger a recession. Signaling the markets are acknowledging long-term slow economic growth but are demanding some return on their money anyway. The impact on global currencies would be dramatic.
In a world of near zero and negative interest rates where you are guaranteed a return less than what you invested and with massive debts that can never be repaid in several lifetimes, does it make sense that there could be massive bond selling when the world realizes that central banks have blown the biggest bond bubble in human history? Again, we think so. The question isn’t “if” it will happen, but “when.” When it does happen, the flood of investors rushing to sell bonds, will drive down prices and will learn, in horror, that “safe” bonds weren’t so safe.
As tactical investors, we are looking for the signs that bond selling might begin. Our research signals will pick up early selling and allow us time to move defensively, by either hedging, going to cash, moving to the rising U.S. dollar or perhaps, moving into inverse positions.
Climate change, has become the description for global warming and has become a major worldwide issue. In December, 196 nations signed an agreement at the 2015 United Nations Climate Change Conference (COP 21 or CMP 11), declaring that climate change is a monumental problem that needs to be addressed by every nation.
In April of this year, 174 of those nations co-signed the agreement. The result is that they started implementing changes to their legal systems to tighten environmental protection standards related to climate change. By virtue of the number of nations signing and the amount of global greenhouse gas emissions they represented, the agreement became international law.
The goal of the agreement is to do whatever is possible to limit the increase in the planet’s temperature by no more than 2°C, but with a target of 1.5°C by century end. Island nations were particularly adamant as they feel their very existence is threatened by rising sea levels brought on by melting icecaps.
While there is no real enforcement mechanism, make no mistake about it, most nations are at least partially fulfilling their promises to change pollutant output already. There will be massive economic shifts due to this agreement, both good and bad. The wheels are already turning and mechanisms are in motion.
Among the most influential visuals of what is causing climate change is this chart from NASA:
The planet has broken out of a range for CO2 that had lasted for nearly 400,000 years. The US Department of Defense in its Quadrennial Defense Review cited climate change as a “threat multiplier.” They pointed out climate change’s potential to “devastate homes, land and infrastructure” and could “exacerbate water scarcity and lead to sharp increases in food costs.” The US Department of Defense is planning for a world in which “climate change will influence resource competition while placing additional burdens on economies, societies, and governance institutions around the world.”
Worth considering, that if global economic growth is poised to be slow, then climate change could be used as a tool in generating economic growth. The rebuilding and retooling of much of the global economy could generate work and wealth for generations.
In addition, younger generations of the planet are supportive of the idea that man is changing the planet’s temperature and that is dangerous, thus we ought to be taking measures to mitigate our impact.
As investors, we must apply serious thought to how the economy and investment climate will be impacted going forward as a result of climate change and climate change policy. Clean energy may become an investing opportunity, but prices have been volatile. We are researching smart grid funds, especially in light of a new energy and a smart grid bill that is working its way through Congress in a bipartisan way.
Navigating through massive tectonic shifts will require investors to have a tactical investment component as opportunities present themselves.
The Micro Global View
By micro we mean a particular market in the world such as the large-cap US equity market, represented by the S&P 500. The macro trends will impact all that goes on at the micro levels.
The graph above demonstrates, the earnings of companies within the S&P 500. Earnings have fallen from a high of $106.94 to $86.53 for the 500 companies in the S&P 500. That is a reduction in earnings of 19% with stock prices maintaining their highs.
The impact of the falling earnings with stock prices remaining about the same can be seen in the Shiller CAPE (Cyclically Adjusted PE) ratio rising to a historically above average valuation:
The question investors must ask is – what is driving the valuation expansion in the U.S. large capitalization stocks? What factors explain why stock prices haven’t fallen along with falling earnings?
We think there are three factors primarily responsible for the buoyancy of stock prices in the U.S. and the lack of large corrections in many others around the world.
First, many investors see no alternative but to invest in equities. The term making the rounds in the media is “TINA” – as in “there-is-no-alternative” to investing in stocks since interest rates are next to nothing or lower than nothing.
Second, corporate buybacks have been at record highs. We call this “Corporate QE,” or quantitative easing. When you reduce the “S” in Earnings-per-Share (EPS) without increasing the “E,” you get a higher share price without any actual earnings growth. With corporations buying back their own stock AND retired baby boomers in their second year of required minimum distributions (RMD), both are contributing to the reduction in the outstanding share count.
Corporate buybacks have been running at record highs on the back of quantitative easing and low borrowing costs. Yardeni Research, Inc. has pointed out that buybacks plus dividends now exceed operating earnings, meaning that some of the buybacks are being financed with debt. Debt financed spending cannot last forever, especially at the corporate level. According to Bloomberg, buybacks are likely to fall significantly in the second half of this year if earnings don’t improve.
The third factor, is central banks, as well as, national pension trusts – particularly Japan – and sovereign wealth funds, have been putting a continuous bid on stock prices.
Our overall observation regarding the equity markets is that unless earnings pick up significantly in a sustained way, the stock market is likely to suffer its first significant set-back in years. Over the next two years, it would not surprise us to see a legitimate bear market set in. As tactical investors, we are using math to guide our way in this 3-dimensional game of chess. We are not afraid of volatility as it gives us an opportunity to create value in portfolios.
Investment Trends and Tactical Asset Allocation
In the past several months, many of the ideas discussed in this letter have come to fruition. In particular, since February, we have seen a large rebound in commodities. While most people think of oil and gold, it stretches across base metals and agriculture as well.
Our weekly asset class trend rankings demonstrates, that basic materials, precious metals, real estate and energy have all done very well. Each being up at least 16% the first six months of the year. We will see if inflation or deflation play out next. Ultimately, extreme monetary policies lead to inflation. The last time the U. S. experienced inflation in the double digits, most money managers were in diapers. However, we are preparing to seize the investment opportunities to preserve wealth.
Utilities and telecoms are up over 20% in the first half of 2016. These defensive sectors are doing well as investors reach for yield, due to low-interest rates. We may be seeing overvaluation setting into both of these sectors. We will wait for the math to tell us that a corrective period is setting in and act accordingly.
With the S&P 500 hitting a new high as of the day of this final edit, it is interesting how broad-based the rise in the market has been. Over 200 companies are at new 52 week highs today. That’s an incredible number! Many international markets are also rallying since Ben Bernanke’s trip to Japan to meet with Prime Minister, Shitzo Abe, on hope for further “Abenomics” stimulus out of Japan and the belief that Brexit wasn’t systemic. Only central banks have enough fire-power to lift an entire market.
Our thesis is that eventually markets will correct the disparity between earnings and prices. As we have discussed for years in our “Mega-Trends” presentations to clients and advisers, when the unwinding of mis-priced assets occurs, it could be a very disorderly event, which is why tactical money managers may be of value.
Investors and advisers can visit our website at gvcmanagement.com for more complete information on the indicators we track.
What We’re Watching
In the coming quarter, we will be watching corporate earnings. We will also be watching central banks, particularly the Fed, to see if there is any significant change in policy. The futures market tells us that it’s unlikely there will be a rate hike in 2016, it is becoming likely that the Fed could reverse course and resort to helicopter money or negative interest rates if there were a shock to the system.
We will also be closely watching international affairs. The list is long, but a few to think about are the continuing developments in Brexit, Japan’s failing economy, China’s desire to manage their growth, India’s potential rise, troubles in emerging markets and Europe’s problems with strengthening nationalism.
Among potential risk spots, Japan seems to be at high risk of an event related to their demographic and corporate issues. At a minimum we could see their markets impacted as the Bank of Japan is a top 10 shareholder in 90% of the companies in the Nikkei 225, effectively nationalizing their free market.
Russia is also a country worth paying attention to. A rebound for oil and a better relationship with the west could result in an even stronger rebound for Russian stocks.
China could slow down faster than markets are prepared for. In retrospect, last summer’s global market sell-off was triggered by the devaluation of the Yuan by the Bank of China. The Chinese devalued their currency four times in the past year. Something may be challenging China’s economy more than they are letting on. Could it be the hard landing that George Soros and others have warned about? Trade data with some of China’s partners seem to indicate a significant slowdown is indeed underway.
Finally, with the U.S. election upon us, we will have posts on how both candidates, Hillary Clinton and Donald Trump, may impact the economy and your finances. We expect this to be wildly popular!
So, until next time, think tactically, live well and treat others as you’d like to be treated.
The Global View Capital Management Team