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Archive for January 2015

Archive for January, 2015

Outside the Box: 2015 Investment Themes

 

“If it ain’t broke, don’t fix it,” says my friend Gary Shilling as he kicks off today’s Outside the Box. He’s referring to his investment themes for 2015. He first gives us 11 reasons to continue favoring long Treasury bonds. That’s an obvious play for him if you know his view, but it’s nevertheless a compelling one this year and one that you should think through, given the specter of deflation about in the world, the firing up of QE in Japan and Europe (which gives folks money to buy … Treasurys), and the safe-haven status of the US dollar.

Gary’s reason #9 for buying Treasurys is that “The odds of a near-term Fed rate hike are receding. He sees any Fed rate increase being pushed out “as the deflationary effects of the oil price plunge sink in and investors – and the Fed – realize that foreign central bank stimuli amount to Fed tightening [in relative terms].”

Gary’s remaining themes for 2015 include some other clear winners like the US dollar and Japanese equities (no surprise there), but also some interesting defensive plays like consumer staples and foods and what Gary calls “small luxuries.”

Be sure to see the special offer for Gary Shilling’s INSIGHT at the conclusion of the letter.

An interesting thing happened last week. I get a lot of email from readers and do try and sift through them. I got a very kind note from one reader who thanked me for the introductions we do for Outside the Box – he said they compel him to read the articles, which he finds useful. Of course, that one made me feel good. Then less than an hour later I got a polite note from another reader who complained about my introductions, because he prefers to just jump right in, without my stealing any of the author’s thunder. Both comments made me think more about the process of bringing OTBs to you, which is also good. Sometimes we just do things out of habits that have accreted over time, and I may need to be more aware of what I am actually presenting. I really do appreciate your feedback, positive or constructive.

This has been an extremely busy week, as the entire Mauldin Economics team has been in my home for the past three days, sharing ideas, shooting videos, making plans. That means I get a little behind on some things, but being with smart, creative people really gets my juices flowing.

Tonight is sushi with even more guests (and Neil Howe is in town). More planning and meetings and more things that get added to my to-do list.  But it is all fun and exciting.

You have a great week, and now let’s look at Gary’s investing themes for 2015.

Your overwhelmed with ideas analyst,

Your wondering if we will have flying cars analyst,

John Mauldin, Editor
Outside the Box
subscribers@mauldineconomics.com

 

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2015 Investment Themes

(Excerpted from the January 2015 edition of A. Gary Shilling’s INSIGHT)

Our 2015 investment themes are quite similar to our 2014 list that worked well for us. If it ain’t broke, don’t fix it.

The Treasury “bond rally of a lifetime” still seems intact. The “risk on” investment climate for U.S. equities persists, but as in 2014, we approach it with trepidation and with a defensive portfolio position. The U.S. economy is continuing to grow but at subpar rates (Chart 1) while growth in China is slowing, is very sluggish in the eurozone and negative in Japan.

The dollar is reigning supreme (Chart 2)—and 2015 may turn out to be the year of the greenback as almost every other currency declines against the buck, especially the euro and yen.

Commodity prices may drop much further, especially petroleum, while financial problems in Russia, Venezuela and elsewhere escalate severely. Deflation is spreading worldwide and may expand beyond the energy sector to prices in general. And low-quality bonds here and abroad are likely to keep declining as are emerging market stocks.

Here are our 13 investment themes for 2015.

1. Treasury bonds. There are many reasons why we continue to favor long Treasury bonds. Here are 10:

1. Safe haven. Like the U.S. dollar, Treasurys are a safe haven in times of global turmoil and uncertainty, of which there are plenty today.

2. Deflation, extant in many countries (Chart 3) and looming in many others including the eurozone, makes current Treasury note and bond yields attractive.

3. Quantitative Ease, underway in Japan and likely soon in the eurozone, provides money to invest in U.S. Treasurys.

4. Treasury yields are attractive relative to those abroad. The 2.17% yield on the 10-year Treasury note vastly exceeds the 0.54% yield on 10-year German bunds, 0.33% for 10-year Japanese governments (Chart 4) and almost every other developed country 10-year sovereign (Chart 5). With the new round of QE in Japan and impending QE in the eurozone, the BOJ and ECB will be buying more government securities, sending yields even lower. The U.S. government obligation is probably at least as high quality as any of these others, and the rising dollar against the euro and yen enhances the appeal to foreigners of buying U.S. debt. What are we missing?

5. Foreigners are buying Treasurys. In the December sale of $13 billion in 30-year Treasurys, indirect bids, a measure of foreign demand, took 50%. The Fed is no longer adding to its Treasury portfolio but foreigners, as well as domestic investors, are more than replacing Fed purchases. With half of Treasurys owned abroad, it is truly a global market.

6. U.S. banks are buying Treasurys as they move away from lower-quality assets, in part to comply with new rules requiring the biggest banks to hold more liquid assets and 60% of these must be backed by the federal government. Also, in counting towards liquid assets, corporate obligations get a 50% haircut but those backed by the full faith and credit of the federal government get 100% credit.

7. Long Treasurys continue to be attractive to pension funds and life insurance that want to match their long-maturity liabilities with similar duration assets.

8. Junk and corporate bonds are losing favor vs. Treasurys. The spreads between junk vs. Treasurys are widening as Treasurys rally while junk bonds sell off under the weight of heavy issues and investor worries about defaults, especially on weak energy company issues. At the same time, the spreads between Treasury and investment-grade yields are widening. Note that energy bonds represent about 20% of most fixed-income benchmarks. Companies are issuing debt at the fastest rate on record, often to fund dividends and share buybacks. Meanwhile, the issuance of Treasurys is shrinking as the federal deficit falls (Chart 6). Unlike the ECB, which is likely to buy corporate debt, the Fed is highly unlikely to do so. This pushes money from U.S. corporates to those in Europe.

9. The odds of a near-term Fed rate hike are receding. Early last year, the futures markets assigned a high probability to an increase by year’s end. Now these markets indicate that the odds are receding, with a 24% probability of an initial Fed rate increase by June and 51% by July. And these numbers will no doubt be pushed out further as the deflationary effects of the oil price plunge sink in and investors—and the Fed—realize that foreign central bank stimuli amount to Fed tightening, relatively.

After its December policy meeting, the Fed said it would be “patient” before raising interest rates, adding that the overall outlook hadn’t changed much from earlier assurances that its policy rates would stay at essentially zero for a “considerable time.” Fifteen of the 17 policy committee members expect rates to rise this year and their median forecast was for 1.125% in 12 months through December, 2.5% in 2016 and 3.625% in 2017. As we’ve noted in past Insights, however, in recent years they’ve consistently forecast stronger economic growth and quicker rises in interest rates than have materialized.

Of course, the Fed is right in step with private forecasters. The Wall Street Journal’s poll of 49 forecasters (not including us) back in January 2014 found that 48 expected yields in the 10-year Treasury note to rise from 2.9% at that time to an average forecast of 3.5% by year’s end. It moved in the opposite direction and ended 2014 at 2.17%, as noted earlier.

We continue to believe it will be years before the Age of Deleveraging ends and, with it, slow growth, and the Fed shifting to selling securities and raising rates. The recent nosedive in commodity prices and deflationary implications will probably stretch out the central bank’s time line.

But what if, contrary to our forecast, the Fed raises its benchmark rate before the Age of Deleveraging is completed? When it hinted at tapering its then-$85 billion in monthly asset purchases in May and June of 2013, Treasury note and bond yields leaped. Nevertheless, these moves were out of keeping with history. Interest rates rose in the post-World War II era up until 1981 as inflation rates climbed, but have fallen since then with receding inflation. After removing these trends, first up and then down, we examined the relationship between the Fed benchmark, the federal funds rate, and the yields on both 10-year Treasury notes and 30-year bonds.

On average, the spillover from federal funds was small, with a one percentage-point rise pushing up the 10-year note yield by 0.35 percentage points and the 30-year bond yield by just 0.23 points. So, we don’t expect a nosedive in Treasury note and bond prices even if the Fed tightens credit earlier than we forecast—unless the 2013 Taper Tantrum marked the beginning of a new relationship. Recall, however, the sage words of Sir John Templeton: “The most dangerous words in the English language are, this time it’s different.”

10. Postwar babies are aging and this favors Treasurys as older people reduce the riskiness of their portfolios and favor high-quality bonds, despite low yields.

11. Speculators are increasingly short the benchmark 10-year Treasury note in the futures market. If the rally in Treasury prices persists, sooner or later they will be forced to buy back their shorts, adding to demand.

More Treasury Rally Ahead

We expect a further rally in Treasury prices with the 30-year yield dropping from the current 2.75% to 2.0%, perhaps by the end of 2015. If so, the Long Bond would provide a total return of 18.8% and the 30-year zero coupon bond, 24.6%. If the 10-year note yield drops from the current 2.17% to 1.0%, as we forecast, the total return would be 12.4%. These may seem like big gains for yield declines of only about one percentage point, but that’s what happens when yields are low. In any event, we believe that “the bond rally of a lifetime” marches on.

2. Selected income-producing securities, including investment-grade corporate and municipal bonds as well as utilities and other stable high dividend-paying stocks, remain attractive. In fact, with municipal bonds on average yielding more than Treasurys, they are very attractive to bond buyers who concentrate on yields, especially on an after-tax basis (Chart 7). Furthermore, the yields on investment-grade corporates and munis are almost the same, after adjusting corporate yields for the minimum 39% individual income tax rate, and even higher in many states.

U.S. stocks are expensive. The Fed’s largess, which we believe was behind the rally that started in March 2009, is no longer there with the end of QE (Chart 8). The leap in the price-earnings ratio that accounted for 67% of the 29.6% rise in the S&P 500 in 2013 is no longer present, and at 19 at present, it is well above the long-term average of 15.5.

3. Consumer staples and foods. We favor these stocks, but defensively, advocating things that people buy regardless of economic circumstances—utilities, consumer staples and health care—in sectors that also tend to have attractive dividend yields.

4. Selected healthcare providers benefit from the increasing health care needs of aging postwar babies as well as the newly insured under Obamacare. Medical office buildings continue to be attractive as physicians migrate to hospitals from stand-alone practices in view of increasing regulatory costs.

5. Low P/E stocks with meaningful dividends also fit into our defensive category.

6. Small luxuries, things that financially-stressed consumers buy to get the best of what they can afford, also is defensive and benefits from the many Americans and people abroad who still have compressed incomes, including in developing countries. Global consumer products companies like Unilever and Proctor & Gamble are finding that poor people in countries like India with static or even declining wages and little discretionary income will still pay more for fancier soap, shampoo, razors and mouthwash.

7. Productivity enhancers should continue to thrive as slow sales growth and lack of market acceptance of higher raise prices keep businesses focused on cost-cutting and productivity improvement.

8. Japanese stocks remain attractive as the Abe government strives to stimulate economic growth while trashing the yen.

9. The dollar continues to look profitable vs. the loonie, kiwi, Aussie (Chart 9) and other commodity currencies as commodity prices, led by oil, keep dropping along with the deliberately-trashed yen and euro. Virtually all currencies are being devalued against the dollar, which, as the world’s reserve and major trading currency, can’t really be devalued. It’s a matter of other currencies falling against the greenback, the established norm, not the buck rising against them.

The euro looks especially vulnerable as the chasm between the Teutonic North, led by Germany, and the Club Med South, spearheaded by France, continues to widen. Labor reform efforts and other measures to improve efficiency in the Italian government and private sectors continue to meet huge resistance, and the Italian economy is back in recession. Meanwhile, economic growth is trivial and government debt levels huge (Chart 10). Greece is facing another national election with the anti-eurozone Syriza Party showing strength.

We seldom make explicit forecasts for investment themes because we seldom know how far investments moving in our favor will go. In the case of the euro, however, it’s interesting to note that it started out in 1999 with the dollar worth about 1.10 euros (Chart 11). It dropped to 0.85 in May 2001 before climbing to 1.58 in March 2008. Since then, it’s been on a downward trend. With all the problems in the eurozone and ECB President Draghi’s determination to devalue the currency, the euro might well drop back to 1.00, or parity with the greenback this year.

Similarly, the yen could drop substantially from here. Note in Chart 12 that in November 1982, it hit 278 per dollar. That’s a long way from the current 120, and a collapse to 278 would be a disaster for Japan and the whole world. Still, given the newly-re-elected Abe’s determination to trash the yen, it’s reasonable to see the yen dropping to 150 or 200 per greenback. Notice that Abe used his re-election momentum recently to recommend a corporate tax cut from 34.6% to 32.1% in the fiscal year starting in April and to 31.3% in the following fiscal year.

Unattractive Themes

Our unattractive themes list includes 10. Industrial commodities, especially copper (Chart 13), which we love to short. As in 2014, we’re refraining from shorting crude oil because of uncertainty over OPEC actions and the outcome of the Saudis’ game of chicken with weak OPEC producers as well as American frackers.

We do, however, continue to list 11. Natural gas as a short because of the spillover from oil and the abundance created by U.S. fracturing—at least until LNG exports become substantial. It goes without saying that we’ve dropped our North American energy theme on the attractive side.

12. Emerging country stocks and bonds continue to be unattractive, in our view. With developing countries that depend on oil exports in deep trouble and other commodity exporters such as Brazil in doubtful positions, this whole investment sector is under pressure with both stock and government bond prices falling on average of late (Chart 14).

13. Junk bonds (Chart 15) continue to be interesting on the short side, especially those issued by energy-related companies. The rest may well be dragged down as investors flee to safe havens.

A Shock

In past Insights, we’ve explored the Grand Disconnect between slowly-growing major economies and soaring equity markets, propelled by central bank money and, in the U.S., by unsustainable corporate cost-cutting as well.

This gap will get closed sooner or later, either by Fed tightening and the recession that has followed in 11 of 12 similar incidences in the post-World War II era, or a substantial shock that will have the same effect. The resulting recession will no doubt become global, given the already weak state of many foreign economies and financial structures.

We also stated that it will be years before the Age of Deleveraging and slow economic growth are concluded, and the Fed then begins to raise interest rates and shrink or sterilize the $2.3 trillion in excess member bank reserves that have accumulated with QE. So a major shock may occur before the Fed shifts gears toward credit restraint. The obvious current possibility, of course, is the financial fallout from the ongoing weakness in commodity prices, especially crude oil, and the soaring greenback.

In “Past External Financial Shocks and Their Effects” (also in our January 2015 Insight report), we examine the effects of past shocks on the U.S. economy, going back to the 1973 Arab oil embargo.

The dollar was up over 7% last year against emerging economy currencies, and about $1 trillion in their corporate bonds were issued before the buck surged. So the cost of servicing those dollar debts is climbing, much as in the late 1990s when a similar problem with government dollar issues precipitated the Asian financial crisis that led to defaults in many Far Eastern economies as well as Russia, Brazil and Argentina.

Last year, companies in emerging markets issued almost $280 billion in dollar-denominated bonds to take advantage of low interest costs. Governments have joined this parade but not as extensively as in the late 1990s. Still, total company and sovereign debt issuers had $6 trillion in outstanding bonds at the end of 2014, up four times since the 2008 financial crisis.

As investors retreat from these emerging markets to dollars, local currencies will fall even further. The Indonesian rupeah, Chilean peso, Brazilian real and Turkish lira are near multi-year lows and the Mexican central bank recently spent $200 million to support its peso. The IMF and Bank for International Settlements worry that exchange rate problems could sire corporate defaults and asset price busts worldwide.

In any event, a major shock and resulting recession would shift the investment climate from the current “risk on” to “risk off,” emphasizing what we call the Quartet—Treasurys and the dollar would be attractive as safe havens while equities of all types, be they in developed, developing or frontier markets, would be dumped along with commodities. Interestingly, three of the four members of the Quartet are already on the stage and beginning to play. Treasurys are leaping in price. The dollar is soaring against almost every foreign currency. And commodity prices are plummeting. Only stocks are yet to enter the stage and tune down.

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Important Disclosures

The article Outside the Box: 2015 Investment Themes was originally published at mauldineconomics.com.

Thoughts from the Frontline: How Global Interest Rates Deceive Markets

 

“You keep on using that word. I do not think it means what you think it means.”

– Inigo Montoya, The Princess Bride

“In the economic sphere an act, a habit, an institution, a law produces not only one effect, but a series of effects. Of these effects, the first alone is immediate; it appears simultaneously with its cause; it is seen. The other effects emerge only subsequently; they are not seen; we are fortunate if we foresee them.

“There is only one difference between a bad economist and a good one: the bad economist confines himself to the visible effect; the good economist takes into account both the effect that can be seen and those effects that must be foreseen.

“Yet this difference is tremendous; for it almost always happens that when the immediate consequence is favorable, the later consequences are disastrous, and vice versa. Whence it follows that the bad economist pursues a small present good that will be followed by a great evil to come, while the good economist pursues a great good to come, at the risk of a small present evil.”

– From an 1850 essay by Frédéric Bastiat, “That Which Is Seen and That Which Is Unseen”

All right class, it’s time for an open book test. I’m going to give you a list of yields on various 10-year bonds, and I want to you to tell me what it means.

United States: 1.80%

Germany: 0.36%

France: 0.54%

Italy: 1.56%

UK: 1.48%

Canada: 1.365%

Australia: 2.63%

Japan: 0.22%

I see that hand up in the back. Yes, the list does appear to tell us what interest rates the market is willing to take in order to hold money in a particular country’s currency for 10 years. It may or may not tell us about the creditworthiness of the country, but it does tell us something about the expectations that investors have about potential returns on other possible investments. The more astute among you will notice that French bonds have dropped from 2.38% exactly one year ago to today’s rather astonishing low of 0.54%. Likewise, Germany has seen its 10-year Bund rates drop from 1.66% to a shockingly low 0.36%. What does it mean that European interest rates simply fell out of bed this week? Has the opportunity set in Europe diminished? Are the French really that much better a credit risk than the United States is? If not, what is that number, 0.54%, telling us? What in the wide, wide world of fixed-income investing is going on?

Quick segue – but hopefully a little fun. One of the pleasures of having children is that you get to watch the classic movie The Princess Bride over and over. (If you haven’t appreciated it, go borrow a few kids for the weekend and watch it.) There is a classic line in the movie that is indelibly imprinted on my mind.

In the middle of the film, a villainous but supposedly genius Sicilian named Vizzini keeps using the word “inconceivable” to describe certain events. A mysterious ship is following the group at sea? “Inconceivable!” The ship’s captain starts climbing the bad guys’ rope up the Cliffs of Insanity and even starts to gain on them? “Inconceivable!” The villain doesn’t fall from said cliff after Vizzini cuts the rope that all of them were climbing? “Inconceivable!” Finally, master swordsman – and my favorite character in the movie – Inigo, famous for this and other awesome catchphrases, comments on Vizzini’s use of this word inconceivable:

“You keep on using that word. I do not think it means what you think it means.”

(You can see all the uses of Vizzini’s use of the word inconceivable and hear Inigo’s classic retort here.)

When it comes to interpreting what current interest rates are telling us about the markets in various countries, I have to say that I do not think they mean what the market seems to think they mean. In fact, buried in that list of bond yields is “false information” – information so distorted and yet so readily misunderstood that it leads to wrong conclusions and decisions – and to bad investments. In today’s letter we are going to look at what interest rates actually mean in the modern-day context of currency wars and interest-rate manipulation by central banks. I think you will come to agree with me that an interest rate may not mean what the market thinks it means.

Let me begin by briefly summarizing what I want to demonstrate in this letter. First, I think Japanese interest rates not only contain no information but also that markets are misreading this non-information as meaningful because they are interpreting the data as if it were normal market information in a familiar market environment, when the truth is that we sailed beyond the boundaries of the known economic world some time ago. The old maps are no longer reliable. Secondly, Europe is making the decision to go down the same path as the Japanese have done; and contrary to the expectations of European central bankers, the potential to end up with the same results as Japan is rather high.

The false information paradox is highlighted by the recent Swiss National Bank decision. Couple that with the surprise decisions by Canada and Denmark to cut rates, the complete retracement of the euro against the yen over the past few weeks, and Bank of Japan Governor Kuroda’s telling the World Economic Forum in Davos that he is prepared to do more (shades of “whatever it takes”) to create inflation, and you have the opening salvos of the next skirmish in the ongoing currency wars I predicted a few years ago in Code Red. All of this means that capital is going to be misallocated and that the current efforts to create jobs and growth and inflation are insufficient. Indeed, I think those efforts might very well produce a net negative effect.

But before we go any farther, a quick note. We will start taking registrations for the 12th annual Strategic Investment Conference next week. There will be an early-bird rate for those of you who go ahead to register quickly. The conference will run from April 29 through May 2 at the Manchester Grand Hyatt in San Diego. For those of you familiar with the conference, there will be the “usual” lineup of brilliant speakers and thought leaders trying to help us understand investing in a world of divergence. For those not familiar, this conference is unlike the vast majority of other investment conferences, in that speakers representing various sponsors do not pay to address the audience. Instead, we bring in only “A-list” speakers from around the world, people you really want to meet and talk with. This year we’re going to have a particularly large and diverse group of presenters, and we structure the conference so that attendees can mingle with the speakers and with each other.

I am often told by attendees that this is the best economic and investment conference they attend in any given year. I think it is a measure of the quality of the conference that many of the speakers seek us out. Not only do they want to speak, they want to attend the conference to hear and interact with the other speakers and conference guests. This conference is full of speakers that other speakers (especially including myself) want to hear. And you will, too. Save the date and look for registration and other information shortly in your mail.

Now let’s consider what today’s interest rates do and do not mean as we navigate uncharted waters.

Are We All Turning Japanese?

Japan is an interesting case study. It’s a highly developed nation with a very sophisticated culture, increasingly productive in dollar terms (although in yen terms nominal GDP has not moved all that much), and carrying an unbelievable 250% debt-to-GDP burden, but with a 10-year bond rate of 0.22%, which in theory could eventually mean that the total interest expenses of Japan would be less than those of the US on 5-6 times the amount of debt. Japan has an aging population and a savings rate that has plunged in recent years. The country has been saddled with either low inflation or deflation for most of the past 25 years. At the same time, it is an export power, with some of the world’s most competitive companies in automobiles, electronics, robotics, automation, machine tools, etc. The Japanese have a large national balance sheet from decades of running trade surpluses. If nothing else, they have given the world sushi, for which I will always hold them in high regard.

We talk about Japan’s “lost decades” during which growth has been muted at best. They are just coming out of a triple-dip recession after a disastrous downturn during the Great Recession. And through it all, for decades, there is been a widening government deficit. The chart below shows the yawning gap between Japanese government expenditures and revenues.

This next chart, from a Societe Generale report, seems to show that the Japanese are financing 40% of their budget. I say “seems” because there is a quirk in the way the Japanese do their fiscal accounting. Pay attention, class. This is important to understand. If you do not grasp this, you will not understand Japanese budgets and how they deal with their debt.

To continue reading this article from Thoughts from the Frontline – a free weekly publication by John Mauldin, renowned financial expert, best-selling author, and Chairman of Mauldin Economics – please click here.

Important Disclosures

Outside the Box: The Cult of Central Banking

 

In today’s Outside the Box, good friend Ben Hunt informs us that we have entered the cult phase of the Golden Age of the Central Banker:

We pray for extraordinary monetary policy accommodation as a sign of our Central Bankers’ love, not because we think the policy will do much of anything to solve our real-world economic problems, but because their favor gives us confidence to stay in the market. I mean, does anyone really think that the problem with the Italian economy is that interest rates aren’t low enough? Gosh, if only ECB intervention could get the Italian 10-yr bond down to 1.75% from the current 1.85%, why then we’d be off to the races! Really? But God forbid that Mario Draghi doesn’t (finally) put his money where his mouth is and announce a trillion euro sovereign debt purchase plan. That would be a disaster, says Mr. Market. Why? Not because the absence of a debt purchase plan would be terrible for the real economy. That’s not a big deal one way or another. It would be a disaster because it would mean that the Central Bank gods are no longer responding to our prayers.

But, he points out, the cult phase of any human society is a stable phase in the sense that, while change may happen, it will not happen from within:

There is such an unwavering faith in Central Bank control over market outcomes, such a universal assumption of god-like omnipotence within this realm, that any internal market shock is going to be willed away.

However, there is a minor catch: external market risk factors are all screaming red.

I’ve been doing this for a long time, and I can’t remember a time when there was such a gulf between the environmental or exogenous risks to the market and the internal or behavioral dynamics of the market. The market today is Wile E. Coyote wearing his latest purchase from the Acme Company – a miraculous bat-wing costume that prevents the usual plunge into the canyon below by sheer dint of will.

Ben identifies the three most pressing exogenous risks as the “supply shock” of collapsing oil prices, a realigning Greek election, and the realpolitik dynamics of the West vs. Islam and the West vs. Russia. (You or I might want to expand Ben’s list with one or two of our own favorites; but the point is, it’s a big, bad, volatile world out there right now.) Ben admits that it feels a bit weird to have written on all three of his chosen topics a few weeks before each of them appeared on investors’ radar screens. “Call me Cassandra,” says Ben. (Naw, I’ll stay with Ben.)

I wouldn’t want to steal too much of Ben’s thunder here, but I just can’t help sharing with you the punch line to his piece: “The gods always end up disappointing us mere mortals.”  This is one of Ben’s better pieces, and I really commend it to you as something you need to think about.

Before we examine our collective religious delusions (or at least our central banking delusions), let’s have a little fun. My friend Dennis Gartman (who could be the hardest-working writer in the business) found this gem and shared it with his readers this morning. It is about the supposed lack of environmental concern of the Boomer generation has. And some of you will read it that way.

But I want those of you who are of a certain age (ahem) to realize just how much your world has changed in the last 50 years. If you are young, yes, we really did all the stuff listed below. I personally experienced every one of the rather long list of activities mentioned by the “little old lady.” Major changes in lifestyle since then? No, not really. But I’ll grand you that things are a good deal more convenient and time-saving today. Now sit back and enjoy.

Checking out at the store, the young cashier suggested to the much older lady that she should bring her own grocery bags, because plastic bags are not good for the environment. The woman apologized to the young girl and explained, “We didn’t have this ‘green thing’ back in my earlier days.” The young clerk responded, “That’s our problem today. Your generation did not care enough to save our environment for future generations.” The older lady said that she was right – her generation didn’t have the “green thing” in its day. The older lady went on to explain: “Back then, we returned milk bottles, soda bottles and beer bottles to the store. The store sent them back to the plant to be washed and sterilized and refilled, so it could use the same bottles over and over. So they really were recycled. But we didn’t have the ‘green thing’ back in our day. Grocery stores bagged our groceries in brown paper bags that we reused for numerous things. Most memorable besides household garbage bags was the use of brown paper bags as book covers for our school books. This was to ensure that public property (the books provided for our use by the school) was not defaced by our scribblings. Then we were able to personalize our books on the brown paper bags. But, too bad we didn’t do the ‘green thing’ back then. We walked up stairs because we didn’t have an escalator in every store and office building. We walked to the grocery store and didn’t climb into a 300-horsepower machine every time we had to go two blocks. But you’re right, we didn’t have the ‘green thing’ in our day. Back then we washed the baby’s diapers because we didn’t have the throwaway kind. We dried clothes on a line, not in an energy-gobbling machine burning up 220volts. Wind and solar power really did dry our clothes back in the early days. Kids got hand-me-down clothes from their brothers or sisters (and cousins), not always brand-new clothing. But you’re right, young lady; we didn’t have the ‘green thing’ back in our day. Back then we had one TV, or radio, in the house – not a TV in every room. And the TV had a screen the size of a handkerchief [remember them?], not a screen the size of the state of Montana. In the kitchen we blended and stirred by hand because we didn’t have electric machines to do everything for us. When we packaged a fragile item to send in the mail, we used wadded up old newspapers to cushion it, not Styrofoam or plastic bubble wrap. Back then, we didn’t fire up an engine and burn gasoline just to cut the lawn. We used a push mower that ran on human power. We exercised by working, so we didn’t need to go to a health club to run on treadmills that operate on electricity.” But you’re right; we didn’t have the ‘green thing’ back then. We drank from a fountain when we were thirsty instead of using a cup or a plastic bottle every time we had a drink of water. We refilled writing pens with ink instead of buying a new pen, and we replaced the razor blade in a razor instead of throwing away the whole razor just because the blade got dull. But we didn’t have the ‘green thing back then. Back then, people took the streetcar or the bus, and kids rode their bikes to school or walked instead of turning their moms into a 24-hour taxi service in the family’s $45,000 SUV or van, which cost what a whole house did before the ‘green thing.’ We had one electrical outlet in a room, not an entire bank of sockets to power a dozen appliances. And we didn’t need a computerized gadget to receive a signal beamed from satellites 23,000 miles out in space in order to find the nearest burger joint. But, isn’t it sad, how the current generation laments how wasteful we old folks were just because we didn’t have the ‘green thing’ back then?”

I wonder what our grandchildren will be telling their grandchildren in 50 years… “I remember a time when we actually used combustion engines to drive our cars that belched out dirty gases. We actually had massive electricity-generating power plants and wires everywhere to deliver the electricity, rather than the small, efficient home units that produce free electricity for us now. We used something called glasses to help us see. People actually had to carry their communications devices around, and computers were measured in pounds not ounces. We had to do something called “typing” to write; and while we didn’t have to actually go to places called libraries like our grandparents did, we could and did spend all day searching through a disorganized Internet for what we needed. You weren’t connected biologically to your computer, so getting information in and out of it was a drag.

“People actually got sick and died; and though the situation was getting better, billions of people didn’t have enough food at night. People went to big stores to buy what was needed rather than just ordering it or producing it on the spot. We actually threw garbage away in huge resource-consuming “dumps” rather than completely recycling it into new products at the back of the house. It took like forever to get from one point to another. People actually had to “drive” their car rather than just getting in it and telling it where to go. And people died all the time in those cars – they were so dangerous and uncomfortable. In those days you couldn’t even instantly communicate with anybody by just thinking. You had to push buttons on that clumsy communication device you hauled around, and then talk into it; and if you lost it you were out of touch and out of luck. We didn’t even have intelligent personal robots in those days. It was so Stone Age.”

I could go on and on, but you get the drift. The changes in the last 50 years are simply a down payment on the change we’ll see and live in the next 50.

When I think about central banks and markets and try to figure out how to get preserve and grow assets from where we are today to where we will be in 10 years, it can be a rather daunting and sometimes even a depressing task. But then I think about what the world will be like and how much fun my grandkids are going to have, and I get all optimistic and smiling again.

Have a great week. The future is going to turn out just fine.

Your wondering if we will have flying cars analyst,

John Mauldin, Editor
Outside the Box
subscribers@mauldineconomics.com

 

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“Catch-22”

By Ben Hunt, Salient Partners
Epsilon Theory, Jan. 12, 2015

Four times during the first six days they were assembled and briefed and then sent back. Once, they took off and were flying in formation when the control tower summoned them down. The more it rained, the worse they suffered. The worse they suffered, the more they prayed that it would continue raining. All through the night, men looked at the sky and were saddened by the stars. All through the day, they looked at the bomb line on the big, wobbling easel map of Italy that blew over in the wind and was dragged in under the awning of the intelligence tent every time the rain began. The bomb line was a scarlet band of narrow satin ribbon that delineated the forward most position of the Allied ground forces in every sector of the Italian mainland.

For hours they stared relentlessly at the scarlet ribbon on the map and hated it because it would not move up high enough to encompass the city.

When night fell, they congregated in the darkness with flashlights, continuing their macabre vigil at the bomb line in brooding entreaty as though hoping to move the ribbon up by the collective weight of their sullen prayers. “I really can’t believe it,” Clevinger exclaimed to Yossarian in a voice rising and falling in protest and wonder. “It’s a complete reversion to primitive superstition. They’re confusing cause and effect. It makes as much sense as knocking on wood or crossing your fingers. They really believe that we wouldn’t have to fly that mission tomorrow if someone would only tiptoe up to the map in the middle of the night and move the bomb line over Bologna. Can you imagine? You and I must be the only rational ones left.”

In the middle of the night Yossarian knocked on wood, crossed his fingers, and tiptoed out of his tent to move the bomb line up over Bologna.

― Joseph Heller, “Catch-22” (1961)

A visitor to Niels Bohr’s country cottage, noticing a horseshoe hanging on the wall, teased the eminent scientist about this ancient superstition. “Can it be true that you, of all people, believe it will bring you luck?”

“Of course not,” replied Bohr, “but I understand it brings you luck whether you believe it or not.”

― Niels Bohr (1885 – 1962)

Here’s an easy way to figure out if you’re in a cult: If you’re wondering whether you’re in a cult, the answer is yes.

― Stephen Colbert, “I Am America (And So Can You!)” (2007)

I won’t insult your intelligence by suggesting that you really believe what you just said.

― William F. Buckley Jr. (1925 – 2008)

A new type of superstition has got hold of people’s minds, the worship of the state.

― Ludwig von Mises (1881 – 1973)

The cult is not merely a system of signs by which the faith is outwardly expressed; it is the sum total of means by which that faith is created and recreated periodically. Whether the cult consists of physical operations or mental ones, it is always the cult that is efficacious.

― Emile Durkheim, “The Elementary Forms of Religious Life” (1912)

At its best our age is an age of searchers and discoverers, and at its worst, an age that has domesticated despair and learned to live with it happily.

― Flannery O’Connor (1925 – 1964)

Man is certainly stark mad; he cannot make a worm, and yet he will be making gods by dozens.

― Michel de Montaigne (1533 – 1592)

Since man cannot live without miracles, he will provide himself with miracles of his own making. He will believe in witchcraft and sorcery, even though he may otherwise be a heretic, an atheist, and a rebel.

― Fyodor Dostoyevsky, “The Brothers Karamazov” (1880)

One Ring to rule them all; one Ring to find them.
One Ring to bring them all and in the darkness bind them.

― J.R.R. Tolkien, “The Lord of the Rings” (1954)

Nothing’s changed.
I still love you, oh, I still love you. Only slightly, only slightly less Than I used to.

― The Smiths, “Stop Me If You’ve Heard This One Before” (1987)

So much of education, I think, relies on reading the right book at the right time. My first attempt at Catch-22 was in high school, and I was way too young to get much out of it. But fortunately I picked it up again in my late 20’s, after a few experiences with The World As It is, and it’s stuck with me ever since. The power of the novel is first in the recognition of how often we are stymied by Catch-22’s – problems that can’t be solved because the answer violates a condition of the problem. The Army will grant your release request if you’re insane, but to ask for your release proves that you’re not insane. If X and Y, then Z. But X implies not-Y. That’s a Catch-22.

Here’s the Fed’s Catch-22. If the Fed can use extraordinary monetary policy measures to force market risk-taking (the avowed intention of both Zero Interest Rate Policy and Large Scale Asset Purchases) AND the real economy engages in productive risk-taking (small business loan demand, wage increases, business investment for growth, etc.), THEN we have a self-sustaining and robust economic recovery underway. But the Fed’s extraordinary efforts to force market risk-taking and inflate financial assets discourage productive risk-taking in the real economy, both because the Fed’s easy money is used by corporations for non-productive uses (stock buy-backs, anyone?) and because no one is willing to invest ahead of global growth when no one believes that the leading indicator of that growth – the stock market – means what it used to mean.

If X and Y, then Z. But X denies Y. Catch-22.

There’s a Catch-22 for pretty much everyone in the Golden Age of the Central Banker. Are you a Keynesian? Your Y to go along with the Central Bank X is expansionary fiscal policy and deficit spending. Good luck getting that through your polarized Congress or Parliament or whatever if your Central Bank is carrying the anti-deflation water and providing enough accommodation to keep your economy from tanking. Are you a structural reformer? Your Y to go along with the Central Bank X is elimination of bureaucratic red tape and a shrinking of the public sector. Again, good luck with that as extraordinary monetary policy prevents the economic trauma that might give you a chance of passing those reforms through your legislative process.

Here’s the thing. A Catch-22 world is a frustrating, absurd world, a world where we domesticate despair and learn to live with it happily. It’s also a very stable world. And that’s the real message of Heller’s book, as Yossarian gradually recognizes what Catch-22 really IS. There is no Catch-22. It doesn’t exist, at least not in the sense of the bureaucratic regulation that it purports to be. But because everyone believes that it exists, then an entire world of self-regulated pseudo-religious behavior exists around Catch-22. Sound familiar?

We’ve entered a new phase in the Golden Age of the Central Banker – the cult phase, to use the anthropological lingo. We pray for extraordinary monetary policy accommodation as a sign of our Central Bankers’ love, not because we think the policy will do much of anything to solve our real-world economic problems, but because their favor gives us confidence to stay in the market. I mean … does anyone really think that the problem with the Italian economy is that interest rates aren’t low enough? Gosh, if only ECB intervention could get the Italian 10-yr bond down to 1.75% from the current 1.85%, why then we’d be off to the races! Really? But God forbid that Mario Draghi doesn’t (finally) put his money where his mouth is and announce a trillion euro sovereign debt purchase plan. That would be a disaster, says Mr. Market. Why? Not because the absence of a debt purchase plan would be terrible for the real economy. That’s not a big deal one way or another. It would be a disaster because it would mean that the Central Bank gods are no longer responding to our prayers. The faith-based system that underpins current financial asset price levels would take a body blow. And that would indeed be a disaster.

Monetary policy has become a pure signifier – a totem. It’s useful only in so far as it indicates that the entire edifice of Central Bank faith, both its mental and physical constructs, remains “efficacious”, to use Emile Durkheim’s path-breaking sociological analysis of a cult. All of us are Yossarian today, far too rational to think that the totem of a red line on a map actually makes a difference in whether we have to fly a dangerous mission. And yet here we are sneaking out at night to move that line on the map. All of us are Niels Bohr today, way too smart to believe that the totem of a horseshoe actually bring us good luck. And yet here we are keeping that horseshoe up on our wall, because … well … you know.

The notion of saying our little market prayers and bowing to our little market talismans is nothing new. “Hey, is that a reverse pennant pattern I see in this stock chart?” “You know, the third year of a Presidential Administration is really good for stocks.” “I thought the CFO’s
body language at the investor conference was very encouraging.” “Well, with the stock trading at less than 10 times cash flow I’m getting paid to wait.” Please. I recognize aspects of myself in all four of these cult statements, and if you’re being honest with yourself I bet you do, too.

 

No, what’s new today is that all of our little faiths have now converged on the Narrative of Central Bank Omnipotence. It’s the One Ring that binds us all.

I loved this headline article in last Wednesday’s Wall Street Journal – “Eurozone Consumer Prices Fall for First Time in Five Years” – a typically breathless piece trumpeting the “specter of deflation” racing across Europe as … oh-my-god … December consumer prices were 0.2% lower than they were last December. Buried at the end of paragraph six, though, was this jewel: “Excluding food, energy, and other volatile items, core inflation rose to 0.8%, up a notch from November.” Say what? You mean that if you measure inflation as the US measures inflation, then European consumer prices aren’t going down at all, but are increasing at an accelerating pace? You mean that the dreadful “specter of deflation” that is “cementing” expectations of massive ECB action is entirely caused by the decline in oil prices, something that from the consumer’s perspective acts like an inflationary tax cut? Ummm … yep. That’s exactly what I mean. The entire article is an exercise in Narrative creation, facts be damned. The entire article is a wail from a minaret, a paean to the ECB gods, a calling of the faithful to prayer. An entirely successful calling, I might add, as both European and US markets turned after the article appeared, followed by Thursday’s huge move up in both markets.

When I say that a Catch-22 world is a stable world, or that the cult phase of a human society is a stable phase, here’s what I mean: change can happen, but it will not happen from within. For everyone out there waiting for some Minsky Moment, where a debt bubble of some sort ultimately pops from some unexpected internal cause like a massive corporate default, leading to systemic fear and pain in capital markets … I think you’re going to be waiting for a loooong time. Are there debt bubbles to be popped? Absolutely. The energy sector, particularly its high yield debt, is Exhibit #1, and I think this could be a monster trade. But is this something that can take down the market? I don’t see it. There is such an unwavering faith in Central Bank control over market outcomes, such a universal assumption of god-like omnipotence within this realm, that any internal market shock is going to be willed away.

So is that it? Is this a brave new world of BTFD market stability? Should we double down on our whack- a-mole volatility strategies? For internal market risks like leverage and debt bubble scares … yes, I think so. But while the internal market risk factors that I monitor are quite benign, mostly green lights with a little yellow/caution peeking through, the external market risk factors that I monitor are all screaming red. These are Epsilon Theory risk factors – political shocks, trade/forex shocks, supply shocks, etc. – and they’ve got my risk antennae quivering like crazy. I’ve been doing this for a long time, and I can’t remember a time when there was such a gulf between the environmental or exogenous risks to the market and the internal or behavioral dynamics of the market. The market today is Wile E. Coyote wearing his latest purchase from the Acme Company – a miraculous bat-wing costume that prevents the usual plunge into the canyon below by sheer dint of will. There’s absolutely nothing internal to Coyote or his bat suit that prevents him from flying around happily forever. It’s only that rock wall that’s about to come into the frame that will change Coyote’s world.

My last three big Epsilon Theory notes – “The Unbearable Over-Determination of Oil”, “Now There’s Something You Don’t See Every Day, Chauncey”, and “The Clash of Civilizations” – have delved into what I think are the most pressing of these environmental or exogenous risks to the market: the “supply shock” of collapsing oil prices, a realigning Greek election, and the realpolitik dynamics of the West vs. Islam and the West vs. Russia. I gotta say, it’s been weird to write about these topics a few weeks before ALL of them come to pass. Call me Cassandra. I stand by everything I wrote in those notes, so no need to repeat all that here, but a short update paragraph on each.

First, Greece. And I’ll keep it very short. Greece is on. This will not be pretty and this will not be easy. Existential Euro doubt will raise its ugly head once again, particularly when Italy imports the Greek political experience.

Second, oil. I get a lot of questions about why oil can’t catch a break, about why it’s stuck down here with a 40 handle as the absurd media Narrative of “global supply glut forever and ever, amen” whacks it on the head day after day after day. And it is an absurd Narrative … very Heller-esque, in fact … about as realistic as “Peak Oil” has been over the past decade or two. Here’s the answer: oil is trapped in a positive Narrative feedback loop. Not positive in the sense of it being “good”, whatever that means, but positive in the sense of the dominant oil Narrative amplifying the uber-dominant Central Bank Narrative, and vice versa. The most common prayer to the Central Banking gods is to save us from deflation, and if oil prices were not falling there would be no deflation anywhere in the world, making the prayer moot. God forbid that oil prices go up and, among other things, push European consumer prices higher. Can’t have that! Otherwise we’d need to find another prayer for the ECB to answer. By finding a role in service to the One Ring of Central Bank Omnipotence, the dominant supply-glut oil Narrative has a new lease on life, and until the One Ring is destroyed I don’t see what makes the oil Narrative shift.

Third, the Islamist attack in Paris. Look … I’ve got a LOT to say about “je suis Charlie”, both the stupefying hypocrisy of how that slogan is being used by a lot of people who should really know better, as well as the central truth of what that slogan says about the Us vs. Them nature of The World As It Is, but both are topics for another day. What I’ll mention here are the direct political repercussions in France. The National Front, which promotes a policy platform that would make Benito Mussolini beam with pride, would probably have gotten the most votes of any political party in France before the attack. Today I think they’re a shoo-in to have first crack at forming a government whenever new Parliamentary elections are held, and if you don’t recognize that this is 100 times more threatening to the entire European project than the prospects of Syriza forming a government in Greece … well, I just don’t know what to say.

There’s another thing to keep in mind here in 2015, another reason why selling volatility whenever it spikes up and buying the dip are now, to my way of thinking, picking up pennies in front of a steam roller: the gods always end up disappointing us mere mortals. The cult phase is a stable system on its own terms (a social equilibrium, in the parlance), but it’s rarely what an outsider would consider to be a particularly happy or vibrant system. There’s no way that Draghi can possibly announce a bond- buying program that lives up to the hype, not with peripheral sovereign debt trading inside US debt. There’s no way that the Fed can reverse course and start loosening again, not if forward guidance is to have any meaning (and even the gods have rules they must obey). Yes, I expect our prayers will still be answered, but each time I expect we will ask in louder and louder voices, “Is that all there is?” Yes, we will still love our gods, even as they disappoint us, but we will love them a little less each time they do.

And that’s when the rock wall enters the cartoon frame.

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Thoughts from the Frontline: The Swiss Release the Kraken!

 

“Below the thunders of the upper deep,
Far far beneath in the abysmal sea,
His ancient, dreamless, uninvaded sleep
The Kraken sleepeth: faintest sunlights flee….

“There hath he lain for ages, and will lie
Battening upon huge sea-worms in his sleep,
Until the latter fire shall heat the deep;
Then once by man and angels to be seen,
In roaring he shall rise and on the surface die.”

– Alfred, Lord Tennyson, “The Kraken

“The exact contrary of what is generally believed is often the truth.”

– Jean De La Bruyère

“Cry ‘Havoc!’ And let slip the dogs of war!”

– William Shakespeare, Julius Caesar, Act III, Scene I

“No mas!”

 – Roberto Duran to the referee at the end of his fight with Sugar Ray Leonard, 1980

If you want evidence that central bankers play by their own rules, regardless of what they say or what conventional wisdom tells us, last week’s action by the Swiss National Bank should pretty much fill the bill. My friend Anatole Kaletsky, in a CNBC interview not long after the announcement, quipped (with a completely straight face) that just as James Bond has a license to kill, central bankers have a license to lie.

Swiss National Bank Chairman Thomas Jordan had assured us just the week before that the Swiss would continue to “hold the peg” whereby the SNB kept the value of the Swiss franc from rising higher than €1.22. “The cap is absolutely central,” he said. And SNB Vice Chairman Jean-Pierre Danthine said publicly only last Monday that the peg would remain a cornerstone of Swiss banking policy.

Early Thursday morning the Swiss abandoned that policy. Much of the press coverage in the (largish) wake of their surprise move has focused on the costs to banks and hedge funds around the world, but you have to realize that serious pain is being felt in Switzerland itself. Every bank and business that held non-Swiss-franc debt or investments took an immediate 15–20%+ haircut on its holdings. Swiss investors lost at least 10% on investments in their own stock market and more on shares they held in other stock markets. Forty percent of Swiss exports go to the Eurozone, and the Swiss franc is now over 30% higher than it was five years ago – with almost half that movement coming in one day. Those exporters just got hammered.

And this was not a painless policy decision for the SNB. Citibank estimates the SNB’s losses to be close to 60 billion Swiss francs. Let’s try to add a little perspective on that. The US is (very) roughly 40 times the size of Switzerland in both GDP and population. At today’s conversion rate, the Swiss lost something like $70 billion if Citibank is right. That’s like the US Federal Reserve’s losing $2.8 trillion. That, my friends, will leave a red mark on any central bank’s balance sheet. Not that the Swiss can’t afford it or that they’re going to be out on the corner with a tin cup, but they do have a considerable quantity of euros that are now much less valuable. And dollars and yen and pounds and renminbi. But then again, they are in the privileged position of having a currency that the rest of the world wants, so much that in order to hold it you will have to take a haircut on your deposits at the SNB, a haircut that is going to increase (more on that later).

There are also serious losses in the international banking community. We are just now beginning to learn how many funds and brokerages will have to close.

Do you think that SNB Chairman Thomas Jordan will be going into the local restaurants and getting high-fives and fist bumps? Exactly what do you think his reception will be in Davos (where he is scheduled to appear)? Christine Lagarde, the managing director of the IMF, gave a somewhat frosty reply to my friend Steve Liesman at CNBC when he asked her only a few hours after Jordan’s move (in what was clearly an already-scheduled interview) about her thoughts on the surprise announcement. She was not amused, but she kept her professional stage smile in place. (It was a very good interview.)

In Norse mythology, the Kraken was a sea monster that attacked ships unaware. In Greek mythology, it was a pet sea monster (of either Hades or Zeus) that would be released upon enemies that annoyed its master. It has been an iconic figure in comics and movies for the last 30 years. “Release the Kraken!” is the standard line prior all hell breaking loose.

In an era when central bankers are supposed to be more open, collaborative, and communicative, what would make the Swiss National Bank decide to turn on a dime and shock the markets – to release the Kraken, as it were? Note that in fact all hell did break loose. Rather than delivering hints accompanied by a few well-placed leaks, the Swiss decided it would be best to completely surprise the markets. It will be a long time before we get the full story on what must have been going through their heads as they reached the decision.

I have spent the last few days reading a great deal and talking with friends, trying to understand the “why” of the suddenness of the Swiss action. If we can get some insight into this question, perhaps it will give us a few clues as to upcoming global central bank policy changes in general and the problems facing Europe in particular.

While I do fully intend to try to reduce the length of my letters this year, this one is going to be longer because it will contain a significant number of charts. We’ll look at the data that made Thomas Jordan and his team at the SNB throw in the towel on their peg policy, and I think we should look at it in depth. Just as Roberto Duran walked away from Sugar Ray Leonard at the end of the eighth round of their famous fight in 1980, telling the referee “No mas,” the SNB signaled that it had had all the pain it could deal with.

The First Casualty of the Currency Wars

My last book, Code Red, was all about the currency wars that I expect to dominate the latter part of this decade, triggered by Japan’s massive quantitative easing. Jonathan Tepper and I pointed out that, going forward, it is every central banker for himself. While the world’s central bankers typically matriculated at the same schools and espouse the same beliefs, and while they regularly meet each other at conferences and BIS meetings and freely employ words like cooperation and collaboration in their dealings with one another, the reality is that they are all politically captive to the countries they serve.

While central bankers may espouse independence from their governments, they do live and work in their particular countries and are largely responsible for those countries’ economic well-being. They are going to do whatever they feel is necessary to help their governments and domestic businesses perform as well as they can, while trying to maintain the stability of their local currencies.

Japan is not going to cater to Korea with its monetary policy; neither is Indonesia really interested in helping Singapore or Malaysia; and countries like Switzerland and Sweden carve out their own paths on the flanks of the Eurozone. The US Federal Reserve has made clear on many occasions that it is not responsible for the policy decisions and outcomes of any other country. If you were the Swiss National Bank and looked at the following data, what would you do? The simple fact is that Europe and the Eurozone just don’t make sense; nor, given the recent Swiss action, do they seem to be pursuing the sorts of policies that would improve their condition.

It’s not just about deflation. Switzerland is experiencing deflation and yet has full employment, a balanced budget, and a positive trade balance. Germany, France, Austria, Belgium, the Netherlands, Finland, Sweden, and Denmark are all either in deflation or close to it.

Recent central bank policy has led to the anomaly of negative interest rates. Negative rates began to show up a few years ago and are now pervasive. I’m going to post close to a dozen charts from Bloomberg. You might want to save this letter so you can show it to your grandkids in 30 years when they complain about aberrant economic conditions and volatility. “Kids, you have no idea what we went through back in the mid-teens! It was way wacko back then.”

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Important Disclosures

Outside the Box: A War Between Two Worlds

 

The terrorist attacks in Paris have fixated the world’s attention on the contrast between competing worldviews and what constitutes acceptable behavior in modern society. What are the principles by which society should be organized and run? Who gets to set those rules, and to what standards should others who do not believe in them be held?

While at their core these are philosophical questions, the way we answer those questions can have profound economic consequences. They are especially important to understand in the context of Europe. For today’s Outside the Box reading, I think we should look at two essays by old friends to OTB, Charles Gave and George Friedman.

Charles writes as a patrician French patriot and examines the question “[Do] France and its neighbors have a part of their population that rejects the rules on which the nation is based and wishes to build a nation under a different set of rules?”

He offers a very nuanced and thoughtful analysis of the difficulty of answering that question by means of simplistic reactions. And he comes to the uncomfortable conclusion that

As far as France and most other Western nations are concerned, it is obvious that these questions will now more than ever (in spite of mainstream politicians’ best efforts to keep them out) enter the political stream and discourse. And instead of calming tensions in an era of great economic discomfort, this will likely amplify them.

George sees the problem in terms of geopolitical analysis and through the lens of history (emphasis mine):

The Mediterranean borderland was a place of conflict well before Christianity and Islam existed. It will remain a place of conflict even if both lose their vigorous love of their own beliefs. It is an illusion to believe that conflicts rooted in geography can be abolished. It is also a mistake to be so philosophical as to disengage from the human fear of being killed at your desk for your ideas. We are entering a place that has no solutions. Such a place does have decisions, and all of the choices will be bad. What has to be done will be done, and those who refused to make choices will see themselves as more moral than those who did. There is a war, and like all wars, this one is very different from the last in the way it is prosecuted. But it is war nonetheless, and denying that is denying the obvious.”

George has written a book called Flashpoints: The Emerging Crisis in Europe, which will not be available until later in January, although he graciously sent me a review copy. I’ll get started with that one but will also go ahead and buy it in a couple weeks, so I can read it on my iPad Kindle app. I find reading books on my iPad far more efficient and easy than toting around three or four books in a briefcase. I can highlight and make notes and have them available online anywhere in the world without having to go back and search through a book that I read years ago. I know that many people relish the feel of a physical book, and I admit to that pleasure; but the pain of not being able to find a specific quote or note, or worse, not being able to find the book at all because you lent it to somebody and it’s not back on your bookshelf, is far more of a driver to make me go almost totally online.

That said, when I found out that my flights to Cincinnati and back would not have on-board Wi-Fi, I did jump into George’s book. I think it’s his best work to date. It recalls to mind so many conversations we have had over the years about the tensions in Europe, and it’s giving me a deeper understanding of a region of the world that I am really quite fond of. I suspect we will revisit George’s work in future letters. It is especially relevant to the research I’m doing for my own current book-writing project on the future of the global economy.

Cincinnati is as the Weather Channel forecasted, cold and grey with snow flurries, as I look out my hotel window. That gloom aside, I spent several hours this morning visiting with friends who run a private biotechnology startup across the river. That was a decidedly ungloomy get together, as the optimism that a cure for cancer is potentially in the offing in the not-too-distant future was evident to us all, even as they explained the (to me very frustrating) process of securing regulatory approval. Hopefully that process will come to a reasonable conclusion sooner rather than later, given that over 1,500 people a day die from cancer in the US alone (many more actually contract cancer and undergo treatment and live). The savings in human lives brought about by a cure would be incalculable, but the savings in dollars to our healthcare system and the elimination of other economic losses caused by cancer would be in the hundreds of billions. And that is just in the US.

And on that hopeful note, let’s turn to Charles and George, where the news is not as optimistic. Have a great week!

Your pondering Europe analyst,

John Mauldin, Editor
Outside the Box
subscribers@mauldineconomics.com

 

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Setting Aside Emotion and Seeking Reason

By Charles Gave, Gavekal
January 12, 2015

Une nation est une âme, un principe spirituel. Deux choses qui, à vrai dire, n’en font qu’une, constituent cette âme, ce principe spirituel. L’une est dans le passé, l’autre dans le présent. L’une est la possession en commun d’un riche legs de souvenirs ; l’autre est le consentement actuel, le désir de vivre ensemble, la volonté de continuer à faire valoir l’héritage qu’on a reçu indivis. Ernest Renan, Conférence à la Sorbonne, March 1883

In order to define a nation Ernest Renan spoke of a will to live together, from which emerged the institution of the state. This state would then have a monopoly on violence (except for genuine cases of self-defense).

Throughout history, there have been cases where this willingness to live together vanished because part of a population wanted to break away and form another nation (the US civil war, Yugoslavia). There have also been cases where a regime captured a legitimate state using violence against a population that was, in fact, willing to live together (Russia under the communists?). Finally, it can occur that a significant part of the population expresses a desire to live under different rules, and that this desire spills over into tensions and armed conflict (i.e., Spanish civil war).

What happened last week in Paris begs the question whether Western Europe faces a problem in the last category; i.e., does France and its neighbors have a part of their population that rejects the rules on which the nation is based, and wishes to build a nation under a different set of rules? At the outset, it is important to draw a distinction between the two assassins of the Charlie Hebdo staff, and the lone killer of the kosher supermarket. Indeed, the Charlie Hebdo killers operated under the principles of a different civilization; principles that are very much the opposite of those that hold the French nation together (respect for free speech, etc…) but principles nonetheless. Meanwhile, the murders in the kosher supermarket are of a different nature. There, defenseless people were murdered simply for being Jewish, an outcome completely devoid of any principles other than the crassest form of anti-Semitism, which no religion condones.

The courageous Charlie Hebdo journalists took a risk and paid with their lives. As the wife of cartoonist Georges Wolinski put it, he died in the ‘field of battle, with heroes and men of honor’. Wolinski, Charb, Cabu and all the other Charlie Hebdo staff died defending the ideals they believed in and nothing can be greater than that. In the second case the fact that the Islamist fundamentalist murdered civilians simply for being Jewish makes it a more ghastly act; something akin to the events in Toulouse a couple of years ago. For every Frenchman, the first set of murders should inspire rage. The second set of murders should inspire shame and outrage. The heroes at Charlie Hebdo had taken a calculated risk which they embraced and assumed. The second set of victims had done nothing more but share the faith of their forefathers.

Which brings us back to the simple fact that the Charlie journalists were assassinated in application of a [blasphemy] law, which France rejects, but a law that, in the eyes of religious fundamentalists, trumps all others. At least, this much is clear from the declarations of the assassins who, on the scene of the crime declared ‘we have avenged the prophet’. Very clearly, the Charlie Hebdo killers did not share in what Renan called le legs constitutif de l’âme française. Instead, their reference points where, they seem to believe, in a legs constitutif of the Muslim ummah. And if this this is the case, then we should ask ourselves a number of questions:

1) The first is that the men who committed these crimes were raised in schools of the French republic. So how did they come to reject, and even hate, the republic’s values so much?

2) The second is that most French people have no problem with Islam per se. This was clear after almost four million people yesterday walked in the name of tolerance, and also from the ‘pride’ taken in one of the policemen, who died defending the Charlie Hedbo office, being a Muslim, as was the young Malian supermarket clerk who helped shoppers hide from the murderous terrorist. Still, the question must be asked whether Western nations are nursing a small minority of individuals who want to impose a system of Sharia law that opposes everything the majority holds dear? And, if so, and if that minority is large enough, do we risk more blood on our streets (whether in Paris, Sydney, Ottawa, Toulouse…). The question that then emerges is what can Western nations do about it without compromising the values they hold dear?

3) The above is not a racist question (as some commentators hint). Indeed, profound devotion to the tenets of a religion does not emanate from nature (as races do) but from thought. In that regard, being an ‘islamistphobe’ is more akin to being a ‘communistphobe’ or a ‘fascistphobe’ than a racist. At stake is the question of whether fundamentalist Islam presents a core set of values and beliefs which may, or may not, prove compatible with a) democracy and b) the ability to live in the multicultural/multi-value society most Western societies have come to cherish. For example, today, a record number of French Jews are emigrating to Israel because of the rising anti- Semitism which was on display at the Kosher supermarket—so if this emigration trend is pushed to its conclusion (i.e., no more Jews in France), France will end up being less of a multi-cultural society.

4) The question of Islam’s compatibility with Western democratic values is not a question that we, in the West, can answer. This is a question that only the Muslim world itself can answer. For example, can a line of the Koran be changed or interpreted in different ways? After all, like most holy books, the Koran states many contradictory things and one can find quotes to justify almost anything. But the Koran is different from other religious books in that it was written by Mohammed, but dictated by God (through an archangel). Meanwhile, the Torah, as well as the Ancient and New Testaments, were written by men, inspired (or not) by God. These men are accepted to have been imperfect, unlike Mohammed, whom as the Charlie Hebdo staff paid dearly to show, one cannot criticize. So the Bible can be criticized and even re-interpreted. Can the Koran? Can this be done without criticizing the prophet? Or is the Sharia not adaptable and thus, for the true followers, an almost guarantee of conflicting systems?

Let us hope that this latest drama forces the Muslim World to confront these challenging questions. As far as France and most other Western nations are concerned, it is obvious that these questions will now, more than ever (and in spite of the mainstream politicians’ best efforts to keep them out) enter the political stream and discourse. And instead of calming tensions in an era of great economic discomfort, this will likely amplify them.

A War Between Two Worlds

By George Friedman
January 13, 2105

The murders of cartoonists who made fun of Islam and of Jews shopping for their Sabbath meals by Islamists in Paris last week have galvanized the world. A galvanized world is always dangerous. Galvanized people can do careless things. It is in the extreme and emotion-laden moments that distance and coolness are most required. I am tempted to howl in rage. It is not my place to do so. My job is to try to dissect the event, place it in context and try to understand what has happened and why. From that, after the rage cools, plans for action can be made. Rage has its place, but actions must be taken with discipline and thought.

I have found that in thinking about things geopolitically, I can cool my own rage and find, if not meaning, at least explanation for events such as these. As it happens, my new book will be published on Jan. 27. Titled Flashpoints: The Emerging Crisis in Europe, it is about the unfolding failure of the great European experiment, the European Union, and the resurgence of European nationalism. It discusses the re-emerging borderlands and flashpoints of Europe and raises the possibility that Europe’s attempt to abolish conflict will fail. I mention this book because one chapter is on the Mediterranean borderland and the very old conflict between Islam and Christianity. Obviously this is a matter I have given some thought to, and I will draw on Flashpoints to begin making sense of the murderers and murdered, when I think of things in this way.

Let me begin by quoting from that chapter:

We’ve spoken of borderlands, and how they are both linked and divided. Here is a border sea, differing in many ways but sharing the basic characteristic of the borderland. Proximity separates as much as it divides. It facilitates trade, but also war. For Europe this is another frontier both familiar and profoundly alien.

Islam invaded Europe twice from the Mediterranean — first in Iberia, the second time in southeastern Europe, as well as nibbling at Sicily and elsewhere. Christianity invaded Islam multiple times, the first time in the Crusades and in the battle to expel the Muslims from Iberia. Then it forced the Turks back from central Europe. The Christians finally crossed the Mediterranean in the 19th century, taking control of large parts of North Africa. Each of these two religions wanted to dominate the other. Each seemed close to its goal. Neither was successful. What remains true is that Islam and Christianity were obsessed with each other from the first encounter. Like Rome and Egypt they traded with each other and made war on each other.

Christians and Muslims have been bitter enemies, battling for control of Iberia. Yet, lest we forget, they also have been allies: In the 16th century, Ottoman Turkey and Venice allied to control the Mediterranean. No single phrase can summarize the relationship between the two save perhaps this: It is rare that two religions might be so obsessed with each other and at the same time so ambivalent. This is an explosive mixture.

Migration, Multiculturalism and Ghettoization

The current crisis has its origins in the collapse of European hegemony over North Africa after World War II and the Europeans’ need for cheap labor. As a result of the way in which they ended their imperial relations, they were bound to allow the migration of Muslims into Europe, and the permeable borders of the European Union enabled them to settle where they chose. The Muslims, for their part, did not come to join in a cultural transformation. They came for work, and money, and for the simplest reasons. The Europeans’ appetite for cheap labor and the Muslims’ appetite for work combined to generate a massive movement of populations.

The matter was complicated by the fact that Europe was no longer simply Christian. Christianity had lost its hegemonic control over European culture over the previous centuries and had been joined, if not replaced, by a new doctrine of secularism. Secularism drew a radical distinction between public and private life, in which religion, in any traditional sense, was relegated to the private sphere with no hold over public life. There are many charms in secularism, in particular the freedom to believe what you will in private. But secularism also poses a public problem. There are those whose beliefs are so different from others’ beliefs that finding common ground in the public space is impossible. And then there are those for whom the very distinction between private and public is either meaningless or unacceptable. The complex contrivances of secularism have their charm, but not everyone is charmed.

Europe solved the problem with the weakening of Christianity that made the ancient battles between Christian factions meaningless. But they had invited in people who not only did not share the core doctrines of secularism, they rejected them. What Christianity had come to see as progress away from sectarian conflict, Muslims (and some Christians) may see as simply decadence, a weakening of faith and the loss of conviction.

There is here a question of what we mean when we speak of things like Christianity, Islam and secularism. There are more than a billion Christians and more than a billion Muslims and uncountable secularists who mix all things. It is difficult to decide what you mean when you say any of these words and easy to claim that anyone else’s meaning is (or is not) the right one. There is a built-in indeterminacy in our use of language that allows us to shift responsibility for actions in Paris away from a religion to a minor strand in a religion, or to the actions of only those who pulled the trigger. This is the universal problem of secularism, which eschews stereotyping. It leaves unclear who is to be held responsible for what. By devolving all responsibility on the individual, secularism tends to absolve nations and religions from responsibility.

This is not necessarily wrong, but it creates a tremendous practical problem. If no one but the gunmen and their immediate supporters are responsible for the action, and all others who share their faith are guiltless, you have made a defensible moral judgment. But as a practical matter, you have paralyzed your ability to defend yourselves. It is impossible to defend against random violence and impermissible to impose collective responsibility. As Europe has been for so long, its moral complexity has posed for it a problem it cannot easily solve. Not all Muslims — not even most Muslims — are responsible for this. But all who committed these acts were Muslims claiming to speak for Muslims. One might say this is a Muslim problem and then hold the Muslims responsible for solving it. But what happens if they don’t? And so the moral debate spins endlessly.

This dilemma is compounded by Europe’s hidden secret: The Europeans do not see Muslims from North Africa or Turkey as Europeans, nor do they intend to allow them to be Europeans. The European solution to their isolation is the concept of multiculturalism — on the surface a most liberal notion, and in practice, a movement for both cultural fragmentation and ghettoization. But behind this there is another problem, and it is also geopolitical. I say in Flashpoints that:

Multiculturalism and the entire immigrant enterprise faced another challenge. Europe was crowded. Unlike the United States, it didn’t have the room to incorporate millions of immigrants — certainly not on a permanent basis. Even with population numbers slowly declining, the increase in population, particularly in the more populous countries, was difficult to manage. The doctrine of multiculturalism naturally encouraged a degree of separatism. Culture implies a desire to live with your own people. Given the economic status of immigrants the world over, the inevitable exclusion that is perhaps unintentionally incorporated in multiculturalism and the desire of like to live with like, the Muslims found themselves living in extraordinarily crowded and squalid conditions. All around Paris there are high-rise apartment buildings housing and separating Muslims from the French, who live elsewhere.

These killings have nothing to do with poverty, of course. Newly arrived immigrants are always poor. That’s why they immigrate. And until they learn the language and customs of their new homes, they are always ghettoized and alien. It is the next generation that flows into the dominant culture. But the dirty secret of multiculturalism was that its consequence was to perpetuate Muslim isolation. And it was not the intention of Muslims to become Europeans, even if they could. They came to make money, not become French. The shallowness of the European postwar values system thereby becomes the horror show that occurred in Paris last week. 

The Role of Ideology

But while the Europeans have particular issues with Islam, and have had them for more than 1,000 years, there is a more generalizable problem. Christianity has been sapped of its evangelical zeal and no longer uses the sword to kill and convert its enemies. At least parts of Islam retain that zeal. And saying that not all Muslims share this vision does not solve the problem. Enough Muslims share that fervency to endanger the lives of those they despise, and this tendency toward violence cannot be tolerated by either their Western targets or by Muslims who refuse to subscribe to a jihadist ideology. And there is no way to distinguish those who might kill from those who won’t. The Muslim community might be able to make this distinction, but a 25-year-old European or American policeman cannot. And the Muslims either can’t or won’t police themselves. Therefore, we are left in a state of war. French Prime Minister Manuel Valls has called this a war on radical Islam. If only they wore uniforms or bore distinctive birthmarks, then fighting only the radical Islamists would not be a problem. But Valls’ distinctions notwithstanding, the world can either accept periodic attacks, or see the entire Muslim community as a potential threat until proven otherwise. These are terrible choices, but history is filled with them. Calling for a war on radical Islamists is like calling for war on the followers of Jean-Paul Sartre. Exactly what do they look like?

The European inability to come to terms with the reality it has created for itself in this and other matters does not preclude the realization that wars involving troops are occurring in many Muslim countries. The situation is complex, and morality is merely another weapon for proving the other guilty and oneself guiltless. The geopolitical dimensions of Islam’s relationship with Europe, or India, or Thailand, or the United States, do not yield to moralizing.

Something must be done. I don’t know what needs to be done, but I suspect I know what is coming. First, if it is true that Islam is merely responding to crimes against it, those crimes are not new and certainly didn’t originate in the creation of Israel, the invasion of Iraq or recent events. This has been going on far longer than that. For instance, the Assassins were a secret Islamic order to make war on individuals they saw as Muslim heretics. There is nothing new in what is going on, and it will not end if peace comes to Iraq, Muslims occupy Kashmir or Israel is destroyed. Nor is secularism about to sweep the Islamic world. The Arab Spring was a Western fantasy that the collapse of communism in 1989 was repeating itself in the Islamic world with the same results. There are certainly Muslim liberals and secularists. However, they do not control events — no single group does — and it is the events, not the theory, that shape our lives.

Europe’s sense of nation is rooted in shared history, language, ethnicity and yes, in Christianity or its heir, secularism. Europe has no concept of the nation except for these things, and Muslims share in none of them. It is difficult to imagine another outcome save for another round of ghettoization and deportation. This is repulsive to the European sensibility now, but certainly not alien to European history. Unable to distinguish radical Muslims from other Muslims, Europe will increasingly and unintentionally move in this direction.

Paradoxically, this will be exactly what the radical Muslims want because it will strengthen their position in the Islamic world in general, and North Africa and Turkey in particular. But the alternative to not strengthening the radical Islamists is living with the threat of death if they are offended. And that is not going to be endured in Europe.

Perhaps a magic device will be found that will enable us to read the minds of people to determine what their ideology actually is. But given the offense many in the West have taken to governments reading emails, I doubt that they would allow this, particularly a few months from now when the murders and murderers are forgotten, and Europeans will convince themselves that the security apparatus is simply trying to oppress everyone. And of course, never minimize the oppressive potential of security forces.

The United States is different in this sense. It is an artificial regime, not a natural one. It was invented by our founders on certain principles and is open to anyone who embraces those principles. Europe’s nationalism is romantic, naturalistic. It depends on bonds that stretch back through time and cannot be easily broken. But the idea of shared principles other than their own is offensive to the religious everywhere, and at this moment in history, this aversion is most commonly present among Muslims. This is a truth that must be faced.

The Mediterranean borderland was a place of conflict well before Christianity and Islam existed. It will remain a place of conflict even if both lose their vigorous love of their own beliefs. It is an illusion to believe that conflicts rooted in geography can be abolished. It is also a mistake to be so philosophical as to disengage from the human fear of being killed at your desk for your ideas. We are entering a place that has no solutions. Such a place does have decisions, and all of the choices will be bad. What has to be done will be done, and those who refused to make choices will see themselves as more moral than those who did. There is a war, and like all wars, this one is very different from the last in the way it is prosecuted. But it is war nonetheless, and denying that is denying the obvious.

Editor’s Note: The newest book by Stratfor chairman and founder George Friedman, Flashpoints: The Emerging Crisis in Europe, will be released Jan. 27. It is now available for pre-order.

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The article Outside the Box: A War Between Two Worlds was originally published at mauldineconomics.com.

Thoughts from the Frontline: A Five-Year Global Financial Forecast: Tsunami Warning

 

It is the time of the year for forecasts; but rather than do an annual forecast, which is as much a guessing game as anything else (and I am bad at guessing games), I’m going to do a five-year forecast to take us to the end of the decade, which I think may be useful for longer-term investors. We will focus on events and trends that I think have a high probability, and I’ll state what I think the probabilities are for my forecasts to actually happen. While I could provide several dozen items, I think there are seven major trends that are going to sweep over the globe and that as an investor you need to have on your radar screen. You will need to approach these trends with caution, but they will also provide significant opportunities.

There is a book in here somewhere, but I do not intend to write one today. In fact, my New Year’s resolution is to write shorter letters in 2015. Over the last decade and a half, the letter has tended to get longer. A little more here, a little more there, and pretty soon it just gets to be a bit too much to read in one sitting. That means I need to either be more concise, break up my topics into two sessions or, if further writing is necessary, post the additional work on the website for those interested.

So I’m writing today’s letter in that spirit. Each of the major topics we’ll be covering will show up in other letters over the next few months. I would appreciate your feedback and any links to articles and/or data points that you think I should know about regarding these topics.

But first, this is generally the most downloaded letter of the year. I want to invite new readers to become one of my 1 million closest friends by simply entering your email address here. You can follow my work throughout the year, absolutely free (and see how my prognostications are turning out). And if you’re a regular reader, why not send this to a few of your friends and suggest they join you? At the very least, Thoughts from the Frontline should make for some interesting conversations this year. Thanks. Now let’s get on with the forecasting.

Seven Significant Changes for the Next Five Years

Let’s look at what I think are six inexorable trends or waves that will each have a major impact in its own right but that when taken together will amount to a tsunami of change for the global economy.

1. Japan will continue its experiment with the most radical quantitative easing attempted by a major country in the history of the world… and the experiment is getting dangerous. The Bank of Japan is effectively exporting the island nation’s deflation to its trade competitors like Germany, China, and South Korea and inviting a currency war that could shake the world. I’ve been saying this for years now, but the story took a nasty turn on Halloween Day, when the Bank of Japan announced it was greatly expanding and changing the mix of its asset purchases. The results have been downright scary, and a major slide in the JPY/USD exchange rate is almost certain over the next five years. I give it a 90% probability. All this while the population of Japan shrinks before our very eyes.

2. Europe is headed for a crisis at least as severe as the Grexit scare was in 2012 – and for the resulting run-up in interest rates and a sovereign debt scare in the peripheral countries. After all these years of struggle, the structural flaws in the EMU’s design remain; and now major economies like Italy and France are headed for trouble. In the very near future we will finally know the answer to the question, “Is the euro a currency or an experiment?” The changes required to answer that question will be wrenching and horrifically expensive. There are no good answers, only difficult choices about who pays how much and to whom. Again, I see the deepening of the Eurozone crisis as a 90% probability.

3. China is approaching its day of reckoning as it tries to reduce its dependency on debt in its bid for growth, while creating a consumer society. The world is simply not prepared for China to experience an outright “hard landing” or recession, but I think there is a 70% probability that it will do so within the next five years. And the probability that China will suffer either a hard landing OR a long period of Japanese-style stagnation (in the event that the Chinese government is forced to absorb nonperforming loans to prevent a debt crisis) is over 95%. To be sure, it is still quite possible that the Chinese economy will be significantly larger in 2025 (ten years from now) than it is today, but realizing that potential largely depends on President Xi Jinping’s ability to accomplish an extremely difficult task: deleveraging the debt overhang that threatens the country’s MASSIVE financial system while rebalancing the national economy to a more sustainable growth model (either through either a vast expansion of China’s export market or the rapid development of “new economy” sectors like technology, services, and consumption; or both). This will not be the end of China, which I’m quite bullish on over the very long term, but such transitions are never easy. Even given this rather stark forecast, it is still likely (in my opinion) that the Chinese economy will be 20 to 25% bigger as 2020 opens than it is today; and every other major economy in the world (including the US) would be thrilled to have such growth. At the very least, though, China’s slowdown and rebalancing is going to put pressure on commodity exporters, which are generally emerging markets plus Australia, Canada, and Norway.

4. All of the above will tend to be bullish for the dollar, which will make dollar-denominated debt in emerging-market countries more difficult to pay back. And given the amount of debt that has been created in the last few years, it is likely that we’ll see a series of crises in emerging-market countries, along with an uncomfortably high level of risk of setting off an LTCM-style global financial shock. My colleague Worth Wray spoke about this new era of volatile FX flows and growing risk of capital flight from emerging markets at my Strategic Investor Conference last May, and he has continued to remind us of those risks in recent months (“A Scary Story for Emerging Markets” and “Why the World Needs the US Economy to Struggle”). Now that Russia has tumbled into a full-fledged currency crisis with serious signs of contagion, Worth’s prediction is already playing out, and I would assign an 80 to 90% probability that it will continue to do so, as a function of (1) the rising US dollar and a reversal in cross-border capital flows, (2) falling commodity prices, or (3) both. This massive wave is going to create a lot of opportunities for courageous investors who are ready to surf when countries are cheap.

5. I do not believe that the secular bear market in the United States that I began to describe in 1999 has ended. Secular bull markets simply do not begin from valuations like those we have today. Either we began a secular bull market in 2009, or we have one more major correction in front of us. Obviously, I think it is the latter. It has been some time since I’ve discussed the difference between secular bull and bear markets and cyclical bull and bear markets, and I will briefly touch on the topic today and go into much more detail in later letters. For US-focused investors, this is of major importance. The secular bear is not something to be scared of but simply something to be played. It also offers a great deal of opportunity. If I am right, then the next major leg down will bring on the end of the secular bear and the beginning of a very long-term secular bull. We will all get to be geniuses in the 2020s and perhaps even before the last half of this decade runs out. Won’t that be fun? Let’s call the end of the secular bear a 90% probability in five years and move on.

6. Finally, the voters of the United States are going to have to make a decision about the direction they want to take the country. We can either opt for growth, which will mean a new tax and regulatory regime, or we can double down on the current direction and become Europe and Japan. I’ve traveled to both Europe and Japan, and they’re both pleasant-enough places to live, but I wouldn’t want to be a citizen of either Japan or the Eurozone for the rest of this decade. (I particularly love Italy, but it is beginning to resemble a basket case, with last year’s optimistic drive for reforms seemingly stalled.)

However, I would rather live and work and invest in a high-growth country, with opportunities all around me, a country where we reduce income inequality by increasing wealth and opportunities at the lower end of the income scale instead of trying to legislate parity by increasing taxes and imposing government-mandated wealth redistribution, which slows growth and squelches opportunity for everyone.

A restructuring of the US tax and regulatory regime does not mean a capitulation to the wealthy, big banks, or big business. Properly conceived and constructed, it will allow the renewal of the middle class and result in higher income for all. Sadly, it is not clear to me that either the Republican or Democratic parties are up to the task of making the difficult political decisions necessary. They each have constituencies that tend to opt for the status quo. But I see hope on both sides of the political spectrum that change is possible. The course they set will give us an idea where we will want to focus our portfolios in the decade of the ’20s. It is a 100% probability that we will have to make a decision. It is less than 50% that we will make the right one – or at least the one that I think is the right one.

7.  We have entered the Age of Transformation. We’re going to see the development of new technologies that will simply astound us – from increasingly capable robots and other applications of AI to huge breakthroughs in biotechnology. The winners are going to be those who identified the truly transformational technologies early on in their development and invested wisely. While riskier (potentially far riskier) than most of your investments should be, a basket of new-technology stocks should be considered for the growth part of your portfolio. I see the Age of Transformation as a 100% probability.

Just for the record, I also see a continuation of the global deflationary environment and a slowing of the velocity of money until we have some type of resolution concerning sovereign debt. Central banks will continue to try to solve the “crises” I mentioned above with monetary policy, but monetary policy will simply not be enough to stem the tide. Central banks can paddle as hard as they like into the waves of change, but they cannot reverse their powerful flow.

Now, let’s look further at each of the waves that are forming into a potential tsunami.

 

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Important Disclosures

Outside the Box: Stray Reflections

 

’Tis the season for making forecasts. I will be sending my own five-year projections this weekend, but today for your Outside the Box reading pleasure we look at some similarly longer-term prognostications from the newest member of the Mauldin Economics writing team, Jawad Mian. Jawad writes a monthly global macro advisory publication called Stray Reflections, which is read by some of the world’s largest hedge funds, family offices, and asset managers. I and my team have become fascinated with his work. Jawad is not, in my opinion, non-consensus or even contrarian, but seemingly comes at macroeconomic issues from right angles, offering a viewpoint far different from almost anything else I read.

Born and raised in the UAE, educated in Canada, and now based in Dubai, Jawad views the world differently from the vast majority of Western-born and -trained analysts. A thoughtful and clear communicator, he is a rising star in the macroeconomic space, and I am glad to have him with us at Mauldin Economics.

As Jawad himself said as we were comparing views on a phone call yesterday, The beauty of Mauldin Economics is that none of our team is constrained to a “house view” but are encouraged to present independent insights. We are gathering a wide-ranging group of sophisticated thinkers so that we can cover all scenarios for our readers, based on our best judgment. 

The truth of that statement will become clear as you read Jawad’s forecast. Over the longer term, he and I are in general agreement, but we see definitely see the world developing differently over the next one to two years. It is decidedly helpful to pay attention to variant views, so that as time unfolds we don’t find ourselves totally surprised if things don’t happen to turn out quite the way our “most likely” scenarios suggest.

Let me share something that Jawad expressed as he and I were communicating about some of our similarities and differences:

My view about the US dollar is “different” from yours, John, in the following sense. There is zen-like certainty about a stronger dollar due to the Fed’s hiking rates and US economic outperformance. I prove that Fed rate hiking has historically led to a weaker, not a stronger dollar and argue that the dollar rally is cyclical, not structural, and will soon end. Both conclusions are contrary to what the majority expects in 2015 and beyond. The consensus is misinformed of history in my view and is wrongly reading fundamentals and technicals. I expect the US dollar to be lower on a one- and three-year time frame versus most currencies, except against the yen. Relative to expectations and views held by the [rest of the] Mauldin team, I’m more optimistic about Europe, Japan, and China. I think both Japan and China are implementing the correct policy responses and are headed in the right direction, and that Europe is not facing a major deflationary bust, and all is not lost. The risk of EM contagion is also way over-hyped in my view, as are the implications of a reversal in cross-border flows. US stock outperformance versus the rest of the world should end sometime in 2015 and will coincide with the peak in the US dollar, which will ultimately result in higher gold and commodity prices and even inflation readings. Therefore I am bearish on the US dollar for at least the next two years.

I will present a considerably different view this weekend, while fully acknowledging that there are possible scenarios by which Jawad could prove to be the more on-target forecaster. Then in two weeks Jawad will join Jared Dillian (who hangs out in New York and South Carolina), Tony Sagami (who will fly in from Bangkok), Worth Wray (now based in Houston), and the rest of our team (scattered all over the US) here in Dallas for three days of what I think will be rather intense discussions. (Patrick Cox is in the final stages of writing a book, so he will miss this week, but we will be getting together when that is done!)

One of the items we will discuss is the rollout and further evolution of a new service called Mauldin PRO, which will be primarily for professional brokers and advisors who are responsible for portfolio management and asset allocation. If you’re interested in finding out about the service, you can give us your email here and we will notify you prior to launch.

Now, I will let Jawad’s writing speak for itself. We have elected to include his entire letter, which also offers some personal musings and the results of his meditation on the long-term outlook for the US dollar. So, omitting my usual personal comments, let’s enjoy the latest edition of Stray Reflections.

Your enjoying being part of a team analyst,

John Mauldin, Editor
Outside the Box
subscribers@mauldineconomics.com

 

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Stray Reflections

December 2014

Jawad S. Mian, CFA, CMT
Managing Editor
jawad@stray-reflections.com

Awakenings

There is an old story about a beautiful peasant girl named Layla, who was passing through a farmland while going to another village. There was a man offering his prayers out in the open. The custom was that no one should cross in front of the place where anyone was praying. When the girl returned from the village, this man was still sitting there.

He voiced, “O girl, what terrible sin have you committed earlier!”

“What did I do?” she asked, puzzled.

“I was offering prayers here, and you passed over this place.”

“What do you mean by offering prayers?”

“Thinking of God,” he replied.

“Really? Were you thinking of God? I was thinking of my young man whom I was going to meet, and I did not see you. Then how did you see me while you were thinking of God?”

Over the summer, Science magazine published an instructive report that spoke to the challenges of the disengaged mind. We quote from the editor’s summary:

Nowadays, we enjoy any number of inexpensive and readily accessible stimuli, be they books, videos, or social media. We need never be alone, with no one to talk to and nothing to do. Wilson et al. explored the state of being alone with one’s thoughts and found that it appears to be an unpleasant experience. In eleven studies, they found that participants typically did not enjoy spending 6 to 15 minutes in a room by themselves with nothing to do but think, that they enjoyed doing mundane external activities much more, and that many preferred to administer electric shocks to themselves instead of being left alone with their thoughts. Most people seem to prefer to be doing something rather than nothing, even if that something is negative.

How strange. Perhaps the French philosopher Blaise Pascal was correct in observing that “Distraction is the only thing that consoles us for our miseries, and yet it is itself the greatest of our miseries.” Life is difficult for many of us, but very often we make it even more difficult for ourselves by the way we think. In our age of connectedness and perpetual motion, there is something to be said for cultivating stillness in order to summon some emotional and mental clarity. We suspect that most of man’s problems arise from his abandoning the religion of solitude. Pico Iyer, in The Art of Stillness, reveals the unexpected pleasures of sitting still, without being distracted, as a way to uncover a form of well-being that is inherent to the nature of our minds.

He reflects with a sense of nostalgia:

Not many years ago, it was access to information and movement that seemed our greatest luxury; nowadays it’s often freedom from information, the chance to sit still, that feels like the ultimate prize…. We’ve lost our Sundays, our weekends, our nights off—our holy days, as some would have it; our bosses, junk mailers, our parents can find us wherever we are, at any time of day or night. More and more of us feel like emergency-room physicians, permanently on call, required to heal ourselves but unable to find the prescription for all the clutter on our desk.

Iyer believes that this is the reason why many people seem to be turning to yoga or meditation or tai chi. They are all desperate to unplug.

How many times have we imagined sitting on the banks of a river in perfect tranquility or leaving everything behind and retreating to the top of a mountain to live an unperturbed life?

From time to time, we all feel overwhelmed by the demands of this world and would like nothing more than to withdraw into a more peaceful state. But, as the example of the man in the opening story shows, harmony eludes the untutored mind. But it is surely something we can attain if we put our heart to it, as demonstrated by Layla when she went in search of her Majnun.

Much has been written about meditation as the solution for the modern man or woman, given his or her frantic schedule. According to popular blogger Maria Popova:

Over the centuries, the ancient Eastern practice has had a variety of exports and permutations in the West, but at no point has it been more vital to our sanity and psychoemotional survival than amidst our current epidemic of hurrying and cult of productivity. It is remarkable how much we, as a culture, invest in the fitness of the body and how little, by and large, in the fitness of the spirit and the psyche—which is essentially what meditation provides.

Research has shown this can lead to better health and clearer thinking, even emotional intelligence. And if you’re Ray Dalio, it can even lead to bigger profits. As acknowledged by the founder of the world’s largest hedge fund, “Meditation, more than any other factor, has been the reason for what success I’ve had.”

We find all cultures of the world steeped in esoteric practices of one form or another to provide an effective means for acquiring self-knowledge. A kind of introspection and detached observation that helps people discover an even higher aspect of themselves. In the Judeo-Christian tradition, it is contemplative prayer. In the far Eastern traditions, vehicles of meditation often have to do with mastering aspects of breathing or the heartbeat. In the Zen Buddhist tradition, it is sitting with an awareness of thoughts and feelings without clinging to them. In Islamic tradition, it is emptying your heart and invoking God’s name. The objective of these practices is not to force yourself into a state of peace – which would be counterintuitive – but instead, to refocus your attention away from the ego or intellect toward the calm, pristine depths within. To attain harmony, one has to seek that lilt which is present in the innermost core of our being. According to Inayat Khan, “It is just like the sea: the surface of the sea is ever moving, yet the depth of the sea is still. And so it is with our life. If our life is thrown into the sea of activity, it is on the surface. We still live in the profound depths that are still, in that peace. But the key is to become conscious of that peace which can be found within ourselves.” As the Roman emperor Marcus Aurelius shared in one of his Meditations, nowhere can man find a quieter or more untroubled retreat than in his own soul. You need not sail to St. Barts or travel to the Himalayas.

Meditation, in the words of Inayat Khan, is not some stoic physical position or arduous mental exercise that you do for 20 minutes a day. It is really a letting go, the lifting of a veil, in our view, which leads to a marvelous change of viewpoint. By awakening our self, we develop more attentive and appreciative eyes that are so essential for a true reflection of the world. We don’t view it as just another to-do item.

At Stray Reflections, there are times when we sit around the office and do nothing. We just try to cultivate our receptive capacities as we “meditate“ about the world. We find the thoughts that come to us unbidden are far more original and profitable than the ones we consciously seek out. It still takes us a long time, though, to coalesce our stray reflections into some actionable trade ideas. But one thing is for certain: when we let our mind go, we discover that we can see the world more clearly. As Pico Iyer alleged in one of his earlier essays, “It’s only by having some distance from the world that you can see it whole, and understand what you should be doing with it.”

We don’t do much with it, frankly. Just as not too long ago it was access to information and price movements that seemed the greatest luxury for an investor, nowadays we think it’s often freedom from information overload and the chance to sit still and not feel compelled to trade on every earnings release that feels like the ultimate prize. As the demands on our attention have increased in this madly accelerating world, we prefer to pull ourselves away from the screen every now and then to hone the power of detachment. We now experience fairly undisturbed thoughts and emotions with regard to volatility spikes, and don’t always search for a well-reasoned explanation.

It’s not that we have declared a Trading Sabbath (different from our CNBC Sabbath). It is essential to stay in touch with markets and to know what’s going on in our positions. We have just developed habits of observation that we feel are far more important in our research process than fairly large and frequent accumulations of consensus groupthink. We endeavor to narrow the differences between what we choose to focus on and what actually gets us results. We take seriously our duty to our cherished readers and hope to provide a valuable return on your time.

Your harmony is important to us. And right now, our harmony is being threatened by the relentless rise in the dollar.

Source: James Clear

Investment Observations

This month we meditate about the long-term outlook for the US dollar.

One of the dominant macro themes since the summer has been monetary policy divergence on the back of US economic outperformance. As a result, the dollar has climbed to its highest level in nearly six years, influenced by expectations of Fed tightening in response to a maturing US recovery. Lots of pundits have postulated that the US has decoupled from subpar foreign economic activity, and they expect this trend to continue in 2015, even as global inflation expectations melt down.

According to economist Tim Duy,

The US economy is far more resilient than it is given credit for. None of the downside risks of recent years have been sufficient to derail the recovery, nor will the supposed downside risks of next year. They are mostly external, while the primary engine of US growth is internal and flexible…. Hence my probability of recession in the next twelve months: 0%. I would place similar odds on the following twelve months as well. Perhaps, just perhaps, the US economic expansion has been consistently undersold, and continues to be undersold. It is worth considering that maybe it is time to just accept the good news without the desperate search for every dark cloud.

The IMF just upped their 2015 US growth forecast to 3.5% from 3.1% previously. So, as urged by Nancy Lazar of Cornerstone Macro at the University of Virginia’s 7th Annual Investing Conference, “Close the book on how you look at the world right now. It’s changing. Past evaluations don’t work. Emerging markets are no longer the driver of global growth. The US is the driver of global growth.”

Bearing in mind the blowout jobs numbers in December, we can appreciate the unbridled economic optimism. The latest non-farm payrolls release showed employment increased by 321k in November, with healthy upward revisions to September and October data as well. This was the 10th successive month of 200k+ payrolls and is being taken as a clear sign of an acceleration in the positive economic forces. The unemployment rate was unchanged at 6-year lows of 5.8%, while labour participation also held constant at 62.8%. We saw encouraging signs of wage growth, but it still remains tepid at around 2% on an annual basis.

We are currently at levels in job-market indicators which suggest that the Fed funds rate should already be higher than current levels. According to James Paulsen at Wells Fargo:

With job creation rising about 2% a year while the labor supply is rising only about 0.5%, the unemployment rate is set to continue falling by about 1.5% annually. Imagine seeing the unemployment rate in the low 4% range this time next year. This would represent one of the lowest unemployment rates in the last 50 years! Even if labor force growth accelerates to about 1% and the unemployment rate falls by only 1% in 2015, it would still decline below 5%. Whether wage inflation rises or not, will the Fed still be debating whether it should lift short-term interest rates from zero?

Based on the Taylor Rule, the Fed funds rate should be at 1.5% currently.

The decoupling thesis is clearly gaining traction among investors. Foreign inflows into US financial assets rose to a record in September, according to the latest TIC data, while traders’ long US dollar speculative positions have reached a new all-time high of $48 billion. So here and now, the dollar has strengthened as an investment currency. It is up 12% from the year’s summer low. But does that strengthening still have a long way to go, as it did in the 1980s and 1990s?

The two late-20th century moves in the dollar came in times of robust growth and relatively tight monetary policy. There are some loose parallels that can be drawn. According to Jens Nordvig of Nomura,

In the early 1980s, USD was boosted by the combination of fiscal policy stimulus and tight monetary policy (the Volcker era). This was during the Reagan years, where tax cuts were implemented and the structural deficit moved close to 6% of potential GDP. In addition, USD benefitted from a substantial terms-of-trade improvement as oil prices fell dramatically in real terms. Finally, inflation dynamics at the time played into USD strength. Inflation came down sharply to 2.5% by 1983 from 14.8% in 1980, helping to sustain an environment of high real interest rates and reduced fears about a ‘debasement’ of the dollar. USD also benefitted from some risk aversion flows throughout the period (linked at various intervals to geopolitical tensions in the Middle East and the Latin American debt crisis). In the late 1990s, there were a number of simultaneous USD-supportive dynamics. US growth was robust and US capital markets attracted very substantial capital inflows from abroad (both in the form of FDI and equity portfolio inflows. In addition, there were waves of uncertainty around the world, ranging from the Asian crisis (1997), the Russian default (1998) and tension in Brazil (1999). All these events in the emerging market space generated additional support for the dollar. In addition, global growth was fairly weak, allowing the US economy to outpace the rest of the world.

Source: Market Anthropology

The US dollar reached a peak against major currencies in 1985 and fell 52% to a low in August 2011, which, ironically enough, coincided with the S&P rating downgrade. Based on conventional wisdom, the upward movement since then is seen as the start of multi-year mega-uptrend. The argument for broad-based dollar strength is supported by (i) decent US growth, (ii) higher yields than those of its main trading partners, (iii) external balances that are in good shape, (iv) cheap currency valuation on a real effective exchange-rate basis, and (v) deliberate devalutions in the rest of the world.

In general, we are skeptical of the consensus mindset and don’t think that the US dollar can appreciate significantly over the next five years. We view the recent strong run-up in the currency’s value as a cyclical phenomenon – not a secular upturn – and suspect it offers an excellent opportunity for investors to diversify outside of the dollar.

As we analyze our macro signals, we continue to find the bullish narrative directed towards the US economy and the US dollar exceedingly optimistic. Much ink has been spilled to prove American exceptionalism in a slowing global growth environment. But as they write (in fine print) at the bottom of every hedge fund’s fact sheet: past performance is not indicative of future results. The risk of a synchronized global downturn, while not our baseline view, is all too real, with global leading economic indicators (including those for the US) tipping over from their 2014 highs. Based on the Fed’s models, a large appreciation of the dollar is estimated to cut GDP growth by around 0.5% over the following year. As per Ashraf Laidi, the Fed’s priority may be displaced from containing any unwarranted rise in bond yields to that of monitoring the rise of the dollar.

We believe people are greatly overestimating the resilience of the US recovery, especially when we consider the prospect that we may have just seen “peak payrolls.” It is undeniable that the oil and gas sector has become a key driver of US economic activity. According to The Perryman Group, it has been responsible for about 30% of the 10 million national increase in jobs since the global financial crisis. With oil prices plunging, the expected slowdown in drilling and weaker capex spending darkens the job market outlook for the energy sector. It is possible that this will be offset by other parts of the economy that experience an oil windfall, but we would be hesitant to draw such a conclusion, with jobless claims numbers already slowing from a rate-of-change perspective. The labor market usually peaks 7 months in advance of a recession, since unemployment is a lagging indicator. In the coming year, we think the labor market will be demonstrably weaker than indicated by the unemployment rate, as the pace of job growth stalls. This is one of the consequences of the “New Oil Normal” theme we discussed in November. It certainly looks like US 3rd quarter GDP was the peak on a sequential basis. According to BCA Research, the biggest boost from the most cyclical parts of the economy (housing and consumer durables) is already behind us.

One of the less-cited factors for dollar strength is the improvement in the US current account. The chief benefit of QE was the cheapening of the dollar to its lowest level in the postwar era. It was one of a host of factors that led to a decline in the current account deficit from a peak of 6% of GDP in 2006 to about 2% of GDP in 2014. It was partly the reduction in the current account deficit that led to fewer US dollars being available in the international market, thus swelling the dollar’s value. The “short squeeze” on two-thirds of the $11 trillion cross-border loans that are denominated in dollars reversed institutional investment flows back into US, according to Morgan Stanley.

The last time the US had a current account surplus was in 1991, when the trade-weighted dollar was nearly 40% stronger than it is today. So the fact that, even with the dollar’s major undervaluation since 2011, the US has been unable to return to a surplus suggests that the current account deficit is really structural in nature. We believe the dollar is now vulnerable to a rewidening of the current account deficit on the back of stronger household consumption. The temporary fillip to the current account from the shale oil boom, weak import demand, and lower interest rates should reverse in the next five years. The US trade deficit is already back to the record lows seen before the financial crisis in 2008, if we exclude oil. Even with the drop in oil prices, US terms of trade will benefit less due to much lower sensitivity relative to history. It is for this reason that we believe US will struggle to attract the same amount of external capital as it has in the past.

Source: Nordea Markets and Macrobond

Since we don’t employ an army of clairvoyants, we can’t tell you what the exact jobless rate or the Fed funds rate will be a year from now. While we believe that the US economy can withstand non-zero short-term rates at this point, the anomalous divergence between payrolls growth and inflation expectations complicates the way forward. The global macro environment today is beset with deflationary tendencies. Based on our best judgement, monetary policy is unlikely to tighten at the pace it did during the last two cyclical bull markets in the dollar: the early 1980s and the late 1990s.

Inflation, as measured by the personal consumption expenditure (PCE) index, is 1.4% currently, and it has been below the Fed’s target of 2% since April 2012. Measures of long-term inflation expectations based on the CPI swaps market have meanwhile fallen below levels that preceded QE2, QE3, and Operation Twist. The drop has occurred against the backdrop of dollar strength, weakening commodity prices, and slowing global growth. Even the University of Michigan consumer inflation expectations measure has fallen to the lowest level since March 2009, which means both survey-based and market-based measures are indicating the same message. At a bare minimum, this implies the Fed will begin to make more frequent overtures to rein in the dollar.

Source: BCA Research

The latest FOMC minutes revealed policymakers will be “attentive” to evidence of a further downward shift in longer-term inflation expectations because it “…would be even more worrisome if growth faltered.” Current market estimates for liftoff now point to Q3 of 2015, and recent comments by Fed Vice Chairman Stanley Fischer suggest the central bank is inclined to start raising rates even if inflation is lower than the Fed’s 2% target. However, if deflation expectations accelerate in the coming year or in the event of any negative growth surprises, we think the Fed will adopt a more relaxed attitude to policy normalization than is currently anticipated. “Premature rate increases would carry a high risk of short-circuiting the recovery” warned former Fed Chairman Ben Bernanke in a March 2013 speech, “possibly leading to an even longer period of low long-term rates.” The folly of a number of central banks that were forced to reverse their decisions later is all too evident to Fed officials, so we don’t expect them to repeat the same mistake.

But even if they do, will rising US interest rates imply a stronger dollar?

By reviewing past tightening cycles, we learned that exchange rates can follow many paths that do not always correspond to the predictions from monetary policy actions. The evidence shows that sustained and large increases in the Fed funds rate can lead to an appreciation of the dollar, but it often takes two years for those effects to take noticeable hold. There is a substantial delay between the policy actions and the maximal effect on the dollar. For instance, the Fed’s last tightening cycle began in mid-2004 when the unemployment rate had fallen to 5.5% and other metrics of the labor market were significantly stronger than they are now. The US dollar fell in the following six months, and by the time of the last rate hike during the summer of 2006, the dollar was at about the same level as when the liftoff began. Over an extended period of time, rising US interest rates are not necessarily accompanied by a rising foreign exchange value of the US dollar. Fed rate hiking since the early 1970s has actually been, on average, consistent with the dollar getting weaker, not stronger.

Source: Aurelija Augulyte (Nordea Markets)

At this stage of the business cycle, real interest rates are typically rising as economic activity gathers pace and a self-sustaining recovery takes hold, leading to an adjustment higher in the interest rate path. Yet in our current experience, real interest rates are mostly rising due to the sharp decline in inflation expectations, which in the past has generally been disastrous for asset prices. We interpret this to mean that a stock market correction is a possible “tail risk” in 2015. It used to just be a “risk,” but given its infrequent appearance lately, we would consider it to be a tail event. 

As we wrote in our October issue,

The AOL Time Warner merger in 2000 culminated in the tech crash, the Blackstone IPO in 2007 presaged the 2008 financial market meltdown, and the Glencore listing in 2011 marked the peak in iron ore prices and the commodity super-cycle. We can’t escape the feeling that the Alibaba IPO may also be sending an ominous message for future market returns.

In our view, the balance between adequate and sustained growth and financial stability will become more difficult over the foreseeable horizon than has been the case traditionally. If the S&P 500 were to suddenly shed 15 or 20% of its value, how might Yellen react? We don’t believe that volatility can be kept supressed when liquidity provisions are diminishing. Markets are living precariously without the Fed put.

Indeed, if the Fed raises interest rates next year, the Fed will also lower price-to-earnings multiples. As per James Paulsen:

It is difficult to look at the 60-year relationship illustrated in the chart and not conclude that if the Fed begins to raise the funds rate next year, the S&P 500 P/E multiple is likely to decline. Indeed, P/E risk in 2015 is probably further augmented because the current P/E multiple is quite high (i.e., the current P/E multiple is higher than about 70% of the time since 1955) and because it has risen by 50% (from about 12 times to about 18 times) in the last three years! Those expecting the Fed to finally begin increasing the funds rate in 2015 should also anticipate a meaningful decline in the stock market’s P/E multiple…. The ability of earnings to entirely offset Fed tightening seems unlikely. US profit margins are already near postwar highs, and the profit cycle is much more mature compared to past recoveries.

Source: Wells Capital Management

If we assume a 10% decline in the P/E multiple (from about 18 to 16) and multiply that against our expected S&P EPS of $125 next year, we get an index value of 2000 for the S&P 500.

A positive co-movement has developed between the trade-weighted dollar and US stocks, which suggests that the dollar may not be the usual safe haven if equity markets slide.

And if we are correct in our thinking about the dollar, it also means we are nearing the end of US stocks’ outperformance compared with the rest of the world.

We recommend investors to diversify into the euro. We believe aggressive assumptions about the expansion of the ECB’s balance sheet will need to be pared down. In the six months since Mario Draghi first announced plans for fresh stimulus, the ECB balance sheet has actually shrunk by over €100 billion. It is still possible that the QE Rubicon will be crossed in 2015, but there remain plenty of political and legal obstacles before purchases of sovereign bonds can be used as a monetary policy tool. The ECB’s board is divided on the vague plans for a €1 trillion liquidity salvo. In any case, a full-scale QE might not have a lasting downward impact on the euro. According to BCA Research:

In the euro area, the correlation between the stock market and the currency has been consistently and strongly positive. Therefore, while the ECB’s monetary loosening may initially weaken the euro, if it also lifts asset prices, the second-round impact works in the opposite direction. It strengthens the euro.

Meanwhile, the decline in EUR/USD has already priced in a meaningful balance sheet expansion, in our view. Therefore, downside in the euro is limited. We think the end of European bank deleveraging may lead to better growth prospects in 2015, which could reverse the extreme pessimism. Our analysis leads us to conclude that the risk of a major deflationary bust in Europe, while not exaggerated, is likely to recede in the coming months and that economic indicators should improve, even if it takes time.

Source: Nautilus Research

Taken as a whole, Europe has some of the strongest fundamentals in the world right now, given the size of its budget deficit; its primary balance; or its current account surplus, which stands at a record €250 billion in the last twelve months. The eurozone’s oil import bill totaled over €300 bn in the last year. As this declines with lower oil prices, it will push the current account surplus to new record highs in 2015. This will underpin formidable support for European assets and should act against any attempts to weaken the currency on a sustained basis.

We feel the situation is no different to what Japanese policymakers faced when they found it difficult to stop the appreciation of the yen during the 1990s. Even though the yen dropped at the start of the Japanese recession, it rallied strongly in the mid-1990s despite numerous efforts to weaken the currency and remained strong throughout the next decade.

The European crisis is also forcing tough fiscal adjustments and structural reforms that will serve to benefit the common currency in the long run. And after Trichet (French) and Draghi (Italian), our speculation is that a German (Weidmann?) will become the next ECB President. Can you imagine the performance of the euro under German diktat?

We also suspect the popular Abenomics trade has likely run its course over the intermediate term. This implies that the Japanese yen may strengthen against the US dollar in a violent countertrend move. This will confound the majority of anlaysts that are racing to keep up with the yen’s decline, with expectations of a further expansion in Japanese QE by June.

It is assumed that the BoJ’s unprecedented balance sheet growth and Abe’s second-term election win will lead USD/JPY to rise even farther and faster in the months ahead. We would caution against such linear thinking. In our view, it is important to pay particular attention to the embedded beliefs in financial markets and assess valuations and trends in this context. It is not necessary that rising total assets on the BoJ’s balance sheet will result in sustained yen depreciation. Between 2002 and 2005, the BoJ’s balance sheet increased by nearly 40%, yet USD/JPY fell from 135 to 100.

We lean on the astute Louis Gave, founder of GaveKal Research, for his shrewd analysis of Japan’s conundrum:

With the Nikkei breaking out to new highs, Abe obviously feels now is the time to try and cement his party’s dominant position in the Diet. But is Abe’s decision really such good news for investors? Doesn’t it suggest that near-term stock market gains may be capped? Obviously Abe, like everyone else, has no clue where the Nikkei will be in six or 12 months time. But if the prime minister had any more market-boosting tricks up his sleeves, wouldn’t he have deployed them first, waited for stocks to rally further, and only then called an election—in which he may have stood a greater chance of winning the two-thirds majority he needs to change the constitution and upgrade Japan’s military, his ultimate goal. The reality of the Japanese equity market in recent years is that it has largely been a play on the yen’s exchange rate. Of course, the yen took another leg down—and the market a leg up—when BoJ governor Haruhiko Kuroda announced another aggressive round of quantitative easing at the end of October. But this latest move begs the question: What will drive the yen weaker from here? Given the BoJ’s aggressive money printing, and the Government Pension Investment Fund’s (GPIF) commitment to invest more abroad, the yen should easily drift down to ¥120 to the US dollar. But beyond that, what will be the catalyst for further yen weakness? The single most obvious catalyst would be the start of a tightening cycle in the US. Historically, the single biggest driver of US dollar-yen exchange rate has been the difference in interest rates. But if the Federal Reserve refrains from raising rates in the near future, then what else could drive the yen lower? In all probability it will not be the BoJ, at least in the near term. After Kuroda put his hand in his pocket last month, it is unlikely he will be called upon to act again until the second half of 2015 at the earliest. More importantly, the combination of the decline in the yen over the last two years, the continued gradual decline in global energy prices, and the very slow restart of Japan’s nuclear plants means Japan’s trade balance is likely to see a net improvement over the next few quarters.”

Finance Minister Aso and former officials like Sakakibara are also getting more concerned about the pace and level of yen devaluation. The exchange rate is now the cheapest versus the US dollar since late 1985. Based on the OECD’s measure of purchasing power parity, the yen is undervalued by 15% against the dollar now, compared to an overvaluation of 23% when Abe was elected two years ago. It is the most undervalued of the major currencies.

Source: GaveKal Capital

We believe the Abenomics trade will face a critical test in the weeks and months ahead. We are approaching a pretty important turning point, in our view. On December 1st, just as the Nikkei closed at a seven-year high, Moody’s cut Japan’s credit rating to A1 from AA3. Rating agencies are notorious for always arriving late to a party.

We think, rather counterintuitively, that with Japan’s economy now back in recession (Q3 GDP dropped 1.9% year-on-year) and with nearly 85% of all respondents to a recent Kyodo News poll clearly saying they did not feel that the economy has recovered, the yen is about to embark upon a major rally. We would look for a peak in USD/JPY around the 122 area.

Finally, what to do about gold?

Gold peaked in 2011 and has since dropped more than 40%. Is the powerful bull market since 2001 still alive or is gold entering a multi-year decline?

The catalysts for higher prices, which were present for much of the last decade, have clearly diminished: real interest rates around the world are no longer negative, although they will remain low for some time; and central bank policy is not as expansionary, even though competitive devaluations are still in vogue. As the world “looks better,” the price of gold has adjusted down to reduced tail risk across the global macro spectrum. Gold tends to perform quite poorly when real yields are rising, Fed tightening is brought forward, economic surprises are positive, and the equity risk premium is shrinking. Should we see a sharp rise in volatility and fall in asset prices, all of these forces are prone to reverse, and gold should prove to be an effective hedge in that environment. Even if you are worried about the Fed hiking rates next year, keep in mind that gold rallied from 2004 to 2006, even as the Fed funds rate increased.

Anyone interested in a safe haven, or has systemic risk reached a secular crescendo? 

The price of gold already appears to have stabilized, despite weak inflation readings and lackluster broad money growth. From a technical perspective, gold is sitting on trend-line support that extends from the November 2001 pivot, with momentum at positive divergence on both a weekly and monthly time frame. We find market extremes in both sentiment and positioning and believe liquidation of gold ETF holdings will soon reach an inflection point. The only factor that has given a reliable signal for gold prices is the US dollar. Based on our discussion so far, we believe the reversal in the dollar will lead gold to recapture some of its lost glitter.

The “no” vote for the “Save Our Swiss Gold” campaign did not come as a shock to us. The proposal, which called for ‘protecting the country’s wealth by investing in gold,” was rejected by 78% of the voters. After a three-year bear market, the Swiss can be forgiven for falling out of love with gold. The Swiss National Bank is particularly relieved, as it would otherwise have had to hold at least 20% of its balance sheet in gold reserves, which would make its monetary machinations far more cumbersome. But we really can’t help but wonder whether this decision will be remembered along with the infamous “Brown’s Bottom,” when Britain’s Gordon Brown, then Chancellor of the Exchequer, decided to unload half of the UK’s gold reserves in a series of auctions, at an average gold price of $275 over a span of three years. Will the Swiss eventually look back in anger at possibly passing on a golden opportunity?

The price of gold is up 7% since the vote.

‘Tis the Season of Shame

Shortly after I graduated from university, I landed a job as a bank teller in Toronto. It was, surprisingly enough, one of the best things that could have happened to me at the time.

I was pretty shy growing up. I’m not a big talker. I was always the quiet one in our group of friends; I probably still am. But as a bank teller I was forced to interact with everyone: comely girls, creepy men, and cranky old people. Slowly, I began to get comfortable with my role, and with time I gained confidence. It was a small neighbourhood branch, so it had a very sociable atmosphere. The branch manager (Vicky) was Italian, the two personal bankers (Nitee and Niadia) were Indian and Spanish, the financial advisor (Akis) was Greek, and my two side-kicks at the till were Irish (Julian) and Canadian (Kathy). I was there for three months and absolutely loved it.

What I remember most fondly from my experience was the period leading up to Christmas.

I can’t stand the cold. Even after having spent nearly a quarter of my life in Canada, I have never gotten used to the winters there. But for some reason, during each Christmas season, I wouldn’t mind freezing. I think it had much to do with the wonderful holiday spirit.

It was fascinating for me to see the entire city come alive. Trees and malls would be decorated with lovely-looking lights long before snowfall had any chance to cover them in its fold. From November onwards, you could shop till you drop, with big discounts at every store. I would spend from my purse to buy blank cards and gifts for people I worked with. And every morning, as I picked up my “double double” from Tim Hortons, I would smile at the sight of Santa and his reindeer doing the rounds on my coffee cup.

At our branch, the local radio station was always on as background score for our daily activities. In December, all they played were Christmas carols. For the first few days I went mad listening, but as time drew on, I found myself humming along.

My favorite was Chris Rea’s “Driving Home for Christmas” and The Pogues and Kirsty MacColl’s “Fairytale of New York.”

I noticed our customers become friendlier as well. The grumpy old man was not so grumpy anymore, and the harried small business owner found the time to say hello first. As Charles Dickens once observed,

I have always thought of Christmas time, when it has come round, as a good time; a kind, forgiving, charitable time; the only time I know of, in the long calendar of the year, when men and women seem by one consent to open their shut-up hearts freely, and to think of people below them as if they really were fellow passengers to the grave, and not another race of creatures bound on other journeys. I will honor Christmas in my heart, and try to keep it all the year.

Just like my colleagues at the bank, we may all have come from different places, but we all still belong to humanity. No one has exclusivity.

As the late musician Jeff Buckley said, “The soil from America can differ from the soil in Malaysia, but its soil, it’s still the same. And the color of people’s skin can differ from place to place, but it’s still skin. And, in that regard, there is no difference.” We are all but travellers heading to the same destination, even if not in the same direction.

If there is any moral principle that we must understand, it is that humanity is as one single body; and each nation, all races, are the different organs. The well-being of each of those organs determines the happiness and well-being of the entire body. The shame is in not feeling the strain when one organ of the body is in pain. The need of the world today is for a selfless conscience, together with a sense of awakened justice. The world will crumble when all selfless people cease to exist. In many ways, it would appear their number is thinning quite rapidly.

Our welfare is not in looking after ourselves but in looking after others. This season, what we truly need is to give a damn.

In the end we all belong to God, and to Him we shall return.

Jawad

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Important Disclosures

The article Outside the Box: Stray Reflections was originally published at mauldineconomics.com.

Thoughts from the Frontline: Why the World Needs the US Economy to Struggle

 

The headlines this morning talk about the US dollar hitting an 11-year high. I have been saying for years that the dollar is going to go higher than anyone can imagine. This trade is just in the early innings. And the repercussions will be dramatic, not only for emerging markets that have financed projects in dollars, but also for commodities and energy, gold, and a variety of other investments. The world is at the doorstep of a new era of volatility and currency wars.

In this week’s letter, my associate Worth Wray explores what a rising dollar means for emerging markets and what central banks are likely to do in response. Can they smooth the ride, or will it be the world’s scariest roller coaster? This letter will print long because of the number of fabulous charts Worth provides. I might make a brief comment or two at the end. Here’s Worth.

On the Verge of a Disaster… or a Miracle

By Worth Wray

Twenty years after the first divergence-induced currency crisis of the 1990s, commodity prices are tumbling, the US dollar is rallying, and externally fragile emerging markets are reliving the horrors of their not-so-distant past. Except, this time, major economies like the United States, the United Kingdom, the Eurozone, Japan, and the People’s Republic of China may not be able to side-step the ensuing contagion.

With 2014 now behind us, I want to focus this week’s letter on what may prove to be the most important global macro pressure points in the coming year(s):

  • The growing divergence among the world’s most important central banks
  • The ongoing collapse in oil and other commodity prices as a function of excess supply and/or weakening global demand
  • The rise of the US dollar, driven by divergence and risk aversion… and the squeeze it’s putting on the multi-trillion-dollar carry trade into emerging markets
  • The vicious slide in emerging-market currencies
  • The rising risk of 1990s-style contagion and financial shocks
  • And what, if anything, can avert the next global financial crisis

But first, let me tell you a story.

As some of you already know, I was born and raised in Baton Rouge, Louisiana – an old Southern city built on a bluff above the Mississippi River. It’s about an hour northwest of New Orleans – you can see it circled on the map below.

Given its inland position, Baton Rouge is fairly insulated from the fiercest impact of coastal storms; but hurricane season still tends to be the most stressful time of year. Our oak-covered neighborhoods and low-lying swamplands are vulnerable to the high winds and flood rains that can accompany a direct hit – not to mention the violent tornadoes that occasionally occur in the unpredictable northeastern quadrant of the tropical cyclone zone.

These storms don’t hit us often, but locals recall a handful of hurricanes that dealt heavy blows to the area over the years. And it goes without saying that the damage from any storm gets dramatically worse the closer you get to the Gulf of Mexico. Entire towns along the Gulf Coast have been swallowed up and swept away over the years by catastrophic storms like Camille (1969), Andrew (1994), and more recently Katrina (2005).

Twelve years ago, my father and I found ourselves in the path of such a storm.

According to the National Hurricane Center, Hurricane Lili was “supposed” to make landfall as a relatively weak storm. Just another named hurricane for the record books that would soon fade from our collective memory… or so we thought.

At 10:00 PM on Tuesday, October 1, 2002, Lili was a Category 2 hurricane with maximum sustained winds of 105 mph. Routine hurricane season stuff.

I went to sleep that night expecting a little rain and few uneventful days home from school; but when I woke up on Wednesday, October 2, I was shocked to see Lili develop an incredibly well-articulated eye wall and grow more powerful by the hour – from 110 mph at 7:00 AM that morning to 135 mph at 1:00 PM and finally to 145 mph at 10 PM that night.

I remember the nervous look on my dad’s face that night as the two of us boarded up our doors and windows. A little earlier that evening, one of his local government contacts shared that, behind closed doors, state and local officials were expecting “mass casualties” from Morgan City (on the coast) to Baton Rouge… but it was already too late to order an evacuation so far inland. Given the mild forecasts, few were prepared for a major hurricane; and at that point in the day, making a public announcement would do little more than spark a panic. The best we could do was hunker down and pray.

This was the last advisory I saw before my head hit the pillow that night: Lili had strengthened to a strong Category 4 hurricane with maximum sustained winds around 145 mph, reported gusts above 210 mph, and the very real possibility of making landfall as a merciless Category 5. If you look at the Saffir Simpson hurricane scale, there’s a reason the first word you see next to Category 4 and 5 storms is catastrophic. These storms are real killers.

Expecting to wake up early the next morning to sounds of thunder, pounding rain, and the eerie whistle of gale-force winds – or worse, I went to sleep Wednesday night with this image swirling through my mind:

But when I woke, I was shocked once more to learn that Lili – for reasons no one had anticipated – had all but died in the night and made landfall that morning as a small Category 1 hurricane with maximum sustained winds of only 90 miles per hour. In less than twelve hours, it had sharply decelerated from what could easily have been one of the most catastrophic storms on record to an inconvenience for most inland communities. Sure, it inflicted some damage along the coast – tearing up marshlands, knocking down power lines, blowing over trees, and flooding homes – but a Category 4 or 5 storm would have swallowed those areas whole.

As far as I know, there was no precedent in the Gulf of Mexico – or anywhere in the world – for Lili’s sudden death. It baffled even the most experienced meteorologists and left us all scratching our heads. Some people talked of miracles; others insisted there had to be a logical explanation. I imagine there’s some truth to both ideas.

While the press coverage surrounding Lili’s remarkable weakening has largely faded into obscurity, I was able to find one surviving article from USA Today that captures the confusion in the storm’s aftermath: “Scientists Don’t Know Yet Why Lili Suddenly Collapsed.”

Hurricane Lili showed forecasters there is still a lot they don’t know about hurricane intensity. Lili weakened in the hours before landfall Thursday as rapidly as it had strengthened into a ferocious storm the day before. Forecasters with the National Hurricane Center in Miami had hinted as early as Monday that Lili could rev up into a dangerous hurricane over the extraordinarily warm Gulf of Mexico, though they were surprised to see it grow so strong so quickly. But Lili’s quick demise … had them admitting they didn’t know what had happened…. National Hurricane Center Director Max Mayfield agrees. At a loss to explain Lili’s fluctuations, he says, “A lot of Ph.D.s will be written about this.”

We still don’t have a definitive answer, but three theories emerged in the immediate aftermath:

1) Dry air was pulled into the storm and ate away at its moisture-sucking core;

2) Winds aloft increased across the storm, creating wind shear and tipping the delicate balance that keeps intense storms going;

3) Water cooler than the 80° necessary to sustain a hurricane sapped Lili’s strength when it moved over the same part of the north-central Gulf of Mexico that had been churned up by a smaller hurricane, Isadore, a week earlier.

Regardless of why it happened, I learned something that day that will stay with me for the rest of my life: Even when a disastrous course of events is set in motion, disaster does not always strike. Surprises happen. Even miracles. Forecasts are often wrong – but it always pays to prepare.

Let me explain…

Boom & Gloom

Just before Halloween, I wrote a letter (“A Scary Story for Emerging Markets”) explaining that the widening gap in economic activity among the United States, Japan, and the Eurozone was starting to demand a dangerous divergence in monetary policy.

Within a matter of days, the FOMC announced the end of its QE3 program… and then the Bank of Japan shocked the world, announcing a massive expansion in its own asset purchases timed to coincide with the government pension fund’s announcement that it was getting out of JGBs and into global equities.

Just as I had feared, the US dollar and Japanese yen were breaking out in opposite directions on real policy action, as Mario Draghi meanwhile continued to talk the euro down with the threat of future action. This may seem like a trivial shift in global FX markets, but it may have been the most important development we have seen since the global crisis peaked in 2008.

Since then, global economics has been a story of boom, gloom, and doom, as Marc Faber likes to say. We’re seeing a boom in US economic activity (or as much of a boom as you can expect with a massive debt overhang); a gloomy slowdown and slide toward deflation across Europe and China, along with the still-likely failure of Abenomics in Japan and renewed signs of FX contagion in emerging markets; and doom in commodities markets, particularly oil.

I’ve shared this next chart before, but it’s worth an update. Those of us who watch the US dollar were not surprised by the collapse in oil prices, because the dollar’s surge was already telling us something about global demand.

What did surprise a lot of economists (myself included) was the breakdown within OPEC, particularly Saudi Arabia’s willingness to accept whatever price the market offered in order to protect its market share. Conspiracy theories aside as to whether OPEC’s move constitutes an anti-American trade war against US shale producers or a pro-American squeeze on Russia, Iran, and Venezuela, it’s already putting a serious squeeze on Texas oil men, Russian “oiligarchs,” and oil-exporting emerging markets.

We’ll revisit the oil shock in a bit, but for now let’s get back to the US dollar.

To continue reading this article from Thoughts from the Frontline – a free weekly publication by John Mauldin, renowned financial expert, best-selling author, and Chairman of Mauldin Economics – please click here.

Important Disclosures

Outside the Box: 15 Surprises for 2015

 

It’s that time of year when people start thinking about New Year’s resolutions and investment planning for the future. It’s also the time of year when analysts feel more or less compelled to offer up forecasts. My friend Doug Kass turns the forecasting process on its head by offering 15 potential surprises for 2015 (plus 10 also-rans).  But he does so with a healthy measure of humility, starting out with a quote from our mutual friend James Montier (now at GMO):

(E)conomists can’t forecast for toffee … They have missed every recession in the last four decades. And it isn’t just growth that economists can’t forecast; it’s also inflation, bond yields, unemployment, stock market price targets and pretty much everything else … If we add greater uncertainty, as reflected by the distribution of the new normal, to the mix, then the difficulty of investing based upon economic forecasts is likely to be squared!

Lessons Learned Over the Years

“I’m astounded by people who want to ‘know’ the universe when it’s hard enough to find your way around Chinatown.” – Woody Allen

There are five core lessons I have learned over the course of my investing career that form the foundation of my annual surprise lists:

  1. How wrong conventional wisdom can consistently be.
     
  2. That uncertainty will persist.
     
  3. To expect the unexpected.
     
  4. That the occurrence of black swan events are growing in frequency.
     
  5. With rapidly-changing conditions, investors can’t change the direction of the wind, but we can adjust our sails (and our portfolios) in an attempt to reach our destination of good investment returns.

Quoting from a very eclectic group of names, Doug does indeed give us a few surprises to think about, and I pass his thoughts on to you as this week’s Outside the Box. (Doug publishes his regular writings in RealMoneyPro on theStreet.com.)

As a bonus, and as a thoughtful way to begin the new year, we have a letter that my good friend and co-author of my last two books Jonathan Tepper wrote to his nephews. He began penning it on a very turbulent plane ride that he was uncertain of surviving. It made him think hard about what was really important that he would want to pass on to his nephews. As the song goes, I found a few aces that I can keep in this hand. I think you will too.

His letter made me think about what I want to be passing on to my grandchildren, including the newest one, Henry Junior, who showed up less than 24 hours ago. They are going to grow up in a very different world than the one I grew up in, and I mostly think that’s a good thing. But the values that I hope can be passed on don’t change. Good character never goes out of fashion.

My associate Worth Wray came down with a very nasty bug this past weekend, so he missed his deadline for delivering his 2015 forecast to you. We’re giving him a few more days and will run it this weekend – which also of course gives me a little more time to mull over my own forecast. Taking to heart James Montier’s quote above, I’m going to forgo the usual 12-month forecast and look farther out, thinking about what major events are likely to come our way over the next five years. I actually think that approach will be for more useful for our longer-term planning.

Thanks for being with me and the rest of the team at Mauldin Economics this past year; and from all of us, but especially from me, we wish you the best and most prosperous of new years.

You’re staring hard at crystal balls analyst,

John Mauldin, Editor
Outside the Box
subscribers@mauldineconomics.com

 

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15 Surprises for 2015

Doug Kass, Seabreeze Partners
Dec. 29, 2014 | 8:12 AM EST

Stock quotes in this article:

CSBUXTSLATWTRGMGLDJNKSPYQQQAAPLBAC, GOOGLFBCSCO

It’s that time of year again.

“Never make predictions, especially about the future.” – Casey Stengel

By means of background and for those new to Real Money Pro, 12 years ago I set out and prepared a list of possible surprises for the coming year, taking a page out of the estimable Byron Wien’s playbook. Wien originally delivered his list while chief investment strategist at Morgan Stanley, then Pequot Capital Management and now at Blackstone. (Byron Wien’s list will be out in early January and it will be fun to compare our surprises.)

It takes me about two to three weeks of thinking and writing to compile and construct my annual surprise list column. I typically start with about 30-40 surprises, which are accumulated during the months leading up to my column. In the days leading up to this publication I cull the list to come up with my final 15 surprises. (Last year I included five also-ran surprises.)

I often speak to and get input from some of the wise men and women that I know in the investment and media businesses. I have always associated the moment of writing the final draft (in the weekend before publication) of my annual surprise list with a moment of lift, of joy and hopefully with the thought of unexpected investment rewards in the New Year.

This year is no different.

I set out as a primary objective for my surprise list to deliver a critical and variant view relative to consensus that can provide alpha or excess returns. 

The publication of my annual surprise list is in recognition that economic and stock market histories have proven that (more often than generally thought) consensus expectations of critical economic and market variables may be off base.

History demonstrates that inflection points are relatively rare and that the crowds often outsmart the remnants. In recognition, investors, strategists, economists and money managers tend to operate and think in crowds. They are far more comfortable being a part of the herd rather than expressing – in their views and portfolio structure – a variant or extreme vision.

Confidence is the most abundant quality on Wall Street as, over time, stocks climb higher. Good markets mean happy investors and even happier investment professionals.

The factors stated above help to explain the crowded and benign consensus that every year begins with, whether measured either by economic, market or interest-rate forecasts.

But an outlier’s studied view can be profitable and add alpha. Consider the course of interest rates and commodities in 2014, which differed dramatically from the consensus expectations.

To a large degree the business media perpetuates group-think. Consider the preponderance of bullish talk in the financial press. All too often the opinions of guests who failed to see the crippling 2007-09 drama are forgotten and some of the same (and previously wrong-footed) talking heads are paraded as seers in the media after continued market gains in recent years.

Memories are short (especially of a media kind). Nevertheless, if the criteria for appearances was accuracy there would have been few available guests in 2009-2010 qualified to appear on CNBC, Bloomberg and Fox News Business.

Indeed, the few bears remaining are now ridiculed openly by the business media in their limited appearances, reminding me of Mickey Mantle’s quote, “You don’t know how easy this game is until you enter the broadcasting booth.” 

Abba Eban, the Israeli foreign minister in the late 1960s and early 1970s once said that the consensus is what many people say in chorus, but do not believe as individuals.

GMO’s James Moniter, in an excellent essay published several years ago, made note of the consistent weakness embodied in consensus forecasts.

As he put it:

“(E)conomists can’t forecast for toffee … They have missed every recession in the last four decades. And it isn’t just growth that economists can’t forecast; it’s also inflation, bond yields, unemployment, stock market price targets and pretty much everything else … If we add greater uncertainty, as reflected by the distribution of the new normal, to the mix, then the difficulty of investing based upon economic forecasts is likely to be squared!”

Lessons Learned Over the Years

“I’m astounded by people who want to ‘know’ the universe when it’s hard enough to find your way around Chinatown.” – Woody Allen

There are five core lessons I have learned over the course of my investing career that form the foundation of my annual surprise lists:

  1. How wrong conventional wisdom can consistently be.
     
  2. That uncertainty will persist.
     
  3. To expect the unexpected.
     
  4. That the occurrence of black swan events are growing in frequency.
     
  5. With rapidly-changing conditions, investors can’t change the direction of the wind, but we can adjust our sails (and our portfolios) in an attempt to reach our destination of good investment returns.

“Let’s face it: Bottom-up consensus earnings forecasts have a miserable track record. The traditional bias is well-known. And even when analysts, as a group, rein in their enthusiasm, they are typically the last ones to anticipate swings in margins.” – UBS (top 10 surprises for 2012)

Let’s get back to what I mean to accomplish in creating my annual surprise list.

It is important to note that my surprises are not intended to be predictions, but rather events that have a reasonable chance of occurring despite being at odds with the consensus. I call these possible-improbable events. In sports, betting my surprises would be called an overlay, a term commonly used when the odds on a proposition are in favor of the bettor rather than the house.

The real purpose of this endeavor is a practical one – that is, to consider positioning a portion of my portfolio in accordance with outlier events, with the potential for large payoffs on small wagers/investments.

Since the mid-1990s, Wall Street research has deteriorated in quantity and quality (due to competition for human capital at hedge funds, brokerage industry consolidation and former New York Attorney General Eliot Spitzer-initiated reforms) and remains, more than ever, maintenance-oriented, conventional and group-think (or group-stink, as I prefer to call it). Mainstream and consensus expectations are just that and, in most cases, they are deeply embedded into today’s stock prices.

It has been said that if life were predictable, it would cease to be life, so if I succeed in making you think (and possibly position) for outlier events, then my endeavor has been worthwhile.

Nothing is more obstinate than a fashionable consensus and my annual exercise recognizes that, over the course of time, conventional wisdom is often wrong.

As a society (and as investors), we are consistently bamboozled by appearance and consensus.

Too often, we are played as suckers, as we just accept the trend, momentum and/or the superficial as certain truth without a shred of criticism. Just look at those who bought into the success of Enron, Saddam Hussein’s weapons of mass destruction, the heroic home-run production of steroid-laced Major League Baseball players Barry Bonds and Mark McGwire, the financial supermarket concept at what was once the largest money center bank, Citigroup (C), the uninterrupted profit growth at Fannie Mae and Freddie Mac, housing’s new paradigm (in the mid-2000s) of non-cyclical growth and ever-rising home prices, the uncompromising principles of former New York Governor Eliot Spitzer, the morality of other politicians (e.g., John Edwards, John Ensign and Larry Craig), the consistency of Bernie Madoff’s investment returns (and those of other hucksters) and the clean-cut image of Tiger Woods.

My Surprises for 2014

These generally proved in line with my historic percentages.

“How’m I doin’?” –  Ed Koch, former New York City mayor

While over recent years many of my surprise lists have been eerily prescient (e.g. my 2011 surprise that the S&P 500 would end exactly flat was exactly correct), my 15 Surprises for 2014 had a success rate of about 40%, about in line with what I have achieved over the last 11 years.

As we entered 2014, most strategists expressed a constructive economic view of a self-sustaining domestic recovery, held to an upbeat (though not wide-eyed) corporate profits picture and generally shared the view that the S&P 500 would rise by between 8-10%.

Those strategists proved to be correct on profit growth (but only because of several non-operating factors and financial engineering), were too optimistic regarding domestic and global economic growth and recognized (unlike myself) that excessive liquidity provided by the world’s central bankers would continue to lift valuations and promote attractive market gains in 2015. Not one major strategist foresaw the emerging deflationary conditions, the precipitous drop in the price of oil and the broad decline in domestic and non-U.S. interest rates.

Many readers of this annual column assume that my surprise list will have a bearish bent (to be sure that is the case for 2015). But I have not always expressed a negative outlook in my surprise list. Two years ago my 2012 surprise list had an out-of-consensus positive tone to it, but 2013′s list was noticeably downbeat relative to the general expectations. I specifically called for a stock market top in early 2013, which couldn’t have been further from last year’s reality, as January proved to be the market’s nadir. The S&P closed at its high on the last day of the year and exhibited its largest yearly advance since 1997. (I steadily increased my fair market value calculation throughout the year and, at last count, I concluded that the S&P 500′s fair market value was about 1645.)

As I said, in 2014 my success rate was at about 40% (which included five also-ran predictions).

This contrasted with my 15 surprises for 2013, which had the poorest success rate since 2005′s list (20%).

By comparison, my 2012 surprise list achieved about a 50% hit ratio, similar to my experience in 2011. About 40% of my 2010 surprises were achieved, while I had a 50% success rate in 2009, 60% in 2008, 50% in 2007, 33% in 2006, 20% in 2005, 45% in 2004 and 33% came to pass in the first year of my surprises in 2003.

Below is a report card of my 15 surprises for 2014 (and the five also-ran  surprises).

Surprise No. 1: Slowing global economic growth. RIGHT

Surprise No. 2: Corporate profits disappoint. HALF RIGHT (as financial engineering buoyed EPS).

Surprise No. 3: Stock prices and P/E multiples decline. WRONG

Surprise No. 4: Bonds outperform stocks. Closed-end municipal bond funds are among the best asset classes, achieving a total return of +15%. VERY RIGHT

Surprise No. 5: A number of major surprises affect individual stocks and sectors. (Starbucks (SBUX) falls, 3D printing stocks halve in price, General Motors (GM) drops by 20% in 2014). MORE WRONG THAN RIGHT

Surprise No. 6: Volkswagen AG acquires Tesla Motors (TSLA). WRONG

Surprise No. 7: Twitter’s (TWTR) shares fall by 70% as a disruptive competitor appears. MORE RIGHT THAN WRONG

Surprise No. 8:  Buffett names successor. WRONG

Surprise No. 9: Bitcoin becomes a roller coaster. RIGHT

Surprise No. 10: The Republican Party gains control of the Senate and maintains control of the House. Obama becomes a lame duck President incapable of launching policy initiatives. RIGHT

Surprise No. 11: Secretary Hillary Clinton bows out as a presidential candidate. WRONG

Surprise No. 12: Social unrest and riots appear in the U.S. RIGHT

Surprise No. 13: Africa becomes a new hotbed of turmoil and South Africa precipitates an emerging debt crisis. HALF RIGHT

Surprise No. 14: The next big thing? A marijuana IPO rises by more than 400% on its first day of trading. WRONG

Surprise No. 15: An escalation of friction between China and Japan hints at war-like behavior between the two countries. WRONG

Also-Ran Surprises: Crude oil trades under $75 a barrel (short crude and energy stocks) RIGHT, VIX trades under 10 (short VIX) RIGHT, gold trades under $1,000 (Short GLD) DIRECTIONALLY RIGHT.

What Was the Consensus for 2014 and What Is the Consensus for 2015?

“The only thing people are worried about is that no one is worried about anything … That isn’t a real worry.” – Adam Parker, chief U.S. strategist at Morgan Stanley

“In ambiguous situations, it’s a good bet that the crowd will generally stick together – and be wrong.” – Doug Sherman and William Hendricks

As mentioned earlier, we entered 2014 there was a generally upbeat outlook for global economic and profit growth, as well as upbeat prospects for the U.S. stock market. Projections for bond yields were universally for higher yields throughout the year and the same could be said for the general expectation of rising oil prices.  As is typical, most sell-side projections for earnings, the economy, bond yields and stock prices were grouped in an extraordinarily tight range.

  • Both U.S. and global economic growth disappointed the consensus (despite a strong third-quarter 2014 U.S. GDP number).
     
  • S&P earnings were a slight beat, but only because of more-aggressive-than-anticipated share repurchase programs, lower depreciation and interest expenses and a decline in effective tax rates.
     
  • Bond yields declined unexpectedly. The 10-year yield dropped to about 2.2% from 3.05%.
     
  • Deflationary forces were also a surprise, most notably no one projected that oil prices would fall to under $60 s barrel and that the Bloomberg Commodity Index would hit a five-year low in December, 2014.
     
  • Stock prices ended the year about 5% above beginning-of-the-year consensus forecasts.

Virtually all strategists are now self-confident bulls, as gloom-and-doom forecasts have all but disappeared. After another year with no reactions of 10% or more, any future setbacks are being viewed by the consensus as bumps in the road and as opportunities to buy because (after the correction(s)) we will be up, up and away.”

After missing the 25% rise in valuations in 2013 (and a further expansion in P/E ratios in 2014), the consensus now assumes that valuations will expand slightly again in 2015. (Note: The average P/E ratio has increased by about 2% per year over the last 25 years.)

The domestic economy has forward momentum (as witnessed by +5% Real GDP growth in 3Q 2014), so the extrapolation of heady growth is now in full force by the consensus.

In terms of the markets, the consensus remains of the view that liquidity (albeit, at a slowing rate) will overcome complacency and valuations again as it did last year, but my surprises incorporate the notion that the extremes that exist today (in price and bullish sentiment) put the markets in a different and less secure starting point in 2015.

“We expect the growth recovery to broaden as global growth picks up to 3.4% in 2015 from 3% in 2014. Inflation is likely to remain low, in part due to declines in commodity prices, and as a result monetary policy should remain easy. We think this backdrop supports a pro-risk asset allocation.” – Goldman Sachs, Global Opportunity Asset Locator (December 2014)

As we enter 2015, investors and strategists are again grouped in a narrow consensus and expect a sweet spot of global economic corporate profit growth that will translate to higher stock prices.

The consensus is for U.S. economic growth of +2.5% to +3.25% real GDP, bond yields to be 50-75 basis points higher than year-end 2014 and closing 2015 stock market price targets to be up by about 8-10% (on average). Indeed, most strategists suggest (in sharp contrast to their views 12 months ago) that the big surprise for 2015 will be that there is upside to consensus economic growth and stock market price targets.

Here were Goldman Sach’s views for 2014 made 12 months ago (with actual in parentheses). As can be seen, the brokerage’s growth forecasts for the real economy (as was the entire sell side) were too optimistic, while price targets for the S&P were not ambitious enough:

  • U.S. real GDP was estimated at +3.1% for 2014. ( +2.4%A)
     
  • Global real GDP was estimated at+3.6% for 2014. (+3.0%A)
     
  • S&P 500 EPS $116 top-down estimate and $119 bottom-up estimate for 2014 ($119/shareA)
     
  • Year-end S&P 2014 S&P 500 price target was estimated for 2014 at 1900 (2080A)
     
  • Inflation/headline CPI +1.5% for 2014. (+1.1%A)
     
  • U.S 10-year Treasury yield 3.25% for year-end 2014. (2.20%A)

Again, let’s use Goldman Sachs’ principal 2015s views of expected economic growth, corporate profits, inflation, interest rates and stock market performance as a proxy for the consensus for the coming year. This year the brokerage, like most, is following the bullish trend and is more optimistic on the market relative to its uninspiring expectations last year.

  • 2015/2016 U.S. real GDP +3.1%, +3.0%
     
  • 2015/2016 global real GDP +3.6%, +3.9%
     
  • 2015 S&P 500 operating per share profits $122/share
     
  • Year-end 2015 S&P 500 price target 2100
     
  • 2015/2016 Consumer Prices +1.0%, +2.4%
     
  • 2015 closing yield on the U.S. 10-year Treasury note 3%

The Rationale Behind My Downbeat Surprises for 2015

There are numerous reasons for my downbeat theme this year. In no order of importance: corporate profit margins remain elevated, the rate of domestic economic growth is decelerating (despite five years of QE and ZIRP), a quarter of the world is experiencing minimum growth in GDP, optimism and complacency are elevated, signs of malinvestment are appearing, valuations (P/E ratios) rose again after a 25% expansion in 2013 (compared to only +2% annual growth since the late-1980s. As well, so many gauges of valuations are stretched (market cap/GDP, the Shiller P/E ratio and many others). 

Above all, I expect the theme of the U.S. as an oasis of prosperity will be tested in 2015-16 as contagion might be a bi**h.

Moreover, given the large array of potentially adverse economic, geopolitical and other outcomes, the markets have grown complacent after a trebling in prices over the last five years.

Finally, my downbeat surprises this year recognize, that as we enter 2015, we should not lose sight of the notion that if pessimism is the friend of the rational buyer, optimism is the enemy of the rational buyer.

My 15 Surprises for 2015

At last, here are my 15 surprises for 2015 (with a strategy that might be employed in order for an investor to profit from the occurrence of these possible improbables).

Surprise No.1 – Faith in central bankers is tested (stocks sink and gold soars).

“Investment bubbles and high animal spirits do not materialize out of thin air.  They need extremely favorable economic fundamentals together with free and easy, cheap credit and they need it for at least two or three years. Importantly, they also need serial pleasant surprises in such critical variables as global GNP growth.” – Jeremy Grantham

“The highly abnormal is becoming uncomfortably normal. Central banks and markets have been pushing benchmark sovereign yields to extraordinary lows – unimaginable just a few years back. Three-year government bond yields are well below zero in Germany, around zero in Japan and below 1 per cent in the United States. Moreover, estimates of term premia are pointing south again, with some evolving firmly in negative territory. And as all this is happening, global growth – in inflation-adjusted terms – is close to historical averages. There is something vaguely troubling when the unthinkable becomes routine.” – Claudio Borio

European QE Backfires: The ECB initiates a sovereign QE in January 2015, but it is modest in scale (relative to expectations) as Germany won’t permit a more aggressive strategy. Markets are disappointed with the small size of the ECB’s initiative and European banks choose to hold their bonds instead of selling. ECB balance sheet still can’t get to 3 trillion euros and the euro actually rallies sharply. Bottom line, QE fails to work (economic growth doesn’t accelerate and inflationary expectations don’t lift). 

Draghi Is Exposed: Mario Draghi is exposed for what he really is: the big kid of which everyone is scared. For some time, no one wanted to fight him (or fade sovereign debt bonds, which would be contra to his policy). But, after the meek January QE, the response changes. He is now seen as the bully who never throws a punch and who always has gotten his way. But at the time of the January QE a medium-sized kid (and a market participant) teases him and Draghi warns him again to stop it. The kid keeps teasing. Draghi the bully takes a swing, it turns out he can’t fight and the medium-sized kid whips his butt. From then on, the big kid is feared no more. For some time Draghi has said he will do “whatever it takes,” but he never really had to do anything. When he finally gets going and has to act rather than talk, he will expose himself as only a bully and as a weak big kid. Mario Draghi gets fed up with the Germans and returns to Italy (where he was governor of the Bank of Italy between 2006-2011) and becomes the country’s president. 

Shinzo Abe and Haruhiko Kuroda Resign: Kuroda, an advocate of looser monetary policy, stays on at the Bank of Japan (for most of the year), but the yen enters freefall to 140 vs. the dollar and wage growth lags badly. Japanese people have had enough and, by year end, Prime Minister Shinzo Abe and Haruhiko Kuroda are forced to resign. 

The Fed Is Trapped: The Federal Reserve surprises the markets and hikes the federal funds rate in April 2015. A modest 25-basis-point rise in rates causes such global market turmoil that it is the only hike made all year. The Federal Reserve is now viewed by market participants as completely trapped, as an ah-ha-moment arrives in which there is limited policy flexibility to cope with a steepening downturn in the business cycle in late 2015/early 2016. Stated simply, the bull market in confidence in the Federal Reserve comes to an abrupt halt.

Malinvestment Becomes the It-Word in 2015: Steeped in denial of past mistakes and bathing in the buoyancy of liquidity and the elevation of stock prices in 2014, market participants come to the realization that the world’s central bankers in general, and the Fed in particular, once again has taken us down an all-too-familiar and dangerous path that previously set the stage for The Great Decession of 2007-09. It becomes clear that the consequences of unprecedented monetary easing and the repression of interest rates has only invited unproductive investment and speculative carry trades. The impact of a lengthy period of depressed interest rates uncork malinvestment that has percolated and detonates among differing asset classes as the year progresses. Already seen in the deterioration and heightened volatility in commodities (the price of crude, copper, etc.), in widening spreads in the energy high yield (with yields up to 10% today, compared with only 5% a few months ago) and with the average yield on the SPDR Barclays High Yield Bond ETF (JNK) up to 7% (from a low of 5% earlier in 2014), the consequences of financial engineering (zero-interest-rate policy and quantitative easing) and lack of attention to burgeoning country debt loads and central bankers’ balance sheets, in addition to inertia on the fiscal front result in rising volatility in the currency markets. Malinvestment in countries like Brazil (where consumer debt has risen by 8x and export accounts have quintupled over the last eight years on the strength of a peaking export boom, in oil and iron ore, so dependent on the China infrastructure story that has now ended) translate into a deepening economic crisis in Latin America and in other emerging markets.

Then, EU sovereign debt yields, suppressed so long by Draghi’s jawboning, begin to rise. Slowly at first and then more rapidly, EU bond prices fall, putting intense pressure on the entire European banking system. (In his greatest score, George Soros makes $2.5 billion shorting German Bunds). The contagion spreads to other region’s financial institutions. Shortly after, social media and high valuation stocks get routed and, ultimately, so does the world’s stock markets.

As a result of the influences above, the VIX rises above 30. The price of gold soars to $1,800-$2000 and the precious metal is the best-performing asset class for all of 2015.

Strategy: Buy GLD and VIX, Short SPY/QQQ and German Bunds

Surprise No. 2 – The U.S. stock market falters in 2015.

“In a theater, it happened that a fire started offstage. The clown came out to tell the audience. They thought it was a joke and applauded. He told them again and they became more hilarious. This is the way, I suppose, that the world will be destroyed – amid the universal hilarity of wits and wags who think it is all a joke.” – Soren Kierkegaard.

Market High Seen in January, Low Seen in December (at Year End): The U.S. stock market experiences a 10%+ loss for the full year. (Note: Not one single strategist in Barron’s Survey is calling for a lower stock market in 2015. Projected gains by the sell side are between +6-16%, with a median market gain forecast at +11%). The S&P Index makes its yearly high in the first quarter and closes 2015 at its yearly low as signs of a deepening global economic slowdown intensify in the June-December period. 

While earnings expectations disappoint, the real source of the market decline in 2015 is a contraction in valuations (price-earnings multiples) after several years of robust gains. Investors begin to recognize that low interest rates, massive corporate buybacks, the suppression of wages, phony stock option accounting and other factors artificially goosed reported earnings and that earnings power and organic earnings are less than previously thought. So, 2015 is a year in which the relevant ways of measuring overvaluation (market cap/GDP currently at 1.25 vs. 0.70 mean) and the Shiller CAPE ratio (currently at 27x vs. 17x mean) become, well, relevant.

With few having the intestinal fortitude to maintain skepticism and short positions into the unrelenting bull market of 2013-14, there is none of the customary support of short sellers to cover positions and soften the market decline, when it occurs.

Stocks begin to drop in the first half, well before the real economy tapers, underscoring the notion (often forgotten) that the stock market is not the economy.

But by mid-year it becomes clear that U.S. economic growth is unable to thrive without the Fed’s support.

Year-over-year profits for the S&P decline modestly in the second half of 2015. Domestic Real GDP growth falls to under +1.5% in the third and fourth quarters.

By year end the market begins to focus on The Recession of 2016-17, which looms ahead in the not so distant future.

Strategy: Short SPY

Surprise No. 3 – The drop in oil prices fails to help the economy.

“In its November 14, 2014 Daily Observations (“The Implications of $75 Oil for the US Economy”), the highly respected hedge fund Bridgewater Associates, LP confirmed that lower oil prices will have a negative impact on the economy. After an initial transitory positive impact on GDP, Bridgewater explains that lower oil investment and production will lead to a drag on real growth of 0.5% of GDP. The firm noted that over the past few years, oil production and investment have been adding about 0.5% to nominal GDP growth but that if oil levels out at $75 per barrel, this would shift to something like -0.7% over the next year, creating a material hit to income growth of 1-1.5%.” – Mike Lewitt, The Credit Strategist

Despite the near-universal view that lower oil prices will benefit the economy, the reverse turns out to be the case in 2015 as the economy as a whole may not have more money – it might have less money.

Continued higher costs for food, rent, insurance, education, etc. eat up the benefit of lower oil prices. Some of the savings from lower oil is saved by the consumer who is frightened by slowing domestic growth, a slowdown in job creation and a deceleration in the rate of growth in wages and salaries. 

And the unfavorable drain on oil-related capital spending and lower-employment levels serve to further drain the benefits of lower gasoline and heating oil prices.

In The Financial Times, recently, Martin Wolf wrote: “(A) $40 fall in the price of oil represents a shift of roughly $1.3 trillion (close to 2 per cent of world gross output) from producers to consumers annually. This is significant. Since, on balance, consumers are also more likely to spend quickly than producers, this should generate a modest boost to world demand.”

But Wolf, and the many other observers, as Mike Lewitt again reminds us, “fail to explain how the $1.3 trillion that has been deducted from the global economy is able to shift from one group to another. “

Surprise No. 4: The mother of all flash crashes.

“America is the ‘arch criminal’ and ‘unchangeable principal enemy’ of North Korea.” (Dec. 22, 2014)

“America is a ‘toothless wolf’ and ‘the empire of devils.”” (March 27, 2010)

“North Korean missiles will reduce Washington, D.C. to ‘ashes.’” (August 19, 2014)

“America is a ‘group of Satan’ bent on destroying Korean religion.” (April 22, 2013)

“American ‘ideological and cultural poisoning’ is undermining socialism around the world.” (July 16, 2014)

– Selected quotes from North Korea’s state-controlled media

Hackers attack the NYSE and Nasdaq computer apparatus and systems by introducing a flood of fictitious sell orders that result in a flash crash that dwarfs anything ever seen in history.

In the space of one hour the S&P Index falls by more than 5%.

The identity of the attacker goes unknown for several days and it turns out to be North Korea. 

Strategy: Buy VIX, Short SPY/QQQ

Surprise No. 5: The great three-decade bull market in bonds is over in 2015.

“Take then thy bond thou thy pound of flesh…” – Portia, The Merchant of Venice

Last year not one strategist saw lower interest rates (though that was my No. 1 Surprise last year). This year, not one strategist expects a spike in interest rates.

In the first half of 2015, European yields and U.S. yields start to converge, in that European yields begin to jump to where the U.S. 10-year yield resides. The failure of Draghi’s policy (see Surprise No. 1) will result in an acceleration in the European debt yields rising and in a decay in debt prices. That will mark the end of the great three-decade bond bull market in the U.S. and it will occur as global growth eases.

Strategy: None

Surprise No.6 – China devalues its currency by more than 3% vs. the U.S. dollar.

“It’s not like I’m anti-China. I just think it’s ridiculous that we allow them to do what they’re doing to this country, with the manipulation of the currency, that you write about and understand, and all of the other things that they do.” – Donald Trump

For years, China has essentially pegged it’s currency to the U.S. dollar. (liberalization meant that a narrow trading range is permitted). With the huge run in the U.S. Dollar, China’s currency has appreciated compared with other Asian currencies. As a result, China has lost its manufacturing edge and its trade surplus has all but disappeared. Whether it’s a permitted day-to-day weakening, changing the peg from the dollar to a basket of currencies or whether there is an overnight surprise devaluation, China’s currency will weaken materially in 2015.

Strategy: None

Surprise No. 7 – Apple (AAPL) becomes the first $1 trillion company.

“There’s an old Wayne Gretzky quote that I love. ‘I skate to where the puck is going to be, not where it has been.’ And we’ve always tried to do that at Apple. Since the very, very beginning. And we always will.” – Steve Jobs

Apple’s next generation iPhone is seen to likely outsell its latest phone iteration as Re/Code uncovers (and reveals) some amazing and unique new features/applications that are planned for the next generation phone.

I don’t know what features it will have or how it will improve design or performance. But I think there is now a near-consensus that it won’t and that the next product upgrade cycle is a while away.

So, I predict Apple 2016 estimates rise significantly (to $10/share) and, despite a weak market backdrop, Apple becomes the first $1 trillion dollar market-cap company and the best-performing large-cap in 2015.

Apple becomes the only one-decision stock during the stock market swoon during the last half of 2015. It is a must own.

Strategy: Buy APPL

Surprise No. 8 – Legislation is introduced that allows for repatriation for foreign cash.

“The only difference between death and taxes is that death doesn’t get worse every time Congress meets.” – Will Rogers

As signs of domestic economic growth fade in the second half of 2015, Congress and the Administration agree on a broad program to repatriate foreign cash at a low tax rate.

The deal briefly rallies the U.S. stock market, but equities soon succumb to a slowing domestic economy and diminishing corporate profit growth.  

Strategy: None

Surprise No. 9 – Energy goes from the worst-performing group in 2014 to the best-performing group in the first half of 2015 and then falls back later in the year.

“Oil vey!” – Kass Daily Diary term

Energy stocks are on a roller coaster in 2015.

As the price of crude oil rises steadily (towards $65 a barrel) in early 2015, the energy sector (which was among the worst in 2014) becomes the best market group in the first half of the year. Slowing global economic growth during the last half of the year leads to profit-taking in the energy sector as the price of crude oil closes the year at under $50 and at its lowest price in 2015.

In a surprise move, the president signs approval for the Keystone Pipeline in the second half of the year.

Strategy: Buy oil stocks in first six months of the year, sell/short mid-year.

Surprise No. 10 – More chaos in the Democratic Party.

“Mothers all want their sons to grow up to be president, but they don’t want them to become politicians in the process.” – John F. Kennedy

Sen. Elizabeth Warren pushes Secretary Hillary Clinton so far to the left that she loses independent voters, though she easily gains the Democratic nomination for president. 

Former President George H.W. Bush passes away during the first half of the year and Governor Jeb Bush immediately declares his candidacy.

By the end of 2015, Jeb Bush is well ahead in the polls and is a big favorite to win the presidency in 2016.

Strategy: None

Surprise No. 11 – Food inflation accelerates after Russia halts wheat exports.

“As life’s pleasures go, food is second only to sex. Except for salami and eggs. Now that’s better than sex, but only if the salami is thickly sliced.” – Alan King

Russian turmoil continues and Putin decides to halt exports of wheat again to keep as much homeland as possible, resulting in a price spike in wheat, but also corn and soybeans. This price rise, on top of U.S. food inflation that is already running higher, offsets the consumer benefit of still-relatively-low gasoline and heating oil prices.

Strategy: None

Surprise No. 12 – Home prices fall in the second half of 2015.

“I told my mother-in-law that my house was her house and she said, ‘Get the hell off my property.’” – Joan Rivers

Under the weight of reduced home affordability, still-low household formation gains and continued pressure on real incomes, home prices fall in 2015.

Builders lose pricing power.

Strategy: Short homebuilders.

Surprise No. 13 – Individual and sector market surprises.

“Those who are easily shocked should be shocked more often.” – Mae West

  • Bank Stocks Fall – Though bank stocks have been recent market leaders, the weight of a flattening yield curve, still-tepid loan demand and an implosion in the European banking system make the sector among the worst market performers. Moreover, a major cyber attack against Bank of America (BAC) that actually destroys a percentage of customer records further diminishes enthusiasm for the group.
     
  • Twitter Feeding – Carl Icahn, calling it his “new Netflix,” discloses a 9.9% position in Twitter. This stimulates a bidding war between Google (GOOGL) and Facebook (FB) to acquire the company. Google wins the battle and pays $60 a share for Twitter.
     
  • Volatility Rising – The VIX rises to over 30 in the second half of the year.
     
  • Google Institutes a Share Buyback and Shaves Capital Spending – After a lackluster performance in 2014, Google’s management reverses course on its previously outsized capital spending program on non-core businesses and becomes more shareholder friendly. The company dials back spending and institutes a stock buyback program.
     
  • Corporate Inefficiency in Large-Cap Technology Targets Activist Investors –- Two hedge funds establish a filing position in Cisco (CSCO) and force Chairman John Chambers out. The new CEO announces a large special dividend and a massive stock buyback and a cutback to the employees’ too-generous stock option plan. More than 10% of the workforce is laid off and Cisco’s shares soar. Several other tech companies are targeted.

Strategy: Long AAPL TWTR, CSCO, VIX, GOOGL and short banks

Surprise No. 14 – Berkshire Hathaway (BRK.A) makes its largest acquisition in history.

“When I was 15 years old, I read an articls about Ivan Boesky, the well-known takeover trader – turned out years later it was all on inside information! But before that came to light, he was very successful, very flamboyant. And I thought, ‘This is what I want to do.’ So I’m 15 years old, I decide I’m going to Wall Street.” –  Karen Finerman

During the depths of the market’s swoon in the later part of the year, Warren Buffett scoops up his largest acquisition ever. The $55+ billion acquisition is not in his customary comfort zone (a consumer goods company), but rather the deal is for a company in the energy, retail or construction/equipment areas.   

Strategy: None

Surprise No. 15 – A derivative blowup precipitates an abrupt market drop.

“I view derivatives as time bombs, both for the parties that deal in them and the economic system.” – Warren Buffett

The $300 trillion holdings of derivatives by the U.S. banking industry has been all but forgotten.

The four-largest U.S. banks account for $240 trillion of that total, dwarfing their combined $750 billion in statutory capital! This sort of exposure in which notional derivatives are more than 300x the banks’ net worth, is, as my friend The Credit Strategist’s Mike Lewitt has written, “would be laughable if the consequences of a financial accident were not so potentially catastrophic.”

To make matters worse, the passage of the $1.1 trillion spending bill passed this month (written by lobbyists and voted on by bought-and-paid-for legislators who probably neither read nor understood the complex spending bill) has kept taxpayers on the hook –through the FDIC – for those derivatives (what Warren Buffett previously called “financial weapons of mass destruction.”) 

On any measure, the sheer size of these derivative portfolios pose potential risk to the world’s financial stability. What we have learned from the past cycle is how opaque the exposure really is and how stupid and avaricious our bankers really are when allowed to venture into territories of leverage.

Whether it is energy derivatives or some other asset class, a derivative blowup in 2015 will serve to preserve the wise words of Benjamin Disraeli (who served twice as Great Britain’s Prime Minister) that “what we have learned from history is that we haven’t learned from history.”

It will also harm our markets, once again.

Strategy: Short SPY

10 Also-Ran Suprises for 2015

By DOUG KASS
Dec. 26, 2014 | 7:32 AM EST

Stock quotes in this article: BABASHLDIBMBRK.AMONIF

  • On Monday I will deliver my 15 Surprises for 2015.  I think it is my most interesting list in years.

Here are my 10 also-ran Surprises for 2015 that I had considered but didn’t make the top 15.

  1. China’s Real GDP growth falls below 5% in 2015 as economic growth decelerates markedly in the second half of the year.
     
  2. An accounting “discrepancy” is found at Alibaba (BABA). The shares plummet and the hedge fund community feels the pain.
     
  3. Under pressure from suppliers and a falling stock price, Ron Johnson is installed as CEO ofSears Holdings (SHLD).
     
  4. George Soros makes $2.5 billion by shorting German Bunds.
     
  5. The price of crude oil drops below $40 a barrel in the second half of 2015.
     
  6. The consumer price index turns negative (year over year).
     
  7. IBM (IBM) whiffs and the share price drops below $125 a share. Berkshire Hathaway(BRK.A) suffers a near-$4 billion loss (on paper). At Buffett’s suggestion, senior management is replaced.
     
  8. Warren Buffett announces his successor.
     
  9. Uber goes public at a $50 billion capitalization. The share price never exceeds the IPO price in 2015.
     
  10. Monitise’s (MONIF) subscription adds far outpace expectations this year. (The shares double in price).

Letter to My Nephews

By Jonathan Tepper
December 29, 2014 in Uncategorized

You can learn a lot from books, but many things can only be learned the hard way by living, suffering and enjoying life.

A year and a half ago, I was in a plane with very bad turbulence, and I worried that if the plane went down, many of the lessons I’ve learned in life would end up at the bottom of the ocean.  I wrote a letter to my nephews for them to read when they were older.  I hope they’ll find it useful.

—————–

Dear nephews,

I’m writing this on a plane. The reason I started writing this was that I feared the plane might go down, and if it went down, all the lessons I’ve learned in life would disappear with me. By writing this, I hope to pass on the few lessons I’ve learned.

The most important lesson is that the vast majority of things you worry about will not bother you the next day. A year later you will not even be able to remember them if you try. When you grow older, you will not worry about what grades you got. You won’t worry about games you lost.   You won’t worry about what other people thought about you. Most of the things you worry about will never happen. Even if the worst things that you worry about happen, life will still go on. Learn to enjoy every day, and try to enjoy it as if it is your last. It has taken me a long time to understand this, and I wish I had understood it sooner.

Happiness is not a destination but a journey. You will never be smart enough, rich enough, have a pretty enough girlfriend, boyfriend, husband or wife, or win enough prizes and awards. Whatever it is you want, there is always something better. Enjoy the journey of learning, working, and living. If you enjoy the journey, you’ll probably achieve a lot more than if you focused on goals.

Money can provide security, but once you have security, more money cannot buy you more happiness. If you show me someone who thinks money can buy happiness, I’ll show you someone who has never had a lot of money.

Things don’t make you happy, but memories will always stay with you. Whatever it is that you buy, you will soon get used to it. It will make you happy for a short while, but it will not make you happy forever. Experiences and memories can make you happy forever. I can’t even remember most of the toys I’ve had in my life, but I still think of my times with Timothy and your Grandmom with great happiness and fondness. I remember walking Timothy to school and how happy we were. I remember hugging your Gradmom when I came home for a weekend. Those memories will never go away. The happiest memories of my friends are my travels and dinners with them, not the things I’ve bought for myself. You’ll remember dinners and travels with friends and family more than any shiny things you’ll ever have.

Your family is the most important thing you have in life. Friends, boyfriends, girlfriends and co-workers come and go, but the only thing that you can always count on is your family. (If you find a friend who is always there for you, you’re extremely lucky. They exist, but they’re very rare.) One day, you will have your own family. You must love them and look after them. You will understand one day that just as your grandparents die, your parents will as well. Strive to be a good son and daughter. One day, you will be like your parents. Your parents are not perfect, and you will not be either. But you can be loving and be a good son and daughter. One day you can be a good parent.

Never stop learning, and always be ready to teach yourself things you don’t know. The only things you will remember are things you care about. You will forget about all the rest. You must teach yourself and care about what you learn. No one can teach you everything you need to know at school or university. You will also forget most of what you study, and that is fine. As Jacques Barzun said, “Civilization is all that remains after you have forgot all that you specifically set out to remember.”

Never live someone else’s life. Find your gifts and the things that give you pleasure, develop those gifts, and pursue them.   Do what makes you happy and be great at it. You have skills and gifts that no one will ever have or see again. If you’re a businessman, build businesses. If you’re a writer, write. If you’re a scientist, discover. If you do what you love and love what you do, you will work very hard, but you will enjoy every day.

One of the things that most influenced me was something Steve Jobs once said:

When you grow up, you tend to get told that the world is the way it is and your life is just to live your life inside the world, try not to bash into the walls too much, try to have a nice family life, have fun, save a little money.

That’s a very limited life. Life can be much broader once you discover one simple fact, and that is that everything around you that you call life was made up by people that were no smarter than you. And you can change it, you can influence it, you can build your own things that other people can use. Once you learn that, you’ll never be the same again.

And the minute that you understand that you can poke life and actually something will, you know if you push in, something will pop out the other side, that you can change it, you can mold it. That’s maybe the most important thing. It’s to shake off this erroneous notion that life is there and you’re just going live in it, versus embrace it, change it, improve it, make your mark upon it.

I think that’s very important and however you learn that, once you learn it, you’ll want to change life and make it better, cause it’s kind of messed up, in a lot of ways. Once you learn that, you’ll never be the same again.

I hope that you will find what you love and you will change the world.

Life is full of struggle, and many bad things will happen to you. This is one thing that I can guarantee you. Most of my friends died of AIDS, and your uncle Timothy died in a car accident and your Grandmother committed suicide after suffering from a very bad brain tumor. These things happened and cannot be changed. Many people suffer great tragedies and live full and happy lives. Remember the people you love and mourn them. Accept that terrible things happen, and try to live as if each day is your last with those you love. There is nothing else you can do.

The best way to avoid anxiety, stress and unhappiness is to avoid internal contradiction. Don’t think that one thing is right and do the opposite. Listen to your conscience and obey it. Be a good person and live according to your convictions. You cannot answer for other people, but you can always answer for yourself. As long as you live according to your most basic beliefs, you will not have regrets or guilt. You will be able to die happily knowing that you looked after the poor and needy, that you were loving to those around you, and that you failed often but did your best. You will not lose a night of sleep if you always try to do your best.

I love you very much.

Much love,

Uncle Jonathan

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Important Disclosures

The article Outside the Box: 15 Surprises for 2015 was originally published at mauldineconomics.com.