Altus Insight: February, 2017

The Altus Insight

Market news, commentary and relevant topics for today’s alternative asset investor

Date: February 28, 2017
FR: Forrest Jinks
RE: Raging Bear

I fully admit to being a raging bear. Readers probably think I am a pessimist.  When contemplating the macroeconomic picture confronting us as investors, a nation, or even a world, I probably do lean a bit pessimistic, except that I might call it conservative. But isn’t that what you want in a company presenting investment opportunities? And I am not always so bearish. We bought back into the real estate market in California in October of 2008. That property produced a 150% margin, on COSTS. Throughout 2009 and over the next couple years we tried to buy as much as we could. The difficulty wasn’t finding things to buy, it was finding investors that wanted to participate. When most of the investing world was pretty bearish I was a complete real estate bull, and we ran the company in such a fashion.

I had a lot of trouble getting my thoughts together for this article. There are reams of things to talk about, most of them interconnected, but many of them residing in economic details that only an economics nerd like myself would enjoy deciphering. Instead of getting into one topic in depth, which would likely require cross pollination with some of the other topics, the following is a bullet list of some of what is in process and some fun facts of where we currently stand. Despite me leaning bearish the last few years, the items below aren’t automatically to be assumed to be of bearish nature. (The good news is that any mention of political leaders is only in passing as relates to what is going on around them/us, and not the topic of the conversation). But first, input from someone else who is:

David Stockman was Budget Director under the Reagan Administration. The following are his thoughts on the current stock market rally and US fiscal situation.

“I think we are likely to have more of a fiscal bloodbath rather than fiscal stimulus.  Unfortunately for Donald Trump, not only did the public vote the establishment out, they left on his doorstep the inheritance of 30 years of debt build-up and a fiscal policy that’s been really reckless in the extreme.  People would like to think he’s the second coming of Ronald Reagan and we are going to have morning in America.  Unfortunately, I don’t think it looks that promising because Trump is inheriting a mess that pales into insignificance what we had to deal with in January of 1981 when I joined the Reagan White House as Budget Director…I don’t think there is a snowball’s chance in the hot place that’s going to happen. This is delusional.  This is the greatest suckers’ rally of all time. It is based on pure hopium and not any analysis at all as what it will take to push through a big tax cut. Donald Trump is in a trap.  Today the debt is $20 trillion.  It’s 106% of GDP. . .Trump is inheriting a built-in deficit of $10 trillion over the next decade under current policies that are built in. Yet, he wants more defense spending, not less.  He wants drastic sweeping tax cuts for corporations and individuals. He wants to spend more money on border security and law enforcement.  He’s going to do more for the veterans.  He wants this big trillion dollar infrastructure program.  You put all that together and it’s madness.  It doesn’t even begin to add up, and it won’t happen when you are struggling with the $10 trillion of debt that’s coming down the pike and the $20 trillion that’s already on the books.”

Some Things to Think About:

  • When the US officially left the gold standard in 1971 the US GDP was slightly larger than the total outstanding debt in the US. Outstanding US debt and GDP stayed roughly in lockstep, where they had been for decades upon decades, until 1980, at which time outstanding debt started to grow faster than GDP. In the early to mid-2000s debt growth “went vertical”, dipped slightly in 2008 and has resumed its upward climb ever since. Outstanding debt is now roughly six times larger than the US GDP. 1980 = Comparable, 2017 = 6X larger. If too much debt caused the Great Recession, what could more debt than prior to the Great Recession cause?
  • The idea of wanting to bring back manufacturing jobs lost to China (and elsewhere) through changes in trade agreements is a nice thought and is easy to sell to the public. However, over 80% of manufacturing jobs that have disappeared in the last twenty years have not been lost to “offshoring” but rather to improvements in technology. Even Foxconn, the Chinese manufacturer of IPhones is now reducing their headcount through the introduction of technology, so it isn’t just a western world issue. Of the remaining 20% of lost manufacturing jobs that we can considered lost to “offshoring” a sizeable percentage of those were moved out of the US not to save cost, but rather to save time. One of our investors was a long-time manufacturing engineer at Hewlett Packard/Agilent. They set up manufacturing lines in Malaysia at no discernable cost savings simply because the company could have the line up, running, calibrated, and producing before they could even get approval for the new line through the required regulatory bodies here in the US. Admittedly, 20% of lost manufacturing jobs is still a lot of jobs, even when jobs taken offshore for reasons other than cost savings are taken into account, but with the rate of technological advancements and integration accelerating (and boosted by the low cost of financing) that number is getting smaller all the time. The next horizon is service jobs. Improved and improving robotics are already eliminating service jobs and this trend is only going to accelerate over the next few years.
  • The US political party system has been turned upside down. I think most Americans don’t want to acknowledge it yet because we likely identify with our party more than we identify with the policies of the party. Because of the winners and losers created by policy, this could have a substantial impact on investment portfolios over the next several years (I will likely go more in depth on this phenomena in a future Insight).
  • Speaking of winners and losers, tax code creates winners and losers as well. Oil? Winner. Solar? Winner. Homeowners with debt? Winner. Renter? Not so much. I don’t think there are many people that would argue our tax system needs a major overhaul to deal with the changing demographics and our out of control spending. A clean and easy to understand tax code would have a myriad of benefits for the country. However, it would also create losers out of the current favored class of winners. Assuming it is true overhaul and not just tinkering around the edges, it will create serious economic upheaval. I am fully in favor looking past the short-term pain in order to provide a better long term situation, but I am also fully aware that the pain will be real indeed.
    • I don’t know if “The Better Way” proposal is the tax system overhaul that will create the long-term stability we need. People will have lots of opinions and the proposal will morph many times before it gets signed into law (if it ever gets signed into law). Assuming it or an offspring does go into law, only time will give an honest report of its effectiveness, and even then, only in comparison to hypothetical parallel futures. I applaud the effort but want to make sure I keep an eye on its progress. This proposal will create serious economic upheaval. I would rather be in front of the change than behind it.
    • Importers and exporters (or manufacturers of “Made in the USA”) will feel very differently about the “Border Adjustment Tax” that is part of the proposal. Importers? Losers. Exporters? Winners. And who would have ever thought the Republican Party, as the party of free trade, would be the authors of such an import tax? To be fair, most other countries already have such a tax on good imported into their countries in the way of a Value Added Tax (VAT) so US manufacturers are working at a disadvantage, but whether or not it is “fair”, we can safely assume other countries are not going to take kindly to their exports to the US being less competitive than they were previously.
    • A stated component of The Better Way proposal, and part of the long-term justification for the Border Adjustment Tax, is that it will create a stronger dollar, which in turn will re-level the playing field between Importers and Exporters so that there is no long term net winner or loser. This is diametrically opposed to the goals of the President, who desperately needs a weaker dollar if he hopes to achieve even a portion of his ambitious economic promises.
  • Don’t believe everything you read (the Altus Insight probably included). Politicos and the financial press all promised economic doom upon Great Britain if Brexit passed. Brexit passed and the western economy with the highest GDP in the second half of 2016 (post Brexit)? That’s right, Great Britain. There is still a long way to go through the process of withdrawing from the EU and there is still ample opportunity economic hardship, but, at least thus far, things are looking up.  The real lesson is buying on the advice of the financial press can be harmful to our financial health.
  • The post Trump election “reflation” trade saw the stock markets rally and the bond markets get crushed. This was all based on the expectation of higher inflation. Janet Yellen commented mid-month that the Federal Reserve feels higher inflation is coming. Based on her comments the stock market continued its upward climb and the bond market, instead of falling as would be expected on news of higher inflation and expected interest rate hikes, roared higher with Ten Year Treasury Yields falling 8% in a little over a week. Generally speaking, the smart money is in bonds so keep an eye on bonds as a harbinger of things to come. (Note: yields bounced back up the last couple days of the month after this article was originally written.)
  • We often get asked if interest rates are going up or down. Our immediate, and most accurate, answer is we have no idea. If pressed, I admit that if I had to place a bet on the movement of rates I would bet that interest rates will test post WW2 lows before they crest 4% (as measured by the Ten-Year Treasury). However, because the risk of being wrong on such a bet is far greater than the benefit of being correct, we still run our business as if rates will increase. If they decrease, we end up with trapped equity on investments creating cash flow. However, if we were to make investment decisions based on the assumption of falling rates and they instead increased, we could end up in negative cash flow and negative equity situations. Definitely not where we want to be.

It is highly likely we will experience substantial market change and disruption in the next couple years. Change and disruption is painful. However, with change and disruption comes opportunity to the bold.

Happy Investing.

Forrest Jinks