Weekly Economic Update 01-05-2018

Inflation, Tax Cuts and Trump

I recently read a piece on investor psychology that said American’s have a bias towards investing in any asset that is rising in value. American’s not only like things that are rising in value, but they will chase it to the top and ride it down to the bottom. This explains the tech bubble of the 1990’s, the housing bubble of the early 2000’s, and now the everything bubble – including cryptocurrencies. Interestingly enough, foreigners do the exact opposite. They prefer to buy assets that are low or undervalued and hold them until they appreciate.

Everything appears to be rising in value these days – stocks, real estate, earnings, profits, cryptocurrencies and more. The rapid ascent of these assets over the past year has the public believing that inflation is here. The only missing piece is wage inflation, which we are told will be coming soon now that the tax cuts have been passed. While I remain completely skeptical that wages will rise, it hasn’t stopped the American consumer from binge-charging on their credit cards.

Most people believe inflation comes from rising prices, but ask them how or why prices rise, and they won’t have a good answer. Inflation is the undue expansion of the money supply, most commonly associated with countries who do not have specie, or a physical metal, backing their currency. In other words, inflation occurs when a country with a fiat currency prints money to solve their financial issues.

Inflation is a transfer of wealth from those on the bottom of the economic scale to those on top – those who hold their wealth in real tangible assets. For example, let’s say I own a rental property valued at $100,000 that holds a $95,000 loan. I currently have a tenant in that property that pays me 1% of the value per month in rent, or $1,000. Over the course of the next year, inflation takes off due to excessive money printing and the value of my rental property increases to $200,000. Since I charge my tenet 1% of the value, their rent increases to $2,000 per month. But more importantly to me, the amount of my debt on the property, which we’ll assume holds constant, is only $95,000. My debt-to-income ratio just fell due to inflation, meaning I can now borrow against the equity in the property to purchase more real assets. Meanwhile, my tenet receives no additional benefit from their increase in rent, thus making them poorer while I become wealthier.

This evidence of this wealth transfer can be seen in the household income data. Since 2000, the median household income has fallen. Today the median household income is less than it was in 2008, which was less than it was in 2000. Inflation slowly eats away at our money and our standard of living. But for those on the top of the socioeconomic ladder, inflation is very beneficial. Today the top 1% in the world, by net worth, own a staggering 50% of all real assets, making the top 1% as wealthy as they have ever been in modern history.

When Donald Trump was on the campaign trail, he stated he wanted a weaker dollar, which is a polite way of saying he wants to see higher rates of inflation. What surprised me is that the public appeared to want this! One of the reasons American’s have enjoyed a high standard of living is due to our strong currency and low inflation. If we have a weak currency, which will happen by printing more money, then our standard of living will fall. While a weak currency would create more jobs by allowing the United States to increase its exports, life, as we know it today, would change for the worse.

A weaker dollar would have its benefits. It would allow our government to print enough money to cover the shortfall on all the entitlement benefits, such as Social Security and Medicare, to fund the military, pay for tax cuts and to pay for badly needed infrastructure repairs. But it’s the cost of the weaker dollar that few really understand. Yes, the government can print (or borrow) as much as they want if the Fed monetizes the debt, but that has its own consequences. Should we go down that path, the dollar will be worth far less than it is today when compared to currencies from other countries. The result would mean that the cost of goods and services in the United States would skyrocket. A weaker currency would allow the government to pay all its promises, but most Americans would find themselves financially worse off because wages and entitlement benefits often fail to keep pace with inflation.

Following Trump’s win last November, the American consumer began preparing themselves for inflation. This behavior is interesting because the last time we saw high rates of inflation was the 1970’s. For those who remember the 1970’s, there were no less than four recessions that decade and the stock market was range-bound, meaning investment returns were mediocre at best. When the public responded to the election by dumping bonds and gold to buy stocks, and then proceeded to charge up their credit cards, I was a perplexed about what they were thinking was going to happen. What consumers were hoping for were wage increases, which haven’t materialized.

Now we’re are being told that the recent tax cuts will lead to wage increases. I too find this perplexing, because corporations have spent $3-4 trillion since the Great Financial Crisis buying back their stock and paying dividends. Very little of that money went to wage increases, capital improvements or to shore up underfunded pension liabilities. This is part of the reason I remain skeptical that corporate pocketbooks are suddenly going to rain down on their employees. If there was a demand for wage increases, it should be happening already.

On the topic of tax cuts, any transfer of wealth from a government to the public that is above the normal transfers are considered stimulative. Meaning stocks and interest rates should continue rising in anticipation of this new influx of money into the economy, but both have barely moved since the passing of the tax bill. The reason the market has paused is that the tax cut is not revenue neutral, meaning the government is expected to borrow $1-1.5 trillion to pay for it. According to Austrian economic theory, when a transfer of wealth is funded by taking on additional debt, the transfer is not inflationary. Therefore, the markets paused, because everyone was expecting much larger tax cuts along with cuts to government spending.

When a government increases deficit spending to fund a wealth transfer, those increased deficits generally lead to inflation. While taxes may go down, the price of goods tends to rise, which offsets the tax cut. If a tax cut comes with a matching cut in government spending, then the economy will grow. In 1920 the U.S. economy headed into a depression and President Wilson did the unthinkable – he cuts taxes and government spending. Prevailing economic theory says that a government should cut taxes and increase spending to end economic downturns, but President Wilson stuck to his decision. By 1921 the economy was turning around and by 1922 the economy had fully recovered, making it the fastest recovery from a depression in United States history.

Video Topic of the Week – The Fed’s Balance Sheet Unwind

The Fed is set to increase the pace at which it sells off its balance sheet. Bullish or bearish – tune in this week to find out!

Chart of the Week – The Fed Balance Sheet and Treasury Yields

Are interest rates headed up or down? Be sure to check out this week’s charts to see if Treasury yields should be rising or falling as the Fed continues to unwind.

Portfolio Shield™ Update

Monthly rebalance went smoothly and the strategy remains 100% allocated to equities. As with the prior updates, there is a system delay with the ‘Equity Style Box’ updating, so I should have the January investment detail report for you next week.

Still working on the new algorithm. Hopefully, I’ll have a meaningful update in the next couple weeks. I appreciate all of the e-mails and calls for support on my latest endeavor.

2018 Opportunities

I want to continue with the theme from last week and explain how commodities generate returns. Most people are familiar with stocks and how the rise, fall and move in between, but commodities are different. Commodities generate their returns in short bursts that can be a year or less in duration. Anyone who has worked in the oil industry or traded oil, for example, knows that it can rise from $30 to $120 and back to $30 in a couple years.

Commodities are usually traded by very large investors, or the “smart” money because there is a huge amount of inventory that can be purchased, which is useful if you are managing hundreds of billions of dollars. The way it works is usually there is a consolidation period that can last months or years in length where the smart money is buying up all of the supply. As they end their buying scheme, technical traders will sense a large price move and join in on the action driving the price of the commodity up. As prices rapidly rise, the public eventually gets wind of the price move and starts buying late in the rally. As prices peak, the smart money begins its selling program along with the technical traders. Once they have sold, they drive the price down to repeat the process. This is in general how commodities and bonds are traded.

The key to understanding how returns will come is as simple as the amount of time involved in the consolidation period. When the smart money decides to begin a buying program, they have a target price in mind. Looking at the price movements following consolidation periods, the target annual return is around 20%. Meaning if there is a one-year consolidation period followed by a one-year move up, that would imply a total move up in the price of 40% — 20% per each year.

The goal should be to buy towards the end of the consolidation period to catch the breakout, but that’s not always easy. The nice part is that if you find yourself investing early in the consolidation phase, you can simply wait it out as long as you’re confident that the big price move will be in your favor. When I see gold futures consolidating in a very long four-year phase, which is highly unusual, that tells me that the smart money is planning on a big return. And since the miners are a leveraged play on the metal, there will be an even bigger return for them.

Hopefully, that helps you understand how I expect returns to come from our positions in agricultural commodities, gold (our focus is on the miners), and Treasuries, which happen to move in spurts just like commodities.

Weekly Broad Market / Economy Commentary

A year ago investors were buying stocks because of the dividend yield. Today the largest S&P 500 Exchange Traded Fund (ETF) has an annual yield less than 2%. A five-year Treasury bond has a 2.3% yield and the implicit guarantee that an investors money will be returned in five years. I’m not sure the same statement is can be said about the S&P 500.

The Congressional Budget Office stated that the tax cuts will be good for the economy so long as we don’t enter a recession in the next ten years. Based on historic market cycles, we should have two recessions in the next ten years.

All eyes are on Friday’s Nonfarm Payrolls report that should indicate a strengthening labor market that should lead to higher wages. I think investors should be aware that the average American family has been using their credit cards for the past 24 consecutive months to finance the gap between their household income and rising costs of living. While governments may be able to run perpetual deficits, households can’t. And with rising short-term interest rates, the minimum payment on all that credit card debt is set to rise.

The big risk to markets is that the Fed is stepping up the unwind of their balance sheet. Most investors are ignoring this because the fourth quarter unwind didn’t seem to affect markets much. I’m covering some of this in the charts this week and I’ll cover this in more detail in next week’s update.