Bulls v Bears: Accelerating with the Brakes On

Bulls v Bears: Accelerating with the Brakes On

It is no wonder the stock market has been having fits given we have fiscal policy stepping on the accelerator while monetary policy looks to be putting both feet squarely on the breaks. On the fiscal side, we have a roughly $1.5 trillion tax cut with an additional $300 billion spending plan which is looking to take the deficit to $1.2 trillion or about 5.4% of GDP. President Trump proposed today a $4.4 trillion budget that would widen the federal deficit to $984 billion in the next fiscal year, which begins September 30th. Analysts estimate that after tax cuts and the two-year budget deal, the deficit will be above $1 trillion next year.

On the monetary policy side, in December the market was pricing in 3 hikes during 2018 at just 30%. That’s increased to about 70%. The Federal Reserve is unwinding its massive balance sheet on top of those rate hikes, which means not only will Fed rates be higher, but the supply of bonds in the marketplace will be increasing both from the deficit spending as well as the Fed’s balance sheet unwind. The new Federal Reserve Chair Powell is giving signals that he is unlikely to provide quite the safety blanket that Chair Yellen did for asset prices.

The monetary brakes aren’t just here in the U.S. The Bank of England is set to increase rates at a less gradual pace with the European Central Bank not to far behind and shortly to be (most likely) run by a German instead of an Italian – a meaningful difference. In Japan the economy appears to have escaped deflation and is expanding, making the 10-year Japanese bond yield at zero difficult to maintain for much longer.

(Hat tip to WSJ The Daily Shot for chart below)

Add in that we’ve seen record flows into equity ETFs recently, many in the markets today have never experienced a real downturn and the market has been trained, for nearly a decade, to buy the dips as central bankers will always step in to push asset prices back up, and it is no wonder the 14-day change in the 14-day RSI was the biggest in recorded history. Volatility is coming back to play!

Tematica’s Take on Mnuchin’s Reforms and Growth Prospects

Tematica’s Take on Mnuchin’s Reforms and Growth Prospects

There are several drivers of a company’s business as well as the price of its shares, assuming it is publicly traded. We described many of these in Cocktail Investing: Distilling Everyday Noise into Clear Investment Signals for Better Returns, but a short list includes new technology, regulatory mandates, the overall speed of the global economy and new policies flowing out of Washington. From a business perspective, more regulations and taxes tend to drive costs higher, leaving companies with smaller profits to spread across developing new products and services, implementing new technologies and creating more jobs – in other words investing for the company’s future.


We’re seeing this today in the restaurant industry, which is struggling with the impact of higher minimum wages as companies like McDonald’s (MCD) and others look to bring mobile ordering, as well as in-store kiosks like those found at Panera Bread (PNRA), to market. There has been much made about the low to no growth in the US economy over the last several years, but headwinds, like our aging population that has people shifting from spenders to savers and rising consumer debt levels that weigh on disposable income levels and consumer spending, make prospect for growth challenging.


Last week Treasury Secretary Steve Mnuchin reiterated in his testimony in front of the Senate Banking, Housing, and Urban Affairs Committee that the Trump administration’s goal of 3 percent or better GDP is achievable provided, “we make historic reforms to both taxes and regulation.” Mnuchin went on to say, “he’s got 100 bodies working on tax system reform and that they’re working on far more than just undoing the Dodd-Frank Act” including overhauling housing finance reform.


Over the weekend in a radio interview, Mnuchin noted, “The good news is that [the administration and Congress] all agree on the fundamental principles: simplifying personal taxes, creating a middle-income tax cut and making our business taxes more competitive.” Mnuchin went on to acknowledge that over the past eight years, the US economy has had very low growth, but “tax and regulatory changes and better trade deals” can unleash more historically typically growth rates in this country,” with “sustainable levels of 3 percent growth.”


The key word employed by Mnuchin is “reform,” and no matter which definition of the word offered by Merriam Webster – “to amend or improve by change of form or removal of faults or abuses” or “to put an end to (an evil) by enforcing or introducing a better method or course of action” – it’s rather clear Mnuchin’s language suggests something far more historic than a temporary tax cut or other one-time band aids like we’ve seen in recent years. That resetting should help reduce regulatory and litigation costs, but also a lower corporate tax rate, which would benefit predominantly US based companies like Verizon Communications (VZ), CVS Health (CVS), Walt Disney (DIS), Norfolk Southern (NSC) and others as well as their shareholders.


With true regulatory and tax reform, there would be the added benefit of certainty or at least greater certainty that would allow for longer-term corporate planning. It’s rather well understood the stock market abhors uncertainty, but uncertainty in the form of short-term tax cuts and ones that are about to expire as well as a shifting regulatory environment wreak havoc on corporate planning and subsequently spending. One example is Research & Experimentation Tax Credit (better known as R&D Tax Credit) was originally introduced in the Economic Recovery Tax Act of 1981 with an original expiration date of December 31, 1985.


Flash forward a few years, and the credit has expired eight times and has been extended fifteen times with the last extension expired on December 31, 2014. Not exactly a boon to corporate planning, but in 2015, Congress made permanent the research and development tax credit, which now allows more consistent planning and product development at companies ranging from Apple (AAPL) and Facebook (FB) to II-VI (IIVI) and Oracle (ORCL), not to mention food and beverage companies like Coca-Cola (KO) and PepsiCo (PEP). Douglas L. Peterson, President and Chief Executive Officer of S&P Global Inc. summed it up well when he said, “If we knew where the cost was going…and we’re able to predict it over the long run, we could have a completely different planning cycle and invest in the long run.”


While these reforms are likely to help reignite growth in the US economy, the stark reality is between increased spending to rebuild US infrastructure as well as the US military and ensuring entitlement programs are in place for our aging population, there is a deficit funding gap at least in the short to medium term that will need to be addressed. While there are several mechanisms being bandied about, a recurring one is the Border Adjustment Tax. There are those that oppose it, particularly retailers that source heavily from outside the US, but the argument for the Border Adjustment Tax is that it would help level the playing field between imported goods and those crafted within the US as well as encourage companies to source within the US, thereby developing industries and creating jobs.


The challenge here is that with the gap between Job Openings and Hirings already well above historical norms as companies struggle to find the right talent for open positions as we sit at what has been the lower range of the unemployment rate over the past fifty years, who is going to take these jobs? Regular Tematica readers will quickly recognize how this pertains to our Tooling and Re-tooling investment theme.



We frequently discuss here at Tematica Research how economic growth requires that either the labor pool grows and/or productivity must rise. If companies are able to keep more of their income thanks to tax cuts, they can invest back into their own operations so that the productivity of their workforce improves. That being said, cutting corporate tax rates doesn’t guarantee that companies will do such reinvestment as they could also look to return the additional funds to investors through dividends, fund buyback programs or hold onto it if there is concern that times could get tough in the near to medium-term future. Investors need to assess the overall economic conditions and business drivers as well as other incentives facing companies when it comes to decided just what to do with those tax savings.


As Team Trump and his allies, including Mnuchin, look to reset the administration’s timetable for meaningful reform, investors should begin doing their homework on which companies stand to benefit. If we see lower corporate tax rates like those being discussed, we could see greater earnings falling to corporate bottom lines, which could spur shares in those companies higher, outside of any decision on just what to do with those newly saved funds. If we see infrastructure spending beginning, it offers another shot in the arm for companies like US Concrete (USCR), Granite Construction (GVA) and aggregates companies like Martin Marietta (MLM). Any boost in defense spending would likely bode well for companies such as General Dynamics (GD), Raytheon (RTN) and Northrop Grumman (NOC).


The key is for investors to develop their wish list today and be ready to strike once we know the particulars on the actual reforms. While that is likely a sound strategy, we would suggest investors go one step further and utilize our thematic perspective to identify those companies already benefiting from pronounced multi-year tailwinds that could also benefit from tax and regulatory reform, rather than being dependent solely on these reforms making it through the D.C. sausage factory.

Global Picture – What Trump Doesn't Know

Global Picture – What Trump Doesn't Know

Donald Trump has been making headlines lately with his rants over China’s currency, but there is a lot more to the global picture – What Trump doesn’t know…

A little over a week ago the Netherlands Bureau for Economic Policy Analysis reported that global trade shrunk in the first six months of 2015 at the fastest pace since global trade collapsed in 2009 following the financial crisis, down 1.5% in Q1 and another 0.5% in Q2.  This is big, very big, yet very few are talking about it! Which is why we are.  According to a report from the Economic Cycle Research Institute, the last time export price deflation was this intense every G7 economy was in a recession.  



The Eurozone’s growth wasn’t as strong as expected in the second quarter, with overall GDP rising by 0.3%, (barely above stagnation) and slower than the 0.4% in Q1.  The two largest economies in Europe disappointed with Germany growing 0.4% versus expectations for 0.5% while France didn’t grow a bit versus expectations for 0.2% growth. Italy eked out 0.2% growth versus expectations of 0.3%.  The Netherlands was similar with 0.1% versus expectations for 0.3%.

Despite the massive efforts by the Bank of Japan to get the economy roaring, Japan’s Q2 GDP didn’t give us much to cheer about either, declining at a 1.6% annual pace.  Brazil also surprised to the downside, its economy contracting by 1.9% versus expectations for 1.7%, the biggest contraction for the nation in over six years!

So what may be happening here? Well, about 45% of the world’s GDP comes from commodity producing nations, and commodity prices have been taking a serious beating as is illustrated in the next chart.  If a nation can’t sell as much of its own stuff (commodities), it isn’t going to be able to buy as much stuff from the rest of the world… pretty simple! (You can see a bigger version of the image below if you click on it)



Across the board, save for a few unique standouts such as tea, (traumatizing to your Irish author here) olive oil, (thanks to a nasty bug attacking trees throughout Tuscany) and uranium, (Japan is getting its reactors back up after the horrors of the tsunami) commodity prices are falling dramatically across the board.  Even the world’s biggest producer of diamonds, De Beers, announced on August 24th that they would be lowering their prices by 9%.  Apparently, diamonds are a little bit less of a girl’s best friend. These prices are down so much for two main reasons: the strengthening dollar and growth rates are well below historical norms, both here in the U.S. and abroad, which means commodity producers need to continue to cut back on production.

The slowing global growth story shows up in many places. While the US may be the world’s largest economy, China is second and it is the world’s largest goods-producing economy.  When it is slowing, that’s telling you a lot about global demand.  For one thing, all those commodity-producing countries aren’t buying as much stuff from the Chinese. Germany is a big exporter to China so when China slows, Germany feels it and that affects the rest of the Eurozone. The decline in oil prices coupled with sanctions has seriously hurt Russia, which in turn is hurting Germany as German exports to Russia decreased by almost 31% on an annual basis in the first half of 2015. Getting hit by declining demand from both Russia and China is putting a lot of pressure on Germany, the nation that has long been the engine of growth for the Eurozone.

Now what’s the story behind the dollar’s strength?  Remember all those quantitative easing programs?  QE1, QE2, QE3…?  For those the Fed bought up tons and tons of “longer-term securities issued by the U.S. government and longer-term securities issued or guaranteed by government-sponsored agencies such as Fannie Mae or Freddie Mac” in an attempt to inject more and more money into the economy thinking that would spur demand and get the economy back on its feet.  The next chart shows the magnitude of the program.  From January 2003 to today, the Fed’s balance sheet has expanded 511% as it purchased trillions of Treasury bonds and mortgage-backed securities.  U.S. GDP today stands around $18 trillion, so this means the Fed tried to increase the amount of money in the economy by nearly 20%!  Yet we didn’t see crazy inflation, which at the time seemed a likely possibility.



Where did all that money go?  Mostly into asset prices…the ending of QE saw the dollar strengthening versus other currencies and the fall of commodity prices… with more likely to come.

While the Fed was buying up Treasuries in order to put more money into the economy, China was continuing its unprecedented reserve-accumulation exercise which, starting in 2003, amassed almost four trillion of foreign assets!  That is more than all of the Fed’s QE programs combined.  So what we really experienced on a global level was hyper-QE.

Today the story in China is a little different with the economy suffering from both a decline in exports due to the global slowdown and a shift from a primarily goods-exporting and manufacturing driven economy to a more service-oriented and internal demand driven one.  The nation’s economy has evolved into one in which about 20-25% of its citizens have a middle-class lifestyle while much the rest of the country lives more on par with Nigeria.  This is an untenable situation and Chinese leadership knows it, but is under a mountain of pressure from every angle.  Chinese state and private debt is estimated to be around 300% of GDP, if you can believe the GDP numbers.  If you think, like we do, that they are likely less than those reported by the government, then the situation is even worse.

So what’s all this about China’s crashing stock market kicking off the correction here?  The next chart shows the massive run up that China’s main index experienced, rising over 130% from last August to early June and the correction it’s suffered since those highs.  By August 26th, the Shanghai Composite had fallen over 43%. By the close of last week it had recovered a bit to be was down 37% from the highs.


The enormous run up in China’s stock prices over the past year was not due to improving fundamentals, as its economy has been slowing.This run up was based more on the assumption that the government would do whatever necessary to keep the market moving up combined with increasing use of leverage, (meaning people borrowed to buy more stocks).  Not exactly a unique phenomenon these days!

Understandably, Chinese officials took steps to rein in the use of leverage.  In January, they raised the minimum amount of cash needed to trade on margin, which would restrict the practice to wealthier investors.  They also took steps to punish companies that had been lax on enforcing the margin rules with their clients.  In April, Chinese regulators cracked down on “Wealth Management Products,” WMPs which are similar to U.S. money market funds, but in some cases WMPs were being used to generate funds that were then used to finance individual and corporate stock market investors at ratios of up to 10:1!  They also banned “umbrella trusts” which helped clients evade the margin trading limits. The market still went up.

Dissatisfied with the results of their tightening, on June 12th regulators then reduced the total amount of margin lending stock brokers could do, while also reiterating forcefully the ban on illicit margin trading through mechanisms like umbrella trusts. This time investors listened, the market bull run broke and the plummet began.

In early July regulators pulled an “Our bad” and did an about-face, reducing the amount of money required to open a margin-trading account.  Yep, first lowered this a few years ago and then raised it back up again in January and after watching a gut-wrenching slide in stock prices they reversed yet again!  Since July, the government has taken a variety of steps to try to pump the market back up.  Last week the market reversed its downward spiral only when the government announced it would engage in a large-scale asset purchase program in order to keep up stock prices.  The markets in China and around the world rallied on the news.  Then in yet another about face, (dizzy yet?) Sunday China announced that it had decided to abandon attempts to boost the stock market and will instead intensify efforts to find and punish those it suspects of “destabilizing the market” by “spreading rumors!”   Over the past two months, state-owned investment funds and institutions have collectively spent around $200 billion attempting to prop up the market, with limited success.

This weekend 197 people were arrested for “spreading rumors” and “false information” online about the recent stock market crash and the explosion in Tianjin, including a journalist and stock market officials. On August 24, Wang Xiaolu, a leading journalist at one of China’s most widely read financial publications was arrested, and admitted to causing “panic and disorder” in a public confession aired on state television. Unsurprisingly, the Committee to Protect Journalists has condemned his arrest and subsequent “confession”. I thank my lucky stars every day that I was born where I am free to say what I think.  Those who know me have assured me that I’d likely be six feet under if I’d been born under a different regime!

One final thought on China’s economy. When we take a deeper look, we see that according to official figures, gross fixed investment was 44% of gross domestic product in 2014. While figures for investment are more likely to be correct than those for GDP, does it really make economic sense for an economy to invest 44% of GDP and yet grow at only 5%? We think not! Talk about horrible returns. If these figures are to be at all trusted, investment could fall sharply going forward. That would mean further weakness in demand from China for commodities used to the enormous infrastructure projects for which it has become famous.

We’ll wrap up with China’s yuan and currencies across the world.  As we mentioned in our May issue, China is attempting to be included in the International Monetary Fund’s Special Drawing Rights, which means it needs to let its currency float more freely.  Earlier this month it took another step towards that end by loosening its hold on its currency, which resulted in the yuan falling some 3-4% versus the dollar. The following chart shows the performance of a wide range of currencies from across the globe versus the U.S. dollar over the past year. (You can see a bigger version of the image below if you click on it)

Currencies one year


The one in red is China’s, (couldn’t resist!).  As you can see, almost every major currency in the world has dropped in value relative to the dollar over the past year.  Here are a few numbers to go with the chart above:

  • Australian Dollar down 31%
  • Canadian Dollar down 22%
  • Chilean Peso down 20%
  • Euro down 16%
  • Japanese yen down 15%
  • Indian Rupee down 9%
  • British pound down 7%
  • Swiss Franc down 4%
  • Chinese yuan renminbi down 4%

Keep these numbers in mind as you hear Presidential candidates tossing insults at one another and at other countries around the world. China isn’t the only nation whose currency has declined in value against the dollar.  Furthermore, if the argument is that China has been “artificially” keeping its currency cheap relative to the dollar in order to make its exports more attractive to the rest of the world, then why did its currency immediately decline in value the moment the government loosened its hold, proving that the government’s intervention has been keeping its currency higher than it would be were it allowed to float freely?  This also makes intuitive sense.  China pegged its currency to a band around the dollar.  The dollar has been strengthening significantly while China’s economy has weakened.  It is unsurprising that the market’s pressure is to push China’s currency lower.  Yet another example of how headlines and TV talking points are often misleading.

For a broader historical perspective, the next chart shows the performance of a slightly smaller set of currencies against the dollar from 2010 through the end of 2013.  The weakening of the dollar against these currencies is directly related to the various quantitative easing programs, the termination of which was announced when the Fed released the June 2014 FOMC (Federal Open Markets Committee) notes in early July 2014. (You can see a bigger version of the image below if you click on it)

Currencies three year


Here we see that during those three years it was actually the dollar that was falling relative to global currencies.  In fact, during this time China’s yuan actually strengthened versus the dollar by 11%.  You don’t hear any candidates ranting about how the dollar devalued versus other currencies for years! There is a lot more to the situation in China than is discussed in the popular media, and it is something that could have a very big impact on the global economy and if affects the Fed’s decision on raising rates.



GDP Numbers Keep Getting Worse

GDP Numbers Keep Getting Worse

tumblr_m9fgrhrwCG1rdzt86o1_1280Yesterday we received the first estimates for GDP in Q2 and along with it some major revisions to the numbers for 2012-2014 and Q1 2015 went from a contraction to a bit of growth – very little bit, but still better than a contraction.  Yup, the US GDP numbers keep getting worse!

The financial press was all a twitter with this, but I’ve noticed that in mainstream, there isn’t much useful discussion. I suspect this is because most people haven’t been taught much, if any economics, and the way this material is presented is often less exciting than a symposium on medieval sewing techniques.

So let’s see what these new numbers tell us.  In the 138 years from 1870 to 2008, the US economy expanded by about an average of 3% a year.  After the revisions to GDP data from 2012-2014, we see that the U.S. economy since the financial crisis has been growing an average of 2.0% a year versus the earlier 2.3%.  The difference between 3% and 2% may not sound like much, but think of it this way:

At a 3% growth rate the economy doubles in about 24 years

At a 2% growth rate the economy doubles in about 36 years – 50% MORE time!

The chart below breaks out growth by quarter on an annualized basis.  So we can see that growth rates in the first quarter are typically the lowest, in the second quarter usually strongest, down a bit in the third and then a bit stronger to finish the year in the fourth quarter.

Looking back at data to 1990, the years 1990-2000 were the strongest on average in every quarter and we can see an overall decline in every time frame since then.  Please note I excluded the years 2007-2008 from the data below as the recession was so dire that it makes the data more difficult to interpret.  Most importantly, 2010-2014 was weaker in every quarter except the second and 2015 so far has been the worst yet!

2015-07-31 US GDP by Quarter


Next we look at Private Consumption Expenditures, which is basically the stuff households buy.

2015-07-31 PCE by Quarter


Not looking good either.  That one’s been falling since the 1990-2000 period as well.  This past quarter it looks to have given a better showing, but with all the revisions we’re seeing, I have to say I’m a bit skeptical that this one may be revised downwards later. This isn’t too surprising when you think about the fact that the percentage of the population actually employed is at multi-decade lows as are household income levels. Not many people have a lot left over at the end of the day to buy fun stuff!

As a matter of fact, wages and salaries in the U.S. rose in the second quarter at the slowest pace on record! The 0.2% in Q2 was the smallest since the data began being tracked in 1982 and follows a grim 0.7% increase in Q1.  So much for the headlines touting a healthy labor market – yet one more reason to think the Fed won’t raise rates in September.

2015-07 Q2 Wage Growth

This next chart helps to explain the lack of productivity growth as this metric includes things like the construction of new offices and factories, and the purchase of machinery, computers, and any other equipment used to assist labor in the production of goods and services. Business investment counts as gross investment, which includes purchases of machinery to replace worn-out equipment; if a firm replaces one machine with another that does not increase output, then nothing is added to the nation’s economy. You’ll notice that during the 1900s, there was considerable investment in future productive capacity.  Post dot-com investments lagged, but were increased a bit again post financial crisis.  For 2015 investment by businesses has been particularly weak.  You’ve probably seen in the headlines that an unprecedented level of publicly traded firms have chosen to use their cash to buyback shares rather than invest in future growth.  This says a lot about the perception of future opportunities!

2015-07-31 Non Residential by Quarter


Last quarter it looks like businesses sold a lot less stuff than they’d expected, as inventories rose an unusual amount.

2015-07-31 Inventory by Quarter


In the second quarter, it looks as though expectations were better established, so some of that excessive build up was able to be drawn down. This tells us that spending in the first quarter was much weaker than had been anticipated.  They were not surprised in the second quarter and were even able to draw down a little bit of that excessive built up from the first quarter.

Finally, the strong dollar is definitely having an impact on exports, with last quarter’s drop really hurting GDP.  The negative numbers mean that we are buying more stuff from the rest of the world than selling to it.

2015-07-31 Net Exports by Quarter


Now that we’ve looked at the highlights, talk about what makes an economy grow. After all, most people make their decisions at the polls based on either what or who they think is better economically or socially.

An economy is really just about 2 things: People and the stuff they produce.

An economy grows if

  • There are more people making stuff
  • The people making stuff can make more stuff
  • Or both

So how many people are making stuff today in the U.S.?

2015-07 Employment Population Ratio


What this tells us is that the portion of the population making stuff is a lot less than it used to be. That means that those who do make stuff, earning a living, have a bigger burden for support, which means there is less money left over to invest in the future.

We also have an aging population, meaning a higher percentage of the population is in or about to be in retirement, which also affects how many people can or want to work. Plus, when people are in retirement, they usually spend their savings rather than saving for the future and investing.

Like much of the rest of the developed world, US fertility rates are not quite at replacement rates, meaning that for the population to growth, we need to have immigration. Keep that in mind when you hear the politicians, (or former Reality TV characters) work themselves into a frenzy over immigration.

So how do people make more stuff?

  • Better equipment (businesses investment in the tools used)
  • Or improved skills (better at what you do)

The third chart from above showed that businesses have been investing less and less in their own future productivity.  Post financial crisis most have chosen to repurchase their own shares in order to improve their EPS (earnings-per-share) numbers rather than invest in future productive capabilities, so we won’t be gaining much ground with this.

The other option is to have improved skills, but the American skill set is a serious problem, which is evident in the employment data but rarely talked about as the reasons behind the problem can get pretty contentious. This problem is visible in the JOLTS Report (Job Openings and Labor Turnover Survey) from the BLS (Bureau of Labor Statistics) which shows that the rate of job openings is reaching a 15 year high, but the percentage of the population employed remains near 30+ year lows. There are jobs available, but companies can’t find the right fit.

2015-07-31 JOLTS Openings

According to the NFIB (National Association of Independent Businesses) June 2015 Small Business Optimism Report, 24% of all business owners reported job openings they could not fill in the current period, down 5 points, after reaching the highest level since April 2006 in February – another confirming data point.

Why is this such a problem? First, the housing bubble had entirely too many people develop skills in industries that were going to have a lot less jobs after the crisis. Think about all the construction jobs, mortgage-related and residential housing-related jobs that are not likely to return in our lifetime.

We also have a welfare system that punishes people for getting any kind of job by reducing their benefits by more than their newly earned income, dis-incentivizing those who are receiving aid from ever developing the skills necessary to become self-sufficient.

So there you have it in a not-so-small nutshell.  US growth continues to slow and those factors that could induce better growth in the future are giving us no reason to think things will improve.  Overall businesses are choosing to boost their share prices today through financial engineering (through share buybacks and the like) rather than by investing in future capabilities. This affects the productivity potential for Americans, who are already feeling pretty dour with income levels that have been stagnant for decades and a government that keeps telling them they need more and more help taking care of themselves.

Today there are 136 people receiving some sort of government benefit for every 100 people employed in the private sector.

American confidence is so low that the nation once built upon the sweat of immigrants risking it all for a better life, now sees those same immigrants as a threat. The nation founded on the principles of self-determination now looks to the government, preferring endless false promises of security over risks that were once inspiring, but are now viewed as insurmountable with rewards unobtainable.

America has lost its mojo. The entire world desperately needs her to get it back.

Greek Crisis with Neil Cavuto

On July 6th I spoke about the Greek Crisis with Neil Cavuto, a tragedy which is starting to feel like a Sisyphean set of negotiations stuck in a Groundhog day style loop. Bottom line is Greece cannot be expected to honor its debts. Any additional debt is simply a form of much needed aid, to help the country until it comes to terms with the reality of just how many promises that have been made to its citizens will need to be broken. This Greek tragedy reveals the extent to which all nations within the Eurozone may be forced to give up their sovereignty when things get really tough. The concept of the Eurozone was intended to ensure peace between nations weary of centuries of war and prosperity for all.  Prosperity is a long way off for many and peace, well the level of acrimony is becoming dangerously high.

Greece in Hotel California

Greece in Hotel California

Greece was all over the headlines again last week as the deadline for debt talks neared. The           Maastricht Treaty, which created the European Union, is starting to sound an awful like the Eagles “Hotel California,” with many in Greece left rethinking, “This could be Heaven or this could be Hell.” The treaty provided a lengthy list of requirements to enter the Eurozone “hotel,” but provides no way to exit, making all members, “…just prisoners here, of our own device.” Greece, among quite a few others, didn’t exactly meet the economic fitness requirements to obtain membership in the Eurozone. The current members were well aware that Greece was essentially doping to get the level of performance required and were all too willing to look the other way. After all, “We are programmed to receive. You can check-out any time you like, but you can never leave!”


After Greece made it onto the Eurozone team, things went quite well for a while. The global economy appeared to be performing in tip-top shape and “dealers” for Greece’s performance-enhancing creative debt securitizations were ubiquitous. Now before anyone gives into the desire to finger wag, first recall that parts of the US economy also indulged in such performance-enhancing financial supplements, (housing and now the auto sector). Frankly, pre-financial crisis the proliferation of creative debt securitization on the global stage was a lot like an excerpt from a Lance Armstrong post-2012 doping deposition, “Everyone was doing it. You had to if you didn’t want to be left in the dust.” Pssst, a version of this is still going on today, just ask any company that is juicing its EPS by using newly issued debt to fund stock buybacks such as Apple (AAPL), IBM (IBM), Monsanto (MON), CBS (CBS) and many more.


Today, global economic conditions are such that the hills have gotten a hell of a lot steeper, the pavement is full of cracks, there are powerful headwinds, rain flurries and Greece’s pre-crisis performance-enhancing suppliers are no where to be seen. Debt-doping allowed the nation to get away with all kinds of economic sins, gorging itself on regulations and labor laws akin to years of multiple-pint nightly threesomes with my two favorite partners-in-crime, Ben and Jerry, followed by many a lazy day-after spent series-binging on “Ex-wives of Rock” while sprawled on the couch munching on peanut butter Cap’n Crunch out of the box. Now with no “supplements” available, an overweight, out-of-shape and endocrine-exhausted Greece is being told to get pedaling faster and faster on a bike with bald tires, a broken gearbox and gyrating handlebars.


You would think that Germany, of all countries, would remember that driving a nation into the economic ground is never a good idea. Most economists and politicians refer to Germany’s understandable fear of hyperinflation but that overlooks the much more relevant and painful lesson from the impossible demands placed on the country post WWI, which destroyed not only its relationship with its neighbors, but also its democracy and ultimately led to WWII. How ironic that the Maastricht Treaty, which was conceived in part to prevent another war between European neighbors, is now the cause of so much inter-European strife!


Greece simply cannot pay its debt, which is pretty much its standard operating procedure. According to Kenneth Rogoff and Carmen Reinhart, “from 1800 to 2008, Greece was in default 50.6% of the time,” so angry bondholders, how about a reality check? Last week we mentioned that the nation’s economy had contracted by 26% from 2008-2013, yet it is still managing to remain current on its debt payments while running a primary surplus of about 1.5%. That would be a seriously crowd-pleasing performance on NBC’s The Biggest Loser!  The problem is its creditors want Greece to increase that surplus, meaning ride even faster up that blasted hill! Even Jillian Michaels wouldn’t push that hard.


Last Thursday Greece formally requested a 6 month extension after four weeks of brinkmanship, which was quickly returned with an “I don’t think so,” from Germany.  On Friday night a four month interim pact was reached that will once again kick the can down the road, albeit a much shorter road than after previous kerfuffles, conditional on Greece submitting a list of reforms by Monday 23rd.  Greece submitted such a list close to midnight on Monday, which the eurozone commission officials claim contains significant changes from “a more vague outline originally discussed at the weekend.”  One official reportedly said, “We are notably encouraged by the strong commitment to combat tax evasion and corruption.”


The Eurozone finance ministers will hold a conference call on Tuesday to determine the acceptability of Greece’s proposed reform plans.  Most likely an agreement will be reached.  The bailout money will continue to come and the European Central bank will continue to stand behind the nation’s banking system.  However, all the finger pointing and accusatory language has greatly damaged relationships and backed both parties into difficult corners.  The next round of talks in four months could be even more contentious.

State of the Economy

State of the Economy

The flattening of the yield curve as interest rates fall is bad news for banks that make money by borrowing short-term and lending long, yet another sector that under current conditions is a headwind for the economy. Frustratingly, the yield curve isn’t the only headwind to banks as last week, Morgan Stanley (MS) was the last of the major Wall Street firm’s to report disappointing fourth quarter earnings citing, like many others, weak trading volumes. So far J.P. Morgan Chase (JPM), Bank of America Corp. (BAC), and Citigroup Inc. (C) all failed to meet expectations while Wells Fargo (WFC) met them and only Goldman Sachs Group Inc., (GS) was able to beat.

So just how is the economy doing?

Unprecedented Weak Growth: The long-run average growth rate for the United States is 3%. Typically the economy experiences several years of above average growth rates, which helps households and businesses recover from the recession. No such V-shaped rebound has occurred and we have yet to achieve even the long-term normal rate of growth on an annual basis. Although, the U.S. economy did grow at a 4.6% rate in the second quarter and an impressive 5% rate in the third quarter of 2014, which was the highest in 11 years.

Consumer is still suffering: The income of the median U.S. household was $51,900 in 2013, according to the U.S. Census Bureau. That’s nearly unchanged from 2012, after adjusting for inflation, is 8% lower than in 2007, before the recession began and 9% below the all-time high from 1999!   A decade and a half later and household income is still down 9%.

Fewer and fewer working: As of December 2014, the labor force participation rate was 62.7%. This rate peaked in early 2000 at 67.3%, but is now at levels not seen since the late 1970s. This is harmful to the economy because it means there is a smaller portion of the population working to support their families, pay taxes that fund government spending, and support programs such as Medicare and Social Security.

2015-01-30 Gallup Biz Death BirthWeak Business Environment: For the first time in 35 years, American business deaths now outnumber business births. The U.S. now ranks 12th among developed nations in terms of business startup activity.  Yes, you read that right. According to the US Census Bureau, Countries such as Hungary, Denmark, Finland, New Zealand, Sweden, Israel and even Italy all have higher startup rates than America does. Keep that bit about Italy in mind as you read later on just how benevolent the business environment is in Italy relative to say… Rwanda. This is a very, very big deal and explains a lot of income and employment. The key driver for employment in any economy is the growth of new businesses, and without it a significant level of new jobs and material income growth is darn near impossible.

Italy and California: A Sisyphean Nightmare?

Italy and California: A Sisyphean Nightmare?

I think most people are clear that in a robust, healthy economy entrepreneurs are able to quickly turn their ideas into reality, in the process creating jobs and occasionally having an enormous impact on the way we live, as in the case of Apple, Amazon, and for the ladies out there, Spanx.  My two homes, Italy and California both appear to be hell bent on becoming Sisyphean nightmares for not only the budding entrepreneur, but even for well-established, international corporations.

Yesterday the Wall Street Journal ran a piece entitled, “Can Italy Find it’s Way Back?”  The article opens with an example of just how difficult it is to get a business going in the country.  We are told of an entrepreneur who bought a tract of land when he was 45 with the intention of building a supermarket on it.  At 88 years old, he’s finally received the necessary permits!  Seriously!?  Colleagues of mine in Italy have shared similar insane tales of government bureaucracy, their frustration mounting and gesticulations increasingly animated as the bottles of vino empty.  It is Italy after all and intense conversation requires a good bottle of champagne or a rich bottle of red.

California is moving rapidly in the same direction, making it more and more difficult for entrepreneurs to translate a passion into reality, while for existing companies the regulator and tax burden is pushing them to locate elsewhere.  The headlines for years have told of one company after another deciding to leave the state.  Carl’s Junior announced that it would not open one more restaurant in the state because it takes too long and is too expensive to get through all the red tape.  Just this week Toyota announced it is moving a facility it has had in Torrance, California for over 30 years to Texas.

This is what I like to call, for obvious reasons, Elle’s Law of Unintended Consequences whereby bureaucrats’ attempts to protect invariably end up harming the very thing their legislation intended to protect.

Entrepreneurs, being adventurous types by definition, rationally choose to go where there are fewer barriers to success.  Large corporations may find that over time, the benefits of being in a specific locale are falling further and further below the associated costs.  When bureaucrats enact legislation that creates barriers, any reasonable businessperson will have to compare the associated costs with the potential benefits of operating under such conditions.

In Italy, labor laws have become so onerous that the economy is bizarrely bifurcated into two distinct types of businesses:  very small, family-run, mom-and-pop shops and large multi-national corporations that were already large by the time they entered the Italian market.  Why is this?  The labor laws that were enacted in Italy with the intention of protecting workers have made it inconceivably risky to hire anyone, because if it doesn’t work out, firing them is almost prohibitively costly.  If you have a small shop, with just you and your partner, it is insanely risky bring on additional help, so you simply don’t grow.  The economy is deprived of the potential success you could have had if the risks of expanding weren’t so great!  Think of how many jobs wouldn’t exist today if Google had never made it out of the basement.  Large multinationals that come into the country face a slightly easier mountain as for them, the likelihood of a high portion of hires not working out is fairly low.  Due to their size, they can survive having some level of deadweight, unlike the small firms.

Unfortunately, the damage doesn’t stop here.  The culture of protecting labor in this manner comes from a history of communism and socialism that emerged as a violent reaction to the hell experienced under fascism.  This mentality applies subtle negative attributes to those who attempt to be special, to do something unique and worthy of attention.  Thus there is a disincentive for putting in the extra effort, for taking the risks associated with overachieving and given this cultural climate, overachievers aren’t compensated much more than their colleagues who do the bare minimum.  Couple this with the reality that it is really difficult to fire someone, so imagine the incentives!  Shockingly enough, human beings, like all animals, respond strongly to incentives.  If I won’t get compensated much more for working my tail off, why would I put in the effort and take the risks to be outstanding?  If I can’t be fired, the floor for the level of performance I consider reasonable is going to be a lot lower than if I know there’s a line of people just waiting to take my place!  Now while we’ve all had days when this situation would sound awful comfortable, think about what it means for the performance level of the society as a whole.  How often have you heard envious tales of Italian efficiency and professionalism?

Is it any wonder that Italy’s economy is essentially stagnant?  How can it possibly grow when entrepreneurs are so heavily hamstrung and when workers have very little incentive to do more than the bare minimum where their is neither a carrot, nor a stick.

Sadly, every time I leave Italy and return to California I am struck more by the similarities than the differences.  The U.S. would be wise to look across the pond and understand what it is that is keeping so many countries in the eurozone economically stagnant and fight like hell to move in the opposite direction.

Michael Jordan and the B-Ball Inequality

Michael Jordan and the B-Ball Inequality

MKI know that this may come as a surprise to many of my regular readers, but I have a confession to make.  Michael Jordan is a better basketball player than I.  This basketball skill spread needs to be addressed. He shouldn’t be that much better than I. It isn’t fair.  No matter how much I practice, no matter what coaching I get, no matter how hard I train in the gym and follow a strictly regimented diet, he will always be better than I.  Unfortunately for Mike, the only way to address this issue, (given that there is a clear cap to my potential at 5’8″ with a proportional wingspan and at best, only slightly better than average springs) is to handicap him.  Now wouldn’t the world be a better place if the difference in our abilities were materially reduced?

You probably get where I’m going with this.  Before anyone gets into a tizzy and starts making all kinds of accusations about how mean and uncaring I am.  There is a serious problem today with respect to income, but the problem, thus the cure, isn’t what is preached in the popular media.

The billionaires at Davos, in what can only be described as irony of epic proportions, all agreed that “Severe income inequality” is one of the top 10 global risks of greatest concern for 2014.  You can read the report here.

So let’s break this problem down.  When people talk about income inequality there is a knee-jerk assumption that by definition, income inequality is bad, which in reality is quite destructive to society as a whole.  It intuitively doesn’t make sense that as a society we should strive to have income equality where regardless of what value an individual generates, income ought to be equal.  The guy who chooses to work 3 days a week sweeping floors at the local Walmart clearly should not enjoy the same income as Steve Jobs! So some degree of income inequality is Ok, right?  But not too much?  Hmmm, ok, then how much?  Who gets to decide how much is too much and how do they make that determination?  Then how do they enforce it? How do we trust that the person we give such enormous power to won’t abuse that power?  For argument’s sake let’s say they don’t.  What about their successor?  How likely is it that we continue to have only angelic geniuses that are able to manipulate society into a Utopian income spread without ever falling prey to corruption and graft?  So far the record throughout history doesn’t lead one to believe that is it all likely.

I spend a great deal of my time in Italy, where I sadly witness first-hand the awful consequences of this sort of societal structure.  If I get paid roughly the same amount whether I work my tail off and take risks trying to improve my performance or if I put in essentially the bare minimum level of effort, why try?  I see this everywhere.  Incredibly bright people who could be innovating like crazy, coming up with all kinds of solutions that would benefit their companies and eventually their nation are beaten down by a system that provides no incentive for those who really try to do something great.  Those who are naturally innovators want desperately to try new things, take risks, but for them there is only downside risk.  They can’t improve their income level through hard work and risk taking.  They only risk annoying their colleagues and supervisors by trying to improve things.  Status quo is the rational choice.  Notice the level of innovation coming out of Italy and its rate of growth!?

I sit at dinner and hear the agony in my friend’s voices as they vent their frustrations and their anger at how a colleague who does very little gets paid roughly the same as they do.  This type of structure infects relationships because it forces people to live in a lie, a lie which is painfully obvious to everyone. The guy who barely shows up to the office and only does the bare minimum knows that the guy who’s working his tail off, (he can’t help but try as innovation is in his DNA) is angry that they both get paid roughly the same.  They both are aware of the resentments, but are powerless to do anything about it because society tells them that this is a far better way to live.  It is more fair. What the hell?  More fair that those who are willing to sacrifice and take risks are basically barred from enjoying any benefit from doing so?  My Italian friends all talk wistfully about how great it would be to work in the U.S. where at least there they can hope to get rewarded for accomplishing something great.

As for the U.S., I struggle to see where this horrific trend we keep hearing about is evidenced.  The table below is from an excellent study by Alan Reynolds of the Cato Institute.  You can read the entire report here. The data does not prove out the claims, at least in the U.S..  The bottom two quartiles and the top quartile enjoyed nearly the same increase in income on a percentage basis from 1989 – 2007.  From 2007 – 2010, the bottom quartile experienced a rise in income, while all others experienced a decline.

Now where is inequality a problem?  Barriers and disincentives to improve one’s lot in life ARE problems.  Subsidies such as those in the Affordable Care Act put the poor in a veritable poverty trap in that as they work to improve their situation, the subsidies are taken away at such a pace as to make them far better off overall working less.  That is both demeaning to the individual and immoral in that it forces others to eternally be enslaved to subsidize their fellow citizen, despite the reality that the guy being subsidized may desperately want to get out of his situation, but is faced with overwhelming incentives that keep him dependent, resentful and demoralized.

There is also something horribly wrong with a system in which savers are punished through financial repression.  The Federal Reserve, by keeping interest rates low, forces savers to go into inappropriately risky investments just to try and get a reasonable return.  Those who are already wealthy and are able to invest heavily in the stock market enjoy out-sized returns courtesy of the Fed’s QEInfinity as evidenced by the 90% correlation between the Fed’s balance sheet and the stock market starting in 2008.  Previously the correlation was essentially 0!

The free market system is far from perfect, full of all kinds of flaws, but it is infinitely better than anything else out there.  There are no angelic, omniscient bureaucrats that can manipulate our world into a more Utopian state.  Be wary of any who claim they can.

That there is a Pavlovian dog: Obamacare and mismatched incentives

That there is a Pavlovian dog: Obamacare and mismatched incentives

This one ought to go down in the annals of “You just can’t make this stuff up,” but sadly when it comes to the twisted rewards system innate in government, this is more the rule than the exception.

Recently the Daily Caller reported that the very firm responsible for the disastrous roll out of Obamacare was awarded six more contracts by the administration’s Centers for Medicare and Medicaid Services AFTER the massive flop of a launch!  Yes, you read that right… AFTER!

In the private sector, businesses and individuals are rewarded for doing more with less.  The company that is able to provide a better product that costs them less to make will be able to charge less than the competition and will sell more.  Win!

Individuals that are able to accomplish more in less time or with fewer resources tend to get promoted, get raises, bonuses, more responsibilities.  Win!  Their behavior gets rewarded, so they do more of it.  The incentive system focuses them on being more efficient, accomplishing more with less.

The company that is able to generate greater returns for investors with fewer resources is rewarded with increased investor interest, lower borrowing costs, (as they’ve shown they are less risky) and better talent shows up on their doorstep, wanting to be associated with such a successful organization, (think Google).

These normal human desires, when expressed in the public sector, get seriously wonky.  Bureaucrats publicly state with great pride that some societal ill is a serious problem and they are going to marshal their resources to address it.  Fantastic.  We’d all like to see a lot less of whatever ill is the flavor of the week.  Who could possibly be against that?  So now all these well meaning sorts get together to work on the problem.  They come up with a budget to address the issue over the next few years and off we go.

Except unexpected things happen along the way, as they always do, and we can’t quite get this addressed the way we originally planned.  The easiest solution would to just get more money.  In the private sector, getting additional funds takes a lot of work, is time consuming and in the end may be impossible.  In the public sector, just whip up some stories that pull at the heart-strings and what politician can risk appearing heartless?  More funds are granted and government spending goes up.  If the plan actually starts to work, now we have to worry, as how do we justify our salaries?  The budget we control?  Ah ha, scope creep!  Now we need to expand into yet another area that is in “crisis” and probably need a bigger budget too while we are at it.

In the private sector, more funds are awarded when you prove you are able to accomplish your goals.  In the public sector, more funds are awarded when you can’t accomplish your goal as originally planned.  In the public sector, the greater the problem, the harder it becomes to solve, the larger your budget.

The private sector pressures individuals and organizations to be efficient with the resources, (money and time) that is invested in them.  The public sector rewards ineffectiveness with bigger budgets and greater scope … because clearly now that I look at it, this problem is just so much bigger than I originally thought!

Bottom Line:  In the private sector you always have to answer to someone for what you are doing with their money, which keeps the pressure on.  In the public sector, there is no such pressure, so the reward system is no longer tied to effectiveness and taxpayers in the end pay too much for too little.