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Reflation X & Earnings Concerns

April 01, 2016

Reflation X and Earnings Concerns

Reflation X

Nope – it’s not a demographic category.  It’s not a new Tesla model.  It’s not a pharmaceutical drug that Valeant paid $3 Billion for (with debt).  It’s “Reflation X” – a newer, more advanced, monetary policy.  This is not your grandfather’s monetary policy.  This one has scientifically advanced technology.  Ooh…!...  Detect any sarcasm here?  You should, because I’m laying it on awfully thick.

Let’s get the rant out of the way first

Having Reflation X as our sleek, sophisticated monetary policy with this strong of a domestic economic backdrop (though moderate, is nonetheless expansionary), is akin to working an hourly job waiting tables, financing a Tesla (the really expensive one), with zero down, and living in a yurt in the mountains as your primary residence, having to bum places to charge it because you don’t have the electricity source yourself.  Let’s face it, this desperate, unconventional monetary policy is so commonplace around the world because of the deep-rooted, structural issues at hand.  These structural issues exist because of a severe, severe lack of leadership. 

“In a word, instability.  In two words, no leadership.”  - David Rosenberg, Chief Economist Gluskin Sheff – March 31, 2016

You can’t get the structural changes you need from monetary policy.  Fact.  But, hey – full steam ahead!  Haven’t we seen the end of this movie before…?... trying to hold rates down artificially and reflate, and reflate, and reflate?  The balloon will keep expanding and stretching and not pop right? 

"I have long held the view that monetary accommodation is the least efficient way to stimulate an economy."  Byron Wien - April 1, 2016

The heads of monetary policy groups are the extent of the leadership around the world.  People pay way more attention to what Janet Yellen says than what Barack Obama says.  Christine Lagarde of the IMF was on Bloomberg Friday, March 18’th, stating that “negative interest rates have helped a lot.”  That’s stupid.  They have not.  They have muddied the waters to an extent the modern, capitalistic experiment has never, ever seen.  You know something, they’ve prevented actual, economic depressions in parts of the world, but imagine what structural reforms would’ve done instead; or monetary and structural cooperation at least.  This instant gratification culture that is global in nature only illustrates our shallowness as humans.  Ok.  Enough of the rant. 

The future ain’t what it used to be.”  Yogi Berra

I want for the topics embedded within this Insights to relate to one of three concerns (hopefully there’s not too much rambling):

  • Rates;
  • Earnings;
  • A few wise ways to make money if you’re pre-retired / retired;

What happened at the recent Federal Reserve meeting

The Fed made three basic, overall changes in their statement – that’s about it.  Janet Yellen did make several references, however, to “upward pressure on inflation”.  Remember, in October, she didn’t say she was gonna raise the Fed Funds rate in December.  But she did.  Here are the three big changes from March meeting minutes:

  • The Fed said the economy is growing at a “moderate pace, despite” global developments;
  • They lowered the number of interest rate hikes to two from four for 2016 (but they did not change their 2017 and actually increased the number of hikes in 2018 (forecasts of course));
  • They suggested they may stop at 3.25% as their terminus rate in 2019 (I’ve been saying a lower terminus rate for many years if you’ll recall);

Talking down the dollar at the Federal Reserve

Here’s what happened a week later:

Dovish comments came from both Janet Yellen and Bill Dudley at the Economic Club of New York.  Why?  Did that much change in a week?  Nah.  She’s talking down the U.S., dollar.  And so is he. 
“The reflation theme is being underscored by the softening in the U.S., dollar – after failing recently not once, but twice…the DXY dollar index…is now faltering quite badly – at a key technical juncture right now actually, and this was clearly one of Janet Yellen’s goals.”  David Rosenberg – March 31, 2016

Did you know that “what are negative interest rates”, was one of the most searched Google searches recently in the U.S.?

When all of the experts agree and forecasts agree, something else is going to happen.”  Bob Farrell – former, Merrill Lynch Research head – really, really smart guy

There is no deflation in the U.S.  To make sure my thesis was not a forecast I fell in love with, I scheduled time with one of my smartest mentors and with a friend who works for the Bureau of Labor & Statistics in D.C., who does work on the C.P.I.  They both agreed with me.  And both of these guys are not afraid to disagree with me at all.  Suffice it to say that they are much smarter than me.  I may know the credit markets better than they do, but they know statistical economics way, way better than me.

Janet Yellen stated last week that the Fed was not “having discussions”, and was not considering negative interest rates.  I think, at this point in history, against the present economic backdrop, people should believe her when she says that.  It doesn’t mean it never happens, you just can’t make a reasonable case at all presently in the U.S.

Look – I know it’s become cute and cool to doubt everything the Fed says and to think that their projections are always going to be on the high side, but guess what?  One day, soon probably, they’re gonna guess way low vs. actual.  The monetary group in the Great White North, (Bank of Canada), has been predicting slow growth numbers and they missed it by a mile in March (meaning actual growth came in 3x what they predicted).

Low rates and low inflation will rise in the U.S.

“In the fixed-income markets, we have to deal with low rates and low inflation.  Both will rise.  That is not a real good combination.”  Dan Fuss – Vice Chairman, Loomis Sayles – at the Boston CFA Institute’s Fixed Income conference Boston – October 22, 2015

There is a lot of academic and industry pressure both for and against rate hikes.” – Dan Fuss – March 2016.

“In our view, there are more risks to inflation moving to the upside than to the downside, yet markets appear to be pricing in deflation and downside risks.  We think inflation could surprise the markets.”  Michael Hasenstab – CIO - Templeton Global Macro – February 23’rd, 2016

At least right now the charts and data don’t lead one to that conclusion at all.  It would be very unreasonable.  God help us if they ever do – that would be (as my wife says), “something else for me to worry about”.

Don’t get caught up in the chart below at this point in the interest rate cycle.

Clients used to ask me, “Where do you think the 10 year yield will be at the end of the year?”  I used to be able to tell them within a very tight tolerance.  But, at this point in the cycle, let’s not get lost in the weeds on that question…  You know why?  Because up until the July 2012 time-frame, one could make reasonable arguments for the monetary policy backdrop we had.  It was extraordinarily unconventional, but one could make sense of it.  At this point, however, the unconventional nature is extraordinary.

Be thinking instead:  How should I invest (or change how I invest), for my family and for our goals and objectives?

Knowing inflation

“A nickel ain’t worth a dime anymore.” – Yogi Berra

“The last couple of inflation ticks shows me inflation is moving higher.”  Professor Alan Blinder – Princeton University – March 17, 2016

Alan Blinder knows inflation.  Stanley Fischer (Vice Chairman of the Fed), knows inflation.  Janet Yellen knows inflation.  To repeat, she referenced “upward pressure on inflation”, several times in the March minutes.  Energy, alone, is essentially the only segment of the inflation measures that are disinflationary at present.  Bill Dudley of the NY Fed (also knows inflation), all but said they want to raise rates soon and he’s not interested in discussing negative interest rates at all.

Above is a picture of Bill Dudley – President of the Federal Reserve Bank of New York.  Nineteen years ago this month, I was reading his weekly, investment outlook commentaries when he was the Chief Economist at Goldman Sachs.  I enjoyed his perspective then, as I enjoy it now.   Please understand, Bill didn’t say the caption to the left of his face, I’m saying he and Fischer (and Yellen), are thinking that. 

I know, I know, I know – the “dot plots”, got lowered.  It’s official.  She’s made it clear for some time that she’s willing to let this engine run HOT (with inflation above the 2% target rate), for a while before she starts to apply the brake (by raising the Fed Funds rate meeting after meeting, after meeting).  Guess what?  She will at some point.  It may be that it doesn’t happen in full earnest until 2018 – who knows. 

This time it’s different” – those are very, very famous last words.

I do not believe that they are gonna take the U.S., down the same road that Mario Draghi (Eurozone), and Kuroda (Japan), have taken their populace down - at all.  I could be wrong, of course.  That is why we plan and invest with a broad range of potential outcomes.

As long as people like Bill Dudley are still thinking and leading, the capitalistic experiment that is the United States still has an incredible advantage.  We need MORE LEADERSHIP, though; not just monetary policy leadership. 

Fed controlled rates are going higher

Despite what Bill Gross (the former “Bond King”), and Jeff Gundlach (the current “Bond King”), both say to the contrary, I’d say it’s a less than 5% chance of negative interest rates in the United States.  Yellen is the same person who admitted in December 2014 that John Williams’ (San Francisco Fed), research paper concluding that the last variant of Q.E. did very little to help the economy.  It’s the law of diminishing returns.  She and her team will look to use other tools in her tool box…like raising the Fed Funds Rate soon…maybe before June!  Okay, so maybe it’ll be September...  I don’t know.  Gundlach and Gross may be good reads at certain points in the cycle, but they are utter distractions away from what’s important at this point.  They are talking up their books.  This is Fischer’s distinct area of expertise.  He talked about being “concerned” about seeing signs of inflation three weeks ago.  Yellen said in December of 2014 that “…the disinflation of the price of oil will prove to be transitory…”  That was right then and that’s still accurate now.

Now if I’m wrong, and they do the political thing instead of the wise thing, then so be it.  But these folks do not oversee a sick patient such as the Eurozone like Mario Draghi.  Wow.  That’s a mess.  Things don’t get any clearer for a while, though, with the “Brexit”, vote.  In June, the U.K., votes as to whether or not they will stay or go from the Eurozone – it’s called “Brexit”.   And of course, what’s going to happen at the Republican convention?  That’s going to get really ugly.  And will Hillary get indicted?

Give me a giant break Mr. Sensitive Investor

The economy can handle higher short-term rates.  Slightly higher, short-term interest rates are not going to derail the U.S., expansion, but will help avoid the misallocation of capital that’s inevitable if short-term rates remain artificially low.”  Brian Wesbury and Robert Stein – First Trust Advisors - March 17, 2016

In Paul Volcker’s day (and Greenspan’s, too), the Fed somewhat enjoyed wrong-footing the market. 

“The Fed doesn’t like wrong-footing the market anymore”  Rich Clarida – Pimco – March 17, 2016

Reflation X is the next, new stimulus program

The Reflation X trade is ON.  I said in October 2015 that the last time the Fed mentioned “international market concerns as much as they did in September 2015, it was August 1998, and at that point, the fed funds rate was 5.55% and the Fed actually lowered rates then even against the backdrop of 5% GDP growth and very low unemployment.”  Vickery Creek blog - October 20, 2015

I also said then that “if credit spreads don’t narrow considerably by mid-year 2016 (but I think they will by February 2016)…”, that they’d come out with some new program or some way to stabilize credit markets.  Well, Reflation X (lowering of the “dot plots”), is said program.

What I am worried about:  Earnings

Earnings Concerns

“There is a serious problem with the U.S. profit machine.” – One of my business mentors – J.P. Morgan – Atlanta – March 18, 2016

The earnings decline has, thus far, been largely due to the strength of the U.S. dollar.  Valuations are fairly expensive in the S&P 500, against a lower profit margin backdrop.  Wages are likely gonna continue to be on the rise and as you can see from Yardeni's research, we are seeing gross profit margin estimates continuing to be lowered in the U.S.  This is why looking abroad in emerging markets continues to make sense (valuations are less expensive and they've got a currency tailwind rather than a headwind).

S&P 500 Gross Profit Margin

Source:  Yardeni research – March 23, 2016


Expanded view of Net Profit Margins (historical)

January 1, 1973 thru March 31, 2015

It’s no coincidence that the only time the U.S., escaped a recession when the net profit margins of the S&P 500 contracted by 60 bps was in 1985-86.  That was the last time we saw an analogous oil price drop that compares to what we’ve just gone thru.  Remember, however, oil has retraced by 40% in a matter of weeks.  $28 to $40.  It's just that I don't know if the up-move in oil and the drop in the dollar will be enough to help us re-accelerate the profit machine in 2016.  Thus, we may see some more correction-action out of stocks in 2016.  We may not, the low interest rate backdrop may permit stocks to trade at lofty valuation levels though profits are getting squeezed.

I do not think we’ll see an economic recession but I am concerned about a profits recession (seems like we’re in one now to me).

 “Unlike some others, I don’t believe the U.S. economy will enter a recession anytime soon, and it’s not the U.S., consumer that concerns me.  What does concern me:  Corporate sector metrics have been disappointing of late…Some companies are now struggling with an increased debt load as revenues and profits begin to roll over.”  Rick Rieder – Blackrock – March 23, 2016

Next theme:

Companies issuing equity (shelf registering additional company stock to sell in the market), to pay down debt.  Remember I said the gig was up on the corporate borrowing binge?  Rosenberg’s been saying it lately, Blackrock is saying it, Goldman’s saying it.  Moody's is saying it.

There is a huge, global, debt profile.  Huge.   It is worse in some places than others – and it’s corporate, consumer, and governmental.  Auto loans and student loan debt are both a tad scary.  But traditional home mortgage debt is something all together positively different.

Let’s get some pragmatic perspective here folks – things are not all that bad (even though negative sells in the investment community right now)

Buy low and sell high

The investing public has sold more in the last several weeks since 2008.  Folks this ain’t 2008.  The pendulum of fear and greed has swung way to far into the fear zone.  July of 2015 thru January 20’th was a brutal time period as an investor.  I’ll give you that.  But remember, January 2016 was the worst January on record.

Price of oil dropped a’la 1986.  It was entirely a supply driven story and true, jobs in West Texas have been lost, and Alberta real estate is getting hammered in stark contrast to Vancouver and Toronto, but cycles occur in every sector of an economy.  I am not trying to be insensitive here, simply state clinical facts.

“The number of people who are upside down on their mortgage has plunged to 4.4 million from 12 million at the peak of the Great Recession.  61 million homeowners have at least a 25% cushion in their homes, up 10 million from a decade ago.”  Economist David Rosenberg – Gluskin Sheff - March 11, 2016

Remember me saying, if you get the U.S., consumer right, you get most of the equation right?  Well, I’d hate to be betting against the U.S., consumer at this stage of the game.

Political climate – wow (Hollywood can’t make this stuff up)

Even Napoleon had his Watergate.” – Yogi Berra

I get it – there’s WAY TOO MUCH DRAMA in the U.S., political environment presently, and Bernie and Hilary are interrupting each other on stage and so are The Donald and Cruz.  Our pastor, who wisely stays out of politics from the pulpit, stated the other day, “Is this the best we can do?”  He was referring to the group of candidates from which we have to choose.  Seems a reasonable question, doesn’t it? 

President John Q. Public, M.D.

I meet impressive business and academic people every week – and sometimes I feel like asking them…”So um, I know we don’t know each other very well, but, um, would you consider being our President?”

"I've been lonely too long, I've been lonely"

IF, we are, in fact printing 2%+ GDP in 2017, and I think we will be, and the Fed drops rates or contemplates implementing negative interest rates…that’s something to worry about.  That would be so, so, so, very stupid, indeed.  You see, even though I’m small potatoes, I was “country when country wasn’t cool”.  I saw this interest rate deflation thing on its way when my colleagues and mentors were nowhere near such a thesis.  One of my most serious (and successful), business mentors and I have a bet – he bet me that on or before my birthday (April), that the Fed Funds Rate would be 3.5% or higher and that the 10 year US Treasury would be 4.5% or higher.   Now, one could easily argue that if Japan and the Euro weren’t in negative interest rate territory, our 10 year U.S., Treasury would be around 3.5%.  I won’t argue that much against that.  But guess what?  Our 10 year is at 1.86% today.  And the Fed Funds rate is at 0.25%-0.50%.  Well we’ve got a long way to go to see that happen in a month – we’ll see....   Now I say that with humility.  I am really serious about that.  I’ve been too right for too long.  Sung another way, "I've been lonely too long, I've been lonely"  So the edge goes to him in coming years.  Seriously. 

Many in the economics community are making big, big stretches at present.  There are analogous comparisons between our economy and Japan’s and Sweden’s and there are also big stretches (stark differences at this point between our economies).

Back to ways to make money if you’re pre-retired and/or retired.

Being up the capital structure with the right, actively managed bonds, quality-dividend stocks at reasonable prices, notably domestic consumer staples, technology, select industrials, healthcare, utilities (though fairly expensive), defense stocks, bonds tied to commodities and basic materials, High-Yield bonds (spreads poised to compress sharply), select, low annual cost annuities & income-producing Farm-Land

We are super selective in municipal bonds, as forward rates forecasts get adjusted later this year, those are subject to a nice selloff which will be opportunistic when it occurs, but until then munis are very, very expensive.   Selective B+ to BB+ rated corporate bonds are absolutely super-duper attractive at present.  With no recession in the U.S., for 2016 and with spreads behaving as though we’re in the midst of a significant one, there’s tremendous value here.  

Example:  Rollover IRA money:  Tesoro Corp 5.375% to 10/1/22 priced below par sporting a 5.5% yield each year and a 5.5% Yield to Worst (if the bonds are called in 18 months).  This is very attractive to me and I believe that the bonds will carry an investment grade rating before they mature due to the CEO’s determination and stated commitment to help the company achieve that investment grade status.

A few common stocks with 4%+ dividends I believe are reasonably priced and whose dividends are safe from being cut:

ENZL – New Zealand iShares

KSS – Kohl’s Dept., Stores

GSK – Glaxo SmithKline

For the most part, I don’t like REIT’s at these levels. 

I do believe that the American Consumer as a theme has legs and room to run and especially with the positive wage inflation trend (though it took a breather recently), but the valuations of REIT's are severe.  REIT’s at present remind me of where MLP’s were valued a few years ago.  For the most part, we avoided the common stocks and instead invested in a few of the top MLP’ bonds.  I think that’s the wise way to invest in these companies now is by going up the capital structure rather than over-paying so severely for the common stock and being lured into an uber-expensive investment.  Investors pay for earnings streams and it MATTERS the price that you pay for that earnings stream.  Valuations matter.  I do believe rates will trend higher and I also believe that the we're currently in what I’ll call a “peakish” valuation point for multifamily real estate which has been red hot in recent years.  Around February 12'th, Chicago-based AMLI Residential sold an apartment property here in Atlanta to some L.A., investors at what I think was an exorbitant price (Source:  Atlanta Bus., Chronicle).  I am not predicting a real estate crash at all, it’s just that much of investment (non-place of residence), real estate is way too expensive, that’s all.  I believe that avoiding big mistakes in investing is very wise.  Paying reasonable prices makes sense to me - if they're not reasonably priced, avoid them until they are.

Why this particular fixed indexed annuity (call it a private pension)?  It's about the math...5.75% beats 4%, right?

One of the insurance companies (100+ years old and A+ rated), we work with has yet to move to a gender based actuarial table (my guess is that it’s this year or next), and this means that we can score a 5.75% distribution rate guaranteed at age 70.  This may not seem like a big deal, but you really don’t want to be distributing more than 4% from your accounts in retirement to try to make sure you don’t run out of money when you’re older.  The capital markets are telling us practicioners this.  In this case, the insurance company assumes that client longevity risk and at the 5.75% level, the consideration of “how much should I put into that?”, becomes a math question instead of a sales process.  That’s nice math.  5.75% (guaranteed), versus 4% (no guarantee).

The Next Investment Bubble:  TAMPs

The Department of Labor’s new Fiduciary rule (that goes into effect around January 2017), to reduce conflicts of interest and expansion of the term “fiduciary”, and what constitutes “investment advice” is well-intentioned.  But, I think it’s gonna ensure that during the next big, financial market downturn, (maybe years away, who knows), many investors are not just gonna get knocked around, but they will have no idea what they own as they are getting knocked around because their investment dollars are all gonna be in TAMPs.  What are TAMPs?  You might ask...  Answer:  "Product".  In landscaping, a tamping tool is a tool used to compact the soil around sod and to tamp in sod into a lawn when you’re re-sodding it.

In the financial services industry, TAMPs are Turnkey Asset Management Programs.  “Product”.  If you’ve ever worked for a wire-house investment firm for more than five years, you know that sometimes there is too much focus on "product", and not enough focus on the craft of investing.  ERISA attorneys are gonna make a lot of money, but clients and investors are going to get more and more confused.

Solution:  Buy some things like Cooper Tire bonds paying 7% a year.  Buy some stocks, and other things too, but Cooper Tires...Seriously.

Checking in nearly four years later…

In June of 2011 I wrote about seven forks in the road:

     1) Bond yields going lower and staying low for a long time;

     2) The U.S. fork in the road;

          a.  We can go down the Japan road (monetary reform response);

          b.  We can go down the Canada 1998 road (structural reform response).

     3)  Bernanke’s fork in the road;

          a.  QE 5?...?...

          b.  “Moreover, QE2 distracts us from the real microeconomic, tax, and regulatory barriers to growth [structural issues that monetary policy can’t fix].” Professor John Cochrane - University of Chicago School of Business - June 2, 2011

     4)  The investor fork in the road;

           a.  What do you do if rates go where I think they’re going?

     5)  The patience versus “wanting it now”, fork in the road;

          a.  “At one point, North American equity values lost $3 trillion and then by the first quarter close, patient investors ended up making $75 billion”. David Rosenberg – April 1, 2016 - Chief Economist, Gluskin Sheff

     6)  Debt ceiling issue may turn out to be a big deal;

     7)  Role of government going forward;

In closing, “Who are you calling old?”

Source:  UPI - March 2016

“A 65-year-old Canadian man placed his bid to claim the Guinness world record for most knuckle push-ups in a minute when he performed 91 on Tuesday at the Northern Alberta Institue of Technology’s gymnasium.  The old record was 79.”

Enjoy the last part of March Madness (NCAA college basketball), and thank you so much for your interest in how our company can help you “Get There” in retirement.

I have a great job and people like you make it possible.  Have a wonderful day with your family and friends.


Jack Parsons CTFA, AEP

President & Chief Investment Officer

Vickery Creek Capital Mgmt., LLC