Executive Summary
1. Bonds not risky? Think again. At the present juncture, equities are not the only risk assets. As we stand near the end of a 30-year credit cycle, bond yields are poised to rise. We don’t know how fast — that depends on many factors affecting the global economy — but the writing is on the wall. Bond math means that the longer the maturity, the greater the risk to investors’ capital posed by rising yields. Although some government bonds may be excellent credit risks, they can still be very unattractive duration risks; holders of long-dated bonds will be fighting against a receding tide. We continue to suggest that investors avoid bonds, or, if they must hold them, that they shorten the duration of their portfolio to reduce the capital risks posed by rising rates.
2. Workers are getting less eager to leave their jobs for greener pastures — and that’s a problem for growth. Nationwide, a great deal of data shows that American workers have been getting less willing to uproot themselves in search of better job prospects. This lower labor-force fluidity and dynamism is troubling, because it is a drag on productivity and economic growth. Part of it is due to the decline in the formation of new, innovative, and hungry firms to offer promising jobs that entice workers to leave for greener pastures — and that decline, we believe, is closely related to the growth of burdensome regulation on small businesses. It looks like some of decline in labor-force dynamism is also due to a decline in “social capital” — old social networks have frayed, leaving people less trusting, and less supported by networks to connect them to job opportunities and help them in job transitions. Whatever the causes, this decline in labor-force dynamism is a challenge facing the U.S. economy — and one that will be an incremental pressure on economic growth.
3. Trump is a typical real estate developer, and aggressive tax avoidance is par for the course in real estate. The real estate industry has benefitted from decades of lobbying and enjoys tax treatments that offer deep advantages to aggressive developers. We think the tax loopholes and favorable status enjoyed by real estate may start to come under closer scrutiny. Stay tuned.
4. Market summary. Exports are slow in the developing world, but consumption and inflation remain in growth mode. In the developed world, growth is slow, and political upheaval is afoot. Among emerging markets, we would focus on those countries with the possibility of increased consumer demand. In this category India comes to mind. Also, we prefer those whose currencies and primary export products have been deeply depreciated, for example, Brazil and Russia.
In the U.S. stock market, valuations are not low, but demand for stocks persists, and the market is displaying a favorable response to a rate increase in June or July. The industry groups which show the most promise are technology, gold, and oil. The path of the U.S. dollar has a lot to do with the outlook for stocks. If the dollar goes sideways or down from here, we would not be surprised to see a breakout in the S&P 500 over the next few months; a rise in the dollar could create a correction of 4 to 8% sometime in the next few months.
Safety In Bonds? We Disagree
The word is out from the Fed: rates are going up. We all knew this, but the unfounded recession fears that briefly possessed market participants earlier this year made us forget it for a little while. However, as we noted last week, signals from the Fed have been strong.
Yes, the situation the Fed faces is difficult, not to say perilous. Yes, there are complicating aspects to the global macro backdrop, such as the need for the People’s Bank of China to maintain the stability of the Chinese yuan, which is linked to the U.S. dollar. However, when we survey the broad picture, we can see clearly that we are at the end of a more-than-30-year period of declining yields. And when we listen to the message being sent out by the Fed, it is clear that they are preparing us for higher rates.
Rates have been extraordinarily low for an extraordinarily long time. The ZIRP policy of the Fed and the NIRP (negative interest rate) policy of other central banks have, in turn, put extraordinary pressure on investors, both individual and institutional, who need reliable yields for income or to fund liabilities.
Sure Looks Like the End of a Cycle to Us
Source: Federal Reserve Bank of St Louis
These investors have been pushed into higher-risk assets. Typically we think of higher allocations, perhaps to dividend-paying stocks, as examples of such assets. But investors have also “reached for yield” by reaching far out into the future of bond maturities. This “reach for duration” is also a push into areas of higher risk, and this is the case even with supposedly “rock-solid” investments such as government bonds.
Bond mathematics means that the further out in the future a bond’s maturity date, the more rapidly the capital value of the bond declines as interest rates rise (bond prices and yields are inversely related). So although the governments of Germany and the United States, for example, are extremely good credit risks (they are extremely unlikely to default) that does not affect the grave duration risk posed by their longer-dated securities.
Data Source: The Wall Street Journal
The chart above shows how the value of bonds declines in response to rising interest rates. A 3% rise in 30-year yields — from about 2.5% to about 5.5% — would cause a 43% decline in the value of a 30-year bond. We don’t believe that such a rise is imminent or would happen quickly; this is more a mathematical demonstration of how bonds react to rising yields. We anticipate a 1% or greater rise in yields over the next two years.
Perhaps investors will comfort themselves by thinking that they will be holding bonds to maturity — but who can say what events in their life might require some or all of a bond portfolio to be liquidated long before such a distant date?
French, German, and Japanese bonds with 40- and 50-year maturities are being sold to investors… to us, this is little different from legalized theft. Perhaps some holders of 30-year German bunds, who saw their value drop 25% in one two-month period last year, might agree.
Don’t Lose the Forest for the Trees
Once again, we note: when we step back and look at the long view, we are at the end of a cycle. The 30-year bull market in bonds driven by that cycle is coming to an end. We believe reaching for yield by buying long-dated bonds now, is buying at an historic peak. Buying any asset at such a peak is asking for losses that will likely never be made whole.
We do not believe that low rates are the harbinger of a coming global depression; we believe they have been engineered by the world’s central banks in an attempt to fight the lingering deflationary impulse of the financial crisis, support asset prices, and spur economic growth. (For a variety of reasons, including over-indebtedness and excessive regulation, they have not succeeded as well in this effort as they might have.) There is a lower bound to rates; we have reached it; and the rise from that bottom is inevitable, although we do not know how rapid it may be.
Perhaps the troubles faced by the global economy — the over-indebtedness and over-regulation that we mentioned above, as well as demographic challenges in some countries — may mean a prolonged period of tepid growth and low rates. Even so, holders of long-dated bonds will be fighting against a receding tide as they watch the value of their bond portfolios.
This is not to say that further extraordinary measures will not be tried by the world’s central banks before all is said and done; we suspect they are not even close to having brought out their really heavy artillery. But the message is clear: safe bonds are not safe, if “safety” includes any thought of preserving your capital.
Investment implications: Equities are not the only risk assets. As we stand near the end of a 30-year credit cycle, bond yields are poised to rise. We don’t know how fast — that depends on many factors affecting the global economy — but the writing is on the wall. Bond math means that the longer the maturity, the greater the risk to investors’ capital posed by rising yields. Although some government bonds may be excellent credit risks, they can still be very unattractive duration risks; holders of long-dated bonds will be fighting against a receding tide. We continue to suggest that investors avoid bonds, or, if they must hold them, that they shorten the duration of their portfolio to reduce the capital risks posed by rising rates. If you need income, consider stocks with strong and growing dividends over bonds.
Workers Stay Put, and Pinch U.S. Growth
A recent piece in The New York Times alerted us to an interesting paper published by the Brookings Institution and authored by three members of the Federal Reserve Governors’ Board and an economist from Notre Dame. The paper examines a trend noted by a number of different economists in recent years: declining dynamism and fluidity in the U.S. labor market.
What does this mean? In a nutshell, the footloose propensity of Americans to uproot in search of better work opportunities is seeing a long-term decline. The paper’s authors look at a set of trends examined separately in previous research, such as the rate of job-to-job transitions; the formation of new firms; hires and separations; and geographic movements across labor markets. They put this previous research together and construct a composite index of “labor market fluidity,” which they find has decreased as much as 15 percent since the trends began to emerge in the late 1970s or early 1980s.
The authors note: “The implications of these trends for the performance of the aggregate economy could be substantial… declines in labor market fluidity could signal a rise in the costs of making labor market transitions, which are likely to have negative effects on aggregate productivity and economic performance.
Basically, less mobility and fluidity in the labor force means a labor market that is less efficient at getting workers in places where they will be the most productive.”
Workers Willing To Move Make An Economy Grow
Where are the Hungry New Firms Offering Jobs?
Back in January, we wrote that declining trend GDP growth in the U.S. was very likely connected to a decline in business dynamism. Fewer new, hungry, innovative firms are being founded, and that’s been a significant drag on both job creation and economic growth, since such firms are a prime engine of the economy.
So we have fewer energetic entrepreneurs willing to go out on a limb to start job- and growth-generating new firms; and fewer workers across the board who are willing to pack up the U-Haul and head to greener pastures, preferring the security of home the chance of bettering their prospects.
Both of these trends have been in place for decades, possibly accelerating in the last ten years. What is going on with the U.S. economy? Are these the roots of “secular stagnation” — or are they symptoms of deeper forces at work?
Behind Declining Business Dynamism: It’s the Regulation
As we observed in January, declining business dynamism is pretty clearly related to higher regulatory burdens put on new startups. We quoted University of Maryland economist Ryan Decker:
“If an economy experiences an increase in adjustment costs for job destruction (for example, due to increased regulation), then not only will there be a decline in job destruction but also a decline in job creation (including a decline in startups) and ultimately in both productivity and welfare… The same logic applies to changes in regulations or institutions that affect the costs of starting up or expanding a business, including regulations that raise the costs associated with expanding beyond some threshold of size… If the more sluggish pace of adjustment is due to increasingly burdensome regulation and institutions, this has potentially large adverse consequences for intermediate and long-run U.S. job and productivity growth.”
Trust in Others is Falling
That’s business dynamism — what about the decline in labor force dynamism?
The authors of the Brookings paper look at a broad range of possible explanations and try to weed them out by comparing data from different states. They eliminate many possibilities. For example, there are some demographic factors at work: the workforce is aging, and older workers tend to move around less. But by their analysis, that accounts for only a small part of the effect they have observed.
They single out a handful of factors that seem to be influential enough to warrant further research. One of these — surprise, surprise — is falling business dynamism itself. The slowing of job creation and destruction, driven by the slowing birth of new, small, innovative firms, is apparently dampening workers’ willingness to go out on a limb and change jobs. When the opportunities to find work with such a dynamic firm are less, workers are more apt to stay put.
Another factor they note is still more troublesome: falling “social capital.” There is a very long-running survey of American citizens that has been done for more than 40 years, the “General Social Survey,” or GSS. Consistently, survey participants have been asked whether they agree or disagree with the statement, “Most people can be trusted.” The results show a consistent decline over the survey period — and states that answer this question more negatively are likely to have lower-than-average labor force dynamism. In short, if you trust people less, you’re less willing to take the risk of jumping into a new job.
This makes sense to us on a number of levels. Besides feeling that there are job opportunities which offer a real chance of betterment, a worker needs a social network. That network functions to provide support for a transition — as well as connections to new opportunities. As the robustness of such social networks has fallen, people have become less trusting, and less willing and able to take life risks in the absence of old supports. The steady decline in trust — that is, in social capital — suggests to us that the virtual world of “friendship” on social networks such as Facebook [NASDAQ: FB] is not a real substitute for the old, “real-world” networks in which social capital was built up.
Clearly, a good deal more research is going to be done to study falling labor force dynamism and try to see what’s behind it, and what policy responses could be possible. Equally clearly, it is a phenomenon being driven both by secular, cultural forces — such as declining social capital — and by specific trends in government policy — such as the burden of regulation that is suppressing the birth of dynamic new startup firms that create promising new jobs to entice workers to move. For now, we note it as a challenge facing the U.S. economy — and one that, if unaddressed, will be an incremental pressure on growth.
Source: Brookings Institution
Investment implications: Nationwide, a great deal of data shows that American workers have been getting less willing to uproot themselves in search of better job prospects. This lower labor-force fluidity and dynamism is troubling, because it is a drag on productivity and economic growth. Part of it is due to the decline in the formation of new, innovative, and hungry firms to offer promising jobs that entice workers to leave for greener pastures — and that decline, we believe, is closely related to the growth of burdensome regulation on small businesses. It looks like some of the decline in labor-force dynamism is also due to a decline in “social capital” — old social networks have frayed, leaving people less trusting, and less supported by networks to connect them to job opportunities and help them in job transitions. If these forces persist in suppressing the dynamism of the U.S. business ecosystem and the dynamism of the U.S. labor market, they will prove to be a long-term drag on U.S. economic growth. Investors should be aware of such trends, since they will shape the larger environment in which market cycles are embedded.
Real Estate Tax Breaks under the Microscope — Brought to Light by Trump’s Tax Returns
Whatever else can be said about Donald Trump, and whatever uncertainties surround his claimed net worth, it’s certain that he’s the wealthiest candidate of all those in the 2016 race. Many Americans polled believe he should release his tax returns, even before the completion of an IRS audit. They may suspect that the returns will show that he paid very little income tax at all, in spite of what we may presume is his large income.
Even if this proves to be true when his tax returns are eventually released — as he has promised they will be — it will not be very significant. We suspect his effective tax rate to be very low. We do not suspect this because we believe Mr Trump has a predilection for tax dodging. We suspect it because of his chosen business: real estate.
There are many reasons why Donald Trump, a real estate mogul, is wealthier by far than Ben Carson, a neurosurgeon — the latter being a career that is not for those who are challenged in brainpower or work ethic, to be sure.
Real estate benefits from two significant advantages: the application of leverage, and its scalability. Leverage is inherent in the business; when you buy, you borrow, perhaps aggressively, and thus can amass a large portfolio of properties with cash that would buy you a much smaller portfolio of other assets. (Of course, this leverage also increases risk, hence Mr Trump’s businesses’ track record of an occasional tactical bankruptcy, which is also entirely typical for the real estate development business.)
Scalability simply means that when you own a big portfolio of properties, you hire other people to run them… Almost as if Ben Carson could multiply himself, lever up, and run 100 different neurosurgery practices at once. Mr Trump is famous for being “hands on”… But he is also famous for delegating to trusted team members.
However, the decisive advantage of real estate is perhaps not its financial and operational superiority. It is the favorable tax structure that surrounds it.
This is why we will not be shocked to find that Mr Trump has paid little tax on his substantial income. The real scandal will not be that Mr Trump has done this. We are confident that he will be found to simply be taking legal and aggressive advantage of a tax code that benefits thousands of other successful real estate businesspeople. If there is a scandal, it is that real estate receives such favorable tretment — when perhaps there is little compelling economic reason for the tax code to favor it so heavily.
Financial Times journalist Gillian Tett recently quoted an anonymous “real estate titan” as saying, “If you are a developer who is paying tax, you have to be pretty dumb.”
She goes on to point out many of the outlandish loopholes that permit real estate income and profits to be protected from the tax man: creative classification of properties to exploit benefits intended for agriculture; aggressive depreciation; boundary-pushing appraisal methods; deferred taxes under the “1031 clause.” The real estate lobby is powerful, and has been establishing and strengthening these special treatments for decades.
For several years, the real estate sector as a whole has ranked among the most profitable in the U.S., while it has ranked in the bottom in its contribution to tax revenue.
Will that change? Probably not. But the controversy about Mr Trump’s tax returns will serve a good purpose if it opens a conversation about why the sector receives such favorable treatment — and whether that treatment is good for the economy.
Investment implications: The real estate industry has benefitted from decades of lobbying and enjoys tax treatments that offer deep advantages to aggressive developers. We think the tax loopholes and favorable status enjoyed by real estate may start to come under closer scrutiny. Stay tuned.
Market Summary
Global Macro Trends Remain Subdued
Exports are slow in the developing world, but consumption and inflation remain in growth mode. In the developed world, growth is slow, and political upheaval is afoot.
Developed Nations ex-U.S.
Europe may be attractive as a result of the realization that Britain is unlikely to leave the European Union. Japan still looks unattractive to us.
Emerging Markets
In our opinion, some emerging markets should be avoided, while some are attractive.
Those emerging markets which manufacture goods are having a hard time exporting. We would focus on those countries with the possibility of increased consumer demand. In this category India comes to mind; also, we believe, those whose currencies and primary export products have been deeply depreciated. For example, Brazil and Russia — in both cases their currencies have been battered and could recover as the demand for minerals and food in Brazil’s case, and oil and grains in Russia’s. We believe that mineral prices should recover as world inflation returns with some vigor over the next year or two.
U.S. Stocks
In the U.S. stock market, prices are not low, but demand for stocks persists, and the market is displaying a favorable response to a rate increase in June or July. In spite of the projected increase, the trend of the market is positive. The industry groups which show the most promise are technology, gold, and oil, with some people arguing that banking can do better as interest rates gradually rise from this point on for the next few quarters.
Why are gold oil and technology expected to do better than the U.S. market as a whole? Oil and gold are due to continued reversion higher after a brutal few years of decline. Technology may outperform because many tech companies have a visible path forward for continued growth.
As we have repeatedly said, the path of the U.S. dollar has a lot to do with the outlook for stocks. If the dollar goes sideways or down from here, we would not be surprised to see a breakout in the S&P 500 over the next few months; a rise in the dollar could create a correction of 4 to 8% sometime in the next few months.
Our overview of the outlook for the U.S. is positive, and we would focus our holdings on the above-mentioned industries. Current price declines in gold are creating a buying opportunity; a decline in oil to the mid $40s would also create an opportunity. Any decline in the classic growth techs of 5 or 10% creates an opportunity.
Thanks for listening; we welcome your calls and questions.
