Wednesday, December 21, 2016

2016's Biggest Hits and Misses?

Ted Carmichael recently posted a year-end review on his Global Macro blog, The Biggest Global Macro Misses of 2016 (added emphasis is mine):
As the year comes to a close, it is time to review how the macro consensus forecasts for 2016 that were made a year ago fared. Each December, I compile consensus economic and financial market forecasts for the year ahead. When the year comes to a close, I take a look back at the prognostications and compare them with what we know actually occurred. I do this because markets generally do a good job of pricing in consensus views, but then move -- sometimes dramatically -- when the consensus is surprised and a different outcome transpires. When we look back, with 20/20 hindsight, we can see what the surprises were and interpret the market movements the surprises generated.

Of course, the biggest forecast misses of 2016 were not in the economic indicators and financial markets, but in the political arena. The consensus views of political pollsters were that Brits would vote to remain in the European Union and that Hilary Clinton would win the US Presidential election. Instead, the actual outcomes were Brexit and President-elect Donald Trump. These political misses have had and will continue to have significant economic and financial market consequences. In the context of these political surprises, it's not only interesting to look back at the notable global macro misses and the biggest forecast errors of the past year, it also helps us to understand 2016 investment returns.

Real GDP

Since the Great Financial Crisis, forecasters have tended to be over-optimistic in their real GDP forecasts. That was true again in 2016. Average real GDP growth for the twelve countries we monitor is now expected to be 3.0% compared with a consensus forecast of 3.5%. In the twelve economies, real GDP growth fell short of forecasters' expectations in eleven and exceeded expectations in just one. The weighted mean absolute forecast error for 2016 was 0.51 percentage points, down a bit from the 2015 error, but still sizeable relative to the actual growth rate (click on image).



Based on current estimates, 2016 real GDP growth for the US fell short of the December 2015 consensus by 0.8 percentage points, a bigger downside miss than in 2015 (-0.5) or 2014 (-0.1). The biggest downside misses for 2016 were for Russia (-1.6 pct pts), Brazil (-1.4), India (-1.1) and Mexico (-0.8). China's real GDP beat forecasts by 0.1. Canadian forecasters missed by -0.5 pct pts, a little less than the average miss. On balance, it was a sixth consecutive year of global growth trailing expectations.

CPI Inflation

Inflation forecasts for 2016 were also, once again, too high. Average inflation for the twelve countries is now expected to be 2.2% compared with a consensus forecast of 2.6%. Nine of the twelve economies are on track for lower inflation than forecast, while inflation was higher than expected in three countries. The weighted mean absolute forecast error for 2016 for the 12 countries was 0.33 percentage points, a much lower average miss than in the previous two years.


The biggest downside misses on inflation were in Russia (-0.9 pct pts), India (-0.7), Australia (-0.7), and Korea (-0.6). The biggest upside miss on inflation was in China (+0.5). UK and US inflation were also slightly higher than forecast (click on image).

Policy Rates

Economists' forecasts of central bank policy rates for the end of 2016 once again anticipated too much tightening by developed market (DM) central banks, but for emerging market (EM) central banks, it was a more mixed picture (click on image).


In the DM, the Fed failed to tighten as much as forecasters expected. The biggest DM policy rate miss was in the UK, where the Bank of England had been expected to tighten, but instead cut the policy rate after the Brexit vote. The ECB, the Bank of Japan, the Reserve Bank of Australia and the Bank of Canada also unexpectedly cut their policy rates. In the EM, the picture was more mixed. In China, where inflation was higher than expected, the PBoC did not deliver expected easing. In Brazil and India, where inflation fell more than expected, the central banks eased more than expected. In Russia where inflation also fell, Russia's central bank eased less than expected. In Mexico, where the central bank was expected to tighten, the tightening was much greater than expected after the Trump election victory caused the Mexican Peso to fall sharply.

10-year Bond Yields

In nine of the twelve economies, 10-year bond yield forecasts made one year ago were too high. Weaker than expected growth and inflation combined with major central banks’ decisions to delay tightening or to ease further pulled 10-year yields down in most countries compared with forecasts of rising yields made a year ago (click on image).


In five of the six DM economies that we track, 10-year bond yields surprised strategists to the downside. The weighted average DM forecast error was -0.33 percentage points. The biggest misses were in the UK (-0.88 pct. pt.), Eurozone (proxied by Germany, -0.49), Japan (-0.39), and Canada (-0.34). In the EM, bond yields were lower than forecast where inflation fell more than expected, in India and Russia. The biggest miss in the bond market was in Brazil, where inflation fell much more than expected and reduced political uncertainty saw the 10-year bond yield almost 4 percentage points lower than forecast. Bond yields were higher than expected in China, where inflation was higher than expected, and much higher than expected in Mexico where political risk increased with Trump's election.

Exchange Rates

Currency moves against the US dollar were quite mixed in 2016. The weighted mean absolute forecast error for the 11 currencies versus the USD was 5.4% versus the forecast made a year ago, a smaller error than in the previous two years (click on image).


The USD was expected to strengthen because many forecasters believed the Fed would tighten two or three times in 2016. Once again the Fed found various reasons to delay, with only one tightening occurring on December 14. If everything else had been as expected, the Fed's delay would have tended to weaken the USD. But everything else was not as expected. Most other DM central banks eased policy by more than expected and the ECB and the BoJ implemented negative policy rates. In addition, oil and other commodity prices rallied causing commodity currencies like RUB, AUD, and CAD to strengthen more than forecast.

The biggest FX forecast misses were casualties of the big political consensus misses on Brexit and the US presidential election. The GBP was almost 18 percent weaker than forecast a year ago, while the MXN was 17% weaker than forecast after President-elect Trump promised to “tear up” NAFTA. The biggest miss on the upside was for BRL (+27%) where President Dilma Rousseff’s impeachment received a standing ovation from the currency market.

North American Stock Markets

A year ago, equity strategists were optimistic that North American stock markets would turn in a decent, if unspectacular, performance in 2016. However, despite a year characterized by weaker-than-expected real GDP growth and inflation and by political surprises that were widely-perceived as negative, North American equity performance exceeded expectations by a substantial margin. I could only compile consensus equity market forecasts for the US and Canada. News outlets gather such year-end forecasts from high profile US strategists and Canadian bank-owned dealers. As shown below, those forecasts called for 2016 gains of 5.5% for the S&P500 and 10.0% for the S&PTSX Composite (click on image).


As of December 14, 2016, the S&P500, was up 13.6% year-to-date (not including dividends) for an error of +8.1 percentage points. The S&PTSX300, rebounding from a sizeable decline in 2015, was up 17.1% for an error of +7.1 percentage points.

Globally, actual stock market performance was less impressive than that of North American markets, with two notable exceptions, Russia and Brazil (click on image).


Stocks performed poorly the Eurozone and Japan, where deflation worries caused central banks to adopt negative interest rates. China saw the biggest equity loss (-11.3%) of the markets we monitor as slowing growth and fears of currency devaluation fueled large capital outflows. In the US, where the Fed delayed monetary policy tightening, and in the UK, where the BoE unexpectedly eased, equities posted solid gains. In Canada, and Australia, where central banks eased more than expected, equities were also boosted by a recovery in commodity prices. Russia and Brazil posted huge equity market gains, rebounding from large currency and equity market declines in 2015.

Investment Implications

While the 2016 global macro forecast misses were similar in direction, they were generally smaller in magnitude relative to those of 2015 and the investment implications were different. Global nominal GDP growth was once again weaker than expected, reflecting downside forecast errors on both real GDP growth and inflation. In 2016, most central banks either tightened less than expected or eased more than expected, but continued political uncertainty, weaker than expected nominal GDP growth and the strong US dollar held the US equity market in check through early November prior to the US election.

Although many strategists argued that a Trump victory would be bad for US equities, because of uncertainty over his policies in general and his protectionist views in particular, the opposite reaction followed the election. US equities outperformed by a wide margin. US small caps and financials led the gains on Trump’s promise of reduced regulation, corporate tax reform and a steeper yield curve. UK equities rallied in the aftermath of Brexit, boosted by the increased competitiveness generated by the sharp depreciation of the GBP. In Japan and the Eurozone, where governments failed to enact structural reforms and where central banks experimented with negative policy interest rates, equities badly underperformed. In Canada, Australia, Brazil, Mexico and Russia, rebounding commodity prices supported equity markets. In China, one of the few countries where reported nominal GDP growth was stronger than expected (despite on-the-ground reports of economic slowdown), equity prices fell as capital fled the country.

Similar to the previous two years, downside misses on growth and inflation and central bank ease in most countries provided solid, positive returns on DM government bonds in the first 10 months of 2016. However, after the Trump election victory, as markets priced in stronger US growth and inflation and bigger US budget deficits, government bonds across the globe gave back much of their gains and significantly underperformed equities in all regions.

Smaller divergences in growth, inflation and central bank responses, along with firming crude oil and other commodity prices, led to smaller currency forecast errors. For Canadian investors, the stronger than expected 5% appreciation of CAD against the USD meant that returns on investments in both equities and government bonds denominated in US dollars were reduced if the USD currency exposure was left unhedged. The biggest losers for Canadian investors were Eurozone and Chinese equities, as well as most DM sovereign bonds, especially if unhedged.

As 2017 economic and financial market forecasts are rolled out, it is worth reflecting that such forecasts form a very uncertain basis for year-ahead investment strategies. The high hopes (and fears) that markets are currently pricing in for a Trump presidency will surely be recalibrated against actual policy changes and foreign governments’ policy reactions.

The lengthy period in recent years of outperformance by portfolios for Canadian investors that are globally diversified, risk-balanced and currency unhedged may have run its course. Global asset performance may be shifting toward a more US-centric growth profile that could also benefit Canada if Trump’s protectionist tendencies are implemented only against China, Mexico and any other countries a Trump-led America deems to unfair traders. While such an outcome is possible, 2017 will undoubtedly once again see some large consensus forecast misses, as new surprises arise. As an era of rising asset values supercharged by ever-easier unconventional monetary policies seems to be coming to an end, the scope for new surprises to cause dramatic market moves has perhaps never been higher.
First, let me thank Ted for posting this great global macro comment which covers the main macro themes of the year. He really did a wonderful job and I love reading his year-end review to understand the bigger picture.

I myself think back at the year as one where things got off to a very rocky start and then all of a sudden, as if someone turned off the deflation switch and  turned on the reflation switch, it was good times, global growth and inflation coming back, and all this even before Trump was elected into office in early November.

Still, there are critically important macro trends which will define markets going into 2017. I recently discussed the developing US dollar crisis which I think will have a profound effect on the global economy and financial markets next year. The crisis won't be in US dollars, of course, but in its effect on emerging markets dollar-denominated debt and importing global deflation into the United States.

I too am surprised the Trump rally wasn't sold earlier but his victory unleashed those animal spirits, prompting Ray Dalio to praise him and his administration as he worries we're headed back to the future.

All I know is the global pension storm rages on and we better all heed Denmark's dire warning as the Dow 20,000 won't save pensions.

What else? I'm pretty sure Trump won't trump the bond market and that US long bonds will rally like crazy in the new year, especially if another crisis hits Asia or Europe.

What are some of the biggest global macro misses I saw this year? Soros was wrong to warn of another 2008 crisis early in the year and he was wrong on China, for now. The great crash of 2016 never transpired but investors are feeling increasingly uneasy about risk assets levitating higher, quietly making record highs as the world economy still faces deep structural and deflationary headwinds.

The deflation tsunami I warned of in my 2016 outlook was averted, for now, but I have a feeling a much bigger financial crisis is brewing down the road and that expansionary fiscal policy in the US and elsewhere is too little, too late.

Another huge global macro miss was Morgan Stanley's call for the greenback to tumble in early August. Not only did the greenback not tumble, it soared and continues rising and could wreak havoc on the global economy next year.

As far as bonds, it looks like Jamie Dimon was right back in April to claim the Treasury rally will turn into a rout and the bond bubble clowns got some vindication in the last quarter of the year (still, backup in yields is just another big bond buying opportunity).

Dimon also made a killing this year, buying 500,000 shares of JP Morgan (JPM) at the bottom (the "Dimon bottom") and riding the wave up (my advice to him is to dump those shares in Q1 and retire before deflation strikes America). The Oracle of Omaha also did well buying Goldman shares (GS) at their bottom (I'd be dumping those too).

As far as stocks, beware of animal spirits. I continue to recommend to be long the greenback and would take profits or even short emerging market (EEM), Chinese (FXI),  Metal & Mining (XME) and Energy (XLE) shares on any strength in Q1.

In a deflationary, ZIRP & NIRP world, I still maintain nominal bonds (TLT), not gold, will remain the ultimate diversifier and Financials (XLF) will struggle for a long time if a debt deflation cycle hits the world (ultra low or negative rates for years aren't good for financials). The latest run-up in financials should be sold and I would ignore strategists telling you big banks are going to be the big winners next year.

As far as Ultilities (XLU), REITs (IYR), Consumer Staples (XLP), and other dividend plays (DVY), they got hit with the backup in yields but also because they ran up too much as everyone chased yield (might be a good buy in Q1 but be careful, high dividend doesn't mean less risk!).

It is worth noting, however, high yield credit (HYG) continues to perform well which bodes well for risk assets. As long as high yield bonds are rallying, it's hard to get very bearish on markets.

And despite huge volatility, I remain long biotech shares (IBB and equally weighted XBI) and keep finding gems in this sector by examining closely the holdings of top biotech funds. My call to go long biotech before the elections was also one of my best calls all year from a swing trading perspective and I still see more upside (and volatility) in biotech next year.

As far as individual stocks, you can easily look at what rallied this year by clicking here but this list only gives you part of the story as there were some huge moves from the bottom in stocks like Cliff Resources (CLF), Teck Resources (TECK) and US Steel (X). And the best stock of the year was Celator Pharmaceuticals (CPXX) which went from $1 to over $30 (a thirty bagger) before it got bought out by Jazz Pharmaceuticals (JAZZ).

The other great stock trades of the year were on the short side, like shorting Valeant Pharmaceuticals (VRX), something Jim Chanos did well, and more recently, shorting Dryships (DRYS) when it went from $5 to over $100 on a high frequency speculative orgy which lasted about a week before it died down again and shares plunged back down below $5.

There are a lot more big moves in stocks but I can't cover everything here. All I can tell you is 2017 will be different from 2016 and I'm looking forward to getting over window-dressing season so we can start the new year.

On that note, I'm off until Tuesday January 10th where I will reconvene and think about whether it's worth continuing this blog. I'm tired, really tired, and I think it's a lot of effort for too little money and I'm ready to move on and do something else. I have to think a lot of things through over the holidays.

But the number one thing I'm looking forward to now is spending time with my girlfriend, family and friends and just sleeping in and waking up late. I get the deepest sleep of the year this time of year and I love it, it's by far the most important thing for my health.

On that note, let me wish you all a Merry Christmas, Happy Hanukkah, Happy Holidays and a very Happy and Healthy New Year. Enjoy your holidays with your loved ones, eat well and get lots of sleep!

I would also like to thank the individuals who support my work and show their support through donations and subscriptions to my blog. I spend three, four or five to six hours a day every day writing these comments and thinking about interesting topics to cover and trust me, it's a lot of work and it's nice to see people who appreciate it and who take the time to contribute via PayPal under my picture.

Below, in an exclusive interview, Wall Street’s number one ranked strategist, Cornerstone Macro’s François Trahan makes a stunning call. The bull market is almost over and it’s time to get defensive.

I agree, this rally could continue in Q1 but it could also evaporate very quickly and reverse course. Be very careful with all the bulls out there touting their rosy scenarios. Very, very careful.

Tuesday, December 20, 2016

US Pensions Looking North For Inspiration?

Gillian Tan of Bloomberg View reports, Pension Funds Should Look North For Inspiration:
When it comes to at least one type of investing, U.S. pension funds should take a (maple) leaf out of their Canadian counterparts' playbook.

Despite being among the largest private equity investors, U.S. pension funds such as the California Public Employees' Retirement System and the California State Teachers' Retirement System have been slow to transition from a hands-off approach to one that involves actively participating in select deals, a feature known in the industry as direct investing.
A More Direct Approach

The benefits of direct investing are lower (or sometimes no) fees and the potential to enhance returns, and that makes it an attractive proposition. But so far, U.S. pension funds have been pretty content as passive investors for the most part, writing checks in exchange for indirect ownership of a roster of companies but without outsize exposure to any (click on image).

State of the States

State pension funds are comfortable writing checks to private equity firms but could bolster their returns by investing directly in some of those firms' deals (click on image).


Not so Canadian funds. A quick glance at the list of the private equity investors -- commonly referred to as limited partners -- that have been either participating in deals alongside funds managed by firms such as KKR & Co. or doing deals on their own since 2006 shows that these funds have had a resounding head start over those in the U.S.

Notably Absent

Large U.S. pension funds are nowhere to be seen among private equity fund investors that participate directly in deals, a strategy used to amplify their returns (click on image).


Canadian funds' willingness to pursue direct investing is driven in part by tax considerations: they can avoid most U.S. levies thanks to a tax treaty between the two North American nations, while they are exempt from taxes in their own homeland. But U.S. pensions would still benefit from better returns, so it's curious that they haven't been more active in this area.

There's plenty of opportunity for direct investing. Private equity firms are generally willing to let their most sophisticated investors bet on specific deals in order to solidify the relationship (which can hasten the raising of future funds). It also gives them access to additional capital.

Rattling the Can

Private equity firms recognize that offering fund investors the right to participate directly in their deals bolsters their general fundraising efforts (click on image),


The latter point has been a crucial ingredient that has enabled larger transactions and filled the gap caused by the death of the so-called "club" deals (those involving a team of private equity firms) since the crisis.

Seal the Deal

U.S. private equity deals which are partly funded by direct investments from so-called limited partners reached their highest combined total since 2007 (click on image).


There are some added complications. Because some of the deals involve heated auction processes, limited partners must do their own diligence and deliver a verdict fairly quickly. That could prove tricky for U.S. pension funds, which would need to hire a handful of qualified executives and may find it tough to match the compensation offered elsewhere in the industry. Still, the potential for greater investment gains may make it worth the effort -- even for funds like Calpers that are reportedly considering lowering their overall return targets.

With 2017 around the corner, one of the resolutions of chief investment officers at U.S. pension funds should be to evolve their approach to private equity investing. They've got retired teachers, public servants and other beneficiaries to think about.
This article basically talks about how Canada's large pensions leverage off their relationships with private equity general partners to co-invest alongside them on bigger deals.

It even cites one recent example in the footnotes where the  Caisse de dépôt et placement du Québec, or CDPQ, in September announced a $500 million investment in Sedgwick Claims Management Services Inc., joining existing shareholders KKR and Stone Point Capital LLC.

Let me cut to the chase and explain all this. An equity co-investment (or co-investment) is a minority investment, made directly into an operating company, alongside a financial sponsor or other private equity investor, in a leveraged buyout, recapitalization or growth capital transaction.

Unlike infrastructure where they invest almost exclusively directly, in private equity, Canada's top pensions invest in funds and co-invest alongside them to lower fees (typically pay no fees on large co-investments which they get access to once invested in funds where they do pay fees). In order to do this properly, they need to hire qualified people who can analyze a co-investment quickly and have minimum turnaround time.

Unlike US pensions, Canada's large pensions are able to attract, hire and retain very qualified candidates for positions that require a special skill set because they got the governance and compensation right. This is why they engage in a lot more co-investments than US pension funds which focus exclusively on fund investments, paying comparatively more in fees.

[Note: You can read an older (November 2015) Prequin Special Report on the Outlook For Private Equity Co-Investments here.]

On top of this, some of Canada's large pensions are increasingly going direct in private equity, foregoing any fees whatsoever to PE funds. The article above talks about Ontario Teachers. In a recent comment of mine looking at whether size matters for PE fund performance, I brought up what OMERS is doing:
In Canada, there is a big push by pensions to go direct in private equity, foregoing funds altogether. Dasha Afanasieva of Reuters reports, Canada’s OMERS private equity arm makes first European sale:
Ontario’s municipal workers pension fund has sold a majority stake in marine-services company V.Group to buyout firm Advent International in the first sale by the Canadian fund’s private equity arm in Europe.

Pension funds and other institutional investors are a growing force in direct private investment as they seek to bypass investing in traditional buyout funds and boost returns against a backdrop of low global interest rates.

As part of the shift to more direct investment, the Ontario Municipal Employees Retirement System (OMERS) set up a private equity team (OPE) and now has about $10-billion invested.

It started a London operation in 2009 and two years later it bought V.Group, which manages more than 1,000 vessels and employs more than 3,000 people, from Exponent Private Equity for an enterprise value of $520-million (U.S.).

Mark Redman, global head of private equity at OMERS Private Markets, said the V.Group sale was its fourth successful exit worldwide this year and vindicated the fund’s strategy. He said no more private equity sales were in the works for now.

“I am delighted that we have demonstrated ultimate proof of concept with this exit and am confident the global team shall continue to generate the long-term, stable returns necessary to meet the OMERS pension promise,” he said.

OMERS, which has about $80-billion (Canadian) of assets under management, still allocates some $2-billion Canadian dollars through private equity funds, but OPE expects this to decline further as it focuses more on direct investments.

OPE declined to disclose how much Advent paid for 51 per cent of V.Group. OPE will remain a minority investor.

OPE targets investments in companies with enterprise values of $200-million to $1.5-billion with a geographical focus is on Canada, the United States and Europe, with a particular emphasis on Britain.

As pension funds increasingly focus on direct private investments, traditional private equity houses are in turn setting up funds which hold onto companies for longer and target potentially lower returns.

Bankers say this broad trend in the private equity industry has led to higher valuations as the fundraising pool has grown bigger than ever.

Advent has a $13-billion (U.S.) fund for equity investments outside Latin America of between $100-million and $1-billion.

The sale announced on Monday followed bolt on acquisitions of Bibby Ship Management and Selandia Ship Management Group by V.Group.

Goldman Sachs acted as financial advisers to the shipping services company; Weil acted as legal counsel and EY as financial diligence advisers.
Now, a couple of comments. While I welcome OPE's success in going direct, OMERS still needs to invest in private equity funds. And some of Canada's largest pensions, like CPPIB, will never go direct in private equity because they don't feel like they can compete with top funds in this space (they will invest and co-invest with top PE funds but never go purely direct on their own).

[Note: It might help if OPE reports the IRR of their direct operations, net of all expenses relative to the IRR of their fund investments, net of all fees so their stakeholders can understand the pros and cons of going direct in private equity. Here you need to look at a long period.]

There is a lot of misinformation when it comes to Canadian pensions 'going direct' in private equity. Yes, they have a much longer investment horizon than traditional funds which is a competitive advantage, but PE funds are adapting and going longer too and in the end, it will be very hard, if not impossible, for any Canadian pension to compete with top PE funds.

I am not saying there aren't qualified people doing wonderful work investing directly in PE at Canada's large pensions, but the fact is it will be hard for them to match the performance of top PE funds, even after fees and expenses are taken into account.

Who knows, maybe OPE will prove me wrong, but this is a tough environment for private equity and I'm not sure going direct in this asset class is a wise long-term strategy (unlike infrastructure, where most of Canada's large pensions are investing directly).
When it comes to private equity, Mark Wiseman once uttered this to me in a private meeting: "Unlike infrastructure where we invest directly, in private equity it will always be a mixture of fund investments and co-investments." When I asked him why, he bluntly stated: "Because I can't afford to hire David Bonderman. If I could afford to, I would, but I can't."

Keep in mind these are treacherous times for private equity and investors are increasingly scrutinizing any misalignment of interests, but when it comes to the king deal makers, there is no way Canada's top ten pensions are going to compete with the Blackstones, Carlyles and KKRs of this world who will get the first phone call when a nice juicy private deal becomes available.

Again, this is not to say that Canada's large pensions don't have experienced and very qualified private equity professionals working for them but let's be honest, Jane Rowe of Ontario Teachers won't get a call before Steve Schwarzman of Blackstone on a major deal (it just won't happen).

Still, despite this, Canada's large pensions are engaging in more direct private equity deals, sourcing them on their own, and using their competitive advantages (like much longer investment horizon) to make money on these direct deals. They don't always turn out right but when they do, they give even the big PE funds a run for their money.

And yes, US pensions need to do a lot more co-investments to lower fees but to do this properly, they need to hire qualified PE professionals and their compensation system doesn't allow them to do so.

Below, Julie Riewe, Co-Chief of the Asset Management Unit in the Securities and Exchange Commission’s Enforcement Division, sits down with Bloomberg BNA’s Rob Tricchinelli to talk SEC priorities in the private equity industry. You can watch this interview here.

Also, CNBC's David Faber speaks with Scott Sperling, Thomas H. Lee Partners co-president, at the No Labels conference about how President-elect Donald Trump's policies could affect private equity and jobs.

Lastly, regulation has been a "drag on the economy" and the "system needs to be debugged," Blackstone's Stephen Schwarzman recently said on CNBC's "Closing Bell."

Like I stated in my last comment on Ray Dalio's Back to the Future, inequality will skyrocket under a Trump administration and private equity and hedge fund kingpins will profit the most as they look to decrease regulations and increase their profits.


Monday, December 19, 2016

Ray Dalio's Back To The Future?

Ray Dalio, Chairman and CIO at Bridgewater Associates, wrote a comment on LinkedIn, Reflections on the Trump Presidency, One Month after the Election (added emphasis is mine):
Now that we’re a month past the election and most of the cabinet posts have been filled, it is increasingly obvious that we are about to experience a profound, president-led ideological shift that will have a big impact on both the US and the world. This will not just be a shift in government policy, but also a shift in how government policy is pursued. Trump is a deal maker who negotiates hard, and doesn’t mind getting banged around or banging others around. Similarly, the people he chose are bold and hell-bent on playing hardball to make big changes happen in economics and in foreign policy (as well as other areas such as education, environmental policies, etc.). They also have different temperaments and different views that will have to be resolved.

Regarding economics, if you haven’t read Ayn Rand lately, I suggest that you do as her books pretty well capture the mindset. This new administration hates weak, unproductive, socialist people and policies, and it admires strong, can-do, profit makers. It wants to, and probably will, shift the environment from one that makes profit makers villains with limited power to one that makes them heroes with significant power. The shift from the past administration to this administration will probably be even more significant than the 1979-82 shift from the socialists to the capitalists in the UK, US, and Germany when Margaret Thatcher, Ronald Reagan, and Helmut Kohl came to power. To understand that ideological shift you also might read Thatcher’s “The Downing Street Years.” Or, you might reflect on China’s political/economic shift as marked by moving from “protecting the iron rice bowl” to believing that “it’s glorious to be rich.”

This particular shift by the Trump administration could have a much bigger impact on the US economy than one would calculate on the basis of changes in tax and spending policies alone because it could ignite animal spirits and attract productive capital. Regarding igniting animal spirits, if this administration can spark a virtuous cycle in which people can make money, the move out of cash (that pays them virtually nothing) to risk-on investments could be huge. Regarding attracting capital, Trump’s policies can also have a big impact because businessmen and investors move very quickly away from inhospitable environments to hospitable environments. Remember how quickly money left and came back to places like Spain and Argentina? A pro-business US with its rule of law, political stability, property rights protections, and (soon to be) favorable corporate taxes offers a uniquely attractive environment for those who make money and/or have money. These policies will also have shocking negative impacts on certain sectors.

Regarding foreign policy, we should expect the Trump administration to be comparably aggressive. Notably, even before assuming the presidency, Trump is questioning the one-China policy which is a shocking move. Policies pertaining to Iran, Mexico, and most other countries will probably also be aggressive.

The question is whether this administration will be a) aggressive and thoughtful or b) aggressive and reckless. The interactions between Trump, his heavy-weight advisors, and them with each other will likely determine the answer to this question. For example, on the foreign policy front, what Trump, Flynn, Tillerson, and Mattis (and others) are individually and collectively like will probably determine how much the new administration’s policies will be a) aggressive and thoughtful versus b) aggressive and reckless. We are pretty sure that it won’t take long to find out.

In the next section we look at some of the new appointees via some statistics to characterize what they’re like. Most notably, many of the people entering the new administration have held serious responsibilities that required pragmatism and sound judgment, with a notable skew toward businessmen.

Perspective on the Ideology and Experience of the New Trump Administration


We can get a rough sense of the experience of the new Trump administration by adding up the years major appointees have spent in relevant leadership positions. The table below compares the executive/government experience of the Trump administration’s top eight officials* to previous administrations, counting elected positions, government roles with major administrative responsibilities, or time as C-suite corporate executives or equivalent at mid-size or large companies. Trump’s administration stands out for having by far the most business experience and a bit lower than average government experience (lower compared to recent presidents, and in line with Carter and Reagan). But the cumulative years of executive/government experience of his appointees are second-highest. Obviously, this is a very simple, imprecise measure, and there will be gray zones in exactly how you classify people, but it is indicative.

Below we show some rough quantitative measures of the ideological shift to the right we’re likely to see under Trump and the Republican Congress. First, we look at the economic ideology of the incoming US Congress. Trump’s views may differ in some important ways from the Congressional Republicans, but he’ll need Congressional support for many of his policies and he’s picking many of his nominees from the heart of the Republican Party. As the chart below shows, the Republican members of Congress have shifted significantly to the right on economic issues since Reagan; Democratic congressmen have shifted a bit to the left. The measure below is one-dimensional and not precise, but it captures the flavor of the shift. The measure was commissioned by a National Science Foundation grant and is meant to capture economic views with a focus on government intervention on the economy. They looked at each congressman’s voting record, compared it to a measure of what an archetypical liberal or conservative congressman would have done, and rated each member of Congress on a scale of -1 to 1 (with -1 corresponding to an archetypical liberal and +1 corresponding to an archetypical conservative).


When we look more specifically at the ideology of Trump’s cabinet nominees, we see the same shift to the right on economic issues. Below we compare the ideology of Trump’s cabinet nominees to those of prior administrations using the same methodology as described above for the cabinet members who have been in the legislature. By this measure, Trump’s administration is the most conservative in recent American history, but only slightly more conservative than the average Republican congressman. Keep in mind that we are only including members of the new administration who have voting records (which is a very small group of people so far).


While the Trump administration appears very right-leaning by the measures above, it’s worth keeping in mind that Trump’s stated ideology differs from traditional Republicans in a number of ways, most notably on issues related to free trade and protectionism. In addition, a number of key members of his team—such as Steven Mnuchin, Rex Tillerson, and Wilbur Ross—don’t have voting records and may not subscribe to the same brand of conservatism as many Republican congressmen. There’s a degree of difference in ideology and a level of uncertainty that these measures don’t convey.

Comparing the Trump and Reagan Administrations

The above was a very rough quantitative look at Trump’s administration. To draw out some more nuances, below we zoom in on Trump’s particular appointees and compare them to those of the Reagan administration. Trump is still filling in his appointments, so the picture is still emerging and our observations are based on his key appointments so far.

Looking closer, a few observations are worth noting. First, the overall quality of government experience in the Trump administration looks to be a bit less than Reagan’s, while the Trump team’s strong business experience stands out (in particular, the amount of business experience among top cabinet nominees). Even though Reagan’s administration had somewhat fewer years of government experience, the typical quality of that experience was somewhat higher, with more people who had served in senior government positions. Reagan himself had more political experience than Trump does, having served as the governor of California for eight years prior to taking office, and he also had people with significant past government experience in top posts (such as his VP, George HW Bush). By contrast, Trump’s appointees bring lots of high quality business leadership experience from roles that required pragmatism and judgment. Rex Tillerson’s time as head of a global oil company is a good example of high-level international business experience with clear relevance to his role as Secretary of State (to some extent reminiscent of Reagan’s second Secretary of State, George Shultz, who had a mix of past government experience and international business experience as the president of the construction firm Bechtel). Steven Mnuchin and Wilbur Ross have serious business credentials as well, not to mention Trump’s own experience. It’s also of note that Trump has leaned heavily on appointees with military experience to compensate for his lack of foreign policy experience (appointing three generals for Defense, National Security Advisor, and Homeland Security), while Reagan compensated for his weakness in that area with appointees from both military and civilian government backgrounds (Bush had been CIA head and UN ambassador, and Reagan’s first Secretary of State, Alexander Haig, was Supreme Allied Commander of NATO forces during the Cold War). Also, Trump has seemed less willing to make appointments from among his opponents than Reagan was (Reagan’s Chief of Staff had chaired opposing campaigns, and his Vice President had run against him).

By and large, deal-maker businessmen will be running the government. Their boldness will almost certainly make the next four years incredibly interesting and will keep us all on our toes.
I read Ray Dalio's comment on Monday morning and replied the following on LinkedIn (click on image):


If you can't read it, here it is again:
Come on Ray, wait at least four years, then judge his and his administration's track record. By the way, inequality soared under Reagan, it will skyrocket under Trump. So, forget Ayn Rand, go back to the future and read John Kenneth Galbraith who once noted: '"If you feed enough oats to the horse, some will pass through to feed the sparrows" (referring to trickle down economics). Elites of the world unite and rejoice!
It's also worth noting that Bridgewater President David McCormick is rumored to be at the tippy top of President-elect Trump’s list to become the Deputy Secretary of Defense, an appointment which I'm sure sits well with Ray Dalio and might have influenced this glowing review of Trump's top picks.

Interestingly, the last guy in Washington who espoused Ayn Rand's philosophy was Alan Greenspan. Things didn't turn out quite like the Maestro thought when he let unfettered markets do their thing. He testified at an Oversight Committee back in 2008 where he basically admitted he failed to see the biggest financial crisis in history because he allowed his ideology to trump common sense (no pun intended). 

Now we have Ray Dalio and the folks at Bridgewater touting Trump's appointments, paying particular attention to their "serious business experience". The last world leader with "serious business experience" was Italy's Sylvio Berlusconi, the 'bunga bunga' clown who arguably did more harm to that country than all other leaders combined.

True, Trump isn't Berlusconi, even though they both exhibit similar pathological narcissistic traits. And to be fair, President-elect Trump and his administration have some interesting policies which can help at the margin (like spending on infrastructure), but I do know one thing, inequality will skyrocket under Trump's administration and that worries me because it reinforces the deflationary headwinds I keep warning my readers of.   

All weekend, I was reading and watching right-wing and left-wing nonsense that left me speechless. Whether it's Paul Craig Roberts warning that a "CIA-led Coup Against American Democracy Is Unfolding Before Our Eyes" or ABC This Week devoting an entire show on the Russian hackers conspiracy, I'm left dumbfounded at just how stupid some Americans are to buy this nonsense.

First, a note to Paul Craig Roberts. Excuse my English but Trump is the elites. They may not like his brash style and temperament but they sure as hell love his economic policies and despite the rhetoric, the financial and military elite will profit under his administration and that's all they really care about.

Second, if I have to hear CNN commentator Van Jones lecturing me and millions of others on how cyber war is real war, I'm going to literally puke. Note to Van Jones and the ignorant masses, successive American governments have been engaging in cyber war for as long as cyber space has existed and when it comes to hacking, the NSA and several other American agencies (like the FBI and CIA) can annihilate Russia and wreak havoc on its economy with a few key strokes (don't believe nonsense that the US has fallen dangerously behind Russia in cyber warfare capabilities).

My own conspiracy theory is that the Obama administration was well aware of Russia hacking the DNC and didn't intervene not because President Obama didn't want to interfere in the elections, but because deep down, he can't stand the Clintons and didn't want to throw Hillary a life jacket (as far-fetched as it sounds, I don't think he shed a tear watching her drown in her scandals).

All this to say when I watch CNN, Fox News, or read the New York Times and Washington Post, I put on my 'BS' detector glasses and basically filter out all disinformation coming my way, because behind the headlines lies the true story of power and corruption (and that goes for right-wing conservative Republicans and left-wing limousine liberal Democrats with their hypocritical nonsense)

I'm getting very cynical in my old age which is probably why I'm relating more and more to the late George Carlin who captured the essence of American politics brilliantly in his American Dream skit. "It's called the American dream because you have to be asleep to believe it."

On a more serious note, Ray Dalio thinks we are headed back to the future and that the 1930s hold clues to what lies ahead for the economy:
This is not a normal business cycle; monetary policy will be a lot less effective in the future; investment returns will be very low. These have come to be widely held views, but there is little understanding as to why they are true. I have a simple template for looking at how the economic machine works that helps shine some light. It has three parts.

First, there are three main forces that drive all economies: 1) productivity; 2) the short-term debt cycle, or business cycle, running every five to ten years; and 3) the long-term debt cycle, over 50 to 75 years. Most people don’t adequately understand the long-term debt cycle because it comes along so infrequently. But this is the most important force behind what is happening now.

Second, there are three equilibriums that markets gravitate towards: 1) debt growth has to be in line with the income growth that services those debts; 2) economic operating rates and inflation rates can’t be too high or too low for long; and 3) the projected returns of equities have to be above those of bonds, which in turn have to be above those of cash by appropriate risk premiums. Without such risk premiums the transmission mechanisms of capital won’t work and the economy will grind to a halt. In the years ahead, the capital markets’ transmission mechanism will work more poorly than in the past, as interest rates can’t be lowered and risk premiums of other investments are low. Most people have never experienced this before and don’t understand how this will cause low returns, more debt monetisation and a “pushing on a string” situation for monetary policy.

Third, there are two levers that policy-makers can use to bring about these equilibriums: 1) monetary policy, and 2) fiscal policy. With monetary policy becoming relatively impotent, it’s important for these two to be co-ordinated. Yet the current state of political fragmentation around the world makes effective co-ordination hard to imagine.

The long and the short of it


Although circumstances like these have not existed in our lifetimes, they have taken place numerous times in recorded history. During such periods, central banks need to monetise debt, as they have been doing, and conditions become increasingly risky.

What does this template tell us about the future? By and large, productivity growth is slow, business cycles are near their mid-points and long-term debt cycles are approaching the end of their pushing-on-a-string phases. There is only so much one can squeeze out of a long-term debt cycle before monetary policy becomes ineffective, and most countries are approaching that point. Japan is closest, Europe is a step behind it, the United States is a step or two behind Europe and China a few steps behind America.

For most economies, cyclical influences are close to being in equilibrium and debt growth rates are manageable. In contrast to 2007, when my template signalled that we were in a bubble and a debt crisis was ahead, I don’t now see such an abrupt crisis in the immediate future. Instead, I see the beginnings of a longer-term, gradually intensifying financial squeeze. This will be brought about by both income growth and investment returns being low and insufficient to fund large debt-service, pension and health-care liabilities. Monetary and fiscal policies won’t be of much help.

As time passes, how the money flows between asset classes will get more interesting. At current rates of central-bank debt buying, they will soon hit their own constraints, which they will probably have to abandon to continue monetising. That will mean buying riskier assets, which will push prices of these assets higher and future returns lower.

The bond market is risky now and will get more so. Rarely do investors encounter 
a market that is so clearly overvalued and also so close to its clearly defined limits, as there is a limit to how low negative bond yields can go. Bonds will become a very bad deal as ­central banks try to push more money into them, and savers will decide to keep that money elsewhere.

Right now, while a number of riskier assets look like good value compared with bonds and cash, they are not cheap given their risks. They all have low returns with typical volatility, and as people buy them, their reward-to-risk ratio will worsen. This will create a growing risk that savers will seek to escape financial assets and shift to gold and similar non-monetary preserves of wealth, especially as social and political ­tensions intensify.

For those interested in studying analogous periods, I recommend looking at 1935-45, after the 1929-32 stockmarket and economic crashes, and following the great quantitative easings that caused stock prices and economic activity to rebound and led to “pushing on a string” in 1935. That was the last time that the global configuration of fund­amentals was broadly similar to what it is today.
I'm not going to argue each and every point Ray makes but suffice it to say that given my deflation outlook which is reinforced by a developing US dollar crisis which will reverberate around the world, I disagree with Ray, Bob Prince and the folks at Bridgewater when it comes to US bonds.

And the only "Back to the Future" I see ahead is trickle down economic nonsense which will exacerbate rising inequality and deflationary headwinds for many more years.

Importantly, President-elect Trump and his group of billionaires surrounding him won't trump the bond market and if they're not careful, they will create a deflationary storm unlike anything else we've ever experienced which will set the global economy back decades (David Rosenberg gets it).

How's that for some Monday morning Christmas cheer? -:)

Below, I embedded various clips associated with this comment. As always, feel free to reach me at LKolivakis@gmail.com if you have something to add or just want to criticize me and tell me what a fool I am and shouldn't question Ray Dalio, the economic machine and American democracy hypocrisy.




Friday, December 16, 2016

The 2017 Dollar Crisis?

Chelsey Dulaney of the Wall Street Journal reports, Dollar Surges as U.S. Prepares for Higher Rates:
A dollar surge that began after the U.S. election has accelerated with this week’s Federal Reserve interest-rate increase, pointing to a possible reckoning in coming months for economies around the globe.

The WSJ Dollar Index of the dollar’s value against 16 major trading partners hit a 14-year high Thursday, reflecting expectations that the Fed will pick up the pace of rate increases next year as the U.S. economy gains momentum.

A sharp increase in the dollar stands to have long-lived economic consequences, potentially hampering a U.S. earnings recovery and making the trillions in dollar-denominated debt around the world more expensive to pay back.

But the dollar’s renaissance this year already is rippling through global financial markets, sending currencies from Japan and India to Turkey and Brazil tumbling and presenting companies, consumers and governments in those nations with a list of increasingly difficult choices.

In China, fears that a rising dollar will destabilize trading in the yuan has swept financial markets, sending the Chinese currency to its lowest against the dollar in over eight years and raising concerns that outflows could increase. Such an outcome could signal further economic weakness ahead at a time when Chinese growth is slowing and could ripple through currency markets to push other emerging foreign-exchange rates down.

“China is going to become a big concern,” said Paresh Upadhyaya, a portfolio manager at Pioneer Investments. “They’re already trying to manage capital outflows, and this is going to put more pressure on the country.”

Japan’s yen fell to 118.18 against the dollar, its seventh decline in 10 days. That represents about an 11% retreat since Donald Trump was elected president Nov. 8.

The weaker yen will make Japan’s exports more competitive and could boost growth, and Tokyo’s Nikkei 225 stock index has risen for eight consecutive days. But a falling currency will test policy makers at the Bank of Japan who in recent months have sought to anchor the yield of the 10-year Japanese government bond at zero.

Now, though, prices on those bonds have been under pressure amid a global selloff on hopes of an improved economic outlook.

Japan’s central bank is considering raising its assessment of the nation’s economy for the first time since May 2015 as the weaker yen boosts its exports, The Wall Street Journal reported this week.

The euro also edged closer to parity against the dollar, at $1.0415, its lowest level against the dollar since 2003.

A few central banks have already acted to support their faltering currencies. Mexico on Thursday raised interest rates by a half-percentage point—twice what many analysts had expected—as it seeks to curb inflation driven by a weaker peso. Central banks in Indonesia and Malaysia have also moved to prop up their currencies since the U.S. election.

Some analysts said that the Chinese yuan’s decline could revive some fears about competitive devaluations among developing nations, especially if Mr. Trump’s protectionist trade proposals spark a trade war.

In the U.S., bond prices tumbled on Thursday, sending the yield on the 10-year U.S. Treasury note to 2.58%, its highest since September 2014. Prices drop when yields rise. The decline reflected in part a reaction to the Federal Reserve’s indication Wednesday that it expected interest rates to rise faster than previously projected.

The Dow Jones Industrial Average rose 59.71 points, or 0.3%, to 19852.24, coming within 50 points of its first intraday trade above 20000 before cooling off in afternoon trading. Financial shares led Thursday’s gains, extending a sharp rally that began in the hours after Mr. Trump’s election. Since then, the S&P Financials index of banks, insurers and others is up 18%.

A stronger dollar isn’t all bad. It increases the purchasing power of U.S. consumers by making foreign travel and imported products cheaper. And U.S. stock markets have been taking the dollar’s strength in stride with recent all-time highs, despite the threat that the strong dollar will curb a nascent recovery in corporate profits.

In Europe, where growth has also been sluggish, the weaker euro could help support exports and inflation. Morgan Stanley thinks the euro will fall to parity with the dollar around the middle of 2017.

But most vulnerable to the effect are emerging markets. More than $17 billion in foreign investment has departed emerging-market stocks and bonds since the U.S. election, according to the Institute of International Finance.

Investors worry that Mr. Trump’s proposed protectionist trade policies could hurt exports from developing economies. Emerging-market debt also looks less attractive when U.S. and other developed-market bond yields are rising.

Debt in these countries has risen in recent years, as many governments and companies took advantage of the global hunt for yield and issued more debt both at home and abroad. Developing countries have more than $200 billion in dollar-denominated bonds and loans due next year, IIF data show.
Last Friday, I discussed my macro views and stock market views in a lengthy comment going over the unleashing of animal spirits. In that comment, I started off by going over my macro views:
I view the world as a constant struggle between inflation and deflation. If policymakers fail to deliver the right amount of monetary and fiscal stimulus, then deflation will eventually take over and that will clobber risk assets (stocks, corporate bonds, commodities and commodity currencies) but benefit good old US nominal long bonds (TLT), the ultimate diversifier in a deflationary environment.

Where has deflation been most prevalent in the world? Japan, Euroland and China. Notice the article above states that the US dollar index (DXY) is rising and now stands at a five-year high relative to a basket of currencies (click on image):



As you can see, the US dollar has been on a tear since early August when I told my readers to ignore Morgan Stanley's call that the greenback is set to tumble (my best call of the year and their worst one ever). It is basically hitting a multi-year high.

So what does the US dollar rally mean and why should you care? Well, the US dollar has rallied mostly versus the euro (close to parity which is another call I made back in March) and the yen.

The decline in the yen and euro is actually good for Euroland and Japan because it means European and Japanese exporters will benefit from the devaluation in their respective currency. This is why Japanese and European stock markets have rallied sharply. It's also good news for fighting deflation in these regions because a decline in their currency increases import prices there, raising inflation expectations in these regions.

Unfortunately, raising inflation expectations via a declining currency is not the good type of inflation. It's a temporary reprieve to a long-term structural problem. The good type of inflation comes from rising wages when the labor force is expanding because that increases aggregate demand and shows a strong, vibrant economy.

Now, what does the rising US dollar mean for the United States? It's the opposite effect, meaning it will hurt US exporters and lower inflation expectations in the US. In effect, the US is taking on the rest of the world's deflation demons trying to stave off a global deflationary calamity.

Will it work? That is the multi-trillion dollar question which is why I began talking about global deflation and currencies because as Bridgewater's Bob Prince noted in his presentation in Montreal, with interest rates at historic lows and central banks pushing on a string, currency volatility will pick up. I would add this is where the epic battle versus global deflation will take place.

But again, currency devaluation is only a temporary reprieve to a long-term structural problem fueling global deflation. The six structural factors that I keep referring to are:
  1. High structural unemployment in the developed world (too many people are chronically unemployed and we risk seeing a lost generation if trend continues)
  2. Rising and unsustainable inequality (negatively impacts aggregate demand)
  3. Aging demographics, especially in Europe and Japan (older people get, the less they spend, especially if they succumb to pension poverty)
  4. The global pension crisis (shift from DB to DC pensions leads to more pension poverty and exacerbates rising inequality which is deflationary)
  5. High and unsustainable debt (governments with high debt are constrained by how much they can borrow and spend)
  6. Massive technological disruptions (Amazon, Priceline, and robots taking over everything!)
These six structural factors are why I'm convinced that global deflation is gaining steam and why we have yet to see the secular lows in global and US bond yields.

But now we have a newly elected US president who has promised a lot of things, including spending one trillion in infrastructure and cutting personal and corporate tax rates.

What will this fiscal thrust do? Hopefully it will help create more jobs and fight some of the chronic problems plaguing the US labor market. But if you really think about it, this too is a temporary boost to economic activity because once it's all said and done, those infrastructure jobs will disappear and US debt will explode up, which effectively means higher debt servicing costs (especially if interest rates keep rising), and less money to stimulate the economy via fiscal policy down the road.

This is why some people think Donald Trump's new Treasury secretary, Steven Mnuchin, is just kicking the can down the road if he goes ahead and issues Treasurys with longer maturities in an effort to cushion the US economy from rising interest rates.

The above is a condensed version of the major macro themes that are on my mind, but there is another one that bothers me a lot, what does a rising US dollar and Trump's presidency mean for emerging markets (EEM)? As the US dollar rises, it will hurt commodity exporting emerging markets and raise dollar-denominated debt but some think if handled correctly, emerging markets can thrive under President Trump.

That all remains to be seen and my biggest fear is that if a Trump administration follows through with protectionist policies which will antagonize others to retaliate with their own trade tariffs, it will cost American jobs and wreak havoc in emerging markets. And another crisis in Asia will basically cement global deflation for a very long time.

This is the global macro backdrop every investor needs to bear in mind. So far markets don't seem to care. Trump's victory has unleashed animal spirits in the stock market and boosted consumer confidence to a 12-year high.

It's all good, reflation is back, deflation is dead, Trump will make sure of it. Unfortunately, it's not that easy and as I keep warning you, President Trump could feel the wrath of the bond market (just like Bill Clinton and others have done in the past) and if his administration isn't careful, it will make a series of policy errors that will spell the decline of the American economy for a very long time.
At this writing, the US dollar index (DXY) is hovering around 103 and is showing no signs of losing steam any time soon.

There are a lot of moving parts to the global economy but the key things to remember are the following:
  • The surging US dollar continues to gain steam after the US elections, especially relative to the yen and euro. 
  • The weakening yen and euro will temporarily boost exports which is one reason why their stock markets are going well. 
  • The weakening yen and euro will also temporarily raise inflation expectations in these regions as import prices rise, leading to a temporary rise in inflation expectations. This is one factor driving the yields of their sovereign bonds higher and bond prices there lower.
  • In effect, the surging greenback (US dollar) is relieving deflationary tension in these developed markets, allowing them to try to escape a long bout of deflation. The problem is that this is a temporary (cyclical) reprieve based on currency fluctuations, not a long-term structural one based on economic fundamentals which would raise wages and bolster aggregate demand for a long time.
  • The surging greenback however means the US is importing deflation from the rest of the world and this will lower US inflation expectations going forward via lower import prices, which is bullish for US bonds.
  • But the surging US dollar is causing all sorts of problems in China which has its currency pegged to the US dollar and a basket of other currencies. If things get really bad, competitive devaluation in Asia will cause another financial crisis there and create another deflationary tsunami which will spread around the world (this too is bullish for US bonds).
Now, let me go over an article that appeared this week, US import prices dip in November, but trend is away from deflation:
Import prices in the States slipped in November but the underlying trend was for a move away from deflation on the back of rising commodity prices and a waning dampening effect from strength in the US dollar, economists said.

The US import price index dipped by 0.3% month-on-month and 0.1% year-on-year, according to the Bureau of Labor Statistics.

Fuel import prices dropped at a 3.9% pace over the month and advanced by 2.7% on the year, while non-fuel import prices slipped 0.1% on the month and were down by 0.3% in comparison to the year ago month.

On the export side of the equation, prices of exports were off by 0.1% on the month and 0.3% over the past year.

Commenting on the data, Blerina Uruci at Barclays Research said: "Compared with a year ago, nonpetroleum import prices fell 0.2% y/y, a significant improvement from the strong deflationary trend in 2014 and 2015. The recent upward trend suggests that the impulse from the dollar appreciation has faded.

"We maintain our view that import prices will gradually move away from deflation territory in the coming months, following improving global commodity prices and the gradual waning of the effect of a stronger dollar."
Unlike Blerina Uruci at Barclays Research, I don't see the US dollar appreciation as such a benign trend. True, there is no immediate worry of US deflation but longer term, if this trend continues and wreaks havoc in Asian and other economies, it will potentially mean deflation coming to America.

"Give it up Leo, deflation is dead, President-elect Trump will cut personal and corporate taxes, get rid of regulations, spend a trillion dollars on infrastructure, and the US will be booming, growing at 4-5% in no time, leading the world out of this deflationary slump."

I wish it were that easy folks. Unfortunately the "Trump reflation rally" is all smoke and mirrors and a lot of things can go wrong in the next year, chief among them is what I call the US dollar crisis where the strength in the greenback continues and wreaks havoc on emerging Asia.

It's also worth noting Europe is still a mess and the Greek debt crisis is still lurking but is now superseded by an Italian banking crisis. This is why I've been telling my readers to keep shorting the euro and not to be surprised if it hits parity or even goes below parity if another crisis develops there.

A couple of last points you should be made aware of. The big trends in stocks, bonds and currencies typically go on longer than people think because there are multi-billion dollar CTA funds all playing trends as well as large trading outfits that play carry trades. For example, as the yen weakens, hedge funds and large trading outfits are loading up on the yen carry trade to invest in risk assets around the world, including US stocks and corporate bonds.

Something else really irks me. When you read doom and gloom nonsense on Zero Hedge about China and foreign central banks dumping a record $403 billion of US Treasuries, please ignore it. They obviously do not understand basic economic truisms, like one country's current account deficit (US) is another country's capital account surplus (China, Japan and petro countries looking to recycle their US dollar profits back into the US financial system).

Lastly, the Fed raised rates this week and everyone is harping on the inflation reference in the FOMC statement:
Information received since the Federal Open Market Committee met in November indicates that the labor market has continued to strengthen and that economic activity has been expanding at a moderate pace since mid-year. Job gains have been solid in recent months and the unemployment rate has declined. Household spending has been rising moderately but business fixed investment has remained soft. Inflation has increased since earlier this year but is still below the Committee's 2 percent longer-run objective, partly reflecting earlier declines in energy prices and in prices of non-energy imports. Market-based measures of inflation compensation have moved up considerably but still are low; most survey-based measures of longer-term inflation expectations are little changed, on balance, in recent months. 
After reading my comment on how a surging greenback will lower import prices and potentially wreak havoc in emerging markets, what are the odds that a year from now the Fed will still be worried about rising US inflation expectations? I put them at low to zilch and if a crisis develops, the Fed will be more petrified than ever of a global deflationary tsunami that I warned of at the beginning of the year.

As always, please remember to share these comments with as many people as possible and also take the time to read my comment on the unleashing of animal spirits so you can understand my stock and bond market calls in more detail.

Also, please take the time to subscribe or donate to this blog via PayPal at the top right-hand side and support my efforts in bringing you great insights on pensions and investments. The PayPal options are on the right-hand side under my picture (view web version on your cell phones). I thank all the retail and institutional investors who support this blog first and foremost financially, it is greatly appreciated.

Below, the US dollar has surged against the loonie following the Federal Reserve’s interest rate hike. Greg Anderson, FX Strategist, BMO Capital Markets talks to Bloomberg TV Canada about why the rally isn’t over.

Second, the Fed might have projected three rate hikes next year but the stronger USD will slow down its pace of rate hikes, says Citibank Singapore's Zal Devitre. Citi thinks the Fed will hike twice as opposed to three times next year. I'm not even convinced it will hike twice next year, especially if a crisis develops in Asia or Europe.

Third, Brian McMahon, Thornburg Investment Management, and Louis Navellier & Associates share their top stock plays. I'm not particularly interested in their stock picks but agree with Navellier's comments at the end on the rally in financials, energy and metal stocks being nothing more than a big short squeeze which isn't based on real fundamentals.

Fourth, Todd Gordon, TradingAnalysis.com, and Richard Bernstein, Richard Bernstein Advisors, weigh in on what's driving stocks to lofty levels. Notice no discussion on CTAs and the yen carry trade driving all risk assets higher but Bernstein is right, global PMIs have accelerated recently, the last spike (in my opinion) before they come back down to earth next year.

Fifth, Kathy Lien, BK Asset Management, and Chris Retzler, Needham Growth Fund, discuss the market's rally and the strong US dollar.

Lastly, it is the weekend so I embedded The Hitchhiker’s Guide through a Collapsing Europe – by DiEM25ers Yanis Varoufakis & Srećko Horvat. I still think Varoufakis is an insufferable, pompous, and hopelessly arrogant academic who is incapable of admitting his mistakes (he was responsible for closing Greek banks and never understood what Greece really needs).

Still, there is no denying he's very smart and they both raise important issues in this long discussion concerning the future of Europe.