Outside Economics

I have an uncle who, during his professional career, was a very well respected city manager. Periodically he would come and visit us in Los Angeles. On one such trip during my high school years, we all went to dinner and he told us about a developer in his community who was planning to build a shopping center of some sort. My uncle was really excited about this project because it looked like it was really going to happen, and would be a great addition to his community. 

He commented that he had seen many development projects come and go across his desk and they would get down the road a bit and the developer would pull the plug. Upon investigating the reason, he found the interest rate had changed a quarter or a half a percent and the project would no longer cash flow at the new rates.   

That was the first time I remember learning about cash flow. I had known something about interest rates and how if you borrow money you are charged interest. I knew that if you put your money in the bank or owned bonds you earned interest. But cash flow was a different story. He went on to say in these projects “cash is king.”

At this time I had a job, I had been working for the Los Angeles Daily Journal running their dark room, developing film, and printing photos to be published in the news paper (great gig for a 16 year old). I had a bit of cash flow myself, but I never thought of my income as cash flow. And yet that is exactly what it is: Income = Cash Flow.

In financial planning, cash flow is key. It is the basis of all financial decisions. What is the total cash flow? How will this expenditure affect cash flow? Will this investment improve cash flow? Managing cash flow, for some families, can be incredibly difficult; it starts with the goal of self reliance.

Every dollar earned goes in some manner towards self-reliance, which is usually a goal most families have. In today’s world, a large part of that is earning an income. Self-reliance is the sum total of the ability to provide for the necessities of life for our family. 

Spending money always has an effect on our cash position. Unchecked spending will destroy a family’s hard earned resources. I have seen families destroyed because one spouse will not give up the unchecked spending, racking up debt in the process. In counseling with these couples, and helping them understand the difference between needs and wants, can be a challenge, especially when they are set in their ways. I maintain faith that a person can change. 

Needs vs. wants is a tricky thing, simply be cause people can alway justify their spending. After all that is what good marketing is about, “creating the need.” Marketers help us justify spending and perceived needs will always grow to whatever the income is, again justifying the spending. Every spendthrift clearly justifies their spending!

To get an understanding of the most basic needs, a starting place is to list all the places where money is spent, then prioritize that list based on the simple fact if they don’t have that item someone in the family will suffer physically (I realize physical suffering is extreme, but you have to start somewhere). While many people may think cable T.V. is a need, millions in the world get along just fine without it, food and water on the other hand are essential. 

Growing a stable cash flow or improving cash flow is important to the family’s self reliance. As people manage the cash flow for asset growth, self reliance becomes more of a reality. Putting some money aside on a weekly or monthly basis from cash flow is critical to becoming self reliant. The only money that will be in the future is what is sent on ahead. 

One of my financial planning professors use to say, there are only two things you can do with cash flow, to make things balance, increase income or decrease spending. Decreasing spending only works to a certain point, at some point cash flow or income must be increased. To the extent a person can increase or maintain a decent cash flow and keep spending in check they can enjoy the blessings of self reliance.     

Self reliance does not only come to people of great wealth, it comes to people of all income strata; the basic level is simply to live on less than the cash flow that comes in. Diverting some of that cash flow as it comes, into some sort of savings vehicle is how to start becoming self reliant and properly managing income. It is true what George S. Clason said in his world famous book, The Richest Man in Babylon, “part of all I earn is mine to keep.” This is great advice - always keep some of what you work so hard to earn!

REMEMBER:  "Nowadays peopel know the price of everythinga and the value of nothing." Oscar Wilde

The yield on the 10-year U.S. Treasury fell to a record low of 1.318 percent in early July, sending bond prices higher throughout the fixed income markets. Bonds have continued their rally since the beginning of the year as the Fed has held off on raising rates, while central banks in Japan and Europe have maintained unprecedented low rates.

Repercussions from Brexit channeled money towards the perceived safety of German government bonds in July, as Germany became the first country in the EU to sell 10-year government bonds with a negative yield at auction. A negative yield means that investors are willing to essentially pay Germany in exchange for holding funds in German bonds. Germany sold  €4.8 billion ($5.3 billion) of 10-year notes at an auction, with a yield of -0.05 %. 

As of this past month there has been a continuous decline in long-term interest rates for 25 years, spanning from 8.3% in 1991 to 1.36% in July for the 10-year U.S. Treasury. Some bond analysts estimate that any continued decline in yields has become much less probable. But we all know, never say never!

With the Fed and its monetary stimulus efforts at capacity, many economists believe that this leaves ample room for fiscal stimulus in the form of lower tax rates. The presidential campaign has brought about the topic of lowering taxes and perhaps at a timely juncture that would help stimulate economic growth where the Fed may not be able to any longer.

A chellenge with this thought, is that this comes at a time when the federal government needs all the money it can get its hands on. (see the article: How Interest Rates Feed the Pig.) Its a fact that lower taxes has proven to increase the the total tax revenue, however to many people lowering taxes is unfair.  

This news on the heals of all the economy has been through since the Great Recession is a clear indicator that the economy has not completely recovered. With intermediate interest rates way below the historical average of 5.5%, this becomes a very serious concern for retirees who depend on their fixed income securities to help pay for their living expenses.

What to Do

Understanding this, the rate at which a person withdraws money from their retirement accounts will have a huge impact on the longevity of that account. People will need to simply save more for retirement and or live on less than originally expected. Both are unpleasant challenges. Getting out of debt will help with both of those challenges, as it frees up cash flow for additional savings and with little to no debt, it requires much less to live on. 

One strategy would be to take out much less during the earlier years of retirement and allow your savings to continue to grow, even for an additional five to seven years. This extra seasoning of your portfolio would make a world of difference.  Those who are preretirees may want to consider to start winding down their spending and try living on much less income, this will allow you to put more in savings and or get more debt paid off. It will also start you on a road of more discipline in your finances.

Sources: Federal Reserve, Bloomberg

Remember:

Training is everything. The peach was once a bitter almond, and the cauliflower is nothing but a cabbage with a college education.  - Mark Twain

In the United States we have enjoyed the largest economy in the world for so long that we often don't think of how events around the globe affect us. Maybe we just don't want to admit that we are suceptable to the economic occurances that take place twelve thousand miles away in some small country! But those things do affect us now that we really operate in a global economy and the macro view is not just a look at the United States any more - it is a look at the world. Maybe we will have to reference Macro as the Super Macro View for the world economy, vs. the Macro View for the U.S. Economy. Luckly we have not sneezed this year so the rest of the world has not caught a cold, but there are events that have occured that are affecting us. Maybe what we have is a case of "the argues" as old Festus from Gunsmoke use to describe his aches or pains in his body - it was when one part of the body was arguing with the other! (Wow that really dates me!)

Macro Overview

Macro risks are still prevalent throughout the world as the effects of Brexit and terrorism continue to be ongoing concerns. U.S. markets have been resilient to the uncertainties, as major U.S. stock indices reached new highs in July.

Some believe that the outcome of the EU vote, as well as the sentiment in Britain shortly before the vote to leave the EU, has many similarities to the U.S. presidential race. Key election issues and how they may affect the economy include: NAFTA, immigration, terrorism, and banking regulations such as Glass-Steagall and Dodd-Frank.

The presidential campaign has brought about the suggestion of reforming existing regulations, which are adversely affecting the banking and financial services industry. Some candidates argue for the repeal of Dodd-Frank, regulations put in place during the current administration to regulate banking activity.

The problem has been that the costs of the new regulations have inhibited smaller banks and credit unions. Some candidates lobbied to bring back legislation known as Glass-Steagall, put in place during the depression in order to prevent banks from combining financial services and lending simultaneously with the more risky business of investment banking.

In the last eight years since the “Great Recession” there have only been four community banks started in all 50 states, down from about 160 in 2007. Community banks are often a major economic engine for the local economies.

Economic growth, measured as GDP, was reported by the U.S. Department of Commerce to have increased at an annual rate of 1.2 % in the second quarter of 2016, below analyst’s expectations of 2.5%. The dismal GDP report was accompanied by a drop in oil prices of over 15% in July and a record low for the 10-year Treasury yield hitting 1.37%.

Upcoming economic data for the U.S. may influence the Federal Reserve to act on raising rates rather than waiting any longer. Analysts believe that a rate increase by the Fed before the end of 2016 based on U.S. economic data may be a mistake. Rates in Europe and Japan remain in negative territory due to the uncertainty of growth within the EU and the expected derogatory effects of Brexit on global business transactions. Fed members decided to leave interest rates unchanged during their July meeting, stating that it was prudent to wait for more data following the consequences of Britain leaving the EU.

Banks in Italy have become the latest of concerns in Europe as souring loans are being recognized throughout the Italian banking sector. As the third largest economy in the EU, Italy’s banking sector is prone to a crisis that could have dire consequences for the country and neighboring trading partners.

Stagflation On The Horizon – Monetary Policy

Former Fed Chairman Alan Greenspan said that the U.S. may be heading toward stagflation, a slow-growth economy coupled with rising inflationary pressures. Greenspan also said that there seems to be pockets of inflation even though low productivity is prevalent in the economy.

Stagflation is an economic phenomenon when there is slow or stagnant economic growth at the same time as rising inflationary pressures. The 70’s were a period when rapidly rising fuel prices coupled with dismal economic growth, led to stagflation. This same scenario occurred in the first two years of the 80’s, until both monetary and fiscal policies were enacted that halted destructive inflationary pressures and curtailed taxes to boost economic activity.

Inflation is measured by the CPI (Consumer Price Index) and economic growth is gauged by GDP (Gross Domestic Product), which are both released by the Department of Commerce each month. As a barometer of general prices throughout the country as well as current economic activity, both indices help identify any possible stagflation scenarios.

Managing your way through this current economic time can be challenging. It would seem that rates will remain low for the near future, certainly into 2017. The Fed may make minor adjustments, but I don’t think we will see any drastic increases. Wall Street needs better earnings to keep it going, I think they have had their fill of low rates. It’s a good time to review where you are at, and how your plans are shaping up for the year. Additionally, now is the time to start the final work for income tax reduction strategies, as we finish the third quarter. It much better to do this now rather than starting in December!

The current low rate environment, is no longer an effort to keep fueling Wall Street, but in an effort to keep the Federal Government afloat (they are the largest borrower in the world). If rates increase for the government, then ALL TAXES must go up to pay for the increases in interest payments. Don’t get me wrong, lower rates do help the Market, but the Market has adpted to lower rates for some time.  Now the Federal Government needs to get its borrowing under control for the rest of the economy to move forward. (See Feed the Pig Article)

Sources: EuroStat, Dept. of Commerce, BEA, Federal Reserve, ECB

Remember:

"So that the record of history is absolutely crystal clear. That there is no alternative way, so far discovered, of improving the lot of the ordinary people that can hold a candle to the productive activities that are unleashed by a free enterprise system."  Milton Friedman

Interest rates are the economic rain to the world economy. Like rain, when there is too much, it causes flooding and will swamp growth; not enough and a drought ensues then economies don’t thrive. The Fed controls the spicket. Current rates are hurting savers and the retired. While at the same time allowing the government to borrow trillions to grow at dirt cheap rates.

This causes a dilemma: the government needs the cheap interest rates; the retires and savers need higher rates to maintain a shrinking standard of living. This conflict is a problem the world over: what to do about low stagnant interest rates?  

The events in Europe along with the International Monetary Fund (IMF) report released in June indicating that U.S. economic growth would fall short of expectations. This is one reason that prompted the Federal Reserve to subdue its pursuit of any additional rate increases this summer.

Britain’s vote on the EU exit sent U.S. government bond yields to new multi-year lows as well as dimmed trade growth prospects between Europe and the U.S. The dollar’s recent rise is also a headwind for the U.S. since a rise in the dollar’s value drags on U.S. exports; putting downward pressure on U.S. inflation, which is well below the Fed’s 2% target for inflation.

The problem here is, as other countries have economic “occurrences” they send money to the U.S. to buy our treasuries, which are perceived to be a safe haven for storing cash. When a flood of money comes in, it lowers the interest rates people are willing to take just to park money. After all, getting something is far better than getting nothing or losing money all together. 

As more flows in - it strengthens the dollar, which also makes it harder for us to export our goods and services to other countries. It does make it cheaper for us to buy stuff from other countries and to travel, but that may not be the current objective.

Concurrently, the IMF report released in June suggested that the U.S. faces economic “headwinds” and “pernicious” trends including a shrinking middle class that could slow growth in the long term. 

Labor’s share of U.S. income is about 5% lower today than it was 15 years ago, while the middle class has shrunk to its smallest size in the past 30 years. Demographic changes are slowing potential growth and that in turn, is affecting business investment and leading to a less dynamic labor force. The IMF is estimating that U.S. GDP will grow 2.2% this year, which is down from 2.4% in 2015. This may seem like a small percent, but it works out to be $36.0 billion out of an $18 trillion economy. This much money could employ 720,000 people at $50,000 per year. That is a lot of money and a lot of middle class jobs!

Economists believe that both of these occurrences will foster an elongated low interest rate environment throughout the domestic and international fixed income markets. When factoring in the need for the federal government to keep borrowing such large amounts of money for both the annual deficit, and the rolling over of previous year’s debt obligations low interest rates help “feed the pig” so to say, causing income pain to the retirees and savers!

So how does this affect you and your investment or retirement portfolio? Low rates are generally good for the stock market, companies are able to borrow more to expand and grow. Now would be a good time to refinance any debt that may have higher rates or better yet, get it paid off. When debt is paid off early it is like earning that same interest rate. So for example you pay off a credit card that charges 18 percent then you have just earned that 18 percent on the balance by removing that future interest payment obligation. This is not to say go borrow a bunch of money at a high rate and then work to pay it off.

Rearranging your portfolio to a more balanced strategy may help with market upsets and continued low rates. Participating in several asset classes will properly diversify your portfolio. For more information .  

Tot the extent you can get your own house in order you will be greatly strengthened when the headwinds really hit hard. As the old saying goes, it is nice to “sleep when the wind blows”.

Sources: IMF, Bloomberg, Federal Reserve

Remember:

 Those who don't understand interest, pay it; those who do, earn it. - Anonymous

The economy this past quarter has been a great improvement over the first quarter. I am expecting some market stability as we head into the convention season and through this years election cycle. Who is elected will determine much of what happens next. We are however due for a recession soon, depending on which economist you follow. I fully expect we will see something in the next 12 to 24 months. 

Macro Overview 

The British vote to exit the EU (Brexit) was essentially a validation that a disintegration process of the EU is possibly underway, causing destabilization for countries throughout the EU. Britain’s vote may lead to other similar referendums, particularly with the Netherlands and France where populist sentiment is growing.

The British pound fell to a 30-year low versus the U.S. dollar following the outcome of the referendum. Conversely, the fall in value for the British pound can be beneficial for the country as Britain’s exports become cheaper worldwide and tourism increases as stronger foreign currencies come into the country.

The unraveling of Britain from the EU is not expected to be automatic or immediate and may take years for it to finalize. Britain would need to execute a divorce clause titled Article 50 of the EU agreement in order to move forward with the separation from the EU. Several member EU countries, including the IMF, are eager to have Britain expedite the exit in order to minimize uncertainty.

In the wake of the referendum’s outcome, international equity markets tumbled as uncertainty led the course. U.S. financial markets were incredibly resilient following the days after the British EU vote, with U.S. equity and bond prices all propelling to higher levels. 

The Fed’s plan to further increase rates this year took a different course as the repercussions from Britain’s EU vote are expected to lead to slowing economic growth and a sustained low interest rate environment. Some Fed watchers believe that the Fed may ramp up its stimulus efforts again with lowering rates should the EU and Europe’s economy falter.

Overshadowed by the Brexit news, the U.S. Census Bureau reported data that may help solidify the Fed’s wait to raise rates. Durable goods orders fell 2.2% in May, worse than anticipated. Such data is an indicator of whether inflationary pressures are present and if inconsistent expansion exists in the economy due to less capital spending.

In the midst of the Brexit turmoil, the Federal Reserve announced that 33 selected U.S. banks passed an imposed stress test to see how well they would perform under severe circumstances, such as high unemployment, recession, and falling asset prices. The stress test revealed that the 33 banks tested had nearly twice the amount of required capital needed, up significantly from the last stress test conducted.

Equity Update – Domestic & Global Stock Markets

U.S. stocks fared better than international stocks following Britain’s announcement on leaving the EU. U.S. equity markets were resilient once the surprise of Brexit unfolded, with the S&P 500 Index and the Dow Jones Industrial Index both positive for the year.

Domestic equities are more insulated from global developments and any other major equity markets since American companies generate 70% of the revenues from the United States. Japanese companies generate 50% from within their economy only and European companies generating a mere 49% from Europe only.

U.S. equities are considered attractive relative to negative yielding government bonds in Asia and parts of Europe, even as the U.S. 10-year note finished below 1.5% in June. The S&P 500 index currently carries 60% of its stocks with a dividend yield higher than the 10-year treasury bond yield.

The primary British equity index, the FTSE 100, tumbled in June following the Brexit vote. Companies within the index generate about 75% of their revenues outside the U.K., with many maintaining contracts and arrangements with other companies based in other EU countries. Since the actual extraction of Britain from the EU may take years, decisions for capital spending and expansion by European companies may be hindered.

Certain equity sectors are becoming increasingly sensitive to what the presidential candidates are proposing.  Concerns lie with those sectors where newly enacted regulatory policy can inhibit growth and profits. Other sectors are being adversely affected by low rates, such as banks whose earnings are hindered by low rates, which limits the amount of profits they can earn as deposits fall and loan rates drop.

Precious Metals, Oil & Gas, and Wages

Precious metals have increased dramatically this past quarter. Economist, Mark Skousen, said, “I think they (Federal Reserve officials) are working overtime to bring inflation back. Gold, which is finally moving, is the best indicator of future inflation. So we may see a return of inflation here if the gold market continues to rise. So that's what I'm looking at more than the bond market.”

Silver has rallied this year increasing nearly about $6.30 per ounce over the $13.83 at the start of the year. That is a 45.55 percent increase in price. For the past several days it has reacted independently of gold as gold prices have come down a bit; Silver has continued to go up. It seems there may be some hedging going on due to Silver’s expanded use in industrial applications. These are the highest prices for silver since the summer of 2014.  

Oil and Natural Gas are also on the rise. According to Dan Steffens, President of Energy Prospectus Group, (EPG) of Houston, TX, “The combination of rising demand and falling production has pushed the natural gas prices up from $1.70/mmbtu in February to near $3.00 at the end of June. My prediction is now we will see gas trading for more than $4.00/mmbtu by December.” If that is the case, lets hope all the global warming kicks in so we have a mild winter or we will be paying more than double for heat.  

With U.S. oil production down from last year, we are back to importing about 50% of our oil. Other countries are having production issues too, which may cause an increase up to about $70/bbl by the end of the year. Third quarter typically sees an increase in oil demand due to summer travel, which could easily eat up the surplus that has been keeping oil prices low. Some analyst think that oil will remain fairly steady around $50/bbl for the near future.

The Department of Labor reported that average hourly earnings grew by 2.5% over the past year, thus placing pressure on corporate earnings as wages move up. Many analysts believe that wages will continue to increase as unemployment rates remain below 5%, enticing companies to keep performing workers and paying them more.

After a market run up as we have seen this past quarter, I would not be surprised to see some profit taking in the next couple months, particularly if this earnings season does not produce any great results. If inflation takes off  then expect oil, precious metals, wages and other commodities to increase, which will certainly put pressure on corporate profits, and will also stress the markets. Now is a good time to continue to get out of debt and put a little extra away for a rainy day. 

Kind Regards,

Your Arm-Chair Economist

Sources: Eurostat, Department of Labor, S&P, Bloomberg, Federal Reserve, U.S. Census Bureau, EPG

International growth concerns and uncertainty surrounding the Fed’s decision as to when to finally start raising rates continued to roil markets in the 3^rd quarter.

The Fed held interest rates steady during a critical meeting in September, signaling that it intended to raise rates towards the end of the year. The economy’s apparent return to normalcy will be tested when a rate hike does eventually take effect.

The Department of Labor released data for the 3^rd quarter showing that there were improvements for low-income workers across the country, which tends to accelerate when the economy is close to full output. Historically, the Fed has considered full output to be a catalyst for rising rates in order to stem inflationary pressures driven by increasing wages. Consequently, employment data continues to weigh on the Fed’s decision to raise rates.

Markets reacted to mixed signals from the Fed regarding the timing of its anticipated interest rate hike while economic conditions were still questionable. The Bureau of Labor Statistics may have been contributing to the Fed’s uncertainty as it revised 2^nd quarter GDP estimates to a growth rate of 3.9%, up from 3.7%. Such revisions signal a strengthening economy, thus swaying the Fed to a rate rise sooner rather than later. Many economists view a decisive rate increase, a confident attainment of some economic progress.

Many analysts believe that Federal Reserve members have become extremely sensitive to the occurrences in China and the emerging markets, which have been adversely affected by the dollar’s strength. Some propose that the Fed is trying to indirectly minimize the dollar’s strength by keeping interest rates from rising too soon.

Since a stronger dollar has historically been a negative factor for the emerging markets, developing countries such as Brazil and Mexico are taking restrictive actions in order to slow the decline in emerging market currencies.  Brazil implemented sharp interest rate hikes in September while Mexico intervened to sell dollars in order to boost a record low peso. Traditionally, emerging market countries are inclined to raise interest rates in order to stem the decline of their currencies against the U.S. dollar.

It was 7 years ago this September that the financial crisis reached its most critical point when industry behemoths, including Lehman Brothers and Merrill Lynch, were acquired by other institutions.

Commerce Department data released identified construction as the strongest evolving sector of economic growth in September, with construction spending up over 13% for the past 12 months. Construction expenditures have been led by private sector nonresidential building, which includes manufacturing spending that is up considerably over the past year.

Reis, reported in its research that, office space throughout the country became scarcer as the vacancy rate fell to 16.5% in the 3^rd quarter. Department of Labor data showing an increase in higher paying professional positions coincides with the increase in demand for office space.

Sources: Fed, Bloomberg, Dept. of Labor, Commerce Dept.

To Remember:

When things go wrong, don't go with them!  - sign on a church