The Investor December 2019

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May we at RCIS and ShareFinder International wish all our readers everything they would wish themselves over the festive season. Please note our offices will be closed on Monday December 23 and will re-open on Thursday January 2

Rating the Unit Trusts

By Richard Cluver   December 2019

Choosing a unit trust that meets individual needs can be a perplexing matter for the average investor. The plethora of information in the Financial Press and on web sites only serves to further confuse.

 But it is as easy as falling off a log if you are a user of the ShareFinder 6 market analysis software package. If you trigger the icon that looks like the one reproduced on the right you will receive a table which ranks every unit trust in descending order of value performance throughout their lives. This is the result:

Thus, for example, we note that Old Mutual Global Equity currently tops the list in terms of its value performance throughout the period for which the programme database extends; in this case back to May 17, 1995, during which time it has offered investors an impressive compound annual average growth of rate of 18.47 percent. However, noting the column headed “Half” that growth rate slowed to 13.61 percent in the second half of the period under examination.

Click on that “Half” column heading and you will get another display indicating that quite another fund has done rather better in the most recent half of its life since September 2007:

So just how well have these two funds performed over their lives. Well all one needs do is double-click on the name of the fund and you will be offered a performance graph. This is the long-term graph of Old Mutual Global Equity:

Long-term graphs can, however, be visually misleading because of the curvature that occurs as a result of compound growth; an effect known as exponentiation which comes into effect when long periods are involved. Accordingly one can opt to see such graphs displayed on a logarithmic scale which allows one to better manage and view the compounding effect as you can see in the example below. Furthermore, to better understand what has happened over the years it is useful to now overlay the graph with trend lines to measure what happened over specific periods.

In my Log scale example below, I have applied trend lines to the three phases of the fund’s growth that are most obvious and we can thus read off from the computer display that, (as the dark green trend line suggests) between 1995 and the present it grew at compound 18.47 percent annually while (in red) between 1995 and December 2001 it grew at compound 24.2 percent annually while (in mauve) between early 2003 and mid-2007 it grew at compound 22.9 percent while (in yellow) between early 2009 and the present it grew at compound 18.5 percent annually.

If you require the precise dates of these graph turning points you need only hover your cursor over that point and ShareFinder will give it to you as in the example on the right I have picked out the point where the mauve trend line peaked in June 2007. As you can see it was the 4th of June 2007

Returning to our original displays, while it is obvious that had you been an investor back in 1995 the Old Mutual Global fund would have been your best option had you at that time possessed the ability of being able to look into the future when you look to the later period of that fund’s life, it was being outperformed by the Investec Global Equity Fund which, since that period has achieved 15.11 percent compound.

Here is the performance graph of this latter fund:

Is the Investec fund likely to continue such performance into the future? Well ShareFinder has over nearly 20 years proved under audited studies that its artificial intelligence system of future projection is better than 90 percent accurate and so, if you call for a projection you will get the following result:

That mauve trend line suggests that the Investec Global Equity fund will continue rising from now until July 9 next year at compound 9.3 percent before going into a sustained period of decline. However, were you to wait until January 24 when a brief period of weakness is likely to end you will be able to buy into a likely growth rate of 15.9 percent as delimited by the yellow trend line.

Now it has in recent years become very fashionable to rather invest into tracker funds because of the lower management fees that usually apply and a popular choice among investors is the Satrix series, popular because they are trackers which have gained worldwide publicity as generally offering better returns. Of these, the best performer in recent years has been the Satrix Divi. However, relative to the Old Mutual Global Equity fund the Satrix Divi, pictured below, has been rather erratic achieving overall growth with the first period (Red) achieving 25.2% compound followed by (Purple) 3.6% compound followed by (Yellow) minus 7.8% compound and, more recently (red) 11% compound. Overall (Turquoise) the average since February 2009 has been 10.5% compound:

Perhaps it might be better to stick with the managed Investec fund after all. But what about that price ecline forecast to begin next July. Readers who have been following my series ‘The Crash of 2020’ or have bought the e-book which we launched earlier this month, will be aware that I am forecasting the imminent probability of a deep global financial crisis. You can order the e-book at a cost of $10 by clicking on the following link: 

For those who are employing unit trusts as the repository for their savings and are thus able to sell out of share market and bond investments without risking high capital gains taxation consequences, the logical thing to do will be to move into pure money market investments when a sharp equity market decline is predicted. But do not be in a rush to do so. The marketplace is becoming more volatile than I have ever seen it which is hardly surprising considering what is happening both to the world and the local economy as global debt soars to a never-before-experienced 320 percent of global GDP according to International Monetary Fund data. That is why the whole world is in near recession and why a crash is inevitable followed just as inevitably by galloping inflation which will surely decimate the savings of practically everyone; dare I say it, an event that could nake the Great Depression look like a minor event.

To give you an idea of what is coming, I have employed ShareFinder’s artificial intelligence system to project what is likely to happen to one of the oldest and best known of the old-style unit trusts, the Old Mutual Investors Fund from now until the end of 2022. Clearly, long-term investors are likely to experience a very bumpy ride in the near future, but one in which those able to trade in and out of unit trusts might be able to at least quadruple their capital if the graph projection proves to be as correct as the statistical average of past ShareFinder projections have been.

Here a deep word of caution. Pushing ShareFinder’s projection systems far into the future inevitably means that its small inaccuracies are magnified when one takes an ultra-long view. That is why I choose to monitor all of my investments at least weekly under which circumstances observation has shown that the programme’s projections are better than 85 percent accurate. Accordingly, if you would like to trade unit trusts in the turbulent future ahead, it really would be wise to subscribe to a projection system like ShareFinder which is now being rolled out to South Africans at a deeply discounted subscription rate of $20 a month. Go the if you want more details.

An era of inflation

By Richard Cluver

Last month I illustrated how financial engineering has resulted in misdirected monetary creation that has dramatically widened the gap between rich and poor and accordingly ramped up social tensions leading to the rise of political opportunism that threatens to tear society apart as the opposing forces of Capitalism and Socialism face off across a modern battlefield which is currently beginning to explode onto suburban streets in the shape of increasingly ugly demonstrations.

Can we fix this before it is too late and what alternative tools do we have? More importantly, how can ordinary folk minimize the likely impact of coming events upon their own financial wellbeing? To answer we need to understand the strengths and weakness of the monetary system that served us for 2 600-years.

To create the analysis that follows I have drawn on the writings’ of the leading economists of the past century to begin with the conclusion that the Gold Standard imposed discipline upon the monetary affairs of nations inasmuch as governments were not able to manipulate the money supply by the act of printing more banknotes than were guaranteed by reserves held in their treasuries.

But it was an imperfect system and it is not true to argue that currencies remained entirely stable as a consequence or that nations were consequently immune to inflation. When the Conquistadors brought back vast quantities of Inca gold to Spain the result was too many people with too much money chasing too few goods which caused relatively high inflation between the second half of the 15th century and the first half of the 17th century. Prices rose on average roughly six-fold over 150 years which amounts to 1 to 1.5 percent a year, a relatively low rate for modern standards, but uncomfortably high at the time.

Specie flowed through Spain, increasing Spanish prices, and then spread over Western Europe enlarging the money supply and pushing up price levels of many European countries. Furthermore, notwithstanding the enormous inflow of wealth, the royal government was all too frequently in or close to bankruptcy. Massive amounts were spent on crusading against both Islam and Protestantism, while the Netherlands cost more to administer than they brought in.

When Philip III became King of Spain and Portugal in 1598, Spanish commentators were complaining that instead of being used to stimulate industry and business, the treasure from the Americas had created an attitude that held productive work in contempt, while foreigners – Genoese, Dutch, Germans – ran Spain’s trade and finance to their own profit.

Precisely the same occurred in South Africa once the link between the gold price and the dollar was severed. As the profits of our gold mines soared the consequence was a rapid rise in inflation which brought about precisely the circumstances that I detailed earlier.

The principal problem of the gold standard, however, was that it largely constrained the issuing of credit.  The Gold Standard directly linked the value of currencies to that of gold. A country on the gold standard could not increase the amount of money in circulation without also increasing its gold reserves. Because the global gold supply grows only slowly, being on the gold standard would theoretically hold government overspending and inflation in check.

And this posed a major problem for the US Government in the early 1930s when it was faced with mounting unemployment and spiralling deflation in the early 1930s. The restraints posed by the gold standard precluded the U.S. government from stimulating the economy in order to create jobs. To deter people from cashing their bank deposits and depleting the gold supply, governments were obliged to keep interest rates high, which made it too expensive for businesses to borrow.

Most economists now agree that the dominant reason why the US eventually got out of the Great Depression was the break with gold. But they similarly agree that the war effort associated with World War Two was the final determinant that put the US back on the road to economic recovery.

However, changes to the monetary system significantly pre-date the Great Depression and, arguable were a major cause of it. The root cause was a major paradigm shift that occurred in 1913 with the passage of the US Federal Reserve Act which, in a single sweep, changed both the scope and the magnitude of government intervention in the banking and monetary systems. The Act gave the government the power to regulate the size and growth of the money supply, thereby causing inflation or deflation in the economy. Through manipulation of credit, the Federal Reserve System then fuelled a credit expansion the likes of which was previously thought impossible. When the steadily-expanding credit bubble finally burst on “Black Tuesday”, October 29 1929, with the crash of the over-inflated stock market it had created, the consequent credit contraction was more severe than any before.

The Federal Reserve System enacted by the US Congress in 1913 charged The “Fed” with ensuring the appropriate reserves of its member banks, lending to shaky financial institutions to prevent their closure, selling government securities, and regulating the banking industry. That it failed dismally in its objective of ushering in a practical alternative to the Gold Standard and was the direct cause of The Great Depression is now widely recognised. Sadly, however, in the succeeding century mankind has continually failed in that objective which is why we are now on a count-down to yet another economic catastrophe.

Throughout its modern history, the global currency and monetary system has undergone many changes, going from a relatively pure gold standard at its inception to an adulterated standard in the 1940s and finally a total elimination of any gilded ties in the 1970s.

The US Federal Reserve and most of the world’s central banks, including the South African Reserve Bank, have assumed many more responsibilities than the drafters of the original legislation envisioned. Even so, their operations have changed very little over time. The most important of these roles, for our purposes, are: as setter of reserve requirements, lender of last resort, and regulator of the money supply. It is through these three functions that governments manipulate the economies of their countries most fundamentally. Let’s examine each function in greater detail:

Individuals lend banks money in the form of deposits. The banks issue the depositors something conveying a promise to pay on demand. Since the bank now owns this money, it can lend it to others to earn a return. In case the depositor wants his money back, the bank needs to hold some money back from its lending activities. These deposits held back are called reserves. The higher the bank’s reserves, the less it has to fear a fluctuation in its daily needs.

However, if the reserves are kept too high, the loan portfolio is not productive and profitable enough. Therefore, a balance must be struck.

Prior to the US Federal Reserve Act, each American bank had to be responsible for the maintenance of its own reserves although there was an established legal floor. If the bank misjudged its needs, it either had to call in its loans or cease transacting business. Poor judgment led to what is known as a “run” — which occurs when depositors lose confidence in the bank’s ability to meet its obligations and seek to withdraw their money before the bank goes under. If this happens with any prevalence, this can shake the stability of the banking system.

Central bank theorists presume that commercial bankers if left to their own judgment, will stay fully loaned up to the legal reserve requirement floor rather than maintaining an equalising balance between loans and reserves. For this reason, the Federal Reserve system was granted the authority to centrally-alter the reserve requirements of every bank but, far more important than this was its power to determine what constitutes reserves. Previously, individual banks kept reserves of gold or silver species in their own vaults… With the advent of the Federal Reserve System, banks were compelled to maintain their reserves at the regional Federal Reserve Bank and by and large the same process is adhered to by most nations.

In so doing, the Fed also altered the nature of such reserves. Previously, reserves had taken the form of specie deposits withheld from lending operations. Shortly after its inception, the Fed allowed reserves to be kept in either gold or Federal Reserve Notes (the latter ostensibly representing a corresponding amount of gold) as well as government securities at a ratio fixed by the Board of Governors of the Federal Reserve). After the banks had accepted the use of Federal Reserve Notes, the Fed compelled the acceptance of these notes as legal tender. This alteration accomplished two objectives: banks could purchase various vehicles for use as reserves and still be able to lend their deposits, and the government had a ready buyer for any new issues of securities.

The abandonment of the gold standard created a situation in which politicians pressuring for the creation of welfare-states thought they could use the banking system as a means to achieve an unlimited expansion of credit. They created paper reserves in the form of government bonds which, through a complex series of steps, the banks accepted in place of tangible assets and treated as if they were an actual deposit, i.e., as the equivalent of what was formerly a deposit of gold. The holder of a government bond or of a bank deposit created by paper reserves believes that he has a valid claim on a real asset. But the fact is that there are now more claims outstanding than real assets.

One cannot understate the importance of this fundamental change in the banking system. Government expenditures could soar high above revenues and the Federal Reserve would aggressively market the deficit spending to an avaricious banking system eager to expand its ability to extend credit. Or, put another way, the government could create fiat money out of thin air: effectively an edict by expenditure.

Previously, the only means by which government expenditures could increase was by a politically-inexpedient tax hike. Now, it had the Federal Reserve as its overdraft protection and the Fed could draw from the productivity and wealth of the entire American banking system. As I illustrated in my previous chapter, this facility was seriously abused from the outset when rather than raise taxes to pay for the debt arising from the First World War the US Government massively increased the money supply and the first consequence was the Great Depression. And governments all over the world began doing so from the 1980s when they could no longer meet the rising costs of the welfare state by raising further taxes from their citizenry.

Introducing the Federal Reserve Act in the US in 1913 and by similar Acts in most other countries around that time, governments gave themselves the tools to manipulate the supply of money by manipulating the nature of bank reserves. Simultaneously, however, they undermined the soundness of the banking system.

The last thing a bank needs is an aura of insolvency, yet that is precisely what the Federal Reserve System engenders. The Fed issues its Notes at an arbitrary ratio to its gold holdings; the banks then use these Federal Reserve Notes as reserves in another arbitrary ratio to their deposit base. Or, the banks use government securities (created out of thin air) as reserves and lend against them at a large multiple.

The problem in this activity is that the underlying value of the reserves has gone from significant (in the case of actual money stored in a bank’s vault) too insignificant (in the case of gold-based Notes) to none (in the case of fiat government securities). In the banking industry, this is called a lower quality of liquidity.

To cap it all, the Fed also sets the reserve requirements in a vacuum of information. Bankers, by virtue of their daily contact and intimate knowledge of the local business community, were supposedly better able to assess a bank’s balance sheet and respond accordingly. That is the way they attract depositors and customers, by a reputation for fiscal soundness. However, with the advent of automated on-line banking and the disappearance of the traditional “Branch Manager” who had a personal relationship with his clients, even this source of intelligence has been swept away in the 21st century; a victim to cost efficiency being set above the need for accurate information.

When a bank is free to fail, it has an interest in maintaining liquidity. Its management must carefully balance assets against liabilities. Now central banks act in the aggregate in setting reserve requirements, thereby punishing the most able bankers (by setting their reserve requirement above what they would otherwise have) and rewarding the incompetent (by allowing them to keep lower reserves than necessary), responsibility goes out the door.

Central banks were, in the original legislation, charged with operating as “the lender of last resort.” This meant that, if a bank found itself in an illiquid position, it could borrow from the central bank to see it through the situation. Initially, the bank had to pledge some valuable asset — such as commercial paper — as collateral, but that requirement was soon dropped and now anything is eligible. Under this guise, central banks sought to prevent the “bank runs” and systemic bank failures of past times. In effect, the central bank would prop up the banking system using its monopoly on money-creation.

Since the lender of last resort function kicks in when a bank is in a jam this was hoped to correct a supposed “failure” of the nineteenth century’s free-banking system; the former to forestall bank insolvency and the latter to avert bank panics. As with reserve requirements, there are considerable unforeseen consequences to the lender of last resort function. The first and most obvious problem is that it makes no distinction between illiquid banks and insolvent banks. The former are in a bind; the latter are in dire straits. The central bank comes to the rescue of each equally. The effect, then, is to further destabilise an already problematic situation.

The enactment of the Federal Reserve Act brought almost immediate changes to the American banking system. Prior to the Federal Reserve Act when banks kept their own reserves in their own vaults, the reserve ratio hovered around 21.1 percent. By 1917, the Act had legislated the reserve requirement to a mere 10 percent. Furthermore, the gold standard was devalued, since the Federal Reserve was only required to keep gold reserves of 40 percent against the Federal Reserve Notes and 35 percent against its members’ deposits. This all occurred within five years of the System’s inception. These two actions enabled a tremendous credit expansion.

The expansion amounted to $5.8 billion in deposits and $7 billion in loans and investments. This accommodated the financing of World War I in lieu of increased taxation and, at least, had some justification due to the war effort.

What happened next is best summarized by US economist Dr Benjamin Anderson: “We watched bank credit with fear and trembling as it expanded during World War I, because we knew then what we seem since to have forgotten, the dangers of over-expanded bank credit.

“We held it down all we could. But a great expansion was needed and we made it. It was enough. An expansion of $5.8 billion in deposits, with $7 billion in loans and investments, was enough.

“But between the middle of 1922 and April 1928, without need, without justification, light-heartedly, irresponsibly, we expanded bank credit by more than twice as much, and in the years which followed we paid a terrible price for this.”

The episode he spoke of, the 1922-28 credit expansion, began in 1922 with the first large open-market purchase of government securities, increasing the holdings of government securities by the Federal Reserve from $250 million to approximately $650 million; an increase of 260 percent! This first large-scale operation was instigated, not for credit expansion or interest rate suppression, since rediscounting had slackened after the war and Federal Reserve reserves were faltering, but simply because it could be done.

The heady, unintended credit expansion was too profitable to make it a one-time deal. Consequently, two more major open-market purchases of government securities occurred in 1924 and 1927, each amounting to hundreds of millions of dollars; a scale unprecedented in the history of the United States. Plus, due to the multiplying effect of securities qua reserves, billions of dollars became available for lending, again, out of thin air. These purchases were motivated solely by credit expansion, without any thought to the “dangers of over-expanded bank credit.”

By these open-market operations and reserve fiddling, bank credit had expanded $11.5 billion in only five years. If it had reflected a genuine need by businesses, it would have been welcome and salutary.

Since, however, commerce had no use for the available credit, banks sought other venues in which to channel the funds. The three primary vehicles were mortgages, financial instruments, and foreign loans.

Each of these represented a deviation from traditional banking practices, viz., the financing of short-term commercial requests; short-term, because it helped to maintain the liquid position of the bank; commercial, because these tended to be the borrowers best able to repay. Mortgages and financial instruments, like bonds and securities, are particularly susceptible to fluctuations in value. Loans made to foreign governments, predominantly Latin American ones, were risky, since revolution and instability were prevalent.

Moreover, each of these types of loans is ineligible for rediscounting. Since rediscounting was the secondary reserve of the whole system, this meant that a significant portion of the bank’s assets were constrained. As of June 30, 1926, the Federal Reserve released the following statement, “Of the total loans and investments of all member banks on June 30, 1926, sixteen percent was eligible for rediscount at the reserve banks….”

With increased long-term holdings and decreased potential for rediscounting, the banks were in a pretty precarious position by the end of the twenties. All that was needed was a scaling-down of the expansion – maybe even a contraction – thereby allowing banks to liquidate imprudent investments gradually. This could be accomplished by setting the rediscount rate above the market rate and strictly limiting the use of open-market operations.

However, the Federal Reserve Board did precisely the opposite. In 1927, the Federal Reserve Board, under the Chairmanship of Benjamin Strong, inaugurated a new policy of cheap money to help the farmer. The Fed lowered the buying rate on acceptances, essentially future loan drafts, in the summer of 1927; sharply increased – by $320-million – its purchase of government securities through November; and lowered its system-wide rediscount rate to 3.5 percent by September of that year.

This time, the credit expansion was funnelled almost exclusively into stocks. This credit extension started in 1927 and continued right up until the “Crash”.

Towards the end the Federal Reserve authorities desperately tried to reverse their mistake, increasing the rediscount (prime) rate to five percent by July 1928 and selling over $400-million worth of government securities by June 1928. This divestiture reduced bank reserves, necessitating over $600-million in rediscounting; though not enough to fully account for the reduction in reserves.

In the week following the stock market crash, the Fed doubled its holdings of government securities as it desperately tried to increase its reserve situation but could barely keep its head above water due to the counteracting influence of a continuous outflow of gold to other nations. Throughout the crisis period from 1929 to 1933, the Federal Reserve continued its inflationary policies in a futile attempt to initiate another boom akin to that of the twenties. By the end of 1930, however, the fundamental instability of the Federal Reserve System had become widely apparent. The number of commercial banks in the United States stood at 29 087 on June 30, 1920, and at 15 353 on June 30, 1934. In the period 1930-33 alone, a total of 9 106 banks failed.

Bank failures had always been endemic to the Federal Reserve System, averaging 166 per year between 1913 and 1922 and 692 per year between 1923 and 1929. The reason for this should by now be clear. In creating money from nothing for banks to lend, the government distorted the market processes that regulated the economy.

Credit arises from production. It cannot be overextended by private institutions since they do not possess the power to counterfeit and debase. The creation of credit by banks is a productive enterprise in which all participating parties hope to benefit, and in which non-participating parties are not directly affected.

Banks, in selecting where to extend credit, must necessarily be choosy. They must maintain liquidity at all costs while maximizing the return on their investments.

Then, as again in 2008, under the Federal Reserve Act, the banks found themselves awash with credit, regardless of the financial needs of their customers. They felt pressure to lend, without the assistance of a customer seeking a loan. Thus, they sought out anyone willing to take the credit off their hands.

In the competitive world of banking, quality and creditworthiness were luxuries they could not afford to consider. As one banking historian put it, “numerous examiner reports cited bank failures as due to `generosity to borrowers’…with insufficient attention paid to discipline, the result of which is detrimental to both borrowers and lenders in the long run.” …precisely the same situation that occurred again in the years leading up to 2008 when irresponsible mortgage lending to people who could not afford repayments ultimately led to the “Sub-Prime” crisis and the associated share market crash.

Banks ended up carrying a portfolio of speculative stock and real estate loans, long-term mortgages, and loans to impoverished countries. When the public loses confidence in the financial establishment, the banking industry bleeds to death until wholesale liquidation ensues. That is unless the government frees the banking industry from meeting its obligations –through a banking holiday– or unless the government sets the money supply adrift through the abandonment of the gold standard. Both of these things happened in 1933. These two events, then, were the culmination and the pinnacle of intervention in the banking system; the logical outcome of that manipulation.

Another part of the economy that is deeply affected by Federal Reserve policies, albeit indirectly, is the private business sector. When we think of businesses in the Great Depression, we think of joblessness and overproduction. Not unemployment or large inventories on an individual, localized level, but on a nationwide scale.

One must ask the question: how is it that such problems can occur? How can so many individual businessmen make erroneous judgments at the same time? This points to a more fundamental reason, one that can uniformly lead to miscalculation.

Once again, we find that the source of dislocation is expansion of bank credit divorced from any real source of expansion. In a boom (or inflationary period) the businessman engages in a process of predicting the future return or value of present projects. One of the factors entering into his calculations is the interest rate: a measure of the cost of future goods versus present consumption. The drop in interest rates inherent in an inflationary environment interferes with the businessman’s planning. It implies an increase in the rate of thrift (which is traditionally the source of available capital) by individuals and corporations. This causes a shift by the businessman from investment in consumer goods to investment in higher-order capital goods in expectation of soaring future demand. An expansion in production facilities and production of the heavy industries, and in the production of durable producers’ goods, is the most conspicuous mark of the boom.

As the bubble fills, productive capacity is expanded. Capital goods are acquired and implemented. Money flows into the capital goods industry. This money, remember, is not the result of increased savings, but money artificially created by the government in the form of credit expansion. So this boom is illusory for once workers in the higher-order industries receive income in the form of wages and salaries, they, in turn, expand consumption to the same proportion.

In other words, because the savings qua capital is not genuine, the money sunk into higher-order goods is spent according to existing consumption/thrift ratios.

Or, the money spent by the misinformed entrepreneur is ultimately transferred to the consumer goods industries, shifting demand for capital goods. That is, unless the borrowing firm returns to the bank for more credit and temporary salvation, the greater the credit expansion, the longer it will last.

When the expansion ceases, the boom complies. The longer the boom goes on the more wasteful the errors committed, the longer and more severe will be the necessary depression readjustment.”

The historical facts bear out the theory. Productivity per person-hour in the US increased by 63 percent from 1920 to 1929. Share prices quadrupled during the twenties; shares being the primary source of capital. Durable goods, as well as steel production, increased approximately 160 percent while non-durables, large consumer goods, increased only 60 percent. Moreover, wages in the capital goods industries were higher than wages in the consumer goods industries. Hourly wages in manufacturing industries–such as meatpacking, hardware, and clothing–increased an average of 12 percent while those in the capital goods industries rose even higher.

In the period after the boom, industrial production was $114–billion in August 1929 and $54-billion in March 1933. Business construction totalled $8.7-billion in 1929 and $1.4-billion in 1933. There also occurred a 77 percent decline in durable goods manufacturing in the same four-year period. Unemployment rose from 3.2 percent in 1929 to 24.9 percent in 1933. Furthermore, from 1929 to 1932 the money supply was contracting, “and since wages are less elastic than prices, real wages were rising because of deflation making it extremely difficult for business to employ people.”

Turning to the share market, the image that comes to mind immediately is that of the Crash of 1929. It occurred because share price-to-earnings ratios had soared far above any representation of reality because of speculative fever within the general public. Everyone wanted a piece of the action and they were largely able to buy into it.

The Fed’s purchase of government securities in 1924 was the first instance when the additional bank credit was almost exclusively channelled into securities; partly into direct bond purchases by banks and partly into stock/bond collateral loans.

This immense expansion of bank credit, added to the ordinary sources of capital, created the illusion of unlimited capital and made it easy for markets to absorb gigantic quantities of foreign securities as well as a greatly increased volume of American security issues.

Although the 1924 issue was the first instance of influence in the stock market, it was most definitely not the last. The 1927 cheap money policy was the final turn that opened the floodgates of giddy speculation. By lowering the rediscount (prime) rates, the Fed allowed the member banks to lower their own interest rates on stock and bond collateral loans as well as brokers’ loans.

When the Fed reversed its policy late in 1927, it was too late. The psychological intoxication of the boom had taken hold of the American public. Eager speculators ignored increasing interest rates and took greater volumes of brokers’ loans.

Even as member banks dried up the speculative security loans, new sources were utilised, viz., brokers’ loans `for account of others.’

Previously, brokers’ loans would be made for the bank’s account or an out-of-town bank’s account, with an occasional brokers’ loan for other customers. At the beginning of 1926, such loans accounted for $564-million of a total of $3.141-billion in brokers’ loans. By the summer of 1929, these loans totalled $3.372-billion of the total $6.085-billion in brokers’ loans. Furthermore, call loan rates rarely exceeded 10 percent, except just prior to the Crash, when they finally were raised to 20 percent. This also served as a fresh source of speculation money.

The effects of such ubiquitous investment were astounding. On November 15, 1922, the Dow-Jones Industrial Average closed at 9 511. By August 29, 1929, the Average had risen to 37 618. The Standard & Poor’s Common Stocks Indices showed similar fantastic gains: the industrials, rails and public utilities indices had risen from 44.4, 156.0, and 66.6, respectively in 1921 to 172.5, 384.1, and 272.2 just six years later.

When the bubble finally burst in October of 1929 it shattered confidence in the economy. The intoxication of seven years of giddy inflationary credit expansion had resulted in an economic hangover of heretofore unseen proportions. The following year, 1930, marked a watershed. The government’s response to the failings of the Federal Reserve would determine the severity of the necessary liquidation and recession. If the government allowed the market to correct itself, through interest rate hikes and bankruptcy, the consequent recession would be severe but brief. If, however, the government interfered with the market, the country would be in for a slow, arduous bloodletting and, ultimately, a future littered with cyclical depressions which is what occurred. Then, as now governments interfered all over the world and in all cases the results have been the same.

It would be foolish to imply that the Federal Reserve System was the sole factor in the playing out of the Great Depression. Many economists lay equal blame upon the drastic effects of the Smoot Hawley Tariff Act of 1930 which brought about a worldwide trade war…which has been duplicated recently by the Trump trade wars. Britain’s abandonment of the gold standard and the effect of reparations upon the defeated Germany also contributed to the extent and severity of the Depression of 1929-1940.

For many economists, the fundamental idea behind the Federal Reserve System was welfare-statism: the subjugation of individual freedoms and choices to the will and interests of the state, as representative of the “public good.”

In the case of the Federal Reserve, we can see that the Fed essentially dictates to the banking system what it can and cannot do. Consequently, individual depositors experience a reduction in choice among financial institutions. Since they are all treated uniformly, it becomes impossible to determine the reserve quality and sufficiency of an individual bank.

Furthermore, bankers are denied the possibility of issuing banknotes against real reserves and the element of control this encompasses. Businessmen are given mixed, and sometimes false, signals regarding the future cost of activities, leading to malinvestment and wasted capital. Finally, individuals are unable to assess the underlying value of the stock market, due to the dislocations produced by credit expansion on the part of central banks. And volatility is officially sanctioned through the inflationary mechanism.

The lesson of the Great Depression is that interfering with the money supply leads to unintended consequences and undesirable effects and that this is inherent in the system highlights the argument that governments have no business interfering in the private dealings of individuals.

Had the government adopted a hands-off approach to the money supply, the economy would have certainly contracted, but its result would have been a strengthened and sounder economy. By the end of the correction, banks would have found appropriate reserve ratios and liquidated imprudent loans; businesses would have converted misguided endeavours into productive uses and shaken off inefficiencies; and investors would have been be left with more accurately valued stockholdings and a renewed confidence in the financial status of the nation. In short, the economy would have righted itself.

Today, central banks routinely manipulate the money supply with the stated objective of stimulating economies in order to relieve citizens of responsibility for their own misguided investment decisions. But the unfortunate result is that problems are then merely shunted down the road to litter the future like minefields

Economists lightly use the analogy of “Kicking the can down the road” instead of picking it up. Monetary problems that are not adequately dealt with at the time they occur tend not to go away but rather to become magnified over time. Postponed problems are likely to become future catastrophes.

Assessing market returns over the last 10 years

By Brian Kantor Investec Wealth & Investment in the US equity market have done very well since the Global Financial Crisis. But it’s been a different story for JSE investors. We look at the implications.

It’s been 10 years since the Global Financial Crisis. If you had invested R100 in October 2009 in the 500 companies that make up the leading equity index in the world (the S&P 500 Index), your investment would (as at the end of October 2019) be worth R680 on a total return basis (including dividends reinvested in the index). Returns over the period averaged over 18% a year in rands and 13.4% in US dollars.
Most other leading equity markets have not performed as well. For example, R100 invested in the JSE All Share Index or in the MSCI Emerging Market Index (EM), again with dividends reinvested, would now be worth about R276. This is equivalent to an average annual return of about 12% from the JSE and the EM benchmark over the 10 years.
To put this in context, an investment in the SA bond market 10 years ago would have guaranteed the rand investor 9% a year for 10 years. Equity market returns of 12% a year, therefore, did not fully compensate investors for taking on equity market risk over those 10 years – assuming a required equity market risk premium of 4% a year.
The strong outperformance of the S&P 500 began in 2013 and has continued since. This reflects very different fundamentals from those of the JSE and other markets.

The S&P 500 delivered growth in index earnings per share in US dollars of 11.7% a year over the last 10 years. By contrast, the JSE delivered growth in index dollar earnings per share of only 1.46% a year and 5.5% in rands, over the same period, barely ahead of inflation.

Figure 1: S&P, JSE, EM and money market index values (2009=100)

S&P, JSE, EM and money market index values chart

Source: Bloomberg Investec Wealth and Investec Wealth & Investment

Back in September 2009, US Treasuries offered a guaranteed 3.4% a year for 10 years, a good yield by the standards of today. This meant that, at that especially fraught time, investors would have required an average return of about 7.5% a year to justify a full weight in equities, assuming the same required extra equity risk premium of 4% a year. The returns that were realised on the S&P, therefore, exceeded required returns by a substantial 6% a year.
Time has proved that the risks of financial failure in the US had been greatly exaggerated. The lower entry price for bearing equity risk 10 years ago, reflected by the index values of the time, proved unusually attractive.
Dividends per JSE index share, by contrast, have grown from the equivalent of R100 in 2009 to R324 in September 2019, while earnings per share have no more than doubled. The ratio of the JSE Index to its dividends was 41 times in 2009; it is now, in 2019, only 27 times. In other words, the JSE All Share Index dividend yield is up from a 2.4% average in 2009 to 3.7% now.
In short, JSE-listed companies have decided to pay out more cash in the form of dividends. To a lesser extent, they have also been using the cash generated through their operations to buy back their shares in the marketplace, rather than to undertake CAPEX, increase working capital, hire more workers or build inventory and work in progress.

What these reactions reveal is a lack of value-adding investment opportunities for JSE-listed companies. The willingness to pay out more in dividends, rather than to invest the cash (probably unprofitably) in their enterprises, reveals a degree of discipline in the use of shareholder capital. But it also reveals the constraints on their ability to grow their businesses in SA.

By contrast to the rising trend in dividend payments and the reduction in the price to dividend ratio (increase in the dividend yield) for the JSE, JSE earnings per share and their value have matched each other very closely. The ratio of the index to its trailing earnings per share was 16 times in 2009 – and is the same 16 times today.

There has been no derating or rerating for JSE reported earnings. Actual dividend payments are less highly appreciated than they were (see below).
Also, by contrast, emerging market index earnings have grown faster than dividends. Index earnings have grown by 3.6 times since 2009 and Index dividends by 2.6 times. However, both price-to-dividend and price-to-earnings ratios have declined. The EM index now trades at only 13 times, trailing earnings compared to a much more optimistic 23 times in 2009. EM companies have on average clearly derated over the past 10 years.

Figure 2: The JSE All Share Index (2009-2019) – values, earnings, and dividends, as well as price-to-earnings and price-to-dividend ratios

The JSE All Share Index (2009-2019) chart

Figure 3: The MSCI Emerging Market Index (2009-2019) – values, earnings and dividends, as well as price-to-earnings and price-to-dividend ratios

RSA long-term interest rates and sovereign risk spread chart

The equivalent required risk-adjusted return of the highly diversified S&P 500 Index today is a mere 5.8% a year on average.

With long RSA bond yields now offering close to 9% a year, the required risk-adjusted return from the average company listed on the JSE is now at least 13% a year.
It has become increasingly difficult for a SA-based company to add value for shareholders by earning returns on its capital expenditure of over 14% a year, given slow growth and low inflation. SA business has responded accordingly, by saving and investing less and paying out dividends at a much faster rate.
This is not good news for business or the economy. JSE-listed companies would be much more valuable if they could justify investing proportionately more and paying out less, as US companies have done.
South African companies need encouragement from faster growth in their revenues and earnings and lower interest rates. Lower short-term interest rates are in the power of the Reserve Bank and if they were to be reduced it would help stimulate extra spending by households.

SA business and the local share market also need the encouragement of lower required long-term returns. In other words, lower expectations of longer-term inflation would bring down long-term interest rates. Lower inflation expectations (and consequently lower interest rates) means a growing belief that SA will not fall into a debt trap and resort to printing money to escape it – a move that would be highly inflationary.
So far, and after the Medium Term Budget Policy Statement of October 2019, not obviously so good. The jury remains very much out and the cost of capital is still highly elevated.


SA’s uneasy partnership with Africa

By Moeletsi Mbeki

Deputy chair of the SA Institute of International Affairs

SA has something of a fraught relationship with the rest of Africa. The blame rests with the vacillations of the country’s political elite.

South Africans — and indeed most Africans — love to think of their country as unique. And SA is unique — but not for the reasons most people think. The popular view is that what makes SA stand out are the glittering glass and steel skyscrapers scattered over numerous great cities; the cities linked by super-highways and railways; and sprawling industrial, commercial and agricultural enterprises as far as the eye can see.

This, however, is not what makes SA unique on the continent; several countries in Africa are fast catching up.

What does make SA unique is its history, and the continuation of that past in the present. SA is the only country in mainland Africa that imported slaves rather than exporting people into slavery elsewhere. To make way for the imported slaves, as well as their Dutch masters and overseers, SA’s indigenous people were slaughtered in an orchestrated campaign of genocide that lasted more than 100 years.

It is, therefore, something of a miracle that indigenous people today constitute the majority of the population.

SA is the only country in Africa that belongs to what is called New World countries. These were the countries largely created in the Americas after Christopher Columbus’s journeys 500 years ago. They were carved out of North, Central and South America, and the Caribbean islands by the European powers of the day. The primary purpose was to exploit their mineral riches and transform their lands into plantations to produce sugar, tobacco and cotton for European markets.

The native people who resisted this exploitation were exterminated, and slaves from Africa were introduced to replace them. Those who survived were marginalised economically, politically and socially, and were banished to reservations (where many still live in North America). But an important question — one that is seldom asked — is: how did some of SA’s native populations survive the carnage, and go on to eventually gain political control of the country?

When SA emerged from this long and tortuous story in 1994, two elites were in place: a political elite and a business elite. The political elite, through democratic processes, control the state. They are voted in almost exclusively by descendants of the indigenous populations.

The business elite control much of the means of production, distribution and exchange. Their origins lie largely in the populations that shipped in from Europe in the 17th century and later. It should, therefore, come as no surprise that, with these two very powerful elites, SA has two policies towards Africa. The business elite’s relationship with the rest of the continent is fairly clear. Africa presents opportunities as a market and as an investment destination, and so SA investment in Africa jumped from a mere R6.1-bn in 1994 to R431.1-bn in 2014.

The real source of trouble and uncertainty in relations between SA and the rest of Africa is the ambivalence of SA’s political elite, who see themselves as defenders of Africa. But what exactly they are defending, against whom and with what means, is never clear.

We saw, in the makings of the New World, that there were populations that survived the carnage. In the course of the struggles, these populations were stripped of their assets and, in many instances, of their identities as well. New identities were created that were in tune with the new circumstances of subjugation. This was the fate that SA’s political elite suffered. Because they were left with no assets, they were unable to define their national interest as a group, let alone as a country.

There’s also ambiguity in the identity of this political elite. As part of the New World, they saw themselves as an extension of the Old World, which is fundamentally European. At the same time, as survivors of the horrors that gave birth to the New World, the political elite did not fully identify with Western civilisation. So they vacillated, and fell between stools. Today, when they are called upon as an African government to take positions on critical African issues, they often equivocate and are overtaken by events.

This is nowhere better illustrated than in relations between the ANC and Zanu-PF in Zimbabwe. To stay in power, the Zanu-PF government has, since 2000, broken every rule of a functioning democracy — yet the ANC government has stuck by it. It’s gone as far as opening SA’s borders, providing a safety valve so that the aggrieved Zimbabwean population — those who lost their livelihoods as a result of the Zanu-PF government destroying the country’s agricultural system — could escape to SA.

This seeming open-door policy has led to migrants coming to SA from as far afield as Somalia, Nigeria, Ethiopia, Pakistan and Bangladesh. Once here, they have found themselves in poor neighbourhoods, in competition with poor South Africans for resources and opportunities. It has given rise to conflict that the political elite — themselves responsible for distributing resources and creating opportunity — then dismiss simply as criminal activity.

A fractious relationship seems to exist between SA and the rest of Africa, but this friction is driven by SA’s directionless political elite in their attempts to be all things to all people.

Time to review your strategy

By John Mauldin

Year-end is rapidly approaching, which means time to review your investing strategy. Below, I have some time-honoured advice that may help. Both Dennis Gartman and Bob Farrell are legendary traders, and they kindly shared the rules they’ve found most helpful. I know they help me. So read these, and I’ll have a few more words below.

Oh, and by the way, as you read these rules think about your own personal portfolios, investment decisions, and your life, and how these rules may apply to you. It will make the process a lot more valuable.

Several different versions of Gartman’s rules are floating around the internet. This one is my favourite. Note that Dennis is first and foremost a trader, so these are rules for traders but also offer insight to investors.

  1. NEVER, EVER, EVER ADD TO A LOSING POSITION: EVER!: Adding to a losing position eventually leads to ruin, remembering Enron, Long Term Capital Management, Nick Leeson and myriad others.
  2. TRADE LIKE A MERCENARY SOLDIER: As traders/investors we are to fight on the winning side of the trade, not on the side of the trade we may believe to be economically correct. We are pragmatists first, foremost and always.
  3. MENTAL CAPITAL TRUMPS REAL CAPITAL: Capital comes in two forms… mental and real… and defending losing positions diminishes one’s finite and measurable real capital and one’s infinite and immeasurable mental capital accordingly and always.
  4. WE ARE NOT IN THE BUSINESS OF BUYING LOW AND SELLING HIGH: We are in the business of buying high and selling higher, or of selling low and buying lower. Strength begets strength; weakness more weakness.
  5. IN BULL MARKETS ONE MUST TRY ALWAYS TO BE LONG OR NEUTRAL: The corollary, obviously, is that in bear markets one must try always to be short or neutral. There are exceptions, but they are very, very rare.
  6. “MARKETS CAN REMAIN ILLOGICAL FAR LONGER THAN YOU OR I CAN REMAIN SOLVENT:” So said Lord Keynes many years ago and he was… and is… right, for illogic does often reign, despite what the academics would have us believe.
  7. BUY THAT WHICH SHOWS THE GREATEST STRENGTH; SELL THAT WHICH SHOWS THE GREATEST WEAKNESS: Metaphorically, the wettest paper sacks break most easily and the strongest winds carry ships the farthest, fastest.
  8. THINK LIKE A FUNDAMENTALIST; TRADE LIKE A TECHNICIAN: Be bullish… or bearish… only when the technicals and the fundamentals, as you understand them, run in tandem.
  9. TRADING RUNS IN CYCLES; SOME GOOD, MOST BAD: In the “Good Times” even one’s errors are profitable; in the inevitable “Bad Times” even the most well-researched trade shall go awry. This is the nature of trading; accept it and move on.
  10. KEEP YOUR SYSTEMS SIMPLE: Complication breeds confusion; simplicity breeds elegance and profitability.
  11. UNDERSTANDING MASS PSYCHOLOGY IS ALMOST ALWAYS MORE IMPORTANT THAN UNDERSTANDING ECONOMICS: Or more simply put, “When they’re cryin’ you should be buyin’ and when they’re yellin’ you should be sellin’!”
  12. REMEMBER, THERE IS NEVER JUST ONE COCKROACH: The lesson of bad news is that more shall follow… usually hard upon and always with worsening impact.
  14. DO MORE OF THAT WHICH IS WORKING AND LESS OF THAT WHICH IS NOT: This works well in life as well as trading. If there is a “secret” to trading… and to life… this is it.
  15. CLEAN UP AFTER YOURSELF: Need we really say more? Errors only get worse.
  16. SOMEONE’S ALWAYS GOT A BIGGER JUNKYARD DOG: No matter how much “work” we do on a trade, someone knows more and is more prepared than are we… and has more capital!
  17. PAY ATTENTION: The market sends signals more often than not missed and/or disregarded… so pay attention!
  18. WHEN THE FACTS CHANGE, CHANGE! Lord Keynes… again… once said that “ When the facts change, I change; what do you do, Sir?” When the technicals or the fundamentals of a position change, change your position, or at least reduce your exposure and perhaps exit entirely.
  19. ALL RULES ARE MEANT TO BE BROKEN: But they are to be broken only rarely and true genius comes with knowing when, where and why!

Bob Farrell’s Rules for Trading

Bob Farrell was a widely followed genius at Merrill Lynch. Wall Street people still speak of him reverently. Some of the greatest traders and investors I know referred to his rules on a frequent basis, and I suggest you do the same. Here are his rules with commentary from MarketWatch’s Jonathan Burton.

  1. Markets tend to return to the mean over time. By “return to the mean,” Farrell means that when stocks go too far in one direction, they come back. If that sounds elementary, then remember that both euphoric and pessimistic markets can cloud people’s heads.”It’s so easy to get caught up in the heat of the moment and not have perspective,” says Bob Doll, global chief investment officer for equities at money manager BlackRock Inc. “Those that have a plan and stick to it tend to be more successful.”
  2. Excesses in one direction will lead to an opposite excess in the other direction. Think of the market as a constant dieter who struggles to stay within a desired weight range but can’t always hit the mark. “In the 1990s when we were advancing by 20% per year, we were heading for disappointment,” says Sam Stovall, chief investment strategist at Standard & Poor’s Inc. “Sooner or later, you pay it back.”
  3. There are no new eras — excesses are never permanent. This harkens to the first two rules. Many investors try to find the latest hot sector, and soon a fever builds that “this time it’s different.” Of course, it never really is. When that sector cools, individual shareholders are usually among the last to know and are forced to sell at lower prices.”It’s so hard to switch and time the changes from one sector to another,” says John Buckingham, editor of The Prudent Speculator newsletter. “Find a strategy that you believe in and stay put.”
  4. Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways. This is Farrell’s way of saying that a popular sector can stay hot for a long while, but will fall hard when a correction comes. Chinese stocks not long ago were market darlings posting parabolic gains, but investors who came late to this party have been sorry.
  5. The public buys the most at the top and the least at the bottom. Sure, and if they didn’t, contrarian-minded investors would have nothing to crow about. Accordingly, many market technicians use sentiment indicators to gauge investor pessimism or optimism, then recommend that investors head in the opposite direction.
  6. Fear and greed are stronger than long-term resolve. Investors can be their own worst enemy, particularly when emotions take hold. Stock market gains “make us exuberant; they enhance well-being and promote optimism,” says Meir Statman, a finance professor at Santa Clara University in California who studies investor behaviour. “Losses bring sadness, disgust, fear, regret. Fear increases the sense of risk and some react by shunning stocks.”After grim trading days, it’s easy to think you’re the patsy at this card table. To counter those insecure feelings, practice self-control and keep long-range portfolio goals in perspective. That will help you to be proactive instead of reactive.”It’s critical for investors to understand how they’re cut,” says the Prudent Speculator’s Buckingham. “If you can’t handle a 15% or 20% downturn, you need to rethink how you invest.”
  7. Markets are strongest when they are broad and weakest when they narrow to a handful of blue-chip names. Markets and individual sectors can move in powerful waves that take all boats up or down in their wake. There’s strength in numbers, and such broad momentum is hard to stop, Farrell observes. In these conditions, you either lead, follow or get out of the way. When momentum channels into a small number of stocks, it means that many worthy companies are being overlooked and investors essentially are crowding one side of the boat. That’s what happened with the “Nifty 50” stocks of the early 1970s when much of the U.S. market’s gains came from the 50 biggest companies on the New York Stock Exchange. As their price-to-earnings ratios climbed to unsustainable levels, these “one-decision” stocks eventually sunk.
  8. Bear markets have three stages — sharp down, reflexive rebound and a drawn-out fundamental downtrend
  9. When all the experts and forecasts agree — something else is going to happen. As Stovall, the S&P investment strategist, puts it: “If everybody’s optimistic, who is left to buy? If everybody’s pessimistic, who’s left to sell?”Going against the herd as Farrell repeatedly suggests can be very profitable, especially for patient buyers who raise cash from frothy markets and reinvest it when sentiment is darkest.
  10. Bull markets are more fun than bear markets

No Kidding

Stable Prices, Sometimes

By John Mauldin

Contrary to popular opinion, the Federal Reserve System is not independent. Nor does it have to follow the president’s orders, as much as Donald Trump wishes it would. The Fed operates under a legal mandate from Congress. Its monetary policy role is “to promote maximum employment, stable prices and moderate long-term interest rates.”

So how is it doing?

Long-term rates are certainly moderate. Employment is historically high, though wages and job quality aren’t always great. As for that “stable prices” part… it depends on what you are buying. As you see below, for many goods the price is nowhere near “stable.” Unfortunately, if you are in the bottom 60–70% of the income brackets, these are some of the things you buy the most.
Source: Sebastian Sienkiewicz

The Fed believes that 2% annual inflation equals “stable prices.” Yet that small amount adds up over time—to almost 50% in 20 years. Which is about where CPI lands in this 20-year chart, so the Fed is succeeding by that yardstick.

Think about that for a second. The Fed defines “stable prices” as a 2% average. And then another government agency tries to measure those prices, often using “Hedonic Quality Adjustment” to account for changes due to innovation or completely new products. So because the car you are buying has new features, they conclude it’s not more expensive. Does that match your experience? Thought so…

CPI doesn’t reflect real-life spending for most people. Prices have risen dramatically more than average for some of life’s basic necessities. So if you wonder why people are anxious, this might be a clue.

The Fed either doesn’t see this or doesn’t think it is a problem. Officials have been wringing their hands for years at their inability to make inflation reach that 2% level. The Financial Times reported last week that they may soon change their rules.

The Federal Reserve is considering introducing a rule that would let inflation run above its 2 percent target, a potentially significant shift in its interest rate policy.

The Fed’s year-long review of its monetary policy tools is due to conclude next year and, according to interviews with current and former policymakers, the central bank is considering a promise that when it misses its inflation target, it will then temporarily raise that target, to make up for lost inflation.

The idea would be to avoid entrenching low US price growth which has consistently undershot its goal.

The key here is that 2% average inflation isn’t the same as 2% all the time. Having run below 2% for years, Fed leaders now want to go above it, potentially far above it and for long periods. In other words, give themselves permission not to worry about the inflation a low-rate policy might otherwise cause.

As my friend Samuel Rines noted:

Bottom Line: Inflation is not going to be an issue for the Fed—too high or too low—for a while. Whether looking at CPI or the Fed favorite PCE, it is difficult to see an impending surge in underlying inflation. This should help keep longer-term yields in check with a pick-up in activity in 2020. Tariffs are already showing up in the data, but do not matter (much) for the indexes.

While Fed officials may think they have tamed inflation, their ZIRP and QE actually drove real-world prices considerably higher than CPI or PCE show. It showed up mainly in asset valuations, like stocks and real estate. These, in turn, drove up other prices like housing. Aggregate inflation isn’t higher because technology and globalization reduced manufactured goods costs and the shale revolution kept energy costs low.

Try to look at this like an average worker. Your rent keeps rising, your kids can’t go to college without racking up debt, your health insurance is astronomical, and your wages, while up a bit, aren’t keeping up with your living costs.

Meanwhile, the people who are supposed to be looking out for you keep talking about how the economy is improving thanks to their brilliant policies. Of course you’re angst-ridden. How could you not be?

Deaths of Despair

Recently I wrote about the “deaths of despair” among middle-aged white men. This alarming and uniquely American trend is getting worse. Last month an American Medical Association study found US average life expectancy, which had been steadily increasing for decades, has now dropped for three consecutive years. It actually goes back a little further; all-cause mortality rates began rising in 2010. For some groups, it went back to the 1990s.

AMA zeroes in on the driver:

A major contributor has been an increase in mortality from specific causes (e.g., drug overdoses, suicides, organ system diseases) among young and middle-aged adults of all racial groups, with onset as early as the 1990s and with the largest relative increases occurring in the Ohio Valley and New England.

The opioid crisis apparently has a lot to do with this, as do the globalisation-driven factory closures in the Midwest and New England. Economic changes are literally killing us.

But again, think about this from ground level. Under-employed factory workers don’t read a lot of economic analysis. They just know they can’t pay the bills, they’re in physical pain from a life of hard labour, and no one in power seems to care. Many go on disability, which is not even close to minimum wage, and massively discouraging for somebody who wants to work. For some, it leads to depression and, tragically, overdoses or suicide. And it’s common enough to bend the curve in national life expectancy stats that had been rising for decades.

Worse, it’s not like we are powerless to treat these conditions. Medical science knows what to do, and does it pretty well for those with the means to pay. For Americans, that means people who (a) are over 65 and on Medicare, or (b) are poor enough to get Medicaid, or (c) get health insurance through their employers.

Everyone else, like self-employed people or “gig” workers? Not so much. Here’s a tweet from my friend Luke Gromen:

Those prices are pretty typical if you’re trying to buy insurance on the Obamacare exchanges and you’re middle-aged and not subsidy-eligible.

For illustration, let’s apply Luke’s prices to a hypothetical self-employed person making $100,000 a year. The $1,286/month premiums add up to $15,432 annually. But you get no benefits (except a basic wellness exam) until you’ve spent another $12,500. That totals $27,932, or 27.9% of your gross income that will go to healthcare if anyone in your family gets even a minor illness. A lot of angst.

Let’s take that a little further. This self-employed person is paying $12,000+ in Social Security plus another $3,000 in Medicare, plus federal income tax, in addition to state and local taxes. Which means that if someone in that hypothetical family gets sick, the family has to figure out how to make all of their payments on maybe as little as $45,000 net, after taxes and healthcare.

And in that scenario, then what? Spending that much of your income on healthcare means something else must go. Or, it will turn into medical debt and possible bankruptcy, even if you have insurance.

The irony is that much of the country thinks you are rolling in cash and might be inclined to vote for someone who would raise your taxes.
Source: DQYDJ

The angst isn’t just severe, it is creeping up the income ladder. Double that example worker’s income to $200,000 and they’re still spending 7.7% of it on insurance premiums and potentially another 6.3% to meet the deductible.

Imagine the outcry if we imposed extra income taxes at those rates. That’s effectively what is happening. Remember the “yellow vest” protests in France? They were about a new gasoline tax. Small potatoes really. But at the risk of a really bad pun, it just threw gasoline onto a stretched- too-thin public fire. At some point, we may see the same kind of unrest here, and healthcare costs could easily trigger it.

 Yes, yes, I know, the US has the best healthcare in the world. That’s debatable, given these latest mortality numbers, but we certainly have the most expensive healthcare.

(By the way, this cost difference is roughly the same if you look at it in percent-of-GDP terms. OECD has the data here.)

How do we spend so much and still have people dying from despair? That’s another topic. My point today is that the way we distribute that spending is having serious negative economic effects. We can and should debate reform ideas, but this can’t go on indefinitely.

 Healthcare is just one source of angst. Here’s another look at inflation which, according to the Fed, is not high enough.

Source: Lisa Abramowicz

The education part deserves some comment. The narrative goes that today’s young people need more education because work is so much more complicated now. So, we push them to attend college. Higher demand and slow-growing supply raise the cost of college, so they (and/or their families) go into debt to pay for it.

Does it pay off? Sometimes, but far from always. The chart below breaks down the change in college graduate wages since 2000 by percentile. In most cases, after that 2% average inflation the Fed thinks is too low, real wages actually dropped over this period. And note this only looks at those who actually earn degrees. Millions drop out before getting that far (but not before racking up debt).
Source: Economic Policy Institute

So not only is college more expensive, the economic benefit you get from it may well be negative. This is inflation on steroids.

Let’s think about that for a moment. You graduated in 2000 at age 22, got married, had kids, and right about now you’re facing college costs. What’s happened to the price of college? Up over 130% in 20 years. A tad more than 2% inflation.

Look, this isn’t complicated for most people. They need housing somewhere in proximity to their jobs. They want their kids to be safe and have opportunities. And they need to take care of their health. None of those are optional and their costs have risen far more than overall inflation.

To be clear, I’m not predicting higher CPI/PCE inflation, even if the Fed gets more dovish. Its present course will more likely produce more of the same: an asset bubble, lower prices for certain goods, and stable/rising prices for others. It won’t solve the problems regular people face.

 And in fairness, the Fed is not alone in thinking inflation is no problem.
Source: Donald J. Trump

Trump is correct if he means the broad inflation measures like CPI though, as we have seen, even 2% is not “almost no inflation” over long periods. He’s seriously wrong about the things middle-class Americans—including the millions who voted for him—must buy just to keep their heads above water. Those goods are expensive and getting more so.

What we really need are policies that make middle-class life affordable again. Lower interest rates won’t likely do that. Not when, as my friend Peter Boockvar reported last week, the average price of a new car is $34,000 and median household income is $64,000, and it’s that high only because millions need those cars to commute to underpaid jobs far, far away from the distant suburbs where they can afford to live.

In my normal peripatetic research mode, I found a fascinating Time article by Emily Guendelsberger, who wrote a book called On the Clock: What Low-Wage Work Did to Me and How It Drives America Insane. She describes her experiences working in warehouses, call centres, and fast food. I have family members who have worked at the places she names and their stories match. Conditions are more than a little stressful.  

I wasn’t prepared for how exhausting working at Amazon would be. It took my body two weeks to adjust to the agony of walking 15 miles a day and doing hundreds of squats. But as the physical stress got more manageable, the mental stress of being held to the productivity standards of a robot became an even bigger problem.

Technology has enabled employers to enforce a work pace with no room for inefficiency, squeezing every ounce of downtime out of workers’ days. The scan gun I used to do my job was also my own personal digital manager. Every single thing I did was monitored and timed. After I completed a task, the scan gun not only immediately gave me a new one but also started counting down the seconds I had left to do it.

It also alerted a manager if I had too many minutes of “Time Off Task.” At my warehouse, you were expected to be off task for only 18 minutes per shift—mine was 6:30 a.m. to 6 p.m.—which included using the bathroom, getting a drink of water or just walking slower than the algorithm dictated, though we did have a 30-minute unpaid lunch. It created a constant buzz of low-grade panic, and the isolation and monotony of the work left me feeling as if I were losing my mind. Imagine experiencing that month after month.

Vice is starting a series on what it’s like to work at low-paying jobs. The first installment from a young lady describing her experience working at McDonald’s for $9.30 an hour is deeply troubling. You can’t read it and not be emotionally moved.

It’s All Relative…

I mentioned above that even though the poverty level in the US is well above international average incomes, people compare their situation to what they see. My friend Philippa Dunne at The Liscio Report showed two charts demonstrating older generations (read Boomers) are doing much better than Gen-Xers and especially Millennials.

I understand the economic theories that GDP growth will eventually spread widely enough to ease the angst. But I am not sure we can wait that long. People are hurting now and they are increasingly willing to embrace radical solutions. “Just wait for better times” is not cutting it as technology eats into higher-paying jobs and aggravates the stress of lower-income jobs.

That’s doubly true if the economy weakens. Some of the data improved a bit in recent weeks. The November jobs report showed much stronger growth than we’ve seen in a while. That’s good to see and suggests we might postpone recession past 2020. But merely avoiding recession isn’t enough. Another year of sub-2% growth (which is my base case) will be another year of suffering for the millions whom this weak recovery hasn’t helped.

And it’s not clear that we can avoid a recession. One-third of economists surveyed by The Wall Street Journal think we will see a recession next year and almost 2/3s see a recession by 2021.
Source: John Mauldin

 Danielle DiMartino Booth, whose Daily Feather is a must-read for me, showed this yesterday:

Source: Quill Intelligence

Danielle explains the above chart:

Non-manufacturing hours worked have slowed appreciably with growth falling below 2% in the seven months ended October; the ADP report confirmed the weakness in hours worked and exhibited broad-based job declines and slowing across the full spectrum of sectors.

Trade deal headlines and Fed liquidity continue to dictate market trading; the widening breadth of economic weakness suggests fundamentals will eventually prevail though it will take a weak nonfarm payrolls print to truly get the market’s attention.

Angst-Ridden Voters

No one should be surprised the lower 80% of the income pyramid is anxious and depressed. You would be, too, in their situation. And there’s a good chance you will be in their situation in a few years, because angst-ridden people can still vote. Economic theories aren’t relevant to them. They look at their own situations and want change.

History suggests that President Trump should win re-election unless recession strikes by next November. But even if we avoid a recession in 2020, what happens if there is one in 2021 or 2022? Democrats could gain power by 2024, if not sooner.

The already-growing annual budget deficit will soar to over $2 trillion. How do we finance that without creating more angst? I can easily imagine a populist Democrat winning the White House, followed by higher taxes and an echo recession. Then even higher deficits and the national debt spinning out of control. The Fed will give us massive quantitative easing and zero rates, but they may be in fact pushing on a string…

We don’t have much time to get our house in order, either in the US or globally. Everything I’ve said today applies, to various degrees, throughout the developed world. Thinking that 2% inflation or zero interest rates coupled with massive deficits will somehow help is beyond wishful thinking.

We can and should take steps to protect our individual families and lives, but that’s not enough. At the national level, I’m beginning to fear only an enormously stressful Great Reset will deliver the deep but necessary sacrifices. The partisan divide inhibits compromise, so nothing happens and the problems grow.

Think about the late 1930s… Hopefully with just economic turmoil, not kinetic war. It will be hard but without the kind of motivation, I really question whether we will do what it takes.


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