The Investor February 2017

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Watch out for market turbulence ahead

Imagine a world without politicians: its coming!

by Richard Cluver

At home and abroad the world is re-shaping itself into something the scholars have barely prepared us for. We stand at the start of the post industrial age; a new era set to redefine how we think about everything from economics to investment to how we live our day to day lives. So, if you are concerned about the political uncertainties that are shaking our planet and roiling our investment markets you need to understand that what we are witnessing now are the earth tremors of a globalised planet groping its way into a new and uncertain future; into a Post Industrial Society.

In this new era, things that happen on the other side of the planet can have massive impact upon our own comfortable suburbs and the way we live our day to day lives. For several decades observers have been talking of the Global Village. Now it has arrived and it is reaching into the remotest backwaters of every society overturning age-old concepts of morality, religion, status and power. And the process has just begun!

The Encyclopaedia Britannica defines the Post Industrial Society as one “marked by a transition from a manufacturing-based economy to a service-based economy, a transition that is also connected with subsequent societal restructuring. Post Industrialisation is the next evolutionary step from an industrialised society and was most evident at first in countries and regions that were among the first to experience the Industrial Revolution, such as the United States, western Europe, and Japan. But now it is reaching all of us!

American sociologist Daniel Bell first coined the term postindustrial in 1973 in his book The Coming of Post-Industrial Society: A Venture in Social Forecasting, which describes several features of such a society characterized by:

1. A transition from the production of goods to the production of services, with very few firms directly manufacturing any goods.

2. The replacement of blue-collar manual labourers with technical and professional workers—such as computer engineers, doctors, and bankers—as the direct production of goods is moved elsewhere.

3. The replacement of practical knowledge with theoretical knowledge.

4. Greater attention being paid to the theoretical and ethical implications of new technologies, which helps society avoid some of the negative features of introducing new technologies, such as environmental accidents and massive widespread power outages.

5. The development of newer scientific disciplines—such as those that involve new forms of information technology, cybernetics, or artificial intelligence—to assess the theoretical and ethical implications of new technologies.

6. A stronger emphasis on the university and polytechnic institutes, which produce graduates who create and guide the new technologies crucial to a post industrial society.

To cite one example of how this globalisation has begun to change our lives, in recent years, major countries like Holland and Ireland cottoned on to the idea that  in an internet connected world, it was possible for multinational companies to locate their head offices virtually anywhere in the world and so, with appropriate advertising and attractive rates of taxation it would not be difficult to persuade them to re-locate to your country.  So, for example, where South Africa currently charges corporates 28 percent on their earnings, were you to move your head office to the Isle of Man you would pay nothing. It would be the same in the Bahamas, Bahrain, Bermuda, quite a number of Caribbean Islands while in Montenegro you would pay nine percent, in Bosnia and Bulgaria you would only pay 10 percent and in Cyprus you would pay 12.5 percent. You could move to Ireland and pay 12.5 percent. Mauritius only charges 15 percent while Singapore, Taiwan and Slovenia charge 17 percent.

That is why President Donald Trump has been railing at a system which has seen manufacturing plants relocating across the border into Mexico where labour is cheap and corporate tax at 30 percent is clearly more attractive than the US rate of 40 percent. The process has left behind a wasteland of unemployment and falling tax revenue which he aims to correct by competitively lowering corporate taxes in the US and raising tariff barriers against foreign goods entering the US to compete with locally-produced goods. His solution is a proposal to cut corporate taxes to below 15 percent. And the British Government has indicated that it is likely to follow. Ultimately governments will need to reach a concensus on levels of taxation if they are not to become embroiled in a downward competitive spiral to zero!

Countries like South Africa will in such a trend have no option but to follow if we are to have any hope of attracting new investment leaving ministers of finance with little option but to rein in their governments and placing a limit on who can be beneficiaries of social policies like the dole and healthcare which, even at current levels of taxation are unsustainable in the long run.

Meanwhile, we in South Africa are railing against the imports of “cheap” chicken meat which is putting local producers out of business and causing massive labour disruption. Yet housewives complain that they cannot find chicken at affordable prices in our stores. And this problem is reproducing itself all over the world raising discontent and, ultimately, political unrest wherever it finds itself.

Thus we have seen Brexit in Britain, the rise of Donald Trump as the most unlikely president ever. In France the public shivers in worried anticipation at the rise of right wing political favourite Marine Le Pen and here in South Africa we have seen the rise of Julius Malema and Parliament turned into a political circus.

What we need to recognise is the politicians have short-term agendas because their prime objective is to be re-elected at the next election. That is why there is no desire to tackle long-term issues like global warming which is likely to see the ultimate destruction of Planet Earth. But that event is a lot further away than the next election so why should our elected parliamentarians really care. Of course in South Africa we dont actually elect our politicians. We only vote for the party and the party decides who shall represent us. So, not only are our politicains only interested in the next election but we, the voting public, are of less interest to them than their standing in the party.

But note, all this is about to change. Note that political parties win elections by promising to deliver things to their electorate like, for example, in this country the dole which keeps 17-million unemployed people voting for the ANC…and being told by party representatives that, “We know how you vote!”

The problem that governments face all over the world as a result of this approach of short-term vote buying is that the voting public always want more than the system can deliver and so, as in South Africa, governments have inevitably run out of money to spend. And misplaced priorities like these mean that there is no money for long-term capital projects that make it possible to grow our industry and compete with producers overseas. So corporate profits dwindle and workers lose jobs and the tax base shrinks.

For a time governments can ignore the inevitable consequences of such short-term policies by borrowing on the international market. But as global indebtedness rises such an approach becomes unsustainable. An now we have the fact that employers are able to move themselves offshore to wherever the tax environment most favours them. And so the tax base dwindles even further and we get stagnant economies. That is why South Africa was once the global leader in mining and now has not attracted any new mining in a decade. Indeed, our existing miners are moving offshore.

Reality is, however, dawning. Politicians are having their wings clipped and will in time realise that short term goals ultimately guarantee short terms of political office. For the ANC that process has been vividly demonstrated by the loss of municipal power and the probability of the loss of national power in the not too distant future. They have not yet realised, however, that demonising capitalists is the quickest way of ensuring that they will move offshore taking their entrepreneurial skills and their money with them and further running down the tax base.

The interesting question that has begun to arise from this debate is whether politicians are still a necessary evil. We could after all replace them with executive presidents. Imagine companies tendering to run the country and being measured by their efficiency;  with policy decisions being taken by referendum. After all there are more cell phoines in use in this country – and in most other countries – than there are adult citizens and so it is not beyond the wit of the computing community to offer us a simple Yes/Know button on our cell phones with which to vote of the policy issue of the day.

Just imagine a world without politicians! Heaven must look a little like that!

But what if Janet Yellen is dead wrong!

by Danielle DiMartino

“If it were possible to take interest rates into negative territory, I would be voting for that.”

– Janet Yellen, February 2010

As her fame has grown, Janet Yellen is recognized in restaurants and airports around the world. But her world has narrowed. Because the Fed chairman can so easily move markets with a few casual words, Yellen can’t get together regularly and shoot the breeze with businesspeople or analysts who follow the Fed for a living. She must rely on her instincts, her Keynesian training, and the MIT Mafia.

“You can’t think about what is happening in the economy constructively, from a policy standpoint, unless you have some theoretical paradigm in mind,” Yellen had told Lemann of the New Yorker in 2014.

One of Lemann’s final observations: “The Fed, not the Treasury or the White House or Congress, is now the primary economic policymaker in the United States, and therefore the world.”

But what if Yellen’s theoretical paradigm is dead wrong?

The woman who “did not see and did not appreciate what the risks were with securitization, the credit rating agencies, the shadow banking system, the SIVs … until it happened” has led us straight into an abyss.

It’s time to climb out. The Federal Reserve’s leadership must come to grips with its role in creating the extraordinary circumstances in which it now finds itself. It must embrace reforms to regain its credibility.

Even Fedwire finally admitted in August 2016 that the Federal Reserve had lost its mojo, with a story headlined “Years of Fed Missteps Fuelled Disillusion with the Economy and Washington.” In an effort to explain rising extremism in American politics in a series called “The Great Unravelling,” Jon Hilsenrath described a Fed confronting “hardened public scepticism and growing self-doubt.”

Mistakes by the Fed included missing the housing bubble and financial crisis, being “blinded” to the slowdown in the growth of worker productivity, and failing to anticipate how inflation behaved in regard to the job market. The Fed’s economic projections of GDP and how fast the economy would grow were wrong time and again.

People are starting to wake up. A Gallup poll showed that Americans’ confidence that the Fed was doing a “good” or “excellent” job had fallen from 53 percent in September 2003 to 38 percent in November 2014. Another poll in April 2016 showed that only 38 percent of Americans had a great deal or fair amount of confidence in Yellen, while 35 percent had little or  none – a huge shift from the early 2000s when 70 percent and higher expressed confidence (however misguided) in Greenspan.

In early 2016, Yellen told an audience in New York that it was too bad the government had leaned so heavily on the Fed while “tax and spending policies were stymied by disagreements between Congress and the White House.” Maybe if she hadn’t been throwing money at them, lawmakers might have gotten their house in order.

“The Federal Reserve is a giant weapon that has no ammunition left,” Fisher told CNBC on January 6, 2016.

The Fed must retool and rearm.

First things first. Congress should release the Fed from the bondage of its dual mandate.

A singular focus on maintaining price stability will place the duty of maximizing employment back into the hands of politicians, making them responsible for shaping fiscal policy that ensures American businesses enjoy a traditionally competitive landscape in which to build and grow business.

The added bonus: shedding the dual mandate will discourage future forays into unconventional monetary policy.

Next, the Fed needs to get out of the business of trying to compel people to spend by manipulating inflation expectations. Not only has it introduced a dangerous addiction to debt among all players in the economy, it has succeeded in virtually outlawing saving.

Most seniors pine for a return to the beginning of this century when they could get a five-year jumbo CD with a 5 percent APR, offset by inflation somewhere in the neighborhood of 2 percent. Traditionally, 2 to 3 percentage points above inflation is where that old relic, the fed funds rate, traded. The math worked.

Under ZIRP, only fools save for a rainy day. The floor on overnight rates must be permanently raised to at least 2 percent and Fed officials should pledge to never again breach that floor. Not only will it preserve the functionality of the banking system, it will remind people that saving is good, indeed a virtue. And that debt always has a price.

Limit the number of academic PhDs at the Fed, not just among the leadership but on the staffs of the Board and District Banks. Bring in more actual practitioners – businesspeople who have been on the receiving end of Fed policy, CEOs and CFOs, people who have been on the hot seat, who have witnessed the financialisation of the country and believe that American companies should make things and provide services, not just move money around.

Governors should be given terms of five years, like District Bank presidents, with term limits to bring in new blood and fresh ideas.

Grant all the District Bank presidents, not just New York’s, a permanent vote on the FOMC. Why should Wall Street, not Main Street, dominate the Fed’s decision making?

While we’re at it, let’s redraw the Fed’s geographical map to better reflect America’s economic powerhouses.

California’s economy alone is the sixth biggest in the world. Add another Fed Bank to the Twelfth District to better represent how the Western states have flourished over the last hundred years.

Why does Missouri have two Fed banks? Minneapolis and Cleveland can be absorbed into the Chicago Fed. Do Richmond, Philadelphia, and Boston all need Fed District Banks? Consolidate in recognition of the fact that it isn’t 1913 anymore.

Slash the Fed’s bloated Research Department. It’s hard to argue that a thousand Fed economists are productive and providing value-added insight when their forecasting skills are no better than the flip of a coin and half of their studies cannot be replicated.

Send most of the PhD economists back to academia where they belong. Require the rest to focus on research that benefits the Fed, studying how its policies impact American taxpayers and citizens. (Did the Fed do any studies about how ZIRP and QE would impact banking and consumers before it imposed them? No.)

Now take all the money you’ve saved and aim it squarely at Wall Street investment banks intent on always staying one step ahead of the Fed’s regulatory reach. Hire brilliant people for the Fed’s Sup & Reg departments and pay them market rates. Rest assured this will be ground zero of the next crisis.

And mix it up. One of Rosenblum’s students applied for a job at the New York Fed. He came from a blue-collar background, spent seven years in the military, and earned his MBA from SMU on the GI Bill. Smart guy. But he couldn’t get to first base at the New York Fed. They hire people from Yale and Harvard and NYU – people just like themselves. Others need not apply.

Then the top Ivy Leaguers stay for two years and move on to bigger money at Citibank or Goldman Sachs. It’s a tribe that’s been bred over ninety years and slow to change.

But if the culture of extreme deference at the New York Fed (which also exists in District Banks to a lesser degree) is not quashed, regulatory capture will continue with disastrous results. The Fed must give bank examiners the resources they need to understand the ever-evolving financial innovations created by Wall Street and back them up when they challenge high-paid bankers who live to skirt the rules.

Regulators must focus on the big picture as well as nodes of risk. Interconnectedness took down the economy in 2008, not just the shenanigans of a few rogue banks.

Focus on systemic risk and regulation around the FOMC table. Create a post with equal power and authority to that of the chair to focus on supervision and regulation. Yellen talks about monetary policy ad nauseam, but when challenged by the press or Congress on regulatory policy she stumbles and mumbles and does her best doe-in-the-headlights impersonation. Markets need predictability and transparency when it comes to Fed policy, not guesswork, parsing of the chair’s words, and manipulation of FOMC minutes.

Finally, let nature take its course. Re-engage creative destruction. Markets by their nature are supposed to be volatile. Zero interest rates prevent the natural failures of weak companies, weighing down the economy with overcapacity for generations.

Recessions might have been more frequent, the financial losses greater for some, but if the Fed had let the economy heal on its own, America would have been stronger in the end and the bedrock of our nation, capitalism, would not have been corrupted.

I could never have imagined how my near decade-long journey at the Federal Reserve would play out.

In the beginning, I had been a “risk radar” to benefit myself and those closest to me. I wanted to stay out of debt and make certain that my children had great educations and a foundation of financial savvy so that they could pursue their versions of the American dream.

But I realize now the stakes are much higher.

We’ve become a nation of haves and have-nots thanks to Fed policies that benefit the wealthiest investors, punish the savers and the retired, and put the nation’s balance sheet at risk.

As consumers on the receiving end of Fed policies, we must reform our education system so that the American dream can be accessible to everyone. We must campaign for Congress to stop hiding behind the Fed’s skirts.

And we must demand that the Fed stop offering excuse after excuse for its failures.  Short-term interest rates must return to some semblance of normality and the Fed’s outrageously swollen balance sheet must shrink in size. And most of all, the Fed must never follow Europe by taking interest rates into negative territory.

No more excuses. The Fed’s mandate isn’t to have a perfect world. That only exists in fairy tales, dreams, and the Fed’s econometric models.

Higher tax rates are part of the problem not the solution

By Brian Kantor, chief economist and strategist at Investec Wealth & Investment

South Africans will soon learn how much more of their disposable incomes and wealth will be extracted to sustain the nation’s credit rating. They have been forewarned, though they do not appear forearmed, to resist the incoming tide of still more tax and less income to dispose of.

They will be told, correctly, why limiting the borrowing requirements of government (the fiscal deficit) is essential for holding down interest rates and the cost to taxpayers of servicing the debt (old and new) incurred on their behalf.

What will not receive much attention from the Minister of Finance is a recognition of the influence of taxes and tax rates on the ability of economically active South Africans to pay these taxes – so that tax rates have to rise even as the economy continues to flirt with recession.

Evidence of policy failure, in the form of persistently dismal growth in SA incomes, is there for all to recognise. The rating agencies have identified the lack of economic growth in SA and so of its tax base, as the long term threat to the solvency of SA government debt.

It is not good economic policy to tax some goods and services at a much higher rate than others. Nor does it help to subsidise more favoured (by politicians and officials) sources of income. The economy needs less of both taxation and subsidisation that can significantly alter the patterns of consumption and production; interventions that prevent prices and output from revealing the economic value of the resources used in production and distribution. Transport and energy costs, including the particularly adverse taxes on fuel and energy, have a large influence on the prices of everything consumed and produced in SA.

It is a mystery why South Africans appear so complacent about the ever higher specific taxes levied on their demands for transport and energy, yet are so defensive of the inviolate 14% VAT rate with all its significant, hard to justify exemptions that in reality help the better off more than the poor.

The Treasury is now looking to a tax on sugar added to soft drinks. It’s looking to add as much as 20% to the price of a litre of the offending liquid and also, not co-incidentally, hopes to produce significant additional revenue. This focus on extra revenue will deflect attention from the full, perhaps unintended, consequences of such penal taxes: that is not only less sugar consumed but added incentives for producers to avoid taxation, not just the sugar tax but also all the other taxes, VAT and income taxes that accompany the legal production of soft drinks. This has been the case with cigarettes, where highly penal tax rates have driven much of their production and distribution underground. When the price of a cigarette is cheaper on the street than in the supermarket, the practical limits of the ability to tax and also to influence the prices charged, have been exceeded.

The way forward is for the government to spend less, especially on the benefits provided to the nannies employed by an increasingly nanny state, who thrive on an ever-growing but largely dispensable tide of regulation that inhibits production and employment. The full costs, as well as the often marginal benefits of a regulation, need to be better recognised.

The government also needs to recognise the cost savings, were the private sector allowed to deliver more of the services that taxpayers fund, including education and hospital services as well as electricity and transport. And it should look to sell off the assets of these superfluous state-owned enterprises (SOEs) in order to reduce government debt and interest payments that the SOEs have been so assiduously adding to, given their poor operating results.

South Africans should fully recognise that ever-higher tax rates are not helpful to their economic prospects. They should be calling loudly for less government, less spending and interventions by government. This would lead to lower tax rates, faster growth and indeed more revenue collected.

The Counterfactual

by Cees Bruggemans

Not everyone understands the economy or how markets impact. That could be crucial when deciding on a change in underlying policy. SA has been

subjected to such a reality for years, when the focus moved away from market- and business friendly policies to one favouring central authority

directing resource allocation.

In the US we have currently major shifts under way, which especially in trade and migration policy could be heavily damaging. There is a yet bigger

fish, however, still swimming free but coming rapidly into focus. That is monetary policy as conducted by the Fed.

In SA the equivalent would be the policies of the SARB.

Political contrasts of course run deep in the US, and have for centuries. Once in a while, political changes come along that can have a definitive

bearing on the Fed composition, as it can have on the Supreme Court. This doesn’t remain without effect. Via markets, any Fed changes could have even

major global consequences.

Listening to Fed chair Yellen reporting back to Congress lifts the veil on these realities, in ways that can be very disconcerting. The questioning of

chair Yellen can at times be downright rude, by senators and congressmen throwing their weight around, but in the process also showing ignorance on a

remarkable scale.

It is rather clear that many Republicans have the culling knife out for the present Fed and its policies. This has been around for a long time, but

has become much more significant with the recent shifts in power balance.

And though one rude senator or representative doesn’t make a summer, the writing is rather on the wall. Things will change. But with what

consequences?

The one breathtaking thing that stands out is the ignorance on display. All economic outcomes are blamed on the Fed and its monetary policy, as if

there isn’t a fiscal policy or congressional politics to take into account. Also, society has a way of responding to circumstances, through a lack of

confidence, that cannot easily be undone by the Fed’s few instruments.

Especially disconcerting is lack of awareness of the counterfactual. As the great financial crisis started to unfold, the Fed alongside the US

government’s fiscal policy stepped into the breach. But when ere long fiscal policy had to pull back because the long term debt consequences

threaten to overwhelm, it was left to the Fed alone, and central banks in other major regions, to prevent a total collapse.

This seems to be conveniently forgotten. Instead, the Fed is blamed for slow growth and a decade of low interest rates that didn’t favour everyone.

But these erstwhile questioners don’t seem to consider the counterfactual if the Fed had taken the kind of turning that turned the 1930s into the

general depression disaster that it became, ultimately only overcome through the stimulatory character of another global total war.

If Bernanke & friends had not done what they did, and had not kept doing since then, namely to provide liberal monetary support to overcome the worst

of the regressive forces causing markets and economies to fail, the present world generation would have gone through yet another hell difficult to

contemplate.

Be that as it may, as Bernanke would say.

The fact of such ignorance makes one wonder what lies ahead once the Fed composition is changed, regulations are eased and policies are made even more

supportive than they are at present “to stimulate the economy”.

There are adults here playing with fire. Even if the US economy isn’t as yet at full resource utilization, it certainly is approaching that condition

at some speed. To want to institute policies now that would accelerate the pace artificially through simple credit creation, rather than more

fundamental stuff that would help to boost long run productivity growth, might just achieve the opposite of what is wanted. Overheating hasn’t

happened in decades, but it could easily happen before this decade is out. And then the right public servants to manage the situation wouldn’t be in

place.

Just like in the late 1960s and throughout the 1970s. A generation of insight and policy knowledge would become undone, just as these same people a

mere decade ago would apparently have wanted to replay the 1930s.

The worst hasn’t happened yet. But watch it arrive piecemeal, in what could still prove a very short period of time. That is, if these rude Yellen

questioners were to get their hands on the reins, as doesn’t look at all unlikely.

Hope you are ready for all eventualities. SARB I suspect will be.

Markets take “Radical” policy in their stride


by Cees Bruggemans

With the radical economic transformation agenda becoming ever more explicit politically, how is this being absorbed by the SA economy? It used to be

that “shocks” (unexpected events, with forward data implications) caused deep market disturbances (sell-offs…). Shocks could put the economy

into recession if there were sharp inventory corrections, and shocks could trigger booms if affecting sentiment positively (sharp commodity price

rises). How do recent events rate in this respect, and how is the economy affected?

The policy favouring radical economic transformation isn’t of recent origin. It has been around the better part of a decade, though for long implicit

rather than explicit. However, the intensity of these intentions, and accompanying demands, has been increasing, to the point of late offering

seemingly genuine shock value. Financially, markets can reflect such intrusions soonest, while the economy may take time reflecting any impact. In both instances, the impact can

vary from little shock to total shock. There is also the reality of steadily absorbing these realities over time.

Surprise has been expressed about the Rand hardly moving late last week as pandemonium erupted in Parliament, followed by the most blatant vision of

radical economic transformation so far offered. Besides being a spectacle, the evening’s entertainment did not seem to divulge anything that would move markets. The Rand hardly budged.

This doesn’t necessarily mean there are no consequences. The Rand’s long-term undervaluation can be partially traced to poor economic vision and

micro policy.

Also, if it was simply one more nail in our national coffin, in the manner that our institutions are thrashed and become unworkable, it

presumably will become reflected in a belated credit derating. That would move markets. Even so, our macro institutions are keeping their heads above water, and rating agencies may still believe there could be political reform down the

road with the fading of the Zuma era. And thus most data sets seemingly are on hold, waiting.

Regarding the economy, some parts are said to be in recession (mining for instance), but large parts of the remainder seem to keep drifting along,

even without effective political leadership. No growth, but also no precipitous decline. To put it yet differently, the public sector economy has had its efficiency undermined over many years, but may have started to stabilise. The private

sector economy has experienced a loss of confidence over many years and has adapted to this evolving condition, mainly by cutting back fixed

investment, inventory and labour forces, effectively putting large parts of its productive means on a good maintenance basis. And otherwise migrating

their critical mass elsewhere.

One then needs more than just slapstick as per the SONA debate to move the goalposts, genuinely shock expectations and invite a reaction. None of this is encouraging. The economy isn’t brain death, but seems to be on autopilot, going through the motions of keeping things ticking over

instead of fully utilizing our resource potential. The biggest shock potential ahead is the election of the next generation of political leadership. That will provide tipping points, either way. The

good news is that this should be resolved before year end, barely ten months away. The bad news is that the outcome could still be disastrous.

With a general loss of survey credibility in recent times, there may be a similar unwillingness to accept the inevitableness of things later this

year. Whatever it is that markets and economy are imbibing, they are prepared to remain adrift for now, awaiting actual events.

This shifts the real news focus internationally, and how it may affect us, even if our own daily news flow appears to be documenting our steady

institutional demise. Yet markets and economy aren’t apparently fully ready to acknowledge this.

The Energy Rally That Couldn’t

By Patrick Watson

Energy stocks jumped after the November election because investors thought new management in Washington would be their ticket to wealth. But what if it’s not?

On the surface, the stars seem lined up for Big Oil & Gas. President Trump promised to reduce the industry’s regulatory burden and open more federal land and offshore areas to drilling.

Furthermore, lower taxes and friendlier regulation will unleash animal spirits, boosting economic growth—and energy demand with it. Maybe it will all work that way, but simple economics tells me it won’t be so easy.

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The Bullish Case for Energy

So here’s what we know: Energy production is a highly regulated industry, and Trump will make it less so. The president demonstrated when he revived the Keystone and Dakota Access pipeline projects, which had been stalled by his predecessor.

Also, Trump’s key appointees should be a boon for the industry:

· Scott Pruitt, nominated to lead the Environmental Protection Agency, was the energy industry’s best friend as Oklahoma attorney general.

· Former Texas Governor Rick Perry, Trump’s choice for secretary of energy, once advocated abolishing the very department he will soon lead.

· Trump’s nominee for secretary of state, Rex Tillerson, was the CEO of ExxonMobil (XOM) and negotiated many overseas energy deals. US companies will no doubt gain new opportunities under his watch, maybe even in Russia.

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Photo: Getty Images

Reducing compliance headaches will make life much easier for oil and gas companies. All other things being equal, it should translate into higher profits.

There’s just one problem: All other things aren’t equal.

Supply & Demand

As the supply of a good or service goes up, the price rises and demand drops. When supplies fall, the opposite happens—demand rises and the price drops. That’s the law of supply and demand we all learned in economics class.

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Photo: Wikimedia Commons

However, the seller’s cost to acquire the goods isn’t part of this equation. It is an indirect factor. Lower costs let sellers supply more, thereby pushing the unit price lower.

This is the oil industry’s present problem. The very same factors that reduce their costs will also lead to higher supply. In the absence of higher demand, lower prices will follow.

Energy Intensity

So what about that demand growth? Will we use more energy in the coming years? Yes, says the new BP Energy Outlook, an exhaustive report from the former British Petroleum. BP thinks world energy consumption will grow 1.3% per year from 2015 to 2035. That’s impressive until you consider that it grew 2.2% a year from 1995 to 2015.

Why? The amount of energy it takes to generate economic growth, or “energy intensity,” is shrinking fast. Today’s vehicles and technology are far more fuel-efficient than those of the past. BP believes world GDP can double in the next 20 years with energy usage growing only 30%.

Worse, the demand growth isn’t happening here. It will be flat or even decline in the OECD countries (the US and other developed markets), with most growth happening in China, India, the rest of Asia, and Africa. You can see it in this chart from BP.

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The energy mix is changing too. Renewable sources like solar are growing fast in much of the world. Depending on location, in many places solar is now economically on par with fossil fuels, even without government subsidies. And these technologies will only improve.

So if demand for oil, gas, and coal is flat or rising slowly, producing more of these energy sources will keep prices steady at best, and more likely push them lower.

Supply Glut

The left chart below, again from the BP report, shows global proved oil reserves growing steadily since 1980.

Now, in reality the oil supply is not growing at all. Whatever is down there is what we have. So when we say supply is rising, we mean we’re finding more thanks to improved technology.

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The right chart ought to terrify energy bulls. Even if the entire world stopped exploring for oil right now, the amount we’ve already located is more than twice the cumulative projected demand from 2015 to 2050.

So if you own some of those untapped reserves, this tells you to bring your oil to the surface as fast as you possibly can. Sell it to someone while they still have a use for it. Otherwise, you’ll be stuck with a stranded asset nobody wants.

That’s what is happening too, despite the oil price falling sharply since 2014.

Debt-financed energy producers keep producing even when the oil price is below their production cost, just to cover their debt service. They literally can’t afford to stop—and that’s capping the oil price in the $50–$60 range.

Meanwhile, new technologies are pushing production costs even lower by automating the dangerous work formerly done by well-paid humans.

· National Oilwell Varco (NOV), for instance, makes an “Iron Roughneck” that does the tedious, repetitive work of connecting drill pipe segments.

· In offshore fields, submersible drones are doing much of the repair and maintenance work once done by human divers.

· Nabors Industries (NBR) says its new automated drill rigs will cut down the number of workers needed at each site from 20 to just five.

Lower production costs mean the supply curve can shift even more, letting producers supply the same quantity at a lower price. If that happens in a declining-demand environment, the price can drop even lower—and almost certainly will.

Similar trends are underway in coal and natural gas. All these energy sources face abundant supply, falling production costs, and lower demand. In my book, that doesn’t add up to a sustainable bull market.

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Photo: Getty Images

Sunset for the Oil Patch?

I am not predicting doom for the energy sector by any means. There is still plenty of opportunity to earn good revenue and even boost it.

But in the aggregate, the extractive energy sector faces serious headwinds, and there’s nothing President Trump and/or Congress can do to change it.

If you’re a nimble trader, you might be able to extract some profits in the next year or two. I’ve recommended natural-gas pipeline plays in both of my publications, the income-focused Yield Shark and its big brother, Macro Growth & Income Alert, a premium alert service for advanced income investing.

Opportunities exist—for now. Five or 10 years from now is a different story.

If Donald Trump gets a second term as president, the energy industry will be dramatically smaller than it was when he started.

Weighing the possibilities of the Trump plan

by  Van R. Hoisington and

Lacy H. Hunt

The 2016 presidential election has brought about widely anticipated changes in fiscal policy actions. First, tax reductions for both the household and corporate sectors along with a major reform of the tax code have been proposed. In conjunction, a novel program of tax credits to the private sector has been discussed to finance increased outlays for infrastructure. Second, provisions have been suggested to incentivize domestic corporations to repatriate $2.6 trillion of liquid assets held overseas. Third, there is talk of regulatory reform along with measures to increase domestic production of energy. Finally, various measures related to international trade have been discussed in an effort to reduce the current account deficit.

Judging by sharp reactions of U.S. capital and currency markets, success of these proposals has been quickly accepted. Such was the case with the fiscal stimulus package of 2009, as well as with Quantitative Easings 1 and 2; initially there were highly favorable market reactions. In these cases the rush to judgment was misplaced as widespread economic gains did not occur, and the U.S. experienced the weakest expansion in seven decades along with lower inflation. It could be that the fundamental analytical mistake now, like then, is to assume that the economy is “an understandable and controllable machine rather than a complex, adaptive system” (William R. White, in his 2016 Adam Smith Lecture “Ultra-Easy Money: Digging the Hole Deeper?” at the annual meeting of the National Association of Business Economists). While many of the aforementioned proposals include pro-growth features, it appears that there is an underestimation of the nega tive impact of delayed implementation and other lags. Additionally, the risks of unintended adverse consequences and outright failure are high, especially if the enacted programs are heavily financed with borrowed funds and/or monetary conditions continue to work at cross purposes with the fiscal policy goals.

Tax Cuts and Credits

Considering the current public and private debt overhang, tax reductions are not likely to be as successful as the much larger tax cuts were for Presidents Ronald Reagan and George W. Bush. Gross federal debt now stands at 105.5% of GDP, compared with 31.7% and 57.0%, respectively, when the 1981 and 2002 tax laws were implemented. Additionally, tax reductions work slowly, with only 50% of the impact registering within a year and a half after the tax changes are enacted. Thus, while the economy is waiting for increased revenues from faster growth from the tax cuts, surging federal debt is likely to continue to drive U.S. aggregate indebtedness higher, further restraining economic growth.

The key variable to improve domestic economic conditions is to cut the marginal household (middle income) and corporate income tax rates. Due to the extremely high level of federal debt, if the deleterious impact of higher debt on growth is to be avoided, then these tax cuts must be expenditure-balanced to the fullest extent possible along with reductions in federal spending (which has a negative multiplier).

Providing tax credits to the private sector to build infrastructure should be more efficient than the current system, but this new system has to first be put into operation and firms with profits must decide to enter this business. Moreover, all the various rights of way, ownership and environmental requirements suggest that any economic growth impact from the infrastructure proposal is well into the future.

However, if the household and corporate tax reductions and infrastructure tax credits proposed are not financed by other budget offsets, history suggests they will be met with little or no success. The test case is Japan. In implementing tax cuts and massive infrastructure spending, Japanese government debt exploded from 68.9% of GDP in 1997 to 198.0% in the third quarter of 2016. Over that period nominal GDP in Japan has remained roughly unchanged (Chart 1). Additionally, when Japan began these debt experiments, the global economy was far stronger than it is currently, thus Japan was supported by external conditions to a far greater degree than the U.S. would be in present circumstances.

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Tax Repatriation

One of the tax proposals with wide support gives U.S. corporations a window to repatriate approximately $2.6 trillion of foreign held profits under the favorable tax terms of 10% or 15%. There is a catch, however. To ensure that all funds are brought home, the tax is due on all of the un-repatriated funds even if only a portion is brought back to the United States.

Several considerations suggest there is no guarantee that these funds will actually be invested in plant and equipment in the United States. First, the fact that they are currently liquid suggests that physical investment opportunities are already lacking. Second, the bulk of the foreign assets are held by three already cash-rich sectors – high tech, pharmaceutical and energy. The concentrated and liquid nature of these assets suggests that after an estimated $260 billion to $390 billion in taxes are paid, the repatriated funds will probably be shifted into share buybacks, mergers, dividends or debt repayments. Putting funds into financial engineering will improve earnings per share, further raising equity valuations for individual firms; however, such transactions will not grow the economy. Finally, the basic determinants of capital spending have been unfavorable, and they worsened in the fourth quarter. Capacity utilization was only 75% in November 2016, well below the peak of just under 79% reached exactly two years earlier. The U.S. Treasury’s corporate income tax collections for the twelve months ended November 2016 were 13.1% less than a year earlier, suggesting corporate profits eroded considerably last year.

A possible additional negative result of the repatriation is that those assets denominated in foreign currency, estimated to be 10% to 30%, will need to be converted into U.S. dollars. This will place upward pressure on the dollar, reinforcing the loss of market share of U.S. firms in domestic and foreign markets. Tax repatriation was tried on a smaller scale during the Bush 43 administration in 2005-2006 with limited success. A much smaller amount of funds were repatriated, and the dollar showed strength.

Regulatory Reform

Regulatory reform could create increased energy production which would clearly boost real economic activity. This is accomplished by shifting the upward sloping aggregate supply curve outward and thereby lowering inflation. When the aggregate supply curve shifts, it will intersect with the downward sloping aggregate demand curve at a lower price level and a higher level of real GDP. The falling prices are equivalent to a tax cut that is not financed with more federal debt. Regulatory reform is a strong proposal and will benefit the economy greatly, in time, by making the U.S. more efficient and better able to compete in world markets. However, these benefits are likely to build slowly and accrue over time. Without question, the regulatory reform is the most unambiguously positive aspect of the contemplated fiscal policy changes since it will produce faster growth and lower inflation. Since bond yields are very sensitive to inflationary expectations, this program would actually contribute to lower interest costs as the disinflationary aspects of the program become apparent.

International Trade Actions

Proposals to cut the trade deficit by tariffs or import restrictions would have the exact opposite effect of the regulatory reforms and increased energy production. They would shift the aggregate supply curve inward, resulting in a higher price level and a lower level of real GDP. Any improvement in the trade account would reduce foreign saving, which is the inverse of the trade account. Since investment equals domestic and foreign saving, the drop in saving would force consumer spending and/or investment lower. Any improvement in the trade account would be limited since the dollar would rise, undermining the first round gains in trade. The more serious risk is that other countries retaliate. From the mid-1920s until the start of WWII this process resulted in what is known as “a deflationary race to the bottom”.

IMPEDIMENTS TO GROWTH

Over the past few months interest rates and the value of the dollar have risen sharply, and monetary policy’s quantitative indicators have contracted. These monetary restrictions have worsened the structural impediments to U.S. economic growth that existed before the election and continue today. These impediments include: (1) a record level of domestic nonfinancial sector debt relative to GDP and further increases in federal debt that are already built-in for years to come; (2) record global debt relative to GDP; (3) weak and fragile global economic growth resulting from the debt overhang; (4) adverse demographics; and (5) exhaustion of pent-up demand in the domestic economy.

Monetary Restrictions

If monetary conditions are tightened and interest rates continue to rise, economic growth from tax reductions are likely to prove ephemeral. Monetary conditions have turned more restrictive in the broadest terms over the past year and a half. The monetary base and excess reserves of the depository institutions have been reduced by $668 billion (16.4%) and $910 billion (33.7%), respectively, from the peaks reached in 2014 or as the Fed was ending QE3 (Chart 2). This reduction in reserves is in fact an overt tightening of monetary policy, which will restrain economic activity in a meaningful way in the quarters ahead.

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While maintaining the existing large portfolio of treasury and agency securities, the Federal Reserve has engineered contractions in the base and excess reserves by taking advantage of swings in other components of the base. The decrease in the reserve aggregates since 2014 reflects the following developments: (a) the substantial shift in Treasury deposits from depository institutions into the Federal Reserve Banks; (b) an increase in reverse repurchase agreements; (c) a shift from currency in the vaults of depository institutions to nonbanks (i.e. the households and businesses); and (d) a rise in required reserves as a result of higher bank deposits. These changes were necessitated by the Fed’s decision to raise the federal funds rate by 25 basis points in December of both 2015 and 2016. The Fed had the power to offset the reserve-draining effects of the shifting Treasury balances as well as the need for more currency and required reserves, but they chose not t o do so. The cause of the sharp drop in monetary and excess reserves is immaterial, but the effect is that monetary policy became increasingly more restrictive as 2016 ended.

Monetary policy has become asymmetric due to over-indebtedness. This means that an easing of policy produces little stimulus while a modest tightening is very powerful in restraining economic activity. The Nobel laureate Milton Friedman held that through liquidity, income and price effects, (1) monetary accelerations (easing) eventually lead to higher interest rates, and (2) monetary decelerations (tightening) eventually lead to lower rates. (In the near-term monetary accelerations will lower short-term rates and decelerations will raise short-term rates…”the liquidity effect”.) Friedman’s first proposition becomes invalid for extremely indebted economies. When reserves are created by the central bank, even if the amounts are massive, they remain largely unused, rendering monetary policy impotent. That is why M2 growth did not respond to the increase in the monetary base from about $800 billion to over $4 trillion. Plummeting velocity, which reflects too much counterproductive debt, further emasculated the central bank’s effectiveness. Thus, the efficacy of monetary policy has become asymmetric. Excessive debt, rather than rendering monetary deceleration impotent, actually strengthens central bank power because interest expense rises quickly. Therefore, what used to be considered modest changes in monetary restraint that resulted in higher interest rates now has a profound and immediate negative impact on the economy. This is yet another example of the adaptive nature of economies possibly unnoticed by federal officials.

Friedman’s second proposition is clearly in motion. While monetary decelerations may initially lead to higher interest rates the ultimate trend is to lower yields. The Fed’s operations raised short- and intermediate-term yields in 2016. Although Treasury bond yields are mainly determined by inflationary expectations in the long run, the Fed contributed to the elevation of these yields in the second half of 2016 as well as a flattening of the yield curve. Working through both interest rate and quantitative effects, the Fed added to the strength in the dollar, which was further supported by international debt comparisons that favor the United States. The Fed stayed on the tightening course during the fourth quarter as the economy weakened. This suggests that the Fed contributed to both the rise in interest rates and the stronger dollar. More importantly, in view of policy lags, the 2016 measures by the central bank will serve to ultimately weaken M2 growth, reinforce the ongoing slump in money velocity, weaken economic growth in 2017 and accentuate the other constraints previously discussed.

(1) Impediments to Growth: Unproductive Debt

At the end of the third quarter, domestic nonfinancial debt and total debt reached $47.0 and $69.4 trillion, respectively. Neither of these figures include a sizeable volume of vehicle and other leases that will come due in the next few years nor unfunded pension liabilities that will eventually be due. The total figure is much larger as it includes debt of financial institutions as well as foreign debt owed. The broader series points to the complexity of the debt overhang. Netting out the financial institutions and foreign debt is certainly appropriate for closed economies, but it is not appropriate for the current economy. Much of the foreign debt resides in countries that are more indebted than the U.S. with even weaker economic fundamentals and financial institutions that remain thinly capitalized.

A surge in both of the debt aggregates in the latest four quarters indicates the drain on future economic growth. Domestic nonfinancial debt rose by $2.6 trillion in the past four quarters, or $5.00 for each $1.00 dollar of GDP generated. For comparison, from 1952 to 1999, $1.70 of domestic nonfinancial debt generated $1.00 of GDP, and from 2000 to 2015, the figure was $3.30. Total debt gained $3.1 trillion in the past four quarters, or $5.70 dollars for each $1.00 of GDP growth. From 1870 to 2015, $1.90 of total debt generated $1.00 dollar of GDP.

We estimate that approximately $20 trillion of debt in the U.S. will reset within the next two years. Interest rates across the curve are up approximately 100 basis points from the lows of last year. Unless rates reverse, the annual interest costs will jump $200 billion within two years and move steadily higher thereafter as more debt obligations mature. This sum is equivalent to almost two-fifths of the $533 billion in nominal GDP in the past four quarters. This situation is the same problem that has constantly dogged highly indebted economies like the U.S., Japan and the Eurozone. Numerous short-term growth spurts result in simultaneous increases in interest rates that boost interest costs for the heavily indebted economy that, in turn, serves to short circuit incipient gains in economic activity.

(2) Impediments to Growth: Record Global Debt

The IMF calculated that the gross debt in the global non-financial sector was $217 trillion, or 325% of GDP, at the end of the third quarter of 2016. Total debt at the end of the third quarter 2016 was more than triple its level at the end of 1999. In addition to the U.S., global debt surged dramatically in China, the United Kingdom, the Eurozone and Japan. Debt in China surged by $3 trillion in just the first three quarters of 2016. This is staggering considering that the largest rise in nonfinancial U.S. debt over any three quarters is $2.3 trillion, and China accounts for 12.3% of world GDP compared with 22.3% for the U.S. (2016 World Bank estimates). Thus, the $3 trillion jump in Chinese debt is equivalent to an increase of $5.4 trillion of debt in the U.S. economy. Extrapolating this calculation, Chinese debt at the end of the third quarter soared to 390% of GDP, an estimated 20% higher than U.S. debt-to-GDP. This debt surge explains the shortfall in the Chinese growth target for 2016, a major capital flight, a precipitous fall of the Yuan against the dollar and a large hike in their overnight lending rate.

William R. White (as previously cited) describes the debt risks causally, fully and yet succinctly. By pursuing the monetary and fiscal policies in which debts are accumulated worldwide, spending from the future is brought forward to today. “As time passes, and the future becomes the present, the weight of these claims grows ever greater.” Accordingly, such policies lose their effectiveness over time. He quotes Nobel laureate F. A. Hayek (1933): “To combat the depression by a forced credit expansion is to attempt to cure the evil by the very means which brought it about.” White reinforces this view later when he says, “Credit ‘booms’ are commonly followed by an economic ‘bust’ and this has indeed been the case for a number of countries.”

(3) Impediments to Growth: Weak Global Growth

Based on figures from the World Bank and the IMF through 2016, growth in a 60-country composite was just 1.1%, a fraction of the 7.2% average since 1961. Even with the small gain for 2016, the three-year average growth was -0.8%. As such, the last three years have provided more evidence that the benefits of a massive debt surge are elusive.

World trade volume also confirms the fragile state of economic conditions. Trade peaked at 115.4 in February 2016, with September 2016 1.7% below that peak, according to the Netherlands Bureau of Economic Policy Analysis. Over the last 12 months, world trade volume fell 0.7%, compared to the 5.1% average growth since 1992. When world trade and economic growth are stagnant, and one group of currencies loses value relative to another group, market share will shift to the depreciating currencies. However, this shift does not constitute a net gain in global economic activity, merely redistribution. Thus, gains in economic performance of those parts of the world provide little or no information about the status of global economic conditions.

(4) Impediments to Growth: Eroding Demographics

Weak population growth, a baby bust, an aging population and an unprecedented percentage of 18- to 34-year olds living with parents and/or other family members characterize current U.S. demographics, and all constrain economic growth. Moreover, real disposable income per capita is so weak that these trends are more likely to worsen rather than improve (Chart 3).

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In the fiscal year ending July 1, 2016, U.S. population increased by 0.7%, the smallest increase on record since The Great Depression years of 1936-1937 (Census Bureau) (Chart 4). The fertility rate, defined as the number of live births per 1,000 for women ages 15-44, reached all time lows in 2013 and again in 2015 of 62.9 (National Center for Health Statistics). The average age of the U.S. reached an estimated 37.9 years, another record (The CIA World Fact Book). Population experts expect further increases for many years into the future. For the decade ending in 2015, 39.5% of 18-to 34-year olds lived with parents and/or other family members, the highest percentage for a decade since 1900, with the exception of the one when new housing could not be constructed because the materials were needed for World War II.

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Over time, birth, immigration and household formation decisions have been heavily influenced by real per capita income growth. Demographics have, in turn, cycled back to influence economic growth. If they are both rising, a virtuous long-term cycle will emerge. Today, however, a negative spiral is in control. In the ten years ending in 2016, real per capita disposable income rose a mere 1%, less than half of the 50-year average and only one-quarter of the growth of the 3.9% peak reached in 1973. In view of the enlarging debt overhang, which is the cause of these mutually linked developments, economic growth should continue to disappoint. There will likely be intermittent spurts in economic activity, but they will not be sustainable.

(5) Impediments to Growth: Exhausted Pent-Up Demand

In late stage expansions, pent-up demand is exhausted as big-ticket items have already been purchased. At the start of 2017, the current expansion reached its 79th month, more than 20 months longer than the average since the end of World War II. At this stage of the cycle, setting new records is a reason for caution, not optimism. With regard to pent-up demand, the economy is in the opposite condition of a recession or an early stage expansion. The lack of such demand makes the economy susceptible to either slower growth or to the risk of an outright recession. Numerous signposts of this late cycle risk include low factory use, weakness in new and used car prices as well as most discretionary goods, a rising delinquency rate on the riskiest types of vehicle loans and a fall in office and apartment vacancy rates.

Bond Yields

Our economic view for 2017 suggests lower long-term Treasury yields. Considering the actions of the Federal Reserve to curtail the monetary base and excess reserves, M2 growth should moderate to 6% in 2017, down from 6.9% in 2016. In the fourth quarter, on a 3-month annualized basis, M2 growth already decelerated below the 6% pace anticipated for 2017. This is unsurprising given the fall in excess reserves and the monetary base. Velocity fell an estimated 4% in 2016 on a year ending basis. We assume there will be a similar decline for 2017, although in view of the huge debt increase and other considerations, velocity could be even weaker. On this basis, nominal GDP should rise 2% this year, which means inflation and real growth will both be very low. A 2% nominal GDP gain for 2017 points to a similar yield on the 30-year in time, meaning that the secular downward trend in Treasury bond yields is still intact.

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