The Investor May 2015

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Please note that, as usual, there will be no publication of The Investor in June while Richard Cluver is overseas.

A strategy for dealing with Capital Gains Tax

by Richard Cluver

Retired people who are dependent on dividend income have been forced into an untenable position by the manner in which SARS levies Capital Gains Tax because, unlike other countries where investors are not liable for the tax if the money is re-invested within a reasonable period of a capital transaction, South Africans are forced to pay the tax every time a capital transaction occurs.

Take as an example a long-term investor who accumulated a share like Sasol which has paid steadily-increasing dividends over very many years and which would accordingly be regarded as an ideal counter to include in a “Widows and Orphans” portfolio. It would not be unusual to find pensioners who are holding shares in Sasol which they bought 30 years ago when they stood at R6.30 (July 28 1986) compared with a peak price of R643.68 in mid-June last year. In my observation, notwithstanding the ultra blue chip credentials of a carefully-constructed long-term share portfolio, about one share in ten will need to be replaced annually because it will have ceased to deliver above average earnings growth.

Illustrating this fact, in recent years Sasol’s dividend growth rate has, at 11.5% compound trailed far behind the ShareFinder Blue Chip average growth rate of 20 percent and so it would have been sensible for our investor to have got rid of these in order to switch into something that would have offered better dividend growth.

Now the conventional wisdom among prudent long-term investors has always been to create a family trust within which to lodge their investments and this was particularly the case where provision was being made for a disabled child, or by someone with a known terminal disease wanting to make provision for the long-term welfare of a widow. However, during his tenure as Minister of Finance, Pravin Gordhan appeared to take the view that such trusts were a dodge whereby the wealthy sought to avoid taxation and he elected to accordingly both raise the rate of

taxation on such trusts and remove all concessions, such as for example, the right to “trickle down” interest income into the accounts of beneficiaries who could thus take advantage of their tax-free income allowances.

So, assuming our investor made a modest R10 000 investment in Sasol shares back in 1986, then you can see that at its peak last year this investment would be worth R1 021 714 and his capital gain would have been R1 011 714 which, within a trust would attract CGT at 26.7% implying that our investor would have to pay SARS R270 127.63. Now, on the date that Sasol shares peaked in value they were standing at a dividend yield of 2.9% which implies that on that date our investor was expecting to receive a total annual dividend of R29 629.70. In other words, were he to sell the shares the capital gains tax he would have to pay would have wiped out his entire dividend income for the next nine years.


Effectively then, for retirees who depend upon a pension derived from a share portfolio built up during their working lifetime, since the advent of Capital Gains Tax in South Africa it has become practically impossible for them to effectively manage such portfolios so as to replace the underperformers with Blue Chip front runners. There is something of a bitter irony in this fact for in effect, since the government is daily becoming more constrained by the rapidly growing numbers of individuals on the dole: by those who either could not or did not bother to save during their working lives, it has become necessary to tax into oblivion those who scrupulously saved money throughout their lives in order to provide for themselves in their declining years….the prudent are being forced by this tax to pay for the imprudent and that does not seem fair to me!

Happily, although there is no quick fix for this dilemma in respect of those elderly who need all of their investment income to simply make ends meet, those who are still accumulating a retirement nest egg can plan to avoid becoming caught in this capital gains trap. But it does mean that you need to put more aside each month in order to build a capital sum much larger than you would otherwise have needed.

So let us begin with the “How much do I need” question that everyone planning retirement should ask themselves. This is actually quite a simple calculation which

assumes that by the time you retire your children will no longer be dependant upon you and you will have paid off all major debts such as household bonds etc. So, assuming you are currently still meeting such expenses and also assuming you are currently saving at least ten percent of your income, all you need to do is subtract the sum such latter costs from your current after-tax income to determine your current living expenses.

Next you need to take a guess at the likely annual average rate of inflation between now and the time you retire. Currently it would be safe to assume an average of around five percent, but it is better to err on the side of safety so rather assume six percent. And now you apply the “Rule of 72” which effectively means that 72 divided by six percent implies that the sum you will need to live on will double every seven years. Thus, for example, if you currently need R20 000 to live on after tax, bond repayments and child costs, you will need R40 000 in seven years time.

So, let us for convenience sake assume that you will be retiring in 21 years time and your current living cost is R20 000, then you would need to double that sum and double it again to arrive at an inflation-corrected living cost of R80 000 a month, or R960 000 a year in 21 years time. Next, recognising that Blue Chip shares on average pay a dividend of three percent, then a million rand invested will give you R30 000 a year. Divide R960 000 by R30 000 and you will see that the capital sum you will require in 21 years time will be R32-million.

For owners of my ShareFinder software, the next steps are very simple because the programme will create a growth share portfolio tailored to your ability to handle risk. The following is what it would currently recommend for someone fitting the investor profile I have just described:


Noting that such a portfolio would deliver a “Total Return” of 35.25% and the object is to achieve investment capital of R32-million in 21 years time, it is a fairly easy

compound interest calculation to determine that you will need to save R1 000 a week in order to buy these shares which will then in turn grow to the required sum by the time you retire.

But how, you ask, will I overcome the Capital Gains Tax problem when I reach retirement age? Well it is very simple really. As I explained at the start, you will need to plan to grow a much greater sum than you would originally have required such that at retirement it would provide you with sufficient surplus income that, instead of needing to sell underperforming shares in your portfolio, you will have sufficient surplus income so that you will be able to divert this income stream towards buying additional shares. The consequence of such an approach would, furthermore, lead in theory to the creation of a portfolio containing around 30 shares instead of the 10-share high growth portfolio I have illustrated here. While it is supposedly bad investment theory to have such an extended spread, the fact of the matter is that by increasing investment spread you diminish investment risk. Thus while the ideal growth portfolio for a middle-aged investor is ten to 12 shares, for a retired person it is quite acceptable, indeed desirable, to hold a 25 or 30-share portfolio.

Obviously if some of your chosen shares are in companies which over time have seriously lost their way, you will need to prune these away and face up to whatever Capital Gains Taxes arise from these. But the point should be understood that if you are able to constantly expand your portfolio

by buying in blocks of top-performers, the percentage represented by laggards like Sasol, will just as rapidly diminish such that they become relatively insignificant.

Thus, if R1 000 a week saved at your starting point is sufficient to achieve R32- million at retirement, then R2 000 saved each week will logically provide you twice what you will need at retirement. For someone whose living costs after tax, bond and childrens’ costs is R20 000 a month currently, the implication is that their monthly salary is around R35 000 and so their target saving rate would need to be around a fifth of their income.

That would seem to be a challenging sum to try and set aside each month. So the trick is to start with the highest proportion you can manage and annually increment that amount by about two percent of income each year. Thus, were you to save 10 percent in year one and 12 percent in year two, you would reach 28 percent in ten years time. Given also that most of us enjoy an annual pay increment better than inflation, if you try this approach you will find that it is not at all difficult to reach a desirable target.

Inflation rises to 4.5% y/y as


By Annabel Bishop, Investec chief economist

Inflation rises to 4.5% y/y as expected as the previous oil price savings dividend works out of the system, CPI inflation is on track to reach 6.0% y/y by year end and average 6.5% y/y in Q1.16


CPI inflation rose to 4.5% y/y in April, from 4.0% y/y in March, on the large (R1.62/litre) hike in the petrol price in April, including the 80.5c/litre rise in the fuel and RAF levies announced in the Budget. The petrol price did not change in May, but June is currently on track for a petrol price rise of around 50c/litre, which will contribute to higher monthly inflationary pressures.

CPI inflation is likely to rise for the rest of this year, and average 6.6% y/y in the first quarter of 2016 on the statistical base effects generated by CPI inflation reaching a low point in 2015 of 4.1% y/y for Q1.15. In particular, the petrol price was R3.65/litre lower in February 2015 compared to a year ago, establishing a low base.

On its own, the temporary breach in the inflation target in 2016 would not necessitate the SARB to hike interest the repo rate, but the fact that CPI inflation is likely to average close to 6.0% over 2016 turned the MPC’s tone from neutral-to-dovish in January to neutral-to-hawkish in March. While we do not expect the MPC’s tone to turn outright hawkish at this week’s MPC meeting, and so deliver an interest rate

hike in May (21st), the SARB is likely to signal it could hike in H2.15, as is expected.

Weak economic growth is likely to stay the MPC’s hand on the interest rate front at its May MPC meeting. While slightly lower interest rates will not meaningfully stimulate economic growth because of the supply side constraints experienced in the economy (notably electricity), higher interest rates would negatively impact the interest rate sensitive services sector of the economy, which will be the driver of economic growth in 2015 and 2016.


Eskom has instituted a 12.7% y/y hike in the electricity price (14.3% y/y for municipalities), which will impact all consumers by July as usual, although the hike in tariffs is above recent year’s 8.0% y/y increases, and so will place upward pressure on CPI inflation in H2.15, assisting it towards 6.0% y/y by year end. However, there is a possibility of a further increase in the electricity tariffs this year, bringing the total rise to potentially as much as 25.3% y/y.



clip_image012Eskom says “as a result of historical non-cost reflective tariffs and the lag in recovery of eligible expenditure” and “short term power purchases and increased use of open cycle gas turbines” it cannot meet further costs and has reopened the “MYPD 3 application from … 2015/16 … onwards that proposes an adjustment in the tariffs”.

Furthermore, an increase in the environmental levy is likely.

A tariff increase of 25.3% y/y this year (should NERSA give approval) would cause CPI inflation average to 5.0% y/y for 2015 and 6.0% y/y in 2016, from our current forecasts of 4.8% y/y and 5.8% y/y respectively.


The ‘core’ inflation rate (excludes food, non-alcoholic beverages, electricity and petrol prices) dropped to 5.6% y/y as expected.


Thoughts from the Frontline:

Secular Versus Cyclical

by John Mauldin

The consensus I’m hearing and reading from the 500+ attendees at the recent Strategic Investment Conference is that this was the best ever. It was certainly intense, with more divergent views presented this year than at previous conferences. Plus, the range of topics was rather dramatic. This year I was able to listen to all but one of the presentations, and I want to share with you my notes and takeaway thoughts. (In addition to my own notes as a source for this letter, my associate Pat Watson sent me his notes, as well as links to a summary by attendees Chris Bailey and my good friend Steve Blumenthal. I borrow freely.)

I put a great deal of effort into planning the speaking lineup for my conference. It is routinely called the best macroeconomic investing conference in the country each year, and I have to humbly agree. It takes work to make it that way. Last fall, when I began to consider my lineup for this year’s conference, one of the big questions on my mind and the minds of nearly everyone I was speaking to was Federal Reserve policy, so I specifically looked for a few new speakers who could address that concern. The topic of what the Fed would do and what the effects would be was a running theme throughout the conference. That concern is mirrored in the following quote from Stan Druckenmiller. (I think I’ll try to get him to come to the conference next year.)

Earnings don’t move the overall market; it’s the Federal Reserve board. And whatever you do, focus on the central banks and focus on the movement of liquidity. Most people in the market are looking for earnings and conventional measures. It’s liquidity that moves markets.

Note: In a departure from tradition, cosponsor Altegris Investments has agreed to allow me to share one video of a conference speaker per week for the next few months. The videos are in production, and I hope to be able to bring you the first one next week. Now let’s look at my notes.

SIC 2015: Speaker Notes

First up was David Rosenberg. Rosie has been my leadoff hitter for a number of years and is a crowd favourite. Never in all these years has he failed to bring a new presentation. My associate Tony Sagami, along with a number of other attendees, thought that Rosie’s presentation was the best of the conference. It was certainly one of the most bullish. David was consigned to the permabear camp for many years, but he actually turned bullish at my conference about four years ago, which was pretty good timing.

He called the current economic expansion “The Rodney Dangerfield Expansion,” since it gets no respect. The economy is tepid, in large part due to the shrinkage of the working-age population. Baby Boomers didn’t have enough sex, and Millennials are delaying parenthood. There are not enough people to buy houses and consumer goods. (Pat Watson quipped: “I think the Boomer generation had plenty of sex. The problem is it was the non-procreative kind. FDA approved “the pill” in 1960, and birth rates plummeted soon afterward.”)

Nonetheless, at 70 months so far, the weakest post-World War II recovery is still the sixth-longest expansion since the Civil War and deserves more respect.

Rosie contends that interest rate hikes won’t necessarily hurt stocks. The last time the Fed hiked was June 2006, and it took 18 more months before the market started to crack. He offered this slide:


He predicts the Fed rate hike will not bring an end to the economic expansion or bull market. It is when the Fed tightens too much that they invert the yield curve and recessions start. All the “bad stuff” happens after the last Fed rate hike in a cycle.

This expansion will end, too, but may not be over until 2018, Rosie says. On the profits recession: if you strip energy out of the S&P 500, profits are actually up. Energy earnings are down 64%. Central banks are gobbling up the Treasury supply. Note the drop in marketable Treasury securities outstanding from $2 trillion to $700 billion.

S&P 500 earnings ex-energy look fine. Therefore stocks are not as expensive as you think. Real bond yields are negative; bonds are overvalued. (Bonds being overvalued was a theme sounded by multiple speakers at the conference.)

Inflation is running close to 2.5%. There is more inflation beneath the surface than meets the eye. Real yields are negative. Institutions have to buy T-bonds. You don’t

– risk-reward is not in your favor. Bonds today are strictly for speculators. Coupons no longer provide any downside protection. Rosenberg offers his strong conviction: equities will be the best-returning asset class; stocks will outperform bonds.

Credit Sucks

Next up was Peter Briger of Fortress Investment Group, one of the largest private credit funds in the world. He had one of the better lines of the conference, which I just have to note. (Remember, he’s been embedded in the credit world for decades.) “Credit sucks,” he quipped. He’s not interested in any long credit assets. He said this about 20 times in different ways. You get the idea that he really hates credit now.

“Don’t buy anything with a CUSIP.” There are opportunities, but they aren’t easily available to the public. The credit assets you can actually trade do not have a sufficient liquidity premium to justify their risk. We will have great opportunities in a high-default environment when the financial system is on its ass. It’s coming but not here yet. He would love to short German bunds, but trading mechanics make that very hard.

His remarks struck me as being part and parcel of a theme that has begun to show up a great deal recently in conversations and in my reading: there is an accelerating dropoff in the liquidity of fixed-income markets. There are several explanations for this, not the least of which is that the new regulations that resulted from Dodd-Frank have forced banks to pull back from providing liquidity and taking risks with capital. Bond funds promise daily liquidity; but in an exit, when herd mentality kicks in, there will simply be no liquidity for those funds; and pricing will go out the window. I was having lunch with an investment advisor today (who was at the conference), and a theme of our conversation was that bonds have to be considered risky. He is actually reducing exposure to bonds in his conservative portfolios.

Which brings us to the presentation of Dr. Lacy Hunt. Lacy is still recommending to his clients that they be invested in long-dated zero-coupon bonds, which his funds over at Hoisington Asset Management utilize. Lacy (along with Gary Shilling, who followed up with Lucy in the Q&A session) has been recommending long bond positions for 30 years. He does not feel the bond bull market is over. I want to cover some of the ideas he presented and then talk about how both Lacy and Rosie can be right.

Characteristics of Over-Indebted Economies

Lacy is clearly in the deflation camp. Let’s see if I can summarize his conclusions about over-indebted economies:

1. Temporary economic growth spurts can’t be sustained.

2. Weak demand caused by payment obligations creates structural downturns.

3. Productivity falls without inflation.

4. Monetary policy is ineffective.

5. Inflation falls dramatically.

6. T-bonds fall to extremely low levels.

Nominal GDP is the best indicator to judge over-indebtedness. Per capita GDP shows standard of living growth averaged 1.9% from 1790–1990 but only 1.0% from 2000–2014. The real indicator and culprit for the weakness is public plus private debt as a percentage of GDP. Currency devaluations don’t help, because they simply steal growth from others, who then retaliate.

Tendencies of over-indebted economies:

1. High debt tends to be a global phenomenon.

2. Rolling currency devaluations get thwarted by the Nash equilibrium.

3. Currency changes deliver no net gain, only a transitory benefit.

4. Currency devaluations reinforce global disinflationary conditions.

5. The only cure is a significant multi-year savings boom OR austerity.

Austerity is either self-imposed, forced by external demands, or naturally evolves through fortuitous circumstances.

Secular Versus Cyclical

I’m going to be conducting a little “debate” with our new associate at Mauldin Economics, Jawad Mian, who is expecting a return of inflation, which doesn’t exactly sound like one of my themes. He’s going to present his case, and then I will present mine. A few of our mutual readers have wondered how we can have such different views. The answer is actually in our time frames. I’m not really a trader as such and tend to look out over a longer horizon. Jawad comes from a hedge fund background and is quite focused on the current period. (You can see Jawad’s latest letter here – we have made it available for free.)

Lacy has a secular view of interest-rate dynamics, while many of the other conference speakers (but not all) were far more interested in what is going to happen over the next few months and quarters. It is important to understand the time frame of the speakers as well as to understand your own time frame and personality. If you have a long-term investment plan but a short-term mentality, you are not going to be able to stick to your plan. Let me say that there is absolutely nothing wrong with having a shorter-term view of the world if you have a plan that works in that perspective. Trading is a lot harder than it looks, like some of those crazy stunts that are done on TV right after the host looks into the camera and warns the viewing audience, “Don’t try this at home, boys and girls.” Then again, it can be tough to sit through cyclical ups and downs when they are going against you.

Everything That’s Obvious Is Wrong

Lacy was followed by one of my favorite economic commentators, Jim Bianco. His speech consisted of four themes, which I will summarize:

“Everything that’s obvious is wrong.” The earnings game is rigged by Wall Street: companies almost always beat expectations because they keep changing the expectations to match their realities. Jim is worried about the stock market but not afraid of a crash, as in, he doesn’t think one is likely. QE is the problem, not the solution. The Fed thinks it has a third mandate for “market stability.” Therefore it spends all its time trying to make sure Wall Street doesn’t get upset. He had an interesting chart showing that crude oil prices and world growth expectations track closely.

clip_image014Paul McCulley was up next. He was perhaps the most unrepentant Keynesian to present at the conference, where he has been a mainstay for 11 straight years. This is the first time in a very long time that he had absolutely no facial hair. He was almost hard to recognize. He summarized some of his previous correct predictions. Most notably, 2008 was a Minsky Moment (I believe he coined the term), which is a liquidity trap – a period when the private sector has too much debt, which fuels a bubble. The dot-com bubble wasn’t debt-financed, so it popped quickly and was over. The housing bubble was worse because it was debt-based as well as based in illiquid assets.

When a debt-fueled bubble collapses, you get a recession. Monetary policy is ineffective in such recessions. Debt is too large relative to asset value. Private-sector debt generally creates tax revenue, making it easier to justify government stimulus (there we disagree). Fiscal stimulus is the right answer. Austerity is the wrong answer.

Louis-Vincent Gave flew in from Hong Kong to present his rather bullish view, not of the US stock market but of China.

“Money managers are paid to adapt, not to forecast,” he told us. Peak oil was hogwash, so why did it take so long for the oil price to collapse? The oil boom had all the elements of a traditional bubble. Now it has burst. Why? His answer is China. There is a new, ruthless ruler, Xi Jinping. Xi’s deal with Putin shifted the dynamic, putting China in the driver’s seat. The China-driven commodity bubble was a “good” one since capital markets financed it, but it still led to the present deflationary shock. Asia was the biggest commodity consumer, so now it is the biggest beneficiary of lower prices.

Louis believes there is a huge change coming, with China pressuring the IMF to add the renminbi to the basket of four currencies (USD, euro, UK pound sterling, and Japanese yen) that make up the special drawing rights. He thinks they will probably get their wish at the November 2015 IMF meeting. This will let other central banks hold RMB, which they will do because it has a much higher yield than the

alternative currencies (the four listed above). The result would be the lifting of Chinese capital controls and a sharp increase in China’s weighting in world equity indices, forcing everyone to buy. The current China rally is front-running the entire world.

Louis is also bullish on Europe. Everything is lining up well, he says. He thinks the reflation plan will work. He does say to underweight the US. Valuations in the States are too high; P/E expansion can’t continue. More than one third of S&P 500 earnings come from abroad, and dollar strength is killing them.

His broad conclusions? We are still in a deflationary period. The emerging market/developed world dichotomy no longer matters. Asia is in a broad bull market that will continue. Europe is in the sweet spot – a must-seize opportunity.

He did point out some potential risk factors: Russia, Eurozone upheaval, and a US bear market.

Peter Diamandis was our keynote dinner speaker on Thursday, and he really wowed the crowd. He spoke for almost an hour; the Q&A session was an additional hour; and literally nobody was leaving. We had some very special guests for the Q&A session, and I’m looking forward to being able to post that session if Peter will allow it. Peter is a true Renaissance man. He is an engineer and a physician and an entrepreneur best known for founding the X Prize Foundation. His book Abundance is a must-read. He is the ultimate optimist. He is the co-founder, along with Ray Kurzweil, of Singularity University. I have attended their 10-day executive course and highly recommend it.

To Peter, the media is a drug pusher, and their drug of choice is negative news, not the real world. The reason for this is that negative news sells. It appeals to that part of our human brain called the amygdala. Taking the opposite tack, he sees plenty of evidence for continued abundance: increases in global incomes, lifespans, and food production, and a decline of violence. He talks and writes about disruptive technologies – those technologies that will literally change the landscape of business.

The next morning former Fed governor Larry Meyer took the stage. Federal Reserve policy goals are simple – the dual mandate. Unlike many of the other speakers, Larry thinks the hurdles to a rate hike are very low, which he thinks will happen in the September FOMC meeting. The Fed doesn’t need rising inflation or wages to hike, they just want inflation not to be falling. The challenge for us and for the Fed is to extract a signal from all the noise.

Meyer thinks we will be at full employment by September. If not for the oil shock, PCE inflation would be around 1.6%. In the Q&A, I asked him why the Fed fixates on 2% inflation. Why not 0%, 1%, 5%? Larry said the 2% target gives the Fed a cushion to cut rates if it wants to. Monetary policy at the zero bound is not an effective tool.

Grant Williams and Raoul Pal then did a tag-team session presenting what I thought was one of the most interesting ideas of the conference. A monsoon is a wind that blows through South Asia. It brings rain and once blew ships along ancient spice routes. Raoul and Grant presented a long-term forecast about what they call the monsoon region: South Asia and parts of the Mideast, East Africa, and Southern Africa, which they believe will be the next major growth region of the world.

The monsoon region has significant metal/mineral wealth, oil, fertile soil, and a young population. Demographics are on its side. The region is much younger than other areas of the world, with fewer old people to support. They referred to two McKinsey consumer growth studies, on “City 600” and “Emerging 440,” which emphasize this region. Grant and Raoul see opportunities everywhere:

Ethiopia – gangbuster growth, cotton resources, could replace Bangladesh as an apparel manufacturing centre.

Iran – high literacy rate, educated population, no debt (since it has been locked out of markets so long), and low P/E multiples because everyone shuns it. At some point the past will be shed, and the typically outward-looking Persians will turn their nation back into the trading mecca it has traditionally been.

India – with a huge population and, finally, a leader (Modi) who seemingly gets what needs to be done, is simply the giant of the region.

Morocco – bridges MENA with Europe and is the gateway to Algeria’s resource riches. I thought this was a very interesting idea, and I may just need to go to Morocco for myself. Marrakesh, anyone?

Bond guru Jeffrey Gundlach spoke next and titled his speech “To Raise or Not to Raise?” His slides showed that June 2014 was a key turning point. Lots of things changed around that time: the dollar, Europe, oil, and the Fed.

“When will negative rates change behaviour?” he asked. Yields are negative due to lack of supply – there is no net issuance anywhere in the developed world. Fed funds futures indicate no hike in June, and Gundlach agrees. In contrast with Larry Meyer, he thinks there will be no rate hike this year and the Fed will let the economy “run a little hot.” The US dollar will stay strong, in a 10-year uptrend, with commodities generally weak, except that Gundlach said he likes gold. I wasn’t doing the Q&A for that session or I would have asked why he is bullish on gold and the dollar at the same time. Bullish on gold in terms of Euro/USD unity I can understand.

He points out that cross-border CPI comparisons fail because of differing methodologies. In concert with Lacy, he says that nominal GDP is a great indicator of long rates. CPI is a squishy and arbitrary statistic, but it isn’t rigged.

With this next thought from Jeff I’m in total agreement: bond markets will fall gradually, then suddenly. Rates are already rising. Gundlach is still defensive on bonds and thinks too many investors are embracing them. High-yield will get cheaper after the first Fed tightening. He says he will stay out for now and buy HY later when it’s cheaper.

“Everything you know about high-yield bonds is wrong,” he said. He likened all of us to summer insects – we never seen high-yield in a major tightening cycle because the last one was already past when Milken invented HY. Current default rates are deceptive – he expects big problems when issuers have to roll over at higher rates. Going from 5% to 14% will kill some companies. (Briger mentioned something that goes along with this idea as well.) He expects the biggest problems for high-yield to be in the 2019-2022 period.

On a separate note, he thinks the federal budget deficit problem will return, but there is one glimmer of hope: household formation is picking up, which should help tax revenue.

Stephanie Pomboy was our next speaker, and she gave one of the more entertaining presentations of the conference. When we make it available, you really want to set aside some time to watch it. And I guess it was good that she was entertaining, because she was definitely the most bearish of our speakers. She thinks economic growth will stay low and that the consumer is still not back. The Fed will not tighten this year and may even launch QE4.

What would trigger a recession? She thinks it’s a function of whether the stock market sees a sharp correction. In that she agrees with me, as I have wondered sometimes over the past year (in this letter) whether we might see a reversal of the usual bear market pattern: normally we see a recession coming, and then the stock market rolls over. Could it be that this time the market will roll over for reasons outside of the US economy and that will trigger a recession in the US? It’s just a question, but it seems to be on Stephanie’s mind as well. And, of course, she likes gold.

My friend George Friedman was our lunch speaker, and he was in rare form. It’s been a few years since we’ve had him at the conference, but he is always a crowd favourite. He has just completed an excellent book on Europe called Flashpoints: the Emerging Crisis in Europe. In Flashpoints he talks about the frictions in Europe and why they won’t go away anytime soon. The problems are as much cultural as economic or political. George started out talking about the process of creating jobs in Europe and described the regulatory nightmare that is the European Union. “You don’t hire employees in Europe; you adopt them.” The regulatory regime in Europe prevents entrepreneurialism. There will never be a Google in Europe.

The Enlightenment was real, George reminded us, but it didn’t eliminate war. Rather, it intensified war as ever-greater technologies made war even more destructive. He took us back to pre-World War I, when books were being written about how Europe had become too civilized for war. I’ve talked about how European bond markets, almost until the very first WWI engagement between France and Germany, discounted the possibility of war.

George asserts that PIIGS bonds won’t be repaid in any conventional sense. The only question is how long they can paper over the problems and stave off political upheaval. He cautioned us to stop thinking of Europe as a single entity, because it isn’t one.

In the Q&A period he was asked about Russia. He believes that Putin has become a figurehead for the oligarchs. He sees potentially bigger danger ahead when the country starts to fall apart in the 2020s but still has nuclear warheads. This thought provoked a low groan from the audience. Russia – the crisis that keeps on giving. (I will have an afternoon get together and then dinner with George and wife Meredith next Friday here in Dallas, and I am really looking forward to grilling him on a few topics.)

Next, we stayed with our geopolitical theme, and Ian Bremmer gave one of the best presentations of the conference in terms of simple delivery and keeping the crowd focused.

You could summarize his view as, “The geopolitical situation is bad.”

· The US is no longer helping allies as in the past. The US is not becoming isolationist – more like “unilateral.”

· Transatlantic relations are the worst in 30 years. As an example, the Netherlands hired Huawei to rebuild its internet backbone, showing that they are keeping their options open.

· Russia is declining, but Ukraine has been a big domestic success for Putin. His 80%+ approval ratings are real. We underestimate Russian resiliency. Sanctions will backfire and leave Putin with a desire to punish the US. Kerry

didn’t exactly come back from the latest summit with any positive developments. Ian expects more Russian military probes and “accidents” around the NATO periphery. Putin is very dangerous: back him into a corner, and he will jump out and bite you.

· China rising – a 30-year trend. It’s the only country with a coherent global strategy. He worries about long-term Chinese stability but thinks we should be OK for another 5-10 years.

· “Globalization is proceeding. Americanization is not.” That is one that made me think.

· The Cuban government survived 30 years of sanctions but will not survive 3 years of Starbucks. Once you give people a taste of what could be, they are going to want it.

· He sees India becoming more assertive and is rather positive on India. Beijing is trying to counter with its New Silk Road initiative.

What could change his forecast? Three possibilities…

· China overplays its hand

· Middle East war – likely Saudi vs. Iran

· Iran nuclear pact implementation problems

During a free-fire question-and-answer session he gave us the following bullet points:

· Saudi reforms are over with the recent changes at the top. Their FX reserves won’t last forever.

· Russia’s and Iran’s cyberwar capacities are danger points.

· He is optimistic on Brazil as SOEs reform.

· The US will earn a geopolitical risk premium, but only because everywhere else looks even worse. The main US problem: our allies don’t trust us. The Asian Infrastructure Investment Bank proves it.

· The US is in real danger of losing currency reserve status unless we counter China soon.

DDD: Buy the Dax, Hedge It in the Dollar, and Be Done

For the last five years that I’ve been following David Zervos, the chief market strategist for Jefferies, he has developed a theme for investing in the following year. He is on an uncannily good roll. All the themes have been built around the concept of investing in the era of QE. In his conference presentation he explained that he felt the US is now too complicated, but we know what happens with QE, so let’s go where we are seeing QE: Europe. The simple way to structure the trade is to buy the Dax, but in dollar terms, so you hedge the euro in the dollar and you are done – call it a day. So far that has been a good trade for the year.

My good friend Kyle Bass was our Friday night dinner speaker. He asked me to keep his presentation private, although he did share it with the attendees. He has agreed to let me write about his concept of shareholder activism in the hopefully not too distant future. I feel comfortable sharing that he touched on the progress he is making in challenging what he believes is out-of-control manipulation by the pharmaceutical industry in regards to patent protection. Did you know that it is

clip_image015actually illegal for Medicare to negotiate drug prices? I didn’t. Blame both Bush and Obama and a very powerful lobby. How do you get it written into law that the federal government has to pay whatever price you want? I guess by spending billions in lobbying fees. He mentioned that the US could save

$300-$700 billion per year over 10 years if we paid the same prices Canada now pays for the very same drugs. Even more if we paid what Norway pays. Talk about a way to balance the budget!

Saturday morning we started off with Michael Pettis, who is not as bullish on China as Louis Gave is. Pettis is a Beijing-based economic theorist and financial strategist. He is a professor of finance at Guanghua School of Management at Peking University in Beijing. He was founder and co-owner of punk-rock nightclub D22 in Beijing, which closed in January 2012. He produces records for a lot of very innovative Chinese groups, so I guess you could say he is an economic rock star. He has one of the most eclectic and fascinating minds of anybody I’ve ever conversed with. He is also deeply

embedded in the Chinese culture and government thinking. When Michael Pettis speaks, you need to listen. It is a little hard to summarize his fascinating lecture in a few paragraphs, but I will try.

China has seen many recent innovations, but there is a lot of confusion surrounding them. The Chinese government has three goals: slow down credit growth, keep the employment rate high, and repair the national balance sheet and simplify the debt structure. (Note: Chinese government-backed debt has risen precipitously in the last 14 years and even faster in the last 7. It is simply an unsustainable trend, and the Chinese government knows it.)

There is a need to restructure China’s financial system to keep debt within servicing capacity. (Note: we saw the beginning of that restructuring this week as the Chinese government began allowing local governments to issue low-interest long-term bonds to substitute for bank debt. The beginning tranche is rather small compared to the size of the debt, but I think this process will be repeated continuously. I wonder what creative financing we will see for the massive corporate debt, which is over four times larger.)

It is politically difficult to impose reforms, but the Chinese must bring investment down and consumption up. That means shifting money away from tycoons and to

more productive uses, which will be resisted by the people who are currently benefiting, which means, the hierarchy of the Communist Party. He gave us a little insight into Chinese culture, countering some myths by noting that “Confucians don’t save.” There is actually a need to increase the savings rate. Financial repression acts as a tax and is a killer for the economy.

CPI is not a good inflation proxy in China – use the GDP deflator instead. Capital is cheap, so companies use too much of it, which creates a great deal of non- productive spending. Michael thinks China can sustain 3-4% annual growth IF everything goes perfectly. The world is not prepared for a Chinese economy that grows at only 3%. He points out that metal commodities are screwed, but food commodities should do well, as even at 3% growth the demand for more protein and food in general will increase.

The Failure of the Central Banking System

It is hard to say what my “favourite” presentation was, as there were so many excellent ones, but Bill White’s would certainly be on a very short list. He was the former chief economist at the Bank for International Settlements and is now the chairman of the Economic Development and Review Committee at the OECD in Paris.

Bill may not be as familiar to some of my readers as he is to me, but he is one of my economic heroes. A little history: Bill predicted the financial crisis of 2007–2010 before 2007’s subprime mortgage meltdown. As early as 1996 he was one of the critics of Alan Greenspan’s theory of the role of monetary policy. He challenged the former Federal Reserve chairman’s view that central bankers can’t effectively relieve the causes of asset bubbles. On Aug. 28, 2003, White made his argument directly to Greenspan at the Kansas City Fed’s annual meeting in Jackson Hole, Wyoming.

White recommended to “raise interest rates when credit expands too fast and force banks to build up cash cushions in fat times to use in lean years.” Greenspan was unconvinced that this would work and said, “There has never been an instance, of which I’m aware, that leaning against the wind was successfully done.” If you’re not willing to take a little political heat, which clearly Greenspan wasn’t, then we may never know whether that would work. However, I disagree with Greenspan: I think that Volcker leaned quite successfully. Yes, there were recessions, so you might not see that as successful, but I think the long-term positive results of Volcker’s moves are evident.

That is the problem with having a monetary policy that is influenced by the political temperament and decisions of a small group of people. What happens is that people look around for scapegoats when a recession comes along, and they will point to a central bank that wasn’t as accommodative as they would have liked and blame the bank, rather than simply understanding that the business cycle is what it is. Bill White is my favourite central banker.

Central bank models, he told us, are artificial machines. His best quote was, “The basic problem with central banks: they think they know how the economy works.” Their models are built to be gamed and always assume a return to equilibrium. But there is no equilibrium – you are where you are. The problem with equilibrium models is that they don’t reflect reality.

An economy is like a forest ecosystem, not a machine. We are on a very bad path – debt is unsustainable. Notice the environment since the 2008 crisis: the Eurozone crisis is a limited variant on a global crisis; fiscal and regulatory restraint is not helpful; and monetary policy is the only game in town and is not effective.

Does White expect better days ahead? The IMF and OECD expect modest expansion – but they have very poor forecasting records. Why should demand suddenly strengthen?

Is low inflation really so great?

Looking around the world, Bill thinks that Abenomics could backfire. Can China adapt to a new growth model? Can the Eurozone sustain confidence? Political problems are everywhere (which Friedman and Bremmer highlighted!). It is much easier in today’s world for a crisis to spread worldwide because we have increasingly complex systems with far more linkages and rising correlations.

OECD simulations indicate global fragility. Rising rates still threaten fiscal reform. Bill was very critical of the seemingly single-minded focus on monetary policy.

Monetary policy hasn’t delivered, and more of the same won’t help. He offers three endgames:

· Endgame 1: global recession, policy and long rates stay low, debt deflation, more aggressive monetary policy and hyperinflation in some countries. Japan is very vulnerable in this scenario.

· End game 2: Rapid growth with an orderly exit from debt. Rates rise, inflation under control, debt-servicing problems diminish.

· End game 3: Rapid growth with a disorderly exit: long rates rise sharply, a rush to exit from all risk assets, capital outflows from emerging markets, inflation expectations rise sharply, debt service problems increase, inflation fears fuelled by fiscal dominance.

In the Q&A session Bill and I talked about the nature of current economic thinking and why it is inadequate. Independently, we’re both beginning to look at a new way to understand markets called Complexity Economics. It has several sources, but the current centre of gravity is the Santa Fe Institute in Santa Fe, NM. I may be “forced” to go spend some time in Santa Fe, burrowing into this new way to look at economics. It is significantly more complex, as you might imagine, than equilibrium models are; and it will therefore be even harder to create models that actually work, but it is certainly a place to start. By the way, the whole theory of complexity and complexity mathematics is reshaping a number of intellectual areas besides economics. Stay tuned.

Thinking over what I heard some 10 days ago, the questions that I wish I had asked many of the presenters centre around the potential of a liquidity crisis should another event occur along the lines of what happened in the US in 2008 or in Europe in 2010. Because of the new regulations, especially Dodd-Frank, there are those who are beginning to suggest that the current situation might even be worse than in 2007. Can you see the irony? The very regulations that were supposed to prevent the next crisis will be at the root of it instead. There’s a lot to ponder.


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