Latest posts by Christopher Casey (see all)
- Economic Roundtable: Predictions for 2017 - February 12, 2017
- Our Economic Future: Windrock’s 2016 Financial and Economic Roundtable - February 24, 2016
This roundtable discussion of independent investment minds is moderated by Heartland Institute Policy Advisor Christopher Casey.
Casey interviews Rick Rule, President and CEO of Sprott US Holdings, Inc; Brett Rentmeester, President of WindRock Wealth Management; Axel Merk, President and CIO og Merk Investments; and Bud Conrad, author of the book “Profiting from the World’s Economic Crisis.”
CASEY: With the election of Donald Trump, U.S. equity markets moved markedly higher. A lot of people attribute this to a newfound economic optimism and are making comparisons between Trump and Reagan, especially citing their positions on cutting taxes and deregulation. Do you think it is a legitimate comparison?
RULE: I think most of the euphoria is related more to the narrative than to the arithmetic. It’s difficult for me to understand how anybody, including Trump, can overcome $20 trillion in on-balance sheet obligations for the U.S. government, particularly when they propose a $2 trillion deficit. Deregulation would be good. A tax cut would be good. Without dramatically reducing the size of government – which he is not proposing to do – Trump’s ability to change things is limited.
MERK: No. The key difference between Trump and Reagan is the economy, which Trump is inheriting. In the early 1980’s, we had high unemployment and high inflation. Today, we’re coming out of an environment of low unemployment and low inflation. That’s a huge difference, because if you now institute fiscal stimulus, as is widely expected, you’re going to ramp up inflation. They’re really two ways this economy can go. We can have higher real growth due to some sort of deregulation, or we can have high inflation. Because of the policies being implemented, the financial markets see the glass as half full and anticipate significant real economic growth. But I believe it’s going to be a far more mixed picture and I definitely believe the inflation scenario has been severely underpriced by the financial markets.
RENTMEESTER: To the extent that Trump is successful in broadly reducing government via less taxes, less regulation and less bureaucracy, we could see positive developments. However, the economic situation Trump inherits is a difficult one and quite different from that of Reagan. First, the Washington “swamp” that Trump inherits has gotten substantially deeper since Reagan’s era and may prove more difficult to drain despite best efforts. Second, Trump takes over during one of the longest recoveries on record at 91 months versus the average of 69 months. This begs the question of how much longer this aging expansion can continue without a hiccup, irrespective of policy. Also, while Trump has the benefit of working with Republican majorities in both houses of Congress, but he is largely an outsider within his own party.
As it relates to the financial markets, the fundamentals when Reagan took office were ugly, but offered a huge tailwind for investors when the tide turned. Inflation was high, but then subsided; the 10-year Treasury was at 13%, but then declined; and the stock market was unloved and trading at single digit price-to-earnings ratios. All of this allowed massive moves to the upside. Regardless as to Trump’s policies, investor returns over the next four years are more likely to be impacted by interest rates and valuations, both of which are near extremes.
CONRAD: I completely agree that the economic environment for Trump is vastly different than that for Reagan. This allowed Reagan to get away with cutting the taxes. I think today’s higher debt levels and anemic, projected growth are a disaster – and I don’t see any way out of it. Worse, combine debt levels with Trump’s spending plans and tax cuts, and the deficit is going to go through the roof. Which brings up the problem as to whom will the U.S. government sell their Treasuries? Historically, we had a wonderful symbiotic relationship with foreigners where we bought more goods than they purchased from us, so we had a trade deficit. They got extra dollars and they recycled those into our government deficits, keeping everything afloat. Foreigners have stopped doing it. They’ve lost confidence in investing in our Treasuries for various reasons. China doesn’t need over $1.5 trillion Treasuries, they’re selling them off and will continue to do so. The question then is, who buys it? My answer is the Fed.
CASEY: Trump’s election has already brought some rather tense moments with a major trading partner, China. For example, his recent Tweet about their currency devaluation. How significant will any protectionist policies be under Trump?
MERK: Well it’s very difficult to know what Trump is actually going to do. I encourage everybody to watch the 1987 interview Trump gave to Larry King on CNN. There he displays his consistency on two topics: trade and the military. Trump thinks the U.S. gets a rotten deal on trade and also gets a rotten deal on military defense, meaning he feels allies are not paying enough to support U.S. engagement and defense abroad. I do think trade is important to him. Here is how I think this will play out; he is going to cross some line, perhaps by insulting the Chinese, and it will start some tit-for-tat retaliation. So, who benefits and who is hurt by such retaliation: those folks who import a lot from China or more importantly wish to sell a lot in China. Take a company like Apple, their growth market is China. Apple is a high-profile target, so they might directly experience repercussions if the Chinese choose to retaliate against them. Many similar, high-profile firms may be at risk.
RULE: If he’s able to get away with instituting protectionist policies, I think they’ll be very damaging. The truth is that trade is good. Managed trade is less good. Less restriction is good. More restriction is bad. My only hope is that the Deep States and the Republican establishment, and the Democratic establishment, despises him so much that we’ll have four years of nothing. That would be a wonderful outcome: stasis.
RENTMEESTER: Before Trump actually enters office, it’s hard to separate the hype from reality. Some point to insights from his 1987 book “Art of the Deal” and suggest he likes to take an extreme position, but that he intends to negotiate more moderate solutions. Regardless, in today’s world, any protectionist policies such as tariffs are likely to negatively impact global economic growth. Just look at the passage of Smoot-Hawley tariffs in 1930 at what was the beginning of the Great Depression. The tariffs didn’t cause the depression, but were certainly a contributing factor in accelerating the decline. Our view is that tariffs are bad policy and likely to prompt retaliation that can escalate until it negatively impacts global trade.
CONRAD: Yes, protectionist policies are a real concern. Trump has vowed to renegotiate NAFTA, cancel TTIP (the Transatlantic Trade and Investment Partnership) and the TPP (the Trans-Pacific Partnership), and will probably work on raising tariffs. It could lead to higher prices for us as we pay for the tariffs or have to domestically produce these goods with higher cost profiles. And I think this can contribute to inflation. When you have higher inflation, and higher inflation expectations, it leads to higher interest rates. With these debt levels, higher interest rates lead to even higher interest rates. I think it’s a potentially disastrous situation.
CASEY: It’s not just in the U.S., but worldwide that nationalistic, protectionist policies and movements are taking over. Recently we had a referendum in Italy, which many believe is the first step in Italy leaving the European Union. Between this and the upcoming 2017 French elections, do you see the E.U. surviving?
RENTMEESTER: We see the E.U. surviving, but likely in a different state than today. The E.U. is dealing with three major structural issues that they are unlikely to fix: regulation, debt, and unemployment. Too much regulation has contributed to stagnant growth while generous social programs have led to massive debts which in turn limits growth. Stagnant growth has led to high unemployment, mainly in the Mediterranean countries where youth unemployment is as high as 44% in Spain and 36% in Italy – compared to only 7% in Germany. With high unemployment comes enhanced criticism of the E.U.’s policies. History suggests that countries with high youth unemployment are likely to see a growing restlessness until a crisis unfolds.
With their member nations in less control of these issues as part of the E.U., there is growing resentment toward Brussels and the group of unelected bureaucrats pursuing interests that may not be aligned with their citizens. The failure of the E.U. to fix these issues has bred a strong nationalistic tide that is currently sweeping Europe. We think this tide will be hard to contain. We’ve already seen Brexit in England and a failed Italian referendum potentially putting Italy on a path to leave the Eurozone. France and others aren’t far behind. Unlike in the U.S., nationalism in Europe brings the risk of splintering their shared currency and creating chaos in their banking system. 2017 is a critical year where we could see one or more countries vote to abandon the euro to avoid a fate like Greece, which is now a permanent debt slave of the E.U.
RULE: I’m afraid I do see the EU surviving in some form, probably the worst rather than the best. I think that an important part of the reaction you see from ordinary people is an anti-elite, anti-establishment reaction, which is a good thing. I think the opposition of the voters to a fourth level of government that is a different level of parasites in Brussels is a wonderful thing. I think the xenophobic nature of the campaign; the frankly racist, fascist nature, is problematic. Sadly, I don’t see this global trend being a libertarian trend. I see it being a trend where the electorate acknowledges, cynically, that the purpose of government is to steal – but they want themselves to be the beneficiaries rather than other people.
CONRAD: Europe is tremendously burdened by this immigrant situation and the people of Europe are quite unhappy. They’re voting the bums out where they can, and I think we could soon see the French equivalent of Brexit. Certainly, I could see Italy moving to control their own debt with our own lira. I do see the peripheral countries falling out of the euro. I’ve been predicting that for a few years now ever since they papered over Greece with an awful lot of money. I think there are some very serious problems in Europe.
MERK: It’s also important to remember that we also have an election in Germany. Political stability throughout the globe is on the decline. You have a lot of people who are not happy, mainly because their real wages haven’t gone anywhere. These people tend to lean more towards populist politicians. The one common theme amongst populist politicians is that they never blame themselves – they tend to blame minorities and foreigners. Can the E.U. survive? The E.U. has always been a mess and will continue to be a mess, and I don’t think that’s going to change.
CASEY: What does this mean for the euro?
CONRAD: The euro was a great thing for Europe for many years. The euro/U.S. dollar exchange rate has declined from 1.60 to very close to parity today, I think it’s going to go below that. It’s as weak as any currency and the European Central Bank is printing more than the Federal Reserve as they continue to bail out their weaker countries. There are two possibilities: one is that weaker countries are forced out or decide to leave the Eurozone, or it could be that the stronger economic countries, such as Germany and maybe the Netherlands and a few Scandinavian countries say: “Hey we’re going to have our own currency, we don’t want you guys.” There’s been no indication they want to do that latter, so I think the former is more likely path. Even if the latter situation develops, there’s an argument that the euro is better without its weaker siblings, but I think the turmoil would still drive the euro lower. The one thing in favor of the euro is they don’t fund a lot of wars that are undoubtedly expensive and destructive, but on the other hand they are funding a lot of refugees. Refugees can be good for an economy once they’re integrated and can be productive but for now they are a drain due to social programs.
RENTMEESTER: In the near-term, expect continued uncertainty in Europe as their entire overleveraged banking system and low interest rate structure are contingent on holding the member countries together. The euro has lost nearly 34% against the dollar from its high, so we may see some stabilization, but we expect more weakness in general. Longer-term, I agree with Bud, the future of the euro currency depends on who leaves and who stays. If some weaker countries leave to return to their local currencies and Germany and other stronger blocs remain, perhaps the euro actually strengthens. Thus, the euro likely survives, but its value will be a function of the ultimate member states, so expect a bumpy ride until there is more visibility.
CASEY: The dollar has continued to experience a dramatic appreciation relative to other currencies. Do you see this continuing?
RENTMEESTER: In short, yes, we see dollar strength continuing. For the direction of currencies, it is imperative to watch the relative money printing actions across countries. When the U.S. was heavily engaged in quantitative easing, the dollar weakened substantially. Recently, Europe and Japan have fired up their printing presses and are seeing currency weakness versus the dollar. In a world where everyone is printing money, the country that is printing less on a relative basis should see its currency rise, all else equal. Today that is the U.S. Also, if a global recession develops, the U.S. dollar will likely benefit from a safe haven effect. I’ll reiterate something we’ve said for several years now – that the dollar has the most to gain in the near-term, but likely the most to lose in the longer-term as its role as the global reserve currency comes under pressure.
MERK: The market appears to believe U.S. interest rates will go to the stratosphere and European rates will go down to negative infinity. Inflation is creeping higher in the U.S., even as rates have been inching higher. I think inflation pressures are moving at a faster pace. Now take Europe. Recently the European Central Bank announced they reduced their monthly bond purchases. Now in the press conference right afterwards, Mr. Draghi, the head of the European Central Bank, was adamant that this is not tapering. The reason I’m saying all this is that the market is expecting the U.S. will be so much tighter than Europe, and I think the reality is going to be more shades of gray. 2017 may well give us some surprises. I wouldn’t be surprised if that dollar rally is going to run out of steam.
RULE: I see the dollar doing very well for the next 12 months. Not as a consequence of any particular strength in the U.S. economy, but more so because the U.S. dollar is the prettiest mare at the slaughterhouse. Our European clients tell us that there are between 16 and 18 trillion euros in investable assets in private hands in Europe. They expect about 10% of that to flee Europe and come to the United States in the next 12 to 18 months, which should be relatively good for the U.S. dollar.
CONRAD: It’s funny for a guy who’s a gold bug to be the predicting a strong dollar. Here is my scenario: the dollar stays strong for a quarter or two, but then I think it turns around with a vengeance on the other side. If we start putting up trade barriers, foreigners aren’t going to want to hold dollars because they can’t repatriate them as easily. I think we get a currency crisis out of this, in which case the bottom line is: buy real assets such as gold, oil, real estate, agricultural land.
CASEY: Some people would think that in a rising dollar scenario you should avoid commodities in general. Do you agree with that?
CONRAD: I’m in the camp of saying there’s probably some good buys. I keep looking at the agricultural commodities and expecting something to happen and not much has happened, but my view is that any surprises will be to the upside, not the down side.
RULE: I think it’s a function of the duration of the trade that you’re considering. As an example, the global, total cost to produce a barrel of oil, including the cost of capital, is $60 as suggested by Exxon. If you make the stuff for $60 and you sell it for $45, loosing $15 a barrel, 98 million times a day, then ultimately the industry cannibalizes productive capacity. When you have destroyed enough productive capacity and the price begins to move up, the uplift is pretty long-term because the market doesn’t have the productive capacity to respond to price signals. It was precisely this situation in the 2000 to 2002 timeframe that saw the beginnings of the last commodity bull market. The oil price, you will recall, went from $18 to $103. Uranium from $8 to $130. Copper from $0.95 to $4.50. I’m looking for moves like that irrespective of the near-term impact of U.S. dollar pricing.
CASEY: Gold saw a lot of action in 2017; first rising dramatically and then falling since the summer. Where do you see precious metals headed? A lot of people believe gold doesn’t perform well in a rising interest rate environment. If rates do rise, do you still like gold, and if so, why?
MERK: The prime competitor to gold – which doesn’t pay any interest – is cash that pays a real rate of return. And that is really what we have to watch. If people believe that the Federal Reserve is going to be ahead of any inflation, then I think gold is not going to do well. However, if the Fed is going to be behind the curve, meaning that prices are going to creep higher, then I think gold plays as good a role as it has always. Currently the markets are pricing in an optimistic scenario that real growth is going to pick up without inflation. Former Federal Reserve Chairman Greenspan gave an interview with Bloomberg in December where he said that inflation will go up. If that is correct, then I think gold is going up. As a diversifier in a portfolio, it has a very important role.
RENTMEESTER: We view precious metals as the only global currencies without an associated liability. As such, they are the purest investment that investors throughout history have turned to when confidence has been lost in governments, banking systems, or central banks. Most fiat currencies have a massive outstanding debt obligation attached to them. For that reason, precious metals are a must to own. Today’s world of monetary instability – where negative interest rates are the modern-day equivalent of Frankenstein experiments – will likely culminate in a currency crisis somewhere down the road.
The end of 2016 has seen instability in India as well as increased capital controls in China, leading more foreign investors to the safety of gold despite some government efforts to curtain it. From a U.S. investor perspective, a strong dollar has muted some of gold’s benefit, but gold remains a unique hedge against future currency issues. We see precious metals substantially higher five years from now, although timing on how we get there is uncertain. In short, keep accumulating as a long-term play, not a short-term trade.
RULE: If the arithmetic wins out over the narrative, then yes, gold will move higher. The U.S. ten-year Treasury is now yielding about 2.4% which, adjusted for inflation, puts it at a mildly negative real return. The experience we have over the last 40 years has been when the U.S. 10-year Treasury does well, gold does poorly, and vice versa. There have been two exceptions to that. One, the latter half of 1975 which I remember well. The other, the first six or seven months in 2002, which I also remember well. In both of those situations, the U.S. dollar and U.S. securities did well in a sort of flight-to-safety trade. In both cases, ultimately the dollar rolled over and gold continued higher, which I suspect may be the situation in the second half of 2017.
Also, I think investors need to remember that in the greatest gold bull market of my life, the market of the 1970’s, the interest rate on the U.S. 10-year Treasury went up five-fold. What really matters is the reason that the interest rate goes up. If the interest rate goes up because investors perceive that their purchasing power is declining, then gold will do very well in a rising interest rate rise environment.
CONRAD: We have to distinguish between nominal interest rates and real interest rates. The last peak in gold came in 1980 when inflation peaked. Nominal interest rates hit records, but real interest rates were actually negative. Gold doesn’t do well in a high real interest rate environment because of two things. One is that you get a real return, which gold doesn’t pay and the other is that a high real return usually is supportive of the currency. I see inflation rising as fast or faster than interest rates so I see inflation adjusted (real) interest rates falling, even while nominal interest rates are rising. I think of gold as an actual currency. It’s the anti-dollar in my view. If the dollar is rising, that’s not so good for gold. I see gold as the safe haven against the increasing deficits, which drive money printing by the Fed. I’m very bullish on gold in the long term.
CASEY: Interest rates have risen significantly since the summer. Where do you see them headed?
MERK: I can’t tell you where rates will be in 2017, but I do think that inflationary pressures are going to move higher, and with that the rates are going to continue up.
RENTMEESTER: Over the last several years, we expected interest rates to decline due to central bankers suppressing interest rates. We thought the risk of an upside break-out was limited, but now the risks are rising. We’ve said for a while now that when rates turn higher we may be in for a multi-decade bear market. Something akin to the 1950’s to 1970’s period where investors lost money in bonds versus inflation for three decades. That’s literally a lifetime of investing.
If we experience a global recession, there could be one last hurrah in bonds and the 10-year Treasury could trade under 1%. It got to 1.5% in the summer of 2016 without a recession. However, we must ask the question of whether we are at the turning point after 36 years of declining rates? If not, we may be close. The rise in rates in being driven by a lack of foreign demand. Countries such as China and Saudi Arabia are selling their dollar reserves for domestic uses. It is likely that rates on the 10-year Treasury stay range-bound in 2017 between 2% and 3%. They could go below 2% if we have a recession, but a rise above the psychologically important 3% level could also trigger an accelerating sale of bonds and a further spike in rates.
CASEY: Interest rates, while rising, are still low from a historical viewpoint despite record levels of debt, which calls into question the credit worthiness of many economic actors, including countries. Where do you see debt levels headed and how will this affect rates or the financial markets in general?
MERK: In the long term, I just don’t see how the Fed, the European Central Bank, the Bank of Japan, or the Bank of England for that matter are able to impose positive real interest rates over an extended period. To do so just makes it very, very difficult to sustain debt levels. Ultimately, a central bank is only independent as long as fiscal policy is sustainable. Once fiscal policy is unsustainable, central banks lose their independence.
CONRAD: We are not the only government with large deficits. We aren’t the only ones printing money. In fact that’s the issue worldwide, right? It’s the race to debase between all the different currencies. They used to use our trade deficit to finance our government debt. Effectively it was a vendor finance program. But they’ve got their own issues and things they’ll spend their money on, so will other countries continue buying U.S. Treasuries? I doubt it.
The amount of Treasuries bought by foreigners is declining and the Federal Reserve has already jumped in to replace them. What would happen if the Fed actually tried to go into the market and sell them? At that point, there’ll be a big spike in interest rates. It creates a feedback loop, which was actually the subject of my 2009 book, Profiting from the World’s Economic Crisis. Then I predicted that the Federal Reserve would buy $4 trillion dollars of assets because foreigners weren’t going to buy it all, and that was exactly what happened with QE. Going forward, the Fed will have to be a big buyer with newly created money, which is inflationary, which pressures interest rates higher.
RENTMEESTER: Expect debts everywhere to rise. The reality is the world is too burdened with debt to grow quickly. We simply can’t grow fast enough to meet our debt obligations, so the world will continue to print money, at some point creating an inflation outbreak. Since the 2008 recession, “official debt” in the U.S. doubled to nearly $20 trillion, all during a period of “recovery.” As bad as that sounds, it is really just the tip of the iceberg as many debts and obligations of the U.S. are not included in that official figure. If the U.S. really reported its debt under GAAP accounting, like corporations are required to, that figure would look more like $120 trillion. This includes the present value of unfunded obligations related to pensions, Social Security, and Medicare. This is an amount that would take over 30 years of tax revenue to pay-off if we devoted 100% of our taxes to paying down debt. It’s not just the U.S., but also Japan and Europe, so this is a global ticking time bomb.
In the U.S., spending is not slowing down. In fact, the 2016 fiscal cash deficit was $590 billion, up significantly from the previous two years. We are at a point where this debt will never be paid down and is only sustainable due to artificially low interest rates. Higher interest rates would be a catalyst to see this issue become the main global issue. At a 5% interest rate, debt-servicing costs increase by over $600 billion, which is about equal to the 2015 defense budget. (See, The U.S. Government: Adding Illiquidity to Insolvency). We expect debts to continue to rise and for central banks and governments to get more aggressive in trying to create inflation as a way to minimize the debt burden over time.
CASEY: We are not only looking at one of the longest bull markets history, but one of the longest so-called recoveries since the last recession. If rates go up, do you see that potentially plunging the U.S. into a recession? Should we expect a recession in 2017?
CONRAD: I have to say, I’m less negative than I was a year ago. If Trump can eliminate some regulation, if he could give a boost to domestic businesses through the slowing foreign imports, then I think there’s a path, which avoids a recession. But my gut is saying we’re close to a cliff. I’m not feeling like I’m about to be pushed off of it, so I’m not as negative as some other people might be about the probability of recession. I will say there’s much more unpredictability than we’ve ever had, at least in the last decade. I worry more about the world geopolitical changes—like a European break up; China’s assertion of its territorial rights; and continued African and Middle Eastern conflicts—than I do about financial instability. Wars are much more destructive than financial collapse, although they are related.
RULE: I honestly don’t know what rising rates will do to the underlying economy. I suspect that it will be bad for commercial real estate and single family residential. Probably bad for the equities markets if people begin to avoid large cap stocks, which they had been buying for yield, in favor of bonds.
RENTMEESTER: Over the last several years, GDP growth has come in well-below estimates, company sales have been flat, and earnings have contracted for one of the longest periods on record. The near-zero percent interest rate policy in the U.S. over the last 8 years has pushed off the pain, but has led to massive malinvestments which will be in full view when interest rates rise enough to trigger a downturn. A recession is long overdue in the U.S. We believe there are two potential recession triggers to watch closely in 2017: political change in Europe leading to a banking crisis or U.S. interest rates rising much above 3% on the 10-year Treasury.
MERK: I don’t see a recession, but it is possible. One of the reasons why we have this recent interest rate hike is because the market allowed the Fed to have a rate hike. I phrase it this way is because the Fed bases economic recovery on asset price inflation as induced by extraordinarily low interest rates. So, if the Federal Reserve raises rates, it risks crushing asset prices. I just don’t see how the Fed wants to risk this. It would simply prevent a fragile recovery to continue.
CASEY: How will rising interest rates or a recession affect stock markets worldwide?
RENTMEESTER: Our view is that we are in a massively leveraged world where financial engineering and money printing have delayed – but not solved – problems. We’re in a period of heightened systemic risk. Investors with equity exposure should consider methods to hedge risk despite rising bullish sentiment. It’s important to recall that investors are most bullish near market highs and most pessimistic near market lows. In fact, a December 2016 survey released by Forbes showed that consumer sentiment was higher than the level reached in 2006 – which was the height of the housing bubble. In hindsight, that was a time when everyone should have started taking cover. We are not ruling out that the equity bubble could grow larger first, but we now have a feeling of déjà vu with the years 2000 and 2007.
Over a market cycle, investors have never been rewarded for buying stocks at these valuation levels. Future projections of returns at these valuation levels suggest investors may face a decade of near zero real returns in both U.S. equities and bonds. If investors could learn one lesson from financial history, it would be that valuations ultimately matter. Another sobering thought for equity investors: the risks in the world are increasingly interconnected and systemic, so traditional diversification in equities, like small cap versus large cap versus international, is unlikely to provide much cushion in a downturn. Therefore, investors should consider some fundamentally different investments such as hard assets.
One last thing, the stock market has absorbed roughly half a trillion dollars a year in stock buybacks for some time. Will companies be buying back stock during a recession or when borrowing costs rise? I suspect not. That will take some huge demand off the table.
CONRAD: One of the basic theories of investing is that you invest to get a return as adjusted for risk. The return on stocks is to me the earnings divided by the price. That’s sort of like yield for stocks. Right now, 2½ % on the ten-year Treasury is about half of the earnings on the S&P 500, so for the current moment it’s still better to be in stocks. What rate of interest would cause that to flip? Obviously at least once you get to 5% because you would be assured of getting 5% from a bond versus 5% from riskier stocks. Alternatively, a recession with an associated earnings collapse would crash the stock market.
CASEY: Why do you look at earnings and not dividend yields when comparing yields on Treasuries with the stock market?
CONRAD: Earnings are more important than dividends. Management decides how much to pay in dividends. Some technology stocks pay no dividends but are good investments because they are generating earnings and investing their profits in growth. The wild card, though, is that today earnings may be exaggerated by cutting back the number of shares through stock buybacks as well as too-lenient accounting regulations, so 5% is probably overstating the reality. Which means we’re closer to parity than it looks when comparing yields between the bond and stock markets.
CASEY: What investment themes do you like in 2017?
MERK: I mentioned earlier that, due to protectionist policies and retaliatory measures, high-profile companies selling into China may be at risk. Let me expand that theme into an investment thesis. While large, international companies may suffer, smaller, domestically focused companies might be unaffected. Combine this with the fact that regulation is going to be cut. This largely benefits smaller companies since regulation is but a barrier to entry. So, small companies may outperform large cap companies.
Regarding the political instability we discussed, to me this means greater volatility in the markets. It means a greater dispersion of risk. It means a greater role for active management and that’s very much contrary to what we’ve seen in recent years.
So, how do you invest in this sort of environment? Let’s keep in mind that asset prices are not cheap, equities aren’t cheap, and bonds aren’t cheap either. So, the question is: what does one do to diversify your portfolio? One way to do that is, of course, to move to cash, but most people don’t like sitting on cash for too long. I think that as volatility rises in the equity and bond markets, gold will prove to be a valuable diversifier. It’s not a perfect diversifier, but it is the simplest one. You like it or you don’t like it. You can understand it.
Other diversifiers tend to be more complex. Consider long/short equity or long/short currency strategies. Any of those strategies tend to be more complex and that’s the downside. The upside is that they might do well in an environment that’s more volatile.
I can tell you that in my personal investments, I have pretty much neutralized my equity exposure to the extent possible. By neutralizing, I mean I try to take out the equity risk by shorting S&P futures. On the bond side, I try to be positioned for rising rates. There are a couple of ways you can do that. One is of course you can short bonds. I think shorting bonds may well be one of the more profitable investments in 2017. If you cannot or don’t want to do that, another thing you can do is to buy financials as they tend to do well when interest rates move higher. However, they are not cheap, so keep that in mind. Finally, you really may want to consider having a fairly large portion of your portfolio in alternative assets.
CONRAD: Let’s start with one major theme I see, and that is interest rates will have to go higher. That’s a tradable item. There are many ways to do it. There’s a couple of ETF’s that gain when rates rise. I would stay away from bonds. I think they’re set for a fall like the dot-com stocks in 2000. Yields are at a 50 or 60-year record low, so I don’t want any part of fixed income. They have default risk, currency risk, and inflation risk.
Another investment theme involves oil. At $53, it is double last year. With money printing, prices of commodities will rise. Human wealth depends on energy. The possibility of war is increasing. So I think energy is a solid long-term investment. I’m looking at Russia. It is an energy-based economy, and the oil price is rising. Combine this with the likelihood that Trump may remove sanctions and you have an improving situation. The Russian stock market will likely move up more than it has.
In conclusion: civil disruptions, populism, Eurozone destabilization, Chinese confrontation, and changing world power balance will expand central bank money creation, currency debasement, and money controls. These will make careful investment more important and more difficult. I see world debt and monetary inflation bringing price rises for specific physical assets like gold, oil and real estate. Inflation is dangerous for fixed income investments, so short these. The U.S.’s expensive wars and military incursions are a drag on our economic growth so looking for investments outside our country may provide more return.
RENTMEESTER: Thematically, we see private lending and the cannabis industry – which is now legal where 65% of Americans live – as attractive growth industries. We also see a particular niche in rental apartments gaining market share. That niche focuses on communities that look and feel like single-family homes, but are rented out. Rising mortgage rates and job mobility will make rental options more viable than home ownership for many. Areas of value for more patient investors are precious metals, farmland, and deeply distressed opportunities like uranium. We’re also watching areas of relative value, mainly emerging markets. Compared to U.S. equity valuations, they are cheap, but they also have near-term issues such as their sensitivity to a rising dollar. Combine emerging market valuations with the near-term strength of the dollar, and we may have a strong buying opportunity develop. It is really staggering how much the dollar has appreciated from its lows over the last decade against various currencies: for example, it’s risen over 50% against both the Brazilian real and Mexican peso. So, emerging market assets are high up on our shopping list in the future, but not just yet.
RULE: I’m positioning my own portfolio and portfolios of clients who will listen to allocate in 2017 to harvest returns in 2019 or 2020. There are a range of commodities that are priced in the market at less than production costs, which means that either the price of those commodities goes up or the commodities will become unavailable to us in future years. Traditionally, those trades have worked out extremely well for me. They usually take two to four years to develop. Many investors don’t have the patience to put on a trade with the expectation of a profit, even a large profit, in two to four years out.
I will be looking in 2017 at very high-quality, undeveloped copper deposits that will come into production in 2019 or 2020. And very high quality uranium projects that will come into production two or three years hence. If oil declines, which I think it will, and the energy junk bond market begins to blow up, then I’ll be looking to allocate some capital there. I do that not so much because I expect those sectors to greatly outperform other sectors but rather because I have a deep enough expertise in those sectors that I am competitive in terms of separating the winners from the losers. So, the thesis owes as much to my own expertise as much as it does to my outlook for the economy.
I’m also buying global companies that are perceived to be slow-growers but are generating lots of free cash flow. If I find a company that’s generating cash at a level that allows them to pay off all their debts and take themselves private in six years or less, and if they have a durable competitive advantage, I buy the stock in almost any circumstance. I like cheap cash flow generation.
Personally, I’m also beginning to reallocate to very high quality U.S. farmland, particularly in the upper Midwest where there are ample supplies of water. Agricultural commodity prices are off by 50%. As a consequence, high quality farmland prices and high quality farmland rents have fallen. I’m deploying capital to that sector expecting much firmer markets three years from now.