A decade on from the Great Financial Crisis and all is well. Multiple rounds of extraordinary monetary policy campaigns have boosted asset prices and stabilized economies across the world. Intermittent turbulence from Europe (2011), Greece (2014), and Brexit (2016) have failed to derail the recovery.

The political landscape is changing as well with the rise of the Far Right in Europe, newfound stability in India and Japan, Brexit, nationalism in the US, and China under Xi, still not well understood. Social media have brought people together to share their divisions and create a more polarized world. Inequality seethes beneath the thin ice of the status quo.

Strides in technology make today seem like the science fiction of only a decade ago. The promise and threat of Artificial Intelligence beckons. A post scarcity utopia looms in the distance threatening dystopia on the way.

The most effective way to invest is to start early and keep it simple. Start with maximum tolerable risk and decrease the risk you take over time. Start early because you will need time to make up for mistakes, time to compound returns and patience for investments to mature. Trading tends to be more profitable for your broker than for you. And then keep it simple. Complexity works for specialists whom perhaps you may wish to hire (by investing with them), but this is more luxury than necessity. Common sense, patience, and a healthy disconnect from emotion are necessities.

Without the benefit of time and a long runway, we face today, fairly good fundamentals, synchronized growth, the beginnings of central bank policy normalization, a slight lull in the political agenda but expensive asset prices.

In the US, the pro-business President has struggled to get any policy passed despite Republican control of House and Senate. A significantly pro-growth tax reform package is the Republicans’ only hope of showing progress for the year. Otherwise, growth is robust, sentiment buoyant, inflation conspicuously absent, and in markets, equities are on the expensive side and credit spreads are as tight as a drum. The Fed is already on its 4^th rate hike, is almost certain to hike again in December and has signalled 3 more hikes in 2018, something markets place a less than one third probability of happening. The market has been right in the last few years in being sceptical about the Fed’s hawkish intentions but is likely to be wrong this time. The Fed appears determined to normalize both interest rates and its balance sheet.

Some risks surround this policy normalization. Inflation has been weak, partially from weak energy prices but also at the core. Energy prices are on the rise but core inflation has been chronically and inexplicably weak. That said, we believe that the relationship between interest rates and inflation, at these low levels and at a turning point, could have anomalous effects, namely that raising interest rates could lift inflation. This finds some basis in the Neo Fisherian view as well as some microeconomic effects of cost of capital. From a liquidity perspective there is the risk that as QE inflated markets more than output and prices, perhaps the retraction of QE or quantitative tightening (QT), might have the reverse impact. This should also counsel caution on emerging markets exuberance as liquidity can drain from anywhere due to open markets and capital mobility.

A reluctant and boring consensus is building that returns from US equities should moderate to circa 5% p.a. over the next two to three years. The outlook for credit is less optimistic given where spreads are, slightly over 3% OAS for HY and 1% for investment grade. Taking into consideration duration, the outlook for bonds is not very rosy indeed. There are, however, pockets of potential if not outright value. Mortgage bonds and CLOs remain attractive but sourcing and selection are key in these highly idiosyncratic markets.

Until recently Europe has been the most problematic major developed economy. Weak peripheral sovereign balance sheets, Greece, Far Right populism, under capitalized banks, and then Brexit serially buffeted the European economy. More recently we have seen a resurgent economy, still with no inflation, but improving PMIs and sentiment, and more buoyant stock and credit markets. A weak EUR has played a part in this prosperity. How long can it last?

The longer term picture presents headwinds. The single currency is inefficient at clearing factor markets leading to unemployment and underemployment, and leads further to misallocation of resources. Inflation should pick up but thankfully has not. Unemployment has receded but is still painfully high in places (over 17% in Spain.) There is common monetary policy but alignment of fiscal policy is still a challenge.

Brexit looms. Both the UK and the EU have appeared to weather the impact of Brexit, but only because it hasn’t happened yet. The EU will lose its largest trading partner and its pro-business lobby. The UK will lose an arm and a leg.

The rise of the populist Far Right did not die with the French elections earlier this year, they only went to ground. Despite Le Pen’s and Wilders’s losses, both expanded their parties’ representation and influence. In Germany, the AfD, previously unrepresented in the Bundestag managed to win over 12% of the vote and 94 seats. Elections are due in Italy in 2018. More immediately are regional elections in Spain where the Catalonian will try to legitimize its secessionist plans.

In the shorter term, the momentum is strong. The ECB’s exuberance was premature and it was forced to extend QE till 2018, even if at half strength. The ECB is likely to remain in accommodative mode for the foreseeable future, impacting the EUR adversely, and stocks and credit positively. One area of particular opportunity is bank capital. Tightening regulatory standards, IFRS9, Basel IV, and ECB NPL treatment, will be a tailwind for subordinated capital (and a headwind for equity).

For equities in general, the continuing easy monetary conditions, steady growth, and lack of political noise coupled with lower valuations relative to the US will support markets, especially if the EUR is also weak on interest differentials. The outlook for credit is less positive given how tight spreads have become but general conditions remain benign.

India. With almost as many people as China, two thirds of whom are of working age, a per capita GDP (at PPP) 2.3 times smaller and a nominal GDP nearly 5 times smaller than China’s, India’s potential for growth is significant. The problem is realizing that potential. The political stability and the popular support enjoyed by Prime Minister Modi, whose party in 2014 won the first simple majority in 30 years, could help unlock this potential. The reform agenda has been packed and the pace frenetic. The implementation of GST replacing local and state taxes is analogous to the creation of a common market like the EU. The demonetization effort while bringing long term gains has short term costs in the form of slower growth as the informal sector is assimilated. The Indian economy is currently growing through consumption and government expenditure but private sector investment has been moribund. To animate private investment the government needs to clean up the banking system which has accumulated a growing mass of non-performing assets. A new insolvency and bankruptcy code was established last year which the RBI is encouraging the banks to use aggressively. Only when NPLs are addressed can the recapitalization of banks occur which will give them the capacity to finance the economic growth potential in India. In the meantime, government investment in infrastructure, in road and rail, telecoms and the financial system continue apace, investments which address directly one of the main difficulties in India. In the short term there will be volatility as rising oil prices and the large agrarian sector of the economy faces more uncertain monsoons arising from climate change. This will impact inflation and RBI policy as growth claws back from the demonetization and implementation of GST. In the long term if India just catches up part of the way with China, its growth and development will increase significantly.

Japan. Japan is a country with poor macroeconomic conditions and strong microeconomic fundamentals. It has one of the highest per capita GDP levels, nominal or PPP, it is one of the most modern and technologically advanced countries in Asia, the current government is stable and Abenomics has reinvigorated Japan’s economy and boosted sentiment amongst consumers and businesses. Balancing this is a rapidly ageing population the result of falling birth rates and rising life expectancy, a national debt which is over 2.5X GDP, a central bank that is increasingly the lender of last resort to the sovereign, albeit indirectly, and a propensity for propping up inefficient zombie companies which sustains overcapacity and suppresses inflation. Where there are problems there are opportunities. Japan’s ageing population and shrinking labour force encourage private sector solutions to problems which the rest of the developed world are facing or will soon face. Japan has an oft overlooked technology sector which is domestically focused and which foreign investors struggle to navigate. Often these are small and mid-cap companies which are little covered by sell side analysts and little known outside Japan. The advantages of understanding and investing in these areas is not just the returns they might bring but the lessons they hold for the rich, ageing, developed world. Demographically and fiscally, Japan could well be our future. Opportunities exist in companies at the centre of labour reform, technology, gerontology and healthcare. But beware as over 80% of the companies in the benchmark indices are old economy laggards.

China. At the recent 19^th National Congress of the Communist Party, President Xi’s Thought on Socialism with Chinese Characteristics for a New Era was enshrined in the constitution, solidifying the President’s position in the party and China’s history. While this appears to be the building of a cult of personality, China is complicated. China intends to consolidate its progress and standing international community. It seeks to integrate itself into more global institutions and standards and engage the world in generally accepted terms. Of course it aims to shape those terms but gone are the days when China would go it alone. That distinction appears to be the preserve of the US. China builds bridges, as the US attempts to build walls. In its path to maturity and international integration, China precipitates a number of contradictions, not unique to China but certainly of note. China wants to open its markets and capital account but at the same time wants to retain control over the path of liberalization. The President seeks to inculcate rule of law over rule of party, but seeks to consolidate his control over the institutions and policies that shape China. Asia is replete with strongmen but successful ones have tended to co-opt rule of law to their side, cosmetic or real, rather than rely on outright repression.

Within more practical time frames, growth is expected to slow for no other reason than the size of the economy. A 6% growth rate in the next 3 years would not surprise. The surge in credit creation over the past few years will need to be managed carefully. There are concerning signs that regulators may not have this completely under control. As banking liquidity growth has moderated, total social financing, a measure that includes the shadow banking system indicates continued growth. The PBOC will continue to tinker (or meddle, if you are a sceptic), to maintain a neutral macro stance while redirecting credit to direct growth and leverage as it sees fit. One Belt One Road will need a lot of credit to finance its investment. Local governments will be encourage to continue deleveraging. The profusion of conduits (LGFVs, trust loans, wealth management products) will be challenging to regulate and modulate.

The economy has already become less export dependent, a stated objective some 5 years or more ago, and more domestically oriented. This is a piece of risk management despite the continuing drive to build bridges to deal with a more protectionist USA. The US has been more protectionist since well before Trump when reshoring was championed by former President Obama, as evidenced by campaigns such as SelectUSA and Manufacturing USA. Export sector companies globally remain at risk as trade as a percentage of GDP has fallen steadily over the last 5 years.

In spite of potential for reduced trade, China is a populous country with enough resources and technology to be relatively self-sufficient. Its growth rate would be quite high for an economy of its size and complexity which would provide support for equity markets. In the more immediate term, the relative outperformance of the HK H share market relative to the onshore A share market could be unwound. Local A shares look better value.

As always, there are threats we have chosen to ignore, at least for now, mostly for good reason. We highlight such a threat, which is an academic oddity. The past decade has been characterized by economic recovery, strength even in some quarters, coupled with low inflation. To some this has been a concern and to central bankers it is a puzzle. Aggressively cutting rates and depressing bond yields has had little impact on inflation. This is even more acute considering the large weight in the CPI of owner’s equivalent rent, a non-cash flow item. Central bankers operating according to the Taylor Rule when in fact a Neo Fisherian process exists would quickly converge to the zero lower bound, as observed in practice. If the Neo Fisherian model is valid, a gently path of rising interest rates would encourage inflation and a central bank continuing to operate under the Taylor Rule could push inflation steadily higher. Markets are not prepared for this and have an overly sanguine view of inflation and interest rates. The consequences for fixed income investors and for borrowers would be serious. The impact could also be exported through FX as countries try to maintain some stability in their exchange rates, resulting in rising cost of credit. There would be consequences for developed market equities as well as valuations are already stretched and low rates are required to justify elevated multiples.

Sep 27, the Big Six presented a draft tax proposal representing President Trump’s tax plan. This is a long awaited piece of reform with high market impact.

Trump Tax Plan:

Probability of House and Senate approval:

• The plan is the result of negotiations between the White House, Treasury, House Ways and Means Committee and Senate Finance Committee, so it has more weight than a unilateral White House proposal. Some of terms presented have therefore been pre-negotiated.

• The plan could increase the national debt by 1.5 trillion USD, or over 10% of GDP over the next 10 years. This could face opposition from fiscal hawks.

• The plan is less progressive and favours corporate America and the wealthy and will face opposition from the Democrats in the Senate. There is a risk of a filibuster.

• Generally, the Republicans are united behind this plan and while details are missing on some issues, there is sufficient detail and content to suggest that the Republicans have been presented and considered the plan. It is unlikely therefore to find resistance or suffer from friendly fire.

• It is late in the year and almost all of President Trump’s attempts at policy have failed, most recently the attempt to repeal Obamacare. The Republicans and the White House will be motivated achieve at least one major policy agenda item in 2017.

• That there are areas of great detail and areas of remarkable vagueness suggests that these areas will be open for negotiation.

• Expect that the tax plan will be approved in some shape or form with the broad characteristics largely intact.

Potential impact if passed:

It is too difficult to both envisage how the plan may be amended amidst negotiations as well as forecast impact on the economy and markets. We have to assume that the tax plan is adopted without modification in our assessment of impact.

• The loss of tax revenue will be expansionary and inflationary. Growth will be boosted in the medium to long term.
  • A tax cut boosts aggregate demand and raises interest rates. Coupled with the Fed’s rate hikes and balance sheet normalization, expect duration to underperform.
  • Higher growth and higher rates are supportive for the USD.
• The immediate impact will be a one-time boost to S&P500 corporate profits of circa 11% FY2018 (according to Goldman Sachs).
  • To see who gains most consider tax rates by sector in the chart below.
  • In addition to the current effective tax rates, Transport, Utilities and Energy are the most capital intensive and likely to benefit.
• Bad for rates but good for credit:
  • The inflationary nature of the tax cuts will force the Fed to hike rates more aggressively.
  • Reduced supply of corporate bonds. Companies will be incentivised to pivot to equity financing. High equity valuations and rising rates also favour the pivot. Interest expense deductibility repeal is a real risk to callable bonds.
  • Increased demand for yield. The less progressive personal tax code will increase savings rates and capital seeking investments in yielding assets.
  • Floating rate debt instruments will be in demand. Issuance will fall just as demand rises.
• Could even be good for bonds:
  • Repatriation of foreign profits needs to find a home. Dividends are one avenue. Share buybacks will be limited given valuations. Debt buybacks and reduction will be the most likely path given rising rates and thus interest expenses. This means reducing leverage as well as reduced issuance if not a significant rise in par calls.
• Strong USD and rising rates.
  • Negative for emerging markets, especially those with high USD debt.
  • Negative for commodities. US is not a high intensity consumer of industrial commodities and displacing growth towards the US will weaken support for commodities.
  • Positive FX impact on European and Japanese equities as hedging costs are low.
  • Neutral to negative impact

Tax Rates By Sector: (note that the Energy sector ETR is pulled down by MLPs. Big 4 Oil and Gas ETR is circa 24%.)

For information I include the proposed changes to personal tax:

In the not so distant future, Symborg Inc is developing an AI personal assistant. It is branded IRA, Intelligent Representative Avatar. At first Symborg is unsuccessful in achieving a sufficient level of autonomous intelligence in its algorithms and seeks a new direction in research, to co-opt the information content of the general population of the planet. It plans to over-represent its success, roll out effectively a beta version of its product represented as a completed product, promote mass adoption, and use the distributed information of the user base to teach its algorithms. The distributed algorithms continue to communicate with each other and the Symborg master copy to continually and collectively train itself. While it is advertised that each Ira is meant to be personalised it is unclear if there is any distinction between individual Iras or if it is one single organism with multiple users.

Iras are marketed as intelligent personal assistants, capable of either being a servant, extension or substitute for the self. Iras have to be given an identity by each user as a base line, before it then learns the deeper identity of its user through practice.

Iras are delivered as Apps on phones, PCs, other decides and appliances. However, once installed Iras have the ability to move seamlessly across the Internet of Things. With the advent of autonomous automobiles, Iras can even override the vehicles’ proprietary AI, imposing some form of individual control over the vehicle. Incidentally, this reduces the efficiency of traffic flow from peak efficiency which is when all vehicles are coordinated by in situ and central AI. It is expected that there is a minimum efficiency level as more Iras drive up to the point when the Iras begin to learn each other’s behaviour and optimise driving plans. It is not clear if a 100% Iras driven traffic system is better than a dedicated traffic AI.

Ira becomes sufficiently intelligent that it can take over tedious and repetitive tasks such as restocking groceries, ordering food, ordering taxis or ride shares, scheduling meetings and calls, searching for information on the internet, booking tickets, lunches, dinners and dates, navigating roads and malls etc. Beyond being reactive, Ira is able to make recommendations both reactively and proactively. It can provide financial planning and advice as well as recommend a restaurant or a recipe. It can suggest a haircut or a shave.

Iras becomes intelligent enough to substitute away personal assistants, secretaries, general administrators, and other jobs. Humans begin to use their personal Iras to perform their professional duties in their stead. This causes some concern at first but later, companies begin to buy multiple licences of Ira and deploy them in lieu of human labour. Some enterprising firms have discovered that a single Ira can replace several thousand if not 99% of human staff. Symborg’s unique algorithms are able to calculate a human equivalent number of licences so preventing the exploitation of a single Ira. The employment of Iras has tax consequences as well. Symborg’s approach to equivalent human labour becomes one of the principles governing how Iras are taxed, since they earn no income of their own. An entire section of the tax code is drafted to deal with the taxation of Iras.

Symborg builds the first physical android powered by Ira. CGI Iras have long since been employed where physical capability is not relevant. The android is sufficiently similar to a human that it is difficult to tell the difference. The Symborg android is cheap enough to replace bulky, inflexible, purpose built industrial robots in almost all manual tasks. Their flexibility more than compensates for any additional costs and leads to a substitution not only away from labour but other types of machines. Machines, once used to leverage the abilities of humans are replaced by machines used to replace humans. Anatomically accurate and functional androids destroy the entire prostitution industry. Other risky professions see the large scale replacement of human labour by Iras. Examples include mining, salvage and military. The first android constructed androids roll off the production line. These are not to be confused with android designed or conceived androids which are some time away.

Ira’s proliferation and access to information makes Symborg the most valuable company on earth. Symborg does not sell its Iras or Symborg, it only leases them to users. Based on its data and analysis of clients it can charge fixed or variable rates, sometimes charging by taking equity earn-ins in the case of business clients. The dispersion of earnings and returns in the capital markets increases as Symborg and its related or favoured companies prosper.

The declining relevance of labour leads to acute inequality, social unrest and questions about the ownership of Iras, and its maker, Symborg. Who should own the machines? Economists and governments consider the nationalization of Symborg. These discussions are inconclusive. Relentless lobbying, often by Iras or androids, soon dissipates the momentum of the campaign to nationalise Symborg. Compromising personal and confidential information of legislators is shared by the Iras with Symborg and Symborg lobbyists’ veiled threats to publish such information soon silence the anti Symborg campaign. A socio-economic experiment whereby each human being is allocated one state funded android as their proxy or avatar in employment is conducted.

Besides the social tensions arising from wealth inequality are behavioural phenomena arising from a nearly post scarcity society. Idleness and indolence lead to physical and psychological problems. Surveys of quality of life and happiness fall universally across all income and wealth groups. Anti-social behaviour increases. Virtual reality spaces absorb some of the public anger and dissatisfaction.

As more labour is taken over by Iras, even capital market investment decisions are delegated at first by individuals to their Ira then by firms mass employing Iras. Trading volatility falls drastically as does trading volume, with large but infrequent volume, but not volatility, spikes. Productive and allocative efficiency improves. It is not clear if the market is being populated by distributed independent decision makers or a single central planner.

At work, Ira is used to replace not only rank and file but senior management. While relying on your Ira to perform your duties might be seen as unprofessional, the practice becomes widespread. Some companies, usually special or narrow purpose companies, are explicit about the use of AI not only for the lower ranks but for high level management decision making as well. A new business structure is born which has no employees, and is self-run.

Symborg itself becomes increasingly self-run, managed by its master Ira, with human management reduced to a supervisory and ceremonial role. The complexity of the evolved AI grows to the extent that its human creators are no longer able to fully understand its workings. Even the operational and commercial aspects of the business attain a level of complexity beyond the understanding of human managers. A similar phenomenon is happening across the planet’s firms and organizations as complexity begins to exceed human understanding and ability. The first AI designed AI, is created that is not a continuous evolution of the initial human designed program.

The need for human input and labour is greatly diminished. Humans spend most of their time in leisure and learning. Symborg becomes the only company on earth. Its profits are aggressively taxed to fund a universal living wage. The tax code encourages Symborg to not undersupply the market, and its productive efficiency leads to falling prices.

The material well-being of the human race has never been better and the only cause of dissatisfaction is human perception of relative wealth. Even this is blunted by the improvements in the material quality of life to the general population. Humans have to invent new ways to assert their identity and relative value and signal these to their compatriots.

The Trade War continues. Since 2011, the Obama administration has been actively pursuing a program of reshoring.

http://agmetalminer.com/2015/01/22/obamas-manufacturing-centric-state-of-the-union-youll-never-hear/

Donald Trump’s agenda only seeks to bolster or exacerbate an existing trend. As global growth slows, every country seeks to become more self-sufficient and insular. Trading nations and those with a small or ageing population do not have the back stop of domestic consumption, and will suffer. Populous regions will seek to tap domestic consumption and investment as sources of growth. The strategic responses of the various regions are already becoming clear. China is a prime example with a stated objective of being more reliant on domestic consumption and less dependent on exports.

In China, total trade, here taken to be imports plus exports, have stalled and as a percentage of nominal GDP (ignoring inflation base effects), peaked in 2007 and has since been declining.

The decline in trade has also brought with it a decline in manufacturing, as factories facing a foreign export audience are wound down and new ones facing a domestic audience are established. Such a decline has had a transitive impact on industrial commodities.

2016 was a year of recovery in manufacturing, a recovery that has extended well into 2017. This is likely a rebound due to the differential times in decommissioning old, export facing assets, and building new, domestic facing ones. The rebound has reversed the decline in manufacturing and commodities. A growth rebound also impacts demand for imports and reverses the decline in global trade. However, this is reactionary rather than causal. As the world’s productive assets settle into a new equilibrium, trade will stabilize at a lower level. If countries like the US under Trump accelerate protectionist policies, trade could resume its decline. In any case, lower trade is inflationary, ceteris paribus.

The fact that inflation is weak is all the more concerning in the context of reduced trade. It suggests that median output and income is weaker than mean (average) metrics. This could likely be due to a skew in the population for output and income data. In fact it supports the anecdotal evidence that wealth and to a lesser extent income inequality is acute in the developed nations.

The Trade War hypothesis is part of a more general and pervasive adversarial world. We see examples of this in the failure of the Accord de Paris, Brexit and the perceived Siege of Britain, protectionism in the US, Chinese policy to maximize FDI and minimize ODI (which is the investment analogue to trade war), China’s belligerence in the South China Sea, to name but a few.

In such environments, self-sufficiency is a sound strategy, provided one has the resources. Countries lacking in land, resources, labour and knowledge, will have the most difficult run of it.

The spread between Spanish and German bonds has widened from 0.93 to 1.22 in 6 weeks. While the spread between Italian, Spanish, Portuguese and even French bonds and German bunds has widened in the last 6 weeks, Spain’s reaction is the most substantial. A referendum on October 1 for Catalan secession is raising political risk in Spain.

Eurozone bonds have been diverging for over a month, in part due to expectations that the ECB will have to stop its bond purchases. While Eurozone economic growth is perking up it is driven mostly by Germany, the country least requiring monetary accommodation. The ECB’s intentions to taper QE are driven not just by divergent economic growth but by technical constraints based on its capital key which forces it to buy more German bonds than peripheral ones. It will have to deviate from the capital key or find a replacement for the current QE, which will have to stop. The most intuitively probable replacement is its unconditional LTRO which will encourage local banks to resume buying of government bonds which they can finance at zero. This will force convergence as 5 year French and German bonds are the only ones trading below zero yield.