INVESTMENT JOURNAL
October 2016
Premium Prestidigitation
World debt hits record according to IMF as US deficit widens
US jobs report/GDP keeps Fed on track to raise rates in December
Social Security payments stay flat as Obamacare premiums rise dramatically
Markets in October experienced negative returns for every major category:
                    
       
Longer term, U.S. stocks still hold an impressive lead:
          
       
In early October, the International Monetary Fund released a report on the state of the world's debt markets that was as much a policy prescription as it was an analysis. Entitled " Debt - Use It Wisely ", the IMF tallied up a record high $152 trillion of total debt, more than two times the size of the global economy , in what they claimed was the most accurate measure of the world's debt burden ever calculated.
      
            
Borrowing has substantially outpaced global growth in recent years, rising from 200 per cent of gross domestic product in 2002 to 225 per cent last year. The report's findings highlight the contradictions between ultra-low official interest rates that have failed to re-ignite growth, and the dangers that arise from excessive debt levels.

The IMF is renewing their call for "growth friendly fiscal policies", encouraging governments to spend more to stimulate growth, echoing a growing chorus that central banks have been left with too much of the burden to lift the global economy. (The entire report can be read here: https://www.imf.org/external/pubs/ft/fm/2016/02/pdf/fm1602.pdf).

What the report did not say was how these ultra-low and even negative rates have changed the incentives for borrowing. Austria, for instance, borrowed $2 billion in October by issuing a 70 year bond, joining Eurozone neighbors France, Belgium, Italy and Spain in issuing ultra-long (50 year+) debt this year. Saudi Arabia issued $17.5 billion in its debut sovereign bond issue this past month, an emerging market record. It is perfectly logical for these borrowers and others to "back the truck up" when rates are so low: who wouldn't want to borrow money for 70 years like the Austrians just did at cost of 1.5%! Private companies are also racing to lock in these deals of a lifetime. No wonder debt is at a record high.

Of course, for those that really need the money, ultra-low rates are a gift. The U.S., for instance, just ended its fiscal year on September 30 th , and the deficit increased to $587 billion, a 34% increase from $438 billion the prior year , and the first uptick since 2009. Revenues were up less than 1%, while outlays increased 5%. (The report can be read here: https://www.cbo.gov/publication/52086 ). Many observers of the debt have pointed out that the 2010-2015 improvement in the deficit is now over : as the baby boomers retire in ever greater numbers over the next 20 years, the demands on Social Security and Medicare will inexorably rise.

In U.S. economic news, meanwhile, the US Unemployment Report on October 7  showed the economy added +156,000 new jobs last month , a gain "good enough" that some analysts suggest will give the Federal Reserve the green light to raise interest rates by year end.  Job creation in some industries such as energy and manufacturing has slowed since last year, but most segments of the economy are adding workers.  Professional services, high-tech employers, health care companies, and restaurants led the hiring in September.  Jim Baird, chief investment officer in Plante Moran Financial Advisors said " the jobs market remains a relative bright spot in an environment that continues to be characterized by moderate growth overall. "  The unemployment rate rose slightly to 5%, the first uptick since April, mostly due to the fact that an additional 444,000 people entered the labor force.

The Institute for Supply Management (ISM) services index accelerated last month to an 11 month high of 57.1, beating expectations by 4 points.  Growth in the services sector has now reached 80 straight months!  In the ISM report, business activity surged +8.5 points to 60.3, while the index for new orders was up +8.6 points to 60.  Employment in services was also strong, up +6.5 points to 57.2. Numbers above 50 indicate expansion. 

Breaking recent trends, manufacturers reported improved business conditions last month, according to the Institute for Supply Management (ISM) manufacturing index.  The index rose back into expansion to 51.5, after dipping into contraction (sub-50) territory in August.  Forecasts had been for a reading of 50.6.  The survey of executives reported that new orders rose, but the industry is still experiencing soft demand in the United States and weak exports.  Richard Moody, chief economist at Regions Financial stated " All in all, we'd rather have the headline index above 50.0 than below it, but the bottom line is that the manufacturing sector still faces challenging conditions." On a positive note, the measure of new orders jumped to 55.1 from 49.1 and a gauge of production increased +3.2 points to 52.8.

The juxtaposition of these two reports is telling. The services economy is doing fine, while manufacturing struggles.

Across the Atlantic in the United Kingdom, the International Monetary Fund (IMF) stated that Britain will be the fastest-growing G-7 economy this year.  The IMF also accepted the fact that its prediction of a post-Brexit financial crash was overly pessimistic.  The Washington-based IMF said Britain would have a "soft landing" in 2016, with growth of +1.8%.  However, it is sticking with its prediction of sub-par expansion in 2017, re-iterating its view that the economy would eventually suffer from its break with the EU. Notably, the British Pound has declined sharply, since the Brexit vote, enhancing Britain's competitiveness in the export sector. Don't count the Brits out yet!

On Europe's mainland, French President Francois Hollande gave a speech demanding that the United Kingdom pay a heavy price for deciding to leave the EU. The French President called the Brexit referendum the biggest crisis in the EU's history and said its future depended on a determination to be tough during exit talks.  President Hollande stated: " There must be a threat, there must be a risk, there must be a price.  Otherwise we will be in a negotiation that cannot end well."  The comments followed similar tough talk from German Chancellor Angela Merkel, none of which seemed to deter UK Prime Minister May.

In Germany, politicians have accused the US of waging economic war as concern continues to rise among that country's political and corporate leaders over the financial health of Deutsche Bank, its largest financial institution.  Some of Germany's top corporate leaders have come to the support of the bank, stressing its importance to the economy and confidence in the leadership of the bank's CEO John Cryan. 

Deutsche has been under intense pressure since the United States Department of Justice requested the bank pay a $14 billion settlement to settle claims of its misselling of mortgage securities.  Shares fell to their lowest level since 1983 in early October before a rebound following rumors that the settlement was closer to being a much smaller $5.4 billion (shares are down over 95% since their 2007 peak):
     

What is not highlighted in the press is the EU's historic €13 billion fine last month against Apple for "stashing" profits in tax-friendly Ireland. This opening salvo has now been met by the DOJ's return fire against DB: it is quite simply a tit-for-tat payback by the USA in an escalating global battle for more taxes. What many don't realize is that Deutsche Bank has an enormous derivatives exposure that could de-stabilize the world financial system if the bank goes under, so the USA may be playing with fire.

In late October, the Social Security Administration announced a .3% increase in its annual Cost of Living Adjustment (COLA), the smallest increase on record. The maximum earnings subject to Social Security tax was also bumped significantly to $127,200 from $118,500 in 2015, making more W-2 income subject to tax.

Meanwhile, shocking premium increases for health care plans mandated under the Affordable Care Act (i.e. Obamacare) were announced: just under 20%: Colorado, Florida and Idaho; 20% to 29%: Connecticut, Georgia, Indiana, Kentucky, Maine, Maryland; 30% to 49%: Alabama, Delaware, Hawaii, Kansas, Mississippi, Texas; 50% to 92%: Arizona, Illinois, Montana, Oklahoma, Pennsylvania, Tennessee; and 93% in New Mexico! These increases are the consummation of the most masterful sleight of hand (prestidigitation, or trick) ever played on the public by its own government. So much for the "Affordable" Care Act.

Newspapers and media ran with the excuse that "most will qualify for subsidies, and thus not experience much of an increase", but try telling that to the millions of small business owners who have sacrificed to build a profitable business over many years, and are now being penalized for "earning too much" to qualify for subsidies. It's a wonder entrepreneurs just don't all shut down the shop and retire, or go to work for the government or a large institution or company that has a group health plan. Despite its good intentions, Obamacare is in a clear death spiral. We don't know what is next, but it is hard to imagine a more debilitating hit to the US economy than another government-designed health-care program like this one.

As October closed, the government reported that the nation's Gross Domestic Product (GDP) grew at an annualized +2.9% rate in the third quarter, the fastest pace in 2 years. The improvement in GDP was significant compared to the first half of the year, when the U.S. grew just barely over +1% annualized.  The details of the report reveal that consumers increased spending by +2.1%, exports increased the most in almost 3 years, and businesses restocked shelves following a decline in inventories in the spring.

We'll be back to you in early December with our last Investment Journal of the year. Have a great month, and a Happy Thanksgiving!

      
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