May 2017
Euro Euphoria
France elects Centrist President
Puerto Rico files for bankruptcy
Dubai launches world's first Sharia compliant gold-backed currency
State and local pension deficit much worse than official numbers suggest
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Markets in May saw positive returns. Foreign stocks continued to gain strength, while bonds advanced. Gold bounced, while commodities slumped:

May started off with a seemingly encouraging labor market report on May 5: payrolls increased more than expected (+211,000 vs. consensus estimate of 180,000), the unemployment rate dropped (from 4.6% to 4.5%), and average hourly earnings picked up (as did the average workweek). Beneath the surface, though, the report showed a year over year slowdown in wage growth, and more people leaving the labor force. So, while the headline read " lowest unemployment rate since May 2007", there were conflicting signals that point toward the same "muddle through" type economy that has failed to reach escape velocity since the Fed began its "stimulus" program coming out of the Great Recession - almost nine years ago!

On May 7, EU supporters euphorically celebrated the results of the French presidential election, as independent centrist Emmanuel Macronbeat far-right Marine Le Pen with 65% per cent of the vote. The victory was astounding in many ways, as Macron had never held an elected office, and whose political movement En Marche! was set up barely a year ago. He becomes the youngest ever elected French president.

However, little noted was that voter abstention was estimated at 26%, the highest rate since 1969, reflecting a lack of enthusiasm among many voters for both candidates. In addition, it was estimated that 12 per cent of the electorate voted blank or spoiled their ballot papers.

As is the case globally, disgust with politics and politicians is growing. While commentators cheered and markets breathed a sigh of relief (and the Euro rallied strongly), it remains to be seen whether this "europhoria" will help Angela Merkel later this fall as German voters must make the same decision.

Unlike the U.S., the eurozone economy is only now starting to recover from 2008-2009, so the average voter hasn't reaped much benefit from a federalized Europe. And, mostly unbeknownst to them, the EU banking system is in terrible shape, as its' reserves are filled with junk loans and dubious bonds. This is a big risk to all markets that is not going to resolve itself quickly and, in fact, has the potential to become a highly disruptive market event.

Speaking of dubious bonds, the long saga of Puerto Rico's debt hit a new milestone in May, as their Governor officially requested a form of bankruptcy protection, triggering what is sure to be by far the largest municipal debt restructuring in U.S. history.

To put it in perspective, Puerto Rico owes $73 billion in debt, which it can't pay. (Detroit owed $18 billion when it filed for bankruptcy in 2013.) The island has suffered shortages of electricity and water as bills go unpaid, and residents are fleeing in droves. Puerto Rico debt (those bonds that are "uninsured") trades at a steep discount to par (60-70 cents on the dollar), so they are effectively cut-off from selling new debt. Now the court challenges will begin.

This is a textbook case of what lies in store for state and local governments that have promised the moon without thinking through how to fund the promises (see our comments below about the coming state and local government pension crunch).

Meanwhile, the world's first gold backed digital currency launched in May. OneGram, a Dubai technology firm, devised a first-ever digital currency backed by gold. An initial public offering is expected to raise more than $500 million in capital. The "token", called OneGramCoin, is fully compliant with Islamic laws, but is open to all types of investors. OneGramCoin was created using blockchain technology, and its goal is to create a global merchant payments system, similar to VISA or Mastercard, but without the 2 ½% fee.

In addition to accepting these tokens, bitcoins and other digital currencies would also be accepted. The interesting twist is the complete anonymity with which merchants can operate. Given the global hunt for taxes, and the deep corruption and dysfunction in many Islamic governments, this system might actually gain some traction.

Finally, a little noticed report from the Stanford University's Hoover Institute was published in May titled " Hidden Debt, Hidden Deficits: How Pension Promises Are Consuming State and Local Budgets".   Author and pension expert Joshua Rauh exposes the enormous gap between the assets that state and local governments have "set aside" and the liabilities (future pension payments) they have promised their employees: the published (GASB 67 compliant) unfunded liability is $1.19 trillion, versus the "real" amount of $4.76 trillion. Accounting "rules" allow these pension funds to assume a 7.6% rate of return, but the actual number would be closer to 2.6% if a market-based (i.e. real) methodology was used (to be precise, a duration matched asset-liability pool).

The report is an excellent review of states and local issuers who "fib" the most (the prize goes to Nevada and Illinois), but mostly it presents a picture of how deep a hole has been dug for public sector employees. This is not front page news yet, but you can be sure that the coming rise in property and income taxes will not be met quietly. The entire report can be read here:

Thanks for reading our Journal.   Have a great month!

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