In my previous blog, Actions Speak Louder Than Words: Renaming the Fed’s FOMC, (here & here) I noted several key economic indicators showing that the current state of the US economy is not what it’s cracked up to be, and that when it comes to raising interest rates the FED is all talk and no action. As there are a slew of additional indicators supporting my position, I have to maintain that the FED will not raise rates. However, I reserve the right to modify my position as new developments emerge, and that is exactly what I am doing today. The development being the election result: Donald Trump. Keep in mind that Wall Street doesn’t give hoot who wins. Wall Street just cares about how the winners’ policies will make them gobs of money. Our perspective here will be two-fold: how we can piggy back the Street, and what will happen with those rates in December.
Republicans will control the House of Representatives, the Senate, and the Presidency as of January 20, 2017. Trump won’t get everything he wants, but he has a big spending plan in store for the country, and spending requires cash. Lot’s of it. Add to that his frequent admonitions and disdain of the FED and lot’s of uncertainty about what his proposals will do to the economy, and we’re in for some high volatility. With volatility comes opportunity.
That Trump is the president-elect is irrelevant. His spending plan, like all other politicians, will surely add to the national debt, because there is not enough tax revenue to support the current spending of the country, let alone anything additional. To add fuel to the fire is all the social programs that are not on the balance sheet, in the form of future promises such as social security, Medicaid, Medicare, etc. For the current population those liabilities are unfunded as of yet, and estimated to be somewhere around $80-$100 Trillion. The only way to fund that is with even more national debt.
As previously noted, eventually the lenders of that debt will come to realize that America can’t pay it back and there will be only two options left. America either defaults and negotiates cancellation and repayment of the debt, or America just prints the cash to pay it. In either case your cash will be worthless. Before that even happens, the interest rate on all that debt will begin to rise in the open market and irrespective of what the board of governors of the Federal Reserve would like to do, and that means that interest rates for houses, cars, credit, and all the other stuff you buy on borrowed cash will go up.
And what about that FED rate hike we’ve been promised by Janet Yellen? As of this writing the markets are telling us what will happen. The hike was already priced in with 10 year Treasuries hovering at about 1.80% before we said “President-Elect Donald Trump”. Now it is up to 2.10%, or a change of 30 basis points. At this point in time Yellen has nothing to lose, because no matter what she does in December, come January she’ll only hear two infamous words from her new boss at a meeting that will last about 5 seconds: “You’re Fired!” Her last act will be to raise the rate by 25 basis points.
What Yellen is really doing with a rate hike is giving her successor a cushion to begin the next round of easing rates, quantitative easing (QE), buying treasuries, zero interest rate policy (ZIRP), and negative interest rate policy (NIRP). More on that soon…
So we know there will be runaway spending on lots of stuff, and we know the cost of that spending is going to go up. What about some of the other promises that were made this past year? Trump has said many times that he wants to bring jobs back to America through a few initiatives. One is increasing our military strength and also making our VA hospitals better. Both require lots of cash, and even though Mr. Trump is a real estate maven, reducing the costs of improving hospitals will only be a drop in the bucket compared to what is needed to spend on continuing military operations.
Another is taxes. Lowering taxes across the board will certainly help, but there is a limit. At a certain point though, the money saved in taxes will just stay with the companies’ owners and not go into more expansion and hiring. That said, if more Americans are working, it means Americans will be spending more. That will surely benefit the likes of Walmart, Target, and others.
But what about all the products those stores stock, mostly from China? Trump has promised us that he’ll institute tariffs and renegotiate free-trade pacts. You can bank on it that when that happens, the same retailers will pass those added costs on to the American consumer. So America will spend more on retail, but Americans will be spending more because of higher prices. And it’s never a good thing when you have to pay more for the same exact product if your income didn’t rise enough to cover the extra cost.
What all this translates into is falling bond prices and falling stock prices. Remember, last December stocks and bonds both corrected on the rate hike. This time it will be worse, and it will quickly launch the FED into the next round of easing. It will be worse because now during earnings season we are seeing revenue and earnings down for Apple, GE, Honeywell, Caterpillar, Alcoa, and several other bell weather stocks. Some of the CEO’s of these companies have said that orders are falling off the map and they don’t know why. They have made downward revisions for yearly guidance. And they are predicting this pattern to continue into 2017. If you take a look at my last piece mentioned above, you could easily understand why they are also making a prediction of economic slowing at best. So rising costs compounded by falling earning translates into a falling market.
Let’s keep the themes in mind for what to expect going forward. Theme one is continued runaway spending at the federal level. Theme two is higher costs of borrowing and living weighing down on lower taxes for both companies and individuals. Theme three is a December rate hike paving the way for the quick return easy money policies. Theme four, and this is long run, bond defaults at the federal level, for which there will be failed attempts to “bail out”. With these four themes, here’s what we can do now to take advantage and add an extra zero at the end of your account balance.
The first thing you might consider is high levels of cash in your portfolio. If you’ve been in the market for a while it’s a great time to take some profits, especially if you agree that we are due for a correction. Personally I would rather miss a couple percentage points gain than risk losing much more. In the last two days stocks are surging, but that will not last when rates move higher. Cash is a very protected position, and it will allow you to make strategic moves as opportunities present themselves. And there will be opportunities aplenty. Suggestion: take some profits now, and hold lots of cash.
The next area of concern is what will happen around the rest world when Yellen and cohorts raise rates, especially in emerging markets? This is especially disconcerting for investors because emerging market economies rely very heavily on what happens here in America to determine what they do. Many of their currencies are pegged to the dollar, which will depreciate with all the spending and printing and easing (causing their currencies to depreciate as well), and many emerging market central banks follow in lock step with the FED. Many of their companies actually borrow in dollars, with a basis at the rates local to America. Just like our companies will suffer with a rate hike, emerging market companies will suffer too, but at a much greater level. Will they be able to pay back loans in the very same dollars with higher interest rates, especially as their currencies depreciate against trade partners who don’t peg? At first perhaps, but as their economies weaken and the forex trade is exacerbated to their disfavor, they’ll be less and less capable to repay. Suggestion: short emerging markets and the American banks that lend heavily into them.
The next macro trend to profit on is selected sectors that will gain from the runaway spending as well as sectors that will lose from higher interest rates. The gainers will be the military and those companies who do their research and manufacturing. The losers will be retail, discretionary consumption, lenders, housing, and automobiles. My suggestion here is to go long on the winners and short the losers…long on companies and/or ETF’s and funds that are long on defense contractors. Short on the same class of securities in retail, consumer discretionary spending, and banks, banks, banks. Housing will lose out as well with a rate hike, and so will the auto industry. If you’re scared about going short, try buying puts on a company like Ford.
The final recommendation as Trump enters the White House upon his victory will be in the precious metals arena. Last year PM did extremely well with the rate hike, and it will again this time around if Yellen hikes in December. Even if she doesn’t hike, PM will continue to do well. Very well. Again, businesses will suffer, especially those with high levels of debt and emerging market businesses. Investors will be looking for a safe haven, and Gold and Silver are widely considered one of them. Especially outside the US and even more especially in China, India, and Russia. I don’t know how good it will be, but if past is precedent, look to this past year for guidance. Then add more QE, ZIRP, helicopter money, etc, and you’ll have a pretty good cocktail for this asset class.
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