Central Banks, Credit Expansion, and the Importance of Being Impatient

By John Mauldin 

We live in a time of unprecedented financial repression. As I have continued writing about this, I have become increasingly angry about the fact that central banks almost everywhere have decided to address the economic woes of the world by driving down the returns on the savings of those who can least afford it – retirees and pensioners.

This week’s Outside the Box, from my good friend Chris Whalen of Kroll Bond Rating Agency, goes farther and outlines how a low-interest-rate and massive QE environment is also destructive of other parts of the economy. Counterintuitively, the policies pursued by central banks are actually driving the deflationary environment rather than fighting it.

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This is a short but very powerful Outside the Box. And to further Chris’s point I want to share with you a graph that he sent me, from a later essay he wrote. It shows that the cost of funds for US banks has dropped over $100 billion since the financial crisis, but their net interest income is almost exactly the same. What changed? Banks are now paying you and me and businesses $100 billion less. The Fed’s interest rate policy has meant a great deal less income for US savers.

It is of the highest irony that Keynesians wanted to launch a QE policy that would increase the value of financial assets (like stocks), which they claimed would produce a wealth effect. I made fun of this policy some five years ago by calling it “trickle-down monetary policy.” Subsequent research has verified that there is no wealth effect from QE. Well, it did make our stocks go up, on the backs of savers. We’ve transferred interest income from savers into the stock market. We’ve made retirement far riskier for our older pensioners than it should be.

As Chris writes:

Indeed, in the present interest rate environment, to paraphrase John Dizard of the Financial Times, it has become mathematically impossible for fiduciaries [brokers, investment advisors and managers of pension funds and annuities] to meet the beneficiaries’ future investment return target needs through the prudent buying of securities.

Everywhere I go I talk with investment advisors and brokers who are scratching their heads trying to figure out how to create retirement portfolios that provide sufficient income without significantly moving out the risk curve at precisely the wrong time in their client’s lives. It is a conundrum that has been made for more difficult by Federal Reserve policy.

Economics Professor Larry Kotlikoff (Boston University) and our mutual friend syndicated financial columnist Scott Burns came by to visit me last week. I have talked with Larry on and off over the last few years, and Scott and I go back literally decades. A few years ago, Scott and Larry wrote a very good book called The Clash of Generations. Now, Larry has branched off on his own and written a really powerful manual on Social Security called Get What's Yours: The Secrets to Maxing Out Your Social Security.

I will admit I have not paid much attention to Social Security. I just assumed I should start mine when I’m 70, as so many columns I have read suggested. Larry and I recently spent an hour discussing the Social Security system (or perhaps it would be better to call it the Social Security Maze). Three thousand pages of law and tens of thousands of regulations and so many nuances and “gotchas” that it is really difficult to understand what might be best in your particular circumstances. Larry asked me questions for about two minutes and then proceeded to make me $40,000 over the next five years. It turns out I qualify for an obscure (at least to me) regulation that allows me to get some Social Security income for four years prior to turning 70 without affecting my post-70 benefits. There are scores of such obscure rules.

Larry says it is more often the case than not that he can sit down with somebody and make them more money than they thought they were going to get.

As one reviewer says:

This book is necessary for three reasons: Social Security is not intuitive, and sometimes makes no sense at all. Two, Americans act against their best interests, leaving all kinds of money on the table. Three, there is usually a “however” with Social Security rules. Worse, Social Security is now up to three million requests every week, but Congress keeps cutting back budget, staff, hours and whole offices. Combine that with the complexity factor, and the authors conclude you cannot trust what Social Security advises. Great.

If you or your parents are on Social Security or you are approaching “that age,” you really should get this book. Did you know that if you are divorced you can get a check for half of your former spouse’s Social Security income without affecting their income at all? But you can’t know whether this is a good strategy unless you look at other options.

How many retirees or those nearing retirement know about such Social Security options as file and suspend (apply for benefits and then don’t take them)? Or start stop start (start benefits, stop them, then restart them)? Or– just as important – when and how to use these techniques? Get What’s Yours covers the most frequent benefit scenarios faced by married retired couples, by divorced retirees, by widows and widowers, among others. It explains what to do if you’re a retired parent of dependent children, disabled, or an eligible beneficiary who continues to work, and how to plan wisely before retirement. It addresses the tax consequences of your choices, as well as the financial implications for other investments.

The book is written in Larry’s usual easy to read style, and you can jump to the sections that might be most relevant to you. The book is $11 on Kindle and under $15 at Amazon. This might be some of the better financial advice that you get from reading my letter: go get a copy of Get What’s Yours.

I can’t guarantee it will make you $40,000 in five minutes, but it can show you how to navigate the system. Larry also has a website with some inexpensive software to help you maximize your own Social Security. Seeing as how Social Security is the largest source of income for most US retirees, this is something everyone should pay attention to.

It is time to hit the send button. Quickly, we finalized the agenda for the 2015 Strategic Investment Conference. You can see it by clicking on the link. Then go ahead and register before the price goes up. This really is the best economic conference that I know of anywhere this year.

Your wondering how long they’ll pay me Social Security analyst,

John Mauldin, Editor

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Central Banks, Credit Expansion, and the Importance of Being Impatient

This research note is based on the presentation given by Christopher Whalen, Kroll Bond Rating Agency (KBRA) Senior Managing Director and Head of Research, at the Banque de France on Monday, March 23, 2015, for an event organized by the Global Interdependence Center (GIC) entitled “New Policies for the Post Crisis Era.” KBRA is pleased to be a sponsor of the GIC.

Summary

Investors are keenly focused on the Federal Open Market Committee (FOMC) to see whether the U.S. central bank is prepared to raise interest rates later this year – or next. The attention of the markets has been focused on a single word, “patience,” which has been a key indicator of whether the Fed is going to shift policy after nearly 15 years of maintaining extraordinarily low interest rates. This week, the Fed dropped the word “patience” from its written policy guidance, but KBRA does not believe that the rhetorical change will be meaningful to fixed income investors. We do not expect that the Fed will attempt to raise interest rates for the balance of 2015.

This long anticipated shift in policy guidance by the Fed comes even as interest rates in the EU are negative and the European Central Bank has begun to buy securities in open market operations mimicking those conducted by the FOMC over the past several years. Investors and markets need to appreciate that, regardless of what the FOMC decides this month or next, the global economy continues to suffer from the effects of the financial excesses of the 2000s.

The decision by the ECB to finally begin U.S. style “quantitative easing” (QE) almost eight years after the start of the subprime financial crisis in 2007 speaks directly to the failure of policy to address both the causes and the terrible effects of the financial crisis. Consider several points:

• QE by the ECB must be seen in the context of a decade long period of abnormally low interest rates. U.S. interest rate policy has been essentially unchanged since 2001, when interest rates were cut following the 9/11 attack. The addition of QE 1-3 was an effort at further monetary stimulus beyond zero interest rate policy (ZIRP) meant to boost asset prices and thereby change investor tolerance for risk.
   
• QE makes sense only from a Keynesian/socialist perspective, however, and ignores the long-term cost of low interest rate policies to individual investors and financial institutions. Indeed, in the present interest rate environment, to paraphrase John Dizard of the Financial Times, it has become mathematically impossible for fiduciaries to meet the beneficiaries’ future investment return target needs through the prudent buying of securities. (See John Dizard, “Embrace the contradictions of QE and sell all the good stuff,” Financial Times, March 14, 2015.)
   
• The downside of QE in the U.S. and EU is that it does not address the core problems of hidden off- balance sheet debt that caused the massive “run on liquidity” in 2008. That is, banks and markets in the U.S. globally face tens of trillions of dollars in "off-balance sheet" debt that has not been resolved. The bad debt which is visible on the books of U.S. and EU banks is also a burden in the sense that bank managers know that it must eventually be resolved. Whether we talk of loans by German banks to Greece or home equity loans in the U.S. for homes that are underwater on the first mortgage, bad debt is a drag on economic growth.
   
• Despite the fact that many of these debts are uncollectible, governments in the U.S. and EU refuse to restructure because doing so implies capital losses for banks and further expenses for cash- strapped governments. In effect, the Fed and ECB have decided to address the issue of debt by slowly confiscating value from investors via negative rates, this because the fiscal authorities in the respective industrial nations cannot or will not address the problem directly.
   
• ZIRP and QE as practiced by the Fed and ECB are not boosting, but instead depressing, private sector economic activity. By using bank reserves to acquire government and agency securities, the FOMC has actually been retarding private economic growth, even while pushing up the prices of financial assets around the world.
   
• ZIRP has reduced the cost of funds for the $15 trillion asset U.S. banking system from roughly half a trillion dollars annually to less than $50 billion in 2014. This decrease in the interest expense for banks comes directly out of the pockets of savers and financial institutions. While the Fed pays banks 25bp for their reserve deposits, the remaining spread earned on the Fed’s massive securities portfolio is transferred to the U.S. Treasury – a policy that does nothing to support credit creation or growth. The income taken from bond investors due to ZIRP and QE is far larger.
   
• No matter how low interest rates go and how much debt central banks buy, the fact of financial repression where savers are penalized to advantage debtors has an overall deflationary impact on the global economy. Without a commensurate increase in national income, the elevated asset prices resulting from ZIRP and QE cannot be validated and sustained. Thus with the end of QE in the U.S. and the possibility of higher interest rates, global investors face the decline of valuations for both debt and equity securities.
   
• In opposition to the intended goal of low interest rate and QE policies, we also have a regressive framework of regulations and higher bank capital requirements via Basel III and other policies that are actually limiting the leverage of the global financial system. The fact that banks cannot or will not lend to many parts of society because of harsh new financial regulations only exacerbates the impact of financial repression. Thus we take income from savers to advantage debtors, while limiting credit to society as a whole. Only large private corporations and government sponsored enterprises with access to equally large banks and global capital markets are able to function and grow in this environment.

So what is to be done? KBRA believes that the FOMC and policy makers in the U.S. and EU need to refocus their efforts on first addressing the issue of excessive debt and secondly rebalancing fiscal policies so as to boost private sector economic activity. Low or even negative interest rate policies which punish savers in order to pretend that bad debts are actually good are only making things worse and accelerate global deflation. Around the globe, nations from China to Brazil and Greece are all feeling the adverse effects of excessive debt and the related decline in commodity prices and overall economic activity. This decline, in turn, is being felt via lower prices for both commodities and traded goods – that is, deflation.

In the U.S., sectors such as housing and energy, the effects of weak consumer activity and oversupply are combining into a perfect storm of deflation. For example, The Atlanta Fed forecast for real GDP has been falling steadily as the underlying Blue Chip economic forecasts have also declined. The drop in capital expenditures related to oil and gas have resulted in a sharp decline in related economic activity and employment. Falling prices for oil and other key industrial commodities, weak private sector credit creation, falling transaction volumes in the U.S. housing sector, and other macroeconomic indicators all suggest that economic growth remains quite fragile.

To deal with this dangerous situation, the FOMC should move to gradually increase interest rates to restore cash flow to the financial system, following the famous dictum of Adam Smith that the “Great Wheel” of circulation is the means by which the flow of goods and services moves through the economy: “The great wheel of circulation is altogether different from the goods which are circulated by means of it. The revenue of the society consists altogether in those goods, and not in the wheel which circulates them” (Smith 1811: 202).

Increased regulation and a decrease in the effective leverage in many sectors of banking and commerce have contributed to a slowing of credit creation and economic activity overall. And most importantly, the issue of unresolved debt, on and off balance sheet, remains a dead weight retarding economic growth. For this reason, KBRA believes that investors ought to become impatient with policy makers and encourage new approaches to boosting economic growth.

Related Publications:

• U.S. Real Estate Prices Show Signs of Rising Again (Published February 23, 2015)
   
• GSE Litigation Affirms that Fannie Mae and Freddie Mac are Sovereign Credits (Published February 19, 2015)
   
• Swiss Francs & Global Debt Deflation (Published January 21, 2015)

Analytical Contact: Christopher Whalen, Senior Managing Director cwhalen@kbra.com, (646) 731-2366
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The article Outside the Box: Central Banks, Credit Expansion, and the Importance of Being Impatient was originally published at mauldineconomics.com

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15 Surprises for 2015

By John Mauldin

It’s that time of year when people start thinking about New Year’s resolutions and investment planning for the future. It’s also the time of year when analysts feel more or less compelled to offer up forecasts. My friend Doug Kass turns the forecasting process on its head by offering 15 potential surprises for 2015 (plus 10 also-rans).  But he does so with a healthy measure of humility, starting out with a quote from our mutual friend James Montier (now at GMO):

(E)conomists can't forecast for toffee ... They have missed every recession in the last four decades. And it isn't just growth that economists can't forecast; it's also inflation, bond yields, unemployment, stock market price targets and pretty much everything else ... If we add greater uncertainty, as reflected by the distribution of the new normal, to the mix, then the difficulty of investing based upon economic forecasts is likely to be squared!

Lessons Learned Over the Years

"I'm astounded by people who want to 'know' the universe when it's hard enough to find your way around Chinatown." – Woody Allen

There are five core lessons I have learned over the course of my investing career that form the foundation of my annual surprise lists:

1. How wrong conventional wisdom can consistently be.
    
2. That uncertainty will persist.
    
3. To expect the unexpected.
    
4. That the occurrence of black swan events are growing in frequency.
    
5. With rapidly-changing conditions, investors can't change the direction of the wind, but we can adjust our sails (and our portfolios) in an attempt to reach our destination of good investment returns.

Quoting from a very eclectic group of names, Doug does indeed give us a few surprises to think about, and I pass his thoughts on to you as this week’s Outside the Box. (Doug publishes his regular writings in RealMoneyPro on theStreet.com.)

As a bonus, and as a thoughtful way to begin the new year, we have a letter that my good friend and co-author of my last two books Jonathan Tepper wrote to his nephews. He began penning it on a very turbulent plane ride that he was uncertain of surviving. It made him think hard about what was really important that he would want to pass on to his nephews. As the song goes, I found a few aces that I can keep in this hand. I think you will too.

His letter made me think about what I want to be passing on to my grandchildren, including the newest one, Henry Junior, who showed up less than 24 hours ago. They are going to grow up in a very different world than the one I grew up in, and I mostly think that’s a good thing. But the values that I hope can be passed on don’t change. Good character never goes out of fashion.

My associate Worth Wray came down with a very nasty bug this past weekend, so he missed his deadline for delivering his 2015 forecast to you. We’re giving him a few more days and will run it this weekend – which also of course gives me a little more time to mull over my own forecast. Taking to heart James Montier’s quote above, I’m going to forgo the usual 12-month forecast and look farther out, thinking about what major events are likely to come our way over the next five years. I actually think that approach will be for more useful for our longer term planning.

Thanks for being with me and the rest of the team at Mauldin Economics this past year; and from all of us, but especially from me, we wish you the best and most prosperous of new years.
You’re staring hard at crystal balls analyst,

John Mauldin, Editor
Outside the Boxsubscribers@mauldineconomics.com

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15 Surprises for 2015

Doug Kass, Seabreeze Partners
Dec. 29, 2014 | 8:12 AM EST
Stock quotes in this article:
C, SBUX, TSLA, TWTR, GM, GLD, JNK, SPY, QQQ, AAPL, BAC, GOOGL, FB, CSCO

It’s that time of year again.
"Never make predictions, especially about the future." – Casey Stengel

By means of background and for those new to Real Money Pro, 12 years ago I set out and prepared a list of possible surprises for the coming year, taking a page out of the estimable Byron Wien's playbook. Wien originally delivered his list while chief investment strategist at Morgan Stanley, then Pequot Capital Management and now at Blackstone. (Byron Wien's list will be out in early January and it will be fun to compare our surprises.)

It takes me about two to three weeks of thinking and writing to compile and construct my annual surprise list column. I typically start with about 30-40 surprises, which are accumulated during the months leading up to my column. In the days leading up to this publication I cull the list to come up with my final 15 surprises. (Last year I included five also ran surprises.)

I often speak to and get input from some of the wise men and women that I know in the investment and media businesses. I have always associated the moment of writing the final draft (in the weekend before publication) of my annual surprise list with a moment of lift, of joy and hopefully with the thought of unexpected investment rewards in the New Year.

This year is no different.

I set out as a primary objective for my surprise list to deliver a critical and variant view relative to consensus that can provide alpha or excess returns.  The publication of my annual surprise list is in recognition that economic and stock market histories have proven that (more often than generally thought) consensus expectations of critical economic and market variables may be off base.

History demonstrates that inflection points are relatively rare and that the crowds often outsmart the remnants. In recognition, investors, strategists, economists and money managers tend to operate and think in crowds. They are far more comfortable being a part of the herd rather than expressing – in their views and portfolio structure – a variant or extreme vision.

Confidence is the most abundant quality on Wall Street as, over time, stocks climb higher. Good markets mean happy investors and even happier investment professionals.

The factors stated above help to explain the crowded and benign consensus that every year begins with, whether measured either by economic, market or interest-rate forecasts.

But an outlier's studied view can be profitable and add alpha. Consider the course of interest rates and commodities in 2014, which differed dramatically from the consensus expectations.

To a large degree the business media perpetuates group-think. Consider the preponderance of bullish talk in the financial press. All too often the opinions of guests who failed to see the crippling 2007-09 drama are forgotten and some of the same (and previously wrong-footed) talking heads are paraded as seers in the media after continued market gains in recent years.

Memories are short (especially of a media kind). Nevertheless, if the criteria for appearances was accuracy there would have been few available guests in 2009-2010 qualified to appear on CNBC, Bloomberg and Fox News Business.

Indeed, the few bears remaining are now ridiculed openly by the business media in their limited appearances, reminding me of Mickey Mantle's quote, "You don't know how easy this game is until you enter the broadcasting booth."

Abba Eban, the Israeli foreign minister in the late 1960s and early 1970s once said that the consensus is what many people say in chorus, but do not believe as individuals.

GMO's James Moniter, in an excellent essay published several years ago, made note of the consistent weakness embodied in consensus forecasts.

As he put it:

"(E)conomists can't forecast for toffee ... They have missed every recession in the last four decades. And it isn't just growth that economists can't forecast; it's also inflation, bond yields, unemployment, stock market price targets and pretty much everything else ... If we add greater uncertainty, as reflected by the distribution of the new normal, to the mix, then the difficulty of investing based upon economic forecasts is likely to be squared!"

Lessons Learned Over the Years

"I'm astounded by people who want to 'know' the universe when it's hard enough to find your way around Chinatown." – Woody Allen
There are five core lessons I have learned over the course of my investing career that form the foundation of my annual surprise lists:

1. How wrong conventional wisdom can consistently be.
    
2. That uncertainty will persist.
    
3. To expect the unexpected.
    
4. That the occurrence of black swan events are growing in frequency.
    
5. With rapidly-changing conditions, investors can't change the direction of the wind, but we can adjust our sails (and our portfolios) in an attempt to reach our destination of good investment returns.

"Let's face it: Bottom-up consensus earnings forecasts have a miserable track record. The traditional bias is well-known. And even when analysts, as a group, rein in their enthusiasm, they are typically the last ones to anticipate swings in margins." – UBS (top 10 surprises for 2012)

Let's get back to what I mean to accomplish in creating my annual surprise list.

It is important to note that my surprises are not intended to be predictions, but rather events that have a reasonable chance of occurring despite being at odds with the consensus. I call these possible-improbable events. In sports, betting my surprises would be called an overlay, a term commonly used when the odds on a proposition are in favor of the bettor rather than the house.

The real purpose of this endeavor is a practical one – that is, to consider positioning a portion of my portfolio in accordance with outlier events, with the potential for large payoffs on small wagers/investments.

Since the mid-1990s, Wall Street research has deteriorated in quantity and quality (due to competition for human capital at hedge funds, brokerage industry consolidation and former New York Attorney General Eliot Spitzer-initiated reforms) and remains, more than ever, maintenance-oriented, conventional and group-think (or group-stink, as I prefer to call it). Mainstream and consensus expectations are just that and, in most cases, they are deeply embedded into today's stock prices.

It has been said that if life were predictable, it would cease to be life, so if I succeed in making you think (and possibly position) for outlier events, then my endeavor has been worthwhile.

Nothing is more obstinate than a fashionable consensus and my annual exercise recognizes that, over the course of time, conventional wisdom is often wrong.

As a society (and as investors), we are consistently bamboozled by appearance and consensus.

Too often, we are played as suckers, as we just accept the trend, momentum and/or the superficial as certain truth without a shred of criticism. Just look at those who bought into the success of Enron, Saddam Hussein's weapons of mass destruction, the heroic home run production of steroid laced Major League Baseball players Barry Bonds and Mark McGwire, the financial supermarket concept at what was once the largest money center bank, Citigroup (C), the uninterrupted profit growth at Fannie Mae and Freddie Mac, housing's new paradigm (in the mid-2000s) of non-cyclical growth and ever rising home prices, the uncompromising principles of former New York Governor Eliot Spitzer, the morality of other politicians (e.g., John Edwards, John Ensign and Larry Craig), the consistency of Bernie Madoff's investment returns (and those of other hucksters) and the clean-cut image of Tiger Woods.

My Surprises for 2014

These generally proved in line with my historic percentages.
"How'm I doin'?" –  Ed Koch, former New York City mayor

While over recent years many of my surprise lists have been eerily prescient (e.g. my 2011 surprise that the S&P 500 would end exactly flat was exactly correct), my 15 Surprises for 2014 had a success rate of about 40%, about in line with what I have achieved over the last 11 years.

As we entered 2014, most strategists expressed a constructive economic view of a self sustaining domestic recovery, held to an upbeat (though not wide-eyed) corporate profits picture and generally shared the view that the S&P 500 would rise by between 8-10%.

Those strategists proved to be correct on profit growth (but only because of several non operating factors and financial engineering), were too optimistic regarding domestic and global economic growth and recognized (unlike myself) that excessive liquidity provided by the world's central bankers would continue to lift valuations and promote attractive market gains in 2015. Not one major strategist foresaw the emerging deflationary conditions, the precipitous drop in the price of oil and the broad decline in domestic and non-U.S. interest rates.

Many readers of this annual column assume that my surprise list will have a bearish bent (to be sure that is the case for 2015). But I have not always expressed a negative outlook in my surprise list. Two years ago my 2012 surprise list had an out-of-consensus positive tone to it, but 2013's list was noticeably downbeat relative to the general expectations. I specifically called for a stock market top in early 2013, which couldn't have been further from last year's reality, as January proved to be the market's nadir. The S&P closed at its high on the last day of the year and exhibited its largest yearly advance since 1997. (I steadily increased my fair market value calculation throughout the year and, at last count, I concluded that the S&P 500's fair market value was about 1645.)

As I said, in 2014 my success rate was at about 40% (which included five also-ran predictions).
This contrasted with my 15 surprises for 2013, which had the poorest success rate since 2005's list (20%).
By comparison, my 2012 surprise list achieved about a 50% hit ratio, similar to my experience in 2011.

About 40% of my 2010 surprises were achieved, while I had a 50% success rate in 2009, 60% in 2008, 50% in 2007, 33% in 2006, 20% in 2005, 45% in 2004 and 33% came to pass in the first year of my surprises in 2003.

Below is a report card of my 15 surprises for 2014 (and the five also-ran  surprises).

Surprise No. 1: Slowing global economic growth. RIGHT

Surprise No. 2: Corporate profits disappoint. HALF RIGHT (as financial engineering buoyed EPS).

Surprise No. 3: Stock prices and P/E multiples decline. WRONG

Surprise No. 4: Bonds outperform stocks. Closed-end municipal bond funds are among the best asset classes, achieving a total return of +15%. VERY RIGHT

Surprise No. 5: A number of major surprises affect individual stocks and sectors. (Starbucks (SBUX) falls, 3D printing stocks halve in price, General Motors (GM) drops by 20% in 2014). MORE WRONG THAN RIGHT

Surprise No. 6: Volkswagen AG acquires Tesla Motors (TSLA). WRONG

Surprise No. 7: Twitter's (TWTR) shares fall by 70% as a disruptive competitor appears. MORE RIGHT THAN WRONG

Surprise No. 8:  Buffett names successor. WRONG

Surprise No. 9: Bitcoin becomes a roller coaster. RIGHT

Surprise No. 10: The Republican Party gains control of the Senate and maintains control of the House. Obama becomes a lame duck President incapable of launching policy initiatives. RIGHT

Surprise No. 11: Secretary Hillary Clinton bows out as a presidential candidate. WRONG

Surprise No. 12: Social unrest and riots appear in the U.S. RIGHT

Surprise No. 13: Africa becomes a new hotbed of turmoil and South Africa precipitates an emerging debt crisis. HALF RIGHT

Surprise No. 14: The next big thing? A marijuana IPO rises by more than 400% on its first day of trading. WRONG

Surprise No. 15: An escalation of friction between China and Japan hints at war-like behavior between the two countries. WRONG

Also-Ran Surprises: Crude oil trades under $75 a barrel (short crude and energy stocks) RIGHT, VIX trades under 10 (short VIX) RIGHT, gold trades under $1,000 (Short GLD) DIRECTIONALLY RIGHT.

What Was the Consensus for 2014 and What Is the Consensus for 2015?

"The only thing people are worried about is that no one is worried about anything ... That isn't a real worry." – Adam Parker, chief U.S. strategist at Morgan Stanley

"In ambiguous situations, it's a good bet that the crowd will generally stick together – and be wrong." – Doug Sherman and William Hendricks

As mentioned earlier, we entered 2014 there was a generally upbeat outlook for global economic and profit growth, as well as upbeat prospects for the U.S. stock market. Projections for bond yields were universally for higher yields throughout the year and the same could be said for the general expectation of rising oil prices.  As is typical, most sell-side projections for earnings, the economy, bond yields and stock prices were grouped in an extraordinarily tight range.

• Both U.S. and global economic growth disappointed the consensus (despite a strong third quarter 2014 U.S. GDP number).
   
• S&P earnings were a slight beat, but only because of more aggressive than anticipated share repurchase programs, lower depreciation and interest expenses and a decline in effective tax rates.
   
• Bond yields declined unexpectedly. The 10-year yield dropped to about 2.2% from 3.05%.
   
• Deflationary forces were also a surprise, most notably no one projected that oil prices would fall to under $60 s barrel and that the Bloomberg Commodity Index would hit a five-year low in December, 2014.
   
• Stock prices ended the year about 5% above beginning of the year consensus forecasts.

Virtually all strategists are now self-confident bulls, as gloom and doom forecasts have all but disappeared. After another year with no reactions of 10% or more, any future setbacks are being viewed by the consensus as bumps in the road and as opportunities to buy because (after the correction(s)) we will be up, up and away."

After missing the 25% rise in valuations in 2013 (and a further expansion in P/E ratios in 2014), the consensus now assumes that valuations will expand slightly again in 2015. (Note: The average P/E ratio has increased by about 2% per year over the last 25 years.)

The domestic economy has forward momentum (as witnessed by +5% Real GDP growth in 3Q 2014), so the extrapolation of heady growth is now in full force by the consensus.

In terms of the markets, the consensus remains of the view that liquidity (albeit, at a slowing rate) will overcome complacency and valuations again as it did last year, but my surprises incorporate the notion that the extremes that exist today (in price and bullish sentiment) put the markets in a different and less secure starting point in 2015.

"We expect the growth recovery to broaden as global growth picks up to 3.4% in 2015 from 3% in 2014. Inflation is likely to remain low, in part due to declines in commodity prices, and as a result monetary policy should remain easy. We think this backdrop supports a pro-risk asset allocation." – Goldman Sachs, Global Opportunity Asset Locator (December 2014)

As we enter 2015, investors and strategists are again grouped in a narrow consensus and expect a sweet spot of global economic corporate profit growth that will translate to higher stock prices.

The consensus is for U.S. economic growth of +2.5% to +3.25% real GDP, bond yields to be 50-75 basis points higher than year-end 2014 and closing 2015 stock market price targets to be up by about 8-10% (on average). Indeed, most strategists suggest (in sharp contrast to their views 12 months ago) that the big surprise for 2015 will be that there is upside to consensus economic growth and stock market price targets.
Here were Goldman Sach's views for 2014 made 12 months ago (with actual in parentheses). As can be seen, the brokerage's growth forecasts for the real economy (as was the entire sell side) were too optimistic, while price targets for the S&P were not ambitious enough:

• U.S. real GDP was estimated at +3.1% for 2014. ( +2.4%A)
   
• Global real GDP was estimated at+3.6% for 2014. (+3.0%A)
   
• S&P 500 EPS $116 top-down estimate and $119 bottom-up estimate for 2014 ($119/shareA)
   
• Year-end S&P 2014 S&P 500 price target was estimated for 2014 at 1900 (2080A)
   
• Inflation/headline CPI +1.5% for 2014. (+1.1%A)
   
• U.S 10-year Treasury yield 3.25% for year-end 2014. (2.20%A)

Again, let's use Goldman Sachs' principal 2015s views of expected economic growth, corporate profits, inflation, interest rates and stock market performance as a proxy for the consensus for the coming year. This year the brokerage, like most, is following the bullish trend and is more optimistic on the market relative to its uninspiring expectations last year.

• 2015/2016 U.S. real GDP +3.1%, +3.0%
   
• 2015/2016 global real GDP +3.6%, +3.9%
   
• 2015 S&P 500 operating per share profits $122/share
   
• Year-end 2015 S&P 500 price target 2100
   
• 2015/2016 Consumer Prices +1.0%, +2.4%
   
• 2015 closing yield on the U.S. 10 year Treasury note 3%

The Rationale Behind My Downbeat Surprises for 2015

There are numerous reasons for my downbeat theme this year. In no order of importance: corporate profit margins remain elevated, the rate of domestic economic growth is decelerating (despite five years of QE and ZIRP), a quarter of the world is experiencing minimum growth in GDP, optimism and complacency are elevated, signs of malinvestment are appearing, valuations (P/E ratios) rose again after a 25% expansion in 2013 (compared to only +2% annual growth since the late-1980s. As well, so many gauges of valuations are stretched (market cap/GDP, the Shiller P/E ratio and many others).

Above all, I expect the theme of the U.S. as an oasis of prosperity will be tested in 2015-16 as contagion might be a bi**h.

Moreover, given the large array of potentially adverse economic, geopolitical and other outcomes, the markets have grown complacent after a trebling in prices over the last five years.

Finally, my downbeat surprises this year recognize, that as we enter 2015, we should not lose sight of the notion that if pessimism is the friend of the rational buyer, optimism is the enemy of the rational buyer.

My 15 Surprises for 2015

At last, here are my 15 surprises for 2015 (with a strategy that might be employed in order for an investor to profit from the occurrence of these possible improbables).

Surprise No.1 – Faith in central bankers is tested (stocks sink and gold soars).

"Investment bubbles and high animal spirits do not materialize out of thin air.  They need extremely favorable economic fundamentals together with free and easy, cheap credit and they need it for at least two or three years. Importantly, they also need serial pleasant surprises in such critical variables as global GNP growth." – Jeremy Grantham

"The highly abnormal is becoming uncomfortably normal. Central banks and markets have been pushing benchmark sovereign yields to extraordinary lows – unimaginable just a few years back. Three-year government bond yields are well below zero in Germany, around zero in Japan and below 1 per cent in the United States. Moreover, estimates of term premia are pointing south again, with some evolving firmly in negative territory. And as all this is happening, global growth – in inflation-adjusted terms – is close to historical averages. There is something vaguely troubling when the unthinkable becomes routine." – Claudio Borio

European QE Backfires: The ECB initiates a sovereign QE in January 2015, but it is modest in scale (relative to expectations) as Germany won't permit a more aggressive strategy. Markets are disappointed with the small size of the ECB's initiative and European banks choose to hold their bonds instead of selling. ECB balance sheet still can't get to 3 trillion euros and the euro actually rallies sharply. Bottom line, QE fails to work (economic growth doesn't accelerate and inflationary expectations don't lift).

Draghi Is Exposed: Mario Draghi is exposed for what he really is: the big kid of which everyone is scared. For some time, no one wanted to fight him (or fade sovereign debt bonds, which would be contra to his policy). But, after the meek January QE, the response changes. He is now seen as the bully who never throws a punch and who always has gotten his way. But at the time of the January QE a medium sized kid (and a market participant) teases him and Draghi warns him again to stop it. The kid keeps teasing. Draghi the bully takes a swing, it turns out he can't fight and the medium-sized kid whips his butt. From then on, the big kid is feared no more. For some time Draghi has said he will do "whatever it takes," but he never really had to do anything. When he finally gets going and has to act rather than talk, he will expose himself as only a bully and as a weak big kid. Mario Draghi gets fed up with the Germans and returns to Italy (where he was governor of the Bank of Italy between 2006-2011) and becomes the country's president.

Shinzo Abe and Haruhiko Kuroda Resign: Kuroda, an advocate of looser monetary policy, stays on at the Bank of Japan (for most of the year), but the yen enters freefall to 140 vs. the dollar and wage growth lags badly. Japanese people have had enough and, by year end, Prime Minister Shinzo Abe and Haruhiko Kuroda are forced to resign.

The Fed Is Trapped: The Federal Reserve surprises the markets and hikes the federal funds rate in April 2015. A modest 25-basis-point rise in rates causes such global market turmoil that it is the only hike made all year. The Federal Reserve is now viewed by market participants as completely trapped, as an ah-ha-moment arrives in which there is limited policy flexibility to cope with a steepening downturn in the business cycle in late 2015/early 2016. Stated simply, the bull market in confidence in the Federal Reserve comes to an abrupt halt.

Malinvestment Becomes the It-Word in 2015: Steeped in denial of past mistakes and bathing in the buoyancy of liquidity and the elevation of stock prices in 2014, market participants come to the realization that the world's central bankers in general, and the Fed in particular, once again has taken us down an all too familiar and dangerous path that previously set the stage for The Great Decession of 2007-09. It becomes clear that the consequences of unprecedented monetary easing and the repression of interest rates has only invited unproductive investment and speculative carry trades. The impact of a lengthy period of depressed interest rates uncork malinvestment that has percolated and detonates among differing asset classes as the year progresses. Already seen in the deterioration and heightened volatility in commodities (the price of crude, copper, etc.), in widening spreads in the energy high yield (with yields up to 10% today, compared with only 5% a few months ago) and with the average yield on the SPDR Barclays High Yield Bond ETF (JNK) up to 7% (from a low of 5% earlier in 2014), the consequences of financial engineering (zero-interest-rate policy and quantitative easing) and lack of attention to burgeoning country debt loads and central bankers' balance sheets, in addition to inertia on the fiscal front result in rising volatility in the currency markets. Malinvestment in countries like Brazil (where consumer debt has risen by 8x and export accounts have quintupled over the last eight years on the strength of a peaking export boom, in oil and iron ore, so dependent on the China infrastructure story that has now ended) translate into a deepening economic crisis in Latin America and in other emerging markets.

Then, EU sovereign debt yields, suppressed so long by Draghi's jawboning, begin to rise. Slowly at first and then more rapidly, EU bond prices fall, putting intense pressure on the entire European banking system. (In his greatest score, George Soros makes $2.5 billion shorting German Bunds). The contagion spreads to other region's financial institutions. Shortly after, social media and high valuation stocks get routed and, ultimately, so does the world's stock markets.

As a result of the influences above, the VIX rises above 30. The price of gold soars to $1,800-$2000 and the precious metal is the best-performing asset class for all of 2015. Strategy: Buy GLD and VIX, Short SPY/QQQ and German Bunds

Surprise No. 2 – The U.S. stock market falters in 2015.

"In a theater, it happened that a fire started offstage. The clown came out to tell the audience. They thought it was a joke and applauded. He told them again and they became more hilarious. This is the way, I suppose, that the world will be destroyed – amid the universal hilarity of wits and wags who think it is all a joke." – Soren Kierkegaard.

Market High Seen in January, Low Seen in December (at Year End): The U.S. stock market experiences a 10%+ loss for the full year. (Note: Not one single strategist in Barron's Survey is calling for a lower stock market in 2015. Projected gains by the sell side are between +6-16%, with a median market gain forecast at +11%). The S&P Index makes its yearly high in the first quarter and closes 2015 at its yearly low as signs of a deepening global economic slowdown intensify in the June-December period.

While earnings expectations disappoint, the real source of the market decline in 2015 is a contraction in valuations (price-earnings multiples) after several years of robust gains. Investors begin to recognize that low interest rates, massive corporate buybacks, the suppression of wages, phony stock option accounting and other factors artificially goosed reported earnings and that earnings power and organic earnings are less than previously thought. So, 2015 is a year in which the relevant ways of measuring overvaluation (market cap/GDP currently at 1.25 vs. 0.70 mean) and the Shiller CAPE ratio (currently at 27x vs. 17x mean) become, well, relevant.

With few having the intestinal fortitude to maintain skepticism and short positions into the unrelenting bull market of 2013-14, there is none of the customary support of short sellers to cover positions and soften the market decline, when it occurs.

Stocks begin to drop in the first half, well before the real economy tapers, underscoring the notion (often forgotten) that the stock market is not the economy.

But by mid-year it becomes clear that U.S. economic growth is unable to thrive without the Fed's support.
Year-over-year profits for the S&P decline modestly in the second half of 2015. Domestic Real GDP growth falls to under +1.5% in the third and fourth quarters.

By year end the market begins to focus on The Recession of 2016-17, which looms ahead in the not so distant future. Strategy: Short SPY

Surprise No. 3 – The drop in oil prices fails to help the economy.

"In its November 14, 2014 Daily Observations ("The Implications of $75 Oil for the US Economy"), the highly respected hedge fund Bridgewater Associates, LP confirmed that lower oil prices will have a negative impact on the economy. After an initial transitory positive impact on GDP, Bridgewater explains that lower oil investment and production will lead to a drag on real growth of 0.5% of GDP. The firm noted that over the past few years, oil production and investment have been adding about 0.5% to nominal GDP growth but that if oil levels out at $75 per barrel, this would shift to something like -0.7% over the next year, creating a material hit to income growth of 1-1.5%." – Mike Lewitt, The Credit Strategist

Despite the near universal view that lower oil prices will benefit the economy, the reverse turns out to be the case in 2015 as the economy as a whole may not have more money – it might have less money.

Continued higher costs for food, rent, insurance, education, etc. eat up the benefit of lower oil prices. Some of the savings from lower oil is saved by the consumer who is frightened by slowing domestic growth, a slowdown in job creation and a deceleration in the rate of growth in wages and salaries.

And the unfavorable drain on oil related capital spending and lower employment levels serve to further drain the benefits of lower gasoline and heating oil prices.

In The Financial Times, recently, Martin Wolf wrote: "(A) $40 fall in the price of oil represents a shift of roughly $1.3 trillion (close to 2 per cent of world gross output) from producers to consumers annually. This is significant. Since, on balance, consumers are also more likely to spend quickly than producers, this should generate a modest boost to world demand."

But Wolf, and the many other observers, as Mike Lewitt again reminds us, "fail to explain how the $1.3 trillion that has been deducted from the global economy is able to shift from one group to another. "

Surprise No. 4: The mother of all flash crashes.

"America is the 'arch criminal' and 'unchangeable principal enemy' of North Korea." (Dec. 22, 2014)
"America is a 'toothless wolf' and 'the empire of devils."" (March 27, 2010)
"North Korean missiles will reduce Washington, D.C. to 'ashes.'" (August 19, 2014)
"America is a 'group of Satan' bent on destroying Korean religion." (April 22, 2013)
"American 'ideological and cultural poisoning' is undermining socialism around the world." (July 16, 2014)

– Selected quotes from North Korea's state-controlled media

Hackers attack the NYSE and Nasdaq computer apparatus and systems by introducing a flood of fictitious sell orders that result in a flash crash that dwarfs anything ever seen in history.

In the space of one hour the S&P Index falls by more than 5%.

The identity of the attacker goes unknown for several days and it turns out to be North Korea.  Strategy: Buy VIX, Short SPY/QQQ

Surprise No. 5: The great three-decade bull market in bonds is over in 2015.

"Take then thy bond thou thy pound of flesh..." – Portia, The Merchant of Venice
Last year not one strategist saw lower interest rates (though that was my No. 1 Surprise last year). This year, not one strategist expects a spike in interest rates.

In the first half of 2015, European yields and U.S. yields start to converge, in that European yields begin to jump to where the U.S. 10-year yield resides. The failure of Draghi's policy (see Surprise No. 1) will result in an acceleration in the European debt yields rising and in a decay in debt prices. That will mark the end of the great three-decade bond bull market in the U.S. and it will occur as global growth eases. Strategy: None

Surprise No.6 – China devalues its currency by more than 3% vs. the U.S. dollar.

"It's not like I'm anti-China. I just think it's ridiculous that we allow them to do what they're doing to this country, with the manipulation of the currency, that you write about and understand, and all of the other things that they do." – Donald Trump

For years, China has essentially pegged it's currency to the U.S. dollar. (liberalization meant that a narrow trading range is permitted). With the huge run in the U.S. Dollar, China's currency has appreciated compared with other Asian currencies. As a result, China has lost its manufacturing edge and its trade surplus has all but disappeared. Whether it's a permitted day-to-day weakening, changing the peg from the dollar to a basket of currencies or whether there is an overnight surprise devaluation, China's currency will weaken materially in 2015. Strategy: None

Surprise No. 7 – Apple (AAPL) becomes the first $1 trillion company.

"There's an old Wayne Gretzky quote that I love. 'I skate to where the puck is going to be, not where it has been.' And we've always tried to do that at Apple. Since the very, very beginning. And we always will." – Steve Jobs

Apple's next generation iPhone is seen to likely outsell its latest phone iteration as Re/Code uncovers (and reveals) some amazing and unique new features/applications that are planned for the next generation phone.
I don't know what features it will have or how it will improve design or performance. But I think there is now a near-consensus that it won't and that the next product upgrade cycle is a while away.

So, I predict Apple 2016 estimates rise significantly (to $10/share) and, despite a weak market backdrop, Apple becomes the first $1 trillion dollar market-cap company and the best-performing large-cap in 2015.
Apple becomes the only one-decision stock during the stock market swoon during the last half of 2015. It is a must own. Strategy: Buy APPL

Surprise No. 8 – Legislation is introduced that allows for repatriation for foreign cash.

"The only difference between death and taxes is that death doesn't get worse every time Congress meets." – Will Rogers
As signs of domestic economic growth fade in the second half of 2015, Congress and the Administration agree on a broad program to repatriate foreign cash at a low tax rate.
The deal briefly rallies the U.S. stock market, but equities soon succumb to a slowing domestic economy and diminishing corporate profit growth.   Strategy: None

Surprise No. 9 – Energy goes from the worst-performing group in 2014 to the best-performing group in the first half of 2015 and then falls back later in the year.

"Oil vey!" – Kass Daily Diary term
Energy stocks are on a roller coaster in 2015.

As the price of crude oil rises steadily (towards $65 a barrel) in early 2015, the energy sector (which was among the worst in 2014) becomes the best market group in the first half of the year. Slowing global economic growth during the last half of the year leads to profit-taking in the energy sector as the price of crude oil closes the year at under $50 and at its lowest price in 2015.

In a surprise move, the president signs approval for the Keystone Pipeline in the second half of the year.
Strategy: Buy oil stocks in first six months of the year, sell/short mid-year.

Surprise No. 10 – More chaos in the Democratic Party.

"Mothers all want their sons to grow up to be president, but they don't want them to become politicians in the process." – John F. Kennedy

Sen. Elizabeth Warren pushes Secretary Hillary Clinton so far to the left that she loses independent voters, though she easily gains the Democratic nomination for president.  Former President George H.W. Bush passes away during the first half of the year and Governor Jeb Bush immediately declares his candidacy. By the end of 2015, Jeb Bush is well ahead in the polls and is a big favorite to win the presidency in 2016.
Strategy: None

Surprise No. 11 – Food inflation accelerates after Russia halts wheat exports.

"As life's pleasures go, food is second only to sex. Except for salami and eggs. Now that's better than sex, but only if the salami is thickly sliced." – Alan King

Russian turmoil continues and Putin decides to halt exports of wheat again to keep as much homeland as possible, resulting in a price spike in wheat, but also corn and soybeans. This price rise, on top of U.S. food inflation that is already running higher, offsets the consumer benefit of still-relatively-low gasoline and heating oil prices. Strategy: None

Surprise No. 12 – Home prices fall in the second half of 2015.

"I told my mother-in-law that my house was her house and she said, 'Get the hell off my property.'" – Joan Rivers

Under the weight of reduced home affordability, still low household formation gains and continued pressure on real incomes, home prices fall in 2015. Builders lose pricing power. Strategy: Short homebuilders.

Surprise No. 13 – Individual and sector market surprises.

"Those who are easily shocked should be shocked more often." – Mae West

• Bank Stocks Fall – Though bank stocks have been recent market leaders, the weight of a flattening yield curve, still-tepid loan demand and an implosion in the European banking system make the sector among the worst market performers. Moreover, a major cyber attack against Bank of America (BAC) that actually destroys a percentage of customer records further diminishes enthusiasm for the group.
   
• Twitter Feeding – Carl Icahn, calling it his "new Netflix," discloses a 9.9% position in Twitter. This stimulates a bidding war between Google (GOOGL) and Facebook (FB) to acquire the company. Google wins the battle and pays $60 a share for Twitter.
   
• Volatility Rising – The VIX rises to over 30 in the second half of the year.
   
• Google Institutes a Share Buyback and Shaves Capital Spending – After a lackluster performance in 2014, Google's management reverses course on its previously outsized capital spending program on non-core businesses and becomes more shareholder friendly. The company dials back spending and institutes a stock buyback program.
   
• Corporate Inefficiency in Large-Cap Technology Targets Activist Investors –- Two hedge funds establish a filing position in Cisco (CSCO) and force Chairman John Chambers out. The new CEO announces a large special dividend and a massive stock buyback and a cutback to the employees' too-generous stock option plan. More than 10% of the workforce is laid off and Cisco's shares soar. Several other tech companies are targeted.

Strategy: Long AAPL TWTR, CSCO, VIX, GOOGL and short banks


Surprise No. 14 – Berkshire Hathaway (BRK.A) makes its largest acquisition in history.
"When I was 15 years old, I read an articls about Ivan Boesky, the well-known takeover trader – turned out years later it was all on inside information! But before that came to light, he was very successful, very flamboyant. And I thought, 'This is what I want to do.' So I'm 15 years old, I decide I'm going to Wall Street." –  Karen Finerman

During the depths of the market's swoon in the later part of the year, Warren Buffett scoops up his largest acquisition ever. The $55+ billion acquisition is not in his customary comfort zone (a consumer goods company), but rather the deal is for a company in the energy, retail or construction/equipment areas. Strategy: None

Surprise No. 15 – A derivative blowup precipitates an abrupt market drop.

"I view derivatives as time bombs, both for the parties that deal in them and the economic system." – Warren Buffett

The $300 trillion holdings of derivatives by the U.S. banking industry has been all but forgotten. The four largest U.S. banks account for $240 trillion of that total, dwarfing their combined $750 billion in statutory capital! This sort of exposure in which notional derivatives are more than 300x the banks' net worth, is, as my friend The Credit Strategist's Mike Lewitt has written, "would be laughable if the consequences of a financial accident were not so potentially catastrophic."

To make matters worse, the passage of the $1.1 trillion spending bill passed this month (written by lobbyists and voted on by bought-and-paid-for legislators who probably neither read nor understood the complex spending bill) has kept taxpayers on the hook –through the FDIC – for those derivatives (what Warren Buffett previously called "financial weapons of mass destruction.")

On any measure, the sheer size of these derivative portfolios pose potential risk to the world's financial stability. What we have learned from the past cycle is how opaque the exposure really is and how stupid and avaricious our bankers really are when allowed to venture into territories of leverage.

Whether it is energy derivatives or some other asset class, a derivative blowup in 2015 will serve to preserve the wise words of Benjamin Disraeli (who served twice as Great Britain's Prime Minister) that "what we have learned from history is that we haven't learned from history." It will also harm our markets, once again. Strategy: Short SPY

10 Also-Ran Suprises for 2015

By DOUG KASS
Dec. 26, 2014 | 7:32 AM EST
Stock quotes in this article: BABA, SHLD, IBM, BRK.A, MONIF

• On Monday I will deliver my 15 Surprises for 2015.  I think it is my most interesting list in years.

Here are my 10 also-ran Surprises for 2015 that I had considered but didn't make the top 15.

1. China's Real GDP growth falls below 5% in 2015 as economic growth decelerates markedly in the second half of the year.
    
2. An accounting "discrepancy" is found at Alibaba (BABA). The shares plummet and the hedge fund community feels the pain.
    
3. Under pressure from suppliers and a falling stock price, Ron Johnson is installed as CEO ofSears Holdings (SHLD).
    
4. George Soros makes $2.5 billion by shorting German Bunds.
    
5. The price of crude oil drops below $40 a barrel in the second half of 2015.
    
6. The consumer price index turns negative (year over year).
    
7. IBM (IBM) whiffs and the share price drops below $125 a share. Berkshire Hathaway(BRK.A) suffers a near-$4 billion loss (on paper). At Buffett's suggestion, senior management is replaced.
    
8. Warren Buffett announces his successor.
    
9. Uber goes public at a $50 billion capitalization. The share price never exceeds the IPO price in 2015.
    
10. Monitise's (MONIF) subscription adds far outpace expectations this year. (The shares double in price).
11. 
    

Letter to My Nephews

By Jonathan Tepper
December 29, 2014 in Uncategorized

You can learn a lot from books, but many things can only be learned the hard way by living, suffering and enjoying life. A year and a half ago, I was in a plane with very bad turbulence, and I worried that if the plane went down, many of the lessons I’ve learned in life would end up at the bottom of the ocean.  I wrote a letter to my nephews for them to read when they were older.  I hope they’ll find it useful.
—————–
Dear nephews,
I’m writing this on a plane. The reason I started writing this was that I feared the plane might go down, and if it went down, all the lessons I’ve learned in life would disappear with me. By writing this, I hope to pass on the few lessons I’ve learned.

The most important lesson is that the vast majority of things you worry about will not bother you the next day. A year later you will not even be able to remember them if you try. When you grow older, you will not worry about what grades you got. You won’t worry about games you lost.   You won’t worry about what other people thought about you. Most of the things you worry about will never happen. Even if the worst things that you worry about happen, life will still go on. Learn to enjoy every day, and try to enjoy it as if it is your last. It has taken me a long time to understand this, and I wish I had understood it sooner.

Happiness is not a destination but a journey. You will never be smart enough, rich enough, have a pretty enough girlfriend, boyfriend, husband or wife, or win enough prizes and awards. Whatever it is you want, there is always something better. Enjoy the journey of learning, working, and living. If you enjoy the journey, you’ll probably achieve a lot more than if you focused on goals.

Money can provide security, but once you have security, more money cannot buy you more happiness. If you show me someone who thinks money can buy happiness, I’ll show you someone who has never had a lot of money.

Things don’t make you happy, but memories will always stay with you. Whatever it is that you buy, you will soon get used to it. It will make you happy for a short while, but it will not make you happy forever.

Experiences and memories can make you happy forever. I can’t even remember most of the toys I’ve had in my life, but I still think of my times with Timothy and your Grandmom with great happiness and fondness. I remember walking Timothy to school and how happy we were. I remember hugging your Gradmom when I came home for a weekend. Those memories will never go away. The happiest memories of my friends are my travels and dinners with them, not the things I’ve bought for myself. You’ll remember dinners and travels with friends and family more than any shiny things you’ll ever have.

Your family is the most important thing you have in life. Friends, boyfriends, girlfriends and co-workers come and go, but the only thing that you can always count on is your family. (If you find a friend who is always there for you, you’re extremely lucky. They exist, but they’re very rare.) One day, you will have your own family. You must love them and look after them. You will understand one day that just as your grandparents die, your parents will as well. Strive to be a good son and daughter. One day, you will be like your parents. Your parents are not perfect, and you will not be either. But you can be loving and be a good son and daughter. One day you can be a good parent.

Never stop learning, and always be ready to teach yourself things you don’t know. The only things you will remember are things you care about. You will forget about all the rest. You must teach yourself and care about what you learn. No one can teach you everything you need to know at school or university. You will also forget most of what you study, and that is fine. As Jacques Barzun said, “Civilization is all that remains after you have forgot all that you specifically set out to remember.”

Never live someone else’s life. Find your gifts and the things that give you pleasure, develop those gifts, and pursue them.   Do what makes you happy and be great at it. You have skills and gifts that no one will ever have or see again. If you’re a businessman, build businesses. If you’re a writer, write. If you’re a scientist, discover. If you do what you love and love what you do, you will work very hard, but you will enjoy every day.

One of the things that most influenced me was something Steve Jobs once said:

When you grow up, you tend to get told that the world is the way it is and your life is just to live your life inside the world, try not to bash into the walls too much, try to have a nice family life, have fun, save a little money.

That’s a very limited life. Life can be much broader once you discover one simple fact, and that is that everything around you that you call life was made up by people that were no smarter than you. And you can change it, you can influence it, you can build your own things that other people can use. Once you learn that, you’ll never be the same again.

And the minute that you understand that you can poke life and actually something will, you know if you push in, something will pop out the other side, that you can change it, you can mold it. That’s maybe the most important thing. It’s to shake off this erroneous notion that life is there and you’re just going live in it, versus embrace it, change it, improve it, make your mark upon it.

I think that’s very important and however you learn that, once you learn it, you’ll want to change life and make it better, cause it’s kind of messed up, in a lot of ways. Once you learn that, you’ll never be the same again.

I hope that you will find what you love and you will change the world.

Life is full of struggle, and many bad things will happen to you. This is one thing that I can guarantee you. Most of my friends died of AIDS, and your uncle Timothy died in a car accident and your Grandmother committed suicide after suffering from a very bad brain tumor. These things happened and cannot be changed. Many people suffer great tragedies and live full and happy lives. Remember the people you love and mourn them. Accept that terrible things happen, and try to live as if each day is your last with those you love. There is nothing else you can do.

The best way to avoid anxiety, stress and unhappiness is to avoid internal contradiction. Don’t think that one thing is right and do the opposite. Listen to your conscience and obey it. Be a good person and live according to your convictions. You cannot answer for other people, but you can always answer for yourself.

As long as you live according to your most basic beliefs, you will not have regrets or guilt. You will be able to die happily knowing that you looked after the poor and needy, that you were loving to those around you, and that you failed often but did your best. You will not lose a night of sleep if you always try to do your best. I love you very much.
Much love,
Uncle Jonathan

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The article Outside the Box: 15 Surprises for 2015 was originally published at mauldineconomics.com.

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The Burning Questions For 2015

By John Mauldin

Louis Gave is one of my favorite investment and economic thinkers, besides being a good friend and an all-around fun guy. When he and his father Charles and the well-known European journalist Anatole Kaletsky decided to form Gavekal some 15 years ago, Louis moved to Hong Kong, as they felt that Asia and especially China would be a part of the world they would have to understand. Since then Gavekal has expanded its research offices all over the world. The Gavekal team’s various research arms produce an astounding amount of work on an incredibly wide range of topics, but somehow Louis always seems to be on top of all of it.

Longtime readers know that I often republish a piece by someone in their firm (typically Charles or Louis). I have to be somewhat judicious, as their research is actually quite expensive, but they kindly give me permission to share it from time to time.

This week, for your Outside the Box reading, I bring you one of the more thought-provoking pieces I’ve read from Louis in some time. In Thoughts from the Frontline I have been looking at world problems we need to focus on as we enter 2015. Today, Louis also gives us a piece along these lines, called “The Burning Questions for 2015,” in which he thinks about a “Chinese Marshall Plan” (and what a stronger US dollar might do to China), Abenomics as a “sideshow,” US capital misallocation, and whether or not we should even care about Europe. I think you will find the piece well worth your time.

Think about this part of his conclusion as you read:

Most investors go about their job trying to identify ‘winners’. But more often than not, investing is about avoiding losers. Like successful gamblers at the racing track, an investor’s starting point should be to eliminate the assets that do not stand a chance, and then spread the rest of one’s capital amongst the remainder.

Wise words indeed.

A Yellow Card from Barry

What you don’t often get to see is the lively debate that happens among my friends about my writing, even as I comment on theirs. Barry Ritholtz of The Big Picture pulled a yellow card on me over a piece of data he contended I had cherry picked from Zero Hedge. He has a point. I should have either not copied that sentence (the rest of the quote was OK) or noted the issue date. Quoting Barry:

Did you cherry pick this a little much? 

“… because since December 2007, or roughly the start of the global depression, shale oil states have added 1.36 million jobs while non-shale states have lost 424,000 jobs.”

I must point out how intellectually disingenuous this start date is, heading right into the crisis – why not use December 2010? Or 5 or 10 years? This is misleading in other ways:

It is geared to start before the crisis & recovery, so that it forces the 10 million jobs lost in the crisis to be offset by the 10 million new jobs added since the recovery began. That creates a very misleading picture of where growth comes from.

We have created 10 million new jobs since June 2009. Has Texas really created 4 million new jobs? The answer is no.

According to [the St. Louis Fed] FRED [database]:

PAYEMS – or NFP – has gone from 130,944 to 140,045, a gain of 9,101 over that period.
TXNA – Total Nonfarm in Texas – has gone from 10,284 to 11,708, for a gain of 1,424.

That gain represents 15.6% of the 9.1MM total.

Well yes, Barry, but because of oil and other things (like a business-friendly climate), Texas did not lose as many jobs in the recession as the rest of the nation did, which is where you can get skewed data, depending on when you start the count and what you are trying to illustrate.

My main point is that energy production has been a huge upside producer of jobs, and that source of new jobs is going away. And yes, Josh, the net benefit for at least the first six months until the job non production shows up (if it does) is a positive for the economy and the consumer. But I was trying to highlight a potential problem that could hurt US growth. Oil is likely to go to $40 before settling in the $50 range for a while. Will it eventually go back up? Yes. But it’s anybody’s guess as to when.

By the way, a former major hedge fund manager who closed his fund a number of years ago casually mentioned at a party the other night that he hopes oil goes to $35 and that we see a true shakeout in the oil patch. He grew up in a West Texas oil family and truly understands the cycles in the industry, especially for the smaller producers. From his point of view, a substantial shakeout creates massive upside opportunities in lots of places. “Almost enough,” he said, “to tempt me to open a new fund.”

On a different note, everyone is Christmas shopping and trying to find the right gift. Two recommendations. First, the Panasonic wet/dry electric razor (with five blades). I just bought a new set of blades and covers for mine after two years (you do have to replace them every now and then); and the new, improved shave reminded me how much I was in love with it when I bought it. Best shaver ever.

Second, and I know this is a little odd, but for a number of years I’ve been recommending a face cream that contains skin stem cells, which I and quite a number of my readers have noticed really helps rejuvenate our older skin. (I came across the product while researching stem cell companies with Patrick Cox.) It clearly makes a difference for some people. I get ladies coming up all the time and thanking me for the recommendation, and guys too sometimes shyly admit they use it regularly. (It turns out that just as many men buy the product as women.) The company is Lifeline Skin Care, and they have discounted the product for my readers. If you can get past the fact that this is a financial analyst recommending a skin cream for a Christmas gift, then click on this link.

It is time to hit the send button. I trust you are having a good week. Now settle in and grab a cup of coffee or some wine (depending on the time of day and your mood), and let’s see what Louis has to say.
Your trying to catch up analyst,

John Mauldin, Editor
Outside the Boxsubscribers@mauldineconomics.com

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The Burning Questions For 2015

By Louis-Vincent Gave, GavekalDragonomics

With two reports a day, and often more, readers sometimes complain that keeping tabs on the thoughts of the various Gavekal analysts can be a challenge. So as the year draws to a close, it may be helpful if we recap the main questions confronting investors and the themes we strongly believe in, region by region.

1. A Chinese Marshall Plan?

When we have conversations with clients about China – which typically we do between two and four times a day – the talk invariably revolves around how much Chinese growth is slowing (a good bit, and quite quickly); how undercapitalized Chinese banks are (a good bit, but fat net interest margins and preferred share issues are solving the problem over time); how much overcapacity there is in real estate (a good bit, but – like youth – this is a problem that time will fix); how much overcapacity there is in steel, shipping, university graduates and corrupt officials; how disruptive China’s adoption of assembly line robots will be etc.

All of these questions are urgent, and the problems that prompted them undeniably real, which means that China’s policymakers certainly have their plates full. But this is where things get interesting: in all our conversations with Western investors, their conclusion seems to be that Beijing will have little choice but to print money aggressively, devalue the renminbi, fiscally stimulate the economy, and basically follow the path trail-blazed (with such success?) by Western policymakers since 2008. However, we would argue that this conclusion represents a failure both to think outside the Western box and to read Beijing’s signal flags.

In numerous reports (and in Chapters 11 to 14 of Too Different For Comfort) we have argued that the internationalization of the renminbi has been one of the most significant macro events of recent years. This internationalization is continuing apace: from next to nothing in 2008, almost a quarter of Chinese trade will settle in renminbi in 2014:

This is an important development which could have a very positive impact on a number of emerging markets. Indeed, a typical, non oil exporting emerging market policymaker (whether in Turkey, the Philippines, Vietnam, South Korea, Argentina or India) usually has to worry about two things that are completely out of his control:

1)   A spike in the US dollar. Whenever the US currency shoots up, it presents a hurdle for growth in most emerging markets. The first reason is that most trade takes place in US dollars, so a stronger US dollar means companies having to set aside more money for working capital needs. The second is that most emerging market investors tend to think in two currencies: their own and the US dollar. Catch a cab in Bangkok, Cairo, Cape Town or Jakarta and ask for that day’s US dollar exchange rate and chances are that the driver will know it to within a decimal point. This sensitivity to exchange rates is important because it means that when the US dollar rises, local wealth tends to flow out of local currencies as investors sell domestic assets and into US dollar assets, typically treasuries (when the US dollar falls, the reverse is true).

2)   A rapid rise in oil or food prices. Violent spikes in oil and food prices can be highly destabilizing for developing countries, where the median family spends so much more of their income on basic necessities than the typical Western family. Sudden spikes in the price of food or energy can quickly create social and political tensions. And that’s not all; for oil importing countries, a spike in oil prices can lead to a rapid deterioration in trade balances. These tend to scare foreign investors away, so pushing the local currency lower and domestic interest rates higher, which in turn leads to weaker growth etc...

Looking at these two concerns, it is hard to escape the conclusion that, as things stand, China is helping to mitigate both:

• China’s policy of renminbi internationalization means that emerging markets are able gradually to reduce their dependence on the US dollar. As they do, spikes in the value of the US currency (such as we have seen in 2014) are becoming less painful.
   
• The slowdown in Chinese oil demand, as well as China’s ability to capitalize on Putin’s difficulties to transform itself from a price taker to a price setter, means that the impact of oil and commodities on trade balances is much more contained.

Beyond providing stability to emerging markets, the gradual acceptance of the renminbi as a secondary trading and reserve currency for emerging markets has further implications. The late French economist Jacques Rueff showed convincingly how, when global trade moved from a gold based settlement system to a U.S. dollar based system, purchasing power was duplicated. As the authors of a recent Wall Street Journal article citing Reuff’s work explained: “If the Banque de France counts among its reserves dollar claims (and not just gold and French francs) – for example a Banque de France deposit in a New York bank – this increases the money supply in France but without reducing the money supply of the US. So both countries can use these dollar assets to grant credit.” Replace Banque de France with Bank Indonesia, and U.S. dollar with renminbi and the same causes will lead to the same effects.

Consider British Columbia’s recently issued AAA rated two year renminbi dim sum bond. Yielding 2.85%, this bond was actively subscribed to by foreign central banks, which ended up receiving more than 50% of the initial allocation (ten times as much as in the first British Columbia dim sum issue two years ago). After the issue British Columbia takes the proceeds and deposits them in a Chinese bank, thereby capturing a nice spread. In turn, the Chinese bank can multiply this money five times over (so goes money creation in China). Meanwhile, the Indonesian, Korean or Kazakh central banks that bought the bonds now have an asset on their balance sheet which they can use to back an expansion of trade with China...

Of course, for trade to flourish, countries need to be able to specialize in their respective comparative advantages, hence the importance of the kind of free trade deals discussed at the recent APEC meeting. But free trade deals are not enough; countries also need trade infrastructure (ports, airports, telecoms, trade finance banks etc...). This brings us to China’s ‘new silk road’ strategy and the recent announcement by Beijing of a US$40bn fund to help finance road and rail infrastructure in the various ‘stans’ on its western borders in a development that promises to cut the travel time from China to Europe from the current 30 days by sea to ten days or less overland.

Needless to say, such a dramatic reduction in transportation time could help prompt some heavy industry to relocate from Europe to Asia.

That’s not all. At July’s BRICS summit in Brazil, leaders of the five member nations signed a treaty launching the U.S. $50bn New Development Bank, which Beijing hopes will be modeled on China Development Bank, and is likely to compete with the World Bank. This will be followed by the establishment of a China-dominated BRICS contingency fund (challenging the International Monetary Fund). Also on the cards is an Asian Infrastructure Investment Bank to rival the Asian Development Bank.

So what looks likely to take shape over the next few years is a network of railroads and motorways linking China’s main production centers to Bangkok, Singapore, Karachi, Almaty, Moscow, Yangon, Kolkata. We will see pipelines, dams, and power plants built in Siberia, Central Asia, Pakistan and Myanmar; as well as airports, hotels, business centers... and all of this financed with China’s excess savings, and leverage. Given that China today has excess production capacity in all of these sectors, one does not need a fistful of university diplomas to figure out whose companies will get the pick of the construction contracts.

But to finance all of this, and to transform herself into a capital exporter, China needs stable capital markets and a strong, convertible currency. This explains why, despite Hong Kong’s pro democracy demonstrations, Beijing is pressing ahead with the internationalization of the renminbi using the former British colony as its proving ground (witness the Shanghai-HK stock connect scheme and the removal of renminbi restrictions on Hong Kong residents). And it is why renminbi bonds have delivered better risk adjusted returns over the past five years than almost any other fixed income market.

Of course, China’s strategy of internationalizing the renminbi, and integrating its neighbors into its own economy might fall flat on its face. Some neighbors bitterly resent China’s increasing assertiveness.

Nonetheless, the big story in China today is not ‘ghost cities’ (how long has that one been around?) or undercapitalized banks. The major story is China’s reluctance to continue funneling its excess savings into US treasuries yielding less than 2%, and its willingness to use that capital instead to integrate its neighbors’ economies with its own; using its own currency and its low funding costs as an ‘appeal product’ (and having its own companies pick up the contracts as a bonus). In essence, is this so different from what the US did in Europe in the 1940s and 1950s with the Marshall Plan?

2. Japan: Is Abenomics just a sideshow?

With Japan in the middle of a triple dip recession, and Japanese households suffering a significant contraction in real disposable income, it might seem that Prime Minister Shinzo Abe has chosen an odd time to call a snap election. Three big factors explain his decision:

1)   The Japanese opposition is in complete disarray. So Abe’s decision may primarily have been opportunistic.

2)   We must remember that Abe is the most nationalist prime minister Japan has produced in a generation. The expansion of China’s economic presence across Central and South East Asia will have left him feeling at least as uncomfortable as anyone who witnessed his Apec handshake with Xi Jinping three weeks ago. It is not hard to imagine that Abe returned from Beijing convinced that he needs to step up Japan’s military development; a policy that requires him to command a greater parliamentary majority than he holds now.

3)   The final factor explaining Abe’s decision to call an election may be that in Japan the government’s performance in opinion polls seems to mirror the performance of the local stock market (wouldn’t Barack Obama like to see such a correlation in the US?). With the Nikkei breaking out to new highs, Abe may feel that now is the best time to try and cement his party’s dominant position in the Diet.

As he gets ready to face the voters, how should Abe attempt to portray himself? In our view, he could do worse than present himself as Japan Inc’s biggest salesman. Since the start of his second mandate, Abe has visited 49 countries in 21 months, and taken hundreds of different Japanese CEOs along with him for the ride. The message these CEOs have been spreading is simple: Japan is a very different place from 20 years ago. Companies are doing different things, and investment patterns have changed. Many companies have morphed into completely different animals, and are delivering handsome returns as a result. The relative year to date outperformances of Toyo Tire (+117%), Minebea (+95%), Mabuchi (+57%), Renesas (+43%), Fuji Film (+33%), NGK Insulators (+33%) and Nachi-Fujikoshi (+19%) have been enormous. Or take Panasonic as an example: the old television maker has transformed itself into a car parts firm, piggy backing on the growth of Tesla’s model S.

Yet even as these changes have occurred, most foreign investors have stopped visiting Japan, and most sell-side firms have stopped funding genuine and original research. For the alert investor this is good news. As the number of Japanese firms at the heart of the disruptions reshaping our global economy – robotics, electric and self-driving cars, alternative energy, healthcare, care for the elderly – continues to expand, and as the number of investors looking at these same firms continues to shrink, those investors willing to sift the gravel of corporate Japan should be able to find real gems.

Which brings us to the real question confronting investors today: the ‘Kuroda put’ has placed Japanese equities back on investor’s maps. But is this just a short term phenomenon? After all, no nation has ever prospered by devaluing its currency. If Japan is set to attract, and retain, foreign investor flows, it will have to come up with a more compelling story than ‘we print money faster than anyone else’.

In our recent research, we have argued that this is exactly what is happening. In fact, we believe so much in the opportunity that we have launched a dedicated Japan corporate research service (GK Plus Alpha) whose principals (Alicia Walker and Neil Newman) are burning shoe leather to identify the disruptive companies that will trigger Japan’s next wave of growth.

3. Should we worry about capital misallocation in the US?

The US has now ‘enjoyed’ a free cost of money for some six years. The logic behind the zero-interest rate policy was simple enough: after the trauma of 2008, the animal spirits of entrepreneurs needed to be prodded back to life. Unfortunately, the last few years have reminded everyone that the average entrepreneur or investor typically borrows for one of two reasons:

• Capital spending: Business is expanding, so our entrepreneur borrows to open a new plant, or hire more people, etc.
   
• Financial engineering: The entrepreneur or investor borrows in order to purchase an existing cash flow, or stream of income. In this case, our borrower calculates the present value of a given income stream, and if this present value is higher than the cost of the debt required to own it, then the transaction makes sense.

Unfortunately, the second type of borrowing does not lead to an increase in the stock of capital. It simply leads to a change in the ownership of capital at higher and higher prices, with the ownership of an asset often moving away from entrepreneurs and towards financial middlemen or institutions. So instead of an increase in an economy’s capital stock (as we would get with increased borrowing for capital spending), with financial engineering all we see is a net increase in the total amount of debt and a greater concentration of asset ownership. And the higher the debt levels and ownership concentration, the greater the system’s fragility and its inability to weather shocks.

We are not arguing that financial engineering has reached its natural limits in the US. Who knows where those limits stand in a zero interest rate world? However, we would highlight that the recent new highs in US equities have not been accompanied by new lows in corporate spreads. Instead, the spread between 5-year BBB bonds and 5-year US treasuries has widened by more than 30 basis points since this summer.

Behind these wider spreads lies a simple reality: corporate bonds issued by energy sector companies have lately been taken to the woodshed. In fact, the spread between the bonds of energy companies, and those of other US corporates are back at highs not seen since the recession of 2001-2002, when the oil price was at US$30 a barrel.

The market’s behavior raises the question whether the energy industry has been the black hole of capital misallocation in the era of quantitative easing. As our friend Josh Ayers of Paradarch Advisors (Josh publishes a weekly entitled The Right Tale, which is a fount of interesting ideas. He can be reached at josh@paradarchadvisors.com) put it in a recent note: “After surviving the resource nadir of the late 1980s and 1990s, oil and gas firms started pumping up capex as the new millennium began. However, it wasn’t until the purported end of the global financial crisis in 2009 that capital expenditure in the oil patch went into hyperdrive, at which point capex from the S&P 500’s oil and gas subcomponents jumped from roughly 7% of total US fixed investment to over 10% today.”

“It’s no secret that a decade’s worth of higher global oil prices justified much of the early ramp-up in capex, but a more thoughtful look at the underlying data suggests we’re now deep in the malinvestment phase of the oil and gas business cycle. The second chart (above) displays both the total annual capex and the return on that capex (net income/capex) for the ten largest holdings in the Energy Select Sector SPDR (XLE). The most troublesome aspect of this chart is that, since 2010, returns have been declining as capex outlays are increasing. Furthermore, this divergence is occurring despite WTI crude prices averaging nearly $96 per barrel during that period,” Josh noted.

The energy sector may not be the only place where capital has been misallocated on a grand scale. The other industry with a fairly large target on its back is the financial sector. For a start, policymakers around the world have basically decided that, for all intents and purposes, whenever a ‘decision maker’ in the financial industry makes a decision, someone else should be looking over the decision maker’s shoulder to ensure that the decision is appropriate. Take HSBC’s latest results: HSBC added 1400 compliance staff in one quarter, and plans to add another 1000 over the next quarter. From this, we can draw one of two conclusions:

1)   The financial firms that will win are the large firms, as they can afford the compliance costs.

2)   The winners will be the firms that say: “Fine, let’s get rid of the decision maker. Then we won’t need to hire the compliance guy either”.

This brings us to a theme first explored by our friend Paul Jeffery, who back in September wrote: “In 1994 Bill Gates observed: ‘Banking is necessary, banks are not’. The primary function of a bank is to bring savers and users of capital together in order to facilitate an exchange. In return for their role as [trusted] intermediaries banks charge a generous net spread. To date, this hefty added cost has been accepted by the public due to the lack of a credible alternative, as well as the general oligopolistic structure of the banking industry.

What Lending Club and other P2P lenders do is provide an online market place that connects borrowers and lenders directly; think the eBay of loans and you have the right conceptual grasp. Moreover, the business model of online market-place lending breaks with a banking tradition, dating back to 14th century Florence, of operating on a “fractional reserve” basis. In the case of P2P intermediation, lending can be thought of as being “fully reserved” and entails no balance sheet risk on the part of the service facilitator. Instead, the intermediary receives a fee- based revenue stream rather than a spread-based income.”

There is another way we can look at it: finance today is an abnormal industry in two important ways:

1)   The more the sector spends on information and communications technology, the bigger a proportion of the economic pie the industry captures. This is a complete anomaly. In all other industries (retail, energy, telecoms...), spending on ICT has delivered savings for the consumers. In finance, investment in ICT (think shaving seconds of trading times in order to front run customer orders legally) has not delivered savings for consumers, nor even bigger dividends for shareholders, but fatter bonuses and profits for bankers.

2)   The second way finance is an abnormal industry (perhaps unsurprisingly given the first factor) lies in the banks’ inability to pass on anything of value to their customers, at least as far as customer’s perceptions are concerned. Indeed, in ‘brand surveys’ and ‘consumer satisfaction reports’, banks regularly bring up the rear. Who today loves their bank in a way that some people ‘love’ Walmart, Costco, IKEA, Amazon, Apple, Google, Uber, etc?

Most importantly, and as Paul highlights above, if the whole point of the internet is to:

a) measure more efficiently what each individual needs, and

b) eliminate unnecessary intermediaries,

then we should expect a lot of the financial industry’s safe and steady margins to come under heavy pressure. This has already started in the broking and in the money management industries (where mediocre money managers and other closet indexers are being replaced by ETFs). But why shouldn’t we start to see banks’ high return consumer loan, SME loan and credit card loan businesses replaced, at a faster and faster pace, by peer-to-peer lending? Why should consumers continue to pay high fees for bank transfers, or credit cards when increasingly such services are offered at much lower costs by firms such as TransferWise, services like Alipay and Apple Pay, or simply by new currencies such as Bitcoin?

On this point, we should note that in the 17 days that followed the launch of Apple Pay on the iPhone 6, almost 1% of Wholefoods’ transactions were processed using the new payment system. The likes of Apple, Google, Facebook and Amazon have grown into behemoths by upending the media, advertising retail and entertainment industries. Such a rapid take- up rate for Apple Pay is a powerful indicator which sector is likely to be next in line. How else can these tech giants keep growing and avoid the fate that befell Sony, Microsoft and Nokia? On their past record, the technology companies will find margins, and growth, in upending our countries’ financial infrastructure. As they do, a lot of capital (both human and monetary) deployed in the current infrastructure will find itself obsolete.

This possibility raises a number of questions – not least for Gavekal’s own investment process, which relies heavily on changes in the velocity of money and in the willingness and ability of commercial banks to multiply money, to judge whether it makes sense to increase portfolio risk. What happens to a world that moves ‘ex-bank’ and where most new loans are extended peer-to-peer? In such a world, the banking multiplier disappears along with fractional reserve banking (and consequently the need for regulators? Dare to dream...).

As bankers stop lending their clients umbrellas when it is sunny, and taking them away when it rains, will our economic cycles become much tamer? As central banks everywhere print money aggressively, could the market be in the process of creating currencies no longer based on the borders of nation states, but instead on the cross-border networks of large corporations (Alipay, Apple Pay...), or even on voluntary communities (Bitcoin). Does this mean we are approaching the Austrian dream of a world with many, non government-supported, currencies?

4. Should we care about Europe?

In our September Quarterly Strategy Chartbook, we debated whether the eurozone was set for a revival (the point expounded by François) or a continued period stuck in the doldrums (Charles’s view), or whether we should even care (my point). At the crux of this divergence in views is the question whether euroland is broadly following the Japanese deflationary bust path. Pointing to this possibility are the facts that 11 out of 15 eurozone countries are now registering annual year-on-year declines in CPI, that policy responses have so far been late, unclear and haphazard (as they were in Japan), and that the solutions mooted (e.g. European Commission president Jean-Claude Juncker’s €315bn infrastructure spending plan) recall the solutions adopted in Japan (remember all those bridges to nowhere?). And that’s before going into the structural parallels: ageing populations; dysfunctional, undercapitalized and overcrowded banking systems; influential segments of the population eager to maintain the status quo etc....

With the same causes at work, should we expect the same consequences? Does the continued underperformance of eurozone stocks simply reflect that managing companies in a deflationary environment is a very challenging task? If euroland has really entered a Japanese-style deflationary bust likely to extend years into the future, the conclusion almost draws itself.

The main lesson investors have learned from the Japanese experience of 1990-2013 is that the only time to buy stocks in an economy undergoing a deflationary bust is:

a)   when stocks are massively undervalued relative both to their peers and to their own history, and

b)   when a significant policy change is on the way.

This was the situation in Japan in 1999 (the first round of QE under PM Keizo Obuchi), 2005 (PM Junichiro Koizumi’s bank recapitalization program) and of course in 2013-14 (Abenomics). Otherwise, in a deflationary environment with no or low growth, there is no real reason to pile into equities. One does much better in debt. So, if the Japan-Europe parallel runs true, it only makes sense to look at eurozone equities when they are both massively undervalued relative to their own histories and there are expectations of a big policy change. This was the case in the spring of 2012 when valuations were at extremes, and Mario Draghi replaced Jean-Claude Trichet as ECB president. In the absence of these two conditions, the marginal dollar looking for equity risk will head for sunnier climes.

With this in mind, there are two possible arguments for an exposure to eurozone equities:

1)   The analogy of Japan is misleading as euroland will not experience a deflationary bust (or will soon emerge from deflation).

2)   We are reaching the point when our two conditions – attractive valuations, combined with policy shock and awe – are about to be met. Thus we could be reaching the point when euroland equities start to deliver outsized returns.

Proponents of the first argument will want to overweight euroland equities now, as this scenario should lead to a rebound in both the euro and European equities (so anyone underweight in their portfolios would struggle). However, it has to be said that the odds against this first outcome appear to get longer with almost every data release!

Proponents of the second scenario, however, can afford to sit back and wait, because it is likely any outperformance in eurozone equities would be accompanied by euro currency weakness. Hence, as a percentage of a total benchmark, European equities would not surge, because the rise in equities would be offset by the falling euro.

Alternatively, investors who are skeptical about either of these two propositions can – like us – continue to use euroland as a source of, rather than as a destination for, capital. And they can afford safely to ignore events unfolding in euroland as they seek rewarding investment opportunities in the US or Asia. In short, over the coming years investors may adopt the same view towards the eurozone that they took towards Japan for the last decade: ‘Neither loved, nor hated... simply ignored’.

Conclusion:

Most investors go about their job trying to identify ‘winners’. But more often than not, investing is about avoiding losers. Like successful gamblers at the racing track, an investor’s starting point should be to eliminate the assets that do not stand a chance, and then spread the rest of one’s capital amongst the remainder.

For example, if in 1981 an investor had decided to forego investing in commodities and simply to diversify his holdings across other asset classes, his decision would have been enough to earn himself a decade at the beach. If our investor had then returned to the office in 1990, and again made just one decision – to own nothing in Japan – he could once again have gone back to sipping margaritas for the next ten years. In 2000, the decision had to be not to own overvalued technology stocks. By 2006, our investor needed to start selling his holdings in financials around the world. And by 2008, the money-saving decision would have been to forego investing in euroland.

Of course hindsight is twenty-twenty, and any investor who managed to avoid all these potholes would have done extremely well. Nevertheless, the big question confronting investors today is how to avoid the potholes of tomorrow. To succeed, we believe that investors need to answer the following questions:

• Will Japan engineer a revival through its lead in exciting new technologies (robotics, hi-tech help for the elderly, electric and driverless cars etc...), or will Abenomics prove to be the last hurrah of a society unable to adjust to the 21st century? Our research is following these questions closely through our new GK Plus Alpha venture.
   
• Will China slowly sink under the weight of the past decade’s malinvestment and the accompanying rise in debt (the consensus view) or will it successfully establish itself as Asia’s new hegemon? Our Beijing based research team is very much on top of these questions, especially Tom Miller, who by next Christmas should have a book out charting the geopolitical impact of China’s rise.
   
• Will Indian prime minister Narendra Modi succeed in plucking the low-hanging fruit so visible in India, building new infrastructure, deregulating services, cutting protectionism, etc? If so, will India start to pull its weight in the global economy and financial markets?
   
• How will the world deal with a US economy that may no longer run current account deficits, and may no longer be keen to finance large armies? Does such a combination not almost guarantee the success of China’s strategy?
   
• If the US dollar is entering a long term structural bull market, who are the winners and losers? The knee-jerk reaction has been to say ‘emerging markets will be the losers’ (simply because they were in the past. But the reality is that most emerging markets have large US dollar reserves and can withstand a strong US currency. Instead, will the big losers from the US dollar be the commodity producers?
   
• Have we reached ‘peak demand’ for oil? If so, does this mean that we have years ahead of us in which markets and investors will have to digest the past five years of capital misallocation into commodities?
   
• Talking of capital misallocation, does the continued trend of share buybacks render our financial system more fragile (through higher gearing) and so more likely to crack in the face of exogenous shocks? If it does, one key problem may be that although we may have made our banks safer through increased regulations (since banks are not allowed to take risks anymore), we may well have made our financial markets more volatile (since banks are no longer allowed to trade their balance sheets to benefit from spikes in volatility). This much appeared obvious from the behavior of US fixed income markets in the days following Bill Gross’s departure from PIMCO. In turn, if banks are not allowed to take risks at volatile times, then central banks will always be called upon to act, which guarantees more capital misallocation, share buybacks and further fragilization of the system (expect more debates along this theme between Charles, and Anatole).
   
• Will the financial sector be next to undergo disintermediation by the internet (after advertising and the media). If so, what will the macro consequences be? (Hint: not good for the pound or London property.)
   
• Is euroland following the Japanese deflationary bust roadmap?

The answers to these questions will drive performance for years to come. In the meantime, we continue to believe that a portfolio which avoids a) euroland, b) banks, and c) commodities, will do well – perhaps well enough to continue funding Mediterranean beach holidays – especially as these are likely to go on getting cheaper for anyone not earning euros!

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The article Outside the Box: The Burning Questions For 2015 was originally published at mauldin economics

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