Doc Holliday, Jay Powell, Donald Trump & The Piano

“Ready, Fire, Aim”?

In Understanding and Managing Public Organizations, Hal Rainey makes the point that “the intangible issues of culture, values, human relations – matters that many managers regard as fuzzy and unmanageable – can and must be skillfully managed.” The contrary approach, which is favored by many companies and government agencies, can be summarized as “ready, fire, aim.” (Understanding and Managing Public Organizations, https://books.google.com/books?isbn=0787980005)

 

Market Commentary - Cumberland Advisors - Please do not shoot the pianist. He is doing his best

Rainey’s insight will prove relevant as we consider this week’s stock market carnage.

Politico offered this explanation for the carnage:

“WHY MARKETS TANKED AND WHAT’S NEXT — The real surprise is it took this long. Wall Street has been shrugging off a rising 10-year yield, fear over the trade war with China and uncertainty surrounding the midterm election for way too long. The S&P 500 did not record a single move up or down of 1 percent by the closing bell in the third quarter. That hasn’t happened since 1963, according to LPL Financial.

“That kind of calm is what’s abnormal, not the 3 percent decline in the Dow and S&P on Wednesday and the 4 percent decline in the Nasdaq. President Trump blamed the drop in part on the Fed, saying the central bank had ‘gone crazy.’ He also referred to a ‘a correction we’ve been waiting for,’ which is a much better explanation.”
(Politico, 10/11/2018, 8 AM EDT: https://www.politico.com/newsletters/morning-money/2018/10/11/why-markets-tanked-and-whats-next-370573)

Now, in order to assist the fact checkers, here is the full Trump quote:

“The Fed is making a mistake. They’re so tight. I think the Fed has gone crazy. So you could say that, well, that’s a lot of safety actually, and it is a lot of safety, and it gives you a lot of margin, but I think the Fed has gone crazy.”
(Politico, 10/11/2018, 8 AM EDT: https://www.politico.com/newsletters/morning-money/2018/10/11/why-markets-tanked-and-whats-next-370573)

Here’s our take.

The (in)famous Doc Holliday (https://www.historynet.com/spitting-lead-in-leadville-doc-hollidays-last-stand.htm) occasionally played the piano at the legendary Silver Dollar Saloon in Leadville, Colorado. When Oscar Wilde appeared at the Tabor Opera House across the street, he would cross the street to the saloon for a drink or two after his lectures. Wilde noted that there was a sign over the piano that read: “Please do not shoot the pianist. He is doing his best.” (Source: a personal visit to the legendary Silver Dollar Saloon)

The sign over the piano could apply to today’s Federal Reserve. The Fed now has over a 100-year history. It is doing the best it can. Let’s not shoot it.

At the recent NABE conference, Fed Chairman Powell said,

“This historically rare pairing of steady, low inflation and very low unemployment is testament to the fact that we remain in extraordinary times. Our ongoing policy of gradual interest rate normalization reflects our efforts to balance the inevitable risks that come with extraordinary times, so as to extend the current expansion, while maintaining maximum employment and low and stable inflation.”

He added that “The economy is seeing a “remarkably positive outlook … and a modest steepening of the Phillips curve would be unlikely to cause a significant rise in inflation or demand a disruptive policy tightening. Once again the key is anchored expectations.” He welcomed the recent rise in wages and stated, “Higher wages alone need not be inflationary.” We thank Mike Englund and his team at Action Economics (www.actioneconomics.com) for capturing Powell’s quote with precision.

There is a lot of Fed-related jawboning about the recent employment report. Many folks argue that it was distorted by hurricane effects, so we need another month to gain clarity. With Hurricane Michael now added to the natural disaster list, we may hear the same chorus when the October data is compiled and released.

Meanwhile, the inflation outlook is coupled with the question of whether or not wages are trending upward and accelerating. And the negative economic effects of the Trump-Navarro trade war are only beginning to show up in the data. On a positive note the new NAFTA agreement with Canada and Mexico has reduced anxiety in markets and seems to have stabilized a trending deterioration in sentiment. That improvement (the situation is now less worse than expected) may offset the impact of the US-China lack of progress. Without a directional policy change, the China-US imbroglio could prove very serious. The fears that we articulated in our Thucydides Trap pamphlet are sadly being realized. (The pamphlet is available here in PDF form: “Lessons from Thucydides,” https://www.cumber.com/pdf/Lessons-from-Thucydides.pdf.)

Of course, for the investor the issue is, what does all this mean for future Fed policy and interest rates?

The Treasury yield curve has abruptly steepened. We expected that to happen, given the one-time influence of a special tax provision that expired in mid-September. See “Why the Yield Curve Is Flat and Why It May Steepen,” https://www.cumber.com/why-the-yield-curve-is-flat-why-it-may-steepen/. And we looked to the high-grade muni curve for some guidance. See “The Tale of Two Ratios: Shorter and Longer,” https://www.cumber.com/the-tale-of-two-ratios-shorter-and-longer/. The pricing of munis is set mostly by high-income American investors. The muni curve was steep and continues to be so. Treasury yields result from investments by both Americans and foreigners – a blend of influences. Thus the muni curve may be a better source of high-grade forecasting power. We think it deserves some respect.

So what about wages and inflation?

We updated our series of Beveridge curves. Nearly all of them point to a wage acceleration coming. (We will send any reader the 8-chart series if you provide us with a full snail-mail address.) That series depicts specific unemployment rates crossed with other indicators like job openings or quits. It tracks the last expansion period, the Great Recession and financial crisis, and the recovery since. When viewed together, the curves make a compelling case for an acceleration of the upward trend in wages and for rising inflation. Beveridge curves tell you Fed Chairman Jay Powell may soon see his “historically rare pairing” appear more normal.

My friend Michael Drury at McVean Trading had this comment following on his observation that “Wages have grown at a 3.2% apace over the past 11 months.” He expects 3.2% to continue and notes that “3.2% means wages are compensating workers for 2% inflation and 1.2% productivity growth.” Meanwhile, other economists argue about that productivity growth and ask, “Where’s the beef?”

My friend and fishing buddy Danny Blanchflower is a labor economist and ardent student of Keynes and Beveridge. Danny is a Dartmouth professor of economics, Bloomberg contributor, former Bank of England board member, and serious academic researcher. He and I have discussed the concept of NAIRU, the non-accelerating inflation rate of unemployment – in other words, the level of unemployment below which inflation rises. (For more on NAIRU see https://en.wikipedia.org/wiki/NAIRU.)

NAIRU is not observable, so it has to be estimated. Danny notes that there were periods in history when the estimate for NAIRU was as low as an unemployment rate of 1 to 2%. He cites Keynes and Beveridge for that history. He also notes how central bankers routinely miss on their estimates of NAIRU. That means they are playing the saloon piano when it isn’t tuned.

Danny uses something he calls the U-7, which quite simply is the U-6 unemployment rate minus the U-5 unemployment rate. He is trying to find a marginal shift that signals the turning point where NAIRU is reached and the upward pressure from accelerating wages influences inflation. If we use his back-of-the-envelope approach (he has serious research on this), we can estimate that NAIRU may be as low as a 3% unemployment rate, given the present structure of the US labor force. (For a full description of the various US unemployment rates and the methods of data collection, see “How the Government Measures Unemployment,” https://www.bls.gov/cps/cps_htgm.htm.) Furthermore, as the national statistics gravitate toward this 3% NAIRU estimate, regional and state statistics are tending to confirm the trend. Great work on the state data is performed by Philippa Dunne and Doug Henwood. I suggest serious readers check out the October 4th edition of TLR on the Economy. If you are interested, send me an email with your contact information, and I will ask Philippa to send you a copy of that research.

We have taken Danny’s U-7 concept and developed some measures and estimates of the impact of the changes in the U-7 on things like the Consumer Price Index, average hourly wages, and JOLTS (the job openings portion of the labor data). What we are seeing in every series is a trend toward rising wages and rising inflation. It is hard to discern the exact month of acceleration in these series, but there seems to be some consistency. We will send any reader who gives us a snail-mail address a set of our U-7 charts. Researchers now have a road map if they want to develop their own statistics.

Let’s sum this up after we thank those journalists and friends and colleagues cited here. Please remember that anyone who is writing and publishing publicly is under repeated attack these days, as the Constitution’s First Amendment protections seem threatened by political forces unlike those we have seen in American history in recent decades.

We think the president’s attack on the Fed was wrong. It hurts his political party. It hurts the country. And it helped tank the markets. The Trump-Navarro US-China trade war is worsening, and markets don’t like it. Markets now fear that Trump has undone the beneficial effects of his repatriation policy, tax cuts, and deregulation initiative. What started out on a positive path is now a war between the two largest economies of the world. That war now seems to be intensifying. Remember: In a shooting war the guns are pointed at each other; in a trade war the guns are pointed inward. Nobody wins.

The warning on the saloon piano was apt. Don’t shoot the player who is doing his best. (And especially don’t try to shoot the player if it is Doc Holliday.)

Mr. President. You will do what you want. That is continually made very clear by your behavior. The country will determine who is loco. And history will report the results.

We are allocated toward domestic weights in our US ETF managed accounts. We have a cash reserve. We are in a correction.

Positions in portfolios can change at any time.

David R. Kotok
Chairman and Chief Investment Officer
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VIX Inversion

VIX, the “fear gauge,” measures S&P 500 near-term volatility by using options that expire in 23–37 days. Therefore, the VIX we often discuss is the 1-month volatility index. However, the Chicago Board Options Exchange (CBOE) also publishes 3-month (VIX3M) and 6-month (VIX6M) volatility indexes, which are less well known.

Market Commentary - Cumberland Advisors - VIX Inversion

The 3-month and 6-month VIX indexes are usually higher than the 1-month VIX. Similarly, those VIX futures with various expirations tracking short- and long-term VIX movements also remain in contango most of the time. The reason is that the uncertainty inherent in the long term requires a risk premium compared to the short term, comparable to the term premium in fixed-income. Another feature of the different volatility indexes is that the 1-month VIX is more volatile than the 3-month and 6-month indexes.

What if these three volatility indexes break the so-called contango position and become inverted? It doesn’t happen often, and the first time it occurred in 2018 was on Monday, February 5th. Subsequently, the market dropped to 2532.69 on the following Friday, February 9th. To put that move in perspective, the S&P 500 had just hit an all-time high of 2872.87 two weeks before the correction. So is VIX inversion a bearish signal?

Let’s begin with some VIX inversion history (Chart 1). We adopt a strict definition of VIX inversion as follows: 1-month VIX > 3-month VIX > 6-month VIX. We count the turning point of an inversion only, excluding a run of continuous inversions. The VIX indexes are examined from 2008 forward. Since then, 2012, 2013, and 2017 are the only years without any VIX inversion. Noticeably, the average return of the S&P 500 was 23.41% for those 3 years, in contrast to 5.40% for the other years. Among the years with VIX inversions, there are about four inversions on average in each year.

Chart 1. Volatility Indexes Since 2008. Source: CBOE
At first look, VIX inversion might appear to be a non-bullish sign, but we have found a bullish silver lining in the pattern. The inversion per se suggests that the market perceives the 3-month and 6-month trends to be positive. As the result in Table 1 confirms, the 3-month and 6-month returns following the turn to a VIX inversion are higher than the contango cases. Particularly, the 6-month spread is almost 183 bps. Moreover, last time the VIX inverted in October was in 2014, which had a 6.99% 3-month return and 11.74% 6-month return.
Table 1. 3- and 6-Month Returns After VIX Inversion. Data source: Bloomberg

Lastly, betting on VIX inversion does not appear to be a tradable strategy, as it does not happen often. Therefore, you are not likely to trade it successfully.*Data updated on October 5, 2018.

Leo Chen, Ph.D.
Portfolio Manager & Quantitative Strategist
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Another Italian Drama – Why It Matters

Government deficit out of control, irresponsible government policies, tumbling bond prices and bank share prices, threat of rating-agency downgrades, political instability – we have seen similar Italian dramas in the past that, in the end, did not lead to serious financial market contagion. Nevertheless, there are reasons to be concerned that this time the impact could be more adverse for European and global markets.

Cumberland Advisors Market Commentary - Bill Witherell, Ph.D.

The populist coalition government of the anti-establishment Five Star Movement and the far-right League party, formed in late May, surprised markets last week by sharply increasing its government budget deficit targets for 2019–2022, including the Five Star election promise of a “citizenship income,” a form of universal basic income, and the League’s promise of tax cuts. The projected budget deficit of 2.4% of GDP for each of the next three years is three times the 0.8% deficit target for 2019 agreed with the European Commission last year, with improvements to 0.0% predicted for 2020 and a 0.2% surplus for 2021. The Italian government has to submit a draft budget to the European Commission no later than October 15. Tensions will likely increase between the European Commission and Italy over the fiscal measures included in this budget. Comments from the Commission already signal that they consider the draft budget to be incompatible with the stability and growth pact. Reactions of some of the eurosceptics within the government to the mounting pressure from Brussels are stoking market fears of increasing political strife.

A period of continued and possibly increased bond market volatility is looking increasingly likely. This could have negative effects on market liquidity and depth. The volatility limits many investors have on the assets in their portfolios would reduce market demand. Adding to this prospect, the European Central Bank (ECB) is expected to end its net asset purchases at year’s end. Since the beginning of this ECB program, the ECB has purchased 360 billion euros of Italian government bonds. The end of net purchases will coincide with a projected increase in the Italian government’s funding needs. That combination will lead to an increased supply of Italian bonds to the private sector.

It is unclear just how strongly the Commission will wish to pressure Italy because of that country’s backtracking on its commitment to structural fiscal consolidation; however, it is the market reaction that is of greatest concern to us. The Italian sovereign debt market is the third-largest sovereign debt market in the world. Developments in this market matter to both European and global markets. The government’s aggressive loosening of its fiscal stance, together with policies that are not growth-friendly, will increase concerns about the sustainability of Italy’s sovereign debt. Both Moody’s and S&P are expected to update their Italian debt ratings by the end of this month. Currently Moody’s rating for Italy is Baa2 (negative credit watch) and S&P’s rating is BBB (stable outlook). A rating downgrade would likely accentuate the reduction in bond prices that has occurred since last Friday. Calculations by Brown Brothers Harriman using current information imply that a rating of BBB- would be appropriate, a two-notch downgrade. BBB- is the minimum rating for bonds to be considered “investment grade.”

The 3.29% yield on the benchmark 10-year bonds at the closing on Monday, October 1, was the highest closing yield of the year – indeed, Italian bonds were at their weakest in four years. The closing spread over the German yield was 2.83 percentage points, which was not as great as the 3.25 percentage point reached during the summer following the emergence of the populist government. On Tuesday Italian bond prices continued to fall, with the yield rising another 10 basis points. The German-Italian spread increased further as German yields declined.

Wednesday Italian bonds recovered slightly, with the 10-year yield easing 6 basis points. The Italian government slightly revised their budget deficit estimates to -2.2% of GDP in 2020 and  – 2.0% in 2021. The basic situation remains the same and neither the European Commission nor the markets are likely to be moved. The good news is thus far there are no signs of contagion to other debt markets. Should that change, pressure on Brussels and on Italy would mount. The euro is under pressure from these developments, as well as difficulties in the Brexit negotiations, retracing some 50% of its recent rally.

The most immediate concerns about these developments relate to Italy’s banking sector. Declining values in the Italian bond market erode the balance sheets of Italian banks. At the end of last year Italian government bonds were reported to account for about 10% of Italian bank assets. In the second quarter of this year Italian banks increased their holdings of Italian government debt by more than 40 billion euros as foreign investors fled the market. Italian banks are thought to hold over $440 billion in Italian bonds. They are not the only banks at risk. French banks still hold some $319 billion in Italian bonds. German banks have reduced their holdings to $95 billion.

The Italian Economy Minister, Giovanni Tria, has argued that Italy will still be able to reduce debt over the next three years, as higher growth rates in those years would result from the government’s policies. Tria, a nonpolitical technocrat, is widely considered to be the adult in the inexperienced government. But he was unable to deter the populist government from the imprudent, expansive draft budget it released. As the budget has not yet been finalized, Tria may be able to achieve some final moderating changes, if the government becomes concerned about the risk of a crisis and a possible snap election.

Tria has sought to assure the European Commission that Italy will have more latitude going forward, pointing to his projections of a pickup in economic growth in the next several years. We do not find his forecasts convincing, particularly in view of the government’s reversal of some supply-side reforms. He forecast growth of 1.6% in 2019 and 1.7% in 2020. Growth was 1.6% in 2017. This year the economy looks likely to achieve no better than a 1% advance. Next year’s growth is forecast by the European Commission at only 1.1% and could well be less.

Italy’s economy grew at about a 1.0% rate in the first half of this year. According to Markit, the Italian economy appears to have stagnated in the third quarter. The manufacturing sector has weakened through the year with overall growth relying increasingly on a still strong service sector. Domestic demand is weak with depressed real incomes. Forward-looking indicators suggest very little growth in the fourth quarter.

Italy’s equity market has suffered from the above developments. The iShares MSCI Italy ETF, EWI, is down 5.60% over the five days through October 2, a period when Eurozone stocks, as measured by the iShares MSCI Eurozone ETF, EZU, fell 2.27% and the euro slipped 1.83%. Banks account for 30% of EWI’s weight, which means that this ETF is strongly affected by developments in Italy’s banking system and hence in Italy’s bond market. Italy’s banking stocks have suffered significant losses. At Cumberland Advisors we continue to be underweight the Eurozone in our International and Global portfolios, and we do not hold the Italy-specific ETF, EWI.

William Witherell, Ph.D.
Chief Global Economist
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Puerto Rico – Third Quarter 2018 Review

As the third quarter comes to a close, a fragile sense of optimism for the future of the Commonwealth of Puerto Rico has blossomed. It has arisen not just from the resolve of its people in the wake of Hurricane Maria but also from important milestones that have been reached in the long restructuring of Puerto Rico’s debt, starting with the Puerto Rico Oversight, Management, and Economic Stability Act (PROMESA). Economic conditions are beginning to improve.

We now sit a year removed from one the worst natural disasters in the Commonwealth’s history, Hurricane Maria. The monumental storm shattered the lives of the citizens of Puerto Rico, causing billions of dollars in damages and contributing to the deaths of thousands. Today, the people of Puerto Rico remain entrenched in the long, arduous process of recovery and rebuilding. Billions of dollars are set to flow to the Commonwealth, but only a fraction of those funds has been received to date. Eventually, infrastructure will be rebuilt; quick patches will be replaced by permanent fixes; and time will help to heal those who have lost loved ones or their homes or livelihoods.

On the restructuring front we have seen a number of important developments. These include restructuring proposals for the Puerto Rico Sales Tax Financing Corporation (COFINA) and the Puerto Rico Electric Power Authority (PREPA), as well as the continuing Title IV restructuring of the Government Development Bank (GDB) and ongoing negotiations for the possible Title IV restructuring of the Puerto Rico Aqueduct and Sewer Authority (PRASA).

One of the most important milestones to date remains the formal agreement among the Federal Oversight Management Board (FOMB), the government of Puerto Rico, and both senior and junior creditors, as well as monoline insurers, to restructure COFINA’s existing debt. The restructuring of COFINA, at a massive $17.6 billion, would rank among the largest in municipal history. As part of the arrangement, COFINA bondholders have agreed to give up a portion of sales tax revenues to the Commonwealth: 53.65% of the pledged sales tax base amount on a “first dollar” basis would back new COFINA securities, while 46.35% would flow through to the Commonwealth. The disclosed terms would see existing bondholders receive new senior lien bonds secured by a 5.5% sales-and-use tax (SUT), with recoveries of 93% for senior bondholders and 56% for subordinate bondholders. Now supporting the agreement are prominent general-obligation bondholders Aurelius Capital Management and Six PRC Investments LLC. Although the support of such significant players is a welcome sign, it by no means signifies a “done deal.” Unknowns remain, including the treatment of interest payments held in escrow for senior and subordinate bondholders.

The restructuring of PREPA represents another important milestone for Puerto Rico. Under the terms, creditors would receive two series of bonds. The first tranche will provide a recovery of 67.5%, and the second tranche will be a “hope” note at a recovery rate of 10%. Combined, this would be a total recovery of 77.5%, assuming full payment of the “hope” note. The terms have not been enticing enough to bring monoline insurers on board, so we wait for further developments.

In addition to the restructuring proposals for COFINA and PREPA, the restructuring of the GDB continues to move forward. The GDB announced on September 24 that it had received enough votes from creditors to move forward with the territory’s only Title IV restructuring to date. This would cover some $4.2 billion in debt.

These events represent important steps forward for the Commonwealth. Coupled with improving economic conditions, they lead me to the optimism I alluded to in my opening. We urge caution, though, as execution risks remain high. There are no certainties until the plans have been finalized and Judge Swain has given them her blessing.

In the wake of recent developments, uninsured debt has risen dramatically from depressed absolute levels. We consider the movements speculative, as significant risks and hurdles remain. Insured debt has risen as well in response to the positive developments. We continue to favor carefully selected insured debt and believe it can offer an attractive value for clients.

 

Shaun Burgess
Portfolio Manager & Fixed Income Analyst
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Taxable Total Return 3rd Quarter Review

Treasury yields went up across the curve throughout the third quarter of 2018. Once again the rate move was led by the front end of the yield curve, with Treasury bills and notes out to three years experiencing the largest increase in yield.

Cumberland Advisors Market Commentary

The longer-dated Treasuries were not far behind, with the 10-year Treasury holding above 3% and the 30-year Treasury above 3.2%. The table below shows the increase in Treasury yields over the third quarter of 2018.

A yield greater than 3% on the 10-year Treasury has been viewed as a key psychological level for market participants. The belief is that a 10-year Treasury holding above 3% could trigger an upward trajectory in longer rates moving forward. There are a few obstacles that could stand in the way of that happening, however. One of most substantial would be other major government bond markets’ (such as Germany and Japan) having 10-year yields much closer to zero than to 3%. A yield topping 3% makes the US – the largest bond market in the world – an attractive alternative for international investors. In a world starved for yield, the current yield on the 10-year and 30-year Treasuries appears to be the best game around for government bond investors. Increased demand for these securities at current levels could potentially keep yields where they are or even push them lower, leading to continued flattening of the yield curve. This dynamic is something we are continuing to monitor, and it is why we are maintaining a small weighting on the long end of the yield curve. Below is a graph that shows a comparison of 10-year US, German, and Japanese government bonds over the last year.

 

At the September 26th FOMC meeting the Fed raised the fed funds target rate 25 basis points to a target range of 2.00–2.25%. This marks the eighth hike in the cycle and puts the fed funds rate at its highest level since October 2008. The statement accompanying the meeting remained mostly in line with forecasts from the previous meeting. The one major exclusion was the statement regarding monetary policy’s remaining “accommodative,” and its omission could lead people to believe that further hikes would potentially restrict growth moving forward. Other than the elimination of the “accommodative” statement, there were no changes to how the Fed described the current economic environment; and the median forecast for future rate hikes remained unchanged.

As for Cumberland’s Taxable Total Return portfolios, we continue to combat the current rising-interest-rate environment by focusing on an increased weighting in defensive assets on the front end of the barbell strategy while still maintaining a small weighting in longer securities as attractive yields become available. The defensive assets are still anchored by Treasury floating-rate securities and Agency multi-step securities, which have benefited portfolios since the start of the Fed’s hiking cycle at the end of 2015. While we continue to navigate a rising-interest-rate environment, the story remains the same. Our goal is to remain defensive in our approach to investing while making our investment decisions conservatively and extending durations to pick up additional yield as opportunities in the market present themselves.

Daniel Himelberger
Portfolio Manager & Fixed Income Analyst
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SCOTUS

Readers are invited to check out the background of this case scheduled for SCOTUS at the end of this month: https://en.wikipedia.org/wiki/Gamble_v._United_States. Here is the Wikipedia summary: “Gamble v. United States is a pending United States Supreme Court case about the separate sovereignty exception to the Double Jeopardy Clause of the Fifth Amendment to the United States Constitution, which allows both federal and state prosecution of the same crime as the governments are “separate sovereigns”. Terance Martez Gamble was prosecuted under both state and then federal laws for possessing a gun while being a felon; his petition arguing that doing so was double jeopardy was denied due to the exception. In June 2018, the Supreme Court agreed to hear the case.”

Market Commentary - Cumberland Advisors - SCOTUS

A further excerpt from Wikipedia states:

“According to The Atlantic, the U.S. federal government contends that “overturning the dual-sovereignty doctrine would upend the country’s federalist system”, and that the increasing number of federal criminal laws means that it is important that states be allowed to “preserve their own sphere of influence and prevent federal encroachment on law enforcement”. The American Civil Liberties Union, the Cato Institute, and the Constitutional Accountability Center filed a joint amicus brief on the case, arguing that there is no textual basis in the Double Jeopardy Clause, which states that “[n]o person shall be … subject for the same offense to be twice put in jeopardy of life or limb”, for the doctrine, and that the rising amount of federal criminal laws and state-federal task forces means there will be more dual state-federal prosecution. The case has been analyzed in the context of the Special Counsel investigation into the Trump campaign; if the separate sovereigns doctrine is overruled, a pardon for federal crimes from Donald Trump may prevent state prosecution. United States Senator Orrin Hatch filed an amicus brief in the case, arguing against the separate sovereigns doctrine; a spokesperson for him denied any relation of the brief to the investigation, saying that Hatch wants the doctrine to be overturned due to “the rapid expansion of both the scope and substance of modern federal criminal law.” According to Columbia Law professor Daniel Richman, state and federal charges usually have “no overlap, or almost no overlap, that would ring Fifth Amendment chimes in the absence of the dual sovereign analysis”, and so the impact of overturning the separate sovereigns doctrine would be minimal.”

There are numerous accusatory comments about this case and there are various explanations offered as to why there is a sense of urgency to complete the SCOTUS process so that a full nine-judge SCOTUS is in place to decide this case. The SCOTUS docket is public as are the briefs and arguments. So, too, are the many viewpoints expressed on the internet. We will leave it to serious readers to research and decide for themselves.

Readers have asked us about the Kavanaugh saga and its market impacts. Given the galvanizing media show and the intensity of political partisanship, this seems to be a fair question. First, my personal views about SCOTUS nominee Judge Kavanaugh are my own and are private and have not been shared publicly. I have refused to offer them in any interview.

In our 45-person firm, the range of views on Kavanaugh spans from intensely opposed to strongly in favor, with some “I don’t care” and “I can’t do anything about it” and “it is all a sick system” views among our folks. Yes or no on Kavanaugh does not make the agenda for our morning strategy conference calls.

Market reaction to the SCOTUS appointment process is a different subject. We are in the independent investment advisor business. That means government actions require constant scrutiny; and government, by definition, is political, whether its representatives are elected or appointed. Judges, Fed governors, SEC or other board appointees, cabinet secretaries or advisors, all define government and all influence markets.

Here is a research piece, “Q3 2018 Municipal Credit Commentary,” written by our colleague Patty Healy that references two SCOTUS decisions. Each has a large impact on financial markets and alters risk analysis and portfolio composition: http://www.cumber.com/q3-2018-municipal-credit-commentary/

Note, in Patty’s analysis, how important the five-vote SCOTUS majority is in order for the Court to resolve issues. Having an odd number of justices on the Court is critical to governance. Recall how SCOTUS deferred certain decisions when it was four–four with a seat unfilled. There is a reason why the highest court in our rule-of-law society operates with nine justices (though it might be able to function with five or seven). We have a decision-making process; and when that process is disabled, our nation pays a severe price.

Financial markets have largely ignored the pro-Kavanaugh versus anti-Kavanaugh debate. They have looked at the Fed and trade war risk and earnings forecasts and reports. That tendency is likely to continue.

Financial market agents, however, don’t like the nasty, divisive behavior of the political operatives to whom we’re constantly exposed. Ask financial market professionals about political behavior, and they will set aside party preferences and give you an earful on how broken our system is and how ugly it has become.

In markets, financial agents have no methods to deal with anonymous allegations, secret transmissions, and revelations after hearings are over and decades have passed. Financial agents are used to factual reports and audits and opinions rendered as accounting certifications from independent and unconflicted professionals.

There has been real harm done by the many-months-long SCOTUS process. When Republicans screamed harshly and rudely, they harmed us. When Democrats walked out of hearings like petulant children, their behavior harmed us. The SCOTUS process showed us our politics at its worst.

There are also longer-term debilitating impacts. Capable, well-placed financial markets agents are increasingly loath to take on civic duties, accept appointments, expose their personal lives to scrutiny, and watch the mainstream and social media dismember them.

In my view the real casualty from this SCOTUS process is how it has further discouraged participation in government and therefore governance. That reluctance to serve can undermine our nation, our freedoms, and our financial well-being.

Markets are not pricing in the longer-term deleterious effects of failing political systems. Market agents don’t know how to estimate the cost.

Maybe market agents are looking beyond the political ugliness perpetrated by Democrats and Republicans and betting instead on the enduring stability of the United States in spite of the corrosive acts of those who govern us. Maybe that is the explanation for market inaction during this SCOTUS debacle.

But that perception is only a guess. There is no way to know exactly why markets have ignored the SCOTUS saga so far. We who are in this business are all just guessing.

Let me add this postscript to my SCOTUS commentary. Like you, I have heard statements from US Senators of both political parties. Democrats and Republicans alike assert that one of the witnesses lied. Both sides cannot be right. In fact, both may be wrong. The study of memory and experience is an academic discipline that has evolved rapidly in recent years. Please take a few minutes to listen to this TED talk by Daniel Kahneman, a globally recognized expert and lifetime student of behavioral economics: “The Riddle of Experience vs. Memory,” https://www.ted.com/talks/daniel_kahneman_the_riddle_of_experience_vs_memory?language=en. We thank Datatrek for the citation.

And finally, I want to thank those Democrats and Republicans who have remained well-behaved, maintained decorum, and respected the process of governance during this trying episode in our national political life. You exemplify how things ought to be done in our democratic republic.

David R. Kotok
Chairman and Chief Investment Officer
Email | Bio


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FOMC Closes Out Q3 2018

As Treasury markets had correctly predicted, the FOMC raised its target range for federal funds by 25 basis points to 2.0%–2.25% at its meeting on Wednesday, Sept. 26.

Federal Reserve - FOMC

Perhaps more importantly, it also deleted the observation that policy remains accommodative, though Chairman Powell went out of his way in his opening remarks to point out that its removal should not be interpreted as a signal about the future path of rates. Rather, it was simply a reflection of where the Committee saw policy. This so-called clarification, however, didn’t square entirely with his observation that financial conditions remained “accommodative.”

Since the meeting was also one in which the Committee revised its Summary of Economic Projections (SEP), it is worth noting that there were really only three changes or additions worth commenting on. First, both the median GDP growth for 2018 and its central tendency were revised up slightly, which Chairman Powell said reflected the strength of incoming data and robust consumer and business confidence. Second, forecasts for 2021 were added, and GDP for each year after 2018 was projected to be lower than the preceding year’s, with the figure for 2021 showing growth of only 1.8%, equal to that forecast for the longer run. At the same time, there were no significant changes in the forecasts for unemployment or inflation. When asked about that, Chairman Powell simply stated that the inflation dynamics now appear to be different from those of the past, implying that the Phillips curve is essentially flat. Finally, even by the end of 2021, the median federal funds rate is expected to be still almost a half percentage point higher than the longer-run rate.

Looking beyond September to the end of the year and possible rate moves in 2019 and beyond, the dot chart suggests that 12 of the 16 participants think there will be one more hike in 2018. Given that by December the Committee will have an observation on Q3 GDP and a new set of SEP forecasts available, the likelihood is that the rate move will occur at that meeting. Moreover, with regard to the moves that have occurred this tightening cycle, there has been no instance when an increase was approved at a meeting when no press conference was scheduled and no SEP forecasts were available. Note that all meetings in 2019 will be followed by press conferences.

Interestingly, for 2019 the median-rate data suggest three moves that year and two more in 2020, stopping at 3.25% to 3.5%. This policy path would put the funds rate above the Committee’s equilibrium longer-run rate, and that fact triggered questions directed at Chairman Powell as to whether there is likely to be a policy overshoot. His response essentially suggested that people should not take those longer-run rate projections as being firm, since knowing when to stop will be data-dependent. He did observe that the gradual pace of the Committee’s policy moves enables it to monitor how the economy is responding and to minimize the risks of a policy mistake that might trigger a recession.

This observation by Chairman Powell raised the question in the press conference as to what could impact the policy path. Tariffs, deficits, oil shocks, and greater-than-expected growth were all key factors Chairman Powell identified that could impact both the pace of policy and the decision to pause. All in all, Chairman Powell continued his strong performance, exhibiting not only depth and breadth of knowledge but also patience in responding to questions. Given the information flow and the short-term forecast for another rate move in 2018, it would not be surprising to see the term structure move up rather abruptly, by about another 25 basis points, in advance of the December FOMC meeting, as it did leading into this September meeting.

Robert Eisenbeis, Ph.D.
Vice Chairman & Chief Monetary Economist
Email | Bio


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Q3 2018 Municipal Credit Commentary

Updates, budgets, potential future stresses, state ratings, default study, and last but not least, storms

Market Commentary - Cumberland Advisors - Q3 2018 Municipal Credit Commentary

Last quarter we focused our 2Q 2018 municipal credit commentary on two SCOTUS (Supreme Court of the United States) rulings. One allows states to collect tax on out-of-state internet sales while the other restricts public unions from requiring that non-union public sector employees pay agency fees to contribute to the cost of collective bargaining and other activities through fair-share agreements. We consider both rulings positive for municipal credit (http://www.cumber.com/scotus-two-major-rulings-with-positive-implications-for-municipal-bond-credit-quality/). In particular, the ability to collect online sales taxes should help financial operations. A study by the National Conference of State Legislators (NCSL) and the International Council of Shopping Centers (ICSC) estimates that total U.S. uncollected sales and use taxes increased to almost $26 billion in the year 2015. Of this $26 billion, more than $17 billion in uncollected taxes were projected to be from electronic sales. http://www.ncsl.org/research/fiscal-policy/e-fairness-legislation-overview.aspx

Updates

Regarding the sales tax ruling, some states are working toward collecting sales tax retroactively; however, a bill entitled the Online Sales Simplicity and Small Business Relief Act has been proposed that would ban retroactive imposition of a sales tax on out-of-state internet sales, delay implementation to January 2019, and establish a small-seller exemption for companies with gross annual receipts below $10 million, (compared with the $100,000 threshold or 200 transactions per year in the case of South Dakota). The proposed legislation, if passed, should not be a burden, because states have already been adjusting to the lower collections as internet sales have increased over the years. Regarding the fair-share agreements, it may take some time for the SCOTUS ruling to have an effect on public sector-union coffers and political influence. We noted in our Q1 commentary the abundance of teacher strikes (http://www.cumber.com/q1-2018-municipal-credit/). They continued this quarter, with strikes or threatened strikes in a number of Washington state school districts and a vote by the teachers of Los Angeles Unified School District to strike if state mediation does not result in a satisfactory contract.

Budgets

In addition to the SCOTUS rulings, Q2 was notable because all states passed budgets on time or nearly on time – even the states notorious for passing late budgets, such as Illinois, Connecticut, and Pennsylvania. Common threads for this phenomenon include election-year politics, good revenue growth driven by a generally improved economy, and the acceleration of tax collections in 2017 due to the Tax Cut and Jobs Act.

Future expectations

States

A number of states’ rainy day funds are not up to pre-recession levels, leaving analysts and others to worry what might happen in the next downturn. S&P released a September 2018 report in which they subjected state financial operations to the stresses of moderate and severe recessions and then compared 2018 reserves to expected drawdowns. Only 20 states had reserves sufficient to cover loss of revenue and increased social service spending during a moderate recession, and overall the states showed an average revenue shortfall of 9.9%. S&P went further and made adjustments for dependence on more cyclical revenue streams (capital gains taxes for example), level of social-service spending, and fixed costs including pensions and OPEB. After the adjustments 14 states were considered low risk, 21 moderate, and 14 elevated. S&P contends, however, that states have the capacity to make fiscal adjustments in response to a downturn. S&P also notes, though, that there were 19 state downgrades from the beginning of 2016 through August 2018, compared with just four upgrades, and observes that this ratio is abnormal this far into a recovery. The downgrades could reflect increased reliance on income taxes, eroding tax bases, rising entitlement costs, and liability growth.

 

Cities

The National League of Cities’ annual City Fiscal Conditions report, a survey of 341 of its members, found that while cities’ fiscal health is not yet declining, growth is slowing, and there are cautionary signals that echo previous economic downturns. Cities are facing wage pressure as well as shortfalls in required and/or needed contributions to pensions and healthcare. Although revenues are not in decline, they grew only 1.25% in FY 2017 and are expected to stagnate in FY 2018. Expenditures grew 2.16% in FY 2017, with growth for FY 2018 budgeted at 1.97%. The results are uneven. Communities in the Midwest are faring worse than those in other regions. Smaller cities, too, have a poorer fiscal outlook than their larger counterparts do. The report attributes these differences to population declines and industrial losses that began before the Great Recession but were accelerated by it. And not surprisingly, the report found 35% of finance officers report seeing negative fiscal impacts associated with the elimination of tax-exempt advance refunding bonds. According to the NLC, this critical municipal finance tool saved taxpayers more than $2.5 billion last year.

This picture may sound dire; however, municipal analysts are generally a conservative group. In Moody’s annual US Municipal Bond Defaults and Recoveries, 1970–2017, released in July, the rating agency notes that municipal bankruptcies have become more common in the last decade (think Puerto Rico) but are still rare overall. The five-year municipal default rate since 2008 was 0.18%, compared to 0.09% for the entire study period. This figure compares with the global corporate five-year default rate of 6.6% since 2008. The ten-year municipal default rate is 0.17%, while the corporate default rate is 10.24%.

The Municipal Analysts Group of New York (MAGNY), a constituent group of the National Federation of Municipal Analysts (NFMA) staged a luncheon program at the beginning of summer, in which panelists discussed what the next recession may look like. Their conclusion? It depends. Is weakness going to be on the consumption side and affect sales taxes, or will it be on the employment or stock market fronts and affect income taxes? Recently, oil prices have been predicted to rise, so states that are dependent on energy taxes may benefit from additional revenue.

Given the risk of future revenue declines, it is important to know where the risks could rise to determine whether a municipality is preparing for those risks and striving for structural balance. Are revenues at least equal to expenditures, and are those expenditure needs being realistically addressed? When evaluating an issuer we like to see flexibility in the form of conservative assumptions built into a budget. This prudent practice generally means overestimating expenses and underestimating revenue, so that the entity can end the year with a positive balance, contributing to the buildup of a rainy day fund. Rainy day funds are used to address revenue shortfalls or unexpected expenses. Conservative budgeting and the willingness to cut spending or increase revenues are characteristics of strong financial management. This principle is true for the issuers of general-obligation bonds as well as revenue bonds.

State Ratings

Why do we always have a section on states in our quarterly municipal credit commentaries? States provide funds and services to municipalities and institutions in the state, so what is happening at the state level can have implications at the local level. Additionally, as I mentioned in my inaugural commentary at the firm (http://www.cumber.com/3q2016-municipal-credit-its-never-boring-in-muniland/) – wow, has it been two years already?), state ratings are now more volatile than they were in the past.

Since June 2016 there has been only one quarter that has not seen a state rating change, and that was the first quarter of 2018. Historically, state ratings were fairly stable (with some exceptions, such as California). The variability in the past few years is unusual and is attributable to rising pension costs and OPEB expenses, political gridlock, and/or exposure to energy-related revenues.

Some states’ ratings are naturally more cyclical because those states depend more heavily on a cyclical revenue stream. For example California, which is AA-/Aa3 rated now, has been as high as AAA and as low as A because it is a high tax state with high-income earners, which creates swings in income and budgeting. This history contrasts to that of Georgia, which has been rated Aaa by Moody’s since 1974. Fitch has rated the state’s GOs AAA since 1993, while S&P gave its highest rating to the Peach State in 1997.

State Rating Changes

After no changes in Q1, the changes seemed to accelerate in Q2 and Q3. In Q2 there were three downgrades, one upgrade, and a few improvements in outlooks or trend. In the third quarter all rating actions were positive!

 

Finally, our thoughts are with those in North and South Carolina who are still dealing with the aftermath of Florence. In addition, many around the country and the world were affected by fires, volcanoes, and tsunamis this quarter. The initial costs to communities affected by natural disasters can be great; however in the U.S., after a natural disaster, there is usually a surge of economic activity that continues for an extended period as people and communities rebuild and money (insurance and federal aid) and workers flow into the area, increasing income tax and sales tax revenues to municipalities. That economic flip side, however, is not much immediate comfort for those who have lost homes and other property, pets, livestock, income, and for some, even family members. Our hearts go out to those whose lives have been impacted.

Patricia Healy, CFA
Senior Vice President of Research and Portfolio Manager
Email | Bio


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The Tale of Two Ratios: Shorter and Longer

In a year when we have seen commentators talking about the relative flatness of yield curves, we have a conundrum when we look at the US Treasury yield curve and the US muni yield curve (shown here as the Bloomberg AA general obligation yield curve).

Market Commentary - John Mousseau

Curve 1 below is from the beginning of 2017. Curve 2 is from September 2017. Curve 3 is from September of this year.

Curve 1
Source: Bloomberg

Curve 1, at the beginning of 2017, shows a very cheap muni yield curve across the board. Muni yields were at or above Treasury levels at EVERY POINT ON THE YIELD CURVE. This reflected the entire uncertainty surrounding the presidential election. There were questions as to whether we would see a tax bill and how munis would be treated, fear of a big infrastructure bill (and uncertainty over how that would affect munis), what the president would do regarding a new Fed chair, and whether Fed policy would change. All in all, it was an extraordinarily cheap moment for muni bonds. The long end was particularly cheap, as the market had undergone a selloff in the wake of the Trump election, with extreme bond-fund selling.

Curve 2
Source: Bloomberg

Curve 2 is from September of 2017. What happened? Short-term muni yields dropped. The trend really started in the first quarter when then-Chair Janet Yellen made it clear that the Fed would continue on its path of raising short-term interest rates gradually (read: not at every meeting) but would need to keep raising rates to reflect an improving economy. Thus the shorter end of the market essentially began to go lower in yield to reflect the tax structure, and the ratio moves were dramatic for paper inside of five years. Longer munis continued to exhibit cheapness of yield relative to Treasuries. We believe this was related to market knowledge that there would be a change in the tax code coming with the tax bill and to the uncertainty as to how municipal bonds would be treated under that bill. The expectation was that municipal advance refundings (which allowed municipalities to defease older, higher-coupon bonds in advance of their call dates) would be eliminated. Bond markets also expected that private-activity bonds – issued by charter schools, private universities, state housing agencies, and airports among others – would be prohibited. In the end the tax bill eliminated advance refundings but allowed private-activity bonds. The cheapness in the long end of the muni market was due to the expectation that SUPPLY would bulge at year end to beat the tax code changes, and indeed that is what happened.

Curve 3
Source: Bloomberg

Curve 3 is from this September. Two observations jump out. The long end remains absurdly cheap. One factor is some erosion of the buying base. Banks have been smaller buyers of munis because of the lower corporate rate; and individual demand for long munis has been good, but bond funds have not recouped the outflow of funds that they saw in the wake of the 2016 election. The more dramatic move has been the continued drop in ratios inside of 10 years – in some cases to lower than the break-even rate if we assume an average marginal tax rate of 25%.

One of our thoughts is that investors are expecting a possible change in the makeup of Congress this fall and possibly a change in the White House in 2020 and a potential revision of the tax code again. The current individual rates expire in 2025. Therefore, investors are turning over muni portfolios faster and paying more for short-dated securities. They would therefore have money back faster if there if a tax law change in the wake of a switched Congressional majority.

However, we believe the longer end of the bond market remains an extremely good value. A 4% tax-free yield is the taxable equivalent of 6.35% if an investor is in the 37% top tax rate bracket. For states with high income taxes that are no longer deductible, a 4% in-state bond yield is worth even more. At the top state tax rate, a 4% New Jersey tax-free bond is worth 8.97% taxable equivalent; a 4% New York bond is worth 8.82% taxable equivalent; and a California 4% tax-free yield is worth 8.04% taxable equivalent. This is for AA or higher-rated securities. To position the 4% in-state bond correctly credit-wise, it compares to high-grade corporate and long, taxable municipal bonds at the 4.0–4.5% level or a BB junk bond long yield index of 6.5% (source: Bloomberg).  In general, the muni yield curve drifted up 20 basis points during the quarter, across from 2 years out to 30. This is in sympathy with the treasury yield curve, which also experienced slightly higher yield movements across the board.

Curve 3 also is a way to understand Cumberland’s current barbell approach to tax-free bond portfolio management. We want shorter-term securities turning over faster as the Fed raises short-term rates, but we want the longer end locked in because we believe the current cheap yield ratios will eventually go to 100% or below. This happened during the Fed’s hike cycle of 2004–2006, when long muni/Treasury yield ratios fell from 103% to 85%. Our approach should give long munis a great deal of defensive value if overall interest rates rise. It is this defensive quality that causes us to include some longer tax-free bonds in the management of taxable bond portfolios of clients such as pensions, foundations, and charitable trusts. The total-return characteristics of owning a tax-free bond at these levels is very compelling when the expectation is for lower yield ratios over time. Certainly it will take some time for the strategy to work out, as longer Treasury yields are somewhat anchored to the general low level of longer bond yields in the Eurozone countries.

As the Federal Reserve continues to raise short-term interest rates (and we believe they will continue to do so to get the fed funds rate decently above the level of core CPI [currently 2.2%]), we will eventually move some of the shorter end of the barbell out somewhat longer, some of the longer end (where most bonds are callable) to more noncallable structures, and some bonds to the “belly” of the yield curve (where we don’t want to be now but will certainly want to be if we get to a point where the economy slows).

John R. Mousseau, CFA
President and Chief Executive Officer, Director of Fixed Income
Email | Bio


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Trump Trade War & The Keystone Kops

Market Commentary - Cumberland Advisors - Trump Trade War & The Keystone Kops

In his Thoughts from the Frontline letter on Friday, John Mauldin wrapped his own strong remarks on Trump’s trade war with China around a tweet from the vastly experienced and hugely connected Harald Malmgren (https://www.mauldineconomics.com/frontlinethoughts/china-for-the-trade-win):

“Check out this unusually blunt tweet from former trade diplomat Harald Malmgren, who literally wrote the book on US trade policy, serving under presidents starting with JFK. He’s retired now but remains ‘plugged in’ to global finance better than almost anyone I know.”

Mauldin continues, “Now, it may be that the White House team is less talented than they think. Peter Navarro’s continued presence, and the president’s apparent confidence in him, is not reassuring. I said when his name was first mentioned that Navarro understands neither economics nor trade. He has done nothing to change my opinion.

“But another possibility is they have an entirely different strategy than we think. Some of my contacts believe the real goal is to make US businesses pull back from operating in China at all. If that’s the goal, they are off to a good start. But that is not good for US businesses or for the US.”

Then, on Friday evening, the Wall Street Journal chimed in with a news alert titled “China Cancels Trade Talks With U.S. Amid Escalation in Tariff Threats,” which outlined the Chinese response to US pressure:

“China scotched trade talks with the U.S. that were planned for the coming days, according to people briefed on the matter, further dimming prospects for resolving a trade battle between the world’s two largest economies.

“The decision to pull out of the talks follows the latest escalation in trade tensions. On Monday, President Trump announced new tariffs on $200 billion in Chinese imports, prompting Beijing to retaliate with levies on $60 billion in U.S. goods. Mr. Trump then vowed to further ratchet up pressure on China by kicking in tariffs on another $257 billion of Chinese products.

“Chinese officials have said such pressure tactics wouldn’t induce them to cooperate. By declining to participate in the talks, the people said, Beijing is following up on its pledge to avoid negotiating under threat.”

With the Trump Trade War escalating and worsening, we sought to convene a serious and civil discussion about where Trump-Navarro trade policy is inclined to take the United States. To that end a seminar was organized with the help of the Keystone Policy Center (KPC) and the Global Interdependence Center (GIC). It was held on September 20th at Keystone, in Summit County, Colorado. (For geographic orientation, since our readers are worldwide, you may think of the Keystone or Breckinridge sky areas or the towns of Keystone, Frisco, Dillon, or Silverthorne.)

The KPC has been around since the mid-1970s, as has the GIC. Both organizations have a history of neutrality and of convening civil discussions.  KPC’s history is more domestic in focus, with agriculture and mining being strong areas of interest. GIC has a history of global focus on monetary and trade issues.

The Trump Trade War has now offered a bridge for policy forums like KPC and GIC to partner as they pursue truth without the intensity of political acrimony. That is what happened on September 20. At the seminar, opinions were diverse and perceptions varied, but considerable learning occurred through the civil exchange of information.

Mike Englund, Megan Greene, and yours truly as a participating moderator populated the seminar panel. Among the invited attendees were Democrats and Republicans, businesses and white-collar professionals, and public guests. The event was open to the general public at no charge.

Participants included IT businesses that work in China and that have experienced intellectual property theft. Representatives of the soybean industry, finance and market agents, and the retired executives of major institutions were also on hand..
Mike Englund of Action Economics opened with slides and a data set. He has graciously allowed them to be publicly released. Here is the link to Mike’s PowerPoint presentation: Action_Economics_Keystone_GIC_Sep_2018.pptx. (Mike Englund is principal director and chief economist for Action Economics, which offers premium intra-day commentary for the fixed-income and currency markets. They feature analysis of a wide range of global bond and FX markets, with a focus on central bank policy and market activity in the G7 countries. You can learn more here: https://www.actioneconomics.com/index.php/.)

Mike’s slides were updated to include the latest Trump escalation and China’s response. They capture what was known as of September 19. They estimate the primary effects. The second derivatives were a subject of our panel discussion. Suffice it to say, this is a negative picture for US growth and US job creation, and the secondary impacts will only make the situation worse.

Megan Greene is the chief global economist at Manulife Asset Management, whose team includes more than 325 investment professionals, located around the world, who manage a full spectrum of asset classes. You see her on TV and can read her column in the FT. She added a global perspective and described how trade-war effects spread internationally, citing many anecdotes of global interactions. If anyone needed convincing that this Navarro-conceived, Trump-directed policy is now on an irreversible course toward failure, they had only to listen to Megan’s rundown and extrapolate to logical outcomes.

I added a few observations to the discussion and will summarize them here.
1. Shrinking the US trade deficit means shrinking the capital account surplus. To do this when the federal deficit is headed above $1 trillion is to invite a financial crisis. We should be expanding the capital account surplus and enhancing the US dollar’s status as the reliable world reserve currency of choice. Instead, this administration is doing the reverse. Trump and Navarro are shooting our country in both feet.

2. Americans don’t want this. A majority (75%–80%) think that free trade is opportunity. Survey sources include Gallup, 2018 (https://news.gallup.com/poll/228317/positive-attitudes-toward-foreign-trade-stay-high.aspx); Chicago Council Survey, 2017 (https://www.thechicagocouncil.org/publication/chicago-council-survey-data); Pew, 2015 (http://www.people-press.org/2015/05/27/free-trade-agreements-seen-as-good-for-u-s-but-concerns-persist/); and WSJ/NBC, 2017 (https://www.wsj.com/articles/americans-back-immigration-and-trade-at-record-levels-1493092861?mod=wsj_streaming_latest-headlines). Thank you to Barclays research for pointing us to some of these polls.

3. The same political views with regard to trade are held by Democrats, Republicans, and independents. The polling data show that disdain for the direction of this Trump-Navarro policy is bipartisan and growing as the anecdotal evidence of negative effects pile up at Trump’s doorstep.

4. Trade still ranks low in issue importance when voters are asked. Guns, terrorism, education, and immigration rank much higher; but that picture is changing slowly. Remember, trade-war rhetoric has been around all year, but actual policy implementation is just getting underway, and measurable effects are just beginning to appear. Look at Mike Englund’s forecast slide to get a sense of where this is heading.

5. “The United States federal excise tax on gasoline is 18.3 cents per gallon and 24.3 cents per gallon for diesel fuel” (https://www.eia.gov/tools/faqs/faq.php?id=10&t=10). Every penny change in the price of fuels amounts to about $1.5 billion spent annually in the US. At present, with the announced and threatened tariffs, the total cost imposed on Americans will be the equivalent of nearly one dollar of additional tax per gallon of gasoline and diesel fuel. That reference may help readers understand how serious an economic growth threat may greet our nation by early next year.

My takeaway is that the stock markets and bond/credit markets are only starting to worry. Companies are, however, warning about possible future negative earnings surprises from trade-war effects. Credit spreads are still tight. The pain is seen in emerging markets and foreign debt issues. While the amount of US corporate debt is at a record high and the junk-credit portion is high, we haven’t seen credit spreads widen yet. We are minimizing that risk for clients. When markets are priced for perfection, they are fraught with risk. At Cumberland we won’t take that added risk for our clients.

Last thought. For decades we have focused on monetary issues and numeracy and trends that exhibit linearity and mean reversion. At our September 20 seminar, the professionals in attendance admitted how difficult it is to model trade shocks. Unintended consequences are often larger than the initial actions that precipitate them, and the multipliers are unknown. Trade shocks are sequential cliffs. They are nonlinear. Many are irreversible.

We thank the leadership of the Keystone Policy Center and the Global Interdependence Center for agreeing to this first joint organizational forum. We thank the invited attendees and the public guests for taking a few hours away from the beautiful golden Colorado fall foliage to sit in a meeting room and civilly discuss this critical inflection point in America’s trade policy. Many of our participants expressed the wish that our national political leadership might act as we were doing and cease the bellicose, offensive behavior. That wish applies to both Democrats and Republicans.

I was fortunate to moderate this session and to learn from those who attended. Thank you.

Sixty years before the founding of the GIC and KPC, silent movies were the latest rage. The Keystone Kops may now be little-known, but they were a big hit in their day. (See https://www.britannica.com/topic/Keystone-Kops) We all do well to keep our sense of humor in these trying days, and so we can’t help but wonder whether the Keystone Kops might have been the inspiration for today’s trade war police ensconced in Washington. Here’s a taste of those crazy constables: https://www.youtube.com/watch?v=a8jphxpi1ro.

David R. Kotok
Chairman and Chief Investment Officer
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