Shrinkage Tantrum-2 & Hillsdale

We thank readers for their thoughtful comments regarding our discussion entitled “Tax Bill & Shrinkage Tantrum.” For those who may have missed it, here is the link: http://www.cumber.com/tax-bill-shrinkage-tantrum/.

One astute reader called our attention to the internal workings of the Senate via a link to a Politico story about Hillsdale College in Michigan. Here is that link: https://www.politico.com/story/2017/12/01/senate-tax-bill-hillsdale-college-endowment-275980?lo=ap_e1.

The Politico report articulates how this single school was destined for special treatment in the tax bill. The “carve-out” amendment was authored by Senator Pat Toomey (R-Pa). There is no explanation of Toomey’s role as the sponsor. His general statement is quoted by Politico.

In the midst of the notorious Senate debate last Friday evening, a bipartisan effort passed an amendment to strip the Toomey-authored provision from the final bill. The Politico report has the details. It also describes the connections between Hillsdale College and the DeVos family and relationships that allegedly tied the amendment to our Education Secretary.

My point here is not just about this attempt to use a legal provision to favor Hillsdale. I’ve never been to that college and have no plans to visit. My point is that the political forces of our nation continue to use these special interest maneuvers, as Toomey tried to do. Only the intense scrutiny of a free press saves our citizens from many politically motivated giveaways like this. We have written on this issue and cited examples in the past. The best a citizen can do is to protect the freedom of our press and to encourage the press to report without inhibition, to remain observant and vociferous, and to not give up. We must not fall silent.

Incidentally, Hillsdale College advertises a free course called Constitution 101 on social media, along with a batch of other free courses listed at its website. (See https://www.hillsdale.edu/academics/free-online-courses/.) It might be instructive to compare that Constitution 101 course with, say, one from Yale (see for example https://www.coursera.org/learn/written-constitution).

On a different issue, a skilled and seasoned reader (who will remain anonymous) sent the following observation:

“Unfortunately, by the lessons my mentor taught me about econometrics, the reliability of ANY estimate like the CBO estimate you attached, for any year into the future, falls in a parabolic manner. The first year may have 66% reliability, but by year five that’s likely to be no more than 25%, and by year 10 it is entirely garbage. That doesn’t mean Congress is wrong to use these processes – there needs to be some standardized basis for understanding what they are doing. In this case, however, when one combines (1) a demonstrably benign T-rate assumption, (2) absolutely no assumption on the credit spreads that the private sector will have to pay, and (3) the fact that government is now only a tiny fraction of the size of the total US economy (the post WW II data on which I learned econometrics was far more heavily weighted to government than now), whatever may trigger the tantrum you note, it will render this projection irrelevant.”

Another skilled and deeply experienced reader, who shall also remain anonymous, sent an extensive analysis of the tax reform effort. Here is an excerpt:

“Your skepticism about the new tax ‘reform’ impact on economic growth is fully justified. At a meeting last spring of the National Economists Club, the Director of the CBO responded to my question about the CBO’s current assumption of potential GDP growth being only 1.8% a.r. until 2027.

“He cited the following reasons: The secular slowdown in labor and capital productivity, ageing of the population, slowing of net immigration, and the fact that the last two are slowing growth of the labor force. I would add that the U.S. failure to save more (a reflection of private consumption being 70% of GDP and perpetual government deficits) is one of the principal brakes on capital spending which would boost productivity.”

We thank many readers for their comments and observations on our “shrinkage tantrum” missive. We say “yes” to those who argued that tax cuts are stimulative. They can be. Another “yes” to those who noted that repatriation is stimulative or may be. Also “yes” to those who agreed that a debt-to-GDP ratio rising toward 100% is a serious issue. And “yes” to those who agreed that a normalization of interest rates – whatever that means – portends a rising federal interest payment burden.

Finally, a number of readers reminded us of earlier periods in American economic history when rising interest rates led to the “crowding out” of private investment spending. We don’t know whether that situation will be repeated, but we share your concern.

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


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Tax Bill & Shrinkage Tantrum

The Congressional Budget Office (CBO) scoring of the tax bill was released at 8:49 PM on Friday night, and this link will take you to it: https://www.cbo.gov/system/files/115th-congress-2017-2018/costestimate/53362-summarysenatereconciliation.pdf. The title of this one-page document is a mouthful: “Summary of the Deficit Effects of a Bill to Provide for Reconciliation Pursuant to the Concurrent Resolution on the Budget for Fiscal Year 2018, As Filed by the Senate on December 1, 2017.” The numbers here are critically important, though there may be some additional financial adjustments, given that the Senate debate ended in the early hours of Saturday morning and given that the Senate-version text has handwritten notes on the legislation that have not been read (let alone scored) by CBO. We note that some commentators believe the notes are not even legible.

Anyway, this is our political system, like it or not. As Churchill observed in the House of Commons in 1947, “Indeed it has been said that democracy is the worst form of government, except for all those other forms that have been tried from time to time.…” Sir Winston did not originate the line, but he did make it famous. Its origin is subject to debate. I personally verified that factoid with the chief archivist of the Churchill Library.

The Senate version of the tax bill (whatever it is) and the House version (which we have been able to read) will now go to a conference for the next round in this political dogfight. Our view remains that there will be a final tax bill and that Trump will sign it no matter what the final bill looks like.

We will set aside comments on the detailed tax changes, as they have already been discussed and are not final until we get a House-Senate conference version.

Let’s get to the deficit.

We are using the CBO scoring detailed in the link as a guide. Remember that budget and deficit projections have a wide margin of error. They are based on lots of assumptions. About the only thing we really know about those assumptions is that they are wrong on the day you make them. The whole idea is to get the theme right and to try to get close to what the final numbers will be.

Here are the themes.

The additional federal deficit that is expected to occur as a result of this tax bill is added to the baseline of projected deficits. Thus we can combine the baseline we know with the CBO scoring we see, and that leads us to an estimate of total deficit over the next ten years. We know that the interest component and other components (like transfer payments) are fixed as legal obligations and are non-discretionary. The United States will pay the interest on its debt no matter what the rate is. We can project that rate, but we are guessing because we do not know what rates will be set by the Federal Reserve during the next decade.

We do not even know what the rates will be next year. We can only make educated guesses at that. About the only thing we know of long-term interest rate forecasts is they have proven consistently wrong.

We expect that the cumulative effect of these tax bill changes will take the deficit to 100% of the GDP of the nation in the “out years.” Which year that happens is irrelevant! It is the trend that counts. And that trend is up and will be accelerating after the tax bill passes and starts to be phased in.

In 2018 the impact will be small and not meaningfully felt by markets. In 2019 the impact will start to rise, and markets may be absorbing $700–800 billion of incremental new federal debt issuance at the same time the Federal Reserve is disgorging hundreds of billions in federally guaranteed holdings while the Fed also shrinks its balance sheet. Note that the Fed will not be selling: It just won’t buy as much replacement debt when maturities occur.

We have enough information from Fed-official testimony and Fed releases to estimate that the Fed will shrink its balance sheet by a total of about $1 trillion or more. This process will take years. We have a projected path of shrinkage that the Fed has disclosed. But we also know that the Fed does not intend to shock or derail the economy or markets, so there may be some flexibility in the Fed’s path if a crisis unfolds.

We want to coin a new term. We expect that the shrinkage path will not be a smooth one. Paths to shrinkage rarely are. So we expect to see a “shrinkage tantrum.” That tantrum may remind us (and markets) of the “taper tantrum” that ensued when Fed Chairman Bernanke first mentioned a tapering policy half a decade ago.

The shrinkage tantrum may erupt without market preparation and reflect a global change in sentiment. We think the reaction will coincide with the changes that are forthcoming as the European Central Bank starts to taper up to zero from negative rates. It becomes easy to project a ten-year German government bond trading at a positive interest rate of near 1%, while a ten-year US Treasury note trades at a positive interest rate of 3%. Readers can do the rest of the math to create forward rate curves, a calculation we do every day at Cumberland.

Note that these are estimates of levels. They assume that low inflation remains with us; they assume gradualism by the major central banks; and they assume a baseline of no external shocks like North Korea or an Ebola/Zika outbreak or a recession and/or a constriction of consumer demand and consumer spending and/or sharply contractionary impacts from changes in America’s trade policy (including NAFTA).

Market dynamics alone will pressure interest rates upward. Other factors can exacerbate the direction and accelerate the trend change.

When?

Ay,” wrote Willy Shakespeare in Hamlet’s immortal soliloquy, “there’s the rub” (https://www.poets.org/poetsorg/poem/hamlet-act-iii-scene-i-be-or-not-be).

The numbers we see projected are on a path to be gradual. A 3% US Treasury note may not arrive for another 2–3–4 years. That is the benign scenario. But that projection has no margin for errors. And it has no “expectations” component. And that is where we find “the rub.” How far in advance will markets begin to price in these changes, and how much additional interest-rate premia will bond purchasers require for evolving and uncertain risk? No one knows.

In sum…

There will be a final tax bill. There will be a rising deficit that will eventually pressure interest rates higher. The Fed balance sheet shrinkage exacerbates this transition.

Lastly, a “shrinkage tantrum” probably lies ahead. When, and how serious a tantrum it will be, we cannot yet know.

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


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Marvin Goodfriend: What You Get

Marvin Goodfriend’s nomination represents what will be a welcomed and outstanding addition to a depleted Board of Governors of the Federal Reserve System.[1] He brings a lot to the table. First, he is a first-rate economist with a truly international reputation. He has held visiting, consulting, and evaluative positions at numerous central banks and international organizations including the Riksbank (Sweden), Bank of Japan, De Nederlandsche Bank (Amsterdam), Bank of India, Norges Bank (Norway), Swiss National Bank, ECB, Saudi Arabian Monetary Agency, and IMF, just to name a few. Additionally, he has been actively involved with the Federal Reserve System itself since joining the faculty at Carnegie Mellon in 2005 and has been a member of the Shadow Open Market Committee. So he knows central banking and the workings, culture, and staffs of the Board of Governors and the Federal Reserve system more generally; and he has participated in policy evaluations of the performance of several non-US central banks.

Second, his academic credentials are extensive. He has published in the best journals in both the areas of monetary policy and international trade. He has served on the editorial boards of most of the major economics journals and is a research associate at the National Bureau of Economic Research.

Third, when it comes to policy, he understands the models employed. During Marvin’s long tenure at the Richmond Fed, the policy positions taken by then President Broaddus evidenced a concern by both men for inflation and keeping it low. This belief is also reflected in some of Marvin’s writings and transcends his time at the Richmond Fed. However, as was noted in a recent WSJ article summarizing his likely approach to policy, there are also times when one must also be concerned about deflation and how policy might best be conducted in a world where interest rates are zero or perhaps even negative. For example, Marvin proposed policy options for dealing with the so-called “zero lower bound” problem in 2000, long before it became a real issue in the wake of the financial crisis.[2] This demonstrates that he thinks ahead about problems and how to solve them before they become a reality.  At the same time, he has also argued recently for modifications in the Fed’s approach to inflation targeting, suggesting that he is critically concerned about communications and policy credibility.[3]  All of this this means that he will be pragmatic when it comes to policy, but his writings also reflect a keen understanding of alternative theories.

Fourth, less well appreciated but equally important is Marvin’s approach to supervision and regulation. When writing about the zero lower bound, he notes that there are practical problems in using monetary policy, as some have suggested, to moderate extreme and potentially unsustainable movements in asset prices. Here he argues that the better way to deal with such problems is through judicious use of supervision and regulation designed to prevent problems from adversely affecting financial stability.

Fifth, Marvin may have views on Fed credit policies and lending that might not necessarily represent Fed orthodoxy. Based upon his writings, he is likely to be cautious when it comes to both emergency lending and credit expansion, such as took place following 2008. His concern is maintaining Fed independence and reckoning with the potential for such Fed policies to exacerbate economic fluctuation and create moral hazard. His proposed solution is to focus on stable inflation, with Congressional oversight to hold the Fed to its 2% inflation target and to limit the Fed’s asset purchase programs to Treasury debt only.[4]

Finally, Vice Chairman Quarles may find an unexpected supporter when it comes to Fed regulatory policy. Marvin testified last year on the proposed new US liquidity coverage ratio contained in both Dodd–Frank and Basel standards. He argues forcefully that the proposed LCR is complex and fraught with implementation problems when it comes to setting the correct level. The requirements may actually worsen liquidity management by financial institutions and constitute a poor substitute for monetary policy in providing needed market liquidity. In keeping with the Shadow Financial Regulatory Committee’s reactions to such requirements, Marvin’s response is to advocate for a simple leverage ratio as a better alternative. He concludes: “… rules and regulations should… be simple enough so that bankers can manage banks without being expert in complex financial regulations…. [I]f the required leverage ratio can be pushed high enough, then banks could be allowed to choose their risk assets with minimal regulations in return for commensurably higher return on equity.”[5]
Robert Eisenbeis, Ph.D.
Vice Chairman & Chief Monetary Economist
Email | Bio


[1] Marvin and I have known each other for a long time, having overlapped attending FOMC meetings for many years in our capacities as research officers and directors of research at the Federal Reserve Bank of Richmond and Atlanta, respectively.

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Richard Yamarone

Richard Yamarone sings Folsom Prison Blues
Richard Yamarone sings Folsom Prison Blues

By now many know that Richard Yamarone passed away on November 28th, 2017 at age 55. There are many of us who enjoyed his company in Montana and in Maine as part of annual gatherings of fishing, discussions, and camaraderie. We mourn his loss.

I can picture in my mind when he picked up the guitar and sang Folsom Prison Blues. I can picture him standing on the deck at Leen’s Lodge, and in the dining room at Hubbard’s Yellowstone Lodge. We plied him with a glass, or maybe two, of wine. Rich loosened up and he allowed himself the freedom to be himself. Then he had the courage to sing to us.

I can remember how loudly we applauded, how we cheered his effort.  And he had a really good voice.  He grinned a mile wide and beamed with delight.  It was a warm and tender moment for all who were there.  It is a warm and tender memory now.

Richard Yamarone, a friend, a colleague, an economist, a commentator and Camp Kotok attendee.

May he rest in peace.

Video of Richard playing guitar at Camp Kotok:

(Picture and video courtesy of Sharon Prizant.)


Philippa Dunne shares her thoughts below.

Dear Friends,

Many of you already have the heart-breaking news that the wonderful Richard Yamarone stopped breathing yesterday afternoon; he had a heart attack on Thursday morning while playing hockey with his team, his Thanksgiving tradition. A tremendous man, a tremendous friend, and a tremendous economist.

In 2009, Captain Chesley Sullenberger safely landed his crippled plane on the Hudson River. So accomplished was he that he planned to hit the river where he thought there would be no boats, telling passengers to, “Prepare for a hard landing.” I remember thinking at the time it would have been admirable if the monetary officials could have been so blunt in 2007.

Rich was. Back in the early days of the recovery he wrote, “The recent depression—ask any real economist.” He never confused the height of the markets with the state of the economy. He thought about workers and wages, inequities, rigged systems, and he worked incredibly hard. He was incisive, deep, an awesome singer, and truly hilarious. His humor made it easier to take some of his darker observations. Once he was outlining a dreadful eventuality when suddenly he noted it was odd that we were both laughing. (I’ll leave it to those in his league to cover his fly-fishing abilities.)

And he had a burly Welsh heart. Also a pilot, Rich too would have thought about the boats on the river.

Rich was 55.

In today’s note his closest friend Dave Rosenberg wrote that Rich “managed to squeeze many lives into one short one.” Josh Frankel added a lovely image, his idea for a Bloomberg late night show called “Yammy in his Jammies,” featuring Rich running down, say, the nonfarm payrolls in feety pajamas. Dean Eisen called him open and honest about himself—simple words but hard to do. Josh Rosner, “He measured others, generously, by the kindness in their hearts, but few could have truly been measured against his own.”

We loved Richard.

I dreamed last night that a mighty redwood fell in the forest.

Philippa


Please see the other links below for service arrangements and further reflections  from friends of Rich and fellow Camp Kotok attendees.

http://ritholtz.com/2017/11/rip-rich-yamarone-aka-yammy/

Condolences, Visitation, Service, and Interment information:
http://colonialfuneralhomesi.com/book-of-memories/3355190/Yamarone-Richard/service-details.php


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Merkel Matters

German Chancellor Angela Merkel faced a crisis when coalition talks broke down on November 19th. Germany could have endured months of political uncertainty, and it suddenly became possible that Merkel would be forced to resign. The German public and the world awoke to find that the continuation of Germany’s solid, centrist government was threatened. Germany’s stable government under Merkel’s leadership has underpinned the stability of Europe in recent years. Hopes for the much-needed reforms of the European Union proposed by French President Macron are unlikely to be realized without the support of a politically strong Germany. Maintenance of a politically stable Germany at the center of Europe is needed at a time when far-right challenges are arising in neighboring Poland, Austria and Hungary. Merkel’s support will also be important for meeting the challenges of Brexit negotiations and for maintaining the European Central Bank on a steady course. And with President Trump’s pulling back from America’s global leadership role and turning inward, together with the weak political position of England’s Prime Minister May, Germany’s Merkel and France’s Macron are left to uphold the liberal political and economic order constructed following World War II.

Fortunately, Germany’s president, Frank-Walter Steinmeier, has used his considerable political power to exert pressure on the various party leaders to “stop and reconsider their position.” He, as well as Merkel, strongly wish to avoid a minority government or a new election, either of which could bring on a period of instability. At the same time, a sizable number of the center-left Social Democrat (SPD) members of Parliament pressed the SPD leader, Martin Schulz, to reverse his position of ruling out the formation of another “grand coalition” with Mrs. Merkel’s conservative Christian Democrats (CDU) and their sister Bavarian party, CSU. Schulz has been forced to make a U-turn.

On Thursday President Steinmeier is meeting with Schulz, Merkel and Horst Seehofer, head of the CSU, for exploratory talks on forming another grand coalition. While there are significant differences between the parties on issues such as housing, immigration, taxes, and healthcare, it is likely that, with the pressures on them, they will be able to reach compromises sufficient to lead to a majority coalition government.

Meanwhile, the German economy, the largest in Europe, appears to be accelerating in the fourth quarter, following some moderation in the previous quarter, according to the HIS Markit Flash Germany Purchasing Managers’ Index for November, released on November 23rd. The manufacturing sector registered the strongest increase in production since April 2011, and new orders also rose the most in over six and a half years. The downside of this growth spurt is intense pressure on capacity, stretched supply lines, and accelerating increases in output prices.

Investors continued to maintain a positive view of prospects for German equities, despite the uncertain political situation. The largest German equity ETF, iShares MSCI Germany, EWG, is up 27.51% year-to-date November 27th and 1.16% over the past four weeks. At Cumberland, we are maintaining the Germany positions in our International Portfolios while monitoring political developments closely.

Bill Witherell, Ph.D.
Chief Global Economist
Email | Bio

Sources: Financial Times, HIS Markit, Wall Street Journal, Yahoo Finance


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Fed, Bonds & Interest Rates

Ben White had this to say about Fed appointments last week in his Politico “Morning Money” column:

“FED TALK – Look for the vice chair nomination to come fairly soon. Mohamed El-Erian remains in the mix but could also be a candidate for the New York Fed. John Taylor sounds like a no-go for vice chair. The White House is looking for a hard-core economist for the vice chair slot, given that with Jay Powell, Randy Quarles, and Michelle Bowman for the community banker slot, Brainard would be the only remaining economist.

“The White House could also look to fill all the remaining slots after Chair Yellen leaves, bringing the Fed board up to its full seven and giving President Trump a massive imprint on the make-up of the nation’s central bank.” (https://www.politico.com/newsletters/morning-money/2017/11/22/murkowski-looks-like-a-yes-on-taxes-030978)

My colleague Bob Eisenbeis has just written on this subject. Bob’s distinguished career has included serving at the Fed under five different chairmen. Here is the link to his recent missive: http://www.cumber.com/chair-yellen-resigns/.

What do we know?

A year from now the central bank of the United States – the lender of last resort to the US banking system and therefore to the world – will be a very different assemblage of folks than we have been accustomed to. Ten years of QE 1-2-3 and near-ZIRP are over.

What else do we know?

The last ten years of financial tailwinds are giving way to headwinds. Note that one may sail forward against a headwind by tacking back and forth. The process is slow and requires hard work. That is different from the ease of movement experienced with a tailwind.

The US federal deficit ran high for the last ten years, and aggregate US debt under three presidents has increased by nearly $11 trillion in a decade. Meanwhile, the interest expense line item in the federal budget has been flat as interest rates remained low and US debt service was refinanced at low rates. That tailwind is over.

The tax reform bill will raise the authorization to borrow and to add $1.5 trillion to the deficit. This is incremental to existing deficit projections which are already rising.  The total interest bill will be rising. The total debt-to-GDP ratio is headed for 100% with the tax reform bill addition, a level that reminds us of the end of World War II.

In its early stages, trouble in financial markets appears in places where credit and lending issues can be seen and measured. That is where to look for warnings. A partial list of such places follows, along with some stellar observations by Chris Whalen.

Chris has penned an essay on the Fed and on a bright yellow flag. He asks, “Q. Besides stocks, what asset class has benefitted the most from the radical monetary policies of the Federal Open Market Committee? A: Multifamily real estate. And what asset class most worries federal bank regulators today? Same answer.”

See https://t.co/4XvERiw8du for the discussion. We thank Chris for permission to share this with our readers. To subscribe to Chris’s The Institutional Risk Analyst, please email your request to info@rcwhalen.com.

There are other places to worry about credit risk, too. Credit card delinquencies have started to rise. High Yield spreads are very low by historical standards but are recently starting to widen.  Private equity financing of commercial real estate shows trouble spots. Note that twice as many retail spaces closed as opened in the last report period. Note empty mall and highway retail space. Note the secondary effects of these changes on employment and on city, county, and school board tax receipts.

Finally, we have the credit risk around the hot topic of Bitcoin, with its wild price fluctuations. New buyers of crypto and crypto derivatives emerge every day. Some are leveraging; thus credit risk is added to speculative risk.

Even outgoing Fed Chair Janet Yellen admits that too much QE for too long with a ZIRP can lead to difficulty.

We are in the post-Thanksgiving to New Year’s period, which is traditionally upbeat. We encourage you to enjoy the season – but when you ring the bell, we advise you not to drop it on your foot.

Our Cumberland US stock market ETF portfolios are now overweight the smaller and mid-cap area. Our overweight of Tech has been reduced.

Our bond accounts emphasize higher-quality credit, and we are not chasing the high-yield space.

We expect a tax reform bill to pass both houses of Congress and to be signed into law. Political leaders are desperate to produce it, so they will do anything to make a deal and get an “aye” vote.

Next year portends rising volatility and massive political swings of sentiment as we run up to the midterm elections.

Current polling suggests that the Democrats may capture the House majority and thus chair all House committees. An impeachment bill is likely if they prevail.

2018 promises to be an interesting year.

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


Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

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Chair Yellen Resigns

To no one’s surprise, Chair Yellen has announced her intention to resign effective upon the swearing in of her successor, Jerome Powell. Since Governor Powell’s confirmation hearing is set for November 28 of this year, it is possible for him to be confirmed and sworn in before the January 30–31, 2018, initial FOMC meeting, meaning that there could be only three sitting board members at that meeting. While most of the commentary between now and then will likely focus on Chair Yellen’s legacy, more relevant going forward are the implications of her leaving and the effects that efforts to fill the vacancies will have on policy during 2018.

The prospects are slim that any of the four vacancies can or will be filled in the very near future, perhaps not even as soon as mid-2018. First, there is the new requirement that was included in the reauthorization of the Terrorism Risk Insurance Act in 2014 requiring at least one board member to have supervisory or work experience in a community bank with assets of less than $10 billion. According to the WSJ, since the Trump administration has taken office, at least three potential candidates for this seat have actually turned down the position or withdrawn themselves from consideration because of financial divestiture or related requirements.1 This requirement is likely to take time to find an appropriate person; but once filled, that person, because of his or her background and work experience, is not likely to be major contributor to monetary policy and is more likely to focus instead on regulatory issues in cooperation with Vice Chairman Quarles.

As for the other vacancies, numerous names have been floated, but none have as yet been advanced. Who is chosen and what their backgrounds are will critically determine the path of policy. Once Chair Yellen is gone, there will be only one PhD economist, Lael Brainard, on the Board. We have written before that the dearth of economists on the board will put more emphasis on the board staffs’ recommendations, since the staff run the models for the Greenbook and prepare the policy options discussions in the Bluebook. The lack of a deep background in economics, econometrics, and the nuances of economic modeling will be a big disadvantage for the new Chair and non-economist appointees. In the case of the chair, the last three recent Fed chairs have all been economists.

Then there is the question of the politics of the upcoming appointments and the approval and vetting process that must take place before even a Senate confirmation vote can take place. Senate Democrats may not be able to block Fed nominees, but they can certainly delay consideration by employing a variety of tactics. There is always a possibility that Senate Democrats may choose the Fed appointments as the opportunity to retaliate against Republican strategies on both healthcare and tax reform.

So what happens to policy in the meanwhile? This is where the makeup of the FOMC and how the voting presidents position themselves will be important. There are five voting presidents. President Dudley, who is an economist but will also be leaving mid-year, is a permanent member. He has consistently voted with Chair Yellen and the majority, who have favored a gradual and patient approach to policy. He will be joined in 2018 by three other bank presidents who are also accomplished economists. They are President Bostic (FRB Atlanta), President Mester (FRB Cleveland), and President Williams (FRB San Francisco). The first vice president of the Federal Reserve Bank of Richmond will be the fourth member until a new president is selected.2 The Richmond Bank has had an economist as its president since 1972, so it is hard to see it breaking precedent at this time.

President Mester noted in a recent speech that she believes policy has achieved its employment objective but not fulfilled its inflation mandate. However, while she believes that it will take more time for inflation to reach the 2% target because of the lags in monetary policy, a continuation of the gradual increases in the policy rate seem appropriate at this time.3 In other words, she is comfortable with a path of gradual increases in the policy rate, consistent with the FOMC’s SEP rate projections.

John Williams has recently gone on record with the view that the economy is facing a “new normal” in which real interest rates are still quite accommodative, the equilibrium nominal short-term rate is about 2.5% (2 percentage points below the historic norm), unemployment is low, and real growth potential is about 1.5%, a consequence of low productivity growth and slow growth in the labor force. This view suggests a very cautious approach toward the management of interest rates and one that is heavily data-dependent.4

Finally, there is the newest FOMC member, President Bostic. His views echo much of what President Mester and President Williams have observed when it comes to the state of the economy and his dissection of the failure of the FOMC to achieve its inflation objective. He did observe that he doesn’t think policy has been too accommodative because, if it were, inflation pressures would be stronger than presently observed. However, he also indicated that, given the present state of the economy, he would not be uncomfortable with another rate hike in December, barring data suggesting otherwise.5

We glean from these remarks that the three incoming voting presidents on the Committee view policy as being on track and that all are comfortable with a gradual path for policy rate increases. At the same time, they all tend to see an equilibrium with lower inflation and lower economic growth in the near term. These are views consistent with those voiced and supported by incoming chairman Powell. Of course, there is considerable uncertainty concerning the likely path for inflation, and this was a major focus of Chair Yellen’s NABE speech this week. She expressed the view that inflation may be persistently low for some time and as a result policy may have to be more accommodative. Indeed, we have seen that uncertainty manifested in the continual write down of the FOMC’s expected terminal policy rate in its Summary of Economic Projections.

So at least for 2017, we should see – especially given the 3% real GDP growth in Q3 – a rate increase in December and a coalition of bank presidents and Chair Powell embarking on a cautious approach to policy in 2018, with two or possibly three more hikes, at the most, during the year.

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

References:
1 https://www.wsj.com/articles/trump-administration-struggles-to-find-community-banker-for-fed-board-1498555801
2 President Rosengren is the alternate member for the Richmond Bank, and he too is an economist.
3 https://www.clevelandfed.org/en/newsroom-and-events/speeches/sp-20170907-views-on-the-economy-and-monetary-policy.aspx
4 https://www.frbsf.org/our-district/press/presidents-speeches/williams-speeches/2017/october/whats-the-future-of-interest-rates-the-answers-in-the-stars/
5 http://marketrealist.com/2017/10/raphael-bostic-lessons-from-unconventional-monetary-policy/


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Thanksgiving and Mythology

Our American mythology of Thanksgiving is imparted to us as schoolchildren, or at least it used to be. The Pilgrims had voyaged to North America on the Mayflower to escape persecution and had been in Plymouth, Massachusetts, less than a year. They were hungry. A cold winter was setting in, and they lacked food. The Native Americans there, the Wampanoag, befriended them and welcomed them to a feast. Turkeys were plentiful in the woods and harvest time provided ample sources of food.

The mythology of American Thanksgiving was born in 1621. The holiday was made official by President Abraham Lincoln’s proclamation in 1863, in the midst of the Civil War. What began as a uniquely American holiday is now observed in Canada and in a few other countries, such as Liberia. The holiday celebrates the values of sharing and mutual respect, of caring for the hungry and inviting the persecuted to find respite, of admitting strangers into our lives – the list of positive values is very long.

Meanwhile, almost four centuries after that first Thanksgiving feast, the American news flow is clotted with tales of American Senators and wannabe American Senators and sexual harassment and internecine political threats. And we are treated to story after story about American serial killers and shootings in American churches and mass killings at American concerts. Add to all that the torrent of bad news from around the world. A few instances that spring to mind are the promises of nuclear murder by Kim in North Korea, the threats to the Catholic Church by jihadists, and the march organized by Nazi sympathizers in Warsaw.

Here in America we also witness denials of despicable behavior by political leaders of both major parties that govern our nation. These are the same leaders we look to for domestic and global solutions.

We are besieged by nastiness and bitterness and fear, which are rife in our politics and rampant in our media. So we look for places to hide – in Turner Classic Movies or in the “The Voice” or in the football games we enjoy.

I was looking for a metaphor from antiquity to capture the news flow of the 2017 American Thanksgiving. I stumbled across the familiar story of Persephone. In Greek mythology, she was the daughter of Zeus and queen of the underworld. In Roman tradition she was called Proserpina (Proserpine).

She was abducted by Hades (Pluto), who made her his queen. For four months of each year the world would lie barren as Persephone’s mother, Demeter, goddess of the harvest, mourned the loss of her daughter to the shadows of Pluto’s underworld. But with Persephone’s annual return to the sunlight world came spring that would segue to summer and abundance. The late and great chronicler of mythology, Thomas Bulfinch, describes what happened when Venus instructed her son Cupid to shoot the dart that triggered the abduction and rape of Proserpine by Pluto. Bernini’s magnificent sculpture depicts this story, too. I have admired that sculpture, which is found in the Borghese Gallery in Rome. It is a must-see for any visitor: https://en.wikipedia.org/wiki/File:The_Rape_of_Proserpina_2_-_Bernini_-_1622_-_Galleria_Borghese,_Rome.jpg.

So why introduce this ancient story, difficult and troubling (not unlike the news flow in 2017) as we approach our uniquely American holiday of Thanksgiving? The myth of Persephone is certainly a story of violation and destruction; yet it is also a story of resilience, recovery, and renewal. And as ancient Greeks found solace and hope in the return of spring, we can also find solace and healing in the microcosms of American life.

A group of us (seven people) recently went on a post-hurricane fact-finding visit to Key West and five other Keys. On Big Pine Key we saw folks rebuilding their lives and houses and neighborhoods after the devastation Irma inflicted. My colleagues and I interviewed them and heard their stories of survival.

We encountered and supported the American philanthropy that is assisting them. Not government action, which is slow and tedious. Not fights between insurers over whether the damage was done by wind or by water. No, this is philanthropy from organizations with good governance that direct 100% of the money raised to the beneficiaries. This is assistance from organizations that have internal anti-cronyism rules. That is what we saw at work.

In Big Pine Key, you can stand on a road where the water level from the storm surge was at one point many feet above your head. I stood there. The devastation around me was nearly total and measurable in tons of debris.

But the resilience of the local folks is a magnificently positive force, an expression of the American spirit. We are thankful for it.

So there are two metaphors in this missive. In the first, Pluto emerges from the darkness of the earth and abducts Proserpina, whose periodic return results in spring, summer, and harvest. In the second, the Florida Keys are engulfed in a great storm born out of the ocean but are now recovering and rebuilding.

Water and wind are being rebuffed by human spirit. Please note that many volunteers from around the country have traveled to the Keys at their own expense to help with the cleanup and rebuilding. Our group talked with six of them.

The American Thanksgiving spirit is not extinct. We celebrate its endurance – in spite of the political leadership we have elected. And most of us go on about our daily lives in a positive, constructive, neighborly way, even as we also worry about the ugliness that seems so pervasive.

I’ll end with a quote from a British poet, Algernon Charles Swinburne (1839–1919), an excerpt from “The Garden of Proserpine.” The poem seems to encapsulate our present, conflicted world even though it was penned at about the same time that Lincoln proclaimed Thanksgiving as a national holiday.

At the beginning of his elegy, Swinburne writes:

“Here, where the world is quiet;
Here, where all trouble seems
Dead winds’ and spent waves’ riot
In doubtful dreams of dreams;
I watch the green field growing
For reaping folk and sowing,
For harvest-time and mowing,
A sleepy world of streams.

“I am tired of tears and laughter,
And men that laugh and weep;
Of what may come hereafter
For men that sow to reap;
I am weary of days and hours,
Blown buds of barren flowers,
Desires and dreams and powers
And everything but sleep….”

And near the end of the poem, he writes:

“From too much love of living,
From hope and fear set free,
We thank with brief thanksgiving
Whatever gods may be
That no life lives for ever;
That dead men rise up never;
That even the weariest river
Winds somewhere safe to sea.”

We wish our colleagues, clients, and readers a pleasant Thanksgiving respite and a safe holiday journey.

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


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Key West, Bob Bunting

Bob Bunting, a friend and accomplished professor whose expertise includes hurricanes, joined our small, fact-finding group on a trip to Key West and five other Keys that were hit by Hurricane Irma. Here is his narrative of the trip, which he has agreed to share with our readers. We thank Bob for joining us and reflecting on his findings.

On Monday, it was my privilege to accompany David Kotok, a small group of thought leaders and the press to Key West in the wake of Hurricane Irma. David, an avid fisherman, was concerned about the recovery of a small but important group of people who are professional fishing guides. As an atmospheric scientist and a former senior manager not only at NOAA but also at the National Center for Atmospheric Research, I was intrigued. Much of my life has revolved around studying, researching, and predicting severe weather events, especially hurricanes. When I was five, Hurricane Carol struck and damaged my childhood home, scaring my family. That was the moment I knew I wanted to be an atmospheric scientist. As life evolved, other interests have entered, but all have leveraged patterns and predictions as the baseline.

My takeaways from this personally impactful visit to Key West and the lower Florida Keys are far-ranging, and David asked that I share them with you.

With Hurricane Irma leading a record September for hurricanes in the Atlantic, the media was “all hurricanes, all the time.” But how quickly we forget disasters as the news cycle becomes shorter and shorter in the age of social networking, tweets, and 30-second sound bytes. The communications revolution seems to have reduced people’s ability to focus, and as a consequence very little is ever reported about the aftermath of serious disasters like Irma and Maria. That is too bad, in my view. Our visit was rich and impactful and much more interesting and educational than what we are exposed to in the daily blur. How I long for in-depth reporting.

Expectations of the government’s role in disasters have certainly changed over time. Government was created to protect life and property as its first and most important mission. It is not the government’s job to repair all the damage and rebuild once the initial disaster recovery phase is over. This is what I was told when I was forecasting severe weather events for NOAA.

The expectation of a bigger, more costly government role is hurting actual recovery processes. The real recovery structure starts with government, but the handoff after the initial phases is to a complex network of organizations, helpful volunteers, and storm victims, each with different strengths, weaknesses, and time frames.

Upon our arrival at the still lightly damaged Key West International Airport, our host Doug, a leader of professional fishing guides, began an all-day tour. He masterfully guided us as we observed how the hurricane and its aftermath had impacted the venerable and important economic subgroup of professional fishing guides.

Our first stop is a great-looking fishing retail store in downtown Key West. The owner laments that he is waiting for customers who are not coming because their impression is that there has been great damage to Key West.  Key West, 30 miles southwest of where Irma’s eye made US landfall, did sustain damage, but most repairs are complete and the town is open for business.

Next we see Doug’s house, further north and closer to ground zero where Cat 4 Hurricane Irma roared ashore.  As we pull up to his home heavy damage is evident, and the sights and sounds of workmen rebuilding create a memorable scene. Doug says he is experiencing a “too long” lull in business and explains with a half simile that he is “self-insured.” Sadly, while the hurricane was bad, the lingering perception created by media hurricane coverage continues to amplify the negative economic impact some two months after landfall.  The fish, not knowing any of this, are reported to be biting strongly.  Too bad the fishermen are not enjoying themselves here on this nearly perfect day!

Now it’s on to Big Pine Key – ground zero – some 12 miles further north.  It’s two months since landfall and we see massive damage, piles of debris, boats strewn along the roadways, one painted with “Do Not Remove.” Then more visuals, including, wrecked cars, every conceivable household item, piles of broken mangroves, and mangled street signs, one reading “Do Not Dump: $500 Fine,” next to a field of small American Flags.  Goosebumps!

This is where John, a guide with a wife and two young children, once lived. John did not want to join us in his ruined neighborhood where we met the Millennial philanthropists. He and his family are in temporary housing supported by cash philanthropy of the Guides Trust Foundation. But meet him we would at the end of this memorable day!

Money plays a critical role in recovery, but actual human assistance should not be underrated. On Big Pine Key we fortuitously crossed paths with a group of Millennials that were highly motivated to help. Going house to house, helping folks in need and sleeping in a nearby church, these young people were having a wonderful time with one another while doing great service. What a human interest story and one that has been totally missed by the media, which has long departed. BTW, this Y generation is often talked about as being both entitled and spoiled.

While I can attest to those attributes after having taught about a thousand of these young adults in my entrepreneurship classes at the University of Colorado Leeds School of Business, it is also fair to say that they are focused on helping the world be a better place. They should get credit for that! The cadre of young adults on Big Pine Key are building self-esteem and perfecting the ability to communicate socially without devices. This experience will serve them well in a 30-second-soundbite and multi-megabyte world!

All of this is “good news,” and we need to focus on more on it. The media outlet news cycle seems to recognize only political controversy and deviant behavior, while real news stories like this one are not of interest. Having met thousands of people, my guess is that 95% of them are caring, helpful, and good-to-great human beings. Such is the case in Key West, where people have pulled together in the face of great adversity and have become closer, more optimistic, and grateful!

I have questions running though my mind. Isn’t it ironic that gratitude sprouts when times are tough? What ever happened to in-depth reporting? Is it a victim of rapid communication and our multitasking society? Is the communications revolution really increasing communication or making us more remote because human interaction is not needed and perhaps not wanted? I continue to ponder.

After lunch at the No Name Cafe we stop at National Key Deer Refuge. The park ranger assures us that the wildlife and biota are all recovering nicely but says they had to truck in water for the deer because after the storm the water was too salty. Interesting!

As we head back toward Key West, iguanas are darting across the road.  They somehow found their way to the lower Keys and seem to be flourishing on the hibiscus. We pull into a small waterway, where John, the guide without a home, boats in and begins talking with us.

Still worried but not afraid, he is bubbly and optimistic about his family’s future and displays solid determination despite many issues with business and rebuilding his home.  After two months, he still waits for FEMA and the insurance companies to get to his case. His children are in a new school and the family is comfortable, thanks in part to a gift from the Guides Trust Foundation. I am struck by his clarity, resolve, and gratitude in what is a nightmare situation. His children are not afraid of hurricanes but wonder when the next one will hit. John says he has experienced three hurricanes in the past 18 years or so.

He says there is only one thing he hopes will not go back to its pre-storm condition, and that is the connection he now has with his coworkers in the guide business, not just on the Keys but all over.  I realize that John has gained something special from the disaster that took away his home, damaged his livelihood, upset his kids’ schooling, etc. Watching him, I wonder why society is so averse to experiencing setbacks that provide such meaningful learning and growth.

Hurricanes are ever-fascinating, so magnificent in organization, scope, and awesome power – but so scary when they are headed toward you! To see the gradient of damage from downtown Key West to Big Pine Key was amazing, even to someone who has flown into hurricanes. Destruction was contained in Key West but almost beyond belief in Big Pine Key just 29 miles away, where a 10-foot storm surge and 130 mph winds created an unearthly scene. As an atmospheric scientist who is one because of a hurricane long past, I am certain I followed the right path.

The piles of debris are memorable. The fact that we humans lead lives that are defined in part by artificial “needs” and the consumption a lot of stuff hit me. I am told that 1.2 million cubic feet of debris has been removed from the area north of Key West, and it looks like millions more are still waiting for removal. It will take time.

It is remarkable how well the infrastructure did in the face of the storm, even on Big Pine Key, confirming that hurricane-prone areas need to be built using methods and materials that ready them for storms. A few weeks after Irma, Maria hit Puerto Rico. The impacts were similar, but the outcome was different.

Clearly, investments in infrastructure in the Keys have provided a strong backbone, but Puerto Rico lacked that advantage. My takeaway is that governments can function well at strategic levels if the people running them are capable, honest, and motivated to protect. After all, this is the #1 function of government.

As we took off in the Twin Air for our trip back to Sarasota, I looked back at the runways and a view of the beautiful Keys just before sunset. I am ever more clear as to how what happened on Big Pine Key could have happened on Longboat Key/Sarasota, where the forecast was for a Cat 5 hit with a 10-foot storm surge. A very small change in path happened as Irma moved over Big Pine Key – that jog to the north drove Irma inland east of Longboat/Sarasota by about 30 miles… the same distance that separates Key West from Big Pine Key! So grateful!

In closing, I am surprised at how much this trip inspired me. First we saw devastation, then we observed that the initial government-led recovery, followed by a complex web of nongovernmental help backed by individual and organizational philanthropy and victim self-help, seems to be working – more proof, in my opinion, that we can do anything we want once we decide what we want to do. What a Good News story!

Bob Bunting
CEO, Waterstone Strategies
bobsstocks.com

Pledges to the Guides Trust Foundation can be made through their website: http://guidestrustfoundation.org/memberships-donations.cfm


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Tech Sector: Bubble or Not?

Seventeen and a half years ago, on April 1, 2000, we published a piece entitled “Will the NASDAQ sell-off become a crash?” We have now retrieved that piece from our archives and posted it on our website. Here is the link to the original piece: http://www.cumber.com/pdf/nasdaqpe04012000.pdf.

In preparing that piece in 1999–2000, we evaluated the stock market at the time and made a theoretical calculation in which we merged two companies, Cisco and Microsoft. We assumed that their reported earnings were accurate. We found that the two companies together had reported earnings of $10 billion, and their merged theoretical market valuation amounted to $1 trillion. Our conclusion at the time was fairly straightforward: There was nothing wrong with either company. Both Cisco and Microsoft were fine, large, developing, worldwide leaders in the Technology sector. The stock price, however, was wrong. At 100 times earnings, the price of the theoretically merged company’s shares was not justified by any valuation technique. The combined GDP of all countries in the world was estimated at $30 trillion at that time.

We concluded in our piece that the NASDAQ at 5000 was setting up for a crash. The fourth page of that 18-year-old piece measures the value of Cisco against a list of companies (that list included Apple). Take a look at that list, and you will see that Apple had a market cap of about $23 billion and Cisco had a market cap of over $500 billion.

Eighteen years ago we forecast that the NASDAQ 5000 would lose over two-thirds of its value before the crash and the sell-off ran their full course. Never did we think that the result would be a loss of 80% of its value from peak to trough.

Today, we hear a constant litany about technology stocks, and we are questioned about the current time as a replay of the bubble that occurred almost two decades ago. Acronyms like FANG and FAANMG and others are used to aggregate the large-cap tech stocks like Facebook, Amazon, Alphabet (Google), Apple, and others. The collective weight of the Tech sector today is about 25% of the total stock market weight of US stocks. And the value of the entire US stock market in relation to the US GDP is now at the highest level ever, with the sole exception being the tech stock bubble period of 1999–2000. By the way, the 25% weight threshold has marked the top or close to the top of every sector’s peak, not just Technology’s.

We can also note that the market cap of Apple is approaching $1 trillion. And we see Apple now with a forecasted earnings rate that will be four times the earnings noted in the study done nearly two decades ago. If Apple can meet the expectations about its new products and services and worldwide growth, one can argue that it will go higher in stock price and that the earnings and revenues will continue to grow. The same can be said for others in the Tech sector.

So is the current Technology sector a bubble?

Yes, it is if the earnings don’t grow or start to decline. No, it isn’t if the growth rate continues. Which will it be? Determining an answer to that question requires assumptions and estimates, which are the bread and butter of security analysis.

Our conclusion is that the pricing of stocks in the Technology sector currently reflects market prices of assumed good outcomes. The positive outlook for these companies is mostly priced in. In order for them to continue their stellar stock performance, they need to continue to produce the earnings growth that has powered them to the present level.

This set of circumstances is different from the tech stock bubble of 1999–2000. Then you had companies that had no profits and sported market caps in the billions. Instead of price/earnings ratios, we had price/fantasy ratios. Note that in my study written 18 years ago I ignored the companies that were not earning money and eliminated them. That is why the study focused on Cisco and Microsoft at the time it was written. They were real companies with real earnings. The same is true for the present mix of FAANMG.

In our managed portfolios we had carried an overweight position in the Tech sector with pleasant results. We have ratcheted that back.

Will the stock market give us a correction and an entry? Maybe. Will we be reallocating to other sectors? Maybe. Are we abandoning the Tech sector, or just rebalancing the weight to reduce the risk of heavy concentration? Yes, it’s the latter.

Of course, any of this may change at any time.

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


Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

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