Brexit Update – The Irish Roadblock

Significant progress is needed on three “divorce” issues – the future rights of EU citizens in the UK and UK citizens in the EU, the UK’s financial obligations to the EU, and the future border between Northern Ireland and the Republic of Ireland – before the Brexit negotiations can move to the important stage of future trade relations and a transition period. While difficult discussions still are required on the first two issues, agreement on them appears to be achievable. The Irish border issue, however, has suddenly emerged as a serious obstacle to the negotiations.

The Republic of Ireland has moved to bring the border issue to a head now, strongly asserting that it agrees with the European Commission in seeking, before negotiations can proceed, an explicit guarantee from the UK that no ”hard border” requiring border checks will divide the island of Ireland. Dublin is also calling for a five-year transition. The UK also does not want to see a hard border across Ireland but has yet to put forward a realistic proposal on how to avoid this implication of its intention to exit the EU single market and customs union. The Republic of Ireland will remain a member of the EU and continue in the single market and customs union, whereas Northern Ireland is part of the United Kingdom.

Dublin has called for Northern Ireland to continue to apply the rules of the EU customs union and the single market. Brussels is similarly arguing that Northern Ireland may have to remain within the customs union and single market if the border is to remain without barriers. The UK has rejected these ideas, which would pose a threat to Britain’s “constitutional and economic integrity,” presumably because the result would be a hard border within the UK between Northern Ireland and the rest of the UK. Yet the UK has repeated that the 1998 Good Friday peace agreement must not be undermined and a return of a hard border to Ireland must be avoided.

This border issue is of great importance to both the UK and the Republic of Ireland. During the 20 years that the border has been open, free of barriers, trade between the UK and Ireland has grown to 65 billion euros annually, benefitting both Northern Ireland and the Republic of Ireland. The two economies have become increasingly integrated with supply chains crossing the border. The necessity of maintaining the Good Friday Agreement is obvious, and the open border has great political significance for this agreement. Dublin’s demands are understandable. As member of the EU, they are a party to the negotiations, which gives them a role in determining the outcome. It is in their interest that a deal between the EU and the UK be reached in the end, for a “no deal” outcome would be very damaging to Ireland.

In the next several weeks the UK’s government under Prime Minister Theresa May has to produce sufficient progress on the border issue as well as on the other two “divorce” issues noted above to convince the EU at its December summit to begin discussions on future trade relations and a transition arrangement. Meeting this challenge is made more difficult by the necessity of the UK government to depend on the support of the Democratic Unionist party of Northern Ireland. May’s tiny majority is also threatened by internal strife within the Conservative Party, which appears to be at war with itself. Her cabinet includes both pro-Europe “remainers,” ministers who would like the UK to remain in the single market, and “leavers”,  ministers who are pushing for a hard exit, leaving the EU without reaching a deal. May’s leadership is being openly challenged by her foreign secretary, Boris Johnson. He is said to be the leader of some forty eurosceptic Conservative Party MPs ready to sign a letter of no confidence in the prime minister. They certainly will not be pleased by Mrs. May’s commitment this week, in a move towards meeting demands from the remainers in her party and in the Labor Party, that Parliament will eventually have the opportunity to vote on the final Brexit deal, a withdrawal agreement and implementation bill. And should a general election become  necessary, the Labor Party, with its unclear positions on Brexit issues, could well win.

There are increasing concerns about the timetable and the possibility that, in the end, no deal will be reached. The political disarray in the UK gives good reason for doubts in Europe that the UK government will be able in the near term to make the necessary credible commitments for negotiations in order to move to the next phase. The EU’s chief negotiator, Michel Barnier, has warned that “everyone should get prepared” for the possibility of a collapse of Brexit negotiations and a hard exit. UK and European business leaders have warned of the damage that no deal would be to trade for both the UK and Europe. They have pressed for a transition deal that preserves the status quo. A group of major financial institutions with operations in London have warned that “a point of no return” is fast approaching for decisions on moving jobs, capital, and infrastructure if no acceptable transition arrangement is agreed within the next three months. There are estimates that foreign banks in London have developed contingency plans for moving as many as 10,000 jobs. The stakes are indeed high for the City of London.

Thus far the UK economy has held up better than might have been expected. GDP growth for both this year and 2018 looks likely to be at an annual rate of 1.5%. But in a period of strengthening global growth, the UK’s economy’s performance has been relatively sluggish compared with other advanced economies. Consumers’ spending power has been squeezed by a significant uptick in inflation while nominal wage growth has remained subdued. Brexit-related uncertainty has kept business investment flat, and this headwind looks likely to increase.

UK equities have also done fairly well considering the high uncertainty over Brexit and the domestic political situation. The iShares MSCI United Kingdom ETF, EWU, has gained 16.8% year-to-date, November 13th. This performance is significantly below the average for advanced-economy markets outside of North America. The iShares MSCI EAFE ETF, EFA, which covers these markets, has a year-to-date return of 22.58%.

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

Sources: Financial Times, The Economist, Oxford Economics, ETF.com, Yahoo Finance


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Tax Reform?

“The only difference between death and taxes is that death doesn’t get worse every time Congress meets.” – Will Rogers (source: BrainyQuote.com)

The “Chairman’s Mark” is a 247-page document that outlines the items for consideration by the Senate Committee on Finance Markup.  They convene this week. Here is a PDF of the document: https://www.finance.senate.gov/imo/media/doc/11.9.17%20Chairman’s%20Mark.pdf. According to a press release, this committee “has the largest committee jurisdiction in either chamber of Congress, oversees more than 50 percent of the federal budget and has jurisdiction over tax, trade, and healthcare policy.” It is chaired by Senator Orrin Hatch (R-Utah).

Readers who are following the tax reform debate closely know that the target for passage of any tax bill is to get the changes in the tax code to “score” at less than a $1.5 trillion additional deficit when applying the 10-year forward rules. These complex rules are a product of our political system. Like it or not, this is how we function.

Here is a PDF of the scorecard for the current tax bill: https://www.finance.senate.gov/imo/media/doc/11.9.17 JCT.pdf. Set aside your political leanings, if you can, and examine the spreadsheet. On these pages are the details wherein lies the “devil.” Notice that the final number is -$1,495.7 billion. In other words, if this list were to be enacted as it reads, the bill would fall just barely within the $1.5 trillion limit that allows passage by the Senate with a simple majority vote. Passage by the Senate would then allow a simple majority vote of the House to agree.

An alternative would be passage in each chamber and then a conference committee report that would require negotiation, followed by a return of the bill to each chamber for a straight up or down vote. Again, a simple majority in each chamber would be enough if the additional deficit stays under the $1.5 trillion 10-year score.

Here is one example of 10-year scoring. Look under section II, Business Tax Reform, H.2. On that line, entitled “Repeal of advance refunding bonds,” the estimated budget impact is listed for each year of the 10-year period. The 10-year total appears at the far right. According to this estimate, a repeal of refunding in the municipal bond arena will reduce the federal deficit by $16.8 billion over the 10-year test period.

Here is another example. Look at section I, Tax Reform for Individuals, F. That line is entitled “Repeal of the Alternative Minimum Tax on Individuals.” According to the scorecard that repeal would lower federal tax revenues, which is why the score is a negative number of $706.7 billion over 10 years. The negative number means that passage of this item increases the deficit.

I will leave the rest of these details to readers who wish to dig deeply.

We have some takeaways.

First, the tax code will not be made simpler by this bill, and the implementing of a postcard tax form is a political gesture that means nothing. In the details of the scorecard one can detect the work of the many lobbyists who are trying to influence the item they are focused on for the special interest group they represent.

There is a debate about whether a political deal can be reached on a tax reform bill. There is additional debate over which versions will prevail and how the process will ultimately be resolved among the forces in the House, the Senate, and the White House. All this is our system at work.

Here is our guess.

We think the recent elections demonstrated how weak the Republican Party is and how much damage has been done by the President’s belligerent style. Republicans were trounced by Democrats.

The Republican leadership fears a tidal wave of Democratic victories in next year’s midterm elections, so they are desperate to pass a tax reform bill, no matter how the details affect policy decisions. But to get that victory, they have to find enough to agree upon. And those Republicans who have decided to retire next year have no motivation to be party loyalists. They can vote as they see fit. We believe they will.

In addition to those who have been prominent in their disputes with Trump, there are others who are quietly voting their conscience and owe nothing to this president. An example is Frank LoBiondo (R-NJ), who has announced his retirement. Disclosure is needed. I know Frank personally and have for many years, including a long period before he ran for Congress. I encouraged him to run and have supported him. It will be our loss when he retires. He was willing to run in 2016 without endorsing Trump. That was a tough thing to do, but he applied his conscience, as he has over the years. There are others like him. Some are retiring from Congress in 2018, and while they may not make national headlines, their votes will count for the next year.

My conclusion is that there will be a tax reform bill. The Republican leadership must have one and will compromise to get it, no matter what they have to exchange for the necessary votes. I also believe that Trump will sign any tax reform bill that makes its way to his desk. He is desperate for a victory. He will claim all sorts of wonderful political gains. Such is the nature of political hyperbole.

What that final bill will look like is still not clear. A thousand elements are being haggled over, one by one.

We also believe that the deficit will grow. And we expect that the out years are going to see a deficit measured in trillions, not billions. What that means for interest rates is harder, since interest payments on the federal debt suppress the ability to spend in other sections of the budget. In the past 10 years (during Bush’s final years, Obama’s full term, and the first year of Trump’s), the federal government increased its total outstanding debt by over $10 trillion. Meanwhile, the interest bill for the federal budget remained about flat, at or near $400 billion a year, held in check by the decline in interest rates to near zero and the sustaining of that very low level for nearly a decade. That meant the government got to refinance its higher cost debt as well as issue new debt at very low rates.

That’s right. We borrowed an additional $10 trillion from ourselves and the rest of the world. Yet we did NOT add to the cost of debt service, because of the interest rate policy applied by the Federal Reserve.

Now that party is coming to an end. The Fed is slowly raising interest rates. The government is increasing its deficit (read: borrowing). And the Fed is also shrinking its balance sheet, which means a gradual transfer of federal debt back to market agents around the world.

Add to that mix a so-called tax reform bill. These are a lot of moving parts.

We are cautious. We think policy outcomes are highly uncertain. For us at Cumberland, this is an extremely challenging time to manage portfolios. The key is to preserve capital and to reposition rapidly when circumstances change.

Let’s end with two historical judicial references about taxation.

“The power to tax involves the power to destroy.” John Marshall (1819) McCulloch v. Maryland

“The power to tax is not the power to destroy while this court sits.” Oliver Wendell Holmes, Jr. (1928) Panhandle Oil Co. v. Knox

David R Kotok
Chairman and Chief Investment Officer
Email | Bio


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More on Bitcoin

Following up on our recent commentary, and with permission, we continue to quote the excellent work of Nick Colas and Jessica Rabe of DataTrek Research. We encourage readers to give their newly launched service a try. Their website is http://datatrekresearch.com/.

In this segment, Nick focuses on the question “Are cryptocurrencies an asset class?”

“Over my 30+ year career on Wall Street, I have seen scores of investments touted as an ‘Asset Class’. A few examples: US farm land, rare cars and watches, equity market volatility, livestock, high-end real estate, diamonds/rare gems, Asian and other antiques, and expensive artwork. Typically, such chatter picks up after a strong run-up in prices and feels like the smart money looking for an exit rather than a legitimate opportunity.

“For the fiduciary-minded investor, ‘Asset class’ has a very specific and important connotation/meaning. To reach that level of recognition, the assets in question should:

“• Be comprised of investments that have common fundamental characteristics and robust regulatory/legal structure

“• Be large enough in aggregate size to allow institutional liquidity, although this can vary depending on the investment (US equities vs. real estate, for example)

“• Provide non-correlated returns to other asset classes because of their unique fundamentals, so as to provide the benefit of diversification to asset owners

There is a lot of excellent academic work out there which analyzes investments through the lens of ‘Asset Class’, going all the way back to the 1980s (Gary Brinson et al are the most cited). Over the years, most institutional investors have adopted this work, making it a cornerstone of their investment process. The need for higher returns drives allocations to equities, for example. More conservative portfolios own more bonds. Cash, real estate, currencies, and commodities round out the menu. A place for everything, and everything in its place…

“Do cryptocurrencies like bitcoin meet the definition of an ‘Asset class’ for investors that care about that designation? At the moment, the answer has to be ‘No’. A few reasons why:

“• They are too small. The combined market cap of all crypto currencies is just under $200 billion. Compare that to just a slice of the fixed income asset class – US sovereign debt – with $14+ trillion outstanding. Or US stocks at $20+ trillion.

“• Cryptocurrencies do not yet have as robust a regulatory framework around them as stocks, bond, currencies or other traditional asset classes. Some prominent financial markets professionals even think that governments may eventually ban them. No one talks that way about stocks and bonds.

“• Cryptocurrency exchanges and wallet operators around the world operate with varying levels of know-your-customer and anti-money laundering laws. There is no absolute assurance, for example, that a bitcoin you just purchase online didn’t have a member of the North Korean military or Iranian Revolutionary Guards ultimately on the other side of the trade.

“• An asset class needs some level of homogeneity among its constituent investments. GM and Facebook are wildly different companies, but the equity of each represents the same type of claim on residual corporate cash flows. Bitcoin and Ethereum – the two largest cryptocurrencies by market cap – are not the same in terms of structure or purpose. In fact, they aren’t even close.

“• There is not enough history to assess the price relationship between cryptocurrencies to other asset classes. Investors responsible to asset owners need a track record of prices to determine its ability to deliver diversification. There is no shortcut for this requirement.”

We stand by our concern that the mathematically derived crypto has no store of value mechanism since it can be replicated infinitely. The proof is found in the increase in ICO numbers which suggests there is no limit to creation and hence price discovery is a function of speculation and momentum.

Meanwhile, Kerry Smith, a retired Stanford law graduate and serious student of the electricity grid, emailed an observation about how crypto is a large consumer of electricity. He notes that risk.

We contrast it with a gold linked token which can use block chain successfully but is not subject to the electricity constraint. We shall see if gold tokens catch on. The turmoil in the Middle East may be the catalyst.

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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Bitcoin, Gold & President’s Approval Ratings

Readers have seen us previously comment on the developing Bitcoin-crypto phenomenon. And our clients know that we are not investing in crypto today but are watching this carefully. Our clients also know we have a position in a gold-miner ETF. Our email from clients, media, and readers has the Bitcoin versus gold argument and the evolution of crypto at the top of the topic list. There is a lot of buzz.

The buzz is not surprising when a new financial element appears whose price fluctuations can be $1000 in a week. Interest in Bitcoin and crypto in general is expanding at an exponential rate, and the range of opinions for crypto can fill a chasm. At one extreme is the “tulip mania” assessment of crypto. We discussed it last month. See: http://www.cumber.com/tulip-fever/. On the other extreme are forecasts that crypto will replace gold as a reserve and that the ultimate Bitcoin token price level may reach $50,000. We are highly skeptical but realize that our skepticism may be a product of age and experience. Maybe we are guilty of a Luddite mentality.

We are also watching the development of the gold-backed-crypto alternative. We think that is a significant direction that blockchain transactions will take. We wrote about that recently. See http://www.cumber.com/bitcoin-gold-money/.

A perceptive reader asked about the relationship between President Trump’s activities and the gold price. This question was posed in the context of the developing global crypto-gold nexus that we are seeing with the introduction of the Sharia-approved, gold-backed cryptocurrency. The reader struck a chord.

So, we set about examining the relationship of presidential approval ratings and the gold price. There is no history regarding a correlation between presidential approval ratings and the cryptocurrencies, since the only data points are very recent and were mostly established in the Trump administration era, which is only one year old. There is no way to know if the rise in crypto attention originates in a worldwide reaction to the dwindling approval of Donald Trump as a world leader. We can debate this question as a political matter from all points of view, but we cannot find any historical evidence on which to base a solid conclusion. Crypto is just too new.

We can find some solid evidence when we examine the gold price.

Readers are reminded that gold was priced at $20 an ounce a century ago. The “double eagle” was the largest-denomination gold coin. In the Depression era the US government altered that price and restricted the ability of our citizens to own gold. See https://en.wikipedia.org/wiki/Executive_Order_6102.

Under the Bretton Woods (https://en.wikipedia.org/wiki/Bretton_Woods_system) fixed-currency regime, established in 1944, the United States, under President Franklin Delano Roosevelt, agreed to a fixed exchange rate of $35 per ounce of gold, and we settled international transactions with intergovernmental gold exchanges at that price. This agreement defined the operational structure until 1971, when President Richard Nixon closed the “gold window” and reneged on the previous US pledge. The US raised the official price to $42, but that meant nothing, as transactions ceased. See https://en.wikipedia.org/wiki/Nixon_shock.

As Nixon’s presidency deteriorated, the gold price on world markets tripled. Thus the Nixon era is the first case study that can be examined in response to the question posed by our reader. The second case study involves President Bush the younger. Bush Jr. also faced a period of deteriorating approval that correlated with a noticeable gold price change.

These are the only two case studies that have some statistical basis; they are a very limited data set.

We have boiled this exercise down into three slides with help of Cumberland’s Tom Patterson. The link to the three slides, in PDF form, is http://www.cumber.com/pdf/GoldApprovalWebsite.pdf.

The first slide shows all the presidential approval ratings from Richard Nixon to present. Note how most presidencies start off with higher approval ratings, which decline with time under most circumstances. Also note how Donald Trump’s starting point is lower than others, and note how his decline has been persistent. The persistence of decline is not unusual in history, but the rapidity of Trump’s decline is an outlier in history. Trump’s starting point is lower than for the other cases in this study. Of the nine presidents in the study, and at this point in time in his presidency, Trump is clearly the least approved. Note that the rate of change of deterioration is intense.

Readers may also note that the reasons for approval declines are not listed – we are going strictly on the numbers. The reasons may be the subject of discussion and debate, but for the purpose of this analysis, we ignored them. Whether it was Jimmy Carter and Iran’s detention of Americans or Donald Trump’s nasty tweets and belligerent behavior, the causal nature of approval decline was ignored. It isn’t why approval declined that matters; it’s the decline itself. The approval numbers are sourced from the American Presidency Project and Gallup data. The gold price data is from Bloomberg.

Chart two shows the Nixon shock and the change in the gold price at that time. The depiction of gold prices is scaled vertically so that readers can see the rates of change in the gold price as opposed to its absolute level. Thus a gold price move of $80 to $160 has the same visual impact and spacing in the chart as a price change from $160 to $320. The horizontal axis is approval ratings over time, falling from left to right.

In chart two we observe that the approval rating of Richard Nixon worked its way down below 40% and then accelerated downward as the Watergate scandal unfolded. Concomitantly, the gold price doubled. After Nixon resigned, gold traded at a range-bound level throughout the Ford and Carter administrations and until the very end of the Carter period, when the gold price rise became pronounced and accelerated.

The third chart shows the approval ratings of Reagan, Bush Sr., and Clinton. Gold was again broadly range-bound while presidential approvals fluctuated above the 40% threshold. Only when Bush Jr. became unpopular did we see his falling approval coincide with a steeply rising gold price. Why this happened is a subject for political speculation, but the statistical events are clearly observable in the data.

Under Obama and Trump, gold has again been range-bound and approval ratings have fluctuated in the same 40%+ levels as in previous range-bound periods. But now President Trump’s approval level is falling below the threshold that has previously marked a significant gold price rise. That trend raises the specter of another upward price shift in gold. However, this time there is a cryptocurrency alternative to gold that didn’t exist in the other two case study periods.

So, we don’t know how much of the gradually rising uptrend in the gold price that has occurred in the last two years is related to presidential approval ratings for Obama and Trump. And we don’t know how much the cryptocurrency price increases originate from crypto substituting for gold. Maybe it is some of each.

We do know that there are movements in some official gold transactions. We have seen transactions reported by Turkey. (See http://www.barrons.com/articles/gold-a-loser-despite-turkeys-mysterious-demand-1509736352.) And we have seen official sales by Venezuela, which is desperate for liquidity. We are also watching China increase its gold reserve holdings. We know that the collective central banks of the world have increased their assets to about $22 trillion USD equivalent; and even though the Fed is now starting to shrink its balance sheet, combined central bank asset growth is running at about $300 billion per month. (Sources: Bloomberg and hat tips to Dennis Gartman, Mark Grant, and Ed Yardeni.) We know that those reserve additions are mostly in fiat currency asset denominations, very little in gold, and not in crypto at all.

Let’s segue to the crypto-gold debate.

With permission, we are extensively quoting Nick Colas and Jessica Rabe from their newsletter. We know their excellent work from previous affiliations and are delighted to see them venture into this newly launched service. Readers are encouraged to give it a try. Their website is http://datatrekresearch.com/.

Regarding Bitcoin and gold they wrote:

“Physical gold is the world’s oldest store of value; bitcoin is a baby-faced newcomer. But the two have many common features, such as limited supply, efficiency/portability, and privacy. Bitcoin has a long way to go (about 5,000 years) before it can match gold’s success, of course. Gold has a different but equally important challenge – maintaining its relevance in an ever-more digital world.

“That’s what makes the whole bitcoin vs gold debate so interesting. A long-time incumbent and a new kid on the block, competing for attention. It’s not quite the Rumble in the Jungle, but close enough.

“We looked at Google Trends, which counts the number of searches for key words, to see the relative interest in “buy gold” and “buy bitcoin” to see which asset is more popular around the world. Google searches should be a reliable indicator of purchase intent, or at least interest.

“Here’s what we found:

“• On a worldwide basis, “Buy bitcoin” is a more popular search than “buy gold”. The crossover happened in mid-May of this year. As of today, bitcoin Google query volume is 17% higher than that for gold on a global basis.

“• Google Trends also allows you to zero in on what countries search more for bitcoin than gold. Over the last 90 days, for example, bitcoin beats gold across all of Europe and Russia. Even gold producing countries like South Africa and Canada show more bitcoin searches than for gold.

“• Based on Google searches, the United States is undecided on the bitcoin-gold debate. Search volumes are similar over the last 90 days. They do, however, show regional biases. Bitcoin wins in New York, Illinois, and California, for example. Gold still holds the lead pretty much everywhere else.

“The upshot of this analysis: in just a few short years bitcoin has caught up with gold in terms of global interest. Does that mean it has the staying power of gold? Of course not. It needs about 4,995 years to get there.

“Our perspective on this debate: both bitcoin and gold serve a similar purpose, namely to provide investors with a liquid asset outside the global banking system. If that’s your thing, there’s no need to choose one over the other.”

Many thanks to our brilliant reader who triggered today’s discussion with a sharply perceptive question. And many thanks to Nick and Jessica for permission to quote their research work. Please note that they will be present at the GIC discussion of crypto on January 12 in California. For details see the GIC website at www.interdependence.org. You will find the date listed under coming events. Registration is about to open. The meeting will feature Boston Fed president Eric Rosengren. A special conversation with Harry Markowitz is also planned, along with the discussion of crypto.

Only time will reveal the answer to our reader’s question about Trump’s approval rating and the gold price. If Trump’s approval deteriorates further below 40% and if gold rises in price, the history we documented with the Nixon and Bush Jr. eras will be repeated and validated. As for the effect on gold of crypto substitution, that remains impossible to determine today.

At Cumberland, we do not hold any Bitcoin or other crypto positions for our clients. We do have clients who are speculating in cryptocurrencies on their own. They have told us they are doing it. We wish them well.

We continue to maintain a small position in the gold-mining ETF in our US-based ETF portfolios. And we continue to hold some cash reserve in the US portfolios. We are not fully invested.

Of course, any of those decisions and strategies 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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Chairman Powell

President Trump announced on Thursday the elevation of Governor Jerome Powell to succeed Chair Janet Yellen when her four-year term as chair of the Board of Governors expires. For those who may not know, the chair of the Board of Governors is appointed for a four-year term, which is different from the 14 year terms served by governor. [1] Thus, Chair Yellen could continue on the Board until her term is up in 2024. Whether that will happen isn’t clear, since we don’t know yet what her plans are.

The position of chair of the Board is distinct from the position of chair of the FOMC. The chair of the FOMC is elected as the first order of business at the beginning of each year. [2] There is no requirement that the position be filled by the chair of the Board of Governors, although there has yet to be an exception. The only permanent position on the FOMC is that of vice chair, which is filled by the president of the New York Fed.

In selecting Governor Powell, the President achieved a two-for-one. Powell is a Republican, and he’s a moderate when it comes to policy. Perhaps the best clue as to what we will get on the policy side is reflected in comments Powell made in June in New York:

“The healthy state of our economy and favorable outlook suggest that the FOMC should continue the process of normalizing monetary policy. The Committee has been patient in raising rates, and that patience has paid dividends.”   

This stance is a clear endorsement of the current policy approach, and Powell used all the right words, including patient. We should expect no surprises from Governor Powell. But the fact remains that he isn’t an economist, as his most recent predecessors were. Those who think it is important to have someone in the chair position who is sensitive to Wall Street financial markets will be pleased. It is also important to realize, however, that the background and credentials of the chair are less important than his or her sensitivity to the Fed’s culture and willingness to separate the Fed from politics. Arthur Burns was an economist but a disaster as a policy maker. He played to Nixon’s politics and oversaw one of the worst periods of inflation the country has seen. It was the courage of Paul Volcker, who was not a Ph.D. economist, that brought the country back to a long period of stable prices. G. William Miller, who was appointed by President Carter in 1979, was a businessman totally inexperienced with the Fed’s culture who didn’t realize that in that environment he was but one of many equals and not the supreme leader. He lasted only a year and a half.[3]

While attention is now on Governor Powell, there are other issues that will become important. First, there are presently two economists on the four-person Board of Governors, which has three vacancies. Assuming Chair Yellen leaves in January, Governor Brainard will remain as the lone economist. If others are not appointed, then the sitting governors will be totally dependent upon the Board staff, whose command of economic models and forecasts encompasses a depth of expertise and experience that would create a dependency and give the staff an increased role in policy making. At the same time, with, at most, four governors in place, the reserve bank presidents have the ability to outvote the sitting governors should a conflict over policy arise. This situation creates an important role for Chairman Powell to manage the policy process and achieve consensus. It appears that this skill is in his tool bag, but this issue gets more interesting as we move into 2018. The voting reserve bank presidents include Presidents Bostic, Mester, and Williams, all of whom are economists. There has yet to be a new president appointed at the Federal Reserve Bank of Richmond. The point is that the economists on the FOMC are predominantly reserve bank presidents, and all have significant economic credentials that the Board governors will not have next year.

One final point. The October jobs numbers show a rebound to 261K jobs created, despite the hurricanes.  Additionally, although the Atlanta Fed’s GDPNow forecast fell back from 4.5% to 3.3% in the first week of November, any number starting with a three is a very good indication of the overall health of the economy. These job and growth numbers clearly provide sufficient support for the FOMC to continue on its gradual pace of policy tightening. If this is the last policy move in Chair Yellen’s term, then it will provides additional breathing room for Chairman Powell to sit back and reassess where things are in 2018. The biggest risk he faces going forward is placing too much emphasis on achieving the Fed’s 2% inflation objective in the face of possible evidence of developing imbalances in the real economy.

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

[1] If a governor leaves before his or her term is up, a successor first fills the remaining years and then can be appointed to a new 14 year term.
[2] See for example the transcript of the January 2011 meeting, the most recent transcript presently available.
[3] I personally observed all three of these chairmen while on the staff of the Board of Governors during their tenure.

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Munis: First Take on the House Tax Bill

The House bill proposes to keep a 39.6% top rate. Thus there will be no reduction on the demand side for munis for individuals.

The corporate rate is lowered to 20% from 35%. The lower rate may hurt corporation demand for munis, most likely in shorter-term maturities since their yields are far lower than Treasuries yields. The longer end of the muni market remains cheap to Treasuries, so we don’t see much change there. At the margin, buyers may prefer other taxable bonds to munis, but at current tight yield spreads we expect the fall-off to be minimal.

SALT (state and local taxes): The ability to deduct property taxes remains in effect but is capped at $10,000. There will be plenty of grousing from high-tax states. We expect the cap to rise before a bill is passed.

State and local income taxes will NOT be deductible on federal income taxes. This will have three effects. First, citizens will put pressure on states to roll back state taxes – at least to a level where part of the deductibility loss is made up. In addition, look for states to push services and expenses down to the local level as states try to keep the deductibility-issue backlash contained. Finally, the lack of deductibility will mean further migration from high-tax states like New York, New Jersey, Massachusetts, and California to low- or no-income tax states like Nevada, Texas, and Florida. This change will also boost the demand for bonds in high-tax states. There will be less reason to own out-of-state bonds in places like New York, New Jersey, and California, as the state taxes paid on income from out-of-state bonds will no longer be deductible.

Private Activity Bonds issued for stadiums will be phased out next year. This means that that if municipalities want to issue bonds for arenas and stadiums, they will have to do so in the taxable bond market. This will mean more financing by owners, which in the end should keep municipalities from being on the hook for bad stadium deals.

The bill repeals advance refunding bonds. Under a provision of a bill, issuers will be able to issue refunding bonds only as CURRENT refundings (that is, 90 days or less before the redemption date). This will HURT municipalities that have been able to save billions of dollars collectively by issuing advance refunding bonds in which they defease 5% plus original yields with 3% plus additional yields. We expect this provision to be taken out before a final bill is passed. Taking away the ability to benefit from lower interest rates hits municipalities just as they are trying to get a grip on pension issues.

While the standard deduction is nearly doubled and the mortgage deduction is kept intact for existing homes, mortgage interest will be capped at $500,000 for any new purchases, of a new house or a existing house.

We expect the real estate lobby to argue vigorously against provisions.

John R. Mousseau, CFA
Executive Vice President & Director of Fixed Income
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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Zika Update: Brace for Resurgence

Back in 2013 a mild virus nobody paid much attention to underwent one small mutation: A single amino acid (serine) was replaced by another (asparagine), according to Chinese scientists who recently published their research in the journal Science (https://www.washingtonpost.com/news/speaking-of-science/wp/2017/09/28/zika-was-a-mild-bug-a-new-discovery-shows-how-it-turned-monstrous). With that one change, Zika began to deal horrific damage to developing human brains. Zika became the public health threat we know today, one that lurks everywhere that infected mosquitoes range.

Through the summer of 2017, we had gained an edge in the fight against Zika. As of October 11, US states have counted only 291 cases in 2017. Florida saw a 71% drop in the number of cases for the first half of the year; New York saw a 56% drop. Other states likewise saw a reduction. (https://www.usatoday.com/story/news/nation-now/2017/07/13/why-zika-virus-infections-way-down-u-s-summer/474312001/)

But the Zika threat hasn’t disappeared; in fact, it is now poised to make a comeback, along with other mosquito-borne diseases such as dengue and chikungunya. While a single recent case of mosquito-borne transmission in Florida is cause for concern (https://www.usnews.com/news/health-care-news/articles/2017-10-13/florida-confirms-its-first-locally-transmitted-zika-case-of-2017), a greater concern is the ultimate impact of devastating hurricanes Harvey in Texas and Maria in Puerto Rico and Florida.

When a powerful hurricane wreaks devastation, it very nearly wipes out mosquito populations. That’s good news that lasts for about a week – until mosquito eggs hatch and survive in much higher numbers than usual in areas impacted by flooding. In Texas, for example, surveillance teams are finding thousands of mosquitoes in traps where they’d normally see only 10 or 20 (http://www.contagionlive.com/news/zika-virus-news-update-three-new-things-you-should-know).

The situation is similar and worse in Puerto Rico: Reports indicate uncontrolled spikes in mosquito populations on an island that has endured the hardest Zika hit among any US state or territory, with 34,963 confirmed cases of Zika last year and 486 so far this year – until Maria (CDC). We can be sure that no accurate counting is possible now, given dire living conditions on the island and a healthcare system in shambles. Food, water, and shelter are more urgent concerns. It’s inevitable, then, that Puerto Rico will see a surge in mosquito-borne diseases, including Zika, just as areas impacted by Katrina in 2008 saw a doubling in the number of cases of West Nile virus (https://fivethirtyeight.com/features/one-more-thing-for-puerto-rico-to-worry-about-disease-ridden-mosquitoes).

Puerto Rico’s mosquito-borne disease surveillance system used to be one of the world’s best, according to network science professor Samuel Scarpino of Northeastern University. Now, however, the island is in survival mode. Mosquitoes breed unchecked in pools and storm debris; people live and sleep exposed to open air where they will be often bitten; and Puerto Rico’s model programs for mosquito control and capture, disease testing, and reporting have fallen apart with the infrastructure that supported them, destroyed by the storm (https://fivethirtyeight.com/features/one-more-thing-for-puerto-rico-to-worry-about-disease-ridden-mosquitoes).

We know, then, that cases of Zika (along with chikungunya and dengue) in Puerto Rico are destined to spike unchecked and uncounted for a time, and with them the number of Zika’s smallest victims, infants whose lifetime care will cost millions. Worse yet, Puerto Rico’s looming Zika woes are not Puerto Rico’s alone.

Zika is now much more likely to gain a significant foothold in the US mainland as tens of thousand of Puerto Rican–American citizens flee for the continental US (http://www.latimes.com/nation/la-na-puerto-rico-orlando-20171010-story.html). Life was hard in Puerto Rico before Maria swept through – the island faced dire financial straits. The population had already dropped from 3.8 million to 3.4 million over the last decade as some 400,000 Puerto Rican Americans sought a better life in the US mainland. Now, given the lack of power, adequate shelter, food, and clean water, leaving seems the only rational option in the minds of many (https://www.newyorker.com/news/news-desk/how-many-puerto-ricans-will-leave-home-after-hurricane-maria).

And so they come. NPR reports, “Thousands of Puerto Ricans have poured into Florida after Hurricane Maria. More than 27,000 have arrived through Port Everglades and the Miami and Orlando airports alone since Oct. 3, according to the governor’s office. Some will stay temporarily, until power and water are largely restored across the island; but many … are coming to the sunshine state to rebuild their lives” (http://www.npr.org/2017/10/13/557108484/-get-us-out-of-here-amid-broken-infrastructure-puerto-ricans-flee-to-florida).

The influx of people will bring with it an influx of Zika, upping the chances that the virus will make it into local mosquito populations in the continental US, and incidents of mosquito-borne transmission will rise. In short, this is no time to be complacent about Zika; instead, it is time to double down on surveillance, mosquito control, and prevention, and to budget for that challenge. There is no room for congressional incompetence and political gridlock on the funding front, where Zika and other matters are concerned. There is no time for the nonsense of voting no, as some have unwisely done in the past. Timely action against Zika in hurricane-impacted areas and beyond is critical to save children’s futures, billions of dollars in healthcare costs, and productivity hits later on.

Funding to address the Zika emergency – at last approved by Congress in early 2016 after lengthy delays – ended on September 29, 2017, and the CDC consequently had to deactivate its Zika Emergeny Operations Center (https://www.cdc.gov/media/releases/2017/p0929-eoc-deactivation-zika.html). The 2018 budget proposed by Donald Trump includes a 17% decrease in funding for the CDC overall, while the CDC has requested an additional $12.5 million to address vector-borne diseases. The CDC explains that request: “In FY 2018, the U.S. will remain vulnerable to existing and new vector-borne disease threats, like Zika. With increased funding, CDC will provide enhanced support to up to 9 states at the greatest risk for vector-borne disease outbreaks. These resources would allow for enhanced capacity in laboratory, case and outbreak investigation, and vector control.

“Funds will also support the development of cutting edge diagnostic tools and new vector control technologies.” (https://www.cdc.gov/budget/documents/fy2018/fy-2018-cdc-budget-overview.pdf)

With congressional budget battles for fiscal year 2018 looming, it’s critical to note how vital the functions of government are when it comes to time-sensitive threats like Zika. We cannot afford dysfunction in Washington. Also key is an aid package designed to help areas impacted by this year’s hurricanes and devastating wildfires. Rebuilding infrastructure in Puerto Rico and elsewhere is a vital component in the fight against Zika, too, as surveillance and control measures depend on functional infrastructure. The House overwhelmingly approved – minus the support of 69 Republicans – a sorely needed $36.5 billion aid package on October 12. If the Senate and the president approve the bill, that aid package will follow $15.3 billion relief measure passed in September (https://www.nytimes.com/2017/10/12/us/politics/house-congress-disaster-relief-hurricanes-wildfires.html). It will not ultimately be enough, but it will help immensely.

Despite the heightened threat Zika poses in the months ahead, however, there is good news in the fight against the virus; and that news says that this health crisis will ultimately be more manageable if we play our aces now. Some bullets follow:

  • Scientists are releasing male mosquitoes infected with the bacterium Wolbachia in order to interfere with reproduction in mosquito populations that carry Zika. Their goal is to reduce populations by 90%: http://www.cnbc.com/2017/07/22/scientists-breed-a-mosquito-vs-mosquito-war-to-eradicate-zika.html.
  • A team from the University of Miami’s Miller School of Medicine used antibodies cloned from the blood of a person infected with Zika to innoculate a group of macaque monkeys against Zika: http://www.miamiherald.com/news/health-care/article176976391.html.
  • The FDA has approved a test designed to detect the presence of Zika in donated blood: https://www.fda.gov/NewsEvents/Newsroom/PressAnnouncements/ucm579313.htm.
  • Researchers in the field of nanobiotechnology are experimenting with engineered molecules that “act like microscopic Venus flytraps,” according to biotech writer Patrick Cox . “They trap viruses in polymer nanovesicles that pass harmlessly from the body.” (Patrick Cox’s Tech Digest, September 25, 2017).
  • In an interesting twist, it turns out that the Zika virus, which targets the brain’s stem cells with disastrous results in developing brains, can be used to shrink aggressive glioblastoma tumors by targeting glioblastoma stem cells: http://www.bbc.com/news/health-41146628. The adult human brain doesn’t have many stem cells otherwise, so the rest of the brain is unaffected. Hat tip to Patrick Watson, Mauldin Economics.

As is the case with most battles, timing, strategy, effective weapons, and the will to win will prove decisive. The battle with Zika is no exception. If we ignore the threat, if the enemy moves unchecked, we embrace disaster. Thus we cannot fail to fund, develop, and deploy measures and weapons that work.

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

Our previous Zika updates are linked below:

“Zika Update,” July 1, 2017 (http://www.cumber.com/zika-update-3/)
“Zika Update,” March 8, 2017 (http://www.cumber.com/zika-update-2/)
“Cuba & Zika,” October 16, 2016 (http://www.cumber.com/cuba-zika)
“Zika, Cuba, and American Politics,” October 4, 2016 (http://www.cumber.com/zika-cuba-american-politics/)
“Answering a FAQ on Zika Vote,” September 7, 2016 (http://www.cumber.com/answering-a-faq-on-zika-vote/)
“Zika, Congress, and Damaged Lives,” September 7, 2016
(http://www.cumber.com/zika-congress-and-damaged-lives/)
“Zika 4,” September 6, 2016 (http://www.cumber.com/zika-4/)
“More of the Costs of Political Failure on Zika,” August 12, 2016 (http://www.cumber.com/more-on-the-costs-of-political-failure-on-zika/)
“Zika Politics: Democrats & Republicans,” August 2, 2016 (http://www.cumber.com/zika-politics-democrats-republicans/)
“Zika Update,” July 19, 2016 (http://www.cumber.com/zika-update/)
“The Zika Virus and the US Congress,” May 23, 2016 (http://www.cumber.com/the-zika-virus-and-the-us-congress/)


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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Keynes, Kuznets & Trump

At 8:22 a.m. on Saturday morning, @realDonaldTrump greeted the world with this observation: “Very little reporting about the GREAT GDP numbers announced yesterday (3.0 despite the big hurricane hits). Best consecutive Q’s in years!” – Hat tip: Politico.

Our president may wish to revisit the National Income and Product Accounts (NIPA) methodology. He may start with a history lesson about Simon Kuznets who is best known for his studies of national income and its components. Kuznets was a Russian-born American economist and statistician who won the 1971 Nobel Prize for Economics. One may only speculate if Kuznets would have made it into the US today. Readers may want to know more about the father of GDP accounting.  Google will do the rest for you.  Readers may wish to read the NY Times obituary (July 11, 1985) of this Nobel Laureate for an exquisite history lesson by Nicholas Kristof.

Note that this 3% number is a first estimate of the quarter, and such early estimates are notorious for the revisions that almost always follow. Also, the 3% number is an annualized figure from a quarterly statistic, as is always the case with GDP. So was Q3 really the best in years?

In the details we find that inventories grew. Imports strangely fell. And the hurricanes caused a pop in automobiles as flooded cars were replaced. A better indication gleaned from this data release is that domestic demand grew at about 2%, which is consistent with the slow-growth economy we have been experiencing. Meanwhile, inflation measures remain subdued and well under the targeted 2% number that the Fed has sought and found elusive for years (without providing a clear explanation as to why 2% has been so hard to attain). The core Personal Consumption Expenditure (PCE) deflator was 1.3%. That is a long way from the Fed’s 2% target.

Meanwhile, the Fed is hell-bent on raising rates a quarter point before yearend, and the market is anticipating that rate hike. The Fed will simultaneously commence shrinking its balance sheet. The first stage is underway with a $10 billion-a-month reduction that will eventually grow to a monthly $50 billion. At the initial $10 billion level, the market impact is benign. We shall see if pressures develop over the next year as the Fed persists on a dual track of balance sheet shrinkage and interest rate hikes. It is hard to see how such a path lowers market-driven interest rates – the odds favor higher rates. But slower economic growth, at about 2%, and a low inflation rate of well under 2% hamper this upward rate trajectory. This dual policy of balance sheet shrinkage and interest rate increases has never been tried before in American monetary history. Stay tuned.

Meanwhile, the European Central Bank (ECB) continues a “lower for longer” policy. That will extend the life of the zero interest rate policy (ZIRP) for a likely one to two, or even three, more years.  The ECB is tapering the amount of purchases starting next year but allowing extension of zero interest rate time.  The impact is seen in credit spreads and that is one of the downward pressures on US bond rates.  Note that the difference between an AA credit borrower of 5 years and a BB credit rated borrower of 5 years is only 7 basis points in Japan, a country that measures ZIRP by decades.  In Europe, a BB rated corporate borrower pays a lower interest rate on a euro loan than the US government does on its 5 year treasury note denominated in US dollars.  Hat tip: Fundstrat.

So, negative rates are going to persist. About $8 trillion in global debt trades with a negative interest rate. This amount is down from over $13 trillion right after the Brexit vote, but it is still very high. Aggregate global debt is about $49 trillion, and no economic landscape that we recognize as “normal” would have that debt trading at a negative interest rate. So the continued action of the ECB acts as a dampening force on any interest rate rises in the bond markets of the mature economies of the world, the US included.

An unknown is the forthcoming tax reform legislation. If the tax rates for corporations are lowered, the corporate interest expense becomes a greater burden, relatively speaking, because the deduction for interest expense is lessened. A marginal shift away from borrowing will exert a downward pressure on interest rates. While this is true for businesses, the tax bill looks to be benign for municipalities. It seems likely that the highest tax bracket for individual Americans will remain in the upper 30s or even stay near 40%. It also appears that the tax-free nature of borrowing by state and local governments will remain. Thus the tectonic shifts in bond markets are likely to be more dramatic in the taxable Treasury, agency, and corporate markets, and that will actually favor the municipal bond market.

We like tax-free bonds, as we have for years. They remain relatively cheap. That said, the yearend muni calendar buildup may deliver a mild shock, according to my partner John Mousseau. Our separately managed muni accounts are positioning to take advantage of that shock if it comes.

What about the stock market?

The tech/telecom sector has reached about 25% of the total market weight. Because of this sector, the aggregate value of the S&P 500 Index now exceeds the total US GDP by a margin that was exceeded only once before, when the tech stock bubble occurred in 1999–2000. A 25% sector level has been a yellow flag in the past. That was true for the financial sector before the 2007–2009 financial crisis. It was also true for the energy sector in the 1979–1980 oil price spike. A 25% level is a warning. It does not help you trade stocks on a day-to-day basis. It does say that the particular sector is extended, that risk is rising or has risen, or both.

So, our stock accounts have some cash reserves and are not fully invested. Of course, these positions may change at any time.

As for the president’s tweets about GDP and his media bashing, each reader must make a personal evaluation.

As for Cumberland Advisors, we follow a sapient rule of thumb commonly (though perhaps erroneously) attributed to a noted economist who preceded the tweeting era, John Maynard Keynes: “When the facts change, I change my mind.” (https://quoteinvestigator.com/2011/07/22/keynes-change-mind/) We continously map the facts as they emerge and respond accordingly on behalf of our investors.

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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Surplus, Interest, Debt: Personal Finance in a Nutshell

Cumberland Advisors in partnership with the University of South Florida, Sarasota-Manatee (USFSM) and the Global Interdependence Center (GIC), with support from the Financial Planners Association (FPA), are proud to announce the 2nd annual Financial Literacy Day which will be held in Sarasota, FL at USFSM on Thursday, April 5, 2018.  Several nationally recognized speakers are already on the agenda. Stay tuned for further information about our upcoming Financial Literacy Day!

The conference agenda will include high-level discussions on municipal markets, technical analysis, the U.S. banking system, the global stock markets, and the global economic outlook. However, what follows here is a basic guide for individuals regarding their personal approach to debt management and wealth creation. U.S. household consumer debt has reached an all-time high of almost $13 trillion. This includes student loans, auto loans, credit cards, and mortgages/home equity lines of credit. Many of our friends and neighbors of all socioeconomic classes have not been exposed enough to fundamental financial principles.  Feel free to share it with others in your communities who may benefit from a refresher on these basic points.


An easy to share and downloadable PDF version of this piece is available here: cumber.com/pdf/Personal-Finance-in-a-Nutshell.pdf


Surplus, Interest, Debt: Personal Finance in a Nutshell

Far too many people are living beyond their means. Many of us are spending more money than we make. Many of us are living inflated lifestyles supported by debt. Far too many of us are not prepared for unemployment or economic disruptions. A large group of us are not prepared for even minor financial emergencies. Many workers are not saving enough for retirement. Somewhere along the line, a vast majority of us—including high-income earners—have not been taught how to think properly about money or to transcend the cycle of debt and perpetual want.

There is a better way. It begins by thinking properly about surplus and interest and the dangers of indebtedness. We then can learn how consistent saving over time can take part in the grandeur of investment and compound interest. Albert Einstein called compound interest “the greatest mathematical discovery of all time.”(1)  When money is mixed with time, good things can happen. As such, we may benefit from a renewed understanding of the words surplus, interest and debt. We can begin with a very basic socioeconomic classification of people based on these concepts.

Four Economic Classes of People (Which one are you?)
1.      The Destitute: The truly forgotten men, women and sometimes children. They are homeless and often helpless. They need our empathy, respect and assistance to secure food, shelter, clothing and fuel.
2.      The Dependents: They rely on others including the government or family for the majority of their personal maintenance and support.
3.      The Poor: They pay interest.
4.      The Rich: They receive interest.

Everyone has income and expenses. When our expenses are higher than income, we have debt. When the income is higher than our expenses, we have a surplus (Income + Expenses = Surplus or Debt). It is a simple concept that even a child can understand. Whatever one’s circumstances, the key concept is to create a surplus and to then build financial security from there forward.

Things to do:
1. Create a surplus. This can happen on any income.
2. Direct surplus for short-term cash reserve ($1000, then 3 months expenses)
3. Use surplus to pay down debt, start with credit cards, cars, education, home.
4. Use surplus to build savings and then investments to start receiving interest.


Education Charts: Compounding Interest and Growth Rate Returns

Take a look at Chart 1. Starting at age 19, Investor A contributes $2,000 per year for eight years ($16,000 total) and then invests the money until retirement (39 years more). In contrast, Investor B did not start investing until age 27 at $2,000 per year for the next 39 years (total investment $78,000). The charts show returns for each investor assuming average annual returns of 6%, 8% and even 10%. Receiving interest over time can be rewarding.

Take a look at Chart 2. This chart shows how many years it takes an investment of $10,000 to double given the interest rate/portfolio returns it can achieve. It is clear from the chart that getting to 6% per year or greater returns is important for accelerating investment growth.


Chart 1 - Compounding Interest and Growth Rate Returns
Chart 1: Compound Interest & the Time Value of Money

 

Chart 2 - Compounding Interest and Growth Rate Returns
Chart 2: Years Needed to Double Investment (Compound Interest)

The power of compounding interest is one of the finest natural laws, and it does not discriminate. To begin to achieve its benefits, start by generating a surplus. When you increase your lifestyle to consume your present income and even leverage that position through heavy debt loads, then your expenses exceed your earnings and you have no surplus (negative surplus = debt). With no surplus, you forfeit the opportunity to pay down debt and eventually build wealth through receiving interest. Somebody else is getting richer while you are a slave to debt. The future is uncertain if people do not understand nor are taught personal financial management. It is really simple and basic:

If your inflow is less than your outflow, then your upkeep is contributing to your downfall!
Your earning power must be greater than your yearning power!

 

Einstein Einstein Quote - Power of compound Interest

 

In a world plagued by debt spirals both personal and governmental, many people have never been taught about the wonderful effects of living with a surplus and the magic of receiving interest rather than paying it. Consistent surplus and effective investment including owning your own home is the most defensible way to build financial security and even wealth over time. The key to becoming more financially healthy and independent is to begin to think differently and to have a plan to get out of debt. This can be done on any income. We can start with a surplus mentality and build our financial future on that solid foundation.

Michael McNiven, Ph.D.
Managing Director & Portfolio Manager
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(1) “Investing 101: The Concept of Compounding,” Investopedia, found at http://www.investopedia.com/university/beginner/beginner2.asp


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Bitcoin, Gold & Money

We start with a quote by Donald Trump, courtesy of CNN, May 16, 2016: “This is the United States government. First of all, you never have to default because you print the money, I hate to tell you, OK?”

We juxtapose that quote with Francesco Bianchi and Leonardo Melosi’s excellent research paper published by the Federal Reserve Bank of Chicago (working Paper 2017-19). We recommend readers thoughtfully review this paper, which is entitled “The Dire Effects of the Lack of Monetary and Fiscal Coordination.” You can access it here: https://www.chicagofed.org/publications/working-papers/2017/wp2017-19.

Now for a topical anecdote. The following story struck me, since I had just seen the movie Tulip Fever and written a review of it (available here: http://www.cumber.com/tulip-fever/). It seems a young Dutch family has decided to sell virtually everything they own and to plow the proceeds into Bitcoin. They have moved out of their house. They are making a brave but 100% speculative bet on this cryptocurrency. Here’s their story: https://www.cnbc.com/2017/10/17/this-family-bet-it-all-on-bitcoin.html.

Why? The behavior seems bizarre to me.

There are many dimensions in the debate about the relative merits and demerits of cryptocurrencies, fiat currencies, and gold, so today’s commentary may seem a disjointed missive. And it is. No consistent path has yet been determined for the rapidly growing crypto asset class. (I use the term asset class very loosely, since crypto is really still a very new and speculative phenomenon that has not yet gained the respect accorded a traditional asset). Gold, money, and financial instruments such as bonds or stocks denominated in money are generally accepted assets, but crypto is still the subject of intense head scratching.

Let’s get to some bullets.

Of the three asset classes we are considering, the easiest to comment on is fiat currency. There are over 100 in the world. They are available in paper form and can also be transferred electronically in most cases. They are the products of governments. Their transfer usually occurs through some form of government-monitored or -supervised system. They range from the largest, the US dollar – still the world’s reserve currency – to the local paper money of minor countries. The degree of governance varies widely. Venezuela, which has domestic hyperinflation, forces its citizens to use its debased currency and persecutes them when they resort to transactions in the dollar and other harder currencies via an underground system. This is a desperate situation that has been repeated many times in many countries over the past century.

At the other end of the spectrum, we find fiat money being managed by means of hard-money central bank policies that focus on the “classic store of value” function of money. Switzerland’s policy, for example, has been decades in the making: The Swiss have had one of the hardest currencies in the world, although it has ultimately succumbed to pressures from the huge and ongoing monetary experiment of its contiguous neighbors who use the euro. The Swiss National Bank was overwhelmed by the size and direction of monetary policy administered by the European Central Bank (ECB). Serious historians of monetary history will long recall how Switzerland once imposed a negative interest rate of 5% per year on Swiss franc deposits in order to discourage inflows into the “Swissie.” The world was seeking a store of value and didn’t trust the dollar at that time.

Cryptocurrencies have both passionate supporters and vehement detractors, though it is now possible to facilitate transfers between crypto and fiat currencies. Some folks think of crypto as an alternative to credit cards but with a payment mechanism that uses the new blockchain technology. Crypto detractors argue that governments will not go on allowing parties to bypass the fiat currency systems they have created. Here is a full discourse on that subject by Harvard professor Ken Rogoff: https://www.project-syndicate.org/commentary/bitcoin-long-term-price-collapse-by-kenneth-rogoff-2017-10. Rogoff raises important questions:

“What happens from here will depend a lot on how governments react. Will they tolerate anonymous payment systems that facilitate tax evasion and crime? Will they create digital currencies of their own? Another key question is how successfully Bitcoin’s numerous “alt-coin” competitors can penetrate the market.”

Evidence from China is that governments are starting to seriously resist crypto, as Rogoff suggests.

But not all governments are resisting.

In the Middle East, gold-backed crypto tokens are emerging, and they are sponsored by a government. TabbFORUM reports (10/20/2017) that “In the Sharia-compliant OneGram, each crypto token is backed by one gram of gold held in a vault in the Dubai Airport Free Zone. A similar scenario takes place when trading ZenGold, while GoldMint, which is based on a private blockchain, issues tokens backed by physical gold or ETFs as per the prevailing price of gold.”

Gold-backed crypto is very new, and we shall quickly see whether it catches on. Adding a gold backing counters the argument that cryptocurrencies have no tangible value. Gold can relieve and replace mathematically driven systems that attempt to create scarcity value, as in the present crypto mining operations.

We think there is potential for gold-backed crypto. For a full discussion, see “Where Bullion Meets Blockchain”: http://www.lbma.org.uk/assets/alchemist/Alchemist_87/Alch87Coghill.pdf.

Fundstrat’s Tom Lee, a supporter of crypto, has created five indices. One of those baskets contains 300 cryptocurrencies. Lee says, “The indices are designed to accurately reflect the comparative price performance of Bitcoin and other crypto-currencies.” Lee favors the “larger-cap crypto-currencies from a tactical positioning perspective.”

And now the explosion in crypto has taken on a new coloration with the launch of a fund of funds. See this Bloomberg story for details:  https://www.bloomberg.com/news/articles/2017-10-24/crypto-fund-of-funds-emerges-as-digital-coin-sector-explodes.

So far there is no index of gold-backed cryptocurrencies. Tom Lee is the crypto pioneer but not with gold backed included.  They are probably too new and too small. We shall see if that changes. We shall see if ETFs follow those indices.

We note that the world’s gold supply is finite. The central banks of the world hold about 18% of the entire world’s gold. They count it as part of their reserves. The government of China has been a constant buyer of gold and is now the sixth largest governmental gold holder in the world. The largest is the US, followed by Germany, the IMF, Italy, and France. Add Russia (right behind China) and Switzerland and you have just named the holders of about two thirds of the worlds’ officially held gold reserves.

From what we can see, no central bank uses a cryptocurrency as a reserve at this time. Tom Lee believes that they will start doing so once the total crypto asset class exceeds $500 billion in value.

So where do all the emerging developments in crypto leave us today?

Crypto is rapidly expanding. Other than for the new gold-backed entrants, the value of cryptocurrencies is unknown and highly volatile. Meanwhile, the gold price has been slowly rising for the last couple of years, and its volatility is usually tied to a weakening or strengthening US dollar movement in the foreign exchange markets.

Evolution is fascinating to watch, and we are seeing it. We do have a small position in the gold miner ETF in our US dollar-based portfolios.

David R. Kotok
Chairman and Chief Investment Officer
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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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Cumberland Advisors Market Commentaries offer insights and analysis on upcoming, important economic issues that potentially impact global financial markets. Our team shares their thinking on global economic developments, market news and other factors that often influence investment opportunities and strategies.