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
Email | Bio


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U3 or U6: Bob Brusca or Joel Naroff

We are privileged to invite readers to a serious debate and discussion. Recently we published two pieces in which we tried to describe markets in terms of metaphors. We thank readers for their many thoughtful responses.

In the second “metaphor” piece we incorporated three charts prepared by Bob Brusca, an economist and longtime friend. Another longtime friend who is also an economist, Joel Naroff, replied and disagreed with Bob. The result is reproduced below, unedited by me. We thank both of our friends for outlining their views and for giving us permission to make them public.

Here is the link to the second metaphor piece, in which I used Bob’s work: http://www.cumber.com/markets-metaphors-labor-data/.

Below is Joel’s reply to that commentary, and following that is Bob’s response, in which he disagrees with Joel. We hope readers enjoy the articulation of these different views.

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


From Joel Naroff:

David:

Thank you for writing this piece and thank Bob for the research. You have provided the platform for me to make my favorite arguments why the participation rate and U-6 are irrelevant.

Let’s start with the participation rate. If you believe that the decline in the rate explains the decline in the U-3 rate, then you have to be consistent when the participation rate rose.

Consider the period January 1977 to January 1981. The participation rate rose 2.3 points. Using the Brusca rule, there should have been roughly a 2.1 percentage point rise in the unemployment rate. But during that time, the unemployment rate fell as much as 2.3 percentage points and ended up, after four years, down 0.3 percentage points.

So, what are the data telling us about the economy between January 1977 and January 1981? First of all, after four years, you can reasonably say that the unemployment rate was down 2.4 percentage points (2.1 points from the rise in the participation rate and 0.3 from the actual fall in the U-3 rate). That is a really outstanding performance. Also, the unemployment rate averaged 6.6%, which is 1.3 percentage points below where it was in January 1977. Given the huge rise in the participation rate, that is an awesome performance.

In other words, using the participation rate, we now know the answer to Ronald Reagan’s famous question: “Are you better off today than four years ago?” The answer is unambiguously yes. Congratulations, you have made Jimmy Carter an economic guru!

And then there is the U-6, which some call the real unemployment rate and I call the really stupid unemployment rate. One of the major components of the U-6 is the number of people who want full-time jobs but cannot get them. To make comparisons over time, you have to assume there has been no structural shift in the usage of part-time vs. full-time workers. But we know that businesses have been moving toward a higher usage of part-timers as they can more effectively employ them at lower costs.

That more people cannot get full-time jobs is related to the production function, which is shifting. It is not a measure of unemployment. Since the shift has been to more part-timers, the U-6 is biased upwards, which explains the different movements in the two. Very simply, you cannot compare two periods where the production function has shifted, changing the relative usage of labor. Now you can complain that businesses are keeping the “real” or “really stupid” rate up by using more part-timers, but that is a wholly different argument that I doubt you, Bob or any of the others that actually believe the U-6 is meaningful want to make.

Which brings us to Fed policy. If the U-6 doesn’t mean anything, then you have to go back to the U-3 and that is signaling a tight labor market. The problem we face is that given the global labor force and technology changing the way labor is employed, we do not have a good handle on what is full employment. Thus, we don’t know how much slack there really is in the market.

I don’t know how many times I have written this diatribe, but hopefully you will reprint some or all of the argument. You have my permission.

—Joel


From Bob Brusca:

David,

I would like to thank you for featuring some of my work on unemployment. And I would like to thank Joel Naroff for his insightful comments. Now I would like to add a few words to this discussion.

First of all I would like to dispute Joel’s claim that the participation rate should have symmetric effects. I don’t think we should glibly assume the rate impact is symmetric without a closer look. The participation rate is the result of some pretty complicated behavioral relationships and the interplay of supply and demand in the labor market. While economists view the labor/leisure trade off as a fundamental choice of a person, in Adam Smith’s ‘first book’ of the Wealth of Nations (to use the short title) cited one of the main causes of the wealth of a nation to be the proportion of its population that is at work. The participation rate is central to the performance of an economy and when it shifts it can have pronounced and broad macroeconomic effects and so when it shifts we need to think carefully about WHY it shifted to understand what the shift means.

In the US at least three important themes are impacting the participation rate. One is the use of opiates that has been documented to have reduced labor force participation (or a redlining of users by potential employers), the second is aging which is on auto pilot except over very long periods of time, and the third is technological/Global displacement and what it does to the displaced. Since we can’t impose the ‘Benjamin Button’ effect there is no chance that participation rates in the US are going to rise because old people are ‘youthing’ and participating more vigorously in the labor market as they ‘youth’- that won’t happen. Old people are participating in the labor market with more ‘vigor’ that their predecessors in the old-age cohort but that is mostly because this is the first generation to retire on 401Ks rather than on defined-pension benefits and few have saved enough. Even so, the participation rate falls so fast as we age there is virtually no chance that it will rise enough to make it level with the rate of the previous age cohort. So overall participation drops. And early retirement is becoming a feature so the labor force is losing people who disproportionately used to be employed. Now there are more people in this group that retires (and more retire early) and that will bias up the unemployment rate. Still, that does not mean that the lower rate is not ‘real.’

To understand the meaning and impact of the participation rate drop the question we need to ask is this “ is there some force acting on the unemployed today making it more likely that they will leave the labor force rather than go back to work with the same propensities as in the past?” If that is true that the unemployment rate will be lower than it would have been in the past at the same employment level.

The pace of innovation is brutal and as Joel remarks, the shift in the production function is to absorb more part time and less full time labor. These are events that have put more labor into unemployment or under-employment than in the past. It is robots and software too and all sorts of things that have cut out middle class jobs and other jobs, not just reduced hours.

At the same time the administration of disability has become more lax. There are many more people on disability than in the past – that affects the effective labor-leisure tradeoff.

Being in mid-career and out of work is stressful. If you do not go back to work and if you stop looking for work you are no longer unemployed, your work skills atrophy. The longer you are out the less marketable you are at anything like your former wage. I think there is good reason to see dislocation leading to higher unemployment and eventually to labor force reduction and eventually lower unemployment rates, as workers drop out and stop searching for a job. Once marginalized like this you do not get symmetry and roll the clock back; few have an epiphany go back to school for retraining get a job and fire their old boss who once fired them.

I grew up in Detroit. I worked on the assembly lines there to make money for college. When those jobs disappeared huge portions of Michigan (and other industrial areas suffered this fate) generated vast pools of unemployment this chain reaction was put in gear. Michigan has an ‘export economy.’ It made cars and trucks shipped them out of state and the money was shipped in to pay workers. Once that stopped there was no injection of money for that local community and no way for it pull itself up by its own bootstraps. So the cycle of labor market unemployment, discouragement, and drop-out kicked in and played out. These forces do not impact the employed and unemployed evenly and so there is a biased impact on the rate of unemployment. Joel is right. The production function has shifted. It has moved overseas in some cases!

This also gets to why I am vocal about FREE TRADE. I am in favor of it, of course. But I am opposed to the current world trading systems since China (and others) are like the roach motel: jobs go in and none come out. Our industrially or technologically generated unemployed do not get a crack at jobs ( apparently we have no comparative advantage which is quite a concept if you try to think about – Danger DO NOT ATTEMPT TO DO THIS WHILE DRINKING!). This is another reason why the unemployed pool in the US labor market is in heretofore unseen numbers and why a so many people simply ‘exit’ the labor market effectively impacting the participation rate instead of the unemployment rate.

All this happens in the face of the JOLTS survey with job openings data which are spectacularly hilarious. Someone should see if you could get the JOLTS report to host Saturday Night Live, I’m sure it would be a hoot. According to JOLTS there is a RECORD number of job openings. Apparently they are all for jobs which Americans lack the skills to fill. More likely it is that the openings are for jobs that will only be filled by H1B visa holders willing to work for even less and live six-to-an-apartment.

This comment gets to the point that you can call a ‘spade a spade’ but if it’s really ‘a club’ it will not fill out your flush in a poker game. The problem with JOLTS “job openings’ and ‘unemployment’ is that they are not static things. They may not even be the same things over time. Just because you call something by the same name does not mean it has not changed (if you called Hyde Jekyll would he change back?). It’s one of the reasons I will not buy pants or shoes on the internet. Everybody has a different idea of what ‘size is’. Women’s clothing is a hilarious example where you see women shopping for size ‘zero’ or ‘double zero’ or ‘one.’ It’s as though if they print a small number on garment you won’t be as big.

Well what I have discovered is if you also run regressions of average hourly earnings (wages) on the quit rate you find that more quits do raise AHE but not as much as they used to. So there some sense in which a quit is not a quit in the same way a unit of unemployment is no longer a unit of unemployment and a size zero is not the same thing either.

But just as economists study ‘money illusion in the labor market and elsewhere’ economists themselves suffer from ‘data illusion.’ Clearly at the Fed they THINK the SIZE 00 dress is really small…excuse me, I mean that the sub-5% unemployment rate is really low. But is it? Is the quit rate really high? Well one way to answer that is that is that a thing IS what the thing does. If the zero fits wear it! And low unemployment no longer drives wages up (…much i.e. Dead Phillips Curve). And the quit rate has less impact on wages than it used to. So I guess they are different things. BUT THE FED THINKS THEY ARE THE SAME…hence it runs this cautious policy wary of inflation.

Actually the Fed has built a model to adjust for this only the Fed has it backwards. The Fed calculates this thing called R-Star. And it tells the Fed how much the equilibrium Fed funds rate has shifted. Now you can think of this any number of ways. R-star is an apology for monetary policy not working. It says hey rates are low but they are having no impact because the macroeconomic scene has shifted – this unemployment rate is no longer having that effect. So R-star gives Fed members some solace and explanation for why policy is ineffective. But, of course, if the unemployment rate and other variables are not what they used to be (measured badly) well you would get the same results. Imagine not knowing what dress-makers have done to dress sizes and going in try on a size six dress only to come out of the dressing room to think you are dying and have lost tons of weight. No you haven’t, you just need to account for the dress-size shift. So does the Fed.

So this is a bit of a long way to try to explain in some detail with some real life examples why things have shifted and why the Fed and others are wrong to see this numerically low rate of unemployment as akin to a match near a puddle of gasoline. That match is lit, but the puddle is water. It is far closer to putting the match out than lighting on fire. Yet the Fed, spooked by ‘data illusion,’ thinks bottlenecks loom (in a global economy no less!!) and that inflation is about jump out of the dark just when you thought it was dead as in the old movie ‘Wait Until Dark.’ Boo!

There is more than a shifted production function at work in the labor market. And I believe the integrity of the U3 unemployment rate is breached and you see the dynamics of it in U6 as U6 is elevated relative to U3. And that is how this works. Because some people will BE dislocated and disaffected before they become so discouraged that they drop out of U6 as well. It’s a process. And the Fed is in denial. The essential factors are the sucker punch from technology and international trade that has left the US as a high-wage high-cost country. So in world with a lot of ‘new participants paid low wages we expect their workers to displace ours ( China/Asia). It is exactly what is happening. But it is unpopular to say this. The dollar does not fall to restore our competitiveness because exchange rates are ‘fixed; Jimmied’. All kinds of money flow in to finance our current account deficit not for real economic investment only for paper investment.

Governments are too involved in markets. They have created this massive dislocation, disequilibrium because no one wants to roust China or Asia about Free trade. So Americans are left without jobs. Some of it is our fault as we have fallen behind on education. But much of this is about the wage rate. Our standard of living is too high so the work is being done elsewhere. Why do you think US firms have such huge piles of cash overseas they want Trump to let them bring home? Do you think they have been winning at Lotto?

Sincerely,
Bob

Feel free to send this out, or just to share it with Joel.


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A Win for Abe and Japan: Challenges Lie Ahead

Prime Minister Shinzo Abe and his Liberal Democratic Party (LDP) achieved a landslide victory in the snap election held Sunday, assuring that his ruling coalition retains its two-thirds majority in Japan’s lower house. It also makes it very likely that Abe will be selected next year to continue to head the LDP. The LDP faced an opposition that was weak and divided. Abe’s popularity has recovered from damage done by several scandals earlier in the year, helped by his tough statements in reaction to threatening actions by North Korea and a strong economic record. Although the win may turn out to be bullish for Japan’s economy and stocks, the geopolitical implications may be even more important.

Abe has made clear his strong desire to amend Japan’s pacifist constitution, which contains restrictions on defense spending. His hand has been strengthened by this election, the increased threat from North Korea, and the signals from President Xi Jinping that China will follow a more assertive foreign policy. The uncertainty about US foreign policy under President Trump probably adds to Japan’s national security concerns. However, the Japanese public remains divided on the sensitive self-defense issue, and countries in the region are at best uneasy about the prospect of a militarily stronger Japan, which is understandable in view of history. It will take time for Abe to achieve any change in the constitution, which would first be subjected to a public referendum. But the pressure in that direction will be strong, with defense spending surely rising. A stronger Japan will change the geopolitical balance in the region, a development the United States should welcome. China and North Korea will view it adversely.

The prospect for Japan’s economic policy is a continuation of “Abenomics,” which has led the economy to expand for six straight quarters, with unemployment below 3%, the lowest rate in 23 years. This policy consists of three “arrows”: ultra-easy monetary policy under the leadership of Bank of Japan Governor Haruhiko Kuroda, fiscal stimulus, and structural reform. The first two arrows have been pursued aggressively, and this will continue. The Bank of Japan will continue to defend its yield target of “around 0% on ten-year government bond yields” and will avoid any indication of tightening its monetary policy stance. The government’s stimulative stance on fiscal policy is also unlikely to be changed, with increased defense spending helping to offset the effects of a scheduled sales tax increase next year.

On the other hand, Abe has procrastinated over pushing much-needed but unpopular structural reforms. The election results and the strong economy should lead the government to get moving on reform of the pension system, overhaul of the labor market, and increasing competition in Japan’s protected sectors, such as agriculture, retail, and other services. An important headwind for the Japanese economy is the ageing and declining population. So far, Abe has emphasized encouraging labor force participation of older workers. More difficult but needed are measures to improve female participation and promote immigration reform.

The most recent economic indicators suggest that the Japanese economy grew at a healthy 0.5% quarterly rate in the third quarter, only slightly slower than the second quarter’s 0.6% rate. Manufacturing growth rose to a four-month high in September, according to the Nikkei Japan Manufacturing PMI (purchasing managers’ index), published by Markit. Service sector activity slowed a bit, but Japanese service companies continued to increase their hiring. The latest Tankan Survey indicated that business sentiment had improved and that larger profits are leading to higher capital investment. Export growth is strong, with an acceleration of exports to China and exports to the US remaining firm. Economic growth for the current year looks likely to reach 1.7%, substantially stronger than the 1.0% gain in 2016. We are now projecting a similar 1.6% increase in 2018.

Japanese stocks have participated in the global bull market for equities, experiencing their longest winning streak since 1988. The largest Japan equity ETF on the US market, the iShares MSCI Japan ETF, EWJ, which covers about 85% of the investible universe of securities traded in Japan, has gained 18.48% year-to-date October 20 on a total return basis. This is a healthy advance, although less than the 27.38% gain of Eurozone equities as measured by the iShares MSCI Eurozone ETF, EZU. The main difference between these two returns to US dollar-based investors is that the euro gained over 11% during this period while the yen advanced only about 2.5%. As has been the case in a number of national markets, small-cap stocks have outperformed large caps in Japan. The WisdomTree Japan SmallCap Dividend Fund ETF, DFJ, has gained 23.42% year-to-date. It tracks an index of dividend-paying small-cap stocks. The election results lead us to maintain our positive view towards Japanese stocks .
Bill Witherell, Ph.D.
Chief Global Economist
Email | Bio

Sources: Oxford Economics, HIS Markit; The Financial Times, The Economist, Ned Davis Research, Bloomberg


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Markets, Metaphors & Labor Data

We thank readers for their gracious comments on our markets and metaphors missive (http://www.cumber.com/market-history-and-metaphors/), examining historical periods that “rhyme” in one way or another with the circumstances we find ourselves in today. To recap for those who missed it, the historical references we examined were as follows: (1) almost a decade ago the financial meltdown required a massive central bank response, and some of the crisis issues still remain unresolved; (2) in the 1960s inflation and interest rates were both low, and then a rapid acceleration occurred and the Federal Reserve was caught unprepared; and (3) in the 1937–38 post-Great Depression period, the Federal Reserve triggered a recession by raising interest rates too soon.

In our metaphors piece we did not purposefully ignore labor markets; we just thought they would complicate the writing. So the readers who offered that criticism are correct. Today, we want to expand the metaphor set to include labor markets. We will start with three charts posted on our website and available to readers through this link: http://www.cumber.com/pdf/BruscaCharts.pdf. If you cannot open the link to the charts, please email me, and I will have someone help you. We recognize that some readers may still be running text-only email programs that can have problems recognizing hyperlinks.

The charts were updated for us by Bob Brusca, and the equation was his idea. I wish we had thought of it, but we didn’t, so the dinner has to be on me when we grab a meal in New York. For those who do not know Bob, I recommend his newsletter as tough, no-nonsense analysis. He says it like he sees it. You can reach Bob Brusca at Robert.Brusca@verizon.net or call his office at 212-875-8637.

Let’s get to the three charts. The first one shows the relationship between the labor participation rate and the U-3 unemployment rate. As you can see, about 91% of the drop in the unemployment rate cited by the Fed – and used in its dot plots – is attributable to the drop in labor participation. In other words, nearly all of the improvement in the unemployment rate was due to millions of folks dropping out of the labor force for one reason or another (further education to enhance opportunities, working underground and off the books, or dropping out because of disabilities, opioid addictions, caregiving responsibilities, sheer discouragement, or criminal records that deterred firms from hiring them, etc.).

The second chart shows the decline in the traditional (U3) unemployment rate versus what it would look like had the rate of change been the same as for the U6 rate. The U6 is a much broader definition of the unemployed and underemployed than the U3 is. Note that the U6 is not forecast in the Fed’s dot plots, although we can estimate what it would be based on this relationship between the U3 and the U6. To summarize, the U3 would be higher than it is if its rate of change were the same as for the U6. The Fed talks about this but it doesn’t make policy pronouncements based on this gap.

The last chart is most instructive about the risk of the Fed’s current policy stance. It shows what the U3 unemployment rate would be had the labor participation rate been constant since the financial crisis. Now, we expect some critical emails from this analysis. Readers will say that this is a counterfactual, that it’s just an application of a theory, that there have been changes in demographics. Yes, all these criticisms will be correct.

But a thoughtful examination also confirms that the fall in the labor participation rate is the single biggest factor explaining the very low 4% level of the U3 unemployment rate. Does that explanation appeal to those who are wildly optimistic about today’s economy? We think not. But are we, in fact, really getting a robust economic recovery when many millions of people are not seeking work and have dropped out of participating in the pool of American workers and American wannabe workers?

Note also that other indicators of labor market conditions are giving very mixed signals. Barclays computes indicators of labor market conditions and of labor market momentum. Those two indicators are now out of synch and heading in opposite directions. Conditions improved in September, says Barclays; but meanwhile, momentum fell by a large amount. The October 13 report from Barclays warns about hurricane distortions of the data. So in the end, what do we really know? We know that we don’t know.

But we also have the survey data compiled by Bill Dunkelberg and the National Federation of Independent Business. Remember, this is data that reflects the views of those companies that are not trading on the stock exchanges. About half of the private-sector economy in the United States is implied from NFIB, which has several hundred thousand members. That data also conveys a cautionary message. It jumped after the Trump victory. It peaked. And the figures in many categories are now lower than they were at the peak, and the trend is down in many cases. We read Dunk’s report regularly and track those changes.

Back again to Bob Brusca, who summarized the NFIB’s  latest revelations with this assessment:

“So what firms (these are the NFIB members who answered the monthly survey) say they are planning to do and what they are really doing are two different things. And on top of that, poor plans for capital spending are not reassuring. Firms have given very tepid responses to the question about raising or planning to raise their selling price. Worker comp firms admit a greater tendency to having paid higher comp (a 70th percentile standing, but on a lower reading this month), but plans to raise worker comp are an extremely low 16th percentile. Maybe firms in their answers are reflecting that minimum wage legislation forced them to hike wages. In any event there is no sense of a wage price spiral here.”

Bottom line: We do not know whether our 1960s metaphor is the path that lies before us or whether the 1937–38 Fed mistake is about to be repeated. We do know that the Fed seems determined to hike rates before year-end and to simultaneously start the gradual shrinking of its balance sheet.

If we were voting on this policy, we would do these things one at a time. But we do not have a vote on the FOMC. We would remind colleagues of all those research papers that tried to determine what QE meant in terms of an equivalent drop in interest rates. Suddenly they have disappeared from the scene. We wonder, if that argument had merit and QE was the equivalent of lowering rates, isn’t QT the equivalent of raising them?

In our US portfolios we now have a small cash reserve. We have ceased being fully invested.  Of course, we must warn this could change at any time.

In the bond space we remain bullish on tax-free bonds, which are trading in many maturities above the taxable references. We do not see any new tax bill as threatening to the tax-free municipal bond market.

Lastly, credit surveillance is very important. It cannot be taken for granted. Here is a link to a long report on municipal credit, “The Financial State of the States, 2016,” by Truth in Accounting: http://www.truthinaccounting.org/library/doclib/FSOS-BOOKLET.pdf. It may spoil your dinner, but it proves the need for muni credit research in bond management. And here is an article that cites that report in establishing that New Jersey has the worst finances in the nation: http://observer.com/2017/09/new-jersey-has-the-worst-finances-in-the-nation-report-says/.

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


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Tulip Fever

Three levels are apparent in the wonderfully crafted movie Tulip Fever, in which the impeccably cast Judi Dench is both abbess (mother superior) and tulip-speculating vault keeper. The film is a cinematic lesson about trading momentum and human emotions overtaking investment reasoning.

But there is also a lesson in Dutch history, with a marvelous depiction of early 17th-century Amsterdam and only by surmise and projections Amsterdam’s upstart cousin Nieuw Amsterdam, otherwise known as New York. Bottom line: NYC really was and still is a Dutch town.

The movie peeks at the roots of New York during its pre-English years. The attempt at historical accuracy is affirmed in this viewer’s eyes even though there are a couple of dates which conflict by a year or two with records.

Incidentally, Beverly Swerling’s compelling historical novels are a perfect companion to the film. We must give five stars to both Tulip Fever and to City of Dreams: A Novel of Early Manhattan, the first in Swerling’s series. (We subsequently read all the rest.)

A second level in the film concerns art. Please Realize that Tulip Fever is set in Rembrandt’s era, and please observe the paintings closely. So obviously metaphorical is the play on Vermeer and Girl with a Pearl Earring. The movie uses this metaphor brilliantly. (And I have seen that classic work when it was on exhibit.) The movie makes use of other classic artistic themes, too, including portraiture and the mixing of color. How lovely to see an art lesson woven among the story’s other threads.

The tulip craze and collapse is more than just a chapter in Charles Mackay’s famous classic Extraordinary Popular Delusions and the Madness of Crowds. BTW that book is a must read and a classic to be assigned to any and every serious investor.

In the movie, we see tulip prices rising and observe how the extension of credit influenced the path to a peak and then collapse. We see early auction pits in operation in taverns, with high and low intrigue. This all takes place three and a half centuries before Michael Lewis came along. Hmm – some things may never change. My speculation is that Jesse Livermore would love this movie and Ben Graham would want a refund of the ticket price. Warren B, Graham’s disciple, might have an opinion. Is there a view from the Oracle of Omaha?

This third level fascinates those of us who populate and puzzle over the markets. What does this tulip story say about Fama or Samuelson and about efficient markets and price discovery? Is Professor Andrew Lo correct as he leads us down the path of critical thinking with his new book Adaptive Markets? Doesn’t the movie affirm Daniel Kahneman’s lessons in his seminal work Thinking, Fast and Slow?

For us, the movie was entertaining and rewarding. We got our money’s worth. We disagree with the critics who gave it a pan. But what do they know? They’re only out of teenage hood in the last ten years and only know one direction of markets and economics.

If you want a lesson in trading certificates, see Tulip Fever. For a pleasant art history course, see Tulip Fever. And for suspenseful entertainment that ends with a smile, see Tulip Fever.

P.S. Was there a tulip named Bitcoin?

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


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Market History and Metaphors

“History doesn’t repeat itself, but it often rhymes,” Mark Twain supposedly once observed. As the Fed begins to shrink its balance sheet even as it determinedly jacks up interest rates, we would be prudent to consider where history has rhymed before and what we might learn from those instances.

2007–08

This is the tenth anniversary of the launching of a criminal investigation into the collapse of Bear Stearns. Here is a link to a quick chronology of the demise of the firm: reuters.com/article/sppage014-n17240319.

Reflecting on these ten years and the history leading up to and since the financial crisis is important. At Cumberland, we attempt to learn from history, and we respect it. Among our 40-plus people we have some oldies, some not quite so oldies, and also some youngies who were still students when Bear Stearns failed. Our youngest employee’s age was a single digit when the financial crisis entered its early stages.

Let’s think about this for a minute. Anyone in the financial services industry in the United States who is under 40 has no, or only limited, experience of the pre-crisis period. True, there are now many books for those who have the time and inclination to read about what unfolded. A couple of them are ours. But time has presented us with new issues, and ten years of excess reserves in the global banking system and ten years of zero interest rates have been applied as a lubricant to ease recovery following the crisis period.

Few remember that the first primary dealer to fail was Countrywide. And few have read the Federal Reserve history to see how the Fed amended its rules to facilitate the absorption of Countrywide into Bank of America. That was the first instance in which the Fed started to pick winners and losers. As my friend Chris Whalen reminds us, Washington Mutual wasn’t a primary dealer. It was treated differently than Countrywide was. For an interesting history lesson, see this Gretchen Morgenson column from June 2016: nytimes.com/2016/06/26/business/countrywide-mortgage-devastation-lingers.

We can now read how decisions to leverage up at Lehman Brothers were probably influenced by the notion that the Fed treats primary dealers differently than it does others. There was great surprise in autumn of 2008 when market agents learned that that was no longer going to be true.

Fast-forward, and there is now a discussion about releasing AIG from the imposed structures of a decade ago. And we still haven’t addressed the issues surrounding the government-sponsored enterprises (GSEs) like Fannie Mae and Freddie Mac. The housing market and mortgage finance in the US have still not normalized. Furthermore, that is not likely to happen for years more, given the political deadlock in Washington.

The 1960s

Here is some history cited by Credit Suisse in a September 28 research report:

“In January 1966 US inflation was low. Headline PCE inflation was 1.7% (y/y), core was 1.4%. Inflation had for years been low and stable. Since the sixties began, the highest either figure reached was 2.1%, and both averaged 1.3%. The unemployment rate, which was steady near 5% in the early sixties, had recently begun to trend lower, breaching 4% in early 1966.”

More history from that report:

“By late 1966, the core PCE deflator was above 3%. It would drift higher for the next five years, reaching a peak of 5% in early 1971, two years before the oil price shock that would begin the more famous inflationary episodes of the seventies.”

At Cumberland there are four oldies for whom this history is personal experience. There are a few more “not as oldies” who were students at the time. Most of the rest of the Cumberland crew wasn’t born yet. Very few today recall Arthur Burns, who chaired the Fed during those tumultuous times. I recall two meetings with him. My colleague Bob Eisenbeis was in the early days of his career and remembers this period and Arthur Burns well.

Today we have little inflation and have seen a long period of low inflation. Are we about to rhyme over the next few years? Will the late 1960s be the metaphor?

But history has another lesson.

The 1930s

The following link will take you to the Federal Reserve’s policy action archives. Note that the period covered is when the Fed raised interest rates following the Great Depression and tried to ”normalize” policy: federalreserve.gov/monetarypolicy/fomchistorical1937.htm.

Here is a link to a 2011 paper from the New York Fed research website that describes the 1937 “policy mistake”: libertystreeteconomics.newyorkfed.org/2011/06/commodity-prices-and-the-mistake-of-1937-would-modern-economists-make-the-same-mistake.html.

The author, Gauti Eggertsson, opens with the following summary:

“In 1937, on the eve of a major policy mistake, U.S. economic conditions were surprisingly similar to those in the nation today. Consider, for example, the following summary of economic conditions: (1) Signs indicate that the recession is finally over. (2) Short-term interest rates have been close to zero for years but are now expected to rise. (3) Some are concerned about excessive inflation. (4) Inflation concerns are partly driven by a large expansion in the monetary base in recent years and by banks’ massive holding of excess reserves. (5) Furthermore, some are worried that the recent rally in commodity prices threatens to ignite an inflation spiral.”

Readers please note his reference to the monetary base.

Also please note that the adjusted monetary base would be falling today were it not for the increase in currency. As frequent readers know, we believe that currency is a stagnant item and has a zero multiplier in the current world. So if US dollar-denominated currency in circulation is rising by $100 billion a year globally and the Fed is maintaining a constant balance sheet size, as it has done for the last few years, the Fed is actually engaged in a passive tightening process. Now the Fed is going to shrink its balance sheet, which means it may accelerate that passive tightening phase into an active tightening process. My friend Dennis Gartman and I have mutually agreed to talk more about this phenomenon, as it is not getting enough attention by policymakers.

Let’s go back to the original point about history tendency to rhyme.

The 1960s metaphor is a warning about inflation increasing and higher interest rates ahead. The 1937-1938 metaphor is a warning about a forthcoming recession caused by the Fed’s repeating a mistake it made 80 years ago. And the Bear Stearns-Countrywide-Lehman-AIG-GSE metaphor is the most recent historical metaphor, from only a decade ago.

So which one rhymes?

And more importantly, how does one manage portfolios under these conditions?

We don’t know which historical metaphor to use. Neither does the Fed. We do know that all this history helps, and all scenarios must be examined every day and with high-frequency data. That is what we do to earn our daily bread.

Portfolio construction is another matter. Since we are a separate account manager, we can tailor-make a structure to take the client’s risk tolerances into consideration. And we can change quickly if we see a need to make a shift. Our view is that a flexible approach is necessary now. Simply put: That is what you do when you admit that you don’t know.

Right now, we are nearly fully invested and have been enjoying the rising stock market. We think that this long bull market that started in 2009 is not over. And as long as corporate earnings are increasing, it may extend for as much as several more years.

We have favored the high-grade, tax-free bond sector in bond management, and we continue to see value when the high-grade, tax-free debt of a sovereign state or local government pays a higher yield than taxable federal government debt. This upside-down ratio hasn’t made any sense for a decade and still doesn’t make sense.

The United States is not going to repeal income taxation. At best, the current 39.6% top federal bracket may be reduced to 35%. Any compromise tax bill will have to allow for state income taxation. So in high-tax states, we expect the current threshold of total taxation to remain around 50% for the highest tax brackets. One of our NJ clients is in a combined 52% marginal tax bracket. We do not expect tax law to change very much for him.

Please note that any of our specific portfolio strategy recommendations at Cumberland may change rapidly if conditions change. History teaches us to be nimble.

We will close with the words of a favored poet, George Santayana:

“Those who don’t know history are doomed to repeat it.”

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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China Riding the Global Economic Recovery

The global economic recovery is strengthening and becoming more synchronized, according to updated projections for 2017 and 2018 by both the Organization for Economic Cooperation and Development (OECD) and the International Monetary Fund (IMF). China, the world’s second largest economy, is an important part of this improved outlook, and its equity markets have been outperforming.

Last year’s global growth was 3.1%. The OECD is forecasting a 3.5% advance this year and even stronger, 3.7% growth in 2018. China’s economic growth rate is projected at 6.8% this year, compared with 6.7% in 2016. The OECD anticipates moderate slowing to a 6.6% pace in 2018, in response to some easing of stimulus measures and efforts to stabilize corporate debt and further balance the economy.

The IMF sees the present acceleration of the global economy as the broadest in the past 10 years. Their economists project  a 3.6% advance this year, slightly faster than the OECD estimate, and 3.7% growth in 2018. China’s economy is projected to grow 6.8% this year, a 0.2 percentage point increase over the IMF’s April forecast. Similarly, their forecast for 2018 has been increased by 0.3 percentage points to 6.5%, based on the expectation that expansionary policies will be sufficient to maintain such an advance and external demand will remain strong.

The latest economic data for China suggests some easing in growth momentum, but the picture is mixed. Export growth slowed in August, as did investment growth. In contrast, the official manufacturing PMI (Purchasing Managers Index) for September rose, as did the official non-manufacturing PMI. However, the Caixin PMIs for manufacturing and for general services, published by Markit, both declined. The main difference between the official and Caixin manufacturing PMIs is the broader coverage of the Caixin measure, which includes more small enterprises. That measure indicated that manufacturing continued to expand in September but at a slightly weaker rate. The Caixin general services PMI, however, slipped to its lowest level since December 2015.

Chinese equity markets drew back a bit in mid-September but then resumed their outperformance, which has been substantial year-to-date.  The US exchanges currently offer 39 ETFs for Chinese equities. Excluding inverse and leveraged ETFs, there are 31. The majority of them have relatively limited assets under management (AUM) and thus limited liquidity, but nine have AUMs greater than $150 million, and four have AUMs in excess of $1 billion. Of these four, the strongest performer by far is the KraneShares CSI China Internet ETF, KWEB, with a total return year-to-date (as of October 9th) of 68.1%. That return is more than three times the 18.4% gain of the benchmark iShares MSCI All Country ETF, MSCI.  For the other three largest ETFs, the year-to-date returns are iShares MSCI China, MCHI, 50.0%; SPDR S&P China, GXC, 47.5%; and iShares China Large Cap, FXI, 32.1%. Two other strong performers with a tilt towards technology are Guggenheim China Technology, CQQQ, 67.1%; and PowerShares Golden Dragon, PGJ, 56.7%. One attraction of PGJ is it contains only US exchange-listed companies that are headquartered or incorporated in the People’s Republic of China. These companies have had to meet US listing requirements.

Looking forward, the past volatility of Chinese equities should be kept in mind. It has been some time since a significant correction. While the moderation projected in China’s very strong economic growth is slight, China’s equity markets would be vulnerable to monetary policy tightening that was greater than expected, to adverse trade actions by the US, or to geopolitical developments that caused a widespread retreat from risk.

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

 

Sources: OECD Interim Economic Outlook, September 20, 2017; IMF World Economic Outlook, October, 2017; Caixin: HIS Markit; Ned Davis Research; Goldman Sachs Research


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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Q3 2017 Municipal Credit

Whirlwind is an understatement.

Harvey, Irma, and Maria were paramount in our minds during the quarter, but there were wildfires and earthquakes and other flooding here and around the world that really made one think about the choices people make about where to live and in many cases the lack of choice. It also made us consider weather variability, building codes and infrastructure sustainability. People have to live with what Mother Nature throws at them and make do with whatever emergency response systems, and other social structures are available to them. But people are resilient. As always, our thoughts go out to all those affected here and around the globe.

According to an S&P report[1], the federal government spent $209 billion to repair storm-related damage between 2000 and 2015; more than half of that amount was for the destruction Katrina wrought and a quarter for Sandy’s toll. Aid comes from a combination of funds funneled through FEMA, the Housing and Urban Development Corp., and the Small Business Administration and is further supplemented by the National Flood Insurance Program and special appropriations enacted by Congress, such as the $4.5 billion allocated to the Department of Transportation to rebuild roads after the 2005 hurricane season. It will be quite a while until the full damages and costs of the recent storms will be determined. On Tuesday, Sept. 26, the White House approved 100% funding of FEMA aid to Puerto Rico, so there are no matching funds required of the financially beleaguered Commonwealth. The same goes for the US Virgin Islands. Usually the recipient is required to contribute 10% to 25% of the total aid, depending on the type of project, and that will be the case for Florida and Texas. Please go to the Market Commentary section of our website to read our numerous accounts related to the hurricanes: http://cumber.com/category/market-commentary/.

Not only were the winds from three major hurricanes swirling in the third quarter, but the municipal credit markets were active, too. There were state rating changes, improved stock market performance that helped pension funding for a change, and a state capital city considering bankruptcy. Affordable Care Act repeal was feared to affect the 31 states that have expanded Medicaid, which now have a greater dependence on federal Medicaid payments. The bond market also dealt with the perception of overall improvement in the economy and employment, while the Municipal Securities Rulemaking Board offered a new service to make the municipal market more transparent. The Equifax hacking shined a light on the need for vigilance and increased cybersecurity. This is especially true for our municipalities, which not only have access to citizens’ personal information but also provide water and electric service, transportation, healthcare, and other social and infrastructural services that may be vulnerable to hacking.

State Ratings

There are still two states that have not approved a budget for the fiscal year beginning July 1, 2017 – a full three months into the fiscal year! They are Pennsylvania and Connecticut.

Pennsylvania (rated Aa3/A+/AA- by Moody’s, S&P and Fitch, respectively) has again failed to pass its budget on time. Because of short-term liquidity concerns and its chronically late budgets, S&P downgraded Pennsylvania to A+ from AA-. It is now one of five states that have at least one rating below the AA category. Short-term liquidity needs have arisen because the state started the year with a large deficit and has adopted a spending plan but does not have the revenues to pay for it. There is discussion of some additional taxes and internal borrowing to balance the budget, but no word on when a final budget might be hammered out.

The governor of Connecticut (rated A1/A+/A+) vetoed that state legislature’s most recent budget proposal because not enough aid had been designated to cities and other municipalities. The state is operating under an executive order that limits spending to available revenues. As we have written in the past, Connecticut suffers from declining population and employment, high pension obligations, and other fixed costs, even as it remains one of the wealthiest states. Reduced state aid to municipalities could lead to downgrades of various jurisdictions in the state, including the already downgraded capital city of Hartford.

In August, Hartford hired counsel known for its prowess in bankruptcy and restructurings. The city was downgraded two times during the quarter, most recently to Caa3 by Moody’s and to CC by S&P. Approximately half the property of the capital city is exempt from taxation because the buildings are owned by government-related entities. Historically, about half the city’s revenue was in the form of state aid, which so far this year is limited and could be further reduced, given the state’s budgetary issues. There is a note payment due in October, and the city reportedly does not have enough liquidity to make the payment – thus the downgrades by Moody’s and S&P, which reflect the threat of default and less than 100% recovery. Cities in Connecticut need specific state approval to enter into bankruptcy, and a negotiated restructuring of its debt may be the most likely outcome for Hartford. Assured Guaranty, which insures the majority of the city’s outstanding debt, and other bond insurers have offered to work on a restructuring.

Other State Rating Changes

Alaska (rated Aa3/AA/AA+): In July both Moody’s and S&P downgraded the state’s ratings due to the continual lack of agreement on reforms to bring the state into structural balance (where revenues cover expenditures) and to reduce dependence on substantial reserves that have accumulated from taxes, royalties, and other levies related to oil production. The declines in oil prices and a protracted economic slump have led to substantially reduced income to the state, and reserves have been drawn down to balance operations for many years in a row. The large reserves also provide investment returns to the state. Both rating agencies have negative trends on their ratings, indicating that if the drawdown of reserves continues, the ratings could be further downgraded.

Oklahoma (rated Aa2/AA/AA) was downgraded by Fitch to AA from AA+, again due to the downturn in the energy markets and drawdown of its reserve levels. Stable rating outlooks reflect the expectation that the state will take action to reduce its structural imbalance.

As we have noted in the past, states generally have stable ratings, but for the past couple of years that has not been the case as pension and OPEB liabilities have grown, and those states dependent on revenues associated with oil were blindsided by price erosion.

On the bright side for states, Wisconsin was upgraded by Moody’s to Aa1 in August, while in September S&P assigned a positive outlook to its Michigan’s AA- rating. And after numerous ratings downgrades, the outlook on Illinois’ BBB- S&P rating was changed to positive due to passage of the state’s budget, while Fitch and Moody’s removed their BBB/Baa3 ratings from being under review for a potential downgrades. Additionally, in a reversal to a longstanding trend, the outlook on New Jersey’s A- rating was changed to positive by S&P. S&P recognized that although New Jersey has one of the most poorly funded pensions at only 40% on an actuarial basis, projections show that the plan should stabilize or improve over the next year.

Higher returns offered some bright news for pensions. According to Moody’s[2], average pension plan investment returns in fiscal 2017 (most municipalities have a fiscal year from July 1 to June 30) were in the range of 12%, compared with average returns of 2.4% in 2015 and 0.5% in 2016. Moody’s estimates that the higher return will lead to a 7% decline in total state adjusted net pension liability (ANPL), quite a relief from recent years’ increases. However, because of years of paying less than the annually required amount to keep funding levels stable or increasing, and because investment returns have fallen below pension plan return assumptions, those states that have large unfunded pension liabilities will continue to be challenged.

Bond Insurers – Assured Guaranty Municipal (AGM) and National Public Finance Guaranty: The devastation in Puerto Rico cast a light on the bond insurers once again, as did the Commonwealth’s default on its debt last year. However, the bond insurers remain well capitalized and have had their portfolios stress tested internally and by the rating agencies, even for a 100% loss on Puerto Rico. Remember, the bond insurers pay regularly scheduled principal and interest on municipal bonds that have serial or annual repayment terms over 20 to 40 years – and the bond insurers are not required to accelerate. This minimizes draws on its liquidity and gives the defaulting municipality time to regain its financial footing. Assured’s $12 billion in claims-paying resources compares with over $298 billion in net par insured as of March 31, 2017, which is a large number however if the insurers do pay a claim, we emphasize it is only for annual debt service. Puerto Rico exposure is only 1.9% of net par insured, while the exposure to Hartford is less than 0.14%.  The bond insurers often help provide an orderly exit from a distressed situation; and the companies are generally repaid, albeit over a period of time, for funds used to cover debt service. Despite an uptick in reported defaults and bankruptcies, the municipal default rate remains very low.  Moody’s, in its annual default study dated June 27, 2017, reports that although municipal defaults and bankruptcies have become more common, they are still overall rare.  The five-year municipal default rate since 2007 was 0.15% which compares to 0.07% for the period 1970 to 2016. The bond insurers insure a large, diverse portfolio of municipal bonds with credit quality predominantly in the single A and triple B categories. Further, the insurers have surveillance staff that monitors credit quality and can often help solve identified problems to avoid distress.

The municipal market is at times not as transparent as the corporate bond and equity markets. Municipalities are not regulated by the SEC, which requires certain filings and disclosures (although firms that underwrite municipal bonds are required to disclose numerous data points). Individual state standards do not always require audited financials and regular reporting. However, efforts are being made by industry players to increase transparency, and municipalities themselves understand that better market access is a benefit of transparency. In early September the Municipal Securities Rulemaking Board (MSRB) unveiled market-wide trading statistics (price, yield, volume, trade size) for its Electronic Municipal Market Access system (EMMA). This is a welcome addition to the other information that is available, including official statements, financial reports, call and other notices, and interim disclosures such as for rating changes. MSRB maintains a free website so that there can be public access.

At Cumberland we continuously monitor municipal credit and market developments – and increasingly focus on unexpected events such as multiple consecutive storms. We consider the short- and long-term ramifications of these developments, and we evaluate them in the context of how they may affect our municipal holdings and present opportunities to preserve wealth and increase returns.

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

[1] S&P Global Ratings An Overview of U.S. Federal Disaster Funding dated September 19, 2017
[2] Moody’s Investor Service Stable outlook for states reflects continued slow revenue growth dated September 7, 2017 page 7


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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3Q2017 REVIEW: International ETF

Our International ETF strategy analyzes fiscal and interest rate policy and complements that research with trading analytics to determine portfolio risk/reward and valuations. The strategy has the benefit of flexibility in allocation by market cap size and developed vs. emerging markets.

Solid demand for foreign equities continued throughout Q3. Both developed and emerging markets advanced, with Europe and Latin America leading the respective moves. Market cycles will eventually wring out supply at underweight levels, and that appears to have created a coiled spring effect in international stocks as each mild pullback has been met with strong demand. Our previous notes focused on the similarities between the 2015-2016 loose, global monetary policy and the post-financial crises Fed policy moves. Capital tends to flow to asset classes that offer reasonable opportunities for a return on investment. With many foreign equity markets offering dividend yields at 2X to 3X the yield of their respective 10-year bonds, demand has been created.

Developed Markets (60%): Solid quarter across the EAFE names, with small cap continuing to lead the charge. Although the USD has recovered from its Q2-Q3 weakness, we do not feel inclined to hedge our equity positions at this time. While it is important not to let currency markets dictate positioning, we will continue to monitor the USD vs. euro and yen.

Emerging Markets (35%): Demand driven by broad asset allocation shifts continues to benefit emerging markets. Our Latin America positions had very strong runs as we were rewarded for adding exposure into the Brazilian political sell-off in May. It will be important to observe whether the late Q3 relative strength in the developed markets vs. emerging markets continues.

Cash (5%): Fairly low level for our strategy, as we focus much of our work on risk and let the upside take care of itself.

 

Matthew McAleer
Managing Director & Portfolio Manager
Email | Bio


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The Jones Act

With Cumberland’s quarter-end publishing cycle coming to conclusion, we will use this missive to deliver a bullet aimed at the Jones Act. (Readers may have noted that we try to have most of our folks offer comments at the end of each quarter, which is why there has been a flurry of missives.)

The Puerto Rico story has been front-page news and has been discussed several times by my colleagues John Mousseau and Shawn Burgess and myself. See cumber.com/munis-in-third-quarter-2017-all-about-storms/, cumber.com/quick-note-on-hurricane-maria-and-insured-puerto-rico-bonds/, and cumber.com/a-marshall-plan-for-the-caribbean/.

The Marine Merchant Act of 1920 is nearly a century old. Created by Sen. Wesley Jones of Washington, it requires that all goods shipped between US ports be carried on US-built ships owned and operated by Americans. In the wake of Hurricane Maria some members of Congress sent a letter to the Dept. of Homeland Security, asking for a temporary suspension of the Jones Act. Here is the link to that letter: velazquez.house.gov/sites/velazquez.house.gov/files/09252017 FINAL Letter to DHS JonesAct Federal requirements waivers.pdf. (Note that the US Virgin Islands is already permanently exempt from the Jones Act. Source: Fox News)

The Trump Administration granted the waiver. Better if sooner, but it has been done.

Sen. John McCain, R-Ariz., who urged Trump to waive the law, said shipping costs to Puerto Rico are approximately twice as high as to other nearby islands that allow foreign ships to dock. “It is unacceptable to force the people of Puerto Rico to pay at least twice as much for food, clean drinking water, supplies, and infrastructure due to Jones Act requirements as they work to recover from this disaster,” McCain said, as he also called for the “full repeal” of the “archaic and burdensome Act.” McCain has called for repeal of this law before and has offered repeal legislation without success.

We believe Senator McCain is correct. A hundred years ago, the law had one purpose. It was right after World War I, and US shipping needed bolstering. The impact today is to raise prices and slow down shipping. The law protects a few special interests in shipping and labor, who make a spurious argument based on homeland defense and who are bent on economic protectionism, while imposing costs on most of society. We seem to tolerate these politics normally, but every time there is an emergency we use temporary suspension of the Jones Act to overcome obstacles that wouldn’t be there if the act were repealed.

So the law is currently waived because of Hurricane Maria, and it was waived because of Hurricanes Harvey and Irma. It was previously waived after Hurricane Sandy. Most analysts want the law repealed. Hawaii and Alaska officials want the law repealed.

Note, too, that many shipping companies use a workaround method to avoid the Jones Act and ship from the US to a foreign place and then transship to a US port so they are not directly shipping US to US. That practice adds costs and reduces efficiency.

Please understand that we do not want to compromise our nation’s defenses. A Jones Act replacement law could achieve the national defense purpose in times of emergency but not impose higher costs and procedural delays such as we saw for a week during the Puerto Rico crisis.

We should also bear in mind that Puerto Rico has been hurt by the Jones Act for decades. See money.cnn.com/2017/09/28/news/economy/jones-act-puerto-rico.

Here is a modern metaphor. Suppose today the Congress were to pass a law that every commercial airplane flight from a US airport to a US airport had to be on a plane made in the US. Airbus and Bombardier, and others would not be permitted unless they flew from the US to a foreign airport and then had a separate flight from that airport back to the US. The same would be true for delivery of goods by the US Postal Service or FedEx or UPS. What would happen? Costs would skyrocket. Prices of aircraft would rise. Global competition, which has the effect of lowering costs for all of us, would be reduced.

The new law would be couched in an argument that all US aircraft needed to be available for defense purposes first – but that waivers could be granted in emergencies. We wouldn’t for a moment tolerate such a law today for air transport, yet we permit it to continue with shipping.

Our country has trouble repealing bad or unneeded laws. For example, we had a national prohibition on alcoholic beverages, but the method resorted to for repeal of that law was to pass jurisdiction to the states. Now, we are engaged in a fierce debate over healthcare, and the default approach seems to be to pass jurisdiction to the states. We seem trapped in a paradigm that allows the federal government to say yes but not to say no. Once a yes is granted, special interests become embedded, and they then achieve enough influence and financial power to protect their niches. When we have finally had enough or when we come to a real crisis, we end up passing jurisdiction to the states. If the Jones Act were passed to the states and Puerto Rico, it would be repealed by nearly all of them that had seaports.

It usually takes a crisis to get laws like this changed. Puerto Rico is an American territory with American citizens and is in deep trouble. It ranks higher in population of US citizens than 20 of the 50 states (source: US Census Bureau). Not one of those 50 states would tolerate the Jones Act’s doubling its food prices and hampering its gasoline deliveries if that state were hit by a crisis like the one that Puerto Rico is presently enduring.

Let’s get the Jones Act repealed and replaced. Then, when the next hurricane strikes, there won’t be as much needless suffering as the federal process grinds toward a costly temporary waiver.

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


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