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THE LONG, THE SHORT, AND THE IMMEDIATE

World Markets are in a state of panic, and rightly so. The issues contributing to this fear are many, so in order to get a “fix” on the “real” risk in these markets, we need to sort the issues in an orderly and logical manner. Our preference is to categorize issues by whether they are long term in nature (one year to decades), short term (less than one year), or of immediate concern. In most cases, the immediate issues are former long-term and short-term considerations that have evolved to an immediate and critical nature. Let’s start our analysis with the long-term view and move through short-term issues and lastly address the immediate concerns of the market.

Long-Term View

To better understand our current long-term concerns, we must first review a bit of history.

The end of World War II ushered in a dramatic change in global economics and societal demographics. Economies, previously dedicated to meeting the demands of war, necessarily shifted gears toward “rebuilding” destroyed infrastructure, and providing products and services for an emerging consumer class, led by newly formed families associated with a rapidly rising birth rate.

The rebuilding of the ruins of war was largely financed with debt, led by the United States, the new world’s leader and sponsor of the new reserve currency. The rebuilding of cities, highways, power grids, along with our own interstate highway system provided jobs and profits for an industrial base, and generous returns for investors in these industries. Thus, the backbone of a long-term bull market was formed. Investment successes led to a wealth effect, allowing Americans even greater prosperity and the highest standard of living in the world. Companies and industries catering to this more affluent consumer and to the appetites of a maturing “baby boom” population grew at exponential rates, creating even more prosperity while confirming the “American Dream” phenomenon.

Tax law at the time, while featuring higher tax rates, also contained generous allowances for deductions. Sales taxes, consumer credit interest and home borrowing expenses were all deductible. At high tax rates, when an expense is deductible, the government actually carries a greater proportion of that expense. In short, Uncle Sam subsidized consumerism as well as highways, electric grids, agriculture, and even a car for the kids and a trip to Hawaii (all on credit, of course).

The expansion after World War II was dramatic, as were investment results. Further growth was nurtured by a peaceful world. The military might of America assured that peace and the tab was paid with increased borrowings.

The American Dream was alive and well. Other societies around the world observed this miracle and began copying the American Model. The standard of living rose, as did the debt burden, for many 2 societies around the world. As smaller global economies “perked up,” their currencies strengthened as well. On a comparative basis, the American dollar declined where foreign growth rates outpaced our own. Much of this growth came from aggressive borrowings and accommodation by Central Bankers. American investors, seeking high growth, began investing overseas.

The most recent economy to emerge and grow has been China, but in this instance, this emerging economy was extremely large, creating an enormous appetite for industrial commodities and financing. Commodity prices surged, creating a boom for all commodity producing nations, their currencies, and investors participating in this commodity bubble.

Concurrently, the policies invoked by President Obama called for a smaller, less involved military presence around the world. This policy has seemingly diluted the prior peace benefit.

Accordingly, we can now conclude that there are several glaring shortcomings and concerns regarding the global economy, its structure, security, stability, and the overall outlook for growth comes into question.

One current concern about future growth emanates from demographic effects. The baby boom generation of post WWII is no longer increasing consumption. Larger homes, vacation homes, extra cars, expensive vacations, fashion considerations are no longer at the top of their spending priority. Healthcare, instead, becomes the expenditure of choice (or necessity). How, then, can an economy previously built on a generation’s appetite, continue to grow at the same rates? A concern about servicing the debt around the world becomes even more serious if the force of demographics creates a headwind for economic growth and the ability to service debt.

Geopolitical instability promises to become a greater concern as America withdraws and diminishes its role as the world’s policeman.

New found weakness in the Chinese economy has burst the commodity price bubble, creating economic and currency problems for commodity related economies and companies around the world. There is now over $9 trillion in dollar denominated debt owed by foreigners who must service this debt with weakened currencies. The recent strength of the dollar exacerbates this problem as American investors liquidate investments to return home. In reality, this issue moves to the front burner and becomes shortterm or even an immediate problem.

Short-Term Concerns

The economic decline in China combined with the Government’s reactive and controlling response has precipitated a capital flight from that country. The pressure to devalue the yuan increases daily as investors flee China. Whether Beijing can avoid significant devaluation of the yuan remains to be seen.

Any devaluation, however, could seriously affect other commodity producers who hold contract commitments denominated in yuan. Such a ripple effect could involve Brazil, Russia, Australia, Canada and any independent producer holding these commitments. This potential ripple effect is behind the market’s concern about a new financial contagion. The pressure to default on obligations is rising.

Likewise, loans to oil producers carry a high default risk as the price of oil searches for a bottom after a 70% drop. This oil price decline is creating international instability as many oil producing countries suddenly face political survival as their revenues decline.

The massive accumulation of debt since WWII has now become a short-term worry. The cracks in the debt super structure are becoming obvious, and it is no wonder why bank stocks are among the poorest performers in the market. Consider the fact that we have $89 billion of loans outstanding to Brazil alone. Who are the lenders? How much debt does Citicorp or J. P. Morgan own?

The up-coming election is a growing uncertainty. Frankly, our economy needs public policy that will encourage economic growth along with spending discipline in order to be able to cover our many obligations. Without such policies, it becomes unlikely that the United States will be able to service its debt, meet obligations, and serve as the reserve currency for the world in the future.

The election rhetoric so far is mixed with some growth ideas, but proposals from the leading candidates are frightening. Higher tax rates for capital gains, corporate dividends and ordinary income margins, tariffs on foreign goods, corporate penalties for moving off-shore, along with large increases in spending programs add up to a recipe for economic decline and has the market worried. This is a critical election for Americans and the world at large. As the November date nears, this issue will become an immediate and increasing daily concern.

Immediate Fears

Middle Eastern politics are in flux, as the drop in oil price threatens the lifeblood of revenues needed by many of today’s producers of the world’s oil supply.

ISIS has taken over a large portion of Iraq, and threatens to take Libya as well.

The new “deal” with Iran creates angst for rival Sunni governments like Saudi Arabia, who are burning through resources as oil revenues drop.

It would not be surprising to see currency devaluations occur in states like Saudi Arabia, creating further instability in the region.

Russia’s recent involvement in the region introduces an increased risk of expanded conflagration. Markets just don’t like the threat of war.

On this note, China’s military posturing in the Western Pacific only adds to the geopolitical worries confronting the markets.

When we think of market driven losses, people usually think about the stock market. The real damage to date has occurred in the fixed income area, specifically the “high yield” area. Investors seeking yield have purchased bonds and funds holding high yield bonds in order to receive “above market” income. We have recently seen the failure of one high yield fund as it was unable to meet redemptions. This inability to give shareholders their money stems from the fact that there are no buyers for many of the bond holdings in the fund. The bond market is simply not that liquid any more, and the fear of a rout in the high yield fund area is spreading to the stock market.

Finally, the most acute fear comes from concerns about our own economy, and the monetary course of the Federal Reserve (Fed).

Many large companies are guiding earning expectations lower. They see a weak global economy ahead and this lack of confidence is causing analysts to lower earnings projections and project an even weaker economy or recession.

The Fed’s attempt to get itself out of the “QE2 Box” featured an interest rate hike late last year. More importantly, the Fed simultaneously announced a plan to increase interest rates three more times. This plan is completely out of sync with economic signs and implies that the “Fed” will be driving three more nails into the economy’s coffin. We frankly feel that Janet Yellen and her fellow Governors will change their position on rate increases. Another market down draft will help to make our view a certainty. Nevertheless, many investors are expecting the Fed’s implications.

We haven’t given up on the market or the economy, as we see some real signs of life in the numbers. Consumer confidence, new home sales, and auto sales surprise to the upside. The market, however, is focused on the negatives. With the issues surrounding us, it is easy to empathize with the market’s mood.

The very unusual electoral process is perhaps the most serious of all concerns and promises to increase in intensity. Investors are beginning to believe that the United States will soon lose its free enterprise, capitalistic roots, and instead become a socialized, anti-growth and anti-wealth state.

We have more confidence in the wisdom of the American people, which keeps us hopeful. However, our analysis of the facts, as presented in this communication, has steered us to a defensive portfolio structure. Individual client risk tolerances obviously differ, but our typical (median) client portfolio is focused on America with no foreign investments (except for a few American companies that have moved off shore). Fixed income (bonds) and cash outweigh stocks in most portfolios. All bonds are either U.S. Treasuries or high quality corporates, so the high yield (junk bond) crash has not affected us. Our bond durations are relatively short in order to minimize the risk of an interest rate spike. The balance, remaining in cash, is mostly in government paper. As always, liquidity is key for us.

We started moving to this defensive position weeks ago, so our typical portfolios have experienced only a portion of the recent decline. This defensive posture, however, really is an offensive strategy. We see opportunity ahead for investors who have cash and liquidity. We possibly could be looking at the best buying opportunity of the last 12 years. With ample cash on hand, we expect to make investments at bargain basement prices in the not too distant future. The keys from here will be patience, discipline, and decisiveness. We will keep you posted. Thank you for your continued confidence.

About the Author


Harlan J. Cadinha
Founder, Chairman and Chief Strategist
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