Q3 GDP increased 5% in the U.S.  This is great news and indicates that the U.S. economy is taking the world by storm.  If this was the case, then why do interest rates fall under such good news?  Also, after falling 0.2% in the same quarter, why are wages not climbing either? Both interest rates and wages should be rising during a period of such robust growth.  

Let’s take a closer look at the GDP numbers.  First off, our neighbour’s love of defence and war spending continues to add 0.80 basis points (bps) to GDP.  However, the largest gain came from personal consumption (221bps), which is great news.   But the largest growth came from spending on services, which accounted for 115 basis points.  Of this amount, 15 bps was non-profit spending, while the remaining was divided between Healthcare spending and Financial Services/Insurance.  In short, 85% of the contribution to GDP from household spending came from Obamacare, rather than spending on tangible goods that create jobs such as TV’s and cars.  With this in mind, is the U.S. economy really taking off? 

Trade between China and the U.S. finished 2014 off with imports and exports declining 10% and 15%, respectively.  Overall, how can growth in an economy be legitimate if imports and exports declined? 

A dysfunctional American government does not help.  At $18.1t, their government debt is out-of-control.  If they ever want to tackle their liabilities, which appear doubtful, it will take generations to put their finances back in order.  Washington appears happy that they have given their corporations the highest taxes in the world.  It’s odd that they can’t figure out why so many companies have sheltered trillions of currency offshore. 

Shale oil has proven to be a boost to the American economy.  It has created jobs and less imported oil, yet it has had no influence of the country’s trade deficit.  We estimate that after 2018, America will have to increase oil imports.  America is into its 43^rd year of consecutive monthly trade deficits.  This is hardly a sign of a healthy economy.

Boeing and the farmer are the only two segments of the economy keeping the trade deficit from being a complete disaster.  Boeing is conducting robust business delivering new aircraft.  The company has a huge backlog that will keep the company busy well into the next decade.  Soon, Boeing will begin building a revamp version of the 737.  It is worth noting many parts of Boeing airplanes are made in Canada, benefiting mostly Ontario, which needs all the help it can get. 

The Baltic Dry Index, which tracks ocean shipping rates, is trading at its 25-year low.  This is indicative of a weak world trade.   The CRB Index is also sliding.  At today’s level, off 16% from a year ago, it means we have entered deflation.  The lower this index goes, the more damage deflation will do to the economy.  Deflation is a job killer and destroys wealth that is backed by debt (aka real-estate). 

We hate being the bearer of bad news but the U.S. economy is nowhere near as robust as their metrics lead us to believe, nor will it be able to pull the world economy from driving into the ditch.  We still need to eliminate the excesses of commodities, real-estate, and nearly every other good we created over the past two decades before new organic growth can take place.  We cannot see this taking place until 2018, at the earliest. 

Quantitative Easy (QE) is being praised as a success.  This monetary policy is where a central bank issues new money (essentially creating it from nothing), and uses it to purchase assets from other banks. Ideally, the cash the banks receive for their assets can then be lent to borrowers. The idea is that, by making it easier to obtain loans, interest rates will drop and consumers and businesses will borrow. Theoretically, the increased borrowing will result in more consumption, which fosters job creation and, ultimately, creates economic growth.

QE has been a failure because it has resulted in very little true economic growth, if any at all.  The main outcome from the monetary policy is that interest rates have been pushed to historical lows and debt to historical highs.  One of the main outcomes is business has used lower interest rates to issue bonds and use the proceeds to purchase its own stock.  This results in increased earnings per share, causing a rise in share prices.  Business is also using the low interest rates to invest in government debt and stocks rather than building plants and equipment. 

The world economy will bounce along because consumers must spend X amount every day to eat, sleep and for health needs.  This is basically a constant for all economies.  Where the problem lies, which those in charge of government and monetary policies do not understand, is the consumer needs extra income to give an economy a boost. This has not been the case.

As the chart above illustrates, real (adjusted for inflation) median household income in the U.S. is roughly 6% percent lower than it was in June 2009 (the month the recovery technically began), 7 percent lower than in December 2007 (when the most recent recession officially started); 8 percent lower than in January 2000, and only 5% higher than 1995. 

Currently, after-tax wage growth around the world is less than the rate of inflation.  The U.S. has averaged a 1.6% inflation rate since 1995.  Using the data from the chart above, the average American has lost roughly 1.2% of their purchasing power every year since 2005.  For those who are retired, they are getting poorer by the day because low interest rates are causing them to spend their capital at a much faster rate.  This would not be the case if their savings generated a larger income.

In today’s economy, the only way to increase ones passive income is to pick dividend paying shares in a company that raises the dividend each year by a minimum 3%.  One can also pick the right investment to earn capital gains, which has far more to do with luck than brains.  Since probably 80-to-90 percent of people only invest in various types of bank accounts, the majority of savers are sliding backwards even faster thanks to the low interest rate policies that plague the world. 

An economy needs to place as much discretionary income into the consumers’ pocket as possible.  This cannot be achieved by accommodating the borrower with historically low interest rates.  Contrary to the government’s way of thinking, it is the saver that drives the economy, not the borrower.  After all, one cannot lend what you do not have.

There are plenty of things governments can do to stimulate growth and put money into the hands of the consumer.  However, for some unknown reason they do not want to.  Instant results would be realized by lowering personal income taxes and the GST, or by eliminating the destructive capital gains tax.  Governments can also allow a certain amount of passive income to be earned tax free.

Rather than favoring monetary stimulus (QE), which has been a failure, governments should focus on fiscal stimulus such as increase spending on building better infrastructure.  Improvements need to be made in all corners of the world.  This type of spending creates well-paying jobs, which is the key to a prosperous economy. Furthermore, these types of projects tend to pay for themselves by keeping the economy going, which generates taxes along the way.

There is no benefit to catering to the overleveraged.  If one is overextended, it is going to bite them in the rear no matter if rates stay where they are or not.  It may sound a little radical, but the best solution would be to hike interest rates to a level that benefits the saver at the expense of the over-leveraged.  It makes more sense to force a bankruptcy, which one is cleared of in a few years, rather than have the person’s income pay the debt off over 15 or 20.

Asset prices are going to revert to the norm no matter what.  The only factor we can dictate is the duration it will take.  The route governments are taking is simply prolonging the contraction phase of the economy.  Until governments get serious about placing money in the hands of the consumer and rewarding savers, the world economy is going to continue to drift downward.  The stock markets will eventually follow.

Hedge Funds emerged in the early nineties as an investment for wealthy investors.  By 1998, Long Term Capital Management (LTCM) was one of the largest.  It attracted the wealthy in New York and Washington, because the fund was a sure bet.  Afterall, the two people running it, both of whom won a Nobel Prize for economics, had figured out how to beat the stock markets.  Unfortunately, their theory failed in 1998 and the fund became insolvent.  The pursuing market crash nearly took down all stock markets around the world.  As a result, investors in Hedge Funds quickly liquidated their holdings, and much of the industry went into hibernation after a good two-thirds of funds went broke. 

After a few short years, investors returned to Hedge Fund investing because the funds only hired the best brains in the investment business.  By 2007, there were 15,000 hedge funds across the globe.

Hedge Fund managers became rich overnight because of their “Two and Twenty” fee, which entitled the fund to an annual 2% for management fee, plus 20% of all profits earned.  A small hedge fund, employing roughly 20 people, would easily generate a hundred million in fees per year.  It needs to be pointed out that during the 2008 implosion, the average fund lost 23%, and, not surprising, not one fund gave investors back their management fees.  After 2008, investors began withdrawing their money.  Within months, there were only 4,500 hedge funds remaining. 

The stock markets have done well the past couple of years.  This has created a surge in new Hedge Funds.  Today, there are 11,000 funds world-wide controlling $2.9t.  Because of the amounts these funds manage, stock markets can only offer so many opportunities for them to invest in.  As a result, they are now investing in private companies that cannot be openly traded.  We do not recommend these investments for conservative investors because this increases the risk level for the simple reason; how does one value a private company on a daily basis? 

CalPERS, California’s main public pension fund, is the sixth largest in the world.  Over the past 20 years, the fund has averaged an 8.4% annual return.  CalPERS farmed out some of their money to hedge funds over the past few years.  Recently, they fired every hedge fund as most never came close to equalling what the pension fund did on their own.   All investments will now be done ‘in house’. 

While a handful of Hedge Funds make investor’s money, the majority rarely do.  If this was not the case, the number of Hedge Funds would remain stable, rather than watching half of them close within a year in any down market.  We expect many of the funds to disappear in the months ahead.   

All Hedge Funds are high risk.  We recommend one avoid these investments.  Buying blue-chip securities that pay a regular dividend will outperform most hedge funds over ones lifetime.  This will remain the simplest, and most profitable, method of investing.  

The Federal Reserve, along with the central banks of the European Union, Japan and Britain have flooded their respective economies with surplus cash.  The result has been expanding national debt, which is at historical highs. 

America’s debt is near $18t.  This was made possible by decades of irrespsonsbile budgeting as well as the U.S. Federal Reserve keeping the printing presses (Quantitative Easing) working overtime.  The bulk in the growth of their money supply in the last few years has been created for no other reason than to purchase their own short-term debt in order to keep U.S. interest rates at historical lows.  The Federal Reserve has announced that Quantitative Easing is over and they will now begin withdrawing money from the system.  Do not believe it - it is next to impossible for this to occur without interest rates jumping.

Insead, the printing presses will be working overtime for months to come, or, until Washington is forced to correct the financial mess it is in.  Washington, for years to come, will have to pay close to a trillion dollars annually in interest.  This is cash they do not have, other than via the printing press.

Governments cannot dictate interest rates; the market does it for them.  If this was not the case, lending rates would be uniform across the globe no matter the economy.  The stock markets, which are leading indicators, are telling us that things are not rosy in the immediate future.  If you choose to jump into the market tomorrow, make sure it is in companies that will continue to supply society’s needs, as well as one that offers a dividend yield around 4%.  Or, you can continue to be patient and wait for this market to unfold.  Sacola continues to favor cash for the time being.  Sit tight and check back on November 15^th.

One word you rarely hear from politicians is ‘deflation’.  Yet, we feel it is gaining ground around the world and rising house prices are masking it. 

Zero interest rates are deflationary for the simple reason that savers are experiencing falling returns on their bank deposits and dividend yields.  This translates to falling income.  Interest rates around the world continue to slide. This is contrary to economic theory which states that interest rates must rise during inflationary cycles.  For example, the European Central Bank has lowered its rate to .05 of 1%.  Similarly, German 10 year government bonds have fallen, for the first time, to under 1%.  After taxes and inflation all investors are losing money.  This is 100% deflationary. 

Japanese 10 year bonds yield .5%.  They have been this low for 11 years now.  Japan has had 24 years of negative interest rates, and the country has slid into deflation three times over the same period.  Today, a new threat is taking place; Japan has a falling population and one of the world’s highest numbers of people aged over 65.  This has resulted in a shortage of skilled workers.  Oddly enough, wages are falling for the first time in 24 years.  Japan is showing to anyone who is paying attention that prices and wages can fall.  Too many in the West believe prices, especially those for all forms of real estate and wages can only go increase year after year.

We have been told for many months now that the American economy is on the rebound.  Yet, interest rates continue to fall as 10 year government bonds are bouncing at all-time lows.  With real unemployment at 12% (U.S. Debt Clock), the American economy is going nowhere.  New housing starts are up, however,  there remains thousands of new homes built between 2005-2008 that have yet to be sold.

It appears all of Europe is about to take a slide into deflation.  There is very little governments and Central Bankers can do to stop it from happening.  The only thing they can is to put more money into the consumer’s pocket.  Instead, the Bankers only want to reward people who are deep in debt via low interest rates.

History tells us deflation is a real threat.  In the recent issue of the Sacola Financial newsletter we wrote, “on the last Friday of August in both 1929 and 1987, the Dow Jones Industrial Average traded at the then all time high.  Two months later, the stock markets around the world collapsed”.  As a note of interest, the last Friday of August 1987 was the 29^th, the same as this year. 

       On the 29^th  of August, both  the S&P 500 index and the Toronto Stock Exchange  traded at their all time highs.  The Dow Jones Industrial average closed at .02of 1% from its all time high set July 16^th.  Are we about to repeat the fall months of 1929 and 1987?  We do not know, but only a fool ignores history.  To protect oneself, you should have no debts and some cash in the bank.  Cash becomes King during any deflationary period.