Stepping Stones Outlook

Submitted by ub on Fri, 10/16/2015 - 14:50

The recently completed third quarter reminded us that financial markets entail risk even as the
Federal Reserve continues to pursue its extraordinary monetary policies adopted during the
financial crisis seven years ago. The third 10% stock market correction since the bull market
emerged in 2009 came after a record stretch of time without one. However, the volatility was
minor compared to the Black Monday crash of October 19, 1987 which convinced President
Reagan to establish the President’s Working Group on Financial Markets. Comprised of the
Secretary of the Treasury and each of the Chairmen of the Federal Reserve, Securities and
Exchange Commission and the Commodity Futures Trading Commission, their goals included
enhancing the integrity of our financial markets and maintaining investor confidence. They were
so effective over the following decade that the Washington Post referred to the group in 1997 as
the Plunge Protection Team. They would be called upon the next year when the collapse of Long
Term Capital Management and the Asian currency crisis rocked international markets. The US
economy sailed through those events as the fruits of their labors seemingly defeated the business
cycle and brought us “The Great Moderation.” Their star status was marked by Bob Woodward’s
biography of Alan Greenspan titled Maestro and Time magazine’s February 1999 cover featuring
him with Treasury Secretary Robert Rubin and deputy Lawrence Summers as “The Committee To
Save The World.” At the turn of the century, the world was truly enamored with America’s
financial system.

By then, our top engineers were taking advantage of technology and data analysis to devise new
complex financial instruments to smooth the natural volatility of a market economy. Such
derivative products enable manufacturers to better manage their supply chain and farmers to lock
in prices on crops to be harvested in the future. The instruments work fine until they don’t. In
2003 we learned that broadband and carbon futures were among many of the scams run out of
Enron. The subprime mortgage products designed to offload risk became vehicles to enhance risk
beyond manageable proportions in 2007. The role played by financial derivatives in the two
financial disruptions of the new century led former Fed chairman Paul Volker to quip in 2009 that
the most important financial innovation of the preceding twenty years was the automated teller
machine. Maybe it’s good that those financial engineers were not building bridges and buildings.
Volker’s point rang true in the third quarter beset by volatility from massive unwinding of hedge
fund bets as Chinese authorities devalued their currency and the Fed prepared markets for the first
interest rate increase since 2006. Financial and political tumult throughout the world drove the US
stock market down by more than 12% before rebounding partially to end the quarter almost 7%
lower in the weakest quarterly performance since 2011.

Special FX: The two other corrections of this bull market were answered with additional quantitative easing
(QE) from the Federal Reserve but now the central bank is guiding markets to expect rates to be
normalized off their zero interest rate policy (ZIRP). They passed on the opportunity at their July
meeting but the minutes released in August showed the board preparing to pull the trigger in
September on the long awaited interest rate liftoff. The release of those minutes and China’s
surprising currency devaluation several days earlier led to a massive unwinding of one of this
market’s favorite trades, the dollar carry trade. It was a volatile reaction sending the Dow Jones
Industrial Average down by more than 500 points on two sequential days including a several
minute 1,000 point flash crash on August 24th
As bad as it was here, it was worse in China despite herculean efforts from that country’s plunge
protection team. Skeptical Chinese journalists were arrested, corporate insiders were banned from
selling stock, and the government forced brokerage firms to buy shares. The measures seemed to
finally take effect after the climatic selloff on August 24th put the Shanghai Composite more than
40% below its peak. The Chinese market is currently forming a bullish pattern after the Fed
decided against raising rates last month encouraging money to flow back into the dollar carry

ZIRP enables hedge funds to borrow dollars for almost no cost and invest in emerging markets.
The most popular destination had been China with its positive yield on cash deposits and an
appreciating currency making the trade even more attractive. The dollars pouring in over the last
six years funded expansions in China’s industrial sector whose companies built huge stockpiles of
all kinds of commodities. Brazil was a similar favorite with the hot money flowing mostly into its
energy sector. James Grant, editor of Grant’s Interest Rate Observer has pointed out how ZIRP
has ironically contributed to the deflation the Fed is fighting as supply gluts have driven prices
down to the 2009 crisis lows. Selling the borrowed dollars and buying emerging market
currencies has strengthened the latter while weakening the dollar. US multinational corporations
benefited as a weakening dollar makes their products cheaper abroad. Our October 2012 letter
told of Brazil’s finance minister calling the American QE policy “selfish” to which Ben Bernanke
responded that the emerging markets should embrace the stronger currencies resulting from his

He had a valid point. History is clear that economic prosperity is correlated with a strong currency. The Federal Reserve Bank of St. Louis compiles a trade weighted index reflecting the dollar’s value versus our trading partners. You can see on the chart how our last economic boom correlated with a rising value of the dollar
in the 1990s. The plunge protection team of those days was unambiguously clear that a strong dollar was in the national interest and the world took notice. The strengthening dollar this year is seen conversely as a harbinger of deflation and a threat to the earnings of multinational corporations. The recent upward spike is a
function of the world’s other central banks undertaking their own QE programs as the Fed winds
up ours. A stronger dollar is worrying the Fed but it shouldn’t. The economic struggles for most
of this century should be lesson enough that the benefits from a weaker currency are more than
negated by the consequences. Coinciding with that downward slope in the dollar’s value this
century has been the median US household income which has plunged to its lowest level since

International investment flows tend to avoid a country with a depreciating currency because
investment gains will be lost when converting back to their home currency. In the weeks after
China reversed its long term policy of currency appreciation, their plunge protection team was
forced to defend the yuan in markets that came to expect further devaluation. The frantic effort to
support the currency as the hot money flowed out reportedly cost China about $200 billion of their
estimated $1.2 trillion hoard of US Treasury debt. The situation looks worse in Brazil where a
steep recession is coinciding with a collapsing currency and political scandal. The good news is
Brazil has become a popular destination for Americans to travel for cosmetic surgery and if you
have any thoughts on attending next summer’s Olympics in Rio, it is a good time to book. QE
may not have done much for the US economy but it created booms in the emerging markets which
are now crashing as the dollar carry trade gets unwound. The Institute of International Finance, a
global banking association, says this year will see the first net outflow of capital from the
emerging markets since 1988. Reiterating a now common theme in these letters, these are not
normal times.

It is also not normal to have nine out of ten positions lose value over a calendar quarter but that
happened to our fully invested equity ETF strategy. Our two energy positions, the China fund and
the gold miners were all down more than 20%. The currency hedged Japan fund lost almost 15%
and the semiconductor position was down more than 10%. Europe was better along with the value
and consumer staples positions which declined about in line with the broad US market. Our
utilities fund was the standout gainer adding more than 5%. The portfolio of ten ETFs declined by
about 14% on a price basis in the third quarter and is down a little less than that for 2015 thus far.
The decision against liftoff in September followed by the poor employment report on October 2nd
provided a reprieve suggesting the data on which the Fed depends signal further easy money
ahead. Bad news being interpreted as good has sent prices of the most popular carry trade
instruments higher to begin the fourth quarter signaling “risk on” again. We can expect the hedge
funds will ride ZIRP until the next threat of higher rates when they will again bring markets close
enough to the brink to make Yellen blink. As he works the talk show circuit selling his new book,
Ben Bernanke is taking credit for the supposedly healthy economy brought about by the policies
that his successor is unable to terminate.

Fiscal Drag: Bernanke’s memoir titled The Courage to Act recounts the 2008 financial crisis and justifies his
unconventional actions in the eye of that storm. He says nothing could have been done to save
Lehman Brothers but ignores the moral hazard created by the Bear Stearns rescue which led the
market to expect similar treatment for Lehman. That criticism is easy with the benefit of hindsight
so our disagreements focus on the actions Bernanke’s Fed took after the crisis. Fears of runaway
inflation may not have been realized but neither have the Fed’s objectives which gradually move
with the poor results of their policies. Bernanke told “60 Minutes” in 2010 that the Fed has been
“very, very clear that we will not allow inflation to rise above two percent or less” and that they
“could raise interest rates in 15 minutes if we have to.” Now Yellen says 2% is not a ceiling but
an objective. A seemingly unattainable one as the Fed’s preferred inflation measure excluding
food and energy registered 1.8% year over year in August and 1.9% in September. A tenth below
target is still too low for Yellen’s Fed. The current 5.1% unemployment rate was once thought to
be far below a level requiring monetary accommodation but our economic indicators have become
so unreliable that the Fed knows the employment market is much weaker than that statistic
suggests. The labor force participation rate falling to the lowest level since women entered the
workforce almost 40 years ago is more telling.

Failing to recognize the distortions caused by almost a decade of suppressed interest rates,
Bernanke points the finger of economic blame at our political leaders who refuse to confront the
structural problems vexing our economy; an easy mark. Unsustainable entitlement programs are
pushing taxes higher and the regulatory state has kicked into overdrive. Government dictates
regarding health care, finance, energy, labor, internet services and the environment have
fundamentally changed our economy. Regulations have become so vast that virtually everyone is
guilty of some offense to the point that our nation of laws has become one where the law is
arbitrary and capricious. Starting even an ordinary business now requires thousands of dollars to
be spent on consultants and lawyers before any business gets conducted and forget about getting a
bank loan; risk is heavily penalized under Dodd-Frank regulations incentivizing the banks to focus
on Treasury debt instead of commercial loans. That helps the government spenders who find
ample demand for all the bonds they need to issue. Since our modern plunge protection team
supposedly fixed things after 2008, more US companies are dying than being born each year. In
forty years of data, Gallup had never reported that happening until what has now become an eight
year streak.

Bernanke is right when he says the economy is suffering from lower productivity due to decreased
levels of investment. Record low interest rates surely contribute to that reduced investment
activity as much as taxes and regulations do. Investment requires savings but low rates have
shrunk the pool. Established companies with access to financial markets have benefited from the
Fed’s easy money mostly by borrowing to repurchase stock to mask their shrinking businesses
rather than investing to make them grow. Unfortunately, productivity enhancements have
generally come from firing workers. All the financial engineering has not been enough to hide
another quarter of declining earnings as America’s multinationals are catching the economic flu
spreading worldwide which our doctors seem incapable of curing.

That’s not for lack of effort. Yellen maintained ZIRP at their last meeting because the economic
outlook in her words remained “quite uncertain,” as if the future is ever certain. She almost
fainted while giving a speech several days later reiterating her expectations of the long awaited
interest rate liftoff before year end. The bond market disagrees and currently predicts that to
happen in mid-2016 or later. At her press conference, Yellen responded to a question about
adopting a negative interest rate policy (NIRP) calling it “one of our main policy options” if
further accommodation were to become necessary; at least one of her board members thinks it will
be. Early this month the US Treasury sold a three month bill at a zero interest rate for the first
time ever. The poor employment report issued October 2nd and subsequent disappointing
economic reports now have the market preparing for NIRP rather than liftoff from ZIRP.
Our new normal of low rates and stagnant growth has consequences beyond the destruction of US
savings. As bad actors take advantage of an increasingly volatile world, the developed world finds
itself unable to use our most powerful weapon. Economic sanctions restricting access to our
markets are often threatened but rarely undertaken lest the burden tip our economy into recession.
The result is more political disruption which metastasized in the historic refugee crisis that
emerged this summer. It is not only Syrians and Libyans flowing into developed Europe. We are
also experiencing it on our hemisphere as third world Latin Americans seek the relative stability of
developed North America. They are coming at least in part to escape the wreckage caused by the
heavy hand of government that is also smothering the developed economies, only to a lesser

Despite the best intentions of our plunge protection teams, most of the world appears to be in
recession and another quarter of declining US corporate earnings suggest we will not be immune.
That may hold the answer to whether the summer selloff was a correction or the beginning of a
bear market. The volatility suggests the moderation of recent years will be proven false when the
Fed does eventually normalize their policies. It is futile to expect when that will come since their
heightened rhetoric of recent quarters has been proven empty. Maybe they are trying to hold it all
together until the party claiming to oppose activist government takes over, then the ensuing
recession can be blamed on them. We always thought the end of the Fed’s extraordinary monetary
policies would be more disruptive than they told us to expect. We see the current monetary mess
as an argument for a return to free markets rather than enlightened elites deciding on optimal
prices. We are not going to wait for Fed certainty before allocating our larger than usual cash
positions but we are going to wait for better earnings reports or more compelling valuations.
Please feel free to call with any of your financial concerns. Until then and as always, thank you
for your trust and thank you for your business.