wknd notes: Infinite Possible Combinations

“Free expression is the base of human rights, the root of human nature and the mother of truth,” said Liu Xiaobo, R.I.P. “To kill free speech is to insult human rights, to stifle human nature and to suppress truth,” continued China’s Noble Laureate, caged. “I’ve viewed the West as if it were not only the salvation of China but also the natural and ultimate destination of all humanity.” America’s stock market hit all-time highs; our national wealth unparalleled in human history. “My tendency to idealize Western civilization arises from my nationalistic desire to use the West in order to reform China. But this led me to overlook the flaws of Western culture,” said Liu. US Senators unveiled a revised healthcare plan, denying 20mm peasants coverage, earmarking $22bln to battle our opioid epidemic. “Hatred is corrosive of a person’s wisdom and conscience; the mentality of enmity can poison a nation’s spirit, instigate brutal life and death struggles, destroy a society’s tolerance and humanity, and block a nation’s progress to freedom and democracy.” Liu Xiaobo was born in 1955, before Mao’s famine, spent his youth on a farm. Became a poet. Married one too. Fell in love with words. And of the infinite possible combinations, his arrangements led to prison, time and again - his every character banned from bookshelves. “The free world led by the US fought almost all regimes that trampled on human rights,” he said in 2009, bright-eyed, indomitable, off to jail. As our mandarins rescued capitalism from itself, socializing losses, subsidizing risk-takers, imposing no sentences. Robbing society of fairness, justice. “In China, the underworld and officialdom have interpenetrated and become one. Criminal elements have become officialized as officials have become criminalized,” said Liu Xiaobo, back before his cancer, incarceration. “I hope that I will be the last victim in China’s long record of treating words as crimes.” 

Week-in-Review (expressed in YoY terms): Mon: China CPI unch at +1.5% (PPI unch at +5.5%), Japan bank lending +3.3% (machine orders +0.6%), S&P +0.1%; Tue: France to cut wealth tax, Fed’s Brainard “balance sheet trimming to begin soon,” Donald Jr. admits to meeting Russian lawyer to gather damning Clinton info, S&P -0.1%; Wed: Lula convicted (9yr sentence), Canada hikes 25bps to 0.75% (first hike since 2010, hawkish statement), S&P affirms Illinois one-notch above junk (following budget approval), Beige Book “economy expanded at slight to moderate pace and consumer spending is rising across majority of districts,” Fed’s George “would like to see balance sheet reduction sooner rather than later,” oil inventories decline (crude prices +3.2%), S&P +0.7%; Thur: China exports +11.3% (imports +17.2%), Korea rates unch at 1.25% (raises 2017 GDP forecast +0.2 to +2.8%), UK gov’t publishes bill that ends supremacy of EU law in UK, German CPI +0.1 to +1.5%, French CPI -0.1 to +0.8%, Spain CPI unch at +1.6%, US PPI -0.4 to +2.0%, unemployment claims 247k, Senate Republican’s unveil revised healthcare bill, Yellen “I think it’s premature to conclude that the underlying inflation trend is falling well short of 2%,” S&P +0.2%; Fri: South Africa suspends implementation of mining charter that requires 30% black ownership (rand jumps 1.4%), UK strikes conciliatory tone over Brexit bill, German trade surplus +1.0 to 14.7%, US retail sales disappoint, CPI softens -0.3 to +1.6% (core unch at +1.7%), IP posts 3rd strong month, probability of another 2017 rate hike fall below 50%, UMich consumer sentiment -2.0 to 93.1 (+3.4% yoy), Donald Trump Jr dug his Russian hole deeper (new details/attendees continued to emerge from his meeting), S&P +0.5%; Sat/Sun: Mass rallies mark Turkey coup 1yr anniversary.       

Weekly Close: S&P 500 +1.4% and VIX -1.68 at +9.51. Nikkei +1.0%, Shanghai +0.1%, Euro Stoxx +1.8%, Bovespa +5.0%, MSCI World +1.2%, and MSCI Emerging +3.8%. USD fell -3.1% vs Brazil, -2.9% vs Mexico, -2.9% vs Australia, -2.2% vs Turkey, -2.2% vs Russia, -1.7% vs Canada, -1.6% vs Sterling, -1.5% vs Chile, -1.2% vs Yen, -0.6% vs Euro, -0.4% vs Indonesia, -0.4% vs China, and -0.2% vs India. Gold +1.3%, Silver +2.4%, Oil +5.2%, Copper +1.6%, Iron Ore +4.7%, Corn -3.8%. 5y5y inflation swaps (EU flat at 1.58%, US -1bp at 2.24%, JP +4bps at 0.35%, and UK -8bps at 3.26%). 2yr Notes -4bps at 1.36% and 10yr Notes -6bps at 2.33%.

YTD Equity Indexes: Greece +44.6% priced in US dollars (+33.1% priced in euros), Poland +36.6% in dollars (+20.0% in zloty), Turkey +34.3% (+34.6%), Austria +32% (+21.5%), Mexico +31.8% (+12.1%), India +27.7% (+20.8%), Korea +27.4% (+19.2%), Portugal +24.8% (+14.8%), Spain +23.8% (+13.9%), Denmark +23.8% (+13.9%), Hungary +23.3% (+12.2%), Chile +22.8% (+20.5%), Argentina +22.4% (+29.3%), Czech Republic +22.3% (+8.6%), Italy +21.4% (+11.7%), Finland +20.8% (+11.2%), Taiwan +20.7% (+12.9%), Singapore +20.3% (+14.1%), Germany +19.5% (+10.0%), HK +19.1% (+19.9%), Sweden +18.4% (+8.5%), Belgium +17.6% (+8.2%), New Zealand +17.4% (+11.2%), NASDAQ +17.3% (+17.3%), Netherlands +17.2% (+7.8%), France +17% (+7.7%), Euro Stoxx 50 +16.4% (+7.2%), Switzerland +15.9% (+9.9%), Ireland +14.9% (+5.8%), South Africa +13.5% (+7.8%), Philippines +13% (+15.3%), Indonesia +12.1% (+10.1%), Malaysia +11.7% (+6.9%), Israel +10.9% (+2.2%), Brazil +10.9% (+8.6%), Norway +10.1% (+4.7%), Australia +10.1% (+1.8%), S&P 500 +9.8% (+9.8%), UK +9.4% (+3.3%), Japan +9.0% (+5.3%), Colombia +9.0% (+9.5%), Thailand +8.6% (+2.3%), China +6.5% (+3.8%), Canada +5.5% (-0.7%), Russell +5.3% (+5.3%), Saudi Arabia +1.5% (+1.4%), UAE -0.6% (-0.6%), Russia -9.2% (-12.2%).

Roughly: “US stocks rise roughly 7% per year,” he said. “Same holds true for Australia; basically, for all economies uninterrupted by catastrophic war at home.” The 7% roughly equals 5% nominal GDP growth plus an extra 2% which is due to the S&P 500 index periodically kicking out bad companies and replacing them with better ones. “Sometimes the market runs ahead of this 7% rate of return, which doesn’t mean it’s the wrong price, it simply means it’s premature.” In a world of fiat money, high prices are never wrong, they’re only early.

Roughly II: “It took fourteen years for the stock market to return to its 1968 highs,” he continued. “And at that point in 1982, with overnight interest rates at 20% and the S&P 500 price-to-earnings multiple at roughly 8, the market still had miles to run.” By the year 2000 with the S&P 500 P/E multiple at roughly 29, it was kind of the opposite. Then roughly 13 years later, it broke back above that Jan 2000 high, with a P/E ratio of roughly 17. Today the trailing P/E is roughly 26, with overnight rates 19% below the 1982 levels, and 4.5% below the 2000 levels.

Roughly III: “So we’re obviously not at a similar point to 1982,” he continued. “But where are we?” Nerds forecast a 3% a year S&P 500 returns for a decade. Quants say we’re in the top few percentiles of historical valuation across every asset class (except volatility). The S&P 500 is up roughly 10% this year. Which means we’ve realized roughly 3yrs of gains in the first 6mths of 2017. “At some point, you rally so much that your 10yr return forecast turns flat. At which point you could go sideways for a decade.” But roughly speaking, stocks either go up, or down.

Red Tails: “They’re all in tightening mode now,” said the CIO. “But they’re being properly cautious about the pace.” What a difference a year makes. Last summer saw the Brexit panic low in yields. Secular stagnation hit its climax. “But the stock and flow dynamics of this cycle are unlike anything we’ve ever witnessed.” The stock of debt relative to GDP has never been higher outside of wartime. And the flow of nominal GDP has never been this low at the end of a cycle. Nor has inflation. “The combination of low flow and high stock is one tough combination.”

Red Tails II: “But if we’re being really honest here, it’s actually worse,” continued the same CIO. “In previous cycles, all of these off-balance sheet liabilities were so distant that they weren’t real.” Pensions, entitlements. “Now they’re here. State of New Jersey, Connecticut, Illinois, should I continue?” he asked. I was growing bored. Drifting. Two hawks circled high overhead, silent, harmonious, hunting. “And then on the other side of the ledger is our asset base. Tired, worn, unable to support these obligations.” And the sun hit them just so, Red Tails.

Anecdote: “Imagine you and I built a hotel 40yrs ago,” said the CIO. “We knew it’d be hard. Hotels need lots of workers. There’s constant wear and tear.” Rooms need remodeling. “We hired 25yr old’s, trained them well. Those early years were dynamite. The place hummed.” Our workers formed unions. “They had a monopoly position against us, that’s basically what we call democracy.” It worked fine. “We agreed to pension plans. Room rates rose alongside wages, business boomed.” To cover unexpected bills we borrowed. And borrowed. But with today’s rates this low, payments on our record debt are manageable, we’re still making some money. “Now our workers have started to retire.” We’re hiring 25yr old’s again. Though they don’t seem to like us much anymore. In fact, our workers kind of hate us. Maybe it’s because we ask more of them for less pay and benefits. “Our service has slid.” Rooms are run down. No one’s having as much fun as the old days. “So we’ve gone back to our original workers and said, ‘Look at this place, it’s a dump, a disaster. It doesn’t really make enough money to sustainably pay your pensions.’ And to make matters worse, your kids work here now.” This is their future. And a new Chinese hotel has gone up across the street. Filled with 25yr old’s. Cranes are circling in the distance. “We’ve asked our retiring workers to cut us some slack, for the sake of everyone. Don’t they care about their kids? They work in a rundown place, we no longer even train them.” But these parents say ‘No,’ they don’t actually care. They feel they’ve earned these benefits and that’s that. Of course our creditors expect to be paid. They squeeze stones dry. “And that’s the state of the western world.” 

Good luck out there,

Eric Peters

Disclaimer: All characters and events contained herein are entirely fictional. Even those things that appear based on real people and actual events are products of the author’s imagination. Any similarity is merely coincidental. The numbers are unreliable. The statistics too. Consequently, this message does not contain any investment recommendation, advice, or solicitation of any sort for any product, fund or service. The views expressed are strictly those of the author, even if often times they are not actually views held by the author, or directly contradict those views genuinely held by the author. And the views may certainly differ from those of any firm or person that the author may advise, drink with, or otherwise be associated with. Lastly, any inappropriate language, innuendo or dark humor contained herein is not specifically intended to offend the reader. And besides, nothing could possibly be more offensive than the real-life actions of the inept policy makers, corrupt elected leaders and short, paranoid dictators who infest our little planet. Yet we suffer their indignities every day. Oh yeah, past performance is not indicative of future returns.