Chairman’s Message

In my March letter to World Innovators Fund and Strategic Income Fund shareholders, I suggested the possibility that the economy may be undergoing a regime change–a term used by economists to denote a shift in the behavior of the economy. For the past 5 years, we have enjoyed a “good news, good news” economy. Rising growth rates led to declining unemployment rates. The stock market has been buoyant, almost doubling.  

So far 2018 has marked a shift in the economic data as investors became concerned about inflation and rising interest rates. The market strength continued in January, but February brought the collapse of the inverse VIX (XIV) ETF and a sell off in the market. Since then economic news has been mixed and the market has bounced around with some signs of progress over the summer months, especially in August. 

Possibly we’ve moved into a “good news, bad news” economy.

Favorable growth and unemployment data are countered by rising interest rates. Wage pressures are building, suggesting that inflation may lie ahead. On the political scene, the good news of potential better relations with North Korea is offset by the bad news of potential trade wars.

This suggests that a more cautious stance by investors may be warranted. If the market has ceased the “damn the torpedoes, full speed ahead” mode of the prior five years, there are some that are considering the potential for a significant meaningful market setback. Those who fear a setback either worry about the length of the economic expansion we are enjoying or about the growing amount of debt. The argument for such a reversal is usually attributed to the extended duration of the current expansion, or the massive amount of debt which has been accumulated around the globe. I won’t restate either of these bearish concerns here as they have been abundantly discussed elsewhere.

I have my doubts about the likelihood of either of the above worries tipping us into a bear market. I don’t believe that expansions end simply because they have continued for a long time. Instead, I believe that excesses (too much inventory, too much debt) tip an expansion into a recession. Further, I believe that the apparent length of our current expansion is somewhat misleading as we underwent an economic reset in 2015 as the result of plunging energy prices. While this reset did not show up as an official recession, I believe it purged some of the excesses which had been accumulating even as it helped to prolong the official expansion day count.

Excessive debt is potentially more serious.

However, the amount of debt isn’t what usually leads to difficulty. Instead, it is debt service–the inability to make the next payment due–which actually ignites debt problems. Interest rates, the key component of debt service costs, have remained lower for longer, enabling the service of mounting debt. But now the Fed is clearly trying to raise rates to dampen enthusiasm for accumulating adding more debt. If the Fed succeeds in raising rates, the debt burden will become heavier.  

However, market controlled long rates are refusing to cooperate, largely ignoring the rise in Fed controlled short rates. The disparity between long and short rates marks a key economic battleground. On one side are the Fed and other central banks who want to raise rates to ensure that the economy doesn’t overheat. On the other side are savers (e.g. pension funds, retirees) who are relentlessly searching for yield. Rising rates are met–and offset–by a flood of savings. Further, whenever economic problems flare, (e.g. Italian woes, Argentina and Turkey currency collapses), yield hunters are joined by those seeking a safe haven in dollar based assets.   

Despite the power of the Fed and other central banks, the sheer volume of savings seeking an adequate return leaves the future course of long term interest rates in doubt. If the central banks prove unable to dampen economic growth, overheated economies then seem likely to be the inevitable result.

Emerging economies seem to be stuck between a rock and a hard place.

The rise in US interest rates to date has spurred a rise in the dollar. A strong dollar tends to put a damper on emerging economies. In the short run, emerging economies will benefit if the rise ins rates is brought to a halt. But in the long run, all will suffer if the global economy overheats, and emerging economies more than most as they tend to be the tail end of the whip.

Currently the suffering of most emerging economies seems limited to their currency and stock market. For most, business as usual seems to be the case, but for some, such as Argentina and Turkey, there are some genuine issues exacerbated by the strong dollar.

Finally, geopolitics are always an issue, as problems can emerge with little warning. The current spat about trade wars offers a good example. The President is one of the few who thinks “trade wars are good, and easy to win.” Most hope that the latest current spat with China is a negotiating tactic and will not lead to a trade war. While such an accident should never be discounted, I expect the issues in the headlines (including trade with China, currency crises in Turkey and Argentina) to fade to normal.  

For years, I have been describing myself as a cautious bull. Today, I would describe myself as an even more cautious bull. This means that I expect the global economy to continue benign and that the market will eventually muddle through any rough spots ahead.

debt, economy

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