Risk & Opportunity

A quarterly political and economic newsletter published by Michael Cuddehe

Q4 '13

History Repeats Itself

Karl Marx got some things right. “History repeats itself: first as tragedy, then as farce.” The spectacle emanating from Washington in recent months is nothing if not a farce.

Republican neo-Confederate nihilists pushed the limit over the debt limit in October, causing a 16 day shutdown of government services and threatening to drive the U.S. into default on its obligations if they didn’t get their way on spending issues. Threatening default, as Warren Buffet put it, is “an economic weapon of mass destruction” and should be “off the table for everyone, for good.”

The near term damage of this action has been mostly to the Republican Party, which is finally beginning to wake up to that fact and start to push back against the lunatic wing of the party. But the real damage this action has done to America will only be known over the long term. As Larry Summers put it, “future historians may well see today’s crisis as the turning point at which American democracy was shown to be dysfunctional – an example to be avoided rather than emulated.” That would be unfortunate, considering the historic contributions that American democracy has made to human dignity around the world.

Obama held the line against the insurgency. The hostage was released and the matter resolved at the 11th hour. After five years of disengaged leadership, it was bracing to see Obama acting Presidential. Regardless of policy differences, as Bill Clinton put it, the people prefer a President who is “wrong and strong to one who is right but weak.”

Obama then promptly made his own contribution to the farce, snatching political defeat from the jaws of victory with an epic display of incompetence in the rollout of the Affordable Care Act, otherwise known as Obamacare. The result was a solid month of Chicken Little hysteria that has erased the memory of malfeasance by House Republicans over the debt ceiling.

For those who would like to get a handle on the reality of Obamacare, which, for better or worse, is absolutely not going away, I would suggest two recent balanced articles: “A Realist’s Take on Obamacare” by Josh Marshall at Talking Points Memo, and “The Healthcare Reality Conservatives Ignore” by Paul Waldman at CNN.

It’s a shame that Republicans have refused to try to make health care reform actually work, instead of trying by any means to prevent any change in the indefensible status quo. In fact, it’s more than a shame; it’s a betrayal. Americans pay twice the price for an inferior health care outcome relative to every other developed nation on the planet. Republicans should be as concerned about this as Democrats are. As Warren Buffet put it, “Healthcare costs are the tapeworm of American business.” The following chart sums it up.

Description: terrible health care

Markets

So far, markets seem to be treating the madness in Washington as theater, keeping a wary eye on the Fed and a steady bid under the stock market. The resolution of the debt limit hostage episode only kicked the can down the road a few months so we will probably have an attempt at a replay of some sort in January or February. But the “burn the house down” caucus will not have the support of party leadership this time, so the odds of a repeat crisis over the debt limit are not high.

The real test for the markets will probably come with the installation of the new Fed Chairman, Janet Yellen. Stocks are overdue for a good correction and regardless of the trigger, the marketplace may want to test Yellen’s commitment to QE.

It is worth noting that every change in Fed Chairmanship has been accompanied by a market correction of at least 7%, and most of them were complete in the first six months. (Data Courtesy Ned Davis Research).

Description: http://neddavisresearch.com/neddavisresearchlz/Instances/neddavisresearchlz/images/092513ITtable.png

Meanwhile, the recognition that the 30 year bond bull market is finished is gradually penetrating a reluctant marketplace. Selling is quickly forming above any bond rallies and with few options for spare cash, going into stocks, giving support to the Fed driven rally.

Gold and commodities continue to sell off. Fiscal austerity has extended the cyclical deflation that continues to undermine Fed efforts to re-flate.

Economy

The economic “recovery” continues to chug along, weak but persistent, and lately picking up speed. Q3 GDP was 4.1%, housing starts are back over the 1 million mark, at a five year high, and inflation remains muted at 1.2%. The lack of jobs is still the big problem. Official unemployment is down to 6.7%, but the improvement is mostly from people leaving the labor force, not new hiring. Real unemployment (U6) is almost double the official rate at 13.1%.

We can’t dismiss the possibility that our “leaders” in Washington will do something truly destructive, but the stock market is a leading indicator and it appears to be saying that something good this way comes. Stocks continue to climb the wall of worry and all major stock indexes are making new all-time highs, without the irrational exuberance normally seen at a major top.

If the stock market’s discounting function is indeed alive and well, then it is entirely possible that Republicans, who have persistently and aggressively log rolled in front of the recovery so as to undermine Obama, nation be damned, are going to be totally routed in the by election, clearing the way for fiscal stimulus in the form of funds for research and education, desperately needed infrastructure investment and jobs programs, perhaps a national service corp…the kind of things that generate real economic growth.

Policy changes are coming that will finally bring some moderation to the big banks’ untouchable status. The banks have pretty much kneecapped the much anticipated Volker rule, intended to limit the banks’ risk taking. But Elizabeth Warren is leading the charge for a revival of Glass-Steagall to separate commercial and investment banking, noting that the too big to fail banks are now 30% larger than they were in 2008…the five largest controlling half the nation’s banking assets.

In another telling sign, William Dudley, President of the Federal Reserve Bank of New York and a former Chief Economist at Goldman Sachs, delivered a speech entitled “Ending Too Big to Fail” at the Global Economic Policy Forum in November, highlighting Wall Street’s “deep seated cultural and ethical failures.” While commenting on regulatory efforts to deal with the problems of too big to fail banks, Dudley made this astonishing statement…

“Collectively, these enhancements to our current regime may not solve another important problem evident within some large financial institutions -- the apparent lack of respect for law, regulation and the public trust."

Quantitative Easing, initially necessary as triage, is also coming in for some changes. QE has become increasingly ineffective over its iterations and is widely viewed as a growing liability. For his role in QE, former Fed Governor Andrew Huszar made a public apology to the American people in a November 11th Wall Street Journal op-ed piece entitled “Confessions of a Quantitative Easer.” A must read…beginning “I can only say: I’m sorry, America.”

Politics

“Suppose you were an idiot, and suppose you were a member of Congress. But I repeat myself.”

Not much has changed in the 120 years since Mark Twain penned this observation, except that the condition seems to have spread to the other branches of government.

The political scene in America is pretty grim these days. However, lately there have been some signs that democracy is not totally dead. The growing indignation over NSA dragnet spying and demands for reform are heartening. Also, Democrats have finally overcome their cowardice long enough to put an end to the serial abuse of the filibuster by Senate Republicans. Over half of all filibusters since the founding of the republic have occurred in the past five years. Enough is enough.

While the spectacle of nihilism and incompetence in Washington is sucking up all the media oxygen, the political cutting edge has manifested in the election of liberal dark horse Bill DeBlasio as mayor of New York City on his campaign of “two New Yorks,” which is echoing across the political landscape.

There has been virtually no left wing in American politics for the last 30 years. It is now coming back to life. This is the next major trend in American politics. In this two minute video, Elizabeth Warren gives voice to the issues that will define the next era of political discourse in America.

Given the massive amounts of money and effort expended by political operatives to spin the daily news cycle, you would think that there is political gold to be mined from it. This interesting article by Ed Kilgore suggests that it’s all pretty much wasted effort, and that elections are really decided by fundamentals like incumbency, economy and demographics.

Geopolitics

The global scene has been a tinderbox for a long time, with nascent upheavals around the world held in check by an assertive U.S. military presence. With the U.S. fiscally challenged and war weary after long, inconclusive campaigns in Iraq and Afghanistan, that stabilizing influence is in question, and the world is getting even more unstable.

Cycles analysts are pointing to long term cycles of war that indicate rising conflicts over the next decade or so. The Middle East and Asia are the most likely places for a major conflict to erupt. The Ukraine is also spiraling into civil war, and Africa has spawned one more in its seemingly endless and brutal wars, this one in Sudan.

On the Asian front, China and Japan have been increasingly in conflict over the disputed Diaoyu/Senkaku islands, which are also claimed by South Korea and Taiwan. China has recently deployed an air defense zone around the islands. In response, Japan’s Prime Minister, Shinzo Abe, has pushed through a new Secrecy Law giving his government sweeping powers to define what constitutes state secrets and impose draconian punishments on bureaucrats who leak them and journalists who publish them. This move is widely seen as providing cover for his plans to remilitarize Japan. China and Japan appear firmly on a track to war, which would be extremely disruptive to the global economy.

In the Middle East, the ironically named Arab Spring has generated chaos throughout the region. The Obama administration’s vacillating policy in the region has angered America’s Arab allies, and Israel as well. The Syrian civil war in particular continues to metastasize, poisoning the entire Middle East. Egypt appears to be on the path to civil war. Iraq is spiraling into civil war and a resurgent Al Queda is now in control of Falluja!

Iran’s quest for nuclear power is especially troublesome. While the mainstream media have played up Obama’s negotiations with Iran, many observers worry that Obama’s desire to make a deal is blinding him to the bad faith of his negotiation partners. In other words, that Obama is being played by the Iranians just as he has been played by Republicans at home.

Israel views the Iranian nuclear project as an existential crisis, and rightly so. Even worse, if Iran goes nuclear, the entire region will quickly follow, and then it will only be a matter of time until some religiously inspired lunatic presses the button and the entire region goes up in a series of mushroom clouds. Worse yet, the region is rife with militias and access to nuclear weapons by terrorist groups would become much more likely.

The U.S. military -- once seen gratefully in most quarters as a global stabilizing force -- has gradually become deeply resented almost everywhere. The drone wars in particular, and the endless reports of “collateral damage,” (read, dead children and other civilians) are an ongoing PR disaster for the U.S. The blatant dishonesty of Administration claims that there have been zero civilian casualties just adds insult to injury and further degrades America’s moral standing.

It is interesting to note the internal unease about the drone program. Pentagon brass floated a plan to award combat medals to drone jockeys, and it was shouted down by front line officers. The redeeming value in the soldier’s trade is in the courage of those facing death and the honor with which they execute their task. Blowing people up with a joystick from thousands of miles away just doesn’t sit right on that score.

The NSA spying scandal has further undermined America’s position in the world. Not that there is anything new about spying, but the sheer magnitude and pervasiveness of it is shocking, and the apparent lawlessness of it. Enemies and allies alike are reevaluating their relationship with the U.S., and with U.S. technology companies. Germany is especially incensed that Angela Merkel‘s cell phone was bugged, apparently since 2001, and that Obama knew about it and allowed it to continue. Israel is also angry over reports that a former Prime Minister and Defense Ministers have been tapped. Yes, it is true that all countries spy on each other and always have, but phone tapping the German Chancellor and Israeli Prime Minister goes a bit far.

Opportunity

The economy is generally weak, but still expanding. Private equity has been very active in the housing sector, but I think this is probably not going to work out so well for them, and especially not for their renters. If you have the resources, it seems like a good time to buy a home, but real estate as an investment is going to have issues going forward.

In this cycle, advantage is being sought primarily by investing in stocks. Gold is still selling off, but it we are approaching levels that are starting to look attractive for the long term. 50% of the move up from 2001 is $1,063 and the old high from 1980 is $800. Gold is presently hovering just above $1,200.

In the real economy there is a very strong and rapidly growing trend toward Made in America products. If the global scene erupts in conflict, then Made in America will become imperative overnight. Those companies with deep ties to Asia, especially with major investment in mainland China, are at great risk. Economic, social, political and geopolitical developments are all supporting this trend, and policy will increasingly be favoring companies that manufacture in America.

Summary

The economic recovery is gaining steam, and even though the Fed surprised with its December mini-taper, the Fed is not going anywhere and will continue to support at the first sign of weakness. The stock market is at all-time highs without any signs of irrational exuberance or other indications of a major top. In fact, sentiment is surprisingly tepid, arguing for a continuation of the rally.

At the same time, the seating of a new Fed Chairman has historically been the signal for a market correction. This would coincide with the Presidential Cycle, which also indicates a selloff into the spring, and possibly into October of 2014. The selloff could be triggered by a new round of debt limit madness in Washington, or by the eruption of military conflict in the Middle East or Asia.

All things considered, a market selloff in the first half of 2014 should be a buying opportunity, as long term indicators are all in favor of a continuation of the bull market.

Jobs continue to be the big problem economically, and that problem is not going away. Overcapacity and technology, combined with fiscal austerity will continue to undermine any substantial improvement in the employment situation for the foreseeable future.

Geopolitically, cycles of war argue for an increase in global conflicts over the coming decade, and growing economic pressure will give political leaders traditional thoughts of relieving political pressure at home by creating conflicts with external enemies. Given the delicate condition of the global economy and the dollar based monetary system, an outbreak of hostilities could quickly spiral into another major economic crisis. Caution is recommended.

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