Garic’s Macro Update 08/01/16

1. The U.S. financial markets are in an unprecedented situation; the S&P 500 closed at a record high during July, despite no real economic growth over the past year. $12T in negative global sovereign debt and $200B in QE out of Europe and Japan are forcing investors globally into a historic reach for yield which is extending the credit cycle; yet, having no effect on the real economy.

2. Given weak global and domestic demand, excessive global and domestic debt, expect unprecedented global monetary stimulus to continue; U.S. investors remain dangerously under allocated to Gold & Silver.

3. The U.S. economy continues to face significant headwinds: the “ACA”, the effects of outsourcing on wages and consumer spending, and historically excessive total credit market debt to GDP; today, I am adding the negative effects of ZIRP on savings and consumption to that list.

4. Since 2000 corporate profits and profit margins have surged, while developed world wages have stagnated; Brexit was a populist reaction to this reality. Historically high corporate profit margins may be vulnerable over the long term to mean reversion, given growing populism.

5. U.S. macro economists continue to ignore the effects of the “ACA” on consumer spending & small business formation. The current increase in healthcare spending is being reported as real economic growth, when it should be reported as healthcare inflation, thus GDP is overstated.

6. Extreme credit cycles are now routine and are driving U.S. economic growth. Most U.S. investors have not adapted to the reality that these credit cycles are causing wild swings in their investment portfolio’s. These credit cycles are analyzable and predictable.

7. The excess of this credit cycle can be found in corporate and sovereign credit. Equity valuations remain historically high; EV/EBITDA is 95-99 percentile. Given current valuations, the risk to equity portfolio’s include interest rate risk, credit risk, and currency risk.

8. With $70T in debt and equity securities in the U.S. priced off a .25% Fed Funds rate and $200T in unfunded entitlement liabilities, the pressure on the Fed to accommodate the Treasury and financial markets going forward is real.

9. Significant amounts of capital has moved from active management to passive management recently; this herd mentality is bound to be wrong again. Many of the best performing securities in these passive indexes are reporting inflated non-GAAP earnings and borrowing record amounts of debt to buy back stock, to make acquisitions, and to fund current operations. During the next downturn passively indexed investments will be vulnerable. Now is the time to make sure companies are running their businesses prudently from a financial perspective, it is time for CFA’s to perform.

On Friday the BEA reported real GDP up 1.2%, YOY. If healthcare was accounted for properly, real GDP would have been 0%, YOY. In the past these type of numbers only occurred during a recession. GDP was supported by an acceleration in PCE to 4.2%

annualized,which is simply not credible given second quarter earnings releases of major U.S. consumer companies. Recessionary risks increased significantly; the markets yawned!

Friday the BEA reported PCE accelerated to 4.2% annualized in Q2/16; this is simply not credible. The stock prices and guidance of every major department store crashed during the quarter. Across the board analysts warned of a downturn in restaurant sales (a source of strength in this cycle). June auto sales were the worst in 2 years and Thursday Ford cut their guidance for H2/16 North American auto sales. All major airlines warned of continuing weakening of demand; major hotel chains cut guidance. Specialty retailers across the board including Starbux, Nike, Sherwin Williams, O Reilly, and others reported their slowest growth of this expansion. Redbook remains in recessionary territory. Freight shipments continue to point to an economic downturn. Internet commerce and healthcare spending are now the only remaining sources of strength in personal consumption. I would expect Q2/16 GDP to be revized into a contraction at some point in the future. Second half earnings estimates of economically sensitive securities are vulnerable..

Stiffel’s restaurant analyst downgraded

the group and warned of an

impending recession given the rapid deceleration in

restaurant sales.

All major bricks and mortar department

stores crashed during Q2!

Redbook continues to deteriorate; no pick up here!

Financial Times - 7-22-16 “Fast-food chains feel bite of faltering US consumer sentiment - Restaurants from Starbucks to KFC wrestle with America’s waning appetite for eating out... Howard Schultz, Starbucks’ chair-man and chief executive, did not hold back this week when he said that political and social unrest were partly to blame for his company’s third-quarter earnings miss. Brett Levy, an analyst Deutsche Bank, said that slower jobs growth appeared to be weighing on restaurant sales, which he said had an 80 per cent correlation with comparable revenue growth at restaurants.”

Financial Times - 7-28-16 “Marriott and Hilton cut forecasts amid fears of growth peak - Two of the biggest US hotel chains, Marriott International and Hilton Worldwide Holdings, cut their growth forecasts as tightening cor-porate travel budgets and global economic uncertainty put pressure on hotel bookings.”

Reuters 7-28-16 Ford calls an end to U.S. auto boom... Ford Motor Co (F.N) on Thursday declared the U.S. auto industry’s long recovery is at an end, sending its stock and those of rival auto companies tumbling. “The growth is over,” Ford Chief Financial Officer Robert Shanks told Reuters in an interview. Shanks earlier fore-cast U.S. light vehicle sales would fall in 2016 from the record of 17.47 million last year, and fall again in 2017”.

June auto sales at a 2 year low!

The latest surveys from Markit and revisions to capital spending point to continued decelerating economic activity.

Durable good orders continue to point to an ongoing

industrial recession.

The Fed’s LCMI upticked in June, but remains in dangerous territory.

All real-time shipping indicators remain in

contractions!

Markit is picked up an acceleration in manufacturing

in July; unfortunatley, industrial companies from GE to Cat didn’t.

Markit services continues to report a

slowing of PCE services!

Construction spending was up 13%, YOY last June;

it is now flat, YOY and decelerating rapidly!

The U.S. economy continues to face significant headwinds: the “ACA”, the effects of outsourcing on wages and consumer spending, and historically excessive total credit market debt to GDP;

today, I am adding the negative effects of ZIRP on savings and consumption to that list.

WSJ 07-26-16 “Pension Returns Slump, Squeezing States and Cities Long-term returns for U.S. public pensions are expected to drop to the lowest levels ever recorded. The dip is intensifying a national debate over whether states and cities can continue to afford pension obligations, as the soaring costs are squeezing budgets across the U.S. ‘Many states and local governments may be facing difficult choices if investment returns remain low’, said Keith Brainard, research director at the National Association of State Retirement Administrators. ‘The money has to come from somewhere.”

July 25 – Wall Street Journal (Timothy W. Martin): “Long-term returns for U.S. public pensions are expected to drop to the lowest levels ever recorded, portending deeper pain for states and cities as a $1 trillion funding gap widens. CalPERS investment returns fall below 1 percent”

Cal Coast News July 25, 2016 - “CalPERS earned a return on its investments of just .6 percent in the last fiscal year, marking the state retirement fund’s worst performance since 2009.”

Cities and states will have to choose between higher taxes and reduced spending as this year progresses, given the below normal pension returns and the continued increases in the cost of healthcare.

Banks and life insurance companies are now being hurt by continued historically low interest rates. Negative interest rates in Europe appear to be backfiring as the negative consequences to financial institutions are bringing real pain. Savers are choosing to save more to make up for the unprecedented low interest rates.

Retirees including my mother and in-laws have been forced to cut consumption way below what was justified, given their prudent financial planning going into retirement. People saving for retirement must either increase their savings rate or increase the risk they take in their retirement portfolio’s to achieve their goals.

Unfortunately, the Fed appears to be un-accountable for this un intended consequence.

2016 Total Out of Pocket Health Care Expense of U. S. Consumer continues to soar.

Health care is the largest sector of the U.S. economy (18+%); healthcare spending is the second largest household expense. Increases in “Out of Pocket” healthcare expenses are being reported as economic growth and not the inflation they actually are. This inflation is constraining consumer spending and small business formation. “In 2015, the cost of healthcare for a typical American family of four covered by an average employer-sponsored preferred provider organization (PPO) plan is $24,671 (see Figure 1) according to the Milliman Medical Index (MMI)...The amount will almost certainly surpass $25,000 in 2016.” The Wall Street Journal recently reported 2017 insurance premium proposals are as high as 20% in many states! Corporations are shifting the cost of healthcare to their employees through rising deductibles and co-pays. My best estimate is total out of pocket health care expenses will rise 10% in 2016 and 2017 to over $6,000 per family covered by an employers plan and as high as $25,000 for a small business owner. This will continue to be a structural headwind to the U.S. economy. U. S. real economic growth is overstated and structural headwinds are real!

Total cost of employee sponsored healthcare rose 6.2% in 2015 to

$24,671!

Small business optimism remains in recessionary territory. Many surveys

suggest healthcare costs are a problem.

On Friday, the BEA used 1.03% YOY healthcare inflation when computing real GDP, potentially overstating real

GDP by 1.0% or more!

Something changed in 2000!

The negative effects from the outsourcing of manufacturing is one of the structural headwinds that the U.S. economy is facing. Brexit was a predictable populist reaction to the fact that globalization has not benefited the developed world’s middle class. Since 2000 corporate profit margins and corporate profits have surged, while developed world incomes have stagnated. Corporate profit margins have historically reverted to the mean, Brexit may be an early warning signal that this mean reversion may begin.

Outsourcing is one of the causes of weak productivity growth. High wage jobs are being replaced by low wage

jobs, limiting economic growth.

During this credit cycle personal consumption has been awful; anemic

wage growth and credit are headwinds.

Since 2000 average hourly earnings have been anemic; mortgage credit drove consumption in the mid ‘00s.

Since 2000 U.S. manufacturing jobs

plummeted.

Since 2000 corporate profits as a % of GDP surged.

Gold & Silver: short term positioning.

During 2015 I repeatedly stated that Gold and Silver mining equities were the most attractive group of equities I had seen in my career. On April 5th, I published a report on why U.S. investors are dangerously underweighted towards precious metals. Friday’s GDP report only makes the case stronger. With $19T in public debt outstanding and $200T in unfunded liabilities on the Treasuries balance sheet, there will be pressure on the Fed to maintain an accommodative monetary policy. Global central banks continue to pursue a whatever it takes policy. In this unprecedented financial situation, I would expect the rally in precious metals to gain momentum over the long term!

Gold outperformed equities for a decade from 2001>2011 despite

commercials being short the whole time!

After the tremendous run in precious metals equities this year, silver ETF’s appear to have the best risk reward

profile currently.

Gold moved from $35 to $190 between 1971 & 1974, it then corrected to $105 by 1976. As stocks and bonds

faltered due to accelerating inflation, the Gold bull

market slowly gained steam and then accelerated into

panic buying!Gold outperformed stocks from 2000 until 2011. From 2011

to 2015 stocks outperformed Gold significantly. I believe the

beginning of another significant outperformance has begun

1) The Internet credit cycle was driven by an incredible innovation. Human beings responding to greed poured money in at any price. Wall

Street financed any technology company at any price, collecting

massive fees in the process. Eventually supply overwhelmed

demand and the cycle reversed. The Fed should have pushed back against

the speculative behavior. Raising margin requirements would have

been an easy policy fix.

2) As the capital spending cycle reversed, and credit conditions

tightened, unprofitable and fraudulent companies went

bankrupt! Investors responding to fear, bailed out of the market at any price. The Fed stepped in and lowered rates to 1%, setting the stage for the housing credit

cycle!

3) Human beings believing they could get rich quick, piled money into houses and or

borrowed money from their houses, as if they were ATM’s. The Fed should have pushed

back against the clear speculative behavior! But instead allowed Wall Street to do what

Wall Street does, create complicated financial products that were not sustainable!

4) As housing and financial products began to fall, credit

conditions tightened. Negative feedback loops of reduced

purchasing power pushed the U.S. towards a depression.

Investors bailed at any price. The Fed stepped in and

put interest rates at 0 and unleashed QE after QE.

5) The Fed’s ZIRP has given investors a choice

to reach for yield or keep their capital in cash and watch their

purchasing power erode. Corporate

executives are taking on record debt, leveraging

their companies to pay themselves record

bonuses, which is not in the long term interest of

their shareholders.

Austrian economists have long understood easy money and human nature drive credit cycles! Over the past 20 years they have become routine events and are analyzable.

At the 2000 and 2007 tops the equity market began correcting, then business sales corrected, then inventories corrected; this time is different. Central bankers are doing

“whatever it takes” to stop a credit contraction.

Total business sales peaked with the end of QE in 2014 and have been falling since then; it

is broad based!

The last 2 years inventories continued to add to GDP and profits; they are now falling and will now subtract from GDP and profits.

Inter-modal shipments are down, which suggests inventories are contracting.

The inventory to sales ratio is at levels which signaled the last two

recessions.

Diminishing economic returns from continued credit expansion is now real!

Readers of my macro updates, understand that I believe the growth or contraction in credit outstanding is now the major driving force behind the transmission of monetary policy to broad economic and individual sector activity. In short Wall Street has taken over the channels of monetary policy from the traditional U.S. money and banking model. Credit cycles are inherently unstable; they tend to take on a life of their own. With $70T of equities and debt priced off a .25% risk free rate of return, the ability of the Fed to normalize interest rates must be questioned.

The excesses of this credit cycle are sovereign and corporate debt. Between Q2/14 and Q2/16 nominal GDP ex-panded $1.1T (3.1% annualized); total federal public debt outstanding increased $1.7T during this time frame, clearly unsustainable long term. Despite reporting a significant improvement in the budget deficit over the past 5 years, total federal debt outstanding has grown by over $1T annually. From this perspective, Friday morning’s GDP report was a disaster for any serious analysis of the U.S. Treasuries fiscal situation. With $200T in unfund-ed liabilities on the Treasuries balance sheet, the ability of the Treasury to fund the retirement of the baby boomers without help from the Fed, higher taxes or lower entitlement spending must also be questioned.

Corporate debt is one of the excesses of this

credit cycle!

Corporate credit growth has supported equity valuations but not economic growth!

Total public federal debt outstanding is growing faster

than nominal GDP; the Treasuries credit is worse today than when

it was downgraded in 2011!

As Austrian school of economists have warned, eventually expanding credit cycles

will have diminished returns. Friday’s GDP report should be a wake up call to all

intellectually honest economists!

Passive Investing will be vulnerable in the next downturn!

With 31 years of investment experience, I have watched many fads come and go; whenever a product becomes extremely popular, by definition one should avoid that product. Over the past few years an extraordinary amount of capital has moved from active to passive managers. Buying smart beta ETF’s from a smart phone guarantees that no due diligence has been performed on the underlying security. Corporate executives are borrowing record amounts of debt to buy back shares; these purchases drive the stock prices higher, forcing passive indexes to increase the allocation to that equity. The executive receives a bonus for this financial decision. The more risk the company takes on the larger its weighting becomes in the index. On June 28th, the Wall Street Journal reported a record amount of companies are reporting non-GAAP earnings; reporting inflated non-GAAP earnings achieves the same effect described above. While a few major tech companies have significant cash on their balance sheets, the average stock in the S&P 500 is carrying the least amount of cash to debt ever. During the next downturn these companies will become the most vulnerable.

The corporate debt bubble continues to expand.

1. Corporate debt is one of the excesses of this credit cycle; companies have borrowed a record amount to buy back stock, make acquisitions and to fund operations.

2. At this point of the credit/economic cycle companies should be paying down debt and raising cash for a rainy day.

3. Financial engineering is rampant as many companies consistently report non-GAAP earnings. On June 28th the Wall Street Journal reported 94% of the S&P 500 are reporting non-GAAP earnings, a record. Second quarter earnings season this trend accelerated! Companies from Microsoft to General Electric to Verizon are now reporting non-GAAP earnings. Mergers and acquisitions are being completed on non-GAAP assumptions. In the past I had to go through 10 Q’s to figure out purchase accounting abuses, today companies reconcile it for you in their press releases.

4. Corporate profits have peaked and are now falling. It is not just energy, 9 out of 10 S&P sectors have lower consensus estimates today than January 1.

5. Corporate borrowers have defaulted on $50B so far this year. 51 companies were downgraded from investment grade to junk in Q1/16. $265B in corporate debt are now potential “falling angels” up from $105B in Q1/15.

6. A recession would accelerate the pressure on corporate profits and leave many companies financially strapped as we just witnessed in the energy industry.

7. There is currently a significant bid in all fixed income markets, which is supporting high yield credit, despite deteriorating fundamentals. It appears global negative sovereign yields are unleashing a flood of capital seeking positive returns despite the deteriorating credit quality.

Non-financial corporate debt has almost doubled from $3T to $6T in this

credit cycle.

Credit quality is deteriorating!

Broadcom has taken on $26B in long term liabilities in a classic roll up in the semiconductor industry.

Meanwhile, the Internet infrastructure appears to be fully built and smart phone sales are down YOY, for the first time ever. This is not an industry to be

heavily leveraged. The companies use of non-GAAP earnings and purchase accounting is extreme!

Many oil & gas stocks took on substantial debt to build their businesses. The recent failed rally in oil prices makes the rally in high yield market fundamentally vulnerable; so far the historic

reach for yield is overwhelming the fundamentals.

Charter Communications has taken on $96B in long term liabilities to purchase Time Warner Cable

and Bright House. The company faces significant competition from the new AT&T; as well as an

emerging trend of millennial’s unplugging their cable connections.

Simon Properties continues to move higher as the search for yield trumps common sense. Mall

traffic is down and their largest customers are downsizing. SPG has accumulated $22B in long term debt and the U.S. has an over supply of

bricks and mortar retail property.