Garic’s Macro Update November 2016

1. Trump is President- elect. The Good: Infrastructure Spending, Lower Corporate Taxes, Lower Income Taxes. The Bad: Excise Tax. The Ugly: No Entitlement Reform, Healthcare Reform.

2. Emerging Markets, Currencies, Treasuries, Precious Metals, & a Chinese Devaluation all reacted to tightening financial conditions similar to August 2015 and January 2016; record fund flows into the S&P 500 broke the correlation previously witnessed.

3. With $65 Trillion of Total Credit Market Debt Securities Outstanding, the 78 basis point increase in credit risk free Treasury rates in the past 2 months will lead to an annual increase of $507B in interest expense looking out 1 to 2 years. Rising interest rates will offset all of President-elect Trump’s fiscal spending, unless the Fed reverses course. The original surge in precious metals after the election was correct; the subsequent reaction is a buying oppurtunity.

4. Globalization has led to record corporate profit margins and stagnant domestic wages. Corporate profit margins have always reverted to the mean; wages will go higher over time, inflation will follow. There will be winners and losers inside the S&P 500 index, something passive investors cannot analyze. Companies who have borrowed money to buy back stock or make acqusitions while outsourcing their manufacturing are clear losers. Domestic companies with high tax rates and are in a position to benefit from infrastucture spending are clear beneficiaries.

5. Healthcare reform will be a significant hurdle. The all in cost of healthcare for a small business owner is $25,000 in 2016 and forecasted to rise significantly in 2017; in Germany the cost to all companies of an employee is $3500 Euros. Without a cost shift to government, (expanding the deficit further), or a massive reduction in health care spending to public companies in the S&P 500, small business formation will remain a headwind. U.S. 2017 economic forecasts are too high given the healthcare bills outstanding.

6. Asian Central Banks will no longer be buyers of U.S. Treasuries. Either the Fed needs to remain accomodative or interest rates are headed higher potentially popping the corporate debt bubble.

7. Since July stock market participants have been betting on higher interest rates and an accelerating economy, something I have said is the most ulikely scenario for 2 years. The markets original reaction to the end of globalization was correct IMO, it’s subsequent extension of the previous trends appears to be a rationalization of positions already established. Record flows of capital then joined the trend. Will this continue into year end or did commercials use the flows and option expiration to take profits? Leveraged globalized stocks are a sale.

8. With baby boomers continuing to retire, entitlement spending is now growing $100B plus faster than entitlement revenues. The budget deficit has turned higher and is about to get ugly.

9. The markets have already discounted a December rate increase and 1 more for next year. Nominal GDP and Consumption continue to grow at rates that were previously called recessions. In the past the Fed was lowering interest rates by the time Gross Private Domestic Investment had turned lower. A stronger dollar is the result of Japan and Europe devaluing their currencies and higher U.S. interest rates. Economic forecasts for 2017 need to be lowered, since housing, construction, and autos will be hurt by higher interest rates.

In the past, by the time GDPI had turned down

the Fed was cutting rates?

Globalization ended with Donald Trump’s victory!

Steve Bannon (Donald Trump’s Chief Strategist) – Hollywood Reporter News 11-18-2016:

“I’m an economic nationalist,” he tells me. “The globalists gutted the American working class and created a middle class in Asia. The issue now is about Americans looking to not get f—ed over. If we deliver” — by “we” he means the Trump White House — “we’ll get 60 percent of the white vote, and 40 percent of the black and Hispanic vote and we’ll govern for 50 years. That’s what the Demo-crats missed. They were talking to these people with companies with a $9 billion market cap em-ploying nine people. It’s not reality. They lost sight of what the world is about.”

In a nascent administration that seems, at best, random in its beliefs, Bannon can seem to be not just a focused voice, but almost a messianic one:

“Like [Andrew] Jackson’s populism, we’re going to build an entirely new political movement,” he says. “It’s everything related to jobs. The conservatives are going to go crazy. I’m the guy pushing a trillion-dollar infrastructure plan. With negative interest rates throughout the world, it’s the great-est opportunity to rebuild everything. Ship yards, iron works, get them all jacked up. We’re just going to throw it up against the wall and see if it sticks. It will be as exciting as the 1930s, great-er than the Reagan revolution — conservatives, plus populists, in an economic nationalist move-ment.”

New York Times 11/17/2016:

Democrats May Try Surprising Strategy: Align With TrumpBy JENNIFER STEINHAUER • Democrats will try to find common cause with Donald J. Trump on infrastructure spending, child tax credits and dismantling trade agreements. • By focusing on issues that many Republicans resist, Democrats are trying to find favor among the voters Mr. Trump took from them.

Stanley Druckenmiller sold his Gold election night. He was quoted that there is no longer a reason to own it; he said Paul Ryan would stop President-elect Trump from establishing an excise tax. Democratic strategists understand this one issue supported by Bernie Sanders and not by Hillary Clinton determined the election. Emerging market countries have already responded. China, Japan, and Saudi Arabia continue to sell U.S. Treasuries and are the main reason interest rates are rising. Asian central banks will no longer support U.S. domestic spending by buying and holding U.S. Treasuries. China has been buying Gold for the past decade as an insurance against this event.

Street Account 11/17/201:

Foxconn considering moving iPhone production to the U.S. - Nikkei • Citing sources, Nikkei reports that Apple (AAPL) has asked Foxconn, along with Pegatron (4938.TT) to look into the possibility of making iPhones in the U.S. • The report notes that Foxconn agreed to look into it, while Pegatron declinedThe source noted that manufacturing costs will more than double if made in the U.S

Detroit Free Press 11/18/2016:

Ford on Trump tweet: We’ll keep Lincoln MKC in Kentucky

Something changed in 2000! (From Garic’s July Macro Update - Post Brexit)

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 has begun. (Trump’s victory seals the deal - over-owned, over-leveraged, economically sensitive, global stocks are a short).

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.

The greatest bond bull market in the history of the world led to the largest expansion of credit in the history of the world. In 1982 nominal GDP bottomed at 3.4%, YOY, the Fed lowered rates from 20%, an equity bull market began. In 1991 nominal GDP bottomed at 2.7%, the Fed lowered rates from 10%. In 2009 the Fed cut rates to 0% and did QE with nominal GDP negative. Currently nominal GDP is plus 2.8%, YOY. Bridgewater has calculated a 100 basis point increase in rates will lead to $2.4T in credit losses. Bill Gross says you need $2.5T in credit expansion to service the debt and keep the economy growing. If in the past cutting interest rates significantly to accelerate a weak economy was bullish for stocks, why would raising rates with anemic GDP be bullish?

In the past 2.8% nominal GDP growth was considered a recession,

the Fed would be lowering rates?

ZIRP & QE allowed Total Credit Market Debt Outstanding to grow further. How can higher rates be positive for the credit markets?

Correlations broke down in the past month.

I have been writing about the fact that all markets have been correlating since August of 2015, both up and down. Each time the markets began to discount higher U.S. interest rates, emerging market currencies would come under pressure. Emerging market central banks would unload U.S. Treasuries to meet redemptions, rising domestic rates would lead to hedging in the U.S. equity markets. According to Goldman Sachs Fiancial Conditions Index this correlation has broken down as equity prices and credit spreads have not been effected. The balnce of this year will be determined by whether this coninues or if credit spreads and equity prices re-correlate.

Reuters By Trevor Hunnicutt NEW YORK, Nov 17 Investors turned on a dime after Donald Trump’s surprise victory as U.S. president, showering the most money on U.S.-based stock exchange-traded funds ever during the latest week, Lipper data showed on Thursday. The cash movements over the seven days through Wednesdaymarked a drastic turnaround of the major trends in fund investing this year, with a move back to stocks, from bonds, and a powerful reemergence of the inflation trade and sector bets. U.S.-based ETFs that invest in stocks took in $27 billion, their largest weekly inflows on Lipper’s records, which date to 1996, when ETFs were nascent.

As a side note, the previous record was set September of 2007. Trimtabs repeatedly points out that record fund flows in either direction should be faded.

Trim Tabs November 13 2016: “U.S. equity ETFs issued a stunning $22.6 billion (1.6% of assets) from Tuesday through Thursday, the biggest three-day inflow since September 2007, which was shortly before the S&P 500 made a major top.”

Wall Street Journal 10-19-16 • “The case for passive is being made so well and so clearly,” said Mr. Bullen, “it has

become common wisdom.” • “Mr. Sexauer placed $100 million in a so-called balanced portfolio of 70% stock

index funds and 30% bond index funds. “If it outperforms over time, eventually a capable administrative assistant might be able to run the entire investment department, and we’d be OK with that.

• “Public pension plans had 60% of their U.S. stock allocations in index funds in 2015, up from 38% in 2012, according to research firm Greenwich Associates. At endowments and foundations, the index-fund share rose to 63% from 40% in that time period.”

Investors are so confident that the stock market will always go higher that they have put a record amount of money into passively managed index funds and ETF’s. They

are choosing to save money by not paying for research on their investments.

A side effect of QE is that the correlation between stock, bonds, & other financial assets continues

to increase. Which means the safety of the traditional 70-30

model must be questioned.

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1. The reversal top in the Internet Cycle took 10 months to form.2. The reversal top in the Housing Cycle took 8 months to form.3. The current consolidation is 2 years old; the conclusion must be

something is different this time, but what?

For 2 years (since QE3 ended), I have maintained that we are at a major inflection point of the third major credit cycle of the past 20 years. Since July the markets have discounted an accelerating economy with higher interest rates. I continue to believe that is the least likely scenario. Indeed, I continue to believe Gold is going much higher or equities are going much

lower. Central Banks can either continue to support or stop.

1. Dot-Com credit cycle was influenced by easy money and an historic innovation; a classic Austrian boom-bust cycle.

2. The housing cycle which was influenced by easy money and the conviction that housing prices would never fall; a classic Austrian boom-bust cycle.

3. This one is different; it is a global central bank credit cycle; which extends to every part of the financial markets. While ZIRP & QE restored financial assets and real estate values to levels that previously were identified as bubbles, the average citizens of the developed world did not benefit, nor did real economic growth.

3) As credit conditions tightened earlier this year, the ECB & BOJ went to negative rates

and further QE. YTD, $450B in capital has flowed into U.S.

financial markets from overseas extending this cycle further.

Global Central Bank Support 1. Oct 2014 Bullard - QE4 on the Table2. Sep 2015 Fed delays interest rate hike3. Japan & Europe negative rates more QE4. Global Central Bank Swaps established for Brexit5. Did central banks support? Once again volatility sellers win into options expiration and passive investors respond with a weekly record inflow.

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Gold Market Update

In July’s macro update I said “In the short term the commercial short interest in Gold is at extremes; therefore, a correction could occur at any time. Maintain long term positions.” The night of the election Gold initially surged, which means commercials were about to lose serious money; they were not expecting a Trump victory. 700,000 contracts traded Wednesday, a volume I have not witnessed in 15 years of trading Gold. Thursday morning Stanley Druckenmiller was quoted as saying he sold all of his Gold for there was no longer a reason to own Gold (he was not responsible for that much volume). Furthermore, he concluded Paul Ryan would not allow an excise tax; IMO and in China’s, that assumption is wrong. The public has liqudated a record amount of Gold ETF’s in a 2 week period. Trend following CTA’s are now liquidating longs and establishling shorts. Commercials are busy covering their shorts; they routinely use options expiration and futures rollover to cover shorts. December option expiration is Tuesday November 22nd & futures rollover is the following day. This is a routine manipulative event in the futures markets; which I hope a new CFTC will end (something I had also hoped President O’Bama would clean up, but did not). Do not use leverage in this market use the manipulations to build long term positions. Donald Trump’s isolationist policies are likely to generate the inflation the Fed has sought; when velocity of money picks up, you will want to own Gold in your portfolio.

Commercials are now busy covering their record short in Gold, bailed out by a market participant that was involved in 700,000 contracts of trading volume in futures Wednesday November 9th.

China responded to the election of Donald Trump by devaluing their

currency and selling Treasuries. The last 2 times China devalued Gold

surged, this time it tanked?

GLD 2011-2016

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1. Gold peaked at $1900 in August 2011, S&P downgraded U.S. Treasury Debt. Federal Debt Outstanding was $14.5T; today it approaches $20T.

2. The Fed begins QE3. Goldman Sachs recommended shorting Gold and related securities as their economists forecasted the Fed would successfully reach escape velocity and then would be able to normalize interest rates. The Fed never achieved their goal; investors should question why.

3. As the stock market swooned and credit spreads widened in the fall of ‘14, James Bullard suggested QE4 was on the table and Gold rallied sharply.

4. After raising rates for the first time, volatility in stocks picked up and credit spreads widened, global central banks moved to negative rates and the Fed delayed interest rate increases. Gold may have put in a meaningful bottom.

5. The Fed delays interest rate increases over volatility concerns around Brexit. Commercials establish a record short position as speculators establish a record long position.

6. Gold stops correlating with the Chinese devaluations and once again correlates with interest rate expectations. Speculators who bought Gold on Brexit concerns dump Gold on interest rate concerns. Implementation of an excise tax will end the necessity of Asian Central Banks holding U.S. Treasuries. Without the Fed’s help, President-elect Trump’s policies will be overwhelmed by a credit market bear market. The time to sell Gold to buy stocks was 5 years ago:

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Since July the markets have discounted an accelerating economy with higher interest rates. Raising interest rates with anemic economic growth will lower econmic activity not increase it. In the past few weeks GM & Ford have both closed plants. Strong auto sales which have supported retail sales are the result of significant incentives. Housing, autos and construction are rolling over. Small business formation is awful, productivity is awful, corporate tax receipts are signalling a recession. Gross Private Domestic Investment is signalling a recession. Historically, the Fed would be lowering rates

with current economic activity.

The extreme corporate debt cycle may be rolling over again; the price of crude oil will play a role in whether it pops or continues to expand. Despite U.S. oil and gas companies reporting massive all in operating losses, investors continue to lend money to the sector. Incredibly, domestic output has begun to expand again despite these continued losses. High yield corporate prices are now tracking global interest rates and crude oil prices. If I were trying to pop the bubble I would raise rates, introduce an excise tax, and drive oil prices lower.

Since July’s (Brexit) lows, U.S. investors have been buying over-leveraged economically sensitive stocks, despite no confirmation from the companies of any positive momentum. Higher interest rates, a stronger dollar, and

continued health care inflation should be considered as a negative for future estimates of these companies.

Caterpillar is up 27% from July’s Brexit lows, despite 4 years of falling orders. 56% of sales in emerging markets. Yes, infrastructure will be a positive, but an exicse tax will be a

disaster: $35B in debt!

Broadcom is up 500% in the last 3 years. It is a classic rollup story in the fabless semiconductor industry. 100% of their outsourced manufacturing is in Asia. Their business model just changed: $15B in debt!

American Airlines has doubled off it’s Brexit lows. Historically when auto & airlines earnings peak, they

peak for the cycle: $22B in debt!

Investors rushed into financials after the election. While higher interest rates may help their margins; commercial real estate, housing, & auto loan quality will deteriorate; oil & gas

exposure already has. Derivative exposre to DB unknown!

U.S. oil & gas companies continue to lose significant money and are heavily indebted. Yet, investors continue to bid up the price of their shares: $15B in debt!

Amazon’s model of delivering Chinese manufactured prod-ucts directly to your door, just

changed!

Utility stocks have been for sale since July; the index is down 14%. With all of their sales domestic, they are about to receive a 50% corporate tax cut and have little

exposure to a weakening economy.

T, VZ, & VOD are all down significantly since July. VZ & T have little exposure to an excise tax & are about to see a huge

corporate income tax cut!

Many large producing gold equities are down 30-50% since their July highs, when people wanted to hold Gold because of Brexit. The U.S. just Brexited

and investors are rushing out of their Gold?

This is my conclusion from the Market Technicians Presentation

• Credit cycles have been the most important factor on equity market returns and economic growth over the past 20 years; yet, Wall Street analysts and investors ignore them. The Internet cycle and the Housing cycle, while extreme were easily defined because of their interaction with one sector of the real economy. The current cycle is less obvious because it has effected the entire financial market, not an individual sector, nor the real economy.

• We are at a major inflection point of the third great credit expansion of the past 20 years. The Fed’s stated goal of using extraordinary monetary policies to stimulate final demand has failed to materialize, but has left a balanced portfolio of stocks and bonds at the highest valuations in history. The outcome of this cycle is not predetermined as Central Bank’s have unlimited ability to create currency to support financial assets.

• Currently credit is still expanding at a rate which is supportive of financial assets, while having little effect on the real economy. Forecasts for accelerating growth without small business formation, productivity gains, or a pickup in capital spending do not appear credible. Any contraction in credit growth is likely to lead to negative feed back loops to the real economy; therefore, if the Fed attempts to normalize rates the third extended bear market is a significant probability.

• In the next credit contraction there is a significant probability that all financial assets will correlate; therefore, an allocation to short selling may be a more effective hedge than diversification across asset classes. Passive investing has become “common wisdom” similar to the confidence that the public had that housing prices would never fall during the housing credit cycle. Passive investors have decided to not pay for research; excessive corporate credit and non-GAAP earnings will make this a mistake.

• The time to have invested in a balanced portfolio for the long term was 1982, 1991, 2002, or 2009: not 2016. Despite the fact the Federal Reserve has been wrong on their economic forecasts for over a decade, investors massive move into passive investing shows confidence and complacency. The Federal Reserve will soon need to choose between defending the financial markets by resorting to further extraordinary monetary policies, or allowing a painful deleveraging to begin. Precious metals were the best performing asset when the Fed reversed course in ‘02 & ‘09. The precious metals markets have been discounting a normalization in interest rates since 2011. The long term financial risks to the U.S. economy are greater today, than when Gold reached $1900 in 2011. If the Fed reverses course, the rally in the dollar will likely end and a new bull market in precious metals and other commodities would be the most likely outcome.