Download The Rikoon Group Winter commentary – 2015

The Rikoon Group
2218 Old Arroyo Chamiso Rd
Santa Fe, New Mexico 87505
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Telephone: (505) 989-3581
Fax: (505) 983-8086
Winter commentary – 2015
The Markets
The US experienced close to the best of all macro-economic conditions for stocks which served to propel
the market to unprecedented highs in 2014. The Federal Reserve and other central banks continued to
pump money into the world’s major economies and this helped, along with the falling price of oil during the
last six months, to bolster consumer confidence and spending. The S&P 500 closed at record levels 53 times
in 2014 as optimism in the economy and the accommodative stance of the Fed’s easy money policies sent
more and more investors into stocks. The Standard & Poor’s 500 large company stocks rose 11.4%. This
was its third straight annual advance of more than 10% which has only occurred twice before in history. The
Dow Jones average of the 30 largest industrial companies gained 7.5% in 2014 while the Russell 2000 index
of small companies, those that create the most new jobs, advanced 3.5%.
The technology laden NASDAQ composite index rose 13% as investors continue to consider new ways of
communicating and buying electronically as the wave of the future. Intel, one of our holdings, was up 40%
while IBM declined for a second straight year, losing 14% of its value. The health care and utilities industries
were the best performing sectors, up 24% while oil and gas companies fell with renewable energy
equipment providers suffering the worst, down 20.28%. Basic materials were flat, which is not bad
considering that commodity prices declined 17% across the board for their fourth straight annual decline.
Gold went down 1.5% for the year, its first back-to-back decline since 1998.
European stocks rose 1.2% in local currency, while for US investors; European shares lost almost 11% of
their value due to the US dollar’s strong rise during 2014. This means that currency translation, something
most people are not aware of, turned a small profit into a sizable loss. Emerging markets slid 4.6% as the
Russian ruble sank 44% versus the US dollar. Russia and Ukraine’s currencies are melting down, which
portends ill for those nations. Venezuela’s currency, highly dependent on the export of oil, lost 28% in
2014.
It was the best year in a decade for global bonds as investors were rewarded more for being cautious than
taking risks. Government securities, such as US Treasuries and German government bonds, gained the
most, almost 8.3%, while low grade corporate bonds turned in their worst performance since the financial
crisis, returning 2.5%. Global conflicts led to a desire on investors’ part for safe havens and the lack of
inflation allowed the three largest central banks in the world – the Federal Reserve, European Central Bank
and Bank of Japan, to continue their aggressive easy money policies that serve to suppress interest rates.
This sparked demand for the safest of assets – government bonds. Short-term US taxable corporate bonds
gained 1.5% while short-term US tax-free municipal bonds were up .64%.
The day to day economy
A slowdown in US manufacturing orders during the last quarter of 2014 indicates companies are beginning
to scale back their capital spending plans. Many overseas importers reduced their buying of US goods due
to the strong US dollar, though there is weakness on the export side, domestic consumption seems to be
just fine and U.S. consumer optimism is high. A reduction in the price of oil helps some industries by
reducing their cost of materials but it also negatively impacts oil producing states, several of whom are now
looking at their first recession in a decade. Moderate growth in the US will probably keep orders flowing
into factories at a decent rate as predictions are for the US to grow at a moderate pace in 2015. More hiring
and cheaper gasoline are behind US consumers finally feeling that they are reaping significant gains in their
disposable income.
US farmers are tightening their belts as they deal with a second year of lower grain prices. This past fall
brought the US its second straight bumper harvest and therefore prices are expected to remain depressed
throughout this coming year. After seeing their incomes and land values go up to record highs, farmers
bought new machinery and fueled North America’s farm machinery manufacturers biggest and longest rally
in memory. It looks like the entire U.S. agriculture sector is now set to contract. Energy producers are, for
the first time in 40 years, shipping unrefined American oil to Europe and Asia. One of our energy holding
companies, Energy Transfer Partners, LP, got special permission from the Commerce Department to sell oil
to foreign buyers. It is estimated that the US could export up to 1 million barrels of oil per day by the end of
this year.
The Internet continues to increase its importance in the world’s economy. It is interesting that Asian
consumers buy more online than people from any other region of the world. They account for 48% of all
retail Internet commerce; their market share is as much as North America and Europe combined. India and
Indonesia are expected to be the fastest growing e-commerce markets over the next several years. Here in
the US, a debate regarding the management of the Internet grows more intense. Entertainment companies,
telephone and telecommunication firms as well as Google and Amazon have a large stake in who gets what
kind of access to the Internet. The US remains in the middle ranks of nations in terms of the public’s ease
and expense of Internet access.
Emerging markets economies are experiencing a bigger than anticipated slowdown because of the rapid
and persistent rise in the US dollar. This makes it harder for them to export things to America and many of
their central banks hold US dollars obligations which are harder to pay back if the local currency is going
down in value. The European Union’s currency has been declining precipitously, which will make it even
harder for them to overcome the strong deflationary forces currently at work. This will suppress business
growth and employment opportunities in Europe. In response, the European Central Bank is preparing to
flood its financial system with cash to revive tepid economic growth and ward off further deflation. Russia,
the world’s biggest energy exporter, is facing its first recession since 2009 amid sanctions from the EU and
US and also from plunging spot oil prices, which are down more than 50% from their highs of last year.
China’s growth is slowing to the low 7% level, the most anemic since 1990.
The big picture of the global economy
The remainder of this commentary will be devoted to how big picture investment themes such as the
specter of deflation and political disintegration in Europe, Japan’s unprecedented experiment with free
money, China’s long-term plan to extend its empire throughout Asia, the Middle East and Africa, and what
might happen soon to highly leveraged and interdependent Emerging Markets could affect markets in
America.
Europe - Deflation is defined as a sustained period of falling prices that discourages consumers from
spending and businesses from investing or hiring. Europe’s worsening economy is, without a doubt, feeling
the effects of deflation with oil dropping below $50 a barrel and many of its industries contracting. The
European Central Bank will likely announce a program to buy its member nations’ debt in order to channel
cash into the economy, hopefully boosting bank lending to businesses who would in turn hire new
employees. It is unlikely that things will unfold this way because if companies that are convinced that
deflation is here to stay, the will hold off on spending money, no matter how inexpensive it is to borrow as
they feel deflation will make future investment cheaper.
The European Central Bank‘s quantitative easing program that is about to go into high gear, patterned on
the Fed and the Bank of Japan’s actions, may turn out to be too little, too late to deal with the deflationary
forces at work. The timidity and political indecisiveness endemic to the European Union structure may
prevent any large scale resurgence in long-term investment in new plants and equipment that Southern
Europe desperately needs. With ongoing political turmoil on the Eastern border with Russia and in the
south with Greece, we expect European markets to lag the U.S. Europe is our largest trading partner and so
as their economic activity diminishes, so does ours. There is strong anti-European Union sentiment gaining
ground on the continent among Centrist and Nationalist parties and I think it is likely that Europe’s failure
to make meaningful progress in dealing with issues like youth unemployment, immigration, and social
welfare programs will continue to make European businesses reluctant to invest.
Japan - Japan is in the middle of a triple dip recession and households there have suffered a significant
decline in purchasing power. The current Prime Minister is the most nationalistic leader Japan has
produced in 30 years and Japan’s competition with China may take on militaristic tones. While the stock
market in Japan is up, the economy has not shown real signs of life even though the government and the
central bank have morphed from taking an ultra-conservative over to an ultraliberal stand, vis-à-vis the
printing of money. Japan’s anti-immigration stance and rapidly aging population present ongoing challenges
to corporations based there.
The highly devalued Japanese currency has helped Japanese manufacturers sell overseas, but if Japan
wants to attract investment capital, it will have to come up with a better story. The Japanese Bank has
made more and cheaper money available than anywhere else. The Bank of Japan has engaged in the most
massive experiment in quantitative easing the world has ever seen and they are doing it when their
economic trade balances with the rest of the world are in deep trouble.
The highest and best use of Japan’s experience for US investors is to be an example of how not to try and
fix the problems of anemic growth with easy money. It is highly desirable that European policymakers
observe and learn from Japan’s experience so that they do not follow the same path to deflation. Japan and
Europe share several other structural parallels: aging populations, dysfunctional and undercapitalized
financial systems, and outsized influence from parts of the population who want to maintain the status
quo. All of these are anathematic to real growth, which is the only long-term solution for sustainable
economies.
China- China is clearly an important factor in the global economy. The intense capital investment boom of
the last 5 years is cooling, as both real estate building and infrastructure and factory construction have
finally slowed down. We know now that large portions of the country’s recently built structures are under
inhabited and/or under-utilized. China’s international competitiveness in manufacturing is eroding as their
currency becomes more valuable so they need to find another way to create employment for their
humongous labor force. Chinese leaders may decide, by devaluing the yuan, to participate in the
burgeoning global currency devaluation war which is a conflict best described as “beggar thy neighbor”.
China’s boom over the last five years was largely a result of massive increases in debt and the influx of
foreign capital to build plants to manufacture things like cars and computers. The global economy is not
prepared for a major Chinese economic slowdown, nor are Chinese domestic leaders willing to accept it
because it would create large-scale unemployment and social unrest. The unfortunate truth is that there
are no cases in modern history where an economy has grown like China’s has due to government induced
expansionary policies, and then managed to escape a banking crisis or some sort of outright bust. This is
certainly not priced into the Chinese stock market which has boomed as a result of the highly publicized link
up between the Hong Kong and Shanghai stock markets.
China does have a long-term plan for expansion into Asia and Africa. They are preparing for the day when
their currency will act as a freely acceptable unit for global trading in competition to the US dollar. They
have the accumulated savings from a decade of export driven success and it looks like their plan is to use
the US dollars earned in that process to build commercial ties to the rest of Asia and Africa. This would
benefit their domestic companies, who would get the business of building those commercial ties, and it
might well result in the eventual emergence of some cities in China as alternate centers of influence to
London and New York. China is creating alternatives to the International Monetary Fund, the World Bank,
and the US dominated Asian Development Bank, all of which will rely on a stable and strong Chinese
currency. This explains why, despite the pro-democracy demonstration crackdown, Beijing is pressing
ahead with using Hong Kong as a proving ground for its market stability. China’s going forward plan is to
invest in itself and not the US, which it has done by being one of the largest buyers of US debt instruments.
The potential impact of this change has not been felt in our markets yet because plenty of cheap capital is
still coming into the US as part of the flight to safety reaction to global unrest, but that could change in a
heartbeat.
Emerging markets – Due to the super low interest rate environment in the developed world, there has been
a strong movement on the part of emerging economies to issue bonds in US dollars. This has stimulated
emerging-market economies and been a cheap way for them to finance growth. This is not an unmitigated
blessing however, as higher leverage on the part of emerging markets is a concern because their capacity to
service their debt may go away exactly when they need it most. Emerging markets bonds could come under
pressure in much the same way as Greek or Cyprus bonds have in the recent past, and because of shrinking
economic prospects, emerging market access to dollars could disappear overnight, thereby creating a crisis
like the late 1990s, when Russia and other smaller oil producing nations ended up on life support, gasping
for survival.
Over the last 20 years, astute global institutional investors have borrowed money where it was cheap and
invested it where they could earn more. This is what I define the “carry trade”. The carry trade is as
important today as mortgage backed securities trading was in 2007. It is how money moves around the
globe in search of opportunity. The size of the carry trade has exploded since the 2007-8 financial crises
and when it unwinds in a particular country, that country or region can suffer greatly. There was an
extended credit boom in Southeast Asia that culminated in the Asian financial crisis of 1997 and the next
victim was Russia, which technically defaulted in 1998. Large US investors in Russia almost brought down
the rest of the world’s financial system due to the nature of global financing.
Today, we have a carry trade situation that is five times the size it was in the late 1990s and it extends
deeply into the emerging markets. It is complicated, but if the US dollar gets a lot more expensive,
emerging-market companies will have difficulty paying on their loans and people involved may have
problems unwinding their carry trades. This began to happen last year when global markets devalued
currencies in India, Turkey, South Africa, Indonesia, Argentina, Brazil, and Russia all at once. The Federal
Reserve saw this and took steps that did ease the crisis.
Now, with Russia’s economy going downward fast due to EU and US sanctions over the fighting in the
Ukraine and simultaneous oil price declines, other emerging markets are seeing their economic fortunes
decline in unwilling sympathy with Russia. When investors abandon emerging markets, they don’t do so
country by country, but en mass, they give up on the entire group. The US has intervened over the years in
various foreign financial crises. These including Mexico (1994), Southeast Asia(1997), Russia (1998), and
probably more recently in Europe through the European Central Bank (ECB) as the US Federal Reserve Bank
implicitly stands behind the ECB‘s efforts to contain deflation and further economic contraction. If there is
anything the last 30 years has taught us about cross-border capital flows, it’s that herding behavior prevails
and that declining markets can swamp even the largest of government banks. If commodity prices continue
to stay down for an extended period and/or the US dollar continues to appreciate, the carry trade could
turn some small country’s colds into a system wide flu.
The United States – for the purpose of brevity, I will focus on one important facet of two US economyeconomic sectors: finance and energy. Since the financial meltdown of 2007 – 2008, these two areas have
expanded in size way out of proportion to the rest of the economy. Here’s why -they have been particularly
well-suited to take advantage of the nearly free money provided by the Federal Reserve. The logic behind
zero interest rate policy of the government is simple– how can we get companies, investors and consumers
over the trauma created by the near meltdown? The goal was to rekindle economic growth that would
provide good paying job opportunities, etc. The last few years has shown that most of this money did not
end up being used by businesses to expand their capital spending. On the contrary, most manufacturing
companies have paid off debt and shed employees in order to become more profitable. Financial
businesses have borrowed amply, in part to hire more salespeople, but mostly to do more financial
engineering.
Without getting technical, financial engineering (FE) is the use of other people’s money to make money by
manipulating the cash flows of companies. FE leads to changes in the ownership of assets at higher and
higher prices with the ownership of assets moving away from entrepreneurs towards financial institutions.
FE is what hedge funds, private equity, insurance companies, pension funds, and some mutual funds do in
order to generate high returns. It is all based on the manipulation of data. The result of FE is higher debt
levels for companies and greater ownership concentration in the hands of the wealthy, all of which adds to
the system’s fragility in the event one of the big players experiences a real-world shock.
A great deal of the nearly free money created in the US since 2008 has gone into financial engineering, to
what final effect, we do not know. We do know that there is more risk in the financial system now than
ever before and that much of the risk remains outside the view of anyone but the players in the carry trade
game.
Financial leveraging has also been used in the energy industry. Due to the Federal Reserve’s easy money
policy, capital expenditures in the oil and gas regions went into hyper-drive in 2008-9. Again, without
getting mired down in details, there has been a tremendous amounts of capital made available to oil and
gas companies and they have availed themselves of it like pigs at the trough. At the same time, investment
returns on money spent by energy companies have been declining since 2010. The means that there might
well be a great deal of overcapacity in the US oilfields and someone needs to suffer to make things right.
The advent of new drilling techniques has created boom towns in some of the West and parts of the
Northeast, but these classic booms are generally followed by busts, as well described in the Pulitzer Prize
winning book, “The Prize” by Daniel Yergin.
While the US has and will continue to enjoy many benefits from increased domestic energy production,
most notably political independence from the Mideast, the downsides of this expansion have not yet been
widely felt. We are now reading reports of layoffs, bankruptcies, and eventually will see consolidation in the
energy industry which will take out the marginal players. This is the intended effect of Saudi Arabia starting
a supply war by pushing to expand its oil production in the midst of declining oil prices. The US is just
starting to feel the impact of the first shots and while we may enjoy very reasonable gasoline prices at the
pump for a while, once the shakeout occurs and marginal US producers go out of business, prices will rise
again. The need for a coherent and long-term sustainable energy policy does not even seem to be on the
drawing boards of the new Congress but that is a different subject!
Upcoming events and Personnel news
Rob: Daughter Hannah, now 26, has moved to Portland, Oregon, from Santa Fe to continue taking premed courses at the local community college. She is considering both the Naturopathy school in Portland
and a more traditional medical school program once she decides which best suits her interest in the healing
arts. Robyn, 28, is traveling out of the country during the winter as has been her habit for the past several
years. She is in between acting and barista jobs in New York City, where it is apparently cold and gray. We
could use a lot more snow here, preferably high up in the mountains outside Santa Fe and a little less wind!
Juliana: In November I took a road trip, driving with a friend, from Philadelphia back to Santa Fe. It has
been quite a few years since I drove across country and I had forgotten how much fun it is to see all the
different parts of the country from a car window instead of the bird’s eye view of an airplane. Maybe in
2015, I’ll have a chance to drive to NC via back roads instead of I-40. If anyone has any suggestions for
interesting routes, let me know.
Patricia: Happy 2105 everyone! So hard to believe it is another new year already. I was lucky to spend
some time with my son and his wife in New Orleans. They recently bought some property there for shortterm rental and plan on spending time there during the year. The property is called “The Marigny”. It is
outside the French Quarter but in a fun little neighborhood. Also, I have started a Master Gardeners course
in Albuquerque and am excited to see where that takes me as there is a certain amount of volunteer hours
per year with different events. This class is on Tuesdays through the end of April.
Jeff: We went see some family and friends in Phoenix, AZ over Thanksgiving. It was nice to be in the warm
weather for a while, but I’m not too fond of the heavy traffic there. The office enjoyed the home grown
citrus fruit we brought back from my wife’s family farm. I recently attended some music festivals and got to
participate in some guitar workshops that were fun and helpful.
Lauren: I hope that everyone had a nice holiday season. In lieu of the madness of airline travel, I opted to
travel to Chicago by way of the train over Christmas to visit with friends and family. It was a relief to make
the trip a little less stressful and would gladly choose the 24-hour trek over flying in the future. I am hoping
to take a trip out west in the coming months to explore a part of the country that I haven’t visited yet.
Kyle: In November my wife, Tabitha, and I purchased a home in the Eldorado area of Santa Fe. It has been
great settling into a permanent space and we really enjoyed the opportunity to have our own hosting space
over the holidays. We still need to finish furnishing the house, but for now our boys are loving the open
space for running and wrestling. Assuming we get a little more snow, I am looking forward to doing some
skiing and sledding over the next couple months.
Local tea and conference call in dates
The next Rikoon Group gathering will take place at our offices at 2218 Old Arroyo Chamiso in Santa Fe on
Wednesday, February 18th at 3:30pm. Please bring a friend or anyone you think would benefit from
participating in this open ended review that Rob hosts quarterly in regard to the markets and the economy.
The next day, Thursday, February 19th, our quarterly phone conference will take place at 3:30pm MST. The
call-in number is 1-626-677-3000 and the Access Code is 425993. Please email us before the call if you
want Rob to respond to your particular questions or areas of interest.