Garic’s Macro Update 06/01/16

1. The Fed and the Street have overestimated future economic growth for the past six years; despite that fact, the Fed appears determined to raise interest rates again based on these forecasts. With weak global and domestic demand, excessive global and domestic debt, and fragile global and domestic credit conditions, this is dangerous for equity investors.

2. All major retailers (except Amazon) are cutting forecasts, laying off workers, and closing stores. The Fed’s public statements that the economy is continuing to improve should not be credible.

3. For politically correct reasons, U.S. macro economists continue to ignore the effects of the “ACA” on consumer spending & small business formation. Current increases in healthcare spending are being reported as real economic growth; it should be reported as healthcare inflation, thus GDP is overstated.

4. The U.S. economy continues to face 3 significant headwinds: the “ACA”, the effects on outsourcing on wages and thus consumer spending, and historically excessive total credit market debt to GDP.

5. 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.

6. The excesses of this credit cycle is in corporate and sovereign credit. At current valuations, the risk to equity portfolio’s include interest rate risk, credit risk and currency risk. IMO, credit risk continues to be greater than interest rate risk.

7. With $70T in debt and equity securities in the U.S. priced off of a .25% Fed Funds rate and a $200T unfunded entitlement, the pressure on the Fed to accommodate the Treasury going forward is real. U.S. investors are dangerously under allocated to Gold.

8. My model hedge fund exposure remains neutral. At this point of the cycle it is important to avoid “crowded trades”. Allocations to short selling and Gold appear to be timely.

Nominal GDP growth remains stuck in a range that was previously considered recessionary. If the “ACA” were accounted for correctly, real GDP would be 1-2%

lower. The Fed embarked on QE and ZIRP with the explicit goal of reaching escape velocity. Despite not reaching their objectives, they appear ready to raise interest rates again. In the past the Fed raised rates when consumer demand, capital spending, and

credit demand were accelerating, that is not the case today!

The Fed is publicly stating the U.S. economy is improving; yet, the latest flash surveys from Markit and revisions to capital spending point to continued economic weakness!

While the BLS continues to report strong non farm payroll growth, the ASA temp staffing index has been down YOY since June, Treasury tax withholdings remain weak and now Janet Yellen’s

favorite indicator, the Fed’s Labor Market Conditions Index is also down, YOY?

At the 2000 and 2007 tops the equity market began correcting, then business sales corrected, then

inventories corrected.

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.

Total business sales peaked with the end of QE in 2014 and have been falling

since then; it is broad based!

Total credit market debt outstanding remains at dangerous levels.

Readers of my macro piece understand that I believe the growth or contraction in credit outstanding is now the driving force behind broad economic and individual sector growth. In short Wall Street has taken over the channels of monetary policy from the traditional U.S. money and banking model. With $70T of equities and debt priced off of a .25% risk free rate of return, any increase in interest rate could turn this credit cycle down.

Historically high federal debt levels are a long term risk to financial assets: Got Gold?

As federal debt growth slowed, so did the

expansion!

Household debt has not grown during this

expansion, but remains elevated!

Elevated consumer debt is one of the structural

headwinds the U.S. faces.

Corporate debt has been one of the excesses of this

credit cycle!

With $50B in defaults in Q1, this is set to fall

rapidly!

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.

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; 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% increases in some 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 another 10% in 2016 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!

The BEA is reporting 1.45% annualized healthcare inflation

when calculating GDP!

Small business optimism remains in recessionary territory. The cost of

healthcare is a major concern.

Something changed in 2000!

“The growth of productivity—output per unit of input—is the fundamental determinant of the growth of a country’s material standard of living. The most commonly cited measures are output per worker and output per hour—measures of labor productivity.” - Productivity - The Concise Encyclopedia of Economics.

The outsourcing of manufacturing is one of the structural headwinds that the U.S. economy is experiencing.

Since 2000 U.S. manufacturing jobs plummeted. Since 2000 corporate profits

as a share of GDP surged.

Since 2000 average hourly earnings have been anemic.

During this credit cycle personal consumption has been awful.

IMO, the weakness in output per hour has been a direct result of outsourcing.

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 ever seen. Since then many miners have doubled and tripled in price. On April 5th I published a detailed report on why U.S. investors are dangerously under-weighted to Gold & Silver. On May 18th the Fed began signaling they were prepared to raise interest rates. Since then the extremely large open interest by speculators long and commercials short has begun to unwind. Historically, Gold and Silver have witnessed sell offs around options expirations during summer months. Currently, I am focused on the Gold & Silver ETF’s over the miners awaiting a buying opportunity in the miners. IMO, the next major move in Gold & Silver will occur when the market comes to the conclusion the Fed cannot normalize interest rates.

Gold outperformed equities for a decade from 2001>2011 despite

commercials being short the whole time!

Gold & Silver outperformed equities for a decade after the 2000 credit cycle top. The Fed’s easy money

policies intended to avoid a severe economic downturn was at the root of this out-performance. IMO, the beginning of a new bull market in

out-performance has begun.

Speculative open interest in the precious metals have begun to reverse. Until the

markets stop believing the Fed will raise rates, the precious metals markets are vulnerable to a summer liquidation.

The corporate debt bubble may be popping!

1. Corporate debt appears to be one of the excesses of this credit cycle; companies have borrowed a record amount to buy back stock, make acquisitions or 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 appears rampant as many companies consistently report non GAAP earnings. Q1/16 General Electric reported 21c in earnings and on the next line of the press release pointed out GAAP earnings were 2c.

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. 6. 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. 7. Junk borrowings are down 57% year over year; credit cycles need to expand to continue.

Once they start contracting they tend to pop. 8. A recession would accelerate the pressure on corporate profits and leave many companies

financially strapped as we just witnessed in the energy industry.

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

Total business sales have been falling for 18 months, many

companies have used debt to buy back stock to keep earnings growing as revenues are falling.

Corporate profits (the ability to repay that debt) are falling. If the economy has entered

a recession, profits will continue to fall. Corporate profits as a share of GDP are at

record levels, this could change.

The semiconductor industry is not an industry to take on debt during an economic

expansion, especially if your largest customer is Apple! Global industry wide

smart phone sales are down year over year for the first time ever!

Many oil & gas stocks took on substantial debt to build their business around a high capital

spending and rapidly depleting technology. The recent rally in oil prices has taken pressure off of

the high yield market; that could turn quickly.

Many REIT’s have been borrowing money to buy properties at historically

high valuations and low cap rates. With every mall based retailer cutting

guidance and closing stores, SPG may be vulnerable.