Don’t Ignore the Warning Signs

By Wednesday September 13th, 2017 Economy
  • Hurricane Harvey no one off – a wake-up call to the effects of global warming
  • The global pensions crisis is upon us now
  • North Korean crisis will not go away
  • Meanwhile, global growth is OK but likely to lose some momentum
  • Keep your bonds and gold

Maybe it’s in human nature to hope for the best, but a good investor should always assess the risks to the rosy scenario. The extreme weather in Texas, the ongoing pensions and social security crisis and the worrying developments in North Korea are at their core structural problems, not one-offs. Erratic weather has connections to global warming, failing pension funds are linked to ageing populations and North Korea sits in the midst of geopolitical challenge of a resurgent China facing off to the United States.

I would stress again that investors should not mix up their emotional tactical trading with their strategic asset allocation. Structural challenges in the global economy help shape an investor’s strategic asset allocation, they should not push you to extremes of risk taking or risk aversion.

The structural challenges outlined below that I believe investors prefer to downplay in the hope that they go away, only serve to reinforce a structural bias for fixed income in asset allocation and a good allocation to gold.

Hurricane Harvey – a wake-up call to the effects of global warming and good excuse for more government spending

The risks from climate change are staring policymakers in the face, but they have preferred to characterise them as one-offs rather structural issues that have to be addressed. While I wouldn’t state that the hurricane was perfectly predictable, I think it can be stated there were enough warnings from the experts to suggest it was very likely to happen. Hurricanes are a fact of life in Texas, but global warming has intensified the effects of the Hurricanes. The ocean is today warmer than before creating more energy for a hurricane to tap. The warmer atmosphere allows more water vapour to accumulate, which is then dumped on land, pulled down by the hurricane. In approximately one week, 21 trillion gallons of rainwater had fallen on the Texas coast breaking all records.

Despite the warnings of the impact of global warming on Texas there appears to have been insignificant amounts of money spent or planning to mitigate the potential effects of heavy rainfall. It must be remembered that Houston, home to six million people, is built on a flood plain the shape of a bowl. Thorough planning to mitigate some of the effects of the flooding appears to have been absent. The authorities were forced to open floodgates on a dam when the level of the water hit a critical level, releasing thousands of gallons of water on neighbourhoods that were built in the direct path of the released water.

Maybe the issue of climate change will move more substantially onto an investor’s radar. Back in 1990, the Intergovernmental Panel on Climate Change was noting that the single most important impact of climate change might be is human migration. Some studies expect there to be 200 million climate migrants by 2050. That would represent a tenfold increase over recent estimates of those displaced by climate change.

What do all of these opinions on climate change mean for investors? The first easy question to yourself is would you buy real estate that is under threat from flooding. In the United States the cities of New York, Boston and Miami are three major cities that experts say are very vulnerable even today from rising sea levels. New York in 2012 suffered from Hurricane Sandy that created havoc in the financial centre. The experts do not consider these recent hurricanes as anomalous one offs but more an indication of what is to come.

 

On a more positive note, policymakers have more of an excuse for a substantial expansion of government spending in support of infrastructure. Latest estimates suggest about $120 billion in aid will be offered to overcome the effects of Hurricane Harvey. Instead of building a wall to keep out Mexicans, President Trump might consider building more seawalls to keep out the effects of global warming. As a side note, there is a body of evidence that the migration of Mexicans to the United States is due to the degradation of farmland in Mexico due to global warming and poor government policy. Building a wall between Mexico and the United States does not solve the root problem.

The pensions crisis is a crisis for today – a reason for investors to have a long-term bias to bonds

Problems in Houston stretch beyond the recent flooding. Houston faces another challenge that of the global pensions crisis. Resignations in the police force are now running at double the usual rate after the implementation of a reduction in retirement benefits. Houston is aiming to reduce the city’s $8.2 billion unfunded pension liabilities.

The problems of underfunded pensions are endemic in the United States with the latest estimate from Milliman puts the current funded status deficit of the 100 largest corporate defined pension plans at $282 billion. On a much greater scale the credit-rating agency Moody’s estimates that state, local and federal governments pension plans are $7 trillion short in funding about 40% of GDP. It doesn’t stop there. Moody’s also estimate that Social security and Medicare programs have a funding gap of $13.4 trillion 75% of GDP while Hospital Insurance of Medicare amounts to $3.2 trillion some 18% of GDP.

Fidelity report shows that in the UK the average retiree today will walk away with only 12.4% of their pre-retirement income compared to 19.3% ten years ago. Very low-interest rates, poor investment returns, and insufficient savings is leading to a pension crisis that is upon us today.

Too often pension trustees prefer to live the illusion that all is fine when the reality is staring them in the face. By tweaking interest rate forecasts and investment returns to levels that are quite frankly inconceivable they manage to keep their pension funds solvent. When reality hits, the only losers are the pensioners who find themselves unprepared for future retired life.

The funding gaps on social security and pension funds are likely to force a more cautious approach to investment on the part of investors. I expect the fixed income bias of investors to increase as will the sensitivity to downside risk in risk assets. I believe the greater risk is of overvalued bond markets than the persistence of overvalued equities.

North Korean crisis a support for gold and a challenge to China

As I warned some weeks back, the North Korea situation has reached a far more serious level than many had contemplated. Again the risks have not been taken seriously enough by policymakers or the markets. North Korea has now demonstrated that it has a far more credible nuclear threat than the international community had given them credit. The situation could end up becoming more than a distraction for the markets. The threat of military action while still low must have risen. There is a huge difference between the United States providing support for Asian countries threatened by North Korea’s military capabilities and the United States itself feeling threatened. The North Korea crisis is also lying bare the battle for economic influence in the region between China and the United States. China is trying to secure access routes from China to all parts of the world either by road or sea. The North Korean regime has been propped up by China because it protects China’s borders from US influence.

The greatest risk in the near term is that the United States extends sanctions to any company or potentially country that trades with North Korea. Such action might start a trade war with China, given that China is North Korea’s most important trading partner.

Meanwhile, calm in the global economy – reasonable growth with limited inflation

The global economy continues to bumble along with signs of reasonable growth and low inflation. Indeed with data releases for the second quarter near complete JPMorgan estimates that global GDP growth jumped to a 3.8% pace the fastest since mid- 2010. It is comforting to see that the globe can grow at such a pace with more motors to growth than we have seen for some time. Both companies and households appear to have been spending with a little more confidence than we have seen for some time.

However, there is a feeling that global growth is moderating from the heady levels of the second quarter. A significant fiscal boost helped Japan in the first half of the calendar year and data since then has shown a marked deceleration in corporate spending. In China growth remains healthy but is likely to moderate from first half levels. Meanwhile, the challenges of the hurricanes in the United States and Asia and the North Korean crisis are all challenges to near term growth.

Equities and bonds consolidating at their highs

A slow down in the momentum of global growth plus current geopolitical problems are likely to keep equities in their current trading range.

The US 10-year bond remains close to its recent yield low with little to challenge that in the absence of a reacceleration of growth and a pick up in inflation. Credit remains in demand but with more commentators concerned with the tight spreads. However, the 340bps pick up of yield for US high yield will stay attractive given that it represents well over a double the yield of the US 10 year.

Keep your gold even if there is a temptation to take some profits after the strong run-up. Bill Sarrubi my favourite technical analyst writes this week “Gold broke out through the 1290 resistance with a 1380 price target. September has been the single strongest month in any year, up 61% of the time for a 2% gain. Due to the technical strength and the seasonality, I expect rising prices to the end of the month and likely to mid- October. Over the short-term, gold is likely to consolidate or pull back into the 8th. Hold long positions.”

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