Louis Gave (CEO of Gavekal Research) lists 10 key events of 2020.

Key Points:

  • In 2020, Western governments abandoned all pretense of fiscal discipline.
  • Central banks are openly financing government deficits.
  • China is blasting its own separate policy path.
  • The renminbi seems to be making an important turn.
  • “Ricardian growth” is ending as the world worries more about safety than low prices.
  • Taiwan emerged as a new strategic fault line.
  • China’s takeover of Hong Kong changed the world financial system.
  • The energy landscape is shifting rapidly.
  • Europe’s divide is changing from north-south to west-east.
  • Japan is in a quiet bull market.

Bottom Line: The pandemic got most of the attention this year but other important events occurred, too. Now is a good time to review them.

 

Tax Planning Before Year End

 

Any low-cost basis stock or real estate?  If so, you have less than 2 weeks for Long Term Capital Gains tax at 15% before it goes up next year.  Check with your tax advisor, you may benefit by selling low cost basis stock or real estate, pay the capital gains at 15% and establish a higher basis.

  • Roth Conversion this year before year end 2020.  Make sure to stay on track for using this year to convert another chunk of your IRA to Roth.  Make sure to not raise your tax bracket by doing so.
  • The SECURE Act eliminated the stretch IRA. The estate tax exemption and lifetime gift exclusion could be substantially reduced next year, and the step-up basis may be eliminated, which could hit heirs with substantial capital gains taxes. Annual gifting and split gifting could be more important than ever. To help maximize inheritance and minimize potential estate tax concerns, review gifting strategies and beneficiary designations. High-net-worth clients may want to consider leveraging the lifetime gift exemption to reduce their taxable estate. If both parents and grandparents are wealthy, consider transfers to grandchildren in anticipation of changes to the generation-skipping tax.

 

US Economy

 

  • Mortgage originations hit the highest level since the peak of the housing bubble
  • Home equity withdrawals have increased in recent years.
  • Urban rents continue to face downward pressure
  • US industrial production continues to recover, with the November factory output exceeding market expectations.
  • Here is a comparison to the 2008 recession.

 

 

  • Capacity utilization is still well below pre-COVID levels.

 

 

  • Residential construction remains vibrant.
  • Initial jobless claims remain elevated
  • Confidence in the economy has deteriorated.
  • The Philly Fed’s regional manufacturing index softened this month as new orders retreated
  • On the other hand, the Kansas City Fed’s regional index strengthened further.
  • A wider US budget deficit has typically been associated with a weaker dollar.
  • Freight activity is now up on a year-over-year basis.

 

The Fed

 

The Federal Reserve was created by Congress on December 23, 1913, to provide the nation with a safer, more flexible, and more stable monetary and financial system. President Woodrow Wilson signed the Federal Reserve Act into law.

The Fed sets the cost of money and assets are priced relative to that cost. Today, the cost of money is effectively zero.

The Fed concluded its last meeting of the year this past Wednesday. Powell and team ended the year with rates near 0%. The one major change is a promise to continue to buy at least $120 billion of bonds each month “until substantial further progress has been made toward the Committee’s maximum employment and price stability goals.”

Stock prices were lower after the release of the statement, but joy returned when Powell said that the Fed is committed to keeping monetary policy “highly accommodative” for “quite some time.”

Janet Yellen, along with every Fed Chairman since Paul Volker, has almost single-handedly destroyed the bottom 90% of the American economy. To Ms. Yellen, when “you only have a hammer, everything looks like a nail.” Since the days of Ben Bernanke, the answer for every economic ill has been more “stimulus.” Such has led to the current trap Ms. Yellen will find herself in as Treasury Secretary.

Stanley Druckenmiller, one of the greatest investors of our time, is currently bearish on U.S. equities, saying, “We are deep into the longest period ever of excessively easy monetary policies.” He added that this “radical dovishness” has not only prevented firms and individuals from deleveraging, but has encouraged them to take on more debt, which has been frittered away on “financial engineering,” rather than investment. He feels that “higher valuations, three more years of unproductive corporate behavior, limits to further easing, and excessive borrowing from the future suggest that the bull market is exhausting itself.”

 

 

Economic scholars have long argued that for monetary policy to be able to stimulate economic growth, four basic conditions must be met:

  • First, the Fed must be able to control the monetary base by increasing its liabilities, which are assets of the depository institutions. The Fed can create these liabilities at will electronically. In the old days, textbooks said that these IOUs were created at the “stroke of the bookkeeper’s pen.” These liabilities, however, do not meet the definition of money which must be a medium of exchange, store of value and unit of account.
  • The second requirement of the Fed’s power to stimulate economic conditions is a stable relationship between the monetary base (a consolidation of the Fed and Treasury balance sheets) and the money supply, M2. The money multiplier, which is defined as M2 divided by the base, is the measure of that stability.
  • Third, the velocity of money (V) must be stable, although not constant. If V is stable, then changes in M2 will control swings in nominal GDP.
  • Fourth, the Fed must have wide latitude to lower the short-term policy interest rate. It had been long recognized that if short-term rates approached the zero bound, monetary capabilities would be diminished. (Re-read that last sentence)

Four decades ago, the consensus view was that all of these conditions prevailed, and monetary policy was a potent tool of not only restraining economic growth, but also stimulating economic growth. Currently, of these four conditions, only the first one prevails, and it is the least important of the four. The Fed can control the monetary base by increasing its liabilities (bank reserves). The three other, and far more critical, conditions are no longer present due to the extreme over-indebtedness of the U.S. economy.

Conclusion:

  • Monetary policy is left with one-sided capabilities i.e., they can restrain economic activity by reducing reserves and raising rates, but they are not capable of stimulating economic activity to any significant degree. The Fed can stabilize distressed financial markets through their powerful lending abilities.
  • Countries in a debt trap like the U.S., Japan, the U.K., and the Euro Area have experienced a fall in short-term interest rates to the zero bound, and in some cases into the territory of negative rates, thus eliminating the fourth criterion for monetary policy to play a stimulative role in supporting the economy.
  • Debt financed fiscal policy can provide a short-term lift to the economy that lasts one to two quarters. This was the case with the debt financed stimulus packages of 2009, 2018 and 2019. However, the benefit of these actions in 2009, 2018 and 2019, even when the amount of the funds borrowed and spent were substantial, proved to be very fleeting and the deleterious effects of the higher debt remain.
  • Substantial econometric evidence indicates that government debt as a percent of GDP in all of the major economies are well above the levels where these detrimental effects occur. The multi-trillion dollars borrowed for pandemic relief in the second quarter encouraged the beginnings of a “V” shaped recovery, but this additional debt will serve as a persistent restraint on growth going forward.
  • When government debt as a percent of GDP rises above 65% economic growth is severely impacted and becomes very acute at 90%.

To put some perspective to the 90% debt threshold mentioned, let’s take a look at the U.S.:

Note that Government (federal, state, and local) Debt-to-GDP is 123.7% (above the “very acute at 90%” level).

 

 

My two cents: The Fed is not out of ammunition and “the Fed has our back” narrative is in control. However, debt is the elephant in the room and it is growing most everywhere. Until the bad debt clears, low growth is all but guaranteed. We live in a massively complex and interconnected global system. The debt makes the system unstable. Don’t believe the narrative can hold indefinitely.

 

Interesting

 

Despite “peak oil demand,” insufficient investment will create a massive supply gap over the next couple of decades.

 

 

The entire rally since the March lows took place outside market working hours.

 

 

Below is the Q3 GDP growth by country.

 

 

Reaching herd immunity in the US:

 

 

 

 

 

All content is the opinion of Brian J. Decker