The Independent Investor: Turmoil in Turkey
Turkey, a country that represents about 1 percent of the world's gross domestic product, has suddenly become a cause of concern for investors worldwide. Both developed and emerging financial markets have plunged over the last week as that country's currency plummeted. Fear that this tiny country's problems could somehow spark a global financial contagion has everyone on edge.
Those fears are unfounded. There will be no "contagion." What is happening in Turkey is truly a "Tempest in a Teapot" that bears little resemblance to the crisis in Greece several years ago. Yet, over the last week, Turkey's currency, the lira, fell to record lows, interest rates skyrocketed, and their stock market cratered.
Turkey's problems are nothing new. It is a classic case of a country that borrows abroad (in U.S. dollars) to leverage their economy's growth rate, which make the voters happy — until it doesn't. Investors have erroneously compared Turkey's woes to the Greek crisis of a few years ago. But there are big differences.
Turkey's economy is about 1 percent of global GDP, the 17th largest in the world. The country is not a full member of the European Union, nor does it use the Euro as its national currency. In addition, European banks have relatively little exposure to Turkish debt. Unlike Greece, where all the above were real fear factors, Turkey is more of a "corporate debt problem."
It has been companies, and not the government, that have gone on a borrowing spree. And foreign investors, searching for better returns that can be had in safer, more developed markets, were glad to loan Turkish companies' money for a double-digit return. Turkey is not alone in this trend; many other emerging markets have also been able to tap the debt markets in recent years.
The problem in this scheme is that the U.S. dollar has been strengthening all year. Projections are that it is likely to continue to gain against other emerging market currencies. Since Turkey's debt is priced in dollars, every tick up in the greenback makes their debt payments that much higher. At some point, that situation becomes untenable. Debt default could become a real possibility in that case.
And what could happen to Turkey, might also happen to other countries, such as Italy. A crisis in Italy would be a whole new ballgame, similar, but worse, than what happened to Greece. The "Italian Problem" has also been simmering for years, so it is understandable that investors would jump to conclusions prematurely.
And during this tempest, President Trump brought the kettle to boil by doubling tariffs on imported Turkish steel and aluminum in response to Turkey's imprisonment of an American citizen. Although Turkey only sells $1.4 billion of these metals to the U.S., it is the thought that counts. Down went the lira (again), which has now declined 40 percent since the beginning of the years. Their stock market (which is about the size of the market capitalization of McDonald's) plummeted. Interest rates spiked (now 17 percent), while the inflation rate is expected to go higher than its present 17 percent.
While there is little positive news that one can point to in terms of this country's economic prospect over the short term, their situation is purely "Turkish" in nature. There is no need to put down that novel or call your broker from the beach. As I have warned my readers over the past few weeks, manufactured crises that are then blown out of proportion are how traders whittle away the slow days of August. Don't get caught up in the hysteria.
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The Independent Investor: Should You Pay Down Your Mortgage?
The Tax Cut and Jobs Act of 2017, together with rising interest rates have changed the calculus in determining whether to pay down your mortgage or let it ride. Let's examine the pros and cons.
Over the last 10 years, as interest rates fell to almost zero, it made total sense to pay off your high-interest mortgage. At the very least, one could re-finance and save on monthly payments. This was especially true if your mortgage was in the last stages of a 30- or 15-year life.
At that point, the interest portion of the payment, (which is tax deductible) was minimal, while the principal payments represented the lion's share of the monthly bill. For those with new mortgages, or who refinanced at record-low interest rates, the interest banks charged composed most of the payment (and thus a larger tax deduction), so these buyers had fewer reasons to prepay.
All this changed with the new tax act. There is now a cap on how much of a mortgage interest deduction one can claim. Worse still, if you are unlucky enough to live in a state with an income tax, the cap on the mortgage deduction is combined with a cap on state income tax and property taxes deductions. In short, the higher the interest payment on your mortgage, the less tax incentive you have to carry a mortgage.
However, there are some positives to this mortgage equation. Interest rates have already begun to rise, although not by much. If rates continue to rise, at some point, some homeowners will have lower mortgage rates than the interest rates they could obtain in the prevailing market. They would have borrowed "cheap" money at a fixed rate for an extended period. Of course, all bets are off if you have an adjustable rate mortgage or home equity loan. In these loans, your payments rise along with interest rates.
However, for some Americans, an aversion to debt can be an overriding factor in holding a mortgage. We are a nation of debtors overall. But as we grow older, many retirees facing a decline in their income, realize that paying down their debt raises their chances of a satisfying, worry-free retirement. There are others who just hate owing money or resent paying that "pound of flesh" the lending institution demands for the loan.
Putting those emotional issues aside, the key question to ask as a financial planner will always be what is the best use of capital? Can I make more by paying off my loan or keeping it and investing my extra money elsewhere in something that is yielding even more than my mortgage rate.
Given the lower tax incentives for owning a mortgage, why hold a mortgage at all?
Let's take an example. Pretend you are 65 years old, have no debt, except a 30-year fixed, 3.5 percent mortgage. As a retiree, if you are going to pay off your 3.5 percent mortgage, you want a safe, guaranteed return on your money that is higher than that. Certificates of Deposits, therefore, make the most sense. Right now, the best three-year CD rate is around 3.1 percent. So, you would still be making more by using any extra cash in prepaying your higher rate mortgage than putting your money in a CD, but not by much.
As rates move higher, your fixed-rate mortgage looks better and better. Fast forward a year, and now CDs are yielding 4 percent. In which case, it would make more sense to invest your extra cash in that higher-yielding CDs than paying off your mortgage. In a sense, you are borrowing cheap 3.5 percent money and investing it in an investment returning 4 percent.
Given that you will still be receiving some reduced mortgage interest tax benefits under the new tax rules, this example needs to be adjusted for that tax benefit depending on your state of residence. Remember too, that in retirement, you may need cash when you least expect it. Medical emergencies, a new car, home repairs—all seem to crop up when you least expect them. As such, liquidity will be an important variable in your financial line-up. As such, prepaying your mortgage will usually require a severe decline in your available cash.
I guess the good news is that after a decade of low-interest rates and high tax mortgage deductions, the worm has turned. This opportunity may provide conservative investors with alternative investments to at least think about and monitor in the future.
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The Independent Investor: The Incredible Shrinking Stock Market
There was a time, back in the late Nineties, that publicly-traded stocks were the envy of all companies, great and small. But times have changed, and since then the number of public companies have fallen by 50 percent.
You might have missed that trend, however. That's because the market capitalization of equities has been increasing for a decade. This year the market cap of the U.S. stock market hit a record $32.2 trillion. Globally, the World Bank estimates stock market capitalization is above $80 trillion. The largest contributor to this trend has been the large increases in stock prices.
Bottom line: investors are simply bidding up the prices of existing stocks in an incredibly shrinking market.
The peak year for publicly-traded companies was 1996 when there were over 8,000 companies listed. Since then the number has gradually decreased until today, where only 4,336 companies remain in the public sphere. The same trend has been identified in developed markets around the world. European and Canadian stock market trends mirror our own with listed companies falling by anywhere from 20 to 60 percent overseas.
There are several reasons why listing your company on an exchange has lost much of its luster.
Most companies complain of an increasingly complex and expensive mountain of governmental and industrial rules and regulations they are required to obey. Despite the Trump administration's effort to reduce this onerous burden, few companies are planning to reduce their law departments any time soon.
Then there is the media and an increasingly active shareholder base. Every move, every action by management is scrutinized, analyzed and sometimes reported inaccurately by the financial media. Shareholders, both active and passive, respond to the news in a vicious circle of give and take. Short-term activists demand change to "increase shareholder value." Often, these same activists are only interested in goosing the stock price for their own benefit over the short-term.
That's because public companies are increasingly judged by their short-term results. Quarterly earnings performance is a do-or-die event for managements. Wall Street analysts demand guidance on sales and profit numbers that better come in on the nose or else. And more and more of top management's time is spent appeasing these analysts, shareholders and the media. All of which takes time and effort that could be better spent on running their company.
The nature of the stock market has also changed. Back in the day, when a company needed to expand, it went to the stock market to raise that capital. The public market also provided a means for the owners and employees of private companies to "cash out" their sweat equity. But today, there are other means to accomplish the same ends.
More and more large private companies do not need to be listed to raise capital or reward employees. Venture capitalists and other well-heeled investors are only too happy to provide the money in exchange for ownership in the future growth of these private companies. As a result, more and more companies are waiting to go public, enjoying more of the fruits of their labor and sharing less of it with public shareholders.
Leveraged buyouts (LBOs) have also come into vogue. Managements, fed up with the demands of their public companies, have chosen to take their company private by enlisting outside investors to take the company private through purchase of their stocks. These LBOs come in all colors and stripes and have played a big role in the ever-shrinking number of public companies.
Given the nature of the stock market and its participants today, staying or going private may be the right decision for many companies. The downside is that we, their potential shareholders, are being shut out of the opportunity of participating in the lion's share of profits and growth of these future Apples or Googles. Instead, we are simply forced to pay more and more for the same old lineup of public companies.
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The Independent Investor: Tariffs — The Next Chapter
Tariffs on $34 billion in Chinese imports were imposed, as expected, last week. China responded with $34 billion of their own tariffs on American imports. So far, this has been a zero-sum game. The question that investors are asking is whether or not the trade war will escalate.
I could say that this entire trade spat has been "much ado about nothing." The total amount of trade tariffs and counter tariffs don't add up to much given that China is a multitrillion-dollar economy. The war of words and threats between our once-allies, our antagonists, and the president, amount to much more.
Right now, Trump's statements would indicate he is ready to impose $500 billion on Chinese imports alone. If the Chinese (as they have promised) respond by levying a like amount on U.S. goods, we could see $1 trillion or more in additional tariffs. That would hurt the U.S. every bit as much as it would hurt China. If we also consider Trump's trade war on other fronts — Europe, Asia, emerging markets — then, look out below.
We also need to consider how this tariff issue will impact consumer and business confidence. If the tariff threat escalates, it will damage confidence, which, in turn, will reduce the potential for spending and capital investment. That would lead to an abrupt and sudden decline in economic expansion and the end to the bull market in stocks.
How likely is that? Not very, in my opinion; at least for now. In the meantime, the president and his men have managed to turn our allies into antagonists, while giving the Chinese an opening to fill the vacuum we are creating in U.S. international trade. America's attitude toward this development is predictably smug.
"The world needs our goods, especially technology," say the protectionists, "so what do we care that the Chinese will gain market share at our expense?"
As someone who has spent half my career investing in foreign markets, I can tell you that attitude is naïve at best. The global marketplace is extremely competitive. Companies respond to protectionism by moving jobs, plant and equipment to the areas that offer them the highest competitive advantage while down-sizing in those areas that don't.
This is already happening here at home: "Capital spending had been scaled back or postponed as a result of uncertainty over trade policy," wrote the Federal Reserve Bank in its latest meeting minutes. U.S. companies "expressed concern about the possible adverse effects of tariffs and other proposed trade restriction, both domestically and abroad, on future investment activity."
Consumer spending also slowed in this year's first quarter, registering the weakest growth in five years. The jury is still out on that front, however. We will need to see the second quarter numbers before we make a judgment call on spending.
Another unrealized impact of tariffs will be their contribution to the inflation rate. Tariffs do one thing: increase prices. While most investors worry about a tariff war's impact on overall trade, much of world trade will continue, but at higher prices. Tariffs are simply price increases levied by governments and paid for by consumers and business.
The markets are expecting a gradual increase in interest rates as the U.S. central bank works to normalize interest rates after years of easy monetary policy. What they fear most is a spike in inflation. They are already concerned that U.S. labor shortages are reaching a critical point. As companies compete for workers, wage growth will rise and with it the inflation rate.
The last thing the economy needs right now is a trade war, but it seems the president, in his wisdom, believes the opposite. Let's hope he knows something that we don't.
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The Independent Investor: Currencies & Trade Wars
What's up with the dollar? The greenback is strengthening and is having its best quarter since 2016 against an array of foreign currencies. Is this an accident, or is it something far more dangerous?
Economists will tell you that the Trump tariff crusade is responsible. New trade barriers, which the president is suggesting, would usually lead to higher prices at home, according to economic doctrine. Products we import would cost more, whether we are talking about steel, automobiles, or baseball caps.
As prices increase, so should the U.S. inflation rate. As inflation rises, bondholders will demand higher interest rates to keep up with inflation. In turn, higher interest rates would normally lead to a stronger dollar. In the real world, this explanation is not so cut and dried.
There could be any number of macro scenarios that I could spin, which could alter the dollar's rise. For example, the Fed (which controls U.S. interest rates) could decide not to raise interest rates for other reasons. The impact of tariffs might also end up being so minor that prices barely budge. In other cases, breakthroughs in technology (such as oil and gas fracking) or in a manufacturing process could lower the cost of certain products even while others are going up due to the tariffs.
The dollar's strength or weakness will also depend on what is happening overseas. The economic conditions of other nations will impact their own currencies relative to ours. In many countries, the exchange rate is not determined by market forces, as is the greenback. In many cases, currencies are controlled by a central government. A currency could be "pegged" to the U.S. dollar, or to a basket of currencies. It could rise and fall in a pre-set range pre-determined by the government's central bank. Governments can also control how much of any currency their citizens may own.
In a trade war, like Donald Trump appears to be waging, a country can use its currency to countervail the price impact of tariffs on their exports. Let's say you are a Chinese manufacturer of Major League baseball caps. You compete with one of two American companies. They may make a better product, but also charge more for it, let's say 10 percent.
So, being a great patriot and baseball fan, the president decides to slap a 10 percent tariff on all baseball caps imported from China. Now, the Chinese manufacturer has neither a price or quality advantage. His sales suffer and America "wins." However, the Chinese government could alleviate the situation by allowing their currency to devalue by that 10 percent. In this case, the cost to the American importer of Chinese baseball hats remains the same, because it now costs him 10 percent less (in U.S. dollars) to buy the hats.
Fast forward to today. The latest salvo in Trump's trade war is to threaten to raise the amount of Chinese goods taxed by the U.S. to $450 billion. That would mean that tariffs would be applied to nearly all the $505 billion in goods that China exported to the U.S. last year. That would be a real blow to the Chinese economy. To soften that blow, China could decide to let their currency, the yuan, weaken to the point that the impact of tariffs would be erased.
In the past two weeks, the yuan has fallen three percent against the dollar. It is still up about 5 percent against the greenback over the last year, but that can easily change. Is the Chinese government deliberately causing the decline?
If they are, you can't prove it. Going back to the economic models, one could argue that the tariffs Trump is planning to impose would damage the Chinese economy, slow growth, and weaken their currency. The recent decline could only reflect that fear among currency traders.
Whatever the case, China is not the only player that may be tempted to play this game. All of Europe and Asia will be hurt by American tariffs. It makes economic and political sense for nations to protect their own fortunes and those of their people in the event of a trade war. Some would argue that it is their duty to do so.
Since all is fair in love and war, deliberately weakening a nation's currency in relation to the dollar in response to tariffs could be a smart move. Some might even argue it is the patriotic thing to do.
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