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Financial Markets Review by Mark:

U.S. and World Economy

The calm before the storm. Developed world financial markets (U.S., Japan and Europe) have become numb to the long-term effects of unprecedented monetary stimulus. The companies in the S&P500 are now reporting their 6th quarterly drop in revenue and 4th quarterly drop in corporate profits. The labor recovery peaked 8 months ago (job openings and unemployment) as weak hiring is catching up to weak GDP growth. After a 1% revised first half U.S. GDP growth, the second half of the year was supposed to bounce back – it has not. Yet both stock and bond markets remain near all-time highs amidst very low (by historic standards) volatility. The developed world stock markets have benefited from very low cost borrowing to facilitate share buy-backs, artificially creating higher earnings per share; bonds have benefited from Central Bank buy-backs as well.

However, these monetary maneuvers may have peaked this summer. Since then, interest rates have moved higher and the stocks which moved highest the first half of the year have dropped the most in the second half (REITs, utilities, tech). In addition, near-term election cycles here and in Europe have raised the voice of nationalism, border and trade protection. There is talk of “Italeave” ala “Brexit”. We believe that the next major downturn will start in Europe where low and negative interest rates have pulled business forward as much as possible, bringing the weak economic expansion to an earlier than expected close. Initially, the U.S. will be the beneficiary of a flight to quality, but a stronger Dollar set against a falling Yen and Euro will hurt our exports and lead to our own recession.

Unfortunately, we do not see bonds as a safe haven for a weaker U.S. economy. The worldwide bond market is three times the size of the world stock markets and arguably near the end of a 35 year “super cycle”. Both stocks and bonds have been highly correlated lately and we see that trend continuing. We believe that the next major shift in the economy will result in a drop in the price of most financial assets (stocks and bonds) and an increase in the value of hard assets and the emerging market countries which produce them. This is a multi-year trend that we could see starting very soon. Similar to the unreasonably high valuations of the U.S. mortgage markets in 2006-7, BBB- quality sovereign national bonds (like Italy) trading below U.S.’ AAA rated bond yields, could be the bubble that bursts first.

CONTINUE READING: Fourth Quarter 2016 Newsletter