The candidates have released their economic plans and the expected results of their fiscal policies are the subject of great debate and analysis. The choice of which plan will produce growth finds its distinction in tax policy. One model is presented as pay-as-you-go redistribution; the other, a supply-side solution to spur growth using tax incentives. The focus is on the plans posted on the candidates’ websites. What is out-of-focus is what is not mentioned and not debated. What is omitted from the plans will pose the greatest risk.
In broad strokes let us define some of the missing topics that will have a greater profound effect on future economics, and in turn, the capital markets. You would think that policies relating to half the budget would be the salient issues of debate. There is no mention of Social Security or Medicare and barely a whisper on entitlements. So, what is coming relative to interest rates, economic growth, and financial markets?
Revised GDP is at this time under 1.5%. The key to modeling the economic plans is to use expenditure growth of Social Security, Medicare, Obamacare, Interest and Entitlements as a weighted cost of capital to discount revenue growth. This paradigm affords us to see clearly why almost $10 trillion over almost 8 years in added debt has not stimulated the economy. Trade deficits and discounted revenue come right out of GDP. This is the reason for the anemic sub 1.5% growth.
No doubt that military spending to fund war efforts does little for capital formation, as it is difficult to spend a tank. Nevertheless, there is an economic benefit in trade negotiation and avoiding conflicts by military might. The cost of an aircraft carrier that controls a 1500 mile area projects military power supporting international alliances. In this way, even a libertarian may concede that the cost of losing a sea gate is worth the cost. King Solomon over one thousand years ago experienced a peaceful reign through alliances and trade. The cost of the military can be mitigated somewhat, in the same way, today and there is more capital formation creating markets to trade than in war. So the military budget is a necessary part of economic growth.
Where does this leave us for an economic outlook into 2017 and beyond? Economic growth requires that an after-tax risk-adjusted return on invested capital must exceed financial assets returns. Low-interest rates have stoked real assets and mispriced risk on both equities and bonds. As corporate and sovereign and municipal issuance increases, leverage poses a major threat. Companies that have gained EPS growth on the back of stagnant revenues and cheap issuance will experience massive multiple contractions.
The most highly levered sovereignties (i.e. China) create a systemic interest rate shock risk from redemptions. Does anybody truly believe that $1 trillion in reserves is enough of a buffer for China? So we are left with an economic outlook – higher interest rates and growing deficits. Once the United States broke $17.5 trillion in national debt, the cost of debt surpassed revenue growth.
So I expect that commodities and equities with lower operating and financial leverage will do well. I expect that 2017 winners will include short term CEF funds (with floors), managed futures and directional hedge funds. Spreads will broaden in fixed assets in my view, due both to duration and credit risks, and extension risks on mortgages will increase. In this scenario, cap rates will increase by 50% in most sectors. LBO and mezzanine funds should do well as will special situation event-driven strategies.
Peter J. de Marigny
Newport Beach, CA