Yellen Rate Hike: Expect More Pain

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Includes: EDC, EDZ, EEM, EGF, EPGFX, FIBR, FNV, FTT, GLD, GOVT, GTU, IAU, IEMG, OUNZ, PHYS, PLW, QGLDX, SCHE, SGDJ, SGDM, SGOL, TAPR, VWO
by: Mad Genius Economics

Summary

Continuing rate hikes will be bad for stocks and the economy.

The bond market is sitting at the edge of a cliff.

Precious metals now a must in every portfolio.

It's been a while since I last wrote, and for those of you who enjoyed my last piece or two, I apologize for the delay as life can seriously take over from time to time.

But I'm back and what I see coming our way is a new trend. Some trends are still with us, for sure. Like the federal government piling on mountains of debt that are impossible to repay, alongside student loans and a red-hot housing market. In fact, in my neighborhood in Queens, New York, I am hearing that housing prices have gone up by as much as 75% in the last three years alone. And near Lakewood, NJ, where my son is studying, prices have soared by well over 100%. It's not urban legend either. Realtors are confirming the talk on the streets.

The trend that has already formed will last us at least the next four years and possibly up to eight, and there are things you can do to get your portfolios up to par for this trend. The trend actually has a name of three words…President Donald Trump. The reality TV star and real estate mogul has been in office for about a month and he is already on the move. We know what his intentions are too…repeal Obamacare (though that story has changed), kick the living daylights outta ISIS and any other terrorist that wants to mess with the US, build a wall, real immigration reform, infrastructure projects galore, strengthening the military, bring jobs back to America, tax reform, and protectionist economic policies.

It all sounds pretty damn glorious to me until you get into the economic fundamentals of what will drive his reforms and policies, if implemented. The main forces behind all this are printing and spending and printing and spending and printing and spending. And by his side to help him for at least the next two years are Janet Yellen and her Keynesian cohorts at the Federal Reserve. He talks tough about the Fed, but Yellen has been very firm that she is raising rates at least two times this year.

In all fairness, I didn't think she would raise rates at all, neither the first time nor the second time; and I admit my mistake. At this point I think she's trying to make a margin of safety so that she has the ability to come back down. Again, she is creating a margin of safety so that she can come back down. The reason is that she knows that low rates can't go on forever, and the economy is long overdue for a correction or more likely a full-blown recession. At that point she will feel like she has no choice but to come back down, even though she will have the choice to let the economics of the markets work itself out.

But her aggressive rate hike intentions will have dramatic implications for the country and for your personal net worth. Get on the right side of this and you can add an extra zero or two to your net worth. Get on the wrong side and you'll be working low wage jobs for the rest of your life.

So first let's have a look at some of the economics behind what's going on. I mentioned that Yellen is a Keynesian economist. What that means for us at this juncture is that she thinks that she can command and steer economic growth using the central banking policies that we've seen over the last 15+ years, and that she can print money to create a "soft landing" in a faltering economic environment. She also thinks she can lower interest rates to soften the blow even more. But this will not happen. It will only delay the inevitable as she kicks the can down the yellow brick road that she and her two predecessors have painted green with the word "T-Note" on each brick. It's only so long before the curtain is pulled on the Fed's wizard.

I don't think anything is imminently going to happen in the next few months. What I do think will happen is as she raises rates the economy will begin to huff and puff until the Yellen house of cards is blown down. Watch for the 10-year Treasury to cross over 3%. And not an intraday high. A real and lasting crossover that closes a week and then a month, and then a quarter above 3%. When this happens, the optimism we see now on Wall Street regarding the 5,000+ companies they trade will begin to wane. Remember, companies borrow money, and the rate at which they borrow is based on the Treasuries, the prime rate, the LIBOR, or another major interest rate that is carefully watched.

As rates rise, guess what happens to their balance sheets and cash flow statements? If you said that Janet Yellen will have nothing to worry about, I've got a bridge in Brooklyn for sale. The finances of any company with debt will begin to deteriorate as rates rise. That's because more of their available cash will be used to pay for the debt, diverting it from either the cash position or reinvesting back into the growth of the company. In other words, the cash that was once building assets will be used to pay for (interest) and pay down (principal) liabilities. Short-term service payments on all that debt and long-term principal owed will be given the attention it really deserves. Businesses with much lower revenues, like sole proprietorships (70% of all businesses in America) will suffer even more because they tend to rely on high interest credit card debt to meet their immediate cash flow needs. The only businesses that may benefit in the near term are the too-big-to-fail banks, as the yield spread widens in their favor.

So the near-term trend of rising interest rates that will eventually cross and hold above 3% will spell disaster for the vast majority of businesses in America and abroad. As this happens, you can watch from the sidelines for what I have previously stated will occur: interest rates will plummet back to 0%, the Fed will possibly go to a NIRP policy, and it will resume bail-outs and trillions of dollars in bond purchases as well as other asset classes as it tries, unsuccessfully, to create that soft-landing mentioned above. Aside from the enactment of these flawed monetary policies, American and foreign businesses will suffer severe pain.

In addition to what will happen with interest rates, there are two categories of economic policy that I am looking at, which the reality TV star turned POTUS has promised and is now attempting to deliver. One is military spending and infrastructure spending. The other is protectionist economic policies, most notably A) lowered corporate and individual taxes (not a bad thing) and 2) tariffs to make American companies more competitive.

The first issue, lower taxes for all, sounds great. I agree that it should make America more competitive for companies, and fewer corporations like Pfizer (NYSE:PFE) will feel the need to relocate to places like Ireland just to save $1.0+ billion a year in taxes. This should translate into more profitability and more jobs. Those jobs that are created will then bring additional tax revenue to the federal government through personal income taxes, and anyone with a job and income tends to spend a little more than those who don't. So there will probably be more profitability and more corporate taxes being paid as well. Case in point is when Reagan lowered taxes. Job growth was phenomenal and so was the increase in tax revenue.

We might expect the same to happen now, except for the facts: national debt and rising interest rates. Reagan had both in his favor with a much lower national debt (both the actual amount as well as the debt-to-GDP ratio) and interest rates at the 20% range and falling, whereas Trump has severe headwinds with interest rates on the opposite end of the spectrum near all-time lows and rising, and the national debt is now crossing $20 Trillion and over 100% of GDP.

Next, as the economy begins to wane, debt spending can and must increase to make up for the reduced tax revenue that local, state, and federal agencies will receive. Infrastructure like railroads, airports, pipelines, bridges and tunnels, etc., are probably very highly necessary. But if the government doesn't have the cash to spend, it has two choices to either print or borrow. Make no mistake about it, the federal government will do both.

Finally, those tariffs. This is a strong dollar policy that will create a double hit when combined with rising interest rates. From a fundamental perspective, a strong dollar combined with rising interest rates does two things in opposition of each other. It makes it less expensive for us here in the USA to buy stuff from other countries, but at the same time, it makes it harder for all those foreign companies to service and pay back debt denominated in US dollars. In addition to this, if there is a tariff on any goods that are manufactured in another country, the company will not be paying the tariff. It is we the consumer who will be struck with the tariff. So even though the stronger dollar will make it less expensive for us to buy stuff from abroad, tariffs combined with rising interest rates will make it more expensive. So it becomes a wash.

If Mr. Trump's policies get delayed passing through congress or if they are shot down, we'll see tremendous instability in the dollar and in markets. Stocks will drop like a rock in a pond because of the economic implications of the Trump tax cut not passing into law, and bond interest rates will plummet. Yellen will be forced to immediately reverse her aggressive rate hike intentions. And the combined action and instability will be highly positive to precious metals

The bottom line here is that we'll have a rising Dow for a few more months, maybe even hitting 24-25K, but 12-24 months from now, we'll have a completely different picture regardless of what Trump has claimed he'll do to make America great again. Yellen will help him along, but with her telegraphed aggression in interest rates, this wizard should find a new profession. Dorothy, your portfolio needs fixing, and you should relocate from Oz to oz.

Recommendations

When I started writing this article I had a list of about 10 recommendations. I think that's too much and you'll be too overwhelmed into not taking any action. So I've narrowed it down to three things: bonds, emerging markets, and gold. And as an aside, it would be wise to pay off your margin debt (I don't recommend margin debt, that's not the reason the margin account is there for you) and get into a heavy cash position of over 30% of your holdings.

Bonds. No matter how confident you are in your advisor and the holdings he's chosen for you, it would be prescient to ask what will happen to your portfolio as interest rates rise. Also ask him if he has a "plan b" for his clients who will be negatively affected by the bottom dropping out of bonds. Not just Treasuries, but whatever bonds or bond funds you are in now. What you want to hear him say is something like "I'm glad you asked. We are getting our clients prepared by taking some money out of bonds. And we are taking some money off the table from stocks too. We are trying to protect principal." You might be able to short your bond fund (unless it's a short fund). Like a see-saw, as rates rise the price will fall, and this can devastate your bond portfolio. Remember, if you are in a bond fund, your price per share will probably fall as rates rise. You would be better off getting out of bond funds (though maybe not completely) and into another asset class that 1) deleverages your third-party counter risk, and 2) steers you clear of the inevitable bond market crash.

Emerging markets. This asset class has doubled the gains of the American markets this year, but as rates rise and Trump enacts his protectionist policies, it will become a double whammy on any foreign company that has borrowed in dollars. The dollar will rise, making it more difficult to pay bond holders, and rates will rise making it more difficult to service debts. As bearish as I am on stocks right now, I am even more bearish on emerging markets. This is a clear short, and at the very least if you are in emerging markets, you need to get out. Note that I think this could be a black swan event in the waiting that will crush everything in your portfolio in the short term, if it happens.

Gold. We're moving from oz to oz, Dorothy. Call me a gold bug if you want, but the long-term fundamentals are strengthening. The gold market is in the midst of a multi-decade bull run, which began when the yellow metal bottomed around $255/oz over 15 years ago. Prior to last year we had a long correction in the middle of this bull market, but starting last year the case for gold began strengthening once again. Remember, Yellen raised rates, and subsequently stocks fell as gold rose. The same is happening now, and as other fundamental economic factors begin to become clear, the metal will rise even more. Just think about what people do in times of uncertainty: they hold onto cash and move to safe haven assets like gold. Don't think Treasuries here, because these bonds are built on a house of cards for which no wizardly lever pulls can substitute for not having a foundation to begin with.

When it comes to gold, you should have a portion of your cash in physical gold. Only one ounce eagles or bullion bars, and please, I beg you, don't fall for the bait and switch radio schemes to buy numismatic coins. You'll over pay for those by as much as 200%. I don't recommend an ETF like GLD either, because its prospectus is scarier than Bela Lugosi playing Dracula. It doesn't have to redeem your shares for physical gold, and it likely doesn't even have any metal for redemption anyway. Read pages 5-8 of its prospectus, but do it in the morning so you don't have nightmares.

It will also pay handsomely to have a small portion in companies that mine for the metal. If gold itself rises by 15%, the companies will rise by 30-40%. I'd rather buy an ETF from Sprott Asset Management (like the Sprott Junior Gold Miners ETF (SGDJ) or Sprott Gold Miners ETF (SGDM) - I own shares in both) or the fund from Euro-Pacific Capital (like the EuroPac Gold Fund (EPGFX) - I own shares) to get some exposure to the mining industry, instead of hand picking companies. They both make very careful picks of the top companies in the industry, rather than just blindly picking all companies in the industry. If you must own a company, you would do well with Franco-Nevada (NYSE:FNV). It's a royalty streaming company, which means it lends money to mining companies in exchange for being paid a royalty on every future ounce sold, or it buys the ounces for several hundred dollars less than it will sell them for on the open market.

If you consider all the risks apparent in markets today, such as the unpredictability of the Trump presidency, geopolitical fears, and much more, I think there is very limited downside risk to owning gold during the next four years. Hands down gold will outshine all other commodities and (fiat) currencies.

In my next article, I'll be going into the case for gold much deeper, so keep your eyes open for that in the next four weeks or so.

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Disclosure: I am/we are long FNV, EPGFX, SGDM, SGDJ.

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