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MAY 2014 INVESTMENT JOURNAL: SHIFTING SANDS
 
  • Switzerland ditches bank secrecy
  • Russia/China ink historic gas deal
  • Voters reject status quo in game changing EU elections
  • Euro rates may go negative
     

During May, U.S. stocks doubled their gain for the year, and provided returns to investors that were second only to Emerging Markets stocks. Municipal Bonds took the lead for 2014 as the top performing asset, while gold had a significant setback. U.S. bonds also continued their solid performance this year, to the surprise of many Wall Street analysts, who were expecting weakness as the Federal Reserve slowly cuts back its bond purchases:

     

 

     

For the last three years, "hard assets" like gold and commodities have significantly lagged "paper assets" like stocks. Since markets tend towards "mean reversion", it is reasonable to expect the former laggards to play "catch up" at some point:    

            

   

May was a tremendous news month for subtle events of the kind that don't really register at first, but then, like sand shifting, can significantly alter the horizon.

 

As the month began, Switzerland, the world's largest offshore financial center, pledged to automatically hand over the details of foreign bank accounts to other countries, in a significant breakthrough in the global crackdown on tax evasion.

 

For decades, offshore financial centers have offered complete privacy and freedom to well-heeled investors who wished to take their capital away from the prying eyes of government taxing authorities. Switzerland has long been a destination for such capital, from Middle Eastern royalty to third world dictators like Muammar Khadafy.

   

Regardless of the source of wealth, governments everywhere have salivated over the prospect of collecting their share of this loot. After the global meltdown of 2008, as tax revenues plummeted and debts ballooned, the problem became acute.

   

The United States blazed a new tax collection trail by passing the Foreign Account Tax Compliance Act (FACTA) in 2010. For the first time ever, foreign (i.e. sovereign) governments and institutions were forced to withhold taxes on US persons and turn over these monies and information to the IRS or face stiff penalties. In essence, all foreign financial institutions were forced to become collection agencies for the IRS.

  

Consultation and coordination among the OECD has now produced the astonishing result called Automatic Information Exchange, which Switzerland just signed on to. Financial information everywhere will be shared with all government taxing authorities to insure "compliance", regardless of jurisdiction. In short, FACTA has become a universal standard.

  

These new rules are sweeping, and go far beyond just the reporting of dividends and interest. Of special note is the emphasis on identifying "beneficial owners" of corporations and trusts, i.e. "piercing the corporate veil".

   

Unfortunately, the result of this new reporting regime will be to restrict the movement of capital, and thus retard global economic growth and opportunity. (For instance, it is almost impossible for a "US Person" to open a foreign bank account for legitimate needs, like travel and study expenses or business ventures.) Read all about it here:

 

http://www.oecd.org/ctp/exchange-of-tax-information/Automatic_Exchange_of_Financial_Account_Information_Brief.pdf

    

On May 21st, China and Russia signed an historic agreement that will see China importing natural gas from Russia for the next 30 years, with a price tag estimated at $400 billion dollars.  After ten years of negotiations, the deal was announced during a state visit to Beijing by Vladamir Putin.

  

While obviously a "pivot to the East" by Putin, many remarked on the forced opportunity for Europe to finally lessen its dependence on Russia by seeking out other sources of supply. This could be a big win for US energy companies and others who can manage the logistics of getting plentiful natural gas from the U.S. to Europe. The downside is that the U.S. Dollar will not be used by either China or Russia to pay for these new supplies, which plays right into their shared strategy of dethroning the Dollar as the world's reserve currency by isolating it.

  

As the month closed out, elections were held across Europe for representatives to the European Parliament - their version of Congress located in Brussels. The results were a stunning rebuke to the Old Guard, with both far right and far left parties making strong gains.

     

In the UK, Nigel Farage, a fervent Euro-skeptic who founded the Independence Party, won as a third party candidate over both Labour and Tory (conservative) party candidates - a first in modern British history! Farage has long defended Britain's right to remain separate from the creeping federalism of Europe and the loss of economic sovereignty that accompanies it.

   

In France, voters delivered a monumental political upset by electing candidates of the National Front party. Led by Marine Le Pen, this "third party" jolted the establishment of Prime Minister Francois Hollande, who called the results a "political earthquake". Their platform of anti-immigration and "France First" policies resonated with voters who have grown weary of sharp tax increases and self-destructive economic policies dictated by the EU.

     

These shocking results produced little fanfare in the US, but EU citizens clearly voted against immigrants, austerity and the establishment. When two of the largest economies in Europe both vote in third parties, you know that something big is afoot, and what just happened in France and the UK may prefigure what is coming to the rest of Europe.

     

The trick now will be to see how hard the European Commission pushes back. As recent revelations by former US Treasury Secretary Tim Geithner and others have revealed, they are not below even taking out democratically elected leaders. In 2011, for instance, when then Prime Minister Silvio Berlusconi began making noises about removing Italy from the EU and re-adopting the lire as the national currency, EU officials approached Geithner about a plot to depose Berlusconi, asking that the US threaten to withhold IMF loans unless he resigned. The EU used the same tack successfully to depose Greek Prime Minister Papandreou earlier in the year.

   

In short, it looks like we're at a crossroads, where people are fed up with "more of the same", and those in power won't go quietly.  Just as the Ukrainian situation illustrates, civil unrest can quickly escalate, and we wouldn't be surprised if things in Euroland get ugly. In our view, the only missing link is Germany, whose leader Angela Merkel has been a strong supporter of a united Europe, and who must now re-examine the chessboard. Whatever happens, the US stands to benefit, as capital flows out of the turmoil of the Euro and back to the Dollar.

     

As if to underscore that point, as May closed the Financial Times disclosed that officials at the European Central Bank were prepared to lower official rates to less than zero at this week's policy meeting. That's right, as of this week, European banks who leave money on deposit at their central bank will be charged for that privilege - earning a NEGATIVE rate of interest.

   

Capital goes where it is treated best, and, right now, a ten year US Treasury at 2.4% must look mighty appealing. This is another reason why the bond market bears have gotten it so wrong this year. The bond rally may turn into a stampede if investors abandon the Euro in light of this new policy. Stay tuned.

   

In the markets this month, the recent strength in emerging market stocks has been confirmed by a significant "cross" in the Price Momentum Oscillator (PMO), as shown below:

   

       

   

At the end of May, the S&P 500 closed out the month at a new all-time high, but it masks the stark divergence in performance among the various sectors that make up the index. It is clear that being invested in the stronger performing sectors has produced much different returns than being in the weaker ones. Holding positions in Utilities, Healthcare and Energy stocks would have produced superior returns to Consumer Discretionary stocks, and to a lesser degree Financial and Industrial stocks so far this year:
        
  
    
The same holds true when breaking down equity performance by Market Cap (Large/Mid/Small). Smaller companies have lagged behind their larger cap brethren, and Value has, for the most part, done better than Growth:
  
  
    
Thanks for reading our Journal, and have a great month!
  
   
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