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Early this past month I was asked what concerns me the most going into 2016. Shortly thereafter, the San Bernardino shootings occurred and the response, almost unbelievable in its politicization and poison, fully reinforced my chief concern for 2016 and I began writing this month’s Insight newsletter. Several pages into my argument, complete with obscure data and illustrative counterpoints to many of the current hot button “narratives”, my computer went down, taking the effort up to that point with it. In hindsight maybe it was better that it happened that way because what I had written up to that point was sure to have offended nearly every Altus Insight reader, regardless of political ideologies. The issue that concerns me the most is not Democrat or Republican it is a Democrat AND Republican issue, and definitely a societal and press issue. As I rewrite this article my goal this time is to avoid specific examples and communicate the issue in truncated summary. The second part of this article quickly revisits the interest rate move by the Federal Reserve this month.

I am most concerned…Nope, it isn’t global warming, ISIS or even our exploding federal debt (although that is also a concern). It is the increased polarization of our politics and society, and by extension the apparent danger to parts of Constitution, specifically the first Amendment in the Bill of Rights.

For full disclosure, I am a constitutionalist and believe that the rights and privileges afforded in the Constitution should be universally applied across the citizen population of the United States, regardless of whether or not I agree with the actions of the person to whom it is being applied. This means I believe in a person’s right to say what they want to say even if I disagree with what they are saying or the manner in which they are saying it. This means I believe in the freedom of religion and right to peaceable assembly even if I disagree with the religion or the reason for the peaceful assembly. Going through each of the amendments to the Bill of Rights I believe (or should believe if I am acting in integrity) the same.

As political polarization becomes more and more extreme, the interpretation of rights becomes more and more self-serving, and harmful to those with a different point of view. While first glance may give appearance that my concerns are based on anecdotal evidence it turns out this is a documental issue. The following chart published this past June is based on a study by the PEW Research Center and is a big deal, especially in the historical context that it was the 1992 election in which Ross Perot rode voter discontent to an incredible 19% of the popular vote.

As much as we believe that those of opposing political viewpoints are extremist, the reality is that through most of our history a vast majority of voters are pretty moderate. More extreme viewpoints, usually influenced by major events like war, may pull the populace spectrum one way or another but in general a vast majority of the population is in agreement in most of their ideologies. This is shown by the dark blue/purple area in the chart. Notice how in both 1994 and in 2004 well over half of the total voter population would be considered moderate. 2014, however, shows that there are only approximately as many moderate voters as EACH of the left and right leaning voters. Please note that this isn’t an indication of the conservativeness or liberalness of the population as a whole, as that pendulum is constantly adjusting. This is an indication of where the population falls WITHIN the distribution curve around that relative societal political position.

Why is this important? This sort of distribution means politicians gets elected by a more extreme electorate and as a result, encouraged by their voter base, are more extreme in fulfilling their elected position. Extremities, especially within the crony capitalistic society we have become, results in favored groups of people at the expense of others. Extremities mean absolute wins and losses measured by what one side gets and the other loses versus collaboration or compromise. Extremities mean vast power swings between political parties with the ensuing rewards of friends and punishment of enemies.

Extremities, at their own extreme, result in fraudulent elections and banana republic governments. Hugo Chavez is but one example.

Intensely invading our everyday lives this extremism is overwhelming in political correctness and the press. Unfortunately it isn’t just rhetoric. Students getting kicked out of college or scientists being forced out of their jobs because they disagree with the status quo is concerning and is a populace moving in the wrong direction, hopefully not down a slippery slope, but with the definite possibility of such. Hopefully as free thinking citizens we can examine situations, policies, etc. and make our own judgement based on reason and freedoms, not the boiling flood of public opinion. And hopefully we have the fortitude to stand up for those being unjustly steamrolled, even if we don’t agree with their positions or actions.

From an investment standpoint extremism, and the likely resultant whipsaw of political power, greatly increases investment risk while simultaneously reducing the likelihood of being able to obtain outsized returns without an investment being part of the establishment’s favored class. Take coal for instance. Investment in coal mines in 2008 would have likely turned out badly as the regulation surrounding coal production and use was greatly increased under the current administration. Conversely, investment in solar or wind energy production would have benefitted from a nice tail wind as government incentives for those industries were increased. Let me be clear, in this context this isn’t a judgement on the regulation itself. That is a different topic for a different time. On the flip side, should Republicans take back control of the White House and maintain a majority in Legislation we should expect the stocks of companies that would benefit from the Keystone project to benefit.

For our own businesses even little changes can drastically affect our investment returns. For instance, changes to the way insurance companies can invest their money will lead to changes in the premiums that have to be charged. Likewise with changes to building codes that increase the cost to rebuild after a loss. How about changes to tenants’ rights that result in extending the eviction process? Or a change to the tax code that eliminates the interest deduction for home owners? None of those changes, with the possible exemption of the removal of the interest deduction, would be considered large in their own right, but the effect on returns is. A $30,000 change in net operating income has a corresponding change in investment value of somewhere between $375,000 and $550,000, no small change.

I should be clear that I don’t feel like this issue and the resulting effect on investment is a sudden development. Favoritism by politicians has been around for decades. I do feel like it has increased but still not to the point where it is currently a huge issue. The bigger concern is the delayed impact as the political extremities set in. A political whipsaw doesn’t just create the small, under the radar, changes mentioned in the previous paragraph. It will create major changes, and those changes will have major effects on investments. 

“Interesting” Revisited

Earlier this year I wrote a couple different articles about interest rates and the topic is worth revisiting briefly due to recent Federal Reserve move to increase overnight lending rates between banks by ¼%. There is a resultant short term impact onto adjustable rate mortgages and possibly on new debt being issued, but overall I believe it to be more noise than function based on the following points.

1. In the real (non-Fed) market interest rates are set by supply and demand. Without a change in supply an increase in interest rate (yield) creates a decrease in price. A decrease in price results in an increase in demand until the price increases. An increase in the price of debt results in a decrease in the yield (interest rate).

2. All the other Central Banks in the world are decreasing interest rates. A decrease in interest rates means lower yields/higher prices. This creates a better return for investors buying into US debt, thus increasing demand and pushing down interest rates (per #1 above).

3. The Fed has more ability to force interest rates lower than it does to force them higher. Because the Fed can create money out of thin air there is no problem with them paying higher than market prices for debt. Higher prices mean lower interest rates. The Fed increasing its buying also constricts supply, pushing up prices and pushing down interest rates. The Fed can try to do something similar in reverse and has the ability to increase supply by selling off debt it owns but because the market sets the sales price the Fed doesn’t have the same ability to work outside of market prices to increase rates as it does to decrease rates. While the Fed does own a lot of debt and can increase the supply considerably, central banks outside the US continue to buy debt, thus restricting the overall debt supply in the world and reducing the impact of the Fed increasing supply.

4. Increasing interest rates in the US lead to an increase in the strength of the Dollar, already riding a multiyear streak of strengthening. Stronger currency pushes interest rates lower, similar in function to the supply and demand explanation above. Many people believe that a strengthening US Dollar will also continue to harm the US economy, reducing the political ability of the Federal Reserve in their efforts to push rates higher.

5. Many large borrowers have the ability to borrow outside the US. If interest rates are better in Europe (as an example) borrowers will borrow from Europe. This reduces the debt stock availability in the US. Decreased supply means increased price means downward pressure on interest rates.

6. Junk bonds are getting hammered and after several years of extremely low spreads between high quality and low quality debt yields, the spreads are exploding. A large part of this is due to a collapse in junk bond prices but will also put upward pressure on high quality debt due to “flight to quality”.

7. Every meeting the Fed governors do a scatter graph showing their expectations of future interest rate moves. The current trend is they believe interest rates will go up another ½% in 2016. However, every scatter graph since the zero interest rate policy has been implemented (I didn’t look before then) has been optimistic in when and how much rates would be raised. I don’t see any reason this would change now.

So far the market is supporting the above arguments. Since the Fed announced the increase in the overnight rate earlier this month the 30 year mortgage rate has gone down, and is still below 4% and close to historical lows. If the market expected the Fed’s policy change to have much impact on the overall debt market it would be expected that debt investors would require higher returns on their debt investments, not lower.

All the above being said, no one, including me, has a crystal ball. There is currently so much government (and quasi government like the Fed) involvement into the economies of the world that typical rules of economics don’t hold true. They WILL hold true, because at some point they always do, but no one knows when that will happen or how intense the adjustment is going to be. In a perfect world the central banks would be able to facilitate a release of their impacts on the economies in a slow and orderly fashion and there would be little impact. While this is the preferred outcome I personally find it hard to envision it occurring. Economies are complex, living and somewhat unpredictable things and a belief that a few people in a room looking at months old data can pull all the levers correctly is beyond unlikely.

Happy Investing.

About the Author: Forrest Jinks is CEO of Altus Equity Group Inc and a licensed real estate broker. Forrest has decades of experience as principal in a variety of alternative investment segments including real estate (residential rehab, in-fill development, multi-family, office and retail), debt, and small business start-up (online marketing and site retail). He can be reached at fjinks@altusequity.com.

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