mauldin january 28

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Outside the Boxis a free weekly economic e-letter by best-selling author and renowned nancial expert,

John Mauldin. You can learn more and get your free subscription by visiting www.mauldineconomics.com1

2015 Investment Themes

JOHN MAULDIN | January 28, 2015

I it aint broke, dont fix it, says my riend Gary Shilling as he kicks off todays Outside the Box. Hes

reerring to his investment themes or 2015. He first gives us 11 reasons to continue avoring long reasury

bonds. Tats an obvious play or him i you know his view, but its nevertheless a compelling one this year

and one that you should think through, given the specter o deflation about in the world, the firing up o

QE in Japan and Europe (which gives olks money to buy reasurys), and the sae-haven status o the

US dollar.

Garys reason #9 or buying reasurys is that Te odds o a near-term Fed rate hike are receding. He

sees any Fed rate increase being pushed out as the deflationary effects o the oil price plunge sink in and

investors and the Fed realize that oreign central bank stimuli amount to Fed tightening [in relative

terms].

Garys remaining themes or 2015 include some other clear winners like the US dollar and Japanese

equities (no surprise there), but also some interesting deensive plays like consumer staples and oods and

what Gary calls small luxuries.

Be sure to see the special offer or Gary Shillings INSIGHTat the conclusion o the letter.

An interesting thing happened last week. I get a lot o email rom readers and do try and sif through

them. I got a very kind note rom one reader who thanked me or the introductions we do or Outside the

Box he said they compel him to read the articles, which he finds useul. O course, that one made meeel good. Ten less than an hour later I got a polite note rom another reader who complained about my

introductions, because he preers to just jump right in, without my stealing any o the authors thunder.

Both comments made me think more about the process o bringing OBs to you, which is also good.

Sometimes we just do things out o habits that have accreted over time, and I may need to be more aware

o what I am actually presenting. I really do appreciate your eedback, positive or constructive.

Tis has been an extremely busy week, as the entire Mauldin Economics team has been in my home or

the past three days, sharing ideas, shooting videos, making plans. Tat means I get a little behind on some

things, but being with smart, creative people really gets my juices flowing.
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onight is sushi with even more guests (and Neil Howe is in town). More planning and meetings and more

things that get added to my to-do list. But it is all un and exciting.

You have a great week, and now lets look at Garys investing themes or 2015.

Your overwhelmed with ideas analyst,

John Mauldin, Editor

Outside the Box

2015 Investment Themes

(Excerpted rom the January 2015 edition o A. Gary Shillings INSIGHT)

Our 2015 investment themes are quite similar to our 2014 list that worked well or us. I it aint broke, dont

fix it.

Te reasury bond rally o a lietime still seems intact. Te risk on investment climate or U.S. equities

persists, but as in 2014, we approach it with trepidation and with a deensive portolio position. Te U.S.

economy is continuing to grow but at subpar rates (Chart 1) while growth in China is slowing, is very

sluggish in the eurozone and negative in Japan.


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Te dollar is reigning supreme (Chart 2)and 2015 may turn out to be the year o the greenback as almost

every other currency declines against the buck, especially the euro and yen.

Commodity prices may drop much urther, especially petroleum, while financial problems in Russia,

Venezuela and elsewhere escalate severely. Deflation is spreading worldwide and may expand beyond the

energy sector to prices in general. And low-quality bonds here and abroad are likely to keep declining as

are emerging market stocks.

Here are our 13 investment themes or 2015.

1. reasury bonds.Tere are many reasons why we continue to avor long reasury bonds. Here are 10:

1. Sae haven. Like the U.S. dollar, reasurys are a sae haven in times o global turmoil and uncertainty, o

which there are plenty today.

2. Deflation, extant in many countries (Chart 3) and looming in many others including the eurozone,

makes current reasury note and bond yields attractive.


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3. Quantitative Ease, underway in Japan and likely soon in the eurozone, provides money to invest in U.S.

reasurys.


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5. Foreigners are buying reasurys. In the December sale o $13 billion in 30-year reasurys, indirect

bids, a measure o oreign demand, took 50%. Te Fed is no longer adding to its reasury portolio but

oreigners, as well as domestic investors, are more than replacing Fed purchases. With hal o reasurys

owned abroad, it is truly a global market.

6. U.S. banks are buying reasurys as they move away rom lower-quality assets, in part to comply with

new rules requiring the biggest banks to hold more liquid assets and 60% o these must be backed by the

ederal government. Also, in counting towards liquid assets, corporate obligations get a 50% haircut but

those backed by the ull aith and credit o the ederal government get 100% credit.

7. Long reasurys continue to be attractive to pension unds and lie insurance that want to match their

long-maturity liabilities with similar duration assets.

8. Junk and corporate bonds are losing avor vs. reasurys. Te spreads between junk vs. reasurys are

widening as reasurys rally while junk bonds sell off under the weight o heavy issues and investor worries

about deaults, especially on weak energy company issues. At the same time, the spreads between reasury

and investment-grade yields are widening. Note that energy bonds represent about 20% o most fixed-

income benchmarks. Companies are issuing debt at the astest rate on record, ofen to und dividends

and share buybacks. Meanwhile, the issuance o reasurys is shrinking as the ederal deficit alls (Chart6). Unlike the ECB, which is likely to buy corporate debt, the Fed is highly unlikely to do so. Tis pushes

money rom U.S. corporates to those in Europe.

9. Te odds o a near-term Fed rate hike are receding. Early last year, the utures markets assigned a high

probability to an increase by years end. Now these markets indicate that the odds are receding, with a 24%

probability o an initial Fed rate increase by June and 51% by July. And these numbers will no doubt be

pushed out urther as the deflationary effects o the oil price plunge sink in and investorsand the Fed

realize that oreign central bank stimuli amount to Fed tightening, relatively.


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Afer its December policy meeting, the Fed said it would be patient beore raising interest rates, adding

that the overall outlook hadnt changed much rom earlier assurances that its policy rates would stay at

essentially zero or a considerable time. Fifeen o the 17 policy committee members expect rates to

rise this year and their median orecast was or 1.125% in 12 months through December, 2.5% in 2016

and 3.625% in 2017. As weve noted in past Insights, however, in recent years theyve consistently orecast

stronger economic growth and quicker rises in interest rates than have materialized.

O course, the Fed is right in step with private orecasters. Te Wall Street Journals poll o 49 orecasters

(not including us) back in January 2014 ound that 48 expected yields in the 10-year reasury note to rise

rom 2.9% at that time to an average orecast o 3.5% by years end. It moved in the opposite direction and

ended 2014 at 2.17%, as noted earlier.

We continue to believe it will be years beore the Age o Deleveraging ends and, with it, slow growth,

and the Fed shifing to selling securities and raising rates. Te recent nosedive in commodity prices and

deflationary implications will probably stretch out the central banks time line.

But what i, contrary to our orecast, the Fed raises its benchmark rate beore the Age o Deleveraging is

completed? When it hinted at tapering its then-$85 billion in monthly asset purchases in May and June o2013, reasury note and bond yields leaped. Nevertheless, these moves were out o keeping with history.

Interest rates rose in the post-World War II era up until 1981 as inflation rates climbed, but have allen

since then with receding inflation. Afer removing these trends, first up and then down, we examined the

relationship between the Fed benchmark, the ederal unds rate, and the yields on both 10-year reasury

notes and 30-year bonds.

On average, the spillover rom ederal unds was small, with a one percentage-point rise pushing up

the 10-year note yield by 0.35 percentage points and the 30-year bond yield by just 0.23 points. So, we

dont expect a nosedive in reasury note and bond prices even i the Fed tightens credit earlier than we

orecastunless the 2013 aper antrum marked the beginning o a new relationship. Recall, however, the

sage words o Sir John empleton: Te most dangerous words in the English language are, this time itsdifferent.

10. Postwar babies are aging and this avors reasurys as older people reduce the riskiness o their

portolios and avor high-quality bonds, despite low yields.

11. Speculators are increasingly short the benchmark 10-year reasury note in the utures market. I the

rally in reasury prices persists, sooner or later they will be orced to buy back their shorts, adding to

demand.

More reasury Rally Ahead

We expect a urther rally in reasury prices with the 30-year yield dropping rom the current 2.75% to

2.0%, perhaps by the end o 2015. I so, the Long Bond would provide a total return o 18.8% and the

30-year zero coupon bond, 24.6%. I the 10-year note yield drops rom the current 2.17% to 1.0%, as we

orecast, the total return would be 12.4%. Tese may seem like big gains or yield declines o only about

one percentage point, but thats what happens when yields are low. In any event, we believe that the bond

rally o a lietime marches on.


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2. Selected income-producing securities,including investment-grade corporate and municipal

bonds as well as utilities and other stable high dividend-paying stocks, remain attractive. In act, with

municipal bonds on average yielding more than reasurys, they are very attractive to bond buyers who

concentrate on yields, especially on an afer-tax basis (Chart 7). Furthermore, the yields on investment-

grade corporates and munis are almost the same, afer adjusting corporate yields or the minimum 39%

individual income tax rate, and even higher in many states.

U.S. stocks are expensive. Te Feds largess, which we believe was behind the rally that started in March

2009, is no longer there with the end o QE (Chart 8). Te leap in the price-earnings ratio that accounted

or 67% o the 29.6% rise in the S&P 500 in 2013 is no longer present, and at 19 at present, it is well above

the long-term average o 15.5.


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3. Consumer staples and foods.We avor these stocks, but deensively, advocating things that people buy

regardless o economic circumstancesutilities, consumer staples and health carein sectors that also

tend to have attractive dividend yields.

4. Selected healthcare providersbenefit rom the increasing health care needs o aging postwar babies

as well as the newly insured under Obamacare. Medical office buildings continue to be attractive as

physicians migrate to hospitals rom stand-alone practices in view o increasing regulatory costs.

5. Low P/E stockswith meaningul dividends also fit into our deensive category.

6. Small luxuries, things that financially-stressed consumers buy to get the best o what they can afford,

also is deensive and benefits rom the many Americans and people abroad who still have compressed

incomes, including in developing countries. Global consumer products companies like Unilever and

Proctor & Gamble are finding that poor people in countries like India with static or even declining wages

and little discretionary income will still pay more or ancier soap, shampoo, razors and mouthwash.

7. Productivity enhancersshould continue to thrive as slow sales growth and lack o market acceptance o

higher raise prices keep businesses ocused on cost-cutting and productivity improvement.

8. Japanese stocksremain attractive as the Abe government strives to stimulate economic growth while

trashing the yen.

9. Te dollarcontinues to look profitable vs. the loonie, kiwi, Aussie (Chart 9) and other commodity

currencies as commodity prices, led by oil, keep dropping along with the deliberately-trashed yen and

euro. Virtually all currencies are being devalued against the dollar, which, as the worlds reserve and major

trading currency, cant really be devalued. Its a matter o other currencies alling against the greenback, the

established norm, not the buck rising against them.


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Te euro looks especially vulnerable as the chasm between the eutonic North, led by Germany, and the

Club Med South, spearheaded by France, continues to widen. Labor reorm efforts and other measures to

improve efficiency in the Italian government and private sectors continue to meet huge resistance, and the

Italian economy is back in recession. Meanwhile, economic growth is trivial and government debt levels

huge (Chart 10). Greece is acing another national election with the anti-eurozone Syriza Party showing

strength.

We seldom make explicit orecasts or investment themes because we seldom know how ar investments

moving in our avor will go. In the case o the euro, however, its interesting to note that it started out in

1999 with the dollar worth about 1.10 euros (Chart 11). It dropped to 0.85 in May 2001 beore climbing to

1.58 in March 2008. Since then, its been on a downward trend. With all the problems in the eurozone and

ECB President Draghis determination to devalue the currency, the euro might well drop back to 1.00, or

parity with the greenback this year.


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Similarly, the yen could drop substantially rom here. Note in Chart 12 that in November 1982, it hit 278

per dollar. Tats a long way rom the current 120, and a collapse to 278 would be a disaster or Japan and

the whole world. Still, given the newly-re-elected Abes determination to trash the yen, its reasonable to see

the yen dropping to 150 or 200 per greenback. Notice that Abe used his re-election momentum recently to

recommend a corporate tax cut rom 34.6% to 32.1% in the fiscal year starting in April and to 31.3% in the

ollowing fiscal year.

Unattractive Temes

Our unattractive themes list includes 10. Industrial commodities, especially copper (Chart 13), which

we love to short. As in 2014, were reraining rom shorting crude oil because o uncertainty over OPEC

actions and the outcome o the Saudis game o chicken with weak OPEC producers as well as American

rackers.


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We do, however, continue to list 11. Natural gasas a short because o the spillover rom oil and the

abundance created by U.S. racturingat least until LNG exports become substantial. It goes without

saying that weve dropped our North American energy theme on the attractive side.

12. Emerging country stocks and bondscontinue to be unattractive, in our view. With developing

countries that depend on oil exports in deep trouble and other commodity exporters such as Brazil in

doubtul positions, this whole investment sector is under pressure with both stock and government bond

prices alling on average o late (Chart 14).

13. Junk bonds(Chart 15) continue to be interesting on the short side, especially those issued by energy-

related companies. Te rest may well be dragged down as investors flee to sae havens.


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A Shock

In past Insights, weve explored the Grand Disconnect between slowly-growing major economies and

soaring equity markets, propelled by central bank money and, in the U.S., by unsustainable corporate cost-

cutting as well.

Tis gap will get closed sooner or later, either by Fed tightening and the recession that has ollowed in11 o 12 similar incidences in the post-World War II era, or a substantial shock that will have the same

effect. Te resulting recession will no doubt become global, given the already weak state o many oreign

economies and financial structures.

We also stated that it will be years beore the Age o Deleveraging and slow economic growth are

concluded, and the Fed then begins to raise interest rates and shrink or sterilize the $2.3 trillion in excess

member bank reserves that have accumulated with QE. So a major shock may occur beore the Fed shifs

gears toward credit restraint. Te obvious current possibility, o course, is the financial allout rom the

ongoing weakness in commodity prices, especially crude oil, and the soaring greenback.

In Past External Financial Shocks and Teir Effects (also in our January 2015 Insightreport), we examine

the effects o past shocks on the U.S. economy, going back to the 1973 Arab oil embargo.

Te dollar was up over 7% last year against emerging economy currencies, and about $1 trillion in their

corporate bonds were issued beore the buck surged. So the cost o servicing those dollar debts is climbing,

much as in the late 1990s when a similar problem with government dollar issues precipitated the Asian

financial crisis that led to deaults in many Far Eastern economies as well as Russia, Brazil and Argentina.

Last year, companies in emerging markets issued almost $280 billion in dollar-denominated bonds to take

advantage o low interest costs. Governments have joined this parade but not as extensively as in the late

1990s. Still, total company and sovereign debt issuers had $6 trillion in outstanding bonds at the end o

2014, up our times since the 2008 financial crisis.

As investors retreat rom these emerging markets to dollars, local currencies will all even urther.

Te Indonesian rupeah, Chilean peso, Brazilian real and urkish lira are near multi-year lows and the

Mexican central bank recently spent $200 million to support its peso. Te IMF and Bank or International

Settlements worry that exchange rate problems could sire corporate deaults and asset price busts

worldwide.

In any event, a major shock and resulting recession would shif the investment climate rom the current

risk on to risk off, emphasizing what we call the Quartetreasurys and the dollar would be attractive

as sae havens while equities o all types, be they in developed, developing or rontier markets, would be

dumped along with commodities. Interestingly, three o the our members o the Quartet are already on

the stage and beginning to play. reasurys are leaping in price. Te dollar is soaring against almost every

oreign currency. And commodity prices are plummeting. Only stocks are yet to enter the stage and tune

down.


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