QUARTERLY NEWSLETTER – 3RD QUARTER 2018

You’re probably familiar with Rubik’s Cube. It’s the 3‐D combination puzzle with nine differently colored panels on all six sides of the block.

Since 1977 over 350 million Rubik’s Cubes have been sold, and over one billion people have tried to solve the puzzle. To solve the puzzle each side of the cube can have only one of six colors – white, blue, red, orange, green, and yellow.

Solving the puzzle seems deceptively simple at first glance. But it isn’t easy. The Cube has 519 quintillion (519,000,000,000,000,000,000) possible combinations. Just when one side is arranged with the same color, one false turn of a block on a different side of the Cube can mess the whole thing up.

That’s also a great analogy of what is happening in the world today. In today’s Q3 2018 newsletter we’ll look at some of the well‐intenttioned turns being made and the unintended consequences they’re having on our economy.

The Theory of Econophysics

Econophysics takes the law of supply and demand to an entirely new and uncharted level. The theory replaces money and credit (or debt) with money and antimoney. Unlike a traditional balance sheet where assets and liabilities balance each other out, money and antimoney are never added or subtracted to each other.

In the world of econophysics the lender is never paid back by the borrower. Because the borrower receives both money and antimoney from a lender, the borrower simply passes the antimoney along to someone else. The theory goes on to state that it’s possible to do credit types of transactions without interest rates or the quantity of money changing.

The theory of econophysics is alarmingly similar to what the world’s Central Banks have been practicing over the past 10 years. Unfortunately – despite well‐meant academic intentions – this isn’t how the real world works.

The Real World

Contrary to the theory of econophysics, in the real world there’s a direct ‐ albeit sometimes delayed – connection between debt, money supply, interest rates, and inflation. We recently wrote about how while the Fed struggles to see it, signs of inflation are all around us:

• Raw materials – the price of a barrel of WTI is fluctuating somewhat, but currently sits at about $70 per barrel. That’s up from $30 a barrel in February 2016.
• Consumer electronics – iPhones have doubled in price over the past two years, from about $650 to $1,099 today for a basic iPhone Xs Max.
• Postal Service – The U.S. Postal Service is proposing a 10% increase on first‐class stamps. This would be the largest percentage increase in over 30 years.
• State Taxes on Online Sales – The U.S. Supreme Court ruled in June that states have the right to collect potentially billions of dollars in taxes from internet sales. Passing through these taxes to the consumer will increase the cost of online orders by an average of 8% or more, depending on the state.
• Real estate – Since 2012 median home prices across the country have increased by nearly 80% while residential rents have climbed from an average of $1,000 to $1,400 over the same time period.
• Consumer debt – TransUnion reports that over the past four years the average debt per credit card holder has increased by 6% while the 90‐day delinquency rate has risen by over 26%.
• Interest rates – One year ago the 10‐Year Treasury Bond yielded 2.4%. The most recent auction saw the benchmark yield at about 3.1%, an increase of over 77% in just 12 months.

Trade Wars Are the New Norm

The bad thing about wars is that they can go on for much, much longer than people expect. Both the Roman‐Persian Wars and Germanic Wars went on for nearly 700 years. Since the end of World War II, the U.S. has arguably been engaged in one war or another.

Trade wars are no different. Although China accuses the Trump Administration of launching the largest trade war in history, that distinction actually belongs to President Herbert Hoover who signed the Smoot‐Hawley Act in 1930. That law boosted the average U.S. tariff on imported goods to above 45%, created retaliation from most trading partners including Canada and Europe, and is widely blamed for making the Great Depression greater than it already was.

It wasn’t until 20 years later during the post‐World War II economic boom that the economy of the U.S. and the world took a turn for the better. History has a nasty habit of repeating itself, and it would not be surprising to see today’s trade wars become the new norm.

Murphy’s Law

Murphy’s Law states that whatever can go wrong, will go wrong. In social science, unintended consequences are outcomes not foreseen or intended by a purposeful action.

When these two are taken together it’s easy to understand in hindsight how the apparent embrace of econophysics by Central Banks, the inability to see inflation, and trade wars that are intended to create a level playing field are creating completely unanticipated outcomes:

• Chinese investors are taking their money elsewhere – during the 2nd quarter of 2018 Chinese investors become net sellers of commercial real estate in the U.S. Selling nearly $1.3 billion in property while buying only $126 million it’s the first time since the Global Financial Crisis in 2008 that the Chinese sold more U.S. real estate than they bought.
• Debt is becoming the new equity – a rising number of institutional and smart money investors have been taking advantage of the dramatic rise in commercial real estate prices by selling and equity and moving into debt, in preparation for a down market cycle. That’s because an equity investment is a first loss exposure – or the first thing to disappear when the market goes south. Debt, on the other hand, lasts much, much longer.
• World property bubbles – a recent report by UBS noted that over the last three years the number of global real estate markets considered to be in bubble territory has tripled from just two to six. Factors contributing to an inflating worldwide housing bubble include unnaturally low interest rates, assets shifting from stocks driven by cheap money into residential real estate, and mobile capital investing without borders.

Occam’s Razor

Occam’s razor is the problem‐solving principle that states the simplest solution is usually the correct one. While it’s not as intellectually stimulating as creating the theory of econophysics to help justify increasing levels of debt, it’s easy to see how applying Occam’s razor to today’s global challenges could help avoid some of the unintended consequences taking place in the world today.

Here at home, the housing affordability crisis in California is rapidly growing out of control. Even though the number of homes sold has been gradually declining over the last few years, rising interest rates and seller expectations continue to drive the median home price in California up. This year median home prices will probably rise by about 7% compared to last year, and the California Association of Realtors projects prices to rise by more than 3% in 2019.

In November the state ballot included an initiative to repeal the Costa‐Hawkins Rental Housing Act enacted in 1995. Although it did not go through this time, there is evidence it will get more support on the next ballot.

The Act limits municipal rent control ordinances, something that opponents of the Act say is one of the main causes of the lack of affordable housing in California. By allowing municipalities to cap rising rents, housing would become more affordable. In reality, the outright repeal of Costa‐Hawkins would likely have the unintended consequence of making housing in the state even more unaffordable than it already is.

A Simple Way to Make California Housing More Affordable

A simpler solution to make California housing more affordable is to amend Proposition 13 which limits property tax increases. Passed by voters in 1978, the goal of Prop 13 was to help homeowners keep expenses under control by keeping property taxes low while property value skyrocketed.

The unintended consequence of Prop 13 allowed real estate investors to profit from rising market rents while paying below-market property taxes. If non‐primary residences and all commercial property were excluded from the property tax increase protection that Proposition 13 offers:

• Real estate values would decrease as net operating incomes decrease due to increased property taxes
• Supply would increase as there would be less of a financial incentive to hold property without a property tax cap
• Government would have more money from increased property tax payments to spend on infrastructure projects and job creation

Whether in California, the U.S., or around the world, sometimes the simplest solutions are the best. Especially in a world that is beginning to look more and more like a Rubik’s Cube.

Very Truly Yours,

Alexander Philips

Chief Executive and Investment Officer