Arete's Observations 11/20/20

Market observations

Positive news on vaccine results on successive Mondays provided a boost to market sentiments and gave additional credence to the notion of a transition to a reflationary environment. An important part of the optimistic narrative is the ability of the economy to transition from lockdown-imposed hardships to some sense of normalcy with few additional costs.

I find two things especially interesting about this narrative. First, while the results were undoubtedly good news, it should not have been a surprise that some vaccine would have shown positive results by now. Something like the news the last two weeks was basically my baseline expectation.

The other interesting item is that the vaccines don’t solve any of the other pre-existing problems. We don’t get to magically transport from point A to point B. It is a good thing that some of the worst-case scenarios have been eliminated, but unemployment, insolvencies, and disrupted lives are going to continue for some time to come. It appears that a number of public company insiders tend more toward my view that the good news is more than discounted in stock prices.

Coronavirus

The Morning Dispatch: Long Winter Ahead

https://morning.thedispatch.com/p/the-morning-dispatch-long-winter

“A study published in Nature science journal this week used cell phone mobility data to determine where most COVID infections happened early on in the pandemic, from March to May. About eight in 10 infections could be traced back to restaurants, gyms, coffee shops, or other crowded indoor spaces.”

“The world has adjusted since March, however, and more recently public health officials are tracing new infections back to smaller, more casual social gatherings. From dinner parties, to game nights, to sports leagues, to carpools, peoples’ coronavirus ‘bubbles’ are growing in size again as pandemic fatigue wears on.” 

One takeaway is the risk vectors have changed. While indoor dining at restaurants used to be the major source of new infections, now it is small social gatherings. This is good in the sense that with an important risk vector recognized, we can all focus our efforts on mitigating those particular risks.

Another takeaway is the phenomenon of pandemic fatigue. Partly this is a function of people getting fed up with various precautions intended to inhibit spread of the virus. Partly it is a function of people yearning for opportunities to socialize. Regardless, I think it is helpful to be aware of these trends in establishing one’s own safety protocols.

Economy

Markets Can't Avoid the Reality of a Dark Winter

https://www.bloomberg.com/opinion/articles/2020-11-19/markets-can-t-afford-the-reality-of-a-dark-pandemic-winter

“A recent paper by two prominent labor specialists is sounding the alarm.  They calculate that around 12 million Americans will lose their emergency unemployment benefits by year-end.  This will be a huge hit to income and spending, to put it mildly.  By our calculations, it will be even more.  Our number includes 9.4 million currently on Pandemic Unemployment Assistance and another 4.1 million on Pandemic Emergency Unemployment Compensation, totaling 13.5 million that will see their emergency benefits end next month.  Of note, the government did not let extended unemployment benefits from the Great Financial Crisis expire until the end of 2013.  And that loss of benefits affected 1.3 million, only a tenth of what we are about to see next month.”

One point is that a very large number of people are only getting by with the aid of pandemic benefits; this is not the sign of a robust economy. Another point is given the magnitude of potential demand disruption, there is a good chance benefits get extended, even though that will be enormously costly. A final point is, whether benefits get extended or not, the situation highlights the economic uncertainty millions of Americans are experiencing – and that affects consumer behavior.

China

Asia-Pacific countries sign one of the largest free trade deals in history

https://www.ft.com/content/2dff91bd-ceeb-4567-9f9f-c50b7876adce

“By combining a mishmash of separate arrangements into a single deal, RCEP brings Asia a step closer to becoming a coherent trading zone like the EU or North America, even if it is not expected to lead to large overall tariff reductions.”

“But the greatest consequence may be taking the first step towards Asia’s emergence as a coherent trading zone, like Europe or North America. ‘Asia is integrated but it’s for the purpose of delivering goods to other markets,’ said Ms Elms. ‘RCEP changes that’.”

While the new RCEP agreement is not a world-changing event, it does solidify relationships in ways that may have economic and geopolitical consequences. With regionalism already on the rise, this is an important development that bears watching.

Geopolitics

Zambia’s debt crisis casts a long, global shadow

https://www.ft.com/content/35c58b5f-f890-4390-967a-28c0a0a1fb50

“In addition to tapping the bond market, Zambia has borrowed more than $3bn from Chinese lenders, such as China ExIm Bank and China Development Bank, according to Standard & Poor’s. But the opacity of these debts and disagreements over how to treat them has made tackling the crisis fiendishly complicated.” 

“However, this is not a unique situation. China has lent liberally to many developing countries in recent years but has declined to join the Paris Club, the arena where countries restructure bilateral debts. In addition, many Chinese loans have been extended by state-owned financial institutions which makes it hard to judge whether they should be considered bilateral or commercial loans.” 

There are always conflicts in restructurings because different stakeholders have different interests. That challenge takes on an entirely new dimension when a new stakeholder emerges that plays by different rules. If many of the conflicts in the Middle East have ultimately been about oil for the US, it seems fair to expect that many future conflicts in resource-rich geographies will ultimately be about natural resources for China.

Technology

How China’s big tech companies upset Beijing

https://www.ft.com/content/72317ec5-5a5c-44ab-8b8b-a752f9792168

“tactics by ecommerce companies are not leading to healthy development of the retail industry . . . They don’t want three or four companies [dominating] …” 

The “extensive list of well-defined monopolistic practices . . . could be a strong signal of regulatory tightening …”

Another story about Big Tech and another story about the potential for greater regulatory oversight. Except this is coming from China. Apparently Chinese regulators do not like the inordinate power of the handful of Big Tech firms. As a result, they released new antitrust guidelines that focus on an “extensive list of well-defined monopolistic practices.”

It is interesting that the Big Tech regulations that may have the most bite may be coming from China. It is also interesting that the motivation seems to be to provide a set of ground rules that enhances competition. Wouldn’t it be precious irony if China were better able to harvest the advantages of technology by ensuring a more competitive industry?

Investing in cyclicals

Capital Returns: Investing through the capital cycle

“market instability created by lags between changes in supply and production has long been recognized by economists (it is known as the “cobweb effect”).”

“The reduction in investment and contraction in industry supply paves the way for a recovery of profits.”

I highlighted the phenomenon of very long investment cycles for commodities in the 8/21/20 edition of Observations. The book, “Capital Returns”, presents the perspective of another money management firm (in a series of analyst reports) that exploits the same phenomenon. The really important takeaway is that industry supply is an extremely important determining factor for future returns. If you are looking for companies and industries that are most likely to have high future returns, find those that are underinvesting in capacity today.

Currencies

Rogoff Warns Of Dollar "Calm Before The Exchange-Rate Storm"

https://www.zerohedge.com/geopolitical/rogoff-warns-calm-exchange-rate-storm

“Nobody knows for sure what might be keeping currency movements in check. Possible explanations include common shocks, generous Fed provision of dollar swap lines, and massive government fiscal responses around the world. But the most plausible reason is the paralysis of conventional monetary policy.”

“Simply put, there is a fundamental inconsistency over the long run between an ever-rising share of US debt in world markets and an ever-falling share of US output in the global economy. (The International Monetary Fund expects the Chinese economy to be 10% larger at the end of 2021 than it was at the end of 2019.) A parallel problem eventually led to the breakup of the post-war Bretton Woods system of fixed exchange rates, a decade after the Yale economist Robert Triffin first identified it in the early 1960s.”

There are two really good points made here. One is currency movements have been unusually tame given the trauma to the financial system caused by the pandemic. Prices should reflect information which means that disparate effects on different countries should be reflected in exchange rates. This isn’t happening, at least not yet.

The other point is to explicitly recognize a major problem for the global financial system: The share of US economic output is falling while its share of debt is rising. This is not the kind of thing that will affect markets today or tomorrow, but it is absolutely relevant for long-term investors. As Rogoff warns, “it’s worth remembering that economic traumas such as we are now experiencing often prove to be painful turning points.

Gold

Gold, the Golden Constant, and Déjà Vu

https://www.cfainstitute.org/en/research/financial-analysts-journal/2020/0015198X-2020-1817698

“Today’s high real price of gold suggests that gold is an expensive inflation hedge with a low prospective real return. However, the financialization of gold ownership by exchange-traded funds may introduce a period of irrational exuberance.”

This is a good example of the type of research one can find that is right-sounding and comes from a reasonably authoritative source, and yet misses extremely important factors that are critical for investors.

One big issue is the study was done from 1975 to 2020. This time period does not include the withdrawal of the US dollar from gold backing in 1971 which is exactly the type of momentous event gold helps insure against. Further, the study places inordinate attention on demand for gold from gold ETFs. This completely misses the broader reality that “The most important demand factor for physical gold is Asian gold consumption,” as stated in the Incrementum “In Gold we trust” report.

If that isn’t enough, the report also completely fails to address gold supply. OK, what was the basic lesson in economics again? Blank … and demand. Hmmm. Look at the chart below and see “Capital returns” above and decide for yourself if supply should be considered.  

Source: Katusa Research, Tree Rings, 10/30/20, by Luke Gromen

Cryptocurrency

Ray Dalio Has a Point About Bitcoin At $18,000

https://www.bloomberg.com/opinion/articles/2020-11-18/ray-dalio-has-a-point-about-bitcoin-at-18-000

“If anything, Bitcoin looks much more like the stock market on steroids than it does a digital version of gold, which has barely budged since the end of October as confidence about a Covid cure has gradually improved.”

“Nothing had fundamentally fixed Bitcoin’s weakness as a currency or store of value, he [Ray Dalio] says, and if it ever became a threat to governments and central banks it would be keelhauled by regulators.”

Bitcoin and other cryptocurrencies have stolen the hearts, if not the minds, of a lot of people. I very much agree that there will be reckoning for pure fiat currencies and I also very much agree that cryptocurrencies cleverly solve some of the problems of fiat currencies. They also feature technology that will be more widely adopted for other applications.

That is a long way, however, from any realistic possibility that cryptos will replace fiat currencies in the future. Dalio is right on this one: Control over money is power and there is no way governments will cede that power to entities they do not control. This analysis from Bloomberg comes about as close as I’ve found to my own belief about Bitcoin. Specific cryptocurrencies that are independent of central banks form a powerful narrative that for some time will be able to harness some of the excess liquidity trying to find a home in things other than cash. That’s it.

Inflation

Last week I mentioned Florida passing a new minimum wage law and the table below confirms the sentiment is widely held. While there are valid arguments for allowing markets to determine wages, the empirical evidence strongly suggests that isn’t working. As it stands, a lot of people at the lower end of the income spectrum do not have the bargaining power to ensure fair wages on their own.

Hedge funds

Hedge funds under scrutiny over role in March bond market ructions

https://www.ft.com/content/5bab4156-54fd-41ab-b067-794c3050c8cd

“The FSB, a rulemaking body composed of leading central bank and finance ministry officials, explored the role that ‘non-bank financial institutions’ played in the crisis, and highlighted several areas that needed further study — and possible policy action.”

“the market’s ‘dysfunction’ [in March] was ‘exacerbated’ by the unwinding of a popular hedge fund trade that takes advantage of the difference between the prices of Treasury bonds and futures”

It’s fairly widely known that some large hedge funds got stuck in some Treasury trades in March and the Fed totally bailed them out with its interventions. It is hard to tell if the FSB’s ructions now are mainly about saving face and appearing to respond or if there really is some heart for serious regulation. While I would love to see efforts to reign in activity that threatens market stability, I am not especially hopeful. A big part of what hedge funds and banks do is artfully sidestep regulations.  

Implications for investment strategy

Moderna Nudges the Stock Market's Tectonic Plates

https://www.bloomberg.com/opinion/articles/2020-11-17/moderna-vaccine-nudges-the-stock-market-s-tectonic-plates

“There are some more lessons to be gleaned about Moderna. Genuine innovation will be rewarded by Mr. Market. And Mr. Market will also offer new opportunities to profit from it. Moderna’s stock has gained more than 400% so far this year. It faces controversies ahead … But this is still an example of capitalism working as intended; showering rewards on those who make an innovation that will help mankind, along with those who had the courage to back them.”

“Index investing is a great product that has made it far cheaper for people to invest in the stock market … But it has had negative effects. If the after-hours bounce [in TSLA] translates into Tuesday’s opening, Tesla’s market cap will rise by some $50 billion. For perspective, the entirety of Kimberly-Clark Corp. is currently deemed to be worth $47 billion. Moderna’s market cap, after all the excitement, is $38.7 billion. So the selection committee of the S&P 500 have managed to create more market value by adding Tesla to an index than the team of scientists at Moderna did by inventing a successful vaccine against a global pandemic.”

This is a great point and a great example from John Authers at Bloomberg. The notion that innovation gets rewarded is still true. However, it is also true that the rewards bestowed by liquidity and index inclusion are even greater. As opposed to MRNA, the big increase in TSLA market cap doesn’t reflect any new business development. It simply reflects the fact that many passive funds will be forced to buy the stock now.

Short-term, this doesn’t matter a lot. Over longer periods of time, however, the cumulative effect is for large sums of capital to get misallocated. This means our capitalistic, free market economy is a lot less so than it used to be and less so than many people still believe. It also means as long as passive investing continues to grow, it will continue to misallocate capital which will continue to exert a drag on longer term economic growth.

Lender civil warfare pierces credit euphoria

https://www.ft.com/content/9be0794a-f107-449f-845c-edf07ae94fbf

“But rather than try to fight the Fed, it’s clear in the TriMark case at least, that Marks decided to teach ‘cov-lite’ lenders a lesson. As news of the new $120m TriMark loan hit the market, the value of TriMark’s existing debt plummeted; one of the existing loans was reportedly trading at around 20 cents on the dollar, a loss of 80 per cent in a matter of days. That hurts.”

“Some have described these battles as a ‘civil war’ between lenders. But what is actually happening is a correction in the loan market after years of perverting the well-established rules of credit analysis. It’s a long overdue puncturing of yet another credit-related euphoria. What remains unfathomable is why the lessons never seem to be learned until it’s too late.”

These examples are living proof of the notion that you can move risk around but you can’t eliminate it. After the Fed’s extraordinary interventions in March and April, many market participants assumed the Fed would backstop any decline in asset prices and credit spreads duly declined. While the interventions were broad based, they applied only to publicly traded securities, however. That has left other swaths of capital “unprotected”. The Fed can only do so much and I strongly suspect there will be many more stories where this came from.

Principles for Areté’s Observations

  1. All the research I reference is curated in the sense that it comes from what I consider to be reliable sources and to provide meaningful contributions to understanding what is going on. The goal here is to figure things out, not to advocate.

  2. One objective is to simply share some of the interesting tidbits of information that I come across every day from reading and doing research. Many of these do not make big headlines individually, but often shed light on something important.

  3. One of the big problems with investing is that most investment theses are one-sided. This creates a number of problems for investors trying to make good decisions. Whenever there are multiple sides to an issue, I try to present each side with its pros and cons.

  4. Because most investment theses tend to be one-sided, it can be very difficult to determine which is the better argument. Each may be plausible, and even entirely correct, but still have a fatal flaw or miss a higher point. For important debates that have more than one side, I try to represent both sides of an argument and to express my opinion as to which side has the stronger case, and why.

  5. With the high volume of investment-related information available, the bigger issue today is not acquiring information, but being able to make sense of all of it and keep it in perspective. As a result, I describe news stories in the context of bodies of financial knowledge, my studies of financial history, and over thirty years of investment experience.

Note on references

The links provided above refer to several sources that are free but also refer to sources that are behind paywalls. All of these are designed to help you corroborate and investigate on your own. For the paywall sites, it is fair to assume that I subscribe because I derive a great deal of value from the subscription.

Comments

Please direct comments or feedback to drobertson@areteam.com.

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