wknd notes: Dismantling the Deflation Machine

“Regardez! Regardez!” cheered some French children, pointing across the runway, a chilly, grey day. Air Force One lifted off, condensation swirling off its wingtips, leaving the Davos circus behind - Zurich’s airfield crawling in corporate jets. A few adults discretely turned to watch, trying hard to appear not to care. Nearby, a plane full of Chinese disembarked from their long-haul flight. News of the coronavirus was still rather light. But the crowd of Europeans parted like the sea. The Chinese marched right on through, toward immigration, as we held our breath, enroute to distant cities. On this shrinking, little planet.

Overall: It may have come from bats. Then made its way to wild snakes. Which we captured and illegally transported to a market, where we watch as our purchases are butchered, bagged. That last link in the supply chain lets us head home, confident the beast we bought was as advertised. Then again, it may have been another bridge that connected coronavirus to patient zero. We may never know. What we do know is that the more densely we compress living creatures into unnatural spaces, the more likely it is that the viruses in one species cross to another. And we also know that the greater the number of animals to host a virus, the higher probability of mutation. Moments like these remind us we’re inextricably connected. Tiny creatures, spinning in space. Quarantined on earth. It took us 200,000 years to reach 1.0bln humans and another 200 years to hit 7.8bln. Viruses tempered our growth. Bubonic Plague killed 25mm (541-542 AD). Black Death 75-200mm (1346-1353 AD). Spanish Flu 25-50mm (1918-1920). HIV/AIDS 36mm so far. And now we’re changing our climate, we kicked off Earth’s 6th mass extinction. Humanity’s collective intelligence and cumulative knowledge provided us with the means to dominate our planet, without endowing us with sufficient wisdom to rule with humility. In the wake of WWI (40mm) and WWII (75mm) we created a web of global institutions to inoculate ourselves from a return of that uniquely human plague. Now is our moment to act preemptively to forestall what is unfolding. Let’s hope the coronavirus spurs us to reflect on our inextricable links, our common fate. And in the meantime, we distract ourselves with the trivial ways everything is connected. With an Asian pandemic hurting retail sales, reducing global demand, dampening confidence, slowing growth, pressuring equity valuations, and pushing global interest rates inexorably lower.

Week-in-Review (expressed in YoY terms): Mon: Moody’s cuts HK rating one notch to Aa2 on political concerns, UK Chancellor Javid “We will not be in the single market and we will not be in the customs union,” Harry and Meghan quit the Royal family, speculative longs in British Sterling hit Apr 2018 highs, gun-rights rally in Richmond draws 22k attendees, S&P closed for MLK; Tue: China’s coronavirus kills 6 and infects 200 to date, HK protest organizer faces 6yrs in jail, Buenos Aires governor threatens to delay bond payments, EU bank loan demand declines for 1st time in 6yrs, IMF lowers growth forecasts -0.1 to +3.3% in 2020 and -0.2 to +3.4% in 2021, 50th Davos World Economic Forum begins, Trump plans to expand travel ban to 7 more countries, Trump calls for more rate cuts in Davos, 2020 US census kicks of in Alaska, first US case of coronavirus appears in Washington State, natural gas prices fall below $2 (4yr low), S&P -0.3%; Wed: Coronavirus has killed 17 and infected 544 in 13 Chinese provinces, South Korea 2019 GDP -0.8 to +2.0%, Trump mocks Great Thunberg at Davos, Senate begins to hear Democrat’s arguments in impeachment trial, S&P flat; Thur: China quarantines Wuhan (population 11mm), WHO declines to designate the coronavirus a global emergency, Indonesia holds rates unch, world leaders arrive in Israel to mark 7th anniversary of liberation from Auschwitz concentration camp, Britain’s Parliament passes the EU withdrawal agreement, Lagarde kicks off first ECB strategic review in 16yrs, Mnuchin launches verbal attack on Great Thunberg, S&P +0.1%; Fri: Global trade suffers 6th mthly contraction (-1.1% yoy), EU PMI manu unch at 50.9 (exp 51.2), 2nd reported coronavirus in the US, Democrats complete opening arguments in impeachment, S&P -0.9%; Sat/Sun: Xi Jinping expands travel ban and suspends outbound tours from China (41 coronavirus death and 271 severe cases reported), coronavirus now on 4 continents, tens of thousands of Iraqis protest US presence, Republican senators begin defense of Trump in impeachment trial, NYT poll has Bernie leading in Iowa.

Weekly Close: S&P 500 -1.0% and VIX +2.46 at +14.56. Nikkei -0.9%, Shanghai -3.2%, Euro Stoxx -0.2%, Bovespa -0.1%, MSCI World -0.4%, and MSCI Emerging -2.1%. USD rose +4.8% vs Bitcoin, +4.7% vs Ethereum, +0.9% vs Russia, +0.9% vs Turkey, +0.7% vs China, +0.7% vs Australia, +0.7% vs Mexico, +0.6% vs Chile, +0.6% vs Euro, +0.6% vs Canada, +0.5% vs Sweden, +0.5% vs Brazil, and +0.3% vs India. USD fell -0.8% vs Yen, -0.5% vs South Africa, -0.5% vs Indonesia, and -0.4% vs Sterling. Gold +0.9%, Silver +0.4%, Oil -7.9%, Copper -5.7%, Iron Ore -1.3%, Corn -0.7%. 5y5y inflation swaps (EU -4bps at 1.29%, US -2bps at 2.08%, JP +3bps at 0.10%, and UK +1bps at 3.62%). 2yr Notes -6bps at 1.50% and 10yr Notes -14bps at 1.69%.

2020 YTD Equity Index Returns: Turkey +6.9% priced in US dollar (+6.7% priced in lira), Mexico +4% priced in dollars (+3.7% in pesos), Israel +3.9% (+3.9%), NASDAQ +3.8%, UAE +3.3% (+3.3%), Denmark +3.3% (+5.1%), Australia +3.1% (+6.1%), Russia +3% (+3.3%), S&P 500 +2%, Switzerland +1.9% (+2.2%), Finland +1.9% (+3.6%), Czech Republic +1.8% (+2.4%), Canada +1.7% (+2.9%), Portugal +1.6% (+3.5%), Greece +1.6% (+3.5%), Indonesia +1.3% (-0.9%), New Zealand +1.2% (+3.4%), Korea +1.1% (+2.2%), Taiwan +0.9% (+1%), Germany +0.8% (+2.5%), India +0.5% (+0.7%), Japan +0.3% (+0.7%), Italy +0.3% (+2%), Singapore +0% (+0.5%), Saudi Arabia 0% (0%), Netherlands -0.2% (+1.6%), Sweden -0.3% (+2.3%), Poland -0.3% (+1.3%), Russell -0.4%, Malaysia -0.4% (-1%), Belgium -0.6% (+1.2%), HK -0.6% (-0.9%), UK -0.8% (+0.6%), Euro Stoxx 50 -0.9% (+0.9%), France -1% (+0.8%), China -1.6% (-2.4%), Brazil -1.7% (+2.4%), Spain -1.7% (+0.1%), Ireland -1.8% (0%), South Africa -2.3% (+0.8%), Norway -2.3% (+0.4%), Philippines -2.4% (-2.5%), Thailand -2.6% (-0.7%), Austria -2.9% (-1.3%), Colombia -3.2% (-0.9%), Chile -3.8% (-0.6%), Argentina -4.5% (-4.2%), and Hungary -6.5% (-3.4%).

PredictIt.com: Saturday’s NYT poll put Bernie firmly in the lead for Iowa’s Feb 3rd vote. 25% of those polled listed Sanders as their 1st choice. 18% Buttigieg. 17% Biden. 15% Warren. 8% Klobuchar. And in PedictIt.com betting markets for the overall Democratic nomination, Bernie surged ahead of Biden for the first time. Bernie is a 39% probability to face Trump in November. Biden is a 34% probability. Bloomberg 13%. Warren 8%. Buttigieg 5%. As for the probability who wins the presidency in November? PredictIt now gives the Republicans a 52% chance.

Client Prive: “My clients have growing risk appetite, aggressive even,” said the CIO in Switzerland. “It has been too many years of rising markets,” he continued, shrugging ever so slightly. “It is not my way, not after so many gains, but then what am I to do? It is after all, their money.” For years there has been a flow out of hedge funds and into a barbell of liquid risk-premia and illiquid private strategies. But this has evolved into a barbell of liquid equity index products and illiquid private equity funds. “My clients have few hedge funds and no hedges.”

Econ 101: “One man’s debt is another man’s asset,” said the CIO, lifting his palms evenly, bringing them into perfect balance. “The weight of one is perfectly offset by that of the other.” So in theory, it should not matter how large either grows. “But debt creates asymmetric behavior between borrower and lender,” he explained. “When the economy comes under stress, borrowers are forced to retrench, and lenders must then choose whether to fill the economic void left by that adjustment.” By repairing their balance sheets, the borrowers do additional economic damage. 

Econ 101 II: “Lenders tend to wait and see how things shake out before stepping in,” continued the CIO. Central banks provide stimulus to lure them back. “Therefore, the higher the debt level in an economy, the more susceptible it becomes to catastrophic failure and the less responsive it is to stimulus.” So central bankers must work harder. “But by doing so, they slow the necessary adjustments in parts of the economy where balance sheets are unsustainable. And this incentivizes leveraging up in places where balance sheets are strong – creating new excess.”

Econ 101 III: “In a global financial system, these dynamics spill across borders,” he said. 10yr German bunds yield -0.34%. Greeks pay +1.28% to borrow for 10yrs (40bps less than the US). Tesla market capitalization is $102bln. “This is good for the short-term performance of asset prices and economic growth, but down the line, it makes the financial system more prone to catastrophe.” And less responsive to stimulus. “In each downturn, central bankers must step in more and more aggressively. The process is reflexive and ultimately leads to a Minsky extreme.” 

Anecdote: “Financial markets have capitulated to the secular stagnation narrative,” said the CIO, high atop his prodigious pile. “And in so doing, they have tethered themselves to the wrong inevitabilities – to low interest rates forever, to asymmetric central bank reaction functions, to a negative bond-equity correlation,” he added, peering into the distance. “And now a financial system which is structurally intolerant of inflation faces a political-economy regime change which makes inflation an imperative.” Seeking to escape the 1970s inflation, policymakers inadvertently engineered an equally powerful deflation machine. The 2001 ascension of China into the WTO global trading system - combined with decades of Moore’s Law compounding our computational speeds - amplified the machine’s deflationary force. “From the S&P 500 peak in 1972 to the 1974 trough, a 60:40 stock bond portfolio lost 60% of its nominal value.” In real terms, it lost 70%. There was no V-shaped recovery that quickly returned portfolios new highs. “Are we on the cusp of economic regime change and wealth destruction not seen since those dramatic years in the 1970s?” he asked. In the distance, Britain’s politicians readied their plans for an impressive fiscal stimulus. The Americans fought over how to best expand their current 4.5% deficit (with unemployment at levels last seen in the late-1960s and with the economy running above capacity). Will Republicans introduce new tax cuts and infrastructure spending? Or will Democrats expand entitlements on a scale not seen since the 1960s Great Society programs? Or launch a Green New Deal? Both? “It does not take a wild imagination to see where this comes from – a shift in regime with government spending directly financed by central banks, secure in the belief that their deflationary machine will grant them license,” he said. “Today the climate is deflationary to be sure. But the machine is being dismantled. The instability inherent in one extremity can easily swing to the opposite. And such a shift is not merely possible, or even likely, it is inevitable.” 

Good luck out there,

Eric Peters

Chief Investment Officer

One River Asset Management

Disclaimer: All characters and events contained herein are entirely fictional. Even those things that appear based on real people and actual events are products of the author’s imagination. Any similarity is merely coincidental. The numbers are unreliable. The statistics too. Consequently, this message does not contain any investment recommendation, advice, or solicitation of any sort for any product, fund or service. The views expressed are strictly those of the author, even if often times they are not actually views held by the author, or directly contradict those views genuinely held by the author. And the views may certainly differ from those of any firm or person that the author may advise, drink with, or otherwise be associated with. Lastly, any inappropriate language, innuendo or dark humor contained herein is not specifically intended to offend the reader. And besides, nothing could possibly be more offensive than the real-life actions of the inept policy makers, corrupt elected leaders and short, paranoid dictators who infest our little planet. Yet we suffer their indignities every day. Oh yeah, past performance is not indicative of future returns.