wknd notes: Let's Go Back To 2009

“I’m not bothered by the government shutdown,” said the investor. “I feel for the people directly affected, but it won’t last forever. And besides, if you shut the government two months of every year, I bet we discover how to make it more efficient,” he continued. “And I’m guessing Trump wants a deal with China, so I’m not overly bothered by that. I’m more worried about how the market trades after the subsequent rally.” He paused, quietly reflecting on one of the most unusual years in his long career. “But with so much up in the air, I don’t feel like I have any real clarity. And without clarity, I want liquidity,” he said, and zipped off, to continue trimming anything in his portfolio with longer lock ups.

Overall: “China supports North Korea and the US holding summits and achieving results,” said Xi Jinping. The chubby Korean kid had kissed his ring and left Beijing. “I hope that the two leaders meet each other halfway,” continued Xi, sliding into a state of sublime bliss. After enduring two years of US abuse, the opportunity had finally arrived to symbolically position Kim Jong Un and Donald J. Trump as leaders of comparable status. For 2yrs, Xi had humbly endured America’s arrogance while the US economy ran at nearly twice its natural rate. And its stock market soared, spurred by budget deficits that dwarfed anything seen outside of wartime or recession. But these things have a way of running their course, and this one had. Even at full employment, the American’s were now fighting hideously amongst themselves. The entire political process had become paralyzed over a $5.7bln fence. And the Democrats had not yet begun to investigate the president and his family, their newly formed oversight committees were struggling to even choose where to start. Xi smiled. Of course, China’s leader had profound problems of his own: debt, leverage, a slowing economy. But these were problems that every major economy faced, and he had already begun to implement stimulus measures. If these failed, there were other options, the most powerful of which would be to provoke confrontation with the US over its support for Taiwan. Saber-rattling titillates restless youngsters far better than interest rate cuts. The world viewed a Taiwan conquest as a tail event. Xi considered it inevitable - something to take when the US is weakest. And as Xi quietly considered the calendar, North Korea’s official news agency rejoiced at their Supreme Leader’s trip to Beijing and announced, “Xi Jinping said that the legitimate issues raised by the Democratic People’s Republic of North Korea reasonable interests should be justly resolved.” 

Week-in-Review (expressed in YoY terms): Mon: China/US trade talks resume in Beijing, German investor expectations fall for 3rd mth, German factory orders fall 1st time in 4mths, EU retail sales climb for 2nd mth, US ISM services -3.1 to 57.6 (5mth low), S&P +0.7%; Tue: China/US trade talks to extend an extra day (viewed positively), Kim Jong Un visits China, German industrial production -4.7% (stokes fears of recession), World Bank GDP growth forecasts (US +2.5% in 2019 vs +2.9% in 2018, Europe +1.6% vs +1.9%, China +6.2% vs +6.5%), Mexico cuts IPO taxes (surprising market-friendly move), Trump makes national TV address on border/shutdown issue, S&P +1.0%; Wed: China/US trade talks enter 3rd day, China planning new incentives for auto & appliance purchases, Kim Jong Un ends 3-day China visit, Saudi oil minister vows to “stabilize” the market, EU unemployment -0.1 to 7.9% (10yr lows), German unemployment 3.3% (Italy 10.5%), EU youth unemployment 17% (Italy/Spain/Greece roughly 33%), UK productivity +0.2% (lowest rate in 2yrs), Canada holds rates unch at 1.75% (lowers 2019 GDP forecast 0.4 to +1.7% on oil price declines), Fed’s Rosengren “markets have become unduly pessimistic,” Lenar scraps 2019 guidance (rising home prices and mortgage rates slow sales), Bullard “the Fed is bordering on going too far and possibly tipping the economy into recession,” Fed’s Minutes show shift toward greater dovishness/caution, S&P +0.4%; Thur: China CPI +1.9% (exp +2.1%), China PPI +0.9% (exp +1.6%), renminbi hits 5mth high, Bolsonaro approves Boeing’s purchase of 80% of Embraer, Pompeo “US to expel every Iranian boot from Syria,” Powell “Fed to shrink balance sheet to more normal levels,” Trump cancels Davos trip, S&P +0.5%; Fri: China’s top trade official to visit US in coming weeks, Russia calls on Japan to recognize sovereignty over disputed islands, Brazil CPI +3.75% (target is +4.5% plus or minus 1.5%), US CPI +1.9% (core +2.2%), S&P flat; Sat/Sun: US gov’t shutdown becomes longest ever, NYT reports that FBI investigated whether Trump was working for Russia, Canada grants asylum to Saudi teenager, France sees 9th round of nationwide protests (numbers rise from last weekend).

Weekly Close: S&P 500 +2.5% and VIX -3.19 at +18.19. Nikkei +4.1%, Shanghai +1.6%, Euro Stoxx +1.7%, Bovespa +2.0%, MSCI World +2.8%, and MSCI Emerging +3.5%. USD rose +22.5% vs Ethereum, +5.1% vs Bitcoin, +2.5% vs Turkey, and +1.1% vs India. USD fell -1.6% vs Indonesia, -1.5% vs China, -1.4% vs Australia, -1.4% vs Mexico, -1.1% vs Chile, -1.0% vs Russia, -0.9% vs Sterling, -0.9% vs South Africa, -0.8% vs Canada, -0.6% vs Euro, -0.4% vs Sweden, flat vs Brazil, and flat vs Yen. Gold +0.1%, Silver -0.8%, Oil +6.9%, Copper +0.5%, Iron Ore +2.8%, Corn -1.0%. 5y5y inflation swaps (EU +2bps at 1.55%, US +8bps at 2.19%, JP flat at 0.06%, and UK +7bps at 3.69%). 2yr Notes +5bps at 2.54% and 10yr Notes +3bps at 2.70%.

2019 YTD Equity Index Returns: Argentina +14.2% priced in US dollars (+11.9% in pesos), Brazil +11.2% in dollars (+6.6% in reais), Colombia +8.1% (+4.3%), Norway +8% (+5.3%), Chile +7.9% (+4.8%), Mexico +7.5% (+4.6%), Russell +7.3%, Russia +7.3% (+3.2%), Canada +7.1% (+4.3%), Philippines +6.5% (+5.9%), Austria +6.1% (+5.8%), Finland +6.1% (+5.8%), Indonesia +5.9% (+2.7%), Italy +5.7% (+5.3%), South Africa +5.6% (+1.6%), Belgium +5.5% (+5.2%), NASDAQ +5.1%, Singapore +5.1% (+4.2%), Denmark +5% (+4.6%), Switzerland +4.9% (+4.7%), Saudi Arabia +4.9% (+4.9%), Hungary +4.8% (+4.5%), Sweden +4.7% (+4%), Australia +4.7% (+2.3%), Portugal +4.5% (+4.2%), Ireland +4.3% (+4%), Spain +4.2% (+3.9%), China +4.2% (+2.4%), Thailand +4.1% (+2.1%), Israel +4% (+2%), Greece +3.9% (+3.7%), UK +3.7% (+2.8%), Czech Republic +3.6% (+2.5%), Japan +3.6% (+1.7%), S&P 500 +3.6%, New Zealand +3.5% (+1.7%), Germany +3.5% (+3.1%), Poland +3.5% (+2.8%), HK +3.1% (+3.2%), Euro Stoxx 50 +2.6% (+2.3%), Netherlands +2.5% (+2.2%), Korea +1.4% (+1.7%), France +1.3% (+1.1%), UAE +1% (+1%), Malaysia +0.5% (-0.4%), Taiwan -0.5% (+0.3%), India -1.6% (-0.6%), and Turkey -3% (+0.5%).

Decades: The ratio of US household financial assets to GDP has never been higher. Today, that ratio stands at 4.4x. In 1979 at the dawn of history’s greatest secular bull market, it was 2.3x (roughly half of where it is today). A decade later, in 1989, it was 2.7x. In the 1999 dot com bubble the ratio jumped to 3.6x. At the 2009 bear market lows, it was 3.4x. And in these past 10yrs, as the ratio jumped to 4.4x, households increased their financial assets by an amount equal to 1x US GDP. Which is $21trln. If you didn’t own/buy any assets, tough luck, you missed out.

Decades II: As the value of household financial assets relative to GDP surged to historic highs over the past decade, the quantity of US equities shrank. Yet the supply of so many other things expanded during the decade. US gov’t debt grew 115% to $21.5trln, household debt jumped 49% to $4trln, and corporate debt increased by 78% to $6.3trln. But while corporations borrowed $2.8trln, the net supply of US equities contracted by $3.8trln, as CEOs borrowed money and diverted profits to repurchase their shares in quantities that dwarfed new issuance.

Decades III: CEOs are paid in shares, so they naturally buy them back. But that’s not the only way to boost their value. Expanding earnings does it too - increasing revenues, cutting costs, lifting profit margins. Profit margins grew from 10% at the 2007 peak to today’s 12.5% record highs (and 6% in 1979). Reducing the tax you pay also helps. In the past decade over 20 companies redomiciled to reduce their tax burden. Countless other opaque structures helped lessen tax payments too. Then they got a huge tax cut. It’s been an extraordinary decade.

Decades IV: Another powerful way to lift equities is to reduce the discount rate that investors use to value them. Every major global central bank did just that. Over the decade, central banks cut rates to zero and below. Their balance sheets grew by over $14trln through printing money, further depressing yields and in some cases buying stocks directly. Wealth and income inequality naturally rose, achieving levels last seen in the late-1920s. In the 4 decades since 1979, Labor’s share of US national income fell inexorably from 64% to today’s 57%. Capital receives the rest.

Decades V: Americans all want to get rich. We understand risk/reward. We also get right/wrong, fairness, justice. In the past decade, virtually everyone who took reckless risk got bailed out. Practically no one at the center of the greatest financial fiasco since the Great Depression went to jail. This undermined faith in the fundamental relationship between reward/risk, wrong/right, fairness, justice. Capitalism. To top it off, American labor read in the newspapers that US public pensions - despite 10yrs of equity gains that made others rich - were underfunded by $6trln. 

Anecdote: Let’s go back a decade, I told the CIO. We were discussing where to put money for the coming years. Most often investors look backward for trends and extrapolate their trajectories into the future, or they search for beaten down assets, hoping for mean reversion. But what should you do after a year where nearly everything declined? Treasury bills outperformed virtually all assets last year. Such broad outperformance happened only in the early-1980s under Volcker, during the Great Depression, and at the outset of WWI. So before thinking about what to buy, it’s important to explore why such a rare event happened and what it might mean. Imagine we were talking in 2009 and could foresee the decade to come: The household financial asset-to-GDP ratio would hit a record 4.4x. Corporations would borrow $2.7trln. Buybacks would shrink the supply of US equities by $3.8trln. Profit margins would hit historic highs. Labor’s share of national income would decline to record lows. Central banks would bail out overleveraged speculators and amplify economic inequality. Tax policy would favor redomiciling. Politicians would hold no one to account for wrongdoing. Despite the historic rise in wealth, worker’s pensions would remain underfunded by $6trln. And as people lose faith in the system, there would be a dramatic political shift that catches the beneficiaries of these trends by utter surprise. It would be a protest vote. It would be a vote to redistribute the economic pie. To slash corporate profit margins. This trend would go global. And if we had known all this in 2009, would we have expected the trends and investment strategies that would dominate up through 2019 to then extend beyond? Or would we have expected them to face profound challenges? And so today, shouldn’t we look to those strategies that have performed worst to begin to perform best?

Good luck out there,

Eric Peters

Chief Investment Officer

One River Asset Management

Greenwich, CT

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.