wknd notes: The Pretend Containment Game

“We have to take advantage of the window of opportunity,” said the WHO’s director general Dr. Tedros. He was urging African leaders to prepare for the outbreak’s global spread. Meanwhile, around the planet, politicians continued to play the game of pretend containment. You see, the political and economic cost of containment is staggering. And besides, this thing mostly kills the aged and infirm. The poor. So when placed onto a politician’s cost/benefit scale, the solution of choice is pretend containment. Which allows leaders to appear to be doing something and the rest of us to convince ourselves it’ll be okay. Drag that process out long enough, and by the time reality can no longer be denied, we adjust to the new normal, and mostly forget we were pretending all along. 1,200 coronavirus cases have been confirmed outside China, in 26 countries, spreading like the wind, a global flu. The non-partisan Congressional Budget Office forecast a $1trln federal budget deficit. Our leaders pretended that tax cuts for the wealthy pay for themselves. But with the passage of time, that illusion dissolved, replaced by 2020’s 4.6% budget deficit (rising to 5.4% in 2030). America’s CEO compensation surged +940% since 1978 while worker comp rose +12%. The highest tax bracket in 1978 was 70% (on income over $203k), today it’s 37% (incomes over $622k). We no longer pretend that economics trickle down. Instead we imagine we’re battling inequality. We pretend we’re confronting climate change, while ignoring earth’s 5th mass extinction. We pretend state pension plans will generate perpetual +7.5% returns. We pretend America is the world’s only wealthy nation that can’t afford to provide public healthcare. We pretend student debt isn’t stifling our youth. And the Democratic Party establishment is again pretending to administer an unbiased primary process. You see, they’re frightened by Progressives who believe voters have finally tired of pretending to believe in today’s American dream.

Week-in-Review (expressed in YoY terms): Mon: S&P closed for President’s Day; Tue: China reports a total of 72k coronavirus cases (1,868 dead), Afghanistan’s Ghani wins contested re-election (after 5mth delay), Turkey cuts rates 50bps to 10.75% (5th consecutive cut), Britain announces point-based post-Brexit immigration system (no more low-skilled workers), German ZEW investment sentiment -18 to +8.7, Spain announces 3% digital-services tax on big tech, Apple warns as coronavirus impacts sales and supply chain, Empire State survey jumps 8pts to +12.9 (9mth high), Trump commutes Blagojevich sentence (grants clemency to Milken and Kerik), Boeing discovers foreign objects in 737 fuel tanks, S&P -0.3%; Wed: China expels 3 WSJ reporters over op-ed, Japan core machine orders -8.8 to -3.5%, Japanese yen falls sharply without specific catalyst, German anti-immigrant terror attack kills nine, UK CPI +0.5 to +1.8% (core +0.2 to +1.6%), UK retail sales -1.2% (mthly data rebounds after 5th mthly contraction), Fed Minutes “risks to outlook more favorable than last meeting,” some Fed members willing to let inflation run above target for some time, Tesla punches to new all-time high, housing starts fall from 13yr high, housing permits hit 13yr high, PPI +2.1% (highest since 2018), Democratic debate in Nevada (Bloomberg bombs and Dems tear one another apart), Roger Stone sentenced to 40mths, S&P +0.5% (record high); Thur: China cuts 1yr loan rate 10bps to 4.05% and 5yr rate 5bps to 4.75%, China reports 889 new coronavirus cases, Macau’s casinos reopen, South Korea has 156 coronavirus cases, EU 7yr budget negotiations begin, US Philly Fed survey surges +19.7 to 36.7, US director of national intelligence tells lawmakers that Russia is interfering in 2020 election to benefit Trump, Morgan Stanley buys E*Trade for $13bln, S&P -0.4%; Fri: China has reported 75,567 coronavirus cases (2,239 deaths), South Korea coronavirus cases jump 96 to 200 total (6.5x increase in 3-days), Iranian elections (Mullahs disqualify half of candidates and screen out reformists), EU manufacturing PMI +1.2 to 49.1, (UK flash PMI manu unch at 53.3, Germany +2.5 to 47.8), 16 Italians infected by coronavirus, US 30yr bond yield record low 1.92%, S&P -1.1%; Sat/Sun: South Korea reports 229 new coronavirus cases (shuts a Samsung factory), Iran’s death toll hits 5 (most outside of China), US now has 34 cases, Nevada caucus.

Weekly Close: S&P 500 -1.3% and VIX +3.40 at +17.08. Nikkei -1.3%, Shanghai +4.2%, Euro Stoxx -0.6%, Bovespa -0.6%, MSCI World -1.2%, and MSCI Emerging -2.0%. USD rose +7.7% vs Ethereum, +6.9% vs Bitcoin, +2.2% vs Brazil, +1.9% vs Mexico, +1.7% vs Yen, +1.4% vs Chile, +1.3% vs Australia, +0.7% vs Russia, +0.6% vs Sterling, +0.6% vs South Africa, +0.6% vs Turkey, +0.6% vs China, +0.5% vs Indonesia, and +0.4% vs India. USD fell -0.2% vs Canada, -0.1% vs Euro, and -0.1% vs Sweden. Gold +3.7%, Silver +4.2%, Oil +1.8%, Copper +0.2%, Iron Ore +8.2%, Corn -0.3%. 5y5y inflation swaps (EU -5bps at 1.19%, US -6bps at 1.94%, JP -2bps at -0.04%, and UK -5bps at 3.53%). 2yr Notes -7bps at 1.36% and 10yr Notes -12bps at 1.47%.

2020 YTD Equity Index Returns: Denmark +6.8% priced in US dollars (+10.2% priced in euros), NASDAQ +6.7% priced in US dollars, Portugal +5.8% priced in dollars (+9.4% in euros), Israel +3.9% (+3.1%), Switzerland +3.6% (+4.7%), S&P 500 +3.3%, Mexico +2.9% (+2.9%), Finland +2.9% (+6.2%), Canada +2.8% (+4.6%), Italy +2.1% (+5.4%), Sweden +1.7% (+6.1%), Australia +0.8% (+6.8%), Russell +0.6%, Spain +0.1% (+3.5%), Belgium -0.3% (+3.1%), Turkey -0.4% (+2.1%), Germany -0.7% (+2.5%), UAE -0.8% (-0.8%), New Zealand -1.1% (+5.1%), China -1.2% (-0.3%), Russia -1.2% (+2%), Netherlands -1.3% (+2.1%), India -1.7% (-0.7%), Euro Stoxx 50 -1.9% (+1.5%), France -2.5% (+0.9%), Ireland -2.5% (+0.8%), HK -3.1% (-3.1%), Japan -3.6% (-1.1%), UK -4% (-1.8%), Czech Republic -4.1% (-2.4%), Taiwan -4.2% (-2.6%), Austria -4.3% (-1.2%), Saudi Arabia -4.5% (-4.6%), Poland -4.7% (-0.7%), Colombia -4.7% (-1.9%), Singapore -5% (-1.3%), Norway -5.3% (-0.1%), South Africa -5.3% (+1.5%), Hungary -5.6% (-0.7%), Korea -5.7% (-1.6%), Philippines -5.8% (-5.7%), Greece -5.8% (-2.6%), Malaysia -5.9% (-3.6%), Indonesia -6% (-6.6%), Chile -9% (-2.9%), Brazil -9.9% (-1.7%), Thailand -10.1% (-5.4%), Argentina -10.3% (-7.4%).

Maynard: “There’s a structural predisposition to overinvest because it’s politically advantageous,” said the investor. “Something goes wrong in the world, and politicians push for greater investment, production.” Fiscal stimulus, tax breaks, rate cuts, regulatory relaxation, reserve ratio reductions, streamlined project approvals, are all examples. Currency devaluations too. And in a globalized economy, stimulus in one nation spills across borders. “The result is that on a global basis, industrial overcapacity is a near constant state of affairs,” he said.

Flatliners: “America is the exception that proves the rule,” continued the same investor. “The US is the only country in the world where the CFOs are in charge, and they only respond to stimulus if it raises their return on capital.” Return on capital for the Nasdaq index is 10.0%, S&P 500 7.7%, Nikkei 5.2%, Euro Stoxx 3.7%, Shanghai Composite 4.5%. “In 2005, I began wondering why corporate investment relative to sales and profits had basically flatlined.” From 2002-07 US investment stalled. “This was when China really started expanding capacity.”

Dragons: “America’s CFOs sat out an investment cycle,” said the investor. “It was a rational response as China destroyed expected ROIs by expanding capacity in every imaginable industry at a pace unprecedented in human history.” Suppliers to China invested to feed the insatiable serpent. “Whenever the economy hit a bump, Beijing increased investment, production.” China implemented a $586bln stimulus in 2008/09, devalued the RMB in 2015, injected $1trln in credit in 2016, and $400bln in 2017. “These investments made sense if the future resembled the past.”

Tomorrow: Local Motors is an American innovator. Their Olli 2.0 is a 3D-printed autonomous bus. It carts 8-passengers around the University of Sacramento. From the website: The true innovation is the Direct Digital Manufacturing process. DDM creates significant unfair advantages: the ability to produce parts directly from a CAD file; elimination of investments in tooling; reduction in time lag between design and production and, best of all, elimination of penalties for redesigns - unlocking mass customization that was previously unobtainable.

Localized: “Imagine a world where manufacturing no longer requires humans,” said the investor, gently closing his eyes. In labs across America, entrepreneurs connected the world’s most imaginative PhDs with ever-accelerating processing power in a race to relieve humanity of its physical burdens. “Now imagine a future where those autonomous factories are localized,” he said. The image took shape, quite easily. “Now imagine a future unchanged from today, where manufacturers ship products to the US from Asia and Europe,” he said. And I tried but couldn’t.  

Table-Turning: “Fracking ended America’s dependence,” said the investor. “As the US will need others less with each passing year, a hungry world needs America more.” The nation is the planet’s largest food exporter. Global population is growing, diets are shifting to more protein. “As demand for US food rises and manufacturing returns, the heartland will regain its swagger.” Chicago, Detroit, Dayton, New Orleans. “A vast railway infrastructure will be upgraded.” And interstate highways and riverways connect America far more efficiently than China or Europe.

Des Plaines: “The southern and western shores of the Great Lakes sit atop a geological shelf,” said the investor. “The lakes flow east out the St. Lawrence river to the North Atlantic while the Des Plaines river, which runs just west of Chicago city limits, runs south and west ultimately to New Orleans.” A few miles of canals built in the 19th century complete an inland water route from the North Atlantic to the Gulf of Mexico and make Chicago a natural transportation hub. “It all needs work. There’s so much more capital investment required to build out America.”

Anecdote: “Deglobalization is the most powerful theme in the world,” said the investor. “It will reshape politics, economics and markets in profound ways.” The process has only just begun. “Everyone built global supply chains to produce goods for the US consumer.” In making those capital commitments, they assumed the geopolitical landscape and international trade relations in coming decades will remain unchanged. The process hollowed out middle America, while enriching the coasts. “It was inevitable that a leader came along to say this is not okay.” But globalization has advanced past the point where supply chains can be severed abruptly without inflicting catastrophic damage on the US economy. “That leader would have to give US corporations time to disassemble their supply chains and rearchitect their means of production closer to home, while preventing the Chinese economy from imploding and sparking a global depression.” The trade war was the warning shot to American CEOs that began the process. The battle with Huawei over 5G supremacy extended the battle lines to encompass the cybersphere. The coronavirus will accelerate this trend. “What is unfolding is a slow-motion war, where there will be massive destruction of fixed-asset investments. And not just in China, but in Germany, Europe, and nations that supply many of the intermediate goods.” The impact will not leave American companies unscathed in that they too will suffer capital losses on existing supply chain infrastructure. But the US will suffer far less than nations that oriented their economies toward exporting to the American consumer. “And if real interest rates truly mediate the demand for investment capital and the supply of savings, then two things are likely: (1) as in any war, governments will continue to suppress real interest rates to mitigate the pain from the destruction of savings (obsolescence of supply chain capital investments), and (2) that suppression will meet its match as demand for capital (to rebuild North American supply chains) will ultimately lead to a rise in the real rate of interest.” 

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.