wknd notes: They're Not Angels

“What happens when two tribes each believe that theirs can do no wrong?” he asked, sitting on the bank, history flowing like a river. “Or what results when two tribes convince themselves that the other committed some sin first, and this then justifies an unethical response of similar proportion?” he wondered aloud. “And is there ever a point, where the members of one tribe reflect on its own transgressions and become sufficiently unnerved that they switch tribes?” Autumn leaves drifted slowly along, spinning gently, the cycle’s unending waltz. “And when tribes grow so divided, has it ever happened in all of human history that they unite in the absence of an existential threat?”  

Overall: “They’re not angels,” she said, staring at her reflection in the mirror. “They’re not angels,” she repeated, just as America’s Commander-in-Chief had done, abandoning the Kurds, the world’s eyes upon him, appalled, horrified. Europe’s leaders had just confirmed her 8-year appointment and on November 1st she’d begin. Not since Volcker assumed the Federal Reserve’s helm had a central banker accepted such a thankless mission, she thought. Of course, she was right. In fact, rarely was she wrong. And not only that, but she’d always been an adept operator, an astute politician, a lawyer, ambitious, firm, determined. These were things she’d need to extricate Europe from its predicament. “They’re not angels,” she said again, her eyes cold, piercing. When Volker became Fed chairman in 1979 America’s economy was a mess, mired in a decade-long battle with inflation that had reached 13%. In March 1980 he doubled overnight rates to 20%, inflicting immediate economic pain in exchange for uncertain longer-term benefits. Throughout history, rarely are leaders willing to make such unpopular decisions, ensuring immediate collateral damage. And that’s just the problem with central banking, she thought - the costs and benefits are distributed unevenly over time. You see, every decision we make has consequences. With each dose of unorthodox easing, Europe felt immediately better. And the relief allowed politicians in that enormously complex union to forestall the many more difficult decisions required to make it a success. The process has left Europe stunted politically, with its monetary policy now frozen in a permanent state of absolute emergency. This endless conflict had begun, like most wars do, with a patriotic pledge to do whatever it takes, she thought. And it would be her job to somehow find an exit, which would be deeply unpopular, sparking major political conflict, forcing Europe’s leaders to address their differences, to find compromises, a durable solution. “They are not angels,” whispered Christine Lagarde, steeling herself.           

Week-in-Review (expressed in YoY terms): Mon: Chinese unprepared to sing trade deal unless US talks continue, Syrians/Kurds form alliance in wake of US pullout (Turkish troops advance into Syria as Assad troops rush north toward Turkish border), EU industrial production -2.8% (10th consecutive month of YoY declines), Mnuchin “tariffs on $156bln will be imposed if trade deal is not finalized by Dec 15,” Trump to impose sanctions on Turkish officials, Softbank to take control of WeWork to stave off bankruptcy, S&P -0.1%; Tue: Chinese CPI +0.2 to +3.0% (6yr high – driven by pork prices +69.3%), China PPI -1.2% (largest drop since 2017),  UK/EU reportedly close to draft Brexit deal, German ZEW investor confidence –0.3 to -22.8 (was -44.1 in August – 8yr low), EU investor confidence -1.1 to -23.5 (current economic situation index hit record low -26.4), IMF cuts 2019 global growth forecast -0.3 to +3.0% (lowest since 2009), WeWork bonds fall to new lows, S&P +1.0%; Wed: China injects $28bln of liquidity via medium-term lending facility, China’s foreign ministry decries US congressional Act that supports HK protestors, EU CPI -0.2 to +0.8% (core CPI unch at +1.0%), UK CPI unch at +1.7%, US retail sales fall by most in 7mths, Fed’s Beige Book says economy growing at “slight to modest pace” with slowing in manufacturing/agriculture, Beige Book says many businesses have lowered 2020 outlooks, GM and UAW reach tentative deal to end strike, S&P -0.2%; Thur: Russia steps into Syrian conflict and calls for Damascus to control Turkish border, Germany downgrades 2020 GDP forecast -0.5 to +1.0% (holds 2019 GDP forecast at +0.5%), UK retail sales stagnate, US industrial production -0.1% on weak mining and GM auto strike (first YoY decline since 2016), capacity utilization 77.5%, S&P +0.3%; Fri: China Q3 GDP -0.2 to +6.0% (lowest since 1992), China fixed asset investment -0.1 to +5.4% (retail sales +0.3 to +7.8%), Japan core CPI -0.2 to +0.3% to 2.5yr low (core-core CPI -0.1 to +0.5%), Draghi paints grim economic outlook at IMF meeting in DC, G20 finance ministers back plan to coordinate corporate tax regime for multinationals, S&P -0.4%; Sat/Sun: UK parliament delays Brexit vote, Syrian cease fire crumbles, Republican John Kasich calls for Trump’s impeachment.

Weekly Close: S&P 500 +0.5% and VIX -1.33 at +14.25. Nikkei +3.2%, Shanghai -1.2%, Euro Stoxx +0.1%, Bovespa +0.9%, MSCI World +0.7%, and MSCI Emerging +1.2%. USD rose +5.0% vs Bitcoin, +4.3% vs Ethereum, +0.2% vs Chile, +0.2% vs India, +0.1% vs Yen, +0.1% vs South Africa, +0.1% vs Brazil, and +0.1% vs Indonesia. USD fell -2.4% vs Sterling, -1.6% vs Turkey, -1.6% vs Sweden, -1.1% vs Mexico, -1.1% vs Euro, -0.9% vs Australia, -0.8% vs Russia, -0.6% vs Canada, and -0.1% vs China. Gold flat, Silver flat, Oil -2.2%, Copper +0.8%, Iron Ore -4.8%, Corn -1.9%. 5y5y inflation swaps (EU +4bps at 1.22%, US +3bps at 1.98%, JP flat at 0.11%, and UK -4bps at 3.55%). 2yr Notes -2bps at 1.58% and 10yr Notes +2bps at 1.76%.

YTD Equity Index Returns: Greece +37% priced in US dollars (+40.6% priced in euros), Russia +26.3% priced in dollars (+16.2% in rubles), Israel +24.7% (+17.8%), NASDAQ +21.9%, New Zealand +19.3% (+25.6%), S&P 500 +19.1%, Italy +18.8% (+21.8%), Canada +18.7% (+14.3%), Switzerland +18.2% (+18.2%), Germany +16.7% (+19.6%), Euro Stoxx 50 +16.2% (+19.3%), France +16.1% (+19.1%), Taiwan +14.9% (+14.9%), Ireland +14.9% (+18%), Australia +14.5% (+17.8%), Japan +14.4% (+12.4%), China +14.4% (+17.8%), Netherlands +14.4% (+17.4%), Russell +13.9%, Belgium +12.9% (+15.9%), Thailand +12.1% (+4.3%), Sweden +11.9% (+20.5%), Brazil +11.7% (+19.2%), Denmark +11.6% (+14.5%), Portugal +11.6% (+14.5%), Colombia +9.2% (+15.2%), Austria +8.3% (+11%), Philippines +8.2% (+5.6%), UK +7.8% (+6.3%), Mexico +6.6% (+3.7%), Finland +6.5% (+9.3%), Spain +6.4% (+9.2%), Norway +5.7% (+11.1%), India +5.2% (+7.4%), UAE +3.6% (+3.6%), Czech Republic +3.5% (+5.7%), HK +3.2% (+3.4%), South Africa +3.1% (+6%), Indonesia +2.7% (0%), Singapore +1.4% (+1.5%), Chile -0.8% (+1.7%), Hungary -1.3% (+4.3%), Turkey -1.4% (+7.8%), Saudi Arabia -2.4% (-2.4%), Poland -3.1% (-1.2%), Korea -4.6% (+1%), Malaysia -8.2% (-7.1%), Argentina -31.9% (+5.5%).

Cost of Production: “The commodity index price is roughly at the cost of production,” said the CEO, trained in tracking supply and demand. “Prices sometimes falls below production costs, but those periods are brief,” he continued. We were reviewing his historical charts of a range of the world’s most important commodities, each told a story. “By our calculation, only four times since 2000 has the commodity index price been below the average marginal cost of production: in 2001 it was -5% below, 2008 it was -7% below, 2015 it was -12% below, and now it’s -2%.”

Cost of Production II: “But in every other year since 2000, the commodity index price was substantially higher than the average marginal cost of production,” said the same CEO. “In 2002, the price was 20% above, and that was just one year after prices were -5% below production costs.” In 2007 prices were over 50% above. In 2008 they were -7% below. By 2010, prices were nearly 70% above. “When commodity prices fall below production costs, you kind of have an embedded put because producers cut supply, and demand draws down excess inventories. Longer-term, producers usually need roughly a 20% margin to continue capex and production.” 

Cost of Production III: “From 1970-2009 the return for the commodity index (SPGSCI) and the S&P 500 both annualized at roughly +10%” said the same CEO. In the 1970s the S&P 500 annualized at +6.7% in nominal terms while the SPGSCI annualized at +21.2%. In the 1980s, the S&P annualized at +12.0% (SPGSCI +10.7%). In the 1990s the S&P 500 annualized at +14.1% (SPGSCI +3.9%). In 2000-2009 the S&P 500 annualized at +10.1% (SPGSCI +5.1%). “Then QE kicked in. And from 2010-2018 the S&P 500 annualized at +11.7% while the commodity index annualized at -7.7%. So now commodity prices are -23% below where they were in the depths of the worst financial crisis since the Great Depression.”

 Cost of Production IV: “Why are people so uninvested in commodities?” asked the CEO, repeating my question. The Middle East is at war, yet oil trades 5% below the worldwide average marginal cost of production according to his estimates. While gold and silver trade roughly 50% above production costs, wheat and cotton trade 30% below their marginal cost to grow. And when you average out 21 major commodities, they’re about as cheap as they ever get relative to their marginal production costs. “If I’ve learned one thing in all these years, it’s that people rarely look for value in commodities, they buy when things start going up,” he said.  

Last Traded: Betting odds of Trump completing his 1st term traded at 71% (unchanged from last week). Odds of Warren being the Dem nominee fell -6 to 45%. Biden’s odds of being the Dem nominee fell -3 to 19% (new low). Buttigieg climbed to 3rd place at 14% (Bernie at 13%). Odds of a Dem presidency in 2021 are unchanged at 54%. Dem retention of the House was steady at 75%. Republican hold of the Senate last traded unchanged at 65%. A new Pew survey show 54% of American’s want Trump impeached/removed (follow’s Fox’s 51% impeach poll).

Anecdote: “WeWork never had a fighting chance of being worth more than zero,” said Lithium, hands-free on Highway One. “It’s arguable that Uber and Lyft have a chance to make it – at least their business model should survive in some form,” he said, banking a turn, the Pacific to his left, Malibu’s dunes lit by autumn sun. “Softbank mastered the art of the sardine factory.” In legendary investor Seth Klarman’s book – Margin of Safety - Seth told a story of a market craze in sardine trading that erupted when the tasty fish disappeared from Monterey’s waters. The price of a can of sardines soared. One day a buyer decided to treat himself, opened a can and started eating. He immediately became ill and told the seller the sardines were no good. The seller said: You don’t understand, these are not eating sardines, they are trading sardines. “Softbank perfected the process of creating factories that produce trading sardines. In the process, they inflated equity valuations across the private markets,” explained Lithium. “This also lifted public market equities and impacted the real economy in myriad ways.” WeWork was the marginal bidder in the tightest commercial real estate markets. They fueled construction, remodeling. They bought Google ads, Facebook too. All these things expanded in lockstep with the growth of their debt stock. “As trading sardine factories expand, they lose money at an accelerating pace to maintain high growth rates off of an ever-increasing base,” said Lithium, noting that companies that cannot self-fund must sell equity at any price or face extinction, just as WeWork is doing now. “As long as people are getting rich in the process, they’ll put their money into the next scariest thing. But when the last scariest thing stops working, then their appetite to put money into the next scariest thing declines. And it appears that’s about where we are in this cycle.”  

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.