The Most Powerful Force, What Comes Next, The Smartest Man in Global Macro....

May 20, 2020

The most undervalued assets on Wall Street are history books.

- Anonymous

A great many people think they are thinking when they are merely re-arranging their prejudices.

- William James

The task is not so much to see what no one has yet seen, but to think what nobody yet has thought about that which everybody sees.

- Arthur Schopenhauer

A. The Most Powerful Force

The most important and the most powerful force in financial markets over the last thirty years has been falling inflation therefor falling interest rates.

The US 10 Yr Treasury now yields 0.7% and some think it will go negative in 2020 / 2021.

Nothing has done more for rising asset prices than falling interest rates as it reduces the discount rates of future cashflows, makes borrowing cheaper (think buy backs and all leverage) and encourages a reach for riskier assets to get the same returns.

The biggest question now for financial markets is Inflation vs Deflation.

Here’s how I see it.

The deflationary thesis can be summarized as:

  1. Government policies create zombie companies, which leads to over production and over supply and mis-allocation of capital.

  2. At the same time, increased debt loads don’t fix the economy since what we have is a solvency problem and a revenue problem. Yes the FED can buy your bonds, but a) does your business really with your top line down 50,60,70% and b) can you even keep paying your fixed costs.

  3. EM countries suffer the most since de-globalization takes hold, which leads to falling exports, FDI and tourism dollars at a time when debt costs are rising and commodity prices falling (for the exporters).

The longest standing cheerleader for the deflationary camp is Dr. Lacy Hunt - he’s been in the lower rates camp for decades…..

The key to his thesis is this chart - how much GDP do you get per unit of debt.

According to him each round of QE gives us a jolt like chugging a can of red bull after 4 hours of sleep. But that energy fades quickly. In fact it is fading faster and faster.

This ratio of the bang we get for each unit of debt we add is falling because higher debt loads are a) leading to a misallocation of capital into low return assets, b) higher servicing costs, and c) more fragile economy which makes companies focus on the next quarter rather than innovation. Hence the buy backs over R&D.

We can see that impact in the falling velocity of money.

You can hear from Dr. Hunt here on this Macro Voices podcast (22 mins onwards).

On the other hand, the Inflationary camp, can be summarized as:

  1. De-globalization leads to a supply shock. We will be destroying supply chains in cheaper locations and re-building in more expensive jurisdiction. Consumer prices will jump.

  2. UK just did it, and debt monetization will come to the US too. Federal spending will be directly financed by FED purchases, combined with direct cash to consumers. Call this MMT or whatever you want.

  3. Years of underinvestment and low capex in the commodity industry will eventually lead to large supply shortages across the commodity markets. This will lead to real asset / commodity inflation. It’s already happening in Uranium for example.

This debate gets worse, when we then super impose the growing wealth divide.

US policies have already been moving left. Domestic policy are likely to move anti-business, favoring labor much more. Labor has lost almost 10% since the 1970’s in terms of it’s share of GDP. While corporate profitability is up the same amount.

This will also continue to be an election issue (i.e. this matters in 2020) since those under 35 now have a net worth equal to 7% of those between 65-74.

This is about as low as it’s ever been.

The young have little invested in the current system. So why not change it ? I think they will.

Where do you stand on this debate ?

B. What’s Next For COVID-19 ?

Laurie Garrett is probably the world’s foremost expert on Pandemics.

Garrett is a former senior fellow for Global Health at the Council on Foreign Relations and Harvard’s School of Public Health. In 1996, she also won a Pulitzer Prize for Explanatory Journalism for a series of work chronicling the Ebola virus outbreak in Zaire.

Garrett is also the author of several books, including The Coming Plague: Newly Emerging Diseases In A World Out of Balance; Betrayal of Trust: The Collapse of Global Public Health; and Ebola: Story of an Outbreak. Garrett has personally been at ground zero of 30 epidemics.

Pandemics have been Laurie Garrett’s personal crusade for over three decades.

She has believed for years that the first line of defense for a pandemic is a strong public-health system and she did a famous TED talk a few years ago.

Given all the discussion around the economy re-opening and life returning back to the new normal, I thought it important to hear what someone with three decades of experience has to say.

Garrett foresees three basic scenarios for how this pandemic will play out on the ground:

1. Vaccinate the entire world in 36 months.

This is the best-case scenario for a return to normal. For this to happen, a super-effective vaccine needs to be developed in the next 10 months. Second, the vaccine needs to go into large scale (phase III) clinical trials prior to the end of this year. This way, by early next year, it would be clear that the vaccine truly works.

Ideally, the vaccine only requires one dose and no booster. It also would not require refrigeration, so it is easy to transport globally. The vaccine also does not need to be injected. Therefore, a supply chain of syringes and syringe disposals are not required to be built. Instead, it can be taken orally, by nasal injection, or through an intramuscular patch that attaches to the skin.

If all the above milestones are met, the next key hurdle would be ensuring that the vaccine is free of patent protection, to guarantee production worldwide at multiple manufacturing sites.

The final step would be to hire an army of 10 to 20 million people that are deployed worldwide to vaccinate 7.5 billion people.

2. Vaccinate the world gradually over 10 years.

This is what happened with the eradication of smallpox, a disease that killed more human beings in the 20 century than all the wars of that century combined.

A key point and the only reason why the world was able to eliminate smallpox was that the two major superpowers, the U.S. and the Soviet Union, came together at the height of the Cold War, and agreed to work together.

Today, for a similar scenario to occur, the two superpowers, the U.S. and China, would have to put aside their differences and work together.

3. COVID-19 becomes endemic to the human species.

This is the worst case scenario where we are unable to develop an effective vaccine. Unfortunately, for some viruses like HIV, we still have no vaccine nearly four decades and 32 million deaths later. There is also no guarantee that a new vaccine will be effective enough.

For instance, this year’s flu vaccine has proven to be around 45% effective, far below the 70%-plus required to be enough to stop the COVID-19 pandemic. It is still uncertain whether the world will see any respite from the virus from warmer, more humid weather.

Here’s what I worry about now:

1. The 70% Economy - continued multiple outbreaks globally & regionally, forcing a scenario of rolling lockdowns. In a world with no vaccine, countries will struggle to manage outbreaks of the virus potentially at the expense of economic growth. Testing and contact tracing could become part of daily lives in many countries, with abrupt orders to self-isolate.

2. Socialization of Healthcare - we will need to build out a parallel healthcare system because right now many sick people aren’t going to the hospital. They are getting sick but staying at home. This probably means a parallel healthcare system that governments build, one system for COVID-19, one system for everything but. Otherwise we are going to have to deal with a lot of other problems.

3. US as the epicenter of COVID-19 - One of the great things about America is its breadth and diversity. Fifty states, numerous big cities, hundreds of miles of interstate highways, an ocean on each side, hundreds of miles of coast lines. This is usually a recipe for a resilient economy but is now going to be a management nightmare no matter who’s in charge. This probably won’t be a China story going forward.

C. What’s Next For Global Macro

Stanley Druckenmiller, one of the great macro investors chatted with Scott Bessent, CIO at Key Square Capital on the current market and where we go from here (they both worked for Soros in the 90’s / 00’s).

The key parts:

Now, I just want to back up a little bit about the way QE works, or the way I perceive it works. So, let's say the Federal Reserve is going to buy $100 billion worth of bonds. Who is on the other side of that transaction? People like me. And we sell them our $100 billion of Treasuries. If we're selling them $100 billion of Treasuries, which is a risk-free asset, or a low-risk asset, it's highly unlikely that we're going to turn around and put all that money back into Treasuries. So that money leaks into risk assets, and therefore, risks them up. So basically, the QE, the bond buying that the Fed does, spills over into risk assets. And QE1, QE2, QE3 in the last 10 years, that's how the process worked. And that is certainly how it worked in March and April, while you've had this stunning increase in unemployment, from like zero to 30 million people, and yet the market from the low rallies 35%. That's because net of the Treasury issuance $1 trillion in liquidity was created. And everyone is still of the view that liquidity is just fantastic. The problem is that when you look forward, because the Treasury deficits are not only still going to be there, they're just rolling out aggressively now. The financing of them. The Fed front ran this with their actions over a month or two ago. And so what the Fed bought was $1 trillion more than the Treasury issued. What's going to happen now is Treasury issuance has caught up with the Fed. And if they stick to the schedule they've outlined, the net difference between those two actually goes to zero in May, and net borrowing by Treasury relative to the Fed purchases in June, pretty much flat through September, and then liquidity shrinks as far as the eye can see as the Treasury borrowing crowds out not only the private economy but even overwhelms Fed purchases.

So, I guess what I'm saying is it takes a lot of liquidity to drive a market from 2200 to 2900. We're at 2900. We're not at 2200. And the reason we got there, at a very minimum, momentum has peaked and more likely, there's no net new liquidity or no new net spillover coming into financial assets in general. That leads me to believe the risk/reward given the fact that we don't know what's going to happen with the viruses, we have bankruptcies out there, we have some capitalism problems, at 2900, I just think the risk/reward for equities is maybe as bad as I've seen it in my career. The wildcard is the Fed can always step up their purchases relative to what they're saying they're going to do now. But I don't really know why they would have tapered from $500 billion a week to $7 billion a day if they were ready to ratchet right back up again. So, at 2900 I don't see them doing that.

I've said many times in the last four or five years, if I was the Fed and I was trying to create deflation, I would do exactly what they were doing. Because you've never had a deflation without an asset bubble having been created. You never had inflation because you're close to the zero bound. You'll always have deflation because you had an asset bubble and then a bust. And my guess is going into this, there's a good chance that we just cracked the credit bubble that is a result of free money. And this is going to be deflationary, not inflationary, particularly with 15%, 16% unemployment… Yes, unemployment was the lowest it had been in well, 30 or 40 years, and yes, it was exciting. A lot of the people employed had not been able to join the workforce before. But to me, it was a result of reckless fiscal spending.

Huge leveraging on the government side. A $1.4 trillion deficit with that full employment, just unheard of. Remember back in the Clinton days, when we had the last economic boom, we actually had a Treasury surplus for a bit. And also, this time, we just had record corporate borrowing, again, due to the free money. So, to me, going into it, instead of saying we have the strongest economy ever, I'd be thinking, Oh my God, we just popped the biggest credit bubble in history…The deleveraging that is going to be required, if I'm right and this thing snapped, it's going to take many, many, many years of sub-par growth to get out of. And I'm even more fearful that given the government's involvement in business, and how much we're spending, again, for non-investment spending, we're going to have much, much higher taxes and much higher regulations going forward.

This discussion on markets made me think of this chart.

Are the FAANG’s going to end like the Nifty Fifty’s and what is the next big investment theme ?

D. A Few Things Worth Checking Out

1. Jerome Powell, Head of the Federal Reserve was on the 60 Minutes show, discussing how he sees the world.

2. After the last crisis, the book that everyone was reading was Reinhart & Rogoff’s “This Time It’s Different”. Remember that discussion on Debt / GDP ratios.

Ken Rogoff recently wrote an article arguing for negative interest rates (I do think it happens in the US). Then both Reinhart & Rogoff were interviewed for Bloomberg discussing how it really is different this time…..

3. Yes unemployment is at record levels, but bizarrely people are better off, even if just temporary….…Great FiveThirtyEight article.

4. Forbes article on the changes coming to the PE market. I agree with most of them. You ?

5. One of the blowbacks from COVID-19 and it being an election year is the US vs China posturing. You could see from last year that the world was going to split between two spheres of influence - US and China. This great stratechery article discussing that divide in on context of the chip wars and TSMC.

6. The dating app OKCupid studied the people on its platform and found three questions which best predicted the long-term potential for success in a relationship:

Do you like horror movies?

Have you ever traveled around another country alone?

Wouldn’t it be fun to chuck it all and go live on a sail boat?

They found that two people who answered all three questions the same way were likely to belong together.

Maybe ask your partner and see what you find out :-)