The Investor July 2020

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By Richard Cluver July 2020

Financial commentators have for some years been warning of the looming “Great Reset” in which the financial and monetary systems to which we have long used, are completely upended.

So it is worth starting this column with the observation that in the midst of great change, participants often fail until long afterwards to recognize they were participants in such epoch-ending events. Humankind is, quite understandably, too preoccupied with short-term survival to particularly care whether history is currently inserting a full stop or a comma in its great narrative.

Far be it that I should try to claim the authority of a seer, but like many who have had direct links with family and friends who lived through the Great Depression, I have long expected the times we are now living through. For me, the first adult book I ever read was about the experiences of a boy, aged approximately the same as myself at the time I read it, whose his family had been nearly destroyed by the events following the 1929 Wall Street crash. So profound was that impression that I have ever since been a student of that epoch-changing event.

I have thus always been determined not to be a victim of such a catastrophic political failure and it was that motive which led me to a study of economics and, in particular stock exchange investment which has always offered the man in the street the best available protection from poverty.

From the comfort of a century-long standpoint, we have long been able to look back upon the Great Depression, its causes and cures and the lessons it taught us. But few who were actually involved in it at that time, and who were then facing the reality of not knowing where the next Pound was going to come from, would have had much interest in the fact that it was a major turning point in history. All they wanted was for someone to offer them a job or a promise that their next pay cheque would really be forthcoming.

And I sense that most of my readers have pretty much the same concerns today, particularly since the corona virus seems to be presenting us with a slow-moving train wreck with no clear end in sight.
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Richard Cluver will be the guest speaker tonight in a Zoom webinar hosted by The Friends of Kloof Library, an organization dedicated to raising funds to provide books and teaching materials in KZN.

He will be laying out the details of the crisis that faces us in the webinar tonight, 29 July 2020, and, more importantly, he will discuss what readers can do to guarantee their assets and incomes. To make it manageable, it has to be limited to a maximum of 500 viewers on a first-come-first-served basis so we hope you booked early!

Below are all the details on how to book your spot:

Topic: How to successfully navigate turbulent times in investment markets

Date: Wednesday, 29 July 2020

Time: 19:00 to 20:00

Register: Please register for this meeting. Click Here.

Make sure you have a Zoom account. If not, Click Here to setup your free account.

Join:The Zoom link will be sent to all registered attendees at 17:00 on Wednesday 29th July

Proceeds in aid of Friends of Kloof Library, a support body which works with the community for the good of the Library.

Entry Fee:Suggested donation from R50 per viewing, via Zapper or EFT

Banking Details:

Friends of Kloof Library

Bank: Standard Bank

Account number: 58066071

Branch Code: 051001

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If we knew it had six months to run, we could surely make a plan, but with no cure yet in sight, who knows how long we have to plan for. And that is the rub!

Looking back on the Great Depression, we all do so from a perspective of knowing that it did indeed end and, although a few nasty things like World War Two, Nazism, Communism and a lot else besides were the direct result, they too passed so that in the end we were given a world that has enjoyed the longest-ever period of global peace, greater prosperity than the planet has ever before known and the almost complete ending of deep poverty as well as antibiotics and a whole heap of additional benefits too many to detail here. But the point I am making is that the end result was a largely better world. So was it really such a bad thing?

For my own part, since I had the temerity to write a book entitled ‘The Crash of 2020’ in the hope of warning my readership that an economic crisis was imminent, I have been able to take some comfort in noting that to date my predictions seem to be coming true exactly as I forecast them, not that this offers me and my own family any particular peace of mind as, with dividend income largely suspended, I watch my emergency funds dwindling. I do know, however, that this too shall pass and, I am confident that the lessons of the past will in large measure not fail us in the future.

We should not, however, fail to recognize that the world is at a crossroads very similar to the Great Depression; the same sort of crossroads which gave us World War 2 and a whole range of political extremisms which cost our human population most of the freedoms we today enjoy and required the ultimate sacrifice of millions of lives! We thus dare not allow the politicians to take us down the same dreadful road once again using the same arrogant claims that they are stripping us of our civil liberties because they judge themselves to be better equipped than ourselves to make the vital decisions that affect our own personal liberties.

By their inexplicable controversies both here and abroad they have forcibly demonstrated they utterly lack that ability and so the great risk now is that our consequent failure to take them seriously will result in them seeking a stranglehold on

civil liberty by visiting upon South Africans regional command councils which, like the Nazi institution of local gauleiters in the 1930s, led to untold human suffering. Just saying!

And while we are about it, do note that US President Donald Trump has been leading the world’s most militarily powerful nation into an extremely dangerous game of baiting China to the extent that China prejudice is becoming embedded in a multitude of extraneous issues which could have a tragic long-term consequence for world peace!

In the process, Capitalism has come increasingly under attack to the extent that the Secretary General of the United Nations has assumed leadership of a groundswell movement that seeks to legislate compulsory wealth re-distribution.

Fortunately, though the Left Wing seems to sense that “the pandemic has revealed how capitalism has impoverished the masses” and thus holds out a vision that in the aftermath of the virus the tried and failed ideas of socialism might be re-booted, most ordinary folk now well understand that the Welfare State can only exist so long as someone else is able to pay for it. It might even be a blessing that the stark reality of ANC socialism having eaten most people’s lunch during its 26 years of economic misrule means that most of the electorate in South Africa have few illusions that our current crop of politicians can help us.

That virtually every ANC-dominated municipality is, as the latest audits have revealed, still being plundered and, despite mounting public protest most have just passed eye-watering rates and tariff increases while continuing to reward their staff with bonuses and salary increases, clearly underscores the abject failure of the current system.

Ratepayers and taxpayers who have previously talked weakly of revolt, are now actually doing so. In their hundreds of thousands they are failing to meet extortionate taxes, such that both the State Treasury and municipalities are in financial crisis. Yet many municipalities continue to show taxpayers the middle finger when they reward their top people with unaffordable luxuries, like the City of Durban which this month bought a fleet of luxury cars for key personnel.

Against a budget expectoration of being able to collect R1.425-trillion during the current tax year, the SA Treasury has now realized that it will be lucky to collect just R1.09-trillion. So, already we are being warned about what steps we need to take when SARS summarily confiscates the contents of our bank accounts.

Ordinary people who are unsure of where the next meal might be coming from, cannot fail to notice that, under socialism some people are more equal than others; that the politically connected few are partying on as Rome burns.

Diminishing support for the ANC at successive elections in recent years indicates, however, that slogans and failed promises no longer fool the majority and political commentators with their ears close to the ground suggest that the party is, very likely, finally over.

Political parties, of course, come and go, but the broad sweep of mankind’s approach to life could always be likened to a stately ship steaming relentlessly on, barely impacted by the waves it occasionally encounters. If, like me, you thus worry about when the next dividend cheque will arrive, I can with some confidence assure you that the present drought will pass quite quickly. Since so many corporates have won praise and understanding from their shareholders for conservatively holding back dividend payments of late in order to ensure they can weather this storm, it has thus become the fashionable thing to do. Indeed, every seasoned manager will tell you that at times like these you can clear away a lot of rubbish that has been lurking beneath the surfaces of most balance sheets.

You might thus be assured that while a few companies – like Edcon which wise investors should never have included in their portfolios – will inevitably bite the dust during this period, the Blue Chips, which should have been the entire focus of well-constructed portfolios, will emerge stronger, more profitable, and more efficient for having endured this winter of discontent.

Dividends are likely to be resumed sooner than most of us imagine because corporates which require development capital also need a good dividend track record in order to attract investors. It is, after all, a competitive jungle out there and if you want to be a successful corporate you needs must keep a weather eye on the competition and not fall out of line. Today they can be excused for conserving dividends but tomorrow it will be economic suicide to continue doing so!

I have shown you the following graph many times, but whenever I feel a little panicky about the immediate future I like to pull out a graph of the Dow Jones Industrial Index performance over the past 120 years….and I always challenge readers to try and spot the Great Depression or, in this case, World War 2?

I have only shown you the period from the start of World War 2 until the present but, as I always point out, you can barely notice any significant deviation in the upward sweep in value of the average Wall Street share price until we get to the so called Tech Bubble of 2000 to late 2002 and the 2007-2009 “Sub-Prime bubble” which appear to be greater than anything before them because of a mathematic graphing phenomenon known as exponentiation.

Now you might argue that my graph relates to the great era of Capitalism which many of its critics would want to see ended. However, I don’t for a minute believe it will pass because nothing in mankind’s long process of evolution has ever lifted so many out of poverty nor offered everyone an easier route to personal prosperity and financial stability. That it has simultaneously given us things like climate change is, I would argue, more a failure of governments to efficiently regulate the worst offenders than the fault of capitalism itself.

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Like democracy which, Winston Churchill once famously remarked, “It has been said that democracy is the worst form of Government except for all those other forms that have been tried from time to time…” Capitalism is arguably the worst economic system until you consider all the others!

As a final note, the Foschini Group this month cherry picked 371 “commercially-viable Jet stores” which include a distribution centre located in Durban, South Africa and certain stores in Botswana, Lesotho, Namibia and Eswatini together with the acquisition of the associated property, plant and equipment for the commercially viable stores and the Durban distribution centre and all existing stock holdings with a minimum stock value of no less than R800 million for R480-million is ample proof that the entrepreneurial spirit is coming alive.

The move is unlikely to be the only one in coming months and for that, the entrepreneurs will need money…which is where the need will arise to inspire renewed shareholder confidence. The Jet deal is, of course, money for jam, but there are opportunities like that everywhere right now. Rights issues are now being announced nearly every day by corporate looking for capital to expand via a once in a lifetime opportunity to pick up distressed competitors at bargain basement prices.

Some, of course, are seeking funds to rescue themselves from past mistakes like, perhaps, the misconceived City Lodge BEE deal. So, you need to tread carefully before you become a participant. Others could pay off spectacularly over time.

But you need to be a shareholder to hitch a ride!

It’s 2022. What Does Life Look Like?

The pandemic could shape the world, much as World War II and the Great Depression did.

By David Leonhardt writing in the New York Times

David Leonhardt

It’s 2022, and the coronavirus has at long last been defeated. After a miserable year-and-a-half, alternating between lockdowns and new outbreaks, life can finally begin returning to normal.

But it will not be the old normal. It will be a new world, with a reshaped economy, much as war and depression reordered life for previous generations.

Thousands of stores and companies that were vulnerable before the virus arrived have disappeared. Dozens of colleges are shutting down, in the first wave of closures in the history of American higher education. People have also changed long-held patterns of behavior: Outdoor socializing is in, business trips are out.

And American politics — while still divided in many of the same ways it was before the virus — has entered a new era.

All of this, obviously, is conjecture. The future is unknowable. But the pandemic increasingly looks like one of the defining events of our time. The best-case scenarios are now out of reach, and the United States is suffering through a new virus surge that’s worse than in any other country.

With help from economists, politicians and business executives, I have tried to imagine what a post-Covid economy may look like. One message I heard is that the course of the virus itself will play the biggest role in the medium term. If scientific breakthroughs come quickly and the virus is largely defeated this year, there may not be many permanent changes to everyday life. On the other hand, if a vaccine remains out of reach for years, the long-term changes could be truly profound. Any industry that depends on close human contact would be at risk.

Large swaths of the cruise-ship and theme-park industries might go away. So could many movie theatres and minor-league baseball teams. The long-predicted demise of the traditional department store would finally come to pass. Thousands of restaurants would be wiped out (even if they would eventually be replaced by different restaurants).

The changes that I’m imagining in this article are based on neither an unexpectedly fast or slow resolution, but instead on what many scientists consider the baseline.

In this scenario, a vaccine will arrive sometime in 2021. Until then, the world will endure waves of sickness, death and uncertainty. Before we get into the details, there is one more caveat worth mentioning: Many things will not change. That’s one of history’s lessons.

The financial crisis of 2007-9 didn’t cause Americans to sour on stocks, and it didn’t lead to an overhaul of Wall Street. The election of the first Black president didn’t usher in an era of racial conciliation. The 9/11 attacks didn’t make Americans unwilling to fly. The Vietnam War didn’t bring an end to extended foreign wars without a clear mission.

Yet if the pandemic really does shape life for the next year, it will probably be remembered as a more significant historical event than those precedents. It could easily be the most important global experience since World War II and the Great Depression. Events that hold the world’s attention for long stretches — and that alter the rhythms of everyday life — do tend to leave a legacy.

“It’s only when the tide goes out,” Warren Buffett likes to say, “that you learn who’s been swimming naked.” His point is that companies with flawed business models can look healthy in good times. Out of habit, many customers continue to buy from them. But when the economy weakens, people have to make decisions about where to pull back. They often start with products and services that they find the least valuable or that they can replace with a cheaper alternative.

A downturn, says Emily Oster, a Brown University economist, “is an opportunity to revisit inefficiencies.” And the corona virus is likely to cause a larger version of this phenomenon than a typical recession. Local newspapers will be one casualty. They were already struggling, because Google, Facebook and Craigslist had taken away their main source of revenue: print advertising. Between 2008 and 2019, American newspapers eliminated about half of all newsroom jobs.

The virus has led to further declines in advertising and more job cuts — and could end up forcing dozens more papers to fold or become tiny shells of their old selves. If that happens, their cities will be left without perhaps the only major source of information about local politics, business, education and the like.

Traditional department stores are another example. In recent years, they have lost significant business to online retailers and quietly lost even more to big-box stores. Many Americans have decided they prefer either specialty stores (like Home Depot) or discount stores (like Costco) over the one-stop-shopping experience that Sears, Macy’s and J.C. Penney have long offered. Now the virus has interrupted in-person shopping and caused many consumers to shift even more business online, to Amazon, Target and Walmart. “The retailers doing fair to poorly are absolutely not coming out of this,” said Mark Cohen, a former executive at Sears and Federated Department Stores who teaches at Columbia Business School. “Many, many of them are going to fail, have already failed or will fail when they reopen.”

If they do, they will create spillover victims — the hundreds of malls that rely on department stores for rent and foot traffic. The roughly 250 fancier malls around the country, like The Westchester in suburban New York and The Galleria in Houston, are likely to survive, Mr. Cohen predicted. Some will convert old stores into spaces for experiences, like dining, bowling, medical care or a golf driving range. But many of the country’s remaining 1,100 or so traditional malls are at risk of failing.

A third at-risk industry — higher education — is a bit different from the others, because it’s so heavily subsidized by the government. Yet dozens of colleges, both private and public, are facing real trouble. College enrolment in the United States has been growing almost continually since the Civil War. It kept growing even after the baby boomers finished college, because a rising percentage of young people were enrolling.

But the 150-plus-year boom appears to have ended about a decade ago. Undergraduate enrollment fell 8 percent between 2010 and 2018.

Why? Birth rates have fallen, and the percentage of young people going to college isn’t rising significantly anymore. The population trends are especially stark in the Northeast and Midwest, where many colleges are. Late last year, the Chronicle of Higher Education published a bracing report called, “The Looming Enrolment Crisis.”The virus is exacerbating almost every problem that colleges faced. They have already lost revenue from summer school, food service, parking fees and more. Perhaps most significant, the recession is hammering state budgets, which will probably lead to future cuts in college funding.

The immediate question is whether colleges will be able to bring back students this fall, as administrators are desperately hoping. If they can’t, enrolment and tuition revenue are likely to drop sharply, creating existential crises for many less selective private colleges and smaller public universities. Yuval Levin, a conservative policy expert and the founding editor of National Affairs, put it this way: “The top 20 schools are probably not going to change. But what is actually higher education — more than 4,000 universities — I think will change a lot.”

Of course, business failures can be healthy. They are part of the “creative destruction” that the economist Joseph Schumpeter famously described, allowing more efficient and innovative rivals to rise. The disappearance of many old department stores won’t be a tragedy if they are replaced by stores people prefer.

But some of the virus-related destruction will have damaging side effects. When local newspapers close, corruption and political polarization tend to rise, while voter turnout tends to fall, academic research has found. Cuts to higher-education budgets could make it even harder for poor and middle-class students to graduate.

“The biggest danger that we face as a sector,” Ted Mitchell, a former college president who now runs the American Council on Education, an industry group, told me, “is a loss of the gains we’ve made over the past 20 years in the access for first-generation and minority students.” If you talk to students, parents and teachers about remote learning during the pandemic — from preschool through college — they’re likely to tell you that it’s been disappointing. It went “very, very badly” last spring, Mr. Levin says, and many parents assume it will not be much better this fall.

But if you talk to white-collar workers about their experiences with videoconferencing, you will hear a different story: It doesn’t replace the richness of in-person conversations, but many meetings work perfectly well over Zoom, FaceTime or Google Meet.

Millions of workers are returning to the office or will be soon. Many have no choice, including teachers, janitors and retail workers. But for many white-collar workers, the remote-work experiment shows no sign of ending — a trend that could depress the commercial real-estate market and business travel long after a vaccine is available.

Twitter has told many employees that they can plan to work from home forever. In New York, several major companies, including Barclays, JP Morgan Chase and Morgan Stanley, have said they don’t expect to use as much Manhattan office space as they did before the pandemic.

As Satya Nadella, Microsoft’s chief executive, said this spring, “We’ve seen two years’ worth of digital transformation in two months.” Working from home creates its own efficiencies — less time spent on traffic-clogged roads, more flexibility for parents and people caring for elderly relatives.

Mark Zandi, the chief economist at Moody’s Analytics, has 200 economists around the world who report to him, and he has noticed that they are more efficient than before the pandemic struck. In the past, he would often get on a plane for a short meeting with a few economists. The virus has caused them to move these meetings online, where they share screens with one another and work on databases at the same time.

“We’ve gotten used to it very quickly and like it,” Mr. Zandi said. “I just don’t see us going back.” Because other businesses are having the same experience, he predicted, “Business travel is going to fundamentally change.”

In-person meetings and conferences will continue to happen. But the threshold for what requires travel, and the time, cost and fatigue it brings, will rise. “Maybe we’ve discovered that we don’t need to travel as much as we did before,” said Cecilia Rouse, the dean of Princeton’s School of Public and International Affairs. American Airlines and Delta Air Lines recently offered buyouts to employees, and Airbus cut thousands of jobs, signs that the companies expect airline travel to be depressed for years.

The larger theme is that crises can force or accelerate behaviour changes. Some of the old behaviour will revert when the pandemic ends. But not all of it will. In some cases, people will realize that they were sticking to old habits out of inertia and prefer their new habits.

The biggest source of uncertainty about the post-virus American economy is political. Past crises have transformed the economy, but almost always because of government policy.

The Civil War allowed Abraham Lincoln and his allies to create a transcontinental railroad and a national network of public universities. The Great Depression led to a raft of federal laws that reduced inequality. The housing crisis that began in 2007 helped elect a Democratic president and Congress that extended health insurance to millions of people.

If President Trump wins re-election this year, it may not lead to any major new economic legislation, partly because he has not proposed any. But Mr. Trump would continue to have vast regulatory authority, and he is likely to continue giving businesses more flexibility to behave as they want.

One of the key post-virus implications could be further consolidation in many industries, with big companies becoming even bigger. Early signs indicate they are surviving the lockdown better than smaller rivals, in part because they have more cash on hand, better access to loans and an easier time switching to online sales.

Consolidation, in turn, tends to increase income and wealth inequality, in part because the largest companies are run by highly paid executives, typically based in major metro areas, and the companies’ stock is disproportionately owned by the affluent.

“My basic fear,” Heather Boushey, a leading progressive economist, said, “is that it leads to a rule by the oligarchs.” At this point, however, Mr. Trump is the underdog; he trails Joe Biden in both national and swing-state polls. Democrats also have a realistic chance to retake control of the Senate. (They would need to win five of the 11 races that appear competitive.) If Democrats control both the White House and Congress, they will be poised to embark on a sweeping economic agenda.

Some analysts believe that they may even see some support from across the aisle. A big Trump loss, amid a pandemic and recession, could jolt the Republican Party into being more open to government action. “The debate for Republicans to be having in the 21st century is not big or small government — it’s what do we need from our government,” Mr. Levin said.

Jake Sullivan, a top Biden adviser, said: “Even Republicans — younger Republicans — have recognized that the centre of gravity is shifting on the relationship between the state and the market.” The virus, he added, “will only accelerate that.”

True, predictions of forthcoming Republican moderation haven’t fared well in recent years. Yet even if they again prove wrong, Democrats may pursue an ambitious agenda by abandoning the Senate filibuster, as many progressives favour, and passing legislation on a majority basis.

That agenda is shaping up to have two defining features. The first is reducing inequality — through higher taxes on the rich, greater scrutiny of big companies, new efforts to reduce racial injustice and more investments and programs for the middle class and poor, including health care, education and paid leave. The second is acting on climate change, which could cause even more global misery than the corona virus. “Climate change cannot be solved by the private sector,” Senator Chuck Schumer, the Democrats’ minority leader, told me. “People under 45 realize it.”

Mr. Biden may not seem like a history-altering figure, certainly like less of one than Barack Obama did. But he could wind up presiding over a larger scale of political change than Mr. Obama did, for reasons largely independent of the two men themselves.

Ms. Boushey, who runs the Washington Centre for Equitable Growth, argues that progressives are better positioned to pass sweeping change in 2021 than they were in 2009, after the financial crisis. Then, the only major policy area in which Democrats had a comprehensive, politically viable plan was health care — and, not coincidentally, it became Obama’s biggest policy success.

“Although you had this crisis, you didn’t have the ideas that were ready to go,” Ms. Boushey said. Today, by contrast, progressives have spent years working through the details of plans on climate change, high-end tax increases, antitrust policy and more. And while Obama’s team had only a couple of months to plan for taking office amid a national crisis, Mr. Biden’s team would have almost a year. “There is a whole vision that I think is ready,” Ms. Boushey added. “And there is a lot more runway.”

Mr. Biden and congressional Democrats would need to avoid getting bogged down in intramural squabbles between the centre and the left. But the potential exists for the farthest-reaching period of legislative change since Ronald Reagan’s presidency.

In less than 15 years, the United States has suffered the biggest two economic crises since the Great Depression, the worst pandemic in more than a century and the election of two presidents unlike any before them — and diametrically unlike each other.

If there is a single lesson of the current era of American politics, it’s that change can happen more quickly than we imagined.

A Recession Like No Other

By John Mauldin

John MauldinWe just spent the better part of a decade wondering when the next recession would strike. The last two months we stopped wondering. It’s here and a grand council of esteemed economists has confirmed it.

The Business Cycle Dating Committee of the National Bureau of Economic Research has found monthly economic activity had peaked in February 2020. On a quarterly basis, the peak was in Q4 2019, but in either case, a recession is now underway. It’s important to recognize how they define “recession.”

A recession is a significant decline in economic activity spread across the economy, normally visible in production, employment, and other indicators. A recession begins when the economy reaches a peak of economic activity and ends when the economy reaches its trough.

If the trough isn’t here yet, when will it arrive? We don’t know. The NBER committee identifies these in hindsight. If all goes well, they may look back and say March or April was the bottom, making this one of the shortest recessions ever. But it will also be the strangest recession ever, because even if we are “recovering” we will still be further away from the previous peak than ever before, with unemployment well above 10 million.

NBER also said this time is different:

The committee recognizes that the pandemic and the public health response have resulted in a downturn with different characteristics and dynamics than prior recessions.

Considering exactly how this recession is different gives us some insight into how long it may last. Many economists thought a recession was close even before the pandemic. The expansion had run longer than any other. Cracks were forming and the main question was what would trigger a decline.

I thought we were headed for a credit crisis, centred on corporate debt rather than mortgages, as happened in 2008. The Fed’s decades-long easy money policies have many businesses leveraged to the hilt. That remains the case and could still become a bigger problem but for now, we are in something unique: a supply-and-demand-driven recession. Specifically, service supply dried up almost overnight due to virus fears and lockdown orders. Then consumer demand collapsed as people lost those service jobs and, as we will see, those with more money started to save dramatically more, further reducing demand.

My friend (and valued mentor), economist Woody Brock, draws a helpful comparison between this recession and others. I am going to rely upon his June Client Memo for some of these insights and blend them with other analysis and my own views.

https://ggc-mauldin-images.s3.amazonaws.com/uploads/newsletters/Image_1_20200627_TFTF.png

Normally, some kind of trigger or “shock” makes business activity contract. Tighter credit or higher interest rates are often the culprit, not simply falling sales. Unable to finance continued operations, businesses close and lay off workers, who then reduce their consumption. The effects cascade through the economy and recession begins.

This time, the shock came with the corona virus and our reaction to it. Note, it wasn’t just government-ordered shutdowns. Data now shows consumer spending started falling weeks before governors acted. Retail and service businesses saw store traffic falling and, with risks to employees and customers rising, many closed even when not required to. But the result was the same: Business activity contracted and triggered recession.

Woody observes, and I agree, this hit our economy’s weak spot like a laser-guided missile. Unlike the 1800s or the 1930s or as recently as the 1980s, manufacturing and agriculture no longer dominate. Now the service sector accounts for the vast majority of jobs and GDP. The sudden stop was catastrophic. As Woody outlines (his emphasis):

The good news over the past hundred years (as we have often documented) is that the impact of most any shock on consumption has dropped by some 90%.

There are two main reasons for this remarkable decline. First, the advent of unemployment insurance and of two-income families blunted the impact of layoffs on consumption. Second and more important, the percentage of jobs in cyclical industries and farming has collapsed by some 70%, a decline offset by the increase in jobs in the service sector where some 86% of us now earn our living. What matters, of course, is that the service sector is as stable and cycle-free as the other two sectors are not. This is the main reason why the decade-by-decade volatility of GDP has fallen by 85% during the past century. In particular, post-war business cycles have thus been much less severe than they were before the war.

According to this analysis of traditional recessions, both the unemployment rate and the drop in consumption should have and did increase after the initial shock (e.g., a spike in interest rates) occurs—not concurrently. The unemployment rate also peaked after a recovery had already begun.

Note: this is why the current recession is unlike others. Most economic analysis that I read doesn’t distinguish between this service sector implosion and prior recessions of the last 200+ years. Which is why we get all this silly talk of a V-shaped recovery. They are looking at historical models when nothing in history resembles this recession.

This shock, as bad as it is, is only the beginning. More from Woody:

At a causal level, this initial shock caused the unemployment rate immediately to soar to unimaginable levels prior to any formal recession. For the face-to-face contact required to produce many goods and services in the service sector came to an abrupt end once people decided to stay home.

What the market may be missing here is that this initial service sector implosion/shock will cause a more classical recession to follow: thousands of non-service sector businesses will cut back (mining, engineering, auto production) regardless of generous fiscal and monetary assistance. Many firms will fail. As businesses suffer and cut back, they will start laying off workers in the usual manner, and we end up with a proper recession in which layoffs continue until well after an economic recovery arrives.

Thus we will have to add several million more late-stage layoffs to the 32,000,000 early-stage layoffs tabulated to date. The adverse impact of all this on consumer confidence is hard to estimate, but it will surely cause ever further reductions in consumption spending than we have seen to date. The impact on business confidence and investment spending should also be severe.

Theoretically, this new double-decker recession should cause both GDP growth and employment to drop much further and faster than in any other recession on record. And this is exactly what has happened.

If COVID-19 was only the initial trigger, then we still have to deal with the pre-existing conditions even if the virus threat goes away. That doesn’t seem likely this year, at least in the US.

In short, a demand-driven recession can’t end until demand returns. It doesn’t necessarily need to be the same kind of demand. Indeed, it probably won’t be. But something must restore consumer spending. A lot of entrepreneurs are spending late nights (and days) trying to figure out how to restore consumer spending.

Choosing Not to Spend

Other problems aside, there is plenty of reason to think the virus-sparked downturn is not over. We know almost 48 million Americans lost jobs since March (the number of unemployment claims filed). Most haven’t felt a severe income loss thanks to government programs and stimulus payments. Some are even making more now.

This isn’t simply a benefit to unemployed workers. The extra payments let them keep paying their bills, which helps their landlords, lenders, and the stores where they shop. (Anecdotally, one friend relayed to me that he was told by the CEO of the company that over 95% of their 50,000 apartments are still paying their rent, but only 50% of their commercial rentals were being paid). That being said, 30% of mortgage holders failed to make payments in June. Even so, cash is still flowing through the economy. That has helped.

At the same time, less cash is flowing into commerce. The difference shows up in the savings rate and bank deposits. The personal savings rate reached an unprecedented 32% in April. It was still 23% after spending rose in May.

https://ggc-mauldin-images.s3.amazonaws.com/uploads/newsletters/Image_2_20200627_TFTF.pngMuch of this money now flowing into banks would have been spent in restaurants, hotels, and other suffering service businesses. In some cases, it is getting recycled back to those businesses as the banks buy Treasury bonds and the government pumps cash into various programs. But not all of it, and maybe not for long. Some of the CARES Act stimulus measures are set to expire in the next few months.

Mortgage and other lenders have been granting forbearance on debt payments. Courts in many places paused eviction proceedings for renters. Credit card issuers have been generously extending terms. All these help, but they aren’t sustainable indefinitely. They, too, will end at some point, perhaps soon. Then what?

The Wealthy Assume the Foetal Position

One of my most important “reads” every day is Neil Howe and Hedgeye Demography. He starts out by noting a New York Times article and then provides colour.

It’s the richest Americans who have cut their spending the most during the pandemic, which is limiting the economic recovery to a larger degree than in past recessions. Unlike other recessions, this one has decimated the service sector, which depends increasingly on consumption by those at the top.

He goes on to relate much of the same analysis as we discussed above.

https://ggc-mauldin-images.s3.amazonaws.com/uploads/newsletters/Image_3_20200627_TFTF.pngIt has been triggered, in the first instance, by a supply shock: Firms cannot produce or sell to customers. The first firms to get hit are mainly small companies (or sole proprietors) in the service sector—personal services especially. And the first workers to get hit are low-income earners in affluent, urban areas very near to where wealthy people live.

Services, driven by millions of small firms (restaurants alone comprise nearly 15% of all US employers), typically help power our economy through a recessionary patch. This time, services are getting hammered.

 But then we get to the part that really gives us truly valuable insight. The data below is daily credit card receipts which can be tracked by ZIP Code. A Harvard think tank called Opportunity Insights breaks down the data by average household income within a particular ZIP Code. No surprise, the data tracked remarkably closely, both before and after the recognition of the pandemic and lockdowns. But notice what happens after the first stimulus checks are received. Those getting those checks, presumably not the wealthy, spend them. The top 25% of wealth-related ZIP codes spend dramatically less. And that is the problem.

https://ggc-mauldin-images.s3.amazonaws.com/uploads/newsletters/Image_4_20200627_TFTF.png

A few years ago, former Dallas Fed president Richard Fisher, speaking at my conference, was asked how he had positioned his own portfolio. He quipped, “The foetal position.” That is precisely what we are seeing today: extraordinarily high savings rates and less spending from those who are uncertain about the economy.

https://ggc-mauldin-images.s3.amazonaws.com/uploads/newsletters/Image_5_20200627_TFTF.pngNot surprisingly, that means that small businesses in those neighbourhoods have had the biggest drops in revenue.

What kind of businesses are we talking about? Mainly small firms, contractors, and professionals who provide services to wealthy people in relatively wealthy neighborhoods: high-end restaurants, boutique and fashion shops, spas, gyms, therapists, theaters, florists, and so on. Businesses in Manhattan, especially on the upper east side, have been flattened—while businesses in Harlem and South Bronx have been relatively unscathed.

So, what are the rich doing with their money? For now, at least, they’re not spending it. Past recessions have usually been accompanied by some rise in the personal savings rate—with a disproportionate share of that rise coming from the affluent. This time, we’re seeing a grotesquely exaggerated response. The average personal savings rate has skyrocketed to an unprecedented 33% in April. And nearly all of this gain has come from the affluent. According to the Harvard researchers, over half of the consumption decline in April and May came from the top quartile of households. Meanwhile, the lowest quartile has seen virtually no overall decline in consumption. And that is in part thanks to PPP and UI bonus dollars flowing to the very workers who work (or used to work) in Beverly Hills or Sausalito or along Chicago’s Mag Mile.

Over half the spending decline in the current recession is coming from the top 20% income group. The lowest group has only seen aggregate spending drop 5%, thanks to unemployment insurance. Government programs have helped the economy stumble along.

My friend Lance Roberts at Real Investment Advice posted the charts below on Twitter. Note that social benefits (government checks of one form or another) almost doubled to 37% of disposable income in the last few months. The unanswered and difficult question is what will happen if those programs are cut back?

https://ggc-mauldin-images.s3.amazonaws.com/uploads/newsletters/Image_6_20200627_TFTF.png


The next phase of this recession will be when demand stays low because people lack spending power. The open question is how widespread it will be, and that depends largely on health-driven behavioural decisions.

Inevitable and Unacceptable

Spending won’t recover to prior levels unless people feel safe. I emphasize “feel” because perception is what counts. Controlling the corona virus is necessary but not sufficient. Recently I explained how widespread mask-wearing is the best and least expensive economic stimulus program available to us. Older people, those with health conditions that make them vulnerable, and many others simply won’t go back to normal when they see large numbers of unmasked people walking around in public.

Unfortunately, that is easier said than done. Legal mandates and social shaming (you cannot imagine how I hate writing those words) may help but not enough, and can even backfire by breeding resentment. This is a real problem for businesses in which crowds and small spaces are unavoidable.

The airline industry is in turmoil. Traffic counts are coming back but are still way below breakeven rates. Hotels are even worse, not to mention all the businesses that need airlines and hotels to bring customers. Conventions and tourism are a substantial part of the economy, representing millions of jobs. They can’t come back under these conditions. That alone is enough to keep the economy in recession for a long time. You can be optimistic about much of the economy (I certainly am) but a 90% recovery is just not enough.

But that’s really the bestcase outlook. If the outbreaks that are currently intensifying in Arizona, Florida, Texas, and elsewhere get bad enough to make consumers stay home and businesses close again (whether ordered to or not), all bets are off. Texas has already paused its reopening plans, with the governor ordering bars closed again.

Efforts to control the virus, while necessary, have an economic cost. It looks like the European Union will refuse entry to American travellers, as well as others from areas where they deem the virus is insufficiently controlled. The same is happening within the US as recovering states like New York require quarantines for travellers from other states where cases are growing.

International and interstate travel is pretty low anyway, but these measures will reduce it further. Now even some urgent, no-other-way trips can’t happen. This will have unpredictable but potentially severe impact on some businesses. If your factory is closed because you need a machine repaired, and the only person who can repair it can’t enter your state, you are in deep trouble. So are your employees, suppliers, customers, and shareholders.

When NBER said this recession would have “different characteristics and dynamics” than others, the committee wasn’t kidding. This is unlike anything we have seen before. At least 20 million people have been out of work for eight weeks. (H/T Mike Shedlock) Initial claims are still about 1.5 million per week, though down from almost 7 million. Again, 47 million of our neighbors have lost a job. Some are now slowly going back to work. But by all accounts, that work looks significantly different.

https://ggc-mauldin-images.s3.amazonaws.com/uploads/newsletters/Image_7_20200627_TFTF.png

Source: MishTalk

I think governments everywhere, but especially in the US prior to the election, will continue their stimulus programs. But at some point, we cannot maintain the current level of spending. I think it is likely we taper off rather than simply cut them wholesale, but no one really knows.

And remember, TANSTAAFL (There ain’t no such thing as a free lunch) is still an economic law. We may pay for it via lower growth and thus fewer opportunities for everyone, or inflation, other ways, or combinations thereof. That being said, doing nothing would mean an economy worse than the Great Depression. We have no good choices. We’re simply picking the best of some pretty bad choices. Ugh.

When economists talk about the shape of a recovery, relying upon the past data, my best advice is to ignore them. We are in the Stumble-Through Economy. Everything is going to be different in the future. The old playbook won’t get us out of trouble this time. Every business, every family, every investor will have to create a brand-new playbook.

Think of it this way. From time to time the gods of football change the rules. Coaches and players adapt. Now imagine every rule change of the past 40 years was enacted in one month, in the middle of the season, and the referees instructed to rigorously enforce them.

It is time to throw out the old playbook and create a whole new game plan. Nearly everything in the world is going to be re-priced. Some of those changes will be minor but some will be significant. In the middle of all this, governments and central banks will to continue to change rules just to make the challenge a little more difficult.

The Benefits of a Free Society during Pandemics

by Per Bylund

In this time of crisis, many exclaim how impressed they are by the “swift and decisive” actions by the Chinese regime. Instead of recognizing the abhorrent disrespect for human life, the Chinese response is put forth as an exemplar for combating a pandemic.

These hailers conveniently forget the many weeks of silencing and censorship that preceded the brutal shutting down of the city of Wuhan and the whole Hubei Province. They also turn a blind eye to the nature of hierarchy and bureaucracy, pretending what is needed to choose proper action is simply power and that access to accurate, reliable information is of little concern.

The calls for a strongman solution are misguided at best but have been used to paint the picture of freedom as being impotent. Per the strongman delusion, libertarianism would seem to lack exactly what is needed for “swiftly and decisively” dealing with a pandemic—centralized power… But a centralized solution also makes us more vulnerable. An example might illustrate this. Consider the difference between a structured, centralized national defense and an armed populace. Switzerland is the popular example of the latter, but this is not a unique idea. For example, Sweden’s defense comprises both a traditionally structured military and the Home Guard.

While you can rather easily cripple the military by taking out a couple of their bases, the decentralized and dispersed forces of the Home Guard are almost impossible to wipe out. What does this have to do with a virus pandemic? It illustrates the false promises of centralization, which is a costly and inadequate solution that in fact makes a society more vulnerable.

The same argument applies whether it is the national defence, centralized education, or the monopoly of the CDC. A centralized command structure offers only a false sense of security. Libertarian society has exactly the decentralized structure that our present society is lacking. Rather than a pyramid with information selected and repackaged on its way up and orders issued from the top, it would be a collaborative network of individuals and neighborhoods. A neighborhood affected by an outbreak could quickly and easily choose to contain the virus, perhaps in collaboration with adjacent neighborhoods.

Others could choose to temporarily quarantine themselves to not get infected. There would also be little reason for them to not share information. While the Chinese apparently believed they didn’t have to do anything, other than silencing whistleblowers, a government is typically not held responsible for its failures. It’s the other way around: a government agency that fails in its task is not punished, but instead offered larger budgets and more discretion.

In rather stark contrast, a libertarian neighbourhood that chooses to suppress vital information about an outbreak could (and would) be held liable for the harm caused to others. They face the same mechanism as the private store owner, who would be liable if s/he welcomed those knowingly carrying a virus to enter the premises and infect other customers. It is thus in their interest not to hide the facts, as is the government modus operandi, but to share the information and get in front of the problem.

None of what is appropriate action during an outbreak or pandemic requires central command. The downsides of centralization in fact make matters worse and are what made us vulnerable to begin with. The many calls for increased centralization, and their outright dismissal of libertarianism and freedom as “impotent,” are fundamentally confused. Rather than being reasonable and rational, these outcries are emotional and contrary to fact. They are but symptoms of the strongman ideology.

South Africa could lead the way

From ‘The Crash of 2020’ by Richard Cluver

Our perceived weaknesses could be our greatest strengths that could put us in the pound seats in the future. Our ridiculously-weakened Rand offers us export opportunities that few nations possess while an epic rate of unemployment guarantees there will be no labour shortages. All we have to do is fix the way we do things!

Three major issues and lots of smaller ones are turning away foreign investors. We need to fix them fast if we are to have a hope of ending the massive gap between rich and poor in this country. In no special order of importance:

● Laws that make it impossible to fire unproductive workers need to be swept away!

● Capital Gains Taxes block entrepreneurs from mobilizing their money and bring in little for the fiscus. They must go!

● Property Expropriation without Compensation is a threat to everyone thinking of setting up business in South Africa. There are better ways to solve the hunger for land!

● BEE – Black Economic Empowerment legislation that in effect works as an unnecessary tax on businesses yet only benefits a politically-connected few, must go!

● We must urgently find a way to reduce a crippling public sector wage bill as a result of which the government had to borrow R214-billion in the fiscal year ended March 2017. This has risen to R404-billion for the year ended March 2020.


Continuing the serialization of Richard Cluver’s latest book, you can order the full e-book version by right-clicking on the following link
http://www.rcis.co.za/the-crash-of-2020-order-form/






As our recent political history has resoundingly demonstrated, government meddling in the free market system in a usually well-meaning effort to uplift previously disadvantaged people has inevitably resulted in economic stagnation and the worst unemployment rate in our history. At an official rate that ignores those who have given up hope of ever finding work and only takes into account registered work seekers, unemployment now stands at 29.1 percent. As the graph below illustrates, the numbers of unemployed have been constantly rising and currently translate into 16.38-million souls in economic misery; a third of our population. Compare that with the official peak rate of 24.9 reached in a far more populous US during the Great Depression of the 1930s.

The only way the world has ever managed to end unemployment is to give free rein to business. All Government can ever do when the economy collapses is try to offer some succor in the form of a dole. But no government has ever been able to afford sufficient relief to offer the unemployed decent relief from poverty.

The great Industrial Revolution which so enriched everyone in society from the 1760s onwards is generally attributed to the fact that there was a minimum of government involvement in the economy with just 10 percent of GDP extracted from the private sector to run government.

Today, most governments extract over 40 percent of GDP leaving insufficient in the private sector to stimulate development. The list on the right provides an idea of how much governments are extracting.

When the State diverts too great a portion of the total revenue produced by a nation to itself, the inevitable result is economic stagnation. In 2019 South African Government revenue extracted a third of the country’s gross domestic product leaving insufficient money in the free market economy to enable anything remotely approaching buoyancy. This ratio is 50 percent higher than the rate in Britain and France, twice that of the US and seven times higher than the rate in India. It is just too much and it completely explains why the country is in economic stagnation.

In addition to the suggestions I have made, there are scores of reforms we need to tackle, but these are the “low hanging fruit”. We can no longer afford the time to go the route of commissions of enquiry and multiple stakeholder consultations. We need to move quickly and decisively to fix what is wrong with our economy and move forward with lightening speed or it will be too late…we will miss the boat.

No doubt we will make mistakes along the way but none that we cannot go back and fix. The important thing is not to hesitate to do what needs to be done … as soon as possible!

To illustrate the kind of thing we can do I need to go back in time to Durban in the 1980s, when then City Treasurer Ozzie Gorven made a radical proposal to ratepayers. If they would accept a rates levy in return for a promise that their municipal rates would not increases again in the future, he would undertake to make Durban a debt-free city. Residents agreed and within a remarkably short time Durban became one of only two cities in the world to be completely free from debt. Indeed, the city went on to build a substantial investment pile which, had it been allowed to continue, would have made Durban the only rate-free city in the world.

Unfortunately, a change of administration happened and the new council viewed this massive asset with astonished glee. City Councillors who had traditionally offered their services free to the people of Durban because they believed in “Putting something back,” began paying themselves salaries and a lot of other benefits, and before long the city was in debt once more!

What Durban did in the 1980s South Africa could easily do now. Here’s how. If I were made President for a Day, I would immediately sweep away Capital Gains Tax so that people with investments could liquidate them without fear of the Receiver of Revenue snatching half of the realized amount. That would facilitate a massive amount of pent-up innovation to get the country on the move once more.

Next I would offer every South African and all our pension funds the opportunity to buy tax-free bonds and I would use the proceeds to pay off our R3-trillion debt that is currently crippling the economy.

Noting that in order to raise loans, the SA Government must currently offer bonds at greater than a 9 percent yield. In the hands of a South African pensioner, every R100 he invests thus attracts interest of R9 of which the Receiver of Revenue deducts R3.51 in tax leaving him with just R5.49 in his pocket. And given the dire straits our economy is in, he is likely to receive even less in future if taxes increase. Given an inflation rate of 4.3 percent it is clear that his real return is just R1.19: a real taxed return of 1.19 percent.

Thus, if he were offered a sovereign bond that would never be taxed and would pay him R5.50 for every R100 he invested, he would undoubtedly be very interested.

Consider now that the widely issued RSA 186 long bond stood at a yield of 9.238 percent at the time of writing. In the current financial year, the Government will have to pay R204-billion to service its debt. If that debt cost could be cut from 9.238 percent to 5.5 percent that cost could be reduced to R121.45-billion. That saving alone would be more than we currently spend on tertiary education (R77-billion) and housing (R69-billion).

Then there is the debt of State-owned enterprises. The table on the right suggests a figure of R513.2-billion and climbing. There are also the debts of municipalities which as long ago as 2016\17 totalled R225.8 billion. So, between these two you can add at least R739-billion to the debt burden implying a servicing cost of R69-billion upon which we could save another R41 billion by opting for the tax-free bond option.

But what if there was insufficient take-up from the investing public? The total market capitalization of the Johannesburg Stock Exchange is just R16.576-trillion of which foreign investors own 38 percent which implies there is R10.28-trillion in private and institutional South African hands. It would be thus a big ask to assume that investors would be prepared to place about a third of all their money into a tax-free bond issue in order to take over the nation’s debt.

Other sources of capital would be needed which suggests that an income tax levy similar to that requested by then Durban City Treasurer Ozzie Gorven. Of course, it goes without saying that launching such a rescue plan for South Africa’s debt would require a pact such as Ozzie Gorven made to the people of Durban…. that Government would come to the party by cutting its costs and promising a future of lower taxes.

Personal income tax and company tax account for 58 percent of total Government revenue of R1 216.5-billion. That is R707.6-billion and the total is likely to rise to R1 583-billion in the current tax year so a ten percent tax levy could be expected at best to yield around R92-billion a year. That is enough, however, to put us in reach of the nation’s debt servicing costs. The difference between such a levy and the debt service cost, if a tax-free bond option were able to be fully implemented, would require just a 1.86 percent reduction in Government spending in order to bridge the servicing gap.

However, the Government needs to slash its spending and its tax collection by half if it is to put a meaningful sum annually back into private enterprise in the interests of stimulating job-creation. A Rand for Rand undertaking to undertake a ten percent State spending cut would accordingly take us into a position to make meaningful reductions of the debt load.

But there is more. Purists argue that governments have no business doing anything other than administration: at a stretch providing an army, a police force and a justice system…and a taxation department. And South Africa’s experience of State-Owned Enterprises has convincingly proved that government officials and appointees are entirely unsuited to running businesses…particularly so when the State is there to pick up the financial pieces when, as always happens, the enterprise runs at a loss.

It is arguably so that the majority of South African taxpayers are totally fed up with loss-making state-owned enterprises and would be happy to be shot of the lot.

So, what if we offered them all up for sale and for those that we could not find a willing buyer we simply listed and gave shareholding to every citizen for free. That way we would create a nation of shareholders who might quite rapidly develop the collective skill to hold management to account. Either way the fiscus would be shot of the burden of supporting them

Furthermore, what about our schools, hospitals, railways? Private enterprise has shown that these can be efficiently and profitably run and anyway most South Africans would out of choice send their children to a private school and they themselves would prefer a private hospital rather than a state-run institution because they clearly believe that private offers better quality. So, if we cannot sell them, let’s list them on the stock exchange and give the shares to every taxpayer and every old age pension recipient on a rand for rand basis. That way we would pass them on to either sink or swim but no longer be the problem of taxpayers to bail them out whenever, as they currently now inevitably will, lose money.

A rough back of the cigarette box calculation suggests that we could save considerably more than half of government spending if we allowed private enterprise to run the services that Government currently runs so inefficiently. This is not to imply that we should simply abandon out citizenry to fend for themselves. A simple means test could determine how much help every citizen needs to pay in this complex world we live in leaving private enterprise to find the most efficient manner of doing the job of providing a competitive service.

Here, consider how the Canadian Government runs its health service. When a Canadian needs a doctor he makes an appointment with a private practitioner and is treated just as medical aid members are treated in South Africa, except that the practitioner sends the bill to the government. It works for them with all the efficiency of private practice except that doctors there do not have to worry about whether they will be paid or not…they do not have bad debts.

Consider also the land question that is currently so vexing for all South Africans. Given the accuracy with which hand-held global positioning systems operate, it would not be at all difficult to equip an army of government officials with such tools which could allow for accurate mapping of every rural kraal and every squatter shack on municipal lands in our South African cities and towns. It is but a step from there to being able to print out title deeds for everyone who is currently classed as landless. Handing people title deeds which can be mortgaged and sold is probably the quickest way of economically emancipating all of our people….and of freeing up untold currently sterile land-based wealth.

Here it is worth noting that the converse of this proposal was what bankrupted neighboring Zimbabwe when farm invasions were allowed to happen. Since farms were the principal security pledged to Zimbabwean banks in that largely agricultural-based economy, the instant devaluation of all farm land that was the logical outcome, resulted in the economic collapse of that nation. As always in history, a sharp contraction of the monetary base has always ushered in an economic depression. We can do that exercise in reverse and so unleash an economic miracle in South Africa.

These are but a few of the many opportunities that could be opened up with just a little creative thinking. There are many more if we simply put our minds to them. What is clear, however, is that drastic times call for drastic measures and so we have little option but to embrace innovation. What is clear is that Government needs to recognise that private enterprise can create jobs more efficiently than governments ever can and that the concept of the nanny state has long passed its sell by date.

Our backs are to the wall. We desperately need to create jobs for a growing army of the unemployed and we can no longer afford the luxury of cash handouts for everyone who is unemployed. Neither is the “dole” a satisfactory solution for unemployment and it clearly strips the recipients of personal dignity. It is at best a stop-gap that cannot be allowed to continue in the long-term.

It is time to return to the efficiency of a private enterprise-based economy and to do so swiftly lest we be overcome by the monetary crisis that is just a hair’s breadth away. The choice is ours!

Fear debt – not raising equity capital – when it makes economic sense.

 by Brian Kantor

f1The threat to the value of SA retailers as cash has drained away during the lock downs has been as damaging to their landlords. The value of the average market weighted general retailer and property company on the JSE is less than 40 % of what they were worth in January 2018. The damage to the balance sheets of the property company of Covid19 is perhaps far greater than that of the average retailer. Who have shown a greater willingness to raise fresh equity capital to repair their balance sheets?

A number of these JSE listed Real Estate Investment Trusts (Reits) with seemingly little growth in expected to come from SA assets, sought faster growth offshore. These offshore investments were funded very largely sometimes exclusively with foreign currency denominated debt.

The market value of average JSE Reit assets less debts, their net asset value (NAV) had fallen away before the Covid crisis that then decimated their rental revenues at home and abroad. A number of these JSE listed Reits now lack a sufficient buffer of equity to absorb the losses from COVID 19 related shutdowns. Debt to market value ratios have risen and NAV fallen further.

To qualify as Reits and avoid corporate taxes they are required to pay out at least 75% of their income after interest and all other expenses. They are appealing for an exemption from the Treasury and the JSE to skip dividends to conserve cash and still retain their Reit status.

They might do much better to raise equity capital, if they can, issue more shares for cash and pay off foreign and domestic debts. Even if the saving on foreign interest paid is minimal, provided the rand holds up, the improvements to their survival prospects and so market value could be substantial. Shareholders supported by stronger balance sheets could be well served facing up to a reduction in cash distributions per share.  

They would receive less income per share, but with lower risks attached to expectations of future distributions, this could add value to all the shares issued – even when there are more of them.

The purpose in raising capital may be, ideally, to grow a business successfully. Successful businesses mostly fund their growth from the cash they generate from operations. More unusually they may have to raise additional debt or equity capital secure the survival of a still potentially successful business.

The same fundamental question needs to be asked in both circumstances. Will in other words the increase in the market value of the company, plus the dividends paid, both measured in extra rands come to exceed the amount of extra capital raised. Also, in rands. Plus, something extra to cover the opportunity cost of the capita raised. That is will the investment of extra capital return as much as could be expected from any alternative, as risky, a SA investment? Equal that is to the return from the bond market plus an equity risk premium- of about 5% p.a. (About 13% p.a.) If so, investors will get all their capital back – and more – and perhaps very quickly as share prices could respond immediately to the expectation of good returns to come.

Any potential capital raise needed to save or de-risk a business will be reflected in the ongoing survival value of a company. Any surprising refusal of its owners to refuse to supply extra capital, when needed to secure the business as a going concern, will provide a very negative signal and surely damage the share price. Preventing the downside will be part of the upside of any capital raise.

A successful secondary issue, especially when underwritten by bankers exercising due diligence, is perhaps an even stronger signal of favourable longer- term prospects for any company. More so than a rights issue supported by established shareholders with everything to lose. With a successful secondary issue raising capital for the right value adding reasons, established shareholders can expect to have a smaller share of a larger cake and be better off for it.

The obvious way to maintain the share of established shareholders in a company is to raise extra debt, rather than equity capital. But more debt, makes any company more risky, and may destroy rather than add market value for shareholders.

Debt only looks cheaper than equity with hindsight, after the good times have rolled by. And the good times may not last- as we have been so cruelly reminded.

Quick thoughts on GPT3

By Delian Asparouhov

OpenAI, an AI research foundation started by Elon Musk, Sam Altman, Greg Brockman, and a few other leaders in ML, recently released an API and website that allows people to access a new language model called GPT-3. I’ve had the chance to play with it over the past few days and have been truly amazed by its capabilities.

I’d like to start this off by stating that, especially amongst my extremely intelligent ML friends, I am quite the layman, so this post is more aimed for a nontechnical audience and I apologize if I make any technical errors in this post.

GPT-3 is essentially a context-based generative AI. What this means is that when the AI is given some sort of context, it then tries to fill in the rest. If you give it the first half of a script, for example, it will continue the script. Give it the first half of an essay; it will generate the rest of the essay.

Here are some examples that I tweeted, first where I fed it half of an investment memo I have published on my website:

https://cdn.substack.com/image/fetch/w_600,c_limit,f_auto,q_auto:good,fl_progressive:steep/https%3A%2F%2Fpbs.substack.com%2Fmedia%2FEdFnPvGUcAEsMIP.png

https://cdn.substack.com/image/fetch/w_600,c_limit,f_auto,q_auto:good,fl_progressive:steep/https%3A%2F%2Fpbs.substack.com%2Fmedia%2FEdFnkYjVAAAc34C.png
And my second example, where I fed it half of an essay on how to run effective board meetings:

https://cdn.substack.com/image/fetch/w_600,c_limit,f_auto,q_auto:good,fl_progressive:steep/https%3A%2F%2Fpbs.substack.com%2Fmedia%2FEdFtL-jUwAAfTk_.png
https://cdn.substack.com/image/fetch/w_600,c_limit,f_auto,q_auto:good,fl_progressive:steep/https%3A%2F%2Fpbs.substack.com%2Fmedia%2FEdFtNblVAAAeMU0.pnghttps://cdn.substack.com/image/fetch/w_600,c_limit,f_auto,q_auto:good,fl_progressive:steep/https%3A%2F%2Fpbs.substack.com%2Fmedia%2FEdFtPBBUYAAZXqd.png

Both times, the AI was able to generate cogent (although not always correct) additional paragraphs, and in both examples was able to follow the prior formatting, i.e. section headers (ex: risk), and steps.

What’s incredible about the tool is you can feed it almost any context — a script about a gay couple in Italy, an interview between two tech luminaries, or even a political column about an election — and it is able to put together decently coherent arguments.

Now, before you get too excited, this isn’t some sort of general AI, and the machine doesn’t really have a way of understanding if what it is outputting is true or not. The simplest way to explain how it works is that it analyzes a massive sample of text on the internet, and learns to predict what words come next in a sentence given prior context. Based on the context you give it, it responds to you with what it believes is the statistically most likely thing based on learning from all this text data. This is a strategy that OpenAI and other researchers have been pursuing for quite some time, by starting off with a ‘simple’ problem like trying to predict the next word in a sentence. We have now steadily built up to where they are today, where a model like GPT-3 can complete several paragraphs or more. Though an incredible result, even GPT-3 at some point may lose direction and wander aimlessly. Despite its massive size (over 175B parameters), it still may struggle with keeping a long term destination in mind or holding logical, consistent context over many paragraphs.

This means, in my opinion, although there’s debate on this, that while this tool is very impressive, and GPT-4 will likely show further improvements, there are probably diminishing marginal returns to this approach. They can keep getting better at running really complicated statistics on all of the text people have ever written, but the AI is still not capable of “reasoning”.

There’s a good essay that goes into this to explain that this AI has some limitations in relation to passing the Turing test (http://lacker.io/ai/2020/07/06/giving-gpt-3-a-turing-test.html), i.e. if you talk to a AI, can you tell that it’s an AI or not. Remarkably, the easiest way to trip it up is to ask it somewhat nonsensical questions like “how many schnoozles fit in a wambgut?” because statistically, most of the time the AI has seen a question like that on the internet, they are typically answered with a statement that is structured like “3 Xs fit in a Y”, so it answers with “3 schnoozles fit in a wambgut”, rather than a more appropriate answer which would be “those are made-up objects” or “I don’t know”

While there are some limitations, because GPT3 is so good at producing coherent, follow-on thoughts, I think there are a ton of upsides where you include a human in-the-loop as an editor for maintaining correctness.

This tool is phenomenal as a writing buddy. If you’re an playwright setting up a scene, GPT-3 is a great way to explore paths that the scene can take, and it can write dialog, keep track of the characters, and generate dialog that makes sense. If you’re a comic, you start off a funny story about your childhood, and GPT-3 can help you come up with some more riffs. If you’re an entrepreneur trying to increase the productivity of your chat teletherapy company, GPT-3 can probably come up with 3-4 cogent, paragraph-long answers to your users that a human can quickly review and approve, significantly improving their productivity.

There are probably simple use cases where GPT-3 can work entirely on its own, but I think many of the use-cases will involve a human in the loop.

My favorite analogy for explaining GPT-3 is that the iPhone put the world’s knowledge into your pocket, but GPT-3 provides 10,000 PhDs that are willing to converse with you on those topics.

30 years ago, Steve Jobs described computers as “bicycles for the mind.” I’d argue that, even in its current form, GPT-3 is “a racecar for the mind.”

Can’t wait to see what technology entrepreneurs build on this platform and look forward to funding some of them.


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