The Investor March 2020

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By Richard Cluver                      March 2020

Market Meltdown’s Velocity Bruises Investors: a view from Wall Street

By Amrith Ramkumar of The Wall Street Journal

Markets have never unravelled as quickly as they did in the past month. Stocks are falling faster than they did during the financial crisis, the crash of 1987 or the Great Depression.

Investors are retreating from corporate bonds at the swiftest pace ever. An index of raw materials is at all-time lows. And funding shortages around the world have fuelled a race for dollars, powering the U.S. currency to a nearly 18-year high.

As fast as the downturn has been, many fear the worst has yet to come as investment products tied to everything from stock volatility to mortgage-backed securities gyrate. The Cboe Volatility Index, or VIX, rose to an all-time high early last week, upending bets on more placid trading from earlier in the year.

Yet even as stocks extended their drop on Friday, volatility also fell, an abnormal development that adds to a laundry list of exceptional market moves pushing some investors to brace for further declines.

As the novel coronavirus spread around the world at the beginning of the month, Leslie Thompson, managing principal at Spectrum Management Group in Indianapolis, began reducing her investments in stocks and raising cash.

“It seems like an eternity ago,” she said. “I know there’s going to be great value out there. It’s just hard to redeploy money at the moment until we get some stability.”

The unprecedented simultaneous meltdown is straining financial markets and bruising investors like Craig Hodges, portfolio manager for Hodges Funds in Dallas.

The 56-year-old has worked extra hours and handled a 10-fold increase in the number of calls from clients as the Dow Jones Industrial Average erased three years of gains in a month and some of the smaller home builders and industrial stocks he follows plunged more than 70%.

“You almost feel numb,” said Mr. Hodges, who has been buying shares of companies he thinks can survive the crisis. “How many more days can go on like this?”

The speed at which the 11-year bull market in stocks morphed into a historic drop is forcing investors to reassess their positions and challenging policy makers who are trying to respond. The brutal descent and 

violent price swings have rattled markets ranging from crude oil to Treasuries, fuelling widespread selling and big moves toward cash.

Disruptions in the Treasury market, the most liquid and actively traded bond market in the world, have forced the Federal Reserve to make massive purchases to keep strains from worsening. Clogs in short-term money markets at the heart of the financial system have added to the concerns, with companies from Boeing Co. to Ford Motor Co. drawing on credit facilities.

Meanwhile, a price war between Saudi Arabia and Russia crashed oil, pushing the Trump administration to consider intervening in the conflict and prompting Texas regulators to weigh whether to curtail crude production for the first time in decades.

States from California to New York have essentially shut down to contain the corona virus, underscoring how regulators and investors are contending with an unprecedented economic threat. And last week’s market moves signaled that investors are now preparing for the disruptions to last longer than many analysts could have anticipated.

The S&P 500 ended last week down 32% from its Feb. 19 all-time high. The rout has sliced trillions of dollars in market value from U.S. companies, with the Dow industrials falling about 10,000 points in just a month.

“We went from an economy that was growing at 1.5% to 2% per year to shutting off entire industries, and revenue for a certain period of time going to zero in certain segments of the economy,” said Lisa Shalett, chief investment officer of Morgan Stanley Wealth Management.

The S&P’s drop of more than 20% from Feb. 19 to March 12 was its fastest-ever fall from an all-time high to a bear market. The index rose or fell at least 4% in eight consecutive sessions through Wednesday, the longest streak in the index’s history, according to Dow Jones Market Data.

At the same time, investors facing losses in stocks have been forced to sell assets typically viewed as safe, adding to the manic trading. Prices of government bonds around the world have tumbled in recent sessions and gold has dropped 11% since hitting a seven-year high on March 9. Silver, another precious metal, slid 32% in nine sessions through Wednesday, falling to an 11-year low.

Meanwhile, the extra yield, or spread, that investors demand to hold U.S. investment-grade corporate bonds over Treasuries has risen at its fastest pace ever, Bloomberg Barclays data show. High-yield spreads have also surged at a similar clip, signalling waning appetite for corporate debt—another sign that markets are warning of a painful recession.

“It feels like three months. It’s been three weeks,” said Amanda Agati, chief investment strategist at PNC Financial Services Group. “This is what happens in a crisis of confidence… The panic level becomes so significant.”

Ms. Agati said she has received several calls from clients asking whether to buy stocks after their big decline but has advised them to wait until volatility settles down. In the past few weeks, stocks have frequently moved full percentage points in minutes without a clear explanation, punctuating a period of remarkable volatility.

“Seeing the speed with which we’ve fallen, clients naturally extrapolate that,” said Adam Phillips, director of portfolio strategy at wealth management firm EP Wealth Advisors. “That’s the hardest part from a psychological standpoint.”

A Bank of America poll of fund managers recently showed the biggest monthly drop in expectations for the world economy in the history of its survey, which dates back to 1994. At the same time, investors it surveyed drastically lowered their positions in stocks and boosted their cash holdings.

In another sign of investor angst, an index of raw materials critical to everything from transportation and manufacturing recently fell to its lowest level ever in data going back to 1991. Oil has crashed 50% in March to about $22.50 a barrel, sent spiraling by a slump in demand and the Saudi-Russia price war.

Energy companies make up a key chunk of the high-yield bond market, and an expected drop in spending by oil and gas producers marks another blow to the economy that has dinged investor sentiment.

The swings in stocks have even bruised investors using the rout as a long-term buying opportunity. Benjamin Lau, chief investment officer of Irvine, Calif.-based Apriem Advisors, has been buying stocks the past few weeks, only to watch them crash again.

“It is jarring,” he said. “It’s not like it’s down a couple percent—you’re down 10 or 15% really quickly.”

Vasbyt: we’ve seen this before

By Richard Cluver

Like rabbits caught in the headlights of a fast-approaching car, investors all over the world have been either frozen into inaction as they bemusedly read daily financial headlines and pretend it is not their own comfortable retirement plans unravelling before their eyes.

Worse, many are now rushing to sell in order to salvage what they can and in the process are locking themselves into massive loss.

Relax. This too will pass and, provided you act responsibly your fortunes will be restored.

The first market crash I had to report on happened in 1969 when, as a young journalist I had, happily, liquidated my share portfolio to buy my first house and so I missed all the carnage. In 1987 the market crashed again and, as I detailed in my latest book, The Crash of 2020, I went knowingly into that one in a highly leveraged position and thought I had lost my shirt. But, barely a year later the market had recovered all its losses and continued its upward surge as if nothing had happened.

Then came 1990 and with the costs of Apartheid bankrupting the state, the JSE went into slow reverse. Again in 1998 things turned ugly for investors as the market lost 52 percent of its value between May and September and took 19 months to get back to its previous peak.

Then between January 2000 and March 2003 the market slid once more over uncertainty surrounding the transition to democracy losing 26 percent in the process. Yet by August the same year it has recovered all its losses. Again in 2007 the market lost 34 percent of its value between October 29 and October 23 the following year.

Then, between January 30 2018 and October 12 the market lost 21 percent, recovered until April 2019 then fell 14.2 percent before its next upward surge until February 14 this year. Since then it has fallen 28.5 percent.

The story of all these rises and falls is told in one graph below with the red trend line representing the mean of all of these movements and there lies the ultimate secret of share markets. That red line rose throughout at compound 15.5 percent annually. At its lowest point on the left hand side, had you invested R1 000 and done nothing at all in the years in between, notwithstanding the dramatic events of the past fortnight, it would today be worth R263 573.

Most importantly, look at the magnitude of the drop on the extreme right hand side of the graph and compare it with all the others over the years. It is barely seen!

 As I said at the outset, this too will pass.

For what it is worth, I created cash equal to about ten percent of my personal portfolio just ahead of the downturn and I have been buying steadily as ridiculous bargains have been uncovered.

I hope you have been doing the same!

Slavery alive and well today!

By Richard Cluver

Slavery is an outdated concept but it is alive and well and living in the 21st century….if you choose to be a slave!

Extraordinarily, it IS a matter of choice and that is the only difference between the 18th century and 21st century versions. The abolition of serfdom and slavery was a long-winded process but it did not effectively end in the West until 200 years ago. But guess what….it was effectively replaced by economic slavery which ensures that the bulk of humankind is forced to keep on working throughout their effective lives ending with the traditional gold watch and a retirement in comparative penury.

If you doubt me, consider the tempting hire-purchase agreements and low-interest mortgage introductory offers laid out in a glittering row for those who have been diligent enough at their studies so as to earn bachelor degrees. Pity them if they take the bait!

But you should really pity those who fell by the wayside and did not complete their education for theirs is destined to be a life of drudgery and considerable poverty usually accompanied by voluntary slavery as the price for succumbing to the allure of lounge suites, TV sets and other non-essential things that are “nice to have.”

Consider that of those who enrolled for grade ten in South Africa, only 48.1 percent wrote matric and only 37.6 percent passed. Furthermore, the vast majority never even made it to Grade Ten. The stark reality is that for every hundred children that enter our education system, only 12 enter university and only 4 complete a degree.

Not that a degree necessarily guarantees you a future of ease and affluence. A young graduate hoping to settle down into domestic bliss with his university sweetheart can expect that a middle range house in 2020 South Africa would cost around R1.1-million assuming he has the luxury of choosing where he lives. If he if forced by job opportunities to re-locate to Johannesburg, it might cost him a lot more.

Now, assuming he has saved enough for an average deposit of 22 percent, that leaves some R858,000 to be financed by way of a home loan. At the standard home loan interest rate of 10.5 percent, that would put the average monthly bond repayment on a 20-year loan at just under R8,600 of which R7 595 will be the interest portion. And the buyer who pays only this minimum amount each month will pay almost R1.2 million in interest over the life of the loan – or more than the original cost of the property.

In other words, by electing to use mortgage finance he will end up paying the cost of two houses. More if he extends his borrowing period or, as so many folk do, obtains re-advances of his loan in order to finance some other objective like constructing a swimming pool or whatever.

According to poll figures, a new university graduate can expect an average salary of R12 812 a month but the table on the right provided by research group Payscale probably offers the most accurate available data.

There is, however, a huge gap between the median salaries of the highest and lowest earnings groups with MBAs earning R741 720 a year and Bachelor of Science salaries or R318 280 a year with the median around R379 900 for an Msc. That works out at R31 660 a month from which the Receiver of Revenue would collect R7 239 leaving our graduate with a total monthly take-home figure of R24 421. Now take away his mortgage repayment of R8 600 and he is left with just R15 821 to provide for his family.

Next, assuming he and his new wife each buy new cars. Why, after all, should they not like most of their friends replace their old varsity clonkers with shiny new models once they are earning?

Well, let us assume they choose for her one of the cheapest new cars on the market, a Hyundai Atos costing R170 000. To meet this cost the bank will provide finance of R171 207 to meet the buying price plus an “initiation fee” of R1 207.50. Repayment will be over 72 months at a monthly figure of R3 612.48 which is made up of a R69 a month administrative fee and a total of R84 451.33 interest divided into monthly intervals.

For him we chose a larger family car; a mid-range Volkswagen Polo Trendline costing R248 800 plus extras taking the total cost to R260 626.83 plus an “initiation fee” of R1 207.50 requiring a total loan of R261 207.50 which would in turn require a total repayment R395 021.02. This would result from a monthly repayment over 72 months at an interest rate of 14.2 percent of R5 486.40 including a monthly administrative fee of R69.

So, after bond and car repayments our young man has R6 722.12 left over to meet car insurance costs of R2 440.00, property rates of R1 204, water at R1 933.96, electricity costs monthly of R2 153.16, all of which implies that he will be in debt to the tune of R1 009 every month before he begins to think of feeding his young family, clothe them, pay school fees, transportation etc.

Clearly, he cannot imitate the way his parents lived with a stay-at-home mother. Without a second salary they cannot survive let alone think of leisure activities, holidays and the few little luxuries that make life worth living. No wonder our population birth rate is declining throughout the developed world.

Is it possible to escape the tyranny of debt redemption figures? Well the reality is that many capital items such as houses have seldom been as cheap in South Africa simply because of the economic recession we are living in. And that in turn is the consequence of historically high debt loads and our very high interest rate structure which is in turn a reflection of our sovereign bond rate. The latter is one of the world’s highest, only equaled by basket case economies like that of Venezuela, because of the excessive borrowings of the ANC Government.

Hardly surprising, the property market is depressed because of this and the additional burden of young families emigrating to escape the political uncertainties of this country. It has seldom been a better time to buy a house…but only if you can afford to pay cash!

Credit counseling group Kudough believes South Africans spend about three quarters of all personal disposable income toward paying off debt. The company said more than half of people in debt struggle to pay it off, and that the average adult is about R70 000 in debt.

Trading Economics data suggests that household debt in South Africa increased to 34 percent of GDP in the second quarter of 2019 from 33.80 percent of GDP in the first quarter of 2019 and averaged 37.97 percent of GDP from 2008 until 2019.

Strip out debt from the example I initially provided and you will quickly see that our young graduate couple are paying a total of R16 693.88 in interest and redemption figures out of an above average after-tax income of R24 421. That’s 68.4 percent of their after-tax income which could obviously be put to far more productive uses if they were sensible.

So for example, let’s assume for a moment that both are high-flying graduates bringing home between them nearly R50 000 a month after tax. Assuming also that both continued living at home for a few years after university and continued using their student cars so that they could, as rapidly as possible, build up an investment nest egg.

Consider too that they had seen the following graph of the performance of JSE Blue Chip shares over the past 36 years and decided to take advantage of it. That red line describes the fact that an investment in a cross section of these shares would have grown in value at 19.7 percent compound annually.

To make the example super simple, I have assumed that they spent nothing at all for the next few years courtesy of generous parents who wanted to see them off to a good start. But to add a more realistic twist I will also assume that, instead of buying shares each month and benefitting from that growth, they in fact accumulated their money for a full year before buying and continued to do so just once a year. In practice one would normally accumulate cash while keeping a close watch on buying opportunities so as to be able to pounce whenever quality shares hit a cyclical price bottom.

The following graph illustrates how, for example, my ShareFinder programme employs artificial intelligence in order to project with better than 90 percent accuracy that property shares like Growthpoint are probably at their cyclic bottom and could prove to be an outstanding investment in the next few months; currently they could offer a yield of 16.6 percent.

For a generation distinguished by the phrase “I want it all NOW” what I am suggesting is a big ask. But if you consider my table on the right you can see how quickly savings can mount up if they are well-invested in quality shares increasing in value annually in line with the Blue Chip annual average of 19.7 percent compound.

After two years our young couple would have sufficient accumulated to buy an average house and a new car for cash. If they cared to continue the frugal existence for nine years they would have sufficient invested to afford to retire and spend the rest of their lives travelling the world on the income off their investment. That sum of R12.319-million would offer them annual growth of R2.43-million and dividend income of R370 000 a year almost precisely equaling his take home pay if they had stayed behind and continued working.

While I do not for a moment suggest that this a realistic life plan, it serves to illustrate how postponed gratification and a little frugality coupled with a sound investment strategy can GUARANTEE you freedom from the bondage that is the common experience of most South Africans, indeed of most citizens of the world.

I do think it is practical and rational to live at home for a few years after completing your studies and equally realistic to continue using the clapped-out student car for a few years. And, once you have a secure nest egg behind you, it is also practical to pay cash for everything you need.

It means you will have the freedom to choose who you will work for or, if you wish, the freedom to go out into business on your own, to live where you please and, above all, the ability to sleep peacefully at night not having to lie awake worrying about how to meet a growing pile of monthly debts.

Given how simple it really is, for me the mystery is that two out of three South Africans voluntarily elect to make themselves slaves to debt!

Is there an alternative?

From The Crash of 2020 by Richard Cluver

What has emerged from these analyses of the world’s modern history of alternating economic booms and recessions is a clear and probably dominant link between them and the manipulation by central banks of the global money supply, often with the best intentions of alleviating a perceived recessionary trend.

But inevitably this manipulation has proved to be a blunt instrument that has just as inevitably led to recession, unemployment and under-utilisation of resources which in the long-term has caused a reduction of the wealth of nations and actual impoverishment.

Such manipulation was not possible during more than 2 600 years of history when the Gold Standard exercised control. However, strict adherence to the Gold Standard resulted in inflexibility which prevented central banks from responding during recessions and it proved to be the transmission agent which spread catastrophe around the globe. However, it has been equally hazardous to hand over the monetary throttle to central banks when these are likely to be influenced by politicians whose comparatively short-term horizons inevitably include their own prospects for re-election.

Continuing the serialization of Richard Cluver’s latest book, you can order the full e-book version by right clicking on the following link 

In an ideal world economic system there would be continuous and stable growth which would enable workers the security of being able to work productively throughout their lives without fear of retrenchment and unemployment. The consequence should be political stability and the maximization of individual and national wealth. But ours is a far from stable system and the consequence has been the frequent emergence of extremist politics and as Karl Marx so beguilingly observed, antagonism between the “Haves” and the “Have-Nots” together with frequent regional military conflicts have represented the ultimate break-down of society.

What is clearly needed is to put distance between those who control the monetary system and the politicians while at the same time permitting the system to operate in a reasonably strict relationship with indicators of global wealth by utilizing a World Bank that is, by definition, insulated from regional aspirations but sensitive enough to be able to administer “Band Aids” to the localised crises that regularly afflict mankind.

The World Bank and the International Monetary Fund were conceived with something like this in mind but their weakness has always been the political pressure that has been applied to them by voting blocs and the reluctance of sovereign nations to hand over their individual power to manipulate their own currencies. Thus the IMF has frequently had to step in as lender of last resort when commercial markets have been reluctant to make further loans to indebted nations, acting in fact in the same way as central banks do for commercial banks within individual countries.

In microcosm, this is the major flaw within the monetary system of the European Economic Community where, in their hurry to cement together a unitary political system and a common currency, the authors signed away the ability of individual countries within the union to regulate their own economies. The subsequent economic crises in Greece, Ireland, Italy, Spain and, more recently, the chaos of the Brexit debate in Britain, can all be attributed to a loss of individual autonomy that can in each case be traced back to the frustration of a system that is centrally regulated without a perceived sensitivity towards regional needs.

So, would it be possible to tweak the system in order to modify the mandate of the World Bank so that it might be able to offer the world a single stable global currency and act as the bank of last resort to all the central banks of individual nations? In this way each nation’s central bank might be able to retain economic autonomy in the same way that the commercial banks of independent nations operate in relationship with their own national central banks?

Currently, member nations are required to deposit money with the International Monetary Fund in proportion to the size of their economies and are able in times of financial embarrassment to draw down these loans in the form of Special Drawing Rights (SDRs). The IMF in fact acts as a super central bank.

Thus a solution to the problem of currency manipulation by individual nations might be to employ SDRs as a global currency backed by the assets of all its member countries and available to ordinary citizens for their personal transactional purposes. Clearly there would be resistance from many member countries who obviously would fear the loss of control over the assets of their citizenry and from the commercial banks who would stand to lose a significant portion of their earnings from the foreign exchange dealings they do on behalf of their clients, but the Euro experiment has resoundingly demonstrated the advantage of a single currency system. Clearly the concept could easily be magnified into a single global monetary system provided it could be shown to be universally trustworthy.

Furthermore, the rapid take-up of crypto-currencies in the past few years has made it clear that a growing proportion of the world’s citizens have already headed in this direction of a single world currency. While there exists a wide-scale misconception about the nature of crypto-currencies, the primary characteristics of most of these has been that they were produced by a process of cryptomining; a process in which transactions for various forms of cryptocurrency are verified and added to a blockchain digital ledger.

Each time a cryptocurrency transaction is made, a cryptocurrency-miner is responsible for ensuring the authenticity of information and updating the blockchain with the transaction. The mining process itself involves competing with other cryptominers to solve complicated mathematical problems with cryptographic functions that are associated with a block containing the transaction data. The first cryptocurrency miner to crack the code is rewarded by being able to authorise the transaction, and in return for the service provided, cryptominers earn small amounts of cryptocurrency of their own. In order to be competitive with other cryptominers, though, a cryptocurrency-miner needs a computer with specialized hardware.

The cryptomining process is thus likened to gold mining inasmuch as considerable effort and time is required to produce a finite amount of this “coinage” which cannot by any means be counterfeited. The most widely known cryptocurrency is the Bitcoin which, according to a recently published analysis which examined the electricity costs of 115 countries, the United States ranked as the 40th cheapest to mine a single bitcoin, with an average cost of $4,758.

Transactions are sent between peers using software called “cryptocurrency wallets.” The person creating the transaction uses wallet software to transfer balances from one public address to another.

Currently there are a number of crypt exchanges which allow users to exchange individual cryptocurrencies for others and similarly for the official currencies of the world, working in the same process of bid and acceptance as is employed by stock exchanges, a relative value is derived.

Probably the most important single attribute of the cryptocurrencies is, however, the manner in which they are stored by the block chain process in which an encrypted ledger is stored on the on-line computers of millions of computers worldwide.

The cryptocurrency system ascended to semi-official recognition once major retailers worldwide began indicating their preparedness to accept them in exchange for goods and this has become particularly the case in respect of the world’s burgeoning on-line retail industry.

The official administrators of the global monetary system have given the process guarded recognition. Recognising that it would be virtually impossible to outright ban them, central banks and the IMF itself have entered what would be best described as a “wait and see” approach.

Typical, is the official attitude of the European Central Bank which announced that, “Virtual currencies are a contemporary form of private money. Thanks to their technological properties, their global transaction networks are relatively safe, transparent, and fast.

“This gives them good prospects for further development. However, they remain unlikely to challenge the dominant position of sovereign currencies and central banks, especially those in major currency areas. As with other innovations, virtual currencies pose a challenge to financial regulators, in particular because of their anonymity and trans-border character.”

Thus it was obviously only a matter of time before major banks began to fall into line and allow their clients to open crypto-currency accounts and exactly that seemed to be happening recently when the world’s biggest on-line communications channel, Facebook, tried to hijack the process for, the central banks suspected, private gain.

The global digital payments industry already includes Tencent’s WeChat, a giant social network in China with a digital wallet. In India, there’s Paytm. In Kenya, there’s M-Pesa. A lot of the so-called emerging markets implemented this technology early on because their citizens do not have bank accounts, but they do have mobile phones.

To understand how these have helped emancipate millions, In its most recent report on global banking services, the World Bank identified financial inclusion as a key driver of development and cited the example of Kenya where mobile money services have rapidly expanded, enabling women-headed households to increase their savings by more than a fifth; “…allowing 185 000 women to leave farming and develop business or retail activities; and helped reduce extreme poverty among women-headed households by 22 percent.”

The Facebook phone app is thus just another manifestation of a worldwide currency revolution that is sweeping everything before it. Facebook developed a digital wallet called Calibra, which would hold and dispense Libra once the currency was released in an operation planned for early 2020. In addition to its own app, the wallet would be folded into Facebook mobile products, including WhatsApp and Messenger, massively increasing its global reach.

The new blockchain-based currency called the Libra was planned to be controlled by a nonprofit group in which Facebook would share responsibilities with companies ranging from Mastercard and PayPal to Uber and eBay. The currency was expected to launch in 2020 and have the added attraction of “very low fees.”

Facebook touted the new digital currency as a service for the 1.7-billion adults worldwide who, by a World Bank estimate, don’t have access to a bank account, which could particularly benefit women and people in developing countries.

According to the Libra Association, “All over the world, people with less money pay more for financial services,” citing burdens such as steep usage fees and high-interest payday loans.

The association claimed that the cost of that exclusion is high with approximately 70 percent of small businesses in developing countries lacking access to credit and that $25-billion was being lost by migrants every year through remittance fees.

Libra’s initial backing was impressive as their Web page illustrates. Then the project hit a snag as pressure upon it mounted from worried governments determined to stop the cryptocurrency dead in its tracks. Visa, Mastercard, PayPal, Stripe, Mercado Pago, and eBay abandoned the Facebook-led corporate alliance underpinning Libra following an onslaught of criticism from regulators and lawmakers who were skeptical of the company’s ability to manage the risks and rigors of financial services given its many highly-publicised failures in the handling of personal data.

When Facebook CEO Mark Zuckerberg announced Libra amid great fanfare, the idea sounded interesting and innocuous. Anyone with a mobile phone would be able to buy Libra tokens with domestic currency and by standard methods such as debit cards and online banking. Those tokens could then be used to make payments to other Libra users, whether to purchase goods and services or repay debts. To ensure full transparency, all transactions would be handled by blockchain technology and in sharp contrast to Bitcoin, Libra tokens would be fully backed by copper-bottomed assets.

To anchor Libra to tangible assets, the association backing it promised to use its revenues, along with the seed capital contributed by its member companies (at least $10-million each), to buy highly liquid, highly rated financial assets (such as US Treasuries). Given Facebook’s leading role, it was not hard to envisage a moment when half of the planet’s adult population, represented by 2.4-billion monthly-active Facebook users, would suddenly have a new currency allowing them to transact with one another and bypass the rest of the financial system.

It sounds on the face of it, a brilliant solution to the complexity of modern foreign exchange transactions with the added benefit from the perspective of the ordinary citizen, of freedom from the all-pervasive eyes of the world’s tax-gatherers. However, writing from the experience of having acted as the finance minister of Greece during some of its most recent periods of economic crisis, Professor of Economics at the University of Athens, Yanis Varoufakis noted that the authorities’ initial reaction was awkwardly negative. By highlighting the potential criminal uses of Libra, they only succeeded in confirming the libertarian suspicion that, faced with the threat of losing control over money, regulators, politicians, and central bankers prefer to smother liberating monetary innovations.

“This is a pity”, he commented, “because the greatest enabler of illicit activity is old-fashioned cash, and, more important, because Libra would pose a systemic threat to our political economies even if it were never used to finance terrorism or criminality.

“Starting with Libra’s ill effects on individuals, recall the great effort most countries have invested in minimising the volatility of the purchasing power of domestic money. As a result of those efforts, one hundred Euros or dollars buy today more or less the same goods that they will buy next month. But the same could not be said of one hundred Euros or dollars converted into Libra.

“To the extent that Libra would be backed by assets denominated in several currencies, a Libra token’s purchasing power in any given country would fluctuate a great deal more than the domestic currency. Libra would, in fact, resemble the IMF’s internal accounting unit, known as Special Drawing Rights (SDRs), which reflect a weighted average of the world’s leading currencies.

“To see what this means, consider that in 2015, the exchange rate between the US dollar and the SDR fluctuated by up to 20 per cent. Had a US consumer converted $100 into Libra back then, they would be subjected to the agony of watching the tokens’ domestic purchasing power move up and down like a yo-yo. As for residents of developing countries, whose currencies are prone to depreciation, Libra’s facilitation of money changing would accelerate the depreciation, boost domestic inflation, and make capital flight both likelier and more pronounced.

“Since the 2008 financial crash, authorities have struggled to manage inflation, employment, and investment with the fiscal and monetary levers that, prior to the crisis, seemed to work reasonably well. Libra would further diminish our states’ capacity to smooth the business cycle. Fiscal policy’s efficacy would suffer as the tax base shrunk, with every payment shifting to a global payments system residing within Facebook an even greater shock would await monetary policy.

“For better or worse, our central banks manage the quantity and flow of money by withdrawing or adding paper assets to the stock held by private banks. When they want to stimulate economic activity, central banks buy from private banks commercial loans, mortgages, deposits, and other assets. The banks then have more cash to lend. And vice versa when the authorities want to cool down the economy. But the more successful Libra becomes, the more money people will transfer from their bank account to their Libra wallet and the less able central banks will be to stabilise the economy. In other words, the greater the flight to Libra, the deeper the volatility and crises afflicting people and states.

“The sole beneficiary would be the Libra Association, which would collect tremendous interest income on the assets from around the world that it would accumulate using the large portion of global savings attracted to its payment platform. Soon, the association would yield to the temptation to advance credit to individuals and corporations, graduating from a payments system to a gargantuan global bank that no government could ever bail out, regulate, or resolve”.

That is why, he argued that it was a good thing that Libra was unravelling, along with Zuckerberg’s dream of a private global payments monopoly. But, he said, we should not throw the technological baby out with the monopolistic bathwater. The trick would be to entrust implementation of the idea to the International Monetary Fund, on behalf of its member states, with a view to reinventing the international monetary system in a manner reflecting John Maynard Keynes’ rejected original proposal at the 1944 Bretton Woods Conference for an International Clearing Union.

To bring about this new Bretton Woods arrangement, the IMF could issue a blockchain-based, Libra-like token whose exchange rate with domestic currencies would float freely. People would continue to use their domestic currency, but all cross-border trade and capital transfers would be denominated in the Libra and pass through their central bank’s account held at the IMF, he argued.

Trade deficits and surpluses would incur a trade-imbalance levy, while private financial institutions would pay a fee in proportion to any surge of outward capital flows. These penalties would accrue in a Libra-denominated IMF account that operated as a global sovereign wealth fund. Suddenly, all international transactions would become frictionless and fully transparent, while small but significant penalties would keep trade and capital imbalances in check and fund green investment and remedial North-South wealth redistribution.

Prof Varoufakis concluded his analysis with the comment that’ “Brilliant ideas that would be catastrophic in the hands of buccaneering privateers should be pressed into public service. That way, we can benefit from their ingenuity without falling prey to their designs.”

Apart from its global reach, the Libra concept has added a very real fundamental. Though the mining process means that only a limited number could be created and in that way it has a sophisticated link with the costly rarity of gold bullion, in order to win the trust of a global community that grew up on the Gold Standard and reluctantly learned to live with the Bretton Woods sequel of “Reserve Currencies” the perceived weakness of cryptocurrencies is their lack of a meaningful backing of reserves in definable securities like gold bullion, sovereign bonds and so forth. Beguiling as the security of the block-chain process is as a basis for both the holding of wealth and its transfer without the intermediation of banking institutions, this is its major perceived flaw in the eyes of those who would attack it, principally the global tax authorities, because it has no actual hard currency backing. But that could be changed at a stroke if the IMF were prepared to give it legitimacy.

What gives the International Monetary Fund system its perceived validity, apart from the fact that it is institutionally recognized as an arm of the United Nations Organisation to which all the world’s nations are signatories, is the fact that it draws all its resources as quota from its members based broadly on their relative size in the world economy. It is thus backed by the currencies of all member nations.

To explain, on joining the IMF, a country normally pays up to one-quarter of its quota in the form of widely accepted foreign currencies (such as the U.S. dollar, Euro, the Chinese Renminbi, Yen, or Pound Sterling) or Special Drawing Rights (SDRs) . The remaining three-quarters are paid in the country’s own currency.

Disregarding the massive task of arbitraging all these minor currencies into a cohesive base and recognising that all of these currencies are susceptible to value fluctuations because of the influences I have already detailed, there is in effect a constant erosion of the IMF’s real working capital because of global inflation – more about that later.

Accordingly it is obliged to undertake regular reviews of its quota resources. For example, at the 2010 Fourteenth General Quota Review it was agreed to double quota resources to SDR 477 billion (about US $677-billion).  In the review conducted in November 2015, the IMF decided that the Renminbi (Chinese Yuan) would be added to the basket effective October 1, 2016. From that date, the XDR basket consisted of the following five currencies: US dollar 41.73 percent, Euro 30.93 percent, Renminbi (Chinese Yuan) 10.92 percent, Japanese Yen 8.33 percent and the British pound 8.09 percent.

Every five years member nations are called upon to top up their quotas, often at great cost to themselves. Might it not thus be better and exceedingly more attractive to member nations if each were instead called upon to render a once-off portfolio of that nation’s blue chip shares to an aggregate value of the latest quota. I have frequently illustrated how such a portfolio of South African shares has been capable of delivering a ten-year compound average return of as much as 20 percent in the case of developing countries and over 15 percent in developed countries together with an average dividend yield of 2.5 percent making possible an average annual total return of about 20 percent.

A billion dollars invested at compound 20 percent would grow to 2.4-billion dollars in five years, massively increasing the IMF’s ability to perform its bank of last resort function without any further need for nations to perform the five-year top-up function. Furthermore, any currency which appreciated in such a manner would obviously become highly prized and, I venture, probably become the currency of choice for all businesses and individuals of the future.

 Moreover, as my graph of the performance of South African Blue Chips over the past decade makes clear, there is relatively little price volatility about such a national blue chip portfolio which grew at compound 19.1 percent annually from its 2008 low up to the present. How much more stable would it be to have one created from the aggregate performance of the blue chips of many nations?

Just like the original Lydian Lion, should a single-currency planet earth be the consequence of such moves, and particularly if the settlement of debt became solely the purview of a block-chain process, it might logically result in the compromising the ability of individual nations to track the wealth migration of their citizens. In this latter event, one would might conclude that the massively inefficient, infinitely time consuming and frequently litigious tax-gathering processes currently favoured by governments would also fall away to be replaced by a simple sales tax that could be actionable at points of sale.

Just to confirm that this not a situation unique to South Africa, US Blue Chips have performed in the same fashion growing at 19.76 percent compound from their April 2009 low to the present.

Imagine a government stripped down to the simple processes of law-making, policing and defense with all other activities tendered out to the most efficient private contenders! But that is another discussion; just a brief vision of an evolution beyond the “Nanny State”. However, the world is moving rapidly towards such a goal.

Decade of Living Dangerously, Part 2

By John Mauldin

John MauldinIf living dangerously is your goal, just keep adding reasonable, manageable, prudent risks. Eventually they’ll add up to serious danger.

Hyman Minsky showed how stability leads to instability. Humans have a way of reinterpreting stable periods that seemingly redefines words like reasonable, manageable, and prudent. That’s why we continue chasing yield and risk until we go too far.

To think that we have somehow eliminated recessions and risk, or that central banks and the government have somehow become adept at managing the business cycle, is simply foolish. Yet we keep doing it, every single time.

Debt seems harmless enough at first. You have reliable cash flow, repayment is no problem, and you’re going to spend the borrowed money wisely. But human nature tends to make us overdo otherwise good things. And, with debt, you may also have lenders actively urging you to borrow even more. Everything is fine… until it’s not.

Personal debt, while sometimes excessive, isn’t the main problem. Government and corporate debt are the bigger challenge and the reason we will spend the 2020s living dangerously. All that debt is ultimately personal debt, too, since most of us are either taxpayers, shareholders, or both.

In Part 1 of this forecast I described my relatively benign outlook for the next 12 months. The calm may last into 2021 and even beyond. But beneath the surface, pressure will still be increasing. It will grow slowly, almost imperceptibly, but eventually explode.

Or, to use another metaphor: We are frogs in the kettle and someone just turned on the heat. By the time we notice, our good options will be gone.

The Long Now

My friend Ben Hunt at Epsilon Theory has been writing a series called The Long Now. I won’t try to summarize because you should read it yourself. Suffice it to say, it is both thought-provoking and disturbing. A quick snippet from his introduction:

The Long Now is everything we pull into the present from our future selves and our children.

The Long Now is the constant stimulus that Management applies to our economy and the constant fear that Management applies to our politics. (Ben has a rather broad view of what he calls capital “M” Management which includes government, central banks, and others.)

The Long Now is the Fiat World of reality by declaration, where we are TOLD that inflation does not exist, where we are TOLD that wealth inequality and meager productivity and negative savings rates just “happen”, where we are TOLD we must vote for ridiculous candidates to be a good Republican or a good Democrat, where we are TOLD that we must buy ridiculous securities to be a good investor, where we are TOLD we must borrow ridiculous sums to be a good parent or a good spouse or a good child.

Ben’s point goes way beyond debt, but that’s where he starts. By definition, debt is spending that we “pull into the present from our future selves and our children.” Or as I’ve said often, debt is future consumption brought forward in time.

Debt lets you consume more now, but to repay it you (or someone) must consume less in the future. Used properly, debt can enhance growth enough to cover the eventual repayment. That’s not what is happening—and it’s a big problem in a consumer-driven economy.

However, Ben Hunt observes that the problems can simmer much longer than we usually think. Humans have an amazing ability to postpone the inevitable and—when the subject is debt—a financial incentive to do so. That’s true for both borrowers and lenders.

“The Long Now” is a good way to describe the extended simmering period. At any given moment, you’ll be able to say, accurately, the situation is stable (like right now). Since last December we have seen markets go gangbusters. If you were in US stocks, in a buy-and-hold index fund, you made money and lots of it. Even value and dividend players are scooping up big returns. Remember last week and last year I was worrying about corporate bonds? Silly me…

Not Worth the Risk

A huge amount of money is clearly turning to corporate bonds as it reaches for yield. But then again, why not? The world seems stable. We seem to finally have some progress in the US/China trade wars. The market is telling us everything is okay… much like it did in 2007. Then came 2008.

We are using this stability to justify turning up the heat by adding more debt. There’s no reason to think we will stop. The Institute of International Finance, whose Global Debt Monitor tracks the numbers, says worldwide debt climbed $7.5 trillion in the first half of 2019 to hit $250.9 trillion.

In November, IIF estimated global debt would surpass $255 trillion by year end. If so, it was a 4.8% increase for the calendar year. That’s faster than GDP growth for either the entire world or most developed countries. It’s also faster than population growth in most places.

Let’s think about that number for a second. That growth rate, which there’s every reason to think will accelerate further, means we can expect $400 trillion in global debt by 2030. That’s not counting the $120 trillion in US government unfunded liabilities. My friend Larry Kotlikoff thinks it’s closer to $200 trillion and I think it is reasonable to assume Europe is in that ballpark. They too have made pension and healthcare promises that their budgets can’t deliver without significant deficits (thus more debt) and in general, their tax systems are already stretched to the max.

While longtime readers know I’m against higher taxes, I can do the math here in the US. We are going to have to raise taxes if we want to stay anywhere within shouting distance of fiscal sanity.

That which can’t continue, won’t. It is simply not possible for per capita debt to keep growing faster than the economy in which the debtors live. There are limits. Recent experience suggests they are more distant than many of us thought, but they’re out there.

One last thought. When we do have a recession, which again I point out is likely to be after the election (the only meaningful data point between now and the end of next year), the deficit will explode to over $2 trillion per year and, without meaningful reform, never look back. That puts US debt at $35 trillion+ by the end of 2029.

Here’s a chart Patrick Watson and I made a few months back, projecting deficits at the end of the next recession. We assume CBO spending projections (which are likely low) and that tax revenue falls by the same percentage it did in the last recession.

We worry about US government debt, and rightly so, but it’s only the beginning. Corporations have leveraged themselves to the teeth, and much of that debt could easily turn into government debt.

The last financial crisis revolved around mortgages and related derivatives. Millions learned a hard lesson and spent the next decade deleveraging. Yes, people still get in over their heads but it’s far less common now.

However, that missing mortgage debt has been replaced with additional government debt. The overall debt picture continues to worsen. For the moment, it is sustainable because the economy is growing (albeit slowly, but at least it isn’t contracting).

Lacy Hunt of Hoisington Investment Management tracks a number that ought to give us all cold chills. “Debt Productivity” is the amount of new debt associated with a given amount of GDP growth. Last quarter he found that each dollar of global debt generated only $0.42 of global GDP growth. That was down 11.1% from ten years earlier.
Source: Hoisington Investment Management

Worse, this isn’t a linear trend. We can expect it to accelerate as debt grows faster than GDP. At some point, debt becomes completely about consumption and, as noted, bringing consumption forward means less consumption later.

Debt growth isn’t linear, either. It has risen almost everywhere even without the negative events (recession, war, etc.) that historically drive it higher. We might be in better shape if corporations had, like homeowners, used the last decade to deleverage. They didn’t, in part because central banks made borrowing all but irresistible. Companies borrowed vast sums not because they needed to, but because they could. Often they used it to repurchase their own equity and further leverage their balance sheets.

My friend Peter Boockvar says we no longer have a business cycle, but a credit cycle. Central bank rate cuts encourage us to borrow, which is fun, but they can’t cut forever. Then they stop cutting, liquidity dries up, and we panic. Then we get things like the present repo crisis.

This isn’t lost on the powers that be. There is actually something of a debate going on in monetary policy circles. Some at the Federal Reserve think we are in a Goldilocks era, with everything being just about right, and thus more rate cuts and QE are fine. Others have serious concerns and more than likely really wish to pound on the podium. But decorum says they can’t.

Whatever happens, the visible result is that each recovery phase is smaller than the last. Eventually they will stop being recoveries at all until we “rationalize” the aggregate debt. That’s economist-speak for default/monetization/restructuring or whatever term you want to use. Until that happens, the word “recovery” will be meaningless. We can’t repay debt without growth. We’ll have to liquidate it in some fashion.

How do we do that? Inflation is the historically tried-and-true method. Right now central banks are struggling to generate the kind of inflation that would do this. Maybe they’ll figure it out, but I think default is the more likely outcome.

However, it won’t be the kind of default any of us have ever seen before, or even imagined.

The Great Reset

I said all the above to set up my 2020s outlook. In short, I expect we will rock along sideways in this “Long Now” period. At any given time, we’ll look at the data and think we avoided the worst. We will get some recessions and financial crises, but they’ll look “manageable” after we get through them. Indeed, we will manage them.

What we won’t see is sustained expansion of the strength necessary to finance our debt, which will continue growing as The Long Now progresses. So the debt burden will get heavier, and eventually be unbearable. Then the proverbial stuff will hit the fan.

A couple of years ago in my Train Wreck series, I described a multi-step process.

  • The Beginning of Woes: Something, possibly high-yield bonds, will set off a liquidity scramble. It will spread through the already-unstable financial system and trigger a broader credit crisis.
  • Lending Drought: Rising defaults will force banks to reduce lending, depriving previously stable businesses of working capital. This will reduce earnings and economic growth. The lower growth will turn into negative growth and we will enter a recession.
  • Political Backlash: Concurrent with the above, employers will be automating jobs as they grow desperate to cut costs. Suffering workers—who are also voters—will force higher “safety net” spending and government debt will skyrocket. A populist backlash could lead to tax increases that prolong the recession.

I still expect something like that sequence, though it may be more of a drawn-out, rinse-and-repeat process. I think we could see multiple sequences before a final, market-clearing Great Reset, which I expect in the latter half of the 2020s.

After each recession/crisis, and especially as technology begins to eat into middle-class jobs, expect complete political upheaval every four years at a minimum. The politicians will make promises and they will simply not be able to deliver, and a new group will make different promises that don’t work, either.

The deepening political divide isn’t just left and right. It’s also both sides being frustrated with what they consider to be “elites.” If you’re reading this letter, most of the population would probably put you in that category. Yet you probably don’t feel elite. I sure don’t. I am one of the luckiest and most blessed men in the world, but I certainly don’t think, at least from my very humble beginnings, of myself as anything approaching elite. This disconnect is a big part of the problem.

Philippa Dunne recently said in The Liscio Report that we no longer have a shared sense of reality in this country. We observe the same circumstances with our own interpretation of reality, then wonder why other people don’t see it the way we do.

I look at these problems every day and I have trouble understanding the complexities. The average person? A man hears what he wants to hear and disregards the rest. We have retreated into our social media and personal echo chambers and made them our reality, completely different than that of other groups/tribes.

In online gaming worlds, players “grind” through dungeons and zombies to gain points to move on. In my version of The Long Now, we are now entering the “grinding” phase. We just simply push forward, taking on whatever challenge comes next (whether zombies or central bank policy, which may be the same thing). Meanwhile the debt will keep accumulating, slowing growth but buying yet more “grinding” time.

Eventually we will reach The Great Reset, and it won’t just be another recession or even a depression. It will be a true, world-shaking, generational crisis. My friend Neil Howe talks about the Fourth Turning, a societal calamity that happens every 80 years or so. The last one was World War II. My good friend George Friedman has a forthcoming book titled, “The Storm before the Calm.” He sees two cycles in the geopolitical world, one 80 years and one 50 years, that converge in the late 2020s. Coincidence? Maybe, but it’s just about when I think we will have The Great Reset.

We will see political and social upheaval. The capstone: All that debt will be brought to the market, rebalanced, and the market will “clear” at some new valuation. All asset prices (and every debt is someone’s asset) will reset.

There will be winners and losers. Because we don’t know who will be in political control of any particular place when this happens, it is simply impossible to predict the winners and losers today. Plus technology could change the very nature of international currency markets.

But first we will endure The Long Now. It will look like it can go on forever, and maybe it will. I don’t know the future. But my understanding of history, my perceived reality, says it can’t continue. There will be a reckoning, after which we will see real growth and prosperity. Good times are coming. At least I think and hope so.

The Great Reset won’t hurt everyone equally, or in the same ways. The pain will be unequally distributed. As I said, a lot depends on who controls the process. Politically, populists are gaining power in both left and right wings. Their concerns and priorities differ, but both are anti-elite and both want their favoured groups to have “more” and push the costs on someone else.

That sounds like a formula for violence, and it is, but eventually people tire of fighting and become willing to compromise. Or the market forces them to compromise. That will be The Great Reset—a kind of global do-over. No one will get everything they want, but everyone will get a fresh start. Then the cards will fall where they may.

The unknowable part is how much pain we will have to suffer first. It could be a lot…

The good news is that the grind of The Long Now will let you prepare for whatever comes. And we have many examples of countries going through their own individual “Great Resets.” In the case of Argentina and/or Italy, many times. I have visited both countries and they are wonderful places when they are out of crisis.

That’s exactly what I think will happen all over the world after The Great Reset. It will be a wonderful place to be.

You don’t have to be all alone in The Great Reset. Personally, I can’t think of anything better in any crisis than being part of a tight-knit group of like-minded individuals, whether that is close family or my social and business circles.

I know that talking about The Long Now and The Great Reset sounds gloom and doom. But in my personal life, I am launching new businesses, making plans, investing in new ventures, and seriously contemplating an aging-focused venture capital fund. I see opportunity everywhere I look. Humanity has faced problems before. Our time will be different, but progress will continue.

I am the most optimistic man in the room, if a tad realistic about our economic landscape. I just want to make sure that I am on the other side of the island when that big future economic earthquake hits, and have backup power. Just saying…

The Corona virus is much more than a health crisis

by Brian Kantor knows with any degree of confidence how long the economic disruption caused by the responses to the Corona virus will last. And just how much output and income and wealth (savings) will have been sacrificed.

The survival of any business that services crowds of people is gravely threatened as the Chinese lock-down approach to limit infections is widely adopted.  Collateral damage to those enterprises and the large number of self-employed who depend upon opportunities to earn income generated by airlines and airports, cruise ships, hotels, shops, restaurants, theatres, conference, sporting events and their like, even retailers, will be considerable including damage to the banks and others who provide them with credit. The margin of safety for many businesses and the self-employed is always very narrow. They will need financial reserves as well as assistance from governments to survive the turmoil.

Perhaps as much of 10% of one year’s global incomes and output will be sacrificed to contain the virus. This is an enormous sacrifice that is being made to overcome a virus that we are informed is not that morbid and comes with limited mortality risk. Currently around 350 000 people around the world have been infected. Many have now recovered. The number of victims will surely rise – perhaps treble – before the tide turns if the Chinese evidence is relevant.

What we will never know with any certainty is how many infections and deaths will have been avoided as a result of the shutdowns. Some heartless economist will no doubt attempt to calculate the cost in GDP sacrificed for each death avoided- as well as the present value of the lives saved in the form of future earnings -the narrow economic benefit of saving – mostly old lives. It will be a very large number.

It is obvious that any such cost-benefit analysis has not informed policy in any way. Admirably only potential benefits, numbers of lives saved, have driven the responses made. And taking the pressure off health systems that would otherwise have been overwhelmed by the number of supplicants has been the means to the end of saving more lives. Perhaps when the dust is settled the issue of how to develop a health system capable of responding to an emergency of this kind will be addressed – as a more effective solution than putting people off work.

It is a however a generous response that only a relatively well-endowed society with a large reserve of spending power could possibly make. Without such a reserve to provide relief to those unable to earn any income would suffer terribly for want of life’s essentials. And using the reserve to keep businesses and banks afloat so that they can fight another day also makes good economic sense.

The government spending and financial taps are therefore being opened wide- wider than ever. Central banks are not only creating money to buy government bonds they are also buying shares in businesses and securities issued by them. And are offering loans on generous terms not only to banks but directly to businesses. Taxes are being relieved and postponed and access to unemployment benefits widened. Aid to businesses, for example airlines, will be provided on a large scale. The extra spending so facilitated will reduce the loss of output. It will help pay for itself.

South Africa and too many South Africans have little by way of reserves against economic disasters. Our fiscal space is highly constrained as our Budget proposals have made clear. And raising debt to fund extra spending has become even more expensive for SA after the crisis. Yet monetary policy in SA has lots of room to help our economy. There is room for the Reserve Bank to cut interest rates significantly and to offer financial support for banks and businesses. Our frail economy will need all the help it can get. Let us hope that the Reserve Bank can think – must think and act- beyond the narrow inflation fighting box it has hitherto confined itself.

COVID-19: A Crisis the Fed Can’t Fix

By John Mauldin

John MauldinFor the last 3+ years, I have maintained it would take an “exogenous” event to send the United States into recession. Historically suboptimal growth? Sure, but sub-3% growth isn’t a recession.

The corona virus obviously qualifies as an exogenous event. But that doesn’t mean a textbook two-quarter recession, although it certainly may. Financial markets aren’t waiting to find out what COVID-19 will do. Much of the selling is fear of the unknown. The modern world hasn’t faced anything quite like this, and it’s coming at a time when the economy is vulnerable for other reasons.

We actually face two concurrent crises. One is about public health, the other about the economy and markets. They won’t necessarily track each other. We might find the virus is less deadly and infectious than feared but that the fear itself (plus the control and containment measures) harms the economy.  

After talking to economists and medical researchers this week, I am pretty confident in two things.

First, this is going to be a long slog. The virus will spread slowly but widely. The containment measures are simply buying time. There’s no need to panic, but we should all take common-sense protective measures.

Second, as usual, I am the “Muddle Through guy.” I think we’ll get through this. Not without some damage and tragic loss of life, but it won’t be the end of the world. This is not the zombie virus. I wasn’t thinking of viruses when I said the 2020s would be the Decade of Disruption, but COVID-19 may mark the beginning of it.

Here’s the worst part: The Federal Reserve and other central banks can’t bail us out this time. Their tools aren’t designed for this kind of problem. Powell, Lagarde, Kuroda, and others are all making their ritual pledges to “stand ready” with support. They may even be serious. But they have little to offer. Rate cuts are not vaccines.

We may soon, after a dozen years in monetary policy training wheels, find out if we can still ride a bike.

Y2K Redux

Long-time readers may recall these letters began in the late 1990s when I was writing about the “Y2K” computer problem. Looking back, it is hard to believe how much fear it generated. Some people literally headed for the hills. I said, consistently, we would have problems but get through them. And that’s more or less what happened. A few little glitches, then it was over.

However, the problem was real. Many vital systems would have stopped working on 1/1/2000 had they not been painstakingly rebuilt. We avoided catastrophe because smart people got to work and prevented it. Having that fixed date helped focus their efforts. The corona virus is different in that regard; experts are sure it will spread, but they can’t say how fast.

This week I spoke with (among other experts) Dr. Joseph Kim, the CEO of Inovio. His company (like several others) is working on a COVID-19 vaccine. He’s been in this field many years and knows how these diseases spread. And he believes this one is not going to care about borders. The outbreaks we are now seeing in South Korea, Italy, and other places are only the beginning. This virus’s unique challenge is its ability to spread via “asymptomatic” carriers. With SARS and Ebola, it’s very obvious that someone is sick and contagious. They are relatively easy to avoid. Infection mainly happens with medical personnel and family caregivers. With COVID-19, you can seem perfectly healthy, have no fever or other symptoms, but still carry the virus and spread it to others.

You can also catch the virus, recover, and never know you were infected. We don’t know how often that happens, which makes evaluating the data difficult.

The Chinese data seems to show about a 2% fatality rate among the people who show symptoms and are diagnosed positive. That’s not necessarily everyone who is infected, so the true fatality rate could be lower. 

Dr. Mike Roizen said the problem is we don’t know how many people actually have had the virus and how many died as a result. In calculating a fatality rate, we know neither the numerator nor the denominator with truly accurate precision for the equation. As we get more accurate data, we can make better assessments.

That being said, Dr. Roizen and Dr. Kim both told me this virus is far deadlier than our standard influenza. It appears about 20% of symptomatic people are sick enough to need hospital care, even though most ultimately recover. That’s enough to potentially strain our healthcare resources, generating second-order effects as people with other medical conditions have to wait for treatment.

COVID-19 is unlikely to disappear in warm weather. Hong Kong is always warm and that does not seem to be stopping the virus. The likeliest scenario is that the world now has, in effect, another flu-like virus that will be with us for years. If clinical trials are positive, one or more of the vaccines currently in development could be ready later this year. Many biotech companies are working on it. Moderna said it plans Phase 1 trials to start in April. Dr. Kim cautiously (which is his way) said Inovio’s trials should begin in late spring or early summer.

Multiple vaccines will compete, and we will see which is the most effective. But we are, at minimum, several months away from that point, and the virus is still spreading.

In the absence of reliable information, well-meaning people will try to fill the void and make matters worse. A lot of misinformation is spreading on social media, and sometimes in real media, too. I saw one story calling it an “infodemic.” That’s funny but accurate.

We have better data on the economic impact.

Supply Chains Unlinked

We see many comparisons of this virus to the 2003 SARS outbreak. That one also began in Asia and quickly spread worldwide. There was great concern at the time, but the economic damage proved minor.

China’s economy is both much bigger now and more integral to world trade. Chinese GDP is up 4X since then, and its share of worldwide trade flows has grown 10X. Businesses all over the world depend on Chinese-made components and raw materials, many of which can’t be sourced elsewhere, at least not at the same prices. And “just in time” production means producers don’t have much inventory on hand. Right now, it is dwindling as Chinese factories and ports are either shut down or operating at much-reduced capacity.

Here’s how one expert described it to South China Morning Post (with my emphasis).

“It really is death by a thousand cuts,” said John Evans, managing director of Tractus Asia, a company that has 20 years’ experience helping firms move to China, but which over the past two has had more enquiries from businesses looking to leave. “This is a black swan event and I don’t think we’ve seen anything like it in recent history in terms of the economic and supply chain impact in China and across the globe.”

As I write this, China’s travel restrictions have eased, and businesses are starting to reopen. But schools remain closed, which suggests they are not confident the outbreak is truly under control. Beijing is letting local governments set their own rules, so conditions vary greatly across the country.

The economic problem is that inability to obtain one critical component can shut down an entire factory. In this situation, 95% or even 99% may not be good enough. We could be weeks away from some US and European producers running out of input materials. Then what? Plant closures and probably layoffs.

Worse, some Chinese producers depend on parts from the West, which they may stop buying if their own factories stay closed. That’s not only a potentially huge problem for US semiconductor makers but others as well.

And it’s not just China and not just the virus. Growth was already weakening for other reasons, such as the trade war. Here’s David Rosenberg.

The bottom line is that the corona virus occurred with much of the world experiencing anemic growth after a year in which supply chains were already negatively affected by all the tariff actions. “Phase One” did not completely ameliorate that condition. World growth was the weakest in a decade in 2019 and the latest move by the IMF was to trim this year’s outlook. And that was before the corona virus, which has imposed tail risks for the global economy and financial markets.

A tail risk in the sense that we have such little knowledge about this corona virus, why it is spreading, or how to treat it. The spread of the virus outside of China to South Korea, the other economic giants in Asia, and to Italy, is particularly worrisome. The only thing we know with certainty is that South Korea is a massive exporter and much of its outbound manufacturing shipments are inputs into the global production process. So, the implications for disruption to global supply chains are significant, irrespective of the slowing in the rate of infections in China. The cat is out of the bag.

David’s point about South Korea is important. The outbreak there could well lead to the kind of industrial paralysis seen in China. That would have a quick and severe impact on companies in Japan, North America, Europe, and everywhere else. The Italy outbreak could have a similar but smaller result. Italian authorities responded quickly, but people infected there have already spread it throughout Europe.

Japanese Prime Minister Shinzo Abe has asked schools to close throughout Japan. If the map keeps reddening, factory workers may be told to stay home, too, even if their plants can get the parts they need. This would cascade through the world economy.

Fed Futility

We all learn by experience. For a dozen years now, investors have been rewarded for buying every market dip. Indexes always recovered to new highs, often because central banks delivered some kind of stimulus, or at least promised to do so.

So in one sense, seeing this week’s losses as another buying opportunity is rational. Possibly time will show that’s what it was, but count me dubious. We have known for a long time something would pop the balloon. It proved to be Teflon-coated, impervious to everything bears could throw at it. But bears didn’t create this virus.

Nonetheless, investors are increasingly convinced the Fed will respond with more rate cuts. At year-end 2019, the futures-implied probability of three rates cuts this year was only 20%. Now it’s up to 80%.

Source: WSJ

Note, any rate cuts would be on top of the existing T-bill purchase program and repo market liquidity injections. I think those are more likely to be expanded than reduced.

If it happens, the Fed will be in full-on stimulus mode, akin to 2008–2009. But it probably won’t have the same kind of effect. Peter Boockvar explained this week.

A rate cut won’t bring Chinese factories back online any quicker. And a rate cut won’t get people flying and travelling again until the virus peters out. Either way, the US bond market has already eased for them. The US 10-year yield at 1.37% [now 1.18%! – JM] has essentially cut rates by 45 bps over the past two weeks for those looking to refinance or purchase a home.

Lower rates may ease the cost of buying a car but with car prices at record highs (not hedonically adjusted), it won’t do much. Credit card rates with 3 Fed rate cuts are still near 17% so another rate cut or two won’t help much here. And with respect to a rate cut encouraging more capital spending, the cost of capital clearly hasn’t been a binding constraint on any capital decision for years. Will a rate cut or two ‘ease financial conditions’, aka goose asset prices? Maybe but maybe not.

Monetary policy tools just aren’t designed for this situation. All they can do is stimulate demand, and virus containment measures will make any such demand hard to fill. Fiscal stimulus might help but would also increase the already massive deficit.

In China, the government and central bank are responding with targeted loans to affected businesses rather than macro policy changes. That’s probably the right move, but with debt at such high levels, they really had no choice.

That’s the big risk here. I think investors are about to learn central banks won’t always be there for them in every situation. If the delicate faith that’s kept markets rising should break, then what? It’s a long way down.

So what do we do? In my case, this doesn’t change investment strategy. I am not a buy-and-hold advocate. I’m in funds and professionally managed accounts that can move out of the markets or directly hedge when necessary. Some have already done so. I expect others will do likewise if conditions worsen.

As an aside, bond markets are acting as if this is a massively deflationary event.

Some Silver Linings

  • We must remember that 86% of Americans are employed in the service industry/related areas. The manufacturing industry won’t simply shut down, either. Absent multiple large outbreaks in cities across the US, which would cause serious changes in consumer behavior, the US could prove more resilient than some others. This will be contained at some point and business and consumer life move on.
  • Last week, only a few US labs could test for the corona virus. Clearly, we were massively unprepared, but that is changing fast. As you read this, already 93 labs should have testing facilities. A bedside diagnostic is coming, too, as 70 companies are working on it. The FDA is changing its procedures to allow confirmation at labs other than at the CDC’s main headquarters. This will ease concern by quickly separating actual COVID-19 cases from common colds and flu.

I expect the number of labs which can administer tests to increase dramatically over the next few weeks. New testing kits will come online. I can imagine hospital administrators and staff are beginning to think about how they would handle an outbreak in their city.

  • There is a high probability that vaccines will be available by the end of the year/early next year. We may all be getting an annual vaccine for COVID-19 along with the flu shot.
  • This may seem counterintuitive, but in a certain sense, COVID-19 provides a massive wake-up call to the world. We were not prepared. I, perhaps optimistically, think that will be different in the future. This is not the “zombie virus” of the post-apocalyptic movie genre, but it should make mankind in general, and countries in specific, start thinking about the next, perhaps more serious outbreak.
  • On the economic front, I think it is safe to say that supply chains will be radically different by 2022. Technology was already bringing manufacturing closer to the consumers. I expect that trend to accelerate. That should mean significant capital investment after the COVID-19 problem is contained, providing a nice economic stimulus.
  • Governments everywhere (including the US) need to think about the supply chain vulnerability of certain critical necessities. I don’t mean T-shirts and auto parts. I am thinking of medicines and medical supplies, many of which are now produced in China. Do we need multiple sources? Are some items so critical we should produce them in multiple places within countries? Just asking… This should begin now.
  • I think the base case is that China and Europe enter recession. I would think the US is a coin toss. Because we don’t know of the extent of the potential outbreak, it’s really hard to say. The foreign slowdown will have an effect, but recession isn’t inevitable.

On a personal level, I think we should all just exercise common sense. I asked Dr. Kim if he was cutting back on his travel, including his international travel. His answer was no, life has to go on. Other frequent international travellers I know expressed the same sentiments. Some say they will avoid China, more because they don’t want to land in quarantine upon return than fear of getting the virus. Mike Roizen said he will still be travelling within the US, where he is already scheduled.

I have no way of knowing how far the market will fall. But I do expect this current problem will be solved and life will return to normal. This will represent a good, and perhaps great, buying opportunity.

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