The Investor September 2020

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ShareFinder’s prediction for Wall Street for the next EIGHT months:

The State of Play

By Richard Cluver                    September 2020

Those readers who had the tenacity to plough through to the end of my latest book ‘The Crash of 2020’ which I serialized in this publication will remember that I predicted a global share market crash which would result in a sharp contraction of global monetary value following which central banks would flood the system with money in order to ward off a global depression.

Meanwhile, the propensity of Governments, corporates and ordinary citizens worldwide to take on unprecedented levels of debt, has turned into an orgy that can only end badly. If in simple terms, I might liken debt to the tyre pressure of a car, if it keeps on rising the tyre must eventually burst and that can have very nasty consequences if one is travelling at speed. Accordingly, if you could engineer a slow puncture you might be able to deal with the situation before the inevitable occurs.

Failure to act against the rising threat of global debt potentially threatens the livelihoods of everyone of which the current recession is merely an unpleasant foretaste. A catastrophic tyre burst will destroy the lifetime savings of the majority, likely result in extremist politics and, in the worst case, war! That is what the Great Depression caused.

To continue the analogy, the monetary version of a tyre burst is a catastrophic monetary event like the Black Friday stock market crash of 1929 which ushered in the Great Depression or, closer to our own experiences, the market crashes of 1969, 1987, 2002, 2008 and 2020. Depending upon how governments acted in the aftermath, these resulted in economic recessions of varying intensity during which many businesses either had to retrench workers or shut down. Subsequent unemployment figures have provided a useful snapshot of how well monetary authorities reacted to the problem and, hand in hand with these, gross domestic product contraction figures have provided us with another comparable measure of the extent of the problem. time around an unprecedented 51 percent annualised GDP decline – worse than the prelude to the Great Depression – has graphically illustrated how inept the South African government’s central command approach has been with a resultant three million lost jobs; the likely last nail in the ANC coffin.

In human terms, the most effective indicator of how bad the outcome of such monetary mishandling has always been national unemployment rates which, to give the current government its due, have been rising steadily for the past 40 years as the graph on the right, courtesy of the International Monetary Fund, clearly indicates. Before the pandemic, the South African rate was expected to hit 35.3 percent by the end of this year. That’s not quite as bad as the failed economies of Venezuela at 35.54 percent and Zimbabwe for which no verifiable figures exist, but it is a sobering seven times worse than the global average of 5.4 percent.

More critically, however, when we compare it to the global average, as calculated by the International Labour Organisation in my next graph, we find that unemployment had been rising steadily everywhere since its 2007 low. And then came the pandemic.

In the richest nation on earth, the USA, job losses by employee category are really revealing. In hospitality, tourism and sports, there has been at least a 40 percent decline on last year’s trend while in banking & finance and software development, employment is down 30 percent. Surprisingly, job postings in retail have only dropped 4.5 percent while construction has actually seen gains over last year. In summary, 39 percent of employed people in households making less than $40 000 were furloughed or lost their jobs in March according to US Federal Reserve figures while, in households making more than $100 000, just 13 percent did.

It is easy to conclude that the human cost of economic crashes is such that avoiding them at almost any cost is the most socially desirable objective. The problem is that the only tool governments have to regulate their economies is the money supply. If they allow too much money to flow to consumers, whether they be corporates or individuals, the usual result of too much money chasing after the available supply of goods is a rise in prices…..the long-observed economic law of supply and demand driving prices.

Since money is in reality only a measure of work done, services performed or goods manufactured, printing more money than the collective working efforts of mankind naturally results in the buying power of money shrinking. At its worst, as occurred in Germany between the world wars and is currently happening in Zimbabwe, it results in hyperinflation where, ultimately the money printing presses cannot keep up with the rate of monetary devaluation and you need wheel barrow loads of money to buy simple items like loaves of bread.

However, if governments are too aggressive in trying to curb the money supply, the result would be a repeat of the Great Depression when critical levels of unemployment result and become so entrenched that it is nearly-impossible to get the economic engine running once more. And just to complicate things further, throwing money at the problem does not yield immediate results. It can take months for the effects of economic stimulation to get through to the factory floor where jobs are actually created.

Furthermore, it is taking ever greater amounts of money-creation to impact upon the economic pace of nations. Thus the aftermath of the unprecedented increase in global money supply after the 2008 market crash defied the orthodox economists who expected runaway inflation to result. That it did not has given rise to a growing groundswell belief in something known as Modern Economic Theory which is sending chills up the spines of conservative economists because they believe that Central Banks have, in allowing such massive money creation, probably lost the ability to control inflation if it begins to run away.

And technically, if you consider what is happening to the gold price, runaway inflation is what investors worldwide believe we already have…in its very worst form when it is combined with economic stagnation. If you doubt that, consider my graph which shows that since September 2018 the price of gold in US Dollars had been rising at an annual rate of 26.1 percent (red trend line) until July this year when it exploded upwards at a compound rate of 104.6 percent (green trend line).

So, on balance, creating new money seems a good idea, until you lose control. I doubt, however, if anyone could have anticipated the extent to which new money would have been created by the US Federal Reserve. Using the M2 monetary measure which includes cash, checking deposits, savings deposits and money market securities which is the statistic most favoured by economists, US money supply rose on average by $0.34-trillion annually from January 1980 when the total stood at just $1.6-trillion to January this year when the total stood at $15.39-trillion…

Then between January and August this year, it grew at 15 times that rate to put on $3-trillion. That is over ten times the stimulation that was necessary to take America out of the 2007 “Great Recession.”

Such numbers are generally incomprehensible to we ordinary folk so, to put it into perspective, consider the graph below courtesy of the Federal Reserve Bank of St Louis:

And this unprecedented rate of stimulation seems to be working. In the US where good economic record-keeping provides a reasonable picture of what is happening, unemployment initially soared to 14.7 percent in April this year from a long-existing average of 3.6 percent. But as the graph on the right illustrates, since then unemployment has nearly halved once more.

However, inflation is rising rapidly as well. It is up ten-fold since its May level of 0.1 percent but, to be fair, it is still only half the moving average rate of the seven months before America locked down.

With most world governments creating new money to try and ward off a depression, how much new money has been created? Well, the total value of all of the world’s money this month was $95.7-trillion. But that number pales before the mountain of debt the world has incurred since the demise of the Gold Standard. For every dollar in circulation there is $2.64 of debt. Relative to total value of all of the world’s money, the total accumulated debt of governments, corporations and households is $253-trillion which is, in turn 322 percent of global GDP.

It is crudely divided into four roughly equal sections: non-financial corporates owe collectively 29.5 percent of the debt, governments 27.4 percent, households 24.3 percent and the financial sector 18.8 percent of total debt.

The total accumulated debt is, moreover 2.83 times the total value of all the world’s stock markets which is currently estimated to be $89.5-trillion.

But the figure that truly dwarfs all of these is the total value of the world’s derivatives market which, at its minimum is set at $558.5-trillion while the ‘Notional value’ could be as high as $1-quadrillion. For the uninitiated, the notional value of a derivative is the value of the contract multiplied by its “strike price” which is the value that the underlying security has to reach before the derivative becomes active.

The notional value therefore represents the effective total exposure of derivate traders; a number which neatly explains why derivatives are the tail that wags the world economic dog.

Now I know I have lost most of you. But before you switch off, let me explain that a quadrillion is a thousand-trillion. That is 1 followed by 15 zeros while a trillion is thus 1 followed by 12 zeros and a billion is one followed by 9 zeros. Work that out and you will see that the notional value of all derivatives is TEN Times the total monetary wealth of the world and, as anyone who has ever dabbled in derivatives can tell you, it’s a number that can change like lightening in response to global monetary fears.

That is why the world economy is today subject to such frightening volatility; why we can be enjoying a relative boom today…as we were at the end of 2019…. and two months later be headed for a depression. The latter description is frequently used but few really understand what it means. So let me explain that a recession is defined as a severe contraction of the economy lasting more than two quarters while a depression is defined as a severe contraction lasting two or more years. Thus, we will only know if South Africa is in depression if its economy is still contracting by the end of next July.

Put that another way, President Ramaphosa and his team have another ten months to turn the economy around if they do not want to be labeled as being responsible for South Africa’s worst economic mess in a century!

Of course it is not just South Africa. The world is currently experiencing its worst contraction since the Great Depression of 1929 which began when the then greatest Wall Street stock market bubble burst in October 1929. The subsequent depression is nowdays blamed on the then relatively new and inexperienced US Federal Reserve which, alarmed at the bubble-like rapid rise in share prices, began raising interest rates in an attempt to defend the Gold Standard.

The way central banks seek to prevent such bubbles when, in their view too much money is in circulation, is to effectively withdraw money from the system and thereby raise interest rates. When too much money is circulating such that the demand for goods and services increases beyond the ability of manufacturers and service providers to deliver within a reasonable period, prices consequently rise…the phenomenon we all know as “inflation.”

In the 1920s, on top of the massive destruction of money which resulted from the Black Friday share market crash, the US Federal Reserve kept withdrawing money from the system and continuing to raise interest rates until they had effectively contracted the amount of money in circulation by a third.

Since the initial effect was a seemingly desirable reduction in the prices of goods and services at an average rate of ten percent a year, the Fed’s actions seemed to be working But then, in the expectation of further price declines, people began delaying purchases in the expectation of even better prices and, for example, real estate prices fell by a third.

In this latter example, when the average home owner realized that his mortgage to the bank was significantly greater than the price he could obtain by selling his home, people simply mailed their front door keys to the bank and did a flit. Then, as now where South African banks like ABSA have seen their profits decline between 92 and 97 percent as a result of enforced provision for bad debt, back in 1929 banks faced collapse sending waves of monetary panic throughout the global economy. Monetary governance rules are, however, far better today and few observers fear that South African banks will collapse.

The Great Depression began in August 1929 and didn’t end until June 1938. Fortunately, the world has only experienced one Great Depression during which the average annual decline in gross domestic product exceeded anything previously experienced. But the following GDP decline figures look positively benign when compared to the present.

1930: – 8.5%

1931: – 6.4%

1932: – 12.9%

1933: – 1.2%

1938: – 3.3%

During that time U.S. economic output fell from $1.1 trillion in 1929 to $817 billion in 1933, even after removing the effects of deflation. Prices fell 27% between November 1929 and March 1933 while world trade plummeted 66% between 1929 and 1934. By 1933, the unemployment rate had climbed to 24.7% and for those who remained employed, manufacturing wages fell 34% between 1929 and 1932.

All of this explains why the world’s central banks acted in concert in 2007 to pour money into the system when, following a five-year bull market, Wall Street collapsed as a result of the “Sub Prime loans affair. Briefly, the then bull market which had lasted from October 2002 to October 2007 had been fuelled by a torrent of new money that had been manufactured by the commercial banks through a combination of bad mortgage loans to people who had no ability to fund them together with financial excesses made possible by the derivatives market – the tail that now wags the global monetary dog.

It was a system destined to fail and, when it did in October 2007, Wall Street again collapsed. When the market bottomed in March 2009 it had lost 51 percent of its peak value and that massive monetary contraction would undoubtedly have sparked another Great Depression had the banks not acted in a coordinated fashion using the process of “Quantative Easing” to both lower interest rates and create massive amounts of new money. By this action they managed to restore confidence among panicked bankers, who had been unwilling to lend to each other for fear of taking on each other’s subprime mortgages as collateral.

The global result, however, was that all this surplus money remained in the system fuelling the next, longest share market bull run in modern history which saw the Dow Jones Industrial Index rise 46-fold from a low point of 692 649 in March 2009 to a peak on February 12 this year of 29 568 570.

The problem this time around, however was excessively low interest rates. At 1.58 percent when the pandemic crashed world markets in February this year, the US Federal Funds rate, that is the interest rate at which depository institutions (banks and credit unions) lend reserve balances to other depository institutions overnight, had barely increased since the Sub-Prime Crisis rate. So as the graph on the right shows, the Fed did what it could and lowered rates to 0.05 percent and, as it telegraphed this month, it intends holding these rates for the foreseeable future.

Simply put, central banks have now created so much money that it effectively has no value which is why, if you want to deposit money in a German bank today, you have to PAY THE BANK to look after it. It’s called negative interest rates

Just to put South Africa into that picture, our current fear is that government debt will soar to 85.6 percent of GDP by the end of 2021 as a result of pandemic spending. Happily, only a tenth of that debt is denominated in foreign currency and the average maturity profile was 13 years as we entered the current financial year. In actual numbers that debt totaled $11.6-trillion…that’s 11.6 followed by eight zeros representing just 4.58 percent of global debt or less than half a percent of the notional value of global derivatives.

So, we are small fry indeed. Nevertheless we will be buffeted by the same waves of monetary expansion and contraction as the global whales. So, it is instructive to note what happened to global inflation in the aftermath of the 2008 monetary crisis when that figure rose from 2.77 percent in 2009 to a peak of 5.08 before falling back to a low of 2.77 percent in 2015/16. That figure does not look like much but it was an effective inflationary gain of 83.4 percent.

Here in South Africa, as the next graph on the right illustrates, inflation had been on the rise from -1.63 percent in 2003 to a peak after the stimulatory effects of the monetary crisis to 9.31 percent before it began retracing once more. We thus entered the pandemic at 4.1 percent in March and it continued falling to hit a low of 2.1 percent in May, its lowest level in a decade, before beginning to rise once more to reach 3.2 percent in July.

So, what will happen to us if we simply replicate the 2008 experience and get a 10.94 percent absolute gain which would lead us to an effective rate of 13.04 percent. You might not think that is much but at that rate the buying power of the rand will HALVE in five and a half years. Given that the global money supply doubled in the past few months, the greatest increase in monetary history, we might expect a rather worse situation than inflation of just 13.04 percent; to hazard a guess it is likely to at least equal to the all time high of 20.70 percent of January of 1986.

South Africa is, however, a minnow in the raging sea of monetary tempest in which the untested idea of Modern Monetary Theory is taking control. America’s problem, like that of most major nations is the welfare state. Providing the dole, subsidized housing and free health care for billions of people who are unable to contribute to the tax base has seen national debt soar and, if normal interest rates prevailed, many governments would now be past the debt levels where the cost of servicing them would exceed all government income; where default would be inevitable.

Keeping interest rates low has thus become a leading nation necessity which is why it has become essential to promote the Modern Monetary Theory idea that it is possible to keep printing massive amounts of money without the inevitable inflationary consequence.

Not everyone is, however, able to duck the consequence of excess debt. Indebted individuals and businesses are now carrying so much debt that the resultant servicing costs are making it impossible for them to save. Capital creation stagnation is thus a global problem which, I believe, explains why markets are not overheating and inflation is remaining relatively low.

There are other issues as well. Many of the major nations are plagued with the problem of rust belts. Their industrial heartlands are defined by shuttered factories and unemployment because their domestic manufacturers have been unable to compete with smokestack countries like China. If you like, we have arguably been in the grip of a world depression which has been concealed by Welfare Statism and Modern Monetary Theory. That is why, for example, Donald Trump won the US presidential race by promising blue collar workers he would give them back their jobs. True to his promise he thus initiated a trade war with the rest of the world, imposing protective tariffs that have massively disrupted world trade. That similar actions during the Great Depression were a major reason why the depression lasted as long as it did, seems not to have worried the Trump administration. Nevertheless America’s trade balance has remained stubbornly negative.

Now, however, when trade sanctions are allied to monetary expansion, things are beginning to swing in favour of the US. That, presumably, is why the Governor of the US Federal Reserve, Jay Powell, has just announced that he does not think inflation is likely to be a problem and that the Fed’s long-term policy is to keep interests rates at an all time low. So it is no surprise that the value of the US Dollar has been falling quite precipitously relative to the Chinese Yuan. As the graph on the right shows, the dollar exchange rate has fallen from $7.1624 on May 28 to $6.82295 on September 2.

The result is to make Chinese goods relatively more expensive for US consumers which, the administration hopes will help restore the competitiveness of US manufacturers. But the process seems to be VERY slow and, as the graph below illustrates, the deficit has been growing steadily. In July it surged to $63.6-billion which is the highest level in 12 years. And, as I have already illustrated, US inflation has begun to rise.

For investors, the opposite of Fed policy is desirable. You do not want to put your money into a country where the value of the currency is declining unless the underlying assets that you buy are growing faster than the rate of monetary erosion. That is why, for example, investment capital has been flooding out of South Africa because of a stagnant economy and a declining monetary base. But change is in the wind which is why I believe the majority of local fund managers and investment advisers are wrongly advising their clients to send as much money as they can to overseas destinations and particularly to the US.

Booming Wall Street share prices have until recently justified their case but US GDP growth does not. The US economy has in fact been in decline since 2014 as my next graph illustrates.

Moreover, US corporate profits have been in sustained decline for nearly a century as illustrated by the declining revenue that the US Government is able to collect in taxes.

Now, while a declining currency increases a nation’s trade competiveness, primary producer nations like South Africa are enslaved by commodity prices over which they have no control.

Thus, when the minerals we produce start gaining in price at the same time as our currency has been weakening, we get a double benefit as is illustrated by the Rand price of platinum which, as illustrated by the green trend line in my next graph, has gained since its February low to its August peak at a compound annual average rate of 39.6 percent. This can be expected to feed into the local economy in a quite spectacular fashion.

Old market hands well understand how the South African economy as a whole is geared to the commodity cycle, how in time the profits of secondary industry start to rise a year or two down the line as mining prosperity spreads to the rest of the country. While the green line takes in the significant recent price gains since the Chinese economy began to recover from the effects of the pandemic, the red line is a mean which measures the longer-term trend at an also remarkable compound 18 percent.

Furthermore, long-term price gains are not confined to platinum. Iron ore prices, pictured below, have nearly trebled since their low point of $40.5 a ton in December 2015 to a current $108.52 and, of course, the gold price has, as I earlier illustrated, been rising since September 2018 at an annual rate of 26.1 percent until July this year when it exploded upwards at a compound rate of 104.6 percent.

Thus, the future is clearly in the hands of the ANC which has in the past so convincingly illustrated how it is able to destroy the golden opportunities of a rising commodity cycle. The last one passed us by thanks to a failed mining charter and the current failure of Eskom could do the same the second time around. Nevertheless the opportunity exists for our economy to boom once more and, with the world’s second worst unemployment rate, we dare not miss out this time. I hope President Ramaphosa and Energy Minister Gwede Mantashe clearly understand the responsibility they will bear if we miss out again.

Meanwhile, there remains the question of global debt which must eventually either blow out into a global depression or a globally-orchestrated wave of inflation designed to unscramble the greatest accumulation of debt the world has ever seen. This wave is now beginning and investors face two choices; it will either drown you or you can box clever and ride the crest of the wave. Investments like sovereign debt will drown you while Blue Chip shares will enrich you. That much of the future is in your hands!

Tencent may be next

The New York Times

Although the Trump administration’s fight over TikTok is attracting the most attention, buzz is building in Washington about another Chinese tech giant: Tencent. We teamed up with our colleagues Ana Swanson and Erin Griffith to examine what’s at stake. (A representative for Tencent declined to comment.)

Tencent is a true internet colossus. The 22-year-old company has a market cap of more than $630 billion. It owns WeChat, a multi-feature messaging app with over one billion users worldwide, that was recently thrust into legal limbo by the Trump administration (discussed in more detail by the Deal Professor below). Tencent is also a prolific tech investor, taking stakes in hundreds of start-ups during the last decade.

Over the past five years, it has been a part of more than 40 U.S. transactions with a combined value of more than $16 billion, according to Dealogic.

• Its investments in U.S.-based companies have included Activision Blizzard, Epic Games, Riot Games, Snap, Tesla and Uber.

The U.S. government is now interested in Tencent’s past deals. A 2018 law gave the Committee on Foreign Investment in the U.S., or Cfius, more resources to investigate transactions — including minority investments — that closed without being reviewed by the panel. The law also more specifically defined control of personal data as a national security concern. It gives the government the ability to investigate any deals that Tencent did not submit to government review.

• People involved in the creation of the rules said that they were developed largely to deal with a surge in Chinese investors taking minority stakes in Silicon Valley companies and a new appreciation of the power of personal data.

There are limits to the government’s powers. The Cfius panel can’t simply investigate any deal — it first must determine whether one qualifies as a “covered transaction.” There’s no specific calculus for arriving at that conclusion, but the panel’s staff asks about corporate governance, access to certain kinds of personal data (credit card information, for example, doesn’t typically qualify) and nonpublic financial information. If the panel determines that a deal is both reviewable and a potential concern, it can proceed with a full investigation (which is not always made public). That could lead to a recommendation that the president unwind the transaction.

The Tencent inquiries have already begun, with Cfius reaching out to gaming companies, including Epic Games and Riot Games:

• Tim Sweeney, the C.E.O. of Epic, described Tencent, which bought a 40 percent stake in his company in 2012, as a “really awesome partner, purely supportive, never hostile — and never in the least bit attempting to insert China influence into anything we do in the world outside of China.” He acknowledged a Cfius inquiry, adding that his company would “be participating in the process wholeheartedly.”

• A representative for Riot declined to comment.

Unwinding Tencent’s past deals would be a major escalation in the U.S.-China tech war. Along with Alibaba and Baidu, the company is a global symbol of China’s might. Chinese officials have said that the threat of a U.S. ban on WeChat “undermined the global market order.” They are said to be assembling a list of American companies to ban in China, including Cisco, should they need to respond in kind.

PSG and Capitec – Shareholders’ (un)bundle of joy

By Professor Brian Kantor

By unbundling Capitec, PSG has done the right thing for shareholders – but shareholders remain skeptical about its prospects.

PSG shareholders should be pleased. The decision to unbundle PSG’s stake in Capitec has delivered approximately R7.85bn extra to them. This estimated value add for PSG shareholders is calculated by eliminating the discount previously applied to the value of the Capitec shares held indirectly by PSG.

Without the unbundling, the discount applied to the assets of PSG would have been maintained to reduce the value of their Capitec shares. The market value of the 28.1% of all Capitec shares unbundled to PSG shareholders, worth R960 a Capitec share, would have been worth R31.4bn on 16 September. These Capitec shares might have been worth 25% less, or nearly R8bn, to PSG shareholders, had it been kept on the books.

 The PSG holding in Capitec had accounted for a very important 70% of the net asset value (NAV) or the sum of parts of PSG. Before the unbundling cautionary was issued in April 2020, the difference between the NAV and market value of PSG, the discount to NAV, had risen to well over 30%. The difference in NAV and market value of PSG was then approximately R20bn in absolute terms. The discount to NAV then narrowed to about 18% when the decision to proceed with the unbundling was confirmed.

 Now with the unbundling complete, PSG again trades at a much wider discount of 40% or so to its much-reduced NAV. Capitec and PSG delivered well above market returns after 2010. By the end of 2019, the Capitec share price was up over 18 times compared to its 2010 value. By comparison, the PSG share price was then 10 times its 2010 value, and the JSE 2.1 times.  The Capitec share price strongly outpaced that of PSG only after 2017.

The Capitec and PSG share prices, compared to the JSE All Share Index (2010 = 100)

The Capitec and PSG share prices, compared to the JSE All Share Index chart

Source: Iress and Investec Wealth & Investment

The better the established assets of a holding company perform, as in the case of a Capitec hare held by PSG or a Tencent held by Naspers, the more valuable will be the holding company. Its NAV and market value will rise together but the gap between them may remain wide.

Investors will do more than count the value of the listed and unlisted assets reported by the holding company. They will estimate the future cost of running the head office, including the cost of share options and other benefits provided to managers of the holding company.  They will deduct any negative estimate of the present value of head office from its market value. They may attach a lower value to unlisted assets than that reported by the company and included in its NAV.

Investors will also attempt to value the potential pipeline of investments the holding company is expected to undertake. These investments may well be expected to earn less than their cost of capital, in other words, deliver lower returns than shareholders could expect from the wider market. These investments would therefore be expected to diminish the value of the company rather than add to it. They are thus expected to be worth less than the cash allocated to them.

To illustrate this point, assume a company is expected to invest R100 of its cash in a new venture (it may even borrow the cash to be invested or sell shares in its holdings to do so). But the prospects for the investments or acquisitions are not regarded as promising at all. Assume further that the investment programme is expected to realise a rate of return only half of that expected from the marketplace for similarly risky companies. In that case, an investment that costs R100 can only be worth half as much to its shareholders. Hence half of the cash allocated to the investment programme or R50 would have to be deducted from its current market value.

All that value that is expected to be lost in holding company activity will then be offset by a lower share price and market value for the holding company – low enough to provide competitive returns with the market.

This leads to a market value for the company that is less than its NAV. This value loss, the difference between what the holding company is worth to its shareholders and what it would be worth if the company would be unwound, calls for action from the holding company of the sort taken by PSG. It calls for more disciplined allocations of shareholder capital and a much less ambitious investment programme. The company should rather shrink, through share buy backs and dividends, and unbundling its listed assets, rather than attempt to grow. It calls for unbundling and a lean head office and incentives for managers that are linked directly to adding value for shareholders by narrowing the absolute difference between NAV and market value. Management incentives, for that matter, should not be related to the performance of the shares in successful companies owned by the holding company, to which little or no management contribution is made. 
On that score, a final point directed towards Naspers and its management: the gap between your NAV and market value runs into not billions, but trillions of Rands. This gap represents an extremely negative judgment by investors. It reflects the likelihood of value-destroying capital allocations that are expected to continue on a gargantuan scale. It also reflects the cost of what is expected to remain an indulgent and expensive head office

The risk of inflation is rising, leaving many investors exposed

By Coronation

Long-term inflation, to a large extent, is not something you can forecast. Many predictions are made with great care and diligence, yet they are often wrong.

The reason is that future inflation is heavily influenced by human traits such as expectations, perceptions and confidence levels. These are all subject to changing mental models, new narratives and emotions. Much like the future direction of the equity market, no one can predict exactly what will happen next. 

But, despite the inflation bears being wrong for a very long time, what is becoming clearer is that the risks of higher inflation over the medium to longer term are building. And if you are not correctly positioned for the possibility of higher inflation as an investor, you need to take note. 

Why have the inflation bears been wrong for so long?

The American economist and Noble prize winner Milton Friedman famously said, “Inflation is always and everywhere a monetary phenomenon.” According to his monetarist theory, when the quantity of money increases faster than the rate of economic growth, consumer prices will rise.

In practice, however, it hasn’t always worked out that way. 

One recent example of a large monetary expansion that didn’t result in any meaningful inflation was the period following the Global Financial Crisis (GFC) in 2008. Many expected all the new money being created as a result of quantitative easing (QE) to spur inflation. While QE may have created asset price inflation, it did not create inflation at the consumer level.

The likely reason why inflation remained low over the past decade is that the velocity of money – the rate at which money is exchanged through economic activity – did not increase meaningfully. The GFC was first and foremost a financial crisis, caused by concerns about the health of bank balance sheets. Post the crisis, the focus was on repairing balance sheets, which included a reluctance by banks to lend.

So why are we more concerned about inflationary risks today?

There has been a relentless increase in global government debt as a result of the response to the Covid-19 pandemic. The IMF expects the ratio of global government debt to GDP to increase by 19 percentage points this year. Historically, debt growth has never been this quick outside of wartime. And future crises linked to big-ticket societal problems, such as climate change or inequality, may very well be declared emergencies that require similar ‘whatever it takes’ responses, serving as justification for a further big expansion in debt.

In addition, many of the structural drivers that underpinned decades of benign inflation have peaked or are starting to move in the opposite direction. Interest rates have declined dramatically and in many parts of the world have hit the zero bound. Two decades ago, most bonds offered yields above 5%. Today, nearly 90% of bonds yield less than 2%. Politicians are also starting to exert more control over monetary policy, threatening central bank independence, and globalisation (the major engine of low prices and rapid growth over the past three decades) is in reverse gear as populism, nationalism and protectionism are on the rise. 

All this new debt will have to be repaid eventually

There are a number of ways in which repayment can happen (about which you can read more here). When debt can’t be repaid through growth alone and default is unpalatable, higher inflation provides a route out of the quandary. Couple higher prices with financial repression, where governments adopt policies that result in savers earning a rate of return below inflation, and debt can gently be inflated away over time.

What does the prospect of inflation mean for investors?

We recently looked at three very different scenarios to show the impact of inflation on long–term investors: the period of hyperinflation in Germany (1921-1923), high inflation coupled with rapid economic growth in the UK post World War II (1947-1970) and high inflation coupled with low economic growth in the US (1968-1982). While these scenarios are not necessarily representative of what will translate in future, they provide useful perspective on a range of outcomes that have historically prevailed.

The key insight from all of the inflationary scenarios is that while economic conditions have an impact on the quantum of the returns realised by investors, equities outperform bonds in all periods of rising inflation.

But too many investors are incorrectly positioned for an uptick in inflation

Unless you have been primarily invested offshore or in cash over the last five years, returns have been disappointing. Over this period, most multi-asset portfolios are about 4% to 5% p.a. short of investors’ expectations. 

As a result, many investors —retirees in particular— have de-risked by moving out of diversified multi-asset portfolios, resulting in very significant overweight positions in cash or income funds. By our calculations, between R200 and R300 billion worth of capital is currently too conservatively invested in South Africa. 

The potential problem for these investors over the medium to long term is that if you are not invested in real assets and inflation starts to tick up, the effect on your savings will be dramatic over time. Cash yields are much lower than they used to be (close to half of the level at the start of 2020) and will remain so for some time to come.

For example, our expectations for income fund returns over the next 5 years have declined by roughly 3% compared to prior annual returns of between 7 and 9%. 

How do you make your money work harder?

For the foreseeable future, the perceived safety of cash or near-cash investments may become a trap for investors, especially in the event of a possible resurgence in inflation over the medium to longer term.

In a tough economic environment, where financial repression (through lower interest rates over the longer term) may become a necessity, we question the ability of cash to provide appropriate inflation protection, especially when considered relative to alternatives such as more diversified multi-asset portfolios.

To protect yourself against the risk of inflation, we believe it is more sensible to include real assets (such as selected global and domestic equities, infrastructure and property, or inflation-hedged asset classes such as inflation-linked bonds and precious metals) as part of your portfolio. The appropriate exposure level depends on your ability to take risk. 

Those who have de-risked their portfolios over the last five years, or who may have invested too conservatively to begin with, need to consider taking action to increase the risk in their portfolio to an appropriate level.

For 27 years, we’ve actively managed funds that can weather the times, whatever they might be. Over the long term, a well-diversified multi-asset portfolio with a wide mandate and adequate exposure to growth assets remains one of the most robust approaches to protecting your purchasing power. If you’d like to learn more about our approach to building resilient portfolios, visit DM

COVID-19 Compared to Spanish Flu, Great Depression

By Peter Cohan

Reproduced from Forbes Magazine in April

I am certain of one thing about COVID-19: nobody on the planet knows how much death and damage to the economy and stock prices it will ultimately wreak.

Compared to previous catastrophes like the so-called Spanish flu of 1918 and 1919, COVID-19 has so far caused far fewer deaths. As of the morning of April 6, 2020, 70,530 people had died from COVID-19 out of 7.8 billion people on the planet – that represents 0.0009% of the world population.

Back in 1919, when the globe hosted 1.8 billion people, Spanish flu had claimed the lives of an estimated 50 million people – 2.8% of the world’s population. The Great Depression’s toll on the economy, employment and the stock market was ultimately much worse than the damage so far inflicted by COVID-19. How much worse will that damage get?

During the Great Depression which began in 1929, GDP plunged 50% from $105 billion in 1929 to $57 billion in 1932. One reason for the drop in GDP was deflation – between 1929 and 1932, the average level of prices fell 30% — wiping out those who were obliged to repay debt in currency that was not adjusted for inflation, according to the balance.

Nobody knows how much economic contraction will be caused by COVID-19. On March 31, Goldman Sachs predicted COVID-19 would cut U.S. GDP by 34% in the second quarter of 2020 and by 6.2% for all of 2020.

Morningstar constructed several scenarios and its base case envisioned a 5% decline in 2020 U.S. GDP – roughly in the middle of its optimistic and pessimistic scenarios. Morningstar expects global GDP to decline 1.4% in 2020 akin to what happened in the 2008 recession (and a big change from the 3.4% global growth it had predicted for 2020).

These forecasts seem optimistic when considering that Moody’s estimated that with the closure of counties that account for 96% of U.S. national output, U.S. daily output has plunged about 29% since the first week of March 2020, according to the Wall Street Journal. If that 29% drop continues for two more months, U.S. output would be down 75% in the second quarter of 2020, Moody’s chief economist Mark Zandi told the Journal.

The Great Depression caused an exceptionally high level of joblessness. Between 1928 and 1932, the unemployment rate soared from 3.2% to 24.9% – the highest rate in American history, according to the balance. By April 2, U.S. jobless claims in the previous two weeks had totalled nearly 10 million. That day, the U.S. reported about 6.6 million jobless claims, according to CNN, nearly 10 times more than the previous weekly high of 695,000 in 1982.

Goldman Sachs predicted that unemployment in the U.S. would spike to 15% in the second quarter of 2020, according to CNBC. However, The St. Louis Federal Reserve estimated in March 2020 that the unemployment rate could hit a whopping 32% amid 47 million layoffs, according to CNBC.

Zandi emphasized that his model did not take into account the economic effect of how much less all the millions of newly unemployed will be spending — which is particularly relevant given that 70% of economic growth (or decline) is related to consumer spending.

As measured by the percentage of decline, the hardest hit in the Great Depression were those who owned stock. Between 1929 and 1932 the stock market lost 90% of its value and took a quarter of a century to recover to its pre-crash level, according to the balance. The 2008 financial crisis cut the Dow roughly in half. From its October 2007 peak of 14,164.53.1, the Dow fell 53% to bottom out at 6,594.44 by March 2009. 

So far COVID-19 has slashed the value of stocks less severely. By April 3, the S&P 500 had fallen about 26% from its February 20 peak. I have struggled to find anyone willing to predict how much further stocks will fall.

Implications for Leaders:

Since nobody knows what the future will bring for the world during this pandemic, I agree with those who are constructing base-, optimistic- and worst-case scenarios. Scenarios force decision makers to be explicit about their assumptions and to think about contingency planning — what they can do to make things better under each scenario.

Whether you are running a country, a hospital, a restaurant, or a videoconferencing company, one common set of assumptions have to do with how soon the number of new COVID-19 cases drops and dwindles close to zero.

The answer to that question varies by location and by how effectively social distancing and shelter in place policies are implemented. My guess is that two other factors are critical: the ubiquitous availability of effective and quick COVID-19 tests and how soon a safe and effective COVID-19 vaccine can be developed.

Without the tests, any workplace where people would congregate every day cannot safely reopen. Once such tests are available, the healthy can be admitted and the infected can be treated without endangering people in the workplace. And until a vaccine is widely available — which optimistically is not expected for 12 to 18 months — there is little chance of things returning to normal.

Morningstar’s base case and optimistic scenarios would return things to normal in the U.S. sometime in the summer. Its base case assumes a three-month broad shutdown that ends in April or May 2020.

In this scenario schools reopen during the summer resulting in a more moderate second wave of infection through the end of 2020 as treatments to mitigate symptoms become available. In the optimistic case, businesses mostly reopen by June 2020 as treatments for COVID-19 become available.

Morningstar’s pessimistic scenario envisions too many people failing to comply with self-distancing policies, overwhelming the U.S. health care system as a COVID-19 treatment remains elusive.

What should investors do?

The answer depends on your cash position, cash burn rate, and how long you think it will take for stocks to rise again. If you need the cash to survive, sell. If you can keep going without selling your stocks, keep investing every month.

A contrary view!

Why deflation is a bigger risk for the global economy than inflation

By DANIEL MOSS Bloomberg

With gold above $2,000 and central banks flooding the world with cash, the prospect of surging inflation is again starting to exert a grip on the minds of investors. Concern is premature: Deflation remains the bigger threat.

There’s little sign of a meaningful spurt in consumer prices, even after five months of unparalleled easing in fiscal and monetary policy to combat the pandemic. Not that you’d know it from some market commentary. Believers in a looming inflation spiral cite gold’s almost daily records and a slide in the dollar. Inflation expectations as measured by the U.S. 10-year breakeven rate have risen by more than a percentage point to 1.6% from a 12-year low in March. The Federal Reserve has contributed to the zeitgeist with its insistence that it isn’t even thinking about raising interest rates, amid signs the economic recovery will be unimpressive enough to warrant further stimulus.

It may all prove another false dawn. Bumps in consumer prices across Asia last month don’t disrupt the essential story of the past decade: Inflation just isn’t firing and remains significantly below the modest targets of around 2% typically set by central banks.

The crushing of economic growth by Covid-19 has exacerbated this phenomenon, notwithstanding vigorous stimulus from budgets, steep cuts in borrowing costs and the re-emergence of quantitative easing. The collapse in global demand is more powerful than a runaway printing press.

If there is a runaway train approaching, it’s impossible to discern in the figures yet. Consumer prices in Tokyo, usually a leading indicator of Japan’s national numbers, rose 0.4% in July, the government said Aug. 4. That’s up from 0.2% the past two months and above the 0.1% advance forecast by economists. Separate numbers showed Japan’s monetary base rose almost 10% from a year earlier. Neither changes the overall picture that inflation will be hard-pressed to reach even half the Bank of Japan’s 2% target within three years.

The same day in South Korea, the national statistics office said inflation picked up to 0.3% last month. That’s better than June’s zero and May’s negative readings and consistent with signs the economy is brightening. But it’s well below the Bank of Korea’s 2% goal. Inflation believers might have found a fillip in Chinese data released Monday that showed consumer prices climbed 2.7% from a year earlier. Massive flooding that forced food prices up is the culprit, though, rather than virus-induced choke points. A peek at the core index, which excludes such volatile measures, shows China’s inflation is the lowest in a decade.

If Indonesia doesn’t give inflation hawks pause, it’s hard to imagine what might. The republic committed the ultimate heresy in the eyes of hard-money types when the central bank agreed to monetize government debt. In normal times, this would have investors running for the exits, given that monetization is supposed to rob authorities of inflation-fighting zeal. But these aren’t normal times. Indonesian inflation was the lowest in two decades in July. Far from plunging, the country’s bonds were Asia’s top performers last month and third among 47 global markets.

The odds that U.S. inflation will exceed 2.5%, assumed to be the Fed’s tolerance threshold, aren’t trivial, say economists at Cornerstone Macro LLC in Washington. Yet deflation remains far more likely. Only once in the 46 years that Cornerstone tracked was deflation a greater spectre than it is today, and that was for a brief interlude during the global financial crisis.

So what if inflation does genuinely spike, as opposed to merely picking itself back up off the floor? The cost of allowing prices to overshoot is nothing compared to the misery that will be inflicted if this wrenching slump is allowed to linger.

That means the onus is on those who argue that inflation is the danger to prove their case. In 2010, in the aftermath of the Great Recession, a group of economists, academics and money managers sent an open letter to then Fed Chairman Ben Bernanke warning that the central bank’s quantitative easing program risked inflation and currency debasement. It didn’t happen. Having cried wolf too loudly then, such voices should be treated with caution this time around.

Ultra-accommodative monetary policy and a bias toward slow draining of fiscal waters is warranted. If and when the inflation bogeyman finally arrives, it may seem like a good problem to have. – Bloomberg

SPAC Attack: everything a founder or investor should know

By John Luttig

If you’re a founder or investor, you may be wondering what this SPAC thing is that everyone is talking about. And it is even more momentous than the press lets on: there is a frenzy of operators and investors within Silicon Valley that are either forming SPACs or investing in them, many of which are still under wraps. Keep your eyes peeled for high-profile venture funds and operators coming out of the SPAC woodwork in the coming months, as the kings of the SPAC game shift from Wall Street bankers to Silicon Valley techies.

Hot takes range from SPACs “disrupting IPOs” to being “a lousy deal for companies going public”. There’s a philosophical underpinning to the SPAC debate: SPACs let us dream of a world in which companies aren’t dependent on stodgy bankers to go public. In theory, this world is fundamentally more decentralized and equitable.

But putting philosophy aside, as a founder going public, choosing the wrong path could cost you and your team millions in cash and equity. I found it surprisingly difficult to find a balanced and accessible introduction to SPACs and their tradeoffs, so I compiled everything you need to know.

What is a SPAC?

A SPAC is a Special Purpose Acquisition Company. In layperson’s terms, this means a shell company is formed, raises money from investors, IPOs immediately after, finds a late-stage private company, then merges with them so that the late-stage private company is now public. From the SPAC sponsor’s viewpoint, it’s like running a growth or PE fund that can only make one investment. From the late-stage company’s viewpoint, it’s a quicker and easier alternative to an IPO, corporate M&A process, or private fundraise.

Why now?

SPACs have been around since the 1990s – why are they now back in vogue?

Let’s not get carried away, SPACs are still relatively niche. There is $25B of SPACs looking for targets right now, which is the equivalent of one large PE firm – pretty small. And only $34.4B across 139 SPAC-driven transactions took place between 2017-2019, compared to $128B across 512 IPOs in the same period.,c_limit,f_auto,q_auto:good,fl_progressive:steep/

There are a number of reasons why SPACs are gaining public attention today – and record market volatility and retail investor trading volume have a lot to do with it.

Recent successes: SPACs have historically lost money for the SPAC shareholders, underperforming the market by 3% per year between 2010 and 2017. But there have been some recent high-profile successes in the past couple of years, all generating strong returns within a matter of months:,c_limit,f_auto,q_auto:good,fl_progressive:steep/

Robinhood era: IPO bankers typically target companies with revenue scale and a clear path to profitability, whereas SPACs historically have targeted companies that’d otherwise struggle to IPO in a stable manner via a traditional banking process. In contrast to IPOs, SPACs are empowered to acquire more “exciting” businesses – in industries like space exploration, fantasy sports, or electric vehicles – that may appeal to retail investors (read: Robinhood traders). The recent Fisker SPAC announcement, for example, led to a 67% increase in the SPAC’s stock in a matter of days – what Robinhood trader wouldn’t want to see Tesla-style gains from a copycat player? Another electric vehicle example: a SPAC called VectoIQ had their stock jump 3.4x pre-merger on solely the rumor of buying pre-launch electric trucking firm Nikola! Retail investors should be aware that these aren’t always premium companies.

VolatilityVolatility can make IPOs expensive for companies going public. If your investment bank is too conservative and encourages you to price your equity at half of its public market value (euphemized as an “IPO pop” or “high coverage”), you’re diluting yourself and your team twice as much as you need to. This effect is particularly acute in a year like 2020, when volatility is the highest it has been since 2008. High volatility periods make it preferable to lock in a price if you can – which is exactly what SPACs accomplish.

Institutional credibility: SPAC sponsorship used to be a common fee-generating strategy among tier 2 or 3 PE funds. While the SPAC sponsors made money through guaranteed fees, the investments themselves often lost money, which led to adverse selection on the deals. In the past few years, tier one names like Apollo, Michael Klein, Bill Ackman, and Chamath Palihapitiya have begun sponsoring SPACs, popularizing the process for higher quality companies. We’ve also seen top tier banks step in to facilitate SPAC IPOs. Increasingly, there are tech-forward people thinking about SPACs, both as sponsors and investors.

Decreasing structure: SPACs were historically used as an LBO equivalent with heavy deal structure: management changes, earn-outs, secondary sales, debt financing, and other financial engineering tools.

Today, SPACs are becoming truer to an IPO-equivalent – fewer management changes, and a greater focus on technology companies with high growth potential.

Shifting access from private to public: In the dot com era, the conventional wisdom was to IPO after six quarters of revenue growth. This left massive gains for public investors – Amazon, Apple, Microsoft all saw 800x gains after their IPOs.

But then VCs got greedy. By the Softbank Vision Fund era, the IPO window had shifted massively: conventional wisdom has been to stay private until you simply can’t raise any more private capital – which could get you to a $50B+ valuation. This minimizes gains for public investors.

Will the 2020s see a goldilocks IPO window? That’s one promise of SPACs – at scale, SPACs should help to shift the IPO window earlier for companies with a more nuanced story. This gives public investors access to great companies early, and unlocks liquidity for early investors, employees, and founders.

SPACs vs. the alternatives

As a founder, does it make sense to take your company public via a SPAC? This is mostly a question of alternatives – corporate M&A, PE buyout, direct listing, or a traditional IPO.,c_limit,f_auto,q_auto:good,fl_progressive:steep/

From the founder’s perspective, the closest alternative to a SPAC is a bank-led IPO. Existing shareholders get to keep the same upside potential, and the company ends up public either way. Unlike an IPO though, the process for the company is shorter – on the order of 4-6 months instead of 18 for an IPO. This makes SPACs generally less disruptive and closer to a financing round or M&A process in terms of team overhead.

There are a few key differences from a traditional IPO:

The “IPO pop” myth: SPACs reduce the market volatility inherent in an IPO process, since you’re negotiating a fixed price with a single buyer. When you IPO, you don’t have a concrete sense for pricing until you run a full roadshow process with bankers – and if pricing changes during your roadshow, it’s too late to change banks and too expensive to cancel the process. Recent bank-led IPOs like nCino show how bad of a deal IPOs can be for late-stage companies.

As Bill Gurley pointed out, if your IPO is 50x oversubscribed, that probably means the existing shareholders are getting a bad deal. I spoke to Jay Ritter, professor at the UF Warrington College of Business, who shared how egregious IPO pops can be: of the 58 operating company IPOs in the first six months of 2020, the equally weighted average first-day return was 31%, higher than any year since the dot com bubble. This means that $130m in existing shareholder value was left on the table per IPO! Admittedly, investors can’t pull this money out until their lockup is over and the float is substantive, but the cultural encouragement of the IPO pop is a clear market inefficiency. Bankers are playing an iterated game with IPO investors, but a one-time game with your company. Bankers need to make sure they don’t lose money on their IPO underwritings, but don’t forget that a post-IPO pop is a direct wealth transfer from existing shareholders to IPO investors.

Deal structuring flexibility: In the SPAC universe, it is more common to have milestone-based compensation for execs, contingent SPAC fees, secondary sales, and other deal structures that can align company and investor incentives. Every facet of SPACs is bespoke, so the sponsor and the company can negotiate management incentives, secondary sales, dilution, debt, lockup periods, or any other bells and whistles they want. While this is theoretically possible via IPOs, they tend to have more rigid deal structures than SPACs.

Financial forecasts: S-1s prohibit companies from including financial forecasts. SPACs, on the other hand, have a private due diligence process which allows companies to present financial forecasts. This opens up SPACs to merge with more vision-driven or high-growth earlier stage companies, where the trailing financial profile is not representative of the company’s trajectory.

Will SPACs eat IPOs? Probably not. IPOs still have a lot of benefits for founders:

Potentially higher price: Founders may not want a guaranteed SPAC price if the IPO price could (in theory) be even higher.

Fees: IPO fees can be lower than SPAC fees, depending on the company and deal structure. I expect that over time, the fee structure of SPACs will become more compelling as PIPE:SPAC ratios increase (fees taken primarily as % of SPAC), warrants come down, and more founder-friendly SPAC sponsors come onto the market over the next 2-3 years.

Control: Founders have more control over their press cycle and investor base.

Culture: There is still a big cultural premium on “ringing the bell”.

Some businesses are structurally better suited for IPOs today – particularly those with 1) a straightforward growth and margin story, 2) a clear set of comparable public companies, and 3) strong pre-existing investor demand. But as SPACs mature and become increasingly founder friendly in terms of fees and pricing, an increasing percentage of companies may be better off going public via SPACs.

SPAC sponsor timeline

From the SPAC sponsor’s perspective, the timeline from SPAC formation to closed transaction can take anywhere from 5 to 30 months.

💰 Raise SPAC, IPO (2+ months): This can take as little as 45 days (but could be much longer), where the key bottleneck is your ability to raise a few hundred million dollars for a blank check.

SPAC investors are buying into your ability to find a great late-stage acquisition target, with no certainty as to what that company may be. This period involves auditor engagement, SPAC incorporation, S-1 preparation, SEC filing, a roadshow, and closing / funding the IPO. The average SPAC size was $230m in 2019 across 59 deals. The convention is to price SPAC equity at $10 per share, and the shares trade within a narrow band around $10 until an acquisition target is found. Pre-merger SPAC shares may trade at a slight premium if investors are confident in the SPAC sponsor – e.g. Hedosophia II, run by Chamath Palihapitiya, was trading around $13/share at the time of this article despite still searching for an acquisition target. There are currently 99 active SPACs seeking acquisition targets.

🔍 Find acquisition target (6-18 months): SPAC agreements typically allow for a 24 month window to find and acquire a company. During this period, the SPAC is a public company with nearly blank financial statements. Given the merger itself takes 4-6 months, the SPAC sponsor must find their target in the first 18 months in the SPAC’s lifespan.

The SPAC sponsor typically comes up with a list of target late-stage companies, and engages each one to better understand their business and financing needs.

🤝 Execute transaction (4-6 months): The execution of the acquisition takes 4-6 months, requiring due diligence, preliminary tender offer documents, and 8-K filings. SPAC investors must then approve the transaction, which is the biggest risk in the de-SPAC process – if they reject the transaction, it means deal renegotiation or back to the search process. During the tail end of this process, the SPAC sponsor will coordinate a second group of investors who invest into the company alongside the SPAC via a PIPE (private investment in public equity).

PIPE investments typically accompany the de-SPAC transaction, which essentially adds more equity leverage to the SPAC. SPAC sponsors coordinate the PIPE capital raise from hedge funds and PE firms, who are tagging along for the ride. The ratio of PIPE to SPAC money is typically between 2:1 and 3:1. This means that a $400M SPAC could effectively generate a total transaction size of $1.2-1.6B.

There will be fees of around 20% of the size of the original SPAC (excluding the PIPE amount), which goes to the SPAC sponsor in the form of equity – this effectively means a blended fee of 5-6% for the company as a percentage of total capital raised, fairly similar to the 5-7% for a traditional IPO. SPAC fees are mostly equity-based to align the SPAC sponsor and the company, in contrast to the primarily cash-driven fees for IPO bankers. SPAC fees can also be performance-triggered to incentivize fair pricing, such that a portion of the fees will be withheld unless the stock price crosses a certain threshold. Some SPACs use outside bankers to execute the de-SPAC process, which can add some cash fee overhead.

🕴 Manage investment: After the acquisition, the SPAC sponsor looks like a large investor, where they can take a board seat or two. For more PE-style SPACs, this could involve active management and control by the SPAC sponsor. I expect the SPACs of the 2020s, run increasingly by techies, to adopt the founder-friendliness ethos that defines Silicon Valley.

SPACs often incorporate warrants and earn-outs to further align sponsor and company incentives. This gives the SPAC investors the right to purchase additional stock post-merger, unlocking asymmetric upside for them. These equity and milestone-driven compensation structures tend to align investors and companies more than the historical SPAC structures that were focused on squeezing out fees.

Future of SPACs

Between direct listings and SPACs, banks will no longer be the sole gatekeepers of what goes public. And the SPAC sponsors may shift from structure-oriented PE firms to tech-forward VCs – there are natural synergies given late-stage VCs’ synergies with their existing portfolio companies and access to the best companies. I view this as an inevitability as VC firms build out an array of products to support companies throughout their entire lifecycle – a critical leap towards building Sand Hill Sachs.

As SPAC fees compress and founder-first SPAC sponsors enter the market over the coming months, they’ll become an increasingly compelling option for founders to take their companies public.

Bankers that lean into SPACs will get to capture more company upside and sell their services earlier in the company lifecycle. Those that don’t should be nervous: SPACs may be another step in the startup value creation process that slips out of their hands, and into the hands of private investors.

SPACs won’t disrupt IPOs entirely. But they give us hope of a future where companies can go public independent of the archaic and conservative banking institutions that have misaligned incentives on valuation and fees. I think this hope is well-founded. The SPAC model is more decentralized and ad hoc than the bank-led IPO model, which should be good for founders and investors alike. SPACs aren’t for every company, but every founder should consider them as an alternative path to going public.

Inflation Virus Strikes Fed

By John Mauldin

One little-noted aspect of central bank policy is how rarely “policy” happens. Officials at the Federal Reserve and elsewhere long ago learned how to achieve their goals without actually doing anything. Creating perceptions is often enough to modify people’s behaviour.

For instance, if traders simply believe the Fed will intervene should interest rates go above or below a certain level, rates probably won’t breach that level, or even get close to it. No one wants to make the Fed pull its trigger. This is why central banks are so obsessed with “credibility.” They don’t want to actually use their monetary firepower, and they don’t need to use it as long as financial markets respect it. Their most-used weapons are just words.

We saw another example in late August when the Fed unveiled changes to its long-term monetary policy strategy. Among other things, they now say they will let inflation “run hot” for extended periods in order to achieve a 2% long-term average. Reasonable minds can differ on whether that’s a good idea, or whether the Fed can actually do it. But the Fed certainly wants us to believe its new plan. We know this from the enormous effort placed on communicating it.

The problem is that one person’s “policy” is another person’s unintended consequences. Today I want to argue that the unintended consequences from recent Fed “policy” changes, not to mention those initiated in prior decades, have been at the very epicenter of some of the national problems we have. The Fed would vigorously deny this course, but the results are plain for all to see.

We’ll begin with how some of my trusted sources view this Fed move. But first, I’ll let the Fed speak for itself.

Words Are Policy

You may have noticed a pattern recently. Jerome Powell’s speeches and media interviews usually coincide with some kind of significant policy move. I’m sure Powell gets all kinds of invitations. Not by accident, he accepts those he finds useful.

And sure enough, shortly after the Fed revealed its latest change, Powell was online to explain/defend it via his pre-arranged Jackson Hole virtual address.

Here is what the Fed itself characterized in a press release as “the more significant changes.” 

  • On maximum employment, the FOMC emphasized that maximum employment is a broad-based and inclusive goal and reports that its policy decision will be informed by its “assessments of the shortfalls of employment from its maximum level.” The original document referred to “deviations from its maximum level.” [One small word, so much meaning.]
  • On price stability, the FOMC adjusted its strategy for achieving its longer-run inflation goal of 2 percent by noting that it “seeks to achieve inflation that averages 2 percent over time.” To this end, the revised statement states that “following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.” [We’re going to have to unpack these words carefully. It’s hard to even begin with the variety of potential for negative unintended consequences in these innocuous words.]
  • The updates to the strategy statement explicitly acknowledge the challenges for monetary policy posed by a persistently low interest rate environment. Here in the United States and around the world, monetary policy interest rates are more likely to be constrained by their effective lower-bound than in the past. [Am I the only one who is confused? They feel challenges from monetary policy caused by low rates that they have in fact engineered. It’s kind of like saying that adding water to gasoline poses challenges for the proper operation of your automobile.]

We’ll get into what all that means below. For now, savor the irony of a central bank explicitly admitting it “seeks to achieve inflation” at all, never mind the level. Central banks once sought to stop inflation, not achieve it. Now generating it is the goal. Congress, which created the Fed, mandates that it create “stable prices.” In a kind of Orwellian twisting of language, the Fed now interprets the mandate to mean 2% inflation. That means the value of your dollar loses about half its purchasing power every 36 years. At a minimum. As we will see, it can get worse.

No doubt aware of this, the Fed went to great lengths to explain itself. Linked here you will find an overview, the statement itself, a marked guide highlighting changes since the last review (very handy), Powell’s Jackson Hole presentation, speeches by Vice Chair Richard Clarida and Governor Lael Brainard, and a bunch of background documents.

Why such elaborate explanation? Because the words don’t just explain the policy. The words are the policy. They do the work. The Fed wants us to believe 2% inflation is a worthy goal and that the Fed will make it happen. If we do, the Fed will have accomplished what it wants.

Price Instability

My friend Peter Boockvar may be one of the fastest thinkers I know. Every day, he digests the latest economic data and central bank statements and then issues a quick-take analysis, usually within an hour (and sometimes within minutes). I really don’t understand how he does this, but it’s quite useful.

So the very same morning the Fed announced this policy, Peter was out with a short but incisive essay on “The 10 Flaws of Inflation Symmetry.” Some excerpts:

  • Where inflation was in the past should have no bearing on where it should be allowed to go in the future. Is zero inflation one year and 4% the next the new definition of ‘price stability’?
  • Letting inflation run above 2% for a period of time hurts the least able to afford it the most. In other words, LOWER real wages is a growth depressant.
  • There is nothing to equate low inflation with low growth and higher inflation with higher growth.
  • Longer term interest rates are not just going to sit there and let inflation run hot, they will tighten for the Fed. This would then hurt the housing sector and any overindebted company.

Peter starts where I would, with the glaring inconsistency between the Fed’s “price stability” statutory mandate and its official policy promoting the opposite. And that reducing real wages by raising living costs hurts most of the people the Fed supposedly serves.

But more important, Peter notes how this policy is self-defeating. If the Fed by keeping short-term rates low somehow gets inflation moving toward its goal, long-term rates will still rise to reflect the greater inflation risk. This will raise mortgage rates, make it harder for companies to issue equity, and otherwise stifle economic growth.

Why anyone should want that outcome is unclear, but it’s where the Fed wants to take us.

Ideas Have Consequences

The concept of a 2% inflation goal simply did not spring full-blown out of the blue, like the goddess of wisdom Athena from Zeus’s head. It has been discussed in academic circles for quite some time.

I was able to attend a small invitation-only symposium in Boston some seven or eight years ago. It was under strict Chatham House rules but I can tell you had a “Who’s Who” of economic and financial talent. One panel in particular was seared into my mind—a Nobel laureate economists and another economist whose name you probably know. There was general agreement that a 2% inflation target should be the minimum inflation target. One Nobel laureate espoused letting inflation run 4% for a period of time. There was discussion and pushback from some of the audience. An overall very enlightening session.

But the point is that the concept of a 2% (or more!) average inflation level, running even hotter at times, has been discussed in economic circles for many years. It has now reached into the Fed proper. I am sometimes asked why I pay attention to discussions among academic economists. These discussions can become a preview to “policy.” Ideas have consequences, and ideas pushed by those with prestigious academic authority have more consequences.

“One Hell of a Dilemma”

Another oddity is that the Fed has already generated ample inflation, but it’s not visible in the indexes policymakers watch, like the Fed’s preferred “Core PCE” measure.

Back in January, before the pandemic hijacked the news, I explained in Nose Blind to Inflation how none of the benchmarks truly capture the full inflation picture. Everyone experiences inflation differently based on their lifestyle and spending patterns. Yet the Fed indiscriminately forces the same strategy on everyone.

My friend Danielle DiMartino Booth and her Quill Intelligence colleagues recently explained how the Fed ignores the rising healthcare and housing costs that plague most American households.

Core PCE [Personal Consumption Expenditures] understates to the greatest degree of any inflation metric the cost of healthcare and housing. “Systematic” is the word that comes to mind when you look at the hard data. According to the Organization for Economic Cooperation and Development, in the United States, the average married worker with two children paid an 18.8% tax rate in 2019. In a January 2020 report, Harvard’s Joint Center for U.S. Housing reported that the median asking rent for an unfurnished unit completed between July 2018 and June 2019 was $1,620, 37% higher, in real terms, than the median for units completed in 2000. Median income in 2019 was $63,688.

Back of the envelope math based on take home pay of $51,714 gets you to 37.6% that renters were spending out of their pay checks on rent last year. The PCE gives housing a 21.4% weight.

In other words, core PCE captures only 56% of the median family’s rent, but families don’t have a choice to pay only 56% of their rent. Healthcare costs are similarly undercounted because PCE imputes them from Medicare and Medicaid reimbursement rates that are far lower than those paid by most individuals and their private insurers. And that’s without even considering today’s higher premiums and deductibles.

This isn’t a small problem. It is enormously consequential, as the Daily Feather analysis explained.

The core PCE they hide behind is, at best, duplicitous. Fed officials would, however, face one hell of a dilemma if they owned up to a metric that captured true pricing, including that of assets. Inflation would long ago have run so hot we wouldn’t be in the mess we are while interest rates would be normalized sending the zombies where they belong – not just dead but buried.

Inflation is already “running hot” for most Americans, but the Fed doesn’t see it. Core PCE serves the same function as those blinders you used to see on carriage horses. The difference is that horses don’t voluntarily blind themselves. The Fed does, and as a result has kept interest rates artificially low and let zombie companies take over the economy.

Why would the Fed do this? Because using a more accurate benchmark would force them to get serious about price stability, and that would limit their ability to “stoke” the engine of the economy. PCE lets them pretend inflation is low and achieve their unwritten policy objective of keeping the stock market bubbling along.

The Unintended Consequences of Federal Reserve Policy

A few thoughts on the Fed’s twisting the concept of stable prices into a 2% inflation goal.

1. As noted above, 2% inflation cuts the buying power of your savings in half in just 36 years. Combined with a 0% interest rate policy, it means retirees following safe and prudent standards are guaranteed to lose buying power.

Whether you are just beginning to save for retirement, or you are already retired, such a policy makes you run faster just to stay in the same place. Yes, I understand that in a heavily indebted nation there is a perceived “need” for some level of inflation to lower the burden of debt. But lowering one man’s debt burden simultaneously reduces another man’s buying power.

All the words that the Federal Reserve used to describe this new policy never reveal exactly what time period they will use to achieve “average” 2% inflation. That makes a huge difference. It could mean letting inflation run at, say, 4% for several years while keeping short-term interest rates near zero. Does anyone seriously believe that will have no consequences!?!?

2. It follows from the above that at 4% inflation, longer-term interest rates would rise. This, of course, is not what the Fed wants. There is another “policy” being discussed in academic circles today: yield curve control. Will they have to control government rates all along the curve? That will have consequences, too.

Further, the Fed now owns about a third of all US securitized mortgages. One. @#$%5ing. Third. Great for homebuyers. Will they continue this policy? How long? Will the US securitized mortgage market become like the Japanese bond market? That is to say, controlled by the central bank? The Federal Reserve is not buying jumbo loans. Does that mean jumbo loans will rise with inflation, shutting out wealthier people from buying homes, or at least larger homes, and driving down those home prices? Unintended consequences…

This massive manipulation of the bond market and the most important price in the world, the interest rate of the global reserve currency, is nothing but plain and simple price control. Can someone show me an instance where significant price controls actually worked over the long-term? Especially in a market this big? In the world’s reserve currency?

3. Which brings us to another unintended consequence, or at least I assume it is unintended. This is going to have a result of putting significant downward pressure on the dollar, causing commodity prices and US consumer prices to rise and exporting deflation to the rest of the world. The Aussie dollar is already up by 27%. The Europeans are complaining.

4. It is clear that the extraordinary quantitative easing has boosted equity prices. Not to mention home prices. That means that those with homes and equities have seen their net worth increase. For most of us reading this letter, that’s a good thing. But it also increases wealth and income disparity, which is tearing at the nation’s psychological roots. I don’t believe anyone at the Federal Reserve wants to increase wealth disparity, but that is the clear and obvious unintended consequence/result of their “policy.

5. My friend David Bahnsen highlighted another point in a recent market commentary. Quoting (emphasis mine):

But the impact of present Fed policy on the stock market extends well past the zero interest rate policy. In fact, rate policy has not even been the monetary tool that has most impacted markets. The explosive interventions into debt markets, either through direct bond purchases (quantitative easing) or liquidity provisions (commercial paper, corporate debt, asset-backed securities) has had an incalculable impact on equity markets.

Besides the basic reality of $3 trillion (and counting) of new reserves in the banking system and liquidity that finds its way into financial assets far easier than it does the real economy, how significant is it to corporate profitability to have borrowing costs reduced to their lowest level in history? Fed interventions in the corporate bond market (shockingly, both investment grade and high yield) have created extraordinary access to capital for companies that know how to use that capital quite productively.

This pendulum shift cannot be overstated—many companies went from challenging business conditions with high cost of debt and limited access to new debt that they needed for this difficult time, to instead, less challenging conditions with brutally low cost of debt and unlimited access to capital needed for this time and useable for growth measures after this time. That shift from “what could have been” to “what is” in credit markets is the most underappreciated factor driving equity markets today.

6. The combined impact of all this means that the Federal Reserve is putting its thumb on the scale between Wall Street and Main Street, between the haves and have-nots, between the wealthy and the middle class, let alone the poor. Not the intent, I get that. Powell and company are doing what they think will keep the economy moving forward. But unintended or not, the consequences are still there. Is the average man on the street unjustified in thinking that “the elites,” whatever the hell that means, are not looking out for his best interest? When a struggling corporation accesses the debt markets because the Federal Reserve made it easy to do so, they are acting in the best interest of their shareholders. They are simply trying to stay afloat in a crisis. But restaurants, hair salons, and small businesses in general don’t have that same access because they don’t have the same experience or connections.

We have come to this situation because a progression of “policy” decisions by the Federal Reserve and the US government backed us into a corner. No matter who wins the election in November, they will have no good choices. A $2 trillion deficit is not a good choice. And $2 trillion may not be enough to keep the wheels from falling off the economy.

Small business America is getting slammed. It is clear that at least 100,000 small businesses will permanently close. That number could double over the next year. Every one of those businesses represents jobs, including many jobs for lower income Americans. Which is where the brunt of this crisis is being directed.

That is why I wrote a few weeks ago that the economy should be viewed as having three parts. One is doing quite well, we could maybe even characterize it as in a boom. One is in a recession of indeterminate length, but is managing. A smaller but significant chunk is clearly in a depression. And you wonder why emotions are running high?

I hope you can see the Federal Reserve’s words, and the changes in its “policy,” have consequences. And particularly troubling is the consequences that they did not intend.

How Much Computational Power Does It Take to Match the Human Brain?

By Joseph Carlsmith

Let’s grant that in principle, sufficiently powerful computers can perform any cognitive task that the human brain can. How powerful is sufficiently powerful? I investigated what we can learn from the brain about this. I consulted with more than 30 experts, and considered four methods of generating estimates, focusing on floating point operations per second (FLOP/s) as a metric of computational power.

These methods were:

  1. Estimate the FLOP/s required to model the brain’s mechanisms at a level of detail adequate to replicate task-performance (the “mechanistic method”).1
  2. Identify a portion of the brain whose function we can already approximate with artificial systems, and then scale up to a FLOP/s estimate for the whole brain (the “functional method”).
  3. Use the brain’s energy budget, together with physical limits set by Landauer’s principle, to upper-bound required FLOP/s (the “limit method”).
  4. Use the communication bandwidth in the brain as evidence about its computational capacity (the “communication method”). I discuss this method only briefly.

 None of these methods are direct guides to the minimum possible FLOP/s budget, as the most efficient ways of performing tasks need not resemble the brain’s ways, or those of current artificial systems. But if sound, these methods would provide evidence that certain budgets are, at least, big enough (if you had the right software, which may be very hard to create. Here are some of the numbers these methods produce, plotted alongside the FLOP/s capacity of some current computers.


These numbers should be held lightly. They are back-of-the-envelope calculations, offered alongside initial discussion of complications and objections. The science here is very far from settled.

For those open to speculation, though, here’s a summary of what I’m taking away from the investigation:

  • Mechanistic method estimates suggesting that 1013-1017 FLOP/s is enough to match the human brain’s task-performance seem plausible to me. This is partly because various experts are sympathetic to these estimates (others are more skeptical), and partly because of the direct arguments in their support. Some considerations from this method point to higher numbers; and some, to lower numbers. Of these, the latter seem to me stronger.3
  • I give less weight to functional method estimates, primarily due to uncertainties about (a) the FLOP/s required to fully replicate the functions in question, (b) what the relevant portion of the brain is doing (in the case of the visual cortex), and (c) differences between that portion and the rest of the brain (in the case of the retina). However, I take estimates based on the visual cortex as some weak evidence that the mechanistic method range above (1013-1017 FLOP/s) isn’t much too low. Some estimates based on recent deep neural network models of retinal neurons point to higher numbers, but I take these as even weaker evidence.
  • I think it unlikely that the required number of FLOP/s exceeds the bounds suggested by the limit method. However, I don’t think the method itself airtight. Rather, I find some arguments in the vicinity persuasive (though not all of them rely directly on Landauer’s principle); various experts I spoke to (though not all) were quite confident in these arguments; and other methods seem to point to lower numbers.
  • Communication method estimates may well prove informative, but I haven’t vetted them. I discuss this method mostly in the hopes of prompting further work.

Overall, I think it more likely than not that 1015 FLOP/s is enough to perform tasks as well as the human brain (given the right software, which may be very hard to create). And I think it unlikely (<10%) that more than 1021 FLOP/s is required.4 But I’m not a neuroscientist, and there’s no consensus in neuroscience (or elsewhere).

I offer a few more specific probabilities, keyed to one specific type of brain model, in the appendix.5 My current best-guess median for the FLOP/s required to run that particular type of model is around 1015 (note that this is not an estimate of the FLOP/s uniquely “equivalent” to the brain – see discussion in section 1.6).

As can be seen from the figure above, the FLOP/s capacities of current computers (e.g., a V100 at ~1014 FLOP/s for ~$10,000, the Fugaku supercomputer at ~4×1017 FLOP/s for ~$1 billion) cover the estimates I find most plausible.6 However:

  • Computers capable of matching the human brain’s task performance would also need to meet further constraints (for example, constraints related to memory and memory bandwidth).
  • Matching the human brain’s task-performance requires actually creating sufficiently capable and computationally efficient AI systems, and I do not discuss how hard this might be (though note that training an AI system to do X, in machine learning, is much more resource-intensive than using it to do X once trained).7

So even if my best-guesses are right, this does not imply that we’ll see AI systems as capable as the human brain anytime soon.

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