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“International big business has made revolutions before now to safeguard its interests. At one time it made them … in the name of Liberty, Equality and Fraternity. Now, with Socialism to fight, it makes them in the name of Law and Order and Sound Finance. Assassination? If an assassination is going to be good for business, then there will be an assassination.” — Eric Ambler, The Mask of Dimitrios

Earnings Yield to 10-Year Treasury Yield

The ratio of S&P 500 earnings yield (earnings divided by price) to the 10-year Treasury yield, at the end of March, was at its highest level since 1949.

The year 1949 was a great time to invest in the stock market, as the market bottomed in June thereupon began one of the greatest bull markets in US history.

The US equity market was, however, trading at a trailing price-to-earnings multiple of 6.6x and 10-year treasury yields were 2.3 per cent. The challenge faced by long-term investors and asset allocators today is the S&P 500 is trading above 20x trailing earnings and long-terms yields are below 1 per cent.

Of course, as we have discussed in recent weeks, shifts in market structure make valuation metrics, relative or absolute, broadly speaking, unsuitable for temporal comparisons that stretch across multiple market regimes. Rather, valuation metrics are best used as an investment decision making tool when markets are mean-reverting. That is, valuations are most suitable for comparisons within individual market regimes but not across them.

The Lay of the Land

The Federal Reserve by announcing its decision to purchase exchange traded funds that buy high-yield debt, which sparked the biggest rally in junk bonds in more than a decade, has instituted a regime change.

The Fed’s balance sheet will begin to creep into lower and lower rungs of the corporate capital structure. Eventually crowding out private capital by outbidding on price first (i.e. lowering yields below the point of economic profit) and then by becoming the only game in town.

Private capital, other than that mandated or regulated (read: forced) to participate, will first exit the investment grade market and then the high yield market. The question then is, where will private capital be re-directed. The answer is probably more of the same: stocks, leveraged buyouts, growth equity and venture capital. For liquid market participants, occasional bouts of volatility notwithstanding, we may soon enter a phase where the adage of ‘there is no alternative’, or more colloquially TINA, once again becomes the reason to be long stocks.  

Away from capital markets, the economic impact of the decisions made by the Fed and the US Treasury may prove to be even more weighty.

The Fed’s decision to, in effect, backstop the investment grade and junk bond markets will almost definitely entice the assumption of ever greater amounts of leverage by corporations — even though businesses as a whole are already over leveraged. Second, in an environment where the once financial truths of the time value of money and credit risk have been suspended, there will be further misallocation of capital away from productive activities to financial engineering. Lastly, with independent workers and smaller enterprises lacking the staying power and the captive legal expertise to navigate bail-out claims, the biggest benefactors of this crisis will be entrenched “big business”. This will, we think, further the sense of inequality as losses are once again socialised and profits remain the privilege of the very few.

We neither mean to pontificate nor to bemoan the realities. Our intention is to describe the lay of the land so that we be better placed to navigate markets.

COVID-19 Virulence

The above chart, in log scale, is of the aggregate confirmed cases of COVID-19 in the US, UK, Sweden, Brazil, India and New York State.

Obviously, we are not epidemiologists and do not want to pretend to be either. Some points are worth noting, however.

First, be it because testing for the virus is increasing linearly, social distancing measures are working or the COVID-19 is not as virulent as feared, the increase in confirmed cases is no longer increasing exponentially. Of particular note is the flatlining in New York State, hitherto the epicentre of the pandemic in the US.

Second, unless there is systematic underreporting of cases, the trajectory of confirmed cases in Sweden, which has not enacted social distancing measures, suggests that the widespread ‘closure’ of economies may not have been necessary.

Lastly, presupposing no systematic underreporting, the virulence of COVID-19 is proving to be lower in the warmer climes of Brazil and India. If so, as we head into the summer months, there remains hope of a sharp drop off in the spread of the virus. That being said, this also raises the prospect of another wave of cases come the winter.

Ignoring for the moment the potential revival in the winter, if the summer months bring reprieve and confirmed cases peak globally during April, the probability of the S&P 500 re-testing the year-to-date lows is likely to be much lower than anticipated by most. Moreover, with plenty of cash on the side lines, the path of least resistance for stocks may be higher, much higher.

Two Charts

We end this week’s piece with two charts.

Chinese ADRs Outperformance

The above chart compares the price performance of a select few Chinese ADRs trading in the US versus that of the S&P 500 Index and the NASDAQ 100 Index. The Chinese ADRs, we highlight, have significantly outperformed the broader indices and even many of the leading big tech stocks. The only big tech name with comparable performance to most of these ADRs is that of Amazon.

This warrants further digging into Chinese tech plays at some point soon.

Gold-to-Oil Ratio

The below chart is of the gold-to-oil ratio, using Brent crude spot prices. (The dashed lines are the one and two standard deviation points above and below the average of the ratio, which is shown with the black line.)

The fortunes of the two commodities could not be starker. This chart is not so different from the earnings yield to treasury yield chart at the start of the piece.

We are in truly unique times. There will come a time to be long oil, short gold.

Thank you for reading!

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

“We have now sunk to a depth at which restatement of the obvious is the first duty of intelligent men.” ― George Orwell

A comment about China’s manufacturing PMI for March before getting to this week’s update.

China’s manufacturing PMI for March came in unexpectedly strong at 52.0, after recording 40.3 in February and above consensus expectations of 42.5. The kneejerk reaction to this data point from a number of market commentators was that China, once again, was fudging its economic data.

The thing about a kneejerk reaction is that it is an emotional response, one that has not been clearly thought through. And indeed, if one considers (a) the PMI is a diffusion index and (b) the statement from Foxconn, the world’s largest provider of electronics manufacturing services, at the start of March suggesting that their Chinese operations should return to normal during the month, the manufacturing PMI coming in at 52.0 is somewhat unsurprising.

The PMI is a diffusion index based on the number of companies reporting an improvement or deterioration in business activity relative to the previous month. A reading little above 50 suggests that slightly more than half of the companies indicated an improvement in activity relative to February’s historic lows. A much higher reading would have been required to suggest that manufacturing activity is back to normal in China.

Anecdotally, in February we contacted a sample of small and medium Chinese manufacturers through Alibaba and found that all were closed for business. We contacted the same sample of manufacturers again in mid-March and found that they were all up and running and accepting orders.

Armed with data and the correct definitions, a lot of noise can be filtered out.

On to the update.

War Like Symptoms

President Lyndon Johnson declared a war on poverty. President Richard Nixon declared a war on drugs. And last month President Donald Trump described the battle to slow the spread of COVID-19 as “our big war.”

Whether it is a war or not is a matter of debate. US public debt, as a percent of GDP, is, however, started to exhibit war like symptoms even before the passing of the largest stimulus package in US history. When it is all said and done, the US’s debt-to-GDP ratio will have blown out the levels hit during and in the immediate aftermath of World War II.

Modern Monetary Theory is here in everything but name.

From the Wall Street Journal (emphasis added):

“With 20% of Americans locked in their homes, nearly all air travel canceled, and the global supply chain disrupted, you don’t need to be a Keynesian to think the government should intervene. But that doesn’t mean the Cares Act—an acronym for Coronavirus Aid, Relief, and Economic Security—is wise. The last thing we need at this moment is a Keynesian stimulus. Since the lockdowns constrain supply, stimulating demand would lead only to a rise in prices.”

As the purveyor and custodian of the global reserve currency, the US effectively has an ‘elastic currency’, the circulation of which can expand and contract to meet the needs of economic activity. Whether the expansion or contraction leads fluctuations in price levels depends on whether the demand for US dollar liquidity is sufficiently keeping pace with the supply of US dollar liquidity.

Pricing conditions, that is inflationary or deflationary pressures, are primarily a function of the spread between the supply and demand of US dollar liquidity. A condition of excess liquidity exists when there is a greater supply of US dollar liquidity than there is demand for it, gives rise to inflationary pressures. When there is an insufficient supply of US dollar liquidity relative to demand, an economy is beset by deflationary pressures.

So, the creation of a large amount of liquidity in an economic system is not immediately inflationary — rather, if the expansion in liquidity occurs in tandem with an expansion in economic activity, then it can facilitate continued expansion of the economy.

From the Bank for International Settlements on 1 April 2020 (emphasis added):

“On the demand side, institutional investors (insurers, pension funds and other portfolio asset managers) play a key role. Such investors have obligations in domestic currency, but they hold a globally diversified portfolio, with a substantial portion denominated in the US dollar.  To finance the purchase of dollar assets, they swap domestic currency into dollars, thereby gaining access to dollar funding on a currency-hedged basis. Their portfolios have grown substantially since the GFC, giving rise to greater hedging needs.

On the supply side, dollars are provided by banks and other financial intermediaries, who source their dollars in global capital markets. However, in the decade following the GFC, banks that provide such hedging services have become a smaller part of the overall financial system, reflecting narrowing lending margins due to low interest rates, as well as tighter regulation (Erik et al (2020)).

Against this backdrop, the financial turbulence of recent weeks has led to a sharp decline in the supply of hedging services by banks as they retrench in the face of the shock. In addition, banks have experienced drawdowns of credit lines from corporate borrowers, which have crowded out other forms of lending by banks. Prime money market funds that traditionally supply dollar funding have experienced redemptions, leading to thinner supply. Together, the pullback in the supply of dollars from banks and market-based intermediaries (even as dollar demand has remained high) has resulted in the sharp increase in indicators of dollar funding costs.”

Financial intermediaries are stepping away from their core activities. Thereby circumventing the flow of liquidity in the monetary system despite the Federal Reserve and US Treasury’s best efforts to flush the system with dollars. Supply of dollars is falling short of demand. Outside of pockets of price gouging and price spikes for specific highly demanded goods, the probability of a spike in inflation remains low.

 
The below is a chart of four-quarter moving average of the Citi Macro Risk Index versus the year-over-year change non-residential fixed investment by the private sector in the US. (A rising magenta line implies declining macro uncertainty while a rising line implies increasing macro uncertainty.)

Non-residential fixed investment declines during periods of macroeconomic uncertainty.

Given that we are in a period of extremely high levels of uncertainty, capital investment by the private sector is likely to remain low — ergo production capacity utilisation in the economy will remain low. Without low levels of unemployment and high levels of capacity utilisation, inflation is unlikely to manifest. Unless of course one expects a complete loss of faith in the US dollar hegemony — something we do not perceive as a near-to-medium term risk.

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

“Life can only be understood backwards; but it must be lived forwards.” ― Søren Kierkegaard

This week’s piece comprises a few charts and ideas that stem from those charts.

Before getting to the charts, however, we want to address two unrelated points — the second may qualify as a rant.

1. The short-lived coupling of bonds and equities, where both asset classes sold off concomitantly, has been seen by some market participants and commentators as an indication of the market suddenly becoming acutely aware of the risk of rising inflation. Specifically, the broad-based fiscal and monetary measures being taken by governments and central banks leading to a sudden rise in inflation.

While we do consider the official measures being taken, to soften with economic blow from the COVID-19 pandemic, to be sowing the seeds of inflation at some hitherto unknown point in the future, we consider the recent sell-off in bonds to be indicative of:

1. liquidation, where assets are sold off irrespective of price to meet investor redemptions and / or margin calls;
2. foreign central banks and large pools of capital (e.g. pension funds and life insurers) monetising high quality assets to secure US dollars; and
3. some level of profit taking by speculative accounts (e.g. hedge funds) after the sharp move lower in yields.

For as long as demand, specifically consumer demand, remains capped by the drastic measures being taken to “flatten the curve” and we do not reach a stage where demand far outstrips supply, we consider any discussion over fears of a sudden spike in inflation to be premature. Moreover, if the absence of demand, exacerbated by a shortage of US dollars, leads to a spiralling credit default cycle, the deflationary impulse in the global financial system will overpower any and all of the measures being taken by central banks and governments.

As we have said on a number of occasions, a deflationary bust is likely to precede runaway inflation.

Why?

A deflationary bust is what we think brings about the next big Lehman-like casualty amongst the global banking behemoths. In response to which the authorities would have to take unprecedented measures that devolve into a loss of confidence in the major currencies, namely the US dollar and / or the euro.

Do not position the core of your portfolio for rampant inflation or an end-of-fiat currencies type of regime change, at least not yet.

2. At times we hear or read commentators and market participants discussing the “foreseeable future”. For example, “the COVID-19 pandemic has changed the world for the foreseeable future” or “markets are likely to remain volatile for the foreseeable future”.

To that we ask: How much of the future is foreseeable exactly?

The only correct answers to the question are (a) none of it or (b) absolutely none of it.

Certain events are “foreseeable”, say sunset, and certain events are “highly probable”, such as a company with high levels of debt and generating negative free cash flow defaulting during a financial crisis. Even those are few and far between.

Pro-tip: Ignore any recommendations that are based on knowledge of the foreseeable future.

Rant over. On to the charts.

Charts & Ideas

Crude Oil Contango

Definitions:

Contango is the situation in which the spot or cash price of a commodity is lower than the forward price.

Backwardation is the situation in which the spot or cash price of a commodity is higher than the forward price.

The above chart is of the spread between the price per barrel of Brent crude due for delivery in six months from now and that due for delivery in the current month. When the line is above zero, crude oil is said to be in contango and when it is below zero it is said to be in backwardation.

Since OPEC and Russia instituted the policy of supply cuts to rebalance the oil market, the crude oil market was largely in backwardation. That is, immediate supply was (artificially) constrained and the market expected prices to fall once supply was reinstated.

With Saudi Arabia and Russia entering a price war and the price of crude collapsing, the current price is, according to oil market participants, not seen to be sustainable. Current prices are deemed too low to sustain for oil producers be it shale, Russia or Saudi Arabia. Hence, the market has gone into contango.

When a commodity market goes into contango, traders are motivated to hoard supply by buying in the current month and immediately lock in a profit by selling a for delivery futures contract for delivery at some future date. This is exactly what is happening in the oil market.

To hoard oil, traders are required to lease very large crude carriers (VLCCs) and store their oil on these vessels till such time that the delivery has to be made.

The economics of the trade are the spread between spot and future oil prices multiplied by the number of barrels stored for future delivery less the cost of leasing and operating the VLCC till delivery. (VLCCs are leased based on daily rates, unless chartered on long term contracts — something primarily reserved for oil companies and not traders.)

Based on some back of the envelope calculations, and subsequently confirming with shipping brokers, the rule of thumb is that a US dollar 1 spread between spot and the 6 months futures price supports a VLCC rate of roughly US dollars 10,000. That is, traders are willing to pay a daily lease rate of US dollars 10,000 per vessel for each dollar of spread between spot and the futures price.

The current spread as per the above chart is approximately US dollars 10. That should support daily VLCC rates of approximately US dollars 100,000. Depending on the shipping route, VLCC rates are currently averaging around US dollars 100,000 per day. To put that in context, over the last two decades, VLCC rates have averaged approximately US dollars 20,000 per day. Suffice to say, it is a good time to be an owner of a VLCC.

According to a shipping broker we spoke to:

“As long as Saudi keeps the pumps open and demand remains weak, this trend is likely to continue – we believe 15 to 20 VLCCs has been taken up for storage up until now.”

To play this theme, one should buy stocks such as Scorpio Tankers $STNG, Frontline Ltd $FRO and Teekay Tankers $TNK.

USA versus the Rest of the World

Last week we shared a chart of a proxy for the size of the Eurodollar banking system versus that of US money supply M2.  In the chart below, the magenta line is the ratio of US M2 to the Eurodollar proxy. While the yellow line is the ratio of the performance of the S&P 500 Index to the performance of the MSCI All Cap World ex. USA Index.

Until such time that we witness an easing of US dollar shortages in the rest of the world, there is little to no reason to prefer non-US markets to US markets, broadly speaking.

Consumer Staples to Consumer Discretionary

Last chart for this week.

The above chart is a ratio of the consumer staples index to that of the consumer discretionary index. A rising line implies that staples are outperforming discretionary consumer plays.

The last decade has come to be characterised to a certain degree by the growing disparity between the haves and the have nots, by wealth inequality. The rich are more likely to engage in conspicuous consumption. If you look at the consumer brands that have risen to new heights over the last decade — Apple, Lulu Lemon, Louis Vuitton and the brands under the LVMH umbrella, Peloton, etc. — they almost exclusively position themselves to appeal to the classes over the masses. That trend for now at least has been arrested — no one goes shopping for luxury bags when they are worried about catching a virus but everyone needs to eat, wash and clean.

For as long as the COVID-19 pandemic does not subside, we continue to prefer staples. Especially the ones with the most robust supply chains.

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

“History is a cyclic poem written by time upon the memories of man” — Percy Bysshe Shelley

Prior to the Global Financial Crisis, Australia, unlike many other developed nations such as the US and UK, did not have a deposit insurance scheme in place. At the height of the crisis in 2008, the Reserve Bank of Australia (RBA) fearing a run on any one of the Australian banks introduced the Financial Claims Scheme (FCS), under which the Australian Government guarantees the timely repayment of deposits up to a predefined cap.

The RBA’s intention with the introduction of the FCS was to get ahead of a potential destabilisation of the Australian banking system. What the RBA did not take into consideration was that because deposits were not insured, Australian depositors kept a higher portion of their assets — as compared to global averages — in money market funds to take advantage of the higher returns.

The introduction of the FCS meant, however, that deposits were insured while assets held in money market funds were not. During a crisis, given people’s preferences to avoid losses, there was a rush for the exits from Australian money market funds and into bank deposits. A vicious cycle ensued, the outflow of capital from money market funds made them riskier, which led to even more withdrawals, and so forth.

Within four days of the introduction of the FCS, money market funds in Australia were frozen by the RBA. Millions of retirees who relied on withdrawals from money markets to pay for food, housing, and other essential items could no longer afford basic necessities.

“The principles governing the behaviour of systems are not widely understood” — Jay Wright Forrester

With the global spread of the COVID-19 virus, all manners of policies are being introduced the world over. Whether it is Saudi Arabia and Russia starting an oil price war, President Trump halting inbound flights from Continental Europe, the Federal Reserve making vast sums of short-term loans available on Wall Street and committing to purchase Treasury securities, or Italian clinics and hospitals turning away elderly patients to focus on younger patients that statistically have a higher probability of surviving.

One or more of such policies enacted under pressure is bound to lead to unintended consequences. We just do not know what they will be.

Not A Regular Demand Shock

With policymakers the world over flailing desperately — and unsuccessfully — for an effective response to the COVID-19 pandemic, financial markets are now in full-blown panic mode. Corporate credit spreads have gapped to recession-like levels, valuation do not seem to matter, and all backward-looking and even coincident economic data points are useless. Uncertainty reigns supreme.

The question now is, what will stop the rot?

Two weeks ago, we wrote:

Governments will most likely have to introduce some form of fiscal stimulus to counter the global slow down. Fiscal stimulus, we think is unlikely to be instituted, until and unless monetary policy has been loosened to the extent that it (a) cannot be loosened further or (b) proves impotent.

The Fed’s 50 basis point interest rate cut has proven impotent. The Fed’s assurances that it would pump trillions of dollars into the financial system to ease stresses in short-term funding and US Treasury markets also failed to stop the rot.

The reason is simple, the global economy is suffering from a demand shock and the measures being taken or bandied about are supply-side measure. A demand-side problem cannot be solved using supply-side policies.

The below is a diagram from The Holy Grail of Macroeconomics: Lessons from Japan’s Great Recession written by Mr Richard Koo, Chief Economist at Nomura Research Institute. We have shared it in the past, we think it is worth sharing again.

Rather than monetary policy pricking the bubble in stage (1), this time we have had a global pandemic. It is only a matter of time before companies start focusing on debt minimisation (stage 3) as demand for (most) products and services has fallen off a cliff. In stage (3), monetary policy stops working. Government’s must stimulate demand by through fiscal measures.

We think a fiscal stimulus is almost given. A question of if not when.

What is different, however, about the demand shock this time around is that it has coincided with large-scale shuttering of supply. Unlike in prior crises, when production continues despite a lack of demand. This time around the situation will not be exacerbated by high levels of inventory, rather inventory levels are already too low. Therefore, if governments act to deliver fiscal stimulus and the pandemic subsides, the global economy could be in for a positive demand shock and a much swifter recovery than anyone expects.

We assign a much greater probability to such a scenario than most.

Trade Ideas

We have not sent out trade ideas for some time. This is because we have been unable to identify anything resembling a decent opportunity and prefer not to recommend shorts as drastic times can result in policymakers enacting short-sale bans.

As we head into this weekend, however, we think, for those with the stomach for a little risk, there is a case to put some money to work today. This can be done through a broad-based exposure by buying an ETF such as $SPY, a long in some of the very oversold energy names such as Occidental $OXY, or longs in high quality technology plays ($MSFT, $FB). One of the names from our open trade ideas we like adding to here is Slack Technologies $WORK.

Please note a number of our previous ideas have hit their stop losses, we have not sent out emails for those but directly added closed trades to our track record page.

Thank you for reading!

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guarantee

“Knowing reality means constructing systems of transformations that correspond, more or less adequately, to reality.” — Jean Piaget

“We’ve got facts, they say. But facts aren’t everything, at least half the battle consists in how one makes use of them!” — Crime and Punishment, Fyodor Dostoyersky

A short one this week.

The formal definition first.

Duration is a measure of the sensitivity of the price of a bond (or more accurately, any financial instrument) to a change in interest rates. Duration is non-linear and accelerates as time to maturity diminishes, i.e. financial instruments become less sensitive to changes in interest rates as maturity draws closer.

Duration: Now What?

At the start of the year, we advised “Using rallies to reduce equity exposures tactically and increase bond allocations”. This prescription was based on our assessment of the lay of the land prior to the global spread of Covid-19.

The coronavirus has hastened the rush into safe haven assets, pushing 10-year US Treasury yields to all-time lows — 1.2 per cent is the most recent print. Notably, the other safe haven asset, German 10-year bunds, has also followed suit. At the same time, global equity markets are on track to have their worst week since the Global Financial Crisis.

The global spread of the Covid-19 virus has revealed the glaring fragility of the globalised world we live in. As discussed last week, the suspension of Chinese manufacturing has revealed the deep rooted interdependencies within global supply chains — much like the interdependencies between global financial institutions revealed by the Lehman bankruptcy. Given these interdependencies, it is no surprise that there is panic and investors are rushing into safe haven assets.

The corollary of the rush into safe haven assets is that pension managers, already facing an asset-liability duration mismatch, are forced into buying ever more bonds as long-term yields decline. This need to buy an increasing amount of bonds, precipitates a vicious feedback loop — increasing demand for bonds begets further demand for bonds, pushing yields lower and lower. Making bonds the ultimate momentum trade.

It may only be a matter of time before we see a US 10-year yield print with a 0 in front of it.

The long-end is not the only part of the yield curve where the action is. According to The Wall Street Journal:

Federal-funds futures, which traders use to bet on the path of central-bank policy, showed Thursday afternoon that investors thought there was a 72% chance the Fed will lower its key policy rate by a quarter-percentage point at its March 17-18 meeting, according to CME Group data. That was up from just 9% a week ago,

Investors also saw an 83% chance the Fed will cut rates by at least 0.50 percentage point by the end of its July meeting and a 46% chance it will cut rates 0.75 percentage point by that time.

Markets are pricing in short-term US rates heading toward the zero-bound once again. The Fed, publicly at least, is not yet entertaining the need to further ease monetary policy.

In a speech Tuesday, Fed Vice Chairman Richard Clarida said disruptions from the viral outbreak in China “could spill over to the rest of the global economy” but that it is too soon to “even speculate about either the size or the persistence of these effects, or whether they will lead to a material change in the outlook.”

History has shown that once the market starts pricing in rate cuts, it is only a matter of time before the Fed follows through. The longer the Fed fails to communicate as much, the lower the equity markets will go.

It is not a Monetary Policy Issue

The argument against the Fed, or any other major central bank, easing policy is that the global spread of the Covid-19 is not a monetary policy issue. That is, looser monetary policy will not remedy the forced slowdown in global economic activity.

That is true. Governments will most likely have to introduce some form of fiscal stimulus to counter the lobal slow down. Fiscal stimulus, we think is unlikely to be instituted, until and unless monetary policy has been loosened to the extent that it (a) cannot be loosened further or (b) proves impotent.

The Contrarian View: Not Just Keeping Powder Dry

The global economic slowdown is priced in. A sell-off in equity markets is warranted. The question, as always is, how to position for that which is not priced in.

The last decade witnessed long-duration assets, with stable and almost annuity-like cash flows, being bid-up. Be it developed market bonds, corporate credit, technology companies such as the FANGs, software stocks with subscriptions-like revenues and consumer packaged goods companies such as Procter & Gamble.

With equities falling out of favour in the interim and long-term rates collapsing, we think the market is being primed for an almighty rally in stocks with long-duration like attributes. This view is predicated on (1) a vaccine for Covid-19 being found and (2) the Fed easing monetary policy.

Till such time we recommend keeping most of your powder dry and gradually adding high quality technology companies (such as Facebook) to your portfolios. Once the above conditions are met, there may even be room to jump into beaten-up cyclical sectors — energy, industrials and materials.

Thank you for reading!

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

“It became a domino effect, as infected people took foolish risks, knowing full well they could spread the virus.” — Jason Medina, The Manhattanville Incident: An Undead Novel
 
 
“My worlds collide. When one thing happens, it just starts a domino effect – everything else goes on.” — Wanda Sykes
 

We apologise for not having issued any trade alerts or weekly pieces for some time. It has been a complicated few weeks in Singapore. For monthly subscribers your next payment will be refunded and for annual subscribers a month will be added to your subscription.

The Fallout

Over the past 10 days or so, we have been having discussions with management teams at companies operating in many different sectors in Asia to understand the potential fallout from the 2019-nCoV coronavirus outbreak.

In some instances, we will mention the companies by name, please note this information is for your consumption not for public dissemination.

Before we get to the snippets from our discussions what seemed to be almost a constant across all discussions was the overarching conviction that China is almost certainly under-reporting the number of infected people there are across the Mainland

#1 De-Coupling from China is Not Easy

We recently met with the ASEAN retail sector team at GlaxoSmithKline (GSK), the British multinational pharmaceutical company. As an anecdote they shared that typically they have 90 days of inventory on hand of various versions of one its best-selling products, Panadol (generic: Paracetamol) — a level they recently deemed excessive and were implementing initiatives to bring it down to less than 60 days.

As of last week, in ASEAN their inventory at hand had dropped to less than one week of regular demand. Demand is anything but regular at present. Residents are in hoarding mode, particularly of medical, sanitary and food items.

Our discussion with the team at GSK revealed how difficult it is for multinational and regional companies to (1) re-engineer supply chains away from the Mainland and (2) de-couple from China.

Let us elaborate. Given the shortage in Panadol inventory, GSK reached out to manufacturers in Malaysia and offered a higher price than usual if the Malaysian outfit could do an urgent production run for them. The Malaysian producer rather than witnessing a surge in capacity utilisation found its plant almost idle and did not accept the order from GSK. The producer informed GSK that even if it accepted the order from them, it would not be able to fulfil it as the primary active ingredient used in production is sourced from China.

Chinese manufacturers have been temporarily shuttered by the government and will not re-start operations till at least 25 February. Chances of a further delay are not zero.

The issue has been exacerbated by inventory levels across most consumer facing industries already having been low prior to the outbreak due to production having been halted during the extended Chinese New Year break.

#2 Germany is Not a Viable Alternative

Dependence on Chinese manufacturing afflicts almost all industries with a physical product. So, we asked many of the companies what the alternative was. Most management teams were unable to come with a viable alternative. Others cited Vietnam and Germany as potential alternatives but lamented their relative lack of scale, the limited sophistication of the former and the much higher cost of the latter.

Companies operating in more sophisticated, higher priced categories could turn to Germany as a stop-gap measure and in some specific technology related cases to South Korea. For most industries, however, Germany is simply too expensive — anecdotally, 2 to 4 times the cost of China — and, for Asia-specific demand, too far, as shipments from Germany take 2 to 4 weeks longer to arrive. Worse still, in some cases China still becomes a bottleneck as a key input material or component is sourced from China during the normal course of business.

#3 Plastics and Petrochemical Producers to Feel the Pinch

Commodities are priced at the margin. At the margin, demand for petrochemical products is nil. Polyethylene, polypropylene, benzene and other such commodities have seen near-term demand plummet.

We spoke with the commodities trading team at Unilever (producer of consumer brands such as Dove, Red Bull and Lipton), which handles the commodities purchasing activities for the group from London, England to India to the ASEAN and pretty much anywhere in-between.

Our expectation, prior to the discussion, was that Unilever and its peers would actively be locking in lower prices and securing supply needed 9 to 18 months down the line. Turns out that is not the case. Rather, it has become a bit like a game of chicken.

Unilever worried that prices may drop further and that its key competitors may secure better prices is not buying. Instead, if notional loss limits are hit as set by internal policies, the team may be required to unwind positions and sell at prices they would prefer to buy.

We pressed on the point about competitors securing better prices and why it mattered. The argument goes that if they secure better prices, they would be able to offer higher discounts and gain market share at Unilever’s expense.

So, we turned to a contact at Reckitt Benckiser (producer of Dettol and other leading consumer brands), a direct competitor of Unilever across a number of categories. The argument made by Reckitt Benckiser was almost identical to that made by the team at Unilever.

The natural question then is what is their reaction function if prices start to rise. Turns out, they would probably rush to buy to lock in prices just in case their competitors lock-in lower prices…

That’s probably how V-shaped bottoms are formed in commodities markets.

#4 Interim Disconnect Between Finished Good and Commodity Prices

Unilever and Reckitt Benckiser have received an estimated 1 million units of additional daily demand for their Life Buoy and Dettol branded hand sanitizers since the start of the 2019-nCoV coronavirus outbreak, respectively. Regional production capacities are an estimated 250,000 units per day cumulatively.

GSK has little to no inventory of Panadol and other popular products remaining.

One of the leading ASEAN pharmaceutical chains is all out of thermometers, disinfectant sprays, surgical masks and many other hygiene related products.

Demand for many finished goods is far outstripping supply. Where supplies are available, price gouging is starting to occur,  particularly on online market places.

Production has ground to a halt, hurting commodity prices and elevating retail prices. This disconnect could persist unless Chinese production comes online sooner rather than later.

#5 Chinese Aversion but Some Requests are Simply Ridiculous

A number of companies mentioned that Asian consumers are starting to show an aversion toward goods manufactured in China.

In response, one electronics retailer allegedly asked HP if they could provide a letter stating that their laptops, manufactured in Wuhan, would not transmit the virus. HP, obviously, would not expose itself to such a liability. HP laptops were duly removed from the unnamed retailers branch network.

Given all of the above, we think software remains one of the better sectors to be exposed to given the absence of supply chain challenges.

We may issue a follow-up piece to further discuss implications of the outbreak.

Thank you for reading!

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

“Let yourself be silently drawn by the strange pull of what you really love. It will not lead you astray.” — Rumi

“A group experience takes place on a lower level of consciousness than the experience of an individual. This is due to the fact that, when many people gather together to share one common emotion, the total psyche emerging from the group is below the level of the individual psyche. If it is a very large group, the collective psyche will be more like the psyche of an animal, which is the reason why the ethical attitude of large organizations is always doubtful. The psychology of a large crowd inevitably sinks to the level of mob psychology. If, therefore, I have a so-called collective experience as a member of a group, it takes place on a lower level of consciousness than if I had the experience by myself alone.” — The Archetypes and the Collective Unconscious by C.G. Jung

In “Threshold Models of Collective Behavior”, published in The American Journal of Sociology in 1978, Mark Granovetter outlines a simple model that attempts to shed slight on how seemingly identical crowds can each, collectively, react to events in profoundly different ways.

From the paper:

“Imagine 100 people milling around in a square—a potential riot situation. Suppose their riot thresholds are distributed as follows: there is one individual with threshold 0, one with threshold 1, one with threshold 2, and so on up to the last individual with threshold 99. This is a uniform distribution of thresholds.”

That is, there is one individual amongst the 100 that is willing to riot on his or her own, one individual that will riot if he or she witnesses at least one-person rioting, one who will riot if at least two people are rioting, and so forth.

Continuing from the paper (emphasis added):

“The outcome is clear and could be described as a “bandwagon” or “domino” effect: the person with threshold 0, the “instigator,” engages in riot behavior—breaks a window, say. This activates the person with threshold 1; the activity of these two people then activates the person with threshold 2, and so on, until all 100 people have joined. The equilibrium is 100.

Now perturb this distribution as follows. Remove the individual with threshold 1 and replace him by one with threshold 2. By all of our usual ways of describing groups of people, the two crowds are essentially identical. But the outcome in the second case is quite different—the instigator riots, but there is now no one with threshold 1, and so the riot ends at that point, with one rioter.

Even this simple-minded example makes the main point suggested earlier: it is hazardous to infer individual dispositions from aggregate outcomes.”

While by no means exhaustive, Granovetter’s simple threshold model shows why aggregate outcomes in a socioeconomic context can be so difficult to predict. Moreover, from the simple example provided in the paper, we can see how a very small change in the distribution of preferences can lead to large differences in outcomes.

In today’s hyperconnected world where virality is a daily, if not hourly, phenomenon, Granovetter’s model is highly relevant in coming to terms with the unpredictability of virality. It also helps understand why the giants of the internet-era — Google, Facebook, Amazon, etc. — have, subject to limitations, witnessed an acceleration, not deceleration, in growth as they have become larger.

In an investment context, the model highlights the pitfalls of blindly superimposing the experience of one market on to another or from one time period on to another.

Take for instance the experience of investors that have been betting against the Canadian and Australian housing markets, and by extension their banks, since the Global Financial Crisis. These bets have largely fared poorly and could to some extent be described as ‘widow maker’ trades — the moniker usually reserved for shorting the Japanese bond market. From what we have seen of the cases made against Canadian and Australian markets, most analysts have superimposed economic and demographic metrics witnessed in the US, and the UK in some instances, prior to the sub-prime mortgage crisis.

The trajectory of the Australian and Canadian housing markets over the last decade, however, suggests there are subtle, almost unidentifiable, differences in the thresholds of stakeholders and homeowners in those markets when compared to those either in the US or UK. These subtle differences have resulted in far different outcomes despite the overt similarities across the markets. The housing markets in both commodity exporting economies remaining largely intact, despite years of low commodity prices, seems to confirm as much.

Similarly, we can begin to understand why neither historical nor panel data has served well those calling for a hard landing in China or impending doom for the US equity markets.

Subtle variances can lead to huge differences in outcomes.

For anyone but the most extraordinary, identifying subtle differences is nigh on impossible. That is why, it is generally very difficult to call a market top or bottom. The better strategy, and the one we recommend, is to shoot a trend in the back — i.e. short after a clear break of an uptrend — than to time a market top.

“One of the most helpful things that anybody can learn is to give up trying to catch the last eighth—or the first. These two are the most expensive eighths in the world.” — Reminiscences of a Stock Operator by Edwin Lefèvre

Some Caution is Warranted

With that being said, we will somewhat contradict ourselves by arguing that at this juncture in markets, some caution is warranted. We think now is a good time to build up cash to re-deploy on a pull back.

Market momentum, on a global and cross-asset class basis, is the highest it has been since late 2017 — that is, just before the “volmageddon” of February 2018. Almost two fifths of global markets, irrespective of asset class, are at or have recently recorded 52-week highs. More than two thirds of developed and emerging equity markets have recently recorded 52-week highs.

Cross-asset breadth of 35 per cent or above has generally been associated with subsequent market corrections. That is, a cyclical pullback but not an end of the prevailing uptrend. Moreover, given how defensive investors became in the summer of 2019, the outsized moves in markets in recent months suggest that investors have covered shorts / underweights — making markets more susceptible to short-term pullbacks. Commodity Trading Advisors (CTAs), that is trending following strategies, are now at maximum equity market allocations. Target Risk Funds — asset allocation funds that hold a diversified mix of stocks, bonds and other investments — are also at maximum equity market allocations.

To re-iterate, now is a time for caution not courage.

Cyclical Not Secular

For further clarification, we are, however, not calling for an end to either of the long running equity or bond bull markets.

With the centenary anniversary of the Communist Party of China in 2021 and a US Presidential Election at the end of this year, we suspect policymakers in the world’s two largest economies will be pulling out all the stops to keep the uptrend intact.

Thank you for your support!

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed