On Target Newsletter
2020.03.28
In this issue:
- The global crisis
- Managing your money
- Wall Street
- Clash over migration
- Costs of climate change policies
- The motor industry
Sit Tight and Wait Out the Crisis
Black swan events – major shocks that come without warning – are always the most difficult for investors to handle, as they haven’t been able to take pre-emptive actions, or even do any preparatory planning.
This time we’ve been hit by two black swan events – the Covid-19 pandemic and the oil price war – almost simultaneously, and on a global scale.
What are we to do?
I’m old enough to have lived through several global crises. One thing I’ve learned from them is that by the time you’ve awakened to the shock happening, it’s probably too late to do much about limiting the damage to your investments, but too early to look for profits in recovering markets.
One of the basic rules of investing that I preach is that if you’re not sure what to do, do nothing.
When Black Monday hit stock markets in October 1987 – Wall Street fell 23 per cent on a single day – it was such a shock to readers of my newsletter in South Africa that I flew back from New York to calm nerves and provide counsel. En route I stopped in London to see my friend David Fuller, then establishing his formidable reputation as a technical analyst. He predicted that the markets’ collapse would be one of the shortest in history. And he was right. They bottomed within a month.
Now, once again, global investment markets look terrible, and I think they’re likely to fall even further. But not for much longer.
Goldman Sachs, analyzing all the bear markets since 1835, says structural bear markets – those triggered by structural imbalances and financial bubbles – have lasted for an average of 42 months. Cyclical bear markets – typically a function of rising interest rates, impending recessions and falls in profits – have lasted for an average of 27 months. But event-driven markets – those triggered by a one-off shock – have only lasted for nine months.
This is a double-shocked bear market hit by both Covid-19 and Saudi-Arabia’s unexpected decision to launch an oil price war. Which means its peak-to-trough period or its trough-to-recovery may be longer than nine months. There is also the danger that the pandemic will do so much damage to supply chains and to
and that the threat to corporate profits magnifies developing recession into something worse than just an event-driven shock
demand that the threat to corporate profits magnifies developing recession into something worse than just event-driven shock.
Hedge fund manager Ray Dalio has correctly argued that containing the virus – that is, minimizing its spread – will occur best where there are capable leaders who are able to make executive decisions well and quickly; there’s a population that follows orders; a capable bureaucracy to enforce and administer plans; and a capable health system to identify and treat the virus well and quickly.
It’s been interesting to see how well Asian nations — Singapore, South Korea, Taiwan, even China, have been managing the crisis compared to other countries.
The immediate damage being wreaked by the Coronavirus epidemic is obvious and severe with the tourism and entertainment industries shut down and air travel sharply curtailed. But it’s a short-term crisis. Once the 5 per cent or so of those infected have died — far fewer in the Asian countries that seem to be managing the plague most effectively – and the spread of the virus has faded thanks to build-up of “herd resistance,” economic recovery will get under way.
That’s already happening in China. It’s estimated that by the end of this month it will be operating at 70 to 80 per cent of production capacity.
Some of the losses, such as scrapped sporting events, will be permanent. Some of the weakest companies won’t survive. But once families are no longer forced to stay at home and again allowed to travel, they will do so. After a year or two the volumes of travellers will recover. The strongest tourism, airline, hospitality and entertainment businesses will do more than bounce back; they’ll go on to achieve sounder growth.
Some business sectors are actually prospering out of this crisis – all those based on electronic communication such as telecoms, movie rental, on-line education and e-commerce.
Many of the behavioural changes forced on businesses and individuals by lockdowns – they’ve been described as accelerated digitalization — will remain as permanent benefits after the crisis has ended. For example, many companies have discovered it works well to put their entire staffs on Tencent’s WeChat Enterprise, sharing documents and taking advantage of its Zoom-like features for group communication.
The politics of crisis management
Governments are throwing astonishing amounts of money at the crisis. They have abandoned every principle of financial restraint. I expect that to pave the way for nasty consequences when the Covid-19 panic is over. As it soon will be.
John Plender comments that the politics of crisis management are very different from those governments faced in 2008. “It is, after all, much easier to persuade the public of the case for using taxpayers’ money to confront a public health catastrophe than to justify putting a safety net under bankers who have done their best to wreck the global economy.”
Public health, says Jefferies’ Christopher Wood, “is not the sort of issue The Donald is psychologically wired to deal with… because it is not possible to negotiate with a virus.”
Just as China became the locomotive that led the world economy out of the financial crisis, China will once again power the recovery out of the current crisis.
However, there will be a tailwind that limits the strength of that recovery… de-globalization.
For two decades, starting with China’s acceptance into the World Trade Organization in 2001, there has been extraordinary economic growth attributed to globalization. Its most important features have included the scrapping of trade barriers, the mobilization of a billion workers transferred from rural poverty to burgeoning cities, and the evolution of highly-productive supply chains made possible by the Internet revolution.
Now the momentum of globalization is fading.
Its bias against the interests of the lower classes in the developed economies has ignited mounting protectionism. The suffering has spread to legacy industries in the West increasingly under attack from high-technology competitors in the East. Multinationals have suddenly discovered the dangers of undue dependence on factories far from their main markets. Nations have also suddenly found similar undue dependence, the latest example being the revelation that the US needs to import from China 80 per cent of its essential medicines.
So the new key trend in international development is going to be de-globalization.
While it’s pretty obvious that the Covid-19 crisis will be over by the end of this year, the outcome of the other mega-shock, the oil war, is less certain.
The oil price war could be a long one
The three competing giants – Saudi-Arabia, Russia and American shale – have financial resources large enough to withstand for a long time their losses from flooding the markets with cheap oil. Russia’s finance ministry, for example, claims it could weather oil prices of $25-30 a barrel for six to ten years.
Prices have already collapsed into the low $20s. Some consultants now speculate that prices could fall as low as $10.
Russia has larger foreign currency reserves ($570 billion compared to Saudi’s $502 billion), but the oil price it needs to break even is much higher than Saudi’s.
Nearly all of the world’s massive oil and gas industry can carry on for a long time providing prices are enough to meet cash operating costs. However at some stage the accumulating damage to both countries will force them to negotiate an end to the price war. It’s anyone’s guess when that will be.
Investment conclusions?
It’s probably far too late to sell most shares. And there’s still too much uncertainty and immediate downside risks to be confident yet about doing the opposite — using your cash to buy.
However, China is starting to look attractive. Its equities have only lost half as much as Wall Street this year; its currency has held reasonably steady against the dollar; its bond markets have been receiving record inflows from foreign investors.
Although gold was hit hard early this month – probably because investors sold some to raise cash easily to cover equity-market margin calls – it continues to look one of the safest assets to hold in such difficult, highly volatile times.
The danger area that experts are watching isn’t in the headlines… yet. It’s the credit markets. Analysts are talking about the “fallen angel risk.” Something like half of all investment-rated outstanding bonds are in low rating categories. If losing investor confidence causes their ratings to plunge, they would become re-classed as “junk” — no longer investment grade — which would force many institutional holders to sell. That would trigger a bond markets crisis.
There’s also an emerging risk in the broader financial markets triggered by major defaults arising out of the oil wars. Many US shale companies cannot survive in an environment of $30 oil and $2 natural gas. And financial institutions on the wrong side of oil derivatives must be starting to drown in a red sea.
What to do now?
Never sell in a situation like this, advises Bank of America, as by doing so you miss out when it’s best to be invested. Best days to invest are often when things seem the worst.
Equity markets, distorted by panic, have been driven down too far, say Iain Little and Bruce Albrecht of Global Thematic Investors. We are potentially close to a low in the stock market says Eoin Treacy of FullerTreacyMoney.
“There may be worse to come” say Little and Albrecht with bankruptcies in sectors such as airlines, hotels and “bricks and mortar” (traditional) retailing. “On the other hand other sectors, although hit by the same waves of panic selling, may emerge as new long-term leaders in a changing world where personal safety, health fears, depersonalizing technology and e-commerce may enjoy further and more widespread adoption.
“In five years’ time this crisis may be seen as a catalyst, an accelerator of trends and behaviours that were already happening over the last ten years – more technology in commerce, more e-education, more care over health and hygiene issues, more remote working, more technology in communications, more depersonalized in deliveries and trade.” On the other hand there will be fewer giant unprofitable airlines, fewer bricks-and-mortar startups, fewer restaurants, less globalization.
The rebound in the markets, when it comes, “is likely to be strong,” says Goldman Sachs. That looks like being the only certainty we can count on.
More About Managing Money for a Better Life
In my last issue I said that the first step towards learning moneycraft is to know what you’ve got… and what you owe. Now let’s see how to use those facts to plan for a better life.
First you must provide for the basic monthly working capital you need to meet your regular bills such as food, mortgage or rent, electricity, Internet and telephone, repairs. Irregular or annual expenses should be totalled, divided by 12 and added to the monthly budget.
What you have left over from your income should be saved. That’s the only way to provide for the future. But what counts is HOW you save.
Savings should be carefully structured and allocated to the following categories.
► First, sufficient cash that’s readily available to cover emergencies – probably the equivalent of three months’ pay.
► Medium-term savings to finance an expensive luxury such a major holiday abroad, a fancy car or a home upgrade… whatever you yearn for.
► Sufficient retirement savings to ensure you enjoy your later years and the extra leisure they afford.
When planning these last savings, look realistically at your retirement resources, taking into account what pension you can expect from the state. Don’t expect to get an income of more than 4 per cent a year from investment of your capital. That assumes you’ll be able to do much better investing in dividend-paying equities than from fixed-income resources such as bonds or bank deposits.
Any spare cash you can then treat as speculative capital. You may do well out of investing it, or you may not. You’ll certainly lose some of it.
Get into the habit of reviewing regularly what is happening to your money – such as changes in the value of your investments – and update your “balance sheet” (your summary of what you own and what you owe).
Planning for your family’s future security
A good rule-of-thumb for a life-long savings plan is to save about two months’ earned income out of every 12 over a 40-year period. There will be times when you save less, especially when your children are growing up. Once they have left home and completed their education, you should increase your savings rate dramatically.
This plan should ensure a reasonable level of future security.
What if you just can’t save enough? You may be able to increase your income, perhaps by starting a mini-business from home using the Internet. But it’s more likely that there won’t be any practical way that you can earn more. The only solution will be to spend less.
It’s up to you to decide what economies will cause the least disruption to your family, but bear in mind that cutting down on things such as relatively expensive foods that you’re used to, or regular family holidays, often causes a sense of deprivation out of proportion to the savings, and is, for that reason, rarely successful.
Good intentions don’t work. You have to restructure your spending. I know that works when I was young because I did it, moving to a smaller house much closer to my office, cutting travelling costs to work and schools. My monthly outlays dropped dramatically. And stayed lower.
Such changes can even improve your lifestyle and the savings achieved don’t need a constant renewal of sacrificial fervour!
If you’re married, make sure your partner knows what the family’s resources are and has personal funds at her/his disposal irrespective of whether she/he has a job.
Teach your children the realities of money by giving them the experience of handling an allowance. And of running short!
Discuss major financial goals with your family – and how you can all contribute towards attaining them. They will be more co-operative when they know what’s going on. And what’s in it for them.
Above all, get out of the habit of living and spending according to future expectations. Once things could be relied upon to get better and better. Nowadays anything can happen. Rather aim to live so that you could survive on an income drop of some 20 per cent.
Your financial plan for life will be successful only if you set objectives, analyze your resources, and then deploy them to attain those objectives.
Flexibility is the key. Which is why you should review your plan regularly, making necessary adjustments.
The range of possible future economic, political and personal scenarios is infinite. You can’t possibly hope to plan and provide for every eventuality. But you can limit their adverse effects and be many steps ahead of those who leave everything in the hands of fate.
Wall Street: Fat Profits and Dangerous Dependence
Corporate earnings are going to be squeezed, not only by the damage being wreaked by Covid-19, but also by a fading boost that they’ve had from several major positive trends, says the FT’s Rana Foroohar.
“In this new and unsettled era, the main forces that have propelled profit margins over the past 40 years or so – globalization, increasing corporate concentration, a lower tax burden for corporations versus workers, and a larger share of wealth going to companies versus workers – are all facing headwinds.
“The healthy margins of today’s highly optimized, extremely complex multinational corporations have largely depended on their ability to manufacture in China, sell in the US and Europe, and stash wealth wherever it makes sense – particularly in favourable tax destinations like Hong Kong, Dublin or the Cayman Islands.”
The Coronavirus will speed a process that has already begun of decoupling the US and Chinese economic ecosystems, increasing regionalization and localization of production. It will force big companies to make costly choices around labour, productivity and transport to manage a shift away from China.
There is also mounting political determination to curb the power of the tech giants and to tax them more. “In a world where populists are gaining influence, I find it hard to imagine corporate taxes or the labour share of income going in any direction but up.”
Spending by individuals accounts for more than two-thirds of economic activity in the US. That spending is driven by incomes, but also by willingness to use savings or borrow. That in turn is sensitive to personal wealth… the value of shares and bonds.
It’s stunning, says Faroohar, “how utterly dependent American fortunes have become” on the inflation in the prices of those assets. Financial analyst Luke Gromen has calculated that net capital gains, plus taxable distributions from individual retirement accounts, are equal to 200 per cent of year-on-year growth in US personal consumption expenditure.
Rising asset prices, pumped up by easy-money policies, have “made it less obvious to consumers (and voters) that average real weekly earnings for the bottom 80 per cent [of employees] are at about the level they were in 1974. And that the things that make people middle class – healthcare, education and housing – have become unaffordable.”
The level of the S&P 500 index is less a gauge of the broad health of US corporations – or consumers – than it is of the wealth of a few tech firms. And of the value of the 2017 tax cuts, which accounted for two-thirds of the aggregate rise in corporate profits between 2012 and today.
“The US built an economy that is dangerously dependent on the whims of Wall Street.”
Europe and Turkey Clash Over Migration
Turkey has effectively suspended its migration deal with the European Union, opening the doors to a renewed flood of refugees into Europe from the Mideast. Its interior minister, Suleyman Soylu, says more than a million will now make the move.
Turkey’s problem is that nearly a million Syrians fleeing the civil war want to escape into Turkey, which is already choked with 3½ million Syrian refugees. Europe refuses to help to stem the new inflow. So Turkey has decided to put Europe under pressure to do so by suspending its border officials and armed forces’ preventing Syrians and others crossing from Turkey into Greece.
Interestingly, a high proportion of those now entering Europe in this way are not Syrians at all, but originate from other countries such as Kyrgyzstan, Afghanistan, Somalia, Iran. The truth is far from the politically-correct standard narrative that the flood is all about “Syrians fleeing the bloodthirsty Assad.”
The Greeks are unhappy, too, not only with Turkey, but also with its EU fellow-members because they aren’t doing enough to help with the 50,000-odd refugees already in camps in Greece and move them on to other parts of the Union. The Greeks have used their military to fire teargas and stage wargame exercises with live ammunition to prevent thousands of refugees from crossing the border.
Although the EU has been pouring money into Turkey under its three-year-old deal to help the country with its costs of caring for Syrian refugees, it has failed to deliver on its targets to resettle the refugees.
It is getting even harder politically for the Union to meet the costs of managing the migrant inflow. The post-Brexit funding squeeze is likely to cut cash for spending projects such as patrols by Frontex, the EU’s border control agency.
The Massive Costs of Climate Change Policies
The British government has made a string of announcements to follow through on the law it passed last year to make the UK the first major economy to achieve zero carbon emissions by 2050.
It’s estimated that to do that will cost around £3 trillion.
The cost of existing policies is already being passed on to consumers at the rate of £10 billion a year. Matt Ridley says subsidies for wind, solar and biomass electricity have already made household electricity prices about 35 per cent higher than they would otherwise be, while those paid by businesses are about 60 per cent higher and are now among the highest in the world. That’s why aluminium and steel plants have been driven out of business, so now Britain instead imports those metals — from countries that have high carbon emissions.
Every one of the latest announcements “will raise costs to consumers but reward special-interest lobbies of crony capitalists.” Examples include building the HS2 high-speed London-Birmingham railway “complete with its own track-side wind farms;” bringing forward the date of banning non-electric cars; banning coal and wet-wood stoves used by poorer people in rural areas; reopening subsidy schemes for wind and solar power.
The claimed falling cost of offshore wind power “is a big myth” as the system cost, connections and backup required to stabilize a grid relying heavily on intermittent energy “is huge, growing and not included in the headline figure for wind subsidy.’
Studies have now confirmed that capital expenditure per megawatt of new capacity in the wind industry has not fallen significantly. Greater technical efficiencies have been completely offset by the need to move into deeper waters. It will continue to cost £100 per megawatt-hour to get electricity from UK offshore wind farms.
Cars Will Become More Like Smartphones
The electric-vehicle revolution is going to transform the way cars are marketed. Those based on internal combustion engines are widely differentiated. Electric vehicles have far fewer parts, with batteries accounting for much of the cost. Cars are going to be more like commodities.
“The difference between an Apple, Samsung or Google phone,” Eoin Treacy says, “is less about what is on the inside than familiarity with the brand, ease of operation, software, the app ecosystem and the camera. Other than that, they all have pretty much the same internal composition, with some minor differences in the design of the chips – while manufacturing is outsourced to a third party.”
Expect the motor industry to adopt the same model. Corporate success is going to depend on innovation in features such as in-car entertainment or autonomous driving. Those are areas where existing automotive giants don’t have natural competence. It’s driving them into alliances with non-automotive firms that do have such skills. One example is Fiat Chrysler’s multi-billion tie-up with Foxconn, the world’s biggest electronics manufacturer.
Financial Risk Lurks in the Markets
The big threat in US markets is the large amount of corporate debt – now. at $10 trillion, five times bigger than it was in 2001 –that could plunge into default, says Allianz’s chief economic adviser Mohamed El-Erian.
“Years of extremely lax financial conditions have encouraged and enabled massive issuance of debt at ever-lower interest rates… The easier it became for companies to engage in what is known as financial engineering.”
As corporate debt has risen significantly faster than earnings the proportion of it rated only triple B has ballooned from less than one-fifth to half the total investment-grade market. Among the companies on that bottom rung, “a third are rated triple B minus and thus at greater risk of a downgrade to ‘junk’.’”
Factors magnifying that risk include uncomfortable ratios of debt to earnings, inadequate trading in the high-yield market, a proliferation of exchange-traded funds which has increased ownership by “more flighty investors,” a greater potential for disruptions to spread from one market to another, and “a sharp fall in intermediaries ready to make markets in times of stress.”
When It’s Better to Own Equities
When it comes to developing an investment or trading model that tells us when to favour one asset class over another, cyclically-adjusted price/earnings ratios are “useless,” says Eoin Treacy in FullerTreacyMoney.
“Not only are they a lagging indicator by definition, but they say nothing about relative valuation. Outperformance on the other hand is all about relative performance.
“When is the best time to own equities versus bonds? It is generally when the expected return on equities is better than bonds. The easy way to programme that is to take the disparity in the yield between the two asset classes. When stocks yield more than bonds it gives a buy signal.”
Tailpieces
Gold: It’s the top choice for increased investment this year by the mega-rich, according to a survey of 700 family office executives, wealth managers and private bankers by real estate agent Knight Frank. The asset classes that are next most favoured are private equity and cash. Least favoured… listed shares.
Germany: Its international interests are increasingly stretched between two opposed considerations. On the one hand its defence depends on America, which bases 40,000 troops on its territory. On the other hand its largest trading partner is China, accounting for $200 billion a year of its exports and imports.
Ireland: It’s not surprising that the two major political parties were savaged in last month’s general election as (typically) they ignored the issues that mattered most to voters. Over the past five years rents have risen 40 per cent but average earnings only by 14 per cent.
Coal: Despite its public support for global carbomania, Japan plans to build as many as 22 new coal-burning power plants over the next five years. The country has to import four-fifths of its energy resources (in the form of natural gas, oil and coal). Its citizens are very hostile to nuclear power because of what happened at Fukushima.
Brexit: It’s interesting to see how wrong have been nearly all the predictions of the experts who warned that voting for it and then implementing it would be a disaster for Britain. Since the referendum more than a million additional jobs have been created (unemployment is the lowest it has been since 1974).
Rare earths: Although China is still responsible for almost two-thirds of global production of these metals so important in electronics, other players are entering the market to diversify supplies. The US, which ships its rare earths to China for processing – no one wants to do that because it seriously pollutes the environment – plans to build the first processing plant on American soil.
Paper mountain: German banks are reported to be running out of space to store all the mounting hoard of banknotes for wealthy clients unwilling to keep their money in bank deposits where it’s subject to negative interest rates.
The wisdom of Warren Buffett:
“I try to invest in businesses that are so wonderful that an idiot can run them.
Because sooner or later, one will.”
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