WorldoutofWhack

Louise Gave was interviewed by Tyler Hay of Evergreen Gavekal on above topics.

Summary

On Supply Chains

I think the question around global supply chains is already a big focus of the US presidential campaign. The arrow in President Trump’s quiver is to say that this all happened because China is an untrustworthy partner. There’s going to be tremendous pressure on industries coming out of this to reduce their exposure to the international supply chain.

I wrote a piece at the beginning of this crisis called “Exponential Optimization.” I think that if you look at the past decade, we’ve lived in a world where everything has been optimized as much as possible. That includes optimizing balance sheets, share buybacks, and portfolios; but it also meant optimizing the supply chain. If that meant businesses could find a producer in the middle of Wuhan, China that would produce goods cheaper than alternatives, then they would do business there.  Of course, the idea of producing things in Wuhan might no longer seem like the best idea.

One of the first things to look at when constructing a portfolio is how much government pressure will be placed on a business to produce at home rather than in China, which will undoubtably impact margins. Take healthcare as an example. We live in a world where 90% of antibiotics are produced in China. Is that something that the government will feel comfortable with going forward? My guess is that drug companies around the world will be told that if they want to sell their drugs somewhere, they have to be produced at home without regard to cost. We can’t live in a world where all of our drugs are produced somewhere else.

We had a 30-year stretch of globalization in the supply chain, but it turns out that finding the cheapest producer actually has an embedded cost that we weren’t recognizing. Now that we’re recognizing this cost, we’re finding out that it’s actually really, really high. I think there will be big disruptions to the global supply chain and people will probably want to invest in companies that aren’t going to be massively dislocated from needing to relocate their supply chains.

On Inflation vs Deflation

As a firm, Gavekal has been firmly in the deflationary camp for years and years. The reason for this is that every shock to the system was a fundamentally deflationary shock in that it didn’t really reduce supply – in fact, it often increased supply – but it did destroy demand. If you take the 2008 crisis as an example, we saw Quantitative Easing (QE) 1, 2, and 3, and a lot of people made the case that this was going to lead to a massive inflationary problem. But what people missed is China’s response to the crisis. It went on a capital and infrastructure spending boom such as the world has never seen. Up until 2008, if you were producing in China that meant you were either producing in Shenzhen or Shanghai. The production base for China was actually relatively small at that point. After the huge infrastructure spending boom China went through in 2008, you could produce in many other cities in China. The 2008 crisis resulted in nearly 500 million Chinese workers joining the global economy, which was a fundamentally deflationary shock. At the same time, oil prices were at $150/barrel and companies were pouring into new production all around the world. As money poured into energy infrastructure, oil prices came down over the next several years and today we’re much, much lower. Of course, the current economic hit means a destruction in demand, but the big question today is what happens to supply. What I see in the energy space is capital spending being slashed, so if I’m projecting three years down the road, I don’t think there will be an increase in supply of energy but a deterioration in the supply of energy.

Similarly, I don’t think that there will be an increase in the supply of workers. I think that the world will turn their backs on the Chinese workforce. Instead of bringing a supply of 500 million workers to the global economy, we’re going to be pushing them back. So even though I see a destruction in demand, for the first time in quite a while, I also see a destruction in supply. In fact, this entire crisis is really about a destruction in supply. We’re now seeing it in industry after industry.

My big fear is that if you look at the TIPS market (Treasury Inflation-Protected Securities), it’s now projecting inflation of 1.1% every year in the US for the next ten years. Aside for 2008, the US hasn’t had an inflation rate of 1.1% in the modern era. Now we’re supposed to have 10 years in a row?

Right now, the rate of inflation is 1.5%. What happens over the next six months if, instead of going to 1.1% as the market anticipates, inflation goes to 2.0% or 2.5% as the result of supply chain disruptions? I think that would create a whiff of panic in the markets. I’m much more afraid of inflation that’s not priced in, than deflation that’s fully priced into markets.

Russell Clark of Horseman Capital writes

1^st Half (2000-2010)– Reflation trade

From a purely macro perspective, the emerging market and reflation story of the 2000s was a reflection of the exciting macro story of that period, the rapid growth of Chinese exports

– Rising commodity prices, Weak Dollar, Strong growth

2^nd Half (2010-2020)– Deflation trade

The macro story of 2010s has been the tremendous growth in US oil and gas production, to make the US the world’s largest energy producer, and to turn the US from an energy importer to exporter.

Falling commodity prices, Strong Dollar, Weak growth

The tune – Core periphery model– Let me explain the components of this model

Core = US Dollar

Periphery = Rest of the world

1^st half money moves away from core fueling rally in Periphery (emerging markets)

2^nd half …The combination of slower Chinese growth, rapid oil production growth led to a collapse in oil prices, contributing to suppressed inflationary pressures, and this has precipitated a collapse in bond yields as central banks have desperately tried to reignite growth.

Rise in oil supply by shale + existing suppliers

Led to  Deflation

Which led to

which further led to

 Safety trades comprising of high tilt towards growth stocks + gold + long dated bonds

So what do we see happening

Many of these trends will reverse

Well the US shale boom seems to be ending which means us will be a net importer again and restart dollar weakening cycle.

With an uptrend of regulation moving towards the growth sector comprising highly of tech sector and a wave of regulatory green shoots regarding free riding of media platforms on free content we see entry of regulation as a reversal of the growth stock trend. The other parallel is like the dotcom bubble we live in the offload risk on to others platforms and a bubble based on Machine learning.

All this money from growth stocks will mean revert to Value stocks which have underperformed growth for better part of the last decade

Silver might start outperforming GOLD…..

and yield curve might start to re steepen again with help from short term yield capped by central banks.

Most investors are not ready for the change in this narrative and by the time they start repositioning their portfolio to reflect the new realities… major gains would have already been made.

I am talking about my favourite asset i.e Silver .

Gold/Silver ratio hit an all time high ratio of 1:120 in march this year and since then silver is silently outperforming GOLD with this ratio breaking down below 1:100 ( silver outperforming GOLD).

according to Midas Touch consulting

At this moment of time it takes about 97 units of Silver to purchase one unit of Gold. The monthly Gold/Silver-Ratio chart above illustrates that nine years ago it took only 31 units to accomplish the same purchase. Relationships like these rarely stay long in extreme measurements like the two mentioned. Consequently, it is quite reasonable to assume that we will at some point find ourselves near the 200 moving average, a value between those two extremes more likely in the future. Once Silver which is always late and lags, catches up with Gold’s extension, this medium Gold/Silver-Ratio zone will be reached. This means there is a force in place driving Silver prices still higher.

Julian Bridgen of M12 Partners write

After hitting our initial target around $100, the market chopped sideways for a week. But now, the Gold/Silver ratio appears to be starting the next leg. My target is the mid-80’s … a lower gold/silver ratio is historically inflationary!

The best way to capture Silver upside is through Silver Miners.

Keith Dicker has taken us to the uncomfortable corners of the investment world in this month’s newsletter.

The link to newsletter is attached below but I thought of sharing this chart from his newsletter which clearly depicts the outcome of massive money printing across the globe

http://icecapassetmanagement.com/wp-content/uploads/2020/05/2020.05-IceCap-Global-Outlook.pdf

Federal reserve Bank dusted an old trick to kill two birds with one stone.

Federal Reserve Bank of New York President John Williams said policy makers are “thinking very hard” about targeting specific yields on Treasury securities as a way of ensuring borrowing costs stay at rock-bottom levels beyond keeping the benchmark interest rate near zero.

“Yield-curve control, which has now been used in a few other countries, is I think a tool that can complement -– potentially complement –- forward guidance and our other policy actions,” he said in an interview Wednesday on Bloomberg Television with Michael McKee and Jonathan Ferro. “So this is something that obviously we’re thinking very hard about. We’re analyzing not only what’s happened in other countries but also how that may work in the United States.”

This will not only ensure a lower value of USD and increase the inflation expectation but also lower the DEBT/GDP by inflating away the debt.

The same remedy was applied by US in aftermath of WW2 nation building.

The default on bond obligation was more nominal than real. With cap on bond yields and increase in spending, the real interest were negative for better part of decade. The smart money went in search of returns and that decade was one of the best period for US equity markets as higher inflation and lower bond yields coupled with war spending led to higher corporate earnings and reduced the over all Debt/GDP of the US economy.

Conclusion

Fed is increasing floating trail balloons about yield control and I believe we might see the post WW2 playbook again which will lead to -3% to -5% real rates in US in next few years. This will be the decade when real assets makes a come back.

There are three distinct sides of risk –

1.Odds of a phenomenon occurring

2.Average consequences of a phenomenon occurring.

3.Tail end consequences of a phenomenon occurring.

As this crisis and almost every decade we find our financial system being dominated by players who concentrate on the first two aspects of risk and not the last one. These funds like a few quant funds had risk party executed using low vol strategies which blew up even in the face of fed backstops.

These tail risk events don’t matter until they suddenly are the only thing matters as the market swings from purchasing power risk to principal risk. Now is there a class , textbook or special coaching that can allow you to think about tail risk. And the answer seems to be no because such a calculation is not rationally possible by the brain nor is it possibly computable in the fundamentally uncertain universe, we live in.

It is over here that experience or trauma matters because these memories can fundamentally reshape your risk aversion and perception through its effect on the hippocampus and Amygdala of the brain.

The author recounts his own experience where he and two of his other friends would go out skiing sometime in places that they weren’t allowed to as they were prone to avalanches. This one time he actually faces an avalanche that does not turn out to be life threatening but buries his feet in the snow , all the friends laugh it off but he was clearly shaken. The next time he went skiing again with his friends on being asked to ski the dangerous parts again , he unconsciously said no. The author makes the point that these unconscious decisions can affect our lives for better or worse , much more than the conscious decisions which fall into the first two categories of risk.

In investing, the average consequences of risk make up most of the daily news headlines. But the tail-end consequences of risk – like pandemics, and depressions – are what make the pages of history books. They’re all that matter. They’re all you should focus on. We spent the last decade debating whether economic risk meant the Federal Reserve set interest rates at 0.25% or 0.5%. Then 36 million people lost their jobs in two months because of a virus. It’s absurd.

Tail-end events are all that matter.

Once you experience it, you’ll never think otherwise

https://www.collaborativefund.com/blog/the-three-sides-of-risk/

As the Long-term debt cycle dynamics become more important as the day passes. This crisis has been one where we have had demand and supply side contraction at the same time. The current scenario signals deflation and may also render previous inflation indices meaningless.

While previous money printing by central bankers had to led to hyper inflation , Current US M2 shows large jumps in growth , so a combination of constrained output along with rapid monetary growth may signal inflation , if velocity of money follows an uptrend. However , just like the last bout of inflation in the 1970s an unexpected surge in inflation might come about as supply chains fray. The supply chains are concentrated and more fragile than ever before, for example the shutting down of one Tyson food plant had affected 4 to 5% of pork supply in the US.

The probability of highly fragile structures failing and leading to inflation cannot be downplayed and deserves a much important role in portfolios. As a trader remarked on CNBC that the bond market almost universally expects deflation which means there will be inflation.

The problem is if we see the worst possible outcome i.e STAGFLATION. The supply chains are going to be reshored, inventory buildup is no more going to be Just In Time but more long term and this will increase the use of working capital. I agree, the demand will take time to recover, but for STAGFLATION, you don’t require high demand but a reduction in supply.

I believe the outcome of COVID will be a STAGFLATION and don’t count on bond markets to tell you that because any signs of INFLATION/STAGFLATION will lead to capping of yield by central bankers.

In the chart above of US 10 year treasuries you can see that yields are now confined to a range. whether by design or market forces will determine the future performance of different assets.