I’ve been reading the biography of Edison recently and the sheer volume and expanse of his creativity and innovation is almost unbelievable. He is credited with over 1093 patents in his lifetime and with the creation of over 100 companies. What struck me however was that he was not only focused on the creative and generative process, but that every “invention” had to be practical and have some economic feasibility. There would be no WeWorks coming out of Menlo Park. It got me thinking about disruption, and the scope and scale of disruption as it exists today versus Edisons day. You can be sure that there were outstanding ideas and inventions that permeated the labs in that New Jersey suburb, but yet never saw the light of day because they weren’t feasible, feasibility as defined by profitability. Contrast this with WeWork, which was neither innovative nor profitable, however in the absence of both was still able to amass substantial investment dollars, that is until the brick wall that always ends such schemes:Financing. Describing the selection of growth over profits WeWork management stated back in the heydays of early March “We can very much, if we chose to, moderate our growth and become profitable,” Artie Minson, WeWork’s president, said in a telephone interview. “But it’s a time for us to continue to accelerate.”
The disruption in the repo market in the U.S. has generally been dismissed as simply a mechanical problem driven by a regulatory environment which ring fences reserves rather than letting them flow to market driven liquidity events such as what we are seeing currently. What has not been discussed is that the start of such issues began to surface as Treasury borrowing needs started to amplify given that we will have close to a $1Trillion deficit to fund, without the Fed as a partner we might add. Such issues did not surface over the last 10 years as the Fed was a willing participant in the public debt -for private growth tradeoff that we have so mindlessly embraced. Rest assured that there will be more plumbing problems to come, particularly as capital controls and currency wars virtually ensure more unintended consequences.
By now you are aware of the latest unicorn to fall on its own alicorn (look it up!): WeWork. WeWork was the private- equity- funded landlord whose various levels of incremental financing placed a pre-IPO valuation of $45 Billion. Unfortunately for the management of WeWork and its sponsors, the details behind this business model in preliminary prospectuses showed that building out and sub-leasing commercial office space isn’t as revolutionary, or profitable, as was portrayed. In short order, the IPO was scrapped and the existing business was looking compromised as a cash crunch began to emerge with the lack of any near term infusion of capital. Fast forward several weeks later and the original capital source is looking to take the company private at a valuation of less than $8 Billion. Much like in the 2000’s era, you began to get talk about the “lost” $37 Billion, as if the spreadsheet valuations placed on this company represented actual dollars. That $37 Billion was lost only in the sense that the actual business was viewed through the lens of reality and not through the distorted prism-like view afforded many via Central Bank policies. Discounting cash flows (assuming there are any) at minuscule or even negative, rates of interest not only cause distortions like WeWork, they encourage them, so look to see more WeWorks in the future as reality and fantasy come together in a not so happy ending.
As the Presidential race unfolds and the slate of Democratic candidates is winnowed down to a mere 10 or 12, it becomes less clear what the potential outcome of the election might mean for capital markets, particularly given that electing the Donald did not provide any clear cut winners that one might have surmised at the time. As we can see from the last 3 years, The Donald is ostensibly for the following: low taxes, low interest rates, low dollar, and low to no regulation. Democrats (who so aptly put by David Brooks of the NYT, seem to act as if they are all running for president of Brooklyn) are for: higher taxes on the wealthy (wealthy to be determined), strong green initiatives including onerous regulations on energy across the board, and a multitude of changes to health care depending on the day and which candidate you are speaking with at the time. At its very core, its one side playing defense with the other side trying to coalesce enough to play offense. Republicans would have you believe that its about protecting what’s ours via tariffs and targeted tax legislation, Democrats would have you believe that its time to take back what is collectively “ours” through punitive tax laws and re-regulation of industries which are deemed environmentally unsound. While my intent is not to get into a discussion of the relative value of each party position, what is clear is that as the economy weakens further, the efficacy of monetary policy will prove to be less and less outwardly effective at staunching the decline, leading both parties to support (read demand) new monetary policies which stand outside the realm of pure interest rate manipulation i.e. direct payments to individuals. Think cash for clunkers but on a grander scale.
Bloomberg pointed out a study done by The Carlyle Group on the effects that the number of certain headlines had on private business owners. The results of said study was that, not surprisingly, business owners were swayed by what they were currently hearing and reading which led some to the thinking that the feedback loop in the current state of affairs might be stronger than one thinks. While this is no real surprise, some have taken this a step further in suggesting that Central Banks are doing a poor job of driving the narrative and should spend more time “storytelling” in an effort to better craft peoples expectations and henceforth actions. So, in a world of negative rates, Central Banks worldwide are suddenly empowered with one more tool in their monetary tool kit: Storytelling. In fact, comments from the Head of Swedens Riksbank speak to this new monetary weapon when he stated “I’m a shaman,” said Stefan Ingves, governor of Sweden’sRiksbank. “I’m a weatherman, I’m a showman, and I’m an
economist.’’ But above all: “I’m expected to be, and I am, a
storyteller. I tell stories about the future.” The stories that Central Bankers could be telling their constituencies now revolve around the ineffectiveness of interest rates on real economic activity, particularly at negative rates of interest.
The quote regarding the dollar from then Treasury Secretary John Connally as ” The dollar may be our currency, but it is your problem”, may have yet to be surpassed in the annals of currency commentary, but hold unto your seats because we are about ready to experience a good old fashioned currency war. Forget the trade war, the most critical clash we are about to undergo will involve the relative value of ones currency. While the ECB and The Fed may discuss the finer points of monetary policy, $17 Trillion of debt instruments worldwide sit at negative yields and the message they are screaming to us all is, interest rates don’t matter, trade flows do, and in the absence of real fiscal stimulus, trade flows are dictated by relative currency valuations. So, you can read between the lines from any Central Bank commentary, with the understanding that in a deflationary world, the only way to compete is to actively devalue your currency, and one subtle way to do this is through monetary policy.
We can now add the inverted yield curve to the lexicon of the average Joe along with the TED spread, The CDO Market and The VIX. Generally, these inside baseball terms only become suitable for mass consumption when something is amiss, or perceived to be amiss. As we have pointed out repeatedly, things have been non-normal in the global rates markets for many months now, and as of late the gravity of this disconnect between fixed income and the real economy has begun to hit home. It is our contention that the shape of the yield curve is an indicator, a global conglomeration of the forecasts and perceptions of what market participants feel will happen at that moment in time across a wide span of time horizons. The Federal Reserve, through a variety of measures can essentially control the front end of the curve, through its manipulation of the fed funds and discount rates, the rest of the curve is dictated by the market and as such is not necessarily under the direct purview of the Central Bank. It drives us crazy to hear some talk about the need for the Fed to “catch up” with the market, and it makes us even more insane to hear some argue that the Fed needs to forcefully steepen the curve to stave off a recession. Forcing a curve steepening is akin to focusing on the hair loss for a patient undergoing chemotherapy, the hair loss is simply the result of the treatment for the underlying illness and should not be the focal point of care. If one can take away anything from the inversion in the yield curve it is that an inversion in the yield curve at negative real yields indicates only that the linkage between rates and real economic activity has been severed. A steepening of the curve at these levels will accomplish absolutely nothing, particularly if it leads us deeper into negative rate territory.
As we try and understand the implications for ultra-low/negative rates of interest across the globe, we came across the a recent column in the FT addressing this very phenomenon. The article by John Dizard, discusses how the negative rates in Europe and low rates in the U.S. are fueling inefficiencies, bloated government budgets in the case of Europe and excess oil and gas production here in the U.S.. We would take this thesis even further to state that negative rates in Europe have led to stranded capital sitting on the balance sheets of insurance companies and pension funds( in the form of sovereign bonds) while low rates in the U.S. have led to excess capacity across almost the entire U.S. economy, the difference being only the transmission mechanism inherent in European vs. U.S. capital markets. Private equity, IPO activity and a deep credit and leveraged credit market would suggest that “excess” capital has found alternative methods of transmutation into the overall U.S. Economy. A weaker banking system, combined with a less robust private credit market, has generally driven much of the same excess capital into the Euro denominated sovereign bond markets. The end result of this dichotomy in transmission is simply where the stranded capital ends up: one as vapor in the form of negative rates and the other as actual vapor in the form of flared gas at the end of the permian producers pipeline.
An Op-Ed piece in the WSJ today by Peter Coors of Molson Brewing points out the input pressure that firms can encounter when tariffs are imposed, even after the tariffs are taken off. Mr. Coors, an extremely large user of aluminum sheet, primarily for beer cans, was complaining not only about the lack of global transparency in aluminum pricing but also about the apparent stickiness of pricing once certain tariffs were removed. In a world where pricing power is almost non-existent, should it surprise us that firms are taking advantage of artificial supply constraints in order to try to gain some upper hand in pricing. Mr. Coors stated that Alcoa had moved production to Saudi Arabia thus avoiding applicable tariffs, but continued to charge the tariff-based price. If someone like Molson has no market power to push back against such practices, what must it be like for the lesser players?. The problem with this type of “inflation” is that what is inflation to one company is margin compression to someone else, particularly in a sub 2% inflation world. One can assume that we wouldn’t be reading this op-ed at all if Molson had the ability to simply pass through the additional can costs to the consumer.
To paraphrase the philosopher Meghan Trainor:” Its all about the bps, bout the bps, bout the bps no credit”. In a world where the extra basis point, positive or negative (believe it or not) is pushing capital flows irrespective of the credit quality or credit worthiness attached to that incremental yield, or in some cases decremental yield. Italy, Greece, and now a number of, what previously were termed high yield, junk credits are drifting into single digit or negative territories. In a pre-Centrally planned rate environment, credit quality drove spread movement, however in this brave new world, spread movement drives credit analysis or the lack thereof. As Mark Twain was reported to have said ” History may not repeat itself but it often rhymes” and this market is humming some pretty familiar tunes. The reach for decremental yield, without any regard for creditworthiness is a sign of something very wrong with the global capital markets and is not simply indicative of a response to slowing global growth.