Crypto Market Commentary 

28 April 2020

Doc's Daily Commentary

 

The 22 April ReadySetLive session with Doc and Mav is listed below.

Mind Of Mav

Predicting The New World Order

“Those who have knowledge don’t predict. Those who predict don’t have knowledge.” − Lao Tzu

Pattern recognition and mean revision — predictions of what will come based on what came before. Human behavior follows a series of cycles if you know what to look for. Mapping patterns from the past into the present tense gives you a shot at what is likely to come in the near future, admitting there is simply no way to know with absolute certainty.

Still, patterns, by definition, repeat themselves and history tends to rhyme. Imagine a pendulum swinging back and forth over time, reflecting the patterns — the ebbs and flows – of human society throughout time.

For example, last week we covered how, in all likelihood, we’ve reached “peak globalization”. Now, for those of a discerning type, that might seem like a foolish proposition to make. After all, will it truly come to pass that all nations of the world recede back behind their borders and global trade as we know it ceases to exist?

No, of course not.

Peak-globalization simply means that, as the pendulum of casualty starts to swing back, we can observe a shift in global trade as a reaction to the shifting environment. Should global trade fall, as it has, we will inevitably see a return to the previous levels of trade, production, commerce, etc.

But, importantly, this mean revision carries a different tone. What changed? How did it change? What was left behind? What is new?

That is how we look at the future with a degree of understanding — brought about by our recognition of these patterns.

Now, as we were discussing, the beginning of the end of globalization has begun (or has ended?)

How did we get here? What is causing this?

For 40 years now the United States has dismantled international trade barriers and businesses have focused more on the financialization of their businesses through accounting wizardry, the legalization of stock buybacks in 1982 (thus supporting one of the first of many mispriced asset bubbles), and the heralding of CEOs like Jack Welch as a Wall Street darling by inflating the company’s stock price at all costs but largely sinking the company’s long term hopes of remaining competitive. Welch closed factories, reduced R&D and terminated 112,000 employees from 1980 to 1985. 40% of GE’s market capitalization at its peak came from its financial services arm, GE Capital.

Unfortunately, that didn’t work out for them.

As Andrew Haldane, Chief Economist of the Bank of England, eloquently observed: “Financialization has polluted the entire physical investment process, the labor markets, and the innovation cycle of firms. The damage it inflicts on investments in physical and human capital is hugely important, because that’s what slows down growth.”

Back in the 1960s and ’70s, companies invested about 40% of each additional earned or borrowed dollar into the real economy. Since the Reagan era began, all of that has largely gone into the stock market.

This is why, after only weeks of economic disruption, major corporations with billions on their balance sheets are begging for bailouts. Rather than invest their profits into their own company, or store capital in a corporate version of an emergency fund, they’ve instead bought their own stock (stock buybacks) in order to prop up their share price. During the longest bull market in history, this bad behavior was the norm as shares hit all time high after all time high.

CEOs of corporations were incentivized to operate this way based on how bonuses are structured (stock goes up, CEO gets bigger bonus), corporations were incentivized to operate this way because if they didn’t their competition would and become a darling for hungry investors (this is known as moral hazard), politicians were incentivized to allow this because it was “good for the economy” and if they spoke out against it then the other party would label them as “anti-business” and round and round we go.

But, this wasn’t the only factor regarding globalization’s demise.

For the past couple decades, corporations have largely focused on developing the cheapest possible product for the largest consumer base while hiring MBAs and consultants to help drum up additional alpha to prop up their share price. The result? Fewer manufacturing plants stayed open and supply chain innovation largely moved offshore.

This is why we’ve seen such a negative reaction to the status quo as countries have been unable to provide their citizens with protective materials — all of that manufacturing had been moved overseas long ago.

Given the stranglehold on the global supply chain the coronavirus has created, self-sufficiency and domestic manufacturing is now a national security interest. The pendulum of cheap labor and goods outside of the country is now swinging back towards the homeland.

Therefore, it is very likely domestic manufacturing is set to return to developed nations, causing prices of goods will go up — otherwise known as inflation.

The Coming Inflation Avalanche

Assuming domestic manufacturing picks up, prices will be going up along with it. Why? Well, a factory worker in Shenzhen is less expensive than a factory worker in Columbus, Ohio. That’s the simple reason.

Monetary policymakers have been enjoying a steady decline in inflation since, you guessed it, the beginning of the Reagan era.

For 40 years, inflation has been dropping and consumers have rejoiced. Prices for goods have remained incredibly cheap, but risky assets, like houses and stocks, not so much.

You may be thinking, if prices go up and the consumer has less money because of a fractured economy, how do people afford to buy anything?

Let me tell you about Universal Basic Income or UBI.

In the short term, UBI will be the backstop for the initial consumer “sticker shock” from higher prices as well as the impact of automation managing the majority of manufacturing jobs. Yes, manufacturing will likely be coming back to the United States, but most of those jobs will be automated.

Once the UBI ball gets rolling, there is no stopping it, no takebacks. It would be political suicide for a politician to stop paying people to feed their families with their “stimulus checks”. Nearly overnight, the “fiscally responsible” party and current administration went from fighting anything remotely associated with socialism to directly depositing money into citizens’ bank accounts. The about-face is striking, but let’s be clear once you turn on the socialism spigot, it does not get turned off and in fact, only gushes. Quantitative easing (QE) is the canonical example, but it is socialism for the wealthy, not everyone else. Socialism for the rich leads to socialism for all and here we are.

QE To Infinity . . . And Nowhere Beyond

In 2008, the Federal Reserve enacted its first round, QE1, of quantitative easing by purchasing government bonds, mortgage-backed securities, and other assets to add money directly into the economy. By June 2010, the Fed held $2.1 trillion worth of assets on its balance sheet.

Ben Bernanke, the Fed Chairman during the global financial crisis, was convinced that over the long term, his policy would be net-positive for easing the strain on the financial system and would become a tool beyond cutting interest rates to stimulate the economy either in crisis or post-crisis. However, QE was still an experiment that we are now seeing play out quite differently than expected.

QE coupled with the bank bailouts (and eventually General Motors) were deemed necessary at the time to bring order back to markets and instill confidence in the banks and ultimately, consumers. However, cheap money now flooded the markets and with interest rates at zero, the goal of money was not to save it (you earn nothing at 0%) but to spend it, to stimulate the economy. Recall, more than ⅔’s of the country’s GDP is based on consumer spending.

The problem with artificially stimulating the economy by expanding the money supply is that savers can’t save for retirement safely or with little to no risk — they must invest in riskier assets to get a return, hence the meteoric rise seen over the past decade in the housing market, stock markets, venture-backed startups, etc.

And our multi-asset bubble is now growing…

In late February 2020, after 11 years of bidding up risk assets, we began to witness the unraveling of markets that were radically and resoundingly mispriced. The fastest 30%+ drop in the stock market ever recorded as well as one of the most extreme moves in the bond markets ever both occurred, rattling global markets and nearly nuking a number of prominent “risk parity” hedge funds in the process. Don’t fret, they were bailed out first.

Since then, Fed Chairman, Jerome Powell, took what Bernanke started and injected it with steroids. Not only has Powell dramatically increased the Fed’s balance sheet, but he is also expanding the types of assets the Fed can purchase, including, junk-rated bonds. That’s right, junk.

The Fed also announced it would purchase an “unlimited amount” of Treasuries and mortgage-backed securities in order to support the financial market. Once you put QE in motion, it doesn’t stop and it requires more and more to satisfy its needs.

QE infinity is the logical conclusion of QE

This same pattern applies to UBI.

UBI version 1 (call it stimulus checks all you’d like) leads to UBI infinity.

The Fed’s aggressive monetary policy now completely eliminates accurate price discovery/valuation models for businesses. It is clear: The Fed will simply backstop anything they deem risky to economic growth. They will go further down the capital structure, junk bonds, to bailout these businesses. All those economic formulas for valuing companies taught in business school are now meaningless.

To put another way, the Fed is juicing socialism for the rich by propping up and rewarding CEOs of publicly traded companies for poorly managing risk and not allowing them to fail.

By moving further down the capital structure, the Fed is backstopping preferred investors in private businesses and thus ultimately propping up their share prices.

Why? Here’s a simple example.

Let’s assume Boeing is headed for bankruptcy. In a restructuring, equity shareholders get wiped out first as they are at the bottom of the capital structure. Those higher up the structure lose less, if at all. So let’s say you’re a Boeing 2030 (that’s the year) bondholder and you’re worried about losing money on your investment if the company fails. What will you do? You’ll sell the bond to cut your losses.

Now, imagine the Federal Reserve is there to catch you by purchasing those bonds. You got bailed out.

Guess who owns those bonds today? The wealthy (for the most part).

But since credit holders are more or less guaranteed their Boeing bonds will be worth money, the likelihood of the company failing drops and then this is reflected in the share price. So equity holders rejoice! The value of their Boeing stock will continue to rise.

Unfortunately, 92% of all stocks are owned by only 20% of Americans, and the chasm between the rich and poor widens even further.

As you can see, this is a pattern worth recognizing, and the basis of a new breed of Central Bank that is slowly taking over.

Tomorrow we’ll continue this discussion by talking about Nationalization.

 

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