What's up Global Health and Recession Fears?

How crazy a month can do to markets let alone a week. We officially have entered a correction, but the question now is if we will enter a global recession. All 11 S&P sectors are falling, and the only shelter seems locked up in your house (for health reasons) and stored up in Gold (“flight to safety”). The market will continue to fall as long as the virus continues to spread, more people die, supply is restricted, travel is prohibited, and productivity is limited.

Dear Reader,

The Market.

• The Fed cut interest rates by 50 bps in an emergency to control the economy… it did not work. The market is betting on another cut of at least 25 bps (100%) or 50 bps (65%) at their next meeting on March 18th.
  • President Trump and others have been relying on the Feds to maintain economic growth through all means necessary.
  • The Feds can cut rates, but that only increases demand. The real problem is in the supply shock.
  • “Rate cuts cannot stop the spread of the virus, nor are they particularly well-suited to deal with supply chain disruptions; however, they can contribute to an environment where easy financial conditions buffer the economic shock, as opposed to exacerbating it.”
  • The best thing the government can do is increase funding for treatment and resources to stop the spreading of the virus 
• Years of extremely lax financial conditions have encouraged and enabled massive issuance of debt at ever-lower interest rates, including tighter spreads over risk-free government securities. The easier it became for companies to issue bonds, the greater the temptation for companies to engage in what is known as financial engineering to alter their capital structures. This trend has been amplified by private-equity transactions that lever up balance sheets as a matter of course, to fund distributions to investors.
• February 2020 Manufacturing ISM reported at 50.1%. Production growing, new orders and employment contracting, supplier deliveries slowing, backlog growing, raw materials inventories contracting, customers’ inventories too low, prices decreasing, exports growing, and imports contracting.
• Mortgage rates hit a record low.
  • For the week ending March 5, the 30-year fixed-rate mortgage averaged 3.29%, down from 3.45% the prior week. Compared to a year ago, the 30-year fixed-rate mortgage averaged 4.67%.
• Total nonfarm employment rose by 273,000 in February, the unemployment rate dropped back down to 3.5%.
• As of 1:11 pm PST March 6, 2020, the COVID-19 has 101,781 global confirmed cases and 3,460 global deaths.
• The biggest fears of the Virus: the diminishment of our quality of life, a credit crisis (the financial crisis is tightening up, there is stress in consumer lending, it is becoming harder for non-bank companies to service debts, and consumer debt is increasing in delinquencies), and a global recession
• Current opportunities to look at: GOLD, long-term net lease REITS, biotech companies, and food retailing.
  • Everybody should own Gold. Gold is bought as insurance. In times of panic, people cash out their insurance.
• Future opportunities to look at: European banks (trading at half their book value), airlines, cruise lines, and tourist companies (plummeted due to travel restrictions and the fear of traveling), more affordable tech companies, e-commerce companies, and blue-chip stocks.
• Apartment and manufactured home park values tick up 0.3% in February.
• How property prices have been doing since 1997:​

To Lever or Not to Lever. You've probably all heard the term "leverage" before. What does it mean? It simply means to take on debt to finance a project. The more debt you take on, the more levered you are. A logical reaction to this is, "Hey, why would someone/a company purposefully take on debt when they don't have to? Isn't debt the harbinger of doom?" This is where we believe societal connotations have failed society, at the very least in a financial literacy aspect. We have all been brought up thinking that debt is some horrible thing that should be avoided at all costs. While it certainly can be a problem if it gets too high beyond a corporation's reasonable ability to pay it off, it should be looked at in a neutral light. Debt is more important to the economy than equity/stocks. Debt is how corporations finance most of their projects. Debt is what allows tens of millions of Americans to own a house. Why take on debt? For a homeowner, it's easy to see. Most people don't have hundreds of thousands of dollars laying around to buy a house in cash. They take on a mortgage (aka debt) and they slowly pay it off. For a corporation with billions of dollars in cash/cash equivalents, why take on debt? To increase the rate of return. Say there is a new project for a company that has a cost of $1 million for a new facility. Say that, at the end of 5 years, the present value of the 5 annual cash flows equals $1.1 million. The project has returned ~10%. However, what if we used leverage and only put 70% of our own money down and took out a loan for the rest? We spend 700,000 and take a 300,000 loan. Now we have only spent 700,000 but we still generated cash flows of $1.1 million. Of course, we still have to pay the interest. Let's assume interest is $25,000 (in the real world the interest will be an annual/monthly rate that compounds, but this is a newsletter so let's keep it simple).  So we have spent 725,000 to generate 1,100,000, which gives a return of 52%! That is the power of debt. 


Dollar iliquidity Theory - theorized and popularized by Luke Gromen.  Dollar Illiquidity, or a dollar denominated shortage, comes from a mismatch between supply and demand, with the later overpowering the former. When we are mentioning the USD, we are talking about all dollar-denominated safe assets, which are considered like-money. This idea of dollar liquidity can get very complicated, relatively fast, so we will leave it at this definition.
A dollar illiquidity crisis, in its simplest sense, means a dry up of liquidity. This results in a general decrease in loans across the board. The second derivative consequence leads to a rapid appreciation of the USD, leading to strain on international trade and net imports outside of the US. We recently saw a sign of this dollar illiquidity through our repo market, whose rate blew up to over 10% in late 2019. 
Now that we have what it means down, we can get into how this has come about. The major underlying cause of this stems from directly after world war 2, when the USD replaced the British Pound as the new global reserve currency. The global reserve currency is a central currency which is held by a majority of central banks and other monetary authorities for the means of international trade, cross-country investments, and most aspects of the global economy. The global reserve currency cements that nation as the most fundamental aspect of the global system. This creates a large demand for our US greenback, increasing our dollar prices. Realistically, this in part, leads to the US being viewed as a safe haven during times of global doubt. This is net positive for the US, while being negative for the rest of the world. Hypothetically, this should allow the US to not only weight out a global recession, but should lead to increased risk-free and risky asset prices and further dollar appreciation. 

The Death of Titan: “Neutron Jack”. Jack Welch who was the CEO and Chairman of General Electric from 1981-2001 passed away on March 1st, 2020. Mr. Welch was for many people the embodiment of what it signified to be a CEO. During his tenure as CEO, GE’s revenue increased nearly fivefold, skyrocketing the company to become the most valuable in the world. His success in leading GE allowed him to become one of the most well-known business leaders of all time, including making the cover of more newspapers and magazines than any other CEO. At the time of his death, Mr. Welch was worth nearly $750 million, but that was not for nothing. Over two decades for better or for worse Jack Welch lead GE to stardom during some of the most turbulent times in the American industry and helped shape what it means to be a “CEO”. Thanks to some innovative management and organizational strategies, GE’s value increased by $400 billion over 20 years. Mr. Welch pioneered the idea of “a boundaryless company” during a time when corporations put little effort into the corporate culture. In 1990, Mr. Welch introduced GE to his idea stating, “Our dream for the 1990s is a boundaryless company, a company where we knock down the walls that separate us from each other on the inside and from our key constituencies on the outside.” As a result, GE reduced the bureaucracy and instead focused on its employees. This led to a golden age of innovation at GE as it became a company that attracted talented employees who gave their all. Noticing the success this had, Mr. Welch doubled down on his idea and pushed for increased self-confidence among his employees. He gave many of his employees the word “manager” in their title, which lead them to take ownership of their work and see their projects through until completion. To work out the issues that would arise from having lots of passionate people work together GE held “town meetings”. Finally, in what was most likely his single greatest decision he "de-layered" GE. Like every large company at the time GE had grown to be inefficient and was weighted down by its hierarchical organizational levels. By reducing these layers, Mr. Welch reduced costs, minimized delays, and allowed GE to operate as efficiently as a small company while competing on a global scale. This strategy would go on to influence business leaders around the world, especially in Silicon Valley which gave way to a new generation of CEOs. 



Keep Climbing,


The Alchanati Campbell and Associates Team