Alchanati Campbell & Associates
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.
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.
The Alchanati Campbell and Associates Team
WHAT'S UP FRIDAY? is a weekly newsletter that will give you a summary of "What's up?" on Wall Street, in the US and around the World written by The Alchanati Campbell and Associates Team. What makes us unique is we focus on long-term knowledge; knowledge that will still be useful to you 10 years from now.