Author: Mark Sloss (Page 1 of 6)

WCM Chart of the Week for May 1, 2020

This past week we witnessed two of the worst US economic reports many of us have ever seen. On Wednesday, it was reported Q1 GDP contracted 4.8% on an annualized basis, and Thursday’s unemployment report brought the total number of newly unemployed to over 30 million, consuming all of the jobs gains since the depths of the Great Recession. But, even with all the bad news on the economic front over the past several weeks, the US stock market as measured by the S&P 500 posted its strongest monthly gain since 1987. At least for now, the stock market is looking beyond the current rut to the potential for prosperity on the other side. That is certainly reasonable considering the amount of monetary and fiscal stimulus being injected into the economy and capital markets as we have been discussing for several weeks. Against this backdrop we are still compelled to ask ourselves what the trigger for re-testing the March equity drop might be. It could be an acceleration of virus cases, a state-level bankruptcy or two, or China-related backlash or retaliation. Current state of mind – hopeful but watchful. [chart courtesy Standard & Poors and Bloomberg LP © 2020]

A new definition for “systemically important” businesses

At the peak of the Financial Crisis in the stretch from 2007 to 2009, we became familiar with the notion of systemically important institutions. With the failure of major banks and investment banks like Bear Stearns, Lehman Brothers, Countrywide and Washington Mutual, the private and public sectors had to come to grips with the idea that for-profit businesses could be so essential to the orderly functioning of the overall capitalist system that they could not be allowed to fail, even if that required the rescue of a public company with taxpayer money. This notion gave rise in part to a series of laws and regulations including the Dodd-Frank Wall Street Reform and Consumer Protection Act. Certain financial institutions were too important either by virtue of function or size or both to be allowed to fail, undermining confidence and the orderly conduct of our economy and markets. These institutions would be protected, but they would also be more critically regulated to mitigate the risk of failure.

Whether standing in long lines of anxious neighbors to stock up on staples or watching a public address from the White House rose garden, we have been presented with a new and really more fundamental notion of what a systemically important business is. In fact, the shelter-in-place approach to mitigating the spread of COVID-19 has created a new class of systemically important businesses as we redefine, on the fly, what used to be luxuries like working from home or having household staples delivered as now being existential.

Through the present market turmoil, it is difficult to see this new order clearly, but in the months and years to come we will collectively be forced to reflect on what we are learning through experience now. There are fundamentals to the orderly functioning of communities and societies that we all know intuitively, and yet we continually fail to prioritize until we are tested. Right now we are sitting at the bottom of Maslow’s hierarchy of needs, focusing on physiological and safety needs. That’s health, food, water, shelter, personal security, financial security, and so on. Our current situation is depriving us of the ability to climb further and focus even on social belonging because of the paramount importance of the first two.

We can make light of the run on toilet paper, canned goods and hand sanitizer, but that is as explicit a manifestation as there is of what matters right now – health and hygiene and nutrition. The systemically important are food producers and grocery stores, pharmaceutical companies and pharmacies, hospitals and laboratories. They are also the providers of basic infrastructure, public and private, that keep the lights on, the water flowing, and goods and services moving from point A to point B so we can be home and be socially distant. We are also going to get a graphic look at how fragile the bottom of the economic ladder is where access to basic physiological and safety needs is not assured on a good day much less in the midst of a crisis.

From an investor’s perspective, this will cause a re-rating of securities according to what really matters when we are against the wall. From municipal finance to support hospitals and emergency workers to ownership of companies that are essential to the food supply chain, we will have a renewed and clarified sense of where our investment capital is the most needed and where it should be treated with the highest levels of stewardship and oversight, whether or not it is backstopped by government, because these companies and services are simply too systemically important to fail. And with that, there is an opportunity for companies and for governments to rethink stakeholder rights and responsibilities, and to provide best-in-class transparency and good governance and prioritize quality and longevity over short term rewards.

The view from here

In these last hours before the US markets open for this week’s sessions, here are a few more thoughts we have shared in our community.

Global markets finally caught up, in the negative sense, to China’s stock markets as worries about the COVID-19 “novel” coronavirus spread to the developed West faster than the disease itself. A contagion of concern overtook markets and left us with a week of returns we have not experienced since the Financial Crisis in 2008. What is materially different from our perspective is that this correction is not a response to a lack of faith in the system itself. During the Crisis, securities prices collapsed on the fear that it was actually impossible to value many of them, and that large parts of the system were in fact worthless. In certain cases this did prove to be the case as a sudden disappearance of liquidity exposed a large quantity of bad loans and mortgages that had been ingested by major financial institutions, causing the collapse of systemically important operations like Lehman Brothers, Bear Stearns, Washington Mutual and Countrywide. There was absolutely widespread panic that we could be facing a new Great Depression as the financial system itself seized.

This past week was very different. As we have previously explained, COVID-19 of course has and will continue to have economic consequences, but it does not call into question the soundness of markets, banks and whole economies as we experienced a dozen years ago. We find it likely that the response to the virus will impact company earnings and the GDP of nations. Shutting down the 2nd largest economy (China) for weeks if not months would never have gone unnoticed and unpriced. Reasonably, that demands revisiting what companies are worth and whether yesterday’s prices reflect tomorrow’s realities. Prior to the outbreak, fundamentals were reasonably solid around the world. Not boom, but certainly not bust. The situation we find ourselves in could take that optimism down to modestly solid, or perhaps slightly weakened. But even a mild global recession triggered by this moment does not call into question the fundamental underpinnings of finance and commerce. We are seeing steep and sudden drops in stock markets that remind us of 2008, and nearly unprecedented lows in interest rates, without anywhere near the breakage that brought about those kinds of corrections historically.

So, in a word, why? We see a few different forces at work which all feed our collective response to unconstrained uncertainty. Emotion, namely fear, is always a powerful motivator. Fear of the virus, fear of losing money, reasonably make people want to be safe. 2008 still looms large in the minds of investors and a PTSD-type response is not out of character. Fool me once, shame on you. Fool me twice, shame on me.

That emotion is being fed by a toxic brew of real, or worse, real but incomplete, data without framing or context, and quite a lot of false narratives. Add to that the markets are now patrolled and exploited by algorithms and artificial intelligence engines that can actually capture and quantify shifting sentiment and strong moves one direction or another in prices, and exploit or even amplify or aggravate those moves for profit. We have seen numerous isolated examples of this played out in the “Flash Crash”, the “Fat Finger”, and other moments over the last many years which show how quickly and to what extremes things can break loose on little information or bad information. Throw something at the market like the novel coronavirus and we could experience those types of extreme (over)reactions again and again.

We anticipate that clarity and greater understanding around the virus’ pandemic qualities and impacts will help markets firm up, and would not be surprised to see a fair price for securities settle at something less than the peaks from just a couple weeks ago after accounting for the drag from lowered economic activity. It is also our expectation that we will see some manner of coordinated global response across the major central banks to compensate not for falling stock prices but for potential lost GDP from less commerce, less travel, and less work. Depending on the magnitude of the response this could put a floor in prices, or at least slow the descent and tamp down volatility while investors regain their footing.

Less than a novel on novel coronavirus

Following are a few notes we shared with our clients and their trusted advisors earlier in the week that we think warrant repeating as we finish what has shaped up to be the worst week in the markets since the Financial Crisis.

COVID-19, popularly and generically referred to as “the (novel) coronavirus” has become that X factor we look for that comes from outside the markets and the normal news cycle to disrupt the status quo. While issues we have previously discussed like Brexit, the Hong Kong protests, and Iranian conflict are meaningful, markets generally take them in stride and try to price the risk. It may result in days or weeks of volatility, but eventually investors settle on how to value it. COVID-19, like Zika and SARS before it, is different. Brexit or HK are the product of people making active decisions. They may be decisions with adverse outcomes, but they are understandable, observable, and follow some kind of reasoning, whether or not we agree with it. Something like this virus introduces another dimension of uncertainty, because for now, we do not fully grasp the impact it will have on global health. So, even though we can observe and predict human decisions on how they are likely to respond to set information, the responses are and will continue to be dynamic based on the emerging understanding of and consequences of the virus.

We are not doctors, nor do we play them on TV, but we have been closely following not just the news cycle, but the output of expert organizations tasked with addressing this challenge. Indications continue to be that it is more easily spread than SARS and the bird flu, but the health impact appears to be less for healthy populations and the fatality rate lower for at-risk individuals, although most definitely and regrettably not zero. That does not mean this is something we take lightly either as investors or as global citizens. But it does help us chart a path forward. In the near term, the containment efforts are aggressive and the impact on society and commerce severe. As we have seen in China and now in South Korea, this has had an enormous impact on daily life and stopped business more or less in its tracks. The latest round of market reactions was triggered by a cluster of cases in Italy, which brings developed Europe into play. Emerging clusters in other areas like Iran suggest that with China as the vector, anywhere globally they have engagement and influence is a likely launch point for more cases. Inevitably this will lead to spread in parts of the world that either do not have the autocratic control of China or the health care infrastructure of Italy or Japan to address them, and we could see this accelerate to a global pandemic.

But, as counterintuitive as it sounds, from the investor’s perspective this may not be the worst thing. The economic damage being done is mostly from the preventative measures being taken to slow or stop the spread of the virus. Public transit is halted, air travel grounded, borders closed, events canceled, factories shut down, etc. If we find ourselves at a moment where these measures no longer restrain the spread of the illness, the focus will shift to healthcare and hygiene, as with seasonal flu and other communicable illnesses, and business ought to return to some semblance of normal. But in the near term, we are observing the volatility that comes with uncertainty, and also expect some degree of repricing as global economies absorb the consequences of lower activity. It is also not out of the realm of the possible that central banks will follow China’s lead and intervene to keep the economic engines running.

WCM Chart of the Week for February 21, 2020

More and more companies, including airlines and oil companies, are announcing an intention to achieve carbon-neutral operations over the next couple decades. But, it is important to look behind the headlines and understand what that sort of pledge actually means.  What business is the company actually in and does the pledge include their supply chain or product output? From the Climate Accountability Institute (Oct. 9, 2019, data through 2017), global fossil fuel and cement emissions from 1965 to 2018 totaled 1,354 billion tonnes of carbon dioxide and energy-related methane (GtCO2e); The twenty largest investor-owned and state-owned fossil fuel companies produced carbon fuels that emitted 35% of the global total (480 GtCO2e); Looking over the entire historical data set they find their current database of 103 fossil fuel and cement entities emitted 1,221 GtCO2e, or 69.8% of global since 1751 (1.75 TtCO2e); of which the Top Twenty companies are responsible for 526 GtCO2e, or 30% of all fossil fuel and cement emission since 1751. [Charts and data, Climate Accountability Institute, October 2019]

Climate Accountability Institute, October 2019
Climate Accountability Institute, October 2019

WCM Chart of the Week for February 10, 2020

The US Bureau of Labor Statistics has been reporting impressive trends across many demographic categories for several quarters. One of the most important trends we see is development in the female workforce. Total US Labor Market participation reached an impressive 83.1% rate in the key age category of 25-54 year-olds. These levels have not been reached since the pre-crisis era over a decade ago. The real story is gains made by female workers. Women in this demographic have led the overall participation rate, rising from 73.3% in late 2015 to its latest reading of 77%, three times the percentage gain of men in the same category who rose from 88.2% to 89.3% over the same period. Even with this good news, we cannot lose focus on UN SDG #5 (Achieve Gender Equality and Empower All Women and Girls). Women in the US still earn only about 80 cents on the equivalent dollar wage for a man, a gap which expands further for Latinas, black women and women of Native American and Hawai’ian descent. [Chart courtesy Bloomberg LP © 2020, data US BLS]

It’s beginning to look a lot like retail

As our esteemed Doug Wilde regularly points out, manufacturing isn’t the bellwether it once was of US economic output. We are a nation of users, not makers, now, and Retail is what matters. Unless you live in a well-stocked bunker, it is hard to avoid the focus on retail consumption this time of year. We will soon wrap up the big week of consumption capital in motion from “Black Friday” through “Small Business Saturday”, “Cyber Monday” and “Giving Tuesday”. That last one is of course about giving charity and not presents, but the relentless campaigns in person, by phone, and online have made it feel like one more consumption decision while rummaging through the wallet or purse.

From an investor’s point of view it is increasingly difficult to gauge retail activity because how people shop has shifted significantly in just the last few years. Reporters standing in shopping malls near the Santa villages breathlessly pointing to the crowds and bags does not tell the whole story. Even the viral mayhem videos at discount department stores when the throngs pummel each other to grab the BOGO Alexa-enabled combination teddy bear/espresso machine/lawnmower are entertaining yes, anecdotal mostly, informative not so much.

What we hear again and again is that online is killing traditional retail. For anyone who has walked this Earth for long enough there is actually a little bit of schadenfreude since today’s “traditional retail” killed local merchants and main streets a generation or two previously. We do agree that online shopping has been the weapon of choice to kill off department stores and shopping malls, but this is not some great innovation or revelation. Us oldsters remember Sears, JC Penney, Montgomery Ward and other catalogs where almost anything under the sun was a phone call or mail order away. For families that lived out in the boondocks, that was the only way to access a lot of products, not much different from today where significant portions of the population are not close to “traditional retail”.

So why do we care as portfolio managers? First, we do want to obtain a clean look at the American consumer as an indicator of the health of our economy. Second, consumption patterns tell us a lot about where growth can be found, and of course has a direct connection not just to the growth of equities of companies all along various supply chains, but to the growth of debt to finance making, selling and consuming. Employment patterns are also closely tied to consumption patterns, particularly during the holiday season.

We see the mix of retail venues changing. Other than automobiles, where the traditional distribution structure is consolidating but not really changing despite Elon Musk’s best efforts, with whom and when people shop is shifting. We can now do a lot of financial damage with an iPhone while wearing footy pajamas and binging The Office. And even through that little 5.5” window, the process of consumption is changing. An influencer on Instagram can hype a product, provide an in-app link, and voila, you are purchasing it with a couple finger taps. The reality now, as we have written before, is that America is simply over-retailed. There are too many places and ways to buy the same products. A lot of the factors that differentiated channels before have dissolved. Price differences have been arbitraged away because of comprehensive access to competitive pricing information. The quest for instant gratification can be satisfied as easily by clicking and waiting by the front door as heading to the mall. Expertise and consultation are more likely to be found online than with the teenaged clerk who is just counting the hours until the shift is over. And when those teenagers do get off work, they aren’t going to roam the malls and food courts themselves to socialize and maybe spend. They may be going home and meeting up with friends through MMO games and even spending those earned dollars leveling up their avatars with swag or new capabilities. How do you measure that in old retail terms?

If people are buying directly from manufacturers’ branded captive websites and catalogs, or through social media, or through major online portals, and of course through bricks-and-mortar stores, how do we get anything resembling a complete much less accurate picture of retail consumption? Some of that insight can come from looking elsewhere in the supply chain. We can consider raw materials, packaging, shipping and logistics, royalties and licensing fees. We can look at volumes through final mile services like UPS and Fedex. We can look at sales tax receipts (although the patchwork of rules around interstate tax collection means this gets you a massive undercount). We can look at hiring, particularly seasonal hiring, which is moving away from retail counters and towards fulfillment centers. We can also look at aggregate transactional data from consumer credit and newer virtualized and peer-to-peer payment methods.

The big issue is that a lot of this data is scattered, not gathered and reported in a timely fashion, and has to be collated and interpreted. Joe the Weatherman reporting from the mall about how long the lines are and how full the bags is not going to do it. We will also look at but retain healthy skepticism about reports from trade groups like the National Retail Federation, which exists to promote the interests of its members. Useful information, but it has to be viewed in the context of its mission and stakeholders. That leaves us the government statisticians, who don’t necessarily have an axe to grind, but the data is lagged and the coverage has not always kept up well with how the retail landscape has changed. The US Census Bureau will be releasing the November 2019 Advance Monthly Retail report on December 13th.

Right now we see the US consumer as reasonably robust. The change in how consumption is taking place means looking elsewhere in the markets to participate in that growth. For instance, instead of REITs that own shopping malls, favor REITs that own warehouses. Look for themes like electronic payments. And of course, trends toward local, organic, fair trade, reclaimed, and other sustainability themes are driving retail flows and even countering the race to the bottom in pricing.

According to the New York Times, more than 90,000 packages a day go missing daily in New York City, and 1.7 million daily nationally. That is clearly a problem on a massive scale. But if that much can go missing or be stolen daily and not break the system or materially drive up costs, the scale of consumption outside of traditional retail store fronts is extraordinary. Maybe this number more than any other is the bellwether indicator we need to watch.

WCM Chart of the Week for October 18, 2019

Chinese officials announced year-on-year 6% GDP growth for the third quarter, which was slightly below consensus estimates of 6.1%. The main drag on the economy was slowing investment growth while factory output rose along with retail sales. Tightening credit conditions are also contributing to the moderation in growth as officials continue to address excesses in the financial system. The on again/off again US trade negotiations continue to be a source of uncertainty. The government’s target of 6-6.5% growth for 2020 is at odds with market forecasts. The International Monetary Fund (IMF) is expecting Chinese GDP to fall below 6% to 5.8% in 2020 and continue to moderate in subsequent years, slowing to 5.5% in 2024. In the near term, Chinese officials have ample fiscal and monetary flexibility to manage the economy. However, in the long run, the adverse impact of the one child policy will cause demographic trends to deteriorate rapidly. The National Bureau of Statistics previously announced that births dropped to 15.2 million in 2018, representing a 12% annual decline following a decline in 2017. Some see China’s population beginning to shrink as early as 2027 and others argue that it had already begun in 2018. A rapidly aging population will place strain on social services and likely constrain China’s fiscal flexibility in years to come.

WCM Chart of the Week for October 4, 2019

A 1.5 degree Celsius rise in global mean surface temperature over pre-1900 levels is considered to be a critical threshold above which environmental systems start to break down and serious and durable damage from climate change to the world around us really takes hold. 2 degrees is recognized as a tipping point where the damage is both catastrophic and irreversible, at least in terms of human timelines. This week’s chart is from the Intergovernmental Panel on Climate Change (IPCC) and shows us where we have been, and a possible range of temperature outcomes 80 years out, if we reduce anthropogenic (human-caused) CO2 emissions to zero over various time horizons. Even the best case projections, assuming aggressive and immediate emissions reductions, have us only leveling off around 1 degree over 1900, more or less where we find ourselves today. From a capital markets point of view this tells us two things – first, a best case means a continuation of much of what we have been experiencing with extreme climate events and therefore climate resiliency must be factored into risk assessments and securities pricing for equities, real estate, infrastructure, natural resources and bonds in the public and private sectors. Second, if we don’t turn the corner, the system will run away from us, mitigation will no longer be an option and asset prices will be jeopardized globally. Even being motivated solely by profit and loss this challenge is existential to the capital markets and must be addressed.

WCM Chart of the Week for September 27, 2019

On the last day of Climate Week, we shift our focus from where we started with bonds to conclude with global equities. One of the tired old tropes that gets trotted out for people who have not looked at the data is that ESG-oriented strategies are structurally disadvantaged and destined to underperform. Of course, every strategy follows its own course based on benchmarks, PM decisionmaking, trading effectiveness, and a variety of other factors. But if we take the discretionary elements out and just focus on index comparisons, we do not find any persistent lag or advantage. Yes, performance varies somewhat in the short term.

Sometimes ESG leads, sometimes it lags. Over market cycles though, these small variations sort themselves out and you end up in the same place. MSCI, one of the world’s preeminent index authorities, has maintained an ESG Leaders series of equity indices that start in 2007.  According to Bloomberg, since the inception of the global ESG Leaders Index (on September 28, 2007) through September 26, 2019, the ESG index total return is 72.4% compare to 71.3% for the global equity index, or annualized total returns of 4.64% and 4.59%, respectively. This week’s chart shows this relationship graphically and there do appear to be cycles of outperformance as well as underperformance of the ESG index.  However, this is considerably exaggerated by the scale of the chart as the differences measure in fractions of basis points.

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