Fed engineering & desperation still winning for now

Plus megacap math, World Bank debacles, fossil fuel losses, and Hong Kong hot money

Jul 13, 2020

Hey everyone, welcome to another edition of Contention! Hope you enjoy about eight minutes of megacapitalized business dissent.

This week we talk about:

Fed engineering and desperation keep stocks climbing
Megacap monopolies gobble up all growth
Pandemic bonds and dollar drains keep poor countries in line
Fossil fuels take serious losses again
Rapid Round: FB sets back civil rights, HK handles hot money, hard Brexit on the way, structural adjustment comes to Europe

Subscribe if you haven’t already, and follow us on Twitter and Facebook.

Fed engineering and desperation keep stocks climbing

Markets ended up in the green after a volatile week that saw increasing worry about the future of the coronavirus pandemic and dimming economic performance. The Dow gained 1%, the S&P 500 1.8%, and the Nasdaq 4%.

Jobless claims did slightly beat forecasts -- 1.31 million vs. 1.39 million new claims -- and the two main services PMIs gained beyond expectations. But the stubbornly high level of new layoffs indicated a stall out for employment generally, and small business employment in particular. The result has been a “relentless” wave of bankruptcies and widespread consumer default: 32% of U.S. households missed their July housing payments.

So, once again, how are stocks still rising? There are two possible, non-exclusionary explanations, both tied to the way stocks are priced in the first place.

Stock prices reflect discounted future cash flows -- revenue minus expenses over time, multiplied by a risk factor discount rate. The bigger the cash flows or the smaller the discount rate, the higher the stock price.

Explanation one: central banks are suppressing the discount rate through economic engineering. The Fed is buying up interest-bearing assets, raising their prices, pushing down their interest rates, and therefore the discount rate at large. This also liquidates the value of those assets on investor balance sheets, and markets expect this “dry powder” to spark future buying booms.

This distortion carries the risk of a speculative bubble. When the Fed stops its actions -- which they may already be doing -- the bubble bursts. Short sellers are already starting to bet on this.

Explanation two: advancing economic despair actually boosts long-term cash flow. Reduced competition following mass bankruptcies means higher markups, raising top line revenues. Large-scale unemployment drives down wages. Predatory debt and evictions make workers even less secure, further weakening their bargaining power.

If this drop in bottom-line wage costs and the increase in monopoly rents offset the drop in consumer demand, cash flows increase. Bipartisan support for continued government income subsidies makes the calculation even brighter for business, especially since the checks are designed to also push the workers back into the oversupplied labor pool.

So stock valuations may actually be perfectly reasonable right now as long as the institutions controlling the economy today will continue to do so indefinitely. The one risk they aren’t accounting for: a future where their greed and chaos wipes them out altogether. That bubble may burst sooner than they anticipate.

Megacap monopolies gobble up all growth

One possible indicator of an equity bubble: the widening spread between the industrial-weighted Dow and the tech-heavy Nasdaq.

Tech plays are the main bubble beneficiary, with the five largest publicly traded companies -- Apple, Microsoft, Amazon, Alphabet (owner of Google), and Facebook -- accounting for all stock market gains over the last three years. Their explosive 2020 growth is actually hiding a bearish outlook in the midst of the market run.

The five “megacap” balance sheets lay out how these companies make their money:

Apple sells digital devices, mostly iPhones, with Macs, iPads, and all the other Apple gear accounting for most of the rest.
Microsoft primarily sells software, but cloud services account for a third of its business.
Amazon provides cloud services and digital retail. Retail generates 87.5% of its revenue, but Amazon Web Services (AWS) accounts for a majority of its operating income -- profit before taxes.
Alphabet sells advertising, primarily associated with Google, which commands more than 90% of the search engine market.
Facebook also sells advertising -- 98% of its revenue.

Together they are the digital oligopoly, and as digital transactions touch pretty much every business in the world, they ARE the global market.

They lay the foundation through public cloud infrastructure: AWS, Microsoft and Google command two-thirds of that market.

They control access through operating systems and browsers: Google’s Chrome and Apple’s Safari control 82% of the browser market. Windows, iOS, OS X, and Android -- open source, but sponsored by Google -- have 97.5% of the OS market.

They connect sellers with buyers: Amazon controls 38% of online retail, and together Google, Facebook, and Amazon account for 62% of all digital advertising.

All this commerce starts with production processes making raw materials more useful through the application of human labor. Oligopoly market power at strategic points in the global value chain makes the megacap firms price setters, while outsourced producers in capital deficient countries are price takers.

By completing the final sales of the apex products in these chains, or by charging costs to most of those who do, the big five capture the sales revenue of a huge part of global production. At worst, the current crisis means shuffling around income from the businesses in their ecosystem -- most of the world market.

At best -- for them -- it means gobbling up even more market share and control from their few remaining, now bankrupt competitors. They thrive while the rest of the world stagnates: precisely what markets are saying.

Pandemic bonds and dollar drains keep poor countries in line

Two weeks ago the World Bank quietly shelved plans for a second round of its Pandemic Emergency Financing facility, or PEF bonds. The debacle signifies just one of the ways global finance keeps poor countries in line with investor interests.

The Bank did not create the PEFs in response to the coronavirus. They set them up following the 2014 West Africa Ebola outbreak as an “innovative, insurance-based” mechanism for directing private investment to countries facing major epidemics. Donor nations underwrote the facility, and private investors bought a piece at double-digit interest rates. The facility would only pay out if the outbreak met certain criteria, notably at least 2,500 people had to die first.

Good news for investors: many more people than required have now died, prompting an allocation of just under $200 million of the $320 million that the Bank was supposed to raise. The Bank split that amount between 64 countries, with the two largest doses going to Nigeria and Pakistan -- $15 million each. Meanwhile investors received interest payouts of more than $100 million.

Reversing earlier plans to “tweak” the facility, the Bank is shuttering it for good.

While the World Bank was failing to help, its counterpart in the International Monetary Fund was actively making things worse. A new analysis from Action Aid and Public Services International found that the IMF told 24 countries identified by the WHO as critically short on health workers to cut their public sector payrolls -- a guaranteed way to fire doctors and nurses.

Zimbabwe was not one of those countries, but the IMF did impose a “Staff Monitored Program” on the country last year that among other things “emphasized… the adoption of reforms to allow the effective functioning of market-based foreign exchange and debt markets.” Zimbabwe’s coup-installed government obliged, privatizing banking and removing currency controls.

Now global safe haven demand has drained the country of dollars, sparking a new round of hyperinflation. Zimbabwe’s leaders went hat-in-hand two weeks ago to the Paris Club -- an informal group of international creditors that negotiate debt restructurings for the IMF -- asking for help with the crisis. The Club said no: Zimbabwe hasn’t sufficiently honored the very program that caused their devastation in the first place.

Zimbabwe is not an important player in global production except for this: to serve as an example to other low-wage countries what can happen if you don’t fall in line. Financial institutions and the U.S. government won’t let them forget just where they are on the value chain.

Fossil fuels take serious losses again

A series of victories against major oil and gas pipelines last week marked significant progress in the fight against fossil fuel infrastructure.

The U.S. Supreme Court refused to overturn a district court order halting construction of the Keystone XL tar sands pipeline.
The D.C. Circuit Court ordered Energy Transfer Partners to shut down the Dakota Access Pipeline within 30 days.
Dominion Energy and Duke Energy announced they would be cancelling construction of the natural gas Atlantic Coast Pipeline.

Some analysts, however, now believe that the “massacre” of defaults in the oil and gas industry, regulatory/legal frictions, and decarbonization demands are driving investment out of upstream energy development. When demand comes back online, a supply crunch will raise oil prices to $150 a barrel or higher by 2025.

The key variable in this scenario is rising fossil fuel demand. The IEA this week improved demand forecasts for the next two years, but the numbers are still very bad and uncertain. A U.S. Green New Deal is not happening for at least four more years as its advocates unilaterally surrendered last week, but even Shell is backing away from oil.

One trend that doesn’t bode well for the oil bulls: the gold rush for electric vehicle investment. Just last week:

Rivian, an EV venture under contract with Amazon for 100,000 delivery vehicles raised $2.5 billion in new investments. Rivian also announced consumer pickup truck and SUV models for 2021.
China’s Nio -- an EV startup backed by local governments -- secured $1.48 billion in credit from six state-backed banks.
Apollo Global Management is opening a bidding war to take Fisker Automotive public through blank check company Spartan Energy Acquisition Group. Fisker plans to release a luxury SUV in 2022.

All of this is secondary to Tesla’s rise. Just last week its stock gained 25%, pushing past $1,500 a share and knocking on the door of S&P 500 inclusion.

Only those distant, discounted future cash flows could possibly justify such a valuation for the company. If the market is right, the oil bulls are wrong. But even if the bulls are right, the price spike would only accelerate EV adoption. It’s hard to see a path where their thesis works out.

The bottom line: decarbonization is not moving fast enough, but thanks to years of struggle, at least it’s headed in the right direction.

Rapid Round

Civil rights leaders at the head of a global advertising boycott against Facebook expressed “disappointment” following their meeting with company CEO Mark Zuckerberg and COO Sheryl Sandberg on Tuesday. An independent civil rights audit authorized by Facebook also found that the company’s choices represented “serious setbacks for civil rights.” Among the most pressing concerns: racial bias in its core algorithms. Wall Street did not care about any of this, with Facebook’s stock up 4.6% on the week.

“Hot money” flowed into Hong Kong to take advantage of currency appreciation in the Chinese city-state last week, undermining fears about investment flight following the new National Security Law. Nonetheless banks there began to audit their accounts for possible sanctions exposures, especially in light of reports that U.S. officials considered cancelling dollar flows to back Hong Kong’s currency peg. Top party officials continue pressing openly for dollar decoupling and yuan internationalization.

Odds of a “hard Brexit” increased this week, as U.K. Prime Minister Boris Johnson threatened to fully leave the European Union without a trade deal at the end of this year. E.U. officials proposed a $5 billion fund to deal with any fallout from such a break, and major banks accelerated plans to relocate out of London.

The European Union’s internal politics remained strained as the Netherlands continued to threaten any unanimous consent for a Union-wide fiscal package in response to the COVID crisis. Conservative P.M. Mark Rutte shocked French President Emmanuel Macron and German Chancellor Angela Merkel with probing questions about their plans for domestic policy changes to reduce wages, welfare programs, and debt. It seems structural adjustment is not so popular with the Paris Club after all.

Disclaimer

Our only investment advice: check out Sons of Kemet.

CONTENTION