Market Thinking

making sense of the narrative

Market Thinking October

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Markets dropped back during the course of the month as liquidity moved to the sidelines ahead of the US Presidential Elections, which are now entering their final stage. The potential risk from the mid month options expiry in the basket of tech names that were found to have been ‘encouraged’ higher by the Hedge Fund players at SoftBank thankfully passed without too much incident, although the NASDAQ showed a healthy correction over the course of the month – albeit still strongly positive for the quarter as a whole. Elsewhere, the worry remained less on Covid than on the economic damage caused by Government responses to it, with the creeping realisation (to investors if not politicians) that large parts of the private service sector economies may be grievously or even fatally wounded. The increasingly evident lack of strategy beyond the dangerously uncertain one of waiting for a vaccine has left many investors sitting in cash hoping to pick up stranded assets, creating a strange calm in markets generally.

Short Term uncertainties

The month and quarter closed with the first of the Presidential debates and while many were looking to the financial markets reaction for an indication of who they thought might win, more likely in our view is that the sell off reflected a concern about extended uncertainty. In particular the uncertainties around issue of unsolicited mail in ballots are only just starting to be recognised. It is one thing to request a mail in ballot ( a long established and largely successful process) but quite different to send out millions of forms unsolicited. Only 5 states have ever tried this before and the issues around databases and logistical competencies are complex and alarming. If we have learned anything this year from the virus it is that government departments are very far from efficient.

It looks certain that we will not actually ‘know’ the result for several weeks and that during that period tensions will remain high whoever appears to have won on the day. However, we have already had our first ‘October Surprise’ with the news that both the President and First Lady have tested positive for Covid and will accordingly be having to self isolate for 14 days. Meanwhile the daily Covid tweet is likely to disrupt the narrative and simply increase the uncertainty further.

Medium Term Risks

With the V shaped recovery looking more like a U or even a flat line L, investors are rightly nervous, operating a barbell approach of almost passive market exposure and a highly concentrated basket of ‘winners’, principally big tech, which is why the NASDAQ is up 26% year to date while the S&P500 is only up around 5%. Indeed, without the big Tech names embedded within it, the S&P500 would actually be down. For those judged on a relative basis on a calendar quarter (ie most ‘long term’ institutional investors) or short term traders on leverage, this remains highly fraught, but to genuine long term investors it’s a wait and see process. Rather like Covid, which went from a one quarter to what now looks like a one year (at least) event, the US Elections look likely to dominate the whole of the upcoming quarter and equally look like they are also putting decisions on 2021 on hold.

In the west at least that is. In Asia, there are signs that the huge cash reserves sitting on the sidelines are keeping asset prices stable, not least because they are preventing any distressed selling. This is almost certainly a function of the fact that in Asia most long term investors are actually allowed to be long term – the short term pressures on long term investors that dominate western investment asset management being far less prevalent. In Hong Kong for example, market muscle memory from 1997 reminds people of the dangers of getting out when you didn’t need to.

Long Term Themes

US Foreign Policy is all about domestic policy at the moment meaning that international markets are waiting for clarity on longer term policy direction. While trade tensions may ease, the de-coupling strategy looks bi-partisan, especially with the building of the new Great Firewall (by the US) and that means a bi-polar or even tri-polar world emerging under the next Presidency. We also see a deliberate policy of dollar depreciation as a serious possibility – something that will be felt especially keenly in Europe, where we should not forget Germany has its own power shift coming next year with German Federal Elections in October and the exit of Angela Merkel after 16 years,

One important point that emerged from the first Presidential Debate at the end of the month was that Joe Biden said that he did not support the Democrat Green New Deal. This will have come as something of a surprise to many on the left of his party, as well as his running mate who was a co-author of it. Indeed, signing up to it was basically a requirement to secure the nomination. While this is undoubtedly awkward, it does tie in with a perhaps more important longer term thematic that we touched on in an earlier post; this President will be the last of the Boomer Presidents, indeed three of the last four US presidents, Trump, Bush and Clinton were all born within 2 months of each other in the summer of 1946, but they will not be passing the torch to the Millennials.

The next power bloc coming through are Generation X and, mostly, they don’t buy into the more utopian Millennial dreams. Individualistic and pragmatic, they have stood by while the Boomers indulged their (Millennial) offspring and will now seek to look after their own needs and those of their own, Generation Z, children. The key point therefore is not that power passes from Boomer to Millennial, but from Boomer and Millennial to Gen X and Gen Z.

There are numerous lines for this argument to run along, worthy of their own specific post, but the most obvious place to start is with the Social Media, the (so far) perfect meeting of Boomer backing and Millennial programming and engineering skills. Having funded (and got very rich on the back of) the digital world emerging from Silicon Valley since around 2007 (the Annus Mirabilis for US tech), the Boomer generation have largely protected their creations from regulation, and indeed competition, enabling them to become the vast money machines that they are today. However, the digital advertising model requires ever more customers to exploit the near unlimited economies of scale and the intrusion into the digital lives of Generation X is being resisted, particularly as it is now affecting Generation Z. We should therefore expect greater regulation and pushback, perhaps even a set of national ‘utilities’ for basics like email and a messaging account – which after all is why most Gen Z are on social media in the first place. Perhaps the BBC subscription/license model could be adapted to provide this; you pay for an advertising free internet in the same way you used to pay for advertising free Television and Radio. They run your social media for a fee, but no-one gets your data.

Given these social tech companies are dominant in stock markets and given their dominance of recent returns, there is an emerging policy risk around them.

Another big issue might be student debt. Gen X are now facing the prospect of carrying Gen Z’s student loans. In the US these are almost impossible to write off, but in the UK they are in fact a graduate tax, you only pay it back over a certain amount. Now that we have found the magic money tree here are a couple of suggestions that would appeal to everyone except the boomers. In the US get the Fed to buy up all existing loans at the price that existed on a specific (near) date in the past (as it will inevitably leak in the manner that Gordon Brown’s Gold sale did). Then effectively write them off and switch to the UK system.

It may appear to cost a lot of money, but the productive cash flow freed up from the working population would be enormous. It is so obvious that making new debt incredibly cheap is no way to stimulate an economy that is stuck with thousands of dollars of debt and rates of almost 5% that nobody appears to be able to see it. Mortgage Debt is a Boomer/Gen X construct that produced capital gain and an lower debt burden as rates fell and capital values rose. Student Debt however, is largely a Millennial issue., but with Gen Z now entering higher education is destined to become a crisis.

There is an estimated $1.7trn of Student Debt in the US alone, compared to only $480bn in 2006, but with graduate interest rates at around 7% and sometimes up to 12%, coupled with the 10 year repayment period for loans of up to and over $100k, the cash flow implications of buying in the debt are enormous. Note that while interest rates on US Treasuries have fallen from around 5% in 2006 to almost zero today, Graduate loan rates have remained steady at 6.8%. Essentially we have an amount equivalent to over 8% of GDP at egregious rates of interest that is almost impossible to avoid. Unless someone does something radical.

A rough and ready calculation would be up to $250bn a year of cash that could otherwise flow into the real economy. If the US were to combine a form of Debt Jubilee with a switch to the UK system of a graduate tax but to tie it to higher rate tax only and with an interest rate that is equal to a 10 year government bond (as should the UK), then the multiplier effect on economic activity – let alone social cohesion – would be phenomenal. It sounds like a lot of money, but the US has just signed off on over $2trn of aid to the Covid fund. As to the UK, the reality is that most of the loans are written off anyway, but the boost to confidence, let alone populariy would be enormous. And sooner or later the penny is going to drop that cutting debt and restructuring balance sheets rather than simply adding more and more leverage is the real way to sustainable development.

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