Thursday, May 28, 2020

US Declaration of (Cold) War

Coauthored with Jackie Doherty, the senior contributing editor at Yardeni Research, Inc.

The major US equity market indexes continued to rebound, with the Dow Jones Industrial Average crossing back above the 25,000 marker on Wednesday, fueled by the slow reopening of the US economy in the wake of the COVID-19 shutdown. The S&P 500 is now up 35.7% from its March 23 low and is down only 10.3% from its February 19 high (Fig. 1). Investor confidence in the improving economic outlook helped some of the most cyclical sectors outperform on Wednesday, with the S&P 500 Financials up 4.3% and S&P 500 Industrials up 3.3% (Fig. 2). They both clearly outperformed the 1.5% increase in the S&P 500 yesterday.

The Fed’s ultra-easy monetary policies continue to stimulate rebalancing out of bonds and into stocks, boosting forward P/Es faster than forward earnings are dropping. In addition, the gradual reopening of the US economy confirms that we are making progress in our battle with COVID-19. Social distancing should continue to keep a lid on new infections if we keep our distance from others and wear masks. If we are very lucky, a vaccine may be available later this year or early next year.

Nevertheless, investors also should keep an eye on the battle brewing between the US and China. The Trump administration laid out its approach to the country’s relationship with China in a remarkable report that was sent to certain congressional committees on May 21. It throws in the towel on expectations that China will behave according to the global norms of a developed country, stating that we must be “clear-eyed” in our assessment of China and how it has behaved. It also lays out the Trump administration’s return to “principled realism,” acknowledging the strategic competition between the countries. Finally, it proceeds to list the actions the administration has taken to protect the US from China.

Individually, the ideas and actions listed in the report are nothing new to those who have followed the deterioration of US/China relations over the past couple of years. Indeed, Vice President Mike Pence foreshadowed much of the report in an October 4, 2018 speech. But what the document does very effectively is connect economic, military, and political dots to present a picture of a Chinese government behaving badly under the leadership of the Chinese Communist Party (CCP) and a US government, under the Trump administration, acting to protect its interests. Any doubt that the US and China have entered a cold war will fade after reading this document.

In many ways, the report is a US declaration of a cold war with China that accuses the Chinese government of starting this war many years ago on US interests, in particular, and on the post-WWII global order based on free trade with open markets, in general. The report implicitly declares that it is China, not the US, that has upset this order. Here are some of the highlights:

(1) Seeing China more clearly. The Trump administration’s report, United States Strategic Approach to the People’s Republic of China, first reviews the relevant past developments. It notes that US policy was based on hopes that deepening engagement with China would spur the economic and political opening of that country, leading it to become a responsible global citizen with a more open society. However, China did not become a more open society. Its reforms have stalled or reversed. Instead, China has chosen to “exploit the free and open rules-based order and attempt to reshape the international system in its favor. … The [Chinese Communist Party’s] expanding use of economic, political, and military power to compel acquiescence from nation states harms vital American interests and undermines the sovereignty and dignity of countries and individuals around the world.”

(2) Chinese misdeeds aired. The Trump administration doesn’t hold back when enumerating China’s various wrongdoings. After joining the World Trade Organization (WTO) on December 11, 2001, Beijing failed to continue opening its markets. Instead, the report contends China exploited the benefits of WTO membership by becoming the world’s largest exporter, while protecting its domestic markets. The country’s economic policies have led to “massive industrial overcapacity that distorts global prices and allows China to expand global market share at the expense of competitors operating without the unfair advantages that Beijing provides to its firms.”

In addition, the People’s Republic of China (PRC) does not treat companies operating in China fairly. It forces US companies to transfer technology to Chinese partners, restricts US companies’ ability to license their technology on market terms, directs and facilitates acquisition of US companies and assets to obtain cutting-edge technology, and conducts and supports unauthorized cyber intrusions into US networks to steal sensitive information and trade secrets.

The administration casts aspersions on China’s One Belt One Road projects, which it believes the country uses to advance its interests around the world and reshape international norms. These projects are “characterized by poor quality, corruption, environmental degradation, a lack of public oversight or community involvement, opaque loans, and contracts generating or exacerbating governance and fiscal problems in host nations.”

The report continues its criticisms by noting China’s failure to reduce pollution: China has been the world’s largest greenhouse gas emitter; it exports polluting coal-fired power plants to developing countries; and it is the world’s largest source of marine plastic pollution.

The administration criticized the CCP’s methods of leadership at home. The CCP has purged political opposition; prosecuted bloggers, activists and lawyers; arrested ethnic and religious minorities; censored the media and others; and enacted surveillance and social credit-scoring of its citizens. Beijing has detained more than a million Uighurs and other minorities in indoctrination camps and persecuted people based on religion. And now China is exporting the technology and techniques it uses to control its citizens to other authoritarian states.

The report discusses Beijing’s attempts to compel or persuade Chinese nationals and others living in the US to steal technology and intellectual property from companies and academic institutions. It notes that the country is attempting to intimidate neighboring countries by “engaging in provocative and coercive military and paramilitary activities in the Yellow Sea, the East and South China Seas, the Taiwan Strait, and Sino-Indian border areas” and that it is compelling companies such as Huawei and ZTE to cooperate with Chinese security services, creating security vulnerabilities in foreign countries.

(3) US response. Going forward, the Trump administration intends to respond to the PRC’s “actions rather than its stated commitments.” The Department of Justice and the FBI are working to identify and prosecute China’s attempts to steal trade secrets, hack systems, engage in economic espionage, disrupt US infrastructure and supply chains, and subvert American policy.

The US will counter foreigners seeking to influence US policy and respond to CCP propaganda in the US. “We are working with universities to protect the rights of Chinese students on American campuses, provide information to counter CCP propaganda and disinformation, and ensure an understanding of ethical codes of conduct in an American academic environment.” And it will prevent Chinese companies from accessing US technology “through minority investments to modernize the Chinese military.” The US is looking to prohibit the import of counterfeit items, including drugs. And it will use tariffs and work with the European Union and Japan to counter abusive trade practices, including industrial subsidies and forced technology transfers.

The US continues to improve our own military capabilities, help arm our allies, and encourage China to negotiate new arms-control agreements and enter strategic-risk-reduction discussions. “The United States military will continue to exercise the right to navigate and operate wherever international law allows, including in the South China Sea.” We will maintain strong unofficial relations with Taiwan and, as Beijing increases its military, the US will assist the Taiwan military to maintain a credible self-defense to deter aggression. It reinforced prior US calls to respect the rights of Uighurs, Muslims, Tibetan Buddhists, and others being persecuted.

The report noted that the US will criticize China if it doesn’t uphold its international commitments to Hong Kong. Interestingly, the administration’s accusations about China’s role in spreading COVID-19 were not mentioned in the report.

(4) No retreat. In many ways, the conclusion of the 16-page report appears on page 8: “Similarly, the United States does not and will not accommodate Beijing’s actions that weaken a free, open, and rules-based international order. We will continue to refute the CCP’s narrative that the United States is in strategic retreat or will shirk our international security commitments. The United States will work with our robust network of allies and likeminded partners to resist attacks on our shared norms and values, within our own governance institutions, around the world, and in international organizations.”

In all, the report made clear that the administration has reevaluated how the US understands and responds to China. The US/China cold war passes the duck test: If it looks like a duck, swims like a duck, and quacks like a duck, then it probably is a duck.

(5) Bad ending for Hong Kong. Given the events unfolding in Hong Kong, the report takes on even more weight. Protesters returned to Hong Kong’s streets Wednesday after China announced it would write a new national security law for Hong Kong that would prohibit “splittism, subversion, terrorism, any behaviour that gravely threatens national security and foreign interference,” a May 27 FT article explained. The proposal was expanded on Tuesday to also prohibit activities that would seriously endanger national security, which could be interpreted as preventing activists’ protests. If the proposal becomes a law, it would be the first time China bypassed Hong Kong’s legislature and public consultation process to impose a law carrying criminal penalties.

President Trump responded on Tuesday, saying “he is preparing to take action against China this week” over China’s proposed national security laws for Hong Kong, a May 26 Reuters article reported. No details were given. But on Wednesday, Secretary of State Mike Pompeo reported that the US no longer considers Hong Kong autonomous from China. The new designation could change Hong Kong’s favorable trade relationship with the US and open up Chinese officials to sanctions, a May 27 CNBC article reported.

“Hong Kong and its dynamic, enterprising, and free people have flourished for decades as a bastion of liberty, and this decision gives me no pleasure. But sound policy making requires a recognition of reality,” Pompeo said, according to CNBC. “While the United States once hoped that free and prosperous Hong Kong would provide a model for authoritarian China, it is now clear that China is modeling Hong Kong after itself.”

(6) No market impact, so far. It’s interesting to recall that the stock market’s 20% correction in late 2018 was partly attributed to Pence’s belligerent October 4, 2018 speech presenting a litany of complaints about China. The speech was similar to the administration’s latest assessment and set the stage for Trump’s escalating trade war with China until a “Phase 1” deal was reached in January of this year. This time, the market seems totally unfazed by the rapidly deteriorating relations between the US and China. We will continue to monitor the situation to see if this becomes the market’s next worry.

Thursday, May 14, 2020

Stock Market Keeping Score in the Three-Front War Against the Virus

We are still in the midst of VWW-II, the second world war against the coronavirus. VWW-I occurred from 1918-19 as the world battled the Spanish Flu pandemic. It is estimated that about 500 million people, or one-third of the world’s population, became infected with the Spanish Flu virus. The number of deaths is estimated at 50 million worldwide, with about 675,000 in the US. In some ways, the damage from VWW-I exceeded the destruction resulting from WW-I.

So far during VWW-II, 4.1 million people have been infected globally and more than 283,000 have died. Potentially just as deadly is the economic impact of the government-imposed shutdowns around the world to enforce social distancing to reduce the spread of the virus. Millions of people are out of work, and hundreds of thousands of businesses are at risk of going out of business. The resulting human toll in poverty, mental illness, suicides, spousal and child abuse, murders—as well as deaths from non-COVID-related diseases going untreated now—could easily exceed the case count and death count directly attributable to the virus once the war is over.

The stock market is probably the best scorekeeper in the battle between humans and the coronavirus. The virus outbreak in China first made the headlines on Friday, January 24. The S&P 500 dropped 2.5% by the following Monday’s close, but then moved higher to peak at a record 3386.15 on February 19 (Fig. 1). It then plunged 33.9% in just 33 days to 2237.4 on March 23 (Fig. 2). That was the fastest bear market in history, assuming that it ended on March 23, as I believe. It certainly correctly anticipated the economic retreat and calamity that have resulted from the government-imposed lockdowns around the world.

The question now is whether the 30.9% rally in the S&P 500 since the March 23 low through Friday’s close of 2929.80 is correctly predicting a remarkable victory against the virus in coming months. VWW-I has been a three-front war, with a health, economic, and financial front. Lots of progress was made on the financial front since the Fed launched its B-52 bombers and carpet-bombed the markets with liquidity starting on March 23. Undoubtedly, that explains most of the rally in stock prices since then.

I believe that the S&P 500 may consolidate for a while around 2900 until we see significant signs of progress on the health and economic fronts. The lockdowns have successfully imposed social distancing, resulting in the flattening of the case and death curves. Now, as governments are starting to open their economies, there are likely to be flare-ups in so-called hot spots or even widespread second waves of infection. Progress on the health and economic fronts is likely to be in fits and starts, giving investors the jitters.

We saw a bit of those jitters in Monday’s trading action, when South Korea’s capital closed down more than 2,100 bars and other nightspots Saturday because of a new cluster of coronavirus infections, Germany scrambled to contain fresh outbreaks at slaughterhouses, and Italian authorities worried that people were getting too friendly at cocktail hour during the country’s first weekend of eased restrictions.

Meanwhile, the best way to win VWW-II would be to discover a weapon of mass destruction to destroy the virus. Progress is being made on the health front in devising tests, cures, and vaccines. Consider the following recent developments:

(1) Tests. The Food and Drug Administration (FDA) granted emergency-use authorization for Abbott Laboratories’ new coronavirus test that detects COVID-19 antibodies, the company announced Monday. Abbott plans to ship nearly 30 million tests—which can indicate whether a person has had COVID-19 in the past and was either asymptomatic or recovered—in May and will have the capacity to ship 60 million tests in June, the company announced in a press release.

(2) Cures. The S&P 500 rallied 2.7% on April 29, when Gilead Sciences released a study conducted by the National Institute of Allergy and Infectious Diseases. It found that the company’s experimental drug, remdesivir, was the first treatment shown to have even a small effect against COVID-19. The median time that hospitalized COVID-19 patients on remdesivir took to stop needing oxygen or exit the hospital was, at 11 days, four days shorter than those who were on placebo. Critics argue that the reason we have shut our whole society down is not to prevent COVID-19 patients from spending a few more days in the hospital. It is to prevent patients from dying, which the study did not address. (See the May 11 article on, “Inside the NIH’s controversial decision to stop its big remdesivir study.”)

Dr. David Agus, a Professor of Medicine and Engineering at the University of Southern California, was interviewed on May 7 by Howard Stern. He acknowledged that remdesivir isn’t a miracle cure. But he claimed that if the drug is taken as soon as symptoms appear and a test confirms the infection, the outcome for the patient is likely to be less severe and shorter illness and less chance of death. He compared it to taking Tamiflu right away when flu symptoms occur.

On Tuesday, Gilead Sciences announced the signing of licensing agreements with five generic drug makers to manufacture remdesivir in 128 countries, including the US. The deal is “royalty-free” until the World Health Organization says the COVID-19 outbreak is no longer a global health crisis or “until a pharmaceutical product other than remdesivir or a vaccine is approved to treat or prevent Covid-19, whichever is earlier,” the company said.

(3) Vaccines. There are more than 100 different COVID-19 vaccine candidates in various stages of development. So far, eight are already in human trials. Experts are “cautiously optimistic” that the world will get a vaccine, according to a May 9 Deseret News article, which added: “They just don’t know when.” It also reported: “But there’s a big difference between identifying a successful COVID-19 vaccine in a lab and having a studied-at-length, licensed vaccine available in every corner pharmacy. The entire process is laden with potential setbacks—not the least of which is finding enough vials to hold the life-saving serum.”

Here is the real problem with fast-tracking a vaccine: “The next step would be getting emergency use authorization from the FDA, which would allow policymakers to offer the vaccine to health care workers, first responders and essential workers like grocery store clerks and delivery truck drivers. Yet never before has the US vaccinated millions under emergency use authorization.” In the past, vaccine development was “measured in decades—not months, with each step taking years, not weeks.”

Meanwhile, Reuters reported that French drug maker Sanofi SA said on Wednesday that it is working with European regulators to speed up access to a potential coronavirus vaccine in Europe. Sanofi, whose Pasteur division has an established track record of producing influenza vaccines, teamed up with British rival GlaxoSmithKline Plc last month to come up with a candidate that it hopes will be ready next year. The companies have received financial support from the Biomedical Advanced Research and Development Authority (BARDA) of the US Health Department. Given the support from BARDA, doses produced in the US are expected to go to US patients first, a prospect that has raised concern in Europe.

Tuesday, May 5, 2020

Fed Eats Buffett's Lunch

In my recent conference calls with our accounts, I’ve been making the case for investing in crony capitalism. This system differs from entrepreneurial capitalism where the business of companies is to compete with one another fairly and squarely for their customers’ business. Entrepreneurial capitalists who fail to do so go out of business. Those who succeed prosper.

The problem is that successful entrepreneurial capitalists tend to become crony capitalists when they pay off politicians to impose legal and regulatory barriers to market entry by new competitors. It doesn’t seem to matter to them that they succeeded because no such barriers blocked their access. Rather than cherish and protect the system that allowed them to succeed, they cherish and protect the businesses they have built.

A related problem is that politicians view successful entrepreneurial capitalists and their companies as ideal candidates for so-called “rent extraction,” otherwise known as “extortion.” Politicians threaten to use their powers to regulate business to the disadvantage of companies that don’t cooperate with their agenda, which is mostly about getting reelected and more power. Crony capitalism is the result of Big Business colluding with Big Government for their mutual benefit.

President Calvin Coolidge, in a January 1925 speech to newspaper editors, famously said, “The business of America is business!” That’s no longer true for many big enterprises. Doing business with the government has become increasingly essential for companies, as the government has become a bigger customer for many of them and also more powerful in regulating all of their businesses. Despite recurring promises by presidential candidates to banish “special interests” from running Washington, the lobbying industry continues to flourish and grow in our nation’s capital, reflecting the symbiotic growth of Big Business and Big Government, i.e., the triumph of crony capitalism. The lobbying industry is their love child.

President Ronald Reagan famously said, “The nine most terrifying words in the English language are “I'm from the government, and I'm here to help.” On November 18, 2008, Rahm Emanuel, the chief of staff for President-elect Barack Obama, famously stated, “You never want a serious crisis to go to waste. ... This crisis provides the opportunity for us to do things that you could not before.” Lots of politicians and policymakers follow “Rahm’s Rule for Politicians,” as I call it. If Rahm’s advice seems Machiavellian, well, it is. Sixteenth-century Italian political theorist Niccolò Machiavelli advised in his famous treatise The Prince: “Never waste the opportunity offered by a good crisis.” However, it was Winston Churchill who reputedly popularized the sentiment.

Which brings us to the Great Virus Crisis (GVC). The government is here to help, and to get bigger trying. The CARES Act signed by President Donald Trump on March 27 gave the US Treasury Secretary Steve Mnuchin the power to provide up to $2 trillion in assistance to rescue the economy.

The Act provided for $32 billion in grants for the airline industry for payroll support and $25 billion in direct loans or loan guarantees from the Treasury to support passenger air carriers. The CARES Act “requires the Secretary to receive warrants, equity interest, or senior debt instruments issued by the loan recipients as compensation for providing the loans,” according to the Congressional Budget Office.

Businesses that need bailouts, such as the airline industry, will be beholden to the whims of politicians to manage their affairs. That’s why I advocate investing in companies that are likely to benefit from the triumph of crony capitalism. They are big businesses with strong balance sheets that are positioned to survive and even to prosper during the post-GVC era ahead. They don’t need rescuing by the government.

Warren Buffett seems to agree, at least about the prospects for the airline industry. He is widely revered as one of America’s great capitalists. While there is some debate on where he is on the spectrum between entrepreneurial and crony capitalism, his annual meeting of Berkshire Hathaway shareholders is dubbed “Woodstock for Capitalists.” Consider the following:

(1) Dumping airlines. On Saturday, at Berkshire Hathaway’s first virtual annual meeting, Buffett revealed that he sold his sizeable stakes in all his airline stocks. He said: “The world has changed for the airlines. And I don’t know how it’s changed, and I hope it corrects itself in a reasonably prompt way. … I don’t know if Americans have now changed their habits or will change their habits because of the extended period.” But, he added, “I think there are certain industries--and unfortunately, I think that the airline industry [is one], among others--that are really hurt by a forced shutdown by events that are far beyond our control.”

(2) Praising the Fed. Buffett was impressed by the Fed’s QE4ever announcement on March 23. In addition to unlimited and open-ended QE purchases, the Fed moved for the first time into corporate bonds, purchasing the investment-grade securities in primary and secondary markets and through exchange-traded funds. On April 9, the Fed provided term sheets explaining that Special Purpose Vehicles (SPVs) to do so would be funded by capital provided by the Treasury through the CARES Act.

Buffett said, “They reacted in a huge way.” The bond market “had essentially frozen” just prior to the Fed’s action. Yet April turned out to be “the largest month for corporate debt issuance … in history,” he said. He added, “Every one of those people that issued bonds in late March and April ought to send a thank you letter to the Fed because it wouldn’t have happened if they hadn’t operated with really unprecedented speed and determination.” On Thursday, April 30, Boeing was able to raise a stunning $25 billion in funding, allowing it to avoid government help even after it said last month that it would seek $60 billion in federal bailout money.

(3) Getting outbid by the Fed. Buffett isn’t a sore loser. But he should be, given that the Fed acted before he had time to do what he does best—i.e., to take advantage of a financial crisis to buy cheap assets with the record $137 billion on Berkshire Hathaway’s balance sheet. He hasn’t made a major acquisition in several years, not having found anything “that attractive.”

Actually, there were lots of attractive distressed assets resulting from the 33-day bear market in stocks from February 19 through March 23. But Buffett couldn’t act fast enough since the Fed and the Treasury came to the rescue so quickly with so much cash. They are here from the government, and here to help.

(4) Fort Knox. Then again, Buffett seems to be spooked by the GVC, and is worrying about a second wave of infection. Rather than using his cash for acquisitions, he prefers to use it to fortify his company against “worst-case possibilities.” He said, “Our position will be to stay a Fort Knox.”

An October 16, 2008 NYT op-ed by Buffett was titled “Buy American. I Am.” Now, as then, Buffett believes in America. At the recent meeting he said, “The American miracle, the American magic has always prevailed, and it will do so again.”