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The Founders Club Remarks – April 2020

Greetings from my office on the 18th floor of a 27-story Manhattan skyscraper where, according to the lobby security guard, I am the only tenant in the building—which I must say is rather agreeable. “The City that never sleeps” has been put into a medically induced coma. Other than the mid-March visual of military helicopters delivering hospital tents to a field on upper Fifth Avenue, Central Park looks very much like an early Sunday morning in April as I write this.

As someone who routinely bangs out a 20–30 page investor letter in a five-day writing storm every quarter, I must admit to staring at my blank pad for the past three weeks. What to write that isn’t trite? What to write that hasn’t been said? And most of all what to write that I actually believe? Howard Marks took to a manic publishing schedule in March, sending out four investor letters. He pivoted several times over the course of 30 days. I have neither his writing ability nor his penchant for wonderful essays-as-catharsis disposition.

Rather than making a set of predictions full of the nauseating conventional wisdom similar to those pumped out by most investment banks over the past few weeks or proffering an outlook that would prove numbingly embarrassing by the end of the year, I thought it more interesting for this group for me to ask and answer the unusual question:

“How could the world, markets, and economy be better off in 12–18 months than they would have been without the Covid-19 pandemic?”

Over the course of my career, I have learned that asking the questions that seem to have impossible answers is where the real money is made on both the long and the short side. In February of 2016, I was with one of the world’s greatest living investors, and as the market was crashing due to worries of a China meltdown and oil price collapse—sound familiar—he handed me a three-month chart of the S&P 500, turned it upside down and said, “could this actually be bullish?” The look on my face screamed no, but I demurred, “Maybe.” That was 48 hours from the bottom.

As I know there are quite a few Texans in this group, who would have thought that the 1980s energy boom and bust would give us the modern day, diversified economic powerhouse that is today’s Lone Star State? The oil-fueled infrastructure overspend on highways, telecom and excess cheap office space proved irresistible to those companies and individuals looking to flee the high-tax Northeast.

In California, four decades ago, more than 10% of the jobs were in the defense sector. Budget cuts decimated that industry’s job market up and down the state for a few years but forced a reboot of bright scientific minds that gave us Silicon Valley.

The AIDS crisis of the 1980s and 90s created a societal conversation around homosexuality that led to widespread acceptance, gay marriage and a viable gay presidential candidate. Those who died during that period could never imagine the equality of today.

The Asia crisis of the late nineties was followed by one of the most extraordinary decades of wealth creation in the history of the world. As WorldCom and Global Crossing went bankrupt in the early 2000s, who could have dreamed that the glut of broadband they laid across the USA would form the backbone of the internet.

As we watched the second plane hit the World Trade Center on September 11, 2001, saw the towers buckle and fall, and lived with a haze over downtown NYC for months, who would have bet that five years later Tribeca would be the most expensive zip code in Manhattan?

You get the point. John McCain used to misquote Mao Zedong when he said:

“It is always darkest before it goes pitch black.”

That can certainly happen as it has during depressions and wartime.

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Imagining an Optimistic Path

But for a few paragraphs, I’m going to imagine an optimistic path. Then just to assure this group that I haven’t forgotten my short selling roots, I will list a few tail scenarios that could derail the balance of probabilities around a benign outcome.

First, let me begin my optimistic narrative with the proviso that as a people, we are never better off with more deaths. This is not meant in any way to dismiss the psychological, physical and familial traumas of any individual or group of individuals who may have experienced extreme privations since the onset of the Covid-19 pandemic; rather, I am examining how the overall societal, commercial and governmental policies introduced or altered during this period may give way to a central tendency that is more positive than negative.

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Income Inequality and Market-Based Economic Theory

The developed economies, especially the United States, were on a collision course for conflict between labor and capital in the next few years that may have been violent or jarring. Today’s economic imbalance between capital and labor is the result of a four-decade experiment in laissez-faire economics.

I began my freshman year of college in 1980. Margaret Thatcher and Ronald Reagan, two of the most transformative leaders of the late 20th century were elected within 18 months of each other around that time. They promised smaller governments, free markets and power to the individual. Their electorates, tired of labor unions, state interventions and centrally planned economic solutions opted to give market-based capitalism a try. And with the aid of declining inflation, accommodative central banks, dazzling technological innovations and the rise of emerging market economies, they set off to transform the modern welfare state as it had developed since the 1930s.

For the most part, free-market principles have ruled for three and a half decades. But by the mid-2010s, income inequality was becoming more than a heated discussion in pubs, diners, universities and policy circles; it was igniting a global discussion and a revolution at the ballot box. As asset prices soared higher and developed market wages continued to stagnate, the fuse was lit for a social explosion in the 2020s.

Perhaps this current crisis will lead to substantial real income increases for American and European workers as employers are forced to raise wages to entice them back to work.

The value of blue-collar workers has been highlighted over the past several weeks as brave delivery people, postal workers, public sector workers, store clerks, healthcare workers, truckers, food service employees and security guards have not sheltered in place but shown up for work every day, keeping supply chains robust, stocking store shelves, treating the ill and keeping us all safe.

The rule of law has not collapsed because of their efforts. I have a feeling that society may now acknowledge that a plumber is of equal or greater value than a philosopher. In the past two months, my concerns have centered around whether my pipes hold water, not whether my epistemological theories do.

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Airline Industry Fragility

No industry greater epitomizes what has gone wrong with market-based, blind-shareholder-enhancing management as the airline industry. Airline managements bought back approximately $45 billion of their companies’ shares in the past five years. Last month the collective bailout ask from its CEOs was around $50 billion.

The CEOs had benefitted from the appreciation of hundreds of millions of dollars of stock options, while consumers were subjected to astronomical ticket price increases due to industry consolidation.

As Nassim Taleb writes, these companies have made themselves very fragile. In my mind, it is a fortunate outcome that their business models will be reshaped under the guise of this Covid-19 crisis, rather than an economic slowdown where there would have been no sympathy for these corporate cowboys.

They and others will be forced to create traditional liquidity buffers—much as the banking industry was forced to accept in the aftermath of the GFC. Corporates will have the opportunity to reset their capital structures to a more long-run, sustainable level under the cover of Covid-19. Some will even get federal funding to help them do so. After-tax ROEs may drop but sustainability will increase.

I believe that as businesses seek to become more anti-fragile, investors will think more critically about all forms of business risk—climate, treatment of workers, reliability of supply chains—and demand that managements address these issues. Again, it is positive that managements have the opportunity to address these issues under the cloud of the pandemic, rather than on full public display in the depths of a recession.

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Debt Bubble

Coming into the Covid-19 pandemic, my obsession was how and when the greatest accumulation of non-wartime debt in the history of the world would default. Now, with the dual government schemes of fiscal and monetary support, perhaps we can have a tenuous but orderly deflating of the debt bubble, especially in the USA, without an economic meltdown.

Such support would not have been available during an ordinary recession. Given the buildup of leverage in the global system, a recession could have easily turned into a global economic shock that would have made 2008–09 look like the opening act.

The unpopularity of the bailouts during the GFC would have either prevented lawmakers and central bankers from acting with the haste we have seen during the past few weeks, or their policy interventions would have been met with tremendous backlash from the average voter.

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A Rethink of China’s Role in the World

Since the ascendancy of Xi Jinping to the chairmanship of the Chinese Communist Party, the Middle Kingdom has taken on a more aggressive posture in the treatment of its citizenry, regional neighbors and role in the world. Beijing has likely lent close to a trillion dollars to developing nations under development and building schemes.

The CCP has become the largest provocateur in state-sponsored corporate espionage, in my opinion. It has also forced patent and technology transfers as the price for market entry into the Chinese market. Since China’s ascendancy into the WTO, global supply chains have become overly China-dependent.

Now, there is an increasing awareness that China is an unreliable supplier, bad global actor and increasingly belligerent neighbor. This realization comes at a time when the rest of the world is able to engage China in a firm and constructive manner, rather than from a position of rancor or weakness.

Just this week we saw Australia, a country that plays the canary in the coal mine role in this global debate due to its proximity and high economic linkage, start a conversation on the need for transparency and a reset in China relations. We also saw the UK reconsidering its decisions to allow Huawei to build part of its 5G network. I wonder if it is possible that the Western countries will try to create an alternative global 5G champion?

Perhaps the onshoring that will occur in various key industries can be enough to offset the job losses in SMEs and services in the global democracies.

As a result of China’s behavior during the current crisis, the US and Japan will likely offer direct incentives for their corporates to pull manufacturing out of the PRC. This would have been construed as a near-act of war a few months ago. Now, we can actuate an analytical, measured response to this imbalance from a position of strength, rather than a hasty jumble.

This may or may not be a positive over the short-term, but it has surely prevented a future imbroglio. A China that adheres to global norms and is interested in partnership, rather than supremacy, is a necessary component of long-term growth and stability.

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Overstimulation

Several of our partners have asked me if I was surprised by the onset of the Covid-19 pandemic, and I answer that I have been more surprised by the willingness of policymakers to enter into the great shutdown with so little data.

As a macro investor, one of my primary skill sets has to be in analyzing policy responses. My analysis here was flawed—I failed to understand the differing incentives, especially those created by the nature of the US republic-style government. State governors are incented to keep the death numbers as low as possible, not have a Katrina moment and make up for poor historical public healthcare decisions by taking draconian shutdown measures.

Outside of debt management and taxation, state officials are rarely thought of by voters as having responsibility for economic growth. In the minds of voters, the federal government, especially the President and the rest of the executive branch, are tasked with the dual mandate of protecting the citizenry and maintaining the economy. It is this difficult calculus that prevents a neat, definitive plan for lockdown and reopening.

At this time, current Federal Reserve and federal fiscal programs are not really stimulus; they are charged with breathlessly attempting to prevent US GDP from collapsing. The same is true around the world.

These interventions will likely require at least another $2 trillion in the US and a year-end Federal Reserve balance sheet nearing $10 trillion—as an aside, is everyone else having as much trouble inserting the word trillion in conversations as I am?

These policy decisions were made during the darkest moments of the pandemic. Economies were shedding jobs at a faster rate than the Great Depression, stock markets were collapsing and credit creation was non-existent. With the Great Shutdown in full force, the fatality rates of the virus still a mystery, medical facilities faced with being overrun and the need to get money onto Main Street, the scale and magnitude of these policies were appropriate.

And in an election year, it has been easy for both sides to agree to the largest sums possible, continuing to augment them as necessary—even if we start to see both virus and economic mitigation.

What happens if due to lower fatality rates, proven medical interventions and a quicker reopening of the economies, we have overstimulated? What if life support for the economy now turns into steroids as activity recovers with the trillions of monetary and fiscal stimulus in the system?

It is difficult to have this as one’s base case now, but it is an idea that should not be rejected out of hand. The answer to whether we have reenergized our economies beyond what is necessary should be apparent in the next few quarters.

To be clear, I am not criticizing policymakers for the scale and scope of their programs—quite the contrary, I applaud the speed, decisiveness and imagination that they have summoned to truncate the possibility of a global economic collapse.

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Concerns

I have a feeling that my concerns are not that different from those of the larger group tonight; therefore, I will enumerate with much less detail.
	1.	Government control of saved companies
Coming out of this pandemic, the government will rightly have more control of those companies that its programs have saved. How extensive and draconian will these interventions be? The American people have not historically embraced dirigisme but maybe the national mood has changed.
Can we end up with a two-tier corporate landscape—essentially state-controlled publicly traded companies like Europe in the 1980s and 90s and a set of companies that still have control over their own destiny?
In normal times, it would be irresponsible to offer election predictions seven months out. Now it is even more so. Previously, I would have said that a Biden presidency, even with a Democratic House and Senate, would have been slightly less business positive than the previous years. Now, given the scale of government in the private sector, I would think that the Democratic trifecta may be quite business and market unfriendly.
	2.	Small business failures
After a natural disaster, approximately one-third to one-half of small businesses never reopen. What will become of these fallen entrepreneurs? Will their demise and the trauma of losses trigger a wave of risk aversion that may be with us for years to come?
	3.	Anti-China sentiment
If anti-China sentiment becomes the central issue for the coming US elections, and both parties are playing this card as I write this, will we move from a virus-induced shock to a policy-induced slowdown? Will China simply accelerate its policies of creating domestic demand and local industries in a quiet fashion? My inclination is no. The nascent global rebellion against PRC bullying will spawn more PRC bullying.
	4.	Supply and demand curves shifting down
On a more pure classical economics side, the current situation can lead us down several paths. My biggest worry would be that somehow, both the domestic and global supply and demand curves slide down and to the left, leaving us with persistently lower global GDP.
On the supply side, restaurants, movie theaters, retail stores, salons and gyms will need to operate with far more physical distance between customers, meaning a reduction in the number of individuals they can accommodate at any one time.
Likewise on the demand side, it is easy to imagine a future in which individuals want to eat at restaurants, travel for business or leisure, or shop in physical stores far less often than they did previously, permanently impairing demand for certain goods and services.
With supply and demand curves shifting down and to the left, it is almost certain that this pandemic will leave us with a permanently lower path of aggregate output. This is surely a problem given elevated debt levels around the world.
What this means for the price level (i.e., inflation) is harder to discern. Certainly, commodity markets are suggesting a much lower path of inflation ahead. However, given the generous unemployment benefits legislated under the CARES act, with many workers receiving more in unemployment benefits than they were making in their former jobs, the supply of labor may be greatly reduced and employers may have to offer workers substantially higher pay to entice them back to their jobs. This could mean a period of much higher wage inflation, even as unemployment remains stubbornly high.
	5.	Loss of trust in experts
I worry that if we exit this crisis faster than expected, and there is the public perception of a gigantic policy-induced recession brought on by the errors of “the experts,” how will we ever be able to have a discussion of long-term policy problems, having lost the confidence of the citizenry?

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Closing Thoughts

In closing, I want to thank Frank McDonough for asking me to speak to such an engaged and thoughtful group. You have forced me to bring my “A Game” and have obviated my writer’s block.

A childhood friend, a concert pianist and much-in-demand music instructor, recently wrote me from the mountains in North Carolina and said that the past weeks have made him realize that his breakneck career demands had separated him from his family for too long. Hours spent together in rocking chairs on the back porch have made him rethink priorities.

I hope everyone tonight was been able to find their equivalent of a rocking chair on the porch.

THANK YOU