Economic implications of a SARS/Coronavirus outbreak

[over9k]

And it's looking like a choppy night tonight. Futures were all in the green with the nasdaq overwhelmingly the highest but asia's had a pretty shite day so everything's flipped to either flat or mildly negative. We'll see how much the U.S market really care about asia. Microcaps seem to be keeping their head above water and whilst being choppy like you wouldn't believe, are already back above their pre-slump high:



So as said previously, plenty of chop to come yet.

 

[over9k]

Also, not often you get a talking head on the news that I agree with, but there was one just saying that markets are basically going to be directionless/meander (european futures have just gone green and then dragged the U.S ones up with them for example) until the fed meeting later in the week and we get some forward guidance/clarity from them. Janet yellen's already all over the news saying inflation risks are low and the market has completely overreacted.

I completely agree with both.

 

[over9k]

"It's hard for inflation to surge when workers are readily available"

No... YOU THINK?

They even had this headline run across the banner at the literal exact same time:



And the futures, after the nasdaq was deepest in the red a few hours ago whilst asia was open, even now look like this and just keep climbing disproportionately to the nasdaq & r2k:



Amazing.

 

[Smurf1976]

It's not nearly as bad as everyone think it is. Expensive to fix yes, but not overly difficult, and that's the key takeaway here: Winterising everything will be expensive and annoying, but not difficult.

Agreed it's dead easy to do it.

It would however have been an awful lot cheaper to have done it in the first place than to retrofit.

One effect the situation may have is that it gives more ammunition to anyone arguing that such things need to be regulated to make sure that business does indeed plan for unusual occurrences.

It is, after all, not the first time it has occurred (so they can't use that excuse) and the last one was only 10 years ago.

Note that I'm not arguing for or against regulation there, I'm observing that others may do so however and, broadly speaking, business isn't overly keen on being regulated especially when it's of the "spend more but don't increase prices" variety of regulation. That goes for any industry in that situation.

 

[over9k]

Agreed it's dead easy to do it.

It would however have been an awful lot cheaper to have done it in the first place than to retrofit.

One effect the situation may have is that it gives more ammunition to anyone arguing that such things need to be regulated to make sure that business does indeed plan for unusual occurrences.

It is, after all, not the first time it has occurred (so they can't use that excuse) and the last one was only 10 years ago.

Note that I'm not arguing for or against regulation there, I'm observing that others may do so however and, broadly speaking, business isn't overly keen on being regulated especially when it's of the "spend more but don't increase prices" variety of regulation. That goes for any industry in that situation.

No doubt. But this was also a freak weather event that was not expected until long after the windmills had reached end of fatigue life etc. This one was WAY worse than the one 10 years ago no?

They just took a gamble and got stung. The balance of probabilities were in their favour, but such is life. Not how I'd do it, but no point discussing it as we can't change any of it. The key takeaway is just to know that it's going to get fixed and markets have totally overreacted, like usual. Aka "don't panic, everything will be fine".


Meanwhile, to give everyone an idea of just how choppy the markets are at the moment, check this out:



A day-trader's delight... If you can get it right.

 

[over9k]

So here's the day:



Will tomorrow follow this trend and we go back to normal? I have no idea about tomorrow specifically. Everyone are waiting on the next fed meeting & comments with bated breath.

I've been making a big point of just holding our respective nerves despite all this chop. Let me show you why:



The only discrepancy we have that isn't off the EXACT post-bottom trend is the dow vs the nasdaq over the past fortnight and even that looks like it's on its way to reversing.

As I've said in a lot of other posts over the past few months, there's a lot of (accelerated) long term trends driving the market at the moment. We are NOT just reverting/on our way back to the way things were before. These graphs should say a tremendous amount all on their own without any comment at all. All the chop we've seen, even with the gamestop stuff, bond madness, snowstorm, all of it has just been bouncing around and then straight back to trend exactly where things would have been otherwise.

There's only two mild discrepancies even now - let's see if they return back to trend just like the s&p, fangs, semiconductors etc have already shall we?


Assuming no other funny business, all five of these could be back on trend before the end of the week. Three of them already are.

 

[over9k]

So remember this post?

Vaccine intel from Peter Zeihan:


On March 2 the Biden administration announced a vaccine manufacturing partnership between two of the largest and most successful drug manufacturers in the United States: Johnson & Johnson and Merck. Less than a week previous the U.S. FDA approved J&J's vaccine for emergency use in combatting the COVID-19 virus; its formula will now be produced both in J&J and Merck facilities. (At present neither firm has announced expansion schedules or delivery volumes.)

This is big. Of the five proven anti-COVID vaccine formulas that have been approved for use in the First World, only the J&J formula is refrigerator safe and easy to manufacture and a single-dose formula. As such it can be used for inoculations at any facility worldwide that can handle any other vaccine formula. It is this formula that is capable of vaccinating the majority of the world's population against COVID, and with the Merck tie-up I've little doubt the formula will be able to make good on its potential.

Again, this is big. The question now becomes just how big?

Some backstory:

In his early days, the Biden administration activated an option in the Trump administration's supply contracts with Pfizer and Moderna. Each will now provide the United States with at least 300 million doses by the end of July, providing enough vaccine for 300 million Americans. That alone is enough to cover 90% of the American population, children included. Johnson & Johnson (by itself) will kick in another 100 million by the end of June, and since the J&J formula is single shot, that's enough for another 100 million people.

Such figures suggest every adult in the United States who wants to get the vaccine will be able to get it by June 1, and that on-demand, walk-in vaccinations will be available by mid-April.

In fact, this is now the worst-case scenario for vaccine availability in the United States. The manufacturers continue to find ways to optimize their manufacturing. For example, Pfizer has increased their rate of production by more than 80% in just January and February and has simplified its distribution by proving its formula can be stored in normal freezers as opposed to the dry-ice-ultra-cold set-ups it initially used. Such advances likely shaved 4-6 weeks off American vaccination schedules.

There are also two other vaccine formulas – AstraZeneca and Novavax – that will likely contribute millions of doses (maybe tens of millions) to the effort, bringing the American schedule ever forward.

Best yet, this new J&J-Merck tie up isn't included in the above prognostications. Despite what my vaccine optimism might suggest, vaccine manufacture isn't quick. It requires 2-3 months to grow the vaccine cultures in a vat, and then a few more weeks for testing and bottling. And that assumes the facilities are already ready to go. The primary reason the Pfizer and Moderna formulas are moving along so quickly is that they began production last year before they even applied for FDA approval. The J&J-Merck effort is only beginning now. We shouldn't expect to see first doses from the collaboration in the hands of medical professionals until June.

Which raises some very interesting geopolitical possibilities. June 1 is when the United States will have tens of millions of surplus doses from its existing production contracts. The J&J-Merck partnership will add at least 100 million doses on top of that, with many more to come throughout the summer as everyone's efforts continue to expand. While the bulk of the rest of the world will be starved of vaccine, the United States will have a glut. Since the U.S. government is the entity that contracted for the doses, it will be up to the Biden administration to decide where those doses go.

The term you're looking for is "vaccine diplomacy".

It comes at a fortuitous time. The United States has backed away from the world. This isn't a Clinton thing or a W Bush thing or an Obama thing or a Trump thing or a Biden thing, but instead a United States thing. The American people lost interest in playing a constructive role in the world three decades ago, and America's political leadership has molded itself around that fact. Trump may have been instinctually and publicly hostile to all things international, but Biden is only different in tone. Biden's Buy-American program is actually more anti-globalization than Trump's America-First rhetoric as it is an express violation of most of America's international trade commitments. TeamBiden says it wants to reestablish America's global leadership…but it plans to do so without any troops or money. Sorry, but that's not how it works.

Which makes the possibilities for vaccine diplomacy wildly interesting. The United States has no responsibility to provide COVID vaccines to the world. It can – it will – distribute them, but it will want something in return.
Let's begin with the obvious decisions:

Canada: Like the United States, the Canadian government contracted for more doses than it needed from multiple vaccine developers, working from the wise theory that not all would pan out. Like the United States, several of the firms Canada chose did work out, suggesting a similar vaccine glut. But unlike the United States, no vaccines are manufactured in Canada, so Canadians have had to wait. Not much longer. Whether it is because the United States finishes its vaccination program and so frees up manufacturing capacity for its northern neighbor, or because the Biden administration chooses to apply vaccine diplomacy to its closest friend, Canada will get all the vaccine it needs in June. Considering the Canadian health system is far superior to America's, mass vaccination in Canada should be completed by July 1.

Mexico: America's southern neighbor lacks both America's manufacturing capacity and Canada's health system. It was never going to be among the first countries to achieve mass vaccination. If left it its own devices, that is. In reality, Mexico will be second in line. Mexico is one of America's two largest trading partners (based on how you run the math). Mexicans are America's second- or third-largest ethnic group (depending upon how one defines "Mexican"). The Mexican-American border is the most-crossed (legally) in the world (no matter how you count). Completely ignoring health and ethics and good-neighborliness and focusing purely on self-interest, Mexico is the obvious second choice for American vaccine diplomacy. Vaccination there will take longer than Canada. After all, there are 130 million people in Mexico to Canada's 35 million, and the health system isn't nearly as advanced. But I'd be surprised if the Mexican effort wasn't functionally completed – and with it, the broader North American economy recovered – before August 1.

After that, the choices become less obvious.

The very nature of the vaccines and coronavirus limits the options:

China and Russia are out. In addition to the pair becoming increasingly hostile to all things American, both have their own vaccines and are not interested in any sort of quid pro quo with Washington.

Many of the poor portions of the world are out. In part, its an issue of economics and strategy. Its harsh to say but there is only so much that Bolivia or Niger can offer the United States. But just as important, it is about COVID itself. The people the virus tends to kill are over 65. In the world's poorer countries, not all that many live that long. That hardly means coronavirus is something they can just take in stride, but the mass casualties we've seen in the advanced world just don't occur within the younger-aged populations of the poorer parts of the developing world. And the niggling logistical issues remain; While the J&J formula can be distributed easily, it is the only one that can be – and even J&J needs a refrigerator cold chain.

India is probably out as well. Not because an Indo-American tie up wouldn't be a solid idea, but because India has its own vaccine manufacturing capacity. In fact, India has its own vaccine diplomacy program that already stretches from Mongolia to Myanmar (if you have problems with China, you can probably count on New Delhi to help you out with vaccines).

That still leaves us with just under half the global population that are potential American vaccine diplomacy targets. I can't tell you which countries TeamBiden will pick in which order. That will in part be determined by the new administration's evolving priorities as well as the broader geopolitical environment in the last half of 2021. What I can do is lay out the options from cleanest to messiest:

The Five Eyes: Back in the 1950s the Americans worked with the Brits, Canadians, Australians and New Zealanders to build a globe-spanning intelligence collection system. We know that today as the Five Eyes. The five Anglo nations aren't simply friends and allies, they are family, and it would stretch the mind for all not to be included in some degree of vaccine sharing. It was also be eeeeasy. After all, the UK is taking care of itself, and Canada is already first on America's list. Combined, there are only 30 million Aussies and Kiwis; Supplying sufficient doses would be child's play.

Japan and South Korea: Allies? Check. First World countries? Check. Major trading partners? Check. Excellent health infrastructure? Check. Wildly insufficient domestic vaccine manufacturing capacity? Check. Both the Japanese and Koreans loathed Donald Trump's efforts to wring economic and security concessions out of them, but in the end, both had to give in. Biden has indicated zero inclinations to give back anything Trump secured. If anything, the Biden administration will demand more. Vaccine diplomacy is an excellent way to either secure more concessions in specific or salve the relationships in general.

Southeast Asia: There's a brewing competition between China and the United States for influence throughout the region, making a broadscale vaccination program a useful tool. The problems are complexity and scope. There are some 650 million people in the region. It is also politically and strategically messy. A recent military coup in Myanmar and an aging military coup in Thailand suggest diplomatic complications. Singapore is wildly rich and can take care of itself. Indonesia is huge and poor and lacks basic infrastructure for upwards of one-third of its population. Laos and Cambodia are de facto Chinese satellites. Malaysia is…stuffy. The smartest target might prove to be the Philippines. Manila gets petulant from time to time if the United States doesn't toss the Philippines sufficient financial bones. Vaccines could well scratch the itch for years to come.

Colombia and Chile: This pair – courtesy of long-time friendly trade and political relations – are the only South American countries to make the list. Vaccine diplomacy would be a cheap and easy way to firm up ties. It would also underline the broader region that there are indeed benefits to being part of America's Friends & Family Plan.

Taiwan: The Biden administration is doubling down on every anti-China effort the Trump administration started. On the same day of the J&J-Merck announcement, the new U.S. Trade Representative, Katherine Tai, announced a broadscale legal effort to target pretty much everything China does as a matter of course: from genocide in Xinjiang to political repression in Hong Kong to forced labor to unfair state financing. The only thing I can think of that would piss Beijing off more than the United States providing Taiwan with all the vaccine it needs, would be if an American cabinet secretary accompanied the delivery (Defense Secretary Lloyd Austin would be a delightfully inflammatory choice).

The European Union: Phbbbt. The EU's vaccination effort to this point has been a disaster. In part it is bad luck: Unlike the US or Canada or the UK, most of the formulas the Continental Europeans backed didn't work out. In part it is a bad approach: the EU started its negotiations with would-be manufacturers late and the Euros made price-haggling their top priority, so Europe is at the back of the line when it comes to deliveries. In part it was bad politics: the European Commission briefly – and extraordinarily stupidly – threatened border and trade relations with countries that had better vaccination planning. But mostly it is simply that Europe didn't have any health capacity at the EU level and so it is literally making up everything as it goes.

And so, the rest of the world is pulling ahead. Post-Brexit UK is nearly the best in the world with vaccinations (which is galling enough to the Europeans), but economically devastated and strategically isolated Serbia has already vaccinated 20% of its population. The top-in-class EU country – Denmark – is barely half that far.

As a Europhile, I find it disheartening not only how badly the EU is doing, but how quickly EU members of all wealth levels are losing faith. Hungary, Austria and Denmark have opted to stop waiting for the EU to get its act together and so have entered separate agreements with Russia and Israel. The Netherlands, Sweden, Finland and Poland are likely to follow similar paths.

These disconnects provide a wealth of options for the Biden administration.

It could attempt a straight up vaccines-for-NATO program in an effort to achieve with honey what Trump attempted with vinegar: getting the Europeans to take their security seriously and actually commit financial resources to their own defense.

It could trade hundreds of millions of doses to the EU in exchange for broadscale trade concessions from the entire bloc. Aerospace and agriculture are two particularly sticky logjams that could benefit from vaccine-related lubrication.

It could bypass the EU and NATO completely and instead choose to target specific strategic partners in order to lock down long-term security agreements (Italy and Spain come to mind) to the detriment of any European defense planning.

It could trade vaccines for following the American lead against all things China. Say good-bye to the EU's recent investment bilateral with Beijing?

It could provide the doses to the United Kingdom to distribute to Europe as London sees fit, an action which would reduce any bad PR to first derivative effects and give the United States a leg up in post-Brexit trade talks with the Brits.

It could toss enough vaccine into Germany's lap to inoculate the German population but allow Berlin to decide how to distribute the doses. If the doses go to Germans, the EU would politically implode; but if the Germans distribute them to Europe, the German government would fall.

Best yet, the United States is likely to have so many doses by the fourth quarter, it could attempt multiple options.




There are both Canada and Mexico etf's on the market, but Mexico's demographics are way better than Canada's:

View attachment 120940

Versus:

View attachment 120939

There are even leveraged Mexico etf's (ticker MEXX) but as far as I know, there isn't one for Canada.

Then there was:





And now there is:



Zeihan with his finger on the pulse weeks ahead of the rest of the news as usual.

 

[over9k]

Just in case anyone's wondering where the chop and so forth we're seeing lately is coming from, it's literally just these two graphs playing tug-of-war with each other:



Obviously not going to make a big post about the relationship between the bond & equities market if everyone already know how they interact, but if there's any newbies out there that don't know how this all works then let me know and I'll give you a crash course/maybe add it to the duck's thread

 

[over9k]

Love this.

Can Value make a comeback? Or are low IRs really going to keep fuelling large cap Growth?

They aren't going to (artificially) raise rates until we see some decent inflation and once everyone get back to work and both production and shipping can increase, that will actually bring prices DOWN. Not to mention that demand for *things* will drop but services and energy demand will increase as everyone get out and do stuff (movies, theme parks, holidays, sports, skiing etc) rather than be stuck at home (you know, pent up demand and all that).

So despite all this carryon over the last week, medium term, interest rates are more likely to go DOWN rather than up. And that's not even counting the next stimulus package(s):

View attachment 121020

@Junior



Told you

 

[Wilham]

Just in case anyone's wondering where the chop and so forth we're seeing lately is coming from, it's literally just these two graphs playing tug-of-war with each other:

View attachment 121501View attachment 121502

Obviously not going to make a big post about the relationship between the bond & equities market if everyone already know how they interact, but if there's any newbies out there that don't know how this all works then let me know and I'll give you a crash course/maybe add it to the duck's thread

Definitely interested. Even if you understand, you can usually learn something from someone else.

 

[over9k]

Definitely interested. Even if you understand, you can usually learn something from someone else.

Alright I'll get around to it as soon as I can, currently housebound with a shocking head cold so thinking isn't as easy as it normally is.

Meanwhile, some more chop:



And nasdaq futures, after running hard yesterday with the market and then into the green aftermarket, have plummeted:



And bonds thus bounced:



10 different talking head analysts on the news give 10 different answers when queried about what they think is going to happen next, which means that nobody has the slightest clue.

It might be a good period to do some day trades, even if we have a moderate trend in either direction, the volatility we're seeing at the moment is so high that a buy on red day, sell on green day strategy is likely to make some pretty sweet gains. All we need to be sure of for that to work is that we're going to get conflicting data, which there seems to be no shortage of at the moment.

Alternatively, just hold both tech and the banks & energy and note that it'll give you an arbitrage position

 

[over9k]

Here's one for the maths guys, check out the correlation coefficient between 10 year bonds & the nasdaq:



Almost a perfect inverse 1 the vast majority of the time.

For those who don't know what they're looking at here, I'll explain it fully in my bonds-relationship-with-equities post, but the short version is that this is just showing how closely matched (correlated) the movements between these two things are. -1 would mean they would move in perfect opposite ways to each other and +1 would mean they move in the exact same way as each other. 0.5 would mean one's about half the other, -0.5 would mean that one's about half the other but the other way.

As you can see just by looking at the graph, they both move in very obvious opposites to each other, hence the maths showing a number very close to -1 most of the time.

However, remember that correlation is not causation - these could have nothing to do with each other and it's actually some other third thing that's effecting both of them at the same time.


I don't think that's the case here though

 

[over9k]

Aaaand everything was smashed. Talking heads are talking about a "tantrum" in the market. SO insightful.

I'm deploying the remainder of my cash on monday.

 

[over9k]

Post 1/2:

Alright so things are obviously pretty f**ked up right now as inflation fears just keep going and therefore bond yields just keep rising. I'm an economics/geopolitics guy by trade so this stuff is my wheelhouse, so hopefully I can explain what's going on and why by the end of this post and also what we can expect to see in the future, but please, if anyone/any new guys have any questions or don't understand something I say in this post then don't hesitate to ask a question as I love this kind of stuff and teaching people. There are no stupid questions


For those not paying attention, there's currently a titanic fight between economic growth expectations and inflation expectations. In general, economic growth raises earnings but inflation drops price/earnings ratios. So the fight is basically whether an increase in earnings can offset a reduction in the price/earnings ratio enough to keep the price at least steady. The maths behind this is quite simple - if you (and I'm exaggerating to demonstrate the point) doubled your earnings but halved your price/earnings ratio, then your price would be exactly the same. It's the mathematical equivalent of going 2x1, divided by 2. Make sense?

The problem we have is that fear, irrationality, and simple incorrectness can send markets spinning over particular timeframes and this is, in my opinion, what we're seeing at the moment. Remember, only half the job is figuring out what's going on in the economy - the other half is figuring out what's going on in the markets, which is a very different thing.

In other words, you don't just need to know what's going on, you need to know what everyone else are thinking and why they are thinking it. Perception is reality in the market. Even if the market's wrong or irrational, it can stay that way far longer than you can stay solvent. The idea is to either get in on something about to rise or out on something about to drop before everyone else do - whether it should have been rising or falling at the time or not. If the market's wrong and pumps the price of something (or is going to pump the price of something) because of it, who cares, just buy it and then sell it before they realise they're wrong. Conversely, sell it before they do (or just short it) and then rebuy it at a lower price before they realise it was actually something good after all.

This is exactly what happened with roaringkitty, the gamestop guy that's made his millions - he spotted something the market was wrong about (in this case, it had been underestimated/overshorted hugely) and bet on it rising once the market realised. It did, and then the price rose. Massively.

So, for all the budding economics students out there, what we're seeing at the moment is a classic case of how opportunity cost is effecting the markets. In this case, it's a very simple case of risk vs reward, and I'll explain why:


Generally speaking, there's two main asset classes you invest in: stocks, and bonds. There's also other things like commodities but they're not typically a large part of a portfolio - we'll get to them later.

Stocks are simply shares of a company and you're expecting to yield a return on your investment each year through your share of the company profits being paid out to you. The risk you take is that the company may not make as much money next year and so you could have made more money investing in something else. Conversely, a different investment could make more money than you expected it to, and so you again have made the incorrect decision investing in what you did rather than the other thing. Thinking about this for yourself, you can see how the cost of your investment is going to be a combination of how likely you think these things are going to be - the less confidence (more risk) you have in things going the way you think they will, the more incentive (higher the possible return) you're going to need to take that risk. This higher return on the riskier option is called a risk premium, and there's all kinds of both very complex and very simple calculations you can do to estimate it, but like all estimates, bad inputs results in bad outputs.

Again, to use a very simple example, if you were looking at an investment that now has, say, only half the likelihood of paying off that it did before, you're going to want that payoff to be at least twice as big as it was previously. It's a very simple probability equation - getting twice the payout but only half as often results in the same amount being made.

So what does all of this have to do with bonds? Well, to understand that, we need to understand what bonds are and how they work. Bonds are loans. Bonds are when you loan money to an entity (a person, a company, or a government) and they repay you at an agreed particular rate.

Like stocks, there is an element of risk involved with bonds but it is almost always way, way, WAY lower than with stocks.

The largest bond market in the world is U.S government debt - loaning money to the U.S government. Now, the U.S government enjoys a spectacular credit rating (risk rating). It's considered so good, so solid an investment that there is basically a 0% probability of default or to look at it another way, 0% risk for you/the market to lend the U.S government money.

So, let's think about this from an opportunity cost perspective - if we invest in stocks then we're not investing in bonds and if we invest in bonds then we're not investing in stocks, so we have to ask ourselves which we think is the best option and why.

Recall before how much I was talking about risk. If you have one asset class with zero risk (bonds) but another with at least some element of risk (stocks) then stocks are going to need to have some kind of incentive to take that risk. So, the way that works, is that stocks will always enjoy a higher rate of return than bonds because there's at least some probability of not getting the return whereas it is guaranteed with a bond. This extra return is the risk premium I spoke about earlier.

So, let's just pull some numbers out of thin air to demonstrate this: Let's say that bonds, your zero risk investment, earned you 1.4%. This gives you a price floor for all other possible investments as this is the point of zero risk.

This would mean that stocks would have to earn something above 1.4% in order to get you to take the risk of investing in a company by buying its stock. It might, for example, be 2.1% - some 50% higher than the bond rate. This gives us a risk premium of 0.7% (not factoring in anything else).

But what happens if the returns on bonds start to go up? What if bonds increased 50% up to the 2.1% that stocks are? Well, in order to keep the risk premium of stocks we mentioned earlier, then the rate of return on stocks will also need to go up.

So with a rate simply being a percentage, there's therefore only two ways this can happen: Either the company needs to make more profits and thus ups the earnings to a higher percentage of the stock price, or the stock price comes down until the current profit levels reach that higher percentage of the stock price we need to get back to our previous risk premium.


So now that we know the primary (there's more to it than I've mentioned but what I've mentioned is the overwhelmingly single biggest factor) relationship between stocks and bonds, we can take a look at some of the data over the past few weeks and know why it looks like it does:



As we can see, bonds (in blue) have been going up whilst the nasdaq (in orange) has been going down, which means that the market thinks that the rate of return on bonds is increasing faster than the profits for companies in the stock market are.

Ergo, the price of stocks has to come DOWN to keep the rate of return higher and retain the aforementioned risk premium.



But the 6 month graph looks very different, see how stocks were actually increasing at the same time as bond yields were before about the 17th of feb:



This tells us that the market believed that stocks' anticipated profits were actually increasing way way faster than the bond yields were as stocks were actually going up at the same time as bonds were.

As we can see, this all changed at roughly the 17th of feb and I'll get to that in a moment, but there's another question we first need to know the answer to before we can actually get to that:

How do you price a risk-free investment?

Well, it's not actually very complex on the face of it. Let me ask you, what kind of reward always follows zero risk?

We all know the answer, it's the oldest life advice in history: zero risk means zero reward.

But of course, there's always more to it, because zero reward does not necessarily (keyword, necessarily) mean zero interest rate.

So, what then, is an actual zero reward in these terms?


Well, it's calculated with the inflation rate. Inflation is simply how much prices of *stuff* go up in a particular time period. There's several different measures of it, but the primary one used is the Consumer Price Index or CPI.

Now let's think about this - if you stuff your money under the mattress for a year and go to spend it a year later and the price of everything is up by, say, 3%, then your money has actually lost 3% of its value or purchasing power over that period, hasn't it?

In fact, you would have been better off buying stuff with it and then selling that stuff on a year later wouldn't you? You haven't made any money doing that in real (purchasing power) terms, but at least you haven't lost anything.

So let's take this approach to the bond market. Why would you lend someone money at say, 1%, if inflation was at 1.1%? In real terms, you'd be LOSING money.

The answer, of course, is that you wouldn't. You would need to get at least a 1.1% return or otherwise you'd just go and buy *stuff* with your money and sell it on a year later instead.

So it's in this way that (and again, there are other factors at play here, but we're just going to focus on this one as it's the primary/most important) we can understand that the inflation rate gives us a kind of floor on the bond rate. If inflation goes down then the bond rate can and if inflation goes up, then the bond rate has to.

It's in this way that we can understand the zero risk-zero reward nature of bond investing. If bonds are zero risk, all we need to ask ourselves is what the point at which we get zero reward (in real terms) is.

That point, as I've hopefully just shown, is the inflation rate.



SO, now that we all (hopefully) have an understanding of how the bond market interacts with the stock market and inflation rate interacts with the bond market, we can start to take a better look at the data and try to figure out just what on earth has happened lately.

Recall this graph from previously:





As you might be able to imagine, ordinarily, when two curves which usually move in opposite directions to each other aren't, then there's some big driver causing that. Prior to the 17th of feb, it was quite simple - for a variety of reasons, economic growth expectations were way, way, way outpacing inflation expectations.

Ordinarily, you'd expect a very gradual easing of this. You'd basically just expect the two curves to start gradually diverging from one another and then just level out until something new happened to push them in one direction of the other. But that didn't happen here. They essentially just flipped on the spot and went in total opposite directions, in a massive way, incredibly quickly.

Obviously something triggered this. This kind of thing does not just happen for no reason.

The event which triggered it was the massive snowstorm that hit the united states. Snowstorms are not unusual there, but this one was a freak 100 year event that dumped several feet of snow on parts of the country which normally never see any snow at all. This would normally be an economic hit just through the drop in demand - snow everywhere means people stay inside/not doing stuff, so economic activity drops.

But there was far more to it than that. As I posted previously (reposting here for continuity), an enormous amount of the country's electricity and oil production was taken offline due to it simply not being built to handle cold weather, and power prices for example thus went stratospheric:



This was bad. The storm front seized up everything. It coated wind turbines with ice, forcing 7GW—approximately 10% of Texas’s available grid--offline. It turned associated water that often occurs as part of natural gas production to ice, shutting in half of the state's production. Oil was similarly impacted, stopping some two-thirds of Texas’s output. Between these direct issues and follow-on ones – water coolant at nuclear power plants froze, forcing shutdowns; insufficient natural gas led to fuel shortages shutting down nearly 17GW--approximately 25% of Texas’s available grid; oil and power curtailments necessitated shut-downs of the bulk of Texas's refineries leading to mass gas station closures – some seven million Texans lost power. Some for days.

Safeguarding wind turbines so the events of this past week can never happen again only requires some built-in heating elements or a few drone ports to manually de-ice. Once (or maybe twice) and done. But safeguarding more conventional power generation? Insulating every above-ground oil, natural gas, and water pipe in a state that's bigger than France? Building out internal storage for coal piles at coal plans? Developing natural gas storage depots rather than relying upon just-in-time fuel deliveries? Insulating the country's largest concentration of petroleum refineries? Each incremental improvement might be easy, but Texas will need to upgrade everything. The cost will easily run into the tens of billions, and those costs are going to have to be passed on to the consumer.

In other words, the price of electricity will go up. Significantly.

Inflation.


So the market lots its collective mind. Everyone panicked thinking that this is going to increase the inflation rate massively (rather than just a little bit because all the states which do regularly see snow have already winterised their power and oil production and it is actually going to be quite easy for texas to do) and so bond prices shot up in anticipation of that increase in the inflation rate and stocks therefore dropped as we finally had a point at which the market believed that economic growth would be lower and inflation would be higher on account of the snowstorm both being very economically costly and very inflationary at the same time.

Perception is reality in the market

Now it's pretty obvious that I think that the market has way, way, WAY overreacted to this and it's going to be a zillion times easier to fix than they think, but that doesn't mean that the market agrees with me yet.

But the key takeaway here is if inflation were to increase in response to this storm it would have been caused on the supply side because demand will be the same but supply will be more expensive on account of all the costs of winterisation needing to be covered (winterisation effectively raises the cost of producing electricity). Keep this in mind for the next section.



So the market lost its collective mind on inflation concerns, only for the next batch of inflation data to actually be below expectations and therefore cause a massive flip right back in the complete opposite direction to how the market has been moving lately. Just look at how much and how quickly the market moved once the data was released:



And here's the data itself:


As you can see, the inflation rate of all items less food and energy actually dropped. The reason why there's a metric with and without food & energy is because food and energy are such fundamental/important/large parts of the cost of living that one could argue that they're almost the only inflation metric which actually matter on account of their prices effecting the price of everything else. Everything requires energy to produce (energy as an input) including the production of food itself and this is why everyone lost their minds with the texas snowstorm - generally speaking, if energy cost moves, then the price of everything else moves with it.

You can therefore see why it was so significant that energy shot up but inflation of everything else actually moved in the opposite direction - this is incredibly rare.

But then by the next day the market realised that the winterisation of the southern grid hasn't even started yet (and the prices therefore haven't actually really been passed on to the consumer) and went right back to absolutely bricking it about future inflation numbers.


Whilst all this was going on, the same supply-side issues that the entire world has been struggling with for over a year now have only been getting worse and worse and worse. As I demonstrated in another previous big post, shipping, for example, is now at the point of not the 12 ships backed up at anchor outside the L.A ports we saw back in november but rather, 36:




And the problem is so bad that even the suez and panama canals have become shipping chokepoints as companies diverted shipping through them to reach ports that they could (even if the over-land transport costs ended up being higher) actually unload their cargoes at:



And the result is, unsurprisingly, a massive increase in shipping costs (so the costs of actually supplying whatever has been bought):



inflation.


However, this shipping problem is double-edged because a supply choke point doesn't just mean that prices go up (meaning inflation) but it also means that companies literally cannot get (sell) their products to their end consumers, which means lost income.

So you have upwards pressure on inflation and downwards pressure (or at least, a choke) on economic activity/growth at the same time.

The reason isn't complex at all: Everyone are off work sick with coronavirus and so there simply isn't enough able-bodied people in the united states or panama or wherever to actually get the ships unloaded. This is by no means unique to shipping either - any industry which requires in-person work has been absolutely ravaged by coronavirus, shipping is just the easiest demonstrable example.

But thing to remember is that this is yet another supply side problem which is both raising inflation and decreasing economic activity simultaneously.

So we have an enormous amount of supply side restriction in the market at the moment and at the same time, the giant 1.9 trillion stimulus package was just passed, which is expected to increase demand even further (which is, after all, the entire purpose of stimulus) at a time when supply cannot even begin to keep up as it is. Is it little wonder there are inflation concerns out there?


So, am I concerned with inflation (and therefore stocks dropping) like the rest of the market is?

YES.

But my concern is only short term because as I hope I've pointed out, whatever inflation we're going to see is almost entirely caused by a whole series of both supply side inflations and economic growth restrictions at the same time, which I'll get into in the next post.


Post 2/2 continued below.

 

[over9k]

Post 2/3 as I've realised I'm going to need a third post to finish all of this:


Graphically, we need economic activity (earnings) up and/or inflation down in order to see stocks grow. If we get both at the same time, stocks grow a LOT.

What we currently see is a tug-of-war with inflation expectations increasing but economic growth expectations increasing as well:



And obviously, for now, inflation expectations are winning this particular war. But as I've pointed out, I think this is all going to be quite short lived because of how much of this is being caused by supply side effects of coronavirus.

Think about this for a second - if we were to solve all of the shipping problems (for example) tomorrow, we'd see a huge supply side restriction lifted and a huge increase in economic growth at the same time as people can actually get the stuff they want and do so at way cheaper prices. The reason why we can't do this is because all the dockworkers, truck drivers etc etc are all off work and/or quarantined because of the bloody virus.

If that's true (and I think it is) then the key to solving all of this is to simply get people vaccinated. It really is as simple as that. This would both allow the economy to get moving as people go out & do stuff as well as all the supply lines to get moving (and thus bring prices down) simultaneously.

What has me concerned is that almost nobody is actually talking about this at the moment. Everyone are just pointing at bond yields running on inflation expectations, then pointing at the massive stimulus package and saying "that'll drive demand and therefore inflation higher" and at no point is anyone talking about the whole other side of this equation.

Check out this interview with Paul Krugman (who I am generally speaking, no fan of at all) which begins at the 24 minute mark:

Wall Street Week - Full Show (03/19/2021)

One of the most iconic brands in financial television returns for today's issues and today's world. This inflation edition of Wall Street Week features David Westin's interviews with Bridgewater Associates Co-Chairman and Co-CIO Ray Dalio, Former Treasury Secretary Lawrence H. Summers, Nobel...

www.bloomberg.com

Paul correctly points out that the last time the United States saw any kind of significant inflation like everyone are carrying on about them soon being about to get was in the oil shock of the 1970's. Aside from then, you have to go all the way back to the great depression to see anything of any real significance at all.

And what's even more amazing is that the United States, thanks to the shale oil revolution, is now actually oil independent and just ticked over being a net exporter of oil, not importer, just before coronavirus hit:






So not only is the security problem completely taken care of, but shale oil, thanks to technological changes like this:


Is only becoming cheaper and cheaper and cheaper to produce by the day:




So not only is there what appears to be a zero probability of any kind of oil shock, but there is actually deflationary pressure on the entire market on account of the fact that the United States just continues to figure out how to produce oil (energy) and therefore everything else cheaper and cheaper and cheaper as time goes on.

When you combine this with the fact that the vaccine rollout rate is actually accelerating as time goes on:



All I'm seeing is a massive easing of the supply side restriction (inflationary pressure) along with a massive increase in economic activity at the same time as a huge deflationary pressure on energy (and therefore inflation) prices.

Post continued below.

 

[Smurf1976]

So the market lots its collective mind. Everyone panicked thinking that this is going to increase the inflation rate massively (rather than just a little bit because all the states which do regularly see snow have already winterised their power and oil production and it is actually going to be quite easy for texas to do) and so bond prices shot up in anticipation of that increase in the inflation rate and stocks therefore dropped as we finally had a point at which the market believed that economic growth would be lower and inflation would be higher on account of the snowstorm both being very economically costly and very inflationary at the same time.

The other point the market's missing in my view is that Texas accounts for just over 10% of US electricity production and consumption (which apart from network losses are necessarily equal in a state with minimal connection to anywhere else) and about 1.6% of global electricity.

In other words almost 90% of US electricity, and 98.4% globally, is not produced or consumed in Texas. That reality ought to seriously blunt the impact of any price rise when measured at a national or international level.

Texas is extremely important with oil and gas certainly but when it comes to electricity I think the market's over-reacted. It's largely going to be a local issue there in practice not a national or international one unless it comes to the point of ongoing disruptions to the flow of oil and gas which I very much doubt.

 

[over9k]

The only what I might call "real" inflationary shock I can think of is in semiconductors (microchips) which is presently so bad (on account of us all buying gadgets whilst we're stuck indoors) and has brought so much of the world's supply lines of things like cars to a literal screeching halt that the yanks have declared it a national security issue:

https://www.dlapiper.com/en/us/insi...the-semiconductor-manufacturing-supply-chain/

But even that is going to go away once people aren't stuck indoors any more, and ignoring that, it has such solid long term tailwinds behind it that the chip companies are raising absurd amounts of capital at record low interest rates to build massive amounts of more capacity and governments are bending over backwards to help them do it. TSMC are about to build a huge plant in Arizona for example. The company has said construction of the Arizona facility would start in 2021, with production slated to begin in 2024, producing up to 20,000 12 inch silicon wafers a month. For those of you who don't know about this kind of stuff, that is massive:





So even that issue looks like it's going to be solved.





So unless I'm missing something here, all this fear seems to be completely overblown?

Vaccine rollouts mean a massive easing of the supply side restriction (inflationary pressure) along with a massive increase in economic activity far faster than expected at the same time as shale oil and wells coming back online place huge short and long term deflationary pressure on energy prices (and therefore inflation).


I feel like roaringkitty when he was analysing gamestop, all he could see was a whole heap of good stuff that the entire market obviously disagreed with him on which made him feel like he was crazy... until he made a fortune.

This is me currently to the letter from 43.36-45.09:




So am I crazy or has the market missed something really big here?

 

[againsthegrain]

Thanx for taking the time to write that up, hope you don't run out of steam

 

[Smurf1976]

So am I crazy or has the market missed something really big here?

Pure speculation here but if anything's being missed then I'm thinking it'll relate to something blowing up.

I mean a financial blowing up that is, not a physical explosion.

If that's the case then it'll be something far more specific than commodities etc. It'll be a bank, hedge fund, government or whatever that goes kaboom! and starts the fire.

That's a very broad comment but my basic thinking is that given all that's occurred over the past 15 or so months, there's a pretty good chance that someone's been up to wrongdoing. Odds are there's fraud, dodgy accounting and so on or even things simply overlooked amidst all the chaos which will come to light as the world returns to something closer to "normal".

 

[basilio]

Pure speculation here but if anything's being missed then I'm thinking it'll relate to something blowing up.

I mean a financial blowing up that is, not a physical explosion.

If that's the case then it'll be something far more specific than commodities etc. It'll be a bank, hedge fund, government or whatever that goes kaboom! and starts the fire.

That's a very broad comment but my basic thinking is that given all that's occurred over the past 15 or so months, there's a pretty good chance that someone's been up to wrongdoing. Odds are there's fraud, dodgy accounting and so on or even things simply overlooked amidst all the chaos which will come to light as the world returns to something closer to "normal".

Check out Turkey as a detonator. Just sacked the Reserve Bank Governor.

On the better news front the US is doing very well on vaccinating it's population

US reaches 100m Covid vaccine milestone six weeks early as Fauci urges vigilance – as it happened

Biden’s Covid coordinator says US administered 100m vaccine shots in just 58 days – get all the latest politics news

www.theguardian.com