Podcast: Play in new window
Stock Investors Ignore Corona Threat… Should You?
- Will Coronavirus be blamed for the global recession?
- Apple is largest contributor to S&P 500 Gains – That could reverse to largest losses.
- World GDP growth at 29 year lows in spite of flood of artificial liquidity.
The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
Stock Investors Ignore Corona Threat… Should You?
February 12, 2020
“Now you see on display the connections between travel, connections between supply chains, for Apple, for all of your tech industry, for many of your hard manufacturers here in the United States and around the world. You see the world as one complex system. Change the flow of the interactions in a connected world and there are significant effects, not all of them positive.”
– David McAlvany
Kevin: David, sometimes looking at the news, it’s really hard. We have an awful lot of sources. Back in the old days, we had three networks, and even if we were getting a narrative that might have been massaged, most of us shared in that narrative. Now we have Internet, and we have all different sources of that information. And so this morning, in relation to the coronavirus I was talking to a man that I know. I meet with him on Tuesday mornings with a number of other men. And I asked him, “You have a manufacturing company in China, and you’re over there about every six weeks.” His wife is Chinese and just got back. She quarantined herself for two weeks and it looks like she is fine. But my question was, “How serious do we take the coronavirus?”
David: We are left at an interesting place because here we are, a small town in the mountains of Colorado, and it seems like it would be a bubble. In our neighborhood the doctor comes back from vacation. He has been in Thailand for two or three weeks, they stopped in China for three to four days, his daughter gets off the plane with flu-like symptoms. Local doctor is back to work, daughter is quarantined for a couple of weeks in the same house. But again, how close do these things get? Well, it was just the flu, it wasn’t coronavirus. But you realize how interconnected the world is. And as we look at asset markets, we see that there are judgments made about the state of affairs, so we are left to judge the judges.
Kevin: Actually, you can look at how things are being judged in the markets, hopefully, by the price. That’s what free market is. The pricing is who is judging what, going what way?
David: What I mean by judging the judges, this goes back to Keynes, how he described the markets, which is like a beauty contest, not that we are choosing who is the most beautiful contestant, but you’re betting on how the judges will vote. So we are left to judge the judges and we wager on the opinions of others. That’s that nature of the markets. And today’s challenge is the divide between the fixed income investor and the stock market speculator. So both are a part of the collective judgment on where markets go next.
And with reference to the coronavirus, you have global economic implications of a virus, and there is a divergence of opinion. In the treasury category, you have yields which have been coming down. So buyers are pushing yields down, prices of bonds are going up. Gold, too, is holding up very well as a safe haven. That is in contrast to your industrial metals, which show the real concern, as well. Copper is still above its 2016 lows, but it has traded in recent weeks in its longest losing streak since 1971.
Kevin: That sounds like it is signaling recession, at least for the industrial metals.
David: So to recap, you have safe haven bonds. They are attracting buyers even as industrial commodities in the energy markets find sellers. So what you have are the indications from these markets that we have a long and difficult road ahead, and there is consistency in these assets all signaling the same thing. Concern is palpable, and it is tied to a serious of unknown variables. So if you’re judging the judges, the fixed income side of the equation, at least the conservative end of the fixed income market, again, concern is palpable and it is tied to what we don’t know, which is concerning. And that reasonable, frankly, in the investment markets.
Kevin: I wonder if you can hide anything with liquidity for a while because the markets are awash in liquidity. I looked at what the People’s Bank of China was printing. I looked at what our QE and are non-QE4 is putting in, 60 billion dollars a month, plus the repo markets, plus the Fed buying 80% of the treasuries. The markets are awash in liquidity, so is that hiding something? Look what the stock market is doing, Dave. It doesn’t care about the coronavirus.
David: Yes, liquidity is a big key, and you look at loan covenants. They’re getting lighter and lighter, with some bonds now not even having claim to the assets or the income of the underlying entities, which is just crazy. But that is the state of affairs we have, 250 trillion dollars in global debt. So again, yes, there has been a lot of liquidity infused via the credit markets into global economies, and equity investors? That’s the other side of the equation. So we’re talking about judging the judges, and there being a divergence of opinion. The other opinion is the equity investors, to this point, quite sanguine, maybe naïve, overly hopeful given the quantity of unknown variables.
Kevin: Unless you’re in Shanghai.
David: Right, so if you’re in the Shenzhen stock market or the Shanghai stock market, those exchanges have been pretty nasty. But here in the U.S., other than a few days of consolidation, you can see kind of a collective shrug in the equities markets, whether that is due to belief that liquidity from the People’s Bank of China will be sufficient, or that the whole issue is just sort of a small blip on the screen. And we don’t know.
Kevin: Sometimes looking through the front of the windshield is quite different than what is in the rear view mirror. Now, the rear view mirror, if we were to look at earnings – Apple, MacDonald’s, Dow, MasterCard – looking backward they were reporting gains. How are we looking for Q1 in 2020?
David: Maybe it’s better than expected earnings from some of the countries you mentioned, but I would still argue that we are in an environment where you have more liquidity being pushed into the system. The equivalent liquidity being pushed into the system is you had after the attacks of 9/11 and from Leman Brothers. So a massive amount of liquidity in a period of time that predates the announcement of the coronavirus. So these are supportive of speculative trends, and then of course, yes, you have Apple, you have GE and MacDonald’s, Dow Chemical, MasterCard – maybe that, the better than expected earnings supports economic growth thematics. And I guess the word of caution I would have there on that point is that S&P 500 profits have been advertised as rising at about a 6% annual pace.
Kevin: Now, are those profits coming from actual profitability or are there games being played?
David: That’s the point of caution because I think the majority of the benefits and profits have come from an engineered set of results, so talking to CFOs, the majority of those benefits, you are talking about one-time write-offs, you’re talking about short buy-backs, you’re talking about huge compensation packages, which are not expensed, compliments of non-GAAP reporting. And GAAP is the General Accepted Accounting Principles, and what most investors don’t know is that when you looking at your earnings reports and things of that nature, most of them do not fit GAAP reporting. They are non-GAAP in nature. Just kind of a small sub-note, you can kind of make it up as you go along on a non-GAAP basis.
But again, those are just a small sampling of the tricks that are used, the accounting misdirection that is used. It was Fred Hickey that pointed out that from the U.S. government Bureau of Economic Analysis, real business profits have flatlined since 2014. If you’re looking at the non-engineered financial results, U.S. corporate success is kind of hit and miss. It’s not great. And so what is it about GE? Well, I think GE, of anyone in that mix, you could probably pick on in terms of financial engineering. And Apple, they have had good sales. We’ll get to that in a minute.
Kevin: Okay, but let me ask. I was thinking about this this morning when I was making my coffee. I thought, “What can we equate what we are doing with the liquidity to?” All of us have credit cards where we can get cash advances and you can pull that cash out, and actually, you can fatten that wallet up quite a bit, but what you are doing is creating debt. Look at what the world central bankers have done over the last 6, 7, 8 years. They have gotten so cocky about what liquidity can do that the European Central Bank is now saying that maybe we can solve climate change with liquidity. How about coronavirus?
David: That was the point of having the central banker of the Bank of England on late last year was to have an idea of what is the scope of central banking? When you’re talking about unelected power, are there limits? He was very clear that if you don’t have a defined and specific mandate, you are probably going to be operating outside of a lane where you can actually be effective. So one thing is certain. If Christine Lagarde can solve climate change with monetary policy then the coronavirus should be no different. Let’s just give it to her as an assignment.
Kevin: Just spend money.
David: And that’s what he was getting at. He was saying, “Come on. Really? No, there are a few things that we can solve and the majority of the world’s problems we cannot.” But to the equity investor, and that’s where I think we come back around to this difference of opinion, and judging the judges, perhaps it is the equity investor who has concluded that money-printing is a cure-all up to and including the coronavirus.
Kevin: But let’s say that you’re Apple, and a lot of your production is actually coming out of a place that right now is quarantined. Does quarter 1 look like it’s going to be affected relative to Q4 of 2019?
David: Yes, I think when you think about Apple, even with a stellar earnings report most recently, they are acutely vulnerable in Q1. The first quarter of the year you have Chinese markets playing a significant role, both in their success last quarter and in this next reporting cycle. And it plays a role, both in terms of the retail sales, but also the product manufacturing which you talked about in terms of where the production is happening. Foxconn is the Taiwan-based builder of most of your iPhones and they build them on the mainland. So you have product manufacturing which is now behind schedule with extension of the holiday and uncertainty as to whether or not factories will be able to resume full production levels. Not to mention that some of their parts suppliers are in the Wuhan region.
Kevin: And let’s just bring up also, we have talked to guests who are experts in Chinese economy and they said – Stephen Roach said this – “The change that needs to come in China is they need to become consumers of their own goods.” Now, the lunar new year is a big time of spending. China has become a big consumer of its own goods. And from what I understand, there is no spending going on for the holiday, or virtually none.
David: It’s a big season. We see a seasonal uptick in gold because there is gift buying and things of that nature. There is a huge seasonal factor. It is just like the Christmas season for us where you see consumers doing more than they usually do. And if you look at the percentage of retail sales here in the U.S. it is all clustered – I would say 70-80% is clustered around the Christmas season. So the lunar New Year spending, the consumption side there in China, and I’m talking total consumption – restaurant spending, travel, not just buying Apple products – that was down 40% from the previous…
Kevin: 40%. That’s huge.
David: Yes. So again, it’s a period of consumer spending like our Christmas season. Retailers depend on it. Chinese GDP is roughly 50% derived from the service sector, and this is where the big hit is – consumption, services, under pressure.
Kevin: Dave, when I was in college, as you know, I was a toy store manager, and toys did 75% of their business from Thanksgiving to Christmas, a very similar type of thing. Now, if we were down even 5%, that was a massive hit to the industry. Can you imagine? 40% down?
David: Yes, well, Apple is also relevant to keep in view in the context of equity index buying here in the United States. Apple was the largest contributor to the S&P 500’s gains in 2019. In terms of market cap, it added 700 billion to its own market cap last year, topping out at 1.4 trillion. It’s sitting right at about that level today.
Kevin: That’s amazing. Do you remember when it topped a trillion? That same year.
David: Yes, so iPhone sales in China soared at the end of last year after significant price cuts. Big help for Apple as they finished the year on a strong note. That was a far larger contributor than expected, and it helped to make up a decline in revenue from services, which by the way, Tim Cook was very shy about addressing on the conference call. What part of the services was in decline? He would not say. So that was kind of an unexpected hit on the service side, but more than made up for from sales in China, lowered prices, and people clamoring to own the product.
So there is no way for that kind of increase to be repeated. There is no encore performance in Chinese iPhone sales in the 1st quarter where you have a lot of consumers living temporarily as shut-ins, not willing to even go out and get groceries, with food products being delivered to them. They’re not going out. Consumption is held in check.
Kevin: For the listener who is saying, “Yes, but I don’t have Apple so I’m really not that vulnerable. If you look at the indexes, Dave, most of these 401ks are indexed, and it is really four or five stocks like the FAANG stocks that include Apple. So it really does affect the overall bottom line.
David: We’re going back to the issue of capitalization weighting where the largest companies, the primary stock indexes, talking about NASDAQ, Wilshire 5000, S&P 500, the biggest companies like Apple, Alphabet – which is the new name for Google, Amazon, Facebook – they get the biggest flow of fresh money into the index because they are cap weighted, or capitalization weighted indexes. Apple has been riding high on that, catching capital flows both from your index allocators who are putting money into NASDAQ 100 and S&P 500 index funds.
So fast forward to Q1 2020. It’s not out of the realm of possibility to have to this non-virtuous cycle of disappointing results, my expectations for Apple in Q1, followed by a decline in Apple share price. Selling in the index because it is a huge component within the index, and then you have the selling begets more selling daisy-chain, just like a buying begets more buying momentum trend to the upside, except in this case it is in reverse.
Kevin: It is interesting that you would again mention momentum, because momentum has really proven itself over the last 6, 7, 8 years, but especially the last two years. What most people have forgotten is that momentum works both directions.
David: Yes, the bottom line is that Apple’s China, or if you want to consider it sort of coronavirus, exposure puts U.S. indexes at risk in the early part of 2020 and I think this is something to consider, or linger on. Does deflating a 1.4 trillion dollar company have a domino effect into the U.S. markets broadly when that company – Apple is the single largest company on the planet, owned by more investors, more hedge funds, and included in more cap-weighted indexes than any other company on the planet? We’ll see. But if I were CEO of Apple Tim Cook, coming into 1stquarter reporting, just to keep the audience mesmerized and engaged, it is about time to announce 100 billion dollar share buyback and just sort of ooh and ah the folks. “A return of shareholder value. Oh, you don’t want to sell now.” And I’m serious, it may take a carrot that size to keep the market from taking a bite out of Apple.
Kevin: And when you do that you are actually buying Apple at all-time highs. So what you are saying is, you’re going to take 100 billion dollars’ worth of Apple money, buy at all time highs just to keep it from going south.
David: That’s right. So there are other sectors that were already suffering in mainland China prior to the virus outbreak. You had auto sales, which had been in decline every month over the last 18 months, nearly two years. January reports showed auto sales at an 8.2% decline year-over-year. So no surprise. And I think that will continue as we see this month unfold. Families are huddled at home waiting for the virus threat to either peak or dissipate. Maybe it will. We hope it does.
Kevin: Okay, so I’m going to sound conspiratorial. Sorry, I have to do this. But a year ago in January, China just flooded the market with liquidity because things were starting to turn south. GDP has been falling for a while. You’ve talked about auto sales falling. In September, we started seeing massive infusions of liquidity worldwide, including in the United States. And we called clients. There are a lot of people who are listening who got a call from me. And I said, “Hey, I don’t know what’s up but they are acting like there is a crisis right now, before the crisis. We’re seeing infusions of liquidity, quantitative easing 4. All of these things are occurring before a crisis. Then we have the coronavirus come up in December. Now, I’m not necessarily saying they’re tied together, but isn’t it interesting that we now have an excuse for what was already occurring?
David: Well, I won’t go there in terms of the conspiracy side of it just because I think you look at financial conditions and they are unstable. It doesn’t really matter what the trigger is for consequences into the financial markets.
Kevin: You can see where people would make the tie, though, if they were looking ahead.
David: Yes, but the instability is already baked in. We talked about 250 trillion dollars in global debt. That’s kind of a big deal, when you’re talking about 320% of world GDP, that’s massive.
Kevin: They think they’ll call this the corona recession though. In other words, whether it is the trigger or not.
David: Oh sure, it could take the blame. But the PBoC, People’s Bank of China, since the outbreak was really acknowledged, they didn’t want to for a while, but 100, 200 billion dollars, they have done that a couple of times now in terms of infusions, reverse repos and other means of getting money into the market liquidity provisions to keep things steady.
Kevin: Now they are having to also deal with rising prices. You have inflation kicking in in China. That can cause hunger on the low side.
David: Well, again, it’s not just a question of Apple and that being sort of a domino effect into the U.S. markets. We have GDP figures, and you’re talking about inflation, that certainly factors into real GDP growth. Nevertheless, Q1 numbers have got to be ugly. GDP growth was already coming in at 29-year lows. Auto sales reflected consumers struggling between economic reality and their ability to get maybe, somehow, on the liquidity gravy train from the PBoC. A lot of liquidity was flowing toward real estate. Real estate in China very vulnerable.
Kevin: That’s been skyrocketing. Okay, but what about consumer prices? Just the price people pay when they buy food.
David: And that is the big jump. We talked about that in our portfolio manager meeting this week where Chinese consumers are having to deal with a jump in inflation. The all-in CPF figure is higher by 5.4% year-over-year. The food components jumped by over 20%. You have to have some historical reference here. There is nothing like food inaccessibility, either because of supply, or price, to agitate the Chinese population.
Kevin: Speaking of agitation, we have the tariffs that are in place, and I sometimes wonder if because of this crisis we’re not going to see something change. Because the pressure right now is really on the Politburo.
David: The Phase I trade deal basically said we’re not going to do an additional 250 billion dollars, and maybe someday we’ll be friends. But there is still about 350 billion of tariffs that are in place between the U.S. and China, and, if you think about that, that is a pressure point on the Politburo. The consequences of coronavirus put the party in yet sort of a more vulnerable position. We go back to George Friedman’s comments last week.
Kevin: They were scary. He was talking about how weakness actually could turn into some sort of strong-arm action.
David: And he was referencing Russia where, again, you bring in a dictator, and that’s not an indication of strength. Xi-Jinping did this a few years back, placement of a dictator in a position of power for life – is that a sign of weakness or strength? His conclusion is that it is weakness and you’re kind of organizing politics in such a way that you can manage through some sort of decline, whether it is an economic crisis or what have you. But the decline in Chinese economic growth and the potential for unrest have been increasing for several years. And now you have the virus catalyzing discontent in a new way. Because certainly, food inflation has always placed Chinese leadership in the danger zone.
Last year we had massive pig culling. Now you have transportation issues. Transportation constraints, not being able to get animal feed to your poultry farmers. Again, that is complicated by various quarantines and restrictions on movement. That is kind of a big deal when you’re trying to feed 1.5 billion people. Food costs are rising and at some point in there you might even find that price controls just become an ordinary course of events.
Kevin: I think we have talked about you can handle almost any emergency if you have a little bit of savings, if you have some reserves, but the reserves have to last over time. We have talked before about people running out of money before they run out of month. You can actually run out of money before you run out of year or decade if this turns into a long crisis. Duration or the time seems to be the real critical key here, doesn’t it?
David: Yes, sure. And for individuals you might think in terms of neurochemistry and the reserves that you have on an emotional basis or how you invest in a relationship and sort of create a reserve. But when you’re talking about nations, it is really no different. You’re still talking about, with different language, it is no longer bandwidth, but it is savings. It’s reserves. So temporary impact is what we have in China right now. Duration is the key idea I think I’m focusing on here. Duration of a crisis is really critical. WHO, the World Health Organization, declared the virus a public health emergency, you have 27 countries that have confirmed infections. So there is sensitivity now, sensitivity contagion.
Kevin: And planes are not flying in.
David: They suspended all flights. That was because airline pilots, their union was suing the company because they were kind of dragging their feet on pulling the flights. Pilots didn’t want to go. So at last count you have 22 airlines that have cancelled flights into and out of China, 15 different airlines have cut some, or most of their flights. Again, this comes back to the issue of duration. One of the more interesting consequences of the virus in Wuhan is the challenge that it represents. I’ll come back to the duration in a minute. There is a challenge that the Chinese political apparatus has with reputation.
Kevin: They’re used to managing information, Dave.
David: And so maybe it is less of an issue if you plan on strong-arm tactics in managing a crisis in ways that you probably couldn’t as effectively in a democracy. But you had eight doctors, they identified the virus in the first weeks of December. They were censored. They were detained for spreading false rumors. Now you have one of those doctors, 34-year-old, died this week. From then to now, which is false rumors, not an issue, shut up – to now one of the largest quarantine operations in human history. You have basically 50 million people restricted from travel and the reality that the virus is continuing to spread exponentially. A thousand people have died, officially about 40,000 with the virus, and maybe unofficially, I don’t know, could it be twice or three times that? Who knows?
Kevin: This morning I had talked to this man whose family is in China, and his wife’s parents both are retired doctors. And immediately they cancelled all travel plans. This was early on, weeks ago. So when someone says, “All right, well, how serious is this?” You have people who are doctors who are saying, “No, we’re not going to travel.” So within China itself, people have to inform themselves other than what the actual official story is.
David: Again, crisis dynamics are very manageable as long as you’re not dealing with an extended crisis. But if you’re dealing with, again, duration is the key, when crises are short in duration you have reserves, reserves of social, reserves of political capital, and they are typically sufficient.
Kevin: But you burn that savings up if it keeps going.
David: Yes. Extend the crisis and you wear through all of your reserves. If you had all the money in the world, including all the liquidity from all the world’s central banks, but you’ve spent through your social and political capital, you’re doomed.
Kevin: Let’s say we’re a stock market investor now. “Hey, Dave, we’re really near all-time highs. Why wouldn’t we continue to pour in?”
David: That’s where we come back to judging the judges, and there being a difference of opinion between your risk-off and risk-on appetites. You have a few investors who are saying, “Yes, I prefer treasuries, I prefer gold.” And then you have others who – the equity markets, to be judging this one right, if they’re right, if they end up being right, the duration of this crisis has to be short. It has to be short. The question is, how do equity investors know what doctors and scientists cannot be certain of? That’s beyond me, which is why I favor the judgment of the treasury buyer and safe haven investor over the equity index allocator.
Kevin: Let’s take the coronavirus out of the equation. We were talking about things that were already occurring. You had mentioned that Stephen Roach was talking about the declining GDP numbers for the world. The entire globe was already declining before we ever heard of corona.
David: Just one more comment on this equity index allocator. They may end up being right. The duration of this crisis may end up being very short. But they have no evidence to support that. There are questions of faith and fact, and this is the equity investor having faith in something. I don’t know what. But if this comes back to, could it be that this belief in liquidity is a cure-all? Liquidity is a cure-all, including the coronavirus.
Kevin: So do you go long the inoculation announcement? Let’s face it, if somebody came out and said, “Hey, we just figured it out, here’s the inoculation. At that point, do you play long on that?
David: A few weeks ago – you mentioned Stephen Roach, we had this on the Commentary, global GDP is declining for 2019. The IMF figures showed a 2.9% growth figure. Hey, it’s growing. Well, in the light of 40 years of data, we 40 basis points away from signaling a global recession. So when you get into a band between 3.5% and 2.5%, with Stephen Roach’s argument, you’re in a band of concern, and 2.5% GDP growth you’ve already tipped the scale toward global recession.
Kevin: And we’re 2.9 now.
David: 2.9. The IMF numbers were not heartening in that regard. Now factor in China-specific contributions to global GDP. They have been the largest contributor to total global growth. And factor in the regional freeze in travel and consumer behavior, and Asia as a whole, the region, presents a significant drag – China specifically, but Asia as a whole, represents a significant drag on global statistics. So U.S. growth, you may say it’s positive. Okay, it is positive, but as positive as it is, it is still anemic.
Kevin: Yes, we’re spending money we don’t have. What’s a trillion here and there?
David: That’s my point, even if you have a positive number, nearing 2% in the U.S. economy, let’s not forget that a trillion in spending, really, in my view, is not healthy at all. It goes straight to the national deficit. You’re just tacking it onto the 23 trillion that we already owe. Deficit spending, 1 trillion this year, 1.3 trillion next year, and every year for the next ten years.
Kevin: That’s what they’re planning if nothing goes wrong.
David: That’s right. GDP growth here in the U.S. is okay at best when you consider that about 7% of our GDP figure, between 5 and 7, is really future consumption dragged forward into the present by deficit spending. That’s the reality, certainly not growing to a degree here in the U.S. that would offset weakness elsewhere. Not seeing that kind of growth.
Here is where there is a big difference between U.S. domestic economic reality. Again, anemic but positive, not arguing with 50-year records for unemployment. That’s fine.
Kevin: Even if it’s paid for with debt.
David: But financial market realities are a little bit different. Let’s argue that the U.S. economy stands out as a beacon of strength relative to, or compared to, the European and Asian economies. On a relative basis we really do look pretty good. But our financial markets – this is where I think we’re missing something in terms of the pricing of U.S. equities because our financial markets are geared to reflect global trade in goods and services.
Our largest companies, the biggest components in our equity indexes, derive a considerable part of their sales revenue from overseas, from abroad. So you have U.S. listed companies showing very well, but they have a geographically diversified revenue stream. Sometimes that helps you. But here in the first half of 2020 I think it can only hurt you, yet the indexes don’t reflect that vulnerability.
Kevin: It goes back to liquidity. Everything is awash in liquidity. If you’re taking your credit card down and getting cash advances, you’re going to feel rich for a while, but you’re going further and further into debt. So how much does money printing actually cure?
David: We’ve said it before, looking at the collective judgment in the marketplace and seeing this very different move in safe havens, treasuries and gold versus the U.S. equity market. Perhaps the equity investor has concluded that money printing is a cure-all. You don’t have to be concerned with any other facts. And that seems to be the factor in the risk-on buying – liquidity, liquidity, liquidity. Central banks continue to accommodate.
Kevin: But look at how interconnected we saw we were back during the global financial crisis. We actually saw the connection right then. It was almost like a virus as it spread, but it was in the money world. Now what we’re actually talking about is a true metaphor, a true virus.
David: Right, the coronavirus is a fascinating reminder, not only the interconnected world we live in. You’re right, the global financial crisis demonstrated a unified and complex financial linkage. So now you see on display the connections between travel, connections between supply chains.
For Apple, for all of your tech industry, for many of your hard manufacturers here in the United States and around the world, you see the world as one complex system. Change the flow of interactions in a connected world, and there are significant effects, not all of them positive.
