After 18 months of very little volatility a cascading series of events including the escalation between Russia and Ukraine have reverberated throughout markets causing our first 10% percent drawdown in large cap stocks since March 2020. I'm not going to try to predict the path of military actions in Europe but I can try to put into perspective what the economic impact might be from what's taking place in the region.

Geopolitical events by their nature are difficult to predict and tend to be short lived, although there are certainly exceptions.Outside of the commodities sector, Russia is a marginal player in the world economy accounting for only 1.3% of global GDP, and Ukraine makes up an even smaller portion. US exposure to Russia in terms of total trade is a very low 0.1% of GDP. The EU on the other hand sources roughly 1.5% of their total goods trade with Russia. The main exposure is that commodities are a global market with Russia accounting for about 10% of global oil production and the EU has become ever more dependent on imports for energy. EU imports have long represented over 90% of its oil consumption, while the natural gas import share has increased from roughly 50% in 1990 to also over 90% today. By contrast, the US has moved from importing over 50% of its oil & petroleum during the 2000s to being a net exporter today. So in theory the first order effect from rising energy prices should be modest to the overall US economy. Still, the second order effects of a shock to the already tight global energy market is what could be disruptive...

Markets underwent a volatile session today on news that the WHO is monitoring a new covid variant detected in small numbers in South Africa called B.1.1.529. The new variant is purported to contain multiple mutations with increased antibody resistance and rattled markets on a thinly traded day with several of the cyclical & travel related parts of the market getting hit hardest.The development of rising covid cases is a risk to markets but the trend of the world economy recovering from covid is still intact even as new variants create speed bumps in the process. The Delta variant created a hiccup in the recovery earlier in the year but the economic risk ended up being minimal. With winter approaching I would guess that the world will continue its rolling two month cycles of rising and falling covid cases with a combination of antivirals and boosters eventually smoothing infections similar to the flu.

The WHO has said it will take weeks to understand how the new variant may impact transmission or react to vaccines. But for some perspective, South Africa still has very low vaccination rates with only 41% of the population receiving the jab. In most of the developed world vaccination rates are greater than 70%. Also, only ~ 80k tests per day are being administered in South Africa which means the sample size will need to be much larger before data is concrete. And while the new variant is worried to be more transmissible, death rates in South Africa are still very low which is encouraging . We’ll see if that holds in the coming weeks...

Covid has disrupted supply chains in two major ways: surging demand for imported consumer goods in the west, and a decline in workers required to maintain and operate these supply chains. Over the last twenty years supply chains have relentlessly been pushed towards efficiency with the adoption of Just-In-Time(JIT) inventory management in addition to the integration of global component sources. This Evolution has dramatically increased efficiency but has come at the cost of fragility. Covid constantly flipping the on/off switch on these supply chains has exposed this weakness. Shipping is the nexus of the issue. It usually takes 40 days to transport a container from a factory in China to a store in the US. At the moment it takes 73 days meaning goods ordered today may not arrive by the Holidays. Consequently, price of shipping has jumped. Both the Shanghai Shipping Exchange Containerized Freight and the Baltic Exchange Freightos Container indexes are reading at historic highs. Just recently the port of Los Angeles announced they are going to start running at 24 hours a day to ease the cargo backlog but this won't solve the problem overnight. ..

A few weeks ago we sent out a letter followed by a note conveying that after an exceptionally strong 18 month stretch of performance in markets with little-to-no volatility we would be transitioning into a period where market price action would normalize and volatility would likely rise. However, we still see long term equity market performance remaining strong supported by the fundamental backdrop.

That volatility came to fruition as several cascading news headlines have come down in the last week beginning when Evergrande, a large property developer in China, announced that it would likely not be able to pay its financial obligations. Evergrande is widely reported to have around $300bn of liabilities, own 1300 real estate projects in 280 cities and is associated with 3.8million jobs per year. So it’s reach is wide and because of this the fear was that it would have a bleeding effect throughout markets. Because of China's opaqueness it is really hard for outsiders to gauge what is truly happening inside the country but I can give at least my view on what the fallout from Evergrande will be. I think the Chinese government will allow Evergrande to fail but use the country's trillions in reserves to limit the contagion of Evergrande’s liabilities. This will begin with containing the domestic financial risk in China to make sure the collapse does not become systematic. However, I doubt the Chinese government will be as benevolent with foreign holders of Evergrande debt. This view is supported as Chinese high yield bond indexes spiked but investment grade indexes barely moved on the Evergrande news. This indicates that investors in adjacent Chinese debt products do not expect the contagion to escalate into a widespread credit crisis. Also, the nature of China’s centrally planned economy limits the flow of capital outside the country and Chinese investors in Evergrande expect to be reimbursed...

Incredible to think about, but the S&P 500 has advanced over 18% year-to-date and roughly 30% over the last 12 months. From the post-pandemic low last March equities have rallied over 100%. I made the graphic above before the recent 2% sell-off, but nevertheless equities have bounced back much faster than any post-recession period in history. What’s more is that this rebound has been absent of virtually any volatility. The S&P 500 has notched over 45 all-time high closings so far in 2021 while going over 10 months without a 5% pullback. 

Recently our President sent out a letter conveying our premonition that markets would be undergoing a “transition period” whereas they would adjust to peak growth rates & liquidity, and also to reinforce why our investment strategy and philosophy is well positioned to move into this new phase (His letter is available here). When stepping back and taking into account the big picture of equity markets performance in the last 18 months we think it would make sense for markets to digest this strong performance and for volatility to increase. But despite this, looking forward earnings are projected to be strong and while perhaps tightening, liquidity will still be abundant and characteristic of past early tapering periods (see our note on this here)...

Earlier this year stories started to break that the Biden Administration was planning to raise the capital gains tax rate on wealthy Americans to 39.6% and recently whispers are floating around that the new rate could be even higher. Rumors of rising taxes usually invokes an anxious response by markets especially after a strong run like we have had. But the effect to the overall market from the capital gains hike may not be as significant as people think as it will only affect a minority portion of today’s equity accounts. In 1965 80% of US corporate equity was owned in taxable accounts. Today only roughly 30% is owned in taxable vehicles with much of the US holdings shifting to tax deferred accounts which are not affected by capital gains taxes. Foreign investment has also eaten up a large share of domestic equity holdings as the US runs ever growing trade deficits...

Inflation continues to be the hot topic in financial markets and is shaping up to be a defining macro story of the next decade. One aspect of the inflation debate which we did not touch on in our Inflation Fixation note is what about the monetary and fiscal stimulus? US Government spending in response to fighting Covid was the highest since World War 2 at over 30% of GDP with more spending in the pipeline. The spending is high in a vacuum but it is also coordinated throughout the World by both Central Banks and Governments. What’s more is we have a new Presidential regime which has made spending a pillar of its social policy signaling that austerity is probably not in the cards.

Could this combination of a hesitant Fed, aggressive stimulus injection, and ambitious future spending goals signal that the Fed will be behind the ball on curbing inflation? Or will the structure of the economy and a calibration of supply chains revert the World to the muted inflation regime of the last decade?..

Maybe some would say a good problem to have when considering where things were a year ago, but a primary risk to markets now is that the economy is overheating. We have made note of the inflation readings that have jumped meaningfully over the past several months, but why could this signal a risk for markets? Because it raises the possibility of Central Banks pulling back some of the stimulus which has helped support markets since last March. In response to the inflation jump Fed officials have been adamant about portraying the price spikes as transitory. But at the same time have begun to discuss the possible tapering of asset purchases leading many investors to bring forward their expectations for the first rate hike. In our view this will be the key source of volatility for markets in the second half of the year, particularly in August during the Feds annual Jackson Hole meeting where Chairman Powell is likely to signal a tapering of the Feds bond buying program...

If you have tried to buy something like a car or washing machine lately you probably know firsthand about the challenges of lean inventories & price pressures and are not surprised by the surge in inflation readings that have filled media headlines. Inflation is not only salient because it affects businesses/consumers but also because of its effect on interest rates, and therefore asset prices. But inflation is also an economic phenomenon in the sense that it is maybe the most discussed financial topic but also the least understood by forecasters when applied to real world developed economies. In our January 2021 Economic Outlook we highlighted runaway inflation as a key risk for the economy in the New Year, but also why the long-term picture is not as clear.

The view by the Federal Reserve and one which we largely share is that inflation will be transitory driven by supply chain bottlenecks …  but transitory can feel like a long time. When you essentially turn off & turn back on the World economy it will take some time to find balances. Just like the economic data stunned us during the lockdown, the same is happening now with reopening. Very aggressive fiscal and monetary policy has led to a burst in reopening and many parts of the supply-side of the economy are simply trying to keep up. The hope is that shortages will start to ease as supply catches up to demand, but this won't happen overnight. We think we are at least several quarters away from the economy feeling more balanced. If we had to step out and make a forecast on inflation it would be one of phases: 1.) temporary burst in inflation as shortages from shutdowns drive up goods prices and reopening supports services pricing 2.) softening of inflation as economic growth rate peaks in second half of year and supply chains relieve themselves of bottlenecks 3.) labor market pressures push core inflation modestly higher at a faster pace than pre-covid due to wage inflation...

One principle of investing that we constantly reiterate because we believe it is so foundational is the concept of keeping a long term mindset in the capital markets. This is especially difficult in today's world that is rife with instant transmission of information and fast money strategies revolving around SPACs, Crypto, and reddit “meme” stocks. In fact it almost feels inhuman to be indifferent to the constant hurling of strong opinions easily transmitted through social media and instead see the big picture. But history has proven time and time again that the most effective strategy to growing wealth is to purchase shares of strong businesses at reasonable prices and then simply let time and compound interest do its work. Most American fortunes were earned via ownership of strong businesses for many years. 

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Market drawdowns and Bear Markets are a reality when it comes to investing in the equity markets. Part of the reason equity holders receive a higher long-term return over ‘safer’ investments such as bonds is that they take on additional risk and the likelihood that their investment will be negative over stretches of time. Of course no investor wants to experience their investment losing money but this year illustrates perfectly why sticking to a plan and staying invested while owning proven enterprises with strong balance sheets is the prudent approach. This fact of investing is nothing new but the rise of social media and the competitiveness for media headlines since 2010 have given way to a flood of negative market calls which naturally appeals to human negativity bias and our survivorship instincts. This appeal strategy has worked in part because the flood of calls followed two of the deepest bear markets since the great depression: The Tech Bubble & Global Financial Crisis.

Of course, just as there is inherent risk with being invested in the equity markets, there is also risk in not being invested.This is through the opportunity cost of trying to time the markets by jumping in and out of investments or dramatically drifting away from asset allocations due to “Armageddonist” media headlines. For example, $1 shifted from equities to bonds in 2014 in response to mega-bearish commentary would have underperformed equities by roughly 40% as the S&P 500, propelled more by earnings growth than by multiple expansion, rolled on...

Early last week Pfizer announced data on the clinical trial of their COVID-19 Vaccine candidate which was followed up this week by results from Moderna. It’s easy to see why there is so much excitement over the news as the reported 90 and 94.5 percent effectiveness would put the vaccine on par with the Chickenpox, Mumps, Polio, and Whooping Cough vaccine, and much further ahead than our typical flu vaccine. The logistics of distributing the vaccine will be difficult and likely take months but progress in the development aspect is hopeful.

The news comes at the same time that daily cases and hospitalizations are reaching all-time highs. We now have more clarity on what the end destination looks like (vaccine rollout and distribution in second half of 2021) but perhaps less clarity on the path as the spike in cases will weigh on consumer spending in the near-term. At the same time, with news of a vaccine we are likely to see economic growth accelerate going to into 2021. In short, this may end up being a W-shaped recovery. ..

Although a presidential winner may not be determined until potentially the end of the week, one takeaway from election night is that the Republicans will likely keep control of the senate, meaning congress will be divided. This could be partially responsible for the large rally in equities following last night’s initial election results. Historically, equity markets have performed well in this environment with stocks being higher in the last ten years with a split congress. Although this election is far from over with a recount/legal challenge likely, a split congress actually adds some clarity as any significant legislative bill for either party will be difficult to pass. This includes a repeal of the 2017 Tax Cuts & Jobs Act which we wrote about in June and can be found here. ..

Is cash still king? In the world of global payments, not so much anymore. Cash usage is at an all-time low giving way to the transformation to card/digital. According to the latest Nilson report, cash made up less than 20% of US payment volume in 2019 (by total reportable $ value), and is forecasted to fall to less than 15% by 2023. The demise of cash is one of the trends that has been in place for decades but has been accelerated by circumstances arising from COVID-19. The ability for card payments to now be administered in a contactless manner via ‘tap-to-pay’ has been a useful tool for consumers that want to avoid contact at the checkout aisle. Pair this with most consumer spending shifting to Ecommerce channels during quarantine and the demise of cash has been expedited.

The scale of the large pure-play payment networks, Visa and Mastercard, is staggering. Visa alone processes over 160 billion transactions per year totaling trillions of dollars in network spend. It may seem trivial to us as consumers to just swipe at checkout or place an online order using our debit/credit card but the logistics of what goes on behind the scenes is astonishing. The ability to instantly connect millions of cardholders to thousands of banks and merchants in 200+ countries is almost an impossible network to replicate. This decreased payment friction has also allowed cards to be used for smaller purchases that were once dominated by cash. Consumers in the past were hesitant to use their credit/debit cards on small ticket purchases but with the increased convenience of today's payment mediums that is no longer the case. ..

A historical blend of events in 2020 including the COVID-19 pandemic, shift to a work-from-home economy, and record low interest rates, created the perfect storm for large-cap US tech to structurally outperform the broader market. This outperformance has reversed in recent days with the S&P 500 falling 2.27% and the tech-heavy NASDAQ falling 3.25% last week. This sell-off might have been unavoidable given how stretched some of the valuations for the headline growth names have become relative to their historical ranges and profits began to be taken. It is difficult to see how operationally these tech companies will not continue to benefit as they have for so long, but in the near term a “catch up” rotation could be taking place in the market as the reopening of the economy accelerates, and those industries that have been decimated revert to the mean. In our previous blog post "Air Traffic Data Update" we highlighted how some industries were not seeing a stable recovery and that polarization still remains true today. However, recent economic data has come in better than expected boding well for those depressed industries to at least slightly ‘bounce’.

Timing a switch away from an area of the economy that has performed so well to those weakened alternatives is difficult. Still, an eventual mean reversion among valuations across the market is inevitable. Central Banks around the Globe have purchased over $1 Billion of financial assets every hour since the government lockdowns in March. This massive stimulus has coincided with a $1.5 billion increase in the Nasdaq 100’s market cap every hour. As long as this primary support pillar remains intact, owners of financial assets will continue to be the primary beneficiaries of monetary stimulus. ..

Although our investment holdings at Covington consist mainly of large multinational corporations, small businesses make up the backbone of the US economy. The most effective policies for defeating the virus are also the worst for small businesses (absent a vaccine). The mandatory shutdowns created a record number of “temporarily unemployed”  workers who were laid off but expected to return to work quickly. To help small businesses deal with this the government developed the PPP program to maintain their employment levels. This program was certainly not without its flaws, but all things considered, helped cushion the blow at least partially. The $600 additional unemployment benefits was also established. This did help buoy consumer spending but not in a proportional way to benefit small businesses as in lockdown most spending had to go through online shops. The $600/week supplement also created the problem of trying to rehire workers quickly as some low wage workers were now making more from unemployment benefits than they were while working.  

The good news is that these conditions are starting to dissipate as the economy slowly reopens. The NIFB recently released their June print for the Small Business Optimism showing a quick snap back from its plunge in March and April. This is encouraging but small businesses will continue to be dictated by the course of the virus and responses by our government.

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Cases continue to rise with the US registering its new daily record of over 70,000 cases on Friday. Deaths have also increased, but not with the same magnitude as case growth. The disconnect in deaths and cases is partially attributed to the continued ramp in daily testing. The US is now testing over 700,000 citizens a day. One of the attached charts shows the positivity rate (daily new positive tests divided by daily total tests) overlapping daily cases to show the relationship. The positivity rate gives a clearer picture of what the true infection growth is.  

Lawmakers look at this positivity rate in their respective states/counties as one of the key metrics to decide whether to relax, or tighten social distancing measures. If the infection rate is not tamed, it could mean that those industries most affected by shutdowns (Leisure and hospitality) will not be able to open. 

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The European Commission recently released their ‘Summer Forecast’ for the EU/Euro Area economy where they downgraded their own projection from earlier in the year. The original -7.4% GDP contraction expected for the EU economy has been reassessed to -8.3%. Even despite the swift and comprehensive policy response from the European Central Bank and EU governments, the lack of resilient technology giants like the US possesses, along with less diversified economies has hurt the European bloc proportionally worse. Also, social distancing measures were stricter in most EU countries meaning better virus control but worse economic damage to this point. Italy has shouldered the brunt of damage with GDP projected to fall 11.2% in 2020, while Sweden and Denmark are so far the least scathed projecting a < 5.50% decline.

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“This time it’s different” is a dangerous phase in the economics world. Recessions don’t typically result in personal income increasing, but this one has thanks to coordinated global fiscal/monetary support. However, soon the US faces a “benefits cliff” with the additional $600 per week of unemployment benefits set to end on July 31^st and normal UI benefits for those who were part of the initial layoffs in March ending in September. Congress is expected to put together some kind of extension for these stimulus efforts but the two parties remain far apart on what exactly the next phase would look like. This stimulus is important because it has essentially buoyed consumer spending during the shutdowns. All income classes have seen their spending bounce significantly from the late March lows. But as we keep mentioning, stimulus efforts can only be temporary. Economies need to continue reopening and true economic activity needs to continue to regain its footing.

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Certain industries/pockets of the economy are seeing a quicker recovery than others. The TSA keeps track of the amount of passengers originating trips from US airports. On a normal day in March that number is over 2 million, at the height of government shutdowns this year it was less than 90,000. Recently air traffic has recovered with daily passengers in the last week eclipsing 700,000, but this is still a long ways off from a “V-Shaped” recovery in air travel. Keep in mind airlines have high fixed costs, large amounts of overhead, and razor thin margins. Most airlines are simply not solvent if air travel is less than half normal traffic for a prolonged period of time.

We think this polarization in recoveries from one industry to another will continue and even worsen the longer the virus lingers in the economy. Some industries are seeing enormous demand tailwinds (Cloud, Ecommerce, Staple Goods) while others are still trying to claw their way back (Travel, Lodging, Restaurant Dining).

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