This installment of Off The Chain is free for everyone. I send this email to our investors daily. If you would also like to receive it every morning, join the 40,000 other investors today.
To investors,
The Lion King is an animated movie that has captured the imagination of young children for decades. There are many life lessons that can be taken from the film, but one of the core ideas presented is “the circle of life.” In the movie, this has a double meaning — (a) the young cub eventually grows up and becomes King of the Jungle after his father’s death, which is followed by him having his own cub and (b) the animal kingdom relies on energy passing through various forms (ex: animals eat the grass, other animals eat those animals, etc).
This idea of a repeating circle is very obvious in nature, but it also exists in an economy. An over-generalized version of an economy’s circle of life would look something like this:
Materials are produced and sent to suppliers. Suppliers turn those materials into products. Businesses buy the products and re-sell them to consumers. Those businesses take revenue from the consumers and use it to pay rent to the landlords that provide office and retail space. Those landlords make payments to the banks in exchange for financing the purchase of the buildings. And finally, those banks provide capital to the material producers to restart the circle of life. Obviously this is not a perfect description of how the economy works, mainly due to a lack of desire from myself to incorporate complexity into the diagram, but you get the general idea.
This economic circle of life is important to understand right now, because we are about to witness a chain reaction that will start creating problems for every participant in the circle. Everything starts with the businesses right now — they are the most vulnerable link in the circle.
We have recently seen a significant drop in consumer demand coupled with a government-mandated shut down of many businesses. Consumers became scared of COVID-19, which led them to stop spending money on travel, hospitality, and other industries. As the virus became a more serious concern, the government stepped in and began ordering the shut down of any “non-essential” businesses in many cities and states across the United States.
The lack of consumer demand combined with the government-mandated closure of businesses has created a break in the economic circle of life. This has two major impacts on the other participants:
Upstream impact — As businesses close, they no longer need the supplies from their suppliers and vendors. They go from consistent weekly and monthly orders to zero overnight. This obviously leads to lost revenue for the suppliers, along with existing inventory that they can not sell (Read this piece to see how this works in the restaurant industry). The suppliers then need to slow their ordering from the material producers, which creates significant issues for them as well. You can think of the upstream impact as a dam in a river — once the dam is in place, everything upstream backs up and just sits there until the dam is opened or removed.
Downstream impact — Most businesses in America are seeing revenue drop significantly, including many cases where it is going to zero. This could be from the lack of consumer demand or because the government forced the business to shut down. In either case, the company has less money coming in the door, but they still have their fixed costs to pay for. Rent is one of the largest fixed costs for most businesses, so there is immediate pressure applied to a business from the perspective of “how are we going to pay our rent?” This downstream impact is what I want to spend time talking about today.
Estimations that we could see GDP drop 25-50% in the second quarter this year. That would be an unprecedented drop, but this is not just a random number in a spreadsheet. It has a direct impact on how many businesses can continue to pay their rent without revenue coming in the door — short answer: very few.
This puts landlords in a really bad place. They can be overly understanding and give tenants deferred rent plans or some version of rent abatement. It sounds good in theory, but the landlord has loan payments to make to the bank. Unless the bank makes concessions to the landlord, the landlord is likely unable to make concessions to the tenant. So why wouldn’t the banks make concessions to the landlords? Because that may lead to questions of solvency for many bank lenders.
Don’t take my word for it.
Billionaire Tom Barrack published an article last night that outlined a lot of this in a articulate, yet urgent, manner. There are many important points from his piece that I think are worth calling out. He highlights the breaking of the economic circle of life when he says:
“Now everyone, from corporations and small and mid-sized businesses to employees and laborers from all walks of life, has been displaced from the normal chain of revenue generation, cash flow, and income necessary to meet their obligations, from payment of salaries, rent payments, mortgage payments, and all other debts and bills required in the daily life of every business and every American.”
Barrack goes on to call out a “second crisis” that is likely to occur, which is essentially the chain reactions described above:
“As a direct consequence of the necessary response measures to COVID-19, high performing mortgage loans across the entire commercial real estate sector (approximately $16 trillion in aggregate), which had previously been grounded in solid economic fundamentals, are suddenly experiencing a temporary meltdown in cash flows. We are seeing the beginning of a second crisis that will occur in the financial markets that underpin the lifeblood of these employees, workers, and businesses.”
He then explains that one of the key risks currently is that the financial system could lose the trust of the people if this crisis is not handled well:
“Our current crisis is a crisis of trust in two distinct but critical silos: health and finance. The COVID-19 pandemic has caused widespread confusion, fear and hysteria with regard to its’ effect, treatment and longevity, and the global response to effectively halt this virus has completely stopped commerce and social interaction. As a result of the government fiat, America has endured a shutdown of our GDP, and an attendant unstoppable chain of financial calamities. There is no doubt that in order to ensure safety and conservatism during our health crisis we have to prepare and perhaps overshoot for the worst; however, the unintended consequence of responding to the pandemic is a pandemic of mistrust in our financial system.”
Barrack then clearly articulates the challenge at hand in the real estate market:
“The market for commercial real estate mortgage loans in the United States stands on the brink of collapse. The profound impacts of both the COVID-19 pandemic and the public health measures taken in response to it on the American economy have caused high-performing mortgage loans, grounded in solid economic fundamentals, to suddenly and sharply decline in value. As a consequence, banks, publicly traded mortgage REITs and other non-bank lenders now find themselves at a precarious juncture. The actions that they will take in the coming days and weeks carry significant implications for the American economy as a whole. If these institutions are not permitted to maintain the flexibility and patience needed to undertake the loan restructuring efforts that will be critical to weathering the COVID-19 crisis, loan repayment demands are likely to escalate on a systemic level, triggering a domino effect of borrower defaults that will swiftly and severely impact the broad range of stakeholders in the entire real estate market, including property and home owners, landlords, developers, hotel operators and their respective tenants and employees.”
Luckily for Barrack, and many others in the commercial real estate market, it looks like the Federal Reserve is going to step in with some level of assistance. This morning, it announced that it will be increasing their bond buying program in a number of material ways.
Last Sunday, the Fed announced that it would conduct $700 billion of quantitative easing which would allow it to buy $500 billion in treasuries and $200 billion in mortgage-backed securities. This morning, it announced that they would be increasing that $700 billion number to “unlimited” and would be expanding the types of bonds they would purchase to include corporate bonds and “government-backed debt tied to commercial real estate.”
Frankly, this is an insane situation. As much as I want to complain about the actions that the Fed is taking, I’m not sure that we should be complaining right now. This is the ultimate short term - long term trade-off. The Federal Reserve has to take these actions or we risk a downward spiral that ends with something that looks much, much worse than the Great Depression. Quite literally, if they don’t act, America may not survive economically.
The problem is that the actions being taken are good short-term, but they are horrible long-term decisions. We are talking about infinite quantitive easing. Whatever it takes. That is what we need right now, but that will cause incredibly long-term damage to the US dollar and economy. Remember, when countries have previously turned on the printing machine with a lack of discipline, it has almost never ended well.
The United States is the greatest country in the world. We have some of the smartest financial minds in the world at work right now. I have no doubt that we will survive this crisis, but it won’t come without a long-term cost. The economic circle of life has been broken. This causes a systemic breakdown across the economy. Upstream and downstream. The stimulus can provide a band-aid, but nothing will solve the problem like getting American businesses back online and producing again.
Stay safe my friends. We are in for another wild week it appears.
-Pomp
This installment of Off The Chain is free for everyone. I send this email to our investors daily. If you would also like to receive it every morning, join the 40,000 other investors today.
THE RUNDOWN:
Coinbase Broke Traffic Records and Saw Massive Volume During Market Collapse: Coinbase saw record site traffic and a massive surge in 24-hour trading volume during last week’s coronavirus-driven market swings, CEO Brian Armstrong said in a statement shared with CoinDesk. The San Francisco-based crypto exchange said it processed $2 billion in crypto last Thursday and Friday (for comparison, Coinbase saw $394 million in volume over the past 24 hours, according to Bitwise). Last Thursday also beat Coinbase’s previous traffic record by over 50 percent, Armstrong said. Read more.
ICE Pushes Back on Claim Ex-Bakkt CEO Dumped Stocks After Senate COVID Briefing: The new U.S. senator for Georgia, and former CEO of bitcoin derivatives exchange Bakkt, sold between $1.3 million and $3.2 million in stock following a private Senate briefing on COVID-19. Senator Kelly Loeffler (R-Ga.) and husband Jeffrey Sprecher, the founder and CEO of Intercontinental Exchange (ICE), which owns the New York Stock Exchange as well as Bakkt, made a total of 29 transactions in the weeks after the Jan. 24 briefing. In a statement, ICE said Loeffler and Sprecher "have made clear that those transactions were executed by their financial advisors without Mr. Sprecher's or Senator Loeffler's input or direction," and that the trades complied with company policies. Read more.
Tezos Foundation Offloaded Millions of Dollars Worth of Bitcoin in 2019: The non-profit that holds funds raised in Tezos' $400 million ICO sold as many as 8,000 bitcoins in 2019, it reported Thursday. The share of the Tezos Foundation's portfolio made up of bitcoin fell from 61 percent in July, to 47 percent as of the end of January, the non-profit disclosed in its biannual report. The value was reinvested into other cryptocurrencies as well as into other asset classes.
Crypto Lender Cred Is Offering Investors 10% Interest With Spencer Dinwiddie Partnership: Spencer Dinwiddie, the Brooklyn Nets guard who launched his own tokenization platform, has launched an interest-bearing stablecoin service in partnership with crypto lending firm Cred. The new service launched Friday on Dinwiddie’s personal website. Read more.
'This Will and Needs to Be Bitcoin’s Year' Says Mike Novogratz: With vast swaths of the world markets in virtual lockdown amid the coronavirus pandemic, some predict that the shocks rippling through the global economy in early 2020 may yet come to dwarf the magnitude of the 2008 financial crash. Just as Bitcoin’s creation is bound up with 2008 and the Great Recession, Galaxy Digital founder Mike Novogratz sees this year as make-or-break for the cryptocurrency. In a tweet posted on March 22, Novogratz wrote: “$BTC will continue to be volatile over the next few months but the macro backdrop is WHY it was created. This will be and needs to be BTC’s year.” Read more.
LISTEN TO THIS EPISODE OF THE OFF THE CHAIN PODCAST HERE
Meb Faber is co-founder and the Chief Investment Officer of Cambria Investment Management. He and his team takes a highly quantitative approach to asset management, which means that Meb is full of nuggets of data & analysis. I really enjoyed his calm, unemotional approach to the current chaos. This conversation is one of the most educational ones that I’ve done on the podcast so highly recommend!
In this conversation, Meb and I discuss:
How these chaotic markets compare historically
Why global asset allocation is important
How passive and active strategies stack up
What people need to know about share buybacks and bailouts
Why Meb is so heavily invested in farmland
I really enjoyed this conversation with Meb. Hopefully you enjoy it too.
LISTEN TO THIS EPISODE OF THE OFF THE CHAIN PODCAST HERE
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The Economic 'Circle of Life' Has Been Broken