West of the Hudson

Dear Clients:

As we enter our eighth month in this altered state, the coronavirus has killed over one million people worldwide with ~50% of the total fatalities reported in just four countries — the U.S., Brazil, India and Mexico. The virus has swept through nearly every nation and infected well over thirty million people. It has forced businesses and schools to close, wreaked havoc on global economies, and left hundreds of millions unemployed. Appallingly, despite having just 4% of the global population, the U.S. accounts for ~25% of global infections and the most fatalities. The political, social and economic fallout is rampant and governments are faced with extreme pressure to deliver a safe path forward, hope, and vaccine.

Each nation has managed the economic fallout in their own way. The U.S. Congress poured money into the economy in order to help the consumer, but its relief efforts were intended to bridge a short-term gap until the economy could re-open. One-time stimulus checks and expanded unemployment insurance bolstered household finances masking the financial carnage, but the virus persisted while the CARES package lapsed in July and a separate funding program meant to forestall small business bankruptcies ended in August. Political acrimony has stalled additional stimulus, leaving millions in limbo. More successful has been the U.S. Fed’s assistance, as they have once again opened the monetary spigots and provided a level of aid that far outstrips the lost output of the “real” economy. The excess liquidity has found its way into every crevice of the financial system, rewarding investors who stood firm in the economy’s darkest days.

These twin risks — poor virus management and waning fiscal policy support — looms over the country’s economic stabilization even as close to 60% of the lost jobs remain in limbo. More than half of those surveyed in September who remain furloughed say they no longer expect to go back to their old jobs. This is not lost on consumer-facing institutions as U.S. bank balance sheets collectively hold $2.8 trillion in cash — twice what they hold in consumer loans, and 20% more than they hold in residential mortgages. Banks possess unrivaled visibility into every aspect of the economy, especially the consumer, so this positioning is a canary to keep an eye on.

At the lows in March, the market was pricing in coronavirus as the Black Death and a U.S. depression. Now the market is pricing in an imminent vaccine and a steep, brief recession. This optimism is bolstered by explicit Fed policy to remain extremely accommodative for as long as necessary. That the markets have withstood the immolation in U.S.-China trade relations and COVID flare-ups in major global economic zones signifies both the cognitive and absolute impact of Fed liquidity. This is notable because the one-two punch of U.S. trade policy and the pandemic have caused already strained bilateral relations to crater and, depending on the election outcome, sets the stage for many dark years of isolationism and protectionism. That is not a growth challenge that the Fed or a vaccine will easily conquer.

As the long, hot summer of 2020 comes to a close, the pandemic lives-on while the public’s focus turns to the U.S. election. Against this backdrop the equities market continues to set new all-time highs, brushing off election uncertainty, lingering pandemic disruptions, and extreme national debt levels. Thus we provide our annotations for this, our third quarterly letter West of the HudsonTM in 2020.

Flexibility & Resilience

We begin with the emphasis once again on global supply chains, as the self-inflicted wounds of isolationist U.S. policy combine with a pitiful response to the fight against the virus have turned this once dominant operational component into a fulcrum of business uncertainty and intrigue.

Supply chains used to feel abstract, a business necessity that occurred outside the public eye. They were global, coordinated, and delivered goods where they needed to go and when they needed to be there. But the pandemic has revealed just how fragile, lengthy, and complex supply chains can be — and how much society has riding on their continued smooth functioning. If we have learned nothing else, efficiency and cost effectiveness do not equate with resilience. As businesses evaluate the extreme impact the virus had on production and distribution, what was once excused as “unforeseeable” is no longer adequate, and adding operational elasticity and redundancy is now business critical. That it should occur at a time we are engaged in a trade war with threats of reprisal lends greater urgency to the objective.

At the height of the pandemic, bare supermarket shelves and worldwide shortages of personal protective equipment turned supply chains into headline news. Across industries, companies had little time to address logistical disruptions, a scarcity of parts and ingredients, and sudden swings in demand. That required many organizations to rewire their networks on the spot — all while keeping people safe and complying with the myriad challenges meant to slow the spread.

In a recent McKinsey survey of supply-chain executives, the overwhelming majority of respondents said that the crisis had revealed multiple weaknesses requiring investment, including dual-sourcing raw materials, building inventories, regionalizing sourcing, and adding big data analytics across the entire organization. Most interesting was the conclusion that the businesses surveyed “…have the philosophies, concepts, tools and technologies to manage global extended-enterprise supply chains. The failure is in their rigorous application”. (McKinsey, July 2020). The buzzwords now are flexibility and resilience.

Supply chains have gone from back-office obscurity to political scapegoat because they expose economies to shocks beyond their borders. And this is where we find ourselves today. By way of example, we turn again to critical merchandise (we unpacked the steep challenges to the technology supply chain in our 4Q letter from China and are happy to provide another copy upon request). Here we turn our gaze to a topic we began in our most recent 2Q letter — the pharmaceutical supply chain.

Chemical Imbalance

The first worry to emerge from the onset of Covid-19 was the concern about the convoluted and entirely outsourced pharmaceutical supply chain. Not only are most medications used in the U.S. manufactured overseas, but critical ingredients and the chemicals used to make them also are entirely sourced from abroad, with China the principal source of chemical agents, raw materials, and finished product.

How China came to host this most critical responsibility isn’t as diabolical as it’s made out to be. Costs are the primary attraction of Chinese manufacturing of course, but the lack of a U.S. reserve of raw ingredients for drugs is similar to the dearth of domestic strategic, rare earth minerals (of which China is also the de facto global supplier): new facilities are costly to build and operate, and require an alarming amount of highly polluting chemicals. China has comparatively lax environmental safeguards and U.S. and European companies were quick to rid themselves of the environmental costs and associated risks. The U.S. pharmaceutical industry has become reliant on both active ingredients and their chemical precursors — low margin starter materials and components that require huge scale — and, over time, the west ceded the industry to China. Still, the shortage of even basic over-the-counter medicines is startling with an estimated 80% of global supplies of acetaminophen (painkiller), heparin (anticoagulant), and valsartan (blood pressure) made in China. These numbers are even higher for antibiotics amoxicillin, ciprofloxacin and tetracycline.

Even India, the world’s largest producer of generic medicines, depends on China for 80% of its active pharmaceutical ingredients (API), the chemicals that give drugs their medicinal properties. India is committed to ramping up production to reduce their sourcing dependence, but their projected completion date comes with an eight-year time horizon — a lifetime under the present geopolitical circumstances. The U.S. has yet to move beyond declarations of intent and, considering the capital required to cost-effectively develop domestic raw ingredients, build manufacturing facilities, and acquire the necessary equipment, who will pay for the necessary investments will not likely come easily or quickly without meaningful government subsidies.

The Paradox of Choice

On the opposite end of the production supply chain is the consumer products supply chain, where well-publicized disruptions at the grocery store last spring were met with a vigorous operational response to simplify the process. We are all familiar with the paralysis that sets in when we encounter sixty varieties of toothpaste, or an entire aisle of yogurt, cereal, or soup. It’s what consumer psychologists call “the paradox of choice,” where shoppers are paralyzed by too many options.

For years, companies increased options in an attempt to take market share by catering to the whims of the most consumers. Those efforts helped consumer-goods makers claim more shelf space while retail stores and supermarkets morphed into big-box stores and warehouse clubs. In 1975 the average food retailer stocked ~9,000 different items, compared with ~33,000 in 2018. At the outer-bound is the mighty supercenter, which typically stocks ~120,000 items. (Food Industry Association)

As panic buying in March cleared supermarket shelves of staples, retailers fretted over how fast they could replenish supplies. When it became clear that they could not proceed as normal, food makers were forced to reduce options, focus supply chains, and concentrate production on the most in-demanded goods. This is in stark contrast to the very same companies that spent decades trying to please everyone, being all things to all people so that a single product cookie company swelled to two dozen flavors, while the largest potato chip maker grew from four varieties to sixty, and an iconic soup company quadrupled its options (to four hundred).

Food manufactures have embarked on a collective “SKU rationalization,” an industry term for the whittling down of stock-keeping units, with emphasis on fewer, higher-velocity items. The world’s largest confectionary is eliminating 25% of its product line, a top soft drink and snack producer is retiring 20%, the leading manufacturer all-natural pizza has reduced its product lines by a staggering 70%, and a fresh vegetable behemoth has cut its baby carrot lines by 75%. Consumer product companies will continue to struggle if they can’t rationalize ingredients, production, and distribution. One certain benefit of the corona-crisis is that the U.S. businesses that successfully navigate these challenges will be some of the leanest in history.

The Long & Winding Road While the timing is difficult to predict, many things will have to work out to end this pandemic: drug companies will have to develop a safe and effective vaccine and billions of people will have to consent to vaccination. But more mundane challenges are equally problematic, including storage and transportation. Two of the three vaccines currently in Phase 3 trials are made with genetic materials that fall apart when they thaw and need to be stored as low as -112 Fahrenheit (-80 Celsius). Developing a cold-chain infrastructure will not be easy as vaccine(s) will need to travel across continents, and traverse multiple logistics hubs in multiple climates before ending up their destination.

The leading global logistics powerhouses have experience shipping vaccines (including the seasonal flu) and are investing in industrial-sized freezers and smaller last-mile cold boxes. But because it is 2020 where everything is now a side effect of the pandemic, we are facing a looming shortage of shipping coolant. Dry ice is frozen carbon dioxide and is most commonly a byproduct of ethanol production. Ethanol volumes are tied to the demand for gasoline and months of sheltering-in-place have led to less driving, a collapse in production…and the supply of the necessary carbon dioxide.

Then there are the requisite traditional glass vials, which pose two issues: the temperature requirements will make it very difficult for community-level clinics and pharmacies to store and, more problematic, glass vials crack in extreme cold. A manufacturer has started production of a new type of pharmaceutical-grade glass that can withstand freezing temperatures, but mass-production lags the time horizon we are all anxious for. As to that time horizon, we do need to understand that despite an unprecedented effort, a deliverable vaccine might still be many months away with actual vaccination many months after that. It is understandable that politicians are trying to be optimistic — the global economy was pummeled in the first wave, and it is hardly in shape to receive another devastating blow if lockdowns are reinstated this fall.

Historically, vaccines have been made by injecting a live virus into a fertilized chicken egg and letting it replicate. Scientists then extricate the virus-filled egg white from the egg and deactivate the infectious parts of the virus — but it takes months to ensure that the entire virus is dead. Just producing the annual flu vaccine takes six months or more and, due to mutations, is not always effective. Even as public confidence in a quick vaccine wanes and communities let their guard down, the process of vaccine testing can only be rushed up to a point. Clinical trials that assess safety and effectiveness take a certain minimum amount of time. No stimulus or political influence can expedite this process and ensure that safety and efficacy standards are met. The testing itself is likewise time-intensive: once volunteers receive a dose (or placebo), they are monitored over the course of weeks or months to determine if they develop the disease or any dangerous side effects. Scientists can reach a conclusion only after enough data has been collected. Trials can be cut short if the data is overwhelmingly convincing, but that is not the norm.

Vaccines are not like other pharmaceutical drugs, which are usually administered to patients who are already compromised, in many cases severely or terminally. The primary concern of an experimental drug is efficacy, not safety. But the reverse is true for vaccines because they are given to billions of healthy people, so safety is the over-arching goal. Even if the vaccine works, rare but serious side effects can and do occur, which explains why we do not vaccinate against smallpox or, more recently, the 2009 H1N1 influenza (one promising vaccine developed against the SARS virus actually made the disease worse).

It is difficult to overstate the potential damage that a rushed vaccine could inflict on confidence in science. On the flip side, it is equally difficult to overstate the socio-economic damage if a vaccine eludes us in the near-term. Bombarded with contradictory, non-scientific information, and vociferous debates over shutdowns and school re-openings, the public is at wits-end. Malicious misinformation is rampant, and the polls indicate that while the public trusts scientists and doctors, its confidence in a vaccine is depressingly low. Two-thirds of Americans say they won’t rush to be first in line.

This leads to a final observation. Unless a vaccination is universal administered — if not enough people are treated — then the virus, and the current reorganization of all our lives, will persist. Among many concerns, this likely means curtailed travel with hardened borders and quarantines, a devasting possibility for the global travel and tourism industry (airlines, hotels, restaurants, transportation), which, in 2019, accounted for 10.3% of global GDP and employing 330 million people (10% of all jobs). As it is, the penetration of administered doses will be far slower across the developing world, a favorite travel destination for millions each year.

Market is Not the Economy

The message promoted by Wall Street and the White House is that the imminent approval of a vaccine will bring the economy back to its pre-pandemic state of health. However, even if a successful vaccine is deployed and the economy gets back to ‘normal’, the economy was already slowing prior to the outbreak. The year-over-year change in 4Q’19 GDP was 2.3% — which is decent and certainly stronger than the rest of the developed world — but lest we forget, the Fed had to slash interest rates three times in five months to even get that level.

The economy is now in a much more precarious position as trillions of dollars in new debt morph into an unfathomable mass of debt service payments. Still, overwhelming fiscal and monetary response lifted the stock market to an all-time high even as the economy crashed harder and deeper than at any other time in history and remains in an extremely anemic state. This is because the stock market has become more uncoupled from economic reality than ever. As we have discussed over the years, the fundamental change in the economy over the past few decades was financialization, the commodification of everything into a financial asset or income stream that could then be leveraged, bundled and sold globally by our financial institutions. This layer of speculative asset-income mining has little relation to the actual work being done and exists in its own abstract realm.

We have commented on the yawning gap between the stock market and “real” economy in recent communique’s and examined it further in our August note. In 2Q’20, as the world was torn from its moorings, the U.S. economy contracted ~$2.4 trillion at the same time the S&P 500 rallied 21%, adding $4.5 trillion to its market-cap to a record $26.8 trillion. This contradiction was made possible by the rapid one-two punch of $2.3 trillion in fiscal stimulus and $3 trillion in Federal Reserve “liquidity” (increased money supply). The $5.3 trillion in combined stimuli, or medicine, has overwhelmed the pain by nearly a two-to-one margin. The sheer scale of funding for consumers and financial actors buoyed investor confidence and the stock market rallied through the spring and summer. The fact is, the weaker the economy, the better it is for stock prices since it means the Fed will be there to infuse more and more liquidity into the financial system, with the perpetual belief that this trickles down to the real economy.

Monetary support for the stock market — the “Greenspan put” — was coined in 1987 and has been a staple of Fed policy ever since (the term “financial conditions” is a well-known Fed speak for the stock market). Skeptics argue that the Fed needs a bull market in equities because it allows for the on-going financialization of assets. It has nothing to do with the “real” economy and everything to do with the “financialized” economy of which the stock market is increasingly leveraged to.

Final Thought

Following decades of globalization, the pendulum has begun to swing back the other direction, triggering fears that nationalist policies will lead to a breakdown in international cooperation and a destabilization of the world order. The uncoordinated response to the virus, the resulting economic downturns, and the hardening of borders all seem to herald the emergence of a less cooperative world.

The resurgence of Covid-19 cases and related business shutdowns are dashing hopes of a quick recovery, prompting businesses to again shift their strategies and staffing. They are turning furloughs into permanent layoffs and downsizing production. Executives who were bracing for a months-long disruption are now thinking in terms of years. Their job focus has changed from crossing the chasm to reinventing the business. Roles once thought core are now an extravagance. Strategies set in the spring are potentially obsolete, or at least in need of an overhaul. In the private sector, it’s going to take time to return to anything close to normal, and then we are going to have a national debate on how the blowout in public sector deficits and debts will get redressed. Not to mention the mortgage forbearance, unpaid rent and missed debt payments. There are big default and delinquency risks ahead — all these debts will inevitably have to be refinanced or renegotiated.

From the market’s perspective, this is to be treated as just another business cycle, which we find extremely dubious. The events of the last seven months were clearly non-cyclical in nature and not subject to the usual cycle analysis. As we noted in our March communiqué, the root cause of the crisis is medical rather than economic, so cutting interest rates and flooding the economy with liquidity cannot kickstart a “recovery as usual”. This is especially true if there are permanent changes to our way of life — altering travel, office requirements, and activities involving crowds — affects the path of recovery.

If we can just develop an effective vaccine soon, maybe we can go back to our old normal, which wasn’t so bad, all things considered. For now, the virus continues to plague society, increasing tensions and reducing civility. In every nation, no matter the economic system, there are always haves and have-nots as reflected in measures of income and wealth inequality. The virus has sliced the collective pie in whole new ways, with widening divides between people who remain employed and those who have lost their jobs as well as between businesses benefitting from increased demand and those hit so hard that they may not survive. As to our strategy, despite the uncertainty and market volatility, we remain fully invested in the very large, well-run global companies who poses the means and expertise to adapt, grow, and thrive. The set-backs to global businesses are numerous, but innovation never stops and the future remains bright for their businesses.

Either science will defeat this virus, or we will adjust to living with it, but we are all looking forward to better days ahead. In the meantime, from our families to yours, we wish you all peace, prosperity, and continued good health.

Yours truly,

Hirschel B. Abelson

Adam S. Abelson
Chief Investment Officer

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© 2017 Stralem & Company Incorporated