Salve ragazzi,

As I write, U.S. equity markets are screaming higher, in part because the data out of New York suggest that the city may have succeeded in flattening the curve.

It’s too soon to say, but I hope it’s true.

Ostensibly, buyers of stocks anticipate a rapid economic rebound in the United States.

I think they’re over their skis — because cash flow — but that’s what makes a market.

It has been hard to find time to think with schools closed and our shelter-in-place order extended to June, but here are a few things I’ve been pondering since the last update …

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EM Special Situations
If ever there were a time when the use of “special situations” is appropriate, it is now.

According to BIS statistics, EM non-bank, U.S. dollar-denominated debt totaled $3.8 trillion as of Q3 2019. Debt securities constituted $1.8 trillion of the total, which implies a market size roughly 50% larger than U.S. high yield (~$1.2 trillion as of year-end 2019 according to JPM).

Given the volatility in FX and commodity markets, historic capital outflows, the rolling shutdowns that will slow economic activity, and the limited fiscal and monetary space EM governments enjoy, the funnel of stressed and distressed EM companies is likely to be enormous.

LPs that don’t have exposure to an existing fund may want to take a cue from the U.S. Federal Reserve and act with alacrity and ingenuity to get exposure to this opportunity set.

How? Allocating to a fund may be difficult, but it may be worth contacting proven special sits / distressed GPs and establishing SMAs with them.

Maybe these SMAs start small and can be leveled up over time if and as desired. But investors that wait for the fundraising market to return to normal are likely to miss some incredible opportunities.

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(Asset) Price Stability
I don’t think rates will normalize in my lifetime.

With the global debt stock sitting at $255 trillion (>322% of world GDP), the global financial system cannot function with higher rates. The Fed’s response to prior and current crises (expansion of assets on its balance sheet) entails the creation of more debt in the economy, and the volume of leverage inevitably leads to systemic risks.

The Fed has to step in and establish a floor on pricing when market participants and / or market infrastructure fail to transact. The financialization of the economy means too much is at stake to allow the market to dictate outcomes.

It’s a trap.

The Fed’s actions to forestall cardiac arrest includes expanding the quantity and types of financial instruments they purchase (e.g., Treasurys, corporate bonds, MBS, money markets, bridge loans), and I bet dollars to donuts that they end up buying high yield bonds and equities to support prices before all is said and done.

Bottom line: I think we’re moving away from the era of markets playing a leading role in the flow of funds to one where the state plays a bigger role.

Food for thought:

  • Once the infrastructure is in place for the government to underwrite commercial loans, what role will the private banking system play?

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Intertwining of Corporate and National Interests
In a world where markets play less of a role in the flow of funds and states play a greater role, corporate managements are likely to decrease their focus on shareholder interests and increase their focus on national interests.

We’re seeing a clamor to produce PPE, medical equipment, and pharmaceuticals domestically. But as more people wake up to the diffusion of supply chains for the defense industrial base, I wonder whether aerospace and defense companies’ investment decisions will place less emphasis on NPVs and ROICs, and more on self-sufficiency, resilience, and security of supply.

Or consider the shale complex. There is a confluence of interests amongst the state, producers, labor, and investors to keep shale producers alive. However, the credit intensity of shale injects risks to all parties when oil prices fall below breakeven. Why wouldn’t the Fed or U.S. government backstop shale producers by rolling over their (high yield) debt at concessionary rates, or act as a buyer of last resort to establish a floor on prices?

Food for thought:

  • How will the state use its expanded control over the flow of funds to influence corporate decisions?
  • How will corporations use their ties to the state to shape the markets for labor and capital?
  • Which industries will become “strategic sectors” and / or too big to fail?
  • Is this environment conducive for entrepreneurship, or does it entrench the market position of incumbents?
  • How pervasive would patronage become under this kind of system?

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Goodbye Globalization?
The financial system is currently organized for the integration of markets. The dollar is the global currency, and the Fed has become the de facto central bank for the world.

In a world where the United States brings more of its supply chain onshore — and I suspect other countries will do the same — and where the state has greater influence on the flow of funds, does the current system make sense?

I think not.

A shift from specialized production to self-sufficiency would lead to reductions in international trade, FDI, and potentially portfolio capital flows.

Food for thought:

  • Is global dependence on the dollar likely to last in this scenario?
  • What type of financial system will emerge if the world is carved up into trading blocs?
  • How likely are the imposition of capital controls and / or tighter restrictions on foreign direct / portfolio investment?

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Autarky Under Anarchy
The United States can pursue autarky given its resource endowments and scale, but few other countries can. History suggests countries tend to compete for market access and embrace protectionist measures under this scenario.

Food for thought:

  • In recent decades, has the United States supported international institutions or undermined them?
  • Are the relative power positions of large states conducive to peace or conflict?
  • Do the institutions we have for international cooperation — such as the UN — help us to transition from an age of globalization under American leadership to an era of autarky under anarchy?
  • Do the institutions we have for adjudicating trade conflicts — such as the WTO — give us confidence that the world will fairly and / or equitably resolve competitions for market access?

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What have you been thinking the world might look like after quarantine? I’d love to hear your views.

Maybe we could chat over beers on the Zoom? Hit me up.

Remember, we’re all in it together.

We’re going to need a reservoir of goodwill, and a willingness to find principles of unity on the other side of this.

Stay safe everyone. Peace and health be with you.

Alla prossima,
Mike

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From the Bookshelf

For the catastrophe was so overwhelming that men, not knowing what would happen next to them, became indifferent to every rule of religion or law …

In other respects also Athens owed to the plague the beginnings of a state of unprecedented lawlessness. Seeing how quick and abrupt were the changes of fortune which came to the rich who suddenly died and to those who had previously been penniless but now inherited their wealth, people now began openly to venture on acts of self-indulgence which before then they used to keep dark. Thus they resolved to spend their money quickly and to spend it on pleasure, since money and life alike seemed equally ephemeral. As for what is called honour, no one showed himself willing to abide by its laws, so doubtful was it whether one would survive to enjoy the name for it. It was generally agreed that what was both honourable and valuable was the pleasure of the moment and everything that might conceivably contribute to that pleasure. No fear of god or law of man had a restraining influence. As for the gods, it seemed to be the same thing whether one worshipped them or not, when one saw the good and the bad dying indiscriminately. As for offences against human law, no one expected to live long enough to be brought to trial and punished.

— Thucydides, History of the Peloponnesian War (Penguin Classics: 1972)

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