This week, whilst avoiding infection in my daily work, I’ve been thinking macro. I kept coming back to that Buffett selling BH airline stock news (1). Something about it doesn’t hang right.
Market Insider reckons he bought in against his own advice, anticipating that more people would fly and airlines would maintain value and continue stock buybacks (2). He sold out at a $50bn loss (2, 3). Most of the articles reckon this is because Coronavirus has off-the-cage smackdowned flying. They quote Buffett’s “The world has changed” (1). Plenty of airlines are staring into a debt pit and begging governments for handouts. So of course Buffett sold out at a loss, better to lose some rather than all.
So is the Sage of Omaha just a normal investor who called it wrong?
I can’t help but feel someone of Buffett’s experience, who normally play the ultra-long/ value/ invest and hold game, wouldn’t sell out because of profit warnings. There was already talk of government bailouts. Yes those airlines aren’t going to be profitable in the short-medium term, and will probably suck cash at the same rate as oxygen and Jet A-1, but people will still need to fly. Are our choices and habits really going to change that much? Is our society really going to stop the daily business return flights, or the stag weekends in Budapest?
So what’s he seeing?
The market and it’s FOMO rally appears to be convinced of the V-shaped recovery. The NASDAQ has climbed back to where it was pre-COVID (4). Record numbers of investors are buying back in (5). People called January the melt-up, but this feels suspiciously bubbly again (6). Buffett didn’t give much away in this years Berkshire Hathaway AGM (7). Perhaps most intriguing is that $130 billion cash pile.
To try and gain some sense, I went to other unprecedented times; specifically the Great Depression and Stagflation. To be clear, I’m not thinking we’re in a repeat of either, each major crisis is different, but I’m looking to learn.
The Great Depression
Split between Keynesian and monetarist theories. Keynesian’s (demand-driven) believe loss of confidence led to reduction in investment and spending. Holding money becomes profitable as economic deflation sets in. The monetarist theory suggests this was a normal recession that tipped in severity due to scarcity of money supply. These then follow Irving Fishers debt deflation theorem (8).
A third school of thought, the Austrian School of Economics, argues the FED drove the Great Depression. Expansion of money supply in the 1920s (hence the roaring twenties) led to an unsustainable credit boom (9).
To quote Ludwig von Mises:
“Credit expansion cannot increase the supply of real goods. It merely brings about a rearrangement. It diverts capital investment away from the course prescribed by the state of economic wealth and market conditions. It causes production to pursue paths which it would not follow unless the economy were to acquire an increase in material goods. As a result, the upswing lacks a solid base. It is not a real prosperity. It is illusory prosperity. It did not develop from an increase in economic wealth, i.e. the accumulation of savings made available for productive investment. Rather, it arose because the credit expansion created the illusion of such an increase. Sooner or later, it must become apparent that this economic situation is built on sand.” (10)
During the period there was massive deflation, falls in GDP, and high unemployment. The CPI began the decade at 17.1, and had fallen to 14.0 by 1939 (9)
Image Credit: Inflationdata.com
Up until the ’70s it was believed there was a stable inverse relationship between inflation and unemployment. The US economy slowed, in part due to the Arab Oil Crisis. Rapid rises in the price of oil made some companies uneconomic, leading them to sack workers. Rising unemployment was accompanied by rising price inflation. Monetary policy in the late-60s and early-70s period was also expansive, contributing to inflation (11).
The normal response of increasing interest rates to reduce the speed with which money changes hands doesn’t work (12). Annual inflation ran at 7.25%, but in some months touched 13%. The CPI rose from 37.8 to 76.7 (13).
Image Credit: Inflationdata.com
- Both periods preceded by expansionist monetary policy
- Both periods have high unemployment
- Great Depression – economic deflation, low interest rates, fall in aggregate demand
- Stagflation – price inflation, reactionary interest rates, fall in aggregate supply
Concerns about the future are widely shared. The Bank of England is predicting the sharpest recession on record (14). TI in this weeks Weekend Reading covers a bit of the GDP expectations (15). Iona at Young Money Blog takes it further, covering GDP and drawing comparisons with the Great Depression (16). She goes so far as another event-driven collapse, the Great Frost of 1709. The Ermine has also looked to Buffet and seen bad news (and as an ardent Asimov fan, I particularly like his Trump-Mule comparison) (17).
Plumbing the depths of some thought experiments and potential outcomes, what are the current conditions?
- This period has been preceded by expansionist monetary policy (QE).
Though bond/gilt yields and limits on futures lending suggests there remains fear in the market (18).
- We’re about to see high unemployment.
Image Credit: Reddit/ NYT
To some extent the Coronavirus job retention scheme, or whatever name the Government is currently calling it’s buy-itself-out-of-jail card is going by now, has helped. The Gov is footing the bill, and most people will receive an income. This has maintained peoples spending, and therefore aggregate demand in the economy.
This is not infinite. The furlough scheme is due to end in July, at the same time as mortgage holidays (19). It is unlikely we’ll be fully back to normal until autumn at the earliest. Not all companies will start back. Our heavily service-sector dependent economy will probably be the most affected. Services account for 80% of total UK economic output. The purchasing index data for those services is a fifth of what it was pre-Coronavirus (20).
To quote Ermine quoting ZXSpectrum on the Monevator thread (21).
“The high street was obsolete anyway, airlines should go bust, the petroleum industry needs massive downsizing. The FTSE is not coming back because it full of crap companies with obsolete business models. The S&P and Nasdaq are not.
I’m also more relaxed about higher unemployment. The UK made a sort of Faustian bargain: low unemployment for high underemployment and low skill base.
Machine learning and AI is going to make many middle class people unemployed. We might start getting used to it now and stop stigmatizing those who don’t have jobs. A generation or two from now being unemployed might well be the norm.” (17)
So we’ve got mass unemployment, largely of those working in the service industry, most affecting those on zero-hours, casual contracts, or those with minimal qualifications.
- Interest rates have been dropped to record lows
Which, coupled with QE, is putting more money into the market. Again helping perk current demand.
Supply or demand?
The great fear when this kicked off was the supply side. All the factories in China were shut, companies going under because they can’t source product etc. Plenty of anecdotal evidence. This led to various fears that Coronavirus would lead to stagflation through flat economic growth and spiking prices from the supply side shock (22). This could still well be the case.
This article on Econlib makes a good argument for it (23). We’ve seen a fall in aggregate supply. We’re seeing a fall in aggregate demand. If there’s more demand then supply we’ll see stagflation.
I think they’ve got it the wrong way round though.
The aggregate supply has returned through global supply chains. Deliveries happen, and the companies that supply are making bank. Looking at you Amazon.
Demand is the question.
The government has kept aggregate demand going through the furlough scheme etc. That is not indefinite. Will, or even can, companies restart with their employees?
If they can’t, and we see mass unemployment, then what happens to demand?
This could coincide with the end of a Kondratiev wave, such as the transition from a supply/ IT/ service predominance to one of green technologies and an internet of things (24). Ably supported by the rise of home-working through improved IT. Goodbye commercial REITs.
We could see mortgage refinancing risk rear it’s ugly head, coinciding with decreased bank lending due to deflationary concerns, as laid out in this masterful piece by Finumus (25). It has me worried about my rate.
If aggregate demand falls but supply doesn’t, then oversupply drives deflation and job losses. Basic economics. Decreasing supply costs have helped maintain standard of living and low inflation for years – all that offshoring. In days of deflation, oversupply and job losses then cash in the bank is king. Is the governments current demand prop enough to see us through?
Or did Buffett just call it wrong on airlines?
Have a great week,
N.B. I would truly appreciate others thoughts in the comments on posts like this. They are my attempts to reason through processes, and balancing counter-argument is most welcome.
COVID – I advise the use of BMJs information hub for evidence-based updates: