In this week's MacroVoices podcast, host Erik Townsend interviews Jonathan Tepper, author and co-founder of research shop Variant Perception. During the course of a meandering hour-long conversation, the two men discuss everything from VPs outlook on China's economy and oil's role as a recession indicator, to the problems inherent in the US's version of capitalism.
After some well-deserved humblebragging about VP's call to avoid cyclicals and stick with defensive shares, a call that finally panned out during the "Shocktober" market selloff, the two men turned to the subject of China and the possible long-term repercussions of the US-China trade war.
Asked for his view on Chinese markets, Tepper admitted that he had no insight into how the trade war might be resolved - or if it will be resolved. Instead, he seized the opportunity to pitch Variant Perception's Chinese leading indicator index, which he said has consistently put his clients "in front of some of the most cyclical profitable trades out there" in emerging-markets.
Though Tepper offered one meaningful comment about the recent economic weakness in China: That China's economy and currency are weakening because of structural domestic factors, not trade-related anxieties.
So our index gives us an insight into Chinese growth. And I can tell you that I’m sure the trade war is bad and I’m sure it’s going to have some impact. But the slowdown that we’ve seen in China this year predates trade war problems and certainly is not driven by them. It’s driven by domestic monetary conditions.
Some analysts speculate that the record drop in oil over the past few weeks could signal that a global recession is ahead. But Tepper argued that his indicators offer a slightly different take. Looking at oil's moves over the past two years, WTI is still trading at more than double its post-2014 lows.
This pattern more closely resembles the run-up to the recession in 2001, when oil more than doubled following the Asian and Russian crises in the late 1990s. And while oil has reversed some of its advance in dollar terms, when the exchange rate is factored in, the price of oil is far higher in some fragile emerging market economies. With all of this in mind, the rise in oil "is clearly negative" - though, as with any indicator, it doesn't necessarily guarantee that a recession is imminent.
Oil collapsed from 2014 and then bottomed, essentially, early 2016 and then has doubled since. It’s very similar to the 1998–2001 period where oil collapsed after the Asian and Russian crisis and then doubled into 2000. And then you had a recession in 2001. So you could argue that we’ve had a similar dynamic at play.
Oil clearly has doubled and gone up. When you look at emerging markets, everyone looks at oil in dollars but if you look at oil in Turkish lira or you look at oil in Argentinian pesos or – a lot of these emerging currencies – oil is by far higher than it was in 2008. There clearly tends to be drag on economic growth when it takes a larger part of the global wallet.
And that’s fairly negative. But that’s just one input and not the only input that determines recessions. It’s clearly negative; it’s a drag. But you would never base your entire investing strategy on that.
But while oil offers forward looking signals, Tepper explained that this isn't the case for inflation, which he said lags the economic cycle. In lieu of a wonky explanation, Tepper offered an intuitive example that clearly illustrated how this dynamic works.
If you think about it intuitively – let’s say you’re a boss at a factory. You don’t fire your workers just because you have a good month or two of sales. So employment lags the business cycle. Just like employment, if you run a supermarket, you don’t start hiking your prices just because you have a good or bad month of sales.
So unemployment and inflation are two of the most lagging indicators possible when it comes to the economy. So, if you know where the economy was 12 months ago, you can generally get a good read of where inflation is going to be in the future. All of the inputs that go into a leading indicator for inflation, essentially, are taking stock of where the economy was 6 to 12 months ago and then projecting that forward.
Given the flashpoints surrounding Brexit and the Italian populists' running game of economic chicken with Brussels, it was inevitable that Tepper would be asked for his outlook on Europe. And asked he was. But after offering a fairly conventional overview of the euro's flaws...
In the case of Europe, what’s quite interesting is that the euro itself is a completely flawed currency, badly designed. It took them quite some time to get the central bank buying peripheral bond markets. The countries themselves do not understand the implications of the euro.
So for the first seven or eight years, inflation basically proceeded as it did pre-euro, even though the central banks in Spain and Portugal and Greece and Ireland and Italy didn’t control monetary policy the way they used to. So, once the downturn happened, then suddenly not only did you have an epic collapse in Spanish and Irish bubbles, but then you basically had peripheral countries that had vastly overvalued currencies, like a Spanish euro was very overvalued relative to a German euro.
And they’ve had to try to adjust their unit labor costs. Then they couldn’t have the central bank buy their own government bonds. And, also, they couldn’t inflate away their debt in the government bonds. After that, basically once the ECB started buying, they were helped in the short run and it brought down borrowing costs and spending in Italy.
What we’re now seeing is that the market itself is repricing. Where the Spanish and the Italian yields have been very high, they then went absurdly low and priced near Germany. Now they’re starting to widen again. When there is the next downturn in Europe – and there will be, it’s a matter of when, not if.
Then people have to worry about the level of Italian debt. And Italy can’t devalue the euro the way that it did with the lira in the past. And they have to hope the ECB will buy the debt. This is clearly causing a conflict.
...He followed with an interesting contrarian take: That if the euro fails, it will be because Germany has finally become frustrated with the peripheral countries being given a "free ride" by the ECB once the central bank is pressed to buy up all of their bonds to avert another crisis.
So it would be more likely if the euro breaks up it’s because the Germans get fed up with the situation in the same way that the Russians got fed up with the ruble zone and ended it – it wasn’t the "stans" that exited. So I think Europe basically – we’re likely to see more trouble in the Italian bond markets and repricing, but I think it’s unlikely based on history that Italy would be the one leaving the euro area. I think it’s more likely that eventually the ECB buys all periphery debt and the Germans get tired of free riding – in the same way that the Czechoslovakia currency was broken up, it was because the Czech Republic got tired of the Slovaks. Normally that’s just the way it works when currency unions break up.
Following a brief overview of the Australian housing market, which Tepper described as the lynchpin of the country's economic boom, where a rentrenchment could be catastrophic for consumption and availability of credit...
We were going around checking out the housing markets, speaking to bank managers, to mortgage brokers, to potential buyers, going to the auctions. It was truly crazy. And what we realized was that the standards for lending were quite poor. There was not a lot of verification of costs in terms of how much people were spending on children’s education or rent or anything housing related. And at the same time, there were almost no verifications on income.
Most of the mortgages at the time, over 40% of them were interest-only mortgages, so people were really not repaying principle. They were essentially speculating on the increase in the price of the houses. Howard Marks said that if you’re too early you’re, effectively, wrong.
So I would say that I was wrong in the sense that I was too early. But in Australia over the last year they’ve had what they call a Royal Commission, which is essentially an independent body, to look into the behavior of banks. And everything that they have uncovered has corroborated what John Hempton and I did, and pointing out the very poor and lax lending standards that were at play.
Due to this pressure, the banks in Australia are now having much tighter checks on income and costs. And the credit is really turned down and is drying up. So what you’re seeing is declines in prices at a national level. Within specific post codes, you’re seeing 10–20% declines, particularly at the high end in Australia.
So we are seeing a downturn in Australian housing. Building permits have rolled over. The entire economy is massively geared towards the real estate sector and that’s created an enormous wealth effect, which has fed consumption, car purchases, and retail purchases. So there is very much a slowdown and downturn at play in Australia.
...Tepper and Townsend switched to an entirely different subject: The contents of Tepper's recent book, "the Myth of Capitalism." As Tepper explained, he wanted to write the book as a defense of capitalism amid attacks levied by Thomas Piketty that the capitalist system conceals a fatal flaw: That workers receive persistently smaller share of the spoils from corporate earnings.
And what Tepper discovered during his research is that this phenomenon is related to why corporate profits, which Jeremy Grantham once described as the "most mean-reverting data set in finance", haven't undergone a genuine retrenchment in years. Meanwhile, the share of earnings going to workers has consistently shrunk.
But the fact that corporate profits have remained elevated while worker pay in real terms has continued to sink isn't a flaw inherent to the capitalist system, Tepper explained. Rather, it's a flaw inherent in our version of capitalism. And a lot of it is tied to the wave of consolidation that has swept most industries since the 1980s. This consolidation has hampered competition, and caused markets to start behaving in an unhealthy way, which has led to our current secular stagnation and all kinds of other ills. And tech giants like Facebook and Google are among the worst offenders.
It was really when I started digging that I realized the main reason for this is that, in industry after industry in the US, we’ve seen a merger wave every decade since the early ‘80s. The merger wave has basically – it’s like the US Sweet 16 in the NCAA basketball or the World Cup, where you start out with 16 teams and you go down to 8 and then 4 and then 2 and then 1. What’s happened is we moved from an open economy with lots of competitors essentially down to oligopolies and monopolies in many industries. And that has an impact. It affects the way everyone lives, whether it’s in the US or Canada or the UK. The Canadians know this particularly when they pay for their phone bills. The US people know this when they pay for their cable bills or they pay for medical bills. When there is no competition, the prices are very high. And this clearly means you get higher prices. It also means that wages are lower. And, overall, because barriers to interest tend to be very high – I have a chapter on regulation – you just get fewer competitors coming in. So it leads to a collapse in startups.
And while competition has disappeared in traditional industries from health care to cable, few realize how problematic the role of tech giants like Facebook and Google has been. These monopolies have been allowed to expand their market influence virtually unchallenged by regulators, buying competitors and strengthening their monopolies with impunity.
But if you look at the online ad market and talk to people who have been in it for decades – a very good friend of mine actually works at Google – he worked at DoubleClick beforehand. And Google was allowed to buy DoubleClick. So, Google does search ads. DoubleClick did display ads. What’s extraordinary is the FTC allowed for this merger to go through, even though Google was essentially taking out its main competitor in terms of online ads. And Facebook likewise bought Instagram and WhatsApp. They were able to merge WhatsApp with Facebook to the point where you can’t get a Facebook account without a phone number. So now Facebook on thousands of sites across the web functions essentially as your digital passport. You can’t get an account on various apps or websites without a Facebook login.
This has created a "highly centralized" system where the 70% of Web traffic runs through two companies - Google and Facebook - and as Tepper said, that's not good for anyone.
But what should be done to restore competition? Tepper has an idea: Regulators should implement a hard rule that they won't sign off on any mergers that would leave a given industry with fewer than six competitors. But will that undo the damage that has already been done? Well, it's hard to say.
Listen to the full interview below: