Shelter Island Capital Management

Market participants need a point of reference. Currently the focus is on inflation expectations as a gauge of the direction and amplitude of coming monetary policy decisions. Inflation expectations are not astronomy; they are an average measure of market expectations. Why would most investors or central bankers have such respect for the acumen of their peers on this particular estimate is beyond comprehension? At no point in the past few years did the market expect inflation anywhere near where it was in the fall of 2021, well before Russia’s invasion of the Ukraine.

We were early identifying the possibility of a period of higher inflation and lower growth. Larry Summers and other economists brought to our attention an excessive growth in public spending. This observation reinforced our conviction in some of the positions in our portfolio. The risk reward of investing in bonds with negative yields, and often no coupon to boot, was one of the worst, if not the worst, investment proposition we can remember. If your investment advisor did not direct you to sell your fixed income exposure in 2021, you should consider a change and we should talk.

It is also puzzling to observe the volatility in the Treasury market of the past few months. It has often been higher than the volatility of the equity market (perhaps not surprisingly, since the equity market has a higher and usually growing coupon).

Many people seem confused by the return of the Philips Curve to conversations in developed economies. In emerging markets, the trade-off between inflation and unemployment has remained more visible. It is highly likely that the current trend towards reversing decades of globalization will lead to higher inflation in developed economies and economic pain in emerging markets. Workers in developed economies will have even more bargaining power than that already afforded by historically low unemployment and terrible demographic profiles made worse by a self-defeating curb on immigration.

The best thing one can say about the current economic slowdown is that it will not be felt as harshly as other recent slowdowns, as nominal GDP growth will remain high. This will take care of some of the excessive debt stockpiles by boosting tax revenues and lowering the debt/GDP ratio.

Trade barriers came down for a reason

Since very few things come free of charge, the other side of this inflation spike is that individuals who are immune to money illusion will save more for their retirements as real returns on investments come down. The savings rate may also go up further, as many spendthrift governments will raise taxes to continue with their popular profligate ways.

Trade barriers will dent global productivity and the quality of goods and services. The next time you feel like accepting that economic nationalism is a great idea, you should recall that there is a reason your smartphone was not made in the EU. Before the WTO reduced trade barriers, before delocalization of manufacturing and freer trade, we had to contend with second best and also-ran products and services.

Those of you who grew up in Spain before the country joined the EU may remember the shoddy automobiles and consumer electronics that were available. These closed markets also led to abuse as firms had much power over consumers. It was a world where companies sold small unit volumes at fat margins and consumers were constantly short changed.

Back-to-the-future response is lacking

It is worrisome that so many people agree that this back-to-the-future scenario is the intelligent and responsible policy response to Covid, the war in the Ukraine, or China’s reaction to Nancy Pelosi’s provocation. Not a single EU politician is on the side of permitting fracking in the EU in order to gain energy independence. Whether this is a case of ignorance or corruption is an open question.

The largely undisputed enlargement of the role of Government everywhere in the West is also a source of concern. We do not fully agree with the 1980s assumption that the private sector can do anything that the government does better and cheaper. It is nevertheless frustrating to see how the progress made over four decades of increasingly liberal economics in the West is being dismantled precisely because the worst businesses are falling into the lap of the State, most recently EDF.

A wondrous era of globalization seems to be coming to an abrupt end. Mercifully, this is not all bad news in the short term, although we are afraid it is mostly bad news in the long run. There are winners in this backpedalling process, especially among unskilled workers in developed economies. Should you have any doubts just try to hire a waiter in Spain this summer or a construction worker in Florida. Immigration barriers may have the benefit of lowering inequality even if they make everybody poorer.

Peaceful handovers of power no longer a given

Perhaps this new trend will reduce the polarization in domestic politics everywhere and bring about a more sedate public discourse. As in the Cold War era, we do have again very well defined enemies that threaten our security. Donald Trump, Boris Johnson, and Jair Bolsonaro have been able to exploit the fertile ground for populist ideas that misguided austerity brought to the surface in the wake of the Great Financial Crisis. Trump is out of office for now, Johnson will soon be out of office, probably for good, and Bolsonaro recently claimed he would not leave office even if his opponent wins the election in the fall. Perhaps this last bit of news is the most shocking aspect of the zeitgeist, the elected president of one of the world’s largest economies warns that he will not leave office because the election will be fraught with fraud and he has the support of the armed forces.

Trump opened the season for contesting the legitimacy of the outcome of an election. Thus far, he is getting away with his alleged incitement of the storming of the Capitol. Surely, in a bygone era, the elected leaders of western democracies would have commented on Bolsonaro’s provocation. Not today. Claims of electoral fraud and actual electoral fraud used to be the remit of weak democracies such as Mexico’s or frontier countries. Not anymore. The peaceful handover of power is perhaps the most salient feature of modern democracies. Let us hope this remains the case. There are few things more terrifying than a larger state run by unelected officials. Should you need any proof of that just take a close look at the workings of the EU Commission.

The current political and economic environment does not lend itself to much optimism. Unfortunately, as some of you like to point out, we might be a bit too negative at times, yet most of you might agree that today we face some problems.

Let us try to forget for a minute the war in Ukraine. Let us put aside the implosion of the real estate developers and small regional banks in China that is putting the brakes on growth in the second largest economy in the world and driven the Government to put tanks on the streets.

Let us ignore for now Christine Lagarde’s farcical press conference, when it became quite apparent that the leadership of the ECB is both irresponsible and unaccountable. The Council abandoned the forward guidance policy set by Mario Draghi in 2013 because raising rates a month ahead of abandoning QE in July will certainly make a huge difference.

Let us assume that higher rates will be salutatory, that inflation is on the wane, and that a recession, if we get to that, will be short and shallow. Let us skip over the EU Commission’s phantom contingency plan for energy security for the winter or for the long term, even if several member countries are defiantly pushing back.

Let us believe that political turmoil in the United Kingdom may well be for the best, that the government falling in Italy is par for the course, that cohabitation was already tested in France some time ago, or that Bismarck’s analysis of Spain remains true to this day as not even Sanchez will be able to destroy the country. Let us skip over the dreadfully low support enjoyed by President Biden or the fact that the fate of the Republic rests on the desk of an unelected Attorney General of the United States who shall soon decide whether to prosecute former President Trump. Finally, let us brush aside the infernal summer we are experiencing across the world, apparently because the jet stream has wantonly taken on a “wavenumber 5” shape.

Perhaps we can safely ignore all of the dark clouds forming overhead in the manner that financial markets have done so far this month. Is this rally the beginning of a new leg of the long bull market or just a painful bear market rally? We will soon get some clues as earning season progresses.

In any case, this is as good a time as ever to reflect on the many positive aspects of our lifestyles in affluent western democracies. Most of us should count our blessings as we have benefitted from unparalleled affluence and prosperity for decades thanks to peace and globalization. Many of us have been fortunate enough to enjoy some of the benefits.

I was able to study abroad even though Spain still had capital controls in place in the 1980s. Thank goodness, that tuition and room and board were acceptable uses of foreign exchange reserves. The most fortunate among us studied in the United States, which in spite of all current concerns remains the most open and meritocratic society in the world. Certainly, the eighteen years I lived in the US shaped my personal and professional development for the better. How could I ever forget the generosity of my American friends and colleagues?

From my first business meeting in 1991 as a one person JV between a then small, very profitable, up-and-coming Spanish bank and a US broker-dealer, I was dumbfounded by the innate curiosity of most of my interlocutors. Unlike the morose people I had met in a brief stint in Madrid, where I learned the ropes of the trade by meeting investors in the UK and the European continent, American investors were far more inquisitive, engaging, and open about their own views.

Whereas many on the opposite side of the Atlantic were vaguely familiar with the big picture or the details of many of their investments, American investors seemed to be interested in making money by doing their job superbly well. I had the ear of people who managed a lot of money at the best investment managers in the world. I discovered the fascinating world of hedge funds managers interacting with investment professionals at Soros, Tiger, Moore Capital, or Noble Partners, a smaller but very expansive firm in Boston. Some investment professionals at Lazard Freres Asset Management, Wellington, Fidelity, Capital Research, or Merrill Lynch Asset Management were also generous mentors.

The lessons learnt in the 1990s have served me well ever since. Iraq’s ill-fated invasion of Kuwait showed how far away from reality could an autocrat become. The ensuing oil shock was short-lived as Saudi Arabia increased production by 3 million barrels per day to make up for Iraq and Kuwait.

The European Rate Mechanism crisis evidenced that the European Union is not an optimal currency area; we have been trying to fit a square peg into a round hole ever since, with disastrous results for millions of Europeans.

The early 1990s was a fertile ground for a financial education. The policy recommendations known then as the Washington consensus were on the rise. Many emerging economies adopted a fixed or sliding exchange rate regime to anchor inflation expectations. Many also undertook privatizations, fiscal and labour market reforms, joined the WTO, and opened their capital accounts. With the benefit of hindsight, most observers might agree that the IMF and World Bank efforts were an unmitigated disaster.

Some of us realized then that if a rigid exchange rate mechanism had not worked for two G7 countries, the UK and Italy, as their economies needed a different level of interest rates than post-reunification Germany, this scheme was not going to work for many emerging countries either, especially as the Greenspan Fed started tightening in 1994. As a result, we had our 15 minutes of fame for correctly anticipating some momentous events such as the Mexican peso or the Russian rouble’s devaluations.

By the end of the 1990s, the fervour for economic orthodoxy was on the wane throughout Latin America. The dangerous idealists at the IMF had left the financing of the transitional costs to private investors. They ignored that there was no natural buyer for these countries’ foreign currency debt and that, with the notable exception of Chile, none of these countries had developed a local currency bond market capable of financing the domestic demand for credit.

The other important lesson from that period is that democracies and market economies have a difficult time surviving periods of economic hardship, especially in countries where income and wealth inequality are as high as they are in Latin America.

Left-wing socialist and populist parties have been on the ascent since that failed experiment of the 1990s. Today, the Sao Paolo Forum, founded in 1990 by the socialist party of Brazil (PT) to combat neoliberalism in the region, has nearly reached its ultimate objectives. Only Brazil and Ecuador have conservative governments, and this may only last a few more weeks as the PT candidate is ahead in the polls for the Brazilian presidential election in October. Sadly, socialist dictators rule Cuba, Nicaragua, and Venezuela.

We have been concerned that the EU has ignored rising regional inequality and low growth in some countries since the outset of the euro zone sovereign and banking crises. The economic record in the EU is mixed. There are of course success stories such as Poland, the Baltic Republics or Ireland. However, two of the four largest economies – Spain and Italy – have not prospered for years and the core countries have underperformed the US economy in a manner that was unthinkable in the early 1990s when the idea of a common currency was gaining political traction.

Overall, the euro has been a failure because a one-size-fits-all monetary policy has not worked. Nobody is very happy under that roof. In 1990, Italy’s per capita GDP was very similar to France’s or Germany’s, $20,825 vs $21,793 and $22,304. Thirty years later, it is 30% lower than Germany’s and 18% lower than France’s is. So much for euro area convergence and benefits. What about the general benefits of the EU as a whole? In 1990, US GDP per capita was only slightly higher than those of these three countries at $23,886, today at $69,287 it is 36% higher than Germany’s, 59% higher than France’s, and 95% higher than Italy’s is. Italy’s GDP per capita is lower today than in 2007, this is also the case for Spain and Greece (as well as for the UK, Brexit and all). We have been thinking for some time that the EU is becoming a poorer version of Japan but with a major disadvantage as there is no EU nation-state and none is should be expected in our lifetimes.

We are afraid that even The Economist is right from time to time. China may well grow old before it grows rich. Real estate development has been one of the main drivers of the phenomenal growth of the past three decades there. The industry is teetering on the edge of an abyss. This financial crisis may take down with it a large percentage of the foreign exchange reserves of the Central Bank of China, which will likely be used to shore up these companies and their lenders, and lead to a larger depreciation of the renmimbi. Japan continues in critical but stable condition.

When such a large component of global economic activity is slowing down, we should not expect a miraculous performance from the US either. Corporate earnings in particular are fragile there as the global economic slowdown is compounded by the strength of the US dollar and record profit margins.

Whereas many people around us are terribly concerned about the political climate in the US, we are far more concerned with other more clear and present dangers.

• The October meeting of the Central committee of the Chinese Communist Party may return a dictator for life. This will end for good any debate about democracy becoming the inevitable outcome of economic development in that country.
• The failure of some house builders in China is fraught with fraud as some of these firms have misappropriated pre-payments of up to 90% of the home price. This is leading to boycotts on mortgage payments and bank failures.
• Germany AG’s development model consisting of cheap energy and cheap labour from Eastern Europe, exports to China, the US, and the few remaining wealthy EU countries, and recycling massive current account surpluses in the euro zone may no longer be viable.
• An energy supply crisis in Europe is likely this winter. The policy response will be to shut down some industries. This will lead to further fiscal deficits as workers go on government-financed furloughs.
• India remains a source of hope for growth seeking investors. We are afraid that the fragility of India’s terms of trade has not improved since Modi was elected, thus the current surge in energy prices and the US dollar will bite into growth. The political and financial crisis in neighbouring Pakistan are not good omens for stability and prosperity either.
• We hope that the general alarm over widespread famine as fertilizer prices have skyrocketed may prove to be misguided, but we should prepare for a worst-case scenario.
• We should all enjoy our summer vacations to the fullest as the back-to-school season may see the rise of pent-up conflict. We should expect a surge in industrial actions, as wages are not keeping up with inflation. This will lead to more turmoil in politics and a slowdown in economic activity as households and firms retrench.

In view of these developments, it would seem that the US remains the best place to live and do business in an increasingly tumultuous world, if only they would take me back!