The state of play

Christopher Joye

Coolabah Capital

In the AFR this weekend I write that investment decisioning is complex right now because the world is in such an unusual and fluid place. One of the most important tasks for any decision-maker is to continuously stress-test assumptions and mark-to-market their hypotheses as to how the future will unfold. This is a never-ending process whereby one has to recursively iterate back through analysis and logic in a relentless search for the truth. So let’s “nowcast” a little and reflect on the current state of play. Click on that link to read my column or AFR subs can click here. Excerpt enclosed:

The Cold War 2.0 thesis regularly advanced by this column is, for better or worse, well and truly running its course. Almost every day relations between China and the West deteriorate further.

But what do we mean by a new “cold war”? The world is emphatically observing the eruption of a hot economic and information war in non-kinetic terms, which is a critical development. The consensus in Washington is that the US had been unwittingly embroiled in this commercial, ideological and geo-political conflict with China for more than a decade. Most Americans simply did not know it.

The arrival of the Trump Administration coincided with a bi-partisan embrace of this perspective, and the initiation of an aggressive trade-war via the imposition of tariffs that stimulate supply-chain decoupling and other counter-measures to mitigate and prevent espionage, propaganda, intellectual property theft, and to generally level the global playing field.

While neither side wants to go kinetic, the cold physical war could absolutely heat-up through miscalculations over Taiwan and/or in the South China Sea. Our probabilities on this arising are unchanged at 25 per cent to 50 per cent over the next decade. The US is steaming two nuclear-powered aircraft carriers, USS Nimitz and the USS Ronald Reagan, through the South China Sea, which China claims as her sovereign territory in conflict with the legally recognised rights of six different Asian nations. At the same time, the PLA has suddenly relocated eight warplanes to the disputed Woody Island while also firing more than 3000 missiles at moving targets.

Our hypothesis that there will be pervasive Western decoupling vis-à-vis China across major commercial and national security sensitive industries is being validated by the day. We’ve argued that this will take place through a combination of switching to other low-cost countries that are more benign from a strategic standpoint (eg, Vietnam, India, and Mexico) and through "domestication" of supply chains. A recent BofA survey found that 75 per cent of companies were increasing “the scope of their re-shoring plans”.

BoA says that “while each of these stakeholders is examining the location of supply chains from very different perspectives, they are...arriving at the same conclusion: namely, portions of supply chains should relocate, preferably within national borders and failing that, to countries that are deemed allies”.

And the costs of doing so are not as prohibitive as many suppose. “The argument against re-shoring has always been made on the grounds of lost efficiency and ruinous costs,” BofA says. “Our analysis, however, suggests that a US$1 trillion capex cycle, spread over a five-year period, would support the shift of all foreign manufacturing in China that is not intended for consumption in China. This would be significant, but not prohibitive.”

This will be facilitated by the application of greater automation (robotics) and artificial intelligence in production processes. We continue to think that over the medium-term reshoring could be quite inflationary, which is an impulse that will be amplified by unavoidable central bank monetisation of public debts (to allow nation states to service those obligations) and the debasement of fiat currencies.

Indeed, the only thing that can ultimately staunch the “QE to infinity” dynamic, which is the dominant policymaking reflex, will be rampant inflation. But in the immediate term COVID-19 is unambiguously a deflationary shock: the aforementioned price pressures could take many years to play out. One rider to that statement is that the post-GFC epochal end-game of high inflation could be brought forward by a China-US conflict. World War One, World War Two, the Korean War, and the Vietnam War all triggered inflation outbreaks.

Since February we’ve argued the contrarian case that we would get durable vaccines for COVID-19 by the end of 2020 coupled with anti-viral drugs that will help mitigate the disease, specifically citing Gilead Science’s Remdisivir and hydroxychloroquine. While Remdisivir has been a success, hydroxychloroquine has not been embraced.

The latest news on vaccines has been very encouraging, with the US company Moderna and Oxford University releasing successful trial results in recent days. The Oxford trial of 1,077 healthy adults found that its vaccine generated “robust immune responses” in the form of both antibodies and T-cells 56 days after it was applied. “The data is fantastic - as good as it could have been at this stage,” the chair of the UK government’s Vaccine Taskforce, Kate Bingham, was reported as saying. Similarly strong antibody reactions have been reported in trials of vaccines developed by Moderna, CanSino Biologics and Pfizer/BioNTech.

The UK government has already committed to buying 100 million doses of the Oxford vaccine and 90 million doses of the Pfizer/BioNTech product. Oxford’s commercial partner AstraZeneca has agreed to supply European countries with up to 400 million doses, with deliveries to start by the end of this year. It has completed similar agreements with the UK, US, and other countries for another 700 million doses, and agreed a licence with India for the supply of one billion doses. Moderna is currently mass-producing its vaccine at three plants and plans to produce 500 million to one billion doses per year. With the support of extreme monetary and fiscal policy stimulus, markets should climb higher if and when a vaccine is officially confirmed that protects most people for at least 12 months or so.

We asserted that Prime Minister Scott Morrison and Treasurer Josh Frydenberg would once again save Australia’s AAA credit rating (as they did between 2016 and 2018) by outperforming other AAA rated countries and Standard & Poor’s projections. The government has not disappointed. On Thursday S&P highlighted that “the cost of the JobKeeper program...has been materially lower than originally budgeted in March” and that Frydenberg’s “economic and fiscal update consistent with the 'AAA' rating”. The performance of Australia’s current account surplus, iron ore prices, labour market, and the housing market have all been upside surprises for the rating agency and most analysts.

While the heinous policy errors that led to sustained community transmission of COVID-19 in Victoria were both unexpected and disappointing, the number of new cases per day have generally been tracking sideways in line with our projection for a peak somewhere in mid to late July, depending on the efficacy of the government’s containment measures.

Since March we’ve maintained that national house prices would likely flat-line to fall by up to 5 per cent over the next three to six months following which the boom that started in June 2019 would reassert itself. Consensus predicted falls of between 10 per cent and 30 per cent. Thus far the market has obeyed the script with CoreLogic’s national index declining by only about 1.5 per cent since I aired our view in a podcast on March 24.

Prices appreciated over March and April, and have gradually drifted lower thereafter. Auction clearance rates rebounded strongly prior to the surprising second wave in Victoria, which could delay the national recovery until the first quarter of next year given the seasonal downturn in prices over December and January. A second wave in NSW is another downside risk. I know the perma-bears would love for me to change my tune, but I am comfortable with the idea that this shock ends with a decent dose of house price inflation.

One important condition precedent will be the ability of banks to make rational lending decisions. Back in August 2018 we argued that UBS analyst Jon Mott was wrong when he sensationally claimed that Westpac may have breached Australia's responsible lending laws, which risked invalidating the enforceability of hundreds of thousands of loans. At the time, Mott thought this might be Australia's "Lehman Brothers moment".

Our legal analysis found that Mott, the Hayne Royal Commission, and ASIC’s reading of the responsible lending laws were erroneous, which led them to the same flawed conclusion that the banks had systematically run afoul of them. The Federal Court has now concurred with our position on two occasions, and this week ASIC made the sensible decision to drop its case against Westpac and engage with the government on much-needed legislative reform. 

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Portfolio Manager & Chief Investment Officer
Coolabah Capital

Chris co-founded Coolabah in 2011, which today runs over $8 billion with a team of 26 executives focussed on generating credit alpha from mispricings across fixed-income markets. In 2019, Chris was selected as one of FE fundinfo’s Top 10 “Alpha...

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