The Real Long COVID

Summary: Just back from two trips to the Gulf Region, I can report that the world’s billionaires are worried about the same list of geopolitical issues that you and I think about: China/US, Taiwan, Russia/Ukraine, North Korea, nukes, energy, inflation, the Fed and interest rates. Those issues and Long COVID, the brain damage we suffered by living through 3 years of global COVID pandemic, have left us with fragile financial networks and illiquid markets. That warrants extremely defensive investment strategies, as I outline below.

Road Warrior Report

As I type this on my iPhone while flying over the North Pole on the way from Dubai to LAX three things occur to me: 1) I can see the aurora borealis from the airplane window. The colors are extraordinary! 2) I know exactly what my longitude is (zero degrees). 3) I have no idea whether the concept of latitude is even defined at the North (or South) Pole.

I am halfway home on my peaceful 16-hour flight. I love long-haul flights; the phone never rings and it’s the best sleep I ever get. After almost 3 years of COVID isolation, I have made 2 trips to the Gulf region in the past 3 weeks: that’s 64 hours of flying time. I was in Riyadh a few weeks ago where I attended the Davos in the Desert meetings with my 10,000 closest friends. The luminaries were thick on the ground—Presidents, Prime Ministers, Princes, Nobel Prize winners an ocean of garden variety billionaires (I ran into Ray Dalio, a friend of 40 years, standing in line to get into the venue.) My most useful Riyadh observation is to let you know that the billionaires are worried about exactly the same things you and I think about every day—US/China, Taiwan, Russia/Ukraine, North Korea, nukes, energy, inflation, the Fed, and interest rates.

This week’s trip was to speak to 1000 family office types in Dubai at the AIM Alternative Investment Conference. I was scheduled to have a fireside chat with my old friend Nouriel Roubini, also known as Dr. Doom, who always believes the world is ending. (You can see a short video of the conversation by clicking here.) (Spoiler alert. I’m so old that Nouriel is my second Dr. Doom. I remember debating Henry Kaufman in 1981 when the 30-year Treasury was 15%; he was sure that interest rates were going even higher. I argued they were going to fall.) And I gave a dinner talk to a roomful of investors alongside former Treasury Secretary Larry Summers, who was much easier to get along with.

The fireside chat was moderated by Robert Willock from the Economist Intelligence Unit, who is everything a journalist should be—smart, curious, honest, and not afraid to speak his mind. I had the chance to give my message: let’s stop whining and get back to work. The world is complicated but it’s not going to end just yet so we still have to do our day jobs protecting and growing capital.

At the dinner, I spoke to the smaller group about how I think about economics and finance. I have copied my talking points, below, for your reading. My message was simple. Financial crises do happen, just not all the time. Financial crises give investors an opportunity to make real money every decade or so. To do so, you have to be holding plenty of cash at the top, before the crash happens, and your equity portfolio needs to be built from defensive, short-duration, dividend-paying, stock-repurchasing, free-cash-flow-producing companies. (I know—boring.) This is hard for investors to do because the top is exactly when the newspapers, your best friends, and your own belly are screaming for you to buy high-flying growth stocks with imaginary profits. There are signs that we may get to enjoy another credit crisis again soon. Here are some thoughts about how you can make money when that happens.

I hope that you find my analysis, below, of value.

Notes from Dubai dinner talk

The first two papers I have my PhD Macroeconomics students read are Friedrich von Hayek’s lectures on information and knowledge. (You can download the course description and syllabus here.) Von Hayek taught us that a market economy is a vast and efficient information network that solves society’s most important problem, the division of knowledge, by transmitting packets of information about relative wants and scarcities to exactly those people who need the information to make decisions. (More on this here.) We call the packets of information prices; we call the information network a market economy. The result is the full-employment general equilibrium state that economists love to write about. (You can download Hayek’s articles here, complete with my margin notes for my lectures.)

Most macroeconomists today believe that the economy is in or near general equilibrium all the time, except for occasional temporary sojourns caused by essentially random shocks.

As investors, you and I know that those sojourns are very painful and can last for a long time—the dot com crisis, the 2008 subprime debt crisis, and the Covid pandemic come to mind. Financial crises like these, and their aftermath, are when investors make or lose all of the real money in a given decade. If you get those right, you can take the rest of the time off.

I think of financial crises as cascading network failures of Hayek’s beautiful and efficient information network. Cascading network failures happen when people suddenly lose faith that market prices tell them all they need to know to make good decisions. I think of the collapse of an economy into credit crisis as a phase transition from Hayek’s general equilibrium state into a clumsy alternative state (we can call it Non-Price-Rationing) where markets are temporarily broken and credit is temporarily not available at posted prices. (If you want the technical details, you can see my earlier piece on financial crises as cascading network failures here. “How to Understand Economic and Financial Crises Using the Tools from Far-From-Equilibrium Physics.”)

Financial crises are not rare—developed economies are either in, or crawling out of, credit crises about a third of the time. But somehow people are always surprised when they happen.

Once a system finds itself in this ugly alternative state of non-price rationing, it can remain there for quite some time. Eventually, people’s trust in prices and in each other slowly returns, the network regrows, and the economy goes through a long, slow second phase transition back to full-employment general equilibrium. This is the period when investors make extraordinary returns by buying underperforming assets cheap and riding their improving performance and improving valuations back to general equilibrium levels. You can read more about applying this analysis to the 2008 subprime mortgage crisis by clicking here.

But there is a catch. An investor can only do this by holding plenty of cash when the first phase transition, the crash, happens. That’s hard to do when your belly is telling you to buy things because everyone around you is making money.

We almost got a credit crisis in March 2000 when the Treasury market briefly failed to clear but the Fed quickly turned on the fire hose with another round of Quantitative Easing and the Treasury filled our bank accounts with helicopter money. Asset prices quickly inflated and we produced another round of magical investments—SPACs, cryptocurrencies, NFTs, and their associated temporary geniuses.

But magic doesn’t last forever. There are signs now that financial markets are short-circuiting again now that the Fed’s firehouse has been replaced by the giant sucking sound of Quantitative Tightening and the Treasury’s helicopter has been grounded. The bear market in stock and bond prices since January is one obvious sign. Another was last March, when the LME nickel market seized up the bosses made time flow backwards with the shocking decision to reverse transactions that had already been made for the benefit of China’s Tsingshan Holding Group, and certain shareholders. The October failure if the GILT market to clear following a budget announcement and the BOE’s subsequent flip in a New York Minute from QT to QE was another. (NB: A New York Minute is the elapsed time between the traffic light in front of you turning green and the taxi behind you blowing his horn.) The FTX vaporization was another. Micro-spikes, like the false surge in China and Hong Kong stock prices and the sudden drop in the stock prices of Eli Lilley (LLY) and Lockheed (LMT), all triggered by false anonymous social media posts serve as warnings that networks are in a very fragile state.

The Real Long COVID

I think of the damage to our financial, political, and social networks as the real Long COVID. I’m not talking about the months of fatigue, brain fog or other physical symptoms reported by one in four COVID patients after the virus is gone. I mean the systemic damage to our people, our society and our institutions from 3 years of fear in a global pandemic. There have been many plagues and pandemics in history and many things written about their lasting impact on people’s behavior. Thucydides, Boccaccio, Camus and others suggest that plagues are followed by prolonged periods of lawlessness and violence as frightened people separate into tribes and look for others to blame for their pain. You can read a review of the literature on pandemics and their aftermath by clicking here.

Pandemics have lasting effects on our behavior. Eric Kandel won the 2000 Nobel Prize in Physiology for his research showing the impact of prolonged exposure to fear, pain, and other pathogens on brain cells. Based upon his research, prolonged exposure to negative stimuli can triple the number of synapses that connect nerve cells, creating a state of hyper-sensitivity. Interestingly, he found that removal of the stimuli did not return the number of synapses to original levels, i.e., the nerve cells remained permanently hyper-sensitive.

Kandel’s work explains why every decision my parents made during their lifetimes was colored by their experiences living through the Great Depression and World War II. And it may explain certain puzzles about people’s post-COVID behavior as well, including the surprisingly low labor force participation of young people and the reluctance of people to return to the office.

I think Long COVID is going to be with us for many years. People are scared and mistrustful. Frightened people travel in herds and make mistakes. The geopolitical factors that our Dubai session was created to discuss—US/China, Taiwan, Russia/Ukraine, North Korea, energy supplies, Zero-COVID, reduced credit availability, and a Fed that can’t get out of its own way—provide many opportunities for mistakes.

So, what’s an investor to do? Get your brain to do what your belly does not want to do. Hold more cash when the economy is roaring and trailing returns are high. And structure your non-cash investments to be more defensive. Today, that means:

• keep fixed-income durations extremely short. With short-term rates at or above 4%, I see no reason to own anything longer than a three-month Treasury bill.
• keep equity durations short too. That means owning companies with strong front-loaded cash flow and avoiding those with back-loaded projections.
• own companies making profits today, not unprofitable companies projected to make profits in future.
• Own companies with proven histories; avoid startups and venture investments for now.
• Own companies that pay dividends and return cash to shareholders by buying back their own stock.
• Finally, keep significant capital invested in defense companies. The schism between the US and China is real. The Russian invasion of Ukraine has severely depleted inventories of missiles and other weapons systems. Inventories will have to be rebuilt to show strength to China and protect Taiwan. That means we can expect many years of extraordinary increases in revenues for the small number of companies like Lockheed, Northrop, Raytheon, General Dynamics, and Rheinmetall that produce those weapons.

Dr. John

The views and opinions expressed in this article are those of Dr. John Rutledge. Assumptions made in the analysis are not reflective of the position of any entity other than Dr. Rutledge’s. The information contained in this document does not constitute a solicitation, offer or recommendation to purchase or sell any particular security or investment product, or to engage in any particular strategy or in any transaction. You should not rely on any information contained herein in making a decision with respect to an investment. You should not construe the contents of this document as legal, business or tax advice and should consult with your own attorney, business advisor and tax advisor as to the legal, business, tax and related matters related hereto.