Very short stories

ANNOUNCER:

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MICHAEL CEMBALEST: 

Good morning everybody.  This is the mid-February Eye on the Market Podcast.  A lot of topics I wanted to cover briefly this week, all in the form of little short stories.  The global economic rebound is in full swing right now.  If you look at shipping demand and petroleum consumption and manufacturing and capital spending, they're all rising pretty sharply.  Earnings in the fourth quarter actually were higher for the S&P than last year which is not something a lot of people were forecasting a few months ago.  And that's despite negative earnings for energy, airlines, hotels and restaurants. 

As vaccinations rise, we should have some more good economic news to come.  What could rock the boat here? The two top ones for me are a bond market revolt and some vaccines unresponsive to COVID variants.  Those are my two guesses.  So we cover those, too, and other topics in the short stories. 

Let me start with COVID.  Infections are plummeting really rapidly in the US and Europe.  And it's kind of remarkable because at the same time that's happening this B-117 U.K.  Variant which is more contagious and perhaps more deadly has been spreading.  It's now responsible for about 90% of infections in the UK, 20% in Denmark, only 6% in the US but some of our virus science contacts expect it to be the dominant strain in the US by March and the primary strain outstanding in May.

But in spite of this rising variant, infections have been plummeting.  So how can this be explained?  Well it's not easy.  And I don't think anybody has all the answers.  Vaccination rates in the US are only around 5% when infections started tumbling in mid-January so while some of the super spreaders were immunized, I don't think you can explain a 70% collapse in infections with 5% vaccinations.

The rise and fall in infections maybe was also driven in part by the rise and then fall in air and vehicle travel around the holidays but the increases were kind of small and we illustrate them.  There has also been a little bit of a decline in reported testing but all things considered these three factors don't explain the 70% collapse in infections.

My science advisory group can't really explain this either.  And that's okay.  I prefer that to people that spew all sorts of theories that they can't substantiate.  With infections down 70% from peak levels and vaccination is rising, like a lot of other people I expect hospitalization and mortality to continue to improve as well.  Hospitalizations are down half from peak levels and mortality is down around 15% from peak levels. 

The good news is that the approved and pending vaccines look like they provide almost the same efficacy versus this UK B-117 strain as they do against the older incumbent strain.  The news isn't as good versus the South Africa strain which is now around 5% of all infections in Europe so part of this drama still has to play out in terms of how these infections spread.  I think epidemiologically the more successful a mutation is at infecting people the more it's going to infect people.  So if you look at Section 3 on our web portal we have a giant table that shows all the different vaccines against the different strains.

But the bottom line is really two things here.  Number one: all of the usual suspects don't really explain the magnitude of the infection decline, you know, but that's okay.  And the second thing is it's premature to declare mission accomplished with some of these new strains still spreading around.

In terms of Europe I saw some mission accomplished type commentary within JPMorgan and also outside it on the declines in infections and mortality in the UK and Denmark.  Everyone's entitled to their opinion but for anybody to write that and not mention the fact that infections and mortality are down there because of much more stringent lockdown provisions, that's not something I would take very seriously. 

So the real test for Europe is whether it can sustain a decline in infections when lockdowns get lifted.  It's going to be very hard to keep lockdowns in place until all the variants -- until vaccinations rise to very high levels.  When European vaccination rates are mostly outside the UK, only 5% of the population.  So it's good to see the collapse in these infections but in Europe there's even more reason to doubt their durability because of the rise in these lockdown provisions and reductions in mobility.

One last thing on COVID.  A client sent me a report on the risk of facial paralysis and other side effects from COVID vaccines which does happen.  There's a German federal government agency that shows a .02% probability of that happening.  The studies I've seen on the risks of getting COVID and being one of those people who is affected months later by vascular, pulmonary and neurological problems is much higher than .02%.  So as soon as I'm eligible I plan to get the vaccine. 

The next big and important topic this week is the stimulus bill, inflation, bond yields.  So Larry Summers wrote a piece on February 4th in the Washington Post that basically said the labor market is healing rapidly, there's a lot of pent up savings that are going to get deployed as soon as we reach herd immunity and another mega-stimulus bill tacked onto the largest deficits in the post-war era could reignite inflation.  The Fed's not prepared for that.  The bond markets aren't prepared for that.  Inflation has been left for dead and the markets are pricing in the Fed on hold for several years.

Now the Fed Chair says he's going to have tolerance for a temporarily period of above trend inflation.  He thinks that some of the stimulus programs will shrink.  Some economists don't believe that the amount of spare capacity is properly measured.  They think there's even more spare capacity than the typical measures you get from the Congressional Budget Office.  And if so, you don't have to worry about inflation.

I think it's pretty tough to estimate wonky things like output gaps and fiscal multipliers given the unprecedented kind of stimulus programs that are going on today.  And so I think Larry is probably onto something here.  I don't think it happens immediately but I do think the Fed's going to face some very difficult decisions well before the midterm elections.

Look, bond yields have already doubled from very low levels from about 60 basis points on the 10-year to 1.2%.  And with markets pricing in the Fed doing nothing, if you do get some normal levels of inflation, not even above -- way about trend but let's say 2.5 or 2.75% wage and price inflation, you know that's going to be an issue.  And if we get to 3.5% on 10-year Treasuries very quickly I think that could be a journey that involves some pretty substantial equity and credit market corrections.

So I think there are reasons to be a little careful here and watch how this plays out and how big this stimulus bill is going to be.  So we've got some charts in here that show you output gaps and how to measure spare capacity and what stimulus bills might do and when herd immunity might kick in and how pent up spending might be unleashed.  So I think Larry's more right than wrong on this one.  And I think there's too much -- there is too much calm and quiescence about some of these inflation risks.

Another short story this week is on the SPACs.  We did a really deep dive on this last week and I'm not going to revisit that.  I just wanted to provide some additional color on something.  The SPAC sponsors themselves, the people that create them, can make a lot of money here since they typically receive around 25% of all the SPAC IPO shares which typically is a lot of money compared to their upfront expenses which are $2-3 million of upfront structuring costs and underwriting fees on the SPAC itself.

So the thing I wanted to follow up on was there are a headful of SPACs that do a better deal, a better job, aligning the sponsor interests with the interest of the long-term buy and hold investors.  While many of the SPACs involve some kind of sponsor risk sharing, only a handful apply long-term vesting schedules that don't release the sponsored shares unless certain price targets are met, 1, 2, 3, 4 years later.  And this week we show some charts, kind of amazing, showing how buy and hold investors can lose a lot of money when sponsors don't lose any money and how buy and hold investors can be flat and sponsors are earning extremely large returns.

So these multi-year investing schedules for sponsors would solve part of this problem.  They're only present in a small minority of the 300 or so SPACs that are still looking to find a company to bring public.  But I think it's a sign of where the SPAC market will end up in a couple of years after people look back on the results of this latest wave.

Another little short story here is on the Texas power outage.  Just be careful.  Don't take the bait and blame the frozen wind turbines.  Yes, some of them are frozen.  But wind power was only expected to provide around 6 gigawatts of power to Texas in wintertime.  The peak energy demand during the storm was 67 gigawatts and 30 gigawatts of thermal power was off line.  And thermal power essentially is a term that refers to -- typically refers to coal and natural gas.  And in the case of Texas most of the 30 gigawatts of power that were offline were natural gas plants. 

Why did this happen?  Well Texas has a lot less natural gas storage than other states.  They usually rely on Just in Time production from the Permian Basin to meet demand.  Texans and then the storm hits, Texas production of natural gas fell in half from normal levels on Monday because the gathering lines were frozen and the pumps to pump out the natural gas rely on electricity and the electric pumps failed.

You can winterize natural gas production and natural gas electricity generation facilities.  There are plants in Northern Canada that are not far from Nunavik that operate in average temperatures that are below zero every single winter.  The Texas ERCOT system hasn't made all those investments yet which is where the policy discussion will probably go from here.

On another energy topic, I did want to mention there's a lot of expectations on the Biden Administration to accelerate the renewable energy transition.  But there's a couple of things happening that will indicate how hard this is going to be to do. 

So take Hydro Quebec.  It want to sell hydro power from its existing facilities to the US because they've got extra.  A state like New York can strike its own deal.  They share a border with Canada.  And New York is planning a fairly large transmission line buried under Lake Champlain to bring hydro power to New York City. 

But the whole renewable energy transition is going to be delayed if the only time projects can really get done easily is when states control the whole transmission network.  And that's what killed Norther Pass which was a transmission line to bring hydro power from Quebec to the Northeast through New Hampshire, mostly through right of ways or underground.  But New Hampshire killed it. 

And just to think about what that means: Canadian hydro power displaces natural gas and the IPC estimates that hydro power emissions over the entire lifetime of the construction and operation are 5% of natural gas lifetime emissions.  So there's clear climate benefits from this.  And Northern Pass could have reduced Northeastern emissions by 3 million metric tons of CO2 a year. 

But tiny New Hampshire, primarily due to concerns about tourism and property values, killed it, which we wrote here gives new meaning to the New Hampshire State Motto: Live free or die.  Because while they're benefiting from hydro power and nuclear in their own state, they're impeding greater emissions-free generation in neighboring states.  

And you know Massachusetts is trying again now after years and lots of money spent on Northern Pass failing.  They're trying again.  This time through Maine and they've run into another injunction based on local opposition.

And do you know the MIT published a report last year saying that the ideal solution is four gigawatts of new two-way transmission lines between New England and Quebec.  That's essentially four Northern Pass projects.  Good luck with that.

So I think part of what will be interesting to see is whether the Biden Administration uses eminent domain which is a power of the Federal government to try to get these states to cooperate with each other and maybe compensate each other better to provide the incentives.  Because if the only way these cross-border projects are going to happen -- I'm sorry.  If the only way these projects are going to happen is when states control the entire transmission network themselves, this energy transition is going to take a very, very long time.

The last short story this week, and I know I'm running long, but I hope you are still finding this interesting, the last little short story this week is on this not so civil war that’s brewing within the Republican Party.  Some Trump supporters have taken steps to launch a new Patriot Party and at the same time over 100 former GOP officials and Bush and Reagan Administration appointees met to discuss the creation of their own new center right party.  In other words people on both sides within the Republican Party appear to want a divorce.

The polls show that Americans say they're prepared for a third party but political splintering is a really big gamble.  And the more likely outcome are intense primary battles within the GOP that determines the future of the party.

When is the last time that a splintering was successful in terms of generating a new party that had national relevance?  It was in the 1850's.  There was a party called the Whigs.  There were big disputes within the party about slavery.  The Northern antislavery Whigs joined with smaller parties and disgruntled Democrats to form what's known today as the Republican Party. 

And then some of the pro-slavery Southern Whigs joined the Democratic Party.  And then the Whig Party collapsed.  And we have an interesting chart in here that shows the percentage of Congressional members by party in the 1800's so you can see how this all evolved by election year.

So the question is is the successful creation of the Republican Party in the 1850's a template for either the Trump or anti-Trump faction within the GOP today I don't think so.  It took an enormous galvanizing force which was opposition to slavery to create this new party because it attracted the Whigs, it attracted some of the minority parties at the time, and it also attracted large defections from the Democratic Party that existed at the time.

Today a center, a new center right party, from anti-Trumpers might attract some centrist Democrats that are uncomfortable with the progressive wing of the Democratic Party but unless those defections are massive, this party probably wouldn't have a lot of national relevance because it would end up splitting the GOP vote. 

Think about Teddy Roosevelt.  He left the GOP.  He was president and then became a private citizen again, was unhappy with President Taft and left the GOP to form the Progressive Party.  And ended up splitting the GOP vote almost right down the middle in 1912 with incumbent President Taft and that's how Woodrow Wilson, a Democrat, became president despite winning only 40% of the popular vote. 

So this Trump/McConnell dispute is probably unprecedented, right, in terms of how raucous and vicious you’ve got this back and forth between an ex-president and the former Senate Majority Leader of his own party.  And there's a couple of historical parallels in the 20th Century where stuff like this happened but at the end of the day in the past the fences were mended and third party movements weren't launched.

I think this time I don't think the fences will be mended but I think the third parties are just as unlikely.  The censure votes of Republicans that supported impeachment suggests that the primary challenges are coming from the Trump wing of the party and that's what's going to determine the party's future rather than people leaving to form third parties within either faction. 

So thank you very much for listening and stay safe and I look forward to talking to you all again soon.

ANNOUNCER:

Michael Cembalest, Eye on the Market offers a unique perspective on the economy, current events, markets, and investment portfolios and is a production of JPMorgan Asset and Wealth Management.  Michael Cembalest is the Chairman of Market and Investment Strategy for JPMorgan Asset Management and is one of our most renowned and provocative speakers.  For more information please subscribe to the Eye on the Market by contacting your JPMorgan representative.  If you'd like to hear more, please explore episodes on iTunes or on our website.  This podcast is intended for informational purposes only and is a communication on behalf of JPMorgan Institutional Investments, Incorporated.  Views may not be suitable for all investors and are not intended as personal investment advice or as solicitation or recommendation.  Outlooks and past performance are never guarantees of future results.  This is not investment research.  

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