Economy & Markets
Your Fall 2021 syllabus
Greetings. We look forward to seeing you back on campus, although you will not be allowed to gather in groups larger than five, which we expect to reduce COVID transmission and cut down on excessive alcohol consumption and related misbehavior1. Since 85% of you experienced declining grades during online learning last year2, we’ve doubled up your coursework and will require you to take eight classes this semester. Your Fall 2021 syllabus appears below. Update: Biology BI66 “The Origins of COVID” scheduled to be taught by Professor Peter Daszak has been cancelled until further notice. No additional information is available at this time.
[1] Addictive Behaviors AN103 (Anatomy): The Prefrontal Cortex and External Stimuli
Students will explore the addictive consequences of Fed liquidity on the stock market now that the Fed is about to slow its asset purchases, and as the share of US equities more sensitive to liquidity conditions than to economic growth keeps rising. Background reading includes data on Treasury demand from foreign central banks that own 30% of the Treasury market, as well as Treasury demand from banks, pension funds and insurance companies for regulatory and liability management reasons; these demand sources may mitigate the impact of reduced Fed purchases on long term interest rates.
Bar chart shows primary dealer expectations for monthly Fed purchases, shown in billions of dollars. Bars represent the median primary dealer response. Fed purchases were $120 billion in Q2 2021, and are expected to be $120 billion in Q3 and Q4 2021. Purchases are expected to decline to ~$95 billion in Q1 2022, ~$55 billion in Q2 2022, and ~$25 billion in Q3 2022. No purchases are expected from Q4 2022 onwards.
Line chart shows US equity market sensitivities since 1970, shown as the share of US equities. Line chart shows that over 50% of US equities were highly sensitive to economic growth from 1970, but the share began declining in the early 2000s to its most recent level of just under 40%. The chart also shows the share of US equities highly sensitive to liquidity, which steadily increased from around 5% in 1970 to 15% in the late 1990s, then spiked to 45% in 2000 but declined to 20% by the early 2000s. Since 2010, the share of US equities highly sensitive to liquidity has risen steadily from its 2010 level of 10% to its most recent level of around 35%.
[2] Mechanical Engineering ME89 (Engineering): Dynamics of coiled springs
Students will review Hooke’s Law3 and its application to US growth, spending, inventories and inflation. Some leading indicators have weakened recently, a reflection of intense supply chain issues which include a temporary but pronounced semiconductor shortage4. However, look at the big picture: rising wages, government transfers and pandemic issues have boosted pent-up consumer spending, and there’s unprecedented pent-up demand when looking at the gap between low inventory growth and high sales growth. Both of these coiled springs will eventually spring back. So will housing, which is now constrained by soaring prices and the tightest supply conditions since 1990 (2-3 months). There’s consumer resistance to higher prices for durables, cars and homes, but ammunition for healthy US consumer spending is firmly in place particularly given improved household balance sheets. As drags from supply constraints and the Delta variant eventually fade, US and global growth should be supported by reopening dynamics, inventory restocking and a lot more capital spending.
While these dynamics all point to higher GDP growth as production rises to meet demand, it’s also hard to see how inventory vs sales gaps can be closed without higher prices as well. Many companies agree, as indicated by the all-time high 45% of small business respondents planning to increase prices.
Line chart shows excess spending potential, shown in trillions of dollars as the rolling 4-quarter spending potential in excess of consumption. Chart shows that excess spending potential was at or below $0 from 1972 until around 2017, at which point it increased to $0.5 trillion by the end of 2019. In 2020, excess spending potential spiked to over $2 trillion in 2020 and then $3 trillion by Q1 2021. Excess spending potential is estimated to decline to ~$2.3 trillion in Q2 2021.
Line chart shows global manufacturing delivery times since 1998. COVID related supply chain issues have caused the longest manufacturing lead times on record.
Line chart which shows the year over year percent change in real final sales and real private inventories. The chart shows that since 1960, inventory changes have typically tracked demand on a slight lag. However, there is now an unprecedented gap between inventory levels and final sales growth.
Line chart shows the net % of small business survey respondents raising prices and the global 12-month forward consensus capex forecast, shown as the y/y % change. Chart shows that the net % of small businesses raising prices has sharply increased from -20% in 2020 to its most recent value of nearly 50%. Chart shows that the y/y % change in consensus capex forecasts have recently spiked from around -8% in 2020 to 8% at its most recent point, which is close to all its all-time highs of ~10% in the early 2000s.
[3] Military Strategy HS233 (History): The Art of War
Students will learn how tech and communication services companies conquered US equity markets. Readings include David Autor’s “The Fall of the Labor Share and the Rise of Superstar Firms” (MIT, 2019). Implications for investors include the superior risk-reward characteristics of growth equity and venture capital investments focused on software and other high-margin businesses with low labor intensity.
Industry concentration is at an all-time high and is attracting antitrust attention. But the tech/communications services opportunity set is much bigger than the 5 megacap firms: secular growth tech stocks we discussed in our 2021 Outlook are performing in line with the megacap stocks this year, and carry a lot less antitrust baggage. As long as wages are the largest component of overall business expenses (last chart), the corporate sector will look to tech companies to help reduce their unit labor costs and improve productivity. In other words, we expect strong demand for technology goods and services to continue, and do not expect any mean reversion in sector profit margins.
Line chart shows contribution of top firms to overall US market cap. Chart shows that the top 20 firms contribution to overall US market cap has increased from just over 25% in 1990 to a current level of over 40%. The top 5 firms (Apple, Microsoft, Amazon, Alphabet, Facebook) have grown from just over 10% of overall US market cap to 25% as of August 2021.
Line chart shows that tech has been the primary driver for US margin expansion. The chart shows the trailing 12-month average operating margin for S&P 500 companies for information technology, communication services and consumer discretionary, consumer staples, health care and industrials. The operating margin for information technology has risen from around 2% in 2003 to its latest value of around 22%. The average operating margin for consumer discretionary, consumer staples, health care and industrials has remained relatively constant at around 10% but has recently declined to around 8%. The latest operating margin for communication services is around 17%.
Bar chart shows the revenues of the largest 15 companies as a % of US GDP in 1969, 2000 and 2021. The chart shows that the consolidation of tech/telecom/ecommerce companies has surpassed the 1969 industrial peak.
Line chart which shows various business expenses as percent of gross output. The chart includes employee compensation, purchased services, materials, taxes and energy. Wages have been the largest component of business expenses since 1990 and are currently 27% of gross output.
[4] Chinese History CH04 (History): The Creation of a More Just Society
Students will review The Great Leap Forward and The Cultural Revolution as prior examples of Chinese leaders imposing sacrifices in the pursuit of societal goals. Many Chinese stocks have been clobbered after new rules and critical gov’t commentary on the internet5, e-commerce, for-profit tutoring, data sharing, overseas equity listings, cryptocurrency, online finance, real estate, labor practices, anti-trust and competition, drug prices, food product disclosure and corrosive Western decadence such as celebrity-watching, social media and gaming.
Since the Chinese government described online gaming as “spiritual opium”, students will also revisit materials on the Opium Wars of the 1840’s and its consequences: a proliferation of drug addicts and opium dens, a surge in corruption and other criminal behavior, a breakdown in public morality and an exodus of silver shipped abroad by addicts. Around 25% of China’s adult males were addicted to opium, a level of mass addiction not equaled by any nation before or since6. From 1820 to 1870, China’s share of global output fell in half, from 33% to 14%.
For long term investors with patience, there are some attractive opportunities here, but selectivity is key. Despite the large selloff in Chinese equities, the valuation gap vs the US shown in the last 2 charts is not as large since China traded at higher multiples before the crackdown began. We use enterprise value to projected free cash flow to minimize the impact of regional accounting differences and to capture the impact of new rules on future company profits, even though it is probably too early to expect analysts to fully adjust their forecasts.
Bar chart which shows the total return for China equity indices since the February 8th regulatory crackdown. Most equity indices have negative total returns. Hang Seng Tech, the 5 largest China tech stocks, FTSE China Tech and China ADR have fallen 30% or more.
Line chart which shows opium chests imported into China and silver outflows to England and India from 1818 to 1858.
Line chart shows enterprise value to 2021 EBITDA for FTSE China Tech, MSCI China Info Tech and S&P 500 Info Tech. Despite the selloff in Chinese equities, China and US tech valuations are still similar.
Bar chart shows enterprise value to 2021 EBITDA for US and China megacap companies. US companies include Visa, Microsoft, Amazon, Apple, Google and Facebook. China companies include Pinduoduo, Meituan, JD.com, Tencent, Xiamoi, Alibaba and Baidu.
[5] Progressivism in Film FA08 (Arts): Raiding the Temple Granaries
Students will re-enact one of the most progressive scenes in film history: when Moses raids the temple granaries in Cecil B DeMille’s Ten Commandments. The class will then pivot to the current Administration’s progressive plans to raise corporate taxes to pay for infrastructure and other initiatives (clean energy and EV subsidies, child care, family leave, pre-K education and Obamacare premium expansion). At the time this syllabus was prepared, Democrats had not reconciled their competing visions. The most likely scenario is an infrastructure bill with ~$1 trillion in new spending and a reconciliation bill with ~$2 trillion in new spending.
Students will review the base case scenario for corporate taxes: 25% corporate tax rate (up from 21%); an increase in the effective tax rate applied to low tax jurisdictions from 13% to 18%-19% (GILTI tax); a minimum book tax of 15% on large US companies that is unlikely to have much bite given prevailing effective tax rates (see second chart); and partial commingling of foreign tax credits. The bottom line is a modest 5% hit to 2022 S&P earnings per share, with slightly higher tax hikes for tech, healthcare and communication services. While the tax impact on S&P earnings appears modest, students will review the overall cost of the two bills (including tax increases on individuals and pass-through entities), which is large compared to tax bills in the post-war era; see third chart “infrastructure + negotiated reconciliation bill” and fourth chart on marginal effective corporate tax rates across countries, and the impact of the proposed bills.
Note from the Dean: we cannot guarantee film majors anything resembling a viable financial future; you will have to hit the jackpot. One example: recent film graduates of Columbia University who took out student loans had median debt of $181,000, and two years after earning master’s degrees, half earned less than $30,000 a year. Recent Columbia film alumni had the highest debt compared with earnings among graduates of any major university master’s program [WSJ, “Hobbled for Life”, July 8, 2021].
Bar chart shows the potential S&P 500 EPS impact of Biden’s tax agenda. The changes to the statutory rate and minimum foreign & book tax rates would result in a modest 5% hit to 2022 EPS.
Bar chart which shows the distribution of effective tax rates by sector. The chart shows that most sectors effective tax rates are already above the proposed 15% minimum book tax.
Bar chart shows the revenue impact of major tax bills as % of GDP. The chart shows that Biden’s full agenda would have been the largest tax bill on record at more than 1.5% of GDP. However, the most likely outcome is now the infrastructure + negotiated reconciliation bill which is closer to 1% of GDP.
Bar chart shows the effective corporate tax rate on new investment for various countries and the changes in the effective corporate tax rate for the US. It shows that the tax rate in the US in 2016 was around 35% and then after the TCJA was passed the effective rate fell to 23%. If Biden’s infrastructure bill and the negotiated reconciliation bill become law, the marginal effective tax rate will rise to 30%.
[6] American Literature of the 1970’s AL400 (English): Fear of Flying
After discussing Erica Jong’s 1973 second-wave feminist novel Fear of Flying, students will analyze consumer reactions to the Delta variant, which so far also indicate a revived fear of flying7. Other social distancing categories such as bars, restaurants, lodging, parks and theaters are starting to decline as well, but not by nearly as much. As a result, the sharp decline in “COVID recovery” stocks shown in the third chart might represent an interesting opportunity as the Delta variant eventually fades and booster shots rise. While social distancing spending indicates that Americans are circulating and spending in large pre-pandemic numbers, they’re still demonstrating a pronounced aversion to office settings as shown in the last chart.
On aviation, challenges are not just a fear of flying but electronic means for companies to now avoid it. A Bloomberg survey showed 84% of companies expect to spend less on aviation, with budget declines of 20%-40%. While corporate customers normally only represent 12% of seats, they can represent as much as 75% of airline profits. Hotels could see revenue declines of 15%-20% as virtual meetings replace one quarter of corporate travel volumes (mostly internal non-client trips). A Conference Board survey cited reduced business travel as the most likely long term impact of the pandemic.
Line chart shows the change vs 2019 in airline spending from the start of COVID to now. Airline spending fully recovered to pre-COVID levels in June, but has since dropped back down to about -40% vs 2019 levels.
Line chart shows card present transactions for social distancing spending shown as the spending change vs 2019. Since its 2020 low of around -70% vs 2019, spending has steadily increased to around 10% vs 2019 at its most recent level. Social distancing spending includes retail, lodging, restaurants, parks, theaters, and other recreational services.
Line chart shows the COVID recovery vs S&P 500 shown as an index where 100 represents January 2021 levels. Chart shows the COVID domestic recovery is around 112, the COVID international recovery is at 100, and the US consumer recovery is around 95.
Line chart shows office utilization rates by metro area. Austin, Dallas and Houston have recovered to about 50% utilization, while other areas have remained at about 20-30%.
[7] Fundamentals of Organisms BIO50 (Biology): Natural Selection and its rare deviations
Students will review examples of natural selection (peppered moths, rat snakes, Galapagos finches, warrior ants) and rare examples of reverse natural selection, in which species adapt behaviors that are contrary to their own survival. Examples of the latter include COVID vaccine-resistant communities in the United States, where hospitalizations are rising sharply for unvaccinated people and for younger people as well. US hotspot mortality rates are now the highest in the world, alongside Malaysia and Iran, and are 10x higher than mortality rates in the rest of the developed world. Of US states, Florida now has the highest mortality rate, edging out Mississippi and Louisiana.
Line chart shows countries and US states with the 25 highest mortality rates. US hotspot mortality rates are now the highest in the world, alongside Malaysia and Iran, and are 10x higher than mortality rates in the rest of the developed world. Of US states, Florida now has the highest mortality rate, edging out Mississippi and Louisiana.
Line chart shows prior day COVID hospital admissions in US COVID hotspot states by 18-39 and 40-59 age groups. Prior day admissions for the 40-59 age group have risen to about 1,600, which is much higher than the previous peak of about 900 in January. Prior day admissions for the 18-39 age group have risen to about 800, which is also much higher than the small increase to almost 400 in January.
Line chart shows current hospitalization rates vs vaccination rates by US state. With the exception of Florida, lower vaccination rates appear to be related to higher hospitalization rates, and vice versa. Florida is an outlier with current hospitalizations at about 750 despite a vaccination rate of about 53%.
Scatter plot shows fully vaccinated people as a percentage of population vs the percentage of the population who voted for Trump, where each dot represents a US county. The dots illustrate that counties with more Trump voters tend to have lower vaccination rates.
[8] Poetry PY51 (English): Emily Dickinson and mortality
Students will analyze Dickinson’s famous poem “Because I could not stop for death”. For most vaccinated people, you won’t have to either, at least based on the latest vaccine efficacy data. While there is evidence of declining vaccine efficacy over time, such data has to be analyzed carefully to avoid an amalgamation paradox which can produce misleading results when applied to heterogeneous populations with “hidden” variables that explain results more accurately8. In the case of COVID, the hidden variable is age.
The most useful efficacy information comes from studies with data on specific age groups. As shown below, age-specific data from Israel and the UK show that efficacy vs hospitalization and severe infection remain high vs the Delta variant (85%-95%); results for total populations in these studies is misleading (red shaded values due to the paradox cited above). Even so, as with other vaccines, COVID appears to require a three shot regimen for maximum efficacy. I recommend getting a booster as soon as you are eligible: early evidence from Israel shows a 10-fold reduction in infection risk with a booster shot compared to a 2-shot regimen, and shows an increase in implied Pfizer efficacy against severe infection for people aged 60+ from 80% to 93%.
1 33% of US college students engaged in binge drinking in 2019 (5+ drinks in 2 hours for men). College binge drinking has declined since the early 1990’s, and is being substituted/accompanied by rising marijuana use.
Line chart shows college binge drinking and marijuana use since 1980. The chart shows that marijuana use has steadily increased from its early 1990s level of around 27% of college students to its most recent level of around 43%. Binge drinking has steadily declined from its 1990 level of around 43% to its most recent level of around 33%.
2 Inside Higher Ed, January 2021
3 Hooke’s Law: the force of a coiled spring being released is linearly proportional to the distance from its equilibrium length
4 The semiconductor shortage. Most chip shortages are related to older and simpler 200-mm silicon wafers used in cars, computers, monitors, laptops, TVs, refrigerators and washing machines. Demand for many of these items soared during the pandemic as people built out home offices and related projects. There’s limited economic incentive to build new 200-mm chip plants given wafer-thin margins; only a handful of new ones are planned for 2022. Even so, there’s a few billion dollars being invested to expand capacity by ~20% in existing plants, in which case the semiconductor squeeze should start to ease by Q2 2022. Auto manufacturers are also discussing longer term contracts with Tier 2 suppliers that might incent them to build out new 200-mm capacity. A by-product of the semiconductor shortage: Ford is offering customers faster delivery if they agree to “lower feature content”, which translates into fewer semiconductors.
5 Fang Xingdong (Director of the Center for Internet and Society at Zhejiang University) explains the motivation: the Chinese government needs to prevent internet platforms from “breaking the existing institutional framework and challenging the power and governance capacity of the state” [Source: Gavekal Research]
6 Alfred McCoy, University of Wisconsin-Madison Center for Southeast Asian Studies
7 I flew to Canada last week for 3-days of sturgeon fishing. Direct routes from NYC to Vancouver are gone, so you have to connect through Montreal or Toronto and plan for missed connections due to delays related to COVID document checking. My largest catch was a massive 9-foot Fraser River sturgeon near the town of Hope.
8 For more details, see our August 19, 2021 Eye on the Market “Spaccine Efficacy”
