The summer doldrums

A few days sailing around the Balearic Islands are the reason for the lull in our correspondence. We have culminated our tour anchoring in the idyllically quiet Pi de la Posada cove on the north shore of the Pollensa Bay. This is a small enclave with just thirty-eight homes and the Hotel Formentor, currently under renovation like every other hotel in Spain. Howard Marks and Carolina Herrera are the two most famous local summer residents here. As we seat in the saloon below deck we get occasional glimpses of Mr Marks’s house perched on the side of the mountain as this near centenary boat gently rolls. Even in this earthly paradise, we cannot avoid our mind from wandering on the back to school problems facing investors. These include the waning pace of the global economy’s recovery, record inflation prints, the end of direct transfers to families, the end of forbearance for bank loans or rental payments, new progressive policies, a Big Bang of government overreach and encroachment in most OCDE countries and beyond, income redistribution targets, and, last but not least important, new corporate governance targets that we fear will prove uneconomic. 

While the Balearic Islands will retain their charm for many visitors, we fear that those who exposed themselves to the shoddy service and price gouging that the local tourism industry have implemented in order to recover from their worst crisis ever may not come back for a while, if at all. In the very popular island of Fomentera, the Es Moli de Sal restaurant has been delivering paellas to anchored boats for decades. Nowadays, they only deliver lobster paella, or other expensive shellfish versions. This sets a floor price per person of $85. This is just for the rice, mind you, inedible bread and mediocre aioli are an extra $6 per person. At least they picked up the phone. Most restaurants in Ibiza and Formentera seem to leave their phones off the hook from May onwards. This is going on even as the number of visitors is still well below 2019, but capacity restrictions, which may or may not be effective in curbing contagions in open air restaurants, have allowed for prices to remain as high as they were before the pandemic or in some cases go higher.

Because there are many fewer visitors, there are also many fewer seasonal workers in the hospitality industry, including taxi drivers. Getting a taxi is not easy anywhere in these islands, but should you land on Menorca you are in for a shock. The local taxi drivers have set up a phone reservation system, which in 2021 does not work as an app, mind you, but as an actual voice call service. Potential taxi customers are charged €3 per minute to wait for endlessly for an operator so that they may be informed that no cabs are available currently. These charges are illegal in the rest of Spain, but apparently, the Law does not apply to this once British, and later French, island. The regional Government further protects the drivers’ livelihood by not allowing either Uber or Cabify, its domestic copycat, to operate in this touristic region. Even everyday supermarket items are more expensive here than in Madrid in spite of generous subsidies for shipping cots. The final insult came as a wanton 10% surcharge for diesel fuel at the marina in Alcudia, where we returned the boat, compared to the Palma marina 45 minutes away by car.

Some of you may interpret this ranting, as an insensitive tirade from a privileged white male, and you would not be very wrong. Alternatively, these complaints may also be interpreted as an observation on why the rate of inflation we are suffering is much higher than the headline figure indicates. In normal times, the CPI is adjusted downwards to factor-in quality improvements. We do not believe that in these unusual times, statistics offices are adjusting inflation upwards to account for the sharp deterioration in the quality of services. Additionally, in normal times CPI may overstate inflation by not using substitute products. We wonder whether CPI understates inflation because of the dearth of alternative products. In other words, when you cannot replace your car’s shock absorbers because of supply chain bottlenecks, inflation may not be impacted directly, as no sale takes place, but the quality of the garage’s services has diminished significantly because they could not fix your problem. The quality and safety of your ride has also decreased. This loss is not accounted for in any of the national statistics either.

An increasingly large number of market participants are begrudgingly coming to accept that the rate of GDP growth is slowing down. Some believe that this is good news for inflation. We beg to disagree. The external shock caused by the pandemic has led to large fiscal deficits that central banks are monetizing. This will eventually lead to some inflation. There are at least two difference between the financial crisis’s monetary expansion and the Pandemic’s. First, current fiscal deficits are a combination of lower revenues and rising expenditures, and not just lower revenues as in the GFC. Secondly, unlike the quick about face towards fiscal orthodoxy in 2010, very few governments today seem inclined to reverse course for now. Let us not forget that the austerity drives from 2010 onwards led to the rise of new successful political parties and candidates that eroded the power base of traditional politicians around the globe. These mainstream politicians have recovered lost ground everywhere with great pain and effort. We doubt they are about to squander their recent gains easily. History shows that there can be high inflation and low growth, especially when the Government sector gets heavily involved in markets, as is the case today.

The Pandemic, China’s recent crackdown on its “surveillance capitalism” former national champions, runaway government spending, higher than expected inflation prints, supply chain bottlenecks, and the “jobless recovery” in many countries; all seem like a world away from our perch, especially as markets, except for China’s notable exception, seem to rake-in gains most weeks no matter what. The neo-liberal period that started in Europe in the 1970s is over. The era of independent central banks, smaller and less intrusive government, deregulation, trust in unfettered capitalism, and running corporations with the sole target of maximizing shareholder’s value is most definitely over. We believe that securities prices are not reflecting these adverse changes. 

Most politicians, many among the public, and even some CEOs have embraced this new world vision. Unfortunately, there is nothing new in this new paradigm and the results are likely to be as disappointing as were previous attempts at centralized economic policy planning and socialism. As was the case in the post WWII period, central banks in most OCDE countries are exacting a tax on savers to pay for their Government’s profligacy. Financial repression will advance beyond government securities and rates markets, where investors have not been able to find positive inflation adjusted returns for years, to engulf all asset classes. 

Higher taxes on investment income are becoming more popular. Certainly, there is no particular reason why earned income should be taxed at a higher rate than investment income. Of course, there is the argument that shareholders have already paid corporate income tax. Notwithstanding the fact that the effective tax rate is well below the statutory tax rate for most corporations, this argument is specious because corporations may deduct many expenses that individuals may not. These items include depreciation and interest expense. Rather than advocating a minimum global corporate tax rate, the G7 should target a minimum tax on EBITDA or alternatively no tax at all and increase the tax on investment income. The latter is a far more progressive policy. 

In the interim, the working classes of developed economies will continue to suffer the brunt of these policies. Inflation is an insidious and regressive tax. Wages may continue to rise below the cost of education, healthcare or housing, if they rise at all. Politicians will not listen to the siren songs of economic orthodoxy for as long as they can help it. When something is too good to be true, it generally is, and we fear that Modern Monetary Policy is too good to be true. 

The EU is possibly the worst positioned of all three large economies today with China a close second. First of all, unlike the US or China it is neither a federal republic nor a nation state. Secondly, the ageing of the population is a large drag on growth. Thirdly, there is a dearth of entrepreneurship, which is compounded by the fragmentation of capital markets. In spite of these shortcomings, financial gurus continue to recommend investing in EU stocks as the most obvious beneficiaries of a cyclical recovery. Additionally, Chinese officials are doing their utmost to undermine investor confidence in some of the leading companies based in China while some very large domestic companies such as China Evergrande or Huarong are in the brink of reorganization with tens of billions of USD bonds. All things considered, and perhaps only because of a process of elimination, the US remains the most attractive market of the three. Emerging Markets gave regained popularity recently as they typically do in a cyclical recovery; in our moderately well informed opinion, these windows are trading opportunities more so than a new long-term investment universe. We shall soon see in any case.