Author: Autumn Lane Advisors

Executive Summary

• There is a cost to the monetary and fiscal stimulus that has propped up asset prices;
• Market imbalances will result in government intervention through regulation and rising taxes;
• Investment opportunities exist, but a more active approach is recommended.

2021 – The Year Ahead (and Beyond)

In the spring of 1907, the panic on Wall Street first appeared as market volatility increased. Economies of the world were more closely tied to one another than ever before and fear of a global financial contagion was realized. The resulting panic erased nearly 50% of the U.S. stock market’s value and led to intervention by key financial figures, new legislation, and eventually monetary management via a central bank.

The years following the Panic of 1907 included America reluctantly at war and a novel influenza pandemic. Even though the economy was strong, a technological revolution exacerbated the existing income divide even as it improved the lifestyles of many. The war, economy, large-scale unemployment, riots and a desire to make America less interventionist influenced the Presidential campaign with a call for a “return to normalcy.” As 1921 began, America looked forward to a new year.

George Santayana wrote, “Those who do not remember the past are condemned to repeat it.” The similarities of the Panic of 1907 to the Financial Crisis of 2008 are striking. Both were caused by the failure of a bank that led to the evaporation of liquidity and debt unwinding. It was the strong financial leadership by John Pierpont Morgan in 1907 and Hank Paulson in 2008 that arrested the economic fall. Both experiences led to more monetary tools for economic intervention.

The Flu of 1918 and COVID-19 are, of course, coincidences. Both are the result of continuous mutations that eventually produce something awful. These two pandemics occurred nearly 100 years apart (like the cheating scandals that tainted our national pastime – the Chicago Black Sox and the Astros’ Banging Trash Can). While it is a stretch to compare WWI with today’s Middle East and Afghanistan, the resulting desire by many for America to turn its gaze homeward and away from the world is a familiar sentiment.

Today we find ourselves amid a technological revolution. One hundred years ago, the automobile, electricity and the assembly line were changing and, for the most part, improving the lives of everyone. These technological leaps hurt some industries and forced many workers to change occupations, but the efficiency and lifestyle improvements they brought were incredible. Today, we find ourselves in a similar state of technological evolution. Cloud computing, social networking, video conferencing and AI are disrupting the way many people and businesses conduct themselves. And while they are improving efficiency and creating new opportunities, they are also adding to social anxiety. This anxiousness is showing up everywhere, from the boardroom to our family dinner tables.

Sitting at our desks we cannot help but wonder if these similarities continue. Does the next decade look like the roaring 1920’s? Does President Biden imitate President Harding, who stated:

“America’s present need is not heroics, but healing; not nostrums, but normalcy; not revolution, but restoration; not agitation, but adjustment; not surgery, but serenity; not the dramatic, but the dispassionate; not experiment, but equipoise; not submergence in internationality, but sustainment in triumphant nationality.”

More specifically though, does the economy of this decade develop the same time bomb as the economy of the 1920’s? What are the differences that hopefully result in something less depressing?

There are plenty of differences. The biggest is the standing of the United States on the world stage. Following WWI, our nation was just becoming a world power. Whereas today, the U.S. is a superpower, and our dollar has replaced gold as the world’s reserve currency.

A more nuanced difference is the possibility that today’s technological revolution permanently reduces the labor input required for economic activity. Whether it is the rapid adoption of videoconferencing as a substitute for business travel; contactless order and pay features replacing the need for checkout clerks; autonomous driving displacing taxi, truck and ride-sharing drivers; or Artificial Intelligence executing tasks from administrative to reading x-rays, the common thread is less future demand for human labor. This has severely affected the service sector. The big question now is where do these displaced employees land? It is easy to see how the saddleries of the 1900’s could evolve into the filling station of today and factory workers displaced by manufacturing improvements became the truck drivers delivering the mass-produced goods. Yet it is not as easy to see what will happen to the warehouse worker displaced by a robot, the kid at McDonald’s replaced by a mobile device, and the administrative assistant replaced by Siri.

These unemployed or underemployed exacerbate the social unrest that already exists. How much longer can technology companies improve profits by leveraging a low wage workforce? Think about it, Uber is worth $110 billion, and its main means of profit is making sure it doesn’t have employees but rather low-cost contract labor. How America and other world governments will respond to this is not known. However, the populist ideas catching fire across the world provides us with a hint. Governments will try to break up many of these new efficient companies or create policies and regulation that decrease efficiency (i.e. Uber drivers will be employees and subject to a new minimum wage).

Finally, the stimulus that governments have thrown at their economies has been primarily captured by the investor class, and the economic divide between the have and have-nots has continued to widen. What is the most probable government solution to this? Just look back to 1932, when the highest marginal income tax rate jumped from 25% to 63% (on its way to 94% in 1944). It is going to be hard to avoid the redistribution of income and wealth via the tax code.

Another difference and likely justification for increasing tax rates is the total U.S. debt-to-GDP ratio. In 1929, the U.S. Government’s debt to GDP stood at 16%. As of June 30, 2020, the U.S. debt-to-GDP ratio stood at 136%. Old debt is like an anchor when it comes to growth. You must spend money on interest and paying off the old debt before investing in the future. Thus, the US and most developed economies all have a heavy yoke to bear.

What is our prediction for the future? A relatively strong U.S. economy supported by its reserve currency should provide a better path than that of the 1920’s. However, combine increasing regulation and rising tax rates with the potential for inflation caused by a permanent expansion of the money supply, and valuations must come down. So, while we are looking forward to seeing our friends and families, we must unfortunately face the result of a decade of monetary and fiscal stimulus. There is no way around it. When a system becomes unbalanced, something must change to set things right again.

The forced rebalancing will cause a continued increase in the variability of asset prices. This increasing volatility will provide sharp investors with ample opportunity for excess returns. Thus, we believe that shifting a portion of passive market exposure (indexing) to more active, opportunistic investing (public or private) is justified. For those who have known us a long time, what we are saying is contrary to what we have said in the past. But the situation has changed, and a rising tide is about to start receding.

It is very difficult, if not impossible, to time the market. Thus, our belief of keeping risk capital invested remains unchanged; underinvestment is itself a risk. The key is to navigate the upcoming volatility with a more diverse portfolio of uncorrelated investments and stable assets that can withstand the upcoming political and inflationary risks. All of us at Autumn Lane will continue to look for these opportunities.

DISCLOSURES
This information is provided, on a confidential basis, for informational purposes only and does not constitute an offer or solicitation to buy or sell an interest in Autumn Lane Partners, LP (the “Fund”) or any other security. It is intended solely for the named recipient, who, by accepting it, agrees to keep this information confidential. An investment in the Fund is speculative and involves substantial risks. Additional information regarding the Fund including fees, expenses and risks of investment, is contained in the offering memorandum and related documents and should be carefully reviewed. An offer or solicitation of an investment in the Fund will only be made to accredited investors pursuant to a private placement memorandum and associated documents. Interests in the Fund can only be purchased by investors meeting all the requirements of the Fund. There can be no guarantee that the Fund will achieve its investment objectives. The information contained in this material does not purport to be complete, is only current as of the date indicated, and may be superseded by subsequent market events or for other reasons. In preparing this document, Autumn Lane Advisors, LLC has relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources.

This material may not be reproduced in whole or in part in any form, or referred to in any other publication, without express written permission. Send email requests to info@autumnlanellc.com.

Executive Summary

• While we still believe as detailed in the Annual Letter dated March 9th that:
  • Real interest rates will stay low for the foreseeable future (think years);
  • COVID-19 has hijacked the year 2020, and the risk associated with it is real and still not quantifiable;
  • COVID-19 will be contained with a vaccine/treatment at some point; and
  • Upon the containment of COVID-19 and the resumption of normal economic activity, equity markets will snap back due to pent up demand and significant monetary stimulus.
• We want you to consider the risk that the unprecedented monetary expansion will cause a devaluation of fiat currencies, including the US dollar.

Inflation Ahead…

In the months since the COVID-19 pandemic, there’s been a lot of concern about the consequences for our country, especially the 100,000-plus deaths and the economic catastrophe. Amidst unemployment claims topping 40 million, there hasn’t been a lot of attention paid to the threat of inflation which, perhaps, shouldn’t be that surprising. We tend to associate inflation with economies that are growing too fast or suffering a shock in prices like the oil embargo of the mid 1970s not with ones facing record unemployment. Indeed, the annual inflation rate was a mere 0.3 percent for the 12 months ending in April. U.S. consumer prices actually dropped 0.8 percent in April and, as we know all too well in Houston where I’m based, energy prices collapsed. Prices at the pump dropped some 20 percent in April.

But there is a reason for investors to be worried about future inflation and to consider what to do now in preparation. We wanted to share a few thoughts –not as specific investment guidance but as things to think about in the weeks and months ahead.

Why are we worried about the possibility of serious inflation? There are a few reasons. First, is the money that’s been helicopter dropped into the economy–trillions in direct payments to businesses, individuals as well as state and local governments. Congress has approved one $3 trillion package and there’s surely more to come. Then there’s the Federal Reserve not only cutting rates to near zero but engaging in quantitative easing that makes the 2008 financial bailout look like a payday lender. You don’t need to be a tight money zealot to believe that this deluge of money is the classic precondition for devaluing the currency and producing inflation.

You might be comforted by the fact that the economy was not racked by inflation following the Great Financial Crisis of 2008-9. But there’s little solace to be had from that example. Unlike the financial crisis, where the nation’s housing stock was overbuilt and there was lots of excess supply, this time there’s no such surplus. Furthermore, the banking system was in desperate need of support, and much of the money went to shore up banking reserves. Today, the banks are in much better position and do not need balance sheet support. Finally, the size of this government bailout dwarfs the Troubled Assets Relief Program (TARP) or other programs from the decade’s first century. TARP started as a $710 billion program which sounds almost quaint these days and it was cut down to under $500 billion. Eventually, someone is going to stop buying U.S. debt and when that happens, the dollar gets slammed and prices rise even more. Large government deficits lead to continued large debt issuance, which must keep expanding in order to hold government purchases the same. It’s a vicious circle.

Then there’s “cost-push inflation” — what happens when prices go up because it costs more to make things. Consider restaurants. They’re starting to reopen which is great, but most can only open at limited capacity. Already operating on a narrow margin, they not only can’t afford to cut their prices, they would likely have to raise them just to stay in business. The same goes for airlines which may have to cut back the number of seats in each plane not to mention gyms and salons when they start to open en masse. They’re not going to be in a position to cut prices. Hotel chains are going to have to spend more on cleaning to lure customers back. What’s more, there are other cost-push factors now that could well contribute to inflation. The Trump administration is ramping up rhetoric towards China and tariffs and other trade restrictions could well be in our future. This effort to “on shore” manufacturing and other businesses that produce at lower costs in places like Taiwan and move them to Toledo will add to price hikes.

Other prices will start to rise because of “demand-pull inflation,” which arises from the shortage of supply. Oil plunged drastically this spring and winter but that’s going to shoot back up as people come out of lockdown. Who’s going to want to utilize public transportation in the near future? There’s huge pent up demand to travel after being stuck in the house and people are going to do this in their own vehicles. That’s going to send oil demand up. Meanwhile, the crash in oil prices combined with the shrinking of oil investment dollars will reduce supply – leading to an increase in oil prices.

It’s entirely possible we could end up not only with inflation but stagflation, which first emerged in the 1970s when inflation combined with high unemployment. We could get rising prices from all that debt as well as residually high unemployment as jobs in sectors like retail or commercial real estate never bounce back to pre-pandemic levels. I’m not saying this as a prediction, only as something for you to think about.

Finally, we are worried that the Federal Reserve cannot and will not crush inflation like it did in the 1970s and 1980s when Chairman Paul Volcker dramatically raised interest rates. Volker deepened economic misery but dramatically halted rising prices and put the global economy on a good course for 40 years. That hard-earned credibility is atrophying, in part, because it’s widely assumed that the Fed can’t shrink its balance sheet. If the market loses faith in the Fed’s ability to crush inflation, then money expansion is here to stay.

What might be good investments if inflation is on the horizon? Equities should remain a central part of one’s long term strategy. I’ve never really recommended gold but there is a reason to look at it now because it’s a classic hedge against devaluing currency. Residential real estate is also worth examining, especially affordable housing, which a troubled economy will need.

We’ve been through an incredible period as a country in just a few months–a health crisis, an economic crisis, and civil unrest. After all of that, it’s worth thinking about and preparing for different challenges ahead.

Sincerely,

David E. Andrew
Partner
Autumn Lane Advisors, LLC

DISCLOSURES
This information is provided, on a confidential basis, for informational purposes only and does not constitute an offer or solicitation to buy or sell an interest in Autumn Lane Partners, LP (the “Fund”) or any other security. It is intended solely for the named recipient, who, by accepting it, agrees to keep this information confidential. An investment in the Fund is speculative and involves substantial risks. Additional information regarding the Fund including fees, expenses and risks of investment, is contained in the offering memorandum and related documents and should be carefully reviewed. An offer or solicitation of an investment in the Fund will only be made to accredited investors pursuant to a private placement memorandum and associated documents. Interests in the Fund can only be purchased by investors meeting all the requirements of the Fund. There can be no guarantee that the Fund will achieve its investment objectives. The information contained in this material does not purport to be complete, is only current as of the date indicated, and may be superseded by subsequent market events or for other reasons. In preparing this document, Autumn Lane Advisors, LLC has relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources.

This material may not be reproduced in whole or in part in any form, or referred to in any other publication, without express written permission. Send email requests to info@autumnlanellc.com.