Five Lessons from History (4/5)
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"The irony is that growth - if you can stick around - is a more powerful force, because it compounds, but setbacks capture greater attention because they happen suddenly."
- Morgan Housel
Lesson #4: Progress happens too slowly for people to notice; setbacks happen too fast for people to ignore.
Our obsession with drama
I can think of an almost infinite number of incidents which have resulted in a large number of deaths. The worst of them all, the 1918 outbreak of the Spanish flu, caused more than 50 million deaths worldwide, but that is only one of many. The combination of wars, natural disasters, outbreaks of various diseases and other incidents kill millions every year.
I suggest you take a quick look at Exhibit 1a-b below. As you can see in Exhibit 1a, by far the biggest cause of death amongst natural disasters is something to do with water – either droughts or floods. If you then flip to Exhibit 1b, you’ll see that, as a cause of death, natural disasters are less troublesome these days when compared to 50-100 years ago, and that observation doesn’t even take into account that planet Earth is far more densely populated these days.
At least in the developed world, by far the biggest cause of death is a combination of heart and cancer diseases. Causes like natural disasters don’t even make it to the top 10 (see Exhibit 2 which is based on US data only). Despite that, newspapers and other mainstream media spend little time on the former and oceans of time on the latter and, as we have learned in recent months, pandemics are no different. Worldwide, about 233,000 have now died from Covid-19 (see here). In the US alone, every single year, 1¼ million people die from cancer or heart disease, but the Covid-19 story obviously sells more newspapers.
The human yearning for drama
Let’s switch to the financial side of this story. What I tried to demonstrate above is that the human DNA craves drama, i.e. we often pay too much attention to certain developments and not enough to others.
It is akin to the traffic jam that typically builds up on a motorway after an accident. A traffic jam on the same side of the road as where the accident happened is perfectly understandable, but why we almost always have a traffic jam on the other side is beyond me. It goes back to the human yearning for drama.
As I am sure most of you are aware, a number of megatrends which we have identified over the years, drive everything we do at Absolute Return Partners. One of those megatrends is one we call Changing Demographics (see here for details). Should you want to dig deeper on any of those megatrends, I would suggest you subscribe to ARP+ which you can do here.
Changing Demographics is a classic example of a megatrend that doesn’t get the amount of attention day-to-day that it deserves. Many investors believe the oncoming wave of elderly is so slow-that there is still plenty of time to make the necessary portfolio adjustments. Big mistake! The impact of changing demographics can be felt every day, as long as you keep your eyes open.
The older generations, the so-called Baby Boomers, retire in ever bigger numbers, which changes consumption patterns everywhere – more spent on cruise holidays (although that may change after Covid-19!) and less on children’s toys. Meanwhile, the Millennials are setting new compliance standards in terms of how we treat our environment. For many years to come, issues to do with greenhouse gases and other environmental issues on their minds will affect the world as know it today.
One great opportunity for the longer term
Let me share one simple example with you – our love affair with cars. I was born in 1959 and grew up with a father who believed (and still believes) that having a respectable car is critical to one’s self-esteem. Millennials are different. Many young people don’t even own a car these days but will instead rent it when they occasionally need one.
For them, driverless cars cannot be introduced quickly enough, and I believe that will be one of the biggest investment opportunities over the next ten years. So far, most of the investor attention has zoomed in on Tesla (an American car maker), but the investment opportunity associated with driverless cars has little to do with the car itself. Allow me to explain.
As is widely understood, driverless cars are very disruptive; yet many don’t understand the full implications, and the reason is that the true transformation is not the car itself but the underlying digital technology. Reaction times will be dramatically reduced and human error entirely eliminated. That will lead to a dramatic reduction in the number of accidents, hence fewer hospitalisations and a significant drop in the number of fatalities. The net result of that is a significant drop in healthcare costs which is a major positive for society.
Insurance companies, on the other hand, will be negatively affected. This is counterintuitive, so let me explain. As a result of the drop in the number of accidents, insurance premia will fall and probably significantly so. As auto insurance is a major part of most insurance companies’ profits (over 50% in many of them), earnings in the industry will most likely come under significant pressure.
… and here is an even better one
Imagine you have half a bathtub of water – seawater will do – and the amount of lithium that goes into one laptop battery. What will happen then? The purists will probably say “not a lot” and, at first glance, that is indeed correct. That said, if you mix water and lithium in a fusion (nuclear) power plant, a lot will suddenly happen.
The fusion process – converting hydrogen to helium – releases about 10 million times more energy than what is released when burning the same amount of hydrogen. While a 1,000 MW coal-fired power plant requires 2.7 million tonnes of coal per year, a fusion plant, which is geared to deliver the same output, will only require 250 kilos of lithium per year.
Only a few grams of fuel are present in the plasma at any point in time. This makes the fusion reactor incredibly economical in its fuel consumption, and it adds important safety features. Mixing the amount of water and lithium mentioned above will lead to about 200,000 kWh of electricity – about 30 years of UK per capita electricity consumption (Exhibit 3).
Lithium is the fuel used in fusion power plants. Technically, what happens is that you make two hydrogen isotopes, deuterium and tritium, collide, and the fusion produces a heavier element, helium, and a neutron. There is enough seawater to keep the show running for about 6 million years, and there should be enough lithium for at least another 1,000 years.
Eventually, when fusion power plants are rolled out – the fusion process already works successfully in research laboratories but must be scaled up to be commercially viable – it will have a massive impact on the global economy. Electricity produced in a fusion power plant will cost almost nothing, fossil fuel prices will collapse and the greenhouse gas problem will ‘miraculously’ have been resolved. Expect all that to happen within 10-15 years.
Once fusion energy is a reality, all the heating and transportation that still run on fossil fuels will be electrified very quickly, such is the cost advantage of fusion energy. I should add that, only when everything has been electrified, can we take full advantage of all the new technologies on our doorstep – technologies like blockchain, IoT and AI. They shall all require 100% electrification before we can fully benefit.
How will fusion energy affect wind, solar and other alternative energy forms? It is too early to say, but there can be no doubt that electricity generated in a fusion power plant is much cheaper than anything produced by any of these alternative sources. Furthermore, fusion energy is less of a liability environmentally than wind or solar is. Therefore, I think of wind and solar as a stopgap solution to a critical problem but one that will be phased out over time.
It is also worth bearing in mind that, in terms of the bigger geopolitical picture, what I have mentioned so far is only the tip of the iceberg. Countries that are dependent on its fossil fuel industry for its continued economic growth will most likely run into strong headwinds for a period of time, and no OECD country is more dependent on its fossil fuel industry than the US.
Furthermore, political priorities will most likely change when OPEC’s powers begin to fade. As that happens, other countries – those rich on lithium – will move to the forefront. With the Lithium Triangle in South America holding the biggest lithium reserves, and with Chile being the price-setter, could Chile become the new Saudi Arabia? Not as far-fetched as you may think. At the very least, the South American continent’s prominence and political influence will most likely grow as fusion energy becomes more than a distant vision.
Great stories, but why doesn’t anybody pay attention?
With such great innovations on our doorstep, one wonders why, apart from the occasional interest in Tesla, investors do not appear to pay much attention, and I can only guess why that is. The answer probably lies in Morgan Housel’s lesson #4:
Progress happens too slowly for people to notice …
What happens in the present is, in the minds of many investors, far more important than anything that will gradually unfold over the next several years, even if the latter is far more impactful.
Lesson #4 in the context of Covid-19
In the context of the ongoing health crisis and how it has affected financial markets, even if the framework is somewhat different, lesson #4 can also be applied. Although it is pretty obvious that the economic impact of Covid-19 will be devastating, our short attention span (which is a derivative of lesson #4) has resulted in ‘unusual’ equity market behaviour more recently. As soon as governments and central banks started to throw money after the patient, equities started to rally and have rallied pretty much ever since in total disregard to the economic implications of Covid-19, which will soon be felt.
GDP estimates for Q2 are still all over the place but, if analysts are anywhere near correct, GDP on both side of the Atlantic will drop by at least 20% in 2Q20 vs. 2Q19 – probably a great deal more. And, by the way, don’t be fooled if preliminary numbers suggest the impact to be less severe than many analysts have predicted. Preliminary numbers cannot be relied on in a case like this, as they are largely based on trend lines from previous quarters. The shock was so sudden with the global economy in meltdown virtually overnight that a methodology based on trendlines is meaningless. Take for example the US economy, where Goldman Sachs now predict GDP growth in Q2 to be -34%. According to research they have conducted, if GDP growth in Q2 ends up falling by 34%, expect the first number to be released to be approx. -18%.
That is backed up by electricity consumption numbers I have from France. Demand for electricity is highly correlated with GDP growth. Vipin Arora and Jozef Lieskovsky have conducted some great work on the link between economic growth and electricity use and have found that (i) we need much less electricity to produce $1 of GDP today than we did not that many years ago and (ii) the beta today is about 0.4.
Although that number is based on US data, let’s assume it is similar in France. As French electricity consumption in April has been down about 14% from year-ago levels, applying a beta of 0.4 would suggest that economic activity in France in April has been running about 35% below year-ago levels – not dissimilar to Goldman Sachs’ estimate for the US economy.
As far as the full year is concerned, a very bleak picture is emerging (Exhibit 4), meaning that 2020 will most likely turn into only the second year since World War II where global GDP growth is negative over a full calendar year. The only other case of that was 2009 (source: World Bank).
The obvious implication is that (most) equity research analysts are still far too optimistic on corporate results in 2020, and I am struggling to see how investors can continue to ignore fundamentals. The market consensus must be that the economy will recover relatively quickly once it reopens (a so-called V-shaped recovery). Why else would equities rally?
That arguments fails to take into account various supply chain constraints, though. You can shut down a business overnight, but it often takes weeks, sometimes months, to reopen. Staff must be re-hired, inventories re-stocked, etc. etc., and all that takes time. Evidence from China, which is about six weeks ahead of Europe in the disease cycle, very much confirms that view (Exhibit 5).
Adding to that, for a number of months, many consumers have earned less than normal, and some have earned nothing at all. Consequently, all those consumers are not very likely to rush out and spend excessively the first few months. Therefore, the economic cycle may be V-shaped on the way into recession, but the exit is more likely to be U-shaped – not dissimilar to what you see in Exhibit 5.
The mess that pretty much the whole world is in now was hard to predict. As recently as mid to late February, all the talk was about how much the economy would grow this year. There was hardly a cloud on the horizon, and that is only a couple of months ago. Now we are facing the most dramatic economic setback ever – even worse than anything we saw during the great depression of the 1930s.
Do you really think rising equity markets can be justified in such circumstances? I am fully aware that the rally is driven by the Fed’s actions and nothing else but, as I see it, what began as a relief rally has turned into a Greater Fool rally. Increasingly, it reminds me of the latter stages of the Japanese equity rally in the late 1980s, and I can only wish you the best of luck if you are participating.
In next month’s Absolute Return Letter, Morgan Housel’s lesson #5 will come under my scrutiny, and that will be the last of our five letters on Housel’s lessons learned:
Wounds heal, scars last.
Until then, have a great month of May, lockdown or not. And, if you are an ARP+ subscriber, don’t forget to join our webinar on Monday the 4th May at 15:00 BST, where I will present a couple of ideas as to how the massive cost of dealing with the Covid-19 crisis could be financed without having to raise government debt, and I am not suggesting that we should just print the money.
Niels C. Jensen
1 May 2020
Niels Clemen Jensen founded Absolute Return Partners in 2002 and is Chief Investment Officer. He has over 30 years of investment banking and investment management experience and is author of The Absolute Return Letter.
© Absolute Return Partners LLP
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