We’ve constantly been sharing a list of our recent reads in our weekly emails for The Good Investors.
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But since our readership-audience for The Good Investors is wider than our subscriber base, we think sharing the reading list regularly on the blog itself can benefit even more people. The articles we share touch on a wide range of topics, including investing, business, and the world in general.
Here are the articles for the week ending 01 December 2024:
1. America, China, and the Death of the International Monetary Non-System – Russell Napier
Something changed in America in the 1990s. The U.S. federal funds rate began a decline from above 5 percent to reach the effective zero bound by 2009. U.S. ten-year Treasury yields declined from above 6 percent to levels not even recorded during the Great Depression. Credit to the U.S. nonfinancial corporate sector rose from 56 percent of GDP to a new all-time high of 87 percent, and U.S. Government debt rose from 60 percent of GDP to a recent high of 106 percent, very near the peak level recorded during World War II. The valuation of U.S. equities rose from a cyclically adjusted price-to-earnings ratio (CAPE) of 15x to the current level of 34x, having reached a new all-time high of 44x in 2000. U.S. tangible investment declined from 7 percent of GDP to as low as just 1 percent of GDP, a level only previously recorded in the Great Depression and briefly in the hiatus of investment after World War II…
…Today, we have an international monetary system that does not have a name…
…It is a non-system to the extent that its terms and conditions were never agreed upon by all the parties involved, but instead it was born from choices made by a few, most notably China, that the other parties accepted and adjusted to. The extremes of interest rates, debt levels, asset price valuation, and investment in tangible assets in the United States are just part of that global adjustment to the new international monetary system that grew from China’s unilateral decision to manage its exchange rate beginning in 1994. This system would never have been agreed to in any negotiation, as it was a system replete with distortions that would lead to dangerously large imbalances with dangerous political ramifications…
…The crucial distortion imposed by China’s decision in 1994 was a decoupling of developed world growth rates from interest rates, the discount rates used in asset valuations, which many assumed to be a new normal. When interest rates appear to be permanently depressed relative to growth rates, asset valuations rise, leverage increases, and investors are incentivized to pursue gain through rising asset prices rather than through investment in new productive capacity. The decoupling of growth and interest rates was driven by the People’s Bank of China’s (PBOC) appearance as a non-price-sensitive buyer of U.S. Treasury securities, and indirectly by the role China’s excessive fixed-asset investment played in reducing global inflation and hence interest rates…
…For developed-world companies facing the cheap resources, cheap finance, and cheap exchange rate of China, there was little incentive to invest in tangible assets at home. In the United States, in particular, where companies are managed to maximize return on equity and returns to shareholders, the corporation was able to benefit from both cheap Chinese production and the low interest rates that allowed balance sheets to be levered to buy back equity. In other countries, with different social contracts and less focus on rewarding management via stock options, closing productive capacity and pursuing financial engineering were more difficult. Thus, it was U.S. corporations that most fully adapted to the new international monetary system.
When the Bretton Woods system was established, severe restrictions were placed on the free movement of capital. The architects of that system recognized that maintaining exchange rate stability would not be possible if capital were allowed to move freely. Our current system permits, at least into and within the developed world, the free movement of capital. In this system, the private sector capital that left the developed world for China was transformed, via PBOC exchange rate intervention, into an accumulation of developed-world debt securities financed by the creation of renminbi reserves…
…. China’s inability to run sufficient surpluses since 2014 to generate sufficient broad money growth and prevent the escalation of its already high debt-to-GDP ratio is not widely recognized as a similar problem. Yet China’s move to a flexible exchange rate to avoid a debt deflation and create sufficient growth in broad money to reduce its debt burden will end the non-system as surely as President Nixon’s announcement that the U.S. dollar was no longer linked to gold ended Bretton Woods. Few analysts understand the impact that this move will have on the international monetary system and the long-accumulating distortions to credit, money, asset prices and the global economy.
When China moves to a flexible exchange rate, it is difficult to foresee how just one new international monetary system could replace the non-system. Given current geopolitical tensions, the prospect of China and the United States hashing out a new Bretton Woods–style agreement is highly unlikely…
…Predicting how any new U.S.-centric monetary system will develop is not easy, but such a system must allow for excessively high debts, the legacy of the non-system, to be inflated away. While much of the focus is on the high U.S. total nonfinancial debt-to-GDP ratio of 255 percent, there are many countries in the world struggling under even higher debt ratios: Canada, 311 percent; France, 315 percent; Japan, 400 percent; Netherlands, 316 percent; Switzerland, 297 percent, etc.15 The rise and rise of debt-to-GDP levels, a product of the gap between interest rates and growth rates under the non-system, will now have to be addressed.
With austerity, default, hyperinflation, or very high real GDP growth unlikely to be the solution, a new global monetary system will have to be created that offers a path of moderation toward reducing debt‑to-GDP levels. That path of moderation is likely to take the form of financial repression—such as that imposed upon savers in the aftermath of World War II, to force their savings to fund the investment needed for postwar reconstruction, but at interest rates that did not reward them for the current and expected levels of inflation. That is a world in which bankers will create more credit and more money and more inflation than they have in recent decades. Higher nominal GDP growth combined with imposed purchases of low-yielding debt securities will, over time, reduce debt-to-GDP levels, just as it did in the decades following World War II. Whatever the new international monetary system looks like, it will have to accommodate the financial repression that will finally begin to reduce debt-to-GDP levels…
…In the long period in which developed-world debts will have to be inflated away, policymakers will have to take a view as to which section of society will bear the heaviest cost. One of the quickest and least painful ways to enforce a deleveraging is through encouraging a rapid re‑equitization of the private sector. The ability of all corporations to deduct interest expense in calculating their taxes has to be reconsidered. In an era when much greater fixed-asset investment is essential, the tax privilege of deducting interest expense should not be available to corporations using debt to lever up an existing income stream; rather, the tax code should reward corporations using debt to build new businesses and new income streams. There are of course losers from such a change in taxation, but they are those who have been the winners from the prolonged period of falling interest rates and rising asset prices that have been the key feature of our now failing non-system. A long financial repression is in nobody’s interest, and the longer it prevails, the more likely it will create wealth redistributions that threaten social stability. Proactive intervention to force re-equitization upon a small section of society through the withdrawal of a tax privilege is painful for some but is a more equitable path to reducing high debt-to-GDP levels while facilitating greater investment.
To reduce the high and dangerous debt-to-GDP ratios of the developed world, nominal GDP must grow faster than total credit. This can be achieved by increasing the growth rate in bank credit while limiting the growth in nonbank credit. While the non-system was a key driver of the rise and rise of debt-to-GDP, the disintermediation of credit also played a key role. It is commercial bankers who create money, and if nominal GDP growth is to remain at a high enough level to reduce debt-to-GDP levels, bank balance sheets must grow faster than they have over the past three decades. Commercial banks create money when they expand their balance sheets, and if they do not create enough money, nominal GDP growth will remain low while credit growth, spurred by the growth in nonbank credit, can remain high.18 A combination of faster growth in bank credit combined with the restriction of the growth in nonbank credit will be at the core of reducing debt-to-GDP ratios. The targeted ending of interest deductibility in the computation of corporate income tax, mentioned earlier, can assist in promoting the growth in bank credit and hence money at the expense of growth in nonbank credit. If it is bankers who are at the vanguard of funding the necessary investment renaissance in the United States, and not credit markets, then the move to lower debt-to-GDP levels will be less painful than if we are forced to take the hard path of austerity, default, hyperinflation, or a very long financial repression. A new focus on the growth of bank credit and therefore money is at the core of any policy to reduce dangerously high debt-to-GDP ratios.
2. Are U.S. Stocks Overvalued? – Ben Carlson
The S&P 500 is up nearly 90% since election day 2020 yet valuations are essentially identical.
How can that be?…
…Stock prices are up a lot but fundamentals2 have kept pace. In fact, the stock market has actually gotten less expensive over the past couple of years because of earnings growth…
…It’s also important to point out that much of the valuation premium on the S&P 500 comes from the largest stocks…
…These stocks have high valuations for good reason — they’re some of the best-run corporations in the world…
…The good news for valuation-conscious investors is there is plenty of value outside of the mega-cap stocks. Valuations for small and mid cap stocks are still pretty cheap. They are far less expensive now than they were before the pandemic. Maybe there’s a reason for that but stocks don’t get cheap for no reason.
3. Amazon’s Moonshot Plan to Rival Nvidia in AI Chips – Matt Day, Ian King, and Dina Bass
Nvidia’s biggest customers — cloud providers like Amazon Web Services, Microsoft Corp.’s Azure and Alphabet Inc.’s Google Cloud Platform — are eager to reduce their reliance on, if not replace, Nvidia chips. All three are cooking up their own silicon, but Amazon, the largest seller of rented computing power, has deployed the most chips to date…
…Fifteen years ago, the company invented the cloud computing business and then, over time, started building the infrastructure that sustains it. Reducing its reliance on one incumbent after another, including Intel Corp., Amazon ripped out many of the servers and network switches in its data centers and replaced them with custom-built hardware. Then, a decade ago, James Hamilton, a senior vice president and distinguished engineer with an uncanny sense of timing, talked Jeff Bezos into making chips…
…After almost four decades in the business, Hamilton knows taking Amazon’s chip ambitions to the next level won’t be easy. Designing reliable AI hardware is hard. Maybe even harder is writing software capable of making the chips useful to a wide range of customers. Nvidia gear can smoothly handle just about any artificial intelligence task. The company is shipping its next-generation chips to customers, including Amazon, and has started to talk up the products that will succeed them a year from now. Industry observers say Amazon isn’t likely to dislodge Nvidia anytime soon…
… The unit’s first chip was designed to power something called inference — when computers trained to recognize patterns in data make a prediction, such as whether a piece of email is spam. That component, called Inferentia, rolled out to Amazon’s data centers by December 2019, and was later used to help the Alexa voice assistant answer commands. Amazon’s second AI chip, Trainium1, was aimed at companies looking to train machine learning models. Engineers also repackaged the chip with components that made it a better fit for inference, as Inferentia2.
Demand for Amazon’s AI chips was slow at first, meaning customers could get access to them immediately rather than waiting weeks for big batches of Nvidia hardware. Japanese firms looking to quickly join the generative AI revolution took advantage of the situation. Electronics maker Ricoh Co., for example, got help converting large language models trained on English-language data to Japanese.
Demand has since picked up, according to Gadi Hutt, an early Annapurna employee who works with companies using Amazon chips. “I don’t have any excess capacity of Trainium sitting around waiting for customers,” he says. “It’s all being used.”
Trainium2 is the company’s third generation of artificial intelligence chip. By industry reckoning, this is a make-or-break moment. Either the third attempt sells in sufficient volume to make the investment worthwhile, or it flops and the company finds a new path. “I have literally never seen a product deviate from the three-generation rule,” says Naveen Rao, a chip industry veteran who oversees AI work at Databricks Inc., a purveyor of data and analytics software.
Databricks in October agreed to use Trainium as part of a broad agreement with AWS. At the moment, the company’s AI tools primarily run on Nvidia. The plan is to displace some of that work with Trainium, which Amazon has said can offer 30% better performance for the price, according to Rao. “It comes down to sheer economics and availability,” Rao says. “That’s where the battleground is.”…
…Amazon’s Trainium2 will likely be deemed a success if it can take on more of the company’s internal AI work, along with the occasional project from big AWS customers. That would help free up Amazon’s precious supply of high-end Nvidia chips for specialized AI outfits. For Trainium2 to become an unqualified hit, engineers will have to get the software right — no small feat. Nvidia derives much of its strength from the comprehensiveness of its suite of tools, which let customers get machine-learning projects online with little customization. Amazon’s software, called Neuron SDK, is in its infancy by comparison.
Even if companies can port their projects to Amazon without much trouble, checking that the switch-over didn’t break anything can eat up hundreds of hours of engineers’ time, according to an Amazon and chip industry veteran, who requested anonymity to speak freely. An executive at an AWS partner that helps customers with AI projects, who also requested anonymity, says that while Amazon had succeeded in making its general-purpose Graviton chips easy to use, prospective users of the AI hardware still face added complexity.
“There’s a reason Nvidia dominates,” says Chirag Dekate, a vice president at Gartner Inc. who tracks artificial intelligence technologies. “You don’t have to worry about those details.”…
… “We’re particularly impressed by the price-performance of Amazon Trainium chips,” says Tom Brown, Anthropic’s chief compute officer. “We’ve been steadily expanding their use across an increasingly wide range of workloads.”
Hamilton says Anthropic is helping Amazon improve quickly. But he’s clear-eyed about the challenges, saying it’s “mandatory” to create great software that makes it easy for customers to use AWS chips.
4. Key Square Capital 2024 January letter – Scott Bessent and the Key Square team
In essence, a second Trump administration would be expected to embrace a “Peace Through Strength” trade policy. Of course, in the case of recalcitrant trade partners, Trump can always offer them a negotiating session with former US Trade Representative Robert Lighthizer who will likely play a prominent role in his second term.
Our base case is that a re-elected Donald Trump will want to create an economic lollapalooza and engineer what he will likely call “the greatest four years in American history.” Economist Ed Yardeni believes that post-Covid America has the potential to have a boom similar to the “Roaring Twenties” of a century ago. We believe that a returning President Trump would like this to be his legacy. In this scenario, the greatest risk factor, in our opinion, would be a sudden rise in long-end rates.
The talk of revenge will likely be limited to a small group of political enemies, and the wider policies of the administration will be oriented toward de-regulation, energy independence, reviving U.S. manufacturing and extending the tax cuts. We find it unlikely that across-the-board tariffs, as currently reported by the media, would be enacted at the same time as he moves to fix the immigration crisis. The tariff gun will always be loaded and on the table but rarely discharged. Of course, strategic and national security issues around China will remain.
Another differentiated view that we have is that Trump will pursue a weak dollar policy rather than implementing tariffs. Tariffs are inflationary and would strengthen the dollar–hardly a good starting point for a US industrial renaissance. Weakening the dollar early in his second administration would make U.S manufacturing competitive. A weak dollar and plentiful, cheap energy could power a boom. The current Wall Street consensus is for a strong dollar based on the tariffs. We strongly disagree. A strong dollar should emerge by the end of his term if the US reshoring effort is successful.
5. Scott Bessent Sees a Coming ‘Global Economic Reordering.’ He Wants to Be Part of It – Peter Rudegeair and Gregory Zuckerman
In his first interview following his selection, Bessent said his policy priority will be to deliver on Trump’s various tax-cut pledges. Those include making his first-term cuts permanent, and eliminating taxes on tips, social-security benefits and overtime pay…
…Bessent became one of Trump’s closest advisers by adding depth to his economic proposals and defending his plans for more-activist trade policies. He has argued that the president-elect’s plans to extend tax cuts and deregulate parts of the U.S. economy would create an “economic lollapalooza.”…
…Bessent has long been worried about the U.S.’s heavy debt and thinks the main way it can be reduced is by boosting growth, which increases tax revenues.
He has advised Trump to pursue a policy he calls 3-3-3, inspired by former Japanese Prime Minister Shinzo Abe, who revitalized the Japanese economy in the 2010s with his “three-arrow” economic policy. Bessent’s “three arrows” include cutting the budget deficit to 3% of gross domestic product by 2028, spurring GDP growth of 3% through deregulation and producing an additional 3 million barrels of oil or its equivalent a day.
To get government spending under control, Bessent has advocated extending the 2017 Tax Cuts and Jobs Act but with what are called pay-fors to lower its cost. That would involve either reducing spending or increasing revenue elsewhere to offset the impact. He also proposed freezing nondefense discretionary spending and overhauling the subsidies for electric vehicles and other parts of the Inflation Reduction Act.
Earlier this year, Bessent thought about tariffs as a negotiating tool, telling investors in a letter that the “tariff gun will always be loaded and on the table but rarely discharged.” He has since argued for them more forcefully, especially as a source of tax revenue.
In a speech last month titled “Make the International Economic System Great Again,” Bessent argued for increasing tariffs on national-security grounds and for inducing other countries to lower trade barriers with the U.S.
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