Quarterly Newsletter – 3rd Quarter 2019

Dear Friends
of TwinRock,

Are Black Swan Events Really That Difficult to See?

A black swan event is characterized by three things: They’re extremely rare, impossible to predict before hand, and leave severe and widespread consequences in their wake.

We’re certainly not going to argue the last point. The 1997 Asian Financial Crisis, the Dotcom Crash in the early 2000s, and the 2008 Global Financial Crisis are all prominent black swan events that had a dramatic impact on the U.S. and global financial markets and economies.

But are black swan events really that difficult to predict? Or is that just a result of selective attention, where investors, governments, and the public at large choose to pay attention to some stimuli but not others?

In this Q3 2019 Newsletter, we’ll talk about the recent goings on in the overnight repo market, mixed economic messages from the Fed, recession on the other side of the Atlantic, and how one company that We all know managed to lose 80% of its pre-IPO market value in just a couple of months.

These may or may not be black swans circling above. We’ll leave it up to you to make that call.

What’s going on with the repo market?

‘Repo’ is short for ‘repurchase agreements’. The repo market is where cash and collateral are exchanged overnight. Big investors such as mutual funds make money in the repo market by briefly lending their cash to banks and broker-dealers in exchange for the securities they hold and provide liquidity to the market.

Overnight repo rates have been running about 2%. But the middle of September, overnight repo rates skyrocketed to 10% due to the imbalance between too many securities and not enough cash, as reported by The Washington Post. Coincidentally, this occurred just as the Fed was planning to reduce the federal funds rate to 2%.

So, on September 17th, the Fed loaned about $75 billion to primary dealers to fund overnight system repos and push the repo rate down. Banks took nearly $53 billion, and two days later when another $75 billion was offered by the Fed, the banks took it all, according to The Economist.

This was the first time the Fed has to directly deposit cash into the banking sector since the Global Financial Crisis of 2008.

Unfortunately, this cash injection by the Fed into the repo market wasn’t a one-off event. While the first $75 billion was successful in calming markets and pushing the repo rate down to 2%, the New York Federal Reserve Bank also announced plans to increase its overnight operations to $100 billion through October 10th.

Investors should ask themselves two questions.

First, where did the Federal Reserve get the money from to fund these multiple, multi-billion cash injections? Secondly, if the markets become convinced the Fed will pursue a standing repo facility and restart its Permanent Open Market Operations of bond buying, could QE4 be just around the corner?

Is U.S. manufacturing in a recession?

On September 18th, Fed members voted 7-3 to reduce the overnight rate to between 1.75% and 2%, the second rate cut in less than two months. However, not all Fed policy makers were on the same page.

Reuters noted that Fed Vice Chair Richard Clarida believes the U.S. is in a “virtuous circle” of job gains, wage gains, and increased household spending. Household consumption makes up about 70% of the economy in the country.

Speaking on the other end of the spectrum, Boston Federal Reserve President Eric Rosengren claims that the already tight labor market doesn’t need an interest rate cut, with cheaper money “inflating the prices of risky assets and encouraging households and firms to take on too much leverage.”

St. Louis Fed President James Bullard wanted a deeper cut, claiming that the manufacturing sector in the U.S. “already appears to be in a recession”. In fact, data from the Federal Reserve itself and the Institute of Supply Management appear to support Bullard’s view:

  • Industrial Production had been steadily increasing since Q1 2016, but peaked just before the end of 2018 and has been declining this year
  • Purchasing Managers Index is nearing the low last seen the beginning of 2016
  • Exports have slowed since Q1 2018, a result of trade wars and tariffs
  • Factor job additions have dramatically slowed, after showing a steady increase since 2013

None of this is good news for an economy so dependent on consumer spending.

But, similar to the differing viewpoints of Fed members, recent economic data is equally diverse as well. Home sales have been stronger than expected, stock markets are approaching new highs, and U.S.–China trade talks appear to be on again, at least for now.

Germany and the EU may already be in recession

Germany accounts for a little more than 21% of the total GDP of the European Union. That’s good for Germany, but not so good for the EU, especially since Germany appears to have already entered a recession.

In its recent article, “German Industrial Recession Drags Economy Deeper Into Slump”, Bloomberg reports that the country’s economy is suffering its worst downturn in nearly seven years. Factory PMI has reached a 10-year low and growth in services is softening, putting continued pressure on the labor market.

Unfortunately, Germany isn’t alone. France is also showing weak economic activity, while the Brexit debate continues to create havoc in the United Kingdom. These three counties combined generated over 50% of the European Union’s $18.8 trillion GDP last year.

Thomas Cook travel goes belly up

Thomas Cook was a United Kingdom-based travel tour operator whose origins date back to 1841. On September 22nd, the firm collapsed, stranding nearly 600,000 travelers and putting the jobs of 21,000 employees as risk.

The bankruptcy of Thomas Cook triggered the largest peacetime repatriation in the United Kingdom. The UK Civil Aviation Authority told CNN that 40 planes had been chartered to run over 1,000 flights to return all 150,000 UK citizens to their home country. Numerous reports cited hotel operators in Tunisia, Cuba, Thailand, and even Kissimmee, Florida, holding guests “hostage” and demanding extra fees due to the “Thomas Cook situation”.

Nicknamed “Operation Matterhorn”, the UK government estimates it will spend about $750 million to retrieve its stranded citizens. Ironically, Thomas Cook only needed to arrange $250 million in funding for a group of lenders headed by the Royal Bank of Scotland. Unable to do so, the firm went belly up.

Thomas Cook was vertically integrated, operating an airline and owning over 200 hotels. While vertically integrating along a supply chain is sound business practice – a strategy that Amazon is very adept at – it wasn’t enough to save Thomas Cook. Since May 2018 the company’s shares have nosedived by more than 96% due to Brexit uncertainty and the intensely competitive tourism sector.

Disruption has been a consistent theme throughout our weekly TwinRock Power Exchanges and quarterly newsletters.

Thomas Cook pioneered package holidays and made travel possible for millions of people around the world, according to the firm’s CEO. But year after year, online travel booking rivals and low-cost air carriers have consistently gained market share from Thomas Cook while the firm insisted on selling tour packages predominantly from its brick-and-mortar locations.

WeWork loses 80% of its pre-IPO value

Back in 2017, The Wall Street Journal described coworking company WeWork as a “$20 billion startup fueled by Silicon Valley pixie dust.” At the beginning of this year, it looked like WSJ had wildly underestimated the company.

In January 2019, We (the new name for WeWork) had an estimated market value of $47 billion. That valuation promised a huge ROI for SoftBank Vision Fund, one of the largest tech investment funds in history. SoftBank is We’s main backer, investing about $8.6 billion in coworking company over the past few years.

Nine months later, the company’s founder has been removed as CEO, the firm’s IPO is on hold, and We’s market valuation may be as low as $10 billion, according to the Los Angeles Times.

Investors realized that CEO Adam Neumann’s questionable deals within his company, like buying the ‘We’ trademark and selling it back to We and leasing buildings he owned to We, were causing as much damage as were the firm’s $1.9 billion loss in 2018 and $904 million loss through H1 2019.

Now, don’t get us wrong. We’re big fans of the coworking concept.

It wasn’t that long ago that office space was an asset class that many investors wouldn’t touch with a 10-foot pole. That’s when the gig economy was just taking off and work-from-home freelancers didn’t want or need traditional office space.

One could make a good argument that WeWork almost single-handedly made office space “cool” again by transforming four walls, a door and a desk into a creative community for solopreneurs, small business startups, and Fortune 500 companies. Despite We’s plunge in value, there’s no doubt that coworking as a concept is still going strong.

JLL reports that coworking (along with tech) continue to dominate leasing activity through H1 2019. Of the over 59.3 million sq. ft. of new leases signed year-to-date, coworking and tech each account for more than 10 million sq. ft.

In its 2019 US Flexible Workspace Report, Colliers notes that flexible workspace as a share of total office inventory has grown by over 31% between 2016 and Q2 2018. In Manhattan alone, the share of flexible office space has increased by nearly 53% over that same time period.

Connecting the dots

A lot of ‘experts’ say you shouldn’t waste valuable time, money and effort trying to predict black swan events. That’s because they’re unpredictable in the first place, so why bother?

For people who accept the premise of black swan unpredictability, and are more comfortable following the herd, that probably makes perfect sense. But for those who refuse to allow themselves to be fooled by randomness, it may be that seeing black swans before they land simply requires connecting the dots.

Alexander Philips

Chief Executive and Investment Officer

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