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THIS WEEK: Modern Monetary Theory; Disruptive Equity Research; US and China; Coronavirus.
Modern Monetary Theory
“It is not modern, it is not monetary and it is not a theory” fired a widely followed economist/market strategist in a recent article. He may be correct. At first or even second sight, there is not much that is particularly new about Modern Monetary Theory (MMT), other than its blanketing with the veneer of academic respectability (or lack of, depending on your view of economist academics) the same old and tired big government spending.
If MMT looks like uncharted territory, it is mainly because it does not pay heed to old-school concerns such as the tax revenues needed to pay for all that spending or the resulting monster budget deficits. MMT promises that there is no need to balance the books because our capacity to borrow with little or no consequence is infinite. One place where MMT differs from traditional macroeconomics is in its belief that the government can and should keep inflation down by increasing taxes.
In the best case scenario, the trillions upon trillions of government spending will not result in significant inflation and will easily be rolled over and absorbed over time thanks to low interest rates and thanks to growth in the economy. After all, the pandemic has created a very serious emergency and the US ramped up its spending and budget deficit during the last very serious emergency which was WW2. Things turned out well back then and we may be just as lucky this time.
On the other hand, it is not difficult to picture how our experimenting with MMT could end badly: an inflation surprise, that leads to higher expectations of inflation, and then even higher inflation. Rolling over all this new debt at higher rates would be different from what we currently expect. The government would then raise taxes in order to control inflation by dampening economic activity. This then may require more government spending to assist the suffering sectors and individuals.
It all seems circular but it is not, because the parties that are taxed and the parties that are assisted are not the same. It looks then like one giant wealth transfer and as such is as modern as Robin Hood, as monetary as Keynes and as theoretical as…
Disruptive Equity Research
We wrote about Cathie Wood and ARK Invest only two weeks ago. But as noted then, ubiquity requires, nay, demands frequent attention and commentary. Now ARK has released a new base case price target for Tesla stock and it is $3,000 in 2025, a four-fold increase from its current $690. ARK applies a methodical and scientific approach to equity research, in a manner that is congruent with its single-minded focus on disruptive technology. The old base case price target was $1,400 but this is now deemed to be close to the firm’s bear case. The new bear case price target is $1,500.
ARK’s research team has dug deeper into their “Monte-Carlo” model to find additional value of $1,600 per share, or an extra $1.5 trillion of hitherto unsuspected value. To put this additional value in perspective, the entire market value of Google is now $1.4 trillion. That of Apple is $2 trillion. Amazon and Microsoft are at $1.55 and $1.78 trillion. All of these companies derive large profits from their operations, a benefit that has so far eluded Tesla.
ARK’s methodology is either wrong or disruptive in its own right. We should not discount the latter possibility merely because it leads to valuations that are very far outliers. It should be remembered however that the objectivity of equity research is compromised by the fact that analysts and investors watch each other and influence each other. This sharing of information coupled with continuous feedback from the market results in significant mispricing distortions in particular among large cap stocks. ARK’s team is not immune from this influence and feedback loop, in particular given that ARK is already a significant holder of Tesla stock.
It may be that Tesla will be worth $3 trillion one day and that it will dominate for a long time in electric vehicles, in batteries and in automotive software. This would mean that we are now entering a different world. Stock market history has not treated such beliefs kindly. Maybe this time is different?
US and China
The general consensus is that China’s economy will soon surpass that of the US. Maybe, maybe not. There are issues with this prediction that relate to 1) what you measure and 2) what you extrapolate.
If you measure an economy by GDP as most people do, it is possible that China’s total GDP will exceed that of the US. This is not necessarily shocking since China’s population is nearly four times that of the US. In 2019, US GDP was at $21.4 trillion and China’s GDP was at $14.3 trillion (as it were, a mere 5x Tesla’s projected 2025 market value per ARKInvest). But if you use purchasing power parity (PPP), China’s GDP has already exceeded US GDP in 2019, $23.5 trillion to $21.4 trillion (World Bank estimates).
Or you can measure GDP per capita. On a PPP basis, China’s GDP per capita was $16,804 in 2019 compared to the US at $65,298.
There are other issues however. GDP measures activity which is not the same as wealth creation. Two countries can have the same GDP but one may create vastly more wealth than the other. This is crudely similar to two companies with similar revenues but with one operating at 15% margins and another at 35% margins.
Generally speaking, companies and countries that create more intellectual property also create more wealth. Building a road creates wealth because it improves productivity. However, dollar for dollar of investment, new infrastructure creates far less wealth than R&D in intellectual property sectors such as software or pharmaceuticals. The problem for governments is that it is difficult to tax or to take over intellectual property. By definition, its value comes from the fact that it is held by its owners without risk of unfair expropriation. If the state took over Microsoft or Pfizer, it would benefit from its existing intellectual property but it would also destroy the incentive to create new intellectual property.
Then there is linear extrapolation. One of China’s biggest economic tailwinds was the decline in its dependency ratio (the ratio of its young and elderly dependents to its working-age population). But this ratio has now reversed and turned into a headwind. The US faces its own demographic difficulties but they are less challenging than China’s.
After months of decline, daily US confirmed cases have stabilized just over the 50,000 mark. Deaths continue to fall and on current trends should level off near 750 daily within a month. The main concern now is that new variants may create another surge before vaccines reach a sufficient number of people to create herd immunity. It is a race against the clock, but one that we are likely to win with some assistance from warmer temperatures.
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