Creative destruction in times of covid

Is now the time for entrepreneurial true grit?

A STRUGGLING Airbnb was still called AirBed&Breakfast when its founders decided to bet its future on the Democratic National Committee in Denver in 2008. Their air-bed idea was not popular with the 80,000 people congregated to select a presidential candidate. So they focused on breakfast instead, peddling $40 boxes of cereals called Obama O’s and Cap’n McCain’s (their quip: “Be a cereal entrepreneur”).

The timing was as bad as the pun. The event came just weeks before Lehman Brothers collapsed at the height of the financial crisis of 2007-09. Yet shortly afterwards they obtained their first-ever funding. The angel investor who backed them dubbed them “cockroaches” for their survival skills. That may not be the most tasteful way to describe people in the hospitality trade. The founders, though, considered it the best compliment they had ever received.

Like Airbnb, some of the best-known names in business started during steep slumps, including Uber (2009), Microsoft (1975), Disney (1923), General Motors (1908) and General Electric (1890). Disruptive products and services, too, have emerged in times of crisis, notably Apple’s iPod as the dotcom bubble burst in 2000 and Alibaba’s Taobao, an online-shopping mall, during China’s SARS epidemic of 2003.

Such stories loom large in startup folklore as evidence of entrepreneurial true grit. Yet they are rarities. Our calculations indicate that among almost 500 of today’s biggest listed firms in America, whose origins date as far back as 1857, a much larger number started life in expansionary years than during recessions. Of those founded since 1970, more than four-fifths were born in good times (see chart).

That, of course, overlooks innumerable firms created along the way that have either not made it to the top, or fallen by the roadside. But it suggests that however hard it is for the enterprising to build a lasting business, it is even harder for those who start off with the economic winds blowing in their faces.

Save for a few industries such as health care, it is safe to assume that investment in innovation will plummet during the covid-19 pandemic. It usually does in times of crisis. Venture capital (VC) will also dry up as everyone keeps their heads down and tries to preserve cash. In 2007-09, VC funding in America fell by almost 30%.

Yet this column would not be named after Joseph Schumpeter, the father of creative destruction, if it did not believe that following a slump, a burst of entrepreneurial activity will eventually emerge.

As he wrote in “The Theory of Economic Development”, published in 1911 (itself a recessionary year), “the very logic of the capitalist system [is that] after some time of depression, new entrepreneurs would emerge.

And then there would be a new ‘swarm’ of entrepreneurs. A wave of prosperity would start up and the whole cycle would roll on.” Assuming this remains the case, will the protagonists be tiny startups coming out of nowhere?

Will they be better-funded entrepreneurs who have long prepared for such a moment? Or will they be the titans of tech?

With the world in upheaval, enterprising minds are already whirring. Some of them are altruistic: schoolchildren, for instance, have been 3D-printing plastic visors for front-line workers. Some of them are saucy, such as the Thai bodybuilders, put out of work by lockdown, who last month set up Bsamfruit Durian Delivery, promoting it on Facebook not only with photos of durians and mangoes, but of taut abs and bulging bosoms.

Some of them will simply be hungry for fame and fortune, believing, like Michael Moritz of Sequoia Capital, a VC firm, that social changes accelerated by the crisis, such as food delivery, telemedicine and online education, will eventually generate lucrative business opportunities.

They will also expect the economic slump to wipe out incumbents, muting competition and freeing up space and manpower—provided governments do not interfere with the inevitable by propping up zombie firms.

But even with the best ideas in the world, first-time entrepreneurs will struggle to convince investors to give them capital in the depths of the crisis, not least if they can only pitch to them over Zoom.

Instead, the more likely standard-bearers of creative destruction will be existing firms, albeit small ones, which raised enough money before the crisis to survive it and will maintain their flair for innovation throughout, says Daniele Archibugi of Birkbeck, University of London.

There may be plenty of such firms. According to Crunchbase, a data gatherer, startups raised about $600bn worldwide in 2018 and 2019. That provides a cushion of support.

They will, however, have to be quick at shifting from growth to survival and back again, and at embracing new business plans if their old ones are no longer viable.

Betting on an accumulator

Yet it is not just small, scrappy firms that push innovation forward. Big firms have a critical role to play, too. Alongside creative destruction in times of crisis, Schumpetarian academics point to “creative accumulation” in economic upswings, when incremental innovation is carried out in the research-and-development labs of giant firms.

In Europe during the global financial crisis such corporations increased investment into new products and ideas, as did the most innovative small firms. The cash-rich tech giants, such as Microsoft, Amazon, Apple and Alphabet, have become examples of creative accumulation, helping foster innovation during the good times.

They will probably continue to do so during the crisis. As they expand into health care, fintech and other industries, they could even be part of a new wave of creative destruction.

That is the optimist’s scenario. A more pessimistic one is that big tech will use its moneybags and muscle to stifle competition, by buying or scaring off more enterprising rivals. What is in little doubt, though, is that the covid-19 crisis, which has turned so many people’s lives upside down, will eventually produce a wealth of new business opportunities.

If it attracts swarms of entrepreneurs crawling over cosy oligopolies so much the better. But even if the tech titans prevail for now, they will inevitably find themselves victims of the forces of change.

Schumpeter’s “perennial gale of creative destruction” will one day blow them away, too.

Deflation is the real killer of prosperity

The US is grappling with an economic malady that has gone unnoticed

Stephen Moore

Bicyclists pass the U.S. Treasury building in Washington, D.C., U.S., on Thursday, April 16, 2020. President Donald Trump threatened Wednesday to try to force both houses of Congress to adjourn -- an unprecedented move that would likely raise a constitutional challenge -- so that he can make appointments to government jobs without Senate approval. Photographer: Al Drago/Bloomberg
The US Treasury, which is far from being ‘out of ammunition’ © Bloomberg

The coronavirus lockdown has pummelled the US economy, with some 30m jobs destroyed and trillions of dollars of output and wealth lost.

Compounding the havoc is an economic malady that has gone unnoticed: one of the most severe deflations in modern history. Unlike coronavirus, it shows no signs of abating. Prices are tumbling.

The March personal consumption expenditures gauge fell at a 7.5 per cent annual rate, while the Consumer Price Index in April fell by more than in any month since December 2008. More worrisome is the trend in commodity prices, the best day-to-day indicator of inflation. We are now seeing a downward price spiral.

We know that oil prices have plummeted this year, reflecting a rapid fall in global demand, but the shortage of global dollar liquidity is adding to the industry’s pain. Virtually all commodities are seeing declines.

The leading commodity price index, the CRB, is down early a third since February. Or look at the yields on Treasury bonds and Tips (Treasury Inflation-Protected Securities).

Louis Woodhill, a senior fellow at the Committee to Unleash Prosperity, notes that the US Federal Reserve’s “target PCE inflation rate is 2 per cent, and the market is betting that PCE inflation will average barely over half that rate (1.1 per cent) for the next 30 years!”

Both Mr Woodhill and I have been warning of the damage from falling prices for many months.

Our deflation diagnosis may seem surprising because Congress has added some $3tn to the debt and the Fed has injected at least $2.1tn of dollar liquidity into the economy.

The central bank has also cut interest rates close to zero. These actions are normally associated with rising, not falling prices.

So how are we experiencing the opposite result?

When the world gets hit by a catastrophic event one effect is always a stampede to the US dollar for safety. Americans are hoarding dollars, nervous investors are flooding into cash and foreigners are buying the safest investments they can find: US government bonds, which are repaid in dollars.

Deflation, as we discovered during the Depression of the 1930s, when rapid price declines drove the economy to its knees, is a killer of prosperity. Workers get crushed because real labour costs rise, which shrinks hiring and drives up unemployment.

Yet even with every market signal flashing deflation, academics and the Fed are still more worried about inflation. Former Fed governor Larry Lindsey argues in his latest newsletter that there will be a coming inflation when the economy recovers. The inflation hawks may be right, but when 30-year bonds are trading at 1.35 per cent interest rates, the collective wisdom of the market is making a huge bet in the other direction.

Let us assume that the prediction of future inflation, because of all this government borrowing, is correct. This is still not an argument for tolerating the growth-killer of deflation now. If the Fed were targeting commodity prices, it would inject massive dollar liquidity now. As the economy begins to recover, and if commodity prices start to rise rapidly, then it is time to start draining that liquidity.

When your house is on fire, you turn the hoses on and worry about the water damage later.

Have Fed chairman Jay Powell’s interventions failed?

No. If anything, the Fed has actually been too timid in reacting to the crisis. By refusing to let prices guide monetary policy — much as his predecessor Paul Volcker did while killing the inflation of the 1970s — the Fed is still depriving global markets of the dollar liquidity they are pleading for.

If this isn’t corrected, falling prices will prevent the V-shaped recovery that the US and the world desperately need. The good news is the Fed and the Treasury are far from being “out of ammunition”.

They should take the following steps. First, the interest rate that the Fed pays on bank reserves should be reduced to zero (from 0.1 per cent now). Then payroll taxes should be eliminated for the rest of the year (and all those already paid this year by workers and employers refunded) until the deflation abates.

This is much more efficient than more federal spending.

The Treasury should also be authorised to swap T-bills for the non-marketable Treasury securities in the Social Security Trust Fund, so that its trustees can sell them and buy common stocks. If this had been done during the 2008 crisis, social security would have reaped a gain of trillions of dollars, based on the rise in US share prices over the decade.

Share purchases should be done via an exchange traded fund, so that the government has no corporate voting rights.

If the US economy is to get back to the prosperity of Donald Trump’s first three years in office, it isn’t enough to conquer coronavirus.

The Fed and the Treasury must also boldly slay the other invisible killer of growth — deflation.

The writer is a member of Donald Trump’s economic recovery task force and co-founder of the Committee to Unleash Prosperity

Hedge funds braced for second stock market plunge

Managers say asset prices have become too detached from bleak fundamentals

Laurence Fletcher in London

New York Stock Exchange in Wall Street. There are fears investors may have become too complacent after the recent surge in share prices © AFP via Getty Images

Hedge funds are getting ready for another slump in stock markets after growing uneasy that surging prices do not reflect the economic problems ahead.Some managers fear that equity investors, used to buying the dips during the decade-long bull market that ended in March’s sharp sell-off, have become too complacent about how quickly economies can recover from the coronavirus crisis and how effective stimulus packages from central banks and governments can be.

The S&P 500 index completed its best 50-day run in history on Wednesday, according to LPL Financial, closing within 8 per cent of its record high of mid-February.

“The markets are priced to perfection,” said Danny Yong, founding partner at hedge fund Dymon Asia Capital in Singapore.

“The stability in equity markets does not reflect the job losses and the insolvencies ahead of us globally.”Mr Yong has been buying put options — which protect against market falls by allowing their owner to sell at a pre-determined price — on stock indices and also on currencies sensitive to risk appetite such as the Australian dollar and the Korean won.

“I believe we will see new lows in global equity markets later this year,” he added. “As March . . . has shown us, prices cannot diverge from fundamentals for too long.”Other hedge fund managers have expressed concerns about the sharp rebound in stocks from the March lows.

Line chart of S&P 500 index 12-month forward price/earnings ratio showing US blue-chips reach highest valuation since the early 2000s

Stanley Druckenmiller, a protégé of George Soros who stepped back from managing outside money a decade ago, recently said he expected a wave of bankruptcies and that a V-shaped economic recovery was a “fantasy”.

Paul Singer’s Elliott Management, which has $40bn in assets, wrote in its most recent letter to investors that since the impact of the economic downturn is greater than that of the 2008 financial crisis, “our gut tells us that a 50 per cent or deeper decline from the February top might be the ultimate path of global stock markets”.

The fund made money during the first-quarter crash from hedges in stocks and credit, and said it was trying to find new ways of protecting itself against another market fall after some hedges became more expensive.

Despite a slew of bleak economic data — including more than 40m Americans filing for unemployment benefits and an expected record contraction in the eurozone economy in the second quarter — the S&P 500 has surged almost 40 per cent since its trough in March, leaving it down just 3 per cent for the year.

The index is now trading at more than 22 times expected earnings for the next 12 months, according to FactSet figures, taking the common valuation measure back to levels not seen since the early 2000s.

Standard & Poor’s building in New York’s financial district. The S&P 500 has surged almost 40 per cent since its trough in March © Reuters

Mr Yong believes investors could soon discover that the so-called “Fed put” — the concept that the central bank will step in to support markets — may be reaching its limits.

“Some people believe the Fed’s unconventional measures are limitless but this is not the case,” he said.

“It's now about the “Trump Put” — how much more stimulus can he push through? I think he [US president Donald Trump] will be constrained by Democrats in the House.”

Morgan Stanley said in a recent note that its hedge-fund clients hold a net short position of about $40bn in Euro Stoxx 50 futures. Global macro hedge funds have sharply reduced their exposures to stocks this year, according to JPMorgan Cazenove.

“It is entirely possible that there will be a fourth-quarter reckoning, where a second wave of job losses and a prolonged period of business failures tests equity sentiment,” said Seema Shah, chief strategist at Principal Global Investors.

Francesco Filia, head of London-based hedge fund Fasanara Capital, is holding 70 per cent of his fund in cash and also using put options and other instruments to hedge his portfolio while he waits for a “severe rupture” in markets.

He sees threats in the trend towards “deglobalisation,” which could drive inflation higher, and growing political interference in the technology sector, which could hurt shareholder returns.

He expects a potential “2008-style . . . daily liquidity crisis” as investors try to pull money from exchange traded funds that may not be able to meet those redemptions.

However, many fund managers are reluctant to bet outright against stocks in the face of stimulus efforts from the Federal Reserve and European Central Bank, both of which have argued they have firepower in reserve.

The market hitting new lows “is possible”, said Tom Clarke, who has a low exposure to stocks at a macro fund at William Blair in London. But he added that government and central bank stimulus packages have “taken on almost mythical proportions.

There’s no doubt in which direction policymakers want markets to go.”

Additional reporting by Adam Samson

Which Post-Pandemic Government?

Although the COVID-19 pandemic has shown why high-level coordination is sometimes necessary for managing emergencies, it has also underscored the risks of placing too much power in the hands of an incompetent central authority. The best approach is a middle path, with a slight bias in favor of decentralization.

Raghuram G. Rajan

rajan62_Drew AngererGetty Images_ambulancehealthUScapitol

CHICAGO – Even with the COVID-19 pandemic still raging, speculation has turned to what society will look like afterward. Citizens, shocked by how easily their lives can be upended, will want to reduce risk. According to the emerging new consensus, they will favor more government intervention to stimulate demand (by pumping trillions of dollars into the economy), protect workers, expand health care, and, of course, tackle climate change.

But every country has many layers of government, so which one should expand? Clearly, in the United States, only the federal government has the resources and mandate for nationwide decisions on issues such as health care and climate change.

Yet it doesn’t necessarily follow that this level of government should grow larger still. After all, it could adopt policies that protect some constituencies while increasing the risks faced by others.

In the case of COVID-19, some countries have centralized decision-making about when to impose and lift lockdown measures, whereas others have left these choices to state governments, or even municipalities. (Others, like India, are in transition between these approaches.) What has become clear is that not all localities face the same trade-offs.

In crowded New York City, a strict lockdown may have been the only way to get people off the streets, and its economic impact may have been softened by the fact that many there work in skilled services like finance, which can be done remotely.

Moreover, even laid-off waiters and hotel workers know they won’t get their jobs back until the public feels safe going out again. Health concerns seem to be paramount.

In contrast, in Farmington, New Mexico, the New York Times reports that, “few people know anyone who was ill from the coronavirus, but almost everyone knows someone unemployed by it.” The lockdown, imposed by the state’s Democratic governor, seems to be unpopular across a community that was already in serious economic decline before the pandemic. In this case, economic concerns have trumped more modest health worries.

These differences show the drawbacks of a centralized, one-size-fits-all approach. But decentralization can also be problematic. If regions have contained the virus to different degrees, is travel between them still possible? It stands to reason that safer regions would want to bar visitors from potential hot zones – or at least subject them to lengthy quarantines. A fast, cheap, reliable testing system might solve the problem, but that is currently unavailable.

Some degree of harmonization between regions can therefore be beneficial, not least in the procurement of medical supplies. In the absence of federal coordination, US states have been in a bidding war with one another over scarce medical supplies from China. In normal times, competitive markets would allocate such goods most efficiently.

But in a health emergency, markets may perform poorly, allocating goods according to buyers’ ability to pay rather than their need; rich states would buy up all the ventilators and testing kits, leaving poorer states with none. The country’s ability to contain the pandemic would suffer.

In this situation, centralized procurement could keep prices lower, potentially enabling more need-based allocation. But “could” and “potentially” are the operative words. If a central government has questionable motives or simply is incompetent, the calculus changes. As we have seen in Brazil, Mexico, Tanzania, and the US, when heads of government minimize the dangers of the pandemic, they can do considerable harm to their country’s response.

Among other failures, Brazil’s federal government seems to have had difficulty distributing ventilators it bought. In the United States, Republican-governed states have allegedly had easier access to central medical supplies than states where Democrats are in control.

And in India, the central government imposed a stringent lockdown without making the necessary arrangements for millions of migrant workers, who were forced to flee the cities for their home villages.

Families with children walked hundreds of miles, helped only by the kindness of strangers and local authorities, and potentially carrying the virus with them. A decentralized decision-making process might have allowed states that locked down later (because they initially had fewer cases) to learn better management from those that went first.

Given that extremes of centralization and decentralization can both be problematic, a coordinated middle ground may work best. The federal government might establish minimal standards for closing down and opening up, while leaving the actual decision to states and municipalities.

That said, if there is to be a bias, it should be toward decentralization, following the principle of subsidiarity, whereby powers are delegated to the lowest-possible administrative level that will be effective.

There are important reasons to favor a carefully managed decentralization. Not only do members of smaller political entities tend to face similar problems; they also typically demonstrate greater social and political solidarity, which makes it easier for them to engage with one another and find solutions.

While local politics might occasionally resemble the Hatfield-McCoy feud of nineteenth-century Kentucky and West Virginia, it generally suffers less gridlock and antagonism than what one finds in central legislatures today. And people feel a greater sense of ownership over decisions taken by their locally elected or appointed bodies. This empowerment can help them devise policies to benefit from national and global markets, rather than being at their mercy.

This is why, as we prepare policies to aid the recovery and strengthen post-pandemic health, education, and regulatory systems, we should also think about who will make the decisions and where. For example, a fair share of stimulus spending on infrastructure should take the form of block grants to communities, which are in the best position to allocate funds according to need.

And while national climate policies cannot be determined separately in every community, they can at least reflect a bottom-up consensus.

Rising authoritarianism around the world reflects widespread yearning for charismatic political leaders with whom ordinary people can identify with. Such demagogues have used their popular support to avoid constitutional checks and balances, taking their countries down ruinous paths.

Expanding government further while limiting the risk of authoritarianism requires independently powerful bodies that also enjoy popular support. Constitutionally decentralizing more powers to regional and local government may be the way forward.

Raghuram G. Rajan, former Governor of the Reserve Bank of India, is Professor of Finance at the University of Chicago Booth School of Business and the author, most recently, of The Third Pillar: How Markets and the State Leave the Community Behind.

Debt investors lay claim to islands, cruise ships and theme Parks

Companies pledge all manner of assets as collateral for Covid-19 rescue deals

Robert Smith, Joe Rennison and Nikou Asgari in London

Norwegian Cruise Lines pledged its island Great Stirrup Cay as collateral, while Delta Air Lines offered take-off and landing slots © FT montage; James E. Scarborough/CC; Bloomberg

Great Stirrup Cay is an island in the Bahamas that offers tourists the chance to relax on white sandy beaches, snorkel with sea turtles or even swim with wild pigs on a neighbouring islet.

This month the island also offered fund managers enough comfort to buy almost $700m of junk bonds issued by Norwegian Cruise Lines. The Miami-based operator pledged the 268-acre Caribbean idyll it has owned since 1986 as collateral, along with a second island in Belize and a couple of ships.

It was a make-or-break fundraising to tide Norwegian through the Covid-19 crisis that has upended the tourism industry.So-called secured debt deals were once a rarity in the corporate bond market, but American companies are now pawning their family silver as never before.

More than 100 cruise ships, over two dozen theme parks and even the rights to take off and land at airports around the world are all now up for grabs, if companies fail to repay their debts or stumble into bankruptcy.

“I get that some fixed-income investor is not going to want to be the owner of a Caribbean island,” said Tim Conduit, a partner at Allen & Overy in London. “But they are going to want to be in a better position as a creditor. ‘Some collateral is better than no collateral’ is probably what investors are thinking.”

Value and jurisdiction of Carnival’s $4bn bond collateral Net book value

Last month companies issued $21bn of new junk-rated secured bonds in the US, according to Debtwire — a number that bankers and investors believe to be a record. Higher-rated investment-grade companies have also provided extra backing on their bonds, including the cruise liner Carnival, which began the wave of issuance in April with a $4bn debt deal backed by 86 ships.

As the coronavirus crisis intensified in March, the bond market did not seem the obvious place for corporate treasurers to turn for emergency funds. Many companies back then were talking to specialist hedge funds about potential rescue loans on onerous terms.

But after the Federal Reserve launched a package of stimulus measures that buoyed bond markets at the end of that month, Carnival’s bankers found that mainstream fixed-income fund managers were casting an eye over the company’s scores of otherwise unencumbered cruise ships.

Its deal ended up serving as a blueprint. Carnival demonstrated that with a high enough interest rate — near to 12 per cent — and a low loan-to-value, or LTV, ratio — a measure of a company’s debt to the value of the secured assets — even a company leaking $1bn of cash a month could access the bond market.

Miami-based Carnival said its ships were worth more than $27bn on paper, but also warned that finding buyers could be tough, as the market for used cruise ships is small.

Line chart of $500m 10.5% 2025 bond showing AMC's secured bonds plunge straight after issuance

“These are companies with no visibility on their revenue,” said Fraser Lundie, head of credit at Federated Hermes. “The one thing they can provide visibility on is the LTV.”

Some types of collateral are proving more alluring than others.

AMC Entertainment tapped the junk bond market for $500m in April, giving the US cinema chain enough money to ride out a total shutdown of its theatres until Thanksgiving. But investors and traders have subsequently dumped the bonds, driving their price down to just 83 cents on the dollar a month after issuance.

In part that is because of the weaker collateral behind AMC’s deal. The company owns just 62 of its 937 cinemas outright. Along with a few parcels of land including a vacant plot by a highway in Texas, they are the company’s only real physical assets.

Meanwhile, a $2.25bn bond sale from United Airlines failed to get off the ground this month, as investors expressed scepticism about the value of the ageing aircraft the US airline offered as collateral.

By contrast, Delta Air Lines raised $5bn weeks earlier with little difficulty, despite offering up few physical assets. Instead the Atlanta-based carrier pledged its rights to operate gates and fly planes from airports such as Heathrow in London or John F Kennedy in New York.

Roger King, an analyst at research firm CreditSights, described these take-off and landing slots as “fuzzy collateral,” saying their real value to debt investors would be tested only by bankruptcy.

“It’s like a bottle of old wine — you never want to open it up, because you don’t want to know if it’s bad or not,” he said.

Some investors fear that even traditional hard assets such as boats and planes could prove challenging for investors to enforce their claims on. None of the 86 ships Carnival pledged to bondholders, for instance, is registered in the US. The ships are instead flagged in jurisdictions including Bermuda, Panama and Curacao.

That means that seizing the ships to sell them could prove tricky. “The security is governed by the country the asset is situated in,” said Shweta Rao, an analyst at research firm Reorg.

“Enforcing your security on a ship is not easy.”