Econ Weekly (August 16, 2021)

Photo courtesy of the Visit Indiana

Inside this Issue:

  • The Climate Conundrum: Balancing Economy and Ecology      
  • The Metaverse: Facebook’s VR Visions
  • Price Check: Inflation Worries Wane a Bit
  • Chicken Combo: Cargill Gains Poultry Power  
  • Averting Another Hurting: Fixing the Treasury Market’s Broken Plumbing  
  • Eli Lilly: Down on the Pharm
  • Correlation Sensation: There Really Is a Link Between Profits and Stock Prices
  • Missing Medics: America’s Worsening Shortage of Doctors and Nurses
  • Peking Peril: The Hazards of Buying Chinese Stocks
  • Track in the Day: A History of Railroads in the Northeast   
  • And This Week’s Featured Place: Indianapolis, Indiana, The Midwest’s Hoosier Hub

Quote of the Week

“The richest 22 men in the world have more money than all the women in the whole of Africa.”

– Alberto Gallo, Algebris Global Credit Opportunities (speaking on the “Macro Hive Conversations” podcast)

 

Market QuickLook

The Latest

Al Gore called it the “inconvenient truth.” Others might call it the existential threat. Earth’s climate is changing in dangerous ways, leaving humanity in a bind. Few things are more useful to growing an economy—and improving people’s incomes—than burning fossil fuels for energy. But doing so, a new UN report again makes clear, is making the climate change problem worse. Can the world and its largest economy manage to simultaneously address two seemingly conflicting goals: Improving standards of living and quickly reducing greenhouse gas emissions? Failing at either would bring great misfortune.

The dilemma was on display in Washington last week as President Biden both 1) campaigned for legislation heavy on climate mitigation efforts and 2) called on OPEC to produce more oil to ease inflation for American households.

Helpfully, inflation is easing. The latest consumer price index (CPI) for July showed a 0.5% increase from June to July, still high to be sure, but also the slowest monthly increase since February. Energy, as Biden’s message to OPEC suggests, remains a big driver of price gains. Exclude energy and food though—both are tied to the volatile commodity market—and the easing trend was even more pronounced. Price pressures for vehicles are easing for example—the monthly rate of increase in used car prices fell sharply. House prices, remember, while soaring, are considered an investment (like stocks or bonds) and thus not part of the CPI. Housing-related costs that are included, meanwhile, remain relatively stable. Importantly, medical care including pharmaceuticals has been one major area of essentially nonexistent inflation over the past year (it’s been kind of the opposite in recent decades: low inflation except in medical care).

Prices aren’t easing as much for companies, as the producer price index shows. Along with higher energy costs, transportation and warehousing remains a pain point. It’s perhaps becoming more difficult for firms to pass these cost increases on to consumers. But speaking of consumers, they’re apparently growing more pessimistic about the economy, judging from a newly-released University of Michigan survey. New surveys of small businesses suggest unease as well.

A bipartisan infrastructure bill passed the Senate, allotting $1 trillion to projects ranging from road improvements to expanding broadband access. It still must pass the House, however, which could be a challenge. Many would-be House supporters say they’ll only vote yes if combined with a gargantuan $3.5t package addressing issues like affordable housing, clean energy, education, health care and childcare. Others though, say they’ll only accept the infrastructure and care economy bills together if the latter is pared back. As of now, the proposal as envisioned by the Senate includes paid family and medical leave, Medicare coverage for dental and vision benefits, lowering the Medicare eligibility age, extending child tax credits, Universal Pre-K for 3- and 4-year olds, childcare for working families and tuition-free community college. It also includes tax cuts for American households earning less than $400,000 per year but tax increases for those earning above (and on corporations as well).

As fiscal matters unfold on Capitol Hill, the Federal Reserve appears ready to end its monthly bond purchases—or at least announce that they’re ending—sometime this fall or maybe even at a Wyoming symposium later this month. That would be a step toward post-crisis monetary policy normalization and a prelude to eventually raising interest rates. The Fed, meanwhile, along with other financial regulators, have their work cut out addressing worrisome vulnerabilities in the mother of all financial markets: The Treasury market. And that’s separate from the debt ceiling constraint that risks financial armageddon if not removed soon.

If that weren’t enough to test the nerves of Treasury Secretary Janet Yellen, tensions with China threaten the world’s most important bilateral trading relationship. Both economies depend greatly upon each other, a fact to which companies like Apple, Boeing and Walmart would attest. But mutual economic dependence is no guarantee of rational political outcomes.

Should Yellen worry about the big increase in U.S. federal debt? That’s a matter of great debate among economists. What’s clear, though, is that sovereign debt fears are not playing as large a role in policymaking as they did in the aftermath of the last recession. From Washington to Berlin, there’s no longer the sense of urgency to impose fiscal austerity. During the last recession, keep in mind, the economy had a demand problem. Today, it has a supply problem.

It still, unfortunately, has a Covid problem too. Airbnb, while experiencing extremely strong demand this summer, noted a recent slowdown in bookings, perhaps attributable to Covid’s Delta surge. Disney’s great summer too, is clouded by uncertainty about future visits to its theme parks.

In other news, the U.S. Census published more data from its 2020 population count, a major determinant of political power across geography. In the crypto world, Coinbase said Ethereum is now more traded than Bitcoin. Stocks were up. Treasury yields were down.

Be sure to read this week’s profile of Indianapolis, the state capital of Indiana. Its thriving economy rests upon more than just state government though. Read on for more about the care economy and the future of business travel, plus the mystery of the bond market and a history of the railroads. And come back next week as the nation’s big retailers report Q2 earnings. Next week’s Featured Place, meanwhile, isn’t thriving like Indianapolis. Quite the contrary.

Companies

  • Eli Lilly: As the largest private-sector employer in Indianapolis, the drug maker Eli Lilly certainly has friends among Indiana politicians. That’s always helpful in the highly political pharmaceutical industry, which benefits greatly from federal programs like Medicare Part D, implemented in 2006, and the Affordable Care Act of 2010. Naturally, after Uncle Sam started covering prescription drug costs for American retirees, and after the ACA delivered health insurance coverage to more Americans, drug demand increased. Laws can change though, and President Biden just last week said he wants Medicare to have the right to negotiate prices for prescription drugs, just as it’s allowed to negotiate prices with other aspects of health care. It’s a hot issue in light of Biogen’s expensive, controversial and questionably effective new Alzheimer’s drug, which sure enough got lots of attention in Eli Lilly’s Q2 earnings call last week. Eli Lilly too has an Alzheimer’s treatment in development, with plans to submit it for regulatory approval before the end of this year. It will also seek approval for a new diabetes treatment. Its biggest revenue-producing product right now happens to be a diabetes drug, marketed as Trulicity (sales of which spiked 25% y/y last quarter). It’s also a big player in treating cancer. As for Covid-19, Eli Lilly doesn’t produce a vaccine, but it does produce antibody treatments useful for those already afflicted. The company, incidentally, has spent more than $300m on Covid research and development. Separately, it said medicine sales in China are increasing rapidly. And yes, Eli Lilly is a highly profitable company, earning a $1.7b Q2 net profit (ex special items) on $6.7b in revenue.
  • Cargill, the Minneapolis-based food giant, is teaming with New York’s Continental Grain Company to buy Mississippi-based Sanderson Farms for more than $4b. The deal, if approved, would create one of the country’s largest poultry producers, with plants across Alabama, Arkansas, Georgia, Louisiana, Mississippi, North Carolina, and Texas. Cargill is already a big producer of beef and turkey. And it used to be big in pork too, before selling that business. Continental Grain, for its part, owns Wayne Farms, the country’s seventh largest poultry producer. And by combining with Sanderson, they’ll both be better positioned to compete with the two giants of the poultry field: Arkansas-based Tyson Foods and Colorado-based Pilgrim’s (controlled by Brazilian food giant JBS). Purdue, Koch and Mountaire are some of the market’s other big players. In some ways, it’s good to be selling checking right now. Demand for products like chicken wings and sandwiches is at record levels. And so are prices. Indeed, Sanderson last quarter earned a solid 11% operating margin. But navigating the pandemic hasn’t been easy, with plant disruptions, high worker absenteeism due to Covid, price volatility and rising input prices (most importantly for feed grain, i.e., the corn and soybean products required to feed its chickens). The past year saw significant weather disruptions as well. Some of Sanderson’s top customers by the way, including supermarkets like Walmart and Publix, restaurants like TGI Fridays and Buffalo Wild Wings, and providers of food to hospitals and schools, etc. like Sysco.

Tweet of the Week

Sectors

  • Finance: David Beckworth of the Macro Musings podcast turns to professors Kathryn Judge and Anil Kashyap for insights on the stability of the financial system, always a topic of great importance. After the financial debacle of 2008-09, Congress (through the Dodd-Frank Act) mandated heavy capital requirements for banks. But what happened? A lot of lending and other financial activity migrated away from banks, into the shadows. At the same time, Kashyap says, the architecture of the U.S. Treasury market didn’t keep up with changes in the role of Treasuries in global financial markets. Such fragilities were made clear in the fall of 2019, and then again with the onset of the pandemic in the spring of 2020. In the first few weeks of March 2020, investment-grade corporate bonds, equity and high-yield debt lost roughly a fifth of their value. Hedge funds and others, needing cash quickly, liquidated their Treasuries at scale, overwhelming the brokers and dealers who facilitate trading in that market. Only with Federal Reserve intervention were financial markets calmed. Kashyap calls the Treasury market the “anchor of everything” when it comes to finance. One key problem is that the Treasury market depends on those aforementioned brokers and dealers for smooth and liquid trading, but these broker/dealers were disincentivized from playing their role by some of the new regulations. Judge and Kashyap call for reforms like introducing central clearing to the Treasury market. Another recommendation—establishing a standing repo facility to ensure all-weather access to liquidity—was just adopted by the Fed. More generally, says Judge, having static regulations is tantamount to deregulation, because the market is always evolving. Regulators must be given authority to react to changes. The two professors and other colleagues working on financial reform also have ideas on how to prevent further runs on money market funds, a major cause of the last crisis. Kashyap highlights a “festering” problem with insurance markets as well. He wisely says such problems are better addressed “when the sun is shining than after the flood has happened.”
  • Health: Last week’s issue of Econ Weekly mentioned AMN Healthcare Services and its observations about staffing shortages at hospitals and other medical facilities. But it’s not just a Covid thing. AMN made clear that the tight labor market won’t change anytime soon. And this was something the U.S. was dealing with even before the pandemic. Looking ahead, the population of people aged 65 or older will reach 72m in 2030, up from 40m today. That means more demand. But roughly half of all registered nurses and doctors today are aged 50 or older, and a third of all doctors will be 65 or older by 2030. As a result, AMN sees a shortage of 139,000 doctors a decade from now. Annual turnover in the nursing profession, meanwhile, can be as high as 33%. So AMN and other staffing companies rely on recruits from abroad, typically offering work visas valid for two years. The Philippines happens to be a top recruiting spot for nurses. The more general takeaway is that health care—and the care economy more broadly—is today a central feature of the U.S. economy. That wasn’t the case for most of American history, in which manufacturing things—from textiles to automobiles—had a more dominant role. Two essential features of the shift toward a more service-based economy are 1) the overseas outsourcing of manufacturing and 2) the growth of health care.
  • Technology: What’s the hottest industry right now for merger activity? Bloomberg asked this question of Thaddeus Malik, chair of the global mergers and acquisitions practice at Paul Hastings. His answer? Basically, anything technology related. Companies, he said, are racing to digitize their operations, improve their supply chains and monetize their data. And often, it’s cheaper and easier to accomplish such goals by simply buying those capabilities via a takeover.
  • Business Travel: Airlines and hotels are not going to like this: Skift reports that two major consultancies—France’s Capgemini and New Jersey’s Cognizant—plan to “pare down their business travel to an absolute minimum for the post-pandemic future.” Apparently, they’ve concluded that running their businesses virtually works well, or well enough to avoid spending the roughly $900m on travel the two companies collectively spent in 2019. Indeed, global consulting companies are some of the travel industry’s top customers. Will other giants like McKinsey, Bain and BCG adopt a similar stance?
  • Fitness: Nautilus, a Washington State company selling at-home fitness equipment, says 25% of former gym goers “have consistently expressed that they have no plans to ever return to the gym.” Many others, it added, are changing how they balance their workout time between their gyms and their homes. Separately, Nautilus is trying to transform from “a product-led hardware company to a consumer-led digital company.” Not that making good money selling hardware is impossible—look at Apple. But it usually requires more labor, more capital, more overseas outsourcing and lower margins.

Markets

  • Treasuries: Former New York Fed president Bill Dudley, writing in Bloomberg, wonders how 10-year Treasury yields can be so low when the economy is growing at an annualized, inflation-adjusted rate of 6.5% (that’s the Q2 figure), while adding an estimated 850,000 job (in July). All the while, consumer prices have risen 5% over the past year. “Such a low long-term interest rate,” he writes, “is totally inconsistent with rapid economic growth, strong job gains and high inflation… This is shocking not just because the level is low but also because real yields have been falling even as the economy recovers.” He gives two possible explanations. One is demographics: “As the developed world’s population ages, its savings are exceeding desired investment—a secular trend that isn’t likely to change anytime soon.” Put another way, low demand for investment means low demand for borrowing money which means the price of borrowing money (the interest rate) is low. Dudley’s second explanation is the Fed’s quantitative easing (QE), and more specifically its purchase of many longer-term Treasuries. This takes these securities out of circulation, replacing them with bank deposits and reserves. And investors respond by seeking new safe, longterm securities to replenish their holdings, hence a Treasury buying spree that pushes prices up and interest rates down. Investors, meanwhile, would rather a tiny rate of return on Treasuries than the 0% interest a bank deposit would pay (or negative nominal rates that some foreign government debt currently offers). “This is why QE may be considerably more powerful than generally appreciated.” But things could change when the Fed eventually moves to raise rates. Treasuries will then face competition from alternative safe assets (like bank deposits) yielding more than just zero.
  • Labor: In June, the economy had 10.1m job openings, the Labor Department said. That seems weird, given the 8.7m people that are currently unemployed, meaning not working and actively looking for a job. Seems like there are plenty of open jobs for anybody who wants one. Ah, but it’s not so simple. The problem is a skills mismatch, with many jobs going unfilled because available applicants lack the qualifications. Indeed, as the economy gets more and more high-tech, more and more jobs require technical skills that not enough Americans are learning.

Government

  • Monetary Policy: Dallas Fed President Robert Kaplan is unequivocal: It’s time to stop tapering. On the Bloomberg “Odd Lots” podcast, he expressed worry about the unintended consequences of so much asset buying, especially with respect to mortgage-backed securities at a time when housing prices are sharply increasing. The policy, he said, while necessary during the depths of the crisis, tends to yield more benefits to wealthier people who own assets, including houses. More to the point, buying securities can be helpful when trying to generate demand, but the economy has plenty of that now. It’s problem right now is supply, and asset purchases don’t help much with that. He’s not advocating a tight monetary policy, just one that’s not quite so loose. “It might be time,” Kaplan said, “to reduce the RPMs on the car.” In fact, tapering now might give the Fed more flexibility to be dovish on interest rates later. Separately commenting on the current supply and demand imbalances, he warned that semiconductor shortages could ripple into more and more of the economy, and that labor shortages might prove more persistent (in other words less transitory) than many people think. Separately, the large number of people who retired early during the pandemic, plus longterm demographic headwinds, makes productivity gains imperative. To help in that regard, he champions policies to boost childhood education and workforce training. He’s most concerned about the 46m Americans with just a high school education or less. Worryingly, rates of Black and Hispanic enrollment in skills training have dropped during the pandemic. So have high school graduation rates. Dropout rates are up. And these trends can’t be good for future labor force participation. Kaplan also adds that inflation is hurting lower-income people most, while the supply shortages are hurting small businesses most. The Delta variant, meanwhile, is delaying the matching process in labor markets.
  • Monetary Policy: Kaplan is hardly alone among Fed officials saying it’s time to taper. Kansas City Fed chief Esther George is in the same camp, adding another voice to what increasingly seems like a consensus. She provided her thoughts at a virtual seminar hosted by the National Association of Business Economists last week (NABE), saying “the time has come to dial back the settings.” Speaking about the current state of the economy, George raised what seems to be a contradiction: In some respects, the economy seems to have very little production slack (companies can’t find workers, inventories are depleted, input and transport costs are rising, etc.). But at the same time, there are 6m fewer workers in the labor force now than before the pandemic, which seems to indicate lots of slack. George’s Kansas City region by the way, covers seven states that rely heavily on the energy, agriculture and rail transport sectors. Kansas City itself is home to the railroad KCS, currently the target in a takeover battle involving two larger Canadian peers.
  • Economic Measurement: At that same NABE seminar where George presented, economists and statisticians—many of them from government agencies like the Bureaus of Labor Statistics and Economic Analysis (BLS and BEA)—walked through their methodologies for producing closely watched reports like last week’s Consumer Price Index summary. In the age of Big Data, the ability to track and identify economic trends is improving. But there are challenges too, like how to measure prices and output in the ever-growing health care sector. There was lots of discussion about the economy’s performance and prospects too. Here are a few highlights:
    • Lawrence Yun of the National Association of Realtors notes how housing prices are rising faster this year than even in the 1970s, a decade almost synonymous with rising prices. The cause this time, unlike in the mid-2000s, is not unscrupulous lending but a genuine (and severe) housing shortage. But what’s causing the shortage? Yun points to the many family-owned homebuilders that went bust after the last crisis. While many were small, they collectively built more homes than the industry’s big players. Yun mentions strict land use laws as another reason. Helpfully, the U.S. should see about 1.5m housing starts this year, which is roughly what’s required annually to meet demand given rates of new household formation. But that will still leave a big gap following 15 years of underbuilding. There is one area of the market where housing demand is down: Foreign purchases have plummeted in the past 12 months. Separately, Yun raises the question of how climate change could affect real estate markets, especially in western states hit by droughts and fires.
    • A big question all economists are asking: Why has U.S. labor participation trended down since its peak (67%) in 2000? The rate is currently just shy of 62%. (Interestingly, the participation rate among Hispanic males is 80%). Lots of theories have emerged in recent years, blaming the decline on everything from the opioid crisis to the addictive appeal of video games. Previous issues of Econ Weekly have discussed the theories of Anne Case and Angus Deaton, who point to an epidemic-like incidence of poor health and premature “deaths of despair” among working-age U.S. males. Trends can vary great by state, however. Labor participation is highest in the upper Great Plains (i.e., Minnesota) and lowest in West Virginia and across the South more generally.
    • Manuel Balmaseda of Mexico’s Cemex discussed America’s trading relationship with the rest of the world, noting how it imports a lot more than it exports, creating a large current account deficit. But international trade statistics require caution. More than two-thirds of America’s imports from Mexico, for example, are related-party transactions, meaning trade within firms (think General Motors “importing” a part from one of its own plants south of the border). Any discussion on world trade, of course, needs to include China, whose accession to the World Trade Organization was the big “game changer” since 2000, Balmaseda says. The U.S. has since lost lots of share in total global trade. But the market has grown enormously, from $2.3 trillion in 1980 to $7.9 trillion in 2000 to $22.6 trillion today. Recent tariff wars, however, are slowing growth. Finally, Balmaseda highlights that the U.S.—for the first time since the early 1990s—invested less in other countries (foreign direct investment) than vice versa.
    • There are many differences between the recession of 2008-09 and the brief but severe recession of 2020. One important one is that the prior recession resulted in many years of weak demand, while the latest one is causing supply problems, not demand problems. Another difference is that households were heavily indebted during the earlier recession, while now, the corporate sector is much more indebted.
    • Dick Rippe of Evercore ISI talked through his use of the BEA’s corporate profit data to draw insights into the economy. Interestingly, despite the recent meme stock craze and apparent disconnect between stock prices and traditional measures of corporate value, stock prices actually do closely track earnings over the long run. More than 60% of the 2019 earnings generated by S&P 500 companies, by the way, came from just three sectors: technology, finance and health care. In Q1, 2021, U.S. corporations earned an aggregate pretax margin of 12%. And they currently pay an implied corporate tax rate of about 13%, with rates having steadily dropped from the 40% range in the 1960s. They might be poised to go up some soon if the Biden Administration’s $3.5 trillion care economy proposal becomes law.

Depicting Rising Inequality in the U.S.

source: Federal Reserve Board  

Places:

  • Indianapolis, Indiana: Hoosier basketball. Peyton Manning and the golden era of Colts football. The world’s most famous speedway. For a city not even large enough for a Major League Baseball team, Indianapolis is nevertheless a sports colossus. You could see it earlier this year when the city hosted the entire March Madness college basketball tournament. The Indianapolis Motor Speedway, seating some 260,000 people, is the largest sporting venue in the world. Sports, according to a 2014 estimate by Indiana and Purdue Universities, generates $3.4b in annual direct spending for the Indianapolis metro area, not to mention support for nearly 10,000 jobs. Sports are not, however, the defining characteristic of America’s 33rd largest metro area. There’s a lot more to its economy, which stands out—along with its Ohio neighbor to the east Columbus—as one of the Midwestern region’s all-stars. The Midwest of course, is often defined not by its all-stars but by its troubled giants, most prominently Detroit. But Indianapolis never relied on manufacturing jobs to quite the same extent. Unlike Detroit, for starters, it’s a state capital. That alone provides an economic base of 35,000 state government employees. It’s a big base of federal government operations too, specifically the General Services Administration. But government employment is hardly the only prerequisite to a city’s success—look at depressed state capitals like Trenton. Indianapolis is much more than a government town. Its largest private sector employer is the pharmaceutical giant Eli Lilly (see the Companies section above). It’s also a leading transportation hub thanks to its location—less than 200 miles from Chicago, Columbus, Louisville, Dayton and Cincinnati. Add another 100 miles and you’re in the radius of Detroit, St. Louis, Milwaukee and Nashville as well. Few cities have as much importance to the trucking industry, perhaps not surprising given all the interstate highways that meet there. It’s a major intermodal rail hub for CSX. Indianapolis airport, though not a major passenger hub, happens to host Fedex’s largest operation after Memphis. Naturally, as a transportation hub, warehouse activity is bustling—Indianapolis is an important distribution center for Amazon, Walmart and the supermarket giant Kroger. Indiana, to be clear, suffered deeply from America’s shift from a manufacturing to service-based economy. According to the Indianapolis Star, citing data from the Bureau of Economic Analysis, the state lost 235,000 manufacturing jobs between 1969 and 2014. That was almost a third of all its manufacturing jobs. But much of that happened outside of Indianapolis, in cities like Gary (see Econ Weekly’s May 17th issue). Within the Indianapolis metro, auto suppliers remain vibrant, led by companies like Allison Transmission. Foreign manufacturers like Rolls-Royce have a major presence in the area. Notably large is the foreign software services company Infosys from India. Simon Property is another big Indy-based company. Salesforce, though based in San Francisco, has a large Indy office. But that’s not all. The city has become a major regional financial center, with outsized importance in the insurance sector. Anthem, most importantly, is one of the nation’s largest medical insurers. Indianapolis more generally has a large professional and business service sector, which usually means high average incomes. And never forget about the health and education sectors, always accounting for a large portion of a city’s total jobs. For companies considering a move, Indiana is notably aggressive in luring companies with business-friendly policies, often contrasting itself with neighboring Illinois. What it can’t do is lure many retirees looking for sunshine—those folks are going to the sunbelt. As a result, population growth isn’t quite Florida like. But with lots of good jobs, the population of metro area Indianapolis grew a healthy 10% in the 2010s. The good jobs attract educated millennials and Gen Z folks too, with efforts underway to become even more attractive by improving transport and entertainment facilities downtown. The pandemic of course hurt. But the subsequent federal stimulus helps, especially so with all the money allocated for state governments. As Indiana’s state capital, Indianapolis stands to benefit. Now if only the Colts can get back to the Super Bowl.

Abroad

  • Canada is once again welcoming American visitors. But only if they’re vaccinated. The U.S., incidentally, still won’t allow any Canadians to visit, other than those travellng for essential reasons. The two neighbors, in normal times, have a trading relationship worth $718b (that’s the 2019 figure) with a roughly equal value of trade going in each direction. Canada is America’s largest trading partner (including both goods and services) and its largest export market, led by sales of vehicles. Canada’s top export item to the U.S. meanwhile, is energy.
  • Chinese stocks: Scott Galloway, on his “Prof G” podcast, spoke with Lux Capital’s Josh Wolfe about the risks of investing in Chinese stocks. The topic is relevant amid Beijing’s sudden crackdown on some of its biggest and most successful technology companies, causing their stock prices to plummet. Many U.S. investors felt the blow. Always keep in mind, Wolfe warns: If you invest in Chinese companies like Tencent and Didi and Alibaba, “you don’t actually own anything.” You don’t have a true equity stake, nor a claim on the company’s assets, nor any governance influence, nor any right to make demands on management. That’s on top of the risks associated with China’s absence of reliable contract enforcement and rule of law. Buying Chinese stocks is a “casino bet that’s loosely tied to underlying equity.”

Looking back

  • Railroads played a huge role in the history of America’s economy, none more so than the Pennsylvania and New York Central lines, both the subjects of Michael Bezilla book “Branch Line Empires.” Based in Philadelphia, the Pennsylvania Railroad, or PRR, would become the country’s largest privately-owned corporation after the Civil War (which ended in 1865). Just as importantly, it became a company of national identity and influence, gaining size and scale as it won control of lines beyond its home state. Within Pennsylvania, it carried one out of every three passengers while earning most of its profits transporting coal, lumber, agricultural products and other commodities. It was also instrumental in the rise to prominence of America’s steel industry in the late 1800s, centered in Pittsburgh and dominated by Andrew Carnegie. And where the railroads came, towns and settlements would arise. The national rail network reached “high tide” in the first two decades of the 20th century, with national freight traffic hitting 366b ton miles in 1916. That same year (the last before America entered World War I and temporarily nationalized its railroads) the system recorded 35b passenger miles. Also by this time, the industry had become much more regulated as government responded to demands not just from shippers frustrated with high prices but even railroads themselves, frustrated by cutthroat competition and failed pooling arrangements with rivals. Not even government regulation, however, could save the railroads from a new form of competition: The automobile. In the wake of Ford’s Model T success in the 1910s, Pennsylvania’s government began subsidizing state highways that largely overlapped the rail network. Soon, trucks were competing for freight shipments. Airplanes followed. To be clear, railroads remained important economic actors, enjoying a mini renaissance after World War II when energy demand soared, leading to a boom in coal shipments to electric utilities. These utilities in fact became the PRR’s largest customers. Trains themselves, meanwhile, stopped using coal as a power source, switching to more efficient diesel-powered electricity. For companies like the PRR and the New York Central, however, this wasn’t enough to offset heavy losses from legacy passenger operations. As Bezilla writes, ongoing competition from trucks, high terminal costs, rigid government regulations and the northeast’s shrinking industrial base led to severe financial difficulties. In 1968, the PRR and the New York Central merged, taking the Penn Central name. The resulting behemoth employed 104,000 people generating more than $2b in annual revenues. Unfortunately, it didn’t solve the problem. Instead, as Bezilla describes, the newly enlarged PRR suffered from clashing corporate cultures, executive turf battles, incompatible computer systems and expensive job protection agreements. It filed for bankruptcy just two years later in 1970. Congress eventually got involved, creating Amtrak in 1971 (for passenger operations) and Conrail in 1976 (for freight). The latter included Penn Central and six other bankrupt railroads concentrated in the northeast. Even with $2b in federal launch money though, Conrail reported a $349m operating loss in 1980, not much different than the amount PRR was losing before its bankruptcy. Finally, Congress decided to deregulate the industry, concluding that trains now competed less among themselves than with trucks, airplanes, barges, pipelines and other forms of transport. Their rethinking led to the 1980 Staggers Act, part of a transportation deregulation movement that also affected trucking and airlines. The Staggers Act gave railroads the authority to set rates again, and to negotiate private contracts with shippers. In 1981, new legislation allowed Conrail to divest its commuter passenger rail business to local and state governments. It was also allowed to renegotiate labor contracts, reduce staff and shrink its trackage. The measures worked. In 1986, Bezilla notes, Conrail had an operating profit of $348m. Twelve years later, in 1998, Jacksonville’s CSX and Atlanta’s Norfolk Southern jointly acquired Conrail and split its assets between them.

Looking ahead

  • The Metaverse: During Facebook’s Q2 earnings call, CEO Mark Zuckerberg spoke at length about a concept he’s calling the “Metaverse,” borrowing a term that originated in 1990’s science fiction writing. What is it? In the words of Bloomberg columnist Tae Kim, it’s a “futuristic version of an always-on, multiplayer video game where you can play, socialize or even run a moneymaking business in a realistic computer-generated environment.” Kim also shares a description from venture capitalist Matthew Ball, who highlights the presence within the metaverse of a full-functioning economy in real time (no turning on and off like a video game). Ball also mentions the interoperability of digital “belongings” such as clothing across multiple platforms. And Zuckerberg? He depicts the Metaverse as an “embodied internet that you’re inside of, rather than just looking at.” It will be accessible from apps, phones, PCs and other devices, including new ones designed for an immersive virtual and augmented reality experience. Facebook, remember, already has Oculus, which delivers virtual reality games through headsets. But Zuckerberg is looking beyond just games. He wants to create an all-new computing platform useful for work and play, as well as social interaction. In this new virtual environment, you’ll feel like you’re with another person even if you’re physically apart. Facebook has a new business unit—with a big budget—dedicated to developing this Metaverse concept, which Zuckerberg admits will take time to mature. Will it also, like Facebook’s social media business, depend on advertising to generate revenues? That’s unclear. But its dependence on advertising dollars aside, its uncomfortable dependence on Apple would in theory fade with the emergence of a new platform in its own control. As massively profitable as Facebook is, its one big vulnerability is reliance on Apple (and Google’s Android) to reach its billions of users—people typically use the Facebook, WhatsApp and Instagram apps on their mobile devices. Zuckerberg by the way, took another dig at Apple during the earnings call: “Our business model isn’t going to primarily be around trying to sell devices at a large premium or anything like that.” Bottom line: Facebook wants to transition from being a social media company to a metaverse company. Will it succeed? Bloomberg’s Kim issues a warning. Facebook, he predicts, will develop a new dependence, namely on Qualcomm or whoever else builds the advanced semiconductor chips necessary to deliver the immersive experiences inherent to the metaverse. Apple, by contrast, which is also working on virtual reality applications, is developing its own advanced chips in-house. Facebook, he adds, will face a disadvantage developing the software necessary for the metaverse—companies like Nvidia and video game champion Epic are already more advanced in this area. Google too, will be competing in the space.

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