Berlin - A devastating pandemic, a turbulent election and the arrival of “Zoomshock”: Michael Cembalest has watched it all unfold from his New York perch as J.P. Morgan's chairman of market and investment strategy. With a career of more than 34 years at the investment bank behind him, he is responsible for $2.6 trillion in investor assets and writes regularly on financial market topics. We talk to him about his latest report, “The Agony and the Ecstasy”, inflation risks, prospects for companies in China and the fate of Europe's real estate market post-corona.
BERLINER ZEITUNG: Corona wasn't the only big story in 2020. The year saw major political turmoil as well: you warned that President Biden's energy policies would be more progressive than many people think, and you said Trump overturning the election result would be an “American Horror Story” for the markets. Is political risk an increasing trend for the economy?
MICHAEL CEMBALEST: When we look at the various unexpected things that can happen to companies, I don't think political turmoil and tariffs are very high on the list. What you're really looking for are things that can go very wrong so that the company all of a sudden isn't profitable or competitive anymore and there's a substantial decline in value. Tariffs usually don't change the landscape that much.
This paper wasn't written for all our clients. Most clients come to us with money to invest in diversified portfolios, but some clients come to us with very concentrated portfolios. It can be very difficult, mentally, for founders who have spent the last 20 years building a company, and who have 90 per cent or 100 per cent of their wealth in that company, to figure out how to move to something a bit more diversified. This paper is really just meant to walk them through the history of what can happen, both good and bad, to people with very concentrated portfolios.
In the report, you write that about 40 per cent of stocks on the Russell 3000 Index have seen a “catastrophic stock price loss”, while 10 per cent of stocks since 1980 are classed as “megawinners” recording more than 500 per cent price return. What's your recommendation to your clients on that basis?
We recommend investing in a portfolio that is built to be focused on things other than the company itself: so if you make a lot of money in packaging, you wouldn't necessarily want to have a lot of packaging in your diversified portfolio. I would argue that they should start out diversifying 10, 20, or 25 per cent of their concentrated assets - that's a good first step.
We’re just trying to get people to take some money off the table, because when you look at the history of all the companies that have failed, there are very few companies whose demise can be predicted in advance. In a very global world, sometimes it's hard to figure out where your competitors are coming from.
This is the latest edition of this paper - the first being in 2004 and 2014. What was the impetus for writing the first one?
From 2000 to 2003, I was having conversations with clients to discuss the risks of their company. That was a terrible idea, because I've never met any founder who wants to talk about the risks to their own company, or can be objective about it - but they can be objective about the risks that face other companies. So the purpose of this whole exercise is so we can say to clients: look, if you end up as one of the winners, and you don't sell anything, you'll be great. But if the stocks are going to be a winner, and you diversify a little bit, you'll still be fine, but you'll also have some protection in case the world changes in ways that you can't anticipate.
So, your basic recommendation to clients is diversify your investment if you haven't done it already.
The most important message in there is that when something goes wrong, chances are it’s outside your control. We tend to be very successful at getting concentrated families to look at the history and think about what they're doing. The paper is generally helpful, which is why our people asked us to update it - the last one we did was in 2014. The messages are the same, but we updated all the data, the tables and charts and things like that.
You have this long interim of 10 years between the reports – did really nothing change at all in that time?
The percentages didn't change very much. We showed a new list of companies just so that people could see, but we also provided a link to the prior paper, so you can see the old charts. But the story kind of remains the same - and we wrote that this could become even more important in the years ahead as the monetary stimulus in the US and Europe that was put in gradually gets rolled back.
For German readers, the idea that big corporates can fail can be pretty hard to digest. We have some companies that have existed for 100 years and are still blue chips. What are some of the risks they face?
That’s a good point, although, as you know, there was a high profile accounting failure in Germany last year.
Yes, we heard about that. [Wirecard, editor's note]
What you're saying is generally true. In France, Germany and Italy you have something that in the United States we refer to as national champion companies, that are given special treatment and their place in the economy works closely with the government on a lot of issues, such as employment. They can sometimes have close partnerships with the government, and in exchange for that the company gives something up - but it creates more stability in the long run for the company’s investors. A lot of people in the US like that German model, but we don't have partnerships between the federal government and the private sector: private sector companies fend for themselves for good and for bad.
One of the first charts in the piece shows the steady drumbeat of companies coming in and out of the S&P 500 over time. When we looked at the companies that moved from the S&P that then weren't acquired, it was because something bad happened. That kind of event risk is a lot more frequent in the US than in other countries, and I don't really think that's going to be changing. By the way, if anything, the Trump administration stuck to that model and didn't really provide a lot of preferential treatment to companies. He ran on a platform to cut corporate taxes and reduce regulation, but no more bailouts.
At the same time, we always see that the American stock market is far more dynamic - companies that list in New York have greater access to capital for their business ideas. Does the lack of dynamism in Europe come with a downside?
It's kind of complicated. When you look at the European stock market versus the US stock market, the performance difference has been enormous. But if you actually look closely, a big chunk of it is explained simply by the fact that the US has a lot more of the market in technology and healthcare, whereas in Europe, there are more financials and energy and industrial companies, those tend to be lower margin businesses that trade at lower multiples - it's just a sector difference.
What's interesting about Europe is that even though it's got a lot of entrepreneurs, it’s struggled to create the kind of large technology companies that exist in the US. The Digital Service Taxes and things like that are a reflection of Europe saying: well, if we're not going to have an organic tech sector of our own, and US tech companies are going to be making so much money here, we need to tax them for the various parts of the value chain where they exist.
Your report also talks about Zoomshock, meaning the impact on our economic structures by the shift to working from home. What effect is that going to have on commercial as well as private real estate?
The best chart in the report is the chart on office utilisation rates: that tells the story. If those numbers stay below 50 per cent, a lot of companies are going to think about maybe taking some of the space they're renting and putting it on the sublet market, and there's no market where price doesn't respond to supply. The real estate market is not special: if the supply goes up, the price will go down. Residential multi-family real estate should be fine.
It's quite possible that a year from now, everybody's back at work and the virus will have substantially receded, there will be booster shots and more therapeutic treatments for people that do get sick. In a world that goes back to normal, all of these Zoomshocks go away. I got quite a few comments from people in real estate who disagree with my take: they say it's not going to be so bad, companies are all going to come back to work and they’re going to want more space so that employees aren't so crowded. Maybe - but I wanted to start this conversation now so that over the next three and six and nine months, we can see.
Do you think we will see the same effect in Europe?
This Zoomshock shouldn't be quite as severe in Europe because of the tighter office markets - there's less building, more zoning restrictions, and the office markets tend to have much lower levels of vacancy. A normal office market in the US might always be running with 8 to 10 per cent vacancy, even in a good market, whereas in Europe, I think the number’s probably half of that. But Europe's also dealing with more variants circulating. I suspect we're going to see some softening in commercial office rents over the next few months: there are people who believe that the impact on commercial real estate is going to be no more than 1 to 2 per cent vacancy - I think it's going to be above that. And employers think they're going to get 80 to 90 per cent of people back in the office by the end of this year. I think it's going to be below that.
If companies can save money by reducing their office space, why should they insist on their employees coming into the office?
Most CEOs, at least in the US, want their employees back. I think it’s just going to be hard to get there. They think they work harder and better and smarter when they work in groups. It's much harder for young people that don't have a network and they have to meet people electronically. Not all, but most CEOs would like to see a lot of their people back.
Your report also talks about inflation: what's your expectation for that in the US and also for Europe?
I don't know if we'll ever see European inflation in our lifetime. There’s a lot of things there that are structurally different - but every economy is like a patient in a hospital: if you put enough jolts in it, you'll get some inflation. In the US, I think the Fed is trying to find out how many bolts it needs to put in. Until you generate inflation, the stimulus that you're putting in helps because by definition, the economy’s growing faster. The Fed has been speaking recently about monetary policy and interest rates as a way of resolving some of the racial and class differences in the United States by bringing up the lowest levels of income. So as far as the Fed is concerned, the stimulus has economic and socioeconomic benefits. I think they're going to push and push until inflation happens and then they'll stop - I think it'll be one year before that happens.
So, you would be bullish on banks and perhaps classic assets?
Yes - banks, energy and industrials. I don't think inflation is going very high, but it doesn't have to because the Fed is at zero. So all that has to happen is for inflation to go back to two or two and a quarter per cent and the Fed will have to adjust to that.
You’ve previously warned against Armageddonists - market forecasters who made dramatic, apocalyptic predictions before the crisis and suffered huge opportunity losses. Do you still stand by that?
What I like about the asset management industry is that there's a lot of discipline around performance. There are huge industries set up to track how we're doing, like Lipper and Morningstar. They rate the funds based on performance and also based on other factors about management and governance. So I think it's amazing that there's this other industry of people who make these pronouncements. A lot of people listen to them, but there's no disciplined way in which some entity or organisation evaluates what they say and how it turns out.
The two papers I wrote on the subject were an exercise in saying: if you had listened to them, let's see what would have happened. At times, it can be very easy to sell the concept of fear, and what's kind of amazing is sometimes these people get their most bearish after something bad has already happened. I've been at JP Morgan for 34 years, and anybody that's been in the markets for more than a decade knows that after something bad happens, you're supposed to think about buying, you're not supposed to think about selling.
A lot of people in Germany have this same kind of sentiment, and some of them even have their own funds.
Actually, if they have a fund, that's great. There are short funds in the US and sometimes people can be right about a theme but wrong about how they invest in it. Ten years ago, a lot of the people that were bearish about Japan shorted Japanese government bonds, because they thought that was the trade. They were right about some of the issues in Japan but they shorted the wrong asset.
Now that Trump is no longer in office, China’s delisting risks are regarded as being much lower. What’s your view on that?
Well, I don't know about that. Suppose Chinese companies are forcibly delisted from US exchanges, and they list in Hong Kong instead: I don't know how much of an impact that's going to have. Global investors who like those companies are going to buy them. We own companies in Indonesia, Rio, India. There are good companies all over the world.
I think the delisting is bad because it's a sign of how much the China-US relationship has deteriorated, rather than being bad in itself. I think those companies will be able to raise as much money as they need in those other markets. Asia has an enormous amount of excess savings, so if there's a company that needs money and is listed in Hong Kong, they'll get it. Every US investment bank and European investment bank has offices in Hong Kong or Singapore.
What's your take on the Chinese government’s interventions on Jack Ma and Alibaba and the risks associated with that?
It's a huge issue that the US and Europe are in conflict with China. Biden's not really changed a lot of the rhetoric from Trump. I actually think the situation surrounding Ant Financial is different - that's the Chinese government looking at the US and Germany, and at some of the companies that blew up because they weren't properly regulated and saying: Ant Financial is a front end internet portal that's going to issue a bunch of loans that it's not going to own, and they're just going to dump them on the balance sheet of Chinese banks. We've seen in Germany what can happen when you have a complicated normal entity that doesn't have enough accounting around. On this particular issue, I think the Chinese are actually being kind of prudent in terms of preventing shadow banking from expanding more than it already has.
How do you view the risks for the companies linked to vaccination efforts?
As you mentioned, a lot of concentrated families are either in tech or biotech. And a lot of biotech companies are only one bad test away from being challenged by the FDA or its German equivalent. I happen to think the AstraZeneca vaccine is safe based on all the research I've seen, but when vaccines go through trials, they test 40,000 people; when they’re given out to populations, they're given to tens of millions of people. There's always a chance that something was missed in the trials, because you're not giving it to larger populations. That's a risk that pharmaceutical companies and biotech companies face all the time.
I think I read you're not a huge fan of the stimulus programme.
No, I wouldn't say that. My job is not to say whether or not I liked the stimulus. There were a lot of reasons to do it, but now that they're doing it, my job is to decide whether or not it's going to drive up wages and prices in a way that will make the Fed no longer be able to sit at zero rates. I happen to believe that's the case. I'm responding to the events rather than giving some kind of recommendations to what the government or the central bank should do.
The interview was conducted by Maximilian Both and Elizabeth Rushton.