Sep 5, 2019

Axios Capital

By Felix Salmon
Felix Salmon

Did you miss me? I'm back and experimenting with sending this email out on Thursdays rather than Sundays. If you want to read this on Sunday, of course, that's fine by me.

As ever, keep emailing me at felix@axios.com with your opinions and requests about content, the timing of this newsletter, and everything else.

In today's newsletter: Global disintegration, the economics of Peloton and WeWork, tax deductions, convexity, a book about my family, and more. The whole thing is 1,758 words long, which should take you less than 7 minutes to read.

1 big thing: Disintegration

Illustration: Sarah Grillo/Axios

It's the end of the world as we know it. The world is disintegrating, and much of the highly-visible noise and chaos is a symptom of a much deeper problem.

  • In Hong Kong, millions of demonstrators are taking to the streets in a desperate attempt to preserve their democratic freedoms.
  • In Argentina, the government has been forced to implement capital controls to prevent money from fleeing the country.
  • In Britain, incoming Prime Minister Boris Johnson has lost his majority, his long-coveted control over legislation, and even his attempt to call a new election. Brexit uncertainty has never been greater.

These are high-stakes dramas, and their outcomes matter greatly. Hong Kong is a great test of whether Xi Jinping's China is remotely compatible with Western liberalism. Argentina is a great test of whether a market-friendly government, working closely with the IMF, can turn an economy around. Britain is, in many ways, a great test of democracy itself.

  • So far, in all three cases, the outcomes have been profoundly disappointing and depressing, even as some hope remains.

Zoom out: In a bigger sense, the final outcomes don't matter. In all 3 cases — and, most importantly of all, in Trump's America — what we're witnessing is the spectacle of global integration being thrown suddenly and jarringly into reverse.

  • Even if Hong Kong's demonstrators have all 5 of their demands met (right now it's 1 down, 4 to go), China has made it abundantly clear that it has no respect for the "one country, two systems" framework, which in any case is scheduled to end in 2047. Hong Kong is arguably the most internationally integrated city in the world, which means the only direction from here is backwards. As Dan Harris put it 3 weeks ago in China Law Blog, "Hong Kong as an international business and financial center is no more."
  • Even if Argentina's Mauricio Macri wins the general election, yet another bond default is inevitable. Whatever international credibility Argentina had regained over the last four years of Macri's presidency is irretrievably lost.
  • Even if Britain manages to avoid a no-deal Brexit — even if it manages to avoid any Brexit at all — the desire of half the nation to cut itself off from its major trading partners is going to dominate British politics and economics for decades to come.

The bottom line: The postwar economic order was built on ever-increasing integration, and there is no precedent in modern history for how — or even whether — the global economy can cope with its opposite.

Flashback: 1914's reversal of global integration
Archduke Franz Ferdinand of Austria-Hungary and his wife Sophie, the duchess of Hohenberg, moments before they were assassinated in Sarajevo in 1914. Photo: Universal History Archive/Universal Images Group via Getty Images
This era perhaps now bears more similarities with the gold standard era – with its free capital mobility, its open trade, and its staggering complacency – than any other. That era came to an abrupt and violent end with world war one and its key features could not be resuscitated for decades.
Many sage figures bearing considerable similarity to our current political leadership confidently pronounced in the early 20th century that conflict was now completely impossible between developed democratic states, given their economic interconnectedness. We know how that turned out.
— Ivan Rogers, The Spectator, Sept. 2, 2019
2. Unicorn economics

Illustration: Aïda Amer/Axios

Apparently investors love to read IPO prospectuses in August, because both Peloton and WeWork unveiled their S-1 filings last month.

  • The two companies are similar in that they both spend a lot of money on sales and marketing, which they then attempt to recoup over time with monthly payments from their customers.

The big question: How much time does a customer need to remain a customer before she becomes profitable?

In the case of Peloton, the answer is "almost immediately." Customer acquisition costs are roughly equal to the markup on the company's bicycles and treadmills. After that, Peloton makes money every month that the customer pays $39 for a fitness subscription.

  • The catch: Peloton's losses have been rising along with its revenues. As the NYT's Erin Griffith reports, "competitors and copycats are moving in aggressively," often at significantly lower price points. If Peloton wants to maintain or increase its market share, its customer acquisition costs are probably going to increase over time.

WeWork's financials are harder to understand. Rett Wallace, the CEO of private-company intelligence firm Triton, has called the company's S-1 "a masterpiece of obfuscation." It's therefore hard to work out exactly what WeWork's customer acquisition cost is. But Wallace estimates that a tenant needs to stay in place for 13.5 years, on average, before they break even for the company.

  • Between the lines: WeWork's value proposition is that it doesn't lock tenants into long leases. But the company's accounting hides the cost of finding new tenants to replace ones who move out.
  • How it works: After a location has been open for 24 months, its sales and marketing expenses no longer appear in WeWork's corporate sales and marketing budget, and instead are incorporated into the individual budget for the location itself. Shareholders therefore have no way of seeing WeWork's total sales and marketing expenses.

The bottom line: "Customer acquisition costs always go up, not down," says Wallace. Anybody buying into the WeWork or Peloton IPOs should bear that in mind as they try to model when and whether either company might become profitable. In the case of WeWork, the company itself seems to be asking similar questions.

3. The case against tax deductions
Expand chart
Note: Data includes the first 30 weeks of each year; Data: Internal Revenue Service; Chart: Chris Canipe/Axios

Trump's tax cuts were, weirdly, feared by homeowners and charities. Normally, tax cuts make people richer, and richer people spend more money on housing and charity. But both those items have historically benefited from massive tax expenditures, leading to worries that they would be worse off after the tax cuts.

Driving the news: According to the latest data from the IRS, the tax cut worked much as everybody expected it would. The number of people itemizing their taxes plunged by more than 65%, with similar falls for the number of people deducting mortgage interest and charitable contributions.

Yes, but: The other shoe hasn't dropped.

  • Only 8% of taxpayers now deduct mortgage interest, yet home prices continue to rise, with no indication that the new law changed anything at all.
  • Similarly, the charitable contribution deduction has had no visible effect on charitable contributions. Total giving rose by 0.7% to a new record high in 2018, despite a late-year stock market plunge.

The bottom line: Tax deductions are much easier to create than they are to abolish; they're also hugely expensive. The evidence strongly implies that almost all of them are a waste of money.

4. Adventures with convexity
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Chart: Axios Visuals; Data: FactSet

Bond investors are notoriously risk-averse, and it's easy to see why. When you lend a borrower money, the best-case scenario is that they make good on their promise and pay you back. The worst-case scenario is you never get anything back, and lose all your money. The downside is always bigger than the upside.

Or nearly always.

Very long-dated bonds, like the 100-year bonds issued by Austria and Argentina in 2017, have a lot of convexity: They rise in price a lot when yields fall, more than they fall in price when yields rise. The result is that they can actually have more upside than downside.

Argentina's bond, naturally, has imploded as a debt restructuring has become inevitable. After rallying to a high of 103.60 in October 2017, it now trades at a highly-distressed level of less than 40 cents. At the same time, however, Austria's bond has soared in price as yields across the eurozone have fallen.

By the numbers: If you bought both bonds on the last day of February 2018, you would have paid $201.80. A year and a half later, at the end of August 2019, the combined bonds were worth $240.94, and you would also have received $13.84 in coupon payments in the interim.

  • That's a total return of 26%, which is impressive for any bond investment, let alone one where half of the trade has plunged into distressed territory.
5. Ban private jets

Illustration: Aïda Amer/Axios

The president and CEO of Fortune Magazine, Alan Murray, wrote a huge story last month.

  • The headline: "America’s CEOs Seek a New Purpose for the Corporation."
  • The conclusion: "Business leadership is filling the leadership vacuum" left by squabbling politicians.
  • The evidence: A new "Statement on the Purpose of a Corporation" from a trade group called the Business Roundtable.

Reality check: The new statement mostly serves to make CEOs even less accountable than they were before. If they really wanted to make a positive difference in the world, there's something much easier they could do, which is to sign on to the proposal from FT Alphaville editor Izabella Kaminska that all private jets should be banned.

My thought bubble: Listen to Warren Buffett, who named his first private jet "The Indefensible." If private jets were banned, people like Prince Harry wouldn't have to contort themselves to justify using them, and WeWork CEO Adam Neumann would avoid accusations of hypocrisy. (He made his whole company vegetarian for environmental reasons, but flies around the world in a Gulfstream 650.)

The odds: It'll never happen, of course. CEOs are happy to aspire to high-minded ideals, just so long as they don't need to give up any luxuries of their own.

6. Coming up: The August jobs report

Illustration: Rebecca Zisser/Axios

The jobs report tomorrow is expected to show that 150,000 jobs were added last month, writes Axios' Courtenay Brown, while the unemployment rate should hold steady at 3.7%. That's a near 50-year low.

Why it matters: It's a delicate time for the U.S. economy, with many fears that we're in, or approaching, a recession. But so far the labor market has been reassuringly healthy.

  • A “good” report, on the heels of ADP’s strong number this morning, could temper recession fears.
  • But a surprise "bad" report — a miss on expectations, and possibly downward revisions to prior months — could exacerbate them.
7. Salmon news

One of the reasons that I have the great privilege of writing Axios Edge is that I didn't need to spend many years buried in Salmon family archives and paperwork, writing the quite astonishing history of my own family. That's because my cousin Thomas Harding has done so instead, in a fantastic new book that's now out in the U.K.

  • Harding traces the Salmons and the Glucksteins back to 1808, with Lehmann Gluckstein being forced to leave the small town of Jever, in what is now Germany.
  • Once the story reaches England, it encompasses cigarettes, grand hotels, the invention of industrial-scale restaurants, WWII bomb factories, Margaret Thatcher, the world's first corporate computer, a great transgender artist, and an utterly unique family structure. The denouement comes after my grandfather levers the family company up with too much debt, thanks to a buying spree that included Baskin-Robbins ice cream.
  • The book has received great reviews from the Observer, the Guardian, the FT, the Telegraph, the Evening Standard, and the Jewish Chronicle. It's even been reviewed by my cousin Dominic Lawson in the Sunday Times. I can add little more but to thank Thomas for writing this important and necessary book. He did it so much better than I could ever have done.
8. Building of the week: The Bridge of Peace, Tbilisi

Photo: Vano Shlamov/AFP/Getty Images

Italian architect Michele De Lucchi built Tbilisi's undulating Bridge of Peace in 2010, a bold modernist intervention in the historic Georgian capital's old town.

  • The pedestrian bridge is 490 feet long, and lights up at sunset thanks to 1,208 LEDs embedded in the structure. Other LEDs are triggered by motion sensors, illuminating every individual who sets foot on the structure.
Felix Salmon