Read It And Eat 18/06

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Major Headlines:

• McDonald's AI:

• McDonald's like every other company has been trying to integrate artificial intelligence into their companies to improve efficiency and spend less on employee wages. I am of the personal opinion that there are some roles that don’t need the touch of the AI gods and when that happens it becomes a catastrophic failure. An example, in this case where McDonald’s tried to replace the people who take orders in their drive-through. This seems like a corporate decision from the board of directors and was made without the input of the “boots on the ground.” McDonald’s in partnership with IBM was trialling its AI voice ordering system in 100 of its drive-through stores. This, however, was riddled with issues as it relates to the accuracy of the system, a specific lady posted on TikTok that she got 9 sweet teas even though she ordered 1. While there have been successes to date, we feel there is an opportunity to explore voice ordering solutions more broadly,” Mason Smoot, chief restaurant officer for McDonald’s USA, said in the system message. “After a thoughtful review, McDonald’s has decided to end our current partnership with IBM on AOT and the technology will be shut off in all restaurants currently testing it no later than July 26, 2024.” Smoot said the company will continue to evaluate its plans to make “an informed decision on a future voice ordering solution by the end of the year.” [RB Online]

• Wells Fargo Misses On It’s Bet With Bilt:

• In 2022, Wells launched a credit card with Bilt Technologies, a fintech startup with big-name backers including Blackstone and Mastercard. The co-branded card came with a rare perk: Users can pay for rent with it without incurring fees from their landlords while also earning rewards points. More than one million accounts were activated in the first 18 months, many by young adults. But Wells is losing as much as $10 million every month on the program as savvy customers flock to the card, according to current and former employees. Executives made internal projections on key revenue drivers, such as the likelihood that cardholders would carry balances, that turned out to be inaccurate. There is a reason why credit cards hadn’t gained traction in the rent sector until Bilt came along. Most landlords didn’t accept them because they refuse to pay card fees that get pocketed by the banks issuing them and often run between 2% and 3%. Bilt structured the card so landlords won’t incur the fees. Wells instead eats much of that. About six months after the credit card was launched, Wells began paying Bilt a fee of about 0.80% of each rent transaction, even though the bank isn’t collecting interchange fees from landlords. Some Wells employees thought the proposition was crazy, but the bank needed a win and figured Bilt would garner buzz and help attract younger customers. A deal also presented mortgage cross-selling opportunities. Bilt’s cardholders will ultimately want to become homeowners, the thought process at Wells went, and the bank would be well-positioned to give them mortgages. Some Wells employees thought the proposition was crazy, but the bank needed a win and figured Bilt would garner buzz and help attract younger customers. A deal also presented mortgage cross-selling opportunities. Bilt’s cardholders will ultimately want to become homeowners, the thought process at Wells went, and the bank would be well-positioned to give them mortgages. Wells has told Bilt that cardholder behaviour isn’t providing a path for profitability for the bank and that more customers who carry balances and use the card for everyday purchases are needed. Bilt, meanwhile, hasn’t been satisfied with how Wells is marketing the partnership. Wells has replaced some of its marketing of the Bilt card in branches, on its ATMs and elsewhere with that of its own general-purpose cards. [WSJ]
  

• Apple Exits BNPL:

• Apple said on Monday that it has stopped issuing loans through Apple Pay Later, its buy-now-pay-later program that launched last year.The move comes after Apple  later this year in its Apple Pay checkout process through third-party companies, such as Affirm and credit and debit cards from issuers, such as Citigroup. Apple said it would no longer issue Apple Pay Later loans, which enabled customers to buy products online and pay in four interest-free instalments, at prices up to $1,000. The discontinuation is a sign that not every new fintech feature or product that Apple launches becomes a success or fits in with the iPhone maker’s overall strategy. “Starting later this year, users across the globe will be able to access instalment loans offered through credit and debit cards, as well as lenders when checking out with Apple Pay,” an Apple spokesperson told CNBC. “With the introduction of this new global instalment loan offering, we will no longer offer Apple Pay Later in the U.S. Apple said users who wanted instalment plans at checkout would gain access to them through other financial intermediaries in more countries around the world than they would with Apple Pay Later, which was only available in the U.S. Apple said its priority with Apple Pay, the brand name for its contactless and online payment software, was to enable secure and private payments. Users with open loans will continue to have access to Apple Pay Later features to manage and pay their loans, Apple said. Before it was discontinued, Apple Pay Later enabled users to apply for loans within the iPhone Wallet app, and approved users would see a “Pay Later” option when checking out online. [CNBC]

• ZYN vs The U.S.:

• Tobacco giant Philip Morris International said on Monday that it would suspend online sales on Swedish Match North America’s ZYN.com nationwide as the Zyn nicotine pouch maker responds to a subpoena from the District of Columbia. Philip Morris bought Swedish Match in a $16 billion deal in 2022 as the company looked to reduce its reliance on cigarettes amid stricter regulations, and a consumer shift towards alternatives to tobacco and traditional cigarettes. The company said that Swedish Match North America had received a subpoena from D.C.’s attorney general requesting information about its compliance with D.C.’s 2022 ban on the sale of all flavoured tobacco. [Bloomberg]

Minor Headlines

• India pulls in tech giants for its AI ambitions (Financial Times)

• Activist Starboard built a $500M stake in Autodesk (Wall Street Journal)

• Stripe to let employees cash out of stock for third time (Bloomberg)

• GE Aerospace CEO declined Boeing CEO job (Wall Street Journal)

• SCOTUS to hear shareholder lawsuit against Nvidia (Reuters)

• Deutsche Bank counting on IB hiring spree to pay off (Financial Times)

• CampusAI, an AI learning skills startup, raised a $10M pre-seed round from angel Maciej Zientara (FN)

• SEC's crypto chief David Hirsch quit (CD)

NEWS OF THE DAY:

The Power Of Powell

To ensure a proper understanding of this piece I am going to assume that you have a good to loose understanding of the concepts of inflation, interest rate and the institution of the Central Bank. I however will introduce to you the fact that these three concepts are in a love triangle of some sort as they each significantly effect the way the other two respond.

Inflation is defined as a gradual loss of purchasing power reflected in a broad rise in the prices of goods and services over time. The inflation rate is calculated as the average price increase of a bundle of selected goods and services over a fiscal year. In essence, the money in your pocket (wallet, purse or bank account) loses value as it is unable to sufficiently pay for the same amount of goods and services this year as it did last year. Interest rate is the amount a lender charges a borrower and is a percentage of the principal—the amount loaned. The interest rate on a loan is typically noted on an annual basis and expressed as an Annual Percentage Rate or APR. In essence, the lender, which is usually a bank charges you for borrowing money from them. Finally, the institution of the Central Bank, this is known A central bank has been described as the "lender of last resort," which means it is responsible for providing its nation's economy with funds when commercial banks cannot cover a supply shortage. In other words, the central bank prevents the country's banking system from failing. However, the primary goal of central banks is to provide their countries' currencies with price stability by controlling inflation. A central bank also acts as the regulatory authority of a country's monetary policy and is the sole provider and printer of notes and coins in circulation. Time has proved that the central bank can best function in these capacities by remaining independent from government fiscal policy and therefore uninfluenced by the political concerns of any regime. A central bank should also be completely divested of any commercial banking interests. In the U.K. the central bank is called the Bank of England, In Canada, it is called the Bank of Canada, and in Nigeria it is called the Central Bank of Nigeria or the CBN. In most countries it is usually named “The Central Bank of x” as it is in Bahrain, Cyprus and Ireland or “The Bank of x” as it is in France, Estonia and Italy.

In the U.S. the Central Bank is known as The Federal Reserve, also known as The Fed (which shouldn’t be confused with the Feds a colloquial term for the police) headed by Mr. Jerome Powell. He is the person of interest we would be discussing today as unlike other heads of central banks, he is widely discussed and covered in the media. There is a lot of media chatter whenever he, and subsequently The Fed, have to make an announcement, especially towards the end of the fiscal quarter. This is because in these announcements, the Fed produces a report on their findings on the inflation rate and if they intend to raise, reduce or maintain the federal interest rate.

The Relationship Between Interest Rates and Inflation Rates

In the love triangle between interest rates, inflation rate and the central bank. I want you to consider the interest rate and inflation rate as a toxic couple who greatly oppose each other and the central bank as the mediator or therapist who always tries to find a middle ground. This is because the rise of one inversely proportionally causes the fall of the other. When the Fed raises rates, there is a direct consequential fall in the rate of inflation and when the Fed ‘cuts’ rates there is a direct and proportional rise in inflation. Interest rates and inflation rates are pivotal to macroeconomic stability. Central banks, like the Federal Reserve, leverage interest rate adjustments as a principal mechanism to manage inflation levels. This dynamic relationship influences consumer behaviour, investment decisions, and overall economic health.

When central banks raise interest rates, borrowing costs increase, making loans more expensive for consumers and businesses. This tends to dampen spending and investment, which in turn reduces overall economic demand. Lower demand can help to bring down inflation rates. Conversely, when interest rates are lowered, borrowing becomes cheaper, leading to an increase in spending and investment. This boost in economic activity can elevate demand, which may drive up inflation if the supply of goods and services does not keep pace with the increased demand.

The primary aim of central banks is to maintain inflation within a target range, typically around 2%. When inflation exceeds this target, central banks may raise interest rates to curtail economic activity and bring inflation back down. Conversely, if inflation is too low, they may lower rates to spur economic growth.

The Impact of Inflation on Interest Rates

Inflation expectations significantly influence interest rate settings. When consumers and businesses anticipate higher inflation, they demand higher interest rates to compensate for the expected erosion of purchasing power. Central banks, in turn, may raise interest rates preemptively to control these expectations and prevent inflation from escalating.

The distinction between nominal and real interest rates is crucial in this context. Nominal interest rates are the stated rates without adjustments for inflation, while real interest rates are nominal rates adjusted for inflation, representing the true cost of borrowing. The formula to calculate real interest rates is:

Real Interest Rate = Nominal Interest Rate − Inflation Rate

Real Interest Rate = Nominal Interest Rate − Inflation Rate

As inflation rises, nominal interest rates must increase to maintain stable real interest rates, ensuring that the lender’s purchasing power remains unaffected.

Historical Examples and Theoretical Insights

A notable historical example is the Volcker Shock in the 1980s, where the Federal Reserve, led by Chairman Paul Volcker, significantly raised interest rates to combat high inflation. This move successfully reduced inflation but also led to a severe recession, illustrating the powerful impact of interest rate adjustments on inflation control.

The Phillips Curve theory suggests an inverse relationship between inflation and unemployment, highlighting a trade-off where low unemployment can lead to higher inflation. Central banks must balance this trade-off when adjusting interest rates to maintain economic stability.

The Fisher Effect further elaborates on this relationship, positing that nominal interest rates are the sum of real interest rates and expected inflation. This theory underscores the importance of adjusting interest rates to reflect inflation expectations and preserve economic equilibrium.

Practical Implications for Policy and Decision-Making

From a policy perspective, central banks must calibrate interest rate changes carefully to avoid triggering excessive inflation or deflation. A balanced approach ensures long-term economic stability and growth.

For investors, understanding interest rates and inflation trends is crucial for making informed investment decisions. High inflation can erode the value of fixed-income investments, making equities and inflation-protected securities more attractive.

Consumers also benefit from this understanding, as it helps them make better borrowing and saving decisions. For instance, locking in low interest rates before anticipated inflation can lead to significant cost savings.

How Interest Rates Impact Stock Prices

Corporate profits are closely tied to interest rate movements. Many companies borrow for the short term with debt that resets each quarter. The interest on these loans is based on a rate index that mimics changes set by the Federal Reserve using the federal funds rate. The federal funds rate is the interest rate on short-term interbank loans and is typically what is being referred to when folks talk about "rate cuts.”

As a result, even the anticipation of a lower federal funds rate by the Federal Reserve can move other interest rates lower. This, in turn, helps boost general economic growth and corporate profits.

For example, inflation improved throughout 2023, falling to 3.4% by the end of December from 6.4% in 2022. This had the result of lowering a number of different key interest rates throughout the year. For example, the 2-year short-term Treasury yield, which is one interest rate the government uses to borrow money, was last seen at 4.9%, down significantly from its October 2023 peak near 5.24% – a period that coincided with the stock market's most recent lows.

This decline in interest rates occurred even as the Fed kept the federal funds rate at a range of 5.25% to 5.5%. Moreover, gross domestic product (GDP) excelled in Q4, growing at an annual rate of 3.4% according to the Bureau of Economic Analysis. And for all of 2023, the GDP growth rate was 2.5%. This indicated the economy was strong enough to withstand higher interest rates.

Yet at the end of 2024, futures traders were pricing in expectations the first quarter-point rate cut would come in March. In other words, the market's anticipation that the Fed would lower rates had a positive effect stock prices, since it assumes that a company's earnings per share and profits will rise as borrowing costs decline.

In effect, lower interest rates lead to higher price-to-earnings metrics and vice versa. But this is not the only way they help the market. 

Interest Rates And Wall Street

Many trading departments on Wall Street (i.e., Hedge Funds, prop desks at mainline brokerage firms, mutual funds, Private Equity  etc.) use extensive amounts of leverage to purchase their positions in the market. So lower short-term interest rates improve the costs of this borrowing activity. This, in effect, can help boost profits and potentially have a follow-on effect of increasing share prices. 

In addition to stocks, these positions can also include other leveraged securities markets. Think Treasury notes or secondary loan markets such as Collateralised loan obligations (CLOs). For example, the secondary market in CLOs, which are essentially bank loans of major corporations that trade on the market, becomes more liquid and profitable with lower rates. 

The bottom line is that interest rate movements can dramatically affect the borrowing costs of large Wall Street firms. By having lower borrowing costs, these companies can improve their profits. 

As a result, trading institutions tend to push up prices when interest rates and Treasury yields fall. The opposite also occurs when rates rise. But investors have plenty to be excited about this year given the market anticipates lower inflation and lower interest rates as a result. This will potentially lead to higher stock prices, higher bond and note prices (and lower yields).

Interest Rates And Private Equity

From 2012 to 2020, the global economy experienced an era of historically low interest rates, driven primarily by central banks' efforts to stimulate growth following the financial crisis of 2008-2009. These low rates reduced borrowing costs significantly, making it easier for companies to access cheap capital. This period, often characterised by the term "cheap money," allowed firms to finance expansion, operations, and new ventures at minimal costs. The ample liquidity in the financial markets spurred a surge in private equity deals and fuelled investments into new and innovative startups.

During this time, the proliferation of cheap capital led to the rise of numerous unicorn startups—private companies valued at over $1 billion. Startups such as Uber, WeWork, and Airbnb epitomised this era, attracting massive amounts of venture capital due to their disruptive business models and rapid growth potential. The abundant liquidity encouraged investors to bet heavily on high-risk, high-reward opportunities, often leading to valuations that far outstripped the companies' actual revenues or profitability. This environment of easy money allowed these startups to expand aggressively, capturing market share quickly and scaling their operations globally.

The influx of capital into these unicorns not only fostered innovation but also contributed to an overheated startup ecosystem. The ease of raising funds at high valuations created a culture where growth was prioritised over profitability, leading many companies to operate with significant cash burn rates in pursuit of market dominance. This approach, while fostering rapid expansion and technological advancements, also exposed the startups to greater financial vulnerabilities. The aggressive funding rounds and high valuations often led to a bubble-like environment, where investor expectations sometimes exceeded realistic financial performance metrics. Unfortunately, at this time I was getting a bachelor’s degree in Law rather than convincing venture capitalists that my startup was the next Facebook and they should get in on the ground floor.

The culmination of these dynamics led to a period of introspection and correction in the startup ecosystem. High-profile failures and financial struggles of companies like WeWork underscored the risks associated with the model of growth at all costs. As the economic environment shifted and interest rates began to rise, the availability of cheap money diminished, leading to a reassessment of startup valuations and business models. This transition marked a turning point for many unicorns, pushing them to adopt more sustainable financial practices and focus on achieving profitability to justify their valuations and ensure long-term viability.

It is important to note that the effect of the changes in interest rates are not immediate and usually takes about 2 or so years to come into full effect. For example, the rate changes that were instituted post the 2008 financial crisis was what led to the Startup Boom. Another example is the reduction in the interest rate that happened post-pandemic to discourage saving and increase spending to boost the economy that was emerging after the Covid lockdowns.

How Do Interest Rates Affect You

On the assumption that you aren’t a billionaire heir/heiress or a millionaire with a Private Wealth Manager and a portfolio of widely diverse assets, you may not be too concerned with the current interest rates however, it should be something that you should concern yourself with a little bit more. This is because the changes in interest rates have a near-direct impact on you and the things you do.

Changes in interest rates have a significant impact on the average citizen, affecting everything from borrowing costs to savings returns. When central banks, like the Federal Reserve or the Bank of England, adjust interest rates, they directly influence the cost of borrowing money. For instance, when interest rates are lowered, it becomes cheaper to take out loans and mortgages, which can encourage individuals to buy homes or finance other big-ticket items like cars. Lower rates generally make it easier for people to access credit, thereby increasing spending and stimulating economic activity.

Conversely, when interest rates rise, borrowing costs increase, making loans and mortgages more expensive. This can dampen consumer spending as people become more cautious about taking on debt. Higher interest rates can lead to higher monthly payments on variable-rate loans, including credit card debt, which can strain household budgets. For homeowners with variable-rate mortgages, an increase in rates can significantly raise monthly mortgage payments, potentially leading to financial difficulties or a reduced disposable income, which in turn can affect spending on other goods and services.

Interest rate changes also impact savings and investment returns. When interest rates are high, savings accounts, certificates of deposit (CDs), and other interest-bearing accounts offer better returns, encouraging people to save more. This can benefit those who rely on interest income, such as retirees. On the other hand, lower interest rates reduce the returns on these savings vehicles, which can be detrimental for savers. Lower returns may prompt people to seek higher yields in riskier investments, like stocks or real estate, which can have varying implications for personal financial stability

Furthermore, changes in interest rates can influence broader economic conditions, affecting job prospects and wage growth. Lower interest rates can stimulate business investment by reducing the cost of borrowing for companies, potentially leading to job creation and wage increases. Higher interest rates, however, can slow economic growth by making business loans more expensive, which may lead to reduced investment, slower job growth, and wage stagnation. Thus, fluctuations in interest rates can have a cascading effect on various aspects of personal finance and economic well-being for the average citizen.

In Conclusion

The love triangle of the three is more like a toxic relationship between the interest and inflation rates whereby the Central Bank is somewhat a paid third-wheeler who sides with one of the two as it best suits the economy at large. This is of course a gross oversimplification of these concepts and there are a multitude of areas that I never discussed such as how the Central Bank determines whether to raise, reduce or retain the interest rates and the factors they consider, nor how there are financial vehicles or products that are designed on making a profit through quantitatively analysing the data to predict the direction of the rate changes, IE, they make a profit or loss depending on the changes in the interest rate. However, I am certain that this gives a clear understanding of the fiscal responsibilities of the central banking system to significantly affect the economy by their decisions.

GEN-Z WORD OF THE DAY

Aura/Steez

This can be defined as a person’s natural charisma. A person with Aura/Steez is someone to be revered and respected, a person with a certain level of influence and a degree of mystery.  Things that are considered when figuring out if a person has aura/steez include but not limited to:

• Gait

• Charisma

• Charm

• Economic Position

• Political Position

• Self Respect

• Physical build