The US stock market has recently had its fastest 50 percent rise ever, occurring in the span of just over a couple months. Markets are looking forward to a post-crisis investing period, and have priced in a full, eventual recovery.
Nonetheless, because earnings will take a while to recover and many industries will not return to normal for a long time due to virus-related fears, the inflows are definitely mostly speculative.
The expectation for an earnings recovery has gotten pushed out.
Because of all the new liquidity and credit support programs, there’s more capital chasing a diminished earnings pie relative to what was discounted in earlier in the year.
We’re moving into a world where self-sufficiency is of greater importance than efficiency in terms of what production goes where.
In the words of US Trade Representative Peter Navarro:
“Would you rather have cheap, subsidized – illegally subsidized – goods dumped into the Walmart and not have a job and not have your wages go up in 15 years, or would you like to pay a little bit more – not much – a little bit more, have a job, and have your wages going up?”
Prizing self-sufficiency over efficiency has pros and cons. One of the cons is that it’s bad for margins. Earnings become more dependent on revenue growth, which is hard with where debt burdens have ballooned up to.
When you borrow, you are not only borrowing from a lender, you are borrowing from your future self. Eventually you have to spend less, invest less, and/or take less for yourself because you have to pay that money back.
Bonds are not that attractive. Most of the ones that aren’t overly speculative in nature yield nothing in real terms (i.e., inflation-adjusted terms) and barely anything in nominal terms. US government bonds get you less than 1 percent in nominal terms.
Bonds are basically in the same bucket as cash. With how low their rates have become, they are closer to a funding vehicle than an investment vehicle that’s going to give you a return on your capital.
The top three tranches of corporate investment-grade bonds yield negatively in terms of expected real returns. The investment-grade / high-yield cut-off point (Baa3 -> Ba1) only provides around a 2 percent inflation-adjusted yield.
(Source: Moody’s Investment Services. Median yields are for regular coupon bonds rated by Moody’s with maturities between six and eight years and outstanding values of more than $50 million. No zero coupons or floating rate bonds are included. Each observation is unweighted in the sample, and the yields are calculated for end-of-month values.)
Most of the best long-term investment opportunities in the markets currently are likely in the early-stage and private markets, and that’s especially true now that public markets are back to getting (and being) expensive. Private markets are driven by the same dynamics but there tends to be more differentiation without the passive flows and generally better value.
Some markets are entirely divorced from reality. For example, Chesapeake Energy’s stock (CHK), increased in price 3x in one trading day despite the fact that its bonds expiring in January 2025 (11.5 percent coupon) are selling for about five cents on the dollar.
When there’s a lot of money and credit in the financial system and not a lot of great opportunities, it tends to blow bubbles in the most speculative parts of the market. This capital doesn’t tend to go for stable companies where future financial outcomes are pretty well established, like Coca-Cola or utilities that might give you 4-5 percent returns per year.
It goes into securities with a wide distribution of potential future outcomes, like stocks with uncertain shareholder recovery or startup firms selling products or services that are “hot” but whose future market is speculative (not to mention any particular company’s ability to execute on it).
For example, Nikola (NKLA), an upstart electric carmaker, recently saw its market cap exceed that of Ford (F) despite having no revenue. (Ford sells some 5-7 million cars per year profitably.)
When Hertz (HTZ), a rental car company, filed for bankruptcy on May 26, its stock price continued to go up by a factor of more than 10x by June 8.
Obviously it’s nonsensical as its equity is behind $14 billion in vehicle debt and $6 billion in corporate debt. Those obligations need to be paid with cash or a new ownership claim before current common shareholders get anything. It’s merely the type of speculative behavior we’re seeing.
Continued rallies by both the stock and corporate bond markets assume that any financial distress from households, businesses, and state and local governments will not be excessively burdensome relative to formerly discounted expectations.
Liquidity shortfalls are important to remedy before both the private and public sectors begin cutting back expenditures, which would result in a further contraction in business activity.
Labor markets are important for investors to track, even if they are lagging indicators of an economy. (Employers typically cut back on labor needs after financial stress hits.) Central bankers also look heavily at labor market indicators with a mandate of full employment at stable prices (i.e., inflation targeting). That affects their decision-making.
On May 16, there was decline in the number of people receiving state unemployment benefits. This was a positive, denoting a potential bottom in the labor market. Nevertheless, though down from May 9’s record-high 24.9 million, the 21.1 million receiving jobless benefits was well above that seen during the post financial crisis period – May 2009’s then-all-time-high figure of 6.64 million.
The labor market issues associated with the Covid-19 shutdowns make the financial crisis-related stress look small by comparison.
(Source: U.S. Employment and Training Administration)
(Source: Automatic Data Processing, Inc.)
This warns of only a partial recovery of consumer spending. More consumer loan delinquencies are likely, which will put stress on subprime lenders.
Moreover, the 2.14 million initial state unemployment claims on May 23 signal another large decline of payrolls of between 5 to 10 million jobs for the month of May.
A return of jobs growth will require a pace for first-time filings for state unemployment benefits to be well under one million new claims per week.
Both the troubling outlook for debt repayment and the state of flux regarding the labor market emphasizes the speculative nature of the latest rallies in equity and corporate bond markets.
Financial markets lead the economy, producing new highs in some US indices (particularly tech-centric ones) despite a record-high number of countries in recession.
In addition, corporate earnings will take a while to escape from a deep contraction.
Calendar-year US core pre-tax profits peaked in 2014. Accordingly, the subsequent underlying earnings performance of US companies might be viewed as lackluster in the years that have followed.
Even despite 2020’s annualized core pre-tax profits (of US non-financial companies) coming in 13.4 percent under 2014’s calendar-year record high, the market value of US common stock was recently 65 percent above its year-long average of 2014.
After 2019’s stall in corporate earnings, Blue Chip consensus in early May projected a 16 percent annual plunge by 2020’s year-long pre-tax profits followed by a 12.4 percent rebound in 2021.
Obviously, this is all speculative on the amounts, but the general idea is that we’ll see a contraction in earnings in 2020 followed by an expected recovery in 2021.
For a span overlapping the 2008 financial crisis, core pre-tax profits incurred contractions leading up to the downturn – with annual contractions of 6.9 percent in 2007 and 16.1 percent in 2008. This was followed by annual advances of 7.9 percent in 2009 and 24.7 percent in 2010.
(Sources: BEA, Blue Chip, NBER, Moody’s Analytics)
US stocks are now trading at an estimated forward P/E multiple of 22.1. That implies a forward return yield of about 4.5 percent, taking the reciprocal of that figure (i.e., 1 divided by 22.1).
(Source: Yardeni Research)
This compares to something like a 12.9x for emerging markets (7.8 percent forward yield), but this also doesn’t consider the higher risk associated with emerging markets and the difference in sector mix.
For example, the US has more tech firms than Europe, Japan, and emerging markets. These firms tend to grow faster and their cash flows achieved further out in the future than more stable industries like financials, industrials, and utilities, giving them a higher multiple.
That makes earnings multiples expressed one year out – as forward P/E does – less relevant to some industries than others.
China, because of a greater proportion of state-owned enterprises and financial firms, trades at an estimated earnings multiple of 12.5x.
The same is true for a country like Russia, whose largest public companies are state-owned and have a history of corruption, which undermines confidence in free and fair markets, leading to lower market-wide multiples – in this case, estimated at 7x-8x.
Extremely Fast Money Growth Fuels Rallies in Equities and Corporate Debt
The amount of currency and reserves in circulation in the US increased from $3.2 trillion September 2019 to $5.2 trillion by May 2020:
(Source: Board of Governors of the Federal Reserve System (US))
The amount of systemic liquidity added puts the size and speed of QE1, QE2, and QE3 (the Fed’s official quantitative easing programs between March 2009 and October 2014) to shame.
The Fed has never strived to lift the economy out of recession as it has during the coronavirus meltdown.
The Fed can solve a liquidity crisis – i.e., providing bridge loans and other credit and liquidity support to boost an economy. But it cannot solve a solvency problem where a business cannot execute and remain viable.
Many small businesses are facing solvency problems. April’s high-yield default rate came in at about 5.4 percent, but could elevate to around 13 percent by Q1 2021.
Fastest Growth by Commercial and Industrial Loans since 1950-1951
The need to compensate for Covid-19 related liquidity shortfalls is propelling bank business loans at a pace higher than what’s been seen in 70 years.
In concert with the fast-rising monetary base metrics, outstanding bank-held commercial and industrial loans soared higher rose to a record $2.96 trillion in April, up 26.2 percent year-on-year.
April’s yearly increase by bank-held C&I loans was the fastest since the 29.5 annual rate from September 1951.
For all of 1951, nominal GDP’s 15.7 percent rise was accompanied by real GDP growth of 8.0 percent.
From January to April, or the three months ended April, bank-held C&I loans rocketed higher at an unprecedented annualized pace of 149.1 percent.
Prior to 2020, the former pinnacle for the annualized three-month growth rate of bank-held C&I loans was the 48.7 percent of the three months ended September 1950.
For the full calendar-year 1950, the US produced annual growth rates of 10.0 percent for nominal GDP and 8.7 percent for real GDP.
For comparison’s sake, a forward expectation for US growth would be around 1.5-2.0 percent real and 3.0-4.0 percent nominal.
The large economic growth rates of 1950 and 1951 helped to lower the high ratios of US government debt to GDP that came about to primarily help fund World War II.
In view of how publicly traded US government debt will soon approach 100 percent of GDP, the US may be biased toward faster economic growth in the near-term if there’s sufficient stimulus. But given US government debt doesn’t provide benefits that offset its costs, on net, it’s a long-run drag on growth.
However, once profits start to come back or increase at the corporate level, most companies will begin to service debt that’s been incurred for the purpose of maintaining sufficient liquidity.
Inflation or no inflation?
Inflation is an important factor in the real economy and also has implications for the financial economy.
The common question is whether all this new money and credit growth leads to inflation.
The short answer is that it’s inflationary in the financial economy, but probably not in the real economy.
There may be some inflation in the more elastic goods, such as in food and basic healthcare, which we’re already seeing to some extent. But the deflationary forces from all the debt may very overwhelm any inflationary forces simply because they’re so large.
In the financial economy, if the money and credit doesn’t go into spending or reserves, then it ends up in the purchases of financial assets. So, it’s inflationary in the financial sense.
But in the real economy, you’re simply offsetting credit destruction. If the money and credit isn’t brought up to offset the loss in product and service demand, then prices will actually decline.
In emerging markets the dynamic is different because of the foreign currency borrowing. When a shock hits, what often occurs is a decline in the exchange rate between the currency they make their incomes in and the currency (or currencies) they borrow in. This is like a big surge in effective interest rates.
In these cases, the bottom in the currency is found once policymakers set an interest rate on the currency that offsets both the inflation rate and depreciation in the currency based on the underlying capital flow in and out of the country (i.e., their balance of payments).
To shore up bad inflation, they often have to set an interest rate that kills credit creation and causes a major turn down in the economy. If they continue to print, it will generally be moved into other countries or into inflation-hedge assets so their money doesn’t lose value. This exacerbates the domestic currency problem. If the gap is never closed between external spending, income, and debt servicing, a bad inflation situation can turn into hyperinflation.
In a periods of post-crisis investing, it’s time to worry about fiscal cliffs again
State and local government policymakers are facing the most challenging budget environment in at least a generation. Some have never had to deal with these budgetary circumstances.
As a whole, government financial problems tend to get worse over time. Policymakers are always more inclined to spend than not spend given it’s politically popular to do so and don’t always pay much attention to how it will all get paid back. So, there’s a tendency for government finances to get worse over time, especially at the highest level.
The baseline economic outlook is that the contraction in GDP will be more than twice the magnitude of the 2008 financial crisis. The amount of ongoing federal help remains unknown. In the meantime, revenues have fallen by a lot (which one wouldn’t necessarily know looking at the stock market) and spending on social services is accelerating at a record pace across the country.
The risk of a US fiscal policy error is rising.
Moreover, there are a pair of potential fiscal cliffs this summer. If not addressed in a capable way it will cause the economy to underperform expectations in the second half of the year.
For example, one of the major policy errors following the 2008 financial crisis was the premature shift to fiscal austerity.
Between 2010 and 2014, fiscal policy was a drag on GDP growth. The 2009-2020 expansion was long, but slow. This was mostly due to pre-existing debt burdens that hadn’t been worked off. (The Fed’s loose policy measures from 2008 forward were necessary, but also meant the economy would start from a high debt base and produce a slow recovery.)
The budget has blown way out to around $2 trillion per year, or about 10 percent of GDP, which is unnerving to some policymakers.
While lawmakers are not fiscal hawks relative to how the deficit matter used to be treated, some are concerned about providing another round of fiscal stimulus because of the rising debt-to-GDP ratio.
However, failure to provide more support to small businesses along with state and local governments will reduce federal government revenue and push the federal deficit higher. Either way the deficit is going to increase.
Potential fiscal cliffs
There will be a few potential fiscal cliffs this summer if policymakers don’t act on them.
First, the Federal Pandemic Unemployment Compensation adds an extra $600 per week to regular unemployment benefit payments. This is set to expire on July 31.
The issue is that it may not be politically palatable to simply extend the Federal Pandemic Unemployment Compensation as it’s currently set up.
Some policymakers expressed concerns that the extra $600 in additional unemployment insurance benefits is creating a disincentive to work.
About two-thirds of workers receive more being unemployed currently than they did at their jobs. $978 per week (average) in unemployment multiplied out to a monthly rate comes to around $4,200 per month. If that’s averaged over a 40-hour work week, that’s $24-$25/hr. That’s higher than a lot of jobs. Over a year, that’s a bit over $50,000, which would put one in the 61st percentile of income based on 2019 data.
If they keep with those unemployment benefits, that could hamper effective labor allocation going forward. And like all crises, entities adapt and might find they don’t need to rehire a lot of furloughed employees.
Those hit the hardest are lower-skilled workers. They are usually the first out when a crisis hits and the last in on the recovery.
The Fed’s Beige Book is a compendium of anecdotal, on-the-ground research about current economic conditions published eight times per year.
The Fed’s latest version mentioned that several contacts in a variety of industries noted additional labor market challenges. This includes limited access to child care services, which is keeping workers away from their offices and job sites. More workers are requesting to stay home because of fear of the virus. And, as noted, unemployment benefits in some cases are dis-incentivizing workers from rejoining payrolls.
Unemployment benefits need to be extended to avoid this fiscal cliff. One possible option to regarding the disincentive for work is for policymakers to provide a lump-sum payment of the remaining $600 in forward benefits once new employment has been gained.
The July 31 cliff should be easily avoided by extending unemployment benefits.
Paycheck Protection Program
The expiration of the Paycheck Protection Program (PPP) represents another cliff.
These loans expire eight weeks after they’ve been disbursed.
The first round of payments were made in mid-April and the second round in the first half of May.
Small businesses funding their payroll with these loans could come under renewed pressure by early July. Usage of the PPP has gone down recently over uncertainty of what portions are likely to be fully or partially forgiven (e.g., if the funds went toward keeping employees on payroll) and which will need to be paid back.
The Small Business Administration (SBA) has interpreted the abatement in loan approvals as a sign that demand for the program has been met. About eight weeks of eligible payroll, rent, mortgage interest, and total utility expenses for the program would amount to some $700-$800 billion.
Based on that figure, about 70 percent of PPP demand has been met. The remainder may not be wanted due for various reasons.
Deep deficits at the state and local level
Moreover, state and local governments face their own fiscal cliff as the new fiscal year quickly approaches for most.
State and local governments will have virus-related budget cumulative shortfalls of $500 billion (at a minimum) through fiscal year-2022.
This is a lot as its equal to around 20 percent of annual revenues before the Covid-19 crisis broke out. It also doesn’t include healthcare costs at the state level needed to battle the pandemic.
The federal government has picked these up and will need to further. Without doing so, there will be more furloughs, layoffs, and pullbacks in expenditures.
European Central Bank
The European Central Bank recent raised its ongoing quantitative easing purchases under its PEPP programme – an increase of €600 billion to a total of €1.35 trillion.
The purchases are set to run through June 2021, as opposed to through the end of 2020. At the previous pace, the purchases that had already been announced under the ECB’s PEPP programme were set to run out in October.
Traders would have anticipated a lack of central bank buying support as likely to result in a re-widening of bond spreads as the date draws near (i.e., trade structures that short-sell European government bonds purchased as part of the program).
Because of larger and rising debt burdens and consequent increased fragility in the economy, policymakers want to avoid an increase in financing costs. Debt in all the three major reserve-currency parts of the world – US, developed Europe, and Japan – all need to keep interest rates pinned as close to zero (or negative) as possible to keep the debt from becoming a problem.
The European Commission recently announced a fiscal proposal worth €750 billion to help the European Union countries finance the cost of the crisis. However, the funds will probably only start to flow in 2021, which means that the onus will remain on the ECB through the remainder of 2020.
The prevent this from happening, policymakers could:
– increase its asset purchases (as it’s done)
– resolve to buy more assets for a longer period (ditto)
– increase the bank’s tier multiplier to release more money into banks’ reserves while the ECB lowers its TLTRO rates more into negative territory
– lower its deposit rate (unlikely because it’s less effective relative to other measures as banks usually don’t pass off negative rates to depositors)
– Reinvestment of PEPP proceeds (i.e., the same way the proceeds from PSPP investments can), which would allow for deviation away from the capital key*
(*The capital key denotes how much capital each member of the EU contributes to the ECB. This is calculated via their population and GDP in equal proportion. If a country has 5 percent of the EU’s population and 10 percent of its GDP, then its capital key would equal 7.5 percent, the average of those two numbers.)
Beyond semi-traditional policy tools, the ECB could also loosen rules on the types of bonds its willing to buy rather than only certain national and corporate bonds that meet a certain quality. Any issuance pertaining to the EU Recovery Fund could be offset through the ECB buying it and riskier corporate bonds could be purchased as well.
The Gold Market
Gold is at or near its all-time high relative to many currencies globally.
(Source: Trading View)
Gold is not a random commodity that’s disconnected from the rest of the world. It’s deeply intertwined in monetary economics because of its status as a global reserve asset, as it’s been for thousands of years.
That it’s at these highs is not coincidental given the all-time lows in real interest rates in each of the main reserve currencies.
Gold’s long-run price is proportional to currency and reserves in circulation relative to global gold reserves.
Large-scale money printing is a large secular tailwind to the price of gold as priced in fiat currencies.
The gold market is typically choppier than stock and credit markets when they’re taken collectively as it’s not as liquid of a market. It’s only about $3 trillion in size relative to global debt markets of around ~$325tn and equity markets of about ~$80tn.
Gold is increasingly cheap relative to the fundamentals that drive its long-term value. Global gold reserves don’t grow much from year to year, a pretty steady 1 to 3 percent.
Accordingly, it’s largely fiat currency and reserves that dictate it long-run value and that’s been on overdrive to fill in the credit gaps.
Then you have debt-like liabilities that are increasingly coming due – healthcare, pensions, other unfunded obligations – that can’t be fulfilled without a currency depreciation.
The more real rates turn down on a higher quantity of debt and inability to make due on demands in non-depreciated money, the more people begin searching for alternative stores to hold their wealth. The inherent illiquidity in the market can have a material effect on the price should one benefit from outflows from a burgeoning pile of financial assets where the future cash flows don’t support their face values.
All fiat currencies come and go at some point, though they tend to work well for long spells of time such that these inflection points are reached infrequently – decades and sometimes centuries – causing many to underestimate their currency risk and assume it’s never a problem. Diversifying away from holding everything in just one currency is important.
Accordingly, there’s the diversification with respect to not only financial assets but to different currency regimes. There’s fiat currency systems, there’s commodity-linked, and there’s hard backings.
For reserve managers that still have 65 percent or more in US dollars, that’s probably too much, as it’s high in relation to the USD’s proportion of global reserves, international debt holdings, global import invoicing, FX turnover, and global payments. (Not to mention that the US is only about 20 percent of global economic activity now, yet still retains disproportional control over global monetary affairs, largely due to reputation.)
Yet EUR is not attractive; neither is JPY. Real rates are low on all reserve currencies.
Speculative currencies in emerging markets are unstable and not viable storeholds at much of a scale. Things like digital currencies and cryptocurrencies are too volatile and have a very long way to go before they are viable to the large buyers who matter most in currency markets (central banks, large institutions).
Reserve growth is likely to increasingly go into alternative assets like gold. With extreme money creation demands throughout the world because of high debt servicing requirements and large drops in income, most monetary policymakers and investors probably want to diversify away from that. This includes assets that are relatively stable, tried and true over long periods of time, and are not anyone’s liability.
According to the World Gold Council, so far in 2020, central banks have added close to 150 tons of gold to their portfolios. They added 650 tons in 2019 and 656 tons in 2018, the highest since gold-dollar convertibility was suspended in 1971.
The world’s second-largest economy, China, likely keeps a lot of its gold purchases off its books through an entity called the State Administration for Foreign Exchange (SAFE).
According to the WGC:
As we noted in our Q1 2020 Gold Demand Trends report, the case for central banks holding gold remains strong. Especially considering the economic uncertainty caused by the COVID-19 pandemic… Factors related to the economic environment – such as negative interest rates – were overwhelming drivers of these planned purchases. This was supported by gold’s role as a safe haven in times of crisis, as well as its lack of default risk.
Nonetheless, gold and other precious metals should not be overemphasized in a portfolio. It’s not the best investment over long periods of time. It’s simply an alternative form of cash.
For a passive holding, some 5 to 10 percent of a portfolio could be a reasonable range.
In the post-crisis investing world (at the time this is posted, it may still be premature to say that), stocks are pricey and safer forms of bonds are also expensive.
As the world’s main central banks turn on their money creation machines to deal with the economic fallout of the Covid-19 crisis, this undermines the long-run value of money.
Even if it’s not apparent currently, the squeeze pressuring reserve currencies higher will abate once demand for it has been met and/or defaults and restructurings pick up.
Fiscal cliffs will once again become an issue and central governments will have no choice but to keep rates very low for a very long time with their intractable debt problems.
Investors should look toward alternative forms of investments and pay more attention to their currency risk. Diversification is not just buying different stocks or buying both stocks and bonds. Skilled investors in the private markets (e.g., private equity, venture capital, early-stage investments) are likely to see increased demand.
Alternative stores of wealth, like gold and other precious metals, have tailwinds behind them, but shouldn’t be a huge part of one’s portfolio overall.
On the monetary policy front, the Federal Reserve asserted that it sees interest rates near zero through at least 2022 and released new economic projections. That’s a conservative estimate that’s not much different than when they said rates would be at zero through at least 2009.
Eight years later, the Fed gave hiking interest rates a try. But it got a meltdown in risk asset markets after about 200bps. It was a similar mistake to hiking rates in 1937 following the Great Depression.
Central banks pay attention to employment relative to inflation because that’s the statutory mandate in one form or another (depending on the bank). But not enough attention is paid to debt relative to income. This is another important equilibrium.
Debt-to-output ratios are higher now and a bigger drag on growth. Even a 100-bp increase in interest rates globally would increase debt servicing requirements by more than total annual global GDP growth.
Interest rates will remain low for a very long time and will push more investors into stocks and other risk assets, and purposefully away from low-yielding cash and safe bonds to help achieve their policy objectives.