Current State of the Markets
After the most precipitous fall in market history and now a 50% bounce-back, investors are trying to figure which way the wind blows. The NFIB (Natl Federation of Independent Businesses) estimates that half of all small businesses cannot survive the shutdown through June. Small businesses make up half of all employment. We are already seeing massively negative numbers in unemployment claims and PMI surveys. This is expected given our current situation. IF unemployment is going to 25%, has the market priced this in already, albeit briefly? Will the several trillion dollars in stimulus and liquidity overpower economic gravity and keep asset prices elevated? Valuations for stocks had been in the top 2% most expensive of all time, for a couple of years. If prices stay or climb higher without commensurate wage/economic activity, valuations could surpass recent levels—inflation in assets, deflation in wages. In the past, these two generally have not gone together, except in the post 2008 era.
In addition, past recessions have seen job losses increase over several periods. This time, a lot of the economic impact is happening in a short period of time. Much of the impact is being front-loaded AND is expected to be short-lived. Estimates are that GDP has contracted as much as all the previous recession. As we contract further, the risk that we have not done enough stimulus becomes greater, extending the timeframe for recovery which in turn will lower sentiment and expectations for asset prices.
Which is it? Bull or Bear Market?
The terms bull and bear have a long history, dating back to the 18th century during the South Seas Bubble. Some attribute the attacking postures each animal takes, the bull goring and lifting upward; the bear, swiping its claws downward. The definitions we use today though are very new, dating only to the 1970’s. The arbitrary 20% measurement to label a market as a bull market or bear market can be misleading. We say today that the recent fall was greater than 20%, thus a ‘bear’ market; and now we have seen prices rise more than 20% from the bottom, a ‘bull’ market. Do these labels help us in determining whether to be invested in stock markets? Do these labels provide any clarity to the nature or outlook for the markets? No, on both questions. For a far longer time the terms bearish and bullish have been used to describe the nature of the market. Bear-ish and bull-ish can better describe the character of the market one is in. A trend can be described with these terms, also the behavior can be better characterized with these terms. In bearish markets, large daily movements can be seen in the context of a downtrend. Bearish markets move fast. Bullish markets are a slower daily grind in an uptrend with a rare day showing more than 1% or 2% move. Its certainly a subjective interpretation, but the change from a bearish market to a bullish market, in addition to a visible trend change, should also see smaller intraday percentage moves. While the daily trend has turned up, the daily percentage moves remain elevated.
A Visual of Fed Interventions
Recently, some famous names from the 2008 crash reflected on that period and concluded they should have acted faster and with larger amounts of stimulus. The Fed certainly has taken that to heart this time around and indeed has acted with vigor. The first chart below tracks the Fed’s actions overlaid with the S&P500. Even after the bottom, the Fed continued with QE 1, 2, Operation Twist, and QE 3.
All the Fed actions, in real time, did nothing to stem the decline in prices. The S&P 500 Price to Earnings ratio in early 2009 exceeded 100 (trailing 12 months earnings). In late 2008, we saw 50+, prior to banks recognition of their losses. Here is another chart, with recent Fed actions overlaid against the S&P 500.
Looking at these, an honest question is whether the Fed has any influence over equity markets in the short term.
Covid-19 or Global Dollar Funding Issues?
Few remember way back in September 2019 when the US overnight interbank lending rate increased by a factor of 5, rising from the targeted 2.2% to almost 10% (annual rate, intraday) on September 16th. This caused the Fed to intervene, putting $53billion into interbank lending on an overnight basis. The overnight lending quickly morphed into multi-day and multi-week repurchases agreements totaling more than $300B in a few weeks. Previously banks had been lending to each other, overnight, secured with collateral (red line). The Fed went from no participation in the $1 trillion+ overnight market to more than $350 billion, and then moved from repurchase agreement to outright permanent purchases and began the massive balance sheet expansion we are seeing today. The Fed balance sheet rose from $3.76T in mid-September 2019, to $4.3 by March 11, and now is $6.4 trillion. Another $1 trillion and the recent expansion will be larger than QE 1, 2 and 3 combined.
The red line secured overnight lending began spring 2018, right after the February 2018 market correction, AND foreign dollar-funding costs (TED spread- orange line) jumped to the highest level since 2009. The volume of funding increased for several months until banks ran short on capital to use as security, as dictated by liquidity rules in the Volcker Rule. While demand (red line) had been growing for liquid cash dollars, the amount of collateral used to secure this lending was not enough, and when demand outpaces supply, the price (overnight funding rate—green line) goes up. But that price was too high, and the Fed intervened, and the total volume of dollar funding continued to increase (red and blue lines together) at an increasing rate.
We can see how due to the demand for US dollars began to increase in early 2018 (orange line), funding for dollars increased to a point where major banks could not meet demand for dollar liquidity, and the Fed stepped in and took over funding. There was balance in the supply and demand from November 2019 to the end of February 2020. From February 26 to March 4, the TED spread (a measure of stress in markets) began to grow rapidly. The economic contraction stemming from Covid-19 exacerbated the serious issue of dollar funding (less activity means less trade/less dollar flow). Today the Fed is fighting the dollar crisis AND the loss of over $2trillion in US output/GDP.
Monetary Base and the case for S&P 500 to 4000
For most of the post WW2 era, the growth of the monetary base (all currency and bank reserves) tracked the growth in GDP. Historically, growth in GDP lined up very well to growth in the S&P 500 over a full business cycle. During the Great Financial Crisis (GFC) with hundreds of billions of mortgage loans going bad, there was a risk that if all the loans were marked to their true worth that the monetary base would contract, resulting in a deflationary debt spiral. In our current system all money is created by new credit. If too many loans go bad, the monetary base declines as money that was lent/created disappears as collateral prices decline, and loans are not paid back.
The solution was for the Fed, for the first time in its history to accept as collateral (and purchase outright) mortgage-backed securities. As the Fed accepted these securities, it provided cash to banks. Without the burden of non- or poor- performing loan, banks were freed up to lend again. As this new cash was put into the system it also flowed into risk assets like the stock market.
The chart below clearly shows the relationship between QE and the S&P 500. New cash found its way into stocks and pushed prices up. The period after QE3 and the brief ‘balance sheet normalization’ saw the most significant corrections post GFC. A minor 15% correction after the base stopped expanding in early 2016 followed by a 19% decline late 2018 and now the 30% decline most recently. Other banks, namely China did keep expanding their monetary base in late 2015 and into 2016. Then as China’s credit impulse wore off and as mentioned earlier, demand for US dollars kept increasing while the Fed lowered supply, we had the late 2018 market sell off. The Fed backed off its plan to raise interest rates and cut rates summer 2019. These actions aided liquidity and stock moved up after both actions.
With each QE period we saw the monetary base and the S&P 500 market capitalization increase.
Change in S&P 500 Change Monetary Base
QE 1 +37% +33% QE 2 +12% +33% QE3/Twist +53% +52% 2019 Cuts +34% -20% needed rate cuts were due to MB decline 2020 -15% +43%
Currently the Fed is trying to increase the monetary base to keep asset prices and liquidity up. We do not know yet to what degree the current recession will lead to loan losses and other credit destruction. In addition to loans going south there is the general decline in output as we are locked down.
Through April 8th, the Fed has increased the monetary base by $1.2T, or 35% over late 2019 levels. $1.2T may be the approximate output lost during the lockdown. The Fed has expanded its collateral and purchases from treasuries and mortgage backed securities to now include junk bonds, corporate bonds, and other collateralized loans. Over the past week and going forward the Fed will likely continue to monetize these securities, further expanding the monetary base. If we see another $2T to the monetary base (Fed balance sheet expansion) that would approximate a 100% change in the MB and potentially impact the S&P500 similarly, going from 2100 in late March to 4000 by end of the year. In this scenario, one would have to accept a reality of 12% unemployment concurrent with S&P500 at 3500+, and a $2 trillion annual deficit. The wealth disparity would be substantially more extreme than in recent past.
We are entering a period in US history like no other. The reaction to the Covid19 virus has put the economy into a self-induced coma. Current expectations are that monetary and fiscal stimulus will pave over/fill in lost income and liquidity setting the stage for a return to economic growth. The problem with this thesis is that we do not know how long the shutdown will last and after many small businesses run out of cash and close, how many people will get hired back. There is substantial risk of extremely poor economic data to persist for several months. The knock-on effects of a prolonged shutdown are difficult to estimate. The more unknowns, the longer the shutdown, the worse the global dollar shortage, the more extreme market movements we are likely to see.
Adam Waszkowski, CFA