Observations and Outlook April 2020

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.

fed actions vs sp500 2008

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.

fed actions vs sp500 2020 resized

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.

repos global dollar

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%

monetary base

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

 

 

Blame the Fed! (for following through on previously telegraphed guidance)

The Federal Reserve today reiterated it plans to continue what it has been doing and said it would continue to do, much to the chagrin of market participants.

While the last Fed minutes showed more dovishness, actual actions that are indeed ‘dovish’ have yet to occur.  Reducing expected rate increases from 3 to 2 in 2019 was widely interpreted as, ‘the Fed might stop raising rates’, for some reason.  History shows us that the Fed telegraphs well in advance what it intends to do.  Thanks to Alan Greenspan, this has been the case for more than 20 years now.

What has the Fed said it will do in 2019?  Raise rates two more times and continue to drain liquidity from the system via its bond roll-off program.  It is also expected that other nations’ central banks will also cease adding liquidity this year. China may not have gotten the memo though, as they just lower their Reserve Requirement Ratio by 1%, freeing up approximately $100 billion in bank liquidity.  This was announced on Friday, January 4, but was not even mentioned in the Saturday Wall Street Journal!

Here is a picture of global liquidity for 2019.  From adding more than any given year in 2017, to net withdrawal in 2019.   Adjust your expectations accordingly.

qt central bank 10 2018

 

Oberservations and Outlook July 2017

Selected Index Returns 2nd Quarter/ Year to Date
Dow Jones Industrials    3.95%/ 9.35%          S&P 500   3.09%/9.34%         MSCI Europe   7.37%/15.36%

Small Cap (Russell 2000)   2.46%/4.99%     Emerging Mkts  6.27%/18.43%     High Yld Bonds   1.37%/15.3%

US Aggregate Bond 1.45%/2.27%   US Treasury 20+Yr   4.18%/5.66%    DJ/UBS Commodity -3%/-5.26%

2017 and its second quarter continue to be kind to financial assets, with both stocks, bonds and gold all climbing year to date.    European and Emerging Market equities have been the strongest this year, rising smartly after falling by 10% during the second half of 2016.  Emerging Market equity funds are back to a price area that stretches back to 2009!

Bonds continue to vacillate in an upward trend since mid-December. The commodity index is down primarily due to oil, as agriculture and base metals are essentially flat on the year after a recent climb.

Correlations between stocks and bonds have increased recently, with equities being flat over the past 6 weeks as bond prices have declined over the last two weeks.   While this phenomenon is negative for investors, equities appear to remain well inside their uptrend while bonds (and gold) appear to be near medium-term support levels.  We may see both stocks, bonds, and gold again climb concurrently reflecting a continuation of the year to date behavior.

What has been driving stock prices?  Growing earnings, low interest rates, lack of inflation, and ‘moderate’ GDP growth are the most common reasons to explain how prices have gotten to these levels.  Earnings have been on the rise since the end of the ‘earnings recession’ that lasted from June 2014 through March 2016.   After a decline of some 14% we’re now growing again, even robustly, given the low base from the previous year.  Earnings are still one or two quarters away from hitting new all-time highs, yet the S&P500 is roughly 20% higher than in early 2015.  The chart below gives us a visual of what prices rising faster than earnings looks like. Anytime the ratio is moving up indicates prices climbing faster than earnings.

shiller cape 6 30 2017Source: www.multpl.com

By this metric (and there are many others) stocks are valued at a level only exceeded by the roaring ‘20s and the dot-com era.  Can earnings continue to grow to support valuations?  The continued lack of wage growth and continued generationally low labor participation rate are headwinds to growth in consumer spending.  Consumer credit growth has slowed dramatically over the past six months and without wage or credit growth it’s difficult to see how the consumer will spend more to support ‘moderate’ GDP growth.  Low interest rates, or the comparison of low rates to dividend and earnings yield have provided much support over the past several years to the reasoning behind bidding up stocks faster than their earnings growth.

Interest rates bottomed one year ago at 1.3% (10-year treasury) and then ran up to 2.6%, mid-range since 2010 and the upper range of rates since late 2013.  The jury is out still on whether this marks the end of the bond bull market that has lasted since 1981.  The problem is that if consumers and businesses must increase their interest expense, there is that much less left to expand their consumption and investment.   Low rates had been a key enabler of more borrowing, leading to more consumption, and higher profits.  Now, in some areas, analysts are saying that higher rates are ALSO good for stocks because it represents growth expectations.  Frankly we’ve been ‘expecting’ growth now for several years, and the only positive representation of growth (GDP) we have seen is due to a willful under-reporting of inflation.   Gains in expenses in housing, healthcare, and education have far outstripped the general inflation rate.  At the same time, official statisticians tell us our TVs, cell phones, and other tech devices are far cheaper, because we ‘get more’ for our money.  This is called hedonic adjustments.  Look this up and you will understand why one’s personal experience with the cost of living doesn’t mesh with the official inflation statistics.

It seems the main reasons we are given for buoyant stock prices appear tapped out or stretched.  The thing is, it’s been like this for a few years now.  So then, what really is driving prices?  Some of it has to do with FOMO, Fear Of Missing Out.  No one wants to get left behind as prices rise, even if said prices already appear expensive.   As fundamentals have deteriorated over the past few years what is causing or who could be that marginal buyer who always seems to have more money to put towards financial assets? Perhaps this chart has something to do with it.

Central-Bank-Balance-Sheets-Versus-MSCI-World-Index

As central banks have purchased outstanding bonds (and equities in the cases of Japan, Switzerland and Israel among others) the cash or liquidity provided has found its way back into the equity markets.  Additional effects have been to put a bid under bonds, increasing prices and lowering rates.  What many investors in the U.S. don’t realize is that the European and Japanese central banks continue to this day putting approximately $400 billion per month into the financial markets.  If this is the true reason behind stock and bond price levels today, any cessation, slowing or even anticipation of slowing will likely have negative effects on asset prices.  The chart below shows where the U.S. Fed ended its QE efforts while Japan and Europe picked up all the slack and then some.  The astute observer can see where the Fed tapered, while the ECB was not adding liquidity, from 2014 to 2015.  From mid-2014 to early 2016, the Vanguard FTSE Europe ETF dropped by 29%.

central bank buying 4 2017

Beyond central bank liquidity creation there is also the concept of growth in the private sector.  Here too we see that a phenomenal amount of debt must be created to sustain growth.   New debt creation in China dwarfs the rest of the world.  China has put up high growth numbers the past several years, more than 7% annually.

private sector debt creation qe

Going forward it will be crucial to watch for central banks’ behavior as to ending current ‘QE’ policies.  Japan is still committed to a 0% 10yr bond rate, yet the ECB has begun to state that its bond buying won’t last forever, and is likely to slow by mid-2018.  The U.S. Fed has indicated continued tightening via rate hikes (likely one more this year) and to begin to let ‘roll off’ maturing bonds.  The roll-off will take liquidity from the markets.  It will start small and gradually increase in 2019 and thereafter.  These cessation tactics are done under the current understanding that financial conditions are ‘easy’.  Put another way, the banks will start to slow new liquidity and then drain liquidity as long as financial conditions, which include stock market levels, don’t get to difficult.   What exactly is the Fed’s downside tolerance is unknown.  What is knowable, is that the decision-making process takes months to be put into effect and by that time, markets could move down and growth could halt.

Near Term vs Long Term

The concepts of credit creation and central bank balance sheets and their respective monetary policies are will have impacts on asset prices over the longer term.   Year over year earnings growth forecasts, specific companies’ ‘beats’ or ‘misses’ and monthly data on inflation, job growth, and wages all have short term impacts on the stock market.  Currently, earnings are expected to grow robustly, official inflation is subdued and official unemployment are all in the “very good” range.  Combine that with the Fear Of Missing Out concept and that should help keep the markets up and even higher for a while longer.  The problem is that simply because we want markets to move higher doesn’t mean they will.  At some point paying 30x earnings will seem too expensive and the markets will lose some marginal buyers and some will become sellers, for whatever reason.   Based on current valuation metrics and the business cycle, we know that equity returns over the next several years will be very low.  If rates go up, and/or credit (the ability to pay) worsens for individuals and businesses bond funds will likely suffer as well.  Over the long term, avoiding large losses or drawdowns, even while lagging the market on the upside, can have a dramatic positive impact over a full market cycle.

What Can Be Done

If one suspects returns will be lackluster, and prices volatile, should one endure it?  The solution is at once simple and difficult at the same time given our cultural of equity ownership and the media’s constant focus on one asset class: equities.

Diversifying amongst the other 6 asset classes is a start.  Most advice revolves around two classes, stocks and bonds.  If one truly wants to buy low and sell high, one must identify the other areas that are “low”, increase exposure there, and reduce exposure to “high” asset classes.  Not only does this smooth out volatility but can increase long term returns.   Given the outlook for more volatility in stock and bond prices; very low prices (historically and relative to other assets) in precious metals, agriculture and oil; there should be many opportunities to take advantage of short term swings to benefit and move some ‘eggs’ from the equity side into other, non- and lower-correlated asset classes that are currently much lower in price.

Easier said than done, yes.  This is exactly why investors should seek out Investment Advisors willing to do this difficult work and that have a strategy to deal with changing markets.  For more information on how I am doing this for my clients, please contact me.

Adam Waszkowski, CFA

This commentary is not intended as investment advice or an investment recommendation. Past performance is not a guarantee of future results. Price and yield are subject to daily change and as of the specified date. Information provided is solely the opinion or our investment managers at the time of writing. Nothing in the commentary should be construed as a solicitation to buy or sell securities. Information provided has been prepared from sources deemed to be reliable, but is not guaranteed by NAMCO and may not be a complete summary or statement of all available data necessary for making an investment decision.  Liquid securities, such as those held within managed portfolios, can fall in value. Naples Asset Management Company, LLC is an SEC Registered Investment Adviser. For more information, please contact us at awaszkowski@namcoa.com.