A growing number of governors are voicing concern about the damage inflicted on both the revenue and the expenditure sides of their states’ budgets by the COVID-19 pandemic. To allay these concerns, the $2 trillion Coronavirus Aid, Relief, and Economic Securi­ty (or CARES) Act provided $150 billion to state and local governments in addition to a $30 billion educa­tion fund, a $45 billion disaster relief fund, and other smaller programs. But even these massive sums are proving inadequate to prevent the enormous dis­ruptions caused by large-scale business shut-downs, plummeting tax revenues, and new healthcare and unemployment insurance expenses. Moreover, this threat only grows with each day that states like New York, New Jersey, Illinois, and California delay fully re­opening for business.

The situation is particularly dire for the many states that entered the current crisis with “preexisting conditions” that render them less able to cope with these challenges owing to repeated failures in ad­dressing their budget issues. That’s especially true for states with heavily underfunded public employee retirement benefits. Many states that have offered generous retirement benefits to their employees have not funded these benefits in full, partly be­cause the needed money has been spent elsewhere in the budget. Accounting gimmicks, as well as high investment returns in the past decade have kept overburdened states afloat. But just as economic catastrophe is driving debt-laden companies such as JC Penney, Neiman Marcus, and Hertz into bankrupt­cy, many states are being forced to confront similar burdens.

It is in this context that the idea of including states under Chapter 9 of the U.S. bankruptcy code, which allows cities, counties, and other municipalities to file for bankruptcy, has resurfaced. This proposed expansion would allow state governments to file for bankruptcy.

Although controversial, the idea of political juris­dictions filing for bankruptcy is far from radical. In fact, since 1980, there have been a total of fifty-four Chapter 9 filings involving cities, counties, towns, and villages.

In theory, allowing states to go through the bank­ruptcy process would overcome today’s political obstacles and finally create the conditions for finan­cially troubled states to rectify their unsustainable financial conditions.

It this realistic?

Consider the facts.

Ideally, insolvent states would try to right their fiscal conditions. That means legislatures and governors would make the hard budget adjustments necessary for states to meet their obligations to the public, re­tirees, and bondholders. But it is apparent, especial­ly for the most financially overburdened states, that doing so is neither politically feasible nor economi­cally possible without severe cuts to public services.

A decade ago, General Motors and Chrysler both de­scended into bankruptcy after decades of misman­agement and poor performance, as well as excessive labor and retiree costs. In a similar fashion, decades of mismanagement and short-term political deci­sion-making by state governments have finally col­lided with economic reality. But today, states don’t have the option of “wiping the slate clean” via bank­ruptcy.

So, what options do states have? Their preferred option would be to get a federal bailout. But that would provide no incentives to reform overly gen­erous public employee labor compensation, which is the root cause of their problems; such a bailout would only encourage states to continue making poor choices. It would also require residents of fiscal­ly prudent states to bail out states which refuse to live within their means, many of which are wealthy. Al­ternatively, states, as sovereign entities, could simply default on their debts. But that would mean public employees are protected at the expense of taxpay­ers and bondholders. And this would make it unlike­ly that these states could borrow money at anything other than “junk bond rates,” ever again. Worst of all, current taxpayers in New York and Illinois would end up paying higher interest rates, getting fewer services, and funding public-sector retirees now liv­ing in Florida.

Until Senate Majority Leader McConnell made clear that no bailout would be forthcoming this year, the idea of states seeking bankruptcy protection was only a hypothetical suggestion. In fact, McConnell took the bold step of suggesting that expansion of Chapter 9 bankruptcy to include state governments was an attractive alternative which Congress should seriously consider as a means of alleviating the cri­sis many states now face. Naturally, this sent shock waves through states like Illinois, New York, and Cali­fornia with huge underfunded pension liabilities.

But in the absence of a Federal bailout, McConnell’s suggestion appears a better alternative than selec­tive default and debt repudiation, which would cre­ate many new problems and do little to solve current problems. This is especially true since many of the most troubled states are constrained by state consti­tutional provisions that prohibit the flexible options that states should use to rectify their balance sheets in a comprehensive way. Most important, many state constitutions contain provisions that have been interpreted by courts to guarantee that state and local employees have a right to pension bene­fits based on the formula in effect at hire, without reduction, until retirement, essentially rendering these obligations untouchable.

The idea of extending bankruptcy to states is not new.  University of Pennsylvania law pro­fessor David Skeel, a specialist in corporate finance and bankruptcy, first introduced the idea after the Great Recession of 2007-2009. He argued that a procedure for bankruptcy could instantly reduce states’ unsustainable bond debt, cut wasteful spend­ing, and allow states to rework unsustainable public employee retirement benefit obligations. Duke Law professor Steven Schwarcz even designed a model state bankruptcy law that would achieve these ob­jectives.

What’s the bottom line? Extending bankruptcy mechanisms to the states would avoid some of the problems with the current alternatives. But Chapter 9 bankruptcy, as currently formulated, is no panacea for taming countervailing political dynamics. The more recent bankruptcy experiences of larger and more indebted municipalities like Detroit have ex­posed the difficulties of keeping the process free of politics. Furthermore, in order to avoid some of the problems that have arisen in municipal bankruptcies, it appears that commonsense reforms will need to be made before making states eligible for bankrupt­cy.

Here are some options for your consideration.

  • First, this will be an important fault line for the 2020 elections, even though it is unlikely that bankruptcy expansion or Federal bailouts will make it into the Phase Four COVID19 relief act. Democrats have already endorsed state bailouts as part of the so-called HEROES Act. However, few piv­otal states in terms of winning control of the Senate or achieving electoral college victory would bene­fit from this bailout. Furthermore, in many House districts, public employees are increasingly being perceived as “overpaid parasites” by the broader electorate. Meanwhile, voters will watch as, slow-to-reopen blue states like Illinois, New York, New Jersey, and California teeter-on-the-brink, while red states like Missouri, Florida, Georgia, and Texas return to stable growth. —Unless something disrupts this pat­tern before November, it will be a political plus for Republicans and political minus for Democrats.
  • Second, if Republicans win back control of the House and retain the Presidency and Sen­ate, bankruptcy will become available to state governments. To avoid pitfalls, this legislation must be carefully crafted taking into account the unique political and constitutional aspects of the situations. For example, under America’s system of constitu­tional federalism, states as sovereign entities would retain the option to repudiate their debts in whole or in part, subject to their own laws. And, unlike Chap­ter 11 corporate bankruptcy, Chapter 9 provides no option for creditors to initiate involuntary bankrupt­cy proceedings. But, giving states the option to file for bankruptcy would not only provide them with a workable alternative to outright default, it could also give them leverage in reaching consensual ad­justments without ever having to resort to an actual bankruptcy filing.
  • Third, opening-up the bankruptcy alternative to states will allow them to side-step ill-conceived state laws. Under the Supremacy Clause of the U.S. Constitution, Federal bankruptcy law overrides state constitutional constraints letting the court adjust earned and unearned pension benefits of existing workers and current retirees. On paper, bankruptcy preserves the property rights for vested benefits but allows the reworking of all contractual promises, in­cluding public employee pension contracts.
  • Fourth, bankruptcy law rigorously enforced will ensure that all creditors are treated equally and will create incentives to avoid unsustainable fu­ture commitments. Requiring all claimants to share equally in the pain of bankruptcy and demanding that the plan be “economically feasible” is not only fair, it also creates positive incentives for all parties by restraining “moral hazard” and creating incentives to hold state governments accountable. Chapter 9, like Chapter 11, requires that any reorganization plan not “unfairly discriminate” among different groups of creditors that hold the same priority. Raising the possibility that public employee pensions would be subject to cuts as part of bankruptcy would create powerful incentives for public employees to accept more realistic benefit promises and then to pressure state governments to fund them adequately. Thus, the threat of bankruptcy and the shared pain it could bring about would provide incentives for both bond­holders and public employees to pursue greater pub­lic fiscal sustainability going forward. Courts would also rigorously apply the requirement that any plan should be economically feasible, meaning that the plan must promise long-term sustainability, not just short-term relief. Therefore, failure to clearly ad­dress looming, underfunded retirement obligations would render any proposed plan infeasible.
  • Fifth, when Chapter 9 is amended to accommo­date states, judges will be appointed in such a way as to minimize conflicts of interest. There are about 90 bankruptcy districts across the United States, and each one has its own judge. The bank­ruptcy courts generally have their own clerk’s offices. In a regular bankruptcy case, the judge is selected at random by the clerk of the court. However, in Chapter 9 proceedings, the judge is not chosen at random. Instead, the chief judge of the U.S. court of Appeals chooses a judge from the bankruptcy court where the case is located. But since those bankrupt­cy judges have to live in the same community as the public employees whose benefits are on the chop­ping block, this creates personal incentives for the judge to favor public employees over bondholders. Alternatives include appointing a judge from anoth­er state or appointing a judge at random from any of the 90 districts. The stakes are high and failing to keep the judge independent would all but assure that state bankruptcy will fail to achieve its goals and that state debt problems and political obstacles in the path of their resolution will persist.

 

US Banks

 

We have actual data from the Federal Reserve’s quarterly Senior Loan Officer Opinion Survey. US banks, and particularly the US branches of foreign banks, are tightening credit in most categories. It’s worse for small firms. In fact, banks are tightening business loan standards at the fastest pace since 2008.

 

 

The Fed survey also found lower demand for all kinds of lending except residential real estate. I don’t know of any other business where it makes sense to raise the price of your product as demand for it drops. That banks are doing so speaks to how nervous they must be. Worse, it’s happening despite massive Federal Reserve efforts to encourage and subsidize bank lending.

A consultant who helps franchisees get loans, often via SBA guarantees, described a terribly frustrating credit environment in his space. Below is a portion of his thread:

The banks I work with are SBA, conventional lenders who service smaller loans under 2M (million) and generally smaller operators of these franchise systems, and then larger banks who provide loans to larger operators from 2-50M. I’m short—20+ banks across ALL spectrum of SME lending.

I fund 400-500M in loans per year through these banks. In February we were on pace to fund well over 500M and potentially 750M — growing exponentially year over year. Since April 1st we have funded 5M total through only 2 banks. Let’s dive in as to why.

SBA banks—they have lending limits to 5M. Congress has authorized them to go to 10M in the CARES Act but they have ignored it. This will become important later. They currently have guarantees from the govt at 80%—pretty good right? IT DOESN’T MATTER, THEY STILL WON’T LEND.

In fact, they are pushing the government to guarantee 90% of the loans.  In short, SBA has SHUT OFF BORROWERS, waiting for more from Uncle Sam.

They are also being EXTREMELY selective on industries they will do. If you are an industry with “large public gatherings” you better pray to Santa Claus for money.

So, businesses with solid revenue still can’t get capital even when the government will guarantee 80% of the risk. Economic recovery will be very hard if this persists. All those loans not being made represent business activity that won’t happen, buildings not constructed, jobs not created.

 

Debt

 

Everyone (including me) expects Congress to pass another “stimulus” package. My best guess is it will be between $1 to $1.5 trillion. The bulk of that will be spent in 2020. That means US federal debt will be $29 trillion and perhaps $30 trillion as we ring in the new year, or shortly thereafter. Not to mention $3 trillion in state and local debt.

 

Deflation Risk

 

Gary Shilling and Dave Rosenberg discuss deflation risk.

Key Points:

  • Rosenberg and Shilling agree the most important dispute right now is between those who think fiscal/monetary stimulus can support the economy, and those who think the economy is still vulnerable.
  • Both are bearish on stocks, with Shilling expecting a 40-50% decline in the S&P 500.
  • With gains so concentrated in a few mega-cap names, the entire market is in trouble if they roll over.
  • Headline jobs numbers suggest the labor market is healing, but Rosenberg says much of the growth is in part-time employment.
  • Shilling believes we are heading for deflation due to excess supply around the world.
  • Asset bubbles are a side effect of the Fed’s strategy to stop deflation, which it views as the greater threat.

Bottom Line: Shilling and Rosenberg are both in the deflation camp right now, but they acknowledge inflation risk down the road.

 

The Fed’s Mission Statement

 

In the next few months, the Federal Reserve will be solidifying a policy outline that would commit it to low rates for years as it pursues an agenda of higher inflation and a return to the full employment picture that vanished as the coronavirus pandemic hit.

Recent statements from Fed officials and analysis from market veterans and economists point to a move to “average inflation” targeting in which inflation above the central bank’s usual 2% target would be tolerated and even desired.

To achieve that goal, officials would pledge not to raise interest rates until both the inflation and employment targets are hit.

Over the last decade, the Federal Reserve has engaged in never-ending “emergency measures” to support asset markets and the economy. The stated goal was, and remains, such actions would foster full employment and price stability. There has been little evidence of success.

What the Federal Reserve has failed to grasp is that monetary policy is “deflationary” when “debt” is required to fund it.

How do we know this? Monetary velocity tells the story.

What is “monetary velocity?” 

“The velocity of money is important for measuring the rate at which money in circulation is used for purchasing goods and services. Velocity is useful in gauging the health and vitality of the economy. High money velocity is usually associated with a healthy, expanding economy. Low money velocity is usually associated with recessions and contractions.” – Investopedia

With each monetary policy intervention, the velocity of money has slowed along with the breadth and strength of economic activity.

 

 

We can also compare monetary velocity to the deficit:

 

 

To no surprise, monetary velocity increases when the deficit reverses to a surplus. Such allows revenues to move into productive investments rather than debt service.

The only reason Central Bank liquidity “seems” to be a success is when viewed through the lens of the stock market. Through the end of the Q2-2020, using quarterly data, the stock market has returned almost 135% from the 2007 peak. This is more than 12x the growth in GDP and 3.6x the increase in corporate revenue. For the last several years, the Fed’s belief has been inflating asset prices would lead to a rise in economic prosperity and inflation. As noted, the Fed did achieve “asset inflation,” which led to a burgeoning “wealth gap.”

 

The US Economy

 

The good news: In percentage terms, this year’s recession looks far shallower than the Great Depression was, if current forecasts hold. The bad news: It’s way worse than 2008 and may only be getting started.

  • The ISM manufacturing PMI report showed US factory activity expanding at a faster pace in July.
  • New orders accelerated, while export orders returned to growth (PMI > 50).
  • However, manufacturing employment remains in contraction territory.
  • Prices paid by factories are no longer declining.
  • Separately, the Milwaukee (regional) PMI has not yet returned to growth.
  • US construction spending declined for the fourth month in a row in June.
  • Year-over-year growth in private construction spending has stalled.
  • However, public construction expenditures strengthened, boosted by healthcare.
  • Small business employment peaked in late June.
  • PPP small business funding may have significantly curtailed layoffs.
  • The percentage of Americans experiencing loss of employment income keeps climbing.
  • The Midwest registered the largest increase in business applications.
  • Trucking loads have rebounded sharply but appear to be moderating.
  • US vehicle sales improved further in July.
  • School and daycare closings will create a substantial drag on the nation’s GDP growth.
  • High-frequency indicators point to accelerating home price appreciation in recent weeks.
  • Record low interest rates have made home affordability the best it’s been in four years. However, CoreLogic expects home prices to be below current levels next summer.
  • Weak consumer confidence could weigh on housing-related inflation going forward.
  • Credit card delinquencies have been relatively low in recent months.
  • Credit/debit card spending has been flat since mid-June and remains more than 10% below last year’s levels.
  • Factory orders rose sharply in June, boosted by automobile demand.
  • Planned capital expenditures are starting to recover.
  • E-commerce sales have risen well above trend.
  • US foreign trade remains depressed.
  • However, service-sector businesses continue to shed jobs.

The ADP private payrolls report surprised to the downside. Economists expected to see 1.2 million jobs created in July, but we got 167k. This chart shows the absolute level of private payrolls.

 

 

  • Unemployment applications declined last week to the lowest level since March.
  • The total number of Americans receiving unemployment benefits remains near record highs (above 30 million).
  • This year’s layoffs have been unprecedented in recent decades.
  • Credit card balances declined again.
  • Student loan delinquencies plummeted due to the CARES Act emergency relief

 

The Jobs Data

 

The July US jobs report, released this morning, showed more improvement than some expected, given the slower re-opening pace in some states. But “improvement” isn’t the same as “recovery.”

Key Points:

  • Labor Department data shows 1.76 million new jobs added in July, of which 300,000 were government jobs including education.
  • Headline unemployment fell from 11.1% to 10.2%. The broader “U6” measure fell from 18% to 16.5%.
  • Most of the restored jobs were in the service sector, including leisure/hospitality and retail.
  • Hours worked ticked down, causing average weekly earnings to fall slightly despite a rise in hourly pay.
  • Oddly, the Treasury market had almost no initial reaction to this report. Traders apparently remain very concerned about US growth prospects.

Bottom Line: This report was better than expected but we still have a long way to go. The US lost 21.2 million private sector jobs in March and April. So far, only 9.4 million have been added back.

 

China

 

Americans increasingly have an unfavorable view of China.

 

 

COVID Update

 

When will a vaccine become widely available?

 

 

 

 

This chart shows COVID-related fatalities by age.

 

 

Market Data

 

  • In recent months, companies have pulled back drastically on buying back their own shares. At the same time, they’ve been adding to supply by issuing new shares either through IPOs or secondary and add-on offerings. This is one of the most drastic changes in supply in 20 years.
  • Gold miners continue their winning ways. Every one of them has been above their long-term 200-day moving averages for a week straight, not something we’ve seen often over the past 25 years.
  • FAANMG (Facebook, Apple, Amazon, Netflix, Microsoft, Google) stocks are now worth $7 trillion – more than the financial, energy, industrial, and material sectors combined.
  • The past few weeks and months have seen U.S. tech stocks rally relentlessly while other countries’ stock indices bounced sideways. The tech rally managed to drag the S&P 500 towards all-time highs, which is quite amazing given all the doomsday predictions we saw in late-March.
  • Once again on Thursday, the S&P 500’s performance masked underlying weakness. The index gained more than 0.5%, yet there were more declining securities than advancing ones, and more volume flowing into those declining stocks.
  • Just three stocks, Apple, Amazon and Microsoft, make up more than 16% of the S&P 500 Index and over a third of the Nasdaq 100 Index. Together they are now valued at nearly $5 trillion. That’s larger than the entire economy of Germany and roughly the size of the Japanese economy. What is really most astounding, though, is the aggregate valuation of these three behemoths relative to their free cash flow. Only at the peak of the Dotcom Mania have we see anything like it – which begs the question: ‘If that was a bubble, what’s this?

 

 

One of My Favorites!!!!

 

The Race: Life’s Greatest Lesson

By Dee Groberg

Whenever I start to hang my head in front of failure’s face,
my downward fall is broken by the memory of a race.
A children’s race, young boys, young men; how I remember well,
excitement sure, but also fear, it wasn’t hard to tell.
They all lined up so full of hope, each thought to win that race
or tie for first, or if not that, at least take second place.
Their parents watched from off the side, each cheering for their son,
and each boy hoped to show his folks that he would be the one.

The whistle blew and off they flew, like chariots of fire,
to win, to be the hero there, was each young boy’s desire.
One boy in particular, whose dad was in the crowd,
was running in the lead and thought “My dad will be so proud.”
But as he speeded down the field and crossed a shallow dip,
the little boy who thought he’d win, lost his step and slipped.
Trying hard to catch himself, his arms flew everyplace,
and midst the laughter of the crowd he fell flat on his face.
As he fell, his hope fell too; he couldn’t win it now.
Humiliated, he just wished to disappear somehow.

But as he fell his dad stood up and showed his anxious face,
which to the boy so clearly said, “Get up and win that race!”
He quickly rose, no damage done, behind a bit that’s all,
and ran with all his mind and might to make up for his fall.
So anxious to restore himself, to catch up and to win,
his mind went faster than his legs. He slipped and fell again.
He wished that he had quit before with only one disgrace.
“I’m hopeless as a runner now, I shouldn’t try to race.”

But through the laughing crowd he searched and found his father’s face
with a steady look that said again, “Get up and win that race!”
So he jumped up to try again, ten yards behind the last.
“If I’m to gain those yards,” he thought, “I’ve got to run real fast!”
Exceeding everything he had, he regained eight, then ten…
but trying hard to catch the lead, he slipped and fell again.
Defeat! He lay there silently. A tear dropped from his eye.
“There’s no sense running anymore! Three strikes I’m out! Why try?
I’ve lost, so what’s the use?” he thought. “I’ll live with my disgrace.”
But then he thought about his dad, who soon he’d have to face.

“Get up,” an echo sounded low, “you haven’t lost at all,
for all you have to do to win is rise each time you fall.
Get up!” the echo urged him on, “Get up and take your place!
You were not meant for failure here! Get up and win that race!”
So, up he rose to run once more, refusing to forfeit,
and he resolved that win or lose, at least he wouldn’t quit.
So far behind the others now, the most he’d ever been,
still he gave it all he had and ran like he could win.
Three times he’d fallen stumbling, three times he rose again.
Too far behind to hope to win, he still ran to the end.

They cheered another boy who crossed the line and won first place,
head high and proud and happy — no falling, no disgrace.
But, when the fallen youngster crossed the line, in last place,
the crowd gave him a greater cheer for finishing the race.
And even though he came in last with head bowed low, unproud,
you would have thought he’d won the race, to listen to the crowd.
And to his dad he sadly said, “I didn’t do so well.”
“To me, you won,” his father said. “You rose each time you fell.”

And now when things seem dark and bleak and difficult to face,
the memory of that little boy helps me in my own race.
For all of life is like that race, with ups and downs and all.
And all you have to do to win is rise each time you fall.
And when depression and despair shout loudly in my face,
another voice within me says, “Get up and win that race!”