The government just borrowed $760B in May alone! This was the second-largest net issuance of Treasuries in history.
The Federal Reserve on Wednesday left interest rates unchanged and projected interest rates would remain near zero through 2022. The central bank also said it keep buying bonds, adding it would do what it takes to prop up the economy.
“The Fed remains pessimistic about the economy and said the coronavirus outbreak will continue to weigh on economic activity, employment and inflation in the near term. It expects unemployment to remain elevated for years,” said Anthony Denier, CEO of New York-based commission-free trading platform Webull. “Because of this, the Fed is leaving rates unchanged and said it expects to leave them unchanged until 2022.”
Fed officials made clear they plan on holding rates at near zero until they are confident the economy is on track for inflation to reach their 2% target and for the unemployment rate to fall back in line.
“We’re not thinking about raising rates, we’re not even thinking about thinking about raising rates,” Federal Reserve Chairman Jerome Powell told reporters at a press conference following the Fed’s announcement on interest rates.
“We are strongly committed to using our tools to do whatever we can for as long as it takes,” he added.
The Fed said it expects the U.S. economy to contract 6.5% in 2020, but then expand by 5% in 2021, raising the specter of a possible boomerang recovery that may still be fraught with both uncertainty and possibly inflation.
“While the Fed was successful in helping the stock market recover from the coronavirus-driven selloff in March, the jury is out on how much the Fed is helping the economy recover,” said Danielle DiMartino Booth, CEO and chief strategist of Dallas-based Quill Intelligence and a former Fed advisor. “Analyzing the Fed’s economic projections at this time when much of the economy is still opening is riddled with uncertainties.”
It also seems to mean “easy money” forever.
While the Fed is doing a massive amount of QE, the “hole” they are trying to fill is substantially larger. In what I call the “PacMan” chart below, the “economic deficit” will consume more than the Fed has currently committed.
The Federal Reserve must qualify as the worst economic forecasters ever. Despite annual promises of stronger economic growth, that has not yet been the case. Ever.
While the economy will indeed recover in 2021 and 2022, the Fed is likely overestimating the outcome. However, in the short-term, they have little choice.
Unwittingly, the Fed has now become co-dependent on the markets. If they acknowledge the risk of weaker economic growth, the subsequent market selloff would dampen consumer confidence and push economic growth rates lower. Therefore, they have to be overly optimistic.
Before the “Financial Crisis,” the economy had a linear growth trend of real GDP of 3.2%. Following the 2008 recession, the growth rate dropped to the exponential growth trend of roughly 2.2%. Instead of reducing the debt problems, unproductive debt, and leverage increased.
By voting to avoid short-term pain, the Federal Reserve has locked the economy into a long-term economic malaise. Like a “frog in boiling water,” the vast majority of Americans will see their economic prosperity slowly fade to low-to-flat growth in the future.
The stock market is not the economy. It is a distortion of economics due to QE.
Debt
US corporate debt is approaching 50% of GDP, a new record. While this chart is through Q1, the ratio likely climbed further in the current quarter.
The share of US companies whose debt service costs exceed profits continues to rise.
Healthcare companies have loaded up on debt during the last recovery, and their weight in the investment-grade corporate index increased.
Relationship Between Stocks & Economy
Historically when stocks have deviated from the underlying economy, the resolution has always been lower stock prices.
There is a close relationship between the economy, earnings, and asset prices over time. The chart below compares the three going back to 1947 with an estimate for 2020 using the latest data points.
Since 1947, earnings per share have grown at 6.21%, while the economy has expanded by 6.47% annually. That close relationship in growth rates should be logical, particularly given the significant role that consumer spending has in the GDP equation.
While over short periods, the stock market often detaches from underlying economic activity, this is due to psychology as investors latch onto the belief “this time is different.”
Unfortunately, it never is.
While not as precise, a correlation between economic activity and the rise and fall of equity prices does remain. In 2000, and again in 2008, as economic growth declined, corporate earnings contracted by 54% and 88%, respectively. This was despite calls of never-ending earnings growth before both previous contractions.
As earnings disappointed, stock prices adjusted by nearly 50% to realign valuations with both weaker than expected current earnings and slower future earnings growth. While the stock market is once again detached from reality, looking at past earnings contractions, suggests it won’t be the case for long.
The “return to economic normality” faces immense challenges. High rates of unemployment, suppressed wages, and elevated debt levels, makes a “V-shaped” recovery unlikely.
Error with the BLS Unemployment Report
There was a miscalculation of the data in the report:
The drop in the unemployment rate is due precisely to the substantial decrease in the labor force. Since February, according to the BLS, 6.3 million people have decided they no longer wanted to work. Such is substantially more than would be expected even based on the massive increase in unemployment.
Therefore, if we adjust for the labor force, and count the extra 4.9 million people who were “not at work for other reasons,” the “realistic unemployment rate” was 17.1 percent in May.
While that number is down from April, it is still higher than any other unemployment rate in over 70 years. (But the 13.3% number was as well.)
“There were also a large number of workers classified as employed but absent from work. As was the case in March and April, household survey interviewers are instructed to classify employed persons absent from work due to coronavirus-related business closures as unemployed on temporary layoff.
However, not all such workers were classified that way.
If the workers were classified as unemployed on temporary layoff, the overall unemployment rate would be about 3 percentage points higher than reported (on a not seasonally adjusted basis).
If we make the proper adjustments to the unemployment rate for both April and May, it reveals the ugly truth.
In other words, the unemployment rate was 16.3% using their data, which suggests the unemployment total is closer to 26 million.
If my numbers are close to correct, there will be implications to earnings and profits.
COVID Effects on Economy
I am certain the economy will not be “locked down” a second time regardless of the severity of the outbreak. Politicians have learned their lesson. As Steve Mnuchin said on Thursday, “we can’t shut down the economy again”.
A Look at S&P Earnings
2019 full-year GAAP earnings for the S&P 500 came in at $139.47 per share. That is down from 2018’s full-year earnings, which were $148.34 per share. We went into the 2020 pandemic downturn with earnings already weakening.
Ned Davis Research’s (NDR’s) 2020 full-year earnings estimate is $92.06. You’ll see in the next section that Byron Wien estimates $100 in 2020, maybe $120 in 2021, and says perhaps we get back to $140 by 2022 at the earliest.
Market Data
The weight of the top five stocks in the S&P 500 has nearly doubled since 2013.
Who owns all the leveraged-finance debt?
The S&P 500 has diverged from corporate margins.
Based on the 12-month forward earnings expectations, stock valuations look rich.
Food for Thought
All content is the opinion of Brian J. Decker
