Over the weekend, I read John Hussman’s latest research letter. It was long. What grabbed me most were his comments about how the Fed’s purchasing of corporate bonds and junk bonds is in clear violation of the law, which appear about two-thirds of the way down in his letter. It’s what sent me sideways a few weeks ago when they made their announcement. Everything in me screams that it’s wrong.
The Fed prints money and buys bonds from the Treasury. The government bonds then sit as an asset on the books at the Fed. The Treasury then takes the money and uses it to fund something they call a Special Purpose Vehicle, or SPV, each of which is named something that has a warm and friendly feel to it. Next, the Treasury appoints the Fed to take charge of the SPV, and the Fed hires a firm like BlackRock to execute on purchases.
But is it legal? No. After much discussion and healthy debate with trusted friends, I’m certain the Fed’s actions are in violation of the Federal Reserve Act.
But the rules will be amended.
Here’s my two cents on what we will see and what’s important to keep in mind in terms of your investment positioning. In short: Deflation now, inflation later. This is the sell of a lifetime for bonds.
Fed’s Monetary Policy?
- There is no room to cut rates much further. Our starting point this time around was 1%. Take that to -3%, or to -5% in order to jump-start the economy? Not going to happen.
- The Fed is inventing other solutions: QEs and SPVs
- S. capacity utilization is likely down 7% to 10%. There is no way the Fed can create inflation.
- Deflation remains Enemy Number One and Treasury yields are likely headed even lower.
- The Fed’s balance sheet is at $7 trillion. It may grow to $15 to $20 trillion.
- Each injection is designed to hold the system together and provides immediate benefit (a temporary sugar high), but the long-term effect on the economy is bad.
- The Fed’s buying assets under temporary ownership keeps alive entities that should fail… bailing out the most egregious companies, the most indebted, the bad actors… it is bad for the economy in the long term.
This is not a new experiment.
- We are following the Japanese path, which the ECB chose to follow, and which China is now following.
- The money provides support but steals from productivity because it enables bad actors to survive.
As the Fed’s balance sheet heads toward $10 Trillion, the Fed has stated that interest rates will remain low until “such time as the dual mandates of full employment and price stability achieved.” Given economic stability was not achieved in the last decade, it is highly unlikely a more than doubling of the Fed’s balance sheet will improve future outcomes.
Unfortunately, given we now have a decade of experience of watching the “wealth gap” grow under the Federal Reserve’s policies, the next decade will only see the “gap” worsen.
While many are hoping for a “V-shaped” recovery following the “restart” of the economy, the reality is recovery may take much longer than expected.
We now know that surging debt and deficits inhibit organic growth. The massive debt levels added to the backs of taxpayers will only ensure the Fed remains trapped at the zero-bound.
History is pretty clear about future outcomes from the Fed’s current actions. More importantly, these actions are coming at a time where there were already tremendous headwinds plaguing future economic growth.
- An aging demographic
- A heavily indebted economy
- A decline in exports
- Slowing domestic economic growth rates.
- An underemployed younger demographic.
- An inelastic supply-demand curve
- Weak industrial production
- Dependence on productivity increases
The linchpin, like Japan, remains demographics and interest rates. As the aging population grows becoming a net drag on “savings,” the dependency on the “social welfare net” will continue to expand.
Supporting economic growth through increasing levels of debt only makes sense if “growth at all cost” uniformly benefits all citizens. Unfortunately, there is a big difference between growth and prosperity.
But for now, the Fed has no other choice.
How will this affect your portfolio?
The most probable scenario at the moment is the U.S. equity market stays within a trading range with highs held in check and a re-test of the March 2020 low—my best guess is 2,850 to 2,200.
Recall December 2018, when the Fed raised rates and the market crumbled until Powell reversed course the day before Christmas. It will be like that, except the Fed is now trapped. They won’t be able to tighten conditions. Debt is too big. They will attempt to control the yield curve.
With high equity market valuations, the returns will be flat for equities over the coming 10 years and a bumpy ride with peaks and valleys on our way to flat. Not too dissimilar to the 1966-1982 secular bear market, and perhaps somewhat similar to the go-nowhere-for-two-decades Japanese equity market.
Market Valuation
Based on the expected earnings shock over the next 12 months, stocks look very expensive. The S&P 500 forward P/E ratio is now above 20x. It appears that investors are looking beyond the next 12 months, expecting earnings to rebound.
On a very short-term basis, the previous ‘deep oversold’ condition that provided the ‘fuel’ for the rally has been reversed. Also, all primary ‘overbought/sold’ indicators are now fully extended into overbought territory.
If the markets can rally more and break above the downtrend, the 61.8% retracement level becomes a viable target. Above that resides the 200-day moving average. Both levels are going to provide formidable resistance to a move higher, and the Risk/Reward is not good.
Here is the current setup:
Reward:
- 2.3% to the 61.8% retracement from the March 23rd lows.
- 4.7% to the 200-dma.
Risk:
- 2.8% to the 50% retracement (and 50-dma) from the March 23td lows.
- 4.9% to last week’s sell-off lows, which is now minor support.
- 14.5% to the sell-off lows in early April.
- 22.2% to the March 23rd lows.
Many market participants – ourselves included– have expressed incredulity at the fact that the S&P 500 trades just 17% below its all-time high amid the largest economic shock in nearly a century. With unemployment headed to 30-million people, businesses closing, GDP dropping by 20%, and wages/incomes imploding, the amount of debt about to go bad and be downgraded, is mind-bending.
This lack of market breadth is very concerning when the median S&P 500 constituent trades 28% below its record high, putting an 11% gap between the measures of market breadth.
The benchmark S&P 500 Index peaked at 3,386 on February 19. After plunging into a bear market, it fell as low as 2,237 on March 23 – an incredible drop of 34% in about a month.
But over the past five and a half weeks, it has charged up off those lows… The S&P 500 closed today at about 2,940. That’s 31% higher than its bottom. It’s only 13% below its February peak.
The U.S. Bureau of Labor Statistics won’t release the official unemployment rate for April until May 8.
Eventually, the reality of this unemployment situation will catch up with the market. We are expecting a market pullback to digest what has actually happened to earnings, debt, the Fed, the consumer, etc.
High Yield Bonds Flash A Warning
Another concern remains the risk of defaults in the credit markets. While the Fed is bailing out the bond market on the investment-grade side, there is a limit when it comes to supporting the junk bond market, and there is a lot of debt about to go bad.
Importantly, when the debt is downgraded from investment grade (BBB to AAA) to junk status (BB to DDD) pension funds, mutual funds, and portfolio managers who are NOT allowed to own “junk bonds” will be forced to liquidate. Such is why the Fed was willing to buy “junk” bonds in March, which had just been downgraded. There was literally no market.
The question will be if the markets can continue to ignore reality?
We guess that ultimately it won’t.
The Economy
Millions more Americans filed for unemployment benefits last week. With the increase in the figures above, continuing jobless claims probably exceeded 20 million.
What Goods Are Now Categorized as “Glut”?
- Oil – Today, Oil STORAGE is more profitable than Oil production. Storage is full to capacity. In fact, there are dozens of oil TANKERS, anchored offshore, acting as storage because there is nowhere to offload the oil.
- Milk – Farmers are dumping excess milk.
- Pigs – Farmers are euthanizing thousands of pigs each day.
- Cattle – Farmers are destroying thousands of cattle each day.
- New Cars – The length of almost two football fields, the cargo ship Jupiter Spirit arrived in Los Angeles’ harbor on April 24 after an almost three-week journey from Japan, ready to unload its cargo of about 2,000 Nissan Armada SUVs, Rogue crossovers and Infiniti sedans in a quick, half-day operation.
But when the ship, operated by Nissan Motor Co.’s freight arm, got about a mile offshore, its captain was ordered to drop anchor. And there the ship remained for almost a week — a floating symbol of an unprecedented logjam as nearby storage lots covering hundreds of acres overflowed with vehicles that Americans suddenly have little desire to purchase.
There are gluts of all shapes and kinds forming in the U.S. nowadays, a testament to the scope of the economic pain the coronavirus is inflicting. Slaughterhouses are killing and tossing out thousands of pigs a day, dairy farmers are pouring away milk, oil sellers were paying buyers to take barrels off their hands last week, and now, brand-new cars are being left adrift at sea for days.
For the auto industry, the crisis has left cars gathering dust on dealer lots, dealerships shuttered, auction prices slipping and tens of thousands of workers laid off or furloughed. April U.S. sales plummeted 54% for Toyota Motor Corp., 47% for Subaru Corp. and 39% for Hyundai Motor Co.
“Dealers aren’t really accepting cars and fleet sales are down because rental-car and fleet operators aren’t taking delivery either,” said John Felitto, a senior vice president for the U.S. unit of Norwegian shipping company Wallenius Wilhelmsen. “This is different from anything we’ve seen before. Everyone is full to the brim.”
Summary – Because of this glut I will bet that over 100 companies currently in the S&P 500 will not be there 12 to 15 months from now. Just in the last week we have lost Neiman Marcus and J Crew.
Sell in May and Go Away
Historically, the S&P 500 has recorded stronger gains during November-April vs. May-October.
April saw one of the biggest rallies for the month since 1974. These exceedingly large bounces usually occur during bear markets. Unfortunately, in many cases, the majority of those big one-month advances are followed by negative returns.
Debt
Debt is more than 300% to GDP in most countries. It is 361% in Italy, 513% in France, and the debt-to-GDP ratio is 464% in the Eurozone as a whole. It’s 327% in the U.S., but the U.S. has a central bank and common Treasury market. The immediate risk is Europe. Watch the EU banks, keep watch on Italy. In the EU, you need all 19 members to agree on things. Will Germany agree to be on the hook for Italian and French debt? Would New York agree to bail out California’s debt, or vice versa? I don’t think so, but in the U.S. there exists the Fed/Treasury marriage and a Congress in full support of the plan. Blink, print, new SPV. The EU structure is flawed because there is no common government bond.
Earnings Estimates
There is only one-month of Covid-19 effect in the 1st quarter.
Earnings estimates for the next twelve months continue to sink.
Somewhat more realistic earnings multiple assumptions would suggest that the S&P 500 should be meaningfully lower.
Stocks usually bottom when leading indicators begin to improve.
Companies are suspending dividends
While share repurchase activity has slowed.
Coronavirus Update
Will the economy bounce right back when we open in May – June? Americans ARE excited to get back to work BUT they are nervous about going to restaurants and in airplanes.
What will the “open” look like?
South Korea is a few weeks ahead of the US and the picture there is grim, according to the WSJ:
When meeting in an office, people will wear masks. At meals, diners will sit next to each other or in a zigzag pattern, not directly across. Hotel rooms will be ventilated for 15 minutes after travelers check out. Visitors at zoos and aquariums must stand 6 feet apart. Shouting and hugging will be discouraged at sporting events. So will high-fives…
…Kwon Sae-min, 29 years old, who works at a bakery in Seoul, is now taking shoppers’ temperatures at the entrance and asking them to sanitize their hands and swipe their credit cards themselves.
“It’s a lot of extra work to manage customers now,” Ms. Kwon said.
Ms. Kwon puts her finger on the problem. Everything will be a lot of extra work now. The US may give businesses more flexibility than South Korea’s government is, but it’s not the only constraint. Customers have to feel safe. Governors can lift their lockdown orders but they can’t make people shop, nor can they make businesses open.
In parts of the US, restaurants are being allowed to reopen at lower capacity, usually 25% or 50%. They can’t turn a profit that way, even without all the extra costs. So often the financially smartest thing they can do is stay closed, and many are. Maybe they will open in a few weeks, if the virus and associated restrictions ease. But meanwhile, workers stay unemployed and everyone’s spending remains muted.
The same applies in retail. Macy’s is beginning to reopen its stores but one executive told WSJ he expects less than a fifth of normal sales volume at first.
There are multiple problems:
- Customers are reluctant to return
- Those who do return will spend less
- Serving them as now required and/or expected will cost more.
That math is not consistent with a V-shaped recovery, even with all the stimulus funding. You don’t have to search long to realize that the money supposedly flowing to Main Street isn’t getting down to the smallest businesses. Even if they represent only 10 or 15% of the economy, that is enough to spark a severe, prolonged recession.
All Content is the Opinion of Brian Decker
