Fixed income: We have a deflationary shock to the system. Generally in recession the Fed cuts rates 400-600 bps in order to get us out of the default cycle. The system clears.
There is no room to cut rates much further. So the Fed is inventing other solutions: QE’s and now SPV’s (Specialty Purpose Vehicles). US capacity utilization is likely down 7% to 10%. There is so much extra room, the Fed can’t create inflation.
- This is the amount of excess resources in the system. Resources not being used. It will knock the inflation rate down 4% and we are currently at 2%. We will go to -2%.
- That’s negative 2%.
- We are fighting a nuclear hit to the global business system.
- Therefore, in the immediate few years, deflation remains the number one enemy and Treasury yields are likely headed even lower. However, this is a sell of a generation for most bond markets. Long-term Treasuries likely still do well but not much more room to the downside and the upside risk of this bet being wrong is big. Trade, don’t buy and hold bond exposures.
SPV’s: Here how it works. The Fed prints money and uses the money to buy Treasury Bonds from the Treasury. The bonds sit on the books of the Fed and the Treasury gets cash. The Treasury takes that cash and sets up a Special Purpose Vehicle. There are now a handful of SPV’s with very friendly sounding names. The Treasury than appoints the Fed to be in charge of the SPV. The Fed hires Blackrock and Blackrock does the Fed’s bidding (goes into the market and buys stuff).
This is a violation of the law – Federal Reserve Act. But who is going to step up and fight the U.S. Government? The cat is out of the bag and the Fed’s actions continue…. More SPV’s. Each injection is designed to hold the system together. Each creates an immediate but temporary sugar high. The long-term benefits to the economy are not good simply because you’ve enabled too many bad actors to stay in business.
- Businesses are more leveraged than ever going into this mess. Every large economic brush fire will be followed by “what-ever-it-takes” behavior.
- Buying assets under temporary ownership keeps alive entities that should fail… bailing out the most egregious companies, most indebted, bailing out the bad actors… bad for the economy long term.
- I expect the Fed to step outside the law again… more SPV’s.
- We are following the Japan path, which the ECB has chosen to follow, which China is following.
- The money provides support but steals from productivity because it enables bad actors the ability to survive. Normally recession clears the system and the next cycle advances. Do you want all of the teams in the NFL to get the trophy each year or does the platform for competition create the ability for all teams to get better in their pursuit of success? Losing may be the best gift to help us improve and advance. We are enabling bad actors and it’s wrong.
- Corporate balance sheets are a leveraged mess. We will see a coming wave of businesses in trouble. Rising defaults. But this is where we find ourselves right now. But as we see from the early innings or PPP, not all goes as smoothly as planned. Expect rising defaults. And more Fed responses.
Bottom line: From my friend Dr. Lacy Hunt summed it up this way and I think he’s right: “The net effect will further worsen the debt overhang. We know from similar efforts here, in Japan, Europe and China this provides no more than a fleeting boost to economic activity at the expense of additional weakness in future economic activity. This shift results in an even greater misallocation of capital and other resources.” If you are not reading the Hoisington Quarterly Letter, you should. Lacy’s brilliant.
So how will this play out?
We will have markers to watch for. Much depends on the activity of central banks. It is probable that the Fed moves from a $7 billion balance sheet to $15 to $20 billion.
I see there macro scenarios and we have to watch behaviors of authorities as we step forward for it will help determine which of the three scenarios play out – and this affects investors:
1) Deflation yes. We are going to get deflation. But the risk in this scenario is we have a depression. If this happens, interest rates on the U.S. Treasury 30-year bond is heading to 50 bps or less. Depression is bad for corporate bonds, mortgage bonds and municipal bonds due to default risks. Rates in those areas likely rise as investors need to be compensated for the risks. Can the Fed, via SPV after SPV but up the entire debt market? Doubt it. But for the immediate future, the Fed and Government support may keep this from getting too deep. That’s my belief at the moment so I put very low odds on depression. This is bullish for U.S. Government Treasury bonds for the immediate future.
2) The most probable scenario at the moment is the U.S. equity market stays within a trading range with highs held in check and retest of March 2020 low – my best guess is 2850 to 2200. The Fed fires its bazooka and then steps aside to let the markets stand on their own. Fire erupts and Fed rushes back in to put it out. Markets trade higher, Fed lets it function on its own, new fire, new Fed response. Recall December 2018, when the Fed raised rates, the market crumbled until Powell reversed course at 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. More fires, more sugar, more fire, more sugar. So unfortunately, I see long term diminishing returns unless we let bad actors fail, defaults to occur which has the positive effect of letting the system clear and start anew. Scenario 2 is bullish for trading strategies and active stock pickers. By this I mean transformational businesses. It is bullish for long-term Treasury bonds over the next few years but bearish for Treasury bonds beyond that. Scenario 2 punishes passive index buy-and-hold investing. With high valuations, the returns will be flat for equities over the coming 10-years and a bumpy ride up and down on our way to flat. Perhaps not too dissimilar to the 1966-1982 secular bear market and perhaps somewhat similar to the go-nowhere-for-two-decades Japanese equity market.
3) The wild card risk we face is the loss of faith in the developed world governments. This is about loss in trust of governments. If the EU fails, imagine where that money might flow. If your bank was going to fail and you knew it, you’d rush to get your money out of that bank. You’d move it to a safer place. Same if your currency were to fail. Risks in Europe are great because they don’t have a common bond market. Italy defaults and the system crashes. The problems are everywhere. Debt is more than 300% to GDP in most countries. It is 361% in Italy, 513% in France and 464% debt-to-GDP 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. In the EU, you need all 19 members to agree on things. Does Germany want to be on the hook for Italian and French debt? Would New York agree to bail out California? Doubtful, but in the U.S. there exists a Fed/Treasury marriage and a Congress in full support. Blink, print, new SPV. The EU structure is flawed since there is no common government bond. Capital flows to the U.S. and with rates on bonds so low… U.S. equities, at any valuation, will be preferred. Scenario 3 favors US equities, real assets and Gold.
I think we get scenario 2. Low probability of scenario 1 and perhaps a slightly higher probability for scenario 3.
Globally, money creation will continue and the pandemic further enables and accelerates policy response. The fight now is to defeat deflation. Can you trust that the authorities don’t go too far? I don’t. We are in the first or second inning of solving a global debt mess. The pandemic is like a nuclear bomb to the global business system and it hit at a time the global economy was already moving towards recession. “What ever it takes” has been unleashed. The fight is to prevent deflation. All of the printing and debt monetization’s risks inflation. Deflation now, inflation later.
The period ahead favors active investing. Fortunately, the tool kit of available ETFs is fantastic. I think we will get #2 and believe we have a very small probability of #3. Overvalued equity markets can race even higher. This may be unpopular and yes I’m talking about my book, passive is in trouble, especially that 40% allocated to bonds. There early to mid-1980’s was a buy of a lifetime for bonds. We are at the other side of that now: This is a sell of a lifetime for bonds.