You may have been wondering whether April’s stock market recovery marks a turn for the better in terms of the outlook for the economy and portfolios. We addressed this issue at some length in our latest quarterly letter, Through the Looking-Glass, so if you haven’t had a chance to read it yet, I hope you will do so. Here’s the short version. 😊
Although there have been some promising developments in terms of potential treatments and vaccines, the coronavirus is actually not the greatest challenge we face in restoring a healthy economy. The Q1 GDP figures released last week reveal that US activity was already quite weak before the stay-at-home orders were issued. Those took effect in late March, when the quarter was just about over. Personal consumption had been slowing since the middle of last year, then dropped like a stone over the January-March period. That’s far worse than anything we experienced during the Great Recession—and it came before the virus. Non-residential fixed investment had been slowing since the second quarter of 2018, and also dropped by 8% in Q1. Net trade (the difference between US exports and imports) had been decelerating since late 2017, and then collapsed as a result of the trade war and coronavirus-related disruptions.
In other words, an economy that was already extremely fragile—due to heavy debt loads, inflated asset values, slowing (and increasingly concentrated) income growth, and narrow supply chains—simply couldn’t withstand any real shock. In the words of Alhambra Investments’ Jeffrey Snider: “At the first sign of danger the whole damn system folded like a cheap suit…it just buckled.”
Restoring healthy growth will require addressing the sources of fragility at their foundations—not simply throwing more money at the problem. The money we have been throwing around hasn't gone to the those who would help us get through this crisis. Due to dysfunction and disunity in Congress, the vast majority of relief funds have been allocated by the Federal Reserve, via the financial system. That necessarily means that large borrowers, and those closest to the financial industry, have benefited first and most. Whereas small- and medium- size businesses and households have been struggling to survive, the Fed has been helping highly-indebted “zombie” companies “extend and pretend” they’re not insolvent. As a result, companies on the brink of failure—before the crisis hit—massively outperformed the S&P 500 during the month of April:
Does that suggest these are good investments? We very much doubt it, for the reasons explained in our last quarterly letter. We’re not interested in buying junk, so haven’t been tempted to invest in the “relief rally” I anticipated in a March 24 message to clients. Nor do we wish to consign our clients’ portfolios to a fate of near-zero returns by purchasing assets that are more expensive than they’ve ever been. 10-year US Treasury yields at 0.6%? No thanks. Stocks with an earnings yield (inverse P/E) of 3%—even before the possibility of a protracted decline in earnings? We’ll pass.
The Federal Reserve pulled a decade’s worth of investment returns forward by inflating asset prices—and debt loads—with its easy-money policies. It has now doubled down on that failed strategy by agreeing to backstop the US corporate, high-yield and municipal bond markets. You may have surmised that these “liquidity” operations are not enough to prop up a global financial system that’s teetering on the brink—and you’d be right. The Fed has also extended massive US$ swap lines (we give them dollars, they give us local currency) with other central banks, in order to slake foreign commercial banks’ unquenchable thirst for dollars. They include a $7b swap with the Bank of Mexico, who provided emergency funding to the state oil company Pemex, so that it could meet its US$ debt obligations.
The US and Europe made the same mistake Japan did in the 1980s, by lending against (now grossly inflated) assets, rather than income (productive capacity). As debt levels have surged relative to output, the availability of high-quality collateral has progressively declined—and is now on the verge of disappearing.
By high-quality collateral, I don’t simply mean US Treasury securities…or even short-term Treasuries. I mean on-the run short-term Treasuries which, as of mid-March, were the only collateral deemed safe enough for the repo market.* Now that the US federal budget deficit is set to quadruple to $4 trillion in 2020, there will be a lot more Treasuries to go around. For how much longer will they be considered high-quality collateral? If the US Treasury market breaks, then everything else breaks.
We think there will be phenomenal opportunities to invest in the months ahead, since not even the Wizard of Oz, who now sits in the Marriner Eccles building, can backstop the entire global financial system. We’re just waiting for other investors to figure that out. As and when they do, the investments we make on behalf of our clients will offer a rate of return that is at least commensurate with the risks they take.
* From the minutes of the FOMC’s March 15 meeting: “In the Treasury market, following several consecutive days of deteriorating conditions, market participants reported an acute decline in market liquidity. A number of primary dealers found it especially difficult to make markets in off-the-run Treasury securities and reported that this segment of the market had ceased to function effectively. This disruption in intermediation was attributed, in part, to sales of off-the-run Treasury securities and flight-to-quality flows into the most liquid, on-the-run Treasury securities.” Hat Tip to Jeff Snider of Alhambra Investments