“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.”
– Lacy Hunt, Ph.D.,
Executive Vice President of Hoisington Investment Management Company
One of my closest friends, Wade, is a senior manager at JPMorgan. We’ve golfed together for years, and on the course our talks are often around the markets. We’re addicted to both: golf and markets. Wade reads my weekly letter and is one of the funniest people I know. We take jabs at each other and, yes, his jabs are the best. For example, he refers to this missive not as On My Radar, but as Out of My Rear End (actually Rectum, but that word is less fit for print—though I guess I’ve just printed it). Frankly, no one makes me laugh more and, boy, we could all use a little laughter right now. Wade called me this week to chat about the discussions we should have with our clients and our children.
I’m of the belief that we must defend our wealth first and foremost. Why? It all comes down to how money compounds.
Compounding is awesome on the way up, but it is merciless on the way down. If your investment account goes up 30% and then goes down 30%, your $1,000,000 grew to $1,300,000 before it declined to $910,000. Meanwhile, most people think up 30, down 30 takes them back to even; that’s just not the case. Lose 50%—something that happened during the last two recessions—and you need a subsequent 100% return to get back to even. Wade and I agree: This should be the first rule we teach our kids about investing. I share a piece I wrote some years ago called “The Merciless Mathematics of Loss” when you click through below. I hope you find it helpful.
Over the weekend, I read John Hussman’s latest research letter. It was long. He talked about “Containing the Crisis,” and you can find the full post here. 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 its wrong.
What the Fed and the Treasury have done is something of an amazement. 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. This is a really good gig, if you can get it.
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.
So what? Who is going to stop it? The fight will take a patriot with a capitalistic heart, deep pockets, a favorable court (the odds are not as good in NYC or DC) and the fight will be long —including appeals, more battles, and years before it reaches the Supreme Court.
The conclusion? Hussman is right: it isn’t legal. But the rules will be amended. Precedent was set when the Fed bought the AIG portfolio in early 2009. Remember that? Pour another helping of that pink Pepto-Bismol into mom’s extra-large spoon and swallow hard. The cat’s back out of the bag and it’s bigger and more enabled than ever.
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.
I was on an ETF Trends webcast on Wednesday titled, “High Yield: Strategies for Volatile Markets” this week, hosted by good friend Dave Nadig, CIO and Director of Research ETF Trends and ETF Database. Joining us were Sonja Hildebrandt, Vice President and Co-Head of CIO Office at DWS, Marc Pfeffer, CIO at CLS Investments and Sean Edkins, Head of ETF Sales and Strategic Partnerships, DWS. More than 800 people from around the country tuned in. If you are an advisor, send me a note and I’ll get you access to the replay. And they provide CE credits, if you need them.
In preparation for the webcast, I shared some of my thoughts in an email exchange with Dave and his team. I thought I’d share them with you today, as I believe these really are the important questions on the table right now. I want to begin the story by saying that I too am trying to figure them out.
Following are my bullet-point notes shared with ETF Trends prior to the webcast (and a few new additions):
- 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. 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.
- So, the Fed is inventing other solutions: QEs and SPVs.
- Due to the pandemic’s economic hit, U.S. capacity utilization is likely down 7% to 10%. There is no way the Fed can create inflation. With such excess capacity (to make and service things) in the system, prices will remain low and likely go even lower.
- If there is a McDonalds on one corner of an intersection and a Burger King on the other, and then three more fast-food chains set up shop right next to them, all of those players crowd the system, affect gross sales, price and profits. And if more than a few are in debt and mismanaged, they should The strong survive and sales and profits pick up. But ultra-low Fed policy chased many investors into riskier funds, and that money was invested into the bonds of those less-than-responsible stewards. By bailing out bad actors, we are keeping them in business. In a sense, those bad actors are stealing from the business revenues of the good actors. And by keeping them in business, we are not allowing the system to clear.
- Inflation is not today’s problem. The Fed can’t create inflation. They are enabling dis-inflation by keeping the bad actors in business. The bad actors continue to survive on debt, not sales or revenue. Debt keeps them afloat.
- My friend Lacy Hunt told me that an increase by 7% to 10% in excess capacity will knock the inflation rate down 4%, and we are currently at 2%. Inflation will go to -2%. That’s negative 2%.
- We’ve just had a nuclear hit to the global business system. Therefore, in the next few years, deflation remains Enemy Number One and Treasury yields are likely headed even lower.
- But ultimately, how attractive are Treasurys yielding 1% or less? And what problems sit beneath the surface that we don’t yet see due to the shock? Can’t bail everyone out. Problems will present.
- This is the sell of a generation for most bond markets. Long-term dated Treasury bonds will likely still do well, but there is not much more room for rates on the downside and the upside risk of loss is big if the rates do rise.
- My two cents: Think entirely differently about your bond exposures - trade bonds, don’t buy-and-hold.
Just how much love sits in Chairman Jay Powell’s heart? A lot!
- The Fed’s balance sheet is at $7 trillion. It may grow to $15 to $20 trillion. But we can’t know this for sure.
- 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.
- Businesses are more leveraged and the quality of the debt has never been worse (as measured by the Moody’s Covenant Index).
- Every large economic fire will be followed by more sugar from the Fed. When will enough be enough? How do they exit? No one, including the Fed, knows. I suspect too much central bank sugar will ultimately affect our health.
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 my friend Wade put it, “We are capitalists on the way up and socialists on the way down.” We best be careful.
It’s competition that helps us all grow.
- Do you want all the teams in the NFL to get the trophy each year, regardless of their performance, or do you appreciate how the platform for competition—and the fact that not everyone can win—provides the potential for all teams to get better in their pursuit of success?
- It’s not easy when your child gets cut from a team. But that sad day may just be what inspires her to improve, work harder, practice more, and eventually get better. Maybe our greatest gifts in life come from things that didn’t feel much like a gift at the time. Such is the platform in sports and in business.
- Losing is a gift that helps us improve and advance. We are enabling bad actors when they should be benched.
- And frankly, sometimes it’s timing and luck. So be it. Colonel Sanders failed something like five times before establishing Kentucky Fried Chicken, which has become an amazing success.
- Did the Colonel learn from his failures? Did he help others advance, thanks to his ideas? Yes!
- I know some people don’t like capitalism but look around and show me a socialist country that is a great success. If I’m going onto the field to play, while not perfect, ours in the U.S. is a pretty great field to be on. Not everyone gets a trophy and that’s a good thing. We hurt, learn, and get better. We have to remember that.
- We are not letting the bad actors fail. We must.
Since that’s not going to happen in the immediate future, the die is cast for now.
Bottom line: Lacy 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.” BTW: If you are not reading his Hoisington Quarterly Letter, you should be. Lacy’s brilliant.
So how will this play out in the financial markets?
I don’t care who your favorite expert might be, no one knows for sure, including me. With that said, there are markers to watch out for and it’s important to think in terms of probabilities and risk management. Global capital flows, central bankers, politicians, currency battles, and the depth of debt and mismanagement in businesses and governments. No one knows because we don’t yet know how the players in the game will respond. We don’t know who the players will be. But we can guess.
Here are some things to keep in mind:
- Much depends on the activity of central banks.
- Much depends on fiscal policy response. For example: I believe it is probable that the Fed moves from a $7 trillion balance sheet to $15 to $20 trillion. What if they stop at $10 trillion or go to $50 trillion? We don’t yet know.
How will this affect your portfolio?
With the above caveats, I see three potential scenarios and believe scenario 2 to be most probable:
Scenario 1. Depression. We are going to get deflation; that’s a given. The risk in this scenario is we go into a depression. If depression happens, interest rates on the U.S. Treasury 30-year bond will drop to 50 bps or lower. Depression is bad for corporate bonds, mortgage bonds, and municipal bonds due to default risks. But such a move is a home run for long-term Treasury bonds.
Can the Fed, via an SPV, buy up the entire debt market? Doubt it. But for the immediate future, 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. Scenario 1 is bullish for U.S. Government Treasury bonds, and bearish for most other risk assets.
Scenario 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 a re-test of the March 2020 low—my best guess is 2,850 to 2,200. The Fed fires its bazooka and then steps aside to let the markets stand on their own. There’s a burst of flames and the Fed rushes back in to put them out. Markets trade higher, the Fed lets things function on their own, new fire, new Fed response.
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. More fires, more sugar, more fire, more sugar. So, unfortunately, I see long-term diminishing returns unless we let bad actors fail and defaults occur. This would have the positive effect of letting the system clear and start anew. The current players won’t let it clear. Scenario 2 is bullish for trading strategies and active stock pickers (value plays for the more conservative and transformational businesses for the more aggressive). It is bullish for long-term Treasury bonds over the next few years, but bearish for Treasury bonds beyond that. 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.
Scenario 3. A loss of faith in the developed world governments. This is about a loss of trust in 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 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. In scenario 3, capital flows to the U.S. and with rates on bonds so low… U.S. equities are the beneficiary, no matter what the valuation is. Scenario 3 favors U.S. equities, real assets, and gold.
I see a low probability of scenario 1 (depression), and perhaps a slightly higher probability for scenario 3. But ultimately, I think we get scenario 2. Overweight to trading strategies.
Globally, money creation will continue, and the pandemic further enables and accelerates policy response. Do 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 was a nuclear bomb to the global business system. It hit at a time when the global economy was already moving toward recession. The fight now is to prevent deflation/depression. The monetary response is massive. I don’t see depression. Deflation? Yes. But the future risks will tilt to inflation. I don’t think the world authorities, all creating money out of thin air, can pull back on the reins when it’s time. The cat is out of the bag. Deflation now, inflation later.
The early to mid-1980s were the buy of a lifetime for bonds. Rates were very high. We are at the other side of that story now: This is the sell of a lifetime for bonds.
The Mauldin “Virtual” Strategic Investment Conference, May 11-21, 2020
I have been attending my friend and CMG’s chief economist John Mauldin’s Strategic Investment Conference for nearly 15 years. It is simply the best investment conference anywhere, period. Due to the virus, he had to cancel the in-person gathering this year. Instead, though, he has put together a virtual conference with the ultimate dream team of economists, geopolitical thinkers, technology and futurist experts, and sociological and political insiders. They will be covering literally everything happening not only in the investment world, but also in the political/geopolitical/social/technology worlds. There will be almost twice as many speakers. Many are famous investors and economists you will know. Some you’ve never heard of before. All of them are brilliant. And as John so famously does, the conversations are carefully crafted to figure out how were going to get through the next six months and what the post-vaccine world will look like. And the virtual conference is relatively inexpensive.
John wrote a very personal letter describing the entire conference, the speakers, and why he chose them. I highly recommend you read it. You are really going to want to participate. From John:
"Better to have a roadmap with an idea of where to go than simply to walk into the future without a plan. Join me. You know you not only want to, but you need to. This will be a once-in-a-lifetime event, and you don’t want to miss it."
I agree. The SIC has always been the highlight of my year. This year, I’ll be watching it from the comfort of my home. Post conference, you and I will have access to the video recordings and the transcripts, so you can tune in live or catch up later.
Here is the link to his letter. I hope you can join John and me as we journey together into a fabulous and tumultuous future.
Coffee in hand? It’s go time. You’ll find the link to The Merciless Mathematics of Loss piece and Trade Signals when you click through below. And a picture of a masked IPA lover in the personal section. Have a great weekend and thanks for reading!
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