Coronavirus: “We are all Keynesians now”

An economic depression requires a 10% (or more) decline in real GDP or a prolonged recession that lasts two or more years.

The current contraction, sparked by the global coronavirus outbreak, is likely to be severe but its magnitude and duration are still uncertain. After an initial spike in cases, with devastating consequences in many countries — both in terms of the number of deaths and the massive economic impact — the rate of contagion is expected to drop significantly. But we could witness further flare-ups, as with SARS.

Development of a vaccine is the only viable long-term defense against the coronavirus but health experts warn that this is at least 12 to 18 months away — still extremely fast when compared to normal vaccine development programs.

The economic impact may soften after the initial shutdown but some industries such as travel, airlines, hotels, cruise lines, shopping malls, and cinemas are likely to experience lasting changes in consumer behavior. The direct consequences will be with us for some time. So will the indirect consequences: small business and corporate failures, widespread unemployment, collapsing real estate prices, and solvency issues within the financial system. The Fed is going to be busy putting out fires. While it can fix liquidity issues with its printing press, it can’t fix solvency issues.

There are three key factors that are likely to determine whether countries end up with a depression or a recession:

1. Leadership during the crisis

Many countries were caught by surprise and the rapid spread of the virus from its source in Wuhan, China. South Korea, Singapore and Taiwan were best prepared, after dealing with the SARS outbreak in the early 2000s. Extensive testing, tracing and an effective quarantine program helped South Korea to bring the spread under control, after initially being one of the worst-hit.

Daily Increase - South Korea

South Korea: Initial Cases of Coronavirus COVID-19 (JHU)

The World Health Organization (WHO) did little to help, delaying declaration of a pandemic to appease the CCP. Economic and political self-interest has been the root cause of many failures along the way, including China’s failure to alert global authorities of the outbreak (they had already shut down Wuhan Naval College on January 1st). But this was aided by failure of many leaders to heed warnings from infectious disease experts in late January/early February. When they finally did wake up to the threat, many were totally unprepared, resulting in a massive spike in cases across Europe and North America.

Testing is a major bottleneck, with the FDA fast-tracking approval of new tests, but production volumes are still limited. Abbott recently obtained FDA approval for a new 5-minute test kit that can be used in temporary screening locations, outside of a hospital, but production is currently limited to 50,000 per day. A drop in the ocean. It would take 6 months to produce 9 million kits for New York alone.

Daily Increase - USA

USA: Initial Cases of Coronavirus COVID-19 (JHU)

Daily Increase - UK

UK: Initial Cases of Coronavirus COVID-19 (JHU)

Daily Increase - Germany

Germany: Initial Cases of Coronavirus COVID-19 (JHU)

Daily Increase - Italy

Italy: Initial Cases of Coronavirus COVID-19 (JHU)

Widespread testing and tracing, social-distancing, and effective quarantine methods have enabled some countries to flatten the curve. Australia may be succeeding in reducing the number of new cases but inadequate testing and tracing could lead to further flare-ups. One of the biggest dangers is asymptomatic carriers who can infect others. Flattening the curve is the first step, but keeping it flat is essential, and requires widespread testing and tracing.

Daily Increase - Australia

Australia: Initial Cases of Coronavirus COVID-19 (JHU)

The curves for North America and Europe remain exponential. They may even spike a lot higher if hospital facilities are overrun. Success in flattening the curve is critical, not just in minimizing the number of deaths but in containing the economic impact.

2. Economic rescue measures during the crisis

Rescue measures amounting to roughly 10% of annual GDP have been introduced in several countries, including the US and Australia, to soften the economic impact of the shutdown. More Keynesian stimulus may be needed if the coronavirus curve is not flattened. Layoffs have spiked and many small businesses will be unable to recover without substantial support.

3. Economic stimulus after the crisis

This is not a time for half-measures and the $2 trillion infrastructure program proposed in the US is also appropriate in the circumstances. Australia is likely to need a similar program (10% of GDP) but it is essential that the money be spent on productive infrastructure assets. Productive assets must generate a market-related return on investment ….or generate an equivalent increase in government tax revenue but this is much more difficult to measure. Investment in unproductive assets would leave the country with a sizable debt and no ready means of repaying it (much like Donald Trump’s 2017 tax cuts).

Conclusion

Social-distancing and effective quarantine measures are necessary to flatten the curve but widespread testing and tracing is essential to prevent further flare-ups. Development of a vaccine could take two years or more. Until then there is likely to be an on-going economic impact, long after the initial shock. This is likely to be compounded by a solvency crisis in small and large businesses, threatening the stability of the financial system. The best we can hope for, in the circumstances, is to escape with a recession — less than 10% contraction in GDP and less than two year duration — but this will require strong leadership, public cooperation and skillful prioritization of resources.

—–

“We are all Keynesians now.” ~ Richard Nixon (after 1971 collapse of the gold standard)

Lessons from the Panic of 1907

I have read The Panic of 1907 (by Robert Bruner & Sean Carr) four or five times — I read it at every market crash.

The crash occurred more than 100 years ago and is one of many banking crises that beset the United States in the 19th and early 20th century. What made 1907 stand out is that the financial system was saved by the leadership of a private individual, John Pierpont Morgan, head of the banking firm that later became known as J.P. Morgan & Co. Without the 70-year old Morgan’s force of will, the entire financial system would have imploded.

John Pierpont Morgan
John Pierpont Morgan – source: Wikipedia

The crisis led to formation of the Federal Reserve Bank in 1913. The US had not had a central bank since President Andrew Jackson withdrew the charter for the second Bank of the United States in 1837. Bank clearing houses prior to 1913 were private arrangements created by syndicates of banks and were poorly-equipped to deal with the challenges of a banking crisis.

The lessons of 1907 are still relevant today. The authors of the book suggest that “financial crises result from a convergence of forces, a ‘perfect storm’ at work in financial markets.”

They identify seven elements that converged to create a perfect storm in 1907:

  1. Complex Financial Architecture makes it “difficult to know what is going on and establishes linkages that enable contagion of the crisis to spread.”
  2. Buoyant Growth. “Economic expansion creates rising demands for capital and liquidity and ….excessive mistakes that eventually must be corrected.”
  3. Inadequate Safety Buffers. “In the late stages of an economic expansion, borrowers and creditors overreach in their use of debt, lowering the margin of safety in the financial system.”
  4. Adverse Leadership. “Prominent people in the public and private spheres implement policies that raise uncertainty, which impairs confidence and elevates risk.”
  5. Real Economic Shock. “Unexpected events hit the economy and financial system, causing a sudden reversal in the outlook of investors and depositors.”
  6. Undue Fear, Greed and other Behavioral Aberrations. “….a shift from optimism to pessimism that creates a self-reinforcing downward spiral. The more bad news, the more behavior (erupts) that generates bad news.”
  7. Failure of Collective Action. “The best-intended responses by people on the scene prove inadequate to the challenge of the crisis.”

Compare these seven elements to the current crisis in March 2020:

Complex Financial Systems

The global financial system is far more complex than the gold-based financial system of 1907. Regulation has not kept pace with the growth in complexity, with many products designed to avoid regulation and lower costs. The ability to build firebreaks to stop the spread of contagion in unregulated or lightly regulated areas of the financial system is severely limited. And that is where the fires tend to start.

In 1907 the fire started with poorly regulated trust companies that dominated the financial landscape: making loans, receiving deposits, and operating as an effective shadow-banking system. A run on trust companies threatened to engulf the entire financial system.

In 2020 it started with hedge funds leveraged to the hilt through repo markets but soon threatened to spread to other unregulated (or lightly regulated) areas of our shadow banking system:

  • Leveraged hedge funds
  • Risk parity funds
  • International banks lending and taking deposits in the unregulated $6.5 trillion Eurodollar market (these banks are offshore and outside the Fed’s jurisdiction).
  • Money market funds
  • Muni funds
  • Commercial paper markets
  • Leveraged credit
  • Bond ETFs

Many of these offer the attraction of low costs and higher returns, often enhanced through leverage, but what investors are blind to (or choose to ignore) are the risks from lack of proper supervision and the lack of liquidity when money is tight.

Maturity mis-match is often used to boost returns. Short-term investors are channeled into long-term securities such as Treasuries, corporate bonds, munis or credit instruments, with the promise of easy sale or redemption when they require their funds. But this tends to fail when there is a liquidity squeeze, forcing a sell-off in the underlying securities and steeply falling prices.

Rapid Growth

We all welcome strong economic growth but should beware of the attendant risks, especially when financial markets are administered more stimulants than a Russian weightlifter for purely political ends.

Excessive use of Debt

Corporate borrowings are far higher today and rising debt has warned of a coming recession for some time.

Corporate Debt/Profits Before Tax

Public debt is growing even faster, with US federal debt at 98.6% of GDP.

Public Debt/GDP

Adverse Leadership

In the early 1900s, President Teddy Roosevelt led a populist drive to break the big money corporations through Anti-Trust prosecutions. This cast a shadow of uncertainty that fueled the sudden reversal in investor sentiment.

President Theodor Roosevelt

In 2020, we have another populist in the White House. Frequent changes in direction, spats with allies, imposition of trade tariffs, impeachment efforts by Congress, and a heavy-handed approach to trade negotiations have all elevated the level of uncertainty.

Donald Trump

Economic Shock

The great San Francisco earthquake and fire of 1906 created an economic shock that was felt across the Atlantic. The earthquake ruptured gas mains, setting off fires, while fractured water mains hampered firefighting. Over 80% of the city was destroyed. Much of the insurance was carried in London and Europe and led to a sell-off of securities in order to meet claims. The Bank of England became increasingly concerned about the outflow of gold from the UK and hiked its benchmark interest rate from 3.5% to 6.0%. London was then the hub of global financial markets and money became tight.

In 2020 we have the coronavirus impact on global manufacturing, services and financial systems: the mother of all demand and supply shocks.

JHU - CV Confirmed Cases

Undue Fear and Greed

Collapse of highly leveraged ventures in 1907 — with an attempted short squeeze on United Copper shares by connected corporations, banks and broking houses — stirred fears that a leading Trust company was going to fail. The panic soon spread and started a run on a number of trust companies.

A spike in the repo rate in September last year revealed that hedge funds had used repo to leverage their relatively meager capital into a rumored $650 billion exposure to US Treasuries. The Fed had to dive in with liquidity to settle the repo markets, lifeblood of short-term funding by primary dealers. But financial markets were on edge and concerns about funding difficulties in the unregulated $6.5 trillion offshore Eurodollar market and leveraged credit in the US started to grow.  But the coronavirus outbreak in Europe and North America was the eventual spark that set off the conflagration.

Failure of Collective Action

Tust companies failed to organize an effective defense in 1907 against a run on their largest member, The Knickerbocker Trust Company, fueling a panic that threatened to engulf other trusts. Responding to appeals for help, J.P. Morgan intervened and marshaled the banking industry and surviving trusts to mount an effective defense.

Today that role falls to the Federal Reserve. Chairman Jay Powell moved quickly and purposefully to flood financial markets with liquidity, but the Fed was forced to reach far outside their normal ambit — increasing dollar swap lines with foreign central banks (to supply liquidity to international banks operating in the Eurodollar market) and providing liquidity to money market funds, muni funds, commercial paper markets, bond funds, hedge funds (through repo markets) and more. In effect, the Fed had to bail out the shadow banking system.

One thing that strikes me about financial crises is that each one is different, but some things never change:

  • artificially low interest rates;
  • rampant speculation;
  • excessive use of debt;
  • unregulated and highly leveraged shadow-banking with hidden linkages through the financial system;
  • financial engineering (the latest examples are leveraged credit and covenant-lite loans, hedge funds running leveraged arbitrage, risk parity funds with targeted volatility, and management using stock buybacks to enhance earnings per share, support prices and boost their stock-based compensation);
  • misuse of fiscal stimulus (to fund corporate tax cuts while running a $1.4 trillion fiscal deficit);
  • misuse of monetary policy (cutting interest rates when unemployment was at record lows);
  • yield curve inversion; and
  • misallocation of investment (to fund unproductive assets)

Jim Grant (Grant’s Interest Rate Observer) sums up the problem:

“The Fed has intervened at ever-closer intervals to suppress the symptoms of misallocation of resources and the mis-pricing of credit. These radical interventions have become ever-more drastic and the ‘doctor-feel-goods’ of our central banks have worked to destroy the pricing mechanism in credit.

….[credit and equity markets] have become administered government-set indicators, rather than sensitive- and information-rich prices… and we are paying the price for that through the misallocation of resources…..

Is there no salutary role for recessions and bear markets? …..they separate the sound from the unsound, they separate the well-financed from the over-leveraged and if we never have these episodes of economic pain, we will be much the worse for it.”

We haven’t learned much at all in the last 100 years.

Fed brings out the big bazooka

The Fed is on a war footing.

The FOMC announced that it will cut the funds rate to zero. Timing of the announcement — Sunday, March 15th at 5:00 p.m. — signals the level of urgency.

“Consistent with its statutory mandate, the [FOMC] Committee seeks to foster maximum employment and price stability. The effects of the coronavirus will weigh on economic activity in the near term and pose risks to the economic outlook. In light of these developments, the Committee decided to lower the target range for the federal funds rate to 0 to 1/4 percent. The Committee expects to maintain this target range until it is confident that the economy has weathered recent events and is on track to achieve its maximum employment and price stability goals.”

Bond markets have been anticipating this cut since March 4th, when the 3-month T-bill rate plunged to 33 basis points.

Fed Funds Rate, Interest on Excess Reserves and 3-Month T-bills

The Fed also announced further QE of $700 billion, expanding its balance sheet by $500 billion in Treasury securities and $200 billion in mortgage-backed securities (MBS). This is in addition to the $1.5 trillion repo operations announced earlier in the week.

Fed Balance Sheet: Total Assets and Excess Reserves on Deposit

In a related announcement, the Fed is also encouraging banks to use the discount window, cutting the primary credit rate by 150 basis points to 0.25 percent, effective March 16, 2020.

“Narrowing the spread of the primary credit rate relative to the general level of overnight interest rates should help encourage more active use of the window by depository institutions to meet unexpected funding needs. To further enhance the role of the discount window as a tool for banks in addressing potential funding pressures, the Board also today announced that depository institutions may borrow from the discount window for periods as long as 90 days, prepayable and renewable by the borrower on a daily basis. The Federal Reserve continues to accept the same broad range of collateral for discount window loans…”

Not all the $1.5T repo facility is likely to be taken up — the Fed just used a big number for dramatic effect, to get everyone’s attention — but we expect the Fed’s balance sheet expansion to get close to $6 trillion (compared to $4.3T on March 11th) before this is over.

While these rescue operations are normally announced as temporary, they soon become permanent as the market resists any efforts to unwind the Fed’s role.

As I said on Saturday: “To infinity and beyond…

The S&P 500 and Plan B

The S&P 500 penetrated its rising trendline, warning of a re-test of support at 3000. But selling pressure on the Trend Index appears to be secondary.

S&P 500

Transport bellwether Fedex retreated below long-term support at 150 on the monthly chart — on fears of a slow-down in international trade. Follow-through below 140 would strengthen the bear signal, offering a target of 100. The bear-trend warns that economic activity is contracting.

Fedex

Brent crude dropped below $60/barrel on fears of a global slow-down. Expect a test of primary support at 50.

Brent Crude

Dow Jones – UBS Commodity Index broke primary support at 76 on the monthly chart, also anticipating a global slow-down.

DJ-UBS Commodity Index

South Korea’s KOSPI Index is a good barometer for global trade. Expect a re-test of primary support at 250.

KOSPI

While Dr Copper, another useful barometer, warns that the patient (the global economy) is in need of medical assistance.

Copper (S1)

The Fed can keep pumping Dollars into financial markets but at some point, the patient is going to stop responding. In which case you had better have a Plan B.

Irrational Exuberance

I believe this warrants a separate post:

The market is running on more stimulants than a Russian weight-lifter. Unemployment is near record lows but the US Treasury is still running trillion dollar deficits.

Federal Deficit & Unemployment

While the Fed is cutting interest rates.

Fed Funds Rate & Unemployment

And again expanding its balance sheet. More than twelve years after the GFC. The blue line reflects total assets on the Fed’s balance sheet, mainly Treasuries and MBS, while the orange line (right-hand scale) shows how shrinking excess reserves on deposit at the Fed have helped to create a $2 trillion surge in liquidity in financial markets since 2009. Even when the Fed was supposedly tightening, with a shrinking balance sheet, in 2018 to 2019.

Fed Totals Assets & Net of Excess Reserves on Deposit

The triple boost has lifted stock valuations to precarious highs. The chart below compares stock market capitalization to profits after tax over the past 60 years.

Market Cap/Profits After Tax

Ratios above 15 flag that stocks are over-priced and likely to correct. Peaks in 1987 and 2007, shortly before the GFC, are typical of an over-heated market. The Dotcom bubble reflected “irrational exuberance” — a phrase coined by then Fed Chairman Alan Greenspan — and I believe we are entering a second such era.

Recovery of the economy under President Trump is no economic miracle, it is simply the triumph of monetary and fiscal stimulus over rational judgement. Trump knows that he has to keep the party going until November to win the upcoming election, so expect further excess. Whether he succeeds or not is unsure but one thing is certain: the longer the party goes on, the bigger the hangover.

William McChesney Martin Jr., the longest-serving Fed Chairman (1951 to 1970), famously described the role of the Fed as “to take away the punch bowl just as the party gets going.” Unfortunately Jerome Powell seems to have been sufficiently cowed by Trump’s threats (to replace him) and failed to follow that precedent. We are all likely to suffer the consequences.

Bull Markets & Irrational Exuberance

Bob Doll from Nuveen Investments is more bullish on stocks than I am but sets out his thoughts on what could cause the current run to end:

“Stock valuations are starting to look full, and technical factors are beginning to appear stretched. As stock prices have risen since last summer, bond yields have crept higher. Should this trend persist, it could eventually cause a headwind for stocks. Credit spreads are signaling some risks, as non-energy high yield corporate bond spreads have dropped to multi-decade lows.

As such, we think stocks may be due for a near-term correction or consolidation phase. Nevertheless, we expect any such phase to be mild and brief as long as monetary conditions remain accommodative and economic and earnings growth holds up. In other words, although we see some near-term risks, we don’t think this current bull market is ending.

That raises the question of what might eventually cause the current cycle to end. We see three possibilities. First, recession prospects could increase significantly. We see little chance of that happening any time soon, given solid economic fundamentals. Second, a political disruption like a resurgence in trade protectionism could occur. We also don’t think that is likely to happen, especially in an election year. Third, bond yields and interest rates could move higher as economic conditions improve, creating problems for stocks. This one seems like a higher probability, and we’ll keep an eye on it.”

Economy

The upsurge in retail sales and housing starts may have strengthened Bob’s view of the economy but manufacturing is in a slump and slowing employment growth could hurt consumption. The inverted yield curve is a long-term indicator and I don’t yet see any indicators confirming an imminent collapse.

Treasury 10 Year-3 Month Yield Differential

I rate economic risk as medium at present.

Political Disruption

US-China trade risks have eased but I continue to rate political disruption as a risk. This could come from any of a number of sources. US-Iran is not over, the Iranians are simply biding their time. Putin’s attempted constitutional coup in Russia. China-Taiwan. Libya. North Korea. Brexit is not yet over. Huawei and 5G are likely to disrupt relations between China, the US and European allies, with China threatening German automakers. Europe also continues to wrestle with fallout from the euro monetary union, a system that is likely to eventually fail despite widespread political support. Impeachment of Trump may not succeed because of the Republican majority in the senate but could produce even more erratic behavior with an eye on the upcoming election. Who can we bomb next to win more votes?

Bonds & Interest Rates

I don’t see inflation as a major threat — oil prices are low and wages growth is slowing — and the Fed is unlikely to raise interest rates ahead of the November election. Bond yields may rise if China buys less Treasuries, allowing the Yuan to strengthen against the Dollar, but the Fed is likely to plug any hole in demand by further expanding its balance sheet.

Market Risk: Irrational Exuberance

The market is running on more stimulants than a Russian weight-lifter. Unemployment is near record lows but Treasury is still running trillion dollar deficits.

Federal Deficit & Unemployment

While the Fed is cutting interest rates.

Fed Funds Rate & Unemployment

And again expanding its balance sheet. More than twelve years after the GFC. The blue line reflects total assets on the Fed’s balance sheet, mainly Treasuries and MBS, while the orange line (right-hand scale) shows how shrinking excess reserves on deposit at the Fed have helped to create a $2 trillion surge in liquidity in financial markets since 2009. Even when the Fed was supposedly tightening, with a shrinking balance sheet, in 2018 to 2019.

Fed Totals Assets & Net of Excess Reserves on Deposit

The triple boost has lifted stock valuations to precarious highs. The chart below compares stock market capitalization to profits after tax over the past 60 years.

Market Cap/Profits After Tax

Ratios above 15 flag that stocks are over-priced and likely to correct. Peaks in 1987 and 2007, shortly before the GFC, are typical of an over-heated market. The Dotcom bubble reflected “irrational exuberance” — a phrase coined by then Fed Chairman Alan Greenspan — and I believe we are entering a second such era.

Recovery of the economy under President Trump is no economic miracle, it is simply the triumph of monetary and fiscal stimulus over rational judgement. Trump knows that he has to keep the party going until November to win the upcoming election, so expect further excess. Whether he succeeds or not is unsure but one thing is certain: the longer the party goes on, the bigger the hangover.

William McChesney Martin Jr., the longest-serving Fed Chairman (1951 to 1970), famously described the role of the Fed as “to take away the punch bowl just as the party gets going.” Unfortunately Jerome Powell seems to have been sufficiently cowed by Trump’s threats (to replace him) and failed to follow that precedent. We are all likely to suffer the consequences.

Playing the long game

Chart for the Week

GDP growth is slowing, while US corporate profits (before tax) are also declining as a percentage of GDP.

Corporate profits Before Tax/GDP

Yet the S&P 500 and other major indices are rising, lifted by Fed liquidity injections in the repo market. The red line shows total assets on the Fed’s balance sheet.

S&P 500 and Fed Assets

The Long Game

We play the long game — reducing exposure to equities when market risks are high and staying on the defensive until normality is restored — even if this means sitting on cash while equities rise. The only alternative, unless you trust your ability to accurately identify exact market tops and bottoms, is to hang on to your positions no matter what happens. But there are few individuals who can withstand the stress and make rational decisions during a major market draw-down.

Updates for Market Analysis Subscribers

Best wishes for the New Year. It promises to be an eventful one.

Gold bearish on imminent phase 1 deal

The U.S. and China are finalizing a bevy of long-running corporate deals ahead of a high-profile ceremony to sign a trade deal next week that the world’s largest economies seek to cast as a major breakthrough and a marked warming in the relationship. Along with a Chinese delegation led by top negotiator Vice Premier Liu He, executives from American and Chinese companies will also attend the White House event to sign the phase-one agreement on Jan. 15, said the people, who asked not be named discussing private plans. (Bloomberg)

Gold retreated on news that signing of the US-China phase 1 deal is imminent. A tall shadow on the weekly chart warns of selling pressure.  Another test of primary support at $1450 is likely.

Gold (USD/ounce)

Silver also retreated, while declining Trend Index peaks below zero warn of strong selling pressure. Expect another test of support at $16.50.

Silver (USD/ounce)

China’s Yuan broke resistance at 14.35 US cents, while rising Trend Index troughs indicate buying pressure. Expect retracement to test support, but the outlook for the Yuan against the Dollar is turning bullish.

CNYUSD

10-Year Treasury yields found support at 1.70% and a rising Yuan is likely to cause another test of resistance at 2.0%. Breakout would offer a target of 2.50%.

10-Year Treasury Yields

Rising treasury yields increase the opportunity cost of holding precious metals and are bearish for Gold.

Australia

Australia’s All Ordinaries Gold Index penetrated the upper border of its downward trend channel but this week’s tall shadow warns of selling pressure and another test of support at 6000.

All Ordinaries Gold Index

Respect of support at 6000, with follow-through above 7000, would signal that a base has formed.

Patience

Gold is in a long-term up-trend and the current correction may offer an attractive entry point. But we first need a clear breakout from the downward trend channel to confirm that the up-trend is intact.

What is causing the current S&P 500 rise and how is it likely to end?

In November 2007, six months after the inverted yield curve (3M-10Y) recovered to a positive slope, bellwether transport stock Fedex broke primary support at 100 to warn of an economic slow-down.

Today, two months after rate cuts restored an inverted yield curve to positive, Fedex again broke primary support, this time at 150. Their CEO observed that the stock market might be booming but the “industrial economy does not reflect any growth at all.”

Fedex

Real GDP growth is slowing, with our latest estimate, based on weekly hours worked, projecting GDP growth of 1.5% for the calendar year.

Real GDP and Weekly Hours Worked

While real corporate profits are declining.

Corporate Profits Before Tax adjusted for Inflation

What is keeping stocks afloat?

First, a flood of new money from the Fed. They expanded their balance sheet by $375 billion since September 2019 and are expected to double that to $750 billion — bringing total Fed holdings to $4.5 trillion by mid-January — to head off an expected liquidity crisis in repo and FX swap markets. The red line below shows expansion of the Fed’s balance sheet, the blue is the S&P 500 index.

S&P 500 and Fed Assets

Second, ultra-low bond yields have starved investment markets of yield, boosting earnings multiples. P/E of historic earnings rose to 22.01 at the end of the September quarter and is projected to reach 22.82 in the December quarter (based on current S&P earnings estimates).

S&P 500 P/E (maximum of previous earnings)

That is significantly higher than the peak earnings multiples achieved before previous crashes — 18.86 of October 1929 and 18.69 in October 1987 — and is only surpassed by the massive spike of the Dotcom bubble.

How could this end?

First, if the Fed withdraws (or makes any move to withdraw) the $750 billion temporary liquidity injection, intended to tide financial markets over the calendar year-end, I expect that the market would crash within minutes. They are unlikely to be that stupid but we should recognize that the funding is permanent, not temporary.

Second, if bond yields rise, P/E multiples are likely to fall. 10-Year breakout above 2.0% would signal an extended rise in yields.

10-Year Treasury Yields

China has slowed its accumulation of US Dollar reserves, allowing the Yuan to strengthen against the Dollar (or at least weaken at a slower rate). Reduced Treasury purchases are causing yields to rise. The chart below shows in recent months how Treasury yields have tracked the Yuan/US Dollar (CNYUSD) exchange rate.

CNYUSD

Accumulation of USD foreign exchange reserves (by China) is likely to be a central tenet of US trade deal negotiations — as they were with Japan in the 1985 Plaza Accord. Expect upward pressure on Treasury yields as growth in Chinese holdings slows and possibly even declines.

Third, and most importantly, are actual earnings. With 98.6% of S&P 500 companies having reported, earnings for the September quarter are 6.5% below the same quarter last year. Poor Fedex results and low economic growth warn of further poor earnings ahead.

We maintain our view that stocks are over-priced and that investors need to exercise caution. We are over-weight cash and under-weight equities and will hold this position until normal P/E multiples are restored.