Thoughts through the cycle: W1 June ’20

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  • With tax receipts falling and potentially another round of stimulus talks to take place in July, the US primary deficit may well finish 2020 in excess of 20% of GDP. The relevant comparison is July 1942 when the US deficit peaked at 26.4% following the Battle of Midway. By the end of May 2020, 41m Americans had registered as jobless – the relevant comparison here is the 25% unemployment levels of the Great Depression. The Federal Reserve Bank of Atlanta’s ‘nowcast’ of Q2 2020 GDP for the final week of May reached -52.8% (down from -51.2% the previous week) – there is no precedent for this. To this backdrop, let’s talk about the bubble in the US stock market…
  • The term ‘bubble’ is of course pejorative, but for those who are riding fortune’s wheel higher during the bubble’s inflation, it is a wonderful experience. Based on these two premises, one might say it’s only really a bubble after it has burst. Those bubbles which make it to the rogues’ gallery in economics text books (Tulipmania, South Sea Co. etc) tend to have a brief time-span and therefore a ‘wow’ factor. Nonetheless, all bubbles have characteristics in common: a rise in asset prices far beyond conventional estimates of intrinsic or fair value, market professionals leaving or going short and newcomers taking over, and the use of leverage, especially derivatives, as well as ‘innovation’ in this field. Finally, and perhaps controversially, there is always official connivance in getting the asset price movement started. Let us examine the US stock market since mid-March with this in mind.
  • The graph below shows the 12m forward P/E ratio of the Russell 2000 small-cap index from 1990. The current valuation clearly eclipses anything that has gone before, notwithstanding the fact the US is in the worst recession since the 1930s. Consensus estimates suggest the index is trading on a net debt/EBITDA ratio of 6.25x, so these stocks in aggregate are the least well-suited to a deflationary environment. Gross overvaluation is our conclusion here.

Source: Bloomberg, 4th June 2020

  • In terms of professionals leaving the market or going short, April and May have seen high-profile stock-market luminaries such as Warren Buffett reveal share sales in core holdings (airlines, banks in the case of Berkshire Hathaway), as well as those decrying current valuations. In an interview with the Economic Club of New York in early May, Stanley Druckenmiller was recorded as saying, “the risk reward for equity is maybe as bad as I’ve seen it in my career”.
  • Futures open-interest data for the Chicago Mercantile Exchange (CME) for S&P 500 e-mini contract for the week ending 26th May shows a record short interest in speculative contracts (graph below). This suggests both shorting and also hedging by market professionals. Record shorts suggest record scepticism, as well as potentially severe liquidity issues in the cash equity market preventing the sale of long holdings demanding hedging to reduce exposure.

Source: Bloomberg, 4th June 2020

  • Retail trading of the stock market exploded unexpectedly in Q4 2019 following E-Trade’s decision to cut brokerage commissions to zero. With workers furloughed at home, anecdotal evidence suggests activity on retail platforms such as Robinhood has surged, resulting in more leverage and a higher use of derivatives. Charles Schwab has just introduced ‘share slices’ allowing retail investors to buy parts of shares. Much retail buying is price-insensitive and highly speculative, involving buying aggressively what ‘professionals’ are avoiding. As Buffett’s Berkshire Hathaway announced in its Q1 earnings report that it had divested all its airline holdings, the JETS airline exchange-traded fund (ETF) has seen its asset-base rise from $33m to over $1b (‘Bored Millennial Day Traders Boost Airline ETF’s Assets 2930%’, Bloomberg 03/06/2020).
  • Price-insensitive retail investors have been joined by a number of systematic, algorithmic funds which tend to track volatility rather than valuation. With the MOVE (ICE Bank of America 1-month Treasury implied volatility) bond volatility index falling from 160 in March to around 60 in early June, and with the VIX equity volatility index likewise falling from over 80 to the mid-20s during the same period, so have momentum funds started to re-leverage. These funds respond to falling volatility and are entirely blind to valuation considerations. As such, the rally in equities ought to be considered more as a re-leveraging event than a reflation one.
  • The elements of an equity market bubble appear to be forming. The final part is official connivance. Here the role of the Fed needs to be examined. As of the 27th May, the Fed had increased its balance sheet by just under $3tn since the beginning of March. The Fed’s we’ve-got-your-back message has been hammered home on an almost daily basis both on the financial newswires and also on mainstream TV (cf. Fed Chairman Jay Powell’s recent 60-Minutes interview where he held forth about money-printing). The blackout period starting at the end of May ahead of the 9-10th June FOMC meeting has provided welcome relief from the daily drum-beat of Fed officials saying they can do more, print more, expand the balance sheet further and so on.
  • Perhaps the Fed had to act in March to prevent total market meltdown. Perhaps down 35% odd in around three weeks was enough. Reality was though that with rates already so low, the Fed had to resort to extraordinary monetary policy almost immediately, and quantitative easing (QE) tends to be catnip to the US stock market. That cash has in reality flowed into T-Bills and investment-grade credit. The message is always clear – rip stocks up. This is the narrative of the bubble – buy what the Fed buys (credit ETF’s such as LQD.US or JNK.US) or buy what the Fed is surely going to buy next – equities.
  • So much for the bubble story and the Fed narrative. Markets are based on confidence, and the Fed has tried to reassure people following the panic in March. The Fed’s real job relates to its dual mandate of maintaining employment and price stability. With respect to employment, the US currently has the worst figures in almost a century (fail). With respect to inflation, the target of 2% in the medium term seems a long way off. While the University of Michigan 1yr consumer inflation expectations rose to 3.2% (May) and the Confidence Board 12m consumer-inflation expectations (May) have risen to 6.2%, these both probably reflect food-price inflation resulting from supply-chain issues during the lockdown. Core PCE for April fell to 1.0%. Market measures of inflation such as USD 5y5y swaps (5yr inflation in 5yrs time) has levelled out around 1.8%, below the 2% target. The 10yr inflation-adjusted bond (TIPS) break-evens are currently at 1.20%. All that money printing and the bond market has shrugged its shoulders with respect to reflation, let alone ‘proper’ inflation.
  • So, what’s really going on? In a recession, households save. The graph below from the St Louis Fed shows the sharp fall in household credit card balances in the US. Credit is negative saving, so this data suggests a retrenchment in household balance sheets entirely typical of a recession.

Source: St Louis Fed, 31st May 2020

  • With Treasury yields at historic lows, one could be charitable and say that the stock market provides the only place where one can save profitably. This is the ‘there is no alternative’ (TINA) argument. To pile into the stock market in the middle of a severe recession falls into the category of ‘reckless saving’ – an odd phrase for an odd time, but this reflects that fact that by logical necessity, all decisions not to consume are decisions to save, and investment is just the word we use to describe the manner in which we choose to save.
  • Back to the bubble, the Fed and the US Treasury. If the ramp-up of Fed QE was the trigger for the stock market’s animal spirits, then monitoring liquidity is key for equity bubble’s durability. This is where the problems start to emerge, and where reality is starting to differ from narrative.
  • Fed QE peaked at an incredible $125b per day in April and has now fallen to just $4.5b per day. Indeed, on Wednesday 3rd June, the Fed bought only $2.1b of a potential $3.755b 30yr in its daily permanent open market operations (POMO) – perhaps the yield curve is being engineered to levels congruent with a future yield-curve control (YCC) policy. Independently of Fed QE slowing, Treasury issuance has ramped-up. Net positive issuance post Fed QE (Net Treasury issuance less Fed purchases) for May was in fact a massive $556b. This is all liquidity negative.
  • As importantly, the Treasury General Account (TGA) at the Fed has grown to $1.3tn from a usual balance of around $350b. The TGA is effectively the government’s deposit account at the Fed for future spending. Likely it has risen in anticipation of falling tax receipts and also various announced and mooted tax holidays. Either way, this has meant effectively $1tn of liquidity has actually been withdrawn from the system. To put this in context, this is greater than the whole Fed quantitative tightening (QT) policy action of 2018-’19 which resulted in emergency repo operations in September 2019 and two rate cuts.
  • This is where the liquidity narrative needs to be assessed very carefully by investors. The mantra of ‘money printer go brrr’ is the usual rejoinder to explain why the stock market is ripping. Fair enough, but the bond market (inflation expectations) are not saying “brrr” at all. Indeed, if recessions are characterised by balance sheet retrenchment, one ought to stop to ask why there has been more than $1tn of investment-grade issuance in the US in 2020 already. While some equity has been issued, corporates are leveraging up so they have some cash to cover their accounts payable because revenues have collapsed to such a profound extent (this is implicit in the Atlanta Fed’s nowcast reading of -52.8% for Q2). That the Fed kept the bond market open for corporate credit looks more like the Alamo than Yorktown. The situation is so bad that corporates can’t de-lever without risking insolvency.
  • Market participants ought to pay close attention to net liquidity. With net positive Treasury issuance, lower Fed QE purchases, aggressive corporate bond issuance, the momentum behind the stock market looks a little less stable. Even if households are saving recklessly by buying shares, the very act of saving reduces consumption and thereby reduces corporate revenues. This is what Keynes called the paradox of thrift. Re-leveraging is not reflation.

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