Thoughts through the cycle: W5 April ’20

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  • The Nasdaq 100 Index closed on Friday 24th October at 8786.6, up just under 1% for the year. For some astronauts returning to earth after a six-month space flight and checking their 401(k) pension plans, all might seem well with the world. If, however, they were to pick up a newspaper and take a cursory glance at what was actually going on (a list of events including but not limited to a global pandemic), enforced quarantine of much of the workforce, exploding unemployment, industrial and manufacturing collapse, non-payment of mortgages/rents/car loans/credit cards, corporate bankruptcies, rising Sino-US tensions, negative oil prices (really?), and so on, they might think that equities had not got the memo. In fact, they may well say ‘Earth to stock market, like hello?’
  • The macro data is undeniably bad, both in terms of absolute rates of deterioration, and also the speed at which the deterioration has occurred. The graph below shows the US Service PMI updated for April, with readings less than 50 reflecting an economic contraction. A reading of 27 is concerning, but for the US economy where 70% of GDP is service-driven and where the health of the US consumer in many ways acts as a bellwether for the global economy, the meaning of this data cannot be over-estimated. It’s not just the US; France’s April Markit Service PMI reading was an almost unimaginable 10.4, a reading so low that it begs the question of whether any shops were open at all.

Source: Bloomberg as at 27 April 2020

  • The S&P 500 closed on Friday 24th April down 12.2% on the year, but with a sharp fall in earnings predicted due to the pandemic, the multiple on which the Index is currently trading has actually gone up not down in 2020, as the graph below from FactSet shows (12-month forward P/E ratio based on average sell-side estimates).

Source: FactSet as at 27 April 2020

  • The S&P 500 trading on 18x 12-month-forward earnings means one of two things. Either that the medium to long-term impact of the pandemic and lockdown is minimal, or that equities are horrifically overpriced and out of touch with economic reality. There isn’t much common ground between these two points of view. It might therefore be more fruitful to examine why equities have rebounded so sharply, and if they can stay there.
  • The global financial crisis started around July 2007, but it wasn’t until December 2008 that the US Federal Reserve started its first quantitative easing (QE) programme. This time around, the Fed was already buying US T-Bills (as of October 2019) and so just had to turn up the volume, and they did so – to 11. As of the 22nd April, the Fed has increased its balance sheet by $2.41tr in 2020. It was almost inevitable that asset prices had to yield before this monetary onslaught, and this explains the equity rally. That the Fed has also committed to buying corporate debt has led some to suggest it is only a matter of time before equities are included on the shopping list, juicing the rally further.
  • Top-to-bottom in March, the S&P 500 fell 28.5% to record the fastest sell-off ever (graph below). The size and speed of the Fed’s intervention in many ways resulted from the dynamics of the sell-off. The Fed would argue that this action was necessary to prevent a complete market collapse. Given how much leverage existed in the non-bank financial system, this may well have been the case.

Source: Bloomberg as at 27 April 2020

  • There is a certain type of torch-and-pitchfork Fed critic who would argue that the Fed has acted ultra vires and well beyond the mandate set by the 1913 Federal Reserve Act. Whether such people are true patriots or just frustrated short-sellers is a moot question. In any case, common sense would suggest that a central bank that has been highly interventionary in the recent past will likely go on intervening. Rather than parsing the moral rectitude of the Fed’s current activities (this may well happen in the courts at some point), it is better just to look at what these guys are actually saying and what this means they are likely to do, and therefore what equity and bond prices are trying to reflect in terms of policy outlook.


  • Earlier in April, James Bullard, President of the Federal Reserve Bank of St Louis went on the tape as follows:






  • The US Federal Reserve is a notoriously hydra-headed organisation and Bullard may well not be speaking for all members of the central bank, but if one judges the tone of what is being said here, one can easily see why equities are trading where they are. To paraphrase Bullard, if we ignore the economic collapse and set aside any sense of right and wrong, we can keep on printing money to keep markets where they are.
  • The Fed is leaving everyone else in the shade. One would expect with such monetary largesse (and with the potential for the US fiscal deficit to exceed 20% or possibly even 30%) that the dollar would be getting killed, but it isn’t. The graph below shows the US Dollar Index (DYX) still hovering around the 100 level and the general trend looking to be an upward one. This is with the Fed having cut interest rates more and having done more QE than any other central bank.

Source: Bloomberg as at 27 April 2020

  • The dollar is unique amongst fiat currencies as it has de factor reserve status and is the main currency for trade and trade financing. One way of looking at this whole question is to say that while the Fed may have done enough to drive the US equity market back to the highs, the sort of levels of liquidity needed to reflate dollar assets outside the US (the Eurodollar market) is of a size far greater than this (in excess of $10tr, although this is just a guesstimate), hence the rising dollar. Perhaps not even the Fed can print this much. Maybe even Mr. Bullard would draw the line at the Fed acting as the world’s central bank, not just America’s, dollar swap lines notwithstanding.
  • It is perhaps bizarre to think, with US equities near the highs and the economy mired in perhaps the worst downturn since the great depression, that the Fed hasn’t done or can’t do enough. The graph below shows the contract table for West Texas Intermediate (WTI) oil as of 27th The May front-month future briefly traded negatively to much media fanfare. Technical or not, negative oil futures reflect a collapse in demand vs. supply as a result of the pandemic lockdown. What is much more interesting though is the levels at which longer-dated futures are trading.

Source: Bloomberg as at 27 April 2020

  • The Sep ‘21 future is currently trading at $31.90. At this price, much of the US oil industry is insolvent. Aside from that small consideration, oil at 30 bucks a barrel is not the sort of backdrop you would expect from a gung-ho, V-shaped recovery in the US economy, at least not 18 months out from a lockdown. Oil at these prices suggests a protracted period of deflation and sub-par growth – the sort of thing one would expect from a deep and painful recession. While the speed and size of the Fed’s intervention may have juiced equities in the short term, if the liquidity story of the last six weeks gives way to the solvency story hinted at in forward oil prices, then the Fed will have to do a lot more to keep equities at current levels.

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